[Federal Register Volume 72, Number 235 (Friday, December 7, 2007)]
[Rules and Regulations]
[Pages 69288-69445]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 07-5729]



[[Page 69287]]

  
  
  
  
  
  
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Part II

Department of the Treasury
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Office of the Comptroller of the Currency



12 CFR Part 3



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Federal Reserve System
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12 CFR Parts 208 and 225



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Federal Deposit Insurance Corporation
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12 CFR Part 325



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Department of the Treasury
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Office of Thrift Supervision

12 CFR Parts 559, 560, 563, and 567



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Risk-Based Capital Standards: Advanced Capital Adequacy Framework--
Basel II; Final Rule

Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / 
Rules and Regulations

[[Page 69288]]


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DEPARTMENT OF THE TREASURY

Office of the Comptroller of the Currency

12 CFR Part 3

[Docket No. OCC-2007-0018]
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 Parts 559, 560, 563, and 567

RIN 1550-AB56; Docket No. OTS 2007-0021


Risk-Based Capital Standards: Advanced Capital Adequacy Framework 
-- Basel II

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: Final rule.

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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 adopting a new risk-based 
capital adequacy framework that requires some and permits 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 final rule describes the qualifying criteria for 
banks required or seeking to operate under the new 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 final 
rule uses the term ``bank'' to include banks, savings associations, 
and bank holding companies (BHCs). The terms ``bank holding 
company'' and ``BHC'' 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: This final rule is effective April 1, 2008.

FOR FURTHER INFORMATION CONTACT:
    OCC: Mark Ginsberg, Risk Expert, Capital Policy (202-927-4580) or 
Ron Shimabukuro, Senior 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, Chief, Policy Section, Capital Markets 
Branch, (202) 898-3575, Kenton Fox, Senior Policy Analyst, 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; Austin Hong, Senior Analyst, Capital Policy (202) 906-
6389; 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. Executive Summary of the Final Rule
    B. Conceptual Overview
    1. The IRB Approach for Credit Risk
    2. The AMA for Operational Risk
    C. Overview of Final Rule
    D. Structure of Final Rule
    E. Overall Capital Objectives
    F. Competitive Considerations
II. Scope
    A. Core and Opt-In Banks
    B. U.S. Subsidiaries of Foreign Banks
    C. Reservation of Authority
    D. Principle of Conservatism
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
    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)
    Expected Loss Given Default (ELGD)
    Economic Loss and Post-Default Extensions of Credit
    Economic Downturn Conditions
    Supervisory Mapping Function
    Pre-default Reductions in Exposure
    Exposure at Default (EAD)
    General Quantification Principles
    Portfolios With Limited Data or Limited Defaults
    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
    D. Merger and Acquisition Transition Provisions
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 Final Rule and the Market Risk Rule
    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 Exposures
    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 (CRM) Techniques
    1. Collateral
    2. Counterparty Credit Risk of Repo-Style Transactions, Eligible 
Margin Loans, and OTC Derivative Contracts
    Qualifying master netting agreement

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    EAD for Repo-Style Transactions and Eligible Margin Loans
    Collateral Haircut Approach
    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
    Alternative Methods
    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
    Gains-on-Sale and CEIOs
    The Ratings-Based Approach (RBA)
    The Internal Assessment Approach (IAA)
    The Supervisory Formula Approach (SFA)
    Deduction
    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
    Additional Supervisory Guidance
    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. CRM 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
    9. Early Amortization Provisions
    Background
    Controlled Early Amortization
    Non-Controlled Early Amortization
    Securitization of Revolving Residential Mortgage Exposures
    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 the Proposed Rule
    2. General Requirements
    Frequency/Timeliness
    Location of Disclosures and Audit/Attestation Requirements
    Proprietary and Confidential Information
    3. Summary of Specific Public Disclosure Requirements
    4. Regulatory Reporting

I. Introduction

A. Executive Summary of the Final Rule

    On September 25, 2006, the agencies issued a joint notice of 
proposed rulemaking (proposed rule or proposal) (71 FR 55830) seeking 
public comment on a new risk-based regulatory capital framework for 
banks.\2\ The agencies previously issued an advance notice of proposed 
rulemaking (ANPR) related to the new risk-based regulatory capital 
framework (68 FR 45900, August 4, 2003). The proposed rule was based on 
a series of releases from the Basel Committee on Banking Supervision 
(BCBS), culminating in the BCBS's comprehensive June 2006 release 
entitled ``International Convergence of Capital Measurement and Capital 
Standards: A Revised Framework'' (New Accord).\3\ The New Accord sets 
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 New 
Accord includes several methodologies for determining a bank's risk-
based capital requirements for credit, market, and operational risk.
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    \2\ The agencies also issued proposed changes to the risk-based 
capital rule for market risk in a separate notice of proposed 
rulemaking (71 FR 55958, September 25, 2006). A final rule on that 
proposal is under development and will be issued in the near future.
    \3\ The BCBS is a committee of banking supervisory authorities 
established by the central bank governors of the G-10 countries in 
1975. The BCBS issued the New Accord to modernize its first capital 
Accord, which was endorsed by the BCBS members in 1988 and 
implemented by the agencies in 1989. The New Accord, the 1988 
Accord, and other documents issued by the BCBS are available through 
the Bank for International Settlements' Web site at http://
www.bis.org.
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    The proposed rule included the advanced capital methodologies from 
the New Accord, including the advanced internal ratings-based (IRB) 
approach for credit risk and the advanced measurement approaches (AMA) 
for operational risk (together, the advanced approaches). The IRB 
approach 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.\4\
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    \4\ The agencies issued draft guidance on the advanced 
approaches. See 72 FR 9084 (February 28, 2007).
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    The agencies now are adopting this final rule implementing a new 
risk-based regulatory capital framework, based on the New Accord, that 
is mandatory for some U.S. banks and optional for others. While the New 
Accord includes several methodologies for determining risk-based 
capital requirements, the agencies are adopting only the advanced 
approaches at this time.
    The agencies received approximately 90 public comments on the 
proposed rule from banking organizations, trade associations 
representing the banking or financial services industry, supervisory 
authorities, and other interested parties. This section of the preamble 
highlights several fundamental issues that commenters raised about the 
agencies' proposal and briefly describes how the agencies have 
responded to those issues in the final rule. More detail is provided in 
the preamble sections below. Overall, commenters supported the 
development of the framework and the move to more risk-sensitive 
capital requirements. One overarching issue, however, was the areas 
where the proposal differed from the New Accord. Commenters said the 
divergences generally created competitive problems, raised home-host 
issues, entailed extra cost and regulatory burden, and did not 
necessarily improve the overall safety and soundness of banks subject 
to the rule.
    Commenters also generally disagreed with the agencies' proposal to 
adopt only the advanced approaches from the New Accord. Further, 
commenters objected to the agencies' retention of the leverage ratio, 
the transitional arrangements in the proposal, and the 10 percent 
numerical benchmark for identifying material aggregate reductions in 
risk-based capital requirements to be used for evaluating and 
responding to capital outcomes during the parallel run and transitional 
floor periods (discussed below). Commenters also noted numerous 
technical issues with the proposed rule.
    As noted in an interagency press release issued July 20, 2007 
(Banking Agencies Reach Agreement on Basel II Implementation), the 
agencies have agreed to eliminate the language from

[[Page 69290]]

the preamble concerning a 10 percent limitation on aggregate reductions 
in risk-based capital requirements. The press release also stated that 
the agencies are retaining intact the transitional floor periods (see 
preamble sections I.E. and III.A.2.). In addition, while not 
specifically mentioned in the press release, the agencies are retaining 
the leverage ratio and the prompt corrective action (PCA) regulations 
without modification.
    The final rule adopts without change the proposed criteria for 
identifying core banks (banks required to apply the advanced 
approaches) and continues to permit other banks (opt-in banks) to adopt 
the advanced approaches if they meet the applicable qualification 
requirements. Core banks are those with consolidated total assets 
(excluding assets held by an insurance underwriting subsidiary of a 
bank holding company) of $250 billion or more or with consolidated 
total on-balance-sheet foreign exposure of $10 billion or more. A 
depository institution (DI) also is a core bank if it is a subsidiary 
of another DI or bank holding company that uses the advanced 
approaches. The final rule also provides that a bank's primary Federal 
supervisor may determine that application of the final rule is not 
appropriate in light of the bank's asset size, level of complexity, 
risk profile, or scope of operations (see preamble sections II.A. and 
B.).
    As noted above, the final rule includes only the advanced 
approaches. The July 2007 interagency press release stated that the 
agencies have agreed to issue a proposed rule that would provide non-
core banks with the option to adopt an approach consistent with the 
standardized approach included in the New Accord. This new proposal 
(the standardized proposal) will replace the earlier proposal to adopt 
the so-called Basel IA option (Basel 1A proposal).\5\ The press release 
also noted the agencies' intention to finalize the standardized 
proposal before core banks begin the first transitional floor period 
under this final rule.
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    \5\ 71 FR 77445 (Dec. 26, 2006).
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    In response to commenters' concerns that some aspects of the 
proposed rule would result in excessive regulatory burden without 
commensurate safety and soundness enhancements, the agencies included a 
principle of conservatism in the final rule. In general, under this 
principle, in limited situations, a bank may choose not to apply a 
provision of the rule to one or more exposures if the bank can 
demonstrate on an ongoing basis to the satisfaction of its primary 
Federal supervisor that not applying the provision would, in all 
circumstances, unambiguously generate a risk-based capital requirement 
for each such exposure that is greater than that which would otherwise 
be required under the regulation, and the bank meets other specified 
requirements (see preamble section II.D.).
    In the proposal, the agencies modified the definition of default 
for wholesale exposures from that in the New Accord to address issues 
commenters had raised on the ANPR. Commenters objected to the agencies' 
modified definition of default for wholesale exposures, however, 
asserting that a definition different from the New Accord would result 
in competitive inequities and significant implementation burden without 
associated supervisory benefit. In response to these concerns, the 
agencies have adopted a definition of default for wholesale exposures 
that is consistent with the New Accord (see preamble section III.B.2.). 
For retail exposures, the final rule retains the proposed definition of 
default and clarifies that, subject to certain considerations, a 
foreign subsidiary of a U.S. bank may, in its consolidated risk-based 
capital calculations, use the applicable host jurisdiction definition 
of default for retail exposures of the foreign subsidiary in that 
jurisdiction (see preamble section III.B.2.).
    Another concept introduced in the proposal that was not in the New 
Accord was the expected loss given default (ELGD) risk parameter. ELGD 
had four functions in the proposed rule--as a component of the 
calculation of expected credit loss (ECL) in the numerator of the risk-
based capital ratios; in the expected loss (EL) component of the IRB 
risk-based capital formulas; as a floor on the value of the loss given 
default (LGD) risk parameter; and as an input into a supervisory 
mapping function. Many commenters objected to the inclusion of ELGD as 
a departure from the New Accord that would create regulatory burden and 
competitive inequity. Many commenters also objected to the supervisory 
mapping function, which the agencies intended as an alternative for 
banks that were not able to estimate reliably the LGD risk parameter. 
The agencies have eliminated ELGD from the final rule. Banks are 
required to estimate only the LGD risk parameter, which reflects 
economic downturn conditions (see preamble section III.B.3.). The 
supervisory mapping function also has been eliminated from the rule.
    Commenters also objected to the agencies' decision not to include a 
distinct risk weight function for exposures to small- and medium-size 
enterprises (SMEs) as provided in the New Accord. In the proposal, the 
agencies noted they were not aware of compelling evidence that smaller 
firms with the same probability of default (PD) and LGD as larger firms 
are subject to less systemic risk than is already reflected in the 
wholesale risk-based capital functions. The agencies continue to 
believe an SME-specific risk weight function is not supported by 
sufficient evidence and might give rise to competitive inequities 
across U.S. banks, and have not adopted such a function in the final 
rule (see preamble section V.A.1.)
    With regard to the proposed treatment for securitization exposures, 
commenters raised a number of technical issues. Many objected to the 
proposed definition of a securitization exposure, which included 
exposures to investment funds with material liabilities (including 
exposures to hedge funds). The agencies agree with commenters that the 
proposed definition for securitization exposures was quite broad and 
captured some exposures that would more appropriately be treated under 
the wholesale or equity frameworks. To limit the scope of the IRB 
securitization framework, the agencies have modified the definition of 
traditional securitization in the final rule as described in preamble 
section V.A.3. Technical issues related to securitization exposures are 
discussed in preamble sections V.A.3. and V.E.
    For equity exposures, commenters focused on the proposal's lack of 
a grandfathering period. The New Accord provides national discretion 
for each implementing jurisdiction to adopt a grandfather period for 
equity exposures. Commenters asserted that this omission would result 
in competitive inequity for U.S. banks as compared to other 
internationally active institutions. The agencies believe that, 
overall, the proposal's approach to equity exposures results in a 
competitive risk-based capital requirement. The final rule does not 
include a grandfathering provision, and the agencies have adopted the 
proposed treatment for equity exposures without significant change (see 
preamble section V.F.).
    A number of commenters raised issues related to operational risk. 
Most significantly, commenters noted that activities besides securities 
processing and credit card fraud have highly predictable and reasonably 
stable losses and should be considered for operational risk offsets. 
The agencies believe that the proposed definition of

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eligible operational risk offsets allows for the consideration of other 
activities in a flexible and prudent manner and, thus, are retaining 
the proposed definition in the final rule. Commenters also noted that 
the proposal appeared to place limits on the use of operational risk 
mitigants. The agencies have provided flexibility in this regard and 
under the final rule will take into consideration whether a particular 
operational risk mitigant covers potential operational losses in a 
manner equivalent to holding regulatory capital (see preamble sections 
III.B.5. and V.I.).
    Many commenters expressed concern that the proposed public 
disclosures were excessive and would hinder, rather than facilitate, 
market discipline by requiring banks to disclose information that would 
not be well understood by or useful to the market. Commenters also 
expressed concern about possible disclosure of proprietary information. 
The agencies believe that it is important to retain the vast majority 
of the proposed disclosures, which are consistent with the New Accord. 
These disclosures will enable market participants to gain key insights 
regarding a bank's capital structure, risk exposures, risk assessment 
processes, and, ultimately, capital adequacy. The agencies have 
modified the final rule to provide flexibility regarding proprietary 
information.

B. Conceptual Overview

    This final rule is intended to produce risk-based capital 
requirements that are more risk-sensitive than those produced under the 
agencies' existing risk-based capital rules (general risk-based capital 
rules). In particular, the IRB approach requires banks to assign risk 
parameters to wholesale exposures and retail segments and provides 
specific risk-based capital formulas that must be used to transform 
these risk parameters into risk-based capital requirements.
    The framework is based on ``value-at-risk'' (VaR) modeling 
techniques that measure credit risk and operational risk. Because bank 
risk measurement practices are both continually evolving and subject to 
uncertainty, the framework should be viewed as an effort to improve the 
risk sensitivity of the risk-based capital requirements for banks, 
rather than as an effort to produce a statistically precise measurement 
of risk.
    The framework's conceptual foundation is based on the view that 
risk can be quantified through the estimation 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 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.
[GRAPHIC] [TIFF OMITTED] TR07DE07.000

    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 EL amount. A given level 
of UL can be defined by reference to a particular percentile threshold 
of the probability distribution. For example, in the figure UL is 
measured at the 99.9th percentile level and thus is equal to the value 
of the loss distribution corresponding to the 99.9th percentile, less 
the amount of EL. This is shown graphically at the bottom of the 
figure.
    The particular percentile level chosen for the measurement of UL 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 should 
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 UL 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 
rule). Under the market risk

[[Page 69292]]

rule, 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 uncertainty.
1. The IRB Approach for Credit Risk
    The conceptual foundation of this final rule's approach to credit 
risk capital requirements is similar to the market risk rule's approach 
to market risk capital requirements, in the sense that each is VaR-
oriented. Nevertheless, there are important differences between the IRB 
approach and the market risk rule. The current market risk rule 
specifies 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 approach 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.\6\
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    \6\ The theoretical underpinnings for the supervisory model of 
credit risk underlying the IRB approach are provided in a paper by 
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 CreditMetricsTM-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 
(BCBS 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 approach is broadly similar to the credit VaR approaches 
used by a number of 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 approach is an estimate of the amount of 
credit losses above 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 appropriate because it balances the difficulty of 
easily or rapidly exiting non-trading positions against 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.\7\
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    \7\ Banks' internal economic capital models typically focus on 
measures of equity capital, whereas the total regulatory capital 
measure underlying this rule 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 
approach is not directly compatable 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 approach 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. If these assumptions (described in greater detail 
below) are incorrect or otherwise 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 a true 99.9 percent 
confidence level.
    In combination with other supervisory assumptions and parameters 
underlying the IRB approach, the approach's 99.9 percent nominal 
confidence level reflects a judgmental pooling of available 
information, including supervisory experience. The framework underlying 
this final rule reflects a desire on the part of the agencies to 
achieve (i) risk-based capital requirements that are reflective of 
relative risk across different assets and 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 general assumptions and specific 
parameters are built into the IRB approach 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 approach 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 final 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 PD, LGD, exposure at default (EAD), and, for 
wholesale exposures, effective remaining maturity (M). The proposed 
rule included an additional risk parameter, ELGD. As discussed in 
section III.B.3. of the preamble, the agencies have eliminated the ELGD 
risk parameter from the final rule. 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 segments of 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

[[Page 69293]]

diversification within the portfolio, greater overall systematic risk, 
and, hence, a higher risk-based capital requirement.\8\ 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.
---------------------------------------------------------------------------

    \8\ See BCBS Explanatory Note.
---------------------------------------------------------------------------

    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 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 decreasing function of PD. The 
AVCs included in the IRB risk-based capital formulas for both wholesale 
and retail exposures reflect a combination of supervisory judgment and 
empirical evidence.\9\ However, the historical data available for 
estimating correlations among retail exposures, particularly for non-
mortgage retail exposures, was more limited than was the case with 
wholesale exposures. As a result, supervisory judgment played a greater 
role. Moreover, the flat 15 percent AVC for residential mortgage 
exposures is based largely on supervisory experience with and analysis 
of traditional long-term, fixed-rate mortgages.
---------------------------------------------------------------------------

    \9\ See BCBS Explanatory Note, section 5.3.
---------------------------------------------------------------------------

    Several commenters stated that the proposed AVCs for wholesale 
exposures were too high in general, and a few claimed that, in 
particular, the AVCs for multi-family residential real estate exposures 
should be lower. Other commenters suggested that the AVCs of wholesale 
exposures should be a function of obligor size rather than PD. 
Similarly, several commenters maintained that the proposed AVCs for 
retail exposures were too high. Some of these commenters suggested that 
the AVCs for qualifying revolving exposures (QREs), such as credit 
cards, should be in the range of 1 to 2 percent, not 4 percent as 
proposed. Similarly, some of those commenters opposed the proposed flat 
15 percent AVC for residential mortgage exposures; one commenter 
suggested that the agencies should consider employing lower AVCs for 
home equity loans and lines of credit (HELOCs) to take into account 
their shorter maturity relative to traditional mortgage exposures.
    However, most commenters recognized that the proposed AVCs were 
consistent with those in the New Accord and recommended that the 
agencies use the AVCs contained in the New Accord to avoid 
international competitive inequity and unnecessary burden. Several 
commenters suggested that the agencies should reconsider the AVCs going 
forward, working with the BCBS.
    The agencies agree with the prevailing view of the commenters that 
using the AVCs in the New Accord alleviates a potential source of 
international inconsistency and implementation burden. The final rule 
therefore maintains the proposed AVCs. As the agencies gain more 
experience with the advanced approaches, they may revisit the AVCs for 
wholesale exposures and retail exposures, along with other calibration 
issues identified during the parallel run and transitional floor 
periods (as described below) and make changes to the rule as necessary. 
The agencies would address this issue working with the BCBS and other 
supervisory and regulatory authorities, as appropriate.
    Another important conceptual element of the IRB approach concerns 
the treatment of ECL. The IRB approach assumes that reserves should 
cover ECL while capital should cover credit losses exceeding ECL (that 
is, unexpected credit losses). Accordingly, the final rule, consistent 
with the proposal and 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 
may include the excess eligible credit reserves amount in tier 2 
capital, up to 0.6 percent of the bank's credit risk-weighted 
assets.\10\ This treatment is intended to maintain a capital incentive 
to reserve prudently and 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 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 allowance for loan 
and lease losses (ALLL) under the 1988 Accord, based on data obtained 
in the BCBS's Third Quantitative Impact Study (QIS-3).\11\
---------------------------------------------------------------------------

    \10\ In contrast, under the general risk-based capital rules, 
the allowance for loan and lease losses (ALLL) may be included in 
tier 2 capital up to 1.25 percent of total risk-weighted assets.
    \11\ BCBS, ``QIS 3: Third Quantitative Impact Study,'' May 2003.
---------------------------------------------------------------------------

    In developing the New Accord, the BCBS sought broadly to maintain 
the current overall level of minimum risk-based capital requirements 
within the banking system. Using data from QIS-3, the BCBS conducted an 
analysis of the risk-based capital requirements that would be generated 
under the New Accord. Based on this analysis, the BCBS concluded that a 
``scaling factor'' (multiplier) should apply to credit risk-weighted 
assets. The BCBS, in the New Accord, indicated that the best estimate 
of the scaling factor was 1.06. In May 2006, the BCBS decided to 
maintain the 1.06 scaling factor based on the results of a fourth 
quantitative impact study (QIS-4) conducted in some jurisdictions, 
including the United States, and a fifth quantitative impact study 
(QIS-5), not conducted in the United States.\12\ The BCBS noted that 
national supervisory authorities will continue to monitor capital 
requirements during implementation of the New Accord, and that the 
BCBS, in turn, will monitor national experiences with the framework.
---------------------------------------------------------------------------

    \12\ BCBS press release, ``Basel Committee maintains calibration 
of Base II Framework,'' May 24, 2006.
---------------------------------------------------------------------------

    The agencies generally agree with the BCBS regarding calibration of 
the New Accord. Therefore, consistent with the New Accord and the 
proposed rule, the final rule contains a scaling factor of 1.06 for 
credit-risk-weighted assets. As the agencies gain more experience with 
the 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 will make changes 
to the rule as necessary, working with the BCBS and other supervisory 
and regulatory authorities, as appropriate.
2. The AMA for Operational Risk
    The final rule also includes the AMA for determining risk-based 
capital requirements for operational risk. Under the final rule 
(consistent with 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,

[[Page 69294]]

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 must 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 one-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.

C. Overview of Final Rule

    The final 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 in the final rule are also the same as in the general risk-
based capital rules, with a few adjustments described in more detail 
below. The primary difference between the general risk-based capital 
rules and the final rule is the methodologies used for calculating 
risk-weighted assets. Banks applying the final rule generally must 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, banks must use external ratings or supervisory 
risk weights to determine risk-weighted asset amounts. Each of these 
areas is discussed below.
    Banks using the final rule also are 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 remains subject to 
the tier 1 leverage ratio requirement,\13\ and each DI (as defined in 
section 3 of the Federal Deposit Insurance Act (12 U.S.C. 1813)) using 
the advanced approaches remains subject to the prompt corrective action 
(PCA) thresholds.\14\ Banks using the advanced approaches also remain 
subject to the market risk rule, where applicable.
---------------------------------------------------------------------------

    \13\ See 12 CFR part 3.6(b) and (c) (national banks); 12 CFR 
part 208, appendix B (state member banks); 12 CFR part 225, appendix 
D (bank holding companies); 12 CFR 325.3 (state nonmember banks); 12 
CFR 567.2(a)(2) and 567.8 (savings associations).
    \14\ See 12 CFR part 6 (national banks); 12 CFR part 208, 
subpart D (state member banks); 12 CFR 325.103 (state nonmember 
banks); 12 CFR part 565 (savings associations). In addition, savings 
associations remain subject to the tangible capital requirement at 
12 CFR 567.2(a)(3) and 567.9.
---------------------------------------------------------------------------

    Under the final 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 are 
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 final rule include most credit 
exposures to companies, sovereigns, and other governmental entities. 
For each wholesale exposure, a bank must assign four quantitative risk 
parameters: PD (which is expressed as a decimal (that is, 0.01 
corresponds to 1 percent) and is an estimate of the probability that an 
obligor will default over a one-year horizon); LGD (which is expressed 
as a decimal and reflects 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 
may factor into their risk parameter estimates the risk mitigating 
impact of collateral, credit derivatives, and guarantees that meet 
certain criteria. Banks must 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 final rule include most credit exposures 
to individuals and small credit exposures to businesses that are 
managed as part of a segment of exposures with similar risk 
characteristics and not managed on an individual-exposure basis. A bank 
must classify each of its retail exposures into one of three retail 
subcategories--residential mortgage exposures; QREs, such as credit 
cards and overdraft lines; and other retail exposures. Within these 
three subcategories, the bank must group exposures into segments with 
similar risk characteristics. The bank must then assign the risk 
parameters PD, LGD, and EAD to each retail segment. The bank may 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 are used as inputs into an IRB risk-based capital 
formula to determine the risk-based capital requirement for the 
segment.
    For securitization exposures, the bank must 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; the 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), which uses bank inputs that are entered into a 
supervisory formula to risk-weight exposures. Securitization exposures 
in the form of gain-on-sale or credit-enhancing interest-only strips 
(CEIOs)\15\ and securitization exposures that do not qualify for the 
RBA, the IAA, or the SFA must be deducted from regulatory capital.
---------------------------------------------------------------------------

    \15\ A CEIO is an on-balance sheet asset that, in form or in 
substance, (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 may 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

[[Page 69295]]

generally are assigned a 300 percent risk weight and non-publicly 
traded equity exposures generally are assigned a 400 percent risk 
weight. Under both the IMA and the SRWA, equity exposures to certain 
entities or made pursuant to certain statutory authorities (such as 
community development laws) are subject to a 0 to 100 percent risk 
weight.
    Banks must develop qualifying AMA systems to determine risk-based 
capital requirements for operational risk. Under the AMA, a bank must 
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 final rule, a bank must calculate its tier 1 and total 
risk-based capital ratios by dividing tier 1 capital by total risk-
weighted assets and by dividing total qualifying capital by total risk-
weighted assets, respectively. To calculate total risk-weighted assets, 
a bank must first convert the dollar risk-based capital requirements 
for exposures produced by the IRB risk-based capital approaches and the 
AMA 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 must sum these amounts and 
then subtract any excess eligible credit reserves not included in tier 
2 capital to determine total risk-weighted assets.
    The final 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 
capital adequacy of a bank. The public disclosure requirements 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, unless the entity is a subsidiary of a non-U.S. banking 
organization that is subject to comparable disclosure requirements in 
its home jurisdiction. All banks subject to the rule, however, must 
disclose total and tier 1 risk-based capital ratios and the components 
of these ratios. The agencies also proposed a package of regulatory 
reporting templates for the agencies' use in assessing and monitoring 
the levels and components of bank risk-based capital requirements under 
the advanced approaches.\16\ These templates will be finalized shortly.
---------------------------------------------------------------------------

    \16\ 71 FR 55981 (September 25, 2006).
---------------------------------------------------------------------------

    The agencies are aware that the fair value option in generally 
accepted accounting principles as used in the United States (GAAP) 
raises potential risk-based capital issues not contemplated in the 
development of the New Accord. The agencies will continue to analyze 
these issues and may make changes to this rule at a future date as 
necessary. The agencies would address these issues working with the 
BCBS and other supervisory and regulatory authorities, as appropriate.

D. Structure of Final Rule

    The agencies are implementing a regulatory framework for the 
advanced approaches in which each agency has an advanced approaches 
appendix that incorporates (i) definitions of tier 1 and tier 2 capital 
and associated adjustments to the risk-based capital ratio numerators, 
(ii) the qualification requirements for using the advanced approaches, 
and (iii) the details of the advanced approaches.\17\ The agencies also 
are incorporating their respective market risk rules, by cross-
reference.\18\
---------------------------------------------------------------------------

    \17\ As applicable, certain agencies are also making conforming 
changes to existing regulations as necessary to incorporate the new 
appendices.
    \18\ 12 CFR part 3, Appendix B (for national banks), 12 CFR part 
208, Appendix E (for state member banks), 12 CFR part 225, Appendix 
E (for bank holding companies), and 12 CFR part 325, Appendix C (for 
state nonmember banks). OTS intends to codify a market risk rule for 
savings associations at 12 CFR part 567, Appendix D.
---------------------------------------------------------------------------

    In this final rule, as in the proposed rule, the agencies are not 
restating the elements of tier 1 and tier 2 capital, which largely 
remain the same as under the general risk-based capital rules. 
Adjustments to the risk-based capital ratio numerators specific to 
banks applying the final rule are in part II of the rule and explained 
in greater detail in section IV of this preamble.
    The final rule has eight 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 regulatory 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 methodologies for reflecting credit risk mitigation 
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 regulatory text. Definitions, however, are discussed in the 
portions of the preamble where they are most relevant.

E. Overall Capital Objectives

    The preamble to the proposed rule described the agencies' intention 
to avoid a material reduction in overall risk-based capital 
requirements under the advanced approaches. The agencies also 
identified other objectives, such as ensuring that differences in 
capital requirements appropriately reflect differences in risk and 
ensuring that the U.S. implementation of the New Accord will not be a 
significant source of competitive inequity among internationally active 
banks or among domestic banks operating under different risk-based 
capital rules. The final rule modifies and clarifies the approach the 
agencies will use to achieve these objectives.
    The agencies proposed a series of transitional floors to provide a 
smooth transition to the advanced approaches and to temporarily limit 
the amount by which a bank's risk-based capital requirements could 
decline over a period of at least three years. The transitional floors 
are described in more detail in section III.A.2. of this preamble. The 
floors generally prohibit a bank's risk-based capital requirement under 
the advanced approaches from falling below 95 percent, 90 percent, and 
85 percent of what it would be under the general risk-based capital

[[Page 69296]]

rules during the bank's first, second, and third transitional floor 
periods, respectively. The proposal stated that banks would be required 
to receive the approval of their primary Federal supervisor before 
entering each transitional floor period.
    The preamble to the proposal noted that if there was a material 
reduction in aggregate minimum regulatory capital upon implementation 
of the advanced approaches, the agencies would propose regulatory 
changes or adjustments during the transitional floor periods. The 
preamble further noted that in this context, materiality would depend 
on a number of factors, including the size, source, and nature of any 
reduction; the risk profiles of banks authorized to use the advanced 
approaches; and other considerations relevant to the maintenance of a 
safe and sound banking system. The agencies also stated that they would 
view a 10 percent or greater decline in aggregate minimum required 
risk-based capital (without reference to the effects of the 
transitional floors), compared to minimum required risk-based capital 
as determined under the general risk-based capital rules, as a material 
reduction warranting modification to the supervisory risk functions or 
other aspects of the framework.
    Further, the agencies stated that they were ``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.'' The agencies also stated 
that ``[a]t the end of the transitional floor periods, the agencies 
would reevaluate 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.'' 
The agencies viewed the parallel run and transitional floor periods as 
``a trial of the new framework under controlled conditions.'' \19\
---------------------------------------------------------------------------

    \19\ 71 FR 55839-40 (September 25, 2006).
---------------------------------------------------------------------------

    The agencies sought comment on the appropriateness of using a 10 
percent or greater decline in aggregate minimum required risk-based 
capital as a numerical benchmark for material reductions when 
determining whether capital objectives were achieved. Many commenters 
objected to the proposed transitional floors and the 10 percent 
benchmark on the grounds that both safeguards deviated materially from 
the New Accord and the rules implemented by foreign supervisory 
authorities. In particular, commenters expressed concerns that the 
aggregate 10 percent limit added a degree of uncertainty to their 
capital planning process, since the limit was beyond the control of any 
individual bank. They maintained that it might take only a few banks 
that decided to reallocate funds toward lower-risk activities during 
the transition period to impose a penalty on all U.S. banks using the 
advanced approaches. Other commenters stated that the benchmark lacked 
transparency and would be operationally difficult to apply.
    Commenters also criticized the duration, level, and construct of 
the transitional floors in the proposed rule. Commenters believed it 
was inappropriate to extend the transitional floors by an additional 
year (to three years), and raised concerns that the floors were more 
binding than those proposed in the New Accord. Commenters strongly 
urged the agencies to adopt the transition periods and floors in the 
New Accord to limit any competitive inequities that could arise among 
internationally active banks.
    To better balance commenters' concerns and the agencies' capital 
adequacy objectives, the agencies have decided not to include the 10 
percent benchmark language in this preamble. This will alleviate 
uncertainty and enable each bank to develop capital plans in accordance 
with its individual risk profile and business model. The agencies have 
taken a number of steps to address their capital adequacy objectives. 
Specifically, the agencies are retaining the existing leverage ratio 
and PCA requirements and are adopting the three transitional floor 
periods at the proposed numerical levels.
    Under the final rule, the agencies will jointly evaluate the 
effectiveness of the new capital framework. The agencies will issue a 
series of annual reports during the transition period that will provide 
timely and relevant information on the implementation of the advanced 
approaches. In addition, after the end of the second transition year, 
the agencies will publish a study (interagency study) that will 
evaluate the advanced approaches to determine if there are any material 
deficiencies. For any primary Federal supervisor to authorize any bank 
to exit the third transitional floor period, the study must determine 
that there are no such material deficiencies that cannot be addressed 
by then-existing tools, or, if such deficiencies are found, they must 
be first remedied by changes to regulation. Notwithstanding the 
preceding sentence, a primary Federal supervisor that disagrees with 
the finding of material deficiency may not authorize a bank under its 
jurisdiction to exit the third transitional floor period unless the 
supervisor first provides a public report explaining its reasoning.
    The agencies intend to establish a transparent and collaborative 
process for conducting the interagency study, consistent with the 
recommendations made by the U.S. Government Accountability Office (GAO) 
in its report on implementation of the New Accord in the United 
States.\20\ In conducting the interagency study the agencies would 
consider, for example, the following:
---------------------------------------------------------------------------

    \20\ United States Government Accountability Office, ``Risk-
Based Capital: Bank Regulators Need to Improve Transparency and 
Overcome Impediments to Finalizing the Proposed Basel II Framework'' 
(GAO-07-253), February 15, 2007.
---------------------------------------------------------------------------

     The level of minimum required regulatory capital under 
U.S. advanced approaches compared to the capital required by other 
international and domestic regulatory capital standards.
     Peer comparisons of minimum regulatory capital 
requirements, including but not limited to banks' estimates of risk 
parameters for portfolios of similar risk.
     The processes banks use to develop and assess risk 
parameters and advanced systems, and supervisory assessments of their 
accuracy and reliability.
     Potential cyclical implications.
     Changes in portfolio composition or business mix, 
including those that might result in changes in capital requirements 
per dollar of credit exposure.
     Comparison of regulatory capital requirements to market-
based measures of capital adequacy to assess relative minimum capital 
requirements across banks and broad asset categories. Market-based 
measures might include credit default swap spreads, subordinated debt 
spreads, external rating agency ratings, and other market measures of 
risk.
     Examination of the quality and robustness of advanced risk 
management processes related to assessment of capital adequacy, as in 
the comprehensive supervisory assessments performed under Pillar 2.
     Additional reviews, including analysis of interest rate 
and concentration risks that might suggest the need for higher 
regulatory capital requirements.

F. Competitive Considerations

    A fundamental objective of the New Accord is to strengthen the 
soundness

[[Page 69297]]

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 important to promote continual advancement of 
the risk measurement and management practices of large and 
internationally active banks.
    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 a number of banks, the agencies believe that the 
general risk-based capital rules continue to provide a reasonable 
alternative for regulatory risk-based capital measurement purposes. 
However, the agencies recognize that a bifurcated risk-based capital 
framework inevitably raises competitive considerations. The agencies 
have received comments on risk-based capital proposals issued in the 
past several years \21\ stating that for some portfolios, competitive 
inequities would be worse under a bifurcated framework. These 
commenters expressed concern that banks operating under the general 
risk-based capital rules would be at a competitive disadvantage 
relative to banks applying the advanced approaches because the IRB 
approach would likely result in lower risk-based capital requirements 
for certain types of exposures.
---------------------------------------------------------------------------

    \21\ See 68 FR 45900 (Aug. 4, 2003), 70 FR 61068 (Oct. 20, 
2005), 71 FR 55830 (Sept. 25, 2006), and 71 FR 77446 (Dec. 26, 
2006).
---------------------------------------------------------------------------

    The agencies recognize the potential competitive inequities 
associated with a bifurcated risk-based capital framework. As part of 
their effort to develop a risk-based capital framework that minimizes 
competitive inequities and is not disruptive to the banking sector, the 
agencies issued the Basel IA proposal in December 2006. The Basel IA 
proposal included modifications to the general risk-based capital rules 
to improve risk sensitivity and to reduce potential competitive 
disparities between domestic banks subject to the advanced approaches 
and domestic banks not subject to the advanced approaches. Recognizing 
that some banks might prefer not to incur the additional regulatory 
burden of moving to modified capital rules, the Basel IA proposal 
retained the existing general risk-based capital rules and permitted 
banks to opt in to the modified rules. The agencies extended the 
comment period for the advanced approaches proposal to coincide with 
the comment period on the Basel IA proposal so that commenters would 
have an opportunity to analyze the effects of the two proposals 
concurrently.\22\
---------------------------------------------------------------------------

    \22\ See 71 FR 77518 (Dec. 26, 2006).
---------------------------------------------------------------------------

    Seeking to minimize potential competitive inequities and regulatory 
burden, a number of commenters on both the advanced approaches proposal 
and the Basel IA proposal urged the agencies to adopt all of the 
approaches included in the New Accord--including the foundation IRB and 
standardized approaches for credit risk and the standardized and basic 
indicator approaches for operational risk. In response to these 
comments, the agencies have decided to issue a new standardized 
proposal, which would replace the Basel IA proposal for banks that do 
not apply the advanced approaches. The standardized proposal would 
allow banks that are not core banks to implement a standardized 
approach for credit risk and an approach to operational risk consistent 
with the New Accord. Like the Basel IA proposal, the standardized 
proposal will retain the existing general risk-based capital rules for 
those banks that do not wish to move to the new rules. The agencies 
expect to issue the standardized proposal in the first quarter of 2008.
    A number of commenters expressed concern about competitive 
inequities among internationally active banks arising from differences 
in implementation and application of the New Accord by supervisory 
authorities in different countries. In particular, some commenters 
asserted that the proposed U.S. implementation would be different from 
other countries in a number of key areas, such as the definition of 
default, and that these differences would give rise to substantial 
implementation cost and burden. Other commenters continued to raise 
concern about the delayed implementation schedule in the United States.
    As discussed in more detail throughout this preamble, the agencies 
have made a number of changes from the proposal to conform the final 
rule more closely to the New Accord. These changes should help minimize 
regulatory burden and mitigate potential competitive inequities across 
national jurisdictions. In addition, 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. The BCBS also has established a 
Capital Interpretation Group to foster consistency in applying the New 
Accord on an ongoing basis. The agencies intend to participate fully in 
these groups to ensure that issues relating to international 
implementation and competitive effects are addressed. While supervisory 
judgment will play a critical role in the evaluation of risk 
measurement and management practices at individual banks, supervisors 
remain committed to and have made significant progress toward 
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.
    With regard to implementation timing concerns, the agencies believe 
that the transitional arrangements described in preamble section 
III.A.2. below provide a prudent and reasonable framework for moving to 
the advanced approaches. Where international implementation differences 
affect an individual bank, the agencies are working with the bank and 
appropriate national supervisory authorities to ensure that 
implementation proceeds as efficiently as possible.

II. Scope

    The agencies have identified three groups of banks: (i) Large or 
internationally active banks that are required to adopt the advanced 
approaches (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 is required to meet certain qualification requirements to the 
satisfaction of its primary Federal supervisor, which in turn will 
consult with other relevant supervisors, before the bank may use the 
advanced approaches for risk-based capital purposes.
    Pillar 1 of the New Accord requires all banks subject to the New 
Accord to calculate capital requirements for exposure to credit risk 
and operational risk. The New Accord sets forth three approaches to 
calculating the credit risk capital requirement and three approaches to 
calculating the operational risk capital requirement. Outside the 
United States, countries that are replacing Basel I with the New

[[Page 69298]]

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.
    For banks in the United States, the agencies have taken a different 
approach. This final rule focuses on the largest and most 
internationally active banks and requires those banks to comply with 
the most advanced approaches for calculating credit and operational 
risk capital requirements (the IRB and the AMA). The final rule allows 
other U.S. banks to ``opt in'' to the advanced approaches. The agencies 
have decided at this time to require large, internationally active U.S. 
banks to use the most advanced approaches of the New Accord. The less 
advanced approaches of the New Accord lack the degree of risk 
sensitivity of the advanced approaches. The agencies have the view that 
risk-sensitive regulatory capital requirements are integral to ensuring 
that large, sophisticated banks and the financial system have an 
adequate capital cushion to absorb financial losses. Also, the advanced 
approaches provide more substantial incentives for banks to improve 
their risk measurement and management practices than do the other 
approaches. The agencies do not believe that competitive equity 
concerns are sufficiently compelling to warrant permitting large, 
internationally active U.S. banks to adopt the standardized approaches 
in the New Accord.

A. Core and Opt-In Banks

    Under section 1(b) of the proposed rule, a DI would be a core bank 
if it met 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 or 
guarantor located in another country, plus redistributed guaranteed 
amounts to the country of head office or guarantor. The agencies also 
proposed that a DI would be 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 \23\ would be a core 
bank if the BHC had: (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.
---------------------------------------------------------------------------

    \23\ OTS does not currently impose any explicit capital 
requirements on savings and loan holding companies and is not 
implementing the advanced approaches for these holding companies.
---------------------------------------------------------------------------

    The agencies included a question in the proposal seeking 
commenters' views on using consolidated total assets (excluding assets 
held by an insurance underwriting subsidiary) as one criterion to 
determine whether a BHC would be viewed as a core BHC. Some of the 
commenters addressing this issue supported the proposed approach, 
noting it was a reasonable proxy for mandatory applicability of a 
framework designed to measure capital requirements for consolidated 
risk exposures of a BHC. Other commenters, particularly foreign banking 
organizations and their trade associations, contended that the BHC 
asset size threshold criterion instead should be $250 billion of assets 
in U.S. subsidiary DIs. These commenters further suggested that if the 
Board kept the proposed $250 billion consolidated total BHC assets 
criterion, it should limit the scope of this criterion to BHCs with a 
majority of their assets in U.S. DI subsidiaries. The Board has decided 
to retain the proposed approach using consolidated total assets 
(excluding assets held by an insurance underwriting subsidiary) as one 
threshold criterion for BHCs in this final rule. This approach 
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 final rule continues to exclude 
assets held in an insurance underwriting subsidiary of a BHC from the 
asset threshold because the advanced approaches were not designed to 
address insurance underwriting exposures.
    The final rule also retains the threshold criterion for core bank/
BHC status of consolidated total on-balance sheet foreign exposure of 
$10 billion or more at the most recent year-end. The calculation of 
this exposure amount is unchanged in the final rule.
    In the preamble to the proposed rule, the agencies also included a 
question on potential regulatory burden associated with requiring a 
bank that applies the advanced approaches to implement the advanced 
approaches at each subsidiary DI--even if those subsidiary DIs do not 
individually meet a threshold criterion. A number of commenters 
addressed this issue. While they expressed a range of views, most 
commenters maintained that small DI subsidiaries of core banks should 
not be required to implement the advanced approaches. Rather, 
commenters asserted that these DIs should be permitted to use simpler 
methodologies, such as the New Accord's standardized approach. 
Commenters asserted there would be regulatory burden and costs 
associated with the proposed push-down approach, particularly if a 
stand-alone AMA is required at each DI.
    The agencies have considered comments on this issue and have 
decided to retain the proposed approach. Thus, under the final rule, 
each DI subsidiary of a core or opt-in bank is itself a core bank 
required to apply the advanced approaches. The agencies believe that 
this approach serves as an important safeguard against regulatory 
capital arbitrage among affiliated banks that would otherwise be 
subject to substantially different capital rules. Moreover, to 
calculate its consolidated IRB risk-based capital requirements, a bank 
must estimate risk parameters for all credit exposures within the bank 
except for exposures in portfolios that, in the aggregate, are 
immaterial to the bank. Because the consolidated bank must already 
estimate risk parameters for all material portfolios of wholesale and 
retail exposures in all of its consolidated subsidiaries, the agencies 
believe that there is limited additional regulatory burden associated 
with application of the IRB approach at each subsidiary DI. Likewise, 
to calculate its consolidated AMA risk-based capital requirements, a 
bank must estimate its operational risk exposure using a unit of 
measure (defined below) that does not combine business activities or 
operational loss events with demonstrably different risk profiles 
within the same loss distribution. Each subsidiary DI could have a 
demonstrably different risk profile that would require the generation 
of separate loss distributions.
    However, the agencies recognize there may be situations where 
application of the advanced approaches at an individual DI subsidiary 
of an advanced approaches bank may not be appropriate. Therefore, the 
final rule includes the proposed provision that

[[Page 69299]]

permits a core or opt-in bank's primary Federal supervisor to determine 
in writing that application of the advanced approaches is not 
appropriate for the DI in light of the bank's asset size, level of 
complexity, risk profile, or scope of operations.

B. U.S. Subsidiaries of Foreign Banks

    Under the proposed rule, any U.S.-chartered DI that is a subsidiary 
of a foreign banking organization would be subject to the U.S. 
regulatory capital requirements for domestically-owned U.S. DIs. Thus, 
if the U.S. DI subsidiary of a foreign banking organization met any of 
the threshold criteria, it would be a core bank and would be subject to 
the advanced approaches. If it did not meet any of the criteria, the 
U.S. DI could remain a general bank or could opt in to the advanced 
approaches, subject to the same qualification process and requirements 
as a domestically-owned U.S. DI.
    The proposed rule also provided that a top-tier U.S. BHC, and its 
subsidiary DIs, that was owned by a foreign banking organization would 
be subject to the same threshold levels for core bank determination as 
a top-tier BHC that is not owned by a foreign banking organization.\24\ 
The preamble noted that a U.S. BHC that met the conditions in Federal 
Reserve SR letter 01-01 \25\ and that was 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. A DI subsidiary of such a U.S. BHC also 
would be a core bank and would be required to adopt the advanced 
approaches and meet the minimum capital ratio requirements.
---------------------------------------------------------------------------

    \24\ The Board notes that it generally does not apply regulatory 
capital requirements to subsidiary BHCs of top-tier U.S. BHCs, 
regardless of whether the top-tier U.S. BHC is itself a subsidiary 
of a foreign banking organization.
    \25\ SR 01-01, ``Application of the Board's Capital Adequacy 
Guidelines to Bank Holding Companies Owned by Foreign Banking 
Organizations,'' January 5, 2001.
---------------------------------------------------------------------------

    Under the final rule, consistent with SR 01-01, a foreign-owned 
U.S. BHC that is a core bank and that also is subject to SR 01-01 will, 
as a technical matter, be required to adopt the advanced approaches, 
and compute and report its capital ratios and make other required 
disclosures. It will not, however, be required to maintain the minimum 
capital ratios at the U.S. consolidated holding company level unless 
otherwise required to do so by the Board. In response to the potential 
burden issues identified by commenters and outlined above, the Board 
notes that the final rule allows the Board to exempt any BHC from 
mandatory application of the advanced approaches. The Board will make 
such a determination in light of the BHC's asset size (including 
subsidiary DI asset size relative to total BHC asset size), level of 
complexity, risk profile, or scope of operation. Similarly, the final 
rule allows a primary Federal supervisor to exempt any DI under its 
jurisdiction from mandatory application of the advanced approaches. A 
primary Federal supervisor will consider the same factors in making its 
determination.

C. Reservation of Authority

    The proposed rule restated the authority of a bank's primary 
Federal supervisor to require a bank to hold an overall amount of 
capital greater than would otherwise be required under the rule if the 
agency determined that the bank's risk-based capital requirements were 
not commensurate with the bank's credit, market, operational, or other 
risks. In addition, the preamble of the proposed rule noted the 
agencies' expectation that there may be instances when the rule would 
generate a risk-weighted asset amount for specific exposures that is 
not commensurate with the risks posed by such exposures. Accordingly, 
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 
when calculating the risk-weighted asset amount for those exposures. 
Similarly, the proposed rule provided explicit 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 found that the risk-weighted 
asset amount for operational risk produced by the bank under the rule 
was not commensurate with the operational risks of the bank. Any agency 
that exercised a reservation of authority was expected to notify each 
of the other agencies of its determination.
    Several commenters raised concerns with the scope of the 
reservation of authority, particularly as it would apply to operational 
risk. These commenters asserted, for example, that the agencies should 
address identified operational risk-related capital deficiencies 
through Pillar 2, rather than through requiring a bank to adjust input 
variables or techniques used for the calculation of Pillar 1 
operational risk capital requirements. Commenters were concerned that 
excessive agency Pillar 1 intervention on operational risk might 
inhibit innovation.
    While the agencies agree that innovation is important and that 
general supervisory oversight likely would be sufficient in many cases 
to address risk-related capital deficiencies, the agencies also believe 
that it is important to retain as much supervisory flexibility as 
possible as they move forward with implementation of the final rule. In 
general, the proposed reservation of authority represented a 
reaffirmation of the current authority of a bank's primary Federal 
supervisor to require the bank to hold an overall amount of regulatory 
capital or maintain capital ratios greater than would be required under 
the general risk-based capital rules. There may be cases where 
requiring a bank to assign a different risk-weighted asset amount for 
operational risk may not sufficiently address problems associated with 
underlying quantification practices and may cause an ongoing 
misalignment between the operational risk of a bank and the risk-
weighted asset amount for operational risk generated by the bank's 
operational risk quantification system. In view of this and the 
inherent flexibility provided for operational risk measurement under 
the AMA, the agencies believe it is appropriate to articulate the 
specific measures a primary Federal supervisor may take if it 
determines that a bank's risk-weighted asset amount for operational 
risk is not commensurate with the operational risks of the bank. 
Therefore, the final rule retains the reservation of authority as 
proposed. The agencies emphasize that any decision to exercise this 
authority would be made judiciously and that a bank bears the primary 
responsibility for maintaining the integrity, reliability, and accuracy 
of its risk management and measurement systems.

D. Principle of Conservatism

    Several commenters asked whether it would be permissible not to 
apply an aspect of the rule for cost or regulatory burden reasons, if 
the result would be

[[Page 69300]]

a more conservative capital requirement. For example, for purposes of 
the RBA for securitization exposures, some commenters asked whether a 
bank could choose not to track the seniority of a securitization 
exposure and, instead, assume that the exposure is not a senior 
securitization exposure. Similarly, some commenters asked if risk-based 
capital requirements for certain exposures could be calculated ignoring 
the benefits of risk mitigants such as collateral or guarantees.
    The agencies believe that in some cases it may be reasonable to 
allow a bank to implement a simplified capital calculation if the 
result is more conservative than would result from a comprehensive 
application of the rule. Under a new section 1(d) of the final rule, a 
bank may choose not to apply a provision of the rule to one or more 
exposures provided that (i) the bank can demonstrate on an ongoing 
basis to the satisfaction of its primary Federal supervisor that not 
applying the provision would, in all circumstances, unambiguously 
generate a risk-based capital requirement for each exposure greater 
than that which would otherwise be required under this final rule, (ii) 
the bank appropriately manages the risk of those exposures, (iii) the 
bank provides written notification to its primary Federal supervisor 
prior to applying this principle to each exposure, and (iv) the 
exposures to which the bank applies this principle are not, in the 
aggregate, material to the bank.
    The agencies emphasize that a conservative capital requirement for 
a group of exposures does not reduce the need for appropriate risk 
management of those exposures. Moreover, the principle of conservatism 
applies to the determination of capital requirements for specific 
exposures; it does not apply to the qualification or disclosure 
requirements in sections 22 and 71 of the final rule. Sections V.A.1., 
V.A.3., and V.E.2. of this preamble contain examples of the appropriate 
use of this principle of conservatism.

