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Preamble
 Table of Contents
 Introduction
				Scope
				Qualification
				Calculation of Tier 1 Capital and Total Qualifying Capital
				Calculation of Risk-Weighted Assets
				Operational Risk
				Disclosure List of Acronyms
 Regulatory Flexibility Act Analysis
 Paperwork Reduction Act
 Plain Language
 OCC Executive Order 12866
 OTS Executive Order 12866 Determination
 OCC Unfunded Mandates Reform Act of 1995 Determination
 OTS Unfunded Mandates Reform Act of 1995 Determination
  Proposed Regulatory Text
 Table of Contents
 Part I
			General Provisions

			Part II
			Qualifying Capital

			Part III
			Qualification

			Part IV
			Risk-Weighted Assets for General Credit Risk

			Part V
			Risk-Weighted Assets for Securitization Exposures

			Part VI
			Risk-Weighted Assets for Equity Exposures

			Part VII
			Risk-Weighted Assets for Operational Risk

			Part VIII
			Disclosure List of Subjects
  Authority and Issuance
 OCC
 Federal Reserve
 FDIC
 OTS
  OCC
 Federal Reserve
 FDIC
 OTS
 Billing Codes


In general
 Supervisory qualification to use the advanced approaches is a continuous and 
   iterative process that begins when a bank's board of directors adopts an implementation 
   plan and continues as the bank operates under the advanced approaches. Before 
   a bank may use the advanced approaches for risk-based capital purposes, it 
   must develop and adopt a written implementation plan, establish and maintain 
   a comprehensive and sound planning and governance process to oversee the implementation 
   efforts described in the plan, demonstrate to its primary Federal supervisor 
   that it meets the qualification requirements in section 22 of the proposed 
   rule, and complete a satisfactory "parallel run" (discussed below). 
   A bank's primary Federal supervisor would be responsible, after consultation 
   with other relevant supervisors, for evaluating the bank's initial and ongoing 
   compliance with the qualification requirements for the advanced approaches. The agencies will jointly issue supervisory guidance describing agency expectations 
   for wholesale, retail, securitization, and equity exposures, as well as for 
   operational risk.23 
   The agencies recognize that a consistent and transparent process to oversee 
   implementation of the advanced approaches is crucial, and will consult with 
   each other on significant issues raised during the implementation process. Under the proposed rule, a bank preparing to implement the advanced approaches 
   must adopt a written implementation plan, approved by its board of directors, 
   describing in detail how the bank complies, or intends to comply, with the 
   qualification requirements. A core bank must adopt a plan no later than six 
   months after it meets a threshold criterion in section 1(b)(1) of the 
   proposed rule. If a bank meets a threshold criterion on the effective date 
   of the final rule, the bank would have to adopt a plan within six months of 
   the effective date. Banks that do not meet a threshold criterion, but are 
   nearing any criterion by direct growth or merger, would be expected to engage 
   in ongoing dialogue with their primary Federal supervisor regarding implementation 
   strategies to ensure their readiness to adopt the advanced approaches when 
   a threshold criterion is reached. An opt-in bank may adopt an implementation 
   plan at any time, but must adopt an implementation plan and notify its primary 
   Federal supervisor in writing at least twelve months before it proposes to 
   begin the first floor period (as discussed later in this section of the preamble). In developing an implementation plan, a bank must assess its current state 
   of readiness relative to the qualification requirements in this proposed rule 
   and related supervisory guidance. This assessment would include a gap analysis 
   that identifies where additional work is needed and a remediation or action 
   plan that clearly sets forth how the bank intends to fill the gaps it has 
   identified. The implementation plan must comprehensively address the qualification 
   requirements for the bank and each of its consolidated subsidiaries (U.S. 
   and foreign-based) with respect to all portfolios and exposures of the bank 
   and each of its consolidated subsidiaries. The implementation plan must justify 
   and support any proposed temporary or permanent exclusion of a business line, 
   portfolio, or exposure from the advanced approaches. The business lines, portfolios, 
   and exposures that the bank proposes to exclude from the advanced approaches 
   must be, in the aggregate, immaterial to the bank. The implementation plan 
   must include objective, measurable milestones (including delivery dates and 
   a date when the bank's implementation of the advanced approaches will be fully 
   operational). For core banks, the implementation plan must include an explicit 
   first floor period start date that is no later than 36 months after the 
   later of the effective date of the rule or the date the bank meets at least 
   one of the threshold criteria.24 
   Further, the implementation plan must describe the resources that the bank 
   has budgeted and are available to implement the plan. During implementation of the advanced approaches, a bank would work closely 
   with its primary Federal supervisor to ensure that its risk measurement and 
   management systems are fully functional and reliable and are able to generate 
   risk parameter estimates that can be used to calculate the risk-based capital 
   ratios correctly under the advanced approaches. The implementation plan, including 
   the gap analysis and action plan, will provide a basis for ongoing supervisory 
   dialogue and review during this period. The primary Federal supervisor will 
   assess a bank's progress relative to its implementation plan. To the extent 
   that adjustments to target dates are needed, these adjustments would be made 
   subject to the ongoing supervisory discussion between the bank and its primary 
   Federal supervisor. Parallel run and transitional floor periods
 Once a bank has adopted its implementation plan, it must complete a satisfactory 
   parallel run before it may use the advanced approaches to calculate its risk-based 
   capital requirements. A satisfactory parallel run is a period of at least 
   four consecutive calendar quarters during which the bank complies with all 
   of the qualification requirements to the satisfaction of its primary Federal 
   supervisor. During this period, the bank would continue to be subject to the 
   general risk-based capital rules but would simultaneously calculate its risk-based 
   capital ratios under the advanced approaches. During the parallel run period, 
   a bank would report its risk-based capital ratios under both the general risk-based 
   capital rules and the advanced approaches to its primary Federal supervisor 
   through the supervisory process on a quarterly basis. The agencies will share 
   this information with each other for calibration and other analytical purposes. A bank's primary Federal supervisor would notify the bank of the date when 
   it may begin to use the advanced approaches for risk-based capital purposes. 
   A bank would not be permitted to begin using the advanced approaches for risk-based 
   capital purposes until its primary Federal supervisor is satisfied that the 
   bank fully complies with the qualification requirements, the bank has satisfactorily 
   completed a parallel run, and the bank has an adequate process to ensure ongoing 
   compliance with the qualification requirements. To provide for a smooth transition to the advanced approaches, the proposed 
   rule would impose temporary limits on the amount by which a bank's 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 move 
   to stand-alone use of the advanced approaches. Table B sets forth the 
   proposed transitional floor periods for banks moving to the advanced approaches: 
 Transitional floor period
      Transitional floor percentageFirst floor period
      95 percentSecond floor period
      90 percentThird floor period
      85 percent
   During the transitional floor periods, a bank would calculate its risk-weighted 
   assets under the general risk-based capital rules. Next, the bank would multiply 
   this 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 definitions and rules in this proposed rule. These ratios 
   would be referred to as the "advanced approaches risk-based capital ratios." 
   In addition, the bank would calculate a tier 1 leverage ratio using tier 1 
   capital as defined in this proposed rule for the numerator of the ratio. During a bank's transitional floor periods, the bank would report all five 
   regulatory capital ratios described above  two floor-adjusted risk-based 
   capital ratios, two advanced approaches risk-based capital ratios, and one 
   leverage ratio. To determine its applicable capital category for PCA purposes 
   and for all other regulatory and supervisory purposes, a bank's risk-based 
   capital ratios during the transitional floor periods would be set equal to 
   the lower of the respective floor-adjusted risk-based capital ratio and the 
   advanced approaches risk-based capital ratio. During the transitional floor 
   periods, a bank's tier 1 capital and tier 2 capital for all non-risk-based-capital 
   supervisory and regulatory purposes (for example, lending limits and Regulation W 
   quantitative limits) would be the bank's tier 1 capital and tier 2 
   capital as calculated under the advanced approaches. Thus, for example, in order to be well capitalized under PCA, a bank would 
   have to have a floor-adjusted tier 1 risk-based capital ratio and an 
   advanced approaches tier 1 risk-based capital ratio of 6 percent 
   or greater, a floor-adjusted total risk-based capital ratio and an advanced 
   approaches total risk-based capital ratio of 10 percent or greater, and 
   a tier 1 leverage ratio of 5 percent or greater (with tier 1 
   capital calculated under the advanced approaches). Although the PCA rules 
   do not apply to BHCs, a BHC would be required to report all five of these 
   regulatory capital ratios and would have to meet applicable supervisory and 
   regulatory requirements using the lower of the respective floor-adjusted risk-based 
   capital ratio and the advanced approaches risk-based capital ratio. After a bank completes its transitional floor periods and its primary Federal 
   supervisor determines the bank may begin using the advanced approaches with 
   no further transitional floor, the bank would use its tier 1 and total risk-based 
   capital ratios as calculated under the advanced approaches and its tier 1 
   leverage ratio calculated using the advanced approaches definition of tier 1 capital for PCA and all other supervisory and regulatory purposes. The transitional floor calculations described above are linked to the general 
   risk-based capital rules. As noted above, the agencies issued the Basel IA 
   ANPR outlining possible modifications to those rules and are developing an 
   NPR in this regard. The agencies are still considering the extent and nature 
   of these modifications to the general risk-based capital rules and the scope 
   of application of these modifications, including for banks that transition 
   to the advanced approaches. The agencies expect banks that meet the threshold 
   criteria in section 1(b)(1) of the proposed rule (that is, core banks) 
   as of the effective date of the rule, and banks that opt-in pursuant to section 1(b)(2) 
   at the earliest possible date, will use the general risk-based capital rules 
   in place immediately before the rule becomes effective both during the parallel 
   run and as a basis for the transitional floor calculations. Other changes 
   to the general risk-based capital rules (outside the scope of the changes 
   outlined in the Basel IA ANPR) may be considered by the agencies, as 
   appropriate. Question 10: The agencies seek comment on this approach, 
   including the transitional floor thresholds and transition period, and on 
   how and to what extent future modifications to the general risk-based 
   capital rules should be incorporated into the transitional floor calculations 
   for advanced approaches banks. Banks' computation of risk-based capital requirements under both the general 
   risk-based capital rules and the advanced approaches will help the agencies 
   assess the impact of the advanced approaches on overall capital requirements, 
   including whether the change in capital requirements relative to the general 
   risk-based capital rules is consistent with the agencies' overall capital 
   objectives. Question 11: The agencies seek comment on what other information 
   should be considered in deciding whether those overall capital goals have 
   been achieved. The agencies are proposing to make 2008 the first possible year for a bank 
   to conduct its parallel run and 2009-2011 the first possible years for the 
   three transitional floor periods. Question 12: The agencies seek comment 
   on this proposed timetable for implementing the advanced approaches in the 
   United States.  Because the Basel II framework uses banks' estimates of certain key risk 
   parameters to determine risk-based capital requirements, the advanced approaches 
   would introduce greater complexity to the regulatory capital framework and 
   would require banks using the advanced approaches to possess a high level 
   of sophistication in risk measurement and risk management systems. As a result, 
   the agencies propose to require each core or opt-in bank to meet the qualification 
   requirements described in section 22 of the proposed rule to the satisfaction 
   of its primary Federal supervisor for a period of at least four consecutive 
   calendar quarters before using the advanced approaches to calculate its minimum 
   risk-based capital requirements (subject to the transitional floors for at 
   least an additional three years). The qualification requirements are written 
   broadly to accommodate the many ways a bank may design and implement a robust 
   internal credit and operational risk measurement and management system and 
   to permit industry practice to evolve. Many of the qualification requirements relate to a bank's advanced IRB systems. 
