69288 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

1For simplicity, and unless otherwise indicated, 

this final rule uses the term ‘‘bank’’ to include 

banks, savings associations, and bank holding 

companies (BHCs). The terms ‘‘bank holding 

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

companies regulated by the Board and do not 

include savings and loan holding companies 

regulated by the OTS. 

DEPARTMENT OF THE TREASURY 

Office of the Comptroller of the 

Currency 

12 CFR Part 3 

[Docket No. OCC–2007–0018] 

RIN 1557–AC91 

FEDERAL RESERVE SYSTEM 

12 CFR Parts 208 and 225 

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

FEDERAL DEPOSIT INSURANCE 

CORPORATION 

12 CFR Part 325 

RIN 3064–AC73 

DEPARTMENT OF THE TREASURY 

Office of Thrift Supervision 

12 CFR Parts 559, 560, 563, and 567 

RIN 1550–AB56; Docket No. OTS 2007–0021 

Risk-Based Capital Standards: 

Advanced Capital Adequacy 

Framework — Basel II 

AGENCIES: Office of the Comptroller of 

the Currency, Treasury; Board of 

Governors of the Federal Reserve 

System; Federal Deposit Insurance 

Corporation; and Office of Thrift 

Supervision, Treasury. 

ACTION: Final rule. 

SUMMARY: The Office of the Comptroller 

of the Currency (OCC), the Board of 

Governors of the Federal Reserve 

System (Board), the Federal Deposit 

Insurance Corporation (FDIC), and the 

Office of Thrift Supervision (OTS) 

(collectively, the agencies) are adopting 

a new risk-based capital adequacy 

framework that requires some and 

permits other qualifying banks 1 to use 

an internal ratings-based approach to 

calculate regulatory credit risk capital 

requirements and advanced 

measurement approaches to calculate 

regulatory operational risk capital 

requirements. The final rule describes 

the qualifying criteria for banks required 

or seeking to operate under the new 

framework and the applicable risk-based 

capital requirements for banks that 

operate under the framework. 

DATES: This final rule is effective April 

1, 2008. 

FOR FURTHER INFORMATION CONTACT: 

OCC: Mark Ginsberg, Risk Expert, 

Capital Policy (202–927–4580) or Ron 

Shimabukuro, Senior Counsel, 

Legislative and Regulatory Activities 

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

Comptroller of the Currency, 250 E 

Street, SW., Washington, DC 20219. 

Board: Barbara Bouchard, Deputy 

Associate Director (202–452–3072 or 

barbara.bouchard@frb.gov) or Anna Lee 

Hewko, Senior Supervisory Financial 

Analyst (202–530–6260 or 

anna.hewko@frb.gov), Division of 

Banking Supervision and Regulation; or 

Mark E. Van Der Weide, Senior Counsel 

(202–452–2263 or 

mark.vanderweide@frb.gov), Legal 

Division. For users of 

Telecommunications Device for the Deaf 

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

FDIC: Jason C. Cave, Associate 

Director, Capital Markets Branch, (202) 

898–3548, Bobby R. Bean, Chief, Policy 

Section, Capital Markets Branch, (202) 

898–3575, Kenton Fox, Senior Policy 

Analyst, Capital Markets Branch, (202) 

898–7119, Division of Supervision and 

Consumer Protection; or Michael B. 

Phillips, Counsel, (202) 898–3581, 

Supervision and Legislation Branch, 

Legal Division, Federal Deposit 

Insurance Corporation, 550 17th Street, 

NW., Washington, DC 20429. 

OTS: Michael D. Solomon, Director, 

Capital Policy, Supervision Policy (202) 

906–5654; David W. Riley, Senior 

Analyst, Capital Policy (202) 906–6669; 

Austin Hong, Senior Analyst, Capital 

Policy (202) 906–6389; or Karen 

Osterloh, Special Counsel, Regulations 

and Legislation Division (202) 906– 

6639, Office of Thrift Supervision, 1700 

G Street, NW., Washington, DC 20552. 

SUPPLEMENTARY INFORMATION: 

Table of Contents 

I. Introduction 

A. Executive Summary of the Final Rule 

B. Conceptual Overview 

1. The IRB Approach for Credit Risk 

2. The AMA for Operational Risk 

C. Overview of Final Rule 

D. Structure of Final Rule 

E. Overall Capital Objectives 

F. Competitive Considerations 

II. Scope 

A. Core and Opt-In Banks 

B. U.S. Subsidiaries of Foreign Banks 

C. Reservation of Authority 

D. Principle of Conservatism 

III. Qualification 

A. The Qualification Process 

1. In General 

2. Parallel Run and Transitional Floor 

Periods 

B. Qualification Requirements 

1. Process and Systems Requirements 

2. Risk rating and Segmentation Systems 

for Wholesale and Retail Exposures 

Wholesale Exposures 

Retail Exposures 

Rating Philosophy 

Rating and Segmentation Reviews and 

Updates 

3. Quantification of Risk Parameters for 

Wholesale and Retail Exposures 

Probability of Default (PD) 

Loss Given Default (LGD) 

Expected Loss Given Default (ELGD) 

Economic Loss and Post-Default 

Extensions of Credit 

Economic Downturn Conditions 

Supervisory Mapping Function 

Pre-default Reductions in Exposure 

Exposure at Default (EAD) 

General Quantification Principles 

Portfolios With Limited Data or Limited 

Defaults 

4. Optional Approaches That Require Prior 

Supervisory Approval 

5. Operational Risk 

Operational Risk Data and Assessment 

System 

Operational risk Quantification System 

6. Data management and maintenance 

7. Control and oversight mechanisms 

Validation 

Internal Audit 

Stress Testing 

8. Documentation 

C. Ongoing Qualification 

D. Merger and Acquisition Transition 

Provisions 

IV. Calculation of Tier 1 Capital and Total 

Qualifying Capital 

V. Calculation of Risk-Weighted Assets 

A. Categorization of Exposures 

1. Wholesale Exposures 

2. Retail Exposures 

3. Securitization Exposures 

4. Equity Exposures 

5. Boundary Between Operational Risk and 

Other Risks 

6. Boundary Between the Final Rule and 

the Market Risk Rule 

B. Risk-Weighted Assets for General Credit 

Risk (Wholesale Exposures, Retail 

Exposures, On-Balance Sheet Assets that 

Are Not Defined by Exposure Category, 

and Immaterial Credit Exposures) 

1. Phase 1 — Categorization of Exposures 

2. Phase 2 — Assignment of Wholesale 

Obligors and Exposures to Rating Grades 

and retail exposures to segments 

Purchased Wholesale Exposures 

Wholesale Lease Residuals 

3. Phase 3 — Assignment of risk 

Parameters to Wholesale Obligors and 

Exposures and Retail Segments 

4. Phase 4 — Calculation of Risk-Weighted 

Assets 

5. Statutory Provisions on the Regulatory 

Capital Treatment of Certain Mortgage 

Loans 

C. Credit Risk Mitigation (CRM) 

Techniques 

1. Collateral 

2. Counterparty Credit Risk of Repo-Style 

Transactions, Eligible Margin Loans, and 

OTC Derivative Contracts 

Qualifying master netting agreement 

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Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 69289 

2The agencies also issued proposed changes to 

the risk-based capital rule for market risk in a 

separate notice of proposed rulemaking (71 FR 

55958, September 25, 2006). A final rule on that 

proposal is under development and will be issued 

in the near future. 

3The BCBS is a committee of banking supervisory 

authorities established by the central bank 

governors of the G–10 countries in 1975. The BCBS 

issued the New Accord to modernize its first capital 

Accord, which was endorsed by the BCBS members 

in 1988 and implemented by the agencies in 1989. 

The New Accord, the 1988 Accord, and other 

documents issued by the BCBS are available 

through the Bank for International Settlements’ Web 

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

4The agencies issued draft guidance on the 

advanced approaches. See 72 FR 9084 (February 28, 

2007). 

EAD for Repo-Style Transactions and 

Eligible Margin Loans 

Collateral Haircut Approach 

Simple VaR Methodology 

3. EAD for OTC derivative Contracts 

Current Exposure Methodology 

4. Internal Models Methodology 

Maturity Under the Internal Models 

Methodology 

Collateral Agreements Under the Internal 

Models Methodology 

Alternative Methods 

5. Guarantees and Credit Derivatives That 

Cover Wholesale Exposures 

Eligible Guarantees and Eligible Credit 

Derivatives 

PD Substitution Approach 

LGD Adjustment Approach 

Maturity Mismatch Haircut 

Restructuring Haircut 

Currency Mismatch Haircut 

Example 

Multiple Credit Risk Mitigants 

Double Default Treatment 

6. Guarantees and Credit Derivatives That 

Cover Retail Exposures 

D. Unsettled Securities, Foreign Exchange, 

and Commodity Transactions 

E. Securitization Exposures 

1. Hierarchy of Approaches 

Gains-on-Sale and CEIOs 

The Ratings-Based Approach (RBA) 

The Internal Assessment Approach (IAA) 

The Supervisory Formula Approach (SFA) 

Deduction 

Exceptions to the General Hierarchy of 

Approaches 

Servicer Cash Advances 

Amount of a Securitization Exposure 

Implicit Support 

Operational Requirements for Traditional 

Securitizations 

Clean-Up Calls 

Additional Supervisory Guidance 

2. Ratings-Based Approach (RBA) 

3. Internal Assessment Approach (IAA) 

4. Supervisory Formula Approach (SFA) 

General Requirements 

Inputs to the SFA Formula 

5. Eligible Disruption Liquidity Facilities 

6. CRM for Securitization Exposures 

7. Synthetic Securitizations 

Background 

Operational Requirements for Synthetic 

Securitizations 

First-Loss Tranches 

Mezzanine Tranches 

Super-Senior Tranches 

8. Nth-to-Default Credit Derivatives 

9. Early Amortization Provisions 

Background 

Controlled Early Amortization 

Non-Controlled Early Amortization 

Securitization of Revolving Residential 

Mortgage Exposures 

F. Equity Exposures 

1. Introduction and Exposure Measurement 

Hedge Transactions 

Measures of Hedge Effectiveness 

2. Simple Risk-Weight Approach (SRWA) 

Non-Significant Equity Exposures 

3. Internal Models Approach (IMA) 

IMA Qualification 

Risk-Weighted Assets Under the IMA 

4. Equity Exposures to Investment Funds 

Full Look-Through Approach 

Simple Modified Look-Through Approach 

Alternative modified look-through 

approach 

VI. Operational Risk 

VII. Disclosure 

1. Overview 

Comments on the Proposed Rule 

2. General Requirements 

Frequency/Timeliness 

Location of Disclosures and Audit/ 

Attestation Requirements 

Proprietary and Confidential Information 

3. Summary of Specific Public Disclosure 

Requirements 

4. Regulatory Reporting 

I. Introduction 

A. Executive Summary of the Final Rule 

On September 25, 2006, the agencies 

issued a joint notice of proposed 

rulemaking (proposed rule or proposal) 

(71 FR 55830) seeking public comment 

on a new risk-based regulatory capital 

framework for banks.2 The agencies 

previously issued an advance notice of 

proposed rulemaking (ANPR) related to 

the new risk-based regulatory capital 

framework (68 FR 45900, August 4, 

2003). The proposed rule was based on 

a series of releases from the Basel 

Committee on Banking Supervision 

(BCBS), culminating in the BCBS’s 

comprehensive June 2006 release 

entitled ‘‘International Convergence of 

Capital Measurement and Capital 

Standards: A Revised Framework’’ (New 

Accord).3 The New Accord sets forth a 

‘‘three pillar’’ framework encompassing 

risk-based capital requirements for 

credit risk, market risk, and operational 

risk (Pillar 1); supervisory review of 

capital adequacy (Pillar 2); and market 

discipline through enhanced public 

disclosures (Pillar 3). The New Accord 

includes several methodologies for 

determining a bank’s risk-based capital 

requirements for credit, market, and 

operational risk. 

The proposed rule included the 

advanced capital methodologies from 

the New Accord, including the 

advanced internal ratings-based (IRB) 

approach for credit risk and the 

advanced measurement approaches 

(AMA) for operational risk (together, the 

advanced approaches). The IRB 

approach uses risk parameters 

determined by a bank’s internal systems 

in the calculation of the bank’s credit 

risk capital requirements. The AMA 

relies on a bank’s internal estimates of 

its operational risks to generate an 

operational risk capital requirement for 

the bank.4

The agencies now are adopting this 

final rule implementing a new riskbased regulatory capital framework, 

based on the New Accord, that is 

mandatory for some U.S. banks and 

optional for others. While the New 

Accord includes several methodologies 

for determining risk-based capital 

requirements, the agencies are adopting 

only the advanced approaches at this 

time. 

The agencies received approximately 

90 public comments on the proposed 

rule from banking organizations, trade 

associations representing the banking or 

financial services industry, supervisory 

authorities, and other interested parties. 

This section of the preamble highlights 

several fundamental issues that 

commenters raised about the agencies’

proposal and briefly describes how the 

agencies have responded to those issues 

in the final rule. More detail is provided 

in the preamble sections below. Overall, 

commenters supported the development 

of the framework and the move to more 

risk-sensitive capital requirements. One 

overarching issue, however, was the 

areas where the proposal differed from 

the New Accord. Commenters said the 

divergences generally created 

competitive problems, raised home-host 

issues, entailed extra cost and regulatory 

burden, and did not necessarily improve 

the overall safety and soundness of 

banks subject to the rule. 

Commenters also generally disagreed 

with the agencies’ proposal to adopt 

only the advanced approaches from the 

New Accord. Further, commenters 

objected to the agencies’ retention of the 

leverage ratio, the transitional 

arrangements in the proposal, and the 

10 percent numerical benchmark for 

identifying material aggregate 

reductions in risk-based capital 

requirements to be used for evaluating 

and responding to capital outcomes 

during the parallel run and transitional 

floor periods (discussed below). 

Commenters also noted numerous 

technical issues with the proposed rule. 

As noted in an interagency press 

release issued July 20, 2007 (Banking 

Agencies Reach Agreement on Basel II 

Implementation), the agencies have 

agreed to eliminate the language from 

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5 71 FR 77445 (Dec. 26, 2006). 

the preamble concerning a 10 percent 

limitation on aggregate reductions in 

risk-based capital requirements. The 

press release also stated that the 

agencies are retaining intact the 

transitional floor periods (see preamble 

sections I.E. and III.A.2.). In addition, 

while not specifically mentioned in the 

press release, the agencies are retaining 

the leverage ratio and the prompt 

corrective action (PCA) regulations 

without modification. 

The final rule adopts without change 

the proposed criteria for identifying core 

banks (banks required to apply the 

advanced approaches) and continues to 

permit other banks (opt-in banks) to 

adopt the advanced approaches if they 

meet the applicable qualification 

requirements. Core banks are those with 

consolidated total assets (excluding 

assets held by an insurance 

underwriting subsidiary of a bank 

holding company) of $250 billion or 

more or with consolidated total onbalance-sheet foreign exposure of $10 

billion or more. A depository institution 

(DI) also is a core bank if it is a 

subsidiary of another DI or bank holding 

company that uses the advanced 

approaches. The final rule also provides 

that a bank’s primary Federal supervisor 

may determine that application of the 

final rule is not appropriate in light of 

the bank’s asset size, level of 

complexity, risk profile, or scope of 

operations (see preamble sections II.A. 

and B.). 

As noted above, the final rule 

includes only the advanced approaches. 

The July 2007 interagency press release 

stated that the agencies have agreed to 

issue a proposed rule that would 

provide non-core banks with the option 

to adopt an approach consistent with 

the standardized approach included in 

the New Accord. This new proposal (the 

standardized proposal) will replace the 

earlier proposal to adopt the so-called 

Basel IA option (Basel 1A proposal).5

The press release also noted the 

agencies’ intention to finalize the 

standardized proposal before core banks 

begin the first transitional floor period 

under this final rule. 

In response to commenters’ concerns 

that some aspects of the proposed rule 

would result in excessive regulatory 

burden without commensurate safety 

and soundness enhancements, the 

agencies included a principle of 

conservatism in the final rule. In 

general, under this principle, in limited 

situations, a bank may choose not to 

apply a provision of the rule to one or 

more exposures if the bank can 

demonstrate on an ongoing basis to the 

satisfaction of its primary Federal 

supervisor that not applying the 

provision would, in all circumstances, 

unambiguously generate a risk-based 

capital requirement for each such 

exposure that is greater than that which 

would otherwise be required under the 

regulation, and the bank meets other 

specified requirements (see preamble 

section II.D.). 

In the proposal, the agencies modified 

the definition of default for wholesale 

exposures from that in the New Accord 

to address issues commenters had raised 

on the ANPR. Commenters objected to 

the agencies’ modified definition of 

default for wholesale exposures, 

however, asserting that a definition 

different from the New Accord would 

result in competitive inequities and 

significant implementation burden 

without associated supervisory benefit. 

In response to these concerns, the 

agencies have adopted a definition of 

default for wholesale exposures that is 

consistent with the New Accord (see 

preamble section III.B.2.). For retail 

exposures, the final rule retains the 

proposed definition of default and 

clarifies that, subject to certain 

considerations, a foreign subsidiary of a 

U.S. bank may, in its consolidated riskbased capital calculations, use the 

applicable host jurisdiction definition of 

default for retail exposures of the 

foreign subsidiary in that jurisdiction 

(see preamble section III.B.2.). 

Another concept introduced in the 

proposal that was not in the New 

Accord was the expected loss given 

default (ELGD) risk parameter. ELGD 

had four functions in the proposed 

rule—as a component of the calculation 

of expected credit loss (ECL) in the 

numerator of the risk-based capital 

ratios; in the expected loss (EL) 

component of the IRB risk-based capital 

formulas; as a floor on the value of the 

loss given default (LGD) risk parameter; 

and as an input into a supervisory 

mapping function. Many commenters 

objected to the inclusion of ELGD as a 

departure from the New Accord that 

would create regulatory burden and 

competitive inequity. Many commenters 

also objected to the supervisory 

mapping function, which the agencies 

intended as an alternative for banks that 

were not able to estimate reliably the 

LGD risk parameter. The agencies have 

eliminated ELGD from the final rule. 

Banks are required to estimate only the 

LGD risk parameter, which reflects 

economic downturn conditions (see 

preamble section III.B.3.). The 

supervisory mapping function also has 

been eliminated from the rule. 

Commenters also objected to the 

agencies’ decision not to include a 

distinct risk weight function for 

exposures to small- and medium-size 

enterprises (SMEs) as provided in the 

New Accord. In the proposal, the 

agencies noted they were not aware of 

compelling evidence that smaller firms 

with the same probability of default 

(PD) and LGD as larger firms are subject 

to less systemic risk than is already 

reflected in the wholesale risk-based 

capital functions. The agencies continue 

to believe an SME-specific risk weight 

function is not supported by sufficient 

evidence and might give rise to 

competitive inequities across U.S. 

banks, and have not adopted such a 

function in the final rule (see preamble 

section V.A.1.) 

With regard to the proposed treatment 

for securitization exposures, 

commenters raised a number of 

technical issues. Many objected to the 

proposed definition of a securitization 

exposure, which included exposures to 

investment funds with material 

liabilities (including exposures to hedge 

funds). The agencies agree with 

commenters that the proposed 

definition for securitization exposures 

was quite broad and captured some 

exposures that would more 

appropriately be treated under the 

wholesale or equity frameworks. To 

limit the scope of the IRB securitization 

framework, the agencies have modified 

the definition of traditional 

securitization in the final rule as 

described in preamble section V.A.3. 

Technical issues related to 

securitization exposures are discussed 

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

For equity exposures, commenters 

focused on the proposal’s lack of a 

grandfathering period. The New Accord 

provides national discretion for each 

implementing jurisdiction to adopt a 

grandfather period for equity exposures. 

Commenters asserted that this omission 

would result in competitive inequity for 

U.S. banks as compared to other 

internationally active institutions. The 

agencies believe that, overall, the 

proposal’s approach to equity exposures 

results in a competitive risk-based 

capital requirement. The final rule does 

not include a grandfathering provision, 

and the agencies have adopted the 

proposed treatment for equity exposures 

without significant change (see 

preamble section V.F.). 

A number of commenters raised 

issues related to operational risk. Most 

significantly, commenters noted that 

activities besides securities processing 

and credit card fraud have highly 

predictable and reasonably stable losses 

and should be considered for 

operational risk offsets. The agencies 

believe that the proposed definition of 

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Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 69291 

eligible operational risk offsets allows 

for the consideration of other activities 

in a flexible and prudent manner and, 

thus, are retaining the proposed 

definition in the final rule. Commenters 

also noted that the proposal appeared to 

place limits on the use of operational 

risk mitigants. The agencies have 

provided flexibility in this regard and 

under the final rule will take into 

consideration whether a particular 

operational risk mitigant covers 

potential operational losses in a manner 

equivalent to holding regulatory capital 

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

Many commenters expressed concern 

that the proposed public disclosures 

were excessive and would hinder, rather 

than facilitate, market discipline by 

requiring banks to disclose information 

that would not be well understood by or 

useful to the market. Commenters also 

expressed concern about possible 

disclosure of proprietary information. 

The agencies believe that it is important 

to retain the vast majority of the 

proposed disclosures, which are 

consistent with the New Accord. These 

disclosures will enable market 

participants to gain key insights 

regarding a bank’s capital structure, risk 

exposures, risk assessment processes, 

and, ultimately, capital adequacy. The 

agencies have modified the final rule to 

provide flexibility regarding proprietary 

information. 

B. Conceptual Overview 

This final rule is intended to produce 

risk-based capital requirements that are 

more risk-sensitive than those produced 

under the agencies’ existing risk-based 

capital rules (general risk-based capital 

rules). In particular, the IRB approach 

requires banks to assign risk parameters 

to wholesale exposures and retail 

segments and provides specific riskbased capital formulas that must be 

used to transform these risk parameters 

into risk-based capital requirements. 

The framework is based on ‘‘value-atrisk’’ (VaR) modeling techniques that 

measure credit risk and operational risk. 

Because bank risk measurement 

practices are both continually evolving 

and subject to uncertainty, the 

framework should be viewed as an effort 

to improve the risk sensitivity of the 

risk-based capital requirements for 

banks, rather than as an effort to 

produce a statistically precise 

measurement of risk. 

The framework’s conceptual 

foundation is based on the view that 

risk can be quantified through the 

estimation of specific characteristics of 

the probability distribution of potential 

losses over a given time horizon. This 

approach assumes that a suitable 

estimate of that probability distribution, 

or at least of the specific characteristics 

to be measured, can be produced. Figure 

1 illustrates some of the key concepts 

associated with the framework. The 

figure shows a probability distribution 

of potential losses associated with some 

time horizon (for example, one year). It 

could reflect, for example, credit losses, 

operational losses, or other types of 

losses. 

The area under the curve to the right 

of a particular loss amount is the 

probability of experiencing losses 

exceeding this amount within a given 

time horizon. The figure also shows the 

statistical mean of the loss distribution, 

which is equivalent to the amount of 

loss that is ‘‘expected’’ over the time 

horizon. The concept of ‘‘expected loss’’

(EL) is distinguished from that of 

‘‘unexpected loss’’ (UL), which 

represents potential losses over and 

above the EL amount. A given level of 

UL can be defined by reference to a 

particular percentile threshold of the 

probability distribution. For example, in 

the figure UL is measured at the 99.9th 

percentile level and thus is equal to the 

value of the loss distribution 

corresponding to the 99.9th percentile, 

less the amount of EL. This is shown 

graphically at the bottom of the figure. 

The particular percentile level chosen 

for the measurement of UL is referred to 

as the ‘‘confidence level’’ or the 

‘‘soundness standard’’ associated with 

the measurement. If capital is available 

to cover losses up to and including this 

percentile level, then the bank should 

remain solvent in the face of actual 

losses of that magnitude. Typically, the 

choice of confidence level or soundness 

standard reflects a very high percentile 

level, so that there is a very low 

estimated probability that actual losses 

would exceed the UL amount associated 

with that confidence level or soundness 

standard. 