III. Qualification

A. The Qualification Process

1. In General
    Supervisory qualification to use the advanced approaches is an 
iterative and ongoing process that begins when a bank's board of 
directors adopts an implementation plan and continues as the bank 
operates under the advanced approaches. Under the final rule, as under 
the proposal, a bank 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 final rule, and 
complete a satisfactory ``parallel run'' (discussed below) before it 
may use the advanced approaches for risk-based capital purposes. A 
bank's primary Federal supervisor is responsible, after consultation 
with other relevant supervisors, for evaluating the bank's initial and 
ongoing compliance with the qualification requirements for the advanced 
approaches.
    Under the final rule, as 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 final 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 internal growth or merger, 
are 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. Under the final rule, each core and opt-in bank must submit its 
implementation plan, together with a copy of the minutes of the board 
of directors' approval of the plan, to its primary Federal supervisor 
at least 60 days before the bank proposes to begin its parallel run, 
unless the bank's primary Federal supervisor waives this prior notice 
provision. The submission to the primary Federal supervisor should 
indicate the date that the bank proposes to begin its parallel run.
    In developing an implementation plan, a bank must assess its 
current state of readiness relative to the qualification requirements 
in this final rule. This assessment must 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 
transitional 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.\26\ Further, the 
implementation plan must describe the resources that the bank has 
budgeted and that are available to implement the plan.
---------------------------------------------------------------------------

    \26\ The bank's primary Federal supervisor may extend the bank's 
first transitional floor period start date.
---------------------------------------------------------------------------

    The proposed rule allowed a bank to exclude a portfolio of 
exposures from the advanced approaches if the bank could demonstrate to 
the satisfaction of its primary Federal supervisor that the portfolio, 
when combined with all other portfolios of exposures that the bank 
sought to exclude from the advanced approaches, was not material to the 
bank. Some commenters asserted that a bank should be permitted to 
exclude from the advanced approaches any business line, portfolio, or 
exposure that is immaterial on a stand-alone basis (regardless of 
whether the excluded exposures in the aggregate are material to the 
bank). The agencies believe that it is not appropriate for a bank to 
permanently exclude a material portion of its exposures from the 
enhanced risk sensitivity and risk measurement and management 
requirements of the advanced approaches. Accordingly, the final rule 
retains the requirement that 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.
    During implementation of the advanced approaches, a bank should 
work closely with its primary Federal supervisor to ensure that its 
risk measurement and management systems are 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

[[Page 69301]]

implementation plan, including the gap analysis and action plan, will 
provide a basis for ongoing supervisory dialogue and review during the 
qualification process. 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 should be 
made subject to the ongoing supervisory discussion between the bank and 
its primary Federal supervisor.
2. Parallel Run and Transitional Floor Periods
    Under the proposed and final rules, once a bank has adopted its 
implementation plan, it must complete a satisfactory parallel run 
before it may use the advanced approaches to calculate its risk-based 
capital requirements. The proposed rule defined a satisfactory parallel 
run as a period of at least four consecutive calendar quarters during 
which a bank complied with all of the qualification requirements to the 
satisfaction of its primary Federal supervisor.
    Many commenters objected to the proposed requirement that the bank 
had to meet all of the qualification requirements before it could begin 
the parallel run period. The agencies recognize that certain 
qualification requirements, such as outcomes analysis, become more 
meaningful as a bank gains experience employing the advanced 
approaches. The agencies therefore are modifying the definition of a 
satisfactory parallel run in the final rule. Under the final rule, a 
satisfactory parallel run is a period of at least four consecutive 
calendar quarters during which the bank complies with the qualification 
requirements to the satisfaction of its primary Federal supervisor. 
This revised definition, which does not contain the word ``all,'' 
recognizes that the qualification of banks for the advanced approaches 
during the parallel run period will be an iterative and ongoing 
process. The agencies intend to assess individual advanced approaches 
methodologies through numerous discussions, reviews, data collection 
and analysis, and examination activities. The agencies also emphasize 
the critical importance of ongoing validation of advanced approaches 
methodologies both before and after initial qualification decisions. A 
bank's primary Federal supervisor will review a bank's validation 
process and documentation for the advanced approaches on an ongoing 
basis through the supervisory process. The bank should include in its 
implementation plan the steps it will take to enhance compliance with 
the qualification requirements during the parallel run period.
    Commenters also requested the flexibility, permitted under the New 
Accord, to apply the advanced approaches to some portfolios and other 
approaches (such as the standardized approach in the New Accord) to 
other portfolios during the transitional floor periods. The agencies 
believe, however, that banks applying the advanced approaches should 
move expeditiously to extend the robust risk measurement and management 
practices required by the advanced approaches to all material 
exposures. To preserve these positive risk measurement and management 
incentives for banks and to prevent ``cherry picking'' of portfolios, 
the final rule retains the provision in the proposed rule that states 
that a bank may enter the first transitional floor period only if it 
fully complies with the qualification requirements in section 22 of the 
rule. As described above, the final rule allows a simplified approach 
for portfolios that are, in the aggregate, immaterial to the bank.
    Another concern identified by commenters regarding the parallel run 
was the asymmetric treatment of mergers and acquisitions consummated 
before and after the date a bank qualified to use the advanced 
approaches. Under the proposed rule, a bank qualified to use the 
advanced approaches that merged with or acquired a company would have 
up to 24 months following the calendar quarter during which the merger 
or acquisition was consummated to integrate the merged or acquired 
company into the bank's advanced approaches capital calculations. In 
contrast, the proposed rule could be read to provide that a bank that 
merged with or acquired a company before the bank qualified to use the 
advanced approaches had to fully implement the advanced approaches for 
the merged or acquired company before the bank could qualify to use the 
advanced approaches. The agencies agree that this asymmetric treatment 
is not appropriate. Accordingly, the final rule applies the merger and 
acquisition transition provisions both before and after a bank 
qualifies to use the advanced approaches. The merger and acquisition 
transition provisions are described in section III.D. of this preamble.
    During the parallel run period, a bank continues to be subject to 
the general risk-based capital rules but simultaneously calculates its 
risk-based capital ratios under the advanced approaches. During this 
period, a bank will report its risk-based capital ratios under 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.
    As described above, a bank must provide its board-approved 
implementation plan to its primary Federal supervisor at least 60 days 
before the bank proposes to begin its parallel run period. A bank also 
must receive approval from its primary Federal supervisor before 
beginning its first transitional floor period. In evaluating whether to 
grant approval to a bank to begin using the advanced approaches for 
risk-based capital purposes, the bank's primary Federal supervisor must 
determine that the bank fully complies with all the qualification 
requirements, the bank has conducted a satisfactory 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 imposed 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 exit the last 
transitional floor period and move to stand-alone use of the advanced 
approaches. Table A sets forth the proposed transitional floor periods 
for banks moving to the advanced approaches:

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

    During the proposed 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

[[Page 69302]]

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 advanced approaches definitions and rules. 
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 the 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 proposed 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, 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.\27\
---------------------------------------------------------------------------

    \27\ The Board notes that, under the applicable leverage ratio 
rule, a BHC that is rated composite ``1'' or that has adopted the 
market risk rule has a minimum leverage ratio requirement of 3 
percent. For other BHCs, the minimum leverge ratio requirement is 4 
percent.
---------------------------------------------------------------------------

    Under the proposed rule, after a bank completed its transitional 
floor periods and its primary Federal supervisor determined the bank 
could 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.
    Although one commenter supported the proposed transitional 
provisions, many commenters objected to these transitional provisions. 
Commenters urged the agencies to conform the transitional provisions to 
those in the New Accord. Specifically, they requested that the three 
transitional floor periods be reduced to two periods and that the 
transitional floor percentages be reduced from 95 percent, 90 percent, 
and 85 percent to 90 percent and 80 percent. Commenters also requested 
that the transitional floor calculation methodology be conformed to the 
generally less restrictive methodology of the New Accord. Moreover, 
they expressed concern about the requirement that a bank obtain 
supervisory approval to move from one transitional floor period to the 
next, which could potentially extend each floor period beyond four 
calendar quarters.
    The agencies believe that the prudential transitional safeguards 
are necessary to address concerns identified in the analysis of the 
results of QIS-4.\28\ Specifically, the transitional safeguards will 
ensure that implementation of the advanced approaches will not result 
in a precipitous drop in risk-based capital requirements, and will 
provide a smooth transition process as banks refine their advanced 
systems. Banks' computation of risk-based capital requirements under 
both the general risk-based capital rules and the advanced approaches 
during the parallel run and transitional floor periods 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. Therefore, 
the agencies are adopting in this final rule the proposed level, 
duration, and calculation methodology of the transitional floors, with 
the revised process for determining when banks may exit the third 
transitional floor period discussed in section I.E., above.
---------------------------------------------------------------------------

    \28\ Preliminary analysis of the QIS-4 submissions evidenced 
material reductions in the aggregate minimum required capital for 
the QIS-4 participant population and significant dispersion of 
results across institutions and portfolio types. See Interagency 
Press Release, Banking ``Agencies To Perform Additional Analysis 
Before Issuing Notice of Proposed Rulemaking Related To Basel II,'' 
April 29, 2005.
---------------------------------------------------------------------------

    Under the final rule, as under the proposed rule, banks that meet 
the threshold criteria in section 1(b)(1) (core banks) as of the 
effective date of this final rule, and banks that opt in pursuant to 
section 1(b)(2) at the earliest possible date, must use the general 
risk-based capital rules both during the parallel run and as a basis 
for the transitional floor calculations. Should the agencies finalize a 
standardized risk-based capital rule, the agencies expect that a bank 
that opts in after the earliest possible date or becomes a core bank 
after the effective date of the final rule would use the risk-based 
capital regime (the general risk-based capital rules or the 
standardized risk-based capital rules) used by the bank immediately 
before the bank begins its parallel run both during the parallel run 
and as a basis for the transitional floor calculations. Under the final 
rule, 2008 is the first possible year for a bank to begin its parallel 
run and 2009 is the first possible year for a bank to begin its first 
of three transitional floor periods.

B. Qualification Requirements

    Because the advanced approaches use banks' estimates of certain key 
risk parameters to determine risk-based capital requirements, they 
introduce greater complexity to the regulatory capital framework and 
require banks to possess a high level of sophistication in risk 
measurement and risk management systems. As a result, the final rule 
requires each core or opt-in bank to meet the qualification 
requirements described in section 22 of the final 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 floor provisions for at least an additional three 
years). The qualification requirements are written broadly to 
accommodate the many ways a bank may design and implement robust 
internal credit and operational risk measurement and management 
systems, 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

[[Page 69303]]

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 advanced approaches framework is to 
provide appropriate incentives for banks to develop and use better 
techniques for measuring and managing their risks and to ensure that 
capital is adequate to support those risks. Section 3 of the final rule 
requires a bank to hold capital commensurate with the level and nature 
of all risks to which the bank is exposed. Section 22 of the final rule 
specifically requires a bank to have a rigorous process for assessing 
its overall capital adequacy in relation to its risk profile and a 
comprehensive strategy for maintaining appropriate capital levels 
(known as the internal capital adequacy assessment process or ICAAP). 
Another objective of the advanced approaches framework is to ensure 
comprehensive supervisory review of capital adequacy.
    On February 28, 2007, the agencies issued proposed guidance setting 
forth supervisory expectations for a bank's ICAAP and addressing the 
process for a comprehensive supervisory assessment of capital 
adequacy.\29\ As set forth in that guidance, and consistent with 
existing supervisory practice, a bank's primary Federal supervisor will 
evaluate how well the bank is assessing its capital needs relative to 
its risks. The supervisor will assess the bank's overall capital 
adequacy and will take into account a bank's ICAAP, its compliance with 
the minimum capital requirements set forth in this rule, and all other 
relevant information. The primary Federal supervisor will require a 
bank to increase its capital levels or ratios if the supervisor 
determines that current levels or ratios are deficient or some element 
of the bank's business practices suggests the need for higher capital 
levels or ratios. In addition, the primary Federal supervisor may, 
under its enforcement authority, require a bank to modify or enhance 
risk management and internal control authority, or reduce risk 
exposures, or take any other action as deemed necessary to address 
identified supervisory concerns.
---------------------------------------------------------------------------

    \29\ 72 FR 9189.
---------------------------------------------------------------------------

    As outlined in the proposed guidance, the agencies expect banks to 
implement and continually update the fundamental elements of a sound 
ICAAP--identifying and measuring material risks, setting capital 
adequacy goals that relate to risk, and ensuring the integrity of 
internal capital adequacy assessments. A bank is expected to ensure 
adequate capital is held against all material risks.
    In developing its ICAAP, a bank should be particularly mindful of 
the limitations of regulatory risk-based capital requirements as a 
measure of its full risk profile--including risks not covered or not 
adequately quantified in the risk-based capital requirements--as well 
as specific assumptions embedded in risk-based regulatory capital 
requirements (such as diversification in credit portfolios). A bank 
should also be mindful of the capital adequacy effects of 
concentrations that may arise within each risk type or across risk 
types. In general, a bank's ICAAP should reflect an appropriate level 
of conservatism to account for uncertainty in risk identification, risk 
mitigation or control, quantitative processes, and any use of modeling. 
In most cases, this conservatism will result in higher levels of 
capital or higher capital ratios being regarded as adequate.
    As noted above, each core and opt-in bank must apply the advanced 
approaches for risk-based capital purposes at the consolidated top-tier 
U.S. legal entity level (either the top-tier U.S. BHC or top-tier DI 
that is a core or opt-in bank) and at each DI that is a subsidiary of 
such a top-tier legal entity (unless a primary Federal supervisor 
provides an exemption under section 1(b)(3) of the final rule). Each 
bank that applies the advanced approaches must have an appropriate 
infrastructure with risk measurement and management processes that meet 
the final 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 an 
affiliate of the bank, each legal entity that applies the advanced 
approaches must ensure that the risk parameters (PD, LGD, EAD, and, for 
wholesale exposures, M) and reference data used to determine its risk-
based capital requirements are representative of its own credit and 
operational risk exposures.
    The final rule also requires that the systems and processes that an 
advanced approaches bank uses for risk-based capital purposes must be 
consistent with the bank's internal risk management processes and 
management information reporting systems. This means, for example, that 
data from the latter processes and systems can be used to verify the 
reasonableness of the inputs the bank uses for calculating risk-based 
capital ratios.
2. Risk Rating and Segmentation Systems for Wholesale and Retail 
Exposures
    To implement the IRB approach, 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 other governmental entities, as 
well as some exposures to individuals. Retail exposures include most 
credit exposures to individuals and small credit exposures to 
businesses that are managed as part of a segment of exposures with 
homogeneous risk characteristics. Together, wholesale and retail 
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 loss severity rating 
grades (or LGD estimates) that approximately reflect the loss severity 
expected in the event of default during economic downturn conditions. 
As discussed below, the final rule requires banks to treat wholesale 
exposures differently from retail exposures when differentiating among 
degrees of credit risk; specifically, risk parameters for retail 
exposures are assigned at the segment level.
Wholesale Exposures
    Under the proposed rule, a bank would be required to have an 
internal risk rating system that indicates the likelihood of default of 
each individual

[[Page 69304]]

obligor and would either use an internal risk rating system that 
indicates the economic loss rate upon default of each individual 
exposure or directly assign an LGD estimate to each individual 
exposure. A bank would assign an internal risk rating to each wholesale 
obligor that reflected the obligor's likelihood of default.
    Several commenters objected to the proposed requirement to assign 
an internal risk rating to each wholesale obligor that reflected the 
obligor's likelihood of default. Commenters asserted that this 
requirement was burdensome and unnecessary where a bank underwrote an 
exposure based solely on the financial strength of a guarantor and used 
the PD substitution approach (discussed below) to recognize the risk 
mitigating effects of an eligible guarantee on the exposure. In such 
cases, commenters maintained that banks should be allowed to assign a 
PD only to the guarantor and not the underlying obligor.
    While the agencies believe that maintaining internal risk ratings 
of both a protection provider and underlying obligor provides helpful 
information for risk management purposes and facilitates a greater 
understanding of so-called double default effects, the agencies 
appreciate the commenters' concerns about burden in this context. 
Accordingly, the final rule does not require a bank to assign an 
internal risk rating to an underlying obligor to whom the bank extends 
credit based solely on the financial strength of a guarantor, provided 
that all of the bank's exposures to that obligor are fully covered by 
eligible guarantees and the bank applies the PD substitution approach 
to all of those exposures. A bank in this situation is only required to 
assign an internal risk rating to the guarantor. However, a bank must 
immediately assign an internal risk rating to the obligor if a 
guarantee can no longer be recognized under this final rule.
    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 adapt to changes in the economy and 
the competitive environment.
    Under the proposed rule, a bank would assign each legal entity 
wholesale obligor to a single rating grade. Accordingly, if a single 
wholesale exposure of the bank to an obligor triggered the proposed 
rule's definition of default, all of the bank's wholesale exposures to 
that obligor would be in default for risk-based capital purposes. In 
addition, under the proposed rule, a bank would not be allowed to 
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. A bank would, 
however, 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.
    While a few commenters expressly supported the proposal's 
requirement for banks to assign each legal entity wholesale obligor to 
a single rating grade, a substantial number of commenters expressed 
reservations about this requirement. These commenters observed that in 
certain circumstances an exposure's transaction-specific 
characteristics affect its likelihood of default. Commenters asserted 
that the agencies should provide greater flexibility and allow banks to 
depart from the one-rating-per-obligor requirement based on the 
economic substance of an exposure. In particular, commenters maintained 
that income-producing real estate lending should be exempt from the 
one-rating-per-obligor requirement. The commenters noted that the 
probability that an obligor will default on any one such facility 
depends primarily on the cash flows from the individual property 
securing the facility, not the overall condition of the obligor. 
Similarly, several commenters asserted that exposures involving 
transfer risk and non-recourse exposures should be exempted from the 
one-rating-per-obligor requirement.
    In general, the agencies believe that a two-dimensional rating 
system that strictly separates borrower and exposure-level 
characteristics is a critical underpinning of the IRB approach. 
However, the agencies agree that exposures to the same borrower 
denominated in different currencies may have different default 
probabilities. For example, a sovereign government may impose 
prohibitive exchange restrictions that make it impossible for a 
borrower to transfer payments in one particular currency.
    In addition, the agencies agree that certain income-producing real 
estate exposures for which the bank, in economic substance, does not 
have recourse to the borrower beyond the real estate serving as 
collateral for the exposure, have default probabilities distinct from 
that of the borrower. Such situations would arise, for example, where 
real estate collateral is located in a state where a bank, under 
applicable state law, effectively does not have recourse to the 
borrower if the bank pursues the real estate collateral in the event of 
default (for example, in a ``one-action'' state or a state with a 
similar law). In one-action states such as Arizona, California, Idaho, 
Montana, Nevada, and Utah, or in a state with a similar law, such as 
New York, the applicable foreclosure laws materially limit a bank's 
ability to collect against both the collateral and the borrower.
    A third instance in which exposures to the same borrower may have 
significantly different default probabilities is when a borrower enters 
bankruptcy and the bank extends additional credit to the borrower under 
the auspices of the bankruptcy proceedings. This so-called debtor in 
possession (DIP) financing is unique from other exposure types because 
it typically has priority over existing debt, equity, and other claims 
on the borrower. The agencies believe that because of this unique 
priority status, if a bank has an exposure to a borrower that declares 
bankruptcy and defaults on that exposure, and the bank subsequently 
provides DIP financing to that obligor, it may not be appropriate to 
require the bank to treat the DIP financing exposure at inception as an 
exposure to a defaulted borrower.
    To address these circumstances and clarify the application of the 
one-rating-per-obligor requirement, the agencies added a definition of 
obligor in the final rule. The final rule defines an obligor as the 
legal entity or natural person contractually obligated on a wholesale 
exposure except that a bank may treat three types of exposures to the 
same legal entity or natural person as having separate obligors. First, 
exposures to the same legal entity or natural person denominated in 
different currencies. Second, (i) income-producing real estate 
exposures for which all or substantially all of the repayment of the 
exposure is reliant on cash flows of the real estate serving as 
collateral for the exposure;

[[Page 69305]]

the bank, in economic substance, does not have recourse to the borrower 
beyond the real estate serving as collateral for the exposure; and no 
cross-default or cross-acceleration clauses are in place other than 
clauses obtained solely in an abundance of caution; and (ii) other 
credit exposures to the same legal entity or natural person. Third, (i) 
wholesale exposures authorized under section 364 of the U.S. Bankruptcy 
Code (11 U.S.C. 364) to a legal entity or natural person who is a 
debtor-in-possession for purposes of Chapter 11 of the Bankruptcy Code; 
and (ii) other credit exposures to the same legal entity or natural 
person. All exposures to a single legal entity or natural person must 
be treated as exposures to a single obligor unless they qualify for one 
of these three exceptions in the final rule's definition of obligor.
    A bank's obligor 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 differentiate 
sufficiently the creditworthiness of non-defaulted wholesale obligors.
    A bank must capture the estimated loss severity upon default for a 
wholesale exposure either by directly assigning an 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 
LGD of the exposure). LGD is described in more detail below. Whether a 
bank chooses to assign LGD values directly or, alternatively, to assign 
exposures to rating grades and then quantify the LGD for the rating 
grades, the key requirement is that the bank must identify exposure 
characteristics that influence LGD. Each of the loss severity rating 
grades must be associated with an empirically supported LGD estimate. 
Banks employing loss severity grades must have a sufficiently granular 
loss severity grading system to avoid grouping together exposures with 
widely ranging 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 treatment of wholesale and 
retail exposures is that the risk parameters for wholesale exposures 
are assigned at the individual exposure level, whereas risk parameters 
for retail exposures are assigned at the segment 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 final rule's retail framework is that the risk 
parameters for retail exposures are assigned to segments of exposures 
rather than to individual exposures. Under the retail framework, a bank 
groups its retail exposures into segments with homogeneous risk 
characteristics and estimates PD and LGD for each segment.
    Some commenters stated that for internal risk management purposes 
they assign risk parameters at the individual retail exposure level 
rather than at the segment level. These commenters requested 
confirmation that this practice would be permissible for risk-based 
capital purposes under the final rule. The agencies believe that a bank 
may use its advanced systems, including exposure-level risk parameter 
estimates, to group exposures into segments with homogeneous risk 
characteristics. Such exposure-level estimates must be aggregated in 
order to assign segment-level risk parameters to each segment of retail 
exposures.
    A bank must group its retail exposures into three separate 
subcategories: (i) Residential mortgage exposures; (ii) QREs; and (iii) 
other retail exposures. The bank must classify the retail exposures in 
each subcategory into segments to produce a meaningful differentiation 
of risk. The final 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 
LGD to reflect the risk mitigating effects of financial collateral from 
other retail eligible margin loans. Otherwise, the agencies do not 
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 ratios, credit scores, loan 
terms and structure, origination channel, geographical location of the 
borrower, collateral type, and bank internal estimates of likelihood of 
default and loss severity given default. Regardless of the risk drivers 
used, a bank must be able to demonstrate to its primary Federal 
supervisor that its system assigns accurate and reliable PD and LGD 
estimates for each retail segment on a consistent basis.
Definition of Default
    Wholesale 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. The ANPR's definition of default was generally 
consistent with the New Accord.
    A number of commenters on the ANPR encouraged the agencies to use a 
wholesale definition of default that varied from the New Accord but 
conformed more closely to that used by bank risk managers. Many of 
these commenters recommended that the agencies define default for 
wholesale exposures as the entry into non-accrual or charge-off status. 
In the proposed rule, the agencies amended the ANPR definition of 
default to respond to these concerns. Under the proposed definition of 
default, a bank's wholesale obligor would be in default if, for any 
wholesale exposure of the bank to the obligor, the bank had (i) placed 
the exposure on non-accrual status consistent with the Consolidated 
Report of Condition and Income (Call Report) Instructions or the Thrift 
Financial Report (TFR) and the TFR 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.
    The agencies received extensive comment on the proposed definition 
of default for wholesale exposures. Commenters observed that the 
proposed definition of default was different from and more prescriptive 
than the definition in the New Accord and employed in other major 
jurisdictions. They asserted that the proposed definition would impose 
unjustifiable systems burden and expense on banks operating across 
multiple jurisdictions. Commenters also asserted that many

[[Page 69306]]

banks' data collection systems are based on the New Accord's definition 
of default, and therefore historical data relevant to the proposed 
definition of default are limited. Moreover, commenters expressed 
concern that risk parameters estimated using the proposed definition of 
default would differ materially from those estimated using the New 
Accord's definition of default, resulting in different capital 
requirements for U.S. banks relative to their foreign peers.
    The 5 percent credit-related loss trigger in the proposed 
definition of default for wholesale obligors was the focus of 
significant commenter concern. Commenters asserted that the trigger 
inappropriately imported LGD and maturity-related considerations into 
the definition of default, could hamper the use of loan sales as a risk 
management practice, and could cause obligors that are performing on 
their obligations to be considered defaulted. These commenters also 
claimed that the 5 percent trigger would add significant implementation 
burden by, for example, requiring banks to distinguish between credit-
related and non-credit-related losses on sale.
    Many commenters requested that the agencies conform the U.S. 
wholesale definition of default to the New Accord. Other commenters 
requested that banks be allowed the option to apply either the U.S. or 
the New Accord definition of default.
    The agencies agree that the proposed definition of default for 
wholesale obligors could have unintended consequences for 
implementation burden and international consistency. Therefore, the 
final rule contains a definition of default for wholesale obligors that 
is similar to the definition proposed in the ANPR and consistent with 
the New Accord. Specifically, under the final rule, a bank's wholesale 
obligor is in default if, for any wholesale exposure of the bank to the 
obligor: (i) The bank considers that the obligor is unlikely to pay its 
credit obligations to the bank in full, without recourse by the bank to 
actions such as realizing collateral (if held); or (ii) the obligor is 
past due more than 90 days on any material credit obligation to the 
bank. The final rule also clarifies, consistent with the New Accord, 
that an overdraft is past due once the obligor has breached an advised 
limit or has been advised of a limit smaller than the current 
outstanding balance.
    Consistent with the New Accord, the following elements may be 
indications of unlikeliness to pay under this definition:
    (i) The bank places the exposure on non-accrual status consistent 
with the Call Report Instructions or the TFR and the TFR Instruction 
Manual;
    (ii) The bank takes a full or partial charge-off or write-down on 
the exposure due to the distressed financial condition of the obligor;
    (iii) The bank incurs a material credit-related loss 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;
    (iv) The bank consents to a distressed restructuring of the 
exposure that is likely to result in a diminished financial obligation 
caused by the material forgiveness or postponement of principal, 
interest or (where relevant) fees;
    (v) The bank has filed as a creditor of the obligor for purposes of 
the obligor's bankruptcy under the U.S. Bankruptcy Code (or a similar 
proceeding in a foreign jurisdiction regarding the obligor's credit 
obligation to the bank); or
    (vi) The obligor has sought or has been placed in bankruptcy or 
similar protection that would avoid or delay repayment of the exposure 
to the bank.
    If a bank carries a wholesale exposure at fair value for accounting 
purposes, the bank's practices for determining unlikeliness to pay for 
purposes of the definition of default should be consistent with the 
bank's practices for determining credit-related declines in the fair 
value of the exposure.
    Like the proposed definition of default for wholesale obligors, the 
final rule states that 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 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.
    Retail default. In response to comments on the ANPR, the agencies 
proposed to define default for retail exposures according to the 
timeframes for loss classification that banks generally use for 
internal purposes. These timeframes are embodied in the FFIEC's Uniform 
Retail Credit Classification and Account Management Policy. \30\ 
Specifically, revolving retail exposures and residential mortgage 
exposures 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 had 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 had reasonable assurance of repayment and performance for all 
contractual principal and interest payments on the exposure.
---------------------------------------------------------------------------

    \30\ FFIEC, ``Uniform Retail Credit Classification and Account 
Management Policy,'' 65 FR 36903, June 12, 2000.
---------------------------------------------------------------------------

    Although some commenters supported the proposed rule's retail 
definition of default, others urged the agencies to adopt a 90-days-
past-due default trigger consistent with the New Accord's definition of 
default for retail exposures. Other commenters requested that a non-
accrual trigger be added to the retail definition of default similar to 
that in the proposed wholesale definition of default. The commenters 
viewed this as a practical way to allow a foreign banking organization 
to harmonize the U.S. retail definition of default to a home country 
definition of default that has a 90-days-past-due trigger.
    The agencies believe that adding a non-accrual trigger to the 
retail definition of default is not appropriate. Retail non-accrual 
practices vary considerably among banks, and adding a non-accrual 
trigger to the retail definition of default would result in greater 
inconsistency among banks in the treatment of retail exposures. 
Moreover, a bank that considers retail exposures to be defaulted at 90 
days past due could have significantly different risk parameter 
estimates than one that uses 120- and 180-days-past-due thresholds. 
Such a bank would likely have higher PD estimates and lower LGD 
estimates due to the established tendency of a nontrivial proportion of 
U.S. retail exposures to ``cure'' or return to performing status after 
becoming 90 days past due and before becoming 120 or 180 days past due. 
The agencies believe that the 120- and 180-days-past-due thresholds, 
which are consistent with national discretion provided by the New 
Accord, reflect a point at which retail exposures in the United States 
are unlikely to return to performing status. Therefore, the agencies 
are incorporating the proposed retail definition of default without 
substantive change in the final rule. (Parallel to the full or partial

[[Page 69307]]

charge-off or write-down trigger for retail exposures not held at fair 
value, the agencies added a material negative fair value adjustment of 
principal for credit-related reasons trigger for retail exposures held 
at fair value.)
    The New Accord provides discretion for national supervisors to set 
the retail default trigger at up to 180 days past due for different 
products, as appropriate to local conditions. Accordingly, banks 
implementing the IRB approach in multiple jurisdictions may be subject 
to different retail definitions of default in their home and host 
jurisdictions. The agencies recognize that it could be costly and 
burdensome for a U.S. bank to track default data and estimate risk 
parameters based on both the U.S. definition of default and the 
definitions of default in non-U.S. jurisdictions where subsidiaries of 
the U.S. bank implement the IRB approach. The agencies are therefore 
incorporating flexibility into the retail definition of default. 
Specifically, for a retail exposure held by a U.S. bank's non-U.S. 
subsidiary subject to an internal ratings-based approach to capital 
adequacy consistent with the New Accord in a non-U.S. jurisdiction, the 
final rule allows the bank to elect to use the definition of default of 
that jurisdiction, subject to prior approval by the bank's primary 
Federal supervisor. The primary Federal supervisor will revoke approval 
for a bank to use this provision if the supervisor finds that the bank 
uses the provision to arbitrage differences in national definitions of 
default.
    The definition of default for retail exposures differs from the 
definition for the wholesale portfolio in that the retail default 
definition applies on an exposure-by-exposure basis rather than on an 
obligor-by-obligor basis. In other words, default on one retail 
exposure does not require a bank to treat all other retail obligations 
of the same borrower 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 borrowers. In addition, it is quite common for 
retail borrowers that default on some of their obligations to continue 
payment on others.
    Although the retail definition of default does not explicitly 
include credit-related losses in connection with loan sales and the 
agencies have replaced the 5 percent credit-related loss threshold for 
wholesale exposures with a less prescriptive treatment that is 
consistent with the New Accord, the agencies expect banks to ensure 
that exposure sales do not bias or otherwise distort the estimated risk 
parameters assigned by a bank to its wholesale exposures and retail 
segments.
Rating Philosophy
    A bank's internal risk rating policy for wholesale exposures must 
describe the bank's rating philosophy, which 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 rating 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, tend to have ratings that 
migrate more slowly as conditions change. Banks that rate obligors 
based on a more narrow range of likely expected conditions (primarily 
on recent conditions), sometimes called ``point-in-time'' systems, 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 must 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
    Each wholesale obligor rating and (if applicable) wholesale 
exposure loss severity rating must reflect 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. Under the 
proposed rule, a bank's retail exposure segmentation system would 
provide for the review and update (as appropriate) of assignments of 
retail exposures to segments whenever the bank received new material 
information. The proposed rule specified that the review would be 
required no less frequently than quarterly.
    One commenter noted that quarterly reviews may not be appropriate 
for high-quality retail portfolios, such as retail exposures associated 
with a bank's wealth management or private banking businesses. The 
commenter suggested that banks should have the flexibility to review 
and update segmentation assignments for such portfolios on a less 
frequent basis appropriate to the credit quality of the portfolios.
    The agencies agree that it may be appropriate for a bank to review 
and update segmentation assignments for certain high-quality retail 
exposures on a less frequent basis than quarterly, provided a bank is 
following sound risk management practices. Therefore, the final rule 
generally requires a quarterly review and update, as appropriate, of 
retail exposure segmentation assignments, allowing some flexibility to 
accommodate sound internal risk management practices.
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, 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 data, should be 
transparent, well supported, and documented. The following sections of 
the preamble discuss the rule's definitions of the risk parameters for 
wholesale exposures and retail segments.
Probability of Default (PD)
    As noted above, under the final 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 is the bank's empirically based best estimate of 
the long-run average one-year default rate 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.
    In addition, under the final rule, a bank must assign a PD to each 
segment of retail exposures. Some types of retail exposures typically 
display a seasoning pattern--that is, the exposures have

[[Page 69308]]

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. Because of the one-year IRB horizon, the proposed rule 
provided two different definitions of PD for 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. Under the 
proposed rule, PD for a segment of non-defaulted retail exposures for 
which seasoning effects were not material, or for a segment of non-
defaulted retail exposures in a retail exposure subcategory for which 
seasoning effects were 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. PD for a segment of non-defaulted 
retail exposures for which seasoning effects were 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.
    Commenters objected to this treatment of retail exposures with 
material seasoning effects. They asserted that requiring banks to use 
an annualized cumulative default rate to recognize seasoning effects 
was too prescriptive and would preclude other reasonable approaches. 
The agencies believe that commenters have presented reasonable 
alternative approaches to recognizing the effects of seasoning in PD 
and are, therefore, providing additional flexibility for recognizing 
those effects in the final rule.
    Based on comments and additional consideration, the agencies also 
are clarifying that a segment of retail exposures has material 
seasoning effects if there is a material relationship between the time 
since origination of exposures within the segment and the bank's best 
estimate of the long-run average one-year default rate for the 
exposures in the segment. Moreover, because the agencies believe that 
the IRB approach must, at a minimum, require banks to hold appropriate 
amounts of risk-based capital to address credit risks over a one-year 
horizon, the final rule's incorporation of seasoning effects is 
explicitly one-directional. Specifically, a bank must increase PDs 
above the best estimate of the long-run average one-year default rate 
for segments of unseasoned retail exposures, but may not decrease PD 
below the best estimate of the long-run average one-year default rate 
for a segment of retail exposures that the bank estimates will have 
lower PDs in future years due to seasoning.
    The final rule defines PD for a segment of non-defaulted retail 
exposures as the bank's empirically based best estimate of the long-run 
average one-year default rate 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 and 
adjusted upward as appropriate for segments for which seasoning effects 
are material. If a bank does not adjust PD to reflect seasoning effects 
for a segment of exposures, it should be able to demonstrate to its 
primary Federal supervisor, using empirical analysis, why seasoning 
effects are not material or why adjustment is not relevant for the 
segment.
    For wholesale exposures to defaulted obligors and for segments of 
defaulted retail exposures, PD is 100 percent.
Loss Given Default (LGD)
    Under the proposed rule, a bank would directly estimate an ELGD and 
LGD risk parameter for each wholesale exposure or would 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 
downturn loss severity grade. In addition, a bank would estimate an 
ELGD and LGD risk parameter for each segment of retail exposures.
Expected Loss Given Default (ELGD)
    The proposed rule defined 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 expected 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) defaulted within a 
one-year horizon.\31\ The proposed rule defined ELGD for a segment of 
retail exposures as the bank's empirically based best estimate of the 
default-weighted average economic loss per dollar of EAD the bank 
expected to incur on exposures in the segment that default within a 
one-year horizon. ELGD estimates would incorporate a mix of economic 
conditions (including economic downturn conditions). ELGD had four 
functions in the proposed rule--as a component of the calculation of 
ECL in the numerator of the risk-based capital ratios; in the EL 
component of the IRB risk-based capital formulas; as a floor on the 
value of the LGD risk parameter; and as an input into the supervisory 
mapping function.
---------------------------------------------------------------------------

    \31\ Under the proposal, ELGD was not the statistical expected 
value of LGD.
---------------------------------------------------------------------------

    Many commenters objected to the proposed rule's requirement for 
banks to estimate ELGD for each wholesale exposure and retail segment, 
noting that ELGD estimation is not required under the New Accord. 
Commenters asserted that requiring ELGD estimation would create a 
competitive disadvantage by creating additional systems, compliance, 
calculation, and reporting burden for those banks subject to the U.S. 
rule, many of which have already substantially developed their systems 
based on the New Accord. They also maintained that it would decrease 
the comparability of U.S. banks' capital requirements and public 
disclosures relative to those of foreign banking organizations applying 
the advanced approaches. Several commenters also contended that 
defining ECL in terms of ELGD instead of LGD raised tier 1 risk-based 
capital requirements for U.S. banks compared to foreign banks using the 
New Accord's LGD-based ECL definition.
    The agencies have concluded that the regulatory burden and 
potential competitive inequities identified by commenters outweigh the 
supervisory benefits of the proposed ELGD risk parameter, and are, 
therefore, not including it in the final rule. Instead, consistent with 
the New Accord, a bank must use LGD for the calculation of ECL and the 
EL component of the IRB risk-based capital formulas. Because the 
proposed ELGD risk parameter was equal to or less than LGD, this change 
generally will have the effect of decreasing both the numerator and 
denominator of the risk-based capital ratios.
    Consistent with the New Accord, under the final rule, the LGD of a 
wholesale exposure or retail segment must not be less than the bank's

[[Page 69309]]

empirically based best estimate of the long-run default-weighted 
average 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 or segment) were to default within 
a one-year horizon over a mix of economic conditions, including 
economic downturn conditions. The final rule also specifies that LGD 
may not be less than zero. The implications of eliminating the ELGD 
risk parameter for the supervisory mapping function are discussed 
below.
Economic Loss and Post-Default Extensions of Credit
    Commenters requested additional clarity regarding the treatment of 
post-default extensions of credit. LGD is an estimate of the economic 
loss that would be incurred on an exposure, relative to the exposure's 
EAD, if the obligor were to default within a one-year horizon during 
economic downturn conditions. The estimated 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) are expected to occur 
after the date of default, the estimated 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. The 
possibility of post-default extensions of credit made to facilitate 
collection of an exposure would be treated as negative cash flows and 
reflected in LGD.
    For example, assume a loan to a retailer goes into default. The 
bank determines that the recovery would be enhanced by some additional 
expenditure to ensure an orderly workout process. One option would be 
for the bank to hire a third-party to facilitate the collection of the 
loan. Another option would be for the bank to extend additional credit 
directly to the defaulted obligor to allow the obligor to make an 
orderly liquidation of inventory. Both options represent negative cash 
flows on the original exposure, which must be discounted at a rate that 
is appropriate to the risk of the exposure.
Economic Downturn Conditions
    The expected loss severities of some exposures may be substantially 
higher during economic downturn conditions than during other periods, 
while for other types of exposures they may not. Accordingly, the 
proposed rule required banks to use an LGD estimate that reflected 
economic downturn conditions for purposes of calculating the risk-based 
capital requirements for wholesale exposures and retail segments.
    Several commenters objected to the requirement that LGD estimates 
must reflect economic downturn conditions. Some of these commenters 
stated that empirical evidence of correlation between economic downturn 
and LGD is inconclusive, except in certain cases. A few noted that 
estimates of expected LGD include conservative inputs, such as a 
conservative estimate of potential loss in the event of default or a 
conservative discount rate or collateral assumptions. One commenter 
suggested that if a bank can demonstrate it has been prudent in its LGD 
estimation and it has no evidence of the cyclicality of LGDs, it should 
not be required to calculate downturn LGDs. Other commenters remarked 
that the requirement to incorporate downturn conditions into LGD 
estimates should not be used as a surrogate for proper modeling of PD/
LGD correlations. Finally, a number of commenters supported a pillar 2 
approach for addressing LGD estimation.
    Consistent with the New Accord, the final rule maintains the 
requirement for a bank 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. More 
specifically, banks must produce for each wholesale exposure (or 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.
    For the purpose of defining economic downturn conditions, the 
proposed rule identified 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 defined 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) were significantly higher than average.
    The agencies specifically sought 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. Some commenters stated that the proposed 
requirement is at a sufficiently granular level. Others asserted that 
the requirement should be eliminated or made less granular. Those 
commenters favoring less granularity stated that aggregate default 
rates for different product subcategories in different countries are 
unlikely to peak at the same time and that requiring economic downturn 
analysis at the product subcategory and national jurisdiction level 
does not recognize potential diversification effects across products 
and national jurisdictions and is thus overly conservative. Commenters 
also maintained that the proposed granularity requirement adds 
complexity and implementation burden relative to the New Accord.
    The agencies believe that the proposed definition of economic 
downturn conditions incorporates an appropriate level of granularity 
and are incorporating it unchanged in the final rule. 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. The agencies also recognize that diversification 
across those subdivisions may mitigate risk for the overall 
organization. However, the agencies believe that the required minimum 
level of granularity at the subcategory and national jurisdiction level 
provides a suitable balance between allowing for the benefits of 
diversification and appropriate conservatism for risk-based capital 
requirements.
    Under the final rule, a bank must consider economic downturn 
conditions that appropriately reflect its actual exposure profile. For 
example, 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

[[Page 69310]]

regions or industries. The final rule (like the proposed rule) allows 
banks to subdivide exposure subcategories or national jurisdictions as 
they deem appropriate given the exposures held by the bank. Moreover, 
the agencies note that the exposure subcategory/national jurisdiction 
granularity requirement is only a minimum granularity requirement.
Supervisory Mapping Function
    The proposed rule provided banks two methods of generating LGD 
estimates for wholesale exposures and retail segments. First, a bank 
could use its own estimates of LGD for a subcategory of exposures if 
the bank had 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 would consider whether the bank's internal estimates 
of LGD were reliable and sufficiently reflective of economic downturn 
conditions. The supervisor would 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 had supervisory 
approval to use its own estimates of LGD for an exposure subcategory, 
it would use its own estimates of LGD for all exposures within that 
subcategory.
    As an alternative to internal estimates of LGD, the proposed rule 
provided a supervisory mapping function for converting ELGD into LGD 
for risk-based capital purposes. A bank that did not qualify to use its 
own estimates of LGD for a subcategory of exposures would instead 
compute LGD using the linear supervisory mapping function: LGD = 0.08 + 
0.92 x ELGD. 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 this preamble). 
The agencies proposed the supervisory mapping function because of 
concerns that banks may find it difficult 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 limited 
industry experience with incorporating downturn conditions into LGD 
estimates. The supervisory mapping function provided a pragmatic 
methodology for banks to use while refining their LGD estimation 
techniques.
    In general, commenters viewed the supervisory mapping function as a 
significant deviation from the New Accord that would add unwarranted 
prescriptiveness and regulatory burden to the U.S. rule. Commenters 
requested more flexibility to address problems with LGD estimation, 
including the ability to apply appropriate margins of conservatism as 
contemplated in the New Accord. Commenters expressed concern that U.S. 
supervisors would employ an unreasonably high standard for allowing own 
estimates of LGD, forcing banks to use the supervisory mapping function 
for an extended period of time. Commenters also expressed concern that 
supervisors would view the output of the supervisory mapping function 
as a floor on internal estimates of LGD. Commenters asserted that in 
both cases risk-based capital requirements would be increased at U.S. 
banks relative to their foreign competitors, particularly for high-
quality assets, putting U.S. banks at a competitive disadvantage to 
foreign banks.
    In particular, many commenters viewed the supervisory mapping 
function as overly punitive for exposure categories with relatively low 
loss severities, effectively imposing an 8 percent floor on LGD. 
Commenters also objected to the proposed requirement that a bank use 
the supervisory mapping function for an entire subcategory of exposures 
even if it had difficulty estimating LGD only for a small subset of 
those exposures.
    The agencies continue to believe that the supervisory mapping 
function is a reasonable aid for dealing with problems in LGD 
estimation. The agencies recognize, however, that there may be several 
valid methodologies for addressing such problems. For example, a 
relative scarcity of historical loss data for a particular obligor or 
exposure type may be addressed by increased reliance on alternative 
data sources and data-enhancing tools for quantification and 
alternative techniques for validation. In addition, a bank should 
reflect in its estimates of risk parameters a margin of conservatism 
that is related to the likely range of uncertainty. These concepts are 
discussed below in the quantification principles section of the 
preamble.
    Therefore, the agencies are not including the supervisory mapping 
function in the final rule. However, the agencies continue to believe 
that the function (and associated estimation of the long-run default-
weighted average economic loss rate given default within a one-year 
horizon) is one way a bank could address difficulties in estimating 
LGD. However it chooses to estimate LGD, a bank's estimates of LGD must 
be reliable and sufficiently reflective of economic downturn 
conditions, and the bank should have rigorous and well-documented 
policies and procedures for identifying economic downturn conditions 
for each exposure subcategory, identifying changes in material adverse 
relationships between the relevant drivers of default rates and loss 
rates given default, and incorporating identified relationships into 
LGD estimates.
Pre-Default Reductions in Exposure
    The proposed rule incorporated 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 LGD when banks 
can quantify their effectiveness in a reliable manner. In the proposed 
rule, this was achieved by measuring LGD relative to the exposure's EAD 
(defined in the next section) as opposed to the amount actually owed at 
default.\32\
---------------------------------------------------------------------------

    \32\ 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 percent) would exceed the economic loss rate measured 
relative to EAD (48 percent = .60 x ($100 -$20)/$100), because the 
former does not reflect fully the impact of the pre-default 
paydowns.
---------------------------------------------------------------------------

    Commenters agreed that the IRB approach should allow banks to 
recognize in their risk parameters the benefits of expected pre-default 
recoveries and other expected reductions in exposure prior to default. 
Some commenters suggested, however, that it is more appropriate to 
reflect pre-default recoveries in EAD rather than LGD. Other commenters 
supported the proposed rule's approach or asserted that banks should 
have the option of incorporating pre-default recoveries in either LGD 
or EAD. Commenters discouraged the agencies from restricting the types 
of pre-default

[[Page 69311]]

reductions in exposure that could be recognized, and generally 
contended that the reductions should be recognized for all exposures 
for which a pattern of pre-default reductions can be estimated reliably 
and accurately by the bank.
    Consistent with the New Accord, the agencies have decided to 
maintain the proposed treatment of pre-default reductions in exposure 
in the final rule. The final rule does not limit the exposure types to 
which a bank may apply this treatment. However, the agencies have 
clarified their requirement for quantification of LGD in section 
22(c)(4) of the final rule. This section states that where the bank's 
quantification of LGD directly or indirectly incorporates estimates of 
the effectiveness of its credit risk management practices in reducing 
its exposure to troubled obligors prior to default, the bank must 
support such estimates with empirical analysis showing that the 
estimates are consistent with its historical experience in dealing with 
such exposures during economic downturn conditions.
    A bank's methods for reflecting changes in exposure during the 
period prior to default must be consistent with other aspects of the 
final rule. For example, a bank must use a default horizon no longer 
than one year, consistent with the one-year default horizon 
incorporated in other aspects of the final rule, such as the 
quantification of PD. In addition, a pre-default reduction in the 
outstanding amount on one exposure that does not reflect a reduction in 
the bank's total exposure to the obligor, such as a refinancing, should 
not be reflected as a pre-default recovery for LGD quantification 
purposes.
    The following simplified example illustrates how a bank could 
approach incorporating pre-default reductions in exposure in LGD. 
Assume a bank has a portfolio of asset-based loans fully collateralized 
by receivables. The bank maintains a database of such loans that have 
defaulted, which records the exposure at the time of default and the 
losses incurred at and after the date of default. After careful 
analysis of its historical data, the bank finds that for every $100 of 
exposure on a typical asset-based loan at the time of default, properly 
discounted average losses are $80 under economic downturn conditions. 
Thus, the bank may assign an LGD estimate of 80 percent that is based 
on such evidence.
    However, assume that the bank division responsible for collections 
reports that the bank's loan workout practices generally result in 
exposures on the asset-based loans being significantly reduced between 
the time the loan is identified internally as a problem exposure and 
the time when the obligor is in default for risk-based capital 
purposes. The bank studies the pre-default paydown behavior of obligors 
that default within the next one-year horizon and during economic 
downturn conditions. In particular, the bank uses its internal 
historical data to map exposure amounts for asset-based loans at the 
time of default to exposure amounts for the same loans at various 
points in time prior to default and confirms that the pattern of pre-
default paydowns corresponds to reductions in the bank's overall 
exposures to the obligors, as opposed to refinancings.
    Robust empirical analysis further indicates that pre-default 
paydowns for asset-based loans to obligors that default within the next 
one-year horizon during economic downturn conditions depend on the 
length of time the loan has been subject to workout. Specifically, the 
bank finds that the prospects for further pre-default paydowns diminish 
markedly the longer the bank has managed the loan as a problem credit 
exposure. For loans that are not in workout or that the bank has placed 
in workout for fewer than 90 days, the bank's analysis indicates that 
pre-default paydowns on loans to obligors defaulting within the next 
year during economic downturn conditions were, on average, 50 percent 
of the current amount owed by the obligor. In contrast, for asset-based 
loans that have been in workout for at least 90 days, the bank's 
analysis indicates that any further pre-default recoveries tend to be 
immaterial. Thus, provided this analysis is suitable for estimating 
LGDs according to section 22(c) of the final rule, the bank may 
appropriately assign an LGD estimate of 40 percent to asset-based loans 
that are not in workout or that have been in workout for fewer than 90 
days. For asset-based loans that have been in workout for at least 90 
days, the bank should assign an LGD of 80 percent.
Exposure at Default (EAD)
    Under the proposed rule, EAD for the on-balance sheet component of 
a wholesale or retail exposure generally was (i) the bank's carrying 
value for the exposure (including net accrued but unpaid interest and 
fees) \33\ less any allocated transfer risk reserve for the exposure, 
if the exposure was classified as 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 was classified as 
available-for-sale.
---------------------------------------------------------------------------

    \33\ ``Net accrued but unpaid interest and fees'' are accrued 
but unpaid interest and fees net of any amount expensed by the bank 
as uncollectable.
---------------------------------------------------------------------------

    One commenter asserted that banks should not be required to include 
net accrued but unpaid interest and fees in EAD. Rather, this commenter 
requested the flexibility to incorporate such interest and fees in 
either EAD or LGD. The agencies believe that net accrued but unpaid 
interest and fees represent credit exposure to an obligor, similar to 
the unpaid principal of a loan extended to the obligor, and thus are 
most appropriately included in EAD. Moreover, requiring all banks to 
include such interest and fees in EAD rather than LGD promotes 
consistency and comparability across banks for regulatory reporting and 
public disclosure purposes.
    The agencies are therefore maintaining the substance of the 
proposed rule's definition of EAD for on-balance sheet exposures in the 
final rule. The final rule clarifies that, for purposes of EAD, all 
exposures other than securities classified as available-for sale 
receive the treatment specified for exposures classified as held-to-
maturity or for trading under the proposal. Some exposures held at fair 
value, such as partially funded loan commitments, may have both on-
balance sheet and off-balance sheet components. In such cases, a bank 
must compute EAD for both the positive on- and off-balance sheet 
components of the exposure.
    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 under the proposed rule was 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 were likely to occur over the 
remaining life of the exposure assuming the exposure were to go into 
default. This estimate of net additions would reflect what would be 
expected during a period of economic downturn conditions. This 
treatment is retained in the final rule. Also, consistent with the New 
Accord, the final rule extends this ``own estimates'' treatment to 
trade-related letters of credit and for transaction-related 
contingencies. Trade-related letters of credit are short-term self-
liquidating instruments used to finance the movement of goods and are

[[Page 69312]]

collateralized by the underlying goods. A transaction-related 
contingency includes such items as a performance bond or performance-
based standby letter of credit.
    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 was the notional amount of the exposure. This treatment is 
retained in the final rule.
    One commenter asked the agencies to permit banks to employ the New 
Accord's flexibility to reflect additional draws on lines of credit in 
either LGD or EAD. For the same reasons that the agencies are requiring 
banks to include net accrued but unpaid interest and fees in EAD, the 
agencies have decided to continue the requirement in the final rule for 
banks to reflect estimates of additional draws in EAD, consistent with 
the proposed rule.
    Another commenter noted that the ``remaining life of the exposure'' 
concept in the proposed definition of EAD for off-balance sheet 
exposures is ambiguous and inconsistent with defining PD over a one-
year horizon. To address this commenter's concern, the agencies have 
modified the definition of EAD. The final rule requires a bank to 
estimate net additions to the outstanding amount owed the bank in the 
event of default over a one-year horizon.
    Other commenters noted that banks may reduce their exposure to 
certain sectors in periods of economic downturn, and inquired as to the 
extent to which such practices may be reflected in EAD estimates. The 
agencies believe that such practices may be reflected in EAD estimates 
for loan commitments, lines of credit, trade-related letters of credit, 
and transaction-related contingencies to the extent that those 
practices are reflected in the bank's data on defaulted exposures. They 
may be reflected in EAD estimates for on-balance sheet exposures only 
at the time the on-balance sheet exposure is actually reduced.
    To illustrate the EAD concept, assume a bank has a $100 unsecured, 
fully drawn, two-year term loan with $10 of interest payable at the end 
of the first year and a balloon payment of $110 at the end of the term. 
Suppose it has been six months since the loan's origination, and 
accrued interest equals $5. The EAD of this loan would be equal to the 
outstanding principal amount plus accrued interest, or $105.
    Next, consider the case of an open-end revolving credit line of 
$100, on which the borrower had drawn $70 (the unused portion of the 
line is $30). Current accrued but unpaid interest and fees are zero. 
The bank can document that, on average, during economic downturn 
conditions, 20 percent of the remaining undrawn amounts are drawn in 
the year preceding a firm's default. Therefore, the bank's estimate of 
future draws is $6 (20% x $30). Additionally, the bank's analysis 
indicates that, on average, during economic downturn conditions, such a 
facility can be expected to have accrued at the time of default unpaid 
interest and commitment fees equal to three months of interest against 
the drawn amount and 0.5 percent against the undrawn amount, which in 
this example is assumed to equal $0.25. Thus, the EAD for estimated 
future accrued but unpaid interest and fees equals $0.25. In sum, the 
EAD should be the drawn amount plus estimated future accrued but unpaid 
fees plus the estimated amount of future draws = $76.25 ($70 + $0.25 + 
$6).
    Under the proposed rule, EAD for a segment of retail exposures was 
the sum of the EADs for each individual exposure in the segment. The 
agencies have changed this provision in the final rule, recognizing 
that banks typically estimate EAD for a segment of retail exposures 
rather than on an individual exposure basis.
    Under the final and proposed rules, 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 revolving 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 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 final rule (like the proposed rule) contains a separate 
treatment of EAD for OTC derivative contracts, which is in section 32 
of the rule and discussed in more detail in section V.C. of the 
preamble. The final rule also clarifies that a bank may use the 
treatment of EAD in section 32 of the rule for repo-style transactions 
and eligible margin loans, or the bank may use the general definition 
of EAD described in this section for such exposures.
General Quantification Principles
    The final rule, like 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 five years of default data to estimate PD, seven years of 
loss severity data to estimate LGD, and seven years of exposure amount 
data to estimate EAD. For segments of retail exposures, estimation of 
risk parameters must be based on a minimum of five years of default 
data to estimate PD, five years of loss severity data to estimate LGD, 
and five 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, LGD, and EAD on the final 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 are 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 
regarding such exposures. External data refers to information on 
exposures held outside of the bank's portfolio or aggregate information 
across an industry. For new lines of business, where a bank lacks 
sufficient internal data, a bank likely will need to use external data 
to supplement its internal data.
    The agencies recognize that the minimum sample period for reference 
data provided in the final 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 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 size should be weighed against the 
potential for diminished

[[Page 69313]]

comparability of older data to the existing portfolio.
Portfolios With Limited Data or Limited Defaults
    Many commenters requested further clarity about the procedures that 
banks should use to estimate risk parameters for portfolios 
characterized by a lack of internal data or with very little default 
experience. In particular, the GAO report recommended that the agencies 
provide additional clarity on this issue. Several commenters indicated 
that the agencies should establish criteria for identifying homogeneous 
portfolios of low-risk exposures and allow banks to apportion expected 
loss between LGD and PD for those portfolios rather than estimating 
each risk parameter separately. Other commenters suggested that the 
agencies consider whether banks should be permitted to use the New 
Accord's standardized approach for credit risk for such portfolios.
    The final rule requires banks to meet the qualification 
requirements in section 22 for all portfolios of exposures. The 
agencies expect that banks demonstrating appropriately rigorous 
processes and sufficient degrees of conservatism for portfolios with 
limited data or limited defaults will be able to meet the qualification 
requirements. Section 22(c)(3) of the final rule specifically states 
that a bank's risk parameter quantification process ``must produce 
appropriately conservative risk parameter estimates where the bank has 
limited relevant data.'' The agencies believe that this section 
provides sufficient flexibility and incentives for banks to develop and 
document sound practices for applying the IRB approach to portfolios 
lacking sufficient data.
    The section of the preamble below expands upon potential approaches 
to portfolios with limited data. The BCBS publication ``Validation of 
low-default portfolios in the Basel II Framework'' \34\ also provides a 
resource for banks facing this issue. The agencies will work with banks 
through the supervisory and examination processes to address particular 
situations.
---------------------------------------------------------------------------

    \34\ BCBS, Basel Committee Newsletter No. 6, ``Validation of 
low-default portfolios in the Base II Framework,'' September 2005.
---------------------------------------------------------------------------

    Portfolios with limited data. The final rule, like the proposal, 
permits the use of external data in quantification of risk parameters. 
External data should be informative of, and appropriate to, a bank's 
existing exposures. In some cases, a bank may be able to acquire and 
use external data from a third party to estimate risk parameters until 
the bank's internal database meets the requirements of the rule. 
Alternatively, a bank may be able to identify a set of data-rich 
internal exposures that could be used to inform the estimation of risk 
parameters for the portfolio for which it has insufficient data. The 
key considerations for a bank in determining whether to use alternative 
data sources will be whether such data are sufficiently accurate, 
complete, representative and informative of the bank's existing 
exposures and whether the bank's quantification of risk parameters is 
rigorously conducted and well documented.
    For instance, consider a bank that has recently extended its credit 
card operations to include a new market segment for credit card loans 
and, therefore, has limited internal data on the performance of the 
exposures in this new market segment. The bank could acquire external 
data from various vendors that would provide a broad, market-wide 
picture of default and loss experience in the new market segment. This 
external data could then be supplemented by the bank's internal data 
and experience with its existing credit card operations. By comparing 
the bank's experience with its existing customers to the market data, 
the bank can refine the risk parameters estimated from the external 
data on the new market segment and make those parameters more accurate 
for the bank's new market segment of exposures. Using the combination 
of these data sources, the bank may be able to estimate appropriately 
conservative estimates of risk parameters for its new market segment of 
exposures. If the bank is not able to do so, it must include the new 
market segment of exposures in its set of aggregate immaterial 
exposures and apply a 100 percent risk weight.
    Portfolios with limited defaults. Commenters indicated that they 
had experienced very few defaults for some portfolios, most notably 
margin loans and exposures to some sovereign issuers, which made it 
difficult to separately estimate PD and LGD. The agencies recognize 
that some portfolios have experienced very few defaults and have very 
low loss experiences. The absence of defaults or losses in historical 
data does not, however, preclude the potential for defaults or large 
losses to arise in future circumstances. Moreover, as discussed 
previously, the ability to separate EL into PD and LGD is a key 
component of the IRB approach.
    As with the cases described above in which internal data are 
limited in all dimensions, external data from some related portfolios 
or for similar obligors may be used to estimate risk parameters that 
are then mapped to the low default portfolio or obligor. For example, 
banks could consider instances of near default or credit deterioration 
short of default in these low default portfolios to inform estimates of 
what might happen if a default were to occur. Similarly, scenario 
analysis that evaluates the hypothetical impact of severe market 
disruptions may help inform the bank's parameter estimates for margin 
loans. For very low-risk wholesale obligors that have publicly traded 
financial instruments, banks may be able to glean information about the 
relative values of PD and LGD from different changes in credit spreads 
on instruments of different maturity or from different moves in credit 
spreads and equity prices. In all cases, risk parameter estimates 
should incorporate a degree of conservatism that is appropriate for the 
overall rigor of the quantification process.
    Other quantification process considerations. 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, 
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, LGD, and EAD estimates, and the 
consistency of reference data to the definition of default in the final 
rule. Furthermore, a bank must have adequate internal or external data 
to estimate the risk parameters PD, LGD, and EAD (each of which 
incorporates a one-year time horizon) for all wholesale exposure and 
retail segments, including those originated for sale or that are in the 
securitization pipeline.
    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

[[Page 69314]]

conditions, such that exclusion of such periods would bias 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. 
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. A bank is not required to add a 
margin of conservatism at each step if doing so would 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 limitations on 
available reference data or because of inherent differences between the 
reference data and the bank's existing exposures. The bank's risk 
parameter quantification process must produce appropriately 
conservative risk parameter estimates when 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. This 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 materially lower risk parameter estimates may be evidence of 
systematic bias, which is not 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 U.S. government has a legally binding 
commitment to provide.
4. Optional Approaches That Require Prior Supervisory Approval
    A bank that intends to apply the internal models methodology to 
counterparty credit risk, the double default treatment for credit risk 
mitigation, the IAA for securitization exposures to ABCP programs, or 
the IMA to equity exposures must receive prior written approval from 
its primary Federal supervisor. The criteria on which approval will 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 final rule. A bank 
must have an operational risk management function that is independent 
of 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 should be clearly documented. The operational risk 
management function should have an 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. This process must capture 
business environment and internal control factors affecting the bank's 
operational risk profile. 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 final rule defines an operational loss event as an event that 
results in loss and is associated with any of the seven operational 
loss event type categories. Under the final rule, the agencies have 
included definitions of the seven operational loss event type 
categories, consistent with the descriptions outlined in the New 
Accord. The seven operational loss event type categories are: (i) 
Internal fraud, which is the operational loss event type category that 
comprises operational losses resulting from an act involving at least 
one internal party of a type intended to defraud, misappropriate 
property or circumvent regulations, the law or company policy, 
excluding diversity and discrimination-type events; (ii) external 
fraud, which is the operational loss event type category that comprises 
operational losses resulting from an act by a third party of a type 
intended to defraud, misappropriate property or circumvent the law; 
\35\ (iii) employment practices and workplace safety, which is the 
operational loss event type category that comprises operational losses 
resulting from an act inconsistent with employment, health, or safety 
laws or agreements, payment of personal injury claims, or payment 
arising from diversity or discrimination events; (iv) clients, 
products, and business practices, which is the operational loss event 
type category that comprises operational losses resulting from the 
nature or design of a product or from an unintentional or negligent 
failure to meet a professional obligation to specific clients 
(including fiduciary and suitability requirements); (v) damage to 
physical assets, which is the operational loss event type category that 
comprises operational losses resulting from the loss of or damage to 
physical assets from natural disaster or other events; (vi) business 
disruption and system failures, which is the operational loss event 
type category that comprises operational losses resulting from 
disruption of business or system failures; and (vii) execution, 
delivery, and process management, which is the operational loss event 
type category that comprises operational losses resulting from failed 
transaction processing or process management or losses arising from

[[Page 69315]]

relations with trade counterparties and vendors.
---------------------------------------------------------------------------

    \35\ 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.
---------------------------------------------------------------------------

    The final rule does not require a bank to capture internal 
operational loss event data according to these categories. However, 
unlike the proposed rule, the final rule requires that a bank must be 
able to map such data into the seven operational loss event type 
categories. The agencies believe such mapping will promote reporting 
consistency and comparability across banks and is consistent with 
expectations in the New Accord.\36\
---------------------------------------------------------------------------

    \36\ New Accord, ] 673.
---------------------------------------------------------------------------

    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 should have 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 defined operational loss as a loss (excluding 
insurance or tax effects) resulting from an operational loss event. 
Operational losses included 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, 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.
    Many commenters supported the agencies' proposed definition of 
operational loss and viewed it as appropriate and consistent with 
general use within the banking industry. Some commenters, however, 
opposed the inclusion of a specific definition of operational loss and 
asserted that the proposed treatment of operational loss is too 
prescriptive. In addition, some commenters maintained that including a 
definition of operational loss is inconsistent with the New Accord, 
which does not explicitly define operational loss. In response to a 
specific question in the proposal, many commenters asserted that the 
definition of operational loss should relate to its impact on 
regulatory capital rather than economic capital concepts. One 
commenter, however, recommended using the replacement cost of any fixed 
asset affected by an operational loss event to reflect the actual 
financial impact of the event.
    Because operational losses are the building blocks in a bank's 
calculation of its operational risk capital requirement under the AMA, 
the agencies continue to believe that it is necessary to define what is 
meant by operational loss to achieve comparability and foster 
consistency both across banks and across business lines within a bank. 
Additionally, the agencies agree with those commenters who asserted 
that the definition of operational loss should relate to its impact on 
regulatory capital. Therefore, the agencies have adopted the proposed 
definition of operational loss unchanged.
    In the preamble to the proposed rule, the agencies recognized that 
there was a potential to double-count all or a portion of the risk-
based capital requirement associated with fixed assets. Under the 
proposed rule, the credit-risk-weighted asset amount for a bank's 
premises would equal the carrying value of the premises on the 
financial statements of the bank, determined in accordance with GAAP. A 
bank's operational risk exposure estimate addressing bank premises 
generally would be different than, and in addition to, the risk-based 
capital requirement generated under the proposed rule and could, at 
least in part, address the same risk exposure. The majority of 
commenters on this issue recommended removing the credit risk capital 
requirement for premises and other fixed assets and preserving only the 
operational risk capital requirement.
    The agencies are maintaining the proposed rule's treatment of fixed 
assets in the final rule. The New Accord generally provides a risk 
weight of 100 percent for assets for which an IRB treatment is not 
specified.\37\ Consistent with the New Accord, the final rule provides 
that the risk-weighted asset amount for any on-balance sheet asset that 
does not meet the definition of a wholesale, retail, securitization, or 
equity exposure is equal to the carrying value of the asset. Also 
consistent with the New Accord, the final rule continues to include 
damage to physical assets among the operational loss event types 
incorporated into a bank's operational risk exposure estimate.\38\ The 
agencies believe that requiring a bank to calculate both a credit risk 
and operational risk capital requirement for premises and fixed assets 
is justified in light of the fact that the credit risk capital 
requirement covers a broader set of risks, whereas the operational risk 
capital requirement covers potential physical damage to the asset. The 
agencies view this treatment of premises and other fixed assets as 
consistent with the New Accord and have confirmed that the approach is 
consistent with the approaches used by other jurisdictions implementing 
the New Accord.
---------------------------------------------------------------------------

    \37\ New Accord, ] 214.
    \38\ New Accord, Annex 9.
---------------------------------------------------------------------------

    A bank must have a systematic process for capturing and using 
internal operational loss event data in its operational risk data and 
assessment systems. The final rule defines a bank's internal 
operational loss event data as its gross operational loss amounts, 
dates, recoveries, and relevant causal information for operational loss 
events occurring at the bank. Under the proposed rule, a bank's 
operational risk data and assessment system would include a minimum 
historical observation period of five years of internal operational 
losses. With approval of its primary Federal supervisor, however, a 
bank could use a shorter historical observation period to address 
transitional situations such as integrating a new business line. A bank 
also could refrain from collecting internal operational loss event data 
for individual operational losses below established dollar threshold 
amounts if the bank could demonstrate to the satisfaction of its 
primary Federal supervisor that the thresholds were reasonable, did not 
exclude important internal operational loss event data, and permitted 
the bank to capture substantially all the dollar value of the bank's 
operational losses.