   A bank's advanced IRB systems must incorporate five interdependent components 
   in a framework for evaluating credit risk and measuring regulatory capital: (i) A risk rating and segmentation system that assigns ratings to individual 
   wholesale obligors and exposures and assigns individual retail exposures to 
   segments; (ii) A quantification process that translates the risk characteristics 
   of wholesale obligors and exposures and segments of retail exposures into 
   numerical risk parameters that are used as inputs to the IRB risk-based capital 
   formulas; (iii) An ongoing process that validates the accuracy of the rating assignments, 
   segmentations, and risk parameters; (iv) A data management and maintenance system that supports the advanced 
   IRB systems; and (v) Oversight and control mechanisms that ensure the advanced IRB systems 
   are functioning effectively and producing accurate results. Process and systems requirements
 One of the objectives of the proposed framework is to provide appropriate 
   incentives for banks to develop and use better techniques for measuring and 
   managing their risks. The proposed rule specifically requires a bank to have 
   a rigorous process for assessing its overall capital adequacy in relation 
   to its total risk profile and a comprehensive strategy for maintaining appropriate 
   capital levels. Consistent with Pillar 2 of the New Accord, a bank's 
   primary Federal supervisor will evaluate how well the bank is assessing its 
   capital needs relative to its risks and, if deficiencies are identified, will 
   take any necessary action to ensure that appropriate and prudent levels of 
   capital are maintained. A bank should address all of its material risks in its overall capital assessment 
   process. Although not every risk can be measured precisely, the following 
   risks, at a minimum, should be factored into a bank's capital assessment process: 
   credit risk, market risk, operational risk, interest rate risk in the banking 
   book, liquidity risk, concentration risk, reputational risk, and strategic 
   risk. With regard to interest rate risk in the banking book, the agencies 
   note that for some assets  for example, a long-term mortgage loan  
   interest rate risk may be as great as, or greater than, the credit risk of 
   the asset. The agencies will continue to focus attention on exposures where 
   interest rate risk may be significant and will foster sound interest rate 
   risk measurement and management practices across banks. Additionally, because 
   credit risk concentrations can pose substantial risk to a bank that might 
   be managing individual credits in a satisfactory manner, a bank also should 
   give proper attention to such concentrations. Banks already are required to hold capital sufficient to meet their risk profiles, 
   and existing rules allow Federal supervisors to require a bank to increase 
   its capital if its current capital levels are deficient or some element of 
   its business practices suggests the need for more capital. Existing supervisory 
   guidance directs banks to meaningfully tie the identification, monitoring, 
   and evaluation of risk to the determination of the bank's capital needs. Banks 
   are expected to implement and continually update the fundamental elements 
   of a sound internal capital adequacy analysis  identifying and measuring 
   all material risks, setting capital adequacy goals that relate to risk, and 
   assessing conformity to the bank's stated objectives. The agencies expect 
   that all banks operating under the advanced approaches would address specific 
   assumptions embedded in the advanced approaches (such as diversification in 
   credit portfolios), and would evaluate these banks, in part, on their ability 
   to account for deviations from the underlying assumptions in their own portfolios. As noted, each core or opt-in bank would apply the advanced approaches for 
   risk-based capital purposes at the consolidated top-tier legal entity level 
   (that is, either the top-tier BHC or top-tier DI that is a core or opt-in 
   bank) and at the level of each DI that is a subsidiary of such a top-tier 
   legal entity. Thus, each bank that applies the advanced approaches must have 
   an appropriate infrastructure with risk measurement and management processes 
   that meet the proposed rule's qualification requirements and that are appropriate 
   given the bank's size and level of complexity. Regardless of whether the systems 
   and models that generate the risk parameters necessary for calculating a bank's 
   risk-based capital requirements are located at any affiliate of the bank, 
   each legal entity that applies the advanced approaches must ensure that the 
   risk parameters (that is, PD, ELGD, LGD, EAD, and M) and reference data used 
   to determine its risk-based capital requirements are representative of its 
   own credit and operational risk exposures. The proposed rule also requires that the systems and processes that an advanced 
   approaches bank uses for risk-based capital purposes must be sufficiently 
   consistent with the bank's internal risk management processes and management 
   information reporting systems such that data from the latter processes and 
   systems can be used to verify the reasonableness of the inputs the bank uses 
   for risk-based capital purposes. Risk rating and segmentation systems for wholesale and retail exposures
 To implement the IRB framework, a bank must have internal risk rating and 
   segmentation systems that accurately and reliably differentiate between degrees 
   of credit risk for wholesale and retail exposures. As described below, wholesale 
   exposures include most credit exposures to companies, sovereigns, and governmental 
   entities, as well as some exposures to individuals. Retail exposures include 
   most credit exposures to individuals and small businesses that are managed 
   as part of a segment of exposures with homogeneous risk characteristics. Together, 
   wholesale and retail exposures cover most credit exposures of banks. To differentiate among degrees of credit risk, a bank must be able to make 
   meaningful and consistent distinctions among credit exposures along two dimensions 
    default risk and loss severity in the event of a default. In addition, 
   a bank must be able to assign wholesale obligors to rating grades that approximately 
   reflect likelihood of default and must be able to assign wholesale exposures 
   to rating grades (or ELGD and LGD estimates) that approximately reflect the 
   loss severity expected in the event of default. As discussed below, the proposed 
   rule requires banks to treat wholesale exposures differently from retail exposures 
   when differentiating among degrees of credit risk.  For wholesale exposures, a bank must have an internal risk rating system that 
   indicates the likelihood of default of each individual obligor and may use 
   an internal risk rating system that indicates the economic loss rate upon 
   default of each individual exposure.25 A bank would assign an internal risk 
   rating to each wholesale obligor, which should reflect the obligor's PD  
   that is, its long-run average one-year default rate over a reasonable mix 
   of economic conditions. PD is defined in more detail below. In determining an obligor rating, a bank should consider key obligor attributes, 
   including both quantitative and qualitative factors that could affect the 
   obligor's default risk. From a quantitative perspective, this could include 
   an assessment of the obligor's historic and projected financial performance, 
   trends in key financial performance ratios, financial contingencies, industry 
   risk, and the obligor's position in the industry. On the qualitative side, 
   this could include an assessment of the quality of the obligor's financial 
   reporting, non-financial contingencies (for example, labor problems and environmental 
   issues), and the quality of the obligor's management based on an evaluation 
   of management's ability to make realistic projections, management's track 
   record in meeting projections, and management's ability to effectively deal 
   with changes in the economy and the competitive environment. A bank must assign each legal entity wholesale obligor to a single rating 
   grade. Accordingly, if a single wholesale exposure of the bank to an obligor 
   triggers the proposed rule's definition of default, all of the bank's wholesale 
   exposures to that obligor are in default for risk-based capital purposes. 
   In addition, a bank may not consider the value of collateral pledged to support 
   a particular wholesale exposure (or any other exposure-specific characteristics) 
   when assigning a rating to the obligor of the exposure, even in the context 
   of nonrecourse loans and other loans underwritten primarily based on the operating 
   income or cash flows from real estate collateral. A bank may, of course, consider 
   all available financial information about the obligor  including, where 
   applicable, the total operating income or cash flows from all of the obligor's 
   projects or businesses  when assigning an obligor rating. Question13: 
   The agencies seek comment on this aspect of the proposed rule and on any circumstances 
   under which it would be appropriate to assign different obligor ratings to 
   different exposures to the same obligor (for example, income-producing property 
   lending or exposures involving transfer risk). A bank's rating system must have at least seven discrete (non-overlapping) 
   obligor grades for non-defaulted obligors and at least one obligor grade for 
   defaulted obligors. The agencies believe that because the risk-based capital 
   requirement of a wholesale exposure is directly linked to its obligor rating 
   grade, a bank must have at least seven non-overlapping obligor grades to sufficiently 
   differentiate the creditworthiness of non-defaulted wholesale obligors. A bank would capture the estimated loss severity upon default for a wholesale 
   exposure either by directly assigning an ELGD and LGD estimate to the exposure 
   or by grouping the exposure with other wholesale exposures into loss severity 
   rating grades (reflecting the bank's estimate of the ELGD or LGD of the exposure). 
   The LGD of an exposure is an estimate of the economic loss rate on the exposure, 
   taking into account related material costs and recoveries, in the event of 
   the obligor's default during a period of economic downturn conditions. LGD 
   is described in more detail below. Whether a bank chooses to assign ELGD and 
   LGD values directly or, alternatively, to assign exposures to rating grades 
   and then quantify the ELGD or LGD, as appropriate, for the rating grades, 
   the key requirement is that the bank must identify exposure characteristics 
   that influence ELGD and LGD. Each of the loss severity rating grades would 
   be associated with an empirically supported ELGD or LGD estimate. Banks employing 
   loss severity grades must have a sufficiently granular loss severity grading 
   system to avoid grouping together exposures with widely ranging ELGDs or LGDs.  To implement the advanced approach for retail exposures, a bank must have 
   an internal system that segments its retail exposures to differentiate accurately 
   and reliably among degrees of credit risk. The most significant difference 
   between the proposed rule's treatment of wholesale and retail exposures is 
   that the risk parameters for retail exposures are not assigned at the individual 
   exposure level. Banks typically manage retail exposures on a segment basis, 
   where each segment contains exposures with similar risk characteristics. Therefore, 
   a key characteristic of the proposed rule's retail framework is that the risk 
   parameters for retail exposures would be assigned to segments of exposures 
   rather than to individual exposures. Under the retail framework, a bank would 
   group its retail exposures into segments with homogeneous risk characteristics 
   and then estimate PD, ELGD, and LGD for each segment. A bank must first group its retail exposures into three separate subcategories: 
   (i) residential mortgage exposures; (ii) QREs; and (iii) other 
   retail exposures. The bank would then classify the retail exposures in each 
   subcategory into segments to produce a meaningful differentiation of risk. 
