Draft Basel II NPR 

49

DEPARTMENT OF THE TREASURY 

Office of the Comptroller of the Currency 

12 CFR Part 3 

[Docket No. ] 

RIN 

FEDERAL RESERVE SYSTEM 

12 CFR Parts 208 and 225 

[Regulations H and Y; Docket No. ] 

FEDERAL DEPOSIT INSURANCE CORPORATION 

12 CFR Part 325 

RIN 

DEPARTMENT OF THE TREASURY 

Office of Thrift Supervision 

12 CFR Part 567 

RIN 

Risk-Based Capital Standards: Advanced Capital Adequacy Framework 

AGENCIES: Office of the Comptroller of the Currency, Treasury; Board of Governors 

of the Federal Reserve System; Federal Deposit Insurance Corporation; and Office of 

Thrift Supervision, Treasury. 

ACTION: Joint notice of proposed rulemaking. 

SUMMARY: The Office of the Comptroller of the Currency (OCC), the Board of 

Governors of the Federal Reserve System (Board), the Federal Deposit Insurance 

Corporation (FDIC), and the Office of Thrift Supervision (OTS) (collectively, the 

agencies) are proposing a new risk-based capital adequacy framework that would require 

some and permit other qualifying banks1

 to use an internal ratings-based approach to 

calculate regulatory credit risk capital requirements and advanced measurement 

 

1

 For simplicity, and unless otherwise indicated, this notice of proposed rulemaking (NPR) uses the term 

“bank” to include banks, savings associations, and bank holding companies (BHCs). The terms “bank 

holding company” and “BHC” refer only to bank holding companies regulated by the Board and do not 

include savings and loan holding companies regulated by the OTS. 

ATTACHMENT
 Draft Basel II NPR 

50

approaches to calculate regulatory operational risk capital requirements. The proposed 

rule describes the qualifying criteria for banks required or seeking to operate under the 

proposed framework and the applicable risk-based capital requirements for banks that 

operate under the framework. 

DATES: Comments must be received on or before [INSERT DATE 120 DAYS AFTER 

PUBLICATION IN THE FEDERAL REGISTER]. 

ADDRESSES: Comments should be directed to: 

 OCC: You should include OCC and Docket Number ##-## in your comment. 

You may submit comments by any of the following methods: 

• Federal eRulemaking Portal: http://www.regulations.gov. Follow the 

instructions for submitting comments. 

• OCC Web Site: http://www.occ.treas.gov. Click on "Contact the OCC," scroll 

down and click on "Comments on Proposed Regulations." 

• E-mail address: regs.comments@occ.treas.gov. 

• Fax: (202) 874-4448. 

• Mail: Office of the Comptroller of the Currency, 250 E Street, SW, Mail Stop 1-

5, Washington, DC 20219. 

• Hand Delivery/Courier: 250 E Street, SW, Attn: Public Information Room, 

Mail Stop 1-5, Washington, DC 20219. 

Instructions: All submissions received must include the agency name (OCC) and 

docket number or Regulatory Information Number (RIN) for this notice of proposed 

rulemaking. In general, OCC will enter all comments received into the docket without 
 Draft Basel II NPR 

51

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-[____], by any 

of the following methods: 

• Agency Web Site: http://www.federalreserve.gov. Follow the instructions for 

submitting comments at 

http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm. 

• Federal eRulemaking Portal: http://www.regulations.gov. Follow the instructions 

for submitting comments. 

• E-mail: regs.comments@federalreserve.gov. Include docket number in the 

subject line of the message. 

• FAX: 202/452-3819 or 202/452-3102. 

• Mail: Jennifer J. Johnson, Secretary, Board of Governors of the Federal Reserve 

System, 20th Street and Constitution Avenue, NW, Washington, DC 20551. 

All public comments are available from the Board’s web site at 

www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm as submitted, unless 

modified for technical reasons. Accordingly, your comments will not be edited to 

remove any identifying or contact information. Public comments may also be viewed 

electronically or in paper in Room MP-500 of the Board’s Martin Building (20th and C 

Streets, NW) between 9:00 a.m. and 5:00 p.m. on weekdays. 
 Draft Basel II NPR 

52

 FDIC: You may submit comments, identified by RIN number, by any of the 

following methods: 

• Federal eRulemaking Portal: http://www.regulations.gov. Follow the instructions 

for submitting comments. 

• Agency Web Site: http://www.fdic.gov/regulations/laws/federal/propose.html. 

• Mail: Robert E. Feldman, Executive Secretary, Attention: Comments, Federal 

Deposit Insurance Corporation, 550 17th Street, NW, Washington, D.C. 20429. 

• Hand Delivery/Courier: Guard station at rear of the 550 17th Street Building 

(located on F Street) on business days between 7:00 a.m. and 5:00 p.m. 

• E-mail: Comments@FDIC.gov. 

• Public Inspection: Comments may be inspected and photocopied in 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. 

Instructions: Submissions received must include the agency name and RIN for 

this rulemaking. Comments received will be posted without change to 

http://www.fdic.gov/regulations/laws/federal/propose.html including any personal 

information provided. 

 OTS: You may submit comments, identified by No. 2005-XX, by any of the 

following methods: 

• Federal eRulemaking Portal: http://www.regulations.gov. Follow the 

instructions for submitting comments. 
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53

• E-mail address: regs.comments@ots.treas.gov. Please include No. 2005-XX 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. 2005-XX. 

• Hand Delivery/Courier: Guard’s Desk, East Lobby Entrance, 1700 G Street, 

NW, from 9:00 a.m. to 4:00 p.m. on business days, Attention: Regulation Comments, 

Chief Counsel’s Office, Attention: No. 2005-XX. 

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/pagehtml.cfm?catNumber=67&an=1, including any personal 

information provided. 

Docket: For access to the docket to read background documents or comments 

received, go to http://www.ots.treas.gov/pagehtml.cfm?catNumber=67&an=1. 

In addition, you may inspect comments at the Public Reading Room, 1700 G Street, NW, 

by appointment. To make an appointment for access, call (202) 906-5922, send an e-mail 

to public.info@ots.treas.gov, or send a facsimile transmission to (202) 906-7755. (Prior 

notice identifying the materials you will be requesting will assist us in serving you.) We 

schedule appointments on business days between 10:00 a.m. and 4:00 p.m. In most 

cases, appointments will be available the next business day following the date we receive 

a request. 
 Draft Basel II NPR 

54

FOR FURTHER INFORMATION CONTACT: 

 OCC: Roger Tufts, Senior Economic Advisor, Capital Policy (202-874-4925) or 

Ron Shimabukuro, Special Counsel, Legislative and Regulatory Activities Division (202-

874-5090). Office of the Comptroller of the Currency, 250 E Street, SW, Washington, 

DC 20219. 

Board: Barbara Bouchard, Deputy Associate Director (202-452-3072 or 

barbara.bouchard@frb.gov) or Anna Lee Hewko, Senior Supervisory Financial Analyst 

(202-530-6260 or anna.hewko@frb.gov), Division of Banking Supervision and 

Regulation; or Mark E. Van Der Weide, Senior Counsel (202-452-2263 or 

mark.vanderweide@frb.gov), Legal Division. For users of Telecommunications Device 

for the Deaf (“TDD”) only, contact 202-263-4869. 

FDIC: Jason C. Cave, Associate Director, Capital Markets Branch, (202) 898-

3548, Bobby R. Bean, Senior Quantitative Risk Analyst, Capital Markets Branch, (202) 

898-3575, Kenton Fox, Senior Capital Markets Specialist, Capital Markets Branch, (202) 

898-7119, Division of Supervision and Consumer Protection; or Michael B. Phillips, 

Counsel, (202) 898-3581, Supervision and Legislation Branch, Legal Division, Federal 

Deposit Insurance Corporation, 550 17th Street, NW, Washington, DC 20429. 

OTS: Michael D. Solomon, Director, Capital Policy, Supervision Policy (202) 

906-5654; David W. Riley, Senior Analyst, Capital Policy (202) 906-6669; or Karen 

Osterloh, Special Counsel, Regulations and Legislation Division (202) 906-6639, Office 

of Thrift Supervision, 1700 G Street, NW, Washington, DC 20552. 
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SUPPLEMENTARY INFORMATION: 

Table of Contents 

I. Introduction 

A. Background 

B. Conceptual Overview 

1. The IRB framework for credit risk 

2. The AMA for operational risk 

C. Overview of Proposed Rule 

D. Structure of Proposed Rule 

E. Quantitative Impact Study 4 and Overall Capital Objectives 

1. Quantitative Impact Study 4 

 2. Overall capital objectives 

F. Competitive Considerations 

II. Scope 

A. Core and Opt-In Banks 

B. U.S. Bank Subsidiaries of Foreign Banks 

C. Reservation of Authority 

III. Qualification 

A. The Qualification Process 

 1. In general 

2. Parallel run and transitional floor periods 

 

B. Qualification Requirements 

 1. Process and systems requirements 

 2. Risk rating and segmentation systems for wholesale and retail exposures 

 Wholesale exposures 

 Retail exposures 

 Definition of default 

 Rating philosophy 

 Rating and segmentation reviews and updates 

 3. Quantification of risk parameters for wholesale and retail exposures 

 Probability of default (PD) 

 Loss given default (LGD) and expected loss given default (ELGD) 

Exposure at default (EAD) 

 General quantification principles 

 4. Optional approaches that require prior supervisory approval 

5. Operational risk 

Operational risk data and assessment system 

Operational risk quantification system ` 
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 6. Data management and maintenance 

 7. Control and oversight mechanisms 

 Validation 

 Internal audit 

 Stress testing 

 8. Documentation 

C. Ongoing Qualification 

IV. Calculation of Tier 1 Capital and Total Qualifying Capital 

V. Calculation of Risk-Weighted Assets 

A. Categorization of Exposures 

 1. Wholesale exposures 

 2. Retail exposures 

 3. Securitization exposures 

 4. Equity exposures 

 5. Boundary between operational risk and other risks 

 6. Boundary between the proposed rule and the market risk amendment 

B. Risk-Weighted Assets for General Credit Risk (Wholesale Exposures, Retail 

Exposures, On-Balance Sheet Assets that are not Defined by Exposure Category, 

and Immaterial Credit Exposures) 

 1. Phase 1 – Categorization of exposures 

2. Phase 2 – Assignment of wholesale obligors and exposures to rating grades 

and retail exposures to segments 

 Purchased wholesale receivables 

 Wholesale lease residuals 

3. Phase 3 – Assignment of risk parameters to wholesale obligors and exposures 

and retail segments 

 4. Phase 4 – Calculation of risk-weighted assets 

5. Statutory provisions on the regulatory capital treatment of certain mortgage 

loans 

C. Credit Risk Mitigation Techniques 

 1. Collateral 

 2. EAD for counterparty credit risk 

 EAD for repo-style transactions and eligible margin loans 

 Collateral haircut approach 

 Standard supervisory haircuts 

Own estimates of haircuts 

Simple VaR methodology 

 3. EAD for OTC derivative contracts 

 Current exposure methodology 

4. Internal models methodology 
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Maturity under the internal models methodology 

Collateral agreements under the internal models methodology 

Internal estimate of alpha 

Alternative models 

 5. Guarantees and credit derivatives that cover wholesale exposures 

Eligible guarantees and eligible credit derivatives 

 PD substitution approach 

 LGD adjustment approach 

 Maturity mismatch haircut 

 Restructuring haircut 

 Currency mismatch haircut 

 Example 

Multiple credit risk mitigants 

 Double default treatment 

 6. Guarantees and credit derivatives that cover retail exposures 

 

D. Unsettled Securities, Foreign Exchange, and Commodity Transactions 

 

E. Securitization Exposures 

 1. Hierarchy of approaches 

 Exceptions to the general hierarchy of approaches 

 Servicer cash advances 

Amount of a securitization exposure 

Implicit support 

 Operational requirements for traditional securitizations 

 Clean-up calls 

 2. Ratings-based approach (RBA) 

 3. Internal assessment approach (IAA) 

 4. Supervisory formula approach (SFA) 

 General requirements 

 Inputs to the SFA formula 

 5. Eligible disruption liquidity facilities 

 6. Credit risk mitigation for securitization exposures 

 7. Synthetic securitizations 

 Background 

Operational requirements for synthetic securitizations 

 First-loss tranches 

 Mezzanine tranches 

 Super-senior tranches 

 8. Nth-to-default credit derivatives 

 9. Early amortization provisions 

 Background 

 Controlled early amortization 

 Noncontrolled early amortization 

 
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F. Equity Exposures 

1. Introduction and exposure measurement 

 Hedge transactions 

 Measures of hedge effectiveness 

 2. Simple risk-weight approach (SRWA) 

 Non-significant equity exposures 

 3. Internal models approach (IMA) 

 IMA qualification 

 Risk-weighted assets under the IMA 

 4. Equity exposures to investment funds 

 Full look-through approach 

 Simple modified look-through approach 

 Alternative modified look-through approach 

VI. Operational Risk 

VII. Disclosure 

1. Overview 

 Comments on ANPR 

 2. General requirements 

 Frequency/timeliness 

 Location of disclosures and audit/certification requirements 

 Proprietary and confidential information 

 3. Summary of specific public disclosure requirements 

 4. Regulatory reporting 

I. Introduction 

A. Background 

On August 4, 2003, the agencies issued an advance notice of proposed rulemaking 

(ANPR) (68 FR 45900) that sought public comment on a new risk-based regulatory 

capital framework based on the Basel Committee on Banking Supervision (BCBS)2 April 

2003 consultative paper entitled “The New Basel Capital Accord” (Proposed New 

Accord). The Proposed New Accord set forth a “three pillar” framework encompassing 

risk-based capital requirements for credit risk, market risk, and operational risk (Pillar 1); 

 

2

 The BCBS is a committee of banking supervisory authorities, which was established by the central bank 

governors of the G-10 countries in 1975. It consists of senior representatives of bank supervisory 

authorities and central banks from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the 

Netherlands, Spain, Sweden, Switzerland, the United Kingdom, and the United States. 
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59

supervisory review of capital adequacy (Pillar 2); and market discipline through 

enhanced public disclosures (Pillar 3). The Proposed New Accord incorporated several 

methodologies for determining a bank’s risk-based capital requirements for credit, 

market, and operational risk.3

 

The ANPR sought comment on selected regulatory capital approaches contained 

in the Proposed New Accord that the agencies believe are appropriate for large, 

internationally active U.S. banks. These approaches include the internal ratings-based 

(IRB) approach for credit risk and the advanced measurement approaches (AMA) for 

operational risk (together, the advanced approaches). The IRB framework uses risk 

parameters determined by a bank’s internal systems in the calculation of the bank’s credit 

risk capital requirements. The AMA relies on a bank’s internal estimates of its 

operational risks to generate an operational risk capital requirement for the bank. The 

ANPR included a number of questions highlighting various issues for the industry’s 

consideration. The agencies received approximately 100 public comments on the ANPR 

from banks, trade associations, supervisory authorities, and other interested parties. 

These comments addressed the agencies’ specific questions as well as a range of other 

issues. Commenters generally encouraged further development of the framework, and 

most supported the overall direction of the ANPR. Commenters did, however, raise a 

 

3

 The BCBS developed the Proposed New Accord to modernize its first capital Accord, which was 

endorsed by the G-10 governors in 1988 and implemented by the agencies in the United States in 1989. 

The BCBS’s 1988 Accord is described in a document entitled “International Convergence of Capital 

Measurement and Capital Standards.” This document and other documents issued by the BCBS are 

available through the Bank for International Settlements website at www.bis.org. The agencies’ 

implementing regulations are available at 12 CFR part 3, Appendices A and B (national banks); 12 CFR 

part 208, Appendices A and E (state member banks); 12 CFR part 225, Appendices A and E (bank holding 

companies); 12 CFR part 325, Appendices A and C (state non-member banks); and 12 CFR part 567 

(savings associations).
 Draft Basel II NPR 

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number of conceptual and technical issues that they believed required additional 

consideration. 

 Since the issuance of the ANPR, the agencies have worked domestically and with 

other BCBS member countries to modify the methodologies in the Proposed New Accord 

to reflect comments received during the international consultation process and the U.S. 

ANPR comment process. In June 2004, the BCBS issued a document entitled 

“International Convergence of Capital Measurement and Capital Standards: A Revised 

Framework” (New Accord or Basel II). The New Accord recognizes developments in 

financial products, incorporates advances in risk measurement and management 

practices, and assesses capital requirements that are generally more sensitive to risk. It is 

intended for use by individual countries as the basis for national consultation and 

implementation. Accordingly, the agencies are issuing this proposed rule to implement 

the New Accord for banks in the United States. 

B. Conceptual Overview 

 The framework outlined in this proposal (IRB framework) is intended to produce 

risk-based capital requirements that are more risk-sensitive than the existing risk-based 

capital rules of the agencies (general risk-based capital rules). The proposed framework 

seeks to build on improvements to risk assessment approaches that a number of large 

banks have adopted over the last decade. In particular, the proposed framework requires 

banks to assign risk parameters to exposures and provides specific risk-based capital 

formulas that would be used to transform these risk parameters into risk-based capital 

requirements. 
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 The proposed framework is based on the “value-at-risk” (VaR) approach to 

measuring credit risk and operational risk. VaR modeling techniques for measuring risk 

have been the subject of economic research and are used by large banks. The proposed 

framework has benefited significantly from comments on the ANPR, as well as 

consultations organized in conjunction with the BCBS’s development of the New 

Accord. Because bank risk measurement practices are both continually evolving and 

subject to model and other errors, the proposed framework should be viewed less as an 

effort to produce a statistically precise measurement of risk, and more as an effort to 

improve the risk sensitivity of the risk-based capital requirements for banks. 

 The proposed framework’s conceptual foundation is based on the view that risk 

can be quantified through the assessment of specific characteristics of the probability 

distribution of potential losses over a given time horizon. This approach assumes that a 

suitable estimate of that probability distribution, or at least of the specific characteristics 

to be measured, can be produced. Figure 1 illustrates some of the key concepts 

associated with the proposed framework. The figure shows a probability distribution of 

potential losses associated with some time horizon (for example, one year). It could 

reflect, for example, credit losses, operational losses, or other types of losses. 
 Draft Basel II NPR 

62

 

The area under the curve to the right of a particular loss amount is the probability 

of experiencing losses exceeding this amount within a given time horizon. The figure 

also shows the statistical mean of the loss distribution, which is equivalent to the amount 

of loss that is “expected” over the time horizon. The concept of “expected loss” (EL) is 

distinguished from that of “unexpected loss” (UL), which represents potential losses over 

and above the expected loss amount. A given level of unexpected loss can be defined by 

reference to a particular percentile threshold of the probability distribution. In the figure, 

for example, the 99.9th percentile is shown. Unexpected losses, measured at the 99.9th

percentile level, are equal to the value of the loss distribution corresponding to the 99.9th

percentile, less the amount of expected losses. This is shown graphically at the bottom of 

the figure. 

 The particular percentile level chosen for the measurement of unexpected losses is 

referred to as the “confidence level” or the “soundness standard” associated with the 

Mean 

Expected Losses 

99.9 percentile 

Losses

Figure 1 − Probability Distribution of Potential Losses 

Unexpected Losses 

Probability
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measurement. If capital is available to cover losses up to and including this percentile 

level, then the bank will remain solvent in the face of actual losses of that magnitude. 

Typically, the choice of confidence level or soundness standard reflects a very high 

percentile level, so that there is a very low estimated probability that actual losses would 

exceed the unexpected loss amount associated with that confidence level or soundness 

standard. 

 Assessing risk and assigning regulatory capital requirements by reference to a 

specific percentile of a probability distribution of potential losses is commonly referred to 

as a VaR approach. Such an approach was adopted by the FDIC, Board, and OCC for 

assessing a bank’s risk-based capital requirements for market risk in 1996 (market risk 

amendment or MRA). Under the MRA, a bank’s own internal models are used to 

estimate the 99th percentile of the bank’s market risk loss distribution over a ten-businessday horizon. The bank’s market risk capital requirement is based on this VaR estimate, 

generally multiplied by a factor of three. The agencies implemented this multiplication 

factor to provide a prudential buffer for market volatility and modeling error. 

1. The IRB framework for credit risk

The conceptual foundation of this proposal’s approach to credit risk capital 

requirements is similar to the MRA’s approach to market risk capital requirements, in the 

sense that each is VaR-oriented. That is, the proposed framework bases minimum credit 

risk capital requirements largely on estimated statistical measures of credit risk. 

Nevertheless, there are important differences between this proposal and the MRA. The 

MRA approach for assessing market risk capital requirements currently employs a 

nominal confidence level of 99.0 percent and a ten-business-day horizon, but otherwise 
 Draft Basel II NPR 

64

provides banks with substantial modeling flexibility in determining their market risk loss 

distribution and capital requirements. In contrast, the IRB framework for assessing credit 

risk capital requirements is based on a 99.9 percent nominal confidence level, a one-year 

horizon, and a supervisory model of credit losses embodying particular assumptions 

about the underlying drivers of portfolio credit risk, including loss correlations among 

different asset types.4 

 The IRB framework is broadly similar to the credit VaR approaches used by 

many banks as the basis for their internal assessment of the economic capital necessary to 

cover credit risk. It is common for a bank’s internal credit risk models to consider a oneyear loss horizon, and to focus on a high loss threshold confidence level. As with the 

internal credit VaR models used by banks, the output of the risk-based capital formulas in 

the IRB framework is an estimate of the amount of credit losses above expected credit 

losses (ECL) over a one-year horizon that would only be exceeded a small percentage of 

the time. The agencies believe that a one-year horizon is appropriate because it balances 

the fact that banking book positions likely could not be easily or rapidly exited with the 

possibility that in many cases a bank can cover credit losses by raising additional capital 

should the underlying credit problems manifest themselves gradually. The nominal 

confidence level of the IRB risk-based capital formulas (99.9 percent) means that if all 

the assumptions in the IRB supervisory model for credit risk were correct for a bank, 

 

4

 The theoretical underpinnings for the supervisory model of credit risk underlying this proposal are 

provided in Michael Gordy, “A Risk-Factor Model Foundation for Ratings-Based Bank Capital Rules,” 

Journal of Financial Intermediation, July 2003. The IRB formulas are derived as an application of these 

results to a single-factor CreditMetrics-style model. For mathematical details on this model, see Michael 

Gordy, “A Comparative Anatomy of Credit Risk Models,” Journal of Banking and Finance, January 2000, 

or H.U. Koyluogu and A. Hickman, “Reconcilable Differences,” Risk, October 1998. For a less technical 

overview of the IRB formulas, see the BCBS’s “An Explanatory Note on the Basel II Risk Weight 

Functions,” July 2005 (Explanatory Note). The document can be found on the Bank for International 

Settlements website at www.bis.org. 
 Draft Basel II NPR 

65

there would be less than a 0.1 percent probability that credit losses at the bank in any year 

would exceed the IRB risk-based capital requirement.5

 

 As noted above, the supervisory model of credit risk underlying the IRB 

framework embodies specific assumptions about the economic drivers of portfolio credit 

risk at banks. As with any modeling approach, these assumptions represent 

simplifications of very complex real-world phenomena and, at best, are only an 

approximation of the actual credit risks at any bank. To the extent these assumptions 

(described in greater detail below) do not characterize a given bank precisely, the actual 

confidence level implied by the IRB risk-based capital formulas may exceed or fall short 

of the framework’s nominal 99.9 percent confidence level. 

 In combination with other supervisory assumptions and parameters underlying 

this proposal, the IRB framework’s 99.9 percent nominal confidence level reflects a 

judgmental pooling of available information, including supervisory experience. The 

framework underlying this proposal reflects a desire on the part of the agencies to achieve 

(i) relative risk-based capital requirements across different assets that are broadly 

consistent with maintaining at least an investment grade rating (for example, at least 

BBB) on the liabilities funding those assets, even in periods of economic adversity; and 

(ii) for the U.S. banking system as a whole, aggregate minimum regulatory capital 

requirements that are not a material reduction from the aggregate minimum regulatory 

capital requirements under the general risk-based capital rules. 

 

5

 Banks’ internal economic capital models typically focus on measures of equity capital, whereas the total 

regulatory capital measure underlying this proposal includes not only equity capital, but also certain debt 

and hybrid instruments, such as subordinated debt. Thus, the 99.9 percent nominal confidence level 

embodied in the IRB framework is not directly comparable to the nominal solvency standards underpinning 

banks’ economic capital models. 
 Draft Basel II NPR 

66

A number of important explicit generalizing assumptions and specific parameters 

are built into the IRB framework to make the framework applicable to a range of banks 

and to obtain tractable information for calculating risk-based capital requirements. Chief 

among the assumptions embodied in the IRB framework are: (i) assumptions that a 

bank’s credit portfolio is infinitely granular; (ii) assumptions that loan defaults at a bank 

are driven by a single, systematic risk factor; (iii) assumptions that systematic and nonsystematic risk factors are log-normal random variables; and (iv) assumptions regarding 

correlations among credit losses on various types of assets. 

 The specific risk-based capital formulas in this proposed rule require the bank to 

estimate certain risk parameters for its wholesale and retail exposures, which the bank 

may do using a variety of techniques. These risk parameters are probability of default 

(PD), expected loss given default (ELGD), loss given default (LGD), exposure at default 

(EAD), and, for wholesale exposures, effective remaining maturity (M). The risk-based 

capital formulas into which the estimated risk parameters are inserted are simpler than the 

economic capital methodologies typically employed by banks (which often require 

complex computer simulations). In particular, an important property of the IRB riskbased capital formulas is portfolio invariance. That is, the risk-based capital requirement 

for a particular exposure generally does not depend on the other exposures held by the 

bank. Like the general risk-based capital rules, the total credit risk capital requirement 

for a bank’s wholesale and retail exposures is the sum of the credit risk capital 

requirements on individual wholesale exposures and retail exposures. 

The IRB risk-based capital formulas contain supervisory asset value correlation 

(AVC) factors, which have a significant impact on the capital requirements generated by 
 Draft Basel II NPR 

67

the formulas. The AVC assigned to a given portfolio of exposures is an estimate of the 

degree to which any unanticipated changes in the financial conditions of the underlying 

obligors of the exposures are correlated (that is, would likely move up and down 

together). High correlation of exposures in a period of economic downturn conditions is 

an area of supervisory concern. For a portfolio of exposures having the same risk 

parameters, a larger AVC implies less diversification within the portfolio, greater overall 

systematic risk, and, hence, a higher risk-based capital requirement.6 For example, a 15 

percent AVC for a portfolio of residential mortgage exposures would result in a lower 

risk-based capital requirement than a 20 percent AVC and a higher risk-based capital 

requirement than a 10 percent AVC. 

The AVCs that appear in the IRB risk-based capital formulas for wholesale 

exposures decline with increasing PD; that is, the IRB risk-based capital formulas 

generally imply that a group of low-PD wholesale exposures are more correlated than a 

group of high-PD wholesale exposures. Thus, under the proposed rule, a low-PD 

wholesale exposure would have a higher relative risk-based capital requirement than that 

implied by its PD were the AVC in the IRB risk-based capital formulas for wholesale 

exposures fixed rather than a function of PD. This inverse relationship between PD and 

AVC for wholesale exposures is broadly consistent with empirical research undertaken 

by G10 supervisors and moderates the sensitivity of IRB risk-based capital requirements 

for wholesale exposures to the economic cycle. Question 1: The agencies seek comment 

on and empirical analysis of the appropriateness of the proposed rule’s AVCs for 

wholesale exposures in general and for various types of wholesale exposures (for 

example, commercial real estate exposures).

 

6

 See Explanatory Note. 
 Draft Basel II NPR 

68

The AVCs included in the IRB risk-based capital formulas for retail exposures 

also reflect a combination of supervisory judgment and empirical evidence.7

 However, 

the historical data available for estimating these correlations was more limited than was 

the case with wholesale exposures, particularly for non-mortgage retail exposures. As a 

result, supervisory judgment played a greater role. Moreover, the flat 15 percent AVC 

for residential mortgage exposures is based largely on empirical analysis of traditional 

long-term, fixed-rate mortgages. Question 2: The agencies seek comment on and 

empirical analysis of the appropriateness and risk sensitivity of the proposed rule’s AVC 

for residential mortgage exposures – not only for long-term, fixed-rate mortgages, but 

also for adjustable-rate mortgages, home equity lines of credit, and other mortgage 

products – and for other retail portfolios.

Another important conceptual element of the IRB framework concerns the 

treatment of EL. The ANPR generally would have required banks to hold capital against 

the measured amount of UL plus EL over a one-year horizon, except in the limited 

instance of credit card exposures where future margin income (FMI) was allowed to 

offset EL. The ANPR treatment also would have maintained the existing definition of 

regulatory capital, which includes the allowance for loan and lease losses (ALLL) in tier 

2 capital up to a limit equal to 1.25 percent of risk-weighted assets. The ANPR requested 

comment on the proposed treatment of EL. Many commenters on the ANPR objected to 

this treatment on conceptual grounds, arguing that capital is not the appropriate 

mechanism for covering EL. In response to this feedback, the agencies sought and 

obtained changes to the BCBS’s proposals in this area. 

 The agencies supported the BCBS’s proposal, announced in October 2003, to 

 

7

 See Explanatory Note, section 5.3. 
 Draft Basel II NPR 

69

remove ECL (as defined below) from the risk-weighted assets calculation. This NPR, 

consistent with the New Accord, removes ECL from the risk-weighted assets calculation 

but requires a bank to compare its ECL to its eligible credit reserves (as defined below). 

If a bank’s ECL exceeds its eligible credit reserves, the bank must deduct the excess ECL 

amount 50 percent from tier 1 capital and 50 percent from tier 2 capital. If a bank’s 

eligible credit reserves exceed its ECL, the bank would be able to include the excess 

eligible credit reserves amount in tier 2 capital, up to 0.6 percent of the bank’s credit riskweighted assets. This treatment is intended to maintain a capital incentive to reserve 

prudently and seeks to ensure that ECL over a one-year horizon is covered either by 

reserves or capital. This treatment also recognizes that prudent reserving that considers 

probable losses over the life of a loan may result in a bank holding reserves in excess of 

ECL measured with a one-year horizon. The BCBS calibrated the proposed 0.6 percent 

limit on inclusion of excess reserves in tier 2 capital to be approximately as restrictive as 

the existing cap on the inclusion of ALLL under the general risk-based capital rules, 

based on data obtained in the BCBS’s Third Quantitative Impact Study (QIS-3).8

 

Question 3: The agencies seek comment and supporting data on the appropriateness of 

this limit.

The agencies are aware that certain banks believe that FMI should be eligible to 

cover ECL for the purposes of such a calculation, while other banks have asserted that, 

for certain business lines, prudential reserving practices do not involve setting reserves at 

levels consistent with ECL over a horizon as long as one year. The agencies nevertheless 

believe that the proposed approach is appropriate because banks should receive riskbased capital benefits only for the most highly reliable ECL offsets. 

 

8

 BCBS, “QIS 3: Third Quantitative Impact Study,” May 2003. 
 Draft Basel II NPR 

70

 The combined impact of these changes in the treatment of ECL and reserves will 

depend on the reserving practices of individual banks. Nevertheless, if other factors are 

equal, the removal of ECL from the calculation of risk-weighted assets will result in a 

lower amount of risk-weighted assets than the proposals in the ANPR. However, the 

impact on risk-based capital ratios should be partially offset by related changes to the 

numerators of the risk-based capital ratios – specifically, (i) the ALLL will be allowed in 

tier 2 capital up to certain limits only to the extent that it and certain other reserves 

exceed ECL, and (ii) if ECL exceeds reserves, the reserve shortfall must be deducted 

50 percent from tier 1 capital and 50 percent from tier 2 capital. 

Using data from QIS-3, the BCBS conducted an analysis of the risk-based capital 

requirements that would be generated under the New Accord, taking into account the 

aggregate effect of ECL-related changes to both the numerator and the denominator of 

the risk-based capital ratios. The BCBS concluded that to offset these changes relative to 

the credit risk-based capital requirements of the Proposed New Accord, it might be 

necessary under the New Accord to apply a “scaling factor” (multiplier) to credit riskweighted assets. The BCBS, in the New Accord, indicated that the best estimate of the 

scaling factor using QIS-3 data adjusted for the EL-UL decisions was 1.06. The BCBS 

noted that a final determination of any scaling factor would be reconsidered prior to full 

implementation of the new framework. The agencies are proposing a multiplier of 1.06 

at this time, consistent with the New Accord. 

The agencies note that a 1.06 multiplier should be viewed as a placeholder. The 

BCBS is expected to revisit the determination of a scaling factor based on the results of 
 Draft Basel II NPR 

71

the latest international QIS (QIS-5, which was not conducted in the United States).9 The 

agencies will consider the BCBS’s determination, as well as other factors including the 

most recent QIS conducted in the United States (QIS-4, which is described below),10 in 

determining a multiplier for the final rule. As the agencies gain more experience with the 

proposed advanced approaches, the agencies will revisit the scaling factor along with 

other calibration issues identified during the parallel run and transitional floor periods 

(described below) and make changes to the rule as necessary. While a scaling factor is 

one way to ensure that regulatory capital is maintained at a certain level, particularly in 

the short- to medium-term, the agencies also may address calibration issues through 

modifications to the underlying IRB risk-based capital formulas. 

2. The AMA for operational risk 

 The proposed rule also includes the AMA for determining risk-based capital 

requirements for operational risk. Under the proposed rule, operational risk is defined as 

the risk of loss resulting from inadequate or failed internal processes, people, and systems 

or from external events. This definition of operational risk includes legal risk – which is 

the risk of loss (including litigation costs, settlements, and regulatory fines) resulting 

from the failure of the bank to comply with laws, regulations, prudent ethical standards, 

and contractual obligations in any aspect of the bank’s business – but excludes strategic 

and reputational risks. 

Under the AMA, a bank would use its internal operational risk management 

systems and processes to assess its exposure to operational risk. Given the complexities 

involved in measuring operational risk, the AMA provides banks with substantial 

 

9

 See http://www.bis.org/bcbs/qis/qis5.htm. 10See “Summary Findings of the Fourth Quantitative Impact Study,” February 24, 2006. 
 Draft Basel II NPR 

72

flexibility and, therefore, does not require a bank to use specific methodologies or 

distributional assumptions. Nevertheless, a bank using the AMA must demonstrate to the 

satisfaction of its primary Federal supervisor that its systems for managing and measuring 

operational risk meet established standards, including producing an estimate of 

operational risk exposure that meets a one-year, 99.9th percentile soundness standard. A 

bank’s estimate of operational risk exposure includes both expected operational loss 

(EOL) and unexpected operational loss (UOL) and forms the basis of the bank’s riskbased capital requirement for operational risk. 

The AMA allows a bank to base its risk-based capital requirement for operational 

risk on UOL alone if the bank can demonstrate to the satisfaction of its primary Federal 

supervisor that the bank has eligible operational risk offsets, such as certain operational 

risk reserves, that equal or exceed the bank’s EOL. To the extent that eligible operational 

risk offsets are less than EOL, the bank’s risk-based capital requirement for operational 

risk must incorporate the shortfall. 

C. Overview of Proposed Rule 

The proposed rule maintains the general risk-based capital rules’ minimum tier 1 

risk-based capital ratio of 4.0 percent and total risk-based capital ratio of 8.0 percent. 

The components of tier 1 and total capital are also generally the same, with a few 

adjustments described in more detail below. The primary difference between the general 

risk-based capital rules and the proposed rule is the methodologies used for calculating 

risk-weighted assets. Banks applying the proposed rule generally would use their internal 

risk measurement systems to calculate the inputs for determining the risk-weighted asset 

amounts for (i) general credit risk (including wholesale and retail exposures); (ii) 
 Draft Basel II NPR 

73

securitization exposures; (iii) equity exposures; and (iv) operational risk. In certain cases, 

however, external ratings or supervisory risk weights would be used to determine riskweighted asset amounts. Each of these areas is discussed below. 

Banks using the proposed rule also would be subject to supervisory review of 

their capital adequacy (Pillar 2) and certain public disclosure requirements to foster 

transparency and market discipline (Pillar 3). In addition, each bank using the advanced 

approaches would continue to be subject to the tier 1 leverage ratio requirement, and each 

depository institution (DI) (as defined in section 3 of the Federal Deposit Insurance Act 

(12 U.S.C. 1813)) using the advanced approaches would continue to be subject to the 

prompt corrective action (PCA) thresholds. Those banks subject to the MRA also would 

continue to be subject to the MRA. 

Under the proposed rule, a bank must identify whether each of its on- and offbalance sheet exposures is a wholesale, retail, securitization, or equity exposure. Assets 

that are not defined by any exposure category (and certain immaterial portfolios of 

exposures) generally would be assigned risk-weighted asset amounts equal to their 

carrying value (for on-balance sheet exposures) or notional amount (for off-balance sheet 

exposures). 

Wholesale exposures under the proposed rule include most credit exposures to 

companies and governmental entities. For each wholesale exposure, a bank would assign 

five quantitative risk parameters: PD (which is stated as a percentage and measures the 

likelihood that an obligor will default over a one-year horizon); ELGD (which is stated as 

a percentage and is an estimate of the economic loss rate if a default occurs); LGD 

(which is stated as a percentage and is an estimate of the economic loss rate if a default 
 Draft Basel II NPR 

74

occurs during economic downturn conditions); EAD (which is measured in dollars and is 

an estimate of the amount that would be owed to the bank at the time of default); and M 

(which is measured in years and reflects the effective remaining maturity of the 

exposure). Banks would be able to factor into their risk parameter estimates the risk 

mitigating impact of collateral, credit derivatives, and guarantees that meet certain 

criteria. Banks would input the risk parameters for each wholesale exposure into an IRB 

risk-based capital formula to determine the risk-based capital requirement for the 

exposure. 

Retail exposures under the proposed rule include most credit exposures to 

individuals and small businesses that are managed as part of a segment of exposures with 

similar risk characteristics, not on an individual-exposure basis. A bank would classify 

each of its retail exposures into one of three retail subcategories – residential mortgage 

exposures, qualifying revolving exposures (QREs) (for example, credit cards and 

overdraft lines), and other retail exposures. Within these three subcategories, the bank 

would group exposures into segments with similar risk characteristics. The bank would 

then assign the risk parameters PD, ELGD, LGD, and EAD to each retail segment. The 

bank would be able to take into account the risk mitigating impact of collateral and 

guarantees in the segmentation process and in the assignment of risk parameters to retail 

segments. Like wholesale exposures, the risk parameters for each retail segment would 

be used as inputs into an IRB risk-based capital formula to determine the risk-based 

capital requirement for the segment. Question 4: The agencies seek comment on the use 

of a segment-based approach rather than an exposure-by-exposure approach for retail 

exposures. 
 Draft Basel II NPR 

75

For securitization exposures, the bank would apply one of three general 

approaches, subject to various conditions and qualifying criteria: the Ratings-Based 

Approach (RBA), which uses external ratings to risk-weight exposures; an Internal 

Assessment Approach (IAA), which uses internal ratings to risk-weight exposures to 

asset-backed commercial paper programs (ABCP programs); or the Supervisory Formula 

Approach (SFA). Securitization exposures in the form of gain-on-sale or creditenhancing interest-only strips (CEIOs)11 and securitization exposures that do not qualify 

for the RBA, the IAA, or the SFA would be deducted from regulatory capital. 

Banks would be able to use an internal models approach (IMA) for determining 

risk-based capital requirements for equity exposures, subject to certain qualifying criteria 

and floors. If a bank does not have a qualifying internal model for equity exposures, or 

chooses not to use such a model, the bank must apply a simple risk weight approach 

(SRWA) in which publicly traded equity exposures would have a 300 percent risk weight 

and non-publicly traded equity exposures would have a 400 percent risk weight. Under 

both the IMA and the SRWA, equity exposures to certain entities or made pursuant to 

certain statutory authorities would be subject to a 0 to 100 percent risk weight. 

Banks would have to develop qualifying AMA systems to determine risk-based 

capital requirements for operational risk. Under the AMA, a bank would use its own 

methodology to identify operational loss events, measure its exposure to operational risk, 

and assess a risk-based capital requirement for operational risk. 

 

11 A CEIO is an on-balance sheet asset that (i) represents the contractual right to receive some or all of the 

interest and no more than a minimal amount of principal due on the underlying exposures of a 

securitization and (ii) exposes the holder to credit risk directly or indirectly associated with the underlying 

exposures that exceeds its pro rata claim on the underlying exposures whether through subordination 

provisions or other credit-enhancement techniques.
 Draft Basel II NPR 

76

Under the proposed rule, a bank would calculate its risk-based capital ratios by 

first converting any dollar risk-based capital requirements for exposures produced by the 

IRB risk-based capital formulas into risk-weighted asset amounts by multiplying the 

capital requirements by 12.5 (the inverse of the overall 8.0 percent risk-based capital 

requirement). After determining the risk-weighted asset amounts for credit risk and 

operational risk, a bank would sum these amounts and then subtract any allocated transfer 

risk reserves and excess eligible credit reserves not included in tier 2 capital (defined 

below) to determine total risk-weighted assets. The bank would then calculate its riskbased capital ratios by dividing its tier 1 capital and total qualifying capital by the total 

risk-weighted assets amount. 

The proposed rule contains specific public disclosure requirements to provide 

important information to market participants on the capital structure, risk exposures, risk 

assessment processes, and, hence, the capital adequacy of a bank. The public disclosure 

requirements would apply only to the DI or bank holding company representing the top 

consolidated level of the banking group that is subject to the advanced approaches. In 

addition, the agencies are also publishing today proposals to require certain disclosures 

from subsidiary DIs in the banking group through the supervisory reporting process. The 

agencies believe that the reporting of key risk parameter estimates for each DI applying 

the advanced approaches will provide the primary Federal supervisor of the DI and other 

relevant supervisors with important data for assessing the reasonableness and accuracy of 

the institution’s calculation of its risk-based capital requirements under this proposal and 

the adequacy of the institution’s capital in relation to its risks. Some of the proposed 

supervisory reports would be publicly available (for example, on the Call Report or Thrift 
 Draft Basel II NPR 

77

Financial Report), and others would be confidential disclosures to the agencies to 

augment the supervisory process. 

D. Structure of Proposed Rule 

The agencies are considering implementing a comprehensive regulatory 

framework for the advanced approaches in which each agency would have an advanced 

approaches regulation or appendix that sets forth (i) the elements of tier 1 and tier 2 

capital and associated adjustments to the risk-based capital ratio numerator, (ii) the 

qualification requirements for using the advanced approaches, and (iii) the details of the 

advanced approaches. For proposal purposes, the agencies are issuing a single proposed 

regulatory text for comment. Unless otherwise indicated, the term “bank” in the 

regulatory text includes banks, savings associations, and BHCs. The term “[AGENCY]” 

in the regulatory text refers to the primary Federal supervisor of the bank applying the 

rule. Areas where the regulatory text would differ by agency – for example, provisions 

that would only apply to savings associations or to BHCs – are generally indicated in 

appropriate places in the regulatory text. 

In this proposed rule, the agencies are not restating the elements of tier 1 and tier 

2 capital, which would generally remain the same as under the general risk-based capital 

rules. Adjustments to the risk-based capital ratio numerators specific to banks applying 

the advanced approaches are in part II of the proposed rule and explained in greater detail 

in section IV of this preamble. The OCC, Board, and FDIC also are proposing to 

incorporate their existing market risk rules by cross-reference and are proposing 

modifications to the market risk rules in a separate NPR issued concurrently.12 The 

OTS is proposing its own market risk rule, including the proposed modifications, as a 

 

12 [Cite to Federal Register page]. 
 Draft Basel II NPR 

78

part of that separate NPR. In addition, the agencies may need to make additional 

conforming amendments to certain of their regulations that use tier 1 or total qualifying 

capital or the risk-based capital ratios for various purposes. 

The proposed rule is structured in eight broad parts. Part I identifies criteria for 

determining which banks are subject to the rule, provides key definitions, and sets forth 

the minimum risk-based capital ratios. Part II describes the adjustments to the numerator 

of the risk-based capital ratios for banks using the advanced approaches. Part III 

describes the qualification process and provides qualification requirements for obtaining 

supervisory approval for use of the advanced approaches. This part incorporates critical 

elements of supervisory oversight of capital adequacy (Pillar 2). 

Parts IV through VII address the calculation of risk-weighted assets. Part IV 

provides the risk-weighted assets calculation methodologies for wholesale and retail 

exposures; on-balance sheet assets that do not meet the regulatory definition of a 

wholesale, retail, securitization, or equity exposure; and certain immaterial portfolios of 

credit exposures. This part also describes the risk-based capital treatment for over-thecounter (OTC) derivative contracts, repo-style transactions, and eligible margin loans. In 

addition, this part describes the methodology for reflecting eligible credit risk mitigation 

techniques in risk-weighted assets for wholesale and retail exposures. Furthermore, this 

part sets forth the risk-based capital requirements for failed and unsettled securities, 

commodities, and foreign exchange transactions. 

Part V identifies operating criteria for recognizing risk transference in the 

securitization context and outlines the approaches for calculating risk-weighted assets for 

securitization exposures. Part VI describes the approaches for calculating risk-weighted 
 Draft Basel II NPR 

79

assets for equity exposures. Part VII describes the calculation of risk-weighted assets for 

operational risk. Finally, Part VIII provides public disclosure requirements for banks 

employing the advanced approaches (Pillar 3). 

 The structure of the preamble generally follows the structure of the proposed 

regulatory text. Definitions, however, are discussed in the portions of the preamble 

where they are most relevant. 

E. Quantitative Impact Study 4 and Overall Capital Objectives 

1. Quantitative Impact Study 4

After the BCBS published the New Accord, the agencies conducted the additional 

quantitative impact study referenced above, QIS-4, in the fall and winter of 2004-2005, to 

better understand the potential impact of the proposed framework on the risk-based 

capital requirements for individual U.S. banks and U.S. banks as a whole. The results 

showed a substantial dollar-weighted average decline and variation in risk-based capital 

requirements across the 26 participating U.S. banks and their portfolios.13 In an April 

2005 press release,14 the agencies expressed their concern about the magnitude of the 

drop in QIS-4 risk-based capital requirements and the dispersion of those requirements 

and decided to undertake further analysis. 

The QIS-4 analysis indicated a dollar-weighted average reduction of 15.5 percent 

in risk-based capital requirements at participating banks when moving from the current 

 

13 Since neither an NPR and associated supervisory guidance nor final regulations implementing a Basel IIbased framework had been issued in the United States at the time of data collection, all QIS-4 results 

relating to the U.S. implementation of Basel II are based on the description of the framework contained in 

the QIS-4 instructions. These instructions differed from the framework issued by the BCBS in June 2004 

in several respects. For example, the QIS-4 articulation of the Basel II framework does not include the 1.06 

scaling factor. The QIS-4 instructions are available at www.ffiec.gov/qis4. 14 See “Banking Agencies to Perform Additional Analysis Before Issuing Notice of Proposed Rulemaking 

Related to Basel II,” Apr. 29, 2005. 
 Draft Basel II NPR 

80

Basel I-based framework to a Basel II-based framework.15 Table A provides a numerical 

summary of the QIS-4 results, in total and by portfolio, aggregated across all QIS-4 

participants.16 The first column shows changes in dollar-weighted average minimum 

required capital (MRC) both by portfolio and overall, as well as in dollar-weighted 

average overall effective MRC. Column 2 shows the relative contribution of each 

portfolio to the overall dollar-weighted average decline of 12.5 percent in MRC, 

representing both the increase/decrease and relative size of each portfolio. The table also 

shows (column 3) that risk-based capital requirements declined by more than 26 percent 

in half the banks in the study. Most portfolios showed double-digit declines in risk-based 

capital requirements for over half the banks, with the exception of credit cards. It should 

be noted that column 3 gives every participating bank equal weight. Column 4 shows the 

analogous weighted median change, using total exposures as weights. 

Table A — QIS-4 Results 

 

15 The Basel II framework on which QIS-4 is based uses a UL-only approach (even though EL 

requirements were included in QIS-4). But the current Basel I risk-based capital requirements use a 

UL+EL approach. Therefore, in order to compare the Basel II results from QIS-4 with the current Basel I 

requirements, the EL requirements from QIS-4 had to be added to the UL capital requirements from QIS-4. 16 In the table, “Minimum required capital” (MRC) refers to the total risk-based capital requirement before 

incorporating the impact of reserves. “Effective MRC” is equal to MRC adjusted for the impact of 

reserves. As noted above, under the Basel II framework, a shortfall in reserves generally increases the total 

risk-based capital requirement and a surplus in reserves generally reduces the total risk-based capital 

requirement, though not with equal impact.
 Draft Basel II NPR 

81

Column 1: Column 2: Column 3: Column 4: Column 5: Column 6:

Portfolio

% Change 

in Portfolio 

MRC

% Point 

Contrib. to 

MRC 

Change

Median % 

Change in 

Port. MRC

Weighted 

Median % 

Chg in 

Port. MRC

Share of 

Basel I 

MRC

Share of 

Basel II 

MRC*

Wholesale Credit (24.6%) (10.9%) (24.5%) (21.6%) 44.3% 38.2%

Corporate, Bank, Sovereign (21.9%) (7.4%) (29.7%) (13.5%) 33.9% 30.3%

Small Business (26.6%) (1.2%) (27.1%) (24.8%) 4.6% 3.9%

High Volatility CRE (33.4%) (0.6%) (23.2%) (42.4%) 1.8% 1.3%

Income Producing RE (41.4%) (1.7%) (52.5%) (52.4%) 4.0% 2.7%

Retail Credit (25.6%) (7.8%) (49.8%) (28.7%) 30.6% 26.0%

Home Equity (HELOC) (74.3%) (4.6%) (78.6%) (76.8%) 6.1% 1.8%

Residential Mortgage (61.4%) (6.8%) (72.7%) (64.4%) 11.1% 4.9%

Credit Card (QRE) 66.0% 4.0% 62.8% 72.2% 6.1% 11.6%

Other Consumer (6.5%) (0.4%) (35.2%) (18.3%) 6.0% 6.4%

Retail Business Exposures (5.8%) (0.1%) (29.2%) 11.6% 1.2% 1.3%

Equity 6.6% 0.1% (24.4%) 9.6% 1.3% 1.6%

Other assets (11.7%) (1.2%) (3.2%) (11.6%) 10.0% 10.1%

Securitization (17.9%) (1.4%) (39.7%) (45.8%) 8.1% 7.6%

Operational Risk 9.2% 0.0% 10.5%

Trading Book 0.0% 0.0% 0.0% 5.2% 5.9%

Change in MRC (12.5%) (12.5%) (23.8%) (17.1%) 100.0% 100.0%

Change in Effective MRC (15.5%) (26.3%) (21.7%)

* QIS-4 interpretation of Basel II framework as articulated in QIS-4 instructions

QIS-4 Results: Changes in Minimum Required Capital

Notes to the table: The first two columns of the table show the dollar-weighted average percentage change 

in MRC by portfolio and the percentage point contribution of each portfolio to the overall average 

percentage change (of 12.5%). The third column shows the unweighted median percentage change in MRC 

by portfolio. The fourth column shows the weighted median percentage change in MRC by portfolio, 

weighting by total exposures at the portfolio level. The next two columns show the share each portfolio 

contributes to MRC, under the current framework (column 5) and the QIS-4 interpretation of Basel II as 

defined in the QIS-4 instructions (column 6). Entries in parentheses denote negative numbers. There are 

no percentage change numbers for operational risk because it is not separated out as a specific risk-based 

capital requirement under Basel I. 

QIS-4 results (not shown in Table A) also suggested that tier 1 risk-based capital 

requirements under a Basel II-based framework would be lower for many banks than they 

are under the general risk-based capital rules, in part reflecting the move to a UL-only 

risk-based capital requirement. Tier 1 risk-based capital requirements declined by 22 

percent in the aggregate. The unweighted median indicates that half of the participating 

banks reported reductions in tier 1 risk-based capital requirements of over 31 percent. 

The MRC calculations do not take into account the impact of the tier 1 leverage ratio 

requirement. Were such results produced under a fully implemented Basel II-based risk-
 Draft Basel II NPR 

82

based capital regime, the existing tier 1 leverage ratio requirement could be a more 

important constraint than it is currently. 

Evidence from some of the follow-up analysis also illustrated that similar loan 

products at different banks may have resulted in very different risk-based capital 

requirements. Analysis determined that this dispersion in capital requirements not only 

reflected differences in actual risk or portfolio composition, but also reflected differences 

in the banks’ estimated risk parameters for similar exposures. 

Although concerns with dispersion might be remedied to some degree with 

refinements to internal bank risk measurement and management systems and through the 

rulemaking process, the agencies also note that some of the dispersion encountered in the 

QIS-4 exercise is a reflection of the flexibility in methods to quantify the risk parameters 

that may be allowed under implementation of the proposed framework. 

The agencies intend to conduct other analyses of the impact of the Basel II 

framework during both the parallel run and transitional floor periods. These analyses will 

look at both the impact of the Basel II framework and the preparedness of banks to 

compute risk-based capital requirements in a manner consistent with the Basel II 

framework. 

2. Overall capital objectives

The ANPR stated: “The Agencies do not expect the implementation of the New 

Accord to result in a significant decrease in aggregate capital requirements for the U.S. 

banking system. Individual banking organizations may, however, face increases or 
 Draft Basel II NPR 

83

decreases in their minimum risk-based capital requirements because the New Accord is 

more risk sensitive than the 1988 Accord and the Agencies’ existing risk-based capital 

rules (general risk-based capital rules).”17 The ANPR was in this respect consistent with 

statements made by the BCBS in its series of Basel II consultative papers and its final 

text of the New Accord, in which the BCBS stated as an objective broad maintenance of 

the overall level of risk-based capital requirements while allowing some incentives for 

banks to adopt the advanced approaches. 

The agencies remain committed to these objectives. Were the QIS-4 results just 

described produced under an up-and-running risk-based capital regime, the risk-based 

capital requirements generated under the framework would not meet the objectives 

described in the ANPR, and thus would be considered unacceptable. 

When considering QIS-4 results and their implications, it is important to 

recognize that banking organizations participated in QIS-4 on a best-efforts basis. The 

agencies had not qualified any of the participants to use the Basel II framework and had 

not conducted any formal supervisory review of their progress toward meeting the Basel 

II qualification requirements. In addition, the risk measurement and management 

systems of the QIS-4 participants, as indicated by the QIS-4 exercise, did not yet meet the 

Basel II qualification requirements outlined in this proposed rule. 

As banks work with their supervisors to refine their risk measurement and 

management systems, it will become easier to determine the actual quantitative impact of 

the advanced approaches. The agencies have decided, therefore, not to recalibrate the 

framework at the present time based on QIS-4 results, but to await further experience 

with more fully developed bank risk measurement and management systems. 

 

17 68 FR 45900, 45902 (Aug. 4, 2003). 
 Draft Basel II NPR 

84

If there is a material reduction in aggregate minimum regulatory capital 

requirements upon implementation of Basel II-based rules, the agencies will propose 

regulatory changes or adjustments during the transitional floor periods. In this context, 

materiality will depend on a number of factors, including the size, source, and nature of 

any reduction; the risk profiles of banks authorized to use Basel II-based rules; and other 

considerations relevant to the maintenance of a safe and sound banking system. In any 

event, the agencies will view a 10 percent or greater decline in aggregate minimum 

required risk-based capital (without reference to the effects of the transitional floors 

described in a later section of this preamble), compared to minimum required risk-based 

capital as determined under the existing rules, as a material reduction warranting 

modifications to the supervisory risk functions or other aspects of this framework. 

The agencies are, in short, identifying a numerical benchmark for evaluating and 

responding to capital outcomes during the parallel run and transitional floor periods that 

do not comport with the overall capital objectives outlined in the ANPR. At the end of 

the transitional floor periods, the agencies would re-evaluate the consistency of the 

framework, as (possibly) revised during the transitional floor periods, with the capital 

goals outlined in the ANPR and with the maintenance of broad competitive parity 

between banks adopting the framework and other banks, and would be prepared to make 

further changes to the framework if warranted. Question 5: The agencies seek comment 

on this approach to ensuring that overall capital objectives are achieved.

The agencies also noted above that tier 1 capital requirements reported in QIS-4 

declined substantially more than did total capital requirements. The agencies have long 

placed special emphasis on the importance of tier 1 capital in maintaining bank safety and 
 Draft Basel II NPR 

85

soundness because of its ability to absorb losses on a going concern basis. The agencies 

will continue to monitor the trend in tier 1 capital requirements during the parallel run 

and transitional floor periods and will take appropriate action if reductions in tier 1 

capital requirements are inconsistent with the agencies’ overall capital goals. 

Similar to the attention the agencies will give to overall risk-based capital 

requirements for the U.S. banking system, the agencies will carefully consider during the 

transitional floor periods whether dispersion in risk-based capital results across banks and 

portfolios appropriately reflects differences in risk. A conclusion by the agencies that 

dispersion in risk-based capital requirements does not appropriately reflect differences in 

risk could be another possible basis for proposing regulatory adjustments or refinements 

during the transitional floor periods. 

It should also be noted that given the bifurcated regulatory capital framework that 

would result from the adoption of this rule, issues related to overall capital may be 

inextricably linked to the competitive issues discussed elsewhere in this document. The 

agencies indicated in the ANPR that if the competitive effects of differential capital 

requirements were deemed significant, “the Agencies would need to consider potential 

ways to address those effects while continuing to seek the objectives of the current 

proposal. Alternatives could potentially include modifications to the proposed 

approaches, as well as fundamentally different approaches.”18 In this regard, the agencies 

view the parallel run and transitional floor periods as a trial of the new framework under 

controlled conditions. While the agencies hope and expect that regulatory changes 

proposed during those years would be in the nature of adjustments made within the 

 

18 68 FR 45900, 45905 (August 4, 2003). 
 Draft Basel II NPR 

86

framework described in this proposed rule, more fundamental changes cannot be ruled 

out if warranted based on future experience or comments received on this proposal. 

The agencies reiterate that, especially in light of the QIS-4 results, retention of the 

tier 1 leverage ratio and other existing prudential safeguards (for example, PCA) is 

critical for the preservation of a safe and sound regulatory capital framework. In 

particular, the leverage ratio is a straightforward and tangible measure of solvency and 

serves as a needed complement to the risk-sensitive Basel II framework based on internal 

bank inputs. 

F. Competitive Considerations 

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

stability of the international banking system while maintaining sufficient consistency in 

capital adequacy regulation to ensure that the New Accord will not be a significant source 

of competitive inequity among internationally active banks. The agencies support this 

objective and believe that it is crucial to promote continual advancement of the risk 

measurement and management practices of large and internationally active banks. For 

this reason, the agencies propose to implement only the advanced approaches of the New 

Accord because these approaches utilize the most sophisticated and risk-sensitive risk 

measurement and management techniques. 

 While all banks should work to enhance their risk management practices, the 

advanced approaches and the systems required to support their use may not be 

appropriate for many banks from a cost-benefit point of view. For these banks, the 

agencies believe that, with some modifications, the general risk-based capital rules are a 

reasonable alternative. As discussed in section E.2. above, this proposal’s bifurcated 
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approach to risk-based capital requirements raises difficult issues and inextricably links 

competitive considerations with overall capital issues. One such issue relates to concerns 

about competitive inequities between U.S. banks operating under different regulatory 

capital regimes. The ANPR cited this concern, and a number of commenters expressed 

their belief that in some portfolios competitive inequities would be worsened under the 

proposed bifurcated framework. These commenters expressed the concern that the 

Proposed New Accord might place community banks operating under the general riskbased capital rules at a competitive disadvantage to banks applying the advanced 

approaches because the IRB framework would likely result in lower risk-based capital 

requirements on some types of exposures, such as residential mortgage exposures, other 

retail exposures, and small business loans. 

Some commenters asserted that the application of lower risk-based capital 

requirements under the Proposed New Accord would create a competitive disadvantage 

for banks operating under the general risk-based capital rules, which in turn may 

adversely affect their asset quality and cost of capital. Other commenters suggested that 

if the advanced approaches in the Proposed New Accord are implemented, the agencies 

should consider revising their general risk-based capital rules to enhance risk sensitivity 

and to mitigate potential competitive inequities associated with the bifurcated system. 

The agencies recognize that the industry has concerns with the potential 

competitive inequities associated with a bifurcated risk-based capital framework. The 

agencies reaffirm their intention, expressed in the ANPR, to address competitive issues 

while continuing to pursue the objectives of the current proposal. In addition to the QIS4 analysis discussed above, the agencies have also researched discrete topics to further 
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88

understand where competitive pressures might arise. As part of their effort to develop a 

bifurcated risk-based capital framework that minimizes competitive inequities and is not 

disruptive to the banking sector, the agencies issued an Advance Notice of Proposed 

Rulemaking (Basel IA ANPR) considering various modifications to the general riskbased capital rules to improve risk sensitivity and to reduce potential competitive 

disparities between Basel II banks and non-Basel II banks.19 The comment period for the 

Basel IA ANPR ended on January 18, 2006, and the agencies intend to consider all 

comments and issue for public comment a more fully developed risk-based capital 

proposal for non-Basel II banks. The comment period for the non-Basel II proposal is 

expected to overlap that of this proposal, allowing commenters to analyze the effects of 

the two proposals concurrently. 

 In addition, some commenters expressed concern about competitive inequities 

arising from differences in implementation and application of the New Accord by 

supervisory authorities in different countries. In particular, some commenters expressed 

concern about the different implementation timetables of various jurisdictions, and 

differences in the scope of application in various jurisdictions or in the range of 

approaches that different jurisdictions will allow. The BCBS has established an Accord 

Implementation Group, comprised of supervisors from member countries, whose primary 

objectives are to work through implementation issues, maintain a constructive dialogue 

about implementation processes, and harmonize approaches as much as possible within 

the range of national discretion embedded in the New Accord. 

 While supervisory judgment will play a critical role in the evaluation of risk 

measurement and management practices at individual banks, supervisors are committed 

 

19 See 70 FR 61068 (Oct. 20, 2005). 
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to developing protocols and information-sharing arrangements that should minimize 

burdens on banks operating in multiple countries and ensure that supervisory authorities 

are implementing the New Accord as consistently as possible. The New Accord 

identifies numerous areas where national discretion is encouraged. This design was 

intended to enable national supervisors to implement the methodology, or combination of 

methodologies, most appropriate for banks in their jurisdictions. Disparate 

implementation decisions are expected, particularly during the transition years. Over 

time, the agencies expect that industry and supervisory practices likely will converge in 

many areas, thus mitigating differences across countries. Competitive considerations, 

both internationally and domestically, will be monitored and discussed by the agencies on 

an ongoing basis. With regard to implementation timing concerns, the agencies believe 

that the transitional arrangements described in section III.A. of this preamble below 

provide a prudent and reasonable framework for moving to the advanced approaches. 

Where international implementation differences affect an individual bank, the agencies 

expect to work with the bank and appropriate national supervisory authorities for the 

bank to ensure that implementation proceeds as smoothly as possible. Question 6: The 

agencies seek comment on all potential competitive aspects of this proposal and on any 

specific aspects of the proposal that might raise competitive concerns for any bank or 

group of banks.

II. Scope 

The agencies have identified three groups of banks: (i) large or internationally 

active banks that would be required to adopt the advanced approaches in the proposed 

rule (core banks); (ii) banks that voluntarily decide to adopt the advanced approaches 
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(opt-in banks); and (iii) banks that do not adopt the advanced approaches (general banks). 

Each core and opt-in bank would be required to meet certain qualification requirements 

to the satisfaction of its primary Federal supervisor, in consultation with other relevant 

supervisors, before the bank may use the advanced approaches for risk-based capital 

purposes. 

A. Core and Opt-In Banks 

 A DI is a core bank if it meets either of two independent threshold criteria: (i) 

consolidated total assets of $250 billion or more, as reported on the most recent year-end 

regulatory reports; or (ii) consolidated total on-balance sheet foreign exposure of $10 

billion or more at the most recent year-end. To determine total on-balance sheet foreign 

exposure, a bank would sum its adjusted cross-border claims, local country claims, and 

cross-border revaluation gains (calculated in accordance with the Federal Financial 

Institutions Examination Council (FFIEC) Country Exposure Report (FFIEC 009)). 

Adjusted cross-border claims would equal total cross-border claims less claims with the 

head office/guarantor located in another country, plus redistributed guaranteed amounts 

to the country of head office/guarantor. A DI also is a core bank if it is a subsidiary of 

another DI or BHC that uses the advanced approaches. 

 Under the proposed rule, a U.S.-chartered BHC20 is a core bank if the BHC has: 

(i) consolidated total assets (excluding assets held by an insurance underwriting 

subsidiary) of $250 billion or more, as reported on the most recent year-end regulatory 

reports; (ii) consolidated total on-balance sheet foreign exposure of $10 billion or more at 

the most recent year-end; or (iii) a subsidiary DI that is a core bank or opt-in bank. 

 

20 OTS does not currently impose any explicit capital requirements on savings and loan holding companies 

and does not propose to apply the Basel II proposal to these holding companies. 
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Currently 11 top-tier banking organizations meet these criteria. The agencies note that, 

using this approach to define whether a BHC is a core bank, it is possible that no single 

DI under a BHC would meet the threshold criteria, but that all of the BHC’s subsidiary 

DIs would be core banks. 

The proposed BHC consolidated asset threshold is different from the threshold in 

the ANPR, which applied to the total consolidated DI assets of a BHC. The proposed 

shift to total consolidated assets (excluding assets held by an insurance underwriting 

subsidiary) recognizes that BHCs can hold similar assets within and outside of DIs and 

reduces potential incentives to structure BHC assets and activities to arbitrage capital 

regulations. The proposed rule excludes assets held in an insurance underwriting 

subsidiary of a BHC because the New Accord was not designed to address insurance 

company exposures. Question 7: The Board seeks comment on the proposed BHC 

consolidated non-insurance assets threshold relative to the consolidated DI assets 

threshold in the ANPR.

A bank that is subject to the proposed rule either as a core bank or as an opt-in 

bank would be required to apply the rule unless its primary Federal supervisor determines 

in writing that application of the rule is not appropriate in light of the bank’s asset size, 

level of complexity, risk profile, or scope of operations. Question 8: The agencies seek 

comment on the proposed scope of application. In particular, the agencies seek comment 

on the regulatory burden of a framework that requires the advanced approaches to be 

implemented by each subsidiary DI of a BHC or bank that uses the advanced approaches.

B. U.S. DI Subsidiaries of Foreign Banks 
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92

 Any U.S.-chartered DI that is a subsidiary of a foreign banking organization is 

subject to the U.S. regulatory capital requirements applied to domestically-owned U.S. 

DIs. Thus, if the U.S. DI subsidiary of a foreign banking organization meets any of the 

threshold criteria, it would be a core bank and would be subject to the advanced 

approaches. If it does not meet any of the criteria, the U.S. DI may remain a general bank 

or may opt-in to the advanced approaches, subject to the same qualification process and 

requirements as a domestically-owned U.S. DI. A top-tier U.S. BHC, and its subsidiary 

DIs, that is owned by a foreign banking organization also would be subject to the same 

threshold levels for core bank determination as would a top-tier BHC that is not owned 

by a foreign banking organization. A U.S. BHC that meets the conditions in Federal 

Reserve SR letter 01-0121 and is a core bank would not be required to meet the minimum 

capital ratios in the Board’s capital adequacy guidelines, although it would be required to 

adopt the advanced approaches, compute and report its capital ratios in accordance with 

the advanced approaches, and make the required public and regulatory disclosures. 

A DI subsidiary of such a U.S. BHC would be a core bank and would be required 

to adopt the advanced approaches (unless specifically exempted from the advanced 

approaches by its primary Federal supervisor) and meet the minimum capital ratio 

requirements. In addition, the Board retains its supervisory authority to require any BHC, 

including a U.S. BHC owned or controlled by a foreign banking organization that is or is 

treated as a financial holding company (FHC), to maintain capital levels above the 

regulatory minimums. Question 9: The agencies seek comment on the application of the 

 

21 SR 01-01, “Application of the Board’s Capital Adequacy Guidelines to Bank Holding Companies Owned 

by Foreign Banking Organizations,” January 5, 2001. 
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proposed rule to DI subsidiaries of a U.S. BHC that meets the conditions in Federal 

Reserve SR letter 01-01 and on the principle of national treatment in this context.

C. Reservation of Authority 

 The proposed rule would restate the authority of a bank’s primary Federal 

supervisor to require the bank to hold an overall amount of capital greater than would 

otherwise be required under the rule if the agency determines that the bank’s risk-based 

capital requirements under the rule are not commensurate with the bank’s credit, market, 

operational, or other risks. In addition, the agencies anticipate that there may be 

instances when the proposed rule generates a risk-weighted asset amount for specific 

exposures that is not commensurate with the risks posed by such exposures. In these 

cases, under the proposed rule, the bank’s primary Federal supervisor would retain the 

authority to require the bank to use a different risk-weighted asset amount for the 

exposures or to use different risk parameters (for wholesale or retail exposures) or model 

assumptions (for modeled equity or securitization exposures) than those required in the 

proposed rule when calculating the risk-weighted asset amount for those exposures. 

Similarly, the proposed rule would provide authority for a bank’s primary Federal 

supervisor to require the bank to assign a different risk-weighted asset amount for 

operational risk, to change elements of its operational risk analytical framework 

(including distributional and dependence assumptions), or to make other changes to the 

bank’s operational risk management processes, data and assessment systems, or 

quantification systems if the supervisor finds that the risk-weighted asset amount for 

operational risk produced by the bank under the rule is not commensurate with the 
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operational risks of the bank. Any agency that exercises this reservation of authority 

would notify each of the other agencies of its determination. 

III. Qualification 

A. The Qualification Process 

1. In general

Supervisory qualification to use the advanced approaches is a continuous and 

iterative process that begins when a bank’s board of directors adopts an implementation 

plan and continues as the bank operates under the advanced approaches. Before a bank 

may use the advanced approaches for risk-based capital purposes, it must develop and 

adopt a written implementation plan, establish and maintain a comprehensive and sound 

planning and governance process to oversee the implementation efforts described in the 

plan, demonstrate to its primary Federal supervisor that it meets the qualification 

requirements in section 22 of the proposed rule, and complete a satisfactory “parallel run” 

(discussed below). A bank’s primary Federal supervisor would be responsible, after 

consultation with other relevant supervisors, for evaluating the bank’s initial and ongoing 

compliance with the qualification requirements for the advanced approaches. 

The agencies will jointly issue supervisory guidance describing agency 

expectations for wholesale, retail, securitization, and equity exposures, as well as for 

operational risk.22 The agencies recognize that a consistent and transparent process to 

oversee implementation of the advanced approaches is crucial, and will consult with each 

other on significant issues raised during the implementation process. 

 

22 The agencies have issued for public comment draft supervisory guidance on corporate and retail 

exposures and operational risk. See 68 FR 45949 (Aug. 4, 2003); 69 FR 62748 (Oct. 27, 2004). 
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95

 Under the proposed rule, a bank preparing to implement the advanced approaches 

must adopt a written implementation plan, approved by its board of directors, describing 

in detail how the bank complies, or intends to comply, with the qualification 

requirements. A core bank must adopt a plan no later than six months after it meets a 

threshold criterion in section 1(b)(1) of the proposed rule. If a bank meets a threshold 

criterion on the effective date of the final rule, the bank would have to adopt a plan within 

six months of the effective date. Banks that do not meet a threshold criterion, but are 

nearing any criterion by direct growth or merger, would be expected to engage in 

ongoing dialogue with their primary Federal supervisor regarding implementation 

strategies to ensure their readiness to adopt the advanced approaches when a threshold 

criterion is reached. An opt-in bank may adopt an implementation plan at any time, but 

must adopt an implementation plan and notify its primary Federal supervisor in writing at 

least twelve months before it proposes to begin the first floor period (as discussed later in 

this section of the preamble). 

In developing an implementation plan, a bank must assess its current state of 

readiness relative to the qualification requirements in this proposed rule and related 

supervisory guidance. This assessment would include a gap analysis that identifies where 

additional work is needed and a remediation or action plan that clearly sets forth how the 

bank intends to fill the gaps it has identified. The implementation plan must 

comprehensively address the qualification requirements for the bank and each of its 

consolidated subsidiaries (U.S. and foreign-based) with respect to all portfolios and 

exposures of the bank and each of its consolidated subsidiaries. The implementation plan 

must justify and support any proposed temporary or permanent exclusion of a business 
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line, portfolio, or exposure from the advanced approaches. The business lines, portfolios, 

and exposures that the bank proposes to exclude from the advanced approaches must be, 

in the aggregate, immaterial to the bank. The implementation plan must include 

objective, measurable milestones (including delivery dates and a date when the bank’s 

implementation of the advanced approaches will be fully operational). For core banks, 

the implementation plan must include an explicit first floor period start date that is no 

later than 36 months after the later of the effective date of the rule or the date the bank 

meets at least one of the threshold criteria.23 Further, the implementation plan must 

describe the resources that the bank has budgeted and are available to implement the 

plan. 

During implementation of the advanced approaches, a bank would work closely 

with its primary Federal supervisor to ensure that its risk measurement and management 

systems are fully functional and reliable and are able to generate risk parameter estimates 

that can be used to calculate the risk-based capital ratios correctly under the advanced 

approaches. The implementation plan, including the gap analysis and action plan, will 

provide a basis for ongoing supervisory dialogue and review during this period. The 

primary Federal supervisor will assess a bank’s progress relative to its implementation 

plan. To the extent that adjustments to target dates are needed, these adjustments would 

be made subject to the ongoing supervisory discussion between the bank and its primary 

Federal supervisor. 

2. Parallel run and transitional floor periods 

Once a bank has adopted its implementation plan, it must complete a satisfactory 

parallel run before it may use the advanced approaches to calculate its risk-based capital 

 

23 The bank’s primary Federal supervisor may extend the bank’s first floor period start date. 
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requirements. A satisfactory parallel run is a period of at least four consecutive calendar 

quarters during which the bank complies with all of the qualification requirements to the 

satisfaction of its primary Federal supervisor. During this period, the bank would 

continue to be subject to the general risk-based capital rules but would simultaneously 

calculate its risk-based capital ratios under the advanced approaches. During the parallel 

run period, a bank would report its risk-based capital ratios under both the general riskbased capital rules and the advanced approaches to its primary Federal supervisor through 

the supervisory process on a quarterly basis. The agencies will share this information 

with each other for calibration and other analytical purposes. 

A bank’s primary Federal supervisor would notify the bank of the date when it 

may begin to use the advanced approaches for risk-based capital purposes. A bank would 

not be permitted to begin using the advanced approaches for risk-based capital purposes 

until its primary Federal supervisor is satisfied that the bank fully complies with the 

qualification requirements, the bank has satisfactorily completed a parallel run, and the 

bank has an adequate process to ensure ongoing compliance with the qualification 

requirements. 

To provide for a smooth transition to the advanced approaches, the proposed rule 

would impose temporary limits on the amount by which a bank’s risk-based capital 

requirements could decline over a period of at least three years (that is, at least four 

consecutive calendar quarters in each of the three transitional floor periods). Based on its 

assessment of the bank’s ongoing compliance with the qualification requirements, a 

bank’s primary Federal supervisor would determine when the bank is ready to move from 

one transitional floor period to the next period and, after the full transition has been 
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completed, to move to stand-alone use of the advanced approaches. Table B sets forth 

the proposed transitional floor periods for banks moving to the advanced approaches: 

Table B – Transitional Floors 

Transitional floor period Transitional floor percentage 

First floor period 95 percent 

Second floor period 90 percent 

Third floor period 85 percent 

 During the transitional floor periods, a bank would calculate its risk-weighted 

assets under the general risk-based capital rules. Next, the bank would multiply this riskweighted assets amount by the appropriate floor percentage in the table above. This 

product would be the bank’s “floor-adjusted” risk-weighted assets. Third, the bank 

would calculate its tier 1 and total risk-based capital ratios using the definitions of tier 1 

and tier 2 capital (and associated deductions and adjustments) in the general risk-based 

capital rules for the numerator values and floor-adjusted risk-weighted assets for the 

denominator values. These ratios would be referred to as the “floor-adjusted risk-based 

capital ratios.” 

The bank also would calculate its tier 1 and total risk-based capital ratios using 

the definitions and rules in this proposed rule. These ratios would be referred to as the 

“advanced approaches risk-based capital ratios.” In addition, the bank would calculate a 

tier 1 leverage ratio using tier 1 capital as defined in this proposed rule for the numerator 

of the ratio. 

During a bank’s transitional floor periods, the bank would report all five 

regulatory capital ratios described above – two floor-adjusted risk-based capital ratios, 

two advanced approaches risk-based capital ratios, and one leverage ratio. To determine 
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its applicable capital category for PCA purposes and for all other regulatory and 

supervisory purposes, a bank’s risk-based capital ratios during the transitional floor 

periods would be set equal to the lower of the respective floor-adjusted risk-based capital 

ratio and the advanced approaches risk-based capital ratio. During the transitional floor 

periods, a bank’s tier 1 capital and tier 2 capital for all non-risk-based-capital supervisory 

and regulatory purposes (for example, lending limits and Regulation W quantitative 

limits) would be the bank’s tier 1 capital and tier 2 capital as calculated under the 

advanced approaches. 

Thus, for example, in order to be well capitalized under PCA, a bank would have 

to have a floor-adjusted tier 1 risk-based capital ratio and an advanced approaches tier 1 

risk-based capital ratio of 6 percent or greater, a floor-adjusted total risk-based capital 

ratio and an advanced approaches total risk-based capital ratio of 10 percent or greater, 

and a tier 1 leverage ratio of 5 percent or greater (with tier 1 capital calculated under the 

advanced approaches). Although the PCA rules do not apply to BHCs, a BHC would be 

required to report all five of these regulatory capital ratios and would have to meet 

applicable supervisory and regulatory requirements using the lower of the respective 

floor-adjusted risk-based capital ratio and the advanced approaches risk-based capital 

ratio. 

After a bank completes its transitional floor periods and its primary Federal 

supervisor determines the bank may begin using the advanced approaches with no further 

transitional floor, the bank would use its tier 1 and total risk-based capital ratios as 

calculated under the advanced approaches and its tier 1 leverage ratio calculated using the 
 Draft Basel II NPR 

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advanced approaches definition of tier 1 capital for PCA and all other supervisory and 

regulatory purposes. 

The transitional floor calculations described above are linked to the general riskbased capital rules. As noted above, the agencies issued the Basel IA ANPR outlining 

possible modifications to those rules and are developing an NPR in this regard. The 

agencies are still considering the extent and nature of these modifications to the general 

risk-based capital rules and the scope of application of these modifications, including for 

banks that transition to the advanced approaches. The agencies expect banks that meet 

the threshold criteria in section 1(b)(1) of the proposed rule (that is, core banks) as of the 

effective date of the rule, and banks that opt-in pursuant to section 1(b)(2) at the earliest 

possible date, will use the general risk-based capital rules in place immediately before the 

rule becomes effective both during the parallel run and as a basis for the transitional floor 

calculations. Other changes to the general risk-based capital rules (outside the scope of 

the changes outlined in the Basel IA ANPR) may be considered by the agencies, as 

appropriate. Question 10: The agencies seek comment on this approach and on how and 

to what extent future modifications to the general risk-based capital rules should be 

incorporated into the transitional floor calculations for advanced approaches banks.

Banks’ computation of risk-based capital requirements under both the general 

risk-based capital rules and the advanced approaches will help the agencies assess the 

impact of the advanced approaches on overall capital requirements, including whether the 

change in capital requirements relative to the general risk-based capital rules is consistent 

with the agencies’ overall capital objectives. Question 11: The agencies seek comment 
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on what other information should be considered in deciding whether those overall capital 

goals have been achieved.

The agencies are proposing to make 2008 the first possible year for a bank to 

conduct its parallel run and 2009-2011 the first possible years for the three transitional 

floor periods. Question 12: The agencies seek comment on this proposed timetable for 

implementing the advanced approaches in the United States.

B. Qualification Requirements

 Because the Basel II framework uses banks’ estimates of certain key risk 

parameters to determine risk-based capital requirements, the advanced approaches would 

introduce greater complexity to the regulatory capital framework and would require 

banks using the advanced approaches to possess a high level of sophistication in risk 

measurement and risk management systems. As a result, the agencies propose to require 

each core or opt-in bank to meet the qualification requirements described in section 22 of 

the proposed rule to the satisfaction of its primary Federal supervisor for a period of at 

least four consecutive calendar quarters before using the advanced approaches to 

calculate its minimum risk-based capital requirements (subject to the transitional floors 

for at least an additional three years). The qualification requirements are written broadly 

to accommodate the many ways a bank may design and implement a robust internal 

credit and operational risk measurement and management system and to permit industry 

practice to evolve. 

Many of the qualification requirements relate to a bank’s advanced IRB systems. 

A bank’s advanced IRB systems must incorporate five interdependent components in a 

framework for evaluating credit risk and measuring regulatory capital: 
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(i) A risk rating and segmentation system that assigns ratings to individual 

wholesale obligors and exposures and assigns individual retail exposures to segments; 

(ii) A quantification process that translates the risk characteristics of wholesale 

obligors and exposures and segments of retail exposures into numerical risk parameters 

that are used as inputs to the IRB risk-based capital formulas; 

(iii) An ongoing process that validates the accuracy of the rating assignments, 

segmentations, and risk parameters; 

(iv) A data management and maintenance system that supports the advanced IRB 

systems; and 

(v) Oversight and control mechanisms that ensure the advanced IRB systems are 

functioning effectively and producing accurate results. 