Assessing risk and assigning 

regulatory capital requirements by 

reference to a specific percentile of a 

probability distribution of potential 

losses is commonly referred to as a VaR 

approach. Such an approach was 

adopted by the FDIC, Board, and OCC 

for assessing a bank’s risk-based capital 

requirements for market risk in 1996 

(market risk rule). Under the market risk 


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6The theoretical underpinnings for the 

supervisory model of credit risk underlying the IRB 

approach are provided in a paper by Michael 

Gordy, ‘‘A Risk-Factor Model Foundation for 

Ratings-Based Bank Capital Rules,’’ Journal of 

Financial Intermediation, July 2003. The IRB 

formulas are derived as an application of these 

results to a single-factor CreditMetricsTM-style 

model. For mathematical details on this model, see 

Michael Gordy, ‘‘A Comparative Anatomy of Credit 

Risk Models,’’ Journal of Banking and Finance, 

January 2000, or H.U. Koyluogu and A. Hickman, 

‘‘Reconcilable Differences,’’ Risk, October 1998. For 

a less technical overview of the IRB formulas, see 

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

Risk Weight Functions,’’ July 2005 (BCBS 

Explanatory Note). The document can be found on 

the Bank for International Settlements Web site at 

http://www.bis.org. 

7Banks’ internal economic capital models 

typically focus on measures of equity capital, 

whereas the total regulatory capital measure 

underlying this rule includes not only equity 

capital, but also certain debt and hybrid 

instruments, such as subordinated debt. Thus, the 

99.9 percent nominal confidence level embodied in 

the IRB approach is not directly compatable to the 

nominal solvency standards underpinning banks’

economic capital models. 

rule, a bank’s own internal models are 

used to estimate the 99th percentile of 

the bank’s market risk loss distribution 

over a ten-business-day horizon. The 

bank’s market risk capital requirement 

is based on this VaR estimate, generally 

multiplied by a factor of three. The 

agencies implemented this 

multiplication factor to provide a 

prudential buffer for market volatility 

and modeling uncertainty. 

1. The IRB Approach for Credit Risk 

The conceptual foundation of this 

final rule’s approach to credit risk 

capital requirements is similar to the 

market risk rule’s approach to market 

risk capital requirements, in the sense 

that each is VaR-oriented. Nevertheless, 

there are important differences between 

the IRB approach and the market risk 

rule. The current market risk rule 

specifies a nominal confidence level of 

99.0 percent and a ten-business-day 

horizon, but otherwise provides banks 

with substantial modeling flexibility in 

determining their market risk loss 

distribution and capital requirements. In 

contrast, the IRB approach for assessing 

credit risk capital requirements is based 

on a 99.9 percent nominal confidence 

level, a one-year horizon, and a 

supervisory model of credit losses 

embodying particular assumptions 

about the underlying drivers of portfolio 

credit risk, including loss correlations 

among different asset types.6

The IRB approach is broadly similar 

to the credit VaR approaches used by a 

number of banks as the basis for their 

internal assessment of the economic 

capital necessary to cover credit risk. It 

is common for a bank’s internal credit 

risk models to consider a one-year loss 

horizon and to focus on a high loss 

threshold confidence level. As with the 

internal credit VaR models used by 

banks, the output of the risk-based 

capital formulas in the IRB approach is 

an estimate of the amount of credit 

losses above ECL over a one-year 

horizon that would only be exceeded a 

small percentage of the time. The 

agencies believe that a one-year horizon 

is appropriate because it balances the 

difficulty of easily or rapidly exiting 

non-trading positions against the 

possibility that in many cases a bank 

can cover credit losses by raising 

additional capital should the underlying 

credit problems manifest themselves 

gradually. The nominal confidence level 

of the IRB risk-based capital formulas 

(99.9 percent) means that if all the 

assumptions in the IRB supervisory 

model for credit risk were correct for a 

bank, there would be less than a 0.1 

percent probability that credit losses at 

the bank in any year would exceed the 

IRB risk-based capital requirement.7

As noted above, the supervisory 

model of credit risk underlying the IRB 

approach embodies specific 

assumptions about the economic drivers 

of portfolio credit risk at banks. As with 

any modeling approach, these 

assumptions represent simplifications of 

very complex real-world phenomena 

and, at best, are only an approximation 

of the actual credit risks at any bank. If 

these assumptions (described in greater 

detail below) are incorrect or otherwise 

do not characterize a given bank 

precisely, the actual confidence level 

implied by the IRB risk-based capital 

formulas may exceed or fall short of a 

true 99.9 percent confidence level. 

In combination with other 

supervisory assumptions and 

parameters underlying the IRB 

approach, the approach’s 99.9 percent 

nominal confidence level reflects a 

judgmental pooling of available 

information, including supervisory 

experience. The framework underlying 

this final rule reflects a desire on the 

part of the agencies to achieve (i) riskbased capital requirements that are 

reflective of relative risk across different 

assets and that are broadly consistent 

with maintaining at least an investmentgrade rating (for example, at least BBB) 

on the liabilities funding those assets, 

even in periods of economic adversity; 

and (ii) for the U.S. banking system as 

a whole, aggregate minimum regulatory 

capital requirements that are not a 

material reduction from the aggregate 

minimum regulatory capital 

requirements under the general riskbased capital rules. 

A number of important explicit 

general assumptions and specific 

parameters are built into the IRB 

approach to make the framework 

applicable to a range of banks and to 

obtain tractable information for 

calculating risk-based capital 

requirements. Chief among the 

assumptions embodied in the IRB 

approach are: (i) Assumptions that a 

bank’s credit portfolio is infinitely 

granular; (ii) assumptions that loan 

defaults at a bank are driven by a single, 

systematic risk factor; (iii) assumptions 

that systematic and non-systematic risk 

factors are log-normal random variables; 

and (iv) assumptions regarding 

correlations among credit losses on 

various types of assets. 

The specific risk-based capital 

formulas in this final rule require the 

bank to estimate certain risk parameters 

for its wholesale and retail exposures, 

which the bank may do using a variety 

of techniques. These risk parameters are 

PD, LGD, exposure at default (EAD), 

and, for wholesale exposures, effective 

remaining maturity (M). The proposed 

rule included an additional risk 

parameter, ELGD. As discussed in 

section III.B.3. of the preamble, the 

agencies have eliminated the ELGD risk 

parameter from the final rule. The riskbased capital formulas into which the 

estimated risk parameters are inserted 

are simpler than the economic capital 

methodologies typically employed by 

banks, which often require complex 

computer simulations. In particular, an 

important property of the IRB risk-based 

capital formulas is portfolio invariance. 

That is, the risk-based capital 

requirement for a particular exposure 

generally does not depend on the other 

exposures held by the bank. Like the 

general risk-based capital rules, the total 

credit risk capital requirement for a 

bank’s wholesale and retail exposures is 

the sum of the credit risk capital 

requirements on individual wholesale 

exposures and segments of retail 

exposures. 

The IRB risk-based capital formulas 

contain supervisory asset value 

correlation (AVC) factors, which have a 

significant impact on the capital 

requirements generated by the formulas. 

The AVC assigned to a given portfolio 

of exposures is an estimate of the degree 

to which any unanticipated changes in 

the financial conditions of the 

underlying obligors of the exposures are 

correlated (that is, would likely move 

up and down together). High correlation 

of exposures in a period of economic 

downturn conditions is an area of 

supervisory concern. For a portfolio of 

exposures having the same risk 

parameters, a larger AVC implies less 

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8See BCBS Explanatory Note. 

9See BCBS Explanatory Note, section 5.3. 

10 In contrast, under the general risk-based capital 

rules, the allowance for loan and lease losses 

(ALLL) may be included in tier 2 capital up to 1.25 

percent of total risk-weighted assets. 

11BCBS, ‘‘QIS 3: Third Quantitative Impact 

Study,’’ May 2003. 12BCBS press release, ‘‘Basel Committee 

maintains calibration of Base II Framework,’’ May 

24, 2006. 

diversification within the portfolio, 

greater overall systematic risk, and, 

hence, a higher risk-based capital 

requirement.8 For example, a 15 percent 

AVC for a portfolio of residential 

mortgage exposures would result in a 

lower risk-based capital requirement 

than a 20 percent AVC and a higher 

risk-based capital requirement than a 10 

percent AVC. 

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

exposures decline with increasing PD; 

that is, the IRB risk-based capital 

formulas generally imply that a group of 

low-PD wholesale exposures are more 

correlated than a group of high-PD 

wholesale exposures. Thus, under the 

rule, a low-PD wholesale exposure 

would have a higher relative risk-based 

capital requirement than that implied by 

its PD were the AVC in the IRB riskbased capital formulas for wholesale 

exposures fixed rather than a decreasing 

function of PD. The AVCs included in 

the IRB risk-based capital formulas for 

both wholesale and retail exposures 

reflect a combination of supervisory 

judgment and empirical evidence.9

However, the historical data available 

for estimating correlations among retail 

exposures, particularly for non-mortgage 

retail exposures, was more limited than 

was the case with wholesale exposures. 

As a result, supervisory judgment 

played a greater role. Moreover, the flat 

15 percent AVC for residential mortgage 

exposures is based largely on 

supervisory experience with and 

analysis of traditional long-term, fixedrate mortgages. 

Several commenters stated that the 

proposed AVCs for wholesale exposures 

were too high in general, and a few 

claimed that, in particular, the AVCs for 

multi-family residential real estate 

exposures should be lower. Other 

commenters suggested that the AVCs of 

wholesale exposures should be a 

function of obligor size rather than PD. 

Similarly, several commenters 

maintained that the proposed AVCs for 

retail exposures were too high. Some of 

these commenters suggested that the 

AVCs for qualifying revolving exposures 

(QREs), such as credit cards, should be 

in the range of 1 to 2 percent, not 4 

percent as proposed. Similarly, some of 

those commenters opposed the 

proposed flat 15 percent AVC for 

residential mortgage exposures; one 

commenter suggested that the agencies 

should consider employing lower AVCs 

for home equity loans and lines of credit 

(HELOCs) to take into account their 

shorter maturity relative to traditional 

mortgage exposures. 

However, most commenters 

recognized that the proposed AVCs 

were consistent with those in the New 

Accord and recommended that the 

agencies use the AVCs contained in the 

New Accord to avoid international 

competitive inequity and unnecessary 

burden. Several commenters suggested 

that the agencies should reconsider the 

AVCs going forward, working with the 

BCBS. 

The agencies agree with the prevailing 

view of the commenters that using the 

AVCs in the New Accord alleviates a 

potential source of international 

inconsistency and implementation 

burden. The final rule therefore 

maintains the proposed AVCs. As the 

agencies gain more experience with the 

advanced approaches, they may revisit 

the AVCs for wholesale exposures and 

retail exposures, along with other 

calibration issues identified during the 

parallel run and transitional floor 

periods (as described below) and make 

changes to the rule as necessary. The 

agencies would address this issue 

working with the BCBS and other 

supervisory and regulatory authorities, 

as appropriate. 

Another important conceptual 

element of the IRB approach concerns 

the treatment of ECL. The IRB approach 

assumes that reserves should cover ECL 

while capital should cover credit losses 

exceeding ECL (that is, unexpected 

credit losses). Accordingly, the final 

rule, consistent with the proposal and 

the New Accord, removes ECL from the 

risk-weighted assets calculation but 

requires a bank to compare its ECL to its 

eligible credit reserves (as defined 

below). If a bank’s ECL exceeds its 

eligible credit reserves, the bank must 

deduct the excess ECL amount 50 

percent from tier 1 capital and 50 

percent from tier 2 capital. If a bank’s 

eligible credit reserves exceed its ECL, 

the bank may include the excess eligible 

credit reserves amount in tier 2 capital, 

up to 0.6 percent of the bank’s credit 

risk-weighted assets.10 This treatment is 

intended to maintain a capital incentive 

to reserve prudently and ensure that 

ECL over a one-year horizon is covered 

either by reserves or capital. This 

treatment also recognizes that prudent 

reserving that considers probable losses 

over the life of a loan may result in a 

bank holding reserves in excess of ECL 

measured with a one-year horizon. The 

BCBS calibrated the 0.6 percent limit on 

inclusion of excess reserves in tier 2 

capital to be approximately as restrictive 

as the existing cap on the inclusion of 

allowance for loan and lease losses 

(ALLL) under the 1988 Accord, based 

on data obtained in the BCBS’s Third 

Quantitative Impact Study (QIS–3).11

In developing the New Accord, the 

BCBS sought broadly to maintain the 

current overall level of minimum riskbased capital requirements within the 

banking system. Using data from QIS–3, 

the BCBS conducted an analysis of the 

risk-based capital requirements that 

would be generated under the New 

Accord. Based on this analysis, the 

BCBS concluded that a ‘‘scaling factor’’

(multiplier) should apply to credit riskweighted assets. The BCBS, in the New 

Accord, indicated that the best estimate 

of the scaling factor was 1.06. In May 

2006, the BCBS decided to maintain the 

1.06 scaling factor based on the results 

of a fourth quantitative impact study 

(QIS–4) conducted in some 

jurisdictions, including the United 

States, and a fifth quantitative impact 

study (QIS–5), not conducted in the 

United States.12 The BCBS noted that 

national supervisory authorities will 

continue to monitor capital 

requirements during implementation of 

the New Accord, and that the BCBS, in 

turn, will monitor national experiences 

with the framework. 

The agencies generally agree with the 

BCBS regarding calibration of the New 

Accord. Therefore, consistent with the 

New Accord and the proposed rule, the 

final rule contains a scaling factor of 

1.06 for credit-risk-weighted assets. As 

the agencies gain more experience with 

the advanced approaches, the agencies 

will revisit the scaling factor along with 

other calibration issues identified 

during the parallel run and transitional 

floor periods (described below) and will 

make changes to the rule as necessary, 

working with the BCBS and other 

supervisory and regulatory authorities, 

as appropriate. 

2. The AMA for Operational Risk 

The final rule also includes the AMA 

for determining risk-based capital 

requirements for operational risk. Under 

the final rule (consistent with the 

proposed rule), operational risk is 

defined as the risk of loss resulting from 

inadequate or failed internal processes, 

people, and systems or from external 

events. This definition of operational 

risk includes legal risk—which is the 

risk of loss (including litigation costs, 

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69294 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

13See 12 CFR part 3.6(b) and (c) (national banks); 

12 CFR part 208, appendix B (state member banks); 

12 CFR part 225, appendix D (bank holding 

companies); 12 CFR 325.3 (state nonmember banks); 

12 CFR 567.2(a)(2) and 567.8 (savings associations). 

14See 12 CFR part 6 (national banks); 12 CFR part 

208, subpart D (state member banks); 12 CFR 

325.103 (state nonmember banks); 12 CFR part 565 

(savings associations). In addition, savings 

associations remain subject to the tangible capital 

requirement at 12 CFR 567.2(a)(3) and 567.9. 

15A CEIO is an on-balance sheet asset that, in 

form or in substance, (i) represents the contractual 

right to receive some or all of the interest and no 

more than a minimal amount of principal due on 

the underlying exposures of a securitization and (ii) 

exposes the holder to credit risk directly or 

indirectly associated with the underlying exposures 

that exceeds its pro rata claim on the underlying 

exposures, whether through subordination 

provisions or other credit-enhancement techniques. 

settlements, and regulatory fines) 

resulting from the failure of the bank to 

comply with laws, regulations, prudent 

ethical standards, and contractual 

obligations in any aspect of the bank’s 

business—but excludes strategic and 

reputational risks. 

Under the AMA, a bank must use its 

internal operational risk management 

systems and processes to assess its 

exposure to operational risk. Given the 

complexities involved in measuring 

operational risk, the AMA provides 

banks with substantial flexibility and, 

therefore, does not require a bank to use 

specific methodologies or distributional 

assumptions. Nevertheless, a bank using 

the AMA must demonstrate to the 

satisfaction of its primary Federal 

supervisor that its systems for managing 

and measuring operational risk meet 

established standards, including 

producing an estimate of operational 

risk exposure that meets a one-year, 

99.9th percentile soundness standard. A 

bank’s estimate of operational risk 

exposure includes both expected 

operational loss (EOL) and unexpected 

operational loss (UOL) and forms the 

basis of the bank’s risk-based capital 

requirement for operational risk. 

The AMA allows a bank to base its 

risk-based capital requirement for 

operational risk on UOL alone if the 

bank can demonstrate to the satisfaction 

of its primary Federal supervisor that 

the bank has eligible operational risk 

offsets, such as certain operational risk 

reserves, that equal or exceed the bank’s 

EOL. To the extent that eligible 

operational risk offsets are less than 

EOL, the bank’s risk-based capital 

requirement for operational risk must 

incorporate the shortfall. 

C. Overview of Final Rule 

The final rule maintains the general 

risk-based capital rules’ minimum tier 1 

risk-based capital ratio of 4.0 percent 

and total risk-based capital ratio of 8.0 

percent. The components of tier 1 and 

total capital in the final rule are also the 

same as in the general risk-based capital 

rules, with a few adjustments described 

in more detail below. The primary 

difference between the general riskbased capital rules and the final rule is 

the methodologies used for calculating 

risk-weighted assets. Banks applying the 

final rule generally must use their 

internal risk measurement systems to 

calculate the inputs for determining the 

risk-weighted asset amounts for (i) 

general credit risk (including wholesale 

and retail exposures); (ii) securitization 

exposures; (iii) equity exposures; and 

(iv) operational risk. In certain cases, 

however, banks must use external 

ratings or supervisory risk weights to 

determine risk-weighted asset amounts. 

Each of these areas is discussed below. 

Banks using the final rule also are 

subject to supervisory review of their 

capital adequacy (Pillar 2) and certain 

public disclosure requirements to foster 

transparency and market discipline 

(Pillar 3). In addition, each bank using 

the advanced approaches remains 

subject to the tier 1 leverage ratio 

requirement,13 and each DI (as defined 

in section 3 of the Federal Deposit 

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

the advanced approaches remains 

subject to the prompt corrective action 

(PCA) thresholds.14 Banks using the 

advanced approaches also remain 

subject to the market risk rule, where 

applicable. 

Under the final rule, a bank must 

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

retail, securitization, or equity exposure. 

Assets that are not defined by any 

exposure category (and certain 

immaterial portfolios of exposures) 

generally are assigned risk-weighted 

asset amounts equal to their carrying 

value (for on-balance sheet exposures) 

or notional amount (for off-balance 

sheet exposures). 

Wholesale exposures under the final 

rule include most credit exposures to 

companies, sovereigns, and other 

governmental entities. For each 

wholesale exposure, a bank must assign 

four quantitative risk parameters: PD 

(which is expressed as a decimal (that 

is, 0.01 corresponds to 1 percent) and is 

an estimate of the probability that an 

obligor will default over a one-year 

horizon); LGD (which is expressed as a 

decimal and reflects an estimate of the 

economic loss rate if a default occurs 

during economic downturn conditions); 

EAD (which is measured in dollars and 

is an estimate of the amount that would 

be owed to the bank at the time of 

default); and M (which is measured in 

years and reflects the effective 

remaining maturity of the exposure). 

Banks may factor into their risk 

parameter estimates the risk mitigating 

impact of collateral, credit derivatives, 

and guarantees that meet certain 

criteria. Banks must input the risk 

parameters for each wholesale exposure 

into an IRB risk-based capital formula to 

determine the risk-based capital 

requirement for the exposure. 

Retail exposures under the final rule 

include most credit exposures to 

individuals and small credit exposures 

to businesses that are managed as part 

of a segment of exposures with similar 

risk characteristics and not managed on 

an individual-exposure basis. A bank 

must classify each of its retail exposures 

into one of three retail subcategories—

residential mortgage exposures; QREs, 

such as credit cards and overdraft lines; 

and other retail exposures. Within these 

three subcategories, the bank must 

group exposures into segments with 

similar risk characteristics. The bank 

must then assign the risk parameters PD, 

LGD, and EAD to each retail segment. 

The bank may take into account the risk 

mitigating impact of collateral and 

guarantees in the segmentation process 

and in the assignment of risk parameters 

to retail segments. Like wholesale 

exposures, the risk parameters for each 

retail segment are used as inputs into an 

IRB risk-based capital formula to 

determine the risk-based capital 

requirement for the segment. 

For securitization exposures, the bank 

must apply one of three general 

approaches, subject to various 

conditions and qualifying criteria: the 

Ratings-Based Approach (RBA), which 

uses external ratings to risk-weight 

exposures; the Internal Assessment 

Approach (IAA), which uses internal 

ratings to risk-weight exposures to assetbacked commercial paper programs 

(ABCP programs); or the Supervisory 

Formula Approach (SFA), which uses 

bank inputs that are entered into a 

supervisory formula to risk-weight 

exposures. Securitization exposures in 

the form of gain-on-sale or creditenhancing interest-only strips (CEIOs)15

and securitization exposures that do not 

qualify for the RBA, the IAA, or the SFA 

must be deducted from regulatory 

capital. 

Banks may use an internal models 

approach (IMA) for determining riskbased capital requirements for equity 

exposures, subject to certain qualifying 

criteria and floors. If a bank does not 

have a qualifying internal model for 

equity exposures, or chooses not to use 

such a model, the bank must apply a 

simple risk weight approach (SRWA) in 

which publicly traded equity exposures 

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Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 69295 

16 71 FR 55981 (September 25, 2006). 

17As applicable, certain agencies are also making 

conforming changes to existing regulations as 

necessary to incorporate the new appendices. 

18 12 CFR part 3, Appendix B (for national banks), 

12 CFR part 208, Appendix E (for state member 

banks), 12 CFR part 225, Appendix E (for bank 

holding companies), and 12 CFR part 325, 

Appendix C (for state nonmember banks). OTS 

intends to codify a market risk rule for savings 

associations at 12 CFR part 567, Appendix D. 

generally are assigned a 300 percent risk 

weight and non-publicly traded equity 

exposures generally are assigned a 400 

percent risk weight. Under both the IMA 

and the SRWA, equity exposures to 

certain entities or made pursuant to 

certain statutory authorities (such as 

community development laws) are 

subject to a 0 to 100 percent risk weight. 

Banks must develop qualifying AMA 

systems to determine risk-based capital 

requirements for operational risk. Under 

the AMA, a bank must use its own 

methodology to identify operational loss 

events, measure its exposure to 

operational risk, and assess a risk-based 

capital requirement for operational risk. 

Under the final rule, a bank must 

calculate its tier 1 and total risk-based 

capital ratios by dividing tier 1 capital 

by total risk-weighted assets and by 

dividing total qualifying capital by total 

risk-weighted assets, respectively. To 

calculate total risk-weighted assets, a 

bank must first convert the dollar riskbased capital requirements for 

exposures produced by the IRB riskbased capital approaches and the AMA 

into risk-weighted asset amounts by 

multiplying the capital requirements by 

12.5 (the inverse of the overall 8.0 

percent risk-based capital requirement). 

After determining the risk-weighted 

asset amounts for credit risk and 

operational risk, a bank must sum these 

amounts and then subtract any excess 

eligible credit reserves not included in 

tier 2 capital to determine total riskweighted assets. 

The final rule contains specific public 

disclosure requirements to provide 

important information to market 

participants on the capital structure, 

risk exposures, risk assessment 

processes, and, hence, the capital 

adequacy of a bank. The public 

disclosure requirements apply only to 

the DI or bank holding company 

representing the top consolidated level 

of the banking group that is subject to 

the advanced approaches, unless the 

entity is a subsidiary of a non-U.S. 

banking organization that is subject to 

comparable disclosure requirements in 

its home jurisdiction. All banks subject 

to the rule, however, must disclose total 

and tier 1 risk-based capital ratios and 

the components of these ratios. The 

agencies also proposed a package of 

regulatory reporting templates for the 

agencies’ use in assessing and 

monitoring the levels and components 

of bank risk-based capital requirements 

under the advanced approaches.16

These templates will be finalized 

shortly. 

The agencies are aware that the fair 

value option in generally accepted 

accounting principles as used in the 

United States (GAAP) raises potential 

risk-based capital issues not 

contemplated in the development of the 

New Accord. The agencies will continue 

to analyze these issues and may make 

changes to this rule at a future date as 

necessary. The agencies would address 

these issues working with the BCBS and 

other supervisory and regulatory 

authorities, as appropriate. 

D. Structure of Final Rule 

The agencies are implementing a 

regulatory framework for the advanced 

approaches in which each agency has an 

advanced approaches appendix that 

incorporates (i) definitions of tier 1 and 

tier 2 capital and associated adjustments 

to the risk-based capital ratio 

numerators, (ii) the qualification 

requirements for using the advanced 

approaches, and (iii) the details of the 

advanced approaches.17 The agencies 

also are incorporating their respective 

market risk rules, by cross-reference.18

In this final rule, as in the proposed 

rule, the agencies are not restating the 

elements of tier 1 and tier 2 capital, 

which largely remain the same as under 

the general risk-based capital rules. 

Adjustments to the risk-based capital 

ratio numerators specific to banks 

applying the final rule are in part II of 

the rule and explained in greater detail 

in section IV of this preamble. 

