Attachment 1 

31

DEPARTMENT OF THE TREASURY 

Office of the Comptroller of the Currency 

12 CFR Part 3 

[Docket No. 06-09] 

RIN 1557-AC91 

FEDERAL RESERVE SYSTEM 

12 CFR Parts 208 and 225 

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

FEDERAL DEPOSIT INSURANCE CORPORATION 

12 CFR Part 325 

RIN 3064-AC73 

DEPARTMENT OF THE TREASURY 

Office of Thrift Supervision 

12 CFR Parts 559, 560, 563, and 567 

RIN 1550-AB56 

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

II 

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

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

Thrift Supervision, Treasury. 

ACTION: Final rule. 

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

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

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

agencies) are adopting a new risk-based capital adequacy framework that requires some 

and permits other qualifying banks1

 to use an internal ratings-based approach to calculate 

 

1

 For simplicity, and unless otherwise indicated, this final rule uses the term “bank” to include banks, 

savings associations, and bank holding companies (BHCs). The terms “bank holding company” and 
DRAFT November 2, 2007 

32

regulatory credit risk capital requirements and advanced measurement approaches to 

calculate regulatory operational risk capital requirements. The final rule describes the 

qualifying criteria for banks required or seeking to operate under the new framework and 

the applicable risk-based capital requirements for banks that operate under the 

framework. 

DATES: This final rule is effective [INSERT DATE].

FOR FURTHER INFORMATION CONTACT: 

 OCC: Mark Ginsberg, Risk Expert, Capital Policy (202-927-4580) or Ron 

Shimabukuro, Senior Counsel, Legislative and Regulatory Activities Division (202-874-

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

20219. 

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

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

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

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

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

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

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

3548, Bobby R. Bean, Chief, Policy Section, Capital Markets Branch, (202) 898-3575, 

Kenton Fox, Senior Policy Analyst, Capital Markets Branch, (202) 898-7119, Division of 

Supervision and Consumer Protection; or Michael B. Phillips, Counsel, (202) 898-3581, 

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

holding companies regulated by the OTS. 
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33

Supervision and Legislation Branch, Legal Division, Federal Deposit Insurance 

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

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

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

Senior Analyst, Capital Policy (202) 906-6389; or Karen Osterloh, Special Counsel, 

Regulations and Legislation Division (202) 906-6639, Office of Thrift Supervision, 1700 

G Street, NW, Washington, DC 20552. 

SUPPLEMENTARY INFORMATION: 

Table of Contents 

I. Introduction 

A. Executive Summary of the Final Rule 

 

B. Conceptual Overview 

1. The IRB approach for credit risk 

2. The AMA for operational risk 

 

C. Overview of Final Rule 

 

D. Structure of Final Rule 

 

E. Overall Capital Objectives 

F. Competitive Considerations 

II. Scope 

A. Core and Opt-In Banks 

 

B. U.S. Subsidiaries of Foreign Banks 

 

C. Reservation of Authority 

D. Principle of Conservatism 

III. Qualification 
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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) 

 Expected loss given default (ELGD) 

 Economic loss and post-default extensions of credit 

Economic downturn conditions 

Supervisory mapping function 

Pre-default reductions in exposure 

Exposure at default (EAD) 

 General quantification principles 

 Portfolios with limited data or limited defaults 

 4. Optional approaches that require prior supervisory approval 

5. Operational risk 

Operational risk data and assessment system 

Operational risk quantification system ` 

 6. Data management and maintenance 

 7. Control and oversight mechanisms 

 Validation 

 Internal audit 

 Stress testing 

 8. Documentation 

C. Ongoing Qualification 

D. Merger and Acquisition Transition Provisions 

IV. Calculation of Tier 1 Capital and Total Qualifying Capital 

V. Calculation of Risk-Weighted Assets 

A. Categorization of Exposures 

 1. Wholesale exposures 

 2. Retail exposures 

 3. Securitization exposures 
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35

 4. Equity exposures 

 5. Boundary between operational risk and other risks 

 6. Boundary between the final rule and the market risk rule 

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

Exposures, On-Balance Sheet Assets that Are Not Defined by Exposure Category, 

and Immaterial Credit Exposures) 

 1. Phase 1 – Categorization of exposures 

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

and retail exposures to segments 

 Purchased wholesale exposures 

 Wholesale lease residuals 

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

and retail segments 

 4. Phase 4 – Calculation of risk-weighted assets 

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

loans 

C. Credit Risk Mitigation (CRM) Techniques 

 1. Collateral 

 2. Counterparty credit risk of repo-style transactions, eligible margin loans, and 

OTC derivative contracts 

 Qualifying master netting agreement 

EAD for repo-style transactions and eligible margin loans 

 Collateral haircut approach 

Simple VaR methodology 

 3. EAD for OTC derivative contracts 

 Current exposure methodology 

4. Internal models methodology 

Maturity under the internal models methodology 

Collateral agreements under the internal models methodology 

Alternative methods 

 5. Guarantees and credit derivatives that cover wholesale exposures 

Eligible guarantees and eligible credit derivatives 

 PD substitution approach 

 LGD adjustment approach 

 Maturity mismatch haircut 

 Restructuring haircut 

 Currency mismatch haircut 

 Example 

Multiple credit risk mitigants 

 Double default treatment 

 6. Guarantees and credit derivatives that cover retail exposures 

 

D. Unsettled Securities, Foreign Exchange, and Commodity Transactions 

 
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E. Securitization Exposures 

 1. Hierarchy of approaches 

 Gains-on-sale and CEIOs 

The ratings-based approach (RBA) 

The internal assessment approach (IAA) 

The supervisory formula approach (SFA) 

Deduction 

Exceptions to the general hierarchy of approaches 

 Servicer cash advances 

Amount of a securitization exposure 

Implicit support 

 Operational requirements for traditional securitizations 

 Clean-up calls 

 Additional supervisory guidance 

 2. Ratings-based approach (RBA) 

 3. Internal assessment approach (IAA) 

 4. Supervisory formula approach (SFA) 

 General requirements 

 Inputs to the SFA formula 

 5. Eligible disruption liquidity facilities 

 6. CRM for securitization exposures 

 7. Synthetic securitizations 

 Background 

Operational requirements for synthetic securitizations 

 First-loss tranches 

 Mezzanine tranches 

 Super-senior tranches 

 8. Nth-to-default credit derivatives 

 9. Early amortization provisions 

 Background 

 Controlled early amortization 

 Non-controlled early amortization 

 Securitization of revolving residential mortgage exposures 

F. Equity Exposures 

1. Introduction and exposure measurement 

 Hedge transactions 

 Measures of hedge effectiveness 

 2. Simple risk-weight approach (SRWA) 

 Non-significant equity exposures 

 3. Internal models approach (IMA) 

 IMA qualification 

 Risk-weighted assets under the IMA 

 4. Equity exposures to investment funds 

 Full look-through approach 

 Simple modified look-through approach 
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 Alternative modified look-through approach 

VI. Operational Risk 

VII. Disclosure 

1. Overview 

 Comments on the proposed rule 

 2. General requirements 

 Frequency/timeliness 

 Location of disclosures and audit/attestation requirements 

 Proprietary and confidential information 

 3. Summary of specific public disclosure requirements 

 4. Regulatory reporting 

I. Introduction 

A. Executive Summary of the Final Rule 

On September 25, 2006, the agencies issued a joint notice of proposed rulemaking 

(proposed rule or proposal) (71 FR 55830) seeking public comment on a new risk-based 

regulatory capital framework for banks.2

 The agencies previously issued an advance 

notice of proposed rulemaking (ANPR) related to the new risk-based regulatory capital 

framework (68 FR 45900, August 4, 2003). The proposed rule was based on a series of 

releases from the Basel Committee on Banking Supervision (BCBS), culminating in the 

BCBS’s comprehensive June 2006 release entitled “International Convergence of Capital 

Measurement and Capital Standards: A Revised Framework” (New Accord).3

 The New 

Accord sets forth a “three pillar” framework encompassing risk-based capital 

requirements for credit risk, market risk, and operational risk (Pillar 1); supervisory 

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

 

2

 The agencies also issued proposed changes to the risk-based capital rule for market risk in a separate 

notice of proposed rulemaking (71 FR 55958, September 25, 2006). A final rule on that proposal is under 

development and will be issued in the near future. 

3

 The BCBS is a committee of banking supervisory authorities established by the central bank governors of 

the G-10 countries in 1975. The BCBS issued the New Accord to modernize its first capital Accord, which 

was endorsed by the BCBS members in 1988 and implemented by the agencies in 1989. The New Accord, 

the 1988 Accord, and other documents issued by the BCBS are available through the Bank for International 

Settlements’ website at www.bis.org. 
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disclosures (Pillar 3). The New Accord includes several methodologies for determining a 

bank’s risk-based capital requirements for credit, market, and operational risk. 

The proposed rule included the advanced capital methodologies from the New 

Accord, including the advanced internal ratings-based (IRB) approach for credit risk and 

the advanced measurement approaches (AMA) for operational risk (together, the 

advanced approaches). The IRB approach uses risk parameters determined by a bank’s 

internal systems in the calculation of the bank’s credit risk capital requirements. The 

AMA relies on a bank’s internal estimates of its operational risks to generate an 

operational risk capital requirement for the bank.4

 The agencies now are adopting this final rule implementing a new risk-based 

regulatory capital framework, based on the New Accord, that is mandatory for some U.S. 

banks and optional for others. While the New Accord includes several methodologies for 

determining risk-based capital requirements, the agencies are adopting only the advanced 

approaches at this time. 

The agencies received approximately 90 public comments on the proposed rule 

from banking organizations, trade associations representing the banking or financial 

services industry, supervisory authorities, and other interested parties. This section of the 

preamble highlights several fundamental issues that commenters raised about the 

agencies’ proposal and briefly describes how the agencies have responded to those issues 

in the final rule. More detail is provided in the preamble sections below. Overall, 

commenters supported the development of the framework and the move to more risksensitive capital requirements. One overarching issue, however, was the areas where the 

proposal differed from the New Accord. Commenters said the divergences generally 

 

4

 The agencies issued draft guidance on the advanced approaches. See 72 FR 9084 (February 28, 2007). 
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created competitive problems, raised home-host issues, entailed extra cost and regulatory 

burden, and did not necessarily improve the overall safety and soundness of banks subject 

to the rule. 

 Commenters also generally disagreed with the agencies’ proposal to adopt only 

the advanced approaches from the New Accord. Further, commenters objected to the 

agencies’ retention of the leverage ratio, the transitional arrangements in the proposal, 

and the 10 percent numerical benchmark for identifying material aggregate reductions in 

risk-based capital requirements to be used for evaluating and responding to capital 

outcomes during the parallel run and transitional floor periods (discussed below). 

Commenters also noted numerous technical issues with the proposed rule. 

 As noted in an interagency press release issued July 20, 2007 (Banking Agencies 

Reach Agreement on Basel II Implementation), the agencies have agreed to eliminate the 

language from the preamble concerning a 10 percent limitation on aggregate reductions 

in risk-based capital requirements. The press release also stated that the agencies are 

retaining intact the transitional floor periods (see preamble sections I.E. and III.A.2.). In 

addition, while not specifically mentioned in the press release, the agencies are retaining 

the leverage ratio and the prompt corrective action (PCA) regulations without 

modification. 

 The final rule adopts without change the proposed criteria for identifying core 

banks (banks required to apply the advanced approaches) and continues to permit other 

banks (opt-in banks) to adopt the advanced approaches if they meet the applicable 

qualification requirements. Core banks are those with consolidated total assets 

(excluding assets held by an insurance underwriting subsidiary of a bank holding 
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40

company) of $250 billion or more or with consolidated total on-balance-sheet foreign 

exposure of $10 billion or more. A depository institution (DI) also is a core bank if it is a 

subsidiary of another DI or bank holding company that uses the advanced approaches. 

The final rule also provides that a bank’s primary Federal supervisor may determine that 

application of the final rule is not appropriate in light of the bank’s asset size, level of 

complexity, risk profile, or scope of operations (see preamble sections II.A. and B.). 

 As noted above, the final rule includes only the advanced approaches. The July 

2007 interagency press release stated that the agencies have agreed to issue a proposed 

rule that would provide non-core banks with the option to adopt an approach consistent 

with the standardized approach included in the New Accord. This new proposal (the 

standardized proposal) will replace the earlier proposal to adopt the so-called Basel IA 

option (Basel 1A proposal).5

 The press release also noted the agencies’ intention to 

finalize the standardized proposal before core banks begin the first transitional floor 

period under this final rule. 

 In response to commenters’ concerns that some aspects of the proposed rule 

would result in excessive regulatory burden without commensurate safety and soundness 

enhancements, the agencies included a principle of conservatism in the final rule. In 

general, under this principle, in limited situations, a bank may choose not to apply a 

provision of the rule to one or more exposures if the bank can demonstrate on an ongoing 

basis to the satisfaction of its primary Federal supervisor that not applying the provision 

would, in all circumstances, unambiguously generate a risk-based capital requirement for 

each such exposure that is greater than that which would otherwise be required under the 

regulation, and the bank meets other specified requirements (see preamble section II.D.). 

 

5

 71 FR 77445 (Dec. 26, 2006). 
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41

 In the proposal, the agencies modified the definition of default for wholesale 

exposures from that in the New Accord to address issues commenters had raised on the 

ANPR. Commenters objected to the agencies’ modified definition of default for 

wholesale exposures, however, asserting that a definition different from the New Accord 

would result in competitive inequities and significant implementation burden without 

associated supervisory benefit. In response to these concerns, the agencies have adopted 

a definition of default for wholesale exposures that is consistent with the New Accord 

(see preamble section III.B.2.). For retail exposures, the final rule retains the proposed 

definition of default and clarifies that, subject to certain considerations, a foreign 

subsidiary of a U.S. bank may, in its consolidated risk-based capital calculations, use the 

applicable host jurisdiction definition of default for retail exposures of the foreign 

subsidiary in that jurisdiction (see preamble section III.B.2.). 

Another concept introduced in the proposal that was not in the New Accord was 

the expected loss given default (ELGD) risk parameter. ELGD had four functions in the 

proposed rule — as a component of the calculation of expected credit loss (ECL) in the 

numerator of the risk-based capital ratios; in the expected loss (EL) component of the 

IRB risk-based capital formulas; as a floor on the value of the loss given default (LGD) 

risk parameter; and as an input into a supervisory mapping function. Many commenters 

objected to the inclusion of ELGD as a departure from the New Accord that would create 

regulatory burden and competitive inequity. Many commenters also objected to the 

supervisory mapping function, which the agencies intended as an alternative for banks 

that were not able to estimate reliably the LGD risk parameter. The agencies have 

eliminated ELGD from the final rule. Banks are required to estimate only the LGD risk 
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42

parameter, which reflects economic downturn conditions (see preamble section III.B.3.). 

The supervisory mapping function also has been eliminated from the rule. 

 Commenters also objected to the agencies’ decision not to include a distinct risk 

weight function for exposures to small- and medium-size enterprises (SMEs) as provided 

in the New Accord. In the proposal, the agencies noted they were not aware of 

compelling evidence that smaller firms with the same probability of default (PD) and 

LGD as larger firms are subject to less systemic risk than is already reflected in the 

wholesale risk-based capital functions. The agencies continue to believe an SMEspecific risk weight function is not supported by sufficient evidence and might give rise 

to competitive inequities across U.S. banks, and have not adopted such a function in the 

final rule (see preamble section V.A.1.) 

 With regard to the proposed treatment for securitization exposures, commenters 

raised a number of technical issues. Many objected to the proposed definition of a 

securitization exposure, which included exposures to investment funds with material 

liabilities (including exposures to hedge funds). The agencies agree with commenters 

that the proposed definition for securitization exposures was quite broad and captured 

some exposures that would more appropriately be treated under the wholesale or equity 

frameworks. To limit the scope of the IRB securitization framework, the agencies have 

modified the definition of traditional securitization in the final rule as described in 

preamble section V.A.3. Technical issues related to securitization exposures are 

discussed in preamble sections V.A.3. and V.E. 

 For equity exposures, commenters focused on the proposal’s lack of a 

grandfathering period. The New Accord provides national discretion for each 
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implementing jurisdiction to adopt a grandfather period for equity exposures. 

Commenters asserted that this omission would result in competitive inequity for U.S. 

banks as compared to other internationally active institutions. The agencies believe that, 

overall, the proposal’s approach to equity exposures results in a competitive risk-based 

capital requirement. The final rule does not include a grandfathering provision, and the 

agencies have adopted the proposed treatment for equity exposures without significant 

change (see preamble section V.F.). 

 A number of commenters raised issues related to operational risk. Most 

significantly, commenters noted that activities besides securities processing and credit 

card fraud have highly predictable and reasonably stable losses and should be considered 

for operational risk offsets. The agencies believe that the proposed definition of eligible 

operational risk offsets allows for the consideration of other activities in a flexible and 

prudent manner and, thus, are retaining the proposed definition in the final rule. 

Commenters also noted that the proposal appeared to place limits on the use of 

operational risk mitigants. The agencies have provided flexibility in this regard and 

under the final rule will take into consideration whether a particular operational risk 

mitigant covers potential operational losses in a manner equivalent to holding regulatory 

capital (see preamble sections III.B.5. and V.I.). 

 Many commenters expressed concern that the proposed public disclosures were 

excessive and would hinder, rather than facilitate, market discipline by requiring banks to 

disclose information that would not be well understood by or useful to the market. 

Commenters also expressed concern about possible disclosure of proprietary information. 

The agencies believe that it is important to retain the vast majority of the proposed 
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disclosures, which are consistent with the New Accord. These disclosures will enable 

market participants to gain key insights regarding a bank’s capital structure, risk 

exposures, risk assessment processes, and, ultimately, capital adequacy. The agencies 

have modified the final rule to provide flexibility regarding proprietary information. 

B. Conceptual Overview 

 This final rule is intended to produce risk-based capital requirements that are 

more risk-sensitive than those produced under the agencies’ existing risk-based capital 

rules (general risk-based capital rules). In particular, the IRB approach requires banks to 

assign risk parameters to wholesale exposures and retail segments and provides specific 

risk-based capital formulas that must be used to transform these risk parameters into riskbased capital requirements. 

 The framework is based on “value-at-risk” (VaR) modeling techniques that 

measure credit risk and operational risk. Because bank risk measurement practices are 

both continually evolving and subject to uncertainty, the framework should be viewed as 

an effort to improve the risk sensitivity of the risk-based capital requirements for banks, 

rather than as an effort to produce a statistically precise measurement of risk. 

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

quantified through the estimation of specific characteristics of the probability distribution 

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

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

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

the framework. The figure shows a probability distribution of potential losses associated 
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with some time horizon (for example, one year). It could reflect, for example, credit 

losses, operational losses, or other types of losses. 

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

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

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

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

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

and above the EL amount. A given level of UL can be defined by reference to a 

particular percentile threshold of the probability distribution. For example, in the figure 

UL is measured at the 99.9th percentile level and thus is equal to the value of the loss 

distribution corresponding to the 99.9th percentile, less the amount of EL. This is shown 

graphically at the bottom of the figure. 

 The particular percentile level chosen for the measurement of UL is referred to as 

the “confidence level” or the “soundness standard” associated with the measurement. If 

Expected Losses 

Figure 1 − Probability Distribution of Potential Losses 

Losses

Unexpected Losses 

99.9th percentile 

Mean
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capital is available to cover losses up to and including this percentile level, then the bank 

should remain solvent in the face of actual losses of that magnitude. Typically, the 

choice of confidence level or soundness standard reflects a very high percentile level, so 

that there is a very low estimated probability that actual losses would exceed the UL 

amount associated with that confidence level or soundness standard. 

 Assessing risk and assigning regulatory capital requirements by reference to a 

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

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

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

rule). Under the market risk rule, a bank’s own internal models are used to estimate the 

99th percentile of the bank’s market risk loss distribution over a ten-business-day horizon. 

The bank’s market risk capital requirement is based on this VaR estimate, generally 

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

provide a prudential buffer for market volatility and modeling uncertainty. 

1. The IRB approach for credit risk

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

requirements is similar to the market risk rule’s approach to market risk capital 

requirements, in the sense that each is VaR-oriented. Nevertheless, there are important 

differences between the IRB approach and the market risk rule. The current market risk 

rule specifies a nominal confidence level of 99.0 percent and a ten-business-day horizon, 

but otherwise provides banks with substantial modeling flexibility in determining their 

market risk loss distribution and capital requirements. In contrast, the IRB approach for 

assessing credit risk capital requirements is based on a 99.9 percent nominal confidence 
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level, a one-year horizon, and a supervisory model of credit losses embodying particular 

assumptions about the underlying drivers of portfolio credit risk, including loss 

correlations among different asset types.6 

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

number of banks as the basis for their internal assessment of the economic capital 

necessary to cover credit risk. It is common for a bank’s internal credit risk models to 

consider a one-year loss horizon and to focus on a high loss threshold confidence level. 

As with the internal credit VaR models used by banks, the output of the risk-based capital 

formulas in the IRB approach is an estimate of the amount of credit losses above ECL 

over a one-year horizon that would only be exceeded a small percentage of the time. The 

agencies believe that a one-year horizon is appropriate because it balances the difficulty 

of easily or rapidly exiting non-trading positions against the possibility that in many cases 

a bank can cover credit losses by raising additional capital should the underlying credit 

problems manifest themselves gradually. The nominal confidence level of the IRB riskbased capital formulas (99.9 percent) means that if all the assumptions in the IRB 

supervisory model for credit risk were correct for a bank, there would be less than a 0.1 

percent probability that credit losses at the bank in any year would exceed the IRB riskbased capital requirement.7

 

 

6

 The theoretical underpinnings for the supervisory model of credit risk underlying the IRB approach are 

provided in a paper by Michael Gordy, “A Risk-Factor Model Foundation for Ratings-Based Bank Capital 

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

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

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

January 2000, or H.U. Koyluogu and A. Hickman, “Reconcilable Differences,” Risk, October 1998. For a 

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

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

International Settlements website at www.bis.org. 7

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

regulatory capital measure underlying this rule includes not only equity capital, but also certain debt and 
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 As noted above, the supervisory model of credit risk underlying the IRB approach 

embodies specific assumptions about the economic drivers of portfolio credit risk at 

banks. As with any modeling approach, these assumptions represent simplifications of 

very complex real-world phenomena and, at best, are only an approximation of the actual 

credit risks at any bank. If these assumptions (described in greater detail below) are 

incorrect or otherwise do not characterize a given bank precisely, the actual confidence 

level implied by the IRB risk-based capital formulas may exceed or fall short of a true 

99.9 percent confidence level. 

 In combination with other supervisory assumptions and parameters underlying the 

IRB approach, the approach’s 99.9 percent nominal confidence level reflects a 

judgmental pooling of available information, including supervisory experience. The 

framework underlying this final rule reflects a desire on the part of the agencies to 

achieve (i) risk-based capital requirements that are reflective of relative risk across 

different assets and that are broadly consistent with maintaining at least an investmentgrade rating (for example, at least BBB) on the liabilities funding those assets, even in 

periods of economic adversity; and (ii) for the U.S. banking system as a whole, aggregate 

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

aggregate minimum regulatory capital requirements under the general risk-based capital 

rules. 

A number of important explicit general assumptions and specific parameters are 

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

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

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

in the IRB approach is not directly comparable to the nominal solvency standards underpinning banks’ 

economic capital models. 
DRAFT November 2, 2007 

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the assumptions embodied in the IRB approach are: (i) assumptions that a bank’s credit 

portfolio is infinitely granular; (ii) assumptions that loan defaults at a bank are driven by 

a single, systematic risk factor; (iii) assumptions that systematic and non-systematic risk 

factors are log-normal random variables; and (iv) assumptions regarding correlations 

among credit losses on various types of assets. 

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

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

may do using a variety of techniques. These risk parameters are PD, LGD, exposure at 

default (EAD), and, for wholesale exposures, effective remaining maturity (M). The 

proposed rule included an additional risk parameter, ELGD. As discussed in section 

III.B.3. of the preamble, the agencies have eliminated the ELGD risk parameter from the 

final rule. The risk-based capital formulas into which the estimated risk parameters are 

inserted are simpler than the economic capital methodologies typically employed by 

banks, which often require complex computer simulations. In particular, an important 

property of the IRB risk-based capital formulas is portfolio invariance. That is, the riskbased capital requirement for a particular exposure generally does not depend on the 

other exposures held by the bank. Like the general risk-based capital rules, the total 

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

the credit risk capital requirements on individual wholesale exposures and segments of 

retail exposures. 

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

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

the formulas. The AVC assigned to a given portfolio of exposures is an estimate of the 
DRAFT November 2, 2007 

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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.8 For example, a 15 

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

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

requirement than a 10 percent AVC. 

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

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

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

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

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

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

fixed rather than a decreasing function of PD. The AVCs included in the IRB risk-based 

capital formulas for both wholesale and retail exposures reflect a combination of 

supervisory judgment and empirical evidence.9

 However, the historical data available for 

estimating correlations among retail exposures, particularly for non-mortgage retail 

exposures, was more limited than was the case with wholesale exposures. As a result, 

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

 

8

 See BCBS Explanatory Note. 9

 See BCBS Explanatory Note, section 5.3. 
DRAFT November 2, 2007 

51

residential mortgage exposures is based largely on supervisory experience with and 

analysis of traditional long-term, fixed-rate mortgages. 

Several commenters stated that the proposed AVCs for wholesale exposures were 

too high in general, and a few claimed that, in particular, the AVCs for multi-family 

residential real estate exposures should be lower. Other commenters suggested that the 

AVCs of wholesale exposures should be a function of obligor size rather than PD. 

Similarly, several commenters maintained that the proposed AVCs for retail exposures 

were too high. Some of these commenters suggested that the AVCs for qualifying 

revolving exposures (QREs), such as credit cards, should be in the range of 1 to 2 

percent, not 4 percent as proposed. Similarly, some of those commenters opposed the 

proposed flat 15 percent AVC for residential mortgage exposures; one commenter 

suggested that the agencies should consider employing lower AVCs for home equity 

loans and lines of credit (HELOCs) to take into account their shorter maturity relative to 

traditional mortgage exposures. 

However, most commenters recognized that the proposed AVCs were consistent 

with those in the New Accord and recommended that the agencies use the AVCs 

contained in the New Accord to avoid international competitive inequity and unnecessary 

burden. Several commenters suggested that the agencies should reconsider the AVCs 

going forward, working with the BCBS. 

The agencies agree with the prevailing view of the commenters that using the 

AVCs in the New Accord alleviates a potential source of international inconsistency and 

implementation burden. The final rule therefore maintains the proposed AVCs. As the 

agencies gain more experience with the advanced approaches, they may revisit the AVCs 
DRAFT November 2, 2007 

52

for wholesale exposures and retail exposures, along with other calibration issues 

identified during the parallel run and transitional floor periods (as described below) and 

make changes to the rule as necessary. The agencies would address this issue working 

with the BCBS and other supervisory and regulatory authorities, as appropriate. 

Another important conceptual element of the IRB approach concerns the 

treatment of ECL. The IRB approach assumes that reserves should cover ECL while 

capital should cover credit losses exceeding ECL (that is, unexpected credit losses). 

Accordingly, the final rule, consistent with the proposal and the New Accord, removes 

ECL from the risk-weighted assets calculation but requires a bank to compare its ECL to 

its eligible credit reserves (as defined below). If a bank’s ECL exceeds its eligible credit 

reserves, the bank must deduct the excess ECL amount 50 percent from tier 1 capital and 

50 percent from tier 2 capital. If a bank’s eligible credit reserves exceed its ECL, the 

bank may include the excess eligible credit reserves amount in tier 2 capital, up to 0.6 

percent of the bank’s credit risk-weighted assets.10 This treatment is intended to 

maintain a capital incentive to reserve prudently and ensure that ECL over a one-year 

horizon is covered either by reserves or capital. This treatment also recognizes that 

prudent reserving that considers probable losses over the life of a loan may result in a 

bank holding reserves in excess of ECL measured with a one-year horizon. The BCBS 

calibrated the 0.6 percent limit on inclusion of excess reserves in tier 2 capital to be 

approximately as restrictive as the existing cap on the inclusion of allowance for loan and 

 

10 In contrast, under the general risk-based capital rules, the allowance for loan and lease losses (ALLL) 

may be included in tier 2 capital up to 1.25 percent of total risk-weighted assets. 
DRAFT November 2, 2007 

53

lease losses (ALLL) under the 1988 Accord, based on data obtained in the BCBS’s Third 

Quantitative Impact Study (QIS-3).11 

 In developing the New Accord, the BCBS sought broadly to maintain the current 

overall level of minimum risk-based capital requirements within the banking system. 

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

requirements that would be generated under the New Accord. Based on this analysis, the 

BCBS concluded that a “scaling factor” (multiplier) should apply to credit risk-weighted 

assets. The BCBS, in the New Accord, indicated that the best estimate of the scaling 

factor was 1.06. In May 2006, the BCBS decided to maintain the 1.06 scaling factor 

based on the results of a fourth quantitative impact study (QIS-4) conducted in some 

jurisdictions, including the United States, and a fifth quantitative impact study (QIS-5), 

not conducted in the United States.12 The BCBS noted that national supervisory 

authorities will continue to monitor capital requirements during implementation of the 

New Accord, and that the BCBS, in turn, will monitor national experiences with the 

framework. 

 The agencies generally agree with the BCBS regarding calibration of the New 

Accord. Therefore, consistent with the New Accord and the proposed rule, the final rule 

contains a scaling factor of 1.06 for credit-risk-weighted assets. As the agencies gain 

more experience with the advanced approaches, the agencies will revisit the scaling 

factor along with other calibration issues identified during the parallel run and transitional 

floor periods (described below) and will make changes to the rule as necessary, working 

with the BCBS and other supervisory and regulatory authorities, as appropriate. 

 

11 BCBS, “QIS 3: Third Quantitative Impact Study,” May 2003. 

12 BCBS press release, “Basel Committee maintains calibration of Basel II Framework,” May 24, 2006. 
DRAFT November 2, 2007 

54

2. The AMA for operational risk 

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

requirements for operational risk. Under the final rule (consistent with the proposed 

rule), operational risk is defined as the risk of loss resulting from inadequate or failed 

internal processes, people, and systems or from external events. This definition of 

operational risk includes legal risk – which is the risk of loss (including litigation costs, 

settlements, and regulatory fines) resulting from the failure of the bank to comply with 

laws, regulations, prudent ethical standards, and contractual obligations in any aspect of 

the bank’s business – but excludes strategic and reputational risks. 

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

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

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

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

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

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

operational risk meet established standards, including producing an estimate of 

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

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

(EOL) and unexpected operational loss (UOL) and forms the basis of the bank’s 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 
DRAFT November 2, 2007 

55

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

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

risk must incorporate the shortfall. 

C. Overview of Final Rule 

The final rule maintains the general risk-based capital rules’ minimum tier 1 riskbased capital ratio of 4.0 percent and total risk-based capital ratio of 8.0 percent. The 

components of tier 1 and total capital in the final rule are also the same as in the general 

risk-based capital rules, with a few adjustments described in more detail below. The 

primary difference between the general risk-based capital rules and the final rule is the 

methodologies used for calculating risk-weighted assets. Banks applying the final rule 

generally must use their internal risk measurement systems to calculate the inputs for 

determining the risk-weighted asset amounts for (i) general credit risk (including 

wholesale and retail exposures); (ii) securitization exposures; (iii) equity exposures; and 

(iv) operational risk. In certain cases, however, banks must use external ratings or 

supervisory risk weights to determine risk-weighted asset amounts. Each of these areas is 

discussed below. 

Banks using the final rule also are subject to supervisory review of their capital 

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

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

remains subject to the tier 1 leverage ratio requirement,13 and each DI (as defined in 

section 3 of the Federal Deposit Insurance Act (12 U.S.C. 1813)) using the advanced 

 

13 See 12 CFR part 3.6(b) and (c) (national banks); 12 CFR part 208, appendix B (state member banks); 12 

CFR part 225, appendix D (bank holding companies); 12 CFR 325.3 (state nonmember banks); 12 CFR 

567.2(a)(2) and 567.8 (savings associations). 
DRAFT November 2, 2007 

56

approaches remains subject to the prompt corrective action (PCA) thresholds.14 Banks 

using the advanced approaches also remain subject to the market risk rule, where 

applicable. 

Under the final rule, a bank must identify whether each of its on- and off-balance 

sheet exposures is a wholesale, retail, securitization, or equity exposure. Assets that are 

not defined by any exposure category (and certain immaterial portfolios of exposures) 

generally are assigned risk-weighted asset amounts equal to their carrying value (for onbalance sheet exposures) or notional amount (for off-balance sheet exposures). 

Wholesale exposures under the final rule include most credit exposures to 

companies, sovereigns, and other governmental entities. For each wholesale exposure, a 

bank must assign four quantitative risk parameters: PD (which is expressed as a decimal 

(that is, 0.01 corresponds to 1 percent) and is an estimate of the probability that an 

obligor will default over a one-year horizon); LGD (which is expressed as a decimal and 

reflects an estimate of the economic loss rate if a default occurs during economic 

downturn conditions); EAD (which is measured in dollars and is an estimate of the 

amount that would be owed to the bank at the time of default); and M (which is measured 

in years and reflects the effective remaining maturity of the exposure). Banks may factor 

into their risk parameter estimates the risk mitigating impact of collateral, credit 

derivatives, and guarantees that meet certain criteria. Banks must input the risk 

parameters for each wholesale exposure into an IRB risk-based capital formula to 

determine the risk-based capital requirement for the exposure. 

 

14 See 12 CFR part 6 (national banks); 12 CFR part 208, subpart D (state member banks); 12 CFR 325.103 

(state nonmember banks); 12 CFR part 565 (savings associations). In addition, savings associations remain 

subject to the tangible capital requirement at 12 CFR 567.2(a)(3) and 567.9. 
DRAFT November 2, 2007 

57

Retail exposures under the final rule include most credit exposures to individuals 

and small credit exposures to businesses that are managed as part of a segment of 

exposures with similar risk characteristics and not managed on an individual-exposure 

basis. A bank must classify each of its retail exposures into one of three retail 

subcategories – residential mortgage exposures; QREs, such as credit cards and overdraft 

lines; and other retail exposures. Within these three subcategories, the bank must group 

exposures into segments with similar risk characteristics. The bank must then assign the 

risk parameters PD, LGD, and EAD to each retail segment. The bank may take into 

account the risk mitigating impact of collateral and guarantees in the segmentation 

process and in the assignment of risk parameters to retail segments. Like wholesale 

exposures, the risk parameters for each retail segment are used as inputs into an IRB riskbased capital formula to determine the risk-based capital requirement for the segment. 

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

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

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

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

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

Approach (SFA), which uses bank inputs that are entered into a supervisory formula to 

risk-weight exposures. Securitization exposures in the form of gain-on-sale or creditenhancing interest-only strips (CEIOs)15 and securitization exposures that do not qualify 

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

 

15 A CEIO is an on-balance sheet asset that, in form or in substance, (i) represents the contractual right to 

receive some or all of the interest and no more than a minimal amount of principal due on the underlying 

exposures of a securitization and (ii) exposes the holder to credit risk directly or indirectly associated with 
DRAFT November 2, 2007 

58

Banks may use an internal models approach (IMA) for determining risk-based 

capital requirements for equity exposures, subject to certain qualifying criteria and floors. 

If a bank does not have a qualifying internal model for equity exposures, or chooses not 

to use such a model, the bank must apply a simple risk weight approach (SRWA) in 

which publicly traded equity exposures generally are assigned a 300 percent risk weight 

and non-publicly traded equity exposures generally are assigned a 400 percent risk 

weight. Under both the IMA and the SRWA, equity exposures to certain entities or made 

pursuant to certain statutory authorities (such as community development laws) are 

subject to a 0 to 100 percent risk weight. 

Banks must develop qualifying AMA systems to determine risk-based capital 

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

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

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

Under the final rule, a bank must calculate its tier 1 and total risk-based capital 

ratios by dividing tier 1 capital by total risk-weighted assets and by dividing total 

qualifying capital by total risk-weighted assets, respectively. To calculate total riskweighted assets, a bank must first convert the dollar risk-based capital requirements for 

exposures produced by the IRB risk-based capital approaches and the AMA into riskweighted 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 riskweighted asset amounts for credit risk and operational risk, a bank must sum these 

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

subordination provisions or other credit-enhancement techniques.
DRAFT November 2, 2007 

59

amounts and then subtract any excess eligible credit reserves not included in tier 2 capital 

to determine total risk-weighted assets. 

The final rule contains specific public disclosure requirements to provide 

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

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

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

consolidated level of the banking group that is subject to the advanced approaches, unless 

the entity is a subsidiary of a non-U.S. banking organization that is subject to comparable 

disclosure requirements in its home jurisdiction. All banks subject to the rule, however, 

must disclose total and tier 1 risk-based capital ratios and the components of these ratios. 

The agencies also proposed a package of regulatory reporting templates for the agencies’ 

use in assessing and monitoring the levels and components of bank risk-based capital 

requirements under the advanced approaches.16 These templates will be finalized shortly. 

The agencies are aware that the fair value option in generally accepted accounting 

principles as used in the United States (GAAP) raises potential risk-based capital issues 

not contemplated in the development of the New Accord. The agencies will continue to 

analyze these issues and may make changes to this rule at a future date as necessary. The 

agencies would address these issues working with the BCBS and other supervisory and 

regulatory authorities, as appropriate. 

D. Structure of Final Rule 

The agencies are implementing a regulatory framework for the advanced 

approaches in which each agency has an advanced approaches appendix that incorporates 

(i) definitions of tier 1 and tier 2 capital and associated adjustments to the risk-based 

 

16 71 FR 55981 (September 25, 2006). 
DRAFT November 2, 2007 

60

capital ratio numerators, (ii) the qualification requirements for using the advanced 

approaches, and (iii) the details of the advanced approaches.17 The agencies also are 

incorporating their respective market risk rules, by cross-reference.18 

In this final rule, as in the proposed rule, the agencies are not restating the 

elements of tier 1 and tier 2 capital, which largely remain the same as under the general 

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

to banks applying the final rule are in part II of the rule and explained in greater detail in 

section IV of this preamble. 

The final rule has eight parts. Part I identifies criteria for determining which 

banks are subject to the rule, provides key definitions, and sets forth the minimum riskbased capital ratios. Part II describes the adjustments to the numerator of the regulatory 

capital ratios for banks using the advanced approaches. Part III describes the 

qualification process and provides qualification requirements for obtaining supervisory 

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

supervisory oversight of capital adequacy (Pillar 2). 

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

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

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

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

credit exposures. This part also describes the risk-based capital treatment for over-the-

 

17 As applicable, certain agencies are also making conforming changes to existing regulations as necessary 

to incorporate the new appendices. 

18 12 CFR part 3, Appendix B (for national banks), 12 CFR part 208, Appendix E (for state member banks), 

12 CFR part 225, Appendix E (for bank holding companies), and 12 CFR part 325, Appendix C (for state 

nonmember banks). OTS intends to codify a market risk rule for savings associations at 12 CFR part 567, 

Appendix D. 
DRAFT November 2, 2007 

61

counter (OTC) derivative contracts, repo-style transactions, and eligible margin loans. In 

addition, this part describes the methodologies for reflecting credit risk mitigation in riskweighted assets for wholesale and retail exposures. Furthermore, this part sets forth the 

risk-based capital requirements for failed and unsettled securities, commodities, and 

foreign exchange transactions. 

Part V identifies operating criteria for recognizing risk transference in the 

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

securitization exposures. Part VI describes the approaches for calculating risk-weighted 

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

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

employing the advanced approaches (Pillar 3). 

 The structure of the preamble generally follows the structure of the regulatory 

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

most relevant. 

E. Overall Capital Objectives

The preamble to the proposed rule described the agencies’ intention to avoid a 

material reduction in overall risk-based capital requirements under the advanced 

approaches. The agencies also identified other objectives, such as ensuring that 

differences in capital requirements appropriately reflect differences in risk and ensuring 

that the U.S. implementation of the New Accord will not be a significant source of 

competitive inequity among internationally active banks or among domestic banks 

operating under different risk-based capital rules. The final rule modifies and clarifies 

the approach the agencies will use to achieve these objectives. 
DRAFT November 2, 2007 

62

The agencies proposed a series of transitional floors to provide a smooth 

transition to the advanced approaches and to temporarily limit the amount by which a 

bank's risk-based capital requirements could decline over a period of at least three years. 

The transitional floors are described in more detail in section III.A.2. of this preamble. 

The floors generally prohibit a bank’s risk-based capital requirement under the advanced 

approaches from falling below 95 percent, 90 percent, and 85 percent of what it would be 

under the general risk-based capital rules during the bank’s first, second, and third 

transitional floor periods, respectively. The proposal stated that banks would be required 

to receive the approval of their primary Federal supervisor before entering each 

transitional floor period. 

The preamble to the proposal noted that if there was a material reduction in 

aggregate minimum regulatory capital upon implementation of the advanced approaches, 

the agencies would propose regulatory changes or adjustments during the transitional 

floor periods. The preamble further noted that in this context, materiality would depend 

on a number of factors, including the size, source, and nature of any reduction; the risk 

profiles of banks authorized to use the advanced approaches; and other considerations 

relevant to the maintenance of a safe and sound banking system. The agencies also stated 

that they would view a 10 percent or greater decline in aggregate minimum required riskbased capital (without reference to the effects of the transitional floors), compared to 

minimum required risk-based capital as determined under the general risk-based capital 

rules, as a material reduction warranting modification to the supervisory risk functions or 

other aspects of the framework. 
DRAFT November 2, 2007 

63

Further, the agencies stated that they were "identifying a numerical benchmark for 

evaluating and responding to capital outcomes during the parallel run and transitional 

floor periods that do not comport with the overall capital objectives." The agencies also 

stated that "[a]t the end of the transitional floor periods, the agencies would reevaluate the 

consistency of the framework, as (possibly) revised during the transitional floor periods, 

with the capital goals outlined in the ANPR and with the maintenance of broad 

competitive parity between banks adopting the framework and other banks, and would be 

prepared to make further changes to the framework if warranted.” The agencies viewed 

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

controlled conditions."19

The agencies sought comment on the appropriateness of using a 10 percent or 

greater decline in aggregate minimum required risk-based capital as a numerical 

benchmark for material reductions when determining whether capital objectives were 

achieved. Many commenters objected to the proposed transitional floors and the 10 

percent benchmark on the grounds that both safeguards deviated materially from the New 

Accord and the rules implemented by foreign supervisory authorities. In particular, 

commenters expressed concerns that the aggregate 10 percent limit added a degree of 

uncertainty to their capital planning process, since the limit was beyond the control of 

any individual bank. They maintained that it might take only a few banks that decided to 

reallocate funds toward lower-risk activities during the transition period to impose a 

penalty on all U.S. banks using the advanced approaches. Other commenters stated that 

the benchmark lacked transparency and would be operationally difficult to apply. 

 

19 71 FR 55839-40 (September 25, 2006). 
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64

Commenters also criticized the duration, level, and construct of the transitional 

floors in the proposed rule. Commenters believed it was inappropriate to extend the 

transitional floors by an additional year (to three years), and raised concerns that the 

floors were more binding than those proposed in the New Accord. Commenters strongly 

urged the agencies to adopt the transition periods and floors in the New Accord to limit 

any competitive inequities that could arise among internationally active banks. 

To better balance commenters’ concerns and the agencies’ capital adequacy 

objectives, the agencies have decided not to include the 10 percent benchmark language 

in this preamble. This will alleviate uncertainty and enable each bank to develop capital 

plans in accordance with its individual risk profile and business model. The agencies 

have taken a number of steps to address their capital adequacy objectives. Specifically, 

the agencies are retaining the existing leverage ratio and PCA requirements and are 

adopting the three transitional floor periods at the proposed numerical levels. 

Under the final rule, the agencies will jointly evaluate the effectiveness of the new 

capital framework. The agencies will issue a series of annual reports during the transition 

period that will provide timely and relevant information on the implementation of the 

advanced approaches. In addition, after the end of the second transition year, the 

agencies will publish a study (interagency study) that will evaluate the advanced 

approaches to determine if there are any material deficiencies. For any primary Federal 

supervisor to authorize any bank to exit the third transitional floor period, the study must 

determine that there are no such material deficiencies that cannot be addressed by thenexisting tools, or, if such deficiencies are found, they must be first remedied by changes 

to regulation. Notwithstanding the preceding sentence, a primary Federal supervisor that 
DRAFT November 2, 2007 

65

disagrees with the finding of material deficiency may not authorize a bank under its 

jurisdiction to exit the third transitional floor period unless the supervisor first provides a 

public report explaining its reasoning. 

The agencies intend to establish a transparent and collaborative process for 

conducting the interagency study, consistent with the recommendations made by the U.S. 

Government Accountability Office (GAO) in its report on implementation of the New 

Accord in the United States.20 In conducting the interagency study the agencies would 

consider, for example, the following: 

• The level of minimum required regulatory capital under U.S. advanced 

approaches compared to the capital required by other international and domestic 

regulatory capital standards. 

• Peer comparisons of minimum regulatory capital requirements, including but not 

limited to banks’ estimates of risk parameters for portfolios of similar risk. 

• The processes banks use to develop and assess risk parameters and advanced 

systems, and supervisory assessments of their accuracy and reliability. 

• Potential cyclical implications. 

• Changes in portfolio composition or business mix, including those that might 

result in changes in capital requirements per dollar of credit exposure. 

• Comparison of regulatory capital requirements to market-based measures of 

capital adequacy to assess relative minimum capital requirements across banks 

and broad asset categories. Market-based measures might include credit default 

 

20 United States Government Accountability Office, “Risk-Based Capital: Bank Regulators Need to 

Improve Transparency and Overcome Impediments to Finalizing the Proposed Basel II Framework” 

(GAO-07-253), February 15, 2007. 
DRAFT November 2, 2007 

66

swap spreads, subordinated debt spreads, external rating agency ratings, and other 

market measures of risk. 

• Examination of the quality and robustness of advanced risk management 

processes related to assessment of capital adequacy, as in the comprehensive 

supervisory assessments performed under Pillar 2. 

• Additional reviews, including analysis of interest rate and concentration risks that 

might suggest the need for higher regulatory capital requirements. 

F. Competitive Considerations

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

stability of the international banking system while maintaining sufficient consistency in 

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

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

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

measurement and management practices of large and internationally active banks. 

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

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

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

agencies believe that the general risk-based capital rules continue to provide a reasonable 

alternative for regulatory risk-based capital measurement purposes. However, the 

agencies recognize that a bifurcated risk-based capital framework inevitably raises 

competitive considerations. The agencies have received comments on risk-based capital 

proposals issued in the past several years21 stating that for some portfolios, competitive 

 

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

77446 (Dec. 26, 2006). 
DRAFT November 2, 2007 

67

inequities would be worse under a bifurcated framework. These commenters expressed 

concern that banks operating under the general risk-based capital rules would be at a 

competitive disadvantage relative to banks applying the advanced approaches because the 

IRB approach would likely result in lower risk-based capital requirements for certain 

types of exposures. 

The agencies recognize the potential competitive inequities associated with a 

bifurcated risk-based capital framework. As part of their effort to develop a risk-based 

capital framework that minimizes competitive inequities and is not disruptive to the 

banking sector, the agencies issued the Basel IA proposal in December 2006. The Basel 

IA proposal included modifications to the general risk-based capital rules to improve risk 

sensitivity and to reduce potential competitive disparities between domestic banks subject 

to the advanced approaches and domestic banks not subject to the advanced approaches. 

Recognizing that some banks might prefer not to incur the additional regulatory burden 

of moving to modified capital rules, the Basel IA proposal retained the existing general 

risk-based capital rules and permitted banks to opt in to the modified rules. The agencies 

extended the comment period for the advanced approaches proposal to coincide with the 

comment period on the Basel IA proposal so that commenters would have an opportunity 

to analyze the effects of the two proposals concurrently.22

Seeking to minimize potential competitive inequities and regulatory burden, a 

number of commenters on both the advanced approaches proposal and the Basel IA 

proposal urged the agencies to adopt all of the approaches included in the New Accord -- 

including the foundation IRB and standardized approaches for credit risk and the 

standardized and basic indicator approaches for operational risk. In response to these 

 

22 See 71 FR 77518 (Dec. 26, 2006). 
DRAFT November 2, 2007 

68

comments, the agencies have decided to issue a new standardized proposal, which would 

replace the Basel IA proposal for banks that do not apply the advanced approaches. The 

standardized proposal would allow banks that are not core banks to implement a 

standardized approach for credit risk and an approach to operational risk consistent with 

the New Accord. Like the Basel IA proposal, the standardized proposal will retain the 

existing general risk-based capital rules for those banks that do not wish to move to the 

new rules. The agencies expect to issue the standardized proposal in the first quarter of 

2008. 

 A number of commenters expressed concern about competitive inequities among 

internationally active banks arising from differences in implementation and application of 

the New Accord by supervisory authorities in different countries. In particular, some 

commenters asserted that the proposed U.S. implementation would be different from 

other countries in a number of key areas, such as the definition of default, and that these 

differences would give rise to substantial implementation cost and burden. Other 

commenters continued to raise concern about the delayed implementation schedule in the 

United States. 

As discussed in more detail throughout this preamble, the agencies have made a 

number of changes from the proposal to conform the final rule more closely to the New 

Accord. These changes should help minimize regulatory burden and mitigate potential 

competitive inequities across national jurisdictions. In addition, the BCBS has 

established an Accord Implementation Group, comprised of supervisors from member 

countries, whose primary objectives are to work through implementation issues, maintain 

a constructive dialogue about implementation processes, and harmonize approaches as 
DRAFT November 2, 2007 

69

much as possible within the range of national discretion embedded in the New Accord. 

The BCBS also has established a Capital Interpretation Group to foster consistency in 

applying the New Accord on an ongoing basis. The agencies intend to participate fully in 

these groups to ensure that issues relating to international implementation and 

competitive effects are addressed. While supervisory judgment will play a critical role in 

the evaluation of risk measurement and management practices at individual banks, 

supervisors remain committed to and have made significant progress toward developing 

protocols and information-sharing arrangements that should minimize burdens on banks 

operating in multiple countries and ensure that supervisory authorities are implementing 

the New Accord as consistently as possible. 

With regard to implementation timing concerns, the agencies believe that the 

transitional arrangements described in preamble section III.A.2. below provide a prudent 

and reasonable framework for moving to the advanced approaches. Where international 

implementation differences affect an individual bank, the agencies are working with the 

bank and appropriate national supervisory authorities to ensure that implementation 

proceeds as efficiently as possible. 

II. Scope 

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

active banks that are required to adopt the advanced approaches (core banks); (ii) banks 

that voluntarily decide to adopt the advanced approaches (opt-in banks); and (iii) banks 

that do not adopt the advanced approaches (general banks). Each core and opt-in bank is 

required to meet certain qualification requirements to the satisfaction of its primary 
DRAFT November 2, 2007 

70

Federal supervisor, which in turn will consult with other relevant supervisors, before the 

bank may use the advanced approaches for risk-based capital purposes. 

Pillar 1 of the New Accord requires all banks subject to the New Accord to 

calculate capital requirements for exposure to credit risk and operational risk. The New 

Accord sets forth three approaches to calculating the credit risk capital requirement and 

three approaches to calculating the operational risk capital requirement. Outside the 

United States, countries that are replacing Basel I with the New Accord generally have 

required all banks to comply with the New Accord, but have provided banks the option of 

choosing among the New Accord’s various approaches for calculating credit risk and 

operational risk capital requirements. 

For banks in the United States, the agencies have taken a different approach. This 

final rule focuses on the largest and most internationally active banks and requires those 

banks to comply with the most advanced approaches for calculating credit and 

operational risk capital requirements (the IRB and the AMA). The final rule allows other 

U.S. banks to “opt in” to the advanced approaches. The agencies have decided at this 

time to require large, internationally active U.S. banks to use the most advanced 

approaches of the New Accord. The less advanced approaches of the New Accord lack 

the degree of risk sensitivity of the advanced approaches. The agencies have the view 

that risk-sensitive regulatory capital requirements are integral to ensuring that large, 

sophisticated banks and the financial system have an adequate capital cushion to absorb 

financial losses. Also, the advanced approaches provide more substantial incentives for 

banks to improve their risk measurement and management practices than do the other 

approaches. The agencies do not believe that competitive equity concerns are sufficiently 
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compelling to warrant permitting large, internationally active U.S. banks to adopt the 

standardized approaches in the New Accord. 

A. Core and Opt-In Banks 

 Under section 1(b) of the proposed rule, a DI would be a core bank if it met either 

of two independent threshold criteria: (i) consolidated total assets of $250 billion or 

more, as reported on the most recent year-end regulatory reports; or (ii) consolidated total 

on-balance sheet foreign exposure of $10 billion or more at the most recent year end. To 

determine total on-balance sheet foreign exposure, a bank would sum its adjusted crossborder 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 crossborder claims less claims with the head office or guarantor located in another country, 

plus redistributed guaranteed amounts to the country of head office or guarantor. The 

agencies also proposed that a DI would be a core bank if it is a subsidiary of another DI 

or BHC that uses the advanced approaches. 

 Under the proposed rule, a U.S.-chartered BHC23 would be a core bank if the 

BHC had: (i) consolidated total assets (excluding assets held by an insurance 

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

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

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

bank. 

 

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

and is not implementing the advanced approaches for these holding companies. 
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The agencies included a question in the proposal seeking commenters’ views on 

using consolidated total assets (excluding assets held by an insurance underwriting 

subsidiary) as one criterion to determine whether a BHC would be viewed as a core BHC. 

Some of the commenters addressing this issue supported the proposed approach, noting it 

was a reasonable proxy for mandatory applicability of a framework designed to measure 

capital requirements for consolidated risk exposures of a BHC. Other commenters, 

particularly foreign banking organizations and their trade associations, contended that the 

BHC asset size threshold criterion instead should be $250 billion of assets in U.S. 

subsidiary DIs. These commenters further suggested that if the Board kept the proposed 

$250 billion consolidated total BHC assets criterion, it should limit the scope of this 

criterion to BHCs with a majority of their assets in U.S. DI subsidiaries. The Board has 

decided to retain the proposed approach using consolidated total assets (excluding assets 

held by an insurance underwriting subsidiary) as one threshold criterion for BHCs in this 

final rule. This approach recognizes that BHCs can hold similar assets within and outside 

of DIs and reduces potential incentives to structure BHC assets and activities to arbitrage 

capital regulations. The final rule continues to exclude assets held in an insurance 

underwriting subsidiary of a BHC from the asset threshold because the advanced 

approaches were not designed to address insurance underwriting exposures. 

The final rule also retains the threshold criterion for core bank/BHC status of 

consolidated total on-balance sheet foreign exposure of $10 billion or more at the most 

recent year-end. The calculation of this exposure amount is unchanged in the final rule. 

In the preamble to the proposed rule, the agencies also included a question on 

potential regulatory burden associated with requiring a bank that applies the advanced 
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approaches to implement the advanced approaches at each subsidiary DI — even if those 

subsidiary DIs do not individually meet a threshold criterion. A number of commenters 

addressed this issue. While they expressed a range of views, most commenters 

maintained that small DI subsidiaries of core banks should not be required to implement 

the advanced approaches. Rather, commenters asserted that these DIs should be 

permitted to use simpler methodologies, such as the New Accord’s standardized 

approach. Commenters asserted there would be regulatory burden and costs associated 

with the proposed push-down approach, particularly if a stand-alone AMA is required at 

each DI. 

The agencies have considered comments on this issue and have decided to retain 

the proposed approach. Thus, under the final rule, each DI subsidiary of a core or opt-in 

bank is itself a core bank required to apply the advanced approaches. The agencies 

believe that this approach serves as an important safeguard against regulatory capital 

arbitrage among affiliated banks that would otherwise be subject to substantially different 

capital rules. Moreover, to calculate its consolidated IRB risk-based capital 

requirements, a bank must estimate risk parameters for all credit exposures within the 

bank except for exposures in portfolios that, in the aggregate, are immaterial to the bank. 

Because the consolidated bank must already estimate risk parameters for all material 

portfolios of wholesale and retail exposures in all of its consolidated subsidiaries, the 

agencies believe that there is limited additional regulatory burden associated with 

application of the IRB approach at each subsidiary DI. Likewise, to calculate its 

consolidated AMA risk-based capital requirements, a bank must estimate its operational 

risk exposure using a unit of measure (defined below) that does not combine business 
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activities or operational loss events with demonstrably different risk profiles within the 

same loss distribution. Each subsidiary DI could have a demonstrably different risk 

profile that would require the generation of separate loss distributions. 

However, the agencies recognize there may be situations where application of the 

advanced approaches at an individual DI subsidiary of an advanced approaches bank may 

not be appropriate. Therefore, the final rule includes the proposed provision that permits 

a core or opt-in bank’s primary Federal supervisor to determine in writing that 

application of the advanced approaches is not appropriate for the DI in light of the bank’s 

asset size, level of complexity, risk profile, or scope of operations. 

B. U.S. Subsidiaries of Foreign Banks 

 Under the proposed rule, any U.S.-chartered DI that is a subsidiary of a foreign 

banking organization would be subject to the U.S. regulatory capital requirements for 

domestically-owned U.S. DIs. Thus, if the U.S. DI subsidiary of a foreign banking 

organization met any of the threshold criteria, it would be a core bank and would be 

subject to the advanced approaches. If it did not meet any of the criteria, the U.S. DI 

could remain a general bank or could opt in to the advanced approaches, subject to the 

same qualification process and requirements as a domestically-owned U.S. DI. 

The proposed rule also provided that a top-tier U.S. BHC, and its subsidiary DIs, 

that was owned by a foreign banking organization would be subject to the same threshold 

levels for core bank determination as a top-tier BHC that is not owned by a foreign 

banking organization.24 The preamble noted that a U.S. BHC that met the conditions in 

 

24 The Board notes that it generally does not apply regulatory capital requirements to subsidiary BHCs of 

top-tier U.S. BHCs, regardless of whether the top-tier U.S. BHC is itself a subsidiary of a foreign banking 

organization. 
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Federal Reserve SR letter 01-0125 and that was a core bank would not be required to meet 

the minimum capital ratios in the Board’s capital adequacy guidelines, although it would 

be required to adopt the advanced approaches, compute and report its capital ratios in 

accordance with the advanced approaches, and make the required public and regulatory 

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

be required to adopt the advanced approaches and meet the minimum capital ratio 

requirements. 

Under the final rule, consistent with SR 01-01, a foreign-owned U.S. BHC that is 

a core bank and that also is subject to SR 01-01 will, as a technical matter, be required to 

adopt the advanced approaches, and compute and report its capital ratios and make other 

required disclosures. It will not, however, be required to maintain the minimum capital 

ratios at the U.S. consolidated holding company level unless otherwise required to do so 

by the Board. In response to the potential burden issues identified by commenters and 

outlined above, the Board notes that the final rule allows the Board to exempt any BHC 

from mandatory application of the advanced approaches. The Board will make such a 

determination in light of the BHC’s asset size (including subsidiary DI asset size relative 

to total BHC asset size), level of complexity, risk profile, or scope of operation. 

Similarly, the final rule allows a primary Federal supervisor to exempt any DI under its 

jurisdiction from mandatory application of the advanced approaches. A primary Federal 

supervisor will consider the same factors in making its determination. 

C. Reservation of Authority 

 

25 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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 The proposed rule restated the authority of a bank’s primary Federal supervisor to 

require a bank to hold an overall amount of capital greater than would otherwise be 

required under the rule if the agency determined that the bank’s risk-based capital 

requirements were not commensurate with the bank’s credit, market, operational, or other 

risks. In addition, the preamble of the proposed rule noted the agencies’ expectation that 

there may be instances when the rule would generate a risk-weighted asset amount for 

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

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

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

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

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

when calculating the risk-weighted asset amount for those exposures. Similarly, the 

proposed rule provided explicit authority for a bank’s primary Federal supervisor to 

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

change elements of its operational risk analytical framework (including distributional and 

dependence assumptions), or to make other changes to the bank’s operational risk 

management processes, data and assessment systems, or quantification systems if the 

supervisor found that the risk-weighted asset amount for operational risk produced by the 

bank under the rule was not commensurate with the operational risks of the bank. Any 

agency that exercised a reservation of authority was expected to notify each of the other 

agencies of its determination. 

Several commenters raised concerns with the scope of the reservation of 

authority, particularly as it would apply to operational risk. These commenters asserted, 
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for example, that the agencies should address identified operational risk-related capital 

deficiencies through Pillar 2, rather than through requiring a bank to adjust input 

variables or techniques used for the calculation of Pillar 1 operational risk capital 

requirements. Commenters were concerned that excessive agency Pillar 1 intervention 

on operational risk might inhibit innovation. 

While the agencies agree that innovation is important and that general supervisory 

oversight likely would be sufficient in many cases to address risk-related capital 

deficiencies, the agencies also believe that it is important to retain as much supervisory 

flexibility as possible as they move forward with implementation of the final rule. In 

general, the proposed reservation of authority represented a reaffirmation of the current 

authority of a bank’s primary Federal supervisor to require the bank to hold an overall 

amount of regulatory capital or maintain capital ratios greater than would be required 

under the general risk-based capital rules. There may be cases where requiring a bank to 

assign a different risk-weighted asset amount for operational risk may not sufficiently 

address problems associated with underlying quantification practices and may cause an 

ongoing misalignment between the operational risk of a bank and the risk-weighted asset 

amount for operational risk generated by the bank’s operational risk quantification 

system. In view of this and the inherent flexibility provided for operational risk 

measurement under the AMA, the agencies believe it is appropriate to articulate the 

specific measures a primary Federal supervisor may take if it determines that a bank’s 

risk-weighted asset amount for operational risk is not commensurate with the operational 

risks of the bank. Therefore, the final rule retains the reservation of authority as 

proposed. The agencies emphasize that any decision to exercise this authority would be 
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made judiciously and that a bank bears the primary responsibility for maintaining the 

integrity, reliability, and accuracy of its risk management and measurement systems. 

D. Principle of Conservatism 

Several commenters asked whether it would be permissible not to apply an aspect 

of the rule for cost or regulatory burden reasons, if the result would be a more 

conservative capital requirement. For example, for purposes of the RBA for 

securitization exposures, some commenters asked whether a bank could choose not to 

track the seniority of a securitization exposure and, instead, assume that the exposure is 

not a senior securitization exposure. Similarly, some commenters asked if risk-based 

capital requirements for certain exposures could be calculated ignoring the benefits of 

risk mitigants such as collateral or guarantees. 

The agencies believe that in some cases it may be reasonable to allow a bank to 

implement a simplified capital calculation if the result is more conservative than would 

result from a comprehensive application of the rule. Under a new section 1(d) of the final 

rule, a bank may choose not to apply a provision of the rule to one or more exposures 

provided that (i) the bank can demonstrate on an ongoing basis to the satisfaction of its 

primary Federal supervisor that not applying the provision would, in all circumstances, 

unambiguously generate a risk-based capital requirement for each exposure greater than 

that which would otherwise be required under this final rule, (ii) the bank appropriately 

manages the risk of those exposures, (iii) the bank provides written notification to its 

primary Federal supervisor prior to applying this principle to each exposure, and (iv) the 

exposures to which the bank applies this principle are not, in the aggregate, material to 

the bank. 
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The agencies emphasize that a conservative capital requirement for a group of 

exposures does not reduce the need for appropriate risk management of those exposures. 

Moreover, the principle of conservatism applies to the determination of capital 

requirements for specific exposures; it does not apply to the qualification or disclosure 

requirements in sections 22 and 71 of the final rule. Sections V.A.1., V.A.3., and V.E.2. 

of this preamble contain examples of the appropriate use of this principle of 

conservatism. 

III. Qualification 

A. The Qualification Process 

1. In general

Supervisory qualification to use the advanced approaches is an iterative and 

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

plan and continues as the bank operates under the advanced approaches. Under the final 

rule, as under the proposal, a bank must develop and adopt a written implementation 

plan, establish and maintain a comprehensive and sound planning and governance 

process to oversee the implementation efforts described in the plan, demonstrate to its 

primary Federal supervisor that it meets the qualification requirements in section 22 of 

the final rule, and complete a satisfactory “parallel run” (discussed below) before it may 

use the advanced approaches for risk-based capital purposes. A bank’s primary Federal 

supervisor is responsible, after consultation with other relevant supervisors, for 

evaluating the bank’s initial and ongoing compliance with the qualification requirements 

for the advanced approaches. 
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 Under the final rule, as under the proposed rule, a bank preparing to implement 

the advanced approaches must adopt a written implementation plan, approved by its 

board of directors, describing in detail how the bank complies, or intends to comply, with 

the qualification requirements. A core bank must adopt a plan no later than six months 

after it meets a threshold criterion in section 1(b)(1) of the final rule. If a bank meets a 

threshold criterion on the effective date of the final rule, the bank would have to adopt a 

plan within six months of the effective date. Banks that do not meet a threshold criterion, 

but are nearing any criterion by internal growth or merger, are expected to engage in 

ongoing dialogue with their primary Federal supervisor regarding implementation 

strategies to ensure their readiness to adopt the advanced approaches when a threshold 

criterion is reached. An opt-in bank may adopt an implementation plan at any time. 

Under the final rule, each core and opt-in bank must submit its implementation plan, 

together with a copy of the minutes of the board of directors’ approval of the plan, to its 

primary Federal supervisor at least 60 days before the bank proposes to begin its parallel 

run, unless the bank’s primary Federal supervisor waives this prior notice provision. The 

submission to the primary Federal supervisor should indicate the date that the bank 

proposes to begin its parallel run. 

In developing an implementation plan, a bank must assess its current state of 

readiness relative to the qualification requirements in this final rule. This assessment 

must include a gap analysis that identifies where additional work is needed and a 

remediation or action plan that clearly sets forth how the bank intends to fill the gaps it 

has identified. The implementation plan must comprehensively address the qualification 

requirements for the bank and each of its consolidated subsidiaries (U.S. and foreign-
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based) with respect to all portfolios and exposures of the bank and each of its 

consolidated subsidiaries. The implementation plan must justify and support any 

proposed temporary or permanent exclusion of a business line, portfolio, or exposure 

from the advanced approaches. The business lines, portfolios, and exposures that the 

bank proposes to exclude from the advanced approaches must be, in the aggregate, 

immaterial to the bank. The implementation plan must include objective, measurable 

milestones (including delivery dates and a date when the bank’s implementation of the 

advanced approaches will be fully operational). For core banks, the implementation plan 

must include an explicit first transitional floor period start date that is no later than 36 

months after the later of the effective date of the rule or the date the bank meets at least 

one of the threshold criteria.26 Further, the implementation plan must describe the 

resources that the bank has budgeted and that are available to implement the plan. 

The proposed rule allowed a bank to exclude a portfolio of exposures from the 

advanced approaches if the bank could demonstrate to the satisfaction of its primary 

Federal supervisor that the portfolio, when combined with all other portfolios of 

exposures that the bank sought to exclude from the advanced approaches, was not 

material to the bank. Some commenters asserted that a bank should be permitted to 

exclude from the advanced approaches any business line, portfolio, or exposure that is 

immaterial on a stand-alone basis (regardless of whether the excluded exposures in the 

aggregate are material to the bank). The agencies believe that it is not appropriate for a 

bank to permanently exclude a material portion of its exposures from the enhanced risk 

sensitivity and risk measurement and management requirements of the advanced 

approaches. Accordingly, the final rule retains the requirement that the business lines, 

 

26 The bank’s primary Federal supervisor may extend the bank’s first transitional floor period start date. 
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portfolios, and exposures that the bank proposes to exclude from the advanced 

approaches must be, in the aggregate, immaterial to the bank. 

During implementation of the advanced approaches, a bank should work closely 

with its primary Federal supervisor to ensure that its risk measurement and management 

systems are functional and reliable and are able to generate risk parameter estimates that 

can be used to calculate the risk-based capital ratios correctly under the advanced 

approaches. The implementation plan, including the gap analysis and action plan, will 

provide a basis for ongoing supervisory dialogue and review during the qualification 

process. The primary Federal supervisor will assess a bank’s progress relative to its 

implementation plan. To the extent that adjustments to target dates are needed, these 

adjustments should be made subject to the ongoing supervisory discussion between the 

bank and its primary Federal supervisor. 

2. Parallel run and transitional floor periods 

Under the proposed and final rules, once a bank has adopted its implementation 

plan, it must complete a satisfactory parallel run before it may use the advanced 

approaches to calculate its risk-based capital requirements. The proposed rule defined a 

satisfactory parallel run as a period of at least four consecutive calendar quarters during 

which a bank complied with all of the qualification requirements to the satisfaction of its 

primary Federal supervisor. 

Many commenters objected to the proposed requirement that the bank had to meet 

all of the qualification requirements before it could begin the parallel run period. The 

agencies recognize that certain qualification requirements, such as outcomes analysis, 

become more meaningful as a bank gains experience employing the advanced 
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approaches. The agencies therefore are modifying the definition of a satisfactory parallel 

run in the final rule. Under the final rule, a satisfactory parallel run is a period of at least 

four consecutive calendar quarters during which the bank complies with the qualification 

requirements to the satisfaction of its primary Federal supervisor. This revised definition, 

which does not contain the word “all,” recognizes that the qualification of banks for the 

advanced approaches during the parallel run period will be an iterative and ongoing 

process. The agencies intend to assess individual advanced approaches methodologies 

through numerous discussions, reviews, data collection and analysis, and examination 

activities. The agencies also emphasize the critical importance of ongoing validation of 

advanced approaches methodologies both before and after initial qualification decisions. 

A bank’s primary Federal supervisor will review a bank’s validation process and 

documentation for the advanced approaches on an ongoing basis through the supervisory 

process. The bank should include in its implementation plan the steps it will take to 

enhance compliance with the qualification requirements during the parallel run period. 

Commenters also requested the flexibility, permitted under the New Accord, to 

apply the advanced approaches to some portfolios and other approaches (such as the 

standardized approach in the New Accord) to other portfolios during the transitional floor 

periods. The agencies believe, however, that banks applying the advanced approaches 

should move expeditiously to extend the robust risk measurement and management 

practices required by the advanced approaches to all material exposures. To preserve 

these positive risk measurement and management incentives for banks and to prevent 

“cherry picking” of portfolios, the final rule retains the provision in the proposed rule that 

states that a bank may enter the first transitional floor period only if it fully complies with 
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the qualification requirements in section 22 of the rule. As described above, the final rule 

allows a simplified approach for portfolios that are, in the aggregate, immaterial to the 

bank. 

Another concern identified by commenters regarding the parallel run was the 

asymmetric treatment of mergers and acquisitions consummated before and after the date 

a bank qualified to use the advanced approaches. Under the proposed rule, a bank 

qualified to use the advanced approaches that merged with or acquired a company would 

have up to 24 months following the calendar quarter during which the merger or 

acquisition was consummated to integrate the merged or acquired company into the 

bank’s advanced approaches capital calculations. In contrast, the proposed rule could be 

read to provide that a bank that merged with or acquired a company before the bank 

qualified to use the advanced approaches had to fully implement the advanced 

approaches for the merged or acquired company before the bank could qualify to use the 

advanced approaches. The agencies agree that this asymmetric treatment is not 

appropriate. Accordingly, the final rule applies the merger and acquisition transition 

provisions both before and after a bank qualifies to use the advanced approaches. The 

merger and acquisition transition provisions are described in section III.D. of this 

preamble. 

During the parallel run period, a bank continues to be subject to the general riskbased capital rules but simultaneously calculates its risk-based capital ratios under the 

advanced approaches. During this period, a bank will report its risk-based capital ratios 

under the general risk-based capital rules and the advanced approaches to its primary 
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Federal supervisor through the supervisory process on a quarterly basis. The agencies 

will share this information with each other. 

As described above, a bank must provide its board-approved implementation plan 

to its primary Federal supervisor at least 60 days before the bank proposes to begin its 

parallel run period. A bank also must receive approval from its primary Federal 

supervisor before beginning its first transitional floor period. In evaluating whether to 

grant approval to a bank to begin using the advanced approaches for risk-based capital 

purposes, the bank’s primary Federal supervisor must determine that the bank fully 

complies with all the qualification requirements, the bank has conducted a satisfactory 

parallel run, and the bank has an adequate process to ensure ongoing compliance with the 

qualification requirements. 

To provide for a smooth transition to the advanced approaches, the proposed rule 

imposed temporary limits on the amount by which a bank’s risk-based capital 

requirements could decline over a period of at least three years (that is, at least four 

consecutive calendar quarters in each of the three transitional floor periods). Based on its 

assessment of the bank’s ongoing compliance with the qualification requirements, a 

bank’s primary Federal supervisor would determine when the bank is ready to move from 

one transitional floor period to the next period and, after the full transition has been 

completed, to exit the last transitional floor period and move to stand-alone use of the 

advanced approaches. Table A sets forth the proposed transitional floor periods for banks 

moving to the advanced approaches: 

Table A – Transitional Floors 

Transitional floor period Transitional floor percentage 

First floor period 95 percent 
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Second floor period 90 percent 

Third floor period 85 percent 

 During the proposed transitional floor periods, a bank would calculate its riskweighted assets under the general risk-based capital rules. Next, the bank would multiply 

this risk-weighted assets amount by the appropriate floor percentage in the table above. 

This product would be the bank’s “floor-adjusted” risk-weighted assets. Third, the bank 

would calculate its tier 1 and total risk-based capital ratios using the definitions of tier 1 

and tier 2 capital (and associated deductions and adjustments) in the general risk-based 

capital rules for the numerator values and floor-adjusted risk-weighted assets for the 

denominator values. These ratios would be referred to as the “floor-adjusted risk-based 

capital ratios.” 

The bank also would calculate its tier 1 and total risk-based capital ratios using 

the advanced approaches definitions and rules. These ratios would be referred to as the 

“advanced approaches risk-based capital ratios.” In addition, the bank would calculate a 

tier 1 leverage ratio using tier 1 capital as defined in the proposed rule for the numerator 

of the ratio. 

During a bank’s transitional floor periods, the bank would report all five 

regulatory capital ratios described above – two floor-adjusted risk-based capital ratios, 

two advanced approaches risk-based capital ratios, and one leverage ratio. To determine 

its applicable capital category for PCA purposes and for all other regulatory and 

supervisory purposes, a bank’s risk-based capital ratios during the transitional floor 

periods would be set equal to the lower of the respective floor-adjusted risk-based capital 

ratio and the advanced approaches risk-based capital ratio. 
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During the proposed transitional floor periods, a bank’s tier 1 capital and tier 2 

capital for all non-risk-based-capital supervisory and regulatory purposes (for example, 

lending limits and Regulation W quantitative limits) would be the bank’s tier 1 capital 

and tier 2 capital as calculated under the advanced approaches. 

Thus, for example, to be well capitalized under PCA, a bank would have to have a 

floor-adjusted tier 1 risk-based capital ratio and an advanced approaches tier 1 risk-based 

capital ratio of 6 percent or greater, a floor-adjusted total risk-based capital ratio and an 

advanced approaches total risk-based capital ratio of 10 percent or greater, and a tier 1 

leverage ratio of 5 percent or greater (with tier 1 capital calculated under the advanced 

approaches). Although the PCA rules do not apply to BHCs, a BHC would be required to 

report all five of these regulatory capital ratios and would have to meet applicable 

supervisory and regulatory requirements using the lower of the respective floor-adjusted 

risk-based capital ratio and the advanced approaches risk-based capital ratio.27 

Under the proposed rule, after a bank completed its transitional floor periods and 

its primary Federal supervisor determined the bank could begin using the advanced 

approaches with no further transitional floor, the bank would use its tier 1 and total riskbased capital ratios as calculated under the advanced approaches and its tier 1 leverage 

ratio calculated using the advanced approaches definition of tier 1 capital for PCA and all 

other supervisory and regulatory purposes. 

Although one commenter supported the proposed transitional provisions, many 

commenters objected to these transitional provisions. Commenters urged the agencies to 

conform the transitional provisions to those in the New Accord. Specifically, they 

 

27 The Board notes that, under the applicable leverage ratio rule, a BHC that is rated composite “1” or that 

has adopted the market risk rule has a minimum leverage ratio requirement of 3 percent. For other BHCs, 

the minimum leverage ratio requirement is 4 percent. 
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requested that the three transitional floor periods be reduced to two periods and that the 

transitional floor percentages be reduced from 95 percent, 90 percent, and 85 percent to 

90 percent and 80 percent. Commenters also requested that the transitional floor 

calculation methodology be conformed to the generally less restrictive methodology of 

the New Accord. Moreover, they expressed concern about the requirement that a bank 

obtain supervisory approval to move from one transitional floor period to the next, which 

could potentially extend each floor period beyond four calendar quarters. 

The agencies believe that the prudential transitional safeguards are necessary to 

address concerns identified in the analysis of the results of QIS-4.28 Specifically, the 

transitional safeguards will ensure that implementation of the advanced approaches will 

not result in a precipitous drop in risk-based capital requirements, and will provide a 

smooth transition process as banks refine their advanced systems. Banks’ computation of 

risk-based capital requirements under both the general risk-based capital rules and the 

advanced approaches during the parallel run and transitional floor periods will help the 

agencies assess the impact of the advanced approaches on overall capital requirements, 

including whether the change in capital requirements relative to the general risk-based 

capital rules is consistent with the agencies’ overall capital objectives. Therefore, the 

agencies are adopting in this final rule the proposed level, duration, and calculation 

methodology of the transitional floors, with the revised process for determining when 

banks may exit the third transitional floor period discussed in section I.E., above. 

 

28 Preliminary analysis of the QIS-4 submissions evidenced material reductions in the aggregate minimum 

required capital for the QIS-4 participant population and significant dispersion of results across institutions 

and portfolio types. See Interagency Press Release, Banking “Agencies To Perform Additional Analysis 

Before Issuing Notice of Proposed Rulemaking Related To Basel II,” April 29, 2005. 
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Under the final rule, as under the proposed rule, banks that meet the threshold 

criteria in section 1(b)(1) (core banks) as of the effective date of this final rule, and banks 

that opt in pursuant to section 1(b)(2) at the earliest possible date, must use the general 

risk-based capital rules both during the parallel run and as a basis for the transitional floor 

calculations. Should the agencies finalize a standardized risk-based capital rule, the 

agencies expect that a bank that opts in after the earliest possible date or becomes a core 

bank after the effective date of the final rule would use the risk-based capital regime (the 

general risk-based capital rules or the standardized risk-based capital rules) used by the 

bank immediately before the bank begins its parallel run both during the parallel run and 

as a basis for the transitional floor calculations. Under the final rule, 2008 is the first 

possible year for a bank to begin its parallel run and 2009 is the first possible year for a 

bank to begin its first of three transitional floor periods. 

B. Qualification Requirements

 Because the advanced approaches use banks’ estimates of certain key risk 

parameters to determine risk-based capital requirements, they introduce greater 

complexity to the regulatory capital framework and require banks to possess a high level 

of sophistication in risk measurement and risk management systems. As a result, the 

final rule requires each core or opt-in bank to meet the qualification requirements 

described in section 22 of the final rule to the satisfaction of its primary Federal 

supervisor for a period of at least four consecutive calendar quarters before using the 

advanced approaches to calculate its minimum risk-based capital requirements (subject to 

the transitional floor provisions for at least an additional three years). The qualification 

requirements are written broadly to accommodate the many ways a bank may design and 
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implement robust internal credit and operational risk measurement and management 

systems, and to permit industry practice to evolve. 

Many of the qualification requirements relate to a bank’s advanced IRB systems. 

A bank’s advanced IRB systems must incorporate five interdependent components in a 

framework for evaluating credit risk and measuring regulatory capital: 

(i) A risk rating and segmentation system that assigns ratings to individual 

wholesale obligors and exposures and assigns individual retail exposures to segments; 

(ii) A quantification process that translates the risk characteristics of wholesale 

obligors and exposures and segments of retail exposures into numerical risk parameters 

that are used as inputs to the IRB risk-based capital formulas; 

(iii) An ongoing process that validates the accuracy of the rating assignments, 

segmentations, and risk parameters; 

(iv) A data management and maintenance system that supports the advanced IRB 

systems; and 

(v) Oversight and control mechanisms that ensure the advanced IRB systems are 

functioning effectively and producing accurate results. 

1. Process and systems requirements

One of the objectives of the advanced approaches framework is to provide 

appropriate incentives for banks to develop and use better techniques for measuring and 

managing their risks and to ensure that capital is adequate to support those risks. Section 

3 of the final rule requires a bank to hold capital commensurate with the level and nature 

of all risks to which the bank is exposed. Section 22 of the final rule specifically requires 

a bank to have a rigorous process for assessing its overall capital adequacy in relation to 
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its risk profile and a comprehensive strategy for maintaining appropriate capital levels 

(known as the internal capital adequacy assessment process or ICAAP). Another 

objective of the advanced approaches framework is to ensure comprehensive supervisory 

review of capital adequacy. 

 On February 28, 2007, the agencies issued proposed guidance setting forth 

supervisory expectations for a bank’s ICAAP and addressing the process for a 

comprehensive supervisory assessment of capital adequacy.29 As set forth in that 

guidance, and consistent with existing supervisory practice, a bank’s primary Federal 

supervisor will evaluate how well the bank is assessing its capital needs relative to its 

risks. The supervisor will assess the bank’s overall capital adequacy and will take into 

account a bank’s ICAAP, its compliance with the minimum capital requirements set forth 

in this rule, and all other relevant information. The primary Federal supervisor will 

require a bank to increase its capital levels or ratios if the supervisor determines that 

current levels or ratios are deficient or some element of the bank’s business practices 

suggests the need for higher capital levels or ratios. In addition, the primary Federal 

supervisor may, under its enforcement authority, require a bank to modify or enhance risk 

management and internal control authority, or reduce risk exposures, or take any other 

action as deemed necessary to address identified supervisory concerns. 

 As outlined in the proposed guidance, the agencies expect banks to implement 

and continually update the fundamental elements of a sound ICAAP – identifying and 

measuring material risks, setting capital adequacy goals that relate to risk, and ensuring 

the integrity of internal capital adequacy assessments. A bank is expected to ensure 

adequate capital is held against all material risks. 

 

29 72 FR 9189. 
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 In developing its ICAAP, a bank should be particularly mindful of the limitations 

of regulatory risk-based capital requirements as a measure of its full risk profile – 

including risks not covered or not adequately quantified in the risk-based capital 

requirements – as well as specific assumptions embedded in risk-based regulatory capital 

requirements (such as diversification in credit portfolios). A bank should also be mindful 

of the capital adequacy effects of concentrations that may arise within each risk type or 

across risk types. In general, a bank’s ICAAP should reflect an appropriate level of 

conservatism to account for uncertainty in risk identification, risk mitigation or control, 

quantitative processes, and any use of modeling. In most cases, this conservatism will 

result in higher levels of capital or higher capital ratios being regarded as adequate. 

As noted above, each core and opt-in bank must apply the advanced approaches 

for risk-based capital purposes at the consolidated top-tier U.S. legal entity level (either 

the top-tier U.S. BHC or top-tier DI that is a core or opt-in bank) and at each DI that is a 

subsidiary of such a top-tier legal entity (unless a primary Federal supervisor provides an 

exemption under section 1(b)(3) of the final rule). Each bank that applies the advanced 

approaches must have an appropriate infrastructure with risk measurement and 

management processes that meet the final rule’s qualification requirements and that are 

appropriate given the bank’s size and level of complexity. Regardless of whether the 

systems and models that generate the risk parameters necessary for calculating a bank’s 

risk-based capital requirements are located at an affiliate of the bank, each legal entity 

that applies the advanced approaches must ensure that the risk parameters (PD, LGD, 

EAD, and, for wholesale exposures, M) and reference data used to determine its risk-
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based capital requirements are representative of its own credit and operational risk 

exposures. 

The final rule also requires that the systems and processes that an advanced 

approaches bank uses for risk-based capital purposes must be consistent with the bank's 

internal risk management processes and management information reporting systems. 

This means, for example, that data from the latter processes and systems can be used to 

verify the reasonableness of the inputs the bank uses for calculating risk-based capital 

ratios. 

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

To implement the IRB approach, a bank must have internal risk rating and 

segmentation systems that accurately and reliably differentiate between degrees of credit 

risk for wholesale and retail exposures. As described below, wholesale exposures include 

most credit exposures to companies, sovereigns, and other governmental entities, as well 

as some exposures to individuals. Retail exposures include most credit exposures to 

individuals and small credit exposures to businesses that are managed as part of a 

segment of exposures with homogeneous risk characteristics. Together, wholesale and 

retail exposures cover most credit exposures of banks. 

To differentiate among degrees of credit risk, a bank must be able to make 

meaningful and consistent distinctions among credit exposures along two dimensions—

default risk and loss severity in the event of a default. In addition, a bank must be able to 

assign wholesale obligors to rating grades that approximately reflect likelihood of default 

and must be able to assign wholesale exposures to loss severity rating grades (or LGD 

estimates) that approximately reflect the loss severity expected in the event of default 
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during economic downturn conditions. As discussed below, the final rule requires banks 

to treat wholesale exposures differently from retail exposures when differentiating among 

degrees of credit risk; specifically, risk parameters for retail exposures are assigned at the 

segment level. 

Wholesale exposures

Under the proposed rule, a bank would be required to have an internal risk rating 

system that indicates the likelihood of default of each individual obligor and would either 

use an internal risk rating system that indicates the economic loss rate upon default of 

each individual exposure or directly assign an LGD estimate to each individual exposure. 

A bank would assign an internal risk rating to each wholesale obligor that reflected the 

obligor’s likelihood of default. 

Several commenters objected to the proposed requirement to assign an internal 

risk rating to each wholesale obligor that reflected the obligor’s likelihood of default. 

Commenters asserted that this requirement was burdensome and unnecessary where a 

bank underwrote an exposure based solely on the financial strength of a guarantor and 

used the PD substitution approach (discussed below) to recognize the risk mitigating 

effects of an eligible guarantee on the exposure. In such cases, commenters maintained 

that banks should be allowed to assign a PD only to the guarantor and not the underlying 

obligor. 

While the agencies believe that maintaining internal risk ratings of both a 

protection provider and underlying obligor provides helpful information for risk 

management purposes and facilitates a greater understanding of so-called double default 

effects, the agencies appreciate the commenters’ concerns about burden in this context. 
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Accordingly, the final rule does not require a bank to assign an internal risk rating to an 

underlying obligor to whom the bank extends credit based solely on the financial strength 

of a guarantor, provided that all of the bank’s exposures to that obligor are fully covered 

by eligible guarantees and the bank applies the PD substitution approach to all of those 

exposures. A bank in this situation is only required to assign an internal risk rating to the 

guarantor. However, a bank must immediately assign an internal risk rating to the 

obligor if a guarantee can no longer be recognized under this final rule. 

In determining an obligor rating, a bank should consider key obligor attributes, 

including both quantitative and qualitative factors that could affect the obligor’s default 

risk. From a quantitative perspective, this could include an assessment of the obligor’s 

historic and projected financial performance, trends in key financial performance ratios, 

financial contingencies, industry risk, and the obligor’s position in the industry. On the 

qualitative side, this could include an assessment of the quality of the obligor’s financial 

reporting, non-financial contingencies (for example, labor problems and environmental 

issues), and the quality of the obligor’s management based on an evaluation of 

management’s ability to make realistic projections, management’s track record in 

meeting projections, and management’s ability to effectively adapt to changes in the 

economy and the competitive environment. 

Under the proposed rule, a bank would assign each legal entity wholesale obligor 

to a single rating grade. Accordingly, if a single wholesale exposure of the bank to an 

obligor triggered the proposed rule’s definition of default, all of the bank’s wholesale 

exposures to that obligor would be in default for risk-based capital purposes. In addition, 

under the proposed rule, a bank would not be allowed to consider the value of collateral 
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pledged to support a particular wholesale exposure (or any other exposure-specific 

characteristics) when assigning a rating to the obligor of the exposure. A bank would, 

however, consider all available financial information about the obligor – including, where 

applicable, the total operating income or cash flows from all of the obligor’s projects or 

businesses – when assigning an obligor rating. 

While a few commenters expressly supported the proposal’s requirement for 

banks to assign each legal entity wholesale obligor to a single rating grade, a substantial 

number of commenters expressed reservations about this requirement. These 

commenters observed that in certain circumstances an exposure’s transaction-specific 

characteristics affect its likelihood of default. Commenters asserted that the agencies 

should provide greater flexibility and allow banks to depart from the one-rating-perobligor requirement based on the economic substance of an exposure. In particular, 

commenters maintained that income-producing real estate lending should be exempt from 

the one-rating-per-obligor requirement. The commenters noted that the probability that 

an obligor will default on any one such facility depends primarily on the cash flows from 

the individual property securing the facility, not the overall condition of the obligor. 

Similarly, several commenters asserted that exposures involving transfer risk and nonrecourse exposures should be exempted from the one-rating-per-obligor requirement. 

In general, the agencies believe that a two-dimensional rating system that strictly 

separates borrower and exposure-level characteristics is a critical underpinning of the 

IRB approach. However, the agencies agree that exposures to the same borrower 

denominated in different currencies may have different default probabilities. For 
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example, a sovereign government may impose prohibitive exchange restrictions that 

make it impossible for a borrower to transfer payments in one particular currency. 

In addition, the agencies agree that certain income-producing real estate 

exposures for which the bank, in economic substance, does not have recourse to the 

borrower beyond the real estate serving as collateral for the exposure, have default 

probabilities distinct from that of the borrower. Such situations would arise, for example, 

where real estate collateral is located in a state where a bank, under applicable state law, 

effectively does not have recourse to the borrower if the bank pursues the real estate 

collateral in the event of default (for example, in a “one-action” state or a state with a 

similar law). In one-action states such as Arizona, California, Idaho, Montana, Nevada, 

and Utah, or in a state with a similar law, such as New York, the applicable foreclosure 

laws materially limit a bank’s ability to collect against both the collateral and the 

borrower. 

A third instance in which exposures to the same borrower may have significantly 

different default probabilities is when a borrower enters bankruptcy and the bank extends 

additional credit to the borrower under the auspices of the bankruptcy proceedings. This 

so-called debtor in possession (DIP) financing is unique from other exposure types 

because it typically has priority over existing debt, equity, and other claims on the 

borrower. The agencies believe that because of this unique priority status, if a bank has 

an exposure to a borrower that declares bankruptcy and defaults on that exposure, and the 

bank subsequently provides DIP financing to that obligor, it may not be appropriate to 

require the bank to treat the DIP financing exposure at inception as an exposure to a 

defaulted borrower. 
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To address these circumstances and clarify the application of the one-rating-perobligor requirement, the agencies added a definition of obligor in the final rule. The final 

rule defines an obligor as the legal entity or natural person contractually obligated on a 

wholesale exposure except that a bank may treat three types of exposures to the same 

legal entity or natural person as having separate obligors. First, exposures to the same 

legal entity or natural person denominated in different currencies. Second, (i) incomeproducing real estate exposures for which all or substantially all of the repayment of the 

exposure is reliant on cash flows of the real estate serving as collateral for the exposure; 

the bank, in economic substance, does not have recourse to the borrower beyond the real 

estate serving as collateral for the exposure; and no cross-default or cross-acceleration 

clauses are in place other than clauses obtained solely in an abundance of caution; and (ii) 

other credit exposures to the same legal entity or natural person. Third, (i) wholesale 

exposures authorized under section 364 of the U.S. Bankruptcy Code (11 U.S.C. 364) to 

a legal entity or natural person who is a debtor-in-possession for purposes of Chapter 11 

of the Bankruptcy Code; and (ii) other credit exposures to the same legal entity or natural 

person. All exposures to a single legal entity or natural person must be treated as 

exposures to a single obligor unless they qualify for one of these three exceptions in the 

final rule’s definition of obligor. 

A bank’s obligor rating system must have at least seven discrete (nonoverlapping) obligor grades for non-defaulted obligors and at least one obligor grade for 

defaulted obligors. The agencies believe that because the risk-based capital requirement 

of a wholesale exposure is directly linked to its obligor rating grade, a bank must have at 
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least seven non-overlapping obligor grades to differentiate sufficiently the 

creditworthiness of non-defaulted wholesale obligors. 

A bank must capture the estimated loss severity upon default for a wholesale 

exposure either by directly assigning an LGD estimate to the exposure or by grouping the 

exposure with other wholesale exposures into loss severity rating grades (reflecting the 

bank’s estimate of the LGD of the exposure). LGD is described in more detail below. 

Whether a bank chooses to assign LGD values directly or, alternatively, to assign 

exposures to rating grades and then quantify the LGD for the rating grades, the key 

requirement is that the bank must identify exposure characteristics that influence LGD. 

Each of the loss severity rating grades must be associated with an empirically supported 

LGD estimate. Banks employing loss severity grades must have a sufficiently granular 

loss severity grading system to avoid grouping together exposures with widely ranging 

LGDs. 

Retail exposures

To implement the advanced approach for retail exposures, a bank must have an 

internal system that segments its retail exposures to differentiate accurately and reliably 

among degrees of credit risk. The most significant difference between the treatment of 

wholesale and retail exposures is that the risk parameters for wholesale exposures are 

assigned at the individual exposure level, whereas risk parameters for retail exposures are 

assigned at the segment level. Banks typically manage retail exposures on a segment 

basis, where each segment contains exposures with similar risk characteristics. 

Therefore, a key characteristic of the final rule’s retail framework is that the risk 

parameters for retail exposures are assigned to segments of exposures rather than to 
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individual exposures. Under the retail framework, a bank groups its retail exposures into 

segments with homogeneous risk characteristics and estimates PD and LGD for each 

segment. 

Some commenters stated that for internal risk management purposes they assign 

risk parameters at the individual retail exposure level rather than at the segment level. 

These commenters requested confirmation that this practice would be permissible for 

risk-based capital purposes under the final rule. The agencies believe that a bank may 

use its advanced systems, including exposure-level risk parameter estimates, to group 

exposures into segments with homogeneous risk characteristics. Such exposure-level 

estimates must be aggregated in order to assign segment-level risk parameters to each 

segment of retail exposures. 

A bank must group its retail exposures into three separate subcategories: 

(i) residential mortgage exposures; (ii) QREs; and (iii) other retail exposures. The bank 

must classify the retail exposures in each subcategory into segments to produce a 

meaningful differentiation of risk. The final rule requires banks to segment separately 

(i) defaulted retail exposures from non-defaulted retail exposures and (ii) retail eligible 

margin loans for which the bank adjusts EAD rather than LGD to reflect the risk 

mitigating effects of financial collateral from other retail eligible margin loans. 

Otherwise, the agencies do not require that banks consider any particular risk drivers or 

employ any minimum number of segments in any of the three retail subcategories. 

In determining how to segment retail exposures within each subcategory for the 

purpose of assigning risk parameters, a bank should use a segmentation approach that is 

consistent with its approach for internal risk assessment purposes and that classifies 
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exposures according to predominant risk characteristics or drivers. Examples of risk 

drivers could include loan-to-value ratios, credit scores, loan terms and structure, 

origination channel, geographical location of the borrower, collateral type, and bank 

internal estimates of likelihood of default and loss severity given default. Regardless of 

the risk drivers used, a bank must be able to demonstrate to its primary Federal supervisor 

that its system assigns accurate and reliable PD and LGD estimates for each retail 

segment on a consistent basis. 

Definition of default

Wholesale default. In the ANPR, the agencies proposed to define default for a 

wholesale exposure as either or both of the following events: (i) the bank determines that 

the borrower is unlikely to pay its obligations to the bank in full, without recourse to 

actions by the bank such as the realization of collateral; or (ii) the borrower is more than 

90 days past due on principal or interest on any material obligation to the bank. The 

ANPR’s definition of default was generally consistent with the New Accord. 

A number of commenters on the ANPR encouraged the agencies to use a 

wholesale definition of default that varied from the New Accord but conformed more 

closely to that used by bank risk managers. Many of these commenters recommended 

that the agencies define default for wholesale exposures as the entry into non-accrual or 

charge-off status. In the proposed rule, the agencies amended the ANPR definition of 

default to respond to these concerns. Under the proposed definition of default, a bank’s 

wholesale obligor would be in default if, for any wholesale exposure of the bank to the 

obligor, the bank had (i) placed the exposure on non-accrual status consistent with the 

Consolidated Report of Condition and Income (Call Report) Instructions or the Thrift 
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Financial Report (TFR) and the TFR Instruction Manual; (ii) taken a full or partial 

charge-off or write-down on the exposure due to the distressed financial condition of the 

obligor; or (iii) incurred a credit-related loss of 5 percent or more of the exposure’s initial 

carrying value in connection with the sale of the exposure or the transfer of the exposure 

to the held-for-sale, available-for-sale, trading account, or other reporting category. 

The agencies received extensive comment on the proposed definition of default 

for wholesale exposures. Commenters observed that the proposed definition of default 

was different from and more prescriptive than the definition in the New Accord and 

employed in other major jurisdictions. They asserted that the proposed definition would 

impose unjustifiable systems burden and expense on banks operating across multiple 

jurisdictions. Commenters also asserted that many banks’ data collection systems are 

based on the New Accord’s definition of default, and therefore historical data relevant to 

the proposed definition of default are limited. Moreover, commenters expressed concern 

that risk parameters estimated using the proposed definition of default would differ 

materially from those estimated using the New Accord’s definition of default, resulting in 

different capital requirements for U.S. banks relative to their foreign peers. 

The 5 percent credit-related loss trigger in the proposed definition of default for 

wholesale obligors was the focus of significant commenter concern. Commenters 

asserted that the trigger inappropriately imported LGD and maturity-related 

considerations into the definition of default, could hamper the use of loan sales as a risk 

management practice, and could cause obligors that are performing on their obligations to 

be considered defaulted. These commenters also claimed that the 5 percent trigger would 
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add significant implementation burden by, for example, requiring banks to distinguish 

between credit-related and non-credit-related losses on sale. 

Many commenters requested that the agencies conform the U.S. wholesale 

definition of default to the New Accord. Other commenters requested that banks be 

allowed the option to apply either the U.S. or the New Accord definition of default. 

The agencies agree that the proposed definition of default for wholesale obligors 

could have unintended consequences for implementation burden and international 

consistency. Therefore, the final rule contains a definition of default for wholesale 

obligors that is similar to the definition proposed in the ANPR and consistent with the 

New Accord. Specifically, under the final rule, a bank’s wholesale obligor is in default 

if, for any wholesale exposure of the bank to the obligor: (i) the bank considers that the 

obligor is unlikely to pay its credit obligations to the bank in full, without recourse by the 

bank to actions such as realizing collateral (if held); or (ii) the obligor is past due more 

than 90 days on any material credit obligation to the bank. The final rule also clarifies, 

consistent with the New Accord, that an overdraft is past due once the obligor has 

breached an advised limit or has been advised of a limit smaller than the current 

outstanding balance. 

Consistent with the New Accord, the following elements may be indications of 

unlikeliness to pay under this definition: 

(i) The bank places the exposure on non-accrual status consistent with the Call 

Report Instructions or the TFR and the TFR Instruction Manual; 

(ii) The bank takes a full or partial charge-off or write-down on the exposure due 

to the distressed financial condition of the obligor; 
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(iii) The bank incurs a material credit-related loss in connection with the sale of 

the exposure or the transfer of the exposure to the held-for-sale, available-for-sale, 

trading account, or other reporting category; 

(iv) The bank consents to a distressed restructuring of the exposure that is likely 

to result in a diminished financial obligation caused by the material forgiveness or 

postponement of principal, interest or (where relevant) fees; 

(v) The bank has filed as a creditor of the obligor for purposes of the obligor’s 

bankruptcy under the U.S. Bankruptcy Code (or a similar proceeding in a foreign 

jurisdiction regarding the obligor’s credit obligation to the bank); or 

(vi)The obligor has sought or has been placed in bankruptcy or similar protection 

that would avoid or delay repayment of the exposure to the bank. 

If a bank carries a wholesale exposure at fair value for accounting purposes, the 

bank’s practices for determining unlikeliness to pay for purposes of the definition of 

default should be consistent with the bank’s practices for determining credit-related 

declines in the fair value of the exposure. 

Like the proposed definition of default for wholesale obligors, the final rule states 

that a wholesale exposure to an obligor remains in default until the bank has reasonable 

assurance of repayment and performance for all contractual principal and interest 

payments on all exposures of the bank to the obligor (other than exposures that have been 

fully written-down or charged-off). The agencies expect a bank to employ standards for 

determining whether it has a reasonable assurance of repayment and performance that are 

similar to those for determining whether to restore a loan from non-accrual to accrual 

status. 
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Retail default. In response to comments on the ANPR, the agencies proposed to 

define default for retail exposures according to the timeframes for loss classification that 

banks generally use for internal purposes. These timeframes are embodied in the 

FFIEC’s Uniform Retail Credit Classification and Account Management Policy.30 

Specifically, revolving retail exposures and residential mortgage exposures would be in 

default at 180 days past due; other retail exposures would be in default at 120 days past 

due. In addition, a retail exposure would be in default if the bank had taken a full or 

partial charge-off or write-down of principal on the exposure for credit-related reasons. 

Such an exposure would remain in default until the bank had reasonable assurance of 

repayment and performance for all contractual principal and interest payments on the 

exposure. 

Although some commenters supported the proposed rule’s retail definition of 

default, others urged the agencies to adopt a 90-days-past-due default trigger consistent 

with the New Accord’s definition of default for retail exposures. Other commenters 

requested that a non-accrual trigger be added to the retail definition of default similar to 

that in the proposed wholesale definition of default. The commenters viewed this as a 

practical way to allow a foreign banking organization to harmonize the U.S. retail 

definition of default to a home country definition of default that has a 90-days-past-due 

trigger. 

The agencies believe that adding a non-accrual trigger to the retail definition of 

default is not appropriate. Retail non-accrual practices vary considerably among banks, 

and adding a non-accrual trigger to the retail definition of default would result in greater 

 

30 FFIEC, “Uniform Retail Credit Classification and Account Management Policy,” 65 FR 36903, June 12, 

2000. 
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inconsistency among banks in the treatment of retail exposures. Moreover, a bank that 

considers retail exposures to be defaulted at 90 days past due could have significantly 

different risk parameter estimates than one that uses 120- and 180-days-past-due 

thresholds. Such a bank would likely have higher PD estimates and lower LGD estimates 

due to the established tendency of a nontrivial proportion of U.S. retail exposures to 

“cure” or return to performing status after becoming 90 days past due and before 

becoming 120 or 180 days past due. The agencies believe that the 120- and 180-dayspast-due thresholds, which are consistent with national discretion provided by the New 

Accord, reflect a point at which retail exposures in the United States are unlikely to return 

to performing status. Therefore, the agencies are incorporating the proposed retail 

definition of default without substantive change in the final rule. (Parallel to the full or 

partial charge-off or write-down trigger for retail exposures not held at fair value, the 

agencies added a material negative fair value adjustment of principal for credit-related 

reasons trigger for retail exposures held at fair value.) 

