55830 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

1For simplicity, and unless otherwise indicated, 

this notice of proposed rulemaking (NPR) uses the 

term ‘‘bank’’ to include banks, savings associations, 

and bank holding companies (BHCs). The terms 

‘‘bank holding company’’ and ‘‘BHS’’ refer only to 

bank holding companies regulated by the board and 

do not include savings and loan holding companies 

regulated by the OTS. 

DEPARTMENT OF THE TREASURY 

Office of the Comptroller of the 

Currency 

12 CFR Part 3 

[Docket No. 06–09] 

RIN 1557–AC91 

FEDERAL RESERVE SYSTEM 

12 CFR Parts 208 and 225 

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

FEDERAL DEPOSIT INSURANCE 

CORPORATION 

12 CFR Part 325 

RIN 3064–AC73 

DEPARTMENT OF THE TREASURY 

Office of Thrift Supervision 

12 CFR Part 566 

RIN 1550–AB56 

Risk-Based Capital Standards: 

Advanced Capital Adequacy 

Framework 

AGENCIES: Office of the Comptroller of 

the Currency, Treasury; Board of 

Governors of the Federal Reserve 

System; Federal Deposit Insurance 

Corporation; and Office of Thrift 

Supervision, Treasury. 

ACTION: Joint notice of proposed 

rulemaking. 

SUMMARY: The Office of the Comptroller 

of the Currency (OCC), the Board of 

Governors of the Federal Reserve 

System (Board), the Federal Deposit 

Insurance Corporation (FDIC), and the 

Office of Thrift Supervision (OTS) 

(collectively, the agencies) are 

proposing a new risk-based capital 

adequacy framework that would require 

some and permit other qualifying 

banks 1 to use an internal ratings-based 

approach to calculate regulatory credit 

risk capital requirements and advanced 

measurement approaches to calculate 

regulatory operational risk capital 

requirements. The proposed rule 

describes the qualifying criteria for 

banks required or seeking to operate 

under the proposed framework and the 

applicable risk-based capital 

requirements for banks that operate 

under the framework. 

DATES: Comments must be received on 

or before January 23, 2007. 

ADDRESSES: Comments should be 

directed to: 

OCC: You should include OCC and 

Docket Number 06–09 in your comment. 

You may submit comments by any of 

the following methods: 

• Federal eRulemaking Portal: http:// 

www.regulations.gov. Follow the 

instructions for submitting comments. 

• OCC Web Site: http:// 

www.occ.treas.gov. Click on ‘‘Contact 

the OCC,’’ scroll down and click on 

‘‘Comments on Proposed Regulations.’’ 

• E-mail address: 

regs.comments@occ.treas.gov. 

• Fax: (202) 874–4448. 

• Mail: Office of the Comptroller of 

the Currency, 250 E Street, SW., Mail 

Stop 1–5, Washington, DC 20219. 

• Hand Delivery/Courier: 250 E 

Street, SW., Attn: Public Information 

Room, Mail Stop 1–5, Washington, DC 

20219. 

Instructions: All submissions received 

must include the agency name (OCC) 

and docket number or Regulatory 

Information Number (RIN) for this 

notice of proposed rulemaking. In 

general, OCC will enter all comments 

received into the docket without 

change, including any business or 

personal information that you provide. 

You may review comments and other 

related materials by any of the following 

methods: 

• Viewing Comments Personally: You 

may personally inspect and photocopy 

comments at the OCC’s Public 

Information Room, 250 E Street, SW., 

Washington, DC. You can make an 

appointment to inspect comments by 

calling (202) 874–5043. 

Board: You may submit comments, 

identified by Docket No. R–1261, by any 

of the following methods: 

• Agency Web Site: http:// 

www.federalreserve.gov. Follow the 

instructions for submitting comments at 

http://www.federalreserve.gov/ 

generalinfo/foia/ProposedRegs.cfm. 

• Federal eRulemaking Portal: http:// 

www.regulations.gov. Follow the 

instructions for submitting comments. 

• E-mail: 

regs.comments@federalreserve.gov. 

Include docket number in the subject 

line of the message. 

• FAX: 202/452–3819 or 202/452– 

3102. 

• Mail: Jennifer J. Johnson, Secretary, 

Board of Governors of the Federal 

Reserve System, 20th Street and 

Constitution Avenue, NW., Washington, 

DC 20551. 

All public comments are available 

from the Board’s Web site at 

www.federalreserve.gov/generalinfo/ 

foia/ProposedRegs.cfm as submitted, 

unless modified for technical reasons. 

Accordingly, your comments will not be 

edited to remove any identifying or 

contact information. Public comments 

may also be viewed electronically or in 

paper in Room MP–500 of the Board’s 

Martin Building (20th and C Streets, 

NW.) between 9 a.m. and 5 p.m. on 

weekdays. 

FDIC: You may submit comments, 

identified by RIN number, by any of the 

following methods: 

• Federal eRulemaking Portal: http:// 

www.regulations.gov. Follow the 

instructions for submitting comments. 

• Agency Web Site: http:// 

www.fdic.gov/regulations/laws/federal/ 

propose.html. 

• Mail: Robert E. Feldman, Executive 

Secretary, Attention: Comments, Federal 

Deposit Insurance Corporation, 550 17th 

Street, NW., Washington, DC 20429. 

• Hand Delivery/Courier: Guard 

station at rear of the 550 17th Street 

Building (located on F Street) on 

business days between 7 a.m. and 5 p.m. 

• E-mail: Comments@FDIC.gov. 

• Public Inspection: Comments may 

be inspected at the FDIC Public 

Information Center, Room E–1002, 3502 

Fairfax Drive, Arlington, VA 22226, 

between 9 a.m. and 5 p.m. on business 

days. 

Instructions: Submissions received 

must include the agency name and RIN 

for this rulemaking. Comments received 

will be posted without change to http:// 

www.fdic.gov/regulations/laws/federal/ 

propose.html including any personal 

information provided. 

OTS: You may submit comments, 

identified by No. 2006–33, by any of the 

following methods: 

• Federal eRulemaking Portal: http:// 

www.regulations.gov. Follow the 

instructions for submitting comments. 

• E-mail address: 

regs.comments@ots.treas.gov. Please 

include No. 2006–33 in the subject line 

of the message and include your name 

and telephone number in the message. 

• Fax: (202) 906–6518. 

• Mail: Regulation Comments, Chief 

Counsel’s Office, Office of Thrift 

Supervision, 1700 G Street, NW., 

Washington, DC 20552, Attention: No. 

2006–33. 

• Hand Delivery/Courier: Guard’s 

Desk, East Lobby Entrance, 1700 G 

Street, NW., from 9 a.m. to 4 p.m. on 

business days, Attention: Regulation 

Comments, Chief Counsel’s Office, 

Attention: No. 2006–33. 

Instructions: All submissions received 

must include the agency name and 


sroberts on PROD1PC70 with PROPOSALS
Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55831 

docket number or Regulatory 

Information Number (RIN) for this 

rulemaking. All comments received will 

be posted without change to the OTS 

Internet Site at http://www.ots.treas.gov/ 

pagehtml.cfm?catNumber=67&an=1, 

including any personal information 

provided. 

Docket: For access to the docket to 

read background documents or 

comments received, go to http:// 

www.ots.treas.gov/ 

pagehtml.cfm?catNumber=67&an=1. 

In addition, you may inspect 

comments at the Public Reading Room, 

1700 G Street, NW., by appointment. To 

make an appointment for access, call 

(202) 906–5922, send an e-mail to 

public.info@ots.treas.gov, or send a 

facsimile transmission to (202) 906–

7755. (Prior notice identifying the 

materials you will be requesting will 

assist us in serving you.) We schedule 

appointments on business days between 

10 a.m. and 4 p.m. In most cases, 

appointments will be available the next 

business day following the date we 

receive a request. 

FOR FURTHER INFORMATION CONTACT:

OCC: Roger Tufts, Senior Economic 

Advisor, Capital Policy (202–874–4925) 

or Ron Shimabukuro, Special Counsel, 

Legislative and Regulatory Activities 

Division (202–874–5090). Office of the 

Comptroller of the Currency, 250 E 

Street, SW., Washington, DC 20219. 

Board: Barbara Bouchard, Deputy 

Associate Director (202–452–3072 or 

barbara.bouchard@frb.gov) or Anna Lee 

Hewko, Senior Supervisory Financial 

Analyst (202–530–6260 or 

anna.hewko@frb.gov), Division of 

Banking Supervision and Regulation; or 

Mark E. Van Der Weide, Senior Counsel 

(202–452–2263 or 

mark.vanderweide@frb.gov), Legal 

Division. For users of 

Telecommunications Device for the Deaf 

(‘‘TDD’’) only, contact 202–263–4869. 

FDIC: Jason C. Cave, Associate 

Director, Capital Markets Branch, (202) 

898–3548, Bobby R. Bean, Senior 

Quantitative Risk Analyst, Capital 

Markets Branch, (202) 898–3575, 

Kenton Fox, Senior Capital Markets 

Specialist, Capital Markets Branch, 

(202) 898–7119, Division of Supervision 

and Consumer Protection; or Michael B. 

Phillips, Counsel, (202) 898–3581, 

Supervision and Legislation Branch, 

Legal Division, Federal Deposit 

Insurance Corporation, 550 17th Street, 

NW., Washington, DC 20429. 

OTS: Michael D. Solomon, Director, 

Capital Policy, Supervision Policy (202) 

906–5654; David W. Riley, Senior 

Analyst, Capital Policy (202) 906–6669; 

or Karen Osterloh, Special Counsel, 

Regulations and Legislation Division 

(202) 906–6639, Office of Thrift 

Supervision, 1700 G Street, NW., 

Washington, DC 20552. 

SUPPLEMENTARY INFORMATION: 

Table of Contents 

I. Introduction 

A. Background 

B. Conceptual Overview 

1. The IRB Framework for Credit Risk 

2. The AMA for Operational Risk 

C. Overview of Proposed Rule 

D. Structure of Proposed Rule 

E. Quantitative Impact Study 4 and Overall 

Capital Objectives 

1. Quantitative Impact Study 4 

2. Overall Capital Objectives 

F. Competitive Considerations 

II. Scope 

A. Core and Opt-In Banks 

B. U.S. Depository Institution Subsidiaries 

of Foreign Banks 

C. Reservation of Authority 

III. Qualification 

A. The Qualification Process 

1. In General 

2. Parallel Run and Transitional Floor 

Periods 

B. Qualification Requirements 

1. Process and Systems Requirements 

2. Risk Rating and Segmentation Systems 

for Wholesale and Retail Exposures 

Wholesale exposures 

Retail exposures 

Definition of default 

Rating philosophy 

Rating and segmentation reviews and 

updates 

3. Quantification of Risk Parameters for 

Wholesale and Retail Exposures 

Probability of default (PD) 

Loss given default (LGD) and expected loss 

given default (ELGD) 

Exposure at default (EAD) 

General quantification principles 

4. Optional Approaches That Require Prior 

Supervisory Approval 

5. Operational Risk 

Operational risk data and assessment 

system 

Operational risk quantification system 

6. Data Management and Maintenance 

7. Control and Oversight Mechanisms 

Validation 

Internal audit 

Stress testing 

8. Documentation 

C. Ongoing Qualification 

IV. Calculation of Tier 1 Capital and Total 

Qualifying Capital 

V. Calculation of Risk-Weighted Assets 

A. Categorization of Exposures 

1. Wholesale Exposures 

2. Retail Exposures 

3. Securitization Exposures 

4. Equity Exposures 

5. Boundary Between Operational Risk and 

Other Risks 

6. Boundary Between the Proposed Rule 

and the Market Risk Amendment 

B. Risk-Weighted Assets for General Credit 

Risk (Wholesale Exposures, Retail 

Exposures, On-Balance Sheet Assets 

That Are Not Defined by Exposure 

Category, and Immaterial Credit 

Exposures) 

1. Phase 1—Categorization of Exposures 

2. Phase 2—Assignment of Wholesale 

Obligors and Exposures to Rating Grades 

and Retail Exposures to Segments 

Purchased wholesale receivables 

Wholesale lease residuals 

3. Phase 3—Assignment of Risk Parameters 

to Wholesale Obligors and Exposures 

and Retail Segments 

4. Phase 4—Calculation of Risk-Weighted 

Assets 

5. Statutory Provisions on the Regulatory 

Capital Treatment of Certain Mortgage 

Loans 

C. Credit Risk Mitigation Techniques 

1. Collateral 

2. EAD for Counterparty Credit Risk 

EAD for repo-style transactions and eligible 

margin loans 

Collateral haircut approach 

Standard supervisory haircuts 

Own estimates of haircuts 

Simple VaR methodology 

3. EAD for OTC Derivative Contracts 

Current exposure methodology 

4. Internal Models Methodology 

Maturity under the internal models 

methodology 

Collateral agreements under the internal 

models methodology 

Internal estimate of alpha 

Alternative models 

5. Guarantees and Credit Derivatives That 

Cover Wholesale Exposures 

Eligible guarantees and eligible credit 

derivatives 

PD substitution approach 

LGD adjustment approach 

Maturity mismatch haircut 

Restructuring haircut 

Currency mismatch haircut 

Example 

Multiple credit risk mitigants 

Double default treatment 

6. Guarantees and Credit Derivatives That 

Cover Retail Exposures 

D. Unsettled Securities, Foreign Exchange, 

and Commodity Transactions 

E. Securitization Exposures 

1. Hierarchy of Approaches 

Exceptions to the general hierarchy of 

approaches 

Servicer cash advances 

Amount of a securitization exposure 

Implicit support 

Operational requirements for traditional 

securitizations 

Clean-up calls 

2. Ratings-Based Approach (RBA) 

3. Internal Assessment Approach (IAA) 

4. Supervisory Formula Approach (SFA) 

General requirements 

Inputs to the SFA formula 

5. Eligible Disruption Liquidity Facilities 

6. Credit Risk Mitigation for Securitization 

Exposures 

7. Synthetic Securitizations 

Background 

Operational requirements for synthetic 

securitizations 

First-loss tranches 

Mezzanine tranches 

Super-senior tranches 

8. Nth-to-Default Credit Derivatives 


sroberts on PROD1PC70 with PROPOSALS
55832 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

2The BCBS is a committee of banking supervisory 

authorities, which was established by the central 

bank governors of the G–10 countries in 1975. It 

consists of senior representatives of bank 

supervisory authorities and central banks from 

Belgium, Canada, France, Germany, Italy, Japan, 

Luxembourg, the Netherlands, Spain, Sweden, 

Switzerland, the United Kingdom, and the United 

States. 

3The BCBS developed the Proposed New Accord 

to modernize its first capital Accord, which was 

endorsed by the G–10 governors in 1988 and 

implemented by the agencies in the United States 

in 1989. The BCBS’s 1988 Accord is described in 

a document entitled ‘‘International Convergence of 

Capital Measurement and Capital Standards.’’ This 

document and other documents issued by the BCBS 

are available through the Bank for International 

Settlements Web site at http://www.bis.org. The 

agencies’ implementing regulations are available at 

12 CFR part 3, Appendices A and B (national 

banks); 12 CFR part 208, Appendices A and E (state 

member banks); 12 CFR part 225, Appendixes A 

and E (bank holding companies); 12 CFR part 325, 

Appendices A and C (state nonmember banks); and 

12 CFR part 567 (savings associations). 

9. Early Amortization Provisions 

Background 

Controlled early amortization 

Noncontrolled early amortization 

F. Equity Exposures 

1. Introduction and Exposure Measurement 

Hedge transactions 

Measures of hedge effectiveness 

2. Simple Risk-Weight Approach (SRWA) 

Non-significant equity exposures 

3. Internal Models Approach (IMA) 

IMA qualification 

Risk-weighted assets under the IMA 

4. Equity Exposures to Investment Funds 

Full look-through approach 

Simple modified look-through approach 

Alternative modified look-through 

approach 

VI. Operational Risk 

VII. Disclosure 

1. Overview 

Comments on ANPR 

2. General Requirements 

Frequency/timeliness 

Location of disclosures and audit/ 

certification requirements 

Proprietary and confidential information 

3. Summary of Specific Public Disclosure 

Requirements 

4. Regulatory Reporting 

I. Introduction 

A. Background 

On August 4, 2003, the agencies 

issued an advance notice of proposed 

rulemaking (ANPR) (68 FR 45900) that 

sought public comment on a new riskbased regulatory capital framework 

based on the Basel Committee on 

Banking Supervision (BCBS)2 April 

2003 consultative paper entitled ‘‘ New 

Basel Capital Accord’’ (Proposed New 

Accord). The Proposed New Accord set 

forth a ‘‘three pillar’’ framework 

encompassing risk-based capital 

requirements for credit risk, market risk, 

and operational risk (Pillar 1); 

supervisory review of capital adequacy 

(Pillar 2); and market discipline through 

enhanced public disclosures (Pillar 3). 

The Proposed New Accord incorporated 

several methodologies for determining a 

bank’s risk-based capital requirements 

for credit, market, and operational risk.3

The ANPR sought comment on 

selected regulatory capital approaches 

contained in the Proposed New Accord 

that the agencies believe are appropriate 

for large, internationally active U.S. 

banks. These approaches include the 

internal ratings-based (IRB) approach for 

credit risk and the advanced 

measurement approaches (AMA) for 

operational risk (together, the advanced 

approaches). The IRB framework uses 

risk parameters determined by a bank’s 

internal systems in the calculation of 

the bank’s credit risk capital 

requirements. The AMA relies on a 

bank’s internal estimates of its 

operational risks to generate an 

operational risk capital requirement for 

the bank. The ANPR included a number 

of questions highlighting various issues 

for the industry’s consideration. The 

agencies received approximately 100 

public comments on the ANPR from 

banks, trade associations, supervisory 

authorities, and other interested parties. 

These comments addressed the 

agencies’ specific questions as well as a 

range of other issues. Commenters 

generally encouraged further 

development of the framework, and 

most supported the overall direction of 

the ANPR. Commenters did, however, 

raise a number of conceptual and 

technical issues that they believed 

required additional consideration. 

Since the issuance of the ANPR, the 

agencies have worked domestically and 

with other BCBS member countries to 

modify the methodologies in the 

Proposed New Accord to reflect 

comments received during the 

international consultation process and 

the U.S. ANPR comment process. In 

June 2004, the BCBS issued a document 

entitled ‘‘International Convergence of 

Capital Measurement and Capital 

Standards: A Revised Framework’’ (New 

Accord or Basel II). The New Accord 

recognizes developments in financial 

products, incorporates advances in risk 

measurement and management 

practices, and assesses capital 

requirements that are generally more 

sensitive to risk. It is intended for use 

by individual countries as the basis for 

national consultation and 

implementation. Accordingly, the 

agencies are issuing this proposed rule 

to implement the New Accord for banks 

in the United States. 

B. Conceptual Overview 

The framework outlined in this 

proposal (IRB framework) is intended to 

produce risk-based capital requirements 

that are more risk-sensitive than the 

existing risk-based capital rules of the 

agencies (general risk-based capital 

rules). The proposed framework seeks to 

build on improvements to risk 

assessment approaches that a number of 

large banks have adopted over the last 

decade. In particular, the proposed 

framework requires banks to assign risk 

parameters to exposures and provides 

specific risk-based capital formulas that 

would be used to transform these risk 

parameters into risk-based capital 

requirements. 

The proposed framework is based on 

the ‘‘value-at-risk’’ (VaR) approach to 

measuring credit risk and operational 

risk. VaR modeling techniques for 

measuring risk have been the subject of 

economic research and are used by large 

banks. The proposed framework has 

benefited significantly from comments 

on the ANPR, as well as consultations 

organized in conjunction with the 

BCBS’s development of the New 

Accord. Because bank risk measurement 

practices are both continually evolving 

and subject to model and other errors, 

the proposed framework should be 

viewed less as an effort to produce a 

statistically precise measurement of 

risk, and more as an effort to improve 

the risk sensitivity of the risk-based 

capital requirements for banks. 

The proposed framework’s conceptual 

foundation is based on the view that 

risk can be quantified through the 

assessment of specific characteristics of 

the probability distribution of potential 

losses over a given time horizon. This 

approach assumes that a suitable 

estimate of that probability distribution, 

or at least of the specific characteristics 

to be measured, can be produced. Figure 

1 illustrates some of the key concepts 

associated with the proposed 

framework. The figure shows a 

probability distribution of potential 

losses associated with some time 

horizon (for example, one year). It could 

reflect, for example, credit losses, 

operational losses, or other types of 

losses. 


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Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55833 

4The theoretical underpinnings for the 

supervisory model of credit risk underlying this 

proposal are provided in Michael Gordy, ‘‘A RiskFactor Model Foundation for Ratings-Based Bank 

Capital Rules,’’ Journal of Financial Intermediation, 

July 2003. The IRB formulas are derived as an 

application of these results to a single-factor 

CreditMetrics-style model. For mathematical details 

on this model, see Michael Gordy, ‘‘A Comparative 

Anatomy of Credit Risk Models,’’ Journal of 

Banking and Finance, January 2000, or H.U. 

Koyluogu and A. Hickman, ‘‘Reconcilable 

Differences,’’ Risk, October 1998. For a less 

technical overview of the IRB formulas, see the 

BCBS’s ‘‘An Explanatory Note on the Basel II Risk 

Weight Functions,’’ July 2005 (Explanatory Note). 

The document can be found on the Bank for 

International Settlements Web site at http:// 

www.bis.org. 

The area under the curve to the right 

of a particular loss amount is the 

probability of experiencing losses 

exceeding this amount within a given 

time horizon. The figure also shows the 

statistical mean of the loss distribution, 

which is equivalent to the amount of 

loss that is ‘‘expected’’ over the time 

horizon. The concept of ‘‘expected loss’’

(EL) is distinguished from that of 

‘‘unexpected loss’’ (UL), which 

represents potential losses over and 

above the expected loss amount. A 

given level of unexpected loss can be 

defined by reference to a particular 

percentile threshold of the probability 

distribution. In the figure, for example, 

the 99.9th percentile is shown. 

Unexpected losses, measured at the 

99.9th percentile level, are equal to the 

value of the loss distribution 

corresponding to the 99.9th percentile, 

less the amount of expected losses. This 

is shown graphically at the bottom of 

the figure. 

The particular percentile level chosen 

for the measurement of unexpected 

losses is referred to as the ‘‘confidence 

level’’ or the ‘‘soundness standard’’

associated with the measurement. If 

capital is available to cover losses up to 

and including this percentile level, then 

the bank will remain solvent in the face 

of actual losses of that magnitude. 

Typically, the choice of confidence level 

or soundness standard reflects a very 

high percentile level, so that there is a 

very low estimated probability that 

actual losses would exceed the 

unexpected loss amount associated with 

that confidence level or soundness 

standard. 

Assessing risk and assigning 

regulatory capital requirements by 

reference to a specific percentile of a 

probability distribution of potential 

losses is commonly referred to as a VaR 

approach. Such an approach was 

adopted by the FDIC, Board, and OCC 

for assessing a bank’s risk-based capital 

requirements for market risk in 1996 

(market risk amendment or MRA). 

Under the MRA, a bank’s own internal 

models are used to estimate the 99th 

percentile of the bank’s market risk loss 

distribution over a ten-business-day 

horizon. The bank’s market risk capital 

requirement is based on this VaR 

estimate, generally multiplied by a 

factor of three. The agencies 

implemented this multiplication factor 

to provide a prudential buffer for market 

volatility and modeling error. 

1. The IRB Framework for Credit Risk 

The conceptual foundation of this 

proposal’s approach to credit risk 

capital requirements is similar to the 

MRA’s approach to market risk capital 

requirements, in the sense that each is 

VaR-oriented. That is, the proposed 

framework bases minimum credit risk 

capital requirements largely on 

estimated statistical measures of credit 

risk. Nevertheless, there are important 

differences between this proposal and 

the MRA. The MRA approach for 

assessing market risk capital 

requirements currently employs a 

nominal confidence level of 99.0 

percent and a ten-business-day horizon, 

but otherwise provides banks with 

substantial modeling flexibility in 

determining their market risk loss 

distribution and capital requirements. In 

contrast, the IRB framework for 

assessing credit risk capital 

requirements is based on a 99.9 percent 

nominal confidence level, a one-year 

horizon, and a supervisory model of 

credit losses embodying particular 

assumptions about the underlying 

drivers of portfolio credit risk, including 

loss correlations among different asset 

types.4

The IRB framework is broadly similar 

to the credit VaR approaches used by 

many banks as the basis for their 

internal assessment of the economic 

capital necessary to cover credit risk. It 

is common for a bank’s internal credit 

risk models to consider a one-year loss 

horizon, and to focus on a high loss 

threshold confidence level. As with the 

internal credit VaR models used by 

banks, the output of the risk-based 

capital formulas in the IRB framework is 

an estimate of the amount of credit 

losses above expected credit losses 

(ECL) over a one-year horizon that 

would only be exceeded a small 

percentage of the time. The agencies 

believe that a one-year horizon is 


sroberts on PROD1PC70 with PROPOSALSEP25SE06.075</GPH>
55834 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

5Banks’ internal economic capital models 

typically focus on measures of equity capital, 

whereas the total regulatory capital measure 

underlying this proposal includes not only equity 

capital, but also certain debt and hybrid 

instruments, such as subordinated debt. Thus, the 

99.9 percent nominal confidence level embodied in 

the IRB framework is not directly comparable to the 

nominal solvency standards underpinning banks’

economic capital models. 6See Explanatory Note. 7See Explanatory Note, section 5.3. 

appropriate because it balances the fact 

that banking book positions likely could 

not be easily or rapidly exited with the 

possibility that in many cases a bank 

can cover credit losses by raising 

additional capital should the underlying 

credit problems manifest themselves 

gradually. The nominal confidence level 

of the IRB risk-based capital formulas 

(99.9 percent) means that if all the 

assumptions in the IRB supervisory 

model for credit risk were correct for a 

bank, there would be less than a 0.1 

percent probability that credit losses at 

the bank in any year would exceed the 

IRB risk-based capital requirement.5

As noted above, the supervisory 

model of credit risk underlying the IRB 

framework embodies specific 

assumptions about the economic drivers 

of portfolio credit risk at banks. As with 

any modeling approach, these 

assumptions represent simplifications of 

very complex real-world phenomena 

and, at best, are only an approximation 

of the actual credit risks at any bank. To 

the extent these assumptions (described 

in greater detail below) do not 

characterize a given bank precisely, the 

actual confidence level implied by the 

IRB risk-based capital formulas may 

exceed or fall short of the framework’s 

nominal 99.9 percent confidence level. 

In combination with other 

supervisory assumptions and 

parameters underlying this proposal, the 

IRB framework’s 99.9 percent nominal 

confidence level reflects a judgmental 

pooling of available information, 

including supervisory experience. The 

framework underlying this proposal 

reflects a desire on the part of the 

agencies to achieve (i) relative riskbased capital requirements across 

different assets that are broadly 

consistent with maintaining at least an 

investment grade rating (for example, at 

least BBB) on the liabilities funding 

those assets, even in periods of 

economic adversity; and (ii) for the U.S. 

banking system as a whole, aggregate 

minimum regulatory capital 

requirements that are not a material 

reduction from the aggregate minimum 

regulatory capital requirements under 

the general risk-based capital rules. 

A number of important explicit 

generalizing assumptions and specific 

parameters are built into the IRB 

framework to make the framework 

applicable to a range of banks and to 

obtain tractable information for 

calculating risk-based capital 

requirements. Chief among the 

assumptions embodied in the IRB 

framework are: (i) Assumptions that a 

bank’s credit portfolio is infinitely 

granular; (ii) assumptions that loan 

defaults at a bank are driven by a single, 

systematic risk factor; (iii) assumptions 

that systematic and non-systematic risk 

factors are log-normal random variables; 

and (iv) assumptions regarding 

correlations among credit losses on 

various types of assets. 

The specific risk-based capital 

formulas in this proposed rule require 

the bank to estimate certain risk 

parameters for its wholesale and retail 

exposures, which the bank may do 

using a variety of techniques. These risk 

parameters are probability of default 

(PD), expected loss given default 

(ELGD), loss given default (LGD), 

exposure at default (EAD), and, for 

wholesale exposures, effective 

remaining maturity (M). The risk-based 

capital formulas into which the 

estimated risk parameters are inserted 

are simpler than the economic capital 

methodologies typically employed by 

banks (which often require complex 

computer simulations). In particular, an 

important property of the IRB risk-based 

capital formulas is portfolio invariance. 

That is, the risk-based capital 

requirement for a particular exposure 

generally does not depend on the other 

exposures held by the bank. Like the 

general risk-based capital rules, the total 

credit risk capital requirement for a 

bank’s wholesale and retail exposures is 

the sum of the credit risk capital 

requirements on individual wholesale 

exposures and retail exposures. 

The IRB risk-based capital formulas 

contain supervisory asset value 

correlation (AVC) factors, which have a 

significant impact on the capital 

requirements generated by the formulas. 

The AVC assigned to a given portfolio 

of exposures is an estimate of the degree 

to which any unanticipated changes in 

the financial conditions of the 

underlying obligors of the exposures are 

correlated (that is, would likely move 

up and down together). High correlation 

of exposures in a period of economic 

downturn conditions is an area of 

supervisory concern. For a portfolio of 

exposures having the same risk 

parameters, a larger AVC implies less 

diversification within the portfolio, 

greater overall systematic risk, and, 

hence, a higher risk-based capital 

requirement.6 For example, a 15 percent 

AVC for a portfolio of residential 

mortgage exposures would result in a 

lower risk-based capital requirement 

than a 20 percent AVC and a higher 

risk-based capital requirement than a 10 

percent AVC. 

The AVCs that appear in the IRB riskbased capital formulas for wholesale 

exposures decline with increasing PD; 

that is, the IRB risk-based capital 

formulas generally imply that a group of 

low-PD wholesale exposures are more 

correlated than a group of high-PD 

wholesale exposures. Thus, under the 

proposed rule, a low-PD wholesale 

exposure would have a higher relative 

risk-based capital requirement than that 

implied by its PD were the AVC in the 

IRB risk-based capital formulas for 

wholesale exposures fixed rather than a 

function of PD. This inverse 

relationship between PD and AVC for 

wholesale exposures is broadly 

consistent with empirical research 

undertaken by G10 supervisors and 

moderates the sensitivity of IRB riskbased capital requirements for 

wholesale exposures to the economic 

cycle. Question 1: The agencies seek 

comment on and empirical analysis of 

the appropriateness of the proposed 

rule’s AVCs for wholesale exposures in 

general and for various types of 

wholesale exposures (for example, 

commercial real estate exposures). 

The AVCs included in the IRB riskbased capital formulas for retail 

exposures also reflect a combination of 

supervisory judgment and empirical 

evidence.7 However, the historical data 

available for estimating these 

correlations was more limited than was 

the case with wholesale exposures, 

particularly for non-mortgage retail 

exposures. As a result, supervisory 

judgment played a greater role. 

Moreover, the flat 15 percent AVC for 

residential mortgage exposures is based 

largely on empirical analysis of 

traditional long-term, fixed-rate 

mortgages. Question 2: The agencies 

seek comment on and empirical 

analysis of the appropriateness and risk 

sensitivity of the proposed rule’s AVC 

for residential mortgage exposures—not 

only for long-term, fixed-rate mortgages, 

but also for adjustable-rate mortgages, 

home equity lines of credit, and other 

mortgage products—and for other retail 

portfolios. 

Another important conceptual 

element of the IRB framework concerns 

the treatment of EL. The ANPR 

generally would have required banks to 

hold capital against the measured 

amount of UL plus EL over a one-year 

horizon, except in the limited instance 

of credit card exposures where future 


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8BCBS, ‘‘QIS 3: Third Quantitative Impact 

Study,’’ May 2003. 

9See http://www.bis.org/bcbs/qis/qis5.htm. 

10See ‘‘Summary Findings of the Fourth 

Quantitative Impact Study,’’ February 24, 2006. 

margin income (FMI) was allowed to 

offset EL. The ANPR treatment also 

would have maintained the existing 

definition of regulatory capital, which 

includes the allowance for loan and 

lease losses (ALLL) in tier 2 capital up 

to a limit equal to 1.25 percent of riskweighted assets. The ANPR requested 

comment on the proposed treatment of 

EL. Many commenters on the ANPR 

objected to this treatment on conceptual 

grounds, arguing that capital is not the 

appropriate mechanism for covering EL. 

In response to this feedback, the 

agencies sought and obtained changes to 

the BCBS’s proposals in this area. 

The agencies supported the BCBS’s 

proposal, announced in October 2003, 

to remove ECL (as defined below) from 

the risk-weighted assets calculation. 

This NPR, consistent with the New 

Accord, removes ECL from the riskweighted assets calculation but requires 

a bank to compare its ECL to its eligible 

credit reserves (as defined below). If a 

bank’s ECL exceeds its eligible credit 

reserves, the bank must deduct the 

excess ECL amount 50 percent from tier 

1 capital and 50 percent from tier 2 

capital. If a bank’s eligible credit 

reserves exceed its ECL, the bank would 

be able to include the excess eligible 

credit reserves amount in tier 2 capital, 

up to 0.6 percent of the bank’s credit 

risk-weighted assets. This treatment is 

intended to maintain a capital incentive 

to reserve prudently and seeks to ensure 

that ECL over a one-year horizon is 

covered either by reserves or capital. 

This treatment also recognizes that 

prudent reserving that considers 

probable losses over the life of a loan 

may result in a bank holding reserves in 

excess of ECL measured with a one-year 

horizon. The BCBS calibrated the 

proposed 0.6 percent limit on inclusion 

of excess reserves in tier 2 capital to be 

approximately as restrictive as the 

existing cap on the inclusion of ALLL 

under the general risk-based capital 

rules, based on data obtained in the 

BCBS’s Third Quantitative Impact Study 

(QIS–3).8 Question 3: The agencies seek 

comment and supporting data on the 

appropriateness of this limit. 

The agencies are aware that certain 

banks believe that FMI should be 

eligible to cover ECL for the purposes of 

such a calculation, while other banks 

have asserted that, for certain business 

lines, prudential reserving practices do 

not involve setting reserves at levels 

consistent with ECL over a horizon as 

long as one year. The agencies 

nevertheless believe that the proposed 

approach is appropriate because banks 

should receive risk-based capital 

benefits only for the most highly reliable 

ECL offsets. 

The combined impact of these 

changes in the treatment of ECL and 

reserves will depend on the reserving 

practices of individual banks. 

Nevertheless, if other factors are equal, 

the removal of ECL from the calculation 

of risk-weighted assets will result in a 

lower amount of risk-weighted assets 

than the proposals in the ANPR. 

However, the impact on risk-based 

capital ratios should be partially offset 

by related changes to the numerators of 

the risk-based capital ratios—

specifically, (i) the ALLL will be 

allowed in tier 2 capital up to certain 

limits only to the extent that it and 

certain other reserves exceed ECL, and 

(ii) if ECL exceeds reserves, the reserve 

shortfall must be deducted 50 percent 

from tier 1 capital and 50 percent from 

tier 2 capital. 

Using data from QIS–3, the BCBS 

conducted an analysis of the risk-based 

capital requirements that would be 

generated under the New Accord, taking 

into account the aggregate effect of ECLrelated changes to both the numerator 

and the denominator of the risk-based 

capital ratios. The BCBS concluded that 

to offset these changes relative to the 

credit risk-based capital requirements of 

the Proposed New Accord, it might be 

necessary under the New Accord to 

apply a ‘‘scaling factor’’ (multiplier) to 

credit risk-weighted assets. The BCBS, 

in the New Accord, indicated that the 

best estimate of the scaling factor using 

QIS–3 data adjusted for the EL–UL 

decisions was 1.06. The BCBS noted 

that a final determination of any scaling 

factor would be reconsidered prior to 

full implementation of the new 

framework. The agencies are proposing 

a multiplier of 1.06 at this time, 

consistent with the New Accord. 

The agencies note that a 1.06 

multiplier should be viewed as a 

placeholder. The BCBS is expected to 

revisit the determination of a scaling 

factor based on the results of the latest 

international QIS (QIS–5, which was not 

conducted in the United States).9 The 

agencies will consider the BCBS’s 

determination, as well as other factors 

including the most recent QIS 

conducted in the United States (QIS–4, 

which is described below),10 in 

determining a multiplier for the final 

rule. As the agencies gain more 

experience with the proposed advanced 

approaches, the agencies will revisit the 

scaling factor along with other 

calibration issues identified during the 

parallel run and transitional floor 

periods (described below) and make 

changes to the rule as necessary. While 

a scaling factor is one way to ensure that 

regulatory capital is maintained at a 

certain level, particularly in the short- to 

medium-term, the agencies also may 

address calibration issues through 

modifications to the underlying IRB 

risk-based capital formulas. 

2. The AMA for Operational Risk 

The proposed rule also includes the 

AMA for determining risk-based capital 

requirements for operational risk. Under 

the proposed rule, operational risk is 

defined as the risk of loss resulting from 

inadequate or failed internal processes, 

people, and systems or from external 

events. This definition of operational 

risk includes legal risk—which is the 

risk of loss (including litigation costs, 

settlements, and regulatory fines) 

resulting from the failure of the bank to 

comply with laws, regulations, prudent 

ethical standards, and contractual 

obligations in any aspect of the bank’s 

business—but excludes strategic and 

reputational risks. 

Under the AMA, a bank would use its 

internal operational risk management 

systems and processes to assess its 

exposure to operational risk. Given the 

complexities involved in measuring 

operational risk, the AMA provides 

banks with substantial flexibility and, 

therefore, does not require a bank to use 

specific methodologies or distributional 

assumptions. Nevertheless, a bank using 

the AMA must demonstrate to the 

satisfaction of its primary Federal 

supervisor that its systems for managing 

and measuring operational risk meet 

established standards, including 

producing an estimate of operational 

risk exposure that meets a 1-year, 99.9th 

percentile soundness standard. A bank’s 

estimate of operational risk exposure 

includes both expected operational loss 

(EOL) and unexpected operational loss 

(UOL) and forms the basis of the bank’s 

risk-based capital requirement for 

operational risk. 

The AMA allows a bank to base its 

risk-based capital requirement for 

operational risk on UOL alone if the 

bank can demonstrate to the satisfaction 

of its primary Federal supervisor that 

the bank has eligible operational risk 

offsets, such as certain operational risk 

reserves, that equal or exceed the bank’s 

EOL. To the extent that eligible 

operational risk offsets are less than 

EOL, the bank’s risk-based capital 

requirement for operational risk must 

incorporate the shortfall. 


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11A CEIO is an on-balance-sheet asset that (i) 

represents the contractual right to receive some or 

all of the interest and no more than a minimal 

amount of principal due on the underlying 

exposures of a securitization and (ii) exposes the 

holder to credit risk directly or indirectly associated 

with the underlying exposures that exceeds its pro 

rata claim on the underlying exposures whether 

through subordination provisions or other creditenhancement techniques. 

C. Overview of Proposed Rule 

The proposed rule maintains the 

general risk-based capital rules’

minimum tier 1 risk-based capital ratio 

of 4.0 percent and total risk-based 

capital ratio of 8.0 percent. The 

components of tier 1 and total capital 

are also generally the same, with a few 

adjustments described in more detail 

below. The primary difference between 

the general risk-based capital rules and 

the proposed rule is the methodologies 

used for calculating risk-weighted 

assets. Banks applying the proposed 

rule generally would use their internal 

risk measurement systems to calculate 

the inputs for determining the riskweighted asset amounts for (i) general 

credit risk (including wholesale and 

retail exposures); (ii) securitization 

exposures; (iii) equity exposures; and 

(iv) operational risk. In certain cases, 

however, external ratings or supervisory 

risk weights would be used to determine 

risk-weighted asset amounts. Each of 

these areas is discussed below. 

Banks using the proposed rule also 

would be subject to supervisory review 

of their capital adequacy (Pillar 2) and 

certain public disclosure requirements 

to foster transparency and market 

discipline (Pillar 3). In addition, each 

bank using the advanced approaches 

would continue to be subject to the tier 

1 leverage ratio requirement, and each 

depository institution (DI) (as defined in 

section 3 of the Federal Deposit 

Insurance Act (12 U.S.C. 1813)) using 

the advanced approaches would 

continue to be subject to the prompt 

corrective action (PCA) thresholds. 

Those banks subject to the MRA also 

would continue to be subject to the 

MRA. 

Under the proposed rule, a bank must 

identify whether each of its on- and offbalance sheet exposures is a wholesale, 

retail, securitization, or equity exposure. 

Assets that are not defined by any 

exposure category (and certain 

immaterial portfolios of exposures) 

generally would be assigned riskweighted asset amounts equal to their 

carrying value (for on-balance sheet 

exposures) or notional amount (for offbalance sheet exposures). 

Wholesale exposures under the 

proposed rule include most credit 

exposures to companies and 

governmental entities. For each 

wholesale exposure, a bank would 

assign five quantitative risk parameters: 

PD (which is stated as a percentage and 

measures the likelihood that an obligor 

will default over a 1-year horizon); 

ELGD (which is stated as a percentage 

and is an estimate of the economic loss 

rate if a default occurs); LGD (which is 

stated as a percentage and is an estimate 

of the economic loss rate if a default 

occurs during economic downturn 

conditions); EAD (which is measured in 

dollars and is an estimate of the amount 

that would be owed to the bank at the 

time of default); and M (which is 

measured in years and reflects the 

effective remaining maturity of the 

exposure). Banks would be able to factor 

into their risk parameter estimates the 

risk mitigating impact of collateral, 

credit derivatives, and guarantees that 

meet certain criteria. Banks would input 

the risk parameters for each wholesale 

exposure into an IRB risk-based capital 

formula to determine the risk-based 

capital requirement for the exposure. 

Retail exposures under the proposed 

rule include most credit exposures to 

individuals and small businesses that 

are managed as part of a segment of 

exposures with similar risk 

characteristics, not on an individualexposure basis. A bank would classify 

each of its retail exposures into one of 

three retail subcategories—residential 

mortgage exposures, qualifying 

revolving exposures (QREs) (for 

example, credit cards and overdraft 

lines), and other retail exposures. 

Within these three subcategories, the 

bank would group exposures into 

segments with similar risk 

characteristics. The bank would then 

assign the risk parameters PD, ELGD, 

LGD, and EAD to each retail segment. 

The bank would be able to take into 

account the risk mitigating impact of 

collateral and guarantees in the 

segmentation process and in the 

assignment of risk parameters to retail 

segments. Like wholesale exposures, the 

risk parameters for each retail segment 

would be used as inputs into an IRB 

risk-based capital formula to determine 

the risk-based capital requirement for 

the segment. Question 4: The agencies 

seek comment on the use of a segmentbased approach rather than an 

exposure-by-exposure approach for 

retail exposures. 

For securitization exposures, the bank 

would apply one of three general 

approaches, subject to various 

conditions and qualifying criteria: the 

Ratings-Based Approach (RBA), which 

uses external ratings to risk-weight 

exposures; an Internal Assessment 

Approach (IAA), which uses internal 

ratings to risk-weight exposures to assetbacked commercial paper programs 

(ABCP programs); or the Supervisory 

Formula Approach (SFA). Securitization 

exposures in the form of gain-on-sale or 

credit-enhancing interest-only strips 

(CEIOs)11 and securitization exposures 

that do not qualify for the RBA, the IAA, 

or the SFA would be deducted from 

regulatory capital. 

Banks would be able to use an 

internal models approach (IMA) for 

determining risk-based capital 

requirements for equity exposures, 

subject to certain qualifying criteria and 

floors. If a bank does not have a 

qualifying internal model for equity 

exposures, or chooses not to use such a 

model, the bank must apply a simple 

risk weight approach (SRWA) in which 

publicly traded equity exposures would 

have a 300 percent risk weight and nonpublicly traded equity exposures would 

have a 400 percent risk weight. Under 

both the IMA and the SRWA, equity 

exposures to certain entities or made 

pursuant to certain statutory authorities 

would be subject to a 0 to 100 percent 

risk weight. 

Banks would have to develop 

qualifying AMA systems to determine 

risk-based capital requirements for 

operational risk. Under the AMA, a 

bank would use its own methodology to 

identify operational loss events, 

measure its exposure to operational risk, 

and assess a risk-based capital 

requirement for operational risk. 

Under the proposed rule, a bank 

would calculate its risk-based capital 

ratios by first converting any dollar riskbased capital requirements for 

exposures produced by the IRB riskbased capital formulas into riskweighted asset amounts by multiplying 

the capital requirements by 12.5 (the 

inverse of the overall 8.0 percent riskbased capital requirement). After 

determining the risk-weighted asset 

amounts for credit risk and operational 

risk, a bank would sum these amounts 

and then subtract any allocated transfer 

risk reserves and excess eligible credit 

reserves not included in tier 2 capital 

(defined below) to determine total riskweighted assets. The bank would then 

calculate its risk-based capital ratios by 

dividing its tier 1 capital and total 

qualifying capital by the total riskweighted assets amount. 

The proposed rule contains specific 

public disclosure requirements to 

provide important information to 

market participants on the capital 

structure, risk exposures, risk 

assessment processes, and, hence, the 


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12See elsewhere in today’s issue of the Federal 

Register. 

13Since neither an NPR and associated 

supervisory guidance nor final regulations 

implementing a Basel II-based framework had been 

issued in the United States at the time of data 

collection, all QIS–4 results relating to the U.S. 

implementation of Basel II are based on the 

description of the framework contained in the QIS–

4 instructions. These instructions differed from the 

framework issued by the BCBS in June 2004 in 

several respects. For example, the QIS–4 

articulation of the Basel II framework does not 

include the 1.06 scaling factor. The QIS–4 

instructions are available at http://www.ffiec.gov/ 

qis4. 

14See ‘‘Banking Agencies to Perform Additional 

Analysis Before Issuing Notice of Proposed 

Rulemaking Related to Basel II,’’ Apr. 29, 2005. 

15The Basel II framework on which QIS–4 is 

based uses a UL-only approach (even though EL 

requirements were included in QIS–4). But the 

current Basel I risk-based capital requirements use 

a UL+EL approach. Therefore, in order to compare 

the Basel II results from QIS–4 with the current 

Basel I requirements, the EL requirements from 

QIS–4 had to be added to the UL capital 

requirements from QIS–4. 

16 In the table, ‘‘Minimum required capital’’

(MRC) refers to the total risk-based capital 

requirement before incorporating the impact of 

reserves. ‘‘Effective MRC’’ is equal to MRC adjusted 

for the impact of reserves. As noted above, under 

the Basel II framework, a shortfall in reserves 

generally increases the total risk-based capital 

requirement and a surplus in reserves generally 

Continued 

capital adequacy of a bank. The public 

disclosure requirements would apply 

only to the DI or bank holding company 

representing the top consolidated level 

of the banking group that is subject to 

the advanced approaches. In addition, 

the agencies are also publishing today 

proposals to require certain disclosures 

from subsidiary DIs in the banking 

group through the supervisory reporting 

process. The agencies believe that the 

reporting of key risk parameter 

estimates for each DI applying the 

advanced approaches will provide the 

primary Federal supervisor of the DI 

and other relevant supervisors with 

important data for assessing the 

reasonableness and accuracy of the 

institution’s calculation of its risk-based 

capital requirements under this 

proposal and the adequacy of the 

institution’s capital in relation to its 

risks. Some of the proposed supervisory 

reports would be publicly available (for 

example, on the Call Report or Thrift 

Financial Report), and others would be 

confidential disclosures to the agencies 

to augment the supervisory process. 

D. Structure of Proposed Rule 

The agencies are considering 

implementing a comprehensive 

regulatory framework for the advanced 

approaches in which each agency would 

have an advanced approaches regulation 

or appendix that sets forth (i) the 

elements of tier 1 and tier 2 capital and 

associated adjustments to the risk-based 

capital ratio numerator, (ii) the 

qualification requirements for using the 

advanced approaches, and (iii) the 

details of the advanced approaches. For 

proposal purposes, the agencies are 

issuing a single proposed regulatory text 

for comment. Unless otherwise 

indicated, the term ‘‘bank’’ in the 

regulatory text includes banks, savings 

associations, and bank holding 

companies (BHCs). The term 

‘‘[AGENCY]’’ in the regulatory text 

refers to the primary Federal supervisor 

of the bank applying the rule. Areas 

where the regulatory text would differ 

by agency—for example, provisions that 

would only apply to savings 

associations or to BHCs—are generally 

indicated in appropriate places. 

In this proposed rule, the agencies are 

not restating the elements of tier 1 and 

tier 2 capital, which would generally 

remain the same as under the general 

risk-based capital rules. Adjustments to 

the risk-based capital ratio numerators 

specific to banks applying the advanced 

approaches are in part II of the proposed 

rule and explained in greater detail in 

section IV of this preamble. The OCC, 

Board, and FDIC also are proposing to 

incorporate their existing market risk 

rules by cross-reference and are 

proposing modifications to the market 

risk rules in a separate NPR issued 

concurrently.12 The OTS is proposing 

its own market risk rule, including the 

proposed modifications, as a part of that 

separate NPR. In addition, the agencies 

may need to make additional 

conforming amendments to certain of 

their regulations that use tier 1 or total 

qualifying capital or the risk-based 

capital ratios for various purposes. 

The proposed rule is structured in 

eight broad parts. Part I identifies 

criteria for determining which banks are 

subject to the rule, provides key 

definitions, and sets forth the minimum 

risk-based capital ratios. Part II 

describes the adjustments to the 

numerator of the risk-based capital 

ratios for banks using the advanced 

approaches. Part III describes the 

qualification process and provides 

qualification requirements for obtaining 

supervisory approval for use of the 

advanced approaches. This part 

incorporates critical elements of 

supervisory oversight of capital 

adequacy (Pillar 2). 

Parts IV through VII address the 

calculation of risk-weighted assets. Part 

IV provides the risk-weighted assets 

calculation methodologies for wholesale 

and retail exposures; on-balance-sheet 

assets that do not meet the regulatory 

definition of a wholesale, retail, 

securitization, or equity exposure; and 

certain immaterial portfolios of credit 

exposures. This part also describes the 

risk-based capital treatment for over-thecounter (OTC) derivative contracts, 

repo-style transactions, and eligible 

margin loans. In addition, this part 

describes the methodology for reflecting 

eligible credit risk mitigation techniques 

in risk-weighted assets for wholesale 

and retail exposures. Furthermore, this 

part sets forth the risk-based capital 

requirements for failed and unsettled 

securities, commodities, and foreign 

exchange transactions. 

Part V identifies operating criteria for 

recognizing risk transference in the 

securitization context and outlines the 

approaches for calculating risk-weighted 

assets for securitization exposures. Part 

VI describes the approaches for 

calculating risk-weighted assets for 

equity exposures. Part VII describes the 

calculation of risk-weighted assets for 

operational risk. Finally, Part VIII 

provides public disclosure requirements 

for banks employing the advanced 

approaches (Pillar 3). 

The structure of the preamble 

generally follows the structure of the 

proposed regulatory text. Definitions, 

however, are discussed in the portions 

of the preamble where they are most 

relevant. 

E. Quantitative Impact Study 4 and 

Overall Capital Objectives 

1. Quantitative Impact Study 4 

After the BCBS published the New 

Accord, the agencies conducted the 

additional quantitative impact study 

referenced above, QIS–4, in the fall and 

winter of 2004–2005, to better 

understand the potential impact of the 

proposed framework on the risk-based 

capital requirements for individual U.S. 

banks and U.S. banks as a whole. The 

results showed a substantial dollarweighted average decline and variation 

in risk-based capital requirements 

across the 26 participating U.S. banks 

and their portfolios.13 In an April 2005 

press release,14 the agencies expressed 

their concern about the magnitude of 

the drop in QIS–4 risk-based capital 

requirements and the dispersion of 

those requirements and decided to 

undertake further analysis. 

The QIS–4 analysis indicated a dollarweighted average reduction of 15.5 

percent in risk-based capital 

requirements at participating banks 

when moving from the current Basel Ibased framework to a Basel II-based 

framework.15 Table A provides a 

numerical summary of the QIS–4 

results, in total and by portfolio, 

aggregated across all QIS–4 

participants.16 The first column shows 


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reduces the total risk-based capital requirement, 

though not with equal impact. 

changes in dollar-weighted average 

minimum required capital (MRC) both 

by portfolio and overall, as well as in 

dollar-weighted average overall effective 

MRC. Column 2 shows the relative 

contribution of each portfolio to the 

overall dollar-weighted average decline 

of 12.5 percent in MRC, representing 

both the increase/decrease and relative 

size of each portfolio. The table also 

shows (column 3) that risk-based capital 

requirements declined by more than 26 

percent in half the banks in the study. 

Most portfolios showed double-digit 

declines in risk-based capital 

requirements for over half the banks, 

with the exception of credit cards. It 

should be noted that column 3 gives 

every participating bank equal weight. 

Column 4 shows the analogous 

weighted median change, using total 

exposures as weights. 

QIS–4 results (not shown in Table A) 

also suggested that tier 1 risk-based 

capital requirements under a Basel IIbased framework would be lower for 

many banks than they are under the 

general risk-based capital rules, in part 

reflecting the move to a UL-only riskbased capital requirement. Tier 1 riskbased capital requirements declined by 

22 percent in the aggregate. The 

unweighted median indicates that half 

of the participating banks reported 

reductions in tier 1 risk-based capital 

requirements of over 31 percent. The 

MRC calculations do not take into 

account the impact of the tier 1 leverage 

ratio requirement. Were such results 

produced under a fully implemented 

Basel II-based risk-based capital regime, 

the existing tier 1 leverage ratio 

requirement could be a more important 

constraint than it is currently. 

Evidence from some of the follow-up 

analysis also illustrated that similar loan 

products at different banks may have 

resulted in very different risk-based 

capital requirements. Analysis 


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Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55839 

17 68 FR 45900, 45902 (Aug. 4, 2003). 18 68 FR 45900, 45905 (August 4, 2003). 

determined that this dispersion in 

capital requirements not only reflected 

differences in actual risk or portfolio 

composition, but also reflected 

differences in the banks’ estimated risk 

parameters for similar exposures. 

Although concerns with dispersion 

might be remedied to some degree with 

refinements to internal bank risk 

measurement and management systems 

and through the rulemaking process, the 

agencies also note that some of the 

dispersion encountered in the QIS–4 

exercise is a reflection of the flexibility 

in methods to quantify the risk 

parameters that may be allowed under 

implementation of the proposed 

framework. 

The agencies intend to conduct other 

analyses of the impact of the Basel II 

framework during both the parallel run 

and transitional floor periods. These 

analyses will look at both the impact of 

the Basel II framework and the 

preparedness of banks to compute riskbased capital requirements in a manner 

consistent with the Basel II framework. 

2. Overall Capital Objectives 

The ANPR stated: ‘‘The Agencies do 

not expect the implementation of the 

New Accord to result in a significant 

decrease in aggregate capital 

requirements for the U.S. banking 

system. Individual banking 

organizations may, however, face 

increases or decreases in their minimum 

risk-based capital requirements because 

the New Accord is more risk sensitive 

than the 1988 Accord and the Agencies’

existing risk-based capital rules (general 

risk-based capital rules).’’ 17 The ANPR 

was in this respect consistent with 

statements made by the BCBS in its 

series of Basel II consultative papers and 

its final text of the New Accord, in 

which the BCBS stated as an objective 

broad maintenance of the overall level 

of risk-based capital requirements while 

allowing some incentives for banks to 

adopt the advanced approaches. 

The agencies remain committed to 

these objectives. Were the QIS–4 results 

just described produced under an upand-running risk-based capital regime, 

the risk-based capital requirements 

generated under the framework would 

not meet the objectives described in the 

ANPR, and thus would be considered 

unacceptable. 

When considering QIS–4 results and 

their implications, it is important to 

recognize that banking organizations 

participated in QIS–4 on a best-efforts 

basis. The agencies had not qualified 

any of the participants to use the Basel 

II framework and had not conducted 

any formal supervisory review of their 

progress toward meeting the Basel II 

qualification requirements. In addition, 

the risk measurement and management 

systems of the QIS–4 participants, as 

indicated by the QIS–4 exercise, did not 

yet meet the Basel II qualification 

requirements outlined in this proposed 

rule. 

As banks work with their supervisors 

to refine their risk measurement and 

management systems, it will become 

easier to determine the actual 

quantitative impact of the advanced 

approaches. The agencies have decided, 

therefore, not to recalibrate the 

framework at the present time based on 

QIS–4 results, but to await further 

experience with more fully developed 

bank risk measurement and 

management systems. 

If there is a material reduction in 

aggregate minimum regulatory capital 

requirements upon implementation of 

Basel II-based rules, the agencies will 

propose regulatory changes or 

adjustments during the transitional floor 

periods. In this context, materiality will 

depend on a number of factors, 

including the size, source, and nature of 

any reduction; the risk profiles of banks 

authorized to use Basel II-based rules; 

and other considerations relevant to the 

maintenance of a safe and sound 

banking system. In any event, the 

agencies will view a 10 percent or 

greater decline in aggregate minimum 

required risk-based capital (without 

reference to the effects of the 

transitional floors described in a later 

section of this preamble), compared to 

minimum required risk-based capital as 

determined under the existing rules, as 

a material reduction warranting 

modifications to the supervisory risk 

functions or other aspects of this 

framework. 

The agencies are, in short, identifying 

a numerical benchmark for evaluating 

and responding to capital outcomes 

during the parallel run and transitional 

floor periods that do not comport with 

the overall capital objectives outlined in 

the ANPR. At the end of the transitional 

floor periods, the agencies would 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. Question 5: The agencies 

seek comment on this approach to 

ensuring that overall capital objectives 

are achieved. 

The agencies also noted above that 

tier 1 capital requirements reported in 

QIS–4 declined substantially more than 

did total capital requirements. The 

agencies have long placed special 

emphasis on the importance of tier 1 

capital in maintaining bank safety and 

soundness because of its ability to 

absorb losses on a going concern basis. 

The agencies will continue to monitor 

the trend in tier 1 capital requirements 

during the parallel run and transitional 

floor periods and will take appropriate 

action if reductions in tier 1 capital 

requirements are inconsistent with the 

agencies’ overall capital goals. 

Similar to the attention the agencies 

will give to overall risk-based capital 

requirements for the U.S. banking 

system, the agencies will carefully 

consider during the transitional floor 

periods whether dispersion in riskbased capital results across banks and 

portfolios appropriately reflects 

differences in risk. A conclusion by the 

agencies that dispersion in risk-based 

capital requirements does not 

appropriately reflect differences in risk 

could be another possible basis for 

proposing regulatory adjustments or 

refinements during the transitional floor 

periods. 

It should also be noted that given the 

bifurcated regulatory capital framework 

that would result from the adoption of 

this rule, issues related to overall capital 

may be inextricably linked to the 

competitive issues discussed elsewhere 

in this document. The agencies 

indicated in the ANPR that if the 

competitive effects of differential capital 

requirements were deemed significant, 

‘‘the Agencies would need to consider 

potential ways to address those effects 

while continuing to seek the objectives 

of the current proposal. Alternatives 

could potentially include modifications 

to the proposed approaches, as well as 

fundamentally different approaches.’’ 18

In this regard, the agencies view the 

parallel run and transitional floor 

periods as a trial of the new framework 

under controlled conditions. While the 

agencies hope and expect that 

regulatory changes proposed during 

those years would be in the nature of 

adjustments made within the framework 

described in this proposed rule, more 

fundamental changes cannot be ruled 

out if warranted based on future 

experience or comments received on 

this proposal. 

The agencies reiterate that, especially 

in light of the QIS–4 results, retention 

of the tier 1 leverage ratio and other 

existing prudential safeguards (for 

example, PCA) is critical for the 


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

preservation of a safe and sound 

regulatory capital framework. In 

particular, the leverage ratio is a 

straightforward and tangible measure of 

solvency and serves as a needed 

complement to the risk-sensitive Basel II 

framework based on internal bank 

inputs. 

F. Competitive Considerations 

A fundamental objective of the New 

Accord is to strengthen the soundness 

and stability of the international 

banking system while maintaining 

sufficient consistency in capital 

adequacy regulation to ensure that the 

New Accord will not be a significant 

source of competitive inequity among 

internationally active banks. The 

agencies support this objective and 

believe that it is crucial to promote 

continual advancement of the risk 

measurement and management practices 

of large and internationally active 

banks. For this reason, the agencies 

propose to implement only the 

advanced approaches of the New 

Accord because these approaches utilize 

the most sophisticated and risksensitive risk measurement and 

management techniques. 

While all banks should work to 

enhance their risk management 

practices, the advanced approaches and 

the systems required to support their 

use may not be appropriate for many 

banks from a cost-benefit point of view. 

For these banks, the agencies believe 

that, with some modifications, the 

general risk-based capital rules are a 

reasonable alternative. As discussed in 

section E.2. above, this proposal’s 

bifurcated approach to risk-based 

capital requirements raises difficult 

issues and inextricably links 

competitive considerations with overall 

capital issues. One such issue relates to 

concerns about competitive inequities 

between U.S. banks operating under 

different regulatory capital regimes. The 

ANPR cited this concern, and a number 

of commenters expressed their belief 

that in some portfolios competitive 

inequities would be worsened under the 

proposed bifurcated framework. These 

commenters expressed the concern that 

the Proposed New Accord might place 

community banks operating under the 

general risk-based capital rules at a 

competitive disadvantage to banks 

applying the advanced approaches 

because the IRB framework would likely 

result in lower risk-based capital 

requirements on some types of 

exposures, such as residential mortgage 

exposures, other retail exposures, and 

small business loans. 

Some commenters asserted that the 

application of lower risk-based capital 

requirements under the Proposed New 

Accord would create a competitive 

disadvantage for banks operating under 

the general risk-based capital rules, 

which in turn may adversely affect their 

asset quality and cost of capital. Other 

commenters suggested that if the 

advanced approaches in the Proposed 

New Accord are implemented, the 

agencies should consider revising their 

general risk-based capital rules to 

enhance risk sensitivity and to mitigate 

potential competitive inequities 

associated with the bifurcated system. 

The agencies recognize that the 

industry has concerns with the potential 

competitive inequities associated with a 

bifurcated risk-based capital framework. 

The agencies reaffirm their intention, 

expressed in the ANPR, to address 

competitive issues while continuing to 

pursue the objectives of the current 

proposal. In addition to the QIS–4 

analysis discussed above, the agencies 

have also researched discrete topics to 

further understand where competitive 

pressures might arise. As part of their 

effort to develop a bifurcated risk-based 

capital framework that minimizes 

competitive inequities and is not 

disruptive to the banking sector, the 

agencies issued an Advance Notice of 

Proposed Rulemaking (Basel IA ANPR) 

considering various modifications to the 

general risk-based capital rules to 

improve risk sensitivity and to reduce 

potential competitive disparities 

between Basel II banks and non-Basel II 

banks.19 The comment period for the 

Basel IA ANPR ended on January 18, 

2006, and the agencies intend to 

consider all comments and issue for 

public comment a more fully developed 

risk-based capital proposal for nonBasel II banks. The comment period for 

the non-Basel II proposal is expected to 

overlap that of this proposal, allowing 

commenters to analyze the effects of the 

two proposals concurrently. 

In addition, some commenters 

expressed concern about competitive 

inequities arising from differences in 

implementation and application of the 

New Accord by supervisory authorities 

in different countries. In particular, 

some commenters expressed concern 

about the different implementation 

timetables of various jurisdictions, and 

differences in the scope of application 

in various jurisdictions or in the range 

of approaches that different 

jurisdictions will allow. The BCBS has 

established an Accord Implementation 

Group, comprised of supervisors from 

member countries, whose primary 

objectives are to work through 

implementation issues, maintain a 

constructive dialogue about 

implementation processes, and 

harmonize approaches as much as 

possible within the range of national 

discretion embedded in the New 

Accord. 

While supervisory judgment will play 

a critical role in the evaluation of risk 

measurement and management practices 

at individual banks, supervisors are 

committed to developing protocols and 

information-sharing arrangements that 

should minimize burdens on banks 

operating in multiple countries and 

ensure that supervisory authorities are 

implementing the New Accord as 

consistently as possible. The New 

Accord identifies numerous areas where 

national discretion is encouraged. This 

design was intended to enable national 

supervisors to implement the 

methodology, or combination of 

methodologies, most appropriate for 

banks in their jurisdictions. Disparate 

implementation decisions are expected, 

particularly during the transition years. 

Over time, the agencies expect that 

industry and supervisory practices 

likely will converge in many areas, thus 

mitigating differences across countries. 

Competitive considerations, both 

internationally and domestically, will 

be monitored and discussed by the 

agencies on an ongoing basis. With 

regard to implementation timing 

concerns, the agencies believe that the 

transitional arrangements described in 

section III.A. of this preamble below 

provide a prudent and reasonable 

framework for moving to the advanced 

approaches. Where international 

implementation differences affect an 

individual bank, the agencies expect to 

work with the bank and appropriate 

national supervisory authorities for the 

bank to ensure that implementation 

proceeds as smoothly as possible. 

Question 6: The agencies seek comment 

on all potential competitive aspects of 

this proposal and on any specific 

aspects of the proposal that might raise 

competitive concerns for any bank or 

group of banks. 

II. Scope 

The agencies have identified three 

groups of banks: (i) Large or 

internationally active banks that would 

be required to adopt the advanced 

approaches in the proposed rule (core 

banks); (ii) banks that voluntarily decide 

to adopt the advanced approaches (optin banks); and (iii) banks that do not 

adopt the advanced approaches (general 

banks). Each core and opt-in bank 

would be required to meet certain 

qualification requirements to the 

satisfaction of its primary Federal 

supervisor, in consultation with other 


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20 Despite the options provided in national 

legislation and rules, most non-U.S. banks 

comparable in size and complexity to U.S. core 

banks are adopting some form of the advanced 

approaches. For example, based on currently 

available information, the vast majority of large, 

internationally-active banks based outside of the 

United States plan to employ an internal ratingsbased approach in the calculation of credit risk 

capital requirements. 

21OTS does not currently impose any explicit 

capital requirements on savings and loan holding 

companies and does not propose to apply the Basel 

II proposal to these holding companies. 

22SR 01–01, ‘‘Application of the Board’s Capital 

Adequacy Guidelines to Bank Holding Companies 

Owned by Foreign Banking Organizations,’’ January 

5, 2001. 

relevant supervisors, before the bank 

may use the advanced approaches for 

risk-based capital purposes. 

Pillar I of the New Accord requires all 

banks subject to the New Accord to 

calculate capital requirements for 

exposure to both credit risk and 

operational risk. The New Accord 

provides a bank three approaches to 

calculate its credit risk capital 

requirement and three approaches to 

calculate its operational risk capital 

requirement. Outside the United States, 

countries that are replacing Basel I with 

the New Accord generally have required 

all banks to comply with the New 

Accord, but have provided banks the 

option of choosing among the New 

Accord’s various approaches for 

calculating credit risk and operational 

risk capital requirements.20 For banks in 

the United States, the NPR, like the 

ANPR, takes a different approach. It 

would not subject all U.S. banks to the 

New Accord, but instead focuses on 

only the largest and most internationally 

active banks. Due to the size and 

complexity of these banks, the NPR 

would require core banks to comply 

with the most advanced approaches for 

calculating credit and operational risk 

capital requirements ‘‘ that is, the IRB 

and the AMA. In addition, the NPR 

would allow other U.S. banks to ‘‘opt 

in’’ to Basel II-based rules, but, as with 

core banks, the only Basel II-based rules 

available to U.S. ‘‘opt-in’’ banks would 

be the New Accord’s most advanced 

approaches. 

Question 7: The agencies request 

comment on whether U.S. banks subject 

to the advanced approaches in the 

proposed rule (that is, core banks and 

opt-in banks) should be permitted to use 

other credit and operational risk 

approaches similar to those provided 

under the New Accord. With respect to 

the credit risk capital requirement, the 

agencies request comment on whether 

banks should be provided the option of 

using a U.S. version of the so-called 

‘‘standardized approach’’ of the New 

Accord and on the appropriate length of 

time for such an option. 

A. Core and Opt-In Banks 

A DI is a core bank if it meets either 

of two independent threshold criteria: 

(i) Consolidated total assets of $250 

billion or more, as reported on the most 

recent year-end regulatory reports; or (ii) 

consolidated total on-balance sheet 

foreign exposure of $10 billion or more 

at the most recent year-end. To 

determine total on-balance sheet foreign 

exposure, a bank would sum its 

adjusted cross-border claims, local 

country claims, and cross-border 

revaluation gains (calculated in 

accordance with the Federal Financial 

Institutions Examination Council 

(FFIEC) Country Exposure Report 

(FFIEC 009)). Adjusted cross-border 

claims would equal total cross-border 

claims less claims with the head office/ 

guarantor located in another country, 

plus redistributed guaranteed amounts 

to the country of head office/guarantor. 

A DI also is a core bank if it is a 

subsidiary of another DI or BHC that 

uses the advanced approaches. 

Under the proposed rule, a U.S.- 

chartered BHC 21 is a core bank if the 

BHC has: (i) Consolidated total assets 

(excluding assets held by an insurance 

underwriting subsidiary) of $250 billion 

or more, as reported on the most recent 

year-end regulatory reports; (ii) 

consolidated total on-balance sheet 

foreign exposure of $10 billion or more 

at the most recent year-end; or (iii) a 

subsidiary DI that is a core bank or optin bank. Currently 11 top-tier banking 

organizations meet these criteria. The 

agencies note that, using this approach 

to define whether a BHC is a core bank, 

it is possible that no single DI under a 

BHC would meet the threshold criteria, 

but that all of the BHC’s subsidiary DIs 

would be core banks. 

The proposed BHC consolidated asset 

threshold is different from the threshold 

in the ANPR, which applied to the total 

consolidated DI assets of a BHC. The 

proposed shift to total consolidated 

assets (excluding assets held by an 

insurance underwriting subsidiary) 

recognizes that BHCs can hold similar 

assets within and outside of DIs and 

reduces potential incentives to structure 

BHC assets and activities to arbitrage 

capital regulations. The proposed rule 

excludes assets held in an insurance 

underwriting subsidiary of a BHC 

because the New Accord was not 

designed to address insurance company 

exposures. Question 8A: The Board 

seeks comment on the proposed BHC 

consolidated non-insurance assets 

threshold relative to the consolidated DI 

assets threshold in the ANPR. 

A bank that is subject to the proposed 

rule either as a core bank or as an optin bank would be required to apply the 

rule unless its primary Federal 

supervisor determines in writing that 

application of the rule is not appropriate 

in light of the bank’s asset size, level of 

complexity, risk profile, or scope of 

operations. Question 8B: The agencies 

seek comment on the proposed scope of 

application. In particular, the agencies 

seek comment on the regulatory burden 

of a framework that requires the 

advanced approaches to be 

implemented by each subsidiary DI of a 

BHC or bank that uses the advanced 

approaches. 

B. U.S. DI Subsidiaries of Foreign 

Banks 

Any U.S.-chartered DI that is a 

subsidiary of a foreign banking 

organization is subject to the U.S. 

regulatory capital requirements applied 

to domestically-owned U.S. DIs. Thus, if 

the U.S. DI subsidiary of a foreign 

banking organization meets any of the 

threshold criteria, it would be a core 

bank and would be subject to the 

advanced approaches. If it does not 

meet any of the criteria, the U.S. DI may 

remain a general bank or may opt-in to 

the advanced approaches, subject to the 

same qualification process and 

requirements as a domestically-owned 

U.S. DI. A top-tier U.S. BHC, and its 

subsidiary DIs, that is owned by a 

foreign banking organization also would 

be subject to the same threshold levels 

for core bank determination as would a 

top-tier BHC that is not owned by a 

foreign banking organization. A U.S. 

BHC that meets the conditions in 

Federal Reserve SR letter 01–0122 and is 

a core bank would not be required to 

meet the minimum capital ratios in the 

Board’s capital adequacy guidelines, 

although it would be required to adopt 

the advanced approaches, compute and 

report its capital ratios in accordance 

with the advanced approaches, and 

make the required public and regulatory 

disclosures. 

A DI subsidiary of such a U.S. BHC 

would be a core bank and would be 

required to adopt the advanced 

approaches (unless specifically 

exempted from the advanced 

approaches by its primary Federal 

supervisor) and meet the minimum 

capital ratio requirements. In addition, 

the Board retains its supervisory 

authority to require any BHC, including 

a U.S. BHC owned or controlled by a 

foreign banking organization that is or is 

treated as a financial holding company 

(FHC), to maintain capital levels above 


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55842 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

23The agencies have issued for public comment 

draft supervisory guidance on corporate and retail 

exposures and operational risk. See 68 FR 45949 

(Aug. 4, 2003); 69 FR 62748 (Oct. 27, 2004). 

24The bank’s primary Federal supervisor may 

extend the bank’s first floor period start date. 

the regulatory minimums. Question 9: 

The agencies seek comment on the 

application of the proposed rule to DI 

subsidiaries of a U.S. BHC that meets 

the conditions in Federal Reserve SR 

letter 01–01 and on the principle of 

national treatment in this context. 

C. Reservation of Authority 

The proposed rule would restate the 

authority of a bank’s primary Federal 

supervisor to require the bank to hold 

an overall amount of capital greater than 

would otherwise be required under the 

rule if the agency determines that the 

bank’s risk-based capital requirements 

under the rule are not commensurate 

with the bank’s credit, market, 

operational, or other risks. In addition, 

the agencies anticipate that there may be 

instances when the proposed rule 

generates a risk-weighted asset amount 

for specific exposures that is not 

commensurate with the risks posed by 

such exposures. In these cases, under 

the proposed rule, the bank’s primary 

Federal supervisor would retain the 

authority to require the bank to use a 

different risk-weighted asset amount for 

the exposures or to use different risk 

parameters (for wholesale or retail 

exposures) or model assumptions (for 

modeled equity or securitization 

exposures) than those required in the 

proposed rule when calculating the riskweighted asset amount for those 

exposures. Similarly, the proposed rule 

would provide authority for a bank’s 

primary Federal supervisor to require 

the bank to assign a different riskweighted asset amount for operational 

risk, to change elements of its 

operational risk analytical framework 

(including distributional and 

dependence assumptions), or to make 

other changes to the bank’s operational 

risk management processes, data and 

assessment systems, or quantification 

systems if the supervisor finds that the 

risk-weighted asset amount for 

operational risk produced by the bank 

under the rule is not commensurate 

with the operational risks of the bank. 

Any agency that exercises this 

reservation of authority would notify 

each of the other agencies of its 

determination. 

III. Qualification 

A. The Qualification Process 

1. In General 

Supervisory qualification to use the 

advanced approaches is a continuous 

and iterative process that begins when 

a bank’s board of directors adopts an 

implementation plan and continues as 

the bank operates under the advanced 

approaches. Before a bank may use the 

advanced approaches for risk-based 

capital purposes, it must develop and 

adopt a written implementation plan, 

establish and maintain a comprehensive 

and sound planning and governance 

process to oversee the implementation 

efforts described in the plan, 

demonstrate to its primary Federal 

supervisor that it meets the qualification 

requirements in section 22 of the 

proposed rule, and complete a 

satisfactory ‘‘parallel run’’ (discussed 

below). A bank’s primary Federal 

supervisor would be responsible, after 

consultation with other relevant 

supervisors, for evaluating the bank’s 

initial and ongoing compliance with the 

qualification requirements for the 

advanced approaches. 

The agencies will jointly issue 

supervisory guidance describing agency 

expectations for wholesale, retail, 

securitization, and equity exposures, as 

well as for operational risk.23 The 

agencies recognize that a consistent and 

transparent process to oversee 

implementation of the advanced 

approaches is crucial, and will consult 

with each other on significant issues 

raised during the implementation 

process. 

Under the proposed rule, a bank 

preparing to implement the advanced 

approaches must adopt a written 

implementation plan, approved by its 

board of directors, describing in detail 

how the bank complies, or intends to 

comply, with the qualification 

requirements. A core bank must adopt a 

plan no later than six months after it 

meets a threshold criterion in section 

1(b)(1) of the proposed rule. If a bank 

meets a threshold criterion on the 

effective date of the final rule, the bank 

would have to adopt a plan within six 

months of the effective date. Banks that 

do not meet a threshold criterion, but 

are nearing any criterion by direct 

growth or merger, would be expected to 

engage in ongoing dialogue with their 

primary Federal supervisor regarding 

implementation strategies to ensure 

their readiness to adopt the advanced 

approaches when a threshold criterion 

is reached. An opt-in bank may adopt an 

implementation plan at any time, but 

must adopt an implementation plan and 

notify its primary Federal supervisor in 

writing at least twelve months before it 

proposes to begin the first floor period 

(as discussed later in this section of the 

preamble). 

In developing an implementation 

plan, a bank must assess its current state 

of readiness relative to the qualification 

requirements in this proposed rule and 

related supervisory guidance. This 

assessment would include a gap 

analysis that identifies where additional 

work is needed and a remediation or 

action plan that clearly sets forth how 

the bank intends to fill the gaps it has 

identified. The implementation plan 

must comprehensively address the 

qualification requirements for the bank 

and each of its consolidated subsidiaries 

(U.S. and foreign-based) with respect to 

all portfolios and exposures of the bank 

and each of its consolidated 

subsidiaries. The implementation plan 

must justify and support any proposed 

temporary or permanent exclusion of a 

business line, portfolio, or exposure 

from the advanced approaches. The 

business lines, portfolios, and exposures 

that the bank proposes to exclude from 

the advanced approaches must be, in 

the aggregate, immaterial to the bank. 

The implementation plan must include 

objective, measurable milestones 

(including delivery dates and a date 

when the bank’s implementation of the 

advanced approaches will be fully 

operational). For core banks, the 

implementation plan must include an 

explicit first floor period start date that 

is no later than 36 months after the later 

of the effective date of the rule or the 

date the bank meets at least one of the 

threshold criteria.24 Further, the 

implementation plan must describe the 

resources that the bank has budgeted 

and are available to implement the plan. 

During implementation of the 

advanced approaches, a bank would 

work closely with its primary Federal 

supervisor to ensure that its risk 

measurement and management systems 

are fully functional and reliable and are 

able to generate risk parameter estimates 

that can be used to calculate the riskbased capital ratios correctly under the 

advanced approaches. The 

implementation plan, including the gap 

analysis and action plan, will provide a 

basis for ongoing supervisory dialogue 

and review during this period. The 

primary Federal supervisor will assess a 

bank’s progress relative to its 

implementation plan. To the extent that 

adjustments to target dates are needed, 

these adjustments would be made 

subject to the ongoing supervisory 

discussion between the bank and its 

primary Federal supervisor. 

2. Parallel Run and Transitional Floor 

Periods 

Once a bank has adopted its 

implementation plan, it must complete 


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a satisfactory parallel run before it may 

use the advanced approaches to 

calculate its risk-based capital 

requirements. A satisfactory parallel run 

is a period of at least four consecutive 

calendar quarters during which the bank 

complies with all of the qualification 

requirements to the satisfaction of its 

primary Federal supervisor. During this 

period, the bank would continue to be 

subject to the general risk-based capital 

rules but would simultaneously 

calculate its risk-based capital ratios 

under the advanced approaches. During 

the parallel run period, a bank would 

report its risk-based capital ratios under 

both the general risk-based capital rules 

and the advanced approaches to its 

primary Federal supervisor through the 

supervisory process on a quarterly basis. 

The agencies will share this information 

with each other for calibration and other 

analytical purposes. 

A bank’s primary Federal supervisor 

would notify the bank of the date when 

it may begin to use the advanced 

approaches for risk-based capital 

purposes. A bank would not be 

permitted to begin using the advanced 

approaches for risk-based capital 

purposes until its primary Federal 

supervisor is satisfied that the bank 

fully complies with the qualification 

requirements, the bank has satisfactorily 

completed a parallel run, and the bank 

has an adequate process to ensure 

ongoing compliance with the 

qualification requirements. 

To provide for a smooth transition to 

the advanced approaches, the proposed 

rule would impose temporary limits on 

the amount by which a bank’s riskbased capital requirements could 

decline over a period of at least three 

years (that is, at least four consecutive 

calendar quarters in each of the three 

transitional floor periods). Based on its 

assessment of the bank’s ongoing 

compliance with the qualification 

requirements, a bank’s primary Federal 

supervisor would determine when the 

bank is ready to move from one 

transitional floor period to the next 

period and, after the full transition has 

been completed, to move to stand-alone 

use of the advanced approaches. Table 

B sets forth the proposed transitional 

floor periods for banks moving to the 

advanced approaches: 

TABLE B.—TRANSITIONAL FLOORS

Transitional floor period 

Transitional 

floor percentage 

First floor period ................... 95 

Second floor period .............. 90 

Third floor period .................. 85 

During the transitional floor periods, 

a bank would calculate its risk-weighted 

assets under the general risk-based 

capital rules. Next, the bank would 

multiply this risk-weighted assets 

amount by the appropriate floor 

percentage in the table above. This 

product would be the bank’s ‘‘flooradjusted’’ risk-weighted assets. Third, 

the bank would calculate its tier 1 and 

total risk-based capital ratios using the 

definitions of tier 1 and tier 2 capital 

(and associated deductions and 

adjustments) in the general risk-based 

capital rules for the numerator values 

and floor-adjusted risk-weighted assets 

for the denominator values. These ratios 

would be referred to as the ‘‘flooradjusted risk-based capital ratios.’’

The bank also would calculate its tier 

1 and total risk-based capital ratios 

using the definitions and rules in this 

proposed rule. These ratios would be 

referred to as the ‘‘advanced approaches 

risk-based capital ratios.’’ In addition, 

the bank would calculate a tier 1 

leverage ratio using tier 1 capital as 

defined in this proposed rule for the 

numerator of the ratio. 

During a bank’s transitional floor 

periods, the bank would report all five 

regulatory capital ratios described 

above—two floor-adjusted risk-based 

capital ratios, two advanced approaches 

risk-based capital ratios, and one 

leverage ratio. To determine its 

applicable capital category for PCA 

purposes and for all other regulatory 

and supervisory purposes, a bank’s riskbased capital ratios during the 

transitional floor periods would be set 

equal to the lower of the respective 

floor-adjusted risk-based capital ratio 

and the advanced approaches risk-based 

capital ratio. During the transitional 

floor periods, a bank’s tier 1 capital and 

tier 2 capital for all non-risk-basedcapital supervisory and regulatory 

purposes (for example, lending limits 

and Regulation W quantitative limits) 

would be the bank’s tier 1 capital and 

tier 2 capital as calculated under the 

advanced approaches. 

Thus, for example, in order to be well 

capitalized under PCA, a bank would 

have to have a floor-adjusted tier 1 riskbased capital ratio and an advanced 

approaches tier 1 risk-based capital ratio 

of 6 percent or greater, a floor-adjusted 

total risk-based capital ratio and an 

advanced approaches total risk-based 

capital ratio of 10 percent or greater, and 

a tier 1 leverage ratio of 5 percent or 

greater (with tier 1 capital calculated 

under the advanced approaches). 

Although the PCA rules do not apply to 

BHCs, a BHC would be required to 

report all five of these regulatory capital 

ratios and would have to meet 

applicable supervisory and regulatory 

requirements using the lower of the 

respective floor-adjusted risk-based 

capital ratio and the advanced 

approaches risk-based capital ratio. 

After a bank completes its transitional 

floor periods and its primary Federal 

supervisor determines the bank may 

begin using the advanced approaches 

with no further transitional floor, the 

bank would use its tier 1 and total riskbased capital ratios as calculated under 

the advanced approaches and its tier 1 

leverage ratio calculated using the 

advanced approaches definition of tier 1 

capital for PCA and all other 

supervisory and regulatory purposes. 

The transitional floor calculations 

described above are linked to the 

general risk-based capital rules. As 

noted above, the agencies issued the 

Basel IA ANPR outlining possible 

modifications to those rules and are 

developing an NPR in this regard. The 

agencies are still considering the extent 

and nature of these modifications to the 

general risk-based capital rules and the 

scope of application of these 

modifications, including for banks that 

transition to the advanced approaches. 

The agencies expect banks that meet the 

threshold criteria in section 1(b)(1) of 

the proposed rule (that is, core banks) as 

of the effective date of the rule, and 

banks that opt-in pursuant to section 

1(b)(2) at the earliest possible date, will 

use the general risk-based capital rules 

in place immediately before the rule 

becomes effective both during the 

parallel run and as a basis for the 

transitional floor calculations. Other 

changes to the general risk-based capital 

rules (outside the scope of the changes 

outlined in the Basel IA ANPR) may be 

considered by the agencies, as 

appropriate. Question 10: The agencies 

seek comment on this approach, 

including the transitional floor 

thresholds and transition period, and on 

how and to what extent future 

modifications to the general risk-based 

capital rules should be incorporated 

into the transitional floor calculations 

for advanced approaches banks. 

Banks’ computation of risk-based 

capital requirements under both the 

general risk-based capital rules and the 

advanced approaches will help the 

agencies assess the impact of the 

advanced approaches on overall capital 

requirements, including whether the 

change in capital requirements relative 

to the general risk-based capital rules is 

consistent with the agencies’ overall 

capital objectives. Question 11: The 

agencies seek comment on what other 

information should be considered in 

deciding whether those overall capital 

goals have been achieved. 


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The agencies are proposing to make 

2008 the first possible year for a bank 

to conduct its parallel run and 2009–

2011 the first possible years for the three 

transitional floor periods. Question 12: 

The agencies seek comment on this 

proposed timetable for implementing 

the advanced approaches in the United 

States. 

B. Qualification Requirements 

Because the Basel II framework uses 

banks’ estimates of certain key risk 

parameters to determine risk-based 

capital requirements, the advanced 

approaches would introduce greater 

complexity to the regulatory capital 

framework and would require banks 

using the advanced approaches to 

possess a high level of sophistication in 

risk measurement and risk management 

systems. As a result, the agencies 

propose to require each core or opt-in 

bank to meet the qualification 

requirements described in section 22 of 

the proposed rule to the satisfaction of 

its primary Federal supervisor for a 

period of at least four consecutive 

calendar quarters before using the 

advanced approaches to calculate its 

minimum risk-based capital 

requirements (subject to the transitional 

floors for at least an additional three 

years). The qualification requirements 

are written broadly to accommodate the 

many ways a bank may design and 

implement a robust internal credit and 

operational risk measurement and 

management system and to permit 

industry practice to evolve. 

Many of the qualification 

requirements relate to a bank’s 

advanced IRB systems. A bank’s 

advanced IRB systems must incorporate 

five interdependent components in a 

framework for evaluating credit risk and 

measuring regulatory capital: 

(i) A risk rating and segmentation 

system that assigns ratings to individual 

wholesale obligors and exposures and 

assigns individual retail exposures to 

segments; 

(ii) A quantification process that 

translates the risk characteristics of 

wholesale obligors and exposures and 

segments of retail exposures into 

numerical risk parameters that are used 

as inputs to the IRB risk-based capital 

formulas; 

(iii) An ongoing process that validates 

the accuracy of the rating assignments, 

segmentations, and risk parameters; 

(iv) A data management and 

maintenance system that supports the 

advanced IRB systems; and 

(v) Oversight and control mechanisms 

that ensure the advanced IRB systems 

are functioning effectively and 

producing accurate results. 

1. Process and Systems Requirements 

One of the objectives of the proposed 

framework is to provide appropriate 

incentives for banks to develop and use 

better techniques for measuring and 

managing their risks. The proposed rule 

specifically requires a bank to have a 

rigorous process for assessing its overall 

capital adequacy in relation to its total 

risk profile and a comprehensive 

strategy for maintaining appropriate 

capital levels. Consistent with Pillar 2 of 

the New Accord, a bank’s primary 

Federal supervisor will evaluate how 

well the bank is assessing its capital 

needs relative to its risks and, if 

deficiencies are identified, will take any 

necessary action to ensure that 

appropriate and prudent levels of 

capital are maintained. 

A bank should address all of its 

material risks in its overall capital 

assessment process. Although not every 

risk can be measured precisely, the 

following risks, at a minimum, should 

be factored into a bank’s capital 

assessment process: credit risk, market 

risk, operational risk, interest rate risk 

in the banking book, liquidity risk, 

concentration risk, reputational risk, 

and strategic risk. With regard to 

interest rate risk in the banking book, 

the agencies note that for some assets—

for example, a long-term mortgage 

loan—interest rate risk may be as great 

as, or greater than, the credit risk of the 

asset. The agencies will continue to 

focus attention on exposures where 

interest rate risk may be significant and 

will foster sound interest rate risk 

measurement and management practices 

across banks. Additionally, because 

credit risk concentrations can pose 

substantial risk to a bank that might be 

managing individual credits in a 

satisfactory manner, a bank also should 

give proper attention to such 

concentrations. 

Banks already are required to hold 

capital sufficient to meet their risk 

profiles, and existing rules allow 

Federal supervisors to require a bank to 

increase its capital if its current capital 

levels are deficient or some element of 

its business practices suggests the need 

for more capital. Existing supervisory 

guidance directs banks to meaningfully 

tie the identification, monitoring, and 

evaluation of risk to the determination 

of the bank’s capital needs. Banks are 

expected to implement and continually 

update the fundamental elements of a 

sound internal capital adequacy 

analysis—identifying and measuring all 

material risks, setting capital adequacy 

goals that relate to risk, and assessing 

conformity to the bank’s stated 

objectives. The agencies expect that all 

banks operating under the advanced 

approaches would address specific 

assumptions embedded in the advanced 

approaches (such as diversification in 

credit portfolios), and would evaluate 

these banks, in part, on their ability to 

account for deviations from the 

underlying assumptions in their own 

portfolios. 

As noted, each core or opt-in bank 

would apply the advanced approaches 

for risk-based capital purposes at the 

consolidated top-tier legal entity level 

(that is, either the top-tier BHC or toptier DI that is a core or opt-in bank) and 

at the level of each DI that is a 

subsidiary of such a top-tier legal entity. 

Thus, each bank that applies the 

advanced approaches must have an 

appropriate infrastructure with risk 

measurement and management 

processes that meet the proposed rule’s 

qualification requirements and that are 

appropriate given the bank’s size and 

level of complexity. Regardless of 

whether the systems and models that 

generate the risk parameters necessary 

for calculating a bank’s risk-based 

capital requirements are located at any 

affiliate of the bank, each legal entity 

that applies the advanced approaches 

must ensure that the risk parameters 

(that is, PD, ELGD, LGD, EAD, and M) 

and reference data used to determine its 

risk-based capital requirements are 

representative of its own credit and 

operational risk exposures. 

The proposed rule also requires that 

the systems and processes that an 

advanced approaches bank uses for riskbased capital purposes must be 

sufficiently consistent with the bank’s 

internal risk management processes and 

management information reporting 

systems such that data from the latter 

processes and systems can be used to 

verify the reasonableness of the inputs 

the bank uses for risk-based capital 

purposes. 

2. Risk Rating and Segmentation 

Systems for Wholesale and Retail 

Exposures 

To implement the IRB framework, a 

bank must have internal risk rating and 

segmentation systems that accurately 

and reliably differentiate between 

degrees of credit risk for wholesale and 

retail exposures. As described below, 

wholesale exposures include most 

credit exposures to companies, 

sovereigns, and governmental entities, 

as well as some exposures to 

individuals. Retail exposures include 

most credit exposures to individuals 

and small businesses that are managed 

as part of a segment of exposures with 

homogeneous risk characteristics. 

Together, wholesale and retail 


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25As explained below, a bank that chooses not to 

use an internal risk rating system for ELGD and 

LGD for a wholesale exposure must directly assign 

an ELGD and LGD estimate to the wholesale 

exposure. 

exposures cover most credit exposures 

of banks. 

To differentiate among degrees of 

credit risk, a bank must be able to make 

meaningful and consistent distinctions 

among credit exposures along two 

dimensions—default risk and loss 

severity in the event of a default. In 

addition, a bank must be able to assign 

wholesale obligors to rating grades that 

approximately reflect likelihood of 

default and must be able to assign 

wholesale exposures to rating grades (or 

ELGD and LGD estimates) that 

approximately reflect the loss severity 

expected in the event of default. As 

discussed below, the proposed rule 

requires banks to treat wholesale 

exposures differently from retail 

exposures when differentiating among 

degrees of credit risk. 

Wholesale exposures. For wholesale 

exposures, a bank must have an internal 

risk rating system that indicates the 

likelihood of default of each individual 

obligor and may use an internal risk 

rating system that indicates the 

economic loss rate upon default of each 

individual exposure.25 A bank would 

assign an internal risk rating to each 

wholesale obligor, which should reflect 

the obligor’s PD—that is, its long-run 

average one-year default rate over a 

reasonable mix of economic conditions. 

PD is defined in more detail below. 

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, nonfinancial contingencies (for example, 

labor problems and environmental 

issues), and the quality of the obligor’s 

management based on an evaluation of 

management’s ability to make realistic 

projections, management’s track record 

in meeting projections, and 

management’s ability to effectively deal 

with changes in the economy and the 

competitive environment. 

A bank must assign each legal entity 

wholesale obligor to a single rating 

grade. Accordingly, if a single wholesale 

exposure of the bank to an obligor 

triggers the proposed rule’s definition of 

default, all of the bank’s wholesale 

exposures to that obligor are in default 

for risk-based capital purposes. In 

addition, a bank may not consider the 

value of collateral pledged to support a 

particular wholesale exposure (or any 

other exposure-specific characteristics) 

when assigning a rating to the obligor of 

the exposure, even in the context of 

nonrecourse loans and other loans 

underwritten primarily based on the 

operating income or cash flows from 

real estate collateral. A bank may, of 

course, consider all available financial 

information about the obligor—

including, where applicable, the total 

operating income or cash flows from all 

of the obligor’s projects or businesses—

when assigning an obligor rating. 

Question 13: The agencies seek 

comment on this aspect of the proposed 

rule and on any circumstances under 

which it would be appropriate to assign 

different obligor ratings to different 

exposures to the same obligor (for 

example, income-producing property 

lending or exposures involving transfer 

risk). 

