55958 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

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. 


sroberts on PROD1PC70 with PROPOSALS
Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55959 

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–1265, 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, identified by RIN number, 

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. 

Include the RIN number in the subject 

line of the message. 

• 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. 

Instructions: All submissions received 

must include the agency name and RIN 

number for this rulemaking. 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 E–1002, 3502 Fairfax Drive, 

Arlington, VA, 22226, between 9 a.m. 

and 5 p.m. on business days. 

OTS: You may submit comments, 

identified by No. 2006–34 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. 2006–34 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. 

2006–34. 

• 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, No. 

2006–34. 

Instructions: All submissions received 

must include the agency name and 

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/ 

pagehmtl.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/ 

pagehmtl.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: Margot Schwadron, Risk Expert, 

Capital Policy (202–874–6022) or Ron 

Shimabukuro, Special Counsel, 

Legislative and Regulatory Activities 

Division, (202–874–5090). 

Board: Barbara Bouchard, Deputy 

Associate Director (202–452–3072 or 

barbara.bouchard@frb.gov), Mary 

Frances Monroe, Manager (202–452–

5231 or mary.f.monroe@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 

Allison Breault, Attorney (202–452–

3124 or allison.breault@frb.gov), Legal 

Division. For users of 

Telecommunications Device for the Deaf 

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

FDIC: Jason C. Cave, Associate 

Director (202–898–3548), Gloria Ikosi, 

Senior Quantitative Risk Analyst (202–

898–3997), or Karl R. Reitz, Financial 

Analyst (202–898–3857), Capital 

Markets Branch, Division of Supervision 

and Consumer Protection; or Michael B. 

Phillips, Counsel, (202–898–3581), or 

Benjamin W. McDonough, Attorney 

(202–898–7411), Supervision and 

Legislation Branch, Legal Division. 

OTS: Michael D. Solomon, Director, 

Capital Policy (202–906–5654), Austin 

Hong, Senior Analyst (202–906–6389), 

Christine A. Smith, Program Manager 

(202–906–5740) or Karen Osterloh, 

Special Counsel, Regulations and 

Legislation Division (202–906–6639). 

SUPPLEMENTARY INFORMATION: 

Table of Contents 

I. Introduction 

A. Background 

B. Summary of the Current Market Risk 

Capital Rule 

1. Covered Positions 

2. Capital Requirement for Market Risk 


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55960 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 ‘‘BHC’’ refer only to 

bank holding companies regulated by the Board. 

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. Publications of the BCBS, including the 1988 

Capital Accord, the market risk amendment (and 

amendments thereto in 1997 and 2005), the New 

Accord, and the Trading Book Improvements 

(discussed later in this preamble) are available 

through the Bank for International Settlements Web 

site at http://www.bis.org. 

3 61 FR 47358 (September 6, 1996). 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, Appendices A and E (bank 

holding companies), and 12 CFR part 325, 

Appendices A and C (state nonmember banks). 4l FR lll September 25, 2006. 5The treatment of double default effects is 

discussed in section V.C.5 of the proposed 

advanced capital adequacy framework. 

6The agencies’ general risk-based capital rules are 

at 12 CFR part 3, Appendix A (national banks); 12 

CFR part 208, Appendix A (state member banks); 

12 CFR part 225, Appendix A (bank holding 

companies); 12 CFR part 325, Appendix A (state 

nonmember banks); and 12 CFR part 567 (savings 

associations). For purposes of this preamble, credit 

risk capital rules refers to the general risk-based 

capital rules and the proposed advanced capital 

adequacy framework, as applicable to the bank 

applying the proposed rule. 

3. Internal Models-Based Capital 

Requirement 

4. Specific Risk 

5. Calculation of the Risk-Based Capital 

Ratio 

II. Proposed Revisions to the Market Risk 

Capital Rule 

A. Objectives of the Proposed Revisions 

B. Description of the Proposed Revisions to 

the Market Risk Capital Rule 

1. Scope 

2. Reservation of Authority 

3. Modification of the Definition of 

Covered Position 

4. Requirements for the Identification of 

Trading Positions and Management of 

Covered Positions 

5. Requirements for Internal Models in 

General 

Model Use Requirements 

Factors and Risks Reflected in Models 

Quantitative Requirements for VaR-Based 

Measure 

Control, Oversight, and Validation 

Mechanisms 

Internal Assessment of Capital Adequacy 

Documentation 

Backtesting 

6. Revised Modeling Standards for Specific 

Risk 

7. Standard Specific Risk Capital 

Requirement 

8. Incremental Default Risk Capital 

Requirement 

9. Disclosure Requirements 

I. Introduction 

A. Background 

The first international capital 

framework for banks 1 entitled, 

International Convergence of Capital 

Measurement and Capital Standards 

(1988 Capital Accord), was developed 

by the Basel Committee on Banking 

Supervision (BCBS) 2 and endorsed by 

the G–10 governors in 1988. The OCC, 

the Board, the FDIC, and the OTS 

(collectively, the agencies) implemented 

the 1988 Capital Accord in 1989. In 

1996, the BCBS amended the 1988 

Capital Accord to require banks to 

measure and hold capital to cover their 

exposure to market risk associated with 

foreign exchange and commodity 

positions and positions located in the 

trading account (the Market Risk 

Amendment or MRA). The OCC, Board, 

and FDIC implemented the MRA 

effective January 1, 1997 (market risk 

capital rule).3

In June 2004, the BCBS issued a final 

text of a revised regulatory capital 

framework for banks entitled, 

International Convergence of Capital 

Measurement and Capital Standards: A 

Revised Framework (New Accord), 

which was intended for use by 

individual countries as the basis for 

national consultation and 

implementation. The New Accord sets 

forth a ‘‘three pillar’’ framework 

encompassing (1) minimum risk-based 

capital requirements for credit risk, 

market risk, and operational risk; (2) 

supervisory review of capital adequacy; 

and (3) market discipline through 

enhanced public disclosures. The 

changes to the capital framework for 

credit and operational risks are the 

subject of the agencies’ Notice of 

Proposed Rulemaking published 

elsewhere in today’s Federal Register 

(proposed advanced capital adequacy 

framework).4

For market risk, the New Accord 

generally retains the approach 

contained in the MRA. However, in 

releasing the New Accord, the BCBS 

announced that work would continue 

on the treatment of double default 

effects in the New Accord and that 

improvements to the MRA would be 

developed immediately, especially with 

respect to the treatment of specific risk. 

Given the interest of both banks and 

securities firms in this issue, the BCBS 

worked jointly with the International 

Organization of Securities Commissions 

(IOSCO) on this effort, which 

culminated in the July 2005 publication 

of The Application of Basel II to Trading 

Activities and the Treatment of Double 

Default Effects by the BCBS and 

IOSCO.5 The July 2005 publication is 

now incorporated in the New Accord 

and follows its ‘‘three pillar’’ structure. 

With respect to market risk, the Pillar 1 

changes clarify the types of positions 

that are subject to the market risk capital 

framework and revise modeling 

standards; the Pillar 2 changes require 

banks to conduct internal assessments 

of their capital adequacy with respect to 

market risk, taking into account the 

output of their internal models, 

valuation adjustments, and stress tests; 

and the Pillar 3 changes require banks 

to disclose quantitative and qualitative 

information on their valuation 

techniques for covered positions, the 

soundness standard they employ for 

modeling purposes, and the 

methodologies they use to make the 

internal capital adequacy assessment. 

In this proposal, the OCC, Board, and 

FDIC are proposing to amend their 

market risk capital rules to implement 

the BCBS’s 2005 changes to the market 

risk capital rule. The OTS has not yet 

implemented a market risk capital rule 

for savings associations and is 

proposing such a rule in this NPR to 

ensure that savings associations with 

significant market risk measure this 

exposure and hold commensurate 

amounts of regulatory capital. The 

proposed rules will be substantively 

identical for each of the agencies, and in 

this NPR the agencies are publishing a 

common rule text with certain agencyspecific text which appears at the end 

of the common preamble. 

Section I.B of this preamble 

summarizes the current market risk 

capital rule and provides background 

information for banks and other readers 

that are not currently subject to or not 

familiar with the market risk capital 

rule. Part II of this preamble describes 

proposed revisions to the market risk 

capital rule. The effective date of any 

final rule associated with the proposed 

revisions to the market risk capital rule 

would be January 1, 2008, with certain 

exceptions described below. 

B. Summary of the Current Market Risk 

Capital Rule 

The current market risk capital rule 

supplements the general risk-based 

capital rules 6 by requiring any bank 

subject to the rule to adjust its riskbased capital ratio to reflect explicitly 

market risk in its trading activities. The 

rule applies to a bank with worldwide, 

consolidated trading activity equal to at 

least 10 percent of total assets or $1 

billion. The primary Federal supervisor 

of a bank may generally apply the 

market risk capital rule to a bank or 

exempt a bank from application of the 

rule if the supervisor deems it necessary 


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Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55961 

7The primary Federal supervisor of a bank may 

also permit the use of alternative techniques to 

measure the market risk of de minimis exposures 

so long as the techniques adequately measure 

associated market risk. 

or appropriate for safe and sound 

banking practices. 

1. Covered Positions 

The market risk capital rule requires 

a bank to maintain capital against the 

market risk of its covered positions. 

Covered positions are defined as all onand off-balance sheet positions in the 

bank’s trading account (as defined in the 

instructions to the Consolidated Reports 

of Condition and Income (Call Report) 

or FR Y–9C Consolidated Financial 

Statements for Bank Holding Companies 

(FR Y–9C)), and all foreign exchange 

and commodity positions, whether or 

not in the trading account. Covered 

positions exclude all positions in the 

trading account that, in form or 

substance, act as liquidity facilities that 

provide liquidity support to assetbacked commercial paper. 

2. Capital Requirement for Market Risk 

The market risk capital rule defines 

market risk as the risk of loss resulting 

from movements in market prices. 

Market risk consists of general market 

risk and specific risk components. 

General market risk is defined as 

changes in the market value of positions 

resulting from broad market movements, 

such as changes in the general level of 

interest rates, equity prices, foreign 

exchange rates, or commodity prices. 

Specific risk is defined as changes in the 

market value of a position due to factors 

other than broad market movements and 

includes event and default risk as well 

as idiosyncratic variations. Event risk is 

the risk of loss on a position that could 

result from sudden and unexpected 

large changes in market prices or 

specific events other than default of the 

issuer. Default risk is the risk of loss on 

a position that could result from the 

failure of an obligor to make timely 

payments of principal or interest on its 

debt obligation, and the risk of loss that 

could result from bankruptcy, 

insolvency, or similar proceeding. For 

credit derivatives, default risk means 

the risk of loss on a position that could 

result from the default of the reference 

exposures. 

A bank that is subject to the market 

risk capital rule is required to use an 

internal model to calculate a value-atrisk (VaR)-based measure of its exposure 

to market risk. A bank’s total risk-based 

capital requirement for covered 

positions generally consists of a VaRbased capital requirement plus an addon for specific risk, if specific risk is not 

captured in the bank’s internal model.7

A VaR-based capital requirement is one 

that is based on an estimate of the 

maximum amount that the value of one 

or more positions could decline during 

a fixed holding period within a stated 

confidence interval. A bank may 

determine its capital requirement for 

specific risk using a standard specific 

risk approach or, with supervisory 

approval, may use internal models to 

determine its capital requirement for 

specific risk. 

3. Internal Models-Based Capital 

Requirement 

In calculating the capital requirement 

for market risk, a bank is required to use 

an internal model that meets specified 

qualitative and quantitative criteria. The 

qualitative requirements reflect basic 

components of sound market risk 

management. For example, the current 

rule requires an independent risk 

control unit that reports directly to 

senior management and an internal risk 

measurement model that is integrated 

into the daily management process. The 

quantitative criteria include the use of a 

VaR-based measure based on a 99 

percent, one-tailed confidence level. 

The VaR-based measure must be based 

on a price shock equivalent to a tenbusiness-day movement in rates or 

prices. Price changes estimated using 

shorter time periods must be adjusted to 

the ten-business-day standard. The 

minimum effective historical 

observation period for deriving the rate 

or price changes is one year and data 

sets must be updated at least quarterly 

or more frequently if market conditions 

warrant. For many types of covered 

positions it is appropriate for a bank to 

update its data sets more frequently 

than quarterly. In all cases a bank must 

have the capability to update its data 

sets more frequently than quarterly in 

anticipation of market conditions that 

would require such updating. 

A bank need not employ a single 

model to calculate its VaR-based 

measure. A bank’s internal model may 

use any generally accepted approach, 

such as variance-covariance models, 

historical simulations, or Monte Carlo 

simulations. However, the level of 

sophistication of the bank’s internal 

model must be commensurate with the 

nature and size of the positions it 

covers. The internal model must use 

risk factors sufficient to measure the 

market risk inherent in all covered 

positions. The risk factors must address 

interest rate risk, equity price risk, 

foreign exchange rate risk, and 

commodity price risk. 

The market risk capital rule imposes 

backtesting requirements that must be 

calculated quarterly. A bank must 

compare its daily VaR-based measure 

for each of the preceding 250 business 

days against its actual daily trading 

profit or loss, which typically includes 

realized and unrealized gains and losses 

on portfolio positions as well as fee 

income and commissions associated 

with trading activities. If the quarterly 

backtesting shows that the bank’s daily 

net trading loss exceeded its 

corresponding daily VaR-based 

measure, a backtesting exception has 

occurred. If a bank experiences more 

than four backtesting exceptions over 

the preceding 250 business days, it is 

generally required to apply a 

multiplication factor in excess of 3 

when it calculates its risk-based capital 

ratio (see section I.B.5 of this preamble). 

A bank subject to the market risk 

capital rule is also required to conduct 

stress tests to gain information about the 

impact of adverse market events on its 

positions. Specific stress testing 

methodologies are not prescribed. 

4. Specific Risk 

A bank may use an internal model to 

measure its exposure to specific risk if 

it has demonstrated to its primary 

Federal supervisor that the model 

measures the specific risk, including 

event and default risk, as well as 

idiosyncratic variations, of its covered 

debt and equity positions. A bank that 

incorporates specific risk in its internal 

model but fails to demonstrate that the 

model adequately measures all aspects 

of specific risk for covered debt and 

equity positions, including event and 

default risk, is subject to a specific risk 

add-on. If the bank can validly separate 

its VaR-based measure into a specific 

risk portion and a general market risk 

portion, the add-on is equal to the 

previous day’s specific risk portion. If 

the bank cannot separate the VaR-based 

measure into a specific risk portion and 

a general market risk portion, the addon is equal to the sum of the previous 

day’s VaR-based measures for 

subportfolios of covered debt and equity 

positions that contain specific risk. 