   The proposed rule requires banks to segment separately (i) defaulted 
   retail exposures from non-defaulted retail exposures and (ii) retail 
   eligible margin loans for which the bank adjusts EAD rather than ELGD and 
   LGD to reflect the risk mitigating effects of financial collateral from other 
   retail eligible margin loans. Otherwise, the agencies are not proposing to 
   require that banks consider any particular risk drivers or employ any minimum 
   number of segments in any of the three retail subcategories. In determining how to segment retail exposures within each subcategory for 
   the purpose of assigning risk parameters, a bank should use a segmentation 
   approach that is consistent with its approach for internal risk assessment 
   purposes and that classifies exposures according to predominant risk characteristics 
   or drivers. Examples of risk drivers could include loan-to-value (LTV) 
   ratios, credit scores, loan terms and structure (for example, interest only 
   or payment option adjustable rate mortgages), origination channel, geographical 
   location of the borrower, and collateral type. A bank must be able to demonstrate 
   to its primary Federal supervisor that its system assigns accurate and reliable 
   PD, ELGD, and LGD estimates for each retail segment on a consistent basis.  In the ANPR, the agencies proposed to define default for a wholesale exposure 
   as either or both of the following events: (i) the bank determines that 
   the borrower is unlikely to pay its obligations to the bank in full, without 
   recourse to actions by the bank such as the realization of collateral; or 
   (ii) the borrower is more than 90 days past due on principal or 
   interest on any material obligation to the bank. A number of commenters encouraged the agencies to use a definition of default 
   that conforms more closely to that used by bank risk managers. Many of these 
   commenters recommended that the agencies define default as the entry into 
   non-accrual status for wholesale exposures and the number of days past due 
   for retail exposures, or as the entry into charge-off status for wholesale 
   and retail exposures. The agencies have amended the ANPR definitions of default 
   to respond to these concerns and recognize that the definition of default 
   in this proposed rule is different from the definitions that are being implemented 
   in other jurisdictions. Under the proposed rule's definition of default, a bank's wholesale obligor 
   would be in default if, for any credit exposure of the bank to the obligor, 
   the bank has (i) placed the exposure on non-accrual status consistent with 
   the Call Report Instructions or the Thrift Financial Report and the Thrift 
   Financial Report Instruction Manual; (ii) taken a full or partial charge-off 
   or write-down on the exposure due to the distressed financial condition of 
   the obligor; or (iii) incurred a credit-related loss of 5 percent or more 
   of the exposure's initial carrying value in connection with the sale of the 
   exposure or the transfer of the exposure to the held-for-sale, available-for-sale, 
   trading account, or other reporting category. Under the proposed definition, 
   a wholesale exposure to an obligor remains in default until the bank has reasonable 
   assurance of repayment and performance for all contractual principal and interest 
   payments on all exposures of the bank to the obligor (other than exposures 
   that have been fully written-down or charged-off). The agencies would expect 
   a bank to employ standards for determining whether it has a reasonable assurance 
   of repayment and performance that are similar to those for determining whether 
   to restore a loan from non-accrual to accrual status. When a bank sells a set of wholesale exposures, the bank must examine the 
   sale prices of the individual exposures contained in the set and evaluate 
   whether a credit loss of 5 percent or more of the exposure's initial carrying 
   value has occurred on any given exposure. Write-downs of securities that are 
   not credit-related (for example, a write-down that is due to a change in market 
   interest rates) would not be a default event. Question 14: The agencies seek comment on this proposed definition of default 
   and on how well it captures substantially all of the circumstances under which 
   a bank could experience a material credit-related economic loss on a wholesale 
   exposure. In particular, the agencies seek comment on the appropriateness 
   of the 5 percent credit loss threshold for exposures sold or transferred between 
   reporting categories. The agencies also seek commenters' views on specific 
   issues raised by applying different definitions of default in multiple national 
   jurisdictions and on ways to minimize potential regulatory burden, including 
   use of the definition of default in the New Accord, keeping in mind that national 
   bank supervisory authorities must adopt default definitions that are appropriate 
   in light of national banking practices and conditions. In response to comments on the ANPR, the agencies propose to define default 
   for retail exposures according to the timeframes for loss classification that 
   banks generally use for internal purposes and that are embodied in the FFIEC's 
   Uniform Retail Credit Classification and Account Management Policy.26 
   Specifically, revolving retail exposures and residential mortgages would be 
   in default at 180 days past due; other retail exposures would be in default 
   at 120 days past due. In addition, a retail exposure would be in default 
   if the bank has taken a full or partial charge-off or write-down of principal 
   on the exposure for credit-related reasons. Such an exposure would remain 
   in default until the bank has reasonable assurance of repayment and performance 
   for all contractual principal and interest payments on the exposure. The proposed definition of default for retail exposures differs from the proposed 
   definition for the wholesale portfolio in several important respects. First, 
   the proposed retail default definition applies on an exposure-by-exposure 
   basis (rather than, as is the case for wholesale exposures, on an obligor-by-obligor 
   basis). In other words, default on one retail exposure would not require a 
   bank to treat all other obligations of the same obligor to the bank as defaulted. 
   This difference reflects the fact that banks generally manage retail credit 
   risk based on segments of similar exposures rather than through the assignment 
   of ratings to particular obligors. In addition, it is quite common for retail 
   borrowers that default on some of their obligations to continue payment on 
   others. Second, the retail definition of default, unlike the wholesale definition 
   of default, does not include exposures placed on non-accrual status. The agencies 
   recognize that retail non-accrual practices vary considerably among banks. 
   Accordingly, the agencies have determined that removing non-accrual from the 
   retail definition of default would promote greater consistency among banks 
   in the treatment of retail exposures. In addition, the retail definition of default, unlike the wholesale definition 
   of default, does not explicitly state that an exposure is in default if a 
   bank incurs credit-related losses of 5 percent or more in connection with 
   the sale of the exposure. Because of the large number of diverse retail exposures 
   that banks usually sell in a single transaction, banks typically do not allocate 
   the sales price of a pool of retail exposures in such a way as to enable the 
   bank to calculate the premium or discount on individual retail exposures. 
   Although the proposed rule's definition of retail default does not explicitly 
   include credit-related losses in connection with loan sales, the agencies 
   would expect banks to assess carefully the impact of retail exposure sales 
   in quantifying the risk parameters calculated by the bank for its retained 
   retail exposures.  A bank must explain to its primary Federal supervisor its rating philosophy 
    that is, how the bank's wholesale obligor rating assignments are affected 
   by the bank's choice of the range of economic, business, and industry conditions 
   that are considered in the obligor rating process. The philosophical basis 
   of a bank's ratings system is important because, when combined with the credit 
   quality of individual obligors, it will determine the frequency of obligor 
   rating changes in a changing economic environment. Rating systems that rate 
   obligors based on their ability to perform over a wide range of economic, 
   business, and industry conditions, sometimes described as "through-the-cycle" 
   systems, would tend to have ratings that migrate more slowly as conditions 
   change. Banks that rate obligors based on a more narrow range of likely expected 
   conditions (primarily on recent conditions), sometimes called "point-in-time" 
   systems, would tend to have ratings that migrate more frequently. Many banks 
   will rate obligors using an approach that considers a combination of the current 
   conditions and a wider range of other likely conditions. In any case, the 
   bank would need to specify the rating philosophy used and establish a policy 
   for the migration of obligors from one rating grade to another in response 
   to economic cycles. A bank should understand the effects of ratings migration 
   on its risk-based capital requirements and ensure that sufficient capital 
   is maintained during all phases of the economic cycle.  A bank must have a policy that ensures that each wholesale obligor rating 
   and (if applicable) wholesale exposure loss severity rating reflects current 
   information. A bank's internal risk rating system for wholesale exposures 
   must provide for the review and update (as appropriate) of each obligor rating 
   and (if applicable) loss severity rating whenever the bank receives new material 
   information, but no less frequently than annually. A bank's retail exposure 
   segmentation system must provide for the review and update (as appropriate) 
   of assignments of retail exposures to segments whenever the bank receives 
   new material information, but no less frequently than quarterly. Quantification of risk parameters for wholesale and retail exposures
 A bank must have a comprehensive risk parameter quantification process that 
   produces accurate, timely, and reliable estimates of the risk parameters  
   PD, ELGD, LGD, EAD, and (for wholesale exposures) M  for its wholesale 
   obligors and exposures and retail exposures. Statistical methods and models 
   used to develop risk parameter estimates, as well as any adjustments to the 
   estimates or empirical default data, should be transparent, well supported, 
   and documented. The following sections of the preamble discuss the proposed 
   rule's definitions of the risk parameters for wholesale and retail exposures.  As noted above, under the proposed rule, a bank must assign each of its wholesale 
   obligors to an internal rating grade and then must associate a PD with each 
   rating grade. PD for a wholesale exposure to a non-defaulted obligor would 
   be the bank's empirically based best estimate of the long-run average of one-year 
   default rates for the rating grade assigned by the bank to the obligor, capturing 
   the average default experience for obligors in the rating grade over a mix 
   of economic conditions (including economic downturn conditions) sufficient 
   to provide a reasonable estimate of the average one-year default rate over 
   the economic cycle for the rating grade. This estimate of the long-run average 
   PD is converted into an estimate of PD under economic downturn conditions 
   as part of the IRB risk-based capital formulas. In addition, under the proposed rule, a bank must assign a PD to each segment 
   of retail exposures. The proposed rule provides two different definitions 
   of the PD of a segment of non-defaulted retail exposures based on the materiality 
   of seasoning effects for the segment or for the segment's retail exposure 
   subcategory. Some types of retail exposures display a distinct seasoning pattern 
    that is, the exposures have relatively low default rates in their first 
   year, rising default rates in the next few years, and declining default rates 
   for the remainder of their terms. A bank must use a separate definition of 
   PD that addresses seasoning effects for a segment of non-defaulted retail 
   exposures unless the bank has determined that seasoning effects are not material 
   for the segment or for the segment's entire retail exposure subcategory. The proposed rule provides a definition of PD for segments of non-defaulted 
   retail exposures where seasoning is not a material consideration that tracks 
   closely the wholesale PD definition. Specifically, PD for a segment of non-defaulted 
   retail exposures for which seasoning effects are not material, or for a segment 
   of non-defaulted retail exposures in a retail exposure subcategory for which 
   seasoning effects are not material, would be the bank's empirically based 
   best estimate of the long-run average of one-year default rates for the exposures 
   in the segment, capturing the average default experience for exposures in 
   the segment over a mix of economic conditions (including economic downturn 
   conditions) sufficient to provide a reasonable estimate of the average one-year 
   default rate over the economic cycle for the segment. Banks that use this 
   PD formulation for a segment of retail exposures should be able to demonstrate 
   to their primary Federal supervisor, using empirical data, why seasoning effects 
   are not material for the segment or the retail exposure subcategory in which 
   the segment resides. Because of the one-year IRB horizon, the agencies are proposing a different 
   PD definition for retail segments with material seasoning effects. Under the 
   proposed rule, PD for a segment of non-defaulted retail exposures for which 
   seasoning effects are material would be the bank's empirically based best 
   estimate of the annualized cumulative default rate over the expected remaining 
   life of exposures in the segment, capturing the average default experience 
   for exposures in the segment over a mix of economic conditions (including 
   economic downturn conditions) to provide a reasonable estimate of the average 
   performance over the economic cycle for the segment. A bank's PD estimates 
   for these retail segments with material seasoning effects also should reflect 
   potential changes in the expected remaining life of exposures in the segment 
   over the economic cycle. For wholesale exposures to defaulted obligors and for segments of defaulted 
   retail exposures, PD would be 100 percent.  Under the proposed rule, a bank must directly estimate an ELGD and LGD risk 
   parameter for each wholesale exposure or must assign each wholesale exposure 
   to an expected loss severity grade and a downturn loss severity grade, estimate 
   an ELGD risk parameter for each expected loss severity grade, and estimate 
   an LGD risk parameter for each loss severity grade. In addition, a bank must 
   estimate an ELGD and LGD risk parameter for each segment of retail exposures. 