A bank’s rating system must have at 

least seven discrete (non-overlapping) 

obligor grades for non-defaulted obligors 

and at least one obligor grade for 

defaulted obligors. The agencies believe 

that because the risk-based capital 

requirement of a wholesale exposure is 

directly linked to its obligor rating 

grade, a bank must have at least seven 

non-overlapping obligor grades to 

sufficiently differentiate the 

creditworthiness of non-defaulted 

wholesale obligors. 

A bank would capture the estimated 

loss severity upon default for a 

wholesale exposure either by directly 

assigning an ELGD and LGD estimate to 

the exposure or by grouping the 

exposure with other wholesale 

exposures into loss severity rating 

grades (reflecting the bank’s estimate of 

the ELGD or LGD of the exposure). The 

LGD of an exposure is an estimate of the 

economic loss rate on the exposure, 

taking into account related material 

costs and recoveries, in the event of the 

obligor’s default during a period of 

economic downturn conditions. LGD is 

described in more detail below. 

Whether a bank chooses to assign ELGD 

and LGD values directly or, 

alternatively, to assign exposures to 

rating grades and then quantify the 

ELGD or LGD, as appropriate, for the 

rating grades, the key requirement is 

that the bank must identify exposure 

characteristics that influence ELGD and 

LGD. Each of the loss severity rating 

grades would be associated with an 

empirically supported ELGD or LGD 

estimate. Banks employing loss severity 

grades must have a sufficiently granular 

loss severity grading system to avoid 

grouping together exposures with 

widely ranging ELGDs or LGDs. 

Retail exposures. To implement the 

advanced approach for retail exposures, 

a bank must have an internal system 

that segments its retail exposures to 

differentiate accurately and reliably 

among degrees of credit risk. The most 

significant difference between the 

proposed rule’s treatment of wholesale 

and retail exposures is that the risk 

parameters for retail exposures are not 

assigned at the individual exposure 

level. Banks typically manage retail 

exposures on a segment basis, where 

each segment contains exposures with 

similar risk characteristics. Therefore, a 

key characteristic of the proposed rule’s 

retail framework is that the risk 

parameters for retail exposures would 

be assigned to segments of exposures 

rather than to individual exposures. 

Under the retail framework, a bank 

would group its retail exposures into 

segments with homogeneous risk 

characteristics and then estimate PD, 

ELGD, and LGD for each segment. 

A bank must first group its retail 

exposures into three separate 

subcategories: (i) Residential mortgage 

exposures; (ii) QREs; and (iii) other 

retail exposures. The bank would then 

classify the retail exposures in each 

subcategory into segments to produce a 

meaningful differentiation of risk. The 

proposed rule requires banks to segment 

separately (i) defaulted retail exposures 

from non-defaulted retail exposures and 

(ii) retail eligible margin loans for which 

the bank adjusts EAD rather than ELGD 

and LGD to reflect the risk mitigating 

effects of financial collateral from other 

retail eligible margin loans. Otherwise, 

the agencies are not proposing to require 

that banks consider any particular risk 

drivers or employ any minimum 

number of segments in any of the three 

retail subcategories. 

In determining how to segment retail 

exposures within each subcategory for 

the purpose of assigning risk 

parameters, a bank should use a 

segmentation approach that is 

consistent with its approach for internal 

risk assessment purposes and that 

classifies exposures according to 

predominant risk characteristics or 

drivers. Examples of risk drivers could 

include loan-to-value (LTV) ratios, 

credit scores, loan terms and structure 

(for example, interest only or payment 

option adjustable rate mortgages), 

origination channel, geographical 

location of the borrower, and collateral 

type. A bank must be able to 

demonstrate to its primary Federal 


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26FFIEC, ‘‘Uniform Retail Credit Classification 

and Account Management Policy,’’ 65 FR 36903 

(June 12, 2000). 

supervisor that its system assigns 

accurate and reliable PD, ELGD, and 

LGD estimates for each retail segment 

on a consistent basis. 

Definition of default. In the ANPR, the 

agencies proposed to define default for 

a wholesale exposure as either or both 

of the following events: (i) The bank 

determines that the borrower is unlikely 

to pay its obligations to the bank in full, 

without recourse to actions by the bank 

such as the realization of collateral; or 

(ii) the borrower is more than 90 days 

past due on principal or interest on any 

material obligation to the bank. 

A number of commenters encouraged 

the agencies to use a definition of 

default that conforms more closely to 

that used by bank risk managers. Many 

of these commenters recommended that 

the agencies define default as the entry 

into non-accrual status for wholesale 

exposures and the number of days past 

due for retail exposures, or as the entry 

into charge-off status for wholesale and 

retail exposures. The agencies have 

amended the ANPR definitions of 

default to respond to these concerns and 

recognize that the definition of default 

in this proposed rule is different from 

the definitions that are being 

implemented in other jurisdictions. 

Under the proposed rule’s definition 

of default, a bank’s wholesale obligor 

would be in default if, for any credit 

exposure of the bank to the obligor, the 

bank has (i) placed the exposure on nonaccrual status consistent with the Call 

Report Instructions or the Thrift 

Financial Report and the Thrift 

Financial Report Instruction Manual; (ii) 

taken a full or partial charge-off or 

write-down on the exposure due to the 

distressed financial condition of the 

obligor; or (iii) incurred a credit-related 

loss of 5 percent or more of the 

exposure’s initial carrying value in 

connection with the sale of the exposure 

or the transfer of the exposure to the 

held-for-sale, available-for-sale, trading 

account, or other reporting category. 

Under the proposed definition, a 

wholesale exposure to an obligor 

remains in default until the bank has 

reasonable assurance of repayment and 

performance for all contractual 

principal and interest payments on all 

exposures of the bank to the obligor 

(other than exposures that have been 

fully written-down or charged-off). The 

agencies would expect a bank to employ 

standards for determining whether it 

has a reasonable assurance of repayment 

and performance that are similar to 

those for determining whether to restore 

a loan from non-accrual to accrual 

status. 

When a bank sells a set of wholesale 

exposures, the bank must examine the 

sale prices of the individual exposures 

contained in the set and evaluate 

whether a credit loss of 5 percent or 

more of the exposure’s initial carrying 

value has occurred on any given 

exposure. Write-downs of securities that 

are not credit-related (for example, a 

write-down that is due to a change in 

market interest rates) would not be a 

default event. 

Question 14: The agencies seek 

comment on this proposed definition of 

default and on how well it captures 

substantially all of the circumstances 

under which a bank could experience a 

material credit-related economic loss on 

a wholesale exposure. In particular, the 

agencies seek comment on the 

appropriateness of the 5 percent credit 

loss threshold for exposures sold or 

transferred between reporting 

categories. The agencies also seek 

commenters’ views on specific issues 

raised by applying different definitions 

of default in multiple national 

jurisdictions and on ways to minimize 

potential regulatory burden, including 

use of the definition of default in the 

New Accord, keeping in mind that 

national bank supervisory authorities 

must adopt default definitions that are 

appropriate in light of national banking 

practices and conditions. 

In response to comments on the 

ANPR, the agencies propose to define 

default for retail exposures according to 

the timeframes for loss classification 

that banks generally use for internal 

purposes and that are embodied in the 

FFIEC’s Uniform Retail Credit 

Classification and Account Management 

Policy.26 Specifically, revolving retail 

exposures and residential mortgages 

would be in default at 180 days past 

due; other retail exposures would be in 

default at 120 days past due. In 

addition, a retail exposure would be in 

default if the bank has taken a full or 

partial charge-off or write-down of 

principal on the exposure for creditrelated reasons. Such an exposure 

would remain in default until the bank 

has reasonable assurance of repayment 

and performance for all contractual 

principal and interest payments on the 

exposure. 

The proposed definition of default for 

retail exposures differs from the 

proposed definition for the wholesale 

portfolio in several important respects. 

First, the proposed retail default 

definition applies on an exposure-byexposure basis (rather than, as is the 

case for wholesale exposures, on an 

obligor-by-obligor basis). In other words, 

default on one retail exposure would 

not require a bank to treat all other 

obligations of the same obligor to the 

bank as defaulted. This difference 

reflects the fact that banks generally 

manage retail credit risk based on 

segments of similar exposures rather 

than through the assignment of ratings 

to particular obligors. In addition, it is 

quite common for retail borrowers that 

default on some of their obligations to 

continue payment on others. 

Second, the retail definition of 

default, unlike the wholesale definition 

of default, does not include exposures 

placed on non-accrual status. The 

agencies recognize that retail nonaccrual practices vary considerably 

among banks. Accordingly, the agencies 

have determined that removing nonaccrual from the retail definition of 

default would promote greater 

consistency among banks in the 

treatment of retail exposures. 

In addition, the retail definition of 

default, unlike the wholesale definition 

of default, does not explicitly state that 

an exposure is in default if a bank 

incurs credit-related losses of 5 percent 

or more in connection with the sale of 

the exposure. Because of the large 

number of diverse retail exposures that 

banks usually sell in a single 

transaction, banks typically do not 

allocate the sales price of a pool of retail 

exposures in such a way as to enable the 

bank to calculate the premium or 

discount on individual retail exposures. 

Although the proposed rule’s definition 

of retail default does not explicitly 

include credit-related losses in 

connection with loan sales, the agencies 

would expect banks to assess carefully 

the impact of retail exposure sales in 

quantifying the risk parameters 

calculated by the bank for its retained 

retail exposures. 

Rating philosophy. A bank must 

explain to its primary Federal 

supervisor its rating philosophy—that 

is, how the bank’s wholesale obligor 

rating assignments are affected by the 

bank’s choice of the range of economic, 

business, and industry conditions that 

are considered in the obligor rating 

process. The philosophical basis of a 

bank’s ratings system is important 

because, when combined with the credit 

quality of individual obligors, it will 

determine the frequency of obligor 

rating changes in a changing economic 

environment. Rating systems that rate 

obligors based on their ability to 

perform over a wide range of economic, 

business, and industry conditions, 

sometimes described as ‘‘through-thecycle’’ systems, would tend to have 

ratings that migrate more slowly as 

conditions change. Banks that rate 


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obligors based on a more narrow range 

of likely expected conditions (primarily 

on recent conditions), sometimes called 

‘‘point-in-time’’ systems, would tend to 

have ratings that migrate more 

frequently. Many banks will rate 

obligors using an approach that 

considers a combination of the current 

conditions and a wider range of other 

likely conditions. In any case, the bank 

would need to specify the rating 

philosophy used and establish a policy 

for the migration of obligors from one 

rating grade to another in response to 

economic cycles. A bank should 

understand the effects of ratings 

migration on its risk-based capital 

requirements and ensure that sufficient 

capital is maintained during all phases 

of the economic cycle. 

Rating and segmentation reviews and 

updates. A bank must have a policy that 

ensures that each wholesale obligor 

rating and (if applicable) wholesale 

exposure loss severity rating reflects 

current information. A bank’s internal 

risk rating system for wholesale 

exposures must provide for the review 

and update (as appropriate) of each 

obligor rating and (if applicable) loss 

severity rating whenever the bank 

receives new material information, but 

no less frequently than annually. A 

bank’s retail exposure segmentation 

system must provide for the review and 

update (as appropriate) of assignments 

of retail exposures to segments 

whenever the bank receives new 

material information, but no less 

frequently than quarterly. 

3. Quantification of Risk Parameters for 

Wholesale and Retail Exposures 

A bank must have a comprehensive 

risk parameter quantification process 

that produces accurate, timely, and 

reliable estimates of the risk 

parameters—PD, ELGD, LGD, EAD, and 

(for wholesale exposures) M—for its 

wholesale obligors and exposures and 

retail exposures. Statistical methods and 

models used to develop risk parameter 

estimates, as well as any adjustments to 

the estimates or empirical default data, 

should be transparent, well supported, 

and documented. The following 

sections of the preamble discuss the 

proposed rule’s definitions of the risk 

parameters for wholesale and retail 

exposures. 

Probability of default (PD). As noted 

above, under the proposed rule, a bank 

must assign each of its wholesale 

obligors to an internal rating grade and 

then must associate a PD with each 

rating grade. PD for a wholesale 

exposure to a non-defaulted obligor 

would be the bank’s empirically based 

best estimate of the long-run average of 

one-year default rates for the rating 

grade assigned by the bank to the 

obligor, capturing the average default 

experience for obligors in the rating 

grade over a mix of economic conditions 

(including economic downturn 

conditions) sufficient to provide a 

reasonable estimate of the average oneyear default rate over the economic 

cycle for the rating grade. This estimate 

of the long-run average PD is converted 

into an estimate of PD under economic 

downturn conditions as part of the IRB 

risk-based capital formulas. 

In addition, under the proposed rule, 

a bank must assign a PD to each segment 

of retail exposures. The proposed rule 

provides two different definitions of the 

PD of a segment of non-defaulted retail 

exposures based on the materiality of 

seasoning effects for the segment or for 

the segment’s retail exposure 

subcategory. Some types of retail 

exposures display a distinct seasoning 

pattern—that is, the exposures have 

relatively low default rates in their first 

year, rising default rates in the next few 

years, and declining default rates for the 

remainder of their terms. A bank must 

use a separate definition of PD that 

addresses seasoning effects for a 

segment of non-defaulted retail 

exposures unless the bank has 

determined that seasoning effects are 

not material for the segment or for the 

segment’s entire retail exposure 

subcategory. 

The proposed rule provides a 

definition of PD for segments of nondefaulted retail exposures where 

seasoning is not a material 

consideration that tracks closely the 

wholesale PD definition. Specifically, 

PD for a segment of non-defaulted retail 

exposures for which seasoning effects 

are not material, or for a segment of nondefaulted retail exposures in a retail 

exposure subcategory for which 

seasoning effects are not material, 

would be the bank’s empirically based 

best estimate of the long-run average of 

one-year default rates for the exposures 

in the segment, capturing the average 

default experience for exposures in the 

segment over a mix of economic 

conditions (including economic 

downturn conditions) sufficient to 

provide a reasonable estimate of the 

average one-year default rate over the 

economic cycle for the segment. Banks 

that use this PD formulation for a 

segment of retail exposures should be 

able to demonstrate to their primary 

Federal supervisor, using empirical 

data, why seasoning effects are not 

material for the segment or the retail 

exposure subcategory in which the 

segment resides. 

Because of the one-year IRB horizon, 

the agencies are proposing a different 

PD definition for retail segments with 

material seasoning effects. Under the 

proposed rule, PD for a segment of nondefaulted retail exposures for which 

seasoning effects are material would be 

the bank’s empirically based best 

estimate of the annualized cumulative 

default rate over the expected remaining 

life of exposures in the segment, 

capturing the average default experience 

for exposures in the segment over a mix 

of economic conditions (including 

economic downturn conditions) to 

provide a reasonable estimate of the 

average performance over the economic 

cycle for the segment. A bank’s PD 

estimates for these retail segments with 

material seasoning effects also should 

reflect potential changes in the expected 

remaining life of exposures in the 

segment over the economic cycle. 

For wholesale exposures to defaulted 

obligors and for segments of defaulted 

retail exposures, PD would be 100 

percent. 

Loss given default (LGD) and expected 

loss given default (ELGD). Under the 

proposed rule, a bank must directly 

estimate an ELGD and LGD risk 

parameter for each wholesale exposure 

or must assign each wholesale exposure 

to an expected loss severity grade and 

a downturn loss severity grade, estimate 

an ELGD risk parameter for each 

expected loss severity grade, and 

estimate an LGD risk parameter for each 

loss severity grade. In addition, a bank 

must estimate an ELGD and LGD risk 

parameter for each segment of retail 

exposures. The same ELGD and LGD 

may be appropriate for more than one 

retail segment. 

LGD is an estimate of the economic 

loss that would be incurred on an 

exposure, relative to the exposure’s 

EAD, if the exposure were to default 

within a one-year horizon during 

economic downturn conditions. The 

economic loss amount must capture all 

material credit-related losses on the 

exposure (including accrued but unpaid 

interest or fees, losses on the sale of 

repossessed collateral, direct workout 

costs, and an appropriate allocation of 

indirect workout costs). Where positive 

or negative cash flows on a wholesale 

exposure to a defaulted obligor or on a 

defaulted retail exposure (including 

proceeds from the sale of collateral, 

workout costs, and draw-downs of 

unused credit lines) occur after the date 

of default, the economic loss amount 

must reflect the net present value of 

cash flows as of the default date using 

a discount rate appropriate to the risk of 

the exposure. 


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27Under the proposal, ELGD is not the statistical 

expected value of LGD. 

The LGD of some exposures may be 

substantially higher during economic 

downturn conditions than during other 

periods, while for other types of 

exposures it may not. Accordingly, the 

proposed rule requires banks to use an 

LGD estimate that reflects economic 

downturn conditions for purposes of 

calculating the risk-based capital 

requirements for wholesale exposures 

and retail segments; however, the LGD 

of an exposure may never be less than 

the exposure’s ELGD. More specifically, 

banks must produce for each wholesale 

exposure (or downturn loss severity 

rating grade) and retail segment an 

estimate of the economic loss per dollar 

of EAD that the bank would expect to 

incur if default were to occur within a 

one-year horizon during economic 

downturn conditions. The estimate of 

LGD can be thought of as the ELGD plus 

an increase if appropriate to reflect the 

impact of economic downturn 

conditions. 

For the purpose of defining economic 

downturn conditions, the proposed rule 

identifies two wholesale exposure 

subcategories—high-volatility 

commercial real estate (HVCRE) 

wholesale exposures and non-HVCRE 

wholesale exposures (that is, all 

wholesale exposures that are not 

HVCRE exposures)—and three retail 

exposure subcategories—residential 

mortgage exposures, QREs, and other 

retail exposures. The proposed rule 

defines economic downturn conditions 

with respect to an exposure as those 

conditions in which the aggregate 

default rates for the exposure’s entire 

wholesale or retail subcategory held by 

the bank (or subdivision of such 

subcategory selected by the bank) in the 

exposure’s national jurisdiction (or 

subdivision of such jurisdiction selected 

by the bank) are significantly higher 

than average. 

Under this approach, a bank with a 

geographical or industry sector 

concentration in a subcategory of 

exposures may find that information 

relating to a downturn in that 

geographical region or industry sector 

may be more relevant for the bank than 

a general downturn affecting many 

regions or industries. At this time, 

however, the proposed rule does not 

require a bank with a geographical, 

industry sector, or other concentration 

to subdivide exposure subcategories or 

national jurisdictions to reflect such 

concentrations; rather, the proposed 

rule allows banks to subdivide exposure 

subcategories or national jurisdictions 

as they deem appropriate given the 

exposures held by the bank. The 

agencies understand that downturns in 

particular geographical subdivisions of 

national jurisdictions or in particular 

industrial sectors may result in 

significantly increased loss rates in 

material subdivisions of a bank’s 

exposures in an exposure subcategory. 

Question 15: In light of the possibility of 

significantly increased loss rates at the 

subdivision level due to downturn 

conditions in the subdivision, the 

agencies seek comment on whether to 

require banks to determine economic 

downturn conditions at a more granular 

level than an entire wholesale or retail 

exposure subcategory in a national 

jurisdiction. 

The proposed rule provides banks two 

methods of generating LGD estimates for 

wholesale and retail exposures. First, a 

bank may use its own estimates of LGD 

for a subcategory of exposures if the 

bank has prior written approval from its 

primary Federal supervisor to use 

internal estimates for that subcategory of 

exposures. In approving a bank’s use of 

internal estimates of LGD, a bank’s 

primary Federal supervisor will 

consider whether the bank’s internal 

estimates of LGD are reliable and 

sufficiently reflective of economic 

downturn conditions. The supervisor 

will also consider whether the bank has 

rigorous and well-documented policies 

and procedures for identifying 

economic downturn conditions for the 

exposure subcategory, identifying 

material adverse correlations between 

the relevant drivers of default rates and 

loss rates given default, and 

incorporating identified correlations 

into internal LGD estimates. If a bank 

has supervisory approval to use its own 

estimates of LGD for an exposure 

subcategory, it must use its own 

estimates of LGD for all exposures 

within that subcategory. 

As noted above, the LGD of an 

exposure or segment may never be less 

than the ELGD of that exposure or 

segment. The proposed rule defines the 

ELGD of a wholesale exposure as the 

bank’s empirically-based best estimate 

of the default-weighted average 

economic loss per dollar of EAD the 

bank expects to incur in the event that 

the obligor of the exposure (or a typical 

obligor in the loss severity grade 

assigned by the bank to the exposure) 

defaults within a one-year horizon.27

For a segment of retail exposures, ELGD 

is the bank’s empirically-based best 

estimate of the default-weighted average 

economic loss per dollar of EAD the 

bank expects to incur on exposures in 

the segment that default within a oneyear horizon. ELGD estimates must 

incorporate a mix of economic 

conditions (including economic 

downturn conditions). For example, 

given appropriate data, the ELGD could 

be estimated by calculating the defaultweighted average economic loss per 

dollar of EAD given default for 

exposures in a particular loss severity 

grade or segment observed over a 

complete credit cycle. 

As an alternative to internal estimates 

of LGD, the proposed rule provides a 

supervisory mapping function for 

converting ELGD into LGD for riskbased capital purposes. Although the 

agencies encourage banks to develop 

internal LGD estimates, the agencies are 

aware that it may be difficult at this 

time and in the near future for banks to 

produce internal estimates of LGD that 

are sufficient for risk-based capital 

purposes because LGD data for 

important portfolios may be sparse, and 

there is very limited industry 

experience with incorporating 

downturn conditions into LGD 

estimates. Accordingly, under the 

proposed rule, a bank that does not 

qualify for use of its own estimates of 

LGD for a subcategory of exposures 

must instead compute LGD by applying 

a supervisory mapping function to its 

internal estimates of ELGD for such 

exposures. The bank would adjust its 

ELGDs upward to LGDs using the linear 

supervisory mapping function: LGD = 

0.08 + 0.92 x ELGD. Under this mapping 

function, for example, an ELGD of 0 

percent is converted to an LGD of 8 

percent, an ELGD of 20 percent is 

converted to an LGD of 26.4 percent, 

and an ELGD of 50 percent is converted 

to an LGD of 54 percent. A bank would 

not have to apply the supervisory 

mapping function to repo-style 

transactions, eligible margin loans, and 

OTC derivative contracts (defined below 

in section V.C. of the preamble). For 

these exposures, the agencies believe 

that the difference between a bank’s 

estimate of LGD and its estimate of 

ELGD is likely to be small. Instead a 

bank would set LGD equal to ELGD for 

these exposures. 

As noted, the proposed rule would 

permit a bank to use the supervisory 

mapping function to translate ELGDs to 

LGDs and would only permit a bank to 

use its own estimates of LGD for an 

exposure subcategory if the bank has 

received prior written approval from its 

primary Federal supervisor. The 

agencies also are considering whether to 

require every bank, as a condition to 

qualifying for use of the advanced 

approaches, to be able to produce 

credible and reliable internal estimates 

of LGD for all its wholesale and retail 

exposures. Under this stricter approach, 

a bank that is unable to demonstrate to 


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28To illustrate, suppose that for a particular assetbased lending exposure, the EAD equaled $100 and 

that for every $1 owed by the obligor at the time 

of default, the bank’s recovery would be $0.40. 

Furthermore, suppose that in the event of default, 

within a one-year horizon, pre-default paydowns of 

$20 would reduce the exposure amount to $80 at 

the time of default. In this case, the bank’s 

economic loss rate measured relative to the amount 

owed at default (60%) would exceed the economic 

loss rate measured relative to EAD (48% = 60% × 

($100 ¥ $20)/$100), because the former does not 

reflect fully the impact of the pre-default paydowns. 

29 ‘‘Net accrued but unpaid interest and fees’’ are 

accrued but unpaid interest and fees net of any 

amount expensed by the bank as uncollectable. 

its primary Federal supervisor that it 

could produce credible and reliable 

internal estimates of LGD would not be 

permitted to use the advanced 

approaches. 

Question 16: The agencies seek 

comment on and supporting empirical 

analysis of (i) the proposed rule’s 

definitions of LGD and ELGD; (ii) the 

proposed rule’s overall approach to LGD 

estimation; (iii) the appropriateness of 

requiring a bank to produce credible 

and reliable internal estimates of LGD 

for all its wholesale and retail exposures 

as a precondition for using the 

advanced approaches; (iv) the 

appropriateness of requiring all banks to 

use a supervisory mapping function, 

rather than internal estimates, for 

estimating LGDs, due to limited data 

availability and lack of industry 

experience with incorporating economic 

downturn conditions in LGD estimates; 

(v) the appropriateness of the proposed 

supervisory mapping function for 

translating ELGD into LGD for all 

portfolios of exposures and possible 

alternative supervisory mapping 

functions; (vi) exposures for which no 

mapping function would be appropriate; 

and (vii) exposures for which a more 

lenient (that is, producing a lower LGD 

for a given ELGD) or more strict (that is, 

producing a higher LGD for a given 

ELGD) mapping function may be 

appropriate (for example, residential 

mortgage exposures and HVCRE 

exposures). 

The agencies are concerned that some 

approaches to ELGD or LGD 

quantification could produce estimates 

that are pro-cyclical, particularly if 

these estimates are based on economic 

indicators, such as frequently updated 

loan-to-value (LTV) ratios, that are 

highly sensitive to current economic 

conditions. Question 17: The agencies 

seek comment on the extent to which 

ELGD or LGD estimates under the 

proposed rule would be pro-cyclical, 

particularly for longer-term secured 

exposures. The agencies also seek 

comment on alternative approaches to 

measuring ELGDs or LGDs that would 

address concerns regarding potential 

pro-cyclicality without imposing undue 

burden on banks. 

This proposed rule incorporates 

comments on the ANPR suggesting a 

need to better accommodate certain 

credit products, most prominently assetbased lending programs, whose 

structures typically result in a bank 

recovering substantial amounts of the 

exposure prior to the default date—for 

example, through paydowns of 

outstanding principal. The agencies 

believe that actions taken prior to 

default to mitigate losses are an 

important component of a bank’s overall 

credit risk management, and that such 

actions should be reflected in ELGD and 

LGD when banks can quantify their 

effectiveness in a reliable manner. In the 

proposed rule, this is achieved by 

measuring ELGD and LGD relative to the 

exposure’s EAD (defined in the next 

section) as opposed to the amount 

actually owed at default.28

In practice, the agencies would expect 

methods for estimating ELGD and LGD, 

and the way those methods reflect 

changes in exposure during the period 

prior to default, to be consistent with 

other aspects of the proposed rule. For 

example, a default horizon that is longer 

than one year could result in lower 

estimates of economic loss due to 

greater contractual amortization prior to 

default, or a greater likelihood that 

covenants would enable a bank to 

accelerate paydowns of principal as the 

condition of an obligor deteriorates, but 

such long horizons could be 

inconsistent with the one-year default 

horizon incorporated in other aspects of 

this proposed rule, such as the 

quantification of PD. 

The agencies intend to limit 

recognition of the impact on ELGD and 

LGD of pre-default paydowns to certain 

types of exposures where the pattern is 

common, measurable, and especially 

significant, as with various types of 

asset-based lending. In addition, not all 

paydowns during the period prior to 

default warrant recognition as part of 

the recovery process. For example, a 

pre-default reduction in the outstanding 

amount on one exposure may simply 

reflect a refinancing by the obligor with 

the bank, with no reduction in the 

bank’s total exposure to the obligor. 

Question 18: The agencies seek 

comment on the feasibility of 

recognizing such pre-default changes in 

exposure in a way that is consistent with 

the safety and soundness objectives of 

this proposed rule. The agencies also 

seek comment on appropriate 

restrictions to place on any such 

recognition to ensure that the results are 

not counter to the objectives of this 

proposal to ensure adequate capital 

within a more risk-sensitive capital 

framework. In addition, the agencies 

seek comment on whether, for wholesale 

exposures, allowing ELGD and LGD to 

reflect anticipated future contractual 

paydowns prior to default may be 

inconsistent with the proposed rule’s 

imposition of a one-year floor on M (for 

certain types of exposures) or may lead 

to some double-counting of the riskmitigating benefits of shorter maturities 

for exposures not subject to this floor. 

Exposure at default (EAD). Except as 

noted below, EAD for the on-balancesheet component of a wholesale or retail 

exposure means (i) the bank’s carrying 

value for the exposure (including net 

accrued but unpaid interest and fees) 29

less any allocated transfer risk reserve 

for the exposure, if the exposure is heldto-maturity or for trading; or (ii) the 

bank’s carrying value for the exposure 

(including net accrued but unpaid 

interest and fees) less any allocated 

transfer risk reserve for the exposure 

and any unrealized gains on the 

exposure, plus any unrealized losses on 

the exposure, if the exposure is 

available for sale. For the off-balancesheet component of a wholesale or retail 

exposure (other than an OTC derivative 

contract, repo-style transaction, or 

eligible margin loan) in the form of a 

loan commitment or line of credit, EAD 

means the bank’s best estimate of net 

additions to the outstanding amount 

owed the bank, including estimated 

future additional draws of principal and 

accrued but unpaid interest and fees, 

that are likely to occur over the 

remaining life of the exposure assuming 

the exposure were to go into default. 

This estimate of net additions must 

reflect what would be expected during 

a period of economic downturn 

conditions. For the off-balance-sheet 

component of a wholesale or retail 

exposure other than an OTC derivative 

contract, repo-style transaction, eligible 

margin loan, loan commitment, or line 

of credit issued by a bank, EAD means 

the notional amount of the exposure. 

For a segment of retail exposures, 

EAD is the sum of the EADs for each 

individual exposure in the segment. For 

wholesale or retail exposures in which 

only the drawn balance has been 

securitized, the bank must reflect its 

share of the exposures’ undrawn 

balances in EAD. The undrawn balances 

of exposures for which the drawn 

balances have been securitized must be 

allocated between the seller’s and 

investors’ interests on a pro rata basis, 

based on the proportions of the seller’s 

and investors’ shares of the securitized 

drawn balances. For example, if the 


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EAD of a group of securitized exposures’

undrawn balances is $100, and the 

bank’s share (seller’s interest) in the 

securitized exposures is 25 percent, the 

bank must reflect $25 in EAD for the 

undrawn balances. 

The proposed rule contains a special 

treatment of EAD for OTC derivative 

contracts, repo-style transactions, and 

eligible margin loans, which is in 

section 32 of the proposed rule and 

discussed in more detail in section V.C. 

of the preamble. 

General quantification principles. The 

proposed rule requires data used by a 

bank to estimate risk parameters to be 

relevant to the bank’s actual wholesale 

and retail exposures and of sufficient 

quality to support the determination of 

risk-based capital requirements for the 

exposures. For wholesale exposures, 

estimation of the risk parameters must 

be based on a minimum of 5 years of 

default data to estimate PD, 7 years of 

loss severity data to estimate ELGD and 

LGD, and 7 years of exposure amount 

data to estimate EAD. For segments of 

retail exposures, estimation of risk 

parameters must be based on a 

minimum of 5 years of default data to 

estimate PD, 5 years of loss severity data 

to estimate ELGD and LGD, and 5 years 

of exposure amount data to estimate 

EAD. Default, loss severity, and 

exposure amount data must include 

periods of economic downturn 

conditions or the bank must adjust its 

estimates of risk parameters to 

compensate for the lack of data from 

such periods. Banks must base their 

estimates of PD, ELGD, LGD, and EAD 

on the proposed rule’s definition of 

default, and must review at least 

annually and update (as appropriate) 

their risk parameters and risk parameter 

quantification process. 

In all cases, banks would be expected 

to use the best available data for 

quantifying the risk parameters. A bank 

could meet the minimum data 

requirement by using internal data, 

external data, or pooled data combining 

internal data with external data. Internal 

data refers to any data on exposures 

held in a bank’s existing or historical 

portfolios, including data elements or 

information provided by third parties. 

External data refers to information on 

exposures held outside of the bank’s 

portfolio or aggregate information across 

an industry. 

For example, for new lines of business 

where a bank lacks sufficient internal 

data, it must use external data to 

supplement its internal data. The 

agencies recognize that the minimum 

sample period for reference data 

provided in the proposed rule may not 

provide the best available results. A 

longer sample period usually captures 

varying economic conditions better than 

a shorter sample period; in addition, a 

longer sample period will include more 

default observations for ELGD, LGD, and 

EAD estimation. Banks should consider 

using a longer-than-minimum sample 

period when possible. However, the 

potential increase in precision afforded 

by a larger sample should be weighed 

against the potential for diminished 

comparability of older data to the 

existing portfolio; striking the correct 

balance is an important aspect of 

quantitative modeling. 

Both internal and external reference 

data should not differ systematically 

from a bank’s existing portfolio in ways 

that seem likely to be related to default 

risk, loss severity, or exposure at 

default. Otherwise, the derived PD, 

ELGD, LGD, or EAD estimates may not 

be applicable to the bank’s existing 

portfolio. Accordingly, the bank must 

conduct a comprehensive review and 

analysis of reference data at least 

annually to determine the relevance of 

reference data to the bank’s exposures, 

the quality of reference data to support 

PD, ELGD, LGD, and EAD estimates, and 

the consistency of reference data to the 

definition of default contained in the 

proposed rule. Furthermore, a bank 

must have adequate data to estimate risk 

parameters for all its wholesale and 

retail exposures as if they were held to 

maturity, even if some loans are likely 

to be sold or securitized before their 

long-term credit performance can be 

observed. 

As noted above, periods of economic 

downturn conditions must be included 

in the data sample (or adjustments to 

risk parameters must be made). If the 

reference data include data from beyond 

the minimum number of years (to 

capture a period of economic downturn 

conditions or for other valid reasons), 

the reference data need not cover all of 

the intervening years. However, a bank 

should justify the exclusion of available 

data and, in particular, any temporal 

discontinuities in data used. Including 

periods of economic downturn 

conditions increases the size and 

potentially the breadth of the reference 

data set. According to some empirical 

studies, the average loss rate is higher 

during periods of economic downturn 

conditions, such that exclusion of such 

periods would bias ELGD, LGD, or EAD 

estimates downward and unjustifiably 

lower risk-based capital requirements. 

Risk parameter estimates should take 

into account the robustness of the 

quantification process. The assumptions 

and adjustments embedded in the 

quantification process should reflect the 

degree of uncertainty or potential error 

inherent in the process. In practice, a 

reasonable estimation approach likely 

would result in a range of defensible 

risk parameter estimates. The choices of 

the particular assumptions and 

adjustments that determine the final 

estimate, within the defensible range, 

should reflect the uncertainty in the 

quantification process. That is, more 

uncertainty in the process should be 

reflected in the assignment of final risk 

parameter estimates that result in higher 

risk-based capital requirements relative 

to a quantification process with less 

uncertainty. The degree of conservatism 

applied to adjust for uncertainty should 

be related to factors such as the 

relevance of the reference data to a 

bank’s existing exposures, the 

robustness of the models, the precision 

of the statistical estimates, and the 

amount of judgment used throughout 

the process. Margins of conservatism 

need not be added at each step; indeed, 

that could produce an excessively 

conservative result. Instead, the overall 

margin of conservatism should 

adequately account for all uncertainties 

and weaknesses in the quantification 

process. Improvements in the 

quantification process (including use of 

more complete data and better 

estimation techniques) may reduce the 

appropriate degree of conservatism over 

time. 

Judgment will inevitably play a role 

in the quantification process and may 

materially affect the estimates of risk 

parameters. Judgmental adjustments to 

estimates are often necessary because of 

some limitations on available reference 

data or because of inherent differences 

between the reference data and the 

bank’s existing exposures. The bank 

must ensure that adjustments are not 

biased toward optimistically low risk 

parameter estimates. This standard does 

not prohibit individual adjustments that 

result in lower estimates of risk 

parameters, as both upward and 

downward adjustments are expected. 

Individual adjustments are less 

important than broad patterns; 

consistent signs of judgmental decisions 

that lower risk parameter estimates 

materially may be evidence of 

systematic bias, which would not be 

permitted. 

In estimating relevant risk parameters, 

banks should not rely on the possibility 

of U.S. government financial assistance, 

except for the financial assistance that 

the government has legally committed 

to provide. 

4. Optional Approaches That Require 

Prior Supervisory Approval 

A bank that intends to apply the 

internal models methodology to 


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counterparty credit risk, the double 

default treatment for credit risk 

mitigation, the internal assessment 

approach (IAA) for securitization 

exposures to ABCP programs, or the 

internal models approach (IMA) to 

equity exposures must receive prior 

written approval from its primary 

Federal supervisor. The criteria on 

which approval would be based are 

described in the respective sections 

below. 

5. Operational Risk 

A bank must have operational risk 

management processes, data and 

assessment systems, and quantification 

systems that meet the qualification 

requirements in section 22(h) of the 

proposed rule. A bank must have an 

operational risk management function 

independent from business line 

management. The operational risk 

management function is responsible for 

the design, implementation, and 

oversight of the bank’s operational risk 

data and assessment systems, 

operational risk quantification systems, 

and related processes. The roles and 

responsibilities of the operational risk 

management function may vary between 

banks, but must be clearly documented. 

The operational risk management 

function should have organizational 

stature commensurate with the bank’s 

operational risk profile. At a minimum, 

the bank’s operational risk management 

function should ensure the development 

of policies and procedures for the 

explicit management of operational risk 

as a distinct risk to the bank’s safety and 

soundness. 

A bank also must establish and 

document a process to identify, 

measure, monitor, and control 

operational risk in bank products, 

activities, processes, and systems. This 

process should provide for the 

consistent and comprehensive 

collection of the data needed to estimate 

the bank’s exposure to operational risk. 

The process must also ensure reporting 

of operational risk exposures, 

operational loss events, and other 

relevant operational risk information to 

business unit management, senior 

management, and to the board of 

directors (or a designated committee of 

the board). The proposed rule defines 

operational loss events as events that 

result in loss and are associated with 

internal fraud; external fraud; 

employment practices and workplace 

safety; clients, products, and business 

practices; damage to physical assets; 

business disruption and system failures; 

or execution, delivery, and process 

management. A bank’s operational risk 

management processes should reflect 

the scope and complexity of its business 

lines, as well as its corporate 

organizational structure. Each bank’s 

operational risk profile is unique and 

requires a tailored risk management 

approach appropriate for the scale and 

materiality of the operational risks 

present in the bank. 

Operational risk data and assessment 

system. A bank must have an 

operational risk data and assessment 

system that incorporates on an ongoing 

basis the following four elements: 

internal operational loss event data, 

external operational loss event data, 

results of scenario analysis, and 

assessments of the bank’s business 

environment and internal controls. 

These four operational risk elements 

should aid the bank in identifying the 

level and trend of operational risk, 

determining the effectiveness of 

operational risk management and 

control efforts, highlighting 

opportunities to better mitigate 

operational risk, and assessing 

operational risk on a forward-looking 

basis. A bank’s operational risk data and 

assessment system must be structured in 

a manner consistent with the bank’s 

current business activities, risk profile, 

technological processes, and risk 

management processes. 

The proposed rule defines operational 

loss as a loss (excluding insurance or tax 

effects) resulting from an operational 

loss event. Operational losses include 

all expenses associated with an 

operational loss event except for 

opportunity costs, forgone revenue, and 

costs related to risk management and 

control enhancements implemented to 

prevent future operational losses. The 

definition of operational loss is an 

important issue, as it is a critical 

building block in a bank’s calculation of 

its operational risk capital requirement 

under the AMA. More specifically, 

under the proposed rule, the bank’s 

estimate of operational risk exposure—

the basis for determining a bank’s riskweighted asset amount for operational 

risk—is an estimate of aggregate 

operational losses generated by the 

bank’s AMA process. 

The agencies are considering whether 

to define operational loss based solely 

on the effect of an operational loss event 

on a bank’s regulatory capital or to use 

a definition of operational loss that 

incorporates, to a greater extent, 

economic capital concepts. In either 

case, operational losses would continue 

to be determined exclusive of insurance 

and tax effects. 

With respect to most operational loss 

events, the agencies believe that the 

operational loss amount incorporated 

into a bank’s AMA process would be 

substantially the same whether viewed 

from the perspective of its effect on the 

bank’s regulatory capital or an 

alternative approach that more directly 

incorporates economic capital concepts. 

In the case of operational loss events 

associated with premises and other 

fixed assets, however, potential loss 

amounts used in a bank’s estimate of its 

operational risk exposure could be 

considerably different under the two 

approaches. The agencies recognize 

that, for purposes of economic capital 

analysis, banks often use replacement 

cost or market value, and not carrying 

value, to determine the amount of an 

operational loss with respect to fixed 

assets. The use of carrying value would 

be consistent with a definition of 

operational loss that covers a loss 

event’s effect on a bank’s regulatory 

capital, but may not reflect the full 

economic impact of a loss event in the 

case of assets that have a carrying value 

that is different from their market value. 

Further, the agencies recognize that 

there is a potential to double-count all 

or a portion of the risk-based capital 

requirement associated with fixed 

assets. Under section 31(e)(3) of the 

proposed rule, which addresses 

calculation of risk-weighted asset 

amounts for assets that are not included 

in an exposure category, the riskweighted asset amount for a bank’s 

premises will equal the carrying value 

of the premises on the financial 

statements of the bank, determined in 

accordance with generally accepted 

accounting principles (GAAP). A bank’s 

operational risk exposure estimate 

addressing bank premises generally will 

be different than the risk-based capital 

requirement generated under section 

31(e)(3) of the proposed rule and, at 

least in part, will address the same risk 

exposure. 

Question 19: The agencies solicit 

comment on all aspects of the proposed 

treatment of operational loss and, in 

particular, on (i) the appropriateness of 

the proposed definition of operational 

loss; (ii) whether the agencies should 

define operational loss in terms of the 

effect an operational loss event has on 

the bank’s regulatory capital or should 

consider a broader definition based on 

economic capital concepts; and (iii) how 

the agencies should address the 

potential double-counting issue for 

premises and other fixed assets. 

A bank must have a systematic 

process for capturing and using internal 

operational loss event data in its 

operational risk data and assessment 

systems. Consistent with the ANPR, the 

proposed rule defines internal 

operational loss event data for a bank as 

gross operational loss amounts, dates, 


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recoveries, and relevant causal 

information for operational loss events 

occurring at the bank. A bank’s 

operational risk data and assessment 

system must include a minimum 

historical observation period of five 

years of internal operational losses. 

With approval of its primary Federal 

supervisor, however, a bank may use a 

shorter historical observation period to 

address transitional situations such as 

integrating a new business line. A bank 

may refrain from collecting internal 

operational loss event data for 

individual operational losses below 

established dollar threshold amounts if 

the bank can demonstrate to the 

satisfaction of its primary Federal 

supervisor that the thresholds are 

reasonable, do not exclude important 

internal operational loss event data, and 

permit the bank to capture substantially 

all the dollar value of the bank’s 

operational losses. 

A bank also must establish a 

systematic process for determining its 

methodologies for incorporating 

external operational loss event data into 

its operational risk data and assessment 

systems. The proposed rule defines 

external operational loss event data for 

a bank as gross operational loss 

amounts, dates, recoveries, and relevant 

causal information for operational loss 

events occurring at organizations other 

than the bank. External operational loss 

event data may serve a number of 

different purposes in a bank’s 

operational risk data and assessment 

systems. For example, external 

operational loss event data may be a 

particularly useful input in determining 

a bank’s level of exposure to operational 

risk when internal operational loss 

event data are limited. In addition, 

external operational loss event data 

provide a means for the bank to 

understand industry experience and, in 

turn, provide a means for the bank to 

assess the adequacy of its internal 

operational loss event data. 

While internal and external 

operational loss event data provide a 

historical perspective on operational 

risk, it is also important that a bank 

incorporate forward-looking elements in 

its operational risk data and assessment 

systems. Accordingly, a bank must 

incorporate a business environment and 

internal control factor analysis in its 

operational risk data and assessment 

systems to fully assess its exposure to 

operational risk. In principle, a bank 

with strong internal controls in a stable 

business environment would have less 

exposure to operational risk than a bank 

with internal control weaknesses that is 

growing rapidly or introducing new 

products. In this regard, a bank should 

identify and assess the level and trends 

in operational risk and related control 

structures at the bank. These 

assessments should be current, should 

be comprehensive across the bank, and 

should identify the operational risks 

facing the bank. The framework 

established by a bank to maintain these 

risk assessments should be sufficiently 

flexible to accommodate increasing 

complexity, new activities, changes in 

internal control systems, and an 

increasing volume of information. A 

bank must also periodically compare the 

results of its prior business environment 

and internal control factor assessments 

against the bank’s actual operational 

losses incurred in the intervening 

period. 

Similar to business environment and 

internal control factor assessments, the 

results of scenario analysis provide a 

means for a bank to incorporate a 

forward-looking element in its 

operational risk data and assessment 

systems. Under the proposed rule, 

scenario analysis is a systematic process 

of obtaining expert opinions from 

business managers and risk management 

experts to derive reasoned assessments 

of the likelihood and loss impact of 

plausible high-severity operational 

losses that may occur at a bank. A bank 

must establish a systematic process for 

determining its methodologies for 

incorporating scenario analysis into its 

operational risk data and assessment 

systems. As an input to a bank’s 

operational risk data and assessment 

systems, scenario analysis is especially 

relevant for business lines or loss event 

types where internal data, external data, 

and assessments of the business 

environment and internal control factors 

do not provide a sufficiently robust 

estimate of the bank’s exposure to 

operational risk. 

A bank’s operational risk data and 

assessment systems must include 

credible, transparent, systematic, and 

verifiable processes that incorporate all 

four operational risk elements. The bank 

should have clear standards for the 

collection and modification of all 

elements. The bank should combine 

these four elements in a manner that 

most effectively enables it to quantify its 

exposure to operational risk. 

Operational risk quantification 

system. A bank must have an 

operational risk quantification system 

that measures its operational risk 

exposure using its operational risk data 

and assessment systems. The proposed 

rule defines operational risk exposure as 

the 99.9th percentile of the distribution 

of potential aggregate operational losses, 

as generated by the bank’s operational 

risk quantification system over a oneyear horizon (and not incorporating 

eligible operational risk offsets or 

qualifying operational risk mitigants). 

The mean of such a total loss 

distribution is the bank’s EOL. The 

proposed rule defines EOL as the 

expected value of the distribution of 

potential aggregate operational losses, as 

generated by the bank’s operational risk 

quantification system using a one-year 

horizon. The bank’s UOL is the 

difference between the bank’s 

operational risk exposure and the bank’s 

EOL. 

As part of its estimation of its 

operational risk exposure, a bank must 

demonstrate that its unit of measure is 

appropriate for the bank’s range of 

business activities and the variety of 

operational loss events to which it is 

exposed. The proposed rule defines a 

unit of measure as the level (for 

example, organizational unit or 

operational loss event type) at which the 

bank’s operational risk quantification 

system generates a separate distribution 

of potential operational losses. A bank 

must also demonstrate that it has not 

combined business activities or 

operational loss events with different 

risk profiles within the same loss 

distribution. 

The agencies recognize that 

operational losses across operational 

loss event types and business lines may 

be related. A bank may use its internal 

estimates of dependence among 

operational losses within and across 

business lines and operational loss 

event types if the bank can demonstrate 

to the satisfaction of its primary Federal 

supervisor that its process for estimating 

dependence is sound, robust to a variety 

of scenarios, and implemented with 

integrity, and allows for the uncertainty 

surrounding the estimates. The agencies 

expect that a bank’s assumptions 

regarding dependence will be 

conservative given the uncertainties 

surrounding dependence modeling for 

operational risk. If a bank does not 

satisfy the requirements surrounding 

dependence described above, the bank 

must sum operational risk exposure 

estimates across units of measure to 

calculate its operational risk exposure. 

A bank’s chosen unit of measure 

affects how it should account for 

dependence. Explicit assumptions 

regarding dependence across units of 

measure are always necessary to 

estimate operational risk exposure at the 

bank level. However, explicit 

assumptions regarding dependence 

within units of measure are not 

necessary, and under many 

circumstances models assume statistical 

independence within each unit of 

measure. The use of only a few units of 


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

measure heightens the need to ensure 

that dependence within units of 

measure is suitably reflected in the 

operational risk exposure estimate. 

In addition, the bank’s process for 

estimating dependence should provide 

for ongoing monitoring, recognizing that 

dependence estimates can change. The 

agencies expect that a bank’s approach 

for developing explicit and objective 

dependence determinations will 

improve over time. As such, the bank 

should develop a process for assessing 

incremental improvements to the 

approach (for example, through out-ofsample testing). 

A bank must review and update (as 

appropriate) its operational risk 

quantification system whenever the 

bank becomes aware of information that 

may have a material effect on the bank’s 

estimate of operational risk exposure, 

but no less frequently than annually. 

As described above, the agencies 

expect a bank using the AMA to 

demonstrate that its systems for 

managing and measuring operational 

risk meet established standards, 

including producing an estimate of 

operational risk exposure at the 99.9 

percent confidence level. However, the 

agencies recognize that, in limited 

circumstances, there may not be 

sufficient data available for a bank to 

generate a credible estimate of its own 

operational risk exposure at the 99.9 

percent confidence level. In these 

limited circumstances, a bank may 

propose use of an alternative 

operational risk quantification system to 

that specified in section 22(h)(3)(i) of 

the proposed rule, subject to approval 

by the bank’s primary Federal 

supervisor. The alternative approach is 

not available at the BHC level. 

The agencies are not prescribing 

specific estimation methodologies under 

this approach and expect use of an 

alternative approach to occur on a very 

limited basis. A bank proposing to use 

an alternative operational risk 

quantification system must submit a 

proposal to its primary Federal 

supervisor. In evaluating a bank’s 

proposal, the bank’s primary Federal 

supervisor will review the bank’s 

justification for requesting use of an 

alternative approach in light of the 

bank’s size, complexity, and risk profile. 

The bank’s primary Federal supervisor 

will also consider whether the proposed 

approach results in capital levels that 

are commensurate with the bank’s 

operational risk profile, is sensitive to 

changes in the bank’s risk profile, can be 

supported empirically, and allows the 

bank’s board of directors to fulfill its 

fiduciary responsibilities to ensure that 

the bank is adequately capitalized. 

Furthermore, the agencies expect a bank 

using an alternative operational risk 

quantification system to adhere to the 

qualification requirements outlined in 

the proposed rule, including 

establishment and use of operational 

risk management processes and data 

and assessment systems. 

A bank proposing an alternative 

approach to operational risk based on an 

allocation methodology should be aware 

of certain limitations associated with 

use of such an approach. Specifically, 

the agencies will not accept an 

allocation of operational risk capital 

requirements that includes non-DI 

entities or the benefits of diversification 

across entities. The exclusion of 

allocations that include non-DIs is in 

recognition that, unlike the crossguarantee provision of the Federal 

Deposit Insurance Act, which provides 

that a DI is liable for any losses incurred 

by the FDIC in connection with the 

failure of a commonly controlled DI, 

there are no statutory provisions 

requiring cross-guarantees between a DI 

and its non-DI affiliates.30 Furthermore, 

depositors and creditors of a DI 

generally have no legal recourse to 

capital funds that are not held by the DI 

or its affiliate DIs. 

6. Data Management and Maintenance 

A bank must have data management 

and maintenance systems that 

adequately support all aspects of the 

bank’s advanced IRB systems, 

operational risk management processes, 

operational risk data and assessment 

systems, operational risk quantification 

systems, and, to the extent the bank uses 

the following systems, the internal 

models methodology to counterparty 

credit risk, double default excessive 

correlation detection process, IMA to 

equity exposures, and IAA to 

securitization exposures to ABCP 

programs (collectively, advanced 

systems). The bank’s data management 

and maintenance systems must ensure 

the timely and accurate reporting of 

risk-based capital requirements. 

Specifically, a bank must retain 

sufficient data elements to permit 

monitoring, validation, and refinement 

of the bank’s advanced systems. A 

bank’s data management and 

maintenance systems should generally 

support the proposed rule’s 

qualification requirements relating to 

quantification, validation, and control 

and oversight mechanisms, as well as 

the bank’s broader risk management and 

reporting needs. The precise data 

elements to be collected would be 

dictated by the features and 

methodologies of the risk measurement 

and management systems employed by 

the bank. To meet the significant data 

management challenges presented by 

the quantification, validation, and 

control and oversight requirements of 

the advanced approaches, a bank must 

store its data in an electronic format that 

allows timely retrieval for analysis, 

reporting, and disclosure purposes. 

7. Control and Oversight Mechanisms 

The consequences of an inaccurate or 

unreliable advanced system can be 

significant, particularly on the 

calculation of risk-based capital 

requirements. Accordingly, bank senior 

management would be responsible for 

ensuring that all advanced system 

components function effectively and are 

in compliance with the qualification 

requirements of the advanced 

approaches. Moreover, the bank’s board 

of directors (or a designated committee 

of the board) must evaluate at least 

annually the effectiveness of, and 

approve, the bank’s advanced systems. 

To support senior management’s and 

the board of directors’ oversight 

responsibilities, a bank must have an 

effective system of controls and 

oversight that ensures ongoing 

compliance with the qualification 

requirements and maintains the 

integrity, reliability, and accuracy of the 

bank’s advanced systems. Banks would 

have flexibility in how they achieve 

integrity in their risk management 

systems. They would, however, be 

expected to follow standard control 

principles in their systems such as 

checks and balances, separation of 

duties, appropriateness of incentives, 

and data integrity assurance, including 

that of information purchased from 

third parties. Moreover, the oversight 

process should be sufficiently 

independent of the advanced systems’

development, implementation, and 

operation to ensure the integrity of the 

component systems. The objective of 

risk management system oversight is to 

ensure that the various systems used in 

determining risk-based capital 

requirements are operating as intended. 

The oversight process should draw 

conclusions on the soundness of the 

components of the risk management 

system, identify errors and flaws, and 

recommend corrective action as 

appropriate. 

Validation. A bank must validate its 

advanced systems on an ongoing basis. 

Validation is the set of activities 

designed to give the greatest possible 

assurances of accuracy of the advanced 

systems. Validation includes three 

broad components: (i) Evaluation of the 

conceptual soundness of the advanced 


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systems, taking into account industry 

developments; (ii) ongoing monitoring 

that includes process verification and 

comparison of the bank’s internal 

estimates with relevant internal and 

external data sources or results using 

other estimation techniques 

(benchmarking); and (iii) outcomes 

analysis that includes comparisons of 

actual outcomes to the bank’s internal 

estimates by backtesting and other 

methods. 

Each of these three components of 

validation must be applied to the bank’s 

risk rating and segmentation systems, 

risk parameter quantification processes, 

and internal models that are part of the 

bank’s advanced systems. A sound 

validation process should take business 

cycles into account, and any 

adjustments for stages of the economic 

cycle should be clearly specified in 

advance and fully documented as part 

of the validation policy. Senior 

management of the bank should be 

notified of the validation results and 

should take corrective action, where 

appropriate. 

A bank’s validation process must be 

independent of the advanced systems’

development, implementation, and 

operation, or be subject to independent 

assessment of its adequacy and 

effectiveness. A bank should ensure that 

individuals who perform the review are 

independent—that is, are not biased in 

their assessment due to their 

involvement in the development, 

implementation, or operation of the 

processes or products. For example, 

reviews of the internal risk rating and 

segmentation systems should be 

performed by individuals who were not 

part of the development, 

implementation, or maintenance of 

those systems. In addition, individuals 

performing the reviews should possess 

the requisite technical skills and 

expertise to fulfill their mandate. 

The first component of validation is 

evaluating conceptual soundness, which 

involves assessing the quality of the 

design and construction of a risk 

measurement or management system. 

This evaluation of conceptual 

soundness should include 

documentation and empirical evidence 

supporting the methods used and the 

variables selected in the design and 

quantification of the bank’s advanced 

systems. The documentation should 

also include evidence of an 

understanding of the limitations of the 

systems. The development of internal 

risk rating and segmentation systems 

and their quantification processes 

requires banks to adopt methods, choose 

characteristics, and make adjustments; 

each of these actions requires judgment. 

Validation should ensure that these 

judgments are well informed and 

considered, and generally include a 

body of expert opinion. A bank should 

review developmental evidence 

whenever the bank makes material 

changes in its advanced systems. 

The second component of the 

validation process for a bank’s advanced 

systems is ongoing monitoring to 

confirm that the systems were 

implemented appropriately and 

continue to perform as intended. Such 

monitoring involves process verification 

and benchmarking. Process verification 

includes verifying that internal and 

external data are accurate and complete 

and ensuring that internal risk rating 

and segmentation systems are being 

used, monitored, and updated as 

designed and that ratings are assigned to 

wholesale obligors and exposures as 

intended, and that appropriate 

remediation is undertaken if 

deficiencies exist. 

Benchmarking is the set of activities 

that uses alternative data sources or risk 

assessment approaches to draw 

inferences about the correctness of 

internal risk ratings, segmentations, risk 

parameter estimates, or model outputs 

before outcomes are actually known. For 

credit risk ratings, examples of 

alternative data sources include 

independent internal raters (such as 

loan review), external rating agencies, 

wholesale and retail credit risk models 

developed independently, or retail 

credit bureau models. Because it will 

take considerable time before outcomes 

will be available and backtesting is 

possible, benchmarking will be a very 

important validation device. 

Benchmarking would be applied to all 

quantification processes and internal 

risk rating and segmentation activities. 

Benchmarking allows a bank to 

compare its estimates with those of 

other estimation techniques and data 

sources. Results of benchmarking 

exercises can be a valuable diagnostic 

tool in identifying potential weaknesses 

in a bank’s risk quantification system. 

While benchmarking activities allow for 

inferences about the appropriateness of 

the quantification processes and 

internal risk rating and segmentation 

systems, they are not the same as 

backtesting. When differences are 

observed between the bank’s risk 

estimates and the benchmark, this 

should not necessarily indicate that the 

internal risk ratings, segmentation 

decisions, or risk parameter estimates 

are in error. The benchmark itself is an 

alternative prediction, and the 

difference may be due to different data 

or methods. As part of the 

benchmarking exercise, the bank should 

investigate the source of the differences 

and whether the extent of the 

differences is appropriate. 

The third component of the validation 

process is outcomes analysis, which is 

the comparison of the bank’s forecasts of 

risk parameters and other model outputs 

with actual outcomes. A bank’s 

outcomes analysis must include 

backtesting, which is the comparison of 

the bank’s forecasts generated by its 

internal models with actual outcomes 

during a sample period not used in 

model development. In this context, 

backtesting is one form of out-of-sample 

testing. The agencies note that in other 

contexts backtesting may refer to insample fit, but in-sample fit analysis is 

not what the proposed rule requires a 

bank to do as part of the advanced 

approaches validation process. 

Actual outcomes would be compared 

with expected ranges around the 

estimated values of the risk parameters 

and model results. Random chance and 

many other factors will make 

discrepancies between realized 

outcomes and the estimated risk 

parameters inevitable. Therefore the 

expected ranges should take into 

account relevant elements of a bank’s 

internal risk rating or segmentation 

processes. For example, depending on 

the bank’s rating philosophy, year-byyear realized default rates may be 

expected to differ significantly from the 

long-run one-year average. Also, 

changes in economic conditions 

between the historical data and current 

period can lead to differences between 

realizations and estimates. 

Internal audit. A bank must have an 

internal audit function independent of 

business-line management that assesses 

at least annually the effectiveness of the 

controls supporting the bank’s advanced 

systems. At least annually, internal 

audit should review the validation 

process, including validation 

procedures, responsibilities, results, 

timeliness, and responsiveness to 

findings. Further, internal audit should 

evaluate the depth, scope, and quality of 

the risk management system review 

process and conduct appropriate testing 

to ensure that the conclusions of these 

reviews are well founded. Internal audit 

must report its findings at least annually 

to the bank’s board of directors (or a 

committee thereof). 

Stress testing. A bank must 

periodically stress test its advanced 

systems. Stress testing analysis is a 

means of understanding how economic 

cycles, especially downturns as 

described by stress scenarios, affect riskbased capital requirements, including 

migration across rating grades or 

segments and the credit risk mitigation 


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benefits of double default treatment. 

Under the proposed rule, changes in 

borrower credit quality will lead to 

changes in risk-based capital 

requirements. Because credit quality 

changes typically reflect changing 

economic conditions, risk-based capital 

requirements may also vary with the 

economic cycle. During an economic 

downturn, risk-based capital 

requirements would increase if 

wholesale obligors or retail exposures 

migrate toward lower credit quality 

ratings or segments. 

Supervisors expect that banks will 

manage their regulatory capital position 

so that they remain at least adequately 

capitalized during all phases of the 

economic cycle. A bank that is able to 

credibly estimate regulatory capital 

levels during a downturn can be more 

confident of appropriately managing 

regulatory capital. Stress testing analysis 

consists of identifying a stress scenario 

and then translating the scenario into its 

effect on the levels of key performance 

measures, including regulatory capital 

ratios. 

Banks should use a range of plausible 

but severe scenarios and methods when 

stress testing to manage regulatory 

capital. Scenarios could be historical, 

hypothetical, or model-based. Key 

variables specified in a scenario could 

include, for example, interest rates, 

transition matrices (ratings and scoreband 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 subportfolios. The severity of the stress 

scenarios should be consistent with the 

periodic economic downturns 

experienced in the bank’s market areas. 

Such scenarios may be less severe than 

those used for other purposes, such as 

testing a bank’s solvency. 

The scope of stress testing analysis 

should be broad and include all material 

portfolios. The time horizon of the 

analysis should be consistent with the 

specifics of the scenario and should be 

long enough to measure the material 

effects of the scenario on key 

performance measures. For example, if 

a scenario such as a historical recession 

has material income and segment or 

ratings migration effects over two years, 

the appropriate time horizon is at least 

two years. 

8. Documentation 

A bank must document adequately all 

material aspects of its advanced 

systems, including but not limited to the 

internal risk rating and segmentation 

systems, risk parameter quantification 

processes, model design, assumptions, 

and validation results. The guiding 

principle governing documentation is 

that it should support the requirements 

for the quantification, validation, and 

control and oversight mechanisms as 

well as the bank’s broader risk 

management and reporting needs. 

Documentation is also critical to the 

supervisory oversight process. 

The bank should document the 

rationale for all material assumptions 

underpinning its chosen analytical 

frameworks, including the choice of 

inputs, distributional assumptions, and 

weighting of quantitative and qualitative 

elements. The bank also should 

document and justify any subsequent 

changes to these assumptions. 

C. Ongoing Qualification 

An advanced approaches bank must 

meet the qualification requirements on 

an ongoing basis. Banks are expected to 

improve their advanced systems as they 

improve data gathering capabilities and 

as industry practice evolves. To 

facilitate the supervisory oversight of 

such systems changes, a bank must 

notify its primary Federal supervisor 

when it makes a change to its advanced 

systems that results in a material change 

in the bank’s risk-weighted asset 

amount for an exposure type, or when 

the bank makes any significant change 

to its modeling assumptions. 

Due to the advanced approaches’

rigorous systems requirements, a core or 

opt-in bank that merges with or acquires 

another company that does not calculate 

risk-based capital requirements using 

the advanced approaches might not be 

able to use the advanced approaches 

immediately for the merged or acquired 

company’s exposures. Therefore, the 

proposed rule would permit a core or 

opt-in bank to use the general risk-based 

capital rules to compute the riskweighted assets and associated capital 

for the merged or acquired company’s 

exposures for up to 24 months following 

the calendar quarter during which the 

merger or acquisition consummates. 

Any ALLL associated with the 

acquired company’s exposures may be 

included in the acquiring bank’s tier 2 

capital up to 1.25 percent of the 

acquired company’s risk-weighted 

assets. Such ALLL would be excluded 

from the acquiring bank’s eligible credit 

reserves. The risk-weighted assets of the 

acquired company would not be 

included in the acquiring bank’s creditrisk-weighted assets but would be 

included in the acquiring bank’s total 

risk-weighted assets. Any amount of the 

acquired company’s ALLL that was 

eliminated in accounting for the 

acquisition would not be included in 

the acquiring bank’s regulatory capital. 

An acquiring bank using the general 

risk-based capital rules for acquired 

exposures would be required to disclose 

publicly the amounts of risk-weighted 

assets and qualifying capital calculated 

under the general risk-based capital 

rules with respect to the acquired 

company and under the proposed rule 

for the acquiring bank. 

Similarly, due to the substantial 

infrastructure requirements of the 

proposed rule, a core or opt-in bank that 

merges with or acquires another core or 

opt-in bank might not be able to apply 

its own version of the advanced 

approaches immediately to the acquired 

bank’s exposures. Accordingly, the 

proposed rule permits a core or opt-in 

bank that merges with or acquires 

another core or opt-in bank to use the 

acquired bank’s advanced approaches to 

determine the risk-weighted asset 

amounts for, and deductions from 

capital associated with, the acquired 

bank’s exposures for up to 24 months 

following the calendar quarter during 

which the merger or acquisition 

consummates. 

In all mergers and acquisitions 

involving a core or opt-in bank, the 

acquiring bank must submit an 

implementation plan for using advanced 

approaches for the merged or acquired 

company to its primary Federal 

supervisor within 30 days of 

consummating the merger or 

acquisition. A bank’s primary Federal 

supervisor may extend the transition 

period for mergers or acquisitions for up 

to an additional 12 months. The primary 

Federal supervisor of the bank will 

monitor the merger or acquisition to 

determine whether the application of 

the general risk-based capital rules by 

the acquired company produces 

appropriate risk weights for the assets of 

the acquired company in light of the 

overall risk profile of the combined 

bank. 

Question 20: The agencies seek 

comment on the appropriateness of the 

24-month and 30-day time frames for 

addressing the merger and acquisition 

transition situations advanced 

approaches banks may face. 

If a bank that uses the advanced 

approaches to calculate its risk-based 

capital requirements falls out of 

compliance with the qualification 

requirements, the bank must establish a 

plan satisfactory to its primary Federal 

supervisor to return to compliance with 

the qualification requirements. Such a 

bank also must disclose to the public its 

failure to comply with the qualification 

requirements promptly after receiving 

notice of non-compliance from its 


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31See 12 CFR part 3, Appendix A, § 2 (national 

banks); 12 CFR part 208, Appendix A, § II (state 

member banks); 12 CFR part 225, Appendix A, § II 

(bank holding companies); 12 CFR part 325, 

Appendix A (state nonmember banks); and 12 CFR 

567.5 (savings associations). 

32 If the amount deductible from tier 2 capital 

exceeds the bank’s actual tier 2 capital, however, 

the bank must deduct the shortfall amount from tier 

1 capital. 

33See 12 CFR part 3, § 2 (national banks); 12 CFR 

part 208, Appendix A, § 2L3II (state member banks); 

12 CFR part 225, Appendix A, § II (bank holding 

companies); 12 CFR part 325, Appendix A, § II 

(state nonmember banks). OTS existing rules are 

formulated differently, but include similar 

deductions. Under OTS rules, for example, 

goodwill is included within the definition of 

‘‘intangible assets’’ and is deducted from tier 1 

(core) capital along with other intangible assets. See 

12 CFR 567.1 and 567.5(a)(2)(i). Similarly, 

purchased credit card relationships and mortgage 

and non-mortgage servicing assets are included in 

capital to the same extent as the other agencies’

rules. See 12 CFR 567.5(a)(2)(ii) and 567.12. The 

deduction of deferred tax assets is discussed in 

Thrift Bulletin 56. 

34By contrast, OTS rules require the deduction of 

equity investments from total capital. 12 CFR 

567.5(c)(2)(ii). ‘‘Equity investments’’ are defined to 

include (i) investments in equity securities (other 

than investments in subsidiaries, equity 

investments that are permissible for national banks, 

indirect ownership interests in certain pools of 

assets (for example, mutual funds), Federal Home 

Loan Bank stock and Federal Reserve Bank stock); 

and (ii) investments in certain real property. 12 CFR 

567.1. Savings associations applying the proposed 

rule would not be required to deduct investments 

in equity securities. Instead, such investments 

would be subject to the equity treatment in part VI 

of the proposed rule. Equity investments in real 

estate would continue to be deducted to the same 

extent as under the current rules. 

35 12 U.S.C. 3904 does not apply to savings 

associations regulated by the OTS. As a result, the 

OTS rule will not refer to allocated transfer risk 

reserves. 

primary Federal supervisor. If the bank’s 

primary Federal supervisor determines 

that the bank’s risk-based capital 

requirements are not commensurate 

with the bank’s credit, market, 

operational, or other risks, it may 

require the bank to calculate its riskbased capital requirements using the 

general risk-based capital rules or a 

modified form of the advanced 

approaches (for example, with fixed 

supervisory risk parameters). 

IV. Calculation of Tier 1 Capital and 

Total Qualifying Capital 

The proposed rule maintains the 

minimum risk-based capital ratio 

requirements of 4.0 percent tier 1 capital 

to total risk-weighted assets and 8.0 

percent total qualifying capital to total 

risk-weighted assets. Under the 

proposed rule, a bank’s total qualifying 

capital is the sum of its tier 1 (core) 

capital elements and tier 2 

(supplemental) capital elements, subject 

to various limits and restrictions, minus 

certain deductions (adjustments). The 

agencies are not restating the elements 

of tier 1 and tier 2 capital in this 

proposed rule. Those capital elements 

generally remain as they are currently in 

the general risk-based capital rules.31

The agencies have provided proposed 

regulatory text for, and the following 

discussion of, proposed adjustments to 

the capital elements for purposes of the 

advanced approaches. 

The agencies are considering restating 

the elements of tier 1 and tier 2 capital, 

with any necessary conforming and 

technical amendments, in any final 

rules that are issued regarding this 

proposed framework so that a bank 

using the advanced approaches would 

have a single, comprehensive regulatory 

text that describes both the numerator 

and denominator of the bank’s 

minimum risk-based capital ratios. The 

agencies decided not to set forth the 

capital elements in this proposed rule so 

that commenters would be able to focus 

attention on the parts of the risk-based 

capital framework that the agencies 

propose to amend. Question 21: 

Commenters are encouraged to provide 

views on the proposed adjustments to 

the components of the risk-based capital 

numerator as described below. 

Commenters also may provide views on 

numerator-related issues that they 

believe would be useful to the agencies’

consideration of the proposed rule. 

After identifying the elements of tier 

1 and tier 2 capital, a bank would make 

certain adjustments to determine its tier 

1 capital and total qualifying capital 

(that is, the numerator of the total riskbased capital ratio). Some of these 

adjustments would be made only to the 

tier 1 portion of the capital base. Other 

adjustments would be made 50 percent 

from tier 1 capital and 50 percent from 

tier 2 capital.32 Under the proposed 

rule, a bank must still have at least 50 

percent of its total qualifying capital in 

the form of tier 1 capital. 

The bank would continue to deduct 

from tier 1 capital goodwill, other 

intangible assets, and deferred tax assets 

to the same extent that those assets are 

currently required to be deducted from 

tier 1 capital under the general riskbased capital rules. Thus, all goodwill 

would be deducted from tier 1 capital. 

Qualifying intangible assets—including 

mortgage servicing assets, non-mortgage 

servicing assets, and purchased credit 

card relationships—that meet the 

conditions and limits in the general 

risk-based capital rules would not have 

to be deducted from tier 1 capital. 

Likewise, deferred tax assets that are 

dependent upon future taxable income 

and that meet the valuation 

requirements and limits in the general 

risk-based capital rules would not have 

to be deducted from tier 1 capital.33

Under the general risk-based capital 

rules, a bank also must deduct from its 

tier 1 capital certain percentages of the 

adjusted carrying value of its 

nonfinancial equity investments. An 

advanced approaches bank would no 

longer be required to make this 

deduction. Instead, the bank’s equity 

exposures would be subject to the 

equity treatment in part VI of the 

proposed rule and described in section 

V.F. of this preamble.34

Under the general risk-based capital 

rules, a bank is allowed to include in 

tier 2 capital its ALLL up to 1.25 percent 

of risk-weighted assets (net of certain 

deductions). Amounts of ALLL in 

excess of this limit, as well as allocated 

transfer risk reserves, may be deducted 

from the gross amount of risk-weighted 

assets. 

Under the proposed framework, as 

noted above, the ALLL is treated 

differently. The proposed rule includes 

a methodology for adjusting risk-based 

capital requirements based on a 

comparison of the bank’s eligible credit 

reserves to its ECL. The proposed rule 

defines eligible credit reserves as all 

general allowances, including the ALLL, 

that have been established through a 

charge against earnings to absorb credit 

losses associated with on- or off-balance 

sheet wholesale and retail exposures. 

Eligible credit reserves would not 

include allocated transfer risk reserves 

established pursuant to 12 U.S.C. 390435

and other specific reserves created 

against recognized losses. 

The proposed rule defines a bank’s 

total ECL as the sum of ECL for all 

wholesale and retail exposures other 

than exposures to which the bank has 

applied the double default treatment 

(described below). The bank’s ECL for a 

wholesale exposure to a non-defaulted 

obligor or a non-defaulted retail segment 

is the product of PD, ELGD, and EAD for 

the exposure or segment. The bank’s 

ECL for a wholesale exposure to a 

defaulted obligor or a defaulted retail 

segment is equal to the bank’s 

impairment estimate for ALLL purposes 

for the exposure or segment. 

The proposed method of measuring 

ECL for non-defaulted exposures is 

different than the proposed method of 

measuring ECL for defaulted exposures. 

For non-defaulted exposures, ECL 

depends directly on ELGD and hence 

would reflect economic losses, 

including the cost of carry and direct 

and indirect workout expenses. In 

contrast, for defaulted exposures, ECL is 

based on accounting measures of credit 


sroberts on PROD1PC70 with PROPOSALS
Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55857 

36See 12 CFR part 3, Appendix A, section 2(c)(4) 

(national banks); 12 CFR part 208, Appendix A, 

section I.B.1.c. (state member banks); 12 CFR part 

225, Appendix A, section I.B.1.c. (bank holding 

companies); 12 CFR part 325, Appendix A, section 

I.B.5. (state nonmember banks); 12 CFR 

567.5(a)(2)(iii) (savings associations). 

37See 12 CFR 5.39(h)(1) (national banks); 12 CFR 

208.73(a) (state member banks); 12 CFR part 325, 

Appendix A, section I.B.2. (state nonmember 

banks). Again, OTS rules are formulated differently. 

For example, OTS rules do not use the terms 

‘‘unconsolidated banking and finance subsidiary’’

or ‘‘financial subsidiary.’’ Rather, as required by 

section 5(t)(5) of the Home Owners’ Loan Act 

(HOLA), equity and debt investments in nonincludable 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). 

loss incorporated into a bank’s chargeoff and reserving practices. 

The agencies believe that, for 

defaulted exposures, any difference 

between a bank’s best estimate of 

economic losses and its impairment 

estimate for ALLL purposes is likely to 

be small. As a result, the agencies are 

proposing to use a bank’s ALLL 

impairment estimate in the 

determination of ECL for defaulted 

exposures to reduce implementation 

burden for banks. The agencies 

recognize that this proposed treatment 

would require a bank to specify how 

much of its ALLL is attributable to 

defaulted exposures, and that a bank 

still would need to capture all material 

economic losses on defaulted exposures 

when building its databases for 

estimating ELGDs and LGDs for nondefaulted exposures. Question 22: The 

agencies seek comment on the proposed 

ECL approach for defaulted exposures 

as well as on an alternative treatment, 

under which ECL for a defaulted 

exposure would be calculated as the 

bank’s current carrying value of the 

exposure multiplied by the bank’s best 

estimate of the expected economic loss 

rate associated with the exposure 

(measured relative to the current 

carrying value), that would be more 

consistent with the proposed treatment 

of ECL for non-defaulted exposures. The 

agencies also seek comment on whether 

these two approaches would likely 

produce materially different ECL 

estimates for defaulted exposures. In 

addition, the agencies seek comment on 

the appropriate measure of ECL for 

assets held at fair value with gains and 

losses flowing through earnings. 

A bank must compare the total dollar 

amount of its ECL to its eligible credit 

reserves. If there is a shortfall of eligible 

credit reserves compared to total ECL, 

the bank would deduct 50 percent of the 

shortfall from tier 1 capital and 50 

percent from tier 2 capital. If eligible 

credit reserves exceed total ECL, the 

excess portion of eligible credit reserves 

may be included in tier 2 capital up to 

0.6 percent of credit-risk-weighted 

assets. The proposed rule defines creditrisk-weighted assets as 1.06 multiplied 

by the sum of total wholesale and retail 

risk-weighted assets, risk-weighted 

assets for securitization exposures, and 

risk-weighted assets for equity 

exposures. 

A bank must deduct from tier 1 

capital any increase in the bank’s equity 

capital at the inception of a 

securitization transaction (gain-on-sale), 

other than an increase in equity capital 

that results from the bank’s receipt of 

cash in connection with the 

securitization. The agencies have 

designed this deduction to offset 

accounting treatments that produce an 

increase in a bank’s equity capital and 

tier 1 capital at the inception of a 

securitization—for example, a gain 

attributable to a CEIO that results from 

Financial Accounting Standard (FAS) 

140 accounting treatment for the sale of 

underlying exposures to a securitization 

special purpose entity (SPE). Over time, 

as the bank, from an accounting 

perspective, realizes the increase in 

equity capital and tier 1 capital that was 

booked at the inception of the 

securitization through actual receipt of 

cash flows, the amount of the required 

deduction would shrink accordingly. 

Under the general risk-based capital 

rules,36 a bank must deduct CEIOs, 

whether purchased or retained, from tier 

1 capital to the extent that the CEIOs 

exceed 25 percent of the bank’s tier 1 

capital. Under the proposed rule, a bank 

must deduct CEIOs from tier 1 capital to 

the extent they represent gain-on-sale, 

and must deduct any remaining CEIOs 

50 percent from tier 1 capital and 50 

percent from tier 2 capital. 

Under the proposed rule, certain other 

securitization exposures also would be 

deducted from tier 1 and tier 2 capital. 

These exposures include, for example, 

securitization exposures that have an 

applicable external rating (defined 

below) that is more than one category 

below investment grade (for example, 

below BB) and most subordinated 

unrated securitization exposures. When 

a bank must deduct a securitization 

exposure (other than gain-on-sale) from 

regulatory capital, the bank must take 

the deduction 50 percent from tier 1 

capital and 50 percent from tier 2 

capital. Moreover, a bank may calculate 

any deductions from regulatory capital 

with respect to a securitization exposure 

(including after-tax gain-on-sale) net of 

any deferred tax liabilities associated 

with the exposure. 

The proposed rule also requires a 

bank to deduct the bank’s exposure on 

certain unsettled and failed capital 

markets transactions 50 percent from 

tier 1 capital and 50 percent from tier 2 

capital, as discussed in more detail 

below in section V.D. of the preamble. 

The agencies note that investments in 

unconsolidated banking and finance 

subsidiaries and reciprocal holdings of 

bank capital instruments would 

continue to be deducted from regulatory 

capital as described in the general riskbased capital rules. Under the agencies’

current rules, a national or state bank 

that controls or holds an interest in a 

financial subsidiary does not 

consolidate the assets and liabilities of 

the financial subsidiary with those of 

the bank for risk-based capital purposes. 

In addition, the bank must deduct its 

equity investment (including retained 

earnings) in the financial subsidiary 

from regulatory capital—at least 50 

percent from tier 1 capital and up to 50 

percent from tier 2 capital.37 A BHC 

generally does not deconsolidate the 

assets and liabilities of the financial 

subsidiaries of the BHC’s subsidiary 

banks and does not deduct from its 

regulatory capital the equity 

investments of its subsidiary banks in 

financial subsidiaries. Rather, a BHC 

generally fully consolidates the 

financial subsidiaries of its subsidiary 

banks. These treatments would continue 

under the proposed rule. 

For BHCs with consolidated 

insurance underwriting subsidiaries that 

are functionally regulated (or subject to 

comparable supervision and minimum 

regulatory capital requirements in their 

home jurisdiction), the following 

treatment would apply. The assets and 

liabilities of the subsidiary would be 

consolidated for purposes of 

determining the BHC’s risk-weighted 

assets. However, the BHC must deduct 

from tier 1 capital an amount equal to 

the insurance underwriting subsidiary’s 

minimum regulatory capital 

requirement as determined by its 

functional (or equivalent) regulator. For 

U.S. regulated insurance subsidiaries, 

this amount generally would be 200 

percent of the subsidiary’s Authorized 

Control Level as established by the 

appropriate state insurance regulator. 

This approach with respect to 

functionally-regulated consolidated 

insurance underwriting subsidiaries is 

different from the New Accord, which 

broadly endorses a deconsolidation and 

deduction approach for insurance 

subsidiaries. The Board believes a full 

deconsolidation and deduction 


sroberts on PROD1PC70 with PROPOSALS
55858 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

38 70 FR 11827 (Mar. 10, 2005). The final rule also 

allowed internationally active banking 

organizations to include restricted core capital 

elements in their tier 1 capital up to 25 percent of 

the sum of all core capital elements net of goodwill 

less associated deferred tax liability so long as any 

amounts of restricted core capital elements in 

excess of the 15 percent limit were in the form of 

mandatory convertible preferred securities. 

39The proposed rule excludes from the definition 

of a wholesale exposure certain pre-sold one-to-four 

family residential construction loans and certain 

multifamily residential loans. The treatment of such 

loans is discussed below in section V.B.5. of the 

preamble. 

40As described below, tranched guarantees (like 

most transactions that involve a tranching of credit 

risk) generally would be securitization exposures 

under this proposal. The proposal defines a 

guarantee broadly to include almost any transaction 

(other than a credit derivative executed under 

standard industry credit derivative documentation) 

that involves the transfer of the credit risk of an 

exposure from one party to another party. This 

definition of guarantee generally would include, for 

example, a credit spread option under which a bank 

has agreed to make payments to its counterparty in 

the event of an increase in the credit spread 

associated with a particular reference obligation 

issued by a company. 

41 12 CFR part 34, Subpart D (OCC); 12 CFR part 

208, Appendix C (Board); 12 CFR part 365, Subpart 

D (FDIC); and 12 CFR 560.100–560.101 (OTS). 

approach does not fully capture the risk 

in insurance underwriting subsidiaries 

at the consolidated BHC level and, thus, 

has proposed the consolidation and 

deduction approach described above. 

Question 23: The Board seeks comment 

on this proposed treatment and in 

particular on how a minimum insurance 

regulatory capital proxy for tier 1 

deduction purposes should be 

determined for insurance underwriting 

subsidiaries that are not subject to U.S. 

functional regulation. 

A March 10, 2005, final rule issued by 

the Board defined restricted core capital 

elements for BHCs and generally limited 

restricted core capital elements for 

internationally active banking 

organizations to 15 percent of the sum 

of all core capital elements net of 

goodwill less any associated deferred 

tax liability.38 Restricted core capital 

elements are defined as qualifying 

cumulative perpetual preferred stock 

(and related surplus), minority interest 

related to qualifying cumulative 

perpetual preferred stock directly issued 

by a consolidated DI or foreign bank 

subsidiary, minority interest related to 

qualifying common or qualifying 

perpetual preferred stock issued by a 

consolidated subsidiary that is neither a 

DI nor a foreign bank, and qualifying 

trust preferred securities. The final rule 

defined an internationally active 

banking organization to be a BHC that 

(i) as of its most recent year-end FR Y–

9C reports total consolidated assets 

equal to $250 billion or more or (ii) on 

a consolidated basis, reports total onbalance sheet foreign exposure of $10 

billion or more in its filing of the most 

recent year-end FFIEC 009 Country 

Exposure Report. The Board intends to 

change the definition of an 

internationally active banking 

organization in the Board’s capital 

adequacy guidelines for BHCs to make 

it consistent with the definition of a 

core bank. This change would be less 

restrictive on BHCs because the BHC 

threshold in this proposed rule uses 

total consolidated assets excluding 

insurance rather than total consolidated 

assets including insurance. 

V. Calculation of Risk-Weighted Assets 

A bank’s total risk-weighted assets 

would be the sum of its credit riskweighted assets and risk-weighted assets 

for operational risk, minus the sum of 

its excess eligible credit reserves (that is, 

its eligible credit reserves in excess of 

its total ECL) not included in tier 2 

capital and allocated transfer risk 

reserves. 

A. Categorization of Exposures 

To calculate credit risk-weighted 

assets, a bank must group its exposures 

into four general categories: wholesale, 

retail, securitization, and equity. It must 

also identify assets not included in an 

exposure category and any non-material 

portfolios of exposures to which the 

bank elects not to apply the IRB 

framework. In order to exclude a 

portfolio from the IRB framework, a 

bank must demonstrate to the 

satisfaction of its primary Federal 

supervisor that the portfolio (when 

combined with all other portfolios of 

exposures that the bank seeks to exclude 

from the IRB framework) is not material 

to the bank. 

1. Wholesale Exposures 

The proposed rule defines a 

wholesale exposure as a credit exposure 

to a company, individual, sovereign or 

governmental entity (other than a 

securitization exposure, retail exposure, 

or equity exposure).39 The term 

‘‘company’’ is broadly defined to mean 

a corporation, partnership, limited 

liability company, depository 

institution, business trust, SPE, 

association, or similar organization. 

Examples of a wholesale exposure 

include: (i) A non-tranched guarantee 

issued by a bank on behalf of a 

company; 40 (ii) a repo-style transaction 

entered into by a bank with a company 

and any other transaction in which a 

bank posts collateral to a company and 

faces counterparty credit risk; (iii) an 

exposure that the bank treats as a 

covered position under the MRA for 

which there is a counterparty credit risk 

charge in section 32 of the proposed 

rule; (iv) a sale of corporate loans by a 

bank to a third party in which the bank 

retains full recourse; (v) an OTC 

derivative contract entered into by a 

bank with a company; (vi) an exposure 

to an individual that is not managed by 

the bank as part of a segment of 

exposures with homogeneous risk 

characteristics; and (vii) a commercial 

lease. 

The agencies are proposing two 

subcategories of wholesale exposures—

HVCRE exposures and non-HVCRE 

exposures. Under the proposed rule, 

HVCRE exposures would be subject to a 

separate IRB risk-based capital formula 

that would produce a higher risk-based 

capital requirement for a given set of 

risk parameters than the IRB risk-based 

capital formula for non-HVCRE 

wholesale exposures. An HVCRE 

exposure is defined as a credit facility 

that finances or has financed the 

acquisition, development, or 

construction of real property, excluding 

facilities used to finance (i) one- to fourfamily residential properties or (ii) 

commercial real estate projects where: 

(A) The exposure’s LTV ratio is less 

than or equal to the applicable 

maximum supervisory LTV ratio in the 

real estate lending standards of the 

agencies; 41 (B) the borrower has 

contributed capital to the project in the 

form of cash or unencumbered readily 

marketable assets (or has paid 

development expenses out-of-pocket) of 

at least 15 percent of the real estate’s 

appraised ‘‘as completed’’ value; and (C) 

the borrower contributed the amount of 

capital required before the bank 

advances funds under the credit facility, 

and the capital contributed by the 

borrower or internally generated by the 

project is contractually required to 

remain in the project throughout the life 

of the project. 

Once an exposure is determined to be 

HVCRE, it would remain an HVCRE 

exposure until paid in full, sold, or 

converted to permanent financing. After 

considering comments received on the 

ANPR, the agencies are proposing to 

retain a separate IRB risk-based capital 

formula for HVCRE exposures in 

recognition of the high levels of 

systematic risk inherent in some of 

these exposures. The agencies believe 

that the revised definition of HVCRE in 

the proposed rule appropriately 

identifies exposures that are particularly 

susceptible to systematic risk. Question 

24: The agencies seek comment on how 

to strike the appropriate balance 

between the enhanced risk sensitivity 

and marginally higher risk-based capital 


sroberts on PROD1PC70 with PROPOSALS
Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55859 

42The proposed rule excludes from the definition 

of a residential mortgage exposure certain pre-sold 

one-to-four family residential construction loans 

and certain multi-family residential loans. The 

treatment of such loans is discussed below in 

section V.B.5. of the preamble. 

43The proposed rule excludes from the definition 

of an other retail exposure certain pre-sold one-tofour family residential construction loans and 

certain multi-family residential loans. The 

treatment of such loans is discussed below in 

section V.B.5. of the preamble. 

44 In addition, margin loans and other credit 

exposures to personal investment companies, all or 

substantially all of whose assets are financial 

exposures, typically would meet the definition of a 

securitization exposure. 

requirements obtained by separating 

HVCRE exposures from other wholesale 

exposures and the additional 

complexity the separation entails. 

The New Accord identifies five subclasses of specialized lending for which 

the primary source of repayment of the 

obligation is the income generated by 

the financed asset(s) rather than the 

independent capacity of a broader 

commercial enterprise. The sub-classes 

are project finance, object finance, 

commodities finance, income-producing 

real estate, and HVCRE. The New 

Accord provides a methodology to 

accommodate banks that cannot meet 

the requirements for the estimation of 

PD for these exposure types. The 

sophisticated banks that would apply 

the advanced approaches in the United 

States should be able to estimate risk 

parameters for specialized lending 

exposures, and therefore the agencies 

are not proposing a separate treatment 

for specialized lending beyond the 

separate IRB risk-based capital formula 

for HVCRE exposures specified in the 

New Accord. 

In contrast to the New Accord, the 

agencies are not including in this 

proposed rule an adjustment that would 

result in a lower risk weight for a loan 

to a small- and medium-size enterprise 

(SME) that has the same risk parameter 

values as a loan to a larger firm. The 

agencies are not aware of compelling 

evidence that smaller firms with the 

same PD and LGD as larger firms are 

subject to less systematic risk. Question 

25: The agencies request comment and 

supporting evidence on the consistency 

of the proposed treatment with the 

underlying riskiness of SME portfolios. 

Further, the agencies request comment 

on any competitive issues that this 

aspect of the proposed rule may cause 

for U.S. banks. 

2. Retail Exposures 

Under the proposed rule, a retail 

exposure would generally include 

exposures (other than securitization 

exposures or equity exposures) to an 

individual or small business that are 

managed as part of a segment of similar 

exposures, that is, not on an individualexposure basis. Under the proposed 

rule, there are three subcategories of 

retail exposure: (i) Residential mortgage 

exposures; (ii) QREs; and (iii) other 

retail exposures. The agencies propose 

generally to define residential mortgage 

exposure as an exposure that is 

primarily secured by a first or 

subsequent lien on one-to-four-family 

residential property.42 This includes 

both term loans and revolving home 

equity lines of credit (HELOCs). An 

exposure primarily secured by a first or 

subsequent lien on residential property 

that is not one-to-four family would also 

be included as a residential mortgage 

exposure as long as the exposure has 

both an original and current outstanding 

amount of no more than $1 million. 

There would be no upper limit on the 

size of an exposure that is secured by 

one-to-four-family residential 

properties. To be a residential mortgage 

exposure, the bank must manage the 

exposure as part of a segment of 

exposures with homogeneous risk 

characteristics. Residential mortgage 

loans that are managed on an individual 

basis, rather than managed as part of a 

segment, would be categorized as 

wholesale exposures. 

QREs would be defined as exposures 

to individuals that are (i) revolving, 

unsecured, and unconditionally 

cancelable by the bank to the fullest 

extent permitted by Federal law; (ii) 

have a maximum exposure amount 

(drawn plus undrawn) of up to 

$100,000; and (iii) are managed as part 

of a segment with homogeneous risk 

characteristics. In practice, QREs 

typically would include exposures 

where customers’ outstanding 

borrowings are permitted to fluctuate 

based on their decisions to borrow and 

repay, up to a limit established by the 

bank. Most credit card exposures to 

individuals and overdraft lines on 

individual checking accounts would be 

QREs. 

The category of other retail exposures 

would include two types of exposures. 

First, all exposures to individuals for 

non-business purposes (other than 

residential mortgage exposures and 

QREs) that are managed as part of a 

segment of similar exposures would be 

other retail exposures. Such exposures 

may include personal term loans, 

margin loans, auto loans and leases, 

credit card accounts with credit lines 

above $100,000, and student loans. The 

agencies are not proposing an upper 

limit on the size of these types of retail 

exposures to individuals. Second, 

exposures to individuals or companies 

for business purposes (other than 

residential mortgage exposures and 

QREs), up to a single-borrower exposure 

threshold of $1 million, that are 

managed as part of a segment of similar 

exposures would be other retail 

exposures. For the purpose of assessing 

exposure to a single borrower, the bank 

would aggregate all business exposures 

to a particular legal entity and its 

affiliates that are consolidated under 

GAAP. If that legal entity is a natural 

person, any consumer loans (for 

example, personal credit card loans or 

mortgage loans) to that borrower would 

not be part of the aggregate. A bank 

could distinguish a consumer loan from 

a business loan by the loan department 

through which the loan is made. 

Exposures to a borrower for business 

purposes primarily secured by 

residential property would count 

toward the $1 million single-borrower 

other retail business exposure 

threshold.43

The residual value portion of a retail 

lease exposure is excluded from the 

definition of an other retail exposure. A 

bank would assign the residual value 

portion of a retail lease exposure a riskweighted asset amount equal to its 

residual value as described in section 31 

of the proposed rule. 

3. Securitization Exposures 

The proposed rule defines a 

securitization exposure as an on-balance 

sheet or off-balance sheet credit 

exposure that arises from a traditional or 

synthetic securitization. A traditional 

securitization is a transaction in which 

(i) all or a portion of the credit risk of 

one or more underlying exposures is 

transferred to one or more third parties 

other than through the use of credit 

derivatives or guarantees; (ii) the credit 

risk associated with the underlying 

exposures has been separated into at 

least two tranches reflecting different 

levels of seniority; (iii) performance of 

the securitization exposures depends on 

the performance of the underlying 

exposures; and (iv) all or substantially 

all of the underlying exposures are 

financial exposures. Examples of 

financial exposures are loans, 

commitments, receivables, asset-backed 

securities, mortgage-backed securities, 

corporate bonds, equity securities, or 

credit derivatives. For purposes of the 

proposed rule, mortgage-backed passthrough securities guaranteed by Fannie 

Mae or Freddie Mac (whether or not 

issued out of a structure that tranches 

credit risk) also would be securitization 

exposures.44


sroberts on PROD1PC70 with PROPOSALS
55860 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

45 If a bank purchases an asset-backed security 

issued by a securitization SPE and purchases a 

credit derivative to protect itself from credit losses 

associated with the asset-backed security, the 

purchase of the credit derivative by the investing 

bank does not turn the traditional securitization 

into a synthetic securitization. Instead, under the 

proposal, the investing bank would be viewed as 

having purchased a traditional securitization 

exposure and would reflect the CRM benefits of the 

credit derivative through the securitization CRM 

rules described later in the preamble and in section 

46 of the proposed rule. 