If the bank does not model specific 

risk, it must calculate its specific risk 

capital requirement, termed an add-on, 

using the standard approach. Under the 

standard approach for specific risk, the 

specific risk add-on for covered debt 

positions is calculated by multiplying 

the absolute value of the current market 

value of each net long or short debt 

position by the appropriate specific risk 

weighting factor in the rule. The specific 

risk weighting factor ranges from zero to 

8 percent and is based on the identity 


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55962 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

8Under the current market risk capital rule, a 

portfolio is liquid and well-diversified if: (i) It is 

characterized by a limited sensitivity to price 

changes of any single equity issue or closely related 

group of equity issues held in the portfolio; (ii) the 

volatility of the portfolio’s value is not dominated 

by the volatility of any individual equity issue or 

by equity issues from any single industry or 

economic sector; (iii) it contains a large number of 

individual equity positions, with no single position 

representing a substantial portion of the portfolio’s 

total market value; and (iv) it consists mainly of 

issues traded on organized exchanges or in wellestablished over-the-counter markets. 

9 In addition, for futures contracts on broadly 

based indices that are matched by offsetting equity 

baskets, a bank may apply a two percent specific 

risk requirement to the futures and stock basket 

positions if the basket comprises at least 90 percent 

of the capitalization of the index. The two percent 

specific risk requirement applies to only one side 

of certain futures-related arbitrage strategies when 

either: (i) the long and short positions are in exactly 

the same index at different dates or in different 

markets; or (ii) the long and short positions are in 

different but similar indices at the same date. 

10See 71 FR 8932 (February 22, 2006). 

11Tier 1 and tier 2 capital are defined in the 

general risk-based capital rules. Tier 3 capital is 

subordinated debt that is unsecured, is fully paid 

up, has an original maturity of at least two years, 

is not redeemable before maturity without prior 

approval by the primary Federal supervisor, 

includes a lock-in clause precluding payment of 

either interest or principal (even at maturity) if the 

payment would cause the issuing bank’s risk-based 

capital ratio to fall or remain below the minimum 

required under the credit risk capital rules, and 

does not contain and is not covered by any 

covenants, terms, or restrictions that are 

inconsistent with safe and sound banking practices. 

of the obligor, and in the case of some 

positions, the credit rating and 

remaining contractual maturity of the 

position. Derivative instruments are 

risk-weighted according to the market 

value of the effective notional amount of 

the relevant underlying position. A bank 

may net long and short identical debt 

positions (including derivatives) with 

exactly the same issuer, coupon, 

currency, and maturity. A bank may 

also offset a matched position in a 

derivative and its corresponding 

underlying instrument. 

Under the standard approach, the 

specific risk add-on for covered equity 

positions is the sum of the bank’s long 

and short equity positions, multiplied 

by a specific risk-weighting factor. A 

bank may net long and short positions 

(including derivatives) in identical 

equity issues or equity indices in the 

same market. The standard specific risk 

add-on is 8 percent of the net equity 

position, unless the bank’s portfolio is 

both liquid and well-diversified, in 

which case the add-on is 4 percent.8 For 

positions that are index contracts 

comprising a well-diversified portfolio 

of equities, the specific risk add-on is 2 

percent of the net long or short position 

in the index.9

5. Calculation of the Risk-Based Capital 

Ratio 

A bank subject to the market risk 

capital rule must calculate its adjusted 

risk-based capital ratios as follows. First 

the bank must calculate its adjusted 

risk-weighted assets, which equals its 

risk-weighted assets calculated under 

the general risk-based capital rule 

excluding the risk-weighted amounts of 

covered positions (except foreign 

exchange positions held outside the 

trading account and over-the-counter 

derivative instruments) and cashsecured securities borrowing receivables 

that meet the criteria of the market risk 

capital rule.10

The bank next must calculate its 

measure for market risk, which equals 

the sum of the VaR-based capital 

requirement for market risk, the specific 

risk add-on (if any), and the capital 

requirement for de minimis exposures 

(if any). The VaR-based capital 

requirement equals the higher of (i) the 

previous day’s VaR-based measure, and 

(ii) the average of the daily VaR-based 

measures for each of the preceding 60 

business days multiplied by three, or 

such higher multiplier as may be 

required under the backtesting 

requirements of the market risk capital 

rule. The measure for market risk is 

multiplied by 12.5 to calculate marketrisk-equivalent assets. The market-riskequivalent assets are added to adjusted 

risk-weighted assets to compute the 

bank’s risk-based capital ratio 

denominator. 

To calculate the numerator, the bank 

must allocate tier 1 and tier 2 capital 

equal to 8 percent of adjusted riskweighted assets, and further allocate 

excess tier 1, excess tier 2, and tier 3 11

capital equal to the measure for market 

risk. The sum of tier 2 and tier 3 capital 

allocated for market risk may not exceed 

250 percent of tier 1 capital. As a result, 

tier 1 capital must equal at least 28.6 

percent of the measure for market risk. 

The sum of tier 2 (both allocated and 

excess) and allocated tier 3 capital may 

not exceed 100 percent of tier 1 capital 

(both allocated and excess). Term 

subordinated debt and intermediateterm preferred stock and related surplus 

included in tier 2 capital (both allocated 

and excess) may not exceed 50 percent 

of tier 1 capital (both allocated and 

excess). The sum of tier 1 and tier 2 

capital (both allocated and excess) and 

allocated tier 3 capital is the bank’s total 

risk-based capital numerator. 

II. Proposed Revisions to the Market 

Risk Capital Rule 

A. Objectives of the Proposed Revisions 

The key objectives of the proposed 

revisions to the current market risk 

capital rule are to enhance the rule’s 

sensitivity to risks that are not 

adequately captured in the current 

methodologies of the rule, to enhance 

modeling requirements consistent with 

advances in risk management since the 

initial implementation of the MRA 

nearly 10 years ago, and to modify the 

definition of covered position to better 

capture positions for which the market 

risk capital rule is appropriate. The 

objective of enhancing the risk 

sensitivity of the rule reflects the growth 

in traded credit products, such as credit 

default swaps and tranches of 

collateralized debt obligations, other 

structured products, and less liquid 

products. The risks of these products are 

not adequately captured in current VaR 

models and are not fully reflected in a 

10-business-day, 99 percent confidence 

level soundness standard. 

The growth in traded credit products 

has given rise to an increase in default 

risks that should be captured in a 

capital requirement for specific risk but 

have proved difficult to capture 

adequately with current specific risk 

models. Other structured and less liquid 

products may give rise to risks that were 

not entirely contemplated when the 

market risk capital rule was first 

adopted. Moreover, concentration risk 

may not be adequately reflected in a 

VaR-based framework, especially when 

banks rely on proxies to capture the 

risks of actual holdings. Therefore, the 

agencies propose to implement an 

incremental default risk capital 

requirement for a bank that models 

specific risk for one or more portfolios 

of covered positions and to require the 

consideration of liquidity and 

concentration risks in that requirement 

and in the bank’s stress tests and 

internal assessment of capital adequacy. 

In addition, to address the agencies’

concerns about appropriate treatment of 

covered positions with limited price 

transparency, the agencies propose to 

require banks to have a well-defined 

valuation process for all covered 

positions. The specific proposals are 

discussed below. 

B. Description of the Proposed Revisions 

to the Market Risk Capital Rule 

1. Scope 

With the exception of the addition of 

savings associations, the proposed 

revisions to the market risk capital rule 

would not change the set of banks to 

which the rule applies. Thus, the 

proposed rule would continue to apply 

to any bank with aggregate trading 

assets and liabilities equal to 10 percent 

or more of total assets, or $1 billion or 

more. The proposed revisions would 


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12Structural foreign currency positions include 

positions designed to hedge a bank’s capital ratios 

against the effect of adverse exchange rate 

movements on (1) subordinated debt, equity, or 

minority interests in consolidated subsidiaries and 

capital assigned to foreign branches that are 

denominated in foreign currencies, and (2) any 

positions related to unconsolidated subsidiaries and 

other items that are deducted from an institution’s 

capital when calculating its capital base. 

13See 12 CFR part 3, section 3 (national banks); 

12 CFR part 208, Appendix A, section II.B (state 

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

section II.B (bank holding companies); 12 CFR part 

325, Appendix A, section II.B.3 (state nonmember 

banks);12 CFR part 567.6 (savings associations). The 

treatment of guarantees is described in sections 33 

and 34 of the proposed advanced capital adequacy 

framework and discussed in section V.C.5 of the 

framework’s preamble. 

apply to a bank meeting the market risk 

capital rule applicability threshold 

regardless of whether the bank would 

adopt the proposed advanced capital 

adequacy framework or remain under 

the general risk-based capital rule. 

Question 1: The agencies seek comment 

on the thresholds for the application of 

the market risk capital rule and, if they 

should be changed, on what appropriate 

thresholds might be. 

The primary Federal supervisor of a 

bank that does not meet the threshold 

criteria may apply the market risk 

capital rule to the bank if the supervisor 

deems it necessary or appropriate given 

the level of market risk of the bank or 

to ensure safe and sound banking 

practices. A bank that does not meet the 

threshold criteria may request that its 

primary Federal supervisor apply the 

market risk capital rule to it. A primary 

Federal supervisor may also exclude a 

bank that meets the threshold criteria 

from the rule if appropriate based on the 

level of market risk of the bank and 

provided such exemption would be 

consistent with safe and sound banking 

practices. 

2. Reservation of Authority 

The proposed rule would contain a 

reservation of authority that affirms 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 supervisor determines that 

the bank’s risk-based capital 

requirements under the rule are not 

commensurate with the market risk of 

the bank’s covered positions. In 

addition, the agencies anticipate that 

there may be instances when the 

proposed rule generates a risk-based 

capital requirement for a specific 

covered position or portfolio of covered 

positions that is not commensurate with 

the risks posed by such exposures. In 

these cases, a bank’s primary Federal 

supervisor may require the bank to 

assign a different risk-based capital 

requirement to the covered position or 

portfolio of covered positions that better 

reflects the risk of the position or 

portfolio. The proposed rule also would 

provide authority for a bank’s primary 

Federal supervisor to require the bank to 

calculate capital requirements for 

specific positions or portfolios under 

the market risk capital rule or under the 

credit risk capital rule to more 

accurately reflect the risks of the 

positions. Any agency that exercises this 

reservation of authority would notify 

each of the other agencies of its 

determination. 

3. Modification of the Definition of 

Covered Position 

The NPR modifies the definition of a 

covered position to include only trading 

assets and trading liabilities (as reported 

on schedule RC–D of the Call Report, 

Schedule HC–D of the Consolidated 

Financial Statements for Bank Holding 

Companies, or as defined in the 

instructions to the Thrift Financial 

Report) that are trading positions. The 

definition also includes trading assets 

and liabilities that hedge covered 

positions. In addition, the trading asset 

or liability must be free of any 

restrictive covenants on its tradability or 

the bank must be able to hedge its 

material risk elements in a two-way 

market. A trading position would be 

defined as a position that is held by the 

bank for the purpose of short-term resale 

or with the intent of benefiting from 

actual or expected price movements or 

to lock in arbitrage profits. The 

proposed definition of a trading position 

recognizes that the accounting 

definition of trading assets and 

liabilities includes positions that are not 

held with the intent or ability to trade. 

A trading asset or liability that hedges 

a trading position is a covered position 

only if the hedge is within the scope of 

the bank’s hedging strategy (discussed 

below). The agencies encourage the 

sound risk management of trading 

positions and therefore include hedges 

that offset their risk in the definition of 

covered position and thus in the 

measure for market risk. The agencies 

are concerned, however, that a bank 

could craft its hedging strategies in 

order to bring non-trading positions that 

are more appropriately treated under the 

credit risk capital rules into the bank’s 

covered positions. The agencies will 

scrutinize a bank’s hedging strategies to 

ensure that they are not being 

manipulated in this manner. For 

example, mortgage-backed securities 

that are not held with the intent to 

trade, but that are hedged with interest 

rate swaps to mitigate interest rate risk, 

would be subject to the credit risk 

capital rules. Question 2: The agencies 

request comment on all aspects of the 

proposed definition of covered position. 

The agencies are particularly interested 

in comment on additional safeguards 

that the agencies might implement to 

prevent abuse of the hedge component 

of the definition of covered position and 

increase transparency for supervisors. 

Consistent with the current definition, 

a covered position also would include 

any foreign exchange or commodity 

position, whether or not a trading asset 

or trading liability. With prior 

supervisory approval a bank could 

exclude any structural position in a 

foreign currency.12

Also consistent with the current rule, 

the definition of a covered position 

would explicitly exclude any position 

that, in form or substance, acts as a 

liquidity facility that provides support 

to asset-backed commercial paper. In 

addition, under the proposed rule the 

definition of covered position would 

exclude any intangible asset, including 

any servicing asset. Intangible assets are 

excluded from the definition of covered 

position because their risks are 

explicitly addressed in the credit risk 

capital rules, generally through 

deduction from capital. 

In addition, under the proposed rule, 

a credit derivative recognized as a 

guarantee for risk-weighted asset 

amount calculation purposes under the 

credit risk capital rules 13 used to hedge 

a position that is not a covered position 

(for example, a credit derivative hedge 

of a loan that is not a covered position) 

would be excluded from the definition 

of a covered position. This would 

require the bank to include the credit 

derivative in its risk-based capital 

measure for credit risk and exclude it 

from its VaR-based measure for market 

risk. The proposed treatment of a credit 

derivative hedge for regulatory capital 

purposes would avoid the mismatch 

that arises when the hedged position 

(for example, a loan) is not a covered 

position and the credit derivative hedge 

is a covered position. This mismatch 

has the potential to inflate the VaRbased measure of market risk because 

only one side of the transaction is 

reflected in that measure. Question 3: 

The agencies request comment on 

whether there is a better approach that 

matches more effectively the true 

economic impact of these transactions. 

A similar distortion of the VaR-based 

measure may arise in the context of 

interest rate risk. Some banks manage 

their interest rate risk on a portfolio 

basis without distinguishing between 


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14Only transactions with external third parties 

are covered positions because only such 

transactions are trading assets and liabilities for 

consolidated reporting purposes. Internal 

transactions, such as an interest rate derivative 

between a bank’s treasury function and its trading 

desk, are not covered positions. 

15A residual securitization position is any 

securitization position subject to deduction under 

the proposed advanced capital adequacy framework 

or subject to the following provisions under the 

general risk-based capital rules: 12 CFR part 3, 

Appendix A, sections 4 (b) and (f) (national banks); 

12 CFR part 208, Appendix A.III.B.3.b and III.B.3.e 

(State member banks); 12 CFR part 225, Appendix 

A.III.B.3.b and III.B.3.e (bank holding companies); 

12 CFR part 325, Appendix A.II.B.5 (state 

nonmember banks); and 12 CFR 567.6(b)(1) and (2) 

(savings associations). 

covered and noncovered positions by 

using interest rate derivatives with 

external third parties that are covered 

positions under the market risk capital 

rule.14 The interest rate derivatives 

hedge the interest rate risk of covered 

and noncovered positions together; 

however, only the covered positions are 

included in the bank’s VaR-based 

measure. This may result in a regulatory 

capital requirement that does not 

appropriately reflect the interest rate 

risk of all of the offsetting transactions. 