The New Accord provides discretion for national supervisors to set the retail 

default trigger at up to 180 days past due for different products, as appropriate to local 

conditions. Accordingly, banks implementing the IRB approach in multiple jurisdictions 

may be subject to different retail definitions of default in their home and host 

jurisdictions. The agencies recognize that it could be costly and burdensome for a U.S. 

bank to track default data and estimate risk parameters based on both the U.S. definition 

of default and the definitions of default in non-U.S. jurisdictions where subsidiaries of the 

U.S. bank implement the IRB approach. The agencies are therefore incorporating 

flexibility into the retail definition of default. Specifically, for a retail exposure held by a 
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U.S. bank’s non-U.S. subsidiary subject to an internal ratings-based approach to capital 

adequacy consistent with the New Accord in a non-U.S. jurisdiction, the final rule allows 

the bank to elect to use the definition of default of that jurisdiction, subject to prior 

approval by the bank’s primary Federal supervisor. The primary Federal supervisor will 

revoke approval for a bank to use this provision if the supervisor finds that the bank uses 

the provision to arbitrage differences in national definitions of default. 

 The definition of default for retail exposures differs from the definition for the 

wholesale portfolio in that the retail default definition applies on an exposure-byexposure basis rather than on an obligor-by-obligor basis. In other words, default on one 

retail exposure does not require a bank to treat all other retail obligations of the same 

borrower to the bank as defaulted. This difference reflects the fact that banks generally 

manage retail credit risk based on segments of similar exposures rather than through the 

assignment of ratings to particular borrowers. In addition, it is quite common for retail 

borrowers that default on some of their obligations to continue payment on others. 

 Although the retail definition of default does not explicitly include credit-related 

losses in connection with loan sales and the agencies have replaced the 5 percent creditrelated loss threshold for wholesale exposures with a less prescriptive treatment that is 

consistent with the New Accord, the agencies expect banks to ensure that exposure sales 

do not bias or otherwise distort the estimated risk parameters assigned by a bank to its 

wholesale exposures and retail segments. 

Rating philosophy

 A bank’s internal risk rating policy for wholesale exposures must describe the 

bank’s rating philosophy, which is how the bank’s wholesale obligor rating assignments 
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are affected by the bank’s choice of the range of economic, business, and industry 

conditions that are considered in the obligor rating process. The philosophical basis of a 

bank’s rating system is important because, when combined with the credit quality of 

individual obligors, it will determine the frequency of obligor rating changes in a 

changing economic environment. Rating systems that rate obligors based on their ability 

to perform over a wide range of economic, business, and industry conditions, sometimes 

described as “through-the-cycle” systems, tend to have ratings that migrate more slowly 

as conditions change. Banks that rate obligors based on a more narrow range of likely 

expected conditions (primarily on recent conditions), sometimes called “point-in-time” 

systems, tend to have ratings that migrate more frequently. Many banks will rate obligors 

using an approach that considers a combination of the current conditions and a wider 

range of other likely conditions. In any case, the bank must specify the rating philosophy 

used and establish a policy for the migration of obligors from one rating grade to another 

in response to economic cycles. A bank should understand the effects of ratings 

migration on its risk-based capital requirements and ensure that sufficient capital is 

maintained during all phases of the economic cycle. 

Rating and segmentation reviews and updates

Each wholesale obligor rating and (if applicable) wholesale exposure loss severity 

rating must reflect current information. A bank’s internal risk rating system for 

wholesale exposures must provide for the review and update (as appropriate) of each 

obligor rating and (if applicable) loss severity rating whenever the bank receives new 

material information, but no less frequently than annually. Under the proposed rule, a 

bank’s retail exposure segmentation system would provide for the review and update (as 
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appropriate) of assignments of retail exposures to segments whenever the bank received 

new material information. The proposed rule specified that the review would be required 

no less frequently than quarterly. 

One commenter noted that quarterly reviews may not be appropriate for highquality retail portfolios, such as retail exposures associated with a bank’s wealth 

management or private banking businesses. The commenter suggested that banks should 

have the flexibility to review and update segmentation assignments for such portfolios on 

a less frequent basis appropriate to the credit quality of the portfolios. 

The agencies agree that it may be appropriate for a bank to review and update 

segmentation assignments for certain high-quality retail exposures on a less frequent 

basis than quarterly, provided a bank is following sound risk management practices. 

Therefore, the final rule generally requires a quarterly review and update, as appropriate, 

of retail exposure segmentation assignments, allowing some flexibility to accommodate 

sound internal risk management practices. 

3. Quantification of risk parameters for wholesale and retail exposures

A bank must have a comprehensive risk parameter quantification process that 

produces accurate, timely, and reliable estimates of the risk parameters – PD, LGD, EAD, 

and (for wholesale exposures) M – for its wholesale obligors and exposures and retail 

exposures. Statistical methods and models used to develop risk parameter estimates, as 

well as any adjustments to the estimates or empirical data, should be transparent, well 

supported, and documented. The following sections of the preamble discuss the rule’s 

definitions of the risk parameters for wholesale exposures and retail segments. 

Probability of default (PD)
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As noted above, under the final rule, a bank must assign each of its wholesale 

obligors to an internal rating grade and then must associate a PD with each rating grade. 

PD for a wholesale exposure to a non-defaulted obligor is the bank’s empirically based 

best estimate of the long-run average one-year default rate for the rating grade assigned 

by the bank to the obligor, capturing the average default experience for obligors in the 

rating grade over a mix of economic conditions (including economic downturn 

conditions) sufficient to provide a reasonable estimate of the average one-year default 

rate over the economic cycle for the rating grade. 

In addition, under the final rule, a bank must assign a PD to each segment of retail 

exposures. Some types of retail exposures typically display a seasoning pattern – that is, 

the exposures have relatively low default rates in their first year, rising default rates in the 

next few years, and declining default rates for the remainder of their terms. Because of 

the one-year IRB horizon, the proposed rule provided two different definitions of PD for 

a segment of non-defaulted retail exposures based on the materiality of seasoning effects 

for the segment or for the segment’s retail exposure subcategory. Under the proposed 

rule, PD for a segment of non-defaulted retail exposures for which seasoning effects were 

not material, or for a segment of non-defaulted retail exposures in a retail exposure 

subcategory for which seasoning effects were not material, would be the bank’s 

empirically based best estimate of the long-run average of one-year default rates for the 

exposures in the segment, capturing the average default experience for exposures in the 

segment over a mix of economic conditions (including economic downturn conditions) 

sufficient to provide a reasonable estimate of the average one-year default rate over the 

economic cycle for the segment. PD for a segment of non-defaulted retail exposures for 
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which seasoning effects were material would be the bank’s empirically based best 

estimate of the annualized cumulative default rate over the expected remaining life of 

exposures in the segment, capturing the average default experience for exposures in the 

segment over a mix of economic conditions (including economic downturn conditions) to 

provide a reasonable estimate of the average performance over the economic cycle for the 

segment. 

Commenters objected to this treatment of retail exposures with material seasoning 

effects. They asserted that requiring banks to use an annualized cumulative default rate 

to recognize seasoning effects was too prescriptive and would preclude other reasonable 

approaches. The agencies believe that commenters have presented reasonable alternative 

approaches to recognizing the effects of seasoning in PD and are, therefore, providing 

additional flexibility for recognizing those effects in the final rule. 

Based on comments and additional consideration, the agencies also are clarifying 

that a segment of retail exposures has material seasoning effects if there is a material 

relationship between the time since origination of exposures within the segment and the 

bank’s best estimate of the long-run average one-year default rate for the exposures in the 

segment. Moreover, because the agencies believe that the IRB approach must, at a 

minimum, require banks to hold appropriate amounts of risk-based capital to address 

credit risks over a one-year horizon, the final rule’s incorporation of seasoning effects is 

explicitly one-directional. Specifically, a bank must increase PDs above the best estimate 

of the long-run average one-year default rate for segments of unseasoned retail 

exposures, but may not decrease PD below the best estimate of the long-run average one-
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year default rate for a segment of retail exposures that the bank estimates will have lower 

PDs in future years due to seasoning. 

The final rule defines PD for a segment of non-defaulted retail exposures as the 

bank’s empirically based best estimate of the long-run average one-year default rate for 

the exposures in the segment, capturing the average default experience for exposures in 

the segment over a mix of economic conditions (including economic downturn 

conditions) sufficient to provide a reasonable estimate of the average one-year default 

rate over the economic cycle for the segment and adjusted upward as appropriate for 

segments for which seasoning effects are material. If a bank does not adjust PD to reflect 

seasoning effects for a segment of exposures, it should be able to demonstrate to its 

primary Federal supervisor, using empirical analysis, why seasoning effects are not 

material or why adjustment is not relevant for the segment. 

For wholesale exposures to defaulted obligors and for segments of defaulted retail 

exposures, PD is 100 percent. 

Loss given default (LGD) 

Under the proposed rule, a bank would directly estimate an ELGD and LGD risk 

parameter for each wholesale exposure or would assign each wholesale exposure to an 

expected loss severity grade and a downturn loss severity grade, estimate an ELGD risk 

parameter for each expected loss severity grade, and estimate an LGD risk parameter for 

each downturn loss severity grade. In addition, a bank would estimate an ELGD and 

LGD risk parameter for each segment of retail exposures. 

Expected loss given default (ELGD)
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The proposed rule defined the ELGD of a wholesale exposure as the bank’s 

empirically based best estimate of the default-weighted average economic loss per dollar 

of EAD the bank expected to incur in the event that the obligor of the exposure (or a 

typical obligor in the loss severity grade assigned by the bank to the exposure) defaulted 

within a one-year horizon.31 The proposed rule defined ELGD for a segment of retail 

exposures as the bank’s empirically based best estimate of the default-weighted average 

economic loss per dollar of EAD the bank expected to incur on exposures in the segment 

that default within a one-year horizon. ELGD estimates would incorporate a mix of 

economic conditions (including economic downturn conditions). ELGD had four 

functions in the proposed rule—as a component of the calculation of ECL in the 

numerator of the risk-based capital ratios; in the EL component of the IRB risk-based 

capital formulas; as a floor on the value of the LGD risk parameter; and as an input into 

the supervisory mapping function. 

Many commenters objected to the proposed rule’s requirement for banks to 

estimate ELGD for each wholesale exposure and retail segment, noting that ELGD 

estimation is not required under the New Accord. Commenters asserted that requiring 

ELGD estimation would create a competitive disadvantage by creating additional 

systems, compliance, calculation, and reporting burden for those banks subject to the 

U.S. rule, many of which have already substantially developed their systems based on the 

New Accord. They also maintained that it would decrease the comparability of U.S. 

banks’ capital requirements and public disclosures relative to those of foreign banking 

organizations applying the advanced approaches. Several commenters also contended 

that defining ECL in terms of ELGD instead of LGD raised tier 1 risk-based capital 

 

31 Under the proposal, ELGD was not the statistical expected value of LGD. 
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requirements for U.S. banks compared to foreign banks using the New Accord’s LGDbased ECL definition. 

The agencies have concluded that the regulatory burden and potential competitive 

inequities identified by commenters outweigh the supervisory benefits of the proposed 

ELGD risk parameter, and are, therefore, not including it in the final rule. Instead, 

consistent with the New Accord, a bank must use LGD for the calculation of ECL and the 

EL component of the IRB risk-based capital formulas. Because the proposed ELGD risk 

parameter was equal to or less than LGD, this change generally will have the effect of 

decreasing both the numerator and denominator of the risk-based capital ratios. 

Consistent with the New Accord, under the final rule, the LGD of a wholesale 

exposure or retail segment must not be less than the bank’s empirically based best 

estimate of the long-run default-weighted average economic loss, per dollar of EAD, the 

bank would expect to incur if the obligor (or a typical obligor in the loss severity grade 

assigned by the bank to the exposure or segment) were to default within a one-year 

horizon over a mix of economic conditions, including economic downturn conditions. 

The final rule also specifies that LGD may not be less than zero. The implications of 

eliminating the ELGD risk parameter for the supervisory mapping function are discussed 

below. 

Economic loss and post-default extensions of credit

Commenters requested additional clarity regarding the treatment of post-default 

extensions of credit. LGD is an estimate of the economic loss that would be incurred on 

an exposure, relative to the exposure’s EAD, if the obligor were to default within a oneyear horizon during economic downturn conditions. The estimated economic loss 
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amount must capture all material credit-related losses on the exposure (including accrued 

but unpaid interest or fees, losses on the sale of repossessed collateral, direct workout 

costs, and an appropriate allocation of indirect workout costs). Where positive or 

negative cash flows on a wholesale exposure to a defaulted obligor or on a defaulted 

retail exposure (including proceeds from the sale of collateral, workout costs, and drawdowns of unused credit lines) are expected to occur after the date of default, the estimated 

economic loss amount must reflect the net present value of cash flows as of the default 

date using a discount rate appropriate to the risk of the exposure. The possibility of postdefault extensions of credit made to facilitate collection of an exposure would be treated 

as negative cash flows and reflected in LGD. 

For example, assume a loan to a retailer goes into default. The bank determines 

that the recovery would be enhanced by some additional expenditure to ensure an orderly 

workout process. One option would be for the bank to hire a third-party to facilitate the 

collection of the loan. Another option would be for the bank to extend additional credit 

directly to the defaulted obligor to allow the obligor to make an orderly liquidation of 

inventory. Both options represent negative cash flows on the original exposure, which 

must be discounted at a rate that is appropriate to the risk of the exposure. 

Economic downturn conditions

The expected loss severities of some exposures may be substantially higher 

during economic downturn conditions than during other periods, while for other types of 

exposures they may not. Accordingly, the proposed rule required banks to use an LGD 

estimate that reflected economic downturn conditions for purposes of calculating the riskbased capital requirements for wholesale exposures and retail segments. 
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Several commenters objected to the requirement that LGD estimates must reflect 

economic downturn conditions. Some of these commenters stated that empirical 

evidence of correlation between economic downturn and LGD is inconclusive, except in 

certain cases. A few noted that estimates of expected LGD include conservative inputs, 

such as a conservative estimate of potential loss in the event of default or a conservative 

discount rate or collateral assumptions. One commenter suggested that if a bank can 

demonstrate it has been prudent in its LGD estimation and it has no evidence of the 

cyclicality of LGDs, it should not be required to calculate downturn LGDs. Other 

commenters remarked that the requirement to incorporate downturn conditions into LGD 

estimates should not be used as a surrogate for proper modeling of PD/LGD correlations. 

Finally, a number of commenters supported a pillar 2 approach for addressing LGD 

estimation. 

Consistent with the New Accord, the final rule maintains the requirement for a 

bank to use an LGD estimate that reflects economic downturn conditions for purposes of 

calculating the risk-based capital requirements for wholesale exposures and retail 

segments. More specifically, banks must produce for each wholesale exposure (or loss 

severity rating grade) and retail segment an estimate of the economic loss per dollar of 

EAD that the bank would expect to incur if default were to occur within a one-year 

horizon during economic downturn conditions. 

For the purpose of defining economic downturn conditions, the proposed rule 

identified two wholesale exposure subcategories – high-volatility commercial real estate 

(HVCRE) wholesale exposures and non-HVCRE wholesale exposures (that is, all 

wholesale exposures that are not HVCRE exposures) – and three retail exposure 
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subcategories – residential mortgage exposures, QREs, and other retail exposures. The 

proposed rule defined economic downturn conditions with respect to an exposure as those 

conditions in which the aggregate default rates for the exposure’s entire wholesale or 

retail subcategory held by the bank (or subdivision of such subcategory selected by the 

bank) in the exposure’s national jurisdiction (or subdivision of such jurisdiction selected 

by the bank) were significantly higher than average. 

The agencies specifically sought comment on whether to require banks to 

determine economic downturn conditions at a more granular level than an entire 

wholesale or retail exposure subcategory in a national jurisdiction. Some commenters 

stated that the proposed requirement is at a sufficiently granular level. Others asserted 

that the requirement should be eliminated or made less granular. Those commenters 

favoring less granularity stated that aggregate default rates for different product 

subcategories in different countries are unlikely to peak at the same time and that 

requiring economic downturn analysis at the product subcategory and national 

jurisdiction level does not recognize potential diversification effects across products and 

national jurisdictions and is thus overly conservative. Commenters also maintained that 

the proposed granularity requirement adds complexity and implementation burden 

relative to the New Accord. 

The agencies believe that the proposed definition of economic downturn 

conditions incorporates an appropriate level of granularity and are incorporating it 

unchanged in the final rule. The agencies understand that downturns in particular 

geographical subdivisions of national jurisdictions or in particular industrial sectors may 

result in significantly increased loss rates in material subdivisions of a bank’s exposures. 
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The agencies also recognize that diversification across those subdivisions may mitigate 

risk for the overall organization. However, the agencies believe that the required 

minimum level of granularity at the subcategory and national jurisdiction level provides a 

suitable balance between allowing for the benefits of diversification and appropriate 

conservatism for risk-based capital requirements. 

Under the final rule, a bank must consider economic downturn conditions that 

appropriately reflect its actual exposure profile. For example, a bank with a geographical 

or industry sector concentration in a subcategory of exposures may find that information 

relating to a downturn in that geographical region or industry sector may be more 

relevant for the bank than a general downturn affecting many regions or industries. The 

final rule (like the proposed rule) allows banks to subdivide exposure subcategories or 

national jurisdictions as they deem appropriate given the exposures held by the bank. 

Moreover, the agencies note that the exposure subcategory/national jurisdiction 

granularity requirement is only a minimum granularity requirement. 

Supervisory mapping function

The proposed rule provided banks two methods of generating LGD estimates for 

wholesale exposures and retail segments. First, a bank could use its own estimates of 

LGD for a subcategory of exposures if the bank had prior written approval from its 

primary Federal supervisor to use internal estimates for that subcategory of exposures. In 

approving a bank’s use of internal estimates of LGD, a bank’s primary Federal supervisor 

would consider whether the bank’s internal estimates of LGD were reliable and 

sufficiently reflective of economic downturn conditions. The supervisor would also 

consider whether the bank has rigorous and well-documented policies and procedures for 
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identifying economic downturn conditions for the exposure subcategory, identifying 

material adverse correlations between the relevant drivers of default rates and loss rates 

given default, and incorporating identified correlations into internal LGD estimates. If a 

bank had supervisory approval to use its own estimates of LGD for an exposure 

subcategory, it would use its own estimates of LGD for all exposures within that 

subcategory. 

As an alternative to internal estimates of LGD, the proposed rule provided a 

supervisory mapping function for converting ELGD into LGD for risk-based capital 

purposes. A bank that did not qualify to use its own estimates of LGD for a subcategory 

of exposures would instead compute LGD using the linear supervisory mapping function: 

LGD = 0.08 + 0.92 x ELGD. A bank would not have to apply the supervisory mapping 

function to repo-style transactions, eligible margin loans, and OTC derivative contracts 

(defined below in section V.C. of this preamble). The agencies proposed the supervisory 

mapping function because of concerns that banks may find it difficult to produce internal 

estimates of LGD that are sufficient for risk-based capital purposes because LGD data for 

important portfolios may be sparse, and there is limited industry experience with 

incorporating downturn conditions into LGD estimates. The supervisory mapping 

function provided a pragmatic methodology for banks to use while refining their LGD 

estimation techniques. 

In general, commenters viewed the supervisory mapping function as a significant 

deviation from the New Accord that would add unwarranted prescriptiveness and 

regulatory burden to the U.S. rule. Commenters requested more flexibility to address 

problems with LGD estimation, including the ability to apply appropriate margins of 
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conservatism as contemplated in the New Accord. Commenters expressed concern that 

U.S. supervisors would employ an unreasonably high standard for allowing own 

estimates of LGD, forcing banks to use the supervisory mapping function for an extended 

period of time. Commenters also expressed concern that supervisors would view the 

output of the supervisory mapping function as a floor on internal estimates of LGD. 

Commenters asserted that in both cases risk-based capital requirements would be 

increased at U.S. banks relative to their foreign competitors, particularly for high-quality 

assets, putting U.S. banks at a competitive disadvantage to foreign banks. 

In particular, many commenters viewed the supervisory mapping function as 

overly punitive for exposure categories with relatively low loss severities, effectively 

imposing an 8 percent floor on LGD. Commenters also objected to the proposed 

requirement that a bank use the supervisory mapping function for an entire subcategory 

of exposures even if it had difficulty estimating LGD only for a small subset of those 

exposures. 

The agencies continue to believe that the supervisory mapping function is a 

reasonable aid for dealing with problems in LGD estimation. The agencies recognize, 

however, that there may be several valid methodologies for addressing such problems. 

For example, a relative scarcity of historical loss data for a particular obligor or exposure 

type may be addressed by increased reliance on alternative data sources and dataenhancing tools for quantification and alternative techniques for validation. In addition, a 

bank should reflect in its estimates of risk parameters a margin of conservatism that is 

related to the likely range of uncertainty. These concepts are discussed below in the 

quantification principles section of the preamble. 
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Therefore, the agencies are not including the supervisory mapping function in the 

final rule. However, the agencies continue to believe that the function (and associated 

estimation of the long-run default-weighted average economic loss rate given default 

within a one-year horizon) is one way a bank could address difficulties in estimating 

LGD. However it chooses to estimate LGD, a bank’s estimates of LGD must be reliable 

and sufficiently reflective of economic downturn conditions, and the bank should have 

rigorous and well-documented policies and procedures for identifying economic 

downturn conditions for each exposure subcategory, identifying changes in material 

adverse relationships between the relevant drivers of default rates and loss rates given 

default, and incorporating identified relationships into LGD estimates. 

Pre-default reductions in exposure

The proposed rule incorporated comments on the ANPR suggesting a need to 

better accommodate certain credit products, most prominently asset-based lending 

programs, whose structures typically result in a bank recovering substantial amounts of 

the exposure prior to the default date – for example, through paydowns of outstanding 

principal. The agencies believe that actions taken prior to default to mitigate losses are 

an important component of a bank’s overall credit risk management, and that such actions 

should be reflected in LGD when banks can quantify their effectiveness in a reliable 

manner. In the proposed rule, this was achieved by measuring LGD relative to the 

exposure’s EAD (defined in the next section) as opposed to the amount actually owed at 

default.32 

 

32 To illustrate, suppose that for a particular asset-based lending exposure the EAD equaled $100 and that 

for every $1 owed by the obligor at the time of default the bank’s recovery would be $0.40. Furthermore, 

suppose that in the event of default within a one-year horizon, pre-default paydowns of $20 would reduce 

the exposure amount to $80 at the time of default. In this case, the bank’s economic loss rate measured 
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Commenters agreed that the IRB approach should allow banks to recognize in 

their risk parameters the benefits of expected pre-default recoveries and other expected 

reductions in exposure prior to default. Some commenters suggested, however, that it is 

more appropriate to reflect pre-default recoveries in EAD rather than LGD. Other 

commenters supported the proposed rule’s approach or asserted that banks should have 

the option of incorporating pre-default recoveries in either LGD or EAD. Commenters 

discouraged the agencies from restricting the types of pre-default reductions in exposure 

that could be recognized, and generally contended that the reductions should be 

recognized for all exposures for which a pattern of pre-default reductions can be 

estimated reliably and accurately by the bank. 

Consistent with the New Accord, the agencies have decided to maintain the 

proposed treatment of pre-default reductions in exposure in the final rule. The final rule 

does not limit the exposure types to which a bank may apply this treatment. However, 

the agencies have clarified their requirement for quantification of LGD in section 

22(c)(4) of the final rule. This section states that where the bank’s quantification of LGD 

directly or indirectly incorporates estimates of the effectiveness of its credit risk 

management practices in reducing its exposure to troubled obligors prior to default, the 

bank must support such estimates with empirical analysis showing that the estimates are 

consistent with its historical experience in dealing with such exposures during economic 

downturn conditions. 

 relative to the amount owed at default (60 percent) would exceed the economic loss rate measured relative 

to EAD (48 percent = .60 x ($100 -$20)/$100), because the former does not reflect fully the impact of the 

pre-default paydowns. 
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 A bank’s methods for reflecting changes in exposure during the period prior to 

default must be consistent with other aspects of the final rule. For example, a bank must 

use a default horizon no longer than one year, consistent with the one-year default 

horizon incorporated in other aspects of the final rule, such as the quantification of PD. 

In addition, a pre-default reduction in the outstanding amount on one exposure that does 

not reflect a reduction in the bank's total exposure to the obligor, such as a refinancing, 

should not be reflected as a pre-default recovery for LGD quantification purposes. 

The following simplified example illustrates how a bank could approach 

incorporating pre-default reductions in exposure in LGD. Assume a bank has a portfolio 

of asset-based loans fully collateralized by receivables. The bank maintains a database of 

such loans that have defaulted, which records the exposure at the time of default and the 

losses incurred at and after the date of default. After careful analysis of its historical data, 

the bank finds that for every $100 of exposure on a typical asset-based loan at the time of 

default, properly discounted average losses are $80 under economic downturn conditions. 

Thus, the bank may assign an LGD estimate of 80 percent that is based on such evidence. 

However, assume that the bank division responsible for collections reports that 

the bank’s loan workout practices generally result in exposures on the asset-based loans 

being significantly reduced between the time the loan is identified internally as a problem 

exposure and the time when the obligor is in default for risk-based capital purposes. The 

bank studies the pre-default paydown behavior of obligors that default within the next 

one-year horizon and during economic downturn conditions. In particular, the bank uses 

its internal historical data to map exposure amounts for asset-based loans at the time of 

default to exposure amounts for the same loans at various points in time prior to default 
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and confirms that the pattern of pre-default paydowns corresponds to reductions in the 

bank’s overall exposures to the obligors, as opposed to refinancings. 

Robust empirical analysis further indicates that pre-default paydowns for assetbased loans to obligors that default within the next one-year horizon during economic 

downturn conditions depend on the length of time the loan has been subject to workout. 

Specifically, the bank finds that the prospects for further pre-default paydowns diminish 

markedly the longer the bank has managed the loan as a problem credit exposure. For 

loans that are not in workout or that the bank has placed in workout for fewer than 90 

days, the bank’s analysis indicates that pre-default paydowns on loans to obligors 

defaulting within the next year during economic downturn conditions were, on average, 

50 percent of the current amount owed by the obligor. In contrast, for asset-based loans 

that have been in workout for at least 90 days, the bank’s analysis indicates that any 

further pre-default recoveries tend to be immaterial. Thus, provided this analysis is 

suitable for estimating LGDs according to section 22(c) of the final rule, the bank may 

appropriately assign an LGD estimate of 40 percent to asset-based loans that are not in 

workout or that have been in workout for fewer than 90 days. For asset-based loans that 

have been in workout for at least 90 days, the bank should assign an LGD of 80 percent. 

Exposure at default (EAD)

Under the proposed rule, EAD for the on-balance sheet component of a wholesale 

or retail exposure generally was (i) the bank’s carrying value for the exposure (including 

net accrued but unpaid interest and fees)33 less any allocated transfer risk reserve for the 

exposure, if the exposure was classified as held-to-maturity or for trading; or (ii) the 

 

33 “Net accrued but unpaid interest and fees” are accrued but unpaid interest and fees net of any amount 

expensed by the bank as uncollectable. 
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bank’s carrying value for the exposure (including net accrued but unpaid interest and 

fees) less any allocated transfer risk reserve for the exposure and any unrealized gains on 

the exposure plus any unrealized losses on the exposure, if the exposure was classified as 

available-for-sale. 

One commenter asserted that banks should not be required to include net accrued 

but unpaid interest and fees in EAD. Rather, this commenter requested the flexibility to 

incorporate such interest and fees in either EAD or LGD. The agencies believe that net 

accrued but unpaid interest and fees represent credit exposure to an obligor, similar to the 

unpaid principal of a loan extended to the obligor, and thus are most appropriately 

included in EAD. Moreover, requiring all banks to include such interest and fees in EAD 

rather than LGD promotes consistency and comparability across banks for regulatory 

reporting and public disclosure purposes. 

The agencies are therefore maintaining the substance of the proposed rule’s 

definition of EAD for on-balance sheet exposures in the final rule. The final rule clarifies 

that, for purposes of EAD, all exposures other than securities classified as available-for 

sale receive the treatment specified for exposures classified as held-to-maturity or for 

trading under the proposal. Some exposures held at fair value, such as partially funded 

loan commitments, may have both on-balance sheet and off-balance sheet components. 

In such cases, a bank must compute EAD for both the positive on- and off-balance sheet 

components of the exposure. 

For the off-balance sheet component of a wholesale or retail exposure (other than 

an OTC derivative contract, repo-style transaction, or eligible margin loan) in the form of 

a loan commitment or line of credit, EAD under the proposed rule was the bank’s best 
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estimate of net additions to the outstanding amount owed the bank, including estimated 

future additional draws of principal and accrued but unpaid interest and fees, that were 

likely to occur over the remaining life of the exposure assuming the exposure were to go 

into default. This estimate of net additions would reflect what would be expected during 

a period of economic downturn conditions. This treatment is retained in the final rule. 

Also, consistent with the New Accord, the final rule extends this “own estimates” 

treatment to trade-related letters of credit and for transaction-related contingencies. 

Trade-related letters of credit are short-term self-liquidating instruments used to finance 

the movement of goods and are collateralized by the underlying goods. A transactionrelated contingency includes such items as a performance bond or performance-based 

standby letter of credit. 

For the off-balance sheet component of a wholesale or retail exposure other than 

an OTC derivative contract, repo-style transaction, eligible margin loan, loan 

commitment, or line of credit issued by a bank, EAD was the notional amount of the 

exposure. This treatment is retained in the final rule. 

One commenter asked the agencies to permit banks to employ the New Accord’s 

flexibility to reflect additional draws on lines of credit in either LGD or EAD. For the 

same reasons that the agencies are requiring banks to include net accrued but unpaid 

interest and fees in EAD, the agencies have decided to continue the requirement in the 

final rule for banks to reflect estimates of additional draws in EAD, consistent with the 

proposed rule. 

Another commenter noted that the “remaining life of the exposure” concept in the 

proposed definition of EAD for off-balance sheet exposures is ambiguous and 
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inconsistent with defining PD over a one-year horizon. To address this commenter’s 

concern, the agencies have modified the definition of EAD. The final rule requires a 

bank to estimate net additions to the outstanding amount owed the bank in the event of 

default over a one-year horizon. 

Other commenters noted that banks may reduce their exposure to certain sectors 

in periods of economic downturn, and inquired as to the extent to which such practices 

may be reflected in EAD estimates. The agencies believe that such practices may be 

reflected in EAD estimates for loan commitments, lines of credit, trade-related letters of 

credit, and transaction-related contingencies to the extent that those practices are reflected 

in the bank’s data on defaulted exposures. They may be reflected in EAD estimates for 

on-balance sheet exposures only at the time the on-balance sheet exposure is actually 

reduced. 

To illustrate the EAD concept, assume a bank has a $100 unsecured, fully drawn, 

two-year term loan with $10 of interest payable at the end of the first year and a balloon 

payment of $110 at the end of the term. Suppose it has been six months since the loan’s 

origination, and accrued interest equals $5. The EAD of this loan would be equal to the 

outstanding principal amount plus accrued interest, or $105. 

Next, consider the case of an open-end revolving credit line of $100, on which the 

borrower had drawn $70 (the unused portion of the line is $30). Current accrued but 

unpaid interest and fees are zero. The bank can document that, on average, during 

economic downturn conditions, 20 percent of the remaining undrawn amounts are drawn 

in the year preceding a firm’s default. Therefore, the bank’s estimate of future draws is 

$6 (20% x $30). Additionally, the bank’s analysis indicates that, on average, during 
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economic downturn conditions, such a facility can be expected to have accrued at the 

time of default unpaid interest and commitment fees equal to three months of interest 

against the drawn amount and 0.5 percent against the undrawn amount, which in this 

example is assumed to equal $0.25. Thus, the EAD for estimated future accrued but 

unpaid interest and fees equals $0.25. In sum, the EAD should be the drawn amount plus 

estimated future accrued but unpaid fees plus the estimated amount of future draws = 

$76.25 ($70 + $0.25 + $6). 

Under the proposed rule, EAD for a segment of retail exposures was the sum of 

the EADs for each individual exposure in the segment. The agencies have changed this 

provision in the final rule, recognizing that banks typically estimate EAD for a segment 

of retail exposures rather than on an individual exposure basis. 

Under the final and proposed rules, for wholesale or retail exposures in which 

only the drawn balance has been securitized, the bank must reflect its share of the 

exposures’ undrawn balances in EAD. The undrawn balances of revolving exposures for 

which the drawn balances have been securitized must be allocated between the seller’s 

and investors’ interests on a pro rata basis, based on the proportions of the seller’s and 

investors’ shares of the securitized drawn balances. For example, if the EAD of a group 

of securitized exposures’ undrawn balances is $100, and the bank’s share (seller’s 

interest) in the securitized exposures is 25 percent, the bank must reflect $25 in EAD for 

the undrawn balances. 

The final rule (like the proposed rule) contains a separate treatment of EAD for 

OTC derivative contracts, which is in section 32 of the rule and discussed in more detail 

in section V.C. of the preamble. The final rule also clarifies that a bank may use the 
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treatment of EAD in section 32 of the rule for repo-style transactions and eligible margin 

loans, or the bank may use the general definition of EAD described in this section for 

such exposures. 

General quantification principles

The final rule, like the proposed rule, requires data used by a bank to estimate risk 

parameters to be relevant to the bank’s actual wholesale and retail exposures and of 

sufficient quality to support the determination of risk-based capital requirements for the 

exposures. For wholesale exposures, estimation of the risk parameters must be based on 

a minimum of five years of default data to estimate PD, seven years of loss severity data 

to estimate LGD, and seven years of exposure amount data to estimate EAD. For 

segments of retail exposures, estimation of risk parameters must be based on a minimum 

of five years of default data to estimate PD, five years of loss severity data to estimate 

LGD, and five years of exposure amount data to estimate EAD. Default, loss severity, 

and exposure amount data must include periods of economic downturn conditions or the 

bank must adjust its estimates of risk parameters to compensate for the lack of data from 

such periods. Banks must base their estimates of PD, LGD, and EAD on the final rule’s 

definition of default, and must review at least annually and update (as appropriate) their 

risk parameters and risk parameter quantification process. 

In all cases, banks are expected to use the best available data for quantifying the 

risk parameters. A bank could meet the minimum data requirement by using internal 

data, external data, or pooled data combining internal data with external data. Internal 

data refers to any data on exposures held in a bank’s existing or historical portfolios, 

including data elements or information provided by third parties regarding such 
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exposures. External data refers to information on exposures held outside of the bank’s 

portfolio or aggregate information across an industry. For new lines of business, where a 

bank lacks sufficient internal data, a bank likely will need to use external data to 

supplement its internal data. 

The agencies recognize that the minimum sample period for reference data 

provided in the final rule may not provide the best available results. A longer sample 

period usually captures varying economic conditions better than a shorter sample period. 

In addition, a longer sample period will include more default observations for LGD and 

EAD estimation. Banks should consider using a longer-than-minimum sample period 

when possible. However, the potential increase in precision afforded by a larger sample 

size should be weighed against the potential for diminished comparability of older data to 

the existing portfolio. 

Portfolios with limited data or limited defaults

Many commenters requested further clarity about the procedures that banks 

should use to estimate risk parameters for portfolios characterized by a lack of internal 

data or with very little default experience. In particular, the GAO report recommended 

that the agencies provide additional clarity on this issue. Several commenters indicated 

that the agencies should establish criteria for identifying homogeneous portfolios of lowrisk exposures and allow banks to apportion expected loss between LGD and PD for 

those portfolios rather than estimating each risk parameter separately. Other commenters 

suggested that the agencies consider whether banks should be permitted to use the New 

Accord’s standardized approach for credit risk for such portfolios. 
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The final rule requires banks to meet the qualification requirements in section 22 

for all portfolios of exposures. The agencies expect that banks demonstrating 

appropriately rigorous processes and sufficient degrees of conservatism for portfolios 

with limited data or limited defaults will be able to meet the qualification requirements. 

Section 22(c)(3) of the final rule specifically states that a bank’s risk parameter 

quantification process “must produce appropriately conservative risk parameter estimates 

where the bank has limited relevant data.” The agencies believe that this section provides 

sufficient flexibility and incentives for banks to develop and document sound practices 

for applying the IRB approach to portfolios lacking sufficient data. 

The section of the preamble below expands upon potential approaches to 

portfolios with limited data. The BCBS publication “Validation of low-default portfolios 

in the Basel II Framework”34 also provides a resource for banks facing this issue. The 

agencies will work with banks through the supervisory and examination processes to 

address particular situations. 

Portfolios with limited data. The final rule, like the proposal, permits the use of 

external data in quantification of risk parameters. External data should be informative of, 

and appropriate to, a bank’s existing exposures. In some cases, a bank may be able to 

acquire and use external data from a third party to estimate risk parameters until the 

bank’s internal database meets the requirements of the rule. Alternatively, a bank may be 

able to identify a set of data-rich internal exposures that could be used to inform the 

estimation of risk parameters for the portfolio for which it has insufficient data. The key 

considerations for a bank in determining whether to use alternative data sources will be 

 

34 BCBS, Basel Committee Newsletter No. 6, “Validation of low-default portfolios in the Basel II 

Framework,” September 2005. 
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whether such data are sufficiently accurate, complete, representative and informative of 

the bank’s existing exposures and whether the bank’s quantification of risk parameters is 

rigorously conducted and well documented. 

For instance, consider a bank that has recently extended its credit card operations 

to include a new market segment for credit card loans and, therefore, has limited internal 

data on the performance of the exposures in this new market segment. The bank could 

acquire external data from various vendors that would provide a broad, market-wide 

picture of default and loss experience in the new market segment. This external data 

could then be supplemented by the bank’s internal data and experience with its existing 

credit card operations. By comparing the bank’s experience with its existing customers 

to the market data, the bank can refine the risk parameters estimated from the external 

data on the new market segment and make those parameters more accurate for the bank’s 

new market segment of exposures. Using the combination of these data sources, the bank 

may be able to estimate appropriately conservative estimates of risk parameters for its 

new market segment of exposures. If the bank is not able to do so, it must include the 

new market segment of exposures in its set of aggregate immaterial exposures and apply 

a 100 percent risk weight. 

Portfolios with limited defaults. Commenters indicated that they had experienced 

very few defaults for some portfolios, most notably margin loans and exposures to some 

sovereign issuers, which made it difficult to separately estimate PD and LGD. The 

agencies recognize that some portfolios have experienced very few defaults and have 

very low loss experiences. The absence of defaults or losses in historical data does not, 

however, preclude the potential for defaults or large losses to arise in future 
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circumstances. Moreover, as discussed previously, the ability to separate EL into PD and 

LGD is a key component of the IRB approach. 

As with the cases described above in which internal data are limited in all 

dimensions, external data from some related portfolios or for similar obligors may be 

used to estimate risk parameters that are then mapped to the low default portfolio or 

obligor. For example, banks could consider instances of near default or credit 

deterioration short of default in these low default portfolios to inform estimates of what 

might happen if a default were to occur. Similarly, scenario analysis that evaluates the 

hypothetical impact of severe market disruptions may help inform the bank’s parameter 

estimates for margin loans. For very low-risk wholesale obligors that have publicly 

traded financial instruments, banks may be able to glean information about the relative 

values of PD and LGD from different changes in credit spreads on instruments of 

different maturity or from different moves in credit spreads and equity prices. In all 

cases, risk parameter estimates should incorporate a degree of conservatism that is 

appropriate for the overall rigor of the quantification process. 

Other quantification process considerations. Both internal and external reference 

data should not differ systematically from a bank’s existing portfolio in ways that seem 

likely to be related to default risk, loss severity, or exposure at default. Otherwise, the 

derived PD, LGD, or EAD estimates may not be applicable to the bank’s existing 

portfolio. Accordingly, the bank must conduct a comprehensive review and analysis of 

reference data at least annually to determine the relevance of reference data to the bank’s 

exposures, the quality of reference data to support PD, LGD, and EAD estimates, and the 

consistency of reference data to the definition of default in the final rule. Furthermore, a 
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bank must have adequate internal or external data to estimate the risk parameters PD, 

LGD, and EAD (each of which incorporates a one-year time horizon) for all wholesale 

exposure and retail segments, including those originated for sale or that are in the 

securitization pipeline. 

As noted above, periods of economic downturn conditions must be included in the 

data sample (or adjustments to risk parameters must be made). If the reference data 

include data from beyond the minimum number of years (to capture a period of economic 

downturn conditions or for other valid reasons), the reference data need not cover all of 

the intervening years. However, a bank should justify the exclusion of available data 

and, in particular, any temporal discontinuities in data used. Including periods of 

economic downturn conditions increases the size and potentially the breadth of the 

reference data set. According to some empirical studies, the average loss rate is higher 

during periods of economic downturn conditions, such that exclusion of such periods 

would bias LGD or EAD estimates downward and unjustifiably lower risk-based capital 

requirements. 

Risk parameter estimates should take into account the robustness of the 

quantification process. The assumptions and adjustments embedded in the quantification 

process should reflect the degree of uncertainty or potential error inherent in the process. 

In practice, a reasonable estimation approach likely would result in a range of defensible 

risk parameter estimates. The choices of the particular assumptions and adjustments that 

determine the final estimate, within the defensible range, should reflect the uncertainty in 

the quantification process. More uncertainty in the process should be reflected in the 

assignment of final risk parameter estimates that result in higher risk-based capital 
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requirements relative to a quantification process with less uncertainty. The degree of 

conservatism applied to adjust for uncertainty should be related to factors such as the 

relevance of the reference data to a bank’s existing exposures, the robustness of the 

models, the precision of the statistical estimates, and the amount of judgment used 

throughout the process. A bank is not required to add a margin of conservatism at each 

step if doing so would produce an excessively conservative result. Instead, the overall 

margin of conservatism should adequately account for all uncertainties and weaknesses in 

the quantification process. Improvements in the quantification process (including use of 

more complete data and better estimation techniques) may reduce the appropriate degree 

of conservatism over time. 

Judgment will inevitably play a role in the quantification process and may 

materially affect the estimates of risk parameters. Judgmental adjustments to estimates 

are often necessary because of limitations on available reference data or because of 

inherent differences between the reference data and the bank’s existing exposures. The 

bank’s risk parameter quantification process must produce appropriately conservative 

risk parameter estimates when the bank has limited relevant data, and any adjustments 

that are part of the quantification process must not result in a pattern of bias toward lower 

risk parameter estimates. This does not prohibit individual adjustments that result in 

lower estimates of risk parameters, as both upward and downward adjustments are 

expected. Individual adjustments are less important than broad patterns; consistent signs 

of judgmental decisions that materially lower risk parameter estimates may be evidence 

of systematic bias, which is not permitted. 
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In estimating relevant risk parameters, banks should not rely on the possibility of 

U.S. government financial assistance, except for the financial assistance that the U.S. 

government has a legally binding commitment to provide. 

4. Optional approaches that require prior supervisory approval 

A bank that intends to apply the internal models methodology to counterparty 

credit risk, the double default treatment for credit risk mitigation, the IAA for 

securitization exposures to ABCP programs, or the IMA to equity exposures must receive 

prior written approval from its primary Federal supervisor. The criteria on which 

approval will be based are described in the respective sections below. 

5. Operational risk

A bank must have operational risk management processes, data and assessment 

systems, and quantification systems that meet the qualification requirements in 

section 22(h) of the final rule. A bank must have an operational risk management 

function that is independent of business line management. The operational risk 

management function is responsible for the design, implementation, and oversight of the 

bank’s operational risk data and assessment systems, operational risk quantification 

systems, and related processes. The roles and responsibilities of the operational risk 

management function may vary between banks, but should be clearly documented. The 

operational risk management function should have an organizational stature 

commensurate with the bank’s operational risk profile. At a minimum, the bank’s 

operational risk management function should ensure the development of policies and 

procedures for the explicit management of operational risk as a distinct risk to the bank’s 

safety and soundness. 
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A bank also must establish and document a process to identify, measure, monitor, 

and control operational risk in bank products, activities, processes, and systems. This 

process should provide for the consistent and comprehensive collection of the data 

needed to estimate the bank’s exposure to operational risk. This process must capture 

business environment and internal control factors affecting the bank’s operational risk 

profile. The process must also ensure reporting of operational risk exposures, operational 

loss events, and other relevant operational risk information to business unit management, 

senior management, and to the board of directors (or a designated committee of the 

board). 

The final rule defines an operational loss event as an event that results in loss and 

is associated with any of the seven operational loss event type categories. Under the final 

rule, the agencies have included definitions of the seven operational loss event type 

categories, consistent with the descriptions outlined in the New Accord. The seven 

operational loss event type categories are: (i) internal fraud, which is the operational loss 

event type category that comprises operational losses resulting from an act involving at 

least one internal party of a type intended to defraud, misappropriate property or 

circumvent regulations, the law or company policy, excluding diversity and 

discrimination-type events; (ii) external fraud, which is the operational loss event type 

category that comprises operational losses resulting from an act by a third party of a type 

intended to defraud, misappropriate property or circumvent the law; 35 (iii) employment 

practices and workplace safety, which is the operational loss event type category that 

comprises operational losses resulting from an act inconsistent with employment, health, 

 

35 Retail credit card losses arising from non-contractual, third-party initiated fraud (for example, identity 

theft) are external fraud operational losses. All other third-party initiated credit losses are to be treated as 

credit risk losses. 
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or safety laws or agreements, payment of personal injury claims, or payment arising from 

diversity or discrimination events; (iv) clients, products, and business practices, which is 

the operational loss event type category that comprises operational losses resulting from 

the nature or design of a product or from an unintentional or negligent failure to meet a 

professional obligation to specific clients (including fiduciary and suitability 

requirements); (v) damage to physical assets, which is the operational loss event type 

category that comprises operational losses resulting from the loss of or damage to 

physical assets from natural disaster or other events; (vi) business disruption and system 

failures, which is the operational loss event type category that comprises operational 

losses resulting from disruption of business or system failures; and (vii) execution, 

delivery, and process management, which is the operational loss event type category that 

comprises operational losses resulting from failed transaction processing or process 

management or losses arising from relations with trade counterparties and vendors. 

The final rule does not require a bank to capture internal operational loss event 

data according to these categories. However, unlike the proposed rule, the final rule 

requires that a bank must be able to map such data into the seven operational loss event 

type categories. The agencies believe such mapping will promote reporting consistency 

and comparability across banks and is consistent with expectations in the New Accord.36 

A bank’s operational risk management processes should reflect the scope and 

complexity of its business lines, as well as its corporate organizational structure. Each 

bank’s operational risk profile is unique and should have a tailored risk management 

approach appropriate for the scale and materiality of the operational risks present in the 

bank. 

 

36 New Accord, ¶673. 
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Operational risk data and assessment system

A bank must have an operational risk data and assessment system that 

incorporates on an ongoing basis the following four elements: internal operational loss 

event data, external operational loss event data, results of scenario analysis, and 

assessments of the bank’s business environment and internal controls. These four 

operational risk elements should aid the bank in identifying the level and trend of 

operational risk, determining the effectiveness of operational risk management and 

control efforts, highlighting opportunities to better mitigate operational risk, and 

assessing operational risk on a forward-looking basis. A bank’s operational risk data and 

assessment system must be structured in a manner consistent with the bank’s current 

business activities, risk profile, technological processes, and risk management processes. 

 The proposed rule defined operational loss as a loss (excluding insurance or tax 

effects) resulting from an operational loss event. Operational losses included all 

expenses associated with an operational loss event except for opportunity costs, forgone 

revenue, and costs related to risk management and control enhancements implemented to 

prevent future operational losses. The definition of operational loss is an important issue, 

as it is a critical building block in a bank’s calculation of its operational risk capital 

requirement under the AMA. More specifically, the bank’s estimate of operational risk 

exposure – the basis for determining a bank’s risk-weighted asset amount for operational 

risk – is an estimate of aggregate operational losses generated by the bank’s AMA 

process. 

Many commenters supported the agencies’ proposed definition of operational loss 

and viewed it as appropriate and consistent with general use within the banking industry. 
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Some commenters, however, opposed the inclusion of a specific definition of operational 

loss and asserted that the proposed treatment of operational loss is too prescriptive. In 

addition, some commenters maintained that including a definition of operational loss is 

inconsistent with the New Accord, which does not explicitly define operational loss. In 

response to a specific question in the proposal, many commenters asserted that the 

definition of operational loss should relate to its impact on regulatory capital rather than 

economic capital concepts. One commenter, however, recommended using the 

replacement cost of any fixed asset affected by an operational loss event to reflect the 

actual financial impact of the event. 

Because operational losses are the building blocks in a bank’s calculation of its 

operational risk capital requirement under the AMA, the agencies continue to believe that 

it is necessary to define what is meant by operational loss to achieve comparability and 

foster consistency both across banks and across business lines within a bank. 

Additionally, the agencies agree with those commenters who asserted that the definition 

of operational loss should relate to its impact on regulatory capital. Therefore, the 

agencies have adopted the proposed definition of operational loss unchanged. 

In the preamble to the proposed rule, the agencies recognized that there was a 

potential to double-count all or a portion of the risk-based capital requirement associated 

with fixed assets. Under the proposed rule, the credit-risk-weighted asset amount for a 

bank’s premises would equal the carrying value of the premises on the financial 

statements of the bank, determined in accordance with GAAP. A bank’s operational risk 

exposure estimate addressing bank premises generally would be different than, and in 

addition to, the risk-based capital requirement generated under the proposed rule and 
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could, at least in part, address the same risk exposure. The majority of commenters on 

this issue recommended removing the credit risk capital requirement for premises and 

other fixed assets and preserving only the operational risk capital requirement. 

The agencies are maintaining the proposed rule’s treatment of fixed assets in the 

final rule. The New Accord generally provides a risk weight of 100 percent for assets for 

which an IRB treatment is not specified.37 Consistent with the New Accord, the final 

rule provides that the risk-weighted asset amount for any on-balance sheet asset that does 

not meet the definition of a wholesale, retail, securitization, or equity exposure is equal to 

the carrying value of the asset. Also consistent with the New Accord, the final rule 

continues to include damage to physical assets among the operational loss event types 

incorporated into a bank’s operational risk exposure estimate.38 The agencies believe 

that requiring a bank to calculate both a credit risk and operational risk capital 

requirement for premises and fixed assets is justified in light of the fact that the credit risk 

capital requirement covers a broader set of risks, whereas the operational risk capital 

requirement covers potential physical damage to the asset. The agencies view this 

treatment of premises and other fixed assets as consistent with the New Accord and have 

confirmed that the approach is consistent with the approaches used by other jurisdictions 

implementing the New Accord. 

A bank must have a systematic process for capturing and using internal 

operational loss event data in its operational risk data and assessment systems. The final 

rule defines a bank’s internal operational loss event data as its gross operational loss 

amounts, dates, recoveries, and relevant causal information for operational loss events 

 

37 New Accord, ¶214. 

38 New Accord, Annex 9. 
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occurring at the bank. Under the proposed rule, a bank’s operational risk data and 

assessment system would include a minimum historical observation period of five years 

of internal operational losses. With approval of its primary Federal supervisor, however, 

a bank could use a shorter historical observation period to address transitional situations 

such as integrating a new business line. A bank also could refrain from collecting 

internal operational loss event data for individual operational losses below established 

dollar threshold amounts if the bank could demonstrate to the satisfaction of its primary 

Federal supervisor that the thresholds were reasonable, did not exclude important internal 

operational loss event data, and permitted the bank to capture substantially all the dollar 

value of the bank’s operational losses. 

Several commenters expressed concern over the proposal’s five-year minimum 

historical observation period requirement for internal operational loss event data. These 

commenters recommended that the agencies align this provision with the New Accord, 

which allows for a three-year historical observation period upon initial AMA 

implementation. 

 While the proposed rule required a bank to include in its operational risk data and 

assessment systems a historical observation period of at least five years for internal 

operational loss event data, it also provided for a shorter observation period subject to 

agency approval to address transitional situations, such as integrating a new business line. 

The agencies believe that these proposed provisions provide sufficient flexibility to 

consider other situations, on a case-by-case basis, in which a shorter observation period 

may be appropriate, such as a bank’s initial implementation of an AMA. Therefore, the 
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final rule retains the five-year historical observation period requirements and the 

transitional flexibility for internal operational loss event data, as proposed. 

 In relation to the provision that permits a bank to refrain from collecting internal 

operational loss event data below established thresholds, a few commenters sought 

clarification of the proposed requirement that the thresholds must permit the bank to 

capture “substantially all” of the dollar value of a bank’s operational losses. In particular, 

they questioned whether a bank must collect all or a very high percentage of operational 

losses or whether smaller losses could be modeled. 

 To demonstrate the appropriateness of its threshold for internal operational loss 

event data collection, a bank might choose to collect all internal operational loss event 

data, at least for a time, to support a meaningful analysis around the appropriateness of its 

chosen data collection threshold. Alternatively, a bank might be able to obtain data from 

systems outside of its operational risk data and assessment system (for example, the 

bank’s general ledger system) to demonstrate the impact of choosing different thresholds 

on its operational risk exposure estimates. 

 With respect to the commenters’ question regarding modeling smaller losses, the 

agencies would consider permitting such an approach based on whether the approach 

meets the overall qualification requirements outlined in the final rule. In particular, the 

agencies would consider whether the bank satisfies those requirements pertaining to a 

bank’s operational risk quantification system as well as its control, oversight, and 

validation mechanisms. Such modeling considerations, however, would not eliminate the 

requirement for a bank to demonstrate the appropriateness of any established internal 

operational loss event data collection thresholds. 
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A bank also must establish a systematic process to determine its methodologies 

for incorporating external operational loss event data into its operational risk data and 

assessment systems. The proposed and final rules define external operational loss event 

data for a bank as gross operational loss amounts, dates, recoveries, and relevant causal 

information for operational loss events occurring at organizations other than the bank. 

External operational loss event data may serve a number of different purposes in a bank’s 

operational risk data and assessment systems. For example, external operational loss 

event data may be a particularly useful input in determining a bank’s level of exposure to 

operational risk when internal operational loss event data are limited. In addition, 

external operational loss event data provide a means for the bank to understand industry 

experience and, in turn, provide a means for the bank to assess the adequacy of its 

internal operational loss event data. 

While internal and external operational loss event data provide a historical 

perspective on operational risk, it is also important that a bank incorporate forwardlooking elements into its operational risk data and assessment systems. Accordingly, 

under the final rule, as under the proposed rule, a bank must incorporate business 

environment and internal control factors into its operational risk data and assessment 

systems to assess fully its exposure to operational risk. In principle, a bank with strong 

internal controls in a stable business environment would have less exposure to 

operational risk than a bank with internal control weaknesses that is growing rapidly or 

introducing new products. In this regard, a bank should identify and assess the level and 

trends in operational risk and related control structures at the bank. These assessments 

should be current and comprehensive across the bank, and they should identify the 
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operational risks facing the bank. The framework established by a bank to maintain these 

risk assessments should be sufficiently flexible to accommodate increasing complexity, 

new activities, changes in internal control systems, and an increasing volume of 

information. A bank must also periodically compare the results of its prior business 

environment and internal control factor assessments against the bank’s actual operational 

losses incurred in the intervening period. 

A few commenters sought clarification on the agencies’ expectations regarding a 

bank’s periodic comparisons of its prior business environment and internal control factor 

assessments against its actual operational losses. One commenter expressed concern over 

the difficulty of conducting an empirically robust analysis to fulfill the requirement. 

Under the final rule, a bank has flexibility in the approach it uses to conduct its 

business environment and internal control factor assessments. As such, the methods for 

conducting comparisons of these assessments against actual operational loss experience 

may also vary and precise modeling calibration may not be practical. The agencies 

maintain, however, that it is important for a bank to perform such comparisons to ensure 

that its assessments are current, reasonable, and appropriately factored into the bank’s 

AMA framework. In addition, the comparisons could highlight the need for potential 

adjustments to the bank’s operational risk management processes. 

A bank also must have a systematic process for determining its methodologies for 

incorporating scenario analysis into its operational risk data and assessment systems. As 

an input to a bank’s operational risk data and assessment systems, scenario analysis is 

especially relevant for business lines or operational loss event types where internal data, 
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external data, and assessments of the business environment and internal control factors do 

not provide a sufficiently robust estimate of the bank’s exposure to operational risk. 

Similar to business environment and internal control factor assessments, the 

results of scenario analysis provide a means for a bank to incorporate a forward-looking 

element into its operational risk data and assessment systems. Under the proposed rule, 

scenario analysis was defined as a systematic process of obtaining expert opinions from 

business managers and risk management experts to derive reasoned assessments of the 

likelihood and loss impact of plausible high-severity operational losses. The agencies 

have clarified this definition in the final rule to recognize that there are various methods 

and inputs a bank may use to conduct its scenario analysis. For this reason, the modified 

definition indicates that scenario analysis may include the well-reasoned evaluation and 

use of external operational loss event data, adjusted as appropriate to ensure relevance to 

a bank’s operational risk profile and control structure. 

A bank’s operational risk data and assessment systems must include credible, 

transparent, systematic, and verifiable processes that incorporate all four operational risk 

elements (that is, internal operational loss event data, external operational loss event data, 

scenario analysis, and business environment and internal control factors). The bank 

should have clear standards for the collection and modification of all elements. The bank 

should combine these four elements in a manner that most effectively enables it to 

quantify its exposure to operational risk. 

Operational risk quantification system

A bank must have an operational risk quantification system that generates 

estimates of its operational risk exposure using its operational risk data and assessment 
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systems. The final rule defines operational risk exposure as the 99.9th percentile of the 

distribution of potential aggregate operational losses, as generated by the bank’s 

operational risk quantification system over a one-year horizon (and not incorporating 

eligible operational risk offsets or qualifying operational risk mitigants). The mean of 

such a total loss distribution is the bank’s EOL. The final rule defines EOL as the 

expected value of the distribution of potential aggregate operational losses, as generated 

by the bank’s operational risk quantification system using a one-year horizon. The 

bank’s UOL is the difference between the bank’s operational risk exposure and the 

bank’s EOL. 

A few commenters sought clarification on whether the agencies would impose 

specific requirements around the use and weighting of the four elements of a bank’s 

operational risk data and assessment system, and whether there were any limitations on 

how external data or scenario analysis could be used as modeling inputs. Another 

commenter expressed concern that for some U.S.-chartered DIs that were subsidiaries of 

foreign banking organizations, it might be difficult to ever have enough internal 

operational loss event data to generate statistically significant operational risk exposure 

estimates. 

The agencies recognize that banks will have different inputs and methodologies 

for estimating their operational risk exposure given the inherent flexibility of the AMA. 

It follows that the weights assigned in combining the four required elements of a bank’s 

operational risk data and assessment system (internal operational loss event data, external 

operational loss event data, scenario analysis, and assessments of the bank’s business 

environment and internal control factors) will also vary across banks. Factors affecting 
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the weighting include a bank’s operational risk profile, operational loss experience, 

internal control environment, and relative quality and content of the four elements. These 

factors will influence the emphasis placed on certain elements relative to others. As such, 

the agencies are not prescribing specific requirements around the weighting of each 

element, nor are they placing any specific limitations on the use of the elements. In view 

of this flexibility, however, under the final rule a bank’s operational risk quantification 

systems must include a credible, transparent, systematic, and verifiable approach for 

weighting the use of the four elements. 

As part of its operational risk exposure estimate, a bank must use a unit of 

measure that is appropriate for the bank’s range of business activities and the variety of 

operational loss events to which it is exposed. The proposed rule defined a unit of 

measure as the level (for example, organizational unit or operational loss event type) at 

which the bank’s operational risk quantification system generated a separate distribution 

of potential operational losses. Under the proposed rule, a bank could not combine 

business activities or operational loss events with different risk profiles within the same 

loss distribution. 

Many commenters expressed concern that the prohibition against combining 

business activities or operational loss events with different risk profiles within the same 

loss distribution was an impractical standard because some level of combination was 

unavoidable. Additionally, commenters noted that data limitations made it difficult to 

quantify risk profiles at a granular level. Commenters also expressed concern that the 

proposed rule appeared to preclude the use of “top-down” approaches, given that under a 

firm-wide approach business activities or operational loss events with different risk 
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profiles would necessarily be combined within the same loss distribution. One 

commenter suggested that, because of data limitations and the potential for wide 

variations in risk profiles within individual business lines and/or types of operational loss 

events, banks be afforded some latitude in moving from a “top-down” approach to a 

“bottom-up” approach. 

The agencies have retained the proposed definition of unit of measure in the final 

rule. The agencies recognize, however, that there is a need for flexibility in assessing 

whether a bank’s chosen unit of measure is appropriate for the bank’s range of business 

activities and the variety of operational loss events to which it is exposed. In some 

instances, data limitations may indeed prevent a bank’s operational risk quantification 

systems from generating a separate distribution of potential operational losses for certain 

business lines or operational loss event types. Therefore, the agencies have modified the 

final rule to provide a bank more flexibility in devising an appropriate unit of measure. 

Specifically, a bank must employ a unit of measure that is appropriate for its range of 

business activities and the variety of operational loss events to which it is exposed, and 

that does not combine business activities or operational loss events with demonstrably

different risk profiles within the same loss distribution. 

The agencies recognize that operational losses across operational loss event types 

and business lines may be related. Under the final rule, as under the proposed rule, a 

bank may use its internal estimates of dependence among operational losses within and 

across business lines and operational loss event types if the bank can demonstrate to the 

satisfaction of its primary Federal supervisor that its process for estimating dependence is 

sound, robust to a variety of scenarios, implemented with integrity, and allows for the 
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uncertainty surrounding the estimates. The agencies expect that a bank’s assumptions 

regarding dependence will be conservative given the uncertainties surrounding 

dependence modeling for operational risk. If a bank does not satisfy the requirements 

surrounding dependence, the bank must sum operational risk exposure estimates across 

units of measure to calculate its total operational risk exposure. 

Under the proposed rule, dependence was defined as “a measure of the 

association among operational losses across and within business lines and operational 

loss event types.” One commenter recommended that the agencies revise the definition 

of dependence to “a measure of the association among operational losses across and 

within units of measure.” The agencies recognize that examples of units of measure 

include, but are not limited to, business lines and operational loss event types, and that a 

bank’s operational risk quantification system could generate distributions of potential 

operational losses that are separate from its business lines and operational loss event 

types. Units of measure can also encompass correlations over time. Therefore, the 

agencies have amended the final rule to define dependence as a measure of the 

association among operational losses across and within units of measure. 

As noted above, under the proposed rule, a bank that did not satisfy the 

requirements surrounding dependence would sum operational risk exposure estimates 

across units of measure to calculate its total operational risk exposure. Several 

commenters asserted that the New Accord does not require a bank to sum its operational 

risk exposure estimates across units of measure if the bank cannot demonstrate adequate 

support of its dependence assumptions. One commenter asked the agencies to remove 

this requirement from the final rule. Several commenters suggested that if a bank cannot 
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provide sufficient support for its dependence estimates, a conservative assumption of 

positive dependence is warranted, but not an assumption of perfect positive dependence 

as implied by the summation requirement. Another commenter suggested that the 

dependence assumption should be based upon a conservative statistical analysis of 

industry data. 

The New Accord states that, absent a satisfactory demonstration of a bank’s 

“systems for determining correlations” to its national supervisor, “risk measures for 

different operational risk estimates must be added for purposes of calculating the 

regulatory minimum capital requirement.”39 The agencies continue to believe that this 

treatment of operational risk exposure estimates across units of measure is prudent until 

the relationships among operational losses are better understood. Therefore, the final rule 

retains the proposed rule’s requirement regarding the summation of operational risk 

exposure estimates. 

Several commenters believed that a bank should be permitted to demonstrate the 

nature of the relationship between the causes of different operational losses based on any 

available informative empirical evidence. These commenters suggested that such 

evidence could be statistical or anecdotal, and could be based on information ranging 

from established statistical techniques to more general mathematical approaches to clear 

logical arguments about the degree to which risks and losses are related, or the similarity 

of circumstance between the bank and a peer group for which acceptable estimates of 

dependency are available. 

The agencies recognize that there may be different ways to estimate the 

relationship among operational losses across and within units of measure. Therefore, 

 

39New Accord, ¶669. 
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under the final rule, a bank has flexibility to use different methodologies to demonstrate 

dependence across units of measure. However, the bank must demonstrate to the 

satisfaction of its primary Federal supervisor that its process for estimating dependence is 

sound, robust to a variety of scenarios, implemented with integrity, and allows for the 

uncertainty surrounding the estimates. 

A bank’s chosen unit of measure affects how it should account for dependence. 

Explicit assumptions regarding dependence across units of measure are always necessary 

to estimate operational risk exposure at the bank level. However, explicit assumptions 

regarding dependence within units of measure are not necessary, and under many 

circumstances models assume statistical independence within each unit of measure. The 

use of only a few units of measure increases the need to ensure that dependence within 

units of measure is suitably reflected in the operational risk exposure estimate. 

In addition, the bank’s process for estimating dependence should provide for 

ongoing monitoring, recognizing that dependence estimates can change. The agencies 

expect that a bank’s approach for developing explicit and objective dependence 

determinations will improve over time. As such, the bank should develop a process for 

assessing incremental improvements to the approach (for example, through out-of-sample 

testing). 

Under the final rule, as under the proposed rule, a bank must review and update 

(as appropriate) its operational risk quantification system whenever the bank becomes 

aware of information that may have a material effect on the bank’s estimate of 

operational risk exposure, but no less frequently than annually. 
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The agencies recognize that, in limited circumstances, there may not be sufficient 

data available for a bank to generate a credible estimate of its own operational risk 

exposure at the 99.9 percent confidence level. In these limited circumstances, under the 

proposed rule, a bank could use an alternative operational risk quantification system, 

subject to prior approval by the bank’s primary Federal supervisor. The alternative 

approach was not available at the BHC level. 

One commenter asserted that, in line with the New Accord’s continuum of 

operational risk measurement approaches, all banks, including BHCs, should be 

permitted to adopt an alternative operational risk quantification system, such as the New 

Accord’s standardized approach or allocation approach. The commenter further noted 

that a bank’s use of an allocation approach should not be subject to more stringent terms 

and conditions than those set forth in the New Accord. 

The agencies are maintaining the alternative approach provision in the final rule. 

The agencies are not prescribing specific estimation methodologies under this approach 

and expect use of an alternative approach to occur on a very limited basis. A bank 

proposing to use an alternative operational risk quantification system must submit a 

proposal to its primary Federal supervisor. In evaluating a bank’s proposal, the primary 

Federal supervisor will review the bank’s justification for requesting use of an alternative 

approach in light of the bank’s size, complexity, and risk profile. The bank’s primary 

Federal supervisor will also consider whether the estimate of operational risk under the 

alternative approach is appropriate (for example, whether the estimate results in capital 

levels that are commensurate with the bank’s operational risk profile and is sensitive to 

changes in the bank’s risk profile) and can be supported empirically. Furthermore, the 
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agencies expect a bank using an alternative operational risk quantification system to 

adhere to the rule’s qualification requirements, including establishment and use of 

operational risk management processes and data and assessment systems. As under the 

proposed rule, the alternative approach is not available at the BHC level. 

A bank proposing an alternative approach to operational risk based on an 

allocation methodology should be aware of certain limitations associated with the use of 

such an approach. Specifically, the agencies will not permit a DI to accept an allocation 

of operational risk capital requirements that includes non-DIs. Unlike the crossguarantee provision of the Federal Deposit Insurance Act, which provides that a DI is 

liable for any losses incurred by the FDIC in connection with the failure of a commonlycontrolled DI, there are no statutory provisions requiring cross-guarantees between a DI 

and its non-DI affiliates.40 Furthermore, depositors and creditors of a DI generally have 

no legal recourse to 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, the double default excessive correlation detection process, the IMA for 

equity exposures, and the IAA for securitization exposures to ABCP programs 

(collectively, advanced systems). 

The bank’s data management and maintenance systems must adequately support 

the timely and accurate reporting of risk-based capital requirements. Specifically, a bank 

 

40 12 U.S.C. 1815(e). 
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must retain sufficient data elements related to key risk drivers to permit monitoring, 

validation, and refinement of the bank’s advanced systems. A bank’s data management 

and maintenance systems should generally support the rule’s qualification requirements 

relating to quantification, validation, and control and oversight mechanisms, as well as 

the bank’s broader risk management and reporting needs. The precise data elements to 

be collected are dictated by the features and methodologies of the risk measurement and 

management systems employed by the bank. To meet the significant data management 

challenges presented by the quantification, validation, and control and oversight 

requirements of the advanced approaches, a bank must retain data in an electronic format 

that allows timely retrieval for analysis, reporting, and disclosure purposes. The agencies 

did not receive any material comments on these data management requirements. 

7. Control and oversight mechanisms

The consequences of an inaccurate or unreliable advanced system can be 

significant, particularly regarding the calculation of risk-based capital requirements. 

Accordingly, bank senior management is responsible for ensuring that all advanced 

systems function effectively and comply with the qualification requirements. 

Under the proposed rule, a bank’s board of directors (or a designated committee 

of the board) would at least annually evaluate the effectiveness of, and approve, the 

bank’s advanced systems. Multiple commenters objected to this requirement. 

Commenters suggested that a bank’s board of directors should have more narrowly 

defined responsibilities, and that evaluation of a bank’s advanced systems would be more 

effectively and appropriately accomplished by senior management. 
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The agencies believe that a bank’s board of directors has ultimate accountability 

for the effectiveness of the bank’s advanced systems. However, the agencies agree that it 

is not necessarily the responsibility of a bank’s board of directors to conduct an 

evaluation of the effectiveness of a bank’s advanced systems. Evaluation may include 

transaction testing, validation, and audit activities more appropriately the responsibility of 

senior management. Accordingly, the final rule requires a bank’s board of directors to 

review the effectiveness of, and approve, the bank’s advanced systems at least annually. 

To support senior management’s and the board of directors’ oversight 

responsibilities, a bank must have an effective system of controls and oversight that 

ensures ongoing compliance with the qualification requirements; maintains the integrity, 

reliability, and accuracy of the bank’s advanced systems; and includes adequate corporate 

governance and project management processes. Banks have flexibility to determine how 

to achieve integrity in their risk management systems. Banks are, however, expected to 

follow standard control principles in their systems such as checks and balances, 

separation of duties, appropriateness of incentives, and data integrity assurance, including 

that of information purchased from third parties. Moreover, the oversight process should 

be sufficiently independent of the advanced systems’ development, implementation, and 

operation to ensure the integrity of the component systems. The objective of risk 

management system oversight is to ensure that the various systems used in determining 

risk-based capital requirements are operating as intended. The oversight process should 

draw conclusions on the soundness of the components of the risk management system, 

identify errors and flaws, and recommend corrective action as appropriate. 

Validation 
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 A bank must validate its advanced systems on an ongoing basis. Validation is the 

set of activities designed to give the greatest possible assurances of accuracy of the 

advanced systems. Validation includes three broad components: (i) evaluation of the 

conceptual soundness of the advanced systems; (ii) ongoing monitoring that includes 

process verification and comparison of the bank’s internal estimates with relevant 

internal and external data sources or results from other estimation techniques 

(benchmarking); and (iii) outcomes analysis that includes back-testing. 

Each of these three components of validation must be applied to the bank’s risk 

rating and segmentation systems, risk parameter quantification processes, and internal 

models that are part of the bank’s advanced systems. A sound validation process should 

take business cycles into account, and any adjustments for stages of the economic cycle 

should be clearly specified in advance and fully documented as part of the validation 

policy. Senior management of the bank should be notified of the validation results and 

should take corrective action where appropriate. 

A bank’s validation process must be independent of the advanced systems’ 

development, implementation, and operation, or be subject to independent assessment of 

its adequacy and effectiveness. A bank should ensure that individuals who perform the 

review are not biased in their assessment due to their involvement in the development, 

implementation, or operation of the processes or products. For example, reviews of the 

internal risk rating and segmentation systems should be performed by individuals who 

were not part of the development, implementation, or maintenance of those systems. In 

addition, individuals performing the reviews should possess the requisite technical skills 

and expertise to fulfill their mandate. 
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The first component of validation is evaluating conceptual soundness, which 

involves assessing the quality of the design and construction of a risk measurement or 

management system. This evaluation of conceptual soundness should include 

documentation and empirical evidence supporting the methods used and the variables 

selected in the design and quantification of the bank’s advanced systems. The 

documentation should also evidence an understanding of the systems’ limitations. The 

development of internal risk rating and segmentation systems and their quantification 

processes requires banks to exercise judgment. Validation should ensure that these 

judgments are well informed and considered, and generally include a body of expert 

opinion. A bank should review developmental evidence whenever the bank makes 

material changes in its advanced systems. 

The second component of the validation process for a bank’s advanced systems is 

ongoing monitoring to confirm that the systems were implemented appropriately and 

continue to perform as intended. Such monitoring involves process verification and 

benchmarking. Process verification includes verifying that internal and external data are 

accurate and complete, as well as ensuring that: internal risk rating and segmentation 

systems are being used, monitored, and updated as designed; ratings are assigned to 

wholesale obligors and exposures as intended; and appropriate remediation is undertaken 

if deficiencies exist. 

Benchmarking means the comparison of a bank’s internal estimates with relevant 

internal and external data or with estimates based on other estimation techniques. Banks 

are required to use alternative data sources or risk assessment approaches to draw 

inferences about the validity of their internal risk ratings, segmentations, risk parameter 
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estimates, and model outputs on an ongoing basis. For credit risk ratings, examples of 

alternative data sources include independent internal raters (such as loan review), external 

rating agencies, wholesale and retail credit risk models developed independently, or retail 

credit bureau models. Because it may take considerable time before outcomes with 

which to conduct sufficiently robust backtesting are available, benchmarking will be a 

very important validation device. Benchmarking applies to all quantification processes 

and internal risk rating and segmentation activities. 

Benchmarking allows a bank to compare its estimates with those of other 

estimation techniques and data sources. Results of benchmarking exercises can be a 

valuable diagnostic tool in identifying potential weaknesses in a bank’s risk 

quantification system. While benchmarking activities allow for inferences about the 

appropriateness of the quantification processes and internal risk rating and segmentation 

systems, they are not the same as backtesting. Differences observed between the bank’s 

risk estimates and the benchmark do not necessarily indicate that the internal risk ratings, 

segmentation decisions, or risk parameter estimates are in error. The benchmark itself is 

an alternative prediction, and the difference may be due to different data or methods. As 

part of the benchmarking exercise, the bank should investigate the source of the 

differences and whether the extent of the differences is appropriate. 

The third component of the validation process is outcomes analysis, which is the 

comparison of the bank’s forecasts of risk parameters and other model outputs with 

actual outcomes. A bank’s outcomes analysis must include backtesting, which is the 

comparison of the bank’s forecasts generated by its internal models with actual outcomes 

during a sample period not used in model development. In this context, backtesting is 
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one form of out-of-sample testing. The agencies note that in other contexts backtesting 

may refer to in-sample fit, but in-sample fit analysis is not what the rule requires a bank 

to do as part of the advanced approaches validation process. 

Actual outcomes should be compared with expected ranges around the estimated 

values of the risk parameters and model results. Randomness and many other variables 

will make discrepancies between realized outcomes and the estimated risk parameters 

inevitable. Therefore the expected ranges should take into account relevant elements of a 

bank’s internal risk rating or segmentation processes. For example, depending on the 

bank’s rating philosophy, year-by-year realized default rates may be expected to differ 

significantly from the long-run one-year average. Also, changes in economic conditions 

between the historical data and current period can lead to differences between actual 

outcomes and estimates. 

One commenter asserted that requiring a bank to perform a statistically robust 

form of backtesting would be an impractically high standard for AMA qualification given 

the nature of operational risk. The commenter further claimed that validating an 

operational risk model must rely on the robustness of the logical structure of the model 

and the appropriateness of the resultant operational risk exposure when benchmarked 

against other established reference points. 

The agencies recognize that it may take considerable time before actual outcomes 

outside of the sample period used in model development are available that would allow a 

bank to backtest its operational risk models by comparing its internal estimates with these 

outcomes. The agencies also acknowledge that a bank may be unable to backtest an 

operational risk model with the same degree of statistical precision that it is able to 
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backtest an internal market risk model. When a bank’s backtesting process is not 

sufficiently robust, a bank may need to rely more heavily on benchmarking and other 

alternative validation devices. The agencies maintain, however, that backtesting provides 

important feedback on the accuracy of model outputs and that a bank should be able to 

assess how actual losses compare with estimates previously generated by its model. 

Internal audit

A bank must have an internal audit function independent of business-line 

management that at least annually assesses the effectiveness of the controls supporting 

the bank’s advanced systems. Internal audit should review the validation process, 

including validation procedures, responsibilities, results, timeliness, and responsiveness 

to findings. Further, internal audit should evaluate the depth, scope, and quality of the 

risk management system review process and conduct appropriate testing to ensure that 

the conclusions of these reviews are well founded. Internal audit must report its findings 

at least annually to the bank’s board of directors (or a committee thereof). 

Stress testing

A bank must periodically stress test its advanced systems. Stress testing analysis 

is a means of understanding how economic cycles, especially downturns as described by 

stress scenarios, affect risk-based capital requirements, including migration across rating 

grades or segments and the credit risk mitigation benefits of double default treatment. 

Stress testing analysis consists of identifying stress scenarios and then assessing the 

effects of the scenarios on key performance measures, including risk-based capital 

requirements. Under the rule, changes in borrower credit quality will lead to changes in 

risk-based capital requirements. Because credit quality changes typically reflect 
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changing economic conditions, risk-based capital requirements may also vary with the 

economic cycle. During an economic downturn, risk-based capital requirements will 

increase if wholesale obligors or retail exposures migrate toward lower credit quality 

rating grades or segments. 

Supervisors expect banks to manage their regulatory capital position so that they 

remain at least adequately capitalized during all phases of the economic cycle. A bank 

that credibly estimates regulatory capital levels during a downturn can be more confident 

of appropriately managing regulatory capital. 

Banks should use a range of plausible but severe scenarios and methods when 

stress testing to manage regulatory capital. Scenarios may be historical, hypothetical, or 

model-based. Key variables specified in a scenario may include, for example, interest 

rates, transition matrices (ratings and score-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 
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material income and segment or ratings migration effects over two years, the appropriate 

time horizon is at least two years. 

8. Documentation 

A bank must adequately document all material aspects of its advanced systems, 

including but not limited to the internal risk rating and segmentation systems, risk 

parameter quantification processes, model design, assumptions, and validation results. 

The guiding principle governing documentation is that it should support the requirements 

for the quantification, validation, and control and oversight mechanisms as well as the 

bank’s broader risk management and reporting needs. Documentation is also critical to 

the supervisory oversight process. 

The bank should document the rationale for all material assumptions 

underpinning its chosen analytical frameworks, including the choice of inputs, 

distributional assumptions, and weighting of quantitative and qualitative elements. The 

bank also should document and justify any subsequent changes to these assumptions. 

 C. Ongoing Qualification 

A bank using the advanced approaches must meet the qualification requirements 

on an ongoing basis. Banks are expected to improve their advanced systems as they 

improve data gathering capabilities and as industry practice evolves. To facilitate the 

supervisory oversight of systems changes, a bank must notify its primary Federal 

supervisor when it makes a change to its advanced systems that results in a material 

change in the bank’s risk-weighted asset amount for an exposure type, or when the bank 

makes any significant change to its modeling assumptions. 
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If an agency determines that a bank that uses the advanced approaches to 

calculate its risk-based capital requirements has fallen out of compliance with one or 

more of the qualification requirements, the agency will notify the bank of its failure to 

comply. After receiving such notice, a bank must establish and submit a plan satisfactory 

to its primary Federal supervisor to return to compliance. If the bank’s primary Federal 

supervisor determines that the bank’s risk-based capital requirements are not 

commensurate with the bank’s credit, market, operational, or other risks, it may require 

the bank to calculate its risk-based capital requirements using the general risk-based 

capital rules or a modified form of the advanced approaches (for example, with fixed 

supervisory risk parameters). 

Under the proposed rule, a bank that fell out of compliance with the qualification 

requirements would also be required to disclose publicly its noncompliance with the 

qualification requirements promptly after receiving notice of noncompliance from its 

primary Federal supervisor. Commenters objected to this requirement, noting that it is 

not one of the public disclosure requirements of the New Accord. The agencies have 

determined that the public disclosure of noncompliance is not always necessary, because 

the disclosure may not reflect the degree of noncompliance. Therefore, the agencies are 

not including a general noncompliance disclosure requirement in the final rule. However, 

the agencies acknowledge that a bank’s significant noncompliance with the qualification 

requirements is an important factor in market participants’ assessments of the bank’s risk 

profile and, thus, a primary Federal supervisor may require public disclosure of 

noncompliance with the qualification requirements if such noncompliance is significant. 

D. Merger and Acquisition Transition Provisions 
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Due to the advanced approaches’ rigorous systems requirements, a bank that 

merges with or acquires another company might not be able to quickly integrate the 

merged or acquired company’s exposures into its risk-based capital calculations. The 

proposed rule provided transition provisions that would allow the acquiring bank time to 

integrate the merged or acquired company into its advanced approaches, subject to an 

implementation plan submitted to the bank’s primary Federal supervisor. As proposed, 

the transition provisions applied only to banks that had already qualified to use the 

advanced approaches. The agencies recognize, however, that a bank in the process of 

qualifying to use the advanced approaches may merge with or acquire a company and 

need time to integrate the company into its advanced approaches on an implementation 

schedule distinct from its original implementation plan. In the final rule, the agencies are 

therefore allowing banks to take advantage of the proposed rule’s transition provisions 

for mergers and acquisitions both before and after they qualify to use the advanced 

approaches. 

Under the proposed rule, a bank could use the transition provisions for the merged 

or acquired company’s exposures for up to 24 months following the calendar quarter 

during which the merger or acquisition consummates. A bank’s primary Federal 

supervisor could extend the transition period for up to an additional 12 months. 

Commenters generally supported this timeframe and associated supervisory flexibility. 

Therefore, the final rule adopts the proposed rule’s merger and acquisition transition 

timeframe without change. 

To take advantage of the merger and acquisition transition provisions, the 

acquiring bank must submit to its primary Federal supervisor an implementation plan for 
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using the advanced approaches for the merged or acquired company. The proposed rule 

required a bank to submit such a plan within 30 days of consummating the merger or 

acquisition. Many commenters asserted that the 30-day timeframe for submission of an 

implementation plan may be too short, particularly given the many integration activities 

that must take place immediately following the consummation of a merger or acquisition. 

These commenters generally suggested that banks instead be given 90 or 180 days to 

submit the implementation plan. The agencies agree with these commenters that the 

proposed timeframe for submitting an implementation plan may be too short. 

Accordingly, the final rule requires a bank to submit an implementation plan within 90 

days of the consummation of a merger or acquisition. 

Under the final rule, if a bank that uses the advanced approaches to calculate riskbased capital requirements merges with or acquires a company that does not calculate 

risk-based capital requirements using the advanced approaches, the acquiring bank may 

use the general risk-based capital rules to compute the risk-weighted assets and 

associated capital for the merged or acquired company’s exposures during the merger and 

acquisition transition timeframe. Any ALLL (net of allocated transfer risk reserves) 

associated with the acquired company’s exposures may be included in the acquiring 

bank’s tier 2 capital up to 1.25 percent of the acquired company’s risk-weighted assets.41 

Such ALLL is excluded from the acquiring bank’s eligible credit reserves. The riskweighted assets of the acquired company are not included in the acquiring bank’s creditrisk-weighted assets but are included in the acquiring bank’s total risk-weighted assets. If 

the acquiring bank uses the general risk-based capital rules for acquired exposures, it 

 

41 Any amount of the acquired company’s ALLL that was eliminated in accounting for the acquisition is 

not included in the acquiring bank’s regulatory capital.
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must disclose publicly the amounts of risk-weighted assets and qualifying capital 

calculated under the general risk-based capital rules with respect to the acquired company 

and under this rule for the acquiring bank. The primary Federal supervisor of the bank 

will monitor the merger or acquisition to determine whether the acquiring bank’s 

application of the general risk-based capital rules for the acquired company produces 

appropriate risk-based capital requirements for the assets of the acquired company in 

light of the overall risk profile of the acquiring bank. 

Similarly, a core or opt-in bank that merges with or acquires another core or optin bank might not be able to apply its systems for the advanced approaches immediately 

to the acquired bank’s exposures. Accordingly, the final rule permits a core or opt-in 

bank that merges with or acquires another core or opt-in bank to use the acquired bank’s 

advanced approaches to determine the risk-weighted asset amounts for, and deductions 

from capital associated with, the acquired bank’s exposures during the merger and 

acquisition transition timeframe. 

A third potential merger or acquisition scenario is a bank subject to the general 

risk-based capital rules that merges with or acquires a bank that uses the advanced 

approaches. If, after the merger or acquisition, the acquiring bank is not a core bank, it 

could choose to opt in to the advanced approaches or to apply the general risk-based 

capital rules to the consolidated bank. If the acquiring bank chooses to remain on the 

general risk-based capital rules, the bank must immediately apply the general risk-based 

capital rules to all its exposures, including those of the acquired bank. 

If the acquiring bank chooses or is required to move to the advanced approaches, 

however, it could apply the advanced approaches to the acquired exposures (provided 
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that it continues to meet all of the qualification requirements for those exposures) for up 

to 24 months (with a potential 12-month extension) while it completes the process of 

qualifying to use the advanced approaches for the entire bank. If the acquiring bank has 

not begun implementing the advanced approaches at the time of the merger or 

acquisition, it may instead use the transition timeframes described in section III.A. of the 

preamble and section 21 of the final rule. In the latter case, the bank must consult with its 

primary Federal supervisor regarding the appropriate risk-based capital treatment of the 

acquired exposures. In no case may a bank permanently apply the advanced approaches 

only to an acquired bank’s exposures and not to the consolidated bank. 

Because eligible credit reserves and the ALLL are treated differently under the 

general risk-based capital rules and the advanced approaches, the final rule specifies how 

the acquiring bank must treat the general allowances associated with the merged or 

acquired company’s exposures during the period when the general risk-based capital 

rules apply to the acquiring bank. Specifically, ALLL associated with the exposures of 

the merged or acquired company may not be directly included in the acquiring bank’s tier 

2 capital. Rather, any excess eligible credit reserves (that is, eligible credit reserves 

minus total expected credit losses) associated with the merged or acquired company’s 

exposures may be included in the acquiring bank’s tier 2 capital up to 0.6 percent of the 

credit-risk-weighted assets associated with those exposures. 

IV. Calculation of Tier 1 Capital and Total Qualifying Capital 

The final rule maintains the minimum risk-based capital ratio requirements of 4.0 

percent tier 1 capital to total risk-weighted assets and 8.0 percent total qualifying capital 

to total risk-weighted assets. A bank’s total qualifying capital is the sum of its tier 1 
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(core) capital elements and tier 2 (supplemental) capital elements, subject to various 

limits and restrictions, minus certain deductions (adjustments). The agencies are not 

restating the elements of tier 1 and tier 2 capital in the final rule. Those capital elements 

generally remain as they are currently in the general risk-based capital rules.42 Consistent 

with the proposed rule, the final rule includes regulatory text for certain adjustments to 

the capital elements for purposes of the advanced approaches. 

 Under the final rule, consistent with the proposal, after identifying the elements of 

tier 1 and tier 2 capital, a bank must make certain adjustments to determine its tier 1 

capital and total qualifying capital (the numerator of the total risk-based capital ratio). 

Some of these adjustments are made only to the tier 1 portion of the capital base. Other 

adjustments are made 50 percent from tier 1 capital and 50 percent from tier 2 capital.43 

A bank must still have at least 50 percent of its total qualifying capital in the form of tier 

1 capital.44

 Under the final rule, as under the proposal, a bank must deduct from tier 1 capital 

goodwill, other intangible assets, and deferred tax assets to the same extent that those 

assets are deducted from tier 1 capital under the general risk-based capital rules. Thus, 

all goodwill is deducted from tier 1 capital. Certain intangible assets – including 

mortgage servicing assets, non-mortgage servicing assets, and purchased credit card 

relationships – that meet the conditions and limits in the general risk-based capital rules 

do not have to be deducted from tier 1 capital. Likewise, deferred tax assets that are 

 

42 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, § I 

(state nonmember banks); and 12 CFR 567.5 (savings associations).

43 If the amount deductible from tier 2 capital exceeds the bank’s actual tier 2 capital, however, the bank 

must deduct the shortfall amount from tier 1 capital. 

44 Any assets deducted from capital in computing the numerator of the risk-based capital ratios are also not 

included in risk-weighted assets in the denominator of the ratio. 
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dependent upon future taxable income and that meet the valuation requirements and 

limits in the general risk-based capital rules do not have to be deducted from tier 1 

capital.45

 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 is not required to make these deductions. 

Instead, the bank’s equity exposures generally are subject to the equity treatment in part 

VI of the final rule and described in section V.F. of this preamble.46 

 A number of commenters urged the agencies to revisit the existing definitions of 

tier 1 and tier 2 capital, including some of the deductions. Some offered specific 

suggestions, such as removing the requirement to deduct goodwill from tier 1 capital or 

revising the limitations on certain capital instruments that may be included in regulatory 

capital. Other commenters noted that the definition of regulatory capital and related 

deductions should be thoroughly debated internationally before changes are made in any 

one national jurisdiction. The agencies believe that the definition of regulatory capital 

should be as consistent as possible across national jurisdictions. The BCBS has formed a 

 

45 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, § I 

(state nonmember banks). OTS existing rules are formulated differently, but include similar deductions. 

Under OTS rules, for example, goodwill is included within the definition of “intangible assets” and is 

deducted from tier 1 (core) capital along with other intangible assets. See 12 CFR 567.1 and 567.5(a)(2)(i). 

Similarly, purchased credit card relationships and mortgage and non-mortgage servicing assets are included 

in capital to the same extent as the other agencies’ rules. See 12 CFR 567.5(a)(2)(ii) and 567.12. The 

deduction of deferred tax assets is discussed in Thrift Bulletin 56. 

46 By contrast, OTS rules require the deduction of equity investments from total capital. 12 CFR 

567.5(c)(2)(ii). “Equity investments” are defined to include (i) investments in equity securities (other than 

investments in subsidiaries, equity investments that are permissible for national banks, indirect ownership 

interests in certain pools of assets (for example, mutual funds), Federal Home Loan Bank stock and Federal 

Reserve Bank stock); and (ii) investments in certain real property. 12 CFR 567.1. Savings associations 

applying the final rule are not required to deduct investments in equity securities. Instead, such 

investments are subject to the equity treatment in part VI of the final rule. Equity investments in real estate 

continue to be deducted to the same extent as under the general risk-based capital rules. 
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working group that is currently looking at issues related to the definition of regulatory 

capital. Accordingly, the agencies have not modified the existing definition of regulatory 

capital and related deductions at this time, other than with respect to implementation of 

the advanced approaches. 

 Under the general risk-based capital rules, a bank is allowed to include in tier 2 

capital its ALLL up to 1.25 percent of risk-weighted assets (net of certain deductions). 

Amounts of ALLL in excess of this limit are deducted from the gross amount of riskweighted assets. 

Under the proposed rule, the ALLL was treated differently. The proposed rule 

included a methodology for adjusting risk-based capital requirements based on a 

comparison of the bank’s eligible credit reserves to its ECL. The proposed rule defined 

eligible credit reserves as all general allowances, including the ALLL, established 

through a charge against earnings to absorb credit losses associated with on- or offbalance sheet wholesale and retail exposures. As proposed, eligible credit reserves did 

not include allocated transfer risk reserves established pursuant to 12 U.S.C. 390447 and 

other specific reserves created against recognized losses. The final rule maintains the 

proposed definition of eligible credit reserves. 

The proposed rule defined a bank’s total ECL as the sum of ECL for all wholesale 

and retail exposures other than exposures to which the bank applied the double default 

treatment (described below). The bank’s ECL for a wholesale exposure to a nondefaulted obligor or a non-defaulted retail segment was equal to the product of PD, 

ELGD, and EAD for the exposure or segment. The ECL for non-defaulted exposures 

 

47 12 U.S.C. 3904 does not apply to savings associations regulated by the OTS. As a result, the OTS final 

rule does not refer to allocated transfer risk reserves. 
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thus reflected expected economic losses, including the cost of carry and direct and 

indirect workout expenses. The bank’s ECL for a wholesale exposure to a defaulted 

obligor or a defaulted retail segment was equal to the bank’s impairment estimate for 

allowance purposes for the exposure or segment. The ECL for defaulted exposures thus 

was based on accounting measures of credit loss incorporated into a bank’s charge-off 

and reserving practices. 

In the proposal, the agencies solicited comment on a possible alternative treatment 

for determining ECL for a defaulted exposure that would be more consistent with the 

proposed treatment of ECL for non-defaulted exposures. That alternative approach 

calculated ECL as the bank’s current carrying value of the exposure multiplied by the 

bank’s best estimate of the expected economic loss rate associated with the exposure 

(measured relative to the current carrying value). Commenters on this issue generally 

supported the proposed treatment and expressed some concern about the added 

complexity of the alternative treatment. 

The agencies believe that, for defaulted exposures, any difference between a 

bank’s best estimate of economic losses and its impairment estimate for ALLL purposes 

is likely to be small. The agencies also believe that the proposed ALLL impairment 

approach is less burdensome for banks than the “best estimate of economic loss” 

approach. As a result, the agencies are retaining this aspect of the proposed definition of 

ECL for defaulted exposures. The agencies recognize that this treatment requires a bank 

to specify how much of its ALLL is attributable to defaulted exposures, and emphasize 

that a bank must capture all material economic losses on defaulted exposures when 

building its databases for estimating LGDs for non-defaulted exposures. 
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The agencies also sought comment on the appropriate measure of ECL for assets 

held at fair value with gains and losses flowing through earnings. Commenters expressed 

the view that there should be no ECL for such assets because expected losses on such 

assets already have been removed from regulatory capital. The agencies agree with this 

position and, therefore, under the final rule, a bank may assign an ECL of zero to assets 

held at fair value with gains and losses flowing through earnings. The agencies are 

otherwise maintaining the proposed definition of ECL in the final rule, with the 

substitution of LGD for ELGD noted above. 

Under the final rule, consistent with the proposal, a bank must compare the total 

dollar amount of its ECL to its eligible credit reserves. If there is a shortfall of eligible 

credit reserves compared to total ECL, the bank must deduct 50 percent of the shortfall 

from tier 1 capital and 50 percent from tier 2 capital. If eligible credit reserves exceed 

total ECL, the excess portion of eligible credit reserves may be included in tier 2 capital 

up to 0.6 percent of credit-risk-weighted assets. 

A number of commenters objected to the 0.6 percent limit on inclusion of excess 

reserves in tier 2 capital and suggested that there should be a higher or no limit on the 

amount of excess reserves that may be included in regulatory capital. While the 0.6 

percent limit is part of the New Accord, some commenters asserted that this limitation 

would put U.S. banks at a competitive disadvantage because U.S. accounting practices 

(as compared to accounting practices in many other countries) lead to higher reserves that 

are more likely to exceed the limitation. Another commenter asserted that the proposed 

limitation on excess reserves is more restrictive than the current cap on ALLL in the 

general risk-based capital rules. Finally, several commenters suggested that because 
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ALLL is the first buffer against credit losses, it should be included without limit in tier 1 

capital. 

The agencies believe that the proposed 0.6 percent limit on inclusion of excess 

reserves in tier 2 capital is roughly equivalent to the 1.25 percent cap in the general riskbased capital rules and serves to maintain general consistency in the treatment of reserves 

domestically and internationally. Accordingly, the agencies have included the 0.6 

percent cap in the final rule. 

Under the proposed rule, a bank would deduct from tier 1 capital any after-tax 

gain-on-sale. Gain-on-sale was defined as an increase in a bank’s equity capital that 

resulted from a securitization, other than an increase in equity capital that resulted from 

the bank’s receipt of cash in connection with the securitization. The agencies designed 

this deduction to offset accounting treatments that produce an increase in a bank’s equity 

capital and tier 1 capital at the inception of a securitization – for example, a gain 

attributable to a CEIO that results from Financial Accounting Standard (FAS) 140 

accounting treatment for the sale of underlying exposures to a securitization special 

purpose entity (SPE). Over time, as the bank, from an accounting perspective, realizes 

the increase in equity capital and tier 1 capital booked at the inception of the 

securitization through actual receipt of cash flows, the amount of the required deduction 

would shrink accordingly. 

Under the general risk-based capital rules,48 a bank must deduct CEIOs, whether 

purchased or retained, from tier 1 capital to the extent that the CEIOs exceed 25 percent 

 

48 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 nonmember banks); 12 CFR 567.5(a)(2)(iii) and 567.12(d)(2) (savings 

associations). 
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of the bank’s tier 1 capital. Under the proposed rule, a bank would deduct CEIOs from 

tier 1 capital to the extent they represent gain-on-sale, and would deduct any remaining 

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

Under the proposed rule, certain other securitization exposures also would be 

deducted from tier 1 and tier 2 capital. These exposures included, for example, 

securitization exposures with an applicable external rating (defined below) that is more 

than one category below investment grade (for example, below BB-) and most 

subordinated unrated securitization exposures. When a bank deducted a securitization 

exposure (other than gain-on-sale) from regulatory capital, the bank would take the 

deduction 50 percent from tier 1 capital and 50 percent from tier 2 capital. Moreover, 

under the proposal, a bank could calculate any deductions from tier 1 and tier 2 capital 

with respect to a securitization exposure (including after-tax gain-on-sale) net of any 

deferred tax liabilities associated with the exposure. 

The agencies received a number of comments on the proposed securitizationlinked deductions. In particular, some commenters urged the agencies to retain the 

general risk-based capital rule for deducting only CEIOs that exceed 25 percent of tier 1 

capital. Some of these commenters noted that the “harsher” securitization-linked 

deductions under the advanced approaches could have a significant tier 1 capital impact 

and, accordingly, could have an unwarranted effect on a bank’s tier 1 leverage ratio 

calculation. A few commenters encouraged the agencies to permit a bank to replace the 

deduction approach for certain securitization exposures with a 1,250 percent risk weight 

approach, in part to mitigate potential tier 1 leverage ratio effects. 
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The agencies are retaining the securitization-related deductions as proposed. The 

proposed deductions are part of the New Accord’s securitization framework. The 

agencies believe that they should be retained to foster consistency among participants in 

the international securitization markets. 

The proposed rule also required a bank to deduct the bank’s exposure on certain 

unsettled and failed capital markets transactions 50 percent from tier 1 capital and 

50 percent from tier 2 capital. The agencies are retaining this deduction as proposed. 

The agencies are also retaining, as proposed, the deductions in the general riskbased capital rules for investments in unconsolidated banking and finance subsidiaries 

and reciprocal holdings of bank capital instruments. Further, the agencies are retaining 

the current treatment for national and state banks that control or hold an interest in a 

financial subsidiary. As required by the Gramm-Leach-Bliley Act, assets and liabilities 

of the financial subsidiary are not consolidated with those of the bank for risk-based 

capital purposes and the bank must deduct its equity investment (including retained 

earnings) in the financial subsidiary from regulatory capital – 50 percent from tier 1 

capital and 50 percent from tier 2 capital.49 A BHC generally does not deconsolidate the 

assets and liabilities of the financial subsidiaries of the BHC’s subsidiary banks and does 

not deduct from its regulatory capital the equity investments of its subsidiary banks in 

 

49 See Public Law 106-102 (November 12, 1999), codified, among other places, at 12 USC 24a. See also 

12 CFR 5.39(h)(1) (national banks); 12 CFR 208.73(a) (state member banks); 12 CFR part 325, Appendix 

A, § I.B.2. (state nonmember banks). Again, OTS rules are formulated differently. For example, OTS 

rules do not use the terms “unconsolidated banking and finance subsidiary” or “financial subsidiary.” 

Rather, as required by section 5(t)(5) of the Home Owners’ Loan Act (HOLA), equity and debt investments 

in non-includable subsidiaries (generally subsidiaries that are engaged in activities that are not permissible 

for a national bank) are deducted from assets and tier 1 (core) capital. 12 CFR 567.5(a)(2)(iv) and (v). As 

required by HOLA, OTS will continue to deduct non-includable subsidiaries. Reciprocal holdings of bank 

capital instruments are deducted from a savings association’s total capital under 12 CFR 567.5(c)(2). 
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financial subsidiaries. Rather, a BHC generally fully consolidates the financial 

subsidiaries of its subsidiary banks. These treatments continue under the final rule. 

For BHCs with consolidated insurance underwriting subsidiaries that are 

functionally regulated by a State insurance regulator (or subject to comparable 

supervision and regulatory capital requirements in a non-U.S. jurisdiction), the proposed 

rule set forth the following treatment. The assets and liabilities of the subsidiary would 

be consolidated for purposes of determining the BHC’s risk-weighted assets. However, 

the BHC would deduct from tier 1 capital an amount equal to the insurance underwriting 

subsidiary’s minimum regulatory capital requirement as determined by its functional (or 

equivalent) regulator. For U.S. regulated insurance underwriting subsidiaries, this 

amount generally would be 200 percent of the subsidiary’s Authorized Control Level as 

established by the appropriate state insurance regulator. 

The proposal noted that its approach with respect to functionally regulated 

consolidated insurance underwriting subsidiaries was different from the New Accord, 

which broadly endorses a deconsolidation and deduction approach for insurance 

subsidiaries. The proposal acknowledged the Board’s concern that a full deconsolidation 

and deduction approach does not capture the credit risk in insurance underwriting 

subsidiaries at the consolidated BHC level. 

Several commenters objected to the proposed deduction from tier 1 capital and 

instead supported a deduction 50 percent from tier 1 capital and 50 percent from tier 2 

capital. Others supported the full deduction and deconsolidation approach endorsed by 

the New Accord and maintained that, by contrast, the proposed approach was overly 
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conservative and resulted in a double-count of capital requirements for insurance 

regulation and banking regulation. 

The Board continues to believe that a consolidated BHC risk-based capital 

measure should incorporate all credit, market, and operational risks to which the BHC is 

exposed, regardless of the legal entity subsidiary where a risk exposure resides. The 

Board also believes that a fully consolidated approach minimizes the potential for 

regulatory capital arbitrage; it eliminates incentives to book individual exposures at a 

subsidiary that is deducted from the consolidated entity for capital purposes where a 

different, potentially more favorable, capital requirement is applied at the subsidiary. 

Moreover, the Board does not agree that the proposed approach results in a double-count 

of capital requirements. Rather, the capital requirements imposed by a functional 

regulator or other supervisory authority at the subsidiary level reflect the capital needs at 

the particular subsidiary. The consolidated measure of minimum capital requirements 

should reflect the consolidated organization. 