A synthetic securitization is a 

transaction in which (i) all or a portion 

of the credit risk of one or more 

underlying exposures is transferred to 

one or more third parties through the 

use of one or more credit derivatives or 

guarantees (other than a guarantee that 

transfers only the credit risk of an 

individual retail exposure); (ii) the 

credit risk associated with the 

underlying exposures has been 

separated into at least two tranches 

reflecting different levels of seniority; 

(iii) performance of the securitization 

exposures depends on the performance 

of the underlying exposures; and (iv) all 

or substantially all of the underlying 

exposures are financial exposures. 

Accordingly, the proposed definition of 

a securitization exposure would include 

tranched cover or guarantee 

arrangements—that is, arrangements in 

which an entity transfers a portion of 

the credit risk of an underlying 

exposure to one or more other 

guarantors or credit derivative providers 

but also retains a portion of the credit 

risk, where the risk transferred and the 

risk retained are of different seniority 

levels.45

Provided that there is a tranching of 

credit risk, securitization exposures also 

could include, among other things, 

asset-backed and mortgage-backed 

securities; loans, lines of credit, 

liquidity facilities, and financial 

standby letters of credit; credit 

derivatives and guarantees; loan 

servicing assets; servicer cash advance 

facilities; reserve accounts; creditenhancing representations and 

warranties; and CEIOs. Securitization 

exposures also could include assets sold 

with retained tranched recourse. Both 

the designation of exposures as 

securitization exposures and the 

calculation of risk-based capital 

requirements for securitization 

exposures will be guided by the 

economic substance of a transaction 

rather than its legal form. 

As noted above, for a transaction to 

constitute a securitization transaction 

under the proposed rule, all or 

substantially all of the underlying 

exposures must be financial exposures. 

The proposed rule includes this 

requirement because the proposed 

securitization framework was designed 

to address the tranching of the credit 

risk of exposures to which the IRB 

framework can be applied. Accordingly, 

a specialized loan to finance the 

construction or acquisition of large-scale 

projects (for example, airports and 

power plants), objects (for example, 

ships, aircraft, or satellites), or 

commodities (for example, reserves, 

inventories, precious metals, oil, or 

natural gas) generally would not be a 

securitization exposure because the 

assets backing the loan typically would 

be nonfinancial assets (the facility, 

object, or commodity being financed). In 

addition, although some structured 

transactions involving incomeproducing real estate or HVCRE can 

resemble securitizations, these 

transactions generally would not be 

securitizations because the underlying 

exposure would be real estate. 

Consequently, exposures resulting from 

the tranching of the risks of 

nonfinancial assets are not subject to the 

proposed rule’s securitization 

framework, but generally are subject to 

the proposal’s rules for wholesale 

exposures. Question 26: The agencies 

request comment on the appropriate 

treatment of tranched exposures to a 

mixed pool of financial and nonfinancial underlying exposures. The 

agencies specifically are interested in 

the views of commenters as to whether 

the requirement that all or substantially 

all of the underlying exposures of a 

securitization be financial exposures 

should be softened to require only that 

some lesser portion of the underlying 

exposures be financial exposures. 

4. Equity Exposures 

The proposed rule defines an equity 

exposure to mean: 

(i) A security or instrument whether 

voting or non-voting that represents a 

direct or indirect ownership interest in, 

and a residual claim on, the assets and 

income of a company, unless: (A) The 

issuing company is consolidated with 

the bank under GAAP; (B) the bank is 

required to deduct the ownership 

interest from tier 1 or tier 2 capital; (C) 

the ownership interest is redeemable; 

(D) the ownership interest incorporates 

a payment or other similar obligation on 

the part of the issuing company (such as 

an obligation to pay periodic interest); 

or (E) the ownership interest is a 

securitization exposure. 

(ii) A security or instrument that is 

mandatorily convertible into a security 

or instrument described in (i). 

(iii) An option or warrant that is 

exercisable for a security or instrument 

described in (i). 

(iv) Any other security or instrument 

(other than a securitization exposure) to 

the extent the return on the security or 

instrument is based on the performance 

of security or instrument described in 

(i). For example, a short position in an 

equity security or a total return equity 

swap would be characterized as an 

equity exposure. 

Nonconvertible term or perpetual 

preferred stock generally would be 

considered wholesale exposures rather 

than equity exposures. Financial 

instruments that are convertible into an 

equity exposure only at the option of the 

holder or issuer also generally would be 

considered wholesale exposures rather 

than equity exposures provided that the 

conversion terms do not expose the 

bank to the risk of losses arising from 

price movements in that equity 

exposure. Upon conversion, the 

instrument would be treated as an 

equity exposure. 

The agencies note that, as a general 

matter, each of a bank’s exposures will 

fit in one and only one exposure 

category. One principal exception to 

this rule is that equity derivatives 

generally will meet the definition of an 

equity exposure (because of the bank’s 

exposure to the underlying equity 

security) and the definition of a 

wholesale exposure (because of the 

bank’s credit risk exposure to the 

counterparty). In such cases, as 

discussed in more detail below, the 

bank’s risk-based capital requirement 

for the derivative generally would be the 

sum of its risk-based capital 

requirement for the derivative 

counterparty credit risk and for the 

underlying exposure. 

5. Boundary Between Operational Risk 

and Other Risks 

With the introduction of an explicit 

risk-based capital requirement for 

operational risk, issues arise about the 

proper treatment of operational losses 

that could also be attributed to either 

credit risk or market risk. The agencies 

recognize that these boundary issues are 

important and have significant 

implications for how banks would 

compile loss data sets and compute riskbased capital requirements under the 

proposed rule. Consistent with the 

treatment in the New Accord, the 

agencies propose treating operational 

losses that are related to market risk as 

operational losses for purposes of 

calculating risk-based capital 

requirements under this proposed rule. 

For example, losses incurred from a 

failure of bank personnel to properly 

execute a stop loss order, from trading 

fraud, or from a bank selling a security 


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46Multi-lateral development bank is defined as 

any multi-lateral lending institution or regional 

development bank in which the U.S. government is 

a shareholder or contributing member. These 

institutions currently are the International Bank for 

Reconstruction and Development, the International 

Finance Corporation, the Inter-American 

Development Bank, the Asian Development Bank, 

the African Development Bank, and the European 

Bank for Reconstruction and Development. 

47A bank must segment defaulted retail 

exposures separately from non-defaulted retail 

Continued 

when a purchase was intended, would 

be treated as operational losses. 

The agencies generally propose to 

treat losses that are related to both 

operational risk and credit risk as credit 

losses for purposes of calculating riskbased capital requirements. For 

example, where a loan defaults (credit 

risk) and the bank discovers that the 

collateral for the loan was not properly 

secured (operational risk), the bank’s 

resulting loss would be attributed to 

credit risk (not operational risk). This 

general separation between credit and 

operational risk is supported by current 

U.S. accounting standards for the 

treatment of credit risk. 

The proposed exception to this 

standard is retail credit card fraud 

losses. More specifically, retail credit 

card losses arising from non-contractual, 

third party-initiated fraud (for example, 

identity theft) are to be treated as 

external fraud operational losses under 

this proposed rule. All other third partyinitiated losses are to be treated as credit 

losses. Based on discussions with the 

industry, this distinction is consistent 

with prevailing practice in the credit 

card industry, with banks commonly 

considering these losses to be 

operational losses and treating them as 

such for risk management purposes. 

Question 27: The agencies seek 

commenters’ perspectives on other loss 

types for which the boundary between 

credit and operational risk should be 

evaluated further (for example, with 

respect to losses on HELOCs). 

6. Boundary Between the Proposed Rule 

and the Market Risk Amendment (MRA) 

Positions currently subject to the 

MRA include all positions classified as 

trading consistent with GAAP. The New 

Accord sets forth additional criteria for 

positions to be eligible for application of 

the MRA. The agencies propose to 

incorporate these additional criteria into 

the MRA through a separate notice of 

proposed rulemaking concurrently 

published in the Federal Register. 

Advanced approaches banks subject to 

the MRA would use the MRA as 

amended for trading exposures eligible 

for application of the MRA. Advanced 

approaches banks not subject to the 

MRA would use this proposed rule for 

all of their exposures. Question 28: The 

agencies generally seek comment on the 

proposed treatment of the boundaries 

between credit, operational, and market 

risk. 

B. Risk-Weighted Assets for General 

Credit Risk (Wholesale Exposures, Retail 

Exposures, On-Balance Sheet Assets 

That Are Not Defined by Exposure 

Category, and Immaterial Credit 

Portfolios) 

Under the proposed rule, the 

wholesale and retail risk-weighted 

assets calculation consists of four 

phases: (1) Categorization of exposures; 

(2) assignment of wholesale exposures 

to rating grades and segmentation of 

retail exposures; (3) assignment of risk 

parameters to wholesale obligors and 

exposures and segments of retail 

exposures; and (4) calculation of riskweighted asset amounts. Phase 1 

involves the categorization of a bank’s 

exposures into four general categories—

wholesale exposures, retail exposures, 

securitization exposures, and equity 

exposures. Phase 1 also involves the 

further classification of retail exposures 

into subcategories and identifying 

certain wholesale exposures that receive 

a specific treatment within the 

wholesale framework. Phase 2 involves 

the assignment of wholesale obligors 

and exposures to rating grades and the 

segmentation of retail exposures. Phase 

3 requires the bank to assign a PD, 

ELGD, LGD, EAD, and M to each 

wholesale exposure and a PD, ELGD, 

LGD, and EAD to each segment of retail 

exposures. In phase 4, the bank 

calculates the risk-weighted asset 

amount (i) for each wholesale exposure 

and segment of retail exposures by 

inserting the risk parameter estimates 

into the appropriate IRB risk-based 

capital formula and multiplying the 

formula’s dollar risk-based capital 

requirement output by 12.5; and (ii) for 

on-balance sheet assets that are not 

included in one of the defined exposure 

categories and for certain immaterial 

portfolios of exposures by multiplying 

the carrying value or notional amount of 

the exposures by a 100 percent risk 

weight. 

1. Phase 1—Categorization of Exposures 

In phase 1, a bank must determine 

which of its exposures fall into each of 

the four principal IRB exposure 

categories—wholesale exposures, retail 

exposures, securitization exposures, and 

equity exposures. In addition, a bank 

must identify within the wholesale 

exposure category certain exposures that 

receive a special treatment under the 

wholesale framework. These exposures 

include HVCRE exposures, sovereign 

exposures, eligible purchased wholesale 

receivables, eligible margin loans, repostyle transactions, OTC derivative 

contracts, unsettled transactions, and 

eligible guarantees and eligible credit 

derivatives that are used as credit risk 

mitigants. 

The treatment of HVCRE exposures 

and eligible purchased wholesale 

receivables is discussed below in this 

section. The treatment of eligible margin 

loans, repo-style transactions, OTC 

derivative contracts, and eligible 

guarantees and eligible credit 

derivatives that are credit risk mitigants 

is discussed in section V.C. of the 

preamble. In addition, sovereign 

exposures and exposures to or directly 

and unconditionally guaranteed by the 

Bank for International Settlements, the 

International Monetary Fund, the 

European Commission, the European 

Central Bank, and multi-lateral 

development banks 46 are exempt from 

the 0.03 percent floor on PD discussed 

in the next section. 

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 nonmaterial portfolio of exposures to which 

it chooses, subject to supervisory 

review, not to apply the IRB risk-based 

capital formulas. 

2. Phase 2 Assignment of Wholesale 

Obligors and Exposures to Rating 

Grades and Retail Exposures to 

Segments 

In phase 2, a bank must assign each 

wholesale obligor to a single rating 

grade (for purposes of assigning an 

estimated PD) and may assign each 

wholesale exposure to loss severity 

rating grades (for purposes of assigning 

an estimated ELGD and LGD). A bank 

that elects not use a loss severity rating 

grade system for a wholesale exposure 

will directly assign ELGD and LGD to 

the wholesale exposure in phase 3. As 

a part of the process of assigning 

wholesale obligors to rating grades, a 

bank must identify which of its 

wholesale obligors are in default. 

In addition, a bank must divide its 

retail exposures within each retail 

subcategory into segments that have 

homogeneous risk characteristics.47


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55862 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

exposures and, if the bank determines the EAD for 

eligible margin loans using the approach in section 

32(a) of the proposed rule, it must segment retail 

eligible margin loans for which the bank uses this 

approach separately from other retail exposures. 

Segmentation is the grouping of 

exposures within each subcategory 

according to the predominant risk 

characteristics of the borrower (for 

example, credit score, debt-to-income 

ratio, and delinquency) and the 

exposure (for example, product type and 

LTV ratio). In general, retail segments 

should not cross national jurisdictions. 

A bank would have substantial 

flexibility to use the retail portfolio 

segmentation it believes is most 

appropriate for its activities, subject to 

the following broad principles: 

• 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 borrowerrelated risk characteristics and 

exposure-related risk characteristics that 

reliably and consistently over time 

differentiate a segment’s risk from that 

of other segments. 

• Consistency—Risk drivers for 

segmentation should be consistent with 

the predominant risk characteristics 

used by the bank for internal credit risk 

measurement and management. 

• Accuracy—The segmentation 

system should generate segments that 

separate exposures by realized 

performance and should be designed so 

that actual long-run outcomes closely 

approximate the retail risk parameters 

estimated by the bank. 

A bank might choose to segment 

exposures by common risk drivers that 

are relevant and material in determining 

the loss characteristics of a particular 

retail product. For example, a bank may 

segment mortgage loans by LTV band, 

age from origination, geography, 

origination channel, and credit score. 

Statistical modeling, expert judgment, 

or some combination of the two may 

determine the most relevant risk drivers. 

Alternatively, a bank might segment by 

grouping exposures with similar loss 

characteristics, such as loss rates or 

default rates, as determined by 

historical performance of segments with 

similar risk characteristics. 

Banks commonly obtain tranched 

credit protection, for example first-loss 

or second-loss guarantees, on certain 

retail exposures such as residential 

mortgages. The agencies recognize that 

the securitization framework, which 

applies to tranched wholesale 

exposures, is not appropriate for 

individual retail exposures. The 

agencies therefore are proposing to 

exclude tranched guarantees that apply 

only to an individual retail exposure 

from the securitization framework. An 

important result of this exclusion is 

that, in contrast to the treatment of 

wholesale exposures, a bank may 

recognize recoveries from both an 

obligor and a guarantor for purposes of 

estimating the ELGD and LGD for 

certain retail exposures. Question 29: 

The agencies seek comment on this 

approach to tranched guarantees on 

retail exposures and on alternative 

approaches that could more 

appropriately reflect the risk mitigating 

effect of such guarantees while 

addressing the agencies’ concerns about 

counterparty credit risk and correlation 

between the credit quality of an obligor 

and a guarantor. 

Banks have expressed concern about 

the treatment of retail margin loans 

under the New Accord. Due to the 

highly collateralized nature and low 

loss frequency of margin loans, banks 

typically collect little customer-specific 

information that they could use to 

differentiate margin loans into 

segments. The agencies believe that a 

bank could appropriately segment its 

margin loan portfolio using only 

product-specific risk drivers, such as 

product type and origination channel. A 

bank could then use the retail definition 

of default to associate a PD, ELGD, and 

LGD with each segment. As described in 

section 32 of the proposed rule, a bank 

could adjust the EAD of eligible margin 

loans to reflect the risk-mitigating effect 

of financial collateral. For a segment of 

retail eligible margin loans, a bank 

would associate an ELGD and LGD with 

the segment that do not reflect the 

presence of collateral. If a bank is not 

able to estimate PD, ELGD, and LGD for 

a segment of eligible margin loans, the 

bank may apply a 300 percent risk 

weight to the EAD of the segment. 

Question 30: The agencies seek 

comment on wholesale and retail 

exposure types for which banks are not 

able to calculate PD, ELGD, and LGD 

and on what an appropriate risk-based 

capital treatment for such exposures 

might be. 

In phase 3, each retail segment will 

typically be associated with a separate 

PD, ELGD, LGD, and EAD. In some 

cases, it may be reasonable to use the 

same PD, ELGD, LGD, or EAD estimate 

for multiple segments. 

A bank must segment defaulted retail 

exposures separately from nondefaulted retail exposures and should 

base the segmentation of defaulted retail 

exposures on characteristics that are 

most predictive of current loss and 

recovery rates. This segmentation 

should provide meaningful 

differentiation so that individual 

exposures within each defaulted 

segment do not have material 

differences in their expected loss 

severity. 

Purchased wholesale receivables. A 

bank may also elect to use a top-down 

approach, similar to the treatment of 

retail exposures, for eligible purchased 

wholesale receivables. Under this 

approach, in phase 2, a bank would 

group its eligible purchased wholesale 

receivables that, when consolidated by 

obligor, total less than $1 million into 

segments that have homogeneous risk 

characteristics. To be an eligible 

purchased wholesale receivable, several 

criteria must be met: 

• The purchased wholesale receivable 

must be purchased from an unaffiliated 

seller and must not have been directly 

or indirectly originated by the 

purchasing bank; 

• The purchased wholesale receivable 

must be generated on an arm’s-length 

basis between the seller and the obligor. 

Intercompany accounts receivable and 

receivables subject to contra-accounts 

between firms that buy and sell to each 

other are ineligible; 

• The purchasing bank must have a 

claim on all proceeds from the 

receivable or a pro-rata interest in the 

proceeds; and 

• The purchased wholesale receivable 

must have an effective remaining 

maturity of less than one year. 

Wholesale lease residuals. The 

agencies are proposing a treatment for 

wholesale lease residuals that differs 

from the New Accord. A wholesale lease 

residual typically exposes a bank to the 

risk of a decline in value of the leased 

asset and to the credit risk of the lessee. 

Although the New Accord provides for 

a flat 100 percent risk weight for 

wholesale lease residuals, the agencies 

believe this is excessively punitive for 

leases to highly creditworthy lessees. 

Accordingly, the proposed rule would 

require a bank to treat its net investment 

in a wholesale lease as a single exposure 

to the lessee. There would not be a 

separate capital calculation for the 

wholesale lease residual. In contrast, a 

retail lease residual, consistent with the 

New Accord, would be assigned a riskweighted asset amount equal to its 

residual value (as described in more 

detail above). 


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48EAD for repo-style transactions, eligible margin 

loans, and OTC derivatives is calculated as 

described in section 32 of the proposed rule. 

3. Phase 3—Assignment of Risk 

Parameters to Wholesale Obligors and 

Exposures and Retail Segments 

In phase 3, a bank would associate a 

PD with each wholesale obligor rating 

grade; associate an ELGD or LGD with 

each wholesale loss severity rating grade 

or assign an ELGD and LGD to each 

wholesale exposure; assign an EAD and 

M to each wholesale exposure; and 

assign a PD, ELGD, LGD, and EAD to 

each segment of retail exposures. The 

quantification phase can generally be 

divided into four steps—obtaining 

historical reference data, estimating the 

risk parameters for the reference data, 

mapping the historical reference data to 

the bank’s current exposures, and 

determining the risk parameters for the 

bank’s current exposures. 

A bank should base its estimation of 

the values assigned to PD, ELGD, LGD, 

and EAD 48 on historical reference data 

that are a reasonable proxy for the 

bank’s current exposures and that 

provide meaningful predictions of the 

performance of such exposures. A 

‘‘reference data set’’ consists of a set of 

exposures to defaulted wholesale 

obligors and defaulted retail exposures 

(in the case of ELGD, LGD, and EAD 

estimation) or to both defaulted and 

non-defaulted wholesale obligors and 

retail exposures (in the case of PD 

estimation). 

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-toincome ratio, or performance history), or 

other factors that are related in some 

way to the risk parameters. Banks may 

use more than one reference data set to 

improve the robustness or accuracy of 

the parameter estimates. 

A bank should then apply statistical 

techniques to the reference data to 

determine a relationship between risk 

characteristics and the estimated risk 

parameter. The result of this step is a 

model that ties descriptive 

characteristics to the risk parameter 

estimates. In this context, the term 

‘model’ is used in the most general 

sense; a model may be simple, such as 

the calculation of averages, or more 

complicated, such as an approach based 

on advanced regression techniques. This 

step may include adjustments for 

differences between this proposed rule’s 

definition of default and the default 

definition in the reference data set, or 

adjustments for data limitations. This 

step should also include adjustments for 

seasoning effects related to retail 

exposures. 

A bank may use more than one 

estimation technique to generate 

estimates of the risk parameters, 

especially if there are multiple sets of 

reference data or multiple sample 

periods. If multiple estimates are 

generated, the bank must have a clear 

and consistent policy on reconciling 

and combining the different estimates. 

Once a bank estimates PD, ELGD, 

LGD, and EAD for its reference data sets, 

it would create a link between its 

portfolio data and the reference data 

based on corresponding characteristics. 

Variables or characteristics that are 

available for the existing portfolio 

would be mapped or linked to the 

variables used in the default, lossseverity, or exposure amount model. In 

order to effectively map the data, 

reference data characteristics would 

need to allow for the construction of 

rating and segmentation criteria that are 

consistent with those used on the bank’s 

portfolio. An important element of 

mapping is making adjustments for 

differences between reference data sets 

and the bank’s exposures. 

Finally, a bank would apply the risk 

parameters estimated for the reference 

data to the bank’s actual portfolio data. 

The bank would attribute a PD to each 

wholesale obligor and each segment of 

retail exposures, and an ELGD, LGD, 

and EAD to each wholesale exposure 

and to each segment of retail exposures. 

If multiple data sets or estimation 

methods are used, the bank must adopt 

a means of combining the various 

estimates at this stage. 

The proposed rule, as noted above, 

permits a bank to elect to segment its 

eligible purchased wholesale 

receivables like retail exposures. A bank 

that chooses to apply this treatment 

must directly assign a PD, ELGD, LGD, 

EAD, and M to each such segment. If a 

bank can estimate ECL (but not PD or 

LGD) for a segment of eligible purchased 

wholesale receivables, the bank must 

assume that the ELGD and LGD of the 

segment equal 100 percent and that the 

PD of the segment equals ECL divided 

by EAD. The bank must estimate ECL 

for the receivables without regard to any 

assumption of recourse or guarantees 

from the seller or other parties. The 

bank would then use the wholesale 

exposure formula in section 31(e) of the 

proposed rule to determine the riskbased capital requirement for each 

segment of eligible purchased wholesale 

receivables. 

A bank may recognize the credit risk 

mitigation benefits of collateral that 

secures a wholesale exposure by 

adjusting its estimate of the ELGD and 

LGD of the exposure and may recognize 

the credit risk mitigation benefits of 

collateral that secures retail exposures 

by adjusting its estimate of the PD, 

ELGD, and LGD of the segment of retail 

exposures. In certain cases, however, a 

bank may take financial collateral into 

account in estimating the EAD of repostyle transactions, eligible margin loans, 

and OTC derivative contracts (as 

provided in section 32 of the proposed 

rule). 

The proposed rule also provides that 

a bank may use an EAD of zero for (i) 

derivative contracts that are traded on 

an exchange that requires the daily 

receipt and payment of cash-variation 

margin; (ii) derivative contracts and 

repo-style transactions that are 

outstanding with a qualifying central 

counterparty, but not for those 

transactions that the qualifying central 

counterparty has rejected; and (iii) 

credit risk exposures to a qualifying 

central counterparty that arise from 

derivative contracts and repo-style 

transactions in the form of clearing 

deposits and posted collateral. The 

proposed rule defines a qualifying 

central counterparty as a counterparty 

(for example, a clearing house) that: (i) 

Facilitates trades between 

counterparties in one or more financial 

markets by either guaranteeing trades or 

novating contracts; (ii) requires all 

participants in its arrangements to be 

fully collateralized on a daily basis; and 

(iii) the bank demonstrates to the 

satisfaction of its primary Federal 

supervisor is in sound financial 

condition and is subject to effective 

oversight by a national supervisory 

authority. 

Some repo-style transactions and OTC 

derivative contracts giving rise to 

counterparty credit risk may give rise, 

from an accounting point of view, to 

both on- and off-balance sheet 

exposures. Where a bank is using an 

EAD approach to measure the amount of 

risk exposure for such transactions, 

factoring in collateral effects where 

applicable, it would not also separately 

apply a risk-based capital requirement 

to an on-balance sheet receivable from 

the counterparty recorded in connection 

with that transaction. Because any 

exposure arising from the on-balance 

sheet receivable is captured in the 

capital requirement determined under 

the EAD approach, a separate capital 

requirement would double count the 


sroberts on PROD1PC70 with PROPOSALS
55864 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

exposure for regulatory capital 

purposes. 

A bank may take into account the risk 

reducing effects of eligible guarantees 

and eligible credit derivatives in 

support of a wholesale exposure by 

applying the PD substitution approach 

or the LGD adjustment approach to the 

exposure as provided in section 33 of 

the proposed rule or, if applicable, 

applying double default treatment to the 

exposure as provided in section 34 of 

the proposed rule. A bank may decide 

separately for each wholesale exposure 

that qualifies for the double default 

treatment whether to apply the PD 

substitution approach, the LGD 

adjustment approach, or the double 

default treatment. A bank may take into 

account the risk reducing effects of 

guarantees and credit derivatives in 

support of retail exposures in a segment 

when quantifying the PD, ELGD, and 

LGD of the segment. 

There are several supervisory 

limitations imposed on risk parameters 

assigned to wholesale obligors and 

exposures and segments of retail 

exposures. First, the PD for each 

wholesale obligor or segment of retail 

exposures may not be less than 0.03 

percent, except for exposures to or 

directly and unconditionally guaranteed 

by a sovereign entity, the Bank for 

International Settlements, the 

International Monetary Fund, the 

European Commission, the European 

Central Bank, or a multi-lateral 

development bank, to which the bank 

assigns a rating grade associated with a 

PD of less than 0.03 percent. Second, 

the LGD of a segment of residential 

mortgage exposures (other than 

segments of residential mortgage 

exposures for which all or substantially 

all of the principal of the exposures is 

directly and unconditionally guaranteed 

by the full faith and credit of a sovereign 

entity) may not be less than 10 percent. 

These supervisory floors on PD and LGD 

apply regardless of whether the bank 

recognizes an eligible guarantee or 

eligible credit derivative as provided in 

sections 33 and 34 of the proposed rule. 

The agencies would not allow a bank 

to artificially group exposures into 

segments specifically to avoid the LGD 

floor for mortgage products. A bank 

should use consistent risk drivers to 

determine its retail exposure 

segmentations and not artificially 

segment low LGD loans with higher 

LGD loans to avoid the floor. 

A bank also must calculate the 

effective remaining maturity (M) for 

each wholesale exposure. For wholesale 

exposures other than repo-style 

transactions, eligible margin loans, and 

OTC derivative contracts subject to a 

qualifying master netting agreement, M 

would be the weighted-average 

remaining maturity (measured in whole 

or fractional years) of the expected 

contractual cash flows from the 

exposure, using the undiscounted 

amounts of the cash flows as weights. A 

bank may use its best estimate of future 

interest rates to compute expected 

contractual interest payments on a 

floating-rate exposure, but it may not 

consider expected but noncontractually 

required returns of principal, when 

estimating M. A bank could, at its 

option, use the nominal remaining 

maturity (measured in whole or 

fractional years) of the exposure. The M 

for repo-style transactions, eligible 

margin loans, and OTC derivative 

contracts subject to a qualifying master 

netting agreement would be the 

weighted-average remaining maturity 

(measured in whole or fractional years) 

of the individual transactions subject to 

the qualifying master netting agreement, 

with the weight of each individual 

transaction set equal to the notional 

amount of the transaction. Question 31: 

The agencies seek comment on the 

appropriateness of permitting a bank to 

consider prepayments when estimating 

M and on the feasibility and advisability 

of using discounted (rather than 

undiscounted) cash flows as the basis 

for estimating M. 

Under the proposed rule, a qualifying 

master netting agreement is defined to 

mean any written, legally enforceable 

bilateral agreement, provided that: 

(i) The agreement creates a single 

legal obligation for all individual 

transactions covered by the agreement 

upon an event of default, including 

bankruptcy, insolvency, or similar 

proceeding, of the counterparty; 

(ii) The agreement provides the bank 

the right to accelerate, terminate, and 

close-out on a net basis all transactions 

under the agreement and to liquidate or 

set off collateral promptly upon an 

event of default, including upon an 

event of bankruptcy, insolvency, or 

similar proceeding, of the counterparty, 

provided that, in any such case, any 

exercise of rights under the agreement 

will not be stayed or avoided under 

applicable law in the relevant 

jurisdictions; 

(iii) The bank has conducted and 

documented sufficient legal review to 

conclude with a well-founded basis that 

the agreement meets the requirements of 

paragraph (ii) of this definition and that 

in the event of a legal challenge 

(including one resulting from default or 

from bankruptcy, insolvency, or similar 

proceeding) the relevant court and 

administrative authorities would find 

the agreement to be legal, valid, binding, 

and enforceable under the law of the 

relevant jurisdictions; 

(iv) The bank establishes and 

maintains procedures to monitor 

possible changes in relevant law and to 

ensure that the agreement continues to 

satisfy the requirements of this 

definition; and 

(v) The agreement does not contain a 

walkaway clause (that is, a provision 

that permits a non-defaulting 

counterparty to make lower payments 

than it would make otherwise under the 

agreement, or no payment at all, to a 

defaulter or the estate of a defaulter, 

even if the defaulter or the estate of the 

defaulter is a net creditor under the 

agreement). 

The agencies would consider the 

following jurisdictions to be relevant for 

a qualifying master netting agreement: 

The jurisdiction in which each 

counterparty is chartered or the 

equivalent location in the case of noncorporate entities, and if a branch of a 

counterparty is involved, then also the 

jurisdiction in which the branch is 

located; the jurisdiction that governs the 

individual transactions covered by the 

agreement; and the jurisdiction that 

governs the agreement. 

For most exposures, M may be no 

greater than five years and no less than 

one year. For exposures that have an 

original maturity of less than one year 

and are not part of a bank’s ongoing 

financing of the obligor, however, a 

bank may set M equal to the greater of 

one day and M. An exposure is not part 

of a bank’s ongoing financing of the 

obligor if the bank (i) has a legal and 

practical ability not to renew or roll over 

the exposure in the event of credit 

deterioration of the obligor; (ii) makes 

an independent credit decision at the 

inception of the exposure and at every 

renewal or rollover; and (iii) has no 

substantial commercial incentive to 

continue its credit relationship with the 

obligor in the event of credit 

deterioration of the obligor. Examples of 

transactions that may qualify for the 

exemption from the one-year maturity 

floor include due from other banks, 

including deposits in other banks; 

bankers’ acceptances; sovereign 

exposures; short-term self-liquidating 

trade finance exposures; repo-style 

transactions; eligible margin loans; 

unsettled trades and other exposures 

resulting from payment and settlement 

processes; and collateralized OTC 

derivative contracts subject to daily 

remargining. 

4. Phase 4—Calculation of RiskWeighted Assets 

After a bank assigns risk parameters to 

each of its wholesale obligors and 


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exposures and retail segments, the bank 

would calculate the dollar risk-based 

capital requirement for each wholesale 

exposure to a non-defaulted obligor or 

segment of non-defaulted retail 

exposures (except eligible guarantees 

and eligible credit derivatives that 

hedge another wholesale exposure and 

exposures to which the bank is applying 

the double default treatment in section 

34 of the proposed rule) by inserting the 

risk parameters for the wholesale 

obligor and exposure or retail segment 

into the appropriate IRB risk-based 

capital formula specified in Table C and 

multiplying the output of the formula 

(K) by the EAD of the exposure or 

segment. Eligible guarantees and eligible 

credit derivatives that are hedges of a 

wholesale exposure would be reflected 

in the risk-weighted assets amount of 

the hedged exposure (i) through 

adjustments made to the risk parameters 

of the hedged exposure under the PD 

substitution or LGD adjustment 

approach in section 33 of the proposed 

rule or (ii) through a separate double 

default risk-based capital requirement 

formula in section 34 of the proposed 

rule. 

The sum of the dollar risk-based 

capital requirements for wholesale 

exposures to a non-defaulted obligor 

and segments of non-defaulted retail 

exposures (including exposures subject 

to the double default treatment 

described below) would equal the total 

dollar risk-based capital requirement for 

those exposures and segments. The total 

dollar risk-based capital requirement 

would be converted into a risk-weighted 

asset amount by multiplying it by 12.5. 

To compute the risk-weighted asset 

amount for a wholesale exposure to a 

defaulted obligor, a bank would first 

have to compare two amounts: (i) The 

sum of 0.08 multiplied by the EAD of 

the wholesale exposure plus the amount 

of any charge-offs or write-downs on the 

exposure; and (ii) K for the wholesale 

exposure (as determined in Table C 

immediately before the obligor became 

defaulted), multiplied by the EAD of the 

exposure immediately before the 

exposure became defaulted. If the 

amount calculated in (i) is equal to or 

greater than the amount calculated in 

(ii), the dollar risk-based capital 

requirement for the exposure is 0.08 

multiplied by the EAD of the exposure. 

If the amount calculated in (i) is less 

than the amount calculated in (ii), the 


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49See 12 CFR part 3, Appendix A, section 

3(a)(3)(iii) (national banks); 12 CFR part 208, 

Appendix A, section III.C.3. (state member banks); 

12 CFR part 225, Appendix A, section III.C.3. (bank 

holding companies); 12 CFR part 325, Appendix A, 

section II.C.a. (state nonmember banks); 12 CFR 

567.6(a)(1)(iii) and (iv) (savings associations). 

50See sections 618(a) and (b) of the RTCRRI Act. 

The first class includes loans for the construction 

of a residence consisting of 1- to 4-family dwelling 

units that have been pre-sold under firm contracts 

to purchasers who have obtained firm commitments 

for permanent qualifying mortgages and have made 

substantial earnest money deposits. The second 

class includes loans that are secured by a first lien 

on a residence consisting of more than 4 dwelling 

units if the loan meets certain criteria outlined in 

the RTCRRI Act. 

51See sections 618(a) and (b) of the RTCRRI Act. 

52See section 618(a)(1)((B) of the RTCRRI Act. 

53See section 618(b)(1)(B) of the RTCRRI Act. 

54See section 618(a)(2) of the RTCRRI Act. 

dollar risk-based capital requirement for 

the exposure is K for the exposure (as 

determined in Table C immediately 

before the obligor became defaulted), 

multiplied by the EAD of the exposure. 

The reason for this comparison is to 

ensure that a bank does not receive a 

regulatory capital benefit as a result of 

the exposure moving from nondefaulted to defaulted status. 

The proposed rule provides a simpler 

approach for segments of defaulted 

retail exposures. The dollar risk-based 

capital requirement for a segment of 

defaulted retail exposures equals 0.08 

multiplied by the EAD of the segment. 

The agencies are proposing this uniform 

8 percent risk-based capital requirement 

for defaulted retail exposures to ease 

implementation burden on banks and in 

light of accounting and other 

supervisory policies in the retail context 

that would help prevent the sum of a 

bank’s ECL and risk-based capital 

requirement for a retail exposure from 

declining at the time of default. 

To convert the dollar risk-based 

capital requirements to a risk-weighted 

asset amount, the bank would sum the 

dollar risk-based capital requirements 

for all wholesale exposures to defaulted 

obligors and segments of defaulted retail 

exposures and multiply the sum by 

12.5. 

A bank could assign a risk-weighted 

asset amount of zero to cash owned and 

held in all offices of the bank or in 

transit, and for gold bullion held in the 

bank’s own vaults or held in another 

bank’s vaults on an allocated basis, to 

the extent it is offset by gold bullion 

liabilities. On-balance-sheet assets that 

do not meet the definition of a 

wholesale, retail, securitization, or 

equity exposure—for example, property, 

plant, and equipment and mortgage 

servicing rights—and portfolios of 

exposures that the bank has 

demonstrated to its primary Federal 

supervisor’s satisfaction are, when 

combined with all other portfolios of 

exposures that the bank seeks to treat as 

immaterial for risk-based capital 

purposes, not material to the bank 

generally would be assigned riskweighted asset amounts equal to their 

carrying value (for on-balance-sheet 

exposures) or notional amount (for offbalance-sheet exposures). For this 

purpose, the notional amount of an OTC 

derivative contract that is not a credit 

derivative is the EAD of the derivative 

as calculated in section 32 of the 

proposed rule. 

Total wholesale and retail riskweighted assets would be the sum of 

risk-weighted assets for wholesale 

exposures to non-defaulted obligors and 

segments of non-defaulted retail 

exposures, wholesale exposures to 

defaulted obligors and segments of 

defaulted retail exposures, assets not 

included in an exposure category, nonmaterial portfolios of exposures, and 

unsettled transactions minus the 

amounts deducted from capital 

pursuant to the general risk-based 

capital rules (excluding those 

deductions reversed in section 12 of the 

proposed rule). 

5. Statutory Provisions on the 

Regulatory Capital Treatment of Certain 

Mortgage Loans 

The general risk-based capital rules 

assign 50 and 100 percent risk weights 

to certain one- to four-family residential 

pre-sold construction loans and 

multifamily residential loans.49 The 

agencies adopted these provisions as a 

result of the Resolution Trust 

Corporation Refinancing, Restructuring, 

and Improvement Act of 1991 (RTCRRI 

Act).50 The RTCRRI Act mandates that 

each agency provide in its capital 

regulations (i) a 50 percent risk weight 

for certain one- to four-family 

residential pre-sold construction loans 

and multifamily residential loans that 

meet specific statutory criteria set forth 

in the Act and any other underwriting 

criteria imposed by the agencies; and (ii) 

a 100 percent risk weight for one- to 

four-family residential pre-sold 

construction loans for residences for 

which the purchase contract is 

cancelled.51

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 risksensitive IRB approach in the Basel II 

framework. 

For purposes of this proposed rule 

implementing the Basel II IRB approach, 

the agencies are proposing that the three 

types of residential mortgage loans 

addressed by the RTCRRI Act should 

continue to receive the risk weights 

provided in the Act. Specifically, 

consistent with the general risk-based 

capital rules, the proposed rule requires 

a bank to use the following risk weights 

(instead of the risk weights that would 

otherwise be produced under the IRB 

risk-based capital formulas): (i) A 50 

percent risk weight for one- to fourfamily residential construction loans if 

the residences have been pre-sold under 

firm contracts to purchasers who have 

obtained firm commitments for 

permanent qualifying mortgages and 

have made substantial earnest money 

deposits, and the loans meet the other 

underwriting characteristics established 

by the agencies in the general risk-based 

capital rules; 52 (ii) a 50 percent risk 

weight for multifamily residential loans 

that meet certain statutory loan-to-value, 

debt-to-income, amortization, and 

performance requirements, and meet the 

other underwriting characteristics 

established by the agencies in the 

general risk-based capital rules; 53 and 

(iii) a 100 percent risk weight for oneto four-family residential pre-sold 

construction loans for a residence for 

which the purchase contract is 

canceled.54 Mortgage loans that do not 

meet the relevant criteria do not qualify 

for the statutory risk weights and will be 

risk-weighted according to the IRB riskbased capital formulas. 

The agencies understand that there is 

a tension between the statutory risk 

weights provided by the RTCRRI Act 

and the more risk-sensitive IRB 

approaches to risk-based capital that are 

contained in this proposed rule. 

Question 32: The agencies seek 

comment on whether the agencies 

should impose the following 

underwriting criteria as additional 

requirements for a Basel II bank to 

qualify for the statutory 50 percent risk 

weight for a particular mortgage loan: (i) 

That the bank has an IRB risk 

measurement and management system 

in place that assesses the PD and LGD 

of prospective residential mortgage 

exposures; and (ii) that the bank’s IRB 

system generates a 50 percent risk 

weight for the loan under the IRB riskbased capital formulas. The agencies 

note that a capital-related provision of 

the Federal Deposit Insurance 

Corporation Improvement Act of 1991 

(FDICIA), enacted by Congress just four 

days after its adoption of the RTCRRI 

Act, directs each agency to revise its 

risk-based capital standards for DIs to 

ensure that those standards ‘‘reflect the 


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

notes). 

actual performance and expected risk of 

loss of multifamily mortgages.’’ 55

Question 33: The agencies seek 

comment on all aspects of the proposed 

treatment of one- to four-family 

residential pre-sold construction loans 

and multifamily residential loans. 

C. Credit Risk Mitigation (CRM) 

Techniques 

Banks use a number of techniques to 

mitigate credit risk. This section of the 

preamble describes how the proposed 

rule recognizes the risk-mitigating 

effects of both financial collateral 

(defined below) and nonfinancial 

collateral, as well as guarantees and 

credit derivatives, for risk-based capital 

purposes. To recognize credit risk 

mitigants for risk-based capital 

purposes, a bank should have in place 

operational procedures and risk 

management processes that ensure that 

all documentation used in 

collateralizing or guaranteeing a 

transaction is legal, valid, binding, and 

enforceable under applicable law in the 

relevant jurisdictions. The bank should 

have conducted sufficient legal review 

to reach a well-founded conclusion that 

the documentation meets this standard 

and should reconduct such a review as 

necessary to ensure continuing 

enforceability. 

Although the use of CRM techniques 

may reduce or transfer credit risk, it 

simultaneously may increase other 

risks, including operational, liquidity, 

and market risks. Accordingly, it is 

imperative that banks employ robust 

procedures and processes to control 

risks, including roll-off risk and 

concentration risk, arising from the 

bank’s use of CRM techniques and to 

monitor the implications of using CRM 

techniques for the bank’s overall credit 

risk profile. 

1. Collateral 

Under the proposed rule, a bank 

generally recognizes collateral that 

secures a wholesale exposure as part of 

the ELGD and LGD estimation process 

and generally recognizes collateral that 

secures a retail exposure as part of the 

PD, ELGD, and LGD estimation process, 

as described above in section V.B.3. of 

the preamble. However, in certain 

limited circumstances described in the 

next section, a bank may adjust EAD to 

reflect the risk mitigating effect of 

financial collateral. 

When reflecting the credit risk 

mitigation benefits of collateral in its 

estimation of the risk parameters of a 

wholesale or retail exposure, a bank 

should: 

(i) Conduct sufficient legal review to 

ensure, at inception and on an ongoing 

basis, that all documentation used in the 

collateralized transaction is binding on 

all parties and legally enforceable in all 

relevant jurisdictions; 

(ii) Consider the relation (that is, 

correlation) between obligor risk and 

collateral risk in the transaction; 

(iii) Consider any currency and/or 

maturity mismatch between the hedged 

exposure and the collateral; 

(iv) Ground its risk parameter 

estimates for the transaction in 

historical data, using historical recovery 

rates where available; and 

(v) Fully take into account the time 

and cost needed to realize the 

liquidation proceeds and the potential 

for a decline in collateral value over this 

time period. 

The bank also should ensure that: 

(i) The legal mechanism under which 

the collateral is pledged or transferred 

ensures that the bank has the right to 

liquidate or take legal possession of the 

collateral in a timely manner in the 

event of the default, insolvency, or 

bankruptcy (or other defined credit 

event) of the obligor and, where 

applicable, the custodian holding the 

collateral; 

(ii) The bank has taken all steps 

necessary to fulfill legal requirements to 

secure its interest in the collateral so 

that it has and maintains an enforceable 

security interest; 

(iii) The bank has clear and robust 

procedures for the timely liquidation of 

collateral to ensure observation of any 

legal conditions required for declaring 

the default of the borrower and prompt 

liquidation of the collateral in the event 

of default; 

(iv) The bank has established 

procedures and practices for (A) 

conservatively estimating, on a regular 

ongoing basis, the market value of the 

collateral, taking into account factors 

that could affect that value (for example, 

the liquidity of the market for the 

collateral and obsolescence or 

deterioration of the collateral), and (B) 

where applicable, periodically verifying 

the collateral (for example, through 

physical inspection of collateral such as 

inventory and equipment); and 

(v) The bank has in place systems for 

promptly requesting and receiving 

additional collateral for transactions 

whose terms require maintenance of 

collateral values at specified thresholds. 

2. EAD for Counterparty Credit Risk 

This section describes two EAD-based 

methodologies—a collateral haircut 

approach and an internal models 

methodology—that a bank may use 

instead of an ELGD/LGD estimation 

methodology to recognize the benefits of 

financial collateral in mitigating the 

counterparty credit risk associated with 

repo-style transactions, eligible margin 

loans, collateralized OTC derivative 

contracts, and single product groups of 

such transactions with a single 

counterparty subject to a qualifying 

master netting agreement. A third 

methodology, the simple VaR 

methodology, is also available to 

recognize financial collateral mitigating 

the counterparty credit risk of single 

product netting sets of repo-style 

transactions and eligible margin loans. 

A bank may use any combination of 

the three methodologies for collateral 

recognition; however, it must use the 

same methodology for similar 

exposures. A bank may choose to use 

one methodology for agency securities 

lending transactions—that is, repo-style 

transactions in which the bank, acting 

as agent for a customer, lends the 

customer’s securities and indemnifies 

the customer against loss—and another 

methodology for all other repo-style 

transactions. This section also describes 

the methodology for calculating EAD for 

an OTC derivative contract or set of 

OTC derivative contracts subject to a 

qualifying master netting agreement. 

Table D illustrates which EAD 

estimation methodologies may be 

applied to particular types of exposure. 


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56Only repo-style transactions and eligible 

margin loans subject to a single-product qualifying 

master netting agreement are eligible for the simple 

VaR methodology. 

57 In conjunction with the current exposure 

methodology. 

58This requirement is met where all transactions 

under the agreement are (i) executed under U.S. law 

and (ii) constitute ‘‘securities contracts’’ or 

‘‘repurchase agreements’’ under section 555 or 559, 

respectively, of the Bankruptcy Code (11 U.S.C. 555 

or 559), qualified financial contracts under section 

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

U.S.C. 1821(e)(8)), or netting contracts between or 

among financial institutions under sections 401–

407 of the Federal Deposit Insurance Corporation 

Improvement Act of 1991 (12 U.S.C. 4401–4407) or 

the Federal Reserve Board’s Regulation EE (12 CFR 

part 231). 

TABLE D 

Current exposure 

methodology 

Collateral 

haircut approach 

Models approach 

Simple 

VaR 56

methodology 

Internal 

models 

methodology 

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

Recognition of collateral for OTC derivatives .................................................................. X57 X 

Repo-style transaction ..................................................................................................... X X X 

Eligible margin loan ......................................................................................................... X X X 

Cross-product netting set ................................................................................................ X 

Question 34: For purposes of 

determining EAD for counterparty credit 

risk and recognizing collateral 

mitigating that risk, the proposed rule 

allows banks to take into account only 

financial collateral, which, by 

definition, does not include debt 

securities that have an external rating 

lower than one rating category below 

investment grade. The agencies invite 

comment on the extent to which lowerrated debt securities or other securities 

that do not meet the definition of 

financial collateral are used in these 

transactions and on the CRM value of 

such securities. 

EAD for repo-style transactions and 

eligible margin loans. Under the 

proposal, a bank could recognize the 

risk mitigating effect of financial 

collateral that secures a repo-style 

transaction, eligible margin loan, or 

single-product group of such 

transactions with a single counterparty 

subject to a qualifying master netting 

agreement (netting set) through an 

adjustment to EAD rather than ELGD 

and LGD. The bank may use a collateral 

haircut approach or one of two models 

approaches: a simple VaR methodology 

(for single-product netting sets of repostyle transactions or eligible margin 

loans) or an internal models 

methodology. Figure 2 illustrates the 

methodologies available for calculating 

EAD and LGD for eligible margin loans 

and repo-style transactions. 

The proposed rule defines repo-style 

transaction as a repurchase or reverse 

repurchase transaction, or a securities 

borrowing or securities lending 

transaction (including a transaction in 

which the bank acts as agent for a 

customer and indemnifies the customer 

against loss), provided that: 

(i) The transaction is based solely on 

liquid and readily marketable securities 

or cash; 

(ii) The transaction is marked to 

market daily and subject to daily margin 

maintenance requirements; 

(iii) The transaction is executed under 

an agreement that provides the bank the 

right to accelerate, terminate, and closeout the transaction on a net basis and to 

liquidate or set off collateral promptly 

upon an event of default (including 

upon an event of bankruptcy, 

insolvency, or similar proceeding) of the 

counterparty, provided that, in any such 

case, any exercise of rights under the 

agreement will not be stayed or avoided 

under applicable law in the relevant 

jurisdictions; 58 and 


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59This requirement is met under the 

circumstances described in the previous footnote. 

(iv) The bank has conducted and 

documented sufficient legal review to 

conclude with a well-founded basis that 

the agreement meets the requirements of 

paragraph (iii) of this definition and is 

legal, valid, binding, and enforceable 

under applicable law in the relevant 

jurisdictions. 

Question 35: The agencies recognize 

that criterion (iii) above may pose 

challenges for certain transactions that 

would not be eligible for certain 

exemptions from bankruptcy or 

receivership laws because the 

counterparty—for example, a sovereign 

entity or a pension fund—is not subject 

to such laws. The agencies seek 

comment on ways this criterion could be 

crafted to accommodate such 

transactions when justified on 

prudential grounds, while ensuring that 

the requirements in criterion (iii) are 

met for transactions that are eligible for 

those exemptions. 

The proposed rule defines an eligible 

margin loan as an extension of credit 

where: 

(i) The credit extension is 

collateralized exclusively by debt or 

equity securities that are liquid and 

readily marketable; 

(ii) The collateral is marked to market 

daily and the transaction is subject to 

daily margin maintenance requirements; 

(iii) The extension of credit is 

conducted under an agreement that 

provides the bank the right to accelerate 

and terminate the extension of credit 

and to liquidate or set off collateral 

promptly upon an event of default 

(including upon an event of bankruptcy, 

insolvency, or similar proceeding) of the 

counterparty, provided that, in any such 

case, any exercise of rights under the 

agreement will not be stayed or avoided 

under applicable law in the relevant 

jurisdictions;59 and 

(iv) The bank has conducted and 

documented sufficient legal review to 

conclude with a well-founded basis that 

the agreement meets the requirements of 

paragraph (iii) of this definition and is 

legal, valid, binding, and enforceable 

under applicable law in the relevant 

jurisdictions. 

The proposed rule describes various 

ways that a bank may recognize the risk 

mitigating impact of financial collateral. 

The proposed rule defines financial 

collateral as collateral in the form of any 

of the following instruments in which 

the bank has a perfected, first priority 

security interest or the legal equivalent 

thereof: (i) Cash on deposit with the 

bank (including cash held for the bank 

by a third-party custodian or trustee); 

(ii) gold bullion; (iii) long-term debt 

securities that have an applicable 

external rating of one category below 

investment grade or higher (for example, 

at least BB–); (iv) short-term debt 

instruments that have an applicable 

external rating of at least investment 

grade (for example, at least A–3); (v) 

equity securities that are publicly 

traded; (vi) convertible bonds that are 

publicly traded; and (vii) mutual fund 

shares for which a share price is 

publicly quoted daily and money 

market mutual fund shares. Question 

36: The agencies seek comment on the 

appropriateness of requiring that a bank 

have a perfected, first priority security 

interest, or the legal equivalent thereof, 

in the definition of financial collateral. 

The proposed rule defines an external 

rating as a credit rating assigned by a 

nationally recognized statistical rating 

organization (NRSRO) to an exposure 

that fully reflects the entire amount of 

credit risk the holder of the exposure 

has with regard to all payments owed to 

it under the exposure. For example, if a 

holder is owed principal and interest on 

an exposure, the external rating must 


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60Banks should take particular care with these 

requirements where the financial collateral is in the 

form of a securitization exposure. 

61The proposed rule defines a ‘‘main index’’ as 

the S&P 500 Index, the FTSE All-World Index, and 

any other index for which the bank demonstrates 

to the satisfaction of its primary Federal supervisor 

that the equities represented in the index have 

comparable liquidity, depth of market, and size of 

bid-ask spreads as equities in the S&P 500 Index 

and the FTSE All-World Index. 

fully reflect the credit risk associated 

with timely repayment of principal and 

interest. Moreover, the external rating 

must be published in an accessible form 

and must be included in the transition 

matrices made publicly available by the 

NRSRO that summarize the historical 

performance of positions it has rated.60

Under the proposed rule, an exposure’s 

applicable external rating is the lowest 

external rating assigned to the exposure 

by any NRSRO. 

Collateral haircut approach. Under 

the collateral haircut approach, a bank 

would set EAD equal to the sum of three 

quantities: (i) The value of the exposure 

less the value of the collateral; (ii) the 

absolute value of the net position in a 

given security (where the net position in 

a given security equals the sum of the 

current market values of the particular 

security the bank has lent, sold subject 

to repurchase, or posted as collateral to 

the counterparty minus the sum of the 

current market values of that same 

security the bank has borrowed, 

purchased subject to resale, or taken as 

collateral from the counterparty) 

multiplied by the market price volatility 

haircut appropriate to that security; and 

(iii) the sum of the absolute values of 

the net position of both cash and 

securities in each currency that is 

different from the settlement currency 

multiplied by the haircut appropriate to 

each currency mismatch. To determine 

the appropriate haircuts, a bank could 

choose to use standard supervisory 

haircuts or its own estimates of haircuts. 

For purposes of the collateral haircut 

approach, a given security would 

include, for example, all securities with 

a single Committee on Uniform 

Securities Identification Procedures 

(CUSIP) number and would not include 

securities with different CUSIP 

numbers, even if issued by the same 

issuer with the same maturity date. 

Question 37: The agencies recognize 

that this is a conservative approach and 

seek comment on other approaches to 

consider in determining a given security 

for purposes of the collateral haircut 

approach. 

Standard Supervisory Haircuts 

If a bank chooses to use standard 

supervisory haircuts, it would use an 8 

percent haircut for each currency 

mismatch and the haircut appropriate to 

each security in table E below. These 

haircuts are based on the 10-businessday holding period for eligible margin 

loans and may be multiplied by the 

square root of 1⁄2 to convert the standard 

supervisory haircuts to the 5-businessday minimum holding period for repostyle transactions. A bank must adjust 

the standard supervisory haircuts 

upward on the basis of a holding period 

longer than 10 business days for eligible 

margin loans or 5 business days for 

repo-style transactions where and as 

appropriate to take into account the 

illiquidity of an instrument. 

TABLE E.—STANDARD SUPERVISORY MARKET PRICE VOLATILITY HAIRCUTS

Applicable external rating grade category for debt securities Residual maturity for debt 

securities 

Issuers exempt 

from the 3 b.p. 

floor 

Other issuers 

Two highest investment grade rating categories for long-term ratings/highest 

investment grade rating category for short-term ratings.

≤1 year .............................

>1 year, ≤5 years .............

>5 years ...........................

.005 

.02 

.04 

.01 

.04 

.08 

Two lowest investment grade rating categories for both short- and long-term 

ratings.

≤1 year .............................

>1 year, ≤5 years .............

>5 years ...........................

.01 

.03 

.06 

.02 

.06 

.12 

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

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

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

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

security in which the fund can invest. 

Cash on deposit with the bank (including a certificate of deposit issued by the bank) .................................. 0 

As an example, assume a bank that 

uses standard supervisory haircuts has 

extended an eligible margin loan of 

$100 that is collateralized by 5-year U.S. 

Treasury notes with a market value of 

$100. The value of the exposure less the 

value of the collateral would be zero, 

and the net position in the security 

($100) times the supervisory haircut 

(.02) would be $2. There is no currency 

mismatch. Therefore, the EAD of the 

exposure would be $0 + $2 = $2. 

Own estimates of haircuts. With the 

prior written approval of the bank’s 

primary Federal supervisor, a bank may 

calculate security type and currency 

mismatch haircuts using its own 

internal estimates of market price 

volatility and foreign exchange 

volatility. The bank’s primary Federal 

supervisor would base approval to use 

internally estimated haircuts on the 

satisfaction of certain minimum 

qualitative and quantitative standards. 

These standards include: (i) The bank 

must use a 99th percentile one-tailed 

confidence interval and a minimum 5- 

business-day holding period for repostyle transactions and a minimum 10- 

business-day holding period for all 

other transactions; (ii) the bank must 

adjust holding periods upward where 

and as appropriate to take into account 

the illiquidity of an instrument; (iii) the 

bank must select a historical observation 

period for calculating haircuts of at least 

one year; and (iv) the bank must update 

its data sets and recompute haircuts no 

less frequently than quarterly and must 

update its data sets and recompute 

haircuts whenever market prices change 

materially. A bank must estimate 


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individually the volatilities of the 

exposure, the collateral, and foreign 

exchange rates, and may not take into 

account the correlations between them. 

A bank that uses internally estimated 

haircuts would have to adhere to the 

following rules. The bank may calculate 

internally estimated haircuts for 

categories of debt securities that have an 

applicable external rating of at least 

investment grade. The haircut for a 

category of securities would have to be 

representative of the internal volatility 

estimates for securities in that category 

that the bank has actually lent, sold 

subject to repurchase, posted as 

collateral, borrowed, purchased subject 

to resale, or taken as collateral. In 

determining relevant categories, the 

bank would have to take into account (i) 

the type of issuer of the security; (ii) the 

applicable external rating of the 

security; (iii) the maturity of the 

security; and (iv) the interest rate 

sensitivity of the security. A bank would 

calculate a separate internally estimated 

haircut for each individual debt security 

that has an applicable external rating 

below investment grade and for each 

individual equity security. In addition, 

a bank would internally estimate a 

separate currency mismatch haircut for 

each individual mismatch between each 

net position in a currency that is 

different from the settlement currency. 

When a bank calculates an internally 

estimated haircut on a TN-day holding 

period, which is different from the 

minimum holding period for the 

transaction type, the applicable haircut 

(HM) must be calculated using the 

following square root of time formula: 

H H T

T M N

M

N

= , 

Where: 

(i) TM = 5 for repo-style transactions and 10 

for eligible margin loans; 

(ii) TN = holding period used by the bank to 

derive HN; and 

(iii) HN = haircut based on the holding period 

TN. 

Simple VaR methodology. As noted 

above, a bank may use one of two 

internal models approaches to recognize 

the risk mitigating effects of financial 

collateral that secures a repo-style 

transaction or eligible margin loan. This 

section of the preamble describes the 

simple VaR methodology; a later section 

of the preamble describes the internal 

models methodology (which also may 

be used to determine the EAD for OTC 

derivative contracts). 

With the prior written approval of its 

primary Federal supervisor, a bank may 

estimate EAD for repo-style transactions 

and eligible margin loans subject to a 

single product qualifying master netting 

agreement using a VaR model. Under 

the simple VaR methodology, a bank’s 

EAD for the transactions subject to such 

a netting agreement would be equal to 

the value of the exposures minus the 

value of the collateral plus a VaR-based 

estimate of the potential future exposure 

(PFE), that is, the maximum exposure 

expected to occur on a future date with 

a high level of confidence. The value of 

the exposures is the sum of the current 

market values of all securities and cash 

the bank has lent, sold subject to 

repurchase, or posted as collateral to a 

counterparty under the netting set. The 

value of the collateral is the sum of the 

current market values of all securities 

and cash the bank has borrowed, 

purchased subject to resale, or taken as 

collateral from a counterparty under the 

netting set. 

The VaR model must estimate the 

bank’s 99th percentile, one-tailed 

confidence interval for an increase in 

the value of the exposures minus the 

value of the collateral (ΣE ¥ ΣC) over 

a 5-business-day holding period for 

repo-style transactions or over a 10- 

business-day holding period for eligible 

margin loans using a minimum one-year 

historical observation period of price 

data representing the instruments that 

the bank has lent, sold subject to 

repurchase, posted as collateral, 

borrowed, purchased subject to resale, 

or taken as collateral. 

The qualifying requirements for the 

use of a VaR model are less stringent 

than the qualification requirements for 

the internal models methodology 

described below. The main ongoing 

qualification requirement for using a 

VaR model is that the bank must 

validate its VaR model by establishing 

and maintaining a rigorous and regular 

backtesting regime. 

3. EAD for OTC Derivative Contracts 

A bank may use either the current 

exposure methodology or the internal 

models methodology to determine the 

EAD for OTC derivative contracts. An 

OTC derivative contract is defined as a 

derivative contract that is not traded on 

an exchange that requires the daily 

receipt and payment of cash-variation 

margin. A derivative contract is defined 

to include interest rate derivative 

contracts, exchange rate derivative 

contracts, equity derivative contracts, 

commodity derivative contracts, credit 

derivatives, and any other instrument 

that poses similar counterparty credit 

risks. The proposed rule also would 

define derivative contracts to include 

unsettled securities, commodities, and 

foreign exchange trades with a 

contractual settlement or delivery lag 

that is longer than the normal settlement 

period (which the proposed rule defines 

as the lesser of the market standard for 

the particular instrument or 5 business 

days). This would include, for example, 

agency mortgage-backed securities 

transactions conducted in the To-BeAnnounced market. 

Figure 3 illustrates the treatment of 

OTC derivative contracts. 


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62The 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. 

Current exposure methodology. The 

proposed current exposure methodology 

for determining EAD for single OTC 

derivative contracts is similar to the 

methodology in the general risk-based 

capital rules, in that the EAD for an OTC 

derivative contract would be equal to 

the sum of the bank’s current credit 

exposure and PFE on the derivative 

contract. The current credit exposure for 

a single OTC derivative contract is the 

greater of the mark-to-market value of 

the derivative contract or zero. 

The proposed current exposure 

methodology for OTC derivative 

contracts subject to qualifying master 

netting agreements is also similar to the 

treatment set forth in the agencies’

general risk-based capital rules. Banks 

would need to calculate net current 

exposure and adjust the gross PFE using 

a formula that includes the net to gross 

current exposure ratio. Moreover, under 

the agencies’ general risk-based capital 

rules, a bank may not recognize netting 

agreements for OTC derivative contracts 

for capital purposes unless it obtains a 

written and reasoned legal opinion 

representing that, in the event of a legal 

challenge, the bank’s exposure would be 

found to be the net amount in the 

relevant jurisdictions. The agencies are 

proposing to retain this standard for 

netting agreements covering OTC 

derivative contracts. While the legal 

enforceability of contracts is necessary 

for a bank to recognize netting effects in 

the capital calculation, there may be 

ways other than obtaining an explicit 

written opinion to ensure the 

enforceability of a contract. For 

example, the use of industry developed 

standardized contracts for certain OTC 

products and reliance on commissioned 

legal opinions as to the enforceability of 

these contracts in many jurisdictions 

may be sufficient. Question 38: The 

agencies seek comment on methods 

banks would use to ensure 

enforceability of single product OTC 

derivative netting agreements in the 

absence of an explicit written legal 

opinion requirement. 

The proposed rule’s conversion factor 

(CF) matrix used to compute PFE is 

based on the matrices in the general 

risk-based capital rules, with two 

exceptions. First, under the proposed 

rule the CF for credit derivatives that are 

not used to hedge the credit risk of 

exposures subject to an IRB credit risk 

capital requirement is specified to be 5.0 

percent for contracts with investment 

grade reference obligors and 10.0 

percent for contracts with noninvestment grade obligors.62 The CF for 

a credit derivative contract does not 

depend on the remaining maturity of the 

contract. The second change is that 

floating/floating basis swaps would no 

longer be exempted from the CF for 

interest rate derivative contracts. The 

exemption was put into place when 

such swaps were very simple, and the 


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63BCBS, ‘‘The Application of Basel II to Trading 

Activities and the Treatment of Double Default 

Effects,’’ July 2005, ¶ 15. 

agencies believe it is no longer 

appropriate given the evolution of the 

product. The computation of the PFE of 

multiple OTC derivative contracts 

subject to a qualifying master netting 

agreement would not change from the 

general risk-based capital rules. 

If an OTC derivative contract is 

collateralized by financial collateral, a 

bank would first determine an 

unsecured EAD as described above and 

in section 32(b) of the proposed rule. To 

take into account the risk-reducing 

effects of the financial collateral, the 

bank may either adjust the ELGD and 

LGD of the contract or, if the transaction 

is subject to daily marking-to-market 

and remargining, adjust the EAD of the 

contract using the collateral haircut 

approach for repo-style transactions and 

eligible margin loans described above 

and in section 32(a) of the proposed 

rule. 

Under part VI of the proposed rule, a 

bank must treat an equity derivative 

contract as an equity exposure and 

compute a risk-weighted asset amount 

for that exposure. If the bank is using 

the internal models approach for its 

equity exposures, it also must compute 

a risk-weighted asset amount for its 

counterparty credit risk exposure on the 

equity derivative contract. However, if 

the bank is using the simple risk weight 

approach for its equity exposures, it 

may choose not to hold risk-based 

capital against the counterparty credit 

risk of the equity derivative contract. 

Likewise, a bank that purchases a credit 

derivative that is recognized under 

section 33 or 34 of the proposed rule as 

a credit risk mitigant for an exposure 

that is not a covered position under the 

MRA does not have to compute a 

separate counterparty credit risk capital 

requirement for the credit derivative. If 

a bank chooses not to hold risk-based 

capital against the counterparty credit 

risk of such equity or credit derivative 

contracts, it must do so consistently for 

all such equity derivative contracts or 

for all such credit derivative contracts. 

Further, where the contracts are subject 

to a qualifying master netting 

agreement, the bank must either include 

them all or exclude them all from any 

measure used to determine counterparty 

credit risk exposure to all relevant 

counterparties for risk-based capital 

purposes. 

Where a bank provides protection 

through a credit derivative that is not 

treated as a covered position under the 

MRA, it must treat the credit derivative 

as a wholesale exposure to the reference 

obligor and compute a risk-weighted 

asset amount for the credit derivative 

under section 31 of the proposed rule. 

The bank need not compute a 

counterparty credit risk capital 

requirement for the credit derivative, so 

long as it does so consistently for all 

such credit derivatives and either 

includes all or excludes all such credit 

derivatives that are subject to a master 

netting contract from any measure used 

to determine counterparty credit risk 

exposure to all relevant counterparties 

for risk-based capital purposes. Where 

the bank provides protection through a 

credit derivative treated as a covered 

position under the MRA, it must 

compute a counterparty credit risk 

capital requirement under section 32 of 

the proposed rule. 

4. Internal Models Methodology 

This proposed rule includes an 

internal models methodology for the 

calculation of EAD for transactions with 

counterparty credit exposure, namely, 

OTC derivatives, eligible margin loans, 

and repo-style transactions. The internal 

models methodology requires a risk 

model that captures counterparty credit 

risk and estimates EAD at the level of a 

‘‘netting set.’’ A netting set is a group of 

transactions with a single counterparty 

that are subject to a qualifying master 

netting agreement. A transaction not 

subject to a qualifying master netting 

agreement is considered to be its own 

netting set and EAD must be calculated 

for each such transaction individually. 

A bank may use the internal models 

methodology for OTC derivatives 

(collateralized or uncollateralized) and 

single-product netting sets thereof, for 

eligible margin loans and single-product 

netting sets thereof, or for repo-style 

transactions and single-product netting 

sets thereof. A bank that uses the 

internal models methodology for a 

particular transaction type (that is, OTC 

derivative contracts, eligible margin 

loans, or repo-style transactions) must 

use the internal models methodology for 

all transactions in that transaction type. 

However, a bank may choose whether or 

not to use the internal models 

methodology for each transaction type. 

A bank also may use the internal 

models methodology for OTC 

derivatives, eligible margin loans, and 

repo-style transactions subject to a 

qualifying cross-product master netting 

agreement if (i) the bank effectively 

integrates the risk mitigating effects of 

cross-product netting into its risk 

management and other information 

technology systems; and (ii) the bank 

obtains the prior written approval of its 

primary Federal supervisor. 

A qualifying cross-product master 

netting agreement is defined as a 

qualifying master netting agreement that 

provides for termination and close-out 

netting across multiple types of 

financial transactions or qualifying 

master netting agreements in the event 

of a counterparty’s default, provided 

that: 

(i) The underlying financial 

transactions are OTC derivative 

contracts, eligible margin loans, or repostyle transactions; and 

(ii) The bank obtains a written legal 

opinion verifying the validity and 

enforceability of the netting agreement 

under applicable law of the relevant 

jurisdictions if the counterparty fails to 

perform upon an event of default, 

including upon an event of bankruptcy, 

insolvency, or similar proceeding. 

Banks use several measures to manage 

their exposure to counterparty credit 

risk including PFE, expected exposure 

(EE), and expected positive exposure 

(EPE). PFE is the maximum exposure 

estimated to occur on a future date at a 

high level of statistical confidence. 

Banks often use PFE when measuring 

counterparty credit risk exposure 

against counterparty credit limits. EE is 

the probability-weighted average 

exposure to a counterparty estimated to 

exist at any specified future date, 

whereas EPE is the time-weighted 

average of individual expected 

exposures estimated for a given 

forecasting horizon (one year in the 

proposed rule). Banks typically compute 

EPE, EE, and PFE using a common 

stochastic model. 

A paper published by the BCBS in 

July 2005 titled ‘‘The Application of 

Basel II to Trading Activities and the 

Treatment of Double Default Effects’’

notes that EPE is an appropriate EAD 

measure for determining risk-based 

capital requirements for counterparty 

credit risk because transactions with 

counterparty credit risk ‘‘are given the 

same standing as loans with the goal of 

reducing the capital treatment’s 

influence on a firm’s decision to extend 

an on-balance sheet loan rather than 

engage in an economically equivalent 

transaction that involves exposure to 

counterparty credit risk.’’63 An 

adjustment to EPE, called effective EPE 

and described below, is used in the 

calculation of EAD under the internal 

models methodology. EAD is calculated 

as a multiple of effective EPE. 

To address the concern that EE and 

EPE may not capture risk arising from 

the replacement of existing short-term 

positions over the one year horizon used 

for capital requirements (that is, rollover 

risk) or may underestimate the 

exposures of eligible margin loans, repostyle transactions, and OTC derivatives 


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55874 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

with short maturities, the proposed rule 

uses a netting set’s ‘‘effective EPE’’ as 

the basis for calculating EAD for 

counterparty credit risk. Consistent with 

the use of a one-year PD horizon, 

effective EPE is the time-weighted 

average of effective EE over one year 

where the weights are the proportion 

that an individual effective EE 

represents in a one-year time interval. If 

all contracts in a netting set mature 

before one year, effective EPE is the 

average of effective EE until all contracts 

in the netting set mature. For example, 

if the longest maturity contract in the 

netting set matures in six months, 

effective EPE would be the average of 

effective EE over six months. 

Effective EE is defined as: 

Effective EE tk = max(Effective EE tk¥1, 

EE tk) where exposure is measured at 

future dates t1, t2, t3, * * * and 

effective EE t0 equals current exposure. 

Alternatively, a bank may use a measure 

that is more conservative than effective 

EPE for every counterparty (that is, a 

measure based on peak exposure) with 

prior approval of the primary Federal 

supervisor. 

The EAD for instruments with 

counterparty credit risk must be 

determined assuming economic 

downturn conditions. To accomplish 

this determination in a prudent manner, 

the internal models methodology sets 

EAD equal to EPE multiplied by a 

scaling factor termed ‘‘alpha.’’ Alpha is 

set at 1.4; a bank’s primary Federal 

supervisor would have the flexibility to 

raise this value based on the bank’s 

specific characteristics of counterparty 

credit risk. With supervisory approval, a 

bank may use its own estimate of alpha 

as described below, subject to a floor of 

1.2. Question 39: The agencies request 

comment on all aspect of the effective 

EPE approach to counterparty credit 

risk, and in particular on the 

appropriateness of the monotonically 

increasing effective EE function, the 

alpha constant of 1.4, and the floor on 

internal estimates of alpha of 1.2. 

A bank’s primary Federal supervisor 

must determine that the bank meets 

certain qualifying criteria before the 

bank may use the internal models 

methodology. These criteria consist of 

operational requirements, modeling 

standards, and model validation 

requirements. 

First, the bank must have the systems 

capability to estimate EE on a daily 

basis. While this requirement does not 

require the bank to report EE daily, or 

even estimate EE daily, the bank must 

demonstrate that it is capable of 

performing the estimation daily. 

Second, the bank must estimate EE at 

enough future time points to accurately 

reflect all future cash flows of contracts 

in the netting set. To accurately reflect 

the exposure arising from a transaction, 

the model should incorporate those 

contractual provisions, such as reset 

dates, that can materially affect the 

timing, probability, or amount of any 

payment. The requirement reflects the 

need for an accurate estimate of EPE. 

However, in order to balance the ability 

to calculate exposures with the need for 

information on timely basis, the number 

of time points is not specified. 

Third, the bank must have been using 

an internal model that broadly meets the 

minimum standards to calculate the 

distributions of exposures upon which 

the EAD calculation is based for a 

period of at least one year prior to 

approval. This requirement is to insure 

that the bank has integrated the 

modeling into its counterparty credit 

risk management process. 

Fourth, the bank’s model must 

account for the non-normality of 

exposure distribution where 

appropriate. Non-normality of 

exposures means high loss events occur 

more frequently than would be expected 

on the basis of a normal distribution, the 

statistical term for which is 

leptokurtosis. In many instances, there 

may not be a need to account for this. 

Expected exposures are much less likely 

to be affected by leptokurtosis than peak 

exposures or high percentile losses. 

However, the bank must demonstrate 

that its EAD measure is not affected by 

leptokurtosis or must account for it 

within the model. 

Fifth, the bank must measure, 

monitor, and control the exposure to a 

counterparty over the whole life of all 

contracts in the netting set, in addition 

to accurately measuring and actively 

monitoring the current exposure to 

counterparties. The bank should 

exercise active management of both 

existing exposure and exposure that 

could change in the future due to 

market moves. 

Sixth, the bank must measure and 

manage current exposures gross and net 

of collateral held, where appropriate. 

The bank must estimate expected 

exposures for OTC derivative contracts 

both with and without the effect of 

collateral agreements. 

Seventh, the bank must have 

procedures to identify, monitor, and 

control specific wrong-way risk 

throughout the life of an exposure. In 

this context, wrong-way risk is the risk 

that future exposure to a counterparty 

will be high when the counterparty’s 

probability of default is also high. 

Wrong-way risk generally arises from 

events specific to the counterparty, 

rather than broad market downturns. 

Eighth, the data used by the bank 

should be adequate for the measurement 

and modeling of the exposures. In 

particular, current exposures must be 

calculated on the basis of current market 

data. When historical data are used to 

estimate model parameters, at least 

three years of data that cover a wide 

range of economic conditions must be 

used. This requirement reflects the 

longer horizon for counterparty credit 

risk exposures compared to market risk 

exposures. The data must be updated at 

least quarterly. Banks are encouraged 

also to incorporate model parameters 

based on forward looking measures ‘‘ for 

example, using implied volatilities in 

situations where historic volatilities 

may not capture changes in the risk 

drivers anticipated by the market—

where appropriate. 

Ninth, the bank must subject its 

models used in the calculation of EAD 

to an initial validation and annual 

model review process. The model 

review should consider whether the 

inputs and risk factors, as well as the 

model outputs, are appropriate. The 

review of outputs should include a 

rigorous program of backtesting model 

outputs against realized exposures. 

Maturity under the internal models 

methodology. Like corporate loan 

exposures, counterparty exposure on 

netting sets is susceptible to changes in 

economic value that stem from 

deterioration in the counterparty’s 

creditworthiness short of default. The 

effective maturity parameter (M) reflects 

the impact of these changes on capital. 

The formula used to compute M for 

netting sets with maturities greater than 

one year must be different than that 

generally applied to wholesale 

exposures in order to reflect how 

counterparty credit exposures change 

over time. The proposed approach is 

based on a weighted average of expected 

exposures over the life of the 

transactions relative to their one year 

exposures. 

If the remaining maturity of the 

exposure or the longest-dated contract 

contained in a netting set is greater than 

one year, the bank must set M for the 

exposure or netting set equal to the 

lower of 5 years or M(EPE), where: 


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( )i

t df

t

k k

 M (EPE) =1+

EE

effective EE

k

t >1 year

maturity

k

k

× ×

×

∑ ∆

∆ k k ×df

≤

∑k=1

t 1 year k

;

and (ii) df k is the risk-free discount 

factor for future time period t k. The cap 

of five years on M is consistent with the 

treatment of wholesale exposures under 

section 31 o the proposed rule. 

If the remaining maturity of the 

exposure or the longest-dated contract 

in the netting set is one year or less, the 

bank must set M for the exposure or 

netting set equal to 1 year except as 

provided in section 31(d)(7) of the 

proposed rule. In this case, repo-style 

transactions, eligible margin loans, and 

collateralized OTC derivative 

transactions subject to daily remargining 

agreements may use the effective 

maturity of the longest maturity 

transaction in the netting set as M. 

Collateral agreements under the 

internal models methodology. If the 

bank has prior written approval from its 

primary Federal supervisor, it may 

capture the effect on EAD of a collateral 

agreement that requires receipt of 

collateral when exposure to the 

counterparty increases within its 

internal model. In no circumstances 

may the bank take into account in EAD 

collateral agreements triggered by 

deterioration of counterparty credit 

quality. For this purpose, a collateral 

agreement means a legal contract that: 

(i) Specifies the time when, and 

circumstances under which, the 

counterparty is required to exchange 

collateral with the bank for a single 

financial contract or for all financial 

contracts covered under a qualifying 

master netting agreement; and (ii) 

confers upon the bank a perfected, first 

priority security interest, or the legal 

equivalent thereof, in the collateral 

posted by the counterparty under the 

agreement. This security interest must 

provide the bank with a right to close 

out the financial positions and the 

collateral upon an event of default of or 

failure to perform by the counterparty 

under the collateral agreement. A 

contract would not satisfy this 

requirement if the bank’s exercise of 

rights under the agreement may be 

stayed or avoided under applicable law 

in the relevant jurisdictions. 

If the internal model does not capture 

the effects of collateral agreements, the 

following ‘‘shortcut’’ method is 

proposed that will provide some benefit, 

in the form of a smaller EAD, for 

collateralized counterparties. Although 

this ‘‘shortcut’’ method will be 

permitted, the agencies expect banks 

that make extensive use of collateral 

agreements to develop the modeling 

capacity to measure the impact of such 

agreements on EAD. 

The ‘‘shortcut’’ method sets effective 

EPE for a counterparty subject to a 

collateral agreement equal to the lesser 

of: 

(i) The threshold, defined as the 

exposure amount at which the 

counterparty is required to post 

collateral under the collateral 

agreement, if the threshold is positive, 

plus an add-on that reflects the potential 

increase in exposure over the margin 

period of risk. The add-on is computed 

as the expected increase in the netting 

set’s exposure beginning from current 

exposure of zero over the margin period 

of risk; and 

(ii) Effective EPE without a collateral 

agreement. 

The margin period of risk means, with 

respect to a netting set subject to a 

collateral agreement, the time period 

from the most recent exchange of 

collateral with a counterparty until the 

next required exchange of collateral 

plus the period of time required to sell 

and realize the proceeds of the least 

liquid collateral that can be delivered 

under the terms of the collateral 

agreement, and, where applicable, the 

period of time required to re-hedge the 

resulting market risk, upon the default 

of the counterparty. The minimum 

margin period of risk is 5 business days 

for repo-style transactions and 10 days 

for other transactions when liquid 

financial collateral is posted under a 

daily margin maintenance requirement. 

This period should be extended to cover 

any additional time between margin 

calls; any potential closeout difficulties; 

any delays in selling collateral, 

particularly if the collateral is illiquid; 

and any impediments to prompt rehedging of any market risk. 

Own estimate of alpha. This proposed 

rule would allow a bank to estimate a 

bank-wide alpha, subject to prior 

written approval from its primary 

Federal supervisor. The internal 

estimate of alpha would be the ratio of 

economic capital from a full simulation 

of counterparty credit risk exposure that 

incorporates a joint simulation of 

market and credit risk factors 

(numerator) to economic capital based 

on EPE (denominator). For purposes of 

this calculation, economic capital is the 

unexpected losses for all counterparty 

credit risks measured at the 99.9 percent 

confidence level over a one-year 

horizon. Internal estimates of alpha are 

subject to a floor of 1.2. To obtain 

supervisory approval to use an internal 

estimate of alpha in the calculation of 

EAD, a bank must meet the following 

minimum standards to the satisfaction 

of its primary Federal supervisor: 

(i) The bank’s own estimate of alpha 

must capture the effects in the 

numerator of: 

(A) The material sources of stochastic 

dependency of distributions of market 

values of transactions or portfolios of 

transactions across counterparties; 

(B) Volatilities and correlations of 

market risk factors used in the joint 

simulation, which must be related to the 

credit risk factor used in the simulation 

to reflect potential increases in volatility 

or correlation in an economic downturn, 

where appropriate; and 

(C) The granularity of exposures, that 

is, the effect of a concentration in the 

proportion of each counterparty’s 

exposure that is driven by a particular 

risk factor; 

(ii) The bank must assess the potential 

model risk in its estimates of alpha; 

(iii) The bank must calculate the 

numerator and denominator of alpha in 

a consistent fashion with respect to 

modeling methodology, parameter 

specifications, and portfolio 

composition; and 

(iv) The bank must review and adjust 

as appropriate its estimates of the 

numerator and denominator on at least 

a quarterly basis and more frequently as 

appropriate when the composition of 

the portfolio varies over time. 

Alternative models. The proposed 

rule allows a bank to use an alternative 

model to determine EAD, provided that 

the bank can demonstrate to its primary 

Federal supervisor that the model 

output is more conservative than an 

alpha of 1.4 (or higher) times effective 

EPE. This may be appropriate where a 

new product or business line is being 

developed, where a recent acquisition 

has occurred, or where the bank 

believes that other more conservative 

methods to measure counterparty credit 

risk for a category of transactions are 

prudent. The alternative method should 

be applied to all similar transactions. 

When an alternative model is used, the 


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bank should either treat the particular 

transactions concerned as a separate 

netting set with the counterparty or 

apply the alternative model to the entire 

original netting set. 

5. Guarantees and Credit Derivatives 

That Cover Wholesale Exposures 

The New Accord specifies that a bank 

may adjust either the PD or the LGD of 

a wholesale exposure to reflect the risk 

mitigating effects of a guarantee or 

credit derivative. Under the proposed 

rule, a bank may choose either a PD 

substitution or an LGD adjustment 

approach to recognize the risk 

mitigating effects of an eligible 

guarantee or eligible credit derivative on 

a wholesale exposure (or in certain 

circumstances may choose to use a 

double default treatment, as discussed 

below). In all cases a bank must use the 

same risk parameters for calculating 

ECL for a wholesale exposure as it uses 

for calculating the risk-based capital 

requirement for the exposure. Moreover, 

in all cases, a bank’s ultimate PD and 

LGD for the hedged wholesale exposure 

may not be lower than the PD and LGD 

floors discussed above and described in 

section 31(d) of the proposed rule. 

Eligible guarantees and eligible credit 

derivatives. To be recognized as CRM 

for a wholesale exposure under the 

proposed rule, guarantees and credit 

derivatives must meet specific eligibility 

requirements. The proposed rule defines 

an eligible guarantee as a guarantee that: 

(i) Is written and unconditional; 

(ii) Covers all or a pro rata portion of 

all contractual payments of the obligor 

on the reference exposure; 

(iii) Gives the beneficiary a direct 

claim against the protection provider; 

(iv) Is non-cancelable by the 

protection provider for reasons other 

than the breach of the contract by the 

beneficiary; 

(v) Is legally enforceable against the 

protection provider in a jurisdiction 

where the protection provider has 

sufficient assets against which a 

judgment may be attached and enforced; 

and 

(vi) Requires the protection provider 

to make payment to the beneficiary on 

the occurrence of a default (as defined 

in the guarantee) of the obligor on the 

reference exposure without first 

requiring the beneficiary to demand 

payment from the obligor. Clearly, a 

bank could not provide an eligible 

guarantee on its own exposures. 

The proposed rule defines an eligible 

credit derivative as a credit derivative in 

the form of a credit default swap, nthto-default swap, or total return swap 

provided that: 

(i) The contract meets the 

requirements of an eligible guarantee 

and has been confirmed by the 

protection purchaser and the protection 

provider; 

(ii) Any assignment of the contract 

has been confirmed by all relevant 

parties; 

(iii) If the credit derivative is a credit 

default swap or nth-to-default swap, the 

contract includes the following credit 

events: 

(A) Failure to pay any amount due 

under the terms of the reference 

exposure (with a grace period that is 

closely in line with the grace period of 

the reference exposure); and 

(B) Bankruptcy, insolvency, or 

inability of the obligor on the reference 

exposure to pay its debts, or its failure 

or admission in writing of its inability 

generally to pay its debts as they 

become due, and similar events; 

(iv) The terms and conditions 

dictating the manner in which the 

contract is to be settled are incorporated 

into the contract; 

(v) If the contract allows for cash 

settlement, the contract incorporates a 

robust valuation process to estimate loss 

reliably and specifies a reasonable 

period for obtaining post-credit event 

valuations of the reference exposure; 

(vi) If the contract requires the 

protection purchaser to transfer an 

exposure to the protection provider at 

settlement, the terms of the exposure 

provide that any required consent to 

transfer may not be unreasonably 

withheld; 

(vii) If the credit derivative is a credit 

default swap or nth-to-default swap, the 

contract clearly identifies the parties 

responsible for determining whether a 

credit event has occurred, specifies that 

this determination is not the sole 

responsibility of the protection 

provider, and gives the protection 

purchaser the right to notify the 

protection provider of the occurrence of 

a credit event; and 

(viii) If the credit derivative is a total 

return swap and the bank records net 

payments received on the swap as net 

income, the bank records offsetting 

deterioration in the value of the hedged 

exposure (either through reductions in 

fair value or by an addition to reserves). 

Question 40: The agencies request 

comment on the appropriateness of 

these criteria in determining whether 

the risk mitigation effects of a credit 

derivative should be recognized for riskbased capital purposes. 

Under the proposed rule, a bank may 

recognize an eligible credit derivative 

that hedges an exposure that is different 

from the credit derivative’s reference 

exposure used for determining the 

derivative’s cash settlement value, 

deliverable obligation, or occurrence of 

a credit event only if: 

(i) The reference exposure ranks pari 

passu (that is, equal) or junior to the 

hedged exposure; and 

(ii) The reference exposure and the 

hedged exposure share the same obligor 

(that is, the same legal entity) and 

legally enforceable cross-default or 

cross-acceleration clauses are in place. 

PD substitution approach. Under the 

PD substitution approach, if the 

protection amount (as defined below) of 

the eligible guarantee or eligible credit 

derivative is greater than or equal to the 

EAD of the hedged exposure, a bank 

would substitute for the PD of the 

hedged exposure the PD associated with 

the rating grade of the protection 

provider. If the bank determines that 

full substitution leads to an 

inappropriate degree of risk mitigation, 

the bank may substitute a higher PD for 

that of the protection provider. 

If the guarantee or credit derivative 

provides the bank with the option to 

receive immediate payout on triggering 

the protection, then the bank would use 

the lower of the LGD of the hedged 

exposure (not adjusted to reflect the 

guarantee or credit derivative) and the 

LGD of the guarantee or credit 

derivative. The bank also would use the 

ELGD associated with the required LGD. 

If the guarantee or credit derivative does 

not provide the bank with the option to 

receive immediate payout on triggering 

the protection (and instead provides for 

the guarantor to assume the payment 

obligations of the obligor over the 

remaining life of the hedged exposure), 

the bank would use the LGD and ELGD 

of the guarantee or credit derivative. 

If the protection amount of the 

eligible guarantee or eligible credit 

derivative is less than the EAD of the 

hedged exposure, however, the bank 

must treat the hedged exposure as two 

separate exposures (protected and 

unprotected) in order to recognize the 

credit risk mitigation benefit of the 

guarantee or credit derivative. The bank 

must calculate its risk-based capital 

requirement for the protected exposure 

under section 31 of the proposed rule 

(using a PD equal to the protection 

provider’s PD, an ELGD and LGD 

determined as described above, and an 

EAD equal to the protection amount of 

the guarantee or credit derivative). If the 

bank determines that full substitution 

leads to an inappropriate degree of risk 

mitigation, the bank may use a higher 

PD than that of the protection provider. 

The bank must calculate its risk-based 

capital requirement for the unprotected 

exposure under section 31 of the 

proposed rule (using a PD equal to the 


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obligor’s PD, an ELGD and LGD equal to 

the hedged exposure’s ELGD and LGD 

not adjusted to reflect the guarantee or 

credit derivative, and an EAD equal to 

the EAD of the original hedged exposure 

minus the protection amount of the 

guarantee or credit derivative). 

The protection amount of an eligible 

guarantee or eligible credit derivative 

would be the effective notional amount 

of the guarantee or credit derivative 

reduced by any applicable haircuts for 

maturity mismatch, lack of 

restructuring, and currency mismatch 

(each described below). The effective 

notional amount of a guarantee or credit 

derivative would be the lesser of the 

contractual notional amount of the 

credit risk mitigant and the EAD of the 

hedged exposure, multiplied by the 

percentage coverage of the credit risk 

mitigant. For example, the effective 

notional amount of a guarantee that 

covers, on a pro rata basis, 40 percent 

of any losses on a $100 bond would be 

$40. 

LGD adjustment approach. Under the 

LGD adjustment approach, if the 

protection amount of the eligible 

guarantee or eligible credit derivative is 

greater than or equal to the EAD of the 

hedged exposure, the bank’s risk-based 

capital requirement for the hedged 

exposure would be the greater of (i) the 

risk-based capital requirement for the 

exposure as calculated under section 31 

of the proposed rule (with the ELGD and 

LGD of the exposure adjusted to reflect 

the guarantee or credit derivative); or (ii) 

the risk-based capital requirement for a 

direct exposure to the protection 

provider as calculated under section 31 

of the proposed rule (using the bank’s 

PD for the protection provider, the 

bank’s ELGD and LGD for the guarantee 

or credit derivative, and an EAD equal 

to the EAD of the hedged exposure). 

If the protection amount of the 

eligible guarantee or eligible credit 

derivative is less than the EAD of the 

hedged exposure, however, the bank 

must treat the hedged exposure as two 

separate exposures (protected and 

unprotected) in order to recognize the 

credit risk mitigation benefit of the 

guarantee or credit derivative. The 

bank’s risk-based capital requirement 

for the protected exposure would be the 

greater of (i) the risk-based capital 

requirement for the protected exposure 

as calculated under section 31 of the 

proposed rule (with the ELGD and LGD 

of the exposure adjusted to reflect the 

guarantee or credit derivative and EAD 

set equal to the protection amount of the 

guarantee or credit derivative); or (ii) the 

risk-based capital requirement for a 

direct exposure to the protection 

provider as calculated under section 31 

of the proposed rule (using the bank’s 

PD for the protection provider, the 

bank’s ELGD and LGD for the guarantee 

or credit derivative, and an EAD set 

equal to the protection amount of the 

guarantee or credit derivative). The bank 

must calculate its risk-based capital 

requirement for the unprotected 

exposure under section 31 of the 

proposed rule using a PD set equal to 

the obligor’s PD, an ELGD and LGD set 

equal to the hedged exposure’s ELGD 

and LGD (not adjusted to reflect the 

guarantee or credit derivative), and an 

EAD set equal to the EAD of the original 

hedged exposure minus the protection 

amount of the guarantee or credit 

derivative. 

The PD substitution approach allows 

a bank to effectively assess risk-based 

capital against a hedged exposure as if 

it were a direct exposure to the 

protection provider, and the LGD 

adjustment approach produces a riskbased capital requirement for a hedged 

exposure that is never lower than that 

of a direct exposure to the protection 

provider. Accordingly, these approaches 

do not fully reflect the risk mitigation 

benefits certain types of guarantees and 

credit derivatives may provide because 

the resulting risk-based capital 

requirement does not consider the joint 

probability of default of the obligor of 

the hedged exposure and the protection 

provider, sometimes referred to as the 

‘‘double default’’ benefit. The agencies 

have decided, consistent with the New 

Accord, to recognize double default 

benefits in the wholesale framework 

only for certain hedged exposures 

covered by certain guarantees and credit 

derivatives. A later section of the 

preamble describes which hedged 

exposures would be eligible for the 

proposed double default treatment and 

describes the double default treatment 

that would be available to those 

exposures. 

Maturity mismatch haircut. A bank 

that seeks to reduce the risk-based 

capital requirement on a wholesale 

exposure by recognizing an eligible 

guarantee or eligible credit derivative 

would have to adjust the protection 

amount of the credit risk mitigant 

downward to reflect any maturity 

mismatch between the hedged exposure 

and the credit risk mitigant. A maturity 

mismatch occurs when the effective 

residual maturity of a credit risk 

mitigant is less than that of the hedged 

exposure(s). When the hedged 

exposures have different residual 

maturities, the longest residual maturity 

of any of the hedged exposures would 

be used as the residual maturity of all 

hedged exposures. 

The effective residual maturity of a 

hedged exposure should be gauged as 

the longest possible remaining time 

before the obligor is scheduled to fulfil 

its obligation on the exposure. When 

determining the effective residual 

maturity of the guarantee or credit 

derivative, embedded options that may 

reduce the term of the credit risk 

mitigant should be taken into account so 

that the shortest possible residual 

maturity for the credit risk mitigant is 

used to determine the potential maturity 

mismatch. Where a call is at the 

discretion of the protection provider, 

the residual maturity of the guarantee or 

credit derivative would be deemed to be 

at the first call date. If the call is at the 

discretion of the bank purchasing the 

protection, but the terms of the 

arrangement at inception of the 

guarantee or credit derivative contain a 

positive incentive for the bank to call 

the transaction before contractual 

maturity, the remaining time to the first 

call date would be deemed to be the 

residual maturity of the credit risk 

mitigant. For example, where there is a 

step-up in the cost of credit protection 

in conjunction with a call feature or 

where the effective cost of protection 

increases over time even if credit quality 

remains the same or improves, the 

residual maturity of the credit risk 

mitigant would be the remaining time to 

the first call. 