This problem would not exist for 

interest rate derivatives that are direct 

hedges of noncovered positions because, 

under the proposed definition of 

covered position, the interest rate 

derivative would not be a covered 

position. Question 4: The agencies 

request comment on the extent and 

materiality of any distortion of the VaRbased measure due to the inclusion of 

some, but not all, offsetting 

transactions, and on any appropriate 

approaches to address this distortion in 

the final rule, including, subject to 

certain restrictions, (1) permitting a 

bank to include in its VaR-based 

measure the interest rate risk associated 

with certain noncovered positions that 

are hedged by covered positions (while 

remaining subject to a credit risk capital 

requirement for the noncovered 

positions) or (2) permitting a bank to 

include in its VaR-based measure 

certain internal interest rate derivatives 

hedging noncovered positions. The 

agencies also request comment on any 

operational considerations such 

approaches would entail. 

Under the proposed rule, the 

definition of a covered position would 

exclude any securitization position that 

is a residual securitization position,15

subject to a limited market maker 

exception. The market maker exception 

would permit these securitization 

positions to be included as covered 

positions only upon a determination by 

the bank’s primary Federal supervisor 

that: (i) A two-way market exists for the 

securitization position, or in the case of 

a securitization position that relies 

solely on credit derivatives, for the 

securitization position or all of its 

material risk components; (ii) the bank 

holds itself out as ready to buy or sell 

these securitization positions for its own 

account on a regular and continuous 

basis at a quoted price, (iii) the bank’s 

internal models fully capture the 

general market risk and specific risks of 

its securitization positions and 

sufficient market data are available to 

model these risks reliably; and (iv) the 

bank has adequate internal systems and 

controls for the trading of securitization 

positions. 

The general exclusion of these 

securitization positions from the 

definition of covered position provides 

a capital treatment for these positions 

that is appropriate for their risk. The 

agencies recognize, however, that a bank 

may be an active market maker in these 

securitization positions and may have 

the models and internal controls 

capacity to capture the risk of these 

positions in the bank’s VaR-based 

measure of market risk. The agencies 

also note that positions that meet the 

definition of a residual securitization 

position might be different for a bank 

that is subject to the proposed advanced 

capital adequacy framework than for a 

bank that is subject to the general riskbased capital rules. Question 5: The 

agencies seek comment on the proposed 

definition of residual securitization 

position, and on the market maker 

exception and the conditions to use that 

exception. With respect to positions that 

do not qualify for the market maker 

exception, the agencies request 

comment on the treatment of those 

positions under the credit risk capital 

rules and whether such treatment could 

give rise to any operational or other 

issues. 

4. Requirements for the Identification of 

Trading Positions and Management of 

Covered Positions 

The proposal introduces new 

requirements for the identification of 

trading positions and the management 

of covered positions. The agencies 

believe that these new requirements are 

warranted based on the trend towards 

the inclusion of more credit risk-related, 

less liquid, and less actively traded 

products in banks’ covered positions. 

The risks of these positions may not be 

fully reflected in the requirements of the 

market risk capital rule and may be 

more appropriately captured under the 

credit risk capital rules. 

A bank would be required to have 

clearly defined policies and procedures 

for determining which of its trading 

assets and trading liabilities are trading 

positions. In determining the scope of 

trading positions, the bank would be 

required to consider (i) the extent to 

which a position (or a hedge of its 

material risks) could be marked-tomarket daily by reference to a two-way 

market, and (ii) possible impairments to 

the liquidity of a position. 

In addition, the bank must have 

clearly defined trading and hedging 

strategies. The bank’s trading and 

hedging strategies for its trading 

positions must be approved by senior 

management. The trading strategy must 

articulate the expected holding period 

of and the market risk associated with 

each portfolio of trading positions. The 

trading strategy must also articulate 

whether the purpose of each portfolio of 

trading positions is to accommodate 

customer flow, to engage in proprietary 

trading, or to make a market in the 

positions. The hedging strategy must 

articulate for each portfolio the level of 

market risk the bank is willing to accept 

and must detail the instruments, 

techniques, and strategies the bank will 

use to hedge the risk of the portfolio. 

The hedging strategy must clearly 

articulate which positions are being 

hedged and which positions serve as 

hedging instruments. 

A bank would be required to have 

clearly defined policies and procedures 

for actively managing all covered 

positions. In the context of nontraded 

commodities and foreign exchange 

positions, active management could 

focus on managing the risks of those 

positions within the bank’s risk limits. 

For all covered positions, these policies 

and procedures would be required to 

address, at a minimum, marking 

positions to market or model on a daily 

basis; assessing on a daily basis the 

bank’s ability to hedge position and 

portfolio risks and the extent of market 

liquidity; and the establishment and 

daily monitoring of position limits by a 

risk control unit independent of the 

trading business unit. Senior 

management would be required to 

monitor all of this information on a 

daily basis. The policies and procedures 

would be required to provide for 

reassessment by senior management of 

established position limits on at least an 

annual basis, as well as annual 

assessments by qualified personnel of 

the quality of market inputs to the 

valuation process, the soundness of key 

assumptions, the reliability of parameter 

estimation in pricing models, and the 

stability and accuracy of model 

calibration under alternative market 

scenarios. Question 6: The agencies seek 

comment on these requirements and on 

whether different or additional policies 


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and procedures would be beneficial for 

ensuring appropriate identification of 

positions to which the market risk 

capital rule should be applied and 

appropriate risk management of covered 

positions. 

The proposal introduces new 

requirements for the prudent valuation 

of covered positions that include 

policies and procedures on position 

valuation, marking to market or model, 

independent price verification, and 

valuation adjustments or reserves. The 

valuation process would be required to 

consider, as appropriate, unearned 

credit spreads, close-out costs, early 

termination, investing and funding 

costs, future administrative costs, 

liquidity, and model risk. These new 

valuation requirements reflect the 

agencies’ concerns about possible 

shortcomings in the valuation of less 

liquid trading positions, especially in 

light of the historical focus of the market 

risk capital rule on a 10-business-day 

time horizon and a 99 percent 

confidence level, which may be 

inadequate to reflect the full extent of 

the risks of less liquid positions. 

5. Requirements for Internal Models in 

General 

As under the current market risk 

capital rule, a bank would be required 

to use one or more internal models to 

calculate a daily VaR-based measure 

that reflects general market risk for all 

covered positions. The daily VaR-based 

measure may also reflect the bank’s 

specific risk for one or more portfolios 

of covered debt or equity positions. The 

requirements for internal models are 

discussed below. 

Model Use Requirements. The 

proposed revisions would specify that a 

bank must receive the prior written 

approval of its primary Federal 

supervisor before using any internal 

model to calculate its risk-based capital 

requirement for market risk and before 

extending the use of a model for which 

it has received prior written approval to 

an additional business line or product 

type. A bank would also be required to 

notify its primary Federal supervisor 

promptly if it makes any changes to its 

internal models that would result in a 

material change in the bank’s riskweighted asset amount for a portfolio or 

when the bank makes any material 

change to its modeling assumptions. 

The bank’s primary Federal supervisor 

could rescind its approval, in whole or 

in part, of the use of any internal model 

if it determines that the model no longer 

complies with the market risk capital 

rule or fails to reflect accurately the 

risks of the bank’s covered positions. 

For example, if adverse market events or 

other developments reveal that a 

material assumption in a bank’s 

approved model is flawed, a primary 

Federal supervisor may require the bank 

to revise its model assumptions and 

resubmit the model specifications for 

review by the supervisor. 

Factors and Risks Reflected in 

Models. As is the case under the current 

rule, a bank would be required to 

integrate its internal models into its 

daily risk management process, and the 

level of sophistication of a bank’s 

models would need to be commensurate 

with the nature and size of its covered 

positions. The internal models used by 

a bank are required to capture all 

material risks, including basis and 

prepayment risks. The proposed 

revisions add credit spread risk to the 

list of risk factors required to be 

captured as appropriate under the 

current rule (that is, in addition to 

interest rate risk, equity price risk, 

foreign exchange rate risk, and 

commodity price risk). Under the 

current rule, a bank that has material 

exposure to credit spread, basis, or 

prepayment risks should be capturing 

those risks in its internal model. In the 

proposed revisions, the agencies 

decided to specifically enumerate these 

risks to stress their importance in light 

of the growth of traded credit products 

and products with prepayment or basis 

risk at banks since the current rule was 

adopted. The proposed revisions would 

require risks arising from less liquid 

positions and positions with limited 

price transparency to be modeled 

conservatively under realistic market 

scenarios. 

The agencies are concerned that 

certain covered positions, especially 

securitization positions, may contain 

prepayment risk that is not adequately 

captured in the VaR-based measure of 

market risk. Prepayment risk is the risk 

of loss to holders of debt exposures 

arising from the repayment of principal 

differing from the expected or 

scheduled principal repayment. The 

agencies recognize that the VaR-based 

measure may capture a portion of 

prepayment risk for positions as 

potential changes in the value of 

positions due to interest rate risk. 

However, the agencies question the 

degree to which interest rate volatility 

over the 10-business-day horizon 

adequately captures prepayment risk 

associated with positions that are 

subject to significant levels of 

prepayment. The agencies also 

recognize that complete models of 

prepayment include pool and securityspecific factors that are not easily 

incorporated or modeled in daily 

calculations of a VaR-based measure. 

Question 7: The agencies request 

comment on all aspects of prepayment 

risk, including the extent and 

materiality of prepayment risk, whether 

material prepayment risk may warrant a 

further explicit requirement that banks 

hold capital against prepayment risk 

over a one-year horizon under both the 

internal models and standard 

approaches to specific risk, and the 

interplay between prepayment risk and 

default risk for purposes of determining 

the bank’s overall measure for market 

risk. The agencies also seek comment on 

how an explicit capital requirement for 

prepayment risk could be designed. 

The proposed rule also requires a 

bank to have a rigorous process for 

reestimation, reevaluation and updating 

of its models to ensure continued 

applicability and relevance. Further, the 

proposed rule would continue to require 

models to include risks arising from the 

nonlinear price characteristics of option 

positions, and to incorporate empirical 

correlations across and within risk 

factors. 

Quantitative Requirements for VaRBased Measure. The proposed rule 

includes the same quantitative 

requirements for the VaR-based measure 

as the current market risk capital rule 

with respect to daily computations, the 

one-tailed, 99 percent confidence level, 

the 10-business-day holding period, and 

the one-year historical observation 

period. 

The current market risk capital rule 

requires a bank to include in its VaRbased measure only covered positions. 

In contrast, the proposed revisions 

would allow residual securitization 

positions that are trading assets or 

liabilities and term repo-style 

transactions to be included in the VaRbased measure even though these 

positions may not be included within 

the definition of a covered position. A 

term repo-style transaction would be 

defined as a repurchase or reverse 

repurchase transaction or a securities 

borrowing or securities lending 

transaction with an original maturity in 

excess of one day, 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 certain rights of 

acceleration, termination, close-out, and 

set-off, and (iv) the bank has conducted 

and documented sufficient legal review 

to conclude that the agreement includes 

these rights and is legally binding. 

While repo-style transactions typically 

are close adjuncts to trading activities, 

Generally Accepted Accounting 


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Principles (GAAP) traditionally has not 

permitted companies to report them as 

trading assets or liabilities. Repo-style 

transactions included in the VaR-based 

measure will continue to be subject to 

the credit risk capital requirements in 

order to capture counterparty credit 

risks. 

The agencies believe that residual 

securitization positions should be 

subject to the credit risk capital 

requirements. The agencies also 

recognize, however, that these positions 

may be hedged by covered positions and 

believe that it is appropriate to allow 

banks to recognize the hedge in 

calculating their VaR-based measures. 

Residual securitization positions even if 

included in the VaR-based measure will 

continue to be subject to the credit risk 

capital requirements. A bank may 

choose whether or not to include all 

residual securitization positions that are 

trading assets or liabilities or all term 

repo-style transactions in its VaR-based 

measure, and must choose whether or 

not to include them consistently over 

time. 

Control, Oversight, and Validation 

Mechanisms. The proposed rule would 

continue the requirement that a bank 

have a risk control unit that reports 

directly to senior management and is 

independent of its business trading 

units. In addition, the proposed rule 

would impose specific model validation 

standards that are similar to the 

standards in the proposed advanced 

capital adequacy framework. A bank 

would be required to validate its 

internal models initially and on an 

ongoing basis. The validation process 

must be independent of the internal 

model development, implementation, 

and operation, or the validation process 

must be subject to an independent 

review of its adequacy and 

effectiveness. The review personnel 

must be independent of internal model 

development, implementation, and 

operation personnel, but not necessarily 

external to the bank. 

Validation would include evaluation 

of the conceptual soundness of the 

internal models; an ongoing monitoring 

process that includes verification of 

processes and the comparison of the 

bank’s model outputs with relevant 

internal and external data sources or 

estimation techniques; and an outcomes 

analysis process that includes the 

comparison of a bank’s internal 

estimates with actual outcomes during a 

sample period not used in model 

development. The evaluation of 

conceptual soundness should include 

evaluation of empirical evidence and 

documentation supporting the 

methodologies used, important model 

assumptions and their limitations, 

adequacy and robustness of empirical 

data used in parameter estimation and 

model calibration, and evidence of the 

model’s strengths and weaknesses. 

A comparison of the bank’s model 

outputs with relevant internal and 

external data sources or estimation 

techniques is helpful to draw inferences 

about the performance of model 

outputs. Results of this comparison can 

be a valuable diagnostic tool in 

identifying potential weaknesses in a 

bank’s model. As part of this 

comparison, the bank should investigate 

the source of any differences between 

the model estimates and the relevant 

internal or external data or estimation 

techniques and whether the extent of 

the differences is appropriate. 

The proposed revisions expand upon 

the current market risk capital rule’s 

stress testing requirement. Specifically, 

the proposed rule would require a bank 

to stress test the market risk of its 

covered positions at a frequency 

appropriate to the portfolio, and in no 

case less frequently than quarterly. The 

stress tests must take into account 

concentration risk, illiquidity under 

stressed market conditions, and other 

risks that may not be captured 

adequately in the bank’s VaR-based 

measure of market risk. For example, it 

may be appropriate for a bank to include 

in its stress testing gapping of prices, 

one-way markets, non-linear or deep 

out-of-the-money products, jumps-todefault, or significant shifts in 

correlation. With respect to 

concentration risk, the relevant types 

include concentration by name, 

industry, sector, country, and market. 

Market concentration occurs when a 

bank holds a position that represents a 

concentrated share of the market for a 

security. A market concentration is a 

position that is so large, relative to the 

liquidity typically available in the 

market, that it requires a longer than 

usual liquidity horizon to liquidate the 

position without moving the market. A 

bank’s primary Federal supervisor 

would evaluate the robustness and 

appropriateness of a bank’s stress tests 

through the supervisory review process. 