1. Process and systems requirements

One of the objectives of the proposed framework is to provide appropriate 

incentives for banks to develop and use better techniques for measuring and managing 

their risks. The proposed rule specifically requires a bank to have a rigorous process for 

assessing its overall capital adequacy in relation to its total risk profile and a 

comprehensive strategy for maintaining appropriate capital levels. Consistent with Pillar 

2 of the New Accord, a bank’s primary Federal supervisor will evaluate how well the 

bank is assessing its capital needs relative to its risks and, if deficiencies are identified, 

will take any necessary action to ensure that appropriate and prudent levels of capital are 

maintained. 

A bank should address all of its material risks in its overall capital assessment 

process. Although not every risk can be measured precisely, the following risks, at a 
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minimum, should be factored into a bank’s capital assessment process: credit risk, 

market risk, operational risk, interest rate risk in the banking book, liquidity risk, 

concentration risk, reputational risk, and strategic risk. With regard to interest rate risk in 

the banking book, the agencies note that for some assets – for example, a long-term 

mortgage loan – interest rate risk may be as great as, or greater than, the credit risk of the 

asset. The agencies will continue to focus attention on exposures where interest rate risk 

may be significant and will foster sound interest rate risk measurement and management 

practices across banks. Additionally, because credit risk concentrations can pose 

substantial risk to a bank that might be managing individual credits in a satisfactory 

manner, a bank also should give proper attention to such concentrations. 

Banks already are required to hold capital sufficient to meet their risk profiles, 

and existing rules allow Federal supervisors to require a bank to increase its capital if its 

current capital levels are deficient or some element of its business practices suggests the 

need for more capital. Existing supervisory guidance directs banks to meaningfully tie 

the identification, monitoring, and evaluation of risk to the determination of the bank’s 

capital needs. Banks are expected to implement and continually update the fundamental 

elements of a sound internal capital adequacy analysis – identifying and measuring all 

material risks, setting capital adequacy goals that relate to risk, and assessing conformity 

to the bank’s stated objectives. The agencies expect that all banks operating under the 

advanced approaches would address specific assumptions embedded in the advanced 

approaches (such as diversification in credit portfolios), and would evaluate these banks, 

in part, on their ability to account for deviations from the underlying assumptions in their 

own portfolios. 
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 As noted, each core or opt-in bank would apply the advanced approaches for riskbased capital purposes at the consolidated top-tier legal entity level (that is, either the toptier BHC or top-tier DI that is a core or opt-in bank) and at the level of each DI that is a 

subsidiary of such a top-tier legal entity. Thus, each bank that applies the advanced 

approaches must have an appropriate infrastructure with risk measurement and 

management processes that meet the proposed rule’s qualification requirements and that 

are appropriate given the bank’s size and level of complexity. Regardless of whether the 

systems and models that generate the risk parameters necessary for calculating a bank’s 

risk-based capital requirements are located at any affiliate of the bank, each legal entity 

that applies the advanced approaches must ensure that the risk parameters (that is, PD, 

ELGD, LGD, EAD, and M) and reference data used to determine its risk-based capital 

requirements are representative of its own credit and operational risk exposures. 

The proposed rule also requires that the systems and processes that an advanced 

approaches bank uses for risk-based capital purposes must be sufficiently consistent with 

the bank's internal risk management processes and management information reporting 

systems such that data from the latter processes and systems can be used to verify the 

reasonableness of the inputs the bank uses for risk-based capital purposes. 

2. Risk rating and segmentation systems for wholesale and retail exposures

To implement the IRB framework, a bank must have internal risk rating and 

segmentation systems that accurately and reliably differentiate between degrees of credit 

risk for wholesale and retail exposures. As described below, wholesale exposures include 

most credit exposures to companies, sovereigns, and governmental entities, as well as 

some exposures to individuals. Retail exposures include most credit exposures to 
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individuals and small businesses that are managed as part of a segment of exposures with 

homogeneous risk characteristics. Together, wholesale and retail exposures cover most 

credit exposures of banks. 

To differentiate among degrees of credit risk, a bank must be able to make 

meaningful and consistent distinctions among credit exposures along two dimensions—

default risk and loss severity in the event of a default. In addition, a bank must be able to 

assign wholesale obligors to rating grades that approximately reflect likelihood of default 

and must be able to assign wholesale exposures to rating grades (or ELGD and LGD 

estimates) that approximately reflect the loss severity expected in the event of default. 

As discussed below, the proposed rule requires banks to treat wholesale exposures 

differently from retail exposures when differentiating among degrees of credit risk. 

Wholesale exposures

For wholesale exposures, a bank must have an internal risk rating system that 

indicates the likelihood of default of each individual obligor and may use an internal risk 

rating system that indicates the economic loss rate upon default of each individual 

exposure.24 A bank would assign an internal risk rating to each wholesale obligor, which 

should reflect the obligor’s PD – that is, its long-run average one-year default rate over a 

reasonable mix of economic conditions. PD is defined in more detail below. 

In determining an obligor rating, a bank should consider key obligor attributes, 

including both quantitative and qualitative factors that could affect the obligor’s default 

risk. From a quantitative perspective, this could include an assessment of the obligor’s 

historic and projected financial performance, trends in key financial performance ratios, 

 

24 As explained below, a bank that chooses not to use an internal risk rating system for ELGD and LGD for 

a wholesale exposure must directly assign an ELGD and LGD estimate to the wholesale exposure. 
 Draft Basel II NPR 

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financial contingencies, industry risk, and the obligor’s position in the industry. On the 

qualitative side, this could include an assessment of the quality of the obligor’s financial 

reporting, non-financial contingencies (for example, labor problems and environmental 

issues), and the quality of the obligor’s management based on an evaluation of 

management’s ability to make realistic projections, management’s track record in 

meeting projections, and management’s ability to effectively deal with changes in the 

economy and the competitive environment. 

A bank must assign each legal entity wholesale obligor to a single rating grade. 

Accordingly, if a single wholesale exposure of the bank to an obligor triggers the 

proposed rule’s definition of default, all of the bank’s wholesale exposures to that obligor 

are in default for risk-based capital purposes. In addition, a bank may not consider the 

value of collateral pledged to support a particular wholesale exposure (or any other 

exposure-specific characteristics) when assigning a rating to the obligor of the exposure, 

even in the context of nonrecourse loans and other loans underwritten primarily based on 

the operating income or cash flows from real estate collateral. A bank may, of course, 

consider all available financial information about the obligor – including, where 

applicable, the total operating income or cash flows from all of the obligor’s projects or 

businesses – when assigning an obligor rating. Question 13: The agencies seek comment 

on this aspect of the proposed rule and on any circumstances under which it would be 

appropriate to assign different obligor ratings to different exposures to the same obligor

(for example, income-producing property lending or exposures involving transfer risk). 

A bank’s rating system must have at least seven discrete (non-overlapping) 

obligor grades for non-defaulted obligors and at least one obligor grade for defaulted 
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obligors. The agencies believe that because the risk-based capital requirement of a 

wholesale exposure is directly linked to its obligor rating grade, a bank must have at least 

seven non-overlapping obligor grades to sufficiently differentiate the creditworthiness of 

non-defaulted wholesale obligors. 

A bank would capture the estimated loss severity upon default for a wholesale 

exposure either by directly assigning an ELGD and LGD estimate to the exposure or by 

grouping the exposure with other wholesale exposures into loss severity rating grades 

(reflecting the bank’s estimate of the ELGD or LGD of the exposure). The LGD of an 

exposure is an estimate of the economic loss rate on the exposure, taking into account 

related material costs and recoveries, in the event of the obligor’s default during a period 

of economic downturn conditions. LGD is described in more detail below. Whether a 

bank chooses to assign ELGD and LGD values directly or, alternatively, to assign 

exposures to rating grades and then quantify the ELGD or LGD, as appropriate, for the 

rating grades, the key requirement is that the bank must identify exposure characteristics 

that influence ELGD and LGD. Each of the loss severity rating grades would be 

associated with an empirically supported ELGD or LGD estimate. Banks employing loss 

severity grades must have a sufficiently granular loss severity grading system to avoid 

grouping together exposures with widely ranging ELGDs or LGDs. 

Retail exposures

To implement the advanced approach for retail exposures, a bank must have an 

internal system that segments its retail exposures to differentiate accurately and reliably 

among degrees of credit risk. The most significant difference between the proposed 

rule’s treatment of wholesale and retail exposures is that the risk parameters for retail 
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exposures are not assigned at the individual exposure level. Banks typically manage 

retail exposures on a segment basis, where each segment contains exposures with similar 

risk characteristics. Therefore, a key characteristic of the proposed rule’s retail 

framework is that the risk parameters for retail exposures would be assigned to segments 

of exposures rather than to individual exposures. Under the retail framework, a bank 

would group its retail exposures into segments with homogeneous risk characteristics and 

then estimate PD, ELGD, and LGD for each segment. 

A bank must first group its retail exposures into three separate subcategories: 

(i) residential mortgage exposures; (ii) QREs; and (iii) other retail exposures. The bank 

would then classify the retail exposures in each subcategory into segments to produce a 

meaningful differentiation of risk. The proposed rule requires banks to segment 

separately (i) defaulted retail exposures from non-defaulted retail exposures and (ii) retail 

eligible margin loans for which the bank adjusts EAD rather than ELGD and LGD to 

reflect the risk mitigating effects of financial collateral from other retail eligible margin 

loans. Otherwise, the agencies are not proposing to require that banks consider any 

particular risk drivers or employ any minimum number of segments in any of the three 

retail subcategories. 

In determining how to segment retail exposures within each subcategory for the 

purpose of assigning risk parameters, a bank should use a segmentation approach that is 

consistent with its approach for internal risk assessment purposes and that classifies 

exposures according to predominant risk characteristics or drivers. Examples of risk 

drivers could include loan-to-value (LTV) ratios, credit scores, loan terms and structure 

(for example, interest only or payment option adjustable rate mortgages), origination 
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channel, geographical location of the borrower, and collateral type. A bank must be able 

to demonstrate to its primary Federal supervisor that its system assigns accurate and 

reliable PD, ELGD, and LGD estimates for each retail segment on a consistent basis. 

Definition of default

In the ANPR, the agencies proposed to define default for a wholesale exposure as 

either or both of the following events: (i) the bank determines that the borrower is 

unlikely to pay its obligations to the bank in full, without recourse to actions by the bank 

such as the realization of collateral; or (ii) the borrower is more than 90 days past due on 

principal or interest on any material obligation to the bank. 

A number of commenters encouraged the agencies to use a definition of default 

that conforms more closely to that used by bank risk managers. Many of these 

commenters recommended that the agencies define default as the entry into non-accrual 

status for wholesale exposures and the number of days past due for retail exposures, or as 

the entry into charge-off status for wholesale and retail exposures. The agencies have 

amended the ANPR definitions of default to respond to these concerns and recognize that 

the definition of default in this proposed rule is different from the definitions that are 

being implemented in other jurisdictions. 

Under the proposed rule’s definition of default, a bank’s wholesale obligor would 

be in default if, for any credit exposure of the bank to the obligor, the bank has (i) placed 

the exposure on non-accrual status consistent with the Call Report Instructions or the 

Thrift Financial Report and the Thrift Financial Report Instruction Manual; (ii) taken a 

full or partial charge-off or write-down on the exposure due to the distressed financial 

condition of the obligor; or (iii) incurred a credit-related loss of 5 percent or more of the 
 Draft Basel II NPR 

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exposure’s initial carrying value in connection with the sale of the exposure or the 

transfer of the exposure to the held-for-sale, available-for-sale, trading account, or other 

reporting category. Under the proposed definition, a wholesale exposure to an obligor 

remains in default until the bank has reasonable assurance of repayment and performance 

for all contractual principal and interest payments on all exposures of the bank to the 

obligor (other than exposures that have been fully written-down or charged-off). The 

agencies would expect a bank to employ standards for determining whether it has a 

reasonable assurance of repayment and performance that are similar to those for 

determining whether to restore a loan from non-accrual to accrual status. 

When a bank sells a set of wholesale exposures, the bank must examine the sale 

prices of the individual exposures contained in the set and evaluate whether a credit loss 

of 5 percent or more of the exposure’s initial carrying value has occurred on any given 

exposure. Write-downs of securities that are not credit-related (for example, a writedown that is due to a change in market interest rates) would not be a default event. 

Question 14: The agencies seek comment on this proposed definition of default 

and on how well it captures substantially all of the circumstances under which a bank 

could experience a material credit-related economic loss on a wholesale exposure. In 

particular, the agencies seek comment on the appropriateness of the 5 percent credit loss 

threshold for exposures sold or transferred between reporting categories. The agencies 

also seek commenters’ views on specific issues raised by applying different definitions of 

default in multiple national jurisdictions and on ways to minimize potential regulatory 

burden, including use of the definition of default in the New Accord, keeping in mind 
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that national bank supervisory authorities must adopt default definitions that are 

appropriate in light of national banking practices and conditions.

In response to comments on the ANPR, the agencies propose to define default for 

retail exposures according to the timeframes for loss classification that banks generally 

use for internal purposes and that are embodied in the FFIEC’s Uniform Retail Credit 

Classification and Account Management Policy.25 Specifically, revolving retail 

exposures and residential mortgages would be in default at 180 days past due; other retail 

exposures would be in default at 120 days past due. In addition, a retail exposure would 

be in default if the bank has taken a full or partial charge-off or write-down of principal 

on the exposure for credit-related reasons. Such an exposure would remain in default 

until the bank has reasonable assurance of repayment and performance for all contractual 

principal and interest payments on the exposure. 

 The proposed definition of default for retail exposures differs from the proposed 

definition for the wholesale portfolio in several important respects. First, the proposed 

retail default definition applies on an exposure-by-exposure basis (rather than, as is the 

case for wholesale exposures, on an obligor-by-obligor basis). In other words, default on 

one retail exposure would not require a bank to treat all other obligations of the same 

obligor to the bank as defaulted. This difference reflects the fact that banks generally 

manage retail credit risk based on segments of similar exposures rather than through the 

assignment of ratings to particular obligors. In addition, it is quite common for retail 

borrowers that default on some of their obligations to continue payment on others. 

 

25 FFIEC, “Uniform Retail Credit Classification and Account Management Policy,” 65 FR 36903 (June 12, 

2000). 
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Second, the retail definition of default, unlike the wholesale definition of default, 

does not include exposures placed on non-accrual status. The agencies recognize that 

retail non-accrual practices vary considerably among banks. Accordingly, the agencies 

have determined that removing non-accrual from the retail definition of default would 

promote greater consistency among banks in the treatment of retail exposures. 

 In addition, the retail definition of default, unlike the wholesale definition of 

default, does not explicitly state that an exposure is in default if a bank incurs creditrelated losses of 5 percent or more in connection with the sale of the exposure. Because 

of the large number of diverse retail exposures that banks usually sell in a single 

transaction, banks typically do not allocate the sales price of a pool of retail exposures in 

such a way as to enable the bank to calculate the premium or discount on individual retail 

exposures. Although the proposed rule’s definition of retail default does not explicitly 

include credit-related losses in connection with loan sales, the agencies would expect 

banks to assess carefully the impact of retail exposure sales in quantifying the risk 

parameters calculated by the bank for its retained retail exposures. 

Rating philosophy

 A bank must explain to its primary Federal supervisor its rating philosophy – that 

is, how the bank’s wholesale obligor rating assignments are affected by the bank’s choice 

of the range of economic, business, and industry conditions that are considered in the 

obligor rating process. The philosophical basis of a bank’s ratings system is important 

because, when combined with the credit quality of individual obligors, it will determine 

the frequency of obligor rating changes in a changing economic environment. Rating 

systems that rate obligors based on their ability to perform over a wide range of 
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economic, business, and industry conditions, sometimes described as “through-the-cycle” 

systems, would tend to have ratings that migrate more slowly as conditions change. 

Banks that rate obligors based on a more narrow range of likely expected conditions 

(primarily on recent conditions), sometimes called “point-in-time” systems, would tend to 

have ratings that migrate more frequently. Many banks will rate obligors using an 

approach that considers a combination of the current conditions and a wider range of 

other likely conditions. In any case, the bank would need to specify the rating philosophy 

used and establish a policy for the migration of obligors from one rating grade to another 

in response to economic cycles. A bank should understand the effects of ratings 

migration on its risk-based capital requirements and ensure that sufficient capital is 

maintained during all phases of the economic cycle. 

Rating and segmentation reviews and updates

A bank must have a policy that ensures that each wholesale obligor rating and (if 

applicable) wholesale exposure loss severity rating reflects current information. A bank’s 

internal risk rating system for wholesale exposures must provide for the review and 

update (as appropriate) of each obligor rating and (if applicable) loss severity rating 

whenever the bank receives new material information, but no less frequently than 

annually. A bank’s retail exposure segmentation system must provide for the review and 

update (as appropriate) of assignments of retail exposures to segments whenever the bank 

receives new material information, but no less frequently than quarterly. 

3. Quantification of risk parameters for wholesale and retail exposures
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A bank must have a comprehensive risk parameter quantification process that 

produces accurate, timely, and reliable estimates of the risk parameters – PD, ELGD, 

LGD, EAD, and (for wholesale exposures) M – for its wholesale obligors and exposures 

and retail exposures. Statistical methods and models used to develop risk parameter 

estimates, as well as any adjustments to the estimates or empirical default data, should be 

transparent, well supported, and documented. The following sections of the preamble 

discuss the proposed rule’s definitions of the risk parameters for wholesale and retail 

exposures. 

Probability of default (PD)

As noted above, under the proposed rule, a bank must assign each of its wholesale 

obligors to an internal rating grade and then must associate a PD with each rating grade. 

PD for a wholesale exposure to a non-defaulted obligor would be the bank’s empirically 

based best estimate of the long-run average of one-year default rates for the rating grade 

assigned by the bank to the obligor, capturing the average default experience for obligors 

in the rating grade over a mix of economic conditions (including economic downturn 

conditions) sufficient to provide a reasonable estimate of the average one-year default 

rate over the economic cycle for the rating grade. This estimate of the long-run average 

PD is converted into an estimate of PD under economic downturn conditions as part of 

the IRB risk-based capital formulas. 

In addition, under the proposed rule, a bank must assign a PD to each segment of 

retail exposures. The proposed rule provides two different definitions of the PD of a 

segment of non-defaulted retail exposures based on the materiality of seasoning effects 

for the segment or for the segment’s retail exposure subcategory. Some types of retail 
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exposures display a distinct seasoning pattern – that is, the exposures have relatively low 

default rates in their first year, rising default rates in the next few years, and declining 

default rates for the remainder of their terms. A bank must use a separate definition of 

PD that addresses seasoning effects for a segment of non-defaulted retail exposures 

unless the bank has determined that seasoning effects are not material for the segment or 

for the segment’s entire retail exposure subcategory. 

The proposed rule provides a definition of PD for segments of non-defaulted retail 

exposures where seasoning is not a material consideration that tracks closely the 

wholesale PD definition. Specifically, PD for a segment of non-defaulted retail 

exposures for which seasoning effects are not material, or for a segment of non-defaulted 

retail exposures in a retail exposure subcategory for which seasoning effects are not 

material, would be the bank’s empirically based best estimate of the long-run average of 

one-year default rates for the exposures in the segment, capturing the average default 

experience for exposures in the segment over a mix of economic conditions (including 

economic downturn conditions) sufficient to provide a reasonable estimate of the average 

one-year default rate over the economic cycle for the segment. Banks that use this PD 

formulation for a segment of retail exposures should be able to demonstrate to their 

primary Federal supervisor, using empirical data, why seasoning effects are not material 

for the segment or the retail exposure subcategory in which the segment resides. 

Because of the one-year IRB horizon, the agencies are proposing a different PD 

definition for retail segments with material seasoning effects. Under the proposed rule, 

PD for a segment of non-defaulted retail exposures for which seasoning effects are 

material would be the bank’s empirically based best estimate of the annualized 
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cumulative default rate over the expected remaining life of exposures in the segment, 

capturing the average default experience for exposures in the segment over a mix of 

economic conditions (including economic downturn conditions) to provide a reasonable 

estimate of the average performance over the economic cycle for the segment. A bank’s 

PD estimates for these retail segments with material seasoning effects also should reflect 

potential changes in the expected remaining life of exposures in the segment over the 

economic cycle. 

For wholesale exposures to defaulted obligors and for segments of defaulted retail 

exposures, PD would be 100 percent. 

Loss given default (LGD) and expected loss given default (ELGD)

Under the proposed rule, a bank must directly estimate an ELGD and LGD risk 

parameter for each wholesale exposure or must assign each wholesale exposure to an 

expected loss severity grade and a downturn loss severity grade, estimate an ELGD risk 

parameter for each expected loss severity grade, and estimate an LGD risk parameter for 

each loss severity grade. In addition, a bank must estimate an ELGD and LGD risk 

parameter for each segment of retail exposures. The same ELGD and LGD may be 

appropriate for more than one retail segment. 

LGD is an estimate of the economic loss that would be incurred on an exposure, 

relative to the exposure’s EAD, if the exposure were to default within a one-year horizon 

during economic downturn conditions. The economic loss amount must capture all 

material credit-related losses on the exposure (including accrued but unpaid interest or 

fees, losses on the sale of repossessed collateral, direct workout costs, and an appropriate 

allocation of indirect workout costs). Where positive or negative cash flows on a 
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117

wholesale exposure to a defaulted obligor or on a defaulted retail exposure (including 

proceeds from the sale of collateral, workout costs, and draw-downs of unused credit 

lines) occur after the date of default, the economic loss amount must reflect the net 

present value of cash flows as of the default date using a discount rate appropriate to the 

risk of the exposure. 

The LGD of some exposures may be substantially higher during economic 

downturn conditions than during other periods, while for other types of exposures it may 

not. Accordingly, the proposed rule requires banks to use an LGD estimate that reflects 

economic downturn conditions for purposes of calculating the risk-based capital 

requirements for wholesale exposures and retail segments; however, the LGD of an 

exposure may never be less than the exposure’s ELGD. More specifically, banks must 

produce for each wholesale exposure (or downturn loss severity rating grade) and retail 

segment an estimate of the economic loss per dollar of EAD that the bank would expect 

to incur if default were to occur within a one-year horizon during economic downturn 

conditions. The estimate of LGD can be thought of as the ELGD plus an increase if 

appropriate to reflect the impact of economic downturn conditions. 

For the purpose of defining economic downturn conditions, the proposed rule 

identifies two wholesale exposure subcategories – high-volatility commercial real estate 

(HVCRE) wholesale exposures and non-HVCRE wholesale exposures (that is, all 

wholesale exposures that are not HVCRE exposures) – and three retail exposure 

subcategories – residential mortgage exposures, QREs, and other retail exposures. The 

proposed rule defines economic downturn conditions with respect to an exposure as those 

conditions in which the aggregate default rates for the exposure’s entire wholesale or 
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retail subcategory held by the bank (or subdivision of such subcategory selected by the 

bank) in the exposure’s national jurisdiction (or subdivision of such jurisdiction selected 

by the bank) are significantly higher than average. 

Under this approach, a bank with a geographical or industry sector concentration 

in a subcategory of exposures may find that information relating to a downturn in that 

geographical region or industry sector may be more relevant for the bank than a general 

downturn affecting many regions or industries. At this time, however, the proposed rule 

does not require a bank with a geographical, industry sector, or other concentration to 

subdivide exposure subcategories or national jurisdictions to reflect such concentrations; 

rather, the proposed rule allows banks to subdivide exposure subcategories or national 

jurisdictions as they deem appropriate given the exposures held by the bank. The 

agencies understand that downturns in particular geographical subdivisions of national 

jurisdictions or in particular industrial sectors may result in significantly increased loss 

rates in material subdivisions of a bank’s exposures in an exposure subcategory. 

Question 15: In light of the possibility of significantly increased loss rates at the 

subdivision level due to downturn conditions in the subdivision, the agencies seek 

comment on whether to require banks to determine economic downturn conditions at a 

more granular level than an entire wholesale or retail exposure subcategory in a national 

jurisdiction.

The proposed rule provides banks two methods of generating LGD estimates for 

wholesale and retail exposures. First, a bank may use its own estimates of LGD for a 

subcategory of exposures if the bank has prior written approval from its primary Federal 

supervisor to use internal estimates for that subcategory of exposures. In approving a 
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bank’s use of internal estimates of LGD, a bank’s primary Federal supervisor will 

consider whether the bank’s internal estimates of LGD are reliable and sufficiently 

reflective of economic downturn conditions. The supervisor will also consider whether 

the bank has rigorous and well-documented policies and procedures for identifying 

economic downturn conditions for the exposure subcategory, identifying material adverse 

correlations between the relevant drivers of default rates and loss rates given default, and 

incorporating identified correlations into internal LGD estimates. If a bank has 

supervisory approval to use its own estimates of LGD for an exposure subcategory, it 

must use its own estimates of LGD for all exposures within that subcategory. 

As noted above, the LGD of an exposure or segment may never be less than the 

ELGD of that exposure or segment. The proposed rule defines the ELGD of a wholesale 

exposure as the bank’s empirically-based best estimate of the default-weighted average 

economic loss per dollar of EAD the bank expects to incur in the event that the obligor of 

the exposure (or a typical obligor in the loss severity grade assigned by the bank to the 

exposure) defaults within a one-year horizon.26 For a segment of retail exposures, ELGD 

is the bank’s empirically-based best estimate of the default-weighted average economic 

loss per dollar of EAD the bank expects to incur on exposures in the segment that default 

within a one-year horizon. ELGD estimates must incorporate a mix of economic 

conditions (including economic downturn conditions). For example, given appropriate 

data, the ELGD could be estimated by calculating the default-weighted average economic 

loss per dollar of EAD given default for exposures in a particular loss severity grade or 

segment observed over a complete credit cycle. 

 

26 Under the proposal, ELGD is not the statistical expected value of LGD. 
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120

As an alternative to internal estimates of LGD, the proposed rule provides a 

supervisory mapping function for converting ELGD into LGD for risk-based capital 

purposes. Although the agencies encourage banks to develop internal LGD estimates, the 

agencies are aware that it may be difficult at this time and in the near future for banks to 

produce internal estimates of LGD that are sufficient for risk-based capital purposes 

because LGD data for important portfolios may be sparse, and there is very limited 

industry experience with incorporating downturn conditions into LGD estimates. 

Accordingly, under the proposed rule, a bank that does not qualify for use of its own 

estimates of LGD for a subcategory of exposures must instead compute LGD by applying 

a supervisory mapping function to its internal estimates of ELGD for such exposures. 

The bank would adjust its ELGDs upward to LGDs using the linear supervisory mapping 

function: LGD = 0.08 + 0.92 x ELGD. Under this mapping function, for example, an 

ELGD of 0 percent is converted to an LGD of 8 percent, an ELGD of 20 percent is 

converted to an LGD of 26.4 percent, and an ELGD of 50 percent is converted to an LGD 

of 54 percent. A bank would not have to apply the supervisory mapping function to repostyle transactions, eligible margin loans, and OTC derivative contracts (defined below in 

section V.C. of the preamble). For these exposures, the agencies believe that the 

difference between a bank’s estimate of LGD and its estimate of ELGD is likely to be 

small. Instead a bank would set LGD equal to ELGD for these exposures. 

As noted, the proposed rule would permit a bank to use the supervisory mapping 

function to translate ELGDs to LGDs and would only permit a bank to use its own 

estimates of LGD for an exposure subcategory if the bank has received prior written 

approval from its primary Federal supervisor. The agencies also are considering whether 
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121

to require every bank, as a condition to qualifying for use of the advanced approaches, to 

be able to produce credible and reliable internal estimates of LGD for all its wholesale 

and retail exposures. Under this stricter approach, a bank that is unable to demonstrate to 

its primary Federal supervisor that it could produce credible and reliable internal 

estimates of LGD would not be permitted to use the advanced approaches. 

Question 16: The agencies seek comment on and supporting empirical analysis of

(i) the proposed rule’s definitions of LGD and ELGD; (ii) the proposed rule’s overall 

approach to LGD estimation; (iii) the appropriateness of requiring a bank to produce 

credible and reliable internal estimates of LGD for all its wholesale and retail exposures

as a precondition for using the advanced approaches; (iv) the appropriateness of requiring

all banks to use a supervisory mapping function, rather than internal estimates, for 

estimating LGDs, due to limited data availability and lack of industry experience with 

incorporating economic downturn conditions in LGD estimates; (v) the appropriateness 

of the proposed supervisory mapping function for translating ELGD into LGD for all 

portfolios of exposures and possible alternative supervisory mapping functions; (vi) 

exposures for which no mapping function would be appropriate; and (vii) exposures for 

which a more lenient (that is, producing a lower LGD for a given ELGD) or more strict 

(that is, producing a higher LGD for a given ELGD) mapping function may be 

appropriate (for example, residential mortgage exposures and HVCRE exposures). 

The agencies are concerned that some approaches to ELGD or LGD 

quantification could produce estimates that are pro-cyclical, particularly if these estimates 

are based on economic indicators, such as frequently updated loan-to-value (LTV) ratios, 

that are highly sensitive to current economic conditions. Question 17: The agencies seek 
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comment on the extent to which ELGD or LGD estimates under the proposed rule would 

be pro-cyclical, particularly for longer-term secured exposures. The agencies also seek 

comment on alternative approaches to measuring ELGDs or LGDs that would address 

concerns regarding potential pro-cyclicality without imposing undue burden on banks.

This proposed rule incorporates comments on the ANPR suggesting a need to 

better accommodate certain credit products, most prominently asset-based lending 

programs, whose structures typically result in a bank recovering substantial amounts of 

the exposure prior to the default date – for example, through paydowns of outstanding 

principal. The agencies believe that actions taken prior to default to mitigate losses are 

an important component of a bank’s overall credit risk management, and that such actions 

should be reflected in ELGD and LGD when banks can quantify their effectiveness in a 

reliable manner. In the proposed rule, this is achieved by measuring ELGD and LGD 

relative to the exposure’s EAD (defined in the next section) as opposed to the amount 

actually owed at default.27 

In practice, the agencies would expect methods for estimating ELGD and LGD, 

and the way those methods reflect changes in exposure during the period prior to default, 

to be consistent with other aspects of the proposed rule. For example, a default horizon 

that is longer than one year could result in lower estimates of economic loss due to 

greater contractual amortization prior to default, or a greater likelihood that covenants 

would enable a bank to accelerate paydowns of principal as the condition of an obligor 

 

27 To illustrate, suppose that for a particular asset-based lending exposure the EAD equaled $100 and that 

for every $1 dollar owed by the obligor at the time of default the bank’s recovery would be $0.40. 

Furthermore, suppose that in the event of default within a one-year horizon, pre-default paydowns of $20 

would reduce the exposure amount to $80 at the time of default. In this case, the bank’s economic loss rate 

measured relative to the amount owed at default (60%) would exceed the economic loss rate measured 

relative to EAD (48% = 60% x ($100 -$20)/$100), because the former does not reflect fully the impact of 

the pre-default paydowns. 
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deteriorates, but such long horizons could be inconsistent with the one-year default 

horizon incorporated in other aspects of this proposed rule, such as the quantification of 

PD. 

 The agencies intend to limit recognition of the impact on ELGD and LGD of predefault paydowns to certain types of exposures where the pattern is common, measurable, 

and especially significant, as with various types of asset-based lending. In addition, not 

all paydowns during the period prior to default warrant recognition as part of the recovery 

process. For example, a pre-default reduction in the outstanding amount on one exposure 

may simply reflect a refinancing by the obligor with the bank, with no reduction in the 

bank's total exposure to the obligor. Question 18: The agencies seek comment on the 

feasibility of recognizing such pre-default changes in exposure in a way that is consistent 

with the safety and soundness objectives of this proposed rule. The agencies also seek 

comment on appropriate restrictions to place on any such recognition to ensure that the 

results are not counter to the objectives of this proposal to ensure adequate capital within 

a more risk-sensitive capital framework. In addition, the agencies seek comment on 

whether, for wholesale exposures, allowing ELGD and LGD to reflect anticipated future 

contractual paydowns prior to default may be inconsistent with the proposed rule's 

imposition of a one-year floor on M (for certain types of exposures) or may lead to some 

double-counting of the risk-mitigating benefits of shorter maturities for exposures not 

subject to this floor.

Exposure at default (EAD)

Except as noted below, EAD for the on-balance sheet component of a wholesale 

or retail exposure means (i) the bank’s carrying value for the exposure (including net 
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124

accrued but unpaid interest and fees)28 less any allocated transfer risk reserve for the 

exposure, if the exposure is held-to-maturity or for trading; or (ii) the bank’s carrying 

value for the exposure (including net accrued but unpaid interest and fees) less any 

allocated transfer risk reserve for the exposure and any unrealized gains on the exposure, 

plus any unrealized losses on the exposure, if the exposure is available-for-sale. For the 

off-balance sheet component of a wholesale or retail exposure (other than an OTC 

derivative contract, repo-style transaction, or eligible margin loan) in the form of a loan 

commitment or line of credit, EAD means the bank’s best estimate of net additions to the 

outstanding amount owed the bank, including estimated future additional draws of 

principal and accrued but unpaid interest and fees, that are likely to occur over the 

remaining life of the exposure assuming the exposure were to go into default. This 

estimate of net additions must reflect what would be expected during a period of 

economic downturn conditions. For the off-balance sheet component of a wholesale or 

retail exposure other than an OTC derivative contract, repo-style transaction, eligible 

margin loan, loan commitment, or line of credit issued by a bank, EAD means the 

notional amount of the exposure. 

For a segment of retail exposures, EAD is the sum of the EADs for each 

individual exposure in the segment. For wholesale or retail exposures in which only the 

drawn balance has been securitized, the bank must reflect its share of the exposures’ 

undrawn balances in EAD. The undrawn balances of exposures for which the drawn 

balances have been securitized must be allocated between the seller’s and investors’ 

interests on a pro rata basis, based on the proportions of the seller’s and investors’ shares 

 

28 “Net accrued but unpaid interest and fees” are accrued but unpaid interest and fees net of any amount 

expensed by the bank as uncollectable. 
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of the securitized drawn balances. For example, if the EAD of a group of securitized 

exposures’ undrawn balances is $100, and the bank’s share (seller’s interest) in the 

securitized exposures is 25 percent, the bank must reflect $25 in EAD for the undrawn 

balances. 

The proposed rule contains a special treatment of EAD for OTC derivative 

contracts, repo-style transactions, and eligible margin loans, which is in section 32 of the 

proposed rule and discussed in more detail in section V.C. of the preamble. 

General quantification principles

The proposed rule requires data used by a bank to estimate risk parameters to be 

relevant to the bank’s actual wholesale and retail exposures and of sufficient quality to 

support the determination of risk-based capital requirements for the exposures. For 

wholesale exposures, estimation of the risk parameters must be based on a minimum of 5 

years of default data to estimate PD, 7 years of loss severity data to estimate ELGD and 

LGD, and 7 years of exposure amount data to estimate EAD. For segments of retail 

exposures, estimation of risk parameters must be based on a minimum of 5 years of 

default data to estimate PD, 5 years of loss severity data to estimate ELGD and LGD, and 

5 years of exposure amount data to estimate EAD. Default, loss severity, and exposure 

amount data must include periods of economic downturn conditions or the bank must 

adjust its estimates of risk parameters to compensate for the lack of data from such 

periods. Banks must base their estimates of PD, ELGD, LGD, and EAD on the proposed 

rule’s definition of default, and must review at least annually and update (as appropriate) 

their risk parameters and risk parameter quantification process. 
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In all cases, banks would be expected to use the best available data for 

quantifying the risk parameters. A bank could meet the minimum data requirement by 

using internal data, external data, or pooled data combining internal data with external 

data. Internal data refers to any data on exposures held in a bank’s existing or historical 

portfolios, including data elements or information provided by third parties. External 

data refers to information on exposures held outside of the bank’s portfolio or aggregate 

information across an industry. 

For example, for new lines of business where a bank lacks sufficient internal data, 

it must use external data to supplement its internal data. The agencies recognize that the 

minimum sample period for reference data provided in the proposed rule may not provide 

the best available results. A longer sample period usually captures varying economic 

conditions better than a shorter sample period; in addition, a longer sample period will 

include more default observations for ELGD, LGD, and EAD estimation. Banks should 

consider using a longer-than-minimum sample period when possible. However, the 

potential increase in precision afforded by a larger sample should be weighed against the 

potential for diminished comparability of older data to the existing portfolio; striking the 

correct balance is an important aspect of quantitative modeling. 

Both internal and external reference data should not differ systematically from a 

bank’s existing portfolio in ways that seem likely to be related to default risk, loss 

severity, or exposure at default. Otherwise, the derived PD, ELGD, LGD, or EAD 

estimates may not be applicable to the bank’s existing portfolio. Accordingly, the bank 

must conduct a comprehensive review and analysis of reference data at least annually to 

determine the relevance of reference data to the bank’s exposures, the quality of reference 
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data to support PD, ELGD, LGD, and EAD estimates, and the consistency of reference 

data to the definition of default contained in the proposed rule. Furthermore, a bank must 

have adequate data to estimate risk parameters for all its wholesale and retail exposures 

as if they were held to maturity, even if some loans are likely to be sold or securitized 

before their long-term credit performance can be observed. 

As noted above, periods of economic downturn conditions must be included in the 

data sample (or adjustments to risk parameters must be made). If the reference data 

include data from beyond the minimum number of years (to capture a period of economic 

downturn conditions or for other valid reasons), the reference data need not cover all of 

the intervening years. However, a bank should justify the exclusion of available data 

and, in particular, any temporal discontinuities in data used. Including periods of 

economic downturn conditions increases the size and potentially the breadth of the 

reference data set. According to some empirical studies, the average loss rate is higher 

during periods of economic downturn conditions, such that exclusion of such periods 

would bias ELGD, LGD, or EAD estimates downward and unjustifiably lower risk-based 

capital requirements. 

Risk parameter estimates should take into account the robustness of the 

quantification process. The assumptions and adjustments embedded in the quantification 

process should reflect the degree of uncertainty or potential error inherent in the process. 

In practice, a reasonable estimation approach likely would result in a range of defensible 

risk parameter estimates. The choices of the particular assumptions and adjustments that 

determine the final estimate, within the defensible range, should reflect the uncertainty in 

the quantification process. That is, more uncertainty in the process should be reflected in 
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the assignment of final risk parameter estimates that result in higher risk-based capital 

requirements relative to a quantification process with less uncertainty. The degree of 

conservatism applied to adjust for uncertainty should be related to factors such as the 

relevance of the reference data to a bank’s existing exposures, the robustness of the 

models, the precision of the statistical estimates, and the amount of judgment used 

throughout the process. Margins of conservatism need not be added at each step; indeed, 

that could produce an excessively conservative result. Instead, the overall margin of 

conservatism should adequately account for all uncertainties and weaknesses in the 

quantification process. Improvements in the quantification process (including use of 

more complete data and better estimation techniques) may reduce the appropriate degree 

of conservatism over time. 

Judgment will inevitably play a role in the quantification process and may 

materially affect the estimates of risk parameters. Judgmental adjustments to estimates 

are often necessary because of some limitations on available reference data or because of 

inherent differences between the reference data and the bank’s existing exposures. The 

bank must ensure that adjustments are not biased toward optimistically low risk 

parameter estimates. This standard does not prohibit individual adjustments that result in 

lower estimates of risk parameters, as both upward and downward adjustments are 

expected. Individual adjustments are less important than broad patterns; consistent signs 

of judgmental decisions that lower risk parameter estimates materially may be evidence 

of systematic bias, which would not be permitted. 

4. Optional approaches that require prior supervisory approval
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A bank that intends to apply the internal models methodology to counterparty 

credit risk, the double default treatment for credit risk mitigation, the internal assessment 

approach (IAA) for securitization exposures to ABCP programs, or the internal models 

approach (IMA) to equity exposures must receive prior written approval from its primary 

Federal supervisor. The criteria on which approval would be based are described in the 

respective sections below. 

5. Operational risk

A bank must have operational risk management processes, data and assessment 

systems, and quantification systems that meet the qualification requirements in 

section 22(h) of the proposed rule. A bank must have an operational risk management 

function independent from business line management. The operational risk management 

function is responsible for the design, implementation, and oversight of the bank’s 

operational risk data and assessment systems, operational risk quantification systems, and 

related processes. The roles and responsibilities of the operational risk management 

function may vary between banks, but must be clearly documented. The operational risk 

management function should have organizational stature commensurate with the bank’s 

operational risk profile. At a minimum, the bank’s operational risk management function 

should ensure the development of policies and procedures for the explicit management of 

operational risk as a distinct risk to the bank’s safety and soundness. 

A bank also must establish and document a process to identify, measure, monitor, 

and control operational risk in bank products, activities, processes, and systems. This 

process should provide for the consistent and comprehensive collection of the data 

needed to estimate the bank’s exposure to operational risk. The process must also ensure 
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reporting of operational risk exposures, operational loss events, and other relevant 

operational risk information to business unit management, senior management, and to the 

board of directors (or a designated committee of the board). The proposed rule defines 

operational loss events as events that result in loss and are associated with internal fraud; 

external fraud; employment practices and workplace safety; clients, products, and 

business practices; damage to physical assets; business disruption and system failures; or 

execution, delivery, and process management. A bank’s operational risk management 

processes should reflect the scope and complexity of its business lines, as well as its 

corporate organizational structure. Each bank’s operational risk profile is unique and 

requires a tailored risk management approach appropriate for the scale and materiality of 

the operational risks present in the bank. 

Operational risk data and assessment system

A bank must have an operational risk data and assessment system that 

incorporates on an ongoing basis the following four elements: internal operational loss 

event data, external operational loss event data, results of scenario analysis, and 

assessments of the bank’s business environment and internal controls. These four 

operational risk elements should aid the bank in identifying the level and trend of 

operational risk, determining the effectiveness of operational risk management and 

control efforts, highlighting opportunities to better mitigate operational risk, and 

assessing operational risk on a forward-looking basis. A bank’s operational risk data and 

assessment system must be structured in a manner consistent with the bank’s current 

business activities, risk profile, technological processes, and risk management processes. 
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 The proposed rule defines operational loss as a loss (excluding insurance or tax 

effects) resulting from an operational loss event. Operational losses include all expenses 

associated with an operational loss event except for opportunity costs, forgone revenue, 

and costs related to risk management and control enhancements implemented to prevent 

future operational losses. The definition of operational loss is an important issue, as it is 

a critical building block in a bank’s calculation of its operational risk capital requirement 

under the AMA. More specifically, under the proposed rule, the bank’s estimate of 

operational risk exposure – the basis for determining a bank’s risk-weighted asset amount 

for operational risk – is an estimate of aggregate operational losses generated by the 

bank’s AMA process. 

 The agencies are considering whether to define operational loss based solely on 

the effect of an operational loss event on a bank’s regulatory capital or to use a definition 

of operational loss that incorporates, to a greater extent, economic capital concepts. In 

either case, operational losses would continue to be determined exclusive of insurance 

and tax effects. 

With respect to most operational loss events, the agencies believe that the 

operational loss amount incorporated into a bank’s AMA process would be substantially 

the same whether viewed from the perspective of its effect on the bank’s regulatory 

capital or an alternative approach that more directly incorporates economic capital 

concepts. In the case of operational loss events associated with premises and other fixed 

assets, however, potential loss amounts used in a bank’s estimate of its operational risk 

exposure could be considerably different under the two approaches. The agencies 

recognize that, for purposes of economic capital analysis, banks often use replacement 
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132

cost or market value, and not carrying value, to determine the amount of an operational 

loss with respect to fixed assets. The use of carrying value would be consistent with a 

definition of operational loss that covers a loss event’s effect on a bank’s regulatory 

capital, but may not reflect the full economic impact of a loss event in the case of assets 

that have a carrying value that is different from their market value. 

Further, the agencies recognize that there is a potential to double-count all or a 

portion of the risk-based capital requirement associated with fixed assets. Under 

section 31(e)(3) of the proposed rule, which addresses calculation of risk-weighted asset 

amounts for assets that are not included in an exposure category, the risk-weighted asset 

amount for a bank’s premises will equal the carrying value of the premises on the 

financial statements of the bank, determined in accordance with GAAP. A bank’s 

operational risk exposure estimate addressing bank premises generally will be different 

than the risk-based capital requirement generated under section 31(e)(3) of the proposed 

rule and, at least in part, will address the same risk exposure. 

 Question 19: The agencies solicit comment on all aspects of the proposed 

treatment of operational loss and, in particular, on (i) the appropriateness of the proposed 

definition of operational loss; (ii) whether the agencies should define operational loss in 

terms of the effect an operational loss event has on the bank’s regulatory capital or should 

consider a broader definition based on economic capital concepts; and (iii) how the 

agencies should address the potential double-counting issue for premises and other fixed 

assets.

A bank must have a systematic process for capturing and using internal 

operational loss event data in its operational risk data and assessment systems. 
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133

Consistent with the ANPR, the proposed rule defines internal operational loss event data 

for a bank as gross operational loss amounts, dates, recoveries, and relevant causal 

information for operational loss events occurring at the bank. A bank’s operational risk 

data and assessment system must include a minimum historical observation period of five 

years of internal operational losses. With approval of its primary Federal supervisor, 

however, a bank may use a shorter historical observation period to address transitional 

situations such as integrating a new business line. A bank may refrain from collecting 

internal operational loss event data for individual operational losses below established 

dollar threshold amounts if the bank can demonstrate to the satisfaction of its primary 

Federal supervisor that the thresholds are reasonable, do not exclude important internal 

operational loss event data, and permit the bank to capture substantially all the dollar 

value of the bank’s operational losses. 

A bank also must establish a systematic process for determining its methodologies 

for incorporating external operational loss event data into its operational risk data and 

assessment systems. The proposed rule defines external operational loss event data for a 

bank as gross operational loss amounts, dates, recoveries, and relevant causal information 

for operational loss events occurring at organizations other than the bank. External 

operational loss event data may serve a number of different purposes in a bank’s 

operational risk data and assessment systems. For example, external operational loss 

event data may be a particularly useful input in determining a bank’s level of exposure to 

operational risk when internal operational loss event data are limited. In addition, 

external operational loss event data provide a means for the bank to understand industry 
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134

experience and, in turn, provide a means for the bank to assess the adequacy of its 

internal operational loss event data. 

While internal and external operational loss event data provide a historical 

perspective on operational risk, it is also important that a bank incorporate forwardlooking elements in its operational risk data and assessment systems. Accordingly, a 

bank must incorporate a business environment and internal control factor analysis in its 

operational risk data and assessment systems to fully assess its exposure to operational 

risk. In principle, a bank with strong internal controls in a stable business environment 

would have less exposure to operational risk than a bank with internal control weaknesses 

that is growing rapidly or introducing new products. In this regard, a bank should 

identify and assess the level and trends in operational risk and related control structures at 

the bank. These assessments should be current, should be comprehensive across the 

bank, and should identify the operational risks facing the bank. The framework 

established by a bank to maintain these risk assessments should be sufficiently flexible to 

accommodate increasing complexity, new activities, changes in internal control systems, 

and an increasing volume of information. A bank must also periodically compare the 

results of its prior business environment and internal control factor assessments against 

the bank’s actual operational losses incurred in the intervening period. 

Similar to business environment and internal control factor assessments, the 

results of scenario analysis provide a means for a bank to incorporate a forward-looking 

element in its operational risk data and assessment systems. Under the proposed rule, 

scenario analysis is a systematic process of obtaining expert opinions from business 

managers and risk management experts to derive reasoned assessments of the likelihood 
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135

and loss impact of plausible high-severity operational losses that may occur at a bank. A 

bank must establish a systematic process for determining its methodologies for 

incorporating scenario analysis into its operational risk data and assessment systems. As 

an input to a bank’s operational risk data and assessment systems, scenario analysis is 

especially relevant for business lines or loss event types where internal data, external 

data, and assessments of the business environment and internal control factors do not 

provide a sufficiently robust estimate of the bank’s exposure to operational risk. 

A bank’s operational risk data and assessment systems must include credible, 

transparent, systematic, and verifiable processes that incorporate all four operational risk 

elements. The bank should have clear standards for the collection and modification of all 

elements. The bank should combine these four elements in a manner that most 

effectively enables it to quantify its exposure to operational risk. 

Operational risk quantification system

A bank must have an operational risk quantification system that measures its 

operational risk exposure using its operational risk data and assessment systems. The 

proposed rule defines operational risk exposure as the 99.9th percentile of the distribution 

of potential aggregate operational losses, as generated by the bank’s operational risk 

quantification system over a one-year horizon (and not incorporating eligible operational 

risk offsets or qualifying operational risk mitigants). The mean of such a total loss 

distribution is the bank’s EOL. The proposed rule defines EOL as the expected value of 

the distribution of potential aggregate operational losses, as generated by the bank’s 
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operational risk quantification system using a one-year horizon. The bank’s UOL is the 

difference between the bank’s operational risk exposure and the bank’s EOL. 

As part of its estimation of its operational risk exposure, a bank must demonstrate 

that its unit of measure is appropriate for the bank’s range of business activities and the 

variety of operational loss events to which it is exposed. The proposed rule defines a unit 

of measure as the level (for example, organizational unit or operational loss event type) at 

which the bank’s operational risk quantification system generates a separate distribution 

of potential operational losses. A bank must also demonstrate that it has not combined 

business activities or operational loss events with different risk profiles within the same 

loss distribution. 

The agencies recognize that operational losses across operational loss event types 

and business lines may be related. A bank may use its internal estimates of dependence 

among operational losses within and across business lines and operational loss event 

types if the bank can demonstrate to the satisfaction of its primary Federal supervisor that 

its process for estimating dependence is sound, robust to a variety of scenarios, and 

implemented with integrity, and allows for the uncertainty surrounding the estimates. 

The agencies expect that a bank’s assumptions regarding dependence will be 

conservative given the uncertainties surrounding dependence modeling for operational 

risk. If a bank does not satisfy the requirements surrounding dependence described 

above, the bank must sum operational risk exposure estimates across units of measure to 

calculate its operational risk exposure. 

A bank’s chosen unit of measure affects how it should account for dependence. 

Explicit assumptions regarding dependence across units of measure are always necessary 
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to estimate operational risk exposure at the bank level. However, explicit assumptions 

regarding dependence within units of measure are not necessary, and under many 

circumstances models assume statistical independence within each unit of measure. The 

use of only a few units of measure heightens the need to ensure that dependence within 

units of measure is suitably reflected in the operational risk exposure estimate. 

In addition, the bank’s process for estimating dependence should provide for 

ongoing monitoring, recognizing that dependence estimates can change. The agencies 

expect that a bank’s approach for developing explicit and objective dependence 

determinations will improve over time. As such, the bank should develop a process for 

assessing incremental improvements to the approach (for example, through out-of-sample 

testing). 

A bank must review and update (as appropriate) its operational risk quantification 

system whenever the bank becomes aware of information that may have a material effect 

on the bank’s estimate of operational risk exposure, but no less frequently than annually. 

As described above, the agencies expect a bank using the AMA to demonstrate 

that its systems for managing and measuring operational risk meet established standards, 

including producing an estimate of operational risk exposure at the 99.9 percent 

confidence level. However, the agencies recognize that, in limited circumstances, there 

may not be sufficient data available for a bank to generate a credible estimate of its own 

operational risk exposure at the 99.9 percent confidence level. In these limited 

circumstances, a bank may propose use of an alternative operational risk quantification 

system to that specified in section 22(h)(3)(i) of the proposed rule, subject to approval by 
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the bank’s primary Federal supervisor. The alternative approach is not available at the 

BHC level. 

The agencies are not prescribing specific estimation methodologies under this 

approach and expect use of an alternative approach to occur on a very limited basis. A 

bank proposing to use an alternative operational risk quantification system must submit a 

proposal to its primary Federal supervisor. In evaluating a bank’s proposal, the bank’s 

primary Federal supervisor will review the bank’s justification for requesting use of an 

alternative approach in light of the bank’s size, complexity, and risk profile. The bank’s 

primary Federal supervisor will also consider whether the proposed approach results in 

capital levels that are commensurate with the bank’s operational risk profile, is sensitive 

to changes in the bank’s risk profile, can be supported empirically, and allows the bank’s 

board of directors to fulfill its fiduciary responsibilities to ensure that the bank is 

adequately capitalized. Furthermore, the agencies expect a bank using an alternative 

operational risk quantification system to adhere to the qualification requirements outlined 

in the proposed rule, including establishment and use of operational risk management 

processes and data and assessment systems. 

A bank proposing an alternative approach to operational risk based on an 

allocation methodology should be aware of certain limitations associated with use of such 

an approach. Specifically, the agencies will not accept an allocation of operational risk 

capital requirements that includes non-DI entities or the benefits of diversification across 

entities. The exclusion of allocations that include non-DIs is in recognition that, unlike 

the cross-guarantee provision of the Federal Deposit Insurance Act, which provides that a 

DI is liable for any losses incurred by the FDIC in connection with the failure of a 
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139

commonly-controlled DI, there are no statutory provisions requiring cross-guarantees 

between a DI and its non-DI affiliates.29 Furthermore, depositors and creditors of a DI 

generally have no legal recourse to capital funds that are not held by the DI or its affiliate 

DIs. 

6. Data management and maintenance

A bank must have data management and maintenance systems that adequately 

support all aspects of the bank’s advanced IRB systems, operational risk management 

processes, operational risk data and assessment systems, operational risk quantification 

systems, and, to the extent the bank uses the following systems, the internal models 

methodology to counterparty credit risk, double default excessive correlation detection 

process, IMA to equity exposures, and IAA to securitization exposures to ABCP 

programs (collectively, advanced systems). The bank’s data management and 

maintenance systems must ensure the timely and accurate reporting of risk-based capital 

requirements. Specifically, a bank must retain sufficient data elements to permit 

monitoring, validation, and refinement of the bank’s advanced systems. A bank’s data 

management and maintenance systems should generally support the proposed rule’s 

qualification requirements relating to quantification, validation, and control and oversight 

mechanisms, as well as the bank’s broader risk management and reporting needs. The 

precise data elements to be collected would be dictated by the features and methodologies 

of the risk measurement and management systems employed by the bank. To meet the 

significant data management challenges presented by the quantification, validation, and 

control and oversight requirements of the advanced approaches, a bank must store its data 

 

29 12 U.S.C. 1815(e). 
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in an electronic format that allows timely retrieval for analysis, reporting, and disclosure 

purposes. 

7. Control and oversight mechanisms

The consequences of an inaccurate or unreliable advanced system can be 

significant, particularly on the calculation of risk-based capital requirements. 

Accordingly, bank senior management would be responsible for ensuring that all 

advanced system components function effectively and are in compliance with the 

qualification requirements of the advanced approaches. Moreover, the bank’s board of 

directors (or a designated committee of the board) must evaluate at least annually the 

effectiveness of, and approve, the bank’s advanced systems. 

To support senior management’s and the board of directors’ oversight 

responsibilities, a bank must have an effective system of controls and oversight that 

ensures ongoing compliance with the qualification requirements and maintains the 

integrity, reliability, and accuracy of the bank’s advanced systems. Banks would have 

flexibility in how they achieve integrity in their risk management systems. They would, 

however, be expected to follow standard control principles in their systems such as 

checks and balances, separation of duties, appropriateness of incentives, and data 

integrity assurance, including that of information purchased from third parties. 

Moreover, the oversight process should be sufficiently independent of the advanced 

systems’ development, implementation, and operation to ensure the integrity of the 

component systems. The objective of risk management system oversight is to ensure that 

the various systems used in determining risk-based capital requirements are operating as 

intended. The oversight process should draw conclusions on the soundness of the 
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components of the risk management system, identify errors and flaws, and recommend 

corrective action as appropriate. 

Validation 

 A bank must validate its advanced systems on an ongoing basis. Validation is the 

set of activities designed to give the greatest possible assurances of accuracy of the 

advanced systems. Validation includes three broad components: (i) evaluation of the 

conceptual soundness of the advanced systems, taking into account industry 

developments; (ii) ongoing monitoring that includes process verification and comparison 

of the bank’s internal estimates with relevant internal and external data sources or results 

using other estimation techniques (benchmarking); and (iii) outcomes analysis that 

includes comparisons of actual outcomes to the bank’s internal estimates by backtesting 

and other methods. 

Each of these three components of validation must be applied to the bank’s risk 

rating and segmentation systems, risk parameter quantification processes, and internal 

models that are part of the bank’s advanced systems. A sound validation process should 

take business cycles into account, and any adjustments for stages of the economic cycle 

should be clearly specified in advance and fully documented as part of the validation 

policy. Senior management of the bank should be notified of the validation results and 

should take corrective action, where appropriate. 

A bank’s validation process must be independent of the advanced systems’ 

development, implementation, and operation, or be subject to independent assessment of 

its adequacy and effectiveness. A bank should ensure that individuals who perform the 

review are independent – that is, are not biased in their assessment due to their 
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involvement in the development, implementation, or operation of the processes or 

products. For example, reviews of the internal risk rating and segmentation systems 

should be performed by individuals who were not part of the development, 

implementation, or maintenance of those systems. In addition, individuals performing 

the reviews should possess the requisite technical skills and expertise to fulfill their 

mandate. 

The first component of validation is evaluating conceptual soundness, which 

involves assessing the quality of the design and construction of a risk measurement or 

management system. This evaluation of conceptual soundness should include 

documentation and empirical evidence supporting the methods used and the variables 

selected in the design and quantification of the bank’s advanced systems. The 

documentation should also include evidence of an understanding of the limitations of the 

systems. The development of internal risk rating and segmentation systems and their 

quantification processes requires banks to adopt methods, choose characteristics, and 

make adjustments; each of these actions requires judgment. Validation should ensure 

that these judgments are well informed and considered, and generally include a body of 

expert opinion. A bank should review developmental evidence whenever the bank makes 

material changes in its advanced systems. 

The second component of the validation process for a bank’s advanced systems is 

ongoing monitoring to confirm that the systems were implemented appropriately and 

continue to perform as intended. Such monitoring involves process verification and 

benchmarking. Process verification includes verifying that internal and external data are 

accurate and complete and ensuring that internal risk rating and segmentation systems are 
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143

being used, monitored, and updated as designed and that ratings are assigned to 

wholesale obligors and exposures as intended, and that appropriate remediation is 

undertaken if deficiencies exist. 

Benchmarking is the set of activities that uses alternative data sources or risk 

assessment approaches to draw inferences about the correctness of internal risk ratings, 

segmentations, risk parameter estimates, or model outputs before outcomes are actually 

known. For credit risk ratings, examples of alternative data sources include independent 

internal raters (such as loan review), external rating agencies, wholesale and retail credit 

risk models developed independently, or retail credit bureau models. Because it will take 

considerable time before outcomes will be available and backtesting is possible, 

benchmarking will be a very important validation device. Benchmarking would be 

applied to all quantification processes and internal risk rating and segmentation activities. 

Benchmarking allows a bank to compare its estimates with those of other 

estimation techniques and data sources. Results of benchmarking exercises can be a 

valuable diagnostic tool in identifying potential weaknesses in a bank’s risk 

quantification system. While benchmarking activities allow for inferences about the 

appropriateness of the quantification processes and internal risk rating and segmentation 

systems, they are not the same as backtesting. When differences are observed between 

the bank’s risk estimates and the benchmark, this should not necessarily indicate that the 

internal risk ratings, segmentation decisions, or risk parameter estimates are in error. The 

benchmark itself is an alternative prediction, and the difference may be due to different 

data or methods. As part of the benchmarking exercise, the bank should investigate the 

source of the differences and whether the extent of the differences is appropriate. 
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The third component of the validation process is outcomes analysis, which is the 

comparison of the bank’s forecasts of risk parameters and other model outputs with 

actual outcomes. A bank’s outcomes analysis must include backtesting, which is the 

comparison of the bank’s forecasts generated by its internal models with actual outcomes 

during a sample period not used in model development. In this context, backtesting is 

one form of out-of-sample testing. The agencies note that in other contexts backtesting 

may refer to in-sample fit, but in-sample fit analysis is not what the proposed rule 

requires a bank to do as part of the advanced approaches validation process. 

Actual outcomes would be compared with expected ranges around the estimated 

values of the risk parameters and model results. Random chance and many other factors 

will make discrepancies between realized outcomes and the estimated risk parameters 

inevitable. Therefore the expected ranges should take into account relevant elements of a 

bank’s internal risk rating or segmentation processes. For example, depending on the 

bank’s rating philosophy, year-by-year realized default rates may be expected to differ 

significantly from the long-run one-year average. Also, changes in economic conditions 

between the historical data and current period can lead to differences between realizations 

and estimates. 

Internal audit

A bank must have an internal audit function independent of business-line 

management that assesses at least annually the effectiveness of the controls supporting 

the bank’s advanced systems. At least annually, internal audit should review the 

validation process, including validation procedures, responsibilities, results, timeliness, 

and responsiveness to findings. Further, internal audit should evaluate the depth, scope, 
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145

and quality of the risk management system review process and conduct appropriate 

testing to ensure that the conclusions of these reviews are well founded. Internal audit 

must report its findings at least annually to the bank’s board of directors (or a committee 

thereof). 

Stress testing

A bank must periodically stress test its advanced systems. Stress testing analysis 

is a means of understanding how economic cycles, especially downturns as described by 

stress scenarios, affect risk-based capital requirements, including migration across rating 

grades or segments and the credit risk mitigation benefits of double default treatment. 

Under the proposed rule, changes in borrower credit quality will lead to changes in riskbased capital requirements. Because credit quality changes typically reflect changing 

economic conditions, risk-based capital requirements may also vary with the economic 

cycle. During an economic downturn, risk-based capital requirements would increase if 

wholesale obligors or retail exposures migrate toward lower credit quality ratings or 

segments. 

Supervisors expect that banks will manage their regulatory capital position so that 

they remain at least adequately capitalized during all phases of the economic cycle. A 

bank that is able to credibly estimate regulatory capital levels during a downturn can be 

more confident of appropriately managing regulatory capital. Stress testing analysis 

consists of identifying a stress scenario and then translating the scenario into its effect on 

the levels of key performance measures, including regulatory capital ratios. 

Banks should use a range of plausible but severe scenarios and methods when 

stress testing to manage regulatory capital. Scenarios could be historical, hypothetical, or 
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model-based. Key variables specified in a scenario could include, for example, interest 

rates, transition matrices (ratings and score-band segments), asset values, credit spreads, 

market liquidity, economic growth rates, inflation rates, exchange rates, or 

unemployment rates. A bank may choose to have scenarios apply to an entire portfolio, 

or it may identify scenarios specific to various sub-portfolios. The severity of the stress 

scenarios should be consistent with the periodic economic downturns experienced in the 

bank’s market areas. Such scenarios may be less severe than those used for other 

purposes, such as testing a bank’s solvency. 

The scope of stress testing analysis should be broad and include all material 

portfolios. The time horizon of the analysis should be consistent with the specifics of the 

scenario and should be long enough to measure the material effects of the scenario on key 

performance measures. For example, if a scenario such as a historical recession has 

material income and segment or ratings migration effects over two years, the appropriate 

time horizon is at least two years. 

8. Documentation

A bank must document adequately all material aspects of its advanced systems, 

including but not limited to the internal risk rating and segmentation systems, risk 

parameter quantification processes, model design, assumptions, and validation results. 

The guiding principle governing documentation is that it should support the requirements 

for the quantification, validation, and control and oversight mechanisms as well as the 

bank’s broader risk management and reporting needs. Documentation is also critical to 

the supervisory oversight process. 
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The bank should document the rationale for all material assumptions 

underpinning its chosen analytical frameworks, including the choice of inputs, 

distributional assumptions, and weighting of quantitative and qualitative elements. The 

bank also should document and justify any subsequent changes to these assumptions. 

 C. Ongoing Qualification 

An advanced approaches bank must meet the qualification requirements on an 

ongoing basis. Banks are expected to improve their advanced systems as they improve 

data gathering capabilities and as industry practice evolves. To facilitate the supervisory 

oversight of such systems changes, a bank must notify its primary Federal supervisor 

when it makes a change to its advanced systems that results in a material change in the 

bank’s risk-weighted asset amount for an exposure type, or when the bank makes any 

significant change to its modeling assumptions. 

Due to the advanced approaches’ rigorous systems requirements, a core or opt-in 

bank that merges with or acquires another company that does not calculate risk-based 

capital requirements using the advanced approaches might not be able to use the 

advanced approaches immediately for the merged or acquired company’s exposures. 

Therefore, the proposed rule would permit a core or opt-in bank to use the general riskbased capital rules to compute the risk-weighted assets and associated capital for the 

merged or acquired company’s exposures for up to 24 months following the calendar 

quarter during which the merger or acquisition consummates. 

Any ALLL associated with the acquired company’s exposures may be included in 

the acquiring bank’s tier 2 capital up to 1.25 percent of the acquired company’s riskweighted assets. Such ALLL would be excluded from the acquiring bank’s eligible credit 
 Draft Basel II NPR 

148

reserves. The risk-weighted assets of the acquired company would not be included in the 

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

bank’s total risk-weighted assets. Any amount of the acquired company’s ALLL that was 

eliminated in accounting for the acquisition would not be included in the acquiring 

bank’s regulatory capital. An acquiring bank using the general risk-based capital rules 

for acquired exposures would be required to disclose publicly the amounts of riskweighted assets and qualifying capital calculated under the general risk-based capital 

rules with respect to the acquired company and under the proposed rule for the acquiring 

bank. 

 Similarly, due to the substantial infrastructure requirements of the proposed rule, 

a core or opt-in bank that merges with or acquires another core or opt-in bank might not 

be able to apply its own version of the advanced approaches immediately to the acquired 

bank’s exposures. Accordingly, the proposed rule permits a core or opt-in bank that 

merges with or acquires another core or opt-in bank to use the acquired bank’s advanced 

approaches to determine the risk-weighted asset amounts for, and deductions from capital 

associated with, the acquired bank’s exposures for up to 24 months following the 

calendar quarter during which the merger or acquisition consummates. 

In all mergers and acquisitions involving a core or opt-in bank, the acquiring bank 

must submit an implementation plan for using advanced approaches for the merged or 

acquired company to its primary Federal supervisor within 30 days of consummating the 

merger or acquisition. A bank’s primary Federal supervisor may extend the transition 

period for mergers or acquisitions for up to an additional 12 months. The primary 

Federal supervisor of the bank will monitor the merger or acquisition to determine 
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149

whether the application of the general risk-based capital rules by the acquired company 

produces appropriate risk weights for the assets of the acquired company in light of the 

overall risk profile of the combined bank. 

Question 20: The agencies seek comment on the appropriateness of the 24-month 

and 30-day time frames for addressing the merger and acquisition transition situations 

advanced approaches banks may face. 

If a bank that uses the advanced approaches to calculate its risk-based capital 

requirements falls out of compliance with the qualification requirements, the bank must 

establish a plan satisfactory to its primary Federal supervisor to return to compliance with 

the qualification requirements. Such a bank also must disclose to the public its failure to 

comply with the qualification requirements promptly after receiving notice of noncompliance from its primary Federal supervisor. If the bank’s primary Federal supervisor 

determines that the bank’s risk-based capital requirements are not commensurate with the 

bank’s credit, market, operational, or other risks, it may require the bank to calculate its 

risk-based capital requirements using the general risk-based capital rules or a modified 

form of the advanced approaches (for example, with fixed supervisory risk parameters). 

IV. Calculation of Tier 1 Capital and Total Qualifying Capital 

The proposed rule maintains the minimum risk-based capital ratio requirements of 

4.0 percent tier 1 capital to total risk-weighted assets and 8.0 percent total qualifying 

capital to total risk-weighted assets. Under the proposed rule, a bank’s total qualifying 

capital is the sum of its tier 1 (core) capital elements and tier 2 (supplemental) capital 

elements, subject to various limits and restrictions, minus certain deductions 

(adjustments). The agencies are not restating the elements of tier 1 and tier 2 capital in 
 Draft Basel II NPR 

150

this proposed rule. Those capital elements generally remain as they are currently in the 

general risk-based capital rules.30 The agencies have provided proposed regulatory text 

for, and the following discussion of, proposed adjustments to the capital elements for 

purposes of the advanced approaches. 

The agencies are considering restating the elements of tier 1 and tier 2 capital, 

with any necessary conforming and technical amendments, in any final rules that are 

issued regarding this proposed framework so that a bank using the advanced approaches 

would have a single, comprehensive regulatory text that describes both the numerator and 

denominator of the bank’s minimum risk-based capital ratios. The agencies decided not 

to set forth the capital elements in this proposed rule so that commenters would be able to 

focus attention on the parts of the risk-based capital framework that the agencies propose 

to amend. Question 21: Commenters are encouraged to provide views on the proposed 

adjustments to the components of the risk-based capital numerator as described below. 

Commenters also may provide views on numerator-related issues that they believe would 

be useful to the agencies’ consideration of the proposed rule.

 After identifying the elements of tier 1 and tier 2 capital, a bank would make 

certain adjustments to determine its tier 1 capital and total qualifying capital (that is, the 

numerator of the total risk-based capital ratio). Some of these adjustments would be 

made only to the tier 1 portion of the capital base. Other adjustments would be made 

50 percent from tier 1 capital and 50 percent from tier 2 capital.31 Under the proposed 

 

30 See 12 CFR part 3, Appendix A, § 2 (national banks); 12 CFR part 208, Appendix A, § II (state member 

banks); 12 CFR part 225, Appendix A, § II (bank holding companies); 12 CFR part 325, Appendix A (state 

non-member banks); and 12 CFR 567.5 (savings associations). 

31 If the amount deductible from tier 2 capital exceeds the bank’s actual tier 2 capital, however, the bank 

must deduct the shortfall amount from tier 1 capital. 
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151

rule, a bank must still have at least 50 percent of its total qualifying capital in the form of 

tier 1 capital. 

 The bank would continue to deduct from tier 1 capital goodwill, other intangible 

assets, and deferred tax assets to the same extent that those assets are currently required 

to be deducted from tier 1 capital under the general risk-based capital rules. Thus, all 

goodwill would be deducted from tier 1 capital. Qualifying intangible assets – including 

mortgage servicing assets, non-mortgage servicing assets, and purchased credit card 

relationships – that meet the conditions and limits in the general risk-based capital rules 

would not have to be deducted from tier 1 capital. Likewise, deferred tax assets that are 

dependent upon future taxable income and that meet the valuation requirements and 

limits in the general risk-based capital rules would not have to be deducted from tier 1 

capital.32

 Under the general risk-based capital rules, a bank also must deduct from its tier 1 

capital certain percentages of the adjusted carrying value of its nonfinancial equity 

investments. An advanced approaches bank would no longer be required to make this 

deduction. Instead, the bank’s equity exposures would be subject to the equity treatment 

in part VI of the proposed rule and described in section V.F. of this preamble.33 

 

32 See 12 CFR part 3, § 2 (national banks); 12 CFR part 208, Appendix A, § II (state member banks); 12 

CFR part 225, Appendix A, § II (bank holding companies); 12 CFR part 325, Appendix A, § II (state nonmember banks). OTS existing rules are formulated differently, but include similar deductions. Under OTS 

rules, for example, goodwill is included within the definition of “intangible assets” and is deducted from 

tier 1 (core) capital along with other intangible assets. See 12 CFR 567.1 and 567.5(a)(2)(i). Similarly, 

purchased credit card relationships and mortgage and non-mortgage servicing assets are included in capital 

to the same extent as the other agencies’ rules. See 12 CFR 567.5(a)(2)(ii) and 567.12. The deduction of 

deferred tax assets is discussed in Thrift Bulletin 56. 33 By contrast, OTS rules require the deduction of equity investments from total capital. 12 CFR 

567.5(c)(2)(ii). “Equity investments” are defined to include (i) investments in equity securities (other than 

investments in subsidiaries, equity investments that are permissible for national banks, indirect ownership 

interests in certain pools of assets (for example, mutual funds), Federal Home Loan Bank stock and Federal 

Reserve Bank stock); and (ii) investments in certain real property. 12 CFR 567.1. Savings associations 

applying the proposed rule would not be required to deduct investments in equity securities. Instead, such 
 Draft Basel II NPR 

152

 Under the general risk-based capital rules, a bank is allowed to include in tier 2 

capital its ALLL up to 1.25 percent of risk-weighted assets (net of certain deductions). 

Amounts of ALLL in excess of this limit, as well as allocated transfer risk reserves, may 

be deducted from the gross amount of risk-weighted assets. 

Under the proposed framework, as noted above, the ALLL is treated differently. 

The proposed rule includes a methodology for adjusting risk-based capital requirements 

based on a comparison of the bank’s eligible credit reserves to its ECL. The proposed 

rule defines eligible credit reserves as all general allowances, including the ALLL, that 

have been established through a charge against earnings to absorb credit losses associated 

with on- or off-balance sheet wholesale and retail exposures. Eligible credit reserves 

would not include allocated transfer risk reserves established pursuant to 12 U.S.C. 

390434 and other specific reserves created against recognized losses. 

The proposed rule defines a bank’s total ECL as the sum of ECL for all wholesale 

and retail exposures other than exposures to which the bank has applied the double 

default treatment (described below). The bank’s ECL for a wholesale exposure to a nondefaulted obligor or a non-defaulted retail segment is the product of PD, ELGD, and 

EAD for the exposure or segment. The bank’s ECL for a wholesale exposure to a 

defaulted obligor or a defaulted retail segment is equal to the bank’s impairment estimate 

for ALLL purposes for the exposure or segment. 

The proposed method of measuring ECL for non-defaulted exposures is different 

than the proposed method of measuring ECL for defaulted exposures. For non-defaulted 

 investments would be subject to the equity treatment in part VI of the proposed rule. Equity investments in 

real estate would continue to be deducted to the same extent as under the current rules. 34 12 U.S.C. 3904 does not apply to savings associations regulated by the OTS. As a result, the OTS rule 

will not refer to allocated transfer risk reserves. 
 Draft Basel II NPR 

153

exposures, ECL depends directly on ELGD and hence would reflect economic losses, 

including the cost of carry and direct and indirect workout expenses. In contrast, for 

defaulted exposures, ECL is based on accounting measures of credit loss incorporated 

into a bank’s charge-off and reserving practices. 

The agencies believe that, for defaulted exposures, any difference between a 

bank’s best estimate of economic losses and its impairment estimate for ALLL purposes 

is likely to be small. As a result, the agencies are proposing to use a bank’s ALLL 

impairment estimate in the determination of ECL for defaulted exposures to reduce 

implementation burden for banks. The agencies recognize that this proposed treatment 

would require a bank to specify how much of its ALLL is attributable to defaulted 

exposures, and that a bank still would need to capture all material economic losses on 

defaulted exposures when building its databases for estimating ELGDs and LGDs for 

non-defaulted exposures. Question 22: The agencies seek comment on the proposed 

ECL approach for defaulted exposures as well as on an alternative treatment, under which

ECL for a defaulted exposure would be calculated as the bank’s current carrying value of 

the exposure multiplied by the bank’s best estimate of the expected economic loss rate 

associated with the exposure (measured relative to the current carrying value), that would 

be more consistent with the proposed treatment of ECL for non-defaulted exposures. The 

agencies also seek comment on whether these two approaches would likely produce 

materially different ECL estimates for defaulted exposures. In addition, the agencies 

seek comment on the appropriate measure of ECL for assets held at fair value with gains 

and losses flowing through earnings. 
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154

A bank must compare the total dollar amount of its ECL to its eligible credit 

reserves. If there is a shortfall of eligible credit reserves compared to total ECL, the bank 

would deduct 50 percent of the shortfall from tier 1 capital and 50 percent from tier 2 

capital. If eligible credit reserves exceed total ECL, the excess portion of eligible credit 

reserves may be included in tier 2 capital up to 0.6 percent of credit-risk-weighted assets. 

The proposed rule defines credit-risk-weighted assets as 1.06 multiplied by the sum of 

total wholesale and retail risk-weighted assets, risk-weighted assets for securitization 

exposures, and risk-weighted assets for equity exposures. 

A bank must deduct from tier 1 capital any increase in the bank’s equity capital at 

the inception of a securitization transaction (gain-on-sale), other than an increase in 

equity capital that results from the bank’s receipt of cash in connection with the 

securitization. The agencies have designed this deduction to offset accounting treatments 

that produce an increase in a bank’s equity capital and tier 1 capital at the inception of a 

securitization – for example, a gain attributable to a CEIO that results from Financial 

Accounting Standard (FAS) 140 accounting treatment for the sale of underlying 

exposures to a securitization special purpose entity (SPE). Over time, as the bank, from 

an accounting perspective, realizes the increase in equity capital and tier 1 capital that 

was booked at the inception of the securitization through actual receipt of cash flows, the 

amount of the required deduction would shrink accordingly. 

Under the general risk-based capital rules,35 a bank must deduct CEIOs, whether 

purchased or retained, from tier 1 capital to the extent that the CEIOs exceed 25 percent 

of the bank’s tier 1 capital. Under the proposed rule, a bank must deduct CEIOs from tier 

 

35 See 12 CFR part 3, Appendix A, § 2(c)(4) (national banks); 12 CFR part 208, Appendix A, § I.B.1.c. 

(state member banks); 12 CFR part 225, Appendix A, § I.B.1.c. (bank holding companies); 12 CFR part 

325, Appendix A, § I.B.5. (state non-member banks); 12 CFR 567.5(a)(2)(iii) (savings associations). 
 Draft Basel II NPR 

155

1 capital to the extent they represent gain-on-sale, and must deduct any remaining CEIOs 

50 percent from tier 1 capital and 50 percent from tier 2 capital. 

Under the proposed rule, certain other securitization exposures also would be 

deducted from tier 1 and tier 2 capital. These exposures include, for example, 

securitization exposures that have an applicable external rating (defined below) that is 

more than one category below investment grade (for example, below BB) and most 

subordinated unrated securitization exposures. When a bank must deduct a securitization 

exposure (other than gain-on-sale) from regulatory capital, the bank must take the 

deduction 50 percent from tier 1 capital and 50 percent from tier 2 capital. Moreover, a 

bank may calculate any deductions from regulatory capital with respect to a securitization 

exposure (including after-tax gain-on-sale) net of any deferred tax liabilities associated 

with the exposure. 

The proposed rule also requires a bank to deduct the bank’s exposure on certain 

unsettled and failed capital markets transactions 50 percent from tier 1 capital and 

50 percent from tier 2 capital, as discussed in more detail below in section V.D. of the 

preamble. 

The agencies note that investments in unconsolidated banking and finance 

subsidiaries and reciprocal holdings of bank capital instruments would continue to be 

deducted from regulatory capital as described in the general risk-based capital rules. 

Under the agencies’ current rules, a national or state bank that controls or holds an 

interest in a financial subsidiary does not consolidate the assets and liabilities of the 

financial subsidiary with those of the bank for risk-based capital purposes. In addition, 

the bank must deduct its equity investment (including retained earnings) in the financial 
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156

subsidiary from regulatory capital – at least 50 percent from tier 1 capital and up to 50 

percent from tier 2 capital.36 A BHC generally does not deconsolidate the assets and 

liabilities of the financial subsidiaries of the BHC’s subsidiary banks and does not deduct 

from its regulatory capital the equity investments of its subsidiary banks in financial 

subsidiaries. Rather, a BHC generally fully consolidates the financial subsidiaries of its 

subsidiary banks. These treatments would continue under the proposed rule. 

For BHCs with consolidated insurance underwriting subsidiaries that are 

functionally regulated (or subject to comparable supervision and minimum regulatory 

capital requirements in their home jurisdiction), the following treatment would apply. 

The assets and liabilities of the subsidiary would be consolidated for purposes of 

determining the BHC’s risk-weighted assets. However, the BHC must deduct from tier 1 

capital an amount equal to the insurance underwriting subsidiary’s minimum regulatory 

capital requirement as determined by its functional (or equivalent) regulator. For U.S. 

regulated insurance subsidiaries, this amount generally would be 200 percent of the 

subsidiary’s Authorized Control Level as established by the appropriate state insurance 

regulator. 

This approach with respect to functionally-regulated consolidated insurance 

underwriting subsidiaries is different from the New Accord, which broadly endorses a 

deconsolidation and deduction approach for insurance subsidiaries. The Board believes a 

 

36 See 12 CFR 5.39(h)(1) (national banks); 12 CFR 208.73(a) (state member banks); 12 CFR part 325, 

Appendix A, § I.B.2. (state non-member banks). Again, OTS rules are formulated differently. For 

example, OTS rules do not use the terms “unconsolidated banking and finance subsidiary” or “financial 

subsidiary.” Rather, as required by section 5(t)(5) of the Home Owners’ Loan Act (HOLA), equity and 

debt investments in non-includable subsidiaries (generally subsidiaries that are engaged in activities that are 

not permissible for a national bank) are deducted from assets and tier 1 (core) capital. 12 CFR 

567.5(a)(2)(iv) and (v). As required by HOLA, OTS will continue to deduct non-includable subsidiaries. 