Thus, the Board is retaining the proposed requirement that assets and liabilities of 

insurance underwriting subsidiaries are consolidated for determining risk-weighted 

assets. The Board has modified the final rule for BHCs, however, to allow the associated 

capital deduction to be made 50 percent from tier 1 capital and 50 percent from tier 2 

capital. 

V. Calculation of Risk-Weighted Assets 

Under the final rule, a bank’s total risk-weighted assets is the sum of its credit 

risk-weighted assets and risk-weighted assets for operational risk, minus the sum of its 

excess eligible credit reserves (eligible credit reserves in excess of its total ECL) not 
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included in tier 2 capital. Unlike under the proposal, allocated transfer risk reserves are 

not subtracted from total risk-weighted assets under the final rule. Because the EAD of 

wholesale exposures and retail segments is calculated net of any allocated transfer risk 

reserves, a second subtraction of the reserves from risk-weighted assets is not 

appropriate. 

A. Categorization of Exposures 

To calculate credit risk-weighted assets, a bank must determine risk-weighted 

asset amounts for exposures that have been grouped into four general categories: 

wholesale, retail, securitization, and equity. It must also identify and determine riskweighted asset amounts for assets not included in an exposure category and any nonmaterial portfolios of exposures to which the bank elects not to apply the IRB approach. 

To exclude a portfolio from the IRB approach, a bank must demonstrate to the 

satisfaction of its primary Federal supervisor that the portfolio (when combined with all 

other portfolios of exposures that the bank seeks to exclude from the IRB approach) is 

not material to the bank. As described above, credit-risk-weighted assets is defined as 

1.06 multiplied by the sum of total wholesale and retail risk-weighted assets, riskweighted assets for securitization exposures, and risk-weighted assets for equity 

exposures. 

1. Wholesale exposures

Consistent with the proposed rule, the final rule defines a wholesale exposure as a 

credit exposure to a company, individual, sovereign entity, or other governmental entity 
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(other than a securitization exposure, retail exposure, or equity exposure).50 The term 

“company” is broadly defined to mean a corporation, partnership, limited liability 

company, depository institution, business trust, SPE, association, or similar organization. 

Examples of a wholesale exposure include: (i) a non-tranched guarantee issued by a bank 

on behalf of a company;51 (ii) a repo-style transaction entered into by a bank with a 

company and any other transaction in which a bank posts collateral to a company and 

faces counterparty credit risk; (iii) an exposure that a bank treats as a covered position 

under the market risk rule for which there is a counterparty credit risk capital 

requirement; (iv) a sale of corporate loans by a bank to a third party in which the bank 

retains full recourse; (v) an OTC derivative contract entered into by a bank with a 

company; (vi) an exposure to an individual that is not managed by the bank as part of a 

segment of exposures with homogeneous risk characteristics; and (vii) a commercial 

lease. 

The agencies proposed two subcategories of wholesale exposures – HVCRE 

exposures and non-HVCRE exposures. Under the proposed rule, HVCRE exposures 

would be subject to a separate IRB risk-based capital formula that would produce a 

higher risk-based capital requirement for a given set of risk parameters than the IRB riskbased capital formula for non-HVCRE wholesale exposures. Further, the agencies 

 

50 The proposed rule excluded from the definition of a wholesale exposure certain pre-sold one-to-four 

family residential construction loans and certain multifamily residential loans. The treatment of such loans 

under the final rule is discussed below in section V.B.5. of the preamble. 

51 As described below, tranched guarantees (like most transactions that involve a tranching of credit risk) 

generally are securitization exposures under the final rule. The final rule defines a guarantee broadly to 

include almost any transaction (other than a credit derivative) that involves the transfer of the credit risk of 

an exposure from one party to another party. This definition of guarantee generally includes, for example, 

a credit spread option under which a bank has agreed to make payments to its counterparty in the event of 

an increase in the credit spread associated with a particular reference obligation issued by a company. 
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proposed that once an exposure was determined to be an HVCRE exposure, it would 

remain an HVCRE exposure until paid in full, sold, or converted to permanent financing. 

The proposed rule defined an HVCRE exposure as a credit facility that finances 

or has financed the acquisition, development, or construction of real property, excluding 

facilities that finance (i) one- to four-family residential properties or (ii) commercial real 

estate projects that meet the following conditions: (A) the exposure’s loan-to-value 

(LTV) ratio is less than or equal to the applicable maximum supervisory LTV ratio in the 

real estate lending standards of the agencies;52 (B) the borrower has contributed capital to 

the project in the form of cash or unencumbered readily marketable assets (or has paid 

development expenses out-of-pocket) of at least 15 percent of the real estate’s appraised 

“as completed” value; and (C) the borrower contributed the amount of capital required 

before the bank advances funds under the credit facility, and the capital contributed by 

the borrower or internally generated by the project is contractually required to remain in 

the project throughout the life of the project. 

Several commenters raised issues related to the requirement that banks must 

separate HVCRE exposures from other wholesale exposures. One commenter asserted 

that a separate risk-weight function for HVCRE exposures is unnecessary because the 

higher risk associated with such exposures would be reflected in higher PDs and LGDs. 

Other commenters stated that tracking the exception requirements for acquisition, 

development, or construction loans would be burdensome and expressed concern that all 

multifamily loans could be subject to the HVCRE treatment. Yet other commenters 

requested that the agencies exclude from the definition of HVCRE all multifamily 

 

52 12 CFR part 34, Subpart D (OCC); 12 CFR part 208, Appendix C (Board); 12 CFR part 365, Appendix 

A (FDIC); and 12 CFR 560.100-560.101 (OTS). 
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acquisition, development, or construction loans; additional commercial real estate 

exposures; and other exposures with significant project equity and/or pre-sale 

commitments. A few commenters supported the proposed approach to HVCRE 

exposures. 

The agencies have determined that the proposed definition of HVCRE exposures 

strikes an appropriate balance between risk-sensitivity and simplicity. Thus, the final rule 

retains the definition as proposed. If a bank does not want to track compliance with the 

definition for burden-related reasons, the bank may choose to apply the HVCRE riskweight function to all credit facilities that finance the acquisition, construction, or 

development of multifamily and commercial real property. The agencies believe that this 

treatment would be an appropriate application of the principle of conservatism discussed 

in section II.D. of the preamble and set forth in section 1(d) of the final rule. 

The New Accord identifies five sub-classes of specialized lending for which the 

primary source of repayment of the obligation is the income generated by the financed 

asset(s) rather than the independent capacity of a broader commercial enterprise. The 

sub-classes are project finance, object finance, commodities finance, income-producing 

real estate, and HVCRE. The New Accord provides a methodology to accommodate 

banks that cannot meet the requirements for the estimation of PD for these exposure 

types. The proposed rule did not include a separate treatment for specialized lending 

beyond the separate IRB risk-based capital formula for HVCRE exposures specified in 

the New Accord. The agencies noted in the proposal that sophisticated banks that would 

be applying the advanced approaches in the United States should be able to estimate risk 

parameters for specialized lending. The agencies continue to believe that banks using the 
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advanced approaches in the United States should be able to estimate risk parameters for 

specialized lending and, therefore, have not adopted a separate treatment for specialized 

lending in the final rule. 

In contrast to the New Accord, the agencies did not propose a separate risk-based 

capital function for exposures to small- and medium-size enterprises (SMEs). The SME 

function in the New Accord generates a lower risk-based capital requirement for an 

exposure to an SME than for an exposure to a larger firm that has the same risk parameter 

values. The agencies were not aware of compelling evidence that smaller firms are 

subject to less systematic risk than is already reflected in the wholesale exposure riskbased capital formula, which specifies lower AVCs as PDs increase. 

A number of commenters objected to this aspect of the proposal and urged the 

agencies to include in the final rule the SME risk-based capital function from the New 

Accord. Several commenters expressed concern about potential competitive disparities 

in the market for SME lending between U.S. banks and foreign banks subject to rules that 

include the New Accord’s treatment of SME exposures. Others asserted that lower 

AVCs and risk-based capital requirements were appropriate for SME exposures because 

the asset values of exposures to smaller firms are more idiosyncratic than those of 

exposures to larger firms. 

While commenters raised important issues related to SME exposures, the agencies 

have decided not to add a distinct risk-weight function for such exposures to the final 

rule. The agencies continue to believe that a distinct risk-weight function with a lower 

AVC for SME exposures is not substantiated by sufficient empirical evidence and may 
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give rise to a domestic competitive inequity between banks subject to the advanced 

approaches and banks subject to the general risk-based capital rules. 

2. Retail exposures

Under the final rule, as under the proposed rule, retail exposures generally include 

exposures (other than securitization exposures or equity exposures) to an individual and 

small exposures to businesses that are managed as part of a segment of similar exposures, 

not on an individual-exposure basis. There are three subcategories of retail exposure: (i) 

residential mortgage exposures; (ii) QREs; and (iii) other retail exposures. The final rule 

retains the proposed definitions of the retail exposure subcategories and, thus, defines 

residential mortgage exposure as an exposure that is primarily secured by a first or 

subsequent lien on one- to four-family residential property. 53 This includes both term 

loans and HELOCs. An exposure primarily secured by a first or subsequent lien on 

residential property that is not one to four family also is included as a residential 

mortgage exposure as long as the exposure has both an original and current outstanding 

amount of no more than $1 million. There is no upper limit on the size of an exposure 

that is secured by one- to four-family residential properties. To be a residential mortgage 

exposure, the bank must manage the exposure as part of a segment of exposures with 

homogeneous risk characteristics. Residential mortgage loans that are managed on an 

individual basis, rather than managed as part of a segment, are categorized as wholesale 

exposures. 

QREs are defined as exposures to individuals that are (i) revolving, unsecured, 

and unconditionally cancelable by the bank to the fullest extent permitted by Federal law; 

 

53 The proposed rule excluded 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 under the final rule is discussed below in section V.B.5. of the preamble. 
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(ii) have a maximum exposure amount (drawn plus undrawn) of up to $100,000; and 

(iii) are managed as part of a segment of exposures with homogeneous risk 

characteristics. In practice, QREs typically include exposures where customers' 

outstanding borrowings are permitted to fluctuate based on their decisions to borrow and 

repay, up to a limit established by the bank. Most credit card exposures to individuals 

and overdraft lines on individual checking accounts are QREs. 

 The category of other retail exposures includes two types of exposures. First, all 

exposures to individuals for non-business purposes (other than residential mortgage 

exposures and QREs) that are managed as part of a segment of similar exposures are 

other retail exposures. Such exposures may include personal term loans, margin loans, 

auto loans and leases, credit card accounts with credit lines above $100,000, and student 

loans. There is no upper limit on the size of these types of retail exposures to individuals. 

Second, exposures to individuals or companies for business purposes (other than 

residential mortgage exposures and QREs), up to a single-borrower exposure threshold of 

$1 million, that are managed as part of a segment of similar exposures are other retail 

exposures. For the purpose of assessing exposure to a single borrower, the bank must 

aggregate all business exposures to a particular legal entity and its affiliates that are 

consolidated under GAAP. If that borrower is a natural person, any consumer loans (for 

example, personal credit card loans or mortgage loans) to that borrower would not be part 

of the aggregate. A bank could distinguish a consumer loan from a business loan by the 

loan department through which the loan is made. Exposures to a borrower for business 
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purposes primarily secured by residential property count toward the $1 million singleborrower other retail business exposure threshold. 54

The residual value portion of a retail lease exposure is excluded from the 

definition of an other retail exposure. Consistent with the New Accord, a bank must 

assign the residual value portion of a retail lease exposure a risk-weighted asset amount 

equal to its residual value as described in section 31 of the final rule. 

3. Securitization exposures

 The proposed rule defined a securitization exposure as an on-balance sheet or 

off-balance sheet credit exposure that arises from a traditional or synthetic securitization 

(including credit-enhancing representations and warranties). A traditional securitization 

was defined as a transaction in which (i) all or a portion of the credit risk of one or more 

underlying exposures is transferred to one or more third parties other than through the use 

of credit derivatives or guarantees; (ii) the credit risk associated with the underlying 

exposures has been separated into at least two tranches reflecting different levels of 

seniority; (iii) performance of the securitization exposures depends on the performance of 

the underlying exposures; and (iv) all or substantially all of the underlying exposures are 

financial exposures. Examples of financial exposures are loans, commitments, 

receivables, asset-backed securities, mortgage-backed securities, other debt securities, 

equity securities, or credit derivatives. The proposed rule also defined mortgage-backed 

pass-through securities guaranteed by Fannie Mae or Freddie Mac (whether or not issued 

out of a structure that tranches credit risk) as securitization exposures. 

 

54 The proposed rule excluded from the definition of an other retail exposure certain pre-sold one-to-four 

family residential construction loans and certain multifamily residential loans. The treatment of such loans 

under the final rule is discussed below in section V.B.5. of the preamble. 
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 A synthetic securitization was defined as a transaction in which (i) all or a portion 

of the credit risk of one or more underlying exposures is transferred to one or more third 

parties through the use of one or more credit derivatives or guarantees (other than a 

guarantee that transfers only the credit risk of an individual retail exposure); (ii) the credit 

risk associated with the underlying exposures has been separated into at least two 

tranches reflecting different levels of seniority; (iii) performance of the securitization 

exposures depends on the performance of the underlying exposures; and (iv) all or 

substantially all of the underlying exposures are financial exposures. Accordingly, the 

proposed definition of a securitization exposure included tranched cover or guarantee 

arrangements – that is, arrangements in which an entity transfers a portion of the credit 

risk of an underlying exposure to one or more guarantors or credit derivative providers 

but also retains a portion of the credit risk, where the risk transferred and the risk retained 

are of different seniority levels. 

The preamble to the proposal noted that, provided there is a tranching of credit 

risk, securitization exposures could include, among other things, asset-backed and 

mortgage-backed securities; loans, lines of credit, liquidity facilities, and financial 

standby letters of credit; credit derivatives and guarantees; loan servicing assets; servicer 

cash advance facilities; reserve accounts; credit-enhancing representations and 

warranties; and CEIOs. Securitization exposures also could include assets sold with 

retained tranched recourse. 

As explained in the proposal, if a bank purchases an asset-backed security issued 

by a securitization SPE and purchases a credit derivative to protect itself from credit 

losses associated with the asset-backed security, the purchase of the credit derivative by 
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the investing bank does not turn the traditional securitization into a synthetic 

securitization. Instead, the investing bank would be viewed as having purchased a 

traditional securitization exposure and would reflect the CRM benefits of the credit 

derivative through the securitization CRM rules described later in the preamble and in 

section 46 of the rule. Moreover, if a bank provides a guarantee or a credit derivative on 

a securitization exposure, that guarantee or credit derivative would also be a 

securitization exposure. 

Commenters raised several objections to the proposed definitions of traditional 

and synthetic securitizations. First, several commenters objected to the requirement that 

all or substantially all of the underlying exposures must be financial exposures. These 

commenters noted that the securitization market rapidly evolves and expands to cover 

new asset classes – such as intellectual property rights, project finance revenues, and 

entertainment royalties – that may or may not be financial assets. Commenters expressed 

particular concern that the proposed definitions may exclude from the securitization 

framework leases that include a material lease residual component. 

The agencies believe that requiring all or substantially all of the underlying 

exposures for a securitization to be financial exposures creates an important boundary 

between the wholesale and retail frameworks, on the one hand, and the securitization 

framework, on the other hand. Accordingly, the agencies are maintaining this 

requirement in the final rule. The securitization framework was designed to address the 

tranching of the credit risk of financial exposures and was not designed, for example, to 

apply to tranched credit exposures to commercial or industrial companies or nonfinancial 

assets. Accordingly, under the final rule, a specialized loan to finance the construction or 
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acquisition of large-scale projects (for example, airports and power plants), objects (for 

example, ships, aircraft, or satellites), or commodities (for example, reserves, inventories, 

precious metals, oil, or natural gas) generally is not a securitization exposure because the 

assets backing the loan typically are nonfinancial assets (the facility, object, or 

commodity being financed). In addition, although some structured transactions involving 

income-producing real estate or HVCRE can resemble securitizations, these transactions 

generally would not be securitizations because the underlying exposure would be real 

estate. Consequently, exposures resulting from the tranching of the risks of nonfinancial 

assets are not subject to the final rule’s securitization framework, but generally are 

subject to the rules for wholesale exposures. 

Based on their cash flow characteristics, for purposes of the final rule, the 

agencies would consider many of the asset classes identified by commenters — including 

lease residuals and entertainment royalties — to be financial assets. Both the designation 

of exposures as securitization exposures and the calculation of risk-based capital 

requirements for securitization exposures will be guided by the economic substance of a 

transaction rather than its legal form.55

Some commenters asserted that the proposal generally to define as securitization 

exposures all exposures involving credit risk tranching of underlying financial assets was 

too broad. The proposed definition captured many exposures these commenters did not 

consider to be securitization exposures, including tranched exposures to a single 

underlying financial exposure and exposures to many hedge funds and private equity 

 

55 Several commenters asked the agencies to confirm that the typical syndicated credit facility would not be 

a securitization exposure. The agencies confirm that a syndicated credit facility is not a securitization 

exposure so long as less than substantially all of the borrower’s assets are financial exposures. 
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funds. Commenters requested flexibility to apply the wholesale or equity framework 

(depending on the exposure) rather than the securitization framework to these exposures. 

The agencies believe that a single, unified approach to dealing with the tranching 

of credit risk is important to create a level playing field across the securitization, credit 

derivative, and other financial markets, and therefore have decided to maintain the 

proposed treatment of tranched exposures to a single underlying financial asset in the 

final rule. The agencies believe that basing the applicability of the securitization 

framework on the presence of some minimum number of underlying exposures would 

complicate the rule and would create a divergence from the New Accord, without any 

material improvement in risk sensitivity. The securitization framework is designed 

specifically to deal with tranched exposures to credit risk. Moreover, the principal riskbased capital approaches of the securitization framework take into account the effective 

number of underlying exposures. 

 The agencies agree with commenters that the proposed definition for 

securitization exposures was quite broad and captured some exposures that would more 

appropriately be treated under the wholesale or equity frameworks. To limit the scope of 

the IRB securitization framework, the agencies have modified the definition of traditional 

securitization in the final rule to make clear that operating companies are not traditional 

securitizations (even if all or substantially all of their assets are financial exposures). For 

purposes of the final rule’s definition of traditional securitization, operating companies 

generally are companies that produce goods or provide services beyond the business of 

investing, reinvesting, holding, or trading in financial assets. Examples of operating 

companies are depository institutions, bank holding companies, securities brokers and 
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dealers, insurance companies, and non-bank mortgage lenders. Accordingly, an equity 

investment in an operating company, such as a bank, generally would be an equity 

exposure under the final rule; a debt investment in an operating company, such as a bank, 

generally would be a wholesale exposure under the final rule. 

Investment firms, which generally do not produce goods or provide services 

beyond the business of investing, reinvesting, holding, or trading in financial assets, are 

not operating companies for purposes of the final rule and would not qualify for this 

general exclusion from the definition of traditional securitization. Examples of 

investment firms would include companies that are exempted from the definition of an 

investment company under section 3(a) of the Investment Company Act of 1940 (15 

U.S.C. 80a-3(a)) by either section 3(c)(1) (15 U.S.C. 80a-3(c)(1)) or section 3(c)(7) (15 

U.S.C. 80a-3(c)(7)) of the Act. 

The final definition of a traditional securitization also provides the primary 

Federal supervisor of a bank with discretion to exclude from the definition of traditional 

securitization investment firms that exercise substantially unfettered control over the size 

and composition of their assets, liabilities, and off-balance sheet transactions. The 

agencies will consider a number of factors in the exercise of this discretion, including an 

assessment of the investment firm’s leverage, risk profile, and economic substance. This 

supervisory exclusion is intended to provide discretion to a bank’s primary Federal 

supervisor to distinguish structured finance transactions, to which the securitization 

framework was designed to apply, from more flexible investment firms such as many 

hedge funds and private equity funds. Only investment firms that can easily change the 

size and composition of their capital structure, as well as the size and composition of their 
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assets and off-balance sheet exposures, would be eligible for this exclusion from the 

definition of traditional securitization under this new provision. The agencies do not 

consider managed collateralized debt obligation vehicles, structured investment vehicles, 

and similar structures, which allow considerable management discretion regarding asset 

composition but are subject to substantial restrictions regarding capital structure, to have 

substantially unfettered control. Thus, such transactions meet the final rule’s definition 

of traditional securitization. 

 The agencies also have added two additional exclusions to the definition of 

traditional securitization for small business investment companies (SBICs) and 

community development investment vehicles. As a result, a bank’s equity investments in 

SBICs and community development equity investments generally are treated as equity 

exposures under the final rule. 

The agencies remain concerned that the line between securitization exposures and 

non-securitization exposures may be difficult to draw in some circumstances. In addition 

to the supervisory exclusion from the definition of traditional securitization described 

above, the agencies have added a new component to the definition of traditional 

securitization to specifically permit a primary Federal supervisor to scope certain 

transactions into the securitization framework if justified by the economics of the 

transaction. Similar to the analysis for excluding an investment firm from treatment as a 

traditional securitization, the agencies will consider the economic substance, leverage, 

and risk profile of transactions to ensure that the appropriate IRB classification is made. 

The agencies will consider a number of factors when assessing the economic substance of 

a transaction including, for example, the amount of equity in the structure, overall 
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leverage (whether on- or off-balance sheet), whether redemption rights attach to the 

equity investor, and the ability of the junior tranches to absorb losses without interrupting 

contractual payments to more senior tranches. 

One commenter asked whether a bank could ignore the credit protection provided 

by a tranched guarantee for risk-based capital purposes and instead calculate the riskbased capital requirement for the guaranteed exposure as if the guarantee did not exist. 

The agencies believe that this treatment would be an appropriate application of the 

principle of conservatism discussed in section II.D. of this preamble and set forth in 

section 1(d) of the final rule. 

As noted above, the proposed rule defined mortgage-backed pass-through 

securities guaranteed by Fannie Mae or Freddie Mac (whether or not issued out of a 

structure that tranches credit risk) as securitization exposures. The agencies have 

reconsidered this proposal and have concluded that a special treatment for these securities 

is inconsistent with the New Accord and would violate the fundamental credit-tranchingbased nature of the definition of securitization exposures. The final rule therefore does 

not define all mortgage-backed pass-through securities guaranteed by Fannie Mae or 

Freddie Mac to be securitization exposures. As a result, those mortgage-backed 

securities that involve tranching of credit risk will be securitization exposures; those 

mortgage-backed securities that do not involve tranching of credit risk will not be 

securitization exposures.56 

 

56 Several commenters asked the agencies to clarify whether a special purpose entity that issues multiple 

classes of securities that have equal priority in the capital structure of the issuer but different maturities 

would be considered a securitization SPE. The agencies do not believe that maturity differentials alone 

constitute credit risk tranching for purposes of the definitions of traditional securitization and synthetic 

securitization. 
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A few commenters asserted that OTC derivatives with a securitization SPE as the 

counterparty should be excluded from the definition of securitization exposure and 

treated as wholesale exposures. The agencies believe that the securitization framework is 

the most appropriate way to assess the counterparty credit risk of such exposures because 

this risk is a tranched exposure to the credit risk of the underlying financial assets of the 

securitization SPE. The agencies are addressing specific commenter concerns about the 

burden of applying the securitization framework to these exposures in preamble section 

V.E. below and section 42(a)(5) of the final rule. 

4. Equity exposures

The proposed rule defined an equity exposure to mean: 

(i) A security or instrument whether voting or non-voting that represents a direct 

or indirect ownership interest in, and a residual claim on, the assets and income of a 

company, unless: (A) the issuing company is consolidated with the bank under GAAP; 

(B) the bank is required to deduct the ownership interest from tier 1 or tier 2 capital; (C) 

the ownership interest is redeemable; (D) the ownership interest incorporates a payment 

or other similar obligation on the part of the issuing company (such as an obligation to 

pay periodic interest); or (E) the ownership interest is a securitization exposure. 

(ii) A security or instrument that is mandatorily convertible into a security or 

instrument described in (i). 

(iii) An option or warrant that is exercisable for a security or instrument described 

in (i). 

(iv) Any other security or instrument (other than a securitization exposure) to the 

extent the return on the security or instrument is based on the performance of a security 
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or instrument described in (i). For example, a short position in an equity security or a 

total return equity swap would be characterized as an equity exposure. 

The proposal noted that nonconvertible term or perpetual preferred stock 

generally would be considered wholesale exposures rather than equity exposures. 

Financial instruments that are convertible into an equity exposure only at the option of 

the holder or issuer also generally would be considered wholesale exposures rather than 

equity exposures provided that the conversion terms do not expose the bank to the risk of 

losses arising from price movements in that equity exposure. Upon conversion, the 

instrument would be treated as an equity exposure. In addition, the agencies note that 

unfunded equity commitments, which are commitments to make equity investments at a 

future date, meet the definition of an equity exposure. 

Many commenters expressed support for the proposed definition of equity 

exposure, except for the proposed exclusion of equity investments in hedge funds and 

other leveraged investment vehicles, as discussed above. The agencies are adopting the 

proposed definition for equity exposures with one exception. They have eliminated in the 

final rule the exclusion of a redeemable ownership interest from the definition of equity 

exposure. The agencies believe that redeemable ownership interests, such as those in 

mutual funds and private equity funds, are most appropriately treated as equity exposures. 

The agencies anticipate that, as a general matter, each of a bank’s exposures will 

fit in one and only one exposure category. One exception to this principle is that equity 

derivatives generally will meet the definition of an equity exposure (because of the 

bank’s exposure to the underlying equity security) and the definition of a wholesale 

exposure (because of the bank’s credit risk exposure to the counterparty). In such cases, 
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as discussed in more detail below, the bank’s risk-based capital requirement for the 

equity derivative generally is the sum of its risk-based capital requirement for the 

derivative counterparty credit risk and for the underlying exposure. 

5. Boundary between operational risk and other risks

With the introduction of an explicit risk-based capital requirement for operational 

risk, issues arise about the proper treatment of operational losses that also could be 

attributed to either credit risk or market risk. The agencies recognize that these boundary 

issues are important and have significant implications for how banks must compile loss 

data sets and compute risk-based capital requirements under the final rule. Consistent 

with the treatment in the New Accord and the proposed rule, banks must treat operational 

losses that are related to market risk as operational losses for purposes of calculating riskbased capital requirements under this final rule. For example, losses incurred from a 

failure of bank personnel to properly execute a stop loss order, from trading fraud, or 

from a bank selling a security when a purchase was intended, must be treated as 

operational losses. 

Under the proposed rule, banks would treat losses that are related to both 

operational risk and credit risk as credit losses for purposes of calculating risk-based 

capital requirements. For example, where a loan defaults (credit risk) and the bank 

discovers that the collateral for the loan was not properly secured (operational risk), the 

bank’s resulting loss would be attributed to credit risk (not operational risk). This general 

separation between credit and operational risk is supported by current U.S. accounting 

standards for the treatment of credit risk. 
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To be consistent with prevailing practice in the credit card industry, the proposed 

rule included an exception to this standard for retail credit card fraud losses. Specifically, 

retail credit card losses arising from non-contractual, third party-initiated fraud (for 

example, identity theft) would be treated as external fraud operational losses under the 

proposed rule. All other third party-initiated losses would be treated as credit losses. 

 Generally, commenters urged the agencies not to be prescriptive on risk boundary 

issues and to give banks discretion to categorize risk as they deem appropriate, subject to 

supervisory review. Other commenters noted that boundary issues are so significant that 

the agencies should not contemplate any additional exceptions to treating losses related to 

both credit and operational risk as credit losses unless the exceptions are agreed to by the 

BCBS. Several commenters objected to specific aspects of the agencies’ proposal and 

suggested that additional types of losses related to credit risk and operational risk, 

including losses related to check fraud, overdraft fraud, and small business loan fraud, 

should be treated as operational losses for purposes of calculating risk-based capital 

requirements. One commenter expressly noted its support for the agencies’ proposal, 

which effectively requires banks to treat losses on HELOCs related to both credit risk and 

operational risk as credit losses for purposes of calculating risk-based capital 

requirements. 

 Because of the substantial potential impact boundary issues have on risk-based 

capital requirements under the advanced approaches, there should be consistency across 

U.S. banks in how they categorize losses that relate to both credit risk and operational 

risk. Moreover, the agencies believe that international consistency on this issue is an 

important objective. Therefore, the final rule maintains the proposed boundaries for 
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losses that relate to both credit risk and operational risk and does not incorporate any 

additional exemptions beyond that in the proposal. 

6. Boundary between the final rule and the market risk rule 

For banks subject to the market risk rule, the existing market risk rule applies to 

all positions classified as trading positions in regulatory reports. The New Accord 

establishes additional criteria for positions to be eligible for application of the market risk 

rule. The agencies are incorporating these additional criteria into the market risk rule 

through a separate rulemaking that is expected to be finalized soon and published in the 

Federal Register. Under this final rule, as under the proposal, core and opt-in banks 

subject to the market risk rule must use the market risk rule for exposures that are 

covered positions under the market risk rule. Core and opt-in banks not subject to the 

market risk rule must use this final rule for all of their exposures. 

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

Exposures, On-Balance Sheet Assets that Are Not Defined by Exposure Category, 

and Immaterial Credit Portfolios) 

Under the proposed rule, the wholesale and retail risk-weighted assets calculation 

consisted of four phases: (1) categorization of exposures; (2) assignment of wholesale 

exposures to rating grades and segmentation of retail exposures; (3) assignment of risk 

parameters to wholesale obligors and exposures and segments of retail exposures; and 

(4) calculation of risk-weighted asset amounts. The agencies did not receive any negative 

comments on the four phases for calculating wholesale and retail risk-weighted assets 

and, thus, are adopting the four-phase concept as proposed. Where applicable, the 

agencies have clarified particular issues within the four-phase process. 
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1. Phase 1 − Categorization of exposures

In phase 1, a bank must determine which of its exposures fall into each of the four 

principal IRB exposure categories – wholesale exposures, retail exposures, securitization 

exposures, and equity exposures. In addition, a bank must identify within the wholesale 

exposure category certain exposures that receive a special treatment under the wholesale 

framework. These exposures include HVCRE exposures, sovereign exposures, eligible 

purchased wholesale exposures, eligible margin loans, repo-style transactions, OTC 

derivative contracts, unsettled transactions, and eligible guarantees and eligible credit 

derivatives that are used as credit risk mitigants. 

The treatment of HVCRE exposures and eligible purchased wholesale receivables 

is discussed below in this section. The treatment of eligible margin loans, repo-style 

transactions, OTC derivative contracts, and eligible guarantees and eligible credit 

derivatives that are credit risk mitigants is discussed in section V.C. of the preamble. In 

addition, sovereign exposures and exposures to or directly and unconditionally 

guaranteed by the Bank for International Settlements, the International Monetary Fund, 

the European Commission, the European Central Bank, and multilateral development 

banks are exempt from the 0.03 percent floor on PD discussed in the next section. 

The proposed rule recognized as multilateral development banks only those 

multilateral lending institutions or regional development banks in which the U.S. 

government is a shareholder or contributing member. The final rule adopts a slightly 

expanded definition of multilateral development bank. Specifically, under the final rule, 

multilateral development bank is defined to include the International Bank for 

Reconstruction and Development, the International Finance Corporation, the Inter-
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American Development Bank, the Asian Development Bank, the African Development 

Bank, the European Bank for Reconstruction and Development, the European Investment 

Bank, the European Investment Fund, the Nordic Investment Bank, the Caribbean 

Development Bank, the Islamic Development Bank, the Council of Europe Development 

Bank; any multilateral lending institution or regional development bank in which the U.S. 

government is a shareholder or contributing member; and any multilateral lending 

institution that a bank’s primary Federal supervisor determines poses comparable credit 

risk. 

In phase 1, a bank also must subcategorize its retail exposures as residential 

mortgage exposures, QREs, or other retail exposures. In addition, a bank must identify 

any on-balance sheet asset that does not meet the definition of a wholesale, retail, 

securitization, or equity exposure, as well as any non-material portfolio of exposures to 

which it chooses, subject to supervisory review, not to apply the IRB risk-based capital 

formulas. 

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

exposures to segments

In phase 2, a bank must assign each wholesale obligor to a single rating grade (for 

purposes of assigning an estimated PD) and may assign each wholesale exposure to loss 

severity rating grades (for purposes of assigning an estimated LGD). A bank that elects 

not to use a loss severity rating grade system for a wholesale exposure must directly 

assign an estimated LGD to the wholesale exposure in phase 3. As a part of the process 

of assigning wholesale obligors to rating grades, a bank must identify which of its 

wholesale obligors are in default. In addition, a bank must group its retail exposures 
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within each retail subcategory into segments that have homogeneous risk 

characteristics.57 

Segmentation is the grouping of exposures within each subcategory according to 

the predominant risk characteristics of the borrower (for example, credit score, debt-toincome ratio, and delinquency) and the exposure (for example, product type and LTV 

ratio). In general, retail segments should not cross national jurisdictions. A bank has 

substantial flexibility to use the retail portfolio segmentation it believes is most 

appropriate for its activities, subject to the following broad principles: 

• Differentiation of risk – Segmentation should provide meaningful differentiation 

of risk. Accordingly, in developing its risk segmentation system, a bank should consider 

the chosen risk drivers’ ability to separate risk consistently over time and the overall 

robustness of the bank’s approach to segmentation. 

• Reliable risk characteristics – Segmentation should use borrower-related risk 

characteristics and exposure-related risk characteristics that reliably and consistently over 

time differentiate a segment’s risk from that of other segments. 

• Consistency – Risk drivers for segmentation should be consistent with the 

predominant risk characteristics used by the bank for internal credit risk measurement 

and management. 

• Accuracy – The segmentation system should generate segments that separate 

exposures by realized performance and should be designed so that actual long-run 

outcomes closely approximate the retail risk parameters estimated by the bank. 

 

57 If the bank determines the EAD for eligible margin loans using the approach in section 32(b) of the rule, 

it must segment retail eligible margin loans for which the bank uses this approach separately from other 

retail exposures. 
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 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. 

A bank must segment defaulted retail exposures separately from non-defaulted 

retail exposures and should base the segmentation of defaulted retail exposures on 

characteristics that are most predictive of current loss and recovery rates. This 

segmentation should provide meaningful differentiation so that individual exposures 

within each defaulted segment do not have material differences in their expected loss 

severity. 

Banks commonly obtain tranched credit protection, for example first-loss or 

second-loss guarantees, on certain retail exposures such as residential mortgages. The 

proposal recognized that the securitization framework, which applies to tranched 

wholesale exposures, is not appropriate for individual retail exposures. Therefore, the 

agencies proposed to exclude tranched guarantees that apply only to an individual retail 

exposure from the securitization framework. The preamble to the proposal noted that an 

important result of this exclusion is that, in contrast to the treatment of wholesale 

exposures, a bank may recognize recoveries from both a borrower and a guarantor for 

purposes of estimating LGD for certain retail exposures. 
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Most commenters who addressed the agencies’ proposed treatment for tranched 

retail guarantees supported the proposed approach. One commenter urged the agencies to 

extend the treatment of tranched guarantees of retail exposures to wholesale exposures. 

Another commenter asserted that the proposed treatment was inconsistent with the New 

Accord. 

The agencies have determined that while the securitization framework is the most 

appropriate risk-based capital treatment for most tranched guarantees, the regulatory 

burden associated with applying it to tranched guarantees of individual retail exposures 

exceeds the supervisory benefit. The agencies are therefore adopting the proposed 

treatment in the final rule and excluding tranched guarantees of individual retail 

exposures from the securitization framework. 

 Some banks expressed concern about the treatment of eligible margin loans under 

the New Accord. Due to the highly collateralized nature and low loss frequency of 

margin loans, banks typically collect little customer-specific information that they could 

use to differentiate margin loans into segments. The agencies believe that a bank could 

appropriately segment its margin loan portfolio using only product-specific risk drivers, 

such as product type and origination channel. A bank could then use the definition of 

default to associate a PD and LGD with each segment. As described in section 32 of the 

rule, a bank may adjust the EAD of eligible margin loans to reflect the risk-mitigating 

effect of financial collateral. If a bank elects this option to adjust the EAD of eligible 

margin loans, it must associate an LGD with the segment that does not reflect the 

presence of collateral. 
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Under the proposal, if a bank was not able to estimate PD and LGD for an eligible 

margin loan, the bank could apply a 300 percent risk weight to the EAD of the loan. 

Commenters generally objected to this approach. As discussed in section III.B.3. of the 

preamble, several commenters asserted that the agencies should permit banks to treat 

margin loans and other portfolios that exhibit low loss frequency or for which a bank has 

limited data on a portfolio basis, by apportioning EL between PD and LGD for portfolios 

rather than estimating each risk parameter separately. Other commenters suggested that 

banks should be expected to develop sound practices for applying the IRB approach to 

such exposures and adopt an appropriate degree of conservatism to address the level of 

uncertainty in the estimation process. Several commenters added that if a bank simply is 

unable to estimate PD and LGD for eligible margin loans, they would support the 

agencies’ proposal to apply a flat risk weight to the EAD of eligible margin loans. 

However, they asserted that the risk weight should not exceed 100 percent given the low 

levels of loss associated with these types of exposures. 

 As discussed in section III.B.3. of the preamble, the final rule provides flexibility 

and incentives for banks to develop and document sound practices for applying the IRB 

approach to portfolios with limited data or default history, which may include eligible 

margin loans. However, the agencies believe that for banks facing particular challenges 

with respect to estimating PD and LGD for eligible margin loans, the proposed 

application of a 300 percent risk weight to the EAD of an eligible margin loan is a 

reasonable alternative. The option balances pragmatism with the provision of appropriate 

incentives for banks to develop processes to apply the IRB approach to such exposures. 

Accordingly, the final rule continues to provide banks with the option of applying a 300 
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percent risk weight to the EAD of an eligible margin loan for which it cannot estimate PD 

and LGD. 

Purchased wholesale exposures

A bank may also elect to use a top-down approach, similar to the treatment of 

retail exposures, for eligible purchased wholesale exposures. Under the final rule, as 

under the proposal, this approach may be used for exposures purchased directly by the 

bank. In addition, the final rule clarifies that this approach also may be used for 

exposures purchased by a securitization SPE in which the bank has invested and for 

which the bank calculates the capital requirement on the underlying exposures (KIRB) for 

purposes of the SFA (as defined in section V.E.4. of the preamble). Under this approach, 

in phase 2, a bank would group its eligible purchased wholesale exposures into segments 

that have homogeneous risk characteristics. To be an eligible purchased wholesale 

exposure, several criteria must be met: 

• The purchased wholesale exposure must be purchased from an unaffiliated seller 

and must not have been directly or indirectly originated by the purchasing bank or 

securitization SPE; 

• The purchased wholesale exposure must be generated on an arm’s-length basis 

between the seller and the obligor (intercompany accounts receivable and receivables 

subject to contra-accounts between firms that buy and sell to each other would not satisfy 

this criterion); 

• The purchasing bank must have a claim on all proceeds from the exposure or a 

pro rata interest in the proceeds; 
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• The purchased wholesale exposure must have an effective remaining maturity of 

less than one year; and 

• The purchased wholesale exposure must, when consolidated by obligor, not 

represent a concentrated exposure relative to the portfolio of purchased wholesale 

exposures. 

Wholesale lease residuals

The agencies proposed a treatment for wholesale lease residuals that differs from 

the New Accord. A wholesale lease residual typically exposes a bank to the risk of a 

decline in value of the leased asset and to the credit risk of the lessee. Although the New 

Accord provides for a flat 100 percent risk weight for wholesale lease residuals, the 

preamble to the proposal noted that the agencies believed this treatment was excessively 

punitive for leases to highly creditworthy lessees. Accordingly, the proposed rule 

required a bank to treat its net investment in a wholesale lease as a single exposure to the 

lessee. As proposed, there would not be a separate capital calculation for the wholesale 

lease residual. Commenters on this issue broadly supported the agencies’ proposed 

approach. The agencies believe the proposed approach appropriately reflects current 

bank risk management practice and are adopting the proposed approach in the final rule. 

Commenters also requested this treatment for retail lease residuals. However, the 

agencies have determined that the proposal to apply a flat 100 percent risk weight for 

retail lease residuals, consistent with the New Accord, appropriately balances risk 

sensitivity and complexity and are maintaining this treatment in the final rule. 

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

retail segments
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In phase 3, a bank associates a PD with each wholesale obligor rating grade; 

associates an LGD with each wholesale loss severity rating grade or assigns an LGD to 

each wholesale exposure; assigns an EAD and M to each wholesale exposure; and 

assigns a PD, LGD, and EAD to each segment of retail exposures. In some cases it may 

be reasonable to assign the same PD, LGD, or EAD to multiple segments of retail 

exposures. The quantification phase for PD, LGD, and EAD can generally be divided 

into four steps—obtaining historical reference data, estimating the risk parameters for the 

reference data, mapping the historical reference data to the bank’s current exposures, and 

determining the risk parameters for the bank’s current exposures. As discussed in more 

detail below, quantification of M is accomplished through direct computation based on 

the contractual characteristics of the exposure. 

A bank should base its estimation of the values assigned to PD, LGD, and EAD58

on historical reference data that are a reasonable proxy for the bank’s current exposures 

and that provide meaningful predictions of the performance of such exposures. A 

“reference data set” consists of a set of exposures to defaulted wholesale obligors and 

defaulted retail exposures (in the case of LGD and EAD estimation) or to both defaulted 

and non-defaulted wholesale obligors and retail exposures (in the case of PD estimation). 

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 

 

58 EAD for repo-style transactions and eligible margin loans may be calculated as described in section 32 

of the final rule. EAD for OTC derivatives must be calculated as described in section 32 of the final rule. 
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history), or other factors that are related in some way to the risk parameters. Banks may 

use more than one reference data set to improve the robustness or accuracy of the 

parameter estimates. 

A bank should then apply statistical techniques to the reference data to determine 

a relationship between risk characteristics and the estimated risk parameter. The result of 

this step is a model that ties descriptive characteristics to the risk parameter estimates. In 

this context, the term ‘model’ is used in the most general sense; a model may use simple 

concepts, such as the calculation of averages, or more complex ones, such as an approach 

based on rigorous regression techniques. This step may include adjustments for 

differences between this final rule’s definition of default and the default definition in the 

reference data set, or adjustments for data limitations. This step includes adjustments for 

seasoning effects related to retail exposures, if material. 

A bank may use more than one estimation technique to generate estimates of the 

risk parameters, especially if there are multiple sets of reference data or multiple sample 

periods. If multiple estimates are generated, the bank should have a clear and consistent 

policy on reconciling and combining the different estimates. 

Once a bank estimates PD, LGD, and EAD for its reference data sets, it should 

create a link between its portfolio data and the reference data based on corresponding 

characteristics. Variables or characteristics that are available for the existing portfolio 

should be mapped or linked to the variables used in the default, loss-severity, or exposure 

amount model. In order to effectively map the data, reference data characteristics need to 

allow for the construction of rating and segmentation criteria that are consistent with 
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those used on the bank’s portfolio. An important element of mapping is making 

adjustments for differences between reference data sets and the bank’s exposures. 

Finally, a bank must apply the risk parameters estimated for the reference data to 

the bank’s actual portfolio data. As noted above, the bank must attribute a PD to each 

wholesale obligor risk grade, an LGD to each wholesale loss severity grade or wholesale 

exposure, an EAD and M to each wholesale exposure, and a PD, LGD, and EAD to each 

segment of retail exposures. If multiple data sets or estimation methods are used, the 

bank must adopt a means of combining the various estimates at this stage. 

The final rule, as noted above, permits a bank to elect to segment its eligible 

purchased wholesale exposures like retail exposures. A bank that chooses to apply this 

treatment must directly assign a PD, LGD, EAD, and M to each such segment. If a bank 

can estimate ECL (but not PD or LGD) for a segment of eligible purchased wholesale 

exposures, the bank must assume that the LGD of the segment equals 100 percent and 

that the PD of the segment equals ECL divided by EAD. The bank must estimate ECL 

for the eligible purchased wholesale exposures without regard to any assumption of 

recourse or guarantees from the seller or other parties. The bank must then use the 

wholesale exposure formula in section 31(e) of the final rule to determine the risk-based 

capital requirement for each segment of eligible purchased wholesale exposures. 

A bank may recognize the credit risk mitigation benefits of collateral that secures 

a wholesale exposure by adjusting its estimate of the LGD of the exposure and may 

recognize the credit risk mitigation benefits of collateral that secures retail exposures by 

adjusting its estimate of the PD and LGD of the segment of retail exposures. In certain 

cases, however, a bank may take financial collateral into account in estimating the EAD 
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of repo-style transactions, eligible margin loans, and OTC derivative contracts (as 

provided in section 32 of the final rule). 

Consistent with the proposed rule, the final rule also provides that a bank may use 

an EAD of zero for (i) derivative contracts that are publicly traded on an exchange that 

requires the daily receipt and payment of cash-variation margin; (ii) derivative contracts 

and repo-style transactions that are outstanding with a qualifying central counterparty 

(defined below), but not for those transactions that the qualifying central counterparty has 

rejected; and (iii) credit risk exposures to a qualifying central counterparty that arise from 

derivative contracts and repo-style transactions in the form of clearing deposits and 

posted collateral. The final rule, like the proposed rule, defines a qualifying central 

counterparty as a counterparty (for example, a clearing house) that: (i) facilitates trades 

between counterparties in one or more financial markets by either guaranteeing trades or 

novating contracts; (ii) requires all participants in its arrangements to be fully 

collateralized on a daily basis; and (iii) the bank demonstrates to the satisfaction of its 

primary Federal supervisor is in sound financial condition and is subject to effective 

oversight by a national supervisory authority. 

Some repo-style transactions and OTC derivative contracts giving rise to 

counterparty credit risk may result, from an accounting point of view, in both on- and offbalance sheet exposures. A bank that uses an EAD approach to measure the exposure 

amount of such transactions is not required to apply separately a risk-based capital 

requirement to an on-balance sheet receivable from the counterparty recorded in 

connection with that transaction. Because any exposure arising from the on-balance 

sheet receivable is captured in the risk-based capital requirement determined under the 
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EAD approach, a separate capital requirement would double count the exposure for 

regulatory capital purposes. 

A bank may take into account the risk reducing effects of eligible guarantees and 

eligible credit derivatives in support of a wholesale exposure by applying the PD 

substitution approach or the LGD adjustment approach to the exposure as provided in 

section 33 of the final rule or, if applicable, applying the double default treatment to the 

exposure as provided in section 34 of the final rule. A bank may decide separately for 

each wholesale exposure that qualifies for the double default treatment whether to apply 

the PD substitution approach, the LGD adjustment approach, or the double default 

treatment. A bank may take into account the risk-reducing effects of guarantees and 

credit derivatives in support of retail exposures in a segment when quantifying the PD 

and LGD of the segment. 

The proposed rule imposed several supervisory limitations on risk parameters 

assigned to wholesale obligors and exposures and segments of retail exposures. First, the 

PD for each wholesale obligor or segment of retail exposures could not be less than 0.03 

percent, except for exposures to or directly and unconditionally guaranteed by a 

sovereign entity, the Bank for International Settlements, the International Monetary Fund, 

the European Commission, the European Central Bank, or a multilateral development 

bank, to which the bank assigns a rating grade associated with a PD of less than 0.03 

percent. 

Second, the LGD of a segment of residential mortgage exposures (other than 

segments of residential mortgage exposures for which all or substantially all of the 

principal of the exposures is directly and unconditionally guaranteed by the full faith and 
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credit of a sovereign entity) could not be less than 10 percent. These supervisory floors 

on PD and LGD applied regardless of whether the bank recognized an eligible guarantee 

or eligible credit derivative as provided in sections 33 and 34 of the proposed rule. 

Commenters did not object to the floor on PD, and the agencies are including it in 

the final rule. A number of commenters, however, objected to the 10 percent floor on 

LGD for segments of residential mortgage exposures. These commenters asserted that 

the floor would penalize low-risk mortgage lending and would provide a disincentive for 

obtaining high-quality collateral. The agencies continue to believe that the LGD floor is 

appropriate at least until banks and the agencies gain more experience with the advanced 

approaches. Accordingly, the agencies are maintaining the floor in the final rule. As the 

agencies gain more experience with the advanced approaches they will reconsider the 

need for the floor together with other calibration issues identified during the parallel run 

and transitional floor periods. The agencies also intend to address this issue and other 

calibration issues with the BCBS and other supervisory and regulatory authorities, as 

appropriate. 

The 10 percent LGD floor for residential mortgage exposures applies at the 

segment level. The agencies will not allow a bank to artificially group exposures into 

segments to avoid the LGD floor for mortgage products. A bank should use consistent 

risk drivers to determine its retail exposure segmentations and not artificially segment 

low LGD loans with higher LGD loans to avoid the floor. 

A bank also must calculate M for each wholesale exposure. Under the proposed 

rule, for wholesale exposures other than repo-style transactions, eligible margin loans, 

and OTC derivative contracts subject to a qualifying master netting agreement (defined in 
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section V.C.2. of this preamble), M was defined as the weighted-average remaining 

maturity (measured in whole or fractional years) of the expected contractual cash flows 

from the exposure, using the undiscounted amounts of the cash flows as weights. A bank 

could use its best estimate of future interest rates to compute expected contractual interest 

payments on a floating-rate exposure, but it could not consider expected but 

noncontractually required returns of principal, when estimating M. A bank could, at its 

option, use the nominal remaining maturity (measured in whole or fractional years) of the 

exposure. The M for repo-style transactions, eligible margin loans, and OTC derivative 

contracts subject to a qualifying master netting agreement was the weighted-average 

remaining maturity (measured in whole or fractional years) of the individual transactions 

subject to the qualifying master netting agreement, with the weight of each individual 

transaction set equal to the notional amount of the transaction. The M for netting sets for 

which the bank used the internal models methodology was calculated as described in 

section 32(c) of the proposed rule. 

Many commenters requested more flexibility in the definition of M, including the 

ability to estimate noncontractually required prepayments and the ability to use either 

discounted or undiscounted cash flows. However, the agencies believe that the proposed 

definition of M, which is consistent with the New Accord, is appropriately conservative 

and provides for a consistent definition of M across internationally active banks. The 

final rule therefore maintains the proposed definition of M. 

Under the final rule, as under the proposal, for most exposures M may be no 

greater than five years and no less than one year. For exposures that have an original 

maturity of less than one year and are not part of a bank’s ongoing financing of the 
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obligor, however, a bank may set M as low as one day, consistent with the New Accord. 

An exposure is not part of a bank’s ongoing financing of the obligor if the bank (i) has a 

legal and practical ability not to renew or roll over the exposure in the event of credit 

deterioration of the obligor; (ii) makes an independent credit decision at the inception of 

the exposure and at every renewal or rollover; and (iii) has no substantial commercial 

incentive to continue its credit relationship with the obligor in the event of credit 

deterioration of the obligor. Examples of transactions that may qualify for the exemption 

from the one-year maturity floor include amounts due from other banks, including 

deposits in other banks; bankers’ acceptances; sovereign exposures; short-term selfliquidating 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 must calculate the dollar risk-based capital 

requirement for each wholesale exposure to a non-defaulted obligor and each segment of 

non-defaulted retail exposures (except eligible guarantees and eligible credit derivatives 

that hedge another wholesale exposure). Other than for exposures to which the bank 

applies the double default treatment in section 34 of the final rule, a bank makes this 

calculation by inserting the risk parameters for the wholesale obligor and exposure or 

retail segment into the appropriate IRB risk-based capital formula specified in Table B, 

and multiplying the output of the formula (K) by the EAD of the exposure or segment.59 

 

59 Alternatively, as noted above, a bank may apply a 300 percent risk weight to the EAD of an eligible 

margin loan if the bank is not able to assign a rating grade to the obligor of the loan. 
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Section 34 contains a separate double default risk-based capital requirement formula. 

Eligible guarantees and eligible credit derivatives that are hedges of a wholesale exposure 

are reflected in the risk-weighted assets amount of the hedged exposure (i) through 

adjustments made to the risk parameters of the hedged exposure under the PD 

substitution or LGD adjustment approach in section 33 of the final rule or (ii) through a 

separate double default risk-based capital requirement formula in section 34 of the final 

rule. 
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Table B – IRB Risk-Based Capital Formulas for Wholesale Exposures to Non-Defaulted Obligors 

and Segments of Non-Defaulted Retail Exposures1 

Capital 

Requirement 

(K) 

NonDefaulted 

Exposures 

( )⎥

⎥

⎦

⎤

⎢

⎢

⎣

⎡ ×− ⎟

⎟

⎠

⎞

⎜

⎜

⎝

⎛

−

×+ ×=

− −

PDLGD

R

NRPDN NLGDK

1

)( )999.0( 1 1

For residential mortgage exposures: R = 15.0

For qualifying revolving exposures: R = 04.0

Retail 

Correlation 

Factor (R) 

For other retail exposures: PD R e ×− ×+= 35 13.003.0

Capital 

Requirement 

(K) 

NonDefaulted 

Exposures 

( ) ⎟

⎠

⎞ ⎜

⎝

⎛

×−

×−+ ×

⎥

⎥

⎦

⎤

⎢

⎢

⎣

⎡ ×− ⎟

⎟

⎠

⎞

⎜

⎜

⎝

⎛

−

×+ ×=

− −

b

M b PDLGD

R

NRPDN NLGDK

5.11

)5.2(1

1

)( )999.0( 1 1

For HVCRE exposures: 

PD R e ×− ×+= 50

Correlation 0 18.012.

Factor (R) For wholesale exposures other than HVCRE exposures: 

PD R e ×− ×+= 50 0 12.012.

Wholesale 

Maturity 

Adjustment 

(b)

( )

2 b ×−= PD)ln(05478.011852.0

1 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 logarithms, and the function ln(.) 

refers to the natural logarithm of the expression within parentheses. The formulas apply 

when PD is greater than zero. If the PD equals zero, the capital requirement K is equal to 

zero. 

 

 The sum of the dollar risk-based capital requirements for wholesale exposures to 

non-defaulted obligors (including exposures subject to the double default treatment 

described below) and segments of non-defaulted retail exposures equals the total dollar 
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risk-based capital requirement for those exposures and segments. The total dollar riskbased capital requirement multiplied by 12.5 equals the risk-weighted asset amount. 

Under the proposed rule, to compute the risk-weighted asset amount for a 

wholesale exposure to a defaulted obligor, a bank would first have to compare two 

amounts: (i) the sum of 0.08 multiplied by the EAD of the wholesale exposure plus the 

amount of any charge-offs or write-downs on the exposure; and (ii) K for the wholesale 

exposure (as determined in Table B immediately before the obligor became defaulted), 

multiplied by the EAD of the exposure immediately before the exposure became 

defaulted. If the amount calculated in (i) were equal to or greater than the amount 

calculated in (ii), the dollar risk-based capital requirement for the exposure would be 0.08 

multiplied by the EAD of the exposure. If the amount calculated in (i) were less than the 

amount calculated in (ii), the dollar risk-based capital requirement for the exposure would 

be K for the exposure (as determined in Table B immediately before the obligor became 

defaulted), multiplied by the EAD of the exposure. The reason for this comparison was 

to ensure that a bank did not receive a regulatory capital benefit as a result of the 

exposure moving from non-defaulted to defaulted status. 

The proposed rule provided a simpler approach for segments of defaulted retail 

exposures. The dollar risk-based capital requirement for a segment of defaulted retail 

exposures was 0.08 multiplied by the EAD of the segment. 

Some commenters objected to the proposed risk-based capital treatment of 

defaulted wholesale exposures, which differs from the approach in the New Accord. 

These commenters contended that it would be burdensome to track the pre-default riskbased capital requirements for purposes of the proposed comparison. These commenters 
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also claimed that the cost and burden of the proposed treatment of defaulted wholesale 

exposures would subject banks to a competitive disadvantage relative to international 

counterparts subject to an approach similar to that in the New Accord. 

In view of commenters’ concerns about cost and regulatory burden, the final rule 

treats defaulted wholesale exposures the same as defaulted retail exposures. The dollar 

risk-based capital requirement of a wholesale exposure to a defaulted obligor equals 0.08 

multiplied by the EAD of the exposure. The agencies will review banks’ practices to 

ensure that banks are not moving exposures from non-defaulted to defaulted status for the 

primary purpose of obtaining a reduction in risk-based capital requirements. 

To convert the dollar risk-based capital requirements for defaulted exposures into 

a risk-weighted asset amount, the bank must sum the dollar risk-based capital 

requirements for all wholesale exposures to defaulted obligors and segments of defaulted 

retail exposures and multiply the sum by 12.5. 

A bank may assign a risk-weighted asset amount of zero to cash owned and held 

in all offices of the bank or in transit, and for gold bullion held in the bank’s own vaults 

or held in another bank’s vaults on an allocated basis, to the extent the gold bullion assets 

are offset by gold bullion liabilities. The risk-weighted asset amount for an on-balance 

sheet asset that does not meet the definition of a wholesale, retail, securitization, or equity 

exposure – for example, property, plant, and equipment and mortgage servicing rights – 

is its carrying value. The risk-weighted asset amount for a portfolio of exposures that the 

bank has demonstrated to its primary Federal supervisor’s satisfaction is, when combined 

with all other portfolios of exposures that the bank seeks to treat as immaterial for riskbased capital purposes, not material to the bank generally is its carrying value (for on-
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balance sheet exposures) or notional amount (for off-balance sheet exposures). For this 

purpose, the notional amount of an OTC derivative contract that is not a credit derivative 

is the EAD of the derivative as calculated in section 32 of the final rule. If an OTC 

derivative contract is a credit derivative, the notional amount is the notional amount of 

the credit derivative. 

Total wholesale and retail risk-weighted assets are defined as the sum of riskweighted assets for wholesale exposures to non-defaulted obligors and segments of nondefaulted retail exposures, wholesale exposures to defaulted obligors and segments of 

defaulted retail exposures, assets not included in an exposure category, non-material 

portfolios of exposures (as calculated under section 31 of the final rule), and unsettled 

transactions (as calculated under section 35 of the final rule and described in section V.D. 

of the preamble) minus the amounts deducted from capital pursuant to the general riskbased capital rules (excluding those deductions reversed in section 12 of the final rule). 

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

 The general risk-based capital rules assign 50 percent and 100 percent risk 

weights to certain one- to four-family residential pre-sold construction loans and 

multifamily residential loans.60 The agencies adopted these provisions as a result of the 

Resolution Trust Corporation Refinancing, Restructuring, and Improvement Act of 1991 

(RTCRRI Act).61 The RTCRRI Act mandates that each agency provide in its capital 

 

60 See 12 CFR part 3, Appendix A, section 3(a)(3)(iii) (national banks); 12 CFR part 208, Appendix A, 

section III.C.3. (state member banks); 12 CFR part 225, Appendix A, section III.C.3. (bank holding 

companies); 12 CFR part 325, Appendix A, section II.C. (state nonmember banks); 12 CFR 567.6(a)(1)(iii) 

and (iv) (savings associations). 

61 See §§ 618(a) and (b) of the RTCRRI Act, Pub. L. 102-233. The first class includes loans for the 

construction of a residence consisting of 1-to-4 family dwelling units that have been pre-sold under firm 

contracts to purchasers who have obtained firm commitments for permanent qualifying mortgages and have 

made substantial earnest money deposits. The second class includes loans that are secured by a first lien on 
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regulations (i) a 50 percent risk weight for certain one- to four-family residential pre-sold 

construction loans and multifamily residential loans that meet specific statutory criteria in 

the RTCRRI Act and any other underwriting criteria imposed by the agencies; and (ii) a 

100 percent risk weight for one- to four-family residential pre-sold construction loans for 

residences for which the purchase contract is cancelled.62 

When Congress enacted the RTCRRI Act in 1991, the agencies’ risk-based capital 

rules reflected the Basel I framework. Consequently, the risk weight treatment for certain 

categories of mortgage loans in the RTCRRI Act assumes a risk weight bucketing 

approach, instead of the more risk-sensitive IRB approach in the advanced approaches. 

In the proposed rule, the agencies identified three types of residential mortgage 

loans addressed by the RTCRRI Act that would continue to receive the risk weights 

provided in the Act. Consistent with the general risk-based capital rules, the proposed 

rule would apply the following risk weights (instead of the risk weights that would 

otherwise be produced under the IRB risk-based capital formulas): (i) a 50 percent risk 

weight for one- to four-family residential construction loans if the residences have been 

pre-sold under firm contracts to purchasers who have obtained firm commitments for 

permanent qualifying mortgages and have made substantial earnest money deposits, and 

the loans meet the other underwriting characteristics established by the agencies in the 

general risk-based capital rules;63 (ii) a 50 percent risk weight for multifamily residential 

loans that meet certain statutory loan-to-value, debt-to-income, amortization, and 

performance requirements, and meet the other underwriting characteristics established by 

 a residence consisting of more than 4 dwelling units if the loan meets certain criteria outlined in the 

RTCRRI Act. 

62 See §§ 618(a) and (b) of the RTCRRI Act. 63 See § 618(a)(1)((B) of the RTCRRI Act. 
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the agencies in the general risk-based capital rules;64 and (iii) a 100 percent risk weight 

for one- to four-family residential pre-sold construction loans for a residence for which 

the purchase contract is cancelled.65 Under the proposal, mortgage loans that did not 

meet the relevant criteria would not qualify for the statutory risk weights and would be 

risk-weighted according to the IRB risk-based capital formulas. 

Commenters generally opposed the proposed assignment of a 50 percent risk 

weight to multifamily and pre-sold single family residential construction exposures. 

Commenters maintained that the RTCRRI Act capital requirements do not align with 

risk, are contrary to the intent of the New Accord and to its implementation in other 

jurisdictions, and would impose additional compliance burdens on banks without any 

associated benefit. 

The agencies agree with these concerns and have decided to adopt in the final rule 

an alternative described in the preamble to the proposed rule. The proposed rule’s 

preamble noted the tension between the statutory risk weights provided by the RTCRRI 

Act and the more risk-sensitive IRB approaches to risk-based capital requirements. The 

preamble observed that the RTCRRI Act permits the agencies to prescribe additional 

underwriting characteristics for identifying loans that are subject to the 50 percent 

statutory risk weights, provided these underwriting characteristics are “consistent with 

the purposes of the minimum acceptable capital requirements to maintain the safety and 

soundness of financial institutions.” The agencies asked whether they should impose the 

following additional underwriting criteria as additional requirements for a core or opt-in 

bank to qualify for the statutory 50 percent risk weight for a particular mortgage loan: (i) 

 

64 See § 618(b)(1)(B) of the RTCRRI Act. 65 See § 618(a)(2) of the RTCRRI Act. 
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that the bank has an IRB risk measurement and management system in place that assesses 

the PD and LGD of prospective residential mortgage exposures; and (ii) that the bank’s 

IRB system generates a 50 percent risk weight for the loan under the IRB risk-based 

capital formula. If the bank’s IRB system does not generate a 50 percent risk weight for 

a particular loan, the loan would not qualify for the statutory risk weight and would 

receive the risk weight generated by the IRB system. 

A few commenters opposed this alternative approach and indicated that the 

additional underwriting criteria would increase operational burden. Other commenters, 

however, observed that compliance with the additional underwriting criteria would not be 

burdensome. 

After careful consideration of the comments and further analysis of the text, spirit 

and legislative history of the RTCRRI Act, the agencies have concluded that they should 

impose the additional underwriting criteria described in the preamble to the proposed rule 

as minimum requirements for a core or opt-in bank to use the statutory 50 percent risk 

weight for particular loans. The agencies believe that the imposition of these criteria is 

consistent with the plain language of the RTCRRI Act, which allows a bank to use the 50 

percent risk weight only if it meets the additional underwriting characteristics established 

by the agencies. The agencies have concluded that the additional underwriting 

characteristics imposed in the final rule are “consistent with the purposes of the minimum 

acceptable capital requirements to maintain the safety and soundness of financial 

institution,” because the criteria will make the risk-based capital requirement for these 

loans a function of each bank’s historical loss experience for the loans and will therefore 

more accurately reflect the performance and risk of loss for these loans. The additional 
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underwriting characteristics are also consistent with the purposes and legislative history 

of RTCRRI Act, which was designed to reflect the true level of risk associated with these 

types of mortgage loans and to do so in accordance with the Basel Accord.66

A capital-related provision of the Federal Deposit Insurance Corporation 

Improvement Act of 1991 (“FDICIA”), enacted by Congress just four days after its 

adoption of the RTCRRI Act, also supports the addition of the new underwriting 

characteristics. Section 305(b)(1)(B) of FDICIA67 directs each agency to revise its riskbased capital standards for insured depository institutions to ensure that those standards 

“reflect the actual performance and expected risk of loss of multifamily mortgages.” 

Although this addresses only multifamily mortgage loans (and not one- to four-family 

residential pre-sold construction loans), it provides the agencies with a Congressional 

mandate – equal in force and power to section 618 of the RTCRRI Act – to enhance the 

risk sensitivity of the regulatory capital treatment of multifamily mortgage loans. 

Crucially, the IRB approach required of core and opt-in banks will produce capital 

requirements that more accurately reflect both performance and risk of loss for 

multifamily mortgage loans than either the Basel I risk weight or the RTCRRI Act risk 

weight. 

As noted above, section 618(a)(2) of the RTCRRI Act mandates that each agency 

amend its capital regulations to provide a 100 percent risk weight to any single-family 

residential construction loan for which the purchase contract is cancelled. Because the 

statute does not authorize the agencies to establish additional underwriting characteristics 

for this small category of loans, the final rule, like the proposed rule, provides a 

 

66 See, e.g., Floor debate for the Resolution Trust Corporation Refinancing, Restructuring, and 

Improvement Act of 1991, p. H11853, House of Representatives, Nov. 26, 1991 (Rep. Wylie) 

67 12 U.S.C. § 1828. 
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100 percent risk weight for single-family residential construction loans for which the 

purchase contract is cancelled.

C. Credit Risk Mitigation (CRM) Techniques 

 Banks use a number of techniques to mitigate credit risk. This section of the 

preamble describes how the final rule recognizes the risk-mitigating effects of both 

financial collateral (defined below) and nonfinancial collateral, as well as guarantees and 

credit derivatives, for risk-based capital purposes. To recognize credit risk mitigants for 

risk-based capital purposes, a bank should have in place operational procedures and risk 

management processes that ensure that all documentation used in collateralizing or 

guaranteeing a transaction is legal, valid, binding, and enforceable under applicable law 

in the relevant jurisdictions. The bank should have conducted sufficient legal review to 

reach a well-founded conclusion that the documentation meets this standard and should 

reconduct such a review as necessary to ensure continuing enforceability. 

Although the use of CRM techniques may reduce or transfer credit risk, it 

simultaneously may increase other risks, including operational, liquidity, and market 

risks. Accordingly, it is imperative that banks employ robust procedures and processes to 

control risks, including roll-off risk and concentration of risks, arising from the bank’s 

use of CRM techniques and to monitor the implications of using CRM techniques for the 

bank’s overall credit risk profile. 

1. Collateral

Under the final rule, a bank generally recognizes collateral that secures a 

wholesale exposure as part of the LGD estimation process and generally recognizes 

collateral that secures a retail exposure as part of the PD and LGD estimation process, as 
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described above in section V.B.3. of the preamble. However, in certain limited 

circumstances described in the next section, a bank may adjust EAD to reflect the risk 

mitigating effect of financial collateral. 

Although the final rule does not contain specific regulatory requirements about 

how a bank incorporates collateral into PD or LGD estimates, a bank should, when 

reflecting the credit risk mitigation benefits of collateral in its estimation of the risk 

parameters of a wholesale or retail exposure: 

(i) Conduct sufficient legal review to ensure, at inception and on an ongoing 

basis, that all documentation used in the collateralized transaction is binding on all parties 

and legally enforceable in all relevant jurisdictions; 

 (ii) Consider the correlation between obligor risk and collateral risk in the 

transaction; 

 (iii) Consider any currency and/or maturity mismatch between the hedged 

exposure and the collateral; 

 (iv) Ground its risk parameter estimates for the transaction in historical data, 

using historical recovery rates where available; and 

 (v) Fully take into account the time and cost needed to realize the liquidation 

proceeds and the potential for a decline in collateral value over this time period. 

The bank also should ensure that: 

(i) The legal mechanism under which the collateral is pledged or transferred 

ensures that the bank has the right to liquidate or take legal possession of the collateral in 

a timely manner in the event of the default, insolvency, or bankruptcy (or other defined 

credit event) of the obligor and, where applicable, the custodian holding the collateral; 
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(ii) The bank has taken all steps necessary to fulfill legal requirements to secure 

its interest in the collateral so that it has and maintains an enforceable security interest; 

(iii) The bank has clear and robust procedures to ensure observation of any legal 

conditions required for declaring the default of the borrower and prompt liquidation of 

the collateral in the event of default; 

(iv) The bank has established procedures and practices for (A) conservatively 

estimating, on a regular ongoing basis, the market value of the collateral, taking into 

account factors that could affect that value (for example, the liquidity of the market for 

the collateral and obsolescence or deterioration of the collateral), and (B) where 

applicable, periodically verifying the collateral (for example, through physical inspection 

of collateral such as inventory and equipment); and 

(v) The bank has in place systems for promptly requesting and receiving 

additional collateral for transactions whose terms require maintenance of collateral values 

at specified thresholds. 

2. Counterparty credit risk of repo-style transactions, eligible margin loans, and OTC 

derivative contracts

This section describes two EAD-based methodologies — a collateral haircut 

approach and an internal models methodology — that a bank may use instead of an LGD 

estimation methodology to recognize the benefits of financial collateral in mitigating the 

counterparty credit risk associated with repo-style transactions, eligible margin loans, 

collateralized OTC derivative contracts, and single product groups of such transactions 

with a single counterparty subject to a qualifying master netting agreement (netting 
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sets).68 A third methodology, the simple VaR methodology, is also available to recognize 

financial collateral mitigating the counterparty credit risk of single product netting sets of 

repo-style transactions and eligible margin loans. These methodologies are substantially 

the same as those in the proposal, except for a few differences identified below. 

One difference from the proposal is that, consistent with the New Accord, under 

the final rule these three methodologies may also be used to recognize the benefits of any 

collateral (not only financial collateral) mitigating the counterparty credit risk of repostyle transactions that are included in a bank’s VaR-based measure under the market risk 

rule. In response to comments requesting broader application of the EAD-based 

methodologies for recognizing the risk-mitigating effect of collateral, the agencies added 

this flexibility to the final rule to enhance international consistency and reduce regulatory 

burden. 

A bank may use any combination of the three methodologies for collateral 

recognition; however, it must use the same methodology for similar exposures. This 

means that, as a general matter, the agencies expect a bank to use one of the three 

methodologies for all its repo-style transactions, one of the three methodologies for all its 

eligible margin loans, and one of the three methodologies for all its OTC derivative 

contracts. A bank may, however, apply a different methodology to subsets of repo-style 

transactions, eligible margin loans, or OTC derivatives by product type or geographical 

location if its application of different methodologies is designed to separate transactions 

that do not have similar risk profiles and is not designed to arbitrage the rule. For 

example, a bank may choose to use one methodology for agency securities lending 

 

68 For purposes of the internal models methodology in section 32(d) of the rule, discussed below in section 

V.C.4. of this preamble, netting set also means a group of transactions with a single counterparty that are 

subject to a qualifying cross-product master netting agreement. 
DRAFT November 2, 2007 

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transactions – that is, repo-style transactions in which the bank, acting as agent for a 

customer, lends the customer’s securities and indemnifies the customer against loss – and 

another methodology for all other repo-style transactions. 

This section also describes the methodology for calculating EAD for an OTC 

derivative contract or set of OTC derivative contracts subject to a qualifying master 

netting agreement. Table C illustrates which EAD estimation methodologies may be 

applied to particular types of exposure. 

Table C 

 Models approach 

 Current 

exposure 

methodology

Collateral 

haircut 

approach 

Simple 

VaR69

methodology 

Internal 

models 

methodology

OTC derivative X X 

Recognition of collateral 

for OTC derivatives 

 X70 X 

Repo-style transaction X X X 

Eligible margin loan X X X 

Cross-product netting set X 

Qualifying master netting agreement

Under the final rule, consistent with the proposal, a qualifying master netting 

agreement is defined to mean any written, legally enforceable bilateral agreement, 

provided that: 

(i) The agreement creates a single legal obligation for all individual transactions 

covered by the agreement upon an event of default, including bankruptcy, insolvency, or 

similar proceeding, of the counterparty; 

 

69 Only repo-style transactions and eligible margin loans subject to a single-product qualifying master 

netting agreement are eligible for the simple VaR methodology. 

70 In conjunction with the current exposure methodology. 
DRAFT November 2, 2007 

229

(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 

similar proceeding, of the counterparty, provided that, in any such case, any exercise of 

rights under the agreement will not be stayed or avoided under applicable law in the 

relevant jurisdictions; 

(iii) The bank has conducted sufficient legal review to conclude with a wellfounded basis (and has maintained sufficient written documentation of that legal review) 

that the agreement meets the requirements of paragraph (ii) of this definition and that in 

the event of a legal challenge (including one resulting from default or from bankruptcy, 

insolvency, or similar proceeding) the relevant court and administrative authorities would 

find the agreement to be legal, valid, binding, and enforceable under the law of the 

relevant jurisdictions; 

(iv) The bank establishes and maintains procedures to monitor possible changes in 

relevant law and to ensure that the agreement continues to satisfy the requirements of this 

definition; and 

(v) The agreement does not contain a walkaway clause (that is, a provision that 

permits a non-defaulting counterparty to make lower payments than it would make 

otherwise under the agreement, or no payment at all, to a defaulter or the estate of a 

defaulter, even if the defaulter or the estate of the defaulter is a net creditor under the 

agreement). 

The agencies consider the following jurisdictions to be relevant for a qualifying 

master netting agreement: the jurisdiction in which each counterparty is chartered or the 
DRAFT November 2, 2007 

230

equivalent location in the case of non-corporate entities, and if a branch of a counterparty 

is involved, then also the jurisdiction in which the branch is located; the jurisdiction that 

governs the individual transactions covered by the agreement; and the jurisdiction that 

governs the agreement. 

EAD for repo-style transactions and eligible margin loans

Under the final rule, a bank may recognize the risk-mitigating effect of financial 

collateral that secures a repo-style transaction, eligible margin loan, or single-product 

netting set of such transactions and the risk-mitigating effect of any collateral that secures 

a repo-style transaction that is included in a bank’s VaR-based measure under the market 

risk rule through an adjustment to EAD rather than LGD. The bank may use a collateral 

haircut approach or one of two models approaches: a simple VaR methodology (for 

single-product netting sets of repo-style transactions or eligible margin loans) or an 

internal models methodology. Figure 2 illustrates the methodologies available for 

calculating EAD and LGD for eligible margin loans and repo-style transactions. 

Figure 2 – EAD and LGD for Eligible Margin Loans and Repo-Style Transactions 
DRAFT November 2, 2007 

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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 defined a repo-style transaction as a repurchase or reverse 

repurchase transaction, or a securities borrowing or securities lending transaction 

(including a transaction in which the bank acts as agent for a customer and indemnifies 

the customer against loss), provided that: 

(i) The transaction is based solely on liquid and readily marketable securities or 

cash; 

(ii) The transaction is marked to market daily and subject to daily margin 

maintenance requirements; 

(iii) The transaction is executed under an agreement that provides the bank the 

right to accelerate, terminate, and close-out the transaction on a net basis and to liquidate 
DRAFT November 2, 2007 

232

or set off collateral promptly upon an event of default (including upon an event of 

bankruptcy, insolvency, or similar proceeding) of the counterparty, provided that, in any 

such case, any exercise of rights under the agreement will not be stayed or avoided under 

applicable law in the relevant jurisdictions;71 and 

(iv) The bank has conducted and documented sufficient legal review to conclude 

with a well-founded basis that the agreement meets the requirements of paragraph (iii) of 

this definition and is legal, valid, binding, and enforceable under applicable law in the 

relevant jurisdictions. 

In the proposal, the agencies recognized that criterion (iii) above may pose 

challenges for certain transactions that would not be eligible for certain exemptions from 

bankruptcy or receivership laws because the counterparty – for example, a sovereign 

entity or a pension fund – is not subject to such laws. The agencies sought comment on 

ways this criterion could be crafted to accommodate such transactions when justified on 

prudential grounds, while ensuring that the requirements in criterion (iii) are met for 

transactions that are eligible for those exemptions. 

Several commenters responded to this question by urging the agencies to modify 

the third component of the repo-style transaction definition in accordance with the 2006 

interagency securities borrowing rule.72 Under the securities borrowing rule, the 

agencies accorded preferential risk-based capital treatment for cash-collateralized 

securities borrowing transactions that either met a bankruptcy standard such as the 

 

71 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). 

72 71 FR 8932, February 22, 2006. 
DRAFT November 2, 2007 

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standard in criterion (iii) above or were overnight or unconditionally cancelable at any 

time by the bank. Commenters maintained that banks are able to terminate promptly a 

repo-style transaction with a counterparty whose financial condition is deteriorating so 

long as the transaction is done on an overnight basis or is unconditionally cancelable by 

the bank. As a result, these commenters contended that events of default and losses on 

such transactions are very rare. 

The agencies have decided to modify the definition of repo-style transaction 

consistent with this suggestion by commenters and consistent with the 2006 securities 

borrowing rule. The agencies believe that this modification will resolve, in a manner that 

preserves safety and soundness, technical difficulties that banks would have had in 

meeting the proposed rule’s definition for a material proportion of their repo-style 

transactions. Consistent with the 2006 securities borrowing rule, a reasonably short 

notice period, typically no more than the standard settlement period associated with the 

securities underlying the repo-style transaction, would not detract from the 

unconditionality of the bank’s termination rights. With regard to overnight transactions, 

the counterparty generally should have no expectation, either explicit or implicit, that the 

bank will automatically roll over the transaction. The agencies are maintaining in 

substance all the other components of the proposed definition of repo-style transaction. 

The proposed rule defined an eligible margin loan as an extension of credit where: 

(i) The credit extension is collateralized exclusively by debt or equity securities 

that are liquid and readily marketable; 

(ii) The collateral is marked to market daily and the transaction is subject to daily 

margin maintenance requirements; 
DRAFT November 2, 2007 

234

(iii) The extension of credit is conducted under an agreement that provides the 

bank the right to accelerate and terminate the extension of credit and to liquidate or set 

off collateral promptly upon an event of default (including upon an event of bankruptcy, 

insolvency, or similar proceeding) of the counterparty, provided that, in any such case, 

any exercise of rights under the agreement will not be stayed or avoided under applicable 

law in the relevant jurisdictions;73 and 

(iv) The bank has conducted and documented sufficient legal review to conclude 

with a well-founded basis that the agreement meets the requirements of paragraph (iii) of 

this definition and is legal, valid, binding, and enforceable under applicable law in the 

relevant jurisdictions. 

Commenters generally supported this definition, but some objected to the 

prescriptiveness of criterion (iii). Criterion (iii) is necessary to ensure that a bank is 

quickly able to realize the value of its collateral in the event of obligor default. Collateral 

stayed by bankruptcy and not liquidated until a date far in the future is more 

appropriately reflected as a discounted positive cash flow in LGD estimation. Criterion 

(iii) is satisfied when the bank has conducted sufficient legal review to conclude with a 

well-founded basis (and has maintained sufficient written documentation of that legal 

review) that a margin loan would be exempt from the bankruptcy auto-stay. The 

agencies are therefore maintaining substantially the same definition of eligible margin 

loan in the final rule. 

 

73 This requirement is met under the circumstances described in footnote 73. Under the U.S. Bankruptcy 

Code, “margin loans” are a type of securities contract, but the term “margin loan” does not encompass all 

loans that happen to be secured by securities collateral. Rather, Congress intended the term “margin loan” 

to include only those loans commonly known in the industry as margin loans, such as credit permitted in an 

account under the Board’s Regulation T or where a financial intermediary extends credit for the purchase, 

sale, carrying, or trading of securities. See H.R. Rep. No. 109-131, at 119, 130 (2005). 
DRAFT November 2, 2007 

235

 With the exception of repo-style transactions that are included in a bank’s VaRbased measure under the market risk rule (as discussed above), for purposes of 

determining EAD for repo-style transactions, eligible margin loans, and OTC derivatives, 

and recognizing collateral mitigating the counterparty credit risk of such exposures, the 

final rule (consistent with the proposed rule) allows banks to take into account only 

financial collateral. The proposed rule defined financial collateral as collateral in the 

form of any of the following instruments in which the bank has a perfected, first priority 

security interest or the legal equivalent thereof: (i) cash on deposit with the bank 

(including cash held for the bank by a third-party custodian or trustee); (ii) gold bullion; 

(iii) long-term debt securities that have an applicable external rating of one category 

below investment grade or higher (for example, at least BB-); (iv) short-term debt 

instruments that have an applicable external rating of at least investment grade (for 

example, at least A-3); (v) equity securities that are publicly traded; (vi) convertible 

bonds that are publicly traded; and (vii) mutual fund shares and money market mutual 

fund shares if a price for the shares is publicly quoted daily. 

 In connection with this definition, the agencies asked for comment on the 

appropriateness of requiring that a bank have a perfected, first priority security interest, 

or the legal equivalent thereof, in the definition of financial collateral. A couple of 

commenters supported this requirement, but several other commenters objected. The 

objecting commenters acknowledged that the requirement would generally be consistent 

with current U.S. collateral practices for repo-style transactions, eligible margin loans, 

and OTC derivatives, but they criticized the requirement on the grounds that: 

(i) obtaining a perfected, first priority security interest may not be the current market 
DRAFT November 2, 2007 

236

practice outside the United States; (ii) U.S. practices may evolve in such a fashion as to 

not meet this requirement; and (iii) the requirement is not explicit in the New Accord. 

Other commenters asked the agencies to clarify that the requirement would be met for all 

or certain forms of collateral if the bank had possession and control of the collateral and a 

reasonable basis to believe it could promptly liquidate the collateral. 

 The agencies believe that in order to use the EAD adjustment approaches for 

exposures within the United States, a bank must have a perfected, first priority security 

interest in collateral, with the exception of cash on deposit with the bank and certain 

custodial arrangements. The agencies have modified the proposed requirement to address 

a concern raised by several commenters that a bank could fail to satisfy the first priority 

security interest requirement because of the senior security interest of a third-party 

custodian involved as an intermediary in the transaction. Under the final rule, a bank 

meets the security interest requirement so long as the bank has a perfected, first priority 

security interest in the collateral notwithstanding the prior security interest of any 

custodial agent. Outside of the United States, the definition of financial collateral can be 

satisfied as long as the bank has the legal equivalent of a perfected, first priority security 

interest. For example, cash on deposit with the bank is an example of the legal equivalent 

of a perfected, first priority security interest. The agencies intend to apply this “legal 

equivalent” standard flexibly to deal with non-U.S. collateral access regimes. 

 The agencies also invited comment on the extent to which assets that do not meet 

the definition of financial collateral are the basis of repo-style transactions engaged in by 

banks or are taken by banks as collateral for eligible margin loans or OTC derivatives. 
DRAFT November 2, 2007 

237

The agencies also inquired as to whether the definition of financial collateral should be 

expanded to reflect any other asset types. 

 A substantial number of commenters asked the agencies to add asset types to the 

list of financial collateral. The principal recommended additions included: (i) noninvestment-grade externally rated bonds; (ii) bonds that are not externally rated; (iii) all 

financial instruments; (iv) letters of credit; (v) mortgages loans; and (vi) certificates of 

deposit. Some commenters that advocated inclusion of a wider range of bonds admitted 

that it may be reasonable to impose some sort of liquidity requirement on the additional 

bonds and to impose a 25-50 percent standard supervisory haircut for such additional 

bonds. Some of the commenters that advocated inclusion of a broader range of bonds 

and mortgages asserted that such inclusion would be warranted by the exemption from 

bankruptcy auto-stay accorded to repo-style transactions involving such assets by the 

U.S. Bankruptcy Code.74

 As described above, to enhance international consistency and conform the final 

rule more closely to the New Accord, the agencies have decided to permit a bank to use 

the EAD approach for all repo-style transactions that are included in a bank’s VaR-based 

measure under the market risk rule, regardless of the underlying collateral type. The 

agencies are satisfied that such repo-style transactions would be based on collateral that is 

sufficiently liquid to justify applying the EAD approach. 

The agencies have included conforming residential mortgages in the definition of 

financial collateral and as acceptable underlying instruments in the definitions of repostyle transaction and eligible margin loan based on the liquidity of such mortgages and 

their widespread use as collateral in repo-style transactions. However, because this 

 

74 11 U.S.C. 559. 
DRAFT November 2, 2007 

238

inclusion goes beyond the New Accord’s recognition of financial collateral, the agencies 

decided to take a conservative approach and require banks to use the standard supervisory 

haircut approach, with a 25 percent haircut and minimum ten-business-day holding 

period, in order to recognize conforming residential mortgage collateral in EAD (other 

than for repo-style transactions that are included in a bank’s VaR-based measure under 

the market risk rule). Use of the standard supervisory haircut approach for repo-style 

transactions, eligible margin loans, and OTC derivatives collateralized by conforming 

mortgages does not preclude a bank’s use of the other EAD adjustment approaches for 

exposures collateralized by other types of financial collateral. Due to concerns about 

both competitive equity and the liquidity and price availability of other types of 

collateral, the agencies are not otherwise expanding the proposed definition of financial 

collateral in the final rule. 

Collateral haircut approach

Under the collateral haircut approach of the final rule, similar to the proposed 

rule, a bank must set EAD equal to the sum of three quantities: (i) the value of the 

exposure less the value of the collateral; (ii) the absolute value of the net position in a 

given instrument or in gold (where the net position in a given instrument or in gold equals 

the sum of the current market values of the instrument or gold the bank has lent, sold 

subject to repurchase, or posted as collateral to the counterparty minus the sum of the 

current market values of that same instrument or gold the bank has borrowed, purchased 

subject to resale, or taken as collateral from the counterparty) multiplied by the market 

price volatility haircut appropriate to that security; and (iii) the sum of the absolute values 

of the net position of any cash, instruments, or gold in each currency that is different from 
DRAFT November 2, 2007 

239

the settlement currency multiplied by the haircut appropriate to each currency mismatch. 

To determine the appropriate haircuts, a bank may choose to use standard supervisory 

haircuts or, with prior written approval from its primary Federal supervisor, its own 

estimates of haircuts. 

In the preamble to the proposed rule, for purposes of the collateral haircut 

approach, the agencies clarified that a given security would include, for example, all 

securities with a single Committee on Uniform Securities Identification Procedures

(CUSIP) number and would not include securities with different CUSIP numbers, even if 

issued by the same issuer with the same maturity date. The agencies sought comment on 

alternative approaches for determining a given security for purposes of the collateral 

haircut approach. A few commenters expressed support for the proposed CUSIP 

approach to defining a given security, but one commenter asked the agencies to permit 

each bank the flexibility to define given security. The collateral haircut approach in the 

final rule is based on a bank’s net position in a “given instrument or gold” rather than in a 

“given security” to more precisely capture the positions to which a bank must apply the 

haircuts. To enhance safety and soundness and comparability across banks, the agencies 

believe that it is important to preserve the relatively clear CUSIP approach to defining a 

given instrument for purposes of the collateral haircut approach. Accordingly, the 

agencies are maintaining the CUSIP approach as appropriate for determining a given 

instrument for instruments that are securities. 

Standard supervisory haircuts. Under the final rule, as under the proposed rule, if 

a bank chooses to use standard supervisory haircuts, it must use an 8 percent haircut for 

each currency mismatch and the haircut appropriate to each security in Table D below. 
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These haircuts are based on the ten-business-day holding period for eligible margin loans 

and must be multiplied by the square root of 1⁄2 to convert the standard supervisory 

haircuts to the five-business-day minimum holding period for repo-style transactions. A 

bank must adjust the standard supervisory haircuts upward on the basis of a holding 

period longer than ten business days for eligible margin loans or five business days for 

repo-style transactions where and as appropriate to take into account the illiquidity of an 

instrument. 

Table D – Standard Supervisory Market Price Volatility Haircuts 
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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 longterm ratings 

> 5 years .06 .12 

One rating category 

below investment 

grade 

All .15 .25 

Main index equities75 (including convertible bonds) and 

gold 

.15 

Other publicly traded equities (including convertible 

bonds), conforming residential mortgages, and 

nonfinancial collateral 

.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 five-year U.S. Treasury 

notes with a market value of $100. The value of the exposure less the value of the 

collateral would be zero, and the net position in the security ($100) times the supervisory 

haircut (.02) would be $2. There is no currency mismatch. Therefore, the EAD of the 

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

 

75 The proposed and final rules define a “main index” as the S&P 500 Index, the FTSE All-World Index, 

and any other index for which the bank demonstrates to the satisfaction of its primary Federal supervisor 

that the equities represented in the index have comparable liquidity, depth of market, and size of bid-ask 

spreads as equities in the S&P 500 Index and the FTSE All-World Index. 
DRAFT November 2, 2007 

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Own estimates of haircuts. Under the final rule, as under the proposal, with the 

prior written approval of the bank’s primary Federal supervisor, a bank may calculate 

security type and currency mismatch haircuts using its own internal estimates of market 

price volatility and foreign exchange volatility. The bank’s primary Federal supervisor 

would base approval to use internally estimated haircuts on the satisfaction of certain 

minimum qualitative and quantitative standards. These standards include: (i) the bank 

must use a 99th percentile one-tailed confidence interval and a minimum five-businessday holding period for repo-style transactions and a minimum ten-business-day holding 

period for all other transactions; (ii) the bank must adjust holding periods upward where 

and as appropriate to take into account the illiquidity of an instrument; (iii) the bank must 

select a historical observation period for calculating haircuts of at least one year; and 

(iv) the bank must update its data sets and recompute haircuts no less frequently than 

quarterly and reassess data sets and haircuts whenever market prices change materially. 

A bank must estimate individually the volatilities of the exposure, the collateral, and 

foreign exchange rates, and may not take into account the correlations between them. 

Under the final rule, as under the proposal, a bank that uses internally estimated 

haircuts must adhere to the following rules. The bank may calculate internally estimated 

haircuts for categories of debt securities that have an applicable external rating of at least 

investment grade. The haircut for a category of securities must be representative of the 

internal volatility estimates for securities in that category that the bank has lent, sold 

subject to repurchase, posted as collateral, borrowed, purchased subject to resale, or taken 

as collateral. In determining relevant categories, the bank must at a minimum take into 

account (i) the type of issuer of the security; (ii) the applicable external rating of the 
DRAFT November 2, 2007 

243

security; (iii) the maturity of the security; and (iv) the interest rate sensitivity of the 

security. A bank must calculate a separate internally estimated haircut for each 

individual debt security that has an applicable external rating below investment grade and 

for each individual equity security. In addition, a bank must internally estimate a 

separate currency mismatch haircut for each individual mismatch between each net 

position in a currency that is different from the settlement currency. 

One commenter recommended that the agencies permit banks to use categorybased internal estimate haircuts for non-investment-grade bonds and equity securities. 

The agencies have decided to adopt the proposed rule’s provisions on category-based 

haircuts because they are consistent with the New Accord and because the volatilities of 

non-investment-grade bonds and of equity securities are more dependent on 

idiosyncratic, issuer-specific events than the volatility of investment-grade bonds. 

Under the final rule, as under the proposal, when a bank calculates an internally 

estimated haircut on a TN-day holding period, which is different from the minimum 

holding period for the transaction type, the bank must calculate the applicable haircut 

(HM) using the following square root of time formula: 

N

M N T

T H H M

= , 

where 

(i) TM = five for repo-style transactions and ten for eligible margin loans; 

(ii) TN = holding period used by the bank to derive HN; and 

(iii) HN = haircut based on the holding period TN. 

Simple VaR methodology 
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As noted above, under the final rule, as under the proposal, a bank may use one of 

two internal models approaches to recognize the risk mitigating effects of financial 

collateral that secures a repo-style transaction or eligible margin loan. This section of the 

preamble describes the simple VaR methodology; a later section of the preamble 

describes the internal models methodology (which also may be used to determine the 

EAD for OTC derivative contracts). The agencies received no material comments on the 

simple VaR methodology and are adopting the methodology without change from the 

proposal. 

With the prior written approval of its primary Federal supervisor, a bank may 

estimate EAD for repo-style transactions and eligible margin loans subject to a single 

product qualifying master netting agreement using a VaR model. Under the simple VaR 

methodology, a bank’s EAD for the transactions subject to such a netting agreement is 

equal to the value of the exposures minus the value of the collateral plus a VaR-based 

estimate of potential future exposure (PFE). The value of the exposures is the sum of the 

current market values of all securities and cash the bank has lent, sold subject to 

repurchase, or posted as collateral to a counterparty under the netting set. The value of 

the collateral is the sum of the current market values of all securities and cash the bank 

has borrowed, purchased subject to resale, or taken as collateral from a counterparty 

under the netting set. The VaR-based estimate of PFE is an estimate of the bank’s 

maximum exposure on the netting set over a fixed time horizon with a high level of 

confidence. 

Specifically, the VaR model must estimate the bank’s 99th percentile, one-tailed 

confidence interval for an increase in the value of the exposures minus the value of the 
DRAFT November 2, 2007 

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collateral (∑E - ∑C) over a five-business-day holding period for repo-style transactions 

or over a ten-business-day holding period for eligible margin loans using a minimum 

one-year historical observation period of price data representing the instruments that the 

bank has lent, sold subject to repurchase, posted as collateral, borrowed, purchased 

subject to resale, or taken as collateral. 

The qualification requirements for the use of a VaR model are less stringent than 

the qualification requirements for the internal models methodology described below. The 

main ongoing qualification requirement for using a VaR model is that the bank must 

validate its VaR model by establishing and maintaining a rigorous and regular 

backtesting regime. 

3. EAD for OTC derivative contracts

Under the final rule, as under the proposed rule, a bank may use either the current 

exposure methodology or the internal models methodology to determine the EAD for 

OTC derivative contracts. An OTC derivative contract is defined as a derivative contract 

that is not traded on an exchange that requires the daily receipt and payment of cashvariation margin. A derivative contract is defined to include interest rate derivative 

contracts, exchange rate derivative contracts, equity derivative contracts, commodity 

derivative contracts, credit derivatives, and any other instrument that poses similar 

counterparty credit risks. The rule also defines derivative contracts to include unsettled 

securities, commodities, and foreign exchange trades with a contractual settlement or 

delivery lag that is longer than the normal settlement period (which the rule defines as the 

lesser of the market standard for the particular instrument or five business days). This 
DRAFT November 2, 2007 

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includes, for example, agency mortgage-backed securities transactions conducted in the 

To-Be-Announced market. 

 Figure 3 illustrates the treatment of OTC derivative contracts. 

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
DRAFT November 2, 2007 

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The final rule’s current exposure methodology for determining EAD for single 

OTC derivative contracts is similar to the methodology in the general risk-based capital 

rules and is the same as the current exposure methodology in the proposal. Under the 

current exposure methodology, the EAD for an OTC derivative contract is equal to the 

sum of the bank’s current credit exposure and PFE on the derivative contract. The 

current credit exposure for a single OTC derivative contract is the greater of the mark-tomarket value of the derivative contract or zero. 

The final rule’s current exposure methodology for OTC derivative contracts 

subject to qualifying master netting agreements is also similar to the treatment in the 

agencies’ general risk-based capital rules and, with one exception discussed below, is the 

same as the treatment in the proposal. Under the general risk-based capital rules and 

under the proposed rule, a bank could not recognize netting agreements for OTC 

derivative contracts for risk-based capital purposes unless it obtained a written and 

reasoned legal opinion representing that, in the event of a legal challenge, the bank’s 

exposure would be found to be the net amount in the relevant jurisdictions.76 The 

agencies asked for comment on methods banks would use to ensure enforceability of 

single product OTC derivative netting agreements in the absence of an explicit written 

legal opinion requirement. 

Although one commenter supported the proposed rule’s written legal opinion 

requirement, many other commenters asked the agencies to remove this requirement. 

These commenters maintained that, provided a transaction is conducted in a jurisdiction 

and with a counterparty type that is covered by a commissioned legal opinion, use of 

industry-developed standardized contracts for certain OTC derivative products and 

 

76 This requirement was found in footnote 8 of the proposed rule text (in section 32(b)(2)). 
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reliance on commissioned legal opinions as to the enforceability of these contracts should 

be a sufficient guarantor of enforceability. These commenters added that reliance on 

such commissioned legal opinions is standard market practice. 

The agencies continue to believe that the legal enforceability of netting 

agreements is a necessary condition for a bank to recognize netting effects in its capital 

calculation. However, the agencies have conducted additional analysis and agree that a 

unique, written legal opinion is not necessary in all cases to ensure the enforceability of 

an OTC derivative netting agreement. Accordingly, the agencies have removed the 

requirement that a bank obtain a written and well reasoned legal opinion for each of its 

qualifying master netting agreements that cover OTC derivatives. As a result, under the 

final rule, to obtain netting treatment for multiple OTC derivative contracts subject to a 

qualifying master netting agreement, a bank must conduct sufficient legal review to 

conclude with a well-founded basis (and maintain sufficient written documentation of 

that legal review) that the agreement would provide termination netting benefits and is 

legal, valid, binding, and enforceable. In some cases, this requirement could be met by 

reasoned reliance on a commissioned legal opinion or an in-house counsel analysis. In 

other cases, however – for example, involving certain new derivative transactions or 

derivative counterparties in unusual jurisdictions – the bank would need to obtain an 

explicit written legal opinion from external or internal legal counsel addressing the 

particular situation. 

The proposed rule’s conversion factor (CF) matrix used to compute PFE was 

based on the matrices in the general risk-based capital rules, with two exceptions. First, 

under the proposed rule, the CF for credit derivatives that are not used to hedge the credit 
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risk of exposures subject to an IRB credit risk capital requirement was specified to be 5.0 

percent for contracts with investment-grade reference obligors and 10.0 percent for 

contracts with non-investment-grade reference obligors.77 The CF for a credit derivative 

contract did not depend on the remaining maturity of the contract. The second change 

was that floating/floating basis swaps were no longer exempted from the CF for interest 

rate derivative contracts. The exemption was put into place when such swaps were very 

simple, and the agencies believed it was no longer appropriate given the evolution of the 

product. The computation of the PFE of multiple OTC derivative contracts subject to a 

qualifying master netting agreement did not change from the general risk-based capital 

rules. The agencies received no material comment on these provisions of the proposed 

rule and have adopted them as proposed. 

Under the final rule, as under the proposed rule, if an OTC derivative contract is 

collateralized by financial collateral and a bank uses the current exposure methodology to 

determine EAD for the exposure, the bank must first determine an unsecured EAD as 

described above and in section 32(c) of the rule. To take into account the risk-reducing 

effects of the financial collateral, the bank may either adjust the LGD of the contract or, if 

the transaction is subject to daily marking-to-market and remargining, adjust the EAD of 

the contract using the collateral haircut approach for repo-style transactions and eligible 

margin loans described above and in section 32(b) of the rule. 

Under part VI of the final rule, and of the proposed rule, a bank must treat an 

equity derivative contract as an equity exposure and compute a risk-weighted asset 

amount for that exposure. If the bank is using the internal models approach for its equity 

 

77 The counterparty credit risk of a credit derivative that is used to hedge the credit risk of an exposure 

subject to an IRB credit risk capital requirement is captured in the IRB treatment of the hedged exposure, as 

detailed in sections 33 and 34 of the proposed rule. 
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exposures, it also must compute a risk-weighted asset amount for its counterparty credit 

risk exposure on the equity derivative contract. However, if the bank is using the simple 

risk weight approach for its equity exposures, it may choose not to hold risk-based capital 

against the counterparty credit risk of the equity derivative contract. Likewise, a bank 

that purchases a credit derivative that is recognized under section 33 or 34 of the rule as a 

credit risk mitigant for an exposure that is not a covered position under the market risk 

rule does not have to compute a separate counterparty credit risk capital requirement for 

the credit derivative.78 If a bank chooses not to hold risk-based capital against the 

counterparty credit risk of such equity or credit derivative contracts, it must do so 

consistently for all such equity derivative contracts or for all such credit derivative 

contracts. Further, where the contracts are subject to a qualifying master netting 

agreement, the bank must either include them all or exclude them all from any measure 

used to determine counterparty credit risk exposure to all relevant counterparties for riskbased capital purposes. 

In addition, where a bank provides protection through a credit derivative that is 

not treated as a covered position under the market risk rule, it must treat the credit 

derivative as a wholesale exposure to the reference obligor and compute a risk-weighted 

asset amount for the credit derivative under section 31 of the rule. The bank need not 

compute a counterparty credit risk capital requirement for the credit derivative, so long as 

it does so consistently for all such credit derivatives and either includes all or excludes all 

 

78 The agencies recognize that there are reasons why a bank’s credit portfolio might contain purchased 

credit protection on a reference name in a notional principal amount that exceeds the bank’s currently 

measured EAD to that obligor. If the protection amount of the credit derivative is materially greater than 

the EAD of the exposure being hedged, however, the bank generally must treat the credit derivative as two 

separate exposures and calculate a counterparty credit risk capital requirement for the exposure that is not 

providing credit protection to the hedged exposure. 
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such credit derivatives that are subject to a qualifying master netting agreement from any 

measure used to determine counterparty credit risk exposure to all relevant counterparties 

for risk-based capital purposes. Where the bank provides protection through a credit 

derivative treated as a covered position under the market risk rule, it must compute a 

counterparty credit risk capital requirement for the credit derivative under section 31 of 

the rule. 

4. Internal models methodology 

The final rule, like the proposed rule, includes an internal models methodology 

for the calculation of EAD for the counterparty credit exposure of OTC derivatives, 

eligible margin loans, and repo-style transactions. The internal models methodology 

requires a risk model that estimates EAD at the level of a netting set. A transaction not 

subject to a qualifying master netting agreement is considered to be its own netting set 

and a bank must calculate EAD for each such transaction individually. 

A bank may use the internal models methodology for OTC derivatives 

(collateralized or uncollateralized) and single-product netting sets thereof, for eligible 

margin loans and single-product netting sets thereof, or for repo-style transactions and 

single-product netting sets thereof. A bank that uses the internal models methodology for 

a particular transaction type (that is, OTC derivative contracts, eligible margin loans, or 

repo-style transactions) must use the internal models methodology for all transactions of 

that transaction type. However, a bank may choose whether or not to use the internal 

models methodology for each transaction type. 

A bank also may use the internal models methodology for OTC derivatives, 

eligible margin loans, and repo-style transactions subject to a qualifying cross-product 
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master netting agreement if (i) the bank effectively integrates the risk mitigating effects 

of cross-product netting into its risk management and other information technology 

systems; and (ii) the bank obtains the prior written approval of its primary Federal 

supervisor. 