The bank would be required to have 

an internal audit function independent 

of business-line management that at 

least annually assesses the effectiveness 

of the controls supporting the bank’s 

market risk measurement systems, 

including the activities of the business 

trading units and of the independent 

risk control unit, and compliance with 

policies and procedures. At least 

annually, internal audit should review 

the validation processes, 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 Assessment of Capital 

Adequacy. The proposed revisions 

include a requirement that a bank have 

a rigorous process for assessing its 

overall capital adequacy in relation to 

its market risk. The assessment must 

take into account market concentration 

and liquidity risks under stressed 

market conditions, as well as other risks 

that may not be captured appropriately 

in the VaR-based measure. 

Documentation. A bank would be 

required to document adequately all 

material aspects of its internal models, 

the management and valuation of 

covered positions, its control, oversight, 

and validation mechanisms, and its 

internal assessment of capital adequacy. 

This documentation would facilitate the 

supervisory review process as well as 

the bank’s internal audit or other review 

procedures. 

Backtesting. The proposal modifies 

the regulatory backtesting framework for 

determining the multiplication factor 

based on the number of backtesting 

exceptions. Under the current market 

risk rule, a bank must compare its daily 

VaR-based measure to its actual daily 

trading profit or loss, which typically 

includes realized and unrealized gains 

and losses on portfolio positions as well 

as fee income and commissions 

associated with trading activities. Under 

the proposed rule, a bank would be 

required to compare its actual daily 

trading profit or loss excluding fees, 

commissions, reserves and net interest 

income to its daily VaR-based measure. 

These excluded components of trading 

profit and loss are not modeled as part 

of the VaR-based measure and excluding 

them will improve the accuracy of the 

backtesting and provide a better 

assessment of the bank’s internal model. 

The agencies believe that bank trading 

and reporting systems have improved 

sufficiently to allow this type of 

backtesting. 

As noted above, the proposal also 

imposes specific model validation 

standards that include outcomes 

analysis. The agencies expect that 

outcomes analysis used for model 

validation would include hypothetical 

backtesting, that is, comparison of the 

daily VaR-based measure to 

hypothetical changes in portfolio value 

that would occur if there were no intraperiod changes. The hypothetical 

changes in portfolio value would 

exclude the effects of changes in 


sroberts on PROD1PC70 with PROPOSALS
Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55967 

positions due to intraday trading, new 

positions, or other sources of intraperiod changes, and also exclude fees, 

commissions, reserves and net interest 

income. Question 8: The agencies 

request comment on the exclusion of 

fees, commissions, reserves, and net 

interest income for the trading profit or 

loss used for regulatory backtesting, 

including the appropriateness and 

feasibility of these exclusions, and 

whether additional items should also be 

excluded. The agencies also request 

comment on the role of hypothetical 

backtesting— specifically, whether 

hypothetical backtesting is feasible as 

part of model validation; whether other 

forms of backtesting should also be 

used; and whether regulatory 

backtesting should be based on 

hypothetical backtesting. 

6. Revised Modeling Standards for 

Specific Risk 

The proposed rule would more clearly 

specify the modeling standards for 

specific risk and, after a transition 

period, eliminate the current option for 

a bank to model some but not all 

material aspects of specific risk for an 

individual portfolio of covered debt or 

equity positions. As under the current 

market risk capital rule, a bank may use 

one or more internal models to measure 

specific risk. The internal model would 

be required to explain the historical 

price variation in the portfolio, be 

responsive to changes in market 

conditions, be robust to an adverse 

environment, and capture all material 

aspects of specific risk for covered debt 

and equity positions. Specifically, the 

proposed revisions would require that a 

bank’s internal models capture default 

risk, event risk, and idiosyncratic 

variations; capture concentrations and 

demonstrate sensitivity to changes in 

portfolio construction or concentrations; 

and capture material basis risk and 

demonstrate sensitivity to material 

idiosyncratic differences between 

similar, but not identical, positions. The 

requirement to capture default and 

event risk specifies that for debt 

positions, migration risk must be 

captured, and for equity positions, 

events reflected in large changes or 

jumps in prices must be reflected. 

Under the current market risk capital 

rule, if a bank incorporates specific risk 

in its internal model but fails to 

demonstrate to its primary Federal 

supervisor that its internal model 

adequately measures all aspects of 

specific risk for covered debt and equity 

positions, including event and default 

risk, it is subject to a specific risk addon. On and after January 1, 2010, the 

proposed rule would require a bank that 

does not have an approved internal 

model that captures all material aspects 

of specific risk for a particular portfolio 

to use the standard specific risk add-on 

for that portfolio. This proposed change 

reflects the agencies’ interest in creating 

incentives for more robust specific risk 

modeling, while providing banks with a 

reasonable period of time in which to 

improve current modeling techniques. 

The proposed phase-out of partial 

modeling of specific risk would not 

preclude a bank from using an internal 

model to calculate the specific risk of 

some, but not all, portfolios of covered 

debt and equity positions and using the 

standard approach to calculate the 

specific risk of other portfolios. Rather, 

effective January 1, 2010, a bank would 

not be permitted to use an internal 

model to calculate the specific risk addon of a portfolio if the model did not 

capture all material aspects of specific 

risk for that portfolio. The bank would 

be required to use the standard 

approach to calculate the specific risk 

add-on for the portfolio until it receives 

written approval from its primary 

Federal supervisor to measure the 

specific risk for the portfolio using its 

internal model. Question 9: The 

agencies request comment on the 

proposed timeframe for phasing out 

partial modeling of specific risk and on 

whether it would allow banks enough 

time to implement the proposed 

changes. 

While the proposed rule would 

continue to provide for flexibility and a 

combination of approaches to measure 

market risk, including the use of 

different models to measure general 

market risk and the specific risk of one 

or more portfolios of covered debt and 

equity positions, the agencies strongly 

encourage banks to develop and 

implement models that integrate the 

measurement of VaR for general market 

risk and specific risk. A bank’s use of a 

combination of approaches would be 

subject to supervisory review to ensure 

that the overall capital requirement for 

market risk is commensurate with the 

risks of the bank’s covered positions. 

The proposed rule does not contain 

explicit specific risk capital 

requirements for exposures to 

commodities and foreign exchange 

positions. Question 10: The agencies 

seek comment on the extent and 

materiality of specific risk for 

commodities and foreign exchange 

positions and on whether and how a 

specific risk capital requirement for 

those positions could be developed 

under both the internal models and 

standard approaches. 

7. Standard Specific Risk Capital 

Requirement 

The standard specific risk add-ons are 

largely unchanged from the current 

market risk capital rule, as summarized 

above. The proposed rule would make 

the following modifications to the 

treatment of covered debt positions, 

largely to parallel the increased 

recognition of external ratings in the 

New Accord. The government category 

would be expanded to include all 

sovereign debt, and the risk weight for 

sovereign debt would change from zero 

percent to a range from zero to 12 

percent based on the external rating of 

the obligor and remaining contractual 

maturity of the covered debt position. 

The proposed rule would change the 

qualifying category to include all nonsovereign covered debt positions that 

are (i) rated investment grade by at least 

two nationally recognized statistical 

rating organizations (NRSROs); (ii) rated 

investment grade by one NRSRO and 

not rated less than investment grade by 

any other NRSRO; and (iii) unrated debt 

of financial firms and of other firms that 

have publicly traded securities or 

instruments, provided the bank deems 

the debt to have credit risk comparable 

to that of investment grade. The risk 

weight in the other category would be 

raised from 8 percent to 12 percent for 

covered debt positions rated more than 

two categories below investment grade. 

Finally, the proposed rule would 

expand the recognition of netting effects 

for covered debt positions. In this 

regard, there would be no standard 

specific risk add-on when a covered 

debt position is fully hedged by a total 

return swap (or similar instrument 

where there is a matching of payments 

and changes in market value of the 

position) and there is an exact match 

between the reference obligation of the 

swap and the covered debt position and 

between the maturity of the swap and 

the covered debt position. 

If a set of transactions consisting of a 

covered debt position and its credit 

derivative hedge does not meet these 

criteria for no specific risk add-on, the 

add-on would be equal to 20 percent of 

the specific risk capital requirement for 

the side of the transaction with the 

higher specific risk add-on when the 

credit risk of the position is fully 

hedged by a total return swap, credit 

default swap or similar instrument and 

there is an exact match in terms 

(including maturity) of the reference 

obligation of the credit hedge and the 

covered debt position, and of the 

currency of the credit derivative and the 

covered debt position. 


sroberts on PROD1PC70 with PROPOSALS
55968 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

For a set of transactions that consists 

of a covered debt position and its credit 

hedge but do not meet the criteria for 

full offset or the 80 percent offset above, 

the standard specific risk add-on for the 

set would be the standard specific risk 

add-on for the side of the transaction 

with the higher specific risk capital 

requirement. 

8. Incremental Default Risk Capital 

Requirement 

Under the proposed rule, a bank that 

models specific risk for one or more 

portfolios of covered positions would be 

required to measure the incremental 

default risk of those positions. 

Incremental default risk would be 

defined as the default risk of a covered 

position that is not reflected in the 

bank’s VaR-based measure because it 

reflects risk beyond a 10-business-day 

horizon and a 99 percent confidence 

level. In the case of a securitization 

exposure, incremental default risk 

includes the risk of losses that could 

result from default of the assets 

underlying the securitization exposure. 

A bank would be required to measure 

incremental default risk for both 

covered debt and equity positions. 

Under the proposed rule, a bank may 

use one or more internal models to 

measure its incremental default risk. 

The agencies propose to set the 

soundness standard for the incremental 

default risk capital requirement at the 

99.9th percentile, rather than the 99th 

percentile generally used to capture 

market risk. Incremental default risk 

would be measured consistent with a 

one-year time horizon and a one-tailed, 

99.9 percent confidence level (that is, 

comparable to the internal ratings-based 

approach under the proposed advanced 

capital adequacy framework), under the 

assumption of a constant level of risk 

and adjusted where appropriate to 

reflect the impact of liquidity, 

concentrations, hedging, and 

optionality. An incremental default risk 

capital requirement would be consistent 

with an internal ratings-based capital 

requirement for credit risk if it produced 

a default risk measure for an infinitely 

granular portfolio over a one-year time 

horizon that roughly equals the credit 

risk charge under the proposed 

advanced capital adequacy framework. 

The proposed assumption of a 

constant level of risk reflects that a bank 

makes decisions about capital and 

business planning over a horizon that is 

longer than the liquidity horizon of 

many of its trading portfolios. It 

assumes that, while the bank would 

likely change its mix of positions in the 

event of market losses, it would not 

automatically reduce its aggregate level 

of risk-taking. The agencies believe that 

this assumption is more realistic than 

assuming that a bank’s trading positions 

at a point in time would be held 

constant over a longer horizon. 

The agencies are evaluating how a 

bank should adjust the incremental 

default risk capital requirement to 

adjust for the impact of liquidity, 

concentrations, hedging, and 

optionality. One possible approach to 

liquidity would be to measure default 

risk out to an appropriate liquidity 

horizon. The liquidity horizon of a 

position or portfolio is the amount of 

time it takes to sell the position or hedge 

all of its material risks. To produce a 

prudent measure of incremental default 

risk, a bank would set the liquidity 

horizon in a conservative manner 

reflecting stressed market conditions 

and the bank’s own policies and 

procedures for identifying stale 

positions. Some covered debt and equity 

positions such as publicly traded 

equities may have a liquidity horizon 

shorter than the VaR-based measure’s 

10-business-day horizon and thus 

would not have an incremental default 

risk capital requirement. 

The proposed adjustment of the 

incremental default risk measure for 

concentrations of positions would 

require a bank to consider all types of 

concentrations, including name 

concentration and market concentration, 

when measuring incremental default 

risk. The adjustment for hedging would 

reflect offsets of short and long positions 

in a single instrument when they are 

expected to be maintained at least over 

the liquidity horizon. The incremental 

default risk measure could include the 

effects of optionality by reflecting the 

nonlinearity of options or other 

nonlinear positions when it has a 

material impact on default risk. The 

agencies note that nonlinearity would 

be relevant for products such as 

synthetic collateralized debt tranches or 

nth to default baskets, where the loss 

upon the default of one name depends 

on which other names are defaulting in 

the same time period. Question 11: The 

agencies request comment on how a 

bank should adjust the incremental 

default risk capital requirement to 

adjust for the impact of liquidity, 

concentrations, hedging, and 

optionality. 

The proposed rule would provide 

flexibility to a bank in developing an 

approach for the calculation of any 

incremental default risk capital 

requirement for a covered position. At 

present, the agencies anticipate that 

most, if not all, banks would utilize a 

separate model for calculating the 

incremental default risk capital 

requirement, given the difficulties of 

modeling to two different soundness 

standards. Question 12: The agencies 

request comment on all aspects of the 

proposal to reflect in the market risk 

capital requirement a measure of 

incremental default risk. Specifically, 

the agencies seek comment on the 

feasibility of measuring incremental 

default risk at a one-year, 99.9 percent 

confidence level and the 

appropriateness of the assumption of a 

constant level of risk. 

A bank’s primary Federal supervisor 

would review its internal model for 

incremental default risk and approve its 

use for regulatory capital purposes. The 

incremental default risk capital 

requirement would not be subject to the 

multiplier described in paragraphs 

(a)(2)(B) and (c) of section 4 of the 

proposed rule. A bank could adjust its 

incremental default capital requirement 

to minimize double-counting of default 

risk already reflected in the 10-businessday, 99 percent confidence level VaRbased measure using an approach 

agreed upon with its primary Federal 

supervisor. 

In order to provide sufficient time for 

banks to develop methodologies to 

capture fully incremental default risk, a 

bank would have until January 1, 2010 

to obtain the approval of its primary 

Federal supervisor to adopt an approach 

to measure incremental default risk. 

Early adoption would be encouraged. If 

a bank subject to the general risk-based 

capital rules is unable to develop 

internal models for incremental default 

risk on or after January 1, 2010, it would 

be required to use the standard method 

for specific risk. If a bank subject to the 

proposed advanced capital adequacy 

framework is unable to develop an 

approach to incremental default risk on 

or after January 1, 2010, it would be 

required to use the proposed advanced 

capital adequacy framework to calculate 

its incremental default risk capital 

requirement. 

The agencies note that they are 

working with the banking industry 

through the Accord Implementation 

Group of the BCBS to develop guidance 

on acceptable approaches to 

determining the incremental default risk 

capital charge. Question 13: The 

agencies request comment on the extent 

to which banks, at present, measure 

incremental default risk and the 

prospects for development of 

methodologies to capture this risk fully 

in internal models by the proposed 

January 1, 2010 deadline. The agencies 

also request comment on the fallback 

methods proposed for banks unable to 

develop an internal model to capture 


sroberts on PROD1PC70 with PROPOSALS
Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55969 

16Currently, there are approximately 2,934 small 

bank holding companies, 1,090 small national 

banks, 491 small State member banks, 3,249 small 

State nonmember banks, and 446 small savings 

Associations. 

incremental default risk by January 1, 

2010. 