Reciprocal holdings of bank capital instruments are deducted from a savings association’s total capital 

under 12 CFR 567.5(c)(2). 
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157

full deconsolidation and deduction approach does not fully capture the risk in insurance 

underwriting subsidiaries at the consolidated BHC level and, thus, has proposed the 

consolidation and deduction approach described above. Question 23: The Board seeks

comment on this proposed treatment and in particular on how a minimum insurance 

regulatory capital proxy for tier 1 deduction purposes should be determined for insurance 

underwriting subsidiaries that are not subject to U.S. functional regulation.

A March 10, 2005, final rule issued by the Board defined restricted core capital 

elements for BHCs and generally limited restricted core capital elements for 

internationally active banking organizations to 15 percent of the sum of all core capital 

elements net of goodwill less any associated deferred tax liability.37 Restricted core 

capital elements are defined as qualifying cumulative perpetual preferred stock (and 

related surplus), minority interest related to qualifying cumulative perpetual preferred 

stock directly issued by a consolidated DI or foreign bank subsidiary, minority interest 

related to qualifying common or qualifying perpetual preferred stock issued by a 

consolidated subsidiary that is neither a DI nor a foreign bank, and qualifying trust 

preferred securities. The final rule defined an internationally active banking organization 

to be a BHC that (i) as of its most recent year-end FR Y-9C reports total consolidated 

assets equal to $250 billion or more or (ii) on a consolidated basis, reports total onbalance sheet foreign exposure of $10 billion or more in its filing of the most recent yearend FFIEC 009 Country Exposure Report. The Board intends to change the definition of 

an internationally active banking organization in the Board’s capital adequacy guidelines 

 

37 70 FR 11827 (Mar. 10, 2005). The final rule also allowed internationally active banking organizations to 

include restricted core capital elements in their tier 1 capital up to 25 percent of the sum of all core capital 

elements net of goodwill less associated deferred tax liability so long as any amounts of restricted core 

capital elements in excess of the 15 percent limit were in the form of mandatory convertible preferred 

securities. 
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158

for BHCs to make it consistent with the definition of a core bank. This change would be 

less restrictive on BHCs because the BHC threshold in this proposed rule uses total 

consolidated assets excluding insurance rather than total consolidated assets including 

insurance. 

V. Calculation of Risk-Weighted Assets 

A bank’s total risk-weighted assets would be the sum of its credit risk-weighted 

assets and risk-weighted assets for operational risk, minus the sum of its excess eligible 

credit reserves (that is, its eligible credit reserves in excess of its total ECL) not included 

in tier 2 capital and allocated transfer risk reserves. 

A. Categorization of Exposures 

 To calculate credit risk-weighted assets, a bank must group its exposures into four 

general categories: wholesale, retail, securitization, and equity. It must also identify 

assets not included in an exposure category and any non-material portfolios of exposures 

to which the bank elects not to apply the IRB framework. In order to exclude a portfolio 

from the IRB framework, a bank must demonstrate to the satisfaction of its primary 

Federal supervisor that the portfolio (when combined with all other portfolios of 

exposures that the bank seeks to exclude from the IRB framework) is not material to the 

bank. 

1. Wholesale exposures

The proposed rule defines a wholesale exposure as a credit exposure to a 

company, individual, sovereign or governmental entity (other than a securitization 
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159

exposure, retail exposure, or equity exposure).38 The term “company” is broadly defined 

to mean a corporation, partnership, limited liability company, depository institution, 

business trust, SPE, association, or similar organization. Examples of a wholesale 

exposure include: (i) a non-tranched guarantee issued by a bank on behalf of a 

company;39 (ii) a repo-style transaction entered into by a bank with a company and any 

other transaction in which a bank posts collateral to a company and faces counterparty 

credit risk; (iii) an exposure that the bank treats as a covered position under the MRA for 

which there is a counterparty credit risk charge in section 32 of the proposed rule; (iv) a 

sale of corporate loans by a bank to a third party in which the bank retains full recourse; 

(v) an OTC derivative contract entered into by a bank with a company; (vi) an exposure 

to an individual that is not managed by the bank as part of a segment of exposures with 

homogeneous risk characteristics; and (vii) a commercial lease. 

The agencies are proposing two subcategories of wholesale exposures – HVCRE 

exposures and non-HVCRE exposures. Under the proposed rule, HVCRE exposures 

would be subject to a separate IRB risk-based capital formula that would produce a 

higher risk-based capital requirement for a given set of risk parameters than the IRB riskbased capital formula for non-HVCRE wholesale exposures. An HVCRE exposure is 

defined as a credit facility that finances or has financed the acquisition, development, or 

construction of real property, excluding facilities used to finance (i) one- to four-family 

 

38 The proposed rule excludes from the definition of a wholesale exposure certain pre-sold one-to-four 

family residential construction loans and certain multifamily residential loans. The treatment of such loans 

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

39 As described below, tranched guarantees (like most transactions that involve a tranching of credit risk) 

generally would be securitization exposures under this proposal. The proposal defines a guarantee broadly 

to include almost any transaction (other than a credit derivative executed under standard industry credit 

derivative documentation) that involves the transfer of the credit risk of an exposure from one party to 

another party. This definition of guarantee generally would include, for example, a credit spread option 

under which a bank has agreed to make payments to its counterparty in the event of an increase in the credit 

spread associated with a particular reference obligation issued by a company. 
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160

residential properties or (ii) commercial real estate projects where: (A) the exposure’s 

LTV ratio is less than or equal to the applicable maximum supervisory LTV ratio in the 

real estate lending standards of the agencies;40 (B) the borrower has contributed capital to 

the project in the form of cash or unencumbered readily marketable assets (or has paid 

development expenses out-of-pocket) of at least 15 percent of the real estate’s appraised 

“as completed” value; and (C) the borrower contributed the amount of capital required 

before the bank advances funds under the credit facility, and the capital contributed by 

the borrower or internally generated by the project is contractually required to remain in 

the project throughout the life of the project. 

Once an exposure is determined to be HVCRE, it would remain an HVCRE 

exposure until paid in full, sold, or converted to permanent financing. After considering 

comments received on the ANPR, the agencies are proposing to retain a separate IRB 

risk-based capital formula for HVCRE exposures in recognition of the high levels of 

systematic risk inherent in some of these exposures. The agencies believe that the 

revised definition of HVCRE in the proposed rule appropriately identifies exposures that 

are particularly susceptible to systematic risk. Question 24: The agencies seek comment 

on how to strike the appropriate balance between the enhanced risk sensitivity and 

marginally higher risk-based capital requirements obtained by separating HVCRE 

exposures from other wholesale exposures and the additional complexity the separation 

entails. 

The New Accord identifies five sub-classes of specialized lending for which the 

primary source of repayment of the obligation is the income generated by the financed 

 

40 12 CFR part 34, Subpart D (OCC); 12 CFR part 208, Appendix C (Board); 12 CFR part 365, Subpart D 

(FDIC); and 12 CFR 560.100-560.101 (OTS). 
 Draft Basel II NPR 

161

asset(s) rather than the independent capacity of a broader commercial enterprise. The 

sub-classes are project finance, object finance, commodities finance, income-producing 

real estate, and HVCRE. The New Accord provides a methodology to accommodate 

banks that cannot meet the requirements for the estimation of PD for these exposure 

types. The sophisticated banks that would apply the advanced approaches in the United 

States should be able to estimate risk parameters for specialized lending exposures, and 

therefore the agencies are not proposing a separate treatment for specialized lending 

beyond the separate IRB risk-based capital formula for HVCRE exposures specified in 

the New Accord. 

In contrast to the New Accord, the agencies are not including in this proposed rule 

an adjustment that would result in a lower risk weight for a loan to a small- and mediumsize enterprise (SME) that has the same risk parameter values as a loan to a larger firm. 

The agencies are not aware of compelling evidence that smaller firms with the same PD 

and LGD as larger firms are subject to less systematic risk. Question 25: The agencies 

request comment and supporting evidence on the consistency of the proposed treatment 

with the underlying riskiness of SME portfolios. Further, the agencies request comment 

on any competitive issues that this aspect of the proposed rule may cause for U.S. banks. 

2. Retail exposures

Under the proposed rule a retail exposure would generally include exposures 

(other than securitization exposures or equity exposures) to an individual or small 

business that are managed as part of a segment of similar exposures, that is, not on an 

individual-exposure basis. Under the proposed rule, there are three subcategories of retail 

exposure: (i) residential mortgage exposures; (ii) QREs; and (iii) other retail exposures. 
 Draft Basel II NPR 

162

The agencies propose generally to define residential mortgage exposure as an exposure 

that is primarily secured by a first or subsequent lien on one-to-four-family residential 

property. 41 This includes both term loans and revolving home equity lines of credit 

(HELOCs). An exposure primarily secured by a first or subsequent lien on residential 

property that is not one-to-four family would also be included as a residential mortgage 

exposure as long as the exposure has both an original and current outstanding amount of 

no more than $1 million. There would be no upper limit on the size of an exposure that is 

secured by one-to-four-family residential properties. To be a residential mortgage 

exposure, the bank must manage the exposure as part of a segment of exposures with 

homogeneous risk characteristics. Residential mortgage loans that are managed on an 

individual basis, rather than managed as part of a segment, would be categorized as 

wholesale exposures. 

QREs would be defined as exposures to individuals that are (i) revolving, 

unsecured, and unconditionally cancelable by the bank to the fullest extent permitted by 

Federal law; (ii) have a maximum exposure amount (drawn plus undrawn) of up to 

$100,000; and (iii) are managed as part of a segment with homogeneous risk 

characteristics. In practice, QREs typically would include exposures where customers' 

outstanding borrowings are permitted to fluctuate based on their decisions to borrow and 

repay, up to a limit established by the bank. Most credit card exposures to individuals 

and overdraft lines on individual checking accounts would be QREs. 

 The category of other retail exposures would include two types of exposures. 

First, all exposures to individuals for non-business purposes (other than residential 

 

41 The proposed rule excludes from the definition of a residential mortgage exposure certain pre-sold oneto-four family residential construction loans and certain multifamily residential loans. The treatment of 

such loans is discussed below in section V.B.5. of the preamble. 
 Draft Basel II NPR 

163

mortgage exposures and QREs) that are managed as part of a segment of similar 

exposures would be other retail exposures. Such exposures may include personal term 

loans, margin loans, auto loans and leases, credit card accounts with credit lines above 

$100,000, and student loans. The agencies are not proposing an upper limit on the size of 

these types of retail exposures to individuals. Second, exposures to individuals or 

companies for business purposes (other than residential mortgage exposures and QREs), 

up to a single-borrower exposure threshold of $1 million, that are managed as part of a 

segment of similar exposures would be other retail exposures. For the purpose of 

assessing exposure to a single borrower, the bank would aggregate all business exposures 

to a particular legal entity and its affiliates that are consolidated under GAAP. If that 

legal entity is a natural person, any consumer loans (for example, personal credit card 

loans or mortgage loans) to that borrower would not be part of the aggregate. A bank 

could distinguish a consumer loan from a business loan by the loan department through 

which the loan is made. Exposures to a borrower for business purposes primarily secured 

by residential property would count toward the $1 million single-borrower other retail 

business exposure threshold. 42

The residual value portion of a retail lease exposure is excluded from the 

definition of an other retail exposure. A bank would assign the residual value portion of 

a retail lease exposure a risk-weighted asset amount equal to its residual value as 

described in section 31 of the proposed rule. 

3. Securitization exposures

 

42 The proposed rule excludes from the definition of an other retail exposure certain pre-sold one-to-four 

family residential construction loans and certain multifamily residential loans. The treatment of such loans 

is discussed below in section V.B.5. of the preamble. 
 Draft Basel II NPR 

164

 The proposed rule defines a securitization exposure as an on-balance sheet or offbalance sheet credit exposure that arises from a traditional or synthetic securitization. A 

traditional securitization is a transaction in which (i) all or a portion of the credit risk of 

one or more underlying exposures is transferred to one or more third parties other than 

through the use of credit derivatives or guarantees; (ii) the credit risk associated with the 

underlying exposures has been separated into at least two tranches reflecting different 

levels of seniority; (iii) performance of the securitization exposures depends on the 

performance of the underlying exposures; and (iv) all or substantially all of the 

underlying exposures are financial exposures. Examples of financial exposures are loans, 

commitments, receivables, asset-backed securities, mortgage-backed securities, corporate 

bonds, equity securities, or credit derivatives. For purposes of the proposed rule, 

mortgage-backed pass-through securities guaranteed by Fannie Mae or Freddie Mac 

(whether or not issued out of a structure that tranches credit risk) also would be 

securitization exposures.43

 A synthetic securitization is a transaction in which (i) all or a portion of the credit 

risk of one or more underlying exposures is transferred to one or more third parties 

through the use of one or more credit derivatives or guarantees (other than a guarantee 

that transfers only the credit risk of an individual retail exposure); (ii) the credit risk 

associated with the underlying exposures has been separated into at least two tranches 

reflecting different levels of seniority; (iii) performance of the securitization exposures 

depends on the performance of the underlying exposures; and (iv) all or substantially all 

 

43 In addition, margin loans and other credit exposures to personal investment companies, all or 

substantially all of whose assets are financial exposures, typically would meet the definition of a 

securitization exposure. 
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165

of the underlying exposures are financial exposures. Accordingly, the proposed 

definition of a securitization exposure would include tranched cover or guarantee 

arrangements – that is, arrangements in which an entity transfers a portion of the credit 

risk of an underlying exposure to one or more other guarantors or credit derivative 

providers but also retains a portion of the credit risk, where the risk transferred and the 

risk retained are of different seniority levels.44

Provided that there is a tranching of credit risk, securitization exposures also 

could include, among other things, asset-backed and mortgage-backed securities; loans, 

lines of credit, liquidity facilities, and financial standby letters of credit; credit derivatives 

and guarantees; loan servicing assets; servicer cash advance facilities; reserve accounts; 

credit-enhancing representations and warranties; and CEIOs. Securitization exposures 

also could include assets sold with retained tranched recourse. Both the designation of 

exposures as securitization exposures and the calculation of risk-based capital 

requirements for securitization exposures will be guided by the economic substance of a 

transaction rather than its legal form. 

As noted above, for a transaction to constitute a securitization transaction under 

the proposed rule, all or substantially all of the underlying exposures must be financial 

exposures. The proposed rule includes this requirement because the proposed 

securitization framework was designed to address the tranching of the credit risk of 

exposures to which the IRB framework can be applied. Accordingly, a specialized loan 

 

44 If a bank purchases an asset-backed security issued by a securitization SPE and purchases a credit 

derivative to protect itself from credit losses associated with the asset-backed security, the purchase of the 

credit derivative by the investing bank does not turn the traditional securitization into a synthetic 

securitization. Instead, under the proposal, the investing bank would be viewed as having purchased a 

traditional securitization exposure and would reflect the CRM benefits of the credit derivative through the 

securitization CRM rules described later in the preamble and in section 46 of the proposed rule. 
 Draft Basel II NPR 

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to finance the construction or acquisition of large-scale projects (for example, airports 

and power plants), objects (for example, ships, aircraft, or satellites), or commodities (for 

example, reserves, inventories, precious metals, oil, or natural gas) generally would not 

be a securitization exposure because the assets backing the loan typically would be 

nonfinancial assets (the facility, object, or commodity being financed). In addition, 

although some structured transactions involving income-producing real estate or HVCRE 

can resemble securitizations, these transactions generally would not be securitizations 

because the underlying exposure would be real estate. Consequently, exposures resulting 

from the tranching of the risks of nonfinancial assets are not subject to the proposed 

rule’s securitization framework, but generally are subject to the proposal’s rules for 

wholesale exposures. Question 26: The agencies request comment on the appropriate 

treatment of tranched exposures to a mixed pool of financial and non-financial underlying 

exposures. The agencies specifically are interested in the views of commenters as to 

whether the requirement that all or substantially all of the underlying exposures of a 

securitization be financial exposures should be softened to require only that some lesser 

portion of the underlying exposures be financial exposures.

4. Equity exposures

The proposed rule defines an equity exposure to mean: 

(i) A security or instrument whether voting or non-voting that represents a direct 

or indirect ownership interest in, and a residual claim on, the assets and income of a 

company, unless: (A) the issuing company is consolidated with the bank under GAAP; 

(B) the bank is required to deduct the ownership interest from tier 1 or tier 2 capital; (C) 

the ownership interest is redeemable; (D) the ownership interest incorporates a payment 
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or other similar obligation on the part of the issuing company (such as an obligation to 

pay periodic interest); or (E) the ownership interest is a securitization exposure. 

(ii) A security or instrument that is mandatorily convertible into a security or 

instrument described in (i). 

(iii) An option or warrant that is exercisable for a security or instrument described 

in (i). 

(iv) Any other security or instrument (other than a securitization exposure) to the 

extent the return on the security or instrument is based on the performance of security or 

instrument described in (i). For example, a short position in an equity security or a total 

return equity swap would be characterized as an equity exposure. 

Nonconvertible term or perpetual preferred stock generally would be considered 

wholesale exposures rather than equity exposures. Financial instruments that are 

convertible into an equity exposure only at the option of the holder or issuer also 

generally would be considered wholesale exposures rather than equity exposures 

provided that the conversion terms do not expose the bank to the risk of losses arising 

from price movements in that equity exposure. Upon conversion, the instrument would 

be treated as an equity exposure. 

The agencies note that, as a general matter, each of a bank’s exposures will fit in 

one and only one exposure category. One principal exception to this rule is that equity 

derivatives generally will meet the definition of an equity exposure (because of the 

bank’s exposure to the underlying equity security) and the definition of a wholesale 

exposure (because of the bank’s credit risk exposure to the counterparty). In such cases, 

as discussed in more detail below, the bank’s risk-based capital requirement for the 
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derivative generally would be the sum of its risk-based capital requirement for the 

derivative counterparty credit risk and for the underlying exposure. 

5. Boundary between operational risk and other risks

With the introduction of an explicit risk-based capital requirement for operational 

risk, issues arise about the proper treatment of operational losses that could also be 

attributed to either credit risk or market risk. The agencies recognize that these boundary 

issues are important and have significant implications for how banks would compile loss 

data sets and compute risk-based capital requirements under the proposed rule. 

Consistent with the treatment in the New Accord, the agencies propose treating 

operational losses that are related to market risk as operational losses for purposes of 

calculating risk-based capital requirements under this proposed rule. For example, losses 

incurred from a failure of bank personnel to properly execute a stop loss order, from 

trading fraud, or from a bank selling a security when a purchase was intended, would be 

treated as operational losses. 

The agencies generally propose to treat losses that are related to both operational 

risk and credit risk as credit losses for purposes of calculating risk-based capital 

requirements. For example, where a loan defaults (credit risk) and the bank discovers 

that the collateral for the loan was not properly secured (operational risk), the bank’s 

resulting loss would be attributed to credit risk (not operational risk). This general 

separation between credit and operational risk is supported by current U.S. accounting 

standards for the treatment of credit risk. 
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169

The proposed exception to this standard is retail credit card fraud losses. More 

specifically, retail credit card losses arising from non-contractual, third party-initiated 

fraud (for example, identity theft) are to be treated as external fraud operational losses 

under this proposed rule. All other third party-initiated losses are to be treated as credit 

losses. Based on discussions with the industry, this distinction is consistent with 

prevailing practice in the credit card industry, with banks commonly considering these 

losses to be operational losses and treating them as such for risk management purposes. 

Question 27: The agencies seek commenters’ perspectives on other loss types for 

which the boundary between credit and operational risk should be evaluated further (for 

example, with respect to losses on HELOCs).

6. Boundary between the proposed rule and the market risk amendment (MRA) 

Positions currently subject to the MRA include all positions classified as trading 

consistent with GAAP. The New Accord sets forth additional criteria for positions to be 

eligible for application of the MRA. The agencies propose to incorporate these additional 

criteria into the MRA through a separate notice of proposed rulemaking concurrently 

published in the Federal Register. Advanced approaches banks subject to the MRA 

would use the MRA as amended for trading exposures eligible for application of the 

MRA. Advanced approaches banks not subject to the MRA would use this proposed rule 

for all of their exposures. Question 28: The agencies generally seek comment on the 

proposed treatment of the boundaries between credit, operational, and market risk.

B. Risk-Weighted Assets for General Credit Risk (Wholesale Exposures, Retail 

Exposures, On-Balance Sheet Assets that Are Not Defined by Exposure Category, 

and Immaterial Credit Portfolios) 
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Under the proposed rule, the wholesale and retail risk-weighted assets calculation 

consists of four phases: (1) categorization of exposures; (2) assignment of wholesale 

exposures to rating grades and segmentation of retail exposures; (3) assignment of risk 

parameters to wholesale obligors and exposures and segments of retail exposures; and 

(4) calculation of risk-weighted asset amounts. Phase 1 involves the categorization of a 

bank’s exposures into four general categories – wholesale exposures, retail exposures, 

securitization exposures, and equity exposures. Phase 1 also involves the further 

classification of retail exposures into subcategories and identifying certain wholesale 

exposures that receive a specific treatment within the wholesale framework. Phase 2 

involves the assignment of wholesale obligors and exposures to rating grades and the 

segmentation of retail exposures. Phase 3 requires the bank to assign a PD, ELGD, LGD, 

EAD, and M to each wholesale exposure and a PD, ELGD, LGD, and EAD to each 

segment of retail exposures. In phase 4, the bank calculates the risk-weighted asset 

amount (i) for each wholesale exposure and segment of retail exposures by inserting the 

risk parameter estimates into the appropriate IRB risk-based capital formula and 

multiplying the formula’s dollar risk-based capital requirement output by 12.5; and (ii) 

for on-balance sheet assets that are not included in one of the defined exposure categories 

and for certain immaterial portfolios of exposures by multiplying the carrying value or 

notional amount of the exposures by a 100 percent risk weight. 

1. Phase 1 − Categorization of exposures

In phase 1, a bank must determine which of its exposures fall into each of the four 

principal IRB exposure categories – wholesale exposures, retail exposures, securitization 

exposures, and equity exposures. In addition, a bank must identify within the wholesale 
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exposure category certain exposures that receive a special treatment under the wholesale 

framework. These exposures include HVCRE exposures, sovereign exposures, eligible 

purchased wholesale receivables, eligible margin loans, repo-style transactions, OTC 

derivative contracts, unsettled transactions, and eligible guarantees and eligible credit 

derivatives that are used as credit risk mitigants. 

The treatment of HVCRE exposures and eligible purchased wholesale receivables 

is discussed below in this section. The treatment of eligible margin loans, repo-style 

transactions, OTC derivative contracts, and eligible guarantees and eligible credit 

derivatives that are credit risk mitigants is discussed in section V.C. of the preamble. In 

addition, sovereign exposures and exposures to or directly and unconditionally 

guaranteed by the Bank for International Settlements, the International Monetary Fund, 

the European Commission, the European Central Bank, and multi-lateral development 

banks45 are exempt from the 0.03 percent floor on PD discussed in the next section. 

In phase 1, a bank also must subcategorize its retail exposures as residential 

mortgage exposures, QREs, or other retail exposures. In addition, a bank must identify 

any on-balance sheet asset that does not meet the definition of a wholesale, retail, 

securitization, or equity exposure, as well as any non-material portfolio of exposures to 

which it chooses, subject to supervisory review, not to apply the IRB risk-based capital 

formulas. 

2. Phase 2 − Assignment of wholesale obligors and exposures to rating grades and retail 

exposures to segments

 

45 Multi-lateral development bank is defined as any multi-lateral lending institution or regional 

development bank in which the U.S. government is a shareholder or contributing member. These 

institutions currently are the International Bank for Reconstruction and Development, the International 

Finance Corporation, the Inter-American Development Bank, the Asian Development Bank, the African 

Development Bank, and the European Bank for Reconstruction and Development. 
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172

In phase 2, a bank must assign each wholesale obligor to a single rating grade (for 

purposes of assigning an estimated PD) and may assign each wholesale exposure to loss 

severity rating grades (for purposes of assigning an estimated ELGD and LGD). A bank 

that elects not use a loss severity rating grade system for a wholesale exposure will 

directly assign ELGD and LGD to the wholesale exposure in phase 3. As a part of the 

process of assigning wholesale obligors to rating grades, a bank must identify which of 

its wholesale obligors are in default. 

In addition, a bank must divide its retail exposures within each retail subcategory 

into segments that have homogeneous risk characteristics.46 Segmentation is the 

grouping of exposures within each subcategory according to the predominant risk 

characteristics of the borrower (for example, credit score, debt-to-income ratio, and 

delinquency) and the exposure (for example, product type and LTV ratio). In general, 

retail segments should not cross national jurisdictions. A bank would have substantial 

flexibility to use the retail portfolio segmentation it believes is most appropriate for its 

activities, subject to the following broad principles: 

• Differentiation of risk – Segmentation should provide meaningful differentiation 

of risk. Accordingly, in developing its risk segmentation system, a bank should consider 

the chosen risk drivers’ ability to separate risk consistently over time and the overall 

robustness of the bank’s approach to segmentation. 

 

46 A bank must segment defaulted retail exposures separately from non-defaulted retail exposures and, if 

the bank determines the EAD for eligible margin loans using the approach in section 32(a) of the proposed 

rule, it must segment retail eligible margin loans for which the bank uses this approach separately from 

other retail exposures. 
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173

• Reliable risk characteristics – Segmentation should use borrower-related risk 

characteristics and exposure-related risk characteristics that reliably and consistently over 

time differentiate a segment’s risk from that of other segments. 

• Consistency – Risk drivers for segmentation should be consistent with the 

predominant risk characteristics used by the bank for internal credit risk measurement 

and management. 

• Accuracy – The segmentation system should generate segments that separate 

exposures by realized performance and should be designed so that actual long-run 

outcomes closely approximate the retail risk parameters estimated by the bank. 

 A bank might choose to segment exposures by common risk drivers that are 

relevant and material in determining the loss characteristics of a particular retail product. 

For example, a bank may segment mortgage loans by LTV band, age from origination, 

geography, origination channel, and credit score. Statistical modeling, expert judgment, 

or some combination of the two may determine the most relevant risk drivers. 

Alternatively, a bank might segment by grouping exposures with similar loss 

characteristics, such as loss rates or default rates, as determined by historical performance 

of segments with similar risk characteristics. 

Banks commonly obtain tranched credit protection, for example first-loss or 

second-loss guarantees, on certain retail exposures such as residential mortgages. The 

agencies recognize that the securitization framework, which applies to tranched 

wholesale exposures, is not appropriate for individual retail exposures. The agencies 

therefore are proposing to exclude tranched guarantees that apply only to an individual 

retail exposure from the securitization framework. An important result of this exclusion 
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is that, in contrast to the treatment of wholesale exposures, a bank may recognize 

recoveries from both an obligor and a guarantor for purposes of estimating the ELGD and 

LGD for certain retail exposures. Question 29: The agencies seek comment on this 

approach to tranched guarantees on retail exposures and on alternative approaches that 

could more appropriately reflect the risk mitigating effect of such guarantees while 

addressing the agencies’ concerns about counterparty credit risk and correlation between 

the credit quality of an obligor and a guarantor.

 Banks have expressed concern about the treatment of retail margin loans under 

the New Accord. Due to the highly collateralized nature and low loss frequency of 

margin loans, banks typically collect little customer-specific information that they could 

use to differentiate margin loans into segments. The agencies believe that a bank could 

appropriately segment its margin loan portfolio using only product-specific risk drivers, 

such as product type and origination channel. A bank could then use the retail definition 

of default to associate a PD, ELGD, and LGD with each segment. As described in 

section 32 of the proposed rule, a bank could adjust the EAD of eligible margin loans to 

reflect the risk-mitigating effect of financial collateral. For a segment of retail eligible 

margin loans, a bank would associate an ELGD and LGD with the segment that do not 

reflect the presence of collateral. If a bank is not able to estimate PD, ELGD, and LGD 

for a segment of eligible margin loans, the bank may apply a 300 percent risk weight to 

the EAD of the segment. Question 30: The agencies seek comment on wholesale and 

retail exposure types for which banks are not able to calculate PD, ELGD, and LGD and 

on what an appropriate risk-based capital treatment for such exposures might be.
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 In phase 3, each retail segment will typically be associated with a separate PD, 

ELGD, LGD, and EAD. In some cases, it may be reasonable to use the same PD, ELGD, 

LGD, or EAD estimate for multiple segments. 

 A bank must segment defaulted retail exposures separately from non-defaulted 

retail exposures and should base the segmentation of defaulted retail exposures on 

characteristics that are most predictive of current loss and recovery rates. This 

segmentation should provide meaningful differentiation so that individual exposures 

within each defaulted segment do not have material differences in their expected loss 

severity. 

Purchased wholesale receivables

A bank may also elect to use a top-down approach, similar to the treatment of 

retail exposures, for eligible purchased wholesale receivables. Under this approach, in 

phase 2, a bank would group its eligible purchased wholesale receivables that, when 

consolidated by obligor, total less than $1 million into segments that have homogeneous 

risk characteristics. To be an eligible purchased wholesale receivable, several criteria 

must be met: 

• The purchased wholesale receivable must be purchased from an unaffiliated seller 

and must not have been directly or indirectly originated by the purchasing bank; 

• The purchased wholesale receivable must be generated on an arm’s-length basis 

between the seller and the obligor. Intercompany accounts receivable and receivables 

subject to contra-accounts between firms that buy and sell to each other are ineligible; 

• The purchasing bank must have a claim on all proceeds from the receivable or a 

pro-rata interest in the proceeds; and 
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• The purchased wholesale receivable must have an effective remaining maturity of 

less than one year. 

Wholesale lease residuals

The agencies are proposing a treatment for wholesale lease residuals that differs 

from the New Accord. A wholesale lease residual typically exposes a bank to the risk of 

a decline in value of the leased asset and to the credit risk of the lessee. Although the 

New Accord provides for a flat 100 percent risk weight for wholesale lease residuals, the 

agencies believe this is excessively punitive for leases to highly creditworthy lessees. 

Accordingly, the proposed rule would require a bank to treat its net investment in a 

wholesale lease as a single exposure to the lessee. There would not be a separate capital 

calculation for the wholesale lease residual. In contrast, a retail lease residual, consistent 

with the New Accord, would be assigned a risk-weighted asset amount equal to its 

residual value (as described in more detail above). 

3. Phase 3 − Assignment of risk parameters to wholesale obligors and exposures and 

retail segments

In phase 3, a bank would associate a PD with each wholesale obligor rating grade; 

associate an ELGD or LGD with each wholesale loss severity rating grade or assign an 

ELGD and LGD to each wholesale exposure; assign an EAD and M to each wholesale 

exposure; and assign a PD, ELGD, LGD, and EAD to each segment of retail exposures. 

The quantification phase can generally be divided into four steps—obtaining historical 

reference data, estimating the risk parameters for the reference data, mapping the 
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177

historical reference data to the bank’s current exposures, and determining the risk 

parameters for the bank’s current exposures. 

A bank should base its estimation of the values assigned to PD, ELGD, LGD, and 

EAD47 on historical reference data that are a reasonable proxy for the bank’s current 

exposures and that provide meaningful predictions of the performance of such exposures. 

A “reference data set” consists of a set of exposures to defaulted wholesale obligors and 

defaulted retail exposures (in the case of ELGD, LGD, and EAD estimation) or to both 

defaulted and non-defaulted wholesale obligors and retail exposures (in the case of PD 

estimation). 

The reference data set should be described using a set of observed characteristics. 

Relevant characteristics might include debt ratings, financial measures, geographic 

regions, the economic environment and industry/sector trends during the time period of 

the reference data, borrower and loan characteristics related to the risk parameters (such 

as loan terms, LTV ratio, credit score, income, debt-to-income ratio, or performance 

history), or other factors that are related in some way to the risk parameters. Banks may 

use more than one reference data set to improve the robustness or accuracy of the 

parameter estimates. 

A bank should then apply statistical techniques to the reference data to determine 

a relationship between risk characteristics and the estimated risk parameter. The result of 

this step is a model that ties descriptive characteristics to the risk parameter estimates. In 

this context, the term ‘model’ is used in the most general sense; a model may be simple, 

such as the calculation of averages, or more complicated, such as an approach based on 

 

47 EAD for repo-style transactions, eligible margin loans, and OTC derivatives is calculated as described in 

section 32 of the proposed rule. 
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advanced regression techniques. This step may include adjustments for differences 

between this proposed rule’s definition of default and the default definition in the 

reference data set, or adjustments for data limitations. This step should also include 

adjustments for seasoning effects related to retail exposures. 

A bank may use more than one estimation technique to generate estimates of the 

risk parameters, especially if there are multiple sets of reference data or multiple sample 

periods. If multiple estimates are generated, the bank must have a clear and consistent 

policy on reconciling and combining the different estimates. 

Once a bank estimates PD, ELGD, LGD, and EAD for its reference data sets, it 

would create a link between its portfolio data and the reference data based on 

corresponding characteristics. Variables or characteristics that are available for the 

existing portfolio would be mapped or linked to the variables used in the default, lossseverity, or exposure amount model. In order to effectively map the data, reference data 

characteristics would need to allow for the construction of rating and segmentation 

criteria that are consistent with those used on the bank’s portfolio. An important element 

of mapping is making adjustments for differences between reference data sets and the 

bank’s exposures. 

Finally, a bank would apply the risk parameters estimated for the reference data to 

the bank’s actual portfolio data. The bank would attribute a PD to each wholesale obligor 

and each segment of retail exposures, and an ELGD, LGD, and EAD to each wholesale 

exposure and to each segment of retail exposures. If multiple data sets or estimation 

methods are used, the bank must adopt a means of combining the various estimates at this 

stage. 
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The proposed rule, as noted above, permits a bank to elect to segment its eligible 

purchased wholesale receivables like retail exposures. A bank that chooses to apply this 

treatment must directly assign a PD, ELGD, LGD, EAD, and M to each such segment. If 

a bank can estimate ECL (but not PD or LGD) for a segment of eligible purchased 

wholesale receivables, the bank must assume that the ELGD and LGD of the segment 

equal 100 percent and that the PD of the segment equals ECL divided by EAD. The bank 

must estimate ECL for the receivables without regard to any assumption of recourse or 

guarantees from the seller or other parties. The bank would then use the wholesale 

exposure formula in section 31(e) of the proposed rule to determine the risk-based capital 

requirement for each segment of eligible purchased wholesale receivables. 

A bank may recognize the credit risk mitigation benefits of collateral that secures 

a wholesale exposure by adjusting its estimate of the ELGD and LGD of the exposure 

and may recognize the credit risk mitigation benefits of collateral that secures retail 

exposures by adjusting its estimate of the PD, ELGD, and LGD of the segment of retail 

exposures. In certain cases, however, a bank may take financial collateral into account in 

estimating the EAD of repo-style transactions, eligible margin loans, and OTC derivative 

contracts (as provided in section 32 of the proposed rule). 

The proposed rule also provides that a bank may use an EAD of zero for 

(i) derivative contracts that are traded on an exchange that requires the daily receipt and 

payment of cash-variation margin; (ii) derivative contracts and repo-style transactions 

that are outstanding with a qualifying central counterparty, but not for those transactions 

that the qualifying central counterparty has rejected; and (iii) credit risk exposures to a 

qualifying central counterparty that arise from derivative contracts and repo-style 
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transactions in the form of clearing deposits and posted collateral. The proposed rule 

defines a qualifying central counterparty as a counterparty (for example, a clearing 

house) that: (i) facilitates trades between counterparties in one or more financial markets 

by either guaranteeing trades or novating contracts; (ii) requires all participants in its 

arrangements to be fully collateralized on a daily basis; and (iii) the bank demonstrates to 

the satisfaction of its primary Federal supervisor is in sound financial condition and is 

subject to effective oversight by a national supervisory authority. 

Some repo-style transactions and OTC derivative contracts giving rise to 

counterparty credit risk may give rise, from an accounting point of view, to both on- and 

off-balance sheet exposures. Where a bank is using an EAD approach to measure the 

amount of risk exposure for such transactions, factoring in collateral effects where 

applicable, it would not also separately apply a risk-based capital requirement to an onbalance sheet receivable from the counterparty recorded in connection with that 

transaction. Because any exposure arising from the on-balance sheet receivable is 

captured in the capital requirement determined under the EAD approach, a separate 

capital requirement would double count the exposure for regulatory capital purposes. 

A bank may take into account the risk reducing effects of eligible guarantees and 

eligible credit derivatives in support of a wholesale exposure by applying the PD 

substitution approach or the LGD adjustment approach to the exposure as provided in 

section 33 of the proposed rule or, if applicable, applying double default treatment to the 

exposure as provided in section 34 of the proposed rule. A bank may decide separately 

for each wholesale exposure that qualifies for the double default treatment whether to 

apply the PD substitution approach, the LGD adjustment approach, or the double default 
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treatment. A bank may take into account the risk reducing effects of guarantees and 

credit derivatives in support of retail exposures in a segment when quantifying the PD, 

ELGD, and LGD of the segment. 

There are several supervisory limitations imposed on risk parameters assigned to 

wholesale obligors and exposures and segments of retail exposures. First, the PD for 

each wholesale obligor or segment of retail exposures may not be less than 0.03 percent, 

except for exposures to or directly and unconditionally guaranteed by a sovereign entity, 

the Bank for International Settlements, the International Monetary Fund, the European 

Commission, the European Central Bank, or a multi-lateral development bank, to which 

the bank assigns a rating grade associated with a PD of less than 0.03 percent. Second, 

the LGD of a segment of residential mortgage exposures (other than segments of 

residential mortgage exposures for which all or substantially all of the principal of the 

exposures is directly and unconditionally guaranteed by the full faith and credit of a 

sovereign entity) may not be less than 10 percent. These supervisory floors on PD and 

LGD apply regardless of whether the bank recognizes an eligible guarantee or eligible 

credit derivative as provided in sections 33 and 34 of the proposed rule. 

The agencies would not allow a bank to artificially group exposures into segments 

specifically to avoid the LGD floor for mortgage products. A bank should use consistent 

risk drivers to determine its retail exposure segmentations and not artificially segment 

low LGD loans with higher LGD loans to avoid the floor. 

A bank also must calculate the effective remaining maturity (M) for each 

wholesale exposure. For wholesale exposures other than repo-style transactions, eligible 

margin loans, and OTC derivative contracts subject to a qualifying master netting 
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agreement, M would be the weighted-average remaining maturity (measured in whole or 

fractional years) of the expected contractual cash flows from the exposure, using the 

undiscounted amounts of the cash flows as weights. A bank may use its best estimate of 

future interest rates to compute expected contractual interest payments on a floating-rate 

exposure, but it may not consider expected but noncontractually required returns of 

principal, when estimating M. A bank could, at its option, use the nominal remaining 

maturity (measured in whole or fractional years) of the exposure. The M for repo-style 

transactions, eligible margin loans, and OTC derivative contracts subject to a qualifying 

master netting agreement would be the weighted-average remaining maturity (measured 

in whole or fractional years) of the individual transactions subject to the qualifying 

master netting agreement, with the weight of each individual transaction set equal to the 

notional amount of the transaction. Question 31: The agencies seek comment on the 

appropriateness of permitting a bank to consider prepayments when estimating M and on 

the feasibility and advisability of using discounted (rather than undiscounted) cash flows 

as the basis for estimating M.

Under the proposed rule, a qualifying master netting agreement is defined to mean 

any written, legally enforceable bilateral agreement, provided that: 

(i) The agreement creates a single legal obligation for all individual transactions 

covered by the agreement upon an event of default, including bankruptcy, insolvency, or 

similar proceeding, of the counterparty; 

(ii) The agreement provides the bank the right to accelerate, terminate, and closeout on a net basis all transactions under the agreement and to liquidate or set off collateral 

promptly upon an event of default, including upon an event of bankruptcy, insolvency, or 
 Draft Basel II NPR 

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similar proceeding, of the counterparty, provided that, in any such case, any exercise of 

rights under the agreement will not be stayed or avoided under applicable law in the 

relevant jurisdictions; 

(iii) The bank has conducted and documented sufficient legal review to conclude 

with a well-founded basis that the agreement meets the requirements of paragraph (ii) of 

this definition and that in the event of a legal challenge (including one resulting from 

default or from bankruptcy, insolvency, or similar proceeding) the relevant court and 

administrative authorities would find the agreement to be legal, valid, binding, and 

enforceable under the law of the relevant jurisdictions; 

 (iv) The bank establishes and maintains procedures to monitor possible changes 

in relevant law and to ensure that the agreement continues to satisfy the requirements of 

this definition; and 

(v) The agreement does not contain a walkaway clause (that is, a provision that 

permits a non-defaulting counterparty to make lower payments than it would make 

otherwise under the agreement, or no payment at all, to a defaulter or the estate of a 

defaulter, even if the defaulter or the estate of the defaulter is a net creditor under the 

agreement). 

The agencies would consider the following jurisdictions to be relevant for a 

qualifying master netting agreement: the jurisdiction in which each counterparty is 

chartered or the equivalent location in the case of non-corporate entities, and if a branch 

of a counterparty is involved, then also the jurisdiction in which the branch is located; the 

jurisdiction that governs the individual transactions covered by the agreement; and the 

jurisdiction that governs the agreement. 
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For most exposures, M may be no greater than five years and no less than one 

year. For exposures that have an original maturity of less than one year and are not part 

of a bank’s ongoing financing of the obligor, however, a bank may set M equal to the 

greater of one day and M. An exposure is not part of a bank’s ongoing financing of the 

obligor if the bank (i) has a legal and practical ability not to renew or roll over the 

exposure in the event of credit deterioration of the obligor; (ii) makes an independent 

credit decision at the inception of the exposure and at every renewal or rollover; and (iii) 

has no substantial commercial incentive to continue its credit relationship with the 

obligor in the event of credit deterioration of the obligor. Examples of transactions that 

may qualify for the exemption from the one-year maturity floor include due from other 

banks, including deposits in other banks; bankers’ acceptances; sovereign exposures; 

short-term self-liquidating trade finance exposures; repo-style transactions; eligible 

margin loans; unsettled trades and other exposures resulting from payment and settlement 

processes; and collateralized OTC derivative contracts subject to daily remargining. 

4. Phase 4 − Calculation of risk-weighted assets 

After a bank assigns risk parameters to each of its wholesale obligors and 

exposures and retail segments, the bank would calculate the dollar risk-based capital 

requirement for each wholesale exposure to a non-defaulted obligor or segment of nondefaulted retail exposures (except eligible guarantees and eligible credit derivatives that 

hedge another wholesale exposure and exposures to which the bank is applying the 

double default treatment in section 34 of the proposed rule) by inserting the risk 

parameters for the wholesale obligor and exposure or retail segment into the appropriate 

IRB risk-based capital formula specified in Table C and multiplying the output of the 
 Draft Basel II NPR 

185

formula (K) by the EAD of the exposure or segment. Eligible guarantees and eligible 

credit derivatives that are hedges of a wholesale exposure would be reflected in the riskweighted assets amount of the hedged exposure (i) through adjustments made to the risk 

parameters of the hedged exposure under the PD substitution or LGD adjustment 

approach in section 33 of the proposed rule or (ii) through a separate double default riskbased capital requirement formula in section 34 of the proposed rule. 

Table C – IRB risk-based capital formulas for wholesale exposures to non-defaulted obligors and 

segments of non-defaulted retail exposures*

Capital 

Requirement 

(K) 

NonDefaulted 

Exposures

( )⎥

⎥

⎦

⎤

⎢

⎢

⎣

⎡ − × ⎟

⎟

⎠

⎞

⎜

⎜

⎝

⎛

−

+ × = ×

− −

ELGD PD

R

N PD R N K LGD N

1

( ) (0.999 ) 1 1

For residential mortgage exposures: R = 0.15

For qualifying revolving exposures: R = 0.04

Retail 

Correlation 

Factor (R) 

For other retail exposures: PD R e− × = + × 35 0.03 0.13

Capital 

Requirement 

(K) 

NonDefaulted 

Exposures 

( ) ⎟

⎠

⎞ ⎜

⎝

⎛

− ×

+ − × ×

⎥

⎥

⎦

⎤

⎢

⎢

⎣

⎡ − × ⎟

⎟

⎠

⎞

⎜

⎜

⎝

⎛

−

+ × = ×

− −

b

M b ELGD PD

R

N PD R N K LGD N

1 1.5

1 ( 2.5)

1

( ) (0.999 ) 1 1

For HVCRE exposures: 

PD R e− × = + × 50 0 .12 0.18 Correlation 

Factor (R) For wholesale exposures other than HVCRE exposures: 

PD R e− × = + × 50 0 .12 0.12

Wholesale 

Maturity 

Adjustment 

(b)

( )

2 b = 0.11852−0.05478×ln(PD)

*N(.) means the cumulative distribution function for a standard normal random variable. N-1(.) means the inverse 

cumulative distribution function for a standard normal random variable. The symbol e refers to the base of the natural 

logarithm, and the function ln(.) refers to the natural logarithm of the expression within parentheses. 
 Draft Basel II NPR 

186

 The sum of the dollar risk-based capital requirements for wholesale exposures to a 

non-defaulted obligor and segments of non-defaulted retail exposures (including 

exposures subject to the double default treatment described below) would equal the total 

dollar risk-based capital requirement for those exposures and segments. The total dollar 

risk-based capital requirement would be converted into a risk-weighted asset amount by 

multiplying it by 12.5. 

To compute the risk-weighted asset amount for a wholesale exposure to a 

defaulted obligor, a bank would first have to compare two amounts: (i) the sum of 0.08 

multiplied by the EAD of the wholesale exposure plus the amount of any charge-offs or 

write-downs on the exposure; and (ii) K for the wholesale exposure (as determined in 

Table C immediately before the obligor became defaulted), multiplied by the EAD of the 

exposure immediately before the exposure became defaulted. If the amount calculated in 

(i) is equal to or greater than the amount calculated in (ii), the dollar risk-based capital 

requirement for the exposure is 0.08 multiplied by the EAD of the exposure. If the 

amount calculated in (i) is less than the amount calculated in (ii), the dollar risk-based 

capital requirement for the exposure is K for the exposure (as determined in Table C 

immediately before the obligor became defaulted), multiplied by the EAD of the 

exposure. The reason for this comparison is to ensure that a bank does not receive a 

regulatory capital benefit as a result of the exposure moving from non-defaulted to 

defaulted status. 

The proposed rule provides a simpler approach for segments of defaulted retail 

exposures. The dollar risk-based capital requirement for a segment of defaulted retail 

exposures equals 0.08 multiplied by the EAD of the segment. The agencies are 
 Draft Basel II NPR 

187

proposing this uniform 8 percent risk-based capital requirement for defaulted retail 

exposures to ease implementation burden on banks and in light of accounting and other 

supervisory policies in the retail context that would help prevent the sum of a bank’s ECL 

and risk-based capital requirement for a retail exposure from declining at the time of 

default. 

To convert the dollar risk-based capital requirements to a risk-weighted asset 

amount, the bank would sum the dollar risk-based capital requirements for all wholesale 

exposures to defaulted obligors and segments of defaulted retail exposures and multiply 

the sum by 12.5. 

A bank could assign a risk-weighted asset amount of zero to cash owned and held 

in all offices of the bank or in transit, and for gold bullion held in the bank’s own vaults 

or held in another bank’s vaults on an allocated basis, to the extent it is offset by gold 

bullion liabilities. On-balance sheet assets that do not meet the definition of a wholesale, 

retail, securitization, or equity exposure – for example, property, plant, and equipment 

and mortgage servicing rights – and portfolios of exposures that the bank has 

demonstrated to its primary Federal supervisor’s satisfaction are, when combined with all 

other portfolios of exposures that the bank seeks to treat as immaterial for risk-based 

capital purposes, not material to the bank generally would be assigned risk-weighted 

asset amounts equal to their carrying value (for on-balance sheet exposures) or notional 

amount (for off-balance sheet exposures). For this purpose, the notional amount of an 

OTC derivative contract that is not a credit derivative is the EAD of the derivative as 

calculated in section 32 of the proposed rule. 
 Draft Basel II NPR 

188

Total wholesale and retail risk-weighted assets would be the sum of risk-weighted 

assets for wholesale exposures to non-defaulted obligors and segments of non-defaulted 

retail exposures, wholesale exposures to defaulted obligors and segments of defaulted 

retail exposures, assets not included in an exposure category, non-material portfolios of 

exposures, and unsettled transactions minus the amounts deducted from capital pursuant 

to the general risk-based capital rules (excluding those deductions reversed in section 12 

of the proposed rule). 

5. Statutory provisions on the regulatory capital treatment of certain mortgage loans

 The general risk-based capital rules assign 50 and 100 percent risk weights to 

certain one-to-four family residential pre-sold construction loans and multifamily 

residential loans.48 The agencies adopted these provisions as a result of the Resolution 

Trust Corporation Refinancing, Restructuring, and Improvement Act of 1991 (RTCRRI 

Act).49 The RTCRRI Act mandates that each agency provide in its capital regulations 

(i) a 50 percent risk weight for certain one-to-four family residential pre-sold construction 

loans and multifamily residential loans that meet specific statutory criteria set forth in the 

Act and any other underwriting criteria imposed by the agencies; and (ii) a 100 percent 

risk weight for one-to-four family residential pre-sold construction loans for residences 

for which the purchase contract is cancelled.50 

 

48 See 12 CFR part 3, Appendix A, section 3(a)(3)(iii) (national banks); 12 CFR part 208, Appendix A, 

section III.C.3. (state member banks); 12 CFR part 225, Appendix A, section III.C.3. (bank holding 

companies); 12 CFR part 325, Appendix A, section II.C.a. (state non-member banks); 12 CFR 

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

49 See §§ 618(a) and (b) of the RTCRRI Act. The first class includes loans for the construction of a 

residence consisting of 1-to-4 family dwelling units that have been pre-sold under firm contracts to 

purchasers who have obtained firm commitments for permanent qualifying mortgages and have made 

substantial earnest money deposits. The second class includes loans that are secured by a first lien on a 

residence consisting of more than 4 dwelling units if the loan meets certain criteria outlined in the RTCRRI 

Act. 

50 See §§ 618(a) and (b) of the RTCRRI Act. 
 Draft Basel II NPR 

189

When Congress enacted the RTCRRI Act in 1991, the agencies’ risk-based capital 

rules reflected the Basel I framework. Consequently, the risk weight treatment for certain 

categories of mortgage loans in the RTCRRI Act assumes a risk weight bucketing 

approach, instead of the more risk-sensitive IRB approach in the Basel II framework. 

For purposes of this proposed rule implementing the Basel II IRB approach, the 

agencies are proposing that the three types of residential mortgage loans addressed by the 

RTCRRI Act should continue to receive the risk weights provided in the Act. 

Specifically, consistent with the general risk-based capital rules, the proposed rule 

requires a bank to use the following risk weights (instead of the risk weights that would 

otherwise be produced under the IRB risk-based capital formulas): (i) a 50 percent risk 

weight for one-to-four family residential construction loans if the residences have been 

pre-sold under firm contracts to purchasers who have obtained firm commitments for 

permanent qualifying mortgages and have made substantial earnest money deposits, and 

the loans meet the other underwriting characteristics established by the agencies in the 

general risk-based capital rules;51 (ii) a 50 percent risk weight for multifamily residential 

loans that meet certain statutory loan-to-value, debt-to-income, amortization, and 

performance requirements, and meet the other underwriting characteristics established by 

the agencies in the general risk-based capital rules;52 and (iii) a 100 percent risk weight 

for one-to-four family residential pre-sold construction loans for a residence for which 

the purchase contract is canceled.53 Mortgage loans that do not meet the relevant criteria 

do not qualify for the statutory risk weights and will be risk-weighted according to the 

IRB risk-based capital formulas. 

 

51 See § 618(a)(1)((B) of the RTCRRI Act. 52 See § 618(b)(1)(B) of the RTCRRI Act. 53 See § 618(a)(2) of the RTCRRI Act. 
 Draft Basel II NPR 

190

The agencies understand that there is a tension between the statutory risk weights 

provided by the RTCRRI Act and the more risk-sensitive IRB approaches to risk-based 

capital that are contained in this proposed rule. Question 32: The agencies seek 

comment on whether the agencies should impose the following underwriting criteria as 

additional requirements for a Basel II bank to qualify for the statutory 50 percent risk 

weight for a particular mortgage loan: (i) that the bank has an IRB risk measurement and 

management system in place that assesses the PD and LGD of prospective residential 

mortgage exposures; and (ii) that the bank’s IRB system generates a 50 percent risk 

weight for the loan under the IRB risk-based capital formulas. The agencies note that a 

capital-related provision of the Federal Deposit Insurance Corporation Improvement Act 

of 1991 (FDICIA), enacted by Congress just four days after its adoption of the RTCRRI 

Act, directs each agency to revise its risk-based capital standards for DIs to ensure that 

those standards “reflect the actual performance and expected risk of loss of multifamily 

mortgages.”54

Question 33: The agencies seek comment on all aspects of the proposed 

treatment of one-to-four family residential pre-sold construction loans and multifamily 

residential loans. 

C. Credit Risk Mitigation (CRM) Techniques

 Banks use a number of techniques to mitigate credit risk. This section of the 

preamble describes how the proposed rule recognizes the risk-mitigating effects of both 

financial collateral (defined below) and nonfinancial collateral, as well as guarantees and 

credit derivatives, for risk-based capital purposes. To recognize credit risk mitigants for 

 

54 Section 305(b)(1)(B) of FDICIA (12 U.S.C. 1828 notes). 
 Draft Basel II NPR 

191

risk-based capital purposes, a bank should have in place operational procedures and risk 

management processes that ensure that all documentation used in collateralizing or 

guaranteeing a transaction is legal, valid, binding, and enforceable under applicable law 

in the relevant jurisdictions. The bank should have conducted sufficient legal review to 

reach a well-founded conclusion that the documentation meets this standard and should 

reconduct such a review as necessary to ensure continuing enforceability. 

Although the use of CRM techniques may reduce or transfer credit risk, it 

simultaneously may increase other risks, including operational, liquidity, and market 

risks. Accordingly, it is imperative that banks employ robust procedures and processes to 

control risks, including roll-off risk and concentration risk, arising from the bank’s use of 

CRM techniques and to monitor the implications of using CRM techniques for the bank’s 

overall credit risk profile. 

1. Collateral

Under the proposed rule, a bank generally recognizes collateral that secures a 

wholesale exposure as part of the ELGD and LGD estimation process and generally 

recognizes collateral that secures a retail exposure as part of the PD, ELGD, and LGD 

estimation process, as described above in section V.B.3. of the preamble. However, in 

certain limited circumstances described in the next section, a bank may adjust EAD to 

reflect the risk mitigating effect of financial collateral. 

When reflecting the credit risk mitigation benefits of collateral in its estimation of 

the risk parameters of a wholesale or retail exposure, a bank should: 
 Draft Basel II NPR 

192

(i) Conduct sufficient legal review to ensure, at inception and on an ongoing 

basis, that all documentation used in the collateralized transaction is binding on all parties 

and legally enforceable in all relevant jurisdictions; 

 (ii) Consider the relation (that is, correlation) between obligor risk and collateral 

risk in the transaction; 

 (iii) Consider any currency and/or maturity mismatch between the hedged 

exposure and the collateral; 

 (iv) Ground its risk parameter estimates for the transaction in historical data, 

using historical recovery rates where available; and 

 (v) Fully take into account the time and cost needed to realize the liquidation 

proceeds and the potential for a decline in collateral value over this time period. 

The bank also should ensure that: 

(i) The legal mechanism under which the collateral is pledged or transferred 

ensures that the bank has the right to liquidate or take legal possession of the collateral in 

a timely manner in the event of the default, insolvency, or bankruptcy (or other defined 

credit event) of the obligor and, where applicable, the custodian holding the collateral; 

(ii) The bank has taken all steps necessary to fulfill legal requirements to secure 

its interest in the collateral so that it has and maintains an enforceable security interest; 

(iii) The bank has clear and robust procedures for the timely liquidation of 

collateral to ensure observation of any legal conditions required for declaring the default 

of the borrower and prompt liquidation of the collateral in the event of default; 

(iv) The bank has established procedures and practices for (A) conservatively 

estimating, on a regular ongoing basis, the market value of the collateral, taking into 
 Draft Basel II NPR 

193

account factors that could affect that value (for example, the liquidity of the market for 

the collateral and obsolescence or deterioration of the collateral), and (B) where 

applicable, periodically verifying the collateral (for example, through physical inspection 

of collateral such as inventory and equipment); and 

(v) The bank has in place systems for promptly requesting and receiving 

additional collateral for transactions whose terms require maintenance of collateral values 

at specified thresholds. 

2. EAD for counterparty credit risk

This section describes two EAD-based methodologies—a collateral haircut 

approach and an internal models methodology—that a bank may use instead of an 

ELGD/LGD estimation methodology to recognize the benefits of financial collateral in 

mitigating the counterparty credit risk associated with repo-style transactions, eligible 

margin loans, collateralized OTC derivative contracts, and single product groups of such 

transactions with a single counterparty subject to a qualifying master netting agreement. 

A third methodology, the simple VaR methodology, is also available to recognize 

financial collateral mitigating the counterparty credit risk of single product netting sets of 

repo-style transactions and eligible margin loans. 

A bank may use any combination of the three methodologies for collateral 

recognition; however, it must use the same methodology for similar exposures. A bank 

may choose to use one methodology for agency securities lending transactions – that is, 

repo-style transactions in which the bank, acting as agent for a customer, lends the 

customer’s securities and indemnifies the customer against loss – and another 

methodology for all other repo-style transactions. This section also describes the 
 Draft Basel II NPR 

194

methodology for calculating EAD for an OTC derivative contract or set of OTC 

derivative contracts subject to a qualifying master netting agreement. Table D illustrates 

which EAD estimation methodologies may be applied to particular types of exposure. 

Table D 

 Models approach 

 Current 

exposure 

methodology

Collateral 

haircut 

approach 

Simple 

VaR55

methodology 

Internal 

models 

methodology

OTC derivative X X 

Recognition of collateral 

for OTC derivatives 

 X56 X 

Repo-style transaction X X X 

Eligible margin loan X X X 

Cross-product netting set X 

Question 34: For purposes of determining EAD for counterparty credit risk and 

recognizing collateral mitigating that risk, the proposed rule allows banks to take into 

account only financial collateral, which, by definition, does not include debt securities 

that have an external rating lower than one rating category below investment grade. The 

agencies invite comment on the extent to which lower-rated debt securities or other 

securities that do not meet the definition of financial collateral are used in these 

transactions and on the CRM value of such securities.

EAD for repo-style transactions and eligible margin loans

 

55 Only repo-style transactions and eligible margin loans subject to a single-product qualifying master 

netting agreement are eligible for the simple VaR methodology. 

56 In conjunction with the current exposure methodology. 
 Draft Basel II NPR 

195

Under the proposal, a bank could recognize the risk mitigating effect of financial 

collateral that secures a repo-style transaction, eligible margin loan, or single-product 

group of such transactions with a single counterparty subject to a qualifying master 

netting agreement (netting set) through an adjustment to EAD rather than ELGD and 

LGD. The bank may use a collateral haircut approach or one of two models approaches: 

a simple VaR methodology (for single-product netting sets of repo-style transactions or 

eligible margin loans) or an internal models methodology. Figure 2 illustrates the 

methodologies available for calculating EAD and LGD for eligible margin loans and 

repo-style transactions. 
 Draft Basel II NPR 

196

Figure 2 – EAD and LGD for Eligible Margin Loans and Repo-Style 

Transactions

Repo-Style 

Transaction?

Yes No

5 day

Holding Period

Plug PD, Unsecured 

LGD, and Adjusted 

EAD into wholesale 

function

Is there a Master

Netting Agreement?

No Yes

Simple VaR

Methodology

Internal 

Models 

Methodology

Standardized Own Estimates

Eligible Margin Loans &

Repo-Style Transactions

Adjusted Exposure at 

Default Approach

Models 

Approach

Haircut

Approach

10 day

Holding Period

Notional Exposure 

with Adjusted LGD

Plug PD, Adjusted LGD, 

and Notional EAD into 

wholesale function

Repo-Style 

Transaction?

Yes No

5 day

Holding Period

Plug PD, Unsecured 

LGD, and Adjusted 

EAD into wholesale 

function

Is there a Master

Netting Agreement?

No Yes

Simple VaR

Methodology

Internal 

Models 

Methodology

Standardized Own Estimates

Eligible Margin Loans &

Repo-Style Transactions

Adjusted Exposure at 

Default Approach

Models 

Approach

Haircut

Approach

10 day

Holding Period

Notional Exposure 

with Adjusted LGD

Plug PD, Adjusted LGD, 

and Notional EAD into 

wholesale function

The proposed rule defines repo-style transaction as a repurchase or reverse 

repurchase transaction, or a securities borrowing or securities lending transaction 

(including a transaction in which the bank acts as agent for a customer and indemnifies 

the customer against loss), provided that: 

(i) The transaction is based solely on liquid and readily marketable securities or 

cash; 

(ii) The transaction is marked to market daily and subject to daily margin 

maintenance requirements; 
 Draft Basel II NPR 

197

(iii) The transaction is executed under an agreement that provides the bank the 

right to accelerate, terminate, and close-out the transaction on a net basis and to liquidate 

or set off collateral promptly upon an event of default (including upon an event of 

bankruptcy, insolvency, or similar proceeding) of the counterparty, provided that, in any 

such case, any exercise of rights under the agreement will not be stayed or avoided under 

applicable law in the relevant jurisdictions;57 and 

(iv) The bank has conducted and documented sufficient legal review to conclude 

with a well-founded basis that the agreement meets the requirements of paragraph (iii) of 

this definition and is legal, valid, binding, and enforceable under applicable law in the 

relevant jurisdictions. 

Question 35: The agencies recognize that criterion (iii) above may pose 

challenges for certain transactions that would not be eligible for certain exemptions from 

bankruptcy or receivership laws because the counterparty—for example, a sovereign 

entity or a pension fund—is not subject to such laws. The agencies seek comment on 

ways this criterion could be crafted to accommodate such transactions when justified on 

prudential grounds, while ensuring that the requirements in criterion (iii) are met for 

transactions that are eligible for those exemptions.

The proposed rule defines an eligible margin loan as an extension of credit where: 

(i) The credit extension is collateralized exclusively by debt or equity securities 

that are liquid and readily marketable; 

 

57 This requirement is met where all transactions under the agreement are (i) executed under U.S. law and 

(ii) constitute “securities contracts” or “repurchase agreements” under section 555 or 559, respectively, of 

the Bankruptcy Code (11 U.S.C. 555 or 559), qualified financial contracts under section 11(e)(8) of the 

Federal Deposit Insurance Act (12 U.S.C. 1821(e)(8)), or netting contracts between or among financial 

institutions under sections 401-407 of the Federal Deposit Insurance Corporation Improvement Act of 1991 

(12 U.S.C. 4401-4407) or the Federal Reserve Board’s Regulation EE (12 CFR part 231). 
 Draft Basel II NPR 

198

(ii) The collateral is marked to market daily and the transaction is subject to daily 

margin maintenance requirements; 

(iii) The extension of credit is conducted under an agreement that provides the 

bank the right to accelerate and terminate the extension of credit and to liquidate or set 

off collateral promptly upon an event of default (including upon an event of bankruptcy, 

insolvency, or similar proceeding) of the counterparty, provided that, in any such case, 

any exercise of rights under the agreement will not be stayed or avoided under applicable 

law in the relevant jurisdictions;58 and 

(iv) The bank has conducted and documented sufficient legal review to conclude 

with a well-founded basis that the agreement meets the requirements of paragraph (iii) of 

this definition and is legal, valid, binding, and enforceable under applicable law in the 

relevant jurisdictions. 

The proposed rule describes various ways that a bank may recognize the risk 

mitigating impact of financial collateral. The proposed rule defines financial collateral as 

collateral in the form of any of the following instruments in which the bank has a 

perfected, first priority security interest or the legal equivalent thereof: (i) cash on 

deposit with the bank (including cash held for the bank by a third-party custodian or 

trustee); (ii) gold bullion; (iii) long-term debt securities that have an applicable external 

rating of one category below investment grade or higher (for example, at least BB-); (iv) 

short-term debt instruments that have an applicable external rating of at least investment 

grade (for example, at least A-3); (v) equity securities that are publicly traded; 

(vi) convertible bonds that are publicly traded; and (vii) mutual fund shares for which a 

 

58 This requirement is met under the circumstances described in the previous footnote. 
 Draft Basel II NPR 

199

share price is publicly quoted daily and money market mutual fund shares. Question 36: 

The agencies seek comment on the appropriateness of requiring that a bank have a 

perfected, first priority security interest, or the legal equivalent thereof, in the definition 

of financial collateral.

The proposed rule defines an external rating as a credit rating assigned by a 

nationally recognized statistical rating organization (NRSRO) to an exposure that fully 

reflects the entire amount of credit risk the holder of the exposure has with regard to all 

payments owed to it under the exposure. For example, if a holder is owed principal and 

interest on an exposure, the external rating must fully reflect the credit risk associated 

with timely repayment of principal and interest. Moreover, the external rating must be 

published in an accessible form and must be included in the transition matrices made 

publicly available by the NRSRO that summarize the historical performance of positions 

it has rated.59 Under the proposed rule, an exposure’s applicable external rating is the 

lowest external rating assigned to the exposure by any NRSRO. 

Collateral haircut approach

Under the collateral haircut approach, a bank would set EAD equal to the sum of 

three quantities: (i) the value of the exposure less the value of the collateral; (ii) the 

absolute value of the net position in a given security (where the net position in a given 

security equals the sum of the current market values of the particular security the bank 

has lent, sold subject to repurchase, or posted as collateral to the counterparty minus the 

sum of the current market values of that same security the bank has borrowed, purchased 

subject to resale, or taken as collateral from the counterparty) multiplied by the market 

 

59 Banks should take particular care with these requirements where the financial collateral is in the form of 

a securitization exposure. 
 Draft Basel II NPR 

200

price volatility haircut appropriate to that security; and (iii) the sum of the absolute values 

of the net position of both cash and securities in each currency that is different from the 

settlement currency multiplied by the haircut appropriate to each currency mismatch. To 

determine the appropriate haircuts, a bank could choose to use standard supervisory 

haircuts or its own estimates of haircuts. For purposes of the collateral haircut approach, 

a given security would include, for example, all securities with a single Committee on 

Uniform Securities Identification Procedures (CUSIP) number and would not include 

securities with different CUSIP numbers, even if issued by the same issuer with the same 

maturity date. Question 37: The agencies recognize that this is a conservative approach 

and seek comment on other approaches to consider in determining a given security for 

purposes of the collateral haircut approach.

Standard supervisory haircuts

If a bank chooses to use standard supervisory haircuts, it would use an 8 percent 

haircut for each currency mismatch and the haircut appropriate to each security in table E 

below. These haircuts are based on the 10-business-day holding period for eligible 

margin loans and may be multiplied by the square root of 1⁄2 to convert the standard 

supervisory haircuts to the 5-business-day minimum holding period for repo-style 

transactions. A bank must adjust the standard supervisory haircuts upward on the basis 

of a holding period longer than 10 business days for eligible margin loans or 5 business 

days for repo-style transactions where and as appropriate to take into account the 

illiquidity of an instrument. 

Table E – Standard Supervisory Market Price Volatility Haircuts 
 Draft Basel II NPR 

201

Applicable external rating 

grade category for debt 

securities 

Residual maturity for debt securities 

Issuers exempt 

from the 3 b.p. 

floor 

Other issuers 

≤ 1 year .005 .01 

>1 year, ≤ 5 years .02 .04 

Two highest investment 

grade rating categories for 

long-term ratings/highest 

investment grade rating 

category for short-term 

ratings 

> 5 years .04 .08 

≤ 1 year .01 .02 

>1 year, ≤ 5 years .03 .06 

Two lowest investment 

grade rating categories for 

both short- and long-term 

ratings > 5 years .06 .12 

One rating category below 

investment grade 

All .15 .25 

Main index equities60 (including convertible bonds) and gold .15 

Other publicly traded equities (including convertible bonds) .25 

Mutual funds Highest haircut applicable to any 

security in which the fund can invest 

Cash on deposit with the bank (including a certificate of deposit issued 

by the bank) 

0 

As an example, assume a bank that uses standard supervisory haircuts has 

extended an eligible margin loan of $100 that is collateralized by 5-year U.S. Treasury 

notes with a market value of $100. The value of the exposure less the value of the 

collateral would be zero, and the net position in the security ($100) times the supervisory 

haircut (.02) would be $2. There is no currency mismatch. Therefore, the EAD of the 

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

Own estimates of haircuts

With the prior written approval of the bank’s primary Federal supervisor, a bank 

may calculate security type and currency mismatch haircuts using its own internal 

estimates of market price volatility and foreign exchange volatility. The bank’s primary 

 

60 The proposed rule defines a “main index” as the S&P 500 Index, the FTSE All-World Index, and any 

other index for which the bank demonstrates to the satisfaction of its primary Federal supervisor that the 

equities represented in the index have comparable liquidity, depth of market, and size of bid-ask spreads as 

equities in the S&P 500 Index and the FTSE All-World Index. 
 Draft Basel II NPR 

202

Federal supervisor would base approval to use internally estimated haircuts on the 

satisfaction of certain minimum qualitative and quantitative standards. These standards 

include: (i) the bank must use a 99th percentile one-tailed confidence interval and a 

minimum 5-business-day holding period for repo-style transactions and a minimum 10-

business-day holding period for all other transactions; (ii) the bank must adjust holding 

periods upward where and as appropriate to take into account the illiquidity of an 

instrument; (iii) the bank must select a historical observation period for calculating 

haircuts of at least one year; and (iv) the bank must update its data sets and recompute 

haircuts no less frequently than quarterly and must update its data sets and recompute 

haircuts whenever market prices change materially. A bank must estimate individually 

the volatilities of the exposure, the collateral, and foreign exchange rates, and may not 

take into account the correlations between them. 

A bank that uses internally estimated haircuts would have to adhere to the 

following rules. The bank may calculate internally estimated haircuts for categories of 

debt securities that have an applicable external rating of at least investment grade. The 

haircut for a category of securities would have to be representative of the internal 

volatility estimates for securities in that category that the bank has actually lent, sold 

subject to repurchase, posted as collateral, borrowed, purchased subject to resale, or taken 

as collateral. In determining relevant categories, the bank would have to take into 

account (i) the type of issuer of the security; (ii) the applicable external rating of the 

security; (iii) the maturity of the security; and (iv) the interest rate sensitivity of the 

security. A bank would calculate a separate internally estimated haircut for each 

individual debt security that has an applicable external rating below investment grade and 
 Draft Basel II NPR 

203

for each individual equity security. In addition, a bank would internally estimate a 

separate currency mismatch haircut for each individual mismatch between each net 

position in a currency that is different from the settlement currency. 

When a bank calculates an internally estimated haircut on a TN-day holding 

period, which is different from the minimum holding period for the transaction type, the 

applicable haircut (HM) must be calculated using the following square root of time 

formula: 

N

M N T

T H H M

= , 

where 

(i) TM = 5 for repo-style transactions and 10 for eligible margin loans; 

(ii) TN = holding period used by the bank to derive HN; and 

(iii) HN = haircut based on the holding period TN. 

Simple VaR methodology 

As noted above, a bank may use one of two internal models approaches to 

recognize the risk mitigating effects of financial collateral that secures a repo-style 

transaction or eligible margin loan. This section of the preamble describes the simple 

VaR methodology; a later section of the preamble describes the internal models 

methodology (which also may be used to determine the EAD for OTC derivative 

contracts). 

With the prior written approval of its primary Federal supervisor, a bank may 

estimate EAD for repo-style transactions and eligible margin loans subject to a single 

product qualifying master netting agreement using a VaR model. Under the simple VaR 

methodology, a bank’s EAD for the transactions subject to such a netting agreement 
 Draft Basel II NPR 

204

would be equal to the value of the exposures minus the value of the collateral plus a VaRbased estimate of the potential future exposure (PFE), that is, the maximum exposure 

expected to occur on a future date with a high level of confidence. The value of the 

exposures is the sum of the current market values of all securities and cash the bank has 

lent, sold subject to repurchase, or posted as collateral to a counterparty under the netting 

set. The value of the collateral is the sum of the current market values of all securities 

and cash the bank has borrowed, purchased subject to resale, or taken as collateral from a 

counterparty under the netting set. 

The VaR model must estimate the bank’s 99th percentile, one-tailed confidence 

interval for an increase in the value of the exposures minus the value of the collateral (∑E 

- ∑C) over a 5-business-day holding period for repo-style transactions or over a 10-

business-day holding period for eligible margin loans using a minimum one-year 

historical observation period of price data representing the instruments that the bank has 

lent, sold subject to repurchase, posted as collateral, borrowed, purchased subject to 

resale, or taken as collateral. 

The qualifying requirements for the use of a VaR model are less stringent than the 

qualification requirements for the internal models methodology described below. The 

main ongoing qualification requirement for using a VaR model is that the bank must 

validate its VaR model by establishing and maintaining a rigorous and regular 

backtesting regime. 

3. EAD for OTC derivative contracts
 Draft Basel II NPR 

205

A bank may use either the current exposure methodology or the internal models 

methodology to determine the EAD for OTC derivative contracts. An OTC derivative 

contract is defined as a derivative contract that is not traded on an exchange that requires 

the daily receipt and payment of cash-variation margin. A derivative contract is defined 

to include interest rate derivative contracts, exchange rate derivative contracts, equity 

derivative contracts, commodity derivative contracts, credit derivatives, and any other 

instrument that poses similar counterparty credit risks. The proposed rule also would 

define derivative contracts to include unsettled securities, commodities, and foreign 

exchange trades with a contractual settlement or delivery lag that is longer than the 

normal settlement period (which the proposed rule defines as the lesser of the market 

standard for the particular instrument or 5 business days). This would include, for 

example, agency mortgage-backed securities transactions conducted in the To-BeAnnounced market. 

 Figure 3 illustrates the treatment of OTC derivative contracts. 
 Draft Basel II NPR 

206

Figure 3 – EAD and LGD for OTC Derivative Contracts 

Plug PD, Adjusted LGD, 

and EAD into Wholesale 

Function 

EAD for 

OTC 

Derivatives

Internal Models 

Methodology

Plug PD, Unsecured 

LGD, and Adjusted 

EAD into Wholesale 

Function

Collateral 

Considered in 

Internal Models 

Methodology

Current 

Exposure 

Methodology

Yes

Master 

Netting 

Agreement

Net Replacement Cost 

+ Adjusted Potential 

Future Exposure

Transaction Replacement 

Cost + Potential Future 

Exposure

No

Is Collateral Posted?

Yes No

Haircut Collateral 

to Adjust EAD

Adjust LGD

Standardized 

Haircuts

Own 

Estimates

Plug PD, Unsecured 

LGD, and EAD into 

Wholesale Function

Plug PD, Adjusted LGD, 

and EAD into Wholesale 

Function 

EAD for 

OTC 

Derivatives

Internal Models 

Methodology

Plug PD, Unsecured 

LGD, and Adjusted 

EAD into Wholesale 

Function

Collateral 

Considered in 

Internal Models 

Methodology

Current 

Exposure 

Methodology

Yes

Master 

Netting 

Agreement

Net Replacement Cost 

+ Adjusted Potential 

Future Exposure

Transaction Replacement 

Cost + Potential Future 

Exposure

No

Is Collateral Posted?

Yes No

Haircut Collateral 

to Adjust EAD

Adjust LGD

Standardized 

Haircuts

Own 

Estimates

Plug PD, Unsecured 

LGD, and EAD into 

Wholesale Function

Current exposure methodology

The proposed current exposure methodology for determining EAD for single 

OTC derivative contracts is similar to the methodology in the general risk-based capital 

rules, in that the EAD for an OTC derivative contract would be equal to the sum of the 

bank’s current credit exposure and PFE on the derivative contract. The current credit 

exposure for a single OTC derivative contract is the greater of the mark-to-market value 

of the derivative contract or zero. 
 Draft Basel II NPR 

207

The proposed current exposure methodology for OTC derivative contracts subject 

to master netting agreements is also similar to the treatment set forth in the agencies’ 

general risk-based capital rules. Banks would need to calculate net current exposure and 

adjust the gross PFE using a formula that includes the net to gross current exposure ratio. 

Moreover, under the agencies’ general risk-based capital rules, a bank may not recognize 

netting agreements for OTC derivative contracts for capital purposes unless it obtains a 

written and reasoned legal opinion representing that, in the event of a legal challenge, the 

bank’s exposure would be found to be the net amount in the relevant jurisdictions. The 

agencies are proposing to retain this standard for netting agreements covering OTC 

derivative contracts. While the legal enforceability of contracts is necessary for a bank to 

recognize netting effects in the capital calculation, there may be ways other than 

obtaining an explicit written opinion to ensure the enforceability of a contract. For 

example, the use of industry developed standardized contracts for certain OTC products 

and reliance on commissioned legal opinions as to the enforceability of these contracts in 

many jurisdictions may be sufficient. Question 38: The agencies seek comment on 

methods banks would use to ensure enforceability of single product OTC derivative 

netting agreements in the absence of an explicit written legal opinion requirement.

The proposed rule’s credit conversion factor (CCF) matrix used to compute PFE 

is based on the matrices in the general risk-based capital rules, with two exceptions. 

First, under the proposed rule the CCF for credit derivatives that are not used to hedge the 

credit risk of exposures subject to an IRB credit risk capital requirement is specified to be 

5.0 percent for contracts with investment grade reference obligors and 10.0 percent for 
 Draft Basel II NPR 

208

contracts with non-investment grade obligors.61 The CCF for a credit derivative contract 

does not depend on the remaining maturity of the contract. The second change is that 

floating/floating basis swaps would no longer be exempted from the CCF for interest rate 

derivative contracts. The exemption was put into place when such swaps were very 

simple, and the agencies believe it is no longer appropriate given the evolution of the 

product. The computation of the PFE of multiple OTC derivative contracts subject to a 

qualifying master netting agreement would not change from the general risk-based capital 

rules. 

If an OTC derivative contract is collateralized by financial collateral, a bank 

would first determine an unsecured EAD as described above and in section 32(b) of the 

proposed rule. To take into account the risk-reducing effects of the financial collateral, 

the bank may either adjust the ELGD and LGD of the contract or, if the transaction is 

subject to daily marking-to-market and remargining, adjust the EAD of the contract using 

the collateral haircut approach for repo-style transactions and eligible margin loans 

described above and in section 32(a) of the proposed rule. 

Under part VI of the proposed rule, a bank must treat an equity derivative contract 

as an equity exposure and compute a risk-weighted asset amount for that exposure. If the 

bank is using the internal models approach for its equity exposures, it also must compute 

a risk-weighted asset amount for its counterparty credit risk exposure on the equity 

derivative contract. However, if the bank is using the simple risk weight approach for its 

equity exposures, it may choose not to hold risk-based capital against the counterparty 

credit risk of the equity derivative contract. Likewise, a bank that purchases a credit 

 

61 The counterparty credit risk of a credit derivative that is used to hedge the credit risk of an exposure 

subject to an IRB credit risk capital requirement is captured in the IRB treatment of the hedged exposure, as 

detailed in sections 33 and 34 of the proposed rule. 
 Draft Basel II NPR 

209

derivative that is recognized under section 33 or 34 of the proposed rule as a credit risk 

mitigant for an exposure that is not a covered position under the MRA does not have to 

compute a separate counterparty credit risk capital requirement for the credit derivative. 

If a bank chooses not to hold risk-based capital against the counterparty credit risk of 

such equity or credit derivative contracts, it must do so consistently for all such equity 

derivative contracts or for all such credit derivative contracts. Further, where the 

contracts are subject to a qualifying master netting agreement, the bank must either 

include them all or exclude them all from any measure used to determine counterparty 

credit risk exposure to all relevant counterparties for risk-based capital purposes. 

Where a bank provides protection through a credit derivative that is not treated as 

a covered position under the MRA, it must treat the credit derivative as a wholesale 

exposure to the reference obligor and compute a risk-weighted asset amount for the credit 

derivative under section 31 of the proposed rule. The bank need not compute a 

counterparty credit risk capital requirement for the credit derivative, so long as it does so 

consistently for all such credit derivatives and either includes all or excludes all such 

credit derivatives that are subject to a qualifying master netting agreement from any 

measure used to determine counterparty credit risk exposure to all relevant counterparties 

for risk-based capital purposes. Where the bank provides protection through a credit 

derivative treated as a covered position under the MRA, it must compute a counterparty 

credit risk capital requirement under section 32 of the proposed rule. 

4. Internal models methodology 
 Draft Basel II NPR 

210

This proposed rule includes an internal models methodology for the calculation of 

EAD for transactions with counterparty credit exposure, namely, OTC derivatives, 

eligible margin loans, and repo-style transactions. The internal models methodology 

requires a risk model that captures counterparty credit risk and estimates EAD at the level 

of a “netting set.” A netting set is a group of transactions with a single counterparty that 

are subject to a qualifying master netting agreement. A transaction not subject to a 

qualifying master netting agreement is considered to be its own netting set and EAD must 

be calculated for each such transaction individually. A bank may use the internal models 

methodology for OTC derivatives (collateralized or uncollateralized) and single-product 

netting sets thereof, for eligible margin loans and single-product netting sets thereof, or 

for repo-style transactions and single-product netting sets thereof. A bank that uses the 

internal models methodology for a particular transaction type (that is, OTC derivative 

contracts, eligible margin loans, or repo-style transactions) must use the internal models 

methodology for all transactions in that transaction type. However, a bank may choose 

whether or not to use the internal models methodology for each transaction type. 