The final rule tracks the proposed rule by defining a qualifying cross-product 

master netting agreement as a qualifying master netting agreement that provides for 

termination and close-out netting across multiple types of financial transactions or 

qualifying master netting agreements in the event of a counterparty’s default, provided 

that: 

(i) The underlying financial transactions are OTC derivative contracts, eligible 

margin loans, or repo-style transactions; and 

(ii) The bank obtains a written legal opinion verifying the validity and 

enforceability of the netting agreement under applicable law of the relevant jurisdictions 

if the counterparty fails to perform upon an event of default, including upon an event of 

bankruptcy, insolvency, or similar proceeding. 

As discussed in the proposal, banks use several measures to manage their 

exposure to the counterparty credit risk of repo-style transactions, eligible margin loans, 

and OTC derivatives, including PFE, expected exposure (EE), and expected positive 

exposure (EPE). PFE is the maximum exposure estimated to occur over a future horizon 

at a high level of statistical confidence. Banks often use PFE when measuring 

counterparty credit risk exposure against counterparty credit limits. EE is the expected 

value of the probability distribution of non-negative credit risk exposures to a 

counterparty at any specified future date, whereas EPE is the time-weighted average of 
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individual expected exposures estimated for a given forecasting horizon (one year in the 

proposed rule). The final rule clarifies that, when estimating EE, a bank must set any 

negative market values in the probability distribution of market values to a counterparty 

at a specified future date to zero to convert the probability distribution of market values 

to the probability distribution of credit risk exposures. Banks typically compute EPE, 

EE, and PFE using a common stochastic model. 

A paper published by the BCBS in July 2005 titled “The Application of Basel II 

to Trading Activities and the Treatment of Double Default Effects” notes that EPE is an 

appropriate EAD measure for determining risk-based capital requirements for 

counterparty credit risk because transactions with counterparty credit risk “are given the 

same standing as loans with the goal of reducing the capital treatment’s influence on a 

firm’s decision to extend an on-balance sheet loan rather than engage in an economically 

equivalent transaction that involves exposure to counterparty credit risk.”79 An 

adjustment to EPE, called “effective EPE” and described below, is used in the calculation 

of EAD under the internal models methodology. EAD is calculated as a multiple of 

effective EPE. 

To address the concern that EE and EPE may not capture risk arising from the 

replacement of existing short-term positions over the one-year horizon used for capital 

requirements (rollover risk) or may underestimate the exposures of eligible margin loans, 

repo-style transactions, and OTC derivatives with short maturities, the final rule, like the 

proposed rule, uses a netting set’s effective EPE as the basis for calculating EAD for 

counterparty credit risk. Consistent with the use of a one-year PD horizon, effective EPE 

 

79 BCBS, “The Application of Basel II to Trading Activities and the Treatment of Double Default Effects,” 

July 2005, ¶ 15. 
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is the time-weighted average of effective EE over one year where the weights are the 

proportion that an individual effective EE represents in a one-year time interval. If all 

contracts in a netting set mature before one year, effective EPE is the average of effective 

EE until all contracts in the netting set mature. For example, if the longest maturity 

contract in the netting set matures in six months, effective EPE would be the average of 

effective EE over six months. 

Effective EE is defined as: 

Effective EEtk = max(Effective EEtk-1, EEtk) 

where exposure is measured at future dates t1, t2, t3,. . . and effective EEt0 equals 

current exposure. Alternatively, a bank may use a measure that is more conservative than 

effective EPE for every counterparty (that is, a measure based on peak exposure) with 

prior approval of its primary Federal supervisor. 

 The final rule clarifies that if a bank hedges some or all of the counterparty credit 

risk associated with a netting set using an eligible credit derivative, the bank may take the 

reduction in exposure to the counterparty into account when estimating EE. If the bank 

recognizes this reduction in exposure to the counterparty in its estimate of EE, it must 

also use its internal model to estimate a separate EAD for the bank’s exposure to the 

protection provider of the credit derivative. 

The EAD for instruments with counterparty credit risk must be determined 

assuming economic downturn conditions. To accomplish this determination in a prudent 

manner, the internal models methodology sets EAD equal to EPE multiplied by a scaling 

factor termed “alpha.” Alpha is set at 1.4; a bank’s primary Federal supervisor has the 

flexibility to raise this value based on the bank’s specific characteristics of counterparty 
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credit risk. In addition, with supervisory approval, a bank may use its own estimate of 

alpha, subject to a floor of 1.2. 

In the proposal, the agencies requested comment on all aspects of the effective 

EPE approach to counterparty credit risk and, in particular, on the appropriateness of the 

monotonically increasing effective EE function, the alpha constant of 1.4, and the floor 

on internal estimates of alpha of 1.2. Commenters expressed a number of objections to 

the proposed rule’s internal models methodology. 

Several commenters contended that banks that use the internal models 

methodology should be permitted to calculate effective EPE at the counterparty level and 

should not be required to calculate effective EPE at the netting set level. These 

commenters indicated that while the New Accord mandates calculation at the netting set 

level, those banks that currently use an EPE-style approach to measuring counterparty 

credit risk for internal risk management purposes typically use a counterparty-bycounterparty EPE approach. They asserted that forcing banks to use a netting-set-bynetting-set approach would be burdensome for banks and would provide the agencies no 

material regulatory benefits, as netting effects are taken into account in the calculation of 

EE. 

The agencies have retained the netting set focus of the calculation of effective 

EPE to preserve international consistency. The agencies will continue to review the 

implications, particularly with respect to the appropriate recognition of netting benefits, 

of allowing banks to calculate effective EPE at the counterparty level. 

One commenter objected to the proposed rule’s requirement that a bank use 

effective EE (as opposed to EE). This commenter contended that effective EE is an 
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excessively conservative and imprecise mechanism to address rollover risk in a portfolio 

of short-term transactions. The commenter represented that rollover risk should be 

addressed under Pillar 2 rather than Pillar 1. The agencies continue to believe that 

rollover risk is a core credit risk that should be covered by explicit risk-based capital 

requirements. The agencies also remain concerned that EE and EPE (as opposed to 

effective EE and effective EPE) would not adequately incorporate rollover risk and do 

not believe that bank internal estimates of rollover risk are sufficiently reliable at this 

time to use for risk-based capital purposes. To ensure consistency with the New Accord 

and in light of the lack of alternative prudent mechanisms to incorporate rollover risk, the 

agencies continue to include effective EE and effective EPE in the final rule. 

Several commenters criticized the default alpha of 1.4 and the 1.2 floor on 

internal estimates of alpha. These commenters contended that these supervisory alphas 

were too conservative for many dealer banks with large, diverse, and granular portfolios 

of repo-style transactions, eligible margin loans, and OTC derivatives. Although the 

agencies acknowledge the possibility that certain banks with certain types of portfolios at 

certain times could warrant an alpha of less than 1.2, the agencies believe it is important 

to have a supervisory floor on alpha. This floor will ensure consistency with the New 

Accord, comparability among the various banks that use the internal models 

methodology, and sufficient capital through the economic cycle for securities financing 

transactions and OTC derivatives. Therefore, the agencies are retaining the alpha floor as 

proposed. 

Similar to the proposal, under the final rule a bank’s primary Federal supervisor 

must determine that the bank meets certain qualifying criteria before the bank may use 
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the internal models methodology. These criteria consist of the following operational 

requirements, modeling standards, and model validation requirements. 

First, the bank must have the systems capability to estimate EE on a daily basis. 

While this requirement does not require the bank to report EE daily, or even estimate EE 

daily, the bank must demonstrate that it is capable of performing the estimation daily. 

Second, the bank must estimate EE at enough future time points to accurately 

reflect all future cash flows of contracts in the netting set. To accurately reflect the 

exposure arising from a transaction, the model should incorporate those contractual 

provisions, such as reset dates, that can materially affect the timing, probability, or 

amount of any payment. The requirement reflects the need for an accurate estimate of 

EPE. However, in order to balance the ability to calculate exposures with the need for 

information on timely basis, the number of time points is not specified. 

Third, the bank must have been using an internal model that broadly meets the 

minimum standards to calculate the distributions of exposures upon which the EAD 

calculation is based for a period of at least one year prior to approval. This requirement 

is to ensure that the bank has integrated the modeling into its counterparty credit risk 

management process. 

Fourth, the bank’s model must account for the non-normality of exposure 

distribution where appropriate. Non-normality of exposure distribution means high loss 

events occur more frequently than would be expected on the basis of a normal 

distribution, the statistical term for which is leptokurtosis. In many instances, there may 

not be a need to account for this. Expected exposures are much less likely to be affected 

by leptokurtosis than peak exposures or high percentile losses. However, the bank must 
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demonstrate that its EAD measure is not affected by leptokurtosis or must account for it 

within the model. 

Fifth, the bank must measure, monitor, and control the exposure to a counterparty 

over the whole life of all contracts in the netting set, in addition to accurately measuring 

and actively monitoring the current exposure to counterparties. The bank should exercise 

active management of both existing exposure and exposure that could change in the 

future due to market moves. 

Sixth, the bank must be able to measure and manage current exposures gross and 

net of collateral held, where appropriate. The bank must estimate expected exposures for 

OTC derivative contracts both with and without the effect of collateral agreements. By 

contrast, under the proposed rule, a bank would have to measure and manage current 

exposure gross and net of collateral held. Some commenters criticized this requirement 

as inconsistent with the New Accord and bank internal risk management practices. The 

agencies agree and have revised the rule to only require a bank to “be able to” measure 

and manage current exposures gross and net of collateral. 

Seventh, the bank must have procedures to identify, monitor, and control specific 

wrong-way risk throughout the life of an exposure. In this context, wrong-way risk is the 

risk that future exposure to a counterparty will be high when the counterparty’s 

probability of default is also high. Wrong-way risk generally arises from events specific 

to the counterparty, rather than broad market downturns. 

Eighth, the data used by the bank should be adequate for the measurement and 

modeling of the exposures. In particular, the model must use current market data to 

compute current exposures. When a bank uses historical data to estimate model 
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parameters, the bank must use at least three years of data that cover a wide range of 

economic conditions. This requirement reflects the longer horizon for counterparty credit 

risk exposures compared to market risk exposures. The data must be updated at least 

quarterly or more frequently if market conditions warrant. Banks should consider using 

model parameters based on forward looking measures, where appropriate. 

Ninth, the bank must subject its models used in the calculation of EAD to an 

initial validation and annual model review process. The model review should consider 

whether the inputs and risk factors, as well as the model outputs, are appropriate. The 

review of outputs should include a rigorous program of backtesting model outputs against 

realized exposures. 

Maturity under the internal models methodology

Like corporate loan exposures, counterparty exposure on netting sets is 

susceptible to changes in economic value that stem from deterioration in the 

counterparty’s creditworthiness short of default. The effective maturity parameter (M) 

reflects the impact of these changes on capital. The formula used to compute M for 

netting sets with maturities greater than one year must be different than that generally 

applied to wholesale exposures in order to reflect how counterparty credit exposures 

change over time. The final rule’s definition of M under the internal models 

methodology is identical to that of the proposed rule and is based on a weighted average 

of expected exposures over the life of the transactions relative to their one year 

exposures. Consistent with the New Accord, the final rule expands upon the proposal by 

providing that a bank that uses an internal model to calculate a one-sided credit valuation 
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adjustment may use the effective credit duration estimated by the model as M(EPE) in 

place of the formula in the paragraph below. 

If the remaining maturity of the exposure or the longest-dated contract contained 

in a netting set is greater than one year, the bank must set M for the exposure or netting 

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

(i) 

∑

∑

≤

=

>

×Δ×

×Δ×

+=

yeart

k

kkk

maturity

yeart

kkk

k

k

dftEeffectiveE

dftEE

EPEM 1

1

1 ( 1)

and (ii) dfk is the risk-free discount factor for future time period tk. The cap of five years 

on M is consistent with the treatment of wholesale exposures under section 31 of the rule. 

If the remaining maturity of the exposure or the longest-dated contract in the 

netting set is one year or less, the bank must set M for the exposure or netting set equal to 

one year except as provided in section 31(d)(7) of the rule. In this case, repo-style 

transactions, eligible margin loans, and collateralized OTC derivative transactions subject 

to daily remargining agreements may use the effective maturity of the longest maturity 

transaction in the netting set as M. 

Collateral agreements under the internal models methodology

The provisions of the final rule on collateral agreements under the internal models 

methodology are the same as those of the proposed rule. Under the final rule, if a bank 

has prior written approval from its primary Federal supervisor, it may capture within its 
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internal model the effect on EAD of a collateral agreement that requires receipt of 

collateral when exposure to the counterparty increases. In no circumstances, however, 

may a bank take into account in EAD collateral agreements triggered by deterioration of 

counterparty credit quality. Several commenters asked the agencies to permit banks to 

incorporate in EAD collateral agreements that are dependent on a decline in the external 

rating of the counterparty. The agencies do not believe that banks are able to model the 

necessary correlations with sufficient reliability to accept these types of collateral 

agreements under the internal models methodology at this time. 

In the context of the internal models methodology, the rule defines a collateral 

agreement as a legal contract that: (i) specifies the time when, and circumstances under 

which, the counterparty is required to exchange collateral with the bank for a single 

financial contract or for all financial contracts covered under a qualifying master netting 

agreement; and (ii) confers upon the bank a perfected, first priority security interest 

(notwithstanding the prior security interest of any custodial agent), or the legal equivalent 

thereof, in the collateral posted by the counterparty under the agreement. This security 

interest must provide the bank with a right to close out the financial positions and the 

collateral upon an event of default of or failure to perform by the counterparty under the 

collateral agreement. A contract would not satisfy this requirement if the bank’s exercise 

of rights under the agreement may be stayed or avoided under applicable law in the 

relevant jurisdictions. 

If a bank’s internal model does not capture the effects of collateral agreements, 

the final rule provides a “shortcut” method to provide the bank with some benefit, in the 

form of a smaller EAD, for collateralized counterparties. Under the shortcut method, 
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effective EPE is the lesser of a threshold amount (linked to the exposure amount at which 

a counterparty must post collateral) plus an add-on and effective EPE without a collateral 

agreement. Although any bank may use this “shortcut” method under the internal models 

methodology, the agencies expect banks that make extensive use of collateral agreements 

to develop the modeling capacity to measure the impact of such agreements on EAD. 

The shortcut method provided in the final rule is identical to the shortcut method 

provided in the proposed rule. 

Alternative methods 

 Under the final rule, consistent with the proposed rule, a bank using the internal 

models methodology may use an alternative method to determine EAD for certain 

transactions, provided that the bank can demonstrate to its primary Federal supervisor 

that the method’s output is more conservative than an alpha of 1.4 (or higher) times 

effective EPE. 

 Use of an alternative method may be appropriate where a new product or business 

line is being developed, where a recent acquisition has occurred, or where the bank 

believes that other more conservative methods to measure counterparty credit risk for a 

category of transactions are prudent. The alternative method should be applied to all 

similar transactions. When an alternative method is used, the bank should either treat the 

particular transactions concerned as a separate netting set with the counterparty or apply 

the alternative model to the entire original netting set. 

The agencies recognize that for new OTC derivative products a bank may need a 

transition period during which to incorporate a new product into its internal models 

methodology or to demonstrate that an alternative method is more conservative than an 
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alpha of 1.4 (or higher) times effective EPE. The final rule therefore provides that for 

material portfolios of new OTC derivative products, a bank may assume that the current 

exposure methodology in section 32(c) of the rule meets the conservatism requirement 

for a period not longer than 180 days. As a general matter, the agencies expect that the 

current exposure methodology in section 32(c) of the rule would be an acceptable, more 

conservative method for immaterial portfolios of OTC derivatives. 

5. Guarantees and credit derivatives that cover wholesale exposures

The New Accord specifies that a bank may adjust either the PD or the LGD of a 

wholesale exposure to reflect the risk mitigating effects of a guarantee or credit 

derivative. Similarly, under the final rule, as under the proposed rule, a bank may choose 

either a PD substitution or an LGD adjustment approach to recognize the risk mitigating 

effects of an eligible guarantee or eligible credit derivative on a wholesale exposure (or in 

certain circumstances may choose to use a double default treatment, as discussed below). 

In all cases a bank must use the same risk parameters for calculating ECL for a wholesale 

exposure as it uses for calculating the risk-based capital requirement for the exposure. 

Moreover, in all cases, a bank’s ultimate PD and LGD for the hedged wholesale exposure 

may not be lower than the PD and LGD floors discussed above and described in 

section 31(d) of the rule. 

Eligible guarantees and eligible credit derivatives

Under the proposed rule, guarantees and credit derivatives had to meet specific 

eligibility requirements to be recognized as CRM for a wholesale exposure. The 

proposed rule defined an eligible guarantee as a guarantee that: 

(i) Is written and unconditional; 
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(ii) Covers all or a pro rata portion of all contractual payments of the obligor on 

the reference exposure; 

(iii) Gives the beneficiary a direct claim against the protection provider; 

(iv) Is non-cancelable by the protection provider for reasons other than the breach 

of the contract by the beneficiary; 

(v) Is legally enforceable against the protection provider in a jurisdiction where 

the protection provider has sufficient assets against which a judgment may be attached 

and enforced; and 

(vi) Requires the protection provider to make payment to the beneficiary on the 

occurrence of a default (as defined in the guarantee) of the obligor on the reference 

exposure without first requiring the beneficiary to demand payment from the obligor. 

 Commenters suggested a number of improvements to the proposed definition of 

eligible guarantee. One commenter asked the agencies to clarify that the unconditionality 

requirement in criterion (i) of the definition would be interpreted consistently with the 

New Accord’s requirement that “there should be no clause in the protection contract 

outside the direct control of the bank that could prevent the protection provider from 

being obliged to pay out in a timely manner in the event that the original counterparty 

fails to make the payment(s) due.”80 The agencies are not providing the requested 

clarification. The agencies have acquired considerable experience in the intricate issue of 

the conditionality of guarantees under the general risk-based capital rules and intend to 

address the meaning of “unconditional” in the context of eligible guarantees under this 

final rule on a case-by-case basis going forward. 

 

80 New Accord, ¶189. 
DRAFT November 2, 2007 

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 This same commenter also asked the agencies to revise the second criterion of the 

definition from coverage of “all or a pro rata portion of all contractual payments of the 

obligor on the reference exposure” to coverage of “all or a pro rata portion of all principal 

or due and payable amounts on the reference exposure.” The agencies have decided to 

preserve the second criterion of the eligible guarantee definition without change to ensure 

that a bank only obtains CRM benefits from credit risk mitigants that cover all sources of 

credit exposure to the obligor. Although it is appropriate to provide partial CRM benefits 

under the wholesale framework for partial but pro rata guarantees of all contractual 

payments, the agencies are less comfortable with providing partial CRM benefits under 

the wholesale framework where the extent of the loss coverage of the credit exposure is 

not so easily quantifiable. Accordingly, for example, if a bank obtains a principal-only or 

interest-only guarantee of a corporate bond, the guarantee will not qualify as an eligible 

guarantee and the bank will not be able to obtain any CRM benefits from the guarantee. 

 Some commenters asked the agencies to modify the fourth criterion of the eligible 

guarantee definition to clarify, consistent with the New Accord, that a guarantee that is 

terminable by the bank and the protection provider by mutual consent may qualify as an 

eligible guarantee. This is an appropriate clarification of the definition and, therefore, the 

agencies have amended the fourth criterion of the definition to require that the guarantee 

be non-cancelable by the protection provider unilaterally. 

 One commenter asked the agencies to modify the fifth criterion of the eligible 

guarantee definition, which requires the guarantee to be legally enforceable in a 

jurisdiction where the protection provider has sufficient assets, by deleting the word 

“sufficient.” The agencies have preserved the fifth criterion of the proposed definition 
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intact. The agencies do not think that it would be consistent with safety and soundness to 

permit a bank to obtain CRM benefits under the rule if the guarantee were not legally 

enforceable against the protection provider in a jurisdiction where the protection provider 

has sufficient available assets. 

 Finally, some commenters objected to the sixth and final criterion of the eligible 

guarantee definition, which requires the protection provider to make payments to the 

beneficiary upon default of the obligor without first requiring the beneficiary to demand 

payment from the obligor. The agencies have decided to modify this criterion to make it 

more consistent with the New Accord and actual market practice. The final rule’s sixth 

criterion requires only that the guarantee permit the bank to obtain payment from the 

protection provider in the event of an obligor default in a timely manner and without first 

having to take legal actions to pursue the obligor for payment. 

 The agencies also have performed additional analysis and review of the definition 

of eligible guarantee and have decided to add two additional criteria to the definition. 

The first additional criterion prevents guarantees from certain affiliated companies from 

being eligible guarantees. Under the final rule, a guarantee will not be an eligible 

guarantee if the protection provider is an affiliate of the bank (other than an affiliated 

depository institution, bank, securities broker or dealer, or insurance company that does 

not control the bank and that is subject to consolidated supervision and regulation 

comparable to that imposed on U.S. depository institutions, securities broker-dealers, or 

insurance companies). For purposes of the definition, an affiliate of a bank is defined as 

a company that controls, is controlled by, or is under common control with, the bank. 

Control of a company is defined as (i) ownership, control, or holding with power to vote 
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25 percent or more of a class of voting securities of the company; or (ii) consolidation of 

the company for financial reporting purposes. 

 The strong correlations among the financial conditions of affiliated parties would 

typically render guarantees from affiliates of the bank of little value precisely when the 

bank would need them most – when the bank itself is in financial distress.81 For 

example, a guarantee that a bank might receive from its parent shell bank holding 

company would provide little credit risk mitigation to the bank as the bank approached 

insolvency because the financial condition of the holding company would depend 

critically on the financial health of the subsidiary bank. Moreover, the holding company 

typically would experience no increase in its regulatory capital requirement for issuing 

the guarantee because the guarantee would be on behalf of a consolidated subsidiary and 

would be eliminated in the consolidation of the holding company’s financial statements.82

 The agencies have decided, however, that a bank should be able to recognize 

CRM benefits by obtaining a guarantee from an affiliated insured depository institution, 

bank, securities broker or dealer, or insurance company that does not control the bank and 

that is subject to consolidated supervision and regulation comparable to that imposed on 

U.S. depository institutions, securities broker-dealers, or insurance companies (as the 

case may be). A depository institution for this purpose includes all subsidiaries of the 

depository institution except financial subsidiaries. The final rule recognizes guarantees 

from these types of affiliates because they are financial institutions subject to prudential 

 

81 This concern of the agencies is the same concern that led the agencies to exclude from the definition of 

tier 1 capital any instrument that has credit-sensitive features – such as an interest rate or dividend rate that 

increases as the credit quality of the bank issuer declines or an investor put right that is triggered by a 

decline in issuer credit quality. See, e.g., 12 CFR part 208, appendix A, section II.A.1.b. 82 Although the Board’s Regulation W places strict quantitative and qualitative limits on guarantees issued 

by a bank on behalf of an affiliate, it does not restrict all guarantees issued by an affiliate on behalf of a 

bank. See, e.g., 12 CFR 223.3(e). 
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regulation by national or state supervisory authorities. The agencies expect that the 

prudential regulation of the affiliate would help prevent the affiliate from exposing itself 

excessively to the credit exposures of the bank. Similarly, these affiliates would be 

subject to regulatory capital requirements of their own and should experience an increase 

in their regulatory capital requirements for issuing the guarantee. 

 The second additional criterion precludes a guarantee from eligible guarantee 

status if the guarantee increases the beneficiary’s cost of credit protection in response to 

deterioration in the credit quality of the reference exposure. This additional criterion is 

consistent with the New Accord’s treatment of guarantees and with the proposed rule’s 

operational requirements for synthetic securitizations. 

The proposed rule defined an eligible credit derivative as a credit derivative in the 

form of a credit default swap, nth-to-default swap, or total return swap provided that: 

(i) The contract meets the requirements of an eligible guarantee and has been 

confirmed by the protection purchaser and the protection provider; 

(ii) Any assignment of the contract has been confirmed by all relevant parties; 

(iii) If the credit derivative is a credit default swap or nth-to-default swap, the 

contract includes the following credit events: 

(A) Failure to pay any amount due under the terms of the reference exposure 

(with a grace period that is closely in line with the grace period of the reference 

exposure); and 

(B) Bankruptcy, insolvency, or inability of the obligor on the reference exposure 

to pay its debts, or its failure or admission in writing of its inability generally to pay its 

debts as they become due, and similar events; 
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(iv) The terms and conditions dictating the manner in which the contract is to be 

settled are incorporated into the contract; 

(v) If the contract allows for cash settlement, the contract incorporates a robust 

valuation process to estimate loss reliably and specifies a reasonable period for obtaining 

post-credit event valuations of the reference exposure; 

(vi) If the contract requires the protection purchaser to transfer an exposure to the 

protection provider at settlement, the terms of the exposure provide that any required 

consent to transfer may not be unreasonably withheld; 

(vii) If the credit derivative is a credit default swap or nth-to-default swap, the 

contract clearly identifies the parties responsible for determining whether a credit event 

has occurred, specifies that this determination is not the sole responsibility of the 

protection provider, and gives the protection purchaser the right to notify the protection 

provider of the occurrence of a credit event; and 

(viii) If the credit derivative is a total return swap and the bank records net 

payments received on the swap as net income, the bank records offsetting deterioration in 

the value of the hedged exposure (either through reductions in fair value or by an addition 

to reserves). 

Commenters generally supported the proposed rule’s definition of eligible credit 

derivative, but two commenters asked for a series of changes. These commenters asked 

that the final rule specifically reference contingent credit default swaps (CCDSs) in the 

list of eligible forms of credit derivatives. CCDS are a relatively new type of credit 

derivative, and the agencies are still considering their appropriate role within the riskbased capital rules. However, to enable the rule to adapt to future market innovations, the 
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agencies have revised the definition of eligible credit derivative to add to the list of 

eligible credit derivative forms “any other form of credit derivative approved by” the 

bank’s primary Federal supervisor.83

One commenter asked that the agencies amend the third criterion of the eligible 

credit derivative definition, which applies to credit default swaps and nth-to-default 

swaps. The commenter indicated that standard practice in the credit derivatives market is 

for a credit default swap to contain provisions that exempt the protection provider from 

making default payments to the protection purchaser if the reference obligor’s failure to 

pay is in an amount below a de minimis threshold. The agencies do not believe that 

safety and soundness would be materially impaired by conforming this criterion of the 

eligible credit derivative definition to the current standard market practice. Under the 

final rule, therefore, a credit derivative will satisfy the definition of an eligible credit 

derivative if the protection provider’s obligation to make default payments to the 

protection purchaser is triggered only if the reference obligor’s failure to pay exceeds any 

applicable minimal payment threshold that is consistent with standard market practice. 

Finally, a commenter asked for clarification of the meaning of the sixth criterion 

of the definition of eligible credit derivative, which states that if the contract requires the 

protection purchaser to transfer an exposure to the protection provider at settlement, the 

terms of the exposure provide that any required consent to transfer may not be 

unreasonably withheld. To address any potential ambiguity about which exposure’s 

transferability must be analyzed, the agencies have amended the sixth component to read: 

 

83 One commenter also asked the agencies to clarify that a bank should translate the phrase “beneficiary” in 

the definition of eligible guarantee to “protection purchaser” when confirming that a credit derivative meets 

all the requirements of the definition of eligible guarantee. The agencies have not amended the rule to 

address this point, but do confirm that such translation is appropriate. 
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“If the contract requires the protection purchaser to transfer an exposure to the protection 

provider at settlement, the terms of at least one of the exposures that is permitted to be 

transferred under the contract must provide that any required consent to transfer may not 

be unreasonably withheld.” 

The proposed rule also provided that a bank may recognize an eligible credit 

derivative that hedges an exposure that is different from the credit derivative’s reference 

exposure used for determining the derivative’s cash settlement value, deliverable 

obligation, or occurrence of a credit event only if: 

(i) The reference exposure ranks pari passu (that is, equal) or junior to the hedged 

exposure; and 

(ii) The reference exposure and the hedged exposure are exposures to the same 

legal entity, and legally enforceable cross-default or cross-acceleration clauses are in 

place. 

One commenter acknowledged that the proposal’s pari passu ceiling is consistent 

with the New Accord but asked for clarification that the provision only requires reference 

exposure equality or subordination with respect to priority of payments. Although the 

agencies have concluded that it is not necessary to amend the rule to provide this 

clarification, the agencies agree that the pari passu ceiling relates to priority of payments 

only. 

Two commenters also asked the agencies to provide an exception to the crossdefault/cross-acceleration requirement where the hedged exposure is an OTC derivative 

contract or a qualifying master netting agreement that covers OTC derivative contracts. 

Although some parts of the debt markets have incorporated obligations from OTC 
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derivative contracts in cross-default/cross-acceleration clauses, the commenter asserted 

that the practice is not prevalent in many parts of the market. In addition, the commenter 

maintained that, unlike a failure to pay on a loan or a bond, failure to pay on an OTC 

derivative contract generally would not trigger a credit event with respect to the reference 

exposure of the credit default swap. The agencies have not made this change. The 

proposed cross-default/cross-acceleration requirement is consistent with the New Accord. 

In addition, the agencies are reluctant to permit a bank to obtain CRM benefits for an 

exposure hedged by a credit derivative whose reference exposure is different than the 

hedged exposure unless the hedged and reference exposures would default 

simultaneously. If the hedged exposure could default prior to the default of the reference 

exposure, the bank may suffer losses on the hedged exposure and not be able to collect 

default payments on the credit derivative. The final rule clarifies that, in order to 

recognize the credit risk mitigation benefits of an eligible credit derivative, crossdefault/cross-acceleration provisions must assure payments under the credit derivative are 

triggered if the obligor fails to pay under the terms of the hedged exposure. 

PD substitution approach

Under the PD substitution approach of the final rule, as under the proposal, if the 

protection amount (as defined below) of the eligible guarantee or eligible credit 

derivative is greater than or equal to the EAD of the hedged exposure, a bank may 

substitute for the PD of the hedged exposure the PD associated with the rating grade of 

the protection provider. If the bank determines that full substitution leads to an 

inappropriate degree of risk mitigation, the bank may substitute a higher PD for that of 

the protection provider. 
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If the guarantee or credit derivative provides the bank with the option to receive 

immediate payout on triggering the protection, then the bank must use the lower of the 

LGD of the hedged exposure (not adjusted to reflect the guarantee or credit derivative) 

and the LGD of the guarantee or credit derivative. If the guarantee or credit derivative 

does not provide the bank with the option to receive immediate payout on triggering the 

protection (and instead provides for the guarantor to assume the payment obligations of 

the obligor over the remaining life of the hedged exposure), the bank must use the LGD 

of the guarantee or credit derivative. 

If the protection amount of the eligible guarantee or eligible credit derivative is 

less than the EAD of the hedged exposure, however, the bank must treat the hedged 

exposure as two separate exposures (protected and unprotected) to recognize the credit 

risk mitigation benefit of the guarantee or credit derivative. The bank must calculate its 

risk-based capital requirement for the protected exposure under section 31 of the rule 

(using a PD equal to the protection provider’s PD, an LGD determined as described 

above, and an EAD equal to the protection amount of the guarantee or credit derivative). 

If the bank determines that full substitution leads to an inappropriate degree of risk 

mitigation, the bank may use a higher PD than that of the protection provider. The bank 

must calculate its risk-based capital requirement for the unprotected exposure under 

section 31 of the rule (using a PD equal to the obligor’s PD, an LGD equal to the hedged 

exposure’s LGD not adjusted to reflect the guarantee or credit derivative, and an EAD 

equal to the EAD of the original hedged exposure minus the protection amount of the 

guarantee or credit derivative). 
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 The protection amount of an eligible guarantee or eligible credit derivative is 

defined as the effective notional amount of the guarantee or credit derivative reduced by 

any applicable haircuts for maturity mismatch, lack of restructuring, and currency 

mismatch (each described below). The effective notional amount of a guarantee or credit 

derivative is the lesser of the contractual notional amount of the credit risk mitigant and 

the EAD of the hedged exposure, multiplied by the percentage coverage of the credit risk 

mitigant. For example, the effective notional amount of a guarantee that covers, on a pro 

rata basis, 40 percent of any losses on a $100 bond would be $40. 

 The agencies received no material comments on the above-described structure of 

the PD substitution approach, and the final rule’s PD substitution approach is 

substantially the same as that of the proposed rule. 

LGD adjustment approach

Under the LGD adjustment approach of the final rule, as under the proposal, if the 

protection amount of the eligible guarantee or eligible credit derivative is greater than or 

equal to the EAD of the hedged exposure, the bank’s risk-based capital requirement for 

the hedged exposure is the greater of (i) the risk-based capital requirement for the 

exposure as calculated under section 31 of the rule (with the LGD of the exposure 

adjusted to reflect the guarantee or credit derivative); or (ii) the risk-based capital 

requirement for a direct exposure to the protection provider as calculated under 

section 31 of the rule (using the bank’s PD for the protection provider, the bank’s LGD 

for the guarantee or credit derivative, and an EAD equal to the EAD of the hedged 

exposure). 
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If the protection amount of the eligible guarantee or eligible credit derivative is 

less than the EAD of the hedged exposure, however, the bank must treat the hedged 

exposure as two separate exposures (protected and unprotected) in order to recognize the 

credit risk mitigation benefit of the guarantee or credit derivative. The bank’s risk-based 

capital requirement for the protected exposure would be the greater of (i) the risk-based 

capital requirement for the protected exposure as calculated under section 31 of the rule 

(with the LGD of the exposure adjusted to reflect the guarantee or credit derivative and 

EAD set equal to the protection amount of the guarantee or credit derivative); or (ii) the 

risk-based capital requirement for a direct exposure to the protection provider as 

calculated under section 31 of the rule (using the bank’s PD for the protection provider, 

the bank’s LGD for the guarantee or credit derivative, and an EAD set equal to the 

protection amount of the guarantee or credit derivative). The bank must calculate its riskbased capital requirement for the unprotected exposure under section 31 of the rule using 

a PD set equal to the obligor’s PD, an LGD set equal to the hedged exposure’s LGD (not 

adjusted to reflect the guarantee or credit derivative), and an EAD set equal to the EAD 

of the original hedged exposure minus the protection amount of the guarantee or credit 

derivative. 

 The agencies received no material comments on the above-described structure of 

the LGD adjustment approach, and the final rule’s LGD adjustment approach is 

substantially the same as that of the proposed rule. 

The PD substitution approach allows a bank to effectively assess risk-based 

capital against a hedged exposure as if it were a direct exposure to the protection 

provider, and the LGD adjustment approach produces a risk-based capital requirement for 
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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 and the 

proposed rule, to recognize double default benefits in the wholesale framework only for 

certain hedged exposures covered by certain guarantees and credit derivatives. A later 

section of the preamble describes which hedged exposures are eligible for the double 

default treatment and describes the double default treatment that is available to those 

exposures. 

Maturity mismatch haircut

Under the final rule, a bank that seeks to reduce the risk-based capital requirement 

on a wholesale exposure by recognizing an eligible guarantee or eligible credit derivative 

must adjust the effective notional amount of the credit risk mitigant downward to reflect 

any maturity mismatch between the hedged exposure and the credit risk mitigant. A 

maturity mismatch occurs when the residual maturity of a credit risk mitigant is less than 

that of the hedged exposure(s). 

The proposed rule provided, consistent with the New Accord, that when the 

hedged exposures have different residual maturities, the longest residual maturity of any 

of the hedged exposures would be used as the residual maturity of all hedged exposures. 

One commenter criticized this provision as excessively conservative. The agencies agree 
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and have decided to restrict the application of this provision to securitization CRM.84 

Accordingly, under the final rule, to calculate the risk-based capital requirement for a 

group of hedged wholesale exposures that are covered by a single eligible guarantee 

under which the protection provider has agreed to backstop all contractual payments 

associated with each hedged exposure, a bank should treat each hedged exposure as if it 

were fully covered by a separate eligible guarantee. To determine whether any of the 

hedged wholesale exposures has a maturity mismatch with the eligible guarantee, the 

bank must assess whether the residual maturity of the eligible guarantee is less than that 

of the hedged exposure. 

The residual maturity of a hedged exposure is the longest possible remaining time 

before the obligor is scheduled to fulfil its obligation on the exposure. When determining 

the residual maturity of the guarantee or credit derivative, embedded options that may 

reduce the term of the credit risk mitigant must be taken into account so that the shortest 

possible residual maturity for the credit risk mitigant is used to determine the potential 

maturity mismatch. Where a call is at the discretion of the protection provider, the 

residual maturity of the guarantee or credit derivative is the first call date. If the call is at 

the discretion of the bank purchasing the protection, but the terms of the arrangement at 

inception of the guarantee or credit derivative contain a positive incentive for the bank to 

call the transaction before contractual maturity, the remaining time to the first call date is 

the residual maturity of the credit risk mitigant. For example, where there is a step-up in 

the cost of credit protection in conjunction with a call feature or where the effective cost 

 

84 Under the final rule, if an eligible guarantee provides tranched credit protection to a group of hedged 

exposures – for example, the guarantee covers the first 2 percent of aggregate losses for the group – the 

bank must determine the risk-based capital requirements for the hedged exposures under the securitization 

framework. 
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of protection increases over time even if credit quality remains the same or improves, the 

residual maturity of the credit risk mitigant is the remaining time to the first call. 

Eligible guarantees and eligible credit derivatives with maturity mismatches may 

only be recognized if their original maturities are equal to or greater than one year. As a 

result, a guarantee or credit derivative is not recognized for a hedged exposure with an 

original maturity of less than one year unless the credit risk mitigant has an original 

maturity of equal to or greater than one year or an effective residual maturity equal to or 

greater than that of the hedged exposure. In all cases, credit risk mitigants with maturity 

mismatches may not be recognized when they have an effective residual maturity of three 

months or less. 

When a maturity mismatch exists, a bank must apply the following maturity 

mismatch adjustment to determine the effective notional amount of the guarantee or 

credit derivative adjusted for maturity mismatch: Pm = E x (t-0.25)/(T-0.25), where: 

(i) Pm = effective notional amount of the credit risk mitigant adjusted for maturity 

mismatch; 

(ii) E = effective notional amount of the credit risk mitigant; 

(iii) t = lesser of T or effective residual maturity of the credit risk mitigant, 

expressed in years; and 

(iv) T = lesser of 5 or effective residual maturity of the hedged exposure, 

expressed in years. 

Other than as discussed above with respect to pools of hedged exposures with 

different residual maturities, the final rule’s provisions on maturity mismatch do not 

differ from those of the proposed rule. 
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Restructuring haircut

Under the final rule, as under the proposed rule, a bank that seeks to recognize an 

eligible credit derivative that does not include a distressed restructuring as a credit event 

that triggers payment under the derivative must reduce the recognition of the credit 

derivative by 40 percent. A distressed restructuring is a restructuring of the hedged 

exposure involving forgiveness or postponement of principal, interest, or fees that results 

in a charge-off, specific provision, or other similar debit to the profit and loss account. 

In other words, the effective notional amount of the credit derivative adjusted for 

lack of restructuring credit event (and maturity mismatch, if applicable) is: Pr = Pm x 

0.60, where: 

(i) Pr = effective notional amount of the credit risk mitigant, adjusted for lack of 

restructuring credit event (and maturity mismatch, if applicable); and 

(ii) Pm = effective notional amount of the credit risk mitigant adjusted for 

maturity mismatch (if applicable). 

Two commenters opposed the 40 percent restructuring haircut. One commenter 

contended that the 40 percent haircut is too punitive. The other commenter contended 

that the 40 percent haircut should not apply when the hedged exposure is an OTC 

derivative contract or a qualifying master netting agreement that covers OTC derivative 

contracts. The 40 percent haircut is a rough estimate of the reduced CRM benefits that 

accrue to a bank that purchases a credit derivative without restructuring coverage. 

Nonetheless, the agencies recognize that restructuring events could result in substantial 

economic losses to a bank. Moreover, the 40 percent haircut is consistent with the New 

Accord and is a reasonably prudent mechanism for ensuring that banks do not receive 
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excessive CRM benefits for purchasing credit protection that does not cover all material 

sources of economic loss to the bank on the hedged exposure. 

The final rule’s provisions on lack of restructuring as a credit event do not differ 

from those of the proposed rule. 

Currency mismatch haircut

Under the final rule, as under the proposed rule, where the eligible guarantee or 

eligible credit derivative is denominated in a currency different from that in which any 

hedged exposure is denominated, the effective notional amount of the guarantee or credit 

derivative must be adjusted for currency mismatch (and maturity mismatch and lack of 

restructuring credit event, if applicable). The adjusted effective notional amount is 

calculated as: Pc = Pr x (1-Hfx), where: 

(i) Pc = effective notional amount of the credit risk mitigant, adjusted for currency 

mismatch (and maturity mismatch and lack of restructuring credit event, if applicable); 

(ii) Pr = effective notional amount of the credit risk mitigant (adjusted for 

maturity mismatch and lack of restructuring credit event, if applicable); and 

(iii) Hfx = haircut appropriate for the currency mismatch between the credit risk 

mitigant and the hedged exposure. 

 A bank may use a standard supervisory haircut of 8 percent for Hfx (based on a 

ten-business-day holding period and daily marking-to-market and remargining). 

Alternatively, a bank may use internally estimated haircuts for Hfx based on a tenbusiness-day holding period and daily marking-to-market and remargining if the bank 

qualifies to use the own-estimates haircuts in paragraph (b)(2)(iii) of section 32, the 

simple VaR methodology in paragraph (b)(3) of section 32, or the internal models 
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methodology in paragraph (d) of section 32 of the rule. The bank must scale these 

haircuts up using a square root of time formula if the bank revalues the guarantee or 

credit derivative less frequently than once every ten business days. 

 The agencies received no comments on the currency mismatch provisions 

discussed above, and the final rule’s provisions on currency mismatch do not differ from 

those of the proposed rule. 

Example

 Assume that a bank holds a five-year $100 corporate exposure, purchases a $100 

credit derivative to mitigate its credit risk on the exposure, and chooses to use the PD 

substitution approach. The unsecured LGD of the corporate exposure is 30 percent; the 

LGD of the credit derivative is 80 percent. The credit derivative is an eligible credit 

derivative, has the bank’s exposure as its reference exposure, has a three-year maturity, 

no restructuring provision, no currency mismatch with the bank’s hedged exposure, and 

the protection provider assumes the payment obligations of the obligor upon default. The 

effective notional amount and initial protection amount of the credit derivative would be 

$100. The maturity mismatch would reduce the protection amount to $100 x (3-.25)/(5-

.25) or $57.89. The haircut for lack of restructuring would reduce the protection amount 

to $57.89 x 0.6 or $34.74. So the bank would treat the $100 corporate exposure as two 

exposures: (i) an exposure of $34.74 with the PD of the protection provider, an LGD of 

80 percent, and an M of five; and (ii) an exposure of $65.26 with the PD of the obligor, 

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

Multiple credit risk mitigants
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The New Accord provides that if multiple credit risk mitigants (for example, two 

eligible guarantees) cover a single exposure, a bank must disaggregate the exposure into 

portions covered by each credit risk mitigant (for example, the portion covered by each 

guarantee) and must calculate separately the risk-based capital requirement of each 

portion.85 The New Accord also indicates that when credit risk mitigants provided by a 

single protection provider have differing maturities, they should be subdivided into 

separate layers of protection.86 In the proposal, the agencies invited comment on whether 

and how the agencies should address these and other similar situations in which multiple 

credit risk mitigants cover a single exposure. 

Commenters generally agreed that the agencies should provide additional 

guidance about how to address situations where multiple credit risk mitigants cover a 

single exposure. Although one commenter recommended that the agencies permit banks 

effectively to recognize triple default benefits in situations where two credit risk 

mitigants cover a single exposure, commenters did not provide material specific 

suggestions as to their preferred approach to addressing these situations. Thus, the 

agencies have decided to adopt the New Accord’s principles for dealing with multiple 

credit risk mitigant situations. The agencies have added several additional provisions to 

section 33(a) of the final rule to provide clarity in this area. 

Double default treatment

As noted above, the final rule, like the proposed rule, contains a separate riskbased capital methodology for hedged exposures eligible for double default treatment. 

The final rule’s double default provisions are identical to those of the proposed rule, with 

 

85 New Accord, ¶206. 

86 Id. 
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the exception of some limited changes to the definition of an eligible double default 

guarantor discussed below. 

To be eligible for double default treatment, a hedged exposure must be fully 

covered or covered on a pro rata basis (that is, there must be no tranching of credit risk) 

by an uncollateralized single-reference-obligor credit derivative or guarantee (or certain 

nth-to-default credit derivatives) provided by an eligible double default guarantor (as 

defined below). Moreover, the hedged exposure must be a wholesale exposure other than 

a sovereign exposure.87 In addition, the obligor of the hedged exposure must not be an 

eligible double default guarantor, an affiliate of an eligible double default guarantor, or 

an affiliate of the guarantor. 

 The proposed rule defined eligible double default guarantor to include a 

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

(12 U.S.C. 1813)); a bank holding company (as defined in section 2 of the Bank Holding 

Company Act (12 U.S.C. 1841)); a savings and loan holding company (as defined in 

12 U.S.C. 1467a) provided all or substantially all of the holding company’s activities are 

permissible for a financial holding company under 12 U.S.C. 1843(k)); a securities 

broker or dealer registered (under the Securities Exchange Act of 1934) with the 

Securities and Exchange Commission (SEC); an insurance company in the business of 

providing credit protection (such as a monoline bond insurer or re-insurer) that is subject 

to supervision by a state insurance regulator; a foreign bank (as defined in section 211.2 

of the Federal Reserve Board’s Regulation K (12 CFR 211.2)); a non-U.S. securities 

firm; or a non-U.S. based insurance company in the business of providing credit 

 

87 The New Accord permits certain retail small business exposures to be eligible for double default 

treatment. Under the final rule, however, a bank must effectively desegment a retail small business 

exposure (thus rendering it a wholesale exposure) to make it eligible for double default treatment. 
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protection. The proposal required an eligible double default guarantor to (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 

investment grade. In addition, the proposal permitted a non-U.S. based bank, securities 

firm, or insurance company to qualify as an eligible double default guarantor only if the 

firm were subject to consolidated supervision and regulation comparable to that imposed 

on U.S. depository institutions, securities firms, or insurance companies (as the case may 

be) or had issued and outstanding an unsecured long-term debt security without credit 

enhancement that had a long-term applicable external rating in one of the three highest 

investment-grade rating categories. 

 Commenters expressed two principal criticisms of the proposed definition of an 

eligible double default guarantor. First, commenters asked the agencies to conform the 

definition to the New Accord by permitting a foreign financial firm to qualify so long as 

it had an outstanding long-term debt security with an external rating of investment grade 

or higher (for example, BBB- or higher) instead of in one of the three highest investmentgrade rating categories (for example, A- or higher). In light of the other eligibility 

criteria, the agencies have concluded that it would be appropriate to conform this 

provision of the definition to the New Accord. 

 Commenters also requested that the agencies conform the definition of eligible 

double default guarantor to the New Accord by permitting a financial firm to qualify so 

long as it had a bank-assigned PD, at the time the guarantor issued the guarantee or credit 
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derivative or at any time thereafter, that was equal to or lower than the PD associated 

with a long-term external rating of at least the third highest investment-grade rating 

category. In light of the other eligibility criteria, the agencies have concluded that it 

would be appropriate to conform this provision of the definition to the New Accord. 

 Effectively, under the final rule, the scope of an eligible double default guarantor 

is limited to financial firms whose normal business includes the provision of credit 

protection, as well as the management of a diversified portfolio of credit risk. This 

restriction arises from the agencies’ concern to limit double default recognition to 

financial institutions that have a high level of credit risk management expertise and that 

provide sufficient market disclosure. The restriction is also designed to limit the risk of 

excessive correlation between the creditworthiness of the guarantor and the obligor of the 

hedged exposure due to their performance depending on common economic factors 

beyond the systematic risk factor. As a result, hedged exposures to potential credit 

protection providers or affiliates of credit protection providers are not eligible for the 

double default treatment. In addition, the agencies have excluded hedged exposures to 

sovereign entities from eligibility for double default treatment because of the potential 

high correlation between the creditworthiness of a sovereign and that of a guarantor. 

 One commenter urged the agencies to delete the requirement that the obligor of a 

hedged exposure that qualifies for double default treatment not be an eligible double 

default guarantor or an affiliate of such an entity. This commenter represented that this 

requirement significantly constrained the scope of application of double default treatment 

and assumed inappropriately that there is an excessive amount of correlation among all 

financial firms. The agencies acknowledge that this requirement is a crude mechanism to 
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prevent excessive wrong-way risk, but the agencies have decided to retain the 

requirement in light of its consistency with the New Accord and the limited ability of 

banks to measure accurately correlations among obligors. 

In addition to limiting the types of guarantees, credit derivatives, guarantors, and 

hedged exposures eligible for double default treatment, the rule limits wrong-way risk 

further by requiring a bank to implement a process to detect excessive correlation 

between the creditworthiness of the obligor of the hedged exposure and the protection 

provider. The bank must receive prior written approval from its primary Federal 

supervisor for this process in order to recognize double default benefits for risk-based 

capital purposes. To apply double default treatment to a particular hedged exposure, the 

bank must determine that there is not excessive correlation between the creditworthiness 

of the obligor of the hedged exposure and the protection provider. For example, the 

creditworthiness of an obligor and a protection provider would be excessively correlated 

if the obligor derives a high proportion of its income or revenue from transactions with 

the protection provider. If excessive correlation is present, the bank may not use the 

double default treatment for the hedged exposure. 

The risk-based capital requirement for a hedged exposure subject to double 

default treatment is calculated by multiplying a risk-based capital requirement for the 

hedged exposure (as if it were unhedged) by an adjustment factor that considers the PD 

of the protection provider (see section 34 of the rule). Thus, the PDs of both the obligor 

of the hedged exposure and the protection provider are factored into the hedged 

exposure’s risk-based capital requirement. In addition, as under the PD substitution 

treatment in section 33 of the rule, the bank is allowed to set LGD equal to the lower of 
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the LGD of the hedged exposure (not adjusted to reflect the guarantee or credit 

derivative) or the LGD of the guarantee or credit derivative if the guarantee or credit 

derivative provides the bank with the option to receive immediate payout on the 

occurrence of a credit event. Otherwise, the bank must set LGD equal to the LGD of the 

guarantee or credit derivative. Accordingly, in order to apply the double default 

treatment, the bank must estimate a PD for the protection provider and an LGD for the 

guarantee or credit derivative. Finally, a bank using the double default treatment must 

make applicable adjustments to the protection amount of the guarantee or credit 

derivative to reflect maturity mismatches, currency mismatches, and lack of restructuring 

coverage (as under the PD substitution and LGD adjustment approaches in section 33 of 

the rule). 

One commenter objected that the calibration of the double default formula under 

the proposed rule was too conservative because it assumed an excessive amount of 

correlation between the obligor of the hedged exposure and the protection provider. The 

agencies have decided to leave the calibration unaltered in light of its consistency with 

the New Accord. The agencies will evaluate this decision over time and will raise this 

issue with the BCBS if appropriate. 

6. Guarantees and credit derivatives that cover retail exposures

 Like the proposal, the final rule provides a different treatment for guarantees and 

credit derivatives that cover retail exposures than for those that cover wholesale 

exposures. The approach set forth above for guarantees and credit derivatives that cover 

wholesale exposures is an exposure-by-exposure approach consistent with the overall 

exposure-by-exposure approach the rule takes to wholesale exposures. The agencies 
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believe that a different treatment for guarantees that cover retail exposures is necessary 

and appropriate because of the rule’s segmentation approach to retail exposures. The 

approaches to retail guarantees described in this section generally apply only to 

guarantees of individual retail exposures. Guarantees of multiple retail exposures (such 

as pool private mortgage insurance (PMI)) are typically tranched (that is, they cover less 

than the full amount of the hedged exposures) and, therefore, are securitization exposures 

under the final rule. 

The rule does not specify the ways in which guarantees and credit derivatives may 

be taken into account in the segmentation of retail exposures. Likewise, the rule does not 

explicitly limit the extent to which a bank may take into account the credit risk mitigation 

benefits of guarantees and credit derivatives in its estimation of the PD and LGD of retail 

segments, except by the application of overall floors on certain PD and LGD 

assignments. This approach has the principal advantage of being relatively easy for 

banks to implement – the approach generally would not disrupt the existing retail 

segmentation practices of banks and would not interfere with banks’ quantification of PD 

and LGD for retail segments. 

In the proposal, the agencies expressed some concern, however, that this approach 

would provide banks with substantial discretion to incorporate double default and double 

recovery effects. To address these concerns, the preamble to the proposed rule described 

two possible alternative treatments for guarantees of retail exposures. The first 

alternative distinguished between eligible retail guarantees and all other (non-eligible) 

guarantees of retail exposures. Under this alternative, an eligible retail guarantee would 

be an eligible guarantee that applies to a single retail exposure and is (i) PMI issued by a 
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highly creditworthy insurance company; or (ii) issued by a sovereign entity or a political 

subdivision of a sovereign entity. 

Under this alternative, a bank would be able to recognize the credit risk mitigation 

benefits of eligible retail guarantees that cover retail exposures in a segment by adjusting 

its estimates of LGD for the segment to reflect recoveries from the guarantor. However, 

the bank would have to estimate the PD of a segment without reflecting the benefit of 

guarantees. Specifically, a segment’s PD would be an estimate of the stand-alone 

probability of default for the retail exposures in the segment, before taking account of any 

guarantees. Accordingly, for this limited set of traditional guarantees of retail exposures 

by high credit quality guarantors, a bank would be allowed to recognize the benefit of the 

guarantee when estimating LGD but not when estimating PD. 

This alternative approach would provide a different treatment for non-eligible 

retail guarantees. In short, within the retail framework, a bank would not be able to 

recognize non-eligible retail guarantees when estimating PD and LGD for any segment of 

retail exposures. A bank would be required to estimate PD and LGD for segments 

containing retail exposures with non-eligible guarantees as if the exposures were not 

guaranteed. However, a bank would be permitted to recognize non-eligible retail 

guarantees provided by a wholesale guarantor by treating the hedged retail exposure as a 

direct exposure to the guarantor and applying the appropriate wholesale IRB risk-based 

capital formula. In other words, for retail exposures covered by non-eligible retail 

guarantees, a bank would be permitted to reflect the guarantee by “desegmenting” the 

retail exposures (which effectively would convert the retail exposures into wholesale 

exposures) and then applying the rules set forth above for guarantees that cover 
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wholesale exposures. Thus, under this approach, a bank would not be allowed to 

recognize either double default or double recovery effects for non-eligible retail 

guarantees. 

A second alternative that the agencies described in the preamble to the proposed 

rule would permit a bank to recognize the credit risk mitigation benefits of all eligible 

guarantees (whether eligible retail guarantees or not) that cover retail exposures by 

adjusting its estimates of LGD for the relevant segments, but would subject a bank’s riskbased capital requirement for a segment of retail exposures that are covered by one or 

more non-eligible retail guarantees to a floor. Under this second alternative, the agencies 

could impose a floor on risk-based capital requirements of between 2 percent and 

6 percent on such a segment of retail exposures. 

A substantial number of commenters supported the flexible approach in the text of 

the proposed rule. A few commenters also supported the first alternative approach in the 

preamble of the proposed rule. Commenters uniformly urged the agencies not to adopt 

the second alternative approach. The agencies have decided to adopt the approach to 

retail guarantees in the text of the proposed rule and not to adopt either alternative 

approach described in the proposed rule preamble. Although the first alternative 

approach addresses prudential concerns, the agencies have concluded that it is 

excessively conservative and prescriptive and would not harmonize with banks’ internal 

risk measurement and management practices. The agencies also have determined that the 

second alternative approach is insufficiently risk sensitive and is not consistent with the 

New Accord. In light of the final rule’s flexible approach to retail guarantees, the 

agencies expect banks to limit their use of guarantees in the retail segmentation process 
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and retail risk parameter estimation process to situations where the bank has particularly 

reliable data about the CRM benefits of such guarantees. 

D. Unsettled Securities, Foreign Exchange, and Commodity Transactions 

Section 35 of the final rule describes the risk-based capital requirements for 

unsettled and failed securities, foreign exchange, and commodities transactions. The 

agencies did not receive any material comments on this aspect of the proposed rule and 

are adopting it as proposed. 

Under the final rule, certain transaction types are excluded from the scope of 

section 35, including: 

(i) Transactions accepted by a qualifying central counterparty that are subject to 

daily marking-to-market and daily receipt and payment of variation margin (which do not 

have a risk-based capital requirement);88

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

determined under sections 31 and 32 of the final rule); 

(iii) One-way cash payments on OTC derivative contracts (the risk-based capital 

requirements of which are determined under sections 31 and 32 of the final rule); and 

(iv) Transactions with a contractual settlement period that is longer than the 

normal settlement period (defined below), which transactions are treated as OTC 

derivative contracts and assessed a risk-based capital requirement under sections 31 and 

32 of the final rule. The final rule also provides that, in the case of a system-wide failure 

of a settlement or clearing system, the bank’s primary Federal supervisor may waive risk-

 

88 The agencies consider a qualifying central counterparty to be the functional equivalent of an exchange, 

and have long exempted exchange-traded contracts from risk-based capital requirements. 
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based capital requirements for unsettled and failed transactions until the situation is 

rectified. 

The final rule contains separate treatments for delivery-versus-payment (DvP) and 

payment-versus-payment (PvP) transactions with a normal settlement period, on the one 

hand, and non-DvP/non-PvP transactions with a normal settlement period, on the other 

hand. The final rule provides the following definitions of a DvP transaction, a PvP 

transaction, and a normal settlement period. A DvP transaction is a securities or 

commodities transaction in which the buyer is obligated to make payment only if the 

seller has made delivery of the securities or commodities and the seller is obligated to 

deliver the securities or commodities only if the buyer has made payment. A PvP 

transaction is a foreign exchange transaction in which each counterparty is obligated to 

make a final 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 E. The positive 

current exposure of a transaction of a bank is the difference between the transaction value 
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at the agreed settlement price and the current market price of the transaction, if the 

difference results in a credit exposure of the bank to the counterparty. 

Table E − Risk Weights for Unsettled DvP and PvP Transactions 

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, 

or currencies to its counterparty but has not received its corresponding deliverables by the 

end of the same business day. The bank must continue to hold risk-based capital against 

the transaction until the bank has received its corresponding deliverables. From the 

business day after the bank has made its delivery until five business days after the 

counterparty delivery is due, the bank must calculate its risk-based capital requirement 

for the transaction by treating the current market value of the deliverables owed to the 

bank as a wholesale exposure. 

For purposes of computing a bank’s risk-based capital requirement for unsettled 

non-DvP/non-PvP transactions, a bank may assign an internal obligor rating to a 

counterparty for which it is not otherwise required under the final rule to assign an 

obligor rating on the basis of the applicable external rating of any outstanding unsecured 

long-term debt security without credit enhancement issued by the counterparty. A bank 

may estimate a loss severity rating or LGD for the exposure, or may use a 45 percent 

LGD for the exposure provided the bank uses the 45 percent LGD for all such exposures 
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(that is, for all non-DvP/non-PvP transactions subject to a risk-based capital requirement 

other than deduction under section 35 of the final rule). Alternatively, a bank may use a 

100 percent risk weight for all non-DvP/non-PvP transactions subject to a risk-based 

capital requirement other than deduction under section 35 of the final rule. 

If, in a non-DvP/non-PvP transaction with a normal settlement period, the bank 

has not received its deliverables by the fifth business day after counterparty delivery was 

due, the bank must deduct the current market value of the deliverables owed to the bank 

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

The total risk-weighted asset amount for unsettled transactions equals the sum of 

the risk-weighted asset amount for each DvP and PvP transaction with a normal 

settlement period and the risk-weighted asset amount for each non-DvP/non-PvP 

transaction with a normal settlement period. 

E. Securitization Exposures 

This section describes the framework for calculating risk-based capital 

requirements for securitization exposures (the securitization framework). In contrast to 

the framework for wholesale and retail exposures, the securitization framework does not 

permit a bank to rely on its internal assessments of the risk parameters of a securitization 

exposure.89 For securitization exposures, which typically are tranched exposures to a 

pool of underlying exposures, such assessments would require implicit or explicit 

estimates of correlations among the losses on the underlying exposures and estimates of 

the credit risk-transfering consequences of tranching. Such correlation and tranching 

 

89 Although the IAA described below does allow a bank to use an internal-ratings-based approach to 

determine its risk-based capital requirement for an exposure to an ABCP program, banks are required to 

follow NRSRO rating criteria and therefore are required implicitly to use the NRSRO’s determination of 

the correlation of the underlying exposures in the ABCP program. 
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effects are difficult to estimate and validate in an objective manner and on a goingforward basis. Instead, the securitization framework relies principally on two sources of 

information, where available, to determine risk-based capital requirements: (i) an 

assessment of the securitization exposure’s credit risk made by a nationally recognized 

statistical rating organization (NRSRO); or (ii) the risk-based capital requirement for the 

underlying exposures as if the exposures had not been securitized (along with certain 

other objective information about the securitization exposure, such as the size and 

relative seniority of the exposure). 

1. Hierarchy of approaches

The securitization framework contains three general approaches for determining 

the risk-based capital requirement for a securitization exposure: a ratings-based approach 

(RBA), an internal assessment approach (IAA), and a supervisory formula approach 

(SFA). Consistent with the New Accord and the proposal, under the final rule a bank 

generally must apply the following hierarchy of approaches to determine the risk-based 

capital requirement for a securitization exposure. 

Gains-on-sale and CEIOs. 

Under the proposed rule, a bank would deduct from tier 1 capital any after-tax 

gain-on-sale resulting from a securitization and would deduct from total capital any 

portion of a CEIO that does not constitute a gain-on-sale, as described in section 42(a)(1) 

and (c) of the proposed rule. Thus, if the after-tax gain-on-sale associated with a 

securitization equaled $100 while the amount of CEIOs associated with that same 

securitization equaled $120, the bank would deduct $100 from tier 1 capital and $20 from 

total capital ($10 from tier 1 capital and $10 from tier 2 capital). 
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Several commenters asserted that the proposed deductions of gains-on-sale and 

CEIOs were excessively conservative, because such deductions are not reflected in an 

originating bank’s maximum risk-based capital requirement associated with a single 

securitization transaction (described below). Commenters noted that while securitization 

does not increase an originating bank’s overall risk exposure to the securitized assets, in 

some circumstances the proposal would result in a securitization transaction increasing an 

originating bank’s risk-based capital requirement. To address this concern, some 

commenters suggested deducting CEIOs from total capital only when the CEIOs 

constitute a gain-on-sale. Others urged adopting the treatment of CEIOs in the general 

risk-based capital rules. Under this treatment, the entire amount of CEIOs beyond a 

concentration threshold is deducted from total capital and there is no separate gain-onsale deduction. 

The final rule retains the proposed deduction of gains-on-sale and CEIOs. These 

deductions are consistent with the New Accord, and the agencies believe they are 

warranted given historical supervisory concerns with the subjectivity involved in 

valuations of gains-on-sale and CEIOs. Furthermore, although the treatments of gainson-sale and CEIOs can increase an originating bank’s risk-based capital requirement 

following a securitization, the agencies believe that such anomalies will be rare where a 

securitization transfers significant credit risk from the originating bank to third parties. 

Ratings-based approach (RBA). 

If a securitization exposure is not a gain-on-sale or CEIO, a bank must apply the 

RBA to a securitization exposure if the exposure qualifies for the RBA. As a general 

matter, an exposure qualifies for the RBA if the exposure has an external rating from an 
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NRSRO or has an inferred rating (that is, the exposure is senior to another securitization 

exposure in the transaction that has an external rating from an NRSRO).90 For example, 

a bank generally must use the RBA approach to determine the risk-based capital 

requirement for an asset-backed security that has an applicable external rating of AA+ 

from an NRSRO and for another tranche of the same securitization that is unrated but 

senior in all respects to the asset-backed security that was rated. In this example, the 

senior unrated tranche would be treated as if it were rated AA+. 

Internal assessment approach (IAA). 

If a securitization exposure does not qualify for the RBA but the exposure is to an 

ABCP program – such as a credit enhancement or liquidity facility – the bank may apply 

the IAA (if the bank, the exposure, and the ABCP program qualify for the IAA) or the 

SFA (if the bank and the exposure qualify for the SFA) to the exposure. As a general 

matter, a bank will qualify to use the IAA if the bank establishes and maintains an 

internal risk rating system for exposures to ABCP programs that has been approved by 

the bank’s primary Federal supervisor. Alternatively, a bank may use the SFA if the 

bank is able to calculate a set of risk factors relating to the securitization, including the 

risk-based capital requirement for the underlying exposures as if they were held directly 

by the bank. A bank that qualifies for and chooses to use the IAA must use the IAA for 

all exposures that qualify for the IAA. 

A number of commenters asserted that a bank should be permitted to use the IAA 

for a securitization exposure to an ABCP conduit even when the exposure has an inferred 

rating, provided all other IAA eligibility criteria were met. The commenters maintained 

 

90 A securitization exposure held by an originating bank must have two or more external ratings or inferred 

ratings to qualify for the RBA. 
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that the RBA would produce an excessive risk-based capital requirement for an unrated 

securitization exposure, such as a liquidity facility, when the inferred rating is based on a 

rated security that is very junior to the unrated exposure. Commenters suggested that 

allowing a bank to use the IAA instead of the RBA in such circumstances would lead to a 

risk-based capital requirement that was better aligned with the unrated exposure’s actual 

risk. 

Like the New Accord, the final rule does not allow a bank to use the IAA for 

securitization exposures that qualify for the RBA based on an inferred rating. While in 

some cases the IAA might produce a more risk-sensitive capital treatment relative to an 

inferred rating under the RBA, the agencies – as well as the majority of commenters –

believe that it is important to retain as much consistency as possible with the New Accord 

to provide a level international playing field for financial services providers in a 

competitive line of business. The commenters’ concerns relating to inferred ratings apply 

only to a small proportion of outstanding ABCP liquidity facilities. In many cases, a 

bank may mitigate such concerns by having the ABCP program issue an additional, 

intermediate layer of externally rated securities, which would provide a more accurate 

reference for inferring a rating on the unrated liquidity facility. The agencies intend to 

monitor developments in this area and, as appropriate, will coordinate any reassessment 

of the hierarchy of securitization approaches with the BCBS and other supervisory and 

regulatory authorities. 

Supervisory formula approach (SFA). 

If a securitization exposure is not a gain-on-sale or a CEIO, does not qualify for 

the RBA, and is not an exposure to an ABCP program for which the bank is applying the 
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IAA, the bank may apply the SFA to the exposure if the bank is able to calculate the SFA 

risk parameters for the securitization. In many cases, an originating bank would use the 

SFA to determine its risk-based capital requirements for retained securitization 

exposures. 

Deduction. 

If a securitization exposure is not a gain-on-sale or a CEIO and does not qualify 

for the RBA, the IAA, or the SFA, the bank must deduct the exposure from total capital. 

Numerous commenters requested an alternative to deducting the securitization 

exposure from capital. Some of these commenters noted that if a bank does not service 

the underlying assets, the bank may not be able to produce highly accurate estimates of a 

key SFA risk parameter, KIRB, which is the risk-based capital requirement as if the 

underlying assets were held directly by the bank. Commenters expressed concern that, 

under the proposal, a bank would be required to deduct from capital some structured 

lending products that have long histories of low credit losses. Commenters maintained 

that a bank should be allowed to calculate the securitization exposure’s risk-based capital 

requirement using the rules for wholesale exposures or using an IAA-like approach under 

which the bank’s internal risk rating for the exposure would be mapped into an NRSRO’s 

rating category. 

Like the proposal, the final rule contains only those securitization approaches in 

the New Accord. As already noted, the agencies -- and most commenters -- believe that 

it is important to minimize substantive differences between the final rule and the New 

Accord to foster international consistency. Furthermore, the agencies believe that the 

hierarchy of securitization approaches is sufficiently comprehensive to accommodate 
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demonstrably low-risk structured lending arrangements in a risk-sensitive manner. As 

described in greater detail below, for securitization exposures that are not eligible for the 

RBA or the IAA, a bank has flexibility under the SFA to tailor its procedures for 

estimating KIRB to the data that are available. The agencies recognize that, in light of data 

shortcomings, a bank may have to use approaches to estimating KIRB that are less 

sophisticated than what the bank might use for similar assets that it originates, services, 

and holds directly. Supervisors generally will review the reasonableness of KIRB

estimates in the context of available data, and will expect estimates of KIRB to incorporate 

appropriate conservatism to address any data shortcomings. 

Total risk-weighted assets for securitization exposures equals the sum of riskweighted 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 final rule. 

Exceptions to the general hierarchy of approaches

Consistent with the New Accord and the proposed rule, the final rule includes a 

mechanism that generally prevents a bank’s effective risk-based capital requirement from 

increasing as a result of the bank securitizing its assets. Specifically, the rule limits a 

bank’s effective risk-based capital requirement for all of its securitization exposures to a 

single securitization to the applicable risk-based capital requirement if the underlying 

exposures were held directly by the bank. Under the rule, unless one or more of the 

underlying exposures does not meet the definition of a wholesale, retail, securitization, or 

equity exposure, the total risk-based capital requirement for all securitization exposures 

held by a single bank associated with a single securitization (including any regulatory 

capital requirement that relates to an early amortization provision, but excluding any 
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capital requirements that relate to the bank’s gain-on-sale or CEIOs associated with the 

securitization) cannot exceed the sum of (i) the bank’s total risk-based capital 

requirement for the underlying exposures as if the bank directly held the underlying 

exposures; and (ii) the bank’s total ECL for the underlying exposures. 

One commenter urged the agencies to delete the reference to ECL in the capital 

calculation. However, the agencies believe it is appropriate to include the ECL of the 

underlying exposures in this calculation because ECL is included in the New Accord’s 

limit, and because the bank would have had to estimate the ECL of the exposures and 

hold reserves or capital against the ECL if the bank held the underlying exposures on its 

balance sheet. 

 This maximum risk-based capital requirement is different from the general riskbased capital rules. Under the general risk-based capital rules, banks generally are 

required to hold a dollar in capital for every dollar in residual interest, regardless of the 

effective risk-based capital requirement on the underlying exposures. The agencies 

adopted this dollar-for-dollar capital treatment for a residual interest to recognize that in 

many instances the relative size of the residual interest retained by the originating bank 

reveals market information about the quality of the underlying exposures and transaction 

structure that may not have been captured under the general risk-based capital rules. 

Given the significantly heightened risk sensitivity of the IRB approach, the agencies 

believe that the maximum risk-based capital requirement in the final rule is appropriate. 

 The securitization framework also includes provisions to limit the double 

counting of risks in situations involving overlapping securitization exposures. While the 

proposal addressed only those overlapping exposures arising in the context of exposures 
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to ABCP programs and mortgage loan swaps with recourse, the final rule addresses 

overlapping exposures for securitizations more generally. If a bank has multiple 

securitization exposures that provide duplicative coverage of the underlying exposures of 

a securitization (such as when a bank provides a program-wide credit enhancement and 

multiple pool-specific liquidity facilities to an ABCP program), the bank is not required 

to hold duplicative risk-based capital against the overlapping position. Instead, the bank 

would apply to the overlapping position the applicable risk-based capital treatment under 

the securitization framework that results in the highest capital requirement. If different 

banks have overlapping exposures to a securitization, however, each bank must hold 

capital against the entire maximum amount of its exposure. Although duplication of 

capital requirements will not occur for individual banks, some systemic duplication may 

occur where multiple banks have overlapping exposures to the same securitization. 

The proposed rule also addressed the risk-based capital treatment of a 

securitization of non-IRB assets. Claims to future music concert and film receivables are 

examples of financial assets that are not wholesale, retail, securitization, or equity 

exposures. In these cases, the SFA cannot be used because of the absence of a risksensitive measure of the credit risk of the underlying exposures. Specifically, under the 

proposed rule, if a bank had a securitization exposure and any underlying exposure of the 

securitization was not a wholesale, retail, securitization or equity exposure, the bank 

would (i) apply the RBA if the securitization exposure qualifies for the RBA and is not 

gain-on-sale or a CEIO; or (ii) otherwise, deduct the exposure from total capital. 

Numerous commenters asserted that a bank should be allowed to use the IAA in 

these situations since, unlike the SFA, the IAA is tied to NRSRO rating methodologies 
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rather than to the risk-based capital requirement for the underlying exposures. The 

agencies believe that this is a reasonable approach for exposures to ABCP conduits. The 

final rule permits a bank to use the IAA for a securitization exposure for which any 

underlying exposure of the securitization is not a wholesale, retail, securitization or 

equity exposure, provided the securitization exposure is not gain-on-sale, not a CEIO, 

and not eligible for the RBA, and all of the IAA qualification criteria are met. 

As described in section V.A.3. of this preamble, a few commenters asserted that 

OTC derivatives with a securitization SPE as the counterparty should be excluded from 

the definition of securitization exposure. These commenters objected to the burden of 

using the securitization framework to calculate a capital requirement for counterparty 

credit risk for OTC derivatives with a securitization SPE. The agencies continue to 

believe that the securitization framework is the most appropriate way to assess the 

counterparty credit risk of such exposures, and that in many cases the relatively simple 

RBA will apply to such exposures. In response to commenter concerns about burden, the 

agencies have decided to add an optional simple risk weight approach for certain OTC 

derivatives. Under the final rule, if a securitization exposure is an OTC derivative 

contract (other than a credit derivative) that has a first priority claim on the cash flows 

from the underlying exposures (notwithstanding amounts due under interest rate or 

currency derivative contracts, fees due, or other similar payments), a bank may choose to 

apply an effective 100 percent risk weight to the exposure rather than the general 

securitization hierarchy of approaches. This treatment is subject to supervisory approval. 

Like the proposed rule, the final rule contains three additional exceptions to the 

general hierarchy. Each exception parallels the general risk-based capital rules. First, an 
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interest-only mortgage-backed security must be assigned a risk weight that is no less than 

100 percent. Although a number of commenters objected to this risk weight floor on the 

grounds that it was not risk sensitive, the agencies believe that a minimum risk weight of 

100 percent is prudent in light of the uncertainty implied by the substantial price volatility 

of these securities. Second, a sponsoring bank that qualifies as a primary beneficiary and 

must consolidate an ABCP program as a variable interest entity under GAAP generally 

may exclude the consolidated ABCP program assets from risk-weighted assets. 91 In 

such cases, the bank must hold risk-based capital against any securitization exposures of 

the bank to the ABCP program. Third, as required by Federal statute, a special set of 

rules applies to transfers of small business loans and leases with recourse by wellcapitalized depository institutions.92 

Servicer cash advances

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. 

 

91 See Financial Accounting Standards Board, Interpretation No. 46: Consolidation of Variable Interest 

Entities (January 2003). 92 See 12 U.S.C. 1835, which places a cap on the risk-based capital requirement applicable to a wellcapitalized DI that transfers small business loans with recourse. The final rule does not expressly state that 

the agencies may permit adequately capitalized banks to use the small business recourse rule on a case-bycase basis because the agencies may do this under the general reservation of authority contained in 

section 1 of the rule. 
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Under the final rule, as under the proposed rule, a servicing bank must determine 

its risk-based capital requirement for any advances under such a facility using the 

hierarchy of securitization approaches described above. The treatment of the undrawn 

portion of the facility depends on whether the facility is an “eligible” servicer cash 

advance facility. An eligible servicer cash advance facility is a servicer cash advance 

facility in which (i) the servicer is entitled to full reimbursement of advances (except that 

a servicer may be obligated to make non-reimburseable advances for a particular 

underlying exposure if any such advance is limited to an insignificant amount of the 

outstanding principal balance of that exposure); (ii) the servicer’s right to reimbursement 

is senior in right of payment to all other claims on the cash flows from the underlying 

exposures of the securitization; and (iii) the servicer has no legal obligation to, and does 

not, make advances to the securitization if the servicer concludes the advances are 

unlikely to be repaid. Consistent with the general risk-based capital rules with respect to 

residential mortgage servicer cash advances, a servicing bank is not required to hold riskbased capital against the undrawn portion of an eligible servicer cash advance facility. A 

bank that provides a non-eligible servicer cash advance facility must determine its riskbased capital requirement for the undrawn portion of the facility in the same manner as 

the bank would determine its risk-based capital requirement for any other undrawn 

securitization exposure. 

Amount of a securitization exposure

Under the proposed rule, the amount of an on-balance sheet securitization 

exposure was the bank’s carrying value, if the exposure was held-to-maturity or for 

trading, or the bank’s carrying value minus any unrealized gains and plus any unrealized 
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losses on the exposure, if the exposure was available-for-sale. In general, the amount of 

an off-balance sheet securitization exposure was the notional amount of the exposure. 

For an OTC derivative contract that was not a credit derivative, the notional amount was 

the EAD of the derivative contract (as calculated in section 32). 

In the final rule the agencies are maintaining the substance of the proposed 

provision on the amount of a securitization exposure with one exception. The final rule 

provides that the amount of a securitization exposure that is a repo-style transaction, 

eligible margin loan, or OTC derivative (other than a credit derivative) is the EAD of the 

exposure as calculated in section 32 of the final rule. The agencies believe this change is 

consistent with the way banks manage these exposures, more appropriately reflects the 

collateral that directly supports these exposures, and recognizes the credit risk mitigation 

benefits of netting where these exposures are part of a cross-product netting set. Because 

the collateral associated with a repo-style transaction or eligible margin loan is reflected 

in the determination of exposure amount under section 32 of the rule, these transactions 

are not eligible for the general securitization collateral approach in section 46(b) of the 

final rule. Similarly, if a bank chooses to reflect collateral associated with an OTC 

derivative contract in its determination of exposure amount under section 32 of the rule, it 

may not also apply the general securitization collateral approach in section 46(b) of the 

final rule. Similar to the definition of EAD for on-balance sheet exposures, the agencies 

are clarifying that the amount of an on-balance sheet securitization exposure is based on 

whether or not the exposure is classified as an available for sale security. 

Under the proposal, when a securitization exposure to an ABCP program takes 

the form of a commitment, such as a liquidity facility, the notional amount could be 
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reduced to the maximum potential amount that the bank currently would be required to 

fund under the arrangement’s documentation (the maximum potential amount that could 

be drawn given the assets currently held by the program). Within some ABCP programs, 

however, certain commitments, such as liquidity facilities, may be dynamic in that the 

maximum amount that can be drawn at any moment depends on the current credit quality 

of the program’s underlying assets. That is, if the underlying assets were to remain fixed, 

but their credit quality deteriorated, the maximum amount that could be drawn against the 

liquidity facility could increase. 

The final rule clarifies that in such circumstances the notional amount of an offbalance sheet securitization exposure to an ABCP program may be reduced to the 

maximum potential amount that the bank could be required to fund given the program’s 

current assets (calculated without regard to the current credit quality of these assets). 

Thus, if $100 is the maximum amount that could be drawn given the current volume and 

current credit quality of the program’s assets, but the maximum potential draw against 

these same assets could increase to as much as $200 if their credit quality were to 

deteriorate, then the exposure amount is $200. 

Some commenters recommended capping the securitization amount for an ABCP 

liquidity facility at the amount of the outstanding commercial paper covered by that 

facility. The agencies believe, however, that this would be inappropriate if the liquidity 

provider could be required to advance a larger amount. The agencies note that when 

calculating the exposure amount of a liquidity facility, a bank may take into account any 

limits on advances – including limits based on the amount of commercial paper 

outstanding – that are contained in the program’s documentation. 
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Implicit support

 Like the proposed rule, the final rule sets forth the regulatory capital 

consequences if a bank provides support to a securitization in excess of the bank’s 

predetermined contractual obligation to provide credit support to the securitization. First, 

consistent with the general risk-based capital rules,93 a bank that provides such implicit 

support must hold regulatory capital against all of the underlying exposures associated 

with the securitization as if the exposures had not been securitized, and must deduct from 

tier 1 capital any after-tax gain-on-sale resulting from the securitization. Second, the 

bank must disclose publicly (i) that it has provided implicit support to the securitization, 

and (ii) the regulatory capital impact to the bank of providing the implicit support. The 

bank’s primary Federal supervisor also may require the bank to hold regulatory capital 

against all the underlying exposures associated with some or all the bank’s other 

securitizations as if the exposures had not been securitized, and to deduct from tier 1 

capital any after-tax gain-on-sale resulting from such securitizations. 

Operational requirements for traditional securitizations 

In a traditional securitization, an originating bank typically transfers a portion of 

the credit risk of exposures to third parties by selling them to a securitization SPE. Under 

the final rule, consistent with the proposed rule, banks engaging in a traditional 

securitization may exclude the underlying exposures from the calculation of riskweighted 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 

 

93 Interagency Guidance on Implicit Recourse in Asset Securitizations, May 23, 2002. 
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must hold regulatory capital against any securitization exposures they retain in 

connection with the securitization. Originating banks that fail to meet these conditions 

must hold regulatory capital against the transferred exposures as if they had not been 

securitized and must deduct from tier 1 capital any gain-on-sale resulting from the 

transaction. The operational requirements for synthetic securitization are described in 

preamble section V.E.7., below. 

Consistent with the general risk-based capital rules, the above operational 

requirements refer specifically to GAAP for the purpose of determining whether a 

securitization transaction should be treated as an asset sale or a financing. In contrast, the 

New Accord stipulates guiding principles for use in determining whether sale treatment is 

warranted. One commenter requested that the agencies conform the proposed operational 

requirements for traditional securitizations to those in the New Accord. The agencies 

believe that the current conditions to qualify for sale treatment under GAAP are broadly 

consistent with the guiding principles enumerated in the New Accord. However, if 

GAAP in this area were to change materially in the future, the agencies would reassess, 

and possibly revise, the operational standards. 

Clean-up calls

To satisfy the operational requirements for securitizations and enable an 

originating bank to exclude the underlying exposures from the calculation of its riskbased capital requirements, any clean-up call associated with a securitization must be an 

eligible clean-up call. The proposal defined a clean-up call as a contractual provision that 

permits a servicer to call securitization exposures (for example, asset-backed securities) 

before the stated (or contractual) maturity or call date. The preamble to the proposed rule 
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explained that, in the case of a traditional securitization, a clean-up call is generally 

accomplished by repurchasing the remaining securitization exposures once the amount of 

underlying exposures or outstanding securitization exposures falls below a specified 

level. In the case of a synthetic securitization, the clean-up call may take the form of a 

clause that extinguishes the credit protection once the amount of underlying exposures 

has fallen below a specified level. 

Under the proposed rule, an eligible clean-up call would be a clean-up call that: 

(i) Is exercisable solely at the discretion of the servicer; 

(ii) Is not structured to avoid allocating losses to securitization exposures held by 

investors or otherwise structured to provide credit enhancement to the securitization (for 

example, to purchase non-performing underlying exposures); and 

(iii) (A) For a traditional securitization, is only exercisable when 10 percent or 

less of the principal amount of the underlying exposures or securitization exposures 

(determined as of the inception of the securitization) is outstanding. 

(B) For a synthetic securitization, is only exercisable when 10 percent or less of 

the principal amount of the reference portfolio of underlying exposures (determined as of 

the inception of the securitization) is outstanding. 

A number of comments addressed the proposed definitions of clean-up call and 

eligible clean-up call. One commenter observed that prudential concerns would also be 

satisfied if the call were at the discretion of the originator of the underlying exposures. 

The agencies concur with this view and have modified the final rule to state that a cleanup call may permit the servicer or originating bank to call the securitization exposures 

before the stated maturity or call date, and that an eligible clean-up call must be 
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exercisable solely at the discretion of the servicer or the originating bank. Commenters 

also requested clarification whether, for a securitization that involves a master trust, the 

10 percent requirement described above in criteria (iii)(A) and (iii)(B) would be 

interpreted as applying to each series or tranche of securities issued from the master trust. 

The agencies believe this is a reasonable interpretation. Thus, where a securitization SPE 

is structured as a master trust, a clean-up call with respect to a particular series or tranche 

issued by the master trust would meet criteria (iii)(A) and (iii)(B) so long as the 

outstanding principal amount in that series was 10 percent or less of its original amount at 

the inception of the series. 

Additional supervisory guidance

Over the last several years, the agencies have published a significant amount of 

supervisory guidance to assist banks with assessing the extent to which they have 

transferred credit risk and, consequently, may recognize any reduction in required 

regulatory capital as a result of a securitization or other form of credit risk transfer.94 In 

general, the agencies expect banks to continue to use this guidance, most of which 

remains applicable to the advanced approaches securitization framework. Banks are 

encouraged to consult with their primary Federal supervisor about transactions that 

require additional guidance. 

2. Ratings-based approach (RBA)

 Under the final rule, as under the proposal, a bank must determine the riskweighted asset amount for a securitization exposure that is eligible for the RBA by 

multiplying the amount of the exposure by the appropriate risk-weight provided in the 

 

94 See, e.g., OCC Bulletin 99-46 (Dec. 13, 1999) (OCC); FDIC Financial Institution Letter 109-99 (Dec. 13, 

1999) (FDIC); SR Letter 99-37 (Dec. 13, 1999) (Board); CEO Ltr. 99-119 (Dec. 14, 1999) (OTS). 
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tables in section 43 of the rule. Under the proposal, whether a securitization exposure 

was eligible for the RBA would depend on whether the bank holding the securitization 

exposure is an originating bank or an investing bank. An originating bank would be 

eligible to use the RBA for a securitization exposure if (i) the exposure had two or more 

external ratings, or (ii) the exposure had two or more inferred ratings. In contrast, an 

investing bank would be eligible to use the RBA for a securitization exposure if the 

exposure has one or more external or inferred ratings. A bank would be an originating 

bank if it (i) directly or indirectly originated or securitized the underlying exposures 

included in the securitization, or (ii) serves as an ABCP program sponsor to the 

securitization. 

The proposed rule defined an external rating as a credit rating assigned by a 

NRSRO to an exposure, provided (i) the credit rating fully reflects the entire amount of 

credit risk with regard to all payments owed to the holder of the exposure, and (ii) the 

external rating is published in an accessible form and is included in the transition 

matrices made publicly available by the NRSRO that summarize the historical 

performance of positions it has rated. For example, if a holder is owed principal and 

interest on an exposure, the credit rating must fully reflect the credit risk associated with 

timely repayment of principal and interest. Under the proposed rule, an exposure’s 

applicable external rating was the lowest external rating assigned to the exposure by any 

NRSRO. 

The proposed two-rating requirement for originating banks was the only material 

difference between the treatment of originating banks and investing banks under the 

proposed securitization framework. Although the two-rating requirement is not included 
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in the New Accord, it is generally consistent with the treatment of originating and 

investing banks in the general risk-based capital rules. The agencies sought comment on 

whether this treatment was appropriate, and on possible alternative mechanisms that 

could be employed to ensure the reliability of external and inferred ratings on 

securitization exposures retained by originating banks. 

Commenters generally objected to the two-rating requirement for originating 

banks. Many asserted that since the credit risk of a given securitization exposure was the 

same regardless of the holder, the risk-based capital treatments also should be the same. 

Because external ratings would be publicly available, some commenters contended that 

NRSROs will have strong reputational reasons to give unbiased ratings—even to nontraded securitization exposures retained by originating banks. The agencies continue to 

believe that external ratings for securitization exposures retained by an originating bank, 

which typically are not traded, are subject to less market discipline than ratings for 

exposures sold to third parties. This disparity in market discipline warrants more 

stringent conditions on use of the former for risk-based capital purposes. Accordingly, 

the final rule retains the two-rating requirement for originating banks. 

 Consistent with the New Accord, the final rule states that an unrated securitization 

exposure has an inferred rating if another securitization exposure issued by the same 

issuer and secured by the same underlying exposures has an external rating and this rated 

reference exposure (i) is subordinate in all respects to the unrated securitization exposure; 

(ii) does not benefit from any credit enhancement that is not available to the unrated 

securitization exposure; and (iii) has an effective remaining maturity that is equal to or 

longer than the unrated securitization exposure. Under the RBA, securitization exposures 
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with an inferred rating are treated the same as securitization exposures with an identical 

external rating. This definition does not permit a bank to assign an inferred rating based 

on the ratings of the underlying exposures in a securitization, even when the unrated 

securitization exposure is secured by a single, externally rated security. In particular, 

such a look-through approach would fail to meet the requirements that the rated reference 

exposure must be issued by the same issuer, secured by the same underlying assets, and 

subordinated in all respects to the unrated securitization exposure. 

The agencies sought comment on whether they should consider other bases for 

inferring a rating for an unrated securitization position, such as using an applicable credit 

rating on outstanding long-term debt of the issuer or guarantor of the securitization 

exposure. In situations where an unrated securitization exposure benefited from a 

guarantee that covered all contractual payments associated with the securitization 

exposure, several commenters advocated allowing an inferred rating to be assigned based 

on the long-term rating of the guarantor. In addition, some commenters recommended 

that if a senior, unrated securitization exposure is secured by a single externally rated 

underlying security, a bank should be permitted to assign an inferred rating for the 

unrated exposure using a look-through approach. 

The agencies do not believe there is a compelling need at this time to supplement 

the New Accord’s methods for determining an inferred rating. However, if a need 

develops in the future, the agencies will seek to revise the New Accord in coordination 

with the BCBS and other supervisory and regulatory authorities. In the situations cited 

above, the framework already provides simplified methods for calculating a securitization 

exposure’s risk-based capital requirement. For example, when a securitization exposure 
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benefits from a full guarantee, such as from an externally rated monoline insurance 

company, the exposure’s external rating often will reflect that guarantee. When the 

guaranteed securitization exposure is not externally rated, subject to the rules for 

recognition of guarantees of securitization exposures in section 46, the unrated 

securitization exposure may be treated as a direct (wholesale) exposure to the guarantor. 

In addition, when a securitization exposure to an ABCP program is secured by a single, 

externally rated asset, a look-through approach may be possible under the IAA provided 

that such a look-through is no less conservative than the applicable NRSRO rating 

methodologies. 

Under the proposal, if a securitization exposure had multiple external ratings or 

multiple inferred ratings, a bank would be required to use the lowest rating (the rating 

that would produce the highest risk-based capital requirement). Commenters objected 

that this treatment was significantly more conservative than required by the New Accord, 

which permits use of the second most favorable rating, and would unfairly penalize banks 

in situations where the lowest rating was unsolicited or an outlier. The agencies 

recognize commenters’ concerns regarding unsolicited ratings, and note that the New 

Accord states banks should use solicited ratings. To maintain consistency with the 

general risk-based capital rules, the final rule defines the applicable external rating of a 

securitization exposure to be its lowest solicited external rating and the applicable 

inferred rating of a securitization exposure to be the inferred rating based on its lowest 

solicited external rating. 

For securitization exposures eligible for the RBA, the risk-based capital 

requirement per dollar of securitization exposure depends on four factors: (i) the 
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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. In 

response to a specific question posed by the agencies, commenters generally supported 

linking risk weights under the RBA to these factors. 

 In the proposed rule, a “senior securitization exposure” was defined as a 

securitization exposure that has a first priority claim on the cash flows from the 

underlying exposures, disregarding the claims of a service provider (such as a swap 

counterparty or trustee, custodian, or paying agent for the securitization) to fees from the 

securitization. Generally, only the most senior tranche of a securitization would be a 

senior securitization exposure. For example, if multiple tranches of a securitization share 

the transaction’s highest rating, only the tranche with the shortest remaining maturity 

would be treated as senior, since other tranches with the same rating would not have a 

first claim to cash flows throughout their lifetimes. A liquidity facility that supports an 

ABCP program would be a senior securitization exposure if the liquidity facility 

provider’s right to reimbursement of the drawn amounts was senior to all claims on the 

cash flows from the underlying exposures except claims of a service provider to fees. 

In the final rule, the agencies modified this definition to clarify two points. First, 

in the context of an ABCP program, the final rule specifically states that both the most 

senior commercial paper issued by the program and a liquidity facility supporting the 

program may be ‘senior’ exposures if the liquidity facility provider’s right to 

reimbursement of any drawn amounts is senior to all claims on the cash flow from the 

underlying exposures. Second, the final rule clarifies that when determining whether a 
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securitization exposure is senior, a bank is not required to consider any amounts due 

under interest rate or currency derivative contracts, fees due, or other similar payments. 

Consistent with the New Accord, a bank must use Table F below when a 

securitization exposure qualifies for the RBA based on a long-term external rating or an 

inferred rating based on a long-term external rating. A bank may apply the risk weights 

in column 1 of Table F to the securitization exposure only if the N is six or more and the 

securitization exposure is a senior securitization exposure. If N is six or more but the 

securitization exposure is not a senior securitization exposure, the bank must apply the 

risk weights in column 2 of Table F. Applying the principle of conservatism, however, 

if N is six or more a bank may use the risk weights in column 2 of Table F without 

determining whether the exposure is senior. A bank must apply the risk weights in 

column 3 of Table F to the securitization exposure if N is less than six. 

In certain situations the rule provides a simplified approach for determining N. If 

the notional number of underlying exposures of a securitization is 25 or more or if all the 

underlying exposures are retail exposures, a bank may assume that N is six or more 

(unless the bank knows or has reason to know that N is less than six). However, if the 

notional number of underlying exposures of a securitization is less than 25 and one or 

more of the underlying exposures is a non-retail exposure, the bank must compute N as 

described in the SFA section below. 

A few commenters wanted to determine N only at the inception of a securitization 

transaction, due to the burden of tracking N over time. The agencies believe that a bank 

must track N over time to ensure an appropriate risk-based capital requirement. The 

number of underlying exposures in a securitization typically changes over time as some 
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underlying exposures are repaid or default. As the number of underlying exposures 

changes, the risk profile of the associated securitization exposures changes, and a bank 

must reflect this change in risk profile in its risk-based capital requirement. 

Table F – Long-Term Credit Rating Risk Weights under RBA and IAA 

 Column 1 Column 2 Column 3

Applicable 

external or 

inferred 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% 
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One category 

below investment 

grade – positive 

designation (for 

example, BB+) 

250% 

One category 

below investment 

grade (for 

example, BB) 

425% 

One category 

below investment 

grade – negative 

designation (for 

example, BB-) 

650% 

More than one 

category below 

investment grade 

Deduction from tier 1 and tier 2 capital 

 A bank must apply the risk weights in Table G when the securitization exposure 

qualifies for the RBA based on a short-term external rating or an inferred rating based on 

a short-term external rating. A bank must apply the decision rules outlined in the 

previous paragraph to determine which column of Table G applies. 

Table G – Short-Term Credit Rating Risk Weights under RBA and IAA 

 Column 1 Column 2 Column 3

Applicable 

external or 

inferred 

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% 
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Third highest 

investment 

grade (for 

example, A3) 

60% 75% 75% 

All other 

ratings 

Deduction from tier 1 and tier 2 capital 

 Within Tables G and H, risk weights increase as rating grades decline. Under 

column 2 of Table F, for example, the risk weights range from 12 percent for exposures 

with the highest investment-grade rating to 650 percent for exposures rated one category 

below investment grade with a negative designation. This pattern of risk weights is 

broadly consistent with analyses employing standard credit risk models and a range of 

assumptions regarding correlation effects and the types of exposures being securitized.95 

These analyses imply that, compared with a corporate bond having a given level of 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.96 This effect is 

most pronounced for below-investment-grade tranches and is the primary reason why the 

RBA risk-weights increase rapidly as ratings deteriorate over this range – much more 

rapidly than for similarly rated corporate bonds. 

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 

 

95 See Vladislav Peretyatkin and William Perraudin, “Capital for Asset-Backed Securities,” Bank of 

England, February 2003. 

96 See, e.g., Michael Pykhtin and Ashish Dev, “Credit Risk in Asset Securitizations: An Analytical 

Model,” Risk (May 2002) S16-S20.
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exposures. This treatment is intended to discourage a bank from engaging in regulatory 

capital arbitrage by securitizing very high-quality wholesale exposures (wholesale 

exposures with a low PD and LGD), obtaining external ratings on the securitization 

exposures issued by the securitization, and retaining essentially all the credit risk of the 

pool of underlying exposures. 

 A bank must deduct from regulatory capital any securitization exposure with an 

external or inferred rating lower than one category below investment grade for long-term 

ratings or below investment grade for short-term ratings. Although this treatment is more 

conservative than suggested by credit risk modeling analyses, the agencies believe that 

deducting such exposures from regulatory capital is appropriate in light of significant 

modeling uncertainties for such low-rated securitization tranches. Moreover, external 

ratings of these tranches are subject to less market discipline because these positions 

generally are retained by the bank and are not traded. 

The most senior tranches of granular securitizations with long-term investmentgrade external ratings receive a more favorable risk weight as compared to more 

subordinated tranches of the same securitizations. To be considered granular, a 

securitization must have an N of at least six. Consistent with the New Accord, the lowest 

possible risk-weight, 7 percent, applies only to senior securitization exposures receiving 

the highest external rating (for example, AAA) and backed by a granular asset pool. 

The agencies sought comment on how well the risk weights in Tables G and H 

capture the most important risk factors for securitization exposures of varying degrees of 

seniority and granularity. A number of commenters contended that, in the interest of 

competitive equity, the risk weight for senior securitization exposures having the highest 
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rating and backed by a granular asset pool should be 6 percent, the level specified in the 

European Union’s Capital Requirements Directive (CRD). The agencies decided against 

making this change. There is no compelling empirical evidence to support a 6 percent 

risk weight for all exposures satisfying these conditions and, further, a 6 percent risk 

weight is inconsistent with the New Accord. Moreover, estimates of the credit risk 

associated with such positions tend to be highly sensitive to subjective modeling 

assumptions and to the specific types of underlying assets and structure of the transaction, 

which supports the use of the more conservative approach in the New Accord. 

3. Internal assessment approach (IAA)

 Under the final rule, as under the proposal, a bank is permitted to compute its 

risk-based capital requirement for a securitization exposure to an ABCP program (such as 

a liquidity facility or credit enhancement) using the bank’s internal assessment of the 

credit quality of the securitization exposure. The ABCP program may be sponsored by 

the bank itself or by a third party. To apply the IAA, the bank’s internal assessment 

process and the ABCP program must meet certain qualification requirements in 

section 44 of the final rule, and the securitization exposure must initially be internally 

rated at least equivalent to investment grade. A bank that elects to use the IAA for any 

securitization exposure to an ABCP program must use the IAA to compute risk-based 

capital requirements for all securitization exposures that qualify for the IAA. Under the 

IAA, a bank maps its internal credit assessment of a securitization exposure to an 

equivalent external credit rating from an NRSRO. The bank must determine the riskweighted asset amount for a securitization exposure by multiplying the amount of the 
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exposure (using the methodology set forth above in the RBA section) by the appropriate 

risk weight provided in Table F or G above. 

Under the proposal, a bank required prior written approval from its primary 

Federal supervisor before it could use the IAA. Several commenters objected to this 

requirement maintaining that approval is not required under the New Accord and would 

likely delay a bank being authorized to use the IAA for new ABCP programs. Instead, 

commenters requested a submission and non-objection approach, under which a bank 

would be allowed to use the IAA in the absence of any objection from its supervisor 

based on examination findings. The final rule retains the requirement for prior written 

approval before a bank can use the IAA. Like other optional approaches in the final rule 

(for example, the double default treatment and the internal models methodology), it is 

important that the primary Federal supervisor have an opportunity to review a bank’s 

practices relative to the final rule before allowing a bank to use the optional approach. If 

a bank chooses to implement the IAA at the same time that it implements the advanced 

approaches, the IAA review and approval process will be part of the overall qualification 

process. If a bank chooses to implement the IAA after it has qualified for the advanced 

approaches, prior written approval is a necessary safeguard for ensuring appropriate 

application of the IAA. Furthermore, the agencies believe this requirement can be 

implemented without impeding future innovations in ABCP programs. 

Similar to the proposed rule, under the final rule a bank must demonstrate that its 

internal credit assessment process satisfies all the following criteria in order to receive 

approval to use the IAA. 
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The bank’s internal credit assessments of securitization exposures to ABCP 

programs must be based on publicly available rating criteria used by an NRSRO for 

evaluating the credit risk of the underlying exposures. The requirement that an NRSRO’s 

rating criteria be publicly available does not mean that these criteria must be published 

formally by the NRSRO. While the agencies expect banks to rely on published rating 

criteria when these criteria are available, an NRSRO often delays publication of rating 

criteria for securitizations involving new asset types until the NRSRO builds sufficient 

experience with such assets. Similarly, as securitization structures evolve over time, 

published criteria may be revised with some lag. Especially for securitizations involving 

new structures or asset types, the requirement that rating criteria be publicly available 

should be interpreted broadly to encompass not only published criteria, but also criteria 

that are obtained through written correspondence or other communications with an 

NRSRO. In such cases, these communications should be documented and available for 

review by the bank’s primary Federal supervisor. The agencies believe this flexibility is 

appropriate only for unique situations when published rating criteria are not generally 

applicable. 

A commenter asked whether the applicable NRSRO rating criteria must cover all 

contractual payments owed to the bank holding the exposure, or only contractual 

principal and interest. For example, liquidity facilities typically obligate the seller to 

make certain future fee and indemnity payments directly to the liquidity bank. These 

ancillary obligations, however, are not an exposure to the ABCP program and would not 

normally be covered by NRSRO rating criteria, which focus on the risks of the 

underlying assets and the exposure’s vulnerability to those risks. The agencies agree that 
DRAFT November 2, 2007 

325

such ancillary obligations of the seller need not be covered by the applicable NRSRO 

rating criteria for an exposure to be eligible for the IAA. 

To be eligible for the IAA, a bank must also demonstrate that its internal credit 

assessments of securitization exposures used for regulatory capital purposes are 

consistent with those used in its internal risk management process, capital adequacy 

assessment process, and management information reporting systems. The bank must also 

demonstrate that its internal credit assessment process has sufficient granularity to 

identify gradations of risk. Each of the bank’s internal credit assessment categories must 

correspond to an external credit rating of an NRSRO. In addition, the bank’s internal 

credit assessment process, particularly the stress test factors for determining credit 

enhancement requirements, must be at least as conservative as the most conservative of 

the publicly available rating criteria of the NRSROs that have provided external credit 

ratings to the commercial paper issued by the ABCP program. In light of recent events in 

the securitization market, the agencies emphasize that if an NRSRO that provides an 

external rating to an ABCP program’s commercial paper changes its methodology, the 

bank must evaluate whether to revise its internal assessment process. 

Moreover, the bank must have an effective system of controls and oversight that 

ensures compliance with these operational requirements and maintains the integrity and 

accuracy of the internal credit assessments. The bank must also have an internal audit 

function independent from the ABCP program business line and internal credit 

assessment process that assesses at least annually whether the controls over the internal 

credit assessment process function as intended. The bank must review and update each 

internal credit assessment whenever new material information is available, but no less 
DRAFT November 2, 2007 

326

frequently than annually. The bank must also validate its internal credit assessment 

process on an ongoing basis, but not less frequently than annually. 