Eligible guarantees and eligible credit 

derivatives with maturity mismatches 

may only be recognized if their original 

maturities are equal to or greater than 

one year. As a result, a guarantee or 

credit derivative would not be 

recognized for a hedged exposure with 

an original maturity of less than one 

year unless the credit risk mitigant has 

an original maturity of equal to or 

greater than one year or an effective 

residual maturity equal to or greater 

than that of the hedged exposure. In all 

cases, credit risk mitigants with 

maturity mismatches may not be 

recognized when they have an effective 

residual maturity of three months or 

less. 

When a maturity mismatch exists, a 

bank would apply the following 

maturity mismatch adjustment to 

determine the protection amount of the 

guarantee or credit derivative adjusted 

for maturity mismatch: Pm = E × 

(t¥0.25)/(T–0.25), where: 

(i) Pm = protection amount of the 

guarantee or credit derivative adjusted 

for maturity mismatch; 

(ii) E = effective notional amount of 

the guarantee or credit derivative; 

(iii) t = lesser of T or effective residual 

maturity of the guarantee or credit 

derivative, expressed in years; and 


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64New Accord, ¶ 206. 

65 Id. 

66The New Accord permits certain retail small 

business exposures to be eligible for double default 

treatment. Under this proposal, however, a bank 

must effectively desegment a retail small business 

exposure (thus rendering it a wholesale exposure) 

to make it eligible for double default treatment. 

(iv) T = lesser of 5 or effective residual 

maturity of the hedged exposure, 

expressed in years. 

Restructuring haircut. An originating 

bank that seeks to recognize an eligible 

credit derivative that does not include a 

distressed restructuring as a credit event 

that triggers payment under the 

derivative would have to reduce the 

recognition of the credit derivative by 

40 percent. A distressed restructuring is 

a restructuring of the hedged exposure 

involving forgiveness or postponement 

of principal, interest, or fees that results 

in a charge-off, specific provision, or 

other similar debit to the profit and loss 

account. 

In other words, the protection amount 

of the credit derivative adjusted for lack 

of restructuring credit event (and 

maturity mismatch, if applicable) would 

be: Pr = Pm × 0.60, where: 

(i) Pr = protection amount of the 

credit derivative, adjusted for lack of 

restructuring credit event (and maturity 

mismatch, if applicable); and 

(ii) Pm = effective notional amount of 

the credit derivative (adjusted for 

maturity mismatch, if applicable). 

Currency mismatch haircut. Where 

the eligible guarantee or eligible credit 

derivative is denominated in a currency 

different from that in which any hedged 

exposure is denominated, the protection 

amount of the guarantee or credit 

derivative adjusted for currency 

mismatch (and maturity mismatch and 

lack of restructuring credit event, if 

applicable) would be: Pc = Pr × 

(1¥Hfx), where: 

(i) Pc = protection amount of the 

guarantee or credit derivative, adjusted 

for currency mismatch (and maturity 

mismatch and lack of restructuring 

credit event, if applicable); 

(ii) Pr = effective notional amount of 

the guarantee or credit derivative 

(adjusted for maturity mismatch and 

lack of restructuring credit event, if 

applicable); and 

(iii) Hfx = haircut appropriate for the 

currency mismatch between the 

guarantee or credit derivative and the 

hedged exposure. 

A bank may use a standard 

supervisory haircut of 8 percent for Hfx 

(based on a 10-business day holding 

period and daily marking-to-market and 

remargining). Alternatively, a bank may 

use internally estimated haircuts for Hfx 

based on a 10-business day holding 

period and daily marking-to-market and 

remargining if the bank qualifies to use 

the own-estimates haircuts in paragraph 

(a)(2)(iii) of section 32, the simple VaR 

methodology in paragraph (a)(3) of 

section 32, or the internal models 

methodology in paragraph (c) of section 

32 of the proposed rule. The bank must 

scale these haircuts up using a square 

root of time formula if the bank revalues 

the guarantee or credit derivative less 

frequently than once every 10 business 

days. 

Example. Assume that a bank holds a fiveyear $100 corporate exposure, purchases a 

$100 credit derivative to mitigate its credit 

risk on the exposure, and chooses to use the 

PD substitution approach. The unsecured 

ELGD and LGD of the corporate exposure are 

20 and 30 percent, respectively; the ELGD 

and LGD of the credit derivative are 75 and 

80 percent, respectively. The credit 

derivative is an eligible credit derivative, has 

the bank’s exposure as its reference exposure, 

has a three-year maturity, immediate cash 

payout on default, no restructuring provision, 

and no currency mismatch with the bank’s 

hedged exposure. The effective notional 

amount and initial protection amount of the 

credit derivative would be $100. The 

maturity mismatch would reduce the 

protection amount to $100 × (3¥.25)/(5¥.25) 

or $57.89. The haircut for lack of 

restructuring would reduce the protection 

amount to $57.89 × 0.6 or $34.74. So the bank 

would treat the $100 corporate exposure as 

two exposures: (i) An exposure of $34.74 

with the PD of the protection provider, an 

ELGD of 20 percent, an LGD of 30 percent, 

and an M of 5; and (ii) an exposure of $65.26 

with the PD of the obligor, an ELGD of 20 

percent, an LGD of 30 percent, and an M of 

5. 

Multiple credit risk mitigants. The 

New Accord provides that if multiple 

credit risk mitigants (for example, two 

eligible guarantees) cover a single 

exposure, a bank must disaggregate the 

exposure into portions covered by each 

credit risk mitigant (for example, the 

portion covered by each guarantee) and 

must calculate separately the risk-based 

capital requirement of each portion.64

The New Accord also indicates that 

when credit risk mitigants provided by 

a single protection provider have 

differing maturities, they should be 

subdivided into separate layers of 

protection.65 Question 41: The agencies 

are interested in the views of 

commenters as to whether and how the 

agencies should address these and other 

similar situations in which multiple 

credit risk mitigants cover a single 

exposure. 

Double default treatment. As noted 

above, the proposed rule contains a 

separate risk-based capital methodology 

for hedged exposures eligible for double 

default treatment. To be eligible for 

double default treatment, a hedged 

exposure must be fully covered or 

covered on a pro rata basis (that is, there 

must be no tranching of credit risk) by 

an uncollateralized single-referenceobligor credit derivative or guarantee (or 

certain nth-to-default credit derivatives) 

provided by an eligible double default 

guarantor (as defined below). Moreover, 

the hedged exposure must be a 

wholesale exposure other than a 

sovereign exposure.66 In addition, the 

obligor of the hedged exposure must not 

be an eligible double default guarantor, 

an affiliate of an eligible double default 

guarantor, or an affiliate of the 

guarantor. 

The proposed rule defines eligible 

double default guarantor to include a 

depository institution (as defined in 

section 3 of the Federal Deposit 

Insurance Act (12 U.S.C. 1813)); a bank 

holding company (as defined in section 

2 of the Bank Holding Company Act (12 

U.S.C. 1841)); a savings and loan 

holding company (as defined in 12 

U.S.C. 1467a) provided all or 

substantially all of the holding 

company’s activities are permissible for 

a financial holding company under 12 

U.S.C. 1843(k)); a securities broker or 

dealer registered (under the Securities 

Exchange Act of 1934) with the 

Securities and Exchange Commission 

(SEC); an insurance company in the 

business of providing credit protection 

(such as a monoline bond insurer or reinsurer) that is subject to supervision by 

a state insurance regulator; a foreign 

bank (as defined in section 211.2 of the 

Federal Reserve Board’s Regulation K 

(12 CFR 211.2)); a non-U.S. securities 

firm; or a non-U.S. based insurance 

company in the business of providing 

credit protection. To be an eligible 

double default guarantor, the entity 

must (i) have a bank-assigned PD that, 

at the time the guarantor issued the 

guarantee or credit derivative, was equal 

to or lower than the PD associated with 

a long-term external rating of at least the 

third highest investment grade rating 

category; and (ii) have a current bankassigned PD that is equal to or lower 

than the PD associated with a long-term 

external rating of at least investment 

grade. In addition, a non-U.S. based 

bank, securities firm, or insurance 

company may qualify as an eligible 

double default guarantor only if the firm 

is subject to consolidated supervision 

and regulation comparable to that 

imposed on U.S. depository institutions, 

securities firms, or insurance companies 

(as the case may be) or has issued and 

outstanding an unsecured long-term 

debt security without credit 

enhancement that has a long-term 

applicable external rating in one of the 


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three highest investment grade rating 

categories. 

Effectively, the scope of an eligible 

double default guarantor is limited to 

financial firms whose normal business 

includes the provision of credit 

protection, as well as the management 

of a diversified portfolio of credit risk. 

This restriction arises from the agencies’

concern to limit double default 

recognition to professional 

counterparties that have a high level of 

credit risk management expertise and 

that provide sufficient market 

disclosure. The restriction is also 

designed to limit the risk of excessive 

correlation between the 

creditworthiness of the guarantor and 

the obligor of the hedged exposure due 

to their performance depending on 

common economic factors beyond the 

systematic risk factor. As a result, 

hedged exposures to potential credit 

protection providers or affiliates of 

credit protection providers would not be 

eligible for the double default treatment. 

In addition, the agencies have excluded 

hedged exposures to sovereign entities 

from eligibility for double default 

treatment because of the potential high 

correlation between the 

creditworthiness of a sovereign and that 

of a guarantor. 

In addition to limiting the types of 

guarantees, credit derivatives, 

guarantors, and hedged exposures 

eligible for double default treatment, the 

proposed rule limits wrong-way risk 

further by requiring a bank to 

implement a process to detect excessive 

correlation between the 

creditworthiness of the obligor of the 

hedged exposure and the protection 

provider. The bank must receive prior 

written approval from its primary 

Federal supervisor for this process in 

order to recognize double default 

benefits for risk-based capital purposes. 

To apply double default treatment to a 

particular hedged exposure, the bank 

must determine that there is not 

excessive correlation between the 

creditworthiness of the obligor of the 

hedged exposure and the protection 

provider. For example, the 

creditworthiness of an obligor and a 

protection provider would be 

excessively correlated if the obligor 

derives a high proportion of its income 

or revenue from transactions with the 

protection provider. If excessive 

correlation is present, the bank may not 

use the double default treatment for the 

hedged exposure. 

The risk-based capital requirement for 

a hedged exposure subject to double 

default treatment is calculated by 

multiplying a risk-based capital 

requirement for the hedged exposure (as 

if it were unhedged) by an adjustment 

factor that considers the PD of the 

protection provider (see section 34 of 

the proposed rule). Thus, the PDs of 

both the obligor of the hedged exposure 

and the protection provider are factored 

into the hedged exposure’s risk-based 

capital requirement. In addition, as 

under the PD substitution treatment in 

section 33 of the proposed rule, the 

bank would be allowed to set LGD equal 

to the lower of the LGD of the unhedged 

exposure or the LGD of the guarantee or 

credit derivative if the guarantee or 

credit derivative provides the bank with 

the option to receive immediate payout 

on the occurrence of a credit event. 

Otherwise, the bank must set LGD equal 

to the LGD of the guarantee or credit 

derivative. In addition, the bank must 

set ELGD equal to the ELGD associated 

with the required LGD. Accordingly, in 

order to apply the double default 

treatment, the bank must estimate a PD 

for the protection provider and an ELGD 

and LGD for the guarantee or credit 

derivative. Finally, a bank using the 

double default treatment must make 

applicable adjustments to the protection 

amount of the guarantee or credit 

derivative to reflect maturity 

mismatches, currency mismatches, and 

lack of restructuring coverage (as under 

the PD substitution and LGD adjustment 

approaches in section 33 of the 

proposed rule). 

6. Guarantees and Credit Derivatives 

That Cover Retail Exposures 

The proposed rule provides a 

different treatment for guarantees and 

credit derivatives that cover retail 

exposures. The approach set forth above 

for guarantees and credit derivatives 

that cover wholesale exposures is an 

exposure-by-exposure approach 

consistent with the overall exposure-byexposure approach the proposed rule 

takes to wholesale exposures. The 

agencies believe that a different 

treatment for guarantees that cover retail 

exposures is necessary and appropriate 

because of the proposed rule’s 

segmentation approach to retail 

exposures. The approaches to retail 

guarantees described in this section 

generally apply only to guarantees of 

individual retail exposures. Guarantees 

of multiple retail exposures (such as 

pool private mortgage insurance (PMI)) 

are typically tranched (that is, they 

cover less than the full amount of the 

hedged exposures) and, therefore, 

would be securitization exposures. 

The proposed rule does not specify 

the ways in which guarantees and credit 

derivatives may be taken into account in 

the segmentation of retail exposures. 

Likewise, the proposed rule does not 

explicitly limit the extent to which a 

bank may take into account the credit 

risk mitigation benefits of guarantees 

and credit derivatives in its estimation 

of the PD, ELGD, and LGD of retail 

segments, except by the application of 

overall floors on certain PD and LGD 

assignments. This approach has the 

principal advantage of being relatively 

easy for banks to implement—the 

approach generally would not disrupt 

the existing retail segmentation 

practices of banks and would not 

interfere with banks’ quantification of 

PD, ELGD, and LGD for retail segments. 

The agencies are concerned, however, 

that because this approach would 

provide banks with substantial 

discretion to incorporate double default 

and double recovery effects, the 

resulting treatment for guarantees of 

retail exposures would be inconsistent 

with the treatment for guarantees of 

wholesale exposures. 

To address these concerns, the 

agencies are considering for purposes of 

the final rule two principal alternative 

treatments for guarantees of retail 

exposures. The first alternative would 

distinguish between eligible retail 

guarantees and all other (non-eligible) 

guarantees of retail exposures. Under 

this alternative, an eligible retail 

guarantee would be an eligible 

guarantee that applies to a single retail 

exposure and is (i) PMI issued by an 

insurance company that (A) has issued 

a senior unsecured long-term debt 

security without credit enhancement 

that has an applicable external rating in 

one of the two highest investment grade 

rating categories or (B) has a claims 

payment ability that is rated in one of 

the two highest rating categories by an 

NRSRO; or (ii) issued by a sovereign 

entity or a political subdivision of a 

sovereign entity. Under this alternative, 

PMI would be defined as insurance 

provided by a regulated mortgage 

insurance company that protects a 

mortgage lender in the event of the 

default of a mortgage borrower up to a 

predetermined portion of the value of a 

single one-to four-family residential 

property. 

Under this alternative, a bank would 

be able to recognize the credit risk 

mitigation benefits of eligible retail 

guarantees that cover retail exposures in 

a segment by adjusting its estimates of 

ELGD and LGD for the segment to reflect 

recoveries from the guarantor. However, 

the bank would have to estimate the PD 

of a segment without reflecting the 

benefit of guarantees; that is, a 

segment’s PD would be an estimate of 

the stand-alone probability of default for 

the retail exposures in the segment, 

before taking account of any guarantees. 


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55880 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

67The agencies consider a qualifying central 

counterparty to be the functional equivalent of an 

exchange, and have long exempted exchange-traded 

contracts from risk-based capital requirements. 

Transactions rejected by a qualifying central 

counterparty (because, for example, of a 

discrepancy in the details of the transaction such 

as in quantity, price, or in the underlying security, 

between the buyer and seller) potentially give rise 

to risk exposure to either party. 

Accordingly, for this limited set of 

traditional guarantees of retail 

exposures by high credit quality 

guarantors, a bank would be allowed to 

recognize the benefit of the guarantee 

when estimating ELGD and LGD, but 

not when estimating PD. Question 42: 

The agencies seek comment on this 

alternative approach’s definition of 

eligible retail guarantee and treatment 

for eligible retail guarantees, and on 

whether the agencies should provide 

similar treatment for any other forms of 

wholesale credit insurance or 

guarantees on retail exposures, such as 

student loans, if the agencies adopt this 

approach. 

This alternative approach would 

provide a different treatment for noneligible retail guarantees. In short, 

within the retail framework, a bank 

would not be able to recognize noneligible retail guarantees when 

estimating PD, ELGD, and LGD for any 

segment of retail exposures. In other 

words, a bank would be required to 

estimate PD, ELGD, and LGD for 

segments containing retail exposures 

with non-eligible guarantees as if the 

exposures were not guaranteed. 

However, a bank would be permitted to 

recognize non-eligible retail guarantees 

provided by a wholesale guarantor by 

treating the hedged retail exposure as a 

direct exposure to the guarantor and 

applying the appropriate wholesale IRB 

risk-based capital formula. In other 

words, for retail exposures covered by 

non-eligible retail guarantees, a bank 

would be permitted to reflect the 

guarantee by ‘‘desegmenting’’ the retail 

exposures (which effectively would 

convert the retail exposures into 

wholesale exposures) and then applying 

the rules set forth above for guarantees 

that cover wholesale exposures. Thus, 

under this approach, a bank would not 

be allowed to recognize either double 

default or double recovery effects for 

non-eligible retail guarantees. 

The agencies understand that this 

approach to non-eligible retail 

guarantees, while addressing the 

prudential concerns of the agencies, is 

conservative and may not harmonize 

with banks’ internal risk measurement 

and management practices in this area. 

Question 43: The agencies seek 

comment on the types of non-eligible 

retail guarantees banks obtain and the 

extent to which banks obtain credit risk 

mitigation in the form of non-eligible 

retail guarantees. 

A second alternative that the agencies 

are considering for purposes of the final 

rule would permit a bank to recognize 

the credit risk mitigation benefits of all 

eligible guarantees (whether eligible 

retail guarantees or not) that cover retail 

exposures by adjusting its estimates of 

ELGD and LGD for the relevant 

segments, but would subject a bank’s 

risk-based capital requirement for a 

segment of retail exposures that are 

covered by one or more non-eligible 

retail guarantees to a floor. Under this 

second alternative, the agencies could 

impose a floor on risk-based capital 

requirements of between 2 percent and 

6 percent on such a segment of retail 

exposures. 

Question 44: The agencies seek 

comment on both of these alternative 

approaches to guarantees that cover 

retail exposures. The agencies also 

invite comment on other possible 

prudential treatments for such 

guarantees. 

D. Unsettled Securities, Foreign 

Exchange, and Commodity Transactions 

Section 35 of the proposed rule sets 

forth the risk-based capital requirements 

for unsettled and failed securities, 

foreign exchange, and commodities 

transactions. Certain transaction types 

are excluded from the scope of this 

section, including: 

(i) Transactions accepted by a 

qualifying central counterparty that are 

subject to daily marking-to-market and 

daily receipt and payment of variation 

margin (which do not have a risk-based 

capital requirement);67

(ii) Repo-style transactions (the riskbased capital requirements of which are 

determined under sections 31 and 32 of 

the proposed rule); 

(iii) One-way cash payments on OTC 

derivative contracts (the risk-based 

capital requirements of which are 

determined under sections 31 and 32 of 

the proposed rule); and 

(iv) Transactions with a contractual 

settlement period that is longer than the 

normal settlement period (defined 

below), which transactions are treated 

as OTC derivative contracts and 

assessed a risk-based capital 

requirement under sections 31 and 32 of 

the proposed rule. The proposed rule 

also provides that, in the case of a 

system-wide failure of a settlement or 

clearing system, the bank’s primary 

Federal supervisor may waive riskbased capital requirements for unsettled 

and failed transactions until the 

situation is rectified. 

The proposed rule contains separate 

treatments for delivery-versus-payment 

(DvP) and payment-versus-payment 

(PvP) transactions with a normal 

settlement period, on the one hand, and 

non-DvP/non-PvP transactions with a 

normal settlement period, on the other 

hand. The proposed rule provides the 

following definitions of a DvP 

transaction, a PvP transaction, and a 

normal settlement period. A DvP 

transaction is a securities or 

commodities transaction in which the 

buyer is obligated to make payment only 

if the seller has made delivery of the 

securities or commodities and the seller 

is obligated to deliver the securities or 

commodities only if the buyer has made 

payment. A PvP transaction is a foreign 

exchange transaction in which each 

counterparty is obligated to make a final 

transfer of one or more currencies only 

if the other counterparty has made a 

final transfer of one or more currencies. 

A transaction has a normal settlement 

period if the contractual settlement 

period for the transaction is equal to or 

less than the market standard for the 

instrument underlying the transaction 

and equal to or less than five business 

days. 

A bank must hold risk-based capital 

against a DvP or PvP transaction with a 

normal settlement period if the bank’s 

counterparty has not made delivery or 

payment within five business days after 

the settlement date. The bank must 

determine its risk-weighted asset 

amount for such a transaction by 

multiplying the positive current 

exposure of the transaction for the bank 

by the appropriate risk weight in Table 

F. The positive current exposure of a 

transaction of a bank is the difference 

between the transaction value at the 

agreed settlement price and the current 

market price of the transaction, if the 

difference results in a credit exposure of 

the bank to the counterparty. 

TABLE F.—RISK WEIGHTS FOR UNSETTLED DVP AND PVP TRANSACTIONS

Number of business days 

after contractual settlement 

date 

Risk weight to 

be applied to 

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 

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 


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Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55881 

68Although the Internal Assessment Approach 

described below does allow a bank to use an 

internal-ratings-based approach to determine its 

risk-based capital requirement for an exposure to an 

ABCP program, banks are required to follow 

NRSRO rating criteria and therefore are required 

implicitly to use the NRSRO’s determination of the 

correlation of the underlying exposures in the 

ABCP program. 69As noted above, mortgage-backed pass-through 

securities guaranteed by Fannie Mae or Freddie 

Mac are also securitization exposures. 

corresponding deliverables by the end 

of the same business day. The bank 

must continue to hold risk-based capital 

against the transaction until the bank 

has received its corresponding 

deliverables. From the business day 

after the bank has made its delivery 

until five business days after the 

counterparty delivery is due, the bank 

must calculate its risk-based capital 

requirement for the transaction by 

treating the current market value of the 

deliverables owed to the bank as a 

wholesale exposure. 

A bank may assign an internal obligor 

rating to a counterparty for which it is 

not otherwise required under the 

proposed rule to assign an obligor rating 

on the basis of the applicable external 

rating of any outstanding senior 

unsecured long-term debt security 

without credit enhancement issued by 

the counterparty. A bank may estimate 

loss severity ratings or ELGD and LGD 

for the exposure, or may use a 45 

percent ELGD and LGD for the exposure 

provided the bank uses the 45 percent 

ELGD and LGD for all such exposures. 

Alternatively, a bank may use a 100 

percent risk weight for the exposure as 

long as the bank uses this risk weight for 

all such exposures. 

If, in a non-DvP/non-PvP transaction 

with a normal settlement period, the 

bank has not received its deliverables by 

the fifth business day after counterparty 

delivery was due, the bank must deduct 

the current market value of the 

deliverables owed to the bank 50 

percent from tier 1 capital and 50 

percent from tier 2 capital. 

The total risk-weighted asset amount 

for unsettled transactions equals the 

sum of the risk-weighted asset amount 

for each DvP and PvP transaction with 

a normal settlement period and the riskweighted asset amount for each nonDvP/non-PvP transaction with a normal 

settlement period. 

E. Securitization Exposures 

This section describes the framework 

for calculating risk-based capital 

requirements for securitization 

exposures under the proposed rule (the 

securitization framework). In contrast to 

the proposed framework for wholesale 

and retail exposures, the proposed 

securitization framework does not 

permit a bank to rely on its internal 

assessments of the risk parameters of a 

securitization exposure.68 For 

securitization exposures, which 

typically are tranched exposures to a 

pool of underlying exposures, such 

assessments would require implicit or 

explicit estimates of correlations among 

the losses on the underlying exposures 

and estimates of the credit risk 

consequences of tranching. Such 

correlation and tranching effects are 

difficult to estimate and validate in an 

objective manner and on a goingforward basis. Instead, the proposed 

securitization framework relies 

principally on two sources of 

information, where available, to 

determine risk-based capital 

requirements: (i) An assessment of the 

securitization exposure’s credit risk 

made by an NRSRO; or (ii) the riskbased 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). 

A bank must use the securitization 

framework for exposures to any 

transaction that involves the tranching 

of credit risk (with the exception of a 

tranched guarantee that applies only to 

an individual retail exposure), 

regardless of the number of underlying 

exposures in the transaction.69 A single, 

unified approach to dealing with the 

tranching of credit risk is important to 

create a level playing field across the 

securitization, credit derivatives, and 

other financial markets. The agencies 

believe that basing the applicability of 

the proposed securitization framework 

on the presence of some minimum 

number of underlying exposures would 

complicate the proposed rule without 

any material improvement in risk 

sensitivity. The proposed securitization 

framework is designed specifically to 

deal with tranched exposures to credit 

risk, and the principal risk-based capital 

approaches of the proposed 

securitization framework take into 

account the effective number of 

underlying exposures. 

1. Hierarchy of Approaches 

The proposed securitization 

framework contains three general 

approaches for determining the riskbased capital requirement for a 

securitization exposure: A RatingsBased Approach (RBA), an Internal 

Assessment Approach (IAA), and a 

Supervisory Formula Approach (SFA). 

Under the proposed rule, banks 

generally must apply the following 

hierarchy of approaches to determine 

the risk-based capital requirement for a 

securitization exposure. 

First, a bank must deduct from tier 1 

capital any after-tax gain-on-sale 

resulting from a securitization and must 

deduct from total capital any portion of 

a CEIO that does not constitute a gainon-sale, as described in section 42(c) of 

the proposed rule. Second, a bank must 

apply the RBA to a securitization 

exposure if the exposure qualifies for 

the RBA. As a general matter, an 

exposure qualifies for the RBA if the 

exposure has an external rating from an 

NRSRO or has an inferred rating (that is, 

the exposure is senior to another 

securitization exposure in the 

transaction that has an external rating 

from an NRSRO). For example, a bank 

generally must use the RBA approach to 

determine the risk-based capital 

requirement for an asset-backed security 

that has an applicable external rating of 

AA+ from an NRSRO and for another 

tranche of the same securitization that is 

unrated but senior in all respects to the 

asset-backed security that was rated. In 

this example, the senior unrated tranche 

would be treated as if it were rated AA+. 

If a securitization exposure does not 

qualify for the RBA but is an exposure 

to an ABCP program—such as a credit 

enhancement or liquidity facility—the 

bank may apply the IAA (if the bank, 

the exposure, and the ABCP program 

qualify for the IAA) or the SFA (if the 

bank and the exposure qualify for the 

SFA) to the exposure. As a general 

matter, a bank would qualify for use of 

the IAA if the bank establishes and 

maintains an internal risk rating system 

for exposures to ABCP programs that 

has been approved by the bank’s 

primary Federal supervisor. 

Alternatively, a bank may use the SFA 

if the bank is able to calculate a set of 

risk factors relating to the securitization, 

including the risk-based capital 

requirement for the underlying 

exposures as if they were held directly 

by the bank. A bank that chooses to use 

the IAA must use the IAA for all 

exposures that qualify for the IAA. 

If a securitization exposure is not a 

gain-on-sale or a CEIO, does not qualify 

for the RBA and is not an exposure to 

an ABCP program, the bank may apply 

the SFA to the exposure if the bank is 

able to calculate the SFA risk factors for 

the securitization. In many cases an 

originating bank would use the SFA to 

determine its risk-based capital 

requirements for retained securitization 

exposures. If a securitization exposure is 

not a gain-on-sale or a CEIO and does 

not qualify for the RBA, the IAA, or the 

SFA, the bank must deduct the exposure 


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55882 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

70See Financial Accounting Standards Board, 

Interpretation No. 46: Consolidation of Certain 

Variable Interest Entities (Jan. 2003). 

71See 12 U.S.C. 1835, which places a cap on the 

risk-based capital requirement applicable to a wellcapitalized depository institution that transfers 

small business loans with recourse. 

72The proposed rule does not expressly state that 

the agencies may permit adequately capitalized 

banks to use the small business recourse rule on a 

case-by-case basis because the agencies may do this 

under the general reservation of authority contained 

in section 1 of the rule. 

from total capital. Total risk-weighted 

assets for securitization exposures 

would be the sum of risk-weighted 

assets calculated under the RBA, IAA, 

and SFA, plus any risk-weighted asset 

amounts calculated under the early 

amortization provisions in section 47 of 

the proposed rule. 

Numerous commenters criticized the 

complexity of the ANPR’s treatment of 

approaches to securitization exposures 

and the different treatment accorded to 

originating banks versus investing 

banks. As discussed elsewhere in this 

section, the agencies have responded to 

these comments by eliminating most of 

the differences in treatment for 

originating banks and investing banks 

and by eliminating the ‘‘Alternative 

RBA’’ from the hierarchy of approaches. 

As discussed in more detail below, there 

is one difference in treatment between 

originating and investing banks in the 

RBA, consistent with the general riskbased capital rules. 

Some commenters expressed 

dissatisfaction that the ANPR required 

banks to use the RBA to assess riskbased capital requirements against a 

securitization exposure with an external 

or inferred rating. These commenters 

argued that banks should be allowed to 

choose between the RBA and the SFA 

when both approaches are available. 

The agencies have not altered the 

proposed securitization framework to 

provide this element of choice to banks 

because the agencies believe it would 

likely create a means for regulatory 

capital arbitrage. 

Exceptions to the general hierarchy of 

approaches. Under the proposed 

securitization framework, unless one or 

more of the underlying exposures does 

not meet the definition of a wholesale, 

retail, securitization, or equity exposure, 

the total risk-based capital requirement 

for all securitization exposures held by 

a single bank associated with a single 

securitization (including any regulatory 

capital requirement that relates to an 

early amortization provision, but 

excluding any capital requirements that 

relate to the bank’s gain-on-sale or 

CEIOs associated with the 

securitization) cannot exceed the sum of 

(i) the bank’s total risk-based capital 

requirement for the underlying 

exposures as if the bank directly held 

the underlying exposures; and (ii) the 

bank’s total ECL for the underlying 

exposures. The ECL of the underlying 

exposures is included in this calculation 

because if the bank held the underlying 

exposures on its balance sheet, the bank 

would have had to estimate the ECL of 

the exposures and hold reserves or 

capital against the ECL. This cap 

ensures that a bank’s effective risk-based 

capital requirement for exposure to a 

pool of underlying exposures generally 

would not be greater than the applicable 

risk-based capital requirement if the 

underlying exposures were held directly 

by the bank, taking into consideration 

the agencies’ safety and soundness 

concerns with respect to CEIOs. 

This proposed maximum risk-based 

capital requirement would be different 

from the general risk-based capital rules. 

Under the general risk-based capital 

rules, banks generally are required to 

hold a dollar in capital for every dollar 

in residual interest, regardless of the 

effective risk-based capital requirement 

on the underlying exposures. The 

agencies adopted this dollar-for-dollar 

capital treatment for a residual interest 

to recognize that in many instances the 

relative size of the residual interest 

retained by the originating bank reveals 

market information about the quality of 

the underlying exposures and 

transaction structure that may not have 

been captured under the general riskbased capital rules. Given the 

significantly heightened risk sensitivity 

of the IRB framework, the agencies 

believe that the proposed maximum 

risk-based capital requirement in the 

proposed securitization framework is 

more appropriate. 

In addition, the proposed rule would 

address various situations involving 

overlapping exposures. Consistent with 

the general risk-based capital rules, if a 

bank has multiple securitization 

exposures to an ABCP program that 

provide duplicative coverage of the 

underlying exposures of the program 

(such as when a bank provides a 

program-wide credit enhancement and 

multiple pool-specific liquidity facilities 

to an ABCP program), the bank is not 

required to hold duplicative risk-based 

capital against the overlapping position. 

Instead, the bank would apply to the 

overlapping position the applicable riskbased capital treatment under the 

securitization framework that results in 

the highest capital requirement. If 

different banks have overlapping 

exposures to an ABCP program, 

however, each bank must hold capital 

against the entire maximum amount of 

its exposure. Although duplication of 

capital requirements will not occur for 

individual banks, some systemic 

duplication may occur where multiple 

banks have overlapping exposures to the 

same ABCP program. 

The proposed rule also addresses 

overlapping exposures that arise when a 

bank holds a securitization exposure in 

the form of a mortgage-backed security 

or participation certificate that results 

from a mortgage loan swap with 

recourse. In these situations, a bank 

must determine a risk-based capital 

requirement for two separate 

exposures—the retained recourse 

obligation on the swapped loans and the 

percentage of the mortgage-backed 

security or participation certificate that 

is not covered by the recourse 

obligation. The total risk-based capital 

requirement is capped at the risk-based 

capital requirement for the underlying 

exposures as if they were held directly 

on the bank’s balance sheet. 

The proposed rule also addresses the 

risk-based capital treatment of a 

securitization of non-IRB assets. 

Specifically, if a bank has a 

securitization exposure and any 

underlying exposure of the 

securitization is not a wholesale, retail, 

securitization or equity exposure, the 

bank must (i) apply the RBA if the 

securitization exposure qualifies for the 

RBA and is not gain-on-sale or a CEIO; 

or (ii) otherwise, deduct the exposure 

from total capital. Music concert and 

film receivables are examples of types of 

assets that are not wholesale, retail, 

securitization, or equity exposures. 

The proposed rule contains several 

additional exceptions to the general 

hierarchy. For example, in light of the 

substantial volatility in asset value 

related to prepayment risk and interest 

rate risk associated with interest-only 

mortgage-backed securities, the 

proposed rule provides that the risk 

weight for such a security may not be 

less than 100 percent. In addition, the 

proposed rule follows the general riskbased capital rules by allowing a 

sponsoring bank that qualifies as a 

primary beneficiary and must 

consolidate an ABCP program as a 

variable interest entity under GAAP to 

exclude the consolidated ABCP program 

assets from risk-weighted assets. In such 

cases, the bank would hold risk-based 

capital only against any securitization 

exposures of the bank to the ABCP 

program.70 Moreover, the proposed rule 

follows the general risk-based capital 

rules and a Federal statute 71 by 

including a special set of more lenient 

rules for the transfer of small business 

loans and leases with recourse by wellcapitalized depository institutions.72


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Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55883 

73 Interagency Guidance on Implicit Recourse in 

Asset Securitizations, May 23, 2002. 

Servicer cash advances. A traditional 

securitization typically employs a 

servicing bank that—on a day-to-day 

basis—collects principal, interest, and 

other payments from the underlying 

exposures of the securitization and 

forwards such payments to the 

securitization SPE or to investors in the 

securitization. Such servicing banks 

often provide to the securitization a 

credit facility under which the servicing 

bank may advance cash to ensure an 

uninterrupted flow of payments to 

investors in the securitization 

(including advances made to cover 

foreclosure costs or other expenses to 

facilitate the timely collection of the 

underlying exposures). These servicer 

cash advance facilities are securitization 

exposures, and a servicing bank must 

determine its risk-based capital 

requirement for the funded portion of 

any such facility by using the proposed 

securitization framework. 

Consistent with the general risk-based 

capital rules with respect to residential 

mortgage servicer cash advances, 

however, a servicing bank would not be 

required to hold risk-based capital 

against the undrawn portion of an 

‘‘eligible’’ servicer cash advance facility. 

Under the proposed rule, an eligible 

servicer cash advance facility is a 

servicer cash advance facility in which 

(i) the servicer is entitled to full 

reimbursement of advances (except that 

a servicer may be obligated to make 

non-reimburseable advances if any such 

advance with respect to any underlying 

exposure is limited to an insignificant 

amount of the outstanding principal 

balance of the underlying exposure); (ii) 

the servicer’s right to reimbursement is 

senior in right of payment to all other 

claims on the cash flows from the 

underlying exposures of the 

securitization; and (iii) the servicer has 

no legal obligation to, and does not, 

make advances to the securitization if 

the servicer concludes the advances are 

unlikely to be repaid. If these conditions 

are not satisfied, a bank that provides a 

servicer cash advance facility must 

determine its risk-based capital 

requirement for the undrawn portion of 

the facility in the same manner as the 

bank would determine its risk-based 

capital requirement for any other 

undrawn securitization exposure. 

Amount of a securitization exposure. 

For all of the securitization approaches, 

the amount of an on-balance sheet 

securitization exposure is the bank’s 

carrying value, if the exposure is heldto-maturity or for trading, or the bank’s 

carrying value minus any unrealized 

gains and plus any unrealized losses on 

the exposure, if the exposure is 

available for sale. The amount of an offbalance sheet securitization exposure is 

the notional amount of the exposure. 

For a commitment, such as a liquidity 

facility extended to an ABCP program, 

the notional amount may be reduced to 

the maximum potential amount that the 

bank currently would be required to 

fund under the arrangement’s 

documentation (that is, the amount that 

could be drawn given the assets held by 

the program). For an OTC derivative 

contract that is not a credit derivative, 

the notional amount is the EAD of the 

derivative contract (as calculated in 

section 32). 

Implicit support. The proposed rule 

also sets forth the regulatory capital 

consequences if a bank provides support 

to a securitization in excess of the 

bank’s predetermined contractual 

obligation to provide credit support to 

the securitization. First, consistent with 

the general risk-based capital rules,73 a 

bank that provides such implicit 

support must hold regulatory capital 

against all of the underlying exposures 

associated with the securitization as if 

the exposures had not been securitized, 

and must deduct from tier 1 capital any 

after-tax gain-on-sale resulting from the 

securitization. Second, the bank must 

disclose publicly (i) that it has provided 

implicit support to the securitization, 

and (ii) the regulatory capital impact to 

the bank of providing the implicit 

support. The bank’s primary Federal 

supervisor also may require the bank to 

hold regulatory capital against all the 

underlying exposures associated with 

some or all the bank’s other 

securitizations as if the exposures had 

not been securitized, and to deduct from 

tier 1 capital any after-tax gain-on-sale 

resulting from such securitizations. 

Operational requirements for 

traditional securitizations. In a 

traditional securitization, an originating 

bank typically transfers a portion of the 

credit risk of exposures to third parties 

by selling them to an SPE. Banks 

engaging in a traditional securitization 

may exclude the underlying exposures 

from the calculation of risk-weighted 

assets only if each of the following 

conditions is met: (i) The transfer is a 

sale under GAAP; (ii) the originating 

bank transfers to third parties credit risk 

associated with the underlying 

exposures; and (iii) any clean-up calls 

relating to the securitization are eligible 

clean-up calls (as discussed below). 

Originating banks that meet these 

conditions must hold regulatory capital 

against any securitization exposures 

they retain in connection with the 

securitization. Originating banks that 

fail to meet these conditions must hold 

regulatory capital against the transferred 

exposures as if they had not been 

securitized and must deduct from tier 1 

capital any gain-on-sale resulting from 

the transaction. 

Clean-up calls. For purposes of these 

operational requirements, a clean-up 

call is a contractual provision that 

permits a servicer to call securitization 

exposures (for example, asset-backed 

securities) before the stated (or 

contractual) maturity or call date. In the 

case of a traditional securitization, a 

clean-up call is generally accomplished 

by repurchasing the remaining 

securitization exposures once the 

amount of underlying exposures or 

outstanding securitization exposures 

has fallen below a specified level. In the 

case of a synthetic securitization, the 

clean-up call may take the form of a 

clause that extinguishes the credit 

protection once the amount of 

underlying exposures has fallen below a 

specified level. 

To satisfy the operational 

requirements for securitizations—and, 

therefore, to enable an originating bank 

to exclude the underlying exposures 

from the calculation of its risk-based 

capital requirements—any clean-up call 

associated with a securitization must be 

an eligible clean-up call. An eligible 

clean-up call is a clean-up call that: 

(i) Is exercisable solely at the 

discretion of the servicer; 

(ii) Is not structured to avoid 

allocating losses to securitization 

exposures held by investors or 

otherwise structured to provide credit 

enhancement to the securitization (for 

example, to purchase non-performing 

underlying exposures); and 

(iii) (A) For a traditional 

securitization, is only exercisable when 

10 percent or less of the principal 

amount of the underlying exposures or 

securitization exposures (determined as 

of the inception of the securitization) is 

outstanding. 

(B) For a synthetic securitization, is 

only exercisable when 10 percent or less 

of the principal amount of the reference 

portfolio of underlying exposures 

(determined as of the inception of the 

securitization) is outstanding. 

Over the last several years, the 

agencies have published a significant 

amount of supervisory guidance to 

assist banks with assessing the extent to 

which they have transferred credit risk 

and, consequently, may recognize any 

reduction in required regulatory capital 

as a result of a securitization or other 


sroberts on PROD1PC70 with PROPOSALS
55884 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

74See, e.g., OCC Bulletin 99–46 (Dec. 14, 1999) 

(OCC); FDIC Financial Institution Letter 109–99 

(Dec. 13, 1999) (FDIC); SR Letter 99–37 (Dec. 13, 

1999) (Board); CEO Ltr. 99–119 (Dec. 14, 1999) 

(OTS). 

form of credit risk transfer.74 In general, 

the agencies would expect banks to 

continue to use this guidance, most of 

which remains applicable to the 

securitization framework. Banks are 

encouraged to consult with their 

primary Federal supervisor about 

transactions that require additional 

guidance. 

2. Ratings-Based Approach (RBA) 

Under the RBA, a bank would 

determine the risk-weighted asset 

amount for a securitization exposure 

that has an external rating or inferred 

rating by multiplying the amount of the 

exposure by the appropriate risk-weight 

provided in the tables in section 43 of 

the proposed rule. An originating bank 

must use the RBA if its retained 

securitization exposure has at least two 

external ratings or an inferred rating 

based on at least two external ratings; an 

investing bank must use the RBA if its 

securitization exposure has one or more 

external or inferred ratings. For 

purposes of the proposed rule, an 

originating bank means a bank that 

meets either of the following conditions: 

(i) The bank directly or indirectly 

originated or securitized the underlying 

exposures included in the 

securitization; or (ii) the securitization 

is an ABCP program and the bank serves 

as a sponsor of the ABCP program. 

This two-rating requirement for 

originating banks is the only material 

difference between the treatment of 

originating banks and investing banks 

under the securitization framework. 

Although this two-rating requirement is 

not included in the New Accord, it is 

generally consistent with the treatment 

of originating and investing banks in the 

general risk-based capital rules. The 

agencies believe that the market 

discipline evidenced by a third party 

purchasing a securitization exposure 

obviates the need for a second rating for 

an investing bank. Question 45: The 

agencies seek comment on this 

differential treatment of originating 

banks and investing banks and on 

alternative mechanisms that could be 

employed to ensure the reliability of 

external and inferred ratings of nontraded securitization exposures retained 

by originating banks. 

Under the proposed rule, a bank also 

must use the RBA for securitization 

exposures with an inferred rating. 

Similar to the general risk-based capital 

rules, an unrated securitization 

exposure would have an inferred rating 

if another securitization exposure 

associated with the securitization 

transaction (that is, issued by the same 

issuer and backed by the same 

underlying exposures) has an external 

rating and the rated securitization 

exposure (i) is subordinated in all 

respects to the unrated securitization 

exposure; (ii) does not benefit from any 

credit enhancement that is not available 

to the unrated securitization exposure; 

and (iii) has an effective remaining 

maturity that is equal to or longer than 

the unrated securitization exposure. 

Under the RBA, securitization 

exposures with an inferred rating are 

treated the same as securitization 

exposures with an identical external 

rating. Question 46: The agencies seek 

comment on whether they should 

consider other bases for inferring a 

rating for an unrated securitization 

position, such as using an applicable 

credit rating on outstanding long-term 

debt of the issuer or guarantor of the 

securitization exposure. 

Under the RBA, the risk-based capital 

requirement per dollar of securitization 

exposure would depend on four factors: 

(i) The applicable rating of the exposure; 

(ii) whether the rating reflects a longterm or short-term assessment of the 

exposure’s credit risk; (iii) whether the 

exposure is a ‘‘senior’’ exposure; and 

(iv) a measure of the effective number 

(‘‘N’’) of underlying exposures. For a 

securitization exposure with only one 

external or inferred rating, the 

applicable rating of the exposure is that 

external or inferred rating. For a 

securitization exposure with more than 

one external or inferred rating, the 

applicable rating of the exposure is the 

lowest external or inferred rating 

assigned to the exposure. 

A ‘‘senior securitization exposure’’ is 

a securitization exposure that has a first 

priority claim on the cash flows from 

the underlying exposures, disregarding 

the claims of a service provider (such as 

a swap counterparty or trustee, 

custodian, or paying agent for a 

securitization) to fees from the 

securitization. A liquidity facility that 

supports an ABCP program is a senior 

securitization exposure if the liquidity 

facility provider’s right to 

reimbursement of the drawn amounts is 

senior to all claims on the cash flow 

from the underlying exposures except 

claims of a service provider to fees. 

Question 47: The agencies seek 

comment on the appropriateness of 

basing the risk-based capital 

requirement for a securitization 

exposure under the RBA on the seniority 

level of the exposure. 

Under the RBA, a bank must use 

Table G below when the securitization 

exposure’s external rating represents a 

long-term credit rating or its inferred 

rating is based on a long-term credit 

rating. A bank must apply the risk 

weights in column 1 of Table G to the 

securitization exposure if the effective 

number of underlying exposures (N) is 

6 or more and the securitization 

exposure is a senior securitization 

exposure. If the notional number of 

underlying exposures of a securitization 

is 25 or more or if all the underlying 

exposures are retail exposures, a bank 

may assume that N is 6 or more (unless 

the bank knows or has reason to know 

that N is less than 6). If the notional 

number of underlying exposures of a 

securitization is less than 25 and one or 

more of the underlying exposures is a 

non-retail exposure, the bank must 

compute N as described in the SFA 

section below. If N is 6 or more but the 

securitization exposure is not a senior 

securitization exposure, the bank must 

apply the risk weights in column 2 of 

Table G. A bank must apply the risk 

weights in column 3 of Table G to the 

securitization exposure if N is less than 

6. Question 48: The agencies seek 

comment on how well this approach 

captures the most important risk factors 

for securitization exposures of varying 

degrees of seniority and granularity. 


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Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55885 

75See Vladislav Peretyatkin and William 

Perraudin, ‘‘Capital for Asset-Backed Securities,’’

Bank of England, February 2003. 

76See, e.g., Michael Pykhtin and Ashish Dev, 

‘‘Credit Risk in Asset Securitizations: An Analytical 

Model,’’ Risk (May 2002) S16–S20. 

TABLE G.—LONG-TERM CREDIT RATING RISK WEIGHTS UNDER RBA AND IAA 

Applicable rating (illustrative rating example) 

Column 1 Column 2 Column 3 

Risk weights for 

senior 

securitization exposures backed 

by granular pools 

(percent) 

Risk weights for 

non-senior 

securitization exposures backed 

by granular pools 

(percent) 

Risk weights for 

securitization exposures backed 

by non-granular 

pools 

(percent) 

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

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

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

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

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

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

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

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

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

One category below investment grade (for example, BB) ........................................ 425 

One category below investment grade—negative designation (for example, BB¥) 650 

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

A bank must apply the risk weights in 

Table H when the securitization 

exposure’s external rating represents a 

short-term credit rating or its inferred 

rating is based on a short-term credit 

rating. A bank must apply the decision 

rules outlined in the previous paragraph 

to determine which column of Table H 

applies. 

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

Applicable rating (illustrative rating example) 

Column 1 Column 2 Column 3 

Risk weights for 

senior 

securitization exposures backed 

by granular pools 

(percent) 

Risk weights for 

non-senior 

securitization exposures backed 

by granular pools 

(percent) 

Risk weights for 

securitization exposures backed 

by non-granular 

pools 

(percent) 

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

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

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

All other ratings .......................................................................................................... Deduction from tier 1 and tier 2 capital. 

Within tables G and H, risk weights 

increase as rating grades decline. Under 

column 2 of Table G, for example, the 

risk weights range from 12 percent for 

exposures with the highest investment 

grade rating to 650 percent for 

exposures rated one category below 

investment grade with a negative 

designation. This pattern of risk weights 

is broadly consistent with analyses 

employing standard credit risk models 

and a range of assumptions regarding 

correlation effects and the types of 

exposures being securitized.75 These 

analyses imply that, compared with a 

corporate bond having a given level of 

stand-alone credit risk (for example, as 

measured by its expected loss rate), a 

securitization tranche having the same 

level of stand-alone credit risk—but 

backed by a reasonably granular and 

diversified pool—will tend to exhibit 

more systematic risk.76 This effect is 

most pronounced for below-investmentgrade 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. 

Under the RBA, a securitization 

exposure that has an investment grade 

rating and has fewer than six effective 

underlying exposures generally receives 

a higher risk weight than a similarly 

rated securitization exposure with six or 

more effective underlying exposures. 

The agencies have designed the risk 

weights in this manner to discourage a 

bank from engaging in regulatory capital 

arbitrage by securitizing very highquality wholesale exposures (that is, 

wholesale exposures with a low PD and 

LGD), obtaining external ratings on the 

securitization exposures issued by the 

securitization, and retaining essentially 

all the credit risk of the pool of 

underlying exposures. 

Consistent with the ANPR, the 

proposed rule requires a bank to deduct 

from regulatory capital any 

securitization exposure with an external 

or inferred rating below one category 

below investment grade for long-term 

ratings or below investment grade for 

short-term ratings. Several commenters 


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55886 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

argued that this deduction is excessive 

in light of the credit risk of such 

exposures. Although this proposed 

capital treatment is more conservative 

than suggested by credit risk modeling 

analyses, the agencies have decided to 

retain the deduction approach for lownon-investment grade exposures. The 

agencies believe that there are 

significant modeling uncertainties for 

such low-rated securitization tranches. 

Moreover, external ratings of these 

tranches are subject to less market 

discipline because these positions 

generally are retained by the bank. 

The proposed RBA differs in several 

important respects from the RBA in the 

ANPR. First, under the ANPR, an 

originating bank (but not an investing 

bank) would have to deduct from 

regulatory capital the amount of any 

securitization exposure below the riskbased capital requirement for the 

underlying exposures as if they were 

held directly by the bank, regardless of 

whether the exposure would have 

qualified for a lower risk-based capital 

requirement under the RBA. The 

agencies took this position in the ANPR, 

in part, to provide incentives for 

originating banks to shed deeply 

subordinated, high risk, difficult-tovalue securitization exposures. The 

agencies also were concerned that an 

external credit rating may be less 

reliable when the rating applies to a 

retained, non-traded exposure and is 

sought by an originating bank primarily 

for regulatory capital purposes. 

Numerous commenters criticized this 

aspect of the ANPR as lacking risk 

sensitivity and inconsistently treating 

originating and investing banks. After 

further review, the agencies have 

concluded that the risk sensitivity and 

logic of the securitization framework 

would be enhanced by permitting 

originating banks and investing banks to 

use the RBA on generally equal terms. 

The agencies have revised the RBA to 

permit originating banks to use the RBA 

even if the retained securitization 

exposure is below the risk-based capital 

requirement for the underlying 

exposures as if they were held directly 

by the bank. 

In addition, the agencies have 

enhanced the risk sensitivity of the RBA 

in the ANPR by introducing more riskweight gradations for securitization 

exposures with a long-term external or 

inferred rating in the third-highest 

investment grade rating category. 

Although the ANPR RBA applied the 

same risk weight to all securitization 

exposures with long-term external 

ratings in the third-highest investment 

grade rating category, the proposed rule 

provides three different risk weights to 

securitization exposures that have longterm external ratings in the third-highest 

investment grade rating category 

depending on whether the rating has 

positive, negative, or no designation. 

The agencies also have modified the 

ANPR RBA to expand the set of lower 

risk-weights applicable to the most 

senior tranches of reasonably granular 

securitizations to better reflect the low 

systematic risk of such tranches. For 

example, under the ANPR, certain 

relatively senior tranches of reasonably 

granular securitizations with long-term 

external ratings in the two highest 

investment grade rating categories 

received a lower risk-weight than more 

subordinated tranches of the same 

securitizations. Under the proposed 

rule, the most senior tranches of 

reasonably granular securitizations with 

long-term investment grade external 

ratings receive a more favorable riskweight as compared to more 

subordinated tranches of the same 

securitizations. In addition, in response 

to comments, the agencies have reduced 

the granularity requirement for a senior 

securitization exposure to qualify for the 

lower risk weights. Under the ANPR 

RBA, only securitization exposures to a 

securitization that has an N of 100 or 

more could qualify for the lower riskweights. Under the proposed rule, 

securitization exposures to a 

securitization that has an N of 6 or more 

would qualify for the lower risk 

weights. 

Although the proposed rule’s RBA 

expands the availability of the lower 

risk weights for senior securitization 

exposures in several respects, it also has 

a more conservative but simpler 

definition of a senior securitization 

exposure. The ANPR RBA imposed a 

mathematical test for determining the 

relative seniority of a securitization 

tranche. This test allowed the 

designation of multiple senior 

securitization tranches for a particular 

securitization. By contrast, the proposed 

RBA designates the most senior 

securitization tranche in a particular 

securitization as the only securitization 

tranche eligible for the lower risk 

weights. 

In addition, some commenters argued 

that the ANPR RBA risk weights for 

highly-rated senior retail securitization 

exposures were excessive in light of the 

credit risk associated with such 

exposures. The agencies have 

determined that empirical research on 

this point (including that provided by 

commenters) is inconclusive and does 

not warrant a reduction in the RBA risk 

weights of these exposures. 

3. Internal Assessment Approach (IAA) 

The proposed rule permits a bank to 

compute its risk-based capital 

requirement for a securitization 

exposure to an ABCP program (such as 

a liquidity facility or credit 

enhancement) using the bank’s internal 

assessment of the credit quality of the 

securitization exposure. To do so, the 

bank’s internal assessment process and 

the ABCP program must meet certain 

qualification requirements in section 44 

of the proposed rule, and the 

securitization exposure must initially be 

internally rated at least equivalent to 

investment grade. A bank that elects to 

use the IAA for any securitization 

exposure to an ABCP program must use 

the IAA to compute risk-based capital 

requirements for all securitization 

exposures that qualify for the IAA 

approach. Under the IAA, a bank would 

map its internal credit assessment of a 

securitization exposure to an equivalent 

external credit rating from an NRSRO. 

The bank would determine the riskweighted asset amount for a 

securitization exposure by multiplying 

the amount of the exposure (using the 

methodology set forth above in the RBA 

section) by the appropriate risk weight 

provided in Table G or H above. 

The agencies included the IAA for 

securitization exposures to ABCP 

programs in response to comments on 

the ANPR. The ANPR indicated that the 

agencies expected banks to use the SFA 

or a ‘‘Look-Through Approach’’ to 

determine risk-based capital 

requirements for exposures to ABCP 

programs. Under the Look-Through 

Approach, a bank would determine its 

risk-based capital requirement for an 

eligible liquidity facility provided to an 

ABCP program by multiplying (i) 8 

percent; (ii) the maximum potential 

drawdown on the facility; (iii) an 

applicable conversion factor of between 

50 and 100 percent; and (iv) the 

applicable risk weight (which would 

typically be 100 percent). Commenters 

expressed concern that ABCP program 

sponsors would not have sufficient data 

about the underlying exposures in the 

ABCP program to use the SFA and that 

the Look-Through Approach produced 

economically unreasonable capital 

requirements for these historically safe 

credit exposures. The agencies are 

proposing to replace the Look-Through 

Approach with the IAA, which is 

similar to an approach already available 

to qualifying banks under the general 

risk-based capital rules for credit 

enhancements to ABCP programs and 

which the agencies believe would 

provide a more risk-sensitive and 

economically appropriate risk-based 


sroberts on PROD1PC70 with PROPOSALS
Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55887 

capital treatment for bank exposures to 

ABCP programs. 

To use the IAA, a bank must receive 

prior written approval from its primary 

Federal supervisor. To receive such 

approval, the bank would have to 

demonstrate that its internal credit 

assessment process satisfies all the 

following criteria. The bank’s internal 

credit assessments of securitization 

exposures to ABCP programs must be 

based on publicly available rating 

criteria used by an NRSRO for 

evaluating the credit risk of the 

underlying exposures. The bank’s 

internal credit assessments of 

securitization exposures used for 

regulatory capital purposes must be 

consistent with those used in the bank’s 

internal risk management process, 

capital adequacy assessment process, 

and management information reporting 

systems. 

In addition, the bank’s internal credit 

assessment process must have sufficient 

granularity to identify gradations of risk. 

Each of the bank’s internal credit 

assessment categories must correspond 

to an external credit rating of an 

NRSRO. The proposed rule also requires 

that the bank’s internal credit 

assessment process, particularly the 

stress test factors for determining credit 

enhancement requirements, be at least 

as conservative as the most conservative 

of the publicly available rating criteria 

of the NRSROs that have provided 

external credit ratings to the commercial 

paper issued by the ABCP program. 

Moreover, the bank must have an 

effective system of controls and 

oversight that ensures compliance with 

these operational requirements and 

maintains the integrity of the internal 

credit assessments. The bank must 

review and update each internal credit 

assessment whenever new material 

information is available, but no less 

frequently than annually. The bank 

must also validate its internal credit 

assessment process on an ongoing basis, 

but not less frequently than annually. 

To use the IAA on a specific exposure 

to an ABCP program, the program must 

exhibit the following characteristics: 

(i) All the commercial paper issued by 

the ABCP program must have an 

external rating. 

(ii) The ABCP program must have 

robust credit and investment guidelines 

(that is, underwriting standards). 

(iii) The ABCP program must perform 

a detailed credit analysis of the asset 

sellers’ risk profiles. 

(iv) The ABCP program’s 

underwriting policy must establish 

minimum asset eligibility criteria that 

include a prohibition of the purchase of 

assets that are significantly past due or 

defaulted, as well as limitations on 

concentrations to an individual obligor 

or geographic area and the tenor of the 

assets to be purchased. 

(v) The aggregate estimate of loss on 

an asset pool that the ABCP program is 

considering purchasing must consider 

all sources of potential risk, such as 

credit and dilution risk. 

(vi) The ABCP program must 

incorporate structural features into each 

purchase of assets to mitigate potential 

credit deterioration of the underlying 

exposures. Such features may include 

wind-down triggers specific to a pool of 

underlying exposures. 

4. Supervisory Formula Approach (SFA) 

General requirements. Under the SFA, 

a bank would determine the riskweighted asset amount for a 

securitization exposure by multiplying 

the SFA risk-based capital requirement 

for the exposure (as determined by the 

supervisory formula set forth below) by 

12.5. If the SFA risk weight for a 

securitization exposure is 1,250 percent 

or greater, however, the bank must 

deduct the exposure from total capital 

rather than risk weight the exposure. 

Deduction is consistent with the 

treatment of other high-risk 

securitization exposures, such as CEIOs. 

The SFA capital requirement for a 

securitization exposure depends on the 

following seven inputs: 

(i) The amount of the underlying 

exposures (UE); 

(ii) The securitization exposure’s 

proportion of the tranche in which it 

resides (TP); 

(iii) The sum of the risk-based capital 

requirement and ECL for the underlying 

exposures as if they were held directly 

on the bank’s balance sheet divided by 

the amount of the underlying exposures 

(KIRB); 

(iv) The tranche’s credit enhancement 

level (L); 

(v) The tranche’s thickness (T); 

(vi) The securitization’s effective 

number of underlying exposures (N); 

and 

(vii) The securitization’s exposureweighted average loss given default 

(EWALGD). 

A bank may only use the SFA to 

determine its risk-based capital 

requirement for a securitization 

exposure if the bank can calculate each 

of these seven inputs on an ongoing 

basis. In particular, if a bank cannot 

compute KIRB because the bank cannot 

compute the risk-based capital 

requirement for all underlying 

exposures, the bank may not use the 

SFA to compute its risk-based capital 

requirement for the securitization 

exposure. In those cases, the bank 

would deduct the exposure from 

regulatory capital. 

The SFA capital requirement for a 

securitization exposure is UE multiplied 

by TP multiplied by the greater of (i) 

0.0056 * T; or (ii) S[L+T]¥S[L], where: 

( )i S[Y] =

Y when Y K 

K

IRB

IRB

≤

+− + ⋅ − 















⋅ − ( )

KY KK d e wh IRB

Y

[] [ ] K IRB

K

K

IRB

IRB

20

1

20

en Y K > IRB





















 

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

( ) iii K

EWALGD

IRB

N

 h = 1 − 



 



 

( ) iv a = g c ⋅ 


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55888 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

77The conceptual basis for specification of K[x] 

is developed in Michael B. Gordy and David Jones, 

‘‘Random Tranches,’’ Risk. (Mar. 2003) 78–83. 

78See Michael Pykhtin and Ashish Dev, ‘‘Coarsegrained CDOs,’’ Risk (Jan. 2003) 113–116. 

() ( ) v c b = g ⋅ −1 

( ) vi K

h

IRB c = 

1− 

( ) ( ) vii c c

f g = 

1 1 − ⋅ − 

( ) ( )viii v K

h

c

KKv

h

IRB IRB IRB f = +

− − + ( ) − ⋅ −− ⋅

2

2

1

1

1 1000 

( ) ( ). ( ) ix K EWALGD K EWALGD

N IRB

IRB v = ⋅ − + ⋅− 25 1 

( ) ( ) ( [ ; , ]) x h K ab IRB d = 11 1 − − ⋅ −β 

In these expressions, b[Y; a, b] refers 

to the cumulative beta distribution with 

parameters a and b evaluated at Y. In 

the case where N=1 and EWALGD=100 

percent, S[Y] in formula (1) must be 

calculated with K[Y] set equal to the 

product of KIRB and Y, and d set equal 

to 1¥KIRB. The major inputs to the SFA 

formula (UE, TP, KIRB, L, T, EWALGD, 

and N) are defined below and in section 

45 of the proposed rule. 

The SFA formula effectively imposes 

a 56 basis point minimum risk-based 

capital requirement (8 percent of the 7 

percent risk weight) per dollar of 

securitization exposure. A number of 

commenters on the ANPR contended 

that this floor capital requirement in the 

SFA would be excessive for many senior 

securitization exposures. Although such 

a floor may impose a capital 

requirement that is too high for some 

securitization exposures, the agencies 

continue to believe that some minimum 

prudential capital requirement is 

appropriate in the securitization 

context. This 7 percent risk-weight floor 

is also consistent with the lowest capital 

requirement available under the RBA 

and, thus, should reduce incentives for 

regulatory capital arbitrage. 

The SFA formula is a blend of credit 

risk modeling results and supervisory 

judgment. The function S[Y] 

incorporates two distinct features. First, 

a pure model-based estimate of the 

pool’s aggregate systematic or nondiversifiable credit risk that is 

attributable to a first loss position 

covering losses up to and including Y. 

Because the tranche of interest covers 

losses over a specified range (defined in 

terms of L and T), the tranche’s 

systematic risk can be represented as 

S[L+T] ¥ S[L]. The second feature 

involves a supervisory add-on primarily 

intended to avoid behavioral distortions 

associated with what would otherwise 

be a discontinuity in capital 

requirements for relatively thin 

mezzanine tranches lying just below 

and just above the KIRB boundary: all 

tranches at or below KIRB would be 

deducted from capital, whereas a very 

thin tranche just above KIRB would 

incur a pure model-based percentage 

capital requirement that could vary 

between zero and one, depending on the 

number of effective underlying 

exposures (N). The supervisory add-on 

applies primarily to positions just above 

KIRB, and its quantitative effect 

diminishes rapidly as the distance from 

KIRB widens. 

Under the SFA, a bank must deduct 

from regulatory capital any 

securitization exposures (or parts 

thereof) that absorb losses at or below 

the level of KIRB. However, the specific 

securitization exposures that are subject 

to this deduction treatment under the 

SFA may change over time in response 

to variation in the credit quality of the 

pool of underlying exposures. For 

example, if the pool’s IRB capital 

requirement were to increase after the 

inception of a securitization, additional 

portions of unrated securitization 

exposures may fall below KIRB and thus 

become subject to deduction under the 

SFA. Therefore, if a bank owns an 

unrated first-loss securitization 

exposure well in excess of KIRB, the 

capital requirement on the exposure 

could climb rapidly in the event of 

marked deterioration in the credit 

quality of the underlying exposures. 

Apart from the risk-weight floor and 

other supervisory adjustments described 

above, the supervisory formula attempts 

to be as consistent as possible with the 

parameters and assumptions of the IRB 

framework that would apply to the 

underlying exposures if held directly by 

a bank.77 The specification of S[Y] 

assumes that KIRB is an accurate 

measure of the total systematic credit 

risk of the pool of underlying exposures 

and that a securitization merely 

redistributes this systematic risk among 

its various tranches. In this way, S[Y] 

embodies precisely the same asset 

correlations as are assumed elsewhere 

within the IRB framework. In addition, 

this specification embodies the result 

that a pool’s systematic risk (that is, 

KIRB) tends to be redistributed toward 

more senior tranches as the effective 

number of underlying exposures in the 

pool (N) declines.78 The importance of 

pool granularity depends on the pool’s 

average loss severity rate, EWALGD. For 

small values of N, the framework 

implies that, as EWALGD increases, 

systematic risk is shifted toward senior 

tranches. For highly granular pools, 

such as securitizations of retail 

exposures, EWALGD would have no 


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Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55889 

influence on the SFA capital 

requirement. 

Inputs to the SFA formula. The 

proposed rule provides the following 

definitions of the seven inputs into the 

SFA formula. 

(i) Amount of the underlying 

exposures (UE). This input (measured in 

dollars) is the EAD of any underlying 

wholesale and retail exposures plus the 

amount of any underlying exposures 

that are securitization exposures (as 

defined in section 42(e) of the proposed 

rule) plus the adjusted carrying value of 

any underlying equity exposures (as 

defined in section 51(b) of the proposed 

rule). UE also would include any 

funded spread accounts, cash collateral 

accounts, and other similar funded 

credit enhancements. 

(ii) Tranche percentage (TP). TP is the 

ratio of (i) the amount of the bank’s 

securitization exposure to (ii) the 

amount of the securitization tranche 

that contains the bank’s securitization 

exposure. 

(iii) KIRB. KIRB is the ratio of (i) the 

risk-based capital requirement for the 

underlying exposures plus the ECL of 

the underlying exposures (all as 

determined as if the underlying 

exposures were directly held by the 

bank) to (ii) UE. The definition of KIRB

includes the ECL of the underlying 

exposures in the numerator because if 

the bank held the underlying exposures 

on its balance sheet, the bank also 

would hold reserves against the 

exposures. 

The calculation of KIRB must reflect 

the effects of any credit risk mitigant 

applied to the underlying exposures 

(either to an individual underlying 

exposure, a group of underlying 

exposures, or to the entire pool of 

underlying exposures). In addition, all 

assets related to the securitization are to 

be treated as underlying exposures for 

purposes of the SFA, including assets in 

a reserve account (such as a cash 

collateral account). 

(iv) Credit enhancement level (L). L is 

the ratio of (i) the amount of all 

securitization exposures subordinated to 

the securitization tranche that contains 

the bank’s securitization exposure to (ii) 

UE. Banks must determine L before 

considering the effects of any tranchespecific credit enhancements (such as 

third-party guarantees that benefit only 

a single tranche). Any after-tax gain-onsale or CEIOs associated with the 

securitization may not be included in L. 

Any reserve account funded by 

accumulated cash flows from the 

underlying exposures that is 

subordinated to the tranche that 

contains the bank’s securitization 

exposure may be included in the 

numerator and denominator of L to the 

extent cash has accumulated in the 

account. Unfunded reserve accounts 

(that is, reserve accounts that are to be 

funded from future cash flows from the 

underlying exposures) may not be 

included in the calculation of L. 

In some cases, the purchase price of 

receivables will reflect a discount that 

provides credit enhancement (for 

example, first loss protection) for all or 

certain tranches. When this arises, L 

should be calculated inclusive of this 

discount if the discount provides credit 

enhancement for the securitization 

exposure. 

(v) Thickness of tranche (T). T is the 

ratio of (i) the size of the tranche that 

contains the bank’s securitization 

exposure to (ii) UE. 

(vi) Effective number of exposures (N). 

As a general matter, the effective 

number of exposures would be 

calculated as follows: 

N

EAD

EAD

i

i

i

i

=





 

 ∑ 

∑

2

2

where EADi represents the EAD 

associated with the ith instrument in the 

pool of underlying exposures. For 

purposes of computing N, multiple 

exposures to one obligor must be treated 

as a single underlying exposure. In the 

case of a re-securitization (that is, a 

securitization in which some or all of 

the underlying exposures are 

themselves securitization exposures), a 

bank must treat each underlying 

securitization exposure as a single 

exposure and must not look through to 

the exposures that secure the underlying 

securitization exposures. The agencies 

recognize that this simple and 

conservative approach to resecuritizations may result in the 

differential treatment of economically 

similar securitization exposures. 

Question 49: The agencies seek 

comment on suggested alternative 

approaches for determining the N of a 

re-securitization. 

N represents the granularity of a pool 

of underlying exposures using an 

‘‘effective’’ number of exposures 

concept rather than a ‘‘gross’’ number of 

exposures concept to appropriately 

assess the diversification of pools that 

have individual underlying exposures of 

different sizes. An approach that simply 

counts the gross number of underlying 

exposures in a pool treats all exposures 

in the pool equally. This simplifying 

assumption could radically overestimate 

the granularity of a pool with numerous 

small exposures and one very large 

exposure. The effective exposure 

approach captures the notion that the 

risk profile of such an unbalanced pool 

is more like a pool of several mediumsized 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: 

N = +++

+++ = = ( ),

, . 100 1 1 1

100 1 1 1

10 609

10 003

1 06

2

2222

(vii) Exposure-weighted average loss 

given default (EWALGD). The EWALGD 

is calculated as: 

EWALGD

LGD EAD

EAD

i i

i

i

i

=

∑ ⋅

∑

where LGDi represents the average LGD 

associated with all exposures to the ith

obligor. In the case of a re-securitization, 

an LGD of 100 percent must be assumed 

for any underlying exposure that is itself 

a securitization exposure. 

Under certain conditions, a bank may 

employ the following simplifications to 

the SFA. First, for securitizations all of 

whose underlying exposures are retail 

exposures, a bank may set h = 0 and v 

= 0. In addition, if the share of a 

securitization corresponding to the 

largest underlying exposure (C1) is no 

more than 0.03 (or 3 percent of the 

underlying exposures), then for 

purposes of the SFA the bank may set 

EWALGD=0.50 and N equal to the 

following amount: 


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N

C C C C

m m

m

=

+ −

−





 



 −

1

1

0 1

1 max (1 mC1, )

where Cm is the ratio of (i) the sum of 

the amounts of the largest ‘m’

underlying exposures of the 

securitization; to (ii) UE. A bank may 

select the level of ‘m’ in its discretion. 

For example, if the three largest 

underlying exposures of a securitization 

represent 15 percent of the pool of 

underlying exposures, C3 for the 

securitization is 0.15. As an alternative 

simplification option, if only C1 is 

available, and C1 is no more than 0.03, 

then the bank may set EWALGD=0.50 

and N=1/C1. 

5. Eligible Disruption Liquidity 

Facilities 

The version of the SFA contained in 

the New Accord provides a more 

favorable capital treatment for eligible 

disruption liquidity facilities than for 

other securitization exposures. Under 

the New Accord, an eligible disruption 

liquidity facility is a liquidity facility 

that supports an ABCP program and that 

(i) is subject to an asset quality test that 

precludes funding of underlying 

exposures that are in default; (ii) can be 

used to fund only those exposures that 

have an investment grade external rating 

at the time of funding, if the underlying 

exposures that the facility must fund 

against are externally rated exposures at 

the time that the exposures are sold to 

the program; and (iii) may only be 

drawn in the event of a general market 

disruption. Under the New Accord, a 

bank that uses the SFA to compute its 

risk-based capital requirement for an 

eligible disruption liquidity facility may 

multiply the facility’s SFA-determined 

risk weight by 20 percent. Question 50: 

The agencies have not included this 

concept in the proposed rule but seek 

comment on the prevalence of eligible 

disruption liquidity facilities and a 

bank’s expected use of the SFA to 

calculate risk-based capital 

requirements for such facilities. 

6. Credit Risk Mitigation for 

Securitization Exposures 

An originating bank that has obtained 

a credit risk mitigant to hedge its 

securitization exposure to a synthetic or 

traditional securitization that satisfies 

the operational criteria in section 41 of 

the proposed rule may recognize the 

credit risk mitigant, but only as 

provided in section 46 of the proposed 

rule. An investing bank that has 

obtained a credit risk mitigant to hedge 

a securitization exposure also may 

recognize the credit risk mitigant, but 

only as provided in section 46. A bank 

that has used the RBA or IAA to 

calculate its risk-based capital 

requirement for a securitization 

exposure whose external or inferred 

rating (or equivalent internal rating 

under the IAA) reflects the benefits of a 

particular credit risk mitigant provided 

to the associated securitization or that 

supports some or all of the underlying 

exposures, however, may not use the 

securitization credit risk mitigation 

rules to further reduce its risk-based 

capital requirement for the exposure 

based on that credit risk mitigant. For 

example, a bank that owns a AAA-rated 

asset-backed security that benefits, 

along with all the other securities issued 

by the securitization SPE, from an 

insurance wrap that is part of the 

securitization transaction would 

calculate its risk-based capital 

requirement for the security strictly 

under the RBA; no additional credit 

would be given for the presence of the 

insurance wrap. On the other hand, if a 

bank owns a BBB-rated asset-backed 

security and obtains a credit default 

swap from a AAA-rated counterparty to 

protect the bank from losses on the 

security, the bank would be able to 

apply the securitization CRM rules to 

recognize the risk mitigating effects of 

the credit default swap and determine 

the risk-based capital requirement for 

the position. 

The proposed rule contains a separate 

treatment of CRM for securitization 

exposures (versus wholesale and retail 

exposures) because the wholesale and 

retail exposure CRM approaches rely on 

substitutions of, or adjustments to, the 

risk parameters of the hedged exposure. 

Because the securitization framework 

does not rely on risk parameters to 

determine risk-based capital 

requirements for securitization 

exposures, a different treatment of CRM 

for securitization exposures is 

necessary. 

The securitization CRM rules, like the 

wholesale and retail CRM rules, address 

collateral separately from guarantees 

and credit derivatives. A bank is not 

permitted to recognize collateral other 

than financial collateral as a credit risk 

mitigant for securitization exposures. A 

bank may recognize financial collateral 

in determining the bank’s risk-based 

capital requirement for a securitization 

exposure using a collateral haircut 

approach. The bank’s risk-based capital 

requirement for a collateralized 

securitization exposure is equal to the 

risk-based capital requirement for the 

securitization exposure as calculated 

under the RBA or the SFA multiplied by 

the ratio of adjusted exposure amount 

(E*) to original exposure amount (E), 

where: 

(i) E* = max {0, [E ¥ C × (1 ¥ Hs 

¥ Hfx)]}; 

(ii) E = the amount of the 

securitization exposure (as calculated 

under section 42(e) of the proposed 

rule); 

(iii) C = the current market value of 

the collateral; 

(iv) Hs = the haircut appropriate to 

the collateral type; and 

(v) Hfx = the haircut appropriate for 

any currency mismatch between the 

collateral and the exposure. 

Where the collateral is a basket of 

different asset types or a basket of assets 

denominated in different currencies, the 

haircut on the basket will be 

H aHi i

i

= ∑ ,

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 ownestimates haircuts contained in section 

32 of the proposed rule. Banks that use 

own-estimates haircuts for collateralized 

securitization exposures must assume a 

minimum holding period (TM) for 

securitization exposures of 65 business 

days. 

A bank that does not qualify for and 

use own-estimates haircuts must use the 

collateral type haircuts (Hs) in Table 3 

of this preamble and must use a 

currency mismatch haircut (Hfx) of 8 

percent if the exposure and the 

collateral are denominated in different 

currencies. To reflect the longer-term 

nature of securitization exposures as 

compared to eligible margin loans and 

OTC derivative contracts, however, 

these standard supervisory haircuts 

(which are based on a 10-business-day 

holding period and daily marking-toVerDate Aug<31>2005 23:25 Sep 22, 2006 Jkt 208001 PO 00000 Frm 00062 Fmt 4701 Sfmt 4702 E:\FR\FM\25SEP2.SGM 25SEP2

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Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55891 

market and remargining) must be 

adjusted to a 65-business-day holding 

period (the approximate number of 

business days in a calendar quarter) by 

multiplying them by the square root of 

6.5 (2.549510). A bank also must adjust 

the standard supervisory haircuts 

upward on the basis of a holding period 

longer than 65 business days where and 

as appropriate to take into account the 

illiquidity of an instrument. 

A bank may only recognize an eligible 

guarantee or eligible credit derivative 

provided by an eligible securitization 

guarantor in determining the bank’s 

risk-based capital requirement for a 

securitization exposure. Eligible 

guarantee and eligible credit derivative 

are defined the same way as in the CRM 

rules for wholesale and retail exposures. 

An eligible securitization guarantor is 

defined to mean (i) a sovereign entity, 

the Bank for International Settlements, 

the International Monetary Fund, the 

European Central Bank, the European 

Commission, a Federal Home Loan 

Bank, the Federal Agricultural Mortgage 

Corporation (Farmer Mac), a 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 an SPE) that has 

issued and outstanding an unsecured 

long-term debt security without credit 

enhancement that has a long-term 

applicable external rating in one of the 

three highest investment grade rating 

categories; or (iii) any other entity (other 

than an SPE) that has a PD assigned by 

the bank that is lower than or equivalent 

to the PD associated with a long-term 

external rating in the third-highest 

investment grade rating category. 

A bank may recognize an eligible 

guarantee or eligible credit derivative 

provided by an eligible securitization 

guarantor in determining the bank’s 

risk-based capital requirement for the 

securitization exposure as follows. If the 

protection amount of the eligible 

guarantee or eligible credit derivative 

equals or exceeds the amount of the 

securitization exposure, then the bank 

may set the risk-weighted asset amount 

for the securitization exposure equal to 

the risk-weighted asset amount for a 

direct exposure to the eligible 

securitization guarantor (as determined 

in the wholesale risk weight function 

described in section 31 of the proposed 

rule), using the bank’s PD for the 

guarantor, the bank’s ELGD and LGD for 

the guarantee or credit derivative, and 

an EAD equal to the amount of the 

securitization exposure (as determined 

in section 42(e) of the proposed rule). 

If, on the other hand, the protection 

amount of the eligible guarantee or 

eligible credit derivative is less than the 

amount of the securitization exposure, 

then the bank must divide the 

securitization exposure into two 

exposures in order to recognize the 

guarantee or credit derivative. The riskweighted asset amount for the 

securitization exposure is equal to the 

sum of the risk-weighted asset amount 

for the covered portion and the riskweighted asset amount for the 

uncovered portion. The risk-weighted 

asset amount for the covered portion is 

equal to the risk-weighted asset amount 

for a direct exposure to the eligible 

securitization guarantor (as determined 

in the wholesale risk weight function 

described in section 31 of the proposed 

rule), using the bank’s PD for the 

guarantor, the bank’s ELGD and LGD for 

the guarantee or credit derivative, and 

an EAD equal to the protection amount 

of the credit risk mitigant. The riskweighted asset amount for the 

uncovered portion is equal to the 

product of (i) 1.0 minus (the protection 

amount of the eligible guarantee or 

eligible credit derivative divided by the 

amount of the securitization exposure); 

and (ii) the risk-weighted asset amount 

for the securitization exposure without 

the credit risk mitigant (as determined 

in sections 42–45 of the proposed rule). 

For any hedged securitization 

exposure, the bank must make 

applicable adjustments to the protection 

amount as required by the maturity 

mismatch, currency mismatch, and lack 

of restructuring provisions in 

paragraphs (d), (e), and (f) of section 33 

of the proposed rule. If the riskweighted asset amount for a guaranteed 

securitization exposure is greater than 

the risk-weighted asset amount for the 

securitization exposure without the 

guarantee or credit derivative, a bank 

may always elect not to recognize the 

guarantee or credit derivative. 

When a bank recognizes an eligible 

guarantee or eligible credit derivative 

provided by an eligible securitization 

guarantor in determining the bank’s 

risk-based capital requirement for a 

securitization exposure, the bank also 

must (i) calculate ECL for the exposure 

using the same risk parameters that it 

uses for calculating the risk-weighted 

asset amount of the exposure (that is, 

the PD associated with the guarantor’s 

rating grade, the ELGD and LGD of the 

guarantee, and an EAD equal to the 

protection amount of the credit risk 

mitigant); and (ii) add this ECL to the 

bank’s total ECL. 

7. Synthetic Securitizations 

Background. In a synthetic 

securitization, an originating bank uses 

credit derivatives or guarantees to 

transfer the credit risk, in whole or in 

part, of one or more underlying 

exposures to third-party protection 

providers. The credit derivative or 

guarantee may be either collateralized or 

uncollateralized. In the typical synthetic 

securitization, the underlying exposures 

remain on the balance sheet of the 

originating bank, but a portion of the 

originating bank’s credit exposure is 

transferred to the protection provider or 

covered by collateral pledged by the 

protection provider. 

In general, the proposed rule’s 

treatment of synthetic securitizations is 

identical to that of traditional 

securitizations. The operational 

requirements for synthetic 

securitizations are more detailed than 

those for traditional securitizations and 

are intended to ensure that the 

originating bank has truly transferred 

credit risk of the underlying exposures 

to one or more third-party protection 

providers. 

Although synthetic securitizations 

typically employ credit derivatives, 

which might suggest that such 

transactions would be subject to the 

CRM rules in section 33 of the proposed 

rule, banks must first apply the 

securitization framework when 

calculating risk-based capital 

requirements for a synthetic 

securitization exposure. Banks may 

ultimately be redirected to the 

securitization CRM rules to adjust the 

securitization framework capital 

requirement for an exposure to reflect 

the CRM technique used in the 

transaction. 

Operational requirements for 

synthetic securitizations. For synthetic 

securitizations, an originating bank may 

recognize for risk-based capital 

purposes the use of CRM to hedge, or 

transfer credit risk associated with, 

underlying exposures only if each of the 

following conditions is satisfied: 

(i) The credit risk mitigant is financial 

collateral, an eligible credit derivative 

from an eligible securitization guarantor 

(defined above), or an eligible guarantee 

from an eligible securitization 

guarantor. 

(ii) The bank transfers credit risk 

associated with the underlying 

exposures to third-party investors, and 


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55892 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

the terms and conditions in the credit 

risk mitigants employed do not include 

provisions that: 

(A) Allow for the termination of the 

credit protection due to deterioration in 

the credit quality of the underlying 

exposures; 

(B) Require the bank to alter or 

replace the underlying exposures to 

improve the credit quality of the 

underlying exposures; 

(C) Increase the bank’s cost of credit 

protection in response to deterioration 

in the credit quality of the underlying 

exposures; 

(D) Increase the yield payable to 

parties other than the bank in response 

to a deterioration in the credit quality of 

the underlying exposures; or 

(E) Provide for increases in a retained 

first loss position or credit enhancement 

provided by the bank after the inception 

of the securitization. 

(iii) The bank obtains a well-reasoned 

opinion from legal counsel that 

confirms the enforceability of the credit 

risk mitigant in all relevant 

jurisdictions. 

(iv) Any clean-up calls relating to the 

securitization are eligible clean-up calls 

(as discussed above). 

Failure to meet the above operational 

requirements for a synthetic 

securitization would prevent the 

originating bank from using the 

securitization framework and would 

require the originating bank to hold riskbased capital against the underlying 

exposures as if they had not been 

synthetically securitized. A bank that 

provides credit protection to a synthetic 

securitization must use the 

securitization framework to compute 

risk-based capital requirements for its 

exposures to the synthetic securitization 

even if the originating bank failed to 

meet one or more of the operational 

requirements for a synthetic 

securitization. 

Consistent with the treatment of 

traditional securitization exposures, 

banks would be required to use the RBA 

for synthetic securitization exposures 

that have an appropriate number of 

external or inferred ratings. For an 

originating bank, the RBA would 

typically be used only for the most 

senior tranche of the securitization, 

which often would have an inferred 

rating. If a bank has a synthetic 

securitization exposure that does not 

have an external or inferred rating, the 

bank would apply the SFA to the 

exposure (if the bank and the exposure 

qualify for use of the SFA) without 

considering any CRM obtained as part of 

the synthetic securitization. Then, if the 

bank has obtained a credit risk mitigant 

on the exposure as part of the synthetic 

securitization, the bank would apply the 

securitization CRM rules to reduce its 

risk-based capital requirement for the 

exposure. For example, if the credit risk 

mitigant is financial collateral, the bank 

must use the standard supervisory or 

own-estimates haircuts to reduce its 

risk-based capital requirement. If the 

bank is a protection provider to a 

synthetic securitization and has 

obtained a credit risk mitigant on its 

exposure, the bank would also apply the 

securitization CRM rules in section 46 

of the proposed rule to reduce its riskbased capital requirement on the 

exposure. If neither the RBA nor the 

SFA is available, a bank would deduct 

the exposure from regulatory capital. 

First-loss tranches. If a bank has a 

first-loss position in a pool of 

underlying exposures in connection 

with a synthetic securitization, the bank 

must deduct the position from 

regulatory capital unless (i) the position 

qualified for use of the RBA or (ii) the 

bank and the position qualified for use 

of the SFA and a portion of the position 

was above KIRB. 

Mezzanine tranches. In a typical 

synthetic securitization, an originating 

bank obtains credit protection on a 

mezzanine, or second-loss, tranche of a 

synthetic securitization by either (i) 

obtaining a credit default swap or 

financial guarantee from a third-party 

financial institution; or (ii) obtaining a 

credit default swap or financial 

guarantee from an SPE whose 

obligations are secured by financial 

collateral. 

For a bank that creates a synthetic 

mezzanine tranche by obtaining an 

eligible credit derivative or guarantee 

from an eligible securitization 

guarantor, the bank generally would 

treat the notional amount of the credit 

derivative or guarantee (as adjusted to 

reflect any maturity mismatch, lack of 

restructuring coverage, or currency 

mismatch) as a wholesale exposure to 

the protection provider and use the IRB 

framework for wholesale exposures to 

determine the bank’s risk-based capital 

requirement for the exposure. A bank 

that creates the synthetic mezzanine 

tranche by obtaining a guarantee or 

credit derivative that is collateralized by 

financial collateral but provided by a 

non-eligible securitization guarantor 

generally would (i) first use the SFA to 

calculate the risk-based capital 

requirement on the exposure (ignoring 

the guarantee or credit derivative and 

the associated collateral); and (ii) then 

use the securitization CRM rules to 

calculate any reductions to the riskbased capital requirement resulting from 

the associated collateral. The bank may 

look only to the protection provider 

from which it obtains the guarantee or 

credit derivative when determining its 

risk-based capital requirement for the 

exposure (that is, if the protection 

provider hedges the guarantee or credit 

derivative with a guarantee or credit 

derivative from a third party, the bank 

may not look through the protection 

provider to that third party when 

calculating its risk-based capital 

requirement for the exposure). 

For a bank providing credit protection 

on a mezzanine tranche of a synthetic 

securitization, the bank would use the 

RBA to determine the risk-based capital 

requirement for the exposure if the 

exposure has an external or inferred 

rating. If the exposure does not have an 

external or inferred rating and the 

exposure qualifies for use of the SFA, 

the bank would use the SFA to calculate 

the risk-based capital requirement for 

the exposure. If neither the RBA nor the 

SFA are available, the bank would 

deduct the exposure from regulatory 

capital. If a bank providing credit 

protection on the mezzanine tranche of 

a synthetic securitization obtains a 

credit risk mitigant to hedge its 

exposure, the bank could apply the 

securitization CRM rules to reflect the 

risk reduction achieved by the credit 

risk mitigant. 

Super-senior tranches. A bank that 

has the most senior position in a pool 

of underlying exposures in connection 

with a synthetic securitization would 

use the RBA to calculate its risk-based 

capital requirement for the exposure if 

the exposure has at least one external or 

inferred rating (in the case of an 

investing bank) or at least two external 

or inferred ratings (in the case of an 

originating bank). If the super-senior 

tranche does not have an external or 

inferred rating and the bank and the 

exposure qualify for use of the SFA, the 

bank would use the SFA to calculate the 

risk-based capital requirement for the 

exposure. If neither the RBA nor the 

SFA are available, the bank would 

deduct the exposure from regulatory 

capital. If an investing bank in the 

super-senior tranche of a synthetic 

securitization obtains a credit risk 

mitigant to hedge its exposure, however, 

the investing bank may apply the 

securitization CRM rules to reflect the 

risk reduction achieved by the credit 

risk mitigant. 

8. Nth To Default Credit Derivatives 

Credit derivatives that provide credit 

protection only for the nth defaulting 

reference exposure in a group of 

reference exposures (nth to default 

credit derivatives) are similar to 

synthetic securitizations that provide 

credit protection only after the first-loss 


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79The proposed rule defines excess spread for a 

period as gross finance charge collections 

(including market interchange fees) and other 

income received by the SPE over the period minus 

interest paid to holders of securitization exposures, 

servicing fees, charge-offs, and other senior trust 

similar expenses of the SPE over the period, all 

divided by the principal balance of the underlying 

exposures at the end of the period. 

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-todefault credit derivative must determine 

its risk-based capital requirement for the 

underlying exposures as if the bank had 

synthetically securitized only the 

underlying exposure with the lowest 

capital requirement (K) (as calculated 

under Table 2 of the proposed rule) and 

had obtained no credit risk mitigant on 

the other (higher capital requirement) 

underlying exposures. If the bank 

purchases credit protection on a group 

of underlying exposures through an nthto-default credit derivative (other than a 

first-to-default credit derivative), it may 

only recognize the credit protection for 

risk-based capital purposes either if it 

has obtained credit protection on the 

same underlying exposures in the form 

of first-through-(n-1)-to-default credit 

derivatives, or if n-1 of the underlying 

exposures have already defaulted. In 

such a case, the bank would again 

determine its risk-based capital 

requirement for the underlying 

exposures as if the bank had only 

synthetically securitized the n-1 

underlying exposures with the lowest 

capital requirement (K) (as calculated 

under Table 2 of the proposed rule) and 

had obtained no credit risk mitigant on 

the other underlying exposures. 

A bank that provides credit protection 

on a group of underlying exposures 

through a first-to-default credit 

derivative must determine its riskweighted asset amount for the derivative 

by applying the RBA (if the derivative 

qualifies for the RBA) or, if the 

derivative does not qualify for the RBA, 

by setting its risk-weighted asset amount 

for the derivative equal to the product 

of (i) the protection amount of the 

derivative; (ii) 12.5; and (iii) the sum of 

the risk-based capital requirements (K) 

of the individual underlying exposures 

(as calculated under Table 2 of the 

proposed rule), up to a maximum of 100 

percent. If a bank provides credit 

protection on a group of underlying 

exposures through an nth-to-default 

credit derivative (other than a first-todefault 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 riskweighted asset amount for the derivative 

equal to the product of (i) the protection 

amount of the derivative; (ii) 12.5; and 

(iii) the sum of the risk-based capital 

requirements (K) of the individual 

underlying exposures (as calculated 

under Table 2 of the proposed rule and 

excluding the n-1 underlying exposures 

with the lowest risk-based capital 

requirements), up to a maximum of 100 

percent. 

For example, a bank provides credit 

protection in the form of a second-todefault 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 × 12.5 

× (.05 + .10 + .15 + .20) or $625. If the 

derivative were externally rated in the 

lowest investment grade rating category 

with a positive designation, the riskweighted asset amount would be $100 × 

0.50 or $50. 

9. Early Amortization Provisions 

Background. Many securitizations of 

revolving credit facilities (for example, 

credit card receivables) contain 

provisions that require the 

securitization to be wound down and 

investors to be repaid if the excess 

spread falls below a certain threshold.79

This decrease in excess spread may, in 

some cases, be caused by deterioration 

in the credit quality of the underlying 

exposures. An early amortization event 

can increase a bank’s capital needs if 

new draws on the revolving credit 

facilities would need to be financed by 

the bank using on-balance sheet sources 

of funding. The payment allocations 

used to distribute principal and finance 

charge collections during the 

amortization phase of these transactions 

also can expose a bank to greater risk of 

loss than in other securitization 

transactions. To address the risks that 

early amortization of a securitization 

poses to originating banks, the agencies 

propose the capital treatment described 

below. 

The proposed rule would define an 

early amortization provision as a 

provision in a securitization’s governing 

documentation that, when triggered, 

causes investors in the securitization 

exposures to be repaid before the 

original stated maturity of the 

securitization exposure, unless the 

provision is solely triggered by events 

not related to the performance of the 

underlying exposures or the originating 

bank (such as material changes in tax 

laws or regulations). Under the 

proposed rule, an originating bank must 

generally hold regulatory capital against 

the sum of the originating bank’s 

interest and the investors’ interest 

arising from a revolving securitization 

that contains an early amortization 

provision. An originating bank must 

compute its capital requirement for its 

interest using the hierarchy of 

approaches for securitization exposures 

as described above. The originating 

bank’s risk-weighted asset amount with 

respect to the investors’ interest in the 

securitization is equal to the product of 

the following four quantities: (i) The 

EAD associated with the investors’

interest; (ii) the appropriate conversion 

factor (CF) as determined below; (iii) 

KIRB; and (iv) 12.5. 

Under the proposed rule, as noted 

above, a bank is not required to hold 

regulatory capital against the investors’

interest if early amortization is solely 

triggered by events not related to the 

performance of the underlying 

exposures or the originating bank, such 

as material changes in tax laws or 

regulation. Under the New Accord, a 

bank is also not required to hold 

regulatory capital against the investors’

interest if (i) the securitization has a 

replenishment structure in which the 

individual underlying exposures do not 

revolve and the early amortization ends 

the ability of the originating bank to add 

new underlying exposures to the 

securitization; (ii) the securitization 

involves revolving assets and contains 

early amortization features that mimic 

term structures (that is, where the risk 

of the underlying exposures does not 

return to the originating bank); or (iii) 

investors in the securitization remain 

fully exposed to future draws by 

borrowers on the underlying exposures 

even after the occurrence of early 

amortization. Question 51: The agencies 

seek comment on the appropriateness of 

these additional exemptions in the U.S. 

markets for revolving securitizations. 