[[Page 69316]]

    Several commenters expressed concern over the proposal's five-year 
minimum historical observation period requirement for internal 
operational loss event data. These commenters recommended that the 
agencies align this provision with the New Accord, which allows for a 
three-year historical observation period upon initial AMA 
implementation.
    While the proposed rule required a bank to include in its 
operational risk data and assessment systems a historical observation 
period of at least five years for internal operational loss event data, 
it also provided for a shorter observation period subject to agency 
approval to address transitional situations, such as integrating a new 
business line. The agencies believe that these proposed provisions 
provide sufficient flexibility to consider other situations, on a case-
by-case basis, in which a shorter observation period may be 
appropriate, such as a bank's initial implementation of an AMA. 
Therefore, the final rule retains the five-year historical observation 
period requirements and the transitional flexibility for internal 
operational loss event data, as proposed.
    In relation to the provision that permits a bank to refrain from 
collecting internal operational loss event data below established 
thresholds, a few commenters sought clarification of the proposed 
requirement that the thresholds must permit the bank to capture 
``substantially all'' of the dollar value of a bank's operational 
losses. In particular, they questioned whether a bank must collect all 
or a very high percentage of operational losses or whether smaller 
losses could be modeled.
    To demonstrate the appropriateness of its threshold for internal 
operational loss event data collection, a bank might choose to collect 
all internal operational loss event data, at least for a time, to 
support a meaningful analysis around the appropriateness of its chosen 
data collection threshold. Alternatively, a bank might be able to 
obtain data from systems outside of its operational risk data and 
assessment system (for example, the bank's general ledger system) to 
demonstrate the impact of choosing different thresholds on its 
operational risk exposure estimates.
    With respect to the commenters' question regarding modeling smaller 
losses, the agencies would consider permitting such an approach based 
on whether the approach meets the overall qualification requirements 
outlined in the final rule. In particular, the agencies would consider 
whether the bank satisfies those requirements pertaining to a bank's 
operational risk quantification system as well as its control, 
oversight, and validation mechanisms. Such modeling considerations, 
however, would not eliminate the requirement for a bank to demonstrate 
the appropriateness of any established internal operational loss event 
data collection thresholds.
    A bank also must establish a systematic process to determine its 
methodologies for incorporating external operational loss event data 
into its operational risk data and assessment systems. The proposed and 
final rules define 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 into its operational risk 
data and assessment systems. Accordingly, under the final rule, as 
under the proposed rule, a bank must incorporate business environment 
and internal control factors into its operational risk data and 
assessment systems to assess fully 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 and comprehensive across 
the bank, and they 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.
    A few commenters sought clarification on the agencies' expectations 
regarding a bank's periodic comparisons of its prior business 
environment and internal control factor assessments against its actual 
operational losses. One commenter expressed concern over the difficulty 
of conducting an empirically robust analysis to fulfill the 
requirement.
    Under the final rule, a bank has flexibility in the approach it 
uses to conduct its business environment and internal control factor 
assessments. As such, the methods for conducting comparisons of these 
assessments against actual operational loss experience may also vary 
and precise modeling calibration may not be practical. The agencies 
maintain, however, that it is important for a bank to perform such 
comparisons to ensure that its assessments are current, reasonable, and 
appropriately factored into the bank's AMA framework. In addition, the 
comparisons could highlight the need for potential adjustments to the 
bank's operational risk management processes.
    A bank also must have 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 operational 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.
    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 into its operational risk 
data and assessment systems. Under the proposed rule, scenario analysis 
was defined as 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. The agencies have clarified this 
definition in the final rule to recognize that there are various 
methods and inputs a bank may use to conduct its scenario analysis. For 
this reason, the modified definition indicates that scenario analysis 
may

[[Page 69317]]

include the well-reasoned evaluation and use of external operational 
loss event data, adjusted as appropriate to ensure relevance to a 
bank's operational risk profile and control structure.
    A bank's operational risk data and assessment systems must include 
credible, transparent, systematic, and verifiable processes that 
incorporate all four operational risk elements (that is, internal 
operational loss event data, external operational loss event data, 
scenario analysis, and business environment and internal control 
factors). 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 
generates estimates of its operational risk exposure using its 
operational risk data and assessment systems. The final 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 final 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.
    A few commenters sought clarification on whether the agencies would 
impose specific requirements around the use and weighting of the four 
elements of a bank's operational risk data and assessment system, and 
whether there were any limitations on how external data or scenario 
analysis could be used as modeling inputs. Another commenter expressed 
concern that for some U.S.-chartered DIs that were subsidiaries of 
foreign banking organizations, it might be difficult to ever have 
enough internal operational loss event data to generate statistically 
significant operational risk exposure estimates.
    The agencies recognize that banks will have different inputs and 
methodologies for estimating their operational risk exposure given the 
inherent flexibility of the AMA. It follows that the weights assigned 
in combining the four required elements of a bank's operational risk 
data and assessment system (internal operational loss event data, 
external operational loss event data, scenario analysis, and 
assessments of the bank's business environment and internal control 
factors) will also vary across banks. Factors affecting the weighting 
include a bank's operational risk profile, operational loss experience, 
internal control environment, and relative quality and content of the 
four elements. These factors will influence the emphasis placed on 
certain elements relative to others. As such, the agencies are not 
prescribing specific requirements around the weighting of each element, 
nor are they placing any specific limitations on the use of the 
elements. In view of this flexibility, however, under the final rule a 
bank's operational risk quantification systems must include a credible, 
transparent, systematic, and verifiable approach for weighting the use 
of the four elements.
    As part of its operational risk exposure estimate, a bank must use 
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. The proposed rule defined 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 generated a separate 
distribution of potential operational losses. Under the proposed rule, 
a bank could not combine business activities or operational loss events 
with different risk profiles within the same loss distribution.
    Many commenters expressed concern that the prohibition against 
combining business activities or operational loss events with different 
risk profiles within the same loss distribution was an impractical 
standard because some level of combination was unavoidable. 
Additionally, commenters noted that data limitations made it difficult 
to quantify risk profiles at a granular level. Commenters also 
expressed concern that the proposed rule appeared to preclude the use 
of ``top-down'' approaches, given that under a firm-wide approach 
business activities or operational loss events with different risk 
profiles would necessarily be combined within the same loss 
distribution. One commenter suggested that, because of data limitations 
and the potential for wide variations in risk profiles within 
individual business lines and/or types of operational loss events, 
banks be afforded some latitude in moving from a ``top-down'' approach 
to a ``bottom-up'' approach.
    The agencies have retained the proposed definition of unit of 
measure in the final rule. The agencies recognize, however, that there 
is a need for flexibility in assessing whether a bank's chosen 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. In some 
instances, data limitations may indeed prevent a bank's operational 
risk quantification systems from generating a separate distribution of 
potential operational losses for certain business lines or operational 
loss event types. Therefore, the agencies have modified the final rule 
to provide a bank more flexibility in devising an appropriate unit of 
measure. Specifically, a bank must employ a unit of measure that is 
appropriate for its 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 
demonstrably 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. Under the final 
rule, as under the proposed rule, 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, 
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, the bank must sum operational 
risk exposure estimates across units of measure to calculate its total 
operational risk exposure.
    Under the proposed rule, dependence was defined as ``a measure of 
the association among operational losses across and within business 
lines and operational loss event types.'' One commenter recommended 
that the agencies revise the definition of dependence to ``a measure of 
the association among operational losses across and within units of 
measure.'' The agencies recognize that examples of units of measure 
include, but are not limited to, business lines and operational loss 
event types, and that a bank's operational risk quantification system 
could generate distributions of potential operational losses that are

[[Page 69318]]

separate from its business lines and operational loss event types. 
Units of measure can also encompass correlations over time. Therefore, 
the agencies have amended the final rule to define dependence as a 
measure of the association among operational losses across and within 
units of measure.
    As noted above, under the proposed rule, a bank that did not 
satisfy the requirements surrounding dependence would sum operational 
risk exposure estimates across units of measure to calculate its total 
operational risk exposure. Several commenters asserted that the New 
Accord does not require a bank to sum its operational risk exposure 
estimates across units of measure if the bank cannot demonstrate 
adequate support of its dependence assumptions. One commenter asked the 
agencies to remove this requirement from the final rule. Several 
commenters suggested that if a bank cannot provide sufficient support 
for its dependence estimates, a conservative assumption of positive 
dependence is warranted, but not an assumption of perfect positive 
dependence as implied by the summation requirement. Another commenter 
suggested that the dependence assumption should be based upon a 
conservative statistical analysis of industry data.
    The New Accord states that, absent a satisfactory demonstration of 
a bank's ``systems for determining correlations'' to its national 
supervisor, ``risk measures for different operational risk estimates 
must be added for purposes of calculating the regulatory minimum 
capital requirement.'' \39\ The agencies continue to believe that this 
treatment of operational risk exposure estimates across units of 
measure is prudent until the relationships among operational losses are 
better understood. Therefore, the final rule retains the proposed 
rule's requirement regarding the summation of operational risk exposure 
estimates.
---------------------------------------------------------------------------

    \39\ New Accord, ]669.
---------------------------------------------------------------------------

    Several commenters believed that a bank should be permitted to 
demonstrate the nature of the relationship between the causes of 
different operational losses based on any available informative 
empirical evidence. These commenters suggested that such evidence could 
be statistical or anecdotal, and could be based on information ranging 
from established statistical techniques to more general mathematical 
approaches to clear logical arguments about the degree to which risks 
and losses are related, or the similarity of circumstance between the 
bank and a peer group for which acceptable estimates of dependency are 
available.
    The agencies recognize that there may be different ways to estimate 
the relationship among operational losses across and within units of 
measure. Therefore, under the final rule, a bank has flexibility to use 
different methodologies to demonstrate dependence across units of 
measure. However, the bank must demonstrate to the satisfaction of its 
primary Federal supervisor that its process for estimating dependence 
is sound, robust to a variety of scenarios, implemented with integrity, 
and allows for the uncertainty surrounding the estimates.
    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 measure increases 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).
    Under the final rule, as under the proposed rule, 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.
    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, under the proposed 
rule, a bank could use an alternative operational risk quantification 
system, subject to prior approval by the bank's primary Federal 
supervisor. The alternative approach was not available at the BHC 
level.
    One commenter asserted that, in line with the New Accord's 
continuum of operational risk measurement approaches, all banks, 
including BHCs, should be permitted to adopt an alternative operational 
risk quantification system, such as the New Accord's standardized 
approach or allocation approach. The commenter further noted that a 
bank's use of an allocation approach should not be subject to more 
stringent terms and conditions than those set forth in the New Accord.
    The agencies are maintaining the alternative approach provision in 
the final rule. 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 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 estimate of 
operational risk under the alternative approach is appropriate (for 
example, whether the estimate results in capital levels that are 
commensurate with the bank's operational risk profile and is sensitive 
to changes in the bank's risk profile) and can be supported 
empirically. Furthermore, the agencies expect a bank using an 
alternative operational risk quantification system to adhere to the 
rule's qualification requirements, including establishment and use of 
operational risk management processes and data and assessment systems. 
As under the proposed rule, the alternative approach is not available 
at the BHC level.
    A bank proposing an alternative approach to operational risk based 
on an allocation methodology should be aware of certain limitations 
associated with the use of such an approach. Specifically, the agencies 
will not permit a DI to accept an allocation of operational risk 
capital requirements that includes non-DIs. 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. \40\ 
Furthermore, depositors and creditors of a DI generally have no legal 
recourse to

[[Page 69319]]

capital funds that are not held by the DI or its affiliate DIs.
---------------------------------------------------------------------------

    \40\ 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, the double default excessive correlation detection 
process, the IMA for equity exposures, and the IAA for securitization 
exposures to ABCP programs (collectively, advanced systems).
    The bank's data management and maintenance systems must adequately 
support the timely and accurate reporting of risk-based capital 
requirements. Specifically, a bank must retain sufficient data elements 
related to key risk drivers to permit monitoring, validation, and 
refinement of the bank's advanced systems. A bank's data management and 
maintenance systems should generally support the 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 are 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 retain data in an electronic format that allows timely retrieval 
for analysis, reporting, and disclosure purposes. The agencies did not 
receive any material comments on these data management requirements.
7. Control and Oversight Mechanisms
    The consequences of an inaccurate or unreliable advanced system can 
be significant, particularly regarding the calculation of risk-based 
capital requirements. Accordingly, bank senior management is 
responsible for ensuring that all advanced systems function effectively 
and comply with the qualification requirements.
    Under the proposed rule, a bank's board of directors (or a 
designated committee of the board) would at least annually evaluate the 
effectiveness of, and approve, the bank's advanced systems. Multiple 
commenters objected to this requirement. Commenters suggested that a 
bank's board of directors should have more narrowly defined 
responsibilities, and that evaluation of a bank's advanced systems 
would be more effectively and appropriately accomplished by senior 
management.
    The agencies believe that a bank's board of directors has ultimate 
accountability for the effectiveness of the bank's advanced systems. 
However, the agencies agree that it is not necessarily the 
responsibility of a bank's board of directors to conduct an evaluation 
of the effectiveness of a bank's advanced systems. Evaluation may 
include transaction testing, validation, and audit activities more 
appropriately the responsibility of senior management. Accordingly, the 
final rule requires a bank's board of directors to review the 
effectiveness of, and approve, the bank's advanced systems at least 
annually.
    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; maintains the integrity, reliability, and 
accuracy of the bank's advanced systems; and includes adequate 
corporate governance and project management processes. Banks have 
flexibility to determine how to achieve integrity in their risk 
management systems. Banks are, however, 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 systems; (ii) ongoing monitoring that 
includes process verification and comparison of the bank's internal 
estimates with relevant internal and external data sources or results 
from other estimation techniques (benchmarking); and (iii) outcomes 
analysis that includes back-testing.
    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 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 evidence an understanding of the 
systems' limitations. The development of internal risk rating and 
segmentation systems and their quantification processes requires banks 
to exercise 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.

[[Page 69320]]

    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, as well as ensuring that: Internal risk rating 
and segmentation systems are being used, monitored, and updated as 
designed; ratings are assigned to wholesale obligors and exposures as 
intended; and appropriate remediation is undertaken if deficiencies 
exist.
    Benchmarking means the comparison of a bank's internal estimates 
with relevant internal and external data or with estimates based on 
other estimation techniques. Banks are required to use alternative data 
sources or risk assessment approaches to draw inferences about the 
validity of their internal risk ratings, segmentations, risk parameter 
estimates, and model outputs on an ongoing basis. 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 may take considerable time 
before outcomes with which to conduct sufficiently robust backtesting 
are available, benchmarking will be a very important validation device. 
Benchmarking applies 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. Differences observed 
between the bank's risk estimates and the benchmark do 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 rule requires a bank to do as part 
of the advanced approaches validation process.
    Actual outcomes should be compared with expected ranges around the 
estimated values of the risk parameters and model results. Randomness 
and many other variables 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 actual outcomes 
and estimates.
    One commenter asserted that requiring a bank to perform a 
statistically robust form of backtesting would be an impractically high 
standard for AMA qualification given the nature of operational risk. 
The commenter further claimed that validating an operational risk model 
must rely on the robustness of the logical structure of the model and 
the appropriateness of the resultant operational risk exposure when 
benchmarked against other established reference points.
    The agencies recognize that it may take considerable time before 
actual outcomes outside of the sample period used in model development 
are available that would allow a bank to backtest its operational risk 
models by comparing its internal estimates with these outcomes. The 
agencies also acknowledge that a bank may be unable to backtest an 
operational risk model with the same degree of statistical precision 
that it is able to backtest an internal market risk model. When a 
bank's backtesting process is not sufficiently robust, a bank may need 
to rely more heavily on benchmarking and other alternative validation 
devices. The agencies maintain, however, that backtesting provides 
important feedback on the accuracy of model outputs and that a bank 
should be able to assess how actual losses compare with estimates 
previously generated by its model.
Internal Audit
    A 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. 
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 benefits of double default 
treatment. Stress testing analysis consists of identifying stress 
scenarios and then assessing the effects of the scenarios on key 
performance measures, including risk-based capital requirements. Under 
the 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 will increase if wholesale 
obligors or retail exposures migrate toward lower credit quality rating 
grades or segments.
    Supervisors expect banks to manage their regulatory capital 
position so that they remain at least adequately capitalized during all 
phases of the economic cycle. A bank that credibly estimates regulatory 
capital levels during a downturn can be more confident of appropriately 
managing regulatory capital.
    Banks should use a range of plausible but severe scenarios and 
methods when stress testing to manage regulatory capital. Scenarios may 
be historical, hypothetical, or model-based. Key variables specified in 
a scenario may include, for example, interest rates, transition 
matrices (ratings and score-

[[Page 69321]]

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 adequately document 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

    A bank using the advanced approaches 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 
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.
    If an agency determines that a bank that uses the advanced 
approaches to calculate its risk-based capital requirements has fallen 
out of compliance with one or more of the qualification requirements, 
the agency will notify the bank of its failure to comply. After 
receiving such notice, a bank must establish and submit a plan 
satisfactory to its primary Federal supervisor to return to compliance. 
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).
    Under the proposed rule, a bank that fell out of compliance with 
the qualification requirements would also be required to disclose 
publicly its noncompliance with the qualification requirements promptly 
after receiving notice of noncompliance from its primary Federal 
supervisor. Commenters objected to this requirement, noting that it is 
not one of the public disclosure requirements of the New Accord. The 
agencies have determined that the public disclosure of noncompliance is 
not always necessary, because the disclosure may not reflect the degree 
of noncompliance. Therefore, the agencies are not including a general 
noncompliance disclosure requirement in the final rule. However, the 
agencies acknowledge that a bank's significant noncompliance with the 
qualification requirements is an important factor in market 
participants' assessments of the bank's risk profile and, thus, a 
primary Federal supervisor may require public disclosure of 
noncompliance with the qualification requirements if such noncompliance 
is significant.

D. Merger and Acquisition Transition Provisions

    Due to the advanced approaches' rigorous systems requirements, a 
bank that merges with or acquires another company might not be able to 
quickly integrate the merged or acquired company's exposures into its 
risk-based capital calculations. The proposed rule provided transition 
provisions that would allow the acquiring bank time to integrate the 
merged or acquired company into its advanced approaches, subject to an 
implementation plan submitted to the bank's primary Federal supervisor. 
As proposed, the transition provisions applied only to banks that had 
already qualified to use the advanced approaches. The agencies 
recognize, however, that a bank in the process of qualifying to use the 
advanced approaches may merge with or acquire a company and need time 
to integrate the company into its advanced approaches on an 
implementation schedule distinct from its original implementation plan. 
In the final rule, the agencies are therefore allowing banks to take 
advantage of the proposed rule's transition provisions for mergers and 
acquisitions both before and after they qualify to use the advanced 
approaches.
    Under the proposed rule, a bank could use the transition provisions 
for the merged or acquired company's exposures for up to 24 months 
following the calendar quarter during which the merger or acquisition 
consummates. A bank's primary Federal supervisor could extend the 
transition period for up to an additional 12 months. Commenters 
generally supported this timeframe and associated supervisory 
flexibility. Therefore, the final rule adopts the proposed rule's 
merger and acquisition transition timeframe without change.
    To take advantage of the merger and acquisition transition 
provisions, the acquiring bank must submit to its primary Federal 
supervisor an implementation plan for using the advanced approaches for 
the merged or acquired company. The proposed rule required a bank to 
submit such a plan within 30 days of consummating the merger or 
acquisition. Many commenters asserted that the 30-day timeframe for 
submission of an implementation plan may be too short, particularly 
given the many integration activities that must take place immediately 
following the consummation of a merger or acquisition. These commenters 
generally suggested that banks instead be given 90 or 180 days to 
submit the implementation plan. The agencies agree with these 
commenters that the proposed timeframe for submitting an implementation 
plan may be too short. Accordingly, the final rule requires a bank to 
submit an implementation plan within 90 days of the consummation of a 
merger or acquisition.
    Under the final rule, if a bank that uses the advanced approaches 
to calculate risk-based capital requirements merges with or acquires a 
company that does not calculate risk-based capital requirements using 
the advanced approaches, the acquiring bank may use the general risk-
based capital rules to compute the risk-weighted assets and associated 
capital

[[Page 69322]]

for the merged or acquired company's exposures during the merger and 
acquisition transition timeframe. Any ALLL (net of allocated transfer 
risk reserves) 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.\41\ Such ALLL is excluded 
from the acquiring bank's eligible credit reserves. The risk-weighted 
assets of the acquired company are not included in the acquiring bank's 
credit-risk-weighted assets but are included in the acquiring bank's 
total risk-weighted assets. If the acquiring bank uses the general 
risk-based capital rules for acquired exposures, it must 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 this rule for the acquiring bank. The 
primary Federal supervisor of the bank will monitor the merger or 
acquisition to determine whether the acquiring bank's application of 
the general risk-based capital rules for the acquired company produces 
appropriate risk-based capital requirements for the assets of the 
acquired company in light of the overall risk profile of the acquiring 
bank.
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    \41\ Any amount of the acquired company's ALLL that was 
eliminated in accounting for the acquisition is not included in the 
acquiring bank's regulatory capital.
---------------------------------------------------------------------------

    Similarly, a core or opt-in bank that merges with or acquires 
another core or opt-in bank might not be able to apply its systems for 
the advanced approaches immediately to the acquired bank's exposures. 
Accordingly, the final 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 during the merger and acquisition transition timeframe.
    A third potential merger or acquisition scenario is a bank subject 
to the general risk-based capital rules that merges with or acquires a 
bank that uses the advanced approaches. If, after the merger or 
acquisition, the acquiring bank is not a core bank, it could choose to 
opt in to the advanced approaches or to apply the general risk-based 
capital rules to the consolidated bank. If the acquiring bank chooses 
to remain on the general risk-based capital rules, the bank must 
immediately apply the general risk-based capital rules to all its 
exposures, including those of the acquired bank.
    If the acquiring bank chooses or is required to move to the 
advanced approaches, however, it could apply the advanced approaches to 
the acquired exposures (provided that it continues to meet all of the 
qualification requirements for those exposures) for up to 24 months 
(with a potential 12-month extension) while it completes the process of 
qualifying to use the advanced approaches for the entire bank. If the 
acquiring bank has not begun implementing the advanced approaches at 
the time of the merger or acquisition, it may instead use the 
transition timeframes described in section III.A. of the preamble and 
section 21 of the final rule. In the latter case, the bank must consult 
with its primary Federal supervisor regarding the appropriate risk-
based capital treatment of the acquired exposures. In no case may a 
bank permanently apply the advanced approaches only to an acquired 
bank's exposures and not to the consolidated bank.
    Because eligible credit reserves and the ALLL are treated 
differently under the general risk-based capital rules and the advanced 
approaches, the final rule specifies how the acquiring bank must treat 
the general allowances associated with the merged or acquired company's 
exposures during the period when the general risk-based capital rules 
apply to the acquiring bank. Specifically, ALLL associated with the 
exposures of the merged or acquired company may not be directly 
included in the acquiring bank's tier 2 capital. Rather, any excess 
eligible credit reserves (that is, eligible credit reserves minus total 
expected credit losses) associated with the merged or acquired 
company's exposures may be included in the acquiring bank's tier 2 
capital up to 0.6 percent of the credit-risk-weighted assets associated 
with those exposures.

IV. Calculation of Tier 1 Capital and Total Qualifying Capital

    The final 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. 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 the final rule. Those capital elements generally 
remain as they are currently in the general risk-based capital 
rules.\42\ Consistent with the proposed rule, the final rule includes 
regulatory text for certain adjustments to the capital elements for 
purposes of the advanced approaches.
---------------------------------------------------------------------------

    \42\ 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, Sec.  I (state nonmember banks); and 12 CFR 567.5 
(savings associations).
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    Under the final rule, consistent with the proposal, after 
identifying the elements of tier 1 and tier 2 capital, a bank must make 
certain adjustments to determine its tier 1 capital and total 
qualifying capital (the numerator of the total risk-based capital 
ratio). Some of these adjustments are made only to the tier 1 portion 
of the capital base. Other adjustments are made 50 percent from tier 1 
capital and 50 percent from tier 2 capital.\43\ A bank must still have 
at least 50 percent of its total qualifying capital in the form of tier 
1 capital.\44\
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    \43\ 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.
    \44\ Any assets deducted from capital in computing the numerator 
of the risk-based capital ratios are also not included in risk-
weighted assets in the denominator of the ratio.
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    Under the final rule, as under the proposal, a bank must deduct 
from tier 1 capital goodwill, other intangible assets, and deferred tax 
assets to the same extent that those assets are deducted from tier 1 
capital under the general risk-based capital rules. Thus, all goodwill 
is deducted from tier 1 capital. Certain 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 do 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 do not have to be deducted from 
tier 1 capital.\45\
---------------------------------------------------------------------------

    \45\ 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, Sec.  I (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.
---------------------------------------------------------------------------

    Under the general risk-based capital rules, a bank also must deduct 
from its

[[Page 69323]]

tier 1 capital certain percentages of the adjusted carrying value of 
its nonfinancial equity investments. An advanced approaches bank is not 
required to make these deductions. Instead, the bank's equity exposures 
generally are subject to the equity treatment in part VI of the final 
rule and described in section V.F. of this preamble.\46\
---------------------------------------------------------------------------

    \46\ 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 final rule are not required to 
deduct investments in equity securities. Instead, such investments 
are subject to the equity treatment in part VI of the final rule. 
Equity investments in real estate continue to be deducted to the 
same extent as under the general risk-based capital rules.
---------------------------------------------------------------------------

    A number of commenters urged the agencies to revisit the existing 
definitions of tier 1 and tier 2 capital, including some of the 
deductions. Some offered specific suggestions, such as removing the 
requirement to deduct goodwill from tier 1 capital or revising the 
limitations on certain capital instruments that may be included in 
regulatory capital. Other commenters noted that the definition of 
regulatory capital and related deductions should be thoroughly debated 
internationally before changes are made in any one national 
jurisdiction. The agencies believe that the definition of regulatory 
capital should be as consistent as possible across national 
jurisdictions. The BCBS has formed a working group that is currently 
looking at issues related to the definition of regulatory capital. 
Accordingly, the agencies have not modified the existing definition of 
regulatory capital and related deductions at this time, other than with 
respect to implementation of the advanced approaches.
    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 are deducted from the gross amount of risk-weighted assets.
    Under the proposed rule, the ALLL was treated differently. The 
proposed rule included 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 defined eligible credit reserves 
as all general allowances, including the ALLL, established through a 
charge against earnings to absorb credit losses associated with on-or 
off-balance sheet wholesale and retail exposures. As proposed, eligible 
credit reserves did not include allocated transfer risk reserves 
established pursuant to 12 U.S.C. 3904\47\ and other specific reserves 
created against recognized losses. The final rule maintains the 
proposed definition of eligible credit reserves.
---------------------------------------------------------------------------

    \47\ 12 U.S.C. 3904 does not apply to savings associations 
regulated by the OTS. As a result, the OTS final rule does not refer 
to allocated transfer risk reserves.
---------------------------------------------------------------------------

    The proposed rule defined a bank's total ECL as the sum of ECL for 
all wholesale and retail exposures other than exposures to which the 
bank 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 was equal to the product of PD, ELGD, and EAD 
for the exposure or segment. The ECL for non-defaulted exposures thus 
reflected expected economic losses, including the cost of carry and 
direct and indirect workout expenses. The bank's ECL for a wholesale 
exposure to a defaulted obligor or a defaulted retail segment was equal 
to the bank's impairment estimate for allowance purposes for the 
exposure or segment. The ECL for defaulted exposures thus was based on 
accounting measures of credit loss incorporated into a bank's charge-
off and reserving practices.
    In the proposal, the agencies solicited comment on a possible 
alternative treatment for determining ECL for a defaulted exposure that 
would be more consistent with the proposed treatment of ECL for non-
defaulted exposures. That alternative approach calculated ECL 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). Commenters 
on this issue generally supported the proposed treatment and expressed 
some concern about the added complexity of the alternative treatment.
    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. The agencies also 
believe that the proposed ALLL impairment approach is less burdensome 
for banks than the ``best estimate of economic loss'' approach. As a 
result, the agencies are retaining this aspect of the proposed 
definition of ECL for defaulted exposures. The agencies recognize that 
this treatment requires a bank to specify how much of its ALLL is 
attributable to defaulted exposures, and emphasize that a bank must 
capture all material economic losses on defaulted exposures when 
building its databases for estimating LGDs for non-defaulted exposures.
    The agencies also sought comment on the appropriate measure of ECL 
for assets held at fair value with gains and losses flowing through 
earnings. Commenters expressed the view that there should be no ECL for 
such assets because expected losses on such assets already have been 
removed from regulatory capital. The agencies agree with this position 
and, therefore, under the final rule, a bank may assign an ECL of zero 
to assets held at fair value with gains and losses flowing through 
earnings. The agencies are otherwise maintaining the proposed 
definition of ECL in the final rule, with the substitution of LGD for 
ELGD noted above.
    Under the final rule, consistent with the proposal, 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 must 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.
    A number of commenters objected to the 0.6 percent limit on 
inclusion of excess reserves in tier 2 capital and suggested that there 
should be a higher or no limit on the amount of excess reserves that 
may be included in regulatory capital. While the 0.6 percent limit is 
part of the New Accord, some commenters asserted that this limitation 
would put U.S. banks at a competitive disadvantage because U.S. 
accounting practices (as compared to accounting practices in many other 
countries) lead to higher reserves that are more likely to exceed the 
limitation. Another commenter asserted that the proposed limitation on 
excess reserves is more restrictive than the current cap on ALLL in the 
general risk-based capital rules. Finally, several commenters suggested 
that because ALLL is the first buffer against credit losses, it should 
be included without limit in tier 1 capital.
    The agencies believe that the proposed 0.6 percent limit on 
inclusion of excess reserves in tier 2 capital is roughly equivalent to 
the 1.25 percent cap in the general risk-based capital rules and serves 
to maintain general consistency in the treatment of reserves

[[Page 69324]]

domestically and internationally. Accordingly, the agencies have 
included the 0.6 percent cap in the final rule.
    Under the proposed rule, a bank would deduct from tier 1 capital 
any after-tax gain-on-sale. Gain-on-sale was defined as an increase in 
a bank's equity capital that resulted from a securitization, other than 
an increase in equity capital that resulted from the bank's receipt of 
cash in connection with the securitization. The agencies 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 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,\48\ 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 would deduct CEIOs from tier 1 capital to the 
extent they represent gain-on-sale, and would deduct any remaining 
CEIOs 50 percent from tier 1 capital and 50 percent from tier 2 
capital.
---------------------------------------------------------------------------

    \48\ See 12 CFR part 3, Appendix A, Sec.  2(c)(4) (national 
banks); 12 CFR part 208, Appendix A, Sec.  I.B.1.c. (state member 
banks); 12 CFR part 225, Appendix A, Sec.  I.B.1.c. (bank holding 
companies); 12 CFR part 325, Appendix A, Sec.  I.B.5. (state 
nonmember banks); 12 CFR 567.5(a)(2)(iii) and 567.12(d)(2) (savings 
associations).
---------------------------------------------------------------------------

    Under the proposed rule, certain other securitization exposures 
also would be deducted from tier 1 and tier 2 capital. These exposures 
included, for example, securitization exposures with 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 deducted a securitization 
exposure (other than gain-on-sale) from regulatory capital, the bank 
would take the deduction 50 percent from tier 1 capital and 50 percent 
from tier 2 capital. Moreover, under the proposal, a bank could 
calculate any deductions from tier 1 and tier 2 capital with respect to 
a securitization exposure (including after-tax gain-on-sale) net of any 
deferred tax liabilities associated with the exposure.
    The agencies received a number of comments on the proposed 
securitization-linked deductions. In particular, some commenters urged 
the agencies to retain the general risk-based capital rule for 
deducting only CEIOs that exceed 25 percent of tier 1 capital. Some of 
these commenters noted that the ``harsher'' securitization-linked 
deductions under the advanced approaches could have a significant tier 
1 capital impact and, accordingly, could have an unwarranted effect on 
a bank's tier 1 leverage ratio calculation. A few commenters encouraged 
the agencies to permit a bank to replace the deduction approach for 
certain securitization exposures with a 1,250 percent risk weight 
approach, in part to mitigate potential tier 1 leverage ratio effects.
    The agencies are retaining the securitization-related deductions as 
proposed. The proposed deductions are part of the New Accord's 
securitization framework. The agencies believe that they should be 
retained to foster consistency among participants in the international 
securitization markets.
    The proposed rule also required 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. The 
agencies are retaining this deduction as proposed.
    The agencies are also retaining, as proposed, the deductions in the 
general risk-based capital rules for investments in unconsolidated 
banking and finance subsidiaries and reciprocal holdings of bank 
capital instruments. Further, the agencies are retaining the current 
treatment for national and state banks that control or hold an interest 
in a financial subsidiary. As required by the Gramm-Leach-Bliley Act, 
assets and liabilities of the financial subsidiary are not consolidated 
with those of the bank for risk-based capital purposes and the bank 
must deduct its equity investment (including retained earnings) in the 
financial subsidiary from regulatory capital--50 percent from tier 1 
capital and 50 percent from tier 2 capital.\49\ 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 
continue under the final rule.
---------------------------------------------------------------------------

    \49\ See Public Law 106-102 (November 12, 1999), codified, among 
other places, at 12 U.S.C. 24a. See also 12 CFR 5.39(h)(1) (national 
banks); 12 CFR 208.73(a) (state member banks); 12 CFR part 325, 
Appendix A, Sec.  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).
---------------------------------------------------------------------------

    For BHCs with consolidated insurance underwriting subsidiaries that 
are functionally regulated by a State insurance regulator (or subject 
to comparable supervision and regulatory capital requirements in a non-
U.S. jurisdiction), the proposed rule set forth the following 
treatment. The assets and liabilities of the subsidiary would be 
consolidated for purposes of determining the BHC's risk-weighted 
assets. However, the BHC would 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 underwriting subsidiaries, this 
amount generally would be 200 percent of the subsidiary's Authorized 
Control Level as established by the appropriate state insurance 
regulator.
    The proposal noted that its approach with respect to functionally 
regulated consolidated insurance underwriting subsidiaries was 
different from the New Accord, which broadly endorses a deconsolidation 
and deduction approach for insurance subsidiaries. The proposal 
acknowledged the Board's concern that a full deconsolidation and 
deduction approach does not capture the credit risk in insurance 
underwriting subsidiaries at the consolidated BHC level.
    Several commenters objected to the proposed deduction from tier 1 
capital and instead supported a deduction 50 percent from tier 1 
capital and 50 percent from tier 2 capital. Others supported the full 
deduction and deconsolidation approach endorsed by the New Accord and 
maintained that, by contrast, the proposed approach was overly 
conservative and resulted in a double-count of capital requirements for 
insurance regulation and banking regulation.
    The Board continues to believe that a consolidated BHC risk-based 
capital measure should incorporate all credit, market, and operational 
risks to which the BHC is exposed, regardless of the

[[Page 69325]]

legal entity subsidiary where a risk exposure resides. The Board also 
believes that a fully consolidated approach minimizes the potential for 
regulatory capital arbitrage; it eliminates incentives to book 
individual exposures at a subsidiary that is deducted from the 
consolidated entity for capital purposes where a different, potentially 
more favorable, capital requirement is applied at the subsidiary. 
Moreover, the Board does not agree that the proposed approach results 
in a double-count of capital requirements. Rather, the capital 
requirements imposed by a functional regulator or other supervisory 
authority at the subsidiary level reflect the capital needs at the 
particular subsidiary. The consolidated measure of minimum capital 
requirements should reflect the consolidated organization.
    Thus, the Board is retaining the proposed requirement that assets 
and liabilities of insurance underwriting subsidiaries are consolidated 
for determining risk-weighted assets. The Board has modified the final 
rule for BHCs, however, to allow the associated capital deduction to be 
made 50 percent from tier 1 capital and 50 percent from tier 2 capital.

V. Calculation of Risk-Weighted Assets

    Under the final rule, a bank's total risk-weighted assets is the 
sum of its credit risk-weighted assets and risk-weighted assets for 
operational risk, minus the sum of its excess eligible credit reserves 
(eligible credit reserves in excess of its total ECL) not included in 
tier 2 capital. Unlike under the proposal, allocated transfer risk 
reserves are not subtracted from total risk-weighted assets under the 
final rule. Because the EAD of wholesale exposures and retail segments 
is calculated net of any allocated transfer risk reserves, a second 
subtraction of the reserves from risk-weighted assets is not 
appropriate.

A. Categorization of Exposures

    To calculate credit risk-weighted assets, a bank must determine 
risk-weighted asset amounts for exposures that have been grouped into 
four general categories: wholesale, retail, securitization, and equity. 
It must also identify and determine risk-weighted asset amounts for 
assets not included in an exposure category and any non-material 
portfolios of exposures to which the bank elects not to apply the IRB 
approach. To exclude a portfolio from the IRB approach, 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 approach) is not material 
to the bank. As described above, credit-risk-weighted assets is defined 
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.
1. Wholesale Exposures
    Consistent with the proposed rule, the final rule defines a 
wholesale exposure as a credit exposure to a company, individual, 
sovereign entity, or other governmental entity (other than a 
securitization exposure, retail exposure, or equity exposure).\50\ 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; \51\ (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 a 
bank treats as a covered position under the market risk rule for which 
there is a counterparty credit risk capital requirement; (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.
---------------------------------------------------------------------------

    \50\ The proposed rule excluded 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 under the final rule is discussed below in 
section V.B.5. of the preamble.
    \51\ As described below, tranched guarantees (like most 
transactions that involve a tranching of credit risk) generally are 
securitization exposures under the final rule. The final rule 
defines a guarantee broadly to include almost any transaction (other 
than a credit derivative) that involves the transfer of the credit 
risk of an exposure from one party to another party. This definition 
of guarantee generally includes, 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.
---------------------------------------------------------------------------

    The agencies proposed 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. Further, the agencies proposed that once an 
exposure was determined to be an HVCRE exposure, it would remain an 
HVCRE exposure until paid in full, sold, or converted to permanent 
financing.
    The proposed rule defined an HVCRE exposure as a credit facility 
that finances or has financed the acquisition, development, or 
construction of real property, excluding facilities that finance (i) 
one-to four-family residential properties or (ii) commercial real 
estate projects that meet the following conditions: (A) The exposure's 
loan-to-value (LTV) ratio is less than or equal to the applicable 
maximum supervisory LTV ratio in the real estate lending standards of 
the agencies; \52\ (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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    \52\ 12 CFR part 34, Subpart D (OCC); 12 CFR part 208, Appendix 
C (Board); 12 CFR part 365, Appendix A (FDIC); and 12 CFR 560.100-
560.101 (OTS).
---------------------------------------------------------------------------

    Several commenters raised issues related to the requirement that 
banks must separate HVCRE exposures from other wholesale exposures. One 
commenter asserted that a separate risk-weight function for HVCRE 
exposures is unnecessary because the higher risk associated with such 
exposures would be reflected in higher PDs and LGDs. Other commenters 
stated that tracking the exception requirements for acquisition, 
development, or construction loans would be burdensome and expressed 
concern that all multifamily loans could be subject to the HVCRE 
treatment. Yet other commenters requested that the agencies exclude 
from the definition of HVCRE all multifamily acquisition, development, 
or construction loans; additional commercial real estate exposures; and 
other exposures with significant project equity and/or pre-sale 
commitments. A few commenters supported the proposed approach to HVCRE 
exposures.
    The agencies have determined that the proposed definition of HVCRE 
exposures strikes an appropriate balance between risk-sensitivity and 
simplicity.

[[Page 69326]]

Thus, the final rule retains the definition as proposed. If a bank does 
not want to track compliance with the definition for burden-related 
reasons, the bank may choose to apply the HVCRE risk-weight function to 
all credit facilities that finance the acquisition, construction, or 
development of multifamily and commercial real property. The agencies 
believe that this treatment would be an appropriate application of the 
principle of conservatism discussed in section II.D. of the preamble 
and set forth in section 1(d) of the final rule.
    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 proposed rule did not include a 
separate treatment for specialized lending beyond the separate IRB 
risk-based capital formula for HVCRE exposures specified in the New 
Accord. The agencies noted in the proposal that sophisticated banks 
that would be applying the advanced approaches in the United States 
should be able to estimate risk parameters for specialized lending. The 
agencies continue to believe that banks using the advanced approaches 
in the United States should be able to estimate risk parameters for 
specialized lending and, therefore, have not adopted a separate 
treatment for specialized lending in the final rule.
    In contrast to the New Accord, the agencies did not propose a 
separate risk-based capital function for exposures to small- and 
medium-size enterprises (SMEs). The SME function in the New Accord 
generates a lower risk-based capital requirement for an exposure to an 
SME than for an exposure to a larger firm that has the same risk 
parameter values. The agencies were not aware of compelling evidence 
that smaller firms are subject to less systematic risk than is already 
reflected in the wholesale exposure risk-based capital formula, which 
specifies lower AVCs as PDs increase.
    A number of commenters objected to this aspect of the proposal and 
urged the agencies to include in the final rule the SME risk-based 
capital function from the New Accord. Several commenters expressed 
concern about potential competitive disparities in the market for SME 
lending between U.S. banks and foreign banks subject to rules that 
include the New Accord's treatment of SME exposures. Others asserted 
that lower AVCs and risk-based capital requirements were appropriate 
for SME exposures because the asset values of exposures to smaller 
firms are more idiosyncratic than those of exposures to larger firms.
    While commenters raised important issues related to SME exposures, 
the agencies have decided not to add a distinct risk-weight function 
for such exposures to the final rule. The agencies continue to believe 
that a distinct risk-weight function with a lower AVC for SME exposures 
is not substantiated by sufficient empirical evidence and may give rise 
to a domestic competitive inequity between banks subject to the 
advanced approaches and banks subject to the general risk-based capital 
rules.
2. Retail Exposures
    Under the final rule, as under the proposed rule, retail exposures 
generally include exposures (other than securitization exposures or 
equity exposures) to an individual and small exposures to businesses 
that are managed as part of a segment of similar exposures, not on an 
individual-exposure basis. There are three subcategories of retail 
exposure: (i) Residential mortgage exposures; (ii) QREs; and (iii) 
other retail exposures. The final rule retains the proposed definitions 
of the retail exposure subcategories and, thus, defines residential 
mortgage exposure as an exposure that is primarily secured by a first 
or subsequent lien on one- to four-family residential property.\53\ 
This includes both term loans and HELOCs. An exposure primarily secured 
by a first or subsequent lien on residential property that is not one 
to four family also is 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 is 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, are 
categorized as wholesale exposures.
---------------------------------------------------------------------------

    \53\ The proposed rule excluded from the definition of a 
residential mortgage exposure certain pre-sold one- to-four family 
residential construction loans and certain multifamily residential 
loans. The treatment of such loans under the final rule is discussed 
below in section V.B.5. of the preamble.
---------------------------------------------------------------------------

    QREs are 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 of exposures with homogeneous risk characteristics. 
In practice, QREs typically 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 are QREs.
    The category of other retail exposures includes 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 are 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. There is no 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 are other retail exposures. For the purpose of 
assessing exposure to a single borrower, the bank must aggregate all 
business exposures to a particular legal entity and its affiliates that 
are consolidated under GAAP. If that borrower 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 count 
toward the $1 million single-borrower other retail business exposure 
threshold.\54\
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    \54\ The proposed rule excluded from the definition of an other 
retail exposure certain pre-sold one-to-four family residential 
construction loans and certain multifamily residential loans. The 
treatment of such loans under the final rule 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. Consistent with the 
New Accord, a bank must assign the residual value portion

[[Page 69327]]

of a retail lease exposure a risk-weighted asset amount equal to its 
residual value as described in section 31 of the final rule.
3. Securitization Exposures
    The proposed rule defined a securitization exposure as an on-
balance sheet or off-balance sheet credit exposure that arises from a 
traditional or synthetic securitization (including credit-enhancing 
representations and warranties). A traditional securitization was 
defined as 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, other 
debt securities, equity securities, or credit derivatives. The proposed 
rule also defined mortgage-backed pass-through securities guaranteed by 
Fannie Mae or Freddie Mac (whether or not issued out of a structure 
that tranches credit risk) as securitization exposures.
    A synthetic securitization was defined as 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 
included 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 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.
    The preamble to the proposal noted that, provided there is a 
tranching of credit risk, securitization exposures 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.
    As explained in the proposal, 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, 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 rule. Moreover, if a bank provides a guarantee or a credit 
derivative on a securitization exposure, that guarantee or credit 
derivative would also be a securitization exposure.
    Commenters raised several objections to the proposed definitions of 
traditional and synthetic securitizations. First, several commenters 
objected to the requirement that all or substantially all of the 
underlying exposures must be financial exposures. These commenters 
noted that the securitization market rapidly evolves and expands to 
cover new asset classes--such as intellectual property rights, project 
finance revenues, and entertainment royalties--that may or may not be 
financial assets. Commenters expressed particular concern that the 
proposed definitions may exclude from the securitization framework 
leases that include a material lease residual component.
    The agencies believe that requiring all or substantially all of the 
underlying exposures for a securitization to be financial exposures 
creates an important boundary between the wholesale and retail 
frameworks, on the one hand, and the securitization framework, on the 
other hand. Accordingly, the agencies are maintaining this requirement 
in the final rule. The securitization framework was designed to address 
the tranching of the credit risk of financial exposures and was not 
designed, for example, to apply to tranched credit exposures to 
commercial or industrial companies or nonfinancial assets. Accordingly, 
under the final rule, 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 is not a securitization exposure because the 
assets backing the loan typically are 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 final rule's 
securitization framework, but generally are subject to the rules for 
wholesale exposures.
    Based on their cash flow characteristics, for purposes of the final 
rule, the agencies would consider many of the asset classes identified 
by commenters including lease residuals and entertainment royalties--to 
be financial assets. 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.\55\
---------------------------------------------------------------------------

    \55\ Several commenters asked the agencies to confirm that the 
typical syndicated credit facility would not be a securitization 
exposure. The agencies confirm that a syndicated credit facility is 
not a securitization exposure so long as less than substantially all 
of the borrower's assets are financial exposures.
---------------------------------------------------------------------------

    Some commenters asserted that the proposal generally to define as 
securitization exposures all exposures involving credit risk tranching 
of underlying financial assets was too broad. The proposed definition 
captured many exposures these commenters did not consider to be 
securitization exposures, including tranched exposures to a single 
underlying financial exposure and exposures to many hedge funds and 
private equity funds. Commenters requested flexibility to apply the 
wholesale or equity framework (depending on the exposure) rather than 
the securitization framework to these exposures.
    The agencies believe that a single, unified approach to dealing 
with the tranching of credit risk is important to create a level 
playing field across the securitization, credit derivative, and other 
financial markets, and therefore have decided to maintain the proposed 
treatment of tranched exposures to a

[[Page 69328]]

single underlying financial asset in the final rule. The agencies 
believe that basing the applicability of the securitization framework 
on the presence of some minimum number of underlying exposures would 
complicate the rule and would create a divergence from the New Accord, 
without any material improvement in risk sensitivity. The 
securitization framework is designed specifically to deal with tranched 
exposures to credit risk. Moreover, the principal risk-based capital 
approaches of the securitization framework take into account the 
effective number of underlying exposures.
    The agencies agree with commenters that the proposed definition for 
securitization exposures was quite broad and captured some exposures 
that would more appropriately be treated under the wholesale or equity 
frameworks. To limit the scope of the IRB securitization framework, the 
agencies have modified the definition of traditional securitization in 
the final rule to make clear that operating companies are not 
traditional securitizations (even if all or substantially all of their 
assets are financial exposures). For purposes of the final rule's 
definition of traditional securitization, operating companies generally 
are companies that produce goods or provide services beyond the 
business of investing, reinvesting, holding, or trading in financial 
assets. Examples of operating companies are depository institutions, 
bank holding companies, securities brokers and dealers, insurance 
companies, and non-bank mortgage lenders. Accordingly, an equity 
investment in an operating company, such as a bank, generally would be 
an equity exposure under the final rule; a debt investment in an 
operating company, such as a bank, generally would be a wholesale 
exposure under the final rule.
    Investment firms, which generally do not produce goods or provide 
services beyond the business of investing, reinvesting, holding, or 
trading in financial assets, are not operating companies for purposes 
of the final rule and would not qualify for this general exclusion from 
the definition of traditional securitization. Examples of investment 
firms would include companies that are exempted from the definition of 
an investment company under section 3(a) of the Investment Company Act 
of 1940 (15 U.S.C. 80a-3(a)) by either section 3(c)(1) (15 U.S.C. 80a-
3(c)(1)) or section 3(c)(7) (15 U.S.C. 80a-3(c)(7)) of the Act.
    The final definition of a traditional securitization also provides 
the primary Federal supervisor of a bank with discretion to exclude 
from the definition of traditional securitization investment firms that 
exercise substantially unfettered control over the size and composition 
of their assets, liabilities, and off-balance sheet transactions. The 
agencies will consider a number of factors in the exercise of this 
discretion, including an assessment of the investment firm's leverage, 
risk profile, and economic substance. This supervisory exclusion is 
intended to provide discretion to a bank's primary Federal supervisor 
to distinguish structured finance transactions, to which the 
securitization framework was designed to apply, from more flexible 
investment firms such as many hedge funds and private equity funds. 
Only investment firms that can easily change the size and composition 
of their capital structure, as well as the size and composition of 
their assets and off-balance sheet exposures, would be eligible for 
this exclusion from the definition of traditional securitization under 
this new provision. The agencies do not consider managed collateralized 
debt obligation vehicles, structured investment vehicles, and similar 
structures, which allow considerable management discretion regarding 
asset composition but are subject to substantial restrictions regarding 
capital structure, to have substantially unfettered control. Thus, such 
transactions meet the final rule's definition of traditional 
securitization.
    The agencies also have added two additional exclusions to the 
definition of traditional securitization for small business investment 
companies (SBICs) and community development investment vehicles. As a 
result, a bank's equity investments in SBICs and community development 
equity investments generally are treated as equity exposures under the 
final rule.
    The agencies remain concerned that the line between securitization 
exposures and non-securitization exposures may be difficult to draw in 
some circumstances. In addition to the supervisory exclusion from the 
definition of traditional securitization described above, the agencies 
have added a new component to the definition of traditional 
securitization to specifically permit a primary Federal supervisor to 
scope certain transactions into the securitization framework if 
justified by the economics of the transaction. Similar to the analysis 
for excluding an investment firm from treatment as a traditional 
securitization, the agencies will consider the economic substance, 
leverage, and risk profile of transactions to ensure that the 
appropriate IRB classification is made. The agencies will consider a 
number of factors when assessing the economic substance of a 
transaction including, for example, the amount of equity in the 
structure, overall leverage (whether on-or off-balance sheet), whether 
redemption rights attach to the equity investor, and the ability of the 
junior tranches to absorb losses without interrupting contractual 
payments to more senior tranches.
    One commenter asked whether a bank could ignore the credit 
protection provided by a tranched guarantee for risk-based capital 
purposes and instead calculate the risk-based capital requirement for 
the guaranteed exposure as if the guarantee did not exist. The agencies 
believe that this treatment would be an appropriate application of the 
principle of conservatism discussed in section II.D. of this preamble 
and set forth in section 1(d) of the final rule.
    As noted above, the proposed rule defined mortgage-backed pass-
through securities guaranteed by Fannie Mae or Freddie Mac (whether or 
not issued out of a structure that tranches credit risk) as 
securitization exposures. The agencies have reconsidered this proposal 
and have concluded that a special treatment for these securities is 
inconsistent with the New Accord and would violate the fundamental 
credit-tranching-based nature of the definition of securitization 
exposures. The final rule therefore does not define all mortgage-backed 
pass-through securities guaranteed by Fannie Mae or Freddie Mac to be 
securitization exposures. As a result, those mortgage-backed securities 
that involve tranching of credit risk will be securitization exposures; 
those mortgage-backed securities that do not involve tranching of 
credit risk will not be securitization exposures.\56\
---------------------------------------------------------------------------

    \56\ Several commenters asked the agencies to clarify whether a 
special purpose entity that issues multiple classes of securities 
that have equal priority in the capital structure of the issuer but 
different maturities would be considered a securitization SPE. The 
agencies do not believe that maturity differentials alone constitute 
credit risk tranching for purposes of the definitions of traditional 
securitization and synthetic securitization.
---------------------------------------------------------------------------

    A few commenters asserted that OTC derivatives with a 
securitization SPE as the counterparty should be excluded from the 
definition of securitization exposure and treated as wholesale 
exposures. The agencies believe that the securitization framework is 
the most appropriate way to assess the counterparty credit risk of such 
exposures because this risk is a tranched exposure to the credit risk 
of the underlying financial assets of the

[[Page 69329]]

securitization SPE. The agencies are addressing specific commenter 
concerns about the burden of applying the securitization framework to 
these exposures in preamble section V.E. below and section 42(a)(5) of 
the final rule.
4. Equity Exposures
    The proposed rule defined 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 a 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.
    The proposal noted that 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. In addition, the agencies note that unfunded equity 
commitments, which are commitments to make equity investments at a 
future date, meet the definition of an equity exposure.
    Many commenters expressed support for the proposed definition of 
equity exposure, except for the proposed exclusion of equity 
investments in hedge funds and other leveraged investment vehicles, as 
discussed above. The agencies are adopting the proposed definition for 
equity exposures with one exception. They have eliminated in the final 
rule the exclusion of a redeemable ownership interest from the 
definition of equity exposure. The agencies believe that redeemable 
ownership interests, such as those in mutual funds and private equity 
funds, are most appropriately treated as equity exposures.
    The agencies anticipate that, as a general matter, each of a bank's 
exposures will fit in one and only one exposure category. One exception 
to this principle 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 equity derivative generally is 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 also could 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 must compile 
loss data sets and compute risk-based capital requirements under the 
final rule. Consistent with the treatment in the New Accord and the 
proposed rule, banks must treat operational losses that are related to 
market risk as operational losses for purposes of calculating risk-
based capital requirements under this final 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 when 
a purchase was intended, must be treated as operational losses.
    Under the proposed rule, banks would 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.
    To be consistent with prevailing practice in the credit card 
industry, the proposed rule included an exception to this standard for 
retail credit card fraud losses. Specifically, retail credit card 
losses arising from non-contractual, third party-initiated fraud (for 
example, identity theft) would be treated as external fraud operational 
losses under the proposed rule. All other third party-initiated losses 
would be treated as credit losses.
    Generally, commenters urged the agencies not to be prescriptive on 
risk boundary issues and to give banks discretion to categorize risk as 
they deem appropriate, subject to supervisory review. Other commenters 
noted that boundary issues are so significant that the agencies should 
not contemplate any additional exceptions to treating losses related to 
both credit and operational risk as credit losses unless the exceptions 
are agreed to by the BCBS. Several commenters objected to specific 
aspects of the agencies' proposal and suggested that additional types 
of losses related to credit risk and operational risk, including losses 
related to check fraud, overdraft fraud, and small business loan fraud, 
should be treated as operational losses for purposes of calculating 
risk-based capital requirements. One commenter expressly noted its 
support for the agencies' proposal, which effectively requires banks to 
treat losses on HELOCs related to both credit risk and operational risk 
as credit losses for purposes of calculating risk-based capital 
requirements.
    Because of the substantial potential impact boundary issues have on 
risk-based capital requirements under the advanced approaches, there 
should be consistency across U.S. banks in how they categorize losses 
that relate to both credit risk and operational risk. Moreover, the 
agencies believe that international consistency on this issue is an 
important objective. Therefore, the final rule maintains the proposed 
boundaries for losses that relate to both credit risk and operational 
risk and does not incorporate any additional exemptions beyond that in 
the proposal.
6. Boundary Between the Final Rule and the Market Risk Rule
    For banks subject to the market risk rule, the existing market risk 
rule applies to all positions classified as trading positions in 
regulatory reports. The New Accord establishes additional criteria for 
positions to be eligible for application of the market risk rule. The

[[Page 69330]]

agencies are incorporating these additional criteria into the market 
risk rule through a separate rulemaking that is expected to be 
finalized soon and published in the Federal Register. Under this final 
rule, as under the proposal, core and opt-in banks subject to the 
market risk rule must use the market risk rule for exposures that are 
covered positions under the market risk rule. Core and opt-in banks not 
subject to the market risk rule must use this final rule for all of 
their exposures.