A bank also may use the internal models methodology for OTC derivatives, 

eligible margin loans, and repo-style transactions subject to a qualifying cross-product 

master netting agreement if (i) the bank effectively integrates the risk mitigating effects 

of cross-product netting into its risk management and other information technology 

systems; and (ii) the bank obtains the prior written approval of its primary Federal 

supervisor. 

A qualifying cross-product master netting agreement is defined as a qualifying 

master netting agreement that provides for termination and close-out netting across 
 Draft Basel II NPR 

211

multiple types of financial transactions or qualifying master netting agreements in the 

event of a counterparty’s default, provided that: 

(i) The underlying financial transactions are OTC derivative contracts, eligible 

margin loans, or repo-style transactions; and 

(ii) The bank obtains a written legal opinion verifying the validity and 

enforceability of the netting agreement under applicable law of the relevant jurisdictions 

if the counterparty fails to perform upon an event of default, including upon an event of 

bankruptcy, insolvency, or similar proceeding. 

Banks use several measures to manage their exposure to counterparty credit risk 

including PFE, expected exposure (EE), and expected positive exposure (EPE). PFE is 

the maximum exposure estimated to occur on a future date at a high level of statistical 

confidence. Banks often use PFE when measuring counterparty credit risk exposure 

against counterparty credit limits. EE is the probability-weighted average exposure to a 

counterparty estimated to exist at any specified future date, whereas EPE is the timeweighted average of individual expected exposures estimated for a given forecasting 

horizon (one year in the proposed rule). Banks typically compute EPE, EE, and PFE 

using a common stochastic model. 

A paper published by the BCBS in July 2005 titled “The Application of Basel II 

to Trading Activities and the Treatment of Double Default Effects” notes that EPE is an 

appropriate EAD measure for determining risk-based capital requirements for 

counterparty credit risk because transactions with counterparty credit risk “are given the 

same standing as loans with the goal of reducing the capital treatment’s influence on a 

firm’s decision to extend an on-balance sheet loan rather than engage in an economically 
 Draft Basel II NPR 

212

equivalent transaction that involves exposure to counterparty credit risk.”62 An 

adjustment to EPE, called effective EPE and described below, is used in the calculation 

of EAD under the internal models methodology. EAD is calculated as a multiple of 

effective EPE. 

To address the concern that EE and EPE may not capture risk arising from the 

replacement of existing short-term positions over the one year horizon used for capital 

requirements (that is, rollover risk) or may underestimate the exposures of eligible 

margin loans, repo-style transactions, and OTC derivatives with short maturities, the 

proposed rule uses a netting set’s “effective EPE” as the basis for calculating EAD for 

counterparty credit risk. Consistent with the use of a one-year PD horizon, effective EPE 

is the time-weighted average of effective EE over one year where the weights are the 

proportion that an individual effective EE represents in a one-year time interval. If all 

contracts in a netting set mature before one year, effective EPE is the average of effective 

EE until all contracts in the netting set mature. For example, if the longest maturity 

contract in the netting set matures in six months, effective EPE would be the average of 

effective EE over six months. 

Effective EE is defined as: 

Effective EEtk = max(Effective EEtk-1, EEtk) 

where exposure is measured at future dates t1, t2, t3,. . . and effective EEt0 equals 

current exposure. Alternatively, a bank may use a measure that is more conservative than 

effective EPE for every counterparty (that is, a measure based on peak exposure) with 

prior approval of the primary Federal supervisor. 

 

62 BCBS, “The Application of Basel II to Trading Activities and the Treatment of Double Default Effects,” 

July 2005, ¶ 15. 
 Draft Basel II NPR 

213

The EAD for instruments with counterparty credit risk must be determined 

assuming economic downturn conditions. To accomplish this determination in a prudent 

manner, the internal models methodology sets EAD equal to EPE multiplied by a scaling 

factor termed “alpha.” Alpha is set at 1.4; a bank’s primary Federal supervisor would 

have the flexibility to raise this value based on the bank’s specific characteristics of 

counterparty credit risk. With supervisory approval, a bank may use its own estimate of 

alpha as described below, subject to a floor of 1.2. Question 39: The agencies request 

comment on all aspect of the effective EPE approach to counterparty credit risk, and in 

particular on the appropriateness of the monotonically increasing effective EE function, 

the alpha constant of 1.4, and the floor on internal estimates of alpha of 1.2. 

A bank’s primary Federal supervisor must determine that the bank meets certain 

qualifying criteria before the bank may use the internal models methodology. These 

criteria consist of operational requirements, modeling standards, and model validation 

requirements. 

 First, the bank must have the systems capability to estimate EE on a daily basis. 

While this requirement does not require the bank to report EE daily, or even estimate EE 

daily, the bank must demonstrate that it is capable of performing the estimation daily. 

Second, the bank must estimate EE at enough future time points to accurately 

reflect all future cash flows of contracts in the netting set. To accurately reflect the 

exposure arising from a transaction, the model should incorporate those contractual 

provisions, such as reset dates, that can materially affect the timing, probability, or 

amount of any payment. The requirement reflects the need for an accurate estimate of 
 Draft Basel II NPR 

214

EPE. However, in order to balance the ability to calculate exposures with the need for 

information on timely basis, the number of time points is not specified. 

Third, the bank must have been using an internal model that broadly meets the 

minimum standards to calculate the distributions of exposures upon which the EAD 

calculation is based for a period of at least one year prior to approval. This requirement 

is to insure that the bank has integrated the modeling into its counterparty credit risk 

management process. 

Fourth, the bank’s model must account for the non-normality of exposure 

distribution where appropriate. Non-normality of exposures means high loss events 

occur more frequently than would be expected on the basis of a normal distribution, the 

statistical term for which is leptokurtosis. In many instances, there may not be a need to 

account for this. Expected exposures are much less likely to be affected by leptokurtosis 

than peak exposures or high percentile losses. However, the bank must demonstrate that 

its EAD measure is not affected by leptokurtosis or must account for it within the model. 

Fifth, the bank must measure, monitor, and control the exposure to a counterparty 

over the whole life of all contracts in the netting set, in addition to accurately measuring 

and actively monitoring the current exposure to counterparties. The bank should exercise 

active management of both existing exposure and exposure that could change in the 

future due to market moves. 

Sixth, the bank must measure and manage current exposures gross and net of 

collateral held, where appropriate. The bank must estimate expected exposures for OTC 

derivative contracts both with and without the effect of collateral agreements. 
 Draft Basel II NPR 

215

Seventh, the bank must have procedures to identify, monitor, and control specific 

wrong-way risk throughout the life of an exposure. In this context, wrong-way risk is the 

risk that future exposure to a counterparty will be high when the counterparty’s 

probability of default is also high. Wrong-way risk generally arises from events specific 

to the counterparty, rather than broad market downturns. 

Eighth, the data used by the bank should be adequate for the measurement and 

modeling of the exposures. In particular, current exposures must be calculated on the 

basis of current market data. When historical data are used to estimate model parameters, 

at least three years of data that cover a wide range of economic conditions must be used. 

This requirement reflects the longer horizon for counterparty credit risk exposures 

compared to market risk exposures. The data must be updated at least quarterly. Banks 

are encouraged also to incorporate model parameters based on forward looking measures 

– for example, using implied volatilities in situations where historic volatilities may not 

capture changes in the risk drivers anticipated by the market – where appropriate. 

Ninth, the bank must subject its models used in the calculation of EAD to an 

initial validation and annual model review process. The model review should consider 

whether the inputs and risk factors, as well as the model outputs, are appropriate. The 

review of outputs should include a rigorous program of backtesting model outputs against 

realized exposures. 

Maturity under the internal models methodology

Like corporate loan exposures, counterparty exposure on netting sets is 

susceptible to changes in economic value that stem from deterioration in the 
 Draft Basel II NPR 

216

counterparty’s creditworthiness short of default. The effective maturity parameter (M) 

reflects the impact of these changes on capital. The formula used to compute M for 

netting sets with maturities greater than one year must be different than that generally 

applied to wholesale exposures in order to reflect how counterparty credit exposures 

change over time. The proposed approach is based on a weighted average of expected 

exposures over the life of the transactions relative to their one year exposures. 

If the remaining maturity of the exposure or the longest-dated contract contained 

in a netting set is greater than one year, the bank must set M for the exposure or netting 

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

(i) 

∑

∑

≤

=

>

×Δ ×

×Δ ×

= + t year

k

k k k

maturity

t year

k k k

k

k

effectiveEE t df

EE t df

M EPE 1

1

1 ( ; and (ii) df ) 1 k is the risk-free discount factor 

for future time period tk. The cap of five years on M is consistent with the treatment of 

wholesale exposures under section 31 of the proposed rule. 

If the remaining maturity of the exposure or the longest-dated contract in the 

netting set is one year or less, the bank must set M for the exposure or netting set equal to 

1 year except as provided in section 31(d)(7) of the proposed rule. In this case, repo-style 

transactions, eligible margin loans, and collateralized OTC derivative transactions subject 

to daily remargining agreements may use the effective maturity of the longest maturity 

transaction in the netting set as M. 

Collateral agreements under the internal models methodology

If the bank has prior written approval from its primary Federal supervisor, it may 

capture the effect on EAD of a collateral agreement that requires receipt of collateral 
 Draft Basel II NPR 

217

when exposure to the counterparty increases within its internal model. In no 

circumstances may the bank take into account in EAD collateral agreements triggered by 

deterioration of counterparty credit quality. For this purpose, a collateral agreement 

means a legal contract that: (i) specifies the time when, and circumstances under which, 

the counterparty is required to exchange collateral with the bank for a single financial 

contract or for all financial contracts covered under a qualifying master netting 

agreement; and (ii) confers upon the bank a perfected, first priority security interest, or 

the legal equivalent thereof, in the collateral posted by the counterparty under the 

agreement. This security interest must provide the bank with a right to close out the 

financial positions and the collateral upon an event of default of or failure to perform by 

the counterparty under the collateral agreement. A contract would not satisfy this 

requirement if the bank’s exercise of rights under the agreement may be stayed or 

avoided under applicable law in the relevant jurisdictions. 

If the internal model does not capture the effects of collateral agreements, the 

following “shortcut” method is proposed that will provide some benefit, in the form of a 

smaller EAD, for collateralized counterparties. Although this “shortcut” method will be 

permitted, the agencies expect banks that make extensive use of collateral agreements to 

develop the modeling capacity to measure the impact of such agreements on EAD. 

 The “shortcut” method sets effective EPE for a counterparty subject to a collateral 

agreement equal to the lesser of: 

(i) The threshold, defined as the exposure amount at which the counterparty is 

required to post collateral under the collateral agreement, if the threshold is positive, plus 

an add-on that reflects the potential increase in exposure over the margin period of risk. 
 Draft Basel II NPR 

218

The add-on is computed as the expected increase in the netting set’s exposure beginning 

from current exposure of zero over the margin period of risk; and 

(ii) Effective EPE without a collateral agreement.

The margin period of risk means, with respect to a netting set subject to a 

collateral agreement, the time period from the most recent exchange of collateral with a 

counterparty until the next required exchange of collateral plus the period of time 

required to sell and realize the proceeds of the least liquid collateral that can be delivered 

under the terms of the collateral agreement, and, where applicable, the period of time 

required to re-hedge the resulting market risk, upon the default of the counterparty. The 

minimum margin period of risk is 5 business days for repo-style transactions and 10 days 

for other transactions when liquid financial collateral is posted under a daily margin 

maintenance requirement. This period should be extended to cover any additional time 

between margin calls; any potential closeout difficulties; any delays in selling collateral, 

particularly if the collateral is illiquid; and any impediments to prompt re-hedging of any 

market risk. 

Own estimate of alpha

 This proposed rule would allow a bank to estimate a bank-wide alpha, subject to 

prior written approval from its primary Federal supervisor. The internal estimate of alpha 

would be the ratio of economic capital from a full simulation of counterparty credit risk 

exposure that incorporates a joint simulation of market and credit risk factors (numerator) 

to economic capital based on EPE (denominator). For purposes of this calculation, 

economic capital is the unexpected losses for all counterparty credit risks measured at the 

99.9 percent confidence level over a one-year horizon. Internal estimates of alpha are 
 Draft Basel II NPR 

219

subject to a floor of 1.2. To obtain supervisory approval to use an internal estimate of 

alpha in the calculation of EAD, a bank must meet the following minimum standards to 

the satisfaction of its primary Federal supervisor: 

(i) The bank’s own estimate of alpha must capture the effects in the numerator of: 

(A) The material sources of stochastic dependency of distributions of market 

values of transactions or portfolios of transactions across counterparties; 

(B) Volatilities and correlations of market risk factors used in the joint simulation, 

which must be related to the credit risk factor used in the simulation to reflect potential 

increases in volatility or correlation in an economic downturn, where appropriate; and 

(C) The granularity of exposures, that is, the effect of a concentration in the 

proportion of each counterparty’s exposure that is driven by a particular risk factor; 

(ii) The bank must assess the potential model risk in its estimates of alpha; 

(iii) The bank must calculate the numerator and denominator of alpha in a 

consistent fashion with respect to modeling methodology, parameter specifications, and 

portfolio composition; and 

(iv) The bank must review and adjust as appropriate its estimates of the numerator 

and denominator on at least a quarterly basis and more frequently as appropriate when the 

composition of the portfolio varies over time. 

Alternative models 

 The proposed rule allows a bank to use an alternative model to determine EAD, 

provided that the bank can demonstrate to its primary Federal supervisor that the model 
 Draft Basel II NPR 

220

output is more conservative than an alpha of 1.4 (or higher) times effective EPE. This 

may be appropriate where a new product or business line is being developed, where a 

recent acquisition has occurred, or where the bank believes that other more conservative 

methods to measure counterparty credit risk for a category of transactions are prudent. 

The alternative method should be applied to all similar transactions. When an alternative 

model is used, the bank should either treat the particular transactions concerned as a 

separate netting set with the counterparty or apply the alternative model to the entire 

original netting set. 

5. Guarantees and credit derivatives that cover wholesale exposures

The New Accord specifies that a bank may adjust either the PD or the LGD of a 

wholesale exposure to reflect the risk mitigating effects of a guarantee or credit 

derivative. Under the proposed rule, a bank may choose either a PD substitution or an 

LGD adjustment approach to recognize the risk mitigating effects of an eligible guarantee 

or eligible credit derivative on a wholesale exposure (or in certain circumstances may 

choose to use a double default treatment, as discussed below). In all cases a bank must 

use the same risk parameters for calculating ECL for a wholesale exposure as it uses for 

calculating the risk-based capital requirement for the exposure. Moreover, in all cases, a 

bank’s ultimate PD and LGD for the hedged wholesale exposure may not be lower than 

the PD and LGD floors discussed above and described in section 31(d) of the proposed 

rule. 

Eligible guarantees and eligible credit derivatives
 Draft Basel II NPR 

221

To be recognized as CRM for a wholesale exposure under the proposed rule, 

guarantees and credit derivatives must meet specific eligibility requirements. The 

proposed rule defines an eligible guarantee as a guarantee that: 

(i) Is written and unconditional; 

(ii) Covers all or a pro rata portion of all contractual payments of the obligor on 

the reference exposure; 

(iii) Gives the beneficiary a direct claim against the protection provider; 

(iv) Is non-cancelable by the protection provider for reasons other than the breach 

of the contract by the beneficiary; 

(v) Is legally enforceable against the protection provider in a jurisdiction where 

the protection provider has sufficient assets against which a judgment may be attached 

and enforced; and 

(vi) Requires the protection provider to make payment to the beneficiary on the 

occurrence of a default (as defined in the guarantee) of the obligor on the reference 

exposure without first requiring the beneficiary to demand payment from the obligor. 

Clearly, a bank could not provide an eligible guarantee on its own exposures. 

The proposed rule defines an eligible credit derivative as a credit derivative in the 

form of a credit default swap, nth-to-default swap, or total return swap provided that: 

(i) The contract meets the requirements of an eligible guarantee and has been 

confirmed by the protection purchaser and the protection provider; 

(ii) Any assignment of the contract has been confirmed by all relevant parties; 

(iii) If the credit derivative is a credit default swap or nth-to-default swap, the 

contract includes the following credit events: 
 Draft Basel II NPR 

222

(A) Failure to pay any amount due under the terms of the reference exposure 

(with a grace period that is closely in line with the grace period of the reference 

exposure); and 

(B) Bankruptcy, insolvency, or inability of the obligor on the reference exposure 

to pay its debts, or its failure or admission in writing of its inability generally to pay its 

debts as they become due, and similar events; 

(iv) The terms and conditions dictating the manner in which the contract is to be 

settled are incorporated into the contract; 

(v) If the contract allows for cash settlement, the contract incorporates a robust 

valuation process to estimate loss reliably and specifies a reasonable period for obtaining 

post-credit event valuations of the reference exposure; 

(vi) If the contract requires the protection purchaser to transfer an exposure to the 

protection provider at settlement, the terms of the exposure provide that any required 

consent to transfer may not be unreasonably withheld; 

(vii) If the credit derivative is a credit default swap or nth-to-default swap, the 

contract clearly identifies the parties responsible for determining whether a credit event 

has occurred, specifies that this determination is not the sole responsibility of the 

protection provider, and gives the protection purchaser the right to notify the protection 

provider of the occurrence of a credit event; and 

(viii) If the credit derivative is a total return swap and the bank records net 

payments received on the swap as net income, the bank records offsetting deterioration in 

the value of the hedged exposure (either through reductions in fair value or by an addition 

to reserves). 
 Draft Basel II NPR 

223

Question 40: The agencies request comment on the appropriateness of these 

criteria in determining whether the risk mitigation effects of a credit derivative should be 

recognized for risk-based capital purposes.

Under the proposed rule, a bank may recognize an eligible credit derivative that 

hedges an exposure that is different from the credit derivative’s reference exposure used 

for determining the derivative’s cash settlement value, deliverable obligation, or 

occurrence of a credit event only if: 

(i) The reference exposure ranks pari passu (that is, equal) or junior to the hedged 

exposure; and 

(ii) The reference exposure and the hedged exposure share the same obligor (that 

is, the same legal entity) and legally enforceable cross-default or cross-acceleration 

clauses are in place. 

PD substitution approach

Under the PD substitution approach, if the protection amount (as defined below) 

of the eligible guarantee or eligible credit derivative is greater than or equal to the EAD 

of the hedged exposure, a bank would substitute for the PD of the hedged exposure the 

PD associated with the rating grade of the protection provider. If the bank determines 

that full substitution leads to an inappropriate degree of risk mitigation, the bank may 

substitute a higher PD for that of the protection provider. 

If the guarantee or credit derivative provides the bank with the option to receive 

immediate payout on triggering the protection, then the bank would use the lower of the 

LGD of the hedged exposure (not adjusted to reflect the guarantee or credit derivative) 

and the LGD of the guarantee or credit derivative. The bank also would use the ELGD 
 Draft Basel II NPR 

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associated with the required LGD. If the guarantee or credit derivative does not provide 

the bank with the option to receive immediate payout on triggering the protection (and 

instead provides for the guarantor to assume the payment obligations of the obligor over 

the remaining life of the hedged exposure), the bank would use the LGD and ELGD of 

the guarantee or credit derivative. 

If the protection amount of the eligible guarantee or eligible credit derivative is 

less than the EAD of the hedged exposure, however, the bank must treat the hedged 

exposure as two separate exposures (protected and unprotected) in order to recognize the 

credit risk mitigation benefit of the guarantee or credit derivative. The bank must 

calculate its risk-based capital requirement for the protected exposure under section 31 of 

the proposed rule (using a PD equal to the protection provider’s PD, an ELGD and LGD 

determined as described above, and an EAD equal to the protection amount of the 

guarantee or credit derivative). If the bank determines that full substitution leads to an 

inappropriate degree of risk mitigation, the bank may use a higher PD than that of the 

protection provider. The bank must calculate its risk-based capital requirement for the 

unprotected exposure under section 31 of the proposed rule (using a PD equal to the 

obligor’s PD, an ELGD and LGD equal to the hedged exposure’s ELGD and LGD not 

adjusted to reflect the guarantee or credit derivative, and an EAD equal to the EAD of the 

original hedged exposure minus the protection amount of the guarantee or credit 

derivative). 

 The protection amount of an eligible guarantee or eligible credit derivative would 

be the effective notional amount of the guarantee or credit derivative reduced by any 

applicable haircuts for maturity mismatch, lack of restructuring, and currency mismatch 
 Draft Basel II NPR 

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(each described below). The effective notional amount of a guarantee or credit derivative 

would be the lesser of the contractual notional amount of the credit risk mitigant and the 

EAD of the hedged exposure, multiplied by the percentage coverage of the credit risk 

mitigant. For example, the effective notional amount of a guarantee that covers, on a pro 

rata basis, 40 percent of any losses on a $100 bond would be $40. 

LGD adjustment approach

Under the LGD adjustment approach, if the protection amount of the eligible 

guarantee or eligible credit derivative is greater than or equal to the EAD of the hedged 

exposure, the bank’s risk-based capital requirement for the hedged exposure would be the 

greater of (i) the risk-based capital requirement for the exposure as calculated under 

section 31 of the proposed rule (with the ELGD and LGD of the exposure adjusted to 

reflect the guarantee or credit derivative); or (ii) the risk-based capital requirement for a 

direct exposure to the protection provider as calculated under section 31 of the proposed 

rule (using the bank’s PD for the protection provider, the bank’s ELGD and LGD for the 

guarantee or credit derivative, and an EAD equal to the EAD of the hedged exposure). 

If the protection amount of the eligible guarantee or eligible credit derivative is 

less than the EAD of the hedged exposure, however, the bank must treat the hedged 

exposure as two separate exposures (protected and unprotected) in order to recognize the 

credit risk mitigation benefit of the guarantee or credit derivative. The bank’s risk-based 

capital requirement for the protected exposure would be the greater of (i) the risk-based 

capital requirement for the protected exposure as calculated under section 31 of the 

proposed rule (with the ELGD and LGD of the exposure adjusted to reflect the guarantee 

or credit derivative and EAD set equal to the protection amount of the guarantee or credit 
 Draft Basel II NPR 

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derivative); or (ii) the risk-based capital requirement for a direct exposure to the 

protection provider as calculated under section 31 of the proposed rule (using the bank’s 

PD for the protection provider, the bank’s ELGD and LGD for the guarantee or credit 

derivative, and an EAD set equal to the protection amount of the guarantee or credit 

derivative). The bank must calculate its risk-based capital requirement for the 

unprotected exposure under section 31 of the proposed rule using a PD set equal to the 

obligor’s PD, an ELGD and LGD set equal to the hedged exposure’s ELGD and LGD 

(not adjusted to reflect the guarantee or credit derivative), and an EAD set equal to the 

EAD of the original hedged exposure minus the protection amount of the guarantee or 

credit derivative. 

The PD substitution approach allows a bank to effectively assess risk-based 

capital against a hedged exposure as if it were a direct exposure to the protection 

provider, and the LGD adjustment approach produces a risk-based capital requirement for 

a hedged exposure that is never lower than that of a direct exposure to the protection 

provider. Accordingly, these approaches do not fully reflect the risk mitigation benefits 

certain types of guarantees and credit derivatives may provide because the resulting riskbased capital requirement does not consider the joint probability of default of the obligor 

of the hedged exposure and the protection provider, sometimes referred to as the “double 

default” benefit. The agencies have decided, consistent with the New Accord, to 

recognize double default benefits in the wholesale framework only for certain hedged 

exposures covered by certain guarantees and credit derivatives. A later section of the 

preamble describes which hedged exposures would be eligible for the proposed double 
 Draft Basel II NPR 

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default treatment and describes the double default treatment that would be available to 

those exposures. 

Maturity mismatch haircut

A bank that seeks to reduce the risk-based capital requirement on a wholesale 

exposure by recognizing an eligible guarantee or eligible credit derivative would have to 

adjust the protection amount of the credit risk mitigant downward to reflect any maturity 

mismatch between the hedged exposure and the credit risk mitigant. A maturity 

mismatch occurs when the effective residual maturity of a credit risk mitigant is less than 

that of the hedged exposure(s). When the hedged exposures have different residual 

maturities, the longest residual maturity of any of the hedged exposures would be used as 

the residual maturity of all hedged exposures. 

The effective residual maturity of a hedged exposure should be gauged as the 

longest possible remaining time before the obligor is scheduled to fulfil its obligation on 

the exposure. When determining the effective residual maturity of the guarantee or credit 

derivative, embedded options that may reduce the term of the credit risk mitigant should 

be taken into account so that the shortest possible residual maturity for the credit risk 

mitigant is used to determine the potential maturity mismatch. Where a call is at the 

discretion of the protection provider, the residual maturity of the guarantee or credit 

derivative would be deemed to be at the first call date. If the call is at the discretion of 

the bank purchasing the protection, but the terms of the arrangement at inception of the 

guarantee or credit derivative contain a positive incentive for the bank to call the 

transaction before contractual maturity, the remaining time to the first call date would be 

deemed to be the residual maturity of the credit risk mitigant. For example, where there 
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228

is a step-up in the cost of credit protection in conjunction with a call feature or where the 

effective cost of protection increases over time even if credit quality remains the same or 

improves, the residual maturity of the credit risk mitigant would be the remaining time to 

the first call. 

Eligible guarantees and eligible credit derivatives with maturity mismatches may 

only be recognized if their original maturities are equal to or greater than one year. As a 

result, a guarantee or credit derivative would not be recognized for a hedged exposure 

with an original maturity of less than one year unless the credit risk mitigant has an 

original maturity of equal to or greater than one year or an effective residual maturity 

equal to or greater than that of the hedged exposure. In all cases, credit risk mitigants 

with maturity mismatches may not be recognized when they have an effective residual 

maturity of three months or less. 

When a maturity mismatch exists, a bank would apply the following maturity 

mismatch adjustment to determine the protection amount of the guarantee or credit 

derivative adjusted for maturity mismatch: Pm = E x (t-0.25)/(T-0.25), where: 

(i) Pm = protection amount of the guarantee or credit derivative adjusted for 

maturity mismatch; 

(ii) E = effective notional amount of the guarantee or credit derivative; 

(iii) t = lesser of T or effective residual maturity of the guarantee or credit 

derivative, expressed in years; and 

(iv) T = lesser of 5 or effective residual maturity of the hedged exposure, 

expressed in years. 

Restructuring haircut
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229

An originating bank that seeks to recognize an eligible credit derivative that does 

not include a distressed restructuring as a credit event that triggers payment under the 

derivative would have to reduce the recognition of the credit derivative by 40 percent. A 

distressed restructuring is a restructuring of the hedged exposure involving forgiveness or 

postponement of principal, interest, or fees that results in a charge-off, specific provision, 

or other similar debit to the profit and loss account. 

In other words, the protection amount of the credit derivative adjusted for lack of 

restructuring credit event (and maturity mismatch, if applicable) would be: Pr = Pm x 

0.60, where: 

(i) Pr = protection amount of the credit derivative, adjusted for lack of 

restructuring credit event (and maturity mismatch, if applicable); and 

(ii) Pm = effective notional amount of the credit derivative (adjusted for maturity 

mismatch, if applicable). 

Currency mismatch haircut

Where the eligible guarantee or eligible credit derivative is denominated in a 

currency different from that in which any hedged exposure is denominated, the protection 

amount of the guarantee or credit derivative adjusted for currency mismatch (and 

maturity mismatch and lack of restructuring credit event, if applicable) would be: Pc = Pr 

x (1-Hfx), where: 

(i) Pc = protection amount of the guarantee or credit derivative, adjusted for 

currency mismatch (and maturity mismatch and lack of restructuring credit event, if 

applicable); 
 Draft Basel II NPR 

230

(ii) Pr = effective notional amount of the guarantee or credit derivative (adjusted 

for maturity mismatch and lack of restructuring credit event, if applicable); and 

(iii) Hfx = haircut appropriate for the currency mismatch between the guarantee or 

credit derivative and the hedged exposure. 

 A bank may use a standard supervisory haircut of 8 percent for Hfx (based on a 

10-business day holding period and daily marking-to-market and remargining). 

Alternatively, a bank may use internally estimated haircuts for Hfx based on a 10-

business day holding period and daily marking-to-market and remargining if the bank 

qualifies to use the own-estimates haircuts in paragraph (a)(2)(iii) of section 32, the 

simple VaR methodology in paragraph (a)(3) of section 32, or the internal models 

methodology in paragraph (c) of section 32 of the proposed rule. The bank must scale 

these haircuts up using a square root of time formula if the bank revalues the guarantee or 

credit derivative less frequently than once every 10 business days. 

Example

 Assume that a bank holds a five-year $100 corporate exposure, purchases a $100 

credit derivative to mitigate its credit risk on the exposure, and chooses to use the PD 

substitution approach. The unsecured ELGD and LGD of the corporate exposure are 20 

and 30 percent, respectively; the ELGD and LGD of the credit derivative are 75 and 

80 percent, respectively. The credit derivative is an eligible credit derivative, has the 

bank’s exposure as its reference exposure, has a three-year maturity, immediate cash 

payout on default, no restructuring provision, and no currency mismatch with the bank’s 

hedged exposure. The effective notional amount and initial protection amount of the 

credit derivative would be $100. The maturity mismatch would reduce the protection 
 Draft Basel II NPR 

231

amount to $100 x (3-.25)/(5-.25) or $57.89. The haircut for lack of restructuring would 

reduce the protection amount to $57.89 x 0.6 or $34.74. So the bank would treat the 

$100 corporate exposure as two exposures: (i) an exposure of $34.74 with the PD of the 

protection provider, an ELGD of 20 percent, an LGD of 30 percent, and an M of 5; and 

(ii) an exposure of $65.26 with the PD of the obligor, an ELGD of 20 percent, an LGD of 

30 percent, and an M of 5. 

Multiple credit risk mitigants

The New Accord provides that if multiple credit risk mitigants (for example, two 

eligible guarantees) cover a single exposure, a bank must disaggregate the exposure into 

portions covered by each credit risk mitigant (for example, the portion covered by each 

guarantee) and must calculate separately the risk-based capital requirement of each 

portion.63 The New Accord also indicates that when credit risk mitigants provided by a 

single protection provider have differing maturities, they should be subdivided into 

separate layers of protection.64 Question 41: The agencies are interested in the views of 

commenters as to whether and how the agencies should address these and other similar 

situations in which multiple credit risk mitigants cover a single exposure. 

Double default treatment

As noted above, the proposed rule contains a separate risk-based capital 

methodology for hedged exposures eligible for double default treatment. To be eligible 

for double default treatment, a hedged exposure must be fully covered or covered on a 

pro rata basis (that is, there must be no tranching of credit risk) by an uncollateralized 

single-reference-obligor credit derivative or guarantee (or certain nth-to-default credit 

 

63 New Accord, ¶206. 

64 Id. 
 Draft Basel II NPR 

232

derivatives) provided by an eligible double default guarantor (as defined below). 

Moreover, the hedged exposure must be a wholesale exposure other than a sovereign 

exposure.65 In addition, the obligor of the hedged exposure must not be an eligible 

double default guarantor, an affiliate of an eligible double default guarantor, or an 

affiliate of the guarantor. 

 The proposed rule defines eligible double default guarantor to include a 

depository institution (as defined in section 3 of the Federal Deposit Insurance Act 

(12 U.S.C. 1813)); a bank holding company (as defined in section 2 of the Bank Holding 

Company Act (12 U.S.C. 1841)); a savings and loan holding company (as defined in 12 

U.S.C. 1467a) provided all or substantially all of the holding company’s activities are 

permissible for a financial holding company under 12 U.S.C. 1843(k)); a securities 

broker or dealer registered (under the Securities Exchange Act of 1934) with the 

Securities and Exchange Commission (SEC); an insurance company in the business of 

providing credit protection (such as a monoline bond insurer or re-insurer) that is subject 

to supervision by a state insurance regulator; a foreign bank (as defined in section 211.2 

of the Federal Reserve Board’s Regulation K (12 CFR 211.2)); a non-U.S. securities 

firm; or a non-U.S. based insurance company in the business of providing credit 

protection. To be an eligible double default guarantor, the entity must (i) have a bankassigned PD that, at the time the guarantor issued the guarantee or credit derivative, was 

equal to or lower than the PD associated with a long-term external rating of at least the 

third highest investment grade rating category; and (ii) have a current bank-assigned PD 

that is equal to or lower than the PD associated with a long-term external rating of at least 

 

65 The New Accord permits certain retail small business exposures to be eligible for double default 

treatment. Under this proposal, however, a bank must effectively desegment a retail small business 

exposure (thus rendering it a wholesale exposure) to make it eligible for double default treatment. 
 Draft Basel II NPR 

233

investment grade. In addition, a non-U.S. based bank, securities firm, or insurance 

company may qualify as an eligible double default guarantor only if the firm is subject to 

consolidated supervision and regulation comparable to that imposed on U.S. banks, 

securities firms, or insurance companies (as the case may be) or has issued and 

outstanding an unsecured long-term debt security without credit enhancement that has a 

long-term applicable external rating in one of the three highest investment grade rating 

categories. 

 Effectively, the scope of an eligible double default guarantor is limited to 

financial firms whose normal business includes the provision of credit protection, as well 

as the management of a diversified portfolio of credit risk. This restriction arises from 

the agencies’ concern to limit double default recognition to professional counterparties 

that have a high level of credit risk management expertise and that provide sufficient 

market disclosure. The restriction is also designed to limit the risk of excessive 

correlation between the creditworthiness of the guarantor and the obligor of the hedged 

exposure due to their performance depending on common economic factors beyond the 

systematic risk factor. As a result, hedged exposures to potential credit protection 

providers or affiliates of credit protection providers would not be eligible for the double 

default treatment. In addition, the agencies have excluded hedged exposures to sovereign 

entities from eligibility for double default treatment because of the potential high 

correlation between the creditworthiness of a sovereign and that of a guarantor. 

In addition to limiting the types of guarantees, credit derivatives, guarantors, and 

hedged exposures eligible for double default treatment, the proposed rule limits wrongway risk further by requiring a bank to implement a process to detect excessive 
 Draft Basel II NPR 

234

correlation between the creditworthiness of the obligor of the hedged exposure and the 

protection provider. The bank must receive prior written approval from its primary 

Federal supervisor for this process in order to recognize double default benefits for riskbased capital purposes. To apply double default treatment to a particular hedged 

exposure, the bank must determine that there is not excessive correlation between the 

creditworthiness of the obligor of the hedged exposure and the protection provider. For 

example, the creditworthiness of an obligor and a protection provider would be 

excessively correlated if the obligor derives a high proportion of its income or revenue 

from transactions with the protection provider. If excessive correlation is present, the 

bank may not use the double default treatment for the hedged exposure. 

The risk-based capital requirement for a hedged exposure subject to double 

default treatment is calculated by multiplying a risk-based capital requirement for the 

hedged exposure (as if it were unhedged) by an adjustment factor that considers the PD 

of the protection provider (see section 34 of the proposed rule). Thus, the PDs of both 

the obligor of the hedged exposure and the protection provider are factored into the 

hedged exposure’s risk-based capital requirement. In addition, as under the PD 

substitution treatment in section 33 of the proposed rule, the bank would be allowed to set 

LGD equal to the lower of the LGD of the unhedged exposure or the LGD of the 

guarantee or credit derivative if the guarantee or credit derivative provides the bank with 

the option to receive immediate payout on the occurrence of a credit event. Otherwise, 

the bank must set LGD equal to the LGD of the guarantee or credit derivative. In 

addition, the bank must set ELGD equal to the ELGD associated with the required LGD. 

Accordingly, in order to apply the double default treatment, the bank must estimate a PD 
 Draft Basel II NPR 

235

for the protection provider and an ELGD and LGD for the guarantee or credit derivative. 

Finally, a bank using the double default treatment must make applicable adjustments to 

the protection amount of the guarantee or credit derivative to reflect maturity 

mismatches, currency mismatches, and lack of restructuring coverage (as under the PD 

substitution and LGD adjustment approaches in section 33 of the proposed rule). 

6. Guarantees and credit derivatives that cover retail exposures

 The proposed rule provides a different treatment for guarantees and credit 

derivatives that cover retail exposures. The approach set forth above for guarantees and 

credit derivatives that cover wholesale exposures is an exposure-by-exposure approach 

consistent with the overall exposure-by-exposure approach the proposed rule takes to 

wholesale exposures. The agencies believe that a different treatment for guarantees that 

cover retail exposures is necessary and appropriate because of the proposed rule’s 

segmentation approach to retail exposures. The approaches to retail guarantees described 

in this section generally apply only to guarantees of individual retail exposures. 

Guarantees of multiple retail exposures (such as pool private mortgage insurance (PMI)) 

are typically tranched (that is, they cover less than the full amount of the hedged 

exposures) and, therefore, would be securitization exposures. 

The proposed rule does not specify the ways in which guarantees and credit 

derivatives may be taken into account in the segmentation of retail exposures. Likewise, 

the proposed rule does not explicitly limit the extent to which a bank may take into 

account the credit risk mitigation benefits of guarantees and credit derivatives in its 

estimation of the PD, ELGD, and LGD of retail segments, except by the application of 

overall floors on certain PD and LGD assignments. This approach has the principal 
 Draft Basel II NPR 

236

advantage of being relatively easy for banks to implement – the approach generally 

would not disrupt the existing retail segmentation practices of banks and would not 

interfere with banks’ quantification of PD, ELGD, and LGD for retail segments. The 

agencies are concerned, however, that because this approach would provide banks with 

substantial discretion to incorporate double default and double recovery effects, the 

resulting treatment for guarantees of retail exposures would be inconsistent with the 

treatment for guarantees of wholesale exposures. 

To address these concerns, the agencies are considering for purposes of the final 

rule two principal alternative treatments for guarantees of retail exposures. The first 

alternative would distinguish between eligible retail guarantees and all other (noneligible) guarantees of retail exposures. Under this alternative, an eligible retail 

guarantee would be an eligible guarantee that applies to a single retail exposure and is (i) 

PMI issued by an insurance company that (A) has issued a senior unsecured long-term 

debt security without credit enhancement that has an applicable external rating in one of 

the two highest investment grade rating categories or (B) has a claims payment ability 

that is rated in one of the two highest rating categories by an NRSRO; or (ii) issued by a 

sovereign entity or a political subdivision of a sovereign entity. Under this alternative, 

PMI would be defined as insurance provided by a regulated mortgage insurance company 

that protects a mortgage lender in the event of the default of a mortgage borrower up to a 

predetermined portion of the value of a single one- to four-family residential property. 

Under this alternative, a bank would be able to recognize the credit risk mitigation 

benefits of eligible retail guarantees that cover retail exposures in a segment by adjusting 

its estimates of ELGD and LGD for the segment to reflect recoveries from the guarantor. 
 Draft Basel II NPR 

237

However, the bank would have to estimate the PD of a segment without reflecting the 

benefit of guarantees; that is, a segment’s PD would be an estimate of the stand-alone 

probability of default for the retail exposures in the segment, before taking account of any 

guarantees. Accordingly, for this limited set of traditional guarantees of retail exposures 

by high credit quality guarantors, a bank would be allowed to recognize the benefit of the 

guarantee when estimating ELGD and LGD, but not when estimating PD. Question 42: 

The agencies seek comment on this alternative approach’s definition of eligible retail 

guarantee and treatment for eligible retail guarantees, and on whether the agencies should 

provide similar treatment for any other forms of wholesale credit insurance or guarantees 

on retail exposures, such as student loans, if the agencies adopt this approach.

This alternative approach would provide a different treatment for non-eligible 

retail guarantees. In short, within the retail framework, a bank would not be able to 

recognize non-eligible retail guarantees when estimating PD, ELGD, and LGD for any 

segment of retail exposures. In other words, a bank would be required to estimate PD, 

ELGD, and LGD for segments containing retail exposures with non-eligible guarantees 

as if the exposures were not guaranteed. However, a bank would be permitted to 

recognize non-eligible retail guarantees provided by a wholesale guarantor by treating the 

hedged retail exposure as a direct exposure to the guarantor and applying the appropriate 

wholesale IRB risk-based capital formula. In other words, for retail exposures covered 

by non-eligible retail guarantees, a bank would be permitted to reflect the guarantee by 

“desegmenting” the retail exposures (which effectively would convert the retail 

exposures into wholesale exposures) and then applying the rules set forth above for 

guarantees that cover wholesale exposures. Thus, under this approach, a bank would not 
 Draft Basel II NPR 

238

be allowed to recognize either double default or double recovery effects for non-eligible 

retail guarantees. 

The agencies understand that this approach to non-eligible retail guarantees, while 

addressing the prudential concerns of the agencies, is conservative and may not 

harmonize with banks’ internal risk measurement and management practices in this area. 

Question 43: The agencies seek comment on the types of non-eligible retail guarantees 

banks obtain and the extent to which banks obtain credit risk mitigation in the form of 

non-eligible retail guarantees.

A second alternative that the agencies are considering for purposes of the final 

rule would permit a bank to recognize the credit risk mitigation benefits of all eligible 

guarantees (whether eligible retail guarantees or not) that cover retail exposures by 

adjusting its estimates of ELGD and LGD for the relevant segments, but would subject a 

bank’s risk-based capital requirement for a segment of retail exposures that are covered 

by one or more non-eligible retail guarantees to a floor. Under this second alternative, 

the agencies could impose a floor on risk-based capital requirements of between 2 

percent and 6 percent on such a segment of retail exposures. 

Question 44: The agencies seek comment on both of these alternative approaches 

to guarantees that cover retail exposures. The agencies also invite comment on other 

possible prudential treatments for such guarantees.

D. Unsettled Securities, Foreign Exchange, and Commodity Transactions 

Section 35 of the proposed rule sets forth the risk-based capital requirements for 

unsettled and failed securities, foreign exchange, and commodities transactions. Certain 

transaction types are excluded from the scope of this section, including: 
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239

(i) Transactions accepted by a qualifying central counterparty that are subject to 

daily marking-to-market and daily receipt and payment of variation margin (which do not 

have a risk-based capital requirement);66

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

determined under sections 31 and 32 of the proposed rule); 

(iii) One-way cash payments on OTC derivative contracts (the risk-based capital 

requirements of which are determined under sections 31 and 32 of the proposed rule); and 

(iv) Transactions with a contractual settlement period that is longer than the 

normal settlement period (defined below), which transactions are treated as OTC 

derivative contracts and assessed a risk-based capital requirement under sections 31 and 

32 of the proposed rule. The proposed rule also provides that, in the case of a systemwide failure of a settlement or clearing system, the bank’s primary Federal supervisor 

may waive risk-based capital requirements for unsettled and failed transactions until the 

situation is rectified. 

The proposed rule contains separate treatments for delivery-versus-payment 

(DvP) and payment-versus-payment (PvP) transactions with a normal settlement period, 

on the one hand, and non-DvP/non-PvP transactions with a normal settlement period, on 

the other hand. The proposed rule provides the following definitions of a DvP 

transaction, a PvP transaction, and a normal settlement period. A DvP transaction is a 

securities or commodities transaction in which the buyer is obligated to make payment 

 

66 The agencies consider a qualifying central counterparty to be the functional equivalent of an exchange, 

and have long exempted exchange-traded contracts from risk-based capital requirements. Transactions 

rejected by a qualifying central counterparty (because, for example, of a discrepancy in the details of the 

transaction such as in quantity, price, or in the underlying security, between the buyer and seller) 

potentially give rise to risk exposure to either party. 
 Draft Basel II NPR 

240

only if the seller has made delivery of the securities or commodities and the seller is 

obligated to deliver the securities or commodities only if the buyer has made payment. A 

PvP transaction is a foreign exchange transaction in which each counterparty is obligated 

to make a final transfer of one or more currencies only if the other counterparty has made 

a final transfer of one or more currencies. A transaction has a normal settlement period if 

the contractual settlement period for the transaction is equal to or less than the market 

standard for the instrument underlying the transaction and equal to or less than five 

business days. 

A bank must hold risk-based capital against a DvP or PvP transaction with a 

normal settlement period if the bank’s counterparty has not made delivery or payment 

within five business days after the settlement date. The bank must determine its riskweighted asset amount for such a transaction by multiplying the positive current exposure 

of the transaction for the bank by the appropriate risk weight in Table F. The positive 

current exposure of a transaction of a bank is the difference between the transaction value 

at the agreed settlement price and the current market price of the transaction, if the 

difference results in a credit exposure of the bank to the counterparty. 

Table F − Risk Weights for Unsettled DvP and PvP Transactions 

Number of business days 

after contractual 

settlement date 

Risk weight to be 

applied to positive 

current exposure 

From 5 to 15 100% 

From 16 to 30 625% 

From 31 to 45 937.5% 

46 or more 1,250% 

A bank must hold risk-based capital against any non-DvP/non-PvP transaction 

with a normal settlement period if the bank has delivered cash, securities, commodities, 
 Draft Basel II NPR 

241

or currencies to its counterparty but has not received its corresponding deliverables by the 

end of the same business day. The bank must continue to hold risk-based capital against 

the transaction until the bank has received its corresponding deliverables. From the 

business day after the bank has made its delivery until five business days after the 

counterparty delivery is due, the bank must calculate its risk-based capital requirement 

for the transaction by treating the current market value of the deliverables owed to the 

bank as a wholesale exposure. 

A bank may assign an internal obligor rating to a counterparty for which it is not 

otherwise required under the proposed rule to assign an obligor rating on the basis of the 

applicable external rating of any outstanding senior unsecured long-term debt security 

without credit enhancement issued by the counterparty. A bank may estimate loss 

severity ratings or ELGD and LGD for the exposure, or may use a 45 percent ELGD and 

LGD for the exposure provided the bank uses the 45 percent ELGD and LGD for all such 

exposures. Alternatively, a bank may use a 100 percent risk weight for the exposure as 

long as the bank uses this risk weight for all such exposures. 

If, in a non-DvP/non-PvP transaction with a normal settlement period, the bank 

has not received its deliverables by the fifth business day after counterparty delivery was 

due, the bank must deduct the current market value of the deliverables owed to the bank 

50 percent from tier 1 capital and 50 percent from tier 2 capital. 

The total risk-weighted asset amount for unsettled transactions equals the sum of 

the risk-weighted asset amount for each DvP and PvP transaction with a normal 

settlement period and the risk-weighted asset amount for each non-DvP/non-PvP 

transaction with a normal settlement period. 
 Draft Basel II NPR 

242

E. Securitization Exposures 

This section describes the framework for calculating risk-based capital 

requirements for securitization exposures under the proposed rule (the securitization 

framework). In contrast to the proposed framework for wholesale and retail exposures, 

the proposed securitization framework does not permit a bank to rely on its internal 

assessments of the risk parameters of a securitization exposure.67 For securitization 

exposures, which typically are tranched exposures to a pool of underlying exposures, 

such assessments would require implicit or explicit estimates of correlations among the 

losses on the underlying exposures and estimates of the credit risk consequences of 

tranching. Such correlation and tranching effects are difficult to estimate and validate in 

an objective manner and on a going-forward basis. Instead, the proposed securitization 

framework relies principally on two sources of information, where available, to 

determine risk-based capital requirements: (i) an assessment of the securitization 

exposure’s credit risk made by an NRSRO; or (ii) the risk-based capital requirement for 

the underlying exposures as if the exposures had not been securitized (along with certain 

other objective information about the securitization exposure, such as the size and 

relative seniority of the exposure). 

A bank must use the securitization framework for exposures to any transaction 

that involves the tranching of credit risk (with the exception of a tranched guarantee that 

applies only to an individual retail exposure), regardless of the number of underlying 

 

67 Although the Internal Assessment Approach described below does allow a bank to use an internalratings-based approach to determine its risk-based capital requirement for an exposure to an ABCP 

program, banks are required to follow NRSRO rating criteria and therefore are required implicitly to use 

the NRSRO’s determination of the correlation of the underlying exposures in the ABCP program. 
 Draft Basel II NPR 

243

exposures in the transaction.68 A single, unified approach to dealing with the tranching of 

credit risk is important to create a level playing field across the securitization, credit 

derivatives, and other financial markets. The agencies believe that basing the 

applicability of the proposed securitization framework on the presence of some minimum 

number of underlying exposures would complicate the proposed rule without any 

material improvement in risk sensitivity. The proposed securitization framework is 

designed specifically to deal with tranched exposures to credit risk, and the principal riskbased capital approaches of the proposed securitization framework take into account the 

effective number of underlying exposures. 

1. Hierarchy of approaches

The proposed securitization framework contains three general approaches for 

determining the risk-based capital requirement for a securitization exposure: a RatingsBased Approach (RBA), an Internal Assessment Approach (IAA), and a Supervisory 

Formula Approach (SFA). Under the proposed rule, banks generally must apply the 

following hierarchy of approaches to determine the risk-based capital requirement for a 

securitization exposure. 

First, a bank must deduct from tier 1 capital any after-tax gain-on-sale resulting 

from a securitization and must deduct from total capital any portion of a CEIO that does 

not constitute a gain-on-sale, as described in section 42(c) of the proposed rule. Second, 

a bank must apply the RBA to a securitization exposure if the exposure qualifies for the 

RBA. As a general matter, an exposure qualifies for the RBA if the exposure has an 

external rating from an NRSRO or has an inferred rating (that is, the exposure is senior to 

 

68 As noted above, mortgage-backed pass-through securities guaranteed by Fannie Mae or Freddie Mac are 

also securitization exposures. 
 Draft Basel II NPR 

244

another securitization exposure in the transaction that has an external rating from an 

NRSRO). For example, a bank generally must use the RBA approach to determine the 

risk-based capital requirement for an asset-backed security that has an applicable external 

rating of AA+ from an NRSRO and for another tranche of the same securitization that is 

unrated but senior in all respects to the asset-backed security that was rated. In this 

example, the senior unrated tranche would be treated as if it were rated AA+. 

If a securitization exposure does not qualify for the RBA but is an exposure to an 

ABCP program – such as a credit enhancement or liquidity facility – the bank may apply 

the IAA (if the bank, the exposure, and the ABCP program qualify for the IAA) or the 

SFA (if the bank and the exposure qualify for the SFA) to the exposure. As a general 

matter, a bank would qualify for use of the IAA if the bank establishes and maintains an 

internal risk rating system for exposures to ABCP programs that has been approved by 

the bank’s primary Federal supervisor. Alternatively, a bank may use the SFA if the 

bank is able to calculate a set of risk factors relating to the securitization, including the 

risk-based capital requirement for the underlying exposures as if they were held directly 

by the bank. A bank that chooses to use the IAA must use the IAA for all exposures that 

qualify for the IAA. 

If a securitization exposure is not a gain-on-sale or a CEIO, does not qualify for 

the RBA and is not an exposure to an ABCP program, the bank may apply the SFA to the 

exposure if the bank is able to calculate the SFA risk factors for the securitization. In 

many cases an originating bank would use the SFA to determine its risk-based capital 

requirements for retained securitization exposures. If a securitization exposure is not a 

gain-on-sale or a CEIO and does not qualify for the RBA, the IAA, or the SFA, the bank 
 Draft Basel II NPR 

245

must deduct the exposure from total capital. Total risk-weighted assets for securitization 

exposures would be the sum of risk-weighted assets calculated under the RBA, IAA, and 

SFA, plus any risk-weighted asset amounts calculated under the early amortization 

provisions in section 47 of the proposed rule. 

Numerous commenters criticized the complexity of the ANPR’s treatment of 

approaches to securitization exposures and the different treatment accorded to originating 

banks versus investing banks. As discussed elsewhere in this section, the agencies have 

responded to these comments by eliminating most of the differences in treatment for 

originating banks and investing banks and by eliminating the “Alternative RBA” from the 

hierarchy of approaches. As discussed in more detail below, there is one difference in 

treatment between originating and investing banks in the RBA, consistent with the 

general risk-based capital rules. 

Some commenters expressed dissatisfaction that the ANPR required banks to use 

the RBA to assess risk-based capital requirements against a securitization exposure with 

an external or inferred rating. These commenters argued that banks should be allowed to 

choose between the RBA and the SFA when both approaches are available. The agencies 

have not altered the proposed securitization framework to provide this element of choice 

to banks because the agencies believe it would likely create a means for regulatory capital 

arbitrage. 

Exceptions to the general hierarchy of approaches

Under the proposed securitization framework, unless one or more of the 

underlying exposures does not meet the definition of a wholesale, retail, securitization, or 

equity exposure, the total risk-based capital requirement for all securitization exposures 
 Draft Basel II NPR 

246

held by a single bank associated with a single securitization (including any regulatory 

capital requirement that relates to an early amortization provision, but excluding any 

capital requirements that relate to the bank’s gain-on-sale or CEIOs associated with the 

securitization) cannot exceed the sum of (i) the bank’s total risk-based capital 

requirement for the underlying exposures as if the bank directly held the underlying 

exposures; and (ii) the bank’s total ECL for the underlying exposures. The ECL of the 

underlying exposures is included in this calculation because if the bank held the 

underlying exposures on its balance sheet, the bank would have had to estimate the ECL 

of the exposures and hold reserves or capital against the ECL. This cap ensures that a 

bank’s effective risk-based capital requirement for exposure to a pool of underlying 

exposures generally would not be greater than the applicable risk-based capital 

requirement if the underlying exposures were held directly by the bank, taking into 

consideration the agencies’ safety and soundness concerns with respect to CEIOs. 

 This proposed maximum risk-based capital requirement would be different from 

the general risk-based capital rules. Under the general risk-based capital rules, banks 

generally are required to hold a dollar in capital for every dollar in residual interest, 

regardless of the effective risk-based capital requirement on the underlying exposures. 

The agencies adopted this dollar-for-dollar capital treatment for a residual interest to 

recognize that in many instances the relative size of the residual interest retained by the 

originating bank reveals market information about the quality of the underlying 

exposures and transaction structure that may not have been captured under the general 

risk-based capital rules. Given the significantly heightened risk sensitivity of the IRB 
 Draft Basel II NPR 

247

framework, the agencies believe that the proposed maximum risk-based capital 

requirement in the proposed securitization framework is more appropriate. 

 In addition, the proposed rule would address various situations involving 

overlapping exposures. Consistent with the general risk-based capital rules, if a bank has 

multiple securitization exposures to an ABCP program that provide duplicative coverage 

of the underlying exposures of the program (such as when a bank provides a programwide credit enhancement and multiple pool-specific liquidity facilities to an ABCP 

program), the bank is not required to hold duplicative risk-based capital against the 

overlapping position. Instead, the bank would apply to the overlapping position the 

applicable risk-based capital treatment under the securitization framework that results in 

the highest capital requirement. If different banks have overlapping exposures to an 

ABCP program, however, each bank must hold capital against the entire maximum 

amount of its exposure. Although duplication of capital requirements will not occur for 

individual banks, some systemic duplication may occur where multiple banks have 

overlapping exposures to the same ABCP program. 

 The proposed rule also addresses overlapping exposures that arise when a bank 

holds a securitization exposure in the form of a mortgage-backed security or participation 

certificate that results from a mortgage loan swap with recourse. In these situations, a 

bank must determine a risk-based capital requirement for two separate exposures – the 

retained recourse obligation on the swapped loans and the percentage of the mortgagebacked security or participation certificate that is not covered by the recourse obligation. 

The total risk-based capital requirement is capped at the risk-based capital requirement 

for the underlying exposures as if they were held directly on the bank’s balance sheet. 
 Draft Basel II NPR 

248

The proposed rule also addresses the risk-based capital treatment of a 

securitization of non-IRB assets. Specifically, if a bank has a securitization exposure and 

any underlying exposure of the securitization is not a wholesale, retail, securitization or 

equity exposure, the bank must (i) apply the RBA if the securitization exposure qualifies 

for the RBA and is not gain-on-sale or a CEIO; or (ii) otherwise, deduct the exposure 

from total capital. Music concert and film receivables are examples of types of assets 

that are not wholesale, retail, securitization, or equity exposures. 

The proposed rule contains several additional exceptions to the general hierarchy. 

For example, in light of the substantial volatility in asset value related to prepayment risk 

and interest rate risk associated with interest-only mortgage-backed securities, the 

proposed rule provides that the risk weight for such a security may not be less than 

100 percent. In addition, the proposed rule follows the general risk-based capital rules by 

allowing a sponsoring bank that qualifies as a primary beneficiary and must consolidate 

an ABCP program as a variable interest entity under GAAP to exclude the consolidated 

ABCP program assets from risk-weighted assets. In such cases, the bank would hold 

risk-based capital only against any securitization exposures of the bank to the ABCP 

program.69 Moreover, the proposed rule follows the general risk-based capital rules and a 

Federal statute70 by including a special set of more lenient rules for the transfer of small 

business loans and leases with recourse by well-capitalized depository institutions.71 

Servicer cash advances

 

69 See Financial Accounting Standards Board, Interpretation No. 46: Consolidation of Certain Variable 

Interest Entities (Jan. 2003). 70 See 12 U.S.C. 1835, which places a cap on the risk-based capital requirement applicable to a wellcapitalized depository institution that transfers small business loans with recourse. 71 The proposed rule does not expressly state that the agencies may permit adequately capitalized banks to 

use the small business recourse rule on a case-by-case basis because the agencies may do this under the 

general reservation of authority contained in section 1 of the rule. 
 Draft Basel II NPR 

249

A traditional securitization typically employs a servicing bank that – on a day-today basis – collects principal, interest, and other payments from the underlying exposures 

of the securitization and forwards such payments to the securitization SPE or to investors 

in the securitization. Such servicing banks often provide to the securitization a credit 

facility under which the servicing bank may advance cash to ensure an uninterrupted flow 

of payments to investors in the securitization (including advances made to cover 

foreclosure costs or other expenses to facilitate the timely collection of the underlying 

exposures). These servicer cash advance facilities are securitization exposures, and a 

servicing bank must determine its risk-based capital requirement for the funded portion of 

any such facility by using the proposed securitization framework. 

Consistent with the general risk-based capital rules with respect to residential 

mortgage servicer cash advances, however, a servicing bank would not be required to 

hold risk-based capital against the undrawn portion of an “eligible” servicer cash advance 

facility. Under the proposed rule, an eligible servicer cash advance facility is a servicer 

cash advance facility in which (i) the servicer is entitled to full reimbursement of 

advances (except that a servicer may be obligated to make non-reimburseable advances if 

any such advance with respect to any underlying exposure is limited to an insignificant 

amount of the outstanding principal balance of the underlying exposure); (ii) the 

servicer’s right to reimbursement is senior in right of payment to all other claims on the 

cash flows from the underlying exposures of the securitization; and (iii) the servicer has 

no legal obligation to, and does not, make advances to the securitization if the servicer 

concludes the advances are unlikely to be repaid. If these conditions are not satisfied, a 

bank that provides a servicer cash advance facility must determine its risk-based capital 
 Draft Basel II NPR 

250

requirement for the undrawn portion of the facility in the same manner as the bank would 

determine its risk-based capital requirement for any other undrawn securitization 

exposure. 

Amount of a securitization exposure

For all of the securitization approaches, the amount of an on-balance sheet 

securitization exposure is the bank’s carrying value, if the exposure is held-to-maturity or 

for trading, or the bank’s carrying value minus any unrealized gains and plus any 

unrealized losses on the exposure, if the exposure is available for sale. The amount of an 

off-balance sheet securitization exposure is the notional amount of the exposure. For a 

commitment, such as a liquidity facility extended to an ABCP program, the notional 

amount may be reduced to the maximum potential amount that the bank currently would 

be required to fund under the arrangement’s documentation (that is, the amount that could 

be drawn given the assets held by the program). For an OTC derivative contract that is 

not a credit derivative, the notional amount is the EAD of the derivative contract (as 

calculated in section 32). 

Implicit support

 The proposed rule also sets forth the regulatory capital consequences if a bank 

provides support to a securitization in excess of the bank’s predetermined contractual 

obligation to provide credit support to the securitization. First, consistent with the 

general risk-based capital rules,72 a bank that provides such implicit support must hold 

regulatory capital against all of the underlying exposures associated with the 

securitization as if the exposures had not been securitized, and must deduct from tier 1 

capital any after-tax gain-on-sale resulting from the securitization. Second, the bank 

 

72 Interagency Guidance on Implicit Recourse in Asset Securitizations, May 23, 2002. 
 Draft Basel II NPR 

251

must disclose publicly (i) that it has provided implicit support to the securitization, and 

(ii) the regulatory capital impact to the bank of providing the implicit support. The 

bank’s primary Federal supervisor also may require the bank to hold regulatory capital 

against all the underlying exposures associated with some or all the bank’s other 

securitizations as if the exposures had not been securitized, and to deduct from tier 1 

capital any after-tax gain-on-sale resulting from such securitizations. 

Operational requirements for traditional securitizations 

In a traditional securitization, an originating bank typically transfers a portion of 

the credit risk of exposures to third parties by selling them to an SPE. Banks engaging in 

a traditional securitization may exclude the underlying exposures from the calculation of 

risk-weighted assets only if each of the following conditions is met: (i) the transfer is a 

sale under GAAP; (ii) the originating bank transfers to third parties credit risk associated 

with the underlying exposures; and (iii) any clean-up calls relating to the securitization 

are eligible clean-up calls (as discussed below). 

Originating banks that meet these conditions must hold regulatory capital against 

any securitization exposures they retain in connection with the securitization. Originating 

banks that fail to meet these conditions must hold regulatory capital against the 

transferred exposures as if they had not been securitized and must deduct from tier 1 

capital any gain-on-sale resulting from the transaction. 

Clean-up calls

For purposes of these operational requirements, a clean-up call is a contractual 

provision that permits a servicer to call securitization exposures (for example, assetbacked securities) before the stated (or contractual) maturity or call date. In the case of a 
 Draft Basel II NPR 

252

traditional securitization, a clean-up call is generally accomplished by repurchasing the 

remaining securitization exposures once the amount of underlying exposures or 

outstanding securitization exposures has fallen below a specified level. In the case of a 

synthetic securitization, the clean-up call may take the form of a clause that extinguishes 

the credit protection once the amount of underlying exposures has fallen below a 

specified level. 

To satisfy the operational requirements for securitizations – and, therefore, to 

enable an originating bank to exclude the underlying exposures from the calculation of its 

risk-based capital requirements – any clean-up call associated with a securitization must 

be an eligible clean-up call. An eligible clean-up call is a clean-up call that: 

(i) Is exercisable solely at the discretion of the servicer; 

(ii) Is not structured to avoid allocating losses to securitization exposures held by 

investors or otherwise structured to provide credit enhancement to the securitization (for 

example, to purchase non-performing underlying exposures); and 

(iii) (A) For a traditional securitization, is only exercisable when 10 percent or 

less of the principal amount of the underlying exposures or securitization exposures 

(determined as of the inception of the securitization) is outstanding. 

(B) For a synthetic securitization, is only exercisable when 10 percent or less of 

the principal amount of the reference portfolio of underlying exposures (determined as of 

the inception of the securitization) is outstanding. 

Over the last several years, the agencies have published a significant amount of 

supervisory guidance to assist banks with assessing the extent to which they have 

transferred credit risk and, consequently, may recognize any reduction in required 
 Draft Basel II NPR 

253

regulatory capital as a result of a securitization or other form of credit risk transfer.73 In 

general, the agencies would expect banks to continue to use this guidance, most of which 

remains applicable to the securitization framework. Banks are encouraged to consult 

with their primary Federal supervisor about transactions that require additional guidance. 

2. Ratings-based approach (RBA)

 Under the RBA, a bank would determine the risk-weighted asset amount for a 

securitization exposure that has an external rating or inferred rating by multiplying the 

amount of the exposure by the appropriate risk-weight provided in the tables in section 43 

of the proposed rule. An originating bank must use the RBA if its retained securitization 

exposure has at least two external ratings or an inferred rating based on at least two 

external ratings; an investing bank must use the RBA if its securitization exposure has 

one or more external or inferred ratings. For purposes of the proposed rule, an 

originating bank means a bank that meets either of the following conditions: (i) the bank 

directly or indirectly originated or securitized the underlying exposures included in the 

securitization; or (ii) the securitization is an ABCP program and the bank serves as a 

sponsor of the ABCP program. 

This two-rating requirement for originating banks is the only material difference 

between the treatment of originating banks and investing banks under the securitization 

framework. Although this two-rating requirement is not included in the New Accord, it 

is generally consistent with the treatment of originating and investing banks in the 

 

73 See, e.g., OCC Bulletin 99-46 (Dec. 14, 1999) (OCC); FDIC Financial Institution Letter 109-99 (Dec. 13, 

1999) (FDIC); SR Letter 99-37 (Dec. 13, 1999) (Board); CEO Ltr. 99-119 (Dec. 14, 1999) (OTS). 
 Draft Basel II NPR 

254

general risk-based capital rules. The agencies believe that the market discipline 

evidenced by a third party purchasing a securitization exposure obviates the need for a 

second rating for an investing bank. Question 45: The agencies seek comment on this 

differential treatment of originating banks and investing banks and on alternative 

mechanisms that could be employed to ensure the reliability of external and inferred 

ratings of non-traded securitization exposures retained by originating banks.

 Under the proposed rule, a bank also must use the RBA for securitization 

exposures with an inferred rating. Similar to the general risk-based capital rules, an 

unrated securitization exposure would have an inferred rating if another securitization 

exposure associated with the securitization transaction (that is, issued by the same issuer 

and backed by the same underlying exposures) has an external rating and the rated 

securitization exposure (i) is subordinated in all respects to the unrated securitization 

exposure; (ii) does not benefit from any credit enhancement that is not available to the 

unrated securitization exposure; and (iii) has an effective remaining maturity that is equal 

to or longer than the unrated securitization exposure. Under the RBA, securitization 

exposures with an inferred rating are treated the same as securitization exposures with an 

identical external rating. 

 Under the RBA, the risk-based capital requirement per dollar of securitization 

exposure would depend on four factors: (i) the applicable rating of the exposure; 

(ii) whether the rating reflects a long-term or short-term assessment of the exposure’s 

credit risk; (iii) whether the exposure is a “senior” exposure; and (iv) a measure of the 

effective number (“N”) of underlying exposures. For a securitization exposure with only 

one external or inferred rating, the applicable rating of the exposure is that external or 
 Draft Basel II NPR 

255

inferred rating. For a securitization exposure with more than one external or inferred 

rating, the applicable rating of the exposure is the lowest external or inferred rating 

assigned to the exposure. 

 A “senior securitization exposure” is a securitization exposure that has a first 

priority claim on the cash flows from the underlying exposures, disregarding the claims 

of a service provider (such as a swap counterparty or trustee, custodian, or paying agent 

for a securitization) to fees from the securitization. A liquidity facility that supports an 

ABCP program is a senior securitization exposure if the liquidity facility provider’s right 

to reimbursement of the drawn amounts is senior to all claims on the cash flow from the 

underlying exposures except claims of a service provider to fees. Question 46: The 

agencies seek comment on the appropriateness of basing the risk-based capital 

requirement for a securitization exposure under the RBA on the seniority level of the 

exposure.

 Under the RBA, a bank must use Table G below when the securitization 

exposure’s external rating represents a long-term credit rating or its inferred rating is 

based on a long-term credit rating. A bank must apply the risk weights in column 1 of 

Table G to the securitization exposure if the effective number of underlying exposures 

(N) is 6 or more and the securitization exposure is a senior securitization exposure. If the 

notional number of underlying exposures of a securitization is 25 or more or if all the 

underlying exposures are retail exposures, a bank may assume that N is 6 or more (unless 

the bank knows or has reason to know that N is less than 6). If the notional number of 

underlying exposures of a securitization is less than 25 and one or more of the underlying 

exposures is a non-retail exposure, the bank must compute N as described in the SFA 
 Draft Basel II NPR 

256

section below. If N is 6 or more but the securitization exposure is not a senior 

securitization exposure, the bank must apply the risk weights in column 2 of Table G. A 

bank must apply the risk weights in column 3 of Table G to the securitization exposure if 

N is less than 6. Question 47: The agencies seek comment on how well this approach 

captures the most important risk factors for securitization exposures of varying degrees of 

seniority and granularity.
 Draft Basel II NPR 

257

Table G – Long-Term Credit Rating Risk Weights under RBA and IAA 

 Column 1 Column 2 Column 3

Applicable rating 

(Illustrative 

rating example) 

Risk weights for 

senior 

securitization 

exposures backed 

by granular pools 

Risk weights for 

non-senior 

securitization 

exposures backed 

by granular pools 

Risk weights for 

securitization 

exposures backed 

by non-granular 

pools 

Highest 

investment grade 

(for example, 

AAA) 

7% 12% 20% 

Second highest 

investment grade 

(for example, AA) 

8% 15% 25% 

Third-highest 

investment grade –

positive 

designation (for 

example, A+) 

10% 18% 

Third-highest 

investment grade 

(for example, A) 

12% 20% 

Third-highest 

investment grade –

negative 

designation (for 

example, A-) 

20% 35% 

35% 

Lowest investment 

grade—positive 

designation (for 

example, BBB+) 

35% 50% 

Lowest investment 

grade (for 

example, BBB) 

60% 75% 

Lowest investment 

grade—negative 

designation (for 

example, BBB-) 

100% 

One category 

below investment 

grade—positive 

designation (for 

example, BB+) 

250% 

One category 425% 
 Draft Basel II NPR 

258

below investment 

grade (for 

example, BB) 

One category 

below investment 

grade—negative 

designation (for 

example, BB-) 

650% 

More than one 

category below 

investment grade 

Deduction from tier 1 and tier 2 capital 

 A bank must apply the risk weights in Table H when the securitization exposure’s 

external rating represents a short-term credit rating or its inferred rating is based on a 

short-term credit rating. A bank must apply the decision rules outlined in the previous 

paragraph to determine which column of Table H applies. 

Table H – Short-Term Credit Rating Risk Weights under RBA and IAA 

 Column 1 Column 2 Column 3

Applicable 

Rating 

(Illustrative 

rating 

example) 

Risk weights for 

senior securitization 

exposures backed by 

granular pools 

Risk weights for 

non-senior 

securitization 

exposures backed by 

granular pools 

Risk weights for 

securitization 

exposures backed by 

non-granular pools 

Highest 

investment 

grade (for 

example, A1) 

7% 12% 20% 

Second highest 

investment 

grade (for 

example, A2) 

12% 20% 35% 

Third highest 

investment 

grade (for 

example, A3) 

60% 75% 75% 

All other 

ratings 

Deduction from tier 1 and tier 2 capital 
 Draft Basel II NPR 

259

 Within tables G and H, risk weights increase as rating grades decline. Under 

column 2 of Table G, for example, the risk weights range from 12 percent for exposures 

with the highest investment grade rating to 650 percent for exposures rated one category 

below investment grade with a negative designation. This pattern of risk weights is 

broadly consistent with analyses employing standard credit risk models and a range of 

assumptions regarding correlation effects and the types of exposures being securitized.74 

These analyses imply that, compared with a corporate bond having a given level of standalone credit risk (for example, as measured by its expected loss rate), a securitization 

tranche having the same level of stand-alone credit risk – but backed by a reasonably 

granular and diversified pool – will tend to exhibit more systematic risk.75 This effect is 

most pronounced for below-investment-grade tranches and is the primary reason why the 

RBA risk-weights increase rapidly as ratings deteriorate over this range – much more 

rapidly than for similarly rated corporate bonds. 

Under the RBA, a securitization exposure that has an investment grade rating and 

has fewer than six effective underlying exposures generally receives a higher risk weight 

than a similarly rated securitization exposure with six or more effective underlying 

exposures. The agencies have designed the risk weights in this manner to discourage a 

bank from engaging in regulatory capital arbitrage by securitizing very high-quality 

wholesale exposures (that is, wholesale exposures with a low PD and LGD), obtaining 

 

74 See Vladislav Peretyatkin and William Perraudin, “Capital for Asset-Backed Securities,” Bank of 

England, February 2003. 

75 See, e.g., Michael Pykhtin and Ashish Dev, “Credit Risk in Asset Securitizations: An Analytical 

Model,” Risk (May 2002) S16-S20.
 Draft Basel II NPR 

260

external ratings on the securitization exposures issued by the securitization, and retaining 

essentially all the credit risk of the pool of underlying exposures. 

 Consistent with the ANPR, the proposed rule requires a bank to deduct from 

regulatory capital any securitization exposure with an external or inferred rating below 

one category below investment grade for long-term ratings or below investment grade for 

short-term ratings. Several commenters argued that this deduction is excessive in light of 

the credit risk of such exposures. Although this proposed capital treatment is more 

conservative than suggested by credit risk modeling analyses, the agencies have decided 

to retain the deduction approach for low-non-investment grade exposures. The agencies 

believe that there are significant modeling uncertainties for such low-rated securitization 

tranches. Moreover, external ratings of these tranches are subject to less market 

discipline because these positions generally are retained by the bank. 

The proposed RBA differs in several important respects from the RBA in the 

ANPR. First, under the ANPR, an originating bank (but not an investing bank) would 

have to deduct from regulatory capital the amount of any securitization exposure below 

the risk-based capital requirement for the underlying exposures as if they were held 

directly by the bank, regardless of whether the exposure would have qualified for a lower 

risk-based capital requirement under the RBA. The agencies took this position in the 

ANPR, in part, to provide incentives for originating banks to shed deeply subordinated, 

high risk, difficult-to-value securitization exposures. The agencies also were concerned 

that an external credit rating may be less reliable when the rating applies to a retained, 

non-traded exposure and is sought by an originating bank primarily for regulatory capital 

purposes. Numerous commenters criticized this aspect of the ANPR as lacking risk 
 Draft Basel II NPR 

261

sensitivity and inconsistently treating originating and investing banks. After further 

review, the agencies have concluded that the risk sensitivity and logic of the 

securitization framework would be enhanced by permitting originating banks and 

investing banks to use the RBA on generally equal terms. The agencies have revised the 

RBA to permit originating banks to use the RBA even if the retained securitization 

exposure is below the risk-based capital requirement for the underlying exposures as if 

they were held directly by the bank. 

In addition, the agencies have enhanced the risk sensitivity of the RBA in the 

ANPR by introducing more risk-weight gradations for securitization exposures with a 

long-term external or inferred rating in the third-highest investment grade rating category. 

Although the ANPR RBA applied the same risk weight to all securitization exposures 

with long-term external ratings in the third-highest investment grade rating category, the 

proposed rule provides three different risk weights to securitization exposures that have 

long-term external ratings in the third-highest investment grade rating category 

depending on whether the rating has positive, negative, or no designation. 

The agencies also have modified the ANPR RBA to expand the set of lower riskweights applicable to the most senior tranches of reasonably granular securitizations to 

better reflect the low systematic risk of such tranches. For example, under the ANPR, 

certain relatively senior tranches of reasonably granular securitizations with long-term 

external ratings in the two highest investment grade rating categories received a lower 

risk-weight than more subordinated tranches of the same securitizations. Under the 

proposed rule, the most senior tranches of reasonably granular securitizations with longterm investment grade external ratings receive a more favorable risk-weight as compared 
 Draft Basel II NPR 

262

to more subordinated tranches of the same securitizations. In addition, in response to 

comments, the agencies have reduced the granularity requirement for a senior 

securitization exposure to qualify for the lower risk weights. Under the ANPR RBA, 

only securitization exposures to a securitization that has an N of 100 or more could 

qualify for the lower risk-weights. Under the proposed rule, securitization exposures to a 

securitization that has an N of 6 or more would qualify for the lower risk weights. 

Although the proposed rule’s RBA expands the availability of the lower risk 

weights for senior securitization exposures in several respects, it also has a more 

conservative but simpler definition of a senior securitization exposure. The ANPR RBA 

imposed a mathematical test for determining the relative seniority of a securitization 

tranche. This test allowed the designation of multiple senior securitization tranches for a 

particular securitization. By contrast, the proposed RBA designates the most senior 

securitization tranche in a particular securitization as the only securitization tranche 

eligible for the lower risk weights. 

In addition, some commenters argued that the ANPR RBA risk weights for 

highly-rated senior retail securitization exposures were excessive in light of the credit risk 

associated with such exposures. The agencies have determined that empirical research on 

this point (including that provided by commenters) is inconclusive and does not warrant a 

reduction in the RBA risk weights of these exposures. 

3. Internal assessment approach (IAA)

 The proposed rule permits a bank to compute its risk-based capital requirement 

for a securitization exposure to an ABCP program (such as a liquidity facility or credit 

enhancement) using the bank’s internal assessment of the credit quality of the 
 Draft Basel II NPR 

263

securitization exposure. To do so, the bank’s internal assessment process and the ABCP 

program must meet certain qualification requirements in section 44 of the proposed rule, 

and the securitization exposure must initially be internally rated at least equivalent to 

investment grade. A bank that elects to use the IAA for any securitization exposure to an 

ABCP program must use the IAA to compute risk-based capital requirements for all 

securitization exposures that qualify for the IAA approach. Under the IAA, a bank would 

map its internal credit assessment of a securitization exposure to an equivalent external 

credit rating from an NRSRO. The bank would determine the risk-weighted asset amount 

for a securitization exposure by multiplying the amount of the exposure (using the 

methodology set forth above in the RBA section) by the appropriate risk weight provided 

in Table G or H above. 

 The agencies included the IAA for securitization exposures to ABCP programs in 

response to comments on the ANPR. The ANPR indicated that the agencies expected 

banks to use the SFA or a “Look-Through Approach” to determine risk-based capital 

requirements for exposures to ABCP programs. Under the Look-Through Approach, a 

bank would determine its risk-based capital requirement for an eligible liquidity facility 

provided to an ABCP program by multiplying (i) 8 percent; (ii) the maximum potential 

drawdown on the facility; (iii) an applicable conversion factor of between 50 and 

100 percent; and (iv) the applicable risk weight (which would typically be 100 percent). 

Commenters expressed concern that ABCP program sponsors would not have sufficient 

data about the underlying exposures in the ABCP program to use the SFA and that the 

Look-Through Approach produced economically unreasonable capital requirements for 

these historically safe credit exposures. The agencies are proposing to replace the Look-
 Draft Basel II NPR 

264

Through Approach with the IAA, which is similar to an approach already available to 

qualifying banks under the general risk-based capital rules for credit enhancements to 

ABCP programs and which the agencies believe would provide a more risk-sensitive and 

economically appropriate risk-based capital treatment for bank exposures to ABCP 

programs. 

 To use the IAA, a bank must receive prior written approval from its primary 

Federal supervisor. To receive such approval, the bank would have to demonstrate that 

its internal credit assessment process satisfies all the following criteria. The bank’s 

internal credit assessments of securitization exposures to ABCP programs must be based 

on publicly available rating criteria used by an NRSRO for evaluating the credit risk of 

the underlying exposures. The bank’s internal credit assessments of securitization 

exposures used for regulatory capital purposes must be consistent with those used in the 

bank’s internal risk management process, capital adequacy assessment process, and 

management information reporting systems. 

In addition, the bank’s internal credit assessment process must have sufficient 

granularity to identify gradations of risk. Each of the bank’s internal credit assessment 

categories must correspond to an external credit rating of an NRSRO. The proposed rule 

also requires that the bank’s internal credit assessment process, particularly the stress test 

factors for determining credit enhancement requirements, be at least as conservative as 

the most conservative of the publicly available rating criteria of the NRSROs that have 

provided external credit ratings to the commercial paper issued by the ABCP program. 

Moreover, the bank must have an effective system of controls and oversight that 

ensures compliance with these operational requirements and maintains the integrity of the 
 Draft Basel II NPR 

265

internal credit assessments. The bank must review and update each internal credit 

assessment whenever new material information is available, but no less frequently than 

annually. The bank must also validate its internal credit assessment process on an 

ongoing basis, but not less frequently than annually. 

 To use the IAA on a specific exposure to an ABCP program, the program must 

exhibit the following characteristics: 

(i) All the commercial paper issued by the ABCP program must have an external 

rating. 

 (ii) The ABCP program must have robust credit and investment guidelines (that 

is, underwriting standards). 

 (iii) The ABCP program must perform a detailed credit analysis of the asset 

sellers’ risk profiles. 

 (iv) The ABCP program’s underwriting policy must establish minimum asset 

eligibility criteria that include a prohibition of the purchase of assets that are significantly 

past due or defaulted, as well as limitations on concentrations to an individual obligor or 

geographic area and the tenor of the assets to be purchased. 

 (v) The aggregate estimate of loss on an asset pool that the ABCP program is 

considering purchasing must consider all sources of potential risk, such as credit and 

dilution risk. 

 (vi) The ABCP program must incorporate structural features into each purchase of 

assets to mitigate potential credit deterioration of the underlying exposures. Such 

features may include wind-down triggers specific to a pool of underlying exposures. 
 Draft Basel II NPR 

266

4. Supervisory formula approach (SFA)

General requirements

 Under the SFA, a bank would determine the risk-weighted asset amount for a 

securitization exposure by multiplying the SFA risk-based capital requirement for the 

exposure (as determined by the supervisory formula set forth below) by 12.5. If the SFA 

risk weight for a securitization exposure is 1,250 percent or greater, however, the bank 

must deduct the exposure from total capital rather than risk weight the exposure.

Deduction is consistent with the treatment of other high-risk securitization exposures, 

such as CEIOs. 