Under the proposed rule, the 

investors’ interest with respect to a 

revolving securitization captures both 

the drawn balances and undrawn lines 

of the underlying exposures that are 

allocated to the investors in the 

securitization. The EAD associated with 

the investors’ interest is equal to the 

EAD of the underlying exposures 

multiplied by the ratio of the total 

amount of securitization exposures 

issued by the SPE to investors; divided 

by the outstanding principal amount of 

underlying exposures. 


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55894 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

In general, the applicable CF would 

depend on whether the early 

amortization provision repays investors 

through a ‘‘controlled’’ or ‘‘noncontrolled’’ mechanism and whether the 

underlying exposures are revolving 

retail credit facilities that are 

uncommitted—that is, unconditionally 

cancelable by the bank to the fullest 

extent of Federal law (for example, 

credit card receivables)—or are other 

revolving credit facilities (for example, 

revolving corporate credit facilities). 

Under the proposed rule, a ‘‘controlled’’

early amortization provision meets each 

of the following conditions: 

(i) The originating bank has 

appropriate policies and procedures to 

ensure that it has sufficient capital and 

liquidity available in the event of an 

early amortization; 

(ii) Throughout the duration of the 

securitization (including the early 

amortization period) there is the same 

pro rata sharing of interest, principal, 

expenses, losses, fees, recoveries, and 

other cash flows from the underlying 

exposures, based on the originating 

bank’s and the investors’ relative shares 

of the underlying exposures outstanding 

measured on a consistent monthly basis; 

(iii) The amortization period is 

sufficient for at least 90 percent of the 

total underlying exposures outstanding 

at the beginning of the early 

amortization period to have been repaid 

or recognized as in default; and 

(iv) The schedule for repayment of 

investor principal is not more rapid 

than would be allowed by straight-line 

amortization over an 18-month period. 

An early amortization provision that 

does not meet any of the above criteria 

is a ‘‘non-controlled’’ early amortization 

provision. Question 52: The agencies 

solicit comment on the distinction 

between controlled and non-controlled 

early amortization provisions and on 

the extent to which banks use controlled 

early amortization provisions. The 

agencies also invite comment on the 

proposed definition of a controlled early 

amortization provision, including in 

particular the 18-month period set forth 

above. 

Controlled early amortization. To 

calculate the appropriate CF for a 

securitization of uncommitted revolving 

retail exposures that contains a 

controlled early amortization provision, 

a bank must compare the three-month 

average excess spread for the 

securitization to the point at which the 

bank is required to trap excess spread 

under the securitization transaction. In 

securitizations that do not require 

excess spread to be trapped, or that 

specify a trapping point based primarily 

on performance measures other than the 

three-month average excess spread, the 

excess spread trapping point is 4.5 

percent. The bank must divide the 

three-month average excess spread level 

by the excess spread trapping point and 

apply the appropriate CF from Table I. 

Question 53: The agencies seek 

comment on the appropriateness of the 

4.5 percent excess spread trapping point 

and on other types and levels of early 

amortization triggers used in 

securitizations of revolving retail 

exposures that should be considered by 

the agencies. 

TABLE I.—CONTROLLED EARLY AMORTIZATION PROVISIONS

Uncommitted Committed 

Retail Credit Lines ....................................... 3-month average excess spread Conversion Factor (CF) .............................................. 90% CF. 

133.33% of trapping point or more 

0% CF.

less than 133.33% to 100% of trapping point 

1% CF.

less than 100% to 75% of trapping point 

2% CF.

less than 75% to 50% of trapping point 

10% CF.

less than 50% to 25% of trapping point 

20% CF.

less than 25% of trapping point 

40% CF.

Non-retail Credit Lines ................................ 90% CF ............................................................................................................................ 90% CF. 

A bank must apply a 90 percent CF 

for all other revolving underlying 

exposures (that is, committed exposures 

and non-retail exposures) in 

securitizations containing a controlled 

early amortization provision. The CFs 

for uncommitted revolving retail credit 

lines are much lower than for 

committed retail credit lines or for nonretail credit lines because of the 

demonstrated ability of banks to 

monitor and, when appropriate, to 

curtail promptly uncommitted retail 

credit lines for customers of 

deteriorating credit quality. Such 

account management tools are 

unavailable for committed lines, and 

banks may be less proactive about using 

such tools in the case of uncommitted 

non-retail credit lines owing to lender 

liability concerns and the prominence of 

broad-based, longer-term customer 

relationships. 

Question 54: The agencies seek 

comment on and supporting empirical 

analysis of the appropriateness of a 

more simple alternative approach that 

would impose at all times a flat CF on 

the entire investors’ interest of a 

revolving securitization with a 

controlled early amortization provision, 

and on what an appropriate level of 

such a CF would be (for example, 10 or 

20 percent). 

Noncontrolled early amortization. To 

calculate the appropriate CF for 

securitizations of uncommitted 

revolving retail exposures that contain a 

noncontrolled early amortization 

provision, a bank must perform the 

excess spread calculations described in 

the controlled early amortization section 

above and then apply the CFs in Table 

J. 

TABLE J.—NON-CONTROLLED EARLY AMORTIZATION PROVISIONS

Uncommitted Committed 

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


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Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55895 

80The 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. 

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

Uncommitted Committed 

133.33% of trapping point or more 

0% CF.

less than 133.33% to 100% of trapping point 

5% CF.

less than 100% to 75% of trapping point 

15% CF.

less than 75% to 50% of trapping point 

50% CF.

less than 50% of trapping point 

100% CF.

Non-retail Credit Lines ................................ 100% CF .......................................................................................................................... 100% CF. 

A bank must use a 100 percent CF for 

all other revolving underlying exposures 

(that is, committed exposures and 

nonretail exposures) in securitizations 

containing a noncontrolled early 

amortization provision. In other words, 

no risk transference would be 

recognized for these transactions; an 

originating bank’s IRB capital 

requirement would be the same as if the 

underlying exposures had not been 

securitized. 

In circumstances where a 

securitization contains a mix of retail 

and nonretail exposures or a mix of 

committed and uncommitted exposures, 

a bank may take a pro rata approach to 

determining the risk-based capital 

requirement for the securitization’s 

early amortization provision. If a pro 

rata approach is not feasible, a bank 

must treat the securitization as a 

securitization of nonretail exposures if a 

single underlying exposure is a 

nonretail exposure and must treat the 

securitization as a securitization of 

committed exposures if a single 

underlying exposure is a committed 

exposure. 

F. Equity Exposures 

1. Introduction and Exposure 

Measurement 

This section describes the proposed 

rule’s risk-based capital treatment for 

equity exposures. Under the proposed 

rule, a bank would have the option to 

use either a simple risk-weight approach 

(SRWA) or an internal models approach 

(IMA) for equity exposures that are not 

exposures to an investment fund. A 

bank would use a look-through 

approach for equity exposures to an 

investment fund. Under the SRWA, a 

bank would generally assign a 300 

percent risk weight to publicly traded 

equity exposures and a 400 percent risk 

weight to non-publicly traded equity 

exposures. Certain equity exposures to 

sovereigns, multilateral institutions, and 

public sector enterprises would have a 

risk weight of 0 percent, 20 percent, or 

100 percent; and certain community 

development equity exposures, hedged 

equity exposures, and, up to certain 

limits, non-significant equity exposures 

would receive a 100 percent risk weight. 

Alternatively, a bank that meets 

certain minimum quantitative and 

qualitative requirements on an ongoing 

basis and obtains the prior written 

approval of its primary Federal 

supervisor could use the IMA to 

determine its risk-based capital 

requirement for all modeled equity 

exposures. A bank that qualifies to use 

the IMA may apply the IMA to its 

publicly traded and non-publicly traded 

equity exposures, or may choose to 

apply the IMA only to its publicly 

traded equity exposures. However, if the 

bank applies the IMA to its publicly 

traded equity exposures, it must apply 

the IMA to all such exposures. 

Similarly, if a bank applies the IMA to 

both publicly traded and non-publicly 

traded equity exposures, it must apply 

the IMA to all such exposures. If a bank 

does not qualify to use the IMA, or 

elects not to use the IMA, to compute 

its risk-based capital requirements for 

equity exposures, the bank must apply 

the SRWA to assign risk weights to its 

equity exposures. 

The proposed rule defines a publicly 

traded equity exposure as an equity 

exposure traded on (i) any exchange 

registered with the SEC as a national 

securities exchange under section 6 of 

the Securities Exchange Act of 1934 (15 

U.S.C. 78f) or (ii) any non-U.S.-based 

securities exchange that is registered 

with, or approved by, a national 

securities regulatory authority, provided 

that there is a liquid, two-way market 

for the exposure (that is, there are 

enough bona fide offers to buy and sell 

so that a sales price reasonably related 

to the last sales price or current bona 

fide competitive bid and offer 

quotations can be determined promptly 

and a trade can be settled at such a price 

within five business days). Question 55: 

The agencies seek comment on this 

definition. 

A bank using either the IMA or the 

SRWA must determine the adjusted 

carrying value for each equity exposure. 

The proposed rule defines the adjusted 

carrying value of an equity exposure as: 

(i) For the on-balance sheet 

component of an equity exposure, the 

bank’s carrying value of the exposure 

reduced by any unrealized gains on the 

exposure that are reflected in such 

carrying value but excluded from the 

bank’s tier 1 and tier 2 capital; 80 and 

(ii) For the off-balance sheet 

component of an equity exposure, the 

effective notional principal amount of 

the exposure, the size of which is 

equivalent to a hypothetical on-balance 

sheet position in the underlying equity 

instrument that would evidence the 

same change in fair value (measured in 

dollars) for a given small change in the 

price of the underlying equity 

instrument, minus the adjusted carrying 

value of the on-balance sheet 

component of the exposure as 

calculated in (i). 

The agencies created the definition of 

the effective notional principal amount 

of the off-balance sheet portion of an 

equity exposure to provide a uniform 

method for banks to measure the onbalance sheet equivalent of an offbalance 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 


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55896 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

references. The adjusted carrying value 

of the off-balance sheet component of 

the derivative is the current value of 150 

shares of common stock of company X 

minus the adjusted carrying value of 

any on-balance sheet amount associated 

with the derivative. Question 56: The 

agencies seek comment on the approach 

to adjusted carrying value for the offbalance sheet component of equity 

exposures and on alternative 

approaches that may better capture the 

market risk of such exposures. 

Hedge transactions. For purposes of 

determining risk-weighted assets under 

both the SRWA and the IMA, a bank 

may identify hedge pairs, which the 

proposed rule defines as two equity 

exposures that form an effective hedge 

so long as each equity exposure is 

publicly traded or has a return that is 

primarily based on a publicly traded 

equity exposure. A bank may risk 

weight only the effective and ineffective 

portions of a hedge pair rather than the 

entire adjusted carrying value of each 

exposure that makes up the pair. Two 

equity exposures form an effective 

hedge if the exposures either have the 

same remaining maturity or each has a 

remaining maturity of at least three 

months; the hedge relationship is 

formally documented in a prospective 

manner (that is, before the bank acquires 

at least one of the equity exposures); the 

documentation specifies the measure of 

effectiveness (E) the bank will use for 

the hedge relationship throughout the 

life of the transaction; and the hedge 

relationship has an E greater than or 

equal to 0.8. A bank must measure E at 

least quarterly and must use one of three 

alternative measures of E—the dollaroffset method, the variability-reduction 

method, or the regression method. 

It is possible that only part of a bank’s 

exposure to a particular equity 

instrument would be part of a hedge 

pair. For example, assume a bank has an 

equity exposure A with a $300 adjusted 

carrying value and chooses to hedge a 

portion of that exposure with an equity 

exposure B with an adjusted carrying 

value of $100. Also assume that the 

combination of equity exposure B and 

$100 of the adjusted carrying value of 

equity exposure A form an effective 

hedge with an E of 0.8. In this situation 

the bank would treat $100 of equity 

exposure A and $100 of equity exposure 

B as a hedge pair, and the remaining 

$200 of its equity exposure A as a 

separate, stand-alone position. 

The effective portion of a hedge pair 

is E multiplied by the greater of the 

adjusted carrying values of the equity 

exposures forming a hedge pair, 

whereas the ineffective portion is (1–E) 

multiplied by the greater of the adjusted 

carrying values of the equity exposures 

forming a hedge pair. In the above 

example, the effective portion of the 

hedge pair would be 0.8 × $100 = $80 

and the ineffective portion of the hedge 

pair would be (1 ¥ 0.8) × $100 = $20. 

Measures of hedge effectiveness. 

Under the dollar-offset method of 

measuring effectiveness, the bank must 

determine the ratio of the cumulative 

sum of the periodic changes in the value 

of one equity exposure to the 

cumulative sum of the periodic changes 

in the value of the other equity 

exposure, termed the ratio of value 

change (RVC). If the changes in the 

values of the two exposures perfectly 

offset each other, the RVC will be ¥1. 

If RVC is positive, implying that the 

values of the two equity exposures 

moved in the same direction, the hedge 

is not effective and E = 0. If RVC is 

negative and greater than or equal to ¥1 

(that is, between zero and ¥1), then E 

equals the absolute value of RVC. If RVC 

is negative and less than ¥1, then E 

equals 2 plus RVC. 

The variability-reduction method of 

measuring effectiveness compares 

changes in the value of the combined 

position of the two equity exposures in 

the hedge pair (labeled X) to changes in 

the value of one exposure as though that 

one exposure were not hedged (labeled 

A). This measure of E expresses the 

time-series variability in X as a 

proportion of the variability of A. As the 

variability described by the numerator 

becomes small relative to the variability 

described by the denominator, the 

measure of effectiveness improves, but 

is bounded from above by a value of 1. 

E can be computed as: 

E

X X

A A

t t

t

T

t t

t

T = −

( ) −

( ) −

−

=

−

=

∑

∑

1

1

2

1

1

2

1

, where

Xt = At ¥ Bt

A = the value at time t of the one 

exposure in a hedge pair, and 

Bt = the value at time t of the other 

exposure in a hedge pair. 

The value of t will range from zero to 

T, where T is the length of the 

observation period for the values of A 

and B, and is comprised of shorter 

values each labeled t. 

The regression method of measuring 

effectiveness is based on a regression in 

which the change in value of one 

exposure in a hedge pair is the 

dependent variable and the change in 

value of the other exposure in a hedge 

pair is the independent variable. E 

equals the coefficient of determination 

of this regression, which is the 

proportion of the variation in the 

dependent variable explained by 

variation in the independent variable. 

The closer the relationship between the 

values of the two exposures, the higher 

E will be. 

2. Simple Risk-Weight Approach 

(SRWA) 

Under the SRWA in section 52 of the 

proposed rule, a bank would determine 

the risk-weighted asset amount for each 

equity exposure, other than an equity 

exposure to an investment fund, by 

multiplying the adjusted carrying value 

of the equity exposure, or the effective 

portion and ineffective portion of a 

hedge pair as described below, by the 

lowest applicable risk weight in Table 

K. A bank would determine the riskweighted asset amount for an equity 

exposure to an investment fund as set 

forth below (and in section 54 of the 

proposed rule). Use of the SRWA would 

be most appropriate when a bank’s 

equity holdings are principally 

composed of non-traded instruments. 

If a bank exclusively uses the SRWA 

for its equity exposures, the bank’s 

aggregate risk-weighted asset amount for 

its equity exposures (other than equity 

exposures to investment funds) would 

be equal to the sum of the risk-weighted 

asset amounts for each of the bank’s 

individual equity exposures. 

TABLE K 

Risk weight Equity exposure 

0 Percent ................ An equity exposure to an entity whose credit exposures are exempt from the 0.03 percent PD floor. 

20 Percent .............. An equity exposure to a Federal Home Loan Bank or Farmer Mac if the equity exposure is not publicly traded and is held 

as a condition of membership in that entity. 

100 .......................... • Community development equity exposures 81

• Equity exposures to a Federal Home Loan Bank or Farmer Mac not subject to a 20 percent risk weight. 


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81The proposed rule generally defines these 

exposures as exposures that would qualify as 

community development investments under 12 

U.S.C. 24(Eleventh), excluding equity exposures to 

an unconsolidated small business investment 

company and equity exposures held through a 

consolidated small business investment company 

described in section 302 of the Small Business 

Investment Act of 1958 (15 U.S.C. 682). For savings 

associations, community development investments 

would be defined to mean equity investments that 

are designed primarily to promote community 

welfare, including the welfare of low- and 

moderate-income communities or families, such as 

by providing services or jobs, and excluding equity 

exposures to an unconsolidated small business 

investment company and equity exposures held 

through a consolidated small business investment 

company described in section 302 of the Small 

Business Investment Act of 1958 (15 U.S.C. 682). 

TABLE K—Continued 

Risk weight Equity exposure 

• The effective portion of a hedge pair. 

• Non-significant equity exposures to the extent less than 10 percent of tier 1 plus tier 2 capital. 

300 Percent ............ A publicly traded equity exposure (including the ineffective portion of a hedge pair). 

400 Percent ............ An equity exposure that is not publicly traded. 

Non-significant equity exposures. A 

bank may apply a 100 percent risk 

weight to non-significant equity 

exposures, which the proposed rule 

defines as equity exposures to the extent 

that the aggregate adjusted carrying 

value of the exposures does not exceed 

10 percent of the bank’s tier 1 capital 

plus tier 2 capital. To compute the 

aggregate adjusted carrying value of a 

bank’s equity exposures for determining 

non-significance, the bank may exclude 

(i) equity exposures that receive less 

than a 300 percent risk weight under the 

SRWA (other than equity exposures 

determined to be non-significant), (ii) 

the equity exposure in a hedge pair with 

the smaller adjusted carrying value, and 

(iii) a proportion of each equity 

exposure to an investment fund equal to 

the proportion of the assets of the 

investment fund that are not equity 

exposures. If a bank does not know the 

actual holdings of the investment fund, 

the bank may calculate the proportion of 

the assets of the fund that are not equity 

exposures based on the terms of the 

prospectus, partnership agreement, or 

similar contract that defines the fund’s 

permissible investments. If the sum of 

the investment limits for all exposure 

classes81 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 nonsignificance, a bank must first include 

equity exposures to unconsolidated 

small business investment companies or 

held through consolidated small 

business investment companies 

described in section 302 of the Small 

Business Investment Act of 1958 (15 

U.S.C. 682) and then must include 

publicly traded equity exposures 

(including those held indirectly through 

investment funds) and then must 

include non-publicly traded equity 

exposures (including those held 

indirectly through investment funds). 

3. Internal Models Approach (IMA) 

The IMA is designed to provide banks 

with a more sophisticated and risksensitive mechanism for calculating 

risk-based capital requirements for 

equity exposures. To qualify to use the 

IMA, a bank must receive prior written 

approval from its primary Federal 

supervisor. To receive such approval, 

the bank must demonstrate to its 

primary Federal supervisor’s 

satisfaction that the bank meets the 

following quantitative and qualitative 

criteria. 

IMA qualification. First, the bank 

must have a model that (i) assesses the 

potential decline in value of its modeled 

equity exposures; (ii) is commensurate 

with the size, complexity, and 

composition of the bank’s modeled 

equity exposures; and (iii) adequately 

captures both general market risk and 

idiosyncratic risks. Second, the bank’s 

model must produce an estimate of 

potential losses for its modeled equity 

exposures that is no less than the 

estimate of potential losses produced by 

a VaR methodology employing a 99.0 

percent one-tailed confidence interval of 

the distribution of quarterly returns for 

a benchmark portfolio of equity 

exposures comparable to the bank’s 

modeled equity exposures using a longterm sample period. 

In addition, the number of risk factors 

and exposures in the sample and the 

data period used for quantification in 

the bank’s model and benchmarking 

exercise must be sufficient to provide 

confidence in the accuracy and 

robustness of the bank’s estimates. The 

bank’s model and benchmarking 

exercise also must incorporate data that 

are relevant in representing the risk 

profile of the bank’s modeled equity 

exposures, and must include data from 

at least one equity market cycle 

containing adverse market movements 

relevant to the risk profile of the bank’s 

modeled equity exposures. If the bank’s 

model uses a scenario methodology, the 

bank must demonstrate that the model 

produces a conservative estimate of 

potential losses on the bank’s modeled 

equity exposures over a relevant longterm market cycle. If the bank employs 

risk factor models, the bank must 

demonstrate through empirical analysis 

the appropriateness of the risk factors 

used. 

The agencies also would require that 

daily market prices be available for all 

modeled equity exposures, either direct 

holdings or proxies. Finally, the bank 

must be able to demonstrate, using 

theoretical arguments and empirical 

evidence, that any proxies used in the 

modeling process are comparable to the 

bank’s modeled equity exposures and 

that the bank has made appropriate 

adjustments for differences. The bank 

must derive any proxies for its modeled 

equity exposures or benchmark portfolio 

using historical market data that are 

relevant to the bank’s modeled equity 

exposures or benchmark portfolio (or, 

where not, must use appropriately 

adjusted data), and such proxies must 

be robust estimates of the risk of the 

bank’s modeled equity exposures. 

In evaluating a bank’s internal model 

for equity exposures, the bank’s primary 

Federal supervisor would consider, 

among other factors, (i) the nature of the 

bank’s equity exposures, including the 

number and types of equity exposures 

(for example, publicly traded, nonpublicly traded, long, short); (ii) the risk 

characteristics and makeup of the bank’s 

equity exposures, including the extent 

to which publicly available price 

information is obtainable on the 

exposures; and (iii) the level and degree 

of concentration of, and correlations 

among, the bank’s equity exposures. 

Banks with equity portfolios containing 

equity exposures with values that are 

highly nonlinear in nature (for example, 

equity derivatives or convertibles) 

would have to employ an internal 

model designed to appropriately capture 

the risks associated with these 

instruments. 

The agencies do not intend to dictate 

the form or operational details of a 

bank’s internal model for equity 


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55898 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

exposures. Accordingly, the agencies 

would not prescribe any particular type 

of model for determining risk-based 

capital requirements. Although the 

proposed rule requires a bank that uses 

the IMA to ensure that its internal 

model produces an estimate of potential 

losses for its modeled equity exposures 

that is no less than the estimate of 

potential losses produced by a VaR 

methodology employing a 99.0 percent 

one-tailed confidence interval of the 

distribution of quarterly returns for a 

benchmark portfolio of equity 

exposures, the proposed rule does not 

require a bank to use a VaR-based 

model. The agencies recognize that the 

type and sophistication of internal 

models will vary across banks due to 

differences in the nature, scope, and 

complexity of business lines in general 

and equity exposures in particular. The 

agencies recognize that some banks 

employ models for internal risk 

management and capital allocation 

purposes that can be more relevant to 

the bank’s equity exposures than some 

VaR models. For example, some banks 

employ rigorous historical scenario 

analysis and other techniques for 

assessing the risk of their equity 

portfolios. 

Banks that choose to use a VaR-based 

internal model under the IMA should 

use a historical observation period that 

includes a sufficient amount of data 

points to ensure statistically reliable and 

robust loss estimates relevant to the 

long-term risk profile of the bank’s 

specific holdings. The data used to 

represent return distributions should 

reflect the longest sample period for 

which data are available and should 

meaningfully represent the risk profile 

of the bank’s specific equity holdings. 

The data sample should be long-term in 

nature and, at a minimum, should 

encompass at least one complete equity 

market cycle containing adverse market 

movements relevant to the risk profile of 

the bank’s modeled exposures. The data 

used should be sufficient to provide 

conservative, statistically reliable, and 

robust loss estimates that are not based 

purely on subjective or judgmental 

considerations. 

The parameters and assumptions used 

in a VaR model must be subject to a 

rigorous and comprehensive regime of 

stress-testing. Banks utilizing VaR 

models must subject their internal 

model and estimation procedures, 

including volatility computations, to 

either hypothetical or historical 

scenarios that reflect worst-case losses 

given underlying positions in both 

publicly traded and non-publicly traded 

equities. At a minimum, banks that use 

a VaR model must employ stress tests to 

provide information about the effect of 

tail events beyond the level of 

confidence assumed in the IMA. 

Banks using non-VaR internal models 

that are based on stress tests or scenario 

analyses would have to estimate losses 

under worst-case modeled scenarios. 

These scenarios would have to reflect 

the composition of the bank’s equity 

portfolio and should produce risk-based 

capital requirements at least as large as 

those that would be required to be held 

against a representative market index or 

other relevant benchmark portfolio 

under a VaR approach. For example, for 

a portfolio consisting primarily of 

publicly held equity securities that are 

actively traded, risk-based capital 

requirements produced using historical 

scenario analyses should be greater than 

or equal to risk-based capital 

requirements produced by a baseline 

VaR approach for a major index or subindex that is representative of the bank’s 

holdings. Similarly, non-publicly traded 

equity exposures may be benchmarked 

against a representative portfolio of 

publicly traded equity exposures. 

The loss estimate derived from the 

bank’s internal model would constitute 

the regulatory capital requirement for 

the modeled equity exposures. The 

equity capital requirement would be 

incorporated into a bank’s risk-based 

capital ratio through the calculation of 

risk-weighted equivalent assets. To 

convert the equity capital requirement 

into risk-weighted equivalent assets, a 

bank would multiply the capital 

requirement by 12.5. 

Question 57: The agencies seek 

comment on the proposed rule’s 

requirements for IMA qualification, 

including in particular the proposed 

rule’s use of a 99.0 percent, quarterly 

returns standard. 

Risk-weighted assets under the IMA. 

As noted above, a bank may apply the 

IMA only to its publicly traded equity 

exposures or may apply the IMA to its 

publicly traded and non-publicly traded 

equity exposures. In either case, a bank 

is not allowed to apply the IMA to 

equity exposures that receive a 0 or 20 

percent risk weight under Table 9, 

community development equity 

exposures, equity exposures to a Federal 

Home Loan Bank or Farmer Mac that 

receive a 100 percent risk weight, and 

equity exposures to investment funds 

(collectively, excluded equity 

exposures). 

If a bank applies the IMA to both 

publicly traded and non-publicly traded 

equity exposures, the bank’s aggregate 

risk-weighted asset amount for its equity 

exposures would be equal to the sum of 

the risk-weighted asset amount of each 

excluded equity exposure (calculated 

outside of the IMA section of the 

proposed rule) and the risk-weighted 

asset amount of the non-excluded equity 

exposures (calculated under the IMA 

section of the proposed rule). The riskweighted asset amount of the nonexcluded equity exposures is generally 

set equal to the estimate of potential 

losses on the bank’s non-excluded 

equity exposures generated by the 

bank’s internal model multiplied by 

12.5. To ensure that a bank holds a 

minimum amount of risk-based capital 

against its modeled equity exposures, 

however, the proposed rule contains a 

supervisory floor on the risk-weighted 

asset amount of the non-excluded equity 

exposures. As a result of this floor, the 

risk-weighted asset amount of the nonexcluded 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 nonexcluded non-publicly traded equity 

exposures. 

If, on the other hand, a bank applies 

the IMA only to its publicly traded 

equity exposures, the bank’s aggregate 

risk-weighted asset amount for its equity 

exposures would be equal to the sum of 

(i) the risk-weighted asset amount of 

each excluded equity exposure 

(calculated outside of the IMA section of 

the proposed rule); (ii) 400 percent 

multiplied by the aggregate adjusted 

carrying value of the bank’s nonexcluded non-publicly traded equity 

exposures; and (iii) the aggregate riskweighted asset amount of its nonexcluded publicly traded equity 

exposures. The risk-weighted asset 

amount of the non-excluded publicly 

traded equity exposures would be equal 

to the estimate of potential losses on the 

bank’s non-excluded publicly traded 

equity exposures generated by the 

bank’s internal model multiplied by 

12.5. The risk-weighted asset amount for 

the non-excluded publicly traded equity 

exposures would be subject to a floor of 

200 percent multiplied by the aggregate 

adjusted carrying value or ineffective 

portion of hedge pairs, as appropriate, of 

the bank’s non-excluded publicly traded 

equity exposures. Question 58: The 

agencies seek comment on the 

operational aspects of these floor 

calculations. 

4. Equity Exposures to Investment 

Funds 

A bank must determine the riskweighted asset amount for equity 

exposures to investment funds using 


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one of three approaches: the Full LookThrough Approach, the Simple 

Modified Look-Through Approach, or 

the Alternative Modified Look-Through 

Approach, unless the equity exposure to 

an investment fund is a community 

development equity exposure. Such 

equity exposures would be subject to a 

100 percent risk weight. If an equity 

exposure to an investment fund is part 

of a hedge pair, a bank may use the 

ineffective portion of a hedge pair as the 

adjusted carrying value for the equity 

exposure to the investment fund. A 

bank may choose to apply a different 

approach to different equity exposures 

to investment funds; the proposed rule 

does not require a bank to apply the 

same approach to all of its equity 

exposures to investment funds. 

The proposed rule defines an 

investment fund as a company all or 

substantially all of the assets of which 

are financial assets and which has no 

material liabilities. The agencies have 

proposed a separate treatment for equity 

exposures to an investment fund to 

prevent banks from arbitraging the 

proposed rule’s high risk-based capital 

requirements for certain high-risk 

exposures and to ensure that banks do 

not receive a punitive risk-based capital 

requirement for equity exposures to 

investment funds that hold only lowrisk assets. Question 59: The agencies 

seek comment on the necessity and 

appropriateness of the separate 

treatment for equity exposures to 

investment funds and the three 

approaches in the proposed rule. The 

agencies also seek comment on the 

proposed definition of an investment 

fund. 

Each of the approaches to equity 

exposures to investment funds imposes 

a 7 percent minimum risk weight on 

equity exposures to investment funds. 

This minimum risk weight is similar to 

the minimum 7 percent risk weight 

under the RBA for securitization 

exposures and the effective 56 basis 

point minimum risk-based capital 

requirement per dollar of securitization 

exposure under the SFA. The agencies 

believe that this minimum prudential 

capital requirement is appropriate for 

exposures not directly held by the bank. 

Full look-through approach. A bank 

may use the full look-through approach 

only if the bank is able to compute a 

risk-weighted asset amount for each of 

the exposures held by the investment 

fund (calculated under the proposed 

rule as if the exposures were held 

directly by the bank). Under this 

approach, a bank would set the riskweighted asset amount of the bank’s 

equity exposure to the investment fund 

equal to the greater of (i) the product of 

(A) the aggregate risk-weighted asset 

amounts of the exposures held by the 

fund as if they were held directly by the 

bank and (B) the bank’s proportional 

ownership share of the fund; and (ii) 7 

percent of the adjusted carrying value of 

the bank’s equity exposure to the 

investment fund. 

Simple modified look-through 

approach. Under this approach, a bank 

may set the risk-weighted asset amount 

for its equity exposure to an investment 

fund equal to the adjusted carrying 

value of the equity exposure multiplied 

by the highest risk weight in Table L 

that applies to any exposure the fund is 

permitted to hold under its prospectus, 

partnership agreement, or similar 

contract that defines the fund’s 

permissible investments. The bank may 

exclude derivative contracts that are 

used for hedging, not speculative 

purposes, and do not constitute a 

material portion of the fund’s exposures. 

A bank may not assign an equity 

exposure to an investment fund to an 

aggregate risk weight of less than 7 

percent under this approach. 

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

Risk weight Exposure class 

0 percent ................. Sovereign exposures with a long-term external rating in the highest investment grade rating category and sovereign exposures of the United States. 

20 percent ............... Exposures with a long-term external rating in the highest or second-highest investment grade rating category; exposures 

with a short-term external rating in the highest investment grade rating category; and exposures to, or guaranteed by, 

depository institutions, foreign banks (as defined in 12 CFR 211.2), or securities firms subject to consolidated supervision or regulation comparable to that imposed on U.S. securities broker-dealers that are repo-style transactions or 

bankers’ acceptances. 

50 percent ............... Exposures with a long-term external rating in the third- highest investment grade rating category or a short-term external 

rating in the second-highest investment grade rating category. 

100 percent ............. Exposures with a long-term or short-term external rating in percent the lowest investment grade rating category. 

200 percent ............. Exposures with a long-term external rating one rating category percent below investment grade. 

300 percent ............. Publicly traded equity exposures. 

400 percent ............. Non-publicly traded equity exposures; exposures with a long-percent term external rating two or more rating categories 

below investment grade; and unrated exposures (excluding publicly traded equity exposures). 

1,250 percent .......... OTC derivative contracts and exposures that must be deducted percent from regulatory capital or receive a risk weight 

greater than 400 percent under this appendix. 

Alternative modified look-through 

approach. Under this approach, a bank 

may assign the adjusted carrying value 

of an equity exposure to an investment 

fund on a pro rata basis to different riskweight categories in Table L according 

to the investment limits in the fund’s 

prospectus, partnership agreement, or 

similar contract that defines the fund’s 

permissible investments. If the sum of 

the investment limits for all exposure 

classes within the fund exceeds 100 

percent, the bank must assume that the 

fund invests to the maximum extent 

permitted under its investment limits in 

the exposure class with the highest risk 

weight under Table L, and continues to 

make investments in the order of the 

exposure class with the next highest 

risk-weight under Table L until the 

maximum total investment level is 

reached. If more than one exposure class 

applies to an exposure, the bank must 

use the highest applicable risk weight. 

A bank may exclude derivative 

contracts held by the fund that are used 

for hedging, not speculative, purposes 

and do not constitute a material portion 

of the fund’s exposures. The overall risk 

weight assigned to an equity exposure to 

an investment fund under this approach 

may not be less than 7 percent. 

VI. Operational Risk 

This section describes features of the 

AMA framework for determining the 

risk-based capital requirement for 

operational risk. The proposed 

framework remains fundamentally 

similar to that described in the ANPR. 

Under this framework, a bank meeting 

the AMA qualifying criteria would use 


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its internal operational risk 

quantification system to calculate its 

risk-based capital requirement for 

operational risk. 

Currently, the agencies’ general riskbased capital rules do not include an 

explicit capital charge for operational 

risk. Rather, the existing risk-based 

capital rules were designed to cover all 

risks, and therefore implicitly cover 

operational risk. With the introduction 

of the IRB framework for credit risk in 

this NPR, which would result in a more 

risk-sensitive treatment of credit risk, 

there no longer would be an implicit 

capital buffer for other risks. 

The agencies recognize that 

operational risk is a key risk in banks, 

and evidence indicates that a number of 

factors are driving increases in 

operational risk. These factors include 

greater use of automated technology, 

proliferation of new and highly complex 

products, growth of e-banking 

transactions and related business 

applications, large-scale acquisitions, 

mergers, and consolidations, and greater 

use of outsourcing arrangements. 

Furthermore, the recent experience of a 

number of high-profile, high-severity 

losses across the banking industry, 

including those resulting from legal 

settlements, highlight operational risk as 

a major source of unexpected losses. 

Because the implicit regulatory capital 

buffer for operational risk would be 

removed under the proposed rule, the 

agencies propose to require banks using 

the IRB framework for credit risk to use 

the AMA to address operational risk 

when computing a capital charge for 

regulatory capital purposes. 

As defined previously, operational 

risk exposure is the 99.9th percentile of 

the distribution of potential aggregate 

operational losses as generated by the 

bank’s operational risk quantification 

system over a one-year horizon. EOL is 

the expected value of the same 

distribution of potential aggregate 

operational losses. The ANPR specified 

that a bank’s risk-based capital 

requirement for operational risk would 

be the sum of EOL and UOL unless the 

bank could demonstrate that an EOL 

offset would meet supervisory 

standards. The agencies described two 

approaches—reserving and budgeting—

that might allow for some offset of EOL; 

however, the agencies expressed some 

reservation about both approaches. The 

agencies believed that reserves 

established for expected operational 

losses would likely not meet U.S. 

accounting standards and that budgeted 

funds might not be sufficiently capitallike to cover EOL. 

While the proposed framework 

remains fundamentally similar to that 

described in the ANPR and a bank 

would continue to be allowed to 

recognize (i) certain offsets for EOL, and 

(ii) the effect of risk mitigants such as 

insurance in calculating its regulatory 

capital requirement for operational risk, 

the agencies have clarified certain 

aspects of the proposed framework. In 

particular, the agencies have re-assessed 

the ability of banks to take prudent steps 

to offset EOL through internal business 

practices. 

After further analysis and discussions 

with the industry, the agencies believe 

that certain reserves and other internal 

business practices could qualify as an 

EOL offset. Under the proposed rule, a 

bank’s risk-based capital requirement 

for operational risk may be based on 

UOL alone if the bank can demonstrate 

it has offset EOL with eligible 

operational risk offsets, which are 

defined as amounts (i) generated by 

internal business practices to absorb 

highly predictable and reasonably stable 

operational losses, including reserves 

calculated in a manner consistent with 

GAAP; and (ii) available to cover EOL 

with a high degree of certainty over a 

one-year horizon. Eligible operational 

risk offsets may only be used to offset 

EOL, not UOL. 

In determining whether to accept a 

proposed EOL offset, the agencies will 

consider whether the proposed offset 

would be available to cover EOL with a 

high degree of certainty over a one-year 

horizon. Supervisory recognition of EOL 

offsets will be limited to those business 

lines and event types with highly 

predictable, routine losses. Based on 

discussions with the industry and 

empirical data, highly predictable and 

routine losses appear to be limited to 

those relating to securities processing 

and to credit card fraud. Question 60: 

The agencies are interested in 

commenters’ views on other business 

lines or event types in which highly 

predictable, routine losses have been 

observed. 

In determining its operational risk 

exposure, the bank could also take into 

account the effects of risk mitigants 

such as insurance, subject to approval 

from its primary Federal supervisor. In 

order to recognize the effects of risk 

mitigants such as insurance for riskbased capital purposes, the bank must 

estimate its operational risk exposure 

with and without such effects. The 

reduction in a bank’s risk-based capital 

requirement for operational risk due to 

risk mitigants may not exceed 20 

percent of the bank’s risk-based capital 

requirement for operational risk, after 

approved adjustments for EOL offsets. A 

bank must demonstrate that a risk 

mitigant is able to absorb losses with 

sufficient certainty to warrant inclusion 

in the adjustment to the operational risk 

exposure. For a risk mitigant to meet 

this standard, it must be insurance that: 

(i) Is provided by an unaffiliated 

company that has a claims paying 

ability that is rated in one of the three 

highest rating categories by an NRSRO; 

(ii) Has an initial term of at least one 

year and a residual term of more than 

90 days; 

(iii) Has a minimum notice period for 

cancellation of 90 days; 

(iv) Has no exclusions or limitations 

based upon regulatory action or for the 

receiver or liquidator of a failed bank; 

and 

(v) Is explicitly mapped to an actual 

operational risk exposure of the bank. 

The bank’s methodology for 

recognizing risk mitigants must also 

capture, through appropriate discounts 

in the amount of risk mitigants, the 

residual term of the risk mitigant, where 

less than one year; the risk mitigant’s 

cancellation terms, where less than one 

year; the risk mitigant’s timeliness of 

payment; and the uncertainty of 

payment as well as mismatches in 

coverage between the risk mitigant and 

the hedged operational loss event. The 

bank may not recognize for regulatory 

capital purposes risk mitigants with a 

residual term of 90 days or less. 

Commenters on the ANPR raised 

concerns that limiting the risk 

mitigating benefits of insurance to 20 

percent of the bank’s regulatory capital 

requirement for operational risk 

represents an overly prescriptive and 

arbitrary value. Concerns were raised 

that such a cap would inhibit 

development of this important risk 

mitigation tool. Commenters believed 

that the full contract amount of 

insurance should be recognized as the 

risk mitigating value. The agencies, 

however, believe that the 20 percent 

limit continues to be a prudent limit. 

Currently, the primary risk mitigant 

available for operational risk is 

insurance. While certain securities 

products may be developed over time 

that could provide risk mitigation 

benefits, no specific products have 

emerged to-date that have 

characteristics sufficient to be 

considered a capital replacement for 

operational risk. However, as innovation 

in this field continues, a bank may be 

able to realize the benefits of risk 

mitigation through certain capital 

markets instruments with the approval 

of its primary Federal supervisor. 

If a bank does not qualify to use or 

does not have qualifying operational 

risk mitigants, the bank’s dollar riskbased capital requirement for 

operational risk would be its operational 


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82The bank regulatory reports and Thrift 

Financial Reports will be revised to collect some 

additional Basel II-related information, as described 

below in the regulatory reporting section. 

risk exposure minus eligible operational 

risk offsets (if any). If a bank qualifies 

to use operational risk mitigants and has 

qualifying operational risk mitigants, 

the bank’s dollar risk-based capital 

requirement for operational risk would 

be the greater of: (i) The bank’s 

operational risk exposure adjusted for 

qualifying operational risk mitigants 

minus eligible operational risk offsets (if 

any); and (ii) 0.8 multiplied by the 

difference between the bank’s 

operational risk exposure and its 

eligible operational risk offsets (if any). 

The dollar risk-based capital 

requirement for operational risk would 

be multiplied by 12.5 to convert it into 

an equivalent risk-weighted asset 

amount. The resulting amount would be 

added to the comparable amount for 

credit risk in calculating the 

institution’s risk-based capital 

denominator. 

VII. Disclosure 

1. Overview 

The agencies have long supported 

meaningful public disclosure by banks 

with the objective of improving market 

discipline. The agencies recognize the 

importance of market discipline in 

encouraging sound risk management 

practices and fostering financial 

stability. 

Pillar 3 of the New Accord, market 

discipline, complements the minimum 

capital requirements and the 

supervisory review process by 

encouraging market discipline through 

enhanced and meaningful public 

disclosure. These proposed public 

disclosure requirements are intended to 

allow market participants to assess key 

information about an institution’s risk 

profile and its associated level of 

capital. 

The agencies view public disclosure 

as an important complement to the 

advanced approaches to calculating 

minimum regulatory risk-based capital 

requirements, which will be heavily 

based on internal systems and 

methodologies. With enhanced 

transparency of the advanced 

approaches, investors can better 

evaluate a bank’s capital structure, risk 

exposures, and capital adequacy. With 

sufficient and relevant information, 

market participants can better evaluate 

a bank’s risk management performance, 

earnings potential and financial 

strength. 

Improvements in public disclosures 

come not only from regulatory 

standards, but also through efforts by 

bank management to improve 

communications to public shareholders 

and other market participants. In this 

regard, improvements to risk 

management processes and internal 

reporting systems provide opportunities 

to significantly improve public 

disclosures over time. Accordingly, the 

agencies strongly encourage the 

management of each bank to regularly 

review its public disclosures and 

enhance these disclosures, where 

appropriate, to clearly identify all 

significant risk exposures —whether onor off-balance sheet—and their effects 

on the bank’s financial condition and 

performance, cash flow, and earnings 

potential. 

Comments on ANPR. Some 

commenters to the ANPR indicated that 

the proposed disclosures were 

burdensome, excessive, and overly 

prescriptive. Other commenters 

believed that the information provided 

in the disclosures would not be 

comparable across banks because each 

bank will use distinct internal 

methodologies to generate the 

disclosures. These commenters also 

expressed concern that some disclosures 

could be misinterpreted or 

misunderstood by the public. 

The agencies believe, however, the 

required disclosures would enable 

market participants to gain key insights 

regarding a bank’s capital structure, risk 

exposures, risk assessment processes, 

and ultimately, the capital adequacy of 

the institution. Some of the proposed 

disclosure requirements will be new 

disclosures for banks. Nonetheless, the 

agencies believe that a significant 

amount of the proposed disclosure 

requirements are already required by or 

consistent with existing GAAP, SEC 

disclosure requirements, or regulatory 

reporting requirements for banks. 

2. General Requirements 

The public disclosure requirements 

would apply to the top-tier legal entity 

that is a core or opt-in bank within a 

consolidated banking group (that is, the 

top-tier BHC or DI that is a core or optin bank). In general, DIs that are a 

subsidiary of a BHC or another DI would 

not be subject to the disclosure 

requirements 82 except that every DI 

must disclose total and tier 1 capital 

ratios and their components, similar to 

current requirements. If a DI is not a 

subsidiary of a BHC or another DI that 

must make the full set of disclosures, 

the DI must make these disclosures. 

The risks to which a bank is exposed 

and the techniques that it uses to 

identify, measure, monitor, and control 

those risks are important factors that 

market participants consider in their 

assessment of the institution. 

Accordingly, each bank that is subject to 

the disclosure requirements must have a 

formal disclosure policy approved by 

the board of directors that addresses the 

institution’s approach for determining 

the disclosures it should make. The 

policy should address the associated 

internal controls and disclosure controls 

and procedures. The board of directors 

and senior management would be 

expected to ensure that appropriate 

verification of the disclosures takes 

place and that effective internal controls 

and disclosure controls and procedures 

are maintained. 

A bank should decide which 

disclosures are relevant for it based on 

the materiality concept. Information 

would be regarded as material if its 

omission or misstatement could change 

or influence the assessment or decision 

of a user relying on that information for 

the purpose of making investment 

decisions. 

To the extent applicable, a bank 

would be able to fulfill its disclosure 

requirements under this proposed rule 

by relying on disclosures made in 

accordance with accounting standards 

or SEC mandates that are very similar to 

the disclosure requirements in this 

proposed rule. In these situations, a 

bank would explain material differences 

between the accounting or other 

disclosure and the disclosures required 

under this proposed rule. 

Frequency/timeliness. Consistent with 

longstanding requirements in the United 

States for robust quarterly disclosures in 

financial and regulatory reports, and 

considering the potential for rapid 

changes in risk profiles, the agencies 

would require that quantitative 

disclosures be made quarterly. However, 

qualitative disclosures that provide a 

general summary of a bank’s risk 

management objectives and policies, 

reporting system, and definitions may 

be disclosed annually, provided any 

significant changes to these are 

disclosed in the interim. The 

disclosures must be timely, that is, must 

be made no later than the reporting 

deadlines for regulatory reports (for 

example, FR Y–9C) and financial reports 

(for example, SEC Forms 10–Q and 10–

K). When these deadlines differ, the 

later deadline would be used. 

In some cases, management may 

determine that a significant change has 

occurred, such that the most recent 

reported amounts do not reflect the 

bank’s capital adequacy and risk profile. 

In those cases, banks should disclose 

the general nature of these changes and 

briefly describe how they are likely to 


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83Alternatively, banks would be permitted to 

provide the disclosures in more than one place, as 

some of them may be included in public financial 

reports (for example, in Management’s Discussion 

and Analysis included in SEC filings) or other 

regulatory reports (for example, FR Y–9C Reports). 

The agencies would require such banks to provide 

a summary table on their public Web site that 

specifically indicates where all the disclosures may 

be found (for example, regulatory report schedules, 

page numbers in annual reports). 

84These 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.’’

85Proprietary 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. 

affect public disclosures going forward. 

These interim disclosures should be 

made as soon as practicable after the 

determination that a significant change 

has occurred. 

Location of disclosures and audit/ 

certification requirements. The 

disclosures would have to be publicly 

available (for example, included on a 

public Web site) for each of the last 

three years (that is, twelve quarters) or 

such shorter time period since the bank 

entered its first floor period. Except as 

discussed below, management would 

have some discretion to determine the 

appropriate medium and location of the 

disclosures required by this proposed 

rule. Furthermore, banks would have 

flexibility in formatting their public 

disclosures, that is, the agencies are not 

specifying a fixed format for these 

disclosures. 

Management would be encouraged to 

provide all of the required disclosures 

in one place on the entity’s public Web 

site. The public Web site address would 

be reported in a regulatory report (for 

example, the FR Y–9C).83

Disclosure of tier 1 and total capital 

ratios must be provided in the footnotes 

to the year-end audited financial 

statements.84 Accordingly, these 

disclosures must be tested by external 

auditors as part of the financial 

statement audit. Disclosures that are not 

included in the footnotes to the audited 

financial statements would not be 

required to be subject to external audit 

reports for financial statements or 

internal control reports from 

management and the external auditor. 

However, due to the importance of 

reliable disclosures, the agencies would 

require the chief financial officer to 

certify that the disclosures required by 

the proposed rule are appropriate and 

that the board of directors and senior 

management are responsible for 

establishing and maintaining an 

effective internal control structure over 

financial reporting, including the 

information required by this proposed 

rule. 

Proprietary and confidential 

information. The agencies believe that 

the proposed requirements strike an 

appropriate balance between the need 

for meaningful disclosure and the 

protection of proprietary and 

confidential information.85 Accordingly, 

the agencies believe that banks would 

be able to provide all of these 

disclosures without revealing 

proprietary and confidential 

information. However, in rare cases, 

disclosure of certain items of 

information required in the proposed 

rule may prejudice seriously the 

position of a bank by making public 

information that is either proprietary or 

confidential in nature. In such cases, a 

reporting bank may request confidential 

treatment for the information if the bank 

believes that disclosure of specific 

commercial or financial information in 

the report would likely result in 

substantial harm to its competitive 

position, or that disclosure of the 

submitted information would result in 

unwarranted invasion of personal 

privacy. 

Question 61: The agencies seek 

commenters’ views on all of the 

elements proposed to be captured 

through the public disclosure 

requirements. In particular, the agencies 

seek comment on the extent to which 

the proposed disclosures balance 

providing market participants with 

sufficient information to appropriately 

assess the capital strength of individual 

institutions, fostering comparability 

from bank to bank, and reducing burden 

on the banks that are reporting the 

information. 

3. Summary of Specific Public 

Disclosure Requirements 

The public disclosure requirements 

are comprised of 11 tables that provide 

important information to market 

participants on the scope of application, 

capital, risk exposures, risk assessment 

processes, and, hence, the capital 

adequacy of the institution. Again, the 

agencies note that the substantive 

content of the tables is the focus of the 

disclosure requirements, not the tables 

themselves. The table numbers below 

refer to the table numbers in the 

proposed rule. 

Table 11.1 disclosures, Scope of 

Application, include a description of 

the level in the organization to which 

the disclosures apply and an outline of 

any differences in consolidation for 

accounting and regulatory capital 

purposes, as well as a description of any 

restrictions on the transfer of funds and 

capital within the organization. These 

disclosures provide the basic context 

underlying regulatory capital 

calculations. 

Table 11.2 disclosures, Capital 

Structure, provide information on 

various components of regulatory 

capital available to absorb losses and 

allow for an evaluation of the quality of 

the capital available to absorb losses 

within the bank. 

Table 11.3 disclosures, Capital 

Adequacy, provide information about 

how a bank assesses the adequacy of its 

capital and require that the bank 

disclose its minimum capital 

requirements for significant risk areas 

and portfolios. The table also requires 

disclosure of the regulatory capital 

ratios of the consolidated group and 

each DI subsidiary. Such disclosures 

provide insight into the overall 

adequacy of capital based on the risk 

profile of the organization. 

Tables 11.4, 11.5, and 11.7 

disclosures, Credit Risk, provide market 

participants with insight into different 

types and concentrations of credit risk 

to which the bank is exposed and the 

techniques the bank uses to measure, 

monitor, and mitigate those risks. These 

disclosures are intended to enable 

market participants to assess the credit 

risk exposures under the IRB 

framework, without revealing 

proprietary information or duplicating 

the supervisor’s fundamental review of 

the bank’s IRB framework. Table 11.6 

provides the disclosure requirements 

related to credit exposures from 

derivatives. This table was added as a 

supplement to the public disclosures 

initially in the New Accord as a result 

of the BCBS’s additional efforts to 

address certain exposures arising from 

trading activities. See the July 2005 

BCBS publication entitled ‘‘The 

Application of Basel II to Trading 

Activities and the Treatment of Double 

Default Effects.’’

Table 11.8 disclosures, Securitization, 

provide information to market 

participants on the amount of credit risk 

transferred and retained by the 

organization through securitization 

transactions and the types of products 

securitized by the organization. These 

disclosures provide users a better 

understanding of how securitization 

transactions impact the credit risk of the 

bank. 


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Table 11.9 disclosures, Operational 

Risk, provide insight into the bank’s 

application of the AMA for operational 

risk and what internal and external 

factors are considered in determining 

the amount of capital allocated to 

operational risk. 

Table 11.10 disclosures, Equities, 

provide market participants with an 

understanding of the types of equity 

securities held by the bank and how 

they are valued. The table also provides 

information on the capital allocated to 

different equity products and the 

amount of unrealized gains and losses. 

Table 11.11 disclosures, Interest Rate 

Risk in Non-Trading Activities, provide 

information about the potential risk of 

loss that may result from changes in 

interest rates and how the bank 

measures such risk. 

4. Regulatory Reporting 

In addition to the public disclosures 

that would be required by the 

consolidated banking organization 

subject to the advanced approaches, the 

agencies would require certain 

additional regulatory reporting from 

BHCs, their subsidiary DIs, and DIs 

applying the advanced approaches that 

are not subsidiaries of BHCs. The 

agencies believe that the reporting of 

key risk parameter estimates by each DI 

applying the advanced approaches will 

provide the primary Federal supervisor 

and other relevant supervisors with data 

important for assessing the 

reasonableness and accuracy of the 

institution’s calculation of its minimum 

capital requirements under this rule and 

the adequacy of the institution’s capital 

in relation to its risks. This information 

would be collected through regulatory 

reports. The agencies believe that 

requiring certain common reporting 

across banks will facilitate comparable 

application of the proposed rules. 

In this regard, the agencies published 

for comment elsewhere in today’s 

Federal Register a package of proposed 

reporting schedules. The package 

includes a summary schedule with 

aggregate data that would be available to 

the general public. It also includes 

supporting schedules that would be 

viewed as confidential supervisory 

information. These schedules are broken 

out by exposure category and would 

collect risk parameter and other 

pertinent data in a systematic manner. 

The agencies also are exploring ways to 

obtain information that would improve 

supervisors’ understanding of the causes 

behind changes in risk-based capital 

requirements. For example, certain data 

would help explain whether movements 

are attributable to changes in key risk 

parameters or other factors. Under the 

proposed rule, banks would begin 

reporting this information during their 

parallel run on a confidential basis. The 

agencies will share this information 

with each other for calibration and other 

analytical purposes. Question 62: 

Comments on regulatory reporting 

issues may be submitted in response to 

this NPR as well as through the 

regulatory reporting request for 

comment noted above. 

List of Acronyms 

ABCP Asset Backed Commercial Paper 

ALLL Allowance for Loan and Lease 

Losses 

AMA Advanced Measurement 

Approaches 

ANPR Advance Notice of Proposed 

Rulemaking 

AVC Asset Value Correlation 

BCBS Basel Committee on Banking 

Supervision 

BHC Bank Holding Company 

CF Conversion Factor 

CEIO Credit-Enhancing Interest-Only 

Strip 

CRM Credit Risk Mitigation 

DI Depository Institution 

DvP Delivery versus Payment 

E Measure of Effectiveness 

EAD Exposure at Default 

ECL Expected Credit Loss 

EL Expected Loss 

ELGD Expected Loss Given Default 

EOL Expected Operational Loss 

FDIC Federal Deposit Insurance 

Corporation 

FFIEC Federal Financial Institutions 

Examination Council 

FMI Future Margin Income 

GAAP Generally Accepted Accounting 

Principles 

HELOC Home Equity Line of Credit 

HOLA Home Owners’ Loan Act 

HVCRE High-Volatility Commercial 

Real Estate 

IAA Internal Assessment Approach 

IMA Internal Models Approach 

IRB Internal Ratings Based 

KIRB Capital Requirement for 

Underlying Pool of Exposures 

(securitizations) 

LGD Loss Given Default 

LTV Loan-to-Value Ratio 

M Effective Maturity 

MRA Market Risk Amendment 

MRC Minimum Risk-Based Capital 

OCC Office of the Comptroller of the 

Currency 

OTC Over-the-Counter 

OTS Office of Thrift Supervision 

PCA Prompt Corrective Action 

PD Probability of Default 

PFE Potential Future Exposure 

PvP Payment versus Payment 

QIS–3 Quantitative Impact Study 3 

QIS–4 Quantitative Impact Study 4 

QIS–5 Quantitative Impact Study 5 

QRE Qualifying Revolving Exposure 

RBA Ratings-Based Approach 

SFA Supervisory Formula Approach 

SME Small and Medium-Size 

Enterprise 

SPE Special Purpose Entity 

SRWA Simple Risk-Weight Approach 

UL Unexpected Loss 

UOL Unexpected Operational Loss 

VaR Value-at-Risk 

Regulatory Flexibility Act Analysis 

The Regulatory Flexibility Act (RFA) 

requires an agency that is issuing a 

proposed rule to prepare and make 

available for public comment an initial 

regulatory flexibility analysis that 

describes the impact of the proposed 

rule on small entities. 5 U.S.C. 603(a). 

The RFA provides that an agency is not 

required to prepare and publish an 

initial regulatory flexibility analysis if 

the agency certifies that the proposed 

rule will not, if promulgated, have a 

significant economic impact on a 

substantial number of small entities. 5 

U.S.C. 605(b). 

Pursuant to section 605(b) of the RFA 

(5 U.S.C. 605(b)), the agencies certify 

that this proposed rule will not, if 

promulgated in final form, have a 

significant economic impact on a 

substantial number of small entities 

Pursuant to regulations issued by the 

Small Business Administration (13 CFR 

121–201), a ‘‘small entity’’ includes a 

bank holding company, commercial 

bank, or savings association with assets 

of $165 million or less (collectively, 

small banking organizations). The 

proposed rule would require a bank 

holding company, national bank, state 

member bank, state nonmember bank, or 

savings association to calculate its riskbased capital requirements according to 

certain internal-ratings-based and 

internal model approaches if the bank 

holding company, bank, or savings 

association (i) has consolidated total 

assets (as reported on its most recent 

year-end regulatory report) equal to 

$250 billion or more; (ii) has 

consolidated total on-balance sheet 

foreign exposures at the most recent 

year-end equal to $10 billion or more; or 

(iii) is a subsidiary of a bank holding 

company, bank, or savings association 

that would be required to use the 

proposed rule to calculate its risk-based 

capital requirements. 

The agencies estimate that zero small 

bank holding companies (out of a total 

of approximately 2,934 small bank 

holding companies), five small national 

banks (out of a total of approximately 

1,090 small national banks), one small 

state member bank (out of a total of 

approximately 491 small state member 

banks), one small state nonmember bank 


sroberts on PROD1PC70 with PROPOSALS
55904 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

(out of a total of approximately 3,249 

small state nonmember banks), and zero 

small savings associations (out of a total 

of approximately 446 small savings 

associations) would be subject to the 

proposed risk-based capital 

requirements on a mandatory basis. In 

addition, each of the small banking 

organizations subject to the proposed 

rule on a mandatory basis would be a 

subsidiary of a bank holding company 

with over $250 billion in consolidated 

total assets or over $10 billion in 

consolidated total on-balance sheet 

foreign exposure. Therefore, the 

agencies believe that the proposed rule 

will not, if promulgated in final form, 

result in a significant economic impact 

on a substantial number of small 

entities. 

Paperwork Reduction Act 

A. Request for Comment on Proposed 

Information Collection. In accordance 

with the requirements of the Paperwork 

Reduction Act of 1995, the agencies may 

not conduct or sponsor, and the 

respondent is not required to respond 

to, an information collection unless it 

displays a currently valid Office of 

Management and Budget (OMB) control 

number. The agencies are requesting 

comment on a proposed information 

collection. The agencies are also giving 

notice that the proposed collection of 

information has been submitted to OMB 

for review and approval. 

Comments are invited on: 

(a) Whether the collection of 

information is necessary for the proper 

performance of the agencies’ functions, 

including whether the information has 

practical utility; 

(b) The accuracy of the estimates of 

the burden of the information 

collection, including the validity of the 

methodology and assumptions used; 

(c) Ways to enhance the quality, 

utility, and clarity of the information to 

be collected; 

(d) Ways to minimize the burden of 

the information collection on 

respondents, including through the use 

of automated collection techniques or 

other forms of information technology; 

and 

(e) Estimates of capital or start up 

costs and costs of operation, 

maintenance, and purchase of services 

to provide information. 

Comments should be addressed to: 

OCC: Communications Division, 

Office of the Comptroller of the 

Currency, Public Information Room, 

Mail stop 1–5, Attention: 1557–NEW, 

250 E Street, SW., Washington, DC 

20219. In addition, comments may be 

sent by fax to 202–874–4448, or by 

electronic mail to 

regs.comments@occ.treas.gov. You can 

inspect and photocopy the comments at 

the OCC’s Public Information Room, 250 

E Street, SW., Washington, DC 20219. 

You can make an appointment to 

inspect the comments by calling 202–

874–5043. 

Board: You may submit comments, 

identified by Docket No. R–1261, by any 

of the following methods: 

• Agency Web Site: http:// 

www.federalreserve.gov. Follow the 

instructions for submitting comments 

on the http://www.federalreserve.gov/ 

generalinfo/foia/ProposedRegs.cfm. 

• Federal eRulemaking Portal: http:// 

www.regulations.gov. Follow the 

instructions for submitting comments. 

• E-mail: 

regs.comments@federalreserve.gov. 

Include docket number in the subject 

line of the message. 

• FAX: 202–452–3819 or 202–452–

3102. 

• Mail: Jennifer J. Johnson, Secretary, 

Board of Governors of the Federal 

Reserve System, 20th Street and 

Constitution Avenue, NW., Washington, 

DC 20551. 

All public comments are available 

from the Board’s Web site at http:// 

www.federalreserve.gov/generalinfo/ 

foia/ProposedRegs.cfm as submitted, 

unless modified for technical reasons. 

Accordingly, your comments will not be 

edited to remove any identifying or 

contact information. Public comments 

may also be viewed electronically or in 

paper form in Room MP–500 of the 

Board’s Martin Building (20th and C 

Streets, NW.) between 9 a.m. and 5 p.m. 

on weekdays. 

FDIC: You may submit written 

comments, which should refer to 3064–

AC73, by any of the following methods: 

• Agency Web Site: http:// 

www.fdic.gov/regulations/laws/federal/ 

propose.html. Follow the instructions 

for submitting comments on the FDIC 

Web site. 

• Federal eRulemaking Portal: http:// 

www.regulations.gov. Follow the 

instructions for submitting comments. 

• E-mail: Comments@FDIC.gov. 

• Mail: Robert E. Feldman, Executive 

Secretary, Attention: Comments, FDIC, 

550 17th Street, NW., Washington, DC 

20429. 

• Hand Delivery/Courier: Guard 

station at the rear of the 550 17th Street 

Building (located on F Street) on 

business days between 7 a.m. and 5 p.m. 

Public Inspection: All comments 

received will be posted without change 

to http://www.fdic.gov/regulations/laws/ 

federal/propose/html including any 

personal information provided. 

Comments may be inspected at the FDIC 

Public Information Center, Room 100, 

801 17th Street, NW., Washington, DC, 

between 9 a.m. and 4:30 p.m. on 

business days. 

A copy of the comments may also be 

submitted to the OMB desk officer for 

the agencies: By mail to U.S. Office of 

Management and Budget, 725 17th 

Street, NW., #10235, Washington, DC 

20503 or by facsimile to 202–395–6974, 

Attention: Federal Banking Agency Desk 

Officer. 

OTS: Information Collection 

Comments, Chief Counsel’s Office, 

Office of Thrift Supervision, 1700 G 

Street, NW., Washington, DC 20552; 

send a facsimile transmission to (202) 

906–6518; or send an e-mail to 

infocollection.comments@ots.treas.gov. 

OTS will post comments and the related 

index on the OTS Internet site at http:// 

www.ots.treas.gov. In addition, 

interested persons may inspect the 

comments at the Public Reading Room, 

1700 G Street, NW., by appointment. To 

make an appointment, call (202) 906–

5922, send an e-mail to 

public.info@ots.treas.gov, or send a 

facsimile transmission to (202) 906–

7755. 

B. Proposed Information Collection. 

Title of Information Collection: RiskBased Capital Standards: Advanced 

Capital Adequacy Framework. 

Frequency of Response: eventgenerated. 

Affected Public: 

OCC: National banks and Federal 

branches and agencies of foreign banks. 

Board: State member banks, bank 

holding companies, affiliates and 

certain non-bank subsidiaries of bank 

holding companies, uninsured state 

agencies and branches of foreign banks, 

commercial lending companies owned 

or controlled by foreign banks, and Edge 

and agreement corporations. 

FDIC: Insured nonmember banks, 

insured state branches of foreign banks, 

and certain subsidiaries of these 

entities. 

OTS: Savings associations and certain 

of their subsidiaries. 

Abstract: The proposed rule sets forth 

a new risk-based capital adequacy 

framework that would require some 

banks and allow other qualifying banks 

to use an internal ratings-based 

approach to calculate regulatory credit 

risk capital requirements and advanced 

measurement approaches to calculate 

regulatory operational risk capital 

requirements. 

The information collection 

requirements in the proposed rule are 

found in sections 21–23, 42, 44, 53, and 

71. The collections of information are 

necessary in order to implement the 

proposed advanced capital adequacy 

framework. 


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Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55905 

86Executive Order 12866 (September 30, 1993), 

58 FR 51735 (October 4, 1993), as amended by 

Executive Order 13258, 67 FR 9385 (February 28, 

2002). For the complete text of the definition of 

‘‘significant regulatory action,’’ see E.O. 12866 at 

section 3(f). A ‘‘regulatory action’’ is ‘‘any 

substantive action by an agency (normally 

published in the Federal Register) that promulgates 

or is expected to lead to the promulgation of a final 

rule or regulation, including notices of inquiry, 

advance notices of proposed rulemaking, and 

notices of proposed rulemaking.’’ E.O. 12866 at 

section 3(e). 

Sections 21 and 22 require that a bank 

adopt a written implementation plan 

that addresses how it will comply with 

the proposed advanced capital adequacy 

framework’s qualification requirements, 

including incorporation of a 

comprehensive and sound planning and 

governance process to oversee the 

implementation efforts. The bank must 

also develop processes for assessing 

capital adequacy in relation to an 

organization’s risk profile. It must 

establish and maintain internal risk 

rating and segmentation systems for 

wholesale and retail risk exposures, 

including comprehensive risk parameter 

quantification processes and processes 

for annual reviews and analyses of 

reference data to determine their 

relevance. It must document its process 

for identifying, measuring, monitoring, 

controlling, and internally reporting 

operational risk; verify the accurate and 

timely reporting of risk-based capital 

requirements; and monitor, validate, 

and refine its advanced systems. 

Section 23 requires a bank to notify its 

primary Federal supervisor when it 

makes a material change to its advanced 

systems and to develop an 

implementation plan after any mergers. 

Section 42 outlines the capital 

treatment for securitization exposures. 

A bank must disclose publicly that it 

has provided implicit support to the 

securitization and the regulatory capital 

impact to the bank of providing such 

implicit support. 

Section 44 describes the IAA. A bank 

must receive prior written approval 

from its primary Federal supervisor 

before it can use the IAA. A bank must 

review and update each internal credit 

assessment whenever new material is 

available, but at least annually. It must 

validate its internal credit assessment 

process on an ongoing basis and at least 

annually. 

Section 53 outlines the IMA. A bank 

must receive prior written approval 

from its primary Federal supervisor 

before it can use the IMA. 

Section 71 specifies that each 

consolidated bank must publicly 

disclose its total and tier 1 risk-based 

capital ratios and their components. 

Estimated Burden: The burden 

estimates below exclude the following: 

(1) Any burden associated with changes 

to the regulatory reports of the agencies 

(such as the Consolidated Reports of 

Income and Condition for banks (FFIEC 

031 and FFIEC 031; OMB Nos. 7100–

0036, 3064–0052, 1557–0081) and the 

Thrift Financial Report for thrifts (TFR; 

OMB No. 1550–0023); (2) any burden 

associated with capital changes in the 

Basel II market risk rule; and (3) any 

burden associated with the Quantitative 

Impact Study (QIS–4 survey, FR 3045; 

OMB No. 7100–0303). The agencies are 

concurrently publishing notices, which 

will address burden associated with the 

first item (published elsewhere in this 

issue), and jointly publishing a 

rulemaking which will address burden 

associated with the second item. For the 

third item, the Federal Reserve 

previously took burden for the QIS–4 

survey, and some institutions may 

leverage the requirements of the QIS–4 

survey to fulfill the requirements of this 

rule. 

The burden associated with this 

collection of information may be 

summarized as follows: 

OCC 

Number of Respondents: 52. 

Estimated Burden Per Respondent: 

15,570 hours. 

Total Estimated Annual Burden: 

809,640 hours. 

Board 

Number of Respondents: 15. 

Estimated Burden Per Respondent: 

14,422 hours. 

Total Estimated Annual Burden: 

216,330 hours. 

FDIC 

Number of Respondents: 19. 

Estimated Burden Per Respondent: 

410 hours. 

Total Estimated Annual Burden: 

7,800 hours. 

OTS 

Number of Respondents: 4. 

Estimated Burden Per Respondent: 

15,000 hours. 

Total Estimated Annual Burden: 

60,000 hours. 

Plain Language 

Section 722 of the GLB Act requires 

the agencies to use ‘‘plain language’’ in 

all proposed and final rules published 

after January 1, 2000. In light of this 

requirement, the agencies have sought 

to present the proposed rule in a simple 

and straightforward manner. The 

agencies invite comments on whether 

there are additional steps the agencies 

could take to make the proposed rule 

easier to understand. 

OCC Executive Order 12866 

Executive Order 12866 requires 

Federal agencies to prepare a regulatory 

impact analysis for agency actions that 

are found to be ‘‘significant regulatory 

actions.’’ ‘‘Significant regulatory 

actions’’ include, among other things, 

rulemakings that ‘‘have an annual effect 

on the economy of $100 million or more 

or adversely affect in a material way the 

economy, a sector of the economy, 

productivity, competition, jobs, the 

environment, public health or safety, or 

State, local, or tribal governments or 

communities.’’86 Regulatory actions that 

satisfy one or more of these criteria are 

referred to as ‘‘economically significant 

regulatory actions.’’

The OCC anticipates that the 

proposed rule will meet the $100 

million criterion and therefore is an 

economically significant regulatory 

action. In conducting the regulatory 

analysis for an economically significant 

regulatory action, Executive Order 

12866 requires each Federal agency to 

provide to the Administrator of the 

Office of Management and Budget’s 

(OMB) Office of Information and 

Regulatory Affairs (OIRA): 

• The text of the draft regulatory 

action, together with a reasonably 

detailed description of the need for the 

regulatory action and an explanation of 

how the regulatory action will meet that 

need; 

• An assessment of the potential costs 

and benefits of the regulatory action, 

including an explanation of the manner 

in which the regulatory action is 

consistent with a statutory mandate and, 

to the extent permitted by law, promotes 

the President’s priorities and avoids 

undue interference with State, local, 

and tribal governments in the exercise 

of their governmental functions; 

• An assessment, including the 

underlying analysis, of benefits 

anticipated from the regulatory action 

(such as, but not limited to, the 

promotion of the efficient functioning of 

the economy and private markets, the 

enhancement of health and safety, the 

protection of the natural environment, 

and the elimination or reduction of 

discrimination or bias) together with, to 

the extent feasible, a quantification of 

those benefits; 

• An assessment, including the 

underlying analysis, of costs anticipated 

from the regulatory action (such as, but 

not limited to, the direct cost both to the 

government in administering the 

regulation and to businesses and others 

in complying with the regulation, and 

any adverse effects on the efficient 

functioning of the economy, private 

markets (including productivity, 

employment, and competitiveness), 

health, safety, and the natural 

environment), together with, to the 


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55906 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

extent feasible, a quantification of those 

costs; and 

• An assessment, including the 

underlying analysis, of costs and 

benefits of potentially effective and 

reasonably feasible alternatives to the 

planned regulation, identified by the 

agencies or the public (including 

improving the current regulation and 

reasonably viable nonregulatory 

actions), and an explanation why the 

planned regulatory action is preferable 

to the identified potential alternatives. 

Set forth below is a summary of the 

OCC’s regulatory impact analysis, which 

can be found in its entirety at http:// 

www.occ.treas.gov/law/basel.htm under 

the link of ‘‘Regulatory Impact Analysis 

for Risk-Based Capital Standards: 

Revised Capital Adequacy Guidelines 

(Basel II), Office of the Comptroller of 

the Currency, International and 

Economic Affairs (2006)’’. 

I. The Need for the Regulatory Action. 

Federal banking law directs Federal 

banking agencies, including the OCC, to 

require banking organizations to hold 

adequate capital. The law authorizes 

Federal banking agencies to set 

minimum capital levels to ensure that 

banking organizations maintain 

adequate capital. The law also gives 

banking agencies broad discretion with 

respect to capital regulation by 

authorizing them to use any other 

methods that they deem appropriate to 

ensure capital adequacy. 

Capital regulation seeks to address 

market failures that stem from several 

sources. Asymmetric information about 

the risk in a bank’s portfolio creates a 

market failure by hindering the ability 

of creditors and outside monitors to 

discern a bank’s actual risk and capital 

adequacy. Moral hazard creates market 

failure in which the bank’s creditors fail 

to restrain the bank from taking 

excessive risks because deposit 

insurance either fully or partially 

protects them from losses. Public policy 

addresses these market failures because 

individual banks fail to adequately 

consider the positive externality or 

public benefit that adequate capital 

brings to financial markets and the 

economy as a whole. 

Capital regulations cannot be static. 

Innovation in and transformation of 

financial markets require periodic 

reassessments of what may count as 

capital and what amount of capital is 

adequate. Continuing changes in 

financial markets create both a need and 

an opportunity to refine capital 

standards in banking. The Basel II 

framework, and its proposed 

implementation in the United States, 

reflects an appropriate step forward in 

addressing these changes. 

II. Costs and Benefits of the Proposed 

Rule. 

Under the proposed rule, current 

capital rules would remain in effect in 

2008 during a parallel run using both 

current non-Basel II-based and new 

Basel II-based capital rules. For the 

following three years, the proposed rule 

would apply limits on the amount by 

which minimum required capital may 

decrease. This analysis, however, 

considers the costs and benefits of the 

proposed rule as fully phased in. 

Cost and benefit analysis of changes 

in minimum capital requirements 

entails considerable measurement 

problems. On the cost side, it can be 

difficult to attribute particular 

expenditures incurred by institutions to 

the costs of implementation because 

banking organizations would likely 

incur some of these costs as part of their 

ongoing efforts to improve risk 

measurement and management systems. 

On the benefits side, measurement 

problems are even greater because the 

benefits of the proposal are more 

qualitative than quantitative. 

Measurement problems exist even with 

an apparently measurable benefit like 

lower minimum capital because lower 

minimum requirements do not 

necessarily mean lower capital. Healthy 

banking organizations generally hold 

capital well above regulatory minimums 

for a variety of reasons, and the effect 

of reducing the regulatory minimum is 

uncertain and may vary across regulated 

institutions. 

A. Benefits of the Proposed Rule. 

1. Better allocation of capital and 

reduced impact of moral hazard 

through reduction in the scope for 

regulatory arbitrage: By assessing the 

amount of capital required for each 

exposure or pool of exposures, the 

advanced approach does away with the 

simplistic risk buckets of current capital 

rules. Eliminating categorical risk 

weighting and assigning capital based 

on measured risk instead greatly curtails 

or eliminates the ability of troubled 

organizations to ‘‘game’’ regulatory 

capital requirements by finding ways to 

comply technically with the 

requirements while evading their intent 

and spirit. 

2. Improved signal quality of capital 

as an indicator of solvency: The 

advanced approaches of the proposed 

rule are designed to more accurately 

align regulatory capital with risk, which 

should improve the quality of capital as 

an indicator of solvency. The improved 

signaling quality of capital will enhance 

banking supervision and market 

discipline. 

3. Encourages banking organizations 

to improve credit risk management: One 

of the principal objectives of the 

proposed rule is to more closely align 

capital charges and risk. For any type of 

credit, risk increases as either the 

probability of default or the loss given 

default increases. Under the proposed 

rule, risk weights depend on these risk 

measures and consequently capital 

requirements will more closely reflect 

risk. This enhanced link between capital 

requirements and risk will encourage 

banking organizations to improve credit 

risk management. 

4. More efficient use of required bank 

capital: Increased risk sensitivity and 

improvements in risk measurement will 

allow prudential objectives to be 

achieved more efficiently. If capital 

rules can better align capital with risk 

across the system, a given level of 

capital will be able to support a higher 

level of banking activity while 

maintaining the same degree of 

confidence regarding the safety and 

soundness of the banking system. Social 

welfare is enhanced by either the 

stronger condition of the banking 

system or the increased economic 

activity the additional banking services 

facilitate. 

5. Incorporates and encourages 

advances in risk measurement and risk 

management: The proposed rule seeks 

to improve upon existing capital 

regulations by incorporating advances 

in risk measurement and risk 

management made over the past 15 

years. An objective of the proposed rule 

is to speed adoption of new risk 

management techniques and to promote 

the further development of risk 

measurement and management through 

the regulatory process. 

6. Recognizes new developments and 

accommodates continuing innovation in 

financial products by focusing on risk: 

The proposed rule also has the benefit 

of facilitating recognition of new 

developments in financial products by 

focusing on the fundamentals behind 

risk rather than on static product 

categories. 

7. Better aligns capital and 

operational risk and encourages 

banking organizations to mitigate 

operational risk: Introducing an explicit 

capital calculation for operational risk 

eliminates the implicit and imprecise 

‘‘buffer’’ that covers operational risk 

under current capital rules. Introducing 

an explicit capital requirement for 

operational risk improves assessments 

of the protection capital provides, 

particularly at organizations where 

operational risk dominates other risks. 

The explicit treatment also increases the 

transparency of operational risk, which 

could encourage banking organizations 


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Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55907 

87For 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. 

to take further steps to mitigate 

operational risk. 

8. Enhanced supervisory feedback: 

Although U.S. banking organizations 

have long been subject to close 

supervision, aspects of all three pillars 

of the proposed rule aim to enhance 

supervisory feedback from Federal 

banking agencies to managers of banks 

and thrifts. Enhanced feedback could 

further strengthen the safety and 

soundness of the banking system. 

9. Incorporates market discipline into 

the regulatory framework: The proposed 

rule seeks to introduce market 

discipline directly into the regulatory 

framework by requiring specific 

disclosures relating to risk measurement 

and risk management. Market discipline 

could complement regulatory 

supervision to bolster safety and 

soundness. 

10. Preserves the benefits of 

international consistency and 

coordination achieved with the 1988 

Basel Accord: An important objective of 

the 1988 Accord was competitive 

consistency of capital requirements for 

banking organizations competing in 

global markets. Basel II continues to 

pursue this objective. Because achieving 

this objective depends on the 

consistency of implementation in the 

United States and abroad, the Basel 

Committee has established an Accord 

Implementation Group to promote 

consistency in the implementation of 

Basel II. 

11. Ability to opt in offers long-term 

flexibility to nonmandatory banking 

organizations: The proposed U.S. 

implementation of Basel II allows 

banking organizations outside of the 

mandatory group to individually judge 

when the benefits they expect to realize 

from adopting the advanced approaches 

outweigh their costs. Even though the 

cost and complexity of adopting the 

advanced approaches may present 

nonmandatory organizations with a 

substantial hurdle to opting in at 

present, the potential long-term benefits 

of allowing nonmandatory organizations 

to partake in the benefits described 

above may be similarly substantial. 

B. Costs of the Proposed Rule. 

Because banking organizations are 

constantly developing programs and 

systems to improve how they measure 

and manage risk, it is difficult to 

distinguish between expenditures 

explicitly caused by adoption of the 

proposed rule and costs that would have 

occurred irrespective of any new 

regulation. In an effort to identify how 

much banking organizations expect to 

spend to comply with the U.S. 

implementation of Basel II, the Federal 

banking agencies included several 

questions related to compliance costs in 

QIS–4.87

1. Overall Costs: According to the 19 

out of 26 QIS–4 questionnaire 

respondents that provided estimates of 

their implementation costs, 

organizations will spend roughly $42 

million on average to adapt to capital 

requirements implementing Basel II. Not 

all of these respondents are likely 

mandatory organizations. Counting just 

the likely mandatory organizations, the 

average is approximately $46 million, so 

there is little difference between 

organizations that meet a mandatory 

threshold and those that do not. 

Aggregating estimated expenditures 

from all 19 respondents indicates that 

these organizations will spend a total of 

$791 million over several years to 

implement the proposed rule. Estimated 

costs for nine respondents meeting one 

of the mandatory thresholds come to 

$412 million. 

2. Estimate of costs specific to the 

proposal: Ten QIS–4 respondents 

provided estimates of the portion of 

costs they would have incurred even if 

current capital rules remain in effect. 

Those ten indicated that they would 

have spent 45 percent on average, or 

roughly half of their Basel II 

expenditures on improving risk 

management anyway. This suggests that 

of the $42 million organizations expect 

to spend on implementation, 

approximately $21 million may 

represent expenditures each institution 

would have undertaken even without 

Basel II. Thus, pure implementation 

costs may be closer to roughly $395 

million for the 19 QIS–4 respondents. 

3. Ongoing costs: Seven QIS–4 

respondents were able to estimate what 

their recurring costs might be under the 

proposed implementation of Basel II. On 

average, the seven organizations 

estimate that annual recurring expenses 

attributable to the proposed capital 

framework will be $2.4 million. 

Organizations indicated that the 

ongoing costs to maintain related 

technology reflect costs for increased 

personnel and system maintenance. The 

larger one-time expenditures primarily 

involve money for system development 

and software purchases. 

4. Implicit costs: In addition to 

explicit setup and recurring costs, 

banking organizations may also face 

implicit costs arising from the time and 

inconvenience of having to adapt to new 

capital regulations. At a minimum this 

involves the increased time and 

attention required of senior bank and 

thrift management to introduce new 

programs and procedures and the need 

to closely monitor the new activities 

during the inevitable rough patches 

when the proposed rule first takes 

effect. 

5. Government administrative costs: 

OCC expenditures fall into three broad 

categories: training, guidance, and 

supervision. Training includes expenses 

for AMA workshops, IRB workshops, 

and other training courses and seminars 

for examiners. Guidance expenses 

reflect expenditures on the development 

of IRB and AMA guidance. Supervision 

expenses reflect organization-specific 

supervisory activities related to the 

development and implementation of the 

Basel II framework. The largest OCC 

expenditures have been on the 

development of IRB and AMA policy 

guidance. The $4.6 million spent on 

guidance represents 65 percent of the 

estimated total OCC Basel II-related 

expenditure of $7.1 million through the 

2005 fiscal year. In part, this large share 

reflects the absence of data for training 

and supervision costs for several years, 

but it also is indicative of the large 

guidance expenses in 2002 and 2003 

when the Basel II framework was in 

development. To date, Basel II 

expenditures have not been a large part 

of overall OCC expenditures. The $3 

million spent on Basel II in fiscal year 

2005 represents less than one percent of 

the OCC’s $519 million budget for the 

year. 

6. Total cost: The OCC’s estimate of 

the total cost of the proposed rule 

includes expenditures by banking 

organizations and the OCC from the 

present through 2011, the final year of 

the transition period. Combining 

expenditures by mandatory banking 

organizations and the OCC provides a 

present value estimate of $545.9 million 

for the total cost of the proposed rule. 

7. Procyclicality: Procyclicality refers 

to the possibility that banking 

organizations may reduce lending 

during economic downturns and 

increase lending during economic 

expansions as a consequence of 

minimum capital requirements. There is 

some concern that the risk-sensitivity of 

the IRB approach may cause capital 

requirements for credit risk to increase 

during an economic downturn. 

Although procyclicality may be inherent 

in banking to some extent, elements of 

the advanced approaches could reduce 

inherent procyclicality. Risk 

management and information systems 

may provide bank managers with more 


sroberts on PROD1PC70 with PROPOSALS
55908 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

88Patrick de Fontnouvelle, Victoria Garrity, Scott 

Chu, and Eric Rosengren, ‘‘The Potential Impact of 

Explicit Operational Risk Capital Charges on Bank 

Processing Activities,’’ Manuscript, Federal Reserve 

Bank of Boston, January 12, 2005. Available at 

http://www.federalreserve.gov/generalinfo/basel2/ 

whitepapers.htm. 

89Paul S. Calem and James R. Follain, ‘‘An 

Examination of How the Proposed Bifurcated 

Implementation of Basel II in the U.S. May Affect 

Competition Among Banking Organizations for 

Residential Mortgages,’’ manuscript, January 14, 

2005. 

90 Diana Hancock, Andreas Lehnert, Wayne 

Passmore, and Shane M. Sherlund, ‘‘An Analysis of 

the Potential Competitive Impact of Basel II Capital 

Standards on U.S. Mortgage Rates and Mortgage 

Securitization’’, Federal Reserve Board manuscript, 

April 2005. Available at http:// 

www.federalreserve.gov/generalinfo/basel2/ 

whitepapers.htm. 

91Allen N. Berger, ‘‘Potential Competitive Effects 

of Basel II on Banks in SME Credit Markets in the 

United States,’’ Federal Reserve Board Finance and 

Economics Discussion Series, 2004–12. Available at 

http://www.federalreserve.gov/generalinfo/basel2/ 

whitepapers.htm. 

92Timothy H. Hannan and Steven J. Pilloff, ‘‘Will 

the Proposed Application of Basel II in the United 

States Encourage Increased Bank Merger Activity? 

Evidence from Past Merger Activity,’’ Federal 

Reserve Board Finance and Economics Discussion 

Series, 2004–13. Available at http:// 

www.federalreserve.gov/generalinfo/basel2/ 

whitepapers.htm. 

93William W. Lang, Loretta J. Mester, and Todd 

A. Vermilyea, ‘‘Potential Competitive Effects on 

U.S. Bank Credit Card Lending from the Proposed 

Bifurcated Application of Basel II,’’ manuscript, 

December 2005. Available at http:// 

www.federalreserve.gov/generalinfo/basel2/ 

whitepapers.htm. 

forward-looking information about risk 

that would allow them to adjust 

portfolios gradually and with more 

foresight as the economic outlook 

changes over the business cycle. 

Regulatory stress-testing requirements 

included in the proposal also will help 

ensure that institutions anticipate 

cyclicality in capital requirements to the 

greatest extent possible, reducing the 

potential economic impact of changes in 

capital requirements. 

III. Competition Among Providers of 

Financial Services 

One potential concern with any 

regulatory change is the possibility that 

it might create a competitive advantage 

for some organizations relative to others, 

a possibility that certainly applies to a 

change with the scope of this proposed 

rule. However, measurement difficulties 

described in the preceding discussion of 

costs and benefits also extend to any 

consideration of the impact on 

competition. Despite the inherent 

difficulty of drawing definitive 

conclusions, this section considers 

various ways in which competitive 

effects might be manifest, as well as 

available evidence related to those 

potential effects. 

1. Explicit Capital for Operational 

Risk: Some have noted that the explicit 

computation of required capital for 

operational risk could lead to an 

increase in total minimum regulatory 

capital for U.S. ‘‘processing’’ banks, 

generally defined as banking 

organizations that tend to engage in a 

variety of activities related to securities 

clearing, asset management, and 

custodial services. Some have suggested 

that the increase in required capital 

could place such firms at a competitive 

disadvantage relative to competitors that 

do not face a similar capital 

requirement. A careful analysis by 

Fontnouvelle et al 88 considers the 

potential competitive impact of the 

explicit capital requirement for 

operational risk. Overall, the study 

concludes that competitive effects from 

an explicit operational risk capital 

requirement should be, at most, 

extremely modest. 

2. Residential Mortgage Lending: The 

issue of competitive effects has received 

substantial attention with respect to the 

residential mortgage market. The focus 

on the residential mortgage market 

stems from the size and importance of 

the market in the United States and the 

fact that the proposed rule may lead to 

substantial reductions in credit-risk 

capital for residential mortgages. To the 

extent that corresponding operationalrisk capital requirements do not offset 

these credit-risk-related reductions, 

overall capital requirements for 

residential mortgages could decline 

under the proposed rule. Studies by 

Calem and Follain 89 and Hancock, 

Lehnert, Passmore, and Sherlund 90

suggest that banking organizations 

operating under capital rules based on 

Basel II may increase their holdings of 

residential mortgages. Calem and 

Follain argue that the increase would be 

significant and come at the expense of 

general organizations. Hancock et al. 

foresee a more modest increase in 

residential mortgage holdings at 

institutions operating under the new 

Basel II-based rules, and they see this 

increase primarily as a shift away from 

the large government sponsored 

mortgage enterprises. 

3. Small Business Lending: One 

potential avenue for competitive effects 

is small-business lending. Smaller 

banks—those that are less likely to 

adopt the advanced approaches to 

regulatory capital under the proposed 

rule—tend to rely more heavily on 

smaller loans within their commercial 

loan portfolios. To the extent that the 

proposed rule reduces required capital 

for such loans, general banking 

organizations not operating under the 

proposed rule might be placed at a 

competitive disadvantage. A study by 

Berger 91 finds some potential for a 

relatively small competitive effect on 

smaller banks in small business lending. 

However, Berger concludes that the 

small business market for large banks is 

very different from the small business 

market for smaller banks. For instance, 

a ‘‘small business’’ at a larger banking 

organization is usually much larger than 

small businesses at community banking 

organizations. 

4. Mergers and Acquisitions: Another 

concern related to potential changes in 

competitive conditions under the 

proposed rule is that bifurcation of 

capital standards might change the 

landscape with regard to mergers and 

acquisitions in banking and financial 

services. For example, banking 

organizations operating under the new 

Basel II-based capital requirements 

might be placed in a better position to 

acquire other banking organizations 

operating under the non-Basel II-based 

rules, possibly leading to an undesirable 

consolidation of the banking sector. 

Research by Hannan and Pilloff 92

suggests that the proposed rule is 

unlikely to have a significant impact on 

merger and acquisition activity in 

banking. 

5. Credit Card Competition: The 

proposed U.S. implementation of Basel 

II might also affect competition in the 

credit card market. Overall capital 

requirements for credit card loans could 

increase under the proposed rule. This 

raises the possibility of a change in the 

competitive environment among 

banking organizations subject to the 

new Basel II-based capital rules, 

nonbank credit card issuers, and 

banking organizations not subject to the 

new Basel II-based capital rules. A study 

by Lang, Mester, and Vermilyea 93 finds 

that implementation of a rule based on 

Basel II will not affect credit card 

competition at most community and 

regional banking organizations. The 

authors also suggest that higher capital 

requirements for credit cards may only 

pose a modest disadvantage to 

institutions that are subject to rules 

based on Basel II. 

Overall, the evidence regarding the 

impact of the proposed rule on 

competitive equity is mixed. The body 

of recent economic research discussed 

in the body of this report does not reveal 

persuasive evidence of any sizeable 

competitive effects. Nonetheless, the 

Federal banking agencies recognize the 

need to closely monitor the competitive 

landscape subsequent to any regulatory 

change. In particular, the OCC and other 

Federal banking agencies will be alert 


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Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55909 

94 In addition to the United States, members of 

the Basel Committee on Banking Supervision 

considering Basel II are Belgium, Canada, France, 

Germany, Italy, Japan, Luxembourg, the 

Netherlands, Spain, Sweden, Switzerland, and the 

United Kingdom. 

95Cost estimates for adopting a rule that might 

result from the Basel IA ANPR are not currently 

available. 

for early signs of competitive inequities 

that might result from this proposed 

rule. A multi-year transition period 

before full implementation of proposed 

rules based on Basel II should provide 

ample opportunity for the agencies to 

identify any emerging problems. To the 

extent that undesirable competitive 

inequities emerge, the agencies have the 

power to respond to them through many 

channels, including but not limited to 

suitable changes to the capital adequacy 

regulations. 

IV. Analysis of Baseline and 

Alternatives. 

Executive Order 12866 requires a 

comparison between the proposed rule, 

a baseline of what the world would look 

like without the proposed rule, and 

several reasonable alternatives to the 

proposed rule. In this regulatory impact 

analysis, we analyze two baselines and 

three alternatives to the proposed rule. 

We consider two baselines because of 

two very different outcomes that depend 

on the capital rules that other countries 

with internationally active banks might 

adopt absent the implementation of the 

Basel II framework in the United 

States.94 The first baseline considers the 

possibility that neither the United States 

nor these other countries adopt capital 

rules based on the Basel II framework. 

The second baseline analyzes the 

situation where the United States does 

not adopt the proposed rule, but the 

other countries with internationally 

active banking organizations do adopt 

Basel II. 

A. Presentation of Baselines and 

Alternatives. 

1. Baseline Scenario 1: Current capital 

standards based on the 1988 Basel 

Accord continue to apply both here and 

abroad: Abandoning the Basel II 

framework in favor of current capital 

rules would eliminate essentially all of 

the benefits of the proposed rule 

described earlier. In place of these lost 

or diminished benefits, the only 

advantage of continuing to apply 

current capital rules to all banking 

organizations is that maintaining the 

status quo should alleviate concerns 

regarding competition among financial 

service providers. Although the effect of 

the proposed rule on competition is 

uncertain in our estimation, staying 

with current capital rules (or universally 

applying a revised rule that might 

emerge from the Basel IA ANPR) 

eliminates bifurcation and the explicit 

assignment of capital for operational 

risk. Concerns regarding competition 

usually center on these two 

characteristics of the proposed rule. 

While continuing to use current capital 

rules eliminates most of the benefits of 

adopting the proposed capital rule, it 

does not eliminate many costs 

associated with Basel II. Because Basel 

II costs are difficult to separate from the 

banking organization’s ordinary 

development costs and ordinary 

supervisory costs at the agencies, 

dropping the proposal to implement 

Basel II would reduce but not eliminate 

many of these costs associated with the 

proposed rule.95

2. Baseline Scenario 2: Current capital 

standards based on the 1988 Basel 

Accord continue to apply in the United 

States, but the rest of the world adopts 

the Basel II framework: Like the first 

baseline scenario, abandoning a 

framework based on Basel II in favor of 

current capital rules would eliminate 

essentially all of the benefits of the 

proposed rule described earlier. Like the 

first baseline scenario, the one 

advantage of this scenario is that there 

would be no bifurcation of capital rules 

within the United States. However, the 

emergence of different capital rules 

across national borders would at least 

partially offset this advantage. Thus, 

while concerns regarding competition 

among U.S. financial service providers 

might diminish in this scenario, 

concerns regarding cross-border 

competition would likely increase. Just 

as the first baseline scenario eliminated 

most of the benefits of adopting the 

proposed rule, the same holds true for 

the second baseline scenario with one 

important distinction. Because the 

United States would be operating under 

a set of capital rules different from the 

rest of the world, U.S. banking 

organizations that are internationally 

active may face higher costs because 

they will have to track and comply with 

more than one set of capital 

requirements. 