The final rule has eight parts. Part I 

identifies criteria for determining which 

banks are subject to the rule, provides 

key definitions, and sets forth the 

minimum risk-based capital ratios. Part 

II describes the adjustments to the 

numerator of the regulatory capital 

ratios for banks using the advanced 

approaches. Part III describes the 

qualification process and provides 

qualification requirements for obtaining 

supervisory approval for use of the 

advanced approaches. This part 

incorporates critical elements of 

supervisory oversight of capital 

adequacy (Pillar 2). 

Parts IV through VII address the 

calculation of risk-weighted assets. Part 

IV provides the risk-weighted assets 

calculation methodologies for wholesale 

and retail exposures; on-balance sheet 

assets that do not meet the regulatory 

definition of a wholesale, retail, 

securitization, or equity exposure; and 

certain immaterial portfolios of credit 

exposures. This part also describes the 

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

repo-style transactions, and eligible 

margin loans. In addition, this part 

describes the methodologies for 

reflecting credit risk mitigation in riskweighted assets for wholesale and retail 

exposures. Furthermore, this part sets 

forth the risk-based capital requirements 

for failed and unsettled securities, 

commodities, and foreign exchange 

transactions. 

Part V identifies operating criteria for 

recognizing risk transference in the 

securitization context and outlines the 

approaches for calculating risk-weighted 

assets for securitization exposures. Part 

VI describes the approaches for 

calculating risk-weighted assets for 

equity exposures. Part VII describes the 

calculation of risk-weighted assets for 

operational risk. Finally, Part VIII 

provides public disclosure requirements 

for banks employing the advanced 

approaches (Pillar 3). 

The structure of the preamble 

generally follows the structure of the 

regulatory text. Definitions, however, 

are discussed in the portions of the 

preamble where they are most relevant. 

E. Overall Capital Objectives 

The preamble to the proposed rule 

described the agencies’ intention to 

avoid a material reduction in overall 

risk-based capital requirements under 

the advanced approaches. The agencies 

also identified other objectives, such as 

ensuring that differences in capital 

requirements appropriately reflect 

differences in risk and ensuring that the 

U.S. implementation of the New Accord 

will not be a significant source of 

competitive inequity among 

internationally active banks or among 

domestic banks operating under 

different risk-based capital rules. The 

final rule modifies and clarifies the 

approach the agencies will use to 

achieve these objectives. 

The agencies proposed a series of 

transitional floors to provide a smooth 

transition to the advanced approaches 

and to temporarily limit the amount by 

which a bank’s risk-based capital 

requirements could decline over a 

period of at least three years. The 

transitional floors are described in more 

detail in section III.A.2. of this 

preamble. The floors generally prohibit 

a bank’s risk-based capital requirement 

under the advanced approaches from 

falling below 95 percent, 90 percent, 

and 85 percent of what it would be 

under the general risk-based capital 

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

20United States Government Accountability 

Office, ‘‘Risk-Based Capital: Bank Regulators Need 

to Improve Transparency and Overcome 

Impediments to Finalizing the Proposed Basel II 

Framework’’ (GAO–07–253), February 15, 2007. 

rules during the bank’s first, second, 

and third transitional floor periods, 

respectively. The proposal stated that 

banks would be required to receive the 

approval of their primary Federal 

supervisor before entering each 

transitional floor period. 

The preamble to the proposal noted 

that if there was a material reduction in 

aggregate minimum regulatory capital 

upon implementation of the advanced 

approaches, the agencies would propose 

regulatory changes or adjustments 

during the transitional floor periods. 

The preamble further noted that in this 

context, materiality would depend on a 

number of factors, including the size, 

source, and nature of any reduction; the 

risk profiles of banks authorized to use 

the advanced approaches; and other 

considerations relevant to the 

maintenance of a safe and sound 

banking system. The agencies also 

stated that they would view a 10 percent 

or greater decline in aggregate minimum 

required risk-based capital (without 

reference to the effects of the 

transitional floors), compared to 

minimum required risk-based capital as 

determined under the general risk-based 

capital rules, as a material reduction 

warranting modification to the 

supervisory risk functions or other 

aspects of the framework. 

Further, the agencies stated that they 

were ‘‘identifying a numerical 

benchmark for evaluating and 

responding to capital outcomes during 

the parallel run and transitional floor 

periods that do not comport with the 

overall capital objectives.’’ The agencies 

also stated that ‘‘[a]t the end of the 

transitional floor periods, the agencies 

would reevaluate the consistency of the 

framework, as (possibly) revised during 

the transitional floor periods, with the 

capital goals outlined in the ANPR and 

with the maintenance of broad 

competitive parity between banks 

adopting the framework and other 

banks, and would be prepared to make 

further changes to the framework if 

warranted.’’ The agencies viewed the 

parallel run and transitional floor 

periods as ‘‘a trial of the new framework 

under controlled conditions.’’ 19

The agencies sought comment on the 

appropriateness of using a 10 percent or 

greater decline in aggregate minimum 

required risk-based capital as a 

numerical benchmark for material 

reductions when determining whether 

capital objectives were achieved. Many 

commenters objected to the proposed 

transitional floors and the 10 percent 

benchmark on the grounds that both 

safeguards deviated materially from the 

New Accord and the rules implemented 

by foreign supervisory authorities. In 

particular, commenters expressed 

concerns that the aggregate 10 percent 

limit added a degree of uncertainty to 

their capital planning process, since the 

limit was beyond the control of any 

individual bank. They maintained that 

it might take only a few banks that 

decided to reallocate funds toward 

lower-risk activities during the 

transition period to impose a penalty on 

all U.S. banks using the advanced 

approaches. Other commenters stated 

that the benchmark lacked transparency 

and would be operationally difficult to 

apply. 

Commenters also criticized the 

duration, level, and construct of the 

transitional floors in the proposed rule. 

Commenters believed it was 

inappropriate to extend the transitional 

floors by an additional year (to three 

years), and raised concerns that the 

floors were more binding than those 

proposed in the New Accord. 

Commenters strongly urged the agencies 

to adopt the transition periods and 

floors in the New Accord to limit any 

competitive inequities that could arise 

among internationally active banks. 

To better balance commenters’

concerns and the agencies’ capital 

adequacy objectives, the agencies have 

decided not to include the 10 percent 

benchmark language in this preamble. 

This will alleviate uncertainty and 

enable each bank to develop capital 

plans in accordance with its individual 

risk profile and business model. The 

agencies have taken a number of steps 

to address their capital adequacy 

objectives. Specifically, the agencies are 

retaining the existing leverage ratio and 

PCA requirements and are adopting the 

three transitional floor periods at the 

proposed numerical levels. 

Under the final rule, the agencies will 

jointly evaluate the effectiveness of the 

new capital framework. The agencies 

will issue a series of annual reports 

during the transition period that will 

provide timely and relevant information 

on the implementation of the advanced 

approaches. In addition, after the end of 

the second transition year, the agencies 

will publish a study (interagency study) 

that will evaluate the advanced 

approaches to determine if there are any 

material deficiencies. For any primary 

Federal supervisor to authorize any 

bank to exit the third transitional floor 

period, the study must determine that 

there are no such material deficiencies 

that cannot be addressed by thenexisting tools, or, if such deficiencies 

are found, they must be first remedied 

by changes to regulation. 

Notwithstanding the preceding 

sentence, a primary Federal supervisor 

that disagrees with the finding of 

material deficiency may not authorize a 

bank under its jurisdiction to exit the 

third transitional floor period unless the 

supervisor first provides a public report 

explaining its reasoning. 

The agencies intend to establish a 

transparent and collaborative process 

for conducting the interagency study, 

consistent with the recommendations 

made by the U.S. Government 

Accountability Office (GAO) in its 

report on implementation of the New 

Accord in the United States.20 In 

conducting the interagency study the 

agencies would consider, for example, 

the following: 

• The level of minimum required 

regulatory capital under U.S. advanced 

approaches compared to the capital 

required by other international and 

domestic regulatory capital standards. 

• Peer comparisons of minimum 

regulatory capital requirements, 

including but not limited to banks’

estimates of risk parameters for 

portfolios of similar risk. 

• The processes banks use to develop 

and assess risk parameters and 

advanced systems, and supervisory 

assessments of their accuracy and 

reliability. 

• Potential cyclical implications. 

• Changes in portfolio composition or 

business mix, including those that 

might result in changes in capital 

requirements per dollar of credit 

exposure. 

• Comparison of regulatory capital 

requirements to market-based measures 

of capital adequacy to assess relative 

minimum capital requirements across 

banks and broad asset categories. 

Market-based measures might include 

credit default swap spreads, 

subordinated debt spreads, external 

rating agency ratings, and other market 

measures of risk. 

• Examination of the quality and 

robustness of advanced risk 

management processes related to 

assessment of capital adequacy, as in 

the comprehensive supervisory 

assessments performed under Pillar 2. 

• Additional reviews, including 

analysis of interest rate and 

concentration risks that might suggest 

the need for higher regulatory capital 

requirements. 

F. Competitive Considerations 

A fundamental objective of the New 

Accord is to strengthen the soundness 

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21See 68 FR 45900 (Aug. 4, 2003), 70 FR 61068 

(Oct. 20, 2005), 71 FR 55830 (Sept. 25, 2006), and 

71 FR 77446 (Dec. 26, 2006). 22See 71 FR 77518 (Dec. 26, 2006). 

and stability of the international 

banking system while maintaining 

sufficient consistency in capital 

adequacy regulation to ensure that the 

New Accord will not be a significant 

source of competitive inequity among 

internationally active banks. The 

agencies support this objective and 

believe that it is important to promote 

continual advancement of the risk 

measurement and management practices 

of large and internationally active 

banks. 

While all banks should work to 

enhance their risk management 

practices, the advanced approaches and 

the systems required to support their 

use may not be appropriate for many 

banks from a cost-benefit point of view. 

For a number of banks, the agencies 

believe that the general risk-based 

capital rules continue to provide a 

reasonable alternative for regulatory 

risk-based capital measurement 

purposes. However, the agencies 

recognize that a bifurcated risk-based 

capital framework inevitably raises 

competitive considerations. The 

agencies have received comments on 

risk-based capital proposals issued in 

the past several years 21 stating that for 

some portfolios, competitive inequities 

would be worse under a bifurcated 

framework. These commenters 

expressed concern that banks operating 

under the general risk-based capital 

rules would be at a competitive 

disadvantage relative to banks applying 

the advanced approaches because the 

IRB approach would likely result in 

lower risk-based capital requirements 

for certain types of exposures. 

The agencies recognize the potential 

competitive inequities associated with a 

bifurcated risk-based capital framework. 

As part of their effort to develop a riskbased capital framework that minimizes 

competitive inequities and is not 

disruptive to the banking sector, the 

agencies issued the Basel IA proposal in 

December 2006. The Basel IA proposal 

included modifications to the general 

risk-based capital rules to improve risk 

sensitivity and to reduce potential 

competitive disparities between 

domestic banks subject to the advanced 

approaches and domestic banks not 

subject to the advanced approaches. 

Recognizing that some banks might 

prefer not to incur the additional 

regulatory burden of moving to 

modified capital rules, the Basel IA 

proposal retained the existing general 

risk-based capital rules and permitted 

banks to opt in to the modified rules. 

The agencies extended the comment 

period for the advanced approaches 

proposal to coincide with the comment 

period on the Basel IA proposal so that 

commenters would have an opportunity 

to analyze the effects of the two 

proposals concurrently.22

Seeking to minimize potential 

competitive inequities and regulatory 

burden, a number of commenters on 

both the advanced approaches proposal 

and the Basel IA proposal urged the 

agencies to adopt all of the approaches 

included in the New Accord—including 

the foundation IRB and standardized 

approaches for credit risk and the 

standardized and basic indicator 

approaches for operational risk. In 

response to these comments, the 

agencies have decided to issue a new 

standardized proposal, which would 

replace the Basel IA proposal for banks 

that do not apply the advanced 

approaches. The standardized proposal 

would allow banks that are not core 

banks to implement a standardized 

approach for credit risk and an 

approach to operational risk consistent 

with the New Accord. Like the Basel IA 

proposal, the standardized proposal will 

retain the existing general risk-based 

capital rules for those banks that do not 

wish to move to the new rules. The 

agencies expect to issue the 

standardized proposal in the first 

quarter of 2008. 

A number of commenters expressed 

concern about competitive inequities 

among internationally active banks 

arising from differences in 

implementation and application of the 

New Accord by supervisory authorities 

in different countries. In particular, 

some commenters asserted that the 

proposed U.S. implementation would be 

different from other countries in a 

number of key areas, such as the 

definition of default, and that these 

differences would give rise to 

substantial implementation cost and 

burden. Other commenters continued to 

raise concern about the delayed 

implementation schedule in the United 

States. 

As discussed in more detail 

throughout this preamble, the agencies 

have made a number of changes from 

the proposal to conform the final rule 

more closely to the New Accord. These 

changes should help minimize 

regulatory burden and mitigate potential 

competitive inequities across national 

jurisdictions. In addition, the BCBS has 

established an Accord Implementation 

Group, comprised of supervisors from 

member countries, whose primary 

objectives are to work through 

implementation issues, maintain a 

constructive dialogue about 

implementation processes, and 

harmonize approaches as much as 

possible within the range of national 

discretion embedded in the New 

Accord. The BCBS also has established 

a Capital Interpretation Group to foster 

consistency in applying the New Accord 

on an ongoing basis. The agencies 

intend to participate fully in these 

groups to ensure that issues relating to 

international implementation and 

competitive effects are addressed. While 

supervisory judgment will play a critical 

role in the evaluation of risk 

measurement and management practices 

at individual banks, supervisors remain 

committed to and have made significant 

progress toward developing protocols 

and information-sharing arrangements 

that should minimize burdens on banks 

operating in multiple countries and 

ensure that supervisory authorities are 

implementing the New Accord as 

consistently as possible. 

With regard to implementation timing 

concerns, the agencies believe that the 

transitional arrangements described in 

preamble section III.A.2. below provide 

a prudent and reasonable framework for 

moving to the advanced approaches. 

Where international implementation 

differences affect an individual bank, 

the agencies are working with the bank 

and appropriate national supervisory 

authorities to ensure that 

implementation proceeds as efficiently 

as possible. 

II. Scope 

The agencies have identified three 

groups of banks: (i) Large or 

internationally active banks that are 

required to adopt the advanced 

approaches (core banks); (ii) banks that 

voluntarily decide to adopt the 

advanced approaches (opt-in banks); 

and (iii) banks that do not adopt the 

advanced approaches (general banks). 

Each core and opt-in bank is required to 

meet certain qualification requirements 

to the satisfaction of its primary Federal 

supervisor, which in turn will consult 

with other relevant supervisors, before 

the bank may use the advanced 

approaches for risk-based capital 

purposes. 

Pillar 1 of the New Accord requires all 

banks subject to the New Accord to 

calculate capital requirements for 

exposure to credit risk and operational 

risk. The New Accord sets forth three 

approaches to calculating the credit risk 

capital requirement and three 

approaches to calculating the 

operational risk capital requirement. 

Outside the United States, countries that 

are replacing Basel I with the New 

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69298 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

23OTS does not currently impose any explicit 

capital requirements on savings and loan holding 

companies and is not implementing the advanced 

approaches for these holding companies. 

Accord generally have required all 

banks to comply with the New Accord, 

but have provided banks the option of 

choosing among the New Accord’s 

various approaches for calculating 

credit risk and operational risk capital 

requirements. 

For banks in the United States, the 

agencies have taken a different 

approach. This final rule focuses on the 

largest and most internationally active 

banks and requires those banks to 

comply with the most advanced 

approaches for calculating credit and 

operational risk capital requirements 

(the IRB and the AMA). The final rule 

allows other U.S. banks to ‘‘opt in’’ to 

the advanced approaches. The agencies 

have decided at this time to require 

large, internationally active U.S. banks 

to use the most advanced approaches of 

the New Accord. The less advanced 

approaches of the New Accord lack the 

degree of risk sensitivity of the 

advanced approaches. The agencies 

have the view that risk-sensitive 

regulatory capital requirements are 

integral to ensuring that large, 

sophisticated banks and the financial 

system have an adequate capital 

cushion to absorb financial losses. Also, 

the advanced approaches provide more 

substantial incentives for banks to 

improve their risk measurement and 

management practices than do the other 

approaches. The agencies do not believe 

that competitive equity concerns are 

sufficiently compelling to warrant 

permitting large, internationally active 

U.S. banks to adopt the standardized 

approaches in the New Accord. 

A. Core and Opt-In Banks 

Under section 1(b) of the proposed 

rule, a DI would be a core bank if it met 

either of two independent threshold 

criteria: (i) Consolidated total assets of 

$250 billion or more, as reported on the 

most recent year-end regulatory reports; 

or (ii) consolidated total on-balance 

sheet foreign exposure of $10 billion or 

more at the most recent year end. To 

determine total on-balance sheet foreign 

exposure, a bank would sum its 

adjusted cross-border claims, local 

country claims, and cross-border 

revaluation gains calculated in 

accordance with the Federal Financial 

Institutions Examination Council 

(FFIEC) Country Exposure Report 

(FFIEC 009). Adjusted cross-border 

claims would equal total cross-border 

claims less claims with the head office 

or guarantor located in another country, 

plus redistributed guaranteed amounts 

to the country of head office or 

guarantor. The agencies also proposed 

that a DI would be a core bank if it is 

a subsidiary of another DI or BHC that 

uses the advanced approaches. 

Under the proposed rule, a U.S.- 

chartered BHC23 would be a core bank 

if the BHC had: (i) Consolidated total 

assets (excluding assets held by an 

insurance underwriting subsidiary) of 

$250 billion or more, as reported on the 

most recent year-end regulatory reports; 

(ii) consolidated total on-balance sheet 

foreign exposure of $10 billion or more 

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

subsidiary DI that is a core bank or optin bank. 

The agencies included a question in 

the proposal seeking commenters’ views 

on using consolidated total assets 

(excluding assets held by an insurance 

underwriting subsidiary) as one 

criterion to determine whether a BHC 

would be viewed as a core BHC. Some 

of the commenters addressing this issue 

supported the proposed approach, 

noting it was a reasonable proxy for 

mandatory applicability of a framework 

designed to measure capital 

requirements for consolidated risk 

exposures of a BHC. Other commenters, 

particularly foreign banking 

organizations and their trade 

associations, contended that the BHC 

asset size threshold criterion instead 

should be $250 billion of assets in U.S. 

subsidiary DIs. These commenters 

further suggested that if the Board kept 

the proposed $250 billion consolidated 

total BHC assets criterion, it should 

limit the scope of this criterion to BHCs 

with a majority of their assets in U.S. DI 

subsidiaries. The Board has decided to 

retain the proposed approach using 

consolidated total assets (excluding 

assets held by an insurance 

underwriting subsidiary) as one 

threshold criterion for BHCs in this final 

rule. This approach recognizes that 

BHCs can hold similar assets within and 

outside of DIs and reduces potential 

incentives to structure BHC assets and 

activities to arbitrage capital regulations. 

The final rule continues to exclude 

assets held in an insurance 

underwriting subsidiary of a BHC from 

the asset threshold because the 

advanced approaches were not designed 

to address insurance underwriting 

exposures. 

The final rule also retains the 

threshold criterion for core bank/BHC 

status of consolidated total on-balance 

sheet foreign exposure of $10 billion or 

more at the most recent year-end. The 

calculation of this exposure amount is 

unchanged in the final rule. 

In the preamble to the proposed rule, 

the agencies also included a question on 

potential regulatory burden associated 

with requiring a bank that applies the 

advanced approaches to implement the 

advanced approaches at each subsidiary 

DI—even if those subsidiary DIs do not 

individually meet a threshold criterion. 

A number of commenters addressed this 

issue. While they expressed a range of 

views, most commenters maintained 

that small DI subsidiaries of core banks 

should not be required to implement the 

advanced approaches. Rather, 

commenters asserted that these DIs 

should be permitted to use simpler 

methodologies, such as the New 

Accord’s standardized approach. 

Commenters asserted there would be 

regulatory burden and costs associated 

with the proposed push-down 

approach, particularly if a stand-alone 

AMA is required at each DI. 

The agencies have considered 

comments on this issue and have 

decided to retain the proposed 

approach. Thus, under the final rule, 

each DI subsidiary of a core or opt-in 

bank is itself a core bank required to 

apply the advanced approaches. The 

agencies believe that this approach 

serves as an important safeguard against 

regulatory capital arbitrage among 

affiliated banks that would otherwise be 

subject to substantially different capital 

rules. Moreover, to calculate its 

consolidated IRB risk-based capital 

requirements, a bank must estimate risk 

parameters for all credit exposures 

within the bank except for exposures in 

portfolios that, in the aggregate, are 

immaterial to the bank. Because the 

consolidated bank must already 

estimate risk parameters for all material 

portfolios of wholesale and retail 

exposures in all of its consolidated 

subsidiaries, the agencies believe that 

there is limited additional regulatory 

burden associated with application of 

the IRB approach at each subsidiary DI. 

Likewise, to calculate its consolidated 

AMA risk-based capital requirements, a 

bank must estimate its operational risk 

exposure using a unit of measure 

(defined below) that does not combine 

business activities or operational loss 

events with demonstrably different risk 

profiles within the same loss 

distribution. Each subsidiary DI could 

have a demonstrably different risk 

profile that would require the 

generation of separate loss distributions. 

However, the agencies recognize there 

may be situations where application of 

the advanced approaches at an 

individual DI subsidiary of an advanced 

approaches bank may not be 

appropriate. Therefore, the final rule 

includes the proposed provision that 

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24The Board notes that it generally does not 

apply regulatory capital requirements to subsidiary 

BHCs of top-tier U.S. BHCs, regardless of whether 

the top-tier U.S. BHC is itself a subsidiary of a 

foreign banking organization. 

25SR 01–01, ‘‘Application of the Board’s Capital 

Adequacy Guidelines to Bank Holding Companies 

Owned by Foreign Banking Organizations,’’ January 

5, 2001. 

permits a core or opt-in bank’s primary 

Federal supervisor to determine in 

writing that application of the advanced 

approaches is not appropriate for the DI 

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

complexity, risk profile, or scope of 

operations. 

B. U.S. Subsidiaries of Foreign Banks 

Under the proposed rule, any U.S.- 

chartered DI that is a subsidiary of a 

foreign banking organization would be 

subject to the U.S. regulatory capital 

requirements for domestically-owned 

U.S. DIs. Thus, if the U.S. DI subsidiary 

of a foreign banking organization met 

any of the threshold criteria, it would be 

a core bank and would be subject to the 

advanced approaches. If it did not meet 

any of the criteria, the U.S. DI could 

remain a general bank or could opt in 

to the advanced approaches, subject to 

the same qualification process and 

requirements as a domestically-owned 

U.S. DI. 

The proposed rule also provided that 

a top-tier U.S. BHC, and its subsidiary 

DIs, that was owned by a foreign 

banking organization would be subject 

to the same threshold levels for core 

bank determination as a top-tier BHC 

that is not owned by a foreign banking 

organization.24 The preamble noted that 

a U.S. BHC that met the conditions in 

Federal Reserve SR letter 01–01 25 and 

that was a core bank would not be 

required to meet the minimum capital 

ratios in the Board’s capital adequacy 

guidelines, although it would be 

required to adopt the advanced 

approaches, compute and report its 

capital ratios in accordance with the 

advanced approaches, and make the 

required public and regulatory 

disclosures. A DI subsidiary of such a 

U.S. BHC also would be a core bank and 

would be required to adopt the 

advanced approaches and meet the 

minimum capital ratio requirements. 

Under the final rule, consistent with 

SR 01–01, a foreign-owned U.S. BHC 

that is a core bank and that also is 

subject to SR 01–01 will, as a technical 

matter, be required to adopt the 

advanced approaches, and compute and 

report its capital ratios and make other 

required disclosures. It will not, 

however, be required to maintain the 

minimum capital ratios at the U.S. 

consolidated holding company level 

unless otherwise required to do so by 

the Board. In response to the potential 

burden issues identified by commenters 

and outlined above, the Board notes that 

the final rule allows the Board to 

exempt any BHC from mandatory 

application of the advanced approaches. 

The Board will make such a 

determination in light of the BHC’s asset 

size (including subsidiary DI asset size 

relative to total BHC asset size), level of 

complexity, risk profile, or scope of 

operation. Similarly, the final rule 

allows a primary Federal supervisor to 

exempt any DI under its jurisdiction 

from mandatory application of the 

advanced approaches. A primary 

Federal supervisor will consider the 

same factors in making its 

determination. 