9. Disclosure Requirements 

The proposed revisions would impose 

disclosure requirements designed to 

improve market discipline on the toptier consolidated bank that is subject to 

the market risk capital rule. The 

agencies recognize the importance of 

market discipline in encouraging sound 

risk management practices and fostering 

financial stability. With sufficient 

relevant information, market 

participants can better evaluate a bank’s 

risk management performance, earnings 

potential, and financial strength. Many 

of the proposed disclosure requirements 

reflect information already disclosed 

publicly by the banking industry. A 

bank would be encouraged, but not 

required, to make these disclosures in a 

central location on its Web site. 

Consistent with the proposed 

advanced capital adequacy framework, 

the proposed revisions would require a 

bank to comply with the requirements 

of section 8 of the proposed rule unless 

it is a consolidated subsidiary of another 

depository institution or bank holding 

company that is subject to the 

disclosure requirements. A bank subject 

to section 8 would be required to adopt 

a formal disclosure policy approved by 

its board of directors that addresses the 

bank’s 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 verify that the bank 

has made all required disclosures and 

maintains effective internal controls and 

disclosure controls and procedures. The 

chief financial officer would be required 

to certify that disclosures required by 

the proposed rule 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 

information required by this proposed 

rule. 

The proposed revisions would require 

a bank, at least quarterly, to disclose 

publicly for each portfolio of covered 

positions (i) the high, low, and mean 

VaR-based measures over the reporting 

period; (ii) separate VaR-based measures 

for interest rate risk, credit spread risk, 

equity price risk, foreign exchange rate 

risk, and commodity price risk; and (iii) 

a comparison of VaR-based measures 

with actual results and analysis of 

important outliers. A bank would be 

required to make qualitative disclosures 

at least annually, or more frequently in 

the event of material changes, of the 

following information: (i) The 

composition of material portfolios of 

covered positions; (ii) the bank’s 

valuation policies, procedures, and 

methodologies; (iii) the characteristics 

of its internal models; (iv) a description 

of its approaches for validating the 

accuracy of its internal models and 

modeling processes; (v) a description of 

the stress tests applied to each market 

risk factor; (vi) the results of a 

comparison of the bank’s internal 

estimates with actual outcomes during a 

sample period not used in model 

development; and (vii) the soundness 

standard on which its internal capital 

adequacy assessment is based, including 

a description of the methodologies used 

to achieve a capital adequacy 

assessment that is consistent with the 

soundness standard and the 

requirements of the market risk capital 

rule. 

In addition to the public disclosures 

that would be required by the 

consolidated bank, the agencies would 

require certain regulatory reporting from 

all banks applying the market risk 

capital rule in order to assess the 

reasonableness and accuracy of the 

bank’s calculation of its minimum 

capital requirements under this rule and 

the adequacy of the bank’s capital in 

relation to its risks. The agencies believe 

that requiring certain common reporting 

across banks would facilitate 

comparable application of the proposed 

rule. Proposed regulatory reporting 

requirements for banks subject to the 

rule are the subject of a separate joint 

notice and request for comment by the 

agencies [reference]. 

Question 14: The agencies seek 

comment on all aspects of the proposed 

public disclosure requirements. 

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). 

Under 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.16 The proposed 

rule would require a bank holding 

company, bank, or savings association 

to maintain regulatory capital against 

the market risk of covered positions. 

The proposed rule would apply only if 

the bank holding company, bank, or 

savings association has aggregated 

trading assets and liabilities equal to 10 

percent or more of quarter end total 

assets, or $1 billion or more. The 

agencies estimate that no small bank 

holding company, bank, or savings 

association would satisfy these criteria, 

and that no small entities would be 

subject to this rule. Accordingly, each 

agency certifies that the proposed rule 

will not, if promulgated in final form, 

have a significant economic impact on 

a substantial number of small entities. 

OCC/OTS 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. The OCC and OTS each 

has determined that its portion of the 

rule is not a significant regulatory 

action. 

OCC/OTS Unfunded Mandates Reform 

Act of 1995 Determination 

The Unfunded Mandates Reform Act 

of 1995 (Pub. L. 104–4) (UMRA) 

requires that an agency prepare a 

budgetary impact statement before 

promulgating a rule that includes a 

Federal mandate that may result in the 

expenditure by state, local, and tribal 

governments, in the aggregate, or by the 

private sector of $100 million or more 

(adjusted annually for inflation) in any 

one year. The current inflation-adjusted 

expenditure threshold is $119.6 million. 

If a budgetary impact statement is 

required, section 205 of the UMRA also 

requires an agency to identify and 

consider a reasonable number of 

regulatory alternatives before 

promulgating a rule. The OCC and OTS 

each have determined that their 

respective proposed rule will not result 

in expenditure by state, local, and tribal 

governments, or by the private sector, of 


sroberts on PROD1PC70 with PROPOSALS
55970 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

$119.6 million or more. Accordingly, 

neither the OCC nor OTS has prepared 

a budgetary impact statement or 

specifically addressed the regulatory 

alternatives considered. 

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 the Docket number, 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- 

AD10, 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: Steve Hanft, PRA Clearance 

Officer, Legal Division, 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. 

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. 

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. 

B. Proposed Information Collection 

Title of Information Collection: RiskBased Capital Standards: Market Risk. 

Frequency of Response: Varied—some 

requirements are done at least quarterly 

and some at least annually. 

Affected Public: 

OCC: National banks and Federal 

branches and agencies of foreign banks. 

Board: State member banks and bank 

holding companies. 

FDIC: Insured State non-member 

banks, insured State branches of foreign 

banks, and certain subsidiaries of these 

entities. 

OTS: Savings associations and certain 

of their subsidiaries. 

Abstract: The information collection 

requirements are found in sections 3, 5, 

6, and 9 of the proposed rule. They will 

enhance risk sensitivity and introduce 

requirements for public disclosure of 

certain qualitative and quantitative 

information about a bank’s or bank 

holding companies’ market risk. The 

collection of information is necessary to 

ensure capital adequacy according to 

the level of market risk. 

Section-by-section Analysis. Section 3 

sets forth the requirements for applying 

the market risk framework. Section 

3(a)(1)(i) requires clearly defined 

policies and procedures for determining 

which trading assets are trading 

positions and specifies what must be 

taken into account. Section 3(a)(2) 

requires a clearly defined trading and 

hedging strategy for trading positions 

approved by senior management and 

specifies what the strategy must 

articulate. Section 3(b)(1) requires 

clearly defined policies and procedures 

for actively managing all covered 

positions and specifies the minimum 

that they must require. 

Section 5(b)(1) specifies what internal 

models must include and address. 

Sections 6(a) and 6(b) require prior 

written approvals for incremental 

default risk. Section 8(b) requires a 

formal disclosure policy approved by 

the board of directors that addresses the 

bank’s approach for determining the 

market risk disclosures it makes. 


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1Securities subject to repurchase and lending 

agreements are included as if they are still owned 

by the lender. 

2A position that hedges a trading position must 

be within the scope of the bank’s hedging strategy 

described in paragraph (a)(2) of section (3). 

Estimated Burden 

The burden associated with this 

collection of information may be 

summarized as follows: 

OCC 

Number of Respondents: 10. 

Estimated Burden Per Respondent: 

680 hours. 

Total Estimated Annual Burden: 

6,800 hours. 

Board 

Number of Respondents: 22. 

Estimated Burden Per Respondent: 

680 hours. 

Total Estimated Annual Burden: 

14,960 hours. 

FDIC 

Number of Respondents: 2. 

Estimated Burden Per Respondent: 

680 hours. 

Total Estimated Annual Burden: 

1,360 hours. 

OTS 

Number of Respondents: 1. 

Estimated Burden Per Respondent: 

2088 hours. 

Total Estimated Annual Burden: 2088 

hours. 

Text of the Proposed Common Rules 

(All Agencies) 

The text of the proposed common 

rules appears below: 

[Rule] is revised to read as follows: 

Section 1 Purpose, Applicability, and 

Reservation of Authority 

Section 2 Definitions 

Section 3 Requirements for Application of 

the Market Risk Capital Rule 

Section 4 Adjustments to the Risk-Based 

Capital Ratio Calculations 

Section 5 Specific Risk 

Section 6 Incremental Default Risk 

Section 7 Standard Method for Specific 

Risk 

Section 8 Market Risk Disclosures 

Section 1. Purpose, Applicability, and 

Reservation of Authority 

(a) Purpose. This rule establishes riskbased capital requirements for banks 

with significant exposure to market risk 

and provides methods for these banks to 

calculate their risk-based capital 

requirements for market risk. This rule 

supplements and adjusts the risk-based 

capital calculations under [the general 

risk-based capital rules] and [the 

proposed advanced capital adequacy 

framework] and establishes public 

disclosure requirements. 

(b) Applicability—(1) This rule 

applies to any bank with aggregate 

trading assets and liabilities (as reported 

in the bank’s most recent quarterly 

Consolidated Report of Condition and 

Income (Call Report) or as defined in the 

Instructions to the Thrift Financial 

Report and as computed at the end of 

the most recent calendar quarter), equal 

to: 

(i) 10 percent or more of quarter-end 

total assets as reported on the most 

recent quarterly Call Report or Thrift 

Financial Report; or 

(ii) $1 billion or more. 

(2) The [Agency] may apply this rule 

to any bank if the [Agency] deems it 

necessary or appropriate because of the 

level of market risk of the bank or to 

ensure safe and sound banking 

practices. 

(3) The [Agency] may exclude a bank 

that meets the criteria of paragraph 

(b)(1) of this section from coverage 

under this rule if the [Agency] 

determines that the exclusion is 

appropriate based on the level of market 

risk of the bank and is consistent with 

safe and sound banking practices. 

(c) Reservation of authority—(1) The 

[Agency] may require a bank to hold an 

amount of capital greater than otherwise 

required under this rule if the [Agency] 

determines that the bank’s capital 

requirement for market risk as 

calculated under this rule is not 

commensurate with the market risk of 

the bank’s covered positions. In making 

determinations under this paragraph, 

the [Agency] will apply notice and 

response procedures generally in the 

same manner as the notice and response 

procedures described in [12 CFR 3.12, 

12 CFR 263.202, 12 CFR 325.6(c), 12 

CFR 567.3(d)]. 

(2) If the [Agency] determines that the 

risk-based capital requirement 

calculated under this rule by the bank 

for one or more covered positions or 

portfolios of covered positions is not 

commensurate with the risks associated 

with those positions or portfolios, the 

[Agency] may require the bank to assign 

a different risk-based capital 

requirement to the positions or 

portfolios that more accurately reflects 

the risk of the positions or portfolios. 

(3) The [Agency] may also require a 

bank to calculate risk-based capital 

requirements for specific positions or 

portfolios under this rule, or under [the 

proposed advanced capital adequacy 

framework] or [the general risk-based 

capital rules], as appropriate, to more 

accurately reflect the risks of the 

positions. 

(4) Nothing in this rule 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 

For purposes of this rule, the 

following definitions apply: 

Bank holding company is defined in 

section 2(a) of the Bank Holding 

Company Act of 1956 (12 U.S.C. 

1841(a)). 

Commodity position means a position 

for which price risk arises from changes 

in the value of a commodity. 

Covered position means the following 

positions: 

(1) A trading asset or trading liability 

(whether on- or off-balance sheet),1 as 

reported on Schedule RC–D of the Call 

Report, Schedule HC–D of the 

Consolidated Financial Statements for 

Bank Holding Companies, or as defined 

in the Instructions to the Thrift 

Financial Report, that meets the 

following conditions: 

(i) The position is a trading position 

or hedges another covered position 2

and 

(ii) The position is free of any 

restrictive covenants on its tradability or 

the bank is able to hedge the material 

risk elements of the position in a twoway market. 

(2) A foreign exchange or commodity 

position, whether or not a trading asset 

or trading liability (excluding any 

structural position in a foreign currency 

that the bank chooses to exclude with 

prior supervisory approval). 

(3) Notwithstanding paragraphs (1) 

and (2) of this definition, a covered 

position does not include: 

(i) An intangible asset, including any 

servicing asset; 

(ii) Any hedge of a trading position 

that the [Agency] determines to be 

outside the scope of the bank’s hedging 

strategy required in paragraph (a)(2) of 

section 3; 

(iii) Any position that, in form or 

substance, acts as a liquidity facility that 

provides support to asset-backed 

commercial paper; 

(iv) A credit derivative recognized as 

a guarantee for risk-weighted asset 

amount calculation purposes under [the 

proposed advanced capital adequacy 

framework] or [the general risk-based 

capital rules], as applicable, used to 

hedge a position that is not a covered 

position; or 

(v) A securitization position that is a 

residual securitization position, unless 

the [Agency] has determined in writing 

that: 

(A) A two-way market exists for the 

securitization position or, in the case of 


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a securitization that relies solely on 

credit derivatives, for the securitization 

position or all of its material risk 

components; 

(B) The bank holds itself out as ready 

to buy and sell these securitization 

positions for its own account on a 

regular and continuous basis at a quoted 

price; 

(C) The bank’s internal models fully 

capture the general market risk and 

specific risks of the bank’s securitization 

positions and sufficient market data are 

available to model these risks reliably; 

and 

(D) The bank has adequate internal 

systems and controls for the trading of 

securitization positions. 

Credit derivative means a financial 

contract executed under standard 

industry 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). 

Debt position means: 

(1) Any security or similar instrument 

(such as a bond, debenture, or note) that 

is not an equity position and evidences 

a liability of the issuer; 

(2) Preferred stock that is not an 

equity position; and 

(3) A derivative for which the 

underlying position is described in 

paragraph (1) or (2) of this definition. 

Default risk means the risk of loss on 

a position that could result from the 

failure of an obligor to make timely 

payments of principal or interest on its 

debt obligation, and the risk of loss that 

could result from bankruptcy, 

insolvency, or similar proceeding. In the 

case of credit derivatives, default risk 

means the risk of losses that could result 

from the default of the reference 

exposures. 

Depository institution is defined in 

section 3 of the Federal Deposit 

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

Equity position 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 or 

income of a company; 

(2) A security or instrument that is 

mandatorily convertible into a security 

or instrument described in paragraph (1) 

of this definition; and 

(3) Any other security or instrument, 

to the extent its return is based on the 

performance of one or more securities or 

instruments described in paragraph (1) 

of this definition. 

Event risk means the risk of loss on a 

position that could result from sudden 

and unexpected large changes in market 

prices or specific events other than 

default of the issuer. 

Financial firm means a depository 

institution, a bank holding company, a 

savings and loan holding company (as 

defined in section 10(a)(1)(D) of the 

Home Owners’ Loan Act (12 U.S.C. 

1467a(a)(1)(D)), a securities broker or 

dealer registered with the SEC, or a 

banking or securities firm that the bank 

has determined is subject to 

consolidated supervision and regulation 

comparable to that imposed on U.S. 

banks or securities broker-dealers. 

Foreign exchange position means a 

position for which price risk arises from 

changes in foreign exchange rates. 

General market risk means the risk of 

loss that could result from broad market 

movements, such as changes in the 

general level of interest rates, credit 

spreads, equity prices, foreign exchange 

rates, or commodity prices. 

Hedge means a position that offsets all 

or substantially all of the price risk of 

another position. 