 Under the proposed rule, in order for a bank to use the IAA on a specific exposure 

to an ABCP program, the program had to satisfy the following requirements: 

(i) All commercial paper issued by the ABCP program must have an external 

rating. 

 (ii) The ABCP program must have robust credit and investment guidelines 

(underwriting standards). 

 (iii) The ABCP program must perform a detailed credit analysis of the asset 

sellers’ risk profiles. 

 (iv) The ABCP program’s underwriting policy must establish minimum asset 

eligibility criteria that include a prohibition of the purchase of assets that are significantly 

past due or defaulted, as well as limitations on concentrations to an individual obligor or 

geographic area and the tenor of the assets to be purchased. 

 (v) The aggregate estimate of loss on an asset pool that the ABCP program is 

considering purchasing must consider all sources of potential risk, such as credit and 

dilution risk. 

 (vi) The ABCP program must incorporate structural features into each purchase of 

assets to mitigate potential credit deterioration of the underlying exposures. Such 

features may include wind-down triggers specific to a pool of underlying exposures. 

 Commenters suggested that the program-level eligibility criteria should apply 

only to those elements of the ABCP program that are relevant to the securitization 

exposure held by the bank in order to prevent an ABCP program’s purchase of a single 
DRAFT November 2, 2007 

327

asset pool that does not meet the above criteria from disallowing the IAA for 

securitization exposures to that program that are unrelated to the non-qualifying asset 

pool. The agencies agree that this is a reasonable approach. Accordingly, the final rule 

applies criteria (ii) through (vi) to the exposures underlying a securitization exposure, 

rather than to the entire ABCP program. For a program-wide credit enhancement facility, 

all of the separate seller-specific arrangements benefiting from that facility must meet the 

above requirements for the facility to be eligible for the IAA. 

Several commenters objected to the requirement that the ABCP program prohibit 

purchases of significantly past-due or defaulted assets. Commenters contended that such 

purchases should be allowed so long as the applicable NRSRO rating criteria permit and 

deal appropriately with such assets. Like the New Accord, the final rule prohibits the 

ABCP program from purchasing significantly past-due or defaulted assets in order to 

ensure that the IAA is applied only to securitization exposures that are relatively low-risk 

at inception. This criterion would be met if the ABCP program does not fund underlying 

assets that are significantly past due or defaulted when placed into the program (that is, 

the program’s advance rate against such assets is 0 percent) and the securitization 

exposure is not subject to potential losses associated with these assets. The agencies 

observe that the rule does not set a specific number-of-days-past due criterion. In 

addition, the term ‘defaulted assets’ in criterion (iv) does not refer to the wholesale and 

retail definitions of default in the final rule, but rather may be interpreted as referring to 

assets that have been charged off or written down by the seller prior to being placed into 

the ABCP program or to assets that would be charged off or written down under the 

program’s governing contracts. 
DRAFT November 2, 2007 

328

In addition, commenters asked the agencies to clarify that a bank may ignore one 

or more of the eligibility requirements where the requirement is not relevant to a 

particular exposure. For example, in the case of a liquidity facility supporting a static 

pool of term loans, it may not be possible to incorporate features into the transaction that 

mitigate against a potential deterioration in these assets, and there may be no use for 

detailed credit analyses of the seller following the securitization if the seller has no 

further involvement with the transaction. The agencies have modified the final criterion 

for determining whether an exposure qualifies for the IAA, to specify that where relevant, 

the ABCP program must incorporate structural features into each purchase of exposures 

underlying the securitization exposure to mitigate potential credit deterioration of the 

underlying exposures. 

4. Supervisory formula approach (SFA)

General requirements

 Under the proposed rule, a bank using the SFA would determine the riskweighted asset amount for a securitization exposure by multiplying the SFA risk-based 

capital requirement for the exposure (as determined by the supervisory formula set forth 

below) by 12.5. If the SFA risk weight for a securitization exposure was 1,250 percent or 

greater, however, the bank would deduct the exposure from total capital rather than risk 

weight the exposure. The agencies noted that deduction is consistent with the treatment 

of other high-risk securitization exposures, such as CEIOs. 

 The SFA capital requirement for a securitization exposure depends on the 

following seven inputs: 

 (i) The amount of the underlying exposures (UE); 
DRAFT November 2, 2007 

329

 (ii) The securitization exposure’s proportion of the tranche that contains the 

securitization exposure (TP); 

 (iii) The sum of the risk-based capital requirement and ECL for the underlying 

exposures (as determined under the final rule as if the underlying exposures were held 

directly on the bank’s balance sheet) divided by the amount of the underlying exposures 

(KIRB); 

 (iv) The tranche’s credit enhancement level (L); 

 (v) The tranche’s thickness (T); 

 (vi) The securitization’s effective number of underlying exposures (N); and 

 (vii) The securitization’s exposure-weighted average loss given default 

(EWALGD). 

 A bank may only use the SFA to determine its risk-based capital requirement for a 

securitization exposure if the bank can calculate each of these seven inputs on an ongoing 

basis. In particular, if a bank cannot compute KIRB because the bank cannot compute the 

risk-based capital requirement for all underlying exposures, the bank may not use the 

SFA to compute its risk-based capital requirement for the securitization exposure. In 

those cases, the bank must deduct the exposure from regulatory capital. 

 The SFA capital requirement for a securitization exposure is UE multiplied by TP 

multiplied by the greater of (i) 0.0056 * T; or (ii) S[L+T] – S[L], where: 

(i) 

⎪

⎭

⎪

⎬

⎫

⎪

⎩

⎪

⎨

⎧

− > ⋅ +−+

≤

= −⋅

IRB

K

YK

IRB

IRB IRB

IRB

e KYwhen Kd KKYKK

Y KYwhen

YS IRB

IRB

1( ) 20 ][][

][ )(20

 (ii) [ ] ( ) −⋅−= β ⋅ + β + ],1;[],;[1)1(][ ⋅ cbaYYbaYhYK 
DRAFT November 2, 2007 

330

(iii) 

N

IRB

EWALGD

K h ⎟

⎠

⎞ ⎜

⎝

⎛

1 −=

 (iv) ⋅= cga 

 (v) −⋅= cgb )1(

 (vi) h

K

c IRB

− = 1

 (vii) 

1 )1( − ⋅− = f

cc

g

 (viii) 1000)1(

)1(

1

2

2

⋅−

−⋅− +− −+ = hvKK

c

h

Kv f IRB IRB IRB

 (ix) N

EWALGD K EWALGD Kv IRB

IRB

( − + ⋅ 1(25.) − ) ⋅=

 (x) d baKh ]),;[1()1(1 −⋅−−= β IRB

 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 final rule. 

The agencies are modifying the SFA treatment of certain high risk securitization 

exposures in the final rule. Under the proposed treatment described above, a bank would 

have to deduct from total capital any securitization exposure with a SFA risk weight 

equal to 1,250 percent. Under certain circumstances, however, a slight increase in the 

thickness of the tranche that contains the securitization exposure (T), holding other SFA 
DRAFT November 2, 2007 

331

risk parameters fixed, could cause the exposure’s SFA risk-weight to fall below 1,250 

percent. As a result, the bank would not deduct any part of the exposure from capital and 

would, instead, reflect the entire amount of the SFA risk-based capital requirement in its 

risk-weighted assets. Consistent with the New Accord,97 the agencies have removed this 

anomaly from the final rule. Under the final rule a bank must deduct from total capital 

any part of a securitization exposure that incurs a 1,250 percent risk weight under the 

SFA (that is, any part of a securitization exposure covering loss rates on the underlying 

assets between zero and KIRB). Any part of a securitization exposure that incurs less than 

a 1,250 percent risk weight must be risk weighted rather than deducted. 

To illustrate, suppose that an exposure’s SFA capital requirement equaled $15, 

and UE, TP, KIRB, and L equaled $1000, 1.0, 0.10, and 0.095, respectively. The bank 

must deduct from total capital $5 (UE x TP x (KIRB -L)), and the exposure’s riskweighted asset amount would be $125 (($15-$5) x 12.5). 

The specific securitization exposures that are subject to this deduction treatment 

under the SFA may change over time in response to variations in the credit quality of the 

underlying exposures. For example, if the pool’s IRB capital requirement were to 

increase after the inception of a securitization, additional portions of unrated 

securitization exposures may fall below KIRB and thus become subject to deduction under 

the SFA. Therefore, if at the inception of a securitization a bank owns an unrated 

securitization exposure well in excess of KIRB, the capital requirement on the exposure 

could climb rapidly in the event of marked deterioration in the credit quality of the 

underlying exposures and the bank may be required to deduct the exposure. 

 

97 New Accord, Annex 7. 
DRAFT November 2, 2007 

332

 The SFA formula effectively imposes a 56 basis point minimum risk-based 

capital requirement (8 percent of the 7 percent risk weight) per dollar of securitization 

exposure. Although such a floor may impose a capital requirement that is too high for 

some securitization exposures, the agencies continue to believe that some minimum 

prudential capital requirement is appropriate in the securitization context. This 7 percent 

risk-weight floor is also consistent with the lowest capital requirement available under the 

RBA and, thus, should reduce incentives for regulatory capital arbitrage. 

 The SFA formula is a blend of credit risk modeling results and supervisory 

judgment. The function S[Y] incorporates two distinct features. The first is a pure 

model-based estimate of the pool’s aggregate systematic or non-diversifiable credit risk 

that is attributable to a first loss position covering losses up to and including Y. Because 

the tranche of interest covers losses over a specified range (defined in terms of L and T), 

the tranche’s systematic risk can be represented as S[L+T] – S[L]. The second feature 

involves a supervisory add-on primarily intended to avoid behavioral distortions 

associated with what would otherwise be a discontinuity in capital requirements for 

relatively thin mezzanine tranches lying just below and just above the KIRB boundary. 

Without this add-on, all tranches at or below KIRB would be deducted from capital, 

whereas a very thin tranche just above KIRB would incur a pure model-based percentage 

capital requirement that could vary between zero and one, depending on the number of 

effective underlying exposures (N). The supervisory add-on applies primarily to 

positions just above KIRB, and its quantitative effect diminishes rapidly as the distance 

from KIRB widens. 
DRAFT November 2, 2007 

333

 Apart from the risk-weight floor and other supervisory adjustments described 

above, the supervisory formula attempts to be as consistent as possible with the 

parameters and assumptions of the IRB approach that would apply to the underlying 

exposures if held directly by a bank.98 The specification of S[Y] assumes that KIRB is an 

accurate measure of the total systematic credit risk of the pool of underlying exposures 

and that a securitization merely redistributes this systematic risk among its various 

tranches. In this way, S[Y] embodies precisely the same asset correlations as are 

assumed elsewhere within the IRB approach. In addition, this specification embodies the 

result that a pool’s systematic risk (KIRB) tends to be redistributed toward more senior 

tranches as N declines.99 The importance of pool granularity depends on the pool’s 

average loss severity rate, EWALGD. For small values of N, the framework implies that, 

as EWALGD increases, systematic risk is shifted toward senior tranches. For highly 

granular pools, such as securitizations of retail exposures, EWALGD would have no 

influence on the SFA capital requirement. 

Inputs to the SFA formula

 Consistent with the proposal, the final rule defines the seven inputs into the SFA 

formula as follows: 

 (i) Amount of the underlying exposures (UE). This input (measured in dollars) is 

the EAD of any underlying wholesale and retail exposures plus the amount of any 

underlying exposures that are securitization exposures (as defined in section 42(e) of the 

proposed rule) plus the adjusted carrying value of any underlying equity exposures (as 

 

98 The conceptual basis for specification of K[x] is developed in Michael B. Gordy and David Jones, 

“Random Tranches,” Risk (March 2003), 16(3), 78-83. 99 See Michael Pykhtin and Ashish Dev, “Coarse-grained CDOs,” Risk (January 2003), 16(1), 113-116. 
DRAFT November 2, 2007 

334

defined in section 51(b) of the proposed rule). UE also includes any funded spread 

accounts, cash collateral accounts, and other similar funded credit enhancements. 

 (ii) Tranche percentage (TP). TP is the ratio of (i) the amount of the bank’s 

securitization exposure to (ii) the amount of the securitization tranche that contains the 

bank’s securitization exposure. 

 (iii) KIRB. KIRB is the ratio of (i) the risk-based capital requirement for the 

underlying exposures plus the ECL of the underlying exposures (all as determined as if 

the underlying exposures were directly held by the bank) to (ii) UE. The definition of 

KIRB includes the ECL of the underlying exposures in the numerator because if the bank 

held the underlying exposures on its balance sheet, the bank also would hold reserves 

against the exposures. 

 The calculation of KIRB must reflect the effects of any credit risk mitigant applied 

to the underlying exposures (either to an individual underlying exposure, a group of 

underlying exposures, or to the entire pool of underlying exposures). In addition, all 

assets related to the securitization must be treated as underlying exposures for purposes 

of the SFA, including assets in a reserve account (such as a cash collateral account). 

In practice, a bank’s ability to calculate KIRB will often determine whether it can 

use the SFA or whether it must instead deduct an unrated securitization exposure from 

total capital. As noted above, there is a need for flexibility when the estimation of KIRB

is constrained by data shortcomings, such as when the bank holding the securitization 

exposure is not the servicer of the underlying assets. The final rule clarifies that the 

simplified approach for eligible purchased wholesale exposures (Section 31) may be used 

for calculating KIRB. 
DRAFT November 2, 2007 

335

To reduce the operational burden of estimating KIRB, several commenters urged 

the agencies to develop a simple look-through approach such that when all of the assets 

held by the SPE are externally rated, KIRB could be determined directly from the external 

ratings of theses assets. The agencies believe that a look-through approach for estimating 

KIRB would be inconsistent with the New Accord and would increase the potential for 

capital arbitrage. The agencies note that several simplified methods for estimating riskweighted assets for the underlying exposures for the purposes of computing KIRB are 

provided in other parts of the framework. For example, the simplified approach for 

eligible purchased wholesale exposures in section 31 may be available when a bank can 

estimate risk parameters for segments of underlying wholesale exposures but not for each 

of the individual exposures. If the assets held by the SPE are securitization exposures 

with external ratings, the RBA would be used to determine risk-weighted assets for the 

underlying exposures based on these ratings. If the assets held by the SPE represent 

shares in an investment company (that is, unleveraged, pro rata ownership interests in a 

pool of financial assets), the bank may be eligible to determine risk-weighted assets for 

the underlying exposures using the Alternative Modified Look-Through Approach of 

Section 54 (d) based on investment limits specified in the program’s prospectus or similar 

documentation. 

 (iv) Credit enhancement level (L). L is the ratio of (i) the amount of all 

securitization exposures subordinated to the securitization tranche that contains the 

bank’s securitization exposure to (ii) UE. Banks must determine L before considering the 

effects of any tranche-specific credit enhancements (such as third-party guarantees that 
DRAFT November 2, 2007 

336

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 (reserve accounts that are to be 

funded from future cash flows from the underlying exposures) may not be included in the 

calculation of L. 

 In some cases, the purchase price of receivables will reflect a discount that 

provides credit enhancement (for example, first loss protection) for all or certain tranches. 

When this arises, L should be calculated inclusive of this discount if the discount 

provides credit enhancement for the securitization exposure. 

 (v) Thickness of tranche (T). T is the ratio of (i) the size of the tranche that 

contains the bank’s securitization exposure to (ii) UE. 

(vi) Effective number of exposures (N). As a general matter, the effective number 

of exposures is calculated as follows: 

∑

∑ =

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 (a 
DRAFT November 2, 2007 

337

securitization in which some or all of the underlying exposures are themselves 

securitization exposures), a bank must treat each underlying securitization exposure as a 

single exposure and must not look through to the exposures that secure the underlying 

securitization exposures. 

N represents the granularity of a pool of underlying exposures using an 

“effective” number of exposures concept rather than a “gross” number of exposures 

concept to appropriately assess the diversification of pools that have individual 

underlying exposures of different sizes. An approach that simply counts the gross 

number of underlying exposures in a pool treats all exposures in the pool equally. This 

simplifying assumption could radically overestimate the granularity of a pool with 

numerous small exposures and one very large exposure. The effective exposure approach 

captures the notion that the risk profile of such an unbalanced pool is more like a pool of 

several medium-sized exposures than like a pool of a large number of equally sized small 

exposures. 

For example, suppose Pool A contains four loans with EADs of $100 each. 

Under the formula set forth above, N for Pool A would be four, precisely equal to the 

actual number of exposures. Suppose Pool B also contains four loans: one loan with an 

EAD of $100 and three loans with an EAD of $1. Although both pools contain four 

loans, Pool B is much less diverse and granular than Pool A because Pool B is dominated 

by the presence of a single $100 loan. Intuitively, therefore, N for Pool B should be 

closer to one than to four. Under the formula in the rule, N for Pool B is calculated as 

follows: 

06.1

003,10

609,10

111100

)111100(

2222

2

== +++

+++ N =
DRAFT November 2, 2007 

338

As noted above, when calculating N for a re-securitization, a bank must treat each 

underlying securitization exposure as an exposure to a single obligor. This conservative 

treatment addresses the concern that AVCs among securitization exposures can be much 

greater than the AVCs among the underlying individual assets securing these 

securitization exposures. Because the framework’s simple approach to re-securitizations 

may result in the differential treatment of economically similar securitization exposures, 

the agencies sought comment on alternative approaches for determining the N of a resecuritization. While a number of commenters urged that a bank be permitted to 

calculate N for re-securitizations of asset-backed securities by looking through to the 

underlying pools of assets securing these securities, none provided theoretical or 

empirical evidence to support this recommendation. Absent such evidence, the final rule 

remains consistent with New Accord’s measurement of N for re-securitizations. 

 (vii) Exposure-weighted average loss given default (EWALGD). The EWALGD 

is calculated as: 

∑

∑ ⋅

=

i

i

i

i i

EAD

EADLGD

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 a securitization exposure. 

Although this treatment of EWALGD is consistent with the New Accord, several 

commenters asserted that assigning an LGD of 100 percent to all securitization exposures 

in the underlying pool was excessively conservative, particularly for underlying 
DRAFT November 2, 2007 

339

exposures that are senior, highly rated asset-backed securities. The agencies 

acknowledge that in many situations an LGD significantly lower than 100 percent may be 

appropriate. However, determination of the appropriate LGD depends on many complex 

factors, including the characteristics of the underlying assets and structural features of the 

securitization, such as the securitization exposure’s thickness. Moreover, for thin 

securitization exposures or certain mezzanine positions backed by low-quality assets, the 

LGD may in fact be close to 100 percent. In this light, the agencies believe that any 

simple alternative to the New Accord’s measurement of EWALGD would increase the 

potential for capital arbitrage, and any more risk-sensitive alternative would take 

considerable time to develop. Thus, the agencies have retained the proposed treatment, 

consistent with the New Accord. 

Under certain conditions, a bank may employ the following simplifications to the 

SFA. First, for securitizations all of whose underlying exposures are retail exposures, a 

bank may set h = 0 and v = 0. In addition, if the share of a securitization corresponding 

to the largest underlying exposure (C1) is no more than 0.03 (or 3 percent of the 

underlying exposures), then for purposes of the SFA the bank may set N equal to the 

following amount: 

)0,1(max 1

1

1

1

1 Cm

m

CC CC

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’ using its 
DRAFT November 2, 2007 

340

discretion. For example, if the three largest underlying exposures of a securitization 

represent 15 percent of the pool of underlying exposures, C3 for the securitization is 0.15. 

As an alternative simplification option, if only C1 is available, and C1 is no more than 

0.03, then the bank may set N = 1/C1. Under both simplification options a bank may set 

EWALGD = 0.50 unless one or more of the underlying exposures is a securitization 

exposure. If one or more of the underlying exposures is a securitization exposure, a bank 

using a simplification option must set EWALGD = 1. 

5. Eligible market disruption liquidity facilities

 Under the proposed SFA, there was no special treatment provided for ABCP 

liquidity facilities that could be drawn upon only during periods of general market 

disruption. In contrast, the New Accord provides a more favorable capital treatment 

within the SFA for eligible market disruption liquidity facilities than for other liquidity 

facilities. Under the New Accord, an eligible market disruption liquidity facility is a 

liquidity facility that supports an ABCP program and that (i) is subject to an asset quality 

test that precludes funding of underlying exposures that are in default; (ii) can be used to 

fund only those exposures that have an investment-grade external rating at the time of 

funding, if the underlying exposures that the facility must fund against are externally 

rated exposures at the time that the exposures are sold to the program; and (iii) may only 

be drawn in the event of a general market disruption. 

The agencies sought comment on the prevalence of eligible market disruption 

liquidity facilities that might be subject to the SFA and, by implication, whether the final 

rule should incorporate the treatment provided in the New Accord. Commenters 

responded that eligible market disruption liquidity facilities currently are not a material 
DRAFT November 2, 2007 

341

product line for U.S. banks, but urged international consistency in this area. To limit 

additional complexity in the final rule, and because U.S. banks have limited exposure to 

eligible market disruption liquidity facilities, the agencies are not including a separate 

treatment of eligible market disruption liquidity facilities in the final rule. The agencies 

believe that the final rule provide adequate flexibility to determine an appropriate capital 

requirement for market disruption liquidity facilities. 

6. CRM for securitization exposures

The treatment of CRM for securitization exposures differs from that applicable to 

wholesale and retail exposures, and is largely unchanged from the proposal. An 

originating bank that has obtained a credit risk mitigant to hedge its securitization 

exposure to a synthetic or traditional securitization that satisfies the operational criteria in 

section 41 of the final rule may recognize the credit risk mitigant, but only as provided in 

section 46 of the final rule. An investing bank that has obtained a credit risk mitigant to 

hedge a securitization exposure also may recognize the credit risk mitigant, but only as 

provided in section 46. A bank that has used the RBA or IAA to calculate its risk-based 

capital requirement for a securitization exposure whose external or inferred rating (or 

equivalent internal rating under the IAA) reflects the benefits of a particular credit risk 

mitigant provided to the associated securitization or that supports some or all of the 

underlying exposures, however, may not use the securitization credit risk mitigation rules 

to further reduce its risk-based capital requirement for the exposure based on that credit 

risk mitigant. For example, a bank that owns a AAA-rated asset-backed security that 

benefits from an insurance wrap that is part of the securitization transaction must 

calculate its risk-based capital requirement for the security strictly under the RBA. No 
DRAFT November 2, 2007 

342

additional credit is given for the presence of the insurance wrap. On the other hand, if a 

bank owns a BBB-rated asset-backed security and obtains a credit default swap from a 

AAA-rated counterparty to protect the bank from losses on the security, the bank would 

be able to apply the securitization CRM rules to recognize the risk mitigating effects of 

the credit default swap and determine the risk-based capital requirement for the position. 

 As under the proposal, the final rule contains a treatment of CRM for 

securitization exposures separate from the treatment for wholesale and retail exposures 

because the wholesale and retail exposure CRM approaches rely on substitutions of, or 

adjustments to, the risk parameters of the hedged exposure. Because the securitization 

framework does not rely on risk parameters to determine risk-based capital requirements 

for securitization exposures, a different treatment of CRM for securitization exposures is 

necessary. 

The securitization CRM rules, like the wholesale and retail CRM rules, address 

collateral separately from guarantees and credit derivatives. A bank is not permitted to 

recognize collateral other than financial collateral as a credit risk mitigant for 

securitization exposures. A bank may recognize financial collateral in determining the 

bank’s risk-based capital requirement for a securitization exposure that is not a repo-style 

transaction, an eligible margin loan, or an OTC derivative for which the bank has 

reflected collateral in its determination of exposure amount under section 32 of the rule 

by using a collateral haircut approach. The bank’s risk-based capital requirement for a 

collateralized securitization exposure is equal to the risk-based capital requirement for the 

securitization exposure as calculated under the RBA or the SFA multiplied by the ratio of 

adjusted exposure amount (SE*) to original exposure amount (SE), where: 
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(i) SE* = max {0, [SE - C x (1 - Hs - Hfx)]}; 

 (ii) SE = the amount of the securitization exposure (as calculated under 

section 42(e) of the rule); 

 (iii) C = the current market value of the collateral; 

 (iv) Hs = the haircut appropriate to the collateral type; and 

 (v) Hfx = the haircut appropriate for any currency mismatch between the 

collateral and the exposure. 

Where the collateral is a basket of different asset types or a basket of assets denominated 

in different currencies, the haircut on the basket is = ∑

i

HaH ii , where ai is the current 

market value of the asset in the basket divided by the current market value of all assets in 

the basket and Hi is the haircut applicable to that asset. 

With the prior written approval of its primary Federal supervisor, a bank may 

calculate haircuts using its own internal estimates of market price volatility and foreign 

exchange volatility, subject to the requirements for use of own-estimates haircuts 

contained in section 32 of the rule. Banks that use own-estimates haircuts for 

collateralized securitization exposures must assume a minimum holding period (TM) for 

securitization exposures of 65 business days. 

 A bank that does not qualify for and use own-estimates haircuts must use the 

collateral type haircuts (Hs) in Table 3 of the final rule and must use a currency mismatch 

haircut (Hfx) of 8 percent if the exposure and the collateral are denominated in different 

currencies. To reflect the longer-term nature of securitization exposures as compared to 

securities financing transactions, however, these standard supervisory haircuts (which are 

based on a ten-business-day holding period and daily marking-to-market and 
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remargining) must be adjusted to a 65-business-day holding period (the approximate 

number of business days in a calendar quarter) by multiplying them by the square root of 

6.5 (2.549510). A bank also must adjust the standard supervisory haircuts upward on the 

basis of a holding period longer than 65 business days where and as appropriate to take 

into account the illiquidity of the collateral. 

 A bank may only recognize an eligible guarantee or eligible credit derivative 

provided by an eligible securitization guarantor in determining the bank’s risk-based 

capital requirement for a securitization exposure. The definitions of eligible guarantee 

and eligible credit derivative apply to both the wholesale and retail frameworks and the 

securitization framework. An eligible securitization guarantor is defined to mean (i) a 

sovereign entity, the Bank for International Settlements, the International Monetary Fund, 

the European Central Bank, the European Commission, a Federal Home Loan Bank, the 

Federal Agricultural Mortgage Corporation (Farmer Mac), a multilateral development 

bank, a depository institution (as defined in section 3 of the Federal Deposit Insurance 

Act (12 U.S.C. 1813)), a bank holding company (as defined in section 2 of the Bank 

Holding Company Act (12 U.S.C. 1841)), a savings and loan holding company (as 

defined in 12 U.S.C. 1467a) provided all or substantially all of the holding company’s 

activities are permissible for a financial holding company under 12 U.S.C. 1843(k)), a 

foreign bank (as defined in section 211.2 of the Federal Reserve Board’s Regulation K 

(12 CFR 211.2)), or a securities firm; (ii) any other entity (other than a securitization 

SPE) that has issued and outstanding an unsecured long-term debt security without credit 

enhancement that has a long-term applicable external rating in one of the three highest 

investment-grade rating categories; or (iii) any other entity (other than a securitization 
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SPE) that has a PD assigned by the bank that is lower than or equivalent to the PD 

associated with a long-term external rating in the third-highest investment-grade rating 

category. 

A bank must use the following procedures if the bank chooses to recognize an 

eligible guarantee or eligible credit derivative provided by an eligible securitization 

guarantor in determining the bank’s risk-based capital requirement for a securitization 

exposure. If the protection amount of the eligible guarantee or eligible credit derivative 

equals or exceeds the amount of the securitization exposure, the bank must set the riskweighted asset amount for the securitization exposure equal to the risk-weighted asset 

amount for a direct exposure to the eligible securitization guarantor (as determined in the 

wholesale risk weight function described in section 31 of the final rule), using the bank’s 

PD for the guarantor, the bank’s LGD for the guarantee or credit derivative, and an EAD 

equal to the amount of the securitization exposure (as determined in section 42(e) of the 

final rule). 

If the protection amount of the eligible guarantee or eligible credit derivative is 

less than the amount of the securitization exposure, the bank must divide the 

securitization exposure into two exposures in order to recognize the guarantee or credit 

derivative. The risk-weighted asset amount for the securitization exposure is equal to the 

sum of the risk-weighted asset amount for the covered portion and the risk-weighted asset 

amount for the uncovered portion. The risk-weighted asset amount for the covered 

portion is equal to the risk-weighted asset amount for a direct exposure to the eligible 

securitization guarantor (as determined in the wholesale risk weight function described in 

section 31 of the rule), using the bank’s PD for the guarantor, the bank’s LGD for the 
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guarantee or credit derivative, and an EAD equal to the protection amount of the credit 

risk mitigant. The risk-weighted asset amount for the uncovered portion is equal to the 

product of (i) 1.0 minus the ratio of the protection amount of the eligible guarantee or 

eligible credit derivative divided by the amount of the securitization exposure; and (ii) the 

risk-weighted asset amount for the securitization exposure without the credit risk mitigant 

(as determined in sections 42-45 of the final rule). 

For any hedged securitization exposure, the bank must make applicable 

adjustments to the protection amount as required by the maturity mismatch, currency 

mismatch, and lack of restructuring provisions in paragraphs (d), (e), and (f) of section 33 

of the final rule. The agencies have clarified in the final rule that the mismatch 

provisions apply to any hedged securitization exposure and any more senior 

securitization exposure that benefits from the hedge. In the context of a synthetic 

securitization, when an eligible guarantee or eligible credit derivative covers multiple 

hedged exposures that have different residual maturities, the bank must use the longest 

residual maturity of any of the hedged exposures as the residual maturity of all the 

hedged exposures. If the risk-weighted asset amount for a guaranteed securitization 

exposure is greater than the risk-weighted asset amount for the securitization exposure 

without the guarantee or credit derivative, a bank may elect not to recognize the 

guarantee or credit derivative. 

When a bank recognizes an eligible guarantee or eligible credit derivative 

provided by an eligible securitization guarantor in determining the bank’s risk-based 

capital requirement for a securitization exposure, the bank also must (i) calculate ECL for 

the protected portion of the exposure using the same risk parameters that it uses for 
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calculating the risk-weighted asset amount of the exposure (that is, the PD associated 

with the guarantor’s rating grade, the LGD of the guarantee, and an EAD equal to the 

protection amount of the credit risk mitigant); and (ii) add this ECL to the bank’s total 

ECL. 

7. Synthetic securitizations

Background

In a synthetic securitization, an originating bank uses credit derivatives or 

guarantees to transfer the credit risk, in whole or in part, of one or more underlying 

exposures to third-party protection providers. The credit derivative or guarantee may be 

either collateralized or uncollateralized. In the typical synthetic securitization, the 

underlying exposures remain on the balance sheet of the originating bank, but a portion 

of the originating bank’s credit exposure is transferred to the protection provider or 

covered by collateral pledged by the protection provider. 

In general, the final rule’s treatment of synthetic securitizations is identical to that 

of traditional securitizations and to that described in the proposal. The operational 

requirements for synthetic securitizations are more detailed than those for traditional 

securitizations and are intended to ensure that the originating bank has truly transferred 

credit risk of the underlying exposures to one or more third-party protection providers. 

Although synthetic securitizations typically employ credit derivatives, which 

might suggest that such transactions would be subject to the CRM rules in section 33 of 

the final rule, banks must apply the securitization framework when calculating risk-based 

capital requirements for a synthetic securitization exposure. Banks may ultimately be 
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redirected to the securitization CRM rules to adjust the securitization framework capital 

requirement for an exposure to reflect the CRM technique used in the transaction. 

Operational requirements for synthetic securitizations

For synthetic securitizations, an originating bank may recognize for risk-based 

capital purposes the use of CRM to hedge, or transfer credit risk associated with, 

underlying exposures only if each of the following conditions is satisfied: 

(i) The credit risk mitigant is financial collateral, an eligible credit derivative from 

an eligible securitization guarantor (defined above), or an eligible guarantee from an 

eligible securitization guarantor. 

(ii) The bank transfers credit risk associated with the underlying exposures to 

third-party investors, and the terms and conditions in the credit risk mitigants employed 

do not include provisions that: 

(A) Allow for the termination of the credit protection due to deterioration in the 

credit quality of the underlying exposures; 

(B) Require the bank to alter or replace the underlying exposures to improve the 

credit quality of the underlying exposures; 

(C) Increase the bank’s cost of credit protection in response to deterioration in the 

credit quality of the underlying exposures; 

(D) Increase the yield payable to parties other than the bank in response to a 

deterioration in the credit quality of the underlying exposures; or 

(E) Provide for increases in a retained first loss position or credit enhancement 

provided by the bank after the inception of the securitization. 
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(iii) The bank obtains a well-reasoned opinion from legal counsel that confirms 

the enforceability of the credit risk mitigant in all relevant jurisdictions. 

(iv) Any clean-up calls relating to the securitization are eligible clean-up calls (as 

discussed above). 

 Failure to meet the above operational requirements for a synthetic securitization 

prevents the originating bank from using the securitization framework and requires the 

originating bank to hold risk-based capital against the underlying exposures as if they had 

not been synthetically securitized. A bank that provides credit protection to a synthetic 

securitization must use the securitization framework to compute risk-based capital 

requirements for its exposures to the synthetic securitization even if the originating bank 

failed to meet one or more of the operational requirements for a synthetic securitization. 

Consistent with the treatment of traditional securitization exposures, a bank must 

use the RBA for synthetic securitization exposures that have an appropriate number of 

external or inferred ratings. For an originating bank, the RBA will typically be used only 

for the most senior tranche of the securitization, which often has an inferred rating. If a 

bank has a synthetic securitization exposure that does not have an external or inferred 

rating, the bank must apply the SFA to the exposure (if the bank and the exposure qualify 

for use of the SFA) without considering any CRM obtained as part of the synthetic 

securitization. Then, if the bank has obtained a credit risk mitigant on the exposure as 

part of the synthetic securitization, the bank may apply the securitization CRM rules to 

reduce its risk-based capital requirement for the exposure. For example, if the credit risk 

mitigant is financial collateral, the bank may use the standard supervisory or ownestimates haircuts to reduce its risk-based capital requirement. If the bank is a protection 
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provider to a synthetic securitization and has obtained a credit risk mitigant on its 

exposure, the bank may also apply the securitization CRM rules in section 46 of the final 

rule to reduce its risk-based capital requirement on the exposure. If neither the RBA nor 

the SFA is available, a bank must deduct the exposure from regulatory capital. 

First-loss tranches

If a bank has a first-loss position in a pool of underlying exposures in connection 

with a synthetic securitization, the bank must deduct the position from regulatory capital 

unless (i) the position qualifies for use of the RBA or (ii) the bank and the position 

qualify for use of the SFA and KIRB is greater than L. 

Mezzanine tranches

 In a typical synthetic securitization, an originating bank obtains credit protection 

on a mezzanine, or second-loss, tranche of a synthetic securitization by either 

(i) obtaining a credit default swap or financial guarantee from a third-party financial 

institution; or (ii) obtaining a credit default swap or financial guarantee from an SPE 

whose obligations are secured by financial collateral. 

For a bank that creates a synthetic mezzanine tranche by obtaining an eligible 

credit derivative or guarantee from an eligible securitization guarantor, the bank generally 

will treat the notional amount of the credit derivative or guarantee (as adjusted to reflect 

any maturity mismatch, lack of restructuring coverage, or currency mismatch) as a 

wholesale exposure to the protection provider and use the IRB approach for wholesale 

exposures to determine the bank’s risk-based capital requirement for the exposure. A 

bank that creates the synthetic mezzanine tranche by obtaining from a non-eligible 

securitization guarantor a guarantee or credit derivative that is collateralized by financial 
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collateral generally will (i) first use the SFA to calculate the risk-based capital 

requirement on the exposure (ignoring the guarantee or credit derivative and the 

associated collateral); and (ii) then use the securitization CRM rules to calculate any 

reductions to the risk-based capital requirement resulting from the associated collateral. 

The bank may look only to the protection provider from which it obtains the guarantee or 

credit derivative when determining its risk-based capital requirement for the exposure 

(that is, if the protection provider hedges the guarantee or credit derivative with a 

guarantee or credit derivative from a third party, the bank may not look through the 

protection provider to that third party when calculating its risk-based capital requirement 

for the exposure). 

 For a bank providing credit protection on a mezzanine tranche of a synthetic 

securitization, the bank must use the RBA to determine the risk-based capital requirement 

for the exposure if the exposure has an external or inferred rating. If the exposure does 

not have an external or inferred rating and the exposure qualifies for use of the SFA, the 

bank may use the SFA to calculate the risk-based capital requirement for the exposure. If 

neither the RBA nor the SFA are available, the bank must deduct the exposure from 

regulatory capital. If a bank providing credit protection on the mezzanine tranche of a 

synthetic securitization obtains a credit risk mitigant to hedge its exposure, the bank may 

apply the securitization CRM rules to reflect the risk reduction achieved by the credit risk 

mitigant. 

Super-senior tranches

A bank that has the most senior position in a pool of underlying exposures in 

connection with a synthetic securitization must use the RBA to calculate its risk-based 
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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 may 

use the SFA to calculate the risk-based capital requirement for the exposure. If neither 

the RBA nor the SFA are available, the bank must deduct the exposure from regulatory 

capital. If an investing bank in the super-senior tranche of a synthetic securitization 

obtains a credit risk mitigant to hedge its exposure, however, the investing bank may 

apply the securitization CRM rules to reflect the risk reduction achieved by the credit risk 

mitigant. 

8. 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 

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 
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either if it has obtained credit protection on the same underlying exposures in the form of 

first-through-(n-1)-to-default credit derivatives, or if n-1 of the underlying exposures 

have already defaulted. In such a case, the bank must again determine its risk-based 

capital requirement for the underlying exposures as if the bank had only synthetically 

securitized the n – 1 underlying exposures with the lowest capital requirement and had 

obtained no credit risk mitigant on the other underlying exposures. 

A bank that provides credit protection on a group of underlying exposures through 

a first-to-default credit derivative must determine its risk-weighted asset amount for the 

derivative by applying the RBA (if the derivative qualifies for the RBA) or, if the 

derivative does not qualify for the RBA, by setting its risk-weighted asset amount for the 

derivative equal to the product of (i) the protection amount of the derivative; (ii) 12.5; 

and (iii) the sum of the risk-based capital requirements of the individual underlying 

exposures, up to a maximum of 100 percent. If a bank provides credit protection on a 

group of underlying exposures through an 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 of the individual underlying 

exposures (excluding the n-1 underlying exposures with the lowest risk-based capital 

requirements), up to a maximum of 100 percent. 

For example, a bank provides credit protection in the form of a second-to-default 

credit derivative on a basket of five reference exposures. The derivative is unrated and 
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the protection amount of the derivative is $100. The risk-based capital requirements of 

the underlying exposures are 2.5 percent, 5.0 percent, 10.0 percent, 15.0 percent, and 20 

percent. The risk-weighted asset amount of the derivative would be $100 x 12.5 x (.05 + 

.10 + .15 + .20) or $625. If the derivative were externally rated in the lowest investmentgrade rating category with a positive designation, the risk-weighted asset amount would 

be $100 x 0.50 or $50. 

9. Early amortization provisions

Background

Many securitizations of revolving credit facilities (for example, credit card 

receivables) contain provisions that require the securitization to be wound down and 

investors to be repaid if the excess spread falls below a certain threshold.100 This 

decrease in excess spread may, in some cases, be caused by deterioration in the credit 

quality of the underlying exposures. An early amortization event can increase a bank’s 

capital needs if new draws on the revolving credit facilities need to be financed by the 

bank using on-balance sheet sources of funding. The payment allocations used to 

distribute principal and finance charge collections during the amortization phase of these 

transactions also can expose a bank to greater risk of loss than in other securitization 

transactions. The final rule, consistent with the proposed rule, assesses a risk-based 

capital requirement that, in general, is linked to the likelihood of an early amortization 

 

100 The final rule defines excess spread for a period as gross finance charge collections and other income 

received by the securitization SPE (including market interchange fees) over the period minus interest paid 

to holders of securitization exposures, servicing fees, charge-offs, and other senior trust similar expenses of

the securitization SPE over the period, divided by the principal balance of the underlying exposures at the 

end of the period. 
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event to address the risks that early amortization of a securitization poses to originating 

banks. 

 Consistent with the proposed rule, the final rule defines an early amortization 

provision as a provision in a securitization’s governing documentation that, when 

triggered, causes investors in the securitization exposures to be repaid before the original 

stated maturity of the securitization exposure, unless the provision is solely triggered by 

events not related to the performance of the underlying exposures or the originating bank 

(such as material changes in tax laws or regulations). 

Under the proposed rule, a bank would not be required to hold regulatory capital 

against the investors’ interest if early amortization is solely triggered by events not 

related to the performance of the underlying exposures or the originating bank, such as 

material changes in tax laws or regulation. Under the New Accord, a bank is also not 

required to hold regulatory capital against the investors’ interest if (i) the securitization 

has a replenishment structure in which the individual underlying exposures do not 

revolve and the early amortization ends the ability of the originating bank to add new 

underlying exposures to the securitization; (ii) the securitization involves revolving assets 

and contains early amortization features that mimic term structures; or (iii) investors in 

the securitization remain fully exposed to future draws by borrowers on the underlying 

exposures even after the occurrence of early amortization. The agencies sought comment 

on the appropriateness of these additional exemptions in the U.S. markets for revolving 

securitizations. Most commenters asserted that the exemptions provided in the New 

Accord are prudent and should be adopted by the agencies in order to avoid placing U.S. 

banking organizations at a competitive disadvantage relative to foreign competitors. The 
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agencies generally agree with this view of exemption (iii), above, and the definition of 

early amortization provision in the final rule incorporates this exemption. The agencies 

have not included exemption (i) or (ii). The agencies do not believe that the exemption 

for non-revolving exposures is meaningful because the early amortization provisions 

apply only to securitizations with revolving underlying exposures. The agencies also do 

not believe that the exemption for early amortization features that mimic term structures 

is meaningful in the U.S. market. 

Under the final rule, as under the proposed rule, an originating bank must 

generally hold risk-based capital against the sum of the originating bank’s interest and the 

investors’ interest arising from a securitization that contains an early amortization 

provision. An originating bank must compute its capital requirement for its interest using 

the hierarchy of approaches for securitization exposures as described above. The 

originating bank’s risk-weighted asset amount for the investors’ interest in the 

securitization is equal to the product of the following five quantities: (i) the EAD 

associated with the investors’ interest; (ii) the appropriate CF as determined below; 

(iii) KIRB; (iv) 12.5; and (v) the proportion of the underlying exposures in which the 

borrower is permitted to vary the drawn amount within an agreed limit under a line of 

credit. The agencies added (v) to the final rule because, for securitizations containing 

both revolving and non-revolving underlying exposures, only the revolving underlying 

exposures give rise to the risk of early amortization. 

Under the final rule, consistent with the proposal, the investors’ interest with 

respect to a revolving securitization captures both the drawn balances and undrawn lines 

of the underlying exposures that are allocated to the investors in the securitization. The 
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EAD associated with the investors’ interest is equal to the EAD of the underlying 

exposures multiplied by the ratio of: 

(i) the total amount of securitization exposures issued by the securitization SPE 

to investors; divided by 

(ii) the outstanding principal amount of underlying exposures. 

In general, the applicable CF depends on whether the early amortization provision 

repays investors through a controlled or non-controlled mechanism and whether the 

underlying exposures are revolving retail credit facilities that are uncommitted 

(unconditionally cancelable by the bank to the fullest extent of Federal law, such as credit 

card receivables) or are other revolving credit facilities (for example, revolving corporate 

credit facilities). Consistent with the New Accord, under the proposed rule a controlled 

early amortization provision would meet each of the following conditions: 

 (i) The originating bank has appropriate policies and procedures to ensure that it 

has sufficient capital and liquidity available in the event of an early amortization; 

 (ii) Throughout the duration of the securitization (including the early amortization 

period) there is the same pro rata sharing of interest, principal, expenses, losses, fees, 

recoveries, and other cash flows from the underlying exposures, based on the originating 

bank’s and the investors’ relative shares of the underlying exposures outstanding 

measured on a consistent monthly basis; 

 (iii) The amortization period is sufficient for at least 90 percent of the total 

underlying exposures outstanding at the beginning of the early amortization period to 

have been repaid or recognized as in default; and 
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 (iv) The schedule for repayment of investor principal is not more rapid than 

would be allowed by straight-line amortization over an 18-month period. 

An early amortization provision that does not meet any of the above criteria is a 

non-controlled early amortization provision. 

The agencies solicited comment on the distinction between controlled and noncontrolled early amortization provisions and on the extent to which banks use controlled 

early amortization provisions. The agencies also invited comment on the proposed 

definition of a controlled early amortization provision, including in particular the 18-

month period set forth above. Commenters generally believed that very few, if any, 

revolving securitizations would meet the criteria needed to qualify for treatment as a 

controlled early amortization structure. One commenter maintained that a fixed 18-

month straight-line amortization period was too long for certain exposures, such as prime 

credit cards. 

The final rule is unchanged from the proposal with respect to controlled and noncontrolled early amortization provisions. The agencies believe that the proposed 

eligibility criteria for a controlled early amortization are important indicators of the risks 

to which an originating bank would be exposed in the event of any early amortization. 

While a fixed 18-month straight-line amortization period is unlikely to be the most 

appropriate period in all cases, it is a reasonable period for the vast majority of cases. 

The lower operational burden of using a single, fixed amortization period warrants the 

potential diminution in risk-sensitivity. 

Controlled early amortization
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 Under the proposed rule, to calculate the appropriate CF for a securitization of 

uncommitted revolving retail exposures that contains a controlled early amortization 

provision, a bank would compare the three-month average annualized excess spread for 

the securitization to the point at which the bank is required to trap excess spread under 

the securitization transaction. In securitizations that do not require excess spread to be 

trapped, or that specify a trapping point based primarily on performance measures other 

than the three-month average annualized excess spread, the excess spread trapping point 

was 4.5 percent. The bank would divide the three-month average annualized excess 

spread level by the excess spread trapping point and apply the appropriate CF from Table 

H. 

Table H − Controlled Early Amortization Provisions 

 Uncommitted Committed 

Retail Credit 

Lines 

Three-month average annualized 

excess spread 

Conversion Factor (CF) 

90% CF 

133.33% of trapping point or more 

0% CF 

less than 133.33% to 100% of 

trapping point 

1% CF 

less than 100% to 75% of trapping 

point 

2% CF 

less than 75% to 50% of trapping 

point 

10% CF 

less than 50% to 25% of trapping 

point 

20% CF 

less than 25% of trapping point 

40% CF 

Non-retail Credit 

Lines 90% CF 90% CF 
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 A bank would apply a 90 percent CF for all other revolving underlying exposures 

(committed exposures and nonretail exposures) in securitizations containing a controlled

early amortization provision. The proposed CFs for uncommitted revolving retail credit 

lines were much lower than for committed retail credit lines or for non-retail credit lines 

because of the demonstrated ability of banks to monitor and, when appropriate, to curtail 

promptly uncommitted retail credit lines for customers of deteriorating credit quality. 

Such account management tools are unavailable for committed lines, and banks may be 

less proactive about using such tools in the case of uncommitted non-retail credit lines 

owing to lender liability concerns and the prominence of broad-based, longer-term 

customer relationships. 

Non-controlled early amortization

 Under the proposed rule, to calculate the appropriate CF for securitizations of 

uncommitted revolving retail exposures that contain a non-controlled early amortization 

provision, a bank would perform the excess spread calculations described in the 

controlled early amortization section above and then apply the CFs in Table I. 

Table I − Non-Controlled Early Amortization Provisions 

 Uncommitted Committed

Retail Credit Lines 

Three-month average annualized 

excess spread 

Conversion Factor (CF)

100% CF 

133.33% of trapping point or more 

0% CF 

less than 133.33% to 100% of 

trapping point 

5% CF 

less than 100% to 75% of trapping 

point 

15% CF 

less than 75% to 50% of trapping 

point 
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50% CF 

less than 50% of trapping point 

100% CF 

Non-retail Credit 

Lines 

100% CF 100% CF 

 A bank would use a 100 percent CF for all other revolving underlying exposures 

(committed exposures and nonretail exposures) in securitizations containing a 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. 

 A few commenters asserted that the proposed CFs were too high. The agencies 

believe, however, that the proposed CFs appropriately capture the risk to the bank of a 

potential early amortization event. The agencies also believe that the proposed CFs, 

which are consistent with the New Accord, foster consistency across national 

jurisdictions. Therefore, the agencies are maintaining the proposed CFs in the final rule 

with one exception, discussed below. 

In circumstances where a securitization contains a mix of retail and nonretail 

exposures or a mix of committed and uncommitted exposures, a bank may take a pro rata 

approach to determining the CF for the securitization’s early amortization provision. If a 

pro rata approach is not feasible, a bank must treat the securitization as a securitization of 

nonretail exposures if a single underlying exposure is a nonretail exposure and must treat 

the securitization as a securitization of committed exposures if a single underlying 

exposure is a committed exposure. 

Securitizations of revolving residential mortgage exposures
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The agencies sought comment on the appropriateness of the proposed 4.5 percent 

excess spread trapping point and on whether there were other types and levels of early 

amortization triggers used in securitizations of revolving retail exposures that should be 

addressed by the agencies. Although some commenters believed the 4.5 percent trapping 

point assumption was reasonable, others believed that it was inappropriate for 

securitizations of HELOCs. Unlike credit card securitizations, U.S. HELOC 

securitizations typically do not generate material excess spread and typically are 

structured with credit enhancements and early amortization triggers based on other 

factors, such as portfolio loss rates. Under the proposed treatment, banks would be 

required to hold capital against the potential early amortization of most U.S. HELOC 

securitizations at their inception, rather than only if the credit quality of the underlying 

exposures deteriorated. Although the New Accord does not provide an alternative 

methodology, the agencies concluded that the features of the U.S. HELOC securitization 

market warrant an alternative approach. Accordingly, the final rule allows a bank the 

option of applying either (i) the CFs in Tables I and J, as appropriate, or ii) a fixed CF 

equal to 10 percent to its securitizations for which all or substantially all of the 

underlying exposures are revolving residential mortgage exposures. If a bank chooses 

the fixed CF of 10 percent, it must use that CF for all securitizations for which all or 

substantially all of the underlying exposures are revolving residential mortgage 

exposures. The agencies will monitor the implementation of this alternative approach to 

ensure that it is consistent with safety and soundness. 

F. Equity exposures 

1. Introduction and exposure measurement
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 This section describes the final rule’s risk-based capital treatment for equity 

exposures. Consistent with the proposal, under the final rule, a bank has the option to use 

either a simple risk-weight approach (SRWA) or an internal models approach (IMA) for 

equity exposures that are not exposures to an investment fund. A bank must use a lookthrough approach for equity exposures to an investment fund. 

 Although the New Accord provides national supervisors the option to provide a 

grandfathering period for equity exposures – whereby for a maximum of ten years, 

supervisors could permit banks to exempt from the IRB treatment equity investments 

held at the time of the publication of the New Accord – the proposed rule did not include 

such a grandfathering provision. A number of commenters asserted that the proposal was 

inconsistent with the New Accord and would subject banks using the agencies’ advanced 

approaches to significant competitive inequity. 

 The agencies continue to believe that it is not appropriate or necessary to 

incorporate the New Accord’s optional ten-year grandfathering period for equity 

exposures. The grandfathering concept would reduce the risk sensitivity of the SRWA 

and IMA. Moreover, the IRB approach does not provide grandfathering for other types 

of exposures, and the agencies see no compelling reason to do so for equity exposures. 

Further, the agencies believe that the overall final rule approach to equity exposures 

sufficiently mitigates potential competitive issues. Accordingly, the final rule does not 

provide a grandfathering period for equity exposures. 

 Under the proposed SRWA, a bank generally would assign a 300 percent risk 

weight to publicly traded equity exposures and a 400 percent risk weight to non-publicly 

traded equity exposures. Certain equity exposures to sovereigns, multilateral institutions, 
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and public sector enterprises would have a risk weight of 0 percent, 20 percent, or 100 

percent; and certain community development equity exposures, hedged equity exposures, 

and, up to certain limits, non-significant equity exposures would receive a 100 percent 

risk weight. 

Alternatively, under the proposed rule, a bank that met certain minimum 

quantitative and qualitative requirements on an ongoing basis and obtained the prior 

written approval of its primary Federal supervisor could use the IMA to determine its 

risk-based capital requirement for all modeled equity exposures. A bank that qualified to 

use the IMA could apply the IMA to its publicly traded and non-publicly traded equity 

exposures, or could apply the IMA only to its publicly traded equity exposures. 

However, if the bank applied the IMA to its publicly traded equity exposures, it would be 

required to apply the IMA to all such exposures. Similarly, if a bank applied the IMA to 

both publicly traded and non-publicly traded equity exposures, it would be required to 

apply the IMA to all such exposures. If a bank did not qualify to use the IMA, or elected 

not to use the IMA, to compute its risk-based capital requirements for equity exposures, 

the bank would apply the SRWA to assign risk weights to its equity exposures. 

Several commenters objected to the proposed restrictions on the use of the IMA. 

Commenters asserted that banks should be able to apply the SRWA and the IMA for 

different portfolios or subsets of equity exposures, provided that banks’ choices are 

consistent with internal risk management practices. 

The agencies have not relaxed the proposed restrictions regarding use of the 

SRWA and IMA. The agencies remain concerned that if banks are permitted to employ 

either the SRWA or IMA to different equity portfolios, banks could choose one approach 
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over the other to manipulate their risk-based capital requirements and not for risk 

management purposes. In addition, because of concerns about lack of transparency, it is 

not prudent to allow a bank to apply the IMA only to its non-publicly traded equity 

exposures and not its publicly traded equity exposures. 

The proposed rule defined publicly traded to mean traded on (i) any exchange 

registered with the SEC as a national securities exchange under section 6 of the Securities 

Exchange Act of 1934 (15 U.S.C. 78f) or (ii) any non-U.S.-based securities exchange that 

is registered with, or approved by, a national securities regulatory authority and that 

provides a liquid, two-way market for the exposure (that is, there are enough independent 

bona fide offers to buy and sell so that a sales price reasonably related to the last sales 

price or current bona fide competitive bid and offer quotations can be determined 

promptly and a trade can be settled at such a price within five business days). 

Several commenters explicitly supported the proposed definition of publicly 

traded, noting that it is reasonable and consistent with industry practice. Other 

commenters requested that the agencies revise the proposed definition by eliminating the 

requirement that a non-U.S.-based securities exchange provide a liquid, two-way market 

for the exposure. Commenters asserted that this requirement goes beyond the definition 

in the New Accord, which defines a publicly traded equity exposure as any equity 

security traded on a recognized security exchange. They asserted that registration with or 

approval by the national securities regulatory authority should suffice, as registration or 

approval generally would be predicated on the existence of a two-way market. 

The agencies have retained the definition of publicly traded as proposed. The 

agencies believe that the liquid, two-way market requirement is not in addition to the 
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requirements of the New Accord. Rather, this requirement clarifies the intent of “traded” 

in the New Accord and helps to ensure that a sales price reasonably related to the last 

sales price or competitive bid and offer quotations can be determined promptly and 

settled within five business days. 

A bank using either the IMA or the SRWA must determine the adjusted carrying 

value for each equity exposure. The proposed rule defined the adjusted carrying value of 

an equity exposure as: 

(i) For the on-balance sheet component of an equity exposure, the bank’s carrying 

value of the exposure reduced by any unrealized gains on the exposure that are reflected 

in such carrying value but excluded from the bank’s tier 1 and tier 2 capital;101 and 

(ii) For the off-balance sheet component of an equity exposure, the effective 

notional principal amount of the exposure, the size of which is equivalent to a 

hypothetical on-balance sheet position in the underlying equity instrument that would 

evidence the same change in fair value (measured in dollars) for a given small change in 

the price of the underlying equity instrument, minus the adjusted carrying value of the 

on-balance sheet component of the exposure as calculated in (i). 

Commenters generally supported the proposed definition of adjusted carrying 

value and the agencies are adopting the definition as proposed with one minor 

clarification regarding unfunded equity commitments (discussed below). 

The agencies created the definition of the effective notional principal amount of 

the off-balance sheet portion of an equity exposure to provide a uniform method for 

 

101 The potential downward adjustment to the carrying value of an equity exposure reflects the fact that 

100 percent of the unrealized gains on available-for-sale equity exposures are included in carrying value 

but only up to 45 percent of any such unrealized gains are included in regulatory capital. 
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banks to measure the on-balance sheet equivalent of an off-balance sheet exposure. For 

example, if the value of a derivative contract referencing the common stock of company 

X changes the same amount as the value of 150 shares of common stock of company X, 

for a small (for example, 1 percent) change in the value of the common stock of company 

X, the effective notional principal amount of the derivative contract is the current value 

of 150 shares of common stock of company X regardless of the number of shares the 

derivative contract references. The adjusted carrying value of the off-balance sheet 

component of the derivative is the current value of 150 shares of common stock of 

company X minus the adjusted carrying value of any on-balance sheet amount associated 

with the derivative. 

The final rule clarifies the determination of the effective notional principal 

amount of unfunded equity commitments. Under the final rule, for an unfunded equity 

commitment that is unconditional, a bank must use the notional amount of the 

commitment. If the unfunded equity commitment is conditional, the bank must use its 

best estimate of the amount that would be funded during economic downturn conditions. 

Hedge transactions 

The agencies proposed specific rules for recognizing hedged equity exposures; 

they received no substantive comment on these rules and are adopting these rules as 

proposed. For purposes of determining risk-weighted assets under both the SRWA and 

the IMA, a bank may identify hedge pairs, which the final rule defines as two equity 

exposures that form an effective hedge provided each equity exposure is publicly traded 

or has a return that is primarily based on a publicly traded equity exposure. A bank may 

risk weight only the effective and ineffective portions of a hedge pair rather than the 
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entire adjusted carrying value of each exposure that makes up the pair. Two equity 

exposures form an effective hedge if the exposures either have the same remaining 

maturity or each has a remaining maturity of at least three months; the hedge relationship 

is documented formally before the bank acquires at least one of the equity exposures; the 

documentation specifies the measure of effectiveness (E) (defined below) the bank will 

use for the hedge relationship throughout the life of the transaction; and the hedge 

relationship has an E greater than or equal to 0.8. A bank must measure E at least 

quarterly and must use one of three alternative measures of E – the dollar-offset method, 

the variability-reduction method, or the regression method. 

It is possible that only part of a bank’s exposure to a particular equity instrument 

is part of a hedge pair. For example, assume a bank has an equity exposure A with a 

$300 adjusted carrying value and chooses to hedge a portion of that exposure with an 

equity exposure B with an adjusted carrying value of $100. Also assume that the 

combination of equity exposure B and $100 of the adjusted carrying value of equity 

exposure A form an effective hedge with an E of 0.8. In this situation the bank would 

treat $100 of equity exposure A and $100 of equity exposure B as a hedge pair, and the 

remaining $200 of its equity exposure A as a separate, stand-alone equity position. 

The effective portion of a hedge pair is E multiplied by the greater of the adjusted 

carrying values of the equity exposures forming the hedge pair, and the ineffective 

portion is (1-E) multiplied by the greater of the adjusted carrying values of the equity 

exposures forming the hedge pair. In the above example, the effective portion of the 

hedge pair would be 0.8 x $100 = $80 and the ineffective portion of the hedge pair would 

be (1 – 0.8) x $100 = $20. 
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Measures of hedge effectiveness

Under the dollar-offset method of measuring effectiveness, the bank must 

determine the ratio of the cumulative sum of the periodic changes in the value of one 

equity exposure to the cumulative sum of the periodic changes in the value of the other 

equity exposure, termed the ratio of value change (RVC). If the changes in the values of 

the two exposures perfectly offset each other, the RVC will be -1. If RVC is positive, 

implying that the values of the two equity exposures move in the same direction, the 

hedge is not effective and E = 0. If RVC is negative and greater than or equal to -1 (that 

is, between zero and -1), then E equals the absolute value of RVC. If RVC is negative 

and less than -1, then E equals 2 plus RVC. 

The variability-reduction method of measuring effectiveness compares changes in 

the value of the combined position of the two equity exposures in the hedge pair (labeled 

X) to changes in the value of one exposure as though that one exposure were not hedged 

(labeled A). This measure of E expresses the time-series variability in X as a proportion 

of the variability of A. As the variability described by the numerator becomes small 

relative to the variability described by the denominator, the measure of effectiveness 

improves, but is bounded from above by a value of one. E is computed as: 

( )

∑ ( )

∑

=

−

=

−

−

−

−= T

t

tt

T

t

t t

AA

XX

E

1

2

1

1

2

1

1 , where 

−= BAX ttt

At = the value at time t of the one exposure in a hedge pair, and 
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370

Bt = the value at time t of the other exposure in the hedge pair. 

The value of t will range from zero to T, where T is the length of the observation 

period for the values of A and B, and is comprised of shorter values each labeled t. 

The regression method of measuring effectiveness is based on a regression in 

which the change in value of one exposure in a hedge pair is the dependent variable and 

the change in value of the other exposure in the hedge pair is the independent variable. E 

equals the coefficient of determination of this regression, which is the proportion of the 

variation in the dependent variable explained by variation in the independent variable. 

However, if the estimated regression coefficient is positive, then the value of E is zero. 

The closer the relationship between the values of the two exposures, the higher E will be. 

2. Simple risk-weight approach (SRWA)

Under the SRWA in section 52 of the proposed rule, a bank would determine the 

risk-weighted asset amount for each equity exposure, other than an equity exposure to an 

investment fund, by multiplying the adjusted carrying value of the equity exposure, or the 

effective portion and ineffective portion of a hedge pair as described above, by the lowest 

applicable risk weight in Table J. A bank would determine the risk-weighted asset 

amount for an equity exposure to an investment fund under section 54 of the proposed 

rule. 

If a bank exclusively uses the SRWA for its equity exposures, the bank’s 

aggregate risk-weighted asset amount for its equity exposures (other than equity 

exposures to investment funds) would be equal to the sum of the risk-weighted asset 

amounts for each of the bank’s individual equity exposures. 

Table J 
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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 exposures 

• An equity exposure to a Federal Home Loan Bank or Farmer 

Mac not subject to a 20 percent risk weight 

• The effective portion of a hedge pair 

• Non-significant equity exposures to the extent less than 10 

percent of tier 1 plus tier 2 capital 

300 Percent A publicly traded equity exposure (including the ineffective portion of a 

hedge pair) 

400 Percent An equity exposure that is not publicly traded 

 Several commenters addressed the proposed risk weights under the SRWA. A 

few commenters asserted that the 100 percent risk weight for the effective portion of a 

hedge pair is too high. These commenters suggested that the risk weight for such 

exposures should be zero or no more than 7 percent because the effectively hedged 

portion of a hedge pair involves negligible credit risk. One commenter remarked that it 

does not believe there is an economic basis for the different risk weight for an equity 

exposure to a Federal Home Loan Bank depending on whether the equity exposure is 

held as a condition of membership. 

 The agencies do not agree with commenters’ assertion that the effective portion of 

a hedge pair entails negligible credit risk. The agencies believe the 100 percent risk 

weight under the proposal is an appropriate and prudential safeguard; thus, it is 
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maintained in the final rule. Banks that seek to more accurately account for equity 

hedging in their risk-based capital requirements should use the IMA. 

The agencies agree that different risk weights for an equity exposure to a Federal 

Home Loan Bank or Farmer Mac depending on whether the equity exposure is held as a 

condition of membership do not have an economic justification, given the similar risk 

profile of the exposures. Accordingly, under the final rule SRWA, all equity exposures 

to a Federal Home Loan Bank or to Farmer Mac receive a 20 percent risk weight. 

Non-significant equity exposures

Under the SRWA, a bank may apply a 100 percent risk weight to non-significant 

equity exposures. The proposed rule defined non-significant equity exposures as equity 

exposures to the extent that the aggregate adjusted carrying value of the exposures did not 

exceed 10 percent of the bank’s tier 1 capital plus tier 2 capital. 

Several commenters objected to the 10 percent materiality threshold for 

determining significance. They asserted that this standard is more conservative than the 

15 percent threshold under the OCC, FDIC, and Board general risk-based capital rules for 

nonfinancial equity investments. 

The agencies note that the applicable general risk-based capital rules address only 

nonfinancial equity investments; that the 15 percent threshold is a percentage only of tier 

1 capital; and that the 15 percent threshold was designed for that particular rule. The 

proposed materiality threshold of 10 percent of tier 1 plus tier 2 capital is consistent with 

the New Accord and is intended to identify non-significant holdings of equity exposures 

under a different type of capital framework. Thus, the two threshold limits are not 

directly comparable. The agencies believe that the proposed 10 percent threshold for 
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determining non-significant equity exposures is appropriate for the advanced approaches 

and, thus, are adopting it as proposed. 

As discussed above in preamble section V.A.3., the agencies have discretion 

under the final rule to exclude from the definition of a traditional securitization those 

investment firms that exercise substantially unfettered control over the size and 

composition of their assets, liabilities, and off-balance sheet exposures. Equity exposures 

to investment firms that would otherwise be a traditional securitization were it not for the 

specific agency exclusion are leveraged exposures to the underlying financial assets of 

the investment firm. The agencies believe that equity exposure to such firms with greater 

than immaterial leverage warrant a 600 percent risk weight under the SRWA, due to their 

particularly high risk. Moreover, the agencies believe that the 100 percent risk weight 

assigned to non-significant equity exposures is inappropriate for equity exposures to 

investment firms with greater than immaterial leverage. 

Under the final rule, to compute the aggregate adjusted carrying value of a bank’s 

equity exposures for determining non-significance, the bank may exclude (i) equity 

exposures that receive less than a 300 percent risk weight under the SRWA (other than 

equity exposures determined to be non-significant); (ii) the equity exposure in a hedge 

pair with the smaller adjusted carrying value; and (iii) a proportion of each equity 

exposure to an investment fund equal to the proportion of the assets of the investment 

fund that are not equity exposures or that qualify as community development equity 

exposures. If a bank does not know the actual holdings of the investment fund, the bank 

may calculate the proportion of the assets of the fund that are not equity exposures based 

on the terms of the prospectus, partnership agreement, or similar contract that defines the 
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fund’s permissible investments. If the sum of the investment limits for all exposure 

classes within the fund exceeds 100 percent, the bank must assume that the investment 

fund invests to the maximum extent possible in equity exposures. 

When determining which of a bank’s equity exposures qualify for a 100 percent 

risk weight based on non-significance, a bank first must include equity exposures to 

unconsolidated small business investment companies or held through consolidated small 

business investment companies described in section 302 of the Small Business 

Investment Act of 1958 (15 U.S.C. 682), then must include publicly traded equity 

exposures (including those held indirectly through investment funds), and then must 

include non-publicly traded equity exposures (including those held indirectly through 

investment funds). 

The SRWA is summarized in Table K: 

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 
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Risk weight Equity Exposure 

100 Percent • Community development equity exposures102

• The effective portion of a hedge pair 

• Non-significant equity exposures to the extent less than 10 

percent of tier 1 plus tier 2 capital 

300 Percent A publicly traded equity exposure (other than an equity exposure that 

receives a 600 percent risk weight and including the ineffective portion 

of a hedge pair) 

400 Percent An equity exposure that is not publicly traded (other than an equity 

exposure that receives a 600 percent risk weight) 

600 percent 

An equity exposure to an investment firm that (1) would meet the 

definition of a traditional securitization were it not for the primary 

Federal supervisor’s application of paragraph (8) of that definition and 

(2) has greater than immaterial leverage 

3. Internal models approach (IMA)

The IMA is designed to provide banks with a more sophisticated and risksensitive mechanism for calculating risk-based capital requirements for equity exposures. 

To qualify to use the IMA, a bank must receive prior written approval from its primary 

Federal supervisor. To receive such approval, the bank must demonstrate to its primary 

Federal supervisor’s satisfaction that the bank meets the quantitative and qualitative 

criteria discussed below. As noted earlier, a bank may model both publicly traded and 

non-publicly traded equity exposures or model only publicly traded equity exposures. 

 

102 The final rule generally defines these exposures as exposures that would qualify as community 

development investments under 12 U.S.C. 24(Eleventh), excluding equity exposures to an unconsolidated 

small business investment company and equity exposures held through a consolidated small business 

investment company described in section 302 of the Small Business Investment Act of 1958 (15 U.S.C. 

682). For savings associations, community development investments would be defined to mean equity 

investments that are designed primarily to promote community welfare, including the welfare of low- and 

moderate-income communities or families, such as by providing services or jobs, and excluding equity 

exposures to an unconsolidated small business investment company and equity exposures held through a 

consolidated small business investment company described in section 302 of the Small Business 

Investment Act of 1958 (15 U.S.C. 682). 
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 In the final rule, the agencies clarify that under the IMA, a bank may use more 

than one model, as appropriate for its equity exposures, provided that it has received 

supervisory approval for use of the IMA, and each model meets the qualitative and 

quantitative criteria specified below and in section 53 of the rule. 

IMA qualification

The bank must have one or more models that (i) assess the potential decline in 

value of its modeled equity exposures; (ii) are commensurate with the size, complexity, 

and composition of the bank’s modeled equity exposures; and (iii) adequately capture 

both general market risk and idiosyncratic risks. The bank’s models must produce an 

estimate of potential losses for its modeled equity exposures that is no less than the 

estimate of potential losses produced by a VaR methodology employing a 99.0 percent 

one-tailed confidence interval of the distribution of quarterly returns for a benchmark 

portfolio of equity exposures comparable to the bank’s modeled equity exposures using a 

long-term sample period. Banks with equity portfolios containing equity exposures with 

values that are highly nonlinear in nature (for example, equity derivatives or convertibles) 

must employ an internal model designed to appropriately capture the risks associated 

with these instruments. 

 In addition, the number of risk factors and exposures in the sample and the data 

period used for quantification in the bank’s models and benchmarking exercise must be 

sufficient to provide confidence in the accuracy and robustness of the bank’s estimates. 

The bank’s model and benchmarking exercise also must incorporate data that are relevant 

in representing the risk profile of the bank’s modeled equity exposures, and must include 

data from at least one equity market cycle containing adverse market movements relevant 
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to the risk profile of the bank’s modeled equity exposures. In addition, for the reasons 

described below, the final rule adds that the bank’s benchmarking exercise must be based 

on daily market prices for the benchmark portfolio. If the bank’s model uses a scenario 

methodology, the bank must demonstrate that the model produces a conservative estimate 

of potential losses on the bank’s modeled equity exposures over a relevant long-term 

market cycle. If the bank employs risk factor models, the bank must demonstrate through 

empirical analysis the appropriateness of the risk factors used. 

Under the proposed rule, the agencies also required that daily market prices be 

available for all modeled equity exposures. The proposed requirement applied to either 

direct holdings or proxies. Several commenters objected to the requirement of daily 

market prices. A few asserted that proxies for private equity investments are more 

relevant than public market proxies and should be permitted even if they are only 

available on a monthly basis. The agencies agree with commenters on this issue. 

Accordingly, under the final rule, banks are not required to have daily market prices for 

all modeled equity exposures, either direct holdings or proxies. However, to ensure 

sufficient rigor in the modeling process, the final rule requires that a bank’s 

benchmarking exercise be based on daily market prices for the benchmark portfolio, as 

noted above. 

Finally, the bank must be able to demonstrate, using theoretical arguments and 

empirical evidence, that any proxies used in the modeling process are comparable to the 

bank’s modeled equity exposures, and that the bank has made appropriate adjustments for 

differences. The bank must derive any proxies for its modeled equity exposures or 

benchmark portfolio using historical market data that are relevant to the bank’s modeled 
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equity exposures or benchmark portfolio (or, where not, must use appropriately adjusted 

data), and such proxies must be robust estimates of the risk of the bank’s modeled equity 

exposures. 

In evaluating whether a bank has met the criteria described above, the bank’s 

primary Federal supervisor may consider, among other factors, (i) the nature of the 

bank’s equity exposures, including the number and types of equity exposures (for 

example, publicly traded, non-publicly traded, long, short); (ii) the risk characteristics 

and makeup of the bank’s equity exposures, including the extent to which publicly 

available price information is obtainable on the exposures; and (iii) the level and degree 

of concentration of, and correlations among, the bank’s equity exposures. 

The agencies do not intend to dictate the form or operational details of a bank’s 

internal model for equity exposures. Accordingly, the agencies are not prescribing any 

particular type of model for determining risk-based capital requirements. Although the 

final rule requires a bank that uses the IMA to ensure that its internal model produces an 

estimate of potential losses for its modeled equity exposures that is no less than the 

estimate of potential losses produced by a VaR methodology employing a 99.0 percent 

one-tailed confidence interval of the distribution of quarterly returns for a benchmark 

portfolio of equity exposures, the rule does not require a bank to use a VaR-based model. 

The agencies recognize that the type and sophistication of internal models will vary 

across banks due to differences in the nature, scope, and complexity of business lines in 

general and equity exposures in particular. The agencies also recognize that some banks 

employ models for internal risk management and capital allocation purposes that can be 

more relevant to the bank’s equity exposures than some VaR models. For example, some 
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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, 

statistically reliable, and robust loss estimates that are not based purely on subjective or 

judgmental considerations. 

The parameters and assumptions used in a VaR model should be subject to a 

rigorous and comprehensive regime of stress-testing. Banks utilizing VaR models should 

subject their internal model and estimation procedures, including volatility computations, 

to either hypothetical or historical scenarios that reflect worst-case losses given 

underlying positions in both publicly traded and non-publicly traded equities. At a 

minimum, banks that use a VaR model should employ stress tests to provide information 

about the effect of tail events beyond the level of confidence assumed in the IMA. 

Banks using non-VaR internal models that are based on stress tests or scenario 

analyses should estimate losses under worst-case modeled scenarios. These scenarios 

should reflect the composition of the bank’s equity portfolio and should produce risk-
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based capital requirements at least as large as those that would be required to be held 

against a representative market index or other relevant benchmark portfolio under a VaR 

approach. For example, for a portfolio consisting primarily of publicly held equity 

securities that are actively traded, risk-based capital requirements produced using 

historical scenario analyses should be greater than or equal to risk-based capital 

requirements produced by a baseline VaR approach for a major index or sub-index that is 

representative of the bank’s holdings. 

The loss estimate derived from the bank’s internal model constitutes the riskbased capital requirement for the modeled equity exposures (subject to the supervisory 

floors described below). The equity capital requirement is incorporated into a bank’s 

risk-based capital ratio through the calculation of risk-weighted equivalent assets. To 

convert the equity capital requirement into risk-weighted equivalent assets, a bank must 

multiply the capital requirement by 12.5. 

Risk-weighted assets under the IMA

Under the proposed and final rules, as noted above, a bank may apply the IMA 

only to its publicly traded equity exposures or may apply the IMA to its publicly traded 

and non-publicly traded equity exposures. In either case, a bank is not allowed to apply 

the IMA to equity exposures that receive a 0 or 20 percent risk weight under the SRWA, 

community development equity exposures, and equity exposures to investment funds 

(collectively, excluded equity exposures). Unlike the SRWA, the IMA does not provide 

for a 10 percent materiality threshold for non-significant equity exposures. 

Several commenters objected to the fact that the IMA does not provide a 100 

percent risk weight for non-significant equity exposures up to a 10 percent materiality 
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threshold. These commenters maintained that the lack of a materiality threshold under 

the IMA will discourage use of this methodology relative to the SRWA. Commenters 

suggested that the agencies incorporate a materiality threshold into the IMA. 

The agencies do not believe that it is necessary or appropriate to incorporate such 

a threshold under the IMA. The agencies are concerned that a bank could manipulate 

significantly its risk-based capital requirements based on the exposures it chooses to 

model and those which it would deem immaterial (and to which it would apply a 100 

percent risk weight). The agencies also believe that a flat 100 percent risk weight is 

inconsistent with the risk sensitivity of the IMA. 

Under the proposal, if a bank applied the IMA to both publicly traded and nonpublicly traded equity exposures, the bank’s aggregate risk-weighted asset amount for its 

equity exposures would be equal to the sum of the risk-weighted asset amount of 

excluded equity exposures (calculated outside of the IMA) and the risk-weighted asset 

amount of the non-excluded equity exposures (calculated under the IMA). The riskweighted asset amount of the non-excluded equity exposures generally would be set 

equal to the estimate of potential losses on the bank’s non-excluded equity exposures 

generated by the bank’s internal model multiplied by 12.5. To ensure that a bank holds a 

minimum amount of risk-based capital against its modeled equity exposures, however, 

the proposed rule contained a supervisory floor on the risk-weighted asset amount of the 

non-excluded equity exposures. As a result of this floor, the risk-weighted asset amount 

of the non-excluded equity exposures could not fall below the sum of (i) 200 percent 

multiplied by the aggregate adjusted carrying value or ineffective portion of hedge pairs, 

as appropriate, of the bank’s non-excluded publicly traded equity exposures; and 
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(ii) 300 percent multiplied by the aggregate adjusted carrying value of the bank’s nonexcluded non-publicly traded equity exposures. 

Also under the proposal, if a bank applied the IMA only to its publicly traded 

equity exposures, the bank’s aggregate risk-weighted asset amount for its equity 

exposures would be equal to the sum of (i) the risk-weighted asset amount of excluded 

equity exposures (calculated outside of the IMA); (ii) 400 percent multiplied by the 

aggregate adjusted carrying value of the bank’s non-excluded non-publicly traded equity 

exposures; and (iii) the aggregate risk-weighted asset amount of its non-excluded 

publicly traded equity exposures. The risk-weighted asset amount of the non-excluded 

publicly traded equity exposures would be equal to the estimate of potential losses on the 

bank’s non-excluded publicly traded equity exposures generated by the bank’s internal 

model multiplied by 12.5. Under the proposed rule, the risk-weighted asset amount for 

the non-excluded publicly traded equity exposures would be subject to a floor of 

200 percent multiplied by the aggregate adjusted carrying value or ineffective portion of 

hedge pairs, as appropriate, of the bank’s non-excluded publicly traded equity exposures. 

Several commenters did not support the concept of floors in a risk-sensitive 

approach that requires a comparison to estimates of potential losses produced by a VaR 

methodology. If floors are required in the final rule, however, these commenters noted 

that the calculation at the aggregate level would not pose significant operational issues. 

A few commenters, in contrast, objected to the proposed aggregate floors, asserting that it 

would be operationally difficult to determine compliance with such floors. 

The agencies believe that it is prudent to retain the floor requirements in the IMA 

and, thus, are adopting the floor requirements as described above. The agencies note that 
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the New Accord also imposes a 200 percent and 300 percent floor for publicly traded and 

non-publicly traded equity exposures, respectively. Regarding the proposal to calculate 

the floors on an aggregate basis, the agencies believe it is appropriate to maintain this 

approach, given that for most banks it does not seem to pose significant operational 

issues. 

4. Equity exposures to investment funds

The proposed rule included a separate treatment for equity exposures to 

investment funds. As proposed, a bank would determine the risk-weighted asset amount 

for equity exposures to investment funds using one of three approaches: the full lookthrough approach, the simple modified look-through approach, or the alternative 

modified look-through approach, unless the equity exposure to an investment fund is a 

community development equity exposure. Such equity exposures would be subject to a 

100 percent risk weight. If an equity exposure to an investment fund is part of a hedge 

pair, a bank could use the ineffective portion of the hedge pair as the adjusted carrying 

value for the equity exposure to the investment fund. The risk-weighted asset amount of 

the effective portion of the hedge pair is equal to its adjusted carrying value. A bank 

could choose to apply a different approach among the three alternatives to different 

equity exposures to investment funds. 

The agencies proposed a separate treatment for equity exposures to an investment 

fund to prevent banks from arbitraging the proposed rule’s risk-based capital 

requirements for certain high-risk exposures and to ensure that banks do not receive a 

punitive risk-based capital requirement for equity exposures to investment funds that hold 

only low-risk assets. Under the proposal, the agencies defined an investment fund as a 
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company (i) all or substantially all of the assets of which are financial assets and (ii) that 

has no material liabilities. 

Generally, commenters supported the separate treatment for equity exposures to 

investment funds. However, several commenters objected to the exclusion of investment 

funds with material liabilities from this separate treatment, observing that it would 

exclude equity exposures to hedge funds. Several commenters suggested that investment 

funds with material liabilities should be eligible for the look-through approaches. One 

commenter suggested that the agencies should adopt the following definition of 

investment fund: “A company in which all or substantially all of the assets are pooled 

financial assets that are collectively managed in order to generate a financial return, 

including investment companies or funds with material liabilities.” A few commenters 

suggested that equity exposures to investment funds with material liabilities should be 

treated under the SRWA or IMA as non-publicly traded equity exposures rather than the 

separate treatment developed for equity exposures to investment funds. 

The agencies do not agree with commenters that the look-through approaches for 

investment funds should apply to investment vehicles with material liabilities. The lookthrough treatment is designed to capture the risks of an indirect holding of the underlying 

assets of the investment fund. Investment vehicles with material liabilities provide a 

leveraged exposure to the underlying financial assets and have a risk profile that may not 

be appropriately captured by a look-through approach. 

Under the proposal, each of the approaches to equity exposures to investment 

funds imposed a 7 percent minimum risk weight on such exposures. This proposed 

minimum risk weight was similar to the minimum 7 percent risk weight under the RBA 
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for securitization exposures and the effective 56 basis point minimum risk-based capital 

requirement per dollar of securitization exposure under the SFA. 

Several commenters objected to the proposed 7 percent risk weight floor. A few 

commenters suggested that the floor should be decreased or eliminated, particularly for 

low-risk investment funds that receive the highest rating from an NRSRO. Others 

recommended that the 7 percent risk weight floor should be applied on an aggregate basis 

rather than on a fund-by-fund basis. 

The agencies proposed the 7 percent risk weight floor as a minimum risk-based 

capital requirement for exposures not directly held by a bank. However, the agencies 

believe the comments on this issue have merit and recognize that the floor would provide 

banks with an incentive to invest in higher-risk investment funds. Consistent with the 

New Accord, the final rule does not impose a 7 percent risk weight floor on equity 

exposures to investment funds, on either an individual or aggregate basis. 

Full look-through approach

 A bank may use the full look-through approach only if the bank is able to 

compute a risk-weighted asset amount for each of the exposures held by the investment 

fund. Under the proposed rule, a bank would be required to calculate the risk-weighted 

asset amount for each of the exposures held by the investment fund as if the exposures 

were held directly by the bank. Depending on whether the exposures were wholesale, 

retail, securitization, or equity exposures, a bank would apply the appropriate IRB riskbased capital treatment. 

 Several commenters suggested that the agencies should allow a bank with 

supervisory approval to use the IMA to model the underlying assets of an investment 
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fund by including the bank’s pro rata share of the investment fund’s assets in its equities 

model. The commenters believed there is no basis for preventing a bank from using the 

IMA, a sophisticated and risk-sensitive approach, when a bank has full position data for 

an investment fund. 

 The agencies agree with commenters’ views in this regard. If a bank has full 

position data for an investment fund and has been approved by its primary Federal 

supervisor for use of the IMA, it may include the underlying equity exposures held by an 

investment fund, after adjustment for proportional ownership, in its equities model under 

the IMA. Therefore, in the final rule, under the full look-through approach, a bank must 

either (i) set the risk-weighted asset amount of the bank’s equity exposure to the 

investment fund equal to product of (A) the aggregate risk-weighted asset amounts of the 

exposures held by the fund as if they were held directly by the bank and (B) the bank’s 

proportional ownership share of the fund; or (ii) include the bank’s proportional 

ownership share of each exposure held by the fund in the bank’s IMA. If the bank 

chooses (ii), the risk-weighted asset amount for the equity exposure to the investment 

fund is determined together with the risk-weighted asset amount for the bank’s other nonexcluded equity exposures and is subject to the aggregate floors under this approach. 

Simple modified look-through approach

 Under the proposed simple modified look-through approach, a bank would set the 

risk-weighted asset amount for its equity exposure to an investment fund equal to the 

adjusted carrying value of the equity exposure multiplied by the highest risk weight in 

Table L that applies to any exposure the fund is permitted to hold under its prospectus, 

partnership agreement, or similar contract that defines the fund’s permissible 
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investments. The bank could exclude derivative contracts that are used for hedging, not 

speculative purposes, and do not constitute a material portion of the fund’s exposures. 

 Commenters generally supported the simple modified look-through approach as a 

low-burden yet moderately risk-sensitive way of treating equity exposures to an 

investment fund. However, several commenters objected to the large jump in risk 

weights (from a 400 percent to a 1,250 percent risk weight) between investment funds 

permitted to hold non-publicly traded equity exposures and investment funds permitted to 

hold OTC derivative contracts and/or exposures that must be deducted from regulatory 

capital or receive a risk weight greater than 400 percent under the IRB approach. In 

addition, one commenter objected to the proposed 20 percent risk weight for the most 

highly rated money market mutual funds that are subject to SEC rule 2a-7 governing 

portfolio maturity, quality, diversification and liquidity. This commenter asserted that a 7 

percent risk weight for such exposures would be appropriate. 

 The agencies agree that the proposed risk-weighting for highly-rated money 

market mutual funds subject to SEC rule 2a-7 is conservative, given the generally low 

risk of such funds. Accordingly, the agencies added a new investment fund approach—

the Money Market Fund Approach—which applies a 7 percent risk weight to a bank’s 

equity exposure to a money market fund that is subject to SEC rule 2a-7 and that has an 

applicable external rating in the highest investment-grade rating category. 

The agencies have made no changes to address commenters’ concerns about a 

lack of intermediate risk weights between 400 percent and 1,250 percent. The agencies 

believe the range of risk weights is sufficiently granular to accommodate most equity 

exposures to investment funds. 
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Table L – Modified Look-Through Approaches for Equity Exposures to 

Investment Funds 

Risk Weight Exposure Class or Investment Fund Type

0 Percent Sovereign exposures with a long-term external rating in the highest 

investment-grade rating category and sovereign exposures of the 

United States 

20 Percent Exposures with a long-term external rating in the highest or 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 

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 
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Table L based on the investment limits in the fund’s prospectus, partnership agreement, 

or similar contract that defines the fund’s permissible investments. If the sum of the 

investment limits for all exposure classes within the fund exceeds 100 percent, the bank 

must assume that the fund invests to the maximum extent permitted under its investment 

limits in the exposure class with the highest risk weight under Table L, and continues to 

make investments in the order of the exposure class with the next highest risk-weight 

under Table L until the maximum total investment level is reached. If more than one 

exposure class applies to an exposure, the bank must use the highest applicable risk 

weight. A bank may exclude derivative contracts held by the fund that are used for 

hedging, not speculative, purposes and do not constitute a material portion of the fund’s 

exposures. Other than comments addressing the risk weight table and the 7 percent floor 

(addressed above), the agencies did not receive significant comment on this approach and 

have adopted it without significant change. 

VI. Operational Risk 

This section describes features of the AMA framework for determining the riskbased capital requirement for operational risk. A bank meeting the AMA qualifying 

criteria uses its internal operational risk quantification system to calculate its risk-based 

capital requirement for operational risk. 

Currently, the agencies’ general risk-based capital rules do not include an explicit 

capital charge for operational risk. Rather, the existing risk-based capital rules were 

designed to broadly cover all risks, and therefore implicitly cover operational risk. With 

the adoption of the more risk-sensitive treatment under the IRB approach for credit risk in 

this final rule, there no longer is an implicit capital buffer for other risks. 
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 The agencies recognize that operational risk is a key risk in banks, and evidence 

indicates that a number of factors are driving increases in operational risk. These factors 

include greater use of automated technology, proliferation of new and highly complex 

products, growth of e-banking transactions and related business applications, large-scale 

acquisitions, mergers, and consolidations, and greater use of outsourcing arrangements. 

Furthermore, the experience of a number of high-profile, high-severity operational losses 

across the banking industry, including those resulting from legal settlements, highlight 

operational risk as a major source of unexpected losses. Because the implicit regulatory 

capital buffer for operational risk is removed under the final rule, the agencies are 

requiring banks using the IRB approach for credit risk to use the AMA to address 

operational risk when computing their risk-based capital requirement. 

As discussed previously, operational risk exposure is the 99.9th percentile of the 

distribution of potential aggregate operational losses as generated by the bank’s 

operational risk quantification system over a one-year horizon. EOL is the expected 

value of the same distribution of potential aggregate operational losses. Under the 

proposal, a bank’s risk-based capital requirement for operational risk would be the sum of 

EOL and UOL. A bank would be allowed to recognize (i) certain offsets for EOL (such 

as certain reserves and other internal business practices), and (ii) the effect of risk 

mitigants such as insurance in calculating its regulatory capital requirement for 

operational risk. 

Under the proposed rule, the agencies recognized that a bank’s risk-based capital 

requirement for operational risk could be based on UOL alone if the bank could 

demonstrate it has offset EOL with eligible operational risk offsets. Eligible operational 
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risk offsets were defined as amounts, not to exceed EOL, that (i) are generated by internal 

business practices to absorb highly predictable and reasonably stable operational losses, 

including reserves calculated in a manner consistent with GAAP; and (ii) are available to 

cover EOL with a high degree of certainty over a one-year horizon. Eligible operational 

risk offsets could only be used to offset EOL, not UOL. 

The preamble to the proposed rule stated that in determining whether to accept a 

proposed EOL offset, the agencies would consider whether the proposed offset would be 

available to cover EOL with a high degree of certainty over a one-year horizon. 

Supervisory recognition of EOL offsets would be limited to those business lines and 

event types with highly predictable, routine losses. The preamble noted that based on 

discussions with the industry and supervisory experience, highly predictable and routine 

losses appear to be limited to those relating to securities processing and to credit card 

fraud. 

The majority of commenters on this issue recommended that the agencies should 

allow banks to present evidence of additional areas with highly predictable and 

reasonably stable losses for which eligible operational risk offsets could be considered. 

These commenters identified fraud losses pertaining to debit or ATM cards, commercial 

or business credit cards, HELOCs, and external checks in retail banking as additional 

events that have highly predictable and reasonably stable losses. Commenters also 

identified legal reserves set aside for small, predictable legal loss events, budgeted funds, 

and forecasted funds as other items that should be considered eligible operational risk 

offsets. Several commenters also highlighted that the proposed rule was inconsistent 

with the New Accord regarding the ability of budgeted funds to serve as EOL offsets. 
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One commenter proposed eliminating EOL altogether because the commenter already 

factors it into its pricing practices. 

The New Accord permits a supervisor to accept expected loss offsets provided a 

bank is “able to demonstrate to the satisfaction of its national supervisor that it has 

measured and accounted for its EL exposure.”103 To the extent a bank is permitted to 

adjust its estimate of operational risk exposure to reflect potential operational risk offsets, 

it is appropriate to consider the degree to which such offsets meet U.S. accounting 

standards and can be viewed as regulatory capital substitutes. The final rule retains the 

proposed definition described above. The agencies believe that this definition allows for 

the supervisory consideration of EOL offsets in a flexible and prudent manner. 

In determining its operational risk exposure, the bank may also take into account 

the effects of qualifying operational risk mitigants such as insurance. To recognize the 

effects of qualifying operational risk mitigants such as insurance for risk-based capital 

purposes, the bank must estimate its operational risk exposure with and without such 

effects. The reduction in a bank’s risk-based capital requirement for operational risk due 

to qualifying operational risk mitigants may not exceed 20 percent of the bank’s riskbased capital requirement for operational risk, after approved adjustments for EOL 

offsets. 

A risk mitigant must be able to absorb losses with sufficient certainty to warrant 

inclusion as a qualifying operational risk mitigant. For insurance to meet this standard, it 

must: 

(i) be provided by an unaffiliated company that has a claims paying ability 

that is rated in one of the three highest rating categories by an NRSRO; 

 

103 New Accord, ¶669(b). 
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(ii) have an initial term of at least one year and a residual term of more than 

90 days; 

(iii) have a minimum notice period for cancellation of 90 days; 

(iv) have no exclusions or limitations based upon regulatory action or for the 

receiver or liquidator of a failed bank; and 

(v) be explicitly mapped to an actual operational risk exposure of the bank. 

A bank must receive prior written approval from its primary Federal supervisor to 

recognize an operational risk mitigant other than insurance as a qualifying operational 

risk mitigant. In evaluating an operational risk mitigant other than insurance, a primary 

Federal supervisor will consider whether the operational risk mitigant covers potential 

operational losses in a manner equivalent to holding regulatory capital. 

The bank’s methodology for incorporating the effects of insurance must capture, 

through appropriate discounts in the amount of risk mitigation, the residual term of the 

policy, where less than one year; the policy’s cancellation terms, where less than one 

year; the policy’s timeliness of payment; and the uncertainty of payment as well as 

mismatches in coverage between the policy and the hedged operational loss event. The 

bank may not recognize for regulatory capital purposes insurance with a residual term of 

90 days or less. 

 Several commenters criticized the proposal for limiting recognition of noninsurance operational risk mitigants to those mitigants that would cover potential 

operational losses in a manner equivalent to holding regulatory capital. The commenters 

noted that similar limitations are not included in the New Accord. Other commenters 

asserted that qualifying operational risk mitigants should be broader than insurance. 
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The New Accord discusses the use of insurance explicitly as an operational risk 

mitigant and notes that the BCBS “in due course, may consider revising the criteria for 

and limits on the recognition of operational risk mitigants on the basis of growing 

experience.”104 Similarly, under the proposed rule, the agencies provided flexibility that 

recognizes the potential for developing operational risk mitigants other than insurance 

over time. The agencies continue to believe it is appropriate to consider the degree to 

which such mitigants can be viewed as regulatory capital substitutes. Therefore, under 

the final rule, in evaluating such mitigants, the agencies will consider whether the 

operational risk mitigant covers potential operational losses in a manner equivalent to 

holding regulatory capital. 

Under the final rule, as under the proposal, if a bank does not qualify to use or 

does not have qualifying operational risk mitigants, the bank’s dollar risk-based capital 

requirement for operational risk is its operational risk exposure minus eligible operational 

risk offsets (if any). If a bank qualifies to use operational risk mitigants and has 

qualifying operational risk mitigants, the bank’s dollar risk-based capital requirement for 

operational risk is the greater of: (i) the bank’s operational risk exposure adjusted for 

qualifying operational risk mitigants minus eligible operational risk offsets (if any); and 

(ii) 0.8 multiplied by the difference between the bank’s operational risk exposure and its 

eligible operational risk offsets (if any). The dollar risk-based capital requirement for 

operational risk is multiplied by 12.5 to convert it into an equivalent risk-weighted asset 

amount. The resulting amount is added to the comparable amount for credit risk in 

calculating the institution’s risk-based capital denominator. 

VII. Disclosure 

 

104 New Accord, footnote 110. 
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1. Overview

The agencies have long supported meaningful public disclosure by banks with the 

objective of improving market discipline. The agencies recognize the importance of 

market discipline in encouraging sound risk management practices and fostering financial 

stability. 

Pillar 3 of the New Accord, market discipline, complements the minimum capital 

requirements and the supervisory review process by encouraging market discipline 

through enhanced and meaningful public disclosure. The public disclosure requirements 

in the final rule are intended to allow market participants to assess key information about 

a bank’s risk profile and its associated level of capital. 

The agencies view public disclosure as an important complement to the advanced 

approaches to calculating minimum regulatory risk-based capital requirements, which 

will be heavily based on internal systems and methodologies. With enhanced 

transparency regarding banks’ experiences with the advanced approaches, investors can 

better evaluate a bank’s capital structure, risk exposures, and capital adequacy. With 

sufficient and relevant information, market participants can better evaluate a bank’s risk 

management performance, earnings potential and financial strength. 

Improvements in public disclosures come not only from regulatory standards, but 

also through efforts by bank management to improve communications to public 

shareholders and other market participants. In this regard, improvements to risk 

management processes and internal reporting systems provide opportunities to 

significantly improve public disclosures over time. Accordingly, the agencies strongly 

encourage the management of each bank to regularly review its public disclosures and 
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enhance these disclosures, where appropriate, to clearly identify all significant risk 

exposures – whether on- or off-balance sheet – and their effects on the bank’s financial 

condition and performance, cash flow, and earnings potential. 

Comments on the proposed rule

Many commenters expressed concern that the proposed disclosures were 

excessive, burdensome and overly prescriptive and would hinder – rather than facilitate – 

market discipline by requiring banks to disclose items that would not be well understood 

or provide useful information to market participants. In particular, commenters were 

concerned that the differences between the proposed rule and the New Accord (such as 

the proposed ELGD risk parameter and proposed wholesale definition of default) would 

not be meaningful for cross-border comparative purposes, and would increase 

compliance burden for banks subject to the agencies’ risk-based capital rules. Some 

commenters also believed that the information provided in the disclosures would not be 

comparable across banks because each bank would use distinct internal methodologies to 

generate the disclosures. Several commenters suggested that the agencies should delay 

the disclosure requirements until U.S. implementation of the IRB approach has gained 

some maturity. This would allow the agencies and banking industry sufficient time to 

ensure usefulness of the public disclosure requirements and comparability across banks. 

The agencies believe that it is important to retain the vast majority of the proposed 

disclosures, which are consistent with the New Accord. These disclosures will enable 

market participants to gain key insights regarding a bank’s capital structure, risk 

exposures, risk assessment processes, and ultimately, the capital adequacy of the 

institution. The agencies also note that many of the disclosure requirements are already 
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required by, or are consistent with, existing GAAP, SEC disclosure requirements, or 

regulatory reporting requirements for banks. More generally, the agencies view the 

public disclosure requirements as an integral part of the advanced approaches and the 

New Accord and are continuing to require their implementation beginning with a bank’s 

first transitional floor period. 

The agencies are sympathetic, however, to commenters’ concerns about crossborder comparability. The agencies believe that many of the changes they have made to 

the final rule (such as eliminating the ELGD risk parameter and adopting the New 

Accord’s definition of default for wholesale exposures, as discussed above) will address 

commenters’ concerns regarding comparability. In addition, the agencies have made 

several changes to the disclosure requirements to make them more consistent with the 

New Accord. These changes should increase cross-border comparability and reduce 

implementation and compliance burden. These changes are discussed in the relevant 

sections below. 

2. General requirements

Under the proposed rule, the public disclosure requirements would apply to the 

top-tier legal entity that is a core or opt-in bank within a consolidated banking group – the 

top-tier U.S. BHC or DI that is a core or opt-in bank. 

Several commenters objected to this proposal, noting that it is inconsistent with 

the New Accord, which requires such disclosures at the global top consolidated level of a 

banking group to which the framework applies. Commenters asserted that public 

disclosure at the U.S. BHC or DI level for U.S. banking organizations owned by a foreign 
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banking organization is not meaningful and could generate confusion or 

misunderstanding in the market. 

The agencies agree that commenters’ concerns have merit and believe that it is 

important to be consistent with the New Accord. Accordingly, under the final rule, the 

public disclosure requirements will generally be required only at the top-tier global 

consolidated level. Under exceptional circumstances, a primary Federal supervisor may 

require some or all of the public disclosures at the top-tier U.S. level if the primary 

Federal supervisor determines that such disclosures are important for market participants 

to form appropriate insights regarding the bank’s risk profile and associated level of 

capital. A factor the agencies will consider, for example, is whether a U.S. subsidiary of 

a foreign banking organization has debt or equity registered and actively traded in the 

United States. 

In addition, the proposed rule stated that, in general, a DI that is a subsidiary of a 

BHC or another DI would not be subject to the disclosure requirements except that every 

DI would be required to disclose total and tier 1 capital ratios and their components, 

similar to current requirements. Nonetheless, these entities must file applicable bank 

regulatory reports and thrift financial reports. In addition, as described below in the 

regulatory reporting section, the agencies will require certain additional regulatory 

reporting from banks applying the advanced approaches, and a limited amount of the 

reported information will be publicly disclosed. If a DI that is a core or opt-in bank and 

is not a subsidiary of a BHC or another DI that must make the full set of disclosures, the 

DI would be required to make the full set disclosures. 
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One commenter objected to the supervisory flexibility provided to require 

additional disclosures at the subsidiary level. The commenter maintained that in all cases 

DIs that are a subsidiary of a BHC or another DI should not be subject to the disclosure 

requirements beyond disclosing their total and tier 1 capital ratios and the ratio 

components, as proposed. The commenter suggested that the agencies clarify this issue 

in the final rule. 

The agencies do not believe, however, that these changes are appropriate. The 

agencies believe that it is important to preserve some flexibility in the event that the 

primary Federal supervisor believes that disclosures from such a DI are important for 

market participants to form appropriate insights regarding the bank’s risk profile and 

associated level of capital. 

The risks to which a bank is exposed, and the techniques that it uses to identify, 

measure, monitor, and control those risks are important factors that market participants 

consider in their assessment of the bank. Accordingly, under the proposed and final 

rules, each bank that is subject to the disclosure requirements must have a formal 

disclosure policy approved by its board of directors that addresses the bank’s approach 

for determining the disclosures it should make. The policy should address the associated 

internal controls and disclosure controls and procedures. The board of directors and 

senior management must ensure that appropriate review of the disclosures takes place and 

that effective internal controls and disclosure controls and procedures are maintained. 

A bank should decide which disclosures are relevant for it based on the 

materiality concept. Information would be regarded as material if its omission or 
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misstatement could change or influence the assessment or decision of a user relying on 

that information for the purpose of making investment decisions. 

To the extent applicable, a bank may fulfill its disclosure requirements under this 

final rule by relying on disclosures made in accordance with accounting standards or SEC 

mandates that are very similar to the disclosure requirements in this final rule. In these 

situations, a bank must explain material differences between the accounting or other 

disclosure and the disclosures required under this final rule. 

Frequency/timeliness

Under the proposed rule, the agencies required that quantitative disclosures be 

made quarterly. Several commenters objected to this requirement. These commenters 

asserted that banks subject to the U.S. public disclosure requirements would be placed at 

a competitive disadvantage because the New Accord requires banks to make Pillar 3 

public disclosures on a semiannual basis. 

The agencies believe that quarterly public disclosure requirements are important 

to ensure that the market has access to timely and relevant information and therefore have 

decided to retain quarterly quantitative disclosure requirements in the final rule. This 

disclosure frequency is consistent with longstanding requirements in the United States for 

robust quarterly disclosures in financial and regulatory reports, and is appropriate 

considering the potential for rapid changes in risk profiles. Moreover, many of the 

existing SEC, regulatory reporting, and other disclosure requirements that a bank may use 

to help meet its public disclosure requirements in the final rule are already required on a 

quarterly basis. 
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The proposal stated that the disclosures must be timely and that the agencies 

would consider a disclosure to be timely if it was made no later than the reporting 

deadlines for regulatory reports (for example, FR Y-9C) and financial reports (for 

example, SEC Forms 10-Q and 10-K). When these deadlines differ, the later deadline 

should be used. 

Several commenters expressed concern that the tight timeframe for public 

disclosure requirements would be a burden and requested that the agencies provide 

greater flexibility, such as by setting the deadline for public disclosures at 60 days after 

quarter-end. 