C. Reservation of Authority 

The proposed rule restated the 

authority of a bank’s primary Federal 

supervisor to require a bank to hold an 

overall amount of capital greater than 

would otherwise be required under the 

rule if the agency determined that the 

bank’s risk-based capital requirements 

were not commensurate with the bank’s 

credit, market, operational, or other 

risks. In addition, the preamble of the 

proposed rule noted the agencies’

expectation that there may be instances 

when the rule would generate a riskweighted asset amount for specific 

exposures that is not commensurate 

with the risks posed by such exposures. 

Accordingly, under the proposed rule, 

the bank’s primary Federal supervisor 

would retain the authority to require the 

bank to use a different risk-weighted 

asset amount for the exposures or to use 

different risk parameters (for wholesale 

or retail exposures) or model 

assumptions (for modeled equity or 

securitization exposures) than those 

required when calculating the riskweighted asset amount for those 

exposures. Similarly, the proposed rule 

provided explicit authority for a bank’s 

primary Federal supervisor to require 

the bank to assign a different riskweighted asset amount for operational 

risk, to change elements of its 

operational risk analytical framework 

(including distributional and 

dependence assumptions), or to make 

other changes to the bank’s operational 

risk management processes, data and 

assessment systems, or quantification 

systems if the supervisor found that the 

risk-weighted asset amount for 

operational risk produced by the bank 

under the rule was not commensurate 

with the operational risks of the bank. 

Any agency that exercised a reservation 

of authority was expected to notify each 

of the other agencies of its 

determination. 

Several commenters raised concerns 

with the scope of the reservation of 

authority, particularly as it would apply 

to operational risk. These commenters 

asserted, for example, that the agencies 

should address identified operational 

risk-related capital deficiencies through 

Pillar 2, rather than through requiring a 

bank to adjust input variables or 

techniques used for the calculation of 

Pillar 1 operational risk capital 

requirements. Commenters were 

concerned that excessive agency Pillar 1 

intervention on operational risk might 

inhibit innovation. 

While the agencies agree that 

innovation is important and that general 

supervisory oversight likely would be 

sufficient in many cases to address riskrelated capital deficiencies, the agencies 

also believe that it is important to retain 

as much supervisory flexibility as 

possible as they move forward with 

implementation of the final rule. In 

general, the proposed reservation of 

authority represented a reaffirmation of 

the current authority of a bank’s primary 

Federal supervisor to require the bank to 

hold an overall amount of regulatory 

capital or maintain capital ratios greater 

than would be required under the 

general risk-based capital rules. There 

may be cases where requiring a bank to 

assign a different risk-weighted asset 

amount for operational risk may not 

sufficiently address problems associated 

with underlying quantification practices 

and may cause an ongoing misalignment 

between the operational risk of a bank 

and the risk-weighted asset amount for 

operational risk generated by the bank’s 

operational risk quantification system. 

In view of this and the inherent 

flexibility provided for operational risk 

measurement under the AMA, the 

agencies believe it is appropriate to 

articulate the specific measures a 

primary Federal supervisor may take if 

it determines that a bank’s risk-weighted 

asset amount for operational risk is not 

commensurate with the operational 

risks of the bank. Therefore, the final 

rule retains the reservation of authority 

as proposed. The agencies emphasize 

that any decision to exercise this 

authority would be made judiciously 

and that a bank bears the primary 

responsibility for maintaining the 

integrity, reliability, and accuracy of its 

risk management and measurement 

systems. 

D. Principle of Conservatism 

Several commenters asked whether it 

would be permissible not to apply an 

aspect of the rule for cost or regulatory 

burden reasons, if the result would be 

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69300 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

26The bank’s primary Federal supervisor may 

extend the bank’s first transitional floor period start 

date. 

a more conservative capital 

requirement. For example, for purposes 

of the RBA for securitization exposures, 

some commenters asked whether a bank 

could choose not to track the seniority 

of a securitization exposure and, 

instead, assume that the exposure is not 

a senior securitization exposure. 

Similarly, some commenters asked if 

risk-based capital requirements for 

certain exposures could be calculated 

ignoring the benefits of risk mitigants 

such as collateral or guarantees. 

The agencies believe that in some 

cases it may be reasonable to allow a 

bank to implement a simplified capital 

calculation if the result is more 

conservative than would result from a 

comprehensive application of the rule. 

Under a new section 1(d) of the final 

rule, a bank may choose not to apply a 

provision of the rule to one or more 

exposures provided that (i) the bank can 

demonstrate on an ongoing basis to the 

satisfaction of its primary Federal 

supervisor that not applying the 

provision would, in all circumstances, 

unambiguously generate a risk-based 

capital requirement for each exposure 

greater than that which would otherwise 

be required under this final rule, (ii) the 

bank appropriately manages the risk of 

those exposures, (iii) the bank provides 

written notification to its primary 

Federal supervisor prior to applying this 

principle to each exposure, and (iv) the 

exposures to which the bank applies 

this principle are not, in the aggregate, 

material to the bank. 

The agencies emphasize that a 

conservative capital requirement for a 

group of exposures does not reduce the 

need for appropriate risk management of 

those exposures. Moreover, the 

principle of conservatism applies to the 

determination of capital requirements 

for specific exposures; it does not apply 

to the qualification or disclosure 

requirements in sections 22 and 71 of 

the final rule. Sections V.A.1., V.A.3., 

and V.E.2. of this preamble contain 

examples of the appropriate use of this 

principle of conservatism. 

III. Qualification 

A. The Qualification Process 

1. In General 

Supervisory qualification to use the 

advanced approaches is an iterative and 

ongoing process that begins when a 

bank’s board of directors adopts an 

implementation plan and continues as 

the bank operates under the advanced 

approaches. Under the final rule, as 

under the proposal, a bank must 

develop and adopt a written 

implementation plan, establish and 

maintain a comprehensive and sound 

planning and governance process to 

oversee the implementation efforts 

described in the plan, demonstrate to its 

primary Federal supervisor that it meets 

the qualification requirements in section 

22 of the final rule, and complete a 

satisfactory ‘‘parallel run’’ (discussed 

below) before it may use the advanced 

approaches for risk-based capital 

purposes. A bank’s primary Federal 

supervisor is responsible, after 

consultation with other relevant 

supervisors, for evaluating the bank’s 

initial and ongoing compliance with the 

qualification requirements for the 

advanced approaches. 

Under the final rule, as under the 

proposed rule, a bank preparing to 

implement the advanced approaches 

must adopt a written implementation 

plan, approved by its board of directors, 

describing in detail how the bank 

complies, or intends to comply, with the 

qualification requirements. A core bank 

must adopt a plan no later than six 

months after it meets a threshold 

criterion in section 1(b)(1) of the final 

rule. If a bank meets a threshold 

criterion on the effective date of the 

final rule, the bank would have to adopt 

a plan within six months of the effective 

date. Banks that do not meet a threshold 

criterion, but are nearing any criterion 

by internal growth or merger, are 

expected to engage in ongoing dialogue 

with their primary Federal supervisor 

regarding implementation strategies to 

ensure their readiness to adopt the 

advanced approaches when a threshold 

criterion is reached. An opt-in bank may 

adopt an implementation plan at any 

time. Under the final rule, each core and 

opt-in bank must submit its 

implementation plan, together with a 

copy of the minutes of the board of 

directors’ approval of the plan, to its 

primary Federal supervisor at least 60 

days before the bank proposes to begin 

its parallel run, unless the bank’s 

primary Federal supervisor waives this 

prior notice provision. The submission 

to the primary Federal supervisor 

should indicate the date that the bank 

proposes to begin its parallel run. 

In developing an implementation 

plan, a bank must assess its current state 

of readiness relative to the qualification 

requirements in this final rule. This 

assessment must include a gap analysis 

that identifies where additional work is 

needed and a remediation or action plan 

that clearly sets forth how the bank 

intends to fill the gaps it has identified. 

The implementation plan must 

comprehensively address the 

qualification requirements for the bank 

and each of its consolidated subsidiaries 

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

all portfolios and exposures of the bank 

and each of its consolidated 

subsidiaries. The implementation plan 

must justify and support any proposed 

temporary or permanent exclusion of a 

business line, portfolio, or exposure 

from the advanced approaches. The 

business lines, portfolios, and exposures 

that the bank proposes to exclude from 

the advanced approaches must be, in 

the aggregate, immaterial to the bank. 

The implementation plan must include 

objective, measurable milestones 

(including delivery dates and a date 

when the bank’s implementation of the 

advanced approaches will be fully 

operational). For core banks, the 

implementation plan must include an 

explicit first transitional floor period 

start date that is no later than 36 months 

after the later of the effective date of the 

rule or the date the bank meets at least 

one of the threshold criteria.26 Further, 

the implementation plan must describe 

the resources that the bank has budgeted 

and that are available to implement the 

plan. 

The proposed rule allowed a bank to 

exclude a portfolio of exposures from 

the advanced approaches if the bank 

could demonstrate to the satisfaction of 

its primary Federal supervisor that the 

portfolio, when combined with all other 

portfolios of exposures that the bank 

sought to exclude from the advanced 

approaches, was not material to the 

bank. Some commenters asserted that a 

bank should be permitted to exclude 

from the advanced approaches any 

business line, portfolio, or exposure that 

is immaterial on a stand-alone basis 

(regardless of whether the excluded 

exposures in the aggregate are material 

to the bank). The agencies believe that 

it is not appropriate for a bank to 

permanently exclude a material portion 

of its exposures from the enhanced risk 

sensitivity and risk measurement and 

management requirements of the 

advanced approaches. Accordingly, the 

final rule retains the requirement that 

the business lines, portfolios, and 

exposures that the bank proposes to 

exclude from the advanced approaches 

must be, in the aggregate, immaterial to 

the bank. 

During implementation of the 

advanced approaches, a bank should 

work closely with its primary Federal 

supervisor to ensure that its risk 

measurement and management systems 

are functional and reliable and are able 

to generate risk parameter estimates that 

can be used to calculate the risk-based 

capital ratios correctly under the 

advanced approaches. The 

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implementation plan, including the gap 

analysis and action plan, will provide a 

basis for ongoing supervisory dialogue 

and review during the qualification 

process. The primary Federal supervisor 

will assess a bank’s progress relative to 

its implementation plan. To the extent 

that adjustments to target dates are 

needed, these adjustments should be 

made subject to the ongoing supervisory 

discussion between the bank and its 

primary Federal supervisor. 

2. Parallel Run and Transitional Floor 

Periods 

Under the proposed and final rules, 

once a bank has adopted its 

implementation plan, it must complete 

a satisfactory parallel run before it may 

use the advanced approaches to 

calculate its risk-based capital 

requirements. The proposed rule 

defined a satisfactory parallel run as a 

period of at least four consecutive 

calendar quarters during which a bank 

complied with all of the qualification 

requirements to the satisfaction of its 

primary Federal supervisor. 

Many commenters objected to the 

proposed requirement that the bank had 

to meet all of the qualification 

requirements before it could begin the 

parallel run period. The agencies 

recognize that certain qualification 

requirements, such as outcomes 

analysis, become more meaningful as a 

bank gains experience employing the 

advanced approaches. The agencies 

therefore are modifying the definition of 

a satisfactory parallel run in the final 

rule. Under the final rule, a satisfactory 

parallel run is a period of at least four 

consecutive calendar quarters during 

which the bank complies with the 

qualification requirements to the 

satisfaction of its primary Federal 

supervisor. This revised definition, 

which does not contain the word ‘‘all,’’

recognizes that the qualification of 

banks for the advanced approaches 

during the parallel run period will be an 

iterative and ongoing process. The 

agencies intend to assess individual 

advanced approaches methodologies 

through numerous discussions, reviews, 

data collection and analysis, and 

examination activities. The agencies 

also emphasize the critical importance 

of ongoing validation of advanced 

approaches methodologies both before 

and after initial qualification decisions. 

A bank’s primary Federal supervisor 

will review a bank’s validation process 

and documentation for the advanced 

approaches on an ongoing basis through 

the supervisory process. The bank 

should include in its implementation 

plan the steps it will take to enhance 

compliance with the qualification 

requirements during the parallel run 

period. 

Commenters also requested the 

flexibility, permitted under the New 

Accord, to apply the advanced 

approaches to some portfolios and other 

approaches (such as the standardized 

approach in the New Accord) to other 

portfolios during the transitional floor 

periods. The agencies believe, however, 

that banks applying the advanced 

approaches should move expeditiously 

to extend the robust risk measurement 

and management practices required by 

the advanced approaches to all material 

exposures. To preserve these positive 

risk measurement and management 

incentives for banks and to prevent 

‘‘cherry picking’’ of portfolios, the final 

rule retains the provision in the 

proposed rule that states that a bank 

may enter the first transitional floor 

period only if it fully complies with the 

qualification requirements in section 22 

of the rule. As described above, the final 

rule allows a simplified approach for 

portfolios that are, in the aggregate, 

immaterial to the bank. 

Another concern identified by 

commenters regarding the parallel run 

was the asymmetric treatment of 

mergers and acquisitions consummated 

before and after the date a bank 

qualified to use the advanced 

approaches. Under the proposed rule, a 

bank qualified to use the advanced 

approaches that merged with or 

acquired a company would have up to 

24 months following the calendar 

quarter during which the merger or 

acquisition was consummated to 

integrate the merged or acquired 

company into the bank’s advanced 

approaches capital calculations. In 

contrast, the proposed rule could be 

read to provide that a bank that merged 

with or acquired a company before the 

bank qualified to use the advanced 

approaches had to fully implement the 

advanced approaches for the merged or 

acquired company before the bank 

could qualify to use the advanced 

approaches. The agencies agree that this 

asymmetric treatment is not 

appropriate. Accordingly, the final rule 

applies the merger and acquisition 

transition provisions both before and 

after a bank qualifies to use the 

advanced approaches. The merger and 

acquisition transition provisions are 

described in section III.D. of this 

preamble. 

During the parallel run period, a bank 

continues to be subject to the general 

risk-based capital rules but 

simultaneously calculates its risk-based 

capital ratios under the advanced 

approaches. During this period, a bank 

will report its risk-based capital ratios 

under the general risk-based capital 

rules and the advanced approaches to 

its primary Federal supervisor through 

the supervisory process on a quarterly 

basis. The agencies will share this 

information with each other. 

As described above, a bank must 

provide its board-approved 

implementation plan to its primary 

Federal supervisor at least 60 days 

before the bank proposes to begin its 

parallel run period. A bank also must 

receive approval from its primary 

Federal supervisor before beginning its 

first transitional floor period. In 

evaluating whether to grant approval to 

a bank to begin using the advanced 

approaches for risk-based capital 

purposes, the bank’s primary Federal 

supervisor must determine that the bank 

fully complies with all the qualification 

requirements, the bank has conducted a 

satisfactory parallel run, and the bank 

has an adequate process to ensure 

ongoing compliance with the 

qualification requirements. 

To provide for a smooth transition to 

the advanced approaches, the proposed 

rule imposed temporary limits on the 

amount by which a bank’s risk-based 

capital requirements could decline over 

a period of at least three years (that is, 

at least four consecutive calendar 

quarters in each of the three transitional 

floor periods). Based on its assessment 

of the bank’s ongoing compliance with 

the qualification requirements, a bank’s 

primary Federal supervisor would 

determine when the bank is ready to 

move from one transitional floor period 

to the next period and, after the full 

transition has been completed, to exit 

the last transitional floor period and 

move to stand-alone use of the advanced 

approaches. Table A sets forth the 

proposed transitional floor periods for 

banks moving to the advanced 

approaches: 

TABLE A.—TRANSITIONAL FLOORS

Transitional floor period Transitional 

floor percentage 

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

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

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

During the proposed transitional floor 

periods, a bank would calculate its riskweighted assets under the general riskbased capital rules. Next, the bank 

would multiply this risk-weighted 

assets amount by the appropriate floor 

percentage in the table above. This 

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

the bank would calculate its tier 1 and 

total risk-based capital ratios using the 

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69302 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

27The Board notes that, under the applicable 

leverage ratio rule, a BHC that is rated composite 

‘‘1’’ or that has adopted the market risk rule has a 

minimum leverage ratio requirement of 3 percent. 

For other BHCs, the minimum leverge ratio 

requirement is 4 percent. 28Preliminary analysis of the QIS–4 submissions 

evidenced material reductions in the aggregate 

minimum required capital for the QIS–4 participant 

population and significant dispersion of results 

across institutions and portfolio types. See 

Interagency Press Release, Banking ‘‘Agencies To 

Perform Additional Analysis Before Issuing Notice 

of Proposed Rulemaking Related To Basel II,’’ April 

29, 2005. 

definitions of tier 1 and tier 2 capital 

(and associated deductions and 

adjustments) in the general risk-based 

capital rules for the numerator values 

and floor-adjusted risk-weighted assets 

for the denominator values. These ratios 

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

The bank also would calculate its tier 

1 and total risk-based capital ratios 

using the advanced approaches 

definitions and rules. These ratios 

would be referred to as the ‘‘advanced 

approaches risk-based capital ratios.’’ In 

addition, the bank would calculate a tier 

1 leverage ratio using tier 1 capital as 

defined in the proposed rule for the 

numerator of the ratio. 

During a bank’s transitional floor 

periods, the bank would report all five 

regulatory capital ratios described 

above—two floor-adjusted risk-based 

capital ratios, two advanced approaches 

risk-based capital ratios, and one 

leverage ratio. To determine its 

applicable capital category for PCA 

purposes and for all other regulatory 

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

transitional floor periods would be set 

equal to the lower of the respective 

floor-adjusted risk-based capital ratio 

and the advanced approaches risk-based 

capital ratio. 

During the proposed transitional floor 

periods, a bank’s tier 1 capital and tier 

2 capital for all non-risk-based-capital 

supervisory and regulatory purposes (for 

example, lending limits and Regulation 

W quantitative limits) would be the 

bank’s tier 1 capital and tier 2 capital as 

calculated under the advanced 

approaches. 

Thus, for example, to be well 

capitalized under PCA, a bank would 

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

approaches tier 1 risk-based capital ratio 

of 6 percent or greater, a floor-adjusted 

total risk-based capital ratio and an 

advanced approaches total risk-based 

capital ratio of 10 percent or greater, and 

a tier 1 leverage ratio of 5 percent or 

greater (with tier 1 capital calculated 

under the advanced approaches). 

Although the PCA rules do not apply to 

BHCs, a BHC would be required to 

report all five of these regulatory capital 

ratios and would have to meet 

applicable supervisory and regulatory 

requirements using the lower of the 

respective floor-adjusted risk-based 

capital ratio and the advanced 

approaches risk-based capital ratio.27

Under the proposed rule, after a bank 

completed its transitional floor periods 

and its primary Federal supervisor 

determined the bank could begin using 

the advanced approaches with no 

further transitional floor, the bank 

would use its tier 1 and total 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. 

Although one commenter supported 

the proposed transitional provisions, 

many commenters objected to these 

transitional provisions. Commenters 

urged the agencies to conform the 

transitional provisions to those in the 

New Accord. Specifically, they 

requested that the three transitional 

floor periods be reduced to two periods 

and that the transitional floor 

percentages be reduced from 95 percent, 

90 percent, and 85 percent to 90 percent 

and 80 percent. Commenters also 

requested that the transitional floor 

calculation methodology be conformed 

to the generally less restrictive 

methodology of the New Accord. 

Moreover, they expressed concern about 

the requirement that a bank obtain 

supervisory approval to move from one 

transitional floor period to the next, 

which could potentially extend each 

floor period beyond four calendar 

quarters. 

The agencies believe that the 

prudential transitional safeguards are 

necessary to address concerns identified 

in the analysis of the results of QIS–4.28

Specifically, the transitional safeguards 

will ensure that implementation of the 

advanced approaches will not result in 

a precipitous drop in risk-based capital 

requirements, and will provide a 

smooth transition process as banks 

refine their advanced systems. Banks’

computation of risk-based capital 

requirements under both the general 

risk-based capital rules and the 

advanced approaches during the 

parallel run and transitional floor 

periods will help the agencies assess the 

impact of the advanced approaches on 

overall capital requirements, including 

whether the change in capital 

requirements relative to the general riskbased capital rules is consistent with the 

agencies’ overall capital objectives. 

Therefore, the agencies are adopting in 

this final rule the proposed level, 

duration, and calculation methodology 

of the transitional floors, with the 

revised process for determining when 

banks may exit the third transitional 

floor period discussed in section I.E., 

above. 

Under the final rule, as under the 

proposed rule, banks that meet the 

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

banks) as of the effective date of this 

final rule, and banks that opt in 

pursuant to section 1(b)(2) at the earliest 

possible date, must use the general riskbased capital rules both during the 

parallel run and as a basis for the 

transitional floor calculations. Should 

the agencies finalize a standardized riskbased capital rule, the agencies expect 

that a bank that opts in after the earliest 

possible date or becomes a core bank 

after the effective date of the final rule 

would use the risk-based capital regime 

(the general risk-based capital rules or 

the standardized risk-based capital 

rules) used by the bank immediately 

before the bank begins its parallel run 

both during the parallel run and as a 

basis for the transitional floor 

calculations. Under the final rule, 2008 

is the first possible year for a bank to 

begin its parallel run and 2009 is the 

first possible year for a bank to begin its 

first of three transitional floor periods. 

B. Qualification Requirements 

Because the advanced approaches use 

banks’ estimates of certain key risk 

parameters to determine risk-based 

capital requirements, they introduce 

greater complexity to the regulatory 

capital framework and require banks to 

possess a high level of sophistication in 

risk measurement and risk management 

systems. As a result, the final rule 

requires each core or opt-in bank to 

meet the qualification requirements 

described in section 22 of the final rule 

to the satisfaction of its primary Federal 

supervisor for a period of at least four 

consecutive calendar quarters before 

using the advanced approaches to 

calculate its minimum risk-based capital 

requirements (subject to the transitional 

floor provisions for at least an 

additional three years). The 

qualification requirements are written 

broadly to accommodate the many ways 

a bank may design and implement 

robust internal credit and operational 

risk measurement and management 

systems, and to permit industry practice 

to evolve. 

Many of the qualification 

requirements relate to a bank’s 

advanced IRB systems. A bank’s 

advanced IRB systems must incorporate 

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29 72 FR 9189. 

five interdependent components in a 

framework for evaluating credit risk and 

measuring regulatory capital: 

(i) A risk rating and segmentation 

system that assigns ratings to individual 

wholesale obligors and exposures and 

assigns individual retail exposures to 

segments; 

(ii) A quantification process that 

translates the risk characteristics of 

wholesale obligors and exposures and 

segments of retail exposures into 

numerical risk parameters that are used 

as inputs to the IRB risk-based capital 

formulas; 

(iii) An ongoing process that validates 

the accuracy of the rating assignments, 

segmentations, and risk parameters; 

(iv) A data management and 

maintenance system that supports the 

advanced IRB systems; and 

(v) Oversight and control mechanisms 

that ensure the advanced IRB systems 

are functioning effectively and 

producing accurate results. 

1. Process and Systems Requirements 

One of the objectives of the advanced 

approaches framework is to provide 

appropriate incentives for banks to 

develop and use better techniques for 

measuring and managing their risks and 

to ensure that capital is adequate to 

support those risks. Section 3 of the 

final rule requires a bank to hold capital 

commensurate with the level and nature 

of all risks to which the bank is 

exposed. Section 22 of the final rule 

specifically requires a bank to have a 

rigorous process for assessing its overall 

capital adequacy in relation to its risk 

profile and a comprehensive strategy for 

maintaining appropriate capital levels 

(known as the internal capital adequacy 

assessment process or ICAAP). Another 

objective of the advanced approaches 

framework is to ensure comprehensive 

supervisory review of capital adequacy. 

On February 28, 2007, the agencies 

issued proposed guidance setting forth 

supervisory expectations for a bank’s 

ICAAP and addressing the process for a 

comprehensive supervisory assessment 

of capital adequacy.29 As set forth in 

that guidance, and consistent with 

existing supervisory practice, a bank’s 

primary Federal supervisor will 

evaluate how well the bank is assessing 

its capital needs relative to its risks. The 

supervisor will assess the bank’s overall 

capital adequacy and will take into 

account a bank’s ICAAP, its compliance 

with the minimum capital requirements 

set forth in this rule, and all other 

relevant information. The primary 

Federal supervisor will require a bank to 

increase its capital levels or ratios if the 

supervisor determines that current 

levels or ratios are deficient or some 

element of the bank’s business practices 

suggests the need for higher capital 

levels or ratios. In addition, the primary 

Federal supervisor may, under its 

enforcement authority, require a bank to 

modify or enhance risk management 

and internal control authority, or reduce 

risk exposures, or take any other action 

as deemed necessary to address 

identified supervisory concerns. 