3. Alternative A: Permit U.S. banking 

organizations to choose among all three 

Basel II credit risk approaches: The 

principal benefit of Alternative A that 

the proposed rule does not achieve is 

the increased flexibility of the 

regulation for banking organizations that 

would be mandatory banking 

organizations under the proposed rule. 

Banking organizations that are not 

prepared for the adoption of the 

advanced IRB approach to credit risk 

under the proposed rule could choose to 

use the foundation IRB approach or 

even the standardized approach. How 

Alternative A might affect benefits 

depends entirely on how many banking 

organizations select each of the three 

available options. The most significant 

drawback to Alternative A is the 

increased cost of applying a new set of 

capital rules to all U.S. banking 

organizations. The vast majority of 

banking organizations in the United 

States would incur no direct costs from 

new capital rules under the proposed 

rule. Under Alternative A, direct costs 

would increase for every U.S. banking 

organization that would have continued 

with current capital rules under the 

proposed rule. Although it is not clear 

how high these costs might be, general 

banking organizations would face higher 

costs because they would be changing 

capital rules regardless of which option 

they choose under Alternative A. 

4. Alternative B: Permit U.S. banking 

organizations to choose among all three 

Basel II operational risk approaches: 

The operational risk approach that 

banking organizations ultimately 

selected would determine how the 

overall benefits of the new capital 

regulations would change under 

Alternative B. Just as Alternative A 

increases the flexibility of credit risk 

rules for mandatory banking 

organizations, Alternative B is more 

flexible with respect to operational risk. 

Because the Standardized Approach 

tries to be more sensitive to variations 

in operational risk than the Basic 

Indicator Approach and the AMA is 

more sensitive than the Standardized 

Approach, the effect of implementing 

Alternative B depends on how many 

banking organizations select the more 

risk sensitive approaches. As was the 

case with Alternative A, the most 

significant drawback to Alternative B is 

the increased cost of applying a new set 

of capital rules to all U.S. banking 

organizations. Under Alternative B, 

direct costs would increase for every 

U.S. banking organization that would 

have continued with current capital 

rules under the proposed rule. It is not 

clear how much it might cost banking 

organizations to adopt these capital 

measures for operational risk, but 

general banking organizations would 

face higher costs because they would be 

changing capital rules regardless of 

which option they choose under 

Alternative B. 

5. Alternative C: Use a different asset 

amount to determine a mandatory 

organization: The number of mandatory 

banking organizations decreases slowly 

as the size thresholds increase, and the 

number of banking organizations grows 

more quickly as the thresholds decrease. 

Under Alternative C, the framework of 


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55910 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

96The 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. 

the proposed rule would remain the 

same and only the number of mandatory 

banking organizations would change. 

Because the structure of the proposed 

implementation would remain intact, 

Alternative C would capture all of the 

benefits of the proposed rule. However, 

because these benefits derive from 

applying the proposed rule to 

individual banking organizations, 

changing the number of banking 

organizations affected by the rule will 

change the cumulative level of the 

benefits achieved. Generally, the 

benefits associated with the proposed 

rule will rise and fall with the number 

of mandatory banking organizations. 

Because Alternative C would change the 

number of mandatory banking 

organizations subject to the proposed 

rule, aggregate costs will also rise or fall 

with the number of mandatory banking 

organizations. 

B. Overall Comparison of the 

Proposed Rule with Baselines and 

Alternatives. 

The Basel II framework and its 

proposed U.S. implementation seek to 

incorporate risk measurement and risk 

management advances into capital 

requirements. On the basis of their 

analysis, the agencies believe that the 

benefits of the proposed rule are 

significant, durable, and hold the 

potential to increase with time. The 

offsetting costs of implementing the 

proposed rule are also significant, but 

appear to be largely because of 

considerable start-up costs. However, 

much of the apparent start-up costs 

reflect activities that the banking 

organizations would undertake as part 

of their ongoing efforts to improve the 

quality of their internal risk 

measurement and management, even in 

the absence of Basel II and this 

proposed rule. The advanced 

approaches seem to have fairly modest 

ongoing expenses. Against these costs, 

the significant benefits of Basel II 

suggest that the proposed rule offers an 

improvement over either of the two 

baseline scenarios. 

With regard to the three alternative 

approaches we consider, the proposed 

rule seems to offer an important degree 

of flexibility while significantly 

restricting the cost of the proposed rule 

by limiting its application to large, 

complex, internationally active banking 

organizations. Alternatives A and B 

introduce more flexibility from the 

perspective of the large mandatory 

banking organizations, but each is less 

flexible with respect to other banking 

organizations. Either Alternative A or B 

would compel these banking 

organizations to select a new set of 

capital rules and require them to 

undertake the time and expense of 

adjusting to these new rules. Alternative 

C would change the number of 

mandatory banking organizations. If the 

number of mandatory banking 

organizations increases, then the new 

rule would lose some of the flexibility 

the proposed rule achieves with the optin option. Furthermore, costs would 

increase as the new rule would compel 

more banking organizations to incur the 

expense of adopting the advanced 

approaches. Decreasing the number of 

mandatory banking organizations would 

decrease the aggregate social good of 

each benefit achieved with the proposed 

rule. The proposed rule seems to offer 

a better balance between costs and 

benefits than any of the three 

alternatives. 

OTS Executive Order 12866 

Determination. OTS commented on the 

development of, and concurs with, 

OCC’s RIA. Rather than replicate that 

analysis, OTS drafted an RIA 

incorporating OCC’s analysis by 

reference and adding appropriate 

material reflecting the unique aspects of 

the thrift industry. The full text of OTS’s 

RIA is available at the locations for 

viewing the OTS docket indicated in the 

ADDRESSES section above. OTS believes 

that its analysis meets the requirements 

of Executive Order 12866. The following 

discussion supplements OCC’s 

summary of its RIA. 

The NPR would apply to 

approximately eight mandatory and 

potential opt-in savings associations 

representing approximately 46 percent 

of total thrift industry assets. 

Approximately 70 percent of the total 

assets in these eight institutions are 

concentrated in residential mortgagerelated assets. By contrast, national 

banks tend to concentrate their assets in 

commercial loans and other kinds of 

non-mortgage loans. Only about 35 

percent of national bank’s total assets 

are residential mortgage-related assets. 

As a result, the costs and benefits of the 

NPR for OTS-regulated savings 

associations will differ in important 

ways from OCC-regulated national 

banks. These differences are the focus of 

OTS’s analysis. 

Benefits. Among the benefits of the 

NPR, OCC cites: (i) Better allocation of 

capital and reduced impact of moral 

hazard through reduction in the scope 

for regulatory arbitrage; (ii) improved 

signal quality of capital as an indicator 

of institution solvency; and (iii) more 

efficient use of required bank capital. 

From OTS’s perspective, however, the 

NPR may not provide the degree of 

benefits anticipated by OCC from these 

sources. 

Because of the low credit risk 

associated with residential mortgagerelated assets, OTS believes that the 

risk-insensitive leverage ratio, rather 

than the risk-based capital ratio, may be 

more binding on its institutions.96 As a 

result, these institutions may be 

required to hold more capital than 

would be required under proposed 

credit risk-based standards alone. 

Therefore, the NPR may cause these 

institutions to incur much the same 

implementation costs as banks with 

riskier assets, but with reduced benefits. 

Costs. OTS adopts the OCC cost 

analysis with the following 

supplemental information on OTS’s 

administrative costs. OTS did not incur 

a meaningful amount of direct 

expenditures until 2002 when it 

transitioned from a monitoring role to 

active involvement in Basel II. 

Thereafter, expenditures increased 

rapidly. The OTS expenditures fall into 

two broad categories: Policymaking 

expenses incurred in the development 

of the ANPR, this NPR, and related 

guidance; and supervision expenses that 

reflect institution-specific supervisory 

activities. OTS estimates that it incurred 

total expenses of $3,780,000 for fiscal 

years 2002 through 2005, including 

$2,640,000 in policymaking expenses 

and $1,140,000 in supervision expenses. 

OTS anticipates that supervision 

expenses will continue to grow as a 

percentage of the total expense as it 

moves from policy development to 

implementation and training. To date, 

Basel II expenditures have not been a 

large part of overall expenditures. 

Competition. OTS agrees with OCC’s 

analysis of competition among 

providers of financial services. OTS 

adds, however, that some institutions 

with low credit risk portfolios face an 

existing competitive disadvantage 

because they are bound by a non-riskbased capital requirement—the leverage 

ratio. Thus, the agencies regulate a class 

of institutions that currently receive 

fewer capital benefits from risk-based 

capital rules because they are bound by 

the risk-insensitive leverage ratio. This 

anomaly will likely continue under the 

NPR. 


sroberts on PROD1PC70 with PROPOSALS
Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55911 

97Paul S. Calem and James R. Follain, ‘‘An 

Examination of How the Proposed Bifurcated 

Implementation of Basel II in the U.S. May Affect 

Competition Among Banking Organizations for 

Residential Mortgages,’’ manuscript, January 14, 

2005. 

98 Diana Hancock, Andreas Lenhert, Wayne 

Passmore, and Shane M Sherlund, ‘‘An Analysis of 

the Competitive Impacts of Basel II Capital 

Standards on U.S. Mortgage Rates and Mortgage 

Securitization, March 7, 2005, Board of Governors 

of the Federal Reserve System, working paper.’’

99 70 FR 61068 (Oct. 20, 2005). 

1For simplicity, and unless otherwise noted, this 

NPR uses the term [bank] to include banks, savings 

associations, and bank holding companies. 

[AGENCY] refers to the primary Federal supervisor 

of the bank applying the rule. 

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-a`-vis nonadopters and vis-a`-vis adopters who are 

bound by the leverage ratio. Two 

research papers—one by Calem and 

Follain,97 and another by Hancock, 

Lenhert, Passmore, and Sherlund 98

addressed this topic. The Calem and 

Follain paper argues that Basel II will 

significantly affect the competitive 

environment in mortgage lending; 

Hancock, et al. argue that it will not. 

Both papers are predicated, however, on 

the current capital regime for nonadopters. The agencies recently 

published an ANPR seeking comment 

on various modifications to the existing 

risk-based capital rules.99 These changes 

may reduce the competitive disparities 

between adopters and non-adopters of 

Basel II by reducing the competitive 

advantage of Basel II adopters. 

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 inflationadjusted expenditure threshold is 

$119.6 million. The requirements of the 

UMRA include assessing a rule’s effects 

on future compliance costs; particular 

regions or State, local, or tribal 

governments; communities; segments of 

the private sector; productivity; 

economic growth; full employment; 

creation of productive jobs; and the 

international competitiveness of U.S. 

goods and services. The proposed rule 

qualifies as a significant regulatory 

action under the UMRA because its 

Federal mandates may result in the 

expenditure by the private sector of 

$119.6 million or more in any one year. 

As permitted by section 202(c) of the 

UMRA, the required analyses have been 

prepared in conjunction with the 

Executive Order 12866 analysis 

document titled Regulatory Impact 

Analysis for Risk-Based Capital 

Standards: Revised Capital Adequacy 

Guidelines. The analysis is available on 

the Internet at http://www.occ.treas.gov/ 

law/basel.htm under the link of 

‘‘Regulatory Impact Analysis for RiskBased Capital Standards: Revised 

Capital Adequacy Guidelines (Basel II), 

Office of the Comptroller of the 

Currency, International and Economic 

Affairs (2006)’’. 

OTS Unfunded Mandates Reform Act 

of 1995 Determination. The Unfunded 

Mandates Reform Act of 1995 (Pub. L. 

104–4) (UMRA) requires cost-benefit 

and other analyses for a rule that would 

include any Federal mandate that may 

result in the expenditure by State, local, 

and tribal governments, in the aggregate, 

or by the private sector of $100 million 

or more (adjusted annually for inflation) 

in any one year. The current inflationadjusted expenditure threshold is 

$119.6 million. The requirements of the 

UMRA include assessing a rule’s effects 

on future compliance costs; particular 

regions or State, local, or tribal 

governments; communities; segments of 

the private sector; productivity; 

economic growth; full employment; 

creation of productive jobs; and the 

international competitiveness of U.S. 

goods and services. The proposed rule 

qualifies as a significant regulatory 

action under the UMRA because its 

Federal mandates may result in the 

expenditure by the private sector of 

$119.6 or more in any one year. As 

permitted by section 202(c) of the 

UMRA, the required analyses have been 

prepared in conjunction with the 

Executive Order 12866 analysis 

document titled Regulatory Impact 

Analysis for Risk-Based Capital 

Standards: Revised Capital Adequacy 

Guidelines. The analysis is available at 

the locations for viewing the OTS 

docket indicated in the ADDRESSES

section above. 

Text of Common Appendix (All 

Agencies) 

The text of the agencies’ common 

appendix appears below: 

[Appendix to Partll]—Capital 

Adequacy Guidelines for [Bank]s: 100

Internal-Ratings-Based and Advanced 

Measurement Approaches 

Part I General Provisions 

Section 1 Purpose, Applicability, and 

Reservation of Authority 

Section 2 Definitions 

Section 3 Minimum Risk-Based Capital 

Requirements 

Part II Qualifying Capital 

Section 11 Additional Deductions 

Section 12 Deductions and Limitations 

Not Required 

Section 13 Eligible Credit Reserves 

Part III Qualification 

Section 21 Qualification Process 

Section 22 Qualification Requirements 

Section 23 Ongoing Qualification 

Part IV Risk-Weighted Assets for General 

Credit Risk 

Section 31 Mechanics for Calculating 

Total Wholesale and Retail RiskWeighted Assets 

Section 32 Counterparty Credit Risk 

Section 33 Guarantees and Credit 

Derivatives: PD Substitution and LGD 

Adjustment Treatments 

Section 34 Guarantees and Credit 

Derivatives: Double Default Treatment 

Section 35 Risk-Based Capital 

Requirement for Unsettled Transactions 

Part V Risk-Weighted Assets for 

Securitization Exposures 

Section 41 Operational Criteria for 

Recognizing the Transfer of Risk 

Section 42 Risk-Based Capital 

Requirement for Securitization 

Exposures 

Section 43 Ratings-Based Approach 

(RBA) 

Section 44 Internal Assessment Approach 

(IAA) 

Section 45 Supervisory Formula 

Approach (SFA) 

Section 46 Recognition of Credit Risk 

Mitigants for Securitization Exposures 

Section 47 Risk-Based Capital 

Requirement for Early Amortization 

Provisions 

Part VI Risk-Weighted Assets for Equity 

Exposures 

Section 51 Introduction and Exposure 

Measurement 

Section 52 Simple Risk Weight Approach 

(SRWA) 

Section 53 Internal Models Approach 

(IMA) 


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Section 54 Equity Exposures to 

Investment Funds 

Section 55 Equity Derivative Contracts 

Part VII Risk-Weighted Assets for 

Operational Risk 

Section 61 Qualification Requirements 

for Incorporation of Operational Risk 

Mitigants 

Section 62 Mechanics of Risk-Weighted 

Asset Calculation 

Part VIII Disclosure 

Section 71 Disclosure Requirements 

Part I. General Provisions 

Section 1. Purpose, Applicability, and 

Reservation of Authority 

(a) Purpose. This appendix 

establishes: 

(1) Minimum qualifying criteria for 

[bank]s using [bank]-specific internal 

risk measurement and management 

processes for calculating risk-based 

capital requirements; 

(2) Methodologies for such [bank]s to 

calculate their risk-based capital 

requirements; and 

(3) Public disclosure requirements for 

such [bank]s. 

(b) Applicability. (1) This appendix 

applies to a [bank] that: 

(i) Has consolidated total assets, as 

reported on the most recent year-end 

Consolidated Report of Condition and 

Income (Call Report) or Thrift Financial 

Report (TFR), equal to $250 billion or 

more; 

(ii) Has consolidated total on-balance 

sheet foreign exposure at the most 

recent year-end equal to $10 billion or 

more (where total on-balance sheet 

foreign exposure equals total crossborder claims less claims with head 

office or guarantor located in another 

country plus redistributed guaranteed 

amounts to the country of head office or 

guarantor plus local country claims on 

local residents plus revaluation gains on 

foreign exchange and derivative 

products, calculated in accordance with 

the Federal Financial Institutions 

Examination Council (FFIEC) 009 

Country Exposure Report); 

(iii) Is a subsidiary of a depository 

institution that uses 12 CFR part 3, 

Appendix C, 12 CFR part 208, Appendix 

F, 12 CFR part 325, Appendix D, or 12 

CFR part 566, Appendix A, to calculate 

its risk-based capital requirements; or 

(iv) Is a subsidiary of a bank holding 

company (as defined in 12 U.S.C. 1841) 

that uses 12 CFR part 225, Appendix F, 

to calculate its risk-based capital 

requirements. 

(2) Any [bank] may elect to use this 

appendix to calculate its risk-based 

capital requirements. 

(3) A [bank] that is subject to this 

appendix must use this appendix unless 

the [AGENCY] determines in writing 

that application of this appendix is not 

appropriate in light of the [bank]’s asset 

size, level of complexity, risk profile, or 

scope of operations. In making a 

determination under this paragraph, the 

[AGENCY] will apply notice and 

response procedures in the same 

manner and to the same extent as the 

notice and response procedures in 12 

CFR 3.12 (for national banks), 12 CFR 

263.202 (for bank holding companies 

and state member banks), 12 CFR 

325.6(c) (for state nonmember banks), 

and 12 CFR 567.3(d) (for savings 

associations). 

(c) Reservation of authority—(1) 

Additional capital in the aggregate. The 

[AGENCY] may require a [bank] to hold 

an amount of capital greater than 

otherwise required under this appendix 

if the [AGENCY] determines that the 

[bank]’s risk-based capital requirement 

under this appendix is not 

commensurate with the [bank]’s credit, 

market, operational, or other risks. In 

making a determination under this 

paragraph, the [AGENCY] will apply 

notice and response procedures in the 

same manner and to the same extent as 

the notice and response procedures in 

12 CFR 3.12 (for national banks), 12 CFR 

263.202 (for bank holding companies 

and state member banks), 12 CFR 

325.6(c) (for state nonmember banks), 

and 12 CFR 567.3(d) (for savings 

associations). 

(2) Specific risk-weighted asset 

amounts. (i) If the [AGENCY] 

determines that the risk-weighted asset 

amount calculated under this appendix 

by the [bank] for one or more exposures 

is not commensurate with the risks 

associated with those exposures, the 

[AGENCY] may require the [bank] to 

assign a different risk-weighted asset 

amount to the exposures, to assign 

different risk parameters to the 

exposures (if the exposures are 

wholesale or retail exposures), or to use 

different model assumptions for the 

exposures (if the exposures are equity 

exposures under the Internal Models 

Approach (IMA) or securitization 

exposures under the Internal 

Assessment Approach (IAA)), all as 

specified by the [AGENCY]. 

(ii) If the [AGENCY] determines that 

the risk-weighted asset amount for 

operational risk produced by the [bank] 

under this appendix is not 

commensurate with the operational 

risks of the [bank], the [AGENCY] may 

require the [bank] to assign a different 

risk-weighted asset amount for 

operational risk, to change elements of 

its operational risk analytical 

framework, including distributional and 

dependence assumptions, or to make 

other changes to the [bank]’s operational 

risk management processes, data and 

assessment systems, or quantification 

systems, all as specified by the 

[AGENCY]. 

(3) Other supervisory authority. 

Nothing in this appendix limits the 

authority of the [AGENCY] under any 

other provision of law or regulation to 

take supervisory or enforcement action, 

including action to address unsafe or 

unsound practices or conditions, 

deficient capital levels, or violations of 

law. 

Section 2. Definitions 

Advanced internal ratings-based (IRB) 

systems means a [bank]’s internal risk 

rating and segmentation system; risk 

parameter quantification system; data 

management and maintenance system; 

and control, oversight, and validation 

system for credit risk of wholesale and 

retail exposures. 

Advanced systems means a [bank]’s 

advanced IRB systems, operational risk 

management processes, operational risk 

data and assessment systems, 

operational risk quantification systems, 

and, to the extent the [bank] uses the 

following systems, the counterparty 

credit risk model, double default 

excessive correlation detection process, 

IMA for equity exposures, and IAA for 

securitization exposures to ABCP 

programs. 

Affiliate with respect to a company 

means any company that controls, is 

controlled by, or is under common 

control with, the company. For 

purposes of this definition, a person or 

company controls a company if it: 

(1) Owns, controls, or holds with 

power to vote 25 percent or more of a 

class of voting securities of the 

company; or 

(2) Consolidates the company for 

financial reporting purposes. 

Applicable external rating means, 

with respect to an exposure, the lowest 

external rating assigned to the exposure 

by any NRSRO. 

Asset-backed commercial paper 

(ABCP) program means a program that 

primarily issues commercial paper that: 

(1) Has an external rating; and 

(2) Is backed by underlying exposures 

held in a bankruptcy-remote SPE. 

Asset-backed commercial paper 

(ABCP) program sponsor means a [bank] 

that: 

(1) Establishes an ABCP program; 

(2) Approves the sellers permitted to 

participate in an ABCP program; 

(3) Approves the exposures to be 

purchased by an ABCP program; or 

(4) Administers the ABCP program by 

monitoring the underlying exposures, 

underwriting or otherwise arranging for 

the placement of debt or other 

obligations issued by the program, 


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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 outof-sample testing. 

Benchmarking means the comparison 

of a [bank]’s internal estimates with 

relevant internal and external data 

sources or estimation techniques. 

Business environment and internal 

control factors means the indicators of 

a [bank]’s operational risk profile that 

reflect a current and forward-looking 

assessment of the [bank]’s underlying 

business risk factors and internal 

control environment. 

Carrying value means, with respect to 

an asset, the value of the asset on the 

balance sheet of the [bank], determined 

in accordance with GAAP. 

Clean-up call means a contractual 

provision that permits a servicer to call 

securitization exposures before their 

stated maturity or call date. See also 

eligible clean-up call. 

Commodity derivative contract means 

a commodity-linked swap, purchased 

commodity-linked option, forward 

commodity-linked contract, or any other 

instrument linked to commodities that 

gives rise to similar counterparty credit 

risks. 

Company means a corporation, 

partnership, limited liability company, 

depository institution, business trust, 

special purpose entity, association, or 

similar organization. 

Credit derivative means a financial 

contract executed under standard 

industry credit derivative 

documentation that allows one party 

(the protection purchaser) to transfer the 

credit risk of one or more exposures 

(reference exposure) to another party 

(the protection provider). See also 

eligible credit derivative. 

Credit-enhancing interest-only strip 

(CEIO) means an on-balance sheet asset 

that, in form or in substance: 

(1) Represents a contractual right to 

receive some or all of the interest and 

no more than a minimal amount of 

principal due on the underlying 

exposures of a securitization; and 

(2) Exposes the holder to credit risk 

directly or indirectly associated with the 

underlying exposures that exceeds a pro 

rata share of the holder’s claim on the 

underlying exposures, whether through 

subordination provisions or other 

credit-enhancement techniques. 

Credit-enhancing representations and 

warranties means representations and 

warranties that are made or assumed in 

connection with a transfer of underlying 

exposures (including loan servicing 

assets) and that obligate a [bank] to 

protect another party from losses arising 

from the credit risk of the underlying 

exposures. Credit-enhancing 

representations and warranties include 

provisions to protect a party from losses 

resulting from the default or 

nonperformance of the obligors of the 

underlying exposures or from an 

insufficiency in the value of the 

collateral backing the underlying 

exposures. Credit-enhancing 

representations and warranties do not 

include: 

(1) Early default clauses and similar 

warranties that permit the return of, or 

premium refund clauses that cover, 

first-lien residential mortgage exposures 

for a period not to exceed 120 days from 

the date of transfer, provided that the 

date of transfer is within one year of 

origination of the residential mortgage 

exposure; 

(2) Premium refund clauses that cover 

underlying exposures guaranteed, in 

whole or in part, by the U.S. 

government, a U.S. government agency, 

or a U.S. government sponsored 

enterprise, provided that the clauses are 

for a period not to exceed 120 days from 

the date of transfer; or 

(3) Warranties that permit the return 

of underlying exposures in instances of 

misrepresentation, fraud, or incomplete 

documentation. 

Credit risk mitigant means collateral, 

a credit derivative, or a guarantee. 

Credit-risk-weighted assets means 

1.06 multiplied by the sum of: 

(1) Total wholesale and retail riskweighted assets; 

(2) Risk-weighted assets for 

securitization exposures; and 

(3) Risk-weighted assets for equity 

exposures. 

Current exposure means, with respect 

to a netting set, the larger of zero or the 

market value of a transaction or 

portfolio of transactions within the 

netting set that would be lost upon 

default of the counterparty, assuming no 

recovery on the value of the 

transactions. Current exposure is also 

called replacement cost. 

Default—(1) Retail. (i) A retail 

exposure of a [bank] is in default if: 

(A) The exposure is 180 days past 

due, in the case of a residential 

mortgage exposure or revolving 

exposure; 

(B) The exposure is 120 days past due, 

in the case of all other retail exposures; 

or 

(C) The [bank] has taken a full or 

partial charge-off or write-down of 

principal on the exposure for creditrelated reasons. 

(ii) A retail exposure in default 

remains in default until the [bank] has 

reasonable assurance of repayment and 

performance for all contractual 

principal and interest payments on the 

exposure. 

(2) Wholesale. (i) A [bank]’s obligor is 

in default if, for any wholesale exposure 

of the [bank] to the obligor, the [bank] 

has: 

(A) Placed the exposure on nonaccrual status consistent with the Call 

Report Instructions or the TFR and the 

TFR Instruction Manual; 

(B) Taken a full or partial charge-off 

or write-down on the exposure due to 

the distressed financial condition of the 

obligor; or 

(C) Incurred a credit-related loss of 5 

percent or more of the exposure’s initial 

carrying value in connection with the 

sale of the exposure or the transfer of 

the exposure to the held-for-sale, 

available-for-sale, trading account, or 

other reporting category. 

(ii) An obligor in default remains in 

default until the [bank] has reasonable 

assurance of repayment and 

performance for all contractual 

principal and interest payments on all 

exposures of the [bank] to the obligor 

(other than exposures that have been 

fully written-down or charged-off). 

Dependence means a measure of the 

association among operational losses 

across and within business lines and 

operational loss event types. 

Depository institution is defined in 

section 3 of the Federal Deposit 

Insurance Act (12 U.S.C. 1813). 

Derivative contract means a financial 

contract whose value is derived from 

the values of one or more underlying 

assets, reference rates, or indices of asset 

values or reference rates. Derivative 

contracts include interest rate derivative 

contracts, exchange rate derivative 

contracts, equity derivative contracts, 

commodity derivative contracts, credit 

derivatives, and any other instrument 

that poses similar counterparty credit 

risks. Derivative contracts also include 

unsettled securities, commodities, and 

foreign exchange transactions with a 

contractual settlement or delivery lag 

that is longer than the lesser of the 

market standard for the particular 

instrument or 5 business days. 

Early amortization provision means a 

provision in the documentation 

governing a securitization that, when 

triggered, causes investors in the 

securitization exposures to be repaid 

before the original stated maturity of the 

securitization exposures, unless the 

provision is triggered solely by events 

not directly related to the performance 

of the underlying exposures or the 

originating [bank] (such as material 


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55914 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

changes in tax laws or regulations). An 

early amortization provision is a 

controlled early amortization provision 

if it meets all the following conditions: 

(1) The originating [bank] has 

appropriate policies and procedures to 

ensure that it has sufficient capital and 

liquidity available in the event of an 

early amortization; 

(2) Throughout the duration of the 

securitization (including the early 

amortization period), there is the same 

pro rata sharing of interest, principal, 

expenses, losses, fees, recoveries, and 

other cash flows from the underlying 

exposures based on the originating 

[bank]’s and the investors’ relative 

shares of the underlying exposures 

outstanding measured on a consistent 

monthly basis; 

(3) The amortization period is 

sufficient for at least 90 percent of the 

total underlying exposures outstanding 

at the beginning of the early 

amortization period to be repaid or 

recognized as in default; and 

(4) The schedule for repayment of 

investor principal is not more rapid 

than would be allowed by straight-line 

amortization over an 18-month period. 

Economic downturn conditions 

means, with respect to an exposure, 

those conditions in which the aggregate 

default rates for the exposure’s 

wholesale or retail exposure subcategory 

(or subdivision of such subcategory 

selected by the [bank]) in the exposure’s 

national jurisdiction (or subdivision of 

such jurisdiction selected by the [bank]) 

are significantly higher than average. 

Effective maturity (M) of a wholesale 

exposure means: 

(1) For wholesale exposures other 

than repo-style transactions, eligible 

margin loans, and OTC derivative 

contracts subject to a qualifying master 

netting agreement: 

(i) The weighted-average remaining 

maturity (measured in years, whole or 

fractional) of the expected contractual 

cash flows from the exposure, using the 

undiscounted amounts of the cash flows 

as weights; or 

(ii) The nominal remaining maturity 

(measured in years, whole or fractional) 

of the exposure. 

(2) For repo-style transactions, eligible 

margin loans, and OTC derivative 

contracts subject to a qualifying master 

netting agreement, the weighted-average 

remaining maturity (measured in years, 

whole or fractional) of the individual 

transactions subject to the qualifying 

master netting agreement, with the 

weight of each individual transaction 

set equal to the notional amount of the 

transaction. 

Effective notional amount means, for 

an eligible guarantee or eligible credit 

derivative, the lesser of the contractual 

notional amount of the credit risk 

mitigant and the EAD of the hedged 

exposure, multiplied by the percentage 

coverage of the credit risk mitigant. For 

example, the effective notional amount 

of an eligible guarantee that covers, on 

a pro rata basis, 40 percent of any losses 

on a $100 bond would be $40. 

Eligible clean-up call means a cleanup call that: 

(1) Is exercisable solely at the 

discretion of the servicer; 

(2) Is not structured to avoid 

allocating losses to securitization 

exposures held by investors or 

otherwise structured to provide credit 

enhancement to the securitization; and 

(3) (i) For a traditional securitization, 

is only exercisable when 10 percent or 

less of the principal amount of the 

underlying exposures or securitization 

exposures (determined as of the 

inception of the securitization) is 

outstanding; or 

(ii) For a synthetic securitization, is 

only exercisable when 10 percent or less 

of the principal amount of the reference 

portfolio of underlying exposures 

(determined as of the inception of the 

securitization) is outstanding. 

Eligible credit derivative means a 

credit derivative in the form of a credit 

default swap, nth-to-default swap, or 

total return swap provided that: 

(1) The contract meets the 

requirements of an eligible guarantee 

and has been confirmed by the 

protection purchaser and the protection 

provider; 

(2) Any assignment of the contract has 

been confirmed by all relevant parties; 

(3) If the credit derivative is a credit 

default swap or nth-to-default swap, the 

contract includes the following credit 

events: 

(i) Failure to pay any amount due 

under the terms of the reference 

exposure (with a grace period that is 

closely in line with the grace period of 

the reference exposure); and 

(ii) Bankruptcy, insolvency, or 

inability of the obligor on the reference 

exposure to pay its debts, or its failure 

or admission in writing of its inability 

generally to pay its debts as they 

become due, and similar events; 

(4) The terms and conditions dictating 

the manner in which the contract is to 

be settled are incorporated into the 

contract; 

(5) If the contract allows for cash 

settlement, the contract incorporates a 

robust valuation process to estimate loss 

reliably and specifies a reasonable 

period for obtaining post-credit event 

valuations of the reference exposure; 

(6) If the contract requires the 

protection purchaser to transfer an 

exposure to the protection provider at 

settlement, the terms of the exposure 

provide that any required consent to 

transfer may not be unreasonably 

withheld; 

(7) If the credit derivative is a credit 

default swap or nth-to-default swap, the 

contract clearly identifies the parties 

responsible for determining whether a 

credit event has occurred, specifies that 

this determination is not the sole 

responsibility of the protection 

provider, and gives the protection 

purchaser the right to notify the 

protection provider of the occurrence of 

a credit event; and 

(8) If the credit derivative is a total 

return swap and the [bank] records net 

payments received on the swap as net 

income, the [bank] records offsetting 

deterioration in the value of the hedged 

exposure (either through reductions in 

fair value or by an addition to reserves). 

Eligible credit reserves means all 

general allowances that have been 

established through a charge against 

earnings to absorb credit losses 

associated with on-or off-balance sheet 

wholesale and retail exposures, 

including the allowance for loan and 

lease losses (ALLL) associated with such 

exposures but excluding allocated 

transfer risk reserves established 

pursuant to 12 U.S.C. 3904 and other 

specific reserves created against 

recognized losses. 

Eligible double default guarantor, 

with respect to a guarantee or credit 

derivative obtained by a [bank], means: 

(1) U.S.-based entities. A depository 

institution, a bank holding company (as 

defined in section 2 of the Bank Holding 

Company Act (12 U.S.C. 1841)), a 

savings and loan holding company (as 

defined in 12 U.S.C. 1467a) provided all 

or substantially all of the holding 

company’s activities are permissible for 

a financial holding company under 12 

U.S.C. 1843(k), a securities broker or 

dealer registered (under the Securities 

Exchange Act of 1934) with the SEC, an 

insurance company in the business of 

providing credit protection (such as a 

monoline bond insurer or re-insurer) 

that is subject to supervision by a State 

insurance regulator, if: 

(i) At the time the guarantor issued 

the guarantee or credit derivative, the 

[bank] assigned a PD to the guarantor’s 

rating grade that was equal to or lower 

than the PD associated with a long-term 

external rating in the third-highest 

investment grade rating category; and 

(ii) The [bank] currently assigns a PD 

to the guarantor’s rating grade that is 

equal to or lower than the PD associated 

with a long-term external rating in the 

lowest investment grade rating category; 

or 


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2This requirement is met where all transactions 

under the agreement are (i) executed under U.S. law 

and (ii) constitute ‘‘securities contracts’’ or 

‘‘repurchase agreements’’ under section 555 or 559, 

respectively, of the Bankruptcy Code (11 U.S.C. 

555), qualified financial contracts under section 

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

U.S.C. 1821(e)(8)), or netting contracts between or 

among financial institutions under sections 401–

407 of the Federal Deposit Insurance Corporation 

Improvement Act of 1991 (12 U.S.C. 4401–4407) or 

the Federal Reserve Board’s Regulation EE (12 CFR 

part 231). 

3 Intercompany accounts receivable and 

receivables subject to contra-accounts between 

firms that buy and sell to each other do not satisfy 

this criterion. 

(2) Non-U.S.-based entities. A foreign 

bank (as defined in section 211.2 of the 

Federal Reserve Board’s Regulation K 

(12 CFR 211.2)), a non-U.S. securities 

firm, or a non-U.S. based insurance 

company in the business of providing 

credit protection, if: 

(i) The [bank] demonstrates that the 

guarantor is subject to consolidated 

supervision and regulation comparable 

to that imposed on U.S. depository 

institutions, securities broker-dealers, or 

insurance companies (as the case may 

be) or has issued and outstanding an 

unsecured long-term debt security 

without credit enhancement that has a 

long-term applicable external rating in 

one of the three highest investment 

grade rating categories; 

(ii) At the time the guarantor issued 

the guarantee or credit derivative, the 

[bank] assigned a PD to the guarantor’s 

rating grade that was equal to or lower 

than the PD associated with a long-term 

external rating in the third-highest 

investment grade rating category; and 

(iii) The [bank] currently assigns a PD 

to the guarantor’s rating grade that is 

equal to or lower than the PD associated 

with a long-term external rating in the 

lowest investment grade rating category. 

Eligible guarantee means a guarantee 

that: 

(1) Is written and unconditional; 

(2) Covers all or a pro rata portion of 

all contractual payments of the obligor 

on the reference exposure; 

(3) Gives the beneficiary a direct 

claim against the protection provider; 

(4) Is non-cancelable by the protection 

provider for reasons other than the 

breach of the contract by the 

beneficiary; 

(5) Is legally enforceable against the 

protection provider in a jurisdiction 

where the protection provider has 

sufficient assets against which a 

judgment may be attached and enforced; 

and 

(6) Requires the protection provider to 

make payment to the beneficiary on the 

occurrence of a default (as defined in 

the guarantee) of the obligor on the 

reference exposure without first 

requiring the beneficiary to demand 

payment from the obligor. 

Eligible margin loan means an 

extension of credit where: 

(1) The extension of credit is 

collateralized exclusively by debt or 

equity securities that are liquid and 

readily marketable; 

(2) The collateral is marked to market 

daily, and the transaction is subject to 

daily margin maintenance requirements; 

(3) The extension of credit is 

conducted under an agreement that 

provides the [bank] the right to 

accelerate and terminate the extension 

of credit and to liquidate or set off 

collateral promptly upon an event of 

default (including upon an event of 

bankruptcy, insolvency, or similar 

proceeding) of the counterparty, 

provided that, in any such case, any 

exercise of rights under the agreement 

will not be stayed or avoided under 

applicable law in the relevant 

jurisdictions;2 and 

(4) The [bank] has conducted and 

documented sufficient legal review to 

conclude with a well-founded basis that 

the agreement meets the requirements of 

paragraph (3) of this definition and is 

legal, valid, binding, and enforceable 

under applicable law in the relevant 

jurisdictions. 

Eligible operational risk offsets means 

amounts, not to exceed expected 

operational loss, that: 

(1) Are generated by internal business 

practices to absorb highly predictable 

and reasonably stable operational losses, 

including reserves calculated consistent 

with GAAP; and 

(2) Are available to cover expected 

operational losses with a high degree of 

certainty over a one-year horizon. 

Eligible purchased wholesale 

receivable means a purchased wholesale 

receivable that: 

(1) The [bank] purchased from an 

unaffiliated seller and did not directly 

or indirectly originate; 

(2) Was generated on an arm’s-length 

basis between the seller and the 

obligor;3

(3) Provides the [bank] with a claim 

on all proceeds from the receivable or a 

pro-rata interest in the proceeds from 

the receivable; and 

(4) Has an M of less than one year. 

Eligible securitization guarantor 

means: 

(1) A sovereign entity, the Bank for 

International Settlements, the 

International Monetary Fund, the 

European Central Bank, the European 

Commission, a Federal Home Loan 

Bank, Federal Agricultural Mortgage 

Corporation (Farmer Mac), a multilateral development bank, a depository 

institution, a bank holding company (as 

defined in section 2 of the Bank Holding 

Company Act (12 U.S.C. 1841)), a 

savings and loan holding company (as 

defined in 12 U.S.C. 1467a) provided all 

or substantially all of the holding 

company’s activities are permissible for 

a financial holding company under 12 

U.S.C. 1843(k), a foreign bank (as 

defined in section 211.2 of the Federal 

Reserve Board’s Regulation K (12 CFR 

211.2)), or a securities firm; 

(2) Any other entity (other than an 

SPE) that has issued and outstanding an 

unsecured long-term debt security 

without credit enhancement that has a 

long-term applicable external rating in 

one of the three highest investment 

grade rating categories; or 

(3) Any other entity (other than an 

SPE) that has a PD assigned by the 

[bank] that is lower than or equal to the 

PD associated with a long-term external 

rating in the third highest investment 

grade rating category. 

Eligible servicer cash advance facility 

means a servicer cash advance facility 

in which: 

(1) The servicer is entitled to full 

reimbursement of advances, except that 

a servicer may be obligated to make 

non-reimbursable advances for a 

particular underlying exposure if any 

such advance is contractually limited to 

an insignificant amount of the 

outstanding principal balance of that 

exposure; 

(2) The servicer’s right to 

reimbursement is senior in right of 

payment to all other claims on the cash 

flows from the underlying exposures of 

the securitization; and 

(3) The servicer has no legal 

obligation to, and does not, make 

advances to the securitization if the 

servicer concludes the advances are 

unlikely to be repaid. 

Equity derivative contract means an 

equity-linked swap, purchased equitylinked option, forward equity-linked 

contract, or any other instrument linked 

to equities that gives rise to similar 

counterparty credit risks. 

Equity exposure means: 

(1) A security or instrument (whether 

voting or non-voting) that represents a 

direct or indirect ownership interest in, 

and a residual claim on, the assets and 

income of a company, unless: 

(i) The issuing company is 

consolidated with the [bank] under 

GAAP; 

(ii) The [bank] is required to deduct 

the ownership interest from tier 1 or tier 

2 capital under this appendix; 

(iii) The ownership interest is 

redeemable; 

(iv) The ownership interest 

incorporates a payment or other similar 

obligation on the part of the issuing 


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55916 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

company (such as an obligation to pay 

periodic interest); or 

(v) The ownership interest is a 

securitization exposure; 

(2) A security or instrument that is 

mandatorily convertible into a security 

or instrument described in paragraph (1) 

of this definition; 

(3) An option or warrant that is 

exercisable for a security or instrument 

described in paragraph (1) of this 

definition; or 

(4) Any other security or instrument 

(other than a securitization exposure) to 

the extent the return on the security or 

instrument is based on the performance 

of a security or instrument described in 

paragraph (1) of this definition. 

Excess spread for a period means: 

(1) Gross finance charge collections 

and other income received by a 

securitization SPE (including market 

interchange fees) over a period minus 

interest paid to the holders of the 

securitization exposures, servicing fees, 

charge-offs, and other senior trust or 

similar expenses of the SPE over the 

period; divided by 

(2) The principal balance of the 

underlying exposures at the end of the 

period. 

Exchange rate derivative contract 

means a cross-currency interest rate 

swap, forward foreign-exchange 

contract, currency option purchased, or 

any other instrument linked to exchange 

rates that gives rise to similar 

counterparty credit risks. 

Excluded mortgage exposure means: 

(1) Any one-to-four family residential 

pre-sold construction loan or 

multifamily residential loan that would 

receive a 50 percent risk weight under 

section 618(a)(1) or (b)(1) of the 

Resolution Trust Corporation 

Refinancing, Restructuring, and 

Improvement Act of 1991 (RTCRRI Act) 

and under 12 CFR part 3, Appendix A, 

section 3(a)(3)(iii) (for national banks), 

12 CFR part 208, Appendix A, section 

III.C.3. (for state member banks), 12 CFR 

part 225, Appendix A, section III.C.3. 

(for bank holding companies), 12 CFR 

part 325, Appendix A, section II.C.a. (for 

state nonmember banks), or 12 CFR 

567.6(a)(1)(iii) and (iv) (for savings 

associations); and 

(2) Any one-to-four family residential 

pre-sold construction loan for a 

residence for which the purchase 

contract is cancelled that would receive 

a 100 percent risk weight under section 

618(a)(2) of the RTCRRI Act and under 

12 CFR part 3, Appendix A, section 

3(a)(3)(iii) (for national banks), 12 CFR 

part 208, Appendix A, section III.C.3. 

(for state member banks), 12 CFR part 

225, Appendix A, section III.C.3. (for 

bank holding companies), 12 CFR part 

325, Appendix A, section II.C.a. (for 

state nonmember banks), or 12 CFR 

567.6(a)(1)(iii) and (iv) (for savings 

associations). 

Expected credit loss (ECL) means, for 

a wholesale exposure to a non-defaulted 

obligor or segment of non-defaulted 

retail exposures, the product of PD 

times ELGD times EAD for the exposure 

or segment. ECL for a wholesale 

exposure to a defaulted obligor or 

segment of defaulted retail exposures is 

equal to the [bank]’s impairment 

estimate for allowance purposes for the 

exposure or segment. Total ECL is the 

sum of expected credit losses for all 

wholesale and retail exposures other 

than exposures for which the [bank] has 

applied the double default treatment in 

section 34. 

Expected exposure (EE) means the 

expected value of the probability 

distribution of credit risk exposures to 

a counterparty at any specified future 

date before the maturity date of the 

longest term transaction in the netting 

set. 

Expected loss given default (ELGD) 

means: 

(1) For a wholesale exposure, the 

[bank]’s empirically based best estimate 

of the default-weighted average 

economic loss, per dollar of EAD, the 

[bank] expects to incur in the event that 

the obligor of the exposure (or a typical 

obligor in the loss severity grade 

assigned by the [bank] to the exposure) 

defaults within a one-year horizon over 

a mix of economic conditions, including 

economic downturn conditions. 

(2) For a segment of retail exposures, 

the [bank]’s empirically based best 

estimate of the default-weighted average 

economic loss, per dollar of EAD, the 

[bank] expects to incur on exposures in 

the segment that default within a oneyear horizon over a mix of economic 

conditions (including economic 

downturn conditions). 

(3) The economic loss on an exposure 

in the event of default is all material 

credit-related losses on the exposure 

(including accrued but unpaid interest 

or fees, losses on the sale of collateral, 

direct workout costs, and an appropriate 

allocation of indirect workout costs). 

Where positive or negative cash flows 

on a wholesale exposure to a defaulted 

obligor or a defaulted retail exposure 

(including proceeds from the sale of 

collateral, workout costs, and drawdowns of unused credit lines) occur 

after the date of default, the economic 

loss must reflect the net present value 

of cash flows as of the default date using 

a discount rate appropriate to the risk of 

the defaulted exposure. 

Expected operational loss (EOL) 

means the expected value of the 

distribution of potential aggregate 

operational losses, as generated by the 

[bank]’s operational risk quantification 

system using a one-year horizon. 

Expected positive exposure (EPE) 

means the weighted average over time of 

expected (non-negative) exposures to a 

counterparty where the weights are the 

proportion of the time interval that an 

individual expected exposure 

represents. When calculating the 

minimum capital requirement, the 

average is taken over a one-year horizon. 

Exposure at default (EAD). 

(1) For the on-balance sheet 

component of a wholesale or retail 

exposure (other than an OTC derivative 

contract, repo-style transaction, or 

eligible margin loan), EAD means: 

(i) If the exposure is held-to-maturity 

or for trading, the [bank]’s carrying 

value (including net accrued but unpaid 

interest and fees) for the exposure less 

any allocated transfer risk reserve for 

the exposure; or 

(ii) If the exposure is available-forsale, the [bank]’s carrying value 

(including net accrued but unpaid 

interest and fees) for the exposure less 

any allocated transfer risk reserve for 

the exposure, less any unrealized gains 

on the exposure, and plus any 

unrealized losses on the exposure. 

(2) For the off-balance sheet 

component of a wholesale or retail 

exposure (other than an OTC derivative 

contract, repo-style transaction, or 

eligible margin loan) in the form of a 

loan commitment or line of credit, EAD 

means the [bank]’s best estimate of net 

additions to the outstanding amount 

owed the [bank], including estimated 

future additional draws of principal and 

accrued but unpaid interest and fees, 

that are likely to occur over the 

remaining life of the exposure assuming 

the exposure were to go into default. 

This estimate of net additions must 

reflect what would be expected during 

economic downturn conditions. 

(3) For the off-balance sheet 

component of a wholesale or retail 

exposure (other than an OTC derivative 

contract, repo-style transaction, or 

eligible margin loan) in the form of 

anything other than a loan commitment 

or line of credit, EAD means the 

notional amount of the exposure. 

(4) EAD for a segment of retail 

exposures is the sum of the EADs for 

each individual exposure in the 

segment. 

(5) EAD for OTC derivative contracts, 

repo-style transactions, and eligible 

margin loans is calculated as described 

in section 32. 

(6) For wholesale or retail exposures 

in which only the drawn balance has 

been securitized, the [bank] must reflect 


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Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55917 

4The 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. 

its share of the exposures’ undrawn 

balances in EAD. Undrawn balances of 

exposures for which the drawn balances 

have been securitized must be allocated 

between the seller’s and investors’

interests on a pro rata basis, based on 

the proportions of the seller’s and 

investors’ shares of the securitized 

drawn balances. 

Exposure category means any of the 

wholesale, retail, securitization, or 

equity exposure categories. 

External operational loss event data 

means, with respect to a [bank], gross 

operational loss amounts, dates, 

recoveries, and relevant causal 

information for operational loss events 

occurring at organizations other than the 

[bank]. 

External rating means a credit rating 

that is assigned by an NRSRO to an 

exposure, provided: 

(1) The credit rating fully reflects the 

entire amount of credit risk with regard 

to all payments owed to the holder of 

the exposure. If a holder is owed 

principal and interest on an exposure, 

the credit rating must fully reflect the 

credit risk associated with timely 

repayment of principal and interest. If a 

holder is owed only principal on an 

exposure, the credit rating must fully 

reflect only the credit risk associated 

with timely repayment of principal; and 

(2) The credit rating is published in 

an accessible form and is or will be 

included in the transition matrices 

made publicly available by the NRSRO 

that summarize the historical 

performance of positions rated by the 

NRSRO. 

Financial collateral means collateral: 

(1) In the form of: 

(i) Cash on deposit with the [bank] 

(including cash held for the [bank] by a 

third-party custodian or trustee); 

(ii) Gold bullion; 

(iii) Long-term debt securities that 

have an applicable external rating of one 

category below investment grade or 

higher; 

(iv) Short-term debt instruments that 

have an applicable external rating of at 

least investment grade; 

(v) Equity securities that are publicly 

traded; 

(vi) Convertible bonds that are 

publicly traded; or 

(vii) Money market mutual fund 

shares and other mutual fund shares if 

a price for the shares is publicly quoted 

daily; and 

(2) In which the [bank] has a 

perfected, first priority security interest 

or the legal equivalent thereof. 

GAAP means U.S. generally accepted 

accounting principles. 

Gain-on-sale means an increase in the 

equity capital (as reported on Schedule 

RC of the Call Report, schedule HC of 

the FR Y–9C Report, or Schedule SC of 

the Thrift Financial Report) of a [bank] 

that results from a securitization (other 

than an increase in equity capital that 

results from the [bank]’s receipt of cash 

in connection with the securitization). 

Guarantee means a financial 

guarantee, letter of credit, insurance, or 

other similar financial instrument (other 

than a credit derivative) that allows one 

party (beneficiary) to transfer the credit 

risk of one or more specific exposures 

(reference exposure) to another party 

(protection provider). See also eligible 

guarantee. 

High volatility commercial real estate 

(HVCRE) exposure means a credit 

facility that finances or has financed the 

acquisition, development, or 

construction (ADC) of real property, 

unless the facility finances: 

(1) One-to four-family residential 

properties; or 

(2) Commercial real estate projects in 

which: 

(i) The loan-to-value ratio is less than 

or equal to the applicable maximum 

supervisory loan-to-value ratio in the 

[AGENCY]’s real estate lending 

standards at 12 CFR part 34, Subpart D 

(OCC); 12 CFR part 208, Appendix C 

(Board); 12 CFR part 365, Subpart D 

(FDIC); and 12 CFR 560.100–560.101 

(OTS); 

(ii) The borrower has contributed 

capital to the project in the form of cash 

or unencumbered readily marketable 

assets (or has paid development 

expenses out-of-pocket) of at least 15 

percent of the real estate’s appraised ‘‘as 

completed’’ value; and 

(iii) The borrower contributed the 

amount of capital required by paragraph 

(2)(ii) of this definition before the [bank] 

advances funds under the credit facility, 

and the capital contributed by the 

borrower, or internally generated by the 

project, is contractually required to 

remain in the project throughout the 

life 4 of the project. 

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, whenissued securities, or any other 

instrument linked to interest rates that 

gives rise to similar counterparty credit 

risks. 

Internal operational loss event data 

means, with respect to a [bank], gross 

operational loss amounts, dates, 

recoveries, and relevant causal 

information for operational loss events 

occurring at the [bank]. 

Investing [bank] means, with respect 

to a securitization, a [bank] that assumes 

the credit risk of a securitization 

exposure (other than an originating 

[bank] of the securitization). In the 

typical synthetic securitization, the 

investing [bank] sells credit protection 

on a pool of underlying exposures to the 

originating [bank]. 

Investment fund means a company: 

(1) All or substantially all of the assets 

of which are financial assets; and 

(2) That has no material liabilities. 

Investors’ interest EAD means, with 

respect to a securitization, the EAD of 

the underlying exposures multiplied by 

the ratio of: 

(1) The total amount of securitization 

exposures issued by the SPE to 

investors; divided by 

(2) The outstanding principal amount 

of underlying exposures. 

Loss given default (LGD) means: 

(1) For a wholesale exposure: 

(i) If the [bank] has received prior 

written approval from [AGENCY] to use 

internal estimates of LGD for the 

exposure’s wholesale exposure 

subcategory, the greater of: 

(A) The [bank]’s ELGD for the 

exposure (or for the typical exposure in 

the loss severity grade assigned by the 

[bank] to the exposure); or 

(B) The [bank]’s empirically based 

best estimate of the economic loss, per 

dollar of EAD, the [bank] would expect 

to incur if the obligor (or a typical 

obligor in the loss severity grade 

assigned by the [bank] to the exposure) 

were to default within a one-year 

horizon during economic downturn 

conditions. 

(ii) If the [bank] has not received such 

prior approval, 

(A) For an exposure that is not a repostyle transaction, eligible margin loan, 

or OTC derivative contract, the sum of: 

(1) 0.08; and 


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55918 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

5Retail credit card losses arising from noncontractual, 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. 

(2) 0.92 multiplied by the [bank]’s 

ELGD for the exposure (or for the typical 

exposure in the loss severity grade 

assigned by the [bank] to the exposure); 

or 

(B) For an exposure that is a repostyle transaction, eligible margin loan, 

or OTC derivative contract, the [bank]’s 

ELGD for the exposure (or for the typical 

exposure in the loss severity grade 

assigned by the [bank] to the exposure). 

(2) For a segment of retail exposures: 

(i) If the [bank] has received prior 

written approval from [AGENCY] to use 

internal estimates of LGD for the 

segment’s retail exposure subcategory, 

the greater of: 

(A) The [bank]’s ELGD for the segment 

of exposures; or 

(B) The [bank]’s empirically based 

best estimate of the economic loss, per 

dollar of EAD, the [bank] would expect 

to incur on exposures in the segment 

that default within a one-year horizon 

during economic downturn conditions. 

(ii) If the [bank] has not received such 

prior approval, 

(A) For a segment of exposures that 

are not eligible margin loans, the sum 

of: 

(1) 0.08; and 

(2) 0.92 multiplied by the [bank]’s 

ELGD for the segment of exposures; or 

(B) For a segment of exposures that 

are eligible margin loans, the [bank]’s 

ELGD for the segment of exposures. 

(3) In approving a [bank]’s use of 

internal estimates of LGD for a 

wholesale or retail exposure 

subcategory, [AGENCY] will consider 

whether: 

(A) The [bank]’s internal estimates of 

LGD are reliable and sufficiently 

reflective of economic downturn 

conditions; and 

(B) The [bank] has rigorous and welldocumented policies and procedures for 

identifying economic downturn 

conditions for the exposure subcategory, 

identifying material adverse correlations 

between the relevant drivers of default 

rates and loss rates given default, and 

incorporating identified correlations 

into internal LGD estimates. 

(4) The economic loss on an exposure 

in the event of default is all material 

credit-related losses on the exposure 

(including accrued but unpaid interest 

or fees, losses on the sale of collateral, 

direct workout costs, and an appropriate 

allocation of indirect workout costs). 

Where positive or negative cash flows 

on a wholesale exposure to a defaulted 

obligor or a defaulted retail exposure 

(including proceeds from the sale of 

collateral, workout costs, and drawdowns of unused credit lines) occur 

after the date of default, the economic 

loss must reflect the net present value 

of cash flows as of the default date using 

a discount rate appropriate to the risk of 

the defaulted exposure. 

Main index means the Standard & 

Poor’s 500 Index, the FTSE All-World 

Index, and any other index for which 

the [bank] can demonstrate to the 

satisfaction of [AGENCY] that the 

equities represented in the index have 

comparable liquidity, depth of market, 

and size of bid-ask spreads as equities 

in the Standard & Poor’s 500 Index and 

FTSE All-World Index. 

Multi-lateral development bank 

means any multi-lateral lending 

institution or regional development 

bank in which the U.S. government is a 

shareholder or contributing member. 

Nationally recognized statistical 

rating organization (NRSRO) means an 

entity recognized by the Division of 

Market Regulation (or any successor 

division) of the SEC as a nationally 

recognized statistical rating organization 

for various purposes, including the 

SEC’s net capital requirements for 

securities broker-dealers. 

Netting set means a group of 

transactions with a single counterparty 

that are subject to a qualifying master 

netting agreement or qualifying crossproduct master netting agreement. Each 

transaction that is not subject to such a 

master netting agreement is its own 

netting set. 

Nth-to-default credit derivative means 

a credit derivative that provides credit 

protection only for the nth-defaulting 

reference exposure in a group of 

reference exposures. 

Operational loss means a loss 

(excluding insurance or tax effects) 

resulting from an operational loss event. 

Operational loss includes all expenses 

associated with an operational loss 

event except for opportunity costs, 

forgone revenue, and costs related to 

risk management and control 

enhancements implemented to prevent 

future operational losses. 

Operational loss event means an event 

that results in loss and is associated 

with internal fraud; external fraud; 5

employment practices and workplace 

safety; clients, products, and business 

practices; damage to physical assets; 

business disruption and system failures; 

or execution, delivery, and process 

management. 

Operational risk means the risk of loss 

resulting from inadequate or failed 

internal processes, people, and systems 

or from external events (including legal 

risk but excluding strategic and 

reputational risk). 

Operational risk exposure means the 

99.9th percentile of the distribution of 

potential aggregate operational losses, as 

generated by the [bank]’s operational 

risk quantification system over a oneyear horizon (and not incorporating 

eligible operational risk offsets or 

qualifying operational risk mitigants). 

Originating [bank], with respect to a 

securitization, means a [bank] that: 

(1) Directly or indirectly originated or 

securitized the underlying exposures 

included in the securitization; or 

(2) Serves as an ABCP program 

sponsor to the securitization. 

Other retail exposure means an 

exposure (other than a securitization 

exposure, an equity exposure, a 

residential mortgage exposure, an 

excluded mortgage exposure, a 

qualifying revolving exposure, or the 

residual value portion of a lease 

exposure) that is managed as part of a 

segment of exposures with 

homogeneous risk characteristics, not 

on an individual-exposure basis, and is 

either: 

(1) An exposure to an individual for 

non-business purposes; or 

(2) An exposure to an individual or 

company for business purposes if the 

[bank]’s consolidated business credit 

exposure to the individual or company 

is $1 million or less. 

Over-the-counter (OTC) derivative 

contract means a derivative contract 

that is not traded on an exchange that 

requires the daily receipt and payment 

of cash-variation margin. 

Parallel run period means a period of 

at least four consecutive quarters after 

adoption of the [bank]’s implementation 

plan and before the [bank]’s first floor 

period during which the [bank] 

complies with all the qualification 

requirements in section 22 to the 

satisfaction of the [AGENCY]. 

Probability of default (PD) means: 

(1) For a wholesale exposure to a nondefaulted obligor, the [bank]’s 

empirically based best estimate of the 

long-run average of one-year default 

rates for the rating grade assigned by the 

[bank] to the obligor, capturing the 

average default experience for obligors 

in a rating grade over a mix of economic 

conditions (including economic 

downturn conditions) sufficient to 

provide a reasonable estimate of the 

average one-year default rate over the 

economic cycle for the rating grade. 

(2) For a segment of non-defaulted 

retail exposures for which seasoning 

effects are not material, or for a segment 

of non-defaulted retail exposures in a 

retail exposure subcategory for which 

seasoning effects are not material, the 


sroberts on PROD1PC70 with PROPOSALS
Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55919 

6This requirement is met where all transactions 

under the agreement are (i) executed under U.S. law 

and (ii) constitute ‘‘securities contracts’’ or 

‘‘repurchase agreements’’ under section 555 or 559, 

respectively, of the Bankruptcy Code (11 U.S.C. 555 

or 559), qualified financial contracts under section 

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

U.S.C. 1821(e)(8)), or netting contracts between or 

among financial institutions under sections 401–

407 of the Federal Deposit Insurance Corporation 

Improvement Act of 1991 (12 U.S.C. 4401–4407) or 

the Federal Reserve Board’s Regulation EE (12 CFR 

part 231). 

[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 oneyear default rate over the economic 

cycle for the segment. 

(3) For any other segment of nondefaulted retail exposures, the [bank]’s 

empirically based best estimate of the 

annualized cumulative default rate over 

the expected remaining life of exposures 

in the segment, capturing the average 

default experience for exposures in the 

segment over a mix of economic 

conditions (including economic 

downturn conditions) sufficient to 

provide a reasonable estimate of the 

average performance over the economic 

cycle for the segment. 

(4) For a wholesale exposure to a 

defaulted obligor or segment of 

defaulted retail exposures, 100 percent. 

Protection amount (P) means, with 

respect to an exposure hedged by an 

eligible guarantee or eligible credit 

derivative, the effective notional amount 

of the guarantee or credit derivative as 

reduced to reflect any currency 

mismatch, maturity mismatch, or lack of 

restructuring coverage (as provided in 

section 33). 

Publicly traded means traded on: 

(1) Any exchange registered with the 

SEC as a national securities exchange 

under section 6 of the Securities 

Exchange Act of 1934 (15 U.S.C. 78f); or 

(2) Any non-U.S.-based securities 

exchange that: 

(i) Is registered with, or approved by, 

a national securities regulatory 

authority; and 

(ii) Provides a liquid, two-way market 

for the instrument in question, meaning 

that there are enough independent bona 

fide offers to buy and sell so that a sales 

price reasonably related to the last sales 

price or current bona fide competitive 

bid and offer quotations can be 

determined promptly and a trade can be 

settled at such a price within five 

business days. 

Qualifying central counterparty 

means a counterparty (for example, a 

clearing house) that: 

(1) Facilitates trades between 

counterparties in one or more financial 

markets by either guaranteeing trades or 

novating contracts; 

(2) Requires all participants in its 

arrangements to be fully collateralized 

on a daily basis; and 

(3) The [bank] demonstrates to the 

satisfaction of [AGENCY] is in sound 

financial condition and is subject to 

effective oversight by a national 

supervisory authority. 

Qualifying cross-product master 

netting agreement means a qualifying 

master netting agreement that provides 

for termination and close-out netting 

across multiple types of financial 

transactions or qualifying master netting 

agreements in the event of a 

counterparty’s default, provided that: 

(1) The underlying financial 

transactions are OTC derivative 

contracts, eligible margin loans, or repostyle transactions; and 

(2) The [bank] obtains a written legal 

opinion verifying the validity and 

enforceability of the agreement under 

applicable law of the relevant 

jurisdictions if the counterparty fails to 

perform upon an event of default, 

including upon an event of bankruptcy, 

insolvency, or similar proceeding. 

Qualifying master netting agreement 

means any written, legally enforceable 

bilateral agreement, provided that: 

(1) The agreement creates a single 

legal obligation for all individual 

transactions covered by the agreement 

upon an event of default, including 

bankruptcy, insolvency, or similar 

proceeding, of the counterparty; 

(2) The agreement provides the [bank] 

the right to accelerate, terminate, and 

close-out on a net basis all transactions 

under the agreement and to liquidate or 

set off collateral promptly upon an 

event of default, including upon an 

event of bankruptcy, insolvency, or 

similar proceeding, of the counterparty, 

provided that, in any such case, any 

exercise of rights under the agreement 

will not be stayed or avoided under 

applicable law in the relevant 

jurisdictions; 

(3) The [bank] has conducted and 

documented sufficient legal review to 

conclude with a well-founded basis 

that: 

(i) The agreement meets the 

requirements of paragraph (2) of this 

definition; and 

(ii) In the event of a legal challenge 

(including one resulting from default or 

from bankruptcy, insolvency, or similar 

proceeding) the relevant court and 

administrative authorities would find 

the agreement to be legal, valid, binding, 

and enforceable under the law of the 

relevant jurisdictions; 

(4) The [bank] establishes and 

maintains procedures to monitor 

possible changes in relevant law and to 

ensure that the agreement continues to 

satisfy the requirements of this 

definition; and 

(5) The agreement does not contain a 

walkaway clause (that is, a provision 

that permits a non-defaulting 

counterparty to make a lower payment 

than it would make otherwise under the 

agreement, or no payment at all, to a 

defaulter or the estate of a defaulter, 

even if the defaulter or the estate of the 

defaulter is a net creditor under the 

agreement). 

Qualifying revolving exposure (QRE) 

means an exposure (other than a 

securitization exposure or equity 

exposure) to an individual that is 

managed as part of a segment of 

exposures with homogeneous risk 

characteristics, not on an individualexposure 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 preestablished maximum amount); 

(2) Is unsecured and unconditionally 

cancelable by the [bank] to the fullest 

extent permitted by Federal law; and 

(3) Has a maximum exposure amount 

(drawn plus undrawn) of up to 

$100,000. 

Repo-style transaction means a 

repurchase or reverse repurchase 

transaction, or a securities borrowing or 

securities lending transaction, including 

a transaction in which the [bank] acts as 

agent for a customer and indemnifies 

the customer against loss, provided that: 

(1) The transaction is based solely on 

liquid and readily marketable securities 

or cash; 

(2) The transaction is marked-tomarket daily and subject to daily margin 

maintenance requirements; 

(3) The transaction is executed under 

an agreement that provides the [bank] 

the right to accelerate, terminate, and 

close-out the transaction on a net basis 

and to liquidate or set off collateral 

promptly upon an event of default 

(including upon an event of bankruptcy, 

insolvency, or similar proceeding) of the 

counterparty, provided that, in any such 

case, any exercise of rights under the 

agreement will not be stayed or avoided 

under applicable law in the relevant 

jurisdictions; 6 and 

(4) The [bank] has conducted and 

documented sufficient legal review to 

conclude with a well-founded basis that 

the agreement meets the requirements of 

paragraph (3) of this definition and is 

legal, valid, binding, and enforceable 


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under applicable law in the relevant 

jurisdictions. 

Residential mortgage exposure means 

an exposure (other than a securitization 

exposure, equity exposure, or excluded 

mortgage exposure) that is managed as 

part of a segment of exposures with 

homogeneous risk characteristics, not 

on an individual-exposure basis, and is: 

(1) An exposure that is primarily 

secured by a first or subsequent lien on 

one-to four-family residential property; 

or 

(2) An exposure with an original and 

outstanding amount of $1 million or less 

that is primarily secured by a first or 

subsequent lien on residential property 

that is not one-to four-family. 

Retail exposure means a residential 

mortgage exposure, a qualifying 

revolving exposure, or an other retail 

exposure. 

Retail exposure subcategory means 

the residential mortgage exposure, 

qualifying revolving exposure, or other 

retail exposure subcategory. 

Risk parameter means a variable used 

in determining risk-based capital 

requirements for wholesale and retail 

exposures, specifically probability of 

default (PD), expected loss given default 

(ELGD), loss given default (LGD), 

exposure at default (EAD), or effective 

maturity (M). 

Scenario analysis means a systematic 

process of obtaining expert opinions 

from business managers and risk 

management experts to derive reasoned 

assessments of the likelihood and loss 

impact of plausible high-severity 

operational losses. 

SEC means the U.S. Securities and 

Exchange Commission. 

Securitization means a traditional 

securitization or a synthetic 

securitization. 

Securitization exposure means: 

(1) An on-balance sheet or off-balance 

sheet credit exposure that arises from a 

traditional or synthetic securitization 

(including credit-enhancing 

representations and warranties); and 

(2) Mortgage-backed pass-through 

securities guaranteed by Fannie Mae or 

Freddie Mac. 

Senior securitization exposure means 

a securitization exposure that has a first 

priority claim on the cash flows from 

the underlying exposures, disregarding 

the claims of a service provider (such as 

a swap counterparty or trustee, 

custodian, or paying agent for the 

securitization) to fees from the 

securitization. A liquidity facility that 

supports an ABCP program is a senior 

securitization exposure if the liquidity 

facility provider’s right to 

reimbursement of the drawn amounts is 

senior to all claims on the cash flows 

from the underlying exposures except 

claims of a service provider to fees. 

Servicer cash advance facility means 

a facility under which the servicer of the 

underlying exposures of a securitization 

may advance cash to ensure an 

uninterrupted flow of payments to 

investors in the securitization, including 

advances made to cover foreclosure 

costs or other expenses to facilitate the 

timely collection of the underlying 

exposures. See also eligible servicer 

cash advance facility. 

Sovereign entity means a central 

government (including the U.S. 

government) or an agency, department, 

ministry, or central bank of a central 

government. 

Sovereign exposure means: 

(1) A direct exposure to a sovereign 

entity; or 

(2) An exposure directly and 

unconditionally backed by the full faith 

and credit of a sovereign entity. 

Special purpose entity (SPE) means a 

corporation, trust, or other entity 

organized for the specific purpose of 

holding underlying exposures of a 

securitization, the activities of which 

are limited to those appropriate to 

accomplish this purpose, and the 

structure of which is intended to isolate 

the underlying exposures held by the 

entity from the credit risk of the seller 

of the underlying exposures to the 

entity. 

Synthetic securitization means a 

transaction in which: 

(1) All or a portion of the credit risk 

of one or more underlying exposures is 

transferred to one or more third parties 

through the use of one or more credit 

derivatives or guarantees (other than a 

guarantee that transfers only the credit 

risk of an individual retail exposure); 

(2) The credit risk associated with the 

underlying exposures has been 

separated into at least two tranches 

reflecting different levels of seniority; 

(3) Performance of the securitization 

exposures depends upon the 

performance of the underlying 

exposures; and 

(4) All or substantially all of the 

underlying exposures are financial 

exposures (such as loans, commitments, 

credit derivatives, guarantees, 

receivables, asset-backed securities, 

mortgage-backed securities, other debt 

securities, or equity securities). 

Tier 1 capital is defined in [the 

general risk-based capital rules], as 

modified in part II of this appendix. 

Tier 2 capital is defined in [the 

general risk-based capital rules], as 

modified in part II of this appendix. 

Total qualifying capital means the 

sum of tier 1 capital and tier 2 capital, 

after all deductions required in this 

appendix. 

Total risk-weighted assets means: 

(1) The sum of: 

(i) Credit risk-weighted assets; and 

(ii) Risk-weighted assets for 

operational risk; minus 

(2) The sum of: 

(i) Excess eligible credit reserves not 

included in tier 2 capital; and 

(ii) Allocated transfer risk reserves. 

Total wholesale and retail riskweighted assets means the sum of riskweighted assets for wholesale exposures 

to non-defaulted obligors and segments 

of non-defaulted retail exposures; riskweighted assets for wholesale exposures 

to defaulted obligors and segments of 

defaulted retail exposures; riskweighted assets for assets not defined by 

an exposure category; and risk-weighted 

assets for non-material portfolios of 

exposures (all as determined in section 

31) and risk-weighted assets for 

unsettled transactions (as determined in 

section 35) minus the amounts deducted 

from capital pursuant to [the general 

risk-based capital rules] (excluding 

those deductions reversed in section 

12). 

Traditional securitization means a 

transaction in which: 

(1) All or a portion of the credit risk 

of one or more underlying exposures is 

transferred to one or more third parties 

other than through the use of credit 

derivatives or guarantees; 

(2) The credit risk associated with the 

underlying exposures has been 

separated into at least two tranches 

reflecting different levels of seniority; 

(3) Performance of the securitization 

exposures depends upon the 

performance of the underlying 

exposures; and 

(4) All or substantially all of the 

underlying exposures are financial 

exposures (such as loans, commitments, 

credit derivatives, guarantees, 

receivables, asset-backed securities, 

mortgage-backed securities, other debt 

securities, or equity securities). 

Tranche means all securitization 

exposures associated with a 

securitization that have the same 

seniority level. 

Underlying exposures means one or 

more exposures that have been 

securitized in a securitization 

transaction. 

Unexpected operational loss (UOL) 

means the difference between the 

[bank]’s operational risk exposure and 

the [bank]’s expected operational loss. 

Unit of measure means the level (for 

example, organizational unit or 

operational loss event type) at which the 

[bank]’s operational risk quantification 

system generates a separate distribution 

of potential operational losses. 


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Value-at-Risk (VaR) means the 

estimate of the maximum amount that 

the value of one or more exposures 

could decline due to market price or 

rate movements during a fixed holding 

period within a stated confidence 

interval. 

Wholesale exposure means a credit 

exposure to a company, individual, 

sovereign, or governmental entity (other 

than a securitization exposure, retail 

exposure, excluded mortgage exposure, 

or equity exposure). Examples of a 

wholesale exposure include: 

(1) A non-tranched guarantee issued 

by a [bank] on behalf of a company; 

(2) A repo-style transaction entered 

into by a [bank] with a company and 

any other transaction in which a [bank] 

posts collateral to a company and faces 

counterparty credit risk; 

(3) An exposure that the [bank] treats 

as a covered position under [the market 

risk rule] for which there is a 

counterparty credit risk charge in 

section 32; 

(4) A sale of corporate loans by a 

[bank] to a third party in which the 

[bank] retains full recourse; 

(5) An OTC derivative contract 

entered into by a [bank] with a 

company; 

(6) An exposure to an individual that 

is not managed by the [bank] as part of 

a segment of exposures with 

homogeneous risk characteristics; and 

(7) A commercial lease. 

Wholesale exposure subcategory 

means the HVCRE or non-HVCRE 

wholesale exposure subcategory. 

Section 3. Minimum Risk-Based Capital 

Requirements 

(a) Except as modified by paragraph 

(c) of this section or by section 23, each 

[bank] must meet a minimum ratio of: 

(1) Total qualifying capital to total 

risk-weighted assets of 8.0 percent; and 

(2) Tier 1 capital to total risk-weighted 

assets of 4.0 percent. 

(b) Each [bank] must hold capital 

commensurate with the level and nature 

of all risks to which the [bank] is 

exposed. 

(c) When a [bank] subject to [the 

market risk rule] calculates its riskbased capital requirements under this 

appendix, the [bank] must also refer to 

[the market risk rule] for supplemental 

rules to calculate risk-based capital 

requirements adjusted for market risk. 

Part II. Qualifying Capital 

Section 11. Additional Deductions 

(a) General. A [bank] that uses this 

appendix must make the same 

deductions from its tier 1 capital and 

tier 2 capital required in [the general 

risk-based capital rules], except that: 

(1) A [bank] is not required to deduct 

certain equity investments and CEIOs 

(as explained in more detail in section 

12); and 

(2) A [bank] also must make the 

deductions from capital required by 

paragraphs (b) and (c) of this section. 

(b) Deductions from tier 1 capital. A 

[bank] must deduct from tier 1 capital 

any gain-on-sale associated with a 

securitization exposure as provided in 

paragraph (a) of section 41 and 

paragraphs (a)(1), (c), (g)(1), and (h)(1) of 

section 42. 

(c) Deductions from tier 1 and tier 2 

capital. A [bank] must deduct the 

following exposures 50 percent from tier 

1 capital and 50 percent from tier 2 

capital. If the amount deductible from 

tier 2 capital exceeds the [bank]’s actual 

tier 2 capital, however, the [bank] must 

deduct the shortfall amount from tier 1 

capital. 

(1) Credit-enhancing interest-only 

strips (CEIOs). In accordance with 

paragraphs (a)(1) and (c) of section 42, 

any CEIO that does not constitute gainon-sale. 

(2) Non-qualifying securitization 

exposures. In accordance with 

paragraphs (a)(4) and (c) of section 42, 

any securitization exposure that does 

not qualify for the Ratings-Based 

Approach, Internal Assessment 

Approach, or the Supervisory Formula 

Approach under sections 43, 44, and 45, 

respectively. 

(3) Securitizations of non-IRB 

exposures. In accordance with 

paragraphs (c) and (g)(3) of section 42, 

certain exposures to a securitization any 

underlying exposure of which is not a 

wholesale exposure, retail exposure, 

securitization exposure, or equity 

exposure. 

(4) Low-rated securitization 

exposures. In accordance with section 

43 and paragraph (c) of section 42, any 

securitization exposure that qualifies for 

and must be deducted under the 

Ratings-Based Approach. 

(5) High-risk securitization exposures 

subject to the Supervisory Formula 

Approach. In accordance with 

paragraph (b) of section 45 and 

paragraph (c) of section 42, any 

securitization exposure that qualifies for 

the Supervisory Formula Approach and 

has a risk weight equal to 1,250 percent 

as calculated under the Supervisory 

Formula Approach. 

(6) Eligible credit reserves shortfall. In 

accordance with paragraph (a)(1) of 

section 13, any eligible credit reserves 

shortfall. 

(7) Certain failed capital markets 

transactions. In accordance with 

paragraph (e)(3) of section 35, the 

[bank]’s exposure on certain failed 

capital markets transactions. 

Section 12. Deductions and Limitations 

Not Required 

(a) Deduction of CEIOs. A [bank] is 

not required to make the deductions 

from capital for CEIOs in 12 CFR part 

3, Appendix A, § 2(c) (for national 

banks), 12 CFR part 208, Appendix A, 

§ II.B.1.e. (for state member banks), 12 

CFR part 225, Appendix A, § II.B.1.e. 

(for bank holding companies), 12 CFR 

part 325, Appendix A, § 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, § 2(c) (for 

national banks), 12 CFR part 208, 

Appendix A, § II.B.5. (for state member 

banks), 12 CFR part 225, Appendix A, 

§ II.B.5. (for bank holding companies), 

and 12 CFR part 325, Appendix A, 

§ II.B. (for state nonmember banks). 

Section 13. Eligible Credit Reserves 

(a) Comparison of eligible credit 

reserves to expected credit losses—(1) 

Shortfall of eligible credit reserves. If a 

[bank]’s eligible credit reserves are less 

than the [bank]’s total expected credit 

losses, the [bank] must deduct the 

shortfall amount 50 percent from tier 1 

capital and 50 percent from tier 2 

capital. If the amount deductible from 

tier 2 capital exceeds the [bank]’s actual 

tier 2 capital, the [bank] must deduct the 

excess amount from tier 1 capital. 

(2) Excess eligible credit reserves. If a 

[bank]’s eligible credit reserves exceed 

the [bank]’s total expected credit losses, 

the [bank] may include the excess 

amount in tier 2 capital to the extent 

that the excess amount does not exceed 

0.6 percent of the [bank]’s credit-riskweighted assets. 

(b) Treatment of allowance for loan 

and lease losses. Regardless of any 

provision to the contrary in [general 

risk-based capital rules], ALLL is 

included in tier 2 capital only to the 

extent provided in paragraph (a)(2) of 

this section and paragraph (b) of section 

23. 

Part III. Qualification 

Section 21. Qualification Process 

(a) Timing. (1) A [bank] that is 

described in paragraph (b)(1) of section 

1 must adopt a written implementation 

plan no later than six months after the 

later of the effective date of this 

appendix or the date the [bank] meets a 

criterion in that section. The plan must 

incorporate an explicit first floor period 


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55922 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

start date no later than 36 months after 

the later of the effective date of this 

appendix or the date the [bank] meets at 

least one criterion under paragraph 

(b)(1) of section 1. [AGENCY] may 

extend the first floor period start date. 

(2) A [bank] that elects to be subject 

to this appendix under paragraph (b)(2) 

of section 1 must adopt a written 

implementation plan and notify the 

[AGENCY] in writing of its intent at 

least 12 months before it proposes to 

begin its first floor period. 

(b) Implementation plan. The [bank]’s 

implementation plan must address in 

detail how the [bank] complies, or plans 

to comply, with the qualification 

requirements in section 22. The [bank] 

also must maintain a comprehensive 

and sound planning and governance 

process to oversee the implementation 

efforts described in the plan. At a 

minimum, the plan must: 

(1) Comprehensively address the 

qualification requirements in section 22 

for the [bank] and each consolidated 

subsidiary (U.S. and foreign-based) of 

the [bank] with respect to all portfolios 

and exposures of the [bank] and each of 

its consolidated subsidiaries; 

(2) Justify and support any proposed 

temporary or permanent exclusion of 

business lines, portfolios, or exposures 

from application of the advanced 

approaches in this appendix (which 

business lines, portfolios, and exposures 

must be, in the aggregate, immaterial to 

the [bank]); 

(3) Include the [bank]’s selfassessment of: 

(i) The [bank]’s current status in 

meeting the qualification requirements 

in section 22; and 

(ii) The consistency of the [bank]’s 

current practices with the [AGENCY]’s 

supervisory guidance on the 

qualification requirements; 

(4) Based on the [bank]’s selfassessment, identify and describe the 

areas in which the [bank] proposes to 

undertake additional work to comply 

with the qualification requirements in 

section 22 or to improve the consistency 

of the [bank]’s current practices with the 

[AGENCY]’s supervisory guidance on 

the qualification requirements (gap 

analysis); 

(5) Describe what specific actions the 

[bank] will take to address the areas 

identified in the gap analysis required 

by paragraph (b)(4) of this section; 

(6) Identify objective, measurable 

milestones, including delivery dates and 

a date when the [bank]’s 

implementation of the methodologies 

described in this appendix will be fully 

operational; 

(7) Describe resources that have been 

budgeted and are available to 

implement the plan; and 

(8) Receive board of directors 

approval. 

(c) Parallel run. Before determining its 

risk-based capital requirements under 

this appendix and following adoption of 

the implementation plan, the [bank] 

must conduct a satisfactory parallel run. 

A satisfactory parallel run is a period of 

no less than four consecutive calendar 

quarters during which the [bank] 

complies with all of the qualification 

requirements in section 22 to the 

satisfaction of [AGENCY]. During the 

parallel run, the [bank] must report to 

the [AGENCY] on a calendar quarterly 

basis its risk-based capital ratios using 

[the general risk-based capital rules] and 

the risk-based capital requirements 

described in this appendix. During this 

period, the [bank] is subject to [the 

general risk-based capital rules]. 

(d) Approval to calculate risk-based 

capital requirements under this 

appendix. The [AGENCY] will notify 

the [bank] of the date that the [bank] 

may begin its first floor period following 

a determination by the [AGENCY] that: 

(1) The [bank] fully complies with the 

qualification requirements in section 22; 

(2) The [bank] has conducted a 

satisfactory parallel run under 

paragraph (c) of this section; and 

(3) The [bank] has an adequate 

process to ensure ongoing compliance 

with the qualification requirements in 

section 22. 

(e) Transitional floor periods. 

Following a satisfactory parallel run, a 

[bank] is subject to three transitional 

floor periods. 

(1) Risk-based capital ratios during 

the transitional floor periods—(i) Tier 1 

risk-based capital ratio. During a 

[bank]’s transitional floor periods, a 

[bank]’s tier 1 risk-based capital ratio is 

equal to the lower of: 

(A) The [bank]’s floor-adjusted tier 1 

risk-based capital ratio; or 

(B) The [bank]’s advanced approaches 

tier 1 risk-based capital ratio. 

(ii) Total risk-based capital ratio. 

During a [bank]’s transitional floor 

periods, a [bank]’s total risk-based 

capital ratio is equal to the lower of: 

(A) The [bank]’s floor-adjusted total 

risk-based capital ratio; or 

(B) The [bank]’s advanced approaches 

total risk-based capital ratio. 

(2) Floor-adjusted risk-based capital 

ratios. (i) A [bank]’s floor-adjusted tier 1 

risk-based capital ratio during a 

transitional floor period is equal to the 

[bank]’s tier 1 capital as calculated 

under [the general risk-based capital 

rules], divided by the product of: 

(A) The [bank]’s total risk-weighted 

assets as calculated under [the general 

risk-based capital rules]; and 

(B) The appropriate transitional floor 

percentage in Table 1. 

(ii) A [bank]’s floor-adjusted total riskbased capital ratio during a transitional 

floor period is equal to the sum of the 

[bank]’s tier 1 and tier 2 capital as 

calculated under [the general risk-based 

capital rules], divided by the product of: 

(A) The [bank]’s total risk-weighted 

assets as calculated under [the general 

risk-based capital rules]; and 

(B) The appropriate transitional floor 

percentage in Table 1. 

(iii) A [bank] that meets the criteria in 

paragraph (b)(1) or (b)(2) of section 1 as 

of the effective date of this rule must use 

[the general risk-based capital rules] 

effective immediately before this rule 

became effective during the parallel run 

and as the basis for its transitional 

floors. 

TABLE 1—TRANSITIONAL FLOORS

Transitional floor period Transitional floor percentage 

First floor period ........ 95 percent 

Second floor period ... 90 percent 

Third floor period ....... 85 percent 

(3) Advanced approaches risk-based 

capital ratios. (i) A [bank]’s advanced 

approaches tier 1 risk-based capital ratio 

equals the [bank]’s tier 1 risk-based 

capital ratio as calculated under this 

appendix (other than this section on 

transitional floor periods). 

(ii) A [bank]’s advanced approaches 

total risk-based capital ratio equals the 

[bank]’s total risk-based capital ratio as 

calculated under this appendix (other 

than this section on transitional floor 

periods). 

(4) Reporting. During the transitional 

floor periods, a [bank] must report to the 

[AGENCY] on a calendar quarterly basis 

both floor-adjusted risk-based capital 

ratios and both advanced approaches 

risk-based capital ratios. 

(5) Exiting a transitional floor period. 

A [bank] may not exit a transitional 

floor period until the [bank] has spent 

a minimum of four consecutive calendar 

quarters in the period and the 

[AGENCY] has determined that the 

[bank] may exit the floor period. The 

[AGENCY]’s determination will be 

based on an assessment of the [bank]’s 

ongoing compliance with the 

qualification requirements in section 22. 

Section 22. Qualification Requirements 

(a) Process and systems requirements. 

(1) A [bank] must have a rigorous 

process for assessing its overall capital 

adequacy in relation to its risk profile 


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Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55923 

and a comprehensive strategy for 

maintaining an appropriate level of 

capital. 

(2) The systems and processes used by 

a [bank] for risk-based capital purposes 

under this appendix must be consistent 

with the [bank]’s internal risk 

management processes and management 

information reporting systems. 

(3) Each [bank] must have an 

appropriate infrastructure with risk 

measurement and management 

processes that meet the qualification 

requirements of this section and are 

appropriate given the [bank]’s size and 

level of complexity. Regardless of 

whether the systems and models that 

generate the risk parameters necessary 

for calculating a [bank]’s risk-based 

capital requirements are located at any 

affiliate of the [bank], the [bank] itself 

must ensure that the risk parameters 

and reference data used to determine its 

risk-based capital requirements are 

representative of its own credit risk and 

operational risk exposures. 

(b) Risk rating and segmentation 

systems for wholesale and retail 

exposures. (1) A [bank] must have an 

internal risk rating and segmentation 

system that accurately and reliably 

differentiates among degrees of credit 

risk for the [bank]’s wholesale and retail 

exposures. 

(2) For wholesale exposures, a [bank] 

must have an internal risk rating system 

that accurately and reliably assigns each 

obligor to a single rating grade 

(reflecting the obligor’s likelihood of 

default). The [bank]’s wholesale obligor 

rating system must have at least seven 

discrete rating grades for non-defaulted 

obligors and at least one rating grade for 

defaulted obligors. Unless the [bank] has 

chosen to directly assign ELGD and LGD 

estimates to each wholesale exposure, 

the [bank] must have an internal risk 

rating system that accurately and 

reliably assigns each wholesale 

exposure to loss severity rating grades 

(reflecting the [bank]’s estimate of the 

ELGD and LGD of the exposure). A 

[bank] employing loss severity rating 

grades must have a sufficiently granular 

loss severity grading system to avoid 

grouping together exposures with 

widely ranging ELGDs or LGDs. 

(3) For retail exposures, a [bank] must 

have a system that groups exposures 

into segments with homogeneous risk 

characteristics and assigns accurate and 

reliable PD, ELGD, and LGD estimates 

for each segment on a consistent basis. 

The [bank]’s system must group retail 

exposures into the appropriate retail 

exposure subcategory and must group 

the retail exposures in each retail 

exposure subcategory into separate 

segments. The [bank]’s system must 

identify all defaulted retail exposures 

and group them in segments by 

subcategories separate from nondefaulted retail exposures. 

(4) The [bank]’s internal risk rating 

policy for wholesale exposures must 

describe the [bank]’s rating philosophy 

(that is, must describe how wholesale 

obligor rating assignments are affected 

by the [bank]’s choice of the range of 

economic, business, and industry 

conditions that are considered in the 

obligor rating process). 

(5) The [bank]’s internal risk rating 

system for wholesale exposures must 

provide for the review and update (as 

appropriate) of each obligor rating and 

(if applicable) each loss severity rating 

whenever the [bank] receives new 

material information, but no less 

frequently than annually. The [bank]’s 

retail exposure segmentation system 

must provide for the review and update 

(as appropriate) of assignments of retail 

exposures to segments whenever the 

[bank] receives new material 

information, but no less frequently than 

quarterly. 

(c) Quantification of risk parameters 

for wholesale and retail exposures. (1) 

The [bank] must have a comprehensive 

risk parameter quantification process 

that produces accurate, timely, and 

reliable estimates of the risk parameters 

for the [bank]’s wholesale and retail 

exposures. 

(2) Data used to estimate the risk 

parameters must be relevant to the 

[bank]’s actual wholesale and retail 

exposures, and of sufficient quality to 

support the determination of risk-based 

capital requirements for the exposures. 

(3) The [bank]’s risk parameter 

quantification process must produce 

conservative risk parameter estimates 

where the [bank] has limited relevant 

data, and any adjustments that are part 

of the quantification process must not 

result in a pattern of bias toward lower 

risk parameter estimates. 

(4) PD estimates for wholesale and 

retail exposures must be based on at 

least 5 years of default data. ELGD and 

LGD estimates for wholesale exposures 

must be based on at least 7 years of loss 

severity data, and ELGD and LGD 

estimates for retail exposures must be 

based on at least 5 years of loss severity 

data. EAD estimates for wholesale 

exposures must be based on at least 7 

years of exposure amount data, and EAD 

estimates for retail exposures must be 

based on at least 5 years of exposure 

amount data. 

(5) Default, loss severity, and 

exposure amount data must include 

periods of economic downturn 

conditions, or the [bank] must adjust its 

estimates of risk parameters to 

compensate for the lack of data from 

periods of economic downturn 

conditions. 

(6) The [bank]’s PD, ELGD, LGD, and 

EAD estimates must be based on the 

definition of default in this appendix. 

(7) The [bank] must review and 

update (as appropriate) its risk 

parameters and its risk parameter 

quantification process at least annually. 

(8) The [bank] must at least annually 

conduct a comprehensive review and 

analysis of reference data to determine 

relevance of reference data to [bank] 

exposures, quality of reference data to 

support PD, ELGD, LGD, and EAD 

estimates, and consistency of reference 

data to the definition of default 

contained in this appendix. 

(d) Counterparty credit risk model. A 

[bank] must obtain the prior written 

approval of [AGENCY] under section 32 

to use the internal models methodology 

for counterparty credit risk. 

(e) Double default treatment. A [bank] 

must obtain the prior written approval 

of [AGENCY] under section 34 to use 

the double default treatment. 

(f) Securitization exposures. A [bank] 

must obtain the prior written approval 

of [AGENCY] under section 44 to use 

the internal assessment approach for 

securitization exposures to ABCP 

programs. 

(g) Equity exposures model. A [bank] 

must obtain the prior written approval 

of [AGENCY] under section 53 to use 

the internal models approach for equity 

exposures. 

(h) Operational risk—(1) Operational 

risk management processes. A [bank] 

must: 

(i) Have an operational risk 

management function that: 

(A) Is independent of business line 

management; and 

(B) Is responsible for designing, 

implementing, and overseeing the 

[bank]’s operational risk data and 

assessment systems, operational risk 

quantification systems, and related 

processes; 

(ii) Have and document a process to 

identify, measure, monitor, and control 

operational risk in [bank] products, 

activities, processes, and systems 

(which process must capture business 

environment and internal control factors 

affecting the [bank]’s operational risk 

profile); and 

(iii) Report operational risk exposures, 

operational loss events, and other 

relevant operational risk information to 

business unit management, senior 

management, and the board of directors 

(or a designated committee of the 

board). 

(2) Operational risk data and 

assessment systems. A [bank] must have 


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operational risk data and assessment 

systems that capture operational risks to 

which the [bank] is exposed. The 

[bank]’s operational risk data and 

assessment systems must: 

(i) Be structured in a manner 

consistent with the [bank]’s current 

business activities, risk profile, 

technological processes, and risk 

management processes; and 

(ii) Include credible, transparent, 

systematic, and verifiable processes that 

incorporate the following elements on 

an ongoing basis: 

(A) Internal operational loss event 

data. The [bank] must have a systematic 

process for capturing and using internal 

operational loss event data in its 

operational risk data and assessment 

systems. 

(1) The [bank]’s operational risk data 

and assessment systems must include 

an historical observation period of at 

least five years for internal operational 

loss event data (or such shorter period 

approved by [AGENCY] to address 

transitional situations, such as 

integrating a new business line). 

(2) The [bank] may refrain from 

collecting internal operational loss 

event data for individual operational 

losses below established dollar 

threshold amounts if the [bank] can 

demonstrate to the satisfaction of the 

[AGENCY] that the thresholds are 

reasonable, do not exclude important 

internal operational loss event data, and 

permit the [bank] to capture 

substantially all the dollar value of the 

[bank]’s operational losses. 

(B) External operational loss event 

data. The [bank] must have a systematic 

process for determining its 

methodologies for incorporating 

external operational loss data into its 

operational risk data and assessment 

systems. 

(C) Scenario analysis. The [bank] 

must have a systematic process for 

determining its methodologies for 

incorporating scenario analysis into its 

operational risk data and assessment 

systems. 

(D) Business environment and 

internal control factors. The [bank] must 

incorporate business environment and 

internal control factors into its 

operational risk data and assessment 

systems. The [bank] must also 

periodically compare the results of its 

prior business environment and internal 

control factor assessments against its 

actual operational losses incurred in the 

intervening period. 