The agencies believe commenters’ concerns must be balanced against the 

importance of allowing market participants to have access to timely information that is 

reflective of a bank’s risk profile and associated capital levels. Accordingly, the agencies 

have decided to interpret the requirement for timely public disclosures for purposes of 

this final rule to mean within 45 days after calendar quarter-end. 

In some cases, management may determine that a significant change has occurred, 

such that the most recent reported amounts do not reflect the bank’s capital adequacy and 

risk profile. In those cases, banks should disclose the general nature of these changes and 

briefly describe how they are likely to affect public disclosures going forward. These 

interim disclosures should be made as soon as practicable after the determination that a 

significant change has occurred. 

Location of disclosures and audit/attestation requirements

Under the proposed and final rules, the disclosures must be publicly available (for 

example, included on a public website) for each of the latest three years (12 quarters) or 
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such shorter time period since the bank entered its first transitional floor period. Except 

as discussed below, management has discretion to determine the appropriate medium and 

location of the disclosures required by this final rule. Furthermore, banks have flexibility 

in formatting their public disclosures. The agencies are not specifying a fixed format for 

these disclosures. 

The agencies encourage management to provide all of the required disclosures in 

one place on the entity’s public website. The public website addresses are reported in the 

regulatory reports (for example, the FR Y-9C).105 

Disclosure of tier 1 and total capital ratios must be provided in the footnotes to the 

year-end audited financial statements.106 Accordingly, these disclosures must be tested 

by external auditors as part of the financial statement audit. Disclosures that are not 

included in the footnotes to the audited financial statements are not subject to external 

audit reports for financial statements or internal control reports from management and the 

external auditor. 

The preamble to the proposed rule stated that due to the importance of reliable 

disclosures, the agencies would require the chief financial officer to certify that the 

disclosures required by the proposed rule were appropriate and that the board of directors 

and senior management were responsible for establishing and maintaining an effective 

 

105 Alternatively, banks may provide the disclosures in more than one place, as some of them may be 

included in public financial reports (for example, in Management’s Discussion and Analysis included in 

SEC filings) or other regulatory reports (for example, FR Y-9C Reports). Banks must provide a summary 

table on their public website that specifically indicates where all the disclosures may be found (for 

example, regulatory report schedules or page numbers in annual reports). 

106 These ratios are required to be disclosed in the footnotes to the audited financial statements pursuant to 

existing GAAP requirements in Chapter 17 of the “AICPA Audit and Accounting Guide for Depository and 

Lending Institutions: Banks, Savings institutions, Credit unions, Finance companies and Mortgage 

companies.”
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internal control structure over financial reporting, including the information required by 

the proposed rule. 

Several commenters expressed uncertainty regarding the proposed certification 

requirement for the chief financial officer. One commenter asked the agencies to 

articulate the standard of acceptance required for the certification of disclosure standards 

compared with what is required for financial reporting purposes. Another commenter 

questioned whether the chief financial officer would have sufficient familiarity with the 

risk management disclosures to make such a certification. 

To address commenter uncertainty, the agencies have simplified and clarified the 

final rule’s accountability requirements. Specifically, the final rule modifies the 

certification requirement and instead requires one or more senior officers of the bank to 

attest that the disclosures meet the requirements of the final rule. The senior officer may 

be the chief financial officer, the chief risk officer, an equivalent senior officer, or a 

combination thereof.

Proprietary and confidential information

The agencies stated in the preamble to the proposed rule that they believed the 

proposed requirements strike an appropriate balance between the need for meaningful 

disclosure and the protection of proprietary and confidential information.107 Many 

commenters, however, expressed concern that the required disclosures would result in the 

release of proprietary information. Commenters expressed particular concerns about the 

 

107 Proprietary information encompasses information that, if shared with competitors, would render a 

bank’s investment in these products/systems less valuable, and, hence, could undermine its competitive 

position. Information about customers is often confidential, in that it is provided under the terms of a legal 

agreement or counterparty relationship. 
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granularity of the credit loss history and securitization disclosures, as well as disclosures 

for portfolios subject to the IRB risk-based capital formulas. 

As noted above, the final rule provides banks with considerable discretion with 

regard to public disclosure requirements. Bank management determines which 

disclosures are relevant based on a materiality concept. In addition, bank management 

has flexibility regarding formatting and the level of granularity of disclosures, provided 

they meet certain minimum requirements. Accordingly, the agencies believe that banks 

generally can provide these disclosures without revealing proprietary and confidential 

information. Only in rare circumstances might disclosure of certain items of information 

required in the final rule compel a bank to reveal confidential and proprietary 

information. In these unusual situations, the final rule requires that if a bank believes that 

disclosure of specific commercial or financial information would prejudice seriously the 

position of the bank by making public information that is either proprietary or 

confidential in nature, the bank need not disclose those specific items, but must disclose 

more general information about the subject matter of the requirement, together with the 

fact that, and the reason why, the specific items of information have not been disclosed. 

This provision of the final rule applies only to those disclosures required by the final rule 

and does not apply to disclosure requirements imposed by accounting standards or other 

regulatory agencies. 

3. Summary of specific public disclosure requirements

As in the proposed rule, the public disclosure requirements are comprised of 11 

tables that provide important information to market participants on the scope of 

application, capital, risk exposures, risk assessment processes, and, hence, the capital 
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adequacy of the institution. The agencies are adopting the tables as proposed, with the 

exceptions noted below. Again, the agencies note that the substantive content of the 

tables is the focus of the disclosure requirements, not the tables themselves. The table 

numbers below refer to the table numbers in the final rule. 

Table 11.1 disclosures (Scope of Application) include a description of the level in 

the organization to which the disclosures apply and an outline of any differences in 

consolidation for accounting and regulatory capital purposes, as well as a description of 

any restrictions on the transfer of funds and capital within the organization. These 

disclosures provide the basic context underlying regulatory capital calculations. 

One commenter questioned item (e) in Table 11.1, which would require the 

disclosure of the aggregate amount of capital deficiencies in all subsidiaries and the 

name(s) of such subsidiaries. The commenter asserted that the scope of this item should 

be limited to those legal subsidiaries that are subject to banking, securities, or insurance 

regulators’ capital adequacy rules and should not include unregulated entities that are 

consolidated into the top corporate entity or unconsolidated affiliate and joint ventures. 

As stated in a footnote to Table 11.1 in the proposed rule, the agencies limited the 

proposed requirement to legal subsidiaries that are subject to banking, securities, or 

insurance regulators’ capital adequacy rules. The agencies are further clarifying this 

disclosure in Table 11.1. 

 Table 11.2 disclosures (Capital Structure) provide information on various 

components of regulatory capital available to absorb losses and allow for an evaluation of 

the quality of the capital available to absorb losses within the bank. 
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Table 11.3 disclosures (Capital Adequacy) provide information about how a bank 

assesses the adequacy of its capital and require that the bank disclose its minimum capital 

requirements for significant risk areas and portfolios. The table also requires disclosure 

of the regulatory capital ratios of the consolidated group and each DI subsidiary. Such 

disclosures provide insight into the overall adequacy of capital based on the risk profile 

of the organization. 

Tables 11.4, 11.5, and 11.7 disclosures (Credit Risk) provide market participants 

with insight into different types and concentrations of credit risk to which the bank is 

exposed and the techniques the bank uses to measure, monitor, and mitigate those risks. 

These disclosures are intended to enable market participants to assess the credit risk 

exposures under the IRB approach, without revealing proprietary information. 

 Several commenters made suggestions related to Table 11.4. One commenter 

addressed item (b), which requires the disclosure of total and average gross credit risk 

exposures over the period broken down by major types of credit exposure. The 

commenter asked the agencies to clarify that methods used for financial reporting 

purposes are allowed for determining averages. Another commenter requested that the 

agencies clarify what is meant by “gross” in item (b), given that a related footnote 

describes net credit risk exposures in accordance with GAAP. 

As with most of the disclosure requirements, the agencies are not prescriptive 

regarding the methodologies a bank must use for determining averages. Rather, the bank 

must choose whatever methodology it believes to be most reflective of its risk position. 

That methodology may be the one the bank uses for financial reporting purposes. The 

agencies have deleted “gross” and otherwise simplified the wording of item (b) in Table 
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11.4 to enhance clarity. Item (b) now reads “total credit risk exposures and average 

credit risk exposures, after accounting offsets in accordance with GAAP, and without 

taking into account the effects of credit risk mitigation techniques (for example collateral 

and netting not included in GAAP for disclosure), over the period broken down by major 

types of credit exposure.” 

In addition, a commenter noted that the requirements in Table 11.4 regarding the 

breakdown of disclosures by “major types of credit exposure” in items (b) through (e) 

and by “counterparty type” for items (d) and (f) are unclear. Moreover, with respect to 

items (d), (e), and (f), the commenter recommended that disclosures should be provided 

on an annual rather than quarterly basis. The same commenter also asserted that the 

disclosure of remaining contractual maturity breakdown in item (e) should be required 

annually. Finally, regarding items (f) and (g), a few commenters wanted clarification of 

the definition of impaired and past due loans. 

The agencies are not prescriptive with regard to what is meant by “major types of 

credit exposure,” disclosure by counterparty type, or impaired and past due loans. Bank 

management has the discretion to determine the most appropriate disclosure for the 

bank’s risk profile consistent with internal practice, GAAP or regulatory reports (such as 

the FR Y-9C). As noted in the proposal, for major types of credit exposure a bank could 

apply a breakdown similar to that used for accounting purposes, such as (a) loans, offbalance sheet commitments, and other non-derivative off-balance sheet exposures, (b) 

debt securities, and (c) OTC derivatives. The agencies do not believe it is appropriate to 

make an exception to the general quarterly requirement for quantitative disclosures for 

the disclosure in Table 11.4. 
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Commenters provided extensive feedback on several aspects of Table 11.5, 

(Disclosures for Portfolios Subject to IRB Risk-Based Capital Formulas). Several 

commenters were concerned that the required level of detail may compel banks to 

disclose proprietary information. With respect to item (c), a couple of commenters noted 

that the proposal differs from the New Accord in requiring exposure-weighted average 

capital requirements instead of risk weight percentages for groups of wholesale and retail 

exposures. One commenter also suggested that the term “actual losses” required in item 

(d) needs to be defined. Finally, several commenters objected to the proposal in item (e) 

to disclose backtesting results, asserting that such results would not be understood by the 

market. Commenters suggested that disclosure of this item be delayed beyond the 

proposed commencement date of year-end 2010, to commence instead ten years after a 

bank exits from the parallel run period. 

As discussed above, the agencies believe that, in most cases, a bank can make the 

required disclosures without revealing proprietary information and that the rule contains 

appropriate provisions to deal with specific bank concerns. With regard to item (c), the 

agencies agree that there is no strong policy reason to differ from the New Accord and 

have changed item (c) to require the specified disclosures in risk weight percentages 

rather than weighted-average capital requirements. With respect to item (d), the agencies 

are not imposing a prescriptive definition of actual losses and believe that banks should 

determine actual losses consistent with internal practice. Finally, regarding item (e), the 

agencies believe that public disclosure of backtesting results provides important 

information to the market and should not be delayed. However, the agencies have 
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slightly modified the requirement, consistent with the New Accord, to reinforce that 

disclosure of individual risk parameter backtesting is not always required. 

Commenters provided feedback on a few aspects of Table 11.7 (Credit Risk 

Mitigation). One commenter asserted that the table appears to overlap with the 

information on credit risk mitigation required in Table 11.5, item (a) and requested that 

the agencies consolidate and simplify the requirements. In addition, several commenters 

objected to Table 11.7 item (b), which would require public disclosure of the riskweighted asset amount associated with credit risk exposures that are covered by credit 

risk mitigation in the form of guarantees and credit derivatives. The commenter noted 

that this requirement is not contained in the New Accord, which only requires the total 

exposure amount of such credit risk exposures. 

The agencies recognize that there is some duplication between Tables 11.7 and 

11.5. At the same time, both requirements are part of the New Accord. The agencies 

have decided to address this issue by inserting in Table 11.5, item (a), a note that the 

disclosures can be met by completing the disclosures in Table 11.7. With regard to Table 

11.7, item (b), the agencies have decided that there is no strong policy reason for 

requiring banks to disclose risk-weighted assets associated with credit risk exposures that 

are covered by credit risk mitigation in the form of guarantees and credit derivatives. The 

agencies have removed this requirement from the final rule, consistent with the New 

Accord. 

Table 11.6 (General Disclosure for Counterparty Credit Risk of OTC Derivative 

Contracts, Repo-Style Transaction, and Eligible Margin Loans) provides the disclosure 

requirements related to credit exposures from derivatives. See the July 2005 BCBS 
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publication entitled “The Application of Basel II to Trading Activities and the Treatment 

of Double Default Effects.” 

Commenters raised a few issues with respect to Table 11.6. One commenter 

requested that the agencies clarify item (a), which requires a discussion of the impact of 

the amount of collateral the bank would have to provide given a credit rating downgrade. 

The commenter asked whether this disclosure refers to credit downgrade of the bank, the 

counterparty, or some other entity. Another commenter objected to item (b), which 

would require the breakdown of counterparty credit exposure by type of exposure. The 

commenter asserted that this proposed requirement is burdensome, infeasible for netted 

exposures and duplicative of other information generally available in existing GAAP and 

U.S. bank regulatory financial statements. 

The agencies have decided to clarify that item (a) refers in part to the credit rating 

downgrade of the bank making the disclosure. This is consistent with the intent of this 

disclosure requirement in the New Accord. With respect to item (b), the agencies 

recognize that this proposed requirement may be problematic for banks that have 

implemented the internal models methodology. Accordingly, the agencies have decided 

to modify the rule to note that this disclosure item is only required for banks not using the 

internal models methodology in section 32(d). 

Table 11.8 disclosures (Securitization) provide information to market participants 

on the amount of credit risk transferred and retained by the organization through 

securitization transactions and the types of products securitized by the organization. 

These disclosures provide users a better understanding of how securitization transactions 

impact the credit risk of the bank. 
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One commenter asked the agencies to explicitly acknowledge that they will 

accept the definitions and interpretations of the components of securitization exposures 

that a bank uses for financial reporting purposes (FAS 140 reporting disclosures). 

Generally, as noted above, the agencies expect that a bank will be able to fulfill 

some of its disclosure requirements by relying on disclosures made in accordance with 

accounting standards, SEC mandates, or regulatory reports. In these situations, a bank 

must explain any material differences between the accounting or other disclosure and the 

disclosures required under the final rule. The agencies do not believe any changes to the 

rule are necessary to accommodate the commenter’s concern. 

Table 11.9 disclosures (Operational Risk) provide insight into the bank’s 

application of the AMA for operational risk and what internal and external factors are 

considered in determining the amount of capital allocated to operational risk. 

Table 11.10 disclosures (Equities Not Subject to Market Risk Rule) provide 

market participants with an understanding of the types of equity securities held by the 

bank and how they are valued. The table also provides information on the capital 

allocated to different equity products and the amount of unrealized gains and losses. 

Table 11.11 disclosures (Interest Rate Risk in Non-Trading Activities) provide 

information about the potential risk of loss that may result from changes in interest rates 

and how the bank measures such risk. 

4. Regulatory reporting

In addition to the public disclosures required by the consolidated banking 

organization subject to the advanced approaches, the agencies will require certain 

additional regulatory reporting from BHCs, their subsidiary DIs, and DIs applying the 
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advanced approaches that are not subsidiaries of BHCs. The agencies believe that the 

reporting of key risk parameter estimates by each DI applying the advanced approaches 

will provide the primary Federal supervisor and other relevant supervisors with data 

important for assessing the reasonableness and accuracy of the bank’s calculation of its 

minimum capital requirements under this final rule and the adequacy of the institution’s 

capital in relation to its risks. This information will be collected through regulatory 

reports. The agencies believe that requiring certain common reporting across banks will 

facilitate comparable application of the final rule. 

The agencies will publish in the Federal Register reporting schedules based on the 

reporting templates issued for comment in September 2006. Consistent with the 

proposed reporting schedules, these reporting schedules will include a summary schedule 

with aggregate data that will be available to the general public. It also will include 

supporting schedules that will be viewed as confidential supervisory information. These 

schedules will be broken out by exposure category and will collect risk parameter and 

other pertinent data in a systematic manner. Under the final rule, banks must begin 

reporting this information during their parallel run on a confidential basis. The agencies 

will share this information with each other for calibration and other analytical purposes. 

One commenter expressed concerns that some of the confidential information 

requested in the proposed reporting templates was also contained in the public disclosure 

requirements under the proposal. As a result, some information would be classified as 

confidential in the reporting templates and public under the disclosure requirements in the 

final rule. 
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The agencies recognize that there may be some overlap between confidential 

information required in the regulatory reports and public information required in the 

disclosure requirements of the final rule. The agencies will address specific comments on 

the reporting templates separately. In general, the agencies believe that given the 

different purposes of the regulatory reporting and public disclosure requirements under 

the final rule, there may be some instances where the same or similar disclosures may be 

required by both sets of requirements. Many of the public disclosures cover only a subset 

of the information sought in the proposed regulatory reporting templates. For instance, 

banks are required only to disclose publicly information “across a sufficient number of 

PD grades to allow a meaningful differentiation of credit risk,” whereas the proposed 

reporting templates contemplate a much more granular collection of data by specified PD 

bands. Such aggregation of data so as to mask the confidential nature of more granular 

information that is reported to regulators is not unique to the advanced approaches 

reporting. In addition, the agencies believe that a bank may be able to comply with some 

of the public disclosure requirements under this final rule by publicly disclosing, at the 

bank’s discretion and judgment, certain information found in the reporting templates that 

otherwise would be held confidential by the agencies. A bank could disclose this 

information on its website (as described in “location and audit requirements” above) if it 

believes that such disclosures will meet the public disclosure requirements required by 

the rule. 

List of Acronyms 

ABCP Asset-Backed Commercial Paper 

ALLL Allowance for Loan and Lease Losses 
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AMA Advanced Measurement Approaches 

ANPR Advance Notice of Proposed Rulemaking 

AVC Asset Value Correlation 

BCBS Basel Committee on Banking Supervision 

BHC Bank Holding Company 

CCDS Contingent Credit Default Swap 

CF Conversion Factor 

CEIO Credit-Enhancing Interest-Only Strip 

CRM Credit Risk Mitigation 

CUSIP Committee on Uniform Securities Identification Procedures 

DI Depository Institution 

DvP Delivery versus Payment 

E Measure of Effectiveness 

EAD Exposure at Default 

ECL Expected Credit Loss 

EE Expected Exposure 

EL Expected Loss 

ELGD Expected Loss Given Default 

EOL Expected Operational Loss 

EPE Expected Positive Exposure 

EWALGD Exposure-Weighted Average Loss Given Default 

FAS Financial Accounting Standard 

FDIC Federal Deposit Insurance Corporation 
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FFIEC Federal Financial Institutions Examination Council 

GAAP Generally Accepted Accounting Principles 

GAO Government Accountability Office 

HELOC Home Equity Line of Credit 

HOLA Home Owners’ Loan Act 

HVCRE High-Volatility Commercial Real Estate 

IAA Internal Assessment Approach 

ICAAP Internal Capital Adequacy Assessment Process 

IMA Internal Models Approach 

IRB Internal Ratings-Based 

KIRB Capital Requirement for Underlying Pool of Exposures (securitizations) 

LGD Loss Given Default 

LTV Loan-to-Value Ratio 

M Effective Maturity 

NRSRO Nationally Recognized Statistical Rating Organization 

OCC Office of the Comptroller of the Currency 

OTC Over-the-Counter 

OTS Office of Thrift Supervision 

PCA Prompt Corrective Action 

PD Probability of Default 

PFE Potential Future Exposure 

PMI Private Mortgage Insurance 

PvP Payment versus Payment 
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QIS-3 Quantitative Impact Study 3 

QIS-4 Quantitative Impact Study 4 

QIS-5 Quantitative Impact Study 5 

QRE Qualifying Revolving Exposure 

RBA Ratings-Based Approach 

RVC Ratio of Value Change 

SEC Securities and Exchange Commission 

SFA Supervisory Formula Approach 

SME Small- and Medium-Size Enterprise 

SPE Special Purpose Entity 

SRWA Simple Risk-Weight Approach 

TFR Thrift Financial Report 

UL Unexpected Loss 

UOL Unexpected Operational Loss 

VaR Value-at-Risk 

Regulatory Flexibility Act Analysis 

The Regulatory Flexibility Act (RFA) requires an agency that is issuing a final 

rule to prepare and make available a regulatory flexibility analysis that describes the 

impact of the final rule on small entities. 5 U.S.C. 603(a). The RFA provides that an 

agency is not required to prepare and publish a regulatory flexibility analysis if the 

agency certifies that the final rule will not have a significant economic impact on a 

substantial number of small entities. 5 U.S.C. 605(b). 
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Pursuant to section 605(b) of the RFA (5 U.S.C. 605(b)), the agencies certify that 

this final rule will not have a significant economic impact on a substantial number of 

small entities. Pursuant to regulations issued by the Small Business Administration (13 

CFR 121.201), a “small entity” includes a bank holding company, commercial bank, or 

savings association with assets of $165 million or less (collectively, small banking 

organizations). The final rule requires a bank holding company, national bank, state 

member bank, state nonmember bank, or savings association to calculate its risk-based 

capital requirements according to certain internal-ratings-based and internal model 

approaches if the bank holding company, bank, or savings association (i) has 

consolidated total assets (as reported on its most recent year-end regulatory report) equal 

to $250 billion or more; (ii) has consolidated total on-balance sheet foreign exposures at 

the most recent year-end equal to $10 billion or more; or (iii) is a subsidiary of a bank 

holding company, bank, or savings association that would be required to use the proposed 

rule to calculate its risk-based capital requirements. 

 The agencies estimate that zero small bank holding companies (out of a total of 

approximately 2,934 small bank holding companies), 16 small national banks (out of a 

total of approximately 942 small national banks), one small state member bank (out of a 

total of approximately 491 small state member banks), one small state nonmember bank 

(out of a total of approximately 3,249 small state nonmember banks), and zero small 

savings associations (out of a total of approximately 419 small savings associations) 

would be subject to the final rule on a mandatory basis. In addition, each of the small 

banking organizations subject to the final rule on a mandatory basis is a subsidiary of a 

bank holding company with over $250 billion in consolidated total assets or over 
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$10 billion in consolidated total on-balance sheet foreign exposure. Therefore, the 

agencies believe that the final rule will not result in a significant economic impact on a 

substantial number of small entities. 

Paperwork Reduction Act

 In accordance with the requirements of the Paperwork Reduction Act of 1995, the 

agencies may not conduct or sponsor, and respondents are not required to respond to, an 

information collection unless it displays a currently valid Office of Management and 

Budget (OMB) control number. OMB assigned the following control numbers to the 

collections of information: 1557-0234 (OCC), 3064-0153 (FDIC), and 1550-0115 

(OTS). The Board assigned control number 7100-0313. 

In September 2006 the OCC, FDIC, and OTS submitted the information 

collections contained in this rule to OMB for review and approval once the proposed rule 

was published. The Board, under authority delegated to it by OMB, also submitted the 

proposed information collection to OMB. 

 The agencies (OCC, FDIC, the Board, and OTS) determined that sections 21-24, 

42, 44, 53, and 71 of the final rule contain collections of information. The final rule sets 

forth a new risk-based capital adequacy framework that would require some banks and 

allow other qualifying banks to use an internal ratings-based approach to calculate 

regulatory credit risk capital requirements and advanced measurement approaches to 

calculate regulatory operational risk capital requirements. The collections of information 

are necessary in order to implement the proposed advanced capital adequacy framework. 

The agencies received approximately ninety public comments. None of the comment 

letters specifically addressed the proposed burden estimates; therefore, the burden 
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estimates will remain unchanged, as published in the notice of proposed rulemaking 

(71 FR 55830). 

The affected public are: national banks and Federal branches and agencies of 

foreign banks (OCC); state member banks, bank holding companies, affiliates and certain 

non-bank subsidiaries of bank holding companies, uninsured state agencies and branches 

of foreign banks, commercial lending companies owned or controlled by foreign banks, 

and Edge and agreement corporations (Board); insured nonmember banks, insured state 

branches of foreign banks, and certain subsidiaries of these entities (FDIC); and savings 

associations and certain of their subsidiaries (OTS). 

Comment Request

 The agencies have an ongoing interest in your comments. They should be sent 

to [Agency] Desk Officer, [OMB No.], by mail to U.S. Office of Management and 

Budget, 725 17th Street, NW, #10235, Washington, DC 20503, or by fax to (202) 395-

6974. 

 Comments submitted in response to this notice will be shared among the 

agencies. All comments will become a matter of public record. Written comments 

should address the accuracy of the burden estimates and ways to minimize burden 

including the use of automated collection techniques or the use of other forms of 

information technology as well as other relevant aspects of the information collection 

request. 

OCC Executive Order 12866 

Executive Order 12866 requires Federal agencies to prepare a regulatory impact 

analysis for agency actions that are found to be “significant regulatory actions.” 
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“Significant regulatory actions” include, among other things, rulemakings that “have an 

annual effect on the economy of $100 million or more or adversely affect in a material 

way the economy, a sector of the economy, productivity, competition, jobs, the 

environment, public health or safety, or State, local, or tribal governments or 

communities.”108 Regulatory actions that satisfy one or more of these criteria are referred 

to as “economically significant regulatory actions.” 

The OCC anticipates that the final rule will meet the $100 million criterion and 

therefore is an economically significant regulatory action. In conducting the regulatory 

analysis for an economically significant regulatory action, Executive Order 12866 

requires each Federal agency to provide to the Administrator of the Office of 

Management and Budget’s (OMB) Office of Information and Regulatory Affairs (OIRA): 

• The text of the draft regulatory action, together with a reasonably detailed 

description of the need for the regulatory action and an explanation of how the 

regulatory action will meet that need; 

• An assessment of the potential costs and benefits of the regulatory action, 

including an explanation of the manner in which the regulatory action is 

consistent with a statutory mandate and, to the extent permitted by law, promotes 

the President's priorities and avoids undue interference with State, local, and tribal 

governments in the exercise of their governmental functions; 

 

108 Executive Order 12866 (September 30, 1993), 58 FR 51735 (October 4, 1993), as amended by 

Executive Order 13258 (February 26, 2002), 67 FR 9385 (February 28, 2002) and by Executive Order 

13422 (January 18, 2007), 72 FR 2763 (January 23, 2007). For the complete text of the definition of 

"significant regulatory action," see E.O. 12866 at § 3(f). A "regulatory action" is "any substantive action 

by an agency (normally published in the Federal Register) that promulgates or is expected to lead to the 

promulgation of a final rule or regulation, including notices of inquiry, advance notices of proposed 

rulemaking, and notices of proposed rulemaking." E.O. 12866 at § 3(e). 
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• An assessment, including the underlying analysis, of benefits anticipated from the 

regulatory action (such as, but not limited to, the promotion of the efficient 

functioning of the economy and private markets, the enhancement of health and 

safety, the protection of the natural environment, and the elimination or reduction 

of discrimination or bias) together with, to the extent feasible, a quantification of 

those benefits; 

• An assessment, including the underlying analysis, of costs anticipated from the 

regulatory action (such as, but not limited to, the direct cost both to the 

government in administering the regulation and to businesses and others in 

complying with the regulation, and any adverse effects on the efficient 

functioning of the economy, private markets (including productivity, 

employment, and competitiveness), health, safety, and the natural environment), 

together with, to the extent feasible, a quantification of those costs; and 

• An assessment, including the underlying analysis, of costs and benefits of 

potentially effective and reasonably feasible alternatives to the planned regulation, 

identified by the agencies or the public (including improving the current 

regulation and reasonably viable nonregulatory actions), and an explanation why 

the planned regulatory action is preferable to the identified potential alternatives. 

Set forth below is a summary of the OCC’s regulatory impact analysis, which can be 

found in its entirety at [INSERT UPDATED WEB ADDRESS]. 

I. THE NEED FOR THE REGULATORY ACTION 
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Federal banking law directs Federal banking agencies including the Office of the 

Comptroller of the Currency (OCC) to require banking organizations to hold adequate 

capital. The law authorizes Federal banking agencies to set minimum capital levels to 

ensure that banking organizations maintain adequate capital. The law also gives Federal 

banking agencies broad discretion with respect to capital regulation by authorizing them 

to also use any other methods that they deem appropriate to ensure capital adequacy. 

Capital regulation seeks to address market failures that stem from several sources. 

Asymmetric information about the risk in a bank’s portfolio creates a market failure by 

hindering the ability of creditors and outside monitors to discern a bank’s actual risk and 

capital adequacy. Moral hazard creates market failure in which the bank’s creditors fail 

to restrain the bank from taking excessive risks because deposit insurance either fully or 

partially protects them from losses. Public policy addresses these market failures because 

individual banks fail to adequately consider the positive externality or public benefit that 

adequate capital brings to financial markets and the economy as a whole. 

Capital regulations cannot be static. Innovation in and transformation of financial 

markets require periodic reassessments of what may count as capital and what amount of 

capital is adequate. Continuing changes in financial markets create both a need and an 

opportunity to refine capital standards in banking. The Basel Committee on Banking 

Supervision’s “International Convergence of Capital Measurement and Capital 

Standards: A Revised Framework” (New Accord), and its implementation in the United 

States, reflects an appropriate step forward in addressing these changes. 
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II. REGULATORY BACKGROUND 

The capital regulation examined in this analysis will apply to commercial banks 

and savings associations (collectively, banks). Three banking agencies, the OCC, the 

Board of Governors of the Federal Reserve System (Board), and the FDIC regulate 

commercial banks, while the Office of Thrift Supervision (OTS) regulates all federally 

chartered and many state-chartered savings associations. Throughout this document, the 

four are jointly referred to as the Federal banking agencies. 

The New Accord comprises three mutually reinforcing “pillars” as summarized 

below. 

1. Minimum capital requirements (Pillar 1) 

The first pillar establishes a method for calculating minimum regulatory capital. 

It sets new requirements for assessing credit risk and operational risk while retaining the 

approach to market risk as developed in the 1996 amendments to the 1988 Accord. 

The New Accord offers banks a choice of three methodologies for calculating a 

capital charge for credit risk. The first approach, called the Standardized Approach, 

essentially refines the risk-weighting framework of the 1988 Accord. The other two 

approaches are variations on an internal ratings-based (IRB) approach that leverages 

banks’ internal credit-rating systems: a “foundation” methodology in which banks 

estimate the probability of borrower or obligor default, and an “advanced” approach in 

which banks also supply other inputs needed for the capital calculation. In addition, the 
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new framework uses more risk-sensitive methods for dealing with collateral, guarantees, 

credit derivatives, securitizations, and receivables. 

The New Accord also introduces an explicit capital requirement for operational 

risk.109 The New Accord offers banks a choice of three methodologies for calculating 

their capital charge for operational risk. The first method, called the Basic Indicator 

Approach, requires banks to hold capital for operational risk equal to 15 percent of 

annual gross income (averaged over the most recent three years). The second option, 

called the Standardized Approach, uses a formula that divides a bank’s activities into 

eight business lines, calculates the capital charge for each business line as a fixed 

percentage of gross income (12 percent, 15 percent, or 18 percent depending on the 

nature of the business, again averaged over the most recent three years), and then sums 

across business lines. The third option, called the Advanced Measurement Approaches 

(AMA), uses an bank’s internal operational risk measurement system to determine the 

capital requirement. 

2. Supervisory review process (Pillar 2) 

The second pillar calls upon banks to have an internal capital assessment process 

and banking supervisors to evaluate each bank’s overall risk profile as well as its risk 

management and internal control processes. This pillar establishes an expectation that 

banks hold capital beyond the minimums computed under Pillar 1, including additional 

 

109 Operational risk is the risk of loss resulting from inadequate or failed processes, people, and systems or 

from external events. It includes legal risk, but excludes strategic risk and reputation risk. 
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capital for any risks that are not adequately captured under Pillar 1. It encourages banks 

to develop better risk management techniques for monitoring and managing their risks. 

Pillar 2 also charges supervisors with the responsibility to ensure that banks using 

advanced Pillar 1 techniques, such as the IRB approach to credit risk and the AMA for 

operational risk (collectively, advanced approaches), comply with the minimum 

standards and disclosure requirements of those methods, and take action promptly if 

capital is not adequate. 

3. Market discipline (Pillar 3) 

The third pillar of the New Accord sets minimum disclosure requirements for 

banks. The disclosures, covering the composition and structure of the bank’s capital, the 

nature of its risk exposures, its risk management and internal control processes, and its 

capital adequacy, are intended to improve transparency and strengthen market discipline. 

By establishing a common set of disclosure requirements, Pillar 3 seeks to provide a 

consistent and understandable disclosure framework that market participants can use to 

assess key pieces of information on the risks and capital adequacy of a bank. 

B. U.S. implementation 

The rule for implementing the New Accord’s advanced approaches in the United 

States will apply the new framework to the largest and most internationally active banks. 

All banks will fall into one of three regulatory categories. The first category, called 
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“mandatory” banks, consists of banks with consolidated assets of at least $250 billion or 

consolidated on-balance-sheet foreign exposures of $10 billion or more. Mandatory 

banks will have to use the New Accord’s most advanced methods only: the Advanced 

IRB approach to determine capital for credit risk and the AMA to determine capital for 

operational risk. A second category of banks, called “opt-in” banks, includes banks that 

do not meet either size criteria of a mandatory bank but choose voluntarily to comply 

with the advanced approaches specified under the New Accord. The third category, 

called “general” banks, encompasses all other banks, and these will continue to operate 

under existing risk-based capital rules, subject to any amendments. 

Various changes to the rules that apply to non-mandatory banks are under 

consideration. The Federal banking agencies have decided to issue for comment a 

proposal that would allow the voluntary adoption of the standardized approach for credit 

risk and the basic indicator approach for operational risk for non-mandatory banks 

(referred to hereafter as the Standardized Option). Because the Standardized Option 

would be a separate rulemaking, our analysis will focus just on the implementation of the 

Advanced Approaches. However, we will note how the Standardized Option might affect 

the outcome of our analysis if we anticipate the possibility that its adoption could lead to 

a significantly different outcome. 

While introducing many significant changes, the U.S. implementation of the New 

Accord retains many components of the capital rules currently in effect. For example, it 

preserves existing Prompt Corrective Action provisions for all banks. The U.S. 
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implementation of the New Accord also keeps intact most elements of the definition of 

what comprises regulatory capital. 

III. COSTS AND BENEFITS OF THE RULE 

This analysis considers the costs and benefits of the fully phased-in rule. Under 

the rule, current capital rules will remain in effect in 2008 during a parallel run using both 

old and new capital rules. For three years following the parallel run, the final rule will 

apply limits on the amount by which minimum required capital may decrease. This 

analysis, however, considers the costs and benefits of the rule as fully phased in. 

Cost and benefit analysis of changes in minimum capital requirements entail 

considerable measurement problems. On the cost side, it can be difficult to attribute 

particular expenditures incurred by banks to the costs of implementation because banks 

would likely incur some of these costs as part of their ongoing efforts to improve risk 

measurement and management systems. On the benefits side, measurement problems are 

even greater because the benefits of the rule are more qualitative than quantitative. 

Measurement problems exist even with an apparently measurable effect such as lower 

minimum capital because lower minimum requirements do not necessarily mean lower 

capital levels held by banks. Healthy banks generally hold capital well above regulatory 

minimums for a variety of reasons, and the effect of reducing the regulatory minimum is 

uncertain and may vary across regulated banks. 

Benefits of the Rule 
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1. Better allocation of capital and reduced impact of moral hazard through 

reduction in the scope for regulatory arbitrage: By assessing the amount of 

capital required for each exposure or pool of exposures, the advanced 

approaches do away with the simplistic risk buckets of current capital rules. 

Getting rid of categorical risk weighting and assigning capital based on 

measured risk instead greatly curtails or eliminates the ability of troubled 

banks to “game” regulatory capital requirements by finding ways to comply 

technically with the requirements while evading their intent and spirit. 

2. Improved signal quality of capital as an indicator of solvency: The advanced 

approaches are designed to more accurately align regulatory capital with 

risk, which should improve the signal quality of capital as an indicator of 

solvency. The improved signaling quality of capital will enhance banking 

supervision and market discipline. 

3. Encourages banks to improve credit risk management: One of the principal 

objectives of the rule is to more closely align capital charges and risk. For 

any type of credit, risk increases as either the probability of default or the 

loss given default increases. Under the final rule, the capital charge for 

credit risk depends on these risk parameter measures and consequently 

capital requirements will more closely reflect risk. This enhanced link 

between capital requirements and risk will encourage banks to improve 

credit risk management. 

4. More efficient use of required bank capital: Increased risk sensitivity and 

improvements in risk measurement will allow prudential objectives to be 
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achieved more efficiently. If capital rules can better align capital with risk 

across the system, a given level of capital will be able to support a higher 

level of banking activity while maintaining the same degree of confidence 

regarding the safety and soundness of the banking system. Social welfare is 

enhanced by either the stronger condition of the banking system or the 

increased economic activity the additional banking services facilitate. 

5. Incorporates and encourages advances in risk measurement and risk 

management: The rule seeks to improve upon existing capital regulations by 

incorporating advances in risk measurement and risk management made 

over the past 15 years. An objective of the rule is to speed adoption of new 

risk management techniques and to promote the further development of risk 

measurement and management through the regulatory process. 

6. Recognizes new developments and accommodates continuing innovation in 

financial products by focusing on risk: The rule also has the benefit of 

facilitating recognition of new developments in financial products by 

focusing on the fundamentals behind risk rather than on static product 

categories. 

7. Better aligns capital and operational risk and encourages banks to mitigate 

operational risk: Introducing an explicit capital calculation for operational 

risk eliminates the implicit and imprecise “buffer” that covers operational 

risk under current capital rules. Introducing an explicit capital requirement 

for operational risk improves assessments of the protection capital provides, 

particularly at banks where operational risk dominates other risks. The 
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explicit treatment also increases the transparency of operational risk, which 

could encourage banks to take further steps to mitigate operational risk. 

8. Enhanced supervisory feedback: Although U.S. banks have long been 

subject to close supervision, aspects of all three pillars of the rule aim to 

enhance supervisory feedback from Federal banking agencies to managers 

of banks. Enhanced feedback could further strengthen the safety and 

soundness of the banking system. 

9. Enhanced disclosure promotes market discipline: The rule seeks to aid 

market discipline through the regulatory framework by requiring specific 

disclosures relating to risk measurement and risk management. Market 

discipline could complement regulatory supervision to bolster safety and 

soundness. 

10. Preserves the benefits of international consistency and coordination 

achieved with the 1988 Basel Accord: An important objective of the 1988 

Accord was competitive consistency of capital requirements for banks 

competing in global markets. The New Accord continues to pursue this 

objective. Because achieving this objective depends on the consistency of 

implementation in the United States and abroad, the Basel Committee on 

Banking Supervision (BCBS) has established an Accord Implementation 

Group to promote consistency in the implementation of the New Accord. 

11. Ability to opt in offers long-term flexibility to nonmandatory banks: The 

U.S. implementation of the New Accord allows non-mandatory banks to 

individually judge when the benefits they expect to realize from adopting 
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the advanced approaches outweigh their costs. Even though the cost and 

complexity of adopting the advanced methods may present non-mandatory 

banks with a substantial hurdle to opting in at present, the potential longterm benefits of allowing non-mandatory banks to partake in the benefits 

described above may be similarly substantial. 

Costs of the Rule

Because banks are constantly developing programs and systems to improve how 

they measure and manage risk, it is difficult to distinguish between expenditures 

explicitly caused by adoption of this final rule and costs that would have occurred 

irrespective of any new regulation. In an effort to identify how much banks expect to 

spend to comply with the U.S. implementation of the New Accord’s advanced 

approaches, the Federal banking agencies included several questions related to 

compliance costs in the fourth Quantitative Impact Study (QIS-4).110 

1. Overall Costs: According to the 19 out of 26 QIS-4 questionnaire 

respondents that provided estimates of their implementation costs, banks 

will spend roughly $42 million on average to adapt to capital requirements 

implementing the New Accord’s advanced approaches. Not all of these 

respondents are likely mandatory banks. Counting just the likely mandatory 

 

110 For more information on QIS-4, see Office of the Comptroller of the Currency, Board of Governors of 

the Federal Reserve System, Federal Deposit Insurance Corporation, and Office of Thrift Supervision, 

“Summary Findings of the Fourth Quantitative Impact Study,” February 2006, available online at 

http://www.occ.treas.gov/ftp/release/2006-23a.pdf. 
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banks, the average is approximately $46 million, so there is little difference 

between banks that meet a mandatory threshold and those that do not. 

Aggregating estimated expenditures from all 19 respondents indicates that 

these banks will spend a total of $791 million over several years to 

implement the rule. Estimated costs for nine respondents meeting one of the 

mandatory thresholds come to $412 million. 

2. Estimate of costs specific to the rule: Ten QIS-4 respondents provided 

estimates of the portion of costs they would have incurred even if current 

capital rules remain in effect. Those ten indicated that they would have 

spent 45 percent on average, or roughly half of their advanced approaches 

expenditures on improving risk management anyway. This suggests that of 

the $42 million banks expect to spend on implementation, approximately 

$21 million may represent expenditures each bank would have undertaken 

even without the New Accord. Thus, pure implementation costs may be 

closer to roughly $395 million for the 19 QIS-4 respondents. 

3. Ongoing costs: Seven QIS-4 respondents were able to estimate what their 

recurring costs might be under the U.S implementation of the New Accord. 

On average, the seven banks estimate that annual recurring expenses 

attributable to the revised capital framework will be $2.4 million per bank. 

Banks indicated that the ongoing costs to maintain related technology reflect 

costs for increased personnel and system maintenance. The larger one-time 

expenditures to adopt this final rule primarily involve money for system 

development and software purchases. 
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4. Implicit costs: In addition to explicit setup and recurring costs, banks may 

also face implicit costs arising from the time and inconvenience of having to 

adapt to new capital regulations. At a minimum this involves the increased 

time and attention required of senior bank management to introduce new 

programs and procedures and the need to closely monitor the new activities 

during the inevitable rough patches when the rule first takes effect. 

5. Government Administrative Costs: OCC expenditures fall into three broad 

categories: training, guidance, and supervision. Training includes expenses 

for AMA and IRB workshops, and other training courses and seminars for 

examiners. Guidance expenses reflect expenditures on the development of 

IRB and AMA guidance. Supervision expenses reflect bank-specific 

supervisory activities related to the development and implementation of the 

New Accord. The largest OCC expenditures have been on the development 

of IRB and AMA policy guidance. The $5.4 million spent on guidance 

represents 54 percent of the estimated total OCC advanced approachesrelated expenditure of $10.0 million through the 2006 fiscal year. In part, 

this large share reflects the absence of data for training and supervision costs 

for several years, but it also is indicative of the large guidance expenses in 

2002 and 2003 when the New Accord was in development. To date, New 

Accord expenditures have not been a large part of overall OCC 

expenditures. The $3 million spent on the advanced approaches in fiscal 

year 2006 represents less than one percent of the OCC’s $579 million 

budget for the year. 
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6. Total Cost: The OCC’s estimate of the total cost of the rule includes 

expenditures by banks and the OCC from the present through 2011, the final 

year of the transition period. Combining expenditures by mandatory banks 

and the OCC provides a present value estimate of $498.9 million for the 

total cost of the rule. 

7. Procyclicality: Procyclicality refers to the possibility that banks may reduce 

lending during economic downturns and increase lending during economic 

expansions as a consequence of minimum capital requirements. There is 

some concern that the risk-sensitivity of the Advanced IRB approach may 

cause capital requirements for credit risk to increase during an economic 

downturn. Although procyclicality may be inherent in banking to some 

extent, elements of the advanced approaches could reduce inherent 

procyclicality. Risk management and information systems may provide 

bank managers with more forward-looking information about risk that will 

allow them to adjust portfolios gradually and with more foresight as the 

economic outlook changes over the business cycle. Regulatory stresstesting requirements included in the rule also will help ensure that banks 

anticipate cyclicality in capital requirements to the greatest extent possible, 

reducing the potential economic impact of changes in capital requirements. 
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IV. COMPETITION AMONG PROVIDERS OF FINANCIAL SERVICES 

One potential concern with any regulatory change is the possibility that it might 

create a competitive advantage for some banks relative to others, a possibility that 

certainly applies to a change with the scope of this final rule. However, measurement 

difficulties described in the preceding discussion of costs and benefits also extend to any 

consideration of the impact on competition. Despite the inherent difficulty of drawing 

definitive conclusions, this section considers various ways in which competitive effects 

might be manifest, as well as available evidence related to those potential effects. 

1. Explicit Capital for Operational Risk: Some have noted that the explicit 

computation of required capital for operational risk could lead to an increase 

in total minimum regulatory capital for U.S. "processing" banks, generally 

defined as banks that tend to engage in a variety of activities related to 

securities clearing, asset management, and custodial services. Some have 

suggested that the increase in required capital could place such firms at a 

competitive disadvantage relative to competitors that do not face a similar 

capital requirement. A careful analysis by Fontnouvelle et al111 considers 

the potential competitive impact of the explicit capital requirement for 

operational risk. Overall, the study concludes that competitive effects from 

an explicit operational risk capital requirement should be, at most, extremely 

modest. 

 

111 Patrick de Fontnouvelle, Victoria Garrity, Scott Chu, and Eric Rosengren, “The Potential Impact of 

Explicit Basel II Operational Risk Capital Charges on the Competitive Environment of Processing Banks in 

the United States,” manuscript, Federal Reserve Bank of Boston, January 12, 2005. Available at 

www.federalreserve.gov/generalinfo/basel2/whitepapers.htm. 
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2. Residential Mortgage Lending: The issue of competitive effects has received 

substantial attention with respect to the residential mortgage market. The 

focus on the residential mortgage market stems from the size and 

importance of the market in the United States, and the fact that the rule may 

lead to substantial reductions in credit-risk capital for residential mortgages. 

To the extent that corresponding operational-risk capital requirements do not 

offset these credit-risk-related reductions, overall capital requirements for 

residential mortgages could decline under the rule. Studies by Calem and 

Follain112 and Hancock, Lennert, Passmore, and Sherlund113 suggest that 

banks operating under rules based on the New Accord’s advance approaches 

may increase their holdings of residential mortgages. Calem and Follain 

argue that the increase would be significant and come at the expense of 

general banks. Hancock et al foresee a more modest increase in residential 

mortgage holdings at banks operating under the advanced approaches rule, 

and they see this increase primarily as a shift away from the large 

government sponsored mortgage enterprises. 

3. Small Business Lending: One potential avenue for competitive effects is 

small-business lending. Smaller banks – those that are less likely to adopt 

the advanced approaches to regulatory capital under the rule – tend to rely 

more heavily on smaller loans within their commercial loan portfolios. To 

 

112 Paul S. Calem and James R. Follain, “Regulatory Capital Arbitrage and the Potential Competitive 

Impact of Basel II in the Market for Residential Mortgages”, The Journal of Real Estate Finance and 

Economics, Vol. 35, pp. 197-219, August 2007. 113 Diana Hancock, Andreas Lennert, Wayne Passmore, and Shane M. Sherlund, “An Analysis of the 

Potential Competitive Impact of Basel II Capital Standards on U.S. Mortgage Rates and Mortgage 

Securitization”, manuscript, Federal Reserve Board, April 2005. Available at 

www.federalreserve.gov/generalinfo/basel2/whitepapers.htm. 
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the extent that the rule reduces required capital for such loans, general banks 

not operating under the rule might be placed at a competitive disadvantage. 

A study by Berger114 finds some potential for a relatively small competitive 

effect on smaller banks in small business lending. However, Berger 

concludes that the small business market for large banks is very different 

from the small business market for smaller banks. For instance, a “small 

business” at a larger bank is usually much larger than small businesses at 

community banks. 

4. Mergers and Acquisitions: Another concern related to potential changes in 

competitive conditions under the rule is that bifurcation of capital standards 

might change the landscape with regard to mergers and acquisitions in 

banking and financial services. For example, banks operating under this 

final rule might be placed in a better position to acquire banks operating 

under the old rules, possibly leading to an undesirable consolidation of the 

banking sector. Research by Hannan and Pilloff115 suggests that the rule is 

unlikely to have a significant impact on merger and acquisition activity in 

banking. 

5. Credit Card Competition: The U.S. implementation of the New Accord 

might also affect competition in the credit card market. Overall capital 

requirements for credit card loans could increase under the rule. This raises 

 

114 Allen N. Berger, “Potential Competitive Effects of Basel II on Banks in SME Credit Markets in the 

United States,” Journal of Financial Services Research, 29:1, pp. 5-36, 2006. Also available at 

www.federalreserve.gov/generalinfo/basel2/whitepapers.htm. 115 Timothy H. Hannan and Steven J. Pilloff, “Will the Proposed Application of Basel II in the United 

States Encourage Increased Bank Merger Activity? Evidence from Past Merger Activity,” Federal Reserve 

Board Finance and Economics Discussion Series, 2004-13, February 2004. Available at 

www.federalreserve.gov/generalinfo/basel2/whitepapers.htm. 
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the possibility of a change in the competitive environment among banks 

subject to the new rules, nonbank credit card issuers, and banks not subject 

to this final rule. A study by Lang, Mester, and Vermilyea116 finds that 

implementation of a rule based on the New Accord will not affect credit 

card competition at most community and regional banks. The authors also 

suggest that higher capital requirements for credit cards may only pose a 

modest disadvantage to banks that are subject to this final rule. 

Overall, the evidence regarding the impact of this final rule on competitive equity 

is mixed. The body of recent economic research discussed in the body of this report does 

not reveal persuasive evidence of any sizeable competitive effects. Nonetheless, the 

Federal banking agencies recognize the need to closely monitor the competitive 

landscape subsequent to any regulatory change. In particular, the OCC and other Federal 

banking agencies will be alert for early signs of competitive inequities that might result 

from this final rule. A multi-year transition period before full implementation of this 

final rule should provide ample opportunity for the Federal banking agencies to identify 

any emerging problems. In particular, after the end of the second transition year, the 

agencies will conduct and publish a study that evaluates the advanced approaches to 

determine if there are any material deficiencies.117 The Federal banking agencies will 

consider any egregious competitive effects associated with New Accord implementation, 

whether domestic or international in context, to be a material deficiency. To the extent 

 

116 William W. Lang, Loretta J. Mester, and Todd A. Vermilyea, “Potential Competitive Effects on U.S. 

Bank Credit Card Lending from the Proposed Bifurcated Application of Basel II,” manuscript, Federal 

Reserve Bank of Philadelphia, December 2005. Available at 

http://www.philadelphiafed.org/files/wps/2005/wp05-29.pdf 117 The full text of the Regulatory Impact Analysis describes the factors that the interagency study will 

consider. 
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that undesirable competitive inequities emerge, the agencies have the power to respond to 

them through many channels, including but not limited to suitable changes to the capital 

adequacy regulations. 

V. ANALYSIS OF BASELINE AND ALTERNATIVES 

In order to place the costs and benefits of the rule in context, Executive Order 

12866 requires a comparison between this final rule, a baseline of what the world would 

look like without this final rule, and several reasonable alternatives to the rule. In this 

regulatory impact analysis, we analyze a baseline and three alternatives to the rule. The 

baseline analyzes the situation where the Federal banking agencies do not adopt this final 

rule, but other countries with internationally active banks do adopt the New Accord. 118

1. Baseline Scenario: Current capital standards based on the 1988 Basel 

Accord continue to apply to banks operating in the United States, but the 

rest of the world adopts the New Accord: Abandoning the New Accord in 

favor of current capital rules would eliminate essentially all of the benefits 

of the rule described earlier. In place of these lost or diminished benefits, 

the only advantage of continuing to apply current capital rules to all banks is 

that maintaining the status quo should alleviate concerns regarding 

competition among domestic financial service providers. Although the 

effect of the rule on competition is uncertain in our estimation, staying with 

current capital rules (or universally applying a revised rule that might 

 

118 In addition to the United States, members of the BCBS implementing Basel II are Belgium, Canada, 

France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, and the United 

Kingdom. 
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emerge from the Standardized Option) eliminates bifurcation. Concerns 

regarding competition usually center on this characteristic of the rule. 

However, the emergence of different capital rules across national borders 

would at least partially offset this advantage. Thus, while concerns 

regarding competition among U.S. financial service providers might 

diminish in this scenario, concerns regarding cross-border competition 

would likely increase. While continuing to use current capital rules 

eliminates most of the benefits of adopting the capital rule, it does not 

eliminate many costs associated with the New Accord. Because the New 

Accord-related costs are difficult to separate from the bank’s ordinary 

development costs and ordinary supervisory costs at the Federal banking 

agencies, not implementing the New Accord would reduce but not eliminate 

many of these costs associated with the final rule.119 Furthermore, because 

banks in the United States would be operating under a set of capital rules 

different from the rest of the world, U.S. banks that are internationally active 

may face higher costs because they will have to track and comply with more 

than one set of capital requirements. 

2. Alternative A: Permit U.S. banks to choose among all three New Accord

credit risk approaches: The principal benefit of Alternative A that the rule 

does not achieve is the increased flexibility of the regulation for banks that 

would be mandatory banks under the final rule. Banks that are not prepared 

for the adoption of the advanced approach to credit risk under the final rule 

 

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

available. 
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could choose to use the Foundation IRB methodology or even the 

Standardized Approach. How Alternative A might affect benefits depends 

entirely on how many banks select each of the three available options. The 

most significant drawback to Alternative A is the increased cost of applying 

a new set of capital rules to all U.S. banks. The vast majority of banks in 

the United States would incur no direct costs from new capital rules. Under 

Alternative A, direct costs would increase for every U.S. bank that would 

have continued with current capital rules. Although it is not clear how high 

these costs might be, general banks would face higher costs because they 

would be changing capital rules regardless of which option they choose 

under Alternative A. 

3. Alternative B: Permit U.S. banks to choose among all three New Accord

operational risk approaches: The operational risk approach that banks 

ultimately selected would determine how the overall benefits of the new 

capital regulations would change under Alternative B. Just as Alternative A 

increases the flexibility of credit risk rules for mandatory banks, Alternative 

B is more flexible with respect to operational risk. Because the 

Standardized Approach tries to be more sensitive to variations in operational 

risk than the Basic Indicator Approach and AMA is more sensitive than the 

Standardized Approach, the effect of implementing Alternative B depends 

on how many banks select the more risk sensitive approaches. As was the 

case with Alternative A, the most significant drawback to Alternative B is 

the increased cost of applying a new set of capital rules to all U.S. banks. 
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Under Alternative B, direct costs would increase for every U.S. bank that 

would have continued with current capital rules. It is not clear how much it 

might cost banks to adopt these capital measures for operational risk, but 

general banks would face higher costs because they would be changing 

capital rules regardless of which option they choose under Alternative B. 

4. Alternative C: Use a different asset amount to determine a mandatory bank: 

The number of mandatory banks decreases slowly as the size thresholds 

increase, and the number of banks grows more quickly as the thresholds 

decrease. Under Alternative C, the framework of the final rule would 

remain the same and only the number of mandatory banks would change. 

Because the structure of the implementation would remain intact, 

Alternative C would capture all of the benefits of the final rule. However, 

because these benefits derive from applying the final rule to individual 

banks, changing the number of banks affected by the rule will change the 

cumulative level of the benefits achieved. Generally, the benefits associated 

with the rule will rise and fall with the number of mandatory banks. 

Because Alternative C would change the number of mandatory banks 

subject to the rule, aggregate costs will also rise or fall with the number of 

mandatory banks. 

Overall Comparison of the Rule with Baselines and Alternatives 

The New Accord and its U.S. implementation seek to incorporate risk 

measurement and risk management advances into capital requirements. Risk-
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sensitive capital requirements are integral to ensuring an adequate capital cushion 

to absorb financial losses at large complex financial banks. In implementing the 

New Accord’s advanced approaches in the United States, the agencies’ intent is to 

achieve risk-sensitivity while maintaining a regulatory capital regime that is as 

rigorous as the current system. Total capital requirements under the advanced 

approaches, including capital for operational risk, will better allocate capital in the 

system. This will occur regardless of whether the minimum required capital at a 

particular bank is greater or less than it would be under current capital rules. In 

order to ensure that we achieve our goal of increased risk sensitivity without loss 

of rigor, the final rule provides a means for the agencies to identify and address 

deficiencies in the capital requirements that may become apparent during the 

transition period. 

Although the anticipated benefits of the final rule are difficult to quantify in dollar 

terms because of measurement problems, the OCC is confident that the 

anticipated benefits well exceed the anticipated costs of this regulation. On the 

basis of our analysis, we believe that the benefits of the final rule are significant, 

durable, and hold the potential to increase with time. The offsetting costs of 

implementing the final rule are also significant, but appear to be largely because 

of considerable start-up costs. However, much of the apparent start-up costs 

reflect activities that the banks would undertake as part of their ongoing efforts to 

improve the quality of their internal risk measurement and management, even in 

the absence of the New Accord and this final rule. The advanced approaches 

seem to have fairly modest ongoing expenses. Against these costs, the significant 
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benefits of the New Accord suggest that the final rule offers an improvement over 

the baseline scenario. 

(1) With regard to the three alternative approaches we consider, the final rule 

offers an important degree of flexibility while significantly restricting costs by limiting its 

application to large, internationally active banks. Alternatives A and B introduce more 

flexibility from the perspective of the large mandatory banks, but each is less flexible 

with respect to other banks. Either Alternative A or B would compel these nonmandatory banks to select a new set of capital rules and require them to undertake the 

time and expense of adjusting to this final rule. Alternative C would change the number 

of mandatory banks. If the number of mandatory banks increases, then the new rule 

would lose some of the flexibility it achieves with the opt-in option. Furthermore, costs 

would increase as the final rule would compel more banks to incur the expense of 

adopting the advanced approaches. Decreasing the number of mandatory banks would 

decrease the aggregate social good of each benefit achieved with the final rule. The final 

rule offers a better balance between costs and benefits than any of the three alternatives. 

OTS Executive Order 12866 Determination 

OTS commented on the development of, and concurs with, OCC’s RIA. Rather 

than replicate that analysis, OTS drafted an RIA incorporating OCC’s analysis by 

reference and adding appropriate material reflecting the unique aspects of the thrift 

industry. The full text of OTS’s RIA is available at the locations for viewing the OTS 

docket indicated in the ADDRESSES section above. OTS believes that its analysis meets 

the requirements of Executive Order 12866. 

The following discussion supplements OCC’s summary of its RIA. 
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The final rule will apply to approximately six mandatory and potential opt-in 

savings associations representing approximately 52 percent of total thrift industry assets. 

Approximately 76 percent of the total assets in these six institutions are concentrated in 

residential mortgage-related assets. By contrast, national banks tend to concentrate their 

assets in commercial loans and other kinds of non-mortgage loans. Only about 35 

percent of national bank’s total assets are residential mortgage-related assets. As a result, 

the costs and benefits of the final rule for OTS-regulated savings associations will differ 

in important ways from OCC-regulated national banks. These differences are the focus 

of OTS’s analysis. 

Benefits. Among the benefits of the final rule, OCC cites: (i) Better allocation of 

capital and reduced impact of moral hazard through reduction in the scope for regulatory 

arbitrage; (ii) improved signal quality of capital as an indicator of institution solvency; 

and (iii) more efficient use of required bank capital. From OTS’s perspective, however, 

the final rule may not provide the degree of benefits anticipated by OCC from these 

sources. 

Because of the typically low credit risk associated with residential mortgagerelated assets, OTS believes that the risk-insensitive leverage ratio, rather than the riskbased capital ratio, may be more binding on savings association institutions.120 As a 

result, these institutions may be required to hold more capital than would be required 

under Basel II risk-based standards alone. Therefore, the final rule may cause these 

 

120 The leverage ratio is the ratio of core capital to adjusted total assets. Under prompt corrective action 

requirements, savings associations must maintain a leverage ratio of at least five percent to be well 

capitalized and at least four percent to be adequately capitalized. Basel II will primarily affect the 

calculation of risk-weighted assets, rather than the calculation of total assets and will have only a modest 

impact on the calculation of core capital. Thus, the proposed Basel II changes should not significantly 

affect the calculated leverage ratio and a savings association that is currently constrained by the leverage 

ratio would not significantly benefit from the Basel II changes. 
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institutions to incur much the same implementation costs as banks with riskier assets, but 

with reduced benefits. 

Costs. OTS adopts the OCC cost analysis with the following supplemental 

information on OTS’s administrative costs. OTS did not incur a meaningful amount of 

direct expenditures until 2002 when it transitioned from a monitoring role to active 

involvement in Basel II. Thereafter, expenditures increased rapidly. The OTS 

expenditures fall into two broad categories: policymaking expenses incurred in the 

development of the ANPR, the NPR, the final rule and related guidance; and supervision 

expenses that reflect institution-specific supervisory activities. OTS estimates that it 

incurred total expenses of $6,420,000 for fiscal years 2002 through 2006, including 

$4,080,000 in policymaking expenses and $2,340,000 in supervision expenses. OTS 

anticipates that supervision expenses will continue to grow as a percentage of the total 

expense as it moves from policy development to implementation and training. To date, 

Basel II expenditures have not been a large part of overall expenditures. 

Competition. OTS agrees with OCC’s analysis of competition among providers 

of financial services. OTS adds, however, that some institutions with low credit risk 

portfolios face an existing competitive disadvantage because they are bound by a nonrisk-based capital requirement – the leverage ratio. Thus, the agencies regulate a class of 

institutions that currently receive fewer capital benefits from risk-based capital rules 

because they are bound by the risk-insensitive leverage ratio. This anomaly will likely 

continue under the final rule. 

In addition, the results from QIS-3 and QIS-4 suggest that the largest reductions 

in regulatory credit-risk capital requirements from the application of revised rules would 
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occur in the residential mortgage loan area. Thus, to the extent regulatory credit-risk 

capital requirements affect pricing of such loans, it is possible that core and opt-in 

institutions who are not constrained by the leverage ratio may experience an 

improvement in their competitive standing vis-à-vis non-adopters and vis-à-vis adopters 

who are bound by the leverage ratio. Two research papers – one by Calem and 

Follain,121 and another by Hancock, Lenhert, Passmore, and Sherlund122 addressed this 

topic. The Calem and Follain paper argues that Basel II will significantly affect the 

competitive environment in mortgage lending; Hancock, et al. argue that it will not. Both 

papers are predicated, however, on the current capital regime for non-adopters. The 

agencies recently announced that they have agreed to issue a proposed rule that would 

provide non-core banks with the option to adopt an approach consistent with the 

standardized approach included in the Basel II framework. The standardized proposal 

will replace the earlier proposed rule (the Basel IA proposed rule), and would be 

available as an alternative to the existing risk-based capital rules for all U.S. banks other 

than banks that adopt the final Basel II rule. Such modifications, if implemented, would 

likely reduce the competitive advantage of Basel II adopters.

The final rule also has a ten percent floor on loss given default parameter 

estimates for residential mortgage segments that persists beyond the two-year period 

articulated in the international Basel II framework, providing a disincentive for core 

institutions to hold the least risky residential mortgages. This may have the effect of 

 

121 Paul S. Calem and James R. Follain, “An Examination of How the Proposed Bifurcated Implementation 

of Basel II in the U.S. May Affect Competition Among Banking Organizations for Residential Mortgages,” 

manuscript, January 14, 2005. 

122 Diana Hancock, Andreas Lenhert, Wayne Passmore, and Shane M Sherlund, “An Analysis of the 

Competitive Impacts of Basel II Capital Standards on U.S. Mortgage Rates and Mortgage Securitization, 

March 7, 2005, Board of Governors of the Federal Reserve System, working paper. 
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reducing the core banks’ advantage vis-à-vis both non-adopters and their international 

competitors. 

Further, residential mortgages are subject to substantial interest rate risk. The 

agencies will retain the authority to require additional capital to cover interest rate risk. If 

regulatory capital requirements affect asset pricing, a substantial regulatory capital 

interest rate risk component could mitigate any competitive advantages of the proposed 

rule. Moreover, the capital requirement for interest rate risk would be subject to 

interpretation by each agency. A consistent evaluation of interest rate risk by the 

supervisory agencies would present a level playing field among the adopters -- an 

important consideration given the potential size of the capital requirement. 

OCC Unfunded Mandates Reform Act of 1995 Determination

 The Unfunded Mandates Reform Act of 1995 (Pub. L. 104-4) (UMRA) requires 

cost-benefit and other analyses for a rule that would include any Federal mandate that 

may result in the expenditure by State, local, and tribal governments, in the aggregate, or 

by the private sector of $100 million or more (adjusted annually for inflation) in any one 

year. The current inflation-adjusted expenditure threshold is $119.6 million. The 

requirements of the UMRA include assessing a rule’s effects on future compliance costs; 

particular regions or State, local, or tribal governments; communities; segments of the 

private sector; productivity; economic growth; full employment; creation of productive 

jobs; and the international competitiveness of U.S. goods and services. The final rule 

qualifies as a significant regulatory action under the UMRA because its Federal mandates 

may result in the expenditure by the private sector of $119.6 million or more in any one 

year. As permitted by section 202(c) of the UMRA, the required analyses have been 
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prepared in conjunction with the Executive Order 12866 analysis document titled 

Regulatory Impact Analysis for Risk-Based Capital Standards: Revised Capital 

Adequacy Guidelines. The analysis is available on the Internet at 

http://www.occ.treas.gov/law/basel.htm under the link of “Regulatory Impact Analysis 

for Risk-Based Capital Standards: Revised Capital Adequacy Guidelines (Basel II), 

Office of the Comptroller of the Currency, International and Economic Affairs (2006)”.

OTS Unfunded Mandates Reform Act of 1995 Determination 

 The Unfunded Mandates Reform Act of 1995 (Pub. L. 104-4) (UMRA) requires 

cost-benefit and other analyses for a rule that would include any Federal mandate that 

may result in the expenditure by State, local, and tribal governments, in the aggregate, or 

by the private sector of $100 million or more (adjusted annually for inflation) in any one 

year. The current inflation-adjusted expenditure threshold is $119.6 million. The 

requirements of the UMRA include assessing a rule’s effects on future compliance costs; 

particular regions or State, local, or tribal governments; communities; segments of the 

private sector; productivity; economic growth; full employment; creation of productive 

jobs; and the international competitiveness of U.S. goods and services. The final rule 

qualifies as a significant regulatory action under the UMRA because its Federal mandates 

may result in the expenditure by the private sector of $119.6 or more in any one year. As 

permitted by section 202(c) of the UMRA, the required analyses have been prepared in 

conjunction with the Executive Order 12866 analysis document titled Regulatory Impact 

Analysis for Risk-Based Capital Standards: Revised Capital Adequacy Guidelines. The 

analysis is available at the locations for viewing the OTS docket indicated in the 

ADDRESSES section above. 
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Text of Common Appendix (All Agencies) 

The text of the agencies’ common appendix appears below: 

[Appendix __ to Part __] – Capital Adequacy Guidelines for [Banks]:1 InternalRatings-Based and Advanced Measurement Approaches 

Part I General Provisions 

Section 1 Purpose, Applicability, Reservation of Authority, and Principle of 

Conservatism 

Section 2 Definitions 

Section 3 Minimum Risk-Based Capital Requirements 

Part II Qualifying Capital 

Section 11 Additional Deductions 

Section 12 Deductions and Limitations Not Required 

Section 13 Eligible Credit Reserves 

Part III Qualification 

Section 21 Qualification Process 

Section 22 Qualification Requirements 

Section 23 Ongoing Qualification 

Section 24 Merger and Acquisition Transitional Arrangements 

Part IV Risk-Weighted Assets for General Credit Risk 

Section 31 Mechanics for Calculating Total Wholesale and Retail RiskWeighted Assets 

Section 32 Counterparty Credit Risk of Repo-Style Transactions, Eligible 

Margin Loans, and OTC Derivative Contracts 

Section 33 Guarantees and Credit Derivatives: PD Substitution and LGD 

Adjustment Approaches 

Section 34 Guarantees and Credit Derivatives: Double Default Treatment 

Section 35 Risk-Based Capital Requirement for Unsettled Transactions 

Part V Risk-Weighted Assets for Securitization Exposures 

Section 41 Operational Criteria for Recognizing the Transfer of Risk 

Section 42 Risk-Based Capital Requirement for Securitization Exposures 

Section 43 Ratings-Based Approach (RBA) 

Section 44 Internal Assessment Approach (IAA) 

 

1

 For simplicity, and unless otherwise noted, this final rule 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. 
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Section 45 Supervisory Formula Approach (SFA) 

Section 46 Recognition of Credit Risk Mitigants for Securitization Exposures 

Section 47 Risk-Based Capital Requirement for Early Amortization 

Provisions 

Part VI Risk-Weighted Assets for Equity Exposures 

Section 51 Introduction and Exposure Measurement 

Section 52 Simple Risk Weight Approach (SRWA) 

Section 53 Internal Models Approach (IMA) 

Section 54 Equity Exposures to Investment Funds 

Section 55 Equity Derivative Contracts 

Part VII Risk-Weighted Assets for Operational Risk 

Section 61 Qualification Requirements for Incorporation of Operational Risk 

Mitigants 

Section 62 Mechanics of Risk-Weighted Asset Calculation 

Part VIII Disclosure 

Section 71 Disclosure Requirements

Part I. General Provisions 

Section 1. Purpose, Applicability, Reservation of Authority, and Principle of 

Conservatism 

(a) Purpose. This appendix establishes: 

(1) Minimum qualifying criteria for [banks] using [bank]-specific internal risk 

measurement and management processes for calculating risk-based capital requirements; 

(2) Methodologies for such [banks] to calculate their risk-based capital 

requirements; and 

(3) Public disclosure requirements for such [banks]. 

(b) Applicability. (1) This appendix applies to a [bank] that: 

(i) Has consolidated total assets, as reported on the most recent year-end 

Consolidated Report of Condition and Income (Call Report) or Thrift Financial Report 

(TFR), equal to $250 billion or more; 
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(ii) Has consolidated total on-balance sheet foreign exposure at the most recent 

year-end equal to $10 billion or more (where total on-balance sheet foreign exposure 

equals total cross-border claims less claims with head office or guarantor located in 

another country plus redistributed guaranteed amounts to the country of head office or 

guarantor plus local country claims on local residents plus revaluation gains on foreign 

exchange and derivative products, calculated in accordance with the Federal Financial 

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

(iii) Is a subsidiary of a depository institution that uses 12 CFR part 3, 

Appendix C, 12 CFR part 208, Appendix F, 12 CFR part 325, Appendix D, or 12 CFR 

part 567, Appendix C, to calculate its risk-based capital requirements; or 

(iv) Is a subsidiary of a bank holding company that uses 12 CFR part 225, 

Appendix G, to calculate its risk-based capital requirements. 

(2) Any [bank] may elect to use this appendix to calculate its risk-based capital 

requirements. 

(3) A [bank] that is subject to this appendix must use this appendix unless the 

[AGENCY] determines in writing that application of this appendix is not appropriate in 

light of the [bank]’s asset size, level of complexity, risk profile, or scope of operations. 

In making a determination under this paragraph, the [AGENCY] will apply notice and 

response procedures in the same manner and to the same extent as the notice and 

response procedures in 12 CFR 3.12 (for national banks), 12 CFR 263.202 (for bank 

holding companies and state member banks), 12 CFR 325.6(c) (for state nonmember 

banks), and 12 CFR 567.3(d) (for savings associations). 
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(c) Reservation of authority - (1) Additional capital in the aggregate. The 

[AGENCY] may require a [bank] to hold an amount of capital greater than otherwise 

required under this appendix if the [AGENCY] determines that the [bank]’s risk-based 

capital requirement under this appendix is not commensurate with the [bank]’s credit, 

market, operational, or other risks. In making a determination under this paragraph, the 

[AGENCY] will apply notice and response procedures in the same manner and to the 

same extent as the notice and response procedures in 12 CFR 3.12 (for national banks), 

12 CFR 263.202 (for bank holding companies and state member banks), 12 CFR 325.6(c) 

(for state nonmember banks), and 12 CFR 567.3(d) (for savings associations). 

(2) Specific risk-weighted asset amounts. (i) If the [AGENCY] determines that 

the risk-weighted asset amount calculated under this appendix by the [bank] for one or 

more exposures is not commensurate with the risks associated with those exposures, the 

[AGENCY] may require the [bank] to assign a different risk-weighted asset amount to 

the exposures, to assign different risk parameters to the exposures (if the exposures are 

wholesale or retail exposures), or to use different model assumptions for the exposures (if 

relevant), all as specified by the [AGENCY]. 

(ii) If the [AGENCY] determines that the risk-weighted asset amount for 

operational risk produced by the [bank] under this appendix is not commensurate with the 

operational risks of the [bank], the [AGENCY] may require the [bank] to assign a 

different risk-weighted asset amount for operational risk, to change elements of its 

operational risk analytical framework, including distributional and dependence 

assumptions, or to make other changes to the [bank]’s operational risk management 
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processes, data and assessment systems, or quantification systems, all as specified by the 

[AGENCY]. 

(3) Other supervisory authority. Nothing in this appendix limits the authority of 

the [AGENCY] under any other provision of law or regulation to take supervisory or 

enforcement action, including action to address unsafe or unsound practices or 

conditions, deficient capital levels, or violations of law. 

(d) Principle of conservatism. Notwithstanding the requirements of this appendix, 

a [bank] may choose not to apply a provision of this appendix to one or more exposures, 

provided that: 

(1) The [bank] can demonstrate on an ongoing basis to the satisfaction of the 

[AGENCY] that not applying the provision would, in all circumstances, unambiguously 

generate a risk-based capital requirement for each such exposure greater than that which 

would otherwise be required under this appendix; 

(2) The [bank] appropriately manages the risk of each such exposure; 

(3) The [bank] notifies the [AGENCY] in writing prior to applying this principle 

to each such exposure; and 

(4) The exposures to which the [bank] applies this principle are not, in the 

aggregate, material to the [bank]. 

Section 2. Definitions 

Advanced internal ratings-based (IRB) systems means a [bank]’s internal risk 

rating and segmentation system; risk parameter quantification system; data management 

and maintenance system; and control, oversight, and validation system for credit risk of 

wholesale and retail exposures. 
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Advanced systems means a [bank]’s advanced IRB systems, operational risk 

management processes, operational risk data and assessment systems, operational risk 

quantification systems, and, to the extent the [bank] uses the following systems, the 

internal models methodology, double default excessive correlation detection process, 

IMA for equity exposures, and IAA for securitization exposures to ABCP programs. 

Affiliate with respect to a company means any company that controls, is 

controlled by, or is under common control with, the company. 

Applicable external rating means: 

(1) With respect to an exposure that has multiple external ratings assigned by 

NRSROs, the lowest solicited external rating assigned to the exposure by any NRSRO; 

and 

(2) With respect to an exposure that has a single external rating assigned by an 

NRSRO, the external rating assigned to the exposure by the NRSRO. 

Applicable inferred rating means: 

(1) With respect to an exposure that has multiple inferred ratings, the lowest 

inferred rating based on a solicited external rating; and 

(2) With respect to an exposure that has a single inferred rating, the inferred 

rating. 

Asset-backed commercial paper (ABCP) program means a program that primarily 

issues commercial paper that: 

(1) Has an external rating; and 

(2) Is backed by underlying exposures held in a bankruptcy-remote SPE. 

 Asset-backed commercial paper (ABCP) program sponsor means a [bank] that: 
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 (1) Establishes an ABCP program; 

 (2) Approves the sellers permitted to participate in an ABCP program; 

 (3) Approves the exposures to be purchased by an ABCP program; or 

 (4) Administers the ABCP program by monitoring the underlying exposures, 

underwriting or otherwise arranging for the placement of debt or other obligations issued 

by the program, compiling monthly reports, or ensuring compliance with the program 

documents and with the program’s credit and investment policy. 

Backtesting means the comparison of a [bank]’s internal estimates with actual 

outcomes during a sample period not used in model development. In this context, 

backtesting is one form of out-of-sample testing. 

Bank holding company is defined in section 2 of the Bank Holding Company Act 

(12 U.S.C. 1841). 

Benchmarking means the comparison of a [bank]’s internal estimates with 

relevant internal and external data or with estimates based on other estimation techniques. 

 Business environment and internal control factors means the indicators of a 

[bank]’s operational risk profile that reflect a current and forward-looking assessment of 

the [bank]’s underlying business risk factors and internal control environment. 

 Carrying value means, with respect to an asset, the value of the asset on the 

balance sheet of the [bank], determined in accordance with GAAP. 

 Clean-up call means a contractual provision that permits an originating [bank] or 

servicer to call securitization exposures before their stated maturity or call date. See also 

eligible clean-up call. 
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 Commodity derivative contract means a commodity-linked swap, purchased 

commodity-linked option, forward commodity-linked contract, or any other instrument 

linked to commodities that gives rise to similar counterparty credit risks. 

Company means a corporation, partnership, limited liability company, depository 

institution, business trust, special purpose entity, association, or similar organization. 

Control. A person or company controls a company if it: 

(1) Owns, controls, or holds with power to vote 25 percent or more of a class of 

voting securities of the company; or 

(2) Consolidates the company for financial reporting purposes. 

 Controlled early amortization provision means an early amortization provision 

that meets all the following conditions: 

 (1) The originating [bank] has appropriate policies and procedures to ensure that it 

has sufficient capital and liquidity available in the event of an early amortization; 

 (2) Throughout the duration of the securitization (including the early amortization 

period), there is the same pro rata sharing of interest, principal, expenses, losses, fees, 

recoveries, and other cash flows from the underlying exposures based on the originating 

[bank]’s and the investors’ relative shares of the underlying exposures outstanding 

measured on a consistent monthly basis; 

 (3) The amortization period is sufficient for at least 90 percent of the total 

underlying exposures outstanding at the beginning of the early amortization period to be 

repaid or recognized as in default; and 

 (4) The schedule for repayment of investor principal is not more rapid than would 

be allowed by straight-line amortization over an 18-month period. 
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Credit derivative means a financial contract executed under standard industry 

credit derivative documentation that allows one party (the protection purchaser) to 

transfer the credit risk of one or more exposures (reference exposure) to another party 

(the protection provider). See also eligible credit derivative. 

 Credit-enhancing interest-only strip (CEIO) means an on-balance sheet asset that, 

in form or in substance: 

(1) Represents a contractual right to receive some or all of the interest and no 

more than a minimal amount of principal due on the underlying exposures of a 

securitization; and 

(2) Exposes the holder to credit risk directly or indirectly associated with the 

underlying exposures that exceeds a pro rata share of the holder’s claim on the underlying 

exposures, whether through subordination provisions or other credit-enhancement 

techniques. 

 Credit-enhancing representations and warranties means representations and 

warranties that are made or assumed in connection with a transfer of underlying 

exposures (including loan servicing assets) and that obligate a [bank] to protect another 

party from losses arising from the credit risk of the underlying exposures. 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 
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not to exceed 120 days from the date of transfer, provided that the date of transfer is 

within one year of origination of the residential mortgage exposure; 

 (2) Premium refund clauses that cover underlying exposures guaranteed, in whole 

or in part, by the U.S. government, a U.S. government agency, or a U.S. government 

sponsored enterprise, provided that the clauses are for a period not to exceed 120 days 

from the date of transfer; or 

 (3) Warranties that permit the return of underlying exposures in instances of 

misrepresentation, fraud, or incomplete documentation. 

 Credit risk mitigant means collateral, a credit derivative, or a guarantee. 

 Credit-risk-weighted assets means 1.06 multiplied by the sum of: 

(1) Total wholesale and retail risk-weighted assets; 

(2) Risk-weighted assets for securitization exposures; and 

(3) Risk-weighted assets for equity exposures. 

Current exposure means, with respect to a netting set, the larger of zero or the 

market value of a transaction or portfolio of transactions within the netting set that would 

be lost upon default of the counterparty, assuming no recovery on the value of the 

transactions. Current exposure is also called replacement cost. 

Default - (1) Retail. (i) A retail exposure of a [bank] is in default if: 

(A) The exposure is 180 days past due, in the case of a residential mortgage 

exposure or revolving exposure; 

 (B) The exposure is 120 days past due, in the case of all other retail exposures; or 
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(C) The [bank] has taken a full or partial charge-off, write-down of principal, or 

material negative fair value adjustment of principal on the exposure for credit-related 

reasons. 

(ii) Notwithstanding paragraph (1)(i) of this definition, for a retail exposure held 

by a non-U.S. subsidiary of the [bank] that is subject to an internal ratings-based 

approach to capital adequacy consistent with the Basel Committee on Banking 

Supervision’s “International Convergence of Capital Measurement and Capital 

Standards: A Revised Framework” in a non-U.S. jurisdiction, the [bank] may elect to use 

the definition of default that is used in that jurisdiction, provided that the [bank] has 

obtained prior approval from the [AGENCY] to use the definition of default in that 

jurisdiction. 

(iii) A retail exposure in default remains in default until the [bank] has reasonable 

assurance of repayment and performance for all contractual principal and interest 

payments on the exposure. 

(2) Wholesale. (i) A [bank]’s wholesale obligor is in default if: 

(A) The [bank] determines that the obligor is unlikely to pay its credit obligations 

to the [bank] in full, without recourse by the [bank] to actions such as realizing collateral 

(if held); or 

(B) The obligor is past due more than 90 days on any material credit obligation(s) 

to the [bank].2

 

(ii) An obligor in default remains in default until the [bank] has reasonable 

assurance of repayment and performance for all contractual principal and interest 

 

2

 Overdrafts are past due once the obligor has breached an advised limit or been advised of a limit smaller 

than the current outstanding balance. 
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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 units of measure. 

Depository institution is defined in section 3 of the Federal Deposit Insurance Act 

(12 U.S.C. 1813). 

Derivative contract means a financial contract whose value is derived from the 

values of one or more underlying assets, reference rates, or indices of asset values or 

reference rates. Derivative contracts include interest rate derivative contracts, exchange 

rate derivative contracts, equity derivative contracts, commodity derivative contracts, 

credit derivatives, and any other instrument that poses similar counterparty credit risks. 

Derivative contracts also include unsettled securities, commodities, and foreign exchange 

transactions with a contractual settlement or delivery lag that is longer than the lesser of 

the market standard for the particular instrument or five business days. 

 Early amortization provision means a provision in the documentation governing a 

securitization that, when triggered, causes investors in the securitization exposures to be 

repaid before the original stated maturity of the securitization exposures, unless the 

provision: 

 (1) Is triggered solely by events not directly related to the performance of the 

underlying exposures or the originating [bank] (such as material changes in tax laws or 

regulations); or 

 (2) Leaves investors fully exposed to future draws by obligors on the underlying 

exposures even after the provision is triggered. 
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Economic downturn conditions means, with respect to an exposure held by the 

[bank], those conditions in which the aggregate default rates for that exposure’s 

wholesale or retail exposure subcategory (or subdivision of such subcategory selected by 

the [bank]) in the exposure’s national jurisdiction (or subdivision of such jurisdiction 

selected by the [bank]) are significantly higher than average. 

 Effective maturity (M) of a wholesale exposure means: 

(1) For wholesale exposures other than repo-style transactions, eligible margin 

loans, and OTC derivative contracts described in paragraph (2) or (3) of this definition: 

(i) The weighted-average remaining maturity (measured in years, whole or 

fractional) of the expected contractual cash flows from the exposure, using the 

undiscounted amounts of the cash flows as weights; or 

(ii) The nominal remaining maturity (measured in years, whole or fractional) of 

the exposure. 

(2) For repo-style transactions, eligible margin loans, and OTC derivative 

contracts subject to a qualifying master netting agreement for which the [bank] does not 

apply the internal models approach in paragraph (d) of section 32, the weighted-average 

remaining maturity (measured in years, whole or fractional) of the individual transactions 

subject to the qualifying master netting agreement, with the weight of each individual 

transaction set equal to the notional amount of the transaction. 

(3) For repo-style transactions, eligible margin loans, and OTC derivative 

contracts for which the [bank] applies the internal models approach in paragraph (d) of 

section 32, the value determined in paragraph (d)(4) of section 32. 
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 Effective notional amount means, for an eligible guarantee or eligible credit 

derivative, the lesser of the contractual notional amount of the credit risk mitigant and the 

EAD of the hedged exposure, multiplied by the percentage coverage of the credit risk 

mitigant. For example, the effective notional amount of an eligible guarantee that covers, 

on a pro rata basis, 40 percent of any losses on a $100 bond would be $40. 

 Eligible clean-up call means a clean-up call that: 

 (1) Is exercisable solely at the discretion of the originating [bank] or servicer; 

 (2) Is not structured to avoid allocating losses to securitization exposures held by 

investors or otherwise structured to provide credit enhancement to the securitization; and 

 (3) (i) For a traditional securitization, is only exercisable when 10 percent or less 

of the principal amount of the underlying exposures or securitization exposures 

(determined as of the inception of the securitization) is outstanding; or 

 (ii) For a synthetic securitization, is only exercisable when 10 percent or less of 

the principal amount of the reference portfolio of underlying exposures (determined as of 

the inception of the securitization) is outstanding. 

 Eligible credit derivative means a credit derivative in the form of a credit default 

swap, nth-to-default swap, total return swap, or any other form of credit derivative 

approved by the [AGENCY], provided that: 

 (1) The contract meets the requirements of an eligible guarantee and has been 

confirmed by the protection purchaser and the protection provider; 

 (2) Any assignment of the contract has been confirmed by all relevant parties; 

(3) If the credit derivative is a credit default swap or nth-to-default swap, the 

contract includes the following credit events: 
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(i) Failure to pay any amount due under the terms of the reference exposure, 

subject to any applicable minimal payment threshold that is consistent with standard 

market practice and with a grace period that is closely in line with the grace period of the 

reference exposure; and 

(ii) Bankruptcy, insolvency, or inability of the obligor on the reference exposure 

to pay its debts, or its failure or admission in writing of its inability generally to pay its 

debts as they become due, and similar events; 

(4) The terms and conditions dictating the manner in which the contract is to be 

settled are incorporated into the contract; 

(5) If the contract allows for cash settlement, the contract incorporates a robust 

valuation process to estimate loss reliably and specifies a reasonable period for obtaining 

post-credit event valuations of the reference exposure; 

(6) If the contract requires the protection purchaser to transfer an exposure to the 

protection provider at settlement, the terms of at least one of the exposures that is 

permitted to be transferred under the contract provides that any required consent to 

transfer may not be unreasonably withheld; 

(7) If the credit derivative is a credit default swap or 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 
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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, a 

savings and loan holding company (as defined in 12 U.S.C. 1467a) provided all or 

substantially all of the holding company’s activities are permissible for a financial 

holding company under 12 U.S.C. 1843(k), a securities broker or dealer registered with 

the SEC under the Securities Exchange Act of 1934 (15 U.S.C. 78o et seq.), or an 

insurance company in the business of providing credit protection (such as a monoline 

bond insurer or re-insurer) that is subject to supervision by a State insurance regulator, if: 

 (i) At the time the guarantor issued the guarantee or credit derivative or at any 

time thereafter, the [bank] assigned a PD to the guarantor’s rating grade that was equal to 

or lower than the PD associated with a long-term external rating in the third-highest 

investment-grade rating category; and 
DRAFT November 2, 2007 

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 (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.-based securities 

firm, or a non-U.S.-based insurance company in the business of providing credit 

protection, if: 

 (i) The [bank] demonstrates that the guarantor is subject to consolidated 

supervision and regulation comparable to that imposed on U.S. depository institutions, 

securities broker-dealers, or insurance companies (as the case may be), or has issued and 

outstanding an unsecured long-term debt security without credit enhancement that has a 

long-term applicable external rating of at least investment grade; 

 (ii) At the time the guarantor issued the guarantee or credit derivative or at any 

time thereafter, the [bank] assigned a PD to the guarantor’s rating grade that was equal to 

or lower than the PD associated with a long-term external rating in the third-highest 

investment-grade rating category; and 

 (iii) The [bank] currently assigns a PD to the guarantor’s rating grade that is equal 

to or lower than the PD associated with a long-term external rating in the lowest 

investment-grade rating category. 

Eligible guarantee means a guarantee that: 

 (1) Is written and unconditional; 

(2) Covers all or a pro rata portion of all contractual payments of the obligor on 

the reference exposure; 
DRAFT November 2, 2007 

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(3) Gives the beneficiary a direct claim against the protection provider; 

(4) Is not unilaterally cancelable by the protection provider for reasons other than 

the breach of the contract by the beneficiary; 

 (5) Is legally enforceable against the protection provider in a jurisdiction where 

the protection provider has sufficient assets against which a judgment may be attached 

and enforced; 

(6) Requires the protection provider to make payment to the beneficiary on the 

occurrence of a default (as defined in the guarantee) of the obligor on the reference 

exposure in a timely manner without the beneficiary first having to take legal actions to 

pursue the obligor for payment; 

(7) Does not increase the beneficiary’s cost of credit protection on the guarantee 

in response to deterioration in the credit quality of the reference exposure; and 

(8) Is not provided by an affiliate of the [bank], unless the affiliate is an insured 

depository institution, bank, securities broker or dealer, or insurance company that: 

(i) Does not control the [bank]; and 

(ii) Is subject to consolidated supervision and regulation comparable to that 

imposed on U.S. depository institutions, securities broker-dealers, or insurance 

companies (as the case may be). 

 Eligible margin loan means an extension of credit where: 

(1) The extension of credit is collateralized exclusively by liquid and readily 

marketable debt or equity securities, gold, or conforming residential mortgages; 

(2) The collateral is marked to market daily, and the transaction is subject to daily 

margin maintenance requirements; 
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(3) The extension of credit is conducted under an agreement that provides the 

[bank] the right to accelerate and terminate the extension of credit and to liquidate or set 

off collateral promptly upon an event of default (including upon an event of bankruptcy, 

insolvency, or similar proceeding) of the counterparty, provided that, in any such case, 

any exercise of rights under the agreement will not be stayed or avoided under applicable 

law in the relevant jurisdictions;3

 and 

(4) The [bank] has conducted sufficient legal review to conclude with a wellfounded basis (and maintains sufficient written documentation of that legal review) that 

the agreement meets the requirements of paragraph (3) of this definition and is legal, 

valid, binding, and enforceable under applicable law in the relevant jurisdictions. 

Eligible operational risk offsets means amounts, not to exceed expected 

operational loss, that: 

(1) Are generated by internal business practices to absorb highly predictable and 

reasonably stable operational losses, including reserves calculated consistent with GAAP; 

and 

(2) Are available to cover expected operational losses with a high degree of 

certainty over a one-year horizon. 

Eligible purchased wholesale exposure means a purchased wholesale exposure 

that: 

 

3

 This requirement is met where all transactions under the agreement are (i) executed under U.S. law and 

(ii) constitute “securities contracts” under section 555 of the Bankruptcy Code (11 U.S.C. 555), qualified 

financial contracts under section 11(e)(8) of the Federal Deposit Insurance Act (12 U.S.C. 1821(e)(8)), or 

netting contracts between or among financial institutions under sections 401-407 of the Federal Deposit 

Insurance Corporation Improvement Act of 1991 (12 U.S.C. 4401-4407) or the Federal Reserve Board’s 

Regulation EE (12 CFR part 231). 
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(1) The [bank] or securitization SPE purchased from an unaffiliated seller and did 

not directly or indirectly originate; 

(2) Was generated on an arm’s-length basis between the seller and the obligor 

(intercompany accounts receivable and receivables subject to contra-accounts between 

firms that buy and sell to each other do not satisfy this criterion); 

(3) Provides the [bank] or securitization SPE with a claim on all proceeds from 

the exposure or a pro rata interest in the proceeds from the exposure; 

(4) Has an M of less than one year; and 

(5) When consolidated by obligor, does not represent a concentrated exposure 

relative to the portfolio of purchased wholesale exposures. 

 Eligible securitization guarantor means: 

 (1) A sovereign entity, the Bank for International Settlements, the International 

Monetary Fund, the European Central Bank, the European Commission, a Federal Home 

Loan Bank, Federal Agricultural Mortgage Corporation (Farmer Mac), a multilateral 

development bank, a depository institution, a bank holding company, a savings and loan 

holding company (as defined in 12 U.S.C. 1467a) provided all or substantially all of the 

holding company’s activities are permissible for a financial holding company under 12 

U.S.C. 1843(k), a foreign bank (as defined in 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 a securitization SPE) that has issued and 

outstanding an unsecured long-term debt security without credit enhancement that has a 

long-term applicable external rating in one of the three highest investment-grade rating 

categories; or 
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 (3) Any other entity (other than a securitization SPE) that has a PD assigned by 

the [bank] that is lower than or equal to the PD associated with a long-term external 

rating in the third highest investment-grade rating category. 

Eligible servicer cash advance facility means a servicer cash advance facility in 

which: 

 (1) The servicer is entitled to full reimbursement of advances, except that a 

servicer may be obligated to make non-reimbursable advances for a particular underlying 

exposure if any such advance is contractually limited to an insignificant amount of the 

outstanding principal balance of that exposure; 

 (2) The servicer’s right to reimbursement is senior in right of payment to all other 

claims on the cash flows from the underlying exposures of the securitization; and 

 (3) The servicer has no legal obligation to, and does not, make advances to the 

securitization if the servicer concludes the advances are unlikely to be repaid. 

 Equity derivative contract means an equity-linked swap, purchased equity-linked 

option, forward equity-linked contract, or any other instrument linked to equities that 

gives rise to similar counterparty credit risks. 

 Equity exposure means: 

(1) A security or instrument (whether voting or non-voting) that represents a 

direct or indirect ownership interest in, and is a residual claim on, the assets and income 

of a company, unless: 

(i) The issuing company is consolidated with the [bank] under GAAP; 

(ii) The [bank] is required to deduct the ownership interest from tier 1 or tier 2 

capital under this appendix; 
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471

(iii) The ownership interest incorporates a payment or other similar obligation on 

the part of the issuing company (such as an obligation to make periodic payments); or 

(iv) The ownership interest is a securitization exposure; 

(2) A security or instrument that is mandatorily convertible into a security or 

instrument described in paragraph (1) of this definition; 

(3) An option or warrant that is exercisable for a security or instrument described 

in paragraph (1) of this definition; or 

(4) Any other security or instrument (other than a securitization exposure) to the 

extent the return on the security or instrument is based on the performance of a security 

or instrument described in paragraph (1) of this definition. 

 Excess spread for a period means: 

(1) Gross finance charge collections and other income received by a securitization 

SPE (including market interchange fees) over a period minus interest paid to the holders 

of the securitization exposures, servicing fees, charge-offs, and other senior trust or 

similar expenses of the SPE over the period; divided by 

(2) The principal balance of the underlying exposures at the end of the period. 

 Exchange rate derivative contract means a cross-currency interest rate swap, 

forward foreign-exchange contract, currency option purchased, or any other instrument 

linked to exchange rates that gives rise to similar counterparty credit risks. 

Excluded mortgage exposure means any one- to four-family residential pre-sold 

construction loan for a residence for which the purchase contract is cancelled that would 

receive a 100 percent risk weight under section 618(a)(2) of the Resolution Trust 

Corporation Refinancing, Restructuring, and Improvement Act and under 12 CFR part 3, 
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Appendix A, section 3(a)(3)(iii) (for national banks), 12 CFR part 208, Appendix A, 

section III.C.3. (for state member banks), 12 CFR part 225, Appendix A, section III.C.3. 

(for bank holding companies), 12 CFR part 325, Appendix A, section II.C.a. (for state 

nonmember banks), or 12 CFR 567.1 (definition of “qualifying residential construction 

loan”) and 12 CFR 567.6(a)(1)(iv) (for savings associations). 

 Expected credit loss (ECL) means: 

 (1) For a wholesale exposure to a non-defaulted obligor or segment of nondefaulted retail exposures that is carried at fair value with gains and losses flowing 

through earnings or that is classified as held-for-sale and is carried at the lower of cost or 

fair value with losses flowing through earnings, zero. 

(2) For all other wholesale exposures to non-defaulted obligors or segments of 

non-defaulted retail exposures, the product of PD times LGD times EAD for the exposure 

or segment. 

 (3) For a wholesale exposure to a defaulted obligor or segment of defaulted retail 

exposures, the [bank]’s impairment estimate for allowance purposes for the exposure or 

segment. 

 (4) Total ECL is the sum of expected credit losses for all wholesale and retail 

exposures other than exposures for which the [bank] has applied the double default 

treatment in section 34. 

 Expected exposure (EE) means the expected value of the probability distribution 

of non-negative credit risk exposures to a counterparty at any specified future date before 

the maturity date of the longest term transaction in the netting set. Any negative market 

values in the probability distribution of market values to a counterparty at a specified 
DRAFT November 2, 2007 

473

future date are set to zero to convert the probability distribution of market values to the 

probability distribution of credit risk exposures. 

 Expected operational loss (EOL) means the expected value of the distribution of 

potential aggregate operational losses, as generated by the [bank]’s operational risk 

quantification system using a one-year horizon. 

 Expected positive exposure (EPE) means the weighted average over time of 

expected (non-negative) exposures to a counterparty where the weights are the proportion 

of the time interval that an individual expected exposure represents. When calculating 

risk-based capital requirements, the average is taken over a one-year horizon. 

 Exposure at default (EAD). (1) For the on-balance sheet component of a 

wholesale exposure or segment of retail exposures (other than an OTC derivative 

contract, or a repo-style transaction or eligible margin loan for which the [bank] 

determines EAD under section 32), EAD means: 

 (i) If the exposure or segment is a security classified as available-for-sale, the 

[bank]’s carrying value (including net accrued but unpaid interest and fees) for the 

exposure or segment less any allocated transfer risk reserve for the exposure or segment, 

less any unrealized gains on the exposure or segment, and plus any unrealized losses on 

the exposure or segment; or 

(ii) If the exposure or segment is not a security classified as available-for-sale, the 

[bank]’s carrying value (including net accrued but unpaid interest and fees) for the 

exposure or segment less any allocated transfer risk reserve for the exposure or segment. 

(2) For the off-balance sheet component of a wholesale exposure or segment of 

retail exposures (other than an OTC derivative contract, or a repo-style transaction or 
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eligible margin loan for which the [bank] determines EAD under section 32) in the form 

of a loan commitment, line of credit, trade-related letter of credit, or transaction-related 

contingency, EAD means the [bank]’s best estimate of net additions to the outstanding 

amount owed the [bank], including estimated future additional draws of principal and 

accrued but unpaid interest and fees, that are likely to occur over a one-year horizon 

assuming the wholesale exposure or the retail exposures in the segment were to go into 

default. This estimate of net additions must reflect what would be expected during 

economic downturn conditions. Trade-related letters of credit are short-term, selfliquidating instruments that are used to finance the movement of goods and are 

collateralized by the underlying goods. Transaction-related contingencies relate to a 

particular transaction and include, among other things, performance bonds and 

performance-based letters of credit. 

(3) For the off-balance sheet component of a wholesale exposure or segment of 

retail exposures (other than an OTC derivative contract, or a repo-style transaction or 

eligible margin loan for which the [bank] determines EAD under section 32) in the form 

of anything other than a loan commitment, line of credit, trade-related letter of credit, or 

transaction-related contingency, EAD means the notional amount of the exposure or 

segment. 

(4) EAD for OTC derivative contracts is calculated as described in section 32. A 

[bank] also may determine EAD for repo-style transactions and eligible margin loans as 

described in section 32. 

(5) For wholesale or retail exposures in which only the drawn balance has been 

securitized, the [bank] must reflect its share of the exposures’ undrawn balances in EAD. 
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475

Undrawn balances of revolving exposures for which the drawn balances have been 

securitized must be allocated between the seller’s and investors’ interests on a pro rata 

basis, based on the proportions of the seller’s and investors’ shares of the securitized 

drawn balances. 

 Exposure category means any of the wholesale, retail, securitization, or equity 

exposure categories. 

 External operational loss event data means, with respect to a [bank], gross 

operational loss amounts, dates, recoveries, and relevant causal information for 

operational loss events occurring at organizations other than the [bank]. 

 External rating means a credit rating that is assigned by an NRSRO to an 

exposure, provided: 

 (1) The credit rating fully reflects the entire amount of credit risk with regard to 

all payments owed to the holder of the exposure. If a holder is owed principal and 

interest on an exposure, the credit rating must fully reflect the credit risk associated with 

timely repayment of principal and interest. If a holder is owed only principal on an 

exposure, the credit rating must fully reflect only the credit risk associated with timely 

repayment of principal; and 

(2) The credit rating is published in an accessible form and is or will be included 

in the transition matrices made publicly available by the NRSRO that summarize the 

historical performance of positions rated by the NRSRO. 

Financial collateral means collateral: 

(1) In the form of: 
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 (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; 

(vii) Money market mutual fund shares and other mutual fund shares if a price for 

the shares is publicly quoted daily; or 

(viii) Conforming residential mortgages; and 

(2) In which the [bank] has a perfected, first priority security interest or, outside 

of the United States, the legal equivalent thereof (with the exception of cash on deposit 

and notwithstanding the prior security interest of any custodial agent). 

 GAAP means generally accepted accounting principles as used in the United 

States. 

 Gain-on-sale means an increase in the equity capital (as reported on Schedule RC 

of the Call Report, Schedule HC of the FR Y-9C Report, or Schedule SC of the Thrift 

Financial Report) of a [bank] that results from a securitization (other than an increase in 

equity capital that results from the [bank]’s receipt of cash in connection with the 

securitization). 
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477

 Guarantee means a financial guarantee, letter of credit, insurance, or other similar 

financial instrument (other than a credit derivative) that allows one party (beneficiary) to 

transfer the credit risk of one or more specific exposures (reference exposure) to another 

party (protection provider). See also eligible guarantee. 

 High volatility commercial real estate (HVCRE) exposure means a credit facility 

that finances or has financed the acquisition, development, or construction (ADC) of real 

property, unless the facility finances: 

(1) One- to four-family residential properties; or 

(2) Commercial real estate projects in which: 

(i) The loan-to-value ratio is less than or equal to the applicable maximum 

supervisory loan-to-value ratio in the [AGENCY]’s real estate lending standards at 12 

CFR part 34, Subpart D (OCC); 12 CFR part 208, Appendix C (Board); 12 CFR part 365, 

Subpart D (FDIC); and 12 CFR 560.100-560.101 (OTS); 

(ii) The borrower has contributed capital to the project in the form of cash or 

unencumbered readily marketable assets (or has paid development expenses out-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 life of the project. The life 

of a project concludes only when the credit facility is converted to permanent financing 

or is sold or paid in full. Permanent financing may be provided by the [bank] that 
DRAFT November 2, 2007 

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provided the ADC facility as long as the permanent financing is subject to the [bank]’s 

underwriting criteria for long-term mortgage loans. 