The SFA capital requirement for a securitization exposure depends on the 

following seven inputs: 

 (i) The amount of the underlying exposures (UE); 

 (ii) The securitization exposure’s proportion of the tranche in which it resides 

(TP); 

 (iii) The sum of the risk-based capital requirement and ECL for the underlying 

exposures as if they were held directly on the bank’s balance sheet divided by the amount 

of the underlying exposures (KIRB); 

 (iv) The tranche’s credit enhancement level (L); 

 (v) The tranche’s thickness (T); 

 (vi) The securitization’s effective number of underlying exposures (N); and 

 (vii) The securitization’s exposure-weighted average loss given default 

(EWALGD). 
 Draft Basel II NPR 

267

 A bank may only use the SFA to determine its risk-based capital requirement for a 

securitization exposure if the bank can calculate each of these seven inputs on an ongoing 

basis. In particular, if a bank cannot compute KIRB because the bank cannot compute the 

risk-based capital requirement for all underlying exposures, the bank may not use the 

SFA to compute its risk-based capital requirement for the securitization exposure. In 

those cases, the bank would deduct the exposure from regulatory capital. 

 The SFA capital requirement for a securitization exposure is UE multiplied by TP 

multiplied by the greater of (i) 0.0056 * T; or (ii) S[L+T] – S[L], where: 

 (i) 

⎪

⎭

⎪

⎬

⎫

⎪

⎩

⎪

⎨

⎧

− > ⋅ + − +

≤

= ⋅ −

IRB

K

K Y

IRB

IRB IRB

IRB

e when Y K d K K K Y K K

Y when Y K

S Y IRB

IRB

(1 ) 20 [ ] [ ]

[ ] 20 ( )

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

(iii) 

N

IRB

EWALGD

K h ⎟

⎠

⎞ ⎜

⎝

⎛ = 1 −

 (iv) a = g ⋅ c 

 (v) b = g ⋅(1− c)

 (vi) h

K

c IRB

− = 1

 (vii) 

1 (1 ) − − ⋅ = f

c c

g

 (viii) (1 ) 1000

(1 )

1

2

2

− ⋅

− ⋅ − − + −+ = hK K v

c

h

v K f IRB IRB IRB

 (ix) N

EWALGD K EWALGD

v K IRB

IRB

( − ) + .25⋅(1− ) = ⋅

 (x) d 1 (1 h) (1 [K ;a, b]) − β IRB = − − ⋅
 Draft Basel II NPR 

268

 In these expressions, β [Y; a, b] refers to the cumulative beta distribution with 

parameters a and b evaluated at Y. In the case where N=1 and EWALGD=100 percent, 

S[Y] in formula (1) must be calculated with K[Y] set equal to the product of KIRB and Y, 

and d set equal to 1- KIRB. The major inputs to the SFA formula (UE, TP, KIRB, L, T, 

EWALGD, and N) are defined below and in section 45 of the proposed rule. 

 The SFA formula effectively imposes a 56 basis point minimum risk-based 

capital requirement (8 percent of the 7 percent risk weight) per dollar of securitization 

exposure. A number of commenters on the ANPR contended that this floor capital 

requirement in the SFA would be excessive for many senior securitization exposures. 

Although such a floor may impose a capital requirement that is too high for some 

securitization exposures, the agencies continue to believe that some minimum prudential 

capital requirement is appropriate in the securitization context. This 7 percent riskweight floor is also consistent with the lowest capital requirement available under the 

RBA and, thus, should reduce incentives for regulatory capital arbitrage. 

 The SFA formula is a blend of credit risk modeling results and supervisory 

judgment. The function S[Y] incorporates two distinct features. First, a pure modelbased estimate of the pool’s aggregate systematic or non-diversifiable credit risk that is 

attributable to a first loss position covering losses up to and including Y. Because the 

tranche of interest covers losses over a specified range (defined in terms of L and T), the 

tranche’s systematic risk can be represented as S[L+T] – S[L]. The second feature 

involves a supervisory add-on primarily intended to avoid behavioral distortions 

associated with what would otherwise be a discontinuity in capital requirements for 

relatively thin mezzanine tranches lying just below and just above the KIRB boundary: all 
 Draft Basel II NPR 

269

tranches at or below KIRB would be deducted from capital, whereas a very thin tranche 

just above KIRB would incur a pure model-based percentage capital requirement that 

could vary between zero and one, depending on the number of effective underlying 

exposures (N). The supervisory add-on applies primarily to positions just above KIRB, 

and its quantitative effect diminishes rapidly as the distance from KIRB widens. 

Under the SFA, a bank must deduct from regulatory capital any securitization 

exposures (or parts thereof) that absorb losses at or below the level of KIRB. However, 

the specific securitization exposures that are subject to this deduction treatment under the 

SFA may change over time in response to variation in the credit quality of the pool of 

underlying exposures. For example, if the pool’s IRB capital requirement were to 

increase after the inception of a securitization, additional portions of unrated 

securitization exposures may fall below KIRB and thus become subject to deduction under 

the SFA. Therefore, if a bank owns an unrated first-loss securitization exposure well in 

excess of KIRB, the capital requirement on the exposure could climb rapidly in the event 

of marked deterioration in the credit quality of the underlying exposures. 

 Apart from the risk-weight floor and other supervisory adjustments described 

above, the supervisory formula attempts to be as consistent as possible with the 

parameters and assumptions of the IRB framework that would apply to the underlying 

exposures if held directly by a bank.76 The specification of S[Y] assumes that KIRB is an 

accurate measure of the total systematic credit risk of the pool of underlying exposures 

and that a securitization merely redistributes this systematic risk among its various 

tranches. In this way, S[Y] embodies precisely the same asset correlations as are 

 

76 The conceptual basis for specification of K[x] is developed in Michael B. Gordy and David Jones, 

“Random Tranches,” Risk (Mar. 2003) 78-83. 
 Draft Basel II NPR 

270

assumed elsewhere within the IRB framework. In addition, this specification embodies 

the result that a pool’s systematic risk (that is, KIRB) tends to be redistributed toward more 

senior tranches as the effective number of underlying exposures in the pool (N) 

declines.77 The importance of pool granularity depends on the pool’s average loss 

severity rate, EWALGD. For small values of N, the framework implies that, as 

EWALGD increases, systematic risk is shifted toward senior tranches. For highly 

granular pools, such as securitizations of retail exposures, EWALGD would have no 

influence on the SFA capital requirement. 

Inputs to the SFA formula

 The proposed rule provides the following definitions of the seven inputs into the 

SFA formula. 

 (i) Amount of the underlying exposures (UE). This input (measured in dollars) is 

the EAD of any underlying wholesale and retail exposures plus the amount of any 

underlying exposures that are securitization exposures (as defined in section 42(e) of the 

proposed rule) plus the adjusted carrying value of any underlying equity exposures (as 

defined in section 51(b) of the proposed rule). UE also would include any funded spread 

accounts, cash collateral accounts, and other similar funded credit enhancements. 

 (ii) Tranche percentage (TP). TP is the ratio of (i) the amount of the bank’s 

securitization exposure to (ii) the amount of the securitization tranche that contains the 

bank’s securitization exposure. 

 (iii) KIRB. KIRB is the ratio of (i) the risk-based capital requirement for the 

underlying exposures plus the ECL of the underlying exposures (all as determined as if 

 

77 See Michael Pykhtin and Ashish Dev, “Coarse-grained CDOs,” Risk (Jan. 2003) 113-116. 
 Draft Basel II NPR 

271

the underlying exposures were directly held by the bank) to (ii) UE. The definition of 

KIRB includes the ECL of the underlying exposures in the numerator because if the bank 

held the underlying exposures on its balance sheet, the bank also would hold reserves 

against the exposures. 

 The calculation of KIRB must reflect the effects of any credit risk mitigant applied 

to the underlying exposures (either to an individual underlying exposure, a group of 

underlying exposures, or to the entire pool of underlying exposures). In addition, all 

assets related to the securitization are to be treated as underlying exposures for purposes 

of the SFA, including assets in a reserve account (such as a cash collateral account). 

 (iv) Credit enhancement level (L). L is the ratio of (i) the amount of all 

securitization exposures subordinated to the securitization tranche that contains the 

bank’s securitization exposure to (ii) UE. Banks must determine L before considering the 

effects of any tranche-specific credit enhancements (such as third-party guarantees that 

benefit only a single tranche). Any after-tax gain-on-sale or CEIOs associated with the 

securitization may not be included in L. 

 Any reserve account funded by accumulated cash flows from the underlying 

exposures that is subordinated to the tranche that contains the bank’s securitization 

exposure may be included in the numerator and denominator of L to the extent cash has 

accumulated in the account. Unfunded reserve accounts (that is, reserve accounts that are 

to be funded from future cash flows from the underlying exposures) may not be included 

in the calculation of L. 

 In some cases, the purchase price of receivables will reflect a discount that 

provides credit enhancement (for example, first loss protection) for all or certain tranches. 
 Draft Basel II NPR 

272

When this arises, L should be calculated inclusive of this discount if the discount 

provides credit enhancement for the securitization exposure. 

 (v) Thickness of tranche (T). T is the ratio of (i) the size of the tranche that 

contains the bank’s securitization exposure to (ii) UE. 

(vi) Effective number of exposures (N). As a general matter, the effective number 

of exposures would be calculated as follows: 

∑

∑ =

i

i

i

i

EAD

EAD

N 2

2 ( )

, 

where EADi represents the EAD associated with the ith instrument in the pool of 

underlying exposures. For purposes of computing N, multiple exposures to one obligor 

must be treated as a single underlying exposure. In the case of a re-securitization (that is, 

a securitization in which some or all of the underlying exposures are themselves 

securitization exposures), a bank must treat each underlying securitization exposure as a 

single exposure and must not look through to the exposures that secure the underlying 

securitization exposures. The agencies recognize that this simple and conservative 

approach to re-securitizations may result in the differential treatment of economically 

similar securitization exposures. Question 48: The agencies seek comment on suggested 

alternative approaches for determining the N of a re-securitization.

N represents the granularity of a pool of underlying exposures using an 

“effective” number of exposures concept rather than a “gross” number of exposures 

concept to appropriately assess the diversification of pools that have individual 

underlying exposures of different sizes. An approach that simply counts the gross 

number of underlying exposures in a pool treats all exposures in the pool equally. This 
 Draft Basel II NPR 

273

simplifying assumption could radically overestimate the granularity of a pool with 

numerous small exposures and one very large exposure. The effective exposure approach 

captures the notion that the risk profile of such an unbalanced pool is more like a pool of 

several medium-sized exposures than like a pool of a large number of equally sized small 

exposures. 

For example, suppose Pool A contains four loans with EADs of $100 each. 

Under the formula set forth above, N for Pool A would be four, precisely equal to the 

actual number of exposures. Suppose Pool B also contains four loans: one loan with an 

EAD of $100 and three loans with an EAD of $1. Although both pools contain four 

loans, Pool B is much less diverse and granular than Pool A because Pool B is dominated 

by the presence of a single $100 loan. Intuitively, therefore, N for Pool B should be 

closer to one than to four. Under the formula in the rule, N for Pool B is calculated as 

follows: 

1.06

10,003

10,609

100 1 1 1

(100 1 1 1)

2 2 2 2

2

= = + + +

+ + + N =

 (vii) Exposure-weighted average loss given default (EWALGD). The EWALGD 

is calculated as: 

∑

∑ ⋅

=

i

i

i

i i

EAD

LGD EAD

EWALGD

 , 

where LGDi represents the average LGD associated with all exposures to the ith obligor. 

In the case of a re-securitization, an LGD of 100 percent must be assumed for any 

underlying exposure that is itself a securitization exposure. 
 Draft Basel II NPR 

274

Under certain conditions, a bank may employ the following simplifications to the 

SFA. First, for securitizations all of whose underlying exposures are retail exposures, a 

bank may set h = 0 and v = 0. In addition, if the share of a securitization corresponding 

to the largest underlying exposure (C1) is no more than 0.03 (or 3 percent of the 

underlying exposures), then for purposes of the SFA the bank may set EWALGD=0.50 

and N equal to the following amount: 

max(1 ,0) 1

1

1

1

1 mC

m

C C C C

N

m

m − ⎟

⎟

⎠

⎞

⎜

⎜

⎝

⎛

−

− +

= , 

where Cm is the ratio of (i) the sum of the amounts of the largest ‘m’ underlying 

exposures of the securitization; to (ii) UE. A bank may select the level of ‘m’ in its 

discretion. For example, if the three largest underlying exposures of a securitization 

represent 15 percent of the pool of underlying exposures, C3 for the securitization is 0.15. 

As an alternative simplification option, if only C1 is available, and C1 is no more than 

0.03, then the bank may set EWALGD=0.50 and N=1/C1. 

5. Eligible disruption liquidity facilities

 The version of the SFA contained in the New Accord provides a more favorable 

capital treatment for eligible disruption liquidity facilities than for other securitization 

exposures. Under the New Accord, an eligible disruption liquidity facility is a liquidity 

facility that supports an ABCP program and that (i) is subject to an asset quality test that 

precludes funding of underlying exposures that are in default; (ii) can be used to fund 

only those exposures that have an investment grade external rating at the time of funding, 

if the underlying exposures that the facility must fund against are externally rated 

exposures at the time that the exposures are sold to the program; and (iii) may only be 
 Draft Basel II NPR 

275

drawn in the event of a general market disruption. Under the New Accord, a bank that 

uses the SFA to compute its risk-based capital requirement for an eligible disruption 

liquidity facility may multiply the facility’s SFA-determined risk weight by 20 percent. 

Question 49: The agencies have not included this concept in the proposed rule but seek 

comment on the prevalence of eligible disruption liquidity facilities and a bank’s 

expected use of the SFA to calculate risk-based capital requirements for such facilities.

6. Credit risk mitigation for securitization exposures

An originating bank that has obtained a credit risk mitigant to hedge its 

securitization exposure to a synthetic or traditional securitization that satisfies the 

operational criteria in section 41 of the proposed rule may recognize the credit risk 

mitigant, but only as provided in section 46 of the proposed rule. An investing bank that 

has obtained a credit risk mitigant to hedge a securitization exposure also may recognize 

the credit risk mitigant, but only as provided in section 46. A bank that has used the RBA 

or IAA to calculate its risk-based capital requirement for a securitization exposure whose 

external or inferred rating (or equivalent internal rating under the IAA) reflects the 

benefits of a particular credit risk mitigant provided to the associated securitization or 

that supports some or all of the underlying exposures, however, may not use the 

securitization credit risk mitigation rules to further reduce its risk-based capital 

requirement for the exposure based on that credit risk mitigant. For example, a bank that 

owns a AAA-rated asset-backed security that benefits, along with all the other securities 

issued by the securitization SPE, from an insurance wrap that is part of the securitization 

transaction would calculate its risk-based capital requirement for the security strictly 

under the RBA; no additional credit would be given for the presence of the insurance 
 Draft Basel II NPR 

276

wrap. On the other hand, if a bank owns a BBB-rated asset-backed security and obtains a 

credit default swap from a AAA-rated counterparty to protect the bank from losses on the 

security, the bank would be able to apply the securitization CRM rules to recognize the 

risk mitigating effects of the credit default swap and determine the risk-based capital 

requirement for the position. 

 The proposed rule contains a separate treatment of CRM for securitization 

exposures (versus wholesale and retail exposures) because the wholesale and retail 

exposure CRM approaches rely on substitutions of, or adjustments to, the risk parameters 

of the hedged exposure. Because the securitization framework does not rely on risk 

parameters to determine risk-based capital requirements for securitization exposures, a 

different treatment of CRM for securitization exposures is necessary. 

The securitization CRM rules, like the wholesale and retail CRM rules, address 

collateral separately from guarantees and credit derivatives. A bank is not permitted to 

recognize collateral other than financial collateral as a credit risk mitigant for 

securitization exposures. A bank may recognize financial collateral in determining the 

bank’s risk-based capital requirement for a securitization exposure using a collateral 

haircut approach. The bank’s risk-based capital requirement for a collateralized 

securitization exposure is equal to the risk-based capital requirement for the securitization 

exposure as calculated under the RBA or the SFA multiplied by the ratio of adjusted 

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

(i) E* = max {0, [E - C x (1 - Hs - Hfx)]}; 

 (ii) E = the amount of the securitization exposure (as calculated under 

section 42(e) of the proposed rule); 
 Draft Basel II NPR 

277

 (iii) C = the current market value of the collateral; 

 (iv) Hs = the haircut appropriate to the collateral type; and 

 (v) Hfx = the haircut appropriate for any currency mismatch between the 

collateral and the exposure. 

Where the collateral is a basket of different asset types or a basket of assets denominated 

in different currencies, the haircut on the basket will be = ∑

i

H aiHi , where ai is the 

current market value of the asset in the basket divided by the current market value of all 

assets in the basket and Hi is the haircut applicable to that asset. 

With the prior written approval of its primary Federal supervisor, a bank may 

calculate haircuts using its own internal estimates of market price volatility and foreign 

exchange volatility, subject to the requirements for use of own-estimates haircuts 

contained in section 32 of the proposed rule. Banks that use own-estimates haircuts for 

collateralized securitization exposures must assume a minimum holding period (TM) for 

securitization exposures of 65 business days. 

 A bank that does not qualify for and use own-estimates haircuts must use the 

collateral type haircuts (Hs) in Table 3 of this preamble and must use a currency 

mismatch haircut (Hfx) of 8 percent if the exposure and the collateral are denominated in 

different currencies. To reflect the longer-term nature of securitization exposures as 

compared to eligible margin loans and OTC derivative contracts, however, these standard 

supervisory haircuts (which are based on a 10-business-day holding period and daily 

marking-to-market and remargining) must be adjusted to a 65-business-day holding 

period (the approximate number of business days in a calendar quarter) by multiplying 

them by the square root of 6.5 (2.549510). A bank also must adjust the standard 
 Draft Basel II NPR 

278

supervisory haircuts upward on the basis of a holding period longer than 65 business days 

where and as appropriate to take into account the illiquidity of an instrument. 

 A bank may only recognize an eligible guarantee or eligible credit derivative 

provided by an eligible securitization guarantor in determining the bank’s risk-based 

capital requirement for a securitization exposure. Eligible guarantee and eligible credit 

derivative are defined the same way as in the CRM rules for wholesale and retail 

exposures. An eligible securitization guarantor is defined to mean (i) a sovereign entity, 

the Bank for International Settlements, the International Monetary Fund, the European 

Central Bank, the European Commission, a Federal Home Loan Bank, the Federal 

Agricultural Mortgage Corporation (Farmer Mac), a multi-lateral development bank, a 

depository institution (as defined in section 3 of the Federal Deposit Insurance Act 

(12 U.S.C. 1813)), a bank holding company (as defined in section 2 of the Bank Holding 

Company Act (12 U.S.C. 1841)), a savings and loan holding company (as defined in 12 

U.S.C. 1467a) provided all or substantially all of the holding company’s activities are 

permissible for a financial holding company under 12 U.S.C. 1843(k)), a foreign bank (as 

defined in section 211.2 of the Federal Reserve Board’s Regulation K (12 CFR 211.2)), 

or a securities firm; (ii) any other entity (other than an SPE) that has issued and 

outstanding an unsecured long-term debt security without credit enhancement that has a 

long-term applicable external rating in one of the three highest investment grade rating 

categories; or (iii) any other entity (other than an SPE) that has a PD assigned by the bank 

that is lower than or equivalent to the PD associated with a long-term external rating in 

the third-highest investment grade rating category. 
 Draft Basel II NPR 

279

A bank may recognize an eligible guarantee or eligible credit derivative provided 

by an eligible securitization guarantor in determining the bank’s risk-based capital 

requirement for the securitization exposure as follows. If the protection amount of the 

eligible guarantee or eligible credit derivative equals or exceeds the amount of the 

securitization exposure, then the bank may set the risk-weighted asset amount for the 

securitization exposure equal to the risk-weighted asset amount for a direct exposure to 

the eligible securitization guarantor (as determined in the wholesale risk weight function 

described in section 31 of the proposed rule), using the bank’s PD for the guarantor, the 

bank’s ELGD and LGD for the guarantee or credit derivative, and an EAD equal to the 

amount of the securitization exposure (as determined in section 42(e) of the proposed 

rule). 

If, on the other hand, the protection amount of the eligible guarantee or eligible 

credit derivative is less than the amount of the securitization exposure, then the bank 

must divide the securitization exposure into two exposures in order to recognize the 

guarantee or credit derivative. The risk-weighted asset amount for the securitization 

exposure is equal to the sum of the risk-weighted asset amount for the covered portion 

and the risk-weighted asset amount for the uncovered portion. The risk-weighted asset 

amount for the covered portion is equal to the risk-weighted asset amount for a direct 

exposure to the eligible securitization guarantor (as determined in the wholesale risk 

weight function described in section 31 of the proposed rule), using the bank’s PD for the 

guarantor, the bank’s ELGD and LGD for the guarantee or credit derivative, and an EAD 

equal to the protection amount of the credit risk mitigant. The risk-weighted asset 

amount for the uncovered portion is equal to the product of (i) 1.0 minus (the protection 
 Draft Basel II NPR 

280

amount of the eligible guarantee or eligible credit derivative divided by the amount of the 

securitization exposure); and (ii) the risk-weighted asset amount for the securitization 

exposure without the credit risk mitigant (as determined in sections 42-45 of the proposed 

rule). 

For any hedged securitization exposure, the bank must make applicable 

adjustments to the protection amount as required by the maturity mismatch, currency 

mismatch, and lack of restructuring provisions in paragraphs (d), (e), and (f) of section 33 

of the proposed rule. If the risk-weighted asset amount for a guaranteed securitization 

exposure is greater than the risk-weighted asset amount for the securitization exposure 

without the guarantee or credit derivative, a bank may always elect not to recognize the 

guarantee or credit derivative. 

When a bank recognizes an eligible guarantee or eligible credit derivative 

provided by an eligible securitization guarantor in determining the bank’s risk-based 

capital requirement for a securitization exposure, the bank also must (i) calculate ECL for 

the exposure using the same risk parameters that it uses for calculating the risk-weighted 

asset amount of the exposure (that is, the PD associated with the guarantor’s rating grade, 

the ELGD and LGD of the guarantee, and an EAD equal to the protection amount of the 

credit risk mitigant); and (ii) add this ECL to the bank’s total ECL. 

7. Synthetic securitizations

Background
 Draft Basel II NPR 

281

In a synthetic securitization, an originating bank uses credit derivatives or 

guarantees to transfer the credit risk, in whole or in part, of one or more underlying 

exposures to third-party protection providers. The credit derivative or guarantee may be 

either collateralized or uncollateralized. In the typical synthetic securitization, the 

underlying exposures remain on the balance sheet of the originating bank, but a portion 

of the originating bank’s credit exposure is transferred to the protection provider or 

covered by collateral pledged by the protection provider. 

In general, the proposed rule’s treatment of synthetic securitizations is identical to 

that of traditional securitizations. The operational requirements for synthetic 

securitizations are more detailed than those for traditional securitizations and are intended 

to ensure that the originating bank has truly transferred credit risk of the underlying 

exposures to one or more third-party protection providers. 

Although synthetic securitizations typically employ credit derivatives, which 

might suggest that such transactions would be subject to the CRM rules in section 33 of 

the proposed rule, banks must first apply the securitization framework when calculating 

risk-based capital requirements for a synthetic securitization exposure. Banks may 

ultimately be redirected to the securitization CRM rules to adjust the securitization 

framework capital requirement for an exposure to reflect the CRM technique used in the 

transaction. 

Operational requirements for synthetic securitizations

For synthetic securitizations, an originating bank may recognize for risk-based 

capital purposes the use of CRM to hedge, or transfer credit risk associated with, 

underlying exposures only if each of the following conditions is satisfied: 
 Draft Basel II NPR 

282

(i) The credit risk mitigant is financial collateral, an eligible credit derivative from 

an eligible securitization guarantor (defined above), or an eligible guarantee from an 

eligible securitization guarantor. 

(ii) The bank transfers credit risk associated with the underlying exposures to 

third-party investors, and the terms and conditions in the credit risk mitigants employed 

do not include provisions that: 

(A) Allow for the termination of the credit protection due to deterioration in the 

credit quality of the underlying exposures; 

(B) Require the bank to alter or replace the underlying exposures to improve the 

credit quality of the underlying exposures; 

(C) Increase the bank’s cost of credit protection in response to deterioration in the 

credit quality of the underlying exposures; 

(D) Increase the yield payable to parties other than the bank in response to a 

deterioration in the credit quality of the underlying exposures; or 

(E) Provide for increases in a retained first loss position or credit enhancement 

provided by the bank after the inception of the securitization. 

(iii) The bank obtains a well-reasoned opinion from legal counsel that confirms 

the enforceability of the credit risk mitigant in all relevant jurisdictions. 

(iv) Any clean-up calls relating to the securitization are eligible clean-up calls (as 

discussed above). 

 Failure to meet the above operational requirements for a synthetic securitization 

would prevent the originating bank from using the securitization framework and would 

require the originating bank to hold risk-based capital against the underlying exposures as 
 Draft Basel II NPR 

283

if they had not been synthetically securitized. A bank that provides credit protection to a 

synthetic securitization must use the securitization framework to compute risk-based 

capital requirements for its exposures to the synthetic securitization even if the 

originating bank failed to meet one or more of the operational requirements for a 

synthetic securitization. 

Consistent with the treatment of traditional securitization exposures, banks would 

be required to use the RBA for synthetic securitization exposures that have an appropriate 

number of external or inferred ratings. For an originating bank, the RBA would typically 

be used only for the most senior tranche of the securitization, which often would have an 

inferred rating. If a bank has a synthetic securitization exposure that does not have an 

external or inferred rating, the bank would apply the SFA to the exposure (if the bank and 

the exposure qualify for use of the SFA) without considering any CRM obtained as part 

of the synthetic securitization. Then, if the bank has obtained a credit risk mitigant on the 

exposure as part of the synthetic securitization, the bank would apply the securitization 

CRM rules to reduce its risk-based capital requirement for the exposure. For example, if 

the credit risk mitigant is financial collateral, the bank must use the standard supervisory 

or own-estimates haircuts to reduce its risk-based capital requirement. If the bank is a 

protection provider to a synthetic securitization and has obtained a credit risk mitigant on 

its exposure, the bank would also apply the securitization CRM rules in section 46 of the 

proposed rule to reduce its risk-based capital requirement on the exposure. If neither the 

RBA nor the SFA is available, a bank would deduct the exposure from regulatory capital. 

First-loss tranches
 Draft Basel II NPR 

284

If a bank has a first-loss position in a pool of underlying exposures in connection 

with a synthetic securitization, the bank must deduct the position from regulatory capital 

unless (i) the position qualified for use of the RBA or (ii) the bank and the position 

qualified for use of the SFA and a portion of the position was above KIRB. 

Mezzanine tranches

 In a typical synthetic securitization, an originating bank obtains credit protection 

on a mezzanine, or second-loss, tranche of a synthetic securitization by either 

(i) obtaining a credit default swap or financial guarantee from a third-party financial 

institution; or (ii) obtaining a credit default swap or financial guarantee from an SPE 

whose obligations are secured by financial collateral. 

For a bank that creates a synthetic mezzanine tranche by obtaining an eligible 

credit derivative or guarantee from an eligible securitization guarantor, the bank generally 

would treat the notional amount of the credit derivative or guarantee (as adjusted to 

reflect any maturity mismatch, lack of restructuring coverage, or currency mismatch) as a 

wholesale exposure to the protection provider and use the IRB framework for wholesale 

exposures to determine the bank’s risk-based capital requirement for the exposure. A 

bank that creates the synthetic mezzanine tranche by obtaining a guarantee or credit 

derivative that is collateralized by financial collateral but provided by a non-eligible 

securitization guarantor generally would (i) first use the SFA to calculate the risk-based 

capital requirement on the exposure (ignoring the guarantee or credit derivative and the 

associated collateral); and (ii) then use the securitization CRM rules to calculate any 

reductions to the risk-based capital requirement resulting from the associated collateral. 

The bank may look only to the protection provider from which it obtains the guarantee or 
 Draft Basel II NPR 

285

credit derivative when determining its risk-based capital requirement for the exposure 

(that is, if the protection provider hedges the guarantee or credit derivative with a 

guarantee or credit derivative from a third party, the bank may not look through the 

protection provider to that third party when calculating its risk-based capital requirement 

for the exposure). 

 For a bank providing credit protection on a mezzanine tranche of a synthetic 

securitization, the bank would use the RBA to determine the risk-based capital 

requirement for the exposure if the exposure has an external or inferred rating. If the 

exposure does not have an external or inferred rating and the exposure qualifies for use of 

the SFA, the bank would use the SFA to calculate the risk-based capital requirement for 

the exposure. If neither the RBA nor the SFA are available, the bank would deduct the 

exposure from regulatory capital. If a bank providing credit protection on the mezzanine 

tranche of a synthetic securitization obtains a credit risk mitigant to hedge its exposure, 

the bank could apply the securitization CRM rules to reflect the risk reduction achieved 

by the credit risk mitigant. 

Super-senior tranches

A bank that has the most senior position in a pool of underlying exposures in 

connection with a synthetic securitization would use the RBA to calculate its risk-based 

capital requirement for the exposure if the exposure has at least one external or inferred 

rating (in the case of an investing bank) or at least two external or inferred ratings (in the 

case of an originating bank). If the super-senior tranche does not have an external or 

inferred rating and the bank and the exposure qualify for use of the SFA, the bank would 

use the SFA to calculate the risk-based capital requirement for the exposure. If neither 
 Draft Basel II NPR 

286

the RBA nor the SFA are available, the bank would deduct the exposure from regulatory 

capital. If an investing bank in the super-senior tranche of a synthetic securitization 

obtains a credit risk mitigant to hedge its exposure, however, the investing bank may 

apply the securitization CRM rules to reflect the risk reduction achieved by the credit risk 

mitigant. 

8. Nth to default credit derivatives

Credit derivatives that provide credit protection only for the nth defaulting 

reference exposure in a group of reference exposures (nth to default credit derivatives) are 

similar to synthetic securitizations that provide credit protection only after the first-loss 

tranche has defaulted or become a loss. A simplified treatment is available to banks that 

purchase and provide such credit protection. A bank that obtains credit protection on a 

group of underlying exposures through a first-to-default credit derivative must determine 

its risk-based capital requirement for the underlying exposures as if the bank had 

synthetically securitized only the underlying exposure with the lowest capital requirement 

(K) (as calculated under Table 2 of the proposed rule) and had obtained no credit risk 

mitigant on the other (higher capital requirement) underlying exposures. If the bank 

purchases credit protection on a group of underlying exposures through an nth-to-default 

credit derivative (other than a first-to-default credit derivative), it may only recognize the 

credit protection for risk-based capital purposes either if it has obtained credit protection 

on the same underlying exposures in the form of first-through-(n-1)-to-default credit 

derivatives, or if n-1 of the underlying exposures have already defaulted. In such a case, 

the bank would again determine its risk-based capital requirement for the underlying 

exposures as if the bank had only synthetically securitized the n – 1 underlying exposures 
 Draft Basel II NPR 

287

with the lowest capital requirement (K) (as calculated under Table 2 of the proposed rule) 

and had obtained no credit risk mitigant on the other underlying exposures. 

A bank that provides credit protection on a group of underlying exposures through 

a first-to-default credit derivative must determine its risk-weighted asset amount for the 

derivative by applying the RBA (if the derivative qualifies for the RBA) or, if the 

derivative does not qualify for the RBA, by setting its risk-weighted asset amount for the 

derivative equal to the product of (i) the protection amount of the derivative; (ii) 12.5; 

and (iii) the sum of the risk-based capital requirements (K) of the individual underlying 

exposures (as calculated under Table 2 of the proposed rule), up to a maximum of 

100 percent. If a bank provides credit protection on a group of underlying exposures 

through an nth-to-default credit derivative (other than a first-to-default credit derivative), 

the bank must determine its risk-weighted asset amount for the derivative by applying the 

RBA (if the derivative qualifies for the RBA) or, if the derivative does not qualify for the 

RBA, by setting the risk-weighted asset amount for the derivative equal to the product of 

(i) the protection amount of the derivative; (ii) 12.5; and (iii) the sum of the risk-based 

capital requirements (K) of the individual underlying exposures (as calculated under 

Table 2 of the proposed rule and excluding the n-1 underlying exposures with the lowest 

risk-based capital requirements), up to a maximum of 100 percent. 

For example, a bank provides credit protection in the form of a second-to-default 

credit derivative on a basket of five reference exposures. The derivative is unrated and 

the protection amount of the derivative is $100. The risk-based capital requirements of 

the underlying exposures are 2.5 percent, 5.0 percent, 10.0 percent, 15.0 percent, and 20 

percent. The risk-weighted asset amount of the derivative would be $100 x 12.5 x (.05 + 
 Draft Basel II NPR 

288

.10 + .15 + .20) or $625. If the derivative were externally rated in the lowest investment 

grade rating category with a positive designation, the risk-weighted asset amount would 

be $100 x 0.50 or $50. 

9. Early amortization provisions

Background

Many securitizations of revolving credit facilities (for example, credit card 

receivables) contain provisions that require the securitization to be wound down and 

investors to be repaid if the excess spread falls below a certain threshold.78 This decrease 

in excess spread may, in some cases, be caused by deterioration in the credit quality of 

the underlying exposures. An early amortization event can increase a bank’s capital 

needs if new draws on the revolving credit facilities would need to be financed by the 

bank using on-balance sheet sources of funding. The payment allocations used to 

distribute principal and finance charge collections during the amortization phase of these 

transactions also can expose a bank to greater risk of loss than in other securitization 

transactions. To address the risks that early amortization of a securitization poses to 

originating banks, the agencies propose the capital treatment described below. 

 The proposed rule would define an early amortization provision as a provision in 

a securitization’s governing documentation that, when triggered, causes investors in the 

securitization exposures to be repaid before the original stated maturity of the 

securitization exposure, unless the provision is solely triggered by events not related to 

 

78 The proposed rule defines excess spread for a period as gross finance charge collections (including 

market interchange fees) and other income received by the SPE over the period minus interest paid to 

holders of securitization exposures, servicing fees, charge-offs, and other senior trust similar expenses of

the SPE over the period, all divided by the principal balance of the underlying exposures at the end of the 

period. 
 Draft Basel II NPR 

289

the performance of the underlying exposures or the originating bank (such as material 

changes in tax laws or regulations). Under the proposed rule, an originating bank must 

generally hold regulatory capital against the sum of the originating bank’s interest and the 

investors’ interest arising from a revolving securitization that contains an early 

amortization provision. An originating bank must compute its capital requirement for its 

interest using the hierarchy of approaches for securitization exposures as described 

above. The originating bank’s risk-weighted asset amount with respect to the investors’ 

interest in the securitization is equal to the product of the following four quantities: 

(i) the EAD associated with the investors’ interest; (ii) the appropriate credit conversion 

factor (CCF) as determined below; (iii) KIRB; and (iv) 12.5. 

 Under the proposed rule, as noted above, a bank is not required to hold regulatory 

capital against the investors’ interest if early amortization is solely triggered by events 

not related to the performance of the underlying exposures or the originating bank, such 

as material changes in tax laws or regulation. Under the New Accord, a bank is also not 

required to hold regulatory capital against the investors’ interest if (i) the securitization 

has a replenishment structure in which the individual underlying exposures do not 

revolve and the early amortization ends the ability of the originating bank to add new 

underlying exposures to the securitization; (ii) the securitization involves revolving assets 

and contains early amortization features that mimic term structures (that is, where the risk 

of the underlying exposures does not return to the originating bank); or (iii) investors in 

the securitization remain fully exposed to future draws by borrowers on the underlying 

exposures even after the occurrence of early amortization. Question 50: The agencies 
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290

seek comment on the appropriateness of these additional exemptions in the U.S. markets 

for revolving securitizations.

Under the proposed rule, the investors’ interest with respect to a revolving 

securitization captures both the drawn balances and undrawn lines of the underlying 

exposures that are allocated to the investors in the securitization. The EAD associated 

with the investors’ interest is equal to the EAD of the underlying exposures multiplied by 

the ratio of the total amount of securitization exposures issued by the SPE to investors; 

divided by the outstanding principal amount of underlying exposures. 

In general, the applicable CCF would depend on whether the early amortization 

provision repays investors through a “controlled” or “non-controlled” mechanism and 

whether the underlying exposures are revolving retail credit facilities that are 

uncommitted – that is, unconditionally cancelable by the bank to the fullest extent of 

Federal law (for example, credit card receivables) – or are other revolving credit facilities 

(for example, revolving corporate credit facilities). Under the proposed rule, a 

“controlled” early amortization provision meets each of the following conditions: 

 (i) The originating bank has appropriate policies and procedures to ensure that it 

has sufficient capital and liquidity available in the event of an early amortization; 

 (ii) Throughout the duration of the securitization (including the early amortization 

period) there is the same pro rata sharing of interest, principal, expenses, losses, fees, 

recoveries, and other cash flows from the underlying exposures, based on the originating 

bank’s and the investors’ relative shares of the underlying exposures outstanding 

measured on a consistent monthly basis; 
 Draft Basel II NPR 

291

 (iii) The amortization period is sufficient for at least 90 percent of the total 

underlying exposures outstanding at the beginning of the early amortization period to 

have been repaid or recognized as in default; and 

 (iv) The schedule for repayment of investor principal is not more rapid than 

would be allowed by straight-line amortization over an 18-month period. 

An early amortization provision that does not meet any of the above criteria is a 

“non-controlled” early amortization provision. Question 51: The agencies solicit 

comment on the distinction between controlled and non-controlled early amortization 

provisions and on the extent to which banks use controlled early amortization provisions. 

The agencies also invite comment on the proposed definition of a controlled early 

amortization provision, including in particular the 18-month period set forth above.

Controlled early amortization

 To calculate the appropriate CCF for a securitization of uncommitted revolving 

retail exposures that contains a controlled early amortization provision, a bank must 

compare the three-month average excess spread for the securitization to the point at 

which the bank is required to trap excess spread under the securitization transaction. In 

securitizations that do not require excess spread to be trapped, or that specify a trapping 

point based primarily on performance measures other than the three-month average 

excess spread, the excess spread trapping point is 4.5 percent. The bank must divide the 

three-month average excess spread level by the excess spread trapping point and apply 

the appropriate CCF from Table I. Question 52: The agencies seek comment on the 

appropriateness of the 4.5 percent excess spread trapping point and on other types and 
 Draft Basel II NPR 

292

levels of early amortization triggers used in securitizations of revolving retail exposures 

that should be considered by the agencies.

Table I − Controlled Early Amortization Provisions 

 Uncommitted Committed 

Retail Credit 

Lines 

3-month average excess spread 

Credit Conversion Factor (CCF) 90% CCF 

 133.33% of trapping point or more 

0% CCF 

 less than 133.33% to 100% of 

trapping point 

1% CCF 

 less than 100% to 75% of trapping 

point 

2% CCF 

 less than 75% to 50% of trapping 

point 

10% CCF 

 less than 50% to 25% of trapping 

point 

20% CCF 

 less than 25% of trapping point 

40% CCF 

Non-retail Credit 

Lines 90% CCF 90% CCF 

 A bank must apply a 90 percent CCF for all other revolving underlying exposures 

(that is, committed exposures and nonretail exposures) in securitizations containing a 

controlled early amortization provision. The CCFs for uncommitted revolving retail 

credit lines are much lower than for committed retail credit lines or for non-retail credit 

lines because of the demonstrated ability of banks to monitor and, when appropriate, to 

curtail promptly uncommitted retail credit lines for customers of deteriorating credit 

quality. Such account management tools are unavailable for committed lines, and banks 

may be less proactive about using such tools in the case of uncommitted non-retail credit 
 Draft Basel II NPR 

293

lines owing to lender liability concerns and the prominence of broad-based, longer-term 

customer relationships. 

Question 53: The agencies seek comment on and supporting empirical analysis of

the appropriateness of a more simple alternative approach that would impose at all times 

a flat CCF on the entire investors’ interest of a revolving securitization with a controlled 

early amortization provision, and on what an appropriate level of such a CCF would be 

(for example, 10 or 20 percent).

Noncontrolled early amortization

 To calculate the appropriate CCF for securitizations of uncommitted revolving 

retail exposures that contain a noncontrolled early amortization provision, a bank must 

perform the excess spread calculations described in the controlled early amortization 

section above and then apply the CCFs in Table J. 

Table J − Non-Controlled Early Amortization Provisions 

 Uncommitted Committed

Retail Credit Lines 

3-month average excess spread 

Credit Conversion Factor (CCF) 100% CCF 

 133.33% of trapping point or more 

0% CCF 

 less than 133.33% to 100% of 

trapping point 

5% CCF 

 less than 100% to 75% of trapping 

point 

15% CCF 

 less than 75% to 50% of trapping 

point 

50% CCF 

 less than 50% of trapping point 

100% CCF 

Non-retail Credit 

Lines 

100% CCF 100% CCF 
 Draft Basel II NPR 

294

 A bank must use a 100 percent CCF for all other revolving underlying exposures 

(that is, committed exposures and nonretail exposures) in securitizations containing a 

noncontrolled early amortization provision. In other words, no risk transference would 

be recognized for these transactions; an originating bank’s IRB capital requirement 

would be the same as if the underlying exposures had not been securitized. 

In circumstances where a securitization contains a mix of retail and nonretail 

exposures or a mix of committed and uncommitted exposures, a bank may take a pro rata 

approach to determining the risk-based capital requirement for the securitization’s early 

amortization provision. If a pro rata approach is not feasible, a bank must treat the 

securitization as a securitization of nonretail exposures if a single underlying exposure is 

a nonretail exposure and must treat the securitization as a securitization of committed 

exposures if a single underlying exposure is a committed exposure. 

F. Equity exposures 

1. Introduction and exposure measurement

 This section describes the proposed rule’s risk-based capital treatment for equity 

exposures. Under the proposed rule, a bank would have the option to use either a simple 

risk-weight approach (SRWA) or an internal models approach (IMA) for equity 

exposures that are not exposures to an investment fund. A bank would use a lookthrough approach for equity exposures to an investment fund. Under the SRWA, a bank 

would generally assign a 300 percent risk weight to publicly traded equity exposures and 

a 400 percent risk weight to non-publicly traded equity exposures. Certain equity 

exposures to sovereigns, multilateral institutions, and public sector enterprises would 

have a risk weight of 0 percent, 20 percent, or 100 percent; and certain community 
 Draft Basel II NPR 

295

development equity exposures, hedged equity exposures, and, up to certain limits, nonsignificant equity exposures would receive a 100 percent risk weight. 

Alternatively, a bank that meets certain minimum quantitative and qualitative 

requirements on an ongoing basis and obtains the prior written approval of its primary 

Federal supervisor could use the IMA to determine its risk-based capital requirement for 

all modeled equity exposures. A bank that qualifies to use the IMA may apply the IMA 

to its publicly traded and non-publicly traded equity exposures, or may choose to apply 

the IMA only to its publicly traded equity exposures. However, if the bank applies the 

IMA to its publicly traded equity exposures, it must apply the IMA to all such exposures. 

Similarly, if a bank applies the IMA to both publicly traded and non-publicly traded 

equity exposures, it must apply the IMA to all such exposures. If a bank does not qualify 

to use the IMA, or elects not to use the IMA, to compute its risk-based capital 

requirements for equity exposures, the bank must apply the SRWA to assign risk weights 

to its equity exposures. 

The proposed rule defines a publicly traded equity exposure as an equity exposure 

traded on (i) any exchange registered with the SEC as a national securities exchange 

under section 6 of the Securities Exchange Act of 1934 (15 U.S.C. 78f); (ii) NASDAQ; 

or (iii) any non-U.S.-based securities exchange that is registered with, or approved by, a 

national securities regulatory authority, provided that there is a liquid, two-way market 

for the exposure (that is, there are enough bona fide offers to buy and sell so that a sales 

price reasonably related to the last sales price or current bona fide competitive bid and 

offer quotations can be determined promptly and a trade can be settled at such a price 

within five business days). Question 54: The agencies seek comment on this definition.
 Draft Basel II NPR 

296

A bank using either the IMA or the SRWA must determine the adjusted carrying 

value for each equity exposure. The proposed rule defines the adjusted carrying value of 

an equity exposure as: 

(i) For the on-balance sheet component of an equity exposure, the bank’s carrying 

value of the exposure reduced by any unrealized gains on the exposure that are reflected 

in such carrying value but excluded from the bank’s tier 1 and tier 2 capital;79 and 

(ii) For the off-balance sheet component of an equity exposure, the effective 

notional principal amount of the exposure, the size of which is equivalent to a 

hypothetical on-balance sheet position in the underlying equity instrument that would 

evidence the same change in fair value (measured in dollars) for a given small change in 

the price of the underlying equity instrument, minus the adjusted carrying value of the 

on-balance sheet component of the exposure as calculated in (i). 

The agencies created the definition of the effective notional principal amount of 

the off-balance sheet portion of an equity exposure to provide a uniform method for 

banks to measure the on-balance sheet equivalent of an off-balance sheet exposure. For 

example, if the value of a derivative contract referencing the common stock of company 

X changes the same amount as the value of 150 shares of common stock of company X, 

for a small (for example, 1 percent) change in the value of the common stock of company 

X, the effective notional principal amount of the derivative contract is the current value 

of 150 shares of common stock of company X regardless of the number of shares the 

derivative contract references. The adjusted carrying value of the off-balance sheet 

 79 The potential downward adjustment to the carrying value of an equity exposure reflects the fact 

that 100 percent of the unrealized gains on available-for-sale equity exposures are included in carrying 

value but only up to 45 percent of any such unrealized gains are included in regulatory capital. 
 Draft Basel II NPR 

297

component of the derivative is the current value of 150 shares of common stock of 

company X minus the adjusted carrying value of any on-balance sheet amount associated 

with the derivative. Question 55: The agencies seek comment on the approach to 

adjusted carrying value for the off-balance sheet component of equity exposures and on 

alternative approaches that may better capture the market risk of such exposures.

Hedge transactions

For purposes of determining risk-weighted assets under both the SRWA and the 

IMA, a bank may identify hedge pairs, which the proposed rule defines as two equity 

exposures that form an effective hedge so long as each equity exposure is publicly traded 

or has a return that is primarily based on a publicly traded equity exposure. A bank may 

risk weight only the effective and ineffective portions of a hedge pair rather than the 

entire adjusted carrying value of each exposure that makes up the pair. Two equity 

exposures form an effective hedge if the exposures either have the same remaining 

maturity or each has a remaining maturity of at least three months; the hedge relationship 

is formally documented in a prospective manner (that is, before the bank acquires at least 

one of the equity exposures); the documentation specifies the measure of effectiveness 

(E) the bank will use for the hedge relationship throughout the life of the transaction; and 

the hedge relationship has an E greater than or equal to 0.8. A bank must measure E at 

least quarterly and must use one of three alternative measures of E—the dollar-offset 

method, the variability-reduction method, or the regression method. 

It is possible that only part of a bank’s exposure to a particular equity instrument 

would be part of a hedge pair. For example, assume a bank has an equity exposure A 

with a $300 adjusted carrying value and chooses to hedge a portion of that exposure with 
 Draft Basel II NPR 

298

an equity exposure B with an adjusted carrying value of $100. Also assume that the 

combination of equity exposure B and $100 of the adjusted carrying value of equity 

exposure A form an effective hedge with an E of 0.8. In this situation the bank would 

treat $100 of equity exposure A and $100 of equity exposure B as a hedge pair, and the 

remaining $200 of its equity exposure A as a separate, stand-alone position. 

The effective portion of a hedge pair is E multiplied by the greater of the adjusted 

carrying values of the equity exposures forming a hedge pair, whereas the ineffective 

portion is (1-E) multiplied by the greater of the adjusted carrying values of the equity 

exposures forming a hedge pair. In the above example, the effective portion of the hedge 

pair would be 0.8 x $100 = $80 and the ineffective portion of the hedge pair would be (1 

– 0.8) x $100 = $20. 

Measures of hedge effectiveness

Under the dollar-offset method of measuring effectiveness, the bank must 

determine the ratio of the cumulative sum of the periodic changes in the value of one 

equity exposure to the cumulative sum of the periodic changes in the value of the other 

equity exposure, termed the ratio of value change (RVC). If the changes in the values of 

the two exposures perfectly offset each other, the RVC will be -1. If RVC is positive, 

implying that the values of the two equity exposures moved in the same direction, the 

hedge is not effective and E = 0. If RVC is negative and greater than or equal to -1 (that 

is, between zero and -1), then E equals the absolute value of RVC. If RVC is negative 

and less than -1, then E equals 2 plus RVC. 

The variability-reduction method of measuring effectiveness compares changes in 

the value of the combined position of the two equity exposures in the hedge pair (labeled 
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299

X) to changes in the value of one exposure as though that one exposure were not hedged 

(labeled A). This measure of E expresses the time-series variability in X as a proportion 

of the variability of A. As the variability described by the numerator becomes small 

relative to the variability described by the denominator, the measure of effectiveness 

improves, but is bounded from above by a value of 1. E can be computed as: 

( )

∑ ( )

∑

=

−

=

−

−

−

= − T

t

t t

T

t

t t

A A

X X

E

1

2

1

1

2

1

1 , where 

X t = At − Bt

At = the value at time t of the one exposure in a hedge pair, and 

Bt = the value at time t of the other exposure in a hedge pair. 

The value of t will range from zero to T, where T is the length of the observation 

period for the values of A and B, and is comprised of shorter values each labeled t. 

The regression method of measuring effectiveness is based on a regression in 

which the change in value of one exposure in a hedge pair is the dependent variable and 

the change in value of the other exposure in a hedge pair is the independent variable. E 

equals the coefficient of determination of this regression, which is the proportion of the 

variation in the dependent variable explained by variation in the independent variable. 

The closer the relationship between the values of the two exposures, the higher E will be. 

2. Simple risk-weight approach (SRWA)

Under the SRWA in section 52 of the proposed rule, a bank would determine the 

risk-weighted asset amount for each equity exposure, other than an equity exposure to an 
 Draft Basel II NPR 

300

investment fund, by multiplying the adjusted carrying value of the equity exposure, or the 

effective portion and ineffective portion of a hedge pair as described below, by the lowest 

applicable risk weight in Table K. A bank would determine the risk-weighted asset 

amount for an equity exposure to an investment fund as set forth below (and in section 54 

of the proposed rule). Use of the SRWA would be most appropriate when a bank’s 

equity holdings are principally composed of non-traded instruments. 

If a bank exclusively uses the SRWA for its equity exposures, the bank’s 

aggregate risk-weighted asset amount for its equity exposures (other than equity 

exposures to investment funds) would be equal to the sum of the risk-weighted asset 

amounts for each of the bank’s individual equity exposures. 
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Table K 

Risk weight Equity Exposure 

0 Percent An equity exposure to an entity whose credit exposures are exempt from 

the 0.03 percent PD floor 

20 Percent An equity exposure to a Federal Home Loan Bank or Farmer Mac if the 

equity exposure is not publicly traded and is held as a condition of 

membership in that entity 

100 Percent • Community development equity exposures80

• Equity exposures to a Federal Home Loan Bank or Farmer Mac 

not subject to a 20 percent risk weight 

• The effective portion of a hedge pair 

• Non-significant equity exposures to the extent less than 10 

percent of tier 1 plus tier 2 capital 

300 Percent A publicly traded equity exposure (including the ineffective portion of a 

hedge pair) 

400 Percent An equity exposure that is not publicly traded 

Non-significant equity exposures

A bank may apply a 100 percent risk weight to non-significant equity exposures, 

which the proposed rule defines as equity exposures to the extent that the aggregate 

adjusted carrying value of the exposures does not exceed 10 percent of the bank’s tier 1 

capital plus tier 2 capital. To compute the aggregate adjusted carrying value of a bank’s 

equity exposures for determining non-significance, the bank may exclude (i) equity 

 

80 The proposed rule generally defines these exposures as exposures that would qualify as community 

development investments under 12 U.S.C. 24(Eleventh), excluding equity exposures to an unconsolidated 

small business investment company and equity exposures held through a consolidated small business 

investment company described in section 302 of the Small Business Investment Act of 1958 (15 U.S.C. 

682). For savings associations, community development investments would be defined to mean equity 

investments that are designed primarily to promote community welfare, including the welfare of low- and 

moderate-income communities or families, such as by providing services or jobs, and excluding equity 

exposures to an unconsolidated small business investment company and equity exposures held through a 

consolidated small business investment company described in section 302 of the Small Business 

Investment Act of 1958 (15 U.S.C. 682). 
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exposures that receive less than a 300 percent risk weight under the SRWA (other than 

equity exposures determined to be non-significant), (ii) the equity exposure in a hedge 

pair with the smaller adjusted carrying value, and (iii) a proportion of each equity 

exposure to an investment fund equal to the proportion of the assets of the investment 

fund that are not equity exposures. If a bank does not know the actual holdings of the 

investment fund, the bank may calculate the proportion of the assets of the fund that are 

not equity exposures based on the terms of the prospectus, partnership agreement, or 

similar contract that defines the fund’s permissible investments. If the sum of the 

investment limits for all exposure classes within the fund exceeds 100 percent, the bank 

must assume that the investment fund invests to the maximum extent possible in equity 

exposures. 

When determining which of a bank’s equity exposures qualify for a 100 percent 

risk weight based on non-significance, a bank must first include equity exposures to 

unconsolidated small business investment companies or held through consolidated small 

business investment companies described in section 302 of the Small Business 

Investment Act of 1958 (15 U.S.C. 682) and then must include publicly traded equity 

exposures (including those held indirectly through investment funds) and then must 

include non-publicly traded equity exposures (including those held indirectly through 

investment funds). 

3. Internal models approach (IMA)

The IMA is designed to provide banks with a more sophisticated and risksensitive mechanism for calculating risk-based capital requirements for equity exposures. 

To qualify to use the IMA, a bank must receive prior written approval from its primary 
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303

Federal supervisor. To receive such approval, the bank must demonstrate to its primary 

Federal supervisor’s satisfaction that the bank meets the following quantitative and 

qualitative criteria. 

IMA qualification

First, the bank must have a model that (i) assesses the potential decline in value of 

its modeled equity exposures; (ii) is commensurate with the size, complexity, and 

composition of the bank’s modeled equity exposures; and (iii) adequately captures both 

general market risk and idiosyncratic risks. Second, the bank’s model must produce an 

estimate of potential losses for its modeled equity exposures that is no less than the 

estimate of potential losses produced by a VaR methodology employing a 99.0 percent 

one-tailed confidence interval of the distribution of quarterly returns for a benchmark 

portfolio of equity exposures comparable to the bank’s modeled equity exposures using a 

long-term sample period. 

 In addition, the number of risk factors and exposures in the sample and the data 

period used for quantification in the bank’s model and benchmarking exercise must be 

sufficient to provide confidence in the accuracy and robustness of the bank’s estimates. 

The bank’s model and benchmarking exercise also must incorporate data that are relevant 

in representing the risk profile of the bank’s modeled equity exposures, and must include 

data from at least one equity market cycle containing adverse market movements relevant 

to the risk profile of the bank’s modeled equity exposures. If the bank’s model uses a 

scenario methodology, the bank must demonstrate that the model produces a conservative 

estimate of potential losses on the bank’s modeled equity exposures over a relevant long-
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304

term market cycle. If the bank employs risk factor models, the bank must demonstrate 

through empirical analysis the appropriateness of the risk factors used. 

The agencies also would require that daily market prices be available for all 

modeled equity exposures, either direct holdings or proxies. Finally, the bank must be 

able to demonstrate, using theoretical arguments and empirical evidence, that any proxies 

used in the modeling process are comparable to the bank’s modeled equity exposures and 

that the bank has made appropriate adjustments for differences. The bank must derive 

any proxies for its modeled equity exposures or benchmark portfolio using historical 

market data that are relevant to the bank’s modeled equity exposures or benchmark 

portfolio (or, where not, must use appropriately adjusted data), and such proxies must be 

robust estimates of the risk of the bank’s modeled equity exposures. 

In evaluating a bank’s internal model for equity exposures, the bank’s primary 

Federal supervisor would consider, among other factors, (i) the nature of the bank’s 

equity exposures, including the number and types of equity exposures (for example, 

publicly traded, non-publicly traded, long, short); (ii) the risk characteristics and makeup 

of the bank’s equity exposures, including the extent to which publicly available price 

information is obtainable on the exposures; and (iii) the level and degree of concentration 

of, and correlations among, the bank’s equity exposures. Banks with equity portfolios 

containing equity exposures with values that are highly nonlinear in nature (for example, 

equity derivatives or convertibles) would have to employ an internal model designed to 

appropriately capture the risks associated with these instruments. 

The agencies do not intend to dictate the form or operational details of a bank’s 

internal model for equity exposures. Accordingly, the agencies would not prescribe any 
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particular type of model for determining risk-based capital requirements. Although the 

proposed rule requires a bank that uses the IMA to ensure that its internal model produces 

an estimate of potential losses for its modeled equity exposures that is no less than the 

estimate of potential losses produced by a VaR methodology employing a 99.0 percent 

one-tailed confidence interval of the distribution of quarterly returns for a benchmark 

portfolio of equity exposures, the proposed rule does not require a bank to use a VaRbased model. The agencies recognize that the type and sophistication of internal models 

will vary across banks due to differences in the nature, scope, and complexity of business 

lines in general and equity exposures in particular. The agencies recognize that some 

banks employ models for internal risk management and capital allocation purposes that 

can be more relevant to the bank’s equity exposures than some VaR models. For 

example, some banks employ rigorous historical scenario analysis and other techniques 

for assessing the risk of their equity portfolios. 

Banks that choose to use a VaR-based internal model under the IMA should use a 

historical observation period that includes a sufficient amount of data points to ensure 

statistically reliable and robust loss estimates relevant to the long-term risk profile of the 

bank’s specific holdings. The data used to represent return distributions should reflect 

the longest sample period for which data are available and should meaningfully represent 

the risk profile of the bank’s specific equity holdings. The data sample should be longterm in nature and, at a minimum, should encompass at least one complete equity market 

cycle containing adverse market movements relevant to the risk profile of the bank’s 

modeled exposures. The data used should be sufficient to provide conservative, 
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306

statistically reliable, and robust loss estimates that are not based purely on subjective or 

judgmental considerations. 

The parameters and assumptions used in a VaR model must be subject to a 

rigorous and comprehensive regime of stress-testing. Banks utilizing VaR models must 

subject their internal model and estimation procedures, including volatility computations, 

to either hypothetical or historical scenarios that reflect worst-case losses given 

underlying positions in both publicly traded and non-publicly traded equities. At a 

minimum, banks that use a VaR model must employ stress tests to provide information 

about the effect of tail events beyond the level of confidence assumed in the IMA. 

Banks using non-VaR internal models that are based on stress tests or scenario 

analyses would have to estimate losses under worst-case modeled scenarios. These 

scenarios would have to reflect the composition of the bank’s equity portfolio and should 

produce risk-based capital requirements at least as large as those that would be required 

to be held against a representative market index or other relevant benchmark portfolio 

under a VaR approach. For example, for a portfolio consisting primarily of publicly held 

equity securities that are actively traded, risk-based capital requirements produced using 

historical scenario analyses should be greater than or equal to risk-based capital 

requirements produced by a baseline VaR approach for a major index or sub-index that is 

representative of the bank’s holdings. Similarly, non-publicly traded equity exposures 

may be benchmarked against a representative portfolio of publicly traded equity 

exposures. 

The loss estimate derived from the bank’s internal model would constitute the 

regulatory capital requirement for the modeled equity exposures. The equity capital 
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307

requirement would be incorporated into a bank’s risk-based capital ratio through the 

calculation of risk-weighted equivalent assets. To convert the equity capital requirement 

into risk-weighted equivalent assets, a bank would multiply the capital requirement by 

12.5. 

Question 56: The agencies seek comment on the proposed rule’s requirements for 

IMA qualification, including in particular the proposed rule’s use of a 99.0 percent, 

quarterly returns standard. 

Risk-weighted assets under the IMA

As noted above, a bank may apply the IMA only to its publicly traded equity 

exposures or may apply the IMA to its publicly traded and non-publicly traded equity 

exposures. In either case, a bank is not allowed to apply the IMA to equity exposures 

that receive a 0 or 20 percent risk weight under Table 9, community development equity 

exposures, equity exposures to a Federal Home Loan Bank or Farmer Mac that receive a 

100 percent risk weight, and equity exposures to investment funds (collectively, excluded 

equity exposures). 

If a bank applies the IMA to both publicly traded and non-publicly traded equity 

exposures, the bank’s aggregate risk-weighted asset amount for its equity exposures 

would be equal to the sum of the risk-weighted asset amount of each excluded equity 

exposure (calculated outside of the IMA section of the proposed rule) and the riskweighted asset amount of the non-excluded equity exposures (calculated under the IMA 

section of the proposed rule). The risk-weighted asset amount of the non-excluded equity 

exposures is generally set equal to the estimate of potential losses on the bank’s nonexcluded equity exposures generated by the bank’s internal model multiplied by 12.5. To 
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308

ensure that a bank holds a minimum amount of risk-based capital against its modeled 

equity exposures, however, the proposed rule contains a supervisory floor on the riskweighted asset amount of the non-excluded equity exposures. As a result of this floor, 

the risk-weighted asset amount of the non-excluded equity exposures could not fall below 

the sum of (i) 200 percent multiplied by the aggregate adjusted carrying value or 

ineffective portion of hedge pairs, as appropriate, of the bank’s non-excluded publicly 

traded equity exposures; and (ii) 300 percent multiplied by the aggregate adjusted 

carrying value of the bank’s non-excluded non-publicly traded equity exposures. 

If, on the other hand, a bank applies the IMA only to its publicly traded equity 

exposures, the bank’s aggregate risk-weighted asset amount for its equity exposures 

would be equal to the sum of (i) the risk-weighted asset amount of each excluded equity 

exposure (calculated outside of the IMA section of the proposed rule); (ii) 400 percent 

multiplied by the aggregate adjusted carrying value of the bank’s non-excluded nonpublicly traded equity exposures; and (iii) the aggregate risk-weighted asset amount of its 

non-excluded publicly traded equity exposures. The risk-weighted asset amount of the 

non-excluded publicly traded equity exposures would be equal to the estimate of potential 

losses on the bank’s non-excluded publicly traded equity exposures generated by the 

bank’s internal model multiplied by 12.5. The risk-weighted asset amount for the nonexcluded publicly traded equity exposures would be subject to a floor of 200 percent 

multiplied by the aggregate adjusted carrying value or ineffective portion of hedge pairs, 

as appropriate, of the bank’s non-excluded publicly traded equity exposures. Question 

57: The agencies seek comment on the operational aspects of these floor calculations.
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4. Equity exposures to investment funds

A bank must determine the risk-weighted asset amount for equity exposures to 

investment funds using one of three approaches: the Full Look-Through Approach, the 

Simple Modified Look-Through Approach, or the Alternative Modified Look-Through 

Approach, unless the equity exposure to an investment fund is a community development 

equity exposure. Such equity exposures would be subject to a 100 percent risk weight. If 

an equity exposure to an investment fund is part of a hedge pair, a bank may use the 

ineffective portion of a hedge pair as the adjusted carrying value for the equity exposure 

to the investment fund. A bank may choose to apply a different approach to different 

equity exposures to investment funds; the proposed rule does not require a bank to apply 

the same approach to all of its equity exposures to investment funds. 

The proposed rule defines an investment fund as a company all or substantially all 

of the assets of which are financial assets and which has no material liabilities. The 

agencies have proposed a separate treatment for equity exposures to an investment fund 

to prevent banks from arbitraging the proposed rule’s high risk-based capital 

requirements for certain high-risk exposures and to ensure that banks do not receive a 

punitive risk-based capital requirement for equity exposures to investment funds that hold 

only low-risk assets. Question 58: The agencies seek comment on the necessity and 

appropriateness of the separate treatment for equity exposures to investment funds and

the three approaches in the proposed rule. The agencies also seek comment on the 

proposed definition of an investment fund.

Each of the approaches to equity exposures to investment funds imposes a 7 

percent minimum risk weight on equity exposures to investment funds. This minimum 
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310

risk weight is similar to the minimum 7 percent risk weight under the RBA for 

securitization exposures and the effective 56 basis point minimum risk-based capital 

requirement per dollar of securitization exposure under the SFA. The agencies believe 

that this minimum prudential capital requirement is appropriate for exposures not directly 

held by the bank. 

Full look-through approach

 A bank may use the full look-through approach only if the bank is able to 

compute a risk-weighted asset amount for each of the exposures held by the investment 

fund (calculated under the proposed rule as if the exposures were held directly by the 

bank). Under this approach, a bank would set the risk-weighted asset amount of the 

bank’s equity exposure to the investment fund equal to the greater of (i) the product of 

(A) the aggregate risk-weighted asset amounts of the exposures held by the fund as if 

they were held directly by the bank and (B) the bank’s proportional ownership share of 

the fund; and (ii) 7 percent of the adjusted carrying value of the bank’s equity exposure to 

the investment fund. 

Simple modified look-through approach

 Under this approach, a bank may set the risk-weighted asset amount for its equity 

exposure to an investment fund equal to the adjusted carrying value of the equity 

exposure multiplied by the highest risk weight in Table L that applies to any exposure the 

fund is permitted to hold under its prospectus, partnership agreement, or similar contract 

that defines the fund’s permissible investments. The bank may exclude derivative 

contracts that are used for hedging, not speculative purposes, and do not constitute a 
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311

material portion of the fund’s exposures. A bank may not assign an equity exposure to an 

investment fund to an aggregate risk weight of less than 7 percent under this approach. 

Table L – Modified Look-Through Approaches for Equity Exposures to Investment 

Funds 

Risk Weight Exposure Class

0 percent Sovereign exposures with a long-term external rating in the highest 

investment grade rating category and sovereign exposures of the 

United States 

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

external rating in the highest investment grade rating category; and 

exposures to, or guaranteed by, depository institutions, foreign banks 

(as defined in 12 CFR 211.2), or securities firms subject to 

consolidated supervision or regulation comparable to that imposed on 

U.S. securities broker-dealers that are repo-style transactions or 

bankers’ acceptances 

50 percent Exposures with a long-term external rating in the third-highest 

investment grade rating category or a short-term external rating in the 

second-highest investment grade rating category 

100 percent Exposures with a long-term or short-term external rating in the lowest 

investment grade rating category 

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

investment grade 

300 percent Publicly traded equity exposures 

400 percent Non-publicly traded equity exposures; exposures with a long-term 

external rating two or more rating categories below investment grade; 

and unrated exposures (excluding publicly traded equity exposures) 

1,250 percent OTC derivative contracts and exposures that must be deducted from 

regulatory capital or receive a risk weight greater than 400 percent 

under this appendix 
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Alternative modified look-through approach

 Under this approach, a bank may assign the adjusted carrying value of an equity 

exposure to an investment fund on a pro rata basis to different risk-weight categories in 

Table L according to the investment limits in the fund’s prospectus, partnership 

agreement, or similar contract that defines the fund’s permissible investments. If the sum 

of the investment limits for all exposure classes within the fund exceeds 100 percent, the 

bank must assume that the fund invests to the maximum extent permitted under its 

investment limits in the exposure class with the highest risk weight under Table L, and 

continues to make investments in the order of the exposure class with the next highest 

risk-weight under Table L until the maximum total investment level is reached. If more 

than one exposure class applies to an exposure, the bank must use the highest applicable 

risk weight. A bank may exclude derivative contracts held by the fund that are used for 

hedging, not speculative, purposes and do not constitute a material portion of the fund’s 

exposures. The overall risk weight assigned to an equity exposure to an investment fund 

under this approach may not be less than 7 percent. 

VI. Operational Risk 

This section describes features of the AMA framework for determining the riskbased capital requirement for operational risk. The proposed framework remains 

fundamentally similar to that described in the ANPR. Under this framework, a bank 

meeting the AMA qualifying criteria would use its internal operational risk quantification 

system to calculate its risk-based capital requirement for operational risk. 

Currently, the agencies’ general risk-based capital rules do not include an explicit 

capital charge for operational risk. Rather, the existing risk-based capital rules were 
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313

designed to cover all risks, and therefore implicitly cover operational risk. With the 

introduction of the IRB framework for credit risk in this NPR, which would result in a 

more risk-sensitive treatment of credit risk, there no longer would be an implicit capital 

buffer for other risks. 

 The agencies recognize that operational risk is a key risk in banks, and evidence 

indicates that a number of factors are driving increases in operational risk. These factors 

include greater use of automated technology, proliferation of new and highly complex 

products, growth of e-banking transactions and related business applications, large-scale 

acquisitions, mergers, and consolidations, and greater use of outsourcing arrangements. 

Furthermore, the recent experience of a number of high-profile, high-severity losses 

across the banking industry, including those resulting from legal settlements, highlight 

operational risk as a major source of unexpected losses. Because the implicit regulatory 

capital buffer for operational risk would be removed under the proposed rule, the 

agencies propose to require banks using the IRB framework for credit risk to use the 

AMA to address operational risk when computing a capital charge for regulatory capital 

purposes. 

As defined previously, operational risk exposure is the 99.9th percentile of the 

distribution of potential aggregate operational losses as generated by the bank’s 

operational risk quantification system over a one-year horizon. EOL is the expected 

value of the same distribution of potential aggregate operational losses. The ANPR 

specified that a bank’s risk-based capital requirement for operational risk would be the 

sum of EOL and UOL unless the bank could demonstrate that an EOL offset would meet 

supervisory standards. The agencies described two approaches – reserving and budgeting 
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314

– that might allow for some offset of EOL; however, the agencies expressed some 

reservation about both approaches. The agencies believed that reserves established for 

expected operational losses would likely not meet U.S. accounting standards and that 

budgeted funds might not be sufficiently capital-like to cover EOL. 

While the proposed framework remains fundamentally similar to that described in 

the ANPR and a bank would continue to be allowed to recognize (i) certain offsets for 

EOL, and (ii) the effect of risk mitigants such as insurance in calculating its regulatory 

capital requirement for operational risk, the agencies have clarified certain aspects of the 

proposed framework. In particular, the agencies have re-assessed the ability of banks to 

take prudent steps to offset EOL through internal business practices. 

After further analysis and discussions with the industry, the agencies believe that 

certain reserves and other internal business practices could qualify as an EOL offset. 

Under the proposed rule, a bank’s risk-based capital requirement for operational risk may 

be based on UOL alone if the bank can demonstrate it has offset EOL with eligible 

operational risk offsets, which are defined as amounts (i) generated by internal business 

practices to absorb highly predictable and reasonably stable operational losses, including 

reserves calculated in a manner consistent with GAAP; and (ii) available to cover EOL 

with a high degree of certainty over a one-year horizon. Eligible operational risk offsets 

may only be used to offset EOL, not UOL. 

In determining whether to accept a proposed EOL offset, the agencies will 

consider whether the proposed offset would be available to cover EOL with a high degree 

of certainty over a one-year horizon. Supervisory recognition of EOL offsets will be 

limited to those business lines and event types with highly predictable, routine losses. 
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Based on discussions with the industry and empirical data, highly predictable and routine 

losses appear to be limited to those relating to securities processing and to credit card 

fraud. Question 59: The agencies are interested in commenters’ views on other business

lines or event types in which highly predictable, routine losses have been observed. 

In determining its operational risk exposure, the bank could also take into account 

the effects of risk mitigants such as insurance, subject to approval from its primary 

Federal supervisor. In order to recognize the effects of risk mitigants such as insurance 

for risk-based capital purposes, the bank must estimate its operational risk exposure with 

and without such effects. The reduction in a bank’s risk-based capital requirement for 

operational risk due to risk mitigants may not exceed 20 percent of the bank’s risk-based 

capital requirement for operational risk, after approved adjustments for EOL offsets. A 

bank must demonstrate that a risk mitigant is able to absorb losses with sufficient 

certainty to warrant inclusion in the adjustment to the operational risk exposure. For a 

risk mitigant to meet this standard, it must be insurance that: 

(i) is provided by an unaffiliated company that has a claims paying ability that 

is rated in one of the three highest rating categories by an NRSRO; 

(ii) has an initial term of at least one year and a residual term of more than 

90 days; 

(iii) has a minimum notice period for cancellation of 90 days; 

(iv) has no exclusions or limitations based upon regulatory action or for the 

receiver or liquidator of a failed bank; and 

(v) is explicitly mapped to an actual operational risk exposure of the bank. 
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The bank’s methodology for recognizing risk mitigants must also capture, through 

appropriate discounts in the amount of risk mitigants, the residual term of the risk 

mitigant, where less than one year; the risk mitigant’s cancellation terms, where less than 

one year; the risk mitigant’s timeliness of payment; and the uncertainty of payment as 

well as mismatches in coverage between the risk mitigant and the hedged operational loss 

event. The bank may not recognize for regulatory capital purposes risk mitigants with a 

residual term of 90 days or less. 

Commenters on the ANPR raised concerns that limiting the risk mitigating 

benefits of insurance to 20 percent of the bank’s regulatory capital requirement for 

operational risk represents an overly prescriptive and arbitrary value. Concerns were 

raised that such a cap would inhibit development of this important risk mitigation tool. 

Commenters believed that the full contract amount of insurance should be recognized as 

the risk mitigating value. The agencies, however, believe that the 20 percent limit 

continues to be a prudent limit. 

Currently, the primary risk mitigant available for operational risk is insurance. 

While certain securities products may be developed over time that could provide risk 

mitigation benefits, no specific products have emerged to-date that have characteristics 

sufficient to be considered a capital replacement for operational risk. However, as 

innovation in this field continues, a bank may be able to realize the benefits of risk 

mitigation through certain capital markets instruments with the approval of its primary 

Federal supervisor. 

If a bank does not qualify to use or does not have qualifying operational risk 

mitigants, the bank’s dollar risk-based capital requirement for operational risk would be 
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317

its operational risk exposure minus eligible operational risk offsets (if any). If a bank 

qualifies to use operational risk mitigants and has qualifying operational risk mitigants, 

the bank’s dollar risk-based capital requirement for operational risk would be the greater 

of: (i) the bank’s operational risk exposure adjusted for qualifying operational risk 

mitigants minus eligible operational risk offsets (if any); and (ii) 0.8 multiplied by the 

difference between the bank’s operational risk exposure and its eligible operational risk 

offsets (if any). The dollar risk-based capital requirement for operational risk would be 

multiplied by 12.5 to convert it into an equivalent risk-weighted asset amount. The 

resulting amount would be added to the comparable amount for credit risk in calculating 

the institution’s risk-based capital denominator. 

VII. Disclosure 

1. Overview

The agencies have long supported meaningful public disclosure by banks with the 

objective of improving market discipline. The agencies recognize the importance of 

market discipline in encouraging sound risk management practices and fostering financial 

stability. 

Pillar 3 of the New Accord, market discipline, complements the minimum capital 

requirements and the supervisory review process by encouraging market discipline 

through enhanced and meaningful public disclosure. These proposed public disclosure 

requirements are intended to allow market participants to assess key information about an 

institution’s risk profile and its associated level of capital. 

The agencies view public disclosure as an important complement to the advanced 

approaches to calculating minimum regulatory risk-based capital requirements, which 
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318

will be heavily based on internal systems and methodologies. With enhanced 

transparency of the advanced approaches, investors can better evaluate a bank’s capital 

structure, risk exposures, and capital adequacy. With sufficient and relevant information, 

market participants can better evaluate a bank’s risk management performance, earnings 

potential and financial strength. 

Improvements in public disclosures come not only from regulatory standards, but 

also through efforts by bank management to improve communications to public 

shareholders and other market participants. In this regard, improvements to risk 

management processes and internal reporting systems provide opportunities to 

significantly improve public disclosures over time. Accordingly, the agencies strongly 

encourage the management of each bank to regularly review its public disclosures and 

enhance these disclosures, where appropriate, to clearly identify all significant risk 

exposures – whether on- or off-balance sheet – and their effects on the bank’s financial 

condition and performance, cash flow, and earnings potential. 

Comments on ANPR

Some commenters to the ANPR indicated that the proposed disclosures were 

burdensome, excessive, and overly prescriptive. Other commenters believed that the 

information provided in the disclosures would not be comparable across banks because 

each bank will use distinct internal methodologies to generate the disclosures. These 

commenters also expressed concern that some disclosures could be misinterpreted or 

misunderstood by the public. 

The agencies believe, however, the required disclosures would enable market 

participants to gain key insights regarding a bank’s capital structure, risk exposures, risk 
 Draft Basel II NPR 

319

assessment processes, and ultimately, the capital adequacy of the institution. Some of the 

proposed disclosure requirements will be new disclosures for banks. Nonetheless, the 

agencies believe that a significant amount of the proposed disclosure requirements are 

already required by or consistent with existing GAAP, SEC disclosure requirements, or 

regulatory reporting requirements for banks. 

2. General requirements

The public disclosure requirements would apply to the top-tier legal entity that is 

a core or opt-in bank within a consolidated banking group (that is, the top-tier BHC or DI 

that is a core or opt-in bank). In general, DIs that are a subsidiary of a BHC or another 

DI would not be subject to the disclosure requirements81 except that every DI must 

disclose total and tier 1 capital ratios and their components, similar to current 

requirements. If a DI is not a subsidiary of a BHC or another DI that must make the full 

set of disclosures, the DI must make these disclosures. 

The risks to which a bank is exposed and the techniques that it uses to identify, 

measure, monitor, and control those risks are important factors that market participants 

consider in their assessment of the institution. Accordingly, each bank that is subject to 

the disclosure requirements must have a formal disclosure policy approved by the board 

of directors that addresses the institution’s approach for determining the disclosures it 

should make. The policy should address the associated internal controls and disclosure 

controls and procedures. The board of directors and senior management would be 

expected to ensure that appropriate verification of the disclosures takes place and that 

effective internal controls and disclosure controls and procedures are maintained. 

 

81 The bank regulatory reports and Thrift Financial Reports will be revised to collect some additional Basel 

II-related information, as described below in the regulatory reporting section. 
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A bank should decide which disclosures are relevant for it based on the 

materiality concept. Information would be regarded as material if its omission or 

misstatement could change or influence the assessment or decision of a user relying on 

that information for the purpose of making investment decisions. 

To the extent applicable, a bank would be able to fulfill its disclosure 

requirements under this proposed rule by relying on disclosures made in accordance with 

accounting standards or SEC mandates that are very similar to the disclosure 

requirements in this proposed rule. In these situations, a bank would explain material 

differences between the accounting or other disclosure and the disclosures required under 

this proposed rule. 

Frequency/timeliness

Consistent with longstanding requirements in the United States for robust 

quarterly disclosures in financial and regulatory reports, and considering the potential for 

rapid changes in risk profiles, the agencies would require that quantitative disclosures be 

made quarterly. However, qualitative disclosures that provide a general summary of a 

bank’s risk management objectives and policies, reporting system, and definitions may be 

disclosed annually, provided any significant changes to these are disclosed in the interim. 

The disclosures must be timely, that is, must be made no later than the reporting 

deadlines for regulatory reports (for example, FR Y-9C) and financial reports (for 

example, SEC Forms 10-Q and 10-K). When these deadlines differ, the later deadline 

would be used. 

In some cases, management may determine that a significant change has occurred, 

such that the most recent reported amounts do not reflect the bank’s capital adequacy and 
 Draft Basel II NPR 

321

risk profile. In those cases, banks should disclose the general nature of these changes and 

briefly describe how they are likely to affect public disclosures going forward. These 

interim disclosures should be made as soon as practicable after the determination that a 

significant change has occurred. 

Location of disclosures and audit/certification requirements

The disclosures would have to be publicly available (for example, included on a 

public website) for each of the last three years (that is, twelve quarters) or such shorter 

time period since the bank entered its first floor period. Except as discussed below, 

management would have some discretion to determine the appropriate medium and 

location of the disclosures required by this proposed rule. Furthermore, banks would 

have flexibility in formatting their public disclosures, that is, the agencies are not 

specifying a fixed format for these disclosures. 

Management would be encouraged to provide all of the required disclosures in 

one place on the entity’s public website. The public website address would be reported in 

a regulatory report (for example, the FR Y-9C).82 

Disclosure of tier 1 and total capital ratios must be provided in the footnotes to the 

year-end audited financial statements.83 Accordingly, these disclosures must be tested by 

external auditors as part of the financial statement audit. Disclosures that are not 

included in the footnotes to the audited financial statements would not be required to be 

 

82 Alternatively, banks would be permitted to provide the disclosures in more than one place, as some of 

them may be included in public financial reports (for example, in Management’s Discussion and Analysis 

included in SEC filings) or other regulatory reports (for example, FR Y-9C Reports). The agencies would 

require such banks to provide a summary table on their public website that specifically indicates where all 

the disclosures may be found (for example, regulatory report schedules, pages numbers in annual reports). 

83 These ratios are required to be disclosed in the footnotes to the audited financial statements pursuant to 

existing GAAP requirements in Chapter 17 of the “AICPA Audit and Accounting Guide for Depository and 

Lending Institutions: Banks, Savings institutions, Credit unions, Finance companies and Mortgage 

companies.”
 Draft Basel II NPR 

322

subject to external audit reports for financial statements or internal control reports from 

management and the external auditor. However, due to the importance of reliable 

disclosures, the agencies would require the chief financial officer to certify that the 

disclosures required by the proposed rule are appropriate and that the board of directors 

and senior management are responsible for establishing and maintaining an effective 

internal control structure over financial reporting, including the information required by 

this proposed rule. 