   The same ELGD and LGD may be appropriate for more than one retail segment. LGD is an estimate of the economic loss that would be incurred on an exposure, 
   relative to the exposure's EAD, if the exposure were to default within a one-year 
   horizon during economic downturn conditions. The economic loss amount must 
   capture all material credit-related losses on the exposure (including accrued 
   but unpaid interest or fees, losses on the sale of repossessed collateral, 
   direct workout costs, and an appropriate allocation of indirect workout costs). 
   Where positive or negative cash flows on a wholesale exposure to a defaulted 
   obligor or on a defaulted retail exposure (including proceeds from the sale 
   of collateral, workout costs, and draw-downs of unused credit lines) occur 
   after the date of default, the economic loss amount must reflect the net present 
   value of cash flows as of the default date using a discount rate appropriate 
   to the risk of the exposure. The LGD of some exposures may be substantially higher during economic downturn 
   conditions than during other periods, while for other types of exposures it 
   may not. Accordingly, the proposed rule requires banks to use an LGD estimate 
   that reflects economic downturn conditions for purposes of calculating the 
   risk-based capital requirements for wholesale exposures and retail segments; 
   however, the LGD of an exposure may never be less than the exposure's ELGD. 
   More specifically, banks must produce for each wholesale exposure (or downturn 
   loss severity rating grade) and retail segment an estimate of the economic 
   loss per dollar of EAD that the bank would expect to incur if default were 
   to occur within a one-year horizon during economic downturn conditions. The 
   estimate of LGD can be thought of as the ELGD plus an increase if appropriate 
   to reflect the impact of economic downturn conditions. For the purpose of defining economic downturn conditions, the proposed rule 
   identifies two wholesale exposure subcategories  high-volatility commercial 
   real estate (HVCRE) wholesale exposures and non-HVCRE wholesale exposures 
   (that is, all wholesale exposures that are not HVCRE exposures)  and 
   three retail exposure subcategories  residential mortgage exposures, 
   QREs, and other retail exposures. The proposed rule defines economic downturn 
   conditions with respect to an exposure as those conditions in which the aggregate 
   default rates for the exposure's entire wholesale or retail subcategory held 
   by the bank (or subdivision of such subcategory selected by the bank) in the 
   exposure's national jurisdiction (or subdivision of such jurisdiction selected 
   by the bank) are significantly higher than average. Under this approach, a bank with a geographical or industry sector concentration 
   in a subcategory of exposures may find that information relating to a downturn 
   in that geographical region or industry sector may be more relevant for the 
   bank than a general downturn affecting many regions or industries. At this 
   time, however, the proposed rule does not require a bank with a geographical, 
   industry sector, or other concentration to subdivide exposure subcategories 
   or national jurisdictions to reflect such concentrations; rather, the proposed 
   rule allows banks to subdivide exposure subcategories or national jurisdictions 
   as they deem appropriate given the exposures held by the bank. The agencies 
   understand that downturns in particular geographical subdivisions of national 
   jurisdictions or in particular industrial sectors may result in significantly 
   increased loss rates in material subdivisions of a bank's exposures in an 
   exposure subcategory. Question 15: In light of the possibility of significantly 
   increased loss rates at the subdivision level due to downturn conditions in 
   the subdivision, the agencies seek comment on whether to require banks to 
   determine economic downturn conditions at a more granular level than an entire 
   wholesale or retail exposure subcategory in a national jurisdiction. The proposed rule provides banks two methods of generating LGD estimates for 
   wholesale and retail exposures. First, a bank may use its own estimates of 
   LGD for a subcategory of exposures if the bank has prior written approval 
   from its primary Federal supervisor to use internal estimates for that subcategory 
   of exposures. In approving a bank's use of internal estimates of LGD, a bank's 
   primary Federal supervisor will consider whether the bank's internal estimates 
   of LGD are reliable and sufficiently reflective of economic downturn conditions. 
   The supervisor will also consider whether the bank has rigorous and well-documented 
   policies and procedures for identifying economic downturn conditions for the 
   exposure subcategory, identifying material adverse correlations between the 
   relevant drivers of default rates and loss rates given default, and incorporating 
   identified correlations into internal LGD estimates. If a bank has supervisory 
   approval to use its own estimates of LGD for an exposure subcategory, it must 
   use its own estimates of LGD for all exposures within that subcategory. As noted above, the LGD of an exposure or segment may never be less than the 
   ELGD of that exposure or segment. The proposed rule defines the ELGD of a 
   wholesale exposure as the bank's empirically-based best estimate of the default-weighted 
   average economic loss per dollar of EAD the bank expects to incur in the event 
   that the obligor of the exposure (or a typical obligor in the loss severity 
   grade assigned by the bank to the exposure) defaults within a one-year horizon.27 
   For a segment of retail exposures, ELGD is the bank's empirically-based best 
   estimate of the default-weighted average economic loss per dollar of EAD the 
   bank expects to incur on exposures in the segment that default within a one-year 
   horizon. ELGD estimates must incorporate a mix of economic conditions (including 
   economic downturn conditions). For example, given appropriate data, the ELGD 
   could be estimated by calculating the default-weighted average economic loss 
   per dollar of EAD given default for exposures in a particular loss severity 
   grade or segment observed over a complete credit cycle. As an alternative to internal estimates of LGD, the proposed rule provides 
   a supervisory mapping function for converting ELGD into LGD for risk-based 
   capital purposes. Although the agencies encourage banks to develop internal 
   LGD estimates, the agencies are aware that it may be difficult at this time 
   and in the near future for banks to produce internal estimates of LGD that 
   are sufficient for risk-based capital purposes because LGD data for important 
   portfolios may be sparse, and there is very limited industry experience with 
   incorporating downturn conditions into LGD estimates. Accordingly, under the 
   proposed rule, a bank that does not qualify for use of its own estimates of 
   LGD for a subcategory of exposures must instead compute LGD by applying a 
   supervisory mapping function to its internal estimates of ELGD for such exposures. 
   The bank would adjust its ELGDs upward to LGDs using the linear supervisory 
   mapping function: LGD = 0.08 + 0.92 × ELGD. 