Inferred rating. A securitization exposure has an inferred rating equal to the 

external rating referenced in paragraph (2)(i) of this definition if: 

 (1) The securitization exposure does not have an external rating; and 

 (2) Another securitization exposure issued by the same issuer and secured by the 

same underlying exposures: 

(i) Has an external rating; 

 (ii) Is subordinated in all respects to the unrated securitization exposure; 

 (iii) Does not benefit from any credit enhancement that is not available to the 

unrated securitization exposure; and 

 (iv) Has an effective remaining maturity that is equal to or longer than that of the 

unrated securitization exposure. 

Interest rate derivative contract means a single-currency interest rate swap, basis 

swap, forward rate agreement, purchased interest rate option, when-issued securities, or 

any other instrument linked to interest rates that gives rise to similar counterparty credit 

risks. 

Internal operational loss event data means, with respect to a [bank], gross 

operational loss amounts, dates, recoveries, and relevant causal information for 

operational loss events occurring at the [bank]. 

 Investing [bank] means, with respect to a securitization, a [bank] that assumes the 

credit risk of a securitization exposure (other than an originating [bank] of the 
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securitization). In the typical synthetic securitization, the investing [bank] sells credit 

protection on a pool of underlying exposures to the originating [bank]. 

 Investment fund means a company: 

(1) All or substantially all of the assets of which are financial assets; and 

(2) That has no material liabilities. 

Investors’ interest EAD means, with respect to a securitization, the EAD of the 

underlying exposures multiplied by the ratio of: 

(1) The total amount of securitization exposures issued by the securitization SPE 

to investors; divided by 

(2) The outstanding principal amount of underlying exposures. 

Loss given default (LGD) means: 

(1) For a wholesale exposure, the greatest of: 

(i) Zero; 

(ii) The [bank]’s empirically based best estimate of the long-run default-weighted 

average economic loss, per dollar of EAD, the [bank] would expect to incur if the obligor 

(or a typical obligor in the loss severity grade assigned by the [bank] to the exposure) 

were to default within a one-year horizon over a mix of economic conditions, including 

economic downturn conditions; or 

(iii) The [bank]’s empirically based best estimate of the economic loss, per dollar 

of EAD, the [bank] would expect to incur if the obligor (or a typical obligor in the loss 

severity grade assigned by the [bank] to the exposure) were to default within a one-year 

horizon during economic downturn conditions. 

(2) For a segment of retail exposures, the greatest of: 
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(i) Zero; 

(ii) The [bank]’s empirically based best estimate of the long-run default-weighted 

average economic loss, per dollar of EAD, the [bank] would expect to incur if the 

exposures in the segment were to default within a one-year horizon over a mix of 

economic conditions, including economic downturn conditions; or 

(iii) The [bank]’s empirically based best estimate of the economic loss, per dollar 

of EAD, the [bank] would expect to incur if the exposures in the segment were to default 

within a one-year horizon during economic downturn conditions. 

(3) The economic loss on an exposure in the event of default is all material 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, additional extensions of credit to facilitate repayment of the exposure, and 

draw-downs of unused credit lines) occur after the date of default, the economic loss 

must reflect the net present value of cash flows as of the default date using a discount rate 

appropriate to the risk of the defaulted exposure. 

 Main index means the Standard & Poor’s 500 Index, the FTSE All-World Index, 

and any other index for which the [bank] can demonstrate to the satisfaction of the 

[AGENCY] that the equities represented in the index have comparable liquidity, depth of 

market, and size of bid-ask spreads as equities in the Standard & Poor’s 500 Index and 

FTSE All-World Index. 
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 Multilateral development bank means the International Bank for Reconstruction 

and Development, the International Finance Corporation, the Inter-American 

Development Bank, the Asian Development Bank, the African Development Bank, the 

European Bank for Reconstruction and Development, the European Investment Bank, the 

European Investment Fund, the Nordic Investment Bank, the Caribbean Development 

Bank, the Islamic Development Bank, the Council of Europe Development Bank, and 

any other multilateral lending institution or regional development bank in which the U.S. 

government is a shareholder or contributing member or which the [AGENCY] 

determines poses comparable credit risk. 

 Nationally recognized statistical rating organization (NRSRO) means an entity 

registered with the SEC as a nationally recognized statistical rating organization under 

section 15E of the Securities Exchange Act of 1934 (15 U.S.C. 78o-7). 

 Netting set means a group of transactions with a single counterparty that are 

subject to a qualifying master netting agreement or qualifying cross-product master 

netting agreement. For purposes of the internal models methodology in paragraph (d) of 

section 32, 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. 

Obligor means the legal entity or natural person contractually obligated on a 

wholesale exposure, except that a [bank] may treat the following exposures as having 

separate obligors: 
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(1) Exposures to the same legal entity or natural person denominated in different 

currencies; 

(2) (i) An income-producing real estate exposure for which all or substantially all 

of the repayment of the exposure is reliant on the cash flows of the real estate serving as 

collateral for the exposure; the [bank], in economic substance, does not have recourse to 

the borrower beyond the real estate collateral; and no cross-default or cross-acceleration 

clauses are in place other than clauses obtained solely out of an abundance of caution; 

and 

(ii) Other credit exposures to the same legal entity or natural person; and 

(3) (i) A wholesale exposure authorized under section 364 of the U.S. Bankruptcy 

Code (11 U.S.C. 364) to a legal entity or natural person who is a debtor-in-possession for 

purposes of Chapter 11 of the Bankruptcy Code; and 

(ii) Other credit exposures to the same legal entity or natural person. 

 Operational loss means a loss (excluding insurance or tax effects) resulting from 

an operational loss event. Operational loss includes all expenses associated with an 

operational loss event except for opportunity costs, forgone revenue, and costs related to 

risk management and control enhancements implemented to prevent future operational 

losses. 

Operational loss event means an event that results in loss and is associated with 

any of the following seven operational loss event type categories: 

(1) Internal fraud, which means the operational loss event type category that 

comprises operational losses resulting from an act involving at least one internal party of 
DRAFT November 2, 2007 

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a type intended to defraud, misappropriate property, or circumvent regulations, the law, 

or company policy, excluding diversity- and discrimination-type events. 

(2) External fraud, which means the operational loss event type category that 

comprises operational losses resulting from an act by a third party of a type intended to 

defraud, misappropriate property, or circumvent the law. Retail credit card losses arising 

from non-contractual, third-party initiated fraud (for example, identity theft) are external 

fraud operational losses. All other third-party initiated credit losses are to be treated as 

credit risk losses. 

(3) Employment practices and workplace safety, which means the operational loss 

event type category that comprises operational losses resulting from an act inconsistent 

with employment, health, or safety laws or agreements, payment of personal injury 

claims, or payment arising from diversity- and discrimination-type events. 

(4) Clients, products, and business practices, which means the operational loss 

event type category that comprises operational losses resulting from the nature or design 

of a product or from an unintentional or negligent failure to meet a professional 

obligation to specific clients (including fiduciary and suitability requirements). 

(5) Damage to physical assets, which means the operational loss event type 

category that comprises operational losses resulting from the loss of or damage to 

physical assets from natural disaster or other events. 

(6) Business disruption and system failures, which means the operational loss 

event type category that comprises operational losses resulting from disruption of 

business or system failures. 
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(7) Execution, delivery, and process management, which means the operational 

loss event type category that comprises operational losses resulting from failed 

transaction processing or process management or losses arising from relations with trade 

counterparties and vendors. 

 Operational risk means the risk of loss resulting from inadequate or failed internal 

processes, people, and systems or from external events (including legal risk but excluding 

strategic and reputational risk). 

 Operational risk exposure means the 99.9th percentile of the distribution of 

potential aggregate operational losses, as generated by the [bank]’s operational risk 

quantification system over a one-year horizon (and not incorporating eligible operational 

risk offsets or qualifying operational risk mitigants). 

 Originating [bank], with respect to a securitization, means a [bank] that: 

 (1) Directly or indirectly originated or securitized the underlying exposures 

included in the securitization; or 

(2) Serves as an ABCP program sponsor to the securitization. 

 Other retail exposure means an exposure (other than a securitization exposure, an 

equity exposure, a residential mortgage exposure, an excluded mortgage exposure, a 

qualifying revolving exposure, or the residual value portion of a lease exposure) that is 

managed as part of a segment of exposures with homogeneous risk characteristics, not on 

an individual-exposure basis, and is either: 

(1) An exposure to an individual for non-business purposes; or 

 (2) An exposure to an individual or company for business purposes if the [bank]’s 

consolidated business credit exposure to the individual or company is $1 million or less. 
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 Over-the-counter (OTC) derivative contract means a derivative contract that is not 

traded on an exchange that requires the daily receipt and payment of cash-variation 

margin. 

 Probability of default (PD) means: 

(1) For a wholesale exposure to a non-defaulted obligor, the [bank]’s empirically 

based best estimate of the long-run average one-year default rate for the rating grade 

assigned by the [bank] to the obligor, capturing the average default experience for 

obligors in the rating grade over a mix of economic conditions (including economic 

downturn conditions) sufficient to provide a reasonable estimate of the average one-year 

default rate over the economic cycle for the rating grade. 

(2) For a segment of non-defaulted retail exposures, the [bank]’s empirically 

based best estimate of the long-run average one-year default rate for the exposures in the 

segment, capturing the average default experience for exposures in the segment over a 

mix of economic conditions (including economic downturn conditions) sufficient to 

provide a reasonable estimate of the average one-year default rate over the economic 

cycle for the segment and adjusted upward as appropriate for segments for which 

seasoning effects are material. For purposes of this definition, a segment for which 

seasoning effects are material is a segment where there is a material relationship between 

the time since origination of exposures within the segment and the [bank]’s best estimate 

of the long-run average one-year default rate for the exposures in the segment. 

(3) For a wholesale exposure to a defaulted obligor or segment of defaulted retail 

exposures, 100 percent. 
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 Protection amount (P) means, with respect to an exposure hedged by an eligible 

guarantee or eligible credit derivative, the effective notional amount of the guarantee or 

credit derivative, reduced to reflect any currency mismatch, maturity mismatch, or lack of 

restructuring coverage (as provided in section 33). 

 Publicly traded means traded on: 

(1) Any exchange registered with the SEC as a national securities exchange under 

section 6 of the Securities Exchange Act of 1934 (15 U.S.C. 78f); or 

(2) Any non-U.S.-based securities exchange that: 

(i) Is registered with, or approved by, a national securities regulatory authority; 

and 

(ii) Provides a liquid, two-way market for the instrument in question, meaning 

that there are enough independent bona fide offers to buy and sell so that a sales price 

reasonably related to the last sales price or current bona fide competitive bid and offer 

quotations can be determined promptly and a trade can be settled at such a price within 

five business days. 

 Qualifying central counterparty means a counterparty (for example, a clearing 

house) that: 

(1) Facilitates trades between counterparties in one or more financial markets by 

either guaranteeing trades or novating contracts; 

(2) Requires all participants in its arrangements to be fully collateralized on a 

daily basis; and 
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(3) The [bank] demonstrates to the satisfaction of the [AGENCY] is in sound 

financial condition and is subject to effective oversight by a national supervisory 

authority. 

Qualifying cross-product master netting agreement means a qualifying master 

netting agreement that provides for termination and close-out netting across multiple 

types of financial transactions or qualifying master netting agreements in the event of a 

counterparty’s default, provided that: 

(1) The underlying financial transactions are OTC derivative contracts, eligible 

margin loans, or repo-style transactions; and 

(2) The [bank] obtains a written legal opinion verifying the validity and 

enforceability of the agreement under applicable law of the relevant jurisdictions if the 

counterparty fails to perform upon an event of default, including upon an event of 

bankruptcy, insolvency, or similar proceeding. 

Qualifying master netting agreement means any written, legally enforceable 

bilateral agreement, provided that: 

(1) The agreement creates a single legal obligation for all individual transactions 

covered by the agreement upon an event of default, including bankruptcy, insolvency, or 

similar proceeding, of the counterparty; 

(2) The agreement provides the [bank] the right to accelerate, terminate, and 

close-out on a net basis all transactions under the agreement and to liquidate or set off 

collateral promptly upon an event of default, including upon an event of bankruptcy, 

insolvency, or similar proceeding, of the counterparty, provided that, in any such case, 
DRAFT November 2, 2007 

488

any exercise of rights under the agreement will not be stayed or avoided under applicable 

law in the relevant jurisdictions; 

(3) The [bank] has conducted sufficient legal review to conclude with a wellfounded basis (and maintains sufficient written documentation of that legal review) that: 

(i) The agreement meets the requirements of paragraph (2) of this definition; and 

(ii) In the event of a legal challenge (including one resulting from default or from 

bankruptcy, insolvency, or similar proceeding) the relevant court and administrative 

authorities would find the agreement to be legal, valid, binding, and enforceable under 

the law of the relevant jurisdictions; 

(4) The [bank] establishes and maintains procedures to monitor possible changes 

in relevant law and to ensure that the agreement continues to satisfy the requirements of 

this definition; and 

(5) The agreement does not contain a walkaway clause (that is, a provision that 

permits a non-defaulting counterparty to make a lower payment than it would make 

otherwise under the agreement, or no 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); 
DRAFT November 2, 2007 

489

(2) Is unsecured and unconditionally cancelable by the [bank] to the fullest extent 

permitted by Federal law; and 

(3) Has a maximum exposure amount (drawn plus undrawn) of up to $100,000. 

 Repo-style transaction means a repurchase or reverse repurchase transaction, or a 

securities borrowing or securities lending transaction, including a transaction in which the 

[bank] acts as agent for a customer and indemnifies the customer against loss, provided 

that: 

(1) The transaction is based solely on liquid and readily marketable securities, 

cash, gold, or conforming residential mortgages; 

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

maintenance requirements; 

(3) (i) The transaction is a “securities contract” or “repurchase agreement” under 

section 555 or 559, respectively, of the Bankruptcy Code (11 U.S.C. 555 or 559), a 

qualified financial contract under section 11(e)(8) of the Federal Deposit Insurance Act 

(12 U.S.C. 1821(e)(8)), or a netting contract between or among financial institutions 

under sections 401-407 of the Federal Deposit Insurance Corporation Improvement Act 

of 1991 (12 U.S.C. 4401-4407) or the Federal Reserve Board’s Regulation EE (12 CFR 

part 231); or 

(ii) If the transaction does not meet the criteria set forth in paragraph (3)(i) of this 

definition, then either: 

(A) The transaction is executed under an agreement that provides the [bank] the 

right to accelerate, terminate, and close-out the transaction on a net basis and to liquidate 

or set off collateral promptly upon an event of default (including upon an event of 
DRAFT November 2, 2007 

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bankruptcy, insolvency, or similar proceeding) of the counterparty, provided that, in any 

such case, any exercise of rights under the agreement will not be stayed or avoided under 

applicable law in the relevant jurisdictions; or 

(B) The transaction is: 

(1) Either overnight or unconditionally cancelable at any time by the [bank]; and 

(2) Executed under an agreement that provides the [bank] the right to accelerate, 

terminate, and close-out the transaction on a net basis and to liquidate or set off collateral 

promptly upon an event of counterparty default; and 

(4) The [bank] has conducted sufficient legal review to conclude with a wellfounded basis (and maintains sufficient written documentation of that legal review) that 

the agreement meets the requirements of paragraph (3) of this definition and is legal, 

valid, binding, and enforceable under applicable law in the relevant jurisdictions. 

 Residential mortgage exposure means an exposure (other than a securitization 

exposure, equity exposure, or excluded mortgage exposure) that is managed as part of a 

segment of exposures with homogeneous risk characteristics, not on an individualexposure basis, and is: 

(1) An exposure that is primarily secured by a first or subsequent lien on one- to 

four-family residential property; or 

(2) An exposure with an original and outstanding amount of $1 million or less that 

is primarily secured by a first or subsequent lien on residential property that is not one to 

four family. 

 Retail exposure means a residential mortgage exposure, a qualifying revolving 

exposure, or an other retail exposure. 
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491

 Retail exposure subcategory means the residential mortgage exposure, qualifying 

revolving exposure, or other retail exposure subcategory. 

 Risk parameter means a variable used in determining risk-based capital 

requirements for wholesale and retail exposures, specifically probability of default (PD), 

loss given default (LGD), exposure at default (EAD), or effective maturity (M). 

 Scenario analysis means a systematic process of obtaining expert opinions from 

business managers and risk management experts to derive reasoned assessments of the 

likelihood and loss impact of plausible high-severity operational losses. Scenario 

analysis may include the well-reasoned evaluation and use of external operational loss 

event data, adjusted as appropriate to ensure relevance to a [bank]’s operational risk 

profile and control structure. 

SEC means the U.S. Securities and Exchange Commission. 

 Securitization means a traditional securitization or a synthetic securitization. 

Securitization exposure means an on-balance sheet or off-balance sheet credit 

exposure that arises from a traditional or synthetic securitization (including creditenhancing representations and warranties). 

Securitization special purpose entity (securitization SPE) means a corporation, 

trust, or other entity organized for the specific purpose of holding underlying exposures 

of a securitization, the activities of which are limited to those appropriate to accomplish 

this purpose, and the structure of which is intended to isolate the underlying exposures 

held by the entity from the credit risk of the seller of the underlying exposures to the 

entity. 
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Senior securitization exposure means a securitization exposure that has a first 

priority claim on the cash flows from the underlying exposures. When determining 

whether a securitization exposure has a first priority claim on the cash flows from the 

underlying exposures, a [bank] is not required to consider amounts due under interest rate 

or currency derivative contracts, fees due, or other similar payments. Both the most 

senior commercial paper issued by an ABCP program and a liquidity facility that 

supports the ABCP program may be senior securitization exposures if the liquidity 

facility provider’s right to reimbursement of the drawn amounts is senior to all claims on 

the cash flows from the underlying exposures except amounts due under interest rate or 

currency derivative contracts, fees due, or other similar payments. 

 Servicer cash advance facility means a facility under which the servicer of the 

underlying exposures of a securitization may advance cash to ensure an uninterrupted 

flow of payments to investors in the securitization, including advances made to cover 

foreclosure costs or other expenses to facilitate the timely collection of the underlying 

exposures. See also eligible servicer cash advance facility. 

 Sovereign entity means a central government (including the U.S. government) or 

an agency, department, ministry, or central bank of a central government. 

 Sovereign exposure means: 

(1) A direct exposure to a sovereign entity; or 

(2) An exposure directly and unconditionally backed by the full faith and credit of 

a sovereign entity. 

Subsidiary means, with respect to a company, a company controlled by that 

company. 
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 Synthetic securitization means a transaction in which: 

 (1) All or a portion of the credit risk of one or more underlying exposures is 

transferred to one or more third parties through the use of one or more credit derivatives 

or guarantees (other than a guarantee that transfers only the credit risk of an individual 

retail exposure); 

 (2) The credit risk associated with the underlying exposures has been separated 

into at least two tranches reflecting different levels of seniority; 

 (3) Performance of the securitization exposures depends upon the performance of 

the underlying exposures; and 

(4) All or substantially all of the underlying exposures are financial exposures 

(such as loans, commitments, credit derivatives, guarantees, receivables, asset-backed 

securities, mortgage-backed securities, other debt securities, or equity securities). 

 Tier 1 capital is defined in [the general risk-based capital rules], as modified in 

part II of this appendix. 

Tier 2 capital is defined in [the general risk-based capital rules], as modified in 

part II of this appendix. 

Total qualifying capital means the sum of tier 1 capital and tier 2 capital, after all 

deductions required in this appendix. 

 Total risk-weighted assets means: 

(1) The sum of: 

(i) Credit risk-weighted assets; and 

(ii) Risk-weighted assets for operational risk; minus 

(2) Excess eligible credit reserves not included in tier 2 capital. 
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 Total wholesale and retail risk-weighted assets means the sum of risk-weighted 

assets for wholesale exposures to non-defaulted obligors and segments of non-defaulted 

retail exposures; risk-weighted assets for wholesale exposures to defaulted obligors and 

segments of defaulted retail exposures; risk-weighted assets for assets not defined by an 

exposure category; and risk-weighted assets for non-material portfolios of exposures (all 

as determined in section 31) and risk-weighted assets for unsettled transactions (as 

determined in section 35) minus the amounts deducted from capital pursuant to [the 

general risk-based capital rules] (excluding those deductions reversed in section 12). 

 Traditional securitization means a transaction in which: 

(1) All or a portion of the credit risk of one or more underlying exposures is 

transferred to one or more third parties other than through the use of credit derivatives or 

guarantees; 

 (2) The credit risk associated with the underlying exposures has been separated 

into at least two tranches reflecting different levels of seniority; 

 (3) Performance of the securitization exposures depends upon the performance of 

the underlying exposures; 

(4) All or substantially all of the underlying exposures are financial exposures 

(such as loans, commitments, credit derivatives, guarantees, receivables, asset-backed 

securities, mortgage-backed securities, other debt securities, or equity securities); 

(5) The underlying exposures are not owned by an operating company; 

(6) The underlying exposures are not owned by a small business investment 

company described in section 302 of the Small Business Investment Act of 1958 (15 

U.S.C. 682); and 
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495

(7) The underlying exposures are not owned by a firm an investment in which 

qualifies as a community development investment under 12 U.S.C. 24(Eleventh). 

(8) The [AGENCY] may determine that a transaction in which the underlying 

exposures are owned by an investment firm that exercises substantially unfettered control 

over the size and composition of its assets, liabilities, and off-balance sheet exposures is 

not a traditional securitization based on the transaction’s leverage, risk profile, or 

economic substance. 

(9) The [AGENCY] may deem a transaction that meets the definition of a 

traditional securitization, notwithstanding paragraph (5), (6), or (7) of this definition, to 

be a traditional securitization based on the transaction’s leverage, risk profile, or 

economic substance. 

 Tranche means all securitization exposures associated with a securitization that 

have the same seniority level. 

 Underlying exposures means one or more exposures that have been securitized in 

a securitization transaction. 

 Unexpected operational loss (UOL) means the difference between the [bank]’s 

operational risk exposure and the [bank]’s expected operational loss. 

 Unit of measure means the level (for example, organizational unit or operational 

loss event type) at which the [bank]’s operational risk quantification system generates a 

separate distribution of potential operational losses. 

 Value-at-Risk (VaR) means the estimate of the maximum amount that the value 

of one or more exposures could decline due to market price or rate movements during a 

fixed holding period within a stated confidence interval. 
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496

 Wholesale exposure means a credit exposure to a company, natural person, 

sovereign entity, or governmental entity (other than a securitization exposure, retail 

exposure, excluded mortgage exposure, or equity exposure). Examples of a wholesale 

exposure include: 

 (1) A non-tranched guarantee issued by a [bank] on behalf of a company; 

(2) A repo-style transaction entered into by a [bank] with a company and any 

other transaction in which a [bank] posts collateral to a company and faces counterparty 

credit risk; 

(3) An exposure that a [bank] treats as a covered position under [the market risk 

rule] for which there is a counterparty credit risk capital requirement; 

(4) A sale of corporate loans by a [bank] to a third party in which the [bank] 

retains full recourse; 

(5) An OTC derivative contract entered into by a [bank] with a company; 

(6) An exposure to an individual that is not managed by a [bank] as part of a 

segment of exposures with homogeneous risk characteristics; and 

(7) A commercial lease. 

Wholesale exposure subcategory means the HVCRE or non-HVCRE wholesale 

exposure subcategory. 

Section 3. Minimum Risk-Based Capital Requirements 

 (a) Except as modified by paragraph (c) of this section or by section 23, 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. 
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(b) Each [bank] must hold capital commensurate with the level and nature of all 

risks to which the [bank] is exposed. 

 (c) When a [bank] subject to [the market risk rule] calculates its risk-based capital 

requirements under this appendix, the [bank] must also refer to [the market risk rule] for 

supplemental rules to calculate risk-based capital requirements adjusted for market risk. 

Part II. Qualifying Capital 

Section 11. Additional Deductions 

 (a) General. A [bank] that uses this appendix must make the same deductions 

from its tier 1 capital and tier 2 capital required in [the general risk-based capital rules], 

except that: 

 (1) A [bank] is not required to deduct certain equity investments and CEIOs (as 

provided in section 12 of this appendix); and 

(2) A [bank] also must make the deductions from capital required by paragraphs 

(b) and (c) of this section. 

(b) Deductions from tier 1 capital. A [bank] must deduct from tier 1 capital any 

gain-on-sale associated with a securitization exposure as provided in paragraph (a) of 

section 41 and paragraphs (a)(1), (c), (g)(1), and (h)(1) of section 42. 

 (c) Deductions from tier 1 and tier 2 capital. A [bank] must deduct the exposures 

specified in paragraphs (c)(1) through (c)(7) in this section 50 percent from tier 1 capital 

and 50 percent from tier 2 capital. If the amount deductible from tier 2 capital exceeds 

the [bank]’s actual tier 2 capital, however, the [bank] must deduct the excess from tier 1 

capital. 
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498

(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 RatingsBased Approach, the 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)(4) 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 paragraphs (b) and (c) of section 45 and paragraph (c) of 

section 42, certain high-risk securitization exposures (or portions thereof) that qualify for 

the Supervisory Formula Approach. 

 (6) Eligible credit reserves shortfall. In accordance with paragraph (a)(1) of 

section 13, 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 
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499

 (a) Deduction of CEIOs. A [bank] is not required to make the deductions from 

capital for CEIOs in 12 CFR part 3, Appendix A, § 2(c) (for national banks), 12 CFR part 

208, Appendix A, § II.B.1.e. (for state member banks), 12 CFR part 225, Appendix A, 

§ II.B.1.e. (for bank holding companies), 12 CFR part 325, Appendix A, § II.B.5. (for 

state nonmember banks), and 12 CFR 567.5(a)(2)(iii) and 567.12(e) (for savings 

associations).

 (b) Deduction of certain equity investments. A [bank] is not required to make the 

deductions from capital for nonfinancial equity investments in 12 CFR part 3, Appendix 

A, § 2(c) (for national banks), 12 CFR part 208, Appendix A, § II.B.5. (for state member 

banks), 12 CFR part 225, Appendix A, § II.B.5. (for bank holding companies), and 12 

CFR part 325, Appendix A, § II.B. (for state nonmember banks). 

Section 13. Eligible Credit Reserves 

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

of eligible credit reserves. If a [bank]’s eligible credit reserves are less than the [bank]’s 

total expected credit losses, the [bank] must deduct the shortfall amount 50 percent from 

tier 1 capital and 50 percent from tier 2 capital. If the amount deductible from tier 2 

capital exceeds the [bank]’s actual tier 2 capital, the [bank] must deduct the excess 

amount from tier 1 capital. 

 (2) Excess eligible credit reserves. If a [bank]’s eligible credit reserves exceed the 

[bank]’s total expected credit losses, the [bank] may include the excess amount in tier 2 

capital to the extent that the excess amount does not exceed 0.6 percent of the [bank]’s 

credit-risk-weighted assets. 
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 (b) Treatment of allowance for loan and lease losses. Regardless of any provision 

in [the general risk-based capital rules], the ALLL is included in tier 2 capital only to the 

extent provided in paragraph (a)(2) of this section and in section 24. 

Part III. Qualification 

Section 21. Qualification Process 

 (a) Timing. (1) A [bank] that is described in paragraph (b)(1) of section 1 must 

adopt a written implementation plan no later than six months after the later of [INSERT 

EFFECTIVE DATE] or the date the [bank] meets a criterion in that section. The 

implementation plan must incorporate an explicit first floor period start date no later than 

36 months after the later of [INSERT EFFECTIVE DATE] or the date the [bank] meets 

at least one criterion under paragraph (b)(1) of section 1. The [AGENCY] may extend 

the first floor period start date. 

 (2) A [bank] that elects to be subject to this appendix under paragraph (b)(2) of 

section 1 must adopt a written implementation plan. 

 (b) Implementation plan. (1) The [bank]’s implementation plan must address in 

detail how the [bank] complies, or plans to comply, with the qualification requirements in 

section 22. The [bank] also must maintain a comprehensive and sound planning and 

governance process to oversee the implementation efforts described in the plan. At a 

minimum, the plan must: 

 (i) Comprehensively address the qualification requirements in section 22 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; 
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 (ii) Justify and support any proposed temporary or permanent exclusion of 

business lines, portfolios, or exposures from application of the advanced approaches in 

this appendix (which business lines, portfolios, and exposures must be, in the aggregate, 

immaterial to the [bank]); 

 (iii) Include the [bank]’s self-assessment of: 

 (A) The [bank]’s current status in meeting the qualification requirements in 

section 22; and 

 (B) The consistency of the [bank]’s current practices with the [AGENCY]’s 

supervisory guidance on the qualification requirements; 

 (iv) Based on the [bank]’s self-assessment, identify and describe the areas in 

which the [bank] proposes to undertake additional work to comply with the qualification 

requirements in section 22 or to improve the consistency of the [bank]’s current practices 

with the [AGENCY]’s supervisory guidance on the qualification requirements (gap 

analysis); 

 (v) Describe what specific actions the [bank] will take to address the areas 

identified in the gap analysis required by paragraph (b)(1)(iv) of this section; 

 (vi) Identify objective, measurable milestones, including delivery dates and a date 

when the [bank]’s implementation of the methodologies described in this appendix will 

be fully operational; 

 (vii) Describe resources that have been budgeted and are available to implement 

the plan; and 

 (viii) Receive approval of the [bank]’s board of directors. 
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 (2) The [bank] must submit the implementation plan, together with a copy of the 

minutes of the board of directors’ approval, to the [AGENCY] at least 60 days before the 

[bank] proposes to begin its parallel run, unless the [AGENCY] waives prior notice. 

 (c) Parallel run. Before determining its risk-based capital requirements under this 

appendix and following adoption of the implementation plan, the [bank] must conduct a 

satisfactory parallel run. A satisfactory parallel run is a period of no less than four 

consecutive calendar quarters during which the [bank] complies with the qualification 

requirements in section 22 to the satisfaction of the [AGENCY]. During the parallel run, 

the [bank] must report to the [AGENCY] on a calendar quarterly basis its risk-based 

capital ratios using [the general risk-based capital rules] and the risk-based capital 

requirements described in this appendix. During this period, the [bank] is subject to [the 

general risk-based capital rules]. 

 (d) Approval to calculate risk-based capital requirements under this appendix. 

The [AGENCY] will notify the [bank] of the date that the [bank] may begin its first floor 

period if the [AGENCY] determines that: 

 (1) The [bank] fully complies with all the qualification requirements in section 22; 

 (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. 
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 (1) Risk-based capital ratios during the transitional floor periods - (i) Tier 1 riskbased capital ratio. During a [bank]’s transitional floor periods, the [bank]’s tier 1 riskbased capital ratio is equal to the lower of: 

(A) The [bank]’s floor-adjusted tier 1 risk-based capital ratio; or 

(B) The [bank]’s advanced approaches tier 1 risk-based capital ratio. 

(ii) Total risk-based capital ratio. During a [bank]’s transitional floor periods, the 

[bank]’s total risk-based capital ratio is equal to the lower of: 

(A) The [bank]’s floor-adjusted total risk-based capital ratio; or 

(B) The [bank]’s advanced approaches total risk-based capital ratio. 

(2) Floor-adjusted risk-based capital ratios. (i) A [bank]’s floor-adjusted tier 1 

risk-based capital ratio during a transitional floor period is equal to the [bank]’s tier 1 

capital as calculated under [the general risk-based capital rules], divided by the product 

of: 

(A) The [bank]’s total risk-weighted assets as calculated under [the general 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. 
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(iii) A [bank] that meets the criteria in paragraph (b)(1) or (b)(2) of section 1 as of 

[INSERT EFFECTIVE DATE] must use [the general risk-based capital rules] during the 

parallel run and as the basis for its transitional floors. 

Table 1 – Transitional Floors 

Transitional floor period Transitional floor percentage 

First floor period 95 percent 

Second floor period 90 percent 

Third floor period 85 percent 

(3) Advanced approaches risk-based capital ratios. (i) A [bank]’s advanced 

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

as calculated under this appendix (other than this section on transitional floor periods). 

(ii) A [bank]’s advanced approaches total risk-based capital ratio equals the 

[bank]’s total risk-based capital ratio as calculated under this appendix (other than this 

section on transitional floor periods). 

 (4) Reporting. During the transitional floor periods, a [bank] must report to the 

[AGENCY] on a calendar quarterly basis both floor-adjusted risk-based capital ratios and 

both advanced approaches risk-based capital ratios. 

 (5) Exiting a transitional floor period. A [bank] may not exit a transitional floor 

period until the [bank] has spent a minimum of four consecutive calendar quarters in the 

period and the [AGENCY] has determined that the [bank] may exit the floor period. The 

[AGENCY]’s determination will be based on an assessment of the [bank]’s ongoing 

compliance with the qualification requirements in section 22. 
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 (6) Interagency study. After the end of the second transition year (2010), the 

Federal banking agencies will publish a study that evaluates the advanced approaches to 

determine if there are any material deficiencies. For any primary Federal supervisor to 

authorize any institution to exit the third transitional floor period, the study must 

determine that there are no such material deficiencies that cannot be addressed by thenexisting tools, or, if such deficiencies are found, they are first remedied by changes to this 

appendix. Notwithstanding the preceding sentence, a primary Federal supervisor that 

disagrees with the finding of material deficiency may not authorize any institution under 

its jurisdiction to exit the third transitional floor period unless it provides a public report 

explaining its reasoning. 

Section 22. Qualification Requirements 

 (a) Process and systems requirements. (1) A [bank] must have a rigorous process 

for assessing its overall capital adequacy in relation to its risk profile and a 

comprehensive strategy for maintaining an appropriate level of capital. 

 (2) The systems and processes used by a [bank] for risk-based capital purposes 

under this appendix must be consistent with the [bank]’s internal risk management 

processes and management information reporting systems. 

 (3) Each [bank] must have an appropriate infrastructure with risk measurement 

and management processes that meet the qualification requirements of this section and 

are appropriate given the [bank]’s size and level of complexity. Regardless of whether 

the systems and models that generate the risk parameters necessary for calculating a 

[bank]’s risk-based capital requirements are located at any affiliate of the [bank], the 

[bank] itself must ensure that the risk parameters and reference data used to determine its 
DRAFT November 2, 2007 

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risk-based capital requirements are representative of its own credit risk and operational 

risk exposures. 

 (b) Risk rating and segmentation systems for wholesale and retail exposures. (1) 

A [bank] must have an internal risk rating and segmentation system that accurately and 

reliably differentiates among degrees of credit risk for the [bank]’s wholesale and retail 

exposures. 

(2) For wholesale exposures: 

(i) A [bank] must have an internal risk rating system that accurately and reliably 

assigns each obligor to a single rating grade (reflecting the obligor’s likelihood of 

default). A [bank] may elect, however, not to assign to a rating grade an obligor to whom 

the [bank] extends credit based solely on the financial strength of a guarantor, provided 

that all of the [bank]’s exposures to the obligor are fully covered by eligible guarantees, 

the [bank] applies the PD substitution approach in paragraph (c)(1) of section 33 to all 

exposures to that obligor, and the [bank] immediately assigns the obligor to a rating grade 

if a guarantee can no longer be recognized under this appendix. The [bank]’s wholesale 

obligor rating system must have at least seven discrete rating grades for non-defaulted 

obligors and at least one rating grade for defaulted obligors. 

(ii) Unless the [bank] has chosen to directly assign LGD estimates to each 

wholesale exposure, the [bank] must have an internal risk rating system that accurately 

and reliably assigns each wholesale exposure to a loss severity rating grade (reflecting the 

[bank]’s estimate of the LGD of the exposure). A [bank] employing loss severity rating 

grades must have a sufficiently granular loss severity grading system to avoid grouping 

together exposures with widely ranging LGDs. 
DRAFT November 2, 2007 

507

(3) For retail exposures, a [bank] must have an internal system that groups retail 

exposures into the appropriate retail exposure subcategory, groups the retail exposures in 

each retail exposure subcategory into separate segments with homogeneous risk 

characteristics, and assigns accurate and reliable PD and LGD estimates for each segment 

on a consistent basis. The [bank]’s system must identify and group in separate segments 

by subcategories exposures identified in paragraphs (c)(2)(ii) and (iii) of section 31. 

(4) The [bank]’s internal risk rating policy for wholesale exposures must describe 

the [bank]’s rating philosophy (that is, must describe how wholesale obligor rating 

assignments are affected by the [bank]’s choice of the range of economic, business, and 

industry conditions that are considered in the obligor rating process). 

(5) The [bank]’s internal risk rating system for wholesale exposures must provide 

for the review and update (as appropriate) of each obligor rating and (if applicable) each 

loss severity rating whenever the [bank] receives new material information, but no less 

frequently than annually. The [bank]’s retail exposure segmentation system must provide 

for the review and update (as appropriate) of assignments of retail exposures to segments 

whenever the [bank] receives new material information, but generally no less frequently 

than quarterly. 

 (c) Quantification of risk parameters for wholesale and retail exposures. (1) The 

[bank] must have a comprehensive risk parameter quantification process that produces 

accurate, timely, and reliable estimates of the risk parameters for the [bank]’s wholesale 

and retail exposures. 
DRAFT November 2, 2007 

508

(2) Data used to estimate the risk parameters must be relevant to the [bank]’s 

actual wholesale and retail exposures, and of sufficient quality to support the 

determination of risk-based capital requirements for the exposures. 

(3) The [bank]’s risk parameter quantification process must produce appropriately 

conservative risk parameter estimates where the [bank] has limited relevant data, and any 

adjustments that are part of the quantification process must not result in a pattern of bias 

toward lower risk parameter estimates. 

 (4) Where the [bank]’s quantifications of LGD directly or indirectly incorporate 

estimates of the effectiveness of its credit risk management practices in reducing its 

exposure to troubled obligors prior to default, the [bank] must support such estimates 

with empirical analysis showing that the estimates are consistent with its historical 

experience in dealing with such exposures during economic downturn conditions. 

(5) PD estimates for wholesale obligors and retail segments must be based on at 

least five years of default data. LGD estimates for wholesale exposures must be based on 

at least seven years of loss severity data, and LGD estimates for retail segments must be 

based on at least five years of loss severity data. EAD estimates for wholesale exposures 

must be based on at least seven years of exposure amount data, and EAD estimates for 

retail segments must be based on at least five years of exposure amount data. 

(6) 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. 

(7) The [bank]’s PD, LGD, and EAD estimates must be based on the definition of 

default in this appendix. 
DRAFT November 2, 2007 

509

(8) The [bank] must review and update (as appropriate) its risk parameters and its 

risk parameter quantification process at least annually. 

(9) The [bank] must at least annually conduct a comprehensive review and 

analysis of reference data to determine relevance of reference data to the [bank]’s 

exposures, quality of reference data to support PD, LGD, and EAD estimates, and 

consistency of reference data to the definition of default contained in this appendix. 

(d) Counterparty credit risk model. A [bank] must obtain the prior written 

approval of the [AGENCY] under section 32 to use the internal models methodology for 

counterparty credit risk. 

(e) Double default treatment. A [bank] must obtain the prior written approval of 

the [AGENCY] under section 34 to use the double default treatment. 

 (f) Securitization exposures. A [bank] must obtain the prior written approval of 

the [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 

the [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; 
DRAFT November 2, 2007 

510

(ii) Have and document a process (which must capture business environment and 

internal control factors affecting the [bank]’s operational risk profile) to identify, 

measure, monitor, and control operational risk in [bank] products, activities, processes, 

and systems; and 

(iii) Report operational risk exposures, operational loss events, and other relevant 

operational risk information to business unit management, senior management, and the 

board of directors (or a designated committee of the board). 

(2) Operational risk data and assessment systems. A [bank] must have 

operational risk data and assessment systems that capture operational risks to which the 

[bank] is exposed. The [bank]’s operational risk data and assessment systems must: 

(i) Be structured in a manner consistent with the [bank]’s current business 

activities, risk profile, technological processes, and risk management processes; and 

(ii) Include credible, transparent, systematic, and verifiable processes that 

incorporate the following elements on an ongoing basis: 

(A) Internal operational loss event data. The [bank] must have a systematic 

process for capturing and using internal operational loss event data in its operational risk 

data and assessment systems. 

(1) The [bank]’s operational risk data and assessment systems must include a 

historical observation period of at least five years for internal operational loss event data 

(or such shorter period approved by the [AGENCY] to address transitional situations, 

such as integrating a new business line). 

(2) The [bank] must be able to map its internal operational loss event data into the 

seven operational loss event type categories. 
DRAFT November 2, 2007 

511

(3) The [bank] may refrain from collecting internal operational loss event data for 

individual operational losses below established dollar threshold amounts if the [bank] can 

demonstrate to the satisfaction of the [AGENCY] that the thresholds are reasonable, do 

not exclude important internal operational loss event data, and permit the [bank] to 

capture substantially all the dollar value of the [bank]’s operational losses. 

(B) External operational loss event data. The [bank] must have a systematic 

process for determining its methodologies for incorporating external operational loss 

event data into its operational risk data and assessment systems. 

(C) Scenario analysis. The [bank] must have a systematic process for determining 

its methodologies for incorporating scenario analysis into its operational risk data and 

assessment systems. 

(D) Business environment and internal control factors. The [bank] must 

incorporate business environment and internal control factors into its operational risk data 

and assessment systems. The [bank] must also periodically compare the results of its 

prior business environment and internal control factor assessments against its actual 

operational losses incurred in the intervening period. 

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

quantification systems: 

(A) Must generate estimates of the [bank]’s operational risk exposure using its 

operational risk data and assessment systems; 

(B) Must employ a unit of measure that is appropriate for the [bank]’s range of 

business activities and the variety of operational loss events to which it is exposed, and 
DRAFT November 2, 2007 

512

that does not combine business activities or operational loss events with demonstrably 

different risk profiles within the same loss distribution; 

(C) Must include a credible, transparent, systematic, and verifiable approach for 

weighting each of the four elements, described in paragraph (h)(2)(ii) of this section, that 

a [bank] is required to incorporate into its operational risk data and assessment systems; 

(D) May use internal estimates of dependence among operational losses across 

and within units of measure if the [bank] can demonstrate to the satisfaction of the 

[AGENCY] that its process for estimating dependence is sound, robust to a variety of 

scenarios, and implemented with integrity, and allows for the uncertainty surrounding the 

estimates. If the [bank] has not made such a demonstration, it must sum operational risk 

exposure estimates across units of measure to calculate its total operational risk exposure; 

and 

(E) Must be reviewed and updated (as appropriate) whenever the [bank] becomes 

aware of information that may have a material effect on the [bank]’s estimate of 

operational risk exposure, but the review and update must occur no less frequently than 

annually. 

(ii) With the prior written approval of the [AGENCY], a [bank] may generate an 

estimate of its operational risk exposure using an alternative approach to that specified in 

paragraph (h)(3)(i) of this section. A [bank] proposing to use such an alternative 

operational risk quantification system must submit a proposal to the [AGENCY]. In 

determining whether to approve a [bank]’s proposal to use an alternative operational risk 

quantification system, the [AGENCY] will consider the following principles: 
DRAFT November 2, 2007 

513

(A) Use of the alternative operational risk quantification system will be allowed 

only on an exception basis, considering the size, complexity, and risk profile of the 

[bank]; 

(B) The [bank] must demonstrate that its estimate of its operational risk exposure 

generated under the alternative operational risk quantification system is appropriate and 

can be supported empirically; and 

(C) A [bank] must not use an allocation of operational risk capital requirements 

that includes entities other than depository institutions or the benefits of diversification 

across entities. 

 (i) Data management and maintenance. (1) A [bank] must have data management 

and maintenance systems that adequately support all aspects of its advanced systems and 

the timely and accurate reporting of risk-based capital requirements. 

(2) A [bank] must retain data using an electronic format that allows timely 

retrieval of data for analysis, validation, reporting, and disclosure purposes. 

(3) A [bank] must retain sufficient data elements related to key risk drivers to 

permit adequate monitoring, validation, and refinement of its advanced systems. 

 (j) Control, oversight, and validation mechanisms. (1) The [bank]’s senior 

management must ensure that all components of the [bank]’s advanced systems function 

effectively and comply with the qualification requirements in this section. 

(2) The [bank]’s board of directors (or a designated committee of the board) must 

at least annually review the effectiveness of, and approve, the [bank]’s advanced systems. 

(3) A [bank] must have an effective system of controls and oversight that: 
DRAFT November 2, 2007 

514

(i) Ensures ongoing compliance with the qualification requirements in this 

section; 

(ii) Maintains the integrity, reliability, and accuracy of the [bank]’s advanced 

systems; and 

(iii) Includes adequate governance and project management processes. 

(4) The [bank] must validate, on an ongoing basis, its advanced systems. The 

[bank]’s validation process must be independent of the advanced systems’ development, 

implementation, and operation, or the validation process must be subjected to an 

independent review of its adequacy and effectiveness. Validation must include: 

(i) An evaluation of the conceptual soundness of (including developmental 

evidence supporting) the advanced systems; 

(ii) An ongoing monitoring process that includes verification of processes and 

benchmarking; and 

(iii) An outcomes analysis process that includes back-testing. 

(5) The [bank] must have an internal audit function independent of business-line 

management that at least annually assesses the effectiveness of the controls supporting 

the [bank]’s advanced systems and reports its findings to the [bank]’s board of directors 

(or a committee thereof). 

(6) The [bank] must periodically stress test its advanced systems. The stress 

testing must include a consideration of how economic cycles, especially downturns, 

affect risk-based capital requirements (including migration across rating grades and 

segments and the credit risk mitigation benefits of double default treatment). 
DRAFT November 2, 2007 

515

 (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) Failure to comply with qualification requirements. (1) If the [AGENCY] 

determines that a [bank] that uses this appendix and has conducted a satisfactory parallel 

run fails to comply with the qualification requirements in section 22, the [AGENCY] will 

notify the [bank] in writing of the [bank]’s failure to comply. 

 (2) The [bank] must establish and submit a plan satisfactory to the [AGENCY] to 

return to compliance with the qualification requirements. 

 (3) In addition, if the [AGENCY] determines that the [bank]’s risk-based capital 

requirements are not commensurate with the [bank]’s credit, market, operational, or other 

risks, the [AGENCY] may require such a [bank] to calculate its risk-based capital 

requirements: 

 (i) Under [the general risk-based capital rules]; or 

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

Section 24. Merger and Acquisition Transitional Arrangements 

(a) Mergers and acquisitions of companies without advanced systems. If a [bank] 

merges with or acquires a company that does not calculate its risk-based capital 
DRAFT November 2, 2007 

516

requirements using advanced systems, the [bank] may use [the general risk-based capital 

rules] to determine the risk-weighted asset amounts for, and deductions from capital 

associated with, the merged or acquired company’s exposures for up to 24 months after 

the calendar quarter during which the merger or acquisition consummates. The 

[AGENCY] may extend this transition period for up to an additional 12 months. Within 

90 days of consummating the merger or acquisition, the [bank] must submit to the 

[AGENCY] an implementation plan for using its advanced systems for the acquired 

company. During the period when [the general risk-based capital rules] apply to the 

merged or acquired company, any ALLL, net of allocated transfer risk reserves 

established pursuant to 12 U.S.C. 3904, associated with the merged or acquired 

company’s exposures may be included in the acquiring [bank]’s tier 2 capital up to 1.25 

percent of the acquired company’s risk-weighted assets. All general allowances of the 

merged or acquired company must be excluded from the [bank]’s eligible credit reserves. 

In addition, the risk-weighted assets of the merged or acquired company are not included 

in the [bank]’s credit-risk-weighted assets but are included in total risk-weighted assets. 

If a [bank] relies on this paragraph, the [bank] must disclose publicly the amounts of riskweighted assets and qualifying capital calculated under this appendix for the acquiring 

[bank] and under [the general risk-based capital rules] for the acquired company. 

 (b) Mergers and acquisitions of companies with advanced systems - (1) If a 

[bank] merges with or acquires a company that calculates its risk-based capital 

requirements using advanced systems, the [bank] may use the acquired company’s 

advanced systems to determine the risk-weighted asset amounts for, and deductions from 

capital associated with, the merged or acquired company’s exposures for up to 24 months 
DRAFT November 2, 2007 

517

after the calendar quarter during which the acquisition or merger consummates. The 

[AGENCY] may extend this transition period for up to an additional 12 months. Within 

90 days of consummating the merger or acquisition, the [bank] must submit to the 

[AGENCY] an implementation plan for using its advanced systems for the merged or 

acquired company. 

(2) If the acquiring [bank] is not subject to the advanced approaches in this 

appendix at the time of acquisition or merger, during the period when [the general riskbased capital rules] apply to the acquiring [bank], the ALLL associated with the 

exposures of the merged or acquired company may not be directly included in tier 2 

capital. Rather, any excess eligible credit reserves associated with the merged or 

acquired company’s exposures may be included in the [bank]’s tier 2 capital up to 0.6 

percent of the credit-risk-weighted assets associated with those exposures. 

Part IV. Risk-Weighted Assets for General Credit Risk 

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

Assets 

(a) Overview. A [bank] must calculate its total wholesale and retail risk-weighted 

asset amount in four distinct phases: 

(1) Phase 1 – categorization of exposures; 

(2) Phase 2 – assignment of wholesale obligors and exposures to rating grades and 

segmentation of retail exposures; 

(3) Phase 3 – assignment of risk parameters to wholesale exposures and segments 

of retail exposures; and 

(4) Phase 4 – calculation of risk-weighted asset amounts. 
DRAFT November 2, 2007 

518

(b) Phase 1 − Categorization. The [bank] must determine which of its exposures 

are wholesale exposures, retail exposures, securitization exposures, or equity exposures. 

The [bank] must categorize each retail exposure as a residential mortgage exposure, a 

QRE, or an other retail exposure. The [bank] must identify which wholesale exposures 

are HVCRE exposures, sovereign exposures, OTC derivative contracts, repo-style 

transactions, eligible margin loans, eligible purchased wholesale exposures, unsettled 

transactions to which section 35 applies, and eligible guarantees or eligible credit 

derivatives that are used as credit risk mitigants. The [bank] must identify any onbalance sheet asset that does not meet the definition of a wholesale, retail, equity, or 

securitization exposure, as well as any non-material portfolio of exposures described in 

paragraph (e)(4) of this section. 

 (c) Phase 2 – Assignment of wholesale obligors and exposures to rating grades 

and retail exposures to segments - (1) Assignment of wholesale obligors and exposures to 

rating grades. 

(i) The [bank] must assign each obligor of a wholesale exposure to a single 

obligor rating grade and must assign each wholesale exposure to which it does not 

directly assign an LGD estimate to a loss severity rating grade. 

(ii) The [bank] must identify which of its wholesale obligors are in default. 

(2) Segmentation of retail exposures. (i) The [bank] must group the retail 

exposures in each retail subcategory into segments that have homogeneous risk 

characteristics. 
DRAFT November 2, 2007 

519

(ii) The [bank] must identify which of its retail exposures are in default. The 

[bank] must segment defaulted retail exposures separately from non-defaulted retail 

exposures. 

(iii) If the [bank] determines the EAD for eligible margin loans using the 

approach in paragraph (b) of section 32, the [bank] must identify which of its retail 

exposures are eligible margin loans for which the [bank] uses this EAD approach and 

must segment such eligible margin loans separately from other retail exposures. 

 (3) Eligible purchased wholesale exposures. A [bank] may group its eligible 

purchased wholesale exposures into segments that have homogeneous risk characteristics. 

A [bank] must use the wholesale exposure formula in Table 2 in this section to determine 

the risk-based capital requirement for each segment of eligible purchased wholesale 

exposures. 

 (d) Phase 3 − Assignment of risk parameters to wholesale exposures and 

segments of retail exposures - (1) Quantification process. Subject to the limitations in 

this paragraph (d), the [bank] must: 

(i) Associate a PD with each wholesale obligor rating grade; 

(ii) Associate an LGD with each wholesale loss severity rating grade or assign an 

LGD to each wholesale exposure; 

(iii) Assign an EAD and M to each wholesale exposure; and 

(iv) Assign a PD, LGD, and EAD to each segment of retail exposures. 

(2) Floor on PD assignment. The PD for each wholesale obligor or retail segment 

may not be less than 0.03 percent, except for exposures to or directly and unconditionally 

guaranteed by a sovereign entity, the Bank for International Settlements, the International 
DRAFT November 2, 2007 

520

Monetary Fund, the European Commission, the European Central Bank, or a multilateral 

development bank, to which the [bank] assigns a rating grade associated with a PD of less 

than 0.03 percent. 

(3) Floor on LGD estimation. The LGD for each segment of residential mortgage 

exposures (other than segments of residential mortgage exposures for which all or 

substantially all of the principal of each exposure is directly and unconditionally 

guaranteed by the full faith and credit of a sovereign entity) may not be less than 

10 percent. 

(4) Eligible purchased wholesale exposures. A [bank] must assign a PD, LGD, 

EAD, and M to each segment of eligible purchased wholesale exposures. If the [bank] 

can estimate ECL (but not PD or LGD) for a segment of eligible purchased wholesale 

exposures, the [bank] must assume that the LGD of the segment equals 100 percent and 

that the PD of the segment equals ECL divided by EAD. The estimated ECL must be 

calculated for the exposures without regard to any assumption of recourse or guarantees 

from the seller or other parties. 

(5) Credit risk mitigation − credit derivatives, guarantees, and collateral. (i) A 

[bank] may take into account the risk reducing effects of eligible guarantees and eligible 

credit derivatives in support of a wholesale exposure by applying the PD substitution or 

LGD adjustment treatment to the exposure as provided in section 33 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 treatment without recognizing double default effects. 
DRAFT November 2, 2007 

521

(ii) A [bank] may take into account the risk reducing effects of guarantees and 

credit derivatives in support of retail exposures in a segment when quantifying the PD 

and LGD of the segment. 

(iii) Except as provided in paragraph (d)(6) of this section, a [bank] may take into 

account the risk reducing effects of collateral in support of a wholesale exposure when 

quantifying the LGD of the exposure and may take into account the risk reducing effects 

of collateral in support of retail exposures when quantifying the PD and LGD of the 

segment. 

(6) EAD for OTC derivative contracts, repo-style transactions, and eligible 

margin loans. (i) A [bank] must calculate its EAD for an OTC derivative contract as 

provided in paragraphs (c) and (d) of section 32. A [bank] may take into account the 

risk-reducing effects of financial collateral in support of a repo-style transaction or 

eligible margin loan and of any collateral in support of a repo-style transaction that is 

included in the [bank]’s VaR-based measure under [the market risk rule] through an 

adjustment to EAD as provided in paragraphs (b) and (d) of section 32. A [bank] that 

takes collateral into account through such an adjustment to EAD under section 32 may 

not reflect such collateral in LGD. 

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

(A) Derivative contracts that are publicly traded on an exchange that requires the 

daily receipt and payment of cash-variation margin; 

(B) Derivative contracts and repo-style transactions that are outstanding with a 

qualifying central counterparty (but not for those transactions that a qualifying central 

counterparty has rejected); and 
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(C) Credit risk exposures to a qualifying central counterparty in the form of 

clearing deposits and posted collateral that arise from transactions described in paragraph 

(d)(6)(ii)(B) of this section. 

(7) Effective maturity. An exposure’s M must be no greater than five years and 

no less than one year, except that an exposure’s M must be no less than one day if the 

exposure has an original maturity of less than one year and is not part of a [bank]’s 

ongoing financing of the obligor. An exposure is not part of a [bank]’s ongoing financing 

of the obligor if the [bank]: 

(i) Has a legal and practical ability not to renew or roll over the exposure in the 

event of credit deterioration of the obligor; 

(ii) Makes an independent credit decision at the inception of the exposure and at 

every renewal or roll over; and 

(iii) Has no substantial commercial incentive to continue its credit relationship 

with the obligor in the event of credit deterioration of the obligor. 

(e) Phase 4 − Calculation of risk-weighted assets - (1) Non-defaulted exposures. 

(i) A [bank] must calculate the dollar risk-based capital requirement for each of its 

wholesale exposures to a non-defaulted obligor (except eligible guarantees and eligible 

credit derivatives that hedge another wholesale exposure and exposures to which the 

[bank] applies the double default treatment in section 34) and segments of non-defaulted 

retail exposures by inserting the assigned risk parameters for the wholesale obligor and 

exposure or retail segment into the appropriate risk-based capital formula specified in 

Table 2 and multiplying the output of the formula (K) by the EAD of the exposure or 

segment. Alternatively, a [bank] may apply a 300 percent risk weight to the EAD of an 
DRAFT November 2, 2007 

523

eligible margin loan if the [bank] is not able to meet the agencies’ requirements for 

estimation of PD and LGD for the margin loan. 
DRAFT November 2, 2007 

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Table 2 – IRB Risk-Based Capital Formulas for Wholesale Exposures to Non-Defaulted Obligors 

and Segments of Non-Defaulted Retail Exposures1

Capital 

Requirement 

(K) 

NonDefaulted 

Exposures 

( )⎥

⎥

⎦

⎤

⎢

⎢

⎣

⎡ ×− ⎟

⎟

⎠

⎞

⎜

⎜

⎝

⎛

−

×+ ×=

− −

PDLGD

R

NRPDN NLGDK

1

)( )999.0( 1 1

For residential mortgage exposures: R = 15.0

For qualifying revolving exposures: R = 04.0

Retail 

Correlation 

Factor (R) 

For other retail exposures: PD R e ×− ×+= 35 0 13.003.

Capital 

Requirement 

(K) 

NonDefaulted 

Exposures 

( ) ⎟

⎠

⎞ ⎜

⎝

⎛

×−

×−+ ×

⎥

⎥

⎦

⎤

⎢

⎢

⎣

⎡ ×− ⎟

⎟

⎠

⎞

⎜

⎜

⎝

⎛

−

×+ ×=

− −

b

M b PDLGD

R

NRPDN NLGDK

5.11

)5.2(1

1

)( )999.0( 1 1

For HVCRE exposures: 

PD R e ×− ×+= 50

Correlation 0 18.012.

Factor (R) For wholesale exposures other than HVCRE exposures: 

PD R e ×− ×+= 50 0 12.012.

Wholesale 

Maturity 

Adjustment 

(b)

( )

2 b = ×− PD)ln(05478.011852.0

1

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 logarithms, and the function ln(.) 

refers to the natural logarithm of the expression within parentheses. The formulas apply 

when PD is greater than zero. If PD equals zero, the capital requirement K is set equal to 

zero. 

(ii) The sum of all the dollar risk-based capital requirements for each wholesale 

exposure to a non-defaulted obligor and segment of non-defaulted retail exposures 
DRAFT November 2, 2007 

525

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. 

(2) Wholesale exposures to defaulted obligors and segments of defaulted retail 

exposures. (i) The dollar risk-based capital requirement for each wholesale exposure to a 

defaulted obligor equals 0.08 multiplied by the EAD of the exposure. 

 (ii) The dollar risk-based capital requirement for a segment of defaulted retail 

exposures equals 0.08 multiplied by the EAD of the segment. 

(iii) The sum of all the dollar risk-based capital requirements for each wholesale 

exposure to a defaulted obligor calculated in paragraph (e)(2)(i) of this section plus the 

dollar risk-based capital requirements for each segment of defaulted retail exposures 

calculated in paragraph (e)(2)(ii) of this section equals the total dollar risk-based capital 

requirement for those exposures and segments. 

(iv) The aggregate risk-weighted asset amount for wholesale exposures to 

defaulted obligors and segments of defaulted retail exposures equals the total dollar 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. (i) A [bank] may assign a 

risk-weighted asset amount of zero to cash owned and held in all offices of the [bank] or 

in transit and for gold bullion held in the [bank]’s own vaults, or held in another [bank]’s 
DRAFT November 2, 2007 

526

vaults on an allocated basis, to the extent the gold bullion assets are offset by gold bullion 

liabilities. 

(ii) The risk-weighted asset amount for the residual value of a retail lease 

exposure equals such residual value. 

(iii) The risk-weighted asset amount for any other on-balance-sheet asset that does 

not meet the definition of a wholesale, retail, securitization, or equity exposure equals the 

carrying value of the asset. 

(4) Non-material portfolios of exposures. The risk-weighted asset amount of a 

portfolio of exposures for which the [bank] has demonstrated to the [AGENCY]’s 

satisfaction that the portfolio (when combined with all other portfolios of exposures that 

the [bank] seeks to treat under this paragraph) is not material to the [bank] is the sum of 

the carrying values of on-balance sheet exposures plus the notional amounts of offbalance sheet exposures in the portfolio. For purposes of this paragraph (e)(4), the 

notional amount of an OTC derivative contract that is not a credit derivative is the EAD 

of the derivative as calculated in section 32. 

Section 32. Counterparty Credit Risk of Repo-Style Transactions, Eligible Margin 

Loans, and OTC Derivative Contracts 

(a) In General. (1) This section describes two methodologies – a collateral haircut 

approach and an internal models methodology – that a [bank] may use instead of an LGD 

estimation methodology to recognize the benefits of financial collateral in mitigating the 

counterparty credit risk of repo-style transactions, eligible margin loans, collateralized 

OTC derivative contracts, and single product netting sets of such transactions and to 

recognize the benefits of any collateral in mitigating the counterparty credit risk of repo-
DRAFT November 2, 2007 

527

style transactions that are included in a [bank]’s VaR-based measure under [the market 

risk rule]. A third methodology, the simple VaR methodology, is available for single 

product netting sets of repo-style transactions and eligible margin loans. 

(2) This section also describes the methodology for calculating EAD for an OTC 

derivative contract or a set of OTC derivative contracts subject to a qualifying master 

netting agreement. A [bank] also may use the internal models methodology to estimate 

EAD for qualifying cross-product master netting agreements. 

(3) A [bank] may only use the standard supervisory haircut approach with a 

minimum 10-business-day holding period to recognize in EAD the benefits of 

conforming residential mortgage collateral that secures repo-style transactions (other than 

repo-style transactions included in the [bank]’s VaR-based measure under [the market 

risk rule]), eligible margin loans, and OTC derivative contracts. 

(4) A [bank] may use any combination of the three methodologies for collateral 

recognition; however, it must use the same methodology for similar exposures. 

(b) EAD for eligible margin loans and repo-style transactions - (1) General. A 

[bank] may recognize the credit risk mitigation benefits of financial collateral that secures 

an eligible margin loan, repo-style transaction, or single-product netting set of such 

transactions by factoring the collateral into its LGD estimates for the exposure. 

Alternatively, a [bank] may estimate an unsecured LGD for the exposure, as well as for 

any repo-style transaction that is included in the [bank]’s VaR-based measure under [the 

market risk rule], and determine the EAD of the exposure using: 

(i) The collateral haircut approach described in paragraph (b)(2) of this section; 
DRAFT November 2, 2007 

528

(ii) For netting sets only, the simple VaR methodology described in 

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

(iii) The internal models methodology described in paragraph (d) of this section. 

(2) Collateral haircut approach - (i) EAD equation. A [bank] may determine EAD 

for an eligible margin loan, repo-style transaction, or netting set by setting EAD equal to 

max {0, [(∑E - ∑C) + ∑(Es x Hs) + ∑(Efx x Hfx)]}, where: 

 (A) ∑E equals the value of the exposure (the sum of the current market values of 

all instruments, gold, and cash the [bank] has lent, sold subject to repurchase, or posted as 

collateral to the counterparty under the transaction (or netting set)); 

(B) ∑C equals the value of the collateral (the sum of the current market values of 

all instruments, gold, and cash the [bank] has borrowed, purchased subject to resale, or 

taken as collateral from the counterparty under the transaction (or netting set)); 

(C) Es equals the absolute value of the net position in a given instrument or in 

gold (where the net position in a given instrument or in gold equals the sum of the current 

market values of the instrument or gold the [bank] has lent, sold subject to repurchase, or 

posted as collateral to the counterparty minus the sum of the current market values of that 

same instrument or gold the [bank] has borrowed, purchased subject to resale, or taken as 

collateral from the counterparty); 

(D) Hs equals the market price volatility haircut appropriate to the instrument or 

gold referenced in Es; 

(E) Efx equals the absolute value of the net position of instruments and cash in a 

currency that is different from the settlement currency (where the net position in a given 

currency equals the sum of the current market values of any instruments or cash in the 
DRAFT November 2, 2007 

529

currency the [bank] has lent, sold subject to repurchase, or posted as collateral to the 

counterparty minus the sum of the current market values of any instruments or cash in the 

currency the [bank] has borrowed, purchased subject to resale, or taken as collateral from 

the counterparty); and 

(F) Hfx equals the haircut appropriate to the mismatch between the currency 

referenced in Efx and the settlement currency. 

(ii) Standard supervisory haircuts. (A) Under the standard supervisory haircuts 

approach: 

 (1) A [bank] must use the haircuts for market price volatility (Hs) in Table 3, as 

adjusted in certain circumstances as provided in paragraph (b)(2)(ii)(A)(3) and (4) of this 

section; 
DRAFT November 2, 2007 

530

Table 3 – Standard Supervisory Market Price Volatility Haircuts1

Applicable external 

rating grade category 

for debt securities 

Residual maturity for debt 

securities 

Issuers 

exempt from 

the 3 basis 

point floor 

Other issuers 

≤ 1 year 0.005 0.01 

>1 year, ≤ 5 years 0.02 0.04 

Two highest 

investment-grade 

rating categories for 

long-term 

ratings/highest 

investment-grade 

rating category for 

short-term ratings 

> 5 years 0.04 0.08 

≤ 1 year 0.01 0.02 

>1 year, ≤ 5 years 0.03 0.06 

Two lowest 

investment-grade 

rating categories for 

both short- and longterm ratings > 5 years 0.06 0.12 

One rating category 

below investment 

grade 

All 0.15 0.25 

Main index equities (including convertible bonds) and gold 0.15 

Other publicly traded equities (including convertible 

bonds), conforming residential mortgages, and 

nonfinancial collateral 

0.25 

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 

1

The market price volatility haircuts in Table 3 are based on a ten-business-day holding 

period. 

 (2) For currency mismatches, a [bank] must use a haircut for foreign exchange 

rate volatility (Hfx) of 8 percent, as adjusted in certain circumstances as provided in 

paragraph (b)(2)(ii)(A)(3) and (4) of this section. 
DRAFT November 2, 2007 

531

 (3) For repo-style transactions, a [bank] may multiply the supervisory haircuts 

provided in paragraphs (b)(2)(ii)(A)(1) and (2) of this section by the square root of 1⁄2 

(which equals 0.707107). 

 (4) A [bank] must adjust the supervisory haircuts upward on the basis of a holding 

period longer than ten business days (for eligible margin loans) or five business days (for 

repo-style transactions) where and as appropriate to take into account the illiquidity of an 

instrument. 

 (iii) Own internal estimates for haircuts. With the prior written approval of the 

[AGENCY], a [bank] may calculate haircuts (Hs and Hfx) using its own internal 

estimates of the volatilities of market prices and foreign exchange rates. 

(A) To receive [AGENCY] approval to use its own internal estimates, a [bank] 

must satisfy the following minimum quantitative standards: 

 (1) A [bank] must use a 99th percentile one-tailed confidence interval. 

 (2) The minimum holding period for a repo-style transaction is five business days 

and for an eligible margin loan is ten business days. When a [bank] calculates an 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 equals 5 for repo-style transactions and 10 for eligible margin loans; 

(ii) TN equals the holding period used by the [bank] to derive HN; and 

(iii) HN equals the haircut based on the holding period TN. 
DRAFT November 2, 2007 

532

 (3) A [bank] must adjust holding periods upwards where and as appropriate to 

take into account the illiquidity of an instrument. 

 (4) The historical observation period must be at least one year. 

 (5) A [bank] must update its data sets and recompute haircuts no less frequently 

than quarterly and must also reassess data sets and haircuts whenever market prices 

change materially. 

 (B) With respect to debt securities that have an applicable external rating of 

investment grade, a [bank] may calculate haircuts for categories of securities. For a 

category of securities, the [bank] must calculate the haircut on the basis of internal 

volatility estimates for securities in that category that are representative of the securities 

in that category that the [bank] has lent, sold subject to repurchase, posted as collateral, 

borrowed, purchased subject to resale, or taken as collateral. In determining relevant 

categories, the [bank] must at a minimum take into account: 

 (1) The type of issuer of the security; 

 (2) The applicable external rating of the security; 

 (3) The maturity of the security; and 

 (4) The interest rate sensitivity of the security. 

 (C) With respect to debt securities that have an applicable external rating of below 

investment grade and equity securities, a [bank] must calculate a separate haircut for each 

individual security. 

 (D) Where an exposure or collateral (whether in the form of cash or securities) is 

denominated in a currency that differs from the settlement currency, the [bank] must 

calculate a separate currency mismatch haircut for its net position in each mismatched 
DRAFT November 2, 2007 

533

currency based on estimated volatilities of foreign exchange rates between the 

mismatched currency and the settlement currency. 

 (E) A [bank]’s own estimates of market price and foreign exchange rate 

volatilities may not take into account the correlations among securities and foreign 

exchange rates on either the exposure or collateral side of a transaction (or netting set) or 

the correlations among securities and foreign exchange rates between the exposure and 

collateral sides of the transaction (or netting set). 

 (3) Simple VaR methodology. With the prior written approval of the [AGENCY], 

a [bank] may estimate EAD for a netting set using a VaR model that meets the 

requirements in paragraph (b)(3)(iii) of this section. In such event, the [bank] must set 

EAD equal to max {0, [(∑E - ∑C) + PFE]}, where: 

 (i) ∑E equals the value of the exposure (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 (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 five-business-day holding period for repo-style transactions or over a 

ten-business-day holding period for eligible margin loans using a minimum one-year 

historical observation period of price data representing the instruments that the [bank] has 

lent, sold subject to repurchase, posted as collateral, borrowed, purchased subject to 
DRAFT November 2, 2007 

534

resale, or taken as collateral. The [bank] must validate its VaR model, including by 

establishing and maintaining a rigorous and regular back-testing regime. 

(c) EAD for OTC derivative contracts. (1) A [bank] must determine the EAD for 

an OTC derivative contract that is not subject to a qualifying master netting agreement 

using the current exposure methodology in paragraph (c)(5) of this section or using the 

internal models methodology described in paragraph (d) of this section. 

(2) A [bank] must determine the EAD for multiple OTC derivative contracts that 

are subject to a qualifying master netting agreement using the current exposure 

methodology in paragraph (c)(6) of this section or using the internal models methodology 

described in paragraph (d) of this section. 

(3) Counterparty credit risk for credit derivatives. Notwithstanding the above, 

(i) A [bank] that purchases a credit derivative that is recognized under section 33 

or 34 as a credit risk mitigant for an exposure that is not a covered position under [the 

market risk rule] need not compute a separate counterparty credit risk capital requirement 

under this section so long as the [bank] does so consistently for all such credit derivatives 

and either includes all or excludes all such credit derivatives that are subject to a master 

netting agreement from any measure used to determine counterparty credit risk exposure 

to all relevant counterparties for risk-based capital purposes. 

(ii) A [bank] that is the protection provider in a credit derivative must treat the 

credit derivative as a wholesale exposure to the reference obligor and need not compute a 

counterparty credit risk capital requirement for the credit derivative under this section, so 

long as it does so consistently for all such credit derivatives and either includes all or 

excludes all such credit derivatives that are subject to a master netting agreement from 
DRAFT November 2, 2007 

535

any measure used to determine counterparty credit risk exposure to all relevant 

counterparties for risk-based capital purposes (unless the [bank] is treating the credit 

derivative as a covered position under [the market risk rule], in which case the [bank] 

must compute a supplemental counterparty credit risk capital requirement under this 

section). 

(4) Counterparty credit risk for equity derivatives. A [bank] must treat an equity 

derivative contract as an equity exposure and compute a risk-weighted asset amount for 

the equity derivative contract under part VI (unless the [bank] is treating the contract as a 

covered position under [the market risk rule]). In addition, if the [bank] is treating the 

contract as a covered position under [the market risk rule] and in certain other cases 

described in section 55, the [bank] must also calculate a risk-based capital requirement 

for the counterparty credit risk of an equity derivative contract under this part. 

(5) Single OTC derivative contract. Except as modified by paragraph (c)(7) of 

this section, the EAD for a single OTC derivative contract that is not subject to a 

qualifying master netting agreement is equal to the sum of the [bank]’s current credit 

exposure and potential future credit exposure (PFE) on the derivative contract. 

(i) Current credit exposure. The current credit exposure for a single OTC 

derivative contract is the greater of the mark-to-market value of the derivative contract or 

zero. 

(ii) PFE. The PFE for a single OTC derivative contract, including an OTC 

derivative contract with a negative mark-to-market value, is calculated by multiplying the 

notional principal amount of the derivative contract by the appropriate conversion factor 

in Table 4. For purposes of calculating either the PFE under this paragraph or the gross 
DRAFT November 2, 2007 

536

PFE under paragraph (c)(6) of this section for exchange rate contracts and other similar 

contracts in which the notional principal amount is equivalent to the cash flows, notional 

principal amount is the net receipts to each party falling due on each value date in each 

currency. For any OTC derivative contract that does not fall within one of the specified 

categories in Table 4, the PFE must be calculated using the “other” conversion factors. A 

[bank] must use an OTC derivative contract’s effective notional principal amount (that is, 

its apparent or stated notional principal amount multiplied by any multiplier in the OTC 

derivative contract) rather than its apparent or stated notional principal amount in 

calculating PFE. PFE of the protection provider of a credit derivative is capped at the net 

present value of the amount of unpaid premiums. 

Table 4 – Conversion Factor Matrix for OTC Derivative Contracts1

Remaining 

maturity2 

Interest 

rate 

Foreign 

exchange 

rate and 

gold 

Credit 

(investmentgrade 

reference 

obligor)3 

Credit 

(noninvestmentgrade 

reference 

obligor) 

Equity Precious 

metals 

(except 

gold) 

Other 

One year or 

less 

0.00 0.01 0.05 0.10 0.06 0.07 0.10 

Over one to 

five years 

0.005 0.05 0.05 0.10 0.08 0.07 0.12 

Over five 

years 

0.015 0.075 0.05 0.10 0.10 0.08 0.15 

1

For an OTC derivative contract with multiple exchanges of principal, the conversion 

factor is multiplied by the number of remaining payments in the derivative contract. 

2

For an OTC derivative contract that is structured such that on specified dates any 

outstanding exposure is settled and the terms are reset so that the market value of the 

contract is zero, the remaining maturity equals the time until the next reset date. For an 

interest rate derivative contract with a remaining maturity of greater than one year that 

meets these criteria, the minimum conversion factor is 0.005. 

3

A [bank] must use the column labeled “Credit (investment-grade reference obligor)” for 

a credit derivative whose reference obligor has an outstanding unsecured long-term debt 

security without credit enhancement that has a long-term applicable external rating of at 
DRAFT November 2, 2007 

537

least investment grade. A [bank] must use the column labeled “Credit (non-investmentgrade reference obligor)” for all other credit derivatives. 

(6) Multiple OTC derivative contracts subject to a qualifying master netting 

agreement. Except as modified by paragraph (c)(7) of this section, the EAD for multiple 

OTC derivative contracts subject to a qualifying master netting agreement is equal to the 

sum of the net current credit exposure and the adjusted sum of the PFE exposure for all 

OTC derivative contracts subject to the qualifying master netting agreement. 

(i) Net current credit exposure. The net current credit exposure is the greater of: 

(A) The net sum of all positive and negative mark-to-market values of the 

individual OTC derivative contracts subject to the qualifying master netting agreement; 

or 

(B) zero. 

(ii) Adjusted sum of the PFE. The adjusted sum of the PFE, Anet, is calculated as 

Anet = (0.4×Agross)+(0.6×NGR×Agross), where: 

(A) Agross = the gross PFE (that is, the sum of the PFE amounts (as determined 

under paragraph (c)(5)(ii) of this section) for each individual OTC derivative contract 

subject to the qualifying master netting agreement); and 

(B) NGR = the net to gross ratio (that is, the ratio of the net current credit 

exposure to the gross current credit exposure). In calculating the NGR, the gross current 

credit exposure equals the sum of the positive current credit exposures (as determined 

under paragraph (c)(5)(i) of this section) of all individual OTC derivative contracts 

subject to the qualifying master netting agreement. 
DRAFT November 2, 2007 

538

(7) Collateralized OTC derivative contracts. A [bank] may recognize the credit 

risk mitigation benefits of financial collateral that secures an OTC derivative contract or 

single-product netting set of OTC derivatives by factoring the collateral into its LGD 

estimates for the contract or netting set. Alternatively, a [bank] may recognize the credit 

risk mitigation benefits of financial collateral that secures such a contract or netting set 

that is marked to market on a daily basis and subject to a daily margin maintenance 

requirement by estimating an unsecured LGD for the contract or netting set and adjusting 

the EAD calculated under paragraph (c)(5) or (c)(6) of this section using the collateral 

haircut approach in paragraph (b)(2) of this section. The [bank] must substitute the EAD 

calculated under paragraph (c)(5) or (c)(6) of this section for ∑E in the equation in 

paragraph (b)(2)(i) of this section and must use a ten-business-day minimum holding 

period (TM = 10). 

(d) Internal models methodology. (1) With prior written approval from the 

[AGENCY], a [bank] may use the internal models methodology in this paragraph (d) to 

determine EAD for counterparty credit risk for OTC derivative contracts (collateralized 

or uncollateralized) and single-product netting sets thereof, for eligible margin loans and 

single-product netting sets thereof, and for repo-style transactions and single-product 

netting sets thereof. A [bank] that uses the internal models methodology for a particular 

transaction type (OTC derivative contracts, eligible margin loans, or repo-style 

transactions) must use the internal models methodology for all transactions of that 

transaction type. A [bank] may choose to use the internal models methodology for one or 

two of these three types of exposures and not the other types. A [bank] may also use the 
DRAFT November 2, 2007 

539

internal models methodology for OTC derivative contracts, eligible margin loans, and 

repo-style transactions subject to a qualifying cross-product netting agreement if: 

(i) The [bank] effectively integrates the risk mitigating effects of cross-product 

netting into its risk management and other information technology systems; and 

(ii) The [bank] obtains the prior written approval of the [AGENCY]. 

A [bank] that uses the internal models methodology for a transaction type must receive 

approval from the [AGENCY] to cease using the methodology for that transaction type or 

to make a material change to its internal model. 

(2) Under the internal models methodology, a [bank] uses an internal model to 

estimate the expected exposure (EE) for a netting set and then calculates EAD based on 

that EE. 

(i) The [bank] must use its internal model’s probability distribution for changes in 

the market value of a netting set that are attributable to changes in market variables to 

determine EE. 

(ii) Under the internal models methodology, EAD = α x effective EPE, or, subject 

to [AGENCY] approval as provided in paragraph (d)(7), a more conservative measure of 

EAD. 

(A) ∑=

= Δ

n

k

t kt EffectiveEPE txEEffectiveE 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 EEffectiveE t EEEEffectiveE tt 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 
DRAFT November 2, 2007 

540

(2) tk represents the kth future time period in the model and there are n time 

periods represented in the model over the first year; and 

(B) α = 1.4 except as provided in paragraph (d)(6), or when the [AGENCY] has 

determined that the [bank] must set α higher based on the [bank]’s specific characteristics 

of counterparty credit risk. 

(iii) A [bank] may include financial collateral currently posted by the counterparty 

as collateral (but may not include other forms of collateral) when calculating EE. 

(iv) If a [bank] hedges some or all of the counterparty credit risk associated with a 

netting set using an eligible credit derivative, the [bank] may take the reduction in 

exposure to the counterparty into account when estimating EE. If the [bank] recognizes 

this reduction in exposure to the counterparty in its estimate of EE, it must also use its 

internal model to estimate a separate EAD for the [bank]’s exposure to the protection 

provider of the credit derivative.

(3) To obtain [AGENCY] approval to calculate the distributions of exposures 

upon which the EAD calculation is based, the [bank] must demonstrate to the satisfaction 

of the [AGENCY] that it has been using for at least one year an internal model that 

broadly meets the following minimum standards, with which the [bank] must maintain 

compliance: 

(i) The model must have the systems capability to estimate the expected exposure 

to the counterparty on a daily basis (but is not expected to estimate or report expected 

exposure on a daily basis). 

(ii) The model must estimate expected exposure at enough future dates to reflect 

accurately all the future cash flows of contracts in the netting set. 
DRAFT November 2, 2007 

541

(iii) The model must account for the possible non-normality of the exposure 

distribution, where appropriate. 

(iv) The [bank] must measure, monitor, and control current counterparty exposure 

and the exposure to the counterparty over the whole life of all contracts in the netting set. 

(v) The [bank] must be able to measure and manage current exposures gross and 

net of collateral held, where appropriate. The [bank] must estimate expected exposures 

for OTC derivative contracts both with and without the effect of collateral agreements. 

(vi) The [bank] must have procedures to identify, monitor, and control specific 

wrong-way risk throughout the life of an exposure. Wrong-way risk in this context is the 

risk that future exposure to a counterparty will be high when the counterparty’s 

probability of default is also high. 

(vii) The model must use current market data to compute current exposures. 

When estimating model parameters based on historical data, at least three years of 

historical data that cover a wide range of economic conditions must be used and must be 

updated quarterly or more frequently if market conditions warrant. The [bank] should 

consider using model parameters based on forward-looking measures, where appropriate. 

(viii) A [bank] must subject its internal model to an initial validation and annual 

model review process. The model review should consider whether the inputs and risk 

factors, as well as the model outputs, are appropriate. 
DRAFT November 2, 2007 

542

(4) Maturity. (i) If the remaining maturity of the exposure or the longest-dated 

contract in the netting set is greater than one year, the [bank] must set M for the exposure 

or netting set equal to the lower of five years or M(EPE),4

 where: 

(A) 

∑

∑

≤

=

>

×Δ×

×Δ×

+=

yeart

k

kkk

maturity

yeart

kkk

k

k

dftEeffectiveE

dftEE

EPEM 1

1

1 ( ; 1)

(B) dfk is the risk-free discount factor for future time period tk; and 

(C) −=Δ kkk −1 ttt . 

(ii) If the remaining maturity of the exposure or the longest-dated contract in the 

netting set is one year or less, the [bank] must set M for the exposure or netting set equal 

to one year, except as provided in paragraph (d)(7) of section 31. 

(5) Collateral agreements. A [bank] may capture the effect on EAD of a collateral 

agreement that requires receipt of collateral when exposure to the counterparty increases 

but may not capture the effect on EAD of a collateral agreement that requires receipt of 

collateral when counterparty credit quality deteriorates. For this purpose, a collateral 

agreement means a legal contract that specifies the time when, and circumstances under 

which, the counterparty is required to pledge collateral to the [bank] for a single financial 

contract or for all financial contracts in a netting set and confers upon the [bank] a 

perfected, first priority security interest (notwithstanding the prior security interest of any 

custodial agent), or the legal equivalent thereof, in the collateral posted by the 

counterparty under the agreement. This security interest must provide the [bank] with a 

right to close out the financial positions and liquidate the collateral upon an event of 

 

4

 Alternatively, a [bank] that uses an internal model to calculate a one-sided credit valuation adjustment 

may use the effective credit duration estimated by the model as M(EPE) in place of the formula in 

paragraph (d)(4). 
DRAFT November 2, 2007 

543

default of, or failure to perform by, the counterparty under the collateral agreement. A 

contract would not satisfy this requirement if the [bank]’s exercise of rights under the 

agreement may be stayed or avoided under applicable law in the relevant jurisdictions. 

Two methods are available to capture the effect of a collateral agreement: 

(i) With prior written approval from the [AGENCY], a [bank] may include the 

effect of a collateral agreement within its internal model used to calculate EAD. The 

[bank] may set EAD equal to the expected exposure at the end of the margin period of 

risk. The margin period of risk means, with respect to a netting set subject to a collateral 

agreement, the time period from the most recent exchange of collateral with a 

counterparty until the next required exchange of collateral plus the period of time 

required to sell and realize the proceeds of the least liquid collateral that can be delivered 

under the terms of the collateral agreement and, where applicable, the period of time 

required to re-hedge the resulting market risk, upon the default of the counterparty. The 

minimum margin period of risk is five business days for repo-style transactions and ten 

business days for other transactions when liquid financial collateral is posted under a 

daily margin maintenance requirement. This period should be extended to cover any 

additional time between margin calls; any potential closeout difficulties; any delays in 

selling collateral, particularly if the collateral is illiquid; and any impediments to prompt 

re-hedging of any market risk. 

(ii) A [bank] that can model EPE without collateral agreements but cannot 

achieve the higher level of modeling sophistication to model EPE with collateral 

agreements can set effective EPE for a collateralized netting set equal to the lesser of: 
DRAFT November 2, 2007 

544

(A) The threshold, defined as the exposure amount at which the counterparty is 

required to post collateral under the collateral agreement, if the threshold is positive, plus 

an add-on that reflects the potential increase in exposure of the netting set over the 

margin period of risk. The add-on is computed as the expected increase in the netting 

set’s exposure beginning from current exposure of zero over the margin period of risk. 

The margin period of risk must be at least five business days for netting sets consisting 

only of repo-style transactions subject to daily re-margining and daily marking-to-market, 

and ten business days for all other netting sets; or 

(B) Effective EPE without a collateral agreement. 

(6) Own estimate of alpha. With prior written approval of the [AGENCY], a 

[bank] may calculate alpha as the ratio of economic capital from a full simulation of 

counterparty exposure across counterparties that incorporates a joint simulation of market 

and credit risk factors (numerator) and economic capital based on EPE (denominator), 

subject to a floor of 1.2. For purposes of this calculation, economic capital is the 

unexpected losses for all counterparty credit risks measured at a 99.9 percent confidence 

level over a one-year horizon. To receive approval, the [bank] must meet the following 

minimum standards to the satisfaction of the [AGENCY]: 

(i) The [bank]’s own estimate of alpha must capture in the numerator the effects 

of: 

(A) The material sources of stochastic dependency of distributions of market 

values of transactions or portfolios of transactions across counterparties; 
DRAFT November 2, 2007 

545

(B) Volatilities and correlations of market risk factors used in the joint simulation, 

which must be related to the credit risk factor used in the simulation to reflect potential 

increases in volatility or correlation in an economic downturn, where appropriate; and 

(C) The granularity of exposures (that is, the effect of a concentration in the 

proportion of each counterparty’s exposure that is driven by a particular risk factor). 

(ii) The [bank] must assess the potential model uncertainty in its estimates of 

alpha. 

(iii) The [bank] must calculate the numerator and denominator of alpha in a 

consistent fashion with respect to modeling methodology, parameter specifications, and 

portfolio composition. 

(iv) The [bank] must review and adjust as appropriate its estimates of the 

numerator and denominator of alpha on at least a quarterly basis and more frequently 

when the composition of the portfolio varies over time. 

 (7) Other measures of counterparty exposure. With prior written approval of the 

[AGENCY], a [bank] may set EAD equal to a measure of counterparty credit risk 

exposure, such as peak EAD, that is more conservative than an alpha of 1.4 (or higher 

under the terms of paragraph (d)(2)(ii)(B)) times EPE for every counterparty whose EAD 

will be measured under the alternative measure of counterparty exposure. The [bank] 

must demonstrate the conservatism of the measure of counterparty credit risk exposure 

used for EAD. For material portfolios of new OTC derivative products, the [bank] may 

assume that the current exposure methodology in paragraphs (c)(5) and (c)(6) of this 

section meets the conservatism requirement of this paragraph for a period not to exceed 

180 days. For immaterial portfolios of OTC derivative contracts, the [bank] generally 
DRAFT November 2, 2007 

546

may assume that the current exposure methodology in paragraphs (c)(5) and (c)(6) of this 

section meets the conservatism requirement of this paragraph. 

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

Adjustment Approaches

(a) Scope. (1) This section applies to wholesale exposures for which: 

(i) Credit risk is fully covered by an eligible guarantee or eligible credit 

derivative; or 

(ii) Credit risk is covered on a pro rata basis (that is, on a basis in which the 

[bank] and the protection provider share losses proportionately) by an eligible guarantee 

or eligible credit derivative. 

(2) Wholesale exposures on which there is a tranching of credit risk (reflecting at 

least two different levels of seniority) are securitization exposures subject to the 

securitization framework in part V. 

(3) A [bank] may elect to recognize the credit risk mitigation benefits of an 

eligible guarantee or eligible credit derivative covering an exposure described in 

paragraph (a)(1) of this section by using the PD substitution approach or the LGD 

adjustment approach in paragraph (c) of this section or, if the transaction qualifies, using 

the double default treatment in section 34. 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) If multiple eligible guarantees or eligible credit derivatives cover a single 

exposure described in paragraph (a)(1) of this section, a [bank] may treat the hedged 

exposure as multiple separate exposures each covered by a single eligible guarantee or 
DRAFT November 2, 2007 

547

eligible credit derivative and may calculate a separate risk-based capital requirement for 

each separate exposure as described in paragraph (a)(3) of this section. 

(5) If a single eligible guarantee or eligible credit derivative covers multiple 

hedged wholesale exposures described in paragraph (a)(1) of this section, a [bank] must 

treat each hedged exposure as covered by a separate eligible guarantee or eligible credit 

derivative and must calculate a separate risk-based capital requirement for each exposure 

as described in paragraph (a)(3) of this section. 

(6) A [bank] must use the same risk parameters for calculating ECL as it uses for 

calculating the risk-based capital requirement for the exposure. 

(b) Rules of recognition. (1) A [bank] may only recognize the credit risk 

mitigation benefits of eligible guarantees and eligible credit derivatives. 

(2) A [bank] may only recognize the credit risk mitigation benefits of an eligible 

credit derivative to hedge an exposure that is different from the credit derivative’s 

reference exposure used for determining the derivative’s cash settlement value, 

deliverable obligation, or occurrence of a credit event if: 

(i) The reference exposure ranks pari passu (that is, equally) with or is junior to 

the hedged exposure; and 

(ii) The reference exposure and the hedged exposure are exposures to the same 

legal entity, and legally enforceable cross-default or cross-acceleration clauses are in 

place to assure payments under the credit derivative are triggered when the obligor fails 

to pay under the terms of the hedged exposure. 

 (c) Risk parameters for hedged exposures - (1) PD substitution approach - (i) Full 

coverage. If an eligible guarantee or eligible credit derivative meets the conditions in 
DRAFT November 2, 2007 

548

paragraphs (a) and (b) of this section and the protection amount (P) of the guarantee or 

credit derivative is greater than or equal to the EAD of the hedged exposure, a [bank] 

may recognize the guarantee or credit derivative in determining the [bank]’s risk-based 

capital requirement for the hedged exposure by substituting the PD associated with the 

rating grade of the protection provider for the PD associated with the rating grade of the 

obligor in the risk-based capital formula applicable to the guarantee or credit derivative in 

Table 2 and using the appropriate LGD as described in paragraph (c)(1)(iii) of this 

section. If the [bank] determines that full substitution of the protection provider’s PD 

leads to an inappropriate degree of risk mitigation, the [bank] may substitute a higher PD 

than that of the protection provider. 

 (ii) Partial coverage. If an eligible guarantee or eligible credit derivative meets 

the conditions in paragraphs (a) and (b) of this section and the protection amount (P) of 

the guarantee or credit derivative is less than the EAD of the hedged exposure, the [bank] 

must treat the hedged exposure as two separate exposures (protected and unprotected) in 

order to recognize the credit risk mitigation benefit of the guarantee or credit derivative. 

(A) The [bank] must calculate its risk-based capital requirement for the protected 

exposure under section 31, where PD is the protection provider’s PD, LGD is determined 

under paragraph (c)(1)(iii) of this section, and EAD is P. If the [bank] determines that 

full substitution leads to an inappropriate degree of risk mitigation, the [bank] may use a 

higher PD than that of the protection provider. 

(B) The [bank] must calculate its risk-based capital requirement for the 

unprotected exposure under section 31, where PD is the obligor’s PD, LGD is the hedged 
DRAFT November 2, 2007 

549

exposure’s LGD (not adjusted to reflect the guarantee or credit derivative), and EAD is 

the EAD of the original hedged exposure minus P. 

(C) The treatment in this paragraph (c)(1)(ii) is applicable when the credit risk of 

a wholesale exposure is covered on a partial pro rata basis or when an adjustment is made 

to the effective notional amount of the guarantee or credit derivative under paragraph (d), 

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

 (iii) LGD of hedged exposures. The LGD of a hedged exposure under the PD 

substitution approach is equal to: 

(A) The lower of the LGD of the hedged exposure (not adjusted to reflect the 

guarantee or credit derivative) and the LGD of the guarantee or credit derivative, if the 

guarantee or credit derivative provides the [bank] with the option to receive immediate 

payout upon triggering the protection; or 

(B) The LGD of the guarantee or credit derivative, if the guarantee or credit 

derivative does not provide the [bank] with the option to receive immediate payout upon 

triggering the protection. 

 (2) LGD adjustment approach - (i) Full coverage. If an eligible guarantee or 

eligible credit derivative meets the conditions in paragraphs (a) and (b) of this section and 

the protection amount (P) of the guarantee or credit derivative is greater than or equal to 

the EAD of the hedged exposure, the [bank]’s risk-based capital requirement for the 

hedged exposure is the greater of: 

(A) The risk-based capital requirement for the exposure as calculated under 

section 31, with the LGD of the exposure adjusted to reflect the guarantee or credit 

derivative; or 
DRAFT November 2, 2007 

550

(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 

LGD for the guarantee or credit derivative, and an EAD equal to the EAD of the hedged 

exposure. 

 (ii) Partial coverage. If an eligible guarantee or eligible credit derivative meets 

the conditions in paragraphs (a) and (b) of this section and the protection amount (P) of 

the guarantee or credit derivative is less than the EAD of the hedged exposure, the [bank] 

must treat the hedged exposure as two separate exposures (protected and unprotected) in 

order to recognize the credit risk mitigation benefit of the guarantee or credit derivative. 

(A) The [bank]’s risk-based capital requirement for the protected exposure would 

be the greater of: 

(1) The risk-based capital requirement for the protected exposure as calculated 

under section 31, with the 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 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, 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. 
DRAFT November 2, 2007 

551

 (d) Maturity mismatch. (1) A [bank] that recognizes an eligible guarantee or 

eligible credit derivative in determining its risk-based capital requirement for a hedged 

exposure must adjust the effective notional amount of the credit risk mitigant to reflect 

any maturity mismatch between the hedged exposure and the credit risk mitigant. 

 (2) A maturity mismatch occurs when the residual maturity of a credit risk 

mitigant is less than that of the hedged exposure(s). 

 (3) The residual maturity of a hedged exposure is the longest possible remaining 

time before the obligor is scheduled to fulfill its obligation on the exposure. If a credit 

risk mitigant has embedded options that may reduce its term, the [bank] (protection 

purchaser) must use the shortest possible residual maturity for the credit risk mitigant. If 

a call is at the discretion of the protection provider, the residual maturity of the credit risk 

mitigant is at the first call date. If the call is at the discretion of the [bank] (protection 

purchaser), but the terms of the arrangement at origination of the credit risk mitigant 

contain a positive incentive for the [bank] to call the transaction before contractual 

maturity, the remaining time to the first call date is the residual maturity of the credit risk 

mitigant. For example, where there is a step-up in cost in conjunction with a call feature 

or where the effective cost of protection increases over time even if credit quality remains 

the same or improves, the residual maturity of the credit risk mitigant will be the 

remaining time to the first call. 

 (4) A credit risk mitigant with a maturity mismatch may be recognized only if its 

original maturity is greater than or equal to one year and its residual maturity is greater 

than three months. 
DRAFT November 2, 2007 

552

 (5) When a maturity mismatch exists, the [bank] must apply the following 

adjustment to the effective notional amount of the credit risk mitigant: Pm = E x (t0.25)/(T-0.25), where: 

 (i) Pm = effective notional amount of the credit risk mitigant, adjusted for 

maturity mismatch; 

 (ii) E = effective notional amount of the credit risk mitigant; 

 (iii) t = the lesser of T or the residual maturity of the credit risk mitigant, 

expressed in years; and 

 (iv) T = the lesser of five or the residual maturity of the hedged exposure, 

expressed in years. 

 (e) Credit derivatives without restructuring as a credit event. If a [bank] 

recognizes an eligible credit derivative that does not include as a credit event a 

restructuring of the hedged exposure involving forgiveness or postponement of principal, 

interest, or fees that results in a credit loss event (that is, a charge-off, specific provision, 

or other similar debit to the profit and loss account), the [bank] must apply the following 

adjustment to the effective notional amount of the credit derivative: Pr = Pm x 0.60, 

where: 

 (1) Pr = effective notional amount of the credit risk mitigant, adjusted for lack of 

restructuring event (and maturity mismatch, if applicable); and 

 (2) Pm = effective notional amount of the credit risk mitigant adjusted for 

maturity mismatch (if applicable). 

 (f) Currency mismatch. (1) If a [bank] recognizes an eligible guarantee or eligible 

credit derivative that is denominated in a currency different from that in which the 
DRAFT November 2, 2007 

553

hedged exposure is denominated, the [bank] must apply the following formula to the 

effective notional amount of the guarantee or credit derivative: Pc = Pr x (1-HFX), where: 

 (i) Pc = effective notional amount of the credit risk mitigant, adjusted for currency 

mismatch (and maturity mismatch and lack of restructuring event, if applicable); 

 (ii) Pr = effective notional amount of the credit risk mitigant (adjusted for 

maturity mismatch and lack of restructuring event, if applicable); and 

 (iii) HFX = haircut appropriate for the currency mismatch between the credit risk 

mitigant and the hedged exposure. 

(2) A [bank] must set HFX equal to 8 percent unless it qualifies for the use of and 

uses its own internal estimates of foreign exchange volatility based on a ten-business-day 

holding period and daily marking-to-market and remargining. A [bank] qualifies for the 

use of its own internal estimates of foreign exchange volatility if it qualifies for: 

(i) The own-estimates haircuts in paragraph (b)(2)(iii) of section 32; 

(ii) The simple VaR methodology in paragraph (b)(3) of section 32; or 

(iii) The internal models methodology in paragraph (d) 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 

ten business days using the square root of time formula provided in paragraph 

(b)(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 
DRAFT November 2, 2007 

554

an exposure described in paragraph (a)(1) of section 33 by applying the double default 

treatment in this section if all the following criteria are satisfied. 

 (1) The hedged exposure is fully covered or covered on a pro rata basis by: 

(i) An eligible guarantee issued by an eligible double default guarantor; or 

(ii) An eligible credit derivative that meets the requirements of paragraph (b)(2) of 

section 33 and is issued by an eligible double default guarantor. 

 (2) The guarantee or credit derivative is: 

 (i) An uncollateralized guarantee or uncollateralized credit derivative (for 

example, a credit default swap) that provides protection with respect to a single reference 

obligor; or 

 (ii) An nth-to-default credit derivative (subject to the requirements of 

paragraph (m) of section 42). 

 (3) The hedged exposure is a wholesale exposure (other than a sovereign 

exposure). 

 (4) The obligor of the hedged exposure is not: 

 (i) An eligible double default guarantor or an affiliate of an eligible double default 

guarantor; or 

 (ii) An affiliate of the guarantor. 

 (5) The [bank] does not recognize any credit risk mitigation benefits of the 

guarantee or credit derivative for the hedged exposure other than through application of 

the double default treatment as provided in this section. 

 (6) The [bank] has implemented a process (which has received the prior, written 

approval of the [AGENCY]) to detect excessive correlation between the creditworthiness 
DRAFT November 2, 2007 

555

of the obligor of the hedged exposure and the protection provider. If excessive 

correlation is present, the [bank] may not use the double default treatment for the hedged 

exposure. 

 (b) Full coverage. If the transaction meets the criteria in paragraph (a) of this 

section and the protection amount (P) of the guarantee or credit derivative is at least equal 

to the EAD of the hedged exposure, the [bank] may determine its risk-weighted asset 

amount for the hedged exposure under paragraph (e) of this section. 

 (c) Partial coverage. If the transaction meets the criteria in paragraph (a) of this 

section and the protection amount (P) of the guarantee or credit derivative is less than the 

EAD of the hedged exposure, the [bank] must treat the hedged exposure as two separate 

exposures (protected and unprotected) in order to recognize double default treatment on 

the protected portion of the exposure. 

 (1) For the protected exposure, the [bank] must set EAD equal to P and calculate 

its risk-weighted asset amount as provided in paragraph (e) of this section. 

 (2) For the unprotected exposure, the [bank] must set EAD equal to the EAD of 

the original exposure minus P and then calculate its risk-weighted asset amount as 

provided in section 31. 

 (d) Mismatches. For any hedged exposure to which a [bank] applies double 

default treatment, the [bank] must make applicable adjustments to the protection amount 

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

 (e) The double default dollar risk-based capital requirement. The dollar riskbased capital requirement for a hedged exposure to which a [bank] has applied double 
DRAFT November 2, 2007 

556

default treatment is KDD multiplied by the EAD of the exposure. KDD is calculated 

according to the following formula: KDD = Ko x (0.15 + 160 x PDg), 

where: 

 (1) 

⎥

⎦

⎤ ⎢

⎣

⎡

×−

×−+

×

⎥

⎥

⎦

⎤

⎢

⎢

⎣

⎡ −⎟

⎟

⎠

⎞

⎜

⎜

⎝

⎛

−

+

×=

− −

b

bM PD

NPDN

K NLGD o

os

o os

O g 5.11

)5.2(1

1

)999.0()( 1 1

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 hedged exposure (not adjusted to 

reflect the guarantee or credit derivative) and the LGD of the guarantee or credit 

derivative, if the guarantee or credit derivative provides the [bank] with the option to 

receive immediate payout on triggering the protection; or 

(ii) The LGD of the guarantee or credit derivative, if the guarantee or credit 

derivative does not provide the [bank] with the option to receive immediate payout on 

triggering the protection. 

 (5) 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. 

 (6) 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. 

 (7) M (maturity) is the effective maturity of the guarantee or credit derivative, 

which may not be less than one year or greater than five years. 
DRAFT November 2, 2007 

557

Section 35. Risk-Based Capital Requirement for Unsettled Transactions 

(a) Definitions. For purposes of this section: 

(1) Delivery-versus-payment (DvP) transaction means a securities or commodities 

transaction in which the buyer is obligated to make payment only if the seller has made 

delivery of the securities or commodities and the seller is obligated to deliver the 

securities or commodities only if the buyer has made payment. 

(2) Payment-versus-payment (PvP) transaction means a foreign exchange 

transaction in which each counterparty is obligated to make a final transfer of one or 

more currencies only if the other counterparty has made a final transfer of one or more 

currencies. 

(3) Normal settlement period. A transaction has a normal settlement period if the 

contractual settlement period for the transaction is equal to or less than the market 

standard for the instrument underlying the transaction and equal to or less than five 

business days. 

(4) Positive current exposure. The positive current exposure of a [bank] for a 

transaction is the difference between the transaction value at the agreed settlement price 

and the current market price of the transaction, if the difference results in a credit 

exposure of the [bank] to the counterparty. 