Proprietary and confidential information

The agencies believe that the proposed requirements strike an appropriate balance 

between the need for meaningful disclosure and the protection of proprietary and 

confidential information.84 Accordingly, the agencies believe that banks would be able to 

provide all of these disclosures without revealing proprietary and confidential 

information. However, in rare cases, disclosure of certain items of information required 

in the proposed rule may prejudice seriously the position of a bank by making public 

information that is either proprietary or confidential in nature. In such cases, a reporting 

bank may request confidential treatment for the information if the bank believes that 

disclosure of specific commercial or financial information in the report would likely 

result in substantial harm to its competitive position, or that disclosure of the submitted 

information would result in unwarranted invasion of personal privacy. 

 Question 60: The agencies seek commenters’ views on all of the elements 

proposed to be captured through the public disclosure requirements. In particular, the 

 

84 Proprietary information encompasses information that, if shared with competitors, would render a bank’s 

investment in these products/systems less valuable, and, hence, could undermine its competitive position. 

Information about customers is often confidential, in that it is provided under the terms of a legal 

agreement or counterparty relationship. 
 Draft Basel II NPR 

323

agencies seek comment on the extent to which the proposed disclosures balance 

providing market participants with sufficient information to appropriately assess the 

capital strength of individual institutions, fostering comparability from bank to bank, and 

reducing burden on the banks that are reporting the information. 

3. Summary of specific public disclosure requirements

The public disclosure requirements are comprised of 11 tables that provide 

important information to market participants on the scope of application, capital, risk 

exposures, risk assessment processes, and, hence, the capital adequacy of the institution. 

Again, the agencies note that the substantive content of the tables is the focus of the 

disclosure requirements, not the tables themselves. The table numbers below refer to the 

table numbers in the proposed rule. 

Table 11.1 disclosures, Scope of Application, include a description of the level in 

the organization to which the disclosures apply and an outline of any differences in 

consolidation for accounting and regulatory capital purposes, as well as a description of 

any restrictions on the transfer of funds and capital within the organization. These 

disclosures provide the basic context underlying regulatory capital calculations. 

 Table 11.2 disclosures, Capital Structure, provide information on various 

components of regulatory capital available to absorb losses and allow for an evaluation of 

the quality of the capital available to absorb losses within the bank. 

Table 11.3 disclosures, Capital Adequacy, provide information about how a bank 

assesses the adequacy of its capital and require that the bank disclose its minimum capital 

requirements for significant risk areas and portfolios. The table also requires disclosure 

of the regulatory capital ratios of the consolidated group and each DI subsidiary. Such 
 Draft Basel II NPR 

324

disclosures provide insight into the overall adequacy of capital based on the risk profile 

of the organization. 

Tables 11.4, 11.5, and 11.7 disclosures, Credit Risk, provide market participants 

with insight into different types and concentrations of credit risk to which the bank is 

exposed and the techniques the bank uses to measure, monitor, and mitigate those risks. 

These disclosures are intended to enable market participants to assess the credit risk 

exposures under the IRB framework, without revealing proprietary information or 

duplicating the supervisor’s fundamental review of the bank’s IRB framework. Table 

11.6 provides the disclosure requirements related to credit exposures from derivatives. 

This table was added as a supplement to the public disclosures initially in the New 

Accord as a result of the BCBS’s additional efforts to address certain exposures arising 

from trading activities. See the July 2005 BCBS publication entitled “The Application of 

Basel II to Trading Activities and the Treatment of Double Default Effects.” 

Table 11.8 disclosures, Securitization, provide information to market participants 

on the amount of credit risk transferred and retained by the organization through 

securitization transactions and the types of products securitized by the organization. 

These disclosures provide users a better understanding of how securitization transactions 

impact the credit risk of the bank. 

Table 11.9 disclosures, Operational Risk, provide insight into the bank’s 

application of the AMA for operational risk and what internal and external factors are 

considered in determining the amount of capital allocated to operational risk. 

Table 11.10 disclosures, Equities, provide market participants with an 

understanding of the types of equity securities held by the bank and how they are valued. 
 Draft Basel II NPR 

325

The table also provides information on the capital allocated to different equity products 

and the amount of unrealized gains and losses. 

Table 11.11 disclosures, Interest Rate Risk in Non-Trading Activities, provide 

information about the potential risk of loss that may result from changes in interest rates 

and how the bank measures such risk. 

4. Regulatory reporting

In addition to the public disclosures that would be required by the consolidated 

banking organization subject to the advanced approaches, the agencies would require 

certain additional regulatory reporting from BHCs, their subsidiary DIs, and DIs applying 

the advanced approaches that are not subsidiaries of BHCs. The agencies believe that the 

reporting of key risk parameter estimates by each DI applying the advanced approaches 

will provide the primary Federal supervisor and other relevant supervisors with data 

important for assessing the reasonableness and accuracy of the institution’s calculation of 

its minimum capital requirements under this rule and the adequacy of the institution’s 

capital in relation to its risks. This information would be collected through regulatory 

reports. The agencies believe that requiring certain common reporting across banks will 

facilitate comparable application of the proposed rules. 

In this regard, the agencies published for comment in today’s Federal Register a 

package of proposed reporting schedules (see XX FR XXXX). The package includes a 

summary schedule with aggregate data that would be available to the general public. It 

also includes supporting schedules that would be viewed as confidential supervisory 

information. These schedules are broken out by exposure category and would collect risk 

parameter and other pertinent data in a systematic manner. The agencies also are 
 Draft Basel II NPR 

326

exploring ways to obtain information that would improve supervisors’ understanding of 

the causes behind changes in risk-based capital requirements. For example, certain data 

would help explain whether movements are attributable to changes in key risk parameters 

or other factors. Under the proposed rule, banks would begin reporting this information 

during their parallel run on a confidential basis. The agencies will share this information 

with each other for calibration and other analytical purposes. Question 61: Comments 

on regulatory reporting issues may be submitted in response to this NPR as well as 

through the regulatory reporting request for comment noted above.

List of Acronyms 

ABCP Asset Backed Commercial Paper 

ALLL Allowance for Loan and Lease Losses 

AMA Advanced Measurement Approaches 

ANPR Advance Notice of Proposed Rulemaking 

AVC Asset Value Correlation 

BCBS Basel Committee on Banking Supervision 

BHC Bank Holding Company 

CCF Credit Conversion Factor 

CEIO Credit-Enhancing Interest-Only 

CDC Community Development Corporation 

CRM Credit Risk Mitigation 

DI Depository Institution 

DvP Delivery versus Payment 
 Draft Basel II NPR 

327

E Measure of Effectiveness 

EAD Exposure at Default 

ECL Expected Credit Loss 

EL Expected Loss 

ELGD Expected Loss Given Default 

EMRC Effective Minimum Risk-Based Capital 

EOL Expected Operational Loss 

FDIC Federal Deposit Insurance Corporation 

FFIEC Federal Financial Institutions Examination Council 

FMI Future Margin Income 

GAAP Generally Accepted Accounting Principles 

HELOC Home Equity Line of Credit 

HOLA Home Owners’ Loan Act 

HVCRE High-Volatility Commercial Real Estate 

IAA Internal Assessment Approach 

IMA Internal Models Approach 

IRB Internal Ratings Based 

KIRB Capital Requirement for Underlying Pool of Exposures (securitizations) 

LGD Loss Given Default 

LTV Loan-to-Value Ratio 

M Effective Maturity 

MRA Market Risk Amendment 

MRC Minimum Risk-Based Capital 
 Draft Basel II NPR 

328

OCC Office of the Comptroller of the Currency 

OTC Over-the-Counter 

OTS Office of Thrift Supervision 

PCA Prompt Corrective Action 

PD Probability of Default 

PFE Potential Future Exposure 

PvP Payment versus Payment 

QIS-3 Quantitative Impact Study 3 

QIS-4 Quantitative Impact Study 4 

QIS-5 Quantitative Impact Study 5 

QRE Qualifying Revolving Exposure 

RBA Ratings-Based Approach 

SFA Supervisory Formula Approach 

SME Small and Medium-Size Enterprise 

SPE Special Purpose Entity 

SRWA Simple Risk-Weight Approach 

UL Unexpected Loss 

UOL Unexpected Operational Loss 

VaR Value-at-Risk 

Regulatory Flexibility Act Analysis 

The Regulatory Flexibility Act (RFA) requires an agency that is issuing a 

proposed rule to prepare and make available for public comment an initial regulatory 
 Draft Basel II NPR 

329

flexibility analysis that describes the impact of the proposed rule on small entities. 5 

U.S.C. 603(a). The RFA provides that an agency is not required to prepare and publish 

an initial regulatory flexibility analysis if the agency certifies that the proposed rule will 

not, if promulgated, have a significant economic impact on a substantial number of small 

entities. 5 U.S.C. 605(b). 

Pursuant to section 605(b) of the RFA (5 U.S.C. 605(b)), the agencies certify that 

this proposed rule will not, if promulgated in final form, have a significant economic 

impact on a substantial number of small entities. Pursuant to regulations issued by the 

Small Business Administration (13 CFR 121.201), a “small entity” includes a bank 

holding company, commercial bank, or savings association with assets of $165 million or 

less (collectively, small banking organizations). The proposed rule would require a bank 

holding company, national bank, state member bank, state non-member bank, or savings 

association to calculate its risk-based capital requirements according to certain internalratings-based and internal model approaches if the bank holding company, bank, or 

savings association (i) has consolidated total assets (as reported on its most recent yearend regulatory report) equal to $250 billion or more; (ii) has consolidated total onbalance sheet foreign exposures at the most recent year-end equal to $10 billion or more; 

or (iii) is a subsidiary of a bank holding company, bank, or savings association that would 

be required to use the proposed rule to calculate its risk-based capital requirements. 

The agencies estimate that zero small bank holding companies (out of a total of 

approximately 2,934 small bank holding companies), five small national banks (out of a 

total of approximately 1,090 small national banks), one small state member bank (out of a 

total of approximately 491 small state member banks), one small state non-member bank 
 Draft Basel II NPR 

330

(out of a total of approximately 3,249 small state non-member banks), and zero small 

savings associations (out of a total of approximately 446 small savings associations) 

would be subject to the proposed risk-based capital requirements on a mandatory basis. 

In addition, each of the small banking organizations subject to the proposed rule on a 

mandatory basis would be a subsidiary of a bank holding company with over $250 billion 

in consolidated total assets or over $10 billion in consolidated total on-balance sheet 

foreign exposure. Therefore, the agencies believe that the proposed rule will not, if 

promulgated in final form, result in a significant economic impact on a substantial 

number of small entities. 

Paperwork Reduction Act

A. Request for Comment on Proposed Information Collection

 In accordance with the requirements of the Paperwork Reduction Act of 1995, the 

agencies may not conduct or sponsor, and the respondent is not required to respond to, an 

information collection unless it displays a currently valid Office of Management and 

Budget (OMB) control number. The agencies are requesting comment on a proposed 

information collection. The agencies are also giving notice that the proposed collection 

of information has been submitted to OMB for review and approval. 

 Comments are invited on: 

 (a) Whether the collection of information is necessary for the proper performance 

of the agencies’ functions, including whether the information has practical utility; 

 (b) The accuracy of the estimates of the burden of the information collection, 

including the validity of the methodology and assumptions used; 

 (c) Ways to enhance the quality, utility, and clarity of the information to be 
 Draft Basel II NPR 

331

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 _______, 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. 
 Draft Basel II NPR 

332

• 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, except as 

necessary 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-____, by 

any of the following methods: 

• Agency Web Site: http://www.fdic.gov/regulations/laws/federal/propose.html. 

Follow the instructions for submitting comments on the FDIC Web site. 

• Federal eRulemaking Portal: http://www.regulations.gov. Follow the instructions 

for submitting comments. 

• E-mail: Comments@FDIC.gov. 

• Mail: Robert E. Feldman, Executive Secretary, Attention: Comments, FDIC, 550 

17th Street, NW, Washington, DC 20429. 

• Hand Delivery/Courier: Guard station at the rear of the 550 17th Street Building 

(located on F Street) on business days between 7 a.m. and 5 p.m. 

Public Inspection: All comments received will be posted without change to 

http://www.fdic.gov/regulations/laws/federal/propose/html including any personal 

information provided. Comments may be inspected at the FDIC Public Information 
 Draft Basel II NPR 

333

Center, Room 100, 801 17th Street, NW, Washington, DC, between 9 a.m. and 4:30 p.m. 

on business days. 

A copy of the comments may also be submitted to the OMB desk officer for the 

agencies: By mail to U.S. Office of Management and Budget, 725 17th Street, NW, 

#10235, Washington, DC 20503 or by facsimile to 202-395-6974, Attention: Federal 

Banking Agency Desk Officer. 

 OTS: Information Collection Comments, Chief Counsel's Office, Office of Thrift 

Supervision, 1700 G Street, NW, Washington, DC 20552; send a facsimile transmission 

to (202) 906-6518; or send an e-mail to infocollection.comments@ots.treas.gov. OTS 

will post comments and the related index on the OTS Internet site at 

http://www.ots.treas.gov. In addition, interested persons may inspect the comments at the 

Public Reading Room, 1700 G Street, NW, by appointment. To make an appointment, 

call (202) 906-5922, send an e-mail to public.info@ots.treas.gov, or send a facsimile 

transmission to (202) 906-7755. 

B. Proposed Information Collection 

Title of Information Collection: Risk-Based Capital Standards: Advanced Capital 

Adequacy Framework 

Frequency of Response: event-generated 

Affected Public: 

OCC: National banks and Federal branches and agencies of foreign banks. 

Board: State member banks, bank holding companies, affiliates and certain nonbank subsidiaries of bank holding companies, uninsured state agencies and branches of 
 Draft Basel II NPR 

334

foreign banks, commercial lending companies owned or controlled by foreign banks, and 

Edge and agreement corporations. 

FDIC: Insured 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 proposed rule sets forth a new risk-based capital adequacy framework that 

would require some banks and allow other qualifying banks to use an internal ratingsbased approach to calculate regulatory credit risk capital requirements and advanced 

measurement approaches to calculate regulatory operational risk capital requirements. 

 The information collection requirements in the proposed rule are found in sections 

21-23, 42, 44, 53, and 71. The collections of information are necessary in order to 

implement the proposed advanced capital adequacy framework. 

 Sections 21 and 22 require that a bank adopt a written implementation plan that 

addresses how it will comply with the proposed advanced capital adequacy framework’s 

qualification requirements, including incorporation of a comprehensive and sound 

planning and governance process to oversee the implementation efforts. The bank must 

also develop processes for assessing capital adequacy in relation to an organization’s risk 

profile. It must establish and maintain internal risk rating and segmentation systems for 

wholesale and retail risk exposures, including comprehensive risk parameter 

quantification processes and processes for annual reviews and analyses of reference data 

to determine their relevance. It must document its process for identifying, measuring, 

monitoring, controlling, and internally reporting operational risk; verify the accurate and 
 Draft Basel II NPR 

335

timely reporting of risk-based capital requirements; and monitor, validate, and refine its 

advanced systems. 

 Section 23 requires a bank to notify its primary Federal supervisor when it makes 

a material change to its advanced systems and to develop an implementation plan after 

any mergers. 

 Section 42 outlines the capital treatment for securitization exposures. A bank 

must disclose publicly that it has provided implicit support to the securitization and the 

regulatory capital impact to the bank of providing such implicit support. 

 Section 44 describes the IAA. A bank must receive prior written approval from 

its primary Federal supervisor before it can use the IAA. A bank must review and update 

each internal credit assessment whenever new material is available, but at least annually. 

It must validate its internal credit assessment process on an ongoing basis and at least 

annually. 

 Section 53 outlines the IMA. A bank must receive prior written approval from its 

primary Federal supervisor before it can use the IMA. 

 Section 71 specifies that each consolidated bank must publicly disclose its total 

and tier 1 risk-based capital ratios and their components. 

Estimated Burden: The burden estimates below exclude the following: (1) any burden 

associated with changes to the regulatory reports of the agencies (such as the 

Consolidated Reports of Income and Condition for banks (FFIEC 031 and FFIEC 031; 

OMB Nos. 7100-0036, 3064-0052, 1557-0081) and the Thrift Financial Report for thrifts 

(TFR; OMB No. 1550-0023); (2) any burden associated with capital changes in the Basel 

II market risk rule; and (3) any burden associated with the Quantitative Impact Study 
 Draft Basel II NPR 

336

(QIS-4 survey, FR 3045; OMB No. 7100-0303). The agencies are concurrently 

publishing notices, which will address burden associated with the first item (XX FR 

XXXX), and jointly publishing a rulemaking which will address burden associated with 

the second item. For the third item, the Federal Reserve previously took burden for the 

QIS-4 survey, and some institutions may leverage the requirements of the QIS-4 survey 

to fulfill the requirements of this rule. 

The burden associated with this collection of information may be summarized as 

follows: 

OCC

Number of Respondents: 52 

Estimated Burden Per Respondent: 15,570 hours 

Total Estimated Annual Burden: 809,640 hours 

Board

Number of Respondents: 15 

Estimated Burden Per Respondent: 14,422 hours 

Total Estimated Annual Burden: 216,330 hours 

FDIC

Number of Respondents: 

Estimated Burden Per Respondent: 

Total Estimated Annual Burden: 

OTS

Number of Respondents: 4 

Estimated Burden Per Respondent: 15,000 hours 
 Draft Basel II NPR 

337

Total Estimated Annual Burden: 60,000 hours 

Plain Language 

 Section 722 of the GLB Act requires the agencies to use "plain language" in all 

proposed and final rules published after January 1, 2000. In light of this requirement, the 

agencies have sought to present the proposed rule in a simple and straightforward 

manner. The agencies invite comments on whether there are additional steps the agencies 

could take to make the proposed rule easier to understand.

OCC/OTS Executive Order 12866 

OCC/OTS Unfunded Mandates Reform Act of 1995 Determination 

List of Subjects 

12 CFR Part 3 

 Administrative practices and procedure, Capital, National banks, Reporting and 

recordkeeping requirements, Risk. 

12 CFR Part 208 

 Administrative practice and procedure, 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 
 Draft Basel II NPR 

338

 Administrative practice and procedure, Banks, banking, Capital Adequacy, 

Reporting and recordkeeping requirements, Savings associations, State non-member 

banks. 

12 CFR Part 567 

 Capital, reporting and recordkeeping requirements, Savings associations. 

Authority and Issuance 

1. In part [X], a new appendix [F] is added to read as follows: 

Appendix [F] to Part [X] – Capital Adequacy Guidelines for [CHARTER TYPE] 

Banks:1

 Internal-Ratings-Based and Advanced Measurement Approaches 

Part I General Provisions 

Section 1 Purpose, Applicability, and Reservation of Authority 

Section 2 Definitions 

Section 3 Minimum Risk-Based Capital Requirements 

Part II Qualifying Capital 

Section 11 Additional Deductions 

Section 12 Deductions and Limitations Not Required 

Section 13 Eligible Credit Reserves 

Part III Qualification 

Section 21 Qualification Process 

Section 22 Qualification Requirements 

Section 23 Ongoing Qualification 

Part IV Risk-Weighted Assets for General Credit Risk 

Section 31 Mechanics for Calculating Total Wholesale and Retail RiskWeighted Assets 

Section 32 Counterparty Credit Risk 

Section 33 Guarantees and Credit Derivatives: PD Substitution and LGD 

Adjustment Treatments 

 

1

 For simplicity, and unless otherwise noted, this NPR uses the term “bank” to include banks, savings 

associations, and bank holding companies. [AGENCY] refers to the primary Federal supervisor of the 

bank applying the rule. 
 Draft Basel II NPR 

339

Section 34 Guarantees and Credit Derivatives: Double Default Treatment 

Section 35 Risk-Based Capital Requirement for Unsettled Transactions 

Part V Risk-Weighted Assets for Securitization Exposures 

Section 41 Operational Criteria for Recognizing the Transfer of Risk 

Section 42 Risk-Based Capital Requirement for Securitization Exposures 

Section 43 Ratings-Based Approach (RBA) 

Section 44 Internal Assessment Approach (IAA) 

Section 45 Supervisory Formula Approach (SFA) 

Section 46 Recognition of Credit Risk Mitigants for Securitization Exposures 

Section 47 Risk-Based Capital Requirement for Early Amortization 

Provisions 

Part VI Risk-Weighted Assets for Equity Exposures 

Section 51 Introduction and Exposure Measurement 

Section 52 Simple Risk Weight Approach (SRWA) 

Section 53 Internal Models Approach (IMA) 

Section 54 Equity Exposures to Investment Funds 

Section 55 Equity Derivative Contracts 

Part VII Risk-Weighted Assets for Operational Risk 

Section 61 Qualification Requirements for Incorporation of Operational Risk 

Mitigants 

Section 62 Mechanics of Risk-Weighted Asset Calculation 

Part VIII Disclosure 

Section 71 Disclosure Requirements

Part I. General Provisions 

Section 1. Purpose, Applicability, and Reservation of Authority 

(a) Purpose. This appendix establishes: 

(1) Minimum qualifying criteria for banks using bank-specific internal risk 

measurement and management processes for calculating risk-based capital requirements; 

(2) Methodologies for such banks to calculate their risk-based capital 

requirements; and 

(3) Public disclosure requirements for such banks. 

(b) Applicability. (1) This appendix applies to a bank that: 
 Draft Basel II NPR 

340

(i) Has consolidated total assets, as reported on the most recent year-end 

Consolidated Report of Condition and Income (Call Report) or Thrift Financial Report 

(TFR), equal to $250 billion or more;2

(ii) Has consolidated total on-balance sheet foreign exposure at the most recent 

year-end equal to $10 billion or more (where total on-balance sheet foreign exposure 

equals total cross-border claims less claims with head office or guarantor located in 

another country plus redistributed guaranteed amounts to the country of head office or 

guarantor plus local country claims on local residents plus revaluation gains on foreign 

exchange and derivative products, calculated in accordance with the Federal Financial 

Institutions Examination Council (FFIEC) 009 Country Exposure Report); 

(iii) Is a subsidiary of a depository institution that uses [OCC/Fed/FDIC/OTS 

advanced approaches capital rule] to calculate its risk-based capital requirements;3

 or 

(iv) Is a subsidiary of a bank holding company (as defined in 12 U.S.C. 1841) that 

uses [bank holding company advanced approaches capital rule] to calculate its risk-based 

capital requirements. 

(2) Any bank may elect to use this appendix to calculate its risk-based capital 

requirements. 

(3) A bank that is subject to this appendix must use this appendix unless the 

[AGENCY] determines in writing that application of this appendix is not appropriate in 

light of the bank’s asset size, level of complexity, risk profile, or scope of operations. In 

 

2

 [Bank holding company rule would replace this paragraph with: “Is a U.S.-based bank holding company 

that has total consolidated assets (excluding assets held by an insurance underwriting subsidiary), as 

reported on the most recent year-end FR Y-9C, equal to $250 billion or more;”.] 3

 [Bank holding company rule would replace this paragraph with: “Has a subsidiary depository institution 

(as defined in 12 U.S.C. 1813) that is required, or has elected, to use [OCC/Fed/FDIC/OTS advanced 

approaches capital rule] to calculate its risk-based capital requirements;”.] 
 Draft Basel II NPR 

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making a determination under this paragraph, the [AGENCY] will apply notice and 

response procedures in the same manner and to the same extent as the notice and 

response procedures in [12 CFR 3.12; 12 CFR 263.202; 12 CFR 325.6(c); 12 CFR 

567.3(d)]. 

(c) Reservation of authority - (1) Additional capital in the aggregate. The 

[AGENCY] may require a bank to hold an amount of capital greater than otherwise 

required under this appendix if the [AGENCY] determines that the bank’s risk-based 

capital requirement under this appendix is not commensurate with the bank’s credit, 

market, operational, or other risks. In making a determination under this paragraph, the 

[AGENCY] will apply notice and response procedures in the same manner and to the 

same extent as the notice and response procedures in [12 CFR 3.12; 12 CFR 263.202; 12 

CFR 325.6(c), 12 CFR 567.3(d)]. 

(2) Specific risk-weighted asset amounts. (i) If the [AGENCY] determines that 

the risk-weighted asset amount calculated under this appendix by the bank for one or 

more exposures is not commensurate with the risks associated with those exposures, the 

[AGENCY] may require the bank to assign a different risk-weighted asset amount to the 

exposures, to assign different risk parameters to the exposures (if the exposures are 

wholesale or retail exposures), or to use different model assumptions for the exposures (if 

the exposures are equity exposures under the Internal Models Approach (IMA) or 

securitization exposures under the Internal Assessment Approach (IAA)), all as specified 

by the [AGENCY]. 

(ii) If the [AGENCY] determines that the risk-weighted asset amount for 

operational risk produced by the bank under this appendix is not commensurate with the 
 Draft Basel II NPR 

342

operational risks of the bank, the [AGENCY] may require the bank to assign a different 

risk-weighted asset amount for operational risk, to change elements of its operational risk 

analytical framework, including distributional and dependence assumptions, or to make 

other changes to the bank’s operational risk management processes, data and assessment 

systems, or quantification systems, all as specified by the [AGENCY]. 

(3) Other supervisory authority. Nothing in this appendix limits the authority of 

the [AGENCY] under any other provision of law or regulation to take supervisory or 

enforcement action, including action to address unsafe or unsound practices or 

conditions, deficient capital levels, or violations of law. 

Section 2. Definitions 

Advanced internal ratings-based (IRB) systems means a bank’s internal risk rating 

and segmentation system; risk parameter quantification system; data management and 

maintenance system; and control, oversight, and validation system for credit risk of 

wholesale and retail exposures. 

Advanced systems means a bank’s advanced IRB systems, operational risk 

management processes, operational risk data and assessment systems, operational risk 

quantification systems, and, to the extent the bank uses the following systems, the 

counterparty credit risk model, double default excessive correlation detection process, 

IMA for equity exposures, and IAA for securitization exposures to ABCP programs. 

Affiliate with respect to a company means any company that controls, is 

controlled by, or is under common control with, the company. For purposes of this 

definition, a person or company controls a company if it: 
 Draft Basel II NPR 

343

(1) Owns, controls, or holds with power to vote 25 percent or more of a class of 

voting securities of the company; or 

(2) Consolidates the company for financial reporting purposes. 

Applicable external rating means, with respect to an exposure, the lowest external 

rating assigned to the exposure by any NRSRO. 

Asset-backed commercial paper (ABCP) program means a program that primarily 

issues commercial paper that: 

(1) Has an external rating; and 

(2) Is backed by underlying exposures held in a bankruptcy-remote SPE. 

 Asset-backed commercial paper (ABCP) program sponsor means a bank that: 

 (1) Establishes an ABCP program; 

 (2) Approves the sellers permitted to participate in an ABCP program; 

 (3) Approves the exposures to be purchased by an ABCP program; or 

 (4) Administers the ABCP program by monitoring the underlying exposures, 

underwriting or otherwise arranging for the placement of debt or other obligations issued 

by the program, compiling monthly reports, or ensuring compliance with the program 

documents and with the program’s credit and investment policy. 

Backtesting means the comparison of a bank’s internal estimates with actual 

outcomes during a sample period not used in model development. In this context, 

backtesting is one form of out-of-sample testing. 

Benchmarking means the comparison of a bank’s internal estimates with relevant 

internal and external data sources or estimation techniques. 
 Draft Basel II NPR 

344

 Business environment and internal control factors means the indicators of a 

bank’s operational risk profile that reflect a current and forward-looking assessment of 

the bank’s underlying business risk factors and internal control environment. 

 Carrying value means, with respect to an asset, the value of the asset on the 

balance sheet of the bank, determined in accordance with GAAP. 

 Clean-up call means a contractual provision that permits a servicer to call 

securitization exposures before their stated maturity or call date. See also eligible cleanup call. 

 Commodity derivative contract means a commodity-linked swap, purchased 

commodity-linked option, forward commodity-linked contract, or any other instrument 

linked to commodities that gives rise to similar counterparty credit risks. 

 Company means a corporation, partnership, limited liability company, depository 

institution, business trust, special purpose entity, association, or similar organization. 

Credit derivative means a financial contract executed under standard industry 

credit derivative documentation that allows one party (the protection purchaser) to 

transfer the credit risk of one or more exposures (reference exposure) to another party 

(the protection provider). See also eligible credit derivative. 

 Credit-enhancing interest-only strip (CEIO) means an on-balance sheet asset that, 

in form or in substance: 

(1) Represents a contractual right to receive some or all of the interest and no 

more than a minimal amount of principal due on the underlying exposures of a 

securitization; and 
 Draft Basel II NPR 

345

(2) Exposes the holder to credit risk directly or indirectly associated with the 

underlying exposures that exceeds a pro rata share of the holder’s claim on the underlying 

exposures, whether through subordination provisions or other credit-enhancement 

techniques. 

 Credit-enhancing representations and warranties means representations and 

warranties that are made or assumed in connection with a transfer of underlying 

exposures (including loan servicing assets) and that obligate a bank to protect another 

party from losses arising from the credit risk of the underlying exposures. Creditenhancing representations and warranties include provisions to protect a party from 

losses resulting from the default or nonperformance of the obligors of the underlying 

exposures or from an insufficiency in the value of the collateral backing the underlying 

exposures. Credit-enhancing representations and warranties do not include: 

 (1) Early default clauses and similar warranties that permit the return of, or 

premium refund clauses that cover, first-lien residential mortgage exposures for a period 

not to exceed 120 days from the date of transfer, provided that the date of transfer is 

within one year of origination of the residential mortgage exposure; 

 (2) Premium refund clauses that cover underlying exposures guaranteed, in whole 

or in part, by the U.S. government, a U.S. government agency, or a U.S. government 

sponsored enterprise, provided that the clauses are for a period not to exceed 120 days 

from the date of transfer; or 

 (3) Warranties that permit the return of underlying exposures in instances of 

misrepresentation, fraud, or incomplete documentation. 

 Credit risk mitigant means collateral, a credit derivative, or a guarantee. 
 Draft Basel II NPR 

346

 Credit-risk-weighted assets means 1.06 multiplied by the sum of: 

(1) Total wholesale and retail risk-weighted assets; 

(2) Risk-weighted assets for securitization exposures; and 

(3) Risk-weighted assets for equity exposures. 

Current exposure means, with respect to a netting set, the larger of zero or the 

market value of a transaction or portfolio of transactions within the netting set that would 

be lost upon default of the counterparty, assuming no recovery on the value of the 

transactions. Current exposure is also called replacement cost. 

Default - (1) Retail. (i) A retail exposure of a bank is in default if: 

 (A) The exposure is 180 days past due, in the case of a residential mortgage 

exposure or revolving exposure; 

 (B) The exposure is 120 days past due, in the case of all other retail exposures; or 

(C) The bank has taken a full or partial charge-off or write-down of principal on 

the exposure for credit-related reasons. 

(ii) A retail exposure in default remains in default until the bank has reasonable 

assurance of repayment and performance for all contractual principal and interest 

payments on the exposure. 

(2) Wholesale. (i) A bank’s obligor is in default if, for any wholesale exposure of 

the bank to the obligor, the bank has: 

(A) Placed the exposure on non-accrual status consistent with the Call Report 

Instructions or the TFR and the TFR Instruction Manual; 

(B) Taken a full or partial charge-off or write-down on the exposure due to the 

distressed financial condition of the obligor; or 
 Draft Basel II NPR 

347

(C) Incurred a credit-related loss of 5 percent or more of the exposure’s initial 

carrying value in connection with the sale of the exposure or the transfer of the exposure 

to the held-for-sale, available-for-sale, trading account, or other reporting category. 

(ii) An obligor in default remains in default until the bank has reasonable 

assurance of repayment and performance for all contractual principal and interest 

payments on all exposures of the bank to the obligor (other than exposures that have been 

fully written-down or charged-off). 

Dependence means a measure of the association among operational losses across 

and within business lines and operational loss event types. 

Depository institution is defined in section 3 of the Federal Deposit Insurance Act 

(12 U.S.C. 1813). 

Derivative contract means a financial contract whose value is derived from the 

values of one or more underlying assets, reference rates, or indices of asset values or 

reference rates. Derivative contracts include interest rate derivative contracts, exchange 

rate derivative contracts, equity derivative contracts, commodity derivative contracts, 

credit derivatives, and any other instrument that poses similar counterparty credit risks. 

Derivative contracts also include unsettled securities, commodities, and foreign exchange 

transactions with a contractual settlement or delivery lag that is longer than the lesser of 

the market standard for the particular instrument or 5 business days. 

 Early amortization provision means a provision in the documentation governing a 

securitization that, when triggered, causes investors in the securitization exposures to be 

repaid before the original stated maturity of the securitization exposures, unless the 

provision is triggered solely by events not directly related to the performance of the 
 Draft Basel II NPR 

348

underlying exposures or the originating bank (such as material changes in tax laws or 

regulations). An early amortization provision is a controlled early amortization provision

if it meets all the following conditions: 

 (1) The originating bank has appropriate policies and procedures to ensure that it 

has sufficient capital and liquidity available in the event of an early amortization; 

 (2) Throughout the duration of the securitization (including the early amortization 

period), there is the same pro rata sharing of interest, principal, expenses, losses, fees, 

recoveries, and other cash flows from the underlying exposures based on the originating 

bank’s and the investors’ relative shares of the underlying exposures outstanding 

measured on a consistent monthly basis; 

 (3) The amortization period is sufficient for at least 90 percent of the total 

underlying exposures outstanding at the beginning of the early amortization period to be 

repaid or recognized as in default; and 

 (4) The schedule for repayment of investor principal is not more rapid than would 

be allowed by straight-line amortization over an 18-month period. 

Economic downturn conditions means, with respect to an exposure, those 

conditions in which the aggregate default rates for the exposure’s wholesale or retail 

exposure subcategory (or subdivision of such subcategory selected by the bank) in the 

exposure’s national jurisdiction (or subdivision of such jurisdiction selected by the bank) 

are significantly higher than average. 

 Effective maturity (M) of a wholesale exposure means: 

(1) For wholesale exposures other than repo-style transactions, eligible margin 

loans, and OTC derivative contracts subject to a qualifying master netting agreement: 
 Draft Basel II NPR 

349

(i) The weighted-average remaining maturity (measured in years, whole or 

fractional) of the expected contractual cash flows from the exposure, using the 

undiscounted amounts of the cash flows as weights; or 

(ii) The nominal remaining maturity (measured in years, whole or fractional) of 

the exposure. 

(2) For repo-style transactions, eligible margin loans, and OTC derivative 

contracts subject to a qualifying master netting agreement, the weighted-average 

remaining maturity (measured in years, whole or fractional) of the individual transactions 

subject to the qualifying master netting agreement, with the weight of each individual 

transaction set equal to the notional amount of the transaction. 

 Effective notional amount means, for an eligible guarantee or eligible credit 

derivative, the lesser of the contractual notional amount of the credit risk mitigant and the 

EAD of the hedged exposure, multiplied by the percentage coverage of the credit risk 

mitigant. For example, the effective notional amount of an eligible guarantee that covers, 

on a pro rata basis, 40 percent of any losses on a $100 bond would be $40. 

 Eligible clean-up call means a clean-up call that: 

 (1) Is exercisable solely at the discretion of the servicer; 

 (2) Is not structured to avoid allocating losses to securitization exposures held by 

investors or otherwise structured to provide credit enhancement to the securitization; and 

 (3) (i) For a traditional securitization, is only exercisable when 10 percent or less 

of the principal amount of the underlying exposures or securitization exposures 

(determined as of the inception of the securitization) is outstanding; or 
 Draft Basel II NPR 

350

 (ii) For a synthetic securitization, is only exercisable when 10 percent or less of 

the principal amount of the reference portfolio of underlying exposures (determined as of 

the inception of the securitization) is outstanding. 

 Eligible credit derivative means a credit derivative in the form of a credit default 

swap, nth-to-default swap, or total return swap provided that: 

 (1) The contract meets the requirements of an eligible guarantee and has been 

confirmed by the protection purchaser and the protection provider; 

 (2) Any assignment of the contract has been confirmed by all relevant parties; 

(3) If the credit derivative is a credit default swap or nth-to-default swap, the 

contract includes the following credit events: 

(i) Failure to pay any amount due under the terms of the reference exposure (with 

a grace period that is closely in line with the grace period of the reference exposure); and 

(ii) Bankruptcy, insolvency, or inability of the obligor on the reference exposure 

to pay its debts, or its failure or admission in writing of its inability generally to pay its 

debts as they become due, and similar events; 

(4) The terms and conditions dictating the manner in which the contract is to be 

settled are incorporated into the contract; 

(5) If the contract allows for cash settlement, the contract incorporates a robust 

valuation process to estimate loss reliably and specifies a reasonable period for obtaining 

post-credit event valuations of the reference exposure; 

(6) If the contract requires the protection purchaser to transfer an exposure to the 

protection provider at settlement, the terms of the exposure provide that any required 

consent to transfer may not be unreasonably withheld; 
 Draft Basel II NPR 

351

(7) If the credit derivative is a credit default swap or nth-to-default swap, the 

contract clearly identifies the parties responsible for determining whether a credit event 

has occurred, specifies that this determination is not the sole responsibility of the 

protection provider, and gives the protection purchaser the right to notify the protection 

provider of the occurrence of a credit event; and 

 (8) If the credit derivative is a total return swap and the bank records net 

payments received on the swap as net income, the bank records offsetting deterioration in 

the value of the hedged exposure (either through reductions in fair value or by an addition 

to reserves). 

 Eligible credit reserves means all general allowances that have been established 

through a charge against earnings to absorb credit losses associated with on- or offbalance sheet wholesale and retail exposures, including the allowance for loan and lease 

losses (ALLL) associated with such exposures but excluding allocated transfer risk 

reserves established pursuant to 12 U.S.C. 3904 and other specific reserves created 

against recognized losses. 

 Eligible double default guarantor, with respect to a guarantee or credit derivative 

obtained by a bank, means: 

(1) U.S.-based entities. A depository institution, a bank holding company (as 

defined in section 2 of the Bank Holding Company Act (12 U.S.C. 1841)), a savings and 

loan holding company (as defined in 12 U.S.C. 1467a) provided all or substantially all of 

the holding company’s activities are permissible for a financial holding company under 

12 U.S.C. 1843(k), a securities broker or dealer registered (under the Securities Exchange 

Act of 1934) with the SEC, an insurance company in the business of providing credit 
 Draft Basel II NPR 

352

protection (such as a monoline bond insurer or re-insurer) that is subject to supervision by 

a State insurance regulator, if: 

 (i) At the time the guarantor issued the guarantee or credit derivative, the bank 

assigned a PD to the guarantor’s rating grade that was equal to or lower than the PD 

associated with a long-term external rating in the third-highest investment grade rating 

category; and 

 (ii) The bank currently assigns a PD to the guarantor’s rating grade that is equal to 

or lower than the PD associated with a long-term external rating in the lowest investment 

grade rating category; or 

 (2) Non-U.S.-based entities. A foreign bank (as defined in section 211.2 of the 

Federal Reserve Board’s Regulation K (12 CFR 211.2)), a non-U.S. securities firm, or a 

non-U.S. based insurance company in the business of providing credit protection, if: 

 (i) The bank demonstrates that the guarantor is subject to consolidated supervision 

and regulation comparable to that imposed on U.S. banks, securities broker-dealers, or 

insurance companies (as the case may be) or has issued and outstanding an unsecured 

long-term debt security without credit enhancement that has a long-term applicable 

external rating in one of the three highest investment grade rating categories; 

 (ii) At the time the guarantor issued the guarantee or credit derivative, the bank 

assigned a PD to the guarantor’s rating grade that was equal to or lower than the PD 

associated with a long-term external rating in the third-highest investment grade rating 

category; and 
 Draft Basel II NPR 

353

 (iii) The bank currently assigns a PD to the guarantor’s rating grade that is equal 

to or lower than the PD associated with a long-term external rating in the lowest 

investment grade rating category. 

Eligible guarantee means a guarantee that: 

 (1) Is written and unconditional; 

(2) Covers all or a pro rata portion of all contractual payments of the obligor on 

the reference exposure; 

(3) Gives the beneficiary a direct claim against the protection provider; 

(4) Is non-cancelable by the protection provider for reasons other than the breach 

of the contract by the beneficiary; 

 (5) Is legally enforceable against the protection provider in a jurisdiction where 

the protection provider has sufficient assets against which a judgment may be attached 

and enforced; and 

(6) Requires the protection provider to make payment to the beneficiary on the 

occurrence of a default (as defined in the guarantee) of the obligor on the reference 

exposure without first requiring the beneficiary to demand payment from the obligor. 

 Eligible margin loan means an extension of credit where: 

(1) The extension of credit is collateralized exclusively by debt or equity 

securities that are liquid and readily marketable; 

(2) The collateral is marked to market daily, and the transaction is subject to daily 

margin maintenance requirements; 

(3) The extension of credit is conducted under an agreement that provides the 

bank the right to accelerate and terminate the extension of credit and to liquidate or set 
 Draft Basel II NPR 

354

off collateral promptly upon an event of default (including upon an event of bankruptcy, 

insolvency, or similar proceeding) of the counterparty, provided that, in any such case, 

any exercise of rights under the agreement will not be stayed or avoided under applicable 

law in the relevant jurisdictions;4

 and 

(4) The bank has conducted and documented sufficient legal review to conclude 

with a well-founded basis that the agreement meets the requirements of paragraph (3) of 

this definition and is legal, valid, binding, and enforceable under applicable law in the 

relevant jurisdictions. 

 Eligible operational risk offsets means amounts, not to exceed expected 

operational loss, that: 

(1) Are generated by internal business practices to absorb highly predictable and 

reasonably stable operational losses, including reserves calculated consistent with GAAP; 

and 

(2) Are available to cover expected operational losses with a high degree of 

certainty over a one-year horizon. 

Eligible purchased wholesale receivable means a purchased wholesale receivable 

that: 

(1) The bank purchased from an unaffiliated seller and did not directly or 

indirectly originate; 

 

4

 This requirement is met where all transactions under the agreement are (i) executed under U.S. law and 

(ii) constitute “securities contracts” or “repurchase agreements” under section 555 or 559, respectively, of 

the Bankruptcy Code (11 U.S.C. 555), qualified financial contracts under section 11(e)(8) of the Federal 

Deposit Insurance Act (12 U.S.C. 1821(e)(8)), or netting contracts between or among financial institutions 

under sections 401-407 of the Federal Deposit Insurance Corporation Improvement Act of 1991 (12 U.S.C. 

4401-4407) or the Federal Reserve Board’s Regulation EE (12 CFR part 231). 
 Draft Basel II NPR 

355

(2) Was generated on an arm’s-length basis between the seller and the obligor;5

(3) Provides the bank with a claim on all proceeds from the receivable or a prorata interest in the proceeds from the receivable; and 

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

 Eligible securitization guarantor means: 

 (1) A sovereign entity, the Bank for International Settlements, the International 

Monetary Fund, the European Central Bank, the European Commission, a Federal Home 

Loan Bank, Federal Agricultural Mortgage Corporation (Farmer Mac), a multi-lateral 

development bank, a depository institution, a bank holding company (as defined in 

section 2 of the Bank Holding Company Act (12 U.S.C. 1841)), a savings and loan 

holding company (as defined in 12 U.S.C. 1467a) provided all or substantially all of the 

holding company’s activities are permissible for a financial holding company under 12 

U.S.C. 1843(k), a foreign bank (as defined in section 211.2 of the Federal Reserve 

Board’s Regulation K (12 CFR 211.2)), or a securities firm; 

 (2) Any other entity (other than an SPE) that has issued and outstanding an 

unsecured long-term debt security without credit enhancement that has a long-term 

applicable external rating in one of the three highest investment grade rating categories; 

or 

 (3) Any other entity (other than an SPE) that has a PD assigned by the bank that is 

lower than or equal to the PD associated with a long-term external rating in the third 

highest investment grade rating category. 

 

5 Intercompany accounts receivable and receivables subject to contra-accounts between firms that buy and 

sell to each other do not satisfy this criterion.
 Draft Basel II NPR 

356

Eligible servicer cash advance facility means a servicer cash advance facility in 

which: 

 (1) The servicer is entitled to full reimbursement of advances, except that a 

servicer may be obligated to make non-reimbursable advances for a particular underlying 

exposure if any such advance is contractually limited to an insignificant amount of the 

outstanding principal balance of that exposure; 

 (2) The servicer’s right to reimbursement is senior in right of payment to all other 

claims on the cash flows from the underlying exposures of the securitization; and 

 (3) The servicer has no legal obligation to, and does not, make advances to the 

securitization if the servicer concludes the advances are unlikely to be repaid. 

 Equity derivative contract means an equity-linked swap, purchased equity-linked 

option, forward equity-linked contract, or any other instrument linked to equities that 

gives rise to similar counterparty credit risks. 

 Equity exposure means: 

(1) A security or instrument (whether voting or non-voting) that represents a 

direct or indirect ownership interest in, and a residual claim on, the assets and income of 

a company, unless: 

(i) The issuing company is consolidated with the bank under GAAP; 

(ii) The bank is required to deduct the ownership interest from tier 1 or tier 2 

capital under this appendix; 

(iii) The ownership interest is redeemable; 

(iv) The ownership interest incorporates a payment or other similar obligation on 

the part of the issuing company (such as an obligation to pay periodic interest); or 
 Draft Basel II NPR 

357

(v) The ownership interest is a securitization exposure; 

(2) A security or instrument that is mandatorily convertible into a security or 

instrument described in paragraph (1) of this definition; 

(3) An option or warrant that is exercisable for a security or instrument described 

in paragraph (1) of this definition; or 

(4) Any other security or instrument (other than a securitization exposure) to the 

extent the return on the security or instrument is based on the performance of a security 

or instrument described in paragraph (1) of this definition. 

 Excess spread for a period means: 

(1) Gross finance charge collections and other income received by a securitization 

SPE (including market interchange fees) over a period minus interest paid to the holders 

of the securitization exposures, servicing fees, charge-offs, and other senior trust or 

similar expenses of the SPE over the period; divided by 

(2) The principal balance of the underlying exposures at the end of the period. 

 Exchange rate derivative contract means a cross-currency interest rate swap, 

forward foreign-exchange contract, currency option purchased, or any other instrument 

linked to exchange rates that gives rise to similar counterparty credit risks. 

Excluded mortgage exposure means: 

(1) Any one-to-four family residential pre-sold construction loan or multifamily 

residential loan that would receive a 50 percent risk weight under section 618(a)(1) or 

(b)(1) of the Resolution Trust Corporation Refinancing, Restructuring, and Improvement 

Act of 1991 (RTCRRI Act) and the [general risk-based capital rules];6

 and 

 

6

 See 12 CFR part 3, Appendix A, section 3(a)(3)(iii) (national banks); 12 CFR part 208, Appendix A, 

section III.C.3. (state member banks); 12 CFR part 225, Appendix A, section III.C.3. (bank holding 
 Draft Basel II NPR 

358

(2) Any one-to-four family residential pre-sold construction loan for a residence 

for which the purchase contract is cancelled that would receive a 100 percent risk weight 

under section 618(a)(2) of the RTCRRI Act and the [general risk-based capital rules].7

 Expected credit loss (ECL) means, for a wholesale exposure to a non-defaulted 

obligor or segment of non-defaulted retail exposures, the product of PD times ELGD 

times EAD for the exposure or segment. ECL for a wholesale exposure to a defaulted 

obligor or segment of defaulted retail exposures is equal to the bank’s impairment 

estimate for allowance purposes for the exposure or segment. Total ECL is the sum of 

expected credit losses for all wholesale and retail exposures other than exposures for 

which the bank has applied the double default treatment in section 34. 

 Expected exposure (EE) means the expected value of the probability distribution 

of credit risk exposures to a counterparty at any specified future date before the maturity 

date of the longest term transaction in the netting set. 

Expected loss given default (ELGD) means: 

(1) For a wholesale exposure, the bank’s empirically based best estimate of the 

default-weighted average economic loss, per dollar of EAD, the bank expects to incur in 

the event that the obligor of the exposure (or a typical obligor in the loss severity grade 

assigned by the bank to the exposure) defaults within a one-year horizon over a mix of 

economic conditions, including economic downturn conditions. 

(2) For a segment of retail exposures, the bank’s empirically based best estimate 

of the default-weighted average economic loss, per dollar of EAD, the bank expects to 

 companies); 12 CFR part 325, Appendix A, section II.C.a. (state non-member banks); 12 CFR 

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

7

 See id. 
 Draft Basel II NPR 

359

incur on exposures in the segment that default within a one-year horizon over a mix of 

economic conditions (including economic downturn conditions). 

(3) The economic loss on an exposure in the event of default is all material creditrelated losses on the exposure (including accrued but unpaid interest or fees, losses on the 

sale of collateral, direct workout costs, and an appropriate allocation of indirect workout 

costs). Where positive or negative cash flows on a wholesale exposure to a defaulted 

obligor or a defaulted retail exposure (including proceeds from the sale of collateral, 

workout costs, and draw-downs of unused credit lines) occur after the date of default, the 

economic loss must reflect the net present value of cash flows as of the default date using 

a discount rate appropriate to the risk of the defaulted exposure. 

 Expected operational loss (EOL) means the expected value of the distribution of 

potential aggregate operational losses, as generated by the bank’s operational risk 

quantification system using a one-year horizon. 

 Expected positive exposure (EPE) means the weighted average over time of 

expected (non-zero) exposures to a counterparty where the weights are the proportion of 

the time interval that an individual expected exposure represents. When calculating the 

minimum capital requirement, the average is taken over a one-year horizon. 

 Exposure at default (EAD). 

(1) For the on-balance sheet component of a wholesale or retail exposure (other 

than an OTC derivative contract, repo-style transaction, or eligible margin loan), EAD 

means: 
 Draft Basel II NPR 

360

(i) If the exposure is held-to-maturity or for trading, the bank’s carrying value 

(including net accrued but unpaid interest and fees) for the exposure less any allocated 

transfer risk reserve for the exposure; or 

(ii) If the exposure is available-for-sale, the bank’s carrying value (including net 

accrued but unpaid interest and fees) for the exposure less any allocated transfer risk 

reserve for the exposure, less any unrealized gains on the exposure, and plus any 

unrealized losses on the exposure. 

(2) For the off-balance sheet component of a wholesale or retail exposure (other 

than an OTC derivative contract, repo-style transaction, or eligible margin loan) in the 

form of a loan commitment or line of credit, EAD means the bank’s best estimate of net 

additions to the outstanding amount owed the bank, including estimated future additional 

draws of principal and accrued but unpaid interest and fees, that are likely to occur over 

the remaining life of the exposure assuming the exposure were to go into default. This 

estimate of net additions must reflect what would be expected during economic downturn 

conditions. 

(3) For the off-balance sheet component of a wholesale or retail exposure (other 

than an OTC derivative contract, repo-style transaction, or eligible margin loan) in the 

form of anything other than a loan commitment or line of credit, EAD means the notional 

amount of the exposure. 

(4) EAD for a segment of retail exposures is the sum of the EADs for each 

individual exposure in the segment. 

(5) EAD for OTC derivative contracts, repo-style transactions, and eligible 

margin loans is calculated as described in section 32. 
 Draft Basel II NPR 

361

(6) For wholesale or retail exposures in which only the drawn balance has been 

securitized, the bank must reflect its share of the exposures’ undrawn balances in EAD. 

Undrawn balances of exposures for which the drawn balances have been securitized must 

be allocated between the seller’s and investors’ interests on a pro rata basis, based on the 

proportions of the seller’s and investors’ shares of the securitized drawn balances. 

 Exposure category means any of the wholesale, retail, securitization, or equity 

exposure categories. 

 External operational loss event data means, with respect to a bank, gross 

operational loss amounts, dates, recoveries, and relevant causal information for 

operational loss events occurring at organizations other than the bank. 

 External rating means a credit rating that is assigned by an NRSRO to an 

exposure, provided: 

 (1) The credit rating fully reflects the entire amount of credit risk with regard to 

all payments owed to the holder of the exposure. If a holder is owed principal and 

interest on an exposure, the credit rating must fully reflect the credit risk associated with 

timely repayment of principal and interest. If a holder is owed only principal on an 

exposure, the credit rating must fully reflect only the credit risk associated with timely 

repayment of principal; and 

(2) The credit rating is published in an accessible form and is or will be included 

in the transition matrices made publicly available by the NRSRO that summarize the 

historical performance of positions rated by the NRSRO. 

Financial collateral means collateral: 

(1) In the form of: 
 Draft Basel II NPR 

362

 (i) Cash on deposit with the bank (including cash held for the bank by a thirdparty custodian or trustee); 

 (ii) Gold bullion; 

 (iii) Long-term debt securities that have an applicable external rating of one 

category below investment grade or higher; 

 (iv) Short-term debt instruments that have an applicable external rating of at least 

investment grade; 

 (v) Equity securities that are publicly traded; 

(vi) Convertible bonds that are publicly traded; or 

(vii) Money market mutual fund shares and other mutual fund shares if a price for 

the shares is publicly quoted daily; and 

(2) In which the bank has a perfected, first priority security interest or the legal 

equivalent thereof. 

 GAAP means U.S. generally accepted accounting principles. 

 Gain-on-sale means an increase in the equity capital (as reported on Schedule RC 

of the Call Report or Schedule SC of the Thrift Financial Report) of a bank that results 

from a securitization (other than an increase in equity capital that results from the bank’s 

receipt of cash in connection with the securitization). 

 Guarantee means a financial guarantee, letter of credit, insurance, or other similar 

financial instrument (other than a credit derivative) that allows one party (beneficiary) to 

transfer the credit risk of one or more specific exposures (reference exposure) to another 

party (protection provider). See also eligible guarantee. 
 Draft Basel II NPR 

363

 High volatility commercial real estate (HVCRE) exposure means a credit facility 

that finances or has financed the acquisition, development, or construction (ADC) of real 

property, unless the facility finances: 

(1) One- to four-family residential properties; or 

(2) Commercial real estate projects in which: 

(i) The loan-to-value ratio is less than or equal to the applicable maximum 

supervisory loan-to-value ratio in the [AGENCY’s] real estate lending standards at 12 

CFR part 34, Subpart D (OCC); 12 CFR part 208, Appendix C (Board); 12 CFR part 365, 

Subpart D (FDIC); and 12 CFR 560.100-560.101 (OTS); 

(ii) The borrower has contributed capital to the project in the form of cash or 

unencumbered readily marketable assets (or has paid development expenses out-ofpocket) of at least 15 percent of the real estate’s appraised “as completed” value; and 

(iii) The borrower contributed the amount of capital required by paragraph (2)(ii) 

of this definition before the bank advances funds under the credit facility, and the capital 

contributed by the borrower, or internally generated by the project, is contractually 

required to remain in the project throughout the life8

 of the project. 

 Inferred rating. A securitization exposure has an inferred rating equal to the 

external rating referenced in paragraph (2)(i) of this definition if: 

 (1) The securitization exposure does not have an external rating; and 

 (2) Another securitization exposure issued by the same issuer and secured by the 

same underlying exposures: 

(i) Has an external rating; 

 

8 The life of a project concludes only when the credit facility is converted to permanent financing or is sold 

or paid in full. Permanent financing may be provided by the bank that provided the ADC facility as long as 

the permanent financing is subject to the bank’s underwriting criteria for long-term mortgage loans.
 Draft Basel II NPR 

364

 (ii) Is subordinated in all respects to the unrated securitization exposure; 

 (iii) Does not benefit from any credit enhancement that is not available to the 

unrated securitization exposure; and 

 (iv) Has an effective remaining maturity that is equal to or longer than that of the 

unrated securitization exposure. 

 Interest rate derivative contract means a single-currency interest rate swap, basis 

swap, forward rate agreement, purchased interest rate option, when-issued securities, or 

any other instrument linked to interest rates that gives rise to similar counterparty credit 

risks. 

Internal operational loss event data means, with respect to a bank, gross 

operational loss amounts, dates, recoveries, and relevant causal information for 

operational loss events occurring at the bank. 

 Investing bank means, with respect to a securitization, a bank that assumes the 

credit risk of a securitization exposure (other than an originating bank of the 

securitization). In the typical synthetic securitization, the investing bank sells credit 

protection on a pool of underlying exposures to the originating bank. 

 Investment fund means a company: 

(1) All or substantially all of the assets of which are financial assets; and 

(2) That has no material liabilities. 

Investors’ interest EAD means, with respect to a securitization, the EAD of the 

underlying exposures multiplied by the ratio of: 

(1) The total amount of securitization exposures issued by the SPE to investors; 

divided by 
 Draft Basel II NPR 

365

(2) The outstanding principal amount of underlying exposures. 

Loss given default (LGD) means: 

(1) For a wholesale exposure: 

(i) If the bank has received prior written approval from [AGENCY] to use internal 

estimates of LGD for the exposure’s wholesale exposure subcategory, the greater of: 

(A) The bank’s ELGD for the exposure (or for the typical exposure in the loss 

severity grade assigned by the bank to the exposure); or 

(B) The bank’s empirically based best estimate of the economic loss, per dollar of 

EAD, the bank would expect to incur if the obligor (or a typical obligor in the loss 

severity grade assigned by the bank to the exposure) were to default within a one-year 

horizon during economic downturn conditions. 

(ii) If the bank has not received such prior approval, 

(A) For an exposure that is not a repo-style transaction, eligible margin loan, or 

OTC derivative contract, the sum of: 

(1) 0.08; and 

(2) 0.92 multiplied by the bank’s ELGD for the exposure (or for the typical 

exposure in the loss severity grade assigned by the bank to the exposure); or 

(B) For an exposure that is a repo-style transaction, eligible margin loan, or OTC 

derivative contract, the bank’s ELGD for the exposure (or for the typical exposure in the 

loss severity grade assigned by the bank to the exposure). 

(2) For a segment of retail exposures: 

(i) If the bank has received prior written approval from [AGENCY] to use internal 

estimates of LGD for the segment’s retail exposure subcategory, the greater of: 
 Draft Basel II NPR 

366

(A) The bank’s ELGD for the segment of exposures; or 

(B) The bank’s empirically based best estimate of the economic loss, per dollar of 

EAD, the bank would expect to incur on exposures in the segment that default within a 

one-year horizon during economic downturn conditions. 

(ii) If the bank has not received such prior approval, 

(A) For a segment of exposures that are not eligible margin loans, the sum of: 

(1) 0.08; and 

(2) 0.92 multiplied by the bank’s ELGD for the segment of exposures; or 

(B) For a segment of exposures that are eligible margin loans, the bank’s ELGD 

for the segment of exposures. 

(3) In approving a bank’s use of internal estimates of LGD for a wholesale or 

retail exposure subcategory, [AGENCY] will consider whether: 

(A) The bank’s internal estimates of LGD are reliable and sufficiently reflective 

of economic downturn conditions; and 

(B) The bank has rigorous and well-documented policies and procedures for 

identifying economic downturn conditions for the exposure subcategory, identifying 

material adverse correlations between the relevant drivers of default rates and loss rates 

given default, and incorporating identified correlations into internal LGD estimates. 

(4) The economic loss on an exposure in the event of default is all material creditrelated losses on the exposure (including accrued but unpaid interest or fees, losses on the 

sale of collateral, direct workout costs, and an appropriate allocation of indirect workout 

costs). Where positive or negative cash flows on a wholesale exposure to a defaulted 

obligor or a defaulted retail exposure (including proceeds from the sale of collateral, 
 Draft Basel II NPR 

367

workout costs, and draw-downs of unused credit lines) occur after the date of default, the 

economic loss must reflect the net present value of cash flows as of the default date using 

a discount rate appropriate to the risk of the defaulted exposure. 

 Main index means the Standard & Poor’s 500 Index, the FTSE All-World Index, 

and any other index for which the bank can demonstrate to the satisfaction of [AGENCY] 

that the equities represented in the index have comparable liquidity, depth of market, and 

size of bid-ask spreads as equities in the Standard & Poor’s 500 Index and FTSE AllWorld Index. 

 Multi-lateral development bank means any multi-lateral lending institution or 

regional development bank in which the U.S. government is a shareholder or contributing 

member. 

 Nationally recognized statistical rating organization (NRSRO) means an entity 

recognized by the Division of Market Regulation (or any successor division) of the SEC 

as a nationally recognized statistical rating organization for various purposes, including 

the SEC’s net capital requirements for securities broker-dealers. 

 Netting set means a group of transactions with a single counterparty that are 

subject to a qualifying master netting agreement or qualifying cross-product master 

netting agreement. Each transaction that is not subject to such a master netting 

agreement is its own netting set. 

 Nth-to-default credit derivative means a credit derivative that provides credit 

protection only for the nth-defaulting reference exposure in a group of reference 

exposures. 
 Draft Basel II NPR 

368

 Operational loss means a loss (excluding insurance or tax effects) resulting from 

an operational loss event. Operational loss includes all expenses associated with an 

operational loss event except for opportunity costs, forgone revenue, and costs related to 

risk management and control enhancements implemented to prevent future operational 

losses. 

Operational loss event means an event that results in loss and is associated with 

internal fraud; external fraud;9

 employment practices and workplace safety; clients, 

products, and business practices; damage to physical assets; business disruption and 

system failures; or execution, delivery, and process management. 

 Operational risk means the risk of loss resulting from inadequate or failed internal 

processes, people, and systems or from external events (including legal risk but excluding 

strategic and reputational risk). 

 Operational risk exposure means the 99.9th percentile of the distribution of 

potential aggregate operational losses, as generated by the bank’s operational risk 

quantification system over a one-year horizon (and not incorporating eligible operational 

risk offsets or qualifying operational risk mitigants). 

 Originating bank, with respect to a securitization, means a bank that: 

 (1) Directly or indirectly originated or securitized the underlying exposures 

included in the securitization; or 

(2) Serves as an ABCP program sponsor to the securitization. 

 Other retail exposure means an exposure (other than a securitization exposure, an 

equity exposure, a residential mortgage exposure, an excluded mortgage exposure, a 

 

9

 Retail credit card losses arising from non-contractual, third-party initiated fraud (for example, identity 

theft) are external fraud operational losses. All other third-party initiated credit losses are to be treated as 

credit risk losses. 
 Draft Basel II NPR 

369

qualifying revolving exposure, or the residual value portion of a lease exposure) that is 

managed as part of a segment of exposures with homogeneous risk characteristics, not on 

an individual-exposure basis, and is either: 

(1) An exposure to an individual for non-business purposes; or 

 (2) An exposure to an individual or company for business purposes if the bank’s 

consolidated business credit exposure to the individual or company is $1 million or less. 

 Over-the-counter (OTC) derivative contract means a derivative contract that is not 

traded on an exchange that requires the daily receipt and payment of cash-variation 

margin. 

Parallel run period means a period of at least four consecutive quarters after 

adoption of the bank’s implementation plan and before the bank’s first floor period 

during which the bank complies with all the qualification requirements in section 22 to 

the satisfaction of the [AGENCY]. 

Peak exposure means a value representing a high percentile (typically 95 percent 

or 99 percent) of the distribution of exposures at any particular future date before the 

maturity date of the longest transaction in a netting set. A peak exposure value is 

typically generated for many future dates up until the longest maturity date of a 

transaction in a netting set. 

 Probability of default (PD) means: 

(1) For a wholesale exposure to a non-defaulted obligor, the bank’s empirically 

based best estimate of the long-run average of one-year default rates for the rating grade 

assigned by the bank to the obligor, capturing the average default experience for obligors 

in a rating grade over a mix of economic conditions (including economic downturn 
 Draft Basel II NPR 

370

conditions) sufficient to provide a reasonable estimate of the average one-year default 

rate over the economic cycle for the rating grade. 

(2) For a segment of non-defaulted retail exposures for which seasoning effects 

are not material, or for a segment of non-defaulted retail exposures in a retail exposure 

subcategory for which seasoning effects are not material, the bank’s empirically based 

best estimate of the long-run average of one-year default rates for the exposures in the 

segment, capturing the average default experience for exposures in the segment over a 

mix of economic conditions (including economic downturn conditions) sufficient to 

provide a reasonable estimate of the average one-year default rate over the economic 

cycle for the segment. 

(3) For any other segment of non-defaulted retail exposures, the bank’s 

empirically based best estimate of the annualized cumulative default rate over the 

expected remaining life of exposures in the segment, capturing the average default 

experience for exposures in the segment over a mix of economic conditions (including 

economic downturn conditions) sufficient to provide a reasonable estimate of the average 

performance over the economic cycle for the segment. 

(4) For a wholesale exposure to a defaulted obligor or segment of defaulted retail 

exposures, 100 percent. 

 Protection amount (P) means, with respect to an exposure hedged by an eligible 

guarantee or eligible credit derivative, the effective notional amount of the guarantee or 

credit derivative as reduced to reflect any currency mismatch, maturity mismatch, or lack 

of restructuring coverage (as provided in section 33). 

 Publicly traded means traded on: 
 Draft Basel II NPR 

371

(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); 

(2) The National Association of Securities Dealers Automated Quotation System 

(NASDAQ); or 

(3) Any non-U.S.-based securities exchange that: 

(i) Is registered with, or approved by, a national securities regulatory authority; 

and 

(ii) Provides a liquid, two-way market for the instrument in question, meaning 

that there are enough independent bona fide offers to buy and sell so that a sales price 

reasonably related to the last sales price or current bona fide competitive bid and offer 

quotations can be determined promptly and a trade can be settled at such a price within 

five business days. 

 Qualifying central counterparty means a counterparty (for example, a clearing 

house) that: 

(1) Facilitates trades between counterparties in one or more financial markets by 

either guaranteeing trades or novating contracts; 

(2) Requires all participants in its arrangements to be fully collateralized on a 

daily basis; and 

(3) The bank demonstrates to the satisfaction of [AGENCY] is in sound financial 

condition and is subject to effective oversight by a national supervisory authority. 

Qualifying cross-product master netting agreement means a qualifying master 

netting agreement that provides for termination and close-out netting across multiple 
 Draft Basel II NPR 

372

types of financial transactions or qualifying master netting agreements in the event of a 

counterparty’s default, provided that: 

(1) The underlying financial transactions are OTC derivative contracts, eligible 

margin loans, or repo-style transactions; and 

(2) The bank obtains a written legal opinion verifying the validity and 

enforceability of the agreement under applicable law of the relevant jurisdictions if the 

counterparty fails to perform upon an event of default, including upon an event of 

bankruptcy, insolvency, or similar proceeding. 

Qualifying master netting agreement means any written, legally enforceable 

bilateral agreement, provided that: 

(1) The agreement creates a single legal obligation for all individual transactions 

covered by the agreement upon an event of default, including bankruptcy, insolvency, or 

similar proceeding, of the counterparty; 

(2) The agreement provides the bank the right to accelerate, terminate, and closeout on a net basis all transactions under the agreement and to liquidate or set off collateral 

promptly upon an event of default, including upon an event of bankruptcy, insolvency, or 

similar proceeding, of the counterparty, provided that, in any such case, any exercise of 

rights under the agreement will not be stayed or avoided under applicable law in the 

relevant jurisdictions; 

(3) The bank has conducted and documented sufficient legal review to conclude 

with a well-founded basis that: 

(i) The agreement meets the requirements of paragraph (2) of this definition; and 
 Draft Basel II NPR 

373

(ii) In the event of a legal challenge (including one resulting from default or from 

bankruptcy, insolvency, or similar proceeding) the relevant court and administrative 

authorities would find the agreement to be legal, valid, binding, and enforceable under 

the law of the relevant jurisdictions; 

(4) The bank establishes and maintains procedures to monitor possible changes in 

relevant law and to ensure that the agreement continues to satisfy the requirements of this 

definition; and 

(5) The agreement does not contain a walkaway clause (that is, a provision that 

permits a non-defaulting counterparty to make a lower payment than it would make 

otherwise under the agreement, or no payment at all, to a defaulter or the estate of a 

defaulter, even if the defaulter or the estate of the defaulter is a net creditor under the 

agreement). 

 Qualifying revolving exposure (QRE) means an exposure (other than a 

securitization exposure or equity exposure) to an individual that is managed as part of a 

segment of exposures with homogeneous risk characteristics, not on an individualexposure basis, and: 

(1) Is revolving (that is, the amount outstanding fluctuates, determined largely by 

the borrower’s decision to borrow and repay, up to a pre-established maximum amount); 

(2) Is unsecured and unconditionally cancelable by the bank to the fullest extent 

permitted by Federal law; and 

(3) Has a maximum exposure amount (drawn plus undrawn) of up to $100,000. 

 Repo-style transaction means a repurchase or reverse repurchase transaction, or a 

securities borrowing or securities lending transaction, including a transaction in which the 
 Draft Basel II NPR 

374

bank acts as agent for a customer and indemnifies the customer against loss, provided 

that: 

(1) The transaction is based solely on liquid and readily marketable securities or 

cash; 

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

maintenance requirements; 

(3) The transaction is executed under an agreement that provides the bank the 

right to accelerate, terminate, and close-out the transaction on a net basis and to liquidate 

or set off collateral promptly upon an event of default (including upon an event of 

bankruptcy, insolvency, or similar proceeding) of the counterparty, provided that, in any 

such case, any exercise of rights under the agreement will not be stayed or avoided under 

applicable law in the relevant jurisdictions;10 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. 

 Residential mortgage exposure means an exposure (other than a securitization 

exposure, equity exposure, or excluded mortgage exposure) that is managed as part of a 

segment of exposures with homogeneous risk characteristics, not on an individualexposure basis, and is: 

 

10 This requirement is met where all transactions under the agreement are (i) executed under U.S. law and 

(ii) constitute “securities contracts” or “repurchase agreements” under section 555 or 559, respectively, of 

the Bankruptcy Code (11 U.S.C. 555 or 559), qualified financial contracts under section 11(e)(8) of the 

Federal Deposit Insurance Act (12 U.S.C. 1821(e)(8)), or netting contracts between or among financial 

institutions under sections 401-407 of the Federal Deposit Insurance Corporation Improvement Act of 1991 

(12 U.S.C. 4401-4407) or the Federal Reserve Board’s Regulation EE (12 CFR part 231). 
 Draft Basel II NPR 

375

(1) An exposure that is primarily secured by a first or subsequent lien on one- to 

four-family residential property; or 

(2) An exposure with an original and outstanding amount of $1 million or less that 

is primarily secured by a first or subsequent lien on residential property that is not one- to 

four-family. 

 Retail exposure means a residential mortgage exposure, a qualifying revolving 

exposure, or an other retail exposure. 

 Retail exposure subcategory means the residential mortgage exposure, qualifying 

revolving exposure, or other retail exposure subcategory. 

 Risk parameter means a variable used in determining risk-based capital 

requirements for wholesale and retail exposures, specifically probability of default (PD), 

expected loss given default (ELGD), loss given default (LGD), exposure at default 

(EAD), or effective maturity (M). 

 Scenario analysis means a systematic process of obtaining expert opinions from 

business managers and risk management experts to derive reasoned assessments of the 

likelihood and loss impact of plausible high-severity operational losses. 

SEC means the U.S. Securities and Exchange Commission. 

 Securitization means a traditional securitization or a synthetic securitization. 

 Securitization exposure means: 

(1) An on-balance sheet or off-balance sheet credit exposure that arises from a 

traditional or synthetic securitization (including credit-enhancing representations and 

warranties); and 
 Draft Basel II NPR 

376

(2) Mortgage-backed pass-through securities guaranteed by Fannie Mae or 

Freddie Mac. 

Senior securitization exposure means a securitization exposure that has a first 

priority claim on the cash flows from the underlying exposures, disregarding the claims 

of a service provider (such as a swap counterparty or trustee, custodian, or paying agent 

for the securitization) to fees from the securitization. A liquidity facility that supports an 

ABCP program is a senior securitization exposure if the liquidity facility provider’s right 

to reimbursement of the drawn amounts is senior to all claims on the cash flows from the 

underlying exposures except claims of a service provider to fees. 

 Servicer cash advance facility means a facility under which the servicer of the 

underlying exposures of a securitization may advance cash to ensure an uninterrupted 

flow of payments to investors in the securitization, including advances made to cover 

foreclosure costs or other expenses to facilitate the timely collection of the underlying 

exposures. See also eligible servicer cash advance facility. 

 Sovereign entity means a central government (including the U.S. government) or 

an agency, department, ministry, or central bank of a central government. 

 Sovereign exposure means: 

(1) A direct exposure to a sovereign entity; or 

(2) An exposure directly and unconditionally backed by the full faith and credit of 

a sovereign entity. 

Special purpose entity (SPE) means a corporation, trust, or other entity organized 

for the specific purpose of holding underlying exposures of a securitization, the activities 

of which are limited to those appropriate to accomplish this purpose, and the structure of 
 Draft Basel II NPR 

377

which is intended to isolate the underlying exposures held by the entity from the credit 

risk of the seller of the underlying exposures to the entity. 

 Synthetic securitization means a transaction in which: 

 (1) All or a portion of the credit risk of one or more underlying exposures is 

transferred to one or more third parties through the use of one or more credit derivatives 

or guarantees (other than a guarantee that transfers only the credit risk of an individual 

retail exposure); 

 (2) The credit risk associated with the underlying exposures has been separated 

into at least two tranches reflecting different levels of seniority; 

 (3) Performance of the securitization exposures depends upon the performance of 

the underlying exposures; and 

(4) All or substantially all of the underlying exposures are financial exposures 

(such as loans, commitments, credit derivatives, guarantees, receivables, asset-backed 

securities, mortgage-backed securities, other debt securities, or equity securities). 

 Tier 1 capital is defined in [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 non-member banks); 12 CFR 

567.1 (savings associations)] as modified in part II of this appendix. 

Tier 2 capital is defined in [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 non-member banks); 12 CFR 

567.1 (savings associations)] as modified in part II of this appendix. 
 Draft Basel II NPR 

378

Total qualifying capital means the sum of tier 1 capital and tier 2 capital, after all 

deductions required in this appendix. 

 Total risk-weighted assets means: 

(1) The sum of: 

(i) Credit risk-weighted assets; and 

(ii) Risk-weighted assets for operational risk; minus 

(2) The sum of: 

(i) Excess eligible credit reserves not included in tier 2 capital; and 

(ii) Allocated transfer risk reserves. 

 Total wholesale and retail risk-weighted assets means the sum of risk-weighted 

assets for wholesale exposures to non-defaulted obligors and segments of non-defaulted 

retail exposures; risk-weighted assets for wholesale exposures to defaulted obligors and 

segments of defaulted retail exposures; risk-weighted assets for assets not defined by an 

exposure category; and risk-weighted assets for non-material portfolios of exposures (all 

as determined in section 31) and risk-weighted assets for unsettled transactions (as 

determined in section 35) minus the amounts deducted from capital pursuant to [general 

risk-based capital rules] (excluding those deductions reversed in section 12). 

 Traditional securitization means a transaction in which: 

(1) All or a portion of the credit risk of one or more underlying exposures is 

transferred to one or more third parties other than through the use of credit derivatives or 

guarantees; 

 (2) The credit risk associated with the underlying exposures has been separated 

into at least two tranches reflecting different levels of seniority; 
 Draft Basel II NPR 

379

 (3) Performance of the securitization exposures depends upon the performance of 

the underlying exposures; and 

(4) All or substantially all of the underlying exposures are financial exposures 

(such as loans, commitments, credit derivatives, guarantees, receivables, asset-backed 

securities, mortgage-backed securities, other debt securities, or equity securities). 

 Tranche means all securitization exposures associated with a securitization that 

have the same seniority level. 

 Underlying exposures means one or more exposures that have been securitized in 

a securitization transaction. 

 Unexpected operational loss (UOL) means the difference between the bank’s 

operational risk exposure and the bank’s expected operational loss. 

 Unit of measure means the level (for example, organizational unit or operational 

loss event type) at which the bank’s operational risk quantification system generates a 

separate distribution of potential operational losses. 

 Value-at-Risk (VaR) means the estimate of the maximum amount that the value 

of one or more exposures could decline due to market price or rate movements during a 

fixed holding period within a stated confidence interval. 

 Wholesale exposure means a credit exposure to a company, individual, sovereign, 

or governmental entity (other than a securitization exposure, retail exposure, excluded 

mortgage exposure, or equity exposure). Examples of a wholesale exposure include: 

 (1) A non-tranched guarantee issued by a bank on behalf of a company; 
 Draft Basel II NPR 

380

(2) A repo-style transaction entered into by a bank with a company and any other 

transaction in which a bank posts collateral to a company and faces counterparty credit 

risk; 

(3) An exposure that the bank treats as a covered position under [the market risk 

rules] for which there is a counterparty credit risk charge in section 32; 

(4) A sale of corporate loans by a bank to a third party in which the bank retains 

full recourse; 

(5) An OTC derivative contract entered into by a bank with a company; 

(6) An exposure to an individual that is not managed by the bank as part of a 

segment of exposures with homogeneous risk characteristics; and 

(7) A commercial lease. 

Wholesale exposure subcategory means the HVCRE or non-HVCRE wholesale 

exposure subcategory. 

Section 3. Minimum Risk-Based Capital Requirements 

 (a) Except as modified by paragraph (c) of this section or by section 23, each bank 

must meet a minimum ratio of: 

(1) Total qualifying capital to total risk-weighted assets of 8.0 percent; and 

(2) Tier 1 capital to total risk-weighted assets of 4.0 percent. 

(b) Each bank must hold capital commensurate with the level and nature of all 

risks to which the bank is exposed. 

 (c) When a bank subject to the [market risk rule] calculates its risk-based capital 

requirements under this appendix, the bank must also refer to the [market risk rule] for 

supplemental rules to calculate risk-based capital requirements adjusted for market risk. 
 Draft Basel II NPR 

381

Part II. Qualifying Capital 

Section 11. Additional Deductions 

 (a) General. A bank that uses this appendix must make the same deductions from 

its tier 1 capital and tier 2 capital required in [the general risk-based capital rules], except 

that: 

 (1) A bank is not required to deduct certain equity investments and CEIOs (as 

explained in more detail in section 12); and 

(2) A bank also must make the deductions from capital required by paragraphs (b) 

and (c) of this section. 

(b) Deductions from tier 1 capital. A bank must deduct from tier 1 capital any 

gain-on-sale associated with a securitization exposure as provided in paragraph (a) of 

section 41 and paragraphs (a)(1), (c), (g)(1), and (h)(1) of section 42. 11 

 (c) Deductions from tier 1 and tier 2 capital. A bank must deduct the following 

exposures 50 percent from tier 1 capital and 50 percent from tier 2 capital. If the amount 

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

must deduct the shortfall amount from tier 1 capital. 

(1) Credit-enhancing interest-only strips (CEIOs). In accordance with paragraphs 

(a)(1) and (c) of section 42, any CEIO that does not constitute gain-on-sale. 

 (2) Non-qualifying securitization exposures. In accordance with paragraphs (a)(4) 

and (c) of section 42, any securitization exposure that does not qualify for the Ratings-

 

11 [BHC rule will also require deduction of “an amount equal to the minimum regulatory capital 

requirement established by the regulator of any insurance underwriting subsidiary of the BHC. For U.S.-

based insurance underwriting subsidiaries, this amount generally would be 200 percent of the subsidiary’s 

Authorized Control Level as established by the appropriate state regulator of the insurance company.”] 
 Draft Basel II NPR 

382

Based Approach, Internal Assessment Approach, or the Supervisory Formula Approach 

under sections 43, 44, and 45, respectively. 

 (3) Securitizations of non-IRB exposures. In accordance with paragraphs (c) and 

(g)(3) of section 42, certain exposures to a securitization any underlying exposure of 

which is not a wholesale exposure, retail exposure, securitization exposure, or equity 

exposure. 

 (4) Low-rated securitization exposures. In accordance with section 43 and 

paragraph (c) of section 42, any securitization exposure that qualifies for and must be 

deducted under the Ratings-Based Approach. 

 (5) High-risk securitization exposures subject to the Supervisory Formula 

Approach. In accordance with paragraph (b) of section 45 and paragraph (c) of section 

42, any securitization exposure that qualifies for the Supervisory Formula Approach and 

has a risk weight equal to 1,250 percent as calculated under the Supervisory Formula 

Approach. 

 (6) Eligible credit reserves shortfall. In accordance with paragraph (a)(1) of 

section 13, any eligible credit reserves shortfall. 

(7) Certain failed capital markets transactions. In accordance with paragraph 

(e)(3) of section 35, the bank’s exposure on certain failed capital markets transactions. 

Section 12. Deductions and Limitations Not Required 

 (a) Deduction of CEIOs. A bank is not required to make the deductions from 

capital for CEIOs in [the general risk-based capital rules].12

 

12 [12 CFR part 3, Appendix A, § 2(c) for national banks; 12 CFR part 208, Appendix A, § II.B.1.e. for 

state member banks; 12 CFR part 225, Appendix A, § II.B.1.e. for bank holding companies; 12 CFR part 

325, Appendix A, § II.B.5. for state non-member banks; and 12 CFR 567.5(a)(2)(iii) and 567.12(e) for 

savings associations.] 
 Draft Basel II NPR 

383

 (b) Deduction of certain equity investments. A bank is not required to make the 

deductions from capital for nonfinancial equity investments in [the general risk-based 

capital rules].13 14

Section 13. Eligible Credit Reserves 

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

of eligible credit reserves. If a bank’s eligible credit reserves are less than the bank’s 

total expected credit losses, the bank must deduct the shortfall amount 50 percent from 

tier 1 capital and 50 percent from tier 2 capital. If the amount deductible from tier 2 

capital exceeds the bank’s actual tier 2 capital, the bank must deduct the excess amount 

from tier 1 capital. 