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 consisted 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. The agencies did not 
receive any negative comments on the four phases for calculating 
wholesale and retail risk-weighted assets and, thus, are adopting the 
four-phase concept as proposed. Where applicable, the agencies have 
clarified particular issues within the four-phase process.
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 exposures, 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 multilateral development banks are exempt from the 
0.03 percent floor on PD discussed in the next section.
    The proposed rule recognized as multilateral development banks only 
those multilateral lending institutions or regional development banks 
in which the U.S. government is a shareholder or contributing member. 
The final rule adopts a slightly expanded definition of multilateral 
development bank. Specifically, under the final rule, multilateral 
development bank is defined to include the International Bank for 
Reconstruction and Development, the International Finance Corporation, 
the Inter-American Development Bank, the Asian Development Bank, the 
African Development Bank, the European Bank for Reconstruction and 
Development, the European Investment Bank, the European Investment 
Fund, the Nordic Investment Bank, the Caribbean Development Bank, the 
Islamic Development Bank, the Council of Europe Development Bank; any 
multilateral lending institution or regional development bank in which 
the U.S. government is a shareholder or contributing member; and any 
multilateral lending institution that a bank's primary Federal 
supervisor determines poses comparable credit risk.
    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 LGD). A bank that elects not to use a loss 
severity rating grade system for a wholesale exposure must directly 
assign an estimated 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 group its retail exposures within each retail 
subcategory into segments that have homogeneous risk characteristics. 
\57\
---------------------------------------------------------------------------

    \57\ If the bank determines the EAD for eligible margin loans 
using the approach in section 32(b) of the rule, it must segment 
retail eligible margin loans for which the bank uses this approach 
separately from other retail exposures.
---------------------------------------------------------------------------

    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 has 
substantial flexibility to use the retail portfolio segmentation it 
believes is most appropriate for its activities, subject to the 
following broad principles:
     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

[[Page 69331]]

default rates, as determined by historical performance of segments with 
similar risk characteristics.
    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.
    Banks commonly obtain tranched credit protection, for example 
first-loss or second-loss guarantees, on certain retail exposures such 
as residential mortgages. The proposal recognized that the 
securitization framework, which applies to tranched wholesale 
exposures, is not appropriate for individual retail exposures. 
Therefore, the agencies proposed to exclude tranched guarantees that 
apply only to an individual retail exposure from the securitization 
framework. The preamble to the proposal noted that an important result 
of this exclusion is that, in contrast to the treatment of wholesale 
exposures, a bank may recognize recoveries from both a borrower and a 
guarantor for purposes of estimating LGD for certain retail exposures.
    Most commenters who addressed the agencies' proposed treatment for 
tranched retail guarantees supported the proposed approach. One 
commenter urged the agencies to extend the treatment of tranched 
guarantees of retail exposures to wholesale exposures. Another 
commenter asserted that the proposed treatment was inconsistent with 
the New Accord.
    The agencies have determined that while the securitization 
framework is the most appropriate risk-based capital treatment for most 
tranched guarantees, the regulatory burden associated with applying it 
to tranched guarantees of individual retail exposures exceeds the 
supervisory benefit. The agencies are therefore adopting the proposed 
treatment in the final rule and excluding tranched guarantees of 
individual retail exposures from the securitization framework.
    Some banks expressed concern about the treatment of eligible 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 definition of default to associate a PD and LGD 
with each segment. As described in section 32 of the rule, a bank may 
adjust the EAD of eligible margin loans to reflect the risk-mitigating 
effect of financial collateral. If a bank elects this option to adjust 
the EAD of eligible margin loans, it must associate an LGD with the 
segment that does not reflect the presence of collateral.
    Under the proposal, if a bank was not able to estimate PD and LGD 
for an eligible margin loan, the bank could apply a 300 percent risk 
weight to the EAD of the loan. Commenters generally objected to this 
approach. As discussed in section III.B.3. of the preamble, several 
commenters asserted that the agencies should permit banks to treat 
margin loans and other portfolios that exhibit low loss frequency or 
for which a bank has limited data on a portfolio basis, by apportioning 
EL between PD and LGD for portfolios rather than estimating each risk 
parameter separately. Other commenters suggested that banks should be 
expected to develop sound practices for applying the IRB approach to 
such exposures and adopt an appropriate degree of conservatism to 
address the level of uncertainty in the estimation process. Several 
commenters added that if a bank simply is unable to estimate PD and LGD 
for eligible margin loans, they would support the agencies' proposal to 
apply a flat risk weight to the EAD of eligible margin loans. However, 
they asserted that the risk weight should not exceed 100 percent given 
the low levels of loss associated with these types of exposures.
    As discussed in section III.B.3. of the preamble, the final rule 
provides flexibility and incentives for banks to develop and document 
sound practices for applying the IRB approach to portfolios with 
limited data or default history, which may include eligible margin 
loans. However, the agencies believe that for banks facing particular 
challenges with respect to estimating PD and LGD for eligible margin 
loans, the proposed application of a 300 percent risk weight to the EAD 
of an eligible margin loan is a reasonable alternative. The option 
balances pragmatism with the provision of appropriate incentives for 
banks to develop processes to apply the IRB approach to such exposures. 
Accordingly, the final rule continues to provide banks with the option 
of applying a 300 percent risk weight to the EAD of an eligible margin 
loan for which it cannot estimate PD and LGD.
Purchased Wholesale Exposures
    A bank may also elect to use a top-down approach, similar to the 
treatment of retail exposures, for eligible purchased wholesale 
exposures. Under the final rule, as under the proposal, this approach 
may be used for exposures purchased directly by the bank. In addition, 
the final rule clarifies that this approach also may be used for 
exposures purchased by a securitization SPE in which the bank has 
invested and for which the bank calculates the capital requirement on 
the underlying exposures (KIRB) for purposes of the SFA (as 
defined in section V.E.4. of the preamble). Under this approach, in 
phase 2, a bank would group its eligible purchased wholesale exposures 
into segments that have homogeneous risk characteristics. To be an 
eligible purchased wholesale exposure, several criteria must be met:
     The purchased wholesale exposure must be purchased from an 
unaffiliated seller and must not have been directly or indirectly 
originated by the purchasing bank or securitization SPE;
     The purchased wholesale exposure 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 would not satisfy this 
criterion);
     The purchasing bank must have a claim on all proceeds from 
the exposure or a pro rata interest in the proceeds;
     The purchased wholesale exposure must have an effective 
remaining maturity of less than one year; and
     The purchased wholesale exposure must, when consolidated 
by obligor, not represent a concentrated exposure relative to the 
portfolio of purchased wholesale exposures.
Wholesale Lease Residuals
    The agencies proposed 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 
preamble to the proposal noted that the agencies believed this 
treatment was excessively punitive for leases to highly creditworthy 
lessees. Accordingly, the proposed rule required a bank to treat its 
net investment in a wholesale lease as a single exposure to the lessee. 
As proposed, there would not be a separate capital calculation for the 
wholesale lease residual. Commenters on this issue broadly supported 
the agencies'

[[Page 69332]]

proposed approach. The agencies believe the proposed approach 
appropriately reflects current bank risk management practice and are 
adopting the proposed approach in the final rule.
    Commenters also requested this treatment for retail lease 
residuals. However, the agencies have determined that the proposal to 
apply a flat 100 percent risk weight for retail lease residuals, 
consistent with the New Accord, appropriately balances risk sensitivity 
and complexity and are maintaining this treatment in the final rule.
3. Phase 3--Assignment of Risk Parameters to Wholesale Obligors and 
Exposures and Retail Segments
    In phase 3, a bank associates a PD with each wholesale obligor 
rating grade; associates an LGD with each wholesale loss severity 
rating grade or assigns an LGD to each wholesale exposure; assigns an 
EAD and M to each wholesale exposure; and assigns a PD, LGD, and EAD to 
each segment of retail exposures. In some cases it may be reasonable to 
assign the same PD, LGD, or EAD to multiple segments of retail 
exposures. The quantification phase for PD, LGD, and EAD 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. As 
discussed in more detail below, quantification of M is accomplished 
through direct computation based on the contractual characteristics of 
the exposure.
    A bank should base its estimation of the values assigned to PD, 
LGD, and EAD \58\ 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 LGD and EAD estimation) 
or to both defaulted and non-defaulted wholesale obligors and retail 
exposures (in the case of PD estimation).
---------------------------------------------------------------------------

    \58\ EAD for repo-style transactions and eligible margin loans 
may be calculated as described in section 32 of the final rule. EAD 
for OTC derivatives must be calculated as described in section 32 of 
the final 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 use simple concepts, such as the calculation of averages, or more 
complex ones, such as an approach based on rigorous regression 
techniques. This step may include adjustments for differences between 
this final rule's definition of default and the default definition in 
the reference data set, or adjustments for data limitations. This step 
includes adjustments for seasoning effects related to retail exposures, 
if material.
    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 should have a clear and consistent policy on 
reconciling and combining the different estimates.
    Once a bank estimates PD, LGD, and EAD for its reference data sets, 
it should 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 should 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 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 must apply the risk parameters estimated for the 
reference data to the bank's actual portfolio data. As noted above, the 
bank must attribute a PD to each wholesale obligor risk grade, an LGD 
to each wholesale loss severity grade or wholesale exposure, an EAD and 
M to each wholesale exposure, and a PD, LGD, and EAD 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 final rule, as noted above, permits a bank to elect to segment 
its eligible purchased wholesale exposures like retail exposures. A 
bank that chooses to apply this treatment must directly assign a PD, 
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 exposures, 
the bank must assume that the LGD of the segment equals 100 percent and 
that the PD of the segment equals ECL divided by EAD. The bank must 
estimate ECL for the eligible purchased wholesale exposures without 
regard to any assumption of recourse or guarantees from the seller or 
other parties. The bank must then use the wholesale exposure formula in 
section 31(e) of the final rule to determine the risk-based capital 
requirement for each segment of eligible purchased wholesale exposures.
    A bank may recognize the credit risk mitigation benefits of 
collateral that secures a wholesale exposure by adjusting its estimate 
of the 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 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 final rule).
    Consistent with the proposed rule, the final rule also provides 
that a bank may use an EAD of zero for (i) derivative contracts that 
are publicly 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 (defined below), 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 final rule, like 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

[[Page 69333]]

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 result, from an accounting point 
of view, in both on- and off-balance sheet exposures. A bank that uses 
an EAD approach to measure the exposure amount of such transactions is 
not required to apply separately 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 risk-based capital 
requirement determined under the EAD approach, a separate capital 
requirement would double count the 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 final rule 
or, if applicable, applying the double default treatment to the 
exposure as provided in section 34 of the final 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 and LGD of the segment.
    The proposed rule imposed several supervisory limitations 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 could 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 
multilateral 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) could not be less than 10 percent. These supervisory floors on 
PD and LGD applied regardless of whether the bank recognized an 
eligible guarantee or eligible credit derivative as provided in 
sections 33 and 34 of the proposed rule.
    Commenters did not object to the floor on PD, and the agencies are 
including it in the final rule. A number of commenters, however, 
objected to the 10 percent floor on LGD for segments of residential 
mortgage exposures. These commenters asserted that the floor would 
penalize low-risk mortgage lending and would provide a disincentive for 
obtaining high-quality collateral. The agencies continue to believe 
that the LGD floor is appropriate at least until banks and the agencies 
gain more experience with the advanced approaches. Accordingly, the 
agencies are maintaining the floor in the final rule. As the agencies 
gain more experience with the advanced approaches they will reconsider 
the need for the floor together with other calibration issues 
identified during the parallel run and transitional floor periods. The 
agencies also intend to address this issue and other calibration issues 
with the BCBS and other supervisory and regulatory authorities, as 
appropriate.
    The 10 percent LGD floor for residential mortgage exposures applies 
at the segment level. The agencies will not allow a bank to 
artificially group exposures into segments 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 M for each wholesale exposure. Under the 
proposed rule, for wholesale exposures other than repo-style 
transactions, eligible margin loans, and OTC derivative contracts 
subject to a qualifying master netting agreement (defined in section 
V.C.2. of this preamble), M was defined as 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 could use its 
best estimate of future interest rates to compute expected contractual 
interest payments on a floating-rate exposure, but it could 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 was 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. The M for netting sets for which the bank used the 
internal models methodology was calculated as described in section 
32(c) of the proposed rule.
    Many commenters requested more flexibility in the definition of M, 
including the ability to estimate noncontractually required prepayments 
and the ability to use either discounted or undiscounted cash flows. 
However, the agencies believe that the proposed definition of M, which 
is consistent with the New Accord, is appropriately conservative and 
provides for a consistent definition of M across internationally active 
banks. The final rule therefore maintains the proposed definition of M.
    Under the final rule, as under the proposal, 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 as low as one day, consistent with the New Accord. 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 amounts 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.

[[Page 69334]]

4. Phase 4--Calculation of Risk-Weighted Assets
    After a bank assigns risk parameters to each of its wholesale 
obligors and exposures and retail segments, the bank must calculate the 
dollar risk-based capital requirement for each wholesale exposure to a 
non-defaulted obligor and each segment of non-defaulted retail 
exposures (except eligible guarantees and eligible credit derivatives 
that hedge another wholesale exposure). Other than for exposures to 
which the bank applies the double default treatment in section 34 of 
the final rule, a bank makes this calculation 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 
B, and multiplying the output of the formula (K) by the EAD of the 
exposure or segment.\59\ Section 34 contains a separate double default 
risk-based capital requirement formula. Eligible guarantees and 
eligible credit derivatives that are hedges of a wholesale exposure are 
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 final rule or (ii) through a separate double default risk-based 
capital requirement formula in section 34 of the final rule.
---------------------------------------------------------------------------

    \59\ Alternatively, as noted above, a bank may 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.
---------------------------------------------------------------------------

BILLING CODE 4810-33-P; 6210-01-P; 6714-01-P; 6720-01-P

[[Page 69335]]

[GRAPHIC] [TIFF OMITTED] TR07DE07.001

    The sum of the dollar risk-based capital requirements for wholesale 
exposures to non-defaulted obligors (including exposures subject to the 
double default treatment described below) and segments of non-defaulted 
retail exposures equals the total dollar risk-based capital requirement 
for those exposures and segments. The total dollar risk-based capital 
requirement multiplied by 12.5 equals the risk-weighted asset amount.
    Under the proposed rule, 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 B 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) were equal to or 
greater than the amount calculated in (ii), the dollar risk-based 
capital requirement for the exposure would be 0.08 multiplied by the 
EAD of the exposure. If the amount calculated in (i) were less than the 
amount calculated in (ii), the dollar risk-based capital requirement 
for the exposure would be K for the exposure (as determined in Table B 
immediately before the obligor became defaulted), multiplied by the

[[Page 69336]]

EAD of the exposure. The reason for this comparison was to ensure that 
a bank did not receive a regulatory capital benefit as a result of the 
exposure moving from non-defaulted to defaulted status.
    The proposed rule provided a simpler approach for segments of 
defaulted retail exposures. The dollar risk-based capital requirement 
for a segment of defaulted retail exposures was 0.08 multiplied by the 
EAD of the segment.
    Some commenters objected to the proposed risk-based capital 
treatment of defaulted wholesale exposures, which differs from the 
approach in the New Accord. These commenters contended that it would be 
burdensome to track the pre-default risk-based capital requirements for 
purposes of the proposed comparison. These commenters also claimed that 
the cost and burden of the proposed treatment of defaulted wholesale 
exposures would subject banks to a competitive disadvantage relative to 
international counterparts subject to an approach similar to that in 
the New Accord.
    In view of commenters' concerns about cost and regulatory burden, 
the final rule treats defaulted wholesale exposures the same as 
defaulted retail exposures. The dollar risk-based capital requirement 
of a wholesale exposure to a defaulted obligor equals 0.08 multiplied 
by the EAD of the exposure. The agencies will review banks' practices 
to ensure that banks are not moving exposures from non-defaulted to 
defaulted status for the primary purpose of obtaining a reduction in 
risk-based capital requirements.
    To convert the dollar risk-based capital requirements for defaulted 
exposures into a risk-weighted asset amount, the bank must 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 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 the gold bullion assets are offset 
by gold bullion liabilities. The risk-weighted asset amount for an on-
balance sheet asset that does not meet the definition of a wholesale, 
retail, securitization, or equity exposure--for example, property, 
plant, and equipment and mortgage servicing rights--is its carrying 
value. The risk-weighted asset amount for a portfolio of exposures that 
the bank has demonstrated to its primary Federal supervisor's 
satisfaction is, 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 is its 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 final rule. If an OTC derivative 
contract is a credit derivative, the notional amount is the notional 
amount of the credit derivative.
    Total wholesale and retail risk-weighted assets are defined as 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 (as calculated under section 31 of the final 
rule), and unsettled transactions (as calculated under section 35 of 
the final rule and described in section V.D. of the preamble) minus the 
amounts deducted from capital pursuant to the general risk-based 
capital rules (excluding those deductions reversed in section 12 of the 
final rule).
5. Statutory Provisions on the Regulatory Capital Treatment of Certain 
Mortgage Loans
    The general risk-based capital rules assign 50 percent and 100 
percent risk weights to certain one-to four-family residential pre-sold 
construction loans and multifamily residential loans.\60\ The agencies 
adopted these provisions as a result of the Resolution Trust 
Corporation Refinancing, Restructuring, and Improvement Act of 1991 
(RTCRRI Act).\61\ 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 in the RTCRRI 
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.\62\
---------------------------------------------------------------------------

    \60\ 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. 
(state nonmember banks); 12 CFR 567.6(a)(1)(iii) and (iv) (savings 
associations).
    \61\ See Sec. Sec.  618(a) and (b) of the RTCRRI Act, Pub. L. 
102-233. 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.
    \62\ See Sec. Sec.  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 advanced approaches.
    In the proposed rule, the agencies identified three types of 
residential mortgage loans addressed by the RTCRRI Act that would 
continue to receive the risk weights provided in the Act. Consistent 
with the general risk-based capital rules, the proposed rule would 
apply 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; 
\63\ (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; \64\ 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 cancelled.\65\ Under the 
proposal, mortgage loans that did not meet the relevant criteria would 
not qualify for the statutory risk weights and would be risk-weighted 
according to the IRB risk-based capital formulas.
---------------------------------------------------------------------------

    \63\ See Sec.  618(a)(1)((B) of the RTCRRI Act.
    \64\ See Sec.  618(b)(1)(B) of the RTCRRI Act.
    \65\ See Sec.  618(a)(2) of the RTCRRI Act.
---------------------------------------------------------------------------

    Commenters generally opposed the proposed assignment of a 50 
percent risk weight to multifamily and pre-sold single family 
residential construction exposures. Commenters maintained that the 
RTCRRI Act capital requirements do not align with risk, are contrary to 
the

[[Page 69337]]

intent of the New Accord and to its implementation in other 
jurisdictions, and would impose additional compliance burdens on banks 
without any associated benefit.
    The agencies agree with these concerns and have decided to adopt in 
the final rule an alternative described in the preamble to the proposed 
rule. The proposed rule's preamble noted the tension between the 
statutory risk weights provided by the RTCRRI Act and the more risk-
sensitive IRB approaches to risk-based capital requirements. The 
preamble observed that the RTCRRI Act permits the agencies to prescribe 
additional underwriting characteristics for identifying loans that are 
subject to the 50 percent statutory risk weights, provided these 
underwriting characteristics are ``consistent with the purposes of the 
minimum acceptable capital requirements to maintain the safety and 
soundness of financial institutions.'' The agencies asked whether they 
should impose the following additional underwriting criteria as 
additional requirements for a core or opt-in 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 formula. If 
the bank's IRB system does not generate a 50 percent risk weight for a 
particular loan, the loan would not qualify for the statutory risk 
weight and would receive the risk weight generated by the IRB system.
    A few commenters opposed this alternative approach and indicated 
that the additional underwriting criteria would increase operational 
burden. Other commenters, however, observed that compliance with the 
additional underwriting criteria would not be burdensome.
    After careful consideration of the comments and further analysis of 
the text, spirit and legislative history of the RTCRRI Act, the 
agencies have concluded that they should impose the additional 
underwriting criteria described in the preamble to the proposed rule as 
minimum requirements for a core or opt-in bank to use the statutory 50 
percent risk weight for particular loans. The agencies believe that the 
imposition of these criteria is consistent with the plain language of 
the RTCRRI Act, which allows a bank to use the 50 percent risk weight 
only if it meets the additional underwriting characteristics 
established by the agencies. The agencies have concluded that the 
additional underwriting characteristics imposed in the final rule are 
``consistent with the purposes of the minimum acceptable capital 
requirements to maintain the safety and soundness of financial 
institution,'' because the criteria will make the risk-based capital 
requirement for these loans a function of each bank's historical loss 
experience for the loans and will therefore more accurately reflect the 
performance and risk of loss for these loans. The additional 
underwriting characteristics are also consistent with the purposes and 
legislative history of RTCRRI Act, which was designed to reflect the 
true level of risk associated with these types of mortgage loans and to 
do so in accordance with the Basel Accord.\66\
---------------------------------------------------------------------------

    \66\ See, e.g., Floor debate for the Resolution Trust 
Corporation Refinancing, Restructuring, and Improvement Act of 1991, 
p. H11853, House of Representatives, Nov. 26, 1991 (Rep. Wylie)
---------------------------------------------------------------------------

    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, also supports the 
addition of the new underwriting characteristics. Section 305(b)(1)(B) 
of FDICIA \67\ directs each agency to revise its risk-based capital 
standards for insured depository institutions to ensure that those 
standards ``reflect the actual performance and expected risk of loss of 
multifamily mortgages.'' Although this addresses only multifamily 
mortgage loans (and not one-to four-family residential pre-sold 
construction loans), it provides the agencies with a Congressional 
mandate--equal in force and power to section 618 of the RTCRRI Act--to 
enhance the risk sensitivity of the regulatory capital treatment of 
multifamily mortgage loans. Crucially, the IRB approach required of 
core and opt-in banks will produce capital requirements that more 
accurately reflect both performance and risk of loss for multifamily 
mortgage loans than either the Basel I risk weight or the RTCRRI Act 
risk weight.
---------------------------------------------------------------------------

    \67\ 12 U.S.C. 1828.
---------------------------------------------------------------------------

    As noted above, section 618(a)(2) of the RTCRRI Act mandates that 
each agency amend its capital regulations to provide a 100 percent risk 
weight to any single-family residential construction loan for which the 
purchase contract is cancelled. Because the statute does not authorize 
the agencies to establish additional underwriting characteristics for 
this small category of loans, the final rule, like the proposed rule, 
provides a 100 percent risk weight for single-family residential 
construction loans for which the purchase contract is cancelled.

C. Credit Risk Mitigation (CRM) Techniques

    Banks use a number of techniques to mitigate credit risk. This 
section of the preamble describes how the final 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 of risks, 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 final rule, a bank generally recognizes collateral that 
secures a wholesale exposure as part of the LGD estimation process and 
generally recognizes collateral that secures a retail exposure as part 
of the PD 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.
    Although the final rule does not contain specific regulatory 
requirements about how a bank incorporates collateral into PD or LGD 
estimates, a bank should, when reflecting the credit risk mitigation 
benefits of collateral in its estimation of the risk parameters of a 
wholesale or retail exposure:
    (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

[[Page 69338]]

all parties and legally enforceable in all relevant jurisdictions;
    (ii) Consider the 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 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. Counterparty Credit Risk of Repo-Style Transactions, Eligible Margin 
Loans, and OTC Derivative Contracts
    This section describes two EAD-based methodologies--a collateral 
haircut approach and an internal models methodology--that a bank may 
use instead of an 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 (netting sets).\68\ 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. 
These methodologies are substantially the same as those in the 
proposal, except for a few differences identified below.
---------------------------------------------------------------------------

    \68\ For purposes of the internal models methodology in section 
32(d) of the rule, discussed below in section V.C.4. of this 
preamble, netting set also means a group of transactions with a 
single counterparty that are subject to a qualifying cross-product 
master netting agreement.
---------------------------------------------------------------------------

    One difference from the proposal is that, consistent with the New 
Accord, under the final rule these three methodologies may also be used 
to recognize the benefits of any collateral (not only financial 
collateral) mitigating the counterparty credit risk of repo-style 
transactions that are included in a bank's VaR-based measure under the 
market risk rule. In response to comments requesting broader 
application of the EAD-based methodologies for recognizing the risk-
mitigating effect of collateral, the agencies added this flexibility to 
the final rule to enhance international consistency and reduce 
regulatory burden.
    A bank may use any combination of the three methodologies for 
collateral recognition; however, it must use the same methodology for 
similar exposures. This means that, as a general matter, the agencies 
expect a bank to use one of the three methodologies for all its repo-
style transactions, one of the three methodologies for all its eligible 
margin loans, and one of the three methodologies for all its OTC 
derivative contracts. A bank may, however, apply a different 
methodology to subsets of repo-style transactions, eligible margin 
loans, or OTC derivatives by product type or geographical location if 
its application of different methodologies is designed to separate 
transactions that do not have similar risk profiles and is not designed 
to arbitrage the rule. For example, 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 C illustrates which EAD 
estimation methodologies may be applied to particular types of 
exposure.

                                                     Table C
----------------------------------------------------------------------------------------------------------------
                                                                                         Models approach
                                                  Current         Collateral   ---------------------------------
                                                  exposure         haircut      Simple VaR \69\  Internal models
                                                methodology        approach       methodology      methodology
----------------------------------------------------------------------------------------------------------------
OTC derivative..............................               X   ...............  ...............               X
Recognition of collateral for OTC             ...............          \70\ X   ...............               X
 derivatives................................
Repo-style transaction......................  ...............               X                X                X
Eligible margin loan........................  ...............               X                X                X
Cross-product netting set...................  ...............  ...............  ...............               X
----------------------------------------------------------------------------------------------------------------


[[Page 69339]]

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

    \69\ Only repo-style transactions and eligible margin loans 
subject to a single-product qualifying master netting agreement are 
eligible for the simple VaR methodology.
    \70\ In conjunction with the current exposure methodology.
---------------------------------------------------------------------------

Qualifying Master Netting Agreement
    Under the final rule, consistent with the proposal, 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 sufficient legal review to conclude 
with a well-founded basis (and has maintained sufficient written 
documentation of that legal review) 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 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.
EAD for Repo-Style Transactions and Eligible Margin Loans
    Under the final rule, a bank may recognize the risk-mitigating 
effect of financial collateral that secures a repo-style transaction, 
eligible margin loan, or single-product netting set of such 
transactions and the risk-mitigating effect of any collateral that 
secures a repo-style transaction that is included in a bank's VaR-based 
measure under the market risk rule through an adjustment to EAD rather 
than 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.

[[Page 69340]]

[GRAPHIC] [TIFF OMITTED] TR07DE07.002

    The proposed rule defined a 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;\71\ and
---------------------------------------------------------------------------

    \71\ This requirement is met where all transactions under the 
agreement (i) are 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).
---------------------------------------------------------------------------

    (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.
    In the proposal, the agencies recognized 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 sought 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.
    Several commenters responded to this question by urging the 
agencies to modify the third component of the repo-style transaction 
definition in accordance with the 2006 interagency securities borrowing 
rule.\72\ Under the securities borrowing rule, the agencies accorded 
preferential risk-based capital treatment for cash-collateralized 
securities borrowing transactions that either met a bankruptcy standard 
such as the standard in criterion (iii) above or were overnight or 
unconditionally cancelable at any time by the bank. Commenters 
maintained that banks are able to terminate promptly a repo-style 
transaction with a counterparty whose financial condition is 
deteriorating so long as the transaction is done on an overnight basis 
or is unconditionally cancelable by the bank. As a result, these 
commenters contended that events of default and losses on such 
transactions are very rare.
---------------------------------------------------------------------------

    \72\ 71 FR 8932, February 22, 2006.
---------------------------------------------------------------------------

    The agencies have decided to modify the definition of repo-style 
transaction consistent with this suggestion by commenters and 
consistent with the 2006 securities borrowing rule. The agencies 
believe that this modification will resolve, in a manner that preserves 
safety and soundness, technical difficulties that banks would have had 
in meeting the proposed rule's

[[Page 69341]]

definition for a material proportion of their repo-style transactions. 
Consistent with the 2006 securities borrowing rule, a reasonably short 
notice period, typically no more than the standard settlement period 
associated with the securities underlying the repo-style transaction, 
would not detract from the unconditionality of the bank's termination 
rights. With regard to overnight transactions, the counterparty 
generally should have no expectation, either explicit or implicit, that 
the bank will automatically roll over the transaction. The agencies are 
maintaining in substance all the other components of the proposed 
definition of repo-style transaction.
    The proposed rule defined 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; \73\ and
    (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.
---------------------------------------------------------------------------

    \73\ This requirement is met under the circumstances described 
in footnote 73. Under the U.S. Bankruptcy Code, ``margin loans'' are 
a type of securities contract, but the term ``margin loan'' does not 
encompass all loans that happen to be secured by securities 
collateral. Rather, Congress intended the term ``margin loan'' to 
include only those loans commonly known in the industry as margin 
loans, such as credit permitted in an account under the Board's 
Regulation T or where a financial intermediary extends credit for 
the purchase, sale, carrying, or trading of securities. See H.R. 
Rep. No. 109-131, at 119, 130 (2005).
---------------------------------------------------------------------------

    Commenters generally supported this definition, but some objected 
to the prescriptiveness of criterion (iii). Criterion (iii) is 
necessary to ensure that a bank is quickly able to realize the value of 
its collateral in the event of obligor default. Collateral stayed by 
bankruptcy and not liquidated until a date far in the future is more 
appropriately reflected as a discounted positive cash flow in LGD 
estimation. Criterion (iii) is satisfied when the bank has conducted 
sufficient legal review to conclude with a well-founded basis (and has 
maintained sufficient written documentation of that legal review) that 
a margin loan would be exempt from the bankruptcy auto-stay. The 
agencies are therefore maintaining substantially the same definition of 
eligible margin loan in the final rule.
    With the exception of repo-style transactions that are included in 
a bank's VaR-based measure under the market risk rule (as discussed 
above), for purposes of determining EAD for repo-style transactions, 
eligible margin loans, and OTC derivatives, and recognizing collateral 
mitigating the counterparty credit risk of such exposures, the final 
rule (consistent with the proposed rule) allows banks to take into 
account only financial collateral. The proposed rule defined 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 and money market mutual fund shares if a price for 
the shares is publicly quoted daily.
    In connection with this definition, the agencies asked for 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. A couple of commenters supported 
this requirement, but several other commenters objected. The objecting 
commenters acknowledged that the requirement would generally be 
consistent with current U.S. collateral practices for repo-style 
transactions, eligible margin loans, and OTC derivatives, but they 
criticized the requirement on the grounds that: (i) Obtaining a 
perfected, first priority security interest may not be the current 
market practice outside the United States; (ii) U.S. practices may 
evolve in such a fashion as to not meet this requirement; and (iii) the 
requirement is not explicit in the New Accord. Other commenters asked 
the agencies to clarify that the requirement would be met for all or 
certain forms of collateral if the bank had possession and control of 
the collateral and a reasonable basis to believe it could promptly 
liquidate the collateral.
    The agencies believe that in order to use the EAD adjustment 
approaches for exposures within the United States, a bank must have a 
perfected, first priority security interest in collateral, with the 
exception of cash on deposit with the bank and certain custodial 
arrangements. The agencies have modified the proposed requirement to 
address a concern raised by several commenters that a bank could fail 
to satisfy the first priority security interest requirement because of 
the senior security interest of a third-party custodian involved as an 
intermediary in the transaction. Under the final rule, a bank meets the 
security interest requirement so long as the bank has a perfected, 
first priority security interest in the collateral notwithstanding the 
prior security interest of any custodial agent. Outside of the United 
States, the definition of financial collateral can be satisfied as long 
as the bank has the legal equivalent of a perfected, first priority 
security interest. For example, cash on deposit with the bank is an 
example of the legal equivalent of a perfected, first priority security 
interest. The agencies intend to apply this ``legal equivalent'' 
standard flexibly to deal with non-U.S. collateral access regimes.
    The agencies also invited comment on the extent to which assets 
that do not meet the definition of financial collateral are the basis 
of repo-style transactions engaged in by banks or are taken by banks as 
collateral for eligible margin loans or OTC derivatives. The agencies 
also inquired as to whether the definition of financial collateral 
should be expanded to reflect any other asset types.
    A substantial number of commenters asked the agencies to add asset 
types to the list of financial collateral. The principal recommended 
additions included: (i) Non-investment-grade externally rated bonds; 
(ii) bonds that are not externally rated; (iii) all financial 
instruments; (iv) letters of credit; (v) mortgages loans; and (vi) 
certificates of deposit. Some commenters that advocated inclusion of a 
wider range of bonds admitted that it may be reasonable to impose some 
sort of liquidity requirement on the additional bonds and to impose a 
25-50 percent standard supervisory haircut for such additional bonds. 
Some of the commenters that advocated inclusion of

[[Page 69342]]

a broader range of bonds and mortgages asserted that such inclusion 
would be warranted by the exemption from bankruptcy auto-stay accorded 
to repo-style transactions involving such assets by the U.S. Bankruptcy 
Code.\74\
---------------------------------------------------------------------------

    \74\ 11 U.S.C. 559.
---------------------------------------------------------------------------

    As described above, to enhance international consistency and 
conform the final rule more closely to the New Accord, the agencies 
have decided to permit a bank to use the EAD approach for all repo-
style transactions that are included in a bank's VaR-based measure 
under the market risk rule, regardless of the underlying collateral 
type. The agencies are satisfied that such repo-style transactions 
would be based on collateral that is sufficiently liquid to justify 
applying the EAD approach.
    The agencies have included conforming residential mortgages in the 
definition of financial collateral and as acceptable underlying 
instruments in the definitions of repo-style transaction and eligible 
margin loan based on the liquidity of such mortgages and their 
widespread use as collateral in repo-style transactions. However, 
because this inclusion goes beyond the New Accord's recognition of 
financial collateral, the agencies decided to take a conservative 
approach and require banks to use the standard supervisory haircut 
approach, with a 25 percent haircut and minimum ten-business-day 
holding period, in order to recognize conforming residential mortgage 
collateral in EAD (other than for repo-style transactions that are 
included in a bank's VaR-based measure under the market risk rule). Use 
of the standard supervisory haircut approach for repo-style 
transactions, eligible margin loans, and OTC derivatives collateralized 
by conforming mortgages does not preclude a bank's use of the other EAD 
adjustment approaches for exposures collateralized by other types of 
financial collateral. Due to concerns about both competitive equity and 
the liquidity and price availability of other types of collateral, the 
agencies are not otherwise expanding the proposed definition of 
financial collateral in the final rule.
Collateral Haircut Approach
    Under the collateral haircut approach of the final rule, similar to 
the proposed rule, a bank must 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 
instrument or in gold (where the net position in a given instrument or 
in gold equals the sum of the current market values of the instrument 
or gold 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 instrument or gold the bank has borrowed, purchased 
subject to resale, or taken as collateral from the counterparty) 
multiplied by the market price volatility haircut appropriate to the 
instrument or gold; and (iii) the sum of the absolute values of the net 
position of any cash or instruments 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 
may choose to use standard supervisory haircuts or, with prior written 
approval from its primary Federal supervisor, its own estimates of 
haircuts.
    In the preamble to the proposed rule, for purposes of the 
collateral haircut approach, the agencies clarified that 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. The 
agencies sought comment on alternative approaches for determining a 
given security for purposes of the collateral haircut approach. A few 
commenters expressed support for the proposed CUSIP approach to 
defining a given security, but one commenter asked the agencies to 
permit each bank the flexibility to define given security. The 
collateral haircut approach in the final rule is based on a bank's net 
position in a ``given instrument or gold'' rather than in a ``given 
security'' to more precisely capture the positions to which a bank must 
apply the haircuts. To enhance safety and soundness and comparability 
across banks, the agencies believe that it is important to preserve the 
relatively clear CUSIP approach to defining a given instrument for 
purposes of the collateral haircut approach. Accordingly, the agencies 
are maintaining the CUSIP approach as appropriate for determining a 
given instrument for instruments that are securities.
    Standard supervisory haircuts. Under the final rule, as under the 
proposed rule, if a bank chooses to use standard supervisory haircuts, 
it must use an 8 percent haircut for each currency mismatch and the 
haircut appropriate to each security in Table D below. These haircuts 
are based on the ten-business-day holding period for eligible margin 
loans and must be multiplied by the square root of \1/2\ to convert the 
standard supervisory haircuts to the five-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 ten business days for eligible margin loans or five business days 
for repo-style transactions where and as appropriate to take into 
account the illiquidity of an instrument.

[[Page 69343]]

[GRAPHIC] [TIFF OMITTED] TR07DE07.003

    As an example, assume a bank that uses standard supervisory 
haircuts has extended an eligible margin loan of $100 that is 
collateralized by five-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.
---------------------------------------------------------------------------

    \75\ The proposed and final rules define 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. Under the final rule, as under the 
proposal, 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 five-business-day holding 
period for repo-style transactions and a minimum ten-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 reassess data sets and 
haircuts whenever market prices change materially. A bank must estimate 
individually the volatilities of the exposure, the collateral, and 
foreign exchange rates, and may not take into account the correlations 
between them.
    Under the final rule, as under the proposal, a bank that uses 
internally estimated haircuts must 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 must be 
representative of the internal volatility estimates for securities in 
that category that the bank has lent, sold subject to repurchase, 
posted as collateral, borrowed, purchased subject to resale, or taken 
as collateral. In determining

[[Page 69344]]

relevant categories, the bank must at a minimum 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 must 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 must 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.
    One commenter recommended that the agencies permit banks to use 
category-based internal estimate haircuts for non-investment-grade 
bonds and equity securities. The agencies have decided to adopt the 
proposed rule's provisions on category-based haircuts because they are 
consistent with the New Accord and because the volatilities of non-
investment-grade bonds and of equity securities are more dependent on 
idiosyncratic, issuer-specific events than the volatility of 
investment-grade bonds.
    Under the final rule, as under the proposal, 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 bank must calculate the applicable haircut (HM) 
using the following square root of time formula:
[GRAPHIC] [TIFF OMITTED] TR07DE07.006

Where:

(i) TM = five for repo-style transactions and ten 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, under the final rule, as under the proposal, 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). The agencies received 
no material comments on the simple VaR methodology and are adopting the 
methodology without change from the proposal.
    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 is equal to the 
value of the exposures minus the value of the collateral plus a VaR-
based estimate of potential future exposure (PFE). 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-based 
estimate of PFE is an estimate of the bank's maximum exposure on the 
netting set over a fixed time horizon with a high level of confidence.
    Specifically, 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 five-business-day holding period for repo-style transactions or 
over a ten-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 qualification 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
    Under the final rule, as under the proposed rule, 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 rule also defines 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 rule defines as the lesser of the market 
standard for the particular instrument or five business days). This 
includes, for example, agency mortgage-backed securities transactions 
conducted in the To-Be-Announced market.
    Figure 3 illustrates the treatment of OTC derivative contracts.

[[Page 69345]]

[GRAPHIC] [TIFF OMITTED] TR07DE07.004

Current Exposure Methodology
    The final rule's current exposure methodology for determining EAD 
for single OTC derivative contracts is similar to the methodology in 
the general risk-based capital rules and is the same as the current 
exposure methodology in the proposal. Under the current exposure 
methodology, the EAD for an OTC derivative contract is 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 final rule's current exposure methodology for OTC derivative 
contracts subject to qualifying master netting agreements is also 
similar to the treatment in the agencies' general risk-based capital 
rules and, with one exception discussed below, is the same as the 
treatment in the proposal. Under the general risk-based capital rules 
and under the proposed rule, a bank could not recognize netting 
agreements for OTC derivative contracts for risk-based capital purposes 
unless it obtained 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.\76\ The 
agencies asked for 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.
---------------------------------------------------------------------------

    \76\ This requirement was found in footnote 8 of the proposed 
rule text (in section 32(b)(2)).
---------------------------------------------------------------------------

    Although one commenter supported the proposed rule's written legal 
opinion requirement, many other commenters asked the agencies to remove 
this requirement. These commenters maintained that, provided a 
transaction is conducted in a jurisdiction and with a counterparty type 
that is covered by a commissioned legal opinion, use of industry-
developed standardized contracts for certain OTC derivative products 
and reliance on commissioned legal opinions as to the enforceability of 
these contracts should be a sufficient guarantor of enforceability. 
These commenters added that reliance on such commissioned legal 
opinions is standard market practice.
    The agencies continue to believe that the legal enforceability of 
netting agreements is a necessary condition for a bank to recognize 
netting effects in its capital calculation. However, the agencies have 
conducted additional analysis and agree that a unique, written legal 
opinion is not necessary in all cases to ensure the enforceability of 
an OTC derivative netting agreement. Accordingly, the agencies have 
removed the requirement that a bank obtain a written and well reasoned 
legal opinion for each of its qualifying master netting agreements that 
cover OTC derivatives. As a result, under the final rule, to obtain 
netting treatment for multiple OTC derivative contracts subject to a 
qualifying master netting agreement, a

[[Page 69346]]

bank must conduct sufficient legal review to conclude with a well-
founded basis (and maintain sufficient written documentation of that 
legal review) that the agreement would provide termination netting 
benefits and is legal, valid, binding, and enforceable. In some cases, 
this requirement could be met by reasoned reliance on a commissioned 
legal opinion or an in-house counsel analysis. In other cases, 
however--for example, involving certain new derivative transactions or 
derivative counterparties in unusual jurisdictions--the bank would need 
to obtain an explicit written legal opinion from external or internal 
legal counsel addressing the particular situation.
    The proposed rule's conversion factor (CF) matrix used to compute 
PFE was 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 was specified to be 
5.0 percent for contracts with investment-grade reference obligors and 
10.0 percent for contracts with non-investment-grade reference 
obligors.\77\ The CF for a credit derivative contract did not depend on 
the remaining maturity of the contract. The second change was that 
floating/floating basis swaps were no longer exempted from the CF for 
interest rate derivative contracts. The exemption was put into place 
when such swaps were very simple, and the agencies believed it was 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 did not change from the general risk-based 
capital rules. The agencies received no material comment on these 
provisions of the proposed rule and have adopted them as proposed.
---------------------------------------------------------------------------

    \77\ 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.
---------------------------------------------------------------------------

    Under the final rule, as under the proposed rule, if an OTC 
derivative contract is collateralized by financial collateral and a 
bank uses the current exposure methodology to determine EAD for the 
exposure, the bank must first determine an unsecured EAD as described 
above and in section 32(c) of the rule. To take into account the risk-
reducing effects of the financial collateral, the bank may either 
adjust the 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(b) of the rule.
    Under part VI of the final rule, and 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 rule as a credit risk mitigant for an exposure that is not a 
covered position under the market risk rule does not have to compute a 
separate counterparty credit risk capital requirement for the credit 
derivative.\78\ 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.
---------------------------------------------------------------------------

    \78\ The agencies recognize that there are reasons why a bank's 
credit portfolio might contain purchased credit protection on a 
reference name in a notional principal amount that exceeds the 
bank's currently measured EAD to that obligor. If the protection 
amount of the credit derivative is materially greater than the EAD 
of the exposure being hedged, however, the bank generally must treat 
the credit derivative as two separate exposures and calculate a 
counterparty credit risk capital requirement for the exposure that 
is not providing credit protection to the hedged exposure.
---------------------------------------------------------------------------

    In addition, where a bank provides protection through a credit 
derivative that is not treated as a covered position under the market 
risk rule, 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 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 qualifying master netting agreement 
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 market risk rule, it must compute a 
counterparty credit risk capital requirement for the credit derivative 
under section 31 of the rule.
4. Internal Models Methodology
    The final rule, like the proposed rule, includes an internal models 
methodology for the calculation of EAD for the counterparty credit 
exposure of OTC derivatives, eligible margin loans, and repo-style 
transactions. The internal models methodology requires a risk model 
that estimates EAD at the level of a netting set. A transaction not 
subject to a qualifying master netting agreement is considered to be 
its own netting set and a bank must calculate EAD 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 of 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.
    The final rule tracks the proposed rule by defining a qualifying 
cross-product master netting agreement 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

[[Page 69347]]

    (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.
    As discussed in the proposal, banks use several measures to manage 
their exposure to the counterparty credit risk of repo-style 
transactions, eligible margin loans, and OTC derivatives, including 
PFE, expected exposure (EE), and expected positive exposure (EPE). PFE 
is the maximum exposure estimated to occur over a future horizon at a 
high level of statistical confidence. Banks often use PFE when 
measuring counterparty credit risk exposure against counterparty credit 
limits. EE is the expected value of the probability distribution of 
non-negative credit risk exposures to a counterparty 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). The final rule clarifies that, when estimating 
EE, a bank must set any negative market values in the probability 
distribution of market values to a counterparty at a specified future 
date to zero to convert the probability distribution of market values 
to the probability distribution of credit risk exposures. 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.'' \79\ 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.
---------------------------------------------------------------------------

    \79\ 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 (rollover risk) or may 
underestimate the exposures of eligible margin loans, repo-style 
transactions, and OTC derivatives with short maturities, the final 
rule, like 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 EEtk = max(Effective EEtk-1, EEtk)

where exposure is measured at future dates t1, t2, t3, * * * and 
effective EEt0 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 its primary Federal supervisor.