Idiosyncratic variation means 

variation in the value of a position that 

results from factors unique to that 

position. 

Incremental default risk means the 

default risk of a position that is not 

reflected in the bank’s VaR-based 

measure under paragraph (c) of section 

3 of this rule. In the case of 

securitization positions, incremental 

default risk includes the risk of losses 

that could result from the default of the 

underlying assets. 

Market risk means the risk of loss on 

a position that could result from 

movements in market prices. 

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 SEC 

Rule 15c3–1 (broker-dealer net capital 

requirements). 

Over-the-counter (OTC) derivative 

means a derivative contract that is not 

traded on an exchange that requires the 

daily receipt and payment of cashvariation margin. 

Publicly traded means a financial 

instrument that is 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 financial instrument. 

Qualifying securities borrowing 

transaction means a cash-collateralized 

securities borrowing transaction that 

meets the following conditions: 

(1) The transaction is based on liquid 

and readily marketable securities; 

(2) The transaction is marked-tomarket daily; 

(3) The transaction is subject to daily 

margin maintenance requirements; and 

(4)(i) The transaction is a securities 

contract for the purposes of section 555 

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

a qualified financial contract for the 

purposes of section 11(e)(8) of the 

Federal Deposit Insurance Act (12 

U.S.C. 1821(e)(8)), or a netting contract 

between or among financial institutions 

for the purposes of sections 401–407 of 

the Federal Deposit Insurance 

Corporation Improvement Act of 1991 

(12 U.S.C. 4401–4407), or the Board’s 

Regulation EE (12 CFR part 231); or 

(ii) If the transaction does not meet 

the criteria in paragraph (4)(i) of this 

definition, either: 

(A) The bank has conducted sufficient 

legal review to reach a well-founded 

conclusion that: 

(1) The securities borrowing 

agreement executed in connection with 

the transaction provides the bank the 

right to accelerate, terminate, and closeout on a net basis all transactions under 

the agreement and to liquidate or set off 

collateral promptly upon an event of 

counterparty default, including in a 

bankruptcy, insolvency, or other similar 

proceeding of the counterparty; and 

(2) Under applicable law of the 

relevant jurisdiction, its rights under the 

agreement are legal, valid, binding, and 

enforceable and any exercise of rights 

under the agreement will not be stayed 

or avoided; or 

(B) The transaction is either overnight 

or unconditionally cancelable at any 

time by the bank, and the bank has 

conducted sufficient legal review to 

reach a well-founded conclusion that: 

(1) The securities borrowing 

agreement executed in connection with 

the transaction provides the bank the 

right to accelerate, terminate, and closeout on a net basis all transactions under 

the agreement and to liquidate or set off 

collateral promptly upon an event of 

counterparty default; and 

(2) Under the law governing the 

agreement, its rights under the 

agreement are legal, valid, binding, and 

enforceable. 

Residual securitization position 

means any securitization position 

subject to deduction under [the 

proposed advanced capital adequacy 

framework] or subject to the following 

provisions under [the general risk-based 

capital rules]: 12 CFR part 3, Appendix 

A, sections 4 (b) and (f) (national banks); 

12 CFR part 208, Appendix A, section 


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3This 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. 4407), or the 

Federal Reserve Board’s Regulation EE (12 CFR part 

231). 

III.B.3.b and III.B.3.e (state member 

banks); 12 CFR part 225, Appendix 

A.III.B.3.b and III.B.3.e (bank holding 

companies); 12 CFR part 325, Appendix 

A.II.B.5 (state nonmember banks); and 

12 CFR 567.6(b)(1) and (2) (savings 

associations) 

SEC means the U.S. Securities and 

Exchange Commission. 

Securitization position means: 

(1) An on- or off-balance sheet 

position arising from a transaction in 

which: 

(i) All or a portion of the credit risk 

of one or more underlying positions is 

transferred to one or more third parties 

(other than through a guarantee that 

transfers only the credit risk of an 

individual residential mortgage); 

(ii) The credit risk associated with the 

underlying positions has been separated 

into at least two tranches reflecting 

different levels of seniority; 

(iii) Performance of the securitization 

positions depends upon the 

performance of the underlying 

positions; and 

(iv) All, or substantially all, of the 

underlying positions are financial 

positions (such as loans, commitments, 

credit derivatives, guarantees, 

receivables, asset-backed securities, 

mortgage-backed securities, corporate 

bonds, or equity securities); and 

(2) A mortgage-backed pass-through 

security guaranteed by Fannie Mae or 

Freddie Mac. 

Sovereign entity means a central 

government (including the U.S. 

government) or an agency, department, 

ministry, or central bank of a central 

government. 

Specific risk means the risk of loss on 

a position that could result from factors 

other than broad market movements and 

includes event and default risk, and 

idiosyncratic variations in rates, 

spreads, prices, or other risk factors. 

Term 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, that has an 

original maturity in excess of one 

business day, 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 closeout the transaction on a net basis and to 

liquidate or set off collateral promptly 

upon an event of default (including 

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 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. 

Tier 1 capital is defined in [the 

general risk-based capital rules] or [the 

proposed advanced capital adequacy 

framework], as applicable. 

Tier 2 capital is defined in [the 

general risk-based capital rules] or [the 

proposed advanced capital adequacy 

framework], as applicable. 

Tier 3 capital is subordinated debt 

that is unsecured, is fully paid up, has 

an original maturity of at least two 

years, is not redeemable before maturity 

without prior approval of the [Agency], 

includes a lock-in clause precluding 

payment of either interest or principal 

(even at maturity) if the payment would 

cause the issuing bank’s risk-based 

capital ratio to fall or remain below the 

minimum required under [the general 

risk-based capital rules] or [the 

proposed advanced capital adequacy 

framework], as applicable, and does not 

contain and is not covered by any 

covenants, terms, or restrictions that are 

inconsistent with safe and sound 

banking practices. 

Trading position means a position 

that is held by the bank for the purpose 

of short-term resale or with the intent of 

benefiting from actual or expected price 

movements or to lock in arbitrage 

profits. 

Two-way market means a market 

where there are enough independent 

bona fide offers to buy and sell so that 

a price reasonably related to the last 

sales price or current bona fide 

competitive bid and offer quotations can 

be determined within one day and 

settled at such price within a relatively 

short period of time conforming to trade 

custom. 

Value-at-risk (VaR) means the 

estimate of the maximum amount that 

the value of one or more positions could 

decline due to market price or rate 

movements during a fixed holding 

period within a stated confidence 

interval. 

Section 3. Requirements for 

Application of the Market Risk Capital 

Rule 

(a) Trading positions—(1) 

Identification of trading positions. A 

bank must have clearly defined policies 

and procedures for determining which 

of its trading assets and trading 

liabilities are trading positions. These 

policies and procedures must take into 

account: 

(i) The extent to which a position, or 

a hedge of its material risks, can be 

marked-to-market daily by reference to 

a two-way market; and 

(ii) Possible impairments to the 

liquidity of a position or its hedge. 

(2) Trading and hedging strategies. A 

bank must have clearly defined trading 

and hedging strategies for its trading 

positions that are approved by senior 

management of the bank. 

(i) The trading strategy must articulate 

the expected holding period of, and the 

market risk associated with, each 

portfolio of trading positions. The 

trading strategy must also articulate 

whether the purpose of each portfolio of 

trading positions is to accommodate 

customer flow, to engage in proprietary 

trading, or to make a market in the 

positions. 

(ii) The hedging strategy must 

articulate for each portfolio the level of 

market risk the bank is willing to accept 

and must detail the instruments, 

techniques, and strategies the bank will 

use to hedge the risk of the portfolio. 

(b) Management of covered 

positions—(1) Active management. A 

bank must have clearly defined policies 

and procedures for actively managing 

all covered positions. At a minimum, 

these policies and procedures must 

require: 

(i) Marking positions to market or to 

model on a daily basis; 

(ii) Daily assessment of the bank’s 

ability to hedge position and portfolio 

risks, and of the extent of market 

liquidity; 

(iii) Establishment and daily 

monitoring of limits on positions by a 

risk control unit independent of the 

trading business unit; 

(iv) Daily monitoring by senior 

management of information described in 

paragraphs (b)(1)(i) through (b)(1)(iii) of 

this section; 


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(v) At least annual reassessment of 

established limits on positions by senior 

management; and 

(vi) At least annual assessments by 

qualified personnel of the quality of 

market inputs to the valuation process, 

the soundness of key assumptions, the 

reliability of parameter estimation in 

pricing models, and the stability and 

accuracy of model calibration under 

alternative market scenarios. 

(2) Valuation of covered positions. 

The bank must have a process for 

prudent valuation of its covered 

positions that includes policies and 

procedures on the valuation of 

positions, marking to market or to 

model, independent price verification, 

and valuation adjustments or reserves. 

The valuation process must consider, as 

appropriate, unearned credit spreads, 

close-out costs, early termination, 

investing and funding costs, future 

administrative costs, liquidity, and 

model risk. 

(c) Internal models. A bank must use 

one or more internal models to calculate 

daily a VaR-based measure that reflects 

its general market risk for all covered 

positions. The daily VaR-based measure 

may also reflect the bank’s specific risk 

for one or more portfolios of covered 

debt and equity positions, if the internal 

models meet the requirements of 

paragraph (b)(1) of section 5. 

(1) A bank must obtain the prior 

written approval of the [Agency] before 

using any internal model to calculate its 

risk-based capital requirement under 

this rule or extending the use of a model 

for which it has received prior written 

approval to an additional business line 

or product type. 

(2) A bank must meet all of the 

requirements of this section on an 

ongoing basis. The bank must promptly 

notify the [Agency] when the bank 

makes any change to any internal model 

used to calculate risk-based capital 

requirements under this rule that would 

result in a material change in the bank’s 

risk-weighted asset amount for a 

portfolio of covered positions, or when 

the bank makes any material change to 

its modeling assumptions. The [Agency] 

may rescind its approval, in whole or in 

part, of the use of any internal model if 

it determines that the model no longer 

complies with this rule or fails to reflect 

accurately the risks of the bank’s 

covered positions. 

(3) The bank must integrate its 

internal models into the daily risk 

management process. 

(4) The level of sophistication of a 

bank’s internal models must be 

commensurate with the nature and size 

of its covered positions. A bank’s 

internal models may use any of the 

generally accepted approaches, such as 

variance-covariance models, historical 

simulations, or Monte Carlo 

simulations, to measure market risk. 

(5) The bank’s internal models must 

use risk factors sufficient to measure the 

market risk inherent in all covered 

positions. The risk factors must include, 

as appropriate, interest rate risk, credit 

spread risk, equity price risk, foreign 

exchange risk, and commodity price 

risk. For material positions in the major 

currencies and markets, modeling 

techniques must incorporate enough 

segments of the yield curve—in no case 

less than six—to capture differences in 

volatility and less than perfect 

correlation of rates along the yield 

curve. 

(6) The bank’s internal models must 

properly measure all of the material 

risks in its covered positions, including 

basis risks and prepayment risks. 

(7) The bank’s internal models must 

conservatively assess the risks arising 

from less liquid positions and positions 

with limited price transparency under 

realistic market scenarios. 

(8) The bank must have a rigorous and 

well-defined process for reestimation, 

reevaluation, and updating of its 

internal models to ensure continued 

applicability and relevance. 

(9) The VaR-based measure may 

incorporate empirical correlations 

within and across risk factors, provided 

that the bank’s process for measuring 

correlations is sound. If the VaR-based 

measure does not incorporate empirical 

correlations, the bank must add the 

separate VaR-based measures for the 

appropriate market risk factors (interest 

rate risk, credit spread risk, equity price 

risk, foreign exchange rate risk, and/or 

commodity price risk) to determine its 

aggregate VaR-based measure. 

(10) The VaR-based measure must 

include the risks arising from the nonlinear price characteristics of options 

positions or positions with embedded 

optionality and the sensitivity of the 

market value of the positions to changes 

in the volatility of the underlying rates, 

prices, or other key risk factors. A bank 

with a large or complex options 

portfolio must measure the volatility of 

options positions or positions with 

embedded optionality by different 

maturities and/or strikes, where 

material. 

(11) If a bank uses internal models to 

measure specific risk, the internal 

models must satisfy the requirements in 

paragraph (b)(1) of section 5. 

(d) Quantitative requirements for 

VaR-based measure. (1) A bank must 

calculate a VaR-based measure of the 

general market risk of its covered 

positions and, if applicable under 

section 5, its specific risk for one or 

more portfolios of covered debt and 

equity positions. A bank may elect to 

include in its VaR-based measure term 

repo-style transactions and residual 

securitization positions that are trading 

assets or liabilities provided that the 

bank includes all such term repo-style 

transactions or securitization positions 

and that it includes them consistently 

over time. 

(2) The VaR-based measure must be 

calculated on a daily basis using a onetailed, 99.0 percent confidence level, 

and a holding period equivalent to a 

ten-business-day movement in 

underlying risk factors, such as rates, 

spreads, and prices. To calculate VaRbased measures using a ten-businessday holding period, the bank may 

calculate ten-business-day measures 

directly or may convert VaR-based 

measures using holding periods other 

than ten business days to the equivalent 

of a ten-business-day holding period. 

(3) The VaR-based measure must be 

based on a historical observation period 

of at least one year. Data used to 

determine the VaR-based measure must 

be relevant to the bank’s actual 

exposures and of sufficient quality to 

support the determination of risk-based 

capital requirements. For banks that use 

a weighting scheme or other method for 

the historical observation period, the 

effective observation period must be at 

least one year. The bank must update 

data sets at least once every three 

months or more frequently as market 

conditions warrant. 

(e) Control, oversight, and validation 

mechanisms. (1) The bank must have a 

risk control unit that reports directly to 

senior management and is independent 

from the business trading units. 

(2) The bank must validate its internal 

models initially and on an ongoing 

basis. The bank’s validation process 

must be independent of the internal 

models’ development, implementation, 

and operation, or the validation process 

must be subjected to an independent 

review of its adequacy and 

effectiveness. Validation must include: 

(i) Evaluation of the conceptual 

soundness of (including developmental 

evidence supporting) the internal 

models; 

(ii) An ongoing monitoring process 

that includes verification of processes 

and the comparison of the bank’s model 

outputs with relevant internal and 

external data sources or estimation 

techniques; and 

(iii) An outcomes analysis process 

that includes the comparison of a bank’s 

internal estimates with actual outcomes 

during a sample period not used in 

model development. 


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(3) The bank must stress-test the 

market risk of its covered positions at a 

frequency appropriate to each portfolio, 

and in no case less frequently than 

quarterly. The stress tests must take into 

account concentration risk (including 

but not limited to concentrations in 

single issuers, industries, sectors, or 

markets), illiquidity under stressed 

market conditions, and risks arising 

from the bank’s trading activities that 

may not be adequately captured in the 

bank’s internal models. 

(4) 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 market risk 

measurement systems, including the 

activities of the business trading units 

and of the independent risk control 

unit, and compliance with policies and 

procedures. 