As outlined in the proposed guidance, 

the agencies expect banks to implement 

and continually update the fundamental 

elements of a sound ICAAP—identifying 

and measuring material risks, setting 

capital adequacy goals that relate to risk, 

and ensuring the integrity of internal 

capital adequacy assessments. A bank is 

expected to ensure adequate capital is 

held against all material risks. 

In developing its ICAAP, a bank 

should be particularly mindful of the 

limitations of regulatory risk-based 

capital requirements as a measure of its 

full risk profile—including risks not 

covered or not adequately quantified in 

the risk-based capital requirements—as 

well as specific assumptions embedded 

in risk-based regulatory capital 

requirements (such as diversification in 

credit portfolios). A bank should also be 

mindful of the capital adequacy effects 

of concentrations that may arise within 

each risk type or across risk types. In 

general, a bank’s ICAAP should reflect 

an appropriate level of conservatism to 

account for uncertainty in risk 

identification, risk mitigation or control, 

quantitative processes, and any use of 

modeling. In most cases, this 

conservatism will result in higher levels 

of capital or higher capital ratios being 

regarded as adequate. 

As noted above, each core and opt-in 

bank must apply the advanced 

approaches for risk-based capital 

purposes at the consolidated top-tier 

U.S. legal entity level (either the top-tier 

U.S. BHC or top-tier DI that is a core or 

opt-in bank) and at each DI that is a 

subsidiary of such a top-tier legal entity 

(unless a primary Federal supervisor 

provides an exemption under section 

1(b)(3) of the final rule). Each bank that 

applies the advanced approaches must 

have an appropriate infrastructure with 

risk measurement and management 

processes that meet the final rule’s 

qualification requirements and that are 

appropriate given the bank’s size and 

level of complexity. Regardless of 

whether the systems and models that 

generate the risk parameters necessary 

for calculating a bank’s risk-based 

capital requirements are located at an 

affiliate of the bank, each legal entity 

that applies the advanced approaches 

must ensure that the risk parameters 

(PD, LGD, EAD, and, for wholesale 

exposures, M) and reference data used 

to determine its risk-based capital 

requirements are representative of its 

own credit and operational risk 

exposures. 

The final rule also requires that the 

systems and processes that an advanced 

approaches bank uses for risk-based 

capital purposes must be consistent 

with the bank’s internal risk 

management processes and management 

information reporting systems. This 

means, for example, that data from the 

latter processes and systems can be used 

to verify the reasonableness of the 

inputs the bank uses for calculating riskbased capital ratios. 

2. Risk Rating and Segmentation 

Systems for Wholesale and Retail 

Exposures 

To implement the IRB approach, a 

bank must have internal risk rating and 

segmentation systems that accurately 

and reliably differentiate between 

degrees of credit risk for wholesale and 

retail exposures. As described below, 

wholesale exposures include most 

credit exposures to companies, 

sovereigns, and other governmental 

entities, as well as some exposures to 

individuals. Retail exposures include 

most credit exposures to individuals 

and small credit exposures to businesses 

that are managed as part of a segment of 

exposures with homogeneous risk 

characteristics. Together, wholesale and 

retail exposures cover most credit 

exposures of banks. 

To differentiate among degrees of 

credit risk, a bank must be able to make 

meaningful and consistent distinctions 

among credit exposures along two 

dimensions—default risk and loss 

severity in the event of a default. In 

addition, a bank must be able to assign 

wholesale obligors to rating grades that 

approximately reflect likelihood of 

default and must be able to assign 

wholesale exposures to loss severity 

rating grades (or LGD estimates) that 

approximately reflect the loss severity 

expected in the event of default during 

economic downturn conditions. As 

discussed below, the final rule requires 

banks to treat wholesale exposures 

differently from retail exposures when 

differentiating among degrees of credit 

risk; specifically, risk parameters for 

retail exposures are assigned at the 

segment level. 

Wholesale Exposures 

Under the proposed rule, a bank 

would be required to have an internal 

risk rating system that indicates the 

likelihood of default of each individual 

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69304 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

obligor and would either use an internal 

risk rating system that indicates the 

economic loss rate upon default of each 

individual exposure or directly assign 

an LGD estimate to each individual 

exposure. A bank would assign an 

internal risk rating to each wholesale 

obligor that reflected the obligor’s 

likelihood of default. 

Several commenters objected to the 

proposed requirement to assign an 

internal risk rating to each wholesale 

obligor that reflected the obligor’s 

likelihood of default. Commenters 

asserted that this requirement was 

burdensome and unnecessary where a 

bank underwrote an exposure based 

solely on the financial strength of a 

guarantor and used the PD substitution 

approach (discussed below) to recognize 

the risk mitigating effects of an eligible 

guarantee on the exposure. In such 

cases, commenters maintained that 

banks should be allowed to assign a PD 

only to the guarantor and not the 

underlying obligor. 

While the agencies believe that 

maintaining internal risk ratings of both 

a protection provider and underlying 

obligor provides helpful information for 

risk management purposes and 

facilitates a greater understanding of socalled double default effects, the 

agencies appreciate the commenters’

concerns about burden in this context. 

Accordingly, the final rule does not 

require a bank to assign an internal risk 

rating to an underlying obligor to whom 

the bank extends credit based solely on 

the financial strength of a guarantor, 

provided that all of the bank’s exposures 

to that obligor are fully covered by 

eligible guarantees and the bank applies 

the PD substitution approach to all of 

those exposures. A bank in this 

situation is only required to assign an 

internal risk rating to the guarantor. 

However, a bank must immediately 

assign an internal risk rating to the 

obligor if a guarantee can no longer be 

recognized under this final rule. 

In determining an obligor rating, a 

bank should consider key obligor 

attributes, including both quantitative 

and qualitative factors that could affect 

the obligor’s default risk. From a 

quantitative perspective, this could 

include an assessment of the obligor’s 

historic and projected financial 

performance, trends in key financial 

performance ratios, financial 

contingencies, industry risk, and the 

obligor’s position in the industry. On 

the qualitative side, this could include 

an assessment of the quality of the 

obligor’s financial reporting, nonfinancial contingencies (for example, 

labor problems and environmental 

issues), and the quality of the obligor’s 

management based on an evaluation of 

management’s ability to make realistic 

projections, management’s track record 

in meeting projections, and 

management’s ability to effectively 

adapt to changes in the economy and 

the competitive environment. 

Under the proposed rule, a bank 

would assign each legal entity 

wholesale obligor to a single rating 

grade. Accordingly, if a single wholesale 

exposure of the bank to an obligor 

triggered the proposed rule’s definition 

of default, all of the bank’s wholesale 

exposures to that obligor would be in 

default for risk-based capital purposes. 

In addition, under the proposed rule, a 

bank would not be allowed to consider 

the value of collateral pledged to 

support a particular wholesale exposure 

(or any other exposure-specific 

characteristics) when assigning a rating 

to the obligor of the exposure. A bank 

would, however, consider all available 

financial information about the 

obligor—including, where applicable, 

the total operating income or cash flows 

from all of the obligor’s projects or 

businesses—when assigning an obligor 

rating. 

While a few commenters expressly 

supported the proposal’s requirement 

for banks to assign each legal entity 

wholesale obligor to a single rating 

grade, a substantial number of 

commenters expressed reservations 

about this requirement. These 

commenters observed that in certain 

circumstances an exposure’s 

transaction-specific characteristics affect 

its likelihood of default. Commenters 

asserted that the agencies should 

provide greater flexibility and allow 

banks to depart from the one-rating-perobligor requirement based on the 

economic substance of an exposure. In 

particular, commenters maintained that 

income-producing real estate lending 

should be exempt from the one-ratingper-obligor requirement. The 

commenters noted that the probability 

that an obligor will default on any one 

such facility depends primarily on the 

cash flows from the individual property 

securing the facility, not the overall 

condition of the obligor. Similarly, 

several commenters asserted that 

exposures involving transfer risk and 

non-recourse exposures should be 

exempted from the one-rating-perobligor requirement. 

In general, the agencies believe that a 

two-dimensional rating system that 

strictly separates borrower and 

exposure-level characteristics is a 

critical underpinning of the IRB 

approach. However, the agencies agree 

that exposures to the same borrower 

denominated in different currencies 

may have different default probabilities. 

For example, a sovereign government 

may impose prohibitive exchange 

restrictions that make it impossible for 

a borrower to transfer payments in one 

particular currency. 

In addition, the agencies agree that 

certain income-producing real estate 

exposures for which the bank, in 

economic substance, does not have 

recourse to the borrower beyond the real 

estate serving as collateral for the 

exposure, have default probabilities 

distinct from that of the borrower. Such 

situations would arise, for example, 

where real estate collateral is located in 

a state where a bank, under applicable 

state law, effectively does not have 

recourse to the borrower if the bank 

pursues the real estate collateral in the 

event of default (for example, in a ‘‘oneaction’’ state or a state with a similar 

law). In one-action states such as 

Arizona, California, Idaho, Montana, 

Nevada, and Utah, or in a state with a 

similar law, such as New York, the 

applicable foreclosure laws materially 

limit a bank’s ability to collect against 

both the collateral and the borrower. 

A third instance in which exposures 

to the same borrower may have 

significantly different default 

probabilities is when a borrower enters 

bankruptcy and the bank extends 

additional credit to the borrower under 

the auspices of the bankruptcy 

proceedings. This so-called debtor in 

possession (DIP) financing is unique 

from other exposure types because it 

typically has priority over existing debt, 

equity, and other claims on the 

borrower. The agencies believe that 

because of this unique priority status, if 

a bank has an exposure to a borrower 

that declares bankruptcy and defaults 

on that exposure, and the bank 

subsequently provides DIP financing to 

that obligor, it may not be appropriate 

to require the bank to treat the DIP 

financing exposure at inception as an 

exposure to a defaulted borrower. 

To address these circumstances and 

clarify the application of the one-ratingper-obligor requirement, the agencies 

added a definition of obligor in the final 

rule. The final rule defines an obligor as 

the legal entity or natural person 

contractually obligated on a wholesale 

exposure except that a bank may treat 

three types of exposures to the same 

legal entity or natural person as having 

separate obligors. First, exposures to the 

same legal entity or natural person 

denominated in different currencies. 

Second, (i) income-producing real estate 

exposures for which all or substantially 

all of the repayment of the exposure is 

reliant on cash flows of the real estate 

serving as collateral for the exposure; 

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the bank, in economic substance, does 

not have recourse to the borrower 

beyond the real estate serving as 

collateral for the exposure; and no crossdefault or cross-acceleration clauses are 

in place other than clauses obtained 

solely in an abundance of caution; and 

(ii) other credit exposures to the same 

legal entity or natural person. Third, (i) 

wholesale exposures authorized under 

section 364 of the U.S. Bankruptcy Code 

(11 U.S.C. 364) to a legal entity or 

natural person who is a debtor-inpossession for purposes of Chapter 11 of 

the Bankruptcy Code; and (ii) other 

credit exposures to the same legal entity 

or natural person. All exposures to a 

single legal entity or natural person 

must be treated as exposures to a single 

obligor unless they qualify for one of 

these three exceptions in the final rule’s 

definition of obligor. 

A bank’s obligor rating system must 

have at least seven discrete (nonoverlapping) obligor grades for nondefaulted obligors and at least one 

obligor grade for defaulted obligors. The 

agencies believe that because the riskbased 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 differentiate 

sufficiently the creditworthiness of nondefaulted wholesale obligors. 

A bank must capture the estimated 

loss severity upon default for a 

wholesale exposure either by directly 

assigning an LGD estimate to the 

exposure or by grouping the exposure 

with other wholesale exposures into 

loss severity rating grades (reflecting the 

bank’s estimate of the LGD of the 

exposure). LGD is described in more 

detail below. Whether a bank chooses to 

assign LGD values directly or, 

alternatively, to assign exposures to 

rating grades and then quantify the LGD 

for the rating grades, the key 

requirement is that the bank must 

identify exposure characteristics that 

influence LGD. Each of the loss severity 

rating grades must be associated with an 

empirically supported LGD estimate. 

Banks employing loss severity grades 

must have a sufficiently granular loss 

severity grading system to avoid 

grouping together exposures with 

widely ranging LGDs. 

Retail Exposures 

To implement the advanced approach 

for retail exposures, a bank must have 

an internal system that segments its 

retail exposures to differentiate 

accurately and reliably among degrees 

of credit risk. The most significant 

difference between the treatment of 

wholesale and retail exposures is that 

the risk parameters for wholesale 

exposures are assigned at the individual 

exposure level, whereas risk parameters 

for retail exposures are assigned at the 

segment level. Banks typically manage 

retail exposures on a segment basis, 

where each segment contains exposures 

with similar risk characteristics. 

Therefore, a key characteristic of the 

final rule’s retail framework is that the 

risk parameters for retail exposures are 

assigned to segments of exposures rather 

than to individual exposures. Under the 

retail framework, a bank groups its retail 

exposures into segments with 

homogeneous risk characteristics and 

estimates PD and LGD for each segment. 

Some commenters stated that for 

internal risk management purposes they 

assign risk parameters at the individual 

retail exposure level rather than at the 

segment level. These commenters 

requested confirmation that this practice 

would be permissible for risk-based 

capital purposes under the final rule. 

The agencies believe that a bank may 

use its advanced systems, including 

exposure-level risk parameter estimates, 

to group exposures into segments with 

homogeneous risk characteristics. Such 

exposure-level estimates must be 

aggregated in order to assign segmentlevel risk parameters to each segment of 

retail exposures. 

A bank must group its retail 

exposures into three separate 

subcategories: (i) Residential mortgage 

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

retail exposures. The bank must classify 

the retail exposures in each subcategory 

into segments to produce a meaningful 

differentiation of risk. The final rule 

requires banks to segment separately (i) 

defaulted retail exposures from nondefaulted retail exposures and (ii) retail 

eligible margin loans for which the bank 

adjusts EAD rather than LGD to reflect 

the risk mitigating effects of financial 

collateral from other retail eligible 

margin loans. Otherwise, the agencies 

do not require that banks consider any 

particular risk drivers or employ any 

minimum number of segments in any of 

the three retail subcategories. 

In determining how to segment retail 

exposures within each subcategory for 

the purpose of assigning risk 

parameters, a bank should use a 

segmentation approach that is 

consistent with its approach for internal 

risk assessment purposes and that 

classifies exposures according to 

predominant risk characteristics or 

drivers. Examples of risk drivers could 

include loan-to-value ratios, credit 

scores, loan terms and structure, 

origination channel, geographical 

location of the borrower, collateral type, 

and bank internal estimates of 

likelihood of default and loss severity 

given default. Regardless of the risk 

drivers used, a bank must be able to 

demonstrate to its primary Federal 

supervisor that its system assigns 

accurate and reliable PD and LGD 

estimates for each retail segment on a 

consistent basis. 

Definition of Default 

Wholesale default. In the ANPR, the 

agencies proposed to define default for 

a wholesale exposure as either or both 

of the following events: (i) The bank 

determines that the borrower is unlikely 

to pay its obligations to the bank in full, 

without recourse to actions by the bank 

such as the realization of collateral; or 

(ii) the borrower is more than 90 days 

past due on principal or interest on any 

material obligation to the bank. The 

ANPR’s definition of default was 

generally consistent with the New 

Accord. 

A number of commenters on the 

ANPR encouraged the agencies to use a 

wholesale definition of default that 

varied from the New Accord but 

conformed more closely to that used by 

bank risk managers. Many of these 

commenters recommended that the 

agencies define default for wholesale 

exposures as the entry into non-accrual 

or charge-off status. In the proposed 

rule, the agencies amended the ANPR 

definition of default to respond to these 

concerns. Under the proposed definition 

of default, a bank’s wholesale obligor 

would be in default if, for any wholesale 

exposure of the bank to the obligor, the 

bank had (i) placed the exposure on 

non-accrual status consistent with the 

Consolidated Report of Condition and 

Income (Call Report) Instructions or the 

Thrift Financial Report (TFR) and the 

TFR Instruction Manual; (ii) taken a full 

or partial charge-off or write-down on 

the exposure due to the distressed 

financial condition of the obligor; or (iii) 

incurred a credit-related loss of 5 

percent or more of the exposure’s initial 

carrying value in connection with the 

sale of the exposure or the transfer of 

the exposure to the held-for-sale, 

available-for-sale, trading account, or 

other reporting category. 

The agencies received extensive 

comment on the proposed definition of 

default for wholesale exposures. 

Commenters observed that the proposed 

definition of default was different from 

and more prescriptive than the 

definition in the New Accord and 

employed in other major jurisdictions. 

They asserted that the proposed 

definition would impose unjustifiable 

systems burden and expense on banks 

operating across multiple jurisdictions. 

Commenters also asserted that many 

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30FFIEC, ‘‘Uniform Retail Credit Classification 

and Account Management Policy,’’ 65 FR 36903, 

June 12, 2000. 

banks’ data collection systems are based 

on the New Accord’s definition of 

default, and therefore historical data 

relevant to the proposed definition of 

default are limited. Moreover, 

commenters expressed concern that risk 

parameters estimated using the 

proposed definition of default would 

differ materially from those estimated 

using the New Accord’s definition of 

default, resulting in different capital 

requirements for U.S. banks relative to 

their foreign peers. 

The 5 percent credit-related loss 

trigger in the proposed definition of 

default for wholesale obligors was the 

focus of significant commenter concern. 

Commenters asserted that the trigger 

inappropriately imported LGD and 

maturity-related considerations into the 

definition of default, could hamper the 

use of loan sales as a risk management 

practice, and could cause obligors that 

are performing on their obligations to be 

considered defaulted. These 

commenters also claimed that the 5 

percent trigger would add significant 

implementation burden by, for example, 

requiring banks to distinguish between 

credit-related and non-credit-related 

losses on sale. 

Many commenters requested that the 

agencies conform the U.S. wholesale 

definition of default to the New Accord. 

Other commenters requested that banks 

be allowed the option to apply either 

the U.S. or the New Accord definition 

of default. 

The agencies agree that the proposed 

definition of default for wholesale 

obligors could have unintended 

consequences for implementation 

burden and international consistency. 

Therefore, the final rule contains a 

definition of default for wholesale 

obligors that is similar to the definition 

proposed in the ANPR and consistent 

with the New Accord. Specifically, 

under the final rule, a bank’s wholesale 

obligor is in default if, for any wholesale 

exposure of the bank to the obligor: (i) 

The bank considers that the obligor is 

unlikely to pay its credit obligations to 

the bank in full, without recourse by the 

bank to actions such as realizing 

collateral (if held); or (ii) the obligor is 

past due more than 90 days on any 

material credit obligation to the bank. 

The final rule also clarifies, consistent 

with the New Accord, that an overdraft 

is past due once the obligor has 

breached an advised limit or has been 

advised of a limit smaller than the 

current outstanding balance. 

Consistent with the New Accord, the 

following elements may be indications 

of unlikeliness to pay under this 

definition: 

(i) The bank places the exposure on 

non-accrual status consistent with the 

Call Report Instructions or the TFR and 

the TFR Instruction Manual; 

(ii) The bank takes a full or partial 

charge-off or write-down on the 

exposure due to the distressed financial 

condition of the obligor; 

(iii) The bank incurs a material creditrelated loss in connection with the sale 

of the exposure or the transfer of the 

exposure to the held-for-sale, availablefor-sale, trading account, or other 

reporting category; 

(iv) The bank consents to a distressed 

restructuring of the exposure that is 

likely to result in a diminished financial 

obligation caused by the material 

forgiveness or postponement of 

principal, interest or (where relevant) 

fees; 

(v) The bank has filed as a creditor of 

the obligor for purposes of the obligor’s 

bankruptcy under the U.S. Bankruptcy 

Code (or a similar proceeding in a 

foreign jurisdiction regarding the 

obligor’s credit obligation to the bank); 

or 

(vi) The obligor has sought or has 

been placed in bankruptcy or similar 

protection that would avoid or delay 

repayment of the exposure to the bank. 

If a bank carries a wholesale exposure 

at fair value for accounting purposes, 

the bank’s practices for determining 

unlikeliness to pay for purposes of the 

definition of default should be 

consistent with the bank’s practices for 

determining credit-related declines in 

the fair value of the exposure. 

Like the proposed definition of 

default for wholesale obligors, the final 

rule states that a wholesale exposure to 

an obligor remains in default until the 

bank has reasonable assurance of 

repayment and performance for all 

contractual principal and interest 

payments on all exposures of the bank 

to the obligor (other than exposures that 

have been fully written-down or 

charged-off). The agencies expect a bank 

to employ standards for determining 

whether it has a reasonable assurance of 

repayment and performance that are 

similar to those for determining whether 

to restore a loan from non-accrual to 

accrual status. 

Retail default. In response to 

comments on the ANPR, the agencies 

proposed to define default for retail 

exposures according to the timeframes 

for loss classification that banks 

generally use for internal purposes. 

These timeframes are embodied in the 

FFIEC’s Uniform Retail Credit 

Classification and Account Management 

Policy. 30 Specifically, revolving retail 

exposures and residential mortgage 

exposures would be in default at 180 

days past due; other retail exposures 

would be in default at 120 days past 

due. In addition, a retail exposure 

would be in default if the bank had 

taken a full or partial charge-off or 

write-down of principal on the exposure 

for credit-related reasons. Such an 

exposure would remain in default until 

the bank had reasonable assurance of 

repayment and performance for all 

contractual principal and interest 

payments on the exposure. 

Although some commenters 

supported the proposed rule’s retail 

definition of default, others urged the 

agencies to adopt a 90-days-past-due 

default trigger consistent with the New 

Accord’s definition of default for retail 

exposures. Other commenters requested 

that a non-accrual trigger be added to 

the retail definition of default similar to 

that in the proposed wholesale 

definition of default. The commenters 

viewed this as a practical way to allow 

a foreign banking organization to 

harmonize the U.S. retail definition of 

default to a home country definition of 

default that has a 90-days-past-due 

trigger. 

The agencies believe that adding a 

non-accrual trigger to the retail 

definition of default is not appropriate. 

Retail non-accrual practices vary 

considerably among banks, and adding 

a non-accrual trigger to the retail 

definition of default would result in 

greater inconsistency among banks in 

the treatment of retail exposures. 

Moreover, a bank that considers retail 

exposures to be defaulted at 90 days 

past due could have significantly 

different risk parameter estimates than 

one that uses 120- and 180-days-pastdue thresholds. Such a bank would 

likely have higher PD estimates and 

lower LGD estimates due to the 

established tendency of a nontrivial 

proportion of U.S. retail exposures to 

‘‘cure’’ or return to performing status 

after becoming 90 days past due and 

before becoming 120 or 180 days past 

due. The agencies believe that the 120- 

and 180-days-past-due thresholds, 

which are consistent with national 

discretion provided by the New Accord, 

reflect a point at which retail exposures 

in the United States are unlikely to 

return to performing status. Therefore, 

the agencies are incorporating the 

proposed retail definition of default 

without substantive change in the final 

rule. (Parallel to the full or partial 

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charge-off or write-down trigger for 

retail exposures not held at fair value, 

the agencies added a material negative 

fair value adjustment of principal for 

credit-related reasons trigger for retail 

exposures held at fair value.) 

The New Accord provides discretion 

for national supervisors to set the retail 

default trigger at up to 180 days past 

due for different products, as 

appropriate to local conditions. 

Accordingly, banks implementing the 

IRB approach in multiple jurisdictions 

may be subject to different retail 

definitions of default in their home and 

host jurisdictions. The agencies 

recognize that it could be costly and 

burdensome for a U.S. bank to track 

default data and estimate risk 

parameters based on both the U.S. 

definition of default and the definitions 

of default in non-U.S. jurisdictions 

where subsidiaries of the U.S. bank 

implement the IRB approach. The 

agencies are therefore incorporating 

flexibility into the retail definition of 

default. Specifically, for a retail 

exposure held by a U.S. bank’s non-U.S. 

subsidiary subject to an internal ratingsbased approach to capital adequacy 

consistent with the New Accord in a 

non-U.S. jurisdiction, the final rule 

allows the bank to elect to use the 

definition of default of that jurisdiction, 

subject to prior approval by the bank’s 

primary Federal supervisor. The 

primary Federal supervisor will revoke 

approval for a bank to use this provision 

if the supervisor finds that the bank uses 

the provision to arbitrage differences in 

national definitions of default. 

The definition of default for retail 

exposures differs from the definition for 

the wholesale portfolio in that the retail 

default definition applies on an 

exposure-by-exposure basis rather than 

on an obligor-by-obligor basis. In other 

words, default on one retail exposure 

does not require a bank to treat all other 

retail obligations of the same borrower 

to the bank as defaulted. This difference 

reflects the fact that banks generally 

manage retail credit risk based on 

segments of similar exposures rather 

than through the assignment of ratings 

to particular borrowers. In addition, it is 

quite common for retail borrowers that 

default on some of their obligations to 

continue payment on others. 