   Under this mapping function, for example, an ELGD of 0 percent is converted 
   to an LGD of 8 percent, an ELGD of 20 percent is converted to an 
   LGD of 26.4 percent, and an ELGD of 50 percent is converted to an 
   LGD of 54 percent. A bank would not have to apply the supervisory mapping 
   function to repo-style transactions, eligible margin loans, and OTC derivative 
   contracts (defined below in section V.C. of the preamble). For these 
   exposures, the agencies believe that the difference between a bank's estimate 
   of LGD and its estimate of ELGD is likely to be small. Instead a bank would 
   set LGD equal to ELGD for these exposures. As noted, the proposed rule would permit a bank to use the supervisory mapping 
   function to translate ELGDs to LGDs and would only permit a bank to use its 
   own estimates of LGD for an exposure subcategory if the bank has received 
   prior written approval from its primary Federal supervisor. The agencies also 
   are considering whether to require every bank, as a condition to qualifying 
   for use of the advanced approaches, to be able to produce credible and reliable 
   internal estimates of LGD for all its wholesale and retail exposures. Under 
   this stricter approach, a bank that is unable to demonstrate to its primary 
   Federal supervisor that it could produce credible and reliable internal estimates 
   of LGD would not be permitted to use the advanced approaches. Question 16: The agencies seek comment on and supporting empirical analysis 
   of (i) the proposed rule's definitions of LGD and ELGD; (ii) the 
   proposed rule's overall approach to LGD estimation; (iii) the appropriateness 
   of requiring a bank to produce credible and reliable internal estimates of 
   LGD for all its wholesale and retail exposures as a precondition for using 
   the advanced approaches; (iv) the appropriateness of requiring all banks 
   to use a supervisory mapping function, rather than internal estimates, for 
   estimating LGDs, due to limited data availability and lack of industry experience 
   with incorporating economic downturn conditions in LGD estimates; (v) the 
   appropriateness of the proposed supervisory mapping function for translating 
   ELGD into LGD for all portfolios of exposures and possible alternative supervisory 
   mapping functions; (vi) exposures for which no mapping function would 
   be appropriate; and (vii)  exposures for which a more lenient (that is, 
   producing a lower LGD for a given ELGD) or more strict (that is, producing 
   a higher LGD for a given ELGD) mapping function may be appropriate (for example, 
   residential mortgage exposures and HVCRE exposures). The agencies are concerned that some approaches to ELGD or LGD quantification 
   could produce estimates that are pro-cyclical, particularly if these estimates 
   are based on economic indicators, such as frequently updated loan-to-value (LTV) 
   ratios, that are highly sensitive to current economic conditions. Question 17: 
   The agencies seek comment on the extent to which ELGD or LGD estimates under 
   the proposed rule would be pro-cyclical, particularly for longer-term secured 
   exposures. The agencies also seek comment on alternative approaches to measuring 
   ELGDs or LGDs that would address concerns regarding potential pro-cyclicality 
   without imposing undue burden on banks. This proposed rule incorporates comments on the ANPR suggesting a need to 
   better accommodate certain credit products, most prominently asset-based lending 
   programs, whose structures typically result in a bank recovering substantial 
   amounts of the exposure prior to the default date  for example, through 
   paydowns of outstanding principal. The agencies believe that actions taken 
   prior to default to mitigate losses are an important component of a bank's 
   overall credit risk management, and that such actions should be reflected 
   in ELGD and LGD when banks can quantify their effectiveness in a reliable 
   manner. In the proposed rule, this is achieved by measuring ELGD and LGD relative 
   to the exposure's EAD (defined in the next section) as opposed to the amount 
   actually owed at default.28 In practice, the agencies would expect methods for estimating ELGD and LGD, 
   and the way those methods reflect changes in exposure during the period prior 
   to default, to be consistent with other aspects of the proposed rule. For 
   example, a default horizon that is longer than one year could result in lower 
   estimates of economic loss due to greater contractual amortization prior to 
   default, or a greater likelihood that covenants would enable a bank to accelerate 
   paydowns of principal as the condition of an obligor deteriorates, but such 
   long horizons could be inconsistent with the one-year default horizon incorporated 
   in other aspects of this proposed rule, such as the quantification of PD. The agencies intend to limit recognition of the impact on ELGD and LGD of 
   pre-default paydowns to certain types of exposures where the pattern is common, 
   measurable, and especially significant, as with various types of asset-based 
   lending. In addition, not all paydowns during the period prior to default 
   warrant recognition as part of the recovery process. For example, a pre-default 
   reduction in the outstanding amount on one exposure may simply reflect a refinancing 
   by the obligor with the bank, with no reduction in the bank's total exposure 
   to the obligor. Question 18: The agencies seek comment on the feasibility 
   of recognizing such pre-default changes in exposure in a way that is consistent 
   with the safety and soundness objectives of this proposed rule. The agencies 
   also seek comment on appropriate restrictions to place on any such recognition 
   to ensure that the results are not counter to the objectives of this proposal 
   to ensure adequate capital within a more risk-sensitive capital framework. 
   In addition, the agencies seek comment on whether, for wholesale exposures, 
   allowing ELGD and LGD to reflect anticipated future contractual paydowns prior 
   to default may be inconsistent with the proposed rule's imposition of a one-year 
   floor on M (for certain types of exposures) or may lead to some double-counting 
   of the risk-mitigating benefits of shorter maturities for exposures not subject 
   to this floor.  Except as noted below, EAD for the on-balance sheet component of a wholesale 
   or retail exposure means (i) the bank's carrying value for the exposure 
   (including net accrued but unpaid interest and fees)29 
   less any allocated transfer risk reserve for the exposure, if the exposure 
   is held-to-maturity or for trading; or (ii) the bank's carrying value 
   for the exposure (including net accrued but unpaid interest and fees) less 
   any allocated transfer risk reserve for the exposure and any unrealized gains 
   on the exposure, plus any unrealized losses on the exposure, if the exposure 
   is available-for-sale. For the off-balance sheet component of a wholesale 
   or retail exposure (other than an OTC derivative contract, repo-style transaction, 
   or eligible margin loan) in the form of a loan commitment or line of credit, 
   EAD means the bank's best estimate of net additions to the outstanding amount 
   owed the bank, including estimated future additional draws of principal and 
   accrued but unpaid interest and fees, that are likely to occur over the remaining 
   life of the exposure assuming the exposure were to go into default. This estimate 
   of net additions must reflect what would be expected during a period of economic 
   downturn conditions. For the off-balance sheet component of a wholesale or 
   retail exposure other than an OTC derivative contract, repo-style transaction, 
   eligible margin loan, loan commitment, or line of credit issued by a bank, 
   EAD means the notional amount of the exposure. For a segment of retail exposures, EAD is the sum of the EADs for each individual 
   exposure in the segment. For wholesale or retail exposures in which only the 
   drawn balance has been securitized, the bank must reflect its share of the 
   exposures' undrawn balances in EAD. The undrawn balances of exposures for 
   which the drawn balances have been securitized must be allocated between the 
   seller's and investors' interests on a pro rata basis, based on the proportions 
   of the seller's and investors' shares of the securitized drawn balances. For 
   example, if the EAD of a group of securitized exposures' undrawn balances 
   is $100, and the bank's share (seller's interest) in the securitized exposures 
   is 25 percent, the bank must reflect $25 in EAD for the undrawn balances. The proposed rule contains a special treatment of EAD for OTC derivative contracts, 
   repo-style transactions, and eligible margin loans, which is in section 32 
   of the proposed rule and discussed in more detail in section V.C. of 
   the preamble.  The proposed rule requires data used by a bank to estimate risk parameters 
   to be relevant to the bank's actual wholesale and retail exposures and of 
   sufficient quality to support the determination of risk-based capital requirements 
   for the exposures. For wholesale exposures, estimation of the risk parameters 
   must be based on a minimum of 5 years of default data to estimate PD, 7 years 
   of loss severity data to estimate ELGD and LGD, and 7 years of exposure amount 
   data to estimate EAD. For segments of retail exposures, estimation of risk 
   parameters must be based on a minimum of 5 years of default data to estimate 
   PD, 5 years of loss severity data to estimate ELGD and LGD, and 5 years of 
   exposure amount data to estimate EAD. Default, loss severity, and exposure 
   amount data must include periods of economic downturn conditions or the bank 
   must adjust its estimates of risk parameters to compensate for the lack of 
   data from such periods. Banks must base their estimates of PD, ELGD, LGD, 
   and EAD on the proposed rule's definition of default, and must review at least 
   annually and update (as appropriate) their risk parameters and risk parameter 
   quantification process. In all cases, banks would be expected to use the best available data for quantifying 
   the risk parameters. A bank could meet the minimum data requirement by using 
   internal data, external data, or pooled data combining internal data with 
   external data. Internal data refers to any data on exposures held in a bank's 
   existing or historical portfolios, including data elements or information 
   provided by third parties. External data refers to information on exposures 
   held outside of the bank's portfolio or aggregate information across an industry. For example, for new lines of business where a bank lacks sufficient internal 
   data, it must use external data to supplement its internal data. The agencies 
   recognize that the minimum sample period for reference data provided in the 
   proposed rule may not provide the best available results. A longer sample 
   period usually captures varying economic conditions better than a shorter 
   sample period; in addition, a longer sample period will include more default 
   observations for ELGD, LGD, and EAD estimation. Banks should consider using 
   a longer-than-minimum sample period when possible. However, the potential 
   increase in precision afforded by a larger sample should be weighed against 
   the potential for diminished comparability of older data to the existing portfolio; 
   striking the correct balance is an important aspect of quantitative modeling. Both internal and external reference data should not differ systematically 
   from a bank's existing portfolio in ways that seem likely to be related to 
   default risk, loss severity, or exposure at default. Otherwise, the derived 
   PD, ELGD, LGD, or EAD estimates may not be applicable to the bank's existing 
   portfolio. Accordingly, the bank must conduct a comprehensive review and analysis 
   of reference data at least annually to determine the relevance of reference 
   data to the bank's exposures, the quality of reference data to support PD, 
   ELGD, LGD, and EAD estimates, and the consistency of reference data to the 
   definition of default contained in the proposed rule. Furthermore, a bank 
   must have adequate data to estimate risk parameters for all its wholesale 
   and retail exposures as if they were held to maturity, even if some loans 
   are likely to be sold or securitized before their long-term credit performance 
   can be observed. As noted above, periods of economic downturn conditions must be included in 
   the data sample (or adjustments to risk parameters must be made). If the reference 
   data include data from beyond the minimum number of years (to capture a period 
   of economic downturn conditions or for other valid reasons), the reference 
   data need not cover all of the intervening years. However, a bank should justify 
   the exclusion of available data and, in particular, any temporal discontinuities 
   in data used. Including periods of economic downturn conditions increases 
   the size and potentially the breadth of the reference data set. According 
   to some empirical studies, the average loss rate is higher during periods 
   of economic downturn conditions, such that exclusion of such periods would 
   bias ELGD, LGD, or EAD estimates downward and unjustifiably lower risk-based 
   capital requirements. Risk parameter estimates should take into account the robustness of the quantification 
   process. The assumptions and adjustments embedded in the quantification process 
   should reflect the degree of uncertainty or potential error inherent in the 
   process. In practice, a reasonable estimation approach likely would result 
   in a range of defensible risk parameter estimates. The choices of the particular 
   assumptions and adjustments that determine the final estimate, within the 
   defensible range, should reflect the uncertainty in the quantification process. 