 (2) Excess eligible credit reserves. If a bank’s eligible credit reserves exceed the 

bank’s total expected credit losses, the bank may include the excess amount in tier 2 

capital to the extent that the excess amount does not exceed 0.6 percent of the bank’s 

credit-risk-weighted assets. 

 (b) Treatment of allowance for loan and lease losses. Regardless of any provision 

to the contrary in [general risk-based capital rules], ALLL is included in tier 2 capital 

only to the extent provided in paragraph (a)(2) of this section and paragraph (b) of section 

23. 

Part III. Qualification 

 

13 [12 CFR part 3, Appendix A, § 2(c) for national banks; 12 CFR part 208, Appendix A, section II.B.5. for 

state member banks; 12 CFR part 225, Appendix A, section II.B.5. for bank holding companies; 12 CFR 

part 325, Appendix A, § II.B. for state non-member banks.] 

14 [For savings associations substitute “A savings association is not required to deduct equity securities 

from capital under 12 CFR 567.5(c)(2)(ii). However, it must continue to deduct equity investments in real 

estate under that section. See 12 CFR 567.1, which defines equity investments, including equity securities 

and equity investments in real estate.”] 
 Draft Basel II NPR 

384

Section 21. Qualification Process 

 (a) Timing. (1) A bank that is described in paragraph (b)(1) of section 1 must 

adopt a written implementation plan no later than six months after the later of the 

effective date of this appendix or the date the bank meets a criterion in that section. The 

plan must incorporate an explicit first floor period start date no later than 36 months after 

the later of the effective date of this appendix or the date the bank meets at least one 

criterion under paragraph (b)(1) of section 1. [AGENCY] may extend the first floor 

period start date. 

 (2) A bank that elects to be subject to this appendix under paragraph (b)(2) of 

section 1 must adopt a written implementation plan and notify the [AGENCY] in writing 

of its intent at least 12 months before it proposes to begin its first floor period. 

 (b) Implementation plan. The bank’s implementation plan must address in detail 

how the bank complies, or plans to comply, with the qualification requirements in section 

22. The bank also must maintain a comprehensive and sound planning and governance 

process to oversee the implementation efforts described in the plan. At a minimum, the 

plan must: 

 (1) Comprehensively address the qualification requirements in section 22 for the 

bank and each consolidated subsidiary (U.S. and foreign-based) of the bank with respect 

to all portfolios and exposures of the bank and each of its consolidated subsidiaries; 

 (2) Justify and support any proposed temporary or permanent exclusion of 

business lines, portfolios, or exposures from application of the advanced approaches in 

this appendix (which business lines, portfolios, and exposures must be, in the aggregate, 

immaterial to the bank); 
 Draft Basel II NPR 

385

 (3) Include the bank’s self-assessment of: 

 (i) The bank’s current status in meeting the qualification requirements in 

section 22; and 

 (ii) The consistency of the bank’s current practices with the [AGENCY’s] 

supervisory guidance on the qualification requirements; 

 (4) Based on the bank’s self-assessment, identify and describe the areas in which 

the bank proposes to undertake additional work to comply with the qualification 

requirements in section 22 or to improve the consistency of the bank’s current practices 

with the [AGENCY’s] supervisory guidance on the qualification requirements (gap 

analysis); 

 (5) Describe what specific actions the bank will take to address the areas 

identified in the gap analysis required by paragraph (b)(4) of this section; 

 (6) Identify objective, measurable milestones, including delivery dates and a date 

when the bank’s implementation of the methodologies described in this appendix will be 

fully operational; 

 (7) Describe resources that have been budgeted and are available to implement the 

plan; and 

 (8) Receive board of directors approval. 

 (c) Parallel run. Before determining its risk-based capital requirements under this 

appendix and following adoption of the implementation plan, the bank must conduct a 

satisfactory parallel run. A satisfactory parallel run is a period of no less than four 

consecutive calendar quarters during which the bank complies with all of the 

qualification requirements in section 22 to the satisfaction of [AGENCY]. During the 
 Draft Basel II NPR 

386

parallel run, the bank must report to the [AGENCY] on a calendar quarterly basis its riskbased capital ratios using the [general risk-based capital rules] and the risk-based capital 

requirements described in this appendix. During this period, the bank is subject to the 

[general risk-based capital rules]. 

 (d) Approval to calculate risk-based capital requirements under this appendix. 

The [AGENCY] will notify the bank of the date that the bank may begin its first floor 

period following a determination by the [AGENCY] that: 

 (1) The bank fully complies with the qualification requirements in section 22; 

 (2) The bank has conducted a satisfactory parallel run under paragraph (c) of this 

section; and 

 (3) The bank has an adequate process to ensure ongoing compliance with the 

qualification requirements in section 22. 

(e) Transitional floor periods. Following a satisfactory parallel run, a bank is 

subject to three transitional floor periods. 

 (1) Risk-based capital ratios during the transitional floor periods - (i) Tier 1 riskbased capital ratio. During a bank’s transitional floor periods, a bank’s tier 1 risk-based 

capital ratio is equal to the lower of: 

(A) The bank’s floor-adjusted tier 1 risk-based capital ratio; or 

(B) The bank’s advanced approaches tier 1 risk-based capital ratio. 

(ii) Total risk-based capital ratio. During a bank’s transitional floor periods, a 

bank’s total risk-based capital ratio is equal to the lower of: 

(A) The bank’s floor-adjusted total risk-based capital ratio; or 

(B) The bank’s advanced approaches total risk-based capital ratio. 
 Draft Basel II NPR 

387

(2) Floor-adjusted risk-based capital ratios. (i) A bank’s floor-adjusted tier 1 riskbased capital ratio during a transitional floor period is equal to the bank’s tier 1 capital as 

calculated under the [general risk-based capital rules], divided by the product of: 

(A) The bank’s total risk-weighted assets as calculated under the [general riskbased capital rules]; and 

(B) The appropriate transitional floor percentage in Table 1. 

(ii) A bank’s floor-adjusted total risk-based capital ratio during a transitional floor 

period is equal to the sum of the bank’s tier 1 and tier 2 capital as calculated under the 

[general risk-based capital rules], divided by the product of: 

(A) The bank’s total risk-weighted assets as calculated under the [general riskbased capital rules]; and 

(B) The appropriate transitional floor percentage in Table 1. 

(iii) A bank that meets the criteria in paragraph (b)(1) or (2) of section 1 as of the 

effective date of this rule must use the general risk-based capital rules effective 

immediately before this rule became effective during the parallel run and as the basis for 

its transitional floors. 

Table 1 – Transitional Floors 

Transitional floor period Transitional floor percentage 

First floor period 95 percent 

Second floor period 90 percent 

Third floor period 85 percent 
 Draft Basel II NPR 

388

(3) Advanced approaches risk-based capital ratios. (i) A bank’s advanced 

approaches tier 1 risk-based capital ratio equals the bank’s tier 1 risk-based capital ratio 

as calculated under this appendix (other than this section on transitional floor periods). 

(ii) A bank’s advanced approaches total risk-based capital ratio equals the bank’s 

total risk-based capital ratio as calculated under this appendix (other than this section on 

transitional floor periods). 

 (4) Reporting. During the transitional floor periods, a bank must report to the 

[AGENCY] on a calendar quarterly basis both floor-adjusted risk-based capital ratios and 

both advanced approaches risk-based capital ratios. 

 (5) Exiting a transitional floor period. A bank may not exit a transitional floor 

period until the bank has spent a minimum of four consecutive calendar quarters in the 

period and the [AGENCY] has determined that the bank may exit the floor period. The 

[AGENCY]’s determination will be based on an assessment of the bank’s ongoing 

compliance with the qualification requirements in section 22. 

Section 22. Qualification Requirements 

 (a) Process and systems requirements. (1) A bank must have a rigorous process 

for assessing its overall capital adequacy in relation to its risk profile and a 

comprehensive strategy for maintaining an appropriate level of capital. 

 (2) The systems and processes used by a bank for risk-based capital purposes 

under this appendix must be consistent with the bank’s internal risk management 

processes and management information reporting systems. 

 (3) Each bank must have an appropriate infrastructure with risk measurement and 

management processes that meet the qualification requirements of this section and are 
 Draft Basel II NPR 

389

appropriate given the bank’s size and level of complexity. Regardless of whether the 

systems and models that generate the risk parameters necessary for calculating a bank’s 

risk-based capital requirements are located at any affiliate of the bank, the bank itself 

must ensure that the risk parameters and reference data used to determine its risk-based 

capital requirements are representative of its own credit risk and operational risk 

exposures. 

 (b) Risk rating and segmentation systems for wholesale and retail exposures. (1) 

A bank must have an internal risk rating and segmentation system that accurately and 

reliably differentiates among degrees of credit risk for the bank’s wholesale and retail 

exposures. 

(2) For wholesale exposures, a bank must have an internal risk rating system that 

accurately and reliably assigns each obligor to a single rating grade (reflecting the 

obligor’s likelihood of default). The bank’s wholesale obligor rating system must have at 

least seven discrete rating grades for non-defaulted obligors and at least one rating grade 

for defaulted obligors. Unless the bank has chosen to directly assign ELGD and LGD 

estimates to each wholesale exposure, the bank must have an internal risk rating system 

that accurately and reliably assigns each wholesale exposure to loss severity rating grades 

(reflecting the bank’s estimate of the ELGD and LGD of the exposure). A bank 

employing loss severity rating grades must have a sufficiently granular loss severity 

grading system to avoid grouping together exposures with widely ranging ELGDs or 

LGDs. 

(3) For retail exposures, a bank must have a system that groups exposures into 

segments with homogeneous risk characteristics and assigns accurate and reliable PD, 
 Draft Basel II NPR 

390

ELGD, and LGD estimates for each segment on a consistent basis. The bank’s system 

must group retail exposures into the appropriate retail exposure subcategory and must 

group the retail exposures in each retail exposure subcategory into separate segments. 

The bank’s system must identify all defaulted retail exposures and group them in 

segments by subcategories separate from non-defaulted retail exposures. 

(4) The bank’s internal risk rating policy for wholesale exposures must describe 

the bank’s rating philosophy (that is, must describe how wholesale obligor rating 

assignments are affected by the bank’s choice of the range of economic, business, and 

industry conditions that are considered in the obligor rating process). 

(5) The bank’s internal risk rating system for wholesale exposures must provide 

for the review and update (as appropriate) of each obligor rating and (if applicable) each 

loss severity rating whenever the bank receives new material information, but no less 

frequently than annually. The bank’s retail exposure segmentation system must provide 

for the review and update (as appropriate) of assignments of retail exposures to segments 

whenever the bank receives new material information, but no less frequently than 

quarterly. 

 (c) Quantification of risk parameters for wholesale and retail exposures. (1) The 

bank must have a comprehensive risk parameter quantification process that produces 

accurate, timely, and reliable estimates of the risk parameters for the bank’s wholesale 

and retail exposures. 

(2) Data used to estimate the risk parameters must be relevant to the bank’s actual 

wholesale and retail exposures, and of sufficient quality to support the determination of 

risk-based capital requirements for the exposures. 
 Draft Basel II NPR 

391

(3) The bank’s risk parameter quantification process must produce conservative 

risk parameter estimates where the bank has limited relevant data, and any adjustments 

that are part of the quantification process must not result in a pattern of bias toward lower 

risk parameter estimates. 

(4) PD estimates for wholesale and retail exposures must be based on at least 

5 years of default data. ELGD and LGD estimates for wholesale exposures must be 

based on at least 7 years of loss severity data, and ELGD and LGD estimates for retail 

exposures must be based on at least 5 years of loss severity data. EAD estimates for 

wholesale exposures must be based on at least 7 years of exposure amount data, and EAD 

estimates for retail exposures must be based on at least 5 years of exposure amount data. 

(5) Default, loss severity, and exposure amount data must include periods of 

economic downturn conditions, or the bank must adjust its estimates of risk parameters to 

compensate for the lack of data from periods of economic downturn conditions. 

(6) The bank’s PD, ELGD, LGD, and EAD estimates must be based on the 

definition of default in this appendix. 

(7) The bank must review and update (as appropriate) its risk parameters and its 

risk parameter quantification process at least annually. 

(8) The bank must at least annually conduct a comprehensive review and analysis 

of reference data to determine relevance of reference data to bank exposures, quality of 

reference data to support PD, ELGD, LGD, and EAD estimates, and consistency of 

reference data to the definition of default contained in this appendix. 
 Draft Basel II NPR 

392

(d) Counterparty credit risk model. A bank must obtain the prior written approval 

of [AGENCY] under section 32 to use the internal models methodology for counterparty 

credit risk. 

(e) Double default treatment. A bank must obtain the prior written approval of 

[AGENCY] under section 34 to use the double default treatment. 

 (f) Securitization exposures. A bank must obtain the prior written approval of 

[AGENCY] under section 44 to use the internal assessment approach for securitization 

exposures to ABCP programs. 

(g) Equity exposures model. A bank must obtain the prior written approval of 

[AGENCY] under section 53 to use the internal models approach for equity exposures. 

(h) Operational risk - (1) Operational risk management processes. A bank must: 

(i) Have an operational risk management function that: 

(A) Is independent of business line management; and 

(B) Is responsible for designing, implementing, and overseeing the bank’s 

operational risk data and assessment systems, operational risk quantification systems, and 

related processes; 

(ii) Have and document a process to identify, measure, monitor, and control 

operational risk in bank products, activities, processes, and systems (which process must 

capture business environment and internal control factors affecting the bank’s operational 

risk profile); and 

(iii) Report operational risk exposures, operational loss events, and other relevant 

operational risk information to business unit management, senior management, and the 

board of directors (or a designated committee of the board). 
 Draft Basel II NPR 

393

(2) Operational risk data and assessment systems. A bank must have operational 

risk data and assessment systems that capture operational risks to which the bank is 

exposed. The bank’s operational risk data and assessment systems must: 

(i) Be structured in a manner consistent with the bank’s current business 

activities, risk profile, technological processes, and risk management processes; and 

(ii) Include credible, transparent, systematic, and verifiable processes that 

incorporate the following elements on an ongoing basis: 

(A) Internal operational loss event data. The bank must have a systematic process 

for capturing and using internal operational loss event data in its operational risk data and 

assessment systems. 

(1) The bank’s operational risk data and assessment systems must include a 

historical observation period of at least five years for internal operational loss event data 

(or such shorter period approved by [AGENCY] to address transitional situations, such as 

integrating a new business line). 

(2) The bank may refrain from collecting internal operational loss event data for 

individual operational losses below established dollar threshold amounts if the bank can 

demonstrate to the satisfaction of the [AGENCY] that the thresholds are reasonable, do 

not exclude important internal operational loss event data, and permit the bank to capture 

substantially all the dollar value of the bank’s operational losses. 

(B) External operational loss event data. The bank must have a systematic 

process for determining its methodologies for incorporating external operational loss data 

into its operational risk data and assessment systems. 
 Draft Basel II NPR 

394

(C) Scenario analysis. The bank must have a systematic process for determining 

its methodologies for incorporating scenario analysis into its operational risk data and 

assessment systems. 

(D) Business environment and internal control factors. The bank must 

incorporate business environment and internal control factors into its operational risk data 

and assessment systems. The bank must also periodically compare the results of its prior 

business environment and internal control factor assessments against its actual 

operational losses incurred in the intervening period. 

(3) Operational risk quantification systems. (i) The bank’s operational risk 

quantification systems: 

(A) Must generate estimates of the bank’s operational risk exposure using its 

operational risk data and assessment systems; and 

(B) Must employ a unit of measure that is appropriate for the bank’s range of 

business activities and the variety of operational loss events to which it is exposed, and 

that does not combine business activities or operational loss events with different risk 

profiles within the same loss distribution. 

(C) May use internal estimates of dependence among operational losses within 

and across business lines and operational loss events if the bank can demonstrate to the 

satisfaction of [AGENCY] that its process for estimating dependence is sound, robust to a 

variety of scenarios, and implemented with integrity, and allows for the uncertainty 

surrounding the estimates. If the bank has not made such a demonstration, it must sum 

operational risk exposure estimates across units of measure to calculate its total 

operational risk exposure. 
 Draft Basel II NPR 

395

(D) Must be reviewed and updated (as appropriate) whenever the bank becomes 

aware of information that may have a material effect on the bank’s estimate of 

operational risk exposure, but no less frequently than annually. 

(ii) With the prior written approval of [AGENCY], a bank may generate an 

estimate of its operational risk exposure using an alternative approach to that specified in 

paragraph (h)(3)(i) of this section. 15 A bank proposing to use such an alternative 

operational risk quantification system must submit a proposal to [AGENCY]. In 

considering a bank’s proposal to use an alternative operational risk quantification system, 

[AGENCY] will consider the following principles: 

(A) Use of the alternative operational risk quantification system will be allowed 

only on an exception basis, considering the size, complexity, and risk profile of a bank; 

(B) The bank must demonstrate that its estimate of its operational risk exposure 

generated under the alternative operational risk quantification system is appropriate and 

can be supported empirically; and 

(C) A bank must not use an allocation of operational risk capital requirements that 

includes entities other than depository institutions or the benefits of diversification across 

entities. 

 (i) Data management and maintenance. (1) A bank must have data management 

and maintenance systems that adequately support all aspects of its advanced systems and 

the timely and accurate reporting of risk-based capital requirements. 

(2) A bank must retain data using an electronic format that allows timely retrieval 

of data for analysis, validation, reporting, and disclosure purposes. 

 

15 [Paragraph (h)(3)(ii) would not be included in the bank holding company rule.] 
 Draft Basel II NPR 

396

(3) A bank must retain sufficient data elements related to key risk drivers to 

permit adequate monitoring, validation, and refinement of its advanced systems. 

 (j) Control, oversight, and validation mechanisms. (1) The bank’s senior 

management must ensure that all components of the bank’s advanced systems function 

effectively and comply with the qualification requirements in this section. 

(2) The bank’s board of directors (or a designated committee of the board) must at 

least annually evaluate the effectiveness of, and approve, the bank’s advanced systems. 

(3) A bank must have an effective system of controls and oversight that: 

(i) Ensures ongoing compliance with the qualification requirements in this 

section; 

(ii) Maintains the integrity, reliability, and accuracy of the bank’s advanced 

systems; and 

(iii) Includes adequate governance and project management processes. 

(4) The bank must validate, on an ongoing basis, its advanced systems. The 

bank’s validation process must be independent of the advanced systems’ development, 

implementation, and operation, or the validation process must be subjected to an 

independent review of its adequacy and effectiveness. Validation must include: 

(i) The evaluation of the conceptual soundness of (including developmental 

evidence supporting) the advanced systems; 

(ii) An on-going monitoring process that includes verification of processes and 

benchmarking; and 

(iii) An outcomes analysis process that includes back-testing. 
 Draft Basel II NPR 

397

(5) The bank must have an internal audit function independent of business-line 

management that at least annually assesses the effectiveness of the controls supporting 

the bank’s advanced systems and reports its findings to the bank’s board of directors (or a 

committee thereof). 

(6) The bank must periodically stress test its advanced systems. The stress testing 

must include a consideration of how economic cycles, especially downturns, affect riskbased capital requirements (including migration across rating grades and segments and 

the credit risk mitigation benefits of double default treatment). 

 (k) Documentation. The bank must adequately document all material aspects of 

its advanced systems. 

Section 23. Ongoing Qualification 

 (a) Changes to advanced systems. A bank must meet all the qualification 

requirements in section 22 on an ongoing basis. A bank must notify the [AGENCY] 

when the bank makes any change to an advanced system that would result in a material 

change in the bank’s risk-weighted asset amount for an exposure type, or when the bank 

makes any significant change to its modeling assumptions. 

 (b) Mergers and acquisitions - (1) Mergers and acquisitions of companies without 

advanced systems. If a bank merges with or acquires a company that does not calculate 

its risk-based capital requirements using advanced systems, the bank may use the 

[general risk-based capital rules] to determine the risk-weighted asset amounts for, and 

deductions from capital associated with, the merged or acquired company’s exposures for 

up to 24 months after the calendar quarter during which the merger or acquisition 

consummates. [AGENCY] may extend this transition period for up to an additional 12 
 Draft Basel II NPR 

398

months. Within 30 days of consummating the merger or acquisition, the bank must 

submit to [AGENCY] an implementation plan for using its advanced systems for the 

acquired company. During the period when the [general risk-based capital rules] apply to 

the merged or acquired company, any ALLL, net of allocated transfer risk reserves 

established pursuant to 12 U.S.C. 3904, associated with the merged or acquired 

company’s exposures may be included in the bank’s tier 2 capital up to 1.25 percent of 

the acquired company’s risk-weighted assets. All general reserves of the merged or 

acquired company must be excluded from the bank’s eligible credit reserves. In addition, 

the risk-weighted assets of the merged or acquired company are not included in the 

bank’s credit-risk-weighted assets but are included in total risk-weighted assets. If a bank 

relies on this paragraph, the bank must disclose publicly the amounts of risk-weighted 

assets and qualifying capital calculated under this appendix for the acquiring bank and 

under the [general risk-based capital rules] for the acquired company. 

 (2) Mergers and acquisitions of companies with advanced systems. If a bank 

merges with or acquires a company that calculates its risk-based capital requirements 

using advanced systems, the acquiring bank may use the acquired company’s advanced 

systems to determine the risk-weighted asset amounts for, and deductions from capital 

associated with, the merged or acquired company’s exposures for up to 24 months after 

the calendar quarter during which the acquisition or merger consummates. [AGENCY] 

may extend this transition period for up to an additional 12 months. Within 30 days of 

consummating the merger or acquisition, the bank must submit to [AGENCY] an 

implementation plan for using its advanced systems for the merged or acquired company. 
 Draft Basel II NPR 

399

 (c) Failure to comply with qualification requirements. If [AGENCY] determines 

that a bank that is subject to this appendix and has conducted a satisfactory parallel run 

fails to comply with the qualification requirements in section 22, [AGENCY] will notify 

the bank in writing of the bank’s failure to comply. The bank must establish a plan 

satisfactory to the [AGENCY] to return to compliance with the qualification 

requirements and must disclose to the public its failure to comply with the qualification 

requirements promptly after receiving notice from the [AGENCY]. In addition, if the 

[AGENCY] determines that the bank’s risk-based capital requirements are not 

commensurate with the bank’s credit, market, operational, or other risks, the [AGENCY] 

may require such a bank to calculate its risk-based capital requirements: 

 (1) Under the [general risk-based capital rules]; or 

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

Part IV. Risk-Weighted Assets for General Credit Risk 

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

Assets 

(a) Overview. A bank must calculate its total wholesale and retail risk-weighted 

asset amount in four distinct phases: 

(1) Phase 1– categorization of exposures; 

(2) Phase 2 – assignment of wholesale obligors and exposures to rating grades and 

segmentation of retail exposures; 

(3) Phase 3 – assignment of risk parameters to wholesale exposures and segments 

of retail exposures; and 

(4) Phase 4 – calculation of risk-weighted asset amounts. 
 Draft Basel II NPR 

400

(b) Phase 1 − Categorization. The bank must determine which of its exposures 

are wholesale exposures, retail exposures, securitization exposures, or equity exposures. 

The bank must categorize each retail exposure as a residential mortgage exposure, a 

QRE, or an other retail exposure. The bank must identify which wholesale exposures are 

HVCRE exposures, sovereign exposures, OTC derivative contracts, repo-style 

transactions, eligible margin loans, eligible purchased wholesale receivables, unsettled 

transactions to which section 35 applies, and eligible guarantees or eligible credit 

derivatives that are used as credit risk mitigants. The bank must identify any on-balance 

sheet asset that does not meet the definition of a wholesale, retail, equity, or securitization 

exposure, as well as any non-material portfolio of exposures described in paragraph 

(e)(4) of this section. 

 (c) Phase 2 – Assignment of wholesale obligors and exposures to rating grades 

and retail exposures to segments - (1) Assignment of wholesale obligors and exposures to 

rating grades. 

(i) The bank must assign each obligor of a wholesale exposure to a single obligor 

rating grade and may assign each wholesale exposure to loss severity rating grades. 

(ii) The bank must identify which of its wholesale obligors are in default. 

(2) Segmentation of retail exposures. (i) The bank must group the retail 

exposures in each retail subcategory into segments that have homogeneous risk 

characteristics. 

(ii) The bank must identify which of its retail exposures are in default. The bank 

must segment defaulted retail exposures separately from non-defaulted retail exposures. 
 Draft Basel II NPR 

401

(iii) If the bank determines the EAD for eligible margin loans using the approach 

in paragraph (a) of section 32, the bank must identify which of its retail exposures are 

eligible margin loans for which the bank uses this EAD approach and must segment such 

eligible margin loans separately from other retail exposures. 

 (3) Eligible purchased wholesale receivables. A bank may group its eligible 

purchased wholesale receivables that, when consolidated by obligor, total less than 

$1 million into segments that have homogeneous risk characteristics. A bank must use 

the wholesale exposure formula in Table 2 in this section to determine the risk-based 

capital requirement for each segment of eligible purchased wholesale receivables. 

 (d) Phase 3 − Assignment of risk parameters to wholesale exposures and 

segments of retail exposures - (1) Quantification process. Subject to the limitations in 

this paragraph (d), the bank must: 

(i) Associate a PD with each wholesale obligor rating grade; 

(ii) Associate an ELGD or LGD, as appropriate, with each wholesale loss severity 

rating grade or assign an ELGD and LGD to each wholesale exposure; 

(iii) Assign an EAD and M to each wholesale exposure; and 

(iv) Assign a PD, ELGD, LGD, and EAD to each segment of retail exposures. 

(2) Floor on PD assignment. The PD for each wholesale exposure or retail 

segment may not be less than 0.03 percent, except for exposures to or directly and 

unconditionally guaranteed by a sovereign entity, the Bank for International Settlements, 

the International Monetary Fund, the European Commission, the European Central Bank, 

or a multi-lateral development bank, to which the bank assigns a rating grade associated 

with a PD of less than 0.03 percent. 
 Draft Basel II NPR 

402

(3) Floor on LGD estimation. The LGD for each segment of residential mortgage 

exposures (other than segments of residential mortgage exposures for which all or 

substantially all of the principal of each exposure is directly and unconditionally 

guaranteed by the full faith and credit of a sovereign entity) may not be less than 

10 percent. 

(4) Eligible purchased wholesale receivables. A bank must assign a PD, ELGD, 

LGD, EAD, and M to each segment of eligible purchased wholesale receivables. If the 

bank can estimate ECL (but not PD or LGD) for a segment of eligible purchased 

wholesale receivables, the bank must assume that the ELGD and LGD of the segment 

equals 100 percent and that the PD of the segment equals ECL divided by EAD. The 

estimated ECL must be calculated for the receivables without regard to any assumption 

of recourse or guarantees from the seller or other parties. 

(5) Credit risk mitigation − credit derivatives, guarantees, and collateral. (i) A 

bank may take into account the risk reducing effects of eligible guarantees and eligible 

credit derivatives in support of a wholesale exposure by applying the PD substitution or 

LGD adjustment treatment to the exposure as provided in section 33 or, if applicable, 

applying double default treatment to the exposure as provided in section 34. A bank may 

decide separately for each wholesale exposure that qualifies for the double default 

treatment under section 34 whether to apply the double default treatment or to use the PD 

substitution or LGD adjustment approach without recognizing double default effects. 

(ii) A bank may take into account the risk reducing effects of guarantees and 

credit derivatives in support of retail exposures in a segment when quantifying the PD, 

ELGD, and LGD of the segment. 
 Draft Basel II NPR 

403

(iii) Except as provided in paragraph (d)(6) of this section, a bank may take into 

account the risk reducing effects of collateral in support of a wholesale exposure when 

quantifying the ELGD and LGD of the exposure and may take into account the risk 

reducing effects of collateral in support of retail exposures when quantifying the PD, 

ELGD, and LGD of the segment. 

(6) EAD for derivative contracts, repo-style transactions, and eligible margin 

loans. (i) A bank must calculate its EAD for an OTC derivative contract as provided in 

paragraphs (b) and (c) of section 32. A bank may take into account the risk-reducing 

effects of financial collateral in support of a repo-style transaction or eligible margin loan 

through an adjustment to EAD as provided in paragraphs (a) and (c) of section 32. A 

bank that takes financial collateral into account through such an adjustment to EAD 

under section 32 may not adjust ELGD or LGD to reflect the financial collateral. 

(ii) A bank may attribute an EAD of zero to: 

(A) Derivative contracts that are publicly traded on an exchange that requires the 

daily receipt and payment of cash-variation margin; 

(B) Derivative contracts and repo-style transactions that are outstanding with a 

qualifying central counterparty (but not for those transactions that a qualifying central 

counterparty has rejected); and 

(C) Credit risk exposures to a qualifying central counterparty in the form of 

clearing deposits and posted collateral that arise from transactions described in paragraph 

(d)(6)(ii)(B) of this section. 

(7) Effective maturity. An exposure’s M must be no greater than five years and 

no less than one year, except that a bank may set the M of an exposure equal to the 
 Draft Basel II NPR 

404

greater of one day or M if the exposure has an original maturity of less than one year and 

is not part of the bank’s ongoing financing of the obligor. An exposure is not part of a 

bank’s ongoing financing of the obligor if the bank: 

(i) Has a legal and practical ability not to renew or roll over the exposure in the 

event of credit deterioration of the obligor; 

(ii) Makes an independent credit decision at the inception of the exposure and at 

every renewal or roll over; and 

(iii) Has no substantial commercial incentive to continue its credit relationship 

with the obligor in the event of credit deterioration of the obligor. 

(e) Phase 4 − Calculation of risk-weighted assets - (1) Non-defaulted exposures. 

(i) A bank must calculate the dollar risk-based capital requirement for each of its 

wholesale exposures to a non-defaulted obligor and segments of non-defaulted retail 

exposures (except eligible guarantees and eligible credit derivatives that hedge another 

wholesale exposure and exposures to which the bank applies the double default treatment 

in section 34) by inserting the assigned risk parameters for the wholesale obligor and 

exposure or retail segment into the appropriate risk-based capital formula specified in 

Table 2 and multiplying the output of the formula (K) by the EAD of the exposure or 

segment.16

 

16 A bank may instead apply a 300 percent risk weight to the EAD of an eligible margin loan if the bank is 

not able to assign a rating grade to the obligor of the loan. 
 Draft Basel II NPR 

405

Table 2 – IRB risk-based capital formulas for wholesale exposures to non-defaulted obligors and 

segments of non-defaulted retail exposures* 

Capital 

Requirement 

(K) 

Non-Defaulted 

Exposures 

( )⎥

⎥

⎦

⎤

⎢

⎢

⎣

⎡ − × ⎟

⎟

⎠

⎞

⎜

⎜

⎝

⎛

−

+ × = ×

− −

ELGD PD

R

N PD R N K LGD N

1

( ) (0.999 ) 1 1

For residential mortgage exposures: R = 0.15

For qualifying revolving exposures: R = 0.04

Retail 

Correlation 

Factor (R) 

For other retail exposures: PD R e− × = + × 35 0.03 0.13

Capital 

Requirement 

(K) 

Non-Defaulted 

Exposures 

( ) ⎟

⎠

⎞ ⎜

⎝

⎛

− ×

+ − × ×

⎥

⎥

⎦

⎤

⎢

⎢

⎣

⎡ − × ⎟

⎟

⎠

⎞

⎜

⎜

⎝

⎛

−

+ × = ×

− −

b

M b ELGD PD

R

N PD R N K LGD N

1 1.5

1 ( 2.5)

1

( ) (0.999 ) 1 1

For HVCRE exposures: 

PD R e− × = + × 50 0.12 0.18 Correlation 

Factor (R) For wholesale exposures other than HVCRE exposures: 

PD R e− × = + × 50 0.12 0.12

Wholesale

Maturity 

Adjustment (b) ( )

2 b = 0.11852 − 0.05478×ln(PD)

* N(.) means the cumulative distribution function for a standard normal random variable. 

N-1(.) means the inverse cumulative distribution function for a standard normal random 

variable. The symbol e refers to the base of the natural logarithm, and the function ln(.) 

refers to the natural logarithm of the expression within parentheses. 

(ii) The sum of all of the dollar risk-based capital requirements for each wholesale 

exposure to a non-defaulted obligor and segment of non-defaulted retail exposures 

calculated in paragraph (e)(1)(i) of this section and in paragraph (e) of section 34 equals 

the total dollar risk-based capital requirement for those exposures and segments. 

(iii) The aggregate risk-weighted asset amount for wholesale exposures to nondefaulted obligors and segments of non-defaulted retail exposures equals the total dollar 

risk-based capital requirement calculated in paragraph (e)(1)(ii) of this section multiplied 

by 12.5. 
 Draft Basel II NPR 

406

(2) Wholesale exposures to defaulted obligors and segments of defaulted retail 

exposures - (i) Wholesale exposures to defaulted obligors. 

(A) For each wholesale exposure to a defaulted obligor, the bank must compare: 

(1) 0.08 multiplied by the EAD of the wholesale exposure, plus the amount of any 

charge-offs or write-downs on the exposure; and 

(2) K for the wholesale exposure (as determined in Table 2 immediately before 

the obligor became defaulted), multiplied by the EAD of the wholesale exposure 

immediately before the obligor became defaulted. 

(B) If the amount calculated in paragraph (e)(2)(i)(A)(1) is equal to or greater 

than the amount calculated in paragraph (e)(2)(i)(A)(2), the dollar risk-based capital 

requirement for the exposure is 0.08 multiplied by the EAD of the wholesale exposure. 

(C) If the amount calculated in paragraph (e)(2)(i)(A)(1) is less than the amount 

calculated in paragraph (e)(2)(i)(A)(2), the dollar risk-based capital requirement for the 

exposure is K for the wholesale exposure (as determined in Table 2 immediately before 

the obligor became defaulted) multiplied by the EAD of the wholesale exposure. 

(ii) Segments of defaulted retail exposures. The dollar risk-based capital 

requirement for a segment of defaulted retail exposures equals 0.08 multiplied by the 

EAD of the segment. 

(iii) The sum of all the dollar risk-based capital requirements for each wholesale 

exposure to a defaulted obligor calculated in paragraphs (e)(2)(i)(B) and (C) of this 

section plus the dollar risk-based capital requirements for each segment of defaulted retail 

exposures calculated in paragraph (e)(2)(ii) of this section equals the total dollar riskbased capital requirement for those exposures. 
 Draft Basel II NPR 

407

(iv) The aggregate risk-weighted asset amount for wholesale exposures to 

defaulted obligors and segments of defaulted retail exposures equals the total dollar riskbased capital requirement calculated in paragraph (e)(2)(iii) of this section multiplied by 

12.5. 

(3) Assets not included in a defined exposure category. A bank may assign a riskweighted asset amount of zero to cash owned and held in all offices of the bank or in 

transit and for gold bullion held in the bank’s own vaults, or held in another bank’s vaults 

on an allocated basis, to the extent it is offset by gold bullion liabilities. The riskweighted asset amount for the residual value of a retail lease exposure equals such 

residual value. The risk-weighted asset amount for an excluded mortgage exposure is 

determined under the [general risk-based capital rules].17 The risk-weighted asset amount 

for any other on-balance-sheet asset that does not meet the definition of a wholesale, 

retail, securitization, or equity exposure equals the carrying value of the asset. 

(4) Non-material portfolios of exposures. The risk-weighted asset amount of a 

portfolio of exposures for which the bank has demonstrated to [AGENCY’s] satisfaction 

that the portfolio (when combined with all other portfolios of exposures that the bank 

seeks to treat under this paragraph) is not material to the bank is the sum of the carrying 

values of on-balance sheet exposures plus the notional amounts of off-balance sheet 

exposures in the portfolio. For purposes of this paragraph (e)(4), the notional amount of 

an OTC derivative contract that is not a credit derivative is the EAD of the derivative as 

calculated in section 32. 

 

17 See 12 CFR part 3, Appendix A, section 3(a)(3)(iii) (national banks); 12 CFR part 208, Appendix A, 

section III.C.3. (state member banks); 12 CFR part 225, Appendix A, section III.C.3. (bank holding 

companies); 12 CFR part 325, Appendix A, section II.C.a. (state non-member banks); 12 CFR 

567.6(a)(1)(iii) and (iv) (savings associations). 
 Draft Basel II NPR 

408

Section 32. Counterparty Credit Risk 

This section describes two methodologies – a collateral haircut approach and an 

internal models methodology – that a bank may use instead of an ELGD/LGD estimation 

methodology to recognize the benefits of financial collateral in mitigating the 

counterparty credit risk of repo-style transactions, eligible margin loans, and 

collateralized OTC derivative contracts, and single product netting sets of such 

transactions. A third methodology, the simple VaR methodology, is available for single 

product netting sets of repo-style transactions and eligible margin loans. This section 

also describes the methodology for calculating EAD for an OTC derivative contract or a 

set of OTC derivative contracts subject to a qualifying master netting agreement. A bank 

also may use the internal models methodology to estimate EAD for qualifying crossproduct master netting agreements. 

A bank may use any combination of the three methodologies for collateral 

recognition; however, it must use the same methodology for similar exposures. A bank 

may use separate methodologies for agency securities lending transactions – that is, 

securities lending transactions in which the bank, acting as agent for a customer, lends the 

customer’s securities and indemnifies the customer against loss – and all other repo-style 

transactions. 

(a) EAD for eligible margin loans and repo-style transactions - (1) General. A 

bank may recognize the credit risk mitigation benefits of financial collateral that secures 

an eligible margin loan, repo-style transaction, or single-product group of such 

transactions with a single counterparty subject to a qualifying master netting agreement 

(netting set) by factoring the collateral into its ELGD and LGD estimates for the 
 Draft Basel II NPR 

409

exposure. Alternatively, a bank may estimate an unsecured ELGD and LGD for the 

exposure and determine the EAD of the exposure using: 

(i) The collateral haircut approach described in paragraph (a)(2) of this section; 

(ii) For netting sets only, the simple VaR methodology described in 

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

(iii) The internal models methodology described in paragraph (c) of this section. 

(2) Collateral haircut approach - (i) EAD equation. A bank may determine EAD 

for an eligible margin loan, repo-style transaction, or netting set by setting EAD = max 

{0, [(∑E - ∑C) + ∑(Es x Hs) + ∑(Efx x Hfx)]}, where: 

 (A) ∑E equals the value of the exposure (that is, the sum of the current market 

values of all securities and cash the bank has lent, sold subject to repurchase, or posted as 

collateral to the counterparty under the transaction (or netting set)); 

(B) ∑C equals the value of the collateral (that is, the sum of the current market 

values of all securities and cash the bank has borrowed, purchased subject to resale, or 

taken as collateral from the counterparty under the transaction (or netting set)); 

(C) Es = absolute value of the net position in a given security (where the net 

position in a given security equals the sum of the current market values of the particular 

security the bank has lent, sold subject to repurchase, or posted as collateral to the 

counterparty minus the sum of the current market values of that same security the bank 

has borrowed, purchased subject to resale, or taken as collateral from the counterparty); 

(D) Hs = market price volatility haircut appropriate to the security referenced in 

Es; 
 Draft Basel II NPR 

410

(E) Efx = absolute value of the net position of both cash and securities in a 

currency that is different from the settlement currency (where the net position in a given 

currency equals the sum of the current market values of any cash or securities in the 

currency the bank has lent, sold subject to repurchase, or posted as collateral to the 

counterparty minus the sum of the current market values of any cash or securities in the 

currency the bank has borrowed, purchased subject to resale, or taken as collateral from 

the counterparty); and 

(F) Hfx = haircut appropriate to the mismatch between the currency referenced in 

Efx and the settlement currency. 

(ii) Standard supervisory haircuts. (A) Under the “standard supervisory haircuts” 

approach: 

 (1) A bank must use the haircuts for market price volatility (Hs) in Table 3, as 

adjusted in certain circumstances as provided in paragraph (a)(2)(ii)(A)(3) and (4) of this 

section; 
 Draft Basel II NPR 

411

Table 3 – Standard Supervisory Market Price Volatility Haircuts* 

Applicable external rating 

grade category for debt 

securities 

Residual maturity for debt securities 

Issuers exempt 

from the 3 b.p. 

floor 

Other issuers 

≤ 1 year .005 .01 

>1 year, ≤ 5 years .02 .04 

Two highest investment 

grade rating categories for 

long-term ratings/highest 

investment grade rating 

category for short-term 

ratings 

> 5 years .04 .08 

≤ 1 year .01 .02 

>1 year, ≤ 5 years .03 .06 

Two lowest investment 

grade rating categories for 

both short- and long-term 

ratings > 5 years .06 .12 

One rating category below 

investment grade 

All .15 .25 

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

Other publicly traded equities (including convertible bonds) .25 

Mutual funds Highest haircut applicable to any 

security in which the fund can invest 

Cash on deposit with the bank (including a certificate of deposit issued 

by the bank) 

0 

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

period. 

 (2) For currency mismatches, a bank must use a haircut for foreign exchange rate 

volatility (Hfx) of 8 percent, as adjusted in certain circumstances as provided in 

paragraph (a)(2)(ii)(A)(3) and (4) of this section. 

 (3) For repo-style transactions, a bank may multiply the supervisory haircuts 

provided in paragraphs (a)(2)(ii)(A)(1) and (2) by the square root of 1⁄2 (which equals 

0.707107). 

 (4) A bank must adjust the supervisory haircuts upward on the basis of a holding 

period longer than 10 business days (for eligible margin loans) or 5 business days (for 

repo-style transactions) where and as appropriate to take into account the illiquidity of an 

instrument. 
 Draft Basel II NPR 

412

 (iii) Own estimates for haircuts. With the prior written approval of [AGENCY], a 

bank may calculate haircuts (Hs and Hfx) using its own internal estimates of the 

volatilities of market prices and foreign exchange rates. 

(A) To receive [AGENCY] approval to use internal estimates, a bank must satisfy 

the following minimum quantitative standards: 

 (1) A bank must use a 99th percentile one-tailed confidence interval. 

 (2) The minimum holding period for a repo-style transaction is 5 business days 

and for an eligible margin loan is 10 business days. When a bank calculates an ownestimates haircut on a TN-day holding period, which is different from the minimum 

holding period for the transaction type, the applicable haircut (HM) is calculated using the 

following square root of time formula: 

N

M N T

T H H M

= , where 

(i) TM = 5 for repo-style transactions and 10 for eligible margin loans; 

(ii) TN = holding period used by the bank to derive HN; and 

(iii) HN = haircut based on the holding period TN. 

 (3) A bank must adjust holding periods upwards where and as appropriate to take 

into account the illiquidity of an instrument. 

 (4) The historical observation period must be at least one year. 

 (5) A bank must update its data sets and recompute haircuts no less frequently 

than quarterly and must also reassess data sets and haircuts whenever market prices 

change materially. 

 (B) With respect to debt securities that have an applicable external rating of 

investment grade, a bank may calculate haircuts for categories of securities. For a 
 Draft Basel II NPR 

413

category of securities, the bank must calculate the haircut on the basis of internal 

volatility estimates for securities in that category that are representative of the securities 

in that category that the bank has actually lent, sold subject to repurchase, posted as 

collateral, borrowed, purchased subject to resale, or taken as collateral. In determining 

relevant categories, the bank must take into account: 

 (1) The type of issuer of the security; 

 (2) The applicable external rating of the security; 

 (3) The maturity of the security; and 

 (4) The interest rate sensitivity of the security. 

 (C) With respect to debt securities that have an applicable external rating of below 

investment grade and equity securities, a bank must calculate a separate haircut for each 

individual security. 

 (D) Where an exposure or collateral (whether in the form of cash or securities) is 

denominated in a currency that differs from the settlement currency, the bank must 

calculate a separate currency mismatch haircut for its net position in each mismatched 

currency based on estimated volatilities of foreign exchange rates between the 

mismatched currency and the settlement currency. 

 (E) A bank’s own estimates of market price and foreign exchange rate volatilities 

may not take into account the correlations among securities and foreign exchanges rates 

on either the exposure or collateral side of a transaction (or netting set) or the correlations 

among securities and foreign exchange rates between the exposure and collateral sides of 

the transaction (or netting set).
 Draft Basel II NPR 

414

 (3) Simple VaR methodology. With the prior written approval of [AGENCY], a 

bank may estimate EAD for a netting set using a VaR model that meets the requirements 

in paragraph (a)(3)(iii) of this section. In such event, the bank must set EAD = max {0, 

[(∑E - ∑C) + PFE]}, where: 

 (i) ∑E equals the value of the exposure (that is, the sum of the current market 

values of all securities and cash the bank has lent, sold subject to repurchase, or posted as 

collateral to the counterparty under the netting set); 

(ii) ∑C equals the value of the collateral (that is, the sum of the current market 

values of all securities and cash the bank has borrowed, purchased subject to resale, or 

taken as collateral from the counterparty under the netting set); and 

(iii) PFE (potential future exposure) equals the bank’s empirically-based best 

estimate of the 99th percentile, one-tailed confidence interval for an increase in the value 

of (∑E - ∑C) over a 5-business-day holding period for repo-style transactions or over a 

10-business-day holding period for eligible margin loans using a minimum one-year 

historical observation period of price data representing the instruments that the bank has 

lent, sold subject to repurchase, posted as collateral, borrowed, purchased subject to 

resale, or taken as collateral. The bank must validate its VaR model, including by 

establishing and maintaining a rigorous and regular back-testing regime. 

(b) EAD for OTC derivative contracts. (1) A bank must determine the EAD for 

an OTC derivative contract that is not subject to a qualifying master netting agreement 

using the current exposure methodology in paragraph (b)(5) of this section or using the 

internal models methodology described in paragraph (c) of this section. 
 Draft Basel II NPR 

415

(2) A bank must determine the EAD for multiple OTC derivative contracts that 

are subject to a qualifying master netting agreement using the current exposure 

methodology in paragraph (b)(6) of this section or using the internal models methodology 

described in paragraph (c) of this section.18 

(3) Counterparty credit risk for credit derivatives. Notwithstanding the above, 

(i) A bank that purchases a credit derivative that is recognized under section 33 or 

34 as a credit risk mitigant for an exposure that is not a covered position under the 

[market risk rule] need not compute a separate counterparty credit risk capital 

requirement under this section so long as it does so consistently for all such credit 

derivatives and either includes all or excludes all such credit derivatives that are subject 

to a qualifying master netting agreement from any measure used to determine 

counterparty credit risk exposure to all relevant counterparties for risk-based capital 

purposes. 

(ii) A bank that is the protection provider in a credit derivative must treat the 

credit derivative as a wholesale exposure to the reference obligor and need not compute a 

counterparty credit risk capital requirement for the credit derivative under this section, so 

long as it does so consistently for all such credit derivatives and either includes all or 

excludes all such credit derivatives that are subject to a qualifying master netting 

agreement from any measure used to determine counterparty credit risk exposure to all 

relevant counterparties for risk-based capital purposes (unless the bank is treating the 

credit derivative as a covered position under the [market risk rule], in which case the 

 

18 For purposes of this determination, for OTC derivative contracts, a bank must maintain a written and 

well reasoned legal opinion that this agreement meets the criteria set forth in the definition of qualifying 

master netting agreement. 
 Draft Basel II NPR 

416

bank must compute a supplemental counterparty credit risk capital requirement under this 

section). 

(4) Counterparty credit risk for equity derivatives. A bank must treat an equity 

derivative contract as an equity exposure and compute a risk-weighted asset amount for 

the equity derivative contract under part VI (unless the bank is treating the contract as a 

covered position under the [market risk rules]). In addition, if the bank is treating the 

contract as a covered position under the [market risk rules] and in certain other cases 

described in section 55, the bank must also calculate a risk-based capital requirement for 

the counterparty credit risk of an equity derivative contract under this part. 

(5) Single OTC derivative contract. Except as modified by paragraph (b)(7) of 

this section, the EAD for a single OTC derivative contract that is not subject to a 

qualifying master netting agreement is equal to the sum of the bank’s current credit 

exposure and potential future credit exposure on the derivative contract. 

(i) Current credit exposure. The current credit exposure for a single OTC 

derivative contract is the greater of the mark-to-market value of the derivative contract or 

zero. 

(ii) PFE. The PFE for a single OTC derivative contract, including an OTC 

derivative contract with a negative mark-to-market value, is calculated by multiplying the 

notional principal amount of the derivative contract by the appropriate conversion factor 

in Table 4. For purposes of calculating either the potential future credit exposure under 

this paragraph or the gross potential future credit exposure under paragraph (b)(6) of this 

section for exchange rate contracts and other similar contracts in which the notional 

principal amount is equivalent to the cash flows, notional principal amount is the net 
 Draft Basel II NPR 

417

receipts to each party falling due on each value date in each currency. For any OTC 

derivative contract that does not fall within one of the specified categories in Table 4, the 

potential future credit exposure must be calculated using the “other commodity” 

conversion factors. Banks must use an OTC derivative contract’s effective notional 

principal amount (that is, its apparent or stated notional principal amount multiplied by 

any multiplier in the OTC derivative contract) rather than its apparent or stated notional 

principal amount in calculating potential future credit exposure. PFE of the protection 

provider of a credit derivative is capped at the net present value of the amount of unpaid 

premiums. 

Table 4 – Conversion Factor Matrix for OTC Derivative Contracts* 

Remaining 

maturity** 

Interest 

rate 

Foreign 

exchange 

rate and 

gold 

Credit 

(investment 

grade 

reference 

obligor)*** 

Credit 

(noninvestment 

grade 

reference 

obligor) 

Equity Precious 

metals 

(except 

gold) 

Other 

commodity 

One year or less 0.00 0.01 0.05 0.10 0.06 0.07 0.10 

Over one to five 

years 

0.005 0.05 0.05 0.10 0.08 0.07 0.12 

Over five years 0.015 0.075 0.05 0.10 0.10 0.08 0.15 

* For an OTC derivative contract with multiple exchanges of principal, the conversion 

factor is multiplied by the number of remaining payments in the derivative contract. 

** For an OTC derivative contract that is structured such that on specified dates any 

outstanding exposure is settled and the terms are reset so that the market value of the 

contract is zero, the remaining maturity equals the time until the next reset date. For an 

interest rate derivative contract with a remaining maturity of greater than one year that 

meets these criteria, the minimum conversion factor is 0.005. 

*** A bank must use column 4 of this table – “Credit (investment grade reference 

obligor)” – for a credit derivative whose reference obligor has an outstanding unsecured 

long-term debt security without credit enhancement that has a long-term applicable 

external rating of at least investment grade. A bank must use column 5 of the table for all 

other credit derivatives. 
 Draft Basel II NPR 

418

 (6) Multiple OTC derivative contracts subject to a qualifying master netting 

agreement. Except as modified by paragraph (b)(7) of this section, the EAD for multiple 

OTC derivative contracts subject to a qualifying master netting agreement is equal to the 

sum of the net current credit exposure and the adjusted sum of the PFE exposure for all 

OTC derivative contracts subject to the qualifying master netting agreement. 

(i) Net current credit exposure. The net current credit exposure is the greater of: 

(A) The net sum of all positive and negative mark-to-market values of the 

individual OTC derivative contracts subject to the qualifying master netting agreement; 

or 

(B) zero. 

(ii) Adjusted sum of the PFE. The adjusted sum of the PFE is calculated as Anet 

= (0.4×Agross)+(0.6×NGR×Agross), where: 

(A) Anet = the adjusted sum of the PFE; 

(B) Agross = the gross PFE (that is, the sum of the PFE amounts (as determined 

under paragraph (b)(5)(ii) of this section) for each individual OTC derivative contract 

subject to the qualifying master netting agreement); and 

(C) NGR = the net to gross ratio (that is, the ratio of the net current credit 

exposure to the gross current credit exposure). In calculating the NGR, the gross current 

credit exposure equals the sum of the positive current credit exposures (as determined 

under paragraph (b)(5)(i) of this section) of all individual OTC derivative contracts 

subject to the qualifying master netting agreement. 

(7) Collateralized OTC derivative contracts. A bank may recognize the credit risk 

mitigation benefits of financial collateral that secures an OTC derivative contract or 
 Draft Basel II NPR 

419

single-product set of OTC derivatives subject to a qualifying master netting agreement 

(netting set) by factoring the collateral into its ELGD and LGD estimates for the contract 

or netting set. Alternatively, a bank may recognize the credit risk mitigation benefits of 

financial collateral that secures such a contract or netting set that is marked to market on 

a daily basis and subject to a daily margin maintenance requirement by estimating an 

unsecured ELGD and LGD for the contract or netting set and adjusting the EAD 

calculated under paragraph (b)(5) or (6) of this section using the collateral haircut 

approach in paragraph (a)(2) of this section. The bank must substitute the EAD 

calculated under paragraph (b)(5) or (6) of this section for ∑E in the equation in 

paragraph (a)(2)(i) of this section and must use a 10-business-day minimum holding 

period (TM=10). 

(c) Internal models methodology. (1) With prior written approval from 

[AGENCY], a bank may use the internal models methodology in this paragraph (c) to 

determine EAD for counterparty credit risk for OTC derivative contracts (collateralized 

or uncollateralized) and single-product netting sets thereof, for eligible margin loans and 

single-product netting sets thereof, and for repo-style transactions and single-product 

netting sets thereof. A bank that uses the internal models methodology for a particular 

transaction type (OTC derivative contracts, eligible margin loans, or repo-style 

transactions) must use the internal models methodology for all transactions of that 

transaction type. A bank may choose to use the internal models methodology for one or 

two of these three types of exposures and not the other types. A bank may also use the 

internal models methodology for OTC derivative contracts, eligible margin loans, and 

repo-style transactions subject to a qualifying cross-product netting agreement if: 
 Draft Basel II NPR 

420

(i) The bank effectively integrates the risk mitigating effects of cross-product 

netting into its risk management and other information technology systems; and 

(ii) The bank obtains the prior written approval of the [AGENCY]. 

A bank that uses the internal models methodology for a type of exposures must receive 

approval from the [AGENCY] to cease using the methodology for that type of exposures 

or to make a material change to its internal model. 

(2) Under the internal models methodology, a bank uses an internal model to 

estimate the expected exposure (EE) for a netting set and then calculates EAD based on 

that EE. 

(i) The bank must use its internal model’s probability distribution for changes in 

the market value of an exposure or netting set that are attributable to changes in market 

variables to determine EE. The bank may include financial collateral currently posted by 

the counterparty as collateral when calculating EE. 

(ii) Under the internal models methodology, EAD = α x effective EPE, or, subject 

to [AGENCY] approval as provided in paragraph (c)(7), a more conservative measure of 

EAD. 

(A) ∑=

= ∗ Δ

n

k

t t k EffectiveEPE EffectiveEE t k k

1

 (that is, effective EPE is the timeweighted average of effective EE where the weights are the proportion that an individual 

effective EE represents in a one year time interval) where: 

(1) ( ) k k k EffectiveEEt EffectiveEEt EEt max , −1 = (that is, for a specific date tk, 

effective EE is the greater of EE at that date or the effective EE at the previous date); and 

(2) tk represents the kth future time period in the model and there are n time 

periods represented in the model over the first year; and 
 Draft Basel II NPR 

421

(B) α = 1.4 except as provided in paragraph (c)(6), or when [AGENCY] has 

determined that the bank must set α higher based on the bank’s specific characteristics of 

counterparty credit risk. 

(3) To obtain [AGENCY] approval to calculate the distributions of exposures 

upon which the EAD calculation is based, the bank must demonstrate to the satisfaction 

of [AGENCY] that it has been using for at least one year an internal model that broadly 

meets the following minimum standards, with which the bank must maintain compliance: 

(i) The model must have the systems capability to estimate the expected exposure 

to the counterparty on a daily basis (but is not expected to estimate or report expected 

exposure on a daily basis). 

(ii) The model must estimate expected exposure at enough future dates to 

accurately reflect all the future cash flows of contracts in the netting set. 

(iii) The model must account for the possible non-normality of the exposure 

distribution, where appropriate. 

(iv) The bank must measure, monitor, and control current counterparty exposure 

and the exposure to the counterparty over the whole life of all contracts in the netting set. 

(v) The bank must measure and manage current exposures gross and net of 

collateral held, where appropriate. The bank must estimate expected exposures for OTC 

derivative contracts both with and without the effect of collateral agreements. 

(vi) The bank must have procedures to identify, monitor, and control specific 

wrong-way risk throughout the life of an exposure. Wrong-way risk in this context is the 

risk that future exposure to a counterparty will be high when the counterparty’s 

probability of default is also high. 
 Draft Basel II NPR 

422

(vii) The model must use current market data to compute current exposures. 

When estimating model parameters based on historical data, at least three years of 

historical data that cover a wide range of economic conditions must be used and must be 

updated quarterly or more frequently if market conditions warrant. The bank should 

consider using model parameters based on forward-looking measures such as implied 

volatilities, where appropriate. 

(viii) A bank must subject its internal model to an initial validation and annual 

model review process. The model review should consider whether the inputs and risk 

factors, as well as the model outputs, are appropriate. 

(4) Maturity. (i) If the remaining maturity of the exposure or the longest-dated 

contract in the netting set is greater than one year, the bank must set M for the exposure 

or netting set equal to the lower of 5 years or M(EPE), where: 

(A) 

∑

∑

≤

=

>

×Δ ×

×Δ ×

= + t year

k

k k k

maturity

t year

k k k

k

k

effectiveEE t df

EE t df

M EPE 1

1

1 ( ; ) 1

(B) dfk is the risk-free discount factor for future time period tk; and 

(C) Δ k = k − k−1 t t t . 

(ii) If the remaining maturity of the exposure or the longest-dated contract in the 

netting set is one year or less, the bank must set M for the exposure or netting set equal to 

1 year, except as provided in paragraph (d)(7) of section 31. 

(5) Collateral agreements. A bank may capture the effect on EAD of a collateral 

agreement that requires receipt of collateral when exposure to the counterparty increases 

but may not capture the effect on EAD of a collateral agreement that requires receipt of 
 Draft Basel II NPR 

423

collateral when counterparty credit quality deteriorates. For this purpose, a collateral 

agreement means a legal contract that specifies the time when, and circumstances under 

which, the counterparty is required to exchange collateral with the bank for a single 

financial contract or for all financial contracts covered under a qualifying master netting 

agreement and confers upon the bank a perfected, first priority security interest, or the 

legal equivalent thereof, in the collateral posted by the counterparty under the agreement. 

This security interest must provide the bank with a right to close out the financial 

positions and the collateral upon an event of default of, or failure to perform by, the 

counterparty under the collateral agreement. A contract would not satisfy this 

requirement if the bank’s exercise of rights under the agreement may be stayed or 

avoided under applicable law in the relevant jurisdictions. Two methods are available to 

capture the effect of a collateral agreement: 

(i) With prior written approval from [AGENCY], a bank may include the effect of 

a collateral agreement within its internal model used to calculate EAD. The bank may set 

EAD equal to the expected exposure at the end of the margin period of risk. The margin 

period of risk means, with respect to a netting set subject to a collateral agreement, the 

time period from the most recent exchange of collateral with a counterparty until the next 

required exchange of collateral plus the period of time required to sell and realize the 

proceeds of the least liquid collateral that can be delivered under the terms of the 

collateral agreement, and, where applicable, the period of time required to re-hedge the 

resulting market risk, upon the default of the counterparty. The minimum margin period 

of risk is 5 business days for repo-style transactions and 10 business days for other 

transactions when liquid financial collateral is posted under a daily margin maintenance 
 Draft Basel II NPR 

424

requirement. This period should be extended to cover any additional time between 

margin calls; any potential closeout difficulties; any delays in selling collateral, 

particularly if the collateral is illiquid; and any impediments to prompt re-hedging of any 

market risk. 

(ii) A bank that can model EPE without collateral agreements but cannot achieve 

the higher level of modeling sophistication to model EPE with collateral agreements can 

set effective EPE for a collateralized counterparty equal to the lesser of: 

(A) The threshold, defined as the exposure amount at which the counterparty is 

required to post collateral under the collateral agreement, if the threshold is positive, plus 

an add-on that reflects the potential increase in exposure over the margin period of risk. 

The add-on is computed as the expected increase in the netting set’s exposure beginning 

from current exposure of zero over the margin period of risk. The margin period of risk 

must be at least five business days for exposures or netting sets consisting only of repostyle transactions subject to daily re-margining and daily marking-to-market, and 10 

business days for all other exposures or netting sets; or 

(B) Effective EPE without a collateral agreement. 

(6) Own estimate of alpha. With prior written approval of [AGENCY], a bank 

may calculate alpha as the ratio of economic capital from a full simulation of 

counterparty exposure across counterparties that incorporates a joint simulation of market 

and credit risk factors (numerator) and economic capital based on EPE (denominator), 

subject to a floor of 1.2. For purposes of this calculation, economic capital is the 

unexpected losses for all counterparty credit risks measured at a 99.9 percent confidence 
 Draft Basel II NPR 

425

level over a one-year horizon. To receive approval, the bank must meet the following 

minimum standards to the satisfaction of [AGENCY]: 

(i) The bank’s own estimate of alpha must capture in the numerator the effects of: 

(A) The material sources of stochastic dependency of distributions of market 

values of transactions or portfolios of transactions across counterparties; 

(B) Volatilities and correlations of market risk factors used in the joint simulation, 

which must be related to the credit risk factor used in the simulation to reflect potential 

increases in volatility or correlation in an economic downturn, where appropriate; and 

(C) The granularity of exposures, that is, the effect of a concentration in the 

proportion of each counterparty’s exposure that is driven by a particular risk factor. 

(ii) The bank must assess the potential model risk in its estimates of alpha. 

(iii) The bank must calculate the numerator and denominator of alpha in a 

consistent fashion with respect to modeling methodology, parameter specifications, and 

portfolio composition. 

(iv) The bank must review and adjust as appropriate its estimates of the numerator 

and denominator on at least a quarterly basis and more frequently when the composition 

of the portfolio varies over time. 

 (7) Other measures of counterparty exposure. With prior written approval of 

[AGENCY], a bank may set EAD equal to a measure of counterparty credit risk 

exposure, such as peak EAD, that is more conservative than an alpha of 1.4 (or higher 

under the terms of paragraph (c)(2)(ii)(B)) times EPE for every counterparty whose EAD 

will be measured under the alternative measure of counterparty exposure. The bank must 
 Draft Basel II NPR 

426

demonstrate the conservatism of the measure of counterparty credit risk exposure used 

for EAD. 

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

Adjustment Treatments

(a) Scope. (1) This section applies to wholesale exposures for which: 

(i) Credit risk is fully covered by an eligible guarantee or eligible credit 

derivative; and 

(ii) Credit risk is covered on a pro rata basis (that is, on a basis in which the bank 

and the protection provider share losses proportionately) by an eligible guarantee or 

eligible credit derivative. 

(2) Wholesale exposures on which there is a tranching of credit risk (reflecting at 

least two different levels of seniority) are securitization exposures subject to the 

securitization framework in part V. 

(3) A bank may elect to recognize the credit risk mitigation benefits of an eligible 

guarantee or eligible credit derivative covering an exposure described in paragraph (a)(1) 

of this section by using the PD substitution approach or the LGD adjustment approach in 

paragraph (c) of this section or using the double default treatment in section 34 (if the 

transaction qualifies for the double default treatment in section 34). A bank’s PD and 

LGD for the hedged exposure may not be lower than the PD and LGD floors described in 

paragraphs (d)(2) and (d)(3) of section 31. 

(4) A bank must use the same risk parameters for calculating ECL as it uses for 

calculating the risk-based capital requirement for the exposure. 
 Draft Basel II NPR 

427

(b) Rules of recognition. (1) A bank may only recognize the credit risk mitigation 

benefits of eligible guarantees and eligible credit derivatives. 

(2) A bank may only recognize the credit risk mitigation benefits of an eligible 

credit derivative to hedge an exposure that is different from the credit derivative’s 

reference exposure used for determining the derivative’s cash settlement value, 

deliverable obligation, or occurrence of a credit event if: 

(i) The reference exposure ranks pari passu (that is, equally) with or is junior to 

the hedged exposure; and 

(ii) The reference exposure and the hedged exposure share the same obligor (that 

is, the same legal entity), and legally enforceable cross-default or cross-acceleration 

clauses are in place. 

 (c) Risk parameters for hedged exposures - (1) PD substitution approach - (i) Full 

coverage. If an eligible guarantee or eligible credit derivative meets the conditions in 

paragraphs (a) and (b) of this section and the protection amount (P) of the guarantee or 

credit derivative is greater than or equal to the EAD of the hedged exposure, a bank may 

recognize the guarantee or credit derivative in determining the bank’s risk-based capital 

requirement for the hedged exposure by substituting the PD associated with the rating 

grade of the protection provider for the PD associated with the rating grade of the obligor 

in the risk-based capital formula in Table 2 and using the appropriate ELGD and LGD as 

described in paragraphs (c)(1)(iii) and (iv) of this section. If the bank determines that full 

substitution of the protection provider’s PD leads to an inappropriate degree of risk 

mitigation, the bank may substitute a higher PD than that of the protection provider. 
 Draft Basel II NPR 

428

 (ii) Partial coverage. If an eligible guarantee or eligible credit derivative meets 

the conditions in paragraphs (a) and (b) of this section and the protection amount (P) of 

the guarantee or credit derivative is less than the EAD of the hedged exposure, the bank 

must treat the hedged exposure as two separate exposures (protected and unprotected) in 

order to recognize the credit risk mitigation benefit of the guarantee or credit derivative. 

(A) The bank must calculate its risk-based capital requirement for the protected 

exposure under section 31, where PD is the protection provider’s PD, ELGD and LGD 

are determined under paragraphs (c)(1)(iii) and (iv) of this section, and EAD is P. If the 

bank determines that full substitution leads to an inappropriate degree of risk mitigation, 

the bank may use a higher PD than that of the protection provider. 

(B) The bank must calculate its risk-based capital requirement for the unprotected 

exposure under section 31, where PD is the obligor’s PD, ELGD is the hedged exposure’s 

ELGD (not adjusted to reflect the guarantee or credit derivative), LGD is the hedged 

exposure’s LGD (not adjusted to reflect the guarantee or credit derivative), and EAD is 

the EAD of the original hedged exposure minus P. 

(C) The treatment in this paragraph (c)(1)(ii) is applicable when the credit risk of 

a wholesale exposure is covered on a pro rata basis or when an adjustment is made to the 

effective notional amount of the guarantee or credit derivative under paragraphs (d), (e), 

or (f) of this section. 

 (iii) LGD of hedged exposures. The LGD of a hedged exposure under the PD 

substitution approach is equal to: 

(A) The lower of the LGD of the hedged exposure (not adjusted to reflect the 

guarantee or credit derivative) and the LGD of the guarantee or credit derivative, if the 
 Draft Basel II NPR 

429

guarantee or credit derivative provides the bank with the option to receive immediate 

payout upon triggering the protection; or 

(B) The LGD of the guarantee or credit derivative, if the guarantee or credit 

derivative does not provide the bank with the option to receive immediate payout upon 

triggering the protection. 

(iv) ELGD of hedged exposures. The ELGD of a hedged exposure under the PD 

substitution approach is equal to the ELGD associated with the LGD determined under 

paragraph (c)(1)(iii) of this section. 

(2) LGD adjustment approach - (i) Full coverage. If an eligible guarantee or 

eligible credit derivative meets the conditions in paragraphs (a) and (b) of this section and 

the protection amount (P) of the guarantee or credit derivative is greater than or equal to 

the EAD of the hedged exposure, the bank’s risk-based capital requirement for the 

hedged exposure would be the greater of: 

(A) The risk-based capital requirement for the exposure as calculated under 

section 31, with the ELGD and LGD of the exposure adjusted to reflect the guarantee or 

credit derivative; or 

(B) The risk-based capital requirement for a direct exposure to the protection 

provider as calculated under section 31, using the PD for the protection provider, the 

ELGD and LGD for the guarantee or credit derivative, and an EAD equal to the EAD of 

the hedged exposure. 

 (ii) Partial coverage. If an eligible guarantee or eligible credit derivative meets 

the conditions in paragraphs (a) and (b) of this section and the protection amount (P) of 

the guarantee or credit derivative is less than the EAD of the hedged exposure, the bank 
 Draft Basel II NPR 

430

must treat the hedged exposure as two separate exposures (protected and unprotected) in 

order to recognize the credit risk mitigation benefit of the guarantee or credit derivative. 

(A) The bank’s risk-based capital requirement for the protected exposure would 

be the greater of: 

(1) The risk-based capital requirement for the protected exposure as calculated 

under section 31, with the ELGD and LGD of the exposure adjusted to reflect the 

guarantee or credit derivative and EAD set equal to P; or 

(2) The risk-based capital requirement for a direct exposure to the guarantor as 

calculated under section 31, using the PD for the protection provider, the ELGD and 

LGD for the guarantee or credit derivative, and an EAD set equal to P. 

(B) The bank must calculate its risk-based capital requirement for the unprotected 

exposure under section 31, where PD is the obligor’s PD, ELGD is the hedged exposure’s 

ELGD (not adjusted to reflect the guarantee or credit derivative), LGD is the hedged 

exposure’s LGD (not adjusted to reflect the guarantee or credit derivative), and EAD is 

the EAD of the original hedged exposure minus P. 

(3) M of hedged exposures. The M of the hedged exposure is the same as the M 

of the exposure if it were unhedged. 

 (d) Maturity mismatch. (1) A bank that recognizes an eligible guarantee or 

eligible credit derivative in determining its risk-based capital requirement for a hedged 

exposure must adjust the protection amount of the credit risk mitigant to reflect any 

maturity mismatch between the hedged exposure and the credit risk mitigant. 

 (2) A maturity mismatch occurs when the residual maturity of a credit risk 

mitigant is less than that of the hedged exposure(s). When a credit risk mitigant covers 
 Draft Basel II NPR 

431

multiple hedged exposures that have different residual maturities, the longest residual 

maturity of any of the hedged exposures must be taken as the residual maturity of the 

hedged exposures. 

 (3) The residual maturity of a hedged exposure is the longest possible remaining 

time before the obligor is scheduled to fulfil its obligation on the exposure. If a credit 

risk mitigant has embedded options that may reduce its term, the bank (protection 

purchaser) must use the shortest possible residual maturity for the credit risk mitigant. If 

a call is at the discretion of the protection provider, the residual maturity of the credit risk 

mitigant is at the first call date. If the call is at the discretion of the bank (protection 

purchaser), but the terms of the arrangement at origination of the credit risk mitigant 

contain a positive incentive for the bank to call the transaction before contractual 

maturity, the remaining time to the first call date is the residual maturity of the credit risk 

mitigant. For example, where there is a step-up in cost in conjunction with a call feature 

or where the effective cost of protection increases over time even if credit quality remains 

the same or improves, the residual maturity of the credit risk mitigant will be the 

remaining time to the first call. 

 (4) A credit risk mitigant with a maturity mismatch may be recognized only if its 

original maturity is greater than or equal to one year and its residual maturity is greater 

than three months. 

 (5) When a maturity mismatch exists, the bank must apply the following 

adjustment to reduce the protection amount of the credit risk mitigant: Pm = E x (t0.25)/(T-0.25), where: 
 Draft Basel II NPR 

432

 (i) Pm = protection amount of the credit risk mitigant, adjusted for maturity 

mismatch; 

 (ii) E = effective notional amount of the credit risk mitigant; 

 (iii) t = the lesser of T or the residual maturity of the credit risk mitigant, 

expressed in years; and 

 (iv) T = the lesser of 5 or the residual maturity of the hedged exposure, expressed 

in years. 

 (e) Credit derivatives without restructuring as a credit event. If a bank recognizes 

an eligible credit derivative that does not include as a credit event a restructuring of the 

hedged exposure involving forgiveness or postponement of principal, interest, or fees that 

results in a credit loss event (that is, a charge-off, specific provision, or other similar debit 

to the profit and loss account), the bank must apply the following adjustment to reduce 

the protection amount of the credit derivative: Pr = Pm x 0.60, where: 

 (1) Pr = protection amount of the credit derivative, adjusted for lack of 

restructuring event (and maturity mismatch, if applicable); and 

 (2) Pm = effective notional amount of the credit derivative (adjusted for maturity 

mismatch, if applicable). 

 (f) Currency mismatch. (1) If a bank recognizes an eligible guarantee or eligible 

credit derivative that is denominated in a currency different from that in which the 

hedged exposure is denominated, the protection amount of the guarantee or credit 

derivative is reduced by application of the following formula: Pc = Pr x (1-HFX), where: 

 (i) Pc = protection amount of the guarantee or credit derivative, adjusted for 

currency mismatch (and maturity mismatch and lack of restructuring event, if applicable); 
 Draft Basel II NPR 

433

 (ii) Pr = effective notional amount of the guarantee or credit derivative (adjusted 

for maturity mismatch and lack of restructuring event, if applicable); and 

 (iii) HFX = haircut appropriate for the currency mismatch between the guarantee 

or credit derivative and the hedged exposure. 

(2) A bank must set HFX equal to 8 percent unless it qualifies for the use of and 

uses its own internal estimates of foreign exchange volatility based on a 10-business day 

holding period and daily marking-to-market and remargining. A bank qualifies for the 

use of its own internal estimates of foreign exchange volatility if it qualifies for: 

(i) The own-estimates haircuts in paragraph (a)(2)(iii) of section 32; 

(ii) The simple VaR methodology in paragraph (a)(3) of section 32; or 

(iii) The internal models methodology in paragraph (c) of section 32. 

(3) A bank must adjust HFX calculated in paragraph (f)(2) of this section upward if 

the bank revalues the guarantee or credit derivative less frequently than once every 10 

business days using the square root of time formula provided in paragraph 

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

Section 34. Guarantees and Credit Derivatives: Double Default Treatment 

 (a) Eligibility and operational criteria for double default treatment. A bank may 

recognize the credit risk mitigation benefits of a guarantee or credit derivative covering 

an exposure described in paragraph (a)(1) of section 33 by applying the double default 

treatment in this section if all the following criteria are satisfied. 

 (1) The hedged exposure is fully covered or covered on a pro rata basis by: 

(i) An eligible guarantee issued by an eligible double default guarantor; or 
 Draft Basel II NPR 

434

(ii) An eligible credit derivative that meets the requirements of paragraph (b)(2) of 

section 33 and is issued by an eligible double default guarantor. 

 (2) The guarantee or credit derivative is: 

 (i) An uncollateralized guarantee or uncollateralized credit derivative (for 

example, a credit default swap) that provides protection with respect to a single reference 

obligor; or 

 (ii) An nth-to-default credit derivative (subject to the requirements of 

paragraph (m) of section 42). 

 (3) The hedged exposure is a wholesale exposure (other than a sovereign 

exposure). 

 (4) The obligor of the hedged exposure is not: 

 (i) An eligible double default guarantor or an affiliate of an eligible double default 

guarantor; or 

 (ii) An affiliate of the guarantor. 

 (5) The bank does not recognize any credit risk mitigation benefits of the 

guarantee or credit derivative for the hedged exposure other than through application of 

the double default treatment as provided in this section. 

 (6) The bank has implemented a process (which has received the prior, written 

approval of the [AGENCY]) to detect excessive correlation between the creditworthiness 

of the obligor of the hedged exposure and the protection provider. If excessive 

correlation is present, the bank may not use the double default treatment for the hedged 

exposure. 
 Draft Basel II NPR 

435

 (b) Full coverage. If the transaction meets the criteria in paragraph (a) of this 

section and the protection amount (P) of the guarantee or credit derivative is at least equal 

to the EAD of the hedged exposure, the bank may determine its risk-weighted asset 

amount for the hedged exposure under paragraph (e) of this section. 

 (c) Partial coverage. If the transaction meets the criteria in paragraph (a) of this 

section and the protection amount (P) of the guarantee or credit derivative is less than the 

EAD of the hedged exposure, the bank must treat the hedged exposure as two separate 

exposures (protected and unprotected) in order to recognize double default treatment on 

the protected portion of the exposure. 

 (1) For the protected exposure, the bank must set EAD equal to P and calculate its 

risk-weighted asset amount as provided in paragraph (e) of this section. 

 (2) For the unprotected exposure, the bank must set EAD equal to the EAD of the 

original exposure minus P and then calculate its risk-weighted asset amount as provided 

in section 31. 

 (d) Mismatches. For any hedged exposure to which a bank applies double default 

treatment, the bank must make applicable adjustments to the protection amount as 

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

 (e) The double default dollar risk-based capital requirement. The dollar riskbased capital requirement for a hedged exposure to which a bank has applied double 

default treatment is KDD multiplied by the EAD of the exposure. KDD is calculated 

according to the following formula: KDD = Ko x (0.15 + 160 x PDg), 

where: 
 Draft Basel II NPR 

436

 (1) 

( ) ⎥

⎦

⎤ ⎢

⎣

⎡

− ×

+ − ×

×

⎥

⎥

⎦

⎤

⎢

⎢

⎣

⎡ − × ⎟

⎟

⎠

⎞

⎜

⎜

⎝

⎛

−

+ = ×

− −

b

M b ELGD PD

N PD N

K LGD N g o

os

o os

g 1 1.5

1 ( 2.5)

1

( ) (0.999) 1 1

0

ρ

ρ

 (2) PDg = PD of the protection provider. 

 (3) PDo = PD of the obligor of the hedged exposure. 

(4) LGDg = (i) The lower of the LGD of the unhedged exposure and the LGD of 

the guarantee or credit derivative, if the guarantee or credit derivative provides the bank 

with the option to receive immediate payout on triggering the protection; or 

(ii) The LGD of the guarantee or credit derivative, if the guarantee or credit 

derivative does not provide the bank with the option to receive immediate payout on 

triggering the protection. 

(5) ELGDg = The ELGD associated with LGDg. 

 (6) ρos (asset value correlation of the obligor) is calculated according to the 

appropriate formula for (R) provided in Table 2 in section 31, with PD equal to PDo. 

 (7) b (maturity adjustment coefficient) is calculated according to the formula for b 

provided in Table 2 in section 31, with PD equal to the lesser of PDo and PDg. 

 (8) M (maturity) is the effective maturity of the guarantee or credit derivative, 

which may not be less than one year or greater than five years. 

Section 35. Risk-Based Capital Requirement for Unsettled Transactions 

(a) Definitions. For purposes of this section: 

(1) Delivery-versus-payment (DvP) transaction means a securities or commodities 

transaction in which the buyer is obligated to make payment only if the seller has made 

delivery of the securities or commodities and the seller is obligated to deliver the 

securities or commodities only if the buyer has made payment. 
 Draft Basel II NPR 

437

(2) Payment-versus-payment (PvP) transaction means a foreign exchange 

transaction in which each counterparty is obligated to make a final transfer of one or 

more currencies only if the other counterparty has made a final transfer of one or more 

currencies. 

(3) Normal settlement period. A transaction has a normal settlement period if the 

contractual settlement period for the transaction is equal to or less than the market 

standard for the instrument underlying the transaction and equal to or less than 5 business 

days. 

(4) Positive current exposure. The positive current exposure of a bank for a 

transaction is the difference between the transaction value at the agreed settlement price 

and the current market price of the transaction, if the difference results in a credit 

exposure of the bank to the counterparty. 

 (b) Scope. This section applies to all transactions involving securities, foreign 

exchange instruments, and commodities that have a risk of delayed settlement or 

delivery. This section does not apply to: 

(1) Transactions accepted by a qualifying central counterparty that are subject to 

daily marking-to-market and daily receipt and payment of variation margin; 

(2) Repo-style transactions (which are addressed in sections 31 and 32);19

(3) One-way cash payments on OTC derivative contracts (which are addressed in 

sections 31 and 32); or 

(4) Transactions with a contractual settlement period that is longer than the 

normal settlement period (which are treated as OTC derivative contracts and addressed in 

sections 31 and 32). 

 

19 Unsettled repo-style transactions are treated as repo-style transactions under sections 31 and 32. 
 Draft Basel II NPR 

438

(c) System-wide failures. In the case of a system-wide failure of a settlement or 

clearing system, the [AGENCY] may waive risk-based capital requirements for unsettled 

and failed transactions until the situation is rectified. 

(d) Delivery-versus-payment (DvP) and payment-versus-payment (PvP) 

transactions. A bank must hold risk-based capital against any DvP or PvP transaction 

with a normal settlement period if the bank’s counterparty has not made delivery or 

payment within five business days after the settlement date. The bank must determine its 

risk-weighted asset amount for such a transaction by multiplying the positive current 

exposure of the transaction for the bank by the appropriate risk weight in Table 5. 

Table 5 – Risk Weights for Unsettled DvP and PvP Transactions 

Number of business days 

after contractual 

settlement date 

Risk weight to be 

applied to positive 

current exposure 

From 5 to 15 100% 

From 16 to 30 625% 

From 31 to 45 937.5% 

46 or more 1,250% 

(e) Non-DvP (non-delivery-versus-payment) transactions. (1) A bank must hold 

risk-based capital against any non-DvP transaction with a normal settlement period if the 

bank has delivered cash, securities, commodities, or currencies to its counterparty but has 

not received its corresponding deliverables by the end of the same business day. The 

bank must continue to hold risk-based capital against the transaction until the bank has 

received its corresponding deliverables. 

(2) From the business day after the bank has made its delivery until five business 

days after the counterparty delivery is due, the bank must calculate its risk-based capital 
 Draft Basel II NPR 

439

requirement for the transaction by treating the current market value of the deliverables 

owed to the bank as a wholesale exposure. 