Although the retail definition of 

default does not explicitly include 

credit-related losses in connection with 

loan sales and the agencies have 

replaced the 5 percent credit-related 

loss threshold for wholesale exposures 

with a less prescriptive treatment that is 

consistent with the New Accord, the 

agencies expect banks to ensure that 

exposure sales do not bias or otherwise 

distort the estimated risk parameters 

assigned by a bank to its wholesale 

exposures and retail segments. 

Rating Philosophy 

A bank’s internal risk rating policy for 

wholesale exposures must describe the 

bank’s rating philosophy, which is how 

the bank’s wholesale obligor rating 

assignments are affected by the bank’s 

choice of the range of economic, 

business, and industry conditions that 

are considered in the obligor rating 

process. The philosophical basis of a 

bank’s rating system is important 

because, when combined with the credit 

quality of individual obligors, it will 

determine the frequency of obligor 

rating changes in a changing economic 

environment. Rating systems that rate 

obligors based on their ability to 

perform over a wide range of economic, 

business, and industry conditions, 

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

migrate more slowly as conditions 

change. Banks that rate obligors based 

on a more narrow range of likely 

expected conditions (primarily on 

recent conditions), sometimes called 

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

ratings that migrate more frequently. 

Many banks will rate obligors using an 

approach that considers a combination 

of the current conditions and a wider 

range of other likely conditions. In any 

case, the bank must specify the rating 

philosophy used and establish a policy 

for the migration of obligors from one 

rating grade to another in response to 

economic cycles. A bank should 

understand the effects of ratings 

migration on its risk-based capital 

requirements and ensure that sufficient 

capital is maintained during all phases 

of the economic cycle. 

Rating and Segmentation Reviews and 

Updates 

Each wholesale obligor rating and (if 

applicable) wholesale exposure loss 

severity rating must reflect current 

information. A bank’s internal risk 

rating system for wholesale exposures 

must provide for the review and update 

(as appropriate) of each obligor rating 

and (if applicable) loss severity rating 

whenever the bank receives new 

material information, but no less 

frequently than annually. Under the 

proposed rule, a bank’s retail exposure 

segmentation system would provide for 

the review and update (as appropriate) 

of assignments of retail exposures to 

segments whenever the bank received 

new material information. The proposed 

rule specified that the review would be 

required no less frequently than 

quarterly. 

One commenter noted that quarterly 

reviews may not be appropriate for 

high-quality retail portfolios, such as 

retail exposures associated with a bank’s 

wealth management or private banking 

businesses. The commenter suggested 

that banks should have the flexibility to 

review and update segmentation 

assignments for such portfolios on a less 

frequent basis appropriate to the credit 

quality of the portfolios. 

The agencies agree that it may be 

appropriate for a bank to review and 

update segmentation assignments for 

certain high-quality retail exposures on 

a less frequent basis than quarterly, 

provided a bank is following sound risk 

management practices. Therefore, the 

final rule generally requires a quarterly 

review and update, as appropriate, of 

retail exposure segmentation 

assignments, allowing some flexibility 

to accommodate sound internal risk 

management practices. 

3. Quantification of Risk Parameters for 

Wholesale and Retail Exposures 

A bank must have a comprehensive 

risk parameter quantification process 

that produces accurate, timely, and 

reliable estimates of the risk 

parameters—PD, LGD, EAD, and (for 

wholesale exposures) M—for its 

wholesale obligors and exposures and 

retail exposures. Statistical methods and 

models used to develop risk parameter 

estimates, as well as any adjustments to 

the estimates or empirical data, should 

be transparent, well supported, and 

documented. The following sections of 

the preamble discuss the rule’s 

definitions of the risk parameters for 

wholesale exposures and retail 

segments. 

Probability of Default (PD) 

As noted above, under the final rule, 

a bank must assign each of its wholesale 

obligors to an internal rating grade and 

then must associate a PD with each 

rating grade. PD for a wholesale 

exposure to a non-defaulted obligor is 

the bank’s empirically based best 

estimate of the long-run average oneyear default rate for the rating grade 

assigned by the bank to the obligor, 

capturing the average default experience 

for obligors in the rating grade over a 

mix of economic conditions (including 

economic downturn conditions) 

sufficient to provide a reasonable 

estimate of the average one-year default 

rate over the economic cycle for the 

rating grade. 

In addition, under the final rule, a 

bank must assign a PD to each segment 

of retail exposures. Some types of retail 

exposures typically display a seasoning 

pattern—that is, the exposures have 

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69308 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

31Under the proposal, ELGD was not the 

statistical expected value of LGD. 

relatively low default rates in their first 

year, rising default rates in the next few 

years, and declining default rates for the 

remainder of their terms. Because of the 

one-year IRB horizon, the proposed rule 

provided two different definitions of PD 

for a segment of non-defaulted retail 

exposures based on the materiality of 

seasoning effects for the segment or for 

the segment’s retail exposure 

subcategory. Under the proposed rule, 

PD for a segment of non-defaulted retail 

exposures for which seasoning effects 

were not material, or for a segment of 

non-defaulted retail exposures in a retail 

exposure subcategory for which 

seasoning effects were not material, 

would be the bank’s empirically based 

best estimate of the long-run average of 

one-year default rates for the exposures 

in the segment, capturing the average 

default experience for exposures in the 

segment over a mix of economic 

conditions (including economic 

downturn conditions) sufficient to 

provide a reasonable estimate of the 

average one-year default rate over the 

economic cycle for the segment. PD for 

a segment of non-defaulted retail 

exposures for which seasoning effects 

were material would be the bank’s 

empirically based best estimate of the 

annualized cumulative default rate over 

the expected remaining life of exposures 

in the segment, capturing the average 

default experience for exposures in the 

segment over a mix of economic 

conditions (including economic 

downturn conditions) to provide a 

reasonable estimate of the average 

performance over the economic cycle 

for the segment. 

Commenters objected to this 

treatment of retail exposures with 

material seasoning effects. They asserted 

that requiring banks to use an 

annualized cumulative default rate to 

recognize seasoning effects was too 

prescriptive and would preclude other 

reasonable approaches. The agencies 

believe that commenters have presented 

reasonable alternative approaches to 

recognizing the effects of seasoning in 

PD and are, therefore, providing 

additional flexibility for recognizing 

those effects in the final rule. 

Based on comments and additional 

consideration, the agencies also are 

clarifying that a segment of retail 

exposures has material seasoning effects 

if there is a material relationship 

between the time since origination of 

exposures within the segment and the 

bank’s best estimate of the long-run 

average one-year default rate for the 

exposures in the segment. Moreover, 

because the agencies believe that the 

IRB approach must, at a minimum, 

require banks to hold appropriate 

amounts of risk-based capital to address 

credit risks over a one-year horizon, the 

final rule’s incorporation of seasoning 

effects is explicitly one-directional. 

Specifically, a bank must increase PDs 

above the best estimate of the long-run 

average one-year default rate for 

segments of unseasoned retail 

exposures, but may not decrease PD 

below the best estimate of the long-run 

average one-year default rate for a 

segment of retail exposures that the 

bank estimates will have lower PDs in 

future years due to seasoning. 

The final rule defines PD for a 

segment of non-defaulted retail 

exposures as the bank’s empirically 

based best estimate of the long-run 

average one-year default rate for the 

exposures in the segment, capturing the 

average default experience for exposures 

in the segment over a mix of economic 

conditions (including economic 

downturn conditions) sufficient to 

provide a reasonable estimate of the 

average one-year default rate over the 

economic cycle for the segment and 

adjusted upward as appropriate for 

segments for which seasoning effects are 

material. If a bank does not adjust PD to 

reflect seasoning effects for a segment of 

exposures, it should be able to 

demonstrate to its primary Federal 

supervisor, using empirical analysis, 

why seasoning effects are not material 

or why adjustment is not relevant for 

the segment. 

For wholesale exposures to defaulted 

obligors and for segments of defaulted 

retail exposures, PD is 100 percent. 

Loss Given Default (LGD) 

Under the proposed rule, a bank 

would directly estimate an ELGD and 

LGD risk parameter for each wholesale 

exposure or would assign each 

wholesale exposure to an expected loss 

severity grade and a downturn loss 

severity grade, estimate an ELGD risk 

parameter for each expected loss 

severity grade, and estimate an LGD risk 

parameter for each downturn loss 

severity grade. In addition, a bank 

would estimate an ELGD and LGD risk 

parameter for each segment of retail 

exposures. 

Expected Loss Given Default (ELGD) 

The proposed rule defined the ELGD 

of a wholesale exposure as the bank’s 

empirically based best estimate of the 

default-weighted average economic loss 

per dollar of EAD the bank expected to 

incur in the event that the obligor of the 

exposure (or a typical obligor in the loss 

severity grade assigned by the bank to 

the exposure) defaulted within a oneyear horizon.31 The proposed rule 

defined ELGD for a segment of retail 

exposures as the bank’s empirically 

based best estimate of the defaultweighted average economic loss per 

dollar of EAD the bank expected to 

incur on exposures in the segment that 

default within a one-year horizon. ELGD 

estimates would incorporate a mix of 

economic conditions (including 

economic downturn conditions). ELGD 

had four functions in the proposed 

rule—as a component of the calculation 

of ECL in the numerator of the riskbased capital ratios; in the EL 

component of the IRB risk-based capital 

formulas; as a floor on the value of the 

LGD risk parameter; and as an input 

into the supervisory mapping function. 

Many commenters objected to the 

proposed rule’s requirement for banks to 

estimate ELGD for each wholesale 

exposure and retail segment, noting that 

ELGD estimation is not required under 

the New Accord. Commenters asserted 

that requiring ELGD estimation would 

create a competitive disadvantage by 

creating additional systems, 

compliance, calculation, and reporting 

burden for those banks subject to the 

U.S. rule, many of which have already 

substantially developed their systems 

based on the New Accord. They also 

maintained that it would decrease the 

comparability of U.S. banks’ capital 

requirements and public disclosures 

relative to those of foreign banking 

organizations applying the advanced 

approaches. Several commenters also 

contended that defining ECL in terms of 

ELGD instead of LGD raised tier 1 riskbased capital requirements for U.S. 

banks compared to foreign banks using 

the New Accord’s LGD-based ECL 

definition. 

The agencies have concluded that the 

regulatory burden and potential 

competitive inequities identified by 

commenters outweigh the supervisory 

benefits of the proposed ELGD risk 

parameter, and are, therefore, not 

including it in the final rule. Instead, 

consistent with the New Accord, a bank 

must use LGD for the calculation of ECL 

and the EL component of the IRB riskbased capital formulas. Because the 

proposed ELGD risk parameter was 

equal to or less than LGD, this change 

generally will have the effect of 

decreasing both the numerator and 

denominator of the risk-based capital 

ratios. 

Consistent with the New Accord, 

under the final rule, the LGD of a 

wholesale exposure or retail segment 

must not be less than the bank’s 

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empirically based best estimate of the 

long-run default-weighted average 

economic loss, per dollar of EAD, the 

bank would expect to incur if the 

obligor (or a typical obligor in the loss 

severity grade assigned by the bank to 

the exposure or segment) were to default 

within a one-year horizon over a mix of 

economic conditions, including 

economic downturn conditions. The 

final rule also specifies that LGD may 

not be less than zero. The implications 

of eliminating the ELGD risk parameter 

for the supervisory mapping function 

are discussed below. 

Economic Loss and Post-Default 

Extensions of Credit 

Commenters requested additional 

clarity regarding the treatment of postdefault extensions of credit. LGD is an 

estimate of the economic loss that 

would be incurred on an exposure, 

relative to the exposure’s EAD, if the 

obligor were to default within a oneyear horizon during economic downturn 

conditions. The estimated economic 

loss 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) are expected to 

occur after the date of default, the 

estimated economic loss amount must 

reflect the net present value of cash 

flows as of the default date using a 

discount rate appropriate to the risk of 

the exposure. The possibility of postdefault extensions of credit made to 

facilitate collection of an exposure 

would be treated as negative cash flows 

and reflected in LGD. 

For example, assume a loan to a 

retailer goes into default. The bank 

determines that the recovery would be 

enhanced by some additional 

expenditure to ensure an orderly 

workout process. One option would be 

for the bank to hire a third-party to 

facilitate the collection of the loan. 

Another option would be for the bank 

to extend additional credit directly to 

the defaulted obligor to allow the 

obligor to make an orderly liquidation of 

inventory. Both options represent 

negative cash flows on the original 

exposure, which must be discounted at 

a rate that is appropriate to the risk of 

the exposure. 

Economic Downturn Conditions 

The expected loss severities of some 

exposures may be substantially higher 

during economic downturn conditions 

than during other periods, while for 

other types of exposures they may not. 

Accordingly, the proposed rule required 

banks to use an LGD estimate that 

reflected economic downturn 

conditions for purposes of calculating 

the risk-based capital requirements for 

wholesale exposures and retail 

segments. 

Several commenters objected to the 

requirement that LGD estimates must 

reflect economic downturn conditions. 

Some of these commenters stated that 

empirical evidence of correlation 

between economic downturn and LGD 

is inconclusive, except in certain cases. 

A few noted that estimates of expected 

LGD include conservative inputs, such 

as a conservative estimate of potential 

loss in the event of default or a 

conservative discount rate or collateral 

assumptions. One commenter suggested 

that if a bank can demonstrate it has 

been prudent in its LGD estimation and 

it has no evidence of the cyclicality of 

LGDs, it should not be required to 

calculate downturn LGDs. Other 

commenters remarked that the 

requirement to incorporate downturn 

conditions into LGD estimates should 

not be used as a surrogate for proper 

modeling of PD/LGD correlations. 

Finally, a number of commenters 

supported a pillar 2 approach for 

addressing LGD estimation. 

Consistent with the New Accord, the 

final rule maintains the requirement for 

a bank to use an LGD estimate that 

reflects economic downturn conditions 

for purposes of calculating the riskbased capital requirements for 

wholesale exposures and retail 

segments. More specifically, banks must 

produce for each wholesale exposure (or 

loss severity rating grade) and retail 

segment an estimate of the economic 

loss per dollar of EAD that the bank 

would expect to incur if default were to 

occur within a one-year horizon during 

economic downturn conditions. 

For the purpose of defining economic 

downturn conditions, the proposed rule 

identified two wholesale exposure 

subcategories—high-volatility 

commercial real estate (HVCRE) 

wholesale exposures and non-HVCRE 

wholesale exposures (that is, all 

wholesale exposures that are not 

HVCRE exposures)—and three retail 

exposure subcategories—residential 

mortgage exposures, QREs, and other 

retail exposures. The proposed rule 

defined economic downturn conditions 

with respect to an exposure as those 

conditions in which the aggregate 

default rates for the exposure’s entire 

wholesale or retail subcategory held by 

the bank (or subdivision of such 

subcategory selected by the bank) in the 

exposure’s national jurisdiction (or 

subdivision of such jurisdiction selected 

by the bank) were significantly higher 

than average. 

The agencies specifically sought 

comment on whether to require banks to 

determine economic downturn 

conditions at a more granular level than 

an entire wholesale or retail exposure 

subcategory in a national jurisdiction. 

Some commenters stated that the 

proposed requirement is at a sufficiently 

granular level. Others asserted that the 

requirement should be eliminated or 

made less granular. Those commenters 

favoring less granularity stated that 

aggregate default rates for different 

product subcategories in different 

countries are unlikely to peak at the 

same time and that requiring economic 

downturn analysis at the product 

subcategory and national jurisdiction 

level does not recognize potential 

diversification effects across products 

and national jurisdictions and is thus 

overly conservative. Commenters also 

maintained that the proposed 

granularity requirement adds 

complexity and implementation burden 

relative to the New Accord. 

The agencies believe that the 

proposed definition of economic 

downturn conditions incorporates an 

appropriate level of granularity and are 

incorporating it unchanged in the final 

rule. The agencies understand that 

downturns in particular geographical 

subdivisions of national jurisdictions or 

in particular industrial sectors may 

result in significantly increased loss 

rates in material subdivisions of a 

bank’s exposures. The agencies also 

recognize that diversification across 

those subdivisions may mitigate risk for 

the overall organization. However, the 

agencies believe that the required 

minimum level of granularity at the 

subcategory and national jurisdiction 

level provides a suitable balance 

between allowing for the benefits of 

diversification and appropriate 

conservatism for risk-based capital 

requirements. 

Under the final rule, a bank must 

consider economic downturn conditions 

that appropriately reflect its actual 

exposure profile. For example, a bank 

with a geographical or industry sector 

concentration in a subcategory of 

exposures may find that information 

relating to a downturn in that 

geographical region or industry sector 

may be more relevant for the bank than 

a general downturn affecting many 

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32To illustrate, suppose that for a particular assetbased lending exposure the EAD equaled $100 and 

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

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

Furthermore, suppose that in the event of default 

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

$20 would reduce the exposure amount to $80 at 

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

economic loss rate measured relative to the amount 

owed at default (60 percent) would exceed the 

economic loss rate measured relative to EAD (48 

percent = .60 × ($100 ¥$20)/$100), because the 

former does not reflect fully the impact of the predefault paydowns. 

regions or industries. The final rule (like 

the proposed rule) allows banks to 

subdivide exposure subcategories or 

national jurisdictions as they deem 

appropriate given the exposures held by 

the bank. Moreover, the agencies note 

that the exposure subcategory/national 

jurisdiction granularity requirement is 

only a minimum granularity 

requirement. 

Supervisory Mapping Function 

The proposed rule provided banks 

two methods of generating LGD 

estimates for wholesale exposures and 

retail segments. First, a bank could use 

its own estimates of LGD for a 

subcategory of exposures if the bank had 

prior written approval from its primary 

Federal supervisor to use internal 

estimates for that subcategory of 

exposures. In approving a bank’s use of 

internal estimates of LGD, a bank’s 

primary Federal supervisor would 

consider whether the bank’s internal 

estimates of LGD were reliable and 

sufficiently reflective of economic 

downturn conditions. The supervisor 

would also consider whether the bank 

has rigorous and well-documented 

policies and procedures for identifying 

economic downturn conditions for the 

exposure subcategory, identifying 

material adverse correlations between 

the relevant drivers of default rates and 

loss rates given default, and 

incorporating identified correlations 

into internal LGD estimates. If a bank 

had supervisory approval to use its own 

estimates of LGD for an exposure 

subcategory, it would use its own 

estimates of LGD for all exposures 

within that subcategory. 

As an alternative to internal estimates 

of LGD, the proposed rule provided a 

supervisory mapping function for 

converting ELGD into LGD for riskbased capital purposes. A bank that did 

not qualify to use its own estimates of 

LGD for a subcategory of exposures 

would instead compute LGD using the 

linear supervisory mapping function: 

LGD = 0.08 + 0.92 × ELGD. A bank 

would not have to apply the supervisory 

mapping function to repo-style 

transactions, eligible margin loans, and 

OTC derivative contracts (defined below 

in section V.C. of this preamble). The 

agencies proposed the supervisory 

mapping function because of concerns 

that banks may find it difficult to 

produce internal estimates of LGD that 

are sufficient for risk-based capital 

purposes because LGD data for 

important portfolios may be sparse, and 

there is limited industry experience 

with incorporating downturn conditions 

into LGD estimates. The supervisory 

mapping function provided a pragmatic 

methodology for banks to use while 

refining their LGD estimation 

techniques. 

In general, commenters viewed the 

supervisory mapping function as a 

significant deviation from the New 

Accord that would add unwarranted 

prescriptiveness and regulatory burden 

to the U.S. rule. Commenters requested 

more flexibility to address problems 

with LGD estimation, including the 

ability to apply appropriate margins of 

conservatism as contemplated in the 

New Accord. Commenters expressed 

concern that U.S. supervisors would 

employ an unreasonably high standard 

for allowing own estimates of LGD, 

forcing banks to use the supervisory 

mapping function for an extended 

period of time. Commenters also 

expressed concern that supervisors 

would view the output of the 

supervisory mapping function as a floor 

on internal estimates of LGD. 

Commenters asserted that in both cases 

risk-based capital requirements would 

be increased at U.S. banks relative to 

their foreign competitors, particularly 

for high-quality assets, putting U.S. 

banks at a competitive disadvantage to 

foreign banks. 

In particular, many commenters 

viewed the supervisory mapping 

function as overly punitive for exposure 

categories with relatively low loss 

severities, effectively imposing an 8 

percent floor on LGD. Commenters also 

objected to the proposed requirement 

that a bank use the supervisory mapping 

function for an entire subcategory of 

exposures even if it had difficulty 

estimating LGD only for a small subset 

of those exposures. 

The agencies continue to believe that 

the supervisory mapping function is a 

reasonable aid for dealing with 

problems in LGD estimation. The 

agencies recognize, however, that there 

may be several valid methodologies for 

addressing such problems. For example, 

a relative scarcity of historical loss data 

for a particular obligor or exposure type 

may be addressed by increased reliance 

on alternative data sources and dataenhancing tools for quantification and 

alternative techniques for validation. In 

addition, a bank should reflect in its 

estimates of risk parameters a margin of 

conservatism that is related to the likely 

range of uncertainty. These concepts are 

discussed below in the quantification 

principles section of the preamble. 

Therefore, the agencies are not 

including the supervisory mapping 

function in the final rule. However, the 

agencies continue to believe that the 

function (and associated estimation of 

the long-run default-weighted average 

economic loss rate given default within 

a one-year horizon) is one way a bank 

could address difficulties in estimating 

LGD. However it chooses to estimate 

LGD, a bank’s estimates of LGD must be 

reliable and sufficiently reflective of 

economic downturn conditions, and the 

bank should have rigorous and welldocumented policies and procedures for 

identifying economic downturn 

conditions for each exposure 

subcategory, identifying changes in 

material adverse relationships between 

the relevant drivers of default rates and 

loss rates given default, and 

incorporating identified relationships 

into LGD estimates. 

Pre-Default Reductions in Exposure 

The proposed rule incorporated 

comments on the ANPR suggesting a 

need to better accommodate certain 

credit products, most prominently assetbased lending programs, whose 

structures typically result in a bank 

recovering substantial amounts of the 

exposure prior to the default date—for 

example, through paydowns of 

outstanding principal. The agencies 

believe that actions taken prior to 

default to mitigate losses are an 

important component of a bank’s overall 

credit risk management, and that such 

actions should be reflected in LGD 

when banks can quantify their 

effectiveness in a reliable manner. In the 

proposed rule, this was achieved by 

measuring LGD relative to the 

exposure’s EAD (defined in the next 

section) as opposed to the amount 

actually owed at default.32

Commenters agreed that the IRB 

approach should allow banks to 

recognize in their risk parameters the 

benefits of expected pre-default 

recoveries and other expected 

reductions in exposure prior to default. 

Some commenters suggested, however, 

that it is more appropriate to reflect predefault recoveries in EAD rather than 

LGD. Other commenters supported the 

proposed rule’s approach or asserted 

that banks should have the option of 

incorporating pre-default recoveries in 

either LGD or EAD. Commenters 

discouraged the agencies from 

restricting the types of pre-default 

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

accrued but unpaid interest and fees net of any 

amount expensed by the bank as uncollectable. 

reductions in exposure that could be 

recognized, and generally contended 

that the reductions should be 

recognized for all exposures for which 

a pattern of pre-default reductions can 

be estimated reliably and accurately by 

the bank. 

Consistent with the New Accord, the 

agencies have decided to maintain the 

proposed treatment of pre-default 

reductions in exposure in the final rule. 

The final rule does not limit the 

exposure types to which a bank may 

apply this treatment. However, the 

agencies have clarified their 

requirement for quantification of LGD in 

section 22(c)(4) of the final rule. This 

section states that where the bank’s 

quantification of LGD directly or 

indirectly incorporates estimates of the 

effectiveness of its credit risk 

management practices in reducing its 

exposure to troubled obligors prior to 

default, the bank must support such 

estimates with empirical analysis 

showing that the estimates are 

consistent with its historical experience 

in dealing with such exposures during 

economic downturn conditions. 

A bank’s methods for reflecting 

changes in exposure during the period 

prior to default must be consistent with 

other aspects of the final rule. For 

example, a bank must use a default 

horizon no longer than one year, 

consistent with the one-year default 

horizon incorporated in other aspects of 

the final rule, such as the quantification 

of PD. In addition, a pre-default 

reduction in the outstanding amount on 

one exposure that does not reflect a 

reduction in the bank’s total exposure to 

the obligor, such as a refinancing, 

should not be reflected as a pre-default 

recovery for LGD quantification 

purposes. 