(f) Internal assessment of capital 

adequacy. The bank must have a 

rigorous process for assessing its overall 

capital adequacy in relation to its 

market risk. The assessment must take 

into account concentration and liquidity 

risk under stressed market conditions as 

well as other risks that may not be 

captured appropriately in the VaR-based 

measure. 

(g) Documentation. The bank must 

adequately document all material 

aspects of its internal models, 

management and valuation of covered 

positions, control, oversight, and 

validation mechanisms, and internal 

assessment of capital adequacy. 

Section 4. Adjustments to the RiskBased Capital Ratio Calculations 

(a) Risk-based capital ratio 

denominator. The bank must calculate 

its risk-based capital ratio denominator 

as follows: 

(1) Adjusted risk-weighted assets. The 

bank must calculate adjusted riskweighted assets, which equal riskweighted assets (as determined in 

accordance with [the proposed 

advanced capital adequacy framework] 

or [the general risk-based capital rules], 

as applicable), with the following 

adjustments: 

(i) The bank must exclude the riskweighted asset amounts of all covered 

positions (except foreign exchange 

positions that are not trading positions 

and over-the-counter derivative 

positions). 

(ii) A bank subject to [the general riskbased capital rules] may exclude 

receivables that arise from the posting of 

cash collateral and are associated with 

qualifying securities borrowing 

transactions to the extent the receivable 

is collateralized by the market value of 

the borrowed securities; 

(2) Measure for market risk. The bank 

must calculate the measure for market 

risk which equals the sum of the 

following: 

(i) VaR-based capital requirement. 

The VaR-based capital requirement 

equals the higher of: 

(A) The previous day’s VaR-based 

measure; and 

(B) The average of the daily VaRbased measures for each of the 

preceding 60 business days multiplied 

by three, except as provided in 

paragraph (c) of section 4 of this rule. 

(ii) Any specific risk add-on. The 

specific risk add-on is calculated in 

accordance with sections 5 and 7 of this 

rule. 

(iii) Any incremental default risk 

capital requirement. The incremental 

default risk capital requirement is 

calculated under section 6 of this rule. 

(iv) Any capital requirement for de 

minimis exposures. The [Agency] may 

grant prior written approval to a bank to 

calculate a capital requirement for de 

minimis exposures and risks using 

alternative techniques that adequately 

measure associated market risk. 

(3) Market risk equivalent assets. The 

bank must calculate market risk 

equivalent assets as the measure for 

market risk (as calculated in paragraph 

(a)(2) of this section) multiplied by 12.5. 

(4) Denominator calculation. The 

bank must add market risk equivalent 

assets (as calculated in paragraph (a)(3) 

of this section) to adjusted risk-weighted 

assets (as calculated in paragraph (a)(1) 

of this section). The resulting sum is the 

bank’s risk-based capital ratio 

denominator. 

(b) Risk-based capital ratio 

numerator. The bank must calculate its 

risk-based capital ratio numerator by 

allocating capital as follows: 

(1) Credit risk allocation. The bank 

must allocate tier 1 and tier 2 capital 

equal to 8.0 percent of adjusted riskweighted assets (as calculated in 

paragraph (a)(1) of this section). A bank 

may not allocate tier 3 capital to support 

credit risk (as calculated under [the 

proposed advanced capital adequacy 

framework] or [the general risk-based 

capital rules]). 

(2) Market risk allocation. The bank 

must allocate tier 1, tier 2, and tier 3 

capital equal to the measure for market 

risk as calculated in paragraph (a)(2) of 

this section. The sum of tier 2 and tier 

3 capital allocated for market risk must 

not exceed 250 percent of tier 1 capital 

allocated for market risk. As a result, 

tier 1 capital allocated in this paragraph 

(b)(2) must equal at least 28.6 percent of 

the measure for market risk. 

(3) Restrictions. (i) The sum of tier 2 

capital (both allocated and excess) and 

tier 3 capital (allocated under paragraph 

(b)(2) of this section) may not exceed 

100 percent of tier 1 capital (both 

allocated and excess). Excess tier 1 

capital means tier 1 capital that has not 

been allocated in paragraphs (b)(1) and 

(b)(2) of this section. Excess tier 2 

capital means tier 2 capital that has not 

been allocated in paragraph (b)(1) and 

(b)(2) of this section, subject to the 

restrictions in paragraph (b)(3) of this 

section. 

(ii) Term subordinated debt (and 

intermediate-term preferred stock and 

related surplus) included in tier 2 

capital (both allocated and excess) may 

not exceed 50 percent of tier 1 capital 

(both allocated and excess). 

(4) Numerator calculation. The bank 

must add tier 1 capital (both allocated 

and excess), tier 2 capital (both 

allocated and excess), and tier 3 capital 

(allocated under paragraph (b)(2) of this 

section). The resulting sum is the bank’s 

risk-based capital ratio numerator. 

(c) Backtesting. A bank must compare 

each of its most recent 250 business 

days’ actual trading profit or loss 

(excluding fees, commissions, reserves, 

and net interest income) with the 

corresponding daily VaR-based 

measures and calibrated to a one-day 

holding period and a one-tailed, 99.0 

percent confidence level. 

(1) Once each quarter, the bank must 

identify the number of exceptions (that 

is, the number of business days for 

which the actual daily net trading loss, 

if any, exceeds the corresponding daily 

VaR-based measure) that have occurred 

over the preceding 250 business days. 

(2) A bank must use the 

multiplication factor in Table 1 of this 

rule to determine its VaR-based capital 

requirement for market risk under 

paragraph (a)(2)(i) of this section until it 

obtains the next quarter’s backtesting 

results, unless the [Agency] advises the 

bank in writing that a different 

adjustment or other action is 

appropriate. 

TABLE 1.—MULTIPLICATION FACTORS

BASED ON RESULTS OF BACKTESTING

Number of exceptions Multiplication 

factor 

4 or fewer ............................. 3.00 

5 ............................................ 3.40 

6 ............................................ 3.50 

7 ............................................ 3.65 

8 ............................................ 3.75 

9 ............................................ 3.85 

10 or more ............................ 4.00 


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55976 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

Section 5. Specific Risk 

(a) General requirement. A bank must 

use one of the methods in this section 

to measure the specific risk for each of 

its portfolios of covered debt and equity 

positions. 

(b) Modeled specific risk. A bank may 

use one or more internal models to 

measure the specific risk of covered 

debt and equity positions. 

(1) Requirements for specific risk 

modeling. If a bank uses internal models 

to measure the specific risk of a 

portfolio of covered debt or equity 

positions, the internal models must: 

(i) Explain the historical price 

variation in the portfolio; 

(ii) Be responsive to changes in 

market conditions; 

(iii) Be robust to an adverse 

environment, including signaling rising 

risk in an adverse environment; and 

(iv) Capture all material components 

of specific risk for the covered debt and 

equity positions in the portfolio, except 

as permitted under the transitional rule 

described in paragraph (d) of this 

section. Specifically, the internal 

models must: 

(A) Capture default risk, event risk, 

and idiosyncratic variations, including, 

for debt positions, migration risk, and 

for equity positions, events that are 

reflected in large changes or jumps in 

prices; 

(B) Capture material basis risks and 

demonstrate sensitivity to material 

idiosyncratic differences between 

positions that are similar but not 

identical; and 

(C) Capture concentrations 

(magnitude and changes in 

composition) and demonstrate 

sensitivity to changes in portfolio 

composition or concentrations. 

(2) Specific risk fully modeled for all 

portfolios. If the bank’s VaR-based 

measure captures all material aspects of 

specific risk for all of its portfolios of 

covered debt and equity positions, the 

bank has no specific risk add-on for 

purposes of paragraph (a)(2)(ii) of 

section 4. 

(3) Specific risk fully modeled for 

some but not all portfolios. If the bank’s 

VaR-based measure captures all material 

aspects of specific risk for one or more 

of its portfolios of covered debt and 

equity positions, the bank has no 

specific risk add-on for those portfolios 

for purposes of paragraph (a)(2)(ii) of 

section 4. The bank must calculate a 

specific risk add-on under the standard 

method as described in section 7 of this 

rule for any portfolio of covered debt or 

equity positions for which the bank’s 

VaR-based measure does not capture all 

material aspects of specific risk. 

(c) Specific risk not modeled. If the 

bank’s VaR-based measure does not 

capture all material aspects of specific 

risk for any of its portfolios of covered 

debt and equity positions, the bank 

must calculate a specific-risk add-on for 

all portfolios of covered debt and equity 

positions under the standard method as 

described in section 7 of this rule. 

(d) Transitional Rule—Specific risk 

partially modeled for one or more 

portfolios. Until January 1, 2010, if a 

bank has received the [Agency’s] prior 

written approval to model the specific 

risk of one or more portfolios of covered 

debt or equity positions but the 

[Agency] has determined that the 

internal models do not adequately 

measure all material aspects of specific 

risk for covered debt and equity 

positions in the portfolio, including 

event and default risk, the bank must 

calculate a specific risk add-on for the 

partially modeled portfolios using one 

of the following methods: 

(1) If the [Agency] has determined 

that the bank can validly separate its 

VaR-based measure into a specific risk 

portion and a general market risk 

portion, the specific risk add-on is equal 

to the higher of: 

(i) The previous day’s specific risk 

portion; or 

(ii) The average of the daily specific 

risk portions for each of the preceding 

60 business days. 

(2) If the [Agency] has determined 

that the bank cannot validly separate its 

VaR-based measure into a specific risk 

portion and a general market risk 

portion, the specific risk add-on equals 

the higher of: 

(i) The sum of the previous day’s VaRbased measures for portfolios of covered 

debt and equity positions; or 

(ii) The average of the sum of the 

daily VaR-based measures for portfolios 

of covered debt and equity positions for 

each of the preceding 60 business days. 

Section 6. Incremental Default Risk 

(a) General requirement. On and after 

January 1, 2010, a bank that models 

specific risk for one or more portfolios 

of covered debt or equity positions must 

use one of the methods in this section 

to measure the incremental default risk 

of those portfolios. With the prior 

written approval of the [Agency], a bank 

may adjust its incremental default risk 

capital requirement to minimize doublecounting of default risk already reflected 

in the 10-business-day, 99 percent 

confidence level VaR-based measure. 

The incremental default risk capital 

requirement is not subject to the 

multiplier described in paragraphs 

(a)(2)(i)(B) and (c) of section 4. 

(b) Modeled incremental default risk. 

With prior written approval of [Agency], 

a bank may use one or more internal 

models to measure its incremental 

default risk capital requirement. A bank 

that models its incremental default risk 

must measure the incremental default 

risk of its portfolios of covered debt or 

equity positions, consistent with a oneyear time horizon and a one-tailed, 99.9 

percent confidence level, under the 

assumption of a constant level of risk 

and adjusted where appropriate to 

reflect the impact of liquidity, 

concentrations, hedging, and 

optionality. 

(c) Alternative for banks subject to 

[the proposed advanced capital 

adequacy framework]. If a bank subject 

to [the proposed advanced capital 

adequacy framework] does not have a 

model that meets the criteria of 

paragraph (b) of this section for a 

portfolio of covered debt or equity 

positions, the bank’s incremental 

default risk capital requirement for the 

portfolio is equal to the capital 

requirement calculated for those 

positions under [the proposed advanced 

capital adequacy framework]. 

(d) Alternative for banks subject to 

[the general risk-based capital rules]. If 

a bank subject to [the general risk-based 

capital rules] does not have a model that 

meets the criteria in paragraph (b) of 

this section for a portfolio of covered 

debt or equity positions, the bank must 

calculate a specific risk add-on for the 

portfolio using the standard method 

under section 7. A bank that calculates 

a specific risk add-on using the standard 

method described in section 7 for a 

portfolio is not subject to an incremental 

default risk capital requirement for that 

portfolio. 

Section 7. Standard Method for Specific 

Risk 

(a) General requirement. A bank using 

the standard method of calculating the 

specific risk add-on must calculate it in 

accordance with this section. 

(b) Covered debt positions. The 

standard specific risk add-on for 

covered debt positions is the sum of the 

risk-weighted asset amounts for 

individual covered debt positions, as 

computed under this paragraph. A bank 

must multiply the absolute value of the 

current market value of each net long or 

short covered debt position by the 

appropriate specific risk weighting 

factor in Table 2, subject to the 

following requirements: 

(1) For covered debt positions that are 

non-option derivatives, a bank must 

risk-weight the market value of the 

effective notional amount of the 

underlying debt instrument or index 


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Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55977 

portfolio. Swaps must be included as 

the notional positions in the underlying 

debt instrument or portfolio, with a 

receiving side treated as a long position 

and a paying side treated as a short 

position. For covered debt positions that 

are options, whether long or short, a 

bank must risk-weight the market value 

of the effective notional amount of the 

underlying debt instrument or portfolio 

multiplied by the option’s delta; 

(2) A bank may net long and short 

covered debt positions (including 

derivatives) in identical debt issues or 

indices; 

(3) There is no standard specific risk 

add-on when a covered debt position is 

fully hedged by a total return swap (or 

similar instrument where there is a 

matching of payments and changes in 

market value of the position) and there 

is an exact match between the reference 

obligation of the swap and the covered 

debt position and between the maturity 

of the swap and the covered debt 

position; 

(4) The standard specific risk add-on 

for a set of transactions consisting of a 

covered debt position and its credit 

derivative hedge that do not meet the 

criteria of paragraph (b)(3) of this 

section is equal to 20 percent of the 

specific risk add-on for the side of the 

transaction with the higher specific risk 

add-on when the credit risk of the 

position is fully hedged by a total return 

swap, credit default swap or similar 

instrument and there is an exact match 

in terms (including maturity) of the 

reference obligation of the credit hedge 

and the covered debt position, and of 

the currency of the credit derivative and 

the covered debt position. 

(5) The standard specific risk add-on 

for a set of transactions consisting of a 

covered debt position and its hedge that 

do not meet the criteria of either 

paragraph (b)(3) or (b)(4) of this section 

is equal to the specific risk add-on for 

the side of the transaction with the 

higher specific risk add-on. 

TABLE 2.—SPECIFIC RISK WEIGHTING FACTORS FOR COVERED DEBT POSITIONS

Category Applicable NRSRO rating 

(illustrative rating example) 

Remaining contractual 

maturity 

Specific risk 

risk weight 

(percent) 

Sovereign ...................... Highest investment grade to second highest investment grade (for example, AAA to AA-)............................................................................... 0 

Third highest investment grade to lowest investment grade (for example, A+ to BBB¥).Residual term to final maturity 6 months or less 0 .25 

......................................................................... Residual term to final maturity greater than 6 

and up to and including 24 months. 

1 .00 

......................................................................... Residual term to final maturity exceeding 24 

months 

1 .60 

One category below investment grade to two 

categories below investment grade (for example, BB+ to B¥).

.............................................................................. 8 .00 

More than two categories below investment 

grade.

.............................................................................. 12 .00 

Unrated ................................................................ .............................................................................. 8 .00 

Qualifying ....................... Not applicable ...................................................... Residual term to final maturity 6 months or less 0 .25 

Residual term to final maturity greater than 6 

and up to and including 24 months.