   That is, more uncertainty in the process should be reflected in the assignment 
   of final risk parameter estimates that result in higher risk-based capital 
   requirements relative to a quantification process with less uncertainty. The 
   degree of conservatism applied to adjust for uncertainty should be related 
   to factors such as the relevance of the reference data to a bank's existing 
   exposures, the robustness of the models, the precision of the statistical 
   estimates, and the amount of judgment used throughout the process. Margins 
   of conservatism need not be added at each step; indeed, that could produce 
   an excessively conservative result. Instead, the overall margin of conservatism 
   should adequately account for all uncertainties and weaknesses in the quantification 
   process. Improvements in the quantification process (including use of more 
   complete data and better estimation techniques) may reduce the appropriate 
   degree of conservatism over time. Judgment will inevitably play a role in the quantification process and may 
   materially affect the estimates of risk parameters. Judgmental adjustments 
   to estimates are often necessary because of some limitations on available 
   reference data or because of inherent differences between the reference data 
   and the bank's existing exposures. The bank must ensure that adjustments are 
   not biased toward optimistically low risk parameter estimates. This standard 
   does not prohibit individual adjustments that result in lower estimates of 
   risk parameters, as both upward and downward adjustments are expected. Individual 
   adjustments are less important than broad patterns; consistent signs of judgmental 
   decisions that lower risk parameter estimates materially may be evidence of 
   systematic bias, which would not be permitted. In estimating relevant risk parameters, banks should not rely on the 
   possibility of U.S. government financial assistance, except for the 
   financial assistance that the government has legally committed to provide. 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 
   internal assessment approach (IAA) for securitization exposures to ABCP programs, 
   or the internal models approach (IMA) to equity exposures must receive prior 
   written approval from its primary Federal supervisor. The criteria on which 
   approval would be based are described in the respective sections below. Operational risk
 A bank must have operational risk management processes, data and assessment 
   systems, and quantification systems that meet the qualification requirements 
   in section 22(h) of the proposed rule. A bank must have an operational risk 
   management function independent from business line management. The operational 
   risk management function is responsible for the design, implementation, and 
   oversight of the bank's operational risk data and assessment systems, operational 
   risk quantification systems, and related processes. The roles and responsibilities 
   of the operational risk management function may vary between banks, but must 
   be clearly documented. The operational risk management function should have 
   organizational stature commensurate with the bank's operational risk profile. 
   At a minimum, the bank's operational risk management function should ensure 
   the development of policies and procedures for the explicit management of 
   operational risk as a distinct risk to the bank's safety and soundness. A bank also must establish and document a process to identify, measure, monitor, 
   and control operational risk in bank products, activities, processes, and 
   systems. This process should provide for the consistent and comprehensive 
   collection of the data needed to estimate the bank's exposure to operational 
   risk. The process must also ensure reporting of operational risk exposures, 
   operational loss events, and other relevant operational risk information to 
   business unit management, senior management, and to the board of directors 
   (or a designated committee of the board). The proposed rule defines operational 
   loss events as events that result in loss and are associated with internal 
   fraud; external fraud; employment practices and workplace safety; clients, 
   products, and business practices; damage to physical assets; business disruption 
   and system failures; or execution, delivery, and process management. A bank's 
   operational risk management processes should reflect the scope and complexity 
   of its business lines, as well as its corporate organizational structure. 
   Each bank's operational risk profile is unique and requires a tailored risk 
   management approach appropriate for the scale and materiality of the operational 
   risks present in the bank.  A bank must have an operational risk data and assessment system that incorporates 
   on an ongoing basis the following four elements: internal operational loss 
   event data, external operational loss event data, results of scenario analysis, 
   and assessments of the bank's business environment and internal controls. 
   These four operational risk elements should aid the bank in identifying the 
   level and trend of operational risk, determining the effectiveness of operational 
   risk management and control efforts, highlighting opportunities to better 
   mitigate operational risk, and assessing operational risk on a forward-looking 
   basis. A bank's operational risk data and assessment system must be structured 
   in a manner consistent with the bank's current business activities, risk profile, 
   technological processes, and risk management processes. The proposed rule defines operational loss as a loss (excluding insurance 
   or tax effects) resulting from an operational loss event. Operational losses 
   include all expenses associated with an operational loss event except for 
   opportunity costs, forgone revenue, and costs related to risk management and 
   control enhancements implemented to prevent future operational losses. The 
   definition of operational loss is an important issue, as it is a critical 
   building block in a bank's calculation of its operational risk capital requirement 
   under the AMA. More specifically, under the proposed rule, the bank's estimate 
   of operational risk exposure  the basis for determining a bank's risk-weighted 
   asset amount for operational risk  is an estimate of aggregate operational 
   losses generated by the bank's AMA process. The agencies are considering whether to define operational loss based solely 
   on the effect of an operational loss event on a bank's regulatory capital 
   or to use a definition of operational loss that incorporates, to a greater 
   extent, economic capital concepts. In either case, operational losses would 
   continue to be determined exclusive of insurance and tax effects. With respect to most operational loss events, the agencies believe that the 
   operational loss amount incorporated into a bank's AMA process would be substantially 
   the same whether viewed from the perspective of its effect on the bank's regulatory 
   capital or an alternative approach that more directly incorporates economic 
   capital concepts. In the case of operational loss events associated with premises 
   and other fixed assets, however, potential loss amounts used in a bank's estimate 
   of its operational risk exposure could be considerably different under the 
   two approaches. The agencies recognize that, for purposes of economic capital 
   analysis, banks often use replacement cost or market value, and not carrying 
   value, to determine the amount of an operational loss with respect to fixed 
   assets. The use of carrying value would be consistent with a definition of 
   operational loss that covers a loss event's effect on a bank's regulatory 
   capital, but may not reflect the full economic impact of a loss event in the 
   case of assets that have a carrying value that is different from their market 
   value. Further, the agencies recognize that there is a potential to double-count 
   all or a portion of the risk-based capital requirement associated with fixed 
   assets. Under section 31(e)(3) of the proposed rule, which addresses calculation 
   of risk-weighted asset amounts for assets that are not included in an exposure 
   category, the risk-weighted asset amount for a bank's premises will equal 
   the carrying value of the premises on the financial statements of the bank, 
   determined in accordance with generally accepted accounting principales (GAAP). 
   A bank's operational risk exposure estimate 
   addressing bank premises generally will be different than the risk-based capital 
   requirement generated under section 31(e)(3) of the proposed rule and, at 
   least in part, will address the same risk exposure. Question 19: The agencies solicit comment on all aspects of the proposed 
   treatment of operational loss and, in particular, on (i) the appropriateness 
   of the proposed definition of operational loss; (ii) whether the agencies 
   should define operational loss in terms of the effect an operational loss 
   event has on the bank's regulatory capital or should consider a broader definition 
   based on economic capital concepts; and (iii) how the agencies should address 
   the potential double-counting issue for premises and other fixed assets. A bank must have a systematic process for capturing and using internal operational 
   loss event data in its operational risk data and assessment systems. Consistent 
   with the ANPR, the proposed rule defines internal operational loss event data 
   for a bank as gross operational loss amounts, dates, recoveries, and relevant 
   causal information for operational loss events occurring at the bank. A bank's 
   operational risk data and assessment system must include a minimum historical 
   observation period of five years of internal operational losses. With approval 
   of its primary Federal supervisor, however, a bank may use a shorter historical 
   observation period to address transitional situations such as integrating 
   a new business line. A bank may refrain from collecting internal operational 
   loss event data for individual operational losses below established dollar 
   threshold amounts if the bank can demonstrate to the satisfaction of its primary 
   Federal supervisor that the thresholds are reasonable, do not exclude important 
   internal operational loss event data, and permit the bank to capture substantially 
   all the dollar value of the bank's operational losses. A bank also must establish a systematic process for determining its methodologies 
   for incorporating external operational loss event data into its operational 
   risk data and assessment systems. The proposed rule defines external operational 
   loss event data for a bank as gross operational loss amounts, dates, recoveries, 
   and relevant causal information for operational loss events occurring at organizations 
   other than the bank. External operational loss event data may serve a number 
   of different purposes in a bank's operational risk data and assessment systems. 
   For example, external operational loss event data may be a particularly useful 
   input in determining a bank's level of exposure to operational risk when internal 
   operational loss event data are limited. In addition, external operational 
   loss event data provide a means for the bank to understand industry experience 
   and, in turn, provide a means for the bank to assess the adequacy of its internal 
   operational loss event data. While internal and external operational loss event data provide a historical 
   perspective on operational risk, it is also important that a bank incorporate 
   forward-looking elements in its operational risk data and assessment systems. 
   Accordingly, a bank must incorporate a business environment and internal control 
   factor analysis in its operational risk data and assessment systems to fully 
   assess its exposure to operational risk. In principle, a bank with strong 
   internal controls in a stable business environment would have less exposure 
   to operational risk than a bank with internal control weaknesses that is growing 
   rapidly or introducing new products. In this regard, a bank should identify 
   and assess the level and trends in operational risk and related control structures 
   at the bank. These assessments should be current, should be comprehensive 
   across the bank, and should identify the operational risks facing the bank. 
   The framework established by a bank to maintain these risk assessments should 
   be sufficiently flexible to accommodate increasing complexity, new activities, 
   changes in internal control systems, and an increasing volume of information. 
   A bank must also periodically compare the results of its prior business environment 
   and internal control factor assessments against the bank's actual operational 
   losses incurred in the intervening period. Similar to business environment and internal control factor assessments, the 
   results of scenario analysis provide a means for a bank to incorporate a forward-looking 
   element in its operational risk data and assessment systems. Under the proposed 
   rule, scenario analysis is a systematic process of obtaining expert opinions 
   from business managers and risk management experts to derive reasoned assessments 
   of the likelihood and loss impact of plausible high-severity operational losses 
   that may occur at a bank. A bank must establish a systematic process for determining 
   its methodologies for incorporating scenario analysis into its operational 
   risk data and assessment systems. As an input to a bank's operational risk 
   data and assessment systems, scenario analysis is especially relevant for 
   business lines or loss event types where internal data, external data, and 
   assessments of the business environment and internal control factors do not 
   provide a sufficiently robust estimate of the bank's exposure to operational 
   risk. A bank's operational risk data and assessment systems must include credible, 
   transparent, systematic, and verifiable processes that incorporate all four 
   operational risk elements. The bank should have clear standards for the collection 
   and modification of all elements. The bank should combine these four elements 
   in a manner that most effectively enables it to quantify its exposure to operational 
   risk.  A bank must have an operational risk quantification system that measures its 
   operational risk exposure using its operational risk data and assessment systems. 
   The proposed rule defines operational risk exposure as the 99.9th percentilee 
   of the distribution of potential aggregate operational losses, as generated 
   by the bank's operational risk quantification system over a one-year horizon 
   (and not incorporating eligible operational risk offsets or qualifying operational 
   risk mitigants). The mean of such a total loss distribution is the bank's 
   EOL. The proposed rule defines EOL as the expected value of the distribution 
   of potential aggregate operational losses, as generated by the bank's operational 
   risk quantification system using a one-year horizon. The bank's UOL is the 
   difference between the bank's operational risk exposure and the bank's EOL. As part of its estimation of its operational risk exposure, a bank must demonstrate 
   that its unit of measure is appropriate for the bank's range of business activities 
   and the variety of operational loss events to which it is exposed. The proposed 
   rule defines a unit of measure as the level (for example, organizational unit 
   or operational loss event type) at which the bank's operational risk quantification 
   system generates a separate distribution of potential operational losses. 