 (b) Scope. This section applies to all transactions involving securities, foreign 

exchange instruments, and commodities that have a risk of delayed settlement or 

delivery. This section does not apply to: 

(1) Transactions accepted by a qualifying central counterparty that are subject to 

daily marking-to-market and daily receipt and payment of variation margin; 
DRAFT November 2, 2007 

558

(2) Repo-style transactions, including unsettled repo-style transactions (which are 

addressed in sections 31 and 32); 

(3) One-way cash payments on OTC derivative contracts (which are addressed in 

sections 31 and 32); or 

(4) Transactions with a contractual settlement period that is longer than the 

normal settlement period (which are treated as OTC derivative contracts and addressed in 

sections 31 and 32). 

(c) System-wide failures. In the case of a system-wide failure of a settlement or 

clearing system, the [AGENCY] may waive risk-based capital requirements for unsettled 

and failed transactions until the situation is rectified. 

(d) Delivery-versus-payment (DvP) and payment-versus-payment (PvP) 

transactions. A [bank] must hold risk-based capital against any DvP or PvP transaction 

with a normal settlement period if the [bank]’s counterparty has not made delivery or 

payment within five business days after the settlement date. The [bank] must determine 

its risk-weighted asset amount for such a transaction by multiplying the positive current 

exposure of the transaction for the [bank] by the appropriate risk weight in Table 5. 

Table 5 – Risk Weights for Unsettled DvP and PvP Transactions 

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-PvP (non-delivery-versus-payment/non-payment-versuspayment) transactions. (1) A [bank] must hold risk-based capital against any non-
DRAFT November 2, 2007 

559

DvP/non-PvP transaction with a normal settlement period if the [bank] has delivered 

cash, securities, commodities, or currencies to its counterparty but has not received its 

corresponding deliverables by the end of the same business day. The [bank] must 

continue to hold risk-based capital against the transaction until the [bank] has received its 

corresponding deliverables. 

(2) From the business day after the [bank] has made its delivery until five 

business days after the counterparty delivery is due, the [bank] must calculate its riskbased capital requirement for the transaction by treating the current market value of the 

deliverables owed to the [bank] as a wholesale exposure. 

 (i) A [bank] may assign an obligor rating to a counterparty for which it is not 

otherwise required under this appendix to assign an obligor rating on the basis of the 

applicable external rating of any outstanding unsecured long-term debt security without 

credit enhancement issued by the counterparty. 

(ii) A [bank] may use a 45 percent LGD for the transaction rather than estimating 

LGD for the transaction provided the [bank] uses the 45 percent LGD for all transactions 

described in paragraphs (e)(1) and (e)(2) of this section. 

(iii) A [bank] may use a 100 percent risk weight for the transaction provided the 

[bank] uses this risk weight for all transactions described in paragraphs (e)(1) and (e)(2) 

of this section. 

(3) If the [bank] has not received its deliverables by the fifth business day after 

the counterparty delivery was due, the [bank] must deduct the current market value of the 

deliverables owed to the [bank] 50 percent from tier 1 capital and 50 percent from tier 2 

capital. 
DRAFT November 2, 2007 

560

(f) Total risk-weighted assets for unsettled transactions. Total risk-weighted 

assets for unsettled transactions is the sum of the risk-weighted asset amounts of all DvP, 

PvP, and non-DvP/non-PvP transactions. 

Part V. Risk-Weighted Assets for Securitization Exposures 

Section 41. Operational Criteria for Recognizing the Transfer of Risk 

 (a) Operational criteria for traditional securitizations. A [bank] that transfers 

exposures it has originated or purchased to a securitization SPE or other third party in 

connection with a traditional securitization may exclude the exposures from the 

calculation of its risk-weighted assets only if each of the conditions in this paragraph (a) 

is satisfied. A [bank] that meets these conditions must hold risk-based capital against any 

securitization exposures it retains in connection with the securitization. A [bank] that 

fails to meet these conditions must hold risk-based capital against the transferred 

exposures as if they had not been securitized and must deduct from tier 1 capital any 

after-tax gain-on-sale resulting from the transaction. The conditions are: 

 (1) The transfer is considered a sale under GAAP; 

 (2) The [bank] has transferred to third parties credit risk associated with the 

underlying exposures; and 

 (3) Any clean-up calls relating to the securitization are eligible clean-up calls. 

 (b) Operational criteria for synthetic securitizations. For synthetic securitizations, 

a [bank] may recognize for risk-based capital purposes the use of a credit risk mitigant to 

hedge underlying exposures only if each of the conditions in this paragraph (b) is 

satisfied. A [bank] that fails to meet these conditions must hold risk-based capital against 
DRAFT November 2, 2007 

561

the underlying exposures as if they had not been synthetically securitized. The conditions 

are: 

 (1) The credit risk mitigant is an eligible credit derivative from an eligible 

securitization guarantor or an eligible guarantee from an eligible securitization guarantor; 

 (2) The [bank] transfers credit risk associated with the underlying exposures to 

third parties, and the terms and conditions in the credit risk mitigants employed do not 

include provisions that: 

 (i) Allow for the termination of the credit protection due to deterioration in the 

credit quality of the underlying exposures; 

 (ii) Require the [bank] to alter or replace the underlying exposures to improve the 

credit quality of the pool of underlying exposures; 

 (iii) Increase the [bank]’s cost of credit protection in response to deterioration in 

the credit quality of the underlying exposures; 

 (iv) Increase the yield payable to parties other than the [bank] in response to a 

deterioration in the credit quality of the underlying exposures; or 

 (v) Provide for increases in a retained first loss position or credit enhancement 

provided by the [bank] after the inception of the securitization; 

 (3) The [bank] obtains a well-reasoned opinion from legal counsel that confirms 

the enforceability of the credit risk mitigant in all relevant jurisdictions; and 

 (4) Any clean-up calls relating to the securitization are eligible clean-up calls. 

Section 42. Risk-Based Capital Requirement for Securitization Exposures 

 (a) Hierarchy of approaches. Except as provided elsewhere in this section: 
DRAFT November 2, 2007 

562

(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 apply the Internal Assessment Approach in section 44 to the exposure (if the 

[bank], the exposure, and the relevant ABCP program qualify for the Internal Assessment 

Approach) or the Supervisory Formula Approach in section 45 to the exposure (if the 

[bank] and the exposure qualify for the Supervisory Formula Approach). 

(4) If a securitization exposure does not require deduction under paragraph (a)(1) 

of this section and does not qualify for the Ratings-Based Approach, the Internal 

Assessment Approach, or the Supervisory Formula Approach, the [bank] must deduct the 

exposure from total capital in accordance with paragraph (c) of this section. 

(5) If a securitization exposure is an OTC derivative contract (other than a credit 

derivative) that has a first priority claim on the cash flows from the underlying exposures 

(notwithstanding amounts due under interest rate or currency derivative contracts, fees 

due, or other similar payments), with approval of the [AGENCY], a [bank] may choose 

to set the risk-weighted asset amount of the exposure equal to the amount of the exposure 

as determined in paragraph (e) of this section rather than apply the hierarchy of 

approaches described in paragraphs (a)(1) through (4) of this section. 
DRAFT November 2, 2007 

563

(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 tier 1 capital and tier 2 capital for 

a securitization exposure net of any deferred tax liabilities associated with the 

securitization exposure. 

 (d) Maximum risk-based capital requirement. Regardless of any other provisions 

of this part, unless one or more underlying exposures does not meet the definition of a 

wholesale, retail, securitization, or equity exposure, the total risk-based capital 

requirement for all securitization exposures held by a single [bank] associated with a 

single securitization (including any risk-based capital requirements that relate to an early 

amortization provision of the securitization but excluding any risk-based capital 

requirements that relate to the [bank]’s gain-on-sale or CEIOs associated with the 

securitization) may not exceed the sum of: 

(1) The [bank]’s total risk-based capital requirement for the underlying exposures 

as if the [bank] directly held the underlying exposures; and 

(2) The total ECL of the underlying exposures. 
DRAFT November 2, 2007 

564

(e) Amount of a securitization exposure. (1) The amount of an on-balance sheet 

securitization exposure that is not a repo-style transaction, eligible margin loan, or OTC 

derivative contract (other than a credit derivative) is: 

 (i) The [bank]’s carrying value minus any unrealized gains and plus any 

unrealized losses on the exposure, if the exposure is a security classified as available-forsale; or 

(ii) The [bank]’s carrying value, if the exposure is not a security classified as 

available-for-sale. 

(2) The amount of an off-balance sheet securitization exposure that is not an OTC 

derivative contract (other than a credit derivative) is the notional amount of the exposure. 

For an off-balance-sheet securitization exposure to an ABCP program, such as a liquidity 

facility, the notional amount may be reduced to the maximum potential amount that the 

[bank] could be required to fund given the ABCP program’s current underlying assets 

(calculated without regard to the current credit quality of those assets). 

(3) The amount of a securitization exposure that is a repo-style transaction, 

eligible margin loan, or OTC derivative contract (other than a credit derivative) is the 

EAD of the exposure as calculated in section 32. 

 (f) Overlapping exposures. If a [bank] has multiple securitization exposures that 

provide duplicative coverage of the underlying exposures of a securitization (such as 

when a [bank] provides a program-wide credit enhancement and multiple pool-specific 

liquidity facilities to an ABCP program), the [bank] is not required to hold duplicative 

risk-based capital against the overlapping position. Instead, the [bank] may apply to the 
DRAFT November 2, 2007 

565

overlapping position the applicable risk-based capital treatment that results in the highest 

risk-based capital requirement. 

 (g) Securitizations of non-IRB exposures. If a [bank] has a securitization 

exposure where any underlying exposure is not a wholesale exposure, retail exposure, 

securitization exposure, or equity exposure, the [bank] must: 

(1) If the [bank] is an originating [bank], deduct from tier 1 capital any after-tax 

gain-on-sale resulting from the securitization and deduct from total capital in accordance 

with paragraph (c) of this section the portion of any CEIO that does not constitute gainon-sale; 

(2) If the securitization exposure does not require deduction under 

paragraph (g)(1), apply the RBA in section 43 to the securitization exposure if the 

exposure qualifies for the RBA; 

(3) If the securitization exposure does not require deduction under 

paragraph (g)(1) and does not qualify for the RBA, apply the IAA in section 44 to the 

exposure (if the [bank], the exposure, and the relevant ABCP program qualify for the 

IAA); and 

(4) If the securitization exposure does not require deduction under 

paragraph (g)(1) and does not qualify for the RBA or the IAA, deduct the exposure from 

total capital in accordance with paragraph (c) of this section. 

 (h) Implicit support. If a [bank] provides support to a securitization in excess of 

the [bank]’s contractual obligation to provide credit support to the securitization (implicit 

support): 
DRAFT November 2, 2007 

566

 (1) The [bank] must hold regulatory capital against all of the underlying 

exposures associated with the securitization as if the exposures had not been securitized 

and must deduct from tier 1 capital any after-tax gain-on-sale resulting from the 

securitization; and 

 (2) The [bank] must disclose publicly: 

 (i) That it has provided implicit support to the securitization; and 

 (ii) The regulatory capital impact to the [bank] of providing such implicit support. 

 (i) Eligible servicer cash advance facilities. Regardless of any other provisions of 

this part, a [bank] is not required to hold risk-based capital against the undrawn portion of 

an eligible servicer cash advance facility. 

(j) Interest-only mortgage-backed securities. Regardless of any other provisions 

of this part, the risk weight for a non-credit-enhancing interest-only mortgage-backed 

security may not be less than 100 percent. 

(k) Small-business loans and leases on personal property transferred with 

recourse. (1) Regardless of any other provisions of this appendix, a [bank] that has 

transferred small-business loans and leases on personal property (small-business 

obligations) with recourse must include in risk-weighted assets only the contractual 

amount of retained recourse if all the following conditions are met: 

(i) The transaction is a sale under GAAP. 

(ii) The [bank] establishes and maintains, pursuant to GAAP, a non-capital 

reserve sufficient to meet the [bank]'s reasonably estimated liability under the recourse 

arrangement. 
DRAFT November 2, 2007 

567

(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 (15 USC 632). 

(iv) The [bank] is well capitalized, as defined in the [AGENCY]’s prompt 

corrective action regulation -- 12 CFR part 6 (for national banks), 12 CFR part 208, 

subpart D (for state member banks or bank holding companies), 12 CFR part 325, subpart 

B (for state nonmember banks), and 12 CFR part 565 (for savings associations). For 

purposes of determining whether a [bank] is well capitalized for purposes of this 

paragraph, the [bank]’s capital ratios must be calculated without regard to the capital 

treatment for transfers of small-business obligations with recourse specified in paragraph 

(k)(1) of this section. 

(2) The total outstanding amount of recourse retained by a [bank] on transfers of 

small-business obligations receiving the capital treatment specified in paragraph (k)(1) of 

this section cannot exceed 15 percent of the [bank]’s total qualifying capital. 

(3) If a [bank] ceases to be well capitalized or exceeds the 15 percent capital 

limitation, the preferential capital treatment specified in paragraph (k)(1) of this section 

will continue to apply to any transfers of small-business obligations with recourse that 

occurred during the time that the [bank] was well capitalized and did not exceed the 

capital limit. 

(4) The risk-based capital ratios of the [bank] must be calculated without regard to 

the capital treatment for transfers of small-business obligations with recourse specified in 

paragraph (k)(1) of this section as provided in 12 CFR part 3, Appendix A (for national 

banks), 12 CFR part 208, Appendix A (for state member banks), 12 CFR part 225, 
DRAFT November 2, 2007 

568

Appendix A (for bank holding companies), 12 CFR part 325, Appendix A (for state 

nonmember banks), and 12 CFR 567.6(b)(5)(v) (for savings associations). 

 (l) Consolidated ABCP programs. (1) A [bank] that qualifies as a primary 

beneficiary and must consolidate an ABCP program as a variable interest entity under 

GAAP may exclude the consolidated ABCP program assets from risk-weighted assets if 

the [bank] is the sponsor of the ABCP program. If a [bank] excludes such consolidated 

ABCP program assets from risk-weighted assets, the [bank] must hold risk-based capital 

against any securitization exposures of the [bank] to the ABCP program in accordance 

with this part. 

 (2) If a [bank] either is not permitted, or elects not, to exclude consolidated ABCP 

program assets from its risk-weighted assets, the [bank] must hold risk-based capital 

against the consolidated ABCP program assets in accordance with this appendix but is 

not required to hold risk-based capital against any securitization exposures of the [bank] 

to the ABCP program. 

 (m) Nth-to-default credit derivatives - (1) First-to-default credit derivatives - (i) 

Protection purchaser. A [bank] that obtains credit protection on a group of underlying 

exposures through a first-to-default credit derivative must determine its risk-based capital 

requirement for the underlying exposures as if the [bank] synthetically securitized the 

underlying exposure with the lowest risk-based capital requirement 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 
DRAFT November 2, 2007 

569

derivative qualifies for the RBA) or, if the derivative does not qualify for the RBA, by 

setting its risk-weighted asset amount for the derivative equal to the product of: 

(A) The protection amount of the derivative; 

(B) 12.5; and 

(C) The sum of the risk-based capital requirements of the individual underlying 

exposures, up to a maximum of 100 percent. 

(2) Second-or-subsequent-to-default credit derivatives - (i) Protection purchaser. 

(A) A [bank] that obtains credit protection on a group of underlying exposures through a 

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 and had obtained no credit risk mitigant on the 

other underlying exposures. 

(ii) Protection provider. A [bank] that provides credit protection on a group of 

underlying exposures through a nth-to-default credit derivative (other than a first-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 
DRAFT November 2, 2007 

570

derivative does not qualify for the RBA, by setting its risk-weighted asset amount for the 

derivative equal to the product of: 

(A) The protection amount of the derivative; 

(B) 12.5; and 

(C) The sum of the risk-based capital requirements of the individual underlying 

exposures (excluding the n-1 underlying exposures with the lowest risk-based capital 

requirements), up to a maximum of 100 percent. 

Section 43. Ratings-Based Approach (RBA) 

 (a) Eligibility requirements for use of the RBA - (1) Originating [bank]. An 

originating [bank] must use the RBA to calculate its risk-based capital requirement for a 

securitization exposure if the exposure has two or more external ratings or inferred 

ratings (and may not use the RBA if the exposure has fewer than two external ratings or 

inferred ratings). 

(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). 

 (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 Table 6 

and Table 7. 

 (2) A [bank] must apply the risk weights in Table 6 when the securitization 

exposure’s applicable external or applicable inferred rating represents a long-term credit 
DRAFT November 2, 2007 

571

rating, and must apply the risk weights in Table 7 when the securitization exposure’s 

applicable external or applicable inferred rating represents a short-term credit rating. 

 (i) A [bank] must apply the risk weights in column 1 of Table 6 or Table 7 to the 

securitization exposure if: 

 (A) N (as calculated under paragraph (e)(6) of section 45) is six or more (for 

purposes of this section only, if the notional number of underlying exposures is 25 or 

more or if all of the underlying exposures are retail exposures, a [bank] may assume that 

N is six or more unless the [bank] knows or has reason to know that N is less than six); 

and 

 (B) The securitization exposure is a senior securitization exposure. 

 (ii) A [bank] must apply the risk weights in column 3 of Table 6 or Table 7 to the 

securitization exposure if N is less than six, regardless of the seniority of the 

securitization exposure. 

 (iii) Otherwise, a [bank] must apply the risk weights in column 2 of Table 6 or 

Table 7. 

Table 6 – Long-Term Credit Rating Risk Weights under RBA and IAA 

 Column 1 Column 2 Column 3

Applicable external 

or inferred 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% 
DRAFT November 2, 2007 

572

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 

investment grade—

negative designation 

(for example, BB-) 

650% 

More than one 

category below 

investment grade 

Deduction from tier 1 and tier 2 capital 

 

Table 7 – Short-Term Credit Rating Risk Weights under RBA and IAA 

 Column 1 Column 2 Column 3

Applicable external 

or inferred rating 

(Illustrative rating 

example) 

Risk weights for 

senior 

securitization 

exposures backed 

Risk weights for 

non-senior 

securitization 

exposures backed 

Risk weights for 

securitization 

exposures backed by 

non-granular pools 
DRAFT November 2, 2007 

573

by granular pools by 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 [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. 
DRAFT November 2, 2007 

574

 (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 any NRSRO that provides an external rating to the ABCP program’s 

commercial paper changes its methodology (including stress factors), the [bank] must 

evaluate whether to revise its internal assessment process. 

 (v) The [bank] must have an effective system of controls and oversight that 

ensures compliance with these operational requirements and maintains the integrity and 

accuracy of the internal credit assessments. The [bank] must have an internal audit 

function independent from the ABCP program business line and internal credit 

assessment process that assesses at least annually whether the controls over the internal 

credit assessment process function as intended. 

 (vi) The [bank] must review and update each internal credit assessment whenever 

new material information is available, but no less frequently than annually. 
DRAFT November 2, 2007 

575

(vii) The [bank] must validate its internal credit assessment process on an ongoing 

basis and at least annually. 

(2) ABCP-program qualification criteria. An ABCP program qualifies for use of 

the IAA if all commercial paper issued by the ABCP program has an external rating. 

 (3) Exposure qualification criteria. A securitization exposure qualifies for use of 

the IAA if the exposure meets the following criteria: 

(i) The [bank] initially rated the exposure at least the equivalent of investment 

grade. 

 (ii) The ABCP program has robust credit and investment guidelines (that is, 

underwriting standards) for the exposures underlying the securitization exposure. 

 (iii) The ABCP program performs a detailed credit analysis of the sellers of the 

exposures underlying the securitization exposure. 

(iv) The ABCP program’s underwriting policy for the exposures underlying the 

securitization exposure establishes minimum asset eligibility criteria that include the 

prohibition of the purchase of assets that are significantly past due or of assets that are 

defaulted (that is, assets that have been charged off or written down by the seller prior to 

being placed into the ABCP program or assets that would be charged off or written down 

under the program’s governing contracts), as well as limitations on concentration to 

individual obligors or geographic areas and the tenor of the assets to be purchased. 

 (v) The aggregate estimate of loss on the exposures underlying the securitization 

exposure considers all sources of potential risk, such as credit and dilution risk. 

 (vi) Where relevant, the ABCP program incorporates structural features into each 

purchase of exposures underlying the securitization exposure to mitigate potential credit 
DRAFT November 2, 2007 

576

deterioration of the underlying exposures. Such features may include wind-down triggers 

specific to a pool of underlying exposures. 

 (b) Mechanics. A [bank] that elects to use the IAA to calculate the risk-based 

capital requirement for any securitization exposure must use the IAA to calculate the 

risk-based capital requirements for all securitization exposures that qualify for the IAA 

approach. Under the IAA, a [bank] must map its internal assessment of such a 

securitization exposure to an equivalent external rating from an NRSRO. Under the IAA, 

a [bank] must determine the risk-weighted asset amount for such a securitization 

exposure by multiplying the amount of the exposure (as defined in paragraph (e) of 

section 42) by the appropriate risk weight in Table 6 and Table 7 in paragraph (b) of 

section 43. 

Section 45. Supervisory Formula Approach (SFA) 

(a) Eligibility requirements. A [bank] may use the SFA to determine its riskbased capital requirement for a securitization exposure only if the [bank] can calculate on 

an ongoing basis each of the SFA parameters in paragraph (e) of this section. 

 (b) Mechanics. Under the SFA, a securitization exposure incurs a deduction from 

total capital (as described in paragraph (c) of section 42) and/or an SFA risk-based capital 

requirement, as determined in paragraph (c) of this section. The risk-weighted asset 

amount for the securitization exposure equals the SFA risk-based capital requirement for 

the exposure multiplied by 12.5. 

 (c) The SFA risk-based capital requirement. (1) If KIRB is greater than or equal to 

L+T, the entire exposure must be deducted from total capital. 
DRAFT November 2, 2007 

577

 (2) If KIRB is less than or equal to L, the exposure’s SFA risk-based capital 

requirement is UE multiplied by TP multiplied by the greater of: 

 (i) 0.0056 * T; or 

 (ii) S[L+T] – S[L]. 

(3) If KIRB is greater than L and less than L+T, the [bank] must deduct from total 

capital an amount equal to UE*TP*(KIRB –L), and the exposure’s SFA risk-based capital 

requirement is UE multiplied by TP multiplied by the greater of: 

 (i) 0.0056 * (T – (KIRB – L)); or 

 (ii) S[L+T] – S[KIRB]. 

 (d) The supervisory formula: 

 (1) 

⎪

⎭

⎪

⎬

⎫

⎪

⎩

⎪

⎨

⎧

− > ⋅ +−+

≤

= −⋅

IRB

K

YK

IRB

IRB IRB

IRB

e KYwhen Kd KKYKK

Y KYwhen

YS IRB

IRB

1( ) 20 ][][

][ )(20

 (2) [ ] ( ) −⋅−= β ⋅ + β + ],1;[],;[1)1(][ ⋅ cbaYYbaYhYK

 (3) 

N

IRB

EWALGD

K h ⎟

⎠

⎞ ⎜

⎝

⎛

1 −=

 (4) a g ⋅= c 

 (5) −⋅= cgb )1(

 (6) h

K

c IRB

− = 1

 (7) 1 )1( − ⋅− = f

cc

g

 (8) 1000)1(

)1(

1

2

2

⋅−

−⋅− +− −+ = hvKK

c

h

Kv f IRB IRB IRB
DRAFT November 2, 2007 

578

 (9) N

EWALGD K EWALGD Kv IRB

IRB

( − + ⋅ 1(25.) − ) ⋅=

 (10) d baKh ]),;[1()1(1 −⋅−−= β IRB . 
DRAFT November 2, 2007 

579

 (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 exposures that are wholesale and retail exposures (including the 

amount of any funded spread accounts, cash collateral accounts, and other similar funded 

credit enhancements) plus the amount of any underlying exposures that are securitization 

exposures (as defined in paragraph (e) of section 42) plus the adjusted carrying value of 

any underlying exposures that are equity exposures (as defined in paragraph (b) of 

section 51). 

 (2) Tranche percentage (TP). TP is the ratio of the amount of the [bank]’s 

securitization exposure to the amount of the tranche that contains the securitization 

exposure. 

 (3) Capital requirement on underlying exposures (KIRB). (i) KIRB is the ratio of: 

 (A) The sum of the risk-based capital requirements for the underlying exposures 

plus the expected credit losses of the underlying exposures (as determined under this 

appendix as if the underlying exposures were directly held by the [bank]); to 

 (B) UE. 
DRAFT November 2, 2007 

580

 (ii) The calculation of KIRB must reflect the effects of any credit risk mitigant 

applied to the underlying exposures (either to an individual underlying exposure, to a 

group of underlying exposures, or to the entire pool of underlying exposures). 

 (iii) All assets related to the securitization are treated as underlying exposures, 

including assets in a reserve account (such as a cash collateral account). 

 (4) Credit enhancement level (L). (i) L is the ratio of: 

 (A) The amount of all securitization exposures subordinated to the tranche that 

contains the [bank]’s securitization exposure; to 

 (B) UE. 

 (ii) A [bank] must determine L before considering the effects of any tranchespecific credit enhancements. 

 (iii) Any gain-on-sale or CEIO associated with the securitization may not be 

included in L. 

 (iv) Any reserve account funded by accumulated cash flows from the underlying 

exposures that is subordinated to the tranche that contains the [bank]’s securitization 

exposure may be included in the numerator and denominator of L to the extent cash has 

accumulated in the account. Unfunded reserve accounts (that is, reserve accounts that are 

to be funded from future cash flows from the underlying exposures) may not be included 

in the calculation of L. 

 (v) In some cases, the purchase price of receivables will reflect a discount that 

provides credit enhancement (for example, first loss protection) for all or certain tranches 

of the securitization. When this arises, L should be calculated inclusive of this discount if 

the discount provides credit enhancement for the securitization exposure. 
DRAFT November 2, 2007 

581

 (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) Exposure-weighted average loss given default (EWALGD). EWALGD is 

calculated as: 

∑

∑ ⋅

=

i

i

i

i i

EAD

EADLGD

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 the 

underlying exposures that are themselves securitization exposures. 
DRAFT November 2, 2007 

582

 (f) Simplified method for computing N and EWALGD. (1) If all underlying 

exposures of a securitization are retail exposures, a [bank] may apply the SFA using the 

following simplifications: 

 (i) h = 0; and 

 (ii) v = 0. 

 (2) Under the conditions in paragraphs (f)(3) and (f)(4), a [bank] may employ a 

simplified method for calculating N and EWALGD. 

 (3) If C1 is no more than 0.03, a [bank] may set EWALGD = 0.50 if none of the 

underlying exposures is a securitization exposure or EWALGD = 1 if one or more of the 

underlying exposures is a securitization exposure, and may set N equal to the following 

amount: 

)0,1(max 1

1

1

1

1 Cm

m

CC CC

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 if none of the underlying exposures is a securitization 

exposure or EWALGD = 1 if one or more of the underlying exposures is a securitization 

exposure and may set N = 1/C1. 

Section 46. Recognition of Credit Risk Mitigants for Securitization Exposures
DRAFT November 2, 2007 

583

 (a) General. An originating [bank] that has obtained a credit risk mitigant to 

hedge its securitization exposure to a synthetic or traditional securitization that satisfies 

the operational criteria in section 41 may recognize the credit risk mitigant, but only as 

provided in this section. An investing [bank] that has obtained a credit risk mitigant to 

hedge a securitization exposure may recognize the credit risk mitigant, but only as 

provided in this section. A [bank] that has used the RBA in section 43 or the IAA in 

section 44 to calculate its risk-based capital requirement for a securitization exposure 

whose external or inferred rating (or equivalent internal rating under the IAA) reflects the 

benefits of a credit risk mitigant provided to the associated securitization or that supports 

some or all of the underlying exposures may not use the credit risk mitigation rules in this 

section to further reduce its risk-based capital requirement for the exposure to reflect that 

credit risk mitigant. 

(b) Collateral - (1) Rules of recognition. A [bank] may recognize financial 

collateral in determining the [bank]’s risk-based capital requirement for a securitization 

exposure (other than a repo-style transaction, an eligible margin loan, or an OTC 

derivative contract for which the [bank] has reflected collateral in its determination of 

exposure amount under section 32) 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 

under the SFA in section 45 multiplied by the ratio of adjusted exposure amount (SE*) to 

original exposure amount (SE), where: 

(i) SE* = max {0, [SE - C x (1 - Hs - Hfx)]}; 
DRAFT November 2, 2007 

584

 (ii) SE = the amount of the securitization exposure calculated under paragraph (e) 

of section 42; 

 (iii) C = the current market value of the collateral; 

 (iv) Hs = the haircut appropriate to the collateral type; and 

 (v) Hfx = the haircut appropriate for any currency mismatch between the 

collateral and the exposure. 

 (2) Mixed collateral. Where the collateral is a basket of different asset types or a 

basket of assets denominated in different currencies, the haircut on the basket will be 

= ∑

i

HaH ii , 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 
DRAFT November 2, 2007 

585

price volatility and foreign exchange volatility, subject to paragraph (b)(2)(iii) of 

section 32. The minimum holding period (TM) for securitization exposures is 65 business 

days. 

 (c) Guarantees and credit derivatives - (1) Limitations on recognition. A [bank] 

may only recognize an eligible guarantee or eligible credit derivative provided by an 

eligible securitization guarantor in determining the [bank]’s risk-based capital 

requirement for a securitization exposure. 

 (2) ECL for securitization exposures. When a [bank] recognizes an eligible 

guarantee or eligible credit derivative provided by an eligible securitization guarantor in 

determining the [bank]’s risk-based capital requirement for a securitization exposure, the 

[bank] must also: 

(i) Calculate ECL for the protected portion of the exposure using the same risk 

parameters that it uses for calculating the risk-weighted asset amount of the exposure as 

described in paragraph (c)(3) of this section; and 

(ii) Add the exposure’s ECL to the [bank]’s total ECL. 

 (3) Rules of recognition. A [bank] may recognize an eligible guarantee or eligible 

credit derivative provided by an eligible securitization guarantor in determining the 

[bank]’s risk-based capital requirement for the securitization exposure as follows: 

 (i) Full coverage. If the protection amount of the eligible guarantee or eligible 

credit derivative equals or exceeds the amount of the securitization exposure, the [bank] 

may set the risk-weighted asset amount for the securitization exposure equal to the riskweighted asset amount for a direct exposure to the eligible securitization guarantor (as 

determined in the wholesale risk weight function described in section 31), using the 
DRAFT November 2, 2007 

586

[bank]’s PD for the guarantor, the [bank]’s LGD for the guarantee or credit derivative, 

and an EAD equal to the amount of the securitization exposure (as determined in 

paragraph (e) of section 42). 

 (ii) Partial coverage. If the protection amount of the eligible guarantee or eligible 

credit derivative is less than the amount of the securitization exposure, the [bank] may set 

the risk-weighted asset amount for the securitization exposure equal to the sum of: 

 (A) Covered portion. The risk-weighted asset amount for a direct exposure to the 

eligible securitization guarantor (as determined in the wholesale risk weight function 

described in section 31), using the [bank]’s PD for the guarantor, the [bank]’s LGD for 

the guarantee or credit derivative, and an EAD equal to the protection amount of the 

credit risk mitigant; and 

 (B) Uncovered portion. (1) 1.0 minus the ratio of the protection amount of the 

eligible guarantee or eligible credit derivative to the amount of the securitization 

exposure); multiplied by 

 (2) The risk-weighted asset amount for the securitization exposure without the 

credit risk mitigant (as determined in sections 42-45). 

 (4) Mismatches. The [bank] must make applicable adjustments to the protection 

amount as required in paragraphs (d), (e), and (f) of section 33 for any hedged 

securitization exposure and any more senior securitization exposure that benefits from the 

hedge. In the context of a synthetic securitization, when an eligible guarantee or eligible 

credit derivative covers multiple hedged exposures that have different residual maturities, 

the [bank] must use the longest residual maturity of any of the hedged exposures as the 

residual maturity of all the hedged exposures. 
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587

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

 (a) General. (1) An originating [bank] must hold risk-based capital against the 

sum of the originating [bank]’s interest and the investors’ interest in a securitization that: 

(i) Includes one or more underlying exposures in which the borrower is permitted 

to vary the drawn amount within an agreed limit under a line of credit; and 

(ii) Contains an early amortization provision. 

(2) For securitizations described in paragraph (a)(1) of this section, an originating 

[bank] must calculate the risk-based capital requirement for the originating [bank]’s 

interest under sections 42-45, and the risk-based capital requirement for the investors’ 

interest under paragraph (b) of this section. 

 (b) Risk-weighted asset amount for investors’ interest. The originating [bank]’s 

risk-weighted asset amount for the investors’ interest in the securitization is equal to the 

product of the following 5 quantities: 

 (1) The investors’ interest EAD; 

 (2) The appropriate conversion factor in paragraph (c) of this section; 

 (3) KIRB (as defined in paragraph (e)(3) of section 45); 

(4) 12.5; and 

(5) The proportion of the underlying exposures in which the borrower is permitted 

to vary the drawn amount within an agreed limit under a line of credit. 

(c) Conversion factor. (1) (i) Except as provided in paragraph (c)(2) of this 

section, to calculate the appropriate conversion factor, a [bank] must use Table 8 for a 

securitization that contains a controlled early amortization provision and must use Table 

9 for a securitization that contains a non-controlled early amortization provision. In 
DRAFT November 2, 2007 

588

circumstances where a securitization contains a mix of retail and nonretail exposures or a 

mix of committed and uncommitted exposures, a [bank] may take a pro rata approach to 

determining the conversion factor for the securitization’s early amortization provision. If 

a pro rata approach is not feasible, a [bank] must treat the mixed securitization as a 

securitization of nonretail exposures if a single underlying exposure is a nonretail 

exposure and must treat the mixed securitization as a securitization of committed 

exposures if a single underlying exposure is a committed exposure. 

(ii) To find the appropriate conversion factor in the tables, a [bank] must divide 

the three-month average annualized excess spread of the securitization by the excess 

spread trapping point in the securitization structure. In securitizations that do not require 

excess spread to be trapped, or that specify trapping points based primarily on 

performance measures other than the three-month average annualized excess spread, the 

excess spread trapping point is 4.5 percent. 

Table 8 – Controlled Early Amortization Provisions 

 Uncommitted Committed

Retail Credit 

Lines 

Three-month average annualized 

excess spread 

Conversion Factor (CF) 

90% CF 

133.33% of trapping point or more 

0% CF 

less than 133.33% to 100% of 

trapping point 

1% CF 

less than 100% to 75% of trapping 

point 

2% CF 

less than 75% to 50% of trapping 

point 

10% CF 

less than 50% to 25% of trapping 
DRAFT November 2, 2007 

589

point 

20% CF 

less than 25% of trapping point 

40% CF 

Non-retail Credit 

Lines 90% CF 90% CF 

Table 9 – Non-Controlled Early Amortization Provisions 

 Uncommitted Committed

Retail Credit Lines 

Three-month average annualized 

excess spread 

Conversion Factor (CF)

100% CF 

133.33% of trapping point or more 

0% CF 

less than 133.33% to 100% of 

trapping point 

5% CF 

less than 100% to 75% of trapping 

point 

15% CF 

less than 75% to 50% of trapping 

point 

50% CF 

less than 50% of trapping point 

100% CF 

Non-retail Credit 

Lines 

100% CF 100% CF 

 (2) For a securitization for which all or substantially all of the underlying 

exposures are residential mortgage exposures, a [bank] may calculate the appropriate 

conversion factor using paragraph (c)(1) of this section or may use a conversion factor of 

10 percent. If the [bank] chooses to use a conversion factor of 10 percent, it must use that 

conversion factor for all securitizations for which all or substantially all of the underlying 

exposures are residential mortgage exposures. 

Part VI. Risk-Weighted Assets for Equity Exposures 
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590

Section 51. Introduction and Exposure Measurement 

(a) General. To calculate its risk-weighted asset amounts for equity exposures 

that are not equity exposures to investment funds, a [bank] may apply either the Simple 

Risk Weight Approach (SRWA) in section 52 or, if it qualifies to do so, the Internal 

Models Approach (IMA) in section 53. A [bank] must use the look-through approaches 

in section 54 to calculate its risk-weighted asset amounts for equity exposures to 

investment funds. 

 (b) Adjusted carrying value. For purposes of this part, the adjusted carrying value 

of an equity exposure is: 

(1) For the on-balance sheet component of an equity exposure, the [bank]’s 

carrying value of the exposure reduced by any unrealized gains on the exposure that are 

reflected in such carrying value but excluded from the [bank]’s tier 1 and tier 2 capital; 

and 

(2) For the off-balance sheet component of an equity exposure, the effective 

notional principal amount of the exposure, the size of which is equivalent to a 

hypothetical on-balance sheet position in the underlying equity instrument that would 

evidence the same change in fair value (measured in dollars) for a given small change in 

the price of the underlying equity instrument, minus the adjusted carrying value of the 

on-balance sheet component of the exposure as calculated in paragraph (b)(1) of this 

section. For unfunded equity commitments that are unconditional, the effective notional 

principal amount is the notional amount of the commitment. For unfunded equity 

commitments that are conditional, the effective notional principal amount is the [bank]’s 

best estimate of the amount that would be funded under economic downturn conditions. 
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Section 52. Simple Risk Weight Approach (SRWA) 

(a) General. Under the SRWA, a [bank]’s aggregate risk-weighted asset amount 

for its equity exposures is equal to the sum of the risk-weighted asset amounts for each of 

the [bank]’s individual equity exposures (other than equity exposures to an investment 

fund) as determined in this section and the risk-weighted asset amounts for each of the 

[bank]’s individual equity exposures to an investment fund as determined in section 54. 

(b) SRWA computation for individual equity exposures. A [bank] must 

determine the risk-weighted asset amount for an individual equity exposure (other than an 

equity exposure to an investment fund) by multiplying the adjusted carrying value of the 

equity exposure or the effective portion and ineffective portion of a hedge pair (as 

defined in paragraph (c) of this section) by the lowest applicable risk weight in this 

paragraph (b). 

(1) 0 percent risk weight equity exposures. An equity exposure to an entity whose 

credit exposures are exempt from the 0.03 percent PD floor in paragraph (d)(2) of section 

31 is assigned a 0 percent risk weight. 

(2) 20 percent risk weight equity exposures. An equity exposure to a Federal 

Home Loan Bank or Farmer Mac is assigned a 20 percent risk weight. 

(3) 100 percent risk weight equity exposures. The following equity exposures are 

assigned a 100 percent risk weight: 

(i) Community development equity exposures. An equity exposure that qualifies 

as a community development investment under 12 U.S.C. 24(Eleventh), excluding equity 

exposures to an unconsolidated small business investment company and equity exposures 
DRAFT November 2, 2007 

592

held through a consolidated small business investment company described in section 302 

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

(ii) Effective portion of hedge pairs. The effective portion of a hedge pair. 

(iii) Non-significant equity exposures. Equity exposures, excluding exposures to 

an investment firm that (1) would meet the definition of a traditional securitization were 

it not for the [AGENCY]’s application of paragraph (8) of that definition and (2) has 

greater than immaterial leverage, to the extent that the aggregate adjusted carrying value 

of the exposures does not exceed 10 percent of the [bank]’s tier 1 capital plus tier 2 

capital. 

(A) To compute the aggregate adjusted carrying value of a [bank]’s equity 

exposures for purposes of this paragraph (b)(3)(iii), the [bank] may exclude equity 

exposures described in paragraphs (b)(1), (b)(2), (b)(3)(i), and (b)(3)(ii) of this section, 

the equity exposure in a hedge pair with the smaller adjusted carrying value, and a 

proportion of each equity exposure to an investment fund equal to the proportion of the 

assets of the investment fund that are not equity exposures or that meet the criterion of 

paragraph (b)(3)(i) of this section. If a [bank] does not know the actual holdings of the 

investment fund, the [bank] may calculate the proportion of the assets of the fund that are 

not equity exposures based on the terms of the prospectus, partnership agreement, or 

similar contract that defines the fund’s permissible investments. If the sum of the 

investment limits for all exposure classes within the fund exceeds 100 percent, the [bank] 

must assume for purposes of this paragraph (b)(3)(iii) that the investment fund invests to 

the maximum extent possible in equity exposures. 
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593

(B) When determining which of a [bank]’s equity exposures qualify for a 100 

percent risk weight under this paragraph, a [bank] first must include equity exposures to 

unconsolidated small business investment companies or held through consolidated small 

business investment companies described in section 302 of the Small Business 

Investment Act of 1958 (15 U.S.C. 682), then must include publicly traded equity 

exposures (including those held indirectly through investment funds), and then must 

include non-publicly traded equity exposures (including those held indirectly through 

investment funds). 

(4) 300 percent risk weight equity exposures. A publicly traded equity exposure 

(other than an equity exposure described in paragraph (b)(6) of this section and including 

the ineffective portion of a hedge pair) is assigned a 300 percent risk weight. 

(5) 400 percent risk weight equity exposures. An equity exposure (other than an 

equity exposure described in paragraph (b)(6) of this section) that is not publicly traded is 

assigned a 400 percent risk weight. 

(6) 600 percent risk weight equity exposures. An equity exposure to an 

investment firm that (i) would meet the definition of a traditional securitization were it 

not for the [AGENCY]’s application of paragraph (8) of that definition and (ii) has 

greater than immaterial leverage is assigned a 600 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 has a remaining maturity of at 
DRAFT November 2, 2007 

594

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). The RVC 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 equals 0. If RVC is negative and greater than or equal to -1 (that is, 

between zero and -1), then E equals the absolute value of RVC. If RVC is negative and 

less than -1, then E equals 2 plus RVC. 

(ii) Under the variability-reduction method of measuring effectiveness: 

( )

∑ ( )

∑

=

−

=

−

−

−

−= T

t

tt

T

t

t t

AA

XX

E

1

2

1

1

2

1

1 , where 

(A) −= BAX ttt ; 

(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. 
DRAFT November 2, 2007 

595

(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. However, if the estimated regression coefficient 

is positive, then the value of E is zero. 

 (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) 

 (a) General. A [bank] may calculate its risk-weighted asset amount for equity 

exposures using the IMA by modeling publicly traded and non-publicly traded equity 

exposures (in accordance with paragraph (c) of this section) or by modeling only publicly 

traded equity exposures (in accordance with paragraph (d) of this section). 

(b) 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 

[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 one or more models that: 

(i) Assess the potential decline in value of its modeled equity exposures; 

(ii) Are commensurate with the size, complexity, and composition of the [bank]’s 

modeled equity exposures; and 

(iii) Adequately capture both general market risk and idiosyncratic risk. 
DRAFT November 2, 2007 

596

 (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. In 

addition, the [bank]’s benchmarking exercise must be based on daily market prices for 

the benchmark portfolio. If the [bank]’s model uses a scenario methodology, the [bank] 

must demonstrate that the model produces a conservative estimate of potential losses on 

the [bank]’s modeled equity exposures over a relevant long-term market cycle. If the 

[bank] employs risk factor models, the [bank] must demonstrate through empirical 

analysis the appropriateness of the risk factors used. 

(5) 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 
DRAFT November 2, 2007 

597

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. 

(c) Risk-weighted assets calculation for a [bank] modeling publicly traded and 

non-publicly traded equity exposures. If a [bank] models publicly traded and nonpublicly 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 

percent, 20 percent, or 100 percent risk weight under paragraphs (b)(1) through (b)(3)(i) 

of section 52 (as determined under section 52) and each equity exposure to an investment 

fund (as determined under section 54); and 

(2) The greater of: 

(i) The estimate of potential losses on the [bank]’s equity exposures (other than 

equity exposures referenced in paragraph (c)(1) of this section) generated by the [bank]’s 

internal equity exposure model multiplied by 12.5; or 

(ii) The sum of: 

(A) 200 percent multiplied by the aggregate adjusted carrying value of the 

[bank]’s publicly traded equity exposures that do not belong to a hedge pair, do not 

qualify for a 0 percent, 20 percent, or 100 percent risk weight under paragraphs (b)(1) 

through (b)(3)(i) 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 
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598

(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 percent, 20 

percent, or 100 percent risk weight under paragraphs (b)(1) through (b)(3)(i) of 

section 52, and are not equity exposures to an investment fund. 

(d) 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 

percent, 20 percent, or 100 percent risk weight under paragraphs (b)(1) through (b)(3)(i) 

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 or a 600 percent risk weight 

under paragraph (b)(6) 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 (d)(1) of this section) generated by the [bank]’s 

internal equity exposure model multiplied by 12.5; or 

(ii) The sum of: 

(A) 200 percent multiplied by the aggregate adjusted carrying value of the 

[bank]’s publicly traded equity exposures that do not belong to a hedge pair, do not 

qualify for a 0 percent, 20 percent, or 100 percent risk weight under paragraphs (b)(1) 

through (b)(3)(i) of section 52, and are not equity exposures to an investment fund; and 
DRAFT November 2, 2007 

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(B) 200 percent multiplied by the aggregate ineffective portion of all hedge pairs. 

Section 54. Equity Exposures to Investment Funds 

(a) Available approaches. (1) Unless the exposure meets the requirements for a 

community development equity exposure in paragraph (b)(3)(i) of section 52, 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, the Alternative 

Modified Look-Through Approach in paragraph (d) of this section, or, if the investment 

fund qualifies for the Money Market Fund Approach, the Money Market Fund Approach 

in paragraph (e) of this section. 

(2) The risk-weighted asset amount of an equity exposure to an investment fund 

that meets the requirements for a community development equity exposure in paragraph 

(b)(3)(i) of section 52 is its adjusted carrying value. 

(3) If an equity exposure to an investment fund is part of a hedge pair and the 

[bank] does not use the Full Look-Through Approach, the [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. The risk-weighted asset 

amount of the effective portion of the hedge pair is equal to its adjusted carrying value. 

(b) Full Look-Through Approach. A [bank] that is able to calculate a riskweighted asset amount for its proportional ownership share of each exposure held by the 

investment fund (as calculated under this appendix as if the proportional ownership share 

of each exposure were held directly by the [bank]) may either: 
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600

(1) Set the risk-weighted asset amount of the [bank]’s exposure to the fund equal 

to the product of: 

(i) The aggregate risk-weighted asset amounts of the exposures held by the fund 

as if they were held directly by the [bank]; and 

(ii) The [bank]’s proportional ownership share of the fund; or 

(2) Include the [bank]’s proportional ownership share of each exposure held by 

the fund in the [bank]’s IMA. 

(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 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 that do not constitute a material portion of the fund’s exposures). 

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 Non-sovereign 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 November 2, 2007 

601

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 based on the investment 

limits in the fund’s prospectus, partnership agreement, or similar contract that defines the 

fund’s permissible investments. The risk-weighted asset amount for the [bank]’s equity 

exposure to the investment fund equals the sum of each portion of the adjusted carrying 

value assigned to an exposure class multiplied by the applicable risk weight. 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 
DRAFT November 2, 2007 

602

weight. A [bank] may exclude derivative contracts held by the fund that are used for 

hedging rather than for speculative purposes and do not constitute a material portion of 

the fund’s exposures. 

(e) Money Market Fund Approach. The risk-weighted asset amount for a 

[bank]’s equity exposure to an investment fund that is a money market fund subject to 17 

CFR 270.2a-7 and that has an applicable external rating in the highest investment-grade 

rating category equals the adjusted carrying value of the equity exposure multiplied by 7 

percent. 

Section 55. Equity Derivative Contracts 

 Under the IMA, in addition to holding risk-based capital against an equity 

derivative contract under this part, a [bank] must hold risk-based capital against the 

counterparty credit risk in the equity derivative contract by also treating the equity 

derivative contract as a wholesale exposure and computing a supplemental risk-weighted 

asset amount for the contract under part IV. Under the SRWA, a [bank] may choose not 

to hold risk-based capital against the counterparty credit risk of equity derivative 

contracts, as long as it does so for all such contracts. Where the equity derivative 

contracts are subject to a qualified master netting agreement, a [bank] using the SRWA 

must either include all or exclude all of the contracts from any measure used to determine 

counterparty credit risk exposure. 

Part VII. Risk-Weighted Assets for Operational Risk 

Section 61. Qualification Requirements for Incorporation of Operational Risk 

Mitigants 
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603

(a) Qualification to use operational risk mitigants. A [bank] may adjust its 

estimate of operational risk exposure to reflect qualifying operational risk mitigants if: 

(1) The [bank]’s operational risk quantification system is able to generate an 

estimate of the [bank]’s operational risk exposure (which does not incorporate qualifying 

operational risk mitigants) and an estimate of the [bank]’s operational risk exposure 

adjusted to incorporate qualifying operational risk mitigants; and 

(2) The [bank]’s methodology for incorporating the effects of insurance, if the 

[bank] uses insurance as an operational risk mitigant, captures through appropriate 

discounts to the amount of risk mitigation: 

(i) The residual term of the policy, where less than one year; 

(ii) The cancellation terms of the policy, where less than one year; 

(iii) The policy’s timeliness of payment; 

(iv) The uncertainty of payment by the provider of the policy; and 

(v) Mismatches in coverage between the policy and the hedged operational loss 

event. 

(b) Qualifying operational risk mitigants. Qualifying operational risk mitigants 

are: 

(1) Insurance that: 

 (i) Is provided by an unaffiliated company that has a claims payment ability that is 

rated in one of the three highest rating categories by a NRSRO; 

(ii) Has an initial term of at least one year and a residual term of more than 90 

days; 

(iii) Has a minimum notice period for cancellation by the provider of 90 days; 
DRAFT November 2, 2007 

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(iv) Has no exclusions or limitations based upon regulatory action or for the 

receiver or liquidator of a failed depository institution; and 

(v) Is explicitly mapped to a potential operational loss event; and 

(2) Operational risk mitigants other than insurance for which the [AGENCY] has 

given prior written approval. In evaluating an operational risk mitigant other than 

insurance, the [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 
DRAFT November 2, 2007 

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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).5

 

[Disclosure paragraph (b)] 

[Disclosure paragraph (c)] 

END OF COMMON RULE. 

[END OF COMMON TEXT] 

List of Subjects 

12 CFR Part 3 

 Administrative practices and procedure, Capital, National banks, Reporting and 

recordkeeping requirements, Risk. 

12 CFR Part 208 

 Confidential business information, Crime, Currency, Federal Reserve System, 

Mortgages, reporting and recordkeeping requirements, Securities. 

12 CFR Part 225 

 Administrative practice and procedure, Banks, banking, Federal Reserve System, 

Holding companies, Reporting and recordkeeping requirements, Securities. 

12 CFR Part 325 

 Administrative practice and procedure, Banks, banking, Capital Adequacy, 

Reporting and recordkeeping requirements, Savings associations, State nonmember 

banks. 

12 CFR Part 559 

 

5 Other public disclosure requirements continue to apply - for example, Federal securities law and 

regulatory reporting requirements.
DRAFT November 2, 2007 

606

 Reporting and recordkeeping requirements, Savings associations, Subsidiaries. 

12 CFR Part 560 

 Consumer protection, Investments, Manufactured homes, Mortgages, Reporting 

and recordkeeping requirements, Savings associations, Securities. 

12 CFR Part 563 

Accounting, Administrative practice and procedure, Advertising, Conflict of 

interest, Crime, Currency, Holding companies, Investments, Mortgages, Reporting and 

recordkeeping requirements, Savings associations, Securities, Surety bond. 

12 CFR Part 567 

 Capital, Reporting and recordkeeping requirements, Savings associations. 

Adoption of Common Appendix 

 The adoption of the final common rules by the agencies, as modified by agencyspecific text, is set forth below: 
DRAFT November 2, 2007 

607

DEPARTMENT OF THE TREASURY 

Office of the Comptroller of the Currency 

12 CFR Chapter I 

Authority and Issuance 

For the reasons stated in the common preamble, the Office of the Comptroller of the 

Currency amends Part 3 of chapter I of Title 12, Code of Federal Regulations as follows: 

PART 3—MINIMUM CAPITAL RATIOS; ISSUANCE OF DIRECTIVES 

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

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

3907, and 3909. 

 2. New Appendix C to part 3 is added as set forth at the end of the common 

preamble. 

 3. Appendix C to part 3 is amended as set forth below: 

 a. Remove “[AGENCY]” and add “OCC” in its place wherever it appears. 

 b. Remove “[bank]” and add “bank” in its place wherever it appears, remove 

“[banks]” and add “banks” in its place wherever it appears, remove “[Banks]” and add 

“Banks” in its place wherever it appears, and remove “[Bank]” and add “Bank” in its 

place wherever it appears. 

c. Remove “[Appendix __ to Part __]” and add “Appendix C to Part 3” in its 

place wherever it appears. 

 d. Remove “[the general risk-based capital rules]” and add “12 CFR part 3, 

Appendix A” in its place wherever it appears. 
DRAFT November 2, 2007 

608

 e. Remove “[the market risk rule]” and add “12 CFR part 3, Appendix B” in its 

place wherever it appears. 

f. Remove “[Disclosure paragraph (b)]” and add in its place “(b) A bank must 

comply with paragraph (c) of section 71 of appendix G to the Federal Reserve Board’s 

Regulation Y (12 CFR part 225, appendix G) unless it is a consolidated subsidiary of a 

bank holding company or depository institution that is subject to these requirements.” 

g. Remove “[Disclosure paragraph (c)].” 
DRAFT November 2, 2007 

609

BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM 

12 CFR Chapter II 

Authority and Issuance 

For the reasons stated in the common preamble, the Board of Governors of the Federal 

Reserve System amends parts 208 and 225 of chapter II of title 12 of the Code of Federal 

Regulations as follows: 

PART 208—MEMBERSHIP OF STATE BANKING INSTITUTIONS IN THE 

FEDERAL RESERVE SYSTEM (REGULATION H) 

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

Authority: 12 U.S.C. 24, 36, 92a, 93a, 248(a), 248(c), 321-338a, 371d, 461, 481-

486, 601, 611, 1814, 1816, 1818, 1820(d)(9), 1823(j), 1828(o), 1831, 1831o, 1831p-1, 

1831r-1, 1835a, 1882, 2901-2907, 3105, 3310, 3331-3351, and 3906-3909; 15 U.S.C. 

78b, 78l(b), 78l(g), 78l(i), 78o-4(c)(5), 78q, 78q-1, and 78w, 6801, and 6805; 31 U.S.C. 

5318; 42 U.S.C. 4012a, 4104a, 4104b, 4106, and 4128. 

 2. New Appendix F to part 208 is added as set forth at the end of the common 

preamble. 

 3. Appendix F to part 208 is amended as set forth below: 

 a. Remove “[AGENCY]” and add “Federal Reserve” in its place wherever it 

appears. 

 b. Remove “[bank]” and add “bank” in its place wherever it appears, remove 

“[banks]” and add “banks” in its place wherever it appears, remove “[Banks]” and add 

“Banks” in its place wherever it appears, and remove “[Bank]” and add “Bank” in its 

place wherever it appears. 
DRAFT November 2, 2007 

610

 c. Remove “[Appendix __ to Part __]” and add “Appendix F to Part 208” in its 

place wherever it appears. 

 d. Remove “[the general risk-based capital rules]” and add “12 CFR part 208, 

Appendix A” in its place wherever it appears. 

 e. Remove “[the market risk rule]” and add “12 CFR part 208, Appendix E” in its 

place wherever it appears. 

 f. Remove “[Disclosure paragraph (b)]” and add in its place “(b) A bank must 

comply with paragraph (c) of section 71 of appendix G to the Federal Reserve Board’s 

Regulation Y (12 CFR part 225, appendix G) unless it is a consolidated subsidiary of a 

bank holding company or depository institution that is subject to these requirements.” 

g. Remove “[Disclosure paragraph (c)].” 

 
DRAFT November 2, 2007 

611

PART 225—BANK HOLDING COMPANIES AND CHANGE IN BANK 

CONTROL (REGULATION Y) 

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

Authority: 12 U.S.C. 1817(j)(13), 1818, 1828(o), 1831i, 1831p-1, 1843(c)(8), 

1844(b), 1972(1), 3106, 3108, 3310, 3331-3351, 3907, and 3909; 15 U.S.C. 6801 and 

6805. 

 2. New Appendix G to part 225 is added as set forth at the end of the common 

preamble. 

 3. Appendix G to part 225 is amended as set forth below: 

 a. Remove “[AGENCY]” and add “Federal Reserve” in its place wherever it 

appears. 

b. Remove “[bank]” and add in its place “bank holding company” wherever it 

appears, remove “[banks]” and add “bank holding companies” in its place wherever it 

appears, remove “[Banks]” and add “Bank holding companies” in its place wherever it 

appears, and remove “[Bank]” and add “Bank holding company” in its place wherever it 

appears. 

 c. Remove “[Appendix __ to Part __]” and add “Appendix G to Part 225” in its 

place wherever it appears. 

 d. Remove “[the general risk-based capital rules]” and add “12 CFR part 225, 

Appendix A” in its place wherever it appears. 

 e. Remove “[the market risk rule]” and add “12 CFR part 225, Appendix E” in its 

place wherever it appears. 
DRAFT November 2, 2007 

612

 f. Remove the text of section 1(b)(1) and add in its place: “This appendix applies 

to a bank holding company that: 

 (i) Is not a consolidated subsidiary of another bank holding company that uses this 

appendix to calculate its risk-based capital requirements; and 

(ii) That: 

(A) 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; 

(B) 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); or 

(C) Has a subsidiary depository institution (as defined in 12 U.S.C. 1813) that is 

required, or has elected, to use 12 CFR part 3, Appendix C, 12 CFR part 208, Appendix 

F, 12 CFR part 325, Appendix F, or 12 CFR part 567, Appendix C to calculate its riskbased capital requirements.” 

g. Add a new paragraph (8) to section 11(c): “A bank holding company must also 

deduct an amount equal to the minimum regulatory capital requirement established by the 

regulator of any insurance underwriting subsidiary of the holding company. For U.S.-

based insurance underwriting subsidiaries, this amount generally would be 200 percent of 
DRAFT November 2, 2007 

613

the subsidiary’s Authorized Control Level as established by the appropriate state 

regulator of the insurance company.” 

 h. Remove section 22(h)(3)(ii). 

i. In section 31(e)(3), remove “A bank may assign a risk-weighted asset amount 

of zero to cash owned and held in all offices of the bank or in transit and to gold bullion 

held in the bank’s own vaults, or held in another bank’s vaults on an allocated basis, to 

the extent it is offset by gold bullion liabilities” and add in its place “A bank holding 

company may assign a risk-weighted asset amount of zero to cash owned and held in all 

offices of subsidiary depository institutions or in transit and for gold bullion held in either 

a subsidiary depository institution’s own vaults, or held in another depository institution’s 

vaults on an allocated basis, to the extent it is offset by gold bullion liabilities.” 

j. In section 71, remove “[Disclosure paragraph (b)].” 

k. In section 71, remove “[Disclosure paragraph (c)].” 

l. In section 71, add new paragraph (b) to read as follows: 

Section 71. * * * 

* * * * * 

(b) (1) Each consolidated bank holding company that is not a subsidiary of a nonU.S. banking organization that is subject to comparable public disclosure requirements in 

its home jurisdiction and has successfully completed its parallel run must provide timely 

public disclosures each calendar quarter of the information in tables 11.1 – 11.11 below. 

If a significant change occurs, such that the most recent reported amounts are no longer 

reflective of the bank holding company’s capital adequacy and risk profile, then a brief 

discussion of this change and its likely impact must be provided as soon as practicable 
DRAFT November 2, 2007 

614

thereafter. Qualitative disclosures that typically do not change each quarter (for example, 

a general summary of the bank holding company’s risk management objectives and 

policies, reporting system, and definitions) may be disclosed annually, provided any 

significant changes to these are disclosed in the interim. Management is encouraged to 

provide all of the disclosures required by this appendix in one place on the bank holding 

company’s public website.6

 The bank holding company must make these disclosures 

publicly available for each of the last three years (that is, twelve quarters) or such shorter 

period since it began its first floor period. 

(2) Each bank holding company is required to have a formal disclosure policy 

approved by the board of directors that addresses its approach for determining the 

disclosures it makes. The policy must address the associated internal controls and 

disclosure controls and procedures. The board of directors and senior management are 

responsible for establishing and maintaining an effective internal control structure over 

financial reporting, including the disclosures required by this appendix, and must ensure 

that appropriate review of the disclosures takes place. One or more senior officers of the 

bank holding company must attest that the disclosures meet the requirements of this 

appendix. 

(3) If a bank holding company believes that disclosure of specific commercial or 

financial information would prejudice seriously its position by making public information 

that is either proprietary or confidential in nature, the bank holding company need not 

disclose those specific items, but must disclose more general information about the 

 

6

 Alternatively, a bank holding company may provide the disclosures in more than one place, as some of 

them may be included in public financial reports (for example, in Management’s Discussion and Analysis 

included in SEC filings) or other regulatory reports. The bank holding company must provide a summary 

table on its public website that specifically indicates where all the disclosures may be found (for example, 

regulatory report schedules, page numbers in annual reports). 
DRAFT November 2, 2007 

615

subject matter of the requirement, together with the fact that, and the reason why, the 

specific items of information have not been disclosed. 

Table 11.1 – Scope of Application 

(a) The name of the top corporate entity in the group to which the 

appendix applies. 

(b) An outline of differences in the basis of consolidation for 

accounting and regulatory purposes, with a brief description of the 

entities7

 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).

Qualitative 

Disclosures 

(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 by which actual regulatory capital is less 

than the minimum regulatory capital requirement in all subsidiaries 

with regulatory capital requirements and the name(s) of the 

subsidiaries with such deficiencies. 

 

7

 Entities include securities, insurance and other financial subsidiaries, commercial subsidiaries (where 

permitted), and significant minority equity investments in insurance, financial and commercial entities. 
DRAFT November 2, 2007 

616

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; 

• regulatory calculation differences deducted from tier 1 capital;8

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.9

Quantitative 

Disclosures 

(e) Total eligible capital. 

 

8

 Representing 50 percent of the amount, if any, by which total expected credit losses as calculated within 

the IRB approach exceed eligible credit reserves, which must be deducted from tier 1 capital. 

9

 Including 50 percent of the amount, if any, by which total expected credit losses as calculated within the 

IRB approach exceed eligible credit reserves, which must be deducted from tier 2 capital. 
DRAFT November 2, 2007 

617

Table 11.3 – Capital Adequacy 

Qualitative 

disclosures

(a) A summary discussion of the bank holding company’s approach to 

assessing the adequacy of its capital to support current and future 

activities. 

(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 the simple risk weight 

approach; and 

• Equity exposures subject to the internal models 

approach. 

(c) Risk-weighted assets for market risk as calculated under [the 

market risk rule]:10

• 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:11

• For the top consolidated group; and 

• For each DI subsidiary. 

Quantitative 

disclosures

General qualitative disclosure requirement 

For each separate risk area described in tables 11.4 through 11.11, the bank holding 

company must describe its risk management objectives and policies, including: 

• strategies and processes; 

• the structure and organization of the relevant risk management function; 

• the scope and nature of risk reporting and/or measurement systems; 

• policies for hedging and/or mitigating risk and strategies and processes for 

monitoring the continuing effectiveness of hedges/mitigants. 

 

10 Risk-weighted assets determined under [the market risk rule] are to be disclosed only for the approaches 

used. 

11 Total risk-weighted assets should also be disclosed. 
DRAFT November 2, 2007 

618

Table 11.412 – 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; and 

• Discussion of the bank holding company’s credit risk 

management policy. 

(b) Total credit risk exposures and average credit risk exposures, after 

accounting offsets in accordance with GAAP,13 and without taking 

into account the effects of credit risk mitigation techniques (for 

example, collateral and netting), over the period broken down by 

major types of credit exposure.14 

(c) Geographic15 distribution of exposures, broken down in significant 

areas by major types of credit exposure. 

(d) Industry or counterparty type distribution of exposures, broken 

down by major types of credit exposure. 

(e) Remaining contractual maturity breakdown (for example, one year 

or less) of the whole portfolio, broken down by major types of 

credit exposure. 

(f) By major industry or counterparty type: 

• Amount of impaired loans; 

• Amount of past due loans;16

• Allowances; and 

• Charge-offs during the period. 

Quantitative 

Disclosures 

(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.17

 

12 Table 4 does not include equity exposures. 

13 For example, FASB Interpretations 39 and 41. 

14 For example, bank holding companies could apply a breakdown similar to that used for accounting 

purposes. Such a breakdown might, for instance, be (a) loans, off-balance sheet commitments, and other 

non-derivative off-balance sheet exposures, (b) debt securities, and (c) OTC derivatives. 15 Geographical areas may comprise individual countries, groups of countries, or regions within countries. 

A bank holding company might choose to define the geographical areas based on the way the company’s 

portfolio is geographically managed. The criteria used to allocate the loans to geographical areas must be 

specified. 

16 A bank holding company is encouraged also to provide an analysis of the aging of past-due loans. 

17 The portion of general allowance that is not allocated to a geographical area should be disclosed 

separately. 
DRAFT November 2, 2007 

619

(h) Reconciliation of changes in the allowance for loan and lease 

losses.18

Table 11.5 – Credit Risk: Disclosures for Portfolios Subject to IRB Risk-Based Capital 

Formulas 

(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 

(see table 11.7); and 

• Control mechanisms for the rating system, including discussion 

of independence, accountability, and rating systems review. 

Qualitative 

disclosures 

(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; 

and 

• The definitions, methods and data for estimation and validation 

of PD, LGD, and EAD, including assumptions employed in the 

derivation of these variables.19

 

18 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. 

19 This disclosure does not require a detailed description of the model in full – it should provide the reader 

with a broad overview of the model approach, describing definitions of the variables and methods for 

estimating and validating those variables set out in the quantitative risk disclosures below. This should be 

done for each of the four category/subcategories. The bank holding company should disclose any 

significant differences in approach to estimating these variables within each category/subcategories.
DRAFT November 2, 2007 

620

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:20

• Total EAD;21 

• Exposure-weighted average LGD (percentage); 

• Exposure-weighted average risk weight; 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. 

 

20 The PD, LGD and EAD disclosures in Table 11.5(c) should reflect the effects of collateral, qualifying 

master netting agreements, eligible guarantees and eligible credit derivatives as defined in part I. 

Disclosure of each PD grade should include the exposure-weighted average PD for each grade. Where a 

bank holding company aggregates PD grades for the purposes of disclosure, this should be a representative 

breakdown of the distribution of PD grades used for regulatory capital purposes. 

21 Outstanding loans and EAD on undrawn commitments can be presented on a combined basis for these 

disclosures. 
DRAFT November 2, 2007 

621

(d) Actual losses in the preceding period for each category and 

subcategory and how this differs from past experience. A 

discussion of the factors that impacted the loss experience in the 

preceding period – for example, has the bank holding company 

experienced higher than average default rates, loss rates or EADs. 

(e) Bank holding company’s estimates compared against actual 

outcomes over a longer period.22 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.23 

Where appropriate, the bank holding company should further 

decompose this to provide analysis of PD, LGD, and EAD 

outcomes against estimates provided in the quantitative risk 

assessment disclosures above.24

 

Quantitative 

disclosures: 

historical results 

 

 

22 These disclosures are a way of further informing the reader about the reliability of the information 

provided in the “quantitative disclosures: risk assessment” over the long run. The disclosures are 

requirements from year-end 2010; in the meantime, early adoption is encouraged. The phased 

implementation is to allow a bank holding company sufficient time to build up a longer run of data that will 

make these disclosures meaningful. 

23 This regulation is not prescriptive about the period used for this assessment. Upon implementation, it 

might be expected that a bank holding company would provide these disclosures for as long run of data as 

possible – for example, if a bank holding company has 10 years of data, it might choose to disclose the 

average default rates for each PD grade over that 10-year period. Annual amounts need not be disclosed. 

24 A bank holding company should provide this further decomposition where it will allow users greater 

insight into the reliability of the estimates provided in the “quantitative disclosures: risk assessment.” In 

particular, it should provide this information where there are material differences between its estimates of 

PD, LGD or EAD compared to actual outcomes over the long run. The bank holding company should also 

provide explanations for such differences. 
DRAFT November 2, 2007 

622

Table 11.6 – General Disclosure for Counterparty Credit Risk of OTC Derivative 

Contracts, Repo-Style Transactions, and Eligible Margin Loans

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 

holding company would have to provide if the bank holding 

company were to receive 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.25 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, for bank holding companies not using the 

internal models methodology in section 32(d), the distribution of 

current credit exposure by types of credit exposure.26

(c) Notional amount of purchased and sold credit derivatives, 

segregated between use for the bank holding company’s own 

credit portfolio and for 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 has received 

supervisory approval to estimate alpha. 

Table 11.7 – Credit Risk Mitigation 27,28, 29

 

25 Net unsecured credit exposure is the credit exposure after considering the benefits from legally 

enforceable netting agreements and collateral arrangements, without taking into account haircuts for price 

volatility, liquidity, etc. 

26 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.

27 At a minimum, a bank holding company must provide the disclosures in Table 11.7 in relation to credit 

risk mitigation that has been recognized for the purposes of reducing capital requirements under this 

appendix. Where relevant, bank holding companies are encouraged to give further information about 

mitigants that have not been recognized for that purpose. 
DRAFT November 2, 2007 

623

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 uses, on- and off-balance 

sheet netting; 

• policies and processes for collateral valuation and 

management; 

• a description of the main types of collateral taken by the bank 

holding company; 

• the main 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. 

 

28 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. 

29 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 November 2, 2007 

624

Table 11.8 – Securitization 

(a) The general qualitative disclosure requirement with respect to 

securitization (including synthetics), including a discussion of: 

• the bank holding company’s objectives relating to securitization 

activity, including the extent to which these activities transfer 

credit risk of the underlying exposures away from the bank 

holding company to other entities; 

• the roles played by the bank holding company in the 

securitization process30 and an indication of the extent of the 

bank holding company’s involvement in each of them; and 

• the regulatory capital approaches (for example, RBA, IAA and 

SFA) that the bank holding company follows for its 

securitization activities. 

(b) Summary of the bank holding company’s accounting policies for 

securitization activities, including: 

• whether the transactions are treated as sales or financings; 

• recognition of gain-on-sale; 

• key assumptions for valuing retained interests, including any 

significant changes since the last reporting period and the 

impact of such changes; and 

• treatment of synthetic securitizations. 

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 in securitizations that meet the operational criteria in 

section 41 (broken down into traditional/synthetic), by underlying 

exposure type.31,32,33

 

30 For example: originator, investor, servicer, provider of credit enhancement, sponsor of asset backed 

commercial paper facility, liquidity provider, or swap provider. 31 Underlying exposure types may include, for example, one- to four-family residential loans, home equity 

lines, credit card receivables, and auto loans. 

32 Securitization transactions in which the originating bank holding company does not retain any 

securitization exposure should be shown separately but need only be reported for the year of inception. 33 Where relevant, a bank holding company is encouraged to differentiate between exposures resulting from 

activities in which they act only as sponsors, and exposures that result from all other bank holding company 

securitization activities. 
DRAFT November 2, 2007 

625

(e) For exposures securitized by the bank holding company in 

securitizations that meet the operational criteria in Section 41: 

• amount of securitized assets that are impaired/past due; and 

• losses recognized by the bank holding company during the 

current period34 broken down by exposure type. 

(f) Aggregate amount of securitization exposures broken down by 

underlying exposure type. 

(g) Aggregate amount of securitization exposures and the associated 

IRB capital requirements 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 amortization treatment, the 

following items by underlying asset type for securitized facilities: 

• the aggregate drawn exposures attributed to the seller’s and 

investors’ interests; and 

• the aggregate IRB capital charges incurred by the bank 

holding company against the investors’ 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 recognized 

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 

measurement approach. 

(c) A description of the use of insurance for the purpose of mitigating 

operational risk. 

 

34 For example, charge-offs/allowances (if the assets remain on the bank holding company’s balance sheet) 

or write-downs of I/O strips and other residual interests. 
DRAFT November 2, 2007 

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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 held for 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)35

• Total latent revaluation gains (losses)36

• 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 

methodology, as well as the aggregate amounts and the type of 

equity investments subject to any supervisory transition regarding 

regulatory capital requirements.37

 

35 Unrealized gains (losses) recognized in the balance sheet but not through earnings. 36 Unrealized gains (losses) not recognized either in the balance sheet or through earnings. 37 This disclosure should include a breakdown of equities that are subject to the 0 percent, 20 percent, 100 

percent, 300 percent, 400 percent, and 600 percent risk weights, as applicable. 
DRAFT November 2, 2007 

627

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). 

* * * * *
DRAFT November 2, 2007 

628

FEDERAL DEPOSIT INSURANCE CORPORATION 

12 CFR Chapter III 

Authority and Issuance 

For the reasons stated in the common preamble, the Federal Deposit Insurance 

Corporation amends part 325 of chapter III of title 12 of the Code of Federal Regulations 

as follows: 

PART 325—CAPITAL MAINTENANCE 

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

Authority: 12 U.S.C. 1815(a), 1815(b), 1816, 1818(a), 1818(b), 1818(c), 

1818(t), 1819(Tenth), 1828(c), 1828(d), 1828(i), 1828(n), 1828(o), 1831o, 1835, 3907, 

3909, 4808; Pub. L. 102-233, 105 Stat. 1761, 1789, 1790 (12 U.S.C. 1831n note); Pub. L. 

102-242, 105 Stat. 2236, 2355, 2386 (12 U.S.C. 1828 note). 

 2. New Appendix D to part 325 is added as set forth at the end of the common 

preamble. 

 3. Appendix D to part 325 is amended as set forth below: 

 a. Remove “[AGENCY]” and add “FDIC” in its place wherever it appears. 

 b. Remove “[bank]” and add “bank” in its place wherever it appears, remove 

“[banks]” and add “banks” in its place wherever it appears, remove “[Banks]” and add 

“Banks” in its place wherever it appears, and remove “[Bank]” and add “Bank” in its 

place wherever it appears. 

 c. Remove “[Appendix __ to Part __]” and add “Appendix D to Part 325” in its 

place wherever it appears. 

 d. Remove “[the general risk-based capital rules]” and add “12 CFR part 325, 

Appendix A” in its place wherever it appears. 
DRAFT November 2, 2007 

629

 e. Remove “[the market risk rule]” and add “12 CFR part 325, Appendix C” in its 

place wherever it appears. 

f. Remove “[Disclosure paragraph (b)]” and add in its place “(b) A bank must 

comply with paragraph (c) of section 71 of appendix G to the Federal Reserve Board’s 

Regulation Y (12 CFR part 225, appendix G) unless it is a consolidated subsidiary of a 

bank holding company or depository institution that is subject to these requirements.” 

g. Remove “[Disclosure paragraph (c)].”
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630

DEPARTMENT OF THE TREASURY 

OFFICE OF THRIFT SUPERVISION 

12 CFR Chapter V 

Authority and issuance 

For the reasons set out in the preamble, the Office of Thrift Supervision amends Chapter 

12 of title 12 of the Code of Federal Regulations to read as follows: 

PART 559 –SUBORDINATE ORGANIZATIONS 

1. The authority citation for part 559 continues to read as follows: 

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

2. Revise § 559.5(b)(1) to read as follows: 

§ 559.5 How much may a savings association invest in service corporations 

 or lower tier entities? 

* * * * * 

(b) * * * 

(1) You and your GAAP-consolidated subsidiaries may, in the aggregate, make 

loans of up to 15% of your total capital, as described in part 567 of this chapter to each 

subordinate organization that does not qualify as a GAAP-consolidated subsidiary. All 

loans made under this paragraph (b)(1) may not, in the aggregate, exceed 50% of your 

total capital, as described in part 567 of this chapter. 

* * * * * 

PART 560 – LENDING AND INVESTMENT 

3. The authority citation for part 560 continues to read as follows: 
DRAFT November 2, 2007 

631

Authority: 12 U.S.C. 1462, 1462a, 1463, 1464, 1467a, 1701j-3, 1828, 3803, 3806, 42 

U.S.C. 4106. 

§ 560.101 [amended] 

4. In footnote 2 to the appendix to §560.101, remove the phrase “as defined at 12 

CFR 567.5(c)” and add the phrase “as described in part 567 of this chapter” in its place. 

PART 563 –SAVINGS ASSOCIATIONS – OPERATIONS 

5. The authority citation for part 563 continues to read as follows: 

Authority: 12 U.S.C. 375b, 1462, 1462a, 1463, 1464, 1467a, 1468, 1817, 1820, 1828, 

1831o, 3806; 31 U.S.C. 5318; 42 U.S.C. 4106. 

§ 563.74 [amended] 

6. Amend § 563.74 as follows: 

a. In paragraph (i)(2)(iv), remove the phrase “regulatory capital requirement 

under § 567.2 of this chapter” and add the phrase “regulatory capital requirements under 

part 567 of this chapter” in its place. 

b. In paragraph (i)(v) remove the phrase “regulatory capital requirement under § 

567.2 of this chapter” and add the phrase “regulatory capital requirements under part 567 

of this chapter” in its place. 

§ 563.81 [amended] 

7. Amend § 563.83 as follows: 

a. In paragraph (a), remove the phrase “in supplementary capital under 12 CFR 

567.5(b)” and add the phrase “in supplementary capital (tier 2 capital) under part 567 of 

this chapter” in its place. 
DRAFT November 2, 2007 

632

b. In paragraph (d)(2)(ii), remove the phrase “regulatory capital requirements at § 

567.2 of this chapter” and add the phrase “regulatory capital requirements at part 567 of 

this chapter” in its place. 

§ 563.141 [amended] 

8. In § 563.141(b), delete the phrase “in your total capital under 12 CFR 567.5 of 

this chapter” and add the phrase “in your total capital under part 567 of this chapter” in 

its place. 

§ 563.142 [amended] 

9. In § 563.142, amend the definition of “capital” by deleting the phrase “total 

capital, as described under 12 CFR 567.5(c) of this chapter” and adding the phrase “total 

capital, as computed under part 567 of this chapter” in its place. 

PART 567 – CAPITAL 

10. The authority citation for part 567 continues to read as follows: 

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

 11. Add a new subpart A to read as follows 

Subpart A – Scope 

§ 567.0 Scope. 

 (a) This part prescribes the minimum regulatory capital requirements for savings 

associations. Subpart B of this part applies to all savings associations, except as 

described in paragraph (b) of this section. 

(b)(1) A savings association that uses Appendix C of this part must comply with 

the minimum qualifying criteria for internal risk measurement and management processes 

for calculating risk-based capital requirements, utilize the methodologies for calculating 
DRAFT November 2, 2007 

633

risk-based capital requirements, and make the required disclosures described in that 

appendix. 

(2) Subpart B of this part does not apply to the computation of risk-based capital 

requirements by a savings association that uses Appendix C of this part. However, these 

savings associations must: 

(i) Must compute the components of capital under § 567.5, subject to the 

modifications in sections 11 and 12 of Appendix C of this part. 

 (ii) Must meet the leverage ratio requirement at §§ 567.2(a)(2) and 567.8 with tier 

1 capital, as computed under sections 11 and 12 of Appendix C of this part. 

 (iii) Must meet the tangible capital requirement described at §§ 567.2(a)(3) and 

567.9. 

 (iv) Are subject to §§ 567.3 (individual minimum capital requirement), 567.4 

(capital directives); and 567.10 (consequences of failure to meet capital requirements). 

(v) Are subject to the reservations of authority at § 567.11, which supplement the 

reservations of authority at section 1 of Appendix C of this part. 

 12. Designate §§ 567.1 through 567.6 and §§ 567.8 through 567.12 as subpart B 

and add a heading for subpart B to read as follows: 

Subpart B – Regulatory Capital Requirements 

 13. Revise the introductory sentence to § 567.1 to read as follows: 

§ 567.1 Definitions. 

For the purposes of this subpart: 

* * * * * 

 13. In § 567.3, revise paragraphs (a), (b), and (d) to read as follows: 
DRAFT November 2, 2007 

634

§ 567.3 Individual minimum capital requirements. 

(a) Purpose and scope. The rules and procedures specified in this section apply to 

the establishment of an individual minimum capital requirement for a savings association 

that varies from the risk-based capital requirement, the leverage ratio requirement or the 

tangible capital requirement that would otherwise apply to the savings association under 

this part. 

(b) Appropriate considerations for establishing individual minimum capital 

requirements. Minimum capital levels higher than the risk-based capital requirement, the 

leverage ratio requirement or the tangible capital requirement required under this part 

may be appropriate for individual savings associations. Increased individual minimum 

capital requirements may be established upon a determination that the savings 

association's capital is or may become inadequate in view of its circumstances. For 

example, higher capital levels may be appropriate for: * * * 

* * * * * 

 (d) Procedures -- (1) Notification. When the OTS determines that a minimum 

capital requirement is necessary or appropriate for a particular savings association, it 

shall notify the savings association in writing of its proposed individual minimum capital 

requirement; the schedule for compliance with the new requirement; and the specific 

causes for determining that the higher individual minimum capital requirement is 

necessary or appropriate for the savings association. The OTS shall forward the notifying 

letter to the appropriate state supervisor if a state-chartered savings association would be 

subject to an individual minimum capital requirement. 
DRAFT November 2, 2007 

635

* * * * * 

 14. Revise (a)(1) of § 567.4 to read as follows: 

§ 567.4 Capital directives. 

(a) Issuance of a Capital Directive -- (1) Purpose. In addition to any other action 

authorized by law, the Office, may issue a capital directive to a savings association that 

does not have an amount of capital satisfying its minimum capital requirement. Issuance 

of such a capital directive may be based on a savings association's noncompliance with 

the risk-based capital requirement, the leverage ratio requirement, the tangible capital 

requirement, or individual minimum capital requirement established under this part, by a 

written agreement under 12 U.S.C. 1464(s), or as a condition for approval of an 

application. A capital directive may order a savings association to: * * * 

* * ** * 

 15. Revise paragraph (e) of § 567.10 to read as follows 

§ 567.10 Consequences of failure to meet capital requirements. 

* * * * * 

 (e) If a savings association fails to meet the risk-based capital requirement, the 

leverage ratio requirement, or the tangible capital requirement established under this part, 

the Director may, through enforcement proceedings or otherwise, require such savings 

association to take one or more of the following corrective actions: 

* * * * * 

 16. Appendices A and B are added to part 567, and are reserved. 
DRAFT November 2, 2007 

636

17. Appendix C is added to part 567 as set forth at the end of the common 

preamble. 

8. Revise Appendix C of part 567 as follows: 

a. Retitle Appendix C as follows: Risk-Based Capital Requirements - InternalRatings-Based and Advanced Measurement Approaches”. 

 b. Remove [AGENCY] and add “OTS” in its place wherever it appears. 

c. Remove “[bank]” and add “savings association” in its place wherever it 

appears, remove “[banks]” and add “savings associations” in its place wherever it 

appears, remove “[Banks]” and add “Savings associations” in its place wherever it 

appears, and remove “[Bank]” and add “Savings association” in its place wherever it 

appears. 

 d. Remove “[Appendix __ to Part __]” and add “Appendix C to Part 567” in its 

place wherever it appears. 

 e. Remove “[the general risk-based capital rules]” and add “subpart B of part 

567” in its place wherever it appears. 

f. Remove “[the market risk rule]” and add “any applicable market risk rule” in 

its place wherever it appears. 

g. In section 1, revise paragraph (b)(1)(i), the last sentence in paragraph (b)(3), 

and the last sentence in paragraph (c)(1) to read as follows: 

Section 1 Purpose, Applicability, Reservation of Authority, and Principle of 

Conservatism. 

* * * * * 

 (b) Applicability. (1) * * * 
DRAFT November 2, 2007 

637

 (i) Has consolidated assets, as reported on the most recent year-end Thrift 

Financial Report (TFR) equal to $250 billion or more; * * * 

(3) * * * In making a determination under this paragraph, the OTS will apply 

notice and response procedures in the same manner and to the same extent as the notice 

and response procedures in §567.3(d). 

(c) Reservation of authority – (1) * * * In making a determination under this 

paragraph, the OTS will apply notice and response procedures in the same manner and to 

the same extent as the notice and response procedures in §567.3(d). 

* * * * * 

h. In section 2, revise the definition of eligible credit reserves, the definition of 

excluded mortgage exposure, paragraph (1) of the definition of exposure at default 

(EAD), the definition of gain-on-sale, paragraph (2)(i) of the definition of high volatility 

commercial real estate (HVCRE) exposure, and paragraph (7) of the definition of 

traditional securitization, to read as follows: 

Section 2 Definitions. 

****** 

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 specific reserves created 

against recognized losses. 

* * * * * 
DRAFT November 2, 2007 

638

Excluded mortgage exposure means any one- to four-family residential pre-sold 

construction loan for a residence for which the purchase contract is cancelled that would 

receive a 100 percent risk weight under section 618(a)(2) of the Resolution Trust 

Corporation Refinancing, Restructuring, and Improvement Act and under 12 CFR 567.1 

(definition of “qualifying residential construction loan”) and 12 CFR 567.6(a)(1)(iv). 

* * * * * 

 Exposure at default (EAD). 

(1) For the on-balance sheet component of a wholesale exposure or segment of 

retail exposures (other than an OTC derivative contract, or a repo-style transaction, or 

eligible margin loan for which the savings association determines EAD under section 32), 

EAD means: 

(i) If the exposure or segment is a security classified as available-for-sale, the 

savings associations carrying value (including net accrued but unpaid interest and fees) 

for the exposure or segment less any unrealized gains on the exposure or segment and 

plus any unrealized losses on the exposure or segment; or 

(ii) If the exposure or segment is not a security classified as available-for-sale, the 

savings association’s carrying value (including net accrued but unpaid interest and fees) 

for the exposure or segment. 

* * * * * * 

 Gain-on-sale means an increase in the equity capital (as reported on Schedule SC 

of the Thrift Financial Report) of a savings association that results from a securitization 

(other than an increase in equity capital that results from the savings association’s receipt 

of cash in connection with the securitization). 
DRAFT November 2, 2007 

639

* * * * * 

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: * * * 

(2) * * * 

(i) The loan-to-value ratio is less than or equal to the applicable maximum 

supervisory loan-to-value ratio in the OTS’s real estate lending standards at 12 CFR 

560.100-560.101; 

* * * * * 

 Traditional securitization means a transaction in which:* * * 

 (7) The underlying exposures are not owned by a firm an investment in which is 

designed primarily to promote community welfare, including the welfare of low- and 

moderate-income communities or families, such as by providing services or jobs. 

* * * * * 

 i. Revise section 12 to read as follows: 

Section 12 Deductions and limitations not required. 

 (a) Deduction of CEIOs. A savings association is not required to make the 

deduction from capital for CEIOs in 12 CFR 567.5(a)(2)(iii) and 567.12(e). 

(b) Deduction for certain equity investments. 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 November 2, 2007 

640

j. Revise the fourth sentence of section 24(a) to read as follows: 

Section 24 Merger and Acquisition Transition Arrangements 

(a) Mergers and acquisitions of companies without advanced systems. * * * 

During the period when subpart A of this part applies to the merged or acquired 

company, any ALLL associated with the merged or acquired company’s exposures may 

be included in the savings association’s tier 2 capital up to 1.25 percent of the acquired 

company’s risk-weighted assets. * * * 

* * * ** * 

k. Revise the first sentence of paragraph (k)(1)(iv) and paragraph (k)(4) of 

section 42 to read as follows: 

Section 42 Risk-Based Capital Requirement for Securitization Exposures. 

 * * * * * 

 (k) * * * 

 (1) * * * 

 (iv) The savings association is well capitalized, as defined in the OTS ’s prompt 

corrective action regulation at 12 CFR part 565. * * * 

(4) The risk-based capital ratios of the savings association must be calculated 

without regard to the capital treatment for transfers of small-business obligations with 

recourse specified in paragraph (k)(1) of this section as provided in 12 CFR 

567.6(b)(5)(v). 

l. Revise paragraph (b)(3)(i) of section 52 to read as follows: 

Section 52 Simple Risk Weight Approach 

* * * * * 
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641

(b) * * * 

(3) * * * 

(i) An equity exposure that is designed primarily to promote community welfare, 

including the welfare of low- and moderate-income communities or families, such as by 

providing services or jobs, excluding equity exposures to an unconsolidated small 

business investment company and equity exposures held through a consolidated small 

business investment company described in section 302 of the Small Business Investment 

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

* * * * * 

m. Remove “[Disclosure paragraph (b)]” and add in its place “(b) A savings 

association must comply with paragraph (c) of section 71 unless it is a consolidated 

subsidiary of a depository institution or bank holding company that is subject to these 

requirements.” 

n. Remove “[Disclosure paragraph (c)].” 

o. In section 71, add new paragraph (c) to read as follows: 

Section 71 * * * 

* * * * * 

(c)(1) Each consolidated savings association described in paragraph (b) of this 

section that is not a subsidiary of a non-U.S. banking organization that is subject to 

comparable public disclosure requirements in its home jurisdiction and has successfully 

completed its parallel run must provide timely public disclosures each calendar quarter of 

the information in tables 11.1 – 11.11 below. If a significant change occurs, such that the 

most recent reported amounts are no longer reflective of the savings association’s capital 
DRAFT November 2, 2007 

642

adequacy and risk profile, then a brief discussion of this change and its likely impact 

must be provided as soon as practicable thereafter. Qualitative disclosures that typically 

do not change each quarter (for example, a general summary of the savings association’s 

risk management objectives and policies, reporting system, and definitions) may be 

disclosed annually, provided any significant changes to these are disclosed in the interim. 

Management is encouraged to provide all of the disclosures required by this appendix in 

one place on the savings association’s public website.38 The savings association must 

make these disclosures publicly available for each of the last three years (twelve quarters) 

or such shorter period since it began its first floor period. 

(2) Each savings association is required to have a formal disclosure policy 

approved by the board of directors that addresses its approach for determining the 

disclosures it makes. The policy must address the associated internal controls and 

disclosure controls and procedures. The board of directors and senior management are 

responsible for establishing and maintaining an effective internal control structure over 

financial reporting, including the disclosures required by this appendix, and must ensure 

that appropriate review of the disclosures takes place. One or more senior officers of the 

savings association must attest that the disclosures required by this appendix meet the 

requirements of this appendix. 

(3) If a savings association believes that disclosure of specific commercial or 

financial information would prejudice seriously its position by making public information 

 

38 Alternatively, a savings association may provide the disclosures in more than one place, as some of them 

may be included in public financial reports (for example, in Management’s Discussion and Analysis 

included in SEC filings) or other regulatory reports. The savings association must provide a summary table 

on its public website that specifically indicates where all the disclosures may be found (for example, 

regulatory report schedules, page numbers in annual reports). 
DRAFT November 2, 2007 

643

that is either proprietary or confidential in nature, the savings association need not 

disclose those specific items, but must disclose more general information about the 

subject matter of the requirement, together with the fact that, and the reason why, the 

specific items of information have not been disclosed. 

Table 11.1 – Scope of Application 

(a) The name of the top corporate entity in the group to which the 

appendix applies. 

(b) An outline of differences in the basis of consolidation for 

accounting and regulatory purposes, with a brief description of the 

entities39 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).

Qualitative 

Disclosures 

(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 by which actual regulatory capital is less 

than the minimum regulatory capital requirement in all subsidiaries 

with regulatory capital requirements and the name(s) of the 

subsidiaries with such deficiencies. 

 

39 Entities include securities, insurance and other financial subsidiaries, commercial subsidiaries (where 

permitted), and significant minority equity investments in insurance, financial and commercial entities. 
DRAFT November 2, 2007 

644

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; 

• regulatory calculation differences deducted from tier 1 

capital;40 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. 41

Quantitative 

Disclosures 

(e) Total eligible capital. 

 

40 Representing 50 percent of the amount, if any, by which total expected credit losses as calculated within 

the IRB approach exceed eligible credit reserves, which must be deducted from tier 1 capital. 

41 Including 50 percent of the amount, if any, by which total expected credit losses as calculated within the 

IRB approach exceed eligible credit reserves, which must be deducted from tier 2 capital. 
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645

Table 11.3 – Capital Adequacy 

Qualitative 

disclosures

(a) A summary discussion of the savings association’s approach to 

assessing the adequacy of its capital to support current and future 

activities. 

(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 the simple risk weight 

approach; and 

• Equity exposures subject to the internal models 

approach. 

(c) Risk-weighted assets for market risk as calculated under [the 

market risk rule]:42

• 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:43

• For the top consolidated group; and 

• For each DI subsidiary. 

Quantitative 

disclosures

General qualitative disclosure requirement 

For each separate risk area described in tables 11.4 through 11.11, the savings association 

must describe its risk management objectives and policies, including: 

• strategies and processes; 

• the structure and organization of the relevant risk management function; 

• the scope and nature of risk reporting and/or measurement systems; 

• policies for hedging and/or mitigating risk and strategies and processes for 

monitoring the continuing effectiveness of hedges/mitigants. 

 

42 Risk-weighted assets determined under [the market risk rule] are to be disclosed only for the approaches 

used. 

43 Total risk-weighted assets should also be disclosed. 
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646

Table 11.444 – 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; and 

• Discussion of the savings association’s credit risk management 

policy. 

(b) Total credit risk exposures and average credit risk exposures, after 

accounting offsets in accordance with GAAP,45 and without taking 

into account the effects of credit risk mitigation techniques (for 

example, collateral and netting), over the period broken down by 

major types of credit exposure.46 

(c) Geographic47 distribution of exposures, broken down in significant 

areas by major types of credit exposure. 

(d) Industry or counterparty type distribution of exposures, broken 

down by major types of credit exposure. 

(e) Remaining contractual maturity breakdown (for example, one year 

or less) of the whole portfolio, broken down by major types of 

credit exposure. 

(f) By major industry or counterparty type: 

• Amount of impaired loans; 

• Amount of past due loans;48

• Allowances; and 

• Charge-offs during the period. 

Quantitative 

Disclosures 

(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.49

 

44 Table 4 does not include equity exposures. 

45 For example, FASB Interpretations 39 and 41. 

46 For example, savings associations could apply a breakdown similar to that used for accounting purposes. 

Such a breakdown might, for instance, be (a) loans, off-balance sheet commitments, and other nonderivative off-balance sheet exposures, (b) debt securities, and (c) OTC derivatives. 

47 Geographical areas may comprise individual countries, groups of countries, or regions within countries. 

A savings association might choose to define the geographical areas based on the way the company’s 

portfolio is geographically managed. The criteria used to allocate the loans to geographical areas must be 

specified. 

48 A savings association is encouraged also to provide an analysis of the aging of past-due loans. 49 The portion of general allowance that is not allocated to a geographical area should be disclosed 

separately. 
DRAFT November 2, 2007 

647

(h) Reconciliation of changes in the allowance for loan and lease 

losses.50

Table 11.5 – Credit Risk: Disclosures for Portfolios Subject to IRB Risk-Based Capital 

Formulas 

(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 

(see table 11.7); and 

• Control mechanisms for the rating system, including discussion 

of independence, accountability, and rating systems review. 

Qualitative 

disclosures 

(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; 

and 

• The definitions, methods and data for estimation and validation 

of PD, LGD, and EAD, including assumptions employed in the 

derivation of these variables.51

 

50 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. 

51 This disclosure does not require a detailed description of the model in full – it should provide the reader 

with a broad overview of the model approach, describing definitions of the variables and methods for 

estimating and validating those variables set out in the quantitative risk disclosures below. This should be 

done for each of the four category/subcategories. The savings association should disclose any significant 

differences in approach to estimating these variables within each category/subcategories.
DRAFT November 2, 2007 

648

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:52

• Total EAD;53 

• Exposure-weighted average LGD (percentage); 

• Exposure-weighted average risk weight; 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. 

 

52 The PD, LGD and EAD disclosures in Table 11.5(c) should reflect the effects of collateral, qualifying 

master netting agreements, eligible guarantees and eligible credit derivatives as defined in part I. 

Disclosure of each PD grade should include the exposure-weighted average PD for each grade. Where a 

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. 

53 Outstanding loans and EAD on undrawn commitments can be presented on a combined basis for these 

disclosures. 
DRAFT November 2, 2007 

649

(d) Actual losses in the preceding period for each category and 

subcategory and how this differs from past experience. A 

discussion of the factors that impacted the loss experience in the 

preceding period – for example, has the savings association 

experienced higher than average default rates, loss rates or EADs. 

(e) Savings association’s estimates compared against actual outcomes 

over a longer period.54 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.55

Where appropriate, the savings association should further 

decompose this to provide analysis of PD, LGD, and EAD 

outcomes against estimates provided in the quantitative risk 

assessment disclosures above.56

 

Quantitative 

disclosures: 

historical results 

 

 

54 These disclosures are a way of further informing the reader about the reliability of the information 

provided in the “quantitative disclosures: risk assessment” over the long run. The disclosures are 

requirements from year-end 2010; in the meantime, early adoption is encouraged. The phased 

implementation is to allow a savings association sufficient time to build up a longer run of data that will 

make these disclosures meaningful. 

55 This regulation is not prescriptive about the period used for this assessment. Upon implementation, it 

might be expected that a savings association would provide these disclosures for as long run of data as 

possible – for example, if a savings association has 10 years of data, it might choose to disclose the average 

default rates for each PD grade over that 10-year period. Annual amounts need not be disclosed. 

56 A savings association should provide this further decomposition where it will allow users greater insight 

into the reliability of the estimates provided in the “quantitative disclosures: risk assessment.” In particular, 

it should provide this information where there are material differences between its estimates of PD, LGD or 

EAD compared to actual outcomes over the long run. The savings association should also provide 

explanations for such differences. 
DRAFT November 2, 2007 

650

Table 11.6 – General Disclosure for Counterparty Credit Risk of OTC Derivative 

Contracts, Repo-Style Transactions, and Eligible Margin Loans 

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 

savings association would have to provide if the savings 

association were to receive 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.57 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, for savings associations not using the internal 

models methodology in section 32(d), the distribution of current 

credit exposure by types of credit exposure.58

(c) Notional amount of purchased and sold credit derivatives, 

segregated between use for the savings association’s own credit 

portfolio and for 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 savings association has received 

supervisory approval to estimate alpha. 

Table 11.7 – Credit Risk Mitigation 59,60, 61

 

57 Net unsecured credit exposure is the credit exposure after considering the benefits from legally 

enforceable netting agreements and collateral arrangements, without taking into account haircuts for price 

volatility, liquidity, etc. 

58 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.

59 At a minimum, a savings association must provide the disclosures in Table 11.7 in relation to credit risk 

mitigation that has been recognized for the purposes of reducing capital requirements under this appendix. 

Where relevant, savings associations are encouraged to give further information about mitigants that have 

not been recognized for that purpose. 
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651

Qualitative 

Disclosures 

(a) The general qualitative disclosure requirement with respect to 

credit risk mitigation including: 

• policies and processes for, and an indication of the extent to 

which the savings association uses, on- and off-balance sheet 

netting; 

• policies and processes for collateral valuation and 

management; 

• a description of the main types of collateral taken by the 

savings association; 

• the main types of guarantors/credit derivative counterparties 

and their creditworthiness; and 

• information about (market or credit) risk concentrations within 

the mitigation taken. 

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. 

 

60 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. 

61 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 November 2, 2007 

652

Table 11.8 – Securitization 

(a) The general qualitative disclosure requirement with respect to 

securitization (including synthetics), including a discussion of: 

• the savings association’s objectives relating to securitization 

activity, including the extent to which these activities transfer 

credit risk of the underlying exposures away from the savings 

association to other entities; 

• the roles played by the savings association in the securitization 

process62 and an indication of the extent of the savings 

association’s involvement in each of them; and 

• the regulatory capital approaches (for example, RBA, IAA and 

SFA) that the savings association follows for its securitization 

activities. 

(b) Summary of the savings association’s accounting policies for 

securitization activities, including: 

• whether the transactions are treated as sales or financings; 

• recognition of gain-on-sale; 

• key assumptions for valuing retained interests, including any 

significant changes since the last reporting period and the 

impact of such changes; and 

• treatment of synthetic securitizations. 

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 savings 

association in securitizations that meet the operational criteria in 

section 41 (broken down into traditional/synthetic), by underlying 

exposure type.63,64,65

 

62 For example: originator, investor, servicer, provider of credit enhancement, sponsor of asset backed 

commercial paper facility, liquidity provider, or swap provider. 63 Underlying exposure types may include, for example, one- to four-family residential loans, home equity 

lines, credit card receivables, and auto loans. 

64 Securitization transactions in which the originating savings association does not retain any securitization 

exposure should be shown separately but need only be reported for the year of inception. 

65 Where relevant, a savings association is encouraged to differentiate between exposures resulting from 

activities in which they act only as sponsors, and exposures that result from all other savings association 

securitization activities. 
DRAFT November 2, 2007 

653

(e) For exposures securitized by the savings association in 

securitizations that meet the operational criteria in Section 41: 

• amount of securitized assets that are impaired/past due; and 

• losses recognized by the savings association during the current 

period66 broken down by exposure type. 

(f) Aggregate amount of securitization exposures broken down by 

underlying exposure type. 

(g) Aggregate amount of securitization exposures and the associated 

IRB capital requirements 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 amortization treatment, the 

following items by underlying asset type for securitized facilities: 

• the aggregate drawn exposures attributed to the seller’s and 

investors’ interests; and 

• the aggregate IRB capital charges incurred by the savings 

association against the investors’ 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 recognized 

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 savings association’s 

measurement approach. 

(c) A description of the use of insurance for the purpose of mitigating 

operational risk. 

 

66 For example, charge-offs/allowances (if the assets remain on the savings association’s balance sheet) or 

write-downs of I/O strips and other residual interests. 
DRAFT November 2, 2007 

654

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 held for 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)67

• Total latent revaluation gains (losses)68

• 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 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.69

 

67 Unrealized gains (losses) recognized in the balance sheet but not through earnings. 68 Unrealized gains (losses) not recognized either in the balance sheet or through earnings. 69 This disclosure should include a breakdown of equities that are subject to the 0 percent, 20 percent, 100 

percent, 300 percent, 400 percent, and 600 percent risk weights, as applicable. 
DRAFT November 2, 2007 

655

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). 

* * * * * 
DRAFT November 2, 2007 

656

Dated: November XX, 2007 

John C. Dugan, 

Comptroller of the Currency. 
DRAFT November 2, 2007 

657

By order of the Board of Governors of the Federal Reserve System, November XX, 2007 

Jennifer J. Johnson 

Secretary of the Board 
DRAFT November 2, 2007 

658

Dated at Washington, D.C., this Xth day of November, 2007. 

By order of the Board of Directors. 

Federal Deposit Insurance Corporation. 

Robert E. Feldman, 

Executive Secretary. 
DRAFT November 2, 2007 

659

Dated: November XX, 2007 

 BY THE OFFICE OF THRIFT SUPERVISION 

 

 John M. Reich 

 Director 

[FR Doc. 06-_____ Filed _____] 

Billing Codes 4810-33-P (25%), 6210-01-P (25%), 6714-01-P (25%), 6720-01-P (25%)