The following simplified example 

illustrates how a bank could approach 

incorporating pre-default reductions in 

exposure in LGD. Assume a bank has a 

portfolio of asset-based loans fully 

collateralized by receivables. The bank 

maintains a database of such loans that 

have defaulted, which records the 

exposure at the time of default and the 

losses incurred at and after the date of 

default. After careful analysis of its 

historical data, the bank finds that for 

every $100 of exposure on a typical 

asset-based loan at the time of default, 

properly discounted average losses are 

$80 under economic downturn 

conditions. Thus, the bank may assign 

an LGD estimate of 80 percent that is 

based on such evidence. 

However, assume that the bank 

division responsible for collections 

reports that the bank’s loan workout 

practices generally result in exposures 

on the asset-based loans being 

significantly reduced between the time 

the loan is identified internally as a 

problem exposure and the time when 

the obligor is in default for risk-based 

capital purposes. The bank studies the 

pre-default paydown behavior of 

obligors that default within the next 

one-year horizon and during economic 

downturn conditions. In particular, the 

bank uses its internal historical data to 

map exposure amounts for asset-based 

loans at the time of default to exposure 

amounts for the same loans at various 

points in time prior to default and 

confirms that the pattern of pre-default 

paydowns corresponds to reductions in 

the bank’s overall exposures to the 

obligors, as opposed to refinancings. 

Robust empirical analysis further 

indicates that pre-default paydowns for 

asset-based loans to obligors that default 

within the next one-year horizon during 

economic downturn conditions depend 

on the length of time the loan has been 

subject to workout. Specifically, the 

bank finds that the prospects for further 

pre-default paydowns diminish 

markedly the longer the bank has 

managed the loan as a problem credit 

exposure. For loans that are not in 

workout or that the bank has placed in 

workout for fewer than 90 days, the 

bank’s analysis indicates that predefault paydowns on loans to obligors 

defaulting within the next year during 

economic downturn conditions were, on 

average, 50 percent of the current 

amount owed by the obligor. In contrast, 

for asset-based loans that have been in 

workout for at least 90 days, the bank’s 

analysis indicates that any further predefault recoveries tend to be immaterial. 

Thus, provided this analysis is suitable 

for estimating LGDs according to section 

22(c) of the final rule, the bank may 

appropriately assign an LGD estimate of 

40 percent to asset-based loans that are 

not in workout or that have been in 

workout for fewer than 90 days. For 

asset-based loans that have been in 

workout for at least 90 days, the bank 

should assign an LGD of 80 percent. 

Exposure at Default (EAD) 

Under the proposed rule, EAD for the 

on-balance sheet component of a 

wholesale or retail exposure generally 

was (i) the bank’s carrying value for the 

exposure (including net accrued but 

unpaid interest and fees) 33 less any 

allocated transfer risk reserve for the 

exposure, if the exposure was classified 

as held-to-maturity or for trading; or (ii) 

the bank’s carrying value for the 

exposure (including net accrued but 

unpaid interest and fees) less any 

allocated transfer risk reserve for the 

exposure and any unrealized gains on 

the exposure plus any unrealized losses 

on the exposure, if the exposure was 

classified as available-for-sale. 

One commenter asserted that banks 

should not be required to include net 

accrued but unpaid interest and fees in 

EAD. Rather, this commenter requested 

the flexibility to incorporate such 

interest and fees in either EAD or LGD. 

The agencies believe that net accrued 

but unpaid interest and fees represent 

credit exposure to an obligor, similar to 

the unpaid principal of a loan extended 

to the obligor, and thus are most 

appropriately included in EAD. 

Moreover, requiring all banks to include 

such interest and fees in EAD rather 

than LGD promotes consistency and 

comparability across banks for 

regulatory reporting and public 

disclosure purposes. 

The agencies are therefore 

maintaining the substance of the 

proposed rule’s definition of EAD for 

on-balance sheet exposures in the final 

rule. The final rule clarifies that, for 

purposes of EAD, all exposures other 

than securities classified as available-for 

sale receive the treatment specified for 

exposures classified as held-to-maturity 

or for trading under the proposal. Some 

exposures held at fair value, such as 

partially funded loan commitments, 

may have both on-balance sheet and offbalance sheet components. In such 

cases, a bank must compute EAD for 

both the positive on- and off-balance 

sheet components of the exposure. 

For the off-balance sheet component 

of a wholesale or retail exposure (other 

than an OTC derivative contract, repostyle transaction, or eligible margin 

loan) in the form of a loan commitment 

or line of credit, EAD under the 

proposed rule was the bank’s best 

estimate of net additions to the 

outstanding amount owed the bank, 

including estimated future additional 

draws of principal and accrued but 

unpaid interest and fees, that were 

likely to occur over the remaining life of 

the exposure assuming the exposure 

were to go into default. This estimate of 

net additions would reflect what would 

be expected during a period of 

economic downturn conditions. This 

treatment is retained in the final rule. 

Also, consistent with the New Accord, 

the final rule extends this ‘‘own 

estimates’’ treatment to trade-related 

letters of credit and for transactionrelated contingencies. Trade-related 

letters of credit are short-term selfliquidating instruments used to finance 

the movement of goods and are 

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collateralized by the underlying goods. 

A transaction-related contingency 

includes such items as a performance 

bond or performance-based standby 

letter of credit. 

For the off-balance sheet component 

of a wholesale or retail exposure other 

than an OTC derivative contract, repostyle transaction, eligible margin loan, 

loan commitment, or line of credit 

issued by a bank, EAD was the notional 

amount of the exposure. This treatment 

is retained in the final rule. 

One commenter asked the agencies to 

permit banks to employ the New 

Accord’s flexibility to reflect additional 

draws on lines of credit in either LGD 

or EAD. For the same reasons that the 

agencies are requiring banks to include 

net accrued but unpaid interest and fees 

in EAD, the agencies have decided to 

continue the requirement in the final 

rule for banks to reflect estimates of 

additional draws in EAD, consistent 

with the proposed rule. 

Another commenter noted that the 

‘‘remaining life of the exposure’’

concept in the proposed definition of 

EAD for off-balance sheet exposures is 

ambiguous and inconsistent with 

defining PD over a one-year horizon. To 

address this commenter’s concern, the 

agencies have modified the definition of 

EAD. The final rule requires a bank to 

estimate net additions to the 

outstanding amount owed the bank in 

the event of default over a one-year 

horizon. 

Other commenters noted that banks 

may reduce their exposure to certain 

sectors in periods of economic 

downturn, and inquired as to the extent 

to which such practices may be 

reflected in EAD estimates. The agencies 

believe that such practices may be 

reflected in EAD estimates for loan 

commitments, lines of credit, traderelated letters of credit, and transactionrelated contingencies to the extent that 

those practices are reflected in the 

bank’s data on defaulted exposures. 

They may be reflected in EAD estimates 

for on-balance sheet exposures only at 

the time the on-balance sheet exposure 

is actually reduced. 

To illustrate the EAD concept, assume 

a bank has a $100 unsecured, fully 

drawn, two-year term loan with $10 of 

interest payable at the end of the first 

year and a balloon payment of $110 at 

the end of the term. Suppose it has been 

six months since the loan’s origination, 

and accrued interest equals $5. The EAD 

of this loan would be equal to the 

outstanding principal amount plus 

accrued interest, or $105. 

Next, consider the case of an openend revolving credit line of $100, on 

which the borrower had drawn $70 (the 

unused portion of the line is $30). 

Current accrued but unpaid interest and 

fees are zero. The bank can document 

that, on average, during economic 

downturn conditions, 20 percent of the 

remaining undrawn amounts are drawn 

in the year preceding a firm’s default. 

Therefore, the bank’s estimate of future 

draws is $6 (20% × $30). Additionally, 

the bank’s analysis indicates that, on 

average, during economic downturn 

conditions, such a facility can be 

expected to have accrued at the time of 

default unpaid interest and commitment 

fees equal to three months of interest 

against the drawn amount and 0.5 

percent against the undrawn amount, 

which in this example is assumed to 

equal $0.25. Thus, the EAD for 

estimated future accrued but unpaid 

interest and fees equals $0.25. In sum, 

the EAD should be the drawn amount 

plus estimated future accrued but 

unpaid fees plus the estimated amount 

of future draws = $76.25 ($70 + $0.25 + 

$6). 

Under the proposed rule, EAD for a 

segment of retail exposures was the sum 

of the EADs for each individual 

exposure in the segment. The agencies 

have changed this provision in the final 

rule, recognizing that banks typically 

estimate EAD for a segment of retail 

exposures rather than on an individual 

exposure basis. 

Under the final and proposed rules, 

for wholesale or retail exposures in 

which only the drawn balance has been 

securitized, the bank must reflect its 

share of the exposures’ undrawn 

balances in EAD. The undrawn balances 

of revolving exposures for which the 

drawn balances have been securitized 

must be allocated between the seller’s 

and investors’ interests on a pro rata 

basis, based on the proportions of the 

seller’s and investors’ shares of the 

securitized drawn balances. For 

example, if the EAD of a group of 

securitized exposures’ undrawn 

balances is $100, and the bank’s share 

(seller’s interest) in the securitized 

exposures is 25 percent, the bank must 

reflect $25 in EAD for the undrawn 

balances. 

The final rule (like the proposed rule) 

contains a separate treatment of EAD for 

OTC derivative contracts, which is in 

section 32 of the rule and discussed in 

more detail in section V.C. of the 

preamble. The final rule also clarifies 

that a bank may use the treatment of 

EAD in section 32 of the rule for repostyle transactions and eligible margin 

loans, or the bank may use the general 

definition of EAD described in this 

section for such exposures. 

General Quantification Principles 

The final rule, like the proposed rule, 

requires data used by a bank to estimate 

risk parameters to be relevant to the 

bank’s actual wholesale and retail 

exposures and of sufficient quality to 

support the determination of risk-based 

capital requirements for the exposures. 

For wholesale exposures, estimation of 

the risk parameters must be based on a 

minimum of five years of default data to 

estimate PD, seven years of loss severity 

data to estimate LGD, and seven years 

of exposure amount data to estimate 

EAD. For segments of retail exposures, 

estimation of risk parameters must be 

based on a minimum of five years of 

default data to estimate PD, five years of 

loss severity data to estimate LGD, and 

five years of exposure amount data to 

estimate EAD. Default, loss severity, and 

exposure amount data must include 

periods of economic downturn 

conditions or the bank must adjust its 

estimates of risk parameters to 

compensate for the lack of data from 

such periods. Banks must base their 

estimates of PD, LGD, and EAD on the 

final rule’s definition of default, and 

must review at least annually and 

update (as appropriate) their risk 

parameters and risk parameter 

quantification process. 

In all cases, banks are expected to use 

the best available data for quantifying 

the risk parameters. A bank could meet 

the minimum data requirement by using 

internal data, external data, or pooled 

data combining internal data with 

external data. Internal data refers to any 

data on exposures held in a bank’s 

existing or historical portfolios, 

including data elements or information 

provided by third parties regarding such 

exposures. External data refers to 

information on exposures held outside 

of the bank’s portfolio or aggregate 

information across an industry. For new 

lines of business, where a bank lacks 

sufficient internal data, a bank likely 

will need to use external data to 

supplement its internal data. 

The agencies recognize that the 

minimum sample period for reference 

data provided in the final rule may not 

provide the best available results. A 

longer sample period usually captures 

varying economic conditions better than 

a shorter sample period. In addition, a 

longer sample period will include more 

default observations for LGD and EAD 

estimation. Banks should consider using 

a longer-than-minimum sample period 

when possible. However, the potential 

increase in precision afforded by a 

larger sample size should be weighed 

against the potential for diminished 

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34BCBS, Basel Committee Newsletter No. 6, 

‘‘Validation of low-default portfolios in the Base II 

Framework,’’ September 2005. 

comparability of older data to the 

existing portfolio. 

Portfolios With Limited Data or Limited 

Defaults 

Many commenters requested further 

clarity about the procedures that banks 

should use to estimate risk parameters 

for portfolios characterized by a lack of 

internal data or with very little default 

experience. In particular, the GAO 

report recommended that the agencies 

provide additional clarity on this issue. 

Several commenters indicated that the 

agencies should establish criteria for 

identifying homogeneous portfolios of 

low-risk exposures and allow banks to 

apportion expected loss between LGD 

and PD for those portfolios rather than 

estimating each risk parameter 

separately. Other commenters suggested 

that the agencies consider whether 

banks should be permitted to use the 

New Accord’s standardized approach 

for credit risk for such portfolios. 

The final rule requires banks to meet 

the qualification requirements in section 

22 for all portfolios of exposures. The 

agencies expect that banks 

demonstrating appropriately rigorous 

processes and sufficient degrees of 

conservatism for portfolios with limited 

data or limited defaults will be able to 

meet the qualification requirements. 

Section 22(c)(3) of the final rule 

specifically states that a bank’s risk 

parameter quantification process ‘‘must 

produce appropriately conservative risk 

parameter estimates where the bank has 

limited relevant data.’’ The agencies 

believe that this section provides 

sufficient flexibility and incentives for 

banks to develop and document sound 

practices for applying the IRB approach 

to portfolios lacking sufficient data. 

The section of the preamble below 

expands upon potential approaches to 

portfolios with limited data. The BCBS 

publication ‘‘Validation of low-default 

portfolios in the Basel II Framework’’ 34

also provides a resource for banks facing 

this issue. The agencies will work with 

banks through the supervisory and 

examination processes to address 

particular situations. 

Portfolios with limited data. The final 

rule, like the proposal, permits the use 

of external data in quantification of risk 

parameters. External data should be 

informative of, and appropriate to, a 

bank’s existing exposures. In some 

cases, a bank may be able to acquire and 

use external data from a third party to 

estimate risk parameters until the bank’s 

internal database meets the 

requirements of the rule. Alternatively, 

a bank may be able to identify a set of 

data-rich internal exposures that could 

be used to inform the estimation of risk 

parameters for the portfolio for which it 

has insufficient data. The key 

considerations for a bank in determining 

whether to use alternative data sources 

will be whether such data are 

sufficiently accurate, complete, 

representative and informative of the 

bank’s existing exposures and whether 

the bank’s quantification of risk 

parameters is rigorously conducted and 

well documented. 

For instance, consider a bank that has 

recently extended its credit card 

operations to include a new market 

segment for credit card loans and, 

therefore, has limited internal data on 

the performance of the exposures in this 

new market segment. The bank could 

acquire external data from various 

vendors that would provide a broad, 

market-wide picture of default and loss 

experience in the new market segment. 

This external data could then be 

supplemented by the bank’s internal 

data and experience with its existing 

credit card operations. By comparing 

the bank’s experience with its existing 

customers to the market data, the bank 

can refine the risk parameters estimated 

from the external data on the new 

market segment and make those 

parameters more accurate for the bank’s 

new market segment of exposures. 

Using the combination of these data 

sources, the bank may be able to 

estimate appropriately conservative 

estimates of risk parameters for its new 

market segment of exposures. If the 

bank is not able to do so, it must include 

the new market segment of exposures in 

its set of aggregate immaterial exposures 

and apply a 100 percent risk weight. 

Portfolios with limited defaults. 

Commenters indicated that they had 

experienced very few defaults for some 

portfolios, most notably margin loans 

and exposures to some sovereign 

issuers, which made it difficult to 

separately estimate PD and LGD. The 

agencies recognize that some portfolios 

have experienced very few defaults and 

have very low loss experiences. The 

absence of defaults or losses in 

historical data does not, however, 

preclude the potential for defaults or 

large losses to arise in future 

circumstances. Moreover, as discussed 

previously, the ability to separate EL 

into PD and LGD is a key component of 

the IRB approach. 

As with the cases described above in 

which internal data are limited in all 

dimensions, external data from some 

related portfolios or for similar obligors 

may be used to estimate risk parameters 

that are then mapped to the low default 

portfolio or obligor. For example, banks 

could consider instances of near default 

or credit deterioration short of default in 

these low default portfolios to inform 

estimates of what might happen if a 

default were to occur. Similarly, 

scenario analysis that evaluates the 

hypothetical impact of severe market 

disruptions may help inform the bank’s 

parameter estimates for margin loans. 

For very low-risk wholesale obligors 

that have publicly traded financial 

instruments, banks may be able to glean 

information about the relative values of 

PD and LGD from different changes in 

credit spreads on instruments of 

different maturity or from different 

moves in credit spreads and equity 

prices. In all cases, risk parameter 

estimates should incorporate a degree of 

conservatism that is appropriate for the 

overall rigor of the quantification 

process. 

Other quantification process 

considerations. Both internal and 

external reference data should not differ 

systematically from a bank’s existing 

portfolio in ways that seem likely to be 

related to default risk, loss severity, or 

exposure at default. Otherwise, the 

derived PD, LGD, or EAD estimates may 

not be applicable to the bank’s existing 

portfolio. Accordingly, the bank must 

conduct a comprehensive review and 

analysis of reference data at least 

annually to determine the relevance of 

reference data to the bank’s exposures, 

the quality of reference data to support 

PD, LGD, and EAD estimates, and the 

consistency of reference data to the 

definition of default in the final rule. 

Furthermore, a bank must have 

adequate internal or external data to 

estimate the risk parameters PD, LGD, 

and EAD (each of which incorporates a 

one-year time horizon) for all wholesale 

exposure and retail segments, including 

those originated for sale or that are in 

the securitization pipeline. 

As noted above, periods of economic 

downturn conditions must be included 

in the data sample (or adjustments to 

risk parameters must be made). If the 

reference data include data from beyond 

the minimum number of years (to 

capture a period of economic downturn 

conditions or for other valid reasons), 

the reference data need not cover all of 

the intervening years. However, a bank 

should justify the exclusion of available 

data and, in particular, any temporal 

discontinuities in data used. Including 

periods of economic downturn 

conditions increases the size and 

potentially the breadth of the reference 

data set. According to some empirical 

studies, the average loss rate is higher 

during periods of economic downturn 

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35Retail credit card losses arising from noncontractual, third-party initiated fraud (for example, 

identity theft) are external fraud operational losses. 

All other third-party initiated credit losses are to be 

treated as credit risk losses. 

conditions, such that exclusion of such 

periods would bias LGD or EAD 

estimates downward and unjustifiably 

lower risk-based capital requirements. 

Risk parameter estimates should take 

into account the robustness of the 

quantification process. The assumptions 

and adjustments embedded in the 

quantification process should reflect the 

degree of uncertainty or potential error 

inherent in the process. In practice, a 

reasonable estimation approach likely 

would result in a range of defensible 

risk parameter estimates. The choices of 

the particular assumptions and 

adjustments that determine the final 

estimate, within the defensible range, 

should reflect the uncertainty in the 

quantification process. More uncertainty 

in the process should be reflected in the 

assignment of final risk parameter 

estimates that result in higher risk-based 

capital requirements relative to a 

quantification process with less 

uncertainty. The degree of conservatism 

applied to adjust for uncertainty should 

be related to factors such as the 

relevance of the reference data to a 

bank’s existing exposures, the 

robustness of the models, the precision 

of the statistical estimates, and the 

amount of judgment used throughout 

the process. A bank is not required to 

add a margin of conservatism at each 

step if doing so would produce an 

excessively conservative result. Instead, 

the overall margin of conservatism 

should adequately account for all 

uncertainties and weaknesses in the 

quantification process. Improvements in 

the quantification process (including 

use of more complete data and better 

estimation techniques) may reduce the 

appropriate degree of conservatism over 

time. 

Judgment will inevitably play a role 

in the quantification process and may 

materially affect the estimates of risk 

parameters. Judgmental adjustments to 

estimates are often necessary because of 

limitations on available reference data 

or because of inherent differences 

between the reference data and the 

bank’s existing exposures. The bank’s 

risk parameter quantification process 

must produce appropriately 

conservative risk parameter estimates 

when the bank has limited relevant 

data, and any adjustments that are part 

of the quantification process must not 

result in a pattern of bias toward lower 

risk parameter estimates. This does not 

prohibit individual adjustments that 

result in lower estimates of risk 

parameters, as both upward and 

downward adjustments are expected. 

Individual adjustments are less 

important than broad patterns; 

consistent signs of judgmental decisions 

that materially lower risk parameter 

estimates may be evidence of systematic 

bias, which is not permitted. 

In estimating relevant risk parameters, 

banks should not rely on the possibility 

of U.S. government financial assistance, 

except for the financial assistance that 

the U.S. government has a legally 

binding commitment to provide. 

4. Optional Approaches That Require 

Prior Supervisory Approval 

A bank that intends to apply the 

internal models methodology to 

counterparty credit risk, the double 

default treatment for credit risk 

mitigation, the IAA for securitization 

exposures to ABCP programs, or the 

IMA to equity exposures must receive 

prior written approval from its primary 

Federal supervisor. The criteria on 

which approval will be based are 

described in the respective sections 

below. 

5. Operational Risk 

A bank must have operational risk 

management processes, data and 

assessment systems, and quantification 

systems that meet the qualification 

requirements in section 22(h) of the 

final rule. A bank must have an 

operational risk management function 

that is independent of business line 

management. The operational risk 

management function is responsible for 

the design, implementation, and 

oversight of the bank’s operational risk 

data and assessment systems, 

operational risk quantification systems, 

and related processes. The roles and 

responsibilities of the operational risk 

management function may vary between 

banks, but should be clearly 

documented. The operational risk 

management function should have an 

organizational stature commensurate 

with the bank’s operational risk profile. 

At a minimum, the bank’s operational 

risk management function should 

ensure the development of policies and 

procedures for the explicit management 

of operational risk as a distinct risk to 

the bank’s safety and soundness. 

A bank also must establish and 

document a process to identify, 

measure, monitor, and control 

operational risk in bank products, 

activities, processes, and systems. This 

process should provide for the 

consistent and comprehensive 

collection of the data needed to estimate 

the bank’s exposure to operational risk. 

This process must capture business 

environment and internal control factors 

affecting the bank’s operational risk 

profile. The process must also ensure 

reporting of operational risk exposures, 

operational loss events, and other 

relevant operational risk information to 

business unit management, senior 

management, and to the board of 

directors (or a designated committee of 

the board). 

The final rule defines an operational 

loss event as an event that results in loss 

and is associated with any of the seven 

operational loss event type categories. 

Under the final rule, the agencies have 

included definitions of the seven 

operational loss event type categories, 

consistent with the descriptions 

outlined in the New Accord. The seven 

operational loss event type categories 

are: (i) Internal fraud, which is the 

operational loss event type category that 

comprises operational losses resulting 

from an act involving at least one 

internal party of a type intended to 

defraud, misappropriate property or 

circumvent regulations, the law or 

company policy, excluding diversity 

and discrimination-type events; (ii) 

external fraud, which is the operational 

loss event type category that comprises 

operational losses resulting from an act 

by a third party of a type intended to 

defraud, misappropriate property or 

circumvent the law; 35 (iii) employment 

practices and workplace safety, which is 

the operational loss event type category 

that comprises operational losses 

resulting from an act inconsistent with 

employment, health, or safety laws or 

agreements, payment of personal injury 

claims, or payment arising from 

diversity or discrimination events; (iv) 

clients, products, and business 

practices, which is the operational loss 

event type category that comprises 

operational losses resulting from the 

nature or design of a product or from an 

unintentional or negligent failure to 

meet a professional obligation to 

specific clients (including fiduciary and 

suitability requirements); (v) damage to 

physical assets, which is the operational 

loss event type category that comprises 

operational losses resulting from the 

loss of or damage to physical assets from 

natural disaster or other events; (vi) 

business disruption and system failures, 

which is the operational loss event type 

category that comprises operational 

losses resulting from disruption of 

business or system failures; and (vii) 

execution, delivery, and process 

management, which is the operational 

loss event type category that comprises 

operational losses resulting from failed 

transaction processing or process 

management or losses arising from 

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36New Accord, ¶ 673. 

37New Accord, ¶ 214. 

38New Accord, Annex 9. 

relations with trade counterparties and 

vendors. 

The final rule does not require a bank 

to capture internal operational loss 

event data according to these categories. 

However, unlike the proposed rule, the 

final rule requires that a bank must be 

able to map such data into the seven 

operational loss event type categories. 

The agencies believe such mapping will 

promote reporting consistency and 

comparability across banks and is 

consistent with expectations in the New 

Accord.36

A bank’s operational risk management 

processes should reflect the scope and 

complexity of its business lines, as well 

as its corporate organizational structure. 

Each bank’s operational risk profile is 

unique and should have a tailored risk 

management approach appropriate for 

the scale and materiality of the 

operational risks present in the bank. 