    The final rule clarifies that if a bank hedges some or all of the 
counterparty credit risk associated with a netting set using an 
eligible credit derivative, the bank may take the reduction in exposure 
to the counterparty into account when estimating EE. If the bank 
recognizes this reduction in exposure to the counterparty in its 
estimate of EE, it must also use its internal model to estimate a 
separate EAD for the bank's exposure to the protection provider of the 
credit derivative.
    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 has the flexibility 
to raise this value based on the bank's specific characteristics of 
counterparty credit risk. In addition, with supervisory approval, a 
bank may use its own estimate of alpha, subject to a floor of 1.2.
    In the proposal, the agencies requested comment on all aspects 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. Commenters expressed a number of 
objections to the proposed rule's internal models methodology.
    Several commenters contended that banks that use the internal 
models methodology should be permitted to calculate effective EPE at 
the counterparty level and should not be required to calculate 
effective EPE at the netting set level. These commenters indicated that 
while the New Accord mandates calculation at the netting set level, 
those banks that currently use an EPE-style approach to measuring 
counterparty credit risk for internal risk management purposes 
typically use a counterparty-by-counterparty EPE approach. They 
asserted that forcing banks to use a netting-set-by-netting-set 
approach would be burdensome for banks and would provide the agencies 
no material regulatory benefits, as netting effects are taken into 
account in the calculation of EE.
    The agencies have retained the netting set focus of the calculation 
of effective EPE to preserve international consistency. The agencies 
will continue to review the implications, particularly with respect to 
the appropriate recognition of netting benefits, of allowing banks to 
calculate effective EPE at the counterparty level.
    One commenter objected to the proposed rule's requirement that a 
bank use effective EE (as opposed to EE). This commenter contended that 
effective EE is an excessively conservative and imprecise mechanism to 
address rollover risk in a portfolio of short-term transactions. The 
commenter represented that rollover risk should be addressed under 
Pillar 2 rather than Pillar 1. The agencies continue to believe that 
rollover risk is a core credit risk that should be covered by explicit 
risk-based capital requirements. The agencies also remain concerned 
that EE and EPE (as opposed to effective EE and effective EPE) would 
not adequately incorporate rollover risk and do not believe that bank 
internal estimates of rollover risk are sufficiently reliable at this 
time to use for risk-based capital purposes. To ensure consistency with 
the New Accord and in light of the lack of alternative prudent 
mechanisms to incorporate rollover risk, the agencies continue to 
include effective EE and effective EPE in the final rule.
    Several commenters criticized the default alpha of 1.4 and the 1.2 
floor on internal estimates of alpha. These commenters contended that 
these supervisory alphas were too conservative for many dealer banks 
with large, diverse, and granular portfolios of repo-style 
transactions, eligible margin

[[Page 69348]]

loans, and OTC derivatives. Although the agencies acknowledge the 
possibility that certain banks with certain types of portfolios at 
certain times could warrant an alpha of less than 1.2, the agencies 
believe it is important to have a supervisory floor on alpha. This 
floor will ensure consistency with the New Accord, comparability among 
the various banks that use the internal models methodology, and 
sufficient capital through the economic cycle for securities financing 
transactions and OTC derivatives. Therefore, the agencies are retaining 
the alpha floor as proposed.
    Similar to the proposal, under the final rule 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 the following 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 ensure 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 exposure 
distribution 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 be able to 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. By contrast, under the 
proposed rule, a bank would have to measure and manage current exposure 
gross and net of collateral held. Some commenters criticized this 
requirement as inconsistent with the New Accord and bank internal risk 
management practices. The agencies agree and have revised the rule to 
only require a bank to ``be able to'' measure and manage current 
exposures gross and net of collateral.
    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, the model 
must use current market data to compute current exposures. When a bank 
uses historical data to estimate model parameters, the bank must use at 
least three years of data that cover a wide range of economic 
conditions. This requirement reflects the longer horizon for 
counterparty credit risk exposures compared to market risk exposures. 
The data must be updated at least quarterly or more frequently if 
market conditions warrant. Banks should consider using model parameters 
based on forward looking measures, 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 final rule's definition of M 
under the internal models methodology is identical to that of the 
proposed rule and is based on a weighted average of expected exposures 
over the life of the transactions relative to their one year exposures. 
Consistent with the New Accord, the final rule expands upon the 
proposal by providing that a bank that uses an internal model to 
calculate a one-sided credit valuation adjustment may use the effective 
credit duration estimated by the model as M(EPE) in place of the 
formula in the paragraph below.
    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 69349]]

[GRAPHIC] [TIFF OMITTED] TR07DE07.007

and (ii) dfk is the risk-free discount factor for future 
time period tk. The cap of five years on M is consistent 
with the treatment of wholesale exposures under section 31 of the 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 one year except as provided in 
section 31(d)(7) of the 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
    The provisions of the final rule on collateral agreements under the 
internal models methodology are the same as those of the proposed rule. 
Under the final rule, if a bank has prior written approval from its 
primary Federal supervisor, it may capture within its internal model 
the effect on EAD of a collateral agreement that requires receipt of 
collateral when exposure to the counterparty increases. In no 
circumstances, however, may a bank take into account in EAD collateral 
agreements triggered by deterioration of counterparty credit quality. 
Several commenters asked the agencies to permit banks to incorporate in 
EAD collateral agreements that are dependent on a decline in the 
external rating of the counterparty. The agencies do not believe that 
banks are able to model the necessary correlations with sufficient 
reliability to accept these types of collateral agreements under the 
internal models methodology at this time.
    In the context of the internal models methodology, the rule defines 
a collateral agreement as 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 (notwithstanding the prior security interest of any 
custodial agent), 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 a bank's internal model does not capture the effects of 
collateral agreements, the final rule provides a ``shortcut'' method to 
provide the bank with some benefit, in the form of a smaller EAD, for 
collateralized counterparties. Under the shortcut method, effective EPE 
is the lesser of a threshold amount (linked to the exposure amount at 
which a counterparty must post collateral) plus an add-on and effective 
EPE without a collateral agreement. Although any bank may use this 
``shortcut'' method under the internal models methodology, 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 provided in the final rule is identical to 
the shortcut method provided in the proposed rule.
Alternative Methods
    Under the final rule, consistent with the proposed rule, a bank 
using the internal models methodology may use an alternative method to 
determine EAD for certain transactions, provided that the bank can 
demonstrate to its primary Federal supervisor that the method's output 
is more conservative than an alpha of 1.4 (or higher) times effective 
EPE.
    Use of an alternative method 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 method is used, the 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.
    The agencies recognize that for new OTC derivative products a bank 
may need a transition period during which to incorporate a new product 
into its internal models methodology or to demonstrate that an 
alternative method is more conservative than an alpha of 1.4 (or 
higher) times effective EPE. The final rule therefore provides that for 
material portfolios of new OTC derivative products, a bank may assume 
that the current exposure methodology in section 32(c) of the rule 
meets the conservatism requirement for a period not longer than 180 
days. As a general matter, the agencies expect that the current 
exposure methodology in section 32(c) of the rule would be an 
acceptable, more conservative method for immaterial portfolios of OTC 
derivatives.
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. Similarly, under the final rule, 
as 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 rule.
Eligible Guarantees and Eligible Credit Derivatives
    Under the proposed rule, guarantees and credit derivatives had to 
meet specific eligibility requirements to be recognized as CRM for a 
wholesale exposure. The proposed rule defined an eligible guarantee as 
a guarantee that:

[[Page 69350]]

    (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.
    Commenters suggested a number of improvements to the proposed 
definition of eligible guarantee. One commenter asked the agencies to 
clarify that the unconditionality requirement in criterion (i) of the 
definition would be interpreted consistently with the New Accord's 
requirement that ``there should be no clause in the protection contract 
outside the direct control of the bank that could prevent the 
protection provider from being obliged to pay out in a timely manner in 
the event that the original counterparty fails to make the payment(s) 
due.'' \80\ The agencies are not providing the requested clarification. 
The agencies have acquired considerable experience in the intricate 
issue of the conditionality of guarantees under the general risk-based 
capital rules and intend to address the meaning of ``unconditional'' in 
the context of eligible guarantees under this final rule on a case-by-
case basis going forward.
---------------------------------------------------------------------------

    \80\ New Accord, ]189.
---------------------------------------------------------------------------

    This same commenter also asked the agencies to revise the second 
criterion of the definition from coverage of ``all or a pro rata 
portion of all contractual payments of the obligor on the reference 
exposure'' to coverage of ``all or a pro rata portion of all principal 
or due and payable amounts on the reference exposure.'' The agencies 
have decided to preserve the second criterion of the eligible guarantee 
definition without change to ensure that a bank only obtains CRM 
benefits from credit risk mitigants that cover all sources of credit 
exposure to the obligor. Although it is appropriate to provide partial 
CRM benefits under the wholesale framework for partial but pro rata 
guarantees of all contractual payments, the agencies are less 
comfortable with providing partial CRM benefits under the wholesale 
framework where the extent of the loss coverage of the credit exposure 
is not so easily quantifiable. Accordingly, for example, if a bank 
obtains a principal-only or interest-only guarantee of a corporate 
bond, the guarantee will not qualify as an eligible guarantee and the 
bank will not be able to obtain any CRM benefits from the guarantee.
    Some commenters asked the agencies to modify the fourth criterion 
of the eligible guarantee definition to clarify, consistent with the 
New Accord, that a guarantee that is terminable by the bank and the 
protection provider by mutual consent may qualify as an eligible 
guarantee. This is an appropriate clarification of the definition and, 
therefore, the agencies have amended the fourth criterion of the 
definition to require that the guarantee be non-cancelable by the 
protection provider unilaterally.
    One commenter asked the agencies to modify the fifth criterion of 
the eligible guarantee definition, which requires the guarantee to be 
legally enforceable in a jurisdiction where the protection provider has 
sufficient assets, by deleting the word ``sufficient.'' The agencies 
have preserved the fifth criterion of the proposed definition intact. 
The agencies do not think that it would be consistent with safety and 
soundness to permit a bank to obtain CRM benefits under the rule if the 
guarantee were not legally enforceable against the protection provider 
in a jurisdiction where the protection provider has sufficient 
available assets.
    Finally, some commenters objected to the sixth and final criterion 
of the eligible guarantee definition, which requires the protection 
provider to make payments to the beneficiary upon default of the 
obligor without first requiring the beneficiary to demand payment from 
the obligor. The agencies have decided to modify this criterion to make 
it more consistent with the New Accord and actual market practice. The 
final rule's sixth criterion requires only that the guarantee permit 
the bank to obtain payment from the protection provider in the event of 
an obligor default in a timely manner and without first having to take 
legal actions to pursue the obligor for payment.
    The agencies also have performed additional analysis and review of 
the definition of eligible guarantee and have decided to add two 
additional criteria to the definition. The first additional criterion 
prevents guarantees from certain affiliated companies from being 
eligible guarantees. Under the final rule, a guarantee will not be an 
eligible guarantee if the protection provider is an affiliate of the 
bank (other than an affiliated depository institution, bank, securities 
broker or dealer, or insurance company that does not control the bank 
and that is subject to consolidated supervision and regulation 
comparable to that imposed on U.S. depository institutions, securities 
broker-dealers, or insurance companies). For purposes of the 
definition, an affiliate of a bank is defined as a company that 
controls, is controlled by, or is under common control with, the bank. 
Control of a company is defined as (i) ownership, control, or holding 
with power to vote 25 percent or more of a class of voting securities 
of the company; or (ii) consolidation of the company for financial 
reporting purposes.
    The strong correlations among the financial conditions of 
affiliated parties would typically render guarantees from affiliates of 
the bank of little value precisely when the bank would need them most--
when the bank itself is in financial distress.\81\ For example, a 
guarantee that a bank might receive from its parent shell bank holding 
company would provide little credit risk mitigation to the bank as the 
bank approached insolvency because the financial condition of the 
holding company would depend critically on the financial health of the 
subsidiary bank. Moreover, the holding company typically would 
experience no increase in its regulatory capital requirement for 
issuing the guarantee because the guarantee would be on behalf of a 
consolidated subsidiary and would be eliminated in the consolidation of 
the holding company's financial statements.\82\
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    \81\ This concern of the agencies is the same concern that led 
the agencies to exclude from the definition of tier 1 capital any 
instrument that has credit-sensitive features--such as an interest 
rate or dividend rate that increases as the credit quality of the 
bank issuer declines or an investor put right that is triggered by a 
decline in issuer credit quality. See, e.g., 12 CFR part 208, 
appendix A, section II.A.1.b.
    \82\ Although the Board's Regulation W places strict 
quantitative and qualitative limits on guarantees issued by a bank 
on behalf of an affiliate, it does not restrict all guarantees 
issued by an affiliate on behalf of a bank. See, e.g., 12 CFR 
223.3(e).
---------------------------------------------------------------------------

    The agencies have decided, however, that a bank should be able to 
recognize CRM benefits by obtaining a guarantee from an affiliated 
insured depository institution, bank, securities broker or dealer, or 
insurance company that does not control the bank and that 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). A

[[Page 69351]]

depository institution for this purpose includes all subsidiaries of 
the depository institution except financial subsidiaries. The final 
rule recognizes guarantees from these types of affiliates because they 
are financial institutions subject to prudential regulation by national 
or state supervisory authorities. The agencies expect that the 
prudential regulation of the affiliate would help prevent the affiliate 
from exposing itself excessively to the credit exposures of the bank. 
Similarly, these affiliates would be subject to regulatory capital 
requirements of their own and should experience an increase in their 
regulatory capital requirements for issuing the guarantee.
    The second additional criterion precludes a guarantee from eligible 
guarantee status if the guarantee increases the beneficiary's cost of 
credit protection in response to deterioration in the credit quality of 
the reference exposure. This additional criterion is consistent with 
the New Accord's treatment of guarantees and with the proposed rule's 
operational requirements for synthetic securitizations.
    The proposed rule defined 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).
    Commenters generally supported the proposed rule's definition of 
eligible credit derivative, but two commenters asked for a series of 
changes. These commenters asked that the final rule specifically 
reference contingent credit default swaps (CCDSs) in the list of 
eligible forms of credit derivatives. CCDS are a relatively new type of 
credit derivative, and the agencies are still considering their 
appropriate role within the risk-based capital rules. However, to 
enable the rule to adapt to future market innovations, the agencies 
have revised the definition of eligible credit derivative to add to the 
list of eligible credit derivative forms ``any other form of credit 
derivative approved by'' the bank's primary Federal supervisor.\83\
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    \83\ One commenter also asked the agencies to clarify that a 
bank should translate the phrase ``beneficiary'' in the definition 
of eligible guarantee to ``protection purchaser'' when confirming 
that a credit derivative meets all the requirements of the 
definition of eligible guarantee. The agencies have not amended the 
rule to address this point, but do confirm that such translation is 
appropriate.
---------------------------------------------------------------------------

    One commenter asked that the agencies amend the third criterion of 
the eligible credit derivative definition, which applies to credit 
default swaps and nth-to-default swaps. The commenter 
indicated that standard practice in the credit derivatives market is 
for a credit default swap to contain provisions that exempt the 
protection provider from making default payments to the protection 
purchaser if the reference obligor's failure to pay is in an amount 
below a de minimis threshold. The agencies do not believe that safety 
and soundness would be materially impaired by conforming this criterion 
of the eligible credit derivative definition to the current standard 
market practice. Under the final rule, therefore, a credit derivative 
will satisfy the definition of an eligible credit derivative if the 
protection provider's obligation to make default payments to the 
protection purchaser is triggered only if the reference obligor's 
failure to pay exceeds any applicable minimal payment threshold that is 
consistent with standard market practice.
    Finally, a commenter asked for clarification of the meaning of the 
sixth criterion of the definition of eligible credit derivative, which 
states that 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. To address any potential ambiguity about 
which exposure's transferability must be analyzed, the agencies have 
amended the sixth component to read: ``If the contract requires the 
protection purchaser to transfer an exposure to the protection provider 
at settlement, the terms of at least one of the exposures that is 
permitted to be transferred under the contract must provide that any 
required consent to transfer may not be unreasonably withheld.''
    The proposed rule also provided that 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 are exposures 
to the same legal entity, and legally enforceable cross-default or 
cross-acceleration clauses are in place.
    One commenter acknowledged that the proposal's pari passu ceiling 
is consistent with the New Accord but asked for clarification that the 
provision only requires reference exposure equality or subordination 
with respect to priority of payments. Although the agencies have 
concluded that it is not necessary to amend the rule to provide this 
clarification, the agencies agree that the pari passu ceiling relates 
to priority of payments only.
    Two commenters also asked the agencies to provide an exception to 
the cross-default/cross-acceleration requirement where the hedged 
exposure is an OTC derivative contract or a qualifying master netting 
agreement that covers OTC derivative contracts.

[[Page 69352]]

Although some parts of the debt markets have incorporated obligations 
from OTC derivative contracts in cross-default/cross-acceleration 
clauses, the commenter asserted that the practice is not prevalent in 
many parts of the market. In addition, the commenter maintained that, 
unlike a failure to pay on a loan or a bond, failure to pay on an OTC 
derivative contract generally would not trigger a credit event with 
respect to the reference exposure of the credit default swap. The 
agencies have not made this change. The proposed cross-default/cross-
acceleration requirement is consistent with the New Accord. In 
addition, the agencies are reluctant to permit a bank to obtain CRM 
benefits for an exposure hedged by a credit derivative whose reference 
exposure is different than the hedged exposure unless the hedged and 
reference exposures would default simultaneously. If the hedged 
exposure could default prior to the default of the reference exposure, 
the bank may suffer losses on the hedged exposure and not be able to 
collect default payments on the credit derivative. The final rule 
clarifies that, in order to recognize the credit risk mitigation 
benefits of an eligible credit derivative, cross-default/cross-
acceleration provisions must assure payments under the credit 
derivative are triggered if the obligor fails to pay under the terms of 
the hedged exposure.
PD Substitution Approach
    Under the PD substitution approach of the final rule, as under the 
proposal, 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 may 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 must 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. 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 must use the LGD 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) 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 rule (using a PD equal to the protection provider's 
PD, an 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 rule 
(using a PD equal to the obligor's PD, an LGD equal to the hedged 
exposure's 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 is defined as 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 is 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.
    The agencies received no material comments on the above-described 
structure of the PD substitution approach, and the final rule's PD 
substitution approach is substantially the same as that of the proposed 
rule.
LGD Adjustment Approach
    Under the LGD adjustment approach of the final rule, as under the 
proposal, 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 is the greater of (i) the risk-based capital 
requirement for the exposure as calculated under section 31 of the rule 
(with the 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 rule (using the bank's PD for the protection provider, the 
bank's 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 rule (with the 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 rule (using the bank's PD for the protection provider, the bank's 
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 rule using a PD set equal to the 
obligor's PD, an LGD set equal to the hedged exposure's 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 agencies received no material comments on the above-described 
structure of the LGD adjustment approach, and the final rule's LGD 
adjustment approach is substantially the same as that of the proposed 
rule.
    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

[[Page 69353]]

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 and the proposed rule, 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 are eligible for the double default treatment and describes 
the double default treatment that is available to those exposures.
Maturity Mismatch Haircut
    Under the final rule, a bank that seeks to reduce the risk-based 
capital requirement on a wholesale exposure by recognizing an eligible 
guarantee or eligible credit derivative must adjust the effective 
notional 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 residual maturity of a 
credit risk mitigant is less than that of the hedged exposure(s).
    The proposed rule provided, consistent with the New Accord, that 
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. One commenter 
criticized this provision as excessively conservative. The agencies 
agree and have decided to restrict the application of this provision to 
securitization CRM.\84\ Accordingly, under the final rule, to calculate 
the risk-based capital requirement for a group of hedged wholesale 
exposures that are covered by a single eligible guarantee under which 
the protection provider has agreed to backstop all contractual payments 
associated with each hedged exposure, a bank should treat each hedged 
exposure as if it were fully covered by a separate eligible guarantee. 
To determine whether any of the hedged wholesale exposures has a 
maturity mismatch with the eligible guarantee, the bank must assess 
whether the residual maturity of the eligible guarantee is less than 
that of the hedged exposure.
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    \84\ Under the final rule, if an eligible guarantee provides 
tranched credit protection to a group of hedged exposures--for 
example, the guarantee covers the first 2 percent of aggregate 
losses for the group--the bank must determine the risk-based capital 
requirements for the hedged exposures under the securitization 
framework.
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    The residual maturity of a hedged exposure is the longest possible 
remaining time before the obligor is scheduled to fulfil its obligation 
on the exposure. When determining the residual maturity of the 
guarantee or credit derivative, embedded options that may reduce the 
term of the credit risk mitigant must 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 is 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 
is 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 is 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 is not 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 must apply the following 
maturity mismatch adjustment to determine the effective notional amount 
of the guarantee or credit derivative adjusted for maturity mismatch: 
Pm = E x (t-0.25)/(T-0.25), where:

    (i) Pm = effective notional amount of the credit risk mitigant 
adjusted for maturity mismatch;
    (ii) E = effective notional amount of the credit risk mitigant;
    (iii) t = lesser of T or effective residual maturity of the 
credit risk mitigant, expressed in years; and
    (iv) T = lesser of 5 or effective residual maturity of the 
hedged exposure, expressed in years.

    Other than as discussed above with respect to pools of hedged 
exposures with different residual maturities, the final rule's 
provisions on maturity mismatch do not differ from those of the 
proposed rule.
Restructuring Haircut
    Under the final rule, as under the proposed rule, a 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 must 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 effective notional amount of the credit 
derivative adjusted for lack of restructuring credit event (and 
maturity mismatch, if applicable) is: Pr = Pm x 0.60, where:

    (i) Pr = effective notional amount of the credit risk mitigant, 
adjusted for lack of restructuring credit event (and maturity 
mismatch, if applicable); and
    (ii) Pm = effective notional amount of the credit risk mitigant 
adjusted for maturity mismatch (if applicable).

    Two commenters opposed the 40 percent restructuring haircut. One 
commenter contended that the 40 percent haircut is too punitive. The 
other commenter contended that the 40 percent haircut should not apply 
when the hedged exposure is an OTC derivative contract or a qualifying 
master netting agreement that covers OTC derivative contracts. The 40 
percent haircut is a rough estimate of the reduced CRM benefits that 
accrue to a bank that purchases a credit derivative without 
restructuring coverage. Nonetheless, the agencies recognize that 
restructuring events could result in substantial economic losses to a 
bank. Moreover, the 40 percent haircut is consistent with the New 
Accord and is a reasonably prudent mechanism for ensuring that banks do 
not receive excessive CRM benefits for purchasing credit protection 
that does not cover all material sources of economic loss to the bank 
on the hedged exposure.
    The final rule's provisions on lack of restructuring as a credit 
event do not differ from those of the proposed rule.

[[Page 69354]]

Currency Mismatch Haircut
    Under the final rule, as under the proposed rule, where the 
eligible guarantee or eligible credit derivative is denominated in a 
currency different from that in which any hedged exposure is 
denominated, the effective notional amount of the guarantee or credit 
derivative must be adjusted for currency mismatch (and maturity 
mismatch and lack of restructuring credit event, if applicable). The 
adjusted effective notional amount is calculated as: Pc = Pr x (1-Hfx), 
where:

    (i) Pc = effective notional amount of the credit risk mitigant, 
adjusted for currency mismatch (and maturity mismatch and lack of 
restructuring credit event, if applicable);
    (ii) Pr = effective notional amount of the credit risk mitigant 
(adjusted for maturity mismatch and lack of restructuring credit 
event, if applicable); and
    (iii) Hfx = haircut appropriate for the currency mismatch 
between the credit risk mitigant and the hedged exposure.

    A bank may use a standard supervisory haircut of 8 percent for Hfx 
(based on a ten-business-day holding period and daily marking-to-market 
and remargining). Alternatively, a bank may use internally estimated 
haircuts for Hfx based on a ten-business-day holding period and daily 
marking-to-market and remargining if the bank qualifies to use the own-
estimates haircuts in paragraph (b)(2)(iii) of section 32, the simple 
VaR methodology in paragraph (b)(3) of section 32, or the internal 
models methodology in paragraph (d) of section 32 of the 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 ten business days.
    The agencies received no comments on the currency mismatch 
provisions discussed above, and the final rule's provisions on currency 
mismatch do not differ from those of the proposed rule.
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 LGD of the corporate exposure is 30 percent; the LGD of 
the credit derivative is 80 percent. The credit derivative is an 
eligible credit derivative, has the bank's exposure as its reference 
exposure, has a three-year maturity, no restructuring provision, no 
currency mismatch with the bank's hedged exposure, and the 
protection provider assumes the payment obligations of the obligor 
upon default. 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 LGD of 80 percent, 
and an M of five; and (ii) an exposure of $65.26 with the PD of the 
obligor, an LGD of 30 percent, and an M of five.
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.\85\ 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.\86\ In the proposal, the agencies invited comment on 
whether and how the agencies should address these and other similar 
situations in which multiple credit risk mitigants cover a single 
exposure.
---------------------------------------------------------------------------

    \85\ New Accord, ]206.
    \86\ Id.
---------------------------------------------------------------------------

    Commenters generally agreed that the agencies should provide 
additional guidance about how to address situations where multiple 
credit risk mitigants cover a single exposure. Although one commenter 
recommended that the agencies permit banks effectively to recognize 
triple default benefits in situations where two credit risk mitigants 
cover a single exposure, commenters did not provide material specific 
suggestions as to their preferred approach to addressing these 
situations. Thus, the agencies have decided to adopt the New Accord's 
principles for dealing with multiple credit risk mitigant situations. 
The agencies have added several additional provisions to section 33(a) 
of the final rule to provide clarity in this area.
Double Default Treatment
    As noted above, the final rule, like the proposed rule, contains a 
separate risk-based capital methodology for hedged exposures eligible 
for double default treatment. The final rule's double default 
provisions are identical to those of the proposed rule, with the 
exception of some limited changes to the definition of an eligible 
double default guarantor discussed below.
    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 n\th\-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.\87\ 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.
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    \87\ The New Accord permits certain retail small business 
exposures to be eligible for double default treatment. Under the 
final rule, 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 defined 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. 
The proposal required an eligible double default guarantor to (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, the proposal 
permitted a non-U.S. based bank, securities firm, or insurance company 
to qualify as an eligible double default guarantor only if the firm 
were 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 had issued an

[[Page 69355]]

outstanding and unsecured long-term debt security without credit 
enhancement that had a long-term applicable external rating in one of 
the three highest investment-grade rating categories.
    Commenters expressed two principal criticisms of the proposed 
definition of an eligible double default guarantor. First, commenters 
asked the agencies to conform the definition to the New Accord by 
permitting a foreign financial firm to qualify so long as it had an 
outstanding long-term debt security with an external rating of 
investment grade or higher (for example, BBB- or higher) instead of in 
one of the three highest investment-grade rating categories (for 
example, A- or higher). In light of the other eligibility criteria, the 
agencies have concluded that it would be appropriate to conform this 
provision of the definition to the New Accord.
    Commenters also requested that the agencies conform the definition 
of eligible double default guarantor to the New Accord by permitting a 
financial firm to qualify so long as it had a bank-assigned PD, at the 
time the guarantor issued the guarantee or credit derivative or at any 
time thereafter, that 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. In light of the other eligibility criteria, the 
agencies have concluded that it would be appropriate to conform this 
provision of the definition to the New Accord.
    Effectively, under the final rule, 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 financial 
institutions 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 are not 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.
    One commenter urged the agencies to delete the requirement that the 
obligor of a hedged exposure that qualifies for double default 
treatment not be an eligible double default guarantor or an affiliate 
of such an entity. This commenter represented that this requirement 
significantly constrained the scope of application of double default 
treatment and assumed inappropriately that there is an excessive amount 
of correlation among all financial firms. The agencies acknowledge that 
this requirement is a crude mechanism to prevent excessive wrong-way 
risk, but the agencies have decided to retain the requirement in light 
of its consistency with the New Accord and the limited ability of banks 
to measure accurately correlations among obligors.
    In addition to limiting the types of guarantees, credit 
derivatives, guarantors, and hedged exposures eligible for double 
default treatment, the 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 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 rule, the bank is 
allowed to set LGD equal to the lower of the LGD of the hedged exposure 
(not adjusted to reflect the guarantee or credit derivative) 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. 
Accordingly, in order to apply the double default treatment, the bank 
must estimate a PD for the protection provider and an 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 rule).
    One commenter objected that the calibration of the double default 
formula under the proposed rule was too conservative because it assumed 
an excessive amount of correlation between the obligor of the hedged 
exposure and the protection provider. The agencies have decided to 
leave the calibration unaltered in light of its consistency with the 
New Accord. The agencies will evaluate this decision over time and will 
raise this issue with the BCBS if appropriate.
6. Guarantees and Credit Derivatives That Cover Retail Exposures
    Like the proposal, the final rule provides a different treatment 
for guarantees and credit derivatives that cover retail exposures than 
for those that cover wholesale 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 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 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, are securitization exposures under the final rule.
    The rule does not specify the ways in which guarantees and credit 
derivatives may be taken into account in the segmentation of retail 
exposures.

[[Page 69356]]

Likewise, the 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 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 and LGD for retail 
segments.
    In the proposal, the agencies expressed some concern, however, that 
this approach would provide banks with substantial discretion to 
incorporate double default and double recovery effects. To address 
these concerns, the preamble to the proposed rule described two 
possible alternative treatments for guarantees of retail exposures. The 
first alternative distinguished 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 a highly creditworthy insurance company; or (ii) issued by a 
sovereign entity or a political subdivision of a sovereign entity.
    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 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. Specifically, 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. 
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 LGD but not when 
estimating PD.
    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 and LGD for any segment of retail exposures. A bank 
would be required to estimate PD 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.
    A second alternative that the agencies described in the preamble to 
the proposed 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 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.
    A substantial number of commenters supported the flexible approach 
in the text of the proposed rule. A few commenters also supported the 
first alternative approach in the preamble of the proposed rule. 
Commenters uniformly urged the agencies not to adopt the second 
alternative approach. The agencies have decided to adopt the approach 
to retail guarantees in the text of the proposed rule and not to adopt 
either alternative approach described in the proposed rule preamble. 
Although the first alternative approach addresses prudential concerns, 
the agencies have concluded that it is excessively conservative and 
prescriptive and would not harmonize with banks' internal risk 
measurement and management practices. The agencies also have determined 
that the second alternative approach is insufficiently risk sensitive 
and is not consistent with the New Accord. In light of the final rule's 
flexible approach to retail guarantees, the agencies expect banks to 
limit their use of guarantees in the retail segmentation process and 
retail risk parameter estimation process to situations where the bank 
has particularly reliable data about the CRM benefits of such 
guarantees.

D. Unsettled Securities, Foreign Exchange, and Commodity Transactions

    Section 35 of the final rule describes the risk-based capital 
requirements for unsettled and failed securities, foreign exchange, and 
commodities transactions. The agencies did not receive any material 
comments on this aspect of the proposed rule and are adopting it as 
proposed.
    Under the final rule, certain transaction types are excluded from 
the scope of section 35, 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); 
\88\
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    \88\ 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.
---------------------------------------------------------------------------

    (ii) Repo-style transactions (the risk-based capital requirements 
of which are determined under sections 31 and 32 of the final 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 final 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 final 
rule. The final 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 final 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 
final 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

[[Page 69357]]

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 E. 
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 E.--Risk Weights for Unsettled DvP and PvP Transactions
------------------------------------------------------------------------
                                                      Risk weight to be
     Number of business days after contractual       applied to positive
                  settlement 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 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.
    For purposes of computing a bank's risk-based capital requirement 
for unsettled non-DvP/non-PvP transactions, a bank may assign an 
internal obligor rating to a counterparty for which it is not otherwise 
required under the final 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. A bank may estimate a loss severity rating or LGD for the 
exposure, or may use a 45 percent LGD for the exposure provided the 
bank uses the 45 percent LGD for all such exposures (that is, for all 
non-DvP/non-PvP transactions subject to a risk-based capital 
requirement other than deduction under section 35 of the final rule). 
Alternatively, a bank may use a 100 percent risk weight for all non-
DvP/non-PvP transactions subject to a risk-based capital requirement 
other than deduction under section 35 of the final rule.
    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 (the securitization 
framework). In contrast to the framework for wholesale and retail 
exposures, the securitization framework does not permit a bank to rely 
on its internal assessments of the risk parameters of a securitization 
exposure.\89\ 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-
transfering 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 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 a nationally recognized 
statistical rating organization (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).
---------------------------------------------------------------------------

    \89\ Although the IAA 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.
---------------------------------------------------------------------------

1. Hierarchy of Approaches
    The 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). Consistent 
with the New Accord and the proposal, under the final rule a bank 
generally must apply the following hierarchy of approaches to determine 
the risk-based capital requirement for a securitization exposure.
Gains-on-Sale and CEIOs
    Under the proposed rule, a bank would deduct from tier 1 capital 
any after-tax gain-on-sale resulting from a securitization and would 
deduct from total capital any portion of a CEIO that does not 
constitute a gain-on-sale, as described in section 42(a)(1) and (c) of 
the proposed rule. Thus, if the after-tax gain-on-sale associated with 
a securitization equaled $100 while the amount of CEIOs associated with 
that same securitization equaled $120, the bank would deduct $100 from 
tier 1 capital and $20 from total capital ($10 from tier 1 capital and 
$10 from tier 2 capital).
    Several commenters asserted that the proposed deductions of gains-
on-sale and CEIOs were excessively conservative, because such 
deductions are not reflected in an originating bank's maximum risk-
based capital requirement associated with a single securitization 
transaction (described below). Commenters noted that while 
securitization does not increase an originating bank's overall risk 
exposure to the securitized assets, in some circumstances the proposal 
would result in a securitization transaction increasing an originating 
bank's risk-based capital requirement. To address this concern, some 
commenters suggested deducting CEIOs from total capital only when the 
CEIOs constitute a gain-on-sale. Others urged adopting the treatment of 
CEIOs in the general risk-based capital rules. Under this treatment, 
the entire amount

[[Page 69358]]

of CEIOs beyond a concentration threshold is deducted from total 
capital and there is no separate gain-on-sale deduction.
    The final rule retains the proposed deduction of gains-on-sale and 
CEIOs. These deductions are consistent with the New Accord, and the 
agencies believe they are warranted given historical supervisory 
concerns with the subjectivity involved in valuations of gains-on-sale 
and CEIOs. Furthermore, although the treatments of gains-on-sale and 
CEIOs can increase an originating bank's risk-based capital requirement 
following a securitization, the agencies believe that such anomalies 
will be rare where a securitization transfers significant credit risk 
from the originating bank to third parties.
Ratings-Based Approach (RBA)
    If a securitization exposure is not a gain-on-sale or CEIO, 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).\90\ 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+.
---------------------------------------------------------------------------

    \90\ A securitization exposure held by an originating bank must 
have two or more external ratings or inferred ratings to qualify for 
the RBA.
---------------------------------------------------------------------------

Internal Assessment Approach (IAA)
    If a securitization exposure does not qualify for the RBA but the 
exposure is 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 will qualify to use 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 
qualifies for and chooses to use the IAA must use the IAA for all 
exposures that qualify for the IAA.
    A number of commenters asserted that a bank should be permitted to 
use the IAA for a securitization exposure to an ABCP conduit even when 
the exposure has an inferred rating, provided all other IAA eligibility 
criteria were met. The commenters maintained that the RBA would produce 
an excessive risk-based capital requirement for an unrated 
securitization exposure, such as a liquidity facility, when the 
inferred rating is based on a rated security that is very junior to the 
unrated exposure. Commenters suggested that allowing a bank to use the 
IAA instead of the RBA in such circumstances would lead to a risk-based 
capital requirement that was better aligned with the unrated exposure's 
actual risk.
    Like the New Accord, the final rule does not allow a bank to use 
the IAA for securitization exposures that qualify for the RBA based on 
an inferred rating. While in some cases the IAA might produce a more 
risk-sensitive capital treatment relative to an inferred rating under 
the RBA, the agencies--as well as the majority of commenters--believe 
that it is important to retain as much consistency as possible with the 
New Accord to provide a level international playing field for financial 
services providers in a competitive line of business. The commenters' 
concerns relating to inferred ratings apply only to a small proportion 
of outstanding ABCP liquidity facilities. In many cases, a bank may 
mitigate such concerns by having the ABCP program issue an additional, 
intermediate layer of externally rated securities, which would provide 
a more accurate reference for inferring a rating on the unrated 
liquidity facility. The agencies intend to monitor developments in this 
area and, as appropriate, will coordinate any reassessment of the 
hierarchy of securitization approaches with the BCBS and other 
supervisory and regulatory authorities.
Supervisory Formula Approach (SFA)
    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 for 
which the bank is applying the IAA, the bank may apply the SFA to the 
exposure if the bank is able to calculate the SFA risk parameters for 
the securitization. In many cases, an originating bank would use the 
SFA to determine its risk-based capital requirements for retained 
securitization exposures.
Deduction
    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 from total capital.
    Numerous commenters requested an alternative to deducting the 
securitization exposure from capital. Some of these commenters noted 
that if a bank does not service the underlying assets, the bank may not 
be able to produce highly accurate estimates of a key SFA risk 
parameter, KIRB, which is the risk-based capital requirement 
as if the underlying assets were held directly by the bank. Commenters 
expressed concern that, under the proposal, a bank would be required to 
deduct from capital some structured lending products that have long 
histories of low credit losses. Commenters maintained that a bank 
should be allowed to calculate the securitization exposure's risk-based 
capital requirement using the rules for wholesale exposures or using an 
IAA-like approach under which the bank's internal risk rating for the 
exposure would be mapped into an NRSRO's rating category.
    Like the proposal, the final rule contains only those 
securitization approaches in the New Accord. As already noted, the 
agencies--and most commenters--believe that it is important to minimize 
substantive differences between the final rule and the New Accord to 
foster international consistency. Furthermore, the agencies believe 
that the hierarchy of securitization approaches is sufficiently 
comprehensive to accommodate demonstrably low-risk structured lending 
arrangements in a risk-sensitive manner. As described in greater detail 
below, for securitization exposures that are not eligible for the RBA 
or the IAA, a bank has flexibility under the SFA to tailor its 
procedures for estimating KIRB to the data that are 
available. The agencies recognize that, in light of data shortcomings, 
a bank may have to use approaches to estimating KIRB that 
are less sophisticated than what the bank might use for similar assets 
that it originates, services, and holds directly. Supervisors generally 
will review the reasonableness of KIRB estimates in the 
context of available data, and will expect estimates of KIRB 
to incorporate appropriate conservatism to address any data 
shortcomings.
    Total risk-weighted assets for securitization exposures equals the 
sum of risk-weighted assets calculated under the RBA, IAA, and SFA, 
plus any risk-

[[Page 69359]]

weighted asset amounts calculated under the early amortization 
provisions in section 47 of the final rule.
Exceptions to the General Hierarchy of Approaches
    Consistent with the New Accord and the proposed rule, the final 
rule includes a mechanism that generally prevents a bank's effective 
risk-based capital requirement from increasing as a result of the bank 
securitizing its assets. Specifically, the rule limits a bank's 
effective risk-based capital requirement for all of its securitization 
exposures to a single securitization to the applicable risk-based 
capital requirement if the underlying exposures were held directly by 
the bank. Under the rule, 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.
    One commenter urged the agencies to delete the reference to ECL in 
the capital calculation. However, the agencies believe it is 
appropriate to include the ECL of the underlying exposures in this 
calculation because ECL is included in the New Accord's limit, and 
because the bank would have had to estimate the ECL of the exposures 
and hold reserves or capital against the ECL if the bank held the 
underlying exposures on its balance sheet.
    This maximum risk-based capital requirement is 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 approach, the agencies believe that the maximum 
risk-based capital requirement in the final rule is appropriate.
    The securitization framework also includes provisions to limit the 
double counting of risks in situations involving overlapping 
securitization exposures. While the proposal addressed only those 
overlapping exposures arising in the context of exposures to ABCP 
programs and mortgage loan swaps with recourse, the final rule 
addresses overlapping exposures for securitizations more generally. If 
a bank has multiple securitization exposures 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 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 a securitization, 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 securitization.
    The proposed rule also addressed the risk-based capital treatment 
of a securitization of non-IRB assets. Claims to future music concert 
and film receivables are examples of financial assets that are not 
wholesale, retail, securitization, or equity exposures. In these cases, 
the SFA cannot be used because of the absence of a risk-sensitive 
measure of the credit risk of the underlying exposures. Specifically, 
under the proposed rule, if a bank had a securitization exposure and 
any underlying exposure of the securitization was not a wholesale, 
retail, securitization or equity exposure, the bank would (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.
    Numerous commenters asserted that a bank should be allowed to use 
the IAA in these situations since, unlike the SFA, the IAA is tied to 
NRSRO rating methodologies rather than to the risk-based capital 
requirement for the underlying exposures. The agencies believe that 
this is a reasonable approach for exposures to ABCP conduits. The final 
rule permits a bank to use the IAA for a securitization exposure for 
which any underlying exposure of the securitization is not a wholesale, 
retail, securitization or equity exposure, provided the securitization 
exposure is not gain-on-sale, not a CEIO, and not eligible for the RBA, 
and all of the IAA qualification criteria are met.
    As described in section V.A.3. of this preamble, a few commenters 
asserted that OTC derivatives with a securitization SPE as the 
counterparty should be excluded from the definition of securitization 
exposure. These commenters objected to the burden of using the 
securitization framework to calculate a capital requirement for 
counterparty credit risk for OTC derivatives with a securitization SPE. 
The agencies continue to believe that the securitization framework is 
the most appropriate way to assess the counterparty credit risk of such 
exposures, and that in many cases the relatively simple RBA will apply 
to such exposures. In response to commenter concerns about burden, the 
agencies have decided to add an optional simple risk weight approach 
for certain OTC derivatives. Under the final rule, if a securitization 
exposure is an OTC derivative contract (other than a credit derivative) 
that has a first priority claim on the cash flows from the underlying 
exposures (notwithstanding amounts due under interest rate or currency 
derivative contracts, fees due, or other similar payments), a bank may 
choose to apply an effective 100 percent risk weight to the exposure 
rather than the general securitization hierarchy of approaches. This 
treatment is subject to supervisory approval.
    Like the proposed rule, the final rule contains three additional 
exceptions to the general hierarchy. Each exception parallels the 
general risk-based capital rules. First, an interest-only mortgage-
backed security must be assigned a risk weight that is no less than 100 
percent. Although a number of commenters objected to this risk weight 
floor on the grounds that it was not risk sensitive, the agencies 
believe that a minimum risk weight of 100 percent is prudent in light 
of the uncertainty implied by the substantial price volatility of these 
securities. Second, a sponsoring bank that qualifies as a primary 
beneficiary and must consolidate an ABCP program as a variable interest 
entity under GAAP generally may exclude the consolidated ABCP program 
assets from risk-

[[Page 69360]]

weighted assets.\91\ In such cases, the bank must hold risk-based 
capital against any securitization exposures of the bank to the ABCP 
program. Third, as required by Federal statute, a special set of rules 
applies to transfers of small business loans and leases with recourse 
by well-capitalized depository institutions.\92\
---------------------------------------------------------------------------

    \91\ See Financial Accounting Standards Board, Interpretation 
No. 46: Consolidation of Variable Interest Entities (January 2003).
    \92\ See 12 U.S.C. 1835, which places a cap on the risk-based 
capital requirement applicable to a well-capitalized DI that 
transfers small business loans with recourse. The final 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.
---------------------------------------------------------------------------

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.
    Under the final rule, as under the proposed rule, a servicing bank 
must determine its risk-based capital requirement for any advances 
under such a facility using the hierarchy of securitization approaches 
described above. The treatment of the undrawn portion of the facility 
depends on whether the facility is an ``eligible'' servicer cash 
advance facility. 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 for a particular underlying exposure 
if any such advance is limited to an insignificant amount of the 
outstanding principal balance of that 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. Consistent with the general 
risk-based capital rules with respect to residential mortgage servicer 
cash advances, a servicing bank is not required to hold risk-based 
capital against the undrawn portion of an eligible servicer cash 
advance facility. A bank that provides a non-eligible 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
    Under the proposed rule, the amount of an on-balance sheet 
securitization exposure was the bank's carrying value, if the exposure 
was 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 was available-for-sale. In general, the amount of an off-
balance sheet securitization exposure was the notional amount of the 
exposure. For an OTC derivative contract that was not a credit 
derivative, the notional amount was the EAD of the derivative contract 
(as calculated in section 32).
    In the final rule the agencies are maintaining the substance of the 
proposed provision on the amount of a securitization exposure with one 
exception. The final rule provides that the amount of a securitization 
exposure that is a repo-style transaction, eligible margin loan, or OTC 
derivative (other than a credit derivative) is the EAD of the exposure 
as calculated in section 32 of the final rule. The agencies believe 
this change is consistent with the way banks manage these exposures, 
more appropriately reflects the collateral that directly supports these 
exposures, and recognizes the credit risk mitigation benefits of 
netting where these exposures are part of a cross-product netting set. 
Because the collateral associated with a repo-style transaction or 
eligible margin loan is reflected in the determination of exposure 
amount under section 32 of the rule, these transactions are not 
eligible for the general securitization collateral approach in section 
46(b) of the final rule. Similarly, if a bank chooses to reflect 
collateral associated with an OTC derivative contract in its 
determination of exposure amount under section 32 of the rule, it may 
not also apply the general securitization collateral approach in 
section 46(b) of the final rule. Similar to the definition of EAD for 
on-balance sheet exposures, the agencies are clarifying that the amount 
of an on-balance sheet securitization exposure is based on whether or 
not the exposure is classified as an available for sale security.
    Under the proposal, when a securitization exposure to an ABCP 
program takes the form of a commitment, such as a liquidity facility, 
the notional amount could be reduced to the maximum potential amount 
that the bank currently would be required to fund under the 
arrangement's documentation (the maximum potential amount that could be 
drawn given the assets currently held by the program). Within some ABCP 
programs, however, certain commitments, such as liquidity facilities, 
may be dynamic in that the maximum amount that can be drawn at any 
moment depends on the current credit quality of the program's 
underlying assets. That is, if the underlying assets were to remain 
fixed, but their credit quality deteriorated, the maximum amount that 
could be drawn against the liquidity facility could increase.
    The final rule clarifies that in such circumstances the notional 
amount of an off-balance sheet securitization exposure to an ABCP 
program may be reduced to the maximum potential amount that the bank 
could be required to fund given the program's current assets 
(calculated without regard to the current credit quality of these 
assets). Thus, if $100 is the maximum amount that could be drawn given 
the current volume and current credit quality of the program's assets, 
but the maximum potential draw against these same assets could increase 
to as much as $200 if their credit quality were to deteriorate, then 
the exposure amount is $200.
    Some commenters recommended capping the securitization amount for 
an ABCP liquidity facility at the amount of the outstanding commercial 
paper covered by that facility. The agencies believe, however, that 
this would be inappropriate if the liquidity provider could be required 
to advance a larger amount. The agencies note that when calculating the 
exposure amount of a liquidity facility, a bank may take into account 
any limits on advances--including limits based on the amount of 
commercial paper outstanding--that are contained in the program's 
documentation.
Implicit Support
    Like the proposed rule, the final rule 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

[[Page 69361]]

the general risk-based capital rules,\93\ 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.
---------------------------------------------------------------------------

    \93\ 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 a securitization SPE. Under the final rule, consistent 
with the proposed rule, 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. The operational 
requirements for synthetic securitization are described in preamble 
section V.E.7., below.
    Consistent with the general risk-based capital rules, the above 
operational requirements refer specifically to GAAP for the purpose of 
determining whether a securitization transaction should be treated as 
an asset sale or a financing. In contrast, the New Accord stipulates 
guiding principles for use in determining whether sale treatment is 
warranted. One commenter requested that the agencies conform the 
proposed operational requirements for traditional securitizations to 
those in the New Accord. The agencies believe that the current 
conditions to qualify for sale treatment under GAAP are broadly 
consistent with the guiding principles enumerated in the New Accord. 
However, if GAAP in this area were to change materially in the future, 
the agencies would reassess, and possibly revise, the operational 
standards.
Clean-Up Calls
    To satisfy the operational requirements for securitizations and 
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. The 
proposal defined a clean-up call as 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. The preamble to the proposed rule explained that, 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 falls 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.
    Under the proposed rule, an eligible clean-up call would be 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.
    A number of comments addressed the proposed definitions of clean-up 
call and eligible clean-up call. One commenter observed that prudential 
concerns would also be satisfied if the call were at the discretion of 
the originator of the underlying exposures. The agencies concur with 
this view and have modified the final rule to state that a clean-up 
call may permit the servicer or originating bank to call the 
securitization exposures before the stated maturity or call date, and 
that an eligible clean-up call must be exercisable solely at the 
discretion of the servicer or the originating bank. Commenters also 
requested clarification whether, for a securitization that involves a 
master trust, the 10 percent requirement described above in criteria 
(iii)(A) and (iii)(B) would be interpreted as applying to each series 
or tranche of securities issued from the master trust. The agencies 
believe this is a reasonable interpretation. Thus, where a 
securitization SPE is structured as a master trust, a clean-up call 
with respect to a particular series or tranche issued by the master 
trust would meet criteria (iii)(A) and (iii)(B) so long as the 
outstanding principal amount in that series was 10 percent or less of 
its original amount at the inception of the series.
Additional Supervisory Guidance
    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 form of credit risk 
transfer. \94\ In general, the agencies expect banks to continue to use 
this guidance, most of which remains applicable to the advanced 
approaches securitization framework. Banks are encouraged to consult 
with their primary Federal supervisor about transactions that require 
additional guidance.
---------------------------------------------------------------------------

    \94\ See, e.g., OCC Bulletin 99-46 (Dec. 13, 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 final rule, as under the proposal, a bank must determine 
the risk-weighted asset amount for a securitization exposure that is 
eligible for the RBA by multiplying the amount of the exposure by the 
appropriate risk-weight provided in the tables in section 43 of the 
rule. Under the proposal, whether a securitization exposure was 
eligible for the RBA would depend on whether the bank holding the

[[Page 69362]]

securitization exposure is an originating bank or an investing bank. An 
originating bank would be eligible to use the RBA for a securitization 
exposure if (i) the exposure had two or more external ratings, or (ii) 
the exposure had two or more inferred ratings. In contrast, an 
investing bank would be eligible to use the RBA for a securitization 
exposure if the exposure has one or more external or inferred ratings. 
A bank would be an originating bank if it (i) directly or indirectly 
originated or securitized the underlying exposures included in the 
securitization, or (ii) serves as an ABCP program sponsor to the 
securitization.
    The proposed rule defined an external rating as a credit rating 
assigned by a NRSRO to an exposure, provided (i) the credit rating 
fully reflects the entire amount of credit risk with regard to all 
payments owed to the holder of the exposure, and (ii) the external 
rating is published in an accessible form and is included in the 
transition matrices made publicly available by the NRSRO that summarize 
the historical performance of positions it has rated. For example, 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. Under the proposed rule, an exposure's 
applicable external rating was the lowest external rating assigned to 
the exposure by any NRSRO.
    The proposed two-rating requirement for originating banks was the 
only material difference between the treatment of originating banks and 
investing banks under the proposed securitization framework. Although 
the 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 sought 
comment on whether this treatment was appropriate, and on possible 
alternative mechanisms that could be employed to ensure the reliability 
of external and inferred ratings on securitization exposures retained 
by originating banks.
    Commenters generally objected to the two-rating requirement for 
originating banks. Many asserted that since the credit risk of a given 
securitization exposure was the same regardless of the holder, the 
risk-based capital treatments also should be the same. Because external 
ratings would be publicly available, some commenters contended that 
NRSROs will have strong reputational reasons to give unbiased ratings--
even to non-traded securitization exposures retained by originating 
banks. The agencies continue to believe that external ratings for 
securitization exposures retained by an originating bank, which 
typically are not traded, are subject to less market discipline than 
ratings for exposures sold to third parties. This disparity in market 
discipline warrants more stringent conditions on use of the former for 
risk-based capital purposes. Accordingly, the final rule retains the 
two-rating requirement for originating banks.
    Consistent with the New Accord, the final rule states that an 
unrated securitization exposure has an inferred rating if another 
securitization exposure issued by the same issuer and secured by the 
same underlying exposures has an external rating and this rated 
reference exposure (i) is subordinate 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. This 
definition does not permit a bank to assign an inferred rating based on 
the ratings of the underlying exposures in a securitization, even when 
the unrated securitization exposure is secured by a single, externally 
rated security. In particular, such a look-through approach would fail 
to meet the requirements that the rated reference exposure must be 
issued by the same issuer, secured by the same underlying assets, and 
subordinated in all respects to the unrated securitization exposure.
    The agencies sought 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. In 
situations where an unrated securitization exposure benefited from a 
guarantee that covered all contractual payments associated with the 
securitization exposure, several commenters advocated allowing an 
inferred rating to be assigned based on the long-term rating of the 
guarantor. In addition, some commenters recommended that if a senior, 
unrated securitization exposure is secured by a single externally rated 
underlying security, a bank should be permitted to assign an inferred 
rating for the unrated exposure using a look-through approach.
    The agencies do not believe there is a compelling need at this time 
to supplement the New Accord's methods for determining an inferred 
rating. However, if a need develops in the future, the agencies will 
seek to revise the New Accord in coordination with the BCBS and other 
supervisory and regulatory authorities. In the situations cited above, 
the framework already provides simplified methods for calculating a 
securitization exposure's risk-based capital requirement. For example, 
when a securitization exposure benefits from a full guarantee, such as 
from an externally rated monoline insurance company, the exposure's 
external rating often will reflect that guarantee. When the guaranteed 
securitization exposure is not externally rated, subject to the rules 
for recognition of guarantees of securitization exposures in section 
46, the unrated securitization exposure may be treated as a direct 
(wholesale) exposure to the guarantor. In addition, when a 
securitization exposure to an ABCP program is secured by a single, 
externally rated asset, a look-through approach may be possible under 
the IAA provided that such a look-through is no less conservative than 
the applicable NRSRO rating methodologies.
    Under the proposal, if a securitization exposure had multiple 
external ratings or multiple inferred ratings, a bank would be required 
to use the lowest rating (the rating that would produce the highest 
risk-based capital requirement). Commenters objected that this 
treatment was significantly more conservative than required by the New 
Accord, which permits use of the second most favorable rating, and 
would unfairly penalize banks in situations where the lowest rating was 
unsolicited or an outlier. The agencies recognize commenters' concerns 
regarding unsolicited ratings, and note that the New Accord states 
banks should use solicited ratings. To maintain consistency with the 
general risk-based capital rules, the final rule defines the applicable 
external rating of a securitization exposure to be its lowest solicited 
external rating and the applicable inferred rating of a securitization 
exposure to be the inferred rating based on its lowest solicited 
external rating.
    For securitization exposures eligible for the RBA, the risk-based 
capital requirement per dollar of securitization exposure depends 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

[[Page 69363]]

exposure is a ``senior'' exposure; and (iv) a measure of the effective 
number (``N'') of underlying exposures. In response to a specific 
question posed by the agencies, commenters generally supported linking 
risk weights under the RBA to these factors.
    In the proposed rule, a ``senior securitization exposure'' was 
defined as 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. Generally, only the most senior tranche of a 
securitization would be a senior securitization exposure. For example, 
if multiple tranches of a securitization share the transaction's 
highest rating, only the tranche with the shortest remaining maturity 
would be treated as senior, since other tranches with the same rating 
would not have a first claim to cash flows throughout their lifetimes. 
A liquidity facility that supports an ABCP program would be a senior 
securitization exposure if the liquidity facility provider's right to 
reimbursement of the drawn amounts was senior to all claims on the cash 
flows from the underlying exposures except claims of a service provider 
to fees.
    In the final rule, the agencies modified this definition to clarify 
two points. First, in the context of an ABCP program, the final rule 
specifically states that both the most senior commercial paper issued 
by the program and a liquidity facility supporting the program may be 
``senior'' exposures if the liquidity facility provider's right to 
reimbursement of any drawn amounts is senior to all claims on the cash 
flow from the underlying exposures. Second, the final rule clarifies 
that when determining whether a securitization exposure is senior, a 
bank is not required to consider any amounts due under interest rate or 
currency derivative contracts, fees due, or other similar payments.
    Consistent with the New Accord, a bank must use Table F below when 
a securitization exposure qualifies for the RBA based on a long-term 
external rating or an inferred rating based on a long-term external 
rating. A bank may apply the risk weights in column 1 of Table F to the 
securitization exposure only if the N is six or more and the 
securitization exposure is a senior securitization exposure. If N is 
six or more but the securitization exposure is not a senior 
securitization exposure, the bank must apply the risk weights in column 
2 of Table F. Applying the principle of conservatism, however, if N is 
six or more a bank may use the risk weights in column 2 of Table F 
without determining whether the exposure is senior. A bank must apply 
the risk weights in column 3 of Table F to the securitization exposure 
if N is less than six.
    In certain situations the rule provides a simplified approach for 
determining N. 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 six or more (unless the 
bank knows or has reason to know that N is less than six). However, 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.
    A few commenters wanted to determine N only at the inception of a 
securitization transaction, due to the burden of tracking N over time. 
The agencies believe that a bank must track N over time to ensure an 
appropriate risk-based capital requirement. The number of underlying 
exposures in a securitization typically changes over time as some 
underlying exposures are repaid or default. As the number of underlying 
exposures changes, the risk profile of the associated securitization 
exposures changes, and a bank must reflect this change in risk profile 
in its risk-based capital requirement.

                        Table F.--Long-Term Credit Rating Risk Weights Under RBA and IAA
----------------------------------------------------------------------------------------------------------------
                                                         Column 1             Column 2             Column 3
                                                  --------------------------------------------------------------
                                                     Risk weights for     Risk weights for
      Applicable external or inferred rating              senior             non-senior        Risk weights for
          (illustrative rating example)             securitization ex-   securitization ex-   securitization ex-
                                                    posures backed  by   posures backed  by   posures backed  by
                                                      granular pools       granular pools    non-granular  pools
                                                        (percent)            (percent)             (percent)
----------------------------------------------------------------------------------------------------------------
Highest investment grade (for example, AAA)......                    7                   12                   20
----------------------------------------------------------------------------------------------------------------
Second highest investment grade (for example, AA)                    8                   15                   25
----------------------------------------------------------------------------------------------------------------
Third-highest investment grade--positive                            10                   18                   35
 designation (for example, A+)...................
--------------------------------------------------------------------------------------------
Third-highest investment grade (for example, A)..                   12                   20
--------------------------------------------------------------------------------------------
Third-highest investment grade--negative                            20                   35
 designation (for example, A-)...................
----------------------------------------------------------------------------------------------------------------
Lowest investment grade--positive designation                       35                     50
 (for 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
----------------------------------------------------------------------------------------------------------------

[[Page 69364]]

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

    A bank must apply the risk weights in Table G when the 
securitization exposure qualifies for the RBA based on a short-term 
external rating or an inferred rating based on a short-term external 
rating. A bank must apply the decision rules outlined in the previous 
paragraph to determine which column of Table G applies.