   A bank must also demonstrate that it has not combined business activities 
   or operational loss events with different risk profiles within the same loss 
   distribution. The agencies recognize that operational losses across operational loss event 
   types and business lines may be related. A bank may use its internal estimates 
   of dependence among operational losses within and across business lines and 
   operational loss event types if the bank can demonstrate to the satisfaction 
   of its primary Federal supervisor that its process for estimating dependence 
   is sound, robust to a variety of scenarios, and implemented with integrity, 
   and allows for the uncertainty surrounding the estimates. The agencies expect 
   that a bank's assumptions regarding dependence will be conservative given 
   the uncertainties surrounding dependence modeling for operational risk. If 
   a bank does not satisfy the requirements surrounding dependence described 
   above, the bank must sum operational risk exposure estimates across units 
   of measure to calculate its operational risk exposure. A bank's chosen unit of measure affects how it should account for dependence. 
   Explicit assumptions regarding dependence across units of measure are always 
   necessary to estimate operational risk exposure at the bank level. However, 
   explicit assumptions regarding dependence within units of measure are not 
   necessary, and under many circumstances models assume statistical independence 
   within each unit of measure. The use of only a few units of measure heightens 
   the need to ensure that dependence within units of measure is suitably reflected 
   in the operational risk exposure estimate. In addition, the bank's process for estimating dependence should provide for 
   ongoing monitoring, recognizing that dependence estimates can change. The 
   agencies expect that a bank's approach for developing explicit and objective 
   dependence determinations will improve over time. As such, the bank should 
   develop a process for assessing incremental improvements to the approach (for 
   example, through out-of-sample testing). A bank must review and update (as appropriate) its operational risk quantification 
   system whenever the bank becomes aware of information that may have a material 
   effect on the bank's estimate of operational risk exposure, but no less frequently 
   than annually. As described above, the agencies expect a bank using the AMA to demonstrate 
   that its systems for managing and measuring operational risk meet established 
   standards, including producing an estimate of operational risk exposure at 
   the 99.9 percent confidence level. However, the agencies recognize that, in 
   limited circumstances, there may not be sufficient data available for a bank 
   to generate a credible estimate of its own operational risk exposure at the 
   99.9 percent confidence level. In these limited circumstances, a bank may 
   propose use of an alternative operational risk quantification system to that 
   specified in section 22(h)(3)(i) of the proposed rule, subject to approval 
   by the bank's primary Federal supervisor. The alternative approach is not 
   available at the BHC level. The agencies are not prescribing specific estimation methodologies under this 
   approach and expect use of an alternative approach to occur on a very limited 
   basis. A bank proposing to use an alternative operational risk quantification 
   system must submit a proposal to its primary Federal supervisor. In evaluating 
   a bank's proposal, the bank's primary Federal supervisor will review the bank's 
   justification for requesting use of an alternative approach in light of the 
   bank's size, complexity, and risk profile. The bank's primary Federal supervisor 
   will also consider whether the proposed approach results in capital levels 
   that are commensurate with the bank's operational risk profile, is sensitive 
   to changes in the bank's risk profile, can be supported empirically, and allows 
   the bank's board of directors to fulfill its fiduciary responsibilities to 
   ensure that the bank is adequately capitalized. Furthermore, the agencies 
   expect a bank using an alternative operational risk quantification system 
   to adhere to the qualification requirements outlined in the proposed rule, 
   including establishment and use of operational risk management processes and 
   data and assessment systems. A bank proposing an alternative approach to operational risk based on an allocation 
   methodology should be aware of certain limitations associated with use of 
   such an approach. Specifically, the agencies will not accept an allocation 
   of operational risk capital requirements that includes non-DI entities or 
   the benefits of diversification across entities. The exclusion of allocations 
   that include non-DIs is in recognition that, unlike the cross-guarantee provision 
   of the Federal Deposit Insurance Act, which provides that a DI is liable for 
   any losses incurred by the FDIC in connection with the failure of a commonly-controlled 
   DI, there are no statutory provisions requiring cross-guarantees between a 
   DI and its non-DI affiliates.30 Furthermore, depositors and creditors of a DI 
   generally have no legal recourse to capital funds that are not held by the 
   DI or its affiliate DIs. Data management and maintenance
 A bank must have data management and maintenance systems that adequately support 
   all aspects of the bank's advanced IRB systems, operational risk management 
   processes, operational risk data and assessment systems, operational risk 
   quantification systems, and, to the extent the bank uses the following systems, 
   the internal models methodology to counterparty credit risk, double default 
   excessive correlation detection process, IMA to equity exposures, and IAA 
   to securitization exposures to ABCP programs (collectively, advanced systems). 
   The bank's data management and maintenance systems must ensure the timely 
   and accurate reporting of risk-based capital requirements. Specifically, a 
   bank must retain sufficient data elements to permit monitoring, validation, 
   and refinement of the bank's advanced systems. A bank's data management and 
   maintenance systems should generally support the proposed rule's qualification 
   requirements relating to quantification, validation, and control and oversight 
   mechanisms, as well as the bank's broader risk management and reporting needs. 
   The precise data elements to be collected would be dictated by the features 
   and methodologies of the risk measurement and management systems employed 
   by the bank. To meet the significant data management challenges presented 
   by the quantification, validation, and control and oversight requirements 
   of the advanced approaches, a bank must store its data in an electronic format 
   that allows timely retrieval for analysis, reporting, and disclosure purposes. Control and oversight mechanisms
 The consequences of an inaccurate or unreliable advanced system can be significant, 
   particularly on the calculation of risk-based capital requirements. Accordingly, 
   bank senior management would be responsible for ensuring that all advanced 
   system components function effectively and are in compliance with the qualification 
   requirements of the advanced approaches. Moreover, the bank's board of directors 
   (or a designated committee of the board) must evaluate at least annually the 
   effectiveness of, and approve, the bank's advanced systems. To support senior management's and the board of directors' oversight responsibilities, 
   a bank must have an effective system of controls and oversight that ensures 
   ongoing compliance with the qualification requirements and maintains the integrity, 
   reliability, and accuracy of the bank's advanced systems. Banks would have 
   flexibility in how they achieve integrity in their risk management systems. 
   They would, however, be expected to follow standard control principles in 
   their systems such as checks and balances, separation of duties, appropriateness 
   of incentives, and data integrity assurance, including that of information 
   purchased from third parties. Moreover, the oversight process should be sufficiently 
   independent of the advanced systems' development, implementation, and operation 
   to ensure the integrity of the component systems. The objective of risk management 
   system oversight is to ensure that the various systems used in determining 
   risk-based capital requirements are operating as intended. The oversight process 
   should draw conclusions on the soundness of the components of the risk management 
   system, identify errors and flaws, and recommend corrective action as appropriate.  A bank must validate its advanced systems on an ongoing basis. Validation 
   is the set of activities designed to give the greatest possible assurances 
   of accuracy of the advanced systems. Validation includes three broad components: 
   (i) evaluation of the conceptual soundness of the advanced systems, taking 
   into account industry developments; (ii) ongoing monitoring that includes 
   process verification and comparison of the bank's internal estimates with 
   relevant internal and external data sources or results using other estimation 
   techniques (benchmarking); and (iii) outcomes analysis that includes comparisons 
   of actual outcomes to the bank's internal estimates by backtesting and other 
   methods. Each of these three components of validation must be applied to the bank's 
   risk rating and segmentation systems, risk parameter quantification processes, 
   and internal models that are part of the bank's advanced systems. A sound 
   validation process should take business cycles into account, and any adjustments 
   for stages of the economic cycle should be clearly specified in advance and 
   fully documented as part of the validation policy. Senior management of the 
   bank should be notified of the validation results and should take corrective 
   action, where appropriate. A bank's validation process must be independent of the advanced systems' development, 
   implementation, and operation, or be subject to independent assessment of 
   its adequacy and effectiveness. A bank should ensure that individuals who 
   perform the review are independent  that is, are not biased in their 
   assessment due to their involvement in the development, implementation, or 
   operation of the processes or products. For example, reviews of the internal 
   risk rating and segmentation systems should be performed by individuals who 
   were not part of the development, implementation, or maintenance of those 
   systems. In addition, individuals performing the reviews should possess the 
   requisite technical skills and expertise to fulfill their mandate. The first component of validation is evaluating conceptual soundness, which 
   involves assessing the quality of the design and construction of a risk measurement 
   or management system. This evaluation of conceptual soundness should include 
   documentation and empirical evidence supporting the methods used and the variables 
   selected in the design and quantification of the bank's advanced systems. 
   The documentation should also include evidence of an understanding of the 
   limitations of the systems. The development of internal risk rating and segmentation 
   systems and their quantification processes requires banks to adopt methods, 
   choose characteristics, and make adjustments; each of these actions requires 
   judgment. Validation should ensure that these judgments are well informed 
   and considered, and generally include a body of expert opinion. A bank should 
   review developmental evidence whenever the bank makes material changes in 
   its advanced systems. The second component of the validation process for a bank's advanced systems 
   is ongoing monitoring to confirm that the systems were implemented appropriately 
   and continue to perform as intended. Such monitoring involves process verification 
   and benchmarking. Process verification includes verifying that internal and 
   external data are accurate and complete and ensuring that internal risk rating 
   and segmentation systems are being used, monitored, and updated as designed 
   and that ratings are assigned to wholesale obligors and exposures as intended, 
   and that appropriate remediation is undertaken if deficiencies exist. Benchmarking is the set of activities that uses alternative data sources or 
   risk assessment approaches to draw inferences about the correctness of internal 
   risk ratings, segmentations, risk parameter estimates, or model outputs before 
   outcomes are actually known. For credit risk ratings, examples of alternative 
   data sources include independent internal raters (such as loan review), external 
   rating agencies, wholesale and retail credit risk models developed independently, 
   or retail credit bureau models. Because it will take considerable time before 
   outcomes will be available and backtesting is possible, benchmarking will 
   be a very important validation device. Benchmarking would be applied to all 
   quantification processes and internal risk rating and segmentation activities. Benchmarking allows a bank to compare its estimates with those of other estimation 
   techniques and data sources. Results of benchmarking exercises can be a valuable 
   diagnostic tool in identifying potential weaknesses in a bank's risk quantification 
   system. While benchmarking activities allow for inferences about the appropriateness 
   of the quantification processes and internal risk rating and segmentation 
   systems, they are not the same as backtesting. When differences are observed 
   between the bank's risk estimates and the benchmark, this should not necessarily 
   indicate that the internal risk ratings, segmentation decisions, or risk parameter 
   estimates are in error. The benchmark itself is an alternative prediction, 
   and the difference may be due to different data or methods. As part of the 
   benchmarking exercise, the bank should investigate the source of the differences 
   and whether the extent of the differences is appropriate. The third component of the validation process is outcomes analysis, which 
   is the comparison of the bank's forecasts of risk parameters and other model 
   outputs with actual outcomes. A bank's outcomes analysis must include backtesting, 
   which is the comparison of the bank's forecasts generated by its internal 
   models with actual outcomes during a sample period not used in model development. 