1 .00 

Residual term to final maturity exceeding 24 

months.

1 .60 

Other .............................. One category below investment grade to two 

categories below investment grade (for example, BB+ to B¥).

.............................................................................. 8 .00 

More than two categories below investment 

grade.

.............................................................................. 12 .00 

Unrated ................................................................ .............................................................................. 8 .00 

(c) The following definitions apply to 

this section: 

(1) The sovereign category includes all 

debt instruments issued or guaranteed 

by sovereign entities. 

(2) The qualifying category includes 

debt instruments not issued or 

guaranteed by sovereign entities that 

are: 

(i) Rated investment grade by at least 

two NRSROs; 

(ii) Rated investment grade by one 

NRSRO and not rated less than 

investment grade by any other NRSRO; 

or 

(iii) Unrated, but the bank deems to be 

of credit risk comparable to that of 

investment grade and either: 

(A) The issuer is a financial firm; or 

(B) The issuer has publicly traded 

securities or instruments. 

(3) The other category includes debt 

positions that are not included in the 

sovereign or qualifying categories. 

(d) Covered equity positions. The 

standard specific risk add-on for 

covered equity positions is the sum of 

the risk-weighted asset amounts of 

individual covered equity positions, as 

computed under this paragraph (d): 

(1) For covered equity positions that 

are non-option derivatives, a bank must 

risk-weight the market value of the 

effective notional amount of the 

underlying equity instrument or equity 

portfolio. Swaps must be included as 

the effective notional position in the 

underlying equity instrument or 

portfolio, with a receiving side treated 

as a long position and a paying side 

treated as a short position. 

(2) For covered equity positions that 

are options, whether long or short, a 

bank must risk-weight the market value 

of the effective notional amount of the 

underlying equity instrument or 

portfolio multiplied by the option’s 

delta. 

(3) A bank may net long and short 

covered equity positions (including 

derivatives) in identical equity issues or 

identical equity indices. A bank may 

also net positions in depository receipts 

against an opposite position in an 

identical equity in different markets, 

provided that the bank includes the 

costs of conversion. 

(4)(i) The bank must multiply the 

absolute value of the current market 


sroberts on PROD1PC70 with PROPOSALS
55978 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

4A portfolio is liquid and well-diversified if: (i) 

It is characterized by a limited sensitivity to price 

changes of any single equity issue or closely related 

group of equity issues held in the portfolio; (ii) the 

volatility of the portfolio’s value is not dominated 

by the volatility of any individual equity issue or 

by equity issues from any single industry or 

economic sector; (iii) it contains a large number of 

individual equity positions, with no single position 

representing a substantial portion of the portfolio’s 

total market value; (iv) it consists mainly of issues 

traded on organized exchanges or in wellestablished over-the-counter markets; and (v) a twoway market exists for all or substantially all of the 

positions in the portfolio. 

value of each net long or short covered 

equity position by a risk weighting 

factor of 8.0 percent, or 4.0 percent if 

the equity is held in a portfolio that is 

both liquid and well-diversified.4 For 

covered equity positions that are index 

contracts comprising a well-diversified 

portfolio of equity instruments, the 

absolute value of the current market 

value of each net long or short position 

is multiplied by a risk-weighting factor 

of 2.0 percent. 

(ii) For covered equity positions 

arising from the following futuresrelated arbitrage strategies, a bank may 

apply a 2.0 percent risk-weighting factor 

to one side (long or short) of each 

position with the opposite side exempt 

from a specific risk add-on: 

(A) Long and short positions in 

exactly the same index at different dates 

or in different market centers; or 

(B) Long and short positions in index 

contracts at the same date in different 

but similar indices. 

(iii) For futures contracts on broadly 

based indices that are matched by 

offsetting positions in a basket of stocks 

comprising the index, a bank may apply 

a 2.0 percent risk weighting factor to the 

futures and stock basket positions (long 

and short), provided that such trades are 

deliberately entered into and separately 

controlled, and that the basket of stocks 

is comprised of stocks representing at 

least 90 percent of the capitalization of 

the index. 

Section 8. Market Risk Disclosures 

(a) Scope. A bank must comply with 

this section unless it is a consolidated 

subsidiary of a bank holding company 

or a depository institution that is subject 

to these requirements. 

(b) Disclosure policy. The bank must 

have a formal disclosure policy 

approved by the board of directors that 

addresses the bank’s approach for 

determining the market risk 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 must certify that the 

disclosures required by this section 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 section. 

(c) Quantitative disclosures for 

internal models. For each portfolio of 

covered positions, the bank must 

publicly disclose the following 

information at least quarterly: 

(1) The high, low, and mean VaRbased measures over the reporting 

period; 

(2) Separate VaR-based measures for 

interest rate risk, credit spread risk, 

equity price risk, foreign exchange risk, 

and commodity price risk; and 

(3) A comparison of VaR-based 

estimates with actual gains or losses 

experienced by the bank, with analysis 

of important outliers. 

(d) Qualitative disclosures for internal 

models. The bank must publicly 

disclose the following information at 

least annually, or more frequently in the 

event of material changes: 

(1) The composition of material 

portfolios of covered positions; 

(2) The bank’s valuation policies, 

procedures, and methodologies for 

covered positions; 

(3) The characteristics of the internal 

models used for purposes of this rule; 

(4) A description of the approach used 

for validating and evaluating the 

accuracy of the internal models and 

modeling processes for purposes of this 

rule; 

(5) For each market risk factor (that is, 

interest rate risk, credit spread risk, 

equity price risk, foreign exchange risk, 

and commodity price risk), a 

description of the stress tests applied to 

the positions subject to the factor; 

(6) The results of a comparison of the 

bank’s internal estimates for purposes of 

this rule with actual outcomes during a 

sample period not used in model 

development; and 

(7) The soundness standard on which 

the bank’s internal capital adequacy 

assessment under this rule is based, 

including a description of the 

methodologies used to achieve a capital 

adequacy assessment that is consistent 

with the soundness standard and the 

requirements of this 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 non-member banks. 

12 CFR Part 566 

Capital, reporting and recordkeeping 

requirements, Savings associations. 

Authority and Issuance 

Adoption of Common Rule 

The adoption of the proposed 

common rules by the agencies, as 

modified by agency-specific text, is set 

forth below: 

Office of the Comptroller of the 

Currency 

12 CFR Chapter I 

Authority and Issuance 

For the reasons set forth in the 

common preamble, part 3 of chapter I of 

title 12 of the Code of Federal 

Regulations is amended 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, 3907 

and 3909. 

2. Appendix B to part 3 is revised to 

read as set forth at the end of the 

common preamble: 

Appendix B to Part 3—Risk-Based 

Capital Guidelines; Market Risk 

Adjustment 

3. Appendix B is further amended by: 

a. Removing ‘‘[Agency]’’ wherever it 

appears and adding in its place ‘‘OCC’’; 

b. Removing ‘‘[the proposed advanced 

capital adequacy framework]’’ wherever 

it appears and adding in its place 12 

CFR part 3, Appendix C; 

c. Removing ‘‘[Rule]’’ wherever it 

appears and adding in its place 

‘‘Appendix B to Part 3—Risk-Based 

Capital Guidelines; Market Risk 

Adjustment’’; and 


sroberts on PROD1PC70 with PROPOSALS
Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 55979 

d. Removing ‘‘[the general risk-based 

capital rules]’’ wherever it appears and 

adding in its place 12 CFR part 3, 

Appendix A. 

Federal Reserve System 

12 CFR Chapter II 

Authority and Issuance 

For the reasons set forth in the 

common preamble, part 208 of chapter 

II of title 12 of the Code of Federal 

Regulations is amended as follows: 

PART 208—MINIMUM CAPITAL 

RATIOS; ISSUANCE OF DIRECTIVES 

1. The authority citation for part 208 

continues to read as follows: 

Authority: Subpart A of Regulation H (12 

CFR part 208, Subpart A) is issued by the 

Board of Governors of the Federal Reserve 

System (Board) under 12 U.S.C. 24, 36; 

sections 9, 11, 21, 25 and 25A of the Federal 

Reserve Act (12 U.S.C. 321–338a, 248(a), 

248(c), 481–486, 601 and 611); sections 1814, 

1816, 1818, 1831o, 1831p–l, 1831r–l and 

1835a of the Federal Deposit Insurance Act 

(FDI Act) (12 U.S.C. 1814, 1816, 1818, 1831o, 

1831p–l, 1831r–l and 1835); and 12 U.S.C. 

3906–3909. 

2. Appendix E to part 208 is revised 

to read as set forth at the end of the 

common preamble: 

Appendix E to Part 208—Capital 

Adequacy Guidelines for State Member 

Banks: Risk-Based Measure 

3. Appendix E is further amended by: 

a. Removing ‘‘[Agency]’’ wherever it 

appears and adding in its place 

‘‘Board’’; 

b. Removing ‘‘[the proposed advanced 

capital adequacy framework]’’ wherever 

it appears and adding in its place 

‘‘Appendix F’’; 

c. Removing ‘‘[Rule]’’ wherever it 

appears and adding in its place 

‘‘Appendix E to Part 208—Capital 

Adequacy Guidelines for State Member 

Banks: Market Risk Measure’’; and 

d. Removing ‘‘[the general risk-based 

capital rules]’’ wherever it appears and 

adding in its place 12 CFR part 208, 

Appendix A. 

12 CFR Chapter II 

Authority and Issuance 

For the reasons set forth in the 

common preamble, part 225 of chapter 

II of title 12 of the Code of Federal 

Regulations is amended as follows: 

PART 225—MINIMUM CAPITAL 

RATIOS; ISSUANCE OF DIRECTIVES 

1. The authority citation for part 225 

continues to read as follows: 

Authority: This part 1 (Regulation Y) is 

issued by the Board of Governors of the 

Federal Reserve System (Board) under 

section 5(b) of the Bank Holding Company 

Act of 1956, as amended (12 U.S.C. 1844(b)) 

(BHC Act); sections 8 and 13(a) of the 

International Banking Act of 1978 (12 U.S.C. 

3106 and 3108); section 7(j)(13) of the 

Federal Deposit Insurance Act, as amended 

by the Change in Bank Control Act of 1978 

(12 U.S.C. 1817(j)(13)) (Bank Control Act); 

section 8(b) of the Federal Deposit Insurance 

Act (12 U.S.C. 1818(b)); section 914 of the 

Financial Institutions Reform, Recovery and 

Enforcement Act of 1989 (12 U.S.C. 1831i); 

section 106 of the Bank Holding Company 

Act Amendments of 1970 (12 U.S.C. 1972); 

and the International Lending Supervision 

Act of 1983 (Pub. L. 98–181, title IX). The 

BHC Act is codified at 12 U.S.C. 1841, et seq. 

2. Appendix E to part 225 is revised 

to read as set forth at the end of the 

common preamble: 

Appendix E to Part 225—Capital 

Adequacy Guidelines for Bank Holding 

Companies: Risk-Based Measure 

3. Appendix E is further amended by: 

a. Removing ‘‘[Agency]’’ wherever it 

appears and adding in its place 

‘‘Board’’; 

b. Removing ‘‘[the proposed advanced 

capital adequacy framework]’’ wherever 

it appears and adding in its place 

‘‘Appendix F’’; 

c. Removing ‘‘[Rule]’’ wherever it 

appears and adding in its place 

‘‘Appendix E to Part 225—Capital 

Adequacy Guidelines for Bank Holding 

Companies: Market Risk Measure’’; and 

d. Removing ‘‘[the general risk-based 

capital rules]’’ wherever it appears and 

adding in its place 12 CFR part 225, 

Appendix A. 

Federal Deposit Insurance Corporation 

12 CFR Chapter III 

Authority and Issuance 

For the reasons set forth in the 

common preamble, part 325 of chapter 

III of title 12 of the Code of Federal 

Regulations is amended 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, as amended by 

Pub. L. 103–325, 108 Stat. 2160, 2233 (12 

U.S.C. 1828 note); Pub. L. 102–242, 105 Stat. 

2236, 2386, as amended by Pub. L. 102–550, 

106 Stat. 3672, 4089 (12 U.S.C. 1828 note). 

2. Appendix C to part 325 is revised 

to read as set forth at the end of the 

common preamble: 

Appendix C to Part 325—Risk-Based 

Capital for State Nonmember Banks: 

Market Risk 

3. Appendix C is further amended by: 

a. Removing ‘‘[Agency]’’ wherever it 

appears and adding in its place ‘‘FDIC’’; 

b. Removing ‘‘[the proposed advanced 

capital adequacy framework]’’ wherever 

it appears and adding in its place 

‘‘Appendix D’’; 

c. Removing ‘‘[Rule]’’ wherever it 

appears and adding in its place 

‘‘Appendix C to Part 325—Risk-Based 

Capital for State Nonmember Banks: 

Market Risk’’; and 

d. Removing ‘‘[the general risk-based 

capital rules]’’ wherever it appears and 

adding in its place ‘‘12 CFR part 325, 

Appendix A.’’

Office of Thrift Supervision 

2 CFR Chapter V 

Authority and Issuance 

For the reasons set forth in the 

common preamble, the Office of Thrift 

Supervision proposes to add part 566 of 

chapter V of title 12 of the Code of 

Federal Regulations to read 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 

Appendix A to Part 566 [Reserved] 

Authority: 12 U.S.C. 1462, 1462a, 1463, 

1464, 1467a, and 1828(note). 

§ 566.1 Purpose 

(a) [Reserved] 

(b) Market Risk. Appendix B of this 

part establishes risk-based capital 

requirements for banks with significant 

exposure to market risk, provides 

methods for these banks to calculate 

their risk-based capital requirements for 

market risk, and prescribes public 

disclosure requirements regarding 

market risk for these savings 

associations. 

Appendix A to Part 566 [Reserved] 

2. Appendix B to part 566 is added 

and revised to read as set forth at the 

end of the common preamble. 

3. Appendix B to part 566 is further 

amended by: 

a. Removing ‘‘[Agency]’’ wherever it 

appears and adding in its place ‘‘OTS’’; 

b. Removing ‘‘[the proposed advanced 

capital adequacy framework]’’ wherever 

it appears and adding in its place ‘‘12 

CFR part 566, Appendix A’’; 

c. Removing ‘‘[Rule]’’ wherever it 

appears and adding in its place 


sroberts on PROD1PC70 with PROPOSALS
55980 Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 / Proposed Rules 

‘‘Appendix B to Part 566—Market Risk 

Adjustment’’; and 

d. Removing ‘‘[the general risk-based 

capital rules]’’ wherever it appears and 

adding in its place 12 CFR part 567. 

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: August 31, 2006. 

By the Office of Thrift Supervision. 

John M. Reich, 

Director. 

[FR Doc. 06–7673 Filed 9–22–06; 8:45 am] 

BILLING CODE 4810–33–P, 6210–01–P, 6714–01–P, 

6720–01–P 


sroberts on PROD1PC70 with PROPOSALS