(3) Operational risk quantification 

systems. (i) The [bank]’s operational risk 

quantification systems: 

(A) Must generate estimates of the 

[bank]’s operational risk exposure using 

its operational risk data and assessment 

systems; and 

(B) Must employ a unit of measure 

that is appropriate for the [bank]’s range 

of business activities and the variety of 

operational loss events to which it is 

exposed, and that does not combine 

business activities or operational loss 

events with different risk profiles within 

the same loss distribution. 

(C) May use internal estimates of 

dependence among operational losses 

within and across business lines and 

operational loss events if the [bank] can 

demonstrate to the satisfaction of 

[AGENCY] that its process for 

estimating dependence is sound, robust 

to a variety of scenarios, and 

implemented with integrity, and allows 

for the uncertainty surrounding the 

estimates. If the [bank] has not made 

such a demonstration, it must sum 

operational risk exposure estimates 

across units of measure to calculate its 

total operational risk exposure. 

(D) Must be reviewed and updated (as 

appropriate) whenever the [bank] 

becomes aware of information that may 

have a material effect on the [bank]’s 

estimate of operational risk exposure, 

but no less frequently than annually. 

(ii) With the prior written approval of 

[AGENCY], a [bank] may generate an 

estimate of its operational risk exposure 

using an alternative approach to that 

specified in paragraph (h)(3)(i) of this 

section. A [bank] proposing to use such 

an alternative operational risk 

quantification system must submit a 

proposal to [AGENCY]. In considering a 

[bank]’s proposal to use an alternative 

operational risk quantification system, 

[AGENCY] will consider the following 

principles: 

(A) Use of the alternative operational 

risk quantification system will be 

allowed only on an exception basis, 

considering the size, complexity, and 

risk profile of a [bank]; 

(B) The [bank] must demonstrate that 

its estimate of its operational risk 

exposure generated under the 

alternative operational risk 

quantification system is appropriate and 

can be supported empirically; and 

(C) A [bank] must not use an 

allocation of operational risk capital 

requirements that includes entities other 

than depository institutions or the 

benefits of diversification across 

entities. 

(i) Data management and 

maintenance. (1) A [bank] must have 

data management and maintenance 

systems that adequately support all 

aspects of its advanced systems and the 

timely and accurate reporting of riskbased capital requirements. 

(2) A [bank] must retain data using an 

electronic format that allows timely 

retrieval of data for analysis, validation, 

reporting, and disclosure purposes. 

(3) A [bank] must retain sufficient 

data elements related to key risk drivers 

to permit adequate monitoring, 

validation, and refinement of its 

advanced systems. 

(j) Control, oversight, and validation 

mechanisms. (1) The [bank]’s senior 

management must ensure that all 

components of the [bank]’s advanced 

systems function effectively and comply 

with the qualification requirements in 

this section. 

(2) The [bank]’s board of directors (or 

a designated committee of the board) 

must at least annually evaluate the 

effectiveness of, and approve, the 

[bank]’s advanced systems. 

(3) A [bank] must have an effective 

system of controls and oversight that: 

(i) Ensures ongoing compliance with 

the qualification requirements in this 

section; 

(ii) Maintains the integrity, reliability, 

and accuracy of the [bank]’s advanced 

systems; and 

(iii) Includes adequate governance 

and project management processes. 

(4) The [bank] must validate, on an 

ongoing basis, its advanced systems. 

The [bank]’s validation process must be 

independent of the advanced systems’

development, implementation, and 

operation, or the validation process 

must be subjected to an independent 

review of its adequacy and 

effectiveness. Validation must include: 

(i) The evaluation of the conceptual 

soundness of (including developmental 

evidence supporting) the advanced 

systems; 

(ii) An on-going monitoring process 

that includes verification of processes 

and benchmarking; and 

(iii) An outcomes analysis process 

that includes back-testing. 

(5) The [bank] must have an internal 

audit function independent of businessline 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. 


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Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55925 

Section 23. Ongoing Qualification 

(a) Changes to advanced systems. A 

[bank] must meet all the qualification 

requirements in section 22 on an 

ongoing basis. A [bank] must notify the 

[AGENCY] when the [bank] makes any 

change to an advanced system that 

would result in a material change in the 

[bank]’s risk-weighted asset amount for 

an exposure type, or when the [bank] 

makes any significant change to its 

modeling assumptions. 

(b) Mergers and acquisitions—(1) 

Mergers and acquisitions of companies 

without advanced systems. If a [bank] 

merges with or acquires a company that 

does not calculate its risk-based capital 

requirements using advanced systems, 

the [bank] may use [the general riskbased capital rules] to determine the 

risk-weighted asset amounts for, and 

deductions from capital associated with, 

the merged or acquired company’s 

exposures for up to 24 months after the 

calendar quarter during which the 

merger or acquisition consummates. 

[AGENCY] may extend this transition 

period for up to an additional 12 

months. Within 30 days of 

consummating the merger or 

acquisition, the [bank] must submit to 

[AGENCY] an implementation plan for 

using its advanced systems for the 

acquired company. During the period 

when [the general risk-based capital 

rules] apply to the merged or acquired 

company, any ALLL, net of allocated 

transfer risk reserves established 

pursuant to 12 U.S.C. 3904, associated 

with the merged or acquired company’s 

exposures may be included in the 

[bank]’s tier 2 capital up to 1.25 percent 

of the acquired company’s risk-weighted 

assets. All general reserves of the 

merged or acquired company must be 

excluded from the [bank]’s eligible 

credit reserves. In addition, the riskweighted assets of the merged or 

acquired company are not included in 

the [bank]’s credit-risk-weighted assets 

but are included in total risk-weighted 

assets. If a [bank] relies on this 

paragraph, the [bank] must disclose 

publicly the amounts of risk-weighted 

assets and qualifying capital calculated 

under this appendix for the acquiring 

[bank] and under [the general risk-based 

capital rules] for the acquired company. 

(2) Mergers and acquisitions of 

companies with advanced systems. If a 

[bank] merges with or acquires a 

company that calculates its risk-based 

capital requirements using advanced 

systems, the acquiring [bank] may use 

the acquired company’s advanced 

systems to determine the risk-weighted 

asset amounts for, and deductions from 

capital associated with, the merged or 

acquired company’s exposures for up to 

24 months after the calendar quarter 

during which the acquisition or merger 

consummates. [AGENCY] may extend 

this transition period for up to an 

additional 12 months. Within 30 days of 

consummating the merger or 

acquisition, the [bank] must submit to 

[AGENCY] an implementation plan for 

using its advanced systems for the 

merged or acquired company. 

(c) Failure to comply with 

qualification requirements. If [AGENCY] 

determines that a [bank] that is subject 

to this appendix and has conducted a 

satisfactory parallel run fails to comply 

with the qualification requirements in 

section 22, [AGENCY] will notify the 

[bank] in writing of the [bank]’s failure 

to comply. The [bank] must establish a 

plan satisfactory to the [AGENCY] to 

return to compliance with the 

qualification requirements and must 

disclose to the public its failure to 

comply with the qualification 

requirements promptly after receiving 

notice from the [AGENCY]. In addition, 

if the [AGENCY] determines that the 

[bank]’s risk-based capital requirements 

are not commensurate with the [bank]’s 

credit, market, operational, or other 

risks, the [AGENCY] may require such 

a [bank] to calculate its risk-based 

capital requirements: 

(1) Under [the general risk-based 

capital rules]; or 

(2) Under this appendix with any 

modifications provided by the 

[AGENCY]. 

Part IV. Risk-Weighted Assets for 

General Credit Risk 

Section 31. Mechanics for Calculating 

Total Wholesale and Retail RiskWeighted Assets 

(a) Overview. A [bank] must calculate 

its total wholesale and retail riskweighted 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 riskweighted asset amounts. 

(b) Phase 1—Categorization. The 

[bank] must determine which of its 

exposures are wholesale exposures, 

retail exposures, securitization 

exposures, or equity exposures. The 

[bank] must categorize each retail 

exposure as a residential mortgage 

exposure, a QRE, or an other retail 

exposure. The [bank] must identify 

which wholesale exposures are HVCRE 

exposures, sovereign exposures, OTC 

derivative contracts, repo-style 

transactions, eligible margin loans, 

eligible purchased wholesale 

receivables, unsettled transactions to 

which section 35 applies, and eligible 

guarantees or eligible credit derivatives 

that are used as credit risk mitigants. 

The [bank] must identify any on-balance 

sheet asset that does not meet the 

definition of a wholesale, retail, equity, 

or securitization exposure, as well as 

any non-material portfolio of exposures 

described in paragraph (e)(4) of this 

section. 

(c) Phase 2—Assignment of wholesale 

obligors and exposures to rating grades 

and retail exposures to segments—(1) 

Assignment of wholesale obligors and 

exposures to rating grades. 

(i) The [bank] must assign each 

obligor of a wholesale exposure to a 

single obligor rating grade and may 

assign each wholesale exposure to loss 

severity rating grades. 

(ii) The [bank] must identify which of 

its wholesale obligors are in default. 

(2) Segmentation of retail exposures. 

(i) The [bank] must group the retail 

exposures in each retail subcategory 

into segments that have homogeneous 

risk characteristics. 

(ii) The [bank] must identify which of 

its retail exposures are in default. The 

[bank] must segment defaulted retail 

exposures separately from nondefaulted retail exposures. 

(iii) If the [bank] determines the EAD 

for eligible margin loans using the 

approach in paragraph (a) of section 32, 

the [bank] must identify which of its 

retail exposures are eligible margin 

loans for which the [bank] uses this 

EAD approach and must segment such 

eligible margin loans separately from 

other retail exposures. 

(3) Eligible purchased wholesale 

receivables. A [bank] may group its 

eligible purchased wholesale 

receivables that, when consolidated by 

obligor, total less than $1 million into 

segments that have homogeneous risk 

characteristics. A [bank] must use the 

wholesale exposure formula in Table 2 

in this section to determine the riskbased capital requirement for each 

segment of eligible purchased wholesale 

receivables. 

(d) Phase 3—Assignment of risk 

parameters to wholesale exposures and 

segments of retail exposures—(1) 

Quantification process. Subject to the 

limitations in this paragraph (d), the 

[bank] must: 

(i) Associate a PD with each 

wholesale obligor rating grade; 

(ii) Associate an ELGD or LGD, as 

appropriate, with each wholesale loss 


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7A [bank] may instead apply a 300 percent risk 

weight to the EAD of an eligible margin loan if the 

[bank] is not able to assign a rating grade to the 

obligor of the loan. 

severity rating grade or assign an ELGD 

and LGD to each wholesale exposure; 

(iii) Assign an EAD and M to each 

wholesale exposure; and 

(iv) Assign a PD, ELGD, LGD, and 

EAD to each segment of retail 

exposures. 

(2) Floor on PD assignment. The PD 

for each wholesale exposure or retail 

segment may not be less than 0.03 

percent, except for exposures to or 

directly and unconditionally guaranteed 

by a sovereign entity, the Bank for 

International Settlements, the 

International Monetary Fund, the 

European Commission, the European 

Central Bank, or a multi-lateral 

development bank, to which the [bank] 

assigns a rating grade associated with a 

PD of less than 0.03 percent. 

(3) Floor on LGD estimation. The LGD 

for each segment of residential mortgage 

exposures (other than segments of 

residential mortgage exposures for 

which all or substantially all of the 

principal of each exposure is directly 

and unconditionally guaranteed by the 

full faith and credit of a sovereign 

entity) may not be less than 10 percent. 

(4) Eligible purchased wholesale 

receivables. A [bank] must assign a PD, 

ELGD, LGD, EAD, and M to each 

segment of eligible purchased wholesale 

receivables. If the [bank] can estimate 

ECL (but not PD or LGD) for a segment 

of eligible purchased wholesale 

receivables, the [bank] must assume that 

the ELGD and LGD of the segment 

equals 100 percent and that the PD of 

the segment equals ECL divided by 

EAD. The estimated ECL must be 

calculated for the receivables without 

regard to any assumption of recourse or 

guarantees from the seller or other 

parties. 

(5) Credit risk mitigation—credit 

derivatives, guarantees, and collateral. 

(i) A [bank] may take into account the 

risk reducing effects of eligible 

guarantees and eligible credit 

derivatives in support of a wholesale 

exposure by applying the PD 

substitution or LGD adjustment 

treatment to the exposure as provided in 

section 33 or, if applicable, applying 

double default treatment to the exposure 

as provided in section 34. A [bank] may 

decide separately for each wholesale 

exposure that qualifies for the double 

default treatment under section 34 

whether to apply the double default 

treatment or to use the PD substitution 

or LGD adjustment approach without 

recognizing double default effects. 

(ii) A [bank] may take into account the 

risk reducing effects of guarantees and 

credit derivatives in support of retail 

exposures in a segment when 

quantifying the PD, ELGD, and LGD of 

the segment. 

(iii) Except as provided in paragraph 

(d)(6) of this section, a [bank] may take 

into account the risk reducing effects of 

collateral in support of a wholesale 

exposure when quantifying the ELGD 

and LGD of the exposure and may take 

into account the risk reducing effects of 

collateral in support of retail exposures 

when quantifying the PD, ELGD, and 

LGD of the segment. 

(6) EAD for derivative contracts, repostyle transactions, and eligible margin 

loans. (i) A [bank] must calculate its 

EAD for an OTC derivative contract as 

provided in paragraphs (b) and (c) of 

section 32. A [bank] may take into 

account the risk-reducing effects of 

financial collateral in support of a repostyle transaction or eligible margin loan 

through an adjustment to EAD as 

provided in paragraphs (a) and (c) of 

section 32. A [bank] that takes financial 

collateral into account through such an 

adjustment to EAD under section 32 

may not adjust ELGD or LGD to reflect 

the financial collateral. 

(ii) A [bank] may attribute an EAD of 

zero to: 

(A) Derivative contracts that are 

publicly traded on an exchange that 

requires the daily receipt and payment 

of cash-variation margin; 

(B) Derivative contracts and repo-style 

transactions that are outstanding with a 

qualifying central counterparty (but not 

for those transactions that a qualifying 

central counterparty has rejected); and 

(C) Credit risk exposures to a 

qualifying central counterparty in the 

form of clearing deposits and posted 

collateral that arise from transactions 

described in paragraph (d)(6)(ii)(B) of 

this section. 

(7) Effective maturity. An exposure’s 

M must be no greater than five years and 

no less than one year, except that a 

[bank] may set the M of an exposure 

equal to the greater of one day or M if 

the exposure has an original maturity of 

less than one year and is not part of the 

[bank]’s ongoing financing of the 

obligor. An exposure is not part of a 

[bank]’s ongoing financing of the obligor 

if the [bank]: 

(i) Has a legal and practical ability not 

to renew or roll over the exposure in the 

event of credit deterioration of the 

obligor; 

(ii) Makes an independent credit 

decision at the inception of the 

exposure and at every renewal or roll 

over; and 

(iii) Has no substantial commercial 

incentive to continue its credit 

relationship with the obligor in the 

event of credit deterioration of the 

obligor. 

(e) Phase 4—Calculation of riskweighted assets—(1) Non-defaulted 

exposures. (i) A [bank] must calculate 

the dollar risk-based capital requirement 

for each of its wholesale exposures to a 

non-defaulted obligor and segments of 

non-defaulted retail exposures (except 

eligible guarantees and eligible credit 

derivatives that hedge another 

wholesale exposure and exposures to 

which the [bank] applies the double 

default treatment in section 34) by 

inserting the assigned risk parameters 

for the wholesale obligor and exposure 

or retail segment into the appropriate 

risk-based capital formula specified in 

Table 2 and multiplying the output of 

the formula (K) by the EAD of the 

exposure or segment.7


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Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55927 

(ii) The sum of all of the dollar riskbased capital requirements for each 

wholesale exposure to a non-defaulted 

obligor and segment of non-defaulted 

retail exposures calculated in paragraph 

(e)(1)(i) of this section and in paragraph 

(e) of section 34 equals the total dollar 

risk-based capital requirement for those 

exposures and segments. 

(iii) The aggregate risk-weighted asset 

amount for wholesale exposures to nondefaulted obligors and segments of nondefaulted retail exposures equals the 

total dollar risk-based capital 

requirement calculated in paragraph 

(e)(1)(ii) of this section multiplied by 

12.5. 

(2) Wholesale exposures to defaulted 

obligors and segments of defaulted retail 

exposures—(i) Wholesale exposures to 

defaulted obligors. 

(A) For each wholesale exposure to a 

defaulted obligor, the [bank] must 

compare: 

(1) 0.08 multiplied by the EAD of the 

wholesale exposure, plus the amount of 

any charge-offs or write-downs on the 

exposure; and 

(2) K for the wholesale exposure (as 

determined in Table 2 immediately 

before the obligor became defaulted), 

multiplied by the EAD of the wholesale 

exposure immediately before the obligor 

became defaulted. 

(B) If the amount calculated in 

paragraph (e)(2)(i)(A)1 is equal to or 

greater than the amount calculated in 

paragraph (e)(2)(i)(A)2, the dollar riskbased capital requirement for the 

exposure is 0.08 multiplied by the EAD 

of the wholesale exposure. 

(C) If the amount calculated in 

paragraph (e)(2)(i)(A)1 is less than the 

amount calculated in paragraph 

(e)(2)(i)(A)2, the dollar risk-based 

capital requirement for the exposure is 

K for the wholesale exposure (as 

determined in Table 2 immediately 

before the obligor became defaulted) 

multiplied by the EAD of the wholesale 

exposure. 

(ii) Segments of defaulted retail 

exposures. The dollar risk-based capital 

requirement for a segment of defaulted 

retail exposures equals 0.08 multiplied 

by the EAD of the segment. 

(iii) The sum of all the dollar riskbased capital requirements for each 

wholesale exposure to a defaulted 

obligor calculated in paragraphs 

(e)(2)(i)(B) and (C) of this section plus 

the dollar risk-based capital 

requirements for each segment of 

defaulted retail exposures calculated in 

paragraph (e)(2)(ii) of this section equals 

the total dollar risk-based capital 

requirement for those exposures. 

(iv) The aggregate risk-weighted asset 

amount for wholesale exposures to 

defaulted obligors and segments of 

defaulted retail exposures equals the 

total dollar risk-based capital 


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55928 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

requirement calculated in paragraph 

(e)(2)(iii) of this section multiplied by 

12.5. 

(3) Assets not included in a defined 

exposure category. A [bank] may assign 

a risk-weighted asset amount of zero to 

cash owned and held in all offices of the 

[bank] or in transit and for gold bullion 

held in the [bank]’s own vaults, or held 

in another [bank]’s vaults on an 

allocated basis, to the extent it is offset 

by gold bullion liabilities. The riskweighted asset amount for the residual 

value of a retail lease exposure equals 

such residual value. The risk-weighted 

asset amount for an excluded mortgage 

exposure is determined under 12 CFR 

part 3, Appendix A, section 3(a)(3)(iii) 

(for national banks), 12 CFR part 208, 

Appendix A, section III.C.3. (for state 

member banks), 12 CFR part 225, 

Appendix A, section III.C.3. (for bank 

holding companies), 12 CFR part 325, 

Appendix A, section II.C.a. (for state 

nonmember banks), and 12 CFR 

567.6(a)(1)(iii) and (iv) (for savings 

associations). The risk-weighted asset 

amount for any other on-balance-sheet 

asset that does not meet the definition 

of a wholesale, retail, securitization, or 

equity exposure equals the carrying 

value of the asset. 

(4) Non-material portfolios of 

exposures. The risk-weighted asset 

amount of a portfolio of exposures for 

which the [bank] has demonstrated to 

[AGENCY]’s satisfaction that the 

portfolio (when combined with all other 

portfolios of exposures that the [bank] 

seeks to treat under this paragraph) is 

not material to the [bank] is the sum of 

the carrying values of on-balance sheet 

exposures plus the notional amounts of 

off-balance sheet exposures in the 

portfolio. For purposes of this paragraph 

(e)(4), the notional amount of an OTC 

derivative contract that is not a credit 

derivative is the EAD of the derivative 

as calculated in section 32. 

Section 32. Counterparty Credit Risk 

This section describes two 

methodologies—a collateral haircut 

approach and an internal models 

methodology—that a [bank] may use 

instead of an ELGD/LGD estimation 

methodology to recognize the benefits of 

financial collateral in mitigating the 

counterparty credit risk of repo-style 

transactions, eligible margin loans, and 

collateralized OTC derivative contracts, 

and single product netting sets of such 

transactions. A third methodology, the 

simple VaR methodology, is available 

for single product netting sets of repostyle transactions and eligible margin 

loans. This section also describes the 

methodology for calculating EAD for an 

OTC derivative contract or a set of OTC 

derivative contracts subject to a 

qualifying master netting agreement. A 

[bank] also may use the internal models 

methodology to estimate EAD for 

qualifying cross-product master netting 

agreements. 

A [bank] may use any combination of 

the three methodologies for collateral 

recognition; however, it must use the 

same methodology for similar 

exposures. A [bank] may use separate 

methodologies for agency securities 

lending transactions—that is, securities 

lending transactions in which the 

[bank], acting as agent for a customer, 

lends the customer’s securities and 

indemnifies the customer against loss—

and all other repo-style transactions. 

(a) EAD for eligible margin loans and 

repo-style transactions—(1) General. A 

[bank] may recognize the credit risk 

mitigation benefits of financial collateral 

that secures an eligible margin loan, 

repo-style transaction, or single-product 

group of such transactions with a single 

counterparty subject to a qualifying 

master netting agreement (netting set) by 

factoring the collateral into its ELGD 

and LGD estimates for the exposure. 

Alternatively, a [bank] may estimate an 

unsecured ELGD and LGD for the 

exposure and determine the EAD of the 

exposure using: 

(i) The collateral haircut approach 

described in paragraph (a)(2) of this 

section; 

(ii) For netting sets only, the simple 

VaR methodology described in 

paragraph (a)(3) of this section; or 

(iii) The internal models methodology 

described in paragraph (c) of this 

section. 

(2) Collateral haircut approach—(i) 

EAD equation. A [bank] may determine 

EAD for an eligible margin loan, repostyle transaction, or netting set by 

setting EAD = max {0, [(SE ¥ SC) + S(Es 

× Hs) + (Efx × Hfx)]}, where: 

(A) SE equals the value of the 

exposure (that is, the sum of the current 

market values of all securities and cash 

the [bank] has lent, sold subject to 

repurchase, or posted as collateral to the 

counterparty under the transaction (or 

netting set)); 

(B) SC equals the value of the 

collateral (that is, the sum of the current 

market values of all securities and cash 

the [bank] has borrowed, purchased 

subject to resale, or taken as collateral 

from the counterparty under the 

transaction (or netting set)); 

(C) Es = absolute value of the net 

position in a given security (where the 

net position in a given security equals 

the sum of the current market values of 

the particular security the [bank] has 

lent, sold subject to repurchase, or 

posted as collateral to the counterparty 

minus the sum of the current market 

values of that same security the [bank] 

has borrowed, purchased subject to 

resale, or taken as collateral from the 

counterparty); 

(D) Hs = market price volatility 

haircut appropriate to the security 

referenced in Es; 

(E) Efx = absolute value of the net 

position of both cash and securities in 

a currency that is different from the 

settlement currency (where the net 

position in a given currency equals the 

sum of the current market values of any 

cash or securities in the currency the 

[bank] has lent, sold subject to 

repurchase, or posted as collateral to the 

counterparty minus the sum of the 

current market values of any cash or 

securities in the currency the [bank] has 

borrowed, purchased subject to resale, 

or taken as collateral from the 

counterparty); and 

(F) Hfx = haircut appropriate to the 

mismatch between the currency 

referenced in Efx and the settlement 

currency. 

(ii) Standard supervisory haircuts. (A) 

Under the ‘‘standard supervisory 

haircuts’’ approach: 

(1) A [bank] must use the haircuts for 

market price volatility (Hs) in Table 3, 

as adjusted in certain circumstances as 

provided in paragraph (a)(2)(ii)(A)(3) 

and (4) of this section; 

TABLE 3.—STANDARD SUPERVISORY MARKET PRICE VOLATILITY HAIRCUTS* 

Applicable external rating grade category for debt securities Residual maturity for debt securities 

Issuers exempt from the 

3 b.p. floor 

Other issuers 

Two highest investment grade rating categories for long-term ratings/highest investment grade rating category for short-term 

ratings.

≤1 year ........................................................

>1 year, ≤5 years ........................................

>5 years ......................................................

.005 

.02 

.04 

.01 

.04 

.08 


sroberts on PROD1PC70 with PROPOSALS
Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55929 

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

Applicable external rating grade category for debt securities Residual maturity for debt securities 

Issuers exempt from the 

3 b.p. floor 

Other issuers 

Two lowest investment grade ratiing categories for both shortand long-term ratings.≤1 year ........................................................

>1 year, ≤5 years ........................................

>5 years ......................................................

.01 

.03 

.06 

.02 

.06 

.12 

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

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

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

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

any security in which the fund 

can invest. 

Cash on deposit with the [bank] (including a certificate of deposit issued by the [bank]) ..................................... 0

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

(2) For currency mismatches, a [bank] 

must use a haircut for foreign exchange 

rate volatility (Hfx) of 8 percent, as 

adjusted in certain circumstances as 

provided in paragraph (a)(2)(ii)(A)(3) 

and (4) of this section. 

(3) For repo-style transactions, a 

[bank] may multiply the supervisory 

haircuts provided in paragraphs 

(a)(2)(ii)(A)(1) and (2) by the square root 

of 1⁄2 (which equals 0.707107). 

(4) A [bank] must adjust the 

supervisory haircuts upward on the 

basis of a holding period longer than 10 

business days (for eligible margin loans) 

or 5 business days (for repo-style 

transactions) where and as appropriate 

to take into account the illiquidity of an 

instrument. 

(iii) Own estimates for haircuts. With 

the prior written approval of [AGENCY], 

a [bank] may calculate haircuts (Hs and 

Hfx) using its own internal estimates of 

the volatilities of market prices and 

foreign exchange rates. 

(A) To receive [AGENCY] approval to 

use internal estimates, a [bank] must 

satisfy the following minimum 

quantitative standards: 

(1) A [bank] must use a 99th 

percentile one-tailed confidence 

interval. 

(2) The minimum holding period for 

a repo-style transaction is 5 business 

days and for an eligible margin loan is 

10 business days. When a [bank] 

calculates an own-estimates haircut on 

a TN-day holding period, which is 

different from the minimum holding 

period for the transaction type, the 

applicable haircut (HM) is calculated 

using the following square root of time 

formula: 

H H T

T M N

M

N

= , where 

(i) TM = 5 for repo-style transactions 

and 10 for eligible margin loans; 

(ii) TN = holding period used by the 

[bank] to derive HN; and 

(iii) HN = haircut based on the holding 

period TN. 

(3) A [bank] must adjust holding 

periods upwards where and as 

appropriate to take into account the 

illiquidity of an instrument. 

(4) The historical observation period 

must be at least one year. 

(5) A [bank] must update its data sets 

and recompute haircuts no less 

frequently than quarterly and must also 

reassess data sets and haircuts whenever 

market prices change materially. 

(B) With respect to debt securities that 

have an applicable external rating of 

investment grade, a [bank] may 

calculate haircuts for categories of 

securities. For a category of securities, 

the [bank] must calculate the haircut on 

the basis of internal volatility estimates 

for securities in that category that are 

representative of the securities in that 

category that the [bank] has actually 

lent, sold subject to repurchase, posted 

as collateral, borrowed, purchased 

subject to resale, or taken as collateral. 

In determining relevant categories, the 

[bank] must take into account: 

(1) The type of issuer of the security; 

(2) The applicable external rating of 

the security; 

(3) The maturity of the security; and 

(4) The interest rate sensitivity of the 

security. 

(C) With respect to debt securities that 

have an applicable external rating of 

below investment grade and equity 

securities, a [bank] must calculate a 

separate haircut for each individual 

security. 

(D) Where an exposure or collateral 

(whether in the form of cash or 

securities) is denominated in a currency 

that differs from the settlement 

currency, the [bank] must calculate a 

separate currency mismatch haircut for 

its net position in each mismatched 

currency based on estimated volatilities 

of foreign exchange rates between the 

mismatched currency and the 

settlement currency. 

(E) A [bank]’s own estimates of market 

price and foreign exchange rate 

volatilities may not take into account 

the correlations among securities and 

foreign exchanges rates on either the 

exposure or collateral side of a 

transaction (or netting set) or the 

correlations among securities and 

foreign exchange rates between the 

exposure and collateral sides of the 

transaction (or netting set). 

(3) Simple VaR methodology. With 

the prior written approval of [AGENCY], 

a [bank] may estimate EAD for a netting 

set using a VaR model that meets the 

requirements in paragraph (a)(3)(iii) of 

this section. In such event, the [bank] 

must set EAD = max {0, [(SE ¥ SC) + 

PFE]}, where: 


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55930 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

8For purposes of this determination, for OTC 

derivative contracts, a [bank] must maintain a 

written and well reasoned legal opinion that this agreement meets the criteria set forth in the 

definition of qualifying master netting agreement. 

(i) SE equals the value of the exposure 

(that is, the sum of the current market 

values of all securities and cash the 

[bank] has lent, sold subject to 

repurchase, or posted as collateral to the 

counterparty under the netting set); 

(ii) SC equals the value of the 

collateral (that is, the sum of the current 

market values of all securities and cash 

the [bank] has borrowed, purchased 

subject to resale, or taken as collateral 

from the counterparty under the netting 

set); and 

(iii) PFE (potential future exposure) 

equals the [bank]’s empirically-based 

best estimate of the 99th percentile, onetailed confidence interval for an 

increase in the value of (SE ¥ SC) over 

a 5-business-day holding period for 

repo-style transactions or over a 10- 

business-day holding period for eligible 

margin loans using a minimum one-year 

historical observation period of price 

data representing the instruments that 

the [bank] has lent, sold subject to 

repurchase, posted as collateral, 

borrowed, purchased subject to resale, 

or taken as collateral. The [bank] must 

validate its VaR model, including by 

establishing and maintaining a rigorous 

and regular back-testing regime. 

(b) EAD for OTC derivative contracts. 

(1) A [bank] must determine the EAD for 

an OTC derivative contract that is not 

subject to a qualifying master netting 

agreement using the current exposure 

methodology in paragraph (b)(5) of this 

section or using the internal models 

methodology described in paragraph (c) 

of this section. 

(2) A [bank] must determine the EAD 

for multiple OTC derivative contracts 

that are subject to a qualifying master 

netting agreement using the current 

exposure methodology in paragraph 

(b)(6) of this section or using the 

internal models methodology described 

in paragraph (c) of this section.8

(3) Counterparty credit risk for credit 

derivatives. Notwithstanding the above, 

(i) A [bank] that purchases a credit 

derivative that is recognized under 

section 33 or 34 as a credit risk mitigant 

for an exposure that is not a covered 

position under [the market risk rule] 

need not compute a separate 

counterparty credit risk capital 

requirement under this section so long 

as it does so consistently for all such 

credit derivatives and either includes all 

or excludes all such credit derivatives 

that are subject to a master netting 

contract from any measure used to 

determine counterparty credit risk 

exposure to all relevant counterparties 

for risk-based capital purposes. 

(ii) A [bank] that is the protection 

provider in a credit derivative must treat 

the credit derivative as a wholesale 

exposure to the reference obligor and 

need not compute a counterparty credit 

risk capital requirement for the credit 

derivative under this section, so long as 

it does so consistently for all such credit 

derivatives and either includes all or 

excludes all such credit derivatives that 

are subject to a master netting contract 

from any measure used to determine 

counterparty credit risk exposure to all 

relevant counterparties for risk-based 

capital purposes (unless the [bank] is 

treating the credit derivative as a 

covered position under [the market risk 

rule], in which case the [bank] must 

compute a supplemental counterparty 

credit risk capital requirement under 

this section). 

(4) Counterparty credit risk for equity 

derivatives. A [bank] must treat an 

equity derivative contract as an equity 

exposure and compute a risk-weighted 

asset amount for the equity derivative 

contract under part VI (unless the [bank] 

is treating the contract as a covered 

position under [the market risk rule]). In 

addition, if the [bank] is treating the 

contract as a covered position under 

[the market risk rule] and in certain 

other cases described in section 55, the 

[bank] must also calculate a risk-based 

capital requirement for the counterparty 

credit risk of an equity derivative 

contract under this part. 

(5) Single OTC derivative contract. 

Except as modified by paragraph (b)(7) 

of this section, the EAD for a single OTC 

derivative contract that is not subject to 

a qualifying master netting agreement is 

equal to the sum of the [bank]’s current 

credit exposure and potential future 

credit exposure on the derivative 

contract. 

(i) Current credit exposure. The 

current credit exposure for a single OTC 

derivative contract is the greater of the 

mark-to-market value of the derivative 

contract or zero. 

(ii) PFE. The PFE for a single OTC 

derivative contract, including an OTC 

derivative contract with a negative 

mark-to-market value, is calculated by 

multiplying the notional principal 

amount of the derivative contract by the 

appropriate conversion factor in Table 

4. For purposes of calculating either the 

potential future credit exposure under 

this paragraph or the gross potential 

future credit exposure under paragraph 

(b)(6) of this section for exchange rate 

contracts and other similar contracts in 

which the notional principal amount is 

equivalent to the cash flows, notional 

principal amount is the net receipts to 

each party falling due on each value 

date in each currency. For any OTC 

derivative contract that does not fall 

within one of the specified categories in 

Table 4, the potential future credit 

exposure must be calculated using the 

‘‘other commodity’’ conversion factors. 

[Bank]s must use an OTC derivative 

contract’s effective notional principal 

amount (that is, its apparent or stated 

notional principal amount multiplied by 

any multiplier in the OTC derivative 

contract) rather than its apparent or 

stated notional principal amount in 

calculating potential future credit 

exposure. PFE of the protection provider 

of a credit derivative is capped at the 

net present value of the amount of 

unpaid premiums. 

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

Remaining maturity** Interest rate 

Foreign exchange rate 

and gold 

Credit (investment 

grade reference obligor)*** 

Credit (noninvestment 

grade reference obligor) Equity 

Precious 

metals (except gold) 

Other commodity 

One year or less .................................. 0 .00 0 .01 0.05 0.10 0.06 0.07 0.10 

Over one to five years ......................... 0 .005 0 .05 0.05 0.10 0.08 0.07 0.12 

Over five years ..................................... 0 .015 0 .075 0.05 0.10 0.10 0.08 0.15 

* For an OTC derivative contract with multiple exchanges of principal, the conversion factor is multiplied by the number of remaining payments 

in the derivative contract. 


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Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55931 

** For an OTC derivative contract that is structured such that on specified dates any outstanding exposure is settled and the terms are reset so 

that the market value of the contract is zero, the remaining maturity equals the time until the next reset date. For an interest rate derivative contract with a remaining maturity of greater than one year that meets these criteria, the minimum conversion factor is 0.005. 

*** A [bank] must use column 4 of this table—‘‘Credit (investment grade reference obligor)’’—for a credit derivative whose reference obligor has 

an outstanding unsecured long-term debt security without credit enhancement that has a long-term applicable external rating of at least investment grade. A [bank] must use column 5 of the table for all other credit derivatives. 

(6) Multiple OTC derivative contracts 

subject to a qualifying master netting 

agreement. Except as modified by 

paragraph (b)(7) of this section, the EAD 

for multiple OTC derivative contracts 

subject to a qualifying master netting 

agreement is equal to the sum of the net 

current credit exposure and the adjusted 

sum of the PFE exposure for all OTC 

derivative contracts subject to the 

qualifying master netting agreement. 

(i) Net current credit exposure. The 

net current credit exposure is the greater 

of: 

(A) The net sum of all positive and 

negative mark-to-market values of the 

individual OTC derivative contracts 

subject to the qualifying master netting 

agreement; or 

(B) zero. 

(ii) Adjusted sum of the PFE. The 

adjusted sum of the PFE is calculated as 

Anet = (0.4 × Agross) + (0.6 × NGR × 

Agross), where: 

(A) Anet = the adjusted sum of the 

PFE; 

(B) Agross = the gross PFE (that is, the 

sum of the PFE amounts (as determined 

under paragraph (b)(5)(ii) of this 

section) for each individual OTC 

derivative contract subject to the 

qualifying master netting agreement); 

and 

(C) NGR = the net to gross ratio (that 

is, the ratio of the net current credit 

exposure to the gross current credit 

exposure). In calculating the NGR, the 

gross current credit exposure equals the 

sum of the positive current credit 

exposures (as determined under 

paragraph (b)(5)(i) of this section) of all 

individual OTC derivative contracts 

subject to the qualifying master netting 

agreement. 

(7) Collateralized OTC derivative 

contracts. A [bank] may recognize the 

credit risk mitigation benefits of 

financial collateral that secures an OTC 

derivative contract or single-product set 

of OTC derivatives subject to a 

qualifying master netting agreement 

(netting set) by factoring the collateral 

into its ELGD and LGD estimates for the 

contract or netting set. Alternatively, a 

[bank] may recognize the credit risk 

mitigation benefits of financial collateral 

that secures such a contract or netting 

set that is marked to market on a daily 

basis and subject to a daily margin 

maintenance requirement by estimating 

an unsecured ELGD and LGD for the 

contract or netting set and adjusting the 

EAD calculated under paragraph (b)(5) 

or (b)(6) of this section using the 

collateral haircut approach in paragraph 

(a)(2) of this section. The [bank] must 

substitute the EAD calculated under 

paragraph (b)(5) or (b)(6) of this section 

for SE in the equation in paragraph 

(a)(2)(i) of this section and must use a 

10-business-day minimum holding 

period (TM = 10). 

(c) Internal models methodology. (1) 

With prior written approval from 

[AGENCY], a [bank] may use the 

internal models methodology in this 

paragraph (c) to determine EAD for 

counterparty credit risk for OTC 

derivative contracts (collateralized or 

uncollateralized) and single-product 

netting sets thereof, for eligible margin 

loans and single-product netting sets 

thereof, and for repo-style transactions 

and single-product netting sets thereof. 

A [bank] that uses the internal models 

methodology for a particular transaction 

type (OTC derivative contracts, eligible 

margin loans, or repo-style transactions) 

must use the internal models 

methodology for all transactions of that 

transaction type. A [bank] may choose 

to use the internal models methodology 

for one or two of these three types of 

exposures and not the other types. A 

[bank] may also use the internal models 

methodology for OTC derivative 

contracts, eligible margin loans, and 

repo-style transactions subject to a 

qualifying cross-product netting 

agreement if: 

(i) The [bank] effectively integrates 

the risk mitigating effects of crossproduct netting into its risk 

management and other information 

technology systems; and 

(ii) The [bank] obtains the prior 

written approval of the [AGENCY]. 

A [bank] that uses the internal models 

methodology for a type of exposures 

must receive approval from the 

[AGENCY] to cease using the 

methodology for that type of exposures 

or to make a material change to its 

internal model. 

(2) Under the internal models 

methodology, a [bank] uses an internal 

model to estimate the expected 

exposure (EE) for a netting set and then 

calculates EAD based on that EE. 

(i) The [bank] must use its internal 

model’s probability distribution for 

changes in the market value of an 

exposure or netting set that are 

attributable to changes in market 

variables to determine EE. The [bank] 

may include financial collateral 

currently posted by the counterparty as 

collateral when calculating EE. 

(ii) Under the internal models 

methodology, EAD = a × effective EPE, 

or, subject to [AGENCY] approval as 

provided in paragraph (c)(7), a more 

conservative measure of EAD. 

() * A EffectiveEPE = EffectiveEE t t t

k=1

n

k k k ∑ ∆

(that is, effective EPE is the timeweighted average of effective EE where 

the weights are the proportion that an 

individual effective EE represents in a 

one year time interval) where: 

(1) Effective EEtk = max 

(EffectiveEEtk¥1,EEtk (that is, for a 

specific date tk, effective EE is the 

greater of EE at that date or the effective 

EE at the previous date); and 

(2) tk represents the kth future time 

period in the model and there are n time 

periods represented in the model over 

the first year; and 

(B) a = 1.4 except as provided in 

paragraph (c)(6), or when [AGENCY] has 

determined that the [bank] must set a 

higher based on the [bank]’s specific 

characteristics of counterparty credit 

risk. 

(3) To obtain [AGENCY] approval to 

calculate the distributions of exposures 

upon which the EAD calculation is 

based, the [bank] must demonstrate to 

the satisfaction of [AGENCY] that it has 

been using for at least one year an 

internal model that broadly meets the 

following minimum standards, with 

which the [bank] must maintain 

compliance: 


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55932 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

(i) The model must have the systems 

capability to estimate the expected 

exposure to the counterparty on a daily 

basis (but is not expected to estimate or 

report expected exposure on a daily 

basis). 

(ii) The model must estimate expected 

exposure at enough future dates to 

accurately reflect all the future cash 

flows of contracts in the netting set. 

(iii) The model must account for the 

possible non-normality of the exposure 

distribution, where appropriate. 

(iv) The [bank] must measure, 

monitor, and control current 

counterparty exposure and the exposure 

to the counterparty over the whole life 

of all contracts in the netting set. 

(v) The [bank] must measure and 

manage current exposures gross and net 

of collateral held, where appropriate. 

The [bank] must estimate expected 

exposures for OTC derivative contracts 

both with and without the effect of 

collateral agreements. 

(vi) The [bank] must have procedures 

to identify, monitor, and control specific 

wrong-way risk throughout the life of an 

exposure. Wrong-way risk in this 

context is the risk that future exposure 

to a counterparty will be high when the 

counterparty’s probability of default is 

also high. 

(vii) The model must use current 

market data to compute current 

exposures. When estimating model 

parameters based on historical data, at 

least three years of historical data that 

cover a wide range of economic 

conditions must be used and must be 

updated quarterly or more frequently if 

market conditions warrant. The [bank] 

should consider using model parameters 

based on forward-looking measures 

such as implied volatilities, where 

appropriate. 

(viii) A [bank] must subject its 

internal model to an initial validation 

and annual model review process. The 

model review should consider whether 

the inputs and risk factors, as well as the 

model outputs, are appropriate. 

(4) Maturity. (i) If the remaining 

maturity of the exposure or the longestdated contract in the netting set is 

greater than one year, the [bank] must 

set M for the exposure or netting set 

equal to the lower of 5 years or M(EPE), 

where: 

( ) A

t df

t

k k

 M (EPE) =1+

EE

effective EE

k

t >1 year

maturity

k

k

× ×

×

∑ ∆

∆ k k ×df

≤

∑k=1

t 1 year k

;

(B) dfk is the risk-free discount factor 

for future time period tk; and 

(C) Dtk = tk ¥ tk¥1. 

(ii) If the remaining maturity of the 

exposure or the longest-dated contract 

in the netting set is one year or less, the 

[bank] must set M for the exposure or 

netting set equal to 1 year, except as 

provided in paragraph (d)(7) of section 

31. 

(5) Collateral agreements. A [bank] 

may capture the effect on EAD of a 

collateral agreement that requires 

receipt of collateral when exposure to 

the counterparty increases but may not 

capture the effect on EAD of a collateral 

agreement that requires receipt of 

collateral when counterparty credit 

quality deteriorates. For this purpose, a 

collateral agreement means a legal 

contract that specifies the time when, 

and circumstances under which, the 

counterparty is required to exchange 

collateral with the [bank] for a single 

financial contract or for all financial 

contracts covered under a qualifying 

master netting agreement and confers 

upon the [bank] a perfected, first 

priority security interest, or the legal 

equivalent thereof, in the collateral 

posted by the counterparty under the 

agreement. This security interest must 

provide the [bank] with a right to close 

out the financial positions and the 

collateral upon an event of default of, or 

failure to perform by, the counterparty 

under the collateral agreement. A 

contract would not satisfy this 

requirement if the [bank]’s exercise of 

rights under the agreement may be 

stayed or avoided under applicable law 

in the relevant jurisdictions. Two 

methods are available to capture the 

effect of a collateral agreement: 

(i) With prior written approval from 

[AGENCY], a [bank] may include the 

effect of a collateral agreement within 

its internal model used to calculate 

EAD. The [bank] may set EAD equal to 

the expected exposure at the end of the 

margin period of risk. The margin 

period of risk means, with respect to a 

netting set subject to a collateral 

agreement, the time period from the 

most recent exchange of collateral with 

a counterparty until the next required 

exchange of collateral plus the period of 

time required to sell and realize the 

proceeds of the least liquid collateral 

that can be delivered under the terms of 

the collateral agreement, and, where 

applicable, the period of time required 

to re-hedge the resulting market risk, 

upon the default of the counterparty. 

The minimum margin period of risk is 

5 business days for repo-style 

transactions and 10 business days for 

other transactions when liquid financial 

collateral is posted under a daily margin 

maintenance requirement. This period 

should be extended to cover any 

additional time between margin calls; 

any potential closeout difficulties; any 

delays in selling collateral, particularly 

if the collateral is illiquid; and any 

impediments to prompt re-hedging of 

any market risk. 

(ii) A [bank] that can model EPE 

without collateral agreements but 

cannot achieve the higher level of 

modeling sophistication to model EPE 

with collateral agreements can set 

effective EPE for a collateralized 

counterparty equal to the lesser of: 

(A) The threshold, defined as the 

exposure amount at which the 

counterparty is required to post 

collateral under the collateral 

agreement, if the threshold is positive, 

plus an add-on that reflects the potential 

increase in exposure over the margin 

period of risk. The add-on is computed 

as the expected increase in the netting 

set’s exposure beginning from current 

exposure of zero over the margin period 

of risk. The margin period of risk must 

be at least five business days for 

exposures or netting sets consisting only 

of repo-style transactions subject to 

daily re-margining and daily markingto-market, and 10 business days for all 

other exposures or netting sets; or 

(B) Effective EPE without a collateral 

agreement. 

(6) Own estimate of alpha. With prior 

written approval of [AGENCY], a [bank] 

may calculate alpha as the ratio of 

economic capital from a full simulation 

of counterparty exposure across 

counterparties that incorporates a joint 

simulation of market and credit risk 

factors (numerator) and economic 

capital based on EPE (denominator), 

subject to a floor of 1.2. For purposes of 

this calculation, economic capital is the 

unexpected losses for all counterparty 


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Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55933 

credit risks measured at a 99.9 percent 

confidence level over a one-year 

horizon. To receive approval, the [bank] 

must meet the following minimum 

standards to the satisfaction of 

[AGENCY]: 

(i) The [bank]’s own estimate of alpha 

must capture in the numerator the 

effects of: 

(A) The material sources of stochastic 

dependency of distributions of market 

values of transactions or portfolios of 

transactions across counterparties; 

(B) Volatilities and correlations of 

market risk factors used in the joint 

simulation, which must be related to the 

credit risk factor used in the simulation 

to reflect potential increases in volatility 

or correlation in an economic downturn, 

where appropriate; and 

(C) The granularity of exposures, that 

is, the effect of a concentration in the 

proportion of each counterparty’s 

exposure that is driven by a particular 

risk factor. 

(ii) The [bank] must assess the 

potential model risk in its estimates of 

alpha. 

(iii) The [bank] must calculate the 

numerator and denominator of alpha in 

a consistent fashion with respect to 

modeling methodology, parameter 

specifications, and portfolio 

composition. 

(iv) The [bank] must review and 

adjust as appropriate its estimates of the 

numerator and denominator on at least 

a quarterly basis and more frequently 

when the composition of the portfolio 

varies over time. 

(7) Other measures of counterparty 

exposure. With prior written approval of 

[AGENCY], a [bank] may set EAD equal 

to a measure of counterparty credit risk 

exposure, such as peak EAD, that is 

more conservative than an alpha of 1.4 

(or higher under the terms of paragraph 

(c)(2)(ii)(B)) times EPE for every 

counterparty whose EAD will be 

measured under the alternative measure 

of counterparty exposure. The [bank] 

must demonstrate the conservatism of 

the measure of counterparty credit risk 

exposure used for EAD. 

Section 33. Guarantees and Credit 

Derivatives: PD Substitution and LGD 

Adjustment Treatments 

(a) Scope. (1) This section applies to 

wholesale exposures for which: 

(i) Credit risk is fully covered by an 

eligible guarantee or eligible credit 

derivative; and 

(ii) Credit risk is covered on a pro rata 

basis (that is, on a basis in which the 

[bank] and the protection provider share 

losses proportionately) by an eligible 

guarantee or eligible credit derivative. 

(2) Wholesale exposures on which 

there is a tranching of credit risk 

(reflecting at least two different levels of 

seniority) are securitization exposures 

subject to the securitization framework 

in part V. 

(3) A [bank] may elect to recognize the 

credit risk mitigation benefits of an 

eligible guarantee or eligible credit 

derivative covering an exposure 

described in paragraph (a)(1) of this 

section by using the PD substitution 

approach or the LGD adjustment 

approach in paragraph (c) of this section 

or using the double default treatment in 

section 34 (if the transaction qualifies 

for the double default treatment in 

section 34). A [bank]’s PD and LGD for 

the hedged exposure may not be lower 

than the PD and LGD floors described in 

paragraphs (d)(2) and (d)(3) of section 

31. 

(4) A [bank] must use the same risk 

parameters for calculating ECL as it uses 

for calculating the risk-based capital 

requirement for the exposure. 

(b) Rules of recognition. (1) A [bank] 

may only recognize the credit risk 

mitigation benefits of eligible guarantees 

and eligible credit derivatives. 

(2) A [bank] may only recognize the 

credit risk mitigation benefits of an 

eligible credit derivative to hedge an 

exposure that is different from the credit 

derivative’s reference exposure used for 

determining the derivative’s cash 

settlement value, deliverable obligation, 

or occurrence of a credit event if: 

(i) The reference exposure ranks pari 

passu (that is, equally) with or is junior 

to the hedged exposure; and 

(ii) The reference exposure and the 

hedged exposure share the same obligor 

(that is, the same legal entity), and 

legally enforceable cross-default or 

cross-acceleration clauses are in place. 

(c) Risk parameters for hedged 

exposures—(1) PD substitution 

approach—(i) Full coverage. If an 

eligible guarantee or eligible credit 

derivative meets the conditions in 

paragraphs (a) and (b) of this section 

and the protection amount (P) of the 

guarantee or credit derivative is greater 

than or equal to the EAD of the hedged 

exposure, a [bank] may recognize the 

guarantee or credit derivative in 

determining the [bank]’s risk-based 

capital requirement for the hedged 

exposure by substituting the PD 

associated with the rating grade of the 

protection provider for the PD 

associated with the rating grade of the 

obligor in the risk-based capital formula 

in Table 2 and using the appropriate 

ELGD and LGD as described in 

paragraphs (c)(1)(iii) and (iv) of this 

section. If the [bank] determines that 

full substitution of the protection 

provider’s PD leads to an inappropriate 

degree of risk mitigation, the [bank] may 

substitute a higher PD than that of the 

protection provider. 

(ii) Partial coverage. If an eligible 

guarantee or eligible credit derivative 

meets the conditions in paragraphs (a) 

and (b) of this section and the protection 

amount (P) of the guarantee or credit 

derivative is less than the EAD of the 

hedged exposure, the [bank] must treat 

the hedged exposure as two separate 

exposures (protected and unprotected) 

in order to recognize the credit risk 

mitigation benefit of the guarantee or 

credit derivative. 

(A) The [bank] must calculate its riskbased capital requirement for the 

protected exposure under section 31, 

where PD is the protection provider’s 

PD, ELGD and LGD are determined 

under paragraphs (c)(1)(iii) and (iv) of 

this section, and EAD is P. If the [bank] 

determines that full substitution leads to 

an inappropriate degree of risk 

mitigation, the [bank] may use a higher 

PD than that of the protection provider. 

(B) The [bank] must calculate its riskbased capital requirement for the 

unprotected exposure under section 31, 

where PD is the obligor’s PD, ELGD is 

the hedged exposure’s ELGD (not 

adjusted to reflect the guarantee or 

credit derivative), LGD is the hedged 

exposure’s LGD (not adjusted to reflect 

the guarantee or credit derivative), and 

EAD is the EAD of the original hedged 

exposure minus P. 

(C) The treatment in this paragraph 

(c)(1)(ii) is applicable when the credit 

risk of a wholesale exposure is covered 

on a pro rata basis or when an 

adjustment is made to the effective 

notional amount of the guarantee or 

credit derivative under paragraphs (d), 

(e), or (f) of this section. 

(iii) LGD of hedged exposures. The 

LGD of a hedged exposure under the PD 

substitution approach is equal to: 

(A) The lower of the LGD of the 

hedged exposure (not adjusted to reflect 

the guarantee or credit derivative) and 

the LGD of the guarantee or credit 

derivative, if the guarantee or credit 

derivative provides the [bank] with the 

option to receive immediate payout 

upon triggering the protection; or 

(B) The LGD of the guarantee or credit 

derivative, if the guarantee or credit 

derivative does not provide the [bank] 

with the option to receive immediate 

payout upon triggering the protection. 

(iv) ELGD of hedged exposures. The 

ELGD of a hedged exposure under the 

PD substitution approach is equal to the 

ELGD associated with the LGD 

determined under paragraph (c)(1)(iii) of 

this section. 


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55934 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

(2) LGD adjustment approach—(i) 

Full coverage. If an eligible guarantee or 

eligible credit derivative meets the 

conditions in paragraphs (a) and (b) of 

this section and the protection amount 

(P) of the guarantee or credit derivative 

is greater than or equal to the EAD of the 

hedged exposure, the [bank]’s risk-based 

capital requirement for the hedged 

exposure would be the greater of: 

(A) The risk-based capital 

requirement for the exposure as 

calculated under section 31, with the 

ELGD and LGD of the exposure adjusted 

to reflect the guarantee or credit 

derivative; or 

(B) The risk-based capital requirement 

for a direct exposure to the protection 

provider as calculated under section 31, 

using the PD for the protection provider, 

the ELGD and LGD for the guarantee or 

credit derivative, and an EAD equal to 

the EAD of the hedged exposure. 

(ii) Partial coverage. If an eligible 

guarantee or eligible credit derivative 

meets the conditions in paragraphs (a) 

and (b) of this section and the protection 

amount (P) of the guarantee or credit 

derivative is less than the EAD of the 

hedged exposure, the [bank] must treat 

the hedged exposure as two separate 

exposures (protected and unprotected) 

in order to recognize the credit risk 

mitigation benefit of the guarantee or 

credit derivative. 

(A) The [bank]’s risk-based capital 

requirement for the protected exposure 

would be the greater of: 

(1) The risk-based capital requirement 

for the protected exposure as calculated 

under section 31, with the ELGD and 

LGD of the exposure adjusted to reflect 

the guarantee or credit derivative and 

EAD set equal to P; or 

(2) The risk-based capital requirement 

for a direct exposure to the guarantor as 

calculated under section 31, using the 

PD for the protection provider, the 

ELGD and LGD for the guarantee or 

credit derivative, and an EAD set equal 

to P. 

(B) The [bank] must calculate its riskbased capital requirement for the 

unprotected exposure under section 31, 

where PD is the obligor’s PD, ELGD is 

the hedged exposure’s ELGD (not 

adjusted to reflect the guarantee or 

credit derivative), LGD is the hedged 

exposure’s LGD (not adjusted to reflect 

the guarantee or credit derivative), and 

EAD is the EAD of the original hedged 

exposure minus P. 

(3) M of hedged exposures. The M of 

the hedged exposure is the same as the 

M of the exposure if it were unhedged. 

(d) Maturity mismatch. (1) A [bank] 

that recognizes an eligible guarantee or 

eligible credit derivative in determining 

its risk-based capital requirement for a 

hedged exposure must adjust the 

protection amount of the credit risk 

mitigant to reflect any maturity 

mismatch between the hedged exposure 

and the credit risk mitigant. 

(2) A maturity mismatch occurs when 

the residual maturity of a credit risk 

mitigant is less than that of the hedged 

exposure(s). When a credit risk mitigant 

covers multiple hedged exposures that 

have different residual maturities, the 

longest residual maturity of any of the 

hedged exposures must be taken as the 

residual maturity of the hedged 

exposures. 

(3) The residual maturity of a hedged 

exposure is the longest possible 

remaining time before the obligor is 

scheduled to fulfill its obligation on the 

exposure. If a credit risk mitigant has 

embedded options that may reduce its 

term, the [bank] (protection purchaser) 

must use the shortest possible residual 

maturity for the credit risk mitigant. If 

a call is at the discretion of the 

protection provider, the residual 

maturity of the credit risk mitigant is at 

the first call date. If the call is at the 

discretion of the [bank] (protection 

purchaser), but the terms of the 

arrangement at origination of the credit 

risk mitigant contain a positive 

incentive for the [bank] to call the 

transaction before contractual maturity, 

the remaining time to the first call date 

is the residual maturity of the credit risk 

mitigant. For example, where there is a 

step-up in cost in conjunction with a 

call feature or where the effective cost 

of protection increases over time even if 

credit quality remains the same or 

improves, the residual maturity of the 

credit risk mitigant will be the 

remaining time to the first call. 

(4) A credit risk mitigant with a 

maturity mismatch may be recognized 

only if its original maturity is greater 

than or equal to one year and its 

residual maturity is greater than three 

months. 

(5) When a maturity mismatch exists, 

the [bank] must apply the following 

adjustment to reduce the protection 

amount of the credit risk mitigant: Pm 

= E × (t¥0.25)/(T¥0.25), where: 

(i) Pm = protection amount of the 

credit risk mitigant, adjusted for 

maturity mismatch; 

(ii) E = effective notional amount of 

the credit risk mitigant; 

(iii) t = the lesser of T or the residual 

maturity of the credit risk mitigant, 

expressed in years; and 

(iv) T = the lesser of 5 or the residual 

maturity of the hedged exposure, 

expressed in years. 

(e) Credit derivatives without 

restructuring as a credit event. If a 

[bank] recognizes an eligible credit 

derivative that does not include as a 

credit event a restructuring of the 

hedged exposure involving forgiveness 

or postponement of principal, interest, 

or fees that results in a credit loss event 

(that is, a charge-off, specific provision, 

or other similar debit to the profit and 

loss account), the [bank] must apply the 

following adjustment to reduce the 

protection amount of the credit 

derivative: Pr = Pm × 0.60, where: 

(1) Pr = protection amount of the 

credit derivative, adjusted for lack of 

restructuring event (and maturity 

mismatch, if applicable); and 

(2) Pm = effective notional amount of 

the credit derivative (adjusted for 

maturity mismatch, if applicable). 

(f) Currency mismatch. (1) If a [bank] 

recognizes an eligible guarantee or 

eligible credit derivative that is 

denominated in a currency different 

from that in which the hedged exposure 

is denominated, the protection amount 

of the guarantee or credit derivative is 

reduced by application of the following 

formula: Pc = Pr × (1 × HFX), where: 

(i) Pc = protection amount of the 

guarantee or credit derivative, adjusted 

for currency mismatch (and maturity 

mismatch and lack of restructuring 

event, if applicable); 

(ii) Pr = effective notional amount of 

the guarantee or credit derivative 

(adjusted for maturity mismatch and 

lack of restructuring event, if 

applicable); and 

(iii) HFX = haircut appropriate for the 

currency mismatch between the 

guarantee or credit derivative and the 

hedged exposure. 

(2) A [bank] must set HFX equal to 8 

percent unless it qualifies for the use of 

and uses its own internal estimates of 

foreign exchange volatility based on a 

10-business day holding period and 

daily marking-to-market and 

remargining. A [bank] qualifies for the 

use of its own internal estimates of 

foreign exchange volatility if it qualifies 

for: 

(i) The own-estimates haircuts in 

paragraph (a)(2)(iii) of section 32; 

(ii) The simple VaR methodology in 

paragraph (a)(3) of section 32; or 

(iii) The internal models methodology 

in paragraph (c) of section 32. 

(3) A [bank] must adjust HFX

calculated in paragraph (f)(2) of this 

section upward if the [bank] revalues 

the guarantee or credit derivative less 

frequently than once every 10 business 

days using the square root of time 

formula provided in paragraph 

(a)(2)(iii)(A)(2) of section 32. 


sroberts on PROD1PC70 with PROPOSALS
Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55935 

Section 34. Guarantees and Credit 

Derivatives: Double Default Treatment 

(a) Eligibility and operational criteria 

for double default treatment. A [bank] 

may recognize the credit risk mitigation 

benefits of a guarantee or credit 

derivative covering an exposure 

described in paragraph (a)(1) of section 

33 by applying the double default 

treatment in this section if all the 

following criteria are satisfied. 

(1) The hedged exposure is fully 

covered or covered on a pro rata basis 

by: 

(i) An eligible guarantee issued by an 

eligible double default guarantor; or 

(ii) An eligible credit derivative that 

meets the requirements of paragraph 

(b)(2) of section 33 and is issued by an 

eligible double default guarantor. 

(2) The guarantee or credit derivative 

is: 

(i) An uncollateralized guarantee or 

uncollateralized credit derivative (for 

example, a credit default swap) that 

provides protection with respect to a 

single reference obligor; or 

(ii) An nth-to-default credit derivative 

(subject to the requirements of 

paragraph (m) of section 42). 

(3) The hedged exposure is a 

wholesale exposure (other than a 

sovereign exposure). 

(4) The obligor of the hedged 

exposure is not: 

(i) An eligible double default 

guarantor or an affiliate of an eligible 

double default guarantor; or 

(ii) An affiliate of the guarantor. 

(5) The [bank] does not recognize any 

credit risk mitigation benefits of the 

guarantee or credit derivative for the 

hedged exposure other than through 

application of the double default 

treatment as provided in this section. 

(6) The [bank] has implemented a 

process (which has received the prior, 

written approval of the [AGENCY]) to 

detect excessive correlation between the 

creditworthiness of the obligor of the 

hedged exposure and the protection 

provider. If excessive correlation is 

present, the [bank] may not use the 

double default treatment for the hedged 

exposure. 

(b) Full coverage. If the transaction 

meets the criteria in paragraph (a) of this 

section and the protection amount (P) of 

the guarantee or credit derivative is at 

least equal to the EAD of the hedged 

exposure, the [bank] may determine its 

risk-weighted asset amount for the 

hedged exposure under paragraph (e) of 

this section. 

(c) Partial coverage. If the transaction 

meets the criteria in paragraph (a) of this 

section and the protection amount (P) of 

the guarantee or credit derivative is less 

than the EAD of the hedged exposure, 

the [bank] must treat the hedged 

exposure as two separate exposures 

(protected and unprotected) in order to 

recognize double default treatment on 

the protected portion of the exposure. 

(1) For the protected exposure, the 

[bank] must set EAD equal to P and 

calculate its risk-weighted asset amount 

as provided in paragraph (e) of this 

section. 

(2) For the unprotected exposure, the 

[bank] must set EAD equal to the EAD 

of the original exposure minus P and 

then calculate its risk-weighted asset 

amount as provided in section 31. 

(d) Mismatches. For any hedged 

exposure to which a [bank] applies 

double default treatment, the [bank] 

must make applicable adjustments to 

the protection amount as required in 

paragraphs (d), (e), and (f) of section 33. 

(e) The double default dollar riskbased 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 × (0.15 + 

160 × PDg), where: 

( ) . 1

0 999

1

1 1

K LGD N

N PD N

o g ELGD PD g o

O OS

OS

= × ( ) + ( )

−

















− × ( − − ρ

ρ )

















×

+ − ( )×

− ×





 





1 25

1 15

M b

b

.

.

(2) PDg = PD of the protection 

provider. 

(3) PDo = PD of the obligor of the 

hedged exposure. 

(4) LGDg = (i) The lower of the LGD 

of the unhedged exposure and the LGD 

of the guarantee or credit derivative, if 

the guarantee or credit derivative 

provides the [bank] with the option to 

receive immediate payout on triggering 

the protection; or 

(ii) The LGD of the guarantee or credit 

derivative, if the guarantee or credit 

derivative does not provide the [bank] 

with the option to receive immediate 

payout on triggering the protection. 

(5) ELGDg = The ELGD associated 

with LGDg. 

(6) ros (asset value correlation of the 

obligor) is calculated according to the 

appropriate formula for (R) provided in 

Table 2 in section 31, with PD equal to 

PDo. 

(7) b (maturity adjustment coefficient) 

is calculated according to the formula 

for b provided in Table 2 in section 31, 

with PD equal to the lesser of PDo and 

PDg. 

(8) M (maturity) is the effective 

maturity of the guarantee or credit 

derivative, which may not be less than 

one year or greater than five years. 

Section 35. Risk-Based Capital 

Requirement for Unsettled Transactions 

(a) Definitions. For purposes of this 

section: 

(1) Delivery-versus-payment (DvP) 

transaction means a securities or 

commodities transaction in which the 

buyer is obligated to make payment only 

if the seller has made delivery of the 

securities or commodities and the seller 

is obligated to deliver the securities or 

commodities only if the buyer has made 

payment. 

(2) Payment-versus-payment (PvP) 

transaction means a foreign exchange 

transaction in which each counterparty 

is obligated to make a final transfer of 

one or more currencies only if the other 

counterparty has made a final transfer of 

one or more currencies. 

(3) Normal settlement period. A 

transaction has a normal settlement 

period if the contractual settlement 

period for the transaction is equal to or 

less than the market standard for the 

instrument underlying the transaction 

and equal to or less than 5 business 

days. 

(4) Positive current exposure. The 

positive current exposure of a [bank] for 

a transaction is the difference between 

the transaction value at the agreed 

settlement price and the current market 

price of the transaction, if the difference 

results in a credit exposure of the [bank] 

to the counterparty. 

(b) Scope. This section applies to all 

transactions involving securities, foreign 

exchange instruments, and commodities 

that have a risk of delayed settlement or 

delivery. This section does not apply to: 

(1) Transactions accepted by a 

qualifying central counterparty that are 

subject to daily marking-to-market and 

daily receipt and payment of variation 

margin; 


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9Unsettled repo-style transactions are treated as 

repo-style transactions under sections 31 and 32. 

(2) Repo-style transactions (which are 

addressed in sections 31 and 32); 9

(3) One-way cash payments on OTC 

derivative contracts (which are 

addressed in sections 31 and 32); or 

(4) Transactions with a contractual 

settlement period that is longer than the 

normal settlement period (which are 

treated as OTC derivative contracts and 

addressed in sections 31 and 32). 

(c) System-wide failures. In the case of 

a system-wide failure of a settlement or 

clearing system, the [AGENCY] may 

waive risk-based capital requirements 

for unsettled and failed transactions 

until the situation is rectified. 

(d) Delivery-versus-payment (DvP) 

and payment-versus-payment (PvP) 

transactions. A [bank] must hold riskbased 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 riskweighted 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

Number of business days 

after contractual settlement 

date 

Risk weight to 

be applied to 

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-deliveryversus-payment/non-payment-versuspayment) transactions. (1) A [bank] 

must hold risk-based capital against any 

non-DvP/non-PvP transaction with a 

normal settlement period if the [bank] 

has delivered cash, securities, 

commodities, or currencies to its 

counterparty but has not received its 

corresponding deliverables by the end 

of the same business day. The [bank] 

must continue to hold risk-based capital 

against the transaction until the [bank] 

has received its corresponding 

deliverables. 

(2) From the business day after the 

[bank] has made its delivery until five 

business days after the counterparty 

delivery is due, the [bank] must 

calculate its risk-based capital 

requirement for the transaction by 

treating the current market value of the 

deliverables owed to the [bank] as a 

wholesale exposure. 

(i) A [bank] may assign an obligor 

rating to a counterparty for which it is 

not otherwise required under this rule 

to assign an obligor rating on the basis 

of the applicable external rating of any 

outstanding unsecured long-term debt 

security without credit enhancement 

issued by the counterparty. 

(ii) A [bank] may use a 45 percent 

ELGD and LGD for the transaction rather 

than estimating ELGD and LGD for the 

transaction provided the [bank] uses the 

45 percent ELGD and LGD for all 

transactions described in paragraphs 

(e)(1) and (e)(2) of this section. 

(iii) A [bank] may use a 100 percent 

risk weight for the transaction provided 

the [bank] uses this risk weight for all 

transactions described in paragraphs 

(e)(1) and (e)(2) of this section. 

(3) If the [bank] has not received its 

deliverables by the fifth business day 

after counterparty delivery was due, the 

[bank] must deduct the current market 

value of the deliverables owed to the 

[bank] 50 percent from tier 1 capital and 

50 percent from tier 2 capital. 

(f) Total risk-weighted assets for 

unsettled transactions. Total riskweighted assets for unsettled 

transactions is the sum of the riskweighted asset amounts of all DvP, PvP, 

and non-DvP/non-PvP transactions. 

Part V. Risk-Weighted Assets for 

Securitization Exposures 

Section 41. Operational Criteria for 

Recognizing the Transfer of Risk 

(a) Operational criteria for traditional 

securitizations. A [bank] that transfers 

exposures it has originated or purchased 

to an SPE or other third party in 

connection with a traditional 

securitization may exclude the 

exposures from the calculation of its 

risk-weighted assets only if each of the 

conditions in this paragraph (a) is 

satisfied. A [bank] that meets these 

conditions must hold risk-based capital 

against any securitization exposures it 

retains in connection with the 

securitization. A [bank] that fails to 

meet these conditions must hold riskbased capital against the transferred 

exposures as if they had not been 

securitized and must deduct from tier 1 

capital any after-tax gain-on-sale 

resulting from the transaction. The 

conditions are: 

(1) The transfer is considered a sale 

under GAAP; 

(2) The [bank] has transferred to third 

parties credit risk associated with the 

underlying exposures; and 

(3) Any clean-up calls relating to the 

securitization are eligible clean-up calls. 

(b) Operational criteria for synthetic 

securitizations. For synthetic 

securitizations, a [bank] may recognize 

for risk-based capital purposes the use 

of a credit risk mitigant to hedge 

underlying exposures only if each of the 

conditions in this paragraph (b) is 

satisfied. A [bank] that fails to meet 

these conditions must hold risk-based 

capital against the underlying exposures 

as if they had not been synthetically 

securitized. The conditions are: 

(1) The credit risk mitigant is 

financial collateral, an eligible credit 

derivative from an eligible securitization 

guarantor, or an eligible guarantee from 

an eligible securitization guarantor; 

(2) The [bank] transfers credit risk 

associated with the underlying 

exposures to third parties, and the terms 

and conditions in the credit risk 

mitigants employed do not include 

provisions that: 

(i) Allow for the termination of the 

credit protection due to deterioration in 

the credit quality of the underlying 

exposures; 

(ii) Require the [bank] to alter or 

replace the underlying exposures to 

improve the credit quality of the pool of 

underlying exposures; 

(iii) Increase the [bank]’s cost of credit 

protection in response to deterioration 

in the credit quality of the underlying 

exposures; 

(iv) Increase the yield payable to 

parties other than the [bank] in response 

to a deterioration in the credit quality of 

the underlying exposures; or 

(v) Provide for increases in a retained 

first loss position or credit enhancement 

provided by the [bank] after the 

inception of the securitization; 

(3) The [bank] obtains a well-reasoned 

opinion from legal counsel that 

confirms the enforceability of the credit 

risk mitigant in all relevant 

jurisdictions; and 

(4) Any clean-up calls relating to the 

securitization are eligible clean-up calls. 

Section 42. Risk-Based Capital 

Requirement for Securitization 

Exposures 

(a) Hierarchy of approaches. Except as 

provided elsewhere in this section: 

(1) A [bank] must deduct from tier 1 

capital any after-tax gain-on-sale 

resulting from a securitization and must 

deduct from total capital in accordance 

with paragraph (c) of this section the 

portion of any CEIO that does not 

constitute gain-on-sale. 

(2) If a securitization exposure does 

not require deduction under paragraph 

(a)(1) of this section and qualifies for the 

Ratings-Based Approach in section 43, a 

[bank] must apply the Ratings-Based 

Approach to the exposure. 


sroberts on PROD1PC70 with PROPOSALS
Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55937 

(3) If a securitization exposure does 

not require deduction under paragraph 

(a)(1) of this section and does not 

qualify for the Ratings-Based Approach, 

the [bank] may either apply the Internal 

Assessment Approach in section 44 to 

the exposure (if the [bank] and the 

relevant ABCP program qualify for the 

Internal Assessment Approach) or the 

Supervisory Formula Approach in 

section 45 to the exposure (if the [bank] 

and the exposure qualify for the 

Supervisory Formula Approach). 

(4) If a securitization exposure does 

not require deduction under paragraph 

(a)(1) of this section and does not 

qualify for the Ratings-Based Approach, 

the Internal Assessment Approach, or 

the Supervisory Formula Approach, the 

[bank] must deduct the exposure from 

total capital in accordance with 

paragraph (c) of this section. 

(b) Total risk-weighted assets for 

securitization exposures. A [bank]’s 

total risk-weighted assets for 

securitization exposures is equal to the 

sum of its risk-weighted assets 

calculated using the Ratings-Based 

Approach in section 43, the Internal 

Assessment Approach in section 44, and 

the Supervisory Formula Approach in 

section 45, and its risk-weighted assets 

amount for early amortization 

provisions calculated in section 47. 

(c) Deductions. (1) If a [bank] must 

deduct a securitization exposure from 

total capital, the [bank] must take the 

deduction 50 percent from tier 1 capital 

and 50 percent from tier 2 capital. If the 

amount deductible from tier 2 capital 

exceeds the [bank]’s tier 2 capital, the 

[bank] must deduct the excess from tier 

1 capital. 

(2) A [bank] may calculate any 

deduction from regulatory capital for a 

securitization exposure net of any 

deferred tax liabilities associated with 

the securitization exposure. 

(d) Maximum risk-based capital 

requirement. Regardless of any other 

provisions of this part, unless one or 

more underlying exposures does not 

meet the definition of a wholesale, 

retail, securitization, or equity exposure, 

the total risk-based capital requirement 

for all securitization exposures held by 

a single [bank] associated with a single 

securitization (including any risk-based 

capital requirements that relate to an 

early amortization provision of the 

securitization but excluding any riskbased capital requirements that relate to 

the [bank]’s gain-on-sale or CEIOs 

associated with the securitization) may 

not exceed the sum of: 

(1) The [bank]’s total risk-based 

capital requirement for the underlying 

exposures as if the [bank] directly held 

the underlying exposures; plus 

(2) The total ECL of the underlying 

exposures. 

(e) Amount of a securitization 

exposure. (1) The amount of an onbalance sheet securitization exposure is: 

(i) The [bank]’s carrying value, if the 

exposure is held-to-maturity or for 

trading; or 

(ii) The [bank]’s carrying value minus 

any unrealized gains and plus any 

unrealized losses on the exposure, if the 

exposure is available-for-sale. 

(2) The amount of an off-balance sheet 

securitization exposure is the notional 

amount of the exposure. For a 

commitment, such as a liquidity facility 

extended to an ABCP program, the 

notional amount may be reduced to the 

maximum potential amount that the 

[bank] currently would be required to 

fund under the arrangement’s 

documentation. For an OTC derivative 

contract that is not a credit derivative, 

the notional amount is the EAD of the 

derivative contract (as calculated in 

section 32). 

(f) Overlapping exposures—(1) ABCP 

programs. If a [bank] has multiple 

securitization exposures to an ABCP 

program that provide duplicative 

coverage of the underlying exposures of 

a securitization (such as when a [bank] 

provides a program-wide credit 

enhancement and multiple pool-specific 

liquidity facilities to an ABCP program), 

the [bank] is not required to hold 

duplicative risk-based capital against 

the overlapping position. Instead, the 

[bank] may apply to the overlapping 

position the applicable risk-based 

capital treatment that results in the 

highest risk-based capital requirement. 

(2) Mortgage loan swaps. If a [bank] 

holds a mortgage-backed security or 

participation certificate as a result of a 

mortgage loan swap with recourse, and 

the transaction is a securitization 

exposure, the [bank] must determine a 

risk-weighted asset amount for the 

recourse obligation plus the percentage 

of the mortgage-backed security or 

participation certificate that is not 

covered by the recourse obligation. The 

total risk-weighted asset amount for the 

transaction is capped at the riskweighted asset amount for the 

underlying exposures as if they were 

held directly on the [bank]’s balance 

sheet. 

(g) Securitizations of non-IRB 

exposures. Regardless of paragraph (a) 

of this section, if a [bank] has a 

securitization exposure where any 

underlying exposure is not a wholesale 

exposure, retail exposure, securitization 

exposure, or equity exposure, the [bank] 

must: 

(1) If the [bank] is an originating 

[bank], deduct from tier 1 capital any 

after-tax gain-on-sale resulting from the 

securitization and deduct from total 

capital in accordance with paragraph (c) 

of this section the portion of any CEIO 

that does not constitute gain-on-sale; 

(2) If the securitization exposure does 

not require deduction under paragraph 

(g)(1), apply the RBA in section 43 to 

the securitization exposure if the 

exposure qualifies for the RBA; and 

(3) If the securitization exposure does 

not require deduction under paragraph 

(g)(1) and does not qualify for the RBA, 

deduct the exposure from total capital 

in accordance with paragraph (c) of this 

section. 

(h) Implicit support. If a [bank] 

provides support to a securitization in 

excess of the [bank]’s contractual 

obligation to provide credit support to 

the securitization (implicit support): 

(1) The [bank] must hold regulatory 

capital against all of the underlying 

exposures associated with the 

securitization as if the exposures had 

not been securitized and must deduct 

from tier 1 capital any after-tax gain-onsale resulting from the securitization; 

and 

(2) The [bank] must disclose publicly: 

(i) That it has provided implicit 

support to the securitization; and 

(ii) The regulatory capital impact to 

the [bank] of providing such implicit 

support. 

(i) Eligible servicer cash advance 

facilities. Regardless of any other 

provisions of this part, a [bank] is not 

required to hold risk-based capital 

against the undrawn portion of an 

eligible servicer cash advance facility. 

(j) Interest-only mortgage-backed 

securities. Regardless of any other 

provisions of this part, the risk weight 

for a non-credit enhancing interest-only 

mortgage-backed security may not be 

less than 100 percent. 

(k) Small-business loans and leases 

on personal property transferred with 

recourse. (1) Regardless of any other 

provisions of this appendix, a [bank] 

that has transferred small-business loans 

and leases of personal property (smallbusiness 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 noncapital 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 


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55938 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

under section 3(a) of the Small Business 

Act. 

(iv) The [bank] is well capitalized, as 

defined in the [AGENCY]’s prompt 

corrective action regulation—12 CFR 

part 6 (for national banks), 12 CFR part 

208, subpart D (for state member banks 

or bank holding companies), 12 CFR 

part 325, subpart B (for state 

nonmember banks), and 12 CFR part 

565 (for savings associations). For 

purposes of determining whether a 

[bank] is well capitalized for purposes 

of paragraph (k) of this section, the 

[bank]’s capital ratios must be 

calculated without regard to the 

preferential capital treatment for 

transfers of small-business obligations 

with recourse specified in paragraph 

(k)(1) of this section. 

(2) The total outstanding amount of 

recourse retained by a [bank] on 

transfers of small-business obligations 

receiving the preferential capital 

treatment specified in paragraph (k)(1) 

of this section cannot exceed 15 percent 

of the [bank]’s total qualifying capital. 

(3) If a [bank] ceases to be well 

capitalized or exceeds the 15 percent 

capital limitation, the preferential 

capital treatment specified in paragraph 

(k)(1) of this section will continue to 

apply to any transfers of small-business 

obligations with recourse that occurred 

during the time that the [bank] was well 

capitalized and did not exceed the 

capital limit. 

(4) The risk-based capital ratios of the 

[bank] must be calculated without 

regard to the preferential capital 

treatment for transfers of small-business 

obligations with recourse specified in 

paragraph (k)(1) of this section as 

provided in 12 CFR part 3, Appendix A 

(for national banks), 12 CFR part 208, 

Appendix A (for state member banks), 

12 CFR part 225, Appendix A (for bank 

holding companies), 12 CFR part 325, 

Appendix A (for state nonmember 

banks), and 12 CFR 567.6(b)(5)(v) (for 

savings associations). 

(l) Consolidated ABCP programs—(1) 

A [bank] that qualifies as a primary 

beneficiary and must consolidate an 

ABCP program as a variable interest 

entity under GAAP may exclude the 

consolidated ABCP program assets from 

risk-weighted assets if the [bank] is the 

sponsor of the ABCP program. If a 

[bank] excludes such consolidated 

ABCP program assets from riskweighted 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 riskweighted assets, the [bank] must hold 

risk-based capital against the 

consolidated ABCP program assets in 

accordance with this appendix but is 

not required to hold risk-based capital 

against any securitization exposures of 

the [bank] to the ABCP program. 

(m) Nth-to-default credit derivatives—

(1) First-to-default credit derivatives—(i) 

Protection purchaser. A [bank] that 

obtains credit protection on a group of 

underlying exposures through a first-todefault credit derivative must determine 

its risk-based capital requirement for the 

underlying exposures as if the [bank] 

synthetically securitized the underlying 

exposure with the lowest risk-based 

capital requirement (K) (as calculated 

under Table 2) and had obtained no 

credit risk mitigant on the other 

underlying exposures. 

(ii) Protection provider. A [bank] that 

provides credit protection on a group of 

underlying exposures through a first-todefault credit derivative must determine 

its risk-weighted asset amount for the 

derivative by applying the RBA in 

section 43 (if the derivative qualifies for 

the RBA) or, if the derivative does not 

qualify for the RBA, by setting its riskweighted asset amount for the derivative 

equal to the product of: 

(A) The protection amount of the 

derivative; 

(B) 12.5; and 

(C) The sum of the risk-based capital 

requirements (K) of the individual 

underlying exposures (as calculated 

under Table 2), up to a maximum of 100 

percent. 

(2) Second-or-subsequent-to-default 

credit derivatives—(i) Protection 

purchaser. (A) A [bank] that obtains 

credit protection on a group of 

underlying exposures through a nth-todefault credit derivative (other than a 

first-to-default credit derivative) may 

recognize the credit risk mitigation 

benefits of the derivative only if: 

(1) The [bank] also has obtained credit 

protection on the same underlying 

exposures in the form of first-through- 

(n–1)-to-default credit derivatives; or 

(2) If n–1 of the underlying exposures 

have already defaulted. 

(B) If a [bank] satisfies the 

requirements of paragraph (m)(2)(i)(A) 

of this section, the [bank] must 

determine its risk-based capital 

requirement for the underlying 

exposures as if the [bank] had only 

synthetically securitized the underlying 

exposure with the nth lowest risk-based 

capital requirement (K) (as calculated 

under Table 2) and had obtained no 

credit risk mitigant on the other 

underlying exposures. 

(ii) Protection provider. A [bank] that 

provides credit protection on a group of 

underlying exposures through a nth-todefault credit derivative (other than a 

first-to-default credit derivative) must 

determine its risk-weighted asset 

amount for the derivative by applying 

the RBA in section 43 (if the derivative 

qualifies for the RBA) or, if the 

derivative does not qualify for the RBA, 

by setting its risk-weighted asset amount 

for the derivative equal to the product 

of: 

(A) The protection amount of the 

derivative; 

(B) 12.5; and 

(C) The sum of the risk-based capital 

requirements (K) of the individual 

underlying exposures (as calculated 

under Table 2 and excluding the n–1 

underlying exposures with the lowest 

Ks), up to a maximum of 100 percent. 

Section 43. Ratings-Based Approach 

(RBA) 

(a) Eligibility requirements for use of 

the RBA—(1) Originating [bank]. An 

originating [bank] must use the RBA to 

calculate its risk-based capital 

requirement for a securitization 

exposure if the exposure has two or 

more external ratings or an inferred 

rating based on two or more external 

ratings (and may not use the RBA if the 

exposure has fewer than two external 

ratings or an inferred rating based on 

fewer than two external ratings). 

(2) Investing [bank]. An investing 

[bank] must use the RBA to calculate its 

risk-based capital requirement for a 

securitization exposure if the exposure 

has one or more external or inferred 

ratings (and may not use the RBA if the 

exposure has no external or inferred 

rating). 

(b) Ratings-based approach. (1) A 

[bank] must determine the risk-weighted 

asset amount for a securitization 

exposure by multiplying the amount of 

the exposure (as defined in paragraph 

(e) of section 42) by the appropriate risk 

weight provided in the tables in this 

section. 

(2) The applicable rating of a 

securitization exposure that has more 

than one external or inferred rating is 

the lowest rating. 

(3) A [bank] must apply the risk 

weights in Table 6 when the 

securitization exposure’s external or 

inferred rating represents a long-term 

credit rating, and must apply the risk 

weights in Table 7 when the 

securitization exposure’s external or 

inferred rating represents a short-term 

credit rating. 

(i) A [bank] must apply the risk 

weights in column 1 of Table 6 or 7 to 

the securitization exposure if: 

(A) N (as calculated under paragraph 

(e)(6) of section 45) is 6 or more (for 


sroberts on PROD1PC70 with PROPOSALS
Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55939 

purposes of this section 43 only, if the 

notional number of underlying 

exposures is 25 or more or if all of the 

underlying exposures are retail 

exposures, a [bank] may assume that N 

is 6 or more unless the [bank] knows or 

has reason to know that N is less than 

6); and 

(B) The securitization exposure is a 

senior securitization exposure. 

(ii) A [bank] must apply the risk 

weights in column 3 of Table 6 or 7 to 

the securitization exposure if N is less 

than 6, regardless of the seniority of the 

securitization exposure. 

(iii) Otherwise, a [bank] must apply 

the risk weights in column 2 of Table 6 

or 7. 

TABLE 6.—LONG-TERM CREDIT RATING RISK WEIGHTS UNDER RBA AND IAA 

Applicable rating (illustrative rating example) 

Column 1 Column 2 Column 3 

Risk weights for 

senior 

securitization exposures backed 

by granular pools 

(percent) 

Risk weights for 

non-senior 

securitization exposures backed 

by granular pools 

(percent) 

Risk weights for 

securitization exposures backed 

by non-granular 

pools 

(percent) 

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

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

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

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

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

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

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

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

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

One category below investment grade (for example, BB) ........................................ 425 

One category below investment grade—negative designation (for example, BB¥) 650 

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

TABLE 7.—SHORT-TERM CREDIT RATING RISK WEIGHTS UNDER RBA AND IAA 

Applicable Rating (illustrative rating example) 

Column 1 Column 2 Column 3 

Risk weights for 

senior 

securitization exposures backed 

by granular pools 

(percent) 

Risk weights for 

non-senior 

securitization exposures backed 

by granular pools 

(percent) 

Risk weights for 

securitization exposures backed 

by non-granular 

pools 

(percent) 

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

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

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

All other ratings .......................................................................................................... Deduction from tier 1 and tier 2 capital. 

Section 44. Internal Assessment 

Approach (IAA) 

(a) Eligibility requirements. A [bank] 

may apply the IAA to calculate the riskweighted asset amount for a 

securitization exposure that the [bank] 

has to an ABCP program (such as a 

liquidity facility or credit enhancement) 

if the [bank], the ABCP program, and the 

exposure qualify for use of the IAA. 

(1) [Bank] qualification criteria. A 

[bank] qualifies for use of the IAA if the 

[bank] has received the prior written 

approval of the [AGENCY]. To receive 

such approval, the [bank] must 

demonstrate to the [AGENCY]’s 

satisfaction that the [bank]’s internal 

assessment process meets the following 

criteria: 

(i) The [bank]’s internal credit 

assessments of securitization exposures 

must be based on publicly available 

rating criteria used by an NRSRO. 

(ii) The [bank]’s internal credit 

assessments of securitization exposures 

used for risk-based capital purposes 

must be consistent with those used in 

the [bank]’s internal risk management 

process, management information 

reporting systems, and capital adequacy 

assessment process. 

(iii) The [bank]’s internal credit 

assessment process must have sufficient 

granularity to identify gradations of risk. 

Each of the [bank]’s internal credit 

assessment categories must correspond 

to an external rating of an NRSRO. 

(iv) The [bank]’s internal credit 

assessment process, particularly the 

stress test factors for determining credit 

enhancement requirements, must be at 

least as conservative as the most 

conservative of the publicly available 

rating criteria of the NRSROs that have 

provided external ratings to the 

commercial paper issued by the ABCP 

program. 

(A) Where the commercial paper 

issued by an ABCP program has an 

external rating from two or more 

NRSROs and the different NRSROs’

benchmark stress factors require 

different levels of credit enhancement to 

achieve the same external rating 

equivalent, the [bank] must apply the 

NRSRO stress factor that requires the 

highest level of credit enhancement. 

(B) If one of the NRSROs that provides 

an external rating to the ABCP 

program’s commercial paper changes its 

methodology (including stress factors), 

the [bank] must consider the NRSRO’s 

revised rating methodology in 

evaluating whether the internal credit 

assessments assigned by the [bank] to 


sroberts on PROD1PC70 with PROPOSALS
55940 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

securitization exposures must be 

revised. 

(v) The [bank] must have an effective 

system of controls and oversight that 

ensures compliance with these 

operational requirements and maintains 

the integrity and accuracy of the 

internal credit assessments. The [bank] 

must have an internal audit function 

independent from the ABCP program 

business line and internal credit 

assessment process that assesses at least 

annually whether the controls over the 

internal credit assessment process 

function as intended. 

(vi) The [bank] must review and 

update each internal credit assessment 

whenever new material information is 

available, but no less frequently than 

annually. 

(vii) The [bank] must validate its 

internal credit assessment process on an 

ongoing basis and at least annually. 

(2) ABCP-program qualification 

criteria. An ABCP program qualifies for 

use of the IAA if the ABCP program 

meets the following criteria: 

(i) All commercial paper issued by the 

ABCP program must have an external 

rating. 

(ii) The ABCP program must have 

robust credit and investment guidelines 

(that is, underwriting standards). 

(iii) The ABCP program must perform 

a detailed credit analysis of the asset 

sellers’ risk profiles. 

(iv) The ABCP program’s 

underwriting policy must establish 

minimum asset eligibility criteria that 

include the prohibition of the purchase 

of assets that are significantly past due 

or defaulted, as well as limitations on 

concentration to individual obligor or 

geographic area and the tenor of the 

assets to be purchased. 

(v) The aggregate estimate of loss on 

an asset pool that the ABCP program is 

considering purchasing must consider 

all sources of potential risk, such as 

credit and dilution risk. 

(vi) The ABCP program must 

incorporate structural features into each 

purchase of assets to mitigate potential 

credit deterioration of the underlying 

exposures. Such features may include 

wind-down triggers specific to a pool of 

underlying exposures. 

(3) Exposure qualification criteria. A 

securitization exposure qualifies for use 

of the IAA if the [bank] initially rated 

the exposure at least the equivalent of 

investment grade. 

(b) Mechanics. A [bank] that elects to 

use the IAA to calculate the risk-based 

capital requirement for any 

securitization exposure must use the 

IAA to calculate the risk-based capital 

requirements for all securitization 

exposures that qualify for the IAA 

approach. Under the IAA, a [bank] must 

map its internal assessment of such a 

securitization exposure to an equivalent 

external rating from an NRSRO. Under 

the IAA, a [bank] must determine the 

risk-weighted asset amount for such a 

securitization exposure by multiplying 

the amount of the exposure (as defined 

in paragraph (e) of section 42) by the 

appropriate risk weight in the RBA 

tables in paragraph (b) of section 43. 

Section 45. Supervisory Formula 

Approach (SFA) 

(a) Eligibility requirements. A [bank] 

may use the SFA to determine its riskbased capital requirement for a 

securitization exposure only if the 

[bank] can calculate on an ongoing basis 

each of the SFA parameters in 

paragraph (e) of this section. 

(b) Mechanics. Under the SFA, a 

[bank] must determine the risk-weighted 

asset amount for a securitization 

exposure by multiplying the SFA riskbased capital requirement for the 

exposure (as determined in paragraph 

(c) of this section) by 12.5. If the SFA 

risk weight for a securitization exposure 

is 1,250 percent or greater, however, the 

[bank] must deduct the exposure from 

total capital under paragraph (c) of 

section 42 rather than risk weight the 

exposure. The SFA risk weight for a 

securitization exposure is equal to 1,250 

percent multiplied by the ratio of the 

securitization exposure’s SFA risk-based 

capital requirement to the amount of the 

securitization exposure (as defined in 

paragraph (e) of section 42). 

(c) The SFA risk-based capital 

requirement. The SFA risk-based capital 

requirement for a securitization 

exposure is UE multiplied by TP 

multiplied by the greater of: 

(1) 0.0056 * T; or 

(2) S[L+T] ¥ S[L]. 

(d) The supervisory formula: 

( )1 S[Y] =

Y when Y K 

K

IRB

IRB

≤

+− + ⋅ − 















⋅ − ( )

KY KK d e wh IRB

Y

[] [ ] K IRB

K

K

IRB

IRB

20

1

20

en Y K > IRB





















 

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

( ) 3 h = 1 − 



 





K

EWALGD

IRB

N

 

( ) 4 a = g c ⋅ 

() ( ) 5 1 b = g ⋅ − c 

( ) 6

1

 c = 

K

h

IRB

− 


sroberts on PROD1PC70 with PROPOSALSEP25SE06.061</MATH> EP25SE06.062</MATH> EP25SE06.063</MATH> EP25SE06.064</MATH> EP25SE06.065</MATH> EP25SE06.066</MATH>
Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55941 

( ) ( ) 7 1 g = 1 − ⋅ − c c

f 

( ) ( )8

1

1

1 1000

2

2 f = v K

h

c

KKv

h

+ IRB IRB IRB

− − + ( ) − ⋅ −

− ⋅ 

( ) ( ). ( ) 9 25 1 v = K EWALGD K EWALGD

N IRB

IRB ⋅ − + ⋅− 

( ) ( ) ( [ ; , ]) 10 1 1 1 d = −− ⋅− h K ab β IRB 

(11) In these expressions, b[Y; a, b] 

refers to the cumulative beta 

distribution with parameters a and b 

evaluated at Y. In the case where N = 

1 and EWALGD = 100 percent, S[Y] in 

formula (1) must be calculated with 

K[Y] set equal to the product of KIRB and 

Y, and d set equal to 1¥KIRB. 