 (i) A bank may assign an obligor rating to a counterparty for which it is not 

otherwise required under this rule to assign an obligor rating on the basis of the 

applicable external rating of any outstanding unsecured long-term debt security without 

credit enhancement issued by the counterparty. 

(ii) A bank may use a 45 percent ELGD and LGD for the transaction rather than 

estimating ELGD and LGD for the transaction provided the bank uses the 45 percent 

ELGD and LGD for all transactions described in paragraphs (e)(1) and (2) of this section. 

(iii) A bank may use a 100 percent risk weight for the transaction provided the 

bank uses this risk weight for all transactions described in paragraphs (e)(1) and (2) of 

this section. 

(3) If the bank has not received its deliverables by the fifth business day after 

counterparty delivery was due, the bank must deduct the current market value of the 

deliverables owed to the bank 50 percent from tier 1 capital and 50 percent from tier 2 

capital. 

(f) Total risk-weighted assets for unsettled transactions. Total risk-weighted 

assets for unsettled transactions is the sum of the risk-weighted asset amounts of all DvP, 

PvP, and non-DvP transactions. 

Part V. Risk-Weighted Assets for Securitization Exposures 

Section 41. Operational Criteria for Recognizing the Transfer of Risk 

 (a) Operational criteria for traditional securitizations. A bank that transfers 

exposures it has originated or purchased to an SPE or other third party in connection with 
 Draft Basel II NPR 

440

a traditional securitization may exclude the exposures from the calculation of its riskweighted assets only if each of the conditions in this paragraph (a) is satisfied. A bank 

that meets these conditions must hold risk-based capital against any securitization 

exposures it retains in connection with the securitization. A bank that fails to meet these 

conditions must hold risk-based capital against the transferred exposures as if they had 

not been securitized and must deduct from tier 1 capital any after-tax gain-on-sale 

resulting from the transaction. The conditions are: 

 (1) The transfer is considered a sale under GAAP; 

 (2) The bank has transferred to third parties credit risk associated with the 

underlying exposures; and 

 (3) Any clean-up calls relating to the securitization are eligible clean-up calls. 

 (b) Operational criteria for synthetic securitizations. For synthetic securitizations, 

a bank may recognize for risk-based capital purposes the use of a credit risk mitigant to 

hedge underlying exposures only if each of the conditions in this paragraph (b) is 

satisfied. A bank that fails to meet these conditions must hold risk-based capital against 

the underlying exposures as if they had not been synthetically securitized. The conditions 

are: 

 (1) The credit risk mitigant is financial collateral, an eligible credit derivative 

from an eligible securitization guarantor, or an eligible guarantee from an eligible 

securitization guarantor; 

 (2) The bank transfers credit risk associated with the underlying exposures to third 

parties, and the terms and conditions in the credit risk mitigants employed do not include 

provisions that: 
 Draft Basel II NPR 

441

 (i) Allow for the termination of the credit protection due to deterioration in the 

credit quality of the underlying exposures; 

 (ii) Require the bank to alter or replace the underlying exposures to improve the 

credit quality of the pool of underlying exposures; 

 (iii) Increase the bank’s cost of credit protection in response to deterioration in the 

credit quality of the underlying exposures; 

 (iv) Increase the yield payable to parties other than the bank in response to a 

deterioration in the credit quality of the underlying exposures; or 

 (v) Provide for increases in a retained first loss position or credit enhancement 

provided by the bank after the inception of the securitization; 

 (3) The bank obtains a well-reasoned opinion from legal counsel that confirms the 

enforceability of the credit risk mitigant in all relevant jurisdictions; and 

 (4) Any clean-up calls relating to the securitization are eligible clean-up calls. 

Section 42. Risk-Based Capital Requirement for Securitization Exposures 

 (a) Hierarchy of approaches. Except as provided elsewhere in this section: 

(1) A bank must deduct from tier 1 capital any after-tax gain-on-sale resulting 

from a securitization and must deduct from total capital in accordance with paragraph (c) 

of this section the portion of any CEIO that does not constitute gain-on-sale. 

(2) If a securitization exposure does not require deduction under paragraph (a)(1) 

of this section and qualifies for the Ratings-Based Approach in section 43, a bank must 

apply the Ratings-Based Approach to the exposure. 

(3) If a securitization exposure does not require deduction under paragraph (a)(1) 

of this section and does not qualify for the Ratings-Based Approach, the bank may either 
 Draft Basel II NPR 

442

apply the Internal Assessment Approach in section 44 to the exposure (if the bank and the 

relevant ABCP program qualify for the Internal Assessment Approach) or the 

Supervisory Formula Approach in section 45 to the exposure (if the bank and the 

exposure qualify for the Supervisory Formula Approach). 

(4) If a securitization exposure does not require deduction under paragraph (a)(1) 

of this section and does not qualify for the Ratings-Based Approach, the Internal 

Assessment Approach, or the Supervisory Formula Approach, the bank must deduct the 

exposure from total capital in accordance with paragraph (c) of this section. 

(b) Total risk-weighted assets for securitization exposures. A bank’s total riskweighted assets for securitization exposures is equal to the sum of its risk-weighted assets 

calculated using the Ratings-Based Approach in section 43, the Internal Assessment 

Approach in section 44, and the Supervisory Formula Approach in section 45, and its 

risk-weighted assets amount for early amortization provisions calculated in section 47. 

 (c) Deductions. (1) If a bank must deduct a securitization exposure from total 

capital, the bank must take the deduction 50 percent from tier 1 capital and 50 percent 

from tier 2 capital. If the amount deductible from tier 2 capital exceeds the bank’s tier 2 

capital, the bank must deduct the excess from tier 1 capital. 

(2) A bank may calculate any deduction from regulatory capital for a 

securitization exposure net of any deferred tax liabilities associated with the 

securitization exposure. 

 (d) Maximum risk-based capital requirement. Regardless of any other provisions 

of this part, unless one or more underlying exposures does not meet the definition of a 

wholesale, retail, securitization, or equity exposure, the total risk-based capital 
 Draft Basel II NPR 

443

requirement for all securitization exposures held by a single bank associated with a single 

securitization (including any risk-based capital requirements that relate to an early 

amortization provision of the securitization but excluding any risk-based capital 

requirements that relate to the bank’s gain-on-sale or CEIOs associated with the 

securitization) may not exceed the sum of: 

(1) The bank’s total risk-based capital requirement for the underlying exposures 

as if the bank directly held the underlying exposures; plus 

(2) The total ECL of the underlying exposures. 

(e) Amount of a securitization exposure. (1) The amount of an on-balance sheet 

securitization exposure is: 

(i) The bank’s carrying value, if the exposure is held-to-maturity or for trading; or 

(ii) The bank’s carrying value minus any unrealized gains and plus any unrealized 

losses on the exposure, if the exposure is available-for-sale. 

(2) The amount of an off-balance sheet securitization exposure is the notional 

amount of the exposure. For a commitment, such as a liquidity facility extended to an 

ABCP program, the notional amount may be reduced to the maximum potential amount 

that the bank currently would be required to fund under the arrangement’s 

documentation. For an OTC derivative contract that is not a credit derivative, the 

notional amount is the EAD of the derivative contract (as calculated in section 32). 

 (f) Overlapping exposures - (1) ABCP programs. If a bank has multiple 

securitization exposures to an ABCP program that provide duplicative coverage of the 

underlying exposures of a securitization (such as when a bank provides a program-wide 

credit enhancement and multiple pool-specific liquidity facilities to an ABCP program), 
 Draft Basel II NPR 

444

the bank is not required to hold duplicative risk-based capital against the overlapping 

position. Instead, the bank may apply to the overlapping position the applicable riskbased capital treatment that results in the highest risk-based capital requirement. 

(2) Mortgage loan swaps. If a bank holds a mortgage-backed security or 

participation certificate as a result of a mortgage loan swap with recourse, and the 

transaction is a securitization exposure, the bank must determine a risk-weighted asset 

amount for the recourse obligation plus the percentage of the mortgage-backed security 

or participation certificate that is not covered by the recourse obligation. The total riskweighted asset amount for the transaction is capped at the risk-weighted asset amount for 

the underlying exposures as if they were held directly on the bank’s balance sheet. 

 (g) Securitizations of non-IRB exposures. Regardless of paragraph (a) of this 

section, if a bank has a securitization exposure where any underlying exposure is not a 

wholesale exposure, retail exposure, securitization exposure, or equity exposure, the bank 

must: 

(1) If the bank is an originating bank, deduct from tier 1 capital any after-tax gainon-sale resulting from the securitization and deduct from total capital in accordance with 

paragraph (c) of this section the portion of any CEIO that does not constitute gain-onsale; 

(2) If the securitization exposure does not require deduction under 

paragraph (g)(1), apply the RBA in section 43 to the securitization exposure if the 

exposure qualifies for the RBA; and 
 Draft Basel II NPR 

445

(3) If the securitization exposure does not require deduction under 

paragraph (g)(1) and does not qualify for the RBA, deduct the exposure from total capital 

in accordance with paragraph (c) of this section. 

 (h) Implicit support. If a bank provides support to a securitization in excess of the 

bank’s contractual obligation to provide credit support to the securitization (implicit 

support): 

 (1) The bank must hold regulatory capital against all of the underlying exposures 

associated with the securitization as if the exposures had not been securitized and must 

deduct from tier 1 capital any after-tax gain-on-sale resulting from the securitization; and 

 (2) The bank must disclose publicly: 

 (i) That it has provided implicit support to the securitization; and 

 (ii) The regulatory capital impact to the bank of providing such implicit support. 

 (i) Eligible servicer cash advance facilities. Regardless of any other provisions of 

this part, a bank is not required to hold risk-based capital against the undrawn portion of 

an eligible servicer cash advance facility. 

(j) Interest-only mortgage-backed securities. Regardless of any other provisions 

of this part, the risk weight for an interest-only mortgage-backed security may not be less 

than 100 percent. 

(k) Small-business loans and leases on personal property transferred with 

recourse. (1) Regardless of any other provisions of this appendix, a bank that has 

transferred small-business loans and leases of personal property (small-business 

obligations) with recourse must include in risk-weighted assets only the contractual 

amount of retained recourse if all the following conditions are met: 
 Draft Basel II NPR 

446

(i) The transaction is a sale under GAAP. 

(ii) The bank establishes and maintains, pursuant to GAAP, a non-capital reserve 

sufficient to meet the bank's reasonably estimated liability under the recourse 

arrangement. 

(iii) The loans and leases are to businesses that meet the criteria for a smallbusiness concern established by the Small Business Administration under section 3(a) of 

the Small Business Act. 

(iv) The bank is well capitalized, as defined in the [AGENCY]’s prompt 

corrective action regulation.20 For purposes of determining whether a bank is well 

capitalized for purposes of paragraph (k) of this section, the bank’s capital ratios must be 

calculated without regard to the preferential capital treatment for transfers of smallbusiness obligations with recourse specified in paragraph (k)(1) of this section. 

(2) The total outstanding amount of recourse retained by a bank on transfers of 

small-business obligations receiving the preferential capital treatment specified in 

paragraph (k)(1) of this section cannot exceed 15 percent of the bank’s total qualifying 

capital. 

(3) If a bank ceases to be well capitalized or exceeds the 15 percent capital 

limitation, the preferential capital treatment specified in paragraph (k)(1) of this section 

will continue to apply to any transfers of small-business obligations with recourse that 

occurred during the time that the bank was well capitalized and did not exceed the capital 

limit. 

 

20 12 CFR part 6 (national banks); 12 CFR part 208, subpart D (state member banks); 12 CFR part 325, 

subpart B (state non-member banks); and 12 CFR part 565 (savings associations). 
 Draft Basel II NPR 

447

(4) The risk-based capital ratios of the bank must be calculated without regard to 

the preferential capital treatment for transfers of small-business obligations with recourse 

specified in paragraph (k)(1) of this section as provided in 12 CFR part 3, Appendix A 

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

part 225, Appendix A (for bank holding companies); 12 CFR part 325, Appendix A (for 

state non-member banks); and 12 CFR 567.6(b)(5)(v) (for savings associations). 

 (l) Consolidated ABCP programs. (1) A bank that qualifies as a primary 

beneficiary and must consolidate an ABCP program as a variable interest entity under 

GAAP may exclude the consolidated ABCP program assets from risk-weighted assets if 

the bank is the sponsor of the ABCP program. If a bank excludes such consolidated 

ABCP program assets from risk-weighted assets, the bank must hold risk-based capital 

against any securitization exposures of the bank to the ABCP program in accordance with 

this part. 

 (2) If a bank either is not permitted, or elects not, to exclude consolidated ABCP 

program assets from its risk-weighted assets, the bank must hold risk-based capital 

against the consolidated ABCP program assets in accordance with this appendix but is 

not required to hold risk-based capital against any securitization exposures of the bank to 

the ABCP program. 

 (m) Nth-to-default credit derivatives - (1) First-to-default credit derivatives. (i) 

Protection purchaser. A bank that obtains credit protection on a group of underlying 

exposures through a first-to-default credit derivative must determine its risk-based capital 

requirement for the underlying exposures as if the bank synthetically securitized the 

underlying exposure with the lowest risk-based capital requirement (K) (as calculated 
 Draft Basel II NPR 

448

under Table 2) and had obtained no credit risk mitigant on the other underlying 

exposures. 

(ii) Protection provider. A bank that provides credit protection on a group of 

underlying exposures through a first-to-default credit derivative must determine its riskweighted asset amount for the derivative by applying the RBA in section 43 (if the 

derivative qualifies for the RBA) or, if the derivative does not qualify for the RBA, by 

setting its risk-weighted asset amount for the derivative equal to the product of: 

(A) The protection amount of the derivative; 

(B) 12.5; and 

(C) The sum of the risk-based capital requirements (K) of the individual 

underlying exposures (as calculated under Table 2), up to a maximum of 100 percent. 

(2) Second-or-subsequent-to-default credit derivatives - (i) Protection purchaser. 

(A) A bank that obtains credit protection on a group of underlying exposures through a 

nth-to-default credit derivative (other than a first-to-default credit derivative) may 

recognize the credit risk mitigation benefits of the derivative only if: 

(1) The bank also has obtained credit protection on the same underlying exposures 

in the form of first-through-(n-1)-to-default credit derivatives; or 

(2) If n-1 of the underlying exposures have already defaulted. 

(B) If a bank satisfies the requirements of paragraph (m)(2)(i)(A) of this section, 

the bank must determine its risk-based capital requirement for the underlying exposures 

as if the bank had only synthetically securitized the underlying exposure with the nth 

lowest risk-based capital requirement (K) (as calculated under Table 2) and had obtained 

no credit risk mitigant on the other underlying exposures. 
 Draft Basel II NPR 

449

(ii) Protection provider. A bank that provides credit protection on a group of 

underlying exposures through a nth-to-default credit derivative (other than a first-todefault credit derivative) must determine its risk-weighted asset amount for the derivative 

by applying the RBA in section 43 (if the derivative qualifies for the RBA) or, if the 

derivative does not qualify for the RBA, by setting its risk-weighted asset amount for the 

derivative equal to the product of: 

(A) The protection amount of the derivative; 

(B) 12.5; and 

(C) The sum of the risk-based capital requirements (K) of the individual 

underlying exposures (as calculated under Table 2 and excluding the n-1 underlying 

exposures with the lowest Ks), up to a maximum of 100 percent. 

Section 43. Ratings-Based Approach (RBA) 

 (a) Eligibility requirements for use of the RBA - (1) Originating bank. An 

originating bank must use the RBA to calculate its risk-based capital requirement for a 

securitization exposure if the exposure has two or more external ratings or an inferred 

rating based on two or more external ratings (and may not use the RBA if the exposure 

has fewer than two external ratings or an inferred rating based on fewer than two external 

ratings). 

(2) Investing bank. An investing bank must use the RBA to calculate its riskbased capital requirement for a securitization exposure if the exposure has one or more 

external or inferred ratings (and may not use the RBA if the exposure has no external or 

inferred rating). 
 Draft Basel II NPR 

450

 (b) Ratings-based approach. (1) A bank must determine the risk-weighted asset 

amount for a securitization exposure by multiplying the amount of the exposure (as 

defined in paragraph (e) of section 42) by the appropriate risk weight provided in the 

tables in this section. 

 (2) The applicable rating of a securitization exposure that has more than one 

external or inferred rating is the lowest rating. 

 (3) A bank must apply the risk weights in Table 6 when the securitization 

exposure’s external or inferred rating represents a long-term credit rating, and must apply 

the risk weights in Table 7 when the securitization exposure’s external or inferred rating 

represents a short-term credit rating. 

 (i) A bank must apply the risk weights in column 1 of Table 6 or 7 to the 

securitization exposure if: 

 (A) N (as calculated under paragraph (e)(6) of section 45) is 6 or more (for 

purposes of this section 43 only, if the notional number of underlying exposures is 25 or 

more or if all of the underlying exposures are retail exposures, a bank may assume that N 

is 6 or more unless the bank knows or has reason to know that N is less than 6); and 

 (B) The securitization exposure is a senior securitization exposure. 

 (ii) A bank must apply the risk weights in column 3 of Table 6 or 7 to the 

securitization exposure if N is less than 6, regardless of the seniority of the securitization 

exposure. 

 (iii) Otherwise, a bank must apply the risk weights in column 2 of Table 6 or 7. 
 Draft Basel II NPR 

451

Table 6 – Long-Term Credit Rating Risk Weights under RBA and IAA 

 Column 1 Column 2 Column 3

Applicable rating 

(Illustrative rating 

example) 

Risk weights for 

senior 

securitization 

exposures 

backed by 

granular pools 

Risk weights for 

non-senior 

securitization 

exposures backed 

by granular pools 

Risk weights for 

securitization 

exposures backed 

by non-granular 

pools 

Highest investment 

grade (for example, 

AAA) 

7% 12% 20% 

Second highest 

investment grade (for 

example, AA) 

8% 15% 25% 

Third-highest 

investment grade –

positive designation 

(for example, A+) 

10% 18% 

Third-highest 

investment grade (for 

example, A) 

12% 20% 

Third-highest 

investment grade –

negative designation 

(for example, A-) 

20% 35% 

35% 

Lowest investment 

grade—positive 

designation (for 

example, BBB+) 

35% 50% 

Lowest investment 

grade (for example, 

BBB) 

60% 75% 

Lowest investment 

grade—negative 

designation (for 

example, BBB-) 

100% 

One category below 

investment grade—

positive designation 

(for example, BB+) 

250% 

One category below 

investment grade (for 

example, BB) 

425% 

One category below 650% 
 Draft Basel II NPR 

452

investment grade—

negative designation 

(for example, BB-) 

More than one 

category below 

investment grade 

Deduction from tier 1 and tier 2 capital 

 

Table 7 – Short-Term Credit Rating Risk Weights under RBA and IAA 

 Column 1 Column 2 Column 3

Applicable Rating 

(Illustrative rating 

example) 

Risk weights for 

senior 

securitization 

exposures backed 

by granular pools 

Risk weights for 

non-senior 

securitization 

exposures backed 

by granular pools 

Risk weights for 

securitization 

exposures backed by 

non-granular pools 

Highest investment 

grade (for example, 

A1) 

7% 12% 20% 

Second highest 

investment grade 

(for example, A2) 

12% 20% 35% 

Third highest 

investment grade 

(for example, A3) 

60% 75% 75% 

All other ratings Deduction from tier 1 and tier 2 capital 

Section 44. Internal Assessment Approach (IAA)

 (a) Eligibility requirements. A bank may apply the IAA to calculate the riskweighted asset amount for a securitization exposure that the bank has to an ABCP 

program (such as a liquidity facility or credit enhancement) if the bank, the ABCP 

program, and the exposure qualify for use of the IAA. 

(1) Bank qualification criteria. A bank qualifies for use of the IAA if the bank has 

received the prior written approval of the [AGENCY]. To receive such approval, the 
 Draft Basel II NPR 

453

bank must demonstrate to the [AGENCY]’s satisfaction that the bank’s internal 

assessment process meets the following criteria: 

 (i) The bank’s internal credit assessments of securitization exposures must be 

based on publicly available rating criteria used by an NRSRO. 

 (ii) The bank’s internal credit assessments of securitization exposures used for 

risk-based capital purposes must be consistent with those used in the bank’s internal risk 

management process, management information reporting systems, and capital adequacy 

assessment process. 

 (iii) The bank’s internal credit assessment process must have sufficient granularity 

to identify gradations of risk. Each of the bank’s internal credit assessment categories 

must correspond to an external rating of an NRSRO. 

 (iv) The bank’s internal credit assessment process, particularly the stress test 

factors for determining credit enhancement requirements, must be at least as conservative 

as the most conservative of the publicly available rating criteria of the NRSROs that have 

provided external ratings to the commercial paper issued by the ABCP program. 

 (A) Where the commercial paper issued by an ABCP program has an external 

rating from two or more NRSROs and the different NRSROs’ benchmark stress factors 

require different levels of credit enhancement to achieve the same external rating 

equivalent, the bank must apply the NRSRO stress factor that requires the highest level of 

credit enhancement. 

 (B) If one of the NRSROs that provides an external rating to the ABCP program’s 

commercial paper changes its methodology (including stress factors), the bank must 
 Draft Basel II NPR 

454

consider the NRSRO’s revised rating methodology in evaluating whether the internal 

credit assessments assigned by the bank to securitization exposures must be revised. 

 (v) The bank must have an effective system of controls and oversight that ensures 

compliance with these operational requirements and maintains the integrity and accuracy 

of the internal credit assessments. The bank must have an internal audit function 

independent from the ABCP program business line and internal credit assessment process 

that assesses at least annually whether the controls over the internal credit assessment 

process function as intended. 

 (vi) The bank must review and update each internal credit assessment whenever 

new material information is available, but no less frequently than annually. 

(vii) The bank must validate its internal credit assessment process on an ongoing 

basis and at least annually. 

(2) ABCP-program qualification criteria. An ABCP program qualifies for use of 

the IAA if the ABCP program meets the following criteria: 

 (i) All commercial paper issued by the ABCP program must have an external 

rating. 

 (ii) The ABCP program must have robust credit and investment guidelines (that 

is, underwriting standards). 

 (iii) The ABCP program must perform a detailed credit analysis of the asset 

sellers’ risk profiles. 

 (iv) The ABCP program’s underwriting policy must establish minimum asset 

eligibility criteria that include the prohibition of the purchase of assets that are 
 Draft Basel II NPR 

455

significantly past due or defaulted, as well as limitations on concentration to individual 

obligor or geographic area and the tenor of the assets to be purchased. 

 (v) The aggregate estimate of loss on an asset pool that the ABCP program is 

considering purchasing must consider all sources of potential risk, such as credit and 

dilution risk. 

 (vi) The ABCP program must incorporate structural features into each purchase of 

assets to mitigate potential credit deterioration of the underlying exposures. Such 

features may include wind-down triggers specific to a pool of underlying exposures. 

(3) Exposure qualification criteria. A securitization exposure qualifies for use of 

the IAA if the bank initially rated the exposure at least the equivalent of investment 

grade. 

 (b) Mechanics. A bank that elects to use the IAA to calculate the risk-based 

capital requirement for any securitization exposure must use the IAA to calculate the 

risk-based capital requirements for all securitization exposures that qualify for the IAA 

approach. Under the IAA, a bank must map its internal assessment of such a 

securitization exposure to an equivalent external rating from an NRSRO. Under the IAA, 

a bank must determine the risk-weighted asset amount for such a securitization exposure 

by multiplying the amount of the exposure (as defined in paragraph (e) of section 42) by 

the appropriate risk weight in the RBA tables in paragraph (b) of section 43. 

Section 45. Supervisory Formula Approach (SFA) 

(a) Eligibility requirements. A bank may use the SFA to determine its risk-based 

capital requirement for a securitization exposure only if the bank can calculate on an 

ongoing basis each of the SFA parameters in paragraph (e) of this section. 
 Draft Basel II NPR 

456

 (b) Mechanics. Under the SFA, a bank must determine the risk-weighted asset 

amount for a securitization exposure by multiplying the SFA risk-based capital 

requirement for the exposure (as determined in paragraph (c) of this section) by 12.5. If 

the SFA risk weight for a securitization exposure is 1,250 percent or greater, however, 

the bank must deduct the exposure from total capital under paragraph (c) of section 42 

rather than risk weight the exposure. The SFA risk weight for a securitization exposure is 

equal to 1,250 percent multiplied by the ratio of the securitization exposure’s SFA riskbased capital requirement to the amount of the securitization exposure (as defined in 

paragraph (e) of section 42). 

 (c) The SFA risk-based capital requirement. The SFA risk-based capital 

requirement for a securitization exposure is UE multiplied by TP multiplied by the 

greater of: 

 (1) 0.0056 * T; or 

 (2) S[L+T] – S[L]. 

 (d) The supervisory formula: 

 (1) 

⎪

⎭

⎪

⎬

⎫

⎪

⎩

⎪

⎨

⎧

− > ⋅ + − +

≤

= ⋅ −

IRB

K

K Y

IRB

IRB IRB

IRB

e when Y K d K K K Y K K

Y when Y K

S Y IRB

IRB

(1 ) 20 [ ] [ ]

[ ] 20 ( )

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

 (3) 

N

IRB

EWALGD

K h ⎟

⎠

⎞ ⎜

⎝

⎛ = 1 −

 (4) a = g ⋅ c 

 (5) b = g ⋅(1− c)
 Draft Basel II NPR 

457

 (6) h

K

c IRB

− = 1

 (7) 1 (1 ) − − ⋅ = f

c c

g

 (8) (1 ) 1000

(1 )

1

2

2

− ⋅

− ⋅ − − + −

+ = h

K K v

c

h

v K f IRB IRB IRB

 (9) N

EWALGD K EWALGD

v K IRB

IRB

( − ) + .25⋅(1− ) = ⋅

 (10) d 1 (1 h) (1 [K ;a, b]) − β IRB = − − ⋅ . 

 (11) In these expressions, β [Y; a, b] refers to the cumulative beta distribution 

with parameters a and b evaluated at Y. In the case where N=1 and 

EWALGD=100 percent, S[Y] in formula (1) must be calculated with K[Y] set equal to 

the product of KIRB and Y, and d set equal to 1- KIRB. 

 (e) SFA Parameters - (1) Amount of the underlying exposures (UE). UE is the 

EAD of any underlying wholesale and retail exposures (including the amount of any 

funded spread accounts, cash collateral accounts, and other similar funded credit 

enhancements) plus the amount of any underlying exposures that are securitization 

exposures (as defined in paragraph (e) of section 42) plus the adjusted carrying value of 

any underlying equity exposures (as defined in paragraph (b) of section 51). 

 (2) Tranche percentage (TP). TP is the ratio of the amount of the bank’s 

securitization exposure to the amount of the tranche that contains the securitization 

exposure. 

 (3) Capital requirement on underlying exposures (KIRB). (i) KIRB is the ratio of: 
 Draft Basel II NPR 

458

 (A) The sum of the risk-based capital requirements for the underlying exposures 

plus the expected credit losses of the underlying exposures (as determined under this 

appendix as if the underlying exposures were directly held by the bank); to 

 (B) UE 

 (ii) The calculation of KIRB must reflect the effects of any credit risk mitigant 

applied to the underlying exposures (either to an individual underlying exposure, a group 

of underlying exposures, or to the entire pool of underlying exposures). 

 (iii) All assets related to the securitization are treated as underlying exposures, 

including assets in a reserve account (such as a cash collateral account). 

 (4) Credit enhancement level (L). (i) L is the ratio of: 

 (A) The amount of all securitization exposures subordinated to the tranche that 

contains the bank’s securitization exposure; to 

 (B) UE. 

 (ii) Banks must determine L before considering the effects of any tranche-specific 

credit enhancements. 

 (iii) Any gain-on-sale or CEIO associated with the securitization may not be 

included in L. 

 (iv) Any reserve account funded by accumulated cash flows from the underlying 

exposures that is subordinated to the tranche in question may be included in the 

numerator and denominator of L to the extent cash has accumulated in the account. 

Unfunded reserve accounts (that is, reserve accounts that are to be funded from future 

cash flows from the underlying exposures) may not be included in the calculation of L. 
 Draft Basel II NPR 

459

 (v) In some cases, the purchase price of receivables will reflect a discount that 

provides credit enhancement (for example, first loss protection) for all or certain tranches 

of the securitization. When this arises, L should be calculated inclusive of this discount if 

the discount provides credit enhancement for the securitization exposure. 

 (5) Thickness of tranche (T). T is the ratio of: 

 (i) The amount of the tranche that contains the bank’s securitization exposure; to 

 (ii) UE. 

 (6) Effective number of exposures (N). (i) Unless the bank elects to use the 

formula provided in paragraph (f), ∑

∑ =

i

i

i

i

EAD

EAD

N 2

2 ( )

, 

where EADi represents the EAD associated with the ith instrument in the pool of 

underlying exposures. 

 (ii) Multiple exposures to one obligor must be treated as a single underlying 

exposure. 

 (iii) In the case of a re-securitization (that is, a securitization in which some or all 

of the underlying exposures are themselves securitization exposures), the bank must treat 

each underlying exposure as a single underlying exposure and must not look through to 

the originally securitized underlying exposures. 

 (7) Effective weighted average loss given default (EWALGD). EWALGD is 

calculated as: 

EWA ∑

∑ ⋅

=

i

i

i

i i

EAD

LGD EAD

LGD ,
 Draft Basel II NPR 

460

where LGDi represents the average LGD associated with all exposures to the ith obligor. 

In the case of a re-securitization, an LGD of 100 percent must be assumed for the 

underlying exposures that are themselves securitization exposures. 

 (f) Simplified method for computing N and EWALGD. (1) If all underlying 

exposures of a securitization are retail exposures, a bank may apply the SFA using the 

following simplifications: 

 (i) h = 0; and 

 (ii) v = 0. 

 (2) Under the conditions in paragraphs (f)(3) and (4), a bank may employ a 

simplified method for calculating N and EWALGD. 

 (3) If C1 is no more than 0.03, a bank may set EWALGD=0.50 and N equal to the 

following amount: 

max(1 ,0) 1

1

1

1

1 mC

m

C C C C

N

m

m − ⎟

⎟

⎠

⎞

⎜

⎜

⎝

⎛

−

− +

= , 

where: 

(i) Cm is the ratio of the sum of the amounts of the ‘m’ largest underlying 

exposures to UE; and 

(ii) The level of m is to be selected by the bank. 

 (4) Alternatively, if only C1 is available and C1 is no more than 0.03, the bank 

may set EWALGD=0.50 and N=1/C1. 

Section 46. Recognition of Credit Risk Mitigants for Securitization Exposures

 (a) General. An originating bank that has obtained a credit risk mitigant to hedge 

its securitization exposure to a synthetic or traditional securitization that satisfies the 
 Draft Basel II NPR 

461

operational criteria in section 41 may recognize the credit risk mitigant, but only as 

provided in this section. An investing bank that has obtained a credit risk mitigant to 

hedge a securitization exposure may recognize the credit risk mitigant, but only as 

provided in this section. A bank that has used the RBA in section 43 or the IAA in 

section 44 to calculate its risk-based capital requirement for a securitization exposure 

whose external or inferred rating (or equivalent internal rating under the IAA) reflects the 

benefits of a particular credit risk mitigant provided to the associated securitization or 

that supports some or all of the underlying exposures may not use the credit risk 

mitigation rules in this section to further reduce its risk-based capital requirement for the 

exposure to reflect that credit risk mitigant. 

(b) Collateral - (1) Rules of recognition. A bank may recognize financial 

collateral in determining the bank’s risk-based capital requirement for a securitization 

exposure as follows. The bank’s risk-based capital requirement for the collateralized 

securitization exposure is equal to the risk-based capital requirement for the securitization 

exposure as calculated under the RBA in section 43 or the SFA in section 45 multiplied 

by the ratio of adjusted exposure amount (E*) to original exposure amount (E), where: 

(i) E* = max {0, [E - C x (1 - Hs - Hfx)]}; 

 (ii) E = the amount of the securitization exposure calculated under paragraph (e) 

of section 42; 

 (iii) C = the current market value of the collateral; 

 (iv) Hs = the haircut appropriate to the collateral type; and 

 (v) Hfx = the haircut appropriate for any currency mismatch between the 

collateral and the exposure. 
 Draft Basel II NPR 

462

 (2) Mixed collateral. Where the collateral is a basket of different asset types or a 

basket of assets denominated in different currencies, the haircut on the basket will be 

= ∑

i

H aiHi , where ai is the current market value of the asset in the basket divided by 

the current market value of all assets in the basket and Hi is the haircut applicable to that 

asset. 

 (3) Standard supervisory haircuts. Unless a bank qualifies for use of and uses 

own-estimates haircuts in paragraph (b)(4) of this section: 

 (i) A bank must use the collateral type haircuts (Hs) in Table 3; 

 (ii) A bank must use a currency mismatch haircut (Hfx) of 8 percent if the 

exposure and the collateral are denominated in different currencies; 

 (iii) A bank must multiply the supervisory haircuts obtained in 

paragraphs (b)(3)(i) and (ii) by the square root of 6.5 (which equals 2.549510); and 

 (iv) A bank must adjust the supervisory haircuts upward on the basis of a holding 

period longer than 65 business days where and as appropriate to take into account the 

illiquidity of the collateral. 

 (4) Own estimates for haircuts. With the prior written approval of the 

[AGENCY], a bank may calculate haircuts using its own internal estimates of market 

price volatility and foreign exchange volatility, subject to the provisions of paragraph 

(a)(2)(iii) of section 32. The minimum holding period (TM) for securitization exposures 

is 65 business days. 

 (c) Guarantees and credit derivatives - (1) Limitations on recognition. A bank 

may only recognize an eligible guarantee or eligible credit derivative provided by an 
 Draft Basel II NPR 

463

eligible securitization guarantor in determining the bank’s risk-based capital requirement 

for a securitization exposure. 

 (2) ECL for securitization exposures. When a bank recognizes an eligible 

guarantee or eligible credit derivative provided by an eligible securitization guarantor in 

determining the bank’s risk-based capital requirement for a securitization exposure, the 

bank must also: 

(i) Calculate ECL for the exposure using the same risk parameters that it uses for 

calculating the risk-weighted asset amount of the exposure as described in paragraph 

(c)(3) of this section; and 

(ii) Add the exposure’s ECL to the bank’s total ECL. 

 (3) Rules of recognition. A bank may recognize an eligible guarantee or eligible 

credit derivative provided by an eligible securitization guarantor in determining the 

bank’s risk-based capital requirement for the securitization exposure as follows: 

 (i) Full coverage. If the protection amount of the eligible guarantee or eligible 

credit derivative equals or exceeds the amount of the securitization exposure, then the 

bank may set the risk-weighted asset amount for the securitization exposure equal to the 

risk-weighted asset amount for a direct exposure to the eligible securitization guarantor 

(as determined in the wholesale risk weight function described in section 31), using the 

bank’s PD for the guarantor, the bank’s ELGD and LGD for the guarantee or credit 

derivative, and an EAD equal to the amount of the securitization exposure (as determined 

in paragraph (e) of section 42). 
 Draft Basel II NPR 

464

 (ii) Partial coverage. If the protection amount of the eligible guarantee or eligible 

credit derivative is less than the amount of the securitization exposure, then the bank may 

set the risk-weighted asset amount for the securitization exposure equal to the sum of: 

 (A) Covered portion. The risk-weighted asset amount for a direct exposure to the 

eligible securitization guarantor (as determined in the wholesale risk weight function 

described in section 31), using the bank’s PD for the guarantor, the bank’s ELGD and 

LGD for the guarantee or credit derivative, and an EAD equal to the protection amount of 

the credit risk mitigant; and 

 (B) Uncovered portion. (1) 1.0 minus (the protection amount of the eligible 

guarantee or eligible credit derivative divided by the amount of the securitization 

exposure); multiplied by 

 (2) The risk-weighted asset amount for the securitization exposure without the 

credit risk mitigant (as determined in sections 42-45). 

 (4) Mismatches. For any hedged securitization exposure, the bank must make 

applicable adjustments to the protection amount as required in paragraphs (d), (e), and (f) 

of section 33. 

Section 47 Risk-Based Capital Requirement for Early Amortization Provisions 

 (a) General. (1) An originating bank must hold risk-based capital against the sum 

of the originating bank’s interest and the investors’ interest in a securitization that: 

(i) Includes one or more underlying exposures in which the borrower is permitted 

to vary the drawn amount within an agreed limit under a line of credit; and 

(ii) Contains an early amortization provision. 
 Draft Basel II NPR 

465

(2) For securitizations described in paragraph (a)(1) of this section, an originating 

bank must calculate the risk-based capital requirement for the originating bank’s interest 

under sections 42-45, and the risk-based capital requirement for the investors’ interest 

under paragraph (b) of this section. 

 (b) Risk-weighted asset amount for investors’ interest. The originating bank’s 

risk-weighted asset amount for the investors’ interest in the securitization is equal to the 

product of the following four quantities: 

 (1) The investors’ interest EAD; 

 (2) The appropriate conversion factor in paragraph (c) of this section; 

 (3) KIRB (as defined in paragraph (e)(3) of section 45); and 

(4) 12.5. 

(c) Conversion factor. To calculate the appropriate conversion factor discussed in 

paragraph (b)(2) of this section, a bank must use Table 8 for a securitization that contains 

a controlled early amortization provision and must use Table 9 for a securitization that 

contains a non-controlled early amortization provision. A bank must use the 

“uncommitted” column of Tables 8 and 9 if all or substantially all of the underlying 

exposures of the securitization are unconditionally cancelable by the bank to the fullest 

extent permitted by Federal law. Otherwise, a bank must use the “committed” column of 

the tables. To calculate the trapping point described in the tables, a bank must divide the 

three-month excess spread level of the securitization by the excess spread trapping point 

in the securitization structure.21

 

21 In securitizations that do not require excess spread to be trapped, or that specify trapping points based 

primarily on performance measures other than the three-month average excess spread, the excess spread 

trapping point is 4.5 percent. 
 Draft Basel II NPR 

466

Table 8 – Controlled Early Amortization Provisions 

 Uncommitted Committed

Retail Credit 

Lines 

3-month average excess spread 

Credit Conversion Factor (CCF) 90% CCF 

 133.33% of trapping point or more 

0% CCF 

 less than 133.33% to 100% of 

trapping point 

1% CCF 

 less than 100% to 75% of trapping 

point 

2% CCF 

 less than 75% to 50% of trapping 

point 

10% CCF 

 less than 50% to 25% of trapping 

point 

20% CCF 

 less than 25% of trapping point 

40% CCF 

Non-retail Credit 

Lines 90% CCF 90% CCF 
 Draft Basel II NPR 

467

Table 9 – Non-Controlled Early Amortization Provisions 

 Uncommitted Committed

Retail Credit Lines 

3-month average excess spread 

Credit Conversion Factor (CCF) 100% CCF 

 133.33% of trapping point or more 

0% CCF 

 less than 133.33% to 100% of 

trapping point 

5% CCF 

 less than 100% to 75% of trapping 

point 

15% CCF 

 less than 75% to 50% of trapping 

point 

50% CCF 

 less than 50% of trapping point 

100% CCF 

Non-retail Credit 

Lines 

100% CCF 100% CCF 

Part VI. Risk-Weighted Assets for Equity Exposures 

Section 51. Introduction and Exposure Measurement 

(a) General. To calculate its risk-weighted asset amounts for equity exposures 

that are not equity exposures to investment funds, a bank may apply either the Simple 

Risk Weight Approach (SRWA) in section 52 or, if it qualifies to do so, the Internal 

Models Approach (IMA) in section 54. A bank must use the look-through approaches in 

section 53 to calculated its risk-weighted asset amounts for equity exposures to 

investment funds. 

 (b) Adjusted carrying value. For purposes of this part, the “adjusted carrying 

value” of an equity exposure is: 
 Draft Basel II NPR 

468

(1) For the on-balance sheet component of an equity exposure, the bank’s 

carrying value of the exposure reduced by any unrealized gains on the exposure that are 

reflected in such carrying value but excluded from the bank’s tier 1 and tier 2 capital; and 

(2) For the off-balance sheet component of an equity exposure, the effective 

notional principal amount of the exposure, the size of which is equivalent to a 

hypothetical on-balance sheet position in the underlying equity instrument that would 

evidence the same change in fair value (measured in dollars) for a given small change in 

the price of the underlying equity instrument, minus the adjusted carrying value of the 

on-balance sheet component of the exposure as calculated in paragraph (b)(1) of this 

section. 

Section 52. Simple Risk Weight Approach (SRWA) 

(a) In general. Under the SRWA, a bank’s aggregate risk-weighted asset amount 

for its equity exposures is equal to the sum of the risk-weighted asset amounts for each of 

the bank’s individual equity exposures (other than equity exposures to an investment 

fund) as determined in this section and the risk-weighted asset amounts for each of the 

bank’s individual equity exposures to an investment fund as determined in section 54. 

(b) SRWA computation for individual equity exposures. A bank must determine 

the risk-weighted asset amount for an individual equity exposure (other than an equity 

exposure to an investment fund) by multiplying the adjusted carrying value of the equity 

exposure or the effective portion and ineffective portion of a hedge pair (as defined in 

paragraph (c) of this section) by the lowest applicable risk weight in this paragraph (b). 
 Draft Basel II NPR 

469

(1) 0 percent risk weight equity exposures. An equity exposure to an entity whose 

credit exposures are exempt from the 0.03 percent PD floor in paragraph (d)(2) of section 

31 is assigned a 0 percent risk weight. 

(2) 20 percent risk weight equity exposures. An equity exposure to a Federal 

Home Loan Bank or Farmer Mac that is not publicly traded and is held as a condition of 

membership in that entity is assigned a 20 percent risk weight. 

(3) 100 percent risk weight equity exposures. The following equity exposures are 

assigned a 100 percent risk weight: 

(i) Community development equity exposures. An equity exposure that qualifies 

as a community development investment under 12 U.S.C. 24(Eleventh),22 excluding 

equity exposures to an unconsolidated small business investment company and equity 

exposures held through a consolidated small business investment company described in 

section 302 of the Small Business Investment Act of 1958 (15 U.S.C. 682). 

(ii) Certain equity exposures to a Federal Home Loan Bank and Farmer Mac. An 

equity exposure to a Federal Home Loan Bank or Farmer Mac that is not assigned a 

20 percent risk weight. 

(iii) Effective portion of hedge pairs. The effective portion of a hedge pair. 

(iv) Non-significant equity exposures. Equity exposures to the extent that the 

aggregate adjusted carrying value of the exposures does not exceed 10 percent of the 

bank’s tier 1 capital plus tier 2 capital. 

 

22 For savings associations, community development investments would be defined to mean equity 

investments that are designed primarily to promote community welfare, including the welfare of low- and 

moderate-income communities or families, such as by providing services or jobs and excluding equity 

exposures to an unconsolidated small business investment company and equity exposures held through a 

consolidated small business investment company described in section 302 of the Small Business 

Investment Act of 1958 (15 U.S.C. 682). 
 Draft Basel II NPR 

470

(A) To compute the aggregate adjusted carrying value of a bank’s equity 

exposures for purposes of this paragraph (b)(3)(iv), the bank may exclude equity 

exposures described in paragraphs (b)(1), (b)(2), and (b)(3)(i), (ii), and (iii) of this 

section, the equity exposure in a hedge pair with the smaller adjusted carrying value, and 

a proportion of each equity exposure to an investment fund equal to the proportion of the 

assets of the investment fund that are not equity exposures. If a bank does not know the 

actual holdings of the investment fund, the bank may calculate the proportion of the 

assets of the fund that are not equity exposures based on the terms of the prospectus, 

partnership agreement, or similar contract that defines the fund’s permissible 

investments. If the sum of the investment limits for all exposure classes within the fund 

exceeds 100 percent, the bank must assume for purposes of this paragraph (b)(3)(iv) that 

the investment fund invests to the maximum extent possible in equity exposures. 

(B) When determining which of a bank’s equity exposures qualify for a 100 

percent risk weight under this paragraph, a bank must first include equity exposures to 

unconsolidated small business investment companies or held through consolidated small 

business investment companies described in section 302 of the Small Business 

Investment Act of 1958 (15 U.S.C. 682) and then must include publicly traded equity 

exposures (including those held indirectly through investment funds) and then must 

include non-publicly traded equity exposures (including those held indirectly through 

investment funds). 

 (4) 300 percent risk weight equity exposures. A publicly traded equity exposure 

(including the ineffective portion of a hedge pair) is assigned a 300 percent risk weight. 
 Draft Basel II NPR 

471

(5) 400 percent risk weight equity exposures. An equity exposure that is not 

publicly traded is assigned a 400 percent risk weight. 

(c) Hedge transactions - (1) Hedge pair. A hedge pair is two equity exposures that 

form an effective hedge so long as each equity exposure is publicly traded or has a return 

that is primarily based on a publicly traded equity exposure. 

(2) Effective hedge. Two equity exposures form an effective hedge if the 

exposures either have the same remaining maturity or each have a remaining maturity of 

at least three months; the hedge relationship is formally documented in a prospective 

manner (that is, before the bank acquires at least one of the equity exposures); the 

documentation specifies the measure of effectiveness (E) the bank will use for the hedge 

relationship throughout the life of the transaction; and the hedge relationship has an E 

greater than or equal to 0.8. A bank must measure E at least quarterly and must use one 

of three alternative measures of E: 

(i) Under the dollar-offset method of measuring effectiveness, the bank must 

determine the ratio of value change (RVC), that is, the ratio of the cumulative sum of the 

periodic changes in value of one equity exposure to the cumulative sum of the periodic 

changes in the value of the other equity exposure. If RVC is positive, the hedge is not 

effective and E = 0. If RVC is negative and greater than or equal to -1 (that is, between 

zero and -1), then E equals the absolute value of RVC. If RVC is negative and less then -

1, than E equals 2 plus RVC. 

(ii) Under the variability-reduction method of measuring effectiveness: 
 Draft Basel II NPR 

472

( )

∑ ( )

∑

=

−

=

−

−

−

= − T

t

t t

T

t

t t

A A

X X

E

1

2

1

1

2

1

1 , where 

(A) X t = At − Bt ; 

(B) At = the value at time t of one exposure in a hedge pair; and 

(C) Bt = the value at time t of the other exposure in a hedge pair. 

(iii) Under the regression method of measuring effectiveness, E equals the 

coefficient of determination of a regression in which the change in value of one exposure 

in a hedge pair is the dependent variable and the change in value of the other exposure in 

a hedge pair is the independent variable. 

 (3) The effective portion of a hedge pair is E multiplied by the greater of the 

adjusted carrying values of the equity exposures forming a hedge pair. 

(4) The ineffective portion of a hedge pair is (1-E) multiplied by the greater of the 

adjusted carrying values of the equity exposures forming a hedge pair. 

Section 53. Internal Models Approach (IMA) 

 This section describes the two ways that a bank may calculate its risk-weighted 

asset amount for equity exposures using the IMA. A bank may model publicly traded 

and non-publicly traded equity exposures (in accordance with paragraph (b) of this 

section) or model only publicly traded equity exposure (in accordance with paragraph (c) 

of this section). 

(a) Qualifying criteria. To qualify to use the IMA to calculate risk-based capital 

requirements for equity exposures, a bank must receive prior written approval from the 
 Draft Basel II NPR 

473

[AGENCY]. To receive such approval, the bank must demonstrate to the [AGENCY]’s 

satisfaction that the bank meets the following criteria: 

 (1) The bank must have a model that: 

(i) Assesses the potential decline in value of its modeled equity exposures; 

(ii) Is commensurate with the size, complexity, and composition of the bank’s 

modeled equity exposures; and 

(iii) Adequately captures both general market risk and idiosyncratic risk. 

 (2) The bank’s model must produce an estimate of potential losses for its modeled 

equity exposures that is no less than the estimate of potential losses produced by a VaR 

methodology employing a 99.0 percent, one-tailed confidence interval of the distribution 

of quarterly returns for a benchmark portfolio of equity exposures comparable to the 

bank’s modeled equity exposures using a long-term sample period. 

 (3) The number of risk factors and exposures in the sample and the data period 

used for quantification in the bank’s model and benchmarking exercise must be sufficient 

to provide confidence in the accuracy and robustness of the bank’s estimates. 

(4) The bank’s model and benchmarking process must incorporate data that are 

relevant in representing the risk profile of the bank’s modeled equity exposures, and must 

include data from at least one equity market cycle containing adverse market movements 

relevant to the risk profile of the bank’s modeled equity exposures. If the bank’s model 

uses a scenario methodology, the bank must demonstrate that the model produces a 

conservative estimate of potential losses on the bank’s modeled equity exposures over a 

relevant long-term market cycle. If the bank employs risk factor models, the bank must 

demonstrate through empirical analysis the appropriateness of the risk factors used. 
 Draft Basel II NPR 

474

(5) Daily market prices must be available for all modeled equity exposures, either 

direct holdings or proxies. 

(6) The bank must be able to demonstrate, using theoretical arguments and 

empirical evidence, that any proxies used in the modeling process are comparable to the 

bank’s modeled equity exposures and that the bank has made appropriate adjustments for 

differences. The bank must derive any proxies for its modeled equity exposures and 

benchmark portfolio using historical market data that are relevant to the bank’s modeled 

equity exposures and benchmark portfolio (or, where not, must use appropriately adjusted 

data), and such proxies must be robust estimates of the risk of the bank’s modeled equity 

exposures. 

(b) Risk-weighted assets calculation for a bank modeling publicly traded and nonpublicly traded equity exposures. If a bank models publicly traded and non-publicly 

traded equity exposures, the bank’s aggregate risk-weighted asset amount for its equity 

exposures is equal to the sum of: 

(1) The risk-weighted asset amount of each equity exposure that qualifies for a 0-

100 percent risk weight under paragraphs (b)(1) through (3)(ii) of section 52 (as 

determined under section 52) and each equity exposure to an investment fund (as 

determined under section 54); and 

(2) The greater of: 

(i) The estimate of potential losses on the bank’s equity exposures (other than 

equity exposures referenced in paragraph (b)(1) of this section) generated by the bank’s 

internal equity exposure model multiplied by 12.5; or 

(ii) The sum of: 
 Draft Basel II NPR 

475

(A) 200 percent multiplied by the aggregate adjusted carrying value of the bank’s 

publicly traded equity exposures that do not belong to a hedge pair, do not qualify for a 0-

100 percent risk weight under paragraphs (b)(1) through (3)(ii) of section 52, and are not 

equity exposures to an investment fund; 

(B) 200 percent multiplied by the aggregate ineffective portion of all hedge pairs; 

and 

(C) 300 percent multiplied by the aggregate adjusted carrying value of the bank’s 

equity exposures that are not publicly traded, do not qualify for a 0-100 percent risk 

weight under paragraphs (b)(1) through (3)(ii) of section 52, and are not equity exposures 

to an investment fund. 

(c) Risk-weighted assets calculation for a bank using the IMA only for publicly 

traded equity exposures. If a bank models only publicly traded equity exposures, the 

bank’s aggregate risk-weighted asset amount for its equity exposures is equal to the sum 

of: 

(1) The risk-weighted asset amount of each equity exposure that qualifies for a 0-

100 percent risk weight under paragraphs (b)(1) through (3)(ii) of section 52 (as 

determined under section 52), each equity exposure that qualifies for a 400 percent risk 

weight under paragraph (b)(5) of section 52 (as determined under section 52), and each 

equity exposure to an investment fund (as determined under section 54); and 

(2) The greater of: 

(i) The estimate of potential losses on the bank’s equity exposures (other than 

equity exposures referenced in paragraph (c)(1) of this section) generated by the bank’s 

internal equity exposure model multiplied by 12.5; or 
 Draft Basel II NPR 

476

(ii) The sum of: 

(A) 200 percent multiplied by the aggregate adjusted carrying value of the bank’s 

publicly traded equity exposures that do not belong to a hedge pair, do not qualify for a 0-

100 percent risk weight under paragraphs (b)(1) through (3)(ii) of section 52, and are not 

equity exposures to an investment fund; and 

(B) 200 percent multiplied by the aggregate ineffective portion of all hedge pairs. 

Section 54. Equity Exposures to Investment Funds 

(a) Available approaches. A bank must determine the risk-weighted asset amount 

of an equity exposure to an investment fund under the Full Look-Through Approach in 

paragraph (b) of this section, the Simple Modified Look-Through Approach in paragraph 

(c) of this section, or the Alternative Modified Look-Through Approach in paragraph (d) 

of this section unless the exposure would meet the requirements for a community 

development equity exposure in paragraph (b)(3)(i) of section 52. The risk-weighted 

asset amount of such an equity exposure to an investment fund would be its adjusted 

carrying value. If an equity exposure to an investment fund is part of a hedge pair, a bank 

may use the ineffective portion of the hedge pair as determined under paragraph (c) of 

section 52 as the adjusted carrying value for the equity exposure to the investment fund. 

(b) Full look-through approach. A bank that is able to calculate a risk-weighted 

asset amount for each exposure held by the investment fund (as calculated under this 

appendix as if the exposures were held directly by the bank) may set the risk-weighted 

asset amount of the bank’s exposure to the fund equal to the greater of: 

(1) The product of: 
 Draft Basel II NPR 

477

(i) The aggregate risk-weighted asset amounts of the exposures held by the fund 

(as calculated under this appendix) as if the exposures were held directly by the bank; and 

(ii) The bank’s proportional ownership share of the fund; or 

(2) 7 percent of the adjusted carrying value of the bank’s equity exposure to the 

fund. 

(c) Simple modified look-through approach. Under this approach, the riskweighted asset amount for a bank’s equity exposure to an investment fund equals the 

adjusted carrying value of the equity exposure multiplied by the greater of: 

(1) The highest risk weight in Table 10 that applies to any exposure the fund is 

permitted to hold under its prospectus, partnership agreement, or similar contract that 

defines the fund’s permissible investments (excluding derivative contracts that are used 

for hedging rather than speculative purposes and do not constitute a material portion of 

the fund’s exposures); or 

(2) 7 percent. 

Table 10 – Modified Look-Through Approaches for Equity Exposures to 

Investment Funds 

Risk Weight Exposure Class

0 percent Sovereign exposures with a long-term applicable external rating in 

the highest investment grade rating category and sovereign exposures 

of the United States 

20 percent Exposures with a long-term applicable external rating in the highest 

or second-highest investment grade rating category; exposures with a 

short-term applicable external rating in the highest investment grade 

rating category; and exposures to, or guaranteed by, depository 

institutions, foreign banks (as defined in 12 CFR 211.2), or securities 

firms subject to consolidated supervision and regulation comparable 

to that imposed on U.S. securities broker-dealers that are repo-style 

transactions or bankers’ acceptances 
 Draft Basel II NPR 

478

50 percent Exposures with a long-term applicable external rating in the thirdhighest investment grade rating category or a short-term applicable 

external rating in the second-highest investment grade rating category 

100 percent Exposures with a long-term or short-term applicable external rating in 

the lowest investment grade rating category 

200 percent Exposures with a long-term applicable external rating one rating 

category below investment grade 

300 percent Publicly traded equity exposures 

400 percent Non-publicly traded equity exposures; exposures with a long-term 

applicable external rating two rating categories or more below 

investment grade; and exposures without an external rating 

(excluding publicly traded equity exposures) 

1,250 percent OTC derivative contracts and exposures that must be deducted from 

regulatory capital or receive a risk weight greater than 400 percent 

under this appendix 

(d) Alternative Modified Look-Through Approach. Under this approach, a bank 

may assign the adjusted carrying value of an equity exposure to an investment fund on a 

pro rata basis to different risk weight categories in Table 10 according to the investment 

limits in the fund’s prospectus, partnership agreement, or similar contract that defines the 

fund’s permissible investments. If the sum of the investment limits for exposure classes 

within the fund exceeds 100 percent, the bank must assume that the fund invests to the 

maximum extent permitted under its investment limits in the exposure class with the 

highest risk weight under Table 10, and continues to make investments in order of the 

exposure class with the next highest risk weight under Table 10 until the maximum total 

investment level is reached. If more than one exposure class applies to an exposure, the 

bank must use the highest applicable risk weight. A bank may not assign an equity 

exposure to an investment fund to an aggregate risk weight of less than 7 percent. A 

bank may exclude derivative contracts held by the fund that are used for hedging rather 
 Draft Basel II NPR 

479

than speculative purposes and do not constitute a material portion of the fund’s 

exposures. 

Section 55. Equity Derivative Contracts 

 Under the IMA, in addition to holding risk-based capital against an equity 

derivative contract under this part, a bank must hold risk-based capital against the 

counterparty credit risk in the equity derivative contract by also treating the equity 

derivative contract as a wholesale exposure and computing a supplemental risk-weighted 

asset amount for the contract under part IV. Under the SRWA, a bank may choose not to 

hold risk-based capital against the counterparty credit risk of equity derivative contracts, 

as long as it does so for all such contracts. Where the equity derivative contracts are 

subject to a qualifying master netting agreement, a bank using the SRWA must either 

include all or exclude all of the contracts from any measure used to determine 

counterparty credit risk exposure. 

Part VII. Risk-Weighted Assets for Operational Risk 

Section 61. Qualification Requirements for Incorporation of Operational Risk 

Mitigants 

(a) Qualification to use operational risk mitigants. A bank may adjust its estimate 

of operational risk exposure to reflect qualifying operational risk mitigants if: 

(1) The bank’s operational risk quantification system is able to generate an 

estimate of the bank’s operational risk exposure (which does not incorporate qualifying 

operational risk mitigants) and an estimate of the bank’s operational risk exposure 

adjusted to incorporate qualifying operational risk mitigants; and 
 Draft Basel II NPR 

480

(2) The bank’s methodology for incorporating the effects of insurance, if the bank 

uses insurance as an operational risk mitigant, captures through appropriate discounts to 

the amount of risk mitigation: 

(i) The residual term of the policy, where less than one year; 

(ii) The cancellation terms of the policy, where less than one year; 

(iii) The policy’s timeliness of payment; 

(iv) The uncertainty of payment by the provider of the policy; and 

(v) Mismatches in coverage between the policy and the hedged operational loss 

event. 

(b) Qualifying operational risk mitigants. Qualifying operational risk mitigants 

are: 

(1) Insurance that: 

 (i) Is provided by an unaffiliated company that has a claims payment ability that is 

rated in one of the three highest rating categories by a NRSRO; 

(ii) Has an initial term of at least one year and a residual term of more than 90 

days; 

(iii) Has a minimum notice period for cancellation by the provider of 90 days; 

(iv) Has no exclusions or limitations based upon regulatory action or for the 

receiver or liquidator of a failed bank; and 

(v) Is explicitly mapped to a potential operational loss event; and 

(2) Operational risk mitigants other than insurance for which the [AGENCY] has 

given prior written approval. In evaluating an operational risk mitigant other than 
 Draft Basel II NPR 

481

insurance, [AGENCY] will consider whether the operational risk mitigant covers 

potential operational losses in a manner equivalent to holding regulatory capital. 

Section 62. Mechanics of Risk-Weighted Asset Calculation 

(a) If a bank does not qualify to use or does not have qualifying operational risk 

mitigants, the bank’s dollar risk-based capital requirement for operational risk is its 

operational risk exposure minus eligible operational risk offsets (if any). 

(b) If a bank qualifies to use operational risk mitigants and has qualifying 

operational risk mitigants, the bank’s dollar risk-based capital requirement for operational 

risk is the greater of: 

(1) The bank’s operational risk exposure adjusted for qualifying operational risk 

mitigants minus eligible operational risk offsets (if any); or 

(2) 0.8 multiplied by the difference between: 

(i) The bank’s operational risk exposure; and 

(ii) Eligible operational risk offsets (if any). 

(c) The bank’s risk-weighted asset amount for operational risk equals the bank’s 

dollar risk-based capital requirement for operational risk determined under paragraph (a) 

or (b) of this section multiplied by 12.5. 

Part VIII. Disclosure 

Section 71. Disclosure Requirements 

(a) Each bank must publicly disclose each quarter its total and tier 1 risk-based 

capital ratios and their components (that is, tier 1 capital, tier 2 capital, total qualifying 

capital, and total risk-weighted assets).23 

 

23 Other public disclosure requirements continue to apply - for example, Federal securities law and 

regulatory reporting requirements.
 Draft Basel II NPR 

482

(b) A bank must comply with paragraph (c) of section 71 of appendix [Advanced 

Approaches Rule] to the Federal Reserve Board’s Regulation Y (12 CFR part 225, 

appendix F) if it is a bank or bank holding company, or must comply with section 71(c) 

of 12 CFR 567, appendix F if it is a savings association. A bank is not subject to these 

additional disclosure requirements if it is a consolidated subsidiary of a bank holding 

company or depository institution that is subject to these requirements. 

End of common rule. 

[The bank holding company and savings association capital rules will also include 

the following regulatory text: 

(c)(1) Each consolidated [bank holding company/savings association] described in 

paragraph (b) of this section that has successfully completed its parallel run must provide 

timely public disclosures each calendar quarter of the information in tables 11.1 – 11.11 

below. If a significant change occurs, such that the most recent reported amounts are no 

longer reflective of the [bank holding company’s/savings association’s] capital adequacy 

and risk profile, then a brief discussion of this change and its likely impact must be 

provided as soon as practicable thereafter. Qualitative disclosures that typically do not 

change each quarter (for example, a general summary of the [bank holding 

company’s/savings association’s] risk management objectives and policies, reporting 

system, and definitions) may be disclosed annually, provided any significant changes to 

these are disclosed in the interim. Management is encouraged to provide all of the 

disclosures required by this appendix in one place on the [bank holding 

company’s/savings association’s] public website.24 The [bank holding company/savings 

 

24 Alternatively, a [bank holding company/savings association] may provide the disclosures in more than 

one place, as some of them may be included in public financial reports (for example, in Management’s 
 Draft Basel II NPR 

483

association] must make these disclosures publicly available for each of the last three 

years (that is, twelve quarters) or such shorter period since it began its first floor period. 

(2) Each [bank holding company/savings association] is required to have a formal 

disclosure policy approved by the board of directors that addresses its approach for 

determining the disclosures it makes. The policy must address the associated internal 

controls and disclosure controls and procedures. The board of directors and senior 

management must ensure that appropriate verification of the disclosures takes place and 

that effective internal controls and disclosure controls and procedures are maintained. 

The chief financial officer of the [bank holding company/savings association] must 

certify that the disclosures required by this appendix are appropriate, and the board of 

directors and senior management are responsible for establishing and maintaining an 

effective internal control structure over financial reporting, including the disclosures 

required by this appendix. 

Table 11.1 – Scope of Application 

(a) The name of the top corporate entity in the group to which the 

appendix applies. 

Qualitative 

Disclosures 

(b) An outline of differences in the basis of consolidation for 

accounting and regulatory purposes, with a brief description of the 

entities25 within the group (a) that are fully consolidated; (b) that 

are deconsolidated and deducted; (c) for which the regulatory 

capital requirement is deducted; and (d) that are neither 

consolidated nor deducted (for example, where the investment is 

risk-weighted).

 Discussion and Analysis included in SEC filings) or other regulatory reports. The [bank holding 

company/savings association] must provide a summary table on its public website that specifically 

indicates where all the disclosures may be found (for example, regulatory report schedules, page numbers 

in annual reports). 

25 Entities include securities, insurance and other financial subsidiaries, commercial subsidiaries (where 

permitted), significant minority equity investments in insurance, financial and commercial entities. 
 Draft Basel II NPR 

484

(c) Any restrictions, or other major impediments, on transfer of funds 

or regulatory capital within the group. 

(d) The aggregate amount of surplus capital of insurance subsidiaries 

(whether deducted or subjected to an alternative method) included 

in the regulatory capital of the consolidated group. 

Quantitative 

Disclosures 

(e) The aggregate amount of capital deficiencies26 in all subsidiaries 

and the name(s) of such subsidiaries. 

 

26 A capital deficiency is the amount by which actual regulatory capital is less than the minimum regulatory 

capital requirement. 
 Draft Basel II NPR 

485

Table 11.2 – Capital Structure 

Qualitative 

Disclosures 

(a) Summary information on the terms and conditions of the main 

features of all capital instruments, especially in the case of 

innovative, complex or hybrid capital instruments. 

(b) The amount of tier 1 capital, with separate disclosure of: 

• common stock/surplus; 

• retained earnings; 

• minority interests in the equity of subsidiaries; 

• restricted core capital elements as defined in 12 CFR part 225, 

Appendix A (if a bank holding company); 

• regulatory calculation differences deducted from tier 1 capital;

27 and 

• other amounts deducted from tier 1 capital, including goodwill 

and certain intangibles. 

(c) The total amount of tier 2 capital. 

(d) Other deductions from capital. 28

Quantitative 

Disclosures 

(e) Total eligible capital. 

 

27 Representing 50% of the amount, if any, by which total expected credit losses as calculated within the 

IRB framework exceed eligible credit reserves, which must be deducted from Tier 1 capital. 28 Including 50% of the amount, if any, by which total expected credit losses as calculated within the IRB 

framework exceed eligible credit reserves, which must be deducted from Tier 2 capital. 
 Draft Basel II NPR 

486

Table 11.3 – Capital Adequacy 

Qualitative 

disclosures

(a) A summary discussion of the [bank holding company’s/savings 

association’s] approach to assessing the adequacy of its capital to 

support current and future activities. 

(b) Risk-weighted assets for credit risk from: 

• Wholesale exposures; 

• Residential mortgage exposures; 

• Qualifying revolving exposures; 

• Other retail exposures; 

• Securitization exposures; 

• Equity exposures 

• Equity exposures subject to simple risk weight approach; 

and 

• Equity exposures subject to internal models approach. 

(c) Risk-weighted assets for market risk as calculated under [12 CFR 

part 225, Appendix E/ 12 CFR part 567 Market Risk Rule]:29

• Standardized approach for specific risk; and 

• Internal models approach for specific risk. 

(d) Risk-weighted assets for operational risk.

(e) Total and tier 1 risk-based capital ratios:30

• For the top consolidated group; and 

• For each DI subsidiary. 

Quantitative 

disclosures

 

29 Risk-weighted assets determined under [12 CFR part 225, Appendix E/ 12 CFR part 567 Market Risk 

Rule] are to be disclosed only for the approaches used. 

30 Total risk-weighted assets should also be disclosed. 
 Draft Basel II NPR 

487

General qualitative disclosure requirement 

For each separate risk area described in tables 11.4 through 11.11, the [bank holding 

company/savings association] must describe its risk management objectives and policies, 

including: 

• strategies and processes; 

• the structure and organization of the relevant risk management function; 

• the scope and nature of risk reporting and/or measurement systems; 

• policies for hedging and/or mitigating risk and strategies and processes for 

monitoring the continuing effectiveness of hedges/mitigants. 

Table 11.431 – Credit Risk: General Disclosures 

Qualitative 

Disclosures

(a) The general qualitative disclosure requirement with respect to 

credit risk (excluding counterparty credit risk disclosed in 

accordance with Table 11.6), including: 

• Definitions of past due and impaired (for accounting purposes); 

• Description of approaches followed for allowances, including 

statistical methods used where applicable; 

• Discussion of the [bank holding company’s/savings 

association’s] credit risk management policy. 

(b) Total gross credit risk exposures,32 and average gross credit risk 

exposures, over the period broken down by major types of credit 

exposure.33 

(c) Geographic34 distribution of exposures, broken down in significant 

areas by major types of credit exposure. 

(d) Industry or counterparty type distribution of exposures, broken 

down by major types of credit exposure. 

Quantitative 

Disclosures 

(e) Remaining contractual maturity breakdown (for example, one year 

or less) of the whole portfolio, broken down by major types of 

credit exposure. 

 

31 Table 4 does not include equity exposures. 

32 That is, after accounting offsets in accordance with US GAAP (for example, FASB Interpretations 39 

and 41) and without taking into account the effects of credit risk mitigation techniques, for example 

collateral and netting. 

33 This breakdown could be that applied under accounting rules, and might, for instance, be (a) loans, offbalance sheet commitments, and other non-derivative off-balance sheet exposures, (b) debt securities, and 

(c) OTC derivatives. 

34 Geographical areas may comprise individual countries, groups of countries or regions within countries. 

A [bank holding company/savings association] might choose to define the geographical areas based on the 

way the company’s portfolio is geographically managed. The criteria used to allocate the loans to 

geographical areas must be specified. 
 Draft Basel II NPR 

488

(f) By major industry or counterparty type: 

• Amount of impaired loans; 

• Amount of past due loans;35

• Allowances; and 

• Charge-offs during the period. 

(g) Amount of impaired loans and, if available, the amount of past due 

loans broken down by significant geographic areas including, if 

practical, the amounts of allowances related to each geographical 

area.36

(h) Reconciliation of changes in the allowance for loan and lease 

losses.37

Table 11.5 – Credit Risk: Disclosures for Portfolios Subject to IRB Risk-Based Capital 

Formulas 

Qualitative 

disclosures 

(a) Explanation and review of the: 

• Structure of internal rating systems and relation between 

internal and external ratings; 

• Use of risk parameter estimates other than for regulatory 

capital purposes; 

• Process for managing and recognizing credit risk mitigation; 

and 

• Control mechanisms for the rating system, including discussion 

of independence, accountability, and rating systems review. 

 

35 A [bank holding company/savings association] is encouraged also to provide an analysis of the aging of 

past-due loans. 

36 The portion of general allowance that is not allocated to a geographical area should be disclosed 

separately. 

37 The reconciliation should include the following: a description of the allowance; the opening balance of 

the allowance; charge-offs taken against the allowance during the period; amounts provided (or reversed) 

for estimated probable loan losses during the period; any other adjustments (for example, exchange rate 

differences, business combinations, acquisitions and disposals of subsidiaries), including transfers between 

allowances; and the closing balance of the allowance. Charge-offs and recoveries that have been recorded 

directly to the income statement should be disclosed separately. 
 Draft Basel II NPR 

489

(b) Description of the internal ratings process, provided separately for 

the following: 

• Wholesale category; 

• Retail subcategories; 

• Residential mortgage exposures; 

• Qualifying revolving exposures; and 

• Other retail exposures. 

For each category and subcategory the description should include: 

• The types of exposure included in the category/subcategories; 

• The definitions, methods and data for estimation and validation 

of PD, ELGD, LGD, and EAD, including assumptions 

employed in the derivation of these variables.38

Quantitative 

disclosures: risk 

assessment 

(c) For wholesale exposures, present the following information across 

a sufficient number of PD grades (including default) to allow for a 

meaningful differentiation of credit risk:39

• Total EAD;40 

• Exposure-weighted average ELGD and LGD (percentage); 

• Exposure weighted-average capital requirement (K); and 

• Amount of undrawn commitments and exposure-weighted 

average EAD for wholesale exposures; 

For each retail subcategory, present the disclosures outlined above 

across a sufficient number of segments to allow for a meaningful 

differentiation of credit risk. 

 

38 This disclosure does not require a detailed description of the model in full – it should provide the reader 

with a broad overview of the model approach, describing definitions of the variables, and methods for 

estimating and validating those variables set out in the quantitative risk disclosures below. This should be 

done for each of the four category/subcategories. The [bank holding company/savings association] should 

disclose any significant differences in approach to estimating these variables within each 

category/subcategories.

39 The PD, ELGD, LGD and EAD disclosures below should reflect the effects of collateral, qualifying 

master netting agreements, eligible guarantees and eligible credit derivatives as defined in Part 1. 

Disclosure of each PD grade should include the exposure weighted-average PD for each grade. Where a 

[bank holding company/savings association] aggregates PD grades for the purposes of disclosure, this 

should be a representative breakdown of the distribution of PD grades used for regulatory capital purposes. 

40 Outstanding loans and EAD on undrawn commitments can be presented on a combined basis for these 

disclosures. 
 Draft Basel II NPR 

490

(d) Actual losses in the preceding period for each category and 

subcategory and how this differs from past experience. A 

discussion of the factors that impacted the loss experience in the 

preceding period – for example, has the [bank holding 

company/savings association] experienced higher than average 

default rates, loss rates or EADs. 

(e) Comparison of risk parameter estimates against actual outcomes 

over a longer period.41 At a minimum, this should include 

information on estimates of losses against actual losses in the 

wholesale category and each retail subcategory over a period 

sufficient to allow for a meaningful assessment of the performance 

of the internal rating processes for each category/subcategory.42

Where appropriate, the [bank holding company/savings 

association] should further decompose this to provide analysis of 

PD, ELGD, LGD, and EAD outcomes against estimates provided 

in the quantitative risk assessment disclosures above.43

 

Quantitative 

disclosures: 

historical results 

 

41 These disclosures are a way of further informing the reader about the reliability of the information 

provided in the “quantitative disclosures: risk assessment” over the long run. The disclosures are 

requirements from year-end 2010; in the meantime, early adoption is encouraged. The phased 

implementation is to allow a [bank holding company/savings association] sufficient time to build up a 

longer run of data that will make these disclosures meaningful. 

42 This regulation is not prescriptive about the period used for this assessment. Upon implementation, it 

might be expected that a [bank holding company/savings association] would provide these disclosures for 

as long run of data as possible – for example, if a [bank holding company/savings association] has 10 years 

of data, it might choose to disclose the average default rates for each PD grade over that 10-year period. 

Annual amounts need not be disclosed. 

43 A [bank holding company/savings association] should provide this further decomposition where it will 

allow users greater insight into the reliability of the estimates provided in the “quantitative disclosures: risk 

assessment.” In particular, it should provide this information where there are material differences between 

its estimates of PD, ELGD, LGD or EAD compared to actual outcomes over the long run. The [bank 

holding company/savings association] should also provide explanations for such differences. 
 Draft Basel II NPR 

491

Table 11.6 – General Disclosure for Counterparty Credit Risk-Related Exposures 

Qualitative 

Disclosures 

(a) The general qualitative disclosure requirement with respect to 

OTC derivatives, eligible margin loans, and repo-style 

transactions, including: 

• Discussion of methodology used to assign economic capital 

and credit limits for counterparty credit exposures; 

• Discussion of policies for securing collateral, valuing and 

managing collateral, and establishing credit reserves; 

• Discussion of the primary types of collateral taken; 

• Discussion of policies with respect to wrong-way risk 

exposures; and 

• Discussion of the impact of the amount of collateral the bank 

would have to provide given a credit rating downgrade. 

(b) Gross positive fair value of contracts, netting benefits, netted 

current credit exposure, collateral held (including type, for 

example, cash, government securities), and net unsecured credit 

exposure.44 Also report measures for EAD used for regulatory 

capital for these transactions, the notional value of credit 

derivative hedges purchased for counterparty credit risk 

protection, and the distribution of current credit exposure by 

types of credit exposure.45

(c) Notional amount of purchased and sold credit derivatives, 

segregated between use for the institution’s own credit portfolio, 

as well as in its intermediation activities, including the 

distribution of the credit derivative products used, broken down 

further by protection bought and sold within each product group. 

Quantitative 

Disclosures 

(d) The estimate of alpha if the [bank holding company/savings 

association] has received supervisory approval to estimate alpha. 

 

44 Net unsecured credit exposure is the credit exposure after considering both the benefits from legally 

enforceable netting agreements and collateral arrangements without taking into account haircuts for price 

volatility, liquidity, etc. 

45 This may include interest rate derivative contracts, foreign exchange derivative contracts, equity 

derivative contracts, credit derivatives, commodity or other derivative contracts, repo-style transactions, 

and eligible margin loans.
 Draft Basel II NPR 

492

Table 11.7 – Credit Risk Mitigation 46,47, 48

Qualitative 

Disclosures 

(a) The general qualitative disclosure requirement with respect to 

credit risk mitigation including: 

• policies and processes for, and an indication of the extent to 

which the [bank holding company/savings association] uses, 

on- and off-balance sheet netting; 

• policies and processes for collateral valuation and 

management; 

• a description of the main types of collateral taken by the [bank 

holding company/savings association]; 

• the main types of guarantors/credit derivative counterparties 

and their creditworthiness; and 

• information about (market or credit) risk concentrations within 

the mitigation taken. 

Quantitative 

Disclosures 

(b) For each separately disclosed portfolio, the total exposure (after, 

where applicable, on- or off-balance sheet netting) that is covered 

by guarantees/credit derivatives and the risk-weighted asset 

amount associated with that exposure. 

 

46 At a minimum, a [bank holding company/savings association] must give the disclosures below in relation 

to credit risk mitigation that has been recognized for the purposes of reducing capital requirements under 

this Appendix. Where relevant, [bank holding companies/savings associations] are encouraged to give 

further information about mitigants that have not been recognized for that purpose. 

47 Credit derivatives that are treated, for the purposes of this Appendix, as synthetic securitization 

exposures should be excluded from the credit risk mitigation disclosures and included within those relating 

to securitization. 

48 Counterparty credit risk-related exposures disclosed pursuant to Table 11.6 should be excluded from the 

credit risk mitigation disclosures in Table 11.7. 
 Draft Basel II NPR 

493

Table 11.8 – Securitization47

(a) The general qualitative disclosure requirement with respect to 

securitization (including synthetics), including a discussion of: 

• the [bank holding company’s/savings association’s] objectives 

relating to securitization activity, including the extent to which 

these activities transfer credit risk of the underlying exposures 

away from the bank holding company to other entities; 

• the roles played by the [bank holding company/savings 

association] in the securitization process49 and an indication of 

the extent of the bank holding company’s involvement in each 

of them; and 

• the regulatory capital approaches (for example, RBA, IAA and 

SFA) that the [bank holding company/savings association] 

follows for its securitization activities. 

(b) Summary of the [bank holding company’s/savings association’s] 

accounting policies for securitization activities, including: 

• whether the transactions are treated as sales or financings; 

• recognition of gain-on-sale; 

• key assumptions for valuing retained interests, including any 

significant changes since the last reporting period and the 

impact of such changes; and 

• treatment of synthetic securitizations. 

Qualitative 

disclosures 

(c) Names of NRSROs used for securitizations and the types of 

securitization exposure for which each agency is used. 

Quantitative 

disclosures

(d) The total outstanding exposures securitized by the [bank holding 

company/savings association] in securitizations that meet the 

operation criteria in Section 41 (broken down into 

traditional/synthetic), by underlying exposure type.50,51,52

 

49 For example: originator, investor, servicer, provider of credit enhancement, sponsor of asset backed 

commercial paper facility, liquidity provider, swap provider. 50 Underlying exposure types may include, for example, 1-4 family residential loans, home equity lines, 

credit card receivables, and auto loans. 

51 Securitization transactions in which the originating [bank holding company/savings association] does 

not retain any securitization exposure should be shown separately but need only be reported for the year of 

inception. 

52 Where relevant, a [bank holding company/savings association] is encouraged to differentiate between 

exposures resulting from activities in which they act only as sponsors, and exposures that result from all 

other [bank holding company/savings association] securitization activities. 
 Draft Basel II NPR 

494

(e) For exposures securitized by the [bank holding company/savings 

association] in securitizations that meet the operational criteria in 

Section 41:52

• amount of securitized assets that are impaired/past due; and 

• losses recognized by the bank holding company during the 

current period53 broken down by exposure type. 

(f) Aggregate amount of securitization exposures broken down by 

underlying exposure type.50

(g) Aggregate amount of securitization exposures and the associated 

IRB capital charges for these exposures broken down into a 

meaningful number of risk weight bands. Exposures that have been 

deducted from capital should be disclosed separately by type of 

underlying asset. 

(h) For securitizations subject to the early amortisation treatment, the 

following items by underlying asset type for securitized facilities: 

• the aggregate drawn exposures attributed to the seller’s and 

investors’ interests; and 

• the aggregate IRB capital charges incurred by the [bank 

holding company/savings association] against the investor’s 

shares of drawn balances and undrawn lines. 

(i) Summary of current year's securitization activity, including the 

amount of exposures securitized (by exposure type), and recognised 

gain or loss on sale by asset type. 

Table 11.9 – Operational Risk 

(a) The general qualitative disclosure requirement for operational risk. 

Qualitative 

disclosures 

(b) Description of the AMA, including a discussion of relevant internal 

and external factors considered in the [bank holding 

company’s/savings association’s] measurement approach. 

(c) A description of the use of insurance for the purpose of mitigating 

operational risk. 

 

53 For example, charge-offs/allowances (if the assets remain on the [bank holding company’s/savings 

association’s] balance sheet) or write-downs of I/O strips and other residual interests. 
 Draft Basel II NPR 

495

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. 

(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)54

• Total latent revaluation gains (losses)55

• Any amounts of the above included in tier 1 and/or tier 2 

capital. 

Quantitative 

Disclosures 

(f) Capital requirements broken down by appropriate equity 

groupings, consistent with the [bank holding company’s/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.56

 

54 Unrealized gains (losses) recognized in the balance sheet but not through earnings. 55 Unrealized gains (losses) not recognized either in the balance sheet or through earnings. 56 This disclosure should include a breakdown of equities that are subject to the 0%, 20%, 100%, 300%, 

and 400% risk weights, as applicable. 
 Draft Basel II NPR 

496

Table 11.11 – Interest Rate Risk for Non-trading Activities 

Qualitative 

disclosures

(a) The general qualitative disclosure requirement, including the nature 

of interest rate risk for non-trading activities and key assumptions, 

including assumptions regarding loan prepayments and behavior of 

non-maturity deposits, and frequency of measurement of interest 

rate risk for non-trading activities. 

Quantitative 

disclosures

(b) The increase (decline) in earnings or economic 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).