                        Table G.--Short-Term Credit Rating Risk Weights Under RBA and IAA
----------------------------------------------------------------------------------------------------------------
                                                         Column 1             Column 2             Column 3
                                                  --------------------------------------------------------------
                                                     Risk weights for     Risk weights for
      Applicable external or inferred rating              senior             non-senior        Risk weights for
          (illustrative rating example)             securitization ex-   securitization ex-   securitization ex-
                                                    posures backed  by   posures backed  by   posures backed  by
                                                      granular pools       granular pools    non-granular  pools
                                                        (percent)            (percent)             (percent)
----------------------------------------------------------------------------------------------------------------
Highest investment grade (for example, A1).......                    7                   12                   20
----------------------------------------------------------------------------------------------------------------
Second highest investment grade (for example, A2)                   12                   20                   35
----------------------------------------------------------------------------------------------------------------
Third highest investment grade (for example, A3).                   60                   75                   75
----------------------------------------------------------------------------------------------------------------
All other ratings................................            Deduction from tier 1 and tier 2 capital.
----------------------------------------------------------------------------------------------------------------

    Within Tables G and H, risk weights increase as rating grades 
decline. Under column 2 of Table F, 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.\95\ 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.\96\ 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.
---------------------------------------------------------------------------

    \95\ See Vladislav Peretyatkin and William Perraudin, ``Capital 
for Asset-Backed Securities,'' Bank of England, February 2003.
    \96\ 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. This treatment is intended to discourage a bank from 
engaging in regulatory capital arbitrage by securitizing very high-
quality wholesale exposures (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.
    A bank must deduct from regulatory capital any securitization 
exposure with an external or inferred rating lower than one category 
below investment grade for long-term ratings or below investment grade 
for short-term ratings. Although this treatment is more conservative 
than suggested by credit risk modeling analyses, the agencies believe 
that deducting such exposures from regulatory capital is appropriate in 
light of 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 and are not traded.
    The most senior tranches of 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. 
To be considered granular, a securitization must have an N of at least 
six. Consistent with the New Accord, the lowest possible risk-weight, 7 
percent, applies only to senior securitization exposures receiving the 
highest external rating (for example, AAA) and backed by a granular 
asset pool.
    The agencies sought comment on how well the risk weights in Tables 
G and H capture the most important risk factors for securitization 
exposures of varying degrees of seniority and granularity. A number of 
commenters contended that, in the interest of competitive equity, the 
risk weight for senior securitization exposures having the highest 
rating and backed by a granular asset pool should be 6 percent, the 
level specified in the European Union's Capital Requirements Directive 
(CRD). The agencies decided against making this change. There is no 
compelling empirical evidence to support a 6 percent risk weight for 
all exposures satisfying these conditions

[[Page 69365]]

and, further, a 6 percent risk weight is inconsistent with the New 
Accord. Moreover, estimates of the credit risk associated with such 
positions tend to be highly sensitive to subjective modeling 
assumptions and to the specific types of underlying assets and 
structure of the transaction, which supports the use of the more 
conservative approach in the New Accord.
3. Internal Assessment Approach (IAA)
    Under the final rule, as under the proposal, a bank is permitted 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. The ABCP program may be sponsored by 
the bank itself or by a third party. To apply the IAA, the bank's 
internal assessment process and the ABCP program must meet certain 
qualification requirements in section 44 of the final 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. Under the IAA, a bank maps its 
internal credit assessment of a securitization exposure to an 
equivalent external credit rating from an NRSRO. The bank must 
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 F or G above.
    Under the proposal, a bank required prior written approval from its 
primary Federal supervisor before it could use the IAA. Several 
commenters objected to this requirement maintaining that approval is 
not required under the New Accord and would likely delay a bank being 
authorized to use the IAA for new ABCP programs. Instead, commenters 
requested a submission and non-objection approach, under which a bank 
would be allowed to use the IAA in the absence of any objection from 
its supervisor based on examination findings. The final rule retains 
the requirement for prior written approval before a bank can use the 
IAA. Like other optional approaches in the final rule (for example, the 
double default treatment and the internal models methodology), it is 
important that the primary Federal supervisor have an opportunity to 
review a bank's practices relative to the final rule before allowing a 
bank to use the optional approach. If a bank chooses to implement the 
IAA at the same time that it implements the advanced approaches, the 
IAA review and approval process will be part of the overall 
qualification process. If a bank chooses to implement the IAA after it 
has qualified for the advanced approaches, prior written approval is a 
necessary safeguard for ensuring appropriate application of the IAA. 
Furthermore, the agencies believe this requirement can be implemented 
without impeding future innovations in ABCP programs.
    Similar to the proposed rule, under the final rule a bank must 
demonstrate that its internal credit assessment process satisfies all 
the following criteria in order to receive approval to use the IAA.
    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 requirement that an NRSRO's rating criteria be publicly 
available does not mean that these criteria must be published formally 
by the NRSRO. While the agencies expect banks to rely on published 
rating criteria when these criteria are available, an NRSRO often 
delays publication of rating criteria for securitizations involving new 
asset types until the NRSRO builds sufficient experience with such 
assets. Similarly, as securitization structures evolve over time, 
published criteria may be revised with some lag. Especially for 
securitizations involving new structures or asset types, the 
requirement that rating criteria be publicly available should be 
interpreted broadly to encompass not only published criteria, but also 
criteria that are obtained through written correspondence or other 
communications with an NRSRO. In such cases, these communications 
should be documented and available for review by the bank's primary 
Federal supervisor. The agencies believe this flexibility is 
appropriate only for unique situations when published rating criteria 
are not generally applicable.
    A commenter asked whether the applicable NRSRO rating criteria must 
cover all contractual payments owed to the bank holding the exposure, 
or only contractual principal and interest. For example, liquidity 
facilities typically obligate the seller to make certain future fee and 
indemnity payments directly to the liquidity bank. These ancillary 
obligations, however, are not an exposure to the ABCP program and would 
not normally be covered by NRSRO rating criteria, which focus on the 
risks of the underlying assets and the exposure's vulnerability to 
those risks. The agencies agree that such ancillary obligations of the 
seller need not be covered by the applicable NRSRO rating criteria for 
an exposure to be eligible for the IAA.
    To be eligible for the IAA, a bank must also demonstrate that its 
internal credit assessments of securitization exposures used for 
regulatory capital purposes are consistent with those used in its 
internal risk management process, capital adequacy assessment process, 
and management information reporting systems. The bank must also 
demonstrate that its internal credit assessment process has 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. In addition, 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 credit ratings to the commercial paper 
issued by the ABCP program. In light of recent events in the 
securitization market, the agencies emphasize that if an NRSRO that 
provides an external rating to an ABCP program's commercial paper 
changes its methodology, the bank must evaluate whether to revise its 
internal assessment process.
    Moreover, 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 also 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. 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.
    Under the proposed rule, in order for a bank to use the IAA on a 
specific exposure to an ABCP program, the program had to satisfy the 
following requirements:
    (i) All commercial paper issued by the ABCP program must have an 
external rating.

[[Page 69366]]

    (ii) The ABCP program must have robust credit and investment 
guidelines (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.
    Commenters suggested that the program-level eligibility criteria 
should apply only to those elements of the ABCP program that are 
relevant to the securitization exposure held by the bank in order to 
prevent an ABCP program's purchase of a single asset pool that does not 
meet the above criteria from disallowing the IAA for securitization 
exposures to that program that are unrelated to the non-qualifying 
asset pool. The agencies agree that this is a reasonable approach. 
Accordingly, the final rule applies criteria (ii) through (vi) to the 
exposures underlying a securitization exposure, rather than to the 
entire ABCP program. For a program-wide credit enhancement facility, 
all of the separate seller-specific arrangements benefiting from that 
facility must meet the above requirements for the facility to be 
eligible for the IAA.
    Several commenters objected to the requirement that the ABCP 
program prohibit purchases of significantly past-due or defaulted 
assets. Commenters contended that such purchases should be allowed so 
long as the applicable NRSRO rating criteria permit and deal 
appropriately with such assets. Like the New Accord, the final rule 
prohibits the ABCP program from purchasing significantly past-due or 
defaulted assets in order to ensure that the IAA is applied only to 
securitization exposures that are relatively low-risk at inception. 
This criterion would be met if the ABCP program does not fund 
underlying assets that are significantly past due or defaulted when 
placed into the program (that is, the program's advance rate against 
such assets is 0 percent) and the securitization exposure is not 
subject to potential losses associated with these assets. The agencies 
observe that the rule does not set a specific number-of-days-past due 
criterion. In addition, the term `defaulted assets' in criterion (iv) 
does not refer to the wholesale and retail definitions of default in 
the final rule, but rather may be interpreted as referring to assets 
that have been charged off or written down by the seller prior to being 
placed into the ABCP program or to assets that would be charged off or 
written down under the program's governing contracts.
    In addition, commenters asked the agencies to clarify that a bank 
may ignore one or more of the eligibility requirements where the 
requirement is not relevant to a particular exposure. For example, in 
the case of a liquidity facility supporting a static pool of term 
loans, it may not be possible to incorporate features into the 
transaction that mitigate against a potential deterioration in these 
assets, and there may be no use for detailed credit analyses of the 
seller following the securitization if the seller has no further 
involvement with the transaction. The agencies have modified the final 
criterion for determining whether an exposure qualifies for the IAA, to 
specify that where relevant, the ABCP program must incorporate 
structural features into each purchase of exposures underlying the 
securitization exposure to mitigate potential credit deterioration of 
the underlying exposures.
4. Supervisory Formula Approach (SFA)
General Requirements
    Under the proposed rule, a bank using the SFA 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 was 1,250 percent or greater, 
however, the bank would deduct the exposure from total capital rather 
than risk weight the exposure. The agencies noted that 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 that 
contains the securitization exposure (TP);
    (iii) The sum of the risk-based capital requirement and ECL for the 
underlying exposures (as determined under the final rule as if the 
underlying exposures 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 must 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:

[[Page 69367]]

[GRAPHIC] [TIFF OMITTED] TR07DE07.008

    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 final rule.
    The agencies are modifying the SFA treatment of certain high risk 
securitization exposures in the final rule. Under the proposed 
treatment described above, a bank would have to deduct from total 
capital any securitization exposure with a SFA risk weight equal to 
1,250 percent. Under certain circumstances, however, a slight increase 
in the thickness of the tranche that contains the securitization 
exposure (T), holding other SFA risk parameters fixed, could cause the 
exposure's SFA risk-weight to fall below 1,250 percent. As a result, 
the bank would not deduct any part of the exposure from capital and 
would, instead, reflect the entire amount of the SFA risk-based capital 
requirement in its risk-weighted assets. Consistent with the New 
Accord,\97\ the agencies have removed this anomaly from the final rule. 
Under the final rule a bank must deduct from total capital any part of 
a securitization exposure that incurs a 1,250 percent risk weight under 
the SFA (that is, any part of a securitization exposure covering loss 
rates on the underlying assets between zero and KIRB). Any 
part of a securitization exposure that incurs less than a 1,250 percent 
risk weight must be risk weighted rather than deducted.
---------------------------------------------------------------------------

    \97\ New Accord, Annex 7.
---------------------------------------------------------------------------

    To illustrate, suppose that an exposure's SFA capital requirement 
equaled $15, and UE, TP, KIRB, and L equaled $1000, 1.0, 
0.10, and 0.095, respectively. The bank must deduct from total capital 
$5 (UE x TP x (KIRB -L)), and the exposure's risk-weighted 
asset amount would be $125 (($15-$5) x 12.5).
    The specific securitization exposures that are subject to this 
deduction treatment under the SFA may change over time in response to 
variations in the credit quality of the 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 at the inception of a 
securitization a bank owns an unrated 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 and

[[Page 69368]]

the bank may be required to deduct the exposure.
    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. 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. The first is 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. Without this add-on, 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.
    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 approach 
that would apply to the underlying exposures if held directly by a 
bank.\98\ 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 approach. In addition, this specification embodies the 
result that a pool's systematic risk (KIRB) tends to be 
redistributed toward more senior tranches as N declines.\99\ 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 influence on the SFA capital 
requirement.
---------------------------------------------------------------------------

    \98\ The conceptual basis for specification of K[x] is developed 
in Michael B. Gordy and David Jones, ``Random Tranches,'' Risk 
(March 2003), 16(3), 78-83.
    \99\ See Michael Pykhtin and Ashish Dev, ``Coarse-grained 
CDOs,'' Risk (January 2003), 16(1), 113-116.
---------------------------------------------------------------------------

Inputs to the SFA Formula

    Consistent with the proposal, the final rule defines the seven 
inputs into the SFA formula as follows:
    (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 includes 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 must be treated as underlying exposures 
for purposes of the SFA, including assets in a reserve account (such as 
a cash collateral account).
    In practice, a bank's ability to calculate KIRB will 
often determine whether it can use the SFA or whether it must instead 
deduct an unrated securitization exposure from total capital. As noted 
above, there is a need for flexibility when the estimation of 
KIRB is constrained by data shortcomings, such as when the 
bank holding the securitization exposure is not the servicer of the 
underlying assets. The final rule clarifies that the simplified 
approach for eligible purchased wholesale exposures (Section 31) may be 
used for calculating KIRB.
    To reduce the operational burden of estimating KIRB, 
several commenters urged the agencies to develop a simple look-through 
approach such that when all of the assets held by the SPE are 
externally rated, KIRB could be determined directly from the 
external ratings of theses assets. The agencies believe that a look-
through approach for estimating KIRB would be inconsistent 
with the New Accord and would increase the potential for capital 
arbitrage. The agencies note that several simplified methods for 
estimating risk-weighted assets for the underlying exposures for the 
purposes of computing KIRB are provided in other parts of 
the framework. For example, the simplified approach for eligible 
purchased wholesale exposures in section 31 may be available when a 
bank can estimate risk parameters for segments of underlying wholesale 
exposures but not for each of the individual exposures. If the assets 
held by the SPE are securitization exposures with external ratings, the 
RBA would be used to determine risk-weighted assets for the underlying 
exposures based on these ratings. If the assets held by the SPE 
represent shares in an investment company (that is, unleveraged, pro 
rata ownership interests in a pool of financial assets), the bank may 
be eligible to determine risk-weighted assets for the underlying 
exposures using the Alternative Modified Look-Through Approach of 
Section 54 (d) based on investment limits specified in the program's 
prospectus or similar documentation.
    (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-

[[Page 69369]]

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 (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 is calculated as follows:
[GRAPHIC] [TIFF OMITTED] TR07DE07.009

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 (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.
    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] TR07DE07.010

    As noted above, when calculating N for a re-securitization, a bank 
must treat each underlying securitization exposure as an exposure to a 
single obligor. This conservative treatment addresses the concern that 
AVCs among securitization exposures can be much greater than the AVCs 
among the underlying individual assets securing these securitization 
exposures. Because the framework's simple approach to re-
securitizations may result in the differential treatment of 
economically similar securitization exposures, the agencies sought 
comment on alternative approaches for determining the N of a re-
securitization. While a number of commenters urged that a bank be 
permitted to calculate N for re-securitizations of asset-backed 
securities by looking through to the underlying pools of assets 
securing these securities, none provided theoretical or empirical 
evidence to support this recommendation. Absent such evidence, the 
final rule remains consistent with New Accord's measurement of N for 
re-securitizations.
    (vii) Exposure-weighted average loss given default (EWALGD). The 
EWALGD is calculated as:

[GRAPHIC] [TIFF OMITTED] TR07DE07.011

where LGDi represents the average LGD associated with all 
exposures to the i\th\ obligor. In the case of a re-securitization, an 
LGD of 100 percent must be assumed for any underlying exposure that is 
a securitization exposure.
    Although this treatment of EWALGD is consistent with the New 
Accord, several commenters asserted that assigning an LGD of 100 
percent to all securitization exposures in the underlying pool was 
excessively conservative, particularly for underlying exposures that 
are senior, highly rated asset-backed securities. The agencies 
acknowledge that in many situations an LGD significantly lower than 100 
percent may be appropriate. However, determination of the appropriate 
LGD depends on many complex factors, including the characteristics of 
the underlying assets and structural features of the securitization, 
such as the securitization exposure's thickness. Moreover, for thin 
securitization exposures or certain mezzanine positions backed by low-
quality assets, the LGD may in fact be close to 100 percent. In this 
light, the agencies believe that any simple alternative to the New 
Accord's measurement of EWALGD would increase the potential for capital 
arbitrage, and any more risk-sensitive alternative would take 
considerable time to develop. Thus, the agencies have retained the 
proposed treatment, consistent with the New Accord.
    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 N equal to the following amount:
[GRAPHIC] [TIFF OMITTED] TR07DE07.012


[[Page 69370]]


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'' using 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 N=1/C1. Under both 
simplification options a bank may set EWALGD=0.50 unless one or more of 
the underlying exposures is a securitization exposure. If one or more 
of the underlying exposures is a securitization exposure, a bank using 
a simplification option must set EWALGD=1.
5. Eligible Market Disruption Liquidity Facilities
    Under the proposed SFA, there was no special treatment provided for 
ABCP liquidity facilities that could be drawn upon only during periods 
of general market disruption. In contrast, the New Accord provides a 
more favorable capital treatment within the SFA for eligible market 
disruption liquidity facilities than for other liquidity facilities. 
Under the New Accord, an eligible market 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.
    The agencies sought comment on the prevalence of eligible market 
disruption liquidity facilities that might be subject to the SFA and, 
by implication, whether the final rule should incorporate the treatment 
provided in the New Accord. Commenters responded that eligible market 
disruption liquidity facilities currently are not a material product 
line for U.S. banks, but urged international consistency in this area. 
To limit additional complexity in the final rule, and because U.S. 
banks have limited exposure to eligible market disruption liquidity 
facilities, the agencies are not including a separate treatment of 
eligible market disruption liquidity facilities in the final rule. The 
agencies believe that the final rule provides adequate flexibility to 
determine an appropriate capital requirement for market disruption 
liquidity facilities.
6. CRM for Securitization Exposures
    The treatment of CRM for securitization exposures differs from that 
applicable to wholesale and retail exposures, and is largely unchanged 
from the proposal. 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 final rule may recognize the credit risk mitigant, 
but only as provided in section 46 of the final 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 from an insurance wrap that is part of the 
securitization transaction must calculate its risk-based capital 
requirement for the security strictly under the RBA. No additional 
credit is 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.
    As under the proposal, the final rule contains a treatment of CRM 
for securitization exposures separate from the treatment for 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 
that is not a repo-style transaction, an eligible margin loan, or an 
OTC derivative for which the bank has reflected collateral in its 
determination of exposure amount under section 32 of the rule by 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 (SE*) to original exposure amount (SE),

Where:

(i) SE* = max {0, [SE-C x (1-Hs-Hfx)]{time} ;
(ii) SE = the amount of the securitization exposure (as calculated 
under section 42(e) of the 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 is
[GRAPHIC] [TIFF OMITTED] TR07DE07.022

,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 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 the final rule 
and must use a currency mismatch haircut (Hfx) of 8 percent if the 
exposure and the collateral are denominated in different currencies. To

[[Page 69371]]

reflect the longer-term nature of securitization exposures as compared 
to securities financing transactions, however, these standard 
supervisory haircuts (which are based on a ten-business-day holding 
period and daily marking-to-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 the collateral.
    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. The definitions of eligible guarantee and 
eligible credit derivative apply to both the wholesale and retail 
frameworks and the securitization framework. 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 
multilateral 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 a securitization 
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 a securitization 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 must use the following procedures if the bank chooses to 
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. If the 
protection amount of the eligible guarantee or eligible credit 
derivative equals or exceeds the amount of the securitization exposure, 
the bank must 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 final 
rule), using the bank's PD for the guarantor, the bank's 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 final 
rule).
    If the protection amount of the eligible guarantee or eligible 
credit derivative is less than the amount of the securitization 
exposure, 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 rule), using the bank's PD for 
the guarantor, the bank's 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 ratio of 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 final 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 final 
rule. The agencies have clarified in the final rule that the mismatch 
provisions apply to any hedged securitization exposure and any more 
senior securitization exposure that benefits from the hedge. In the 
context of a synthetic securitization, when an eligible guarantee or 
eligible credit derivative covers multiple hedged exposures that have 
different residual maturities, the bank must use the longest residual 
maturity of any of the hedged exposures as the residual maturity of all 
the hedged exposures. 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 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 
protected portion of 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 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 final rule's treatment of synthetic securitizations 
is identical to that of traditional securitizations and to that 
described in the proposal. 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 final rule, banks must 
apply the securitization framework when calculating risk-based capital 
requirements for a synthetic

[[Page 69372]]

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 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 prevents the originating bank from using the 
securitization framework and requires 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, a bank must use the RBA for synthetic securitization 
exposures that have an appropriate number of external or inferred 
ratings. For an originating bank, the RBA will typically be used only 
for the most senior tranche of the securitization, which often has an 
inferred rating. If a bank has a synthetic securitization exposure that 
does not have an external or inferred rating, the bank must 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 may 
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 may 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 may also 
apply the securitization CRM rules in section 46 of the final rule to 
reduce its risk-based capital requirement on the exposure. If neither 
the RBA nor the SFA is available, a bank must 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 
qualifies for use of the RBA or (ii) the bank and the position qualify 
for use of the SFA and KIRB is greater than L.
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 will 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 approach 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 from a non-eligible 
securitization guarantor a guarantee or credit derivative that is 
collateralized by financial collateral generally will (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 must 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 may use the SFA to calculate the risk-based capital requirement 
for the exposure. If neither the RBA nor the SFA are available, the 
bank must 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 may 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 must 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

[[Page 69373]]

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 may use the SFA to calculate the risk-based 
capital requirement for the exposure. If neither the RBA nor the SFA 
are available, the bank must 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. N\th\-to-Default Credit Derivatives
    Credit derivatives that provide credit protection only for the 
n\th\ defaulting reference exposure in a group of reference exposures 
(n\th\-to-default credit derivatives) are similar to synthetic 
securitizations that provide credit protection only after the first-
loss 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 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 n\th\-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 
must 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 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 of the individual underlying exposures, up to a maximum of 
100 percent. If a bank provides credit protection on a group of 
underlying exposures through an n\th\-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 of the individual underlying exposures (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.\100\ 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 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. The final rule, consistent 
with the proposed rule, assesses a risk-based capital requirement that, 
in general, is linked to the likelihood of an early amortization event 
to address the risks that early amortization of a securitization poses 
to originating banks.
---------------------------------------------------------------------------

    \100\ The final rule defines excess spread for a period as gross 
finance charge collections and other income received by the 
securitization SPE (including market interchange fees) over the 
period minus interest paid to holders of securitization exposures, 
servicing fees, charge-offs, and other senior trust similar expenses 
of the securitization SPE over the period, divided by the principal 
balance of the underlying exposures at the end of the period.
---------------------------------------------------------------------------

    Consistent with the proposed rule, the final rule defines 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, a bank would not be 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; 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. The agencies sought comment on the appropriateness of 
these additional exemptions in the U.S. markets for revolving 
securitizations. Most commenters asserted that the exemptions provided 
in the New Accord are prudent and should be adopted by the agencies in 
order to avoid placing U.S. banking organizations at a competitive 
disadvantage relative to foreign competitors. The agencies generally 
agree with this view of exemption (iii), above, and the definition of 
early amortization provision in the final rule incorporates this 
exemption. The

[[Page 69374]]

agencies have not included exemption (i) or (ii). The agencies do not 
believe that the exemption for non-revolving exposures is meaningful 
because the early amortization provisions apply only to securitizations 
with revolving underlying exposures. The agencies also do not believe 
that the exemption for early amortization features that mimic term 
structures is meaningful in the U.S. market.
    Under the final rule, as under the proposed rule, an originating 
bank must generally hold risk-based capital against the sum of the 
originating bank's interest and the investors' interest arising from a 
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 for 
the investors' interest in the securitization is equal to the product 
of the following five quantities: (i) The EAD associated with the 
investors' interest; (ii) the appropriate CF as determined below; (iii) 
KIRB; (iv) 12.5; and (v) the proportion of the underlying 
exposures in which the borrower is permitted to vary the drawn amount 
within an agreed limit under a line of credit. The agencies added (v) 
to the final rule because, for securitizations containing both 
revolving and non-revolving underlying exposures, only the revolving 
underlying exposures give rise to the risk of early amortization.
    Under the final rule, consistent with the proposal, 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:
    (i) The total amount of securitization exposures issued by the 
securitization SPE to investors; divided by
    (ii) The outstanding principal amount of underlying exposures.
    In general, the applicable CF depends 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 (unconditionally 
cancelable by the bank to the fullest extent of Federal law, such as 
credit card receivables) or are other revolving credit facilities (for 
example, revolving corporate credit facilities). Consistent with the 
New Accord, under the proposed rule a controlled early amortization 
provision would meet 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.
    The agencies solicited 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 invited comment on the proposed definition of a 
controlled early amortization provision, including in particular the 
18-month period set forth above. Commenters generally believed that 
very few, if any, revolving securitizations would meet the criteria 
needed to qualify for treatment as a controlled early amortization 
structure. One commenter maintained that a fixed 18-month straight-line 
amortization period was too long for certain exposures, such as prime 
credit cards.
    The final rule is unchanged from the proposal with respect to 
controlled and non-controlled early amortization provisions. The 
agencies believe that the proposed eligibility criteria for a 
controlled early amortization are important indicators of the risks to 
which an originating bank would be exposed in the event of any early 
amortization. While a fixed 18-month straight-line amortization period 
is unlikely to be the most appropriate period in all cases, it is a 
reasonable period for the vast majority of cases. The lower operational 
burden of using a single, fixed amortization period warrants the 
potential diminution in risk-sensitivity.
Controlled Early Amortization
    Under the proposed rule, to calculate the appropriate CF for a 
securitization of uncommitted revolving retail exposures that contains 
a controlled early amortization provision, a bank would compare the 
three-month average annualized 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 
annualized excess spread, the excess spread trapping point was 4.5 
percent. The bank would divide the three-month average annualized 
excess spread level by the excess spread trapping point and apply the 
appropriate CF from Table H.

           Table H.--Controlled Early Amortization Provisions
------------------------------------------------------------------------
                                       Uncommitted          Committed
------------------------------------------------------------------------
Retail Credit Lines............  Three-month average     90% CF
                                  annualized excess
                                  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
------------------------------------------------------------------------


[[Page 69375]]

    A bank would apply a 90 percent CF for all other revolving 
underlying exposures (committed exposures and nonretail exposures) in 
securitizations containing a controlled early amortization provision. 
The proposed CFs for uncommitted revolving retail credit lines were 
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.
Non-controlled Early Amortization
    Under the proposed rule, to calculate the appropriate CF for 
securitizations of uncommitted revolving retail exposures that contain 
a non-controlled early amortization provision, a bank would perform the 
excess spread calculations described in the controlled early 
amortization section above and then apply the CFs in Table I.

         Table I.--Non-Controlled Early Amortization Provisions
------------------------------------------------------------------------
                                       Uncommitted          Committed
------------------------------------------------------------------------
Retail Credit Lines............  Three-month average     100% CF
                                  annualized excess
                                  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
------------------------------------------------------------------------

    A bank would use a 100 percent CF for all other revolving 
underlying exposures (committed exposures and nonretail exposures) in 
securitizations containing a non-controlled 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.
    A few commenters asserted that the proposed CFs were too high. The 
agencies believe, however, that the proposed CFs appropriately capture 
the risk to the bank of a potential early amortization event. The 
agencies also believe that the proposed CFs, which are consistent with 
the New Accord, foster consistency across national jurisdictions. 
Therefore, the agencies are maintaining the proposed CFs in the final 
rule with one exception, discussed below.
    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 CF 
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.
Securitizations of Revolving Residential Mortgage Exposures
    The agencies sought comment on the appropriateness of the proposed 
4.5 percent excess spread trapping point and on whether there were 
other types and levels of early amortization triggers used in 
securitizations of revolving retail exposures that should be addressed 
by the agencies. Although some commenters believed the 4.5 percent 
trapping point assumption was reasonable, others believed that it was 
inappropriate for securitizations of HELOCs. Unlike credit card 
securitizations, U.S. HELOC securitizations typically do not generate 
material excess spread and typically are structured with credit 
enhancements and early amortization triggers based on other factors, 
such as portfolio loss rates. Under the proposed treatment, banks would 
be required to hold capital against the potential early amortization of 
most U.S. HELOC securitizations at their inception, rather than only if 
the credit quality of the underlying exposures deteriorated. Although 
the New Accord does not provide an alternative methodology, the 
agencies concluded that the features of the U.S. HELOC securitization 
market warrant an alternative approach. Accordingly, the final rule 
allows a bank the option of applying either (i) the CFs in Tables I and 
J, as appropriate, or (ii) a fixed CF equal to 10 percent to its 
securitizations for which all or substantially all of the underlying 
exposures are revolving residential mortgage exposures. If a bank 
chooses the fixed CF of 10 percent, it must use that CF for all 
securitizations for which all or substantially all of the underlying 
exposures are revolving residential mortgage exposures. The agencies 
will monitor the implementation of this alternative approach to ensure 
that it is consistent with safety and soundness.

F. Equity Exposures

1. Introduction and Exposure Measurement
    This section describes the final rule's risk-based capital 
treatment for equity exposures. Consistent with the proposal, under the 
final rule, a bank has 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 must use 
a look-through approach for equity exposures to an investment fund.
    Although the New Accord provides national supervisors the option to 
provide a grandfathering period for equity exposures--whereby for a 
maximum of ten years, supervisors could permit banks to exempt from the 
IRB treatment equity investments held at the time of the publication of 
the New Accord--the proposed rule did not include such a grandfathering 
provision. A number of commenters asserted that the proposal was 
inconsistent with the New Accord and would subject banks using the 
agencies' advanced approaches to significant competitive inequity.
    The agencies continue to believe that it is not appropriate or 
necessary to incorporate the New Accord's optional ten-year 
grandfathering period for equity exposures. The grandfathering concept 
would reduce the risk

[[Page 69376]]

sensitivity of the SRWA and IMA. Moreover, the IRB approach does not 
provide grandfathering for other types of exposures, and the agencies 
see no compelling reason to do so for equity exposures. Further, the 
agencies believe that the overall final rule approach to equity 
exposures sufficiently mitigates potential competitive issues. 
Accordingly, the final rule does not provide a grandfathering period 
for equity exposures.
    Under the proposed SRWA, a bank generally would 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, under the proposed rule, a bank that met certain 
minimum quantitative and qualitative requirements on an ongoing basis 
and obtained 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 qualified to 
use the IMA could apply the IMA to its publicly traded and non-publicly 
traded equity exposures, or could apply the IMA only to its publicly 
traded equity exposures. However, if the bank applied the IMA to its 
publicly traded equity exposures, it would be required to apply the IMA 
to all such exposures. Similarly, if a bank applied the IMA to both 
publicly traded and non-publicly traded equity exposures, it would be 
required to apply the IMA to all such exposures. If a bank did not 
qualify to use the IMA, or elected not to use the IMA, to compute its 
risk-based capital requirements for equity exposures, the bank would 
apply the SRWA to assign risk weights to its equity exposures.
    Several commenters objected to the proposed restrictions on the use 
of the IMA. Commenters asserted that banks should be able to apply the 
SRWA and the IMA for different portfolios or subsets of equity 
exposures, provided that banks' choices are consistent with internal 
risk management practices.
    The agencies have not relaxed the proposed restrictions regarding 
use of the SRWA and IMA. The agencies remain concerned that if banks 
are permitted to employ either the SRWA or IMA to different equity 
portfolios, banks could choose one approach over the other to 
manipulate their risk-based capital requirements and not for risk 
management purposes. In addition, because of concerns about lack of 
transparency, it is not prudent to allow a bank to apply the IMA only 
to its non-publicly traded equity exposures and not its publicly traded 
equity exposures.
    The proposed rule defined publicly traded to mean 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 and that 
provides a liquid, two-way market for the exposure (that is, 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).
    Several commenters explicitly supported the proposed definition of 
publicly traded, noting that it is reasonable and consistent with 
industry practice. Other commenters requested that the agencies revise 
the proposed definition by eliminating the requirement that a non-U.S.-
based securities exchange provide a liquid, two-way market for the 
exposure. Commenters asserted that this requirement goes beyond the 
definition in the New Accord, which defines a publicly traded equity 
exposure as any equity security traded on a recognized security 
exchange. They asserted that registration with or approval by the 
national securities regulatory authority should suffice, as 
registration or approval generally would be predicated on the existence 
of a two-way market.
    The agencies have retained the definition of publicly traded as 
proposed. The agencies believe that the liquid, two-way market 
requirement is not in addition to the requirements of the New Accord. 
Rather, this requirement clarifies the intent of ``traded'' in the New 
Accord and helps to ensure that a sales price reasonably related to the 
last sales price or competitive bid and offer quotations can be 
determined promptly and settled within five business days.
    A bank using either the IMA or the SRWA must determine the adjusted 
carrying value for each equity exposure. The proposed rule defined 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; \101\ and
---------------------------------------------------------------------------

    \101\ 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).
    Commenters generally supported the proposed definition of adjusted 
carrying value and the agencies are adopting the definition as proposed 
with one minor clarification regarding unfunded equity commitments 
(discussed below).
    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 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.
    The final rule clarifies the determination of the effective 
notional principal amount of unfunded equity commitments. Under the 
final rule, for an unfunded equity commitment that is unconditional, a 
bank must use the notional amount of the commitment. If the unfunded 
equity commitment is conditional, the bank must use its best estimate 
of the amount that would be funded during economic downturn conditions.

[[Page 69377]]

Hedge Transactions
    The agencies proposed specific rules for recognizing hedged equity 
exposures; they received no substantive comment on these rules and are 
adopting these rules as proposed. For purposes of determining risk-
weighted assets under both the SRWA and the IMA, a bank may identify 
hedge pairs, which the final rule defines as two equity exposures that 
form an effective hedge provided 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 documented formally before the bank 
acquires at least one of the equity exposures; the documentation 
specifies the measure of effectiveness (E) (defined below) 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 is 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 equity position.
    The effective portion of a hedge pair is E multiplied by the 
greater of the adjusted carrying values of the equity exposures forming 
the hedge pair, and the ineffective portion is (1-E) multiplied by the 
greater of the adjusted carrying values of the equity exposures forming 
the 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 move 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 one. E is computed as:
[GRAPHIC] [TIFF OMITTED] TR07DE07.013

Xt = At - Bt
At = 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 the 
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 the 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. However, if the estimated regression coefficient 
is positive, then the value of E is zero. 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 above, by 
the lowest applicable risk weight in Table J. A bank would determine 
the risk-weighted asset amount for an equity exposure to an investment 
fund under section 54 of the proposed rule.
    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 J
------------------------------------------------------------------------
       Risk weight                        Equity exposure
------------------------------------------------------------------------
 0 Percent...............  An equity exposure to an entity whose credit
                            exposures are exempt from the 0.03 percent
                            PD floor.

[[Page 69378]]

 
20 Percent...............  An equity exposure to a Federal Home Loan
                            Bank or Farmer Mac if the equity exposure is
                            not publicly traded and is held as a
                            condition of membership in that entity.
100 Percent..............   Community development equity
                            exposures.
                            An equity exposure to a Federal Home
                            Loan Bank or Farmer Mac not subject to a 20
                            percent risk weight.
                            The effective portion of a hedge
                            pair.
                            Non-significant equity exposures to
                            the extent less than 10 percent of tier 1
                            plus tier 2 capital.
300 Percent..............  A publicly traded equity exposure (including
                            the ineffective portion of a hedge pair).
400 Percent..............  An equity exposure that is not publicly
                            traded.
------------------------------------------------------------------------

    Several commenters addressed the proposed risk weights under the 
SRWA. A few commenters asserted that the 100 percent risk weight for 
the effective portion of a hedge pair is too high. These commenters 
suggested that the risk weight for such exposures should be zero or no 
more than 7 percent because the effectively hedged portion of a hedge 
pair involves negligible credit risk. One commenter remarked that it 
does not believe there is an economic basis for the different risk 
weight for an equity exposure to a Federal Home Loan Bank depending on 
whether the equity exposure is held as a condition of membership.
    The agencies do not agree with commenters' assertion that the 
effective portion of a hedge pair entails negligible credit risk. The 
agencies believe the 100 percent risk weight under the proposal is an 
appropriate and prudential safeguard; thus, it is maintained in the 
final rule. Banks that seek to more accurately account for equity 
hedging in their risk-based capital requirements should use the IMA.
    The agencies agree that different risk weights for an equity 
exposure to a Federal Home Loan Bank or Farmer Mac depending on whether 
the equity exposure is held as a condition of membership do not have an 
economic justification, given the similar risk profile of the 
exposures. Accordingly, under the final rule SRWA, all equity exposures 
to a Federal Home Loan Bank or to Farmer Mac receive a 20 percent risk 
weight.
Non-significant Equity Exposures
    Under the SRWA, a bank may apply a 100 percent risk weight to non-
significant equity exposures. The proposed rule defined non-significant 
equity exposures as equity exposures to the extent that the aggregate 
adjusted carrying value of the exposures did not exceed 10 percent of 
the bank's tier 1 capital plus tier 2 capital.
    Several commenters objected to the 10 percent materiality threshold 
for determining significance. They asserted that this standard is more 
conservative than the 15 percent threshold under the OCC, FDIC, and 
Board general risk-based capital rules for nonfinancial equity 
investments.
    The agencies note that the applicable general risk-based capital 
rules address only nonfinancial equity investments; that the 15 percent 
threshold is a percentage only of tier 1 capital; and that the 15 
percent threshold was designed for that particular rule. The proposed 
materiality threshold of 10 percent of tier 1 plus tier 2 capital is 
consistent with the New Accord and is intended to identify non-
significant holdings of equity exposures under a different type of 
capital framework. Thus, the two threshold limits are not directly 
comparable. The agencies believe that the proposed 10 percent threshold 
for determining non-significant equity exposures is appropriate for the 
advanced approaches and, thus, are adopting it as proposed.
    As discussed above in preamble section V.A.3., the agencies have 
discretion under the final rule to exclude from the definition of a 
traditional securitization those investment firms that exercise 
substantially unfettered control over the size and composition of their 
assets, liabilities, and off-balance sheet exposures. Equity exposures 
to investment firms that would otherwise be a traditional 
securitization were it not for the specific agency exclusion are 
leveraged exposures to the underlying financial assets of the 
investment firm. The agencies believe that equity exposure to such 
firms with greater than immaterial leverage warrant a 600 percent risk 
weight under the SRWA, due to their particularly high risk. Moreover, 
the agencies believe that the 100 percent risk weight assigned to non-
significant equity exposures is inappropriate for equity exposures to 
investment firms with greater than immaterial leverage.
    Under the final rule, 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 or 
that qualify as community development 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 that the investment fund 
invests to the maximum extent possible in equity exposures.
    When determining which of a bank's equity exposures qualify for a 
100 percent risk weight based on non-significance, a bank first must 
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), 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).
    The SRWA is summarized in Table K:

[[Page 69379]]



                                 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.
100 Percent..............   Community development equity
                            exposures.\102\
                            The effective portion of a hedge
                            pair.
                            Non-significant equity exposures to
                            the extent less than 10 percent of tier 1
                            plus tier 2 capital.
300 Percent..............  A publicly traded equity exposure (other than
                            an equity exposure that receives a 600
                            percent risk weight and including the
                            ineffective portion of a hedge pair).
400 Percent..............  An equity exposure that is not publicly
                            traded (other than an equity exposure that
                            receives a 600 percent risk weight).
600 percent..............  An equity exposure to an investment firm that
                            (1) would meet the definition of a
                            traditional securitization were it not for
                            the primary Federal supervisor's application
                            of paragraph (8) of that definition and (2)
                            has greater than immaterial leverage.
------------------------------------------------------------------------
\102\ The final rule generally defines these exposures as exposures that
  would qualify as community development investments under 12 U.S.C.
  24(Eleventh), excluding equity exposures to an unconsolidated small
  business investment company and equity exposures held through a
  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).

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 
quantitative and qualitative criteria discussed below. As noted 
earlier, a bank may model both publicly traded and non-publicly traded 
equity exposures or model only publicly traded equity exposures.
    In the final rule, the agencies clarify that under the IMA, a bank 
may use more than one model, as appropriate for its equity exposures, 
provided that it has received supervisory approval for use of the IMA, 
and each model meets the qualitative and quantitative criteria 
specified below and in section 53 of the rule.
IMA Qualification
    The bank must have one or more models that (i) assess the potential 
decline in value of its modeled equity exposures; (ii) are commensurate 
with the size, complexity, and composition of the bank's modeled equity 
exposures; and (iii) adequately capture both general market risk and 
idiosyncratic risks. The bank's models 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. Banks with equity portfolios containing equity 
exposures with values that are highly nonlinear in nature (for example, 
equity derivatives or convertibles) must employ an internal model 
designed to appropriately capture the risks associated with these 
instruments.
    In addition, the number of risk factors and exposures in the sample 
and the data period used for quantification in the bank's models 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. In addition, for the reasons described below, 
the final rule adds that the bank's benchmarking exercise must be based 
on daily market prices for the benchmark portfolio. 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.
    Under the proposed rule, the agencies also required that daily 
market prices be available for all modeled equity exposures. The 
proposed requirement applied to either direct holdings or proxies. 
Several commenters objected to the requirement of daily market prices. 
A few asserted that proxies for private equity investments are more 
relevant than public market proxies and should be permitted even if 
they are only available on a monthly basis. The agencies agree with 
commenters on this issue. Accordingly, under the final rule, banks are 
not required to have daily market prices for all modeled equity 
exposures, either direct holdings or proxies. However, to ensure 
sufficient rigor in the modeling process, the final rule requires that 
a bank's benchmarking exercise be based on daily market prices for the 
benchmark portfolio, as noted above.
    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 whether a bank has met the criteria described above, 
the bank's primary Federal supervisor may 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

[[Page 69380]]

correlations among, the bank's equity exposures.
    The agencies do not intend to dictate the form or operational 
details of a bank's internal model for equity exposures. Accordingly, 
the agencies are not prescribing any particular type of model for 
determining risk-based capital requirements. Although the final 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 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 also 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 should be 
subject to a rigorous and comprehensive regime of stress-testing. Banks 
utilizing VaR models should 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 should 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 should estimate losses under worst-case modeled 
scenarios. These scenarios should 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.
    The loss estimate derived from the bank's internal model 
constitutes the risk-based capital requirement for the modeled equity 
exposures (subject to the supervisory floors described below). The 
equity capital requirement is 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 must multiply the capital requirement by 
12.5.
Risk-Weighted Assets Under the IMA
    Under the proposed and final rules, 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 the 
SRWA, community development equity exposures, and equity exposures to 
investment funds (collectively, excluded equity exposures). Unlike the 
SRWA, the IMA does not provide for a 10 percent materiality threshold 
for non-significant equity exposures.
    Several commenters objected to the fact that the IMA does not 
provide a 100 percent risk weight for non-significant equity exposures 
up to a 10 percent materiality threshold. These commenters maintained 
that the lack of a materiality threshold under the IMA will discourage 
use of this methodology relative to the SRWA. Commenters suggested that 
the agencies incorporate a materiality threshold into the IMA.
    The agencies do not believe that it is necessary or appropriate to 
incorporate such a threshold under the IMA. The agencies are concerned 
that a bank could manipulate significantly its risk-based capital 
requirements based on the exposures it chooses to model and those which 
it would deem immaterial (and to which it would apply a 100 percent 
risk weight). The agencies also believe that a flat 100 percent risk 
weight is inconsistent with the risk sensitivity of the IMA.
    Under the proposal, if a bank applied 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 excluded equity exposures 
(calculated outside of the IMA) and the risk-weighted asset amount of 
the non-excluded equity exposures (calculated under the IMA). The risk-
weighted asset amount of the non-excluded equity exposures generally 
would be 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 contained 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.
    Also under the proposal, if a bank applied 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 excluded equity exposures (calculated 
outside of the IMA); (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

[[Page 69381]]

bank's non-excluded publicly traded equity exposures generated by the 
bank's internal model multiplied by 12.5. Under the proposed rule, 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.
    Several commenters did not support the concept of floors in a risk-
sensitive approach that requires a comparison to estimates of potential 
losses produced by a VaR methodology. If floors are required in the 
final rule, however, these commenters noted that the calculation at the 
aggregate level would not pose significant operational issues. A few 
commenters, in contrast, objected to the proposed aggregate floors, 
asserting that it would be operationally difficult to determine 
compliance with such floors.
    The agencies believe that it is prudent to retain the floor 
requirements in the IMA and, thus, are adopting the floor requirements 
as described above. The agencies note that the New Accord also imposes 
a 200 percent and 300 percent floor for publicly traded and non-
publicly traded equity exposures, respectively. Regarding the proposal 
to calculate the floors on an aggregate basis, the agencies believe it 
is appropriate to maintain this approach, given that for most banks it 
does not seem to pose significant operational issues.
4. Equity Exposures to Investment Funds
    The proposed rule included a separate treatment for equity 
exposures to investment funds. As proposed, a bank would determine the 
risk-weighted asset amount for equity exposures to investment funds 
using 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 could use the 
ineffective portion of the hedge pair as the adjusted carrying value 
for the equity exposure to the investment fund. The risk-weighted asset 
amount of the effective portion of the hedge pair is equal to its 
adjusted carrying value. A bank could choose to apply a different 
approach among the three alternatives to different equity exposures to 
investment funds.
    The agencies proposed a separate treatment for equity exposures to 
an investment fund to prevent banks from arbitraging the proposed 
rule's 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. Under the proposal, the agencies defined an investment 
fund as a company (i) all or substantially all of the assets of which 
are financial assets and (ii) that has no material liabilities.
    Generally, commenters supported the separate treatment for equity 
exposures to investment funds. However, several commenters objected to 
the exclusion of investment funds with material liabilities from this 
separate treatment, observing that it would exclude equity exposures to 
hedge funds. Several commenters suggested that investment funds with 
material liabilities should be eligible for the look-through 
approaches. One commenter suggested that the agencies should adopt the 
following definition of investment fund: ``A company in which all or 
substantially all of the assets are pooled financial assets that are 
collectively managed in order to generate a financial return, including 
investment companies or funds with material liabilities.'' A few 
commenters suggested that equity exposures to investment funds with 
material liabilities should be treated under the SRWA or IMA as non-
publicly traded equity exposures rather than the separate treatment 
developed for equity exposures to investment funds.
    The agencies do not agree with commenters that the look-through 
approaches for investment funds should apply to investment vehicles 
with material liabilities. The look-through treatment is designed to 
capture the risks of an indirect holding of the underlying assets of 
the investment fund. Investment vehicles with material liabilities 
provide a leveraged exposure to the underlying financial assets and 
have a risk profile that may not be appropriately captured by a look-
through approach.
    Under the proposal, each of the approaches to equity exposures to 
investment funds imposed a 7 percent minimum risk weight on such 
exposures. This proposed minimum risk weight was 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.
    Several commenters objected to the proposed 7 percent risk weight 
floor. A few commenters suggested that the floor should be decreased or 
eliminated, particularly for low-risk investment funds that receive the 
highest rating from an NRSRO. Others recommended that the 7 percent 
risk weight floor should be applied on an aggregate basis rather than 
on a fund-by-fund basis.
    The agencies proposed the 7 percent risk weight floor as a minimum 
risk-based capital requirement for exposures not directly held by a 
bank. However, the agencies believe the comments on this issue have 
merit and recognize that the floor would provide banks with an 
incentive to invest in higher-risk investment funds. Consistent with 
the New Accord, the final rule does not impose a 7 percent risk weight 
floor on equity exposures to investment funds, on either an individual 
or aggregate basis.
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. Under the proposed rule, a bank would be 
required to calculate the risk-weighted asset amount for each of the 
exposures held by the investment fund as if the exposures were held 
directly by the bank. Depending on whether the exposures were 
wholesale, retail, securitization, or equity exposures, a bank would 
apply the appropriate IRB risk-based capital treatment.
    Several commenters suggested that the agencies should allow a bank 
with supervisory approval to use the IMA to model the underlying assets 
of an investment fund by including the bank's pro rata share of the 
investment fund's assets in its equities model. The commenters believed 
there is no basis for preventing a bank from using the IMA, a 
sophisticated and risk-sensitive approach, when a bank has full 
position data for an investment fund.
    The agencies agree with commenters' views in this regard. If a bank 
has full position data for an investment fund and has been approved by 
its primary Federal supervisor for use of the IMA, it may include the 
underlying equity exposures held by an investment fund, after 
adjustment for proportional ownership, in its equities model under the 
IMA. Therefore, in the final rule, under the full look-through 
approach, a bank must either (i) set the risk-weighted asset amount of 
the bank's equity exposure to the investment fund

[[Page 69382]]

equal to 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; or 
(ii) include the bank's proportional ownership share of each exposure 
held by the fund in the bank's IMA. If the bank chooses (ii), the risk-
weighted asset amount for the equity exposure to the investment fund is 
determined together with the risk-weighted asset amount for the bank's 
other non-excluded equity exposures and is subject to the aggregate 
floors under this approach.
Simple Modified Look-Through Approach
    Under the proposed simple modified look-through approach, a bank 
would 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 could exclude derivative contracts 
that are used for hedging, not speculative purposes, and do not 
constitute a material portion of the fund's exposures.
    Commenters generally supported the simple modified look-through 
approach as a low-burden yet moderately risk-sensitive way of treating 
equity exposures to an investment fund. However, several commenters 
objected to the large jump in risk weights (from a 400 percent to a 
1,250 percent risk weight) between investment funds permitted to hold 
non-publicly traded equity exposures and investment funds permitted to 
hold OTC derivative contracts and/or exposures that must be deducted 
from regulatory capital or receive a risk weight greater than 400 
percent under the IRB approach. In addition, one commenter objected to 
the proposed 20 percent risk weight for the most highly rated money 
market mutual funds that are subject to SEC rule 2a-7 governing 
portfolio maturity, quality, diversification and liquidity. This 
commenter asserted that a 7 percent risk weight for such exposures 
would be appropriate.
    The agencies agree that the proposed risk-weighting for highly-
rated money market mutual funds subject to SEC rule 2a-7 is 
conservative, given the generally low risk of such funds. Accordingly, 
the agencies added a new investment fund approach--the Money Market 
Fund Approach--which applies a 7 percent risk weight to a bank's equity 
exposure to a money market fund that is subject to SEC rule 2a-7 and 
that has an applicable external rating in the highest investment-grade 
rating category.
    The agencies have made no changes to address commenters' concerns 
about a lack of intermediate risk weights between 400 percent and 1,250 
percent. The agencies believe the range of risk weights is sufficiently 
granular to accommodate most equity exposures to investment funds.

   Table L.--Modified Look-Through Approaches for Equity Exposures to
                            Investment Funds
------------------------------------------------------------------------
         Risk weight            Exposure class or investment fund type
------------------------------------------------------------------------
0 Percent...................  Sovereign exposures with a long-term
                               external rating in the highest investment-
                               grade rating category and sovereign
                               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 the lowest investment-
                               grade rating category.
200 Percent.................  Exposures with a long-term external rating
                               one rating category below investment
                               grade.
300 Percent.................  Publicly traded equity exposures.
400 Percent.................  Non-publicly traded equity exposures;
                               exposures with a long-term external
                               rating two or more rating categories
                               below investment grade; and unrated
                               exposures (excluding publicly traded
                               equity exposures).
1,250 Percent...............  OTC derivative contracts and exposures
                               that must be deducted from regulatory
                               capital or receive a risk weight greater
                               than 400 percent under this appendix.
------------------------------------------------------------------------

Alternative Modified Look-Through 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 based on 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. Other than comments addressing the risk weight table 
and the 7 percent floor (addressed above), the agencies did not receive 
significant comment on this approach and have adopted it without 
significant change.

VI. Operational Risk

    This section describes features of the AMA framework for 
determining the risk-based capital requirement for operational risk. A 
bank meeting the AMA qualifying criteria uses 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 broadly cover all 
risks, and therefore implicitly cover operational risk. With the 
adoption of the more risk-sensitive treatment under the IRB approach 
for credit risk in this final rule, there no

[[Page 69383]]

longer is 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 experience of a number of 
high-profile, high-severity operational 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 is removed 
under the final rule, the agencies are requiring banks using the IRB 
approach for credit risk to use the AMA to address operational risk 
when computing their risk-based capital requirement.
    As discussed 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. Under the 
proposal, a bank's risk-based capital requirement for operational risk 
would be the sum of EOL and UOL. A bank would be allowed to recognize 
(i) certain offsets for EOL (such as certain reserves and other 
internal business practices), and (ii) the effect of risk mitigants 
such as insurance in calculating its regulatory capital requirement for 
operational risk.
    Under the proposed rule, the agencies recognized that a bank's 
risk-based capital requirement for operational risk could be based on 
UOL alone if the bank could demonstrate it has offset EOL with eligible 
operational risk offsets. Eligible operational risk offsets were 
defined as amounts, not to exceed EOL, that (i) are 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) are available to cover EOL with a high 
degree of certainty over a one-year horizon. Eligible operational risk 
offsets could only be used to offset EOL, not UOL.
    The preamble to the proposed rule stated that in determining 
whether to accept a proposed EOL offset, the agencies would 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 would be limited to those business lines and event types 
with highly predictable, routine losses. The preamble noted that based 
on discussions with the industry and supervisory experience, highly 
predictable and routine losses appear to be limited to those relating 
to securities processing and to credit card fraud.
    The majority of commenters on this issue recommended that the 
agencies should allow banks to present evidence of additional areas 
with highly predictable and reasonably stable losses for which eligible 
operational risk offsets could be considered. These commenters 
identified fraud losses pertaining to debit or ATM cards, commercial or 
business credit cards, HELOCs, and external checks in retail banking as 
additional events that have highly predictable and reasonably stable 
losses. Commenters also identified legal reserves set aside for small, 
predictable legal loss events, budgeted funds, and forecasted funds as 
other items that should be considered eligible operational risk 
offsets. Several commenters also highlighted that the proposed rule was 
inconsistent with the New Accord regarding the ability of budgeted 
funds to serve as EOL offsets. One commenter proposed eliminating EOL 
altogether because the commenter already factors it into its pricing 
practices.
    The New Accord permits a supervisor to accept expected loss offsets 
provided a bank is ``able to demonstrate to the satisfaction of its 
national supervisor that it has measured and accounted for its EL 
exposure.'' \103\ To the extent a bank is permitted to adjust its 
estimate of operational risk exposure to reflect potential operational 
risk offsets, it is appropriate to consider the degree to which such 
offsets meet U.S. accounting standards and can be viewed as regulatory 
capital substitutes. The final rule retains the proposed definition 
described above. The agencies believe that this definition allows for 
the supervisory consideration of EOL offsets in a flexible and prudent 
manner.
---------------------------------------------------------------------------

    \103\ 103 New Accord, ]669(b).
---------------------------------------------------------------------------

    In determining its operational risk exposure, the bank may also 
take into account the effects of qualifying operational risk mitigants 
such as insurance. To recognize the effects of qualifying operational 
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 qualifying operational 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 risk mitigant must be able to absorb losses with sufficient 
certainty to warrant inclusion as a qualifying operational risk 
mitigant. For insurance to meet this standard, it must:
    (i) be 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) have an initial term of at least one year and a residual term 
of more than 90 days;
    (iii) have a minimum notice period for cancellation of 90 days;
    (iv) have no exclusions or limitations based upon regulatory action 
or for the receiver or liquidator of a failed bank; and
    (v) be explicitly mapped to an actual operational risk exposure of 
the bank.
    A bank must receive prior written approval from its primary Federal 
supervisor to recognize an operational risk mitigant other than 
insurance as a qualifying operational risk mitigant. In evaluating an 
operational risk mitigant other than insurance, a primary Federal 
supervisor will consider whether the operational risk mitigant covers 
potential operational losses in a manner equivalent to holding 
regulatory capital.
    The bank's methodology for incorporating the effects of insurance 
must capture, through appropriate discounts in the amount of risk 
mitigation, the residual term of the policy, where less than one year; 
the policy's cancellation terms, where less than one year; the policy's 
timeliness of payment; and the uncertainty of payment as well as 
mismatches in coverage between the policy and the hedged operational 
loss event. The bank may not recognize for regulatory capital purposes 
insurance with a residual term of 90 days or less.
    Several commenters criticized the proposal for limiting recognition 
of non-insurance operational risk mitigants to those mitigants that 
would cover potential operational losses in a manner equivalent to 
holding regulatory capital. The commenters noted that similar 
limitations are not included in the New Accord. Other commenters 
asserted that qualifying operational risk mitigants should be broader 
than insurance.
    The New Accord discusses the use of insurance explicitly as an 
operational risk mitigant and notes that the BCBS ``in due course, may 
consider revising the criteria for and limits on the recognition of 
operational risk mitigants

[[Page 69384]]

on the basis of growing experience.'' \104\ Similarly, under the 
proposed rule, the agencies provided flexibility that recognizes the 
potential for developing operational risk mitigants other than 
insurance over time. The agencies continue to believe it is appropriate 
to consider the degree to which such mitigants can be viewed as 
regulatory capital substitutes. Therefore, under the final rule, in 
evaluating such mitigants, the agencies will consider whether the 
operational risk mitigant covers potential operational losses in a 
manner equivalent to holding regulatory capital.
---------------------------------------------------------------------------

    \104\ New Accord, footnote 110.
---------------------------------------------------------------------------

    Under the final rule, as under the proposal, 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). 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: (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 is 
multiplied by 12.5 to convert it into an equivalent risk-weighted asset 
amount. The resulting amount is 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. The public disclosure requirements in the final rule are 
intended to allow market participants to assess key information about a 
bank'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 regarding banks' 
experiences with 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 the Proposed Rule
    Many commenters expressed concern that the proposed disclosures 
were excessive, burdensome and overly prescriptive and would hinder--
rather than facilitate--market discipline by requiring banks to 
disclose items that would not be well understood or provide useful 
information to market participants. In particular, commenters were 
concerned that the differences between the proposed rule and the New 
Accord (such as the proposed ELGD risk parameter and proposed wholesale 
definition of default) would not be meaningful for cross-border 
comparative purposes, and would increase compliance burden for banks 
subject to the agencies' risk-based capital rules. Some commenters also 
believed that the information provided in the disclosures would not be 
comparable across banks because each bank would use distinct internal 
methodologies to generate the disclosures. Several commenters suggested 
that the agencies should delay the disclosure requirements until U.S. 
implementation of the IRB approach has gained some maturity. This would 
allow the agencies and banking industry sufficient time to ensure 
usefulness of the public disclosure requirements and comparability 
across banks.
    The agencies believe that it is important to retain the vast 
majority of the proposed disclosures, which are consistent with the New 
Accord. These disclosures will 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. The agencies also note that many of the disclosure 
requirements are already required by, or are consistent with, existing 
GAAP, SEC disclosure requirements, or regulatory reporting requirements 
for banks. More generally, the agencies view the public disclosure 
requirements as an integral part of the advanced approaches and the New 
Accord and are continuing to require their implementation beginning 
with a bank's first transitional floor period.
    The agencies are sympathetic, however, to commenters' concerns 
about cross-border comparability. The agencies believe that many of the 
changes they have made to the final rule (such as eliminating the ELGD 
risk parameter and adopting the New Accord's definition of default for 
wholesale exposures, as discussed above) will address commenters' 
concerns regarding comparability. In addition, the agencies have made 
several changes to the disclosure requirements to make them more 
consistent with the New Accord. These changes should increase cross-
border comparability and reduce implementation and compliance burden. 
These changes are discussed in the relevant sections below.
2. General Requirements
    Under the proposed rule, 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--the top-tier U.S. BHC or DI that is a 
core or opt-in bank.
    Several commenters objected to this proposal, noting that it is 
inconsistent with the New Accord, which requires such disclosures at 
the global top consolidated level of a banking group to which the 
framework applies. Commenters asserted that public disclosure at the 
U.S. BHC or DI level for U.S. banking organizations owned by a foreign 
banking organization is not meaningful and could generate confusion or 
misunderstanding in the market.
    The agencies agree that commenters' concerns have merit and believe 
that it is important to be consistent with the

[[Page 69385]]

New Accord. Accordingly, under the final rule, the public disclosure 
requirements will generally be required only at the top-tier global 
consolidated level. Under exceptional circumstances, a primary Federal 
supervisor may require some or all of the public disclosures at the 
top-tier U.S. level if the primary Federal supervisor determines that 
such disclosures are important for market participants to form 
appropriate insights regarding the bank's risk profile and associated 
level of capital. A factor the agencies will consider, for example, is 
whether a U.S. subsidiary of a foreign banking organization has debt or 
equity registered and actively traded in the United States.
    In addition, the proposed rule stated that, in general, a DI that 
is a subsidiary of a BHC or another DI would not be subject to the 
disclosure requirements except that every DI would be required to 
disclose total and tier 1 capital ratios and their components, similar 
to current requirements. Nonetheless, these entities must file 
applicable bank regulatory reports and thrift financial reports. In 
addition, as described below in the regulatory reporting section, the 
agencies will require certain additional regulatory reporting from 
banks applying the advanced approaches, and a limited amount of the 
reported information will be publicly disclosed. If a DI that is a core 
or opt-in bank and is not a subsidiary of a BHC or another DI that must 
make the full set of disclosures, the DI would be required to make the 
full set disclosures.
    One commenter objected to the supervisory flexibility provided to 
require additional disclosures at the subsidiary level. The commenter 
maintained that in all cases DIs that are a subsidiary of a BHC or 
another DI should not be subject to the disclosure requirements beyond 
disclosing their total and tier 1 capital ratios and the ratio 
components, as proposed. The commenter suggested that the agencies 
clarify this issue in the final rule.
    The agencies do not believe, however, that these changes are 
appropriate. The agencies believe that it is important to preserve some 
flexibility in the event that the primary Federal supervisor believes 
that disclosures from such a DI are important for market participants 
to form appropriate insights regarding the bank's risk profile and 
associated level of capital.
    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 bank. Accordingly, under the proposed and final rules, each bank 
that is subject to the disclosure requirements must have a formal 
disclosure policy approved by its board of directors that addresses the 
bank'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 
must ensure that appropriate review 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 may fulfill its disclosure 
requirements under this final rule by relying on disclosures made in 
accordance with accounting standards or SEC mandates that are very 
similar to the disclosure requirements in this final rule. In these 
situations, a bank must explain material differences between the 
accounting or other disclosure and the disclosures required under this 
final rule.
Frequency/Timeliness
    Under the proposed rule, the agencies required that quantitative 
disclosures be made quarterly. Several commenters objected to this 
requirement. These commenters asserted that banks subject to the U.S. 
public disclosure requirements would be placed at a competitive 
disadvantage because the New Accord requires banks to make Pillar 3 
public disclosures on a semiannual basis.
    The agencies believe that quarterly public disclosure requirements 
are important to ensure that the market has access to timely and 
relevant information and therefore have decided to retain quarterly 
quantitative disclosure requirements in the final rule. This disclosure 
frequency is consistent with longstanding requirements in the United 
States for robust quarterly disclosures in financial and regulatory 
reports, and is appropriate considering the potential for rapid changes 
in risk profiles. Moreover, many of the existing SEC, regulatory 
reporting, and other disclosure requirements that a bank may use to 
help meet its public disclosure requirements in the final rule are 
already required on a quarterly basis.
    The proposal stated that the disclosures must be timely and that 
the agencies would consider a disclosure to be timely if it was 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 should be used.
    Several commenters expressed concern that the tight timeframe for 
public disclosure requirements would be a burden and requested that the 
agencies provide greater flexibility, such as by setting the deadline 
for public disclosures at 60 days after quarter-end.
    The agencies believe commenters' concerns must be balanced against 
the importance of allowing market participants to have access to timely 
information that is reflective of a bank's risk profile and associated 
capital levels. Accordingly, the agencies have decided to interpret the 
requirement for timely public disclosures for purposes of this final 
rule to mean within 45 days after calendar quarter-end.
    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 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/Attestation Requirements
    Under the proposed and final rules, the disclosures must be 
publicly available (for example, included on a public Web site) for 
each of the latest three years (12 quarters) or such shorter time 
period since the bank entered its first transitional floor period. 
Except as discussed below, management has discretion to determine the 
appropriate medium and location of the disclosures required by this 
final rule. Furthermore, banks have flexibility in formatting their 
public disclosures. The agencies are not specifying a fixed format for 
these disclosures.
    The agencies encourage management to provide all of the required 
disclosures in one place on the entity's public Web site. The public 
Web site addresses are reported in the regulatory reports (for example, 
the FR Y-9C).\105\
---------------------------------------------------------------------------

    \105\ Alternatively, banks 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 (for example, 
FR Y-9C Reports). Banks must provide a summary table on their public 
Web site that specifically indicates where all the disclosures may 
be found (for example, regulatory report schedules or page numbers 
in annual reports).