(e) SFA Parameters—(1) Amount of 

the underlying exposures (UE). UE is the 

EAD of any underlying wholesale and 

retail exposures (including the amount 

of any funded spread accounts, cash 

collateral accounts, and other similar 

funded credit enhancements) plus the 

amount of any underlying exposures 

that are securitization exposures (as 

defined in paragraph (e) of section 42) 

plus the adjusted carrying value of any 

underlying equity exposures (as defined 

in paragraph (b) of section 51). 

(2) Tranche percentage (TP). TP is the 

ratio of the amount of the [bank]’s 

securitization exposure to the amount of 

the tranche that contains the 

securitization exposure. 

(3) Capital requirement on underlying 

exposures (KIRB). (i) KIRB is the ratio of: 

(A) The sum of the risk-based capital 

requirements for the underlying 

exposures plus the expected credit 

losses of the underlying exposures (as 

determined under this appendix as if 

the underlying exposures were directly 

held by the [bank]); to 

(B) UE. 

(ii) The calculation of KIRB must 

reflect the effects of any credit risk 

mitigant applied to the underlying 

exposures (either to an individual 

underlying exposure, a group of 

underlying exposures, or to the entire 

pool of underlying exposures). 

(iii) All assets related to the 

securitization are treated as underlying 

exposures, including assets in a reserve 

account (such as a cash collateral 

account). 

(4) Credit enhancement level (L). (i) L 

is the ratio of: 

(A) The amount of all securitization 

exposures subordinated to the tranche 

that contains the [bank]’s securitization 

exposure; to (B) UE. 

(ii) [Bank]s must determine L before 

considering the effects of any tranchespecific credit enhancements. 

(iii) Any gain-on-sale or CEIO 

associated with the securitization may 

not be included in L. 

(iv) Any reserve account funded by 

accumulated cash flows from the 

underlying exposures that is 

subordinated to the tranche in question 

may be included in the numerator and 

denominator of L to the extent cash has 

accumulated in the account. Unfunded 

reserve accounts (that is, reserve 

accounts that are to be funded from 

future cash flows from the underlying 

exposures) may not be included in the 

calculation of L. 

(v) In some cases, the purchase price 

of receivables will reflect a discount that 

provides credit enhancement (for 

example, first loss protection) for all or 

certain tranches of the securitization. 

When this arises, L should be calculated 

inclusive of this discount if the discount 

provides credit enhancement for the 

securitization exposure. 

(5) Thickness of tranche (T). T is the 

ratio of: 

(i) The amount of the tranche that 

contains the [bank]’s securitization 

exposure; to 

(ii) UE. 

(6) Effective number of exposures (N). 

(i) Unless the [bank] elects to use the 

formula provided in paragraph (f), 

N

EAD

EAD

i

i

i

i

=





 

 ∑ 

∑

2

2

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: 

EWALGD

LGD EAD

EAD

i i

i

i

i

=

∑ ⋅

∑

where LGDi represents the average LGD 

associated with all exposures to the ith

obligor. In the case of a re-securitization, 

an LGD of 100 percent must be assumed 

for the underlying exposures that are 

themselves securitization exposures. 

(f) Simplified method for computing N 

and EWALGD. (1) If all underlying 

exposures of a securitization are retail 

exposures, a [bank] may apply the SFA 

using the following simplifications: 

(i) h = 0; and 

(ii) v = 0. 

(2) Under the conditions in 

paragraphs (f)(3) and (f)(4), a [bank] may 

employ a simplified method for 

calculating N and EWALGD. 

(3) If C1 is no more than 0.03, a [bank] 

may set EWALGD = 0.50 and N equal to 

the following amount: 


sroberts on PROD1PC70 with PROPOSALSEP25SE06.067</MATH> EP25SE06.068</MATH> EP25SE06.069</MATH> EP25SE06.070</MATH> EP25SE06.071</MATH> EP25SE06.072</MATH>
55942 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

N

C C C C

m m

m

=

+ −

−





 



 −

1

1

0 1

1 max (1 mC1, )

Where: 

(i) Cm is the ratio of the sum of the amounts 

of the ‘m’ largest underlying exposures to 

UE; and 

(ii) The level of m is to be selected by the 

[bank]. 

(4) Alternatively, if only C1 is 

available and C1 is no more than 0.03, 

the [bank] may set EWALGD = 0.50 and 

N = 1/C1. 

Section 46. Recognition of Credit Risk 

Mitigants for Securitization Exposures 

(a) General. An originating [bank] that 

has obtained a credit risk mitigant to 

hedge its securitization exposure to a 

synthetic or traditional securitization 

that satisfies the operational criteria in 

section 41 may recognize the credit risk 

mitigant, but only as provided in this 

section. An investing [bank] that has 

obtained a credit risk mitigant to hedge 

a securitization exposure may recognize 

the credit risk mitigant, but only as 

provided in this section. A [bank] that 

has used the RBA in section 43 or the 

IAA in section 44 to calculate its riskbased capital requirement for a 

securitization exposure whose external 

or inferred rating (or equivalent internal 

rating under the IAA) reflects the 

benefits of a particular credit risk 

mitigant provided to the associated 

securitization or that supports some or 

all of the underlying exposures may not 

use the credit risk mitigation rules in 

this section to further reduce its riskbased capital requirement for the 

exposure to reflect that credit risk 

mitigant. 

(b) Collateral—(1) Rules of 

recognition. A [bank] may recognize 

financial collateral in determining the 

[bank]’s risk-based capital requirement 

for a securitization exposure as follows. 

The [bank]’s risk-based capital 

requirement for the collateralized 

securitization exposure is equal to the 

risk-based capital requirement for the 

securitization exposure as calculated 

under the RBA in section 43 or the SFA 

in section 45 multiplied by the ratio of 

adjusted exposure amount (E*) to 

original exposure amount (E), where: 

(i) E* = max {0, [E¥C × 

(1¥Hs¥Hfx)]}; 

(ii) E = the amount of the 

securitization exposure calculated 

under paragraph (e) of section 42; 

(iii) C = the current market value of 

the collateral; 

(iv) Hs = the haircut appropriate to 

the collateral type; and 

(v) Hfx = the haircut appropriate for 

any currency mismatch between the 

collateral and the exposure. 

(2) Mixed collateral. Where the 

collateral is a basket of different asset 

types or a basket of assets denominated 

in different currencies, the haircut on 

the basket will be 

() * A EffectiveEPE = EffectiveEE t t t

k=1

n

k k k ∑ ∆

where ai is the current market value of 

the asset in the basket divided by the 

current market value of all assets in the 

basket and Hi is the haircut applicable 

to that asset. 

(3) Standard supervisory haircuts. 

Unless a [bank] qualifies for use of and 

uses own-estimates haircuts in 

paragraph (b)(4) of this section: 

(i) A [bank] must use the collateral 

type haircuts (Hs) in Table 3; 

(ii) A [bank] must use a currency 

mismatch haircut (Hfx) of 8 percent if 

the exposure and the collateral are 

denominated in different currencies; 

(iii) A [bank] must multiply the 

supervisory haircuts obtained in 

paragraphs (b)(3)(i) and (ii) by the 

square root of 6.5 (which equals 

2.549510); and 

(iv) A [bank] must adjust the 

supervisory haircuts upward on the 

basis of a holding period longer than 65 

business days where and as appropriate 

to take into account the illiquidity of the 

collateral. 

(4) Own estimates for haircuts. With 

the prior written approval of the 

[AGENCY], a [bank] may calculate 

haircuts using its own internal estimates 

of market price volatility and foreign 

exchange volatility, subject to the 

provisions of paragraph (a)(2)(iii) of 

section 32. The minimum holding 

period (TM) for securitization exposures 

is 65 business days. 

(c) Guarantees and credit 

derivatives—(1) Limitations on 

recognition. A [bank] may only 

recognize an eligible guarantee or 

eligible credit derivative provided by an 

eligible securitization guarantor in 

determining the [bank]’s risk-based 

capital requirement for a securitization 

exposure. 

(2) ECL for securitization exposures. 

When a [bank] recognizes an eligible 

guarantee or eligible credit derivative 

provided by an eligible securitization 

guarantor in determining the [bank]’s 

risk-based capital requirement for a 

securitization exposure, the [bank] must 

also: 

(i) Calculate ECL for the exposure 

using the same risk parameters that it 

uses for calculating the risk-weighted 

asset amount of the exposure as 

described in paragraph (c)(3) of this 

section; and 

(ii) Add the exposure’s ECL to the 

[bank]’s total ECL. 

(3) Rules of recognition. A [bank] may 

recognize an eligible guarantee or 

eligible credit derivative provided by an 

eligible securitization guarantor in 

determining the [bank]’s risk-based 

capital requirement for the 

securitization exposure as follows: 

(i) Full coverage. If the protection 

amount of the eligible guarantee or 

eligible credit derivative equals or 

exceeds the amount of the securitization 

exposure, then the [bank] may set the 

risk-weighted asset amount for the 

securitization exposure equal to the 

risk-weighted asset amount for a direct 

exposure to the eligible securitization 

guarantor (as determined in the 

wholesale risk weight function 

described in section 31), using the 

[bank]’s PD for the guarantor, the 

[bank]’s ELGD and LGD for the 

guarantee or credit derivative, and an 

EAD equal to the amount of the 

securitization exposure (as determined 

in paragraph (e) of section 42). 

(ii) Partial coverage. If the protection 

amount of the eligible guarantee or 

eligible credit derivative is less than the 

amount of the securitization exposure, 

then the [bank] may set the riskweighted asset amount for the 

securitization exposure equal to the sum 

of: 

(A) Covered portion. The riskweighted asset amount for a direct 

exposure to the eligible securitization 

guarantor (as determined in the 

wholesale risk weight function 

described in section 31), using the 

[bank]’s PD for the guarantor, the 

[bank]’s ELGD and LGD for the 

guarantee or credit derivative, and an 

EAD equal to the protection amount of 

the credit risk mitigant; and 

(B) Uncovered portion. (1) 1.0 minus 

(the protection amount of the eligible 

guarantee or eligible credit derivative 

divided by the amount of the 

securitization exposure); multiplied by 

(2) The risk-weighted asset amount for 

the securitization exposure without the 

credit risk mitigant (as determined in 

sections 42–45). 


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10 In securitizations that do not require excess 

spread to be trapped, or that specify trapping points 

based primarily on performance measures other 

than the three-month average excess spread, the 

excess spread trapping point is 4.5 percent. 

(4) Mismatches. For any hedged 

securitization exposure, the [bank] must 

make applicable adjustments to the 

protection amount as required in 

paragraphs (d), (e), and (f) of section 33. 

Section 47. Risk-Based Capital 

Requirement for Early Amortization 

Provisions 

(a) General. (1) An originating [bank] 

must hold risk-based capital against the 

sum of the originating [bank]’s interest 

and the investors’ interest in a 

securitization that: 

(i) Includes one or more underlying 

exposures in which the borrower is 

permitted to vary the drawn amount 

within an agreed limit under a line of 

credit; and 

(ii) Contains an early amortization 

provision. 

(2) For securitizations described in 

paragraph (a)(1) of this section, an 

originating [bank] must calculate the 

risk-based capital requirement for the 

originating [bank]’s interest under 

sections 42–45, and the risk-based 

capital requirement for the investors’

interest under paragraph (b) of this 

section. 

(b) Risk-weighted asset amount for 

investors’ interest. The originating 

[bank]’s risk-weighted asset amount for 

the investors’ interest in the 

securitization is equal to the product of 

the following four quantities: 

(1) The investors’ interest EAD; 

(2) The appropriate conversion factor 

in paragraph (c) of this section; 

(3) Kirb (as defined in paragraph (e)(3) 

of section 45); and 

(4) 12.5. 

(c) Conversion factor. To calculate the 

appropriate conversion factor discussed 

in paragraph (b)(2) of this section, a 

[bank] must use Table 8 for a 

securitization that contains a controlled 

early amortization provision and must 

use Table 9 for a securitization that 

contains a non-controlled early 

amortization provision. A [bank] must 

use the ‘‘uncommitted’’ column of 

Tables 8 and 9 if all or substantially all 

of the underlying exposures of the 

securitization are unconditionally 

cancelable by the [bank] to the fullest 

extent permitted by Federal law. 

Otherwise, a [bank] must use the 

‘‘committed’’ column of the tables. To 

calculate the trapping point described in 

the tables, a [bank] must divide the 

three-month excess spread level of the 

securitization by the excess spread 

trapping point in the securitization 

structure.10

TABLE 8.—CONTROLLED EARLY AMORTIZATION PROVISIONS

Uncommitted Committed 

Retail Credit Lines ....................................... 3-month average excess spread Conversion Factor (CF) .............................................. 90% CF. 

133.33% of trapping point or more 0% CF.

less than 133.33% to 100% of trapping point 1% CF.

less than 100% to 75% of trapping point 2% CF.

less than 75% to 50% of trapping point 10% CF.

less than 50% to 25% of trapping point 20% CF.

less than 25% of trapping point 40% CF.

Non-retail Credit Lines ................................ 90% CF ............................................................................................................................ 90% CF 

TABLE 9.—NON-CONTROLLED EARLY AMORTIZATION PROVISIONS

Uncommitted Committed 

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

133.33% of trapping point or more 0% CF.

less than 133.33% to 100% of trapping point 5% CF.

less than 100% to 75% of trapping point 15% CF.

less than 75% to 50% of trapping point 50% CF.

less than 50% of trapping point 100% CF.

Non-retail Credit Lines ................................ 100% CF .......................................................................................................................... 100% CF 

Part VI. Risk-Weighted Assets for 

Equity Exposures 

Section 51. Introduction and Exposure 

Measurement 

(a) General. To calculate its riskweighted asset amounts for equity 

exposures that are not equity exposures 

to investment funds, a [bank] may apply 

either the Simple Risk Weight Approach 

(SRWA) in section 52 or, if it qualifies 

to do so, the Internal Models Approach 

(IMA) in section 53. A [bank] must use 

the look-through approaches in section 

54 to calculate its risk-weighted asset 

amounts for equity exposures to 

investment funds. 

(b) Adjusted carrying value. For 

purposes of this part, the ‘‘adjusted 

carrying value’’ of an equity exposure is: 

(1) For the on-balance sheet 

component of an equity exposure, the 

[bank]’s carrying value of the exposure 

reduced by any unrealized gains on the 

exposure that are reflected in such 

carrying value but excluded from the 

[bank]’s tier 1 and tier 2 capital; and 

(2) For the off-balance sheet 

component of an equity exposure, the 

effective notional principal amount of 

the exposure, the size of which is 

equivalent to a hypothetical on-balance 

sheet position in the underlying equity 

instrument that would evidence the 

same change in fair value (measured in 

dollars) for a given small change in the 

price of the underlying equity 

instrument, minus the adjusted carrying 

value of the on-balance sheet 

component of the exposure as 

calculated in paragraph (b)(1) of this 

section. 


sroberts on PROD1PC70 with PROPOSALS
55944 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

Section 52. Simple Risk Weight 

Approach (SRWA) 

(a) In general. Under the SRWA, a 

[bank]’s aggregate risk-weighted asset 

amount for its equity exposures is equal 

to the sum of the risk-weighted asset 

amounts for each of the [bank]’s 

individual equity exposures (other than 

equity exposures to an investment fund) 

as determined in this section and the 

risk-weighted asset amounts for each of 

the [bank]’s individual equity exposures 

to an investment fund as determined in 

section 54. 

(b) SRWA computation for individual 

equity exposures. A [bank] must 

determine the risk-weighted asset 

amount for an individual equity 

exposure (other than an equity exposure 

to an investment fund) by multiplying 

the adjusted carrying value of the equity 

exposure or the effective portion and 

ineffective portion of a hedge pair (as 

defined in paragraph (c) of this section) 

by the lowest applicable risk weight in 

this paragraph (b). 

(1) 0 percent risk weight equity 

exposures. An equity exposure to an 

entity whose credit exposures are 

exempt from the 0.03 percent PD floor 

in paragraph (d)(2) of section 31 is 

assigned a 0 percent risk weight. 

(2) 20 percent risk weight equity 

exposures. An equity exposure to a 

Federal Home Loan Bank or Farmer Mac 

that is not publicly traded and is held 

as a condition of membership in that 

entity is assigned a 20 percent risk 

weight. 

(3) 100 percent risk weight equity 

exposures. The following equity 

exposures are assigned a 100 percent 

risk weight: 

(i) Community development equity 

exposures. An equity exposure that 

qualifies as a community development 

investment under 12 U.S.C. 

24(Eleventh), excluding equity 

exposures to an unconsolidated small 

business investment company and 

equity exposures held through a 

consolidated small business investment 

company described in section 302 of the 

Small Business Investment Act of 1958 

(15 U.S.C. 682). 

(ii) Certain equity exposures to a 

Federal Home Loan Bank and Farmer 

Mac. An equity exposure to a Federal 

Home Loan Bank or Farmer Mac that is 

not assigned a 20 percent risk weight. 

(iii) Effective portion of hedge pairs. 

The effective portion of a hedge pair. 

(iv) Non-significant equity exposures. 

Equity exposures to the extent that the 

aggregate adjusted carrying value of the 

exposures does not exceed 10 percent of 

the [bank]’s tier 1 capital plus tier 2 

capital. 

(A) To compute the aggregate adjusted 

carrying value of a [bank]’s equity 

exposures for purposes of this paragraph 

(b)(3)(iv), the [bank] may exclude equity 

exposures described in paragraphs 

(b)(1), (b)(2), and (b)(3)(i), (ii), and (iii) 

of this section, the equity exposure in a 

hedge pair with the smaller adjusted 

carrying value, and a proportion of each 

equity exposure to an investment fund 

equal to the proportion of the assets of 

the investment fund that are not equity 

exposures. If a [bank] does not know the 

actual holdings of the investment fund, 

the [bank] may calculate the proportion 

of the assets of the fund that are not 

equity exposures based on the terms of 

the prospectus, partnership agreement, 

or similar contract that defines the 

fund’s permissible investments. If the 

sum of the investment limits for all 

exposure classes within the fund 

exceeds 100 percent, the [bank] must 

assume for purposes of this paragraph 

(b)(3)(iv) that the investment fund 

invests to the maximum extent possible 

in equity exposures. 

(B) When determining which of a 

[bank]’s equity exposures qualify for a 

100 percent risk weight under this 

paragraph, a [bank] must first include 

equity exposures to unconsolidated 

small business investment companies or 

held through consolidated small 

business investment companies 

described in section 302 of the Small 

Business Investment Act of 1958 (15 

U.S.C. 682) and then must include 

publicly traded equity exposures 

(including those held indirectly through 

investment funds) and then must 

include non-publicly traded equity 

exposures (including those held 

indirectly through investment funds). 

(4) 300 percent risk weight equity 

exposures. A publicly traded equity 

exposure (including the ineffective 

portion of a hedge pair) is assigned a 

300 percent risk weight. 

(5) 400 percent risk weight equity 

exposures. An equity exposure that is 

not publicly traded is assigned a 400 

percent risk weight. 

(c) Hedge transactions—(1) Hedge 

pair. A hedge pair is two equity 

exposures that form an effective hedge 

so long as each equity exposure is 

publicly traded or has a return that is 

primarily based on a publicly traded 

equity exposure. 

(2) Effective hedge. Two equity 

exposures form an effective hedge if the 

exposures either have the same 

remaining maturity or each have a 

remaining maturity of at least three 

months; the hedge relationship is 

formally documented in a prospective 

manner (that is, before the [bank] 

acquires at least one of the equity 

exposures); the documentation specifies 

the measure of effectiveness (E) the 

[bank] will use for the hedge 

relationship throughout the life of the 

transaction; and the hedge relationship 

has an E greater than or equal to 0.8. A 

[bank] must measure E at least quarterly 

and must use one of three alternative 

measures of E: 

(i) Under the dollar-offset method of 

measuring effectiveness, the [bank] must 

determine the ratio of value change 

(RVC), that is, the ratio of the 

cumulative sum of the periodic changes 

in value of one equity exposure to the 

cumulative sum of the periodic changes 

in the value of the other equity 

exposure. If RVC is positive, the hedge 

is not effective and E = 0. If RVC is 

negative and greater than or equal to ¥1 

(that is, between zero and ¥1), then E 

equals the absolute value of RVC. If RVC 

is negative and less than ¥1, then E 

equals 2 plus RVC. 

(ii) Under the variability-reduction 

method of measuring effectiveness: 

E

X X

A A

t t

t

T

t t

t

T = −

( ) −

( ) −

−

=

−

=

∑

∑

1

1

2

1

1

2

1

, where

(A) Xt = At ¥ Bt; 

(B) At the value at time t of one 

exposure in a hedge pair; and 

(C) Bt the value at time t of the other 

exposure in a hedge pair. 

(iii) Under the regression method of 

measuring effectiveness, E equals the 

coefficient of determination of a 

regression in which the change in value 

of one exposure in a hedge pair is the 

dependent variable and the change in 

value of the other exposure in a hedge 

pair is the independent variable. 

(3) The effective portion of a hedge 

pair is E multiplied by the greater of the 

adjusted carrying values of the equity 

exposures forming a hedge pair. 

(4) The ineffective portion of a hedge 

pair is (1¥E) multiplied by the greater 

of the adjusted carrying values of the 

equity exposures forming a hedge pair. 

Section 53. Internal Models Approach 

(IMA) 

This section describes the two ways 

that a [bank] may calculate its riskweighted asset amount for equity 

exposures using the IMA. A [bank] may 

model publicly traded and non-publicly 

traded equity exposures (in accordance 

with paragraph (b) of this section) or 

model only publicly traded equity 

exposure (in accordance with paragraph 

(c) of this section). 

(a) Qualifying criteria. To qualify to 

use the IMA to calculate risk-based 


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capital requirements for equity 

exposures, a [bank] must receive prior 

written approval from the [AGENCY]. 

To receive such approval, the [bank] 

must demonstrate to the [AGENCY]’s 

satisfaction that the [bank] meets the 

following criteria: 

(1) The [bank] must have a model 

that: 

(i) Assesses the potential decline in 

value of its modeled equity exposures; 

(ii) Is commensurate with the size, 

complexity, and composition of the 

[bank]’s modeled equity exposures; and 

(iii) Adequately captures both general 

market risk and idiosyncratic risk. 

(2) The [bank]’s model must produce 

an estimate of potential losses for its 

modeled equity exposures that is no less 

than the estimate of potential losses 

produced by a VaR methodology 

employing a 99.0 percent, one-tailed 

confidence interval of the distribution of 

quarterly returns for a benchmark 

portfolio of equity exposures 

comparable to the [bank]’s modeled 

equity exposures using a long-term 

sample period. 

(3) The number of risk factors and 

exposures in the sample and the data 

period used for quantification in the 

[bank]’s model and benchmarking 

exercise must be sufficient to provide 

confidence in the accuracy and 

robustness of the [bank]’s estimates. 

(4) The [bank]’s model and 

benchmarking process must incorporate 

data that are relevant in representing the 

risk profile of the [bank]’s modeled 

equity exposures, and must include data 

from at least one equity market cycle 

containing adverse market movements 

relevant to the risk profile of the 

[bank]’s modeled equity exposures. If 

the [bank]’s model uses a scenario 

methodology, the [bank] must 

demonstrate that the model produces a 

conservative estimate of potential losses 

on the [bank]’s modeled equity 

exposures over a relevant long-term 

market cycle. If the [bank] employs risk 

factor models, the [bank] must 

demonstrate through empirical analysis 

the appropriateness of the risk factors 

used. 

(5) Daily market prices must be 

available for all modeled equity 

exposures, either direct holdings or 

proxies. 

(6) The [bank] must be able to 

demonstrate, using theoretical 

arguments and empirical evidence, that 

any proxies used in the modeling 

process are comparable to the [bank]’s 

modeled equity exposures and that the 

[bank] has made appropriate 

adjustments for differences. The [bank] 

must derive any proxies for its modeled 

equity exposures and benchmark 

portfolio using historical market data 

that are relevant to the [bank]’s modeled 

equity exposures and benchmark 

portfolio (or, where not, must use 

appropriately adjusted data), and such 

proxies must be robust estimates of the 

risk of the [bank]’s modeled equity 

exposures. 

(b) Risk-weighted assets calculation 

for a [bank] modeling publicly traded 

and non-publicly traded equity 

exposures. If a [bank] models publicly 

traded and non-publicly traded equity 

exposures, the [bank]’s aggregate riskweighted asset amount for its equity 

exposures is equal to the sum of: 

(1) The risk-weighted asset amount of 

each equity exposure that qualifies for a 

0–100 percent risk weight under 

paragraphs (b)(1) through (b)(3)(ii) of 

section 52 (as determined under section 

52) and each equity exposure to an 

investment fund (as determined under 

section 54); and 

(2) The greater of: 

(i) The estimate of potential losses on 

the [bank]’s equity exposures (other 

than equity exposures referenced in 

paragraph (b)(1) of this section) 

generated by the [bank]’s internal equity 

exposure model multiplied by 12.5; or 

(ii) The sum of: 

(A) 200 percent multiplied by the 

aggregate adjusted carrying value of the 

[bank]’s publicly traded equity 

exposures that do not belong to a hedge 

pair, do not qualify for a 0–100 percent 

risk weight under paragraphs (b)(1) 

through (b)(3)(ii) of section 52, and are 

not equity exposures to an investment 

fund; 

(B) 200 percent multiplied by the 

aggregate ineffective portion of all hedge 

pairs; and 

(C) 300 percent multiplied by the 

aggregate adjusted carrying value of the 

[bank]’s equity exposures that are not 

publicly traded, do not qualify for a 0–

100 percent risk weight under 

paragraphs (b)(1) through (b)(3)(ii) of 

section 52, and are not equity exposures 

to an investment fund. 

(c) Risk-weighted assets calculation 

for a [bank] using the IMA only for 

publicly traded equity exposures. If a 

[bank] models only publicly traded 

equity exposures, the [bank]’s aggregate 

risk-weighted asset amount for its equity 

exposures is equal to the sum of: 

(1) The risk-weighted asset amount of 

each equity exposure that qualifies for a 

0–100 percent risk weight under 

paragraphs (b)(1) through (b)(3)(ii) of 

section 52 (as determined under section 

52), each equity exposure that qualifies 

for a 400 percent risk weight under 

paragraph (b)(5) of section 52 (as 

determined under section 52), and each 

equity exposure to an investment fund 

(as determined under section 54); and 

(2) The greater of: 

(i) The estimate of potential losses on 

the [bank]’s equity exposures (other 

than equity exposures referenced in 

paragraph (c)(1) of this section) 

generated by the [bank]’s internal equity 

exposure model multiplied by 12.5; or 

(ii) The sum of: 

(A) 200 percent multiplied by the 

aggregate adjusted carrying value of the 

[bank]’s publicly traded equity 

exposures that do not belong to a hedge 

pair, do not qualify for a 0–100 percent 

risk weight under paragraphs (b)(1) 

through (b)(3)(ii) of section 52, and are 

not equity exposures to an investment 

fund; and 

(B) 200 percent multiplied by the 

aggregate ineffective portion of all hedge 

pairs. 

Section 54. Equity Exposures to 

Investment Funds 

(a) Available approaches. A [bank] 

must determine the risk-weighted asset 

amount of an equity exposure to an 

investment fund under the Full LookThrough Approach in paragraph (b) of 

this section, the Simple Modified LookThrough Approach in paragraph (c) of 

this section, or the Alternative Modified 

Look-Through Approach in paragraph 

(d) of this section unless the exposure 

would meet the requirements for a 

community development equity 

exposure in paragraph (b)(3)(i) of 

section 52. The risk-weighted asset 

amount of such an equity exposure to an 

investment fund would be its adjusted 

carrying value. If an equity exposure to 

an investment fund is part of a hedge 

pair, a [bank] may use the ineffective 

portion of the hedge pair as determined 

under paragraph (c) of section 52 as the 

adjusted carrying value for the equity 

exposure to the investment fund. 

(b) Full look-through approach. A 

[bank] that is able to calculate a riskweighted asset amount for each 

exposure held by the investment fund 

(as calculated under this appendix as if 

the exposures were held directly by the 

[bank]) may set the risk-weighted asset 

amount of the [bank]’s exposure to the 

fund equal to the greater of: 

(1) The product of: 

(i) The aggregate risk-weighted asset 

amounts of the exposures held by the 

fund (as calculated under this appendix) 

as if the exposures were held directly by 

the [bank]; and 

(ii) The [bank]’s proportional 

ownership share of the fund; or 

(2) 7 percent of the adjusted carrying 

value of the [bank]’s equity exposure to 

the fund. 


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55946 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

(c) Simple modified look-through 

approach. Under this approach, the 

risk-weighted asset amount for a 

[bank]’s equity exposure to an 

investment fund equals the adjusted 

carrying value of the equity exposure 

multiplied by the greater of: 

(1) The highest risk weight in Table 

10 that applies to any exposure the fund 

is permitted to hold under its 

prospectus, partnership agreement, or 

similar contract that defines the fund’s 

permissible investments (excluding 

derivative contracts that are used for 

hedging rather than speculative 

purposes and do not constitute a 

material portion of the fund’s 

exposures); or 

(2) 7 percent. 

TABLE 10.—MODIFIED LOOK-THROUGH APPROACHES FOR EQUITY EXPOSURES TO INVESTMENT FUNDS

Risk weight Exposure class 

0 percent .............................. Sovereign exposures with a long-term applicable external rating in the highest investment grade rating category 

and sovereign exposures of the United States. 

20 percent ............................ Exposures with a long-term applicable external rating in the highest or second-highest investment grade rating 

category; exposures with a short-term applicable external rating in the highest investment grade rating category; and exposures to, or guaranteed by, depository institutions, foreign banks (as defined in 12 CFR 211.2), 

or securities firms subject to consolidated supervision and regulation comparable to that imposed on U.S. securities broker-dealers that are repo-style transactions or bankers’ acceptances. 

50 percent ............................ Exposures with a long-term applicable external rating in the third-highest investment grade rating category or a 

short-term applicable external rating in the second-highest investment grade rating category. 

100 percent .......................... Exposures with a long-term or short-term applicable external rating in the lowest investment grade rating category. 

200 percent .......................... Exposures with a long-term applicable external rating one rating category below investment grade. 

300 percent .......................... Publicly traded equity exposures. 

400 percent .......................... Non-publicly traded equity exposures; exposures with a long-term applicable external rating two rating categories 

or more below investment grade; and exposures without an external rating (excluding publicly traded equity exposures). 

1,250 percent ....................... OTC derivative contracts and exposures that must be deducted from regulatory capital or receive a risk weight 

greater than 400 percent under this appendix. 

(d) Alternative Modified LookThrough Approach. Under this 

approach, a [bank] may assign the 

adjusted carrying value of an equity 

exposure to an investment fund on a pro 

rata basis to different risk weight 

categories in Table 10 according to the 

investment limits in the fund’s 

prospectus, partnership agreement, or 

similar contract that defines the fund’s 

permissible investments. If the sum of 

the investment limits for exposure 

classes within the fund exceeds 100 

percent, the [bank] must assume that the 

fund invests to the maximum extent 

permitted under its investment limits in 

the exposure class with the highest risk 

weight under Table 10, and continues to 

make investments in order of the 

exposure class with the next highest risk 

weight under Table 10 until the 

maximum total investment level is 

reached. If more than one exposure class 

applies to an exposure, the [bank] must 

use the highest applicable risk weight. 

A [bank] may not assign an equity 

exposure to an investment fund to an 

aggregate risk weight of less than 7 

percent. A [bank] may exclude 

derivative contracts held by the fund 

that are used for hedging rather than 

speculative purposes and do not 

constitute a material portion of the 

fund’s exposures. 

Section 55. Equity Derivative Contracts 

Under the IMA, in addition to holding 

risk-based capital against an equity 

derivative contract under this part, a 

[bank] must hold risk-based capital 

against the counterparty credit risk in 

the equity derivative contract by also 

treating the equity derivative contract as 

a wholesale exposure and computing a 

supplemental risk-weighted asset 

amount for the contract under part IV. 

Under the SRWA, a [bank] may choose 

not to hold risk-based capital against the 

counterparty credit risk of equity 

derivative contracts, as long as it does 

so for all such contracts. Where the 

equity derivative contracts are subject to 

a qualified master netting agreement, a 

[bank] using the SRWA must either 

include all or exclude all of the 

contracts from any measure used to 

determine counterparty credit risk 

exposure. 

Part VII. Risk-Weighted Assets for 

Operational Risk 

Section 61. Qualification Requirements 

for Incorporation of Operational Risk 

Mitigants 

(a) Qualification to use operational 

risk mitigants. A [bank] may adjust its 

estimate of operational risk exposure to 

reflect qualifying operational risk 

mitigants if: 

(1) The [bank]’s operational risk 

quantification system is able to generate 

an estimate of the [bank]’s operational 

risk exposure (which does not 

incorporate qualifying operational risk 

mitigants) and an estimate of the 

[bank]’s operational risk exposure 

adjusted to incorporate qualifying 

operational risk mitigants; and 

(2) The [bank]’s methodology for 

incorporating the effects of insurance, if 

the [bank] uses insurance as an 

operational risk mitigant, captures 

through appropriate discounts to the 

amount of risk mitigation: 

(i) The residual term of the policy, 

where less than one year; 

(ii) The cancellation terms of the 

policy, where less than one year; 

(iii) The policy’s timeliness of 

payment; 

(iv) The uncertainty of payment by 

the provider of the policy; and 

(v) Mismatches in coverage between 

the policy and the hedged operational 

loss event. 

(b) Qualifying operational risk 

mitigants. Qualifying operational risk 

mitigants are: 

(1) Insurance that: 

(i) Is provided by an unaffiliated 

company that has a claims payment 

ability that is rated in one of the three 

highest rating categories by a NRSRO; 

(ii) Has an initial term of at least one 

year and a residual term of more than 

90 days; 

(iii) Has a minimum notice period for 

cancellation by the provider of 90 days; 

(iv) Has no exclusions or limitations 

based upon regulatory action or for the 

receiver or liquidator of a failed 

depository institution; and 

(v) Is explicitly mapped to a potential 

operational loss event; and 


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11Other public disclosure requirements continue 

to apply—for example, Federal securities law and 

regulatory reporting requirements. 

(2) Operational risk mitigants other 

than insurance for which the [AGENCY] 

has given prior written approval. In 

evaluating an operational risk mitigant 

other than insurance, [AGENCY] will 

consider whether the operational risk 

mitigant covers potential operational 

losses in a manner equivalent to holding 

regulatory capital. 

Section 62. Mechanics of Risk-Weighted 

Asset Calculation 

(a) If a [bank] does not qualify to use 

or does not have qualifying operational 

risk mitigants, the [bank]’s dollar riskbased capital requirement for 

operational risk is its operational risk 

exposure minus eligible operational risk 

offsets (if any). 

(b) If a [bank] qualifies to use 

operational risk mitigants and has 

qualifying operational risk mitigants, 

the [bank]’s dollar risk-based capital 

requirement for operational risk is the 

greater of: 

(1) The [bank]’s operational risk 

exposure adjusted for qualifying 

operational risk mitigants minus eligible 

operational risk offsets (if any); or 

(2) 0.8 multiplied by the difference 

between: 

(i) The [bank]’s operational risk 

exposure; and 

(ii) Eligible operational risk offsets (if 

any). 

(c) The [bank]’s risk-weighted asset 

amount for operational risk equals the 

[bank]’s dollar risk-based capital 

requirement for operational risk 

determined under paragraph (a) or (b) of 

this section multiplied by 12.5. 

Part VIII. Disclosure 

Section 71. Disclosure Requirements 

(a) Each [bank] must publicly disclose 

each quarter its total and tier 1 riskbased capital ratios and their 

components (that is, tier 1 capital, tier 

2 capital, total qualifying capital, and 

total risk-weighted assets).11

[Disclosure paragraph (b)] 

[Disclosure paragraph (c)] 

End of common rule. 

[End of common text] 

List of Subjects 

12 CFR Part 3 

Administrative practices and 

procedure, Capital, National banks, 

Reporting and recordkeeping 

requirements, Risk. 

12 CFR Part 208 

Confidential business information, 

Crime, Currency, Federal Reserve 

System, Mortgages, reporting and 

recordkeeping requirements, Securities. 

12 CFR Part 225 

Administrative practice and 

procedure, Banks, banking, Federal 

Reserve System, Holding companies, 

Reporting and recordkeeping 

requirements, Securities. 

12 CFR Part 325 

Administrative practice and 

procedure, Banks, banking, Capital 

Adequacy, Reporting and recordkeeping 

requirements, Savings associations, 

State nonmember banks. 

12 CFR Part 566 

Capital, reporting and recordkeeping 

requirements, Savings associations. 

Authority and Issuance 

Adoption of Common Appendix 

The adoption of the proposed 

common rules by the agencies, as 

modified by agency-specific text, is set 

forth below: 

Department of the Treasury 

Office of the Comptroller of the 

Currency 

12 CFR Chapter I 

Authority and Issuance 

For the reasons stated in the common 

preamble, the Office of the Comptroller 

of the Currency proposes to amend Part 

3 of chapter I of Title 12, Code of 

Federal Regulations as follows: 

PART 3—MINIMUM CAPITAL RATIOS; 

ISSUANCE OF DIRECTIVES 

1. The authority citation for part 3 

continues to read as follows: 

Authority: 12 U.S.C. 93a, 161, 1818, 

1828(n), 1828 note, 1831n note, 1835, 3907, 

and 3909. 

2. New Appendix C to part 3 is added 

as set forth at the end of the common 

preamble. 

3. Appendix C to part 3 is amended 

as set forth below: 

a. Remove ‘‘[AGENCY]’’ and add 

‘‘OCC’’ in its place wherever it appears. 

b. Remove ‘‘[bank]’’ and add ‘‘bank’’

in its place wherever it appears, and 

remove ‘‘[Bank]’’ and add ‘‘Bank’’ in its 

place wherever it appears. 

c. Remove ‘‘[Appendix l to Part l ]’’

and add ‘‘Appendix C to Part 3’’ in its 

place wherever it appears. 

d. Remove ‘‘[the general risk-based 

capital rules]’’ and add ‘‘12 CFR part 3, 

Appendix A’’ in its place wherever it 

appears. 

e. Remove ‘‘[the market risk rule]’’

and add ‘‘12 CFR part 3, Appendix B’’

in its place wherever it appears. 

f. Remove ‘‘[Disclosure paragraph 

(b)]’’ and add in its place ‘‘(b) A bank 

must comply with paragraph (c) of 

section 71 of appendix F to the Federal 

Reserve Board’s Regulation Y (12 CFR 

part 225, appendix F) unless it is a 

consolidated subsidiary of a bank 

holding company or depository 

institution that is subject to these 

requirements.’’

g. Remove ‘‘[Disclosure paragraph 

(c)].’’

Board of Governors of the Federal 

Reserve System 

12 CFR Chapter II 

Authority and Issuance 

For the reasons stated in the common 

preamble, the Board of Governors of the 

Federal Reserve System proposes to 

amend parts 208 and 225 of chapter II 

of title 12 of the Code of Federal 

Regulations as follows: 

PART 208—MEMBERSHIP OF STATE 

BANKING INSTITUTIONS IN THE 

FEDERAL RESERVE SYSTEM 

(REGULATION H) 

1. The authority citation for part 208 

continues to read as follows: 

Authority: 12 U.S.C. 24, 36, 92a, 93a, 

248(a), 248(c), 321–338a, 371d, 461, 481–486, 

601, 611, 1814, 1816, 1818, 1820(d)(9), 

1823(j), 1828(o), 1831, 1831o, 1831p–1, 

1831r–1, 1835a, 1882, 2901–2907, 3105, 

3310, 3331–3351, and 3906–3909; 15 U.S.C. 

78b, 78l(b), 78l(g), 78l(i), 78o–4(c)(5), 78q, 

78q–1, and 78w, 6801, and 6805; 31 U.S.C. 

5318; 42 U.S.C. 4012a, 4104a, 4104b, 4106, 

and 4128. 

2. New Appendix F to part 208 is 

added as set forth at the end of the 

common preamble. 

3. Appendix F to part 208 is amended 

as set forth below: 

a. Remove ‘‘[AGENCY]’’ and add 

‘‘Board’’ in its place wherever it 

appears. 

b. Remove ‘‘[bank]’’ and add ‘‘bank’’

in its place wherever it appears, and 

remove ‘‘[Bank]’’ and add ‘‘Bank’’ in its 

place wherever it appears. 

c. Remove ‘‘[Appendix l to Part l]’’

and add ‘‘Appendix F to Part 208’’ in its 

place wherever it appears. 

d. Remove ‘‘[the general risk-based 

capital rules]’’ and add ‘‘12 CFR part 

208, Appendix A’’ in its place wherever 

it appears. 

e. Remove ‘‘[the market risk rule]’’

and add ‘‘12 CFR part 208, Appendix E’’

in its place wherever it appears. 

f. Remove ‘‘[Disclosure paragraph 

(b)]’’ and add in its place ‘‘(b) A bank 

must comply with paragraph (c) of 

section 71 of appendix F to the Federal 

Reserve Board’s Regulation Y (12 CFR 

part 225, appendix F) unless it is a 


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55948 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

12Alternatively, a bank holding company may 

provide the disclosures in more than one place, as 

some of them may be included in public financial 

reports (for example, in Management’s Discussion 

and Analysis included in SEC filings) or other 

regulatory reports. The bank holding company must 

provide a summary table on its public Web site that 

specifically indicates where all the disclosures may 

be found (for example, regulatory report schedules, 

page numbers in annual reports). 

13Entities include securities, insurance and other 

financial subsidiaries, commercial subsidiaries 

(where permitted), significant minority equity 

investments in insurance, financial and commercial 

entities. 

14A capital deficiency is the amount by which 

actual regulatory capital is less than the minimum 

regulatory capital requirement. 

consolidated subsidiary of a bank 

holding company or depository 

institution that is subject to these 

requirements.’’

g. Remove ‘‘[Disclosure paragraph 

(c)].’’

PART 225—BANK HOLDING 

COMPANIES AND CHANGE IN BANK 

CONTROL (REGULATION Y) 

1. The authority citation for part 225 

continues to read as follows: 

Authority: 12 U.S.C. 1817(j)(13), 1818, 

1828(o), 1831i, 1831p–1, 1843(c)(8), 1844(b), 

1972(1), 3106, 3108, 3310, 3331–3351, 3907, 

and 3909; 15 U.S.C. 6801 and 6805. 

2. New Appendix G to part 225 is 

added as set forth at the end of the 

common preamble. 

3. Appendix G to part 225 is amended 

as set forth below: 

a. Remove ‘‘[AGENCY]’’ and add 

‘‘Board’’ in its place wherever it 

appears. 

b. Remove ‘‘[bank]’’ and add in its 

place ‘‘bank holding company’’

wherever it appears, and remove 

‘‘[Bank]’’ and add ‘‘Bank holding 

company’’ in its place wherever it 

appears. 

c. Remove ‘‘[Appendix l to Part l]’’

and add ‘‘Appendix G to Part 225’’ in its 

place wherever it appears. 

d. Remove ‘‘[the general risk-based 

capital rules]’’ and add ‘‘12 CFR part 

225, Appendix A’’ in its place wherever 

it appears. 

e. Remove ‘‘[the market risk rule]’’

and add ‘‘12 CFR part 225, Appendix E’’

in its place wherever it appears. 

f. Remove the text of section 1(b)(1)(i) 

and add in its place: ‘‘Is a U.S.-based 

bank holding company that has total 

consolidated assets (excluding assets 

held by an insurance underwriting 

subsidiary), as reported on the most 

recent year-end FR Y–9C, equal to $250 

billion or more;’’. 

g. Remove the text of section 

1(b)(1)(iii) and add in its place: ‘‘Has a 

subsidiary depository institution (as 

defined in 12 U.S.C. 1813) that is 

required, or has elected, to use 12 CFR 

part 3, Appendix C, 12 CFR part 208, 

Appendix F, 12 CFR part 325, Appendix 

F, or 12 CFR 556 to calculate its riskbased capital requirements;’’. 

h. At the end of section 11(b)(1) add 

the following sentence: ‘‘A bank holding 

company also must deduct an amount 

equal to the minimum regulatory capital 

requirement established by the regulator 

of any insurance underwriting 

subsidiary of the holding company. For 

U.S.-based insurance underwriting 

subsidiaries, this amount generally 

would be 200 percent of the subsidiary’s 

Authorized Control Level as established 

by the appropriate state regulator of the 

insurance company.’’

i. Remove section 22(h)(3)(ii). 

j. In section 31(e)(3), remove ‘‘A bank 

may assign a risk-weighted asset amount 

of zero to cash owned and held in all 

offices of the bank or in transit and for 

gold bullion held in the bank’s own 

vaults, or held in another bank’s vaults 

on an allocated basis, to the extent it is 

offset by gold bullion liabilities’’ and 

add in its place ‘‘A bank holding 

company may assign a risk-weighted 

asset amount of zero to cash owned and 

held in all offices of subsidiary 

depository institutions or in transit and 

for gold bullion held in either a 

subsidiary depository institution’s own 

vaults, or held in another’s vaults on an 

allocated basis, to the extent it is offset 

by gold bullion liabilities.’’

k. Remove ‘‘[Disclosure paragraph 

(b)].’’

l. Remove ‘‘[Disclosure paragraph 

(c)].’’

m. In section 71, add new paragraph 

(b) to read as follows: 

Section 71. * * * 

* * * * * 

(b)(1) Each consolidated bank holding 

company that has successfully 

completed its parallel run must provide 

timely public disclosures each calendar 

quarter of the information in tables 

11.1–11.11 below. If a significant change 

occurs, such that the most recent 

reported amounts are no longer 

reflective of the bank holding 

company’s capital adequacy and risk 

profile, then a brief discussion of this 

change and its likely impact must be 

provided as soon as practicable 

thereafter. Qualitative disclosures that 

typically do not change each quarter (for 

example, a general summary of the bank 

holding company’s risk management 

objectives and policies, reporting 

system, and definitions) may be 

disclosed annually, provided any 

significant changes to these are 

disclosed in the interim. Management is 

encouraged to provide all of the 

disclosures required by this appendix in 

one place on the bank holding 

company’s public Web site.12 The bank 

holding company must make these 

disclosures publicly available for each 

of the last three years (that is, twelve 

quarters) or such shorter period since it 

began its first floor period. 

(2) Each bank holding company is 

required to have a formal disclosure 

policy approved by the board of 

directors that addresses its approach for 

determining the disclosures it makes. 

The policy must address the associated 

internal controls and disclosure controls 

and procedures. The board of directors 

and senior management must ensure 

that appropriate verification of the 

disclosures takes place and that 

effective internal controls and 

disclosure controls and procedures are 

maintained. The chief financial officer 

of the bank holding company must 

certify that the disclosures required by 

this appendix are appropriate, and the 

board of directors and senior 

management are responsible for 

establishing and maintaining an 

effective internal control structure over 

financial reporting, including the 

disclosures required by this appendix. 

TABLE 11.1.—SCOPE OF APPLICATION

Qualitative Disclosures ................... (a) The name of the top corporate entity in the group to which the appendix applies. 

(b) An outline of differences in the basis of consolidation for accounting and regulatory purposes, with a 

brief description of the entities 13 within the group (a) that are fully consolidated; (b) that are 

deconsolidated and deducted; (c) for which the regulatory capital requirement is deducted; and (d) that 

are neither consolidated nor deducted (for example, where the investment is risk-weighted). 

(c) Any restrictions, or other major impediments, on transfer of funds or regulatory capital within the group. 

Quantitative Disclosures ................. (d) The aggregate amount of surplus capital of insurance subsidiaries (whether deducted or subjected to 

an alternative method) included in the regulatory capital of the consolidated group. 

(e) The aggregate amount of capital deficiencies 14 in all subsidiaries and the name(s) of such subsidiaries. 


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15Representing 50% of the amount, if any, by 

which total expected credit losses as calculated 

within the IRB framework exceed eligible credit 

reserves, which must be deducted from Tier 1 

capital. 

16 Including 50% of the amount, if any, by which 

total expected credit losses as calculated within the 

IRB framework exceed eligible credit reserves, 

which must be deducted from Tier 2 capital. 

17Risk-weighted assets determined under [the 

market risk rule] are to be disclosed only for the 

approaches used. 

18Total risk-weighted assets should also be 

disclosed. 

TABLE 11.2.—CAPITAL STRUCTURE

Qualitative Disclosures ................... (a) Summary information on the terms and conditions of the main features of all capital instruments, especially in the case of innovative, complex or hybrid capital instruments. 

Quantitative Disclosures ................. (b) The amount of tier 1 capital, with separate disclosure of: 

• Common stock/surplus; 

• Retained earnings; 

• Minority interests in the equity of subsidiaries; 

• Restricted core capital elements as defined in 12 CFR part 225, Appendix A; 

• Regulatory calculation differences deducted from tier 1 capital; 15 and 

• Other amounts deducted from tier 1 capital, including goodwill and certain intangibles. 

(c) The total amount of tier 2 capital. 

(d) Other deductions from capital.16

(e) Total eligible capital. 

TABLE 11.3.—CAPITAL ADEQUACY

Qualitative Disclosures ................... (a) A summary discussion of the bank holding company’s approach to assessing the adequacy of its capital to support current and future activities. 

Quantitative Disclosures ................. (b) Risk-weighted assets for credit risk from: 

• Wholesale exposures; 

• Residential mortgage exposures; 

• Qualifying revolving exposures; 

• Other retail exposures; 

• Securitization exposures; 

• Equity exposures: 

• Equity exposures subject to simple risk weight approach; and 

• Equity exposures subject to internal models approach. 

(c) Risk-weighted assets for market risk as calculated under [the market risk rule]: 17

• Standardized approach for specific risk; and 

• Internal models approach for specific risk. 

(d) Risk-weighted assets for operational risk. 

(e) Total and tier 1 risk-based capital ratios: 18

• For the top consolidated group; and 

• For each DI subsidiary. 

General Qualitative Disclosure 

Requirement 

For each separate risk area described 

in tables 11.4 through 11.11, the bank 

holding company must describe its risk 

management objectives and policies, 

including: 

• Strategies and processes; 

• The structure and organization of 

the relevant risk management function; 

• The scope and nature of risk 

reporting and/or measurement systems; 

• Policies for hedging and/or 

mitigating risk and strategies and 

processes for monitoring the continuing 

effectiveness of hedges/mitigants. 

TABLE 11.4.19—CREDIT RISK: GENERAL DISCLOSURES

Qualitative Disclosures ................... (a) The general qualitative disclosure requirement with respect to credit risk (excluding counterparty credit 

risk disclosed in accordance with Table 11.6), including: 

• Definitions of past due and impaired (for accounting purposes); 

• Description of approaches followed for allowances, including statistical methods used where applicable; 

• Discussion of the bank holding company’s credit risk management policy. 

Quantitative Disclosures ................. (b) Total gross credit risk exposures,20 and average gross credit risk exposures, over the period broken 

down by major types of credit exposure.21

(c) Geographic 22 distribution of exposures, broken down in significant areas by major types of credit exposure. 

(d) Industry or counterparty type distribution of exposures, broken down by major types of credit exposure. 

(e) Remaining contractual maturity breakdown (for example, one year or less) of the whole portfolio, broken down by major types of credit exposure. 

(f) By major industry or counterparty type: 

• Amount of impaired loans; 

• Amount of past due loans; 23 • Allowances; and, 

• Charge-offs during the period. 

(g) Amount of impaired loans and, if available, the amount of past due loans broken down by significant 

geographic areas including, if practical, the amounts of allowances related to each geographical area.24

(h) Reconciliation of changes in the allowance for loan and lease losses.25


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19Table 4 does not include equity exposures. 20That is, after accounting offsets in accordance 

with U.S. GAAP (for example, FASB Interpretations 

39 and 41) and without taking into account the 

effects of credit risk mitigation techniques, for 

example collateral and netting. 21For example, banks could apply a breakdown 

similar to that used for accounting purposes. Such 

a breakdown might, for instance, be (a) loans, offbalance sheet commitments, and other nonderivative off-balance sheet exposures, (b) debt 

securities, and (c) OTC derivatives. 22 Geographical areas may comprise individual 

countries, groups of countries or regions within 

countries. A bank holding company might choose 

to define the geographical areas based on the way 

the company’s portfolio is geographically managed. 

The criteria used to allocate the loans to 

geographical areas must be specified. 23A bank holding company is encouraged also to 

provide an analysis of the aging of past-due loans. 24The portion of general allowance that is not 

allocated to a geographical area should be disclosed 

separately. 25The reconciliation should include the 

following: A description of the allowance; the 

opening balance of the allowance; charge-offs taken 

against the allowance during the period; amounts 

provided (or reversed) for estimated probable loan 

losses during the period; any other adjustments (for 

example, exchange rate differences, business 

combinations, acquisitions and disposals of 

subsidiaries), including transfers between 

allowances; and the closing balance of the 

allowance. Charge-offs and recoveries that have 

been recorded directly to the income statement 

should be disclosed separately. 

26This disclosure does not require a detailed 

description of the model in full—it should provide 

the reader with a broad overview of the model 

approach, describing definitions of the variables, 

and methods for estimating and validating those 

variables set out in the quantitative risk disclosures 

below. This should be done for each of the four 

category/subcategories. The bank holding company 

should disclose any significant differences in 

approach to estimating these variables within each 

category/subcategories. 

27The PD, ELGD, LGD and EAD disclosures in 

Table 11.5(c) should reflect the effects of collateral, 

qualifying master netting agreements, eligible 

guarantees and eligible credit derivatives as defined 

in Part 1. Disclosure of each PD grade should 

include the exposure weighted-average PD for each 

grade. Where a bank holding company aggregates 

PD grades for the purposes of disclosure, this 

should be a representative breakdown of the 

distribution of PD grades used for regulatory capital 

purposes. 

28Outstanding loans and EAD on undrawn 

commitments can be presented on a combined basis 

for these disclosures. 

29These disclosures are a way of further 

informing the reader about the reliability of the 

information provided in the ‘‘quantitative 

disclosures: Risk assessment’’ over the long run. 

The disclosures are requirements from year-end 

2010; in the meantime, early adoption is 

encouraged. The phased implementation is to allow 

a bank holding company sufficient time to build up 

a longer run of data that will make these disclosures 

meaningful. 

30This regulation is not prescriptive about the 

period used for this assessment. Upon 

implementation, it might be expected that a bank 

holding company would provide these disclosures 

for as long run of data as possible—for example, if 

a bank holding company has 10 years of data, it 

might choose to disclose the average default rates 

for each PD grade over that 10-year period. Annual 

amounts need not be disclosed. 

31A bank holding company should provide this 

further decomposition where it will allow users 

greater insight into the reliability of the estimates 

provided in the ‘‘quantitative disclosures: Risk 

assessment.’’ In particular, it should provide this 

information where there are material differences 

between is estimates of PD, ELGD, LGD or EAD 

compared to actual outcomes over the long run. The 

bank holding company should also provide 

explanations for such differences. 

TABLE 11.5.—CREDIT RISK: DISCLOSURES FOR PORTFOLIOS SUBJECT TO IRB RISK-BASED CAPITAL FORMULAS

Qualitative disclosures .................... (a) Explanation and review of the: 

• Structure of internal rating systems and relation between internal and external ratings; 

• Use of risk parameter estimates other than for regulatory capital purposes; 

• Process for managing and recognizing credit risk mitigation; and 

• Control mechanisms for the rating system, including discussion of independence, accountability, and 

rating systems review. 

(b) Description of the internal ratings process, provided separately for the following: 

• Wholesale category; 

• Retail subcategories: 

• Residential mortgage exposures; 

• Qualifying revolving exposures; and 

• Other retail exposures. 

For each category and subcategory the description should include: 

• The types of exposure included in the category subcategories; 

• The definitions, methods and data for estimation and validation of PD, ELGD, LGD, and EAD, including 

assumptions employed in the derivation of these variables.26

Quantitative disclosures: Risk assessment.(c) For wholesale exposures, present the following information across a sufficient number of PD grades 

(including default) to allow for a meaningful differentiation of credit risk: 27

• Total EAD; 28

• Exposure-weighted average ELGD and LGD (percentage); 

• Exposure weighted-average capital requirement (K); and 

• Amount of undrawn commitments and exposure-weighted average EAD for wholesale exposures. 

For each retail subcategory, present the disclosures outlined above across a sufficient number of segments to allow for a meaningful differentiation of credit risk. 

Quantitative disclosures: historical 

results.

(d) Actual losses in the preceding period for each category and subcategory and how this differs from past 

experience. A discussion of the factors that impacted the loss experience in the preceding period—for 

example, has the bank holding company experienced higher than average default rates, loss rates or 

EADs. 

(e) Comparison of risk parameter estimates against actual outcomes over a longer period.29 At a minimum, this should include information on estimates of losses against actual losses in the wholesale category and each retail subcategory over a period sufficient to allow for a meaningful assessment of the 

performance of the internal rating processes for each category/subcategory.30 Where appropriate, the 

bank holding company should further decompose this to provide analysis of PD, ELGD, LGD, and EAD 

outcomes against estimates provided in the quantitative risk assessment disclosures above.31


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32Net unsecured credit exposure is the credit 

exposure after considering both the benefits from 

legally enforceable netting agreements and 

collateral arrangements without taking into account 

haircuts for price volatility, liquidity, etc. 33This may include interest rate derivative 

contracts, foreign exchange derivative contracts, 

equity derivative contracts, credit derivatives, 

commodity or other derivative contracts, repo-style 

transactions, and eligible margin loans. 

34At a minimum, a bank holding company must 

give the disclosures in Table 11.7 in relation to 

credit risk mitigation that has been recognized for 

the purposes of reducing capital requirements 

under this Appendix. Where relevant, bank holding 

companies are encouraged to give further 

information about mitigants that have not been 

recognized for that purpose. 35Credit derivatives that are treated, for the 

purposes of this Appendix, as synthetic 

securitization exposures should be excluded from 

the credit risk mitigation disclosures and included 

within those relating to securitization. 

36Counterparty credit risk-related exposures 

disclosed pursuant to Table 11.6 should be 

excluded from the credit risk mitigation disclosures 

in Table 11.7. 

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

Qualitative Disclosures ................... (a) The general qualitative processes for disclosure requirement with respect to OTC derivatives, eligible 

margin loans, and repo-style transactions, including: 

• Discussion of methodology used to assign economic capital and credit limits for counterparty credit 

exposures; 

• Discussion of policies and securing collateral, valuing and managing collateral, and establishing credit 

reserves; 

• Discussion of the primary types of collateral taken; 

• Discussion of policies with respect to wrong-way risk exposures; and 

• Discussion of the impact of the amount of collateral the bank would have to provide given a credit rating 

downgrade. 

Quantitative Disclosures ................. (b) Gross positive fair value of contracts, netting benefits, netted current credit exposure, collateral held (including type, for example, cash, government securities), and net unsecured credit exposure.32 Also report measures for EAD used for regulatory capital for these transactions, the notional value of credit derivative hedges purchased for counterparty credit risk protection, and the distribution of current credit exposure by types of credit exposure.33

(c) Notional amount of purchased and sold credit derivatives, segregated between use for the institution’s 

own credit portfolio, as well as in its intermediation activities, including the distribution of the credit derivative products used, broken down further by protection bought and sold within each product group. 

(d) The estimate of alpha if the bank holding company has received supervisory approval to estimate 

alpha. 

TABLE 11.7.—CREDIT RISK MITIGATION 34, 35, 36

Qualitative Disclosure ..................... (a) The general qualitative disclosure requirement with respect to credit risk mitigation including: 

• Policies and processes for, and an indication of the extent to which the bank holding company uses, onand off-balance sheet netting; 

• Policies and processes for collateral valuation and management; 

• A description of the main types of collateral taken by the bank holding company; 

• The main type of guarantors/credit derivative counterparties and their creditworthiness; and 

• Information about (market or credit) risk concentrations within the mitigation taken. 

Quantitative Disclosure ................... (b) For each separately disclosed portfolio, the total exposure (after, where applicable, on- or off-balance 

sheet netting) that is covered by guarantees/credit derivatives and the risk-weighted asset amount associated with that exposure. 

TABLE 11.8.—SECURITIZATION

Qualitative disclosures .................... (a) The general qualitative disclosure requirement disclosures with respect to securitization (including synthetics), including a discussion of: 

∑ The bank holding company’s objectives relating to securitization activity, including the extent to which 

these activities transfer credit risk of the underlying exposures away from the bank holding company to 

other entities; 

∑ The roles played by the bank holding company in the securitization process 37 and an indication of the 

extent of the bank holding company’s involvement in each of them; and 

∑ The regulatory capital approaches (for example, RBA, IAA and SFA) that the bank holding company 

follows for its securitization activities. 

(b) Summary of the bank holding company’s accounting policies for securitization activities, including: 

∑ Whether the transactions are treated as sales or financings; 

∑ Recognition of gain-on-sale; 

∑ Key assumptions for valuing retained interests, including any significant changes since the last reporting 

period and the impact of such changes; and 

∑ Treatment of synthetic securitizations. 

(c) Names of NRSROs used for securitizations and the types of securitization exposure for which each 

agency is used. 


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37For example: originator, investor, servicer, 

provider of credit enhancement, sponsor of asset 

backed commercial paper facility, liquidity 

provider, swap provider. 38Underlying exposure types may include, for 

example, 1–4 family residential loans, home equity 

lines, credit card receivables, and auto loans. 39Securitization transactions in which the 

originating bank holding company does not retain 

any securitization exposure should be shown 

separately but need only be reported for the year 

of inception. 

40Where relevant, a bank holding company is 

encouraged to differentiate between exposures 

resulting from activities in which they act only as 

sponsors, and exposures that result from all other 

bank holding company securitization activities. 

41For example, charge-offs/allowances (if the 

assets remain on the bank holding company’s 

balance sheet) or write-downs of I/O strips and 

other residual interests. 

42Unrealized gains (losses) recognized in the 

balance sheet but not through earnings. 

43Unrealized gains (losses) not recognized either 

in the balance sheet or through earnings. 

44This disclosure should include a breakdown of 

equities that are subject to the 0%, 20%, 100%, 

300%, and 400% risk weights, as applicable. 

TABLE 11.8.—SECURITIZATION—Continued 

Quantitative disclosures .................. (d) The total outstanding exposures securitized by the bank holding company in securitizations that meet 

the operation criteria in Section 41 (broken down into traditional/synthetic), by underlying exposure 

type.38, 39, 40

(e) For exposures securitized by the bank holding company in securitizations that meet the operational criteria in Section 41: 

∑ Amount of securitized assets that are impaired/past due; and 

∑ Losses recognized by the bank holding company during the current period 41 broken down by exposure 

type. 

(f) Aggregate amount of securitization exposures broken down by underlying exposure type. 

(g) Aggregate amount of securitization exposures and the associated IRB capital charges for these exposures broken down into a meaningful number of risk weight bands. Exposures that have been deducted 

from capital should be disclosed separately by type of underlying asset. 

(h) For securitizations subject to the early amortisation treatment, the following items by underlying asset 

type for securitized facilities: 

∑ The aggregate drawn exposures attributed to the seller’s and investors’ interests; and 

∑ The aggregate IRB capital charges incurred by the bank holding company against the investor’s shares 

of drawn balances and undrawn lines. 

(i) Summary of current year’s securitization activity, including the amount of exposures securitized (by exposure type), and recognised gain or loss on sale by asset type. 

TABLE 11.9.—OPERATIONAL RISK

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

(b) Description of the AMA, including a discussion of relevant internal and external factors considered in 

the bank holding company’s measurement approach. 

(c) A description of the use of insurance for the purpose of mitigating operational risk. 

TABLE 11.10.—EQUITIES NOT SUBJECT TO MARKET RISK RULE

Qualitative Disclosures ................... (a) The general qualitative disclosure requirement with respect to equity risk, including: 

∑ Differentiation between holdings on which capital gains are expected and those taken under other objectives including for relationship and strategic reasons; and 

∑ Discussion of important policies covering the valuation of and accounting for equity holdings in the 

banking book. This includes the accounting techniques and valuation methodologies used, including 

key assumptions and practices affecting valuation as well as significant changes in these practices. 

Quantitative Disclosures ................. (b) Value disclosed in the balance sheet of investments, as well as the fair value of those investments; for 

quoted securities, a comparison to publicly-quoted share values where the share price is materially different from fair value. 

(c) The types and nature of investments, including the amount that is: 

∑ Publicly traded; and 

∑ Non-publicly traded. 

(d) The cumulative realized gains (losses) arising from sales and liquidations in the reporting period. 

(e) Total unrealized gains (losses); 42

∑ Total latent revaluation gains (losses); 43 and 

∑ Any amounts of the above included in tier 1 and/or tier 2 capital. 

(f) Capital requirements broken down by appropriate equity groupings, consistent with the bank holding 

company’s methodology, as well as the aggregate amounts and the type of equity investments subject 

to any supervisory transition regarding regulatory capital requirements. 44

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

Qualitative disclosures .................... (a) The general qualitative disclosure requirement, including the nature of interest rate risk for non-trading 

activities and key assumptions, including assumptions regarding loan prepayments and behavior of nonmaturity deposits, and frequency of measurement of interest rate risk for non-trading activities. 


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45Alternatively, a savings association may 

provide the disclosures in more than one place, as 

Continued 

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

Quantitative disclosures .................. (b) The increase (decline) in earnings or economic value (or relevant measure used by management) for 

upward and downward rate shocks according to management’s method for measuring interest rate risk 

for non-trading activities, broken down by currency (as appropriate). 

* * * * * 

Federal Deposit Insurance Corporation 

12 CFR Chapter III 

Authority and Issuance 

For the reasons stated in the common 

preamble, the Federal Deposit Insurance 

Corporation proposes to amend part 325 

of chapter III of title 12 of the Code of 

Federal Regulations as follows: 

PART 325—CAPITAL MAINTENANCE 

1. The authority citation for part 325 

continues to read as follows: 

Authority: 12 U.S.C. 1815(a), 1815(b), 

1816, 1818(a), 1818(b), 1818(c), 1818(t), 

1819(Tenth), 1828(c), 1828(d), 1828(i), 

1828(n), 1828(o), 1831o, 1835, 3907, 3909, 

4808; Pub. L. 102–233, 105 Stat. 1761, 1789, 

1790 (12 U.S.C. 1831n note); Pub. L. 102–

242, 105 Stat. 2236, 2355, 2386 (12 U.S.C. 

1828 note). 

2. New Appendix D to part 325 is 

added as set forth at the end of the 

common preamble. 

3. Appendix D to part 325 is amended 

as set forth below: 

a. Remove ‘‘[AGENCY]’’ and add 

‘‘FDIC’’ in its place wherever it appears. 

b. Remove ‘‘[bank]’’ and add ‘‘bank’’

in its place wherever it appears, and 

remove ‘‘[Bank]’’ and add ‘‘Bank’’ in its 

place wherever it appears. 

c. Remove ‘‘[Appendix ll to Part 

ll]’’ and add ‘‘Appendix D to Part 

325’’ in its place wherever it appears. 

d. Remove ‘‘[the general risk-based 

capital rules]’’ and add ‘‘12 CFR part 

325, Appendix A’’ in its place wherever 

it appears. 

e. Remove ‘‘[the market risk rule]’’

and add ‘‘12 CFR part 325, Appendix C’’

in its place wherever it appears. 

f. Remove ‘‘[Disclosure paragraph 

(b)]’’ and add in its place ‘‘(b) A bank 

must comply with paragraph (c) of 

section 71 of appendix F to the Federal 

Reserve Board’s Regulation Y (12 CFR 

part 225, appendix F) unless it is a 

consolidated subsidiary of a bank 

holding company or depository 

institution that is subject to these 

requirements.’’

g. Remove ‘‘Disclosure paragraph 

(c)].’’

Department of the Treasury 

Office of Thrift Supervision 

12 CFR Chapter V 

Authority and Issuance 

For the reasons stated in the common 

preamble, the Office of Thrift 

Supervision proposes to amend part 566 

of chapter V of title 12 of the Code of 

Federal Regulations as follows: 

1. Add a new part 566 to read as 

follows: 

PART 566—ADVANCED CAPITAL 

ADEQUACY FRAMEWORK AND 

MARKET RISK ADJUSTMENT 

Sec. 

566.1 Purpose 

Authority: 12 U.S.C. 1462, 1462a, 1463, 

1464, 1467a, 1828(note). 

§ 566.1 Purpose. 

(a) Advanced Capital Framework. 

Appendix A of this part establishes: 

minimum qualifying criteria for savings 

associations using internal risk 

measurement and management 

processes for calculating risk based 

capital requirements, methodologies for 

these savings associations to calculate 

their risk-based capital requirement, and 

public disclosure requirements for these 

savings associations. 

(b) [Reserved] 

2. Appendix A to part 566 is added 

to read as set forth at the end of the 

common preamble. 

3. Appendix A to part 566 is amended 

as set forth below: 

a. Remove ‘‘[AGENCY]’’ and add 

‘‘OTS’’ in its place wherever it appears. 

b. Remove ‘‘[bank]’’ and add ‘‘savings 

association’’ in its place wherever it 

appears, and remove ‘‘[Bank]’’ and add 

‘‘Savings association’’ in its place 

wherever it appears. 

c. Remove ‘‘[Appendixllto 

Partll]’’ and add ‘‘Appendix A to Part 

566’’ in its place wherever it appears. 

d. Remove ‘‘[the general risk-based 

capital rules]’’ and add ‘‘12 CFR part 

567’’ in its place wherever it appears. 

e. Remove ‘‘[the market risk rule]’’

and add ‘‘12 CFR part 566, Subpart B’’

in its place wherever it appears. 

f. Remove the text of section 12(b) and 

add in its place: ‘‘A savings association 

is not required to deduct equity 

securities from capital under 12 CFR 

567.5(c)(2)(ii). However, it must 

continue to deduct equity investments 

in real estate under that section. See 12 

CFR 567.1, which defines equity 

investments, including equity securities 

and equity investments in real estate.’’

g. Remove the text of section 

52(b)(3)(i) and add in its place: ‘‘An 

equity exposure that is designed 

primarily to promote community 

welfare, including the welfare of lowand moderate-income communities or 

families, such as by providing services 

or jobs, excluding equity exposures to 

an unconsolidated small business 

investment company and equity 

exposures held through a consolidated 

small business investment company 

described in section 302 of the Small 

Business Investment Act of 1958 (15 

U.S.C. 682).’’

h. Remove ‘‘[Disclosure paragraph 

(b)]’’ and add in its place ‘‘(b) A savings 

association must comply with paragraph 

(c) of section 71 unless it is a 

consolidated subsidiary of a depository 

institution or bank holding company 

that is subject to these requirements.’’

i. Remove ‘‘[Disclosure paragraph 

(c)].’’

j. In section 71, add new paragraph (c) 

to read as follows: 

Section 71 * * * 

* * * * * 

(c)(1) Each consolidated savings 

association described in paragraph (b) of 

this section that has successfully 

completed its parallel run must provide 

timely public disclosures each calendar 

quarter of the information in tables 

11.1–11.11 below. If a significant change 

occurs, such that the most recent 

reported amounts are no longer 

reflective of the savings association’s 

capital adequacy and risk profile, then 

a brief discussion of this change and its 

likely impact must be provided as soon 

as practicable thereafter. Qualitative 

disclosures that typically do not change 

each quarter (for example, a general 

summary of the savings association’s 

risk management objectives and 

policies, reporting system, and 

definitions) may be disclosed annually, 

provided any significant changes to 

these are disclosed in the interim. 

Management is encouraged to provide 

all of the disclosures required by this 

appendix in one place on the savings 

association’s public Web site.45 The 


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some of them may be included in public financial 

reports (for example, in Management’s Discussion 

and Analysis included in SEC filings) or other 

regulatory reports. The savings association must 

provide a summary table on its public Website that 

specifically indicates where all the disclosures may 

be found (for example, regulatory report schedules, 

page numbers in annual reports). 

46Entities include securities, insurance and other 

financial subsidiaries, commercial subsidiaries 

(where permitted), significant minority equity 

investments in insurance, financial and commercial 

entities. 

47A capital deficiency is the amount by which 

actual regulatory capital is less than the minimum 

regulatory capital requirements. 

48Representing 50% of the amount, if any, by 

which total expected credit losses as calculated 

within the IRB framework exceed eligible credit 

reserves, which must be deducted from Tier 1 

capital. 

49 Including 50% of the amount, if any, by which 

total expected credit losses as calculated within the 

IRB framework exceed eligible credit reserves, 

which must be deducted from Tier 2 capital. 

savings association must make these 

disclosures publicly available for each 

of the last three years (that is, twelve 

quarters) or such shorter period since it 

began its first floor period. 

(2) Each savings association is 

required to have a formal disclosure 

policy approved by the board of 

directors that addresses its approach for 

determining the disclosures it makes. 

The policy must address the associated 

internal controls and disclosure controls 

and procedures. The board of directors 

and senior management must ensure 

that appropriate verification of the 

disclosures takes place and that 

effective internal controls and 

disclosure controls and procedures are 

maintained. The chief financial officer 

of the savings association must certify 

that the disclosures required by this 

appendix are appropriate, and the board 

of directors and senior management are 

responsible for establishing and 

maintaining an effective internal control 

structure over financial reporting, 

including the disclosures required by 

this appendix. 

TABLE 11.1.—SCOPE OF APPLICATION

Qualitative Disclosures ................... (a) The name of the top corporate entity in the group to which the appendix applies. 

(b) An outline of differences in the basis of consolidation for accounting and regulatory purposes, with a 

brief description of the entities 46 within the group (a) that are fully consolidated; (b) that are 

deconsolidated and deducted; (c) for which the regulatory capital requirement is deducted; and (d) that 

are neither consolidated nor deducted (for example, where the investment is risk-weighted). 

(c) Any restrictions, or other major impediments, on transfer of funds or regulatory capital within the group. 

Quantitative Disclosures ................. (d) The aggregate amount of surplus capital of insurance subsidiaries (whether deducted or subjected to 

an alternative method) included in the regulatory capital of the consolidated group. 

(e) The aggregate amount of capital deficiencies 47 in all subsidiaries and the name(s) of such subsidiaries. 

TABLE 11.2.—CAPITAL STRUCTURE

Qualitative disclosures .................... (a) Summary information on the terms and conditions of the main features of all capital instruments, especially in the case of innovative, complex or hybrid capital instruments. 

Quantitative disclosures .................. (b) The amount of tier 1 capital, with separate disclosure of: 

∑ Common stock/surplus; 

∑ Retained earnings; 

∑ Minority interests in the equity of subsidiaries; regulatory calculation differences deducted from tier 1 

capital; 48 and 

∑ Other amounts deducted from tier 1 capital, including goodwill and certain intangibles. 

(c) The total amount of tier 2 capital. 

(d) Other deductions from capital.49

(e) Total eligible capital. 

TABLE 11.3.—CAPITAL ADEQUACY

Qualitative disclosures .................... (a) A summary discussion of the savings association’s approach to assessing the adequacy of its capital to 

support current and future activities. 

Quantitative disclosures .................. (b) Risk-weighted assets for credit risk from: 

∑ Wholesale exposures; 

∑ Residential mortgage exposures; 

∑ Qualifying revolving exposures; 

∑ Other retail exposures; 

∑ Securitization exposures; and 

∑ Equity exposures: 

∑ Equity exposures subject to simple risk weight approach; and 

∑ Equity exposures subject to internal models approach. 

(c) Risk-weighted assets for market risk as calculated under [the market risk rule]: 50

∑ Standardized approach for specific risk; and 

∑ Internal models approach for specific risk. 

(d) Risk-weighted assets for operational risk. 

(e) Total and tier 1 risk-based capital ratios: 51


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50Risk-weighted assets determined under [the 

market risk rule] are to be disclosed only for the 

approaches used. 

51Total risk-weighted assets should also be 

disclosed. 

52Table 4 does not include equity exposures. 

53That is, after accounting offsets in accordance 

with US GAAP (for example, FASB Interpretations 

39 and 41) and without taking into account the 

effects of credit risk mitigation techniques, for 

example collateral and netting. 

54For example, banks could apply a breakdown 

similar to that used for accounting purposes. Such 

a breakdown might, for instance, be (a) loans, offbalance sheet commitments, and other nonderivative off-balance sheet exposures, (b) debt 

securities, and (c) OTC derivatives. 55 Geographical areas may comprise individual 

countries, groups of countries or regions within 

countries. A savings association might choose to 

define the geographical areas based on the way the 

company’s portfolio is geographically managed. The 

criteria used to allocate the loans to geographical 

areas must be specified. 56A savings association is encouraged also to 

provide an analysis of the aging of past-due loans. 57The portion of general allowance that is not 

allocated to a geographical area should be disclosed 

separately. 

58The reconciliation should include the 

following: A description of the allowance; the 

opening balance of the allowance; charge-offs taken 

against the allowance during the period; amounts 

provided (or reversed) for estimated probable loan 

losses during the period; any other adjustments (for 

example, exchange rate differences, business 

combinations, acquisitions and disposals of 

subsidiaries), including transfers between 

allowances; and the closing balance of the 

allowance. Charge-offs and recoveries that have 

been recorded directly to the income statement 

should be disclosed separately. 

TABLE 11.3.—CAPITAL ADEQUACY—Continued 

∑ For the top consolidated group; and 

∑ For each DI subsidiary. 

General Qualitative Disclosure 

Requirement 

For each separate risk area described 

in tables 11.4 through 11.11, the savings 

association must describe its risk 

management objectives and policies, 

including: 

• Strategies and processes; 

• The structure and organization of 

the relevant risk management function; 

• The scope and nature of risk 

reporting and/or measurement systems; 

• Policies for hedging and/or 

mitigating risk and strategies and 

processes for monitoring the continuing 

effectiveness of hedges/mitigants. 

TABLE 11.4.52—CREDIT RISK: GENERAL DISCLOSURES

Qualitative Disclosures ................... (a) The general qualitative disclosure requirement with respect to credit risk (excluding counterparty credit 

risk disclosed in accordance with Table 11.6), including: 

• Definitions of past due and impaired (for accounting purposes); 

• Description of approaches followed for allowances, including statistical methods used where applicable; 

• Discussion of the savings association’s credit risk management policy. 

Quantitative Disclosures ................. (b) Total gross credit risk exposures,53 and average gross credit risk exposures, over the period broken 

down by major types of credit exposure.54

(c) Geographic 55 distribution of exposures, broken down in significant areas by major types of credit exposure. 

(d) Industry or counterparty type distribution of exposures, broken down by major types of credit exposure. 

(e) Remaining contractual maturity breakdown (for example, one year or less) of the whole portfolio, broken down by major types of credit exposure. 

(f) By major industry or counterparty type: 

• Amount of impaired loans; 

• Amount of past due loans;56 • Allowances; and 

• Charge-offs during the period. 

(g) Amount of impaired loans and, if available, the amount of past due loans broken down by significant 

geographic areas including, if practical, the amounts of allowances related to each geographical area.57

(h) Reconciliation of changes in the allowance for loan and lease losses.58

TABLE 11.5.—CREDIT RISK: DISCLOSURES FOR PORTFOLIOS SUBJECT TO IRB RISK-BASED CAPITAL FORMULAS

Qualitative disclosures .................... (a) Explanation and review of the: 

• Structure of internal rating systems and relation between internal and external ratings; 

• Use of risk parameter estimates other than for regulatory capital purposes; 

• Process for managing and recognizing credit risk mitigation; and 

• Control mechanisms for the rating system, including discussion of independence, accountability, and 

rating systems review. 

(b) Description of the internal ratings process, provided separately for the following: 

• Wholesale category; and 

• Retail subcategories: residential mortgage exposures; 

• Qualifying revolving exposures; and 

• Other retail exposures. 

For each category and subcategory the description should include: 

• The types of exposure included in the category/subcategories; 

• The definitions, methods and data for estimation and validation of PD, ELGD, LGD, and EAD, including 

assumptions employed in the derivation of these variables.59

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

(including default) to allow for a meaningful differentiation of credit risk: 60

• Total EAD; 61 • Exposure-weighted average ELGD and LGD (percentage); 

• Exposure weighted-average capital requirement (K); and 


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59This disclosure does not require a detailed 

description of the model in full—it should provide 

the reader with a broad overview of the model 

approach, describing definitions of the variables, 

and methods for estimating and validating those 

variables set out in the quantitative risk disclosures 

below. This should be done for each of the four 

category/subcategories. The savings association 

should disclose any significant differences in 

approach to estimating these variables within each 

category/subcategories. 

60The PD, ELGD, LGD and EAD disclosures in 

Table 11.5(c) should reflect the effects of collateral, 

qualifying master netting agreements, eligible 

guarantees and eligible credit derivatives as defined 

in Part 1. Disclosure of each PD grade should 

include the exposure weighted-average PD for each 

grade. Where a savings association aggregates PD 

grades PD for the purposes of disclosure, this 

should be a representative breakdown of the 

distribution of PD grades used for regulatory capital 

purposes. 61Outstanding loans and EAD on undrawn 

commitments can be presented on a combined basis 

for these disclosures. 62These disclosures are a way of further 

informing the reader about the reliability of the 

information provided in the ‘‘quantitative 

disclosures: risk assessment’’ over the long run. The 

disclosures are requirements from year-end 2010; in 

the meantime, early adoption is encouraged. The 

phased implementation is to allow a savings 

association sufficient time to build up a longer run 

of data that will make these disclosures meaningful. 63This regulation is not prescriptive about the 

period used for this assessment. Upon 

implementation, it might be expected that a savings 

association would provide these disclosures for as 

long run of data as possible—for example, if a 

savings association has 10 years of data, it might 

choose to disclose the average default rates 

64A savings association should provide this 

further decomposition where it will allow users 

greater insight into the reliability of the estimates 

provided in the ‘‘quantitative disclosures: risk 

assessment.’’ In particular, it should provide this 

information where there are material differences 

between its estimates of PD, ELGD, LGD or EAD 

compared to actual outcomes over the long run. The 

savings association should also provide 

explanations for such differences. 

65Net unsecured credit exposure is the cedit 

exposure after considering both the benefits from 

legally enforceable netting agreements and 

collateral arrangements without taking into account 

haircuts for price volatility, liquidity, etc. 

66This may include interest rate derivative 

contracts, foreign exchange derivative contracts, 

equity derivative contracts, credit derivatives, 

commodity or other derivative contracts, repo-style 

transactions, and eligible margin loans. 

TABLE 11.5.—CREDIT RISK: DISCLOSURES FOR PORTFOLIOS SUBJECT TO IRB RISK-BASED CAPITAL FORMULAS—

Continued 

• Amount of undrawn commitments and exposure-weighted average EAD for wholesale exposures. 

For each retail subcategory, present the disclosures outlined above across a sufficient number of segments to allow for a meaningful differentiation of credit risk. 

Quantitative disclosures: historical 

results.

(d) Actual losses in the preceding period for each category and subcategory and how this differs from past 

experience. A discussion of the factors that impacted the loss experience in the preceding period—for 

example, has the savings association experienced higher than average default rates, loss rates or 

EADs. 

(e) Comparison of risk parameter estimates against actual outcomes over a longer period.62 At a minimum, this should include information on estimates of losses against actual losses in the wholesale category and each retail subcategory over a period sufficient to allow for a meaningful assessment of the 

performance of the internal rating processes for each category/subcategory.63 Where appropriate, the 

savings association should further decompose this to provide analysis of PD, ELGD, LGD, and EAD outcomes against estimates provided in the quantitative risk assessment disclosures above.64

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

Qualitative Disclosures ................... (a) The general qualitative disclosure requirement with respect to OTC derivatives, eligible margin loans, 

and repo-style transactions, including: 

∑ Discussion of methodology used to assign economic capital and credit limits for counterparty credit 

exposures; 

∑ Discussion of policies for securing collateral, valuing and managing collateral, and establishing credit 

reserves; 

∑ Discussion of the primary types of collateral taken; 

∑ Discussion of policies with respect to wrong-way risk exposures; and 

∑ Discussions of the impact of the amount of collateral the bank would have to provide given a credit 

rating downgrade. 

Quantitative Disclosures ................. (b) Gross positive fair value of contracts, netting benefits, netted current credit exposure, collateral held (including type, for example, cash, government securities), and net unsecured credit exposure.65 Also report measures for EAD used for regulatory capital for these transactions, the notional value of credit derivative hedges purchased for counterparty credit risk protection, and the distribution of current credit exposure by types of credit exposure.66

(c) Notional amount of purchased and sold credit derivatives, segregated between use for the institution’s 

own credit portfolio, as well as in its intermediation activities, including the distribution of the credit derivative products used, broken down further by protection bought and sold within each product group. 

(d) The estimate of alpha if the savings association has received supervisory approval to estimate alpha. 

TABLE 11.7.—CREDIT RISK MITIGATION67 68 69

Qualitative Disclosures ................... (a) The general qualitative disclosure requirement with respect to credit risk mitigation including: 

∑ Policies and processes for, and an indication of the extent to which the savings association uses, onand off-balance sheet netting; 

∑ Policies and processes for collateral valuation and management; 

∑ A description of the main types of collateral taken by the savings association; 

∑ The main types of guarantors/credit derivative counterparties and their creditworthiness; and 

∑ Information about (market or credit) risk concentrations within the mitigation taken. 


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67At a minimum, a savings association must give 

the disclosures in Table 11.7 in relation to credit 

risk mitigation that has been recognized for the 

purposes of reducing capital requirements under 

this Appendix. Where relevant, savings associations 

are encouraged to give further information about 

mitigants that have not been recognized for that 

purpose. 

68Credit derivatives that are treated, for the 

purposes of this Appendix, as synthetic 

securitization exposures should be excluded from 

the credit risk mitigation disclosures and included 

within those relating to securitization. 

69Counterparty credit risk-related exposures 

disclosed pursuant to Table 11.6 should be 

excluded from the credit risk mitgation disclosures 

in Table 11.7. 70For example: Originator, investor, servicer, 

provider of credit enhancement, sponsor of asset 

backed commercial paper facility, liquidity 

provider, swap provider. 71Underlying exposure types may include, for 

example, 1–4 family residential loans, from equity 

lines, credit card receivables, and auto loans. 72Securitization transactions in which the 

originating savings association does not retain any 

securitization exposure should be shown separately 

but need only be reported for the year of inception. 

73Where relevant, a savings association is 

encouraged to differentiate between exposures 

resulting from activities in which they act only as 

sponsors, and exposures that result from all other 

savings association securitization activities. 

74For example, charge-offs/allowances (if the 

assets remain on the savings association’s balance 

sheet) or write-downs of I/O strips and other 

residual interests. 

TABLE 11.7.—CREDIT RISK MITIGATION67 68 69—Continued 

Quantitative Disclosures ................. (b) For each separately disclosed portfolio, the total exposure (after, where applicable, on- or off-balance 

sheet netting) that is covered by guarantees/credit derivatives and the risk-weighted asset amount associated with that exposure. 

TABLE 11.8.—SECURITIZATION

Qualitative Disclosures ................... (a) The general qualitative disclosure requirement with respect to securitization (including synthetics), including a discussion of: 

∑ The savings association’s objectives relating to securitization activity, including the extent to which 

these activities transfer credit risk of the underlying exposures away from the savings association to 

other entities; 

∑ The roles played by the savings association in the securitization process 70 and an indication of the 

extent of the savings association’s involvement in each of them; and 

∑ The regulatory capital approaches (for example, RBA, IAA and SFA) that the savings association follows for its securitization activities. 

(b) Summary of the savings association’s accounting policies for securitization activities, including: 

∑ Whether the transactions are treated as sales or financings; 

∑ Recognition of gain-on-sale; 

∑ Key assumptions for valuing retained interests, including any significant changes since the last reporting period and the impact of such changes; and 

∑ Treatment of synthetic securitizations. 

(c) Names of NRSROs used for securitizations and the types of securitization exposure for which each 

agency is used. 

Quantitative Disclosures ................. (d) The total outstanding exposures securitized by the savings association in securitizations that meet the 

operation criteria in Section 41 (broken down into traditional/synthetic), by underlying exposure 

type.71,72,73

(e) For exposures securitized by the savings association in securitizations that meet the operational criteria 

in Section 41: 

∑ Amount of securitized assets that are impaired/past due; and 

∑ Losses recognized by the savings association during the current period 74 broken down by exposure 

type. 

(f) Aggregate amount of securitization exposures broken down by underlying exposure type. 

(g) Aggregate amount of securitization exposures and the associated IRB capital charges for these exposures broken down into a meaningful number of risk weight bands. Exposures that have been deducted 

from capital should be disclosed separately by type of underlying asset. 

(h) For securitizations subject to the early amortisation treatment, the following items by underlying asset 

type for securitized facilities: 

∑ The aggregate drawn exposures attributed to the seller’s and investors’ interests; and 

∑ The aggregate IRB capital charges incurred by the savings association against the investor’s shares 

of drawn balances and undrawn lines. 

(i) Summary of current year’s securitization activity, including the amount of exposures securitized (by exposure type), and recognised gain or loss on sale by asset type. 

TABLE 11.9.—OPERATIONAL RISK

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

(b) Description of the AMA, including a discussion of relevant internal and external factors considered in 

the savings association’s measurement approach. 

(c) A description of the use of insurance for the purpose of mitigating operational risk. 


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75Unrealized gains (losses) recognized in the 

balance sheet but not through earnings. 

76Unrealized gains (losses) not recognized either 

in the balance sheet or through earnings. 

77This disclosure should include a breakdown of 

equities that are subject to the 0%, 20%, 100%, 

300%, and 400% risk weights, as applicable. 

TABLE 11.10.—EQUITIES NOT SUBJECT TO MARKET RISK RULE

Qualitative Disclosures ................... (a) The general qualitative disclosure requirement with respect to equity risk, including: 

∑ Differentiation between holdings on which capital gains are expected and those taken under other objectives including for relationship and strategic reasons; and 

∑ Discussion of important policies covering the valuation of and accounting for equity holdings in the 

banking book. This includes the accounting techniques and valuation methodologies used, including 

key assumptions and practices affecting valuation as well as significant changes in these practices. 

Quantitative Disclosures ................. (b) Value disclosed in the balance sheet of investments, as well as the fair value of those investments; for 

quoted securities, a comparison to publicly-quoted share values where the share price is materially different from fair value. 

(c) The types and nature of investments, including the amount that is: 

∑ Publicly traded; and 

∑ Non-publicly traded. 

(d) The cumulative realized gains (losses) arising from sales and liquidations in the reporting period. 

(e)∑ Total unrealized gains (losses); 75

∑ Total latent revaluation gains (losses); 76 and 

∑ Any amounts of the above included in tier 1 and/or tier 2 capital. 

(f) Capital requirements broken down by appropriate equity groupings, consistent with the savings association’s methodology, as well as the aggregate amounts and the type of equity investments subject to any 

supervisory transition regarding regulatory capital requirements.77

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

Qualitative disclosures .................... (a) The general qualitative disclosure requirement, including the nature of interest rate risk for non-trading 

activities and key assumptions, including assumptions regarding loan prepayments and behavior of nonmaturity deposits, and frequency of measurement of interest rate risk for non-trading activities. 

Quantitative disclosures .................. (b) The increase (decline) in earnings or economic disclosures value (or relevant measure used by management) for upward and downward rate shocks according to management’s method for measuring interest rate risk for non-trading activities, broken down by currency (as appropriate). 

* * * * * 

Dated: September 5, 2006. 

John C. Dugan, 

Comptroller of the Currency. 

By order of the Board of Governors of the 

Federal Reserve System, September 11, 2006. 

Jennifer J. Johnson, 

Secretary of the Board. 

Dated at Washington, DC, this 5th day of 

September, 2006. 

By order of the Board of Directors. 

Federal Deposit Insurance Corporation. 

Robert E. Feldman, 

Executive Secretary. 

Dated: September 5, 2006. 

By the Office of Thrift Supervision. 

John M. Reich, 

Director. 

[FR Doc. 06–7656 Filed 9–22–06] 

BILLING CODES 4810–33–P, 6210–01–P, 6714–01–P, 

6720–01–P 

DEPARTMENT OF THE TREASURY 

Office of the Comptroller of the 

Currency 

12 CFR Part 3 

[Docket No. 06–10] 

RIN 1557–AC99 

FEDERAL RESERVE SYSTEM 

12 CFR Parts 208 and 225 

[Regulations H and Y; Docket No. R–1266] 

FEDERAL DEPOSIT INSURANCE 

CORPORATION 

12 CFR Part 325 

RIN 3064–AD10 

DEPARTMENT OF THE TREASURY 

Office of Thrift Supervision 

12 CFR Part 566 

[Docket No. 2006–34] 

RIN 1550–AC02 

Risk-Based Capital Standards: Market 

Risk 

AGENCIES: Office of the Comptroller of 

the Currency, Treasury; Board of 

Governors of the Federal Reserve 

System; Federal Deposit Insurance 

Corporation, and Office of Thrift 

Supervision, Treasury. 

ACTION: Joint notice of proposed 

rulemaking. 

SUMMARY: The Office of the Comptroller 

of the Currency (OCC), the Board of 

Governors of the Federal Reserve 

System (Board), and the Federal Deposit 

Insurance Corporation (FDIC) are 

proposing revisions to the market risk 

capital rule to enhance its risk 

sensitivity and introduce requirements 

for public disclosure of certain 

qualitative and quantitative information 

about the market risk of a bank or bank 

holding company. The Office of Thrift 

Supervision (OTS) currently does not 

apply a market risk capital rule to 

savings associations and is proposing in 

this notice a market risk capital rule for 

savings associations. The proposed rules 

for each agency are substantively 

identical. 

DATES: Comments must be received on 

or before January 23, 2007. 

ADDRESSES: Comments should be 

directed to: 

OCC: You should include OCC and 

Docket Number 06–10 in your comment. 


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