   In this context, backtesting is one form of out-of-sample testing. The agencies 
   note that in other contexts backtesting may refer to in-sample fit, but in-sample 
   fit analysis is not what the proposed rule requires a bank to do as part of 
   the advanced approaches validation process. Actual outcomes would be compared with expected ranges around the estimated 
   values of the risk parameters and model results. Random chance and many other 
   factors will make discrepancies between realized outcomes and the estimated 
   risk parameters inevitable. Therefore the expected ranges should take into 
   account relevant elements of a bank's internal risk rating or segmentation 
   processes. For example, depending on the bank's rating philosophy, year-by-year 
   realized default rates may be expected to differ significantly from the long-run 
   one-year average. Also, changes in economic conditions between the historical 
   data and current period can lead to differences between realizations and estimates.  A bank must have an internal audit function independent of business-line management 
   that assesses at least annually the effectiveness of the controls supporting 
   the bank's advanced systems. At least annually, internal audit should review 
   the validation process, including validation procedures, responsibilities, 
   results, timeliness, and responsiveness to findings. Further, internal audit 
   should evaluate the depth, scope, and quality of the risk management system 
   review process and conduct appropriate testing to ensure that the conclusions 
   of these reviews are well founded. Internal audit must report its findings 
   at least annually to the bank's board of directors (or a committee thereof).  A bank must periodically stress test its advanced systems. Stress testing 
   analysis is a means of understanding how economic cycles, especially downturns 
   as described by stress scenarios, affect risk-based capital requirements, 
   including migration across rating grades or segments and the credit risk mitigation 
   benefits of double default treatment. Under the proposed rule, changes in 
   borrower credit quality will lead to changes in risk-based capital requirements. 
   Because credit quality changes typically reflect changing economic conditions, 
   risk-based capital requirements may also vary with the economic cycle. During 
   an economic downturn, risk-based capital requirements would increase if wholesale 
   obligors or retail exposures migrate toward lower credit quality ratings or 
   segments. Supervisors expect that banks will manage their regulatory capital position 
   so that they remain at least adequately capitalized during all phases of the 
   economic cycle. A bank that is able to credibly estimate regulatory capital 
   levels during a downturn can be more confident of appropriately managing regulatory 
   capital. Stress testing analysis consists of identifying a stress scenario 
   and then translating the scenario into its effect on the levels of key performance 
   measures, including regulatory capital ratios. Banks should use a range of plausible but severe scenarios and methods when 
   stress testing to manage regulatory capital. Scenarios could be historical, 
   hypothetical, or model-based. Key variables specified in a scenario could 
   include, for example, interest rates, transition matrices (ratings and score-band 
   segments), asset values, credit spreads, market liquidity, economic growth 
   rates, inflation rates, exchange rates, or unemployment rates. A bank may 
   choose to have scenarios apply to an entire portfolio, or it may identify 
   scenarios specific to various sub-portfolios. The severity of the stress scenarios 
   should be consistent with the periodic economic downturns experienced in the 
   bank's market areas. Such scenarios may be less severe than those used for 
   other purposes, such as testing a bank's solvency. The scope of stress testing analysis should be broad and include all material 
   portfolios. The time horizon of the analysis should be consistent with the 
   specifics of the scenario and should be long enough to measure the material 
   effects of the scenario on key performance measures. For example, if a scenario 
   such as a historical recession has material income and segment or ratings 
   migration effects over two years, the appropriate time horizon is at least 
   two years. Documentation
 A bank must document adequately all material aspects of its advanced systems, 
   including but not limited to the internal risk rating and segmentation systems, 
   risk parameter quantification processes, model design, assumptions, and validation 
   results. The guiding principle governing documentation is that it should support 
   the requirements for the quantification, validation, and control and oversight 
   mechanisms as well as the bank's broader risk management and reporting needs. 
   Documentation is also critical to the supervisory oversight process. The bank should document the rationale for all material assumptions underpinning 
   its chosen analytical frameworks, including the choice of inputs, distributional 
   assumptions, and weighting of quantitative and qualitative elements. The bank 
   also should document and justify any subsequent changes to these assumptions.  An advanced approaches bank must meet the qualification requirements on an 
   ongoing basis. Banks are expected to improve their advanced systems as they 
   improve data gathering capabilities and as industry practice evolves. To facilitate 
   the supervisory oversight of such systems changes, a bank must notify its 
   primary Federal supervisor when it makes a change to its advanced systems 
   that results in a material change in the bank's risk-weighted asset amount 
   for an exposure type, or when the bank makes any significant change to its 
   modeling assumptions. Due to the advanced approaches' rigorous systems requirements, a core or opt-in 
   bank that merges with or acquires another company that does not calculate 
   risk-based capital requirements using the advanced approaches might not be 
   able to use the advanced approaches immediately for the merged or acquired 
   company's exposures. Therefore, the proposed rule would permit a core or opt-in 
   bank to use the general risk-based capital rules to compute the risk-weighted 
   assets and associated capital for the merged or acquired company's exposures 
   for up to 24 months following the calendar quarter during which the merger 
   or acquisition consummates. Any ALLL associated with the acquired company's exposures may be included 
   in the acquiring bank's tier 2 capital up to 1.25 percent of the acquired 
   company's risk-weighted assets. Such ALLL would be excluded from the acquiring 
   bank's eligible credit reserves. The risk-weighted assets of the acquired 
   company would not be included in the acquiring bank's credit-risk-weighted 
   assets but would be included in the acquiring bank's total risk-weighted assets. 
   Any amount of the acquired company's ALLL that was eliminated in accounting 
   for the acquisition would not be included in the acquiring bank's regulatory 
   capital. An acquiring bank using the general risk-based capital rules for 
   acquired exposures would be required to disclose publicly the amounts of risk-weighted 
   assets and qualifying capital calculated under the general risk-based capital 
   rules with respect to the acquired company and under the proposed rule for 
   the acquiring bank. Similarly, due to the substantial infrastructure requirements of the proposed 
   rule, a core or opt-in bank that merges with or acquires another core or opt-in 
   bank might not be able to apply its own version of the advanced approaches 
   immediately to the acquired bank's exposures. Accordingly, the proposed rule 
   permits a core or opt-in bank that merges with or acquires another core or 
   opt-in bank to use the acquired bank's advanced approaches to determine the 
   risk-weighted asset amounts for, and deductions from capital associated with, 
   the acquired bank's exposures for up to 24 months following the calendar 
   quarter during which the merger or acquisition consummates. In all mergers and acquisitions involving a core or opt-in bank, the acquiring 
   bank must submit an implementation plan for using advanced approaches for 
   the merged or acquired company to its primary Federal supervisor within 30 days 
   of consummating the merger or acquisition. A bank's primary Federal supervisor 
   may extend the transition period for mergers or acquisitions for up to an 
   additional 12 months. The primary Federal supervisor of the bank will 
   monitor the merger or acquisition to determine whether the application of 
   the general risk-based capital rules by the acquired company produces appropriate 
   risk weights for the assets of the acquired company in light of the overall 
   risk profile of the combined bank. Question 20: The agencies seek comment on the appropriateness of the 24-month 
   and 30-day time frames for addressing the merger and acquisition transition 
   situations advanced approaches banks may face. If a bank that uses the advanced approaches to calculate its risk-based capital 
   requirements falls out of compliance with the qualification requirements, 
   the bank must establish a plan satisfactory to its primary Federal supervisor 
   to return to compliance with the qualification requirements. Such a bank also 
   must disclose to the public its failure to comply with the qualification requirements 
   promptly after receiving notice of non-compliance from its primary Federal 
   supervisor. If the bank's primary Federal supervisor determines that the bank's 
   risk-based capital requirements are not commensurate with the bank's credit, 
   market, operational, or other risks, it may require the bank to calculate 
   its risk-based capital requirements using the general risk-based capital rules 
   or a modified form of the advanced approaches (for example, with fixed supervisory 
   risk parameters).   The agencies have issued for public comment draft 
      supervisory guidance on corporate and retail exposures and operational 
      risk. See 68 FR 45949 (Aug. 4, 2003); 69 FR 62748 
      (Oct. 27, 2004).  Return to text
   The bank's primary Federal supervisor may extend 
      the bank's first floor period start date.  Return to text
   As explained below, a bank that chooses not to 
      use an internal risk rating system for ELGD and LGD for a wholesale exposure 
      must directly assign an ELGD and LGD estimate to the wholesale exposure.  Return to text
   FFIEC, "Uniform Retail Credit Classification 
      and Account Management Policy," 65 FR 36903 (June 12, 2000).  Return to text
   Under the proposal, ELGD is not the statistical 
      expected value of LGD.  Return to text
   To illustrate, suppose that for a particular 
      asset-based lending exposure the EAD equaled $100 and that for every 
      $1 owed by the obligor at the time of default the bank's recovery 
      would be $0.40. Furthermore, suppose that in the event of default 
      within a one-year horizon, pre-default paydowns of $20 would reduce the 
      exposure amount to $80 at the time of default. In this case, the bank's 
      economic loss rate measured relative to the amount owed at default (60%) 
      would exceed the economic loss rate measured relative to EAD (48% = 60% × ($100 - $20)/$100), 
      because the former does not reflect fully the impact of the pre-default 
      paydowns.  Return to text
   "Net accrued but unpaid interest and fees" 
      are accrued but unpaid interest and fees net of any amount expensed by 
      the bank as uncollectable.  Return to text
   12 U.S.C. 1815(e).  Return to text


Basel II Capital Accord Notice of Proposed Rulemaking (NPR)  Home Banking information and regulation  Accessibility Contact us  Last update: September 5, 2006