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[[Page 69386]]

    Disclosure of tier 1 and total capital ratios must be provided in 
the footnotes to the year-end audited financial statements.\106\ 
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 are not 
subject to external audit reports for financial statements or internal 
control reports from management and the external auditor.
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    \106\ 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.''
---------------------------------------------------------------------------

    The preamble to the proposed rule stated that 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 
were appropriate and that the board of directors and senior management 
were responsible for establishing and maintaining an effective internal 
control structure over financial reporting, including the information 
required by the proposed rule.
    Several commenters expressed uncertainty regarding the proposed 
certification requirement for the chief financial officer. One 
commenter asked the agencies to articulate the standard of acceptance 
required for the certification of disclosure standards compared with 
what is required for financial reporting purposes. Another commenter 
questioned whether the chief financial officer would have sufficient 
familiarity with the risk management disclosures to make such a 
certification.
    To address commenter uncertainty, the agencies have simplified and 
clarified the final rule's accountability requirements. Specifically, 
the final rule modifies the certification requirement and instead 
requires one or more senior officers of the bank to attest that the 
disclosures meet the requirements of the final rule. The senior officer 
may be the chief financial officer, the chief risk officer, an 
equivalent senior officer, or a combination thereof.
Proprietary and Confidential Information
    The agencies stated in the preamble to the proposed rule that they 
believed the proposed requirements strike an appropriate balance 
between the need for meaningful disclosure and the protection of 
proprietary and confidential information.\107\ Many commenters, 
however, expressed concern that the required disclosures would result 
in the release of proprietary information. Commenters expressed 
particular concerns about the granularity of the credit loss history 
and securitization disclosures, as well as disclosures for portfolios 
subject to the IRB risk-based capital formulas.
---------------------------------------------------------------------------

    \107\ 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.
---------------------------------------------------------------------------

    As noted above, the final rule provides banks with considerable 
discretion with regard to public disclosure requirements. Bank 
management determines which disclosures are relevant based on a 
materiality concept. In addition, bank management has flexibility 
regarding formatting and the level of granularity of disclosures, 
provided they meet certain minimum requirements. Accordingly, the 
agencies believe that banks generally can provide these disclosures 
without revealing proprietary and confidential information. Only in 
rare circumstances might disclosure of certain items of information 
required in the final rule compel a bank to reveal confidential and 
proprietary information. In these unusual situations, the final rule 
requires that if a bank believes that disclosure of specific commercial 
or financial information would prejudice seriously the position of the 
bank by making public information that is either proprietary or 
confidential in nature, the bank need not disclose those specific 
items, but must disclose more general information about the subject 
matter of the requirement, together with the fact that, and the reason 
why, the specific items of information have not been disclosed. This 
provision of the final rule applies only to those disclosures required 
by the final rule and does not apply to disclosure requirements imposed 
by accounting standards or other regulatory agencies.
3. Summary of Specific Public Disclosure Requirements
    As in the proposed rule, 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. The agencies are adopting the tables as proposed, with the 
exceptions noted below. 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 final 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.
    One commenter questioned item (e) in Table 11.1, which would 
require the disclosure of the aggregate amount of capital deficiencies 
in all subsidiaries and the name(s) of such subsidiaries. The commenter 
asserted that the scope of this item should be limited to those legal 
subsidiaries that are subject to banking, securities, or insurance 
regulators' capital adequacy rules and should not include unregulated 
entities that are consolidated into the top corporate entity or 
unconsolidated affiliate and joint ventures.
    As stated in a footnote to Table 11.1 in the proposed rule, the 
agencies limited the proposed requirement to legal subsidiaries that 
are subject to banking, securities, or insurance regulators' capital 
adequacy rules. The agencies are further clarifying this disclosure in 
Table 11.1.
    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

[[Page 69387]]

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 approach, without revealing 
proprietary information.
    Several commenters made suggestions related to Table 11.4. One 
commenter addressed item (b), which requires the disclosure of total 
and average gross credit risk exposures over the period broken down by 
major types of credit exposure. The commenter asked the agencies to 
clarify that methods used for financial reporting purposes are allowed 
for determining averages. Another commenter requested that the agencies 
clarify what is meant by ``gross'' in item (b), given that a related 
footnote describes net credit risk exposures in accordance with GAAP.
    As with most of the disclosure requirements, the agencies are not 
prescriptive regarding the methodologies a bank must use for 
determining averages. Rather, the bank must choose whatever methodology 
it believes to be most reflective of its risk position. That 
methodology may be the one the bank uses for financial reporting 
purposes. The agencies have deleted ``gross'' and otherwise simplified 
the wording of item (b) in Table 11.4 to enhance clarity. Item (b) now 
reads ``total credit risk exposures and average credit risk exposures, 
after accounting offsets in accordance with GAAP, and without taking 
into account the effects of credit risk mitigation techniques (for 
example collateral and netting not included in GAAP for disclosure), 
over the period broken down by major types of credit exposure.''
    In addition, a commenter noted that the requirements in Table 11.4 
regarding the breakdown of disclosures by ``major types of credit 
exposure'' in items (b) through (e) and by ``counterparty type'' for 
items (d) and (f) are unclear. Moreover, with respect to items (d), 
(e), and (f), the commenter recommended that disclosures should be 
provided on an annual rather than quarterly basis. The same commenter 
also asserted that the disclosure of remaining contractual maturity 
breakdown in item (e) should be required annually. Finally, regarding 
items (f) and (g), a few commenters wanted clarification of the 
definition of impaired and past due loans.
    The agencies are not prescriptive with regard to what is meant by 
``major types of credit exposure,'' disclosure by counterparty type, or 
impaired and past due loans. Bank management has the discretion to 
determine the most appropriate disclosure for the bank's risk profile 
consistent with internal practice, GAAP or regulatory reports (such as 
the FR Y-9C). As noted in the proposal, for major types of credit 
exposure a bank could apply a breakdown similar to that used for 
accounting purposes, such as (a) loans, off-balance sheet commitments, 
and other non-derivative off-balance sheet exposures, (b) debt 
securities, and (c) OTC derivatives. The agencies do not believe it is 
appropriate to make an exception to the general quarterly requirement 
for quantitative disclosures for the disclosure in Table 11.4.
    Commenters provided extensive feedback on several aspects of Table 
11.5 (Disclosures for Portfolios Subject to IRB Risk-Based Capital 
Formulas). Several commenters were concerned that the required level of 
detail may compel banks to disclose proprietary information. With 
respect to item (c), a couple of commenters noted that the proposal 
differs from the New Accord in requiring exposure-weighted average 
capital requirements instead of risk weight percentages for groups of 
wholesale and retail exposures. One commenter also suggested that the 
term ``actual losses'' required in item (d) needs to be defined. 
Finally, several commenters objected to the proposal in item (e) to 
disclose backtesting results, asserting that such results would not be 
understood by the market. Commenters suggested that disclosure of this 
item be delayed beyond the proposed commencement date of year-end 2010, 
to commence instead ten years after a bank exits from the parallel run 
period.
    As discussed above, the agencies believe that, in most cases, a 
bank can make the required disclosures without revealing proprietary 
information and that the rule contains appropriate provisions to deal 
with specific bank concerns. With regard to item (c), the agencies 
agree that there is no strong policy reason to differ from the New 
Accord and have changed item (c) to require the specified disclosures 
in risk weight percentages rather than weighted-average capital 
requirements. With respect to item (d), the agencies are not imposing a 
prescriptive definition of actual losses and believe that banks should 
determine actual losses consistent with internal practice. Finally, 
regarding item (e), the agencies believe that public disclosure of 
backtesting results provides important information to the market and 
should not be delayed. However, the agencies have slightly modified the 
requirement, consistent with the New Accord, to reinforce that 
disclosure of individual risk parameter backtesting is not always 
required.
    Commenters provided feedback on a few aspects of Table 11.7 (Credit 
Risk Mitigation). One commenter asserted that the table appears to 
overlap with the information on credit risk mitigation required in 
Table 11.5, item (a) and requested that the agencies consolidate and 
simplify the requirements. In addition, several commenters objected to 
Table 11.7 item (b), which would require public disclosure of the risk-
weighted asset amount associated with credit risk exposures that are 
covered by credit risk mitigation in the form of guarantees and credit 
derivatives. The commenter noted that this requirement is not contained 
in the New Accord, which only requires the total exposure amount of 
such credit risk exposures.
    The agencies recognize that there is some duplication between 
Tables 11.7 and 11.5. At the same time, both requirements are part of 
the New Accord. The agencies have decided to address this issue by 
inserting in Table 11.5, item (a), a note that the disclosures can be 
met by completing the disclosures in Table 11.7. With regard to Table 
11.7, item (b), the agencies have decided that there is no strong 
policy reason for requiring banks to disclose risk-weighted assets 
associated with credit risk exposures that are covered by credit risk 
mitigation in the form of guarantees and credit derivatives. The 
agencies have removed this requirement from the final rule, consistent 
with the New Accord.
    Table 11.6 (General Disclosure for Counterparty Credit Risk of OTC 
Derivative Contracts, Repo-Style Transaction, and Eligible Margin 
Loans) provides the disclosure requirements related to credit exposures 
from derivatives. See the July 2005 BCBS publication entitled ``The 
Application of Basel II to Trading Activities and the Treatment of 
Double Default Effects.''
    Commenters raised a few issues with respect to Table 11.6. One 
commenter requested that the agencies clarify item (a), which requires 
a discussion of the impact of the amount of collateral the bank would 
have to provide given a credit rating downgrade. The commenter asked 
whether this disclosure refers to credit downgrade of the bank, the 
counterparty, or some other entity. Another commenter objected to item 
(b), which would require the breakdown of counterparty credit exposure 
by type of exposure. The commenter asserted that this proposed 
requirement is burdensome, infeasible for netted exposures and 
duplicative of other information generally available in existing GAAP 
and U.S. bank regulatory financial statements.

[[Page 69388]]

    The agencies have decided to clarify that item (a) refers in part 
to the credit rating downgrade of the bank making the disclosure. This 
is consistent with the intent of this disclosure requirement in the New 
Accord. With respect to item (b), the agencies recognize that this 
proposed requirement may be problematic for banks that have implemented 
the internal models methodology. Accordingly, the agencies have decided 
to modify the rule to note that this disclosure item is only required 
for banks not using the internal models methodology in section 32(d).
    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.
    One commenter asked the agencies to explicitly acknowledge that 
they will accept the definitions and interpretations of the components 
of securitization exposures that a bank uses for financial reporting 
purposes (FAS 140 reporting disclosures).
    Generally, as noted above, the agencies expect that a bank will be 
able to fulfill some of its disclosure requirements by relying on 
disclosures made in accordance with accounting standards, SEC mandates, 
or regulatory reports. In these situations, a bank must explain any 
material differences between the accounting or other disclosure and the 
disclosures required under the final rule. The agencies do not believe 
any changes to the rule are necessary to accommodate the commenter's 
concern.
    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 Not Subject to Market Risk Rule) 
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 required by the consolidated 
banking organization subject to the advanced approaches, the agencies 
will 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 bank's calculation of its minimum capital requirements 
under this final rule and the adequacy of the institution's capital in 
relation to its risks. This information will be collected through 
regulatory reports. The agencies believe that requiring certain common 
reporting across banks will facilitate comparable application of the 
final rule.
    The agencies will publish in the Federal Register reporting 
schedules based on the reporting templates issued for comment in 
September 2006. Consistent with the proposed reporting schedules, these 
reporting schedules will include a summary schedule with aggregate data 
that will be available to the general public. It also will include 
supporting schedules that will be viewed as confidential supervisory 
information. These schedules will be broken out by exposure category 
and will collect risk parameter and other pertinent data in a 
systematic manner. Under the final rule, banks must 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.
    One commenter expressed concerns that some of the confidential 
information requested in the proposed reporting templates was also 
contained in the public disclosure requirements under the proposal. As 
a result, some information would be classified as confidential in the 
reporting templates and public under the disclosure requirements in the 
final rule.
    The agencies recognize that there may be some overlap between 
confidential information required in the regulatory reports and public 
information required in the disclosure requirements of the final rule. 
The agencies will address specific comments on the reporting templates 
separately. In general, the agencies believe that given the different 
purposes of the regulatory reporting and public disclosure requirements 
under the final rule, there may be some instances where the same or 
similar disclosures may be required by both sets of requirements. Many 
of the public disclosures cover only a subset of the information sought 
in the proposed regulatory reporting templates. For instance, banks are 
required only to disclose publicly information ``across a sufficient 
number of PD grades to allow a meaningful differentiation of credit 
risk,'' whereas the proposed reporting templates contemplate a much 
more granular collection of data by specified PD bands. Such 
aggregation of data so as to mask the confidential nature of more 
granular information that is reported to regulators is not unique to 
the advanced approaches reporting. In addition, the agencies believe 
that a bank may be able to comply with some of the public disclosure 
requirements under this final rule by publicly disclosing, at the 
bank's discretion and judgment, certain information found in the 
reporting templates that otherwise would be held confidential by the 
agencies. A bank could disclose this information on its Web site (as 
described in ``location and audit requirements'' above) if it believes 
that such disclosures will meet the public disclosure requirements 
required by the rule.

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
CCDS Contingent Credit Default Swap
CF Conversion Factor
CEIO Credit-Enhancing Interest-Only Strip
CRM Credit Risk Mitigation
CUSIP Committee on Uniform Securities Identification Procedures
DI Depository Institution
DvP Delivery versus Payment
E Measure of Effectiveness
EAD Exposure at Default
ECL Expected Credit Loss
EE Expected Exposure
EL Expected Loss
ELGD Expected Loss Given Default
EOL Expected Operational Loss
EPE Expected Positive Exposure
EWALGD Exposure-Weighted Average Loss Given Default
FAS Financial Accounting Standard
FDIC Federal Deposit Insurance Corporation
FFIEC Federal Financial Institutions Examination Council
GAAP Generally Accepted Accounting Principles
GAO Government Accountability Office
HELOC Home Equity Line of Credit
HOLA Home Owners' Loan Act

[[Page 69389]]

HVCRE High-Volatility Commercial Real Estate
IAA Internal Assessment Approach
ICAAP Internal Capital Adequacy Assessment Process
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
NRSRO Nationally Recognized Statistical Rating Organization
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
PMI Private Mortgage Insurance
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
RVC Ratio of Value Change
SEC Securities and Exchange Commission
SFA Supervisory Formula Approach
SME Small- and Medium-Size Enterprise
SPE Special Purpose Entity
SRWA Simple Risk-Weight Approach
TFR Thrift Financial Report
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 final rule to prepare and make available a regulatory 
flexibility analysis that describes the impact of the final rule on 
small entities. 5 U.S.C. 603(a). The RFA provides that an agency is not 
required to prepare and publish a regulatory flexibility analysis if 
the agency certifies that the final rule will not 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 final rule will not 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 final rule 
requires 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 2,919 small bank holding companies), 16 
small national banks (out of a total of approximately 948 small 
national banks), one small state member bank (out of a total of 
approximately 468 small state member banks), one small state nonmember 
bank (out of a total of approximately 3,242 small state nonmember 
banks), and zero small savings associations (out of a total of 
approximately 419 small savings associations) would be subject to the 
final rule on a mandatory basis. In addition, each of the small banking 
organizations subject to the final rule on a mandatory basis is 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 final rule will not result in a significant economic impact on a 
substantial number of small entities.

Paperwork Reduction Act

    In accordance with the requirements of the Paperwork Reduction Act 
of 1995, the agencies may not conduct or sponsor, and respondents are 
not required to respond to, an information collection unless it 
displays a currently valid Office of Management and Budget (OMB) 
control number. OMB assigned the following control numbers to the 
collections of information: 1557-0234 (OCC), 3064-0153 (FDIC), and 
1550-0115 (OTS). The Board assigned control number 7100-0313.
    In September 2006 the OCC, FDIC, and OTS submitted the information 
collections contained in this rule to OMB for review and approval once 
the proposed rule was published. The Board, under authority delegated 
to it by OMB, also submitted the proposed information collection to 
OMB.
    The agencies (OCC, FDIC, the Board, and OTS) determined that 
sections 21-24, 42, 44, 53, and 71 of the final rule contain 
collections of information. The final 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 collections of information are necessary in order to 
implement the proposed advanced capital adequacy framework. The 
agencies received approximately ninety public comments. None of the 
comment letters specifically addressed the proposed burden estimates; 
therefore, the burden estimates will remain unchanged, as published in 
the notice of proposed rulemaking (71 FR 55830).
    The affected public are: national banks and Federal branches and 
agencies of foreign banks (OCC); 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 (Board); insured nonmember banks, 
insured state branches of foreign banks, and certain subsidiaries of 
these entities (FDIC); and savings associations and certain of their 
subsidiaries (OTS).

Comment Request

    The agencies have an ongoing interest in your comments. They should 
be sent to [Agency] Desk Officer, [OMB No.], by mail to U.S. Office of 
Management and Budget, 725 17th Street, NW., 10235, 
Washington, DC 20503, or by fax to (202) 395-6974.
    Comments submitted in response to this notice will be shared among 
the agencies. All comments will become a matter of public record. 
Written comments should address the accuracy of the burden estimates 
and ways to minimize burden including the use of automated collection 
techniques or the use of other forms of information technology as well 
as other relevant aspects of the information collection request.

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

[[Page 69390]]

communities.''\108\ Regulatory actions that satisfy one or more of 
these criteria are referred to as ``economically significant regulatory 
actions.''
---------------------------------------------------------------------------

    \108\ 108 Executive Order 12866 (September 30, 1993), 58 FR 
51735 (October 4, 1993), as amended by Executive Order 13258 
(February 26, 2002), 67 FR 9385 (February 28, 2002) and by Executive 
Order 13422 (January 18, 2007), 72 FR 2763 (January 23, 2007). For 
the complete text of the definition of ``significant regulatory 
action,'' see E.O. 12866 at Sec.  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 Sec.  3(e).
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    The OCC anticipates that the final 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 
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: 
Advanced Approach) 2007''.

I. The Need for the Regulatory Action

    Federal banking law directs Federal banking agencies including the 
Office of the Comptroller of the Currency (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 Federal 
banking agencies broad discretion with respect to capital regulation by 
authorizing them to also 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 Committee 
on Banking Supervision's ``International Convergence of Capital 
Measurement and Capital Standards: A Revised Framework'' (New Accord), 
and its implementation in the United States, reflects an appropriate 
step forward in addressing these changes.

II. Regulatory Background

    The capital regulation examined in this analysis will apply to 
commercial banks and savings associations (collectively, banks). Three 
banking agencies, the OCC, the Board of Governors of the Federal 
Reserve System (Board), and the FDIC regulate commercial banks, while 
the Office of Thrift Supervision (OTS) regulates all federally 
chartered and many state-chartered savings associations. Throughout 
this document, the four are jointly referred to as the Federal banking 
agencies.
    The New Accord comprises three mutually reinforcing ``pillars'' as 
summarized below.
1. Minimum Capital Requirements (Pillar 1)
    The first pillar establishes a method for calculating minimum 
regulatory capital. It sets new requirements for assessing credit risk 
and operational risk while retaining the approach to market risk as 
developed in the 1996 amendments to the 1988 Accord.
    The New Accord offers banks a choice of three methodologies for 
calculating a capital charge for credit risk. The first approach, 
called the Standardized Approach, essentially refines the risk-
weighting framework of the 1988 Accord. The other two approaches are 
variations on an internal ratings-based (IRB) approach that leverages 
banks' internal credit-rating systems: a ``foundation'' methodology in 
which banks estimate the probability of borrower or obligor default, 
and an ``advanced'' approach in which banks also supply other inputs 
needed for the capital calculation. In addition, the new framework uses 
more risk-sensitive methods for dealing with collateral, guarantees, 
credit derivatives, securitizations, and receivables.
    The New Accord also introduces an explicit capital requirement for 
operational risk.\109\ The New Accord offers banks a choice of three 
methodologies for calculating their capital charge for operational 
risk. The first method, called the Basic Indicator Approach, requires 
banks to hold capital for operational risk equal to 15 percent of 
annual gross income (averaged over the most recent three years). The 
second option, called the

[[Page 69391]]

Standardized Approach, uses a formula that divides a bank's activities 
into eight business lines, calculates the capital charge for each 
business line as a fixed percentage of gross income (12 percent, 15 
percent, or 18 percent depending on the nature of the business, again 
averaged over the most recent three years), and then sums across 
business lines. The third option, called the Advanced Measurement 
Approaches (AMA), uses an bank's internal operational risk measurement 
system to determine the capital requirement.
---------------------------------------------------------------------------

    \109\ Operational risk is the risk of loss resulting from 
inadequate or failed processes, people, and systems or from external 
events. It includes legal risk, but excludes strategic risk and 
reputation risk.
---------------------------------------------------------------------------

2. Supervisory Review Process (Pillar 2)
    The second pillar calls upon banks to have an internal capital 
assessment process and banking supervisors to evaluate each bank's 
overall risk profile as well as its risk management and internal 
control processes. This pillar establishes an expectation that banks 
hold capital beyond the minimums computed under Pillar 1, including 
additional capital for any risks that are not adequately captured under 
Pillar 1. It encourages banks to develop better risk management 
techniques for monitoring and managing their risks. Pillar 2 also 
charges supervisors with the responsibility to ensure that banks using 
advanced Pillar 1 techniques, such as the IRB approach to credit risk 
and the AMA for operational risk (collectively, advanced approaches), 
comply with the minimum standards and disclosure requirements of those 
methods, and take action promptly if capital is not adequate.
3. Market Discipline (Pillar 3)
    The third pillar of the New Accord sets minimum disclosure 
requirements for banks. The disclosures, covering the composition and 
structure of the bank's capital, the nature of its risk exposures, its 
risk management and internal control processes, and its capital 
adequacy, are intended to improve transparency and strengthen market 
discipline. By establishing a common set of disclosure requirements, 
Pillar 3 seeks to provide a consistent and understandable disclosure 
framework that market participants can use to assess key pieces of 
information on the risks and capital adequacy of a bank.
4. U.S. Implementation
    The rule for implementing the New Accord's advanced approaches in 
the United States will apply the new framework to the largest and most 
internationally active banks. All banks will fall into one of three 
regulatory categories. The first category, called ``mandatory'' banks, 
consists of banks with consolidated assets of at least $250 billion or 
consolidated on-balance-sheet foreign exposures of $10 billion or more. 
Mandatory banks will have to use the New Accord's most advanced methods 
only: the Advanced IRB approach to determine capital for credit risk 
and the AMA to determine capital for operational risk. A second 
category of banks, called ``opt-in'' banks, includes banks that do not 
meet either size criteria of a mandatory bank but choose voluntarily to 
comply with the advanced approaches specified under the New Accord. The 
third category, called ``general'' banks, encompasses all other banks, 
and these will continue to operate under existing risk-based capital 
rules, subject to any amendments.
    Various changes to the rules that apply to non-mandatory banks are 
under consideration. The Federal banking agencies have decided to issue 
for comment a proposal that would allow the voluntary adoption of the 
standardized approach for credit risk and the basic indicator approach 
for operational risk for non-mandatory banks (referred to hereafter as 
the Standardized Option). Because the Standardized Option would be a 
separate rulemaking, our analysis will focus just on the implementation 
of the Advanced Approaches. However, we will note how the Standardized 
Option might affect the outcome of our analysis if we anticipate the 
possibility that its adoption could lead to a significantly different 
outcome.
    While introducing many significant changes, the U.S. implementation 
of the New Accord retains many components of the capital rules 
currently in effect. For example, it preserves existing Prompt 
Corrective Action provisions for all banks. The U.S. implementation of 
the New Accord also keeps intact most elements of the definition of 
what comprises regulatory capital.

III. Costs and Benefits of the Rule

    This analysis considers the costs and benefits of the fully phased-
in rule. Under the rule, current capital rules will remain in effect in 
2008 during a parallel run using both old and new capital rules. For 
three years following the parallel run, the final rule will apply 
limits on the amount by which minimum required capital may decrease. 
This analysis, however, considers the costs and benefits of the rule as 
fully phased in.
    Cost and benefit analysis of changes in minimum capital 
requirements entail considerable measurement problems. On the cost 
side, it can be difficult to attribute particular expenditures incurred 
by banks to the costs of implementation because banks 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 rule 
are more qualitative than quantitative. Measurement problems exist even 
with an apparently measurable effect such as lower minimum capital 
because lower minimum requirements do not necessarily mean lower 
capital levels held by banks. Healthy banks 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 banks.

Benefits of the 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 approaches do away with the simplistic risk buckets of 
current capital rules. Getting rid of categorical risk weighting and 
assigning capital based on measured risk instead greatly curtails or 
eliminates the ability of troubled banks 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 are designed to more accurately align 
regulatory capital with risk, which should improve the signal quality 
of capital as an indicator of solvency. The improved signaling quality 
of capital will enhance banking supervision and market discipline.
    3. Encourages banks to improve credit risk management: One of the 
principal objectives of the 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 
final rule, the capital charge for credit risk depends on these risk 
parameter measures and consequently capital requirements will more 
closely reflect risk. This enhanced link between capital requirements 
and risk will encourage banks 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

[[Page 69392]]

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 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 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 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 banks 
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 banks where operational risk dominates other risks. The explicit 
treatment also increases the transparency of operational risk, which 
could encourage banks to take further steps to mitigate operational 
risk.
    8. Enhanced supervisory feedback: Although U.S. banks have long 
been subject to close supervision, aspects of all three pillars of the 
rule aim to enhance supervisory feedback from Federal banking agencies 
to managers of banks. Enhanced feedback could further strengthen the 
safety and soundness of the banking system.
    9. Enhanced disclosure promotes market discipline: The rule seeks 
to aid market discipline through 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 banks competing in global markets. The New Accord 
continues to pursue this objective. Because achieving this objective 
depends on the consistency of implementation in the United States and 
abroad, the Basel Committee on Banking Supervision (BCBS) has 
established an Accord Implementation Group to promote consistency in 
the implementation of the New Accord.
    11. Ability to opt in offers long-term flexibility to nonmandatory 
banks: The U.S. implementation of the New Accord allows non-mandatory 
banks 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 methods may present 
non-mandatory banks with a substantial hurdle to opting in at present, 
the potential long-term benefits of allowing non-mandatory banks to 
partake in the benefits described above may be similarly substantial.

Costs of the Rule

    Because banks 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 this 
final rule and costs that would have occurred irrespective of any new 
regulation. In an effort to identify how much banks expect to spend to 
comply with the U.S. implementation of the New Accord's advanced 
approaches, the Federal banking agencies included several questions 
related to compliance costs in the fourth Quantitative Impact Study 
(QIS-4).\110\
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    \110\ 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, 
banks will spend roughly $42 million on average to adapt to capital 
requirements implementing the New Accord's advanced approaches. Not all 
of these respondents are likely mandatory banks. Counting just the 
likely mandatory banks, the average is approximately $46 million, so 
there is little difference between banks that meet a mandatory 
threshold and those that do not. Aggregating estimated expenditures 
from all 19 respondents indicates that these banks will spend a total 
of $791 million over several years to implement the rule. Estimated 
costs for nine respondents meeting one of the mandatory thresholds come 
to $412 million.
    2. Estimate of costs specific to the rule: 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 advanced approaches expenditures on improving risk management 
anyway. This suggests that of the $42 million banks expect to spend on 
implementation, approximately $21 million may represent expenditures 
each bank would have undertaken even without the New Accord. 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 U.S implementation of the 
New Accord. On average, the seven banks estimate that annual recurring 
expenses attributable to the revised capital framework will be $2.4 
million per bank. Banks indicated that the ongoing costs to maintain 
related technology reflect costs for increased personnel and system 
maintenance. The larger one-time expenditures to adopt this final rule 
primarily involve money for system development and software purchases.
    4. Implicit costs: In addition to explicit setup and recurring 
costs, banks 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 management to introduce new programs and procedures and the 
need to closely monitor the new activities during the inevitable rough 
patches when the rule first takes effect.
    5. Government Administrative Costs: OCC expenditures fall into 
three broad categories: training, guidance, and supervision. Training 
includes expenses for AMA and 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 
bank-specific supervisory activities related to the development and 
implementation of the New Accord. The largest OCC expenditures have 
been on the development of IRB and AMA policy guidance. The $5.4 
million spent on guidance represents 54 percent of the estimated total 
OCC advanced

[[Page 69393]]

approaches-related expenditure of $10.0 million through the 2006 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 New 
Accord was in development. To date, New Accord expenditures have not 
been a large part of overall OCC expenditures. The $3 million spent on 
the advanced approaches in fiscal year 2006 represents less than one 
percent of the OCC's $579 million budget for the year.
    6. Total Cost: The OCC's estimate of the total cost of the rule 
includes expenditures by banks and the OCC from the present through 
2011, the final year of the transition period. Combining expenditures 
by mandatory banks and the OCC provides a present value estimate of 
$498.9 million for the total cost of the rule.
    7. Procyclicality: Procyclicality refers to the possibility that 
banks 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 
Advanced 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 forward-looking information 
about risk that will 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 rule also will 
help ensure that banks anticipate cyclicality in capital requirements 
to the greatest extent possible, reducing the potential economic impact 
of changes in capital requirements.

IV. 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 banks relative to 
others, a possibility that certainly applies to a change with the scope 
of this final 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 banks 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.\111\ 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.
---------------------------------------------------------------------------

    \111\ Patrick de Fontnouvelle, Victoria Garrity, Scott Chu, and 
Eric Rosengren, ``The Potential Impact of Explicit Basel II 
Operational Risk Capital Charges on the Competitive Environment of 
Processing Banks in the United States,'' 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 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 rule. Studies by Calem 
and Follain\112\ and Hancock, Lennert, Passmore, and Sherlund \113\ 
suggest that banks operating under rules based on the New Accord's 
advance approaches may increase their holdings of residential 
mortgages. Calem and Follain argue that the increase would be 
significant and come at the expense of general banks. Hancock et al. 
foresee a more modest increase in residential mortgage holdings at 
banks operating under the advanced approaches rule, and they see this 
increase primarily as a shift away from the large government sponsored 
mortgage enterprises.
---------------------------------------------------------------------------

    \112\ Paul S. Calem and James R. Follain, ``Regulatory Capital 
Arbitrage and the Potential Competitive Impact of Basel II in the 
Market for Residential Mortgages'', The Journal of Real Estate 
Finance and Economics, Vol. 35, pp. 197-219, August 2007.
    \113\ Diana Hancock, Andreas Lennert, 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'', manuscript, Federal Reserve Board, 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 
rule--tend to rely more heavily on smaller loans within their 
commercial loan portfolios. To the extent that the rule reduces 
required capital for such loans, general banks not operating under the 
rule might be placed at a competitive disadvantage. A study by 
Berger\114\ 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 bank is usually much larger 
than small businesses at community banks.
---------------------------------------------------------------------------

    \114\ Allen N. Berger, ``Potential Competitive Effects of Basel 
II on Banks in SME Credit Markets in the United States,'' Journal of 
Financial Services Research, 29:1, pp. 5-36, 2006. Also 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 rule is that bifurcation of 
capital standards might change the landscape with regard to mergers and 
acquisitions in banking and financial services. For example, banks 
operating under this final rule might be placed in a better position to 
acquire banks operating under the old rules, possibly leading to an 
undesirable consolidation of the banking sector. Research by Hannan and 
Pilloff \115\ suggests that the rule is unlikely to have a significant 
impact on merger and acquisition activity in banking.
---------------------------------------------------------------------------

    \115\ 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, February 2004. Available at http://
www.federalreserve.gov/generalinfo/basel2/whitepapers.htm.
---------------------------------------------------------------------------

    5. Credit Card Competition: The U.S. implementation of the New 
Accord might also affect competition in the credit card market. Overall 
capital requirements for credit card loans could increase under the 
rule. This raises the possibility of a change in the competitive 
environment among banks subject to the new rules, nonbank credit card 
issuers, and banks not subject to this final rule. A study by Lang, 
Mester,

[[Page 69394]]

and Vermilyea\116\ finds that implementation of a rule based on the New 
Accord will not affect credit card competition at most community and 
regional banks. The authors also suggest that higher capital 
requirements for credit cards may only pose a modest disadvantage to 
banks that are subject to this final rule.
---------------------------------------------------------------------------

    \116\ 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, 
Federal Reserve Bank of Philadelphia, December 2005. Available at 
http://www.philadelphiafed.org/files/wps/2005/wp05-29.pdf.
---------------------------------------------------------------------------

    Overall, the evidence regarding the impact of this final 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 for early signs of 
competitive inequities that might result from this final rule. A multi-
year transition period before full implementation of this final rule 
should provide ample opportunity for the Federal banking agencies to 
identify any emerging problems. In particular, after the end of the 
second transition year, the agencies will conduct and publish a study 
that evaluates the advanced approaches to determine if there are any 
material deficiencies.\117\ The Federal banking agencies will consider 
any egregious competitive effects associated with New Accord 
implementation, whether domestic or international in context, to be a 
material deficiency. 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.
---------------------------------------------------------------------------

    \117\ The full text of the Regulatory Impact Analysis describes 
the factors that the interagency study will consider.
---------------------------------------------------------------------------

V. Analysis of Baseline and Alternatives

    In order to place the costs and benefits of the rule in context, 
Executive Order 12866 requires a comparison between this final rule, a 
baseline of what the world would look like without this final rule, and 
several reasonable alternatives to the rule. In this regulatory impact 
analysis, we analyze a baseline and three alternatives to the rule. The 
baseline analyzes the situation where the Federal banking agencies do 
not adopt this final rule, but other countries with internationally 
active banks do adopt the New Accord.\118\
---------------------------------------------------------------------------

    \118\ In addition to the United States, members of the BCBS 
implementing Basel II are Belgium, Canada, France, Germany, Italy, 
Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, and 
the United Kingdom.
---------------------------------------------------------------------------

    1. Baseline Scenario: Current capital standards based on the 1988 
Basel Accord continue to apply to banks operating in the United States, 
but the rest of the world adopts the New Accord: Abandoning the New 
Accord in favor of current capital rules would eliminate essentially 
all of the benefits of the rule described earlier. In place of these 
lost or diminished benefits, the only advantage of continuing to apply 
current capital rules to all banks is that maintaining the status quo 
should alleviate concerns regarding competition among domestic 
financial service providers. Although the effect of the rule on 
competition is uncertain in our estimation, staying with current 
capital rules (or universally applying a revised rule that might emerge 
from the Standardized Option) eliminates bifurcation. Concerns 
regarding competition usually center on this characteristic of the 
rule. 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. While continuing to use current 
capital rules eliminates most of the benefits of adopting the capital 
rule, it does not eliminate many costs associated with the New Accord. 
Because the New Accord-related costs are difficult to separate from the 
bank's ordinary development costs and ordinary supervisory costs at the 
Federal banking agencies, not implementing the New Accord would reduce 
but not eliminate many of these costs associated with the final 
rule.\119\ Furthermore, because banks in the United States would be 
operating under a set of capital rules different from the rest of the 
world, U.S. banks that are internationally active may face higher costs 
because they will have to track and comply with more than one set of 
capital requirements.
---------------------------------------------------------------------------

    \119\ Cost estimates for adopting a rule that might result from 
the Standardized Option are not currently available.
---------------------------------------------------------------------------

    2. Alternative A: Permit U.S. banks to choose among all three New 
Accord credit risk approaches: The principal benefit of Alternative A 
that the rule does not achieve is the increased flexibility of the 
regulation for banks that would be mandatory banks under the final 
rule. Banks that are not prepared for the adoption of the advanced 
approach to credit risk under the final rule could choose to use the 
Foundation IRB methodology or even the Standardized Approach. How 
Alternative A might affect benefits depends entirely on how many banks 
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. banks. The vast majority of banks in the 
United States would incur no direct costs from new capital rules. Under 
Alternative A, direct costs would increase for every U.S. bank that 
would have continued with current capital rules. Although it is not 
clear how high these costs might be, general banks would face higher 
costs because they would be changing capital rules regardless of which 
option they choose under Alternative A.
    3. Alternative B: Permit U.S. banks to choose among all three New 
Accord operational risk approaches: The operational risk approach that 
banks 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 banks, 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 AMA is more sensitive than the Standardized Approach, the 
effect of implementing Alternative B depends on how many banks 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. banks.
    Under Alternative B, direct costs would increase for every U.S. 
bank that would have continued with current capital rules. It is not 
clear how much it might cost banks to adopt these capital measures for 
operational risk, but general banks would face higher costs because 
they would be changing capital rules regardless of which option they 
choose under Alternative B.
    4. Alternative C: Use a different asset amount to determine a 
mandatory bank: The number of mandatory banks decreases slowly as the 
size thresholds increase, and the number of banks grows more quickly as 
the thresholds decrease. Under Alternative C, the framework of the 
final rule would remain the same and only the number of mandatory banks 
would change. Because the structure of the

[[Page 69395]]

implementation would remain intact, Alternative C would capture all of 
the benefits of the final rule. However, because these benefits derive 
from applying the final rule to individual banks, changing the number 
of banks affected by the rule will change the cumulative level of the 
benefits achieved. Generally, the benefits associated with the rule 
will rise and fall with the number of mandatory banks. Because 
Alternative C would change the number of mandatory banks subject to the 
rule, aggregate costs will also rise or fall with the number of 
mandatory banks.

Overall Comparison of the Rule With Baselines and Alternatives

    The New Accord and its U.S. implementation seek to incorporate risk 
measurement and risk management advances into capital requirements. 
Risk-sensitive capital requirements are integral to ensuring an 
adequate capital cushion to absorb financial losses at large complex 
financial banks. In implementing the New Accord's advanced approaches 
in the United States, the agencies' intent is to achieve risk-
sensitivity while maintaining a regulatory capital regime that is as 
rigorous as the current system. Total capital requirements under the 
advanced approaches, including capital for operational risk, will 
better allocate capital in the system. This will occur regardless of 
whether the minimum required capital at a particular bank is greater or 
less than it would be under current capital rules. In order to ensure 
that we achieve our goal of increased risk sensitivity without loss of 
rigor, the final rule provides a means for the agencies to identify and 
address deficiencies in the capital requirements that may become 
apparent during the transition period.
    Although the anticipated benefits of the final rule are difficult 
to quantify in dollar terms because of measurement problems, the OCC is 
confident that the anticipated benefits well exceed the anticipated 
costs of this regulation. On the basis of our analysis, we believe that 
the benefits of the final rule are significant, durable, and hold the 
potential to increase with time. The offsetting costs of implementing 
the final 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 banks would undertake as part of 
their ongoing efforts to improve the quality of their internal risk 
measurement and management, even in the absence of the New Accord and 
this final rule. The advanced approaches seem to have fairly modest 
ongoing expenses. Against these costs, the significant benefits of the 
New Accord suggest that the final rule offers an improvement over the 
baseline scenario.
    With regard to the three alternative approaches we consider, the 
final rule offers an important degree of flexibility while 
significantly restricting costs by limiting its application to large, 
internationally active banks. Alternatives A and B introduce more 
flexibility from the perspective of the large mandatory banks, but each 
is less flexible with respect to other banks. Either Alternative A or B 
would compel these non-mandatory banks to select a new set of capital 
rules and require them to undertake the time and expense of adjusting 
to this final rule. Alternative C would change the number of mandatory 
banks. If the number of mandatory banks increases, then the new rule 
would lose some of the flexibility it achieves with the opt-in option. 
Furthermore, costs would increase as the final rule would compel more 
banks to incur the expense of adopting the advanced approaches. 
Decreasing the number of mandatory banks would decrease the aggregate 
social good of each benefit achieved with the final rule. The final 
rule offers 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 final rule will apply to approximately six mandatory and 
potential opt-in savings associations representing approximately 52 
percent of total thrift industry assets. Approximately 76 percent of 
the total assets in these six 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 final rule 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 final rule, 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 final rule may not provide the degree of benefits 
anticipated by OCC from these sources.
    Because of the typically 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 savings association institutions.\120\ As a 
result, these institutions may be required to hold more capital than 
would be required under Basel II risk-based standards alone. Therefore, 
the final rule may cause these institutions to incur much the same 
implementation costs as banks with riskier assets, but with reduced 
benefits.
---------------------------------------------------------------------------

    \120\ 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, the NPR, the final rule and related guidance; 
and supervision expenses that reflect institution-specific supervisory 
activities. OTS estimates that it incurred total expenses of $6,420,000 
for fiscal years 2002 through 2006, including $4,080,000 in 
policymaking expenses and $2,340,000 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

[[Page 69396]]

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 
final rule.
    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,\121\ and 
another by Hancock, Lenhert, Passmore, and Sherlund\122\ 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 announced that they have agreed to issue a proposed rule that 
would provide non-core banks with the option to adopt an approach 
consistent with the standardized approach included in the Basel II 
framework. The standardized proposal will replace the earlier proposed 
rule (the Basel IA proposed rule), and would be available as an 
alternative to the existing risk-based capital rules for all U.S. banks 
other than banks that adopt the final Basel II rule. Such 
modifications, if implemented, would likely reduce the competitive 
advantage of Basel II adopters.
---------------------------------------------------------------------------

    \121\ 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.
    \122\ 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.
---------------------------------------------------------------------------

    The final rule also has a ten percent floor on loss given default 
parameter estimates for residential mortgage segments that persists 
beyond the two-year period articulated in the international Basel II 
framework, providing a disincentive for core institutions to hold the 
least risky residential mortgages. This may have the effect of reducing 
the core banks'' advantage vis-[agrave]-vis both non-adopters and their 
international competitors.
    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 final 
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: Advanced Approach) 2007''.

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 final 
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 [Banks]: 
Internal-Ratings-Based and Advanced Measurement Approaches

Part I General Provisions
    Section 1 Purpose, Applicability, Reservation of Authority, and 
Principle of Conservatism
    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

[[Page 69397]]

    Section 24 Merger and Acquisition Transitional Arrangements
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 of Repo-Style Transactions, 
Eligible Margin Loans, and OTC Derivative Contracts
    Section 33 Guarantees and Credit Derivatives: PD Substitution 
and LGD Adjustment Approaches
    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)
    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, Reservation of Authority, and 
Principle of Conservatism

    (a) Purpose. This appendix establishes:
    (1) Minimum qualifying criteria for [banks] using [bank]-
specific internal risk measurement and management processes for 
calculating risk-based capital requirements;
    (2) Methodologies for such [banks] to calculate their risk-based 
capital requirements; and
    (3) Public disclosure requirements for such [banks].
    (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 567, Appendix C, to calculate its 
risk-based capital requirements; or
    (iv) Is a subsidiary of a bank holding company that uses 12 CFR 
part 225, Appendix G, 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 relevant), 
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.
    (d) Principle of conservatism. Notwithstanding the requirements 
of this appendix, a [bank] may choose not to apply a provision of 
this appendix to one or more exposures, provided that:
    (1) The [bank] can demonstrate on an ongoing basis to the 
satisfaction of the [AGENCY] that not applying the provision would, 
in all circumstances, unambiguously generate a risk-based capital 
requirement for each such exposure greater than that which would 
otherwise be required under this appendix;
    (2) The [bank] appropriately manages the risk of each such 
exposure;
    (3) The [bank] notifies the [AGENCY] in writing prior to 
applying this principle to each such exposure; and
    (4) The exposures to which the [bank] applies this principle are 
not, in the aggregate, material to the [bank].

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 internal 
models methodology, 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.
    Applicable external rating means:
    (1) With respect to an exposure that has multiple external 
ratings assigned by NRSROs, the lowest solicited external rating 
assigned to the exposure by any NRSRO; and
    (2) With respect to an exposure that has a single external 
rating assigned by an NRSRO, the external rating assigned to the 
exposure by the NRSRO.
    Applicable inferred rating means:

[[Page 69398]]

    (1) With respect to an exposure that has multiple inferred 
ratings, the lowest inferred rating based on a solicited external 
rating; and
    (2) With respect to an exposure that has a single inferred 
rating, the inferred rating.
    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, 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.
    Bank holding company is defined in section 2 of the Bank Holding 
Company Act (12 U.S.C. 1841).
    Benchmarking means the comparison of a [bank]'s internal 
estimates with relevant internal and external data or with estimates 
based on other 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 an 
originating [bank] or 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.
    Control. 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.
    Controlled early amortization provision means an early 
amortization provision that 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.
    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, write-
down of principal, or material negative fair value adjustment of 
principal on the exposure for credit-related reasons.
    (ii) Notwithstanding paragraph (1)(i) of this definition, for a 
retail exposure held by a non-U.S. subsidiary of the [bank] that is 
subject to an internal ratings-based approach to capital adequacy 
consistent with the Basel Committee on Banking Supervision's 
``International Convergence of Capital Measurement and Capital 
Standards: A Revised Framework'' in a non-U.S. jurisdiction, the 
[bank] may elect to use the definition of default that is used in 
that jurisdiction, provided that the [bank] has obtained prior 
approval from the [AGENCY] to use the definition of default in that 
jurisdiction.
    (iii) 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 wholesale obligor is in default 
if:
    (A) The [bank] determines that the obligor is unlikely to pay 
its credit obligations to the [bank] in full, without recourse by 
the [bank] to actions such as realizing collateral (if held); or
    (B) The obligor is past due more than 90 days on any material 
credit obligation(s) to the [bank].\1\
---------------------------------------------------------------------------

    \1\ Overdrafts are past due once the obligor has breached an 
advised limit or been advised of a limit smaller than the current 
outstanding balance.
---------------------------------------------------------------------------

    (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).

[[Page 69399]]

    Dependence means a measure of the association among operational 
losses across and within units of measure.
    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 five 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:
    (1) Is triggered solely by events not directly related to the 
performance of the underlying exposures or the originating [bank] 
(such as material changes in tax laws or regulations); or
    (2) Leaves investors fully exposed to future draws by obligors 
on the underlying exposures even after the provision is triggered.
    Economic downturn conditions means, with respect to an exposure 
held by the [bank], those conditions in which the aggregate default 
rates for that 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 described in 
paragraph (2) or (3) of this definition:
    (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 for which the [bank] does not apply the internal models 
approach in paragraph (d) of section 32 of this appendix, 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.
    (3) For repo-style transactions, eligible margin loans, and OTC 
derivative contracts for which the [bank] applies the internal 
models approach in paragraph (d) of section 32 of this appendix, the 
value determined in paragraph (d)(4) of section 32 of this appendix.
    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 originating 
[bank] or 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, n\th\-to-default swap, total return swap, 
or any other form of credit derivative approved by the [AGENCY], 
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 n\th\-
to-default swap, the contract includes the following credit events:
    (i) Failure to pay any amount due under the terms of the 
reference exposure, subject to any applicable minimal payment 
threshold that is consistent with standard market practice and 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 at least one of the exposures that is permitted to be 
transferred under the contract provides that any required consent to 
transfer may not be unreasonably withheld;
    (7) If the credit derivative is a credit default swap or n\th\-
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, 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 
with the SEC under the Securities Exchange Act of 1934 (15 U.S.C. 
78o et seq.), or 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 or at any time thereafter, 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
    (2) Non-U.S.-based entities. A foreign bank (as defined in Sec.  
211.2 of the Federal Reserve Board's Regulation K (12 CFR 211.2)), a 
non-U.S.-based 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 of at 
least investment grade;

[[Page 69400]]

    (ii) At the time the guarantor issued the guarantee or credit 
derivative or at any time thereafter, 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 not unilaterally 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;
    (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 in a timely 
manner without the beneficiary first having to take legal actions to 
pursue the obligor for payment;
    (7) Does not increase the beneficiary's cost of credit 
protection on the guarantee in response to deterioration in the 
credit quality of the reference exposure; and
    (8) Is not provided by an affiliate of the [bank], unless the 
affiliate is an insured depository institution, bank, securities 
broker or dealer, or insurance company that:
    (i) Does not control the [bank]; and
    (ii) 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).
    Eligible margin loan means an extension of credit where:
    (1) The extension of credit is collateralized exclusively by 
liquid and readily marketable debt or equity securities, gold, or 
conforming residential mortgages;
    (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
---------------------------------------------------------------------------

    \2\ This requirement is met where all transactions under the 
agreement are (i) executed under U.S. law and (ii) constitute 
``securities contracts'' under section 555 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 sufficient legal review to conclude 
with a well-founded basis (and maintains sufficient written 
documentation of that legal review) 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 exposure means a purchased 
wholesale exposure that:
    (1) The [bank] or securitization SPE 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 (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] or securitization SPE with a claim on 
all proceeds from the exposure or a pro rata interest in the 
proceeds from the exposure;
    (4) Has an M of less than one year; and
    (5) When consolidated by obligor, does not represent a 
concentrated exposure relative to the portfolio of purchased 
wholesale exposures.
    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 multilateral development bank, 
a depository institution, a bank holding company, 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 Sec.  211.2 of the Federal Reserve 
Board's Regulation K (12 CFR 211.2)), or a securities firm;
    (2) Any other entity (other than a securitization 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 a securitization 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 is 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 incorporates a payment or other 
similar obligation on the part of the issuing company (such as an 
obligation to make periodic payments); or
    (iv) 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 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

[[Page 69401]]

section 618(a)(2) of the Resolution Trust Corporation Refinancing, 
Restructuring, and Improvement 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 567.1 (definition of ``qualifying residential 
construction loan'') and 12 CFR 567.6(a)(1)(iv) (for savings 
associations).
    Expected credit loss (ECL) means:
    (1) For a wholesale exposure to a non-defaulted obligor or 
segment of non-defaulted retail exposures that is carried at fair 
value with gains and losses flowing through earnings or that is 
classified as held-for-sale and is carried at the lower of cost or 
fair value with losses flowing through earnings, zero.
    (2) For all other wholesale exposures to non-defaulted obligors 
or segments of non-defaulted retail exposures, the product of PD 
times LGD times EAD for the exposure or segment.
    (3) For a wholesale exposure to a defaulted obligor or segment 
of defaulted retail exposures, the [bank]'s impairment estimate for 
allowance purposes for the exposure or segment.
    (4) 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 of 
this appendix.
    Expected exposure (EE) means the expected value of the 
probability distribution of non-negative credit risk exposures to a 
counterparty at any specified future date before the maturity date 
of the longest term transaction in the netting set. Any negative 
market values in the probability distribution of market values to a 
counterparty at a specified future date are set to zero to convert 
the probability distribution of market values to the probability 
distribution of credit risk exposures.
    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 risk-based 
capital requirements, the average is taken over a one-year horizon.
    Exposure at default (EAD). (1) For the on-balance sheet 
component of a wholesale exposure or segment of retail exposures 
(other than an OTC derivative contract, or a repo-style transaction 
or eligible margin loan for which the [bank] determines EAD under 
section 32 of this appendix), EAD means:
    (i) If the exposure or segment is a security classified as 
available-for-sale, the [bank]'s carrying value (including net 
accrued but unpaid interest and fees) for the exposure or segment 
less any allocated transfer risk reserve for the exposure or 
segment, less any unrealized gains on the exposure or segment, and 
plus any unrealized losses on the exposure or segment; or
    (ii) If the exposure or segment is not a security classified as 
available-for-sale, the [bank]'s carrying value (including net 
accrued but unpaid interest and fees) for the exposure or segment 
less any allocated transfer risk reserve for the exposure or 
segment.
    (2) For the off-balance sheet component of a wholesale exposure 
or segment of retail exposures (other than an OTC derivative 
contract, or a repo-style transaction or eligible margin loan for 
which the [bank] determines EAD under section 32 of this appendix) 
in the form of a loan commitment, line of credit, trade-related 
letter of credit, or transaction-related contingency, 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 a one-year horizon assuming the wholesale exposure or 
the retail exposures in the segment were to go into default. This 
estimate of net additions must reflect what would be expected during 
economic downturn conditions. Trade-related letters of credit are 
short-term, self-liquidating instruments that are used to finance 
the movement of goods and are collateralized by the underlying 
goods. Transaction-related contingencies relate to a particular 
transaction and include, among other things, performance bonds and 
performance-based letters of credit.
    (3) For the off-balance sheet component of a wholesale exposure 
or segment of retail exposures (other than an OTC derivative 
contract, or a repo-style transaction or eligible margin loan for 
which the [bank] determines EAD under section 32 of this appendix) 
in the form of anything other than a loan commitment, line of 
credit, trade-related letter of credit, or transaction-related 
contingency, EAD means the notional amount of the exposure or 
segment.
    (4) EAD for OTC derivative contracts is calculated as described 
in section 32 of this appendix. A [bank] also may determine EAD for 
repo-style transactions and eligible margin loans as described in 
section 32 of this appendix.
    (5) 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. Undrawn balances of 
revolving 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;
    (vii) Money market mutual fund shares and other mutual fund 
shares if a price for the shares is publicly quoted daily; or (viii) 
Conforming residential mortgages; and
    (2) In which the [bank] has a perfected, first priority security 
interest or, outside of the United States, the legal equivalent 
thereof (with the exception of cash on deposit and notwithstanding 
the prior security interest of any custodial agent).
    GAAP means generally accepted accounting principles as used in 
the United States.
    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

[[Page 69402]]

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 of the 
project. 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 
securitization SPE to investors; divided by
    (2) The outstanding principal amount of underlying exposures.
    Loss given default (LGD) means:
    (1) For a wholesale exposure, the greatest of:
    (i) Zero;
    (ii) The [bank]'s empirically based best estimate of the long-
run default-weighted average 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 over a mix of economic 
conditions, including economic downturn conditions; or
    (iii) 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.
    (2) For a segment of retail exposures, the greatest of:
    (i) Zero;
    (ii) The [bank]'s empirically based best estimate of the long-
run default-weighted average economic loss, per dollar of EAD, the 
[bank] would expect to incur if the exposures in the segment were to 
default within a one-year horizon over a mix of economic conditions, 
including economic downturn conditions; or
    (iii) The [bank]'s empirically based best estimate of the 
economic loss, per dollar of EAD, the [bank] would expect to incur 
if the exposures in the segment were to default within a one-year 
horizon during 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, additional extensions of credit to facilitate repayment of 
the exposure, 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 the [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.
    Multilateral development bank means the International Bank for 
Reconstruction and Development, the International Finance 
Corporation, the Inter-American Development Bank, the Asian 
Development Bank, the African Development Bank, the European Bank 
for Reconstruction and Development, the European Investment Bank, 
the European Investment Fund, the Nordic Investment Bank, the 
Caribbean Development Bank, the Islamic Development Bank, the 
Council of Europe Development Bank, and any other multilateral 
lending institution or regional development bank in which the U.S. 
government is a shareholder or contributing member or which the 
[AGENCY] determines poses comparable credit risk.
    Nationally recognized statistical rating organization (NRSRO) 
means an entity registered with the SEC as a nationally recognized 
statistical rating organization under section 15E of the Securities 
Exchange Act of 1934 (15 U.S.C. 78o-7).
    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. For 
purposes of the internal models methodology in paragraph (d) of 
section 32 of this appendix, each transaction that is not subject to 
such a master netting agreement is its own netting set.
    N\th\-to-default credit derivative means a credit derivative 
that provides credit protection only for the n\th\-defaulting 
reference exposure in a group of reference exposures.
    Obligor means the legal entity or natural person contractually 
obligated on a wholesale exposure, except that a [bank] may treat 
the following exposures as having separate obligors:
    (1) Exposures to the same legal entity or natural person 
denominated in different currencies;
    (2) (i) An income-producing real estate exposure for which all 
or substantially all of the repayment of the exposure is reliant on 
the cash flows of the real estate serving as collateral for the 
exposure; the [bank], in economic substance, does not have recourse 
to the borrower beyond the real estate collateral; and no cross-
default or cross-acceleration clauses are in place other than 
clauses obtained solely out of an abundance of caution; and
    (ii) Other credit exposures to the same legal entity or natural 
person; and
    (3) (i) A wholesale exposure authorized under section 364 of the 
U.S. Bankruptcy Code (11 U.S.C. 364) to a legal entity or natural 
person who is a debtor-in-possession for purposes of Chapter 11 of 
the Bankruptcy Code; and
    (ii) Other credit exposures to the same legal entity or natural 
person.
    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 any of the following seven operational loss event 
type categories:
    (1) Internal fraud, which means the operational loss event type 
category that comprises operational losses resulting from an act 
involving at least one internal party of a type intended to defraud, 
misappropriate

[[Page 69403]]

property, or circumvent regulations, the law, or company policy, 
excluding diversity- and discrimination-type events.
    (2) External fraud, which means the operational loss event type 
category that comprises operational losses resulting from an act by 
a third party of a type intended to defraud, misappropriate 
property, or circumvent the law. 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.
    (3) Employment practices and workplace safety, which means the 
operational loss event type category that comprises operational 
losses resulting from an act inconsistent with employment, health, 
or safety laws or agreements, payment of personal injury claims, or 
payment arising from diversity- and discrimination-type events.
    (4) Clients, products, and business practices, which means the 
operational loss event type category that comprises operational 
losses resulting from the nature or design of a product or from an 
unintentional or negligent failure to meet a professional obligation 
to specific clients (including fiduciary and suitability 
requirements).
    (5) Damage to physical assets, which means the operational loss 
event type category that comprises operational losses resulting from 
the loss of or damage to physical assets from natural disaster or 
other events.
    (6) Business disruption and system failures, which means the 
operational loss event type category that comprises operational 
losses resulting from disruption of business or system failures.
    (7) Execution, delivery, and process management, which means the 
operational loss event type category that comprises operational 
losses resulting from failed transaction processing or process 
management or losses arising from relations with trade 
counterparties and vendors.
    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 99.9\th\ 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.
    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 
one-year default rate 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.
    (2) For a segment of non-defaulted retail exposures, the 
[bank]'s empirically based best estimate of the long-run average 
one-year default rate 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 and adjusted 
upward as appropriate for segments for which seasoning effects are 
material. For purposes of this definition, a segment for which 
seasoning effects are material is a segment where there is a 
material relationship between the time since origination of 
exposures within the segment and the [bank]'s best estimate of the 
long-run average one-year default rate for the exposures in the 
segment.
    (3) 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, 
reduced to reflect any currency mismatch, maturity mismatch, or lack 
of restructuring coverage (as provided in section 33 of this 
appendix).
    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 clearinghouse) 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 the [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 sufficient legal review to conclude 
with a well-founded basis (and maintains sufficient written 
documentation of that legal review) 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

[[Page 69404]]

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, cash, gold, or conforming residential 
mortgages;
    (2) The transaction is marked-to-market daily and subject to 
daily margin maintenance requirements;
    (3)(i) The transaction is a ``securities contract'' or 
``repurchase agreement'' under section 555 or 559, respectively, of 
the Bankruptcy Code (11 U.S.C. 555 or 559), a qualified financial 
contract under section 11(e)(8) of the Federal Deposit Insurance Act 
(12 U.S.C. 1821(e)(8)), or a netting contract 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); or
    (ii) If the transaction does not meet the criteria set forth in 
paragraph (3)(i) of this definition, then either:
    (A) 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; or
    (B) The transaction is:
    (1) Either overnight or unconditionally cancelable at any time 
by the [bank]; and
    (2) 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 counterparty default; and
    (4) The [bank] has conducted sufficient legal review to conclude 
with a well-founded basis (and maintains sufficient written 
documentation of that legal review) 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.
    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), 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. Scenario analysis may 
include the well-reasoned evaluation and use of external operational 
loss event data, adjusted as appropriate to ensure relevance to a 
[bank]'s operational risk profile and control structure.
    SEC means the U.S. Securities and Exchange Commission.
    Securitization means a traditional securitization or a synthetic 
securitization.
    Securitization exposure means an on-balance sheet or off-balance 
sheet credit exposure that arises from a traditional or synthetic 
securitization (including credit-enhancing representations and 
warranties).
    Securitization special purpose entity (securitization 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.
    Senior securitization exposure means a securitization exposure 
that has a first priority claim on the cash flows from the 
underlying exposures. When determining whether a securitization 
exposure has a first priority claim on the cash flows from the 
underlying exposures, a [bank] is not required to consider amounts 
due under interest rate or currency derivative contracts, fees due, 
or other similar payments. Both the most senior commercial paper 
issued by an ABCP program and a liquidity facility that supports the 
ABCP program may be senior securitization exposures 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 amounts due under interest rate or currency derivative 
contracts, fees due, or other similar payments.
    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.
    Subsidiary means, with respect to a company, a company 
controlled by that company.
    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) Excess eligible credit reserves not included in tier 2 
capital.
    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-

[[Page 69405]]

material portfolios of exposures (all as determined in section 31 of 
this appendix) and risk-weighted assets for unsettled transactions 
(as determined in section 35 of this appendix) minus the amounts 
deducted from capital pursuant to [the general risk-based capital 
rules] (excluding those deductions reversed in section 12 of this 
appendix).
    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;
    (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);
    (5) The underlying exposures are not owned by an operating 
company;
    (6) The underlying exposures are not owned by a small business 
investment company described in section 302 of the Small Business 
Investment Act of 1958 (15 U.S.C. 682); and
    (7) The underlying exposures are not owned by a firm an 
investment in which qualifies as a community development investment 
under 12 U.S.C. 24(Eleventh).
    (8) The [AGENCY] may determine that a transaction in which the 
underlying exposures are owned by an investment firm that exercises 
substantially unfettered control over the size and composition of 
its assets, liabilities, and off-balance sheet exposures is not a 
traditional securitization based on the transaction's leverage, risk 
profile, or economic substance.
    (9) The [AGENCY] may deem a transaction that meets the 
definition of a traditional securitization, notwithstanding 
paragraph (5), (6), or (7) of this definition, to be a traditional 
securitization based on the transaction's leverage, risk profile, or 
economic substance.
    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.
    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, natural 
person, sovereign entity, 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 a [bank] treats as a covered position under 
[the market risk rule] for which there is a counterparty credit risk 
capital requirement;
    (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 a [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 of this appendix, 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 provided in section 12 of this appendix); 
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 of this appendix.
    (c) Deductions from tier 1 and tier 2 capital. A [bank] must 
deduct the exposures specified in paragraphs (c)(1) through (c)(7) 
in this section 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 excess from tier 1 capital.
    (1) Credit-enhancing interest-only strips (CEIOs). In accordance 
with paragraphs (a)(1) and (c) of section 42 of this appendix, 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 of this appendix, any 
securitization exposure that does not qualify for the Ratings-Based 
Approach, the Internal Assessment Approach, or the Supervisory 
Formula Approach under sections 43, 44, and 45 of this appendix, 
respectively.
    (3) Securitizations of non-IRB exposures. In accordance with 
paragraphs (c) and (g)(4) of section 42 of this appendix, 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 of this appendix, 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 paragraphs (b) and 
(c) of section 45 of this appendix and paragraph (c) of section 42 
of this appendix, certain high-risk securitization exposures (or 
portions thereof) that qualify for the Supervisory Formula Approach.
    (6) Eligible credit reserves shortfall. In accordance with 
paragraph (a)(1) of section 13 of this appendix, any eligible credit 
reserves shortfall.
    (7) Certain failed capital markets transactions. In accordance 
with paragraph (e)(3) of section 35 of this appendix, 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, 
section 2(c) (for national banks), 12 CFR part 208, Appendix A, 
section II.B.1.e. (for state member banks), 12 CFR part 225, 
Appendix A, section II.B.1.e. (for bank holding companies), 12 CFR 
part 325, Appendix A, section 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, section 2(c) (for national 
banks), 12 CFR part 208, Appendix A, section II.B.5. (for state 
member banks), 12 CFR part 225, Appendix A, section II.B.5. (for 
bank holding companies), and 12 CFR part 325, Appendix A, section 
II.B. (for state nonmember banks).

Section 13. Eligible Credit Reserves

    (a) Comparison of eligible credit reserves to expected credit 
losses--(1) Shortfall of

[[Page 69406]]

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 in [the general risk-based capital rules], the ALLL 
is included in tier 2 capital only to the extent provided in 
paragraph (a)(2) of this section and in section 24 of this appendix.

Part III. Qualification

Section 21. Qualification Process

    (a) Timing. (1) A [bank] that is described in paragraph (b)(1) 
of section 1 of this appendix must adopt a written implementation 
plan no later than six months after the later of April 1, 2008, or 
the date the [bank] meets a criterion in that section. The 
implementation plan must incorporate an explicit first floor period 
start date no later than 36 months after the later of April 1, 2008, 
or the date the [bank] meets at least one criterion under paragraph 
(b)(1) of section 1 of this appendix. The [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 of this appendix must adopt a written 
implementation plan.
    (b) Implementation plan. (1) The [bank]'s implementation plan 
must address in detail how the [bank] complies, or plans to comply, 
with the qualification requirements in section 22 of this appendix. 
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:
    (i) Comprehensively address the qualification requirements in 
section 22 of this appendix 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;
    (ii) 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]);
    (iii) Include the [bank]'s self-assessment of:
    (A) The [bank]'s current status in meeting the qualification 
requirements in section 22 of this appendix; and
    (B) The consistency of the [bank]'s current practices with the 
[AGENCY]'s supervisory guidance on the qualification requirements;
    (iv) 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 of this appendix or to improve the consistency of the 
[bank]'s current practices with the [AGENCY]'s supervisory guidance 
on the qualification requirements (gap analysis);
    (v) Describe what specific actions the [bank] will take to 
address the areas identified in the gap analysis required by 
paragraph (b)(1)(iv) of this section;
    (vi) 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;
    (vii) Describe resources that have been budgeted and are 
available to implement the plan; and
    (viii) Receive approval of the [bank]'s board of directors.
    (2) The [bank] must submit the implementation plan, together 
with a copy of the minutes of the board of directors' approval, to 
the [AGENCY] at least 60 days before the [bank] proposes to begin 
its parallel run, unless the [AGENCY] waives prior notice.
    (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 
the qualification requirements in section 22 of this appendix to the 
satisfaction of the [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 if the [AGENCY] 
determines that:
    (1) The [bank] fully complies with all the qualification 
requirements in section 22 of this appendix;
    (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 of this 
appendix.
    (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, the [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, the [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 of this appendix as of April 1, 2008, must use 
[the general risk-based capital rules] 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 of this appendix.
    (6) Interagency study. After the end of the second transition 
year (2010), the Federal banking agencies will publish a study that 
evaluates the advanced approaches to determine if there are any 
material deficiencies. For any primary Federal

[[Page 69407]]

supervisor to authorize any institution to exit the third 
transitional floor period, the study must determine that there are 
no such material deficiencies that cannot be addressed by then-
existing tools, or, if such deficiencies are found, they are first 
remedied by changes to this appendix. Notwithstanding the preceding 
sentence, a primary Federal supervisor that disagrees with the 
finding of material deficiency may not authorize any institution 
under its jurisdiction to exit the third transitional floor period 
unless it provides a public report explaining its reasoning.

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 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:
    (i) 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). A [bank] may 
elect, however, not to assign to a rating grade an obligor to whom 
the [bank] extends credit based solely on the financial strength of 
a guarantor, provided that all of the [bank]'s exposures to the 
obligor are fully covered by eligible guarantees, the [bank] applies 
the PD substitution approach in paragraph (c)(1) of section 33 of 
this appendix to all exposures to that obligor, and the [bank] 
immediately assigns the obligor to a rating grade if a guarantee can 
no longer be recognized under this appendix. 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.
    (ii) Unless the [bank] has chosen to directly assign LGD 
estimates to each wholesale exposure, the [bank] must have an 
internal risk rating system that accurately and reliably assigns 
each wholesale exposure to a loss severity rating grade (reflecting 
the [bank]'s estimate of the 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 LGDs.
    (3) For retail exposures, a [bank] must have an internal system 
that groups retail exposures into the appropriate retail exposure 
subcategory, groups the retail exposures in each retail exposure 
subcategory into separate segments with homogeneous risk 
characteristics, and assigns accurate and reliable PD and LGD 
estimates for each segment on a consistent basis. The [bank]'s 
system must identify and group in separate segments by subcategories 
exposures identified in paragraphs (c)(2)(ii) and (iii) of section 
31 of this appendix.
    (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 generally 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 appropriately 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) The [bank]'s risk parameter estimation process should not 
rely on the possibility of U.S. government financial assistance, 
except for the financial assistance that the U.S. government has a 
legally binding commitment to provide.
    (5) Where the [bank]'s quantifications of LGD directly or 
indirectly incorporate estimates of the effectiveness of its credit 
risk management practices in reducing its exposure to troubled 
obligors prior to default, the [bank] must support such estimates 
with empirical analysis showing that the estimates are consistent 
with its historical experience in dealing with such exposures during 
economic downturn conditions.
    (6) PD estimates for wholesale obligors and retail segments must 
be based on at least five years of default data. LGD estimates for 
wholesale exposures must be based on at least seven years of loss 
severity data, and LGD estimates for retail segments must be based 
on at least five years of loss severity data. EAD estimates for 
wholesale exposures must be based on at least seven years of 
exposure amount data, and EAD estimates for retail segments must be 
based on at least five years of exposure amount data.
    (7) 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.
    (8) The [bank]'s PD, LGD, and EAD estimates must be based on the 
definition of default in this appendix.
    (9) The [bank] must review and update (as appropriate) its risk 
parameters and its risk parameter quantification process at least 
annually.
    (10) The [bank] must at least annually conduct a comprehensive 
review and analysis of reference data to determine relevance of 
reference data to the [bank]'s exposures, quality of reference data 
to support PD, 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 the [AGENCY] under section 32 of this 
appendix to use the internal models methodology for counterparty 
credit risk.
    (e) Double default treatment. A [bank] must obtain the prior 
written approval of the [AGENCY] under section 34 of this appendix 
to use the double default treatment.
    (f) Securitization exposures. A [bank] must obtain the prior 
written approval of the [AGENCY] under section 44 of this appendix 
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 the [AGENCY] under section 53 of this appendix 
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 (which must capture business 
environment and internal control factors affecting the [bank]'s 
operational risk profile) to identify, measure, monitor, and control 
operational risk in [bank] products, activities, processes, and 
systems; and
    (iii) Report operational risk exposures, operational loss 
events, and other relevant operational risk information to business 
unit management, senior management, and the

[[Page 69408]]

board of directors (or a designated committee of the board).
    (2) Operational risk data and assessment systems. A [bank] must 
have 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 a historical observation period of at least five years 
for internal operational loss event data (or such shorter period 
approved by the [AGENCY] to address transitional situations, such as 
integrating a new business line).
    (2) The [bank] must be able to map its internal operational loss 
event data into the seven operational loss event type categories.
    (3) 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 event 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;
    (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 demonstrably 
different risk profiles within the same loss distribution;
    (C) Must include a credible, transparent, systematic, and 
verifiable approach for weighting each of the four elements, 
described in paragraph (h)(2)(ii) of this section, that a [bank] is 
required to incorporate into its operational risk data and 
assessment systems;
    (D) May use internal estimates of dependence among operational 
losses across and within units of measure if the [bank] can 
demonstrate to the satisfaction of the [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; and
    (E) 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 the 
review and update must occur no less frequently than annually.
    (ii) With the prior written approval of the [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 the 
[AGENCY]. In determining whether to approve a [bank]'s proposal to 
use an alternative operational risk quantification system, the 
[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 the [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 review 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) An evaluation of the conceptual soundness of (including 
developmental evidence supporting) the advanced systems;
    (ii) An ongoing 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.

Section 23. Ongoing Qualification

    (a) Changes to advanced systems. A [bank] must meet all the 
qualification requirements in section 22 of this appendix 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) Failure to comply with qualification requirements. (1) If 
the [AGENCY] determines that a [bank] that uses this appendix and 
has conducted a satisfactory parallel run fails to comply with the 
qualification requirements in section 22 of this appendix, the 
[AGENCY] will notify the [bank] in writing of the [bank]'s failure 
to comply.
    (2) The [bank] must establish and submit a plan satisfactory to 
the [AGENCY] to return to compliance with the qualification 
requirements.
    (3) 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:
    (i) Under [the general risk-based capital rules]; or

[[Page 69409]]

    (ii) Under this appendix with any modifications provided by the 
[AGENCY].

Section 24. Merger and Acquisition Transitional Arrangements

    (a) 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. The [AGENCY] may extend 
this transition period for up to an additional 12 months. Within 90 
days of consummating the merger or acquisition, the [bank] must 
submit to the [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 acquiring 
[bank]'s tier 2 capital up to 1.25 percent of the acquired company's 
risk-weighted assets. All general allowances 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.
    (b) Mergers and acquisitions of companies with advanced 
systems--(1) If a [bank] merges with or acquires a company that 
calculates its risk-based capital requirements using advanced 
systems, the [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. The [AGENCY] may extend 
this transition period for up to an additional 12 months. Within 90 
days of consummating the merger or acquisition, the [bank] must 
submit to the [AGENCY] an implementation plan for using its advanced 
systems for the merged or acquired company.
    (2) If the acquiring [bank] is not subject to the advanced 
approaches in this appendix at the time of acquisition or merger, 
during the period when [the general risk-based capital rules] apply 
to the acquiring [bank], the ALLL associated with the exposures of 
the merged or acquired company may not be directly included in tier 
2 capital. Rather, any excess eligible credit reserves associated 
with the merged or acquired company's exposures may be included in 
the [bank]'s tier 2 capital up to 0.6 percent of the credit-risk-
weighted assets associated with those exposures.

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 exposures, unsettled 
transactions to which section 35 of this appendix 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 must assign each wholesale 
exposure to which it does not directly assign an LGD estimate to a 
loss severity rating grade.
    (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 (b) of section 32 of this appendix, 
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 exposures. A [bank] may group 
its eligible purchased wholesale exposures 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 exposures.
    (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 LGD with each wholesale loss severity rating 
grade or assign an LGD to each wholesale exposure;
    (iii) Assign an EAD and M to each wholesale exposure; and
    (iv) Assign a PD, LGD, and EAD to each segment of retail 
exposures.
    (2) Floor on PD assignment. The PD for each wholesale obligor 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 multilateral 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 exposures. A [bank] must assign 
a PD, LGD, EAD, and M to each segment of eligible purchased 
wholesale exposures. If the [bank] can estimate ECL (but not PD or 
LGD) for a segment of eligible purchased wholesale exposures, the 
[bank] must assume that the 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 exposures 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 
of this appendix or, if applicable, applying double default 
treatment to the exposure as provided in section 34 of this 
appendix. A [bank] may decide separately for each wholesale exposure 
that qualifies for the double default treatment under section 34 of 
this appendix whether to apply the double default treatment or to 
use the PD substitution or LGD adjustment treatment 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 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 LGD of the 
exposure and may

[[Page 69410]]

take into account the risk reducing effects of collateral in support 
of retail exposures when quantifying the PD and LGD of the segment.
    (6) EAD for OTC 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 (c) and (d) of 
section 32 of this appendix. A [bank] may take into account the 
risk-reducing effects of financial collateral in support of a repo-
style transaction or eligible margin loan and of any collateral in 
support of a repo-style transaction that is included in the [bank]'s 
VaR-based measure under [the market risk rule] through an adjustment 
to EAD as provided in paragraphs (b) and (d) of section 32 of this 
appendix. A [bank] that takes collateral into account through such 
an adjustment to EAD under section 32 of this appendix may not 
reflect such collateral in LGD.
    (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 an exposure's M 
must be no less than one day if the exposure has an original 
maturity of less than one year and is not part of a [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 (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 of this appendix) and segments of non-defaulted retail 
exposures 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. Alternatively, a [bank] may apply a 300 percent risk 
weight to the EAD of an eligible margin loan if the [bank] is not 
able to meet the agencies'' requirements for estimation of PD and 
LGD for the margin loan.
BILLING CODE 4810-33-P; 6210-01-P; 6714-01-P; 6720-01-P

[[Page 69411]]

[GRAPHIC] [TIFF OMITTED] TR07DE07.005

BILLING CODE 4810-33-C; 6210-01-C; 6714-01-C; 6720-01-C
    (ii) The sum of all 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 of this appendix 
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) The dollar risk-based capital 
requirement for each wholesale exposure to a defaulted obligor 
equals 0.08 multiplied by the EAD of the exposure.
    (ii) 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 
paragraph (e)(2)(i) 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 and 
segments.
    (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 (e)(2)(iii) of this section multiplied by 
12.5.

[[Page 69412]]

    (3) Assets not included in a defined exposure category. (i) 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 the gold bullion assets 
are offset by gold bullion liabilities.
    (ii) The risk-weighted asset amount for the residual value of a 
retail lease exposure equals such residual value.
    (iii) 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 the [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 of this 
appendix.

Section 32. Counterparty Credit Risk of Repo-Style Transactions, 
Eligible Margin Loans, and OTC Derivative Contracts

    (a) In General. (1) This section describes two methodologies--a 
collateral haircut approach and an internal models methodology--that 
a [bank] may use instead of an LGD estimation methodology to 
recognize the benefits of financial collateral in mitigating the 
counterparty credit risk of repo-style transactions, eligible margin 
loans, collateralized OTC derivative contracts, and single product 
netting sets of such transactions and to recognize the benefits of 
any collateral in mitigating the counterparty credit risk of repo-
style transactions that are included in a [bank]'s VaR-based measure 
under [the market risk rule]. A third methodology, the simple VaR 
methodology, is available for single product netting sets of repo-
style transactions and eligible margin loans.
    (2) 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.
    (3) A [bank] may only use the standard supervisory haircut 
approach with a minimum 10-business-day holding period to recognize 
in EAD the benefits of conforming residential mortgage collateral 
that secures repo-style transactions (other than repo-style 
transactions included in the [bank]'s VaR-based measure under [the 
market risk rule]), eligible margin loans, and OTC derivative 
contracts.
    (4) A [bank] may use any combination of the three methodologies 
for collateral recognition; however, it must use the same 
methodology for similar exposures.
    (b) 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 netting set of such 
transactions by factoring the collateral into its LGD estimates for 
the exposure. Alternatively, a [bank] may estimate an unsecured LGD 
for the exposure, as well as for any repo-style transaction that is 
included in the [bank]'s VaR-based measure under [the market risk 
rule], and determine the EAD of the exposure using:
    (i) The collateral haircut approach described in paragraph 
(b)(2) of this section;
    (ii) For netting sets only, the simple VaR methodology described 
in paragraph (b)(3) of this section; or
    (iii) The internal models methodology described in paragraph (d) 
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 equal to max {0, [([Sigma]E-[Sigma]C) 
+ [Sigma](Es x Hs) + [Sigma](Efx x Hfx)]{time} , where:
    (A) [Sigma]E equals the value of the exposure (the sum of the 
current market values of all instruments, gold, 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 (the sum of the 
current market values of all instruments, gold, 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 equals the absolute value of the net position in a given 
instrument or in gold (where the net position in a given instrument 
or in gold equals the sum of the current market values of the 
instrument or gold 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 instrument or gold the [bank] has 
borrowed, purchased subject to resale, or taken as collateral from 
the counterparty);
    (D) Hs equals the market price volatility haircut appropriate to 
the instrument or gold referenced in Es;
    (E) Efx equals the absolute value of the net position of 
instruments and cash 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 instruments or 
cash 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 instruments or cash in the 
currency the [bank] has borrowed, purchased subject to resale, or 
taken as collateral from the counterparty); and
    (F) Hfx equals the 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 (b)(2)(ii)(A)(3) and (4) of this section;

                       Table 3.--Standard Supervisory Market Price Volatility Haircuts \1\
----------------------------------------------------------------------------------------------------------------
                                                                              Issuers exempt
 Applicable external rating grade    Residual maturity for debt securities   from the 3 basis    Other issuers
   category for debt securities                                                point floor
----------------------------------------------------------------------------------------------------------------
Two highest investment-grade        <= 1 year.............................              0.005               0.01
 rating categories for long-term    >1 year, <= 5 years...................               0.02               0.04
 ratings/highest investment-grade   > 5 years.............................               0.04               0.08
 rating category for short-term
 ratings.
----------------------------------------------------------------------------------------------------------------
Two lowest investment-grade rating  <= 1 year.............................               0.01               0.02
 categories for both short- and     > 1 year, <= 5 years..................               0.03               0.06
 long-term ratings.                 > 5 years.............................               0.06               0.12
----------------------------------------------------------------------------------------------------------------
One rating category below           All...................................               0.15               0.25
 investment grade.
----------------------------------------------------------------------------------------------------------------
Main index equities (including convertible bonds) and gold.....0.15.......
----------------------------------------------------------------------------------------------------------------
Other publicly traded equities (including convertible bonds), c0.25rming
 residential mortgages, and nonfinancial collateral.
----------------------------------------------------------------------------------------------------------------

[[Page 69413]]

 
Mutual funds.........................Highest haircut applicable to any security in which the
                                                         fund can invest.
----------------------------------------------------------------------------------------------------------------
Cash on deposit with the [bank] (including a certificate of depo0it issued
 by the [bank]).
----------------------------------------------------------------------------------------------------------------
\1\ The market price volatility haircuts in Table 3 are based on a ten-business-day holding period.

    (2) For currency mismatches, a [bank] must use a haircut for 
foreign exchange rate volatility (Hfx) of 8 percent, as adjusted in 
certain circumstances as provided in paragraph (b)(2)(ii)(A)(3) and 
(4) of this section.
    (3) For repo-style transactions, a [bank] may multiply the 
supervisory haircuts provided in paragraphs (b)(2)(ii)(A)(1) and (2) 
of this section 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 ten business days (for 
eligible margin loans) or five business days (for repo-style 
transactions) where and as appropriate to take into account the 
illiquidity of an instrument.
    (iii) Own internal estimates for haircuts. With the prior 
written approval of the [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 its own 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 
five business days and for an eligible margin loan is ten 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] TR07DE07.014

(i) TM equals 5 for repo-style transactions and 10 for 
eligible margin loans;
(ii) TN equals the holding period used by the [bank] to 
derive HN; and
(iii) HN equals the 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 lent, sold subject to repurchase, posted as collateral, 
borrowed, purchased subject to resale, or taken as collateral. In 
determining relevant categories, the [bank] must at a minimum 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 exchange 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 
the [AGENCY], a [bank] may estimate EAD for a netting set using a 
VaR model that meets the requirements in paragraph (b)(3)(iii) of 
this section. In such event, the [bank] must set EAD equal to max 
{0, [([Sigma]E--[Sigma]C) + PFE]{time} , where:
    (i) [Sigma]E equals the value of the exposure (the sum of the 
current market values of all instruments, gold, 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 (the sum of the 
current market values of all instruments, gold, 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 five-business-day holding period for repo-style 
transactions or over a ten-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.
    (c) 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 (c)(5) of this section or using the 
internal models methodology described in paragraph (d) 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 (c)(6) of this 
section or using the internal models methodology described in 
paragraph (d) of this section.
    (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 of this 
appendix 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 the [bank] 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 agreement 
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 agreement 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

[[Page 69414]]

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 
of this appendix, 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 (c)(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 (PFE) 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 PFE under this 
paragraph or the gross PFE under paragraph (c)(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 PFE must be calculated using the ``other'' conversion 
factors. A [bank] 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 PFE. 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 \1\
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                              Credit       Credit (non-
                                                              Foreign      (investment-     investment-                      Precious
         Remaining maturity \2\            Interest rate   exchange rate       grade           grade          Equity      metals (except       Other
                                                             and gold        reference       reference                         gold)
                                                                            obligor)\3\      obligor)
--------------------------------------------------------------------------------------------------------------------------------------------------------
One year or less........................           0.00            0.01             0.05            0.10            0.06            0.07            0.10
Over one to five years..................           0.005           0.05             0.05            0.10            0.08            0.07            0.12
Over five years.........................           0.015           0.075            0.05            0.10            0.10            0.08           0.15
--------------------------------------------------------------------------------------------------------------------------------------------------------
\1\ For an OTC derivative contract with multiple exchanges of principal, the conversion factor is multiplied by the number of remaining payments in the
  derivative contract.
\2\ For an OTC derivative contract that is structured such that on specified dates any outstanding exposure is settled and the terms are reset so that
  the market value of the contract is zero, the remaining maturity equals the time until the next reset date. For an interest rate derivative contract
  with a remaining maturity of greater than one year that meets these criteria, the minimum conversion factor is 0.005.
\3\ A [bank] must use the column labeled ``Credit (investment-grade reference obligor)'' for a credit derivative whose reference obligor has an
  outstanding unsecured long-term debt security without credit enhancement that has a long-term applicable external rating of at least investment grade.
  A [bank] must use the column labeled ``Credit (non-investment-grade reference obligor)'' for all other credit derivatives.

    (6) Multiple OTC derivative contracts subject to a qualifying 
master netting agreement. Except as modified by paragraph (c)(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, Anet, 
is calculated as Anet = (0.4xAgross)+(0.6xNGRxAgross), where:
    (A) Agross = the gross PFE (that is, the sum of the PFE amounts 
(as determined under paragraph (c)(5)(ii) of this section) for each 
individual OTC derivative contract subject to the qualifying master 
netting agreement); and
    (B) 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 (c)(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 
netting set of OTC derivatives by factoring the collateral into its 
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 LGD for 
the contract or netting set and adjusting the EAD calculated under 
paragraph (c)(5) or (c)(6) of this section using the collateral 
haircut approach in paragraph (b)(2) of this section. The [bank] 
must substitute the EAD calculated under paragraph (c)(5) or (c)(6) 
of this section for [Sigma]E in the equation in paragraph (b)(2)(i) 
of this section and must use a ten-business-day minimum holding 
period (TM = 10).
    (d) Internal models methodology. (1) With prior written approval 
from the [AGENCY], a [bank] may use the internal models methodology 
in this paragraph (d) 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 
transaction type must receive approval from the [AGENCY] to cease 
using the methodology for that transaction type 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 a netting set that 
are attributable to changes in market variables to determine EE.

[[Page 69415]]

    (ii) Under the internal models methodology, EAD = [alpha] x 
effective EPE, or, subject to [AGENCY] approval as provided in 
paragraph (d)(7), a more conservative measure of EAD.
[GRAPHIC] [TIFF OMITTED] TR07DE07.026

(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 (Effective EEtk-
1, EEtk) (that is, for a specific datetk, 
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 (d)(6), or 
when the [AGENCY] has determined that the [bank] must set [alpha] 
higher based on the [bank]'s specific characteristics of 
counterparty credit risk.
    (iii) A [bank] may include financial collateral currently posted 
by the counterparty as collateral (but may not include other forms 
of collateral) when calculating EE.
    (iv) If a [bank] hedges some or all of the counterparty credit 
risk associated with a netting set using an eligible credit 
derivative, the [bank] may take the reduction in exposure to the 
counterparty into account when estimating EE. If the [bank] 
recognizes this reduction in exposure to the counterparty in its 
estimate of EE, it must also use its internal model to estimate a 
separate EAD for the [bank]'s exposure to the protection provider of 
the credit derivative.
    (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 the [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:
    (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 reflect accurately 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 be able to 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, 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 five years or M(EPE),\3\ where:
---------------------------------------------------------------------------

    \3\ Alternatively, a [bank] that uses an internal model to 
calculate a one-sided credit valuation adjustment may use the 
effective credit duration estimated by the model as M(EPE) in place 
of the formula in paragraph (d)(4).
[GRAPHIC] [TIFF OMITTED] TR07DE07.015

    (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 one year, except 
as provided in paragraph (d)(7) of section 31 of this appendix.
    (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 pledge collateral to the [bank] for a 
single financial contract or for all financial contracts in a 
netting set and confers upon the [bank] a perfected, first priority 
security interest (notwithstanding the prior security interest of 
any custodial agent), 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 liquidate 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 the [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 five business days for repo-style 
transactions and ten 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 netting set 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 of the netting set over 
the margin period of risk. The add-on is computed as the

[[Page 69416]]

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 netting sets 
consisting only of repo-style transactions subject to daily re-
margining and daily marking-to-market, and ten business days for all 
other netting sets; or
    (B) Effective EPE without a collateral agreement.
    (6) Own estimate of alpha. With prior written approval of the 
[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 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 the 
[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 uncertainty 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 of alpha 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 the [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 (d)(2)(ii)(B) of this section) 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. For material portfolios of new OTC derivative 
products, the [bank] may assume that the current exposure 
methodology in paragraphs (c)(5) and (c)(6) of this section meets 
the conservatism requirement of this paragraph for a period not to 
exceed 180 days. For immaterial portfolios of OTC derivative 
contracts, the [bank] generally may assume that the current exposure 
methodology in paragraphs (c)(5) and (c)(6) of this section meets 
the conservatism requirement of this paragraph.

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

    (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; or
    (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, if the transaction qualifies, 
using the double default treatment in section 34 of this appendix. 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 of this appendix.
    (4) If multiple eligible guarantees or eligible credit 
derivatives cover a single exposure described in paragraph (a)(1) of 
this section, a [bank] may treat the hedged exposure as multiple 
separate exposures each covered by a single eligible guarantee or 
eligible credit derivative and may calculate a separate risk-based 
capital requirement for each separate exposure as described in 
paragraph (a)(3) of this section.
    (5) If a single eligible guarantee or eligible credit derivative 
covers multiple hedged wholesale exposures described in paragraph 
(a)(1) of this section, a [bank] must treat each hedged exposure as 
covered by a separate eligible guarantee or eligible credit 
derivative and must calculate a separate risk-based capital 
requirement for each exposure as described in paragraph (a)(3) of 
this section.
    (6) 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 are 
exposures to the same legal entity, and legally enforceable cross-
default or cross-acceleration clauses are in place to assure 
payments under the credit derivative are triggered when the obligor 
fails to pay under the terms of the hedged exposure.
    (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 
applicable to the guarantee or credit derivative in Table 2 and 
using the appropriate LGD as described in paragraph (c)(1)(iii) 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 of this appendix, where 
PD is the protection provider's PD, LGD is determined under 
paragraph (c)(1)(iii) 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 of this appendix, 
where PD is the obligor's PD, 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 partial 
pro rata basis or when an adjustment is made to the effective 
notional amount of the guarantee or credit derivative under 
paragraph (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

[[Page 69417]]

derivative does not provide the [bank] with the option to receive 
immediate payout upon triggering the protection.
    (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 is the greater of:
    (A) The risk-based capital requirement for the exposure as 
calculated under section 31 of this appendix, with the 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 of this 
appendix, using the PD for the protection provider, the 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 of this appendix, with the 
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 of this appendix, using 
the PD for the protection provider, the 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 of this appendix, 
where PD is the obligor's PD, 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 
effective notional 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).
    (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 the effective notional amount of the credit 
risk mitigant: Pm = E x (t - 0.25)/(T - 0.25), where:
    (i) Pm = effective notional 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 five 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 the 
effective notional amount of the credit derivative: Pr = Pm x 0.60, 
where:
    (1) Pr = effective notional amount of the credit risk mitigant, 
adjusted for lack of restructuring event (and maturity mismatch, if 
applicable); and
    (2) Pm = effective notional amount of the credit risk mitigant 
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 [bank] must apply the following formula to the 
effective notional amount of the guarantee or credit derivative: Pc 
= Pr x (1 - HFX), where:
    (i) Pc = effective notional amount of the credit risk mitigant, 
adjusted for currency mismatch (and maturity mismatch and lack of 
restructuring event, if applicable);
    (ii) Pr = effective notional amount of the credit risk mitigant 
(adjusted for maturity mismatch and lack of restructuring event, if 
applicable); and
    (iii) HFX = haircut appropriate for the currency 
mismatch between the credit risk mitigant 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 ten-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 (b)(2)(iii) of 
section 32 of this appendix;
    (ii) The simple VaR methodology in paragraph (b)(3) of section 
32 of this appendix; or
    (iii) The internal models methodology in paragraph (d) of 
section 32 of this appendix.
    (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 ten business 
days using the square root of time formula provided in paragraph 
(b)(2)(iii)(A)(2) of section 32 of this appendix.

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 of this appendix 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 of this appendix 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 of this appendix).
    (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.

[[Page 69418]]

    (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 of this 
appendix.
    (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 of this appendix.
    (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:

(1)
[GRAPHIC] [TIFF OMITTED] TR07DE07.016

(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 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 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) [rho]OS (asset value correlation of the obligor) is 
calculated according to the appropriate formula for (R) provided in 
Table 2 in section 31 of this appendix, with PD equal to 
PDo.
(6) b (maturity adjustment coefficient) is calculated according to 
the formula for b provided in Table 2 in section 31 of this 
appendix, with PD equal to the lesser of PDo and 
PDg.
(7) 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 five 
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;
    (2) Repo-style transactions, including unsettled repo-style 
transactions (which are addressed in sections 31 and 32 of this 
appendix);
    (3) One-way cash payments on OTC derivative contracts (which are 
addressed in sections 31 and 32 of this appendix); 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 of this 
appendix).
    (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
Number of business days after contractual settlement      applied to
                        date                           positive 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 appendix 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 LGD for the transaction 
rather than estimating LGD for the transaction provided the [bank] 
uses the 45 percent 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.

[[Page 69419]]

    (3) If the [bank] has not received its deliverables by the fifth 
business day after the 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 a 
securitization 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 of this appendix, a [bank] must 
apply the Ratings-Based Approach to the exposure.
    (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 of this appendix to the exposure 
(if the [bank], the exposure, and the relevant ABCP program qualify 
for the Internal Assessment Approach) or the Supervisory Formula 
Approach in section 45 of this appendix 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.
    (5) If a securitization exposure is an OTC derivative contract 
(other than a credit derivative) that has a first priority claim on 
the cash flows from the underlying exposures (notwithstanding 
amounts due under interest rate or currency derivative contracts, 
fees due, or other similar payments), with approval of the [AGENCY], 
a [bank] may choose to set the risk-weighted asset amount of the 
exposure equal to the amount of the exposure as determined in 
paragraph (e) of this section rather than apply the hierarchy of 
approaches described in paragraphs (a) (1) through (4) 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 of this appendix, the Internal 
Assessment Approach in section 44 of this appendix, and the 
Supervisory Formula Approach in section 45 of this appendix, and its 
risk-weighted assets amount for early amortization provisions 
calculated in section 47 of this appendix.
    (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 tier 1 capital and 
tier 2 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; and
    (2) The total ECL of the underlying exposures.
    (e) Amount of a securitization exposure. (1) The amount of an 
on-balance sheet securitization exposure that is not a repo-style 
transaction, eligible margin loan, or OTC derivative contract (other 
than a credit derivative) is:
    (i) The [bank]'s carrying value minus any unrealized gains and 
plus any unrealized losses on the exposure, if the exposure is a 
security classified as available-for-sale; or
    (ii) The [bank]'s carrying value, if the exposure is not a 
security classified as available-for-sale.
    (2) The amount of an off-balance sheet securitization exposure 
that is not an OTC derivative contract (other than a credit 
derivative) is the notional amount of the exposure. For an off-
balance-sheet securitization exposure to an ABCP program, such as a 
liquidity facility, the notional amount may be reduced to the 
maximum potential amount that the [bank] could be required to fund 
given the ABCP program's current underlying assets (calculated 
without regard to the current credit quality of those assets).
    (3) The amount of a securitization exposure that is a repo-style 
transaction, eligible margin loan, or OTC derivative contract (other 
than a credit derivative) is the EAD of the exposure as calculated 
in section 32 of this appendix.
    (f) Overlapping exposures. If a [bank] has multiple 
securitization exposures 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

[[Page 69420]]

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.
    (g) Securitizations of non-IRB exposures. 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 of this appendix 
to the securitization exposure if the exposure qualifies for the 
RBA;
    (3) If the securitization exposure does not require deduction 
under paragraph (g)(1) and does not qualify for the RBA, apply the 
IAA in section 44 of this appendix to the exposure (if the [bank], 
the exposure, and the relevant ABCP program qualify for the IAA); 
and
    (4) If the securitization exposure does not require deduction 
under paragraph (g)(1) and does not qualify for the RBA or the IAA, 
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 on 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 under section 3(a) of the Small Business Act 
(15 U.S.C. 632).
    (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 this paragraph, the [bank]'s capital ratios must be 
calculated without regard to the 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 
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 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) N th-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 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 of this 
appendix (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 of the 
individual underlying exposures, 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 n\th\-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 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 of this 
appendix (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 of the 
individual underlying exposures (excluding the n-1 underlying 
exposures with the lowest risk-based capital requirements), 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 inferred ratings (and 
may not use the RBA if the exposure has fewer than two external 
ratings or inferred ratings).

[[Page 69421]]

    (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 of this appendix) by the appropriate risk weight 
provided in Table 6 and Table 7.
    (2) A [bank] must apply the risk weights in Table 6 when the 
securitization exposure's applicable external or applicable inferred 
rating represents a long-term credit rating, and must apply the risk 
weights in Table 7 when the securitization exposure's applicable 
external or applicable inferred rating represents a short-term 
credit rating.
    (i) A [bank] must apply the risk weights in column 1 of Table 6 
or Table 7 to the securitization exposure if:
    (A) N (as calculated under paragraph (e)(6) of section 45 of 
this appendix) is six or more (for purposes of this section 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 six or more unless the [bank] knows or has reason 
to know that N is less than six); 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 Table 7 to the securitization exposure if N is less than six, 
regardless of the seniority of the securitization exposure.
    (iii) Otherwise, a [bank] must apply the risk weights in column 
2 of Table 6 or Table 7.

                        Table 6.--Long-Term Credit Rating Risk Weights Under RBA and IAA
----------------------------------------------------------------------------------------------------------------
                                                        Column 1        Column 2        Column 3
                                                    -----------------------------------------------    Applicable
                                                      Risk weights    Risk weights    Risk weights    external or
       Applicable external or inferred rating          for senior    for non-senior        for          inferred
           (Illustrative rating example)             securitization  securitization  securitization      rating
                                                        exposures       exposures       exposures    (Illustrative
                                                        backed by       backed by    backed by non-      rating
                                                     granular pools  granular pools  granular pools     example)
--------------------------------------------------------------------------------------------------- ---------------
Highest investment grade (for example, AAA)........              7%             12%             20%
Second highest investment grade (for example, AA)..              8%             15%             25%
Third-highest investment grade--positive                        10%             18%             35%
 designation (for example, A+).....................
Third-highest investment grade (for example, A)....             12%             20%
Third-highest investment grade--negative                        20%             35%
 designation (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
                                                    -----------------------------------------------    Applicable
                                                      Risk weights    Risk weights    Risk weights    external or
       Applicable external or inferred rating          for senior    for non-senior        for          inferred
           (Illustrative rating example)             securitization  securitization  securitization      rating
                                                        exposures       exposures       exposures    (Illustrative
                                                        backed by       backed by    backed by non-      rating
                                                     granular pools  granular pools  granular pools     example)
--------------------------------------------------------------------------------------------------- ---------------
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

[[Page 69422]]

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 any NRSRO that provides an external rating to the ABCP 
program's commercial paper changes its methodology (including stress 
factors), the [bank] must evaluate whether to revise its internal 
assessment process.
    (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 all commercial paper issued by the 
ABCP program has an external rating.
    (3) Exposure qualification criteria. A securitization exposure 
qualifies for use of the IAA if the exposure meets the following 
criteria:
    (i) The [bank] initially rated the exposure at least the 
equivalent of investment grade.
    (ii) The ABCP program has robust credit and investment 
guidelines (that is, underwriting standards) for the exposures 
underlying the securitization exposure.
    (iii) The ABCP program performs a detailed credit analysis of 
the sellers of the exposures underlying the securitization exposure.
    (iv) The ABCP program's underwriting policy for the exposures 
underlying the securitization exposure establishes minimum asset 
eligibility criteria that include the prohibition of the purchase of 
assets that are significantly past due or of assets that are 
defaulted (that is, assets that have been charged off or written 
down by the seller prior to being placed into the ABCP program or 
assets that would be charged off or written down under the program's 
governing contracts), as well as limitations on concentration to 
individual obligors or geographic areas and the tenor of the assets 
to be purchased.
    (v) The aggregate estimate of loss on the exposures underlying 
the securitization exposure considers all sources of potential risk, 
such as credit and dilution risk.
    (vi) Where relevant, the ABCP program incorporates structural 
features into each purchase of exposures underlying the 
securitization exposure to mitigate potential credit deterioration 
of the underlying exposures. Such features may include wind-down 
triggers specific to a pool of underlying exposures.
    (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 of 
this appendix) by the appropriate risk weight in Table 6 and Table 7 
in paragraph (b) of section 43 of this appendix.

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 securitization exposure incurs a 
deduction from total capital (as described in paragraph (c) of 
section 42 of this appendix) and/or an SFA risk-based capital 
requirement, as determined in paragraph (c) of this section. The 
risk-weighted asset amount for the securitization exposure equals 
the SFA risk-based capital requirement for the exposure multiplied 
by 12.5.
    (c) The SFA risk-based capital requirement. (1) If 
KIRB is greater than or equal to L + T, the entire 
exposure must be deducted from total capital.
    (2) If KIRB is less than or equal to L, the 
exposure's SFA risk-based capital requirement is UE multiplied by TP 
multiplied by the greater of:
    (i) 0.0056 * T; or
    (ii) S[L + T] - S[L].
    (3) If KIRB is greater than L and less than L + T, 
the [bank] must deduct from total capital an amount equal to 
UE*TP*(KIRB - L), and the exposure's SFA risk-based 
capital requirement is UE multiplied by TP multiplied by the greater 
of:
    (i) 0.0056 * (T - (KIRB - L)); or
    (ii) S[L + T] - S[KIRB].
    (d) The supervisory formula:

[[Page 69423]]

[GRAPHIC] [TIFF OMITTED] TR07DE07.017

    (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 exposures that are 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 
of this appendix) plus the adjusted carrying value of any underlying 
exposures that are equity exposures (as defined in paragraph (b) of 
section 51 of this appendix).
    (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, to 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) A [bank] 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 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.
    (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.

[[Page 69424]]

    (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) of this section,
[GRAPHIC] [TIFF OMITTED] TR07DE07.018

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] TR07DE07.019

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) of this 
section, a [bank] may employ a simplified method for calculating N 
and EWALGD.
    (3) If C1 is no more than 0.03, a [bank] may set 
EWALGD = 0.50 if none of the underlying exposures is a 
securitization exposure or EWALGD = 1 if one or more of the 
underlying exposures is a securitization exposure, and may set N 
equal to the following amount:
[GRAPHIC] [TIFF OMITTED] TR07DE07.020

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 
if none of the underlying exposures is a securitization exposure or 
EWALGD = 1 if one or more of the underlying exposures is a 
securitization exposure and may set 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 of this appendix 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 of this appendix or the IAA in section 44 of this appendix 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 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 (other than a repo-style 
transaction, an eligible margin loan, or an OTC derivative contract 
for which the [bank] has reflected collateral in its determination 
of exposure amount under section 32 of this appendix) 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 of this appendix or under the SFA in section 45 of 
this appendix multiplied by the ratio of adjusted exposure amount 
(SE*) to original exposure amount (SE), where:
    (i) SE* = max {0, [SE--C x (1-Hs-Hfx)]{time} ;
    (ii) SE = the amount of the securitization exposure calculated 
under paragraph (e) of section 42 of this appendix;
    (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] TR07DE07.023

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 paragraph (b)(2)(iii) of section 32 of this 
appendix. 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 protected portion of 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

[[Page 69425]]

[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, 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 this appendix), using the 
[bank]'s PD for the guarantor, the [bank]'s 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 of this appendix).
    (ii) Partial coverage. If the protection amount of the eligible 
guarantee or eligible credit derivative is less than the amount of 
the securitization exposure, 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 of this 
appendix), using the [bank]'s PD for the guarantor, the [bank]'s 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 ratio of the protection 
amount of the eligible guarantee or eligible credit derivative to 
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 of this appendix).
    (4) Mismatches. The [bank] must make applicable adjustments to 
the protection amount as required in paragraphs (d), (e), and (f) of 
section 33 of this appendix for any hedged securitization exposure 
and any more senior securitization exposure that benefits from the 
hedge. In the context of a synthetic securitization, when an 
eligible guarantee or eligible credit derivative covers multiple 
hedged exposures that have different residual maturities, the [bank] 
must use the longest residual maturity of any of the hedged 
exposures as the residual maturity of all the hedged exposures.

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 of this appendix, 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 5 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 of this appendix);
    (4) 12.5; and
    (5) The proportion of the underlying exposures in which the 
borrower is permitted to vary the drawn amount within an agreed 
limit under a line of credit.
    (c) Conversion factor. (1) (i) Except as provided in paragraph 
(c)(2) of this section, to calculate the appropriate conversion 
factor, 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. 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 
conversion factor for the securitization's early amortization 
provision. If a pro rata approach is not feasible, a [bank] must 
treat the mixed securitization as a securitization of nonretail 
exposures if a single underlying exposure is a nonretail exposure 
and must treat the mixed securitization as a securitization of 
committed exposures if a single underlying exposure is a committed 
exposure.
    (ii) To find the appropriate conversion factor in the tables, a 
[bank] must divide the three-month average annualized excess spread 
of the securitization by the excess spread trapping point in the 
securitization structure. 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 
annualized excess spread, the excess spread trapping point is 4.5 
percent.

           Table 8.--Controlled Early Amortization Provisions
------------------------------------------------------------------------
                                       Uncommitted          Committed
------------------------------------------------------------------------
Retail Credit Lines............  Three-month average     90% CF
                                  annualized excess
                                  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............  Three-month average     100% CF
                                  annualized excess
                                  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
------------------------------------------------------------------------

    (2) For a securitization for which all or substantially all of 
the underlying exposures are residential mortgage exposures, a 
[bank] may calculate the appropriate conversion factor using 
paragraph (c)(1) of this section or may use a conversion factor of 
10 percent. If the [bank] chooses to use a conversion factor of 10 
percent, it must use that conversion factor for all securitizations 
for which all or substantially all of the underlying exposures are 
residential mortgage exposures.

[[Page 69426]]

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 of this appendix or, if it qualifies to do so, the 
Internal Models Approach (IMA) in section 53 of this appendix. A 
[bank] must use the look-through approaches in section 54 of this 
appendix 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. For unfunded equity 
commitments that are unconditional, the effective notional principal 
amount is the notional amount of the commitment. For unfunded equity 
commitments that are conditional, the effective notional principal 
amount is the [bank]'s best estimate of the amount that would be 
funded under economic downturn conditions.

Section 52. Simple Risk Weight Approach (SRWA)

    (a) 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 of this appendix.
    (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 of this appendix 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 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) Effective portion of hedge pairs. The effective portion of 
a hedge pair.
    (iii) Non-significant equity exposures. Equity exposures, 
excluding exposures to an investment firm that would meet the 
definition of a traditional securitization were it not for the 
[AGENCY]'s application of paragraph (8) of that definition and has 
greater than immaterial leverage, 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)(iii), the [bank] may exclude equity exposures described in 
paragraphs (b)(1), (b)(2), (b)(3)(i), and (b)(3)(ii) 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 or that meet the 
criterion of paragraph (b)(3)(i) of this section. 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 with