Operational Risk Data and Assessment 

System 

A bank must have an operational risk 

data and assessment system that 

incorporates on an ongoing basis the 

following four elements: internal 

operational loss event data, external 

operational loss event data, results of 

scenario analysis, and assessments of 

the bank’s business environment and 

internal controls. These four operational 

risk elements should aid the bank in 

identifying the level and trend of 

operational risk, determining the 

effectiveness of operational risk 

management and control efforts, 

highlighting opportunities to better 

mitigate operational risk, and assessing 

operational risk on a forward-looking 

basis. A bank’s operational risk data and 

assessment system must be structured in 

a manner consistent with the bank’s 

current business activities, risk profile, 

technological processes, and risk 

management processes. 

The proposed rule defined 

operational loss as a loss (excluding 

insurance or tax effects) resulting from 

an operational loss event. Operational 

losses included all expenses associated 

with an operational loss event except for 

opportunity costs, forgone revenue, and 

costs related to risk management and 

control enhancements implemented to 

prevent future operational losses. The 

definition of operational loss is an 

important issue, as it is a critical 

building block in a bank’s calculation of 

its operational risk capital requirement 

under the AMA. More specifically, the 

bank’s estimate of operational risk 

exposure—the basis for determining a 

bank’s risk-weighted asset amount for 

operational risk—is an estimate of 

aggregate operational losses generated 

by the bank’s AMA process. 

Many commenters supported the 

agencies’ proposed definition of 

operational loss and viewed it as 

appropriate and consistent with general 

use within the banking industry. Some 

commenters, however, opposed the 

inclusion of a specific definition of 

operational loss and asserted that the 

proposed treatment of operational loss 

is too prescriptive. In addition, some 

commenters maintained that including a 

definition of operational loss is 

inconsistent with the New Accord, 

which does not explicitly define 

operational loss. In response to a 

specific question in the proposal, many 

commenters asserted that the definition 

of operational loss should relate to its 

impact on regulatory capital rather than 

economic capital concepts. One 

commenter, however, recommended 

using the replacement cost of any fixed 

asset affected by an operational loss 

event to reflect the actual financial 

impact of the event. 

Because operational losses are the 

building blocks in a bank’s calculation 

of its operational risk capital 

requirement under the AMA, the 

agencies continue to believe that it is 

necessary to define what is meant by 

operational loss to achieve 

comparability and foster consistency 

both across banks and across business 

lines within a bank. Additionally, the 

agencies agree with those commenters 

who asserted that the definition of 

operational loss should relate to its 

impact on regulatory capital. Therefore, 

the agencies have adopted the proposed 

definition of operational loss 

unchanged. 

In the preamble to the proposed rule, 

the agencies recognized that there was 

a potential to double-count all or a 

portion of the risk-based capital 

requirement associated with fixed 

assets. Under the proposed rule, the 

credit-risk-weighted asset amount for a 

bank’s premises would equal the 

carrying value of the premises on the 

financial statements of the bank, 

determined in accordance with GAAP. 

A bank’s operational risk exposure 

estimate addressing bank premises 

generally would be different than, and 

in addition to, the risk-based capital 

requirement generated under the 

proposed rule and could, at least in part, 

address the same risk exposure. The 

majority of commenters on this issue 

recommended removing the credit risk 

capital requirement for premises and 

other fixed assets and preserving only 

the operational risk capital requirement. 

The agencies are maintaining the 

proposed rule’s treatment of fixed assets 

in the final rule. The New Accord 

generally provides a risk weight of 100 

percent for assets for which an IRB 

treatment is not specified.37 Consistent 

with the New Accord, the final rule 

provides that the risk-weighted asset 

amount for any on-balance sheet asset 

that does not meet the definition of a 

wholesale, retail, securitization, or 

equity exposure is equal to the carrying 

value of the asset. Also consistent with 

the New Accord, the final rule 

continues to include damage to physical 

assets among the operational loss event 

types incorporated into a bank’s 

operational risk exposure estimate.38

The agencies believe that requiring a 

bank to calculate both a credit risk and 

operational risk capital requirement for 

premises and fixed assets is justified in 

light of the fact that the credit risk 

capital requirement covers a broader set 

of risks, whereas the operational risk 

capital requirement covers potential 

physical damage to the asset. The 

agencies view this treatment of premises 

and other fixed assets as consistent with 

the New Accord and have confirmed 

that the approach is consistent with the 

approaches used by other jurisdictions 

implementing the New Accord. 

A bank must have a systematic 

process for capturing and using internal 

operational loss event data in its 

operational risk data and assessment 

systems. The final rule defines a bank’s 

internal operational loss event data as 

its gross operational loss amounts, 

dates, recoveries, and relevant causal 

information for operational loss events 

occurring at the bank. Under the 

proposed rule, a bank’s operational risk 

data and assessment system would 

include a minimum historical 

observation period of five years of 

internal operational losses. With 

approval of its primary Federal 

supervisor, however, a bank could use 

a shorter historical observation period to 

address transitional situations such as 

integrating a new business line. A bank 

also could refrain from collecting 

internal operational loss event data for 

individual operational losses below 

established dollar threshold amounts if 

the bank could demonstrate to the 

satisfaction of its primary Federal 

supervisor that the thresholds were 

reasonable, did not exclude important 

internal operational loss event data, and 

permitted the bank to capture 

substantially all the dollar value of the 

bank’s operational losses. 

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Several commenters expressed 

concern over the proposal’s five-year 

minimum historical observation period 

requirement for internal operational loss 

event data. These commenters 

recommended that the agencies align 

this provision with the New Accord, 

which allows for a three-year historical 

observation period upon initial AMA 

implementation. 

While the proposed rule required a 

bank to include in its operational risk 

data and assessment systems a historical 

observation period of at least five years 

for internal operational loss event data, 

it also provided for a shorter observation 

period subject to agency approval to 

address transitional situations, such as 

integrating a new business line. The 

agencies believe that these proposed 

provisions provide sufficient flexibility 

to consider other situations, on a caseby-case basis, in which a shorter 

observation period may be appropriate, 

such as a bank’s initial implementation 

of an AMA. Therefore, the final rule 

retains the five-year historical 

observation period requirements and the 

transitional flexibility for internal 

operational loss event data, as proposed. 

In relation to the provision that 

permits a bank to refrain from collecting 

internal operational loss event data 

below established thresholds, a few 

commenters sought clarification of the 

proposed requirement that the 

thresholds must permit the bank to 

capture ‘‘substantially all’’ of the dollar 

value of a bank’s operational losses. In 

particular, they questioned whether a 

bank must collect all or a very high 

percentage of operational losses or 

whether smaller losses could be 

modeled. 

To demonstrate the appropriateness of 

its threshold for internal operational 

loss event data collection, a bank might 

choose to collect all internal operational 

loss event data, at least for a time, to 

support a meaningful analysis around 

the appropriateness of its chosen data 

collection threshold. Alternatively, a 

bank might be able to obtain data from 

systems outside of its operational risk 

data and assessment system (for 

example, the bank’s general ledger 

system) to demonstrate the impact of 

choosing different thresholds on its 

operational risk exposure estimates. 

With respect to the commenters’

question regarding modeling smaller 

losses, the agencies would consider 

permitting such an approach based on 

whether the approach meets the overall 

qualification requirements outlined in 

the final rule. In particular, the agencies 

would consider whether the bank 

satisfies those requirements pertaining 

to a bank’s operational risk 

quantification system as well as its 

control, oversight, and validation 

mechanisms. Such modeling 

considerations, however, would not 

eliminate the requirement for a bank to 

demonstrate the appropriateness of any 

established internal operational loss 

event data collection thresholds. 

A bank also must establish a 

systematic process to determine its 

methodologies for incorporating 

external operational loss event data into 

its operational risk data and assessment 

systems. The proposed and final rules 

define external operational loss event 

data for a bank as gross operational loss 

amounts, dates, recoveries, and relevant 

causal information for operational loss 

events occurring at organizations other 

than the bank. External operational loss 

event data may serve a number of 

different purposes in a bank’s 

operational risk data and assessment 

systems. For example, external 

operational loss event data may be a 

particularly useful input in determining 

a bank’s level of exposure to operational 

risk when internal operational loss 

event data are limited. In addition, 

external operational loss event data 

provide a means for the bank to 

understand industry experience and, in 

turn, provide a means for the bank to 

assess the adequacy of its internal 

operational loss event data. 

While internal and external 

operational loss event data provide a 

historical perspective on operational 

risk, it is also important that a bank 

incorporate forward-looking elements 

into its operational risk data and 

assessment systems. Accordingly, under 

the final rule, as under the proposed 

rule, a bank must incorporate business 

environment and internal control factors 

into its operational risk data and 

assessment systems to assess fully its 

exposure to operational risk. In 

principle, a bank with strong internal 

controls in a stable business 

environment would have less exposure 

to operational risk than a bank with 

internal control weaknesses that is 

growing rapidly or introducing new 

products. In this regard, a bank should 

identify and assess the level and trends 

in operational risk and related control 

structures at the bank. These 

assessments should be current and 

comprehensive across the bank, and 

they should identify the operational 

risks facing the bank. The framework 

established by a bank to maintain these 

risk assessments should be sufficiently 

flexible to accommodate increasing 

complexity, new activities, changes in 

internal control systems, and an 

increasing volume of information. A 

bank must also periodically compare the 

results of its prior business environment 

and internal control factor assessments 

against the bank’s actual operational 

losses incurred in the intervening 

period. 

A few commenters sought 

clarification on the agencies’

expectations regarding a bank’s periodic 

comparisons of its prior business 

environment and internal control factor 

assessments against its actual 

operational losses. One commenter 

expressed concern over the difficulty of 

conducting an empirically robust 

analysis to fulfill the requirement. 

Under the final rule, a bank has 

flexibility in the approach it uses to 

conduct its business environment and 

internal control factor assessments. As 

such, the methods for conducting 

comparisons of these assessments 

against actual operational loss 

experience may also vary and precise 

modeling calibration may not be 

practical. The agencies maintain, 

however, that it is important for a bank 

to perform such comparisons to ensure 

that its assessments are current, 

reasonable, and appropriately factored 

into the bank’s AMA framework. In 

addition, the comparisons could 

highlight the need for potential 

adjustments to the bank’s operational 

risk management processes. 

A bank also must have a systematic 

process for determining its 

methodologies for incorporating 

scenario analysis into its operational 

risk data and assessment systems. As an 

input to a bank’s operational risk data 

and assessment systems, scenario 

analysis is especially relevant for 

business lines or operational loss event 

types where internal data, external data, 

and assessments of the business 

environment and internal control factors 

do not provide a sufficiently robust 

estimate of the bank’s exposure to 

operational risk. 

Similar to business environment and 

internal control factor assessments, the 

results of scenario analysis provide a 

means for a bank to incorporate a 

forward-looking element into its 

operational risk data and assessment 

systems. Under the proposed rule, 

scenario analysis was defined as a 

systematic process of obtaining expert 

opinions from business managers and 

risk management experts to derive 

reasoned assessments of the likelihood 

and loss impact of plausible highseverity operational losses. The agencies 

have clarified this definition in the final 

rule to recognize that there are various 

methods and inputs a bank may use to 

conduct its scenario analysis. For this 

reason, the modified definition 

indicates that scenario analysis may 

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include the well-reasoned evaluation 

and use of external operational loss 

event data, adjusted as appropriate to 

ensure relevance to a bank’s operational 

risk profile and control structure. 

A bank’s operational risk data and 

assessment systems must include 

credible, transparent, systematic, and 

verifiable processes that incorporate all 

four operational risk elements (that is, 

internal operational loss event data, 

external operational loss event data, 

scenario analysis, and business 

environment and internal control 

factors). The bank should have clear 

standards for the collection and 

modification of all elements. The bank 

should combine these four elements in 

a manner that most effectively enables 

it to quantify its exposure to operational 

risk. 

Operational Risk Quantification System 

A bank must have an operational risk 

quantification system that generates 

estimates of its operational risk 

exposure using its operational risk data 

and assessment systems. The final rule 

defines operational risk exposure as the 

99.9th percentile of the distribution of 

potential aggregate operational losses, as 

generated by the bank’s operational risk 

quantification system over a one-year 

horizon (and not incorporating eligible 

operational risk offsets or qualifying 

operational risk mitigants). The mean of 

such a total loss distribution is the 

bank’s EOL. The final rule defines EOL 

as the expected value of the distribution 

of potential aggregate operational losses, 

as generated by the bank’s operational 

risk quantification system using a oneyear horizon. The bank’s UOL is the 

difference between the bank’s 

operational risk exposure and the bank’s 

EOL. 

A few commenters sought 

clarification on whether the agencies 

would impose specific requirements 

around the use and weighting of the 

four elements of a bank’s operational 

risk data and assessment system, and 

whether there were any limitations on 

how external data or scenario analysis 

could be used as modeling inputs. 

Another commenter expressed concern 

that for some U.S.-chartered DIs that 

were subsidiaries of foreign banking 

organizations, it might be difficult to 

ever have enough internal operational 

loss event data to generate statistically 

significant operational risk exposure 

estimates. 

The agencies recognize that banks 

will have different inputs and 

methodologies for estimating their 

operational risk exposure given the 

inherent flexibility of the AMA. It 

follows that the weights assigned in 

combining the four required elements of 

a bank’s operational risk data and 

assessment system (internal operational 

loss event data, external operational loss 

event data, scenario analysis, and 

assessments of the bank’s business 

environment and internal control 

factors) will also vary across banks. 

Factors affecting the weighting include 

a bank’s operational risk profile, 

operational loss experience, internal 

control environment, and relative 

quality and content of the four elements. 

These factors will influence the 

emphasis placed on certain elements 

relative to others. As such, the agencies 

are not prescribing specific 

requirements around the weighting of 

each element, nor are they placing any 

specific limitations on the use of the 

elements. In view of this flexibility, 

however, under the final rule a bank’s 

operational risk quantification systems 

must include a credible, transparent, 

systematic, and verifiable approach for 

weighting the use of the four elements. 

As part of its operational risk 

exposure estimate, a bank must use a 

unit of measure that is appropriate for 

the bank’s range of business activities 

and the variety of operational loss 

events to which it is exposed. The 

proposed rule defined a unit of measure 

as the level (for example, organizational 

unit or operational loss event type) at 

which the bank’s operational risk 

quantification system generated a 

separate distribution of potential 

operational losses. Under the proposed 

rule, a bank could not combine business 

activities or operational loss events with 

different risk profiles within the same 

loss distribution. 

Many commenters expressed concern 

that the prohibition against combining 

business activities or operational loss 

events with different risk profiles within 

the same loss distribution was an 

impractical standard because some level 

of combination was unavoidable. 

Additionally, commenters noted that 

data limitations made it difficult to 

quantify risk profiles at a granular level. 

Commenters also expressed concern 

that the proposed rule appeared to 

preclude the use of ‘‘top-down’’

approaches, given that under a firmwide approach business activities or 

operational loss events with different 

risk profiles would necessarily be 

combined within the same loss 

distribution. One commenter suggested 

that, because of data limitations and the 

potential for wide variations in risk 

profiles within individual business lines 

and/or types of operational loss events, 

banks be afforded some latitude in 

moving from a ‘‘top-down’’ approach to 

a ‘‘bottom-up’’ approach. 

The agencies have retained the 

proposed definition of unit of measure 

in the final rule. The agencies recognize, 

however, that there is a need for 

flexibility in assessing whether a bank’s 

chosen unit of measure is appropriate 

for the bank’s range of business 

activities and the variety of operational 

loss events to which it is exposed. In 

some instances, data limitations may 

indeed prevent a bank’s operational risk 

quantification systems from generating a 

separate distribution of potential 

operational losses for certain business 

lines or operational loss event types. 

Therefore, the agencies have modified 

the final rule to provide a bank more 

flexibility in devising an appropriate 

unit of measure. Specifically, a bank 

must employ a unit of measure that is 

appropriate for its range of business 

activities and the variety of operational 

loss events to which it is exposed, and 

that does not combine business 

activities or operational loss events with 

demonstrably different risk profiles 

within the same loss distribution. 

The agencies recognize that 

operational losses across operational 

loss event types and business lines may 

be related. Under the final rule, as under 

the proposed rule, a bank may use its 

internal estimates of dependence among 

operational losses within and across 

business lines and operational loss 

event types if the bank can demonstrate 

to the satisfaction of its primary Federal 

supervisor that its process for estimating 

dependence is sound, robust to a variety 

of scenarios, implemented with 

integrity, and allows for the uncertainty 

surrounding the estimates. The agencies 

expect that a bank’s assumptions 

regarding dependence will be 

conservative given the uncertainties 

surrounding dependence modeling for 

operational risk. If a bank does not 

satisfy the requirements surrounding 

dependence, the bank must sum 

operational risk exposure estimates 

across units of measure to calculate its 

total operational risk exposure. 

Under the proposed rule, dependence 

was defined as ‘‘a measure of the 

association among operational losses 

across and within business lines and 

operational loss event types.’’ One 

commenter recommended that the 

agencies revise the definition of 

dependence to ‘‘a measure of the 

association among operational losses 

across and within units of measure.’’

The agencies recognize that examples of 

units of measure include, but are not 

limited to, business lines and 

operational loss event types, and that a 

bank’s operational risk quantification 

system could generate distributions of 

potential operational losses that are 

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39New Accord, ¶669. 40 12 U.S.C. 1815(e). 

separate from its business lines and 

operational loss event types. Units of 

measure can also encompass 

correlations over time. Therefore, the 

agencies have amended the final rule to 

define dependence as a measure of the 

association among operational losses 

across and within units of measure. 

As noted above, under the proposed 

rule, a bank that did not satisfy the 

requirements surrounding dependence 

would sum operational risk exposure 

estimates across units of measure to 

calculate its total operational risk 

exposure. Several commenters asserted 

that the New Accord does not require a 

bank to sum its operational risk 

exposure estimates across units of 

measure if the bank cannot demonstrate 

adequate support of its dependence 

assumptions. One commenter asked the 

agencies to remove this requirement 

from the final rule. Several commenters 

suggested that if a bank cannot provide 

sufficient support for its dependence 

estimates, a conservative assumption of 

positive dependence is warranted, but 

not an assumption of perfect positive 

dependence as implied by the 

summation requirement. Another 

commenter suggested that the 

dependence assumption should be 

based upon a conservative statistical 

analysis of industry data. 

The New Accord states that, absent a 

satisfactory demonstration of a bank’s 

‘‘systems for determining correlations’’

to its national supervisor, ‘‘risk 

measures for different operational risk 

estimates must be added for purposes of 

calculating the regulatory minimum 

capital requirement.’’ 39 The agencies 

continue to believe that this treatment of 

operational risk exposure estimates 

across units of measure is prudent until 

the relationships among operational 

losses are better understood. Therefore, 

the final rule retains the proposed rule’s 

requirement regarding the summation of 

operational risk exposure estimates. 

Several commenters believed that a 

bank should be permitted to 

demonstrate the nature of the 

relationship between the causes of 

different operational losses based on 

any available informative empirical 

evidence. These commenters suggested 

that such evidence could be statistical 

or anecdotal, and could be based on 

information ranging from established 

statistical techniques to more general 

mathematical approaches to clear 

logical arguments about the degree to 

which risks and losses are related, or the 

similarity of circumstance between the 

bank and a peer group for which 

acceptable estimates of dependency are 

available. 

The agencies recognize that there may 

be different ways to estimate the 

relationship among operational losses 

across and within units of measure. 

Therefore, under the final rule, a bank 

has flexibility to use different 

methodologies to demonstrate 

dependence across units of measure. 

However, the bank must demonstrate to 

the satisfaction of its primary Federal 

supervisor that its process for estimating 

dependence is sound, robust to a variety 

of scenarios, implemented with 

integrity, and allows for the uncertainty 

surrounding the estimates. 

A bank’s chosen unit of measure 

affects how it should account for 

dependence. Explicit assumptions 

regarding dependence across units of 

measure are always necessary to 

estimate operational risk exposure at the 

bank level. However, explicit 

assumptions regarding dependence 

within units of measure are not 

necessary, and under many 

circumstances models assume statistical 

independence within each unit of 

measure. The use of only a few units of 

measure increases the need to ensure 

that dependence within units of 

measure is suitably reflected in the 

operational risk exposure estimate. 

In addition, the bank’s process for 

estimating dependence should provide 

for ongoing monitoring, recognizing that 

dependence estimates can change. The 

agencies expect that a bank’s approach 

for developing explicit and objective 

dependence determinations will 

improve over time. As such, the bank 

should develop a process for assessing 

incremental improvements to the 

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

Under the final rule, as under the 

proposed rule, a bank must review and 

update (as appropriate) its operational 

risk quantification system whenever the 

bank becomes aware of information that 

may have a material effect on the bank’s 

estimate of operational risk exposure, 

but no less frequently than annually. 

The agencies recognize that, in 

limited circumstances, there may not be 

sufficient data available for a bank to 

generate a credible estimate of its own 

operational risk exposure at the 99.9 

percent confidence level. In these 

limited circumstances, under the 

proposed rule, a bank could use an 

alternative operational risk 

quantification system, subject to prior 

approval by the bank’s primary Federal 

supervisor. The alternative approach 

was not available at the BHC level. 

One commenter asserted that, in line 

with the New Accord’s continuum of 

operational risk measurement 

approaches, all banks, including BHCs, 

should be permitted to adopt an 

alternative operational risk 

quantification system, such as the New 

Accord’s standardized approach or 

allocation approach. The commenter 

further noted that a bank’s use of an 

allocation approach should not be 

subject to more stringent terms and 

conditions than those set forth in the 

New Accord. 

The agencies are maintaining the 

alternative approach provision in the 

final rule. The agencies are not 

prescribing specific estimation 

methodologies under this approach and 

expect use of an alternative approach to 

occur on a very limited basis. A bank 

proposing to use an alternative 

operational risk quantification system 

must submit a proposal to its primary 

Federal supervisor. In evaluating a 

bank’s proposal, the primary Federal 

supervisor will review the bank’s 

justification for requesting use of an 

alternative approach in light of the 

bank’s size, complexity, and risk profile. 

The bank’s primary Federal supervisor 

will also consider whether the estimate 

of operational risk under the alternative 

approach is appropriate (for example, 

whether the estimate results in capital 

levels that are commensurate with the 

bank’s operational risk profile and is 

sensitive to changes in the bank’s risk 

profile) and can be supported 

empirically. Furthermore, the agencies 

expect a bank using an alternative 

operational risk quantification system to 

adhere to the rule’s qualification 

requirements, including establishment 

and use of operational risk management 

processes and data and assessment 

systems. As under the proposed rule, 

the alternative approach is not available 

at the BHC level. 

A bank proposing an alternative 

approach to operational risk based on an 

allocation methodology should be aware 

of certain limitations associated with 

the use of such an approach. 

Specifically, the agencies will not 

permit a DI to accept an allocation of 

operational risk capital requirements 

that includes non-DIs. Unlike the crossguarantee provision of the Federal 

Deposit Insurance Act, which provides 

that a DI is liable for any losses incurred 

by the FDIC in connection with the 

failure of a commonly-controlled DI, 

there are no statutory provisions 

requiring cross-guarantees between a DI 

and its non-DI affiliates. 40 Furthermore, 

depositors and creditors of a DI 

generally have no legal recourse to 

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capital funds that are not held by the DI 

or its affiliate DIs. 

6. Data Management and Maintenance 

A bank must have data management 

and maintenance systems that 

adequately support all aspects of the 

bank’s advanced IRB systems, 

operational risk management processes, 

operational risk data and assessment 

systems, operational risk quantification 

systems, and, to the extent the bank uses 

the following systems, the internal 

models methodology, the double default 

excessive correlation detection process, 

the IMA for equity exposures, and the 

IAA for securitization exposures to 

ABCP programs (collectively, advanced 

systems). 

The bank’s data management and 

maintenance systems must adequately 

support the timely and accurate 

reporting of risk-based capital 

requirements. Specifically, a bank must 

retain sufficient data elements related to 

key risk drivers to permit monitoring, 

validation, and refinement of the bank’s 

advanced systems. A bank’s data 

management and maintenance systems 

should generally support the rule’s 

qualification requirements relating to 

quantification, validation, and control 

and oversight mechanisms, as well as 

the bank’s broader risk management and 

reporting needs. The precise data 

elements to be collected are dictated by 

the features and methodologies of the 

risk measurement and management 

systems employed by the bank. To meet 

the significant data management 

challenges presented by the 

quantification, validation, and control 

and oversight requirements of the 

advanced approaches, a bank must 

retain data in an electronic format that 

allows timely retrieval for analysis, 

reporting, and disclosure purposes. The 

agencies did not receive any material 

comments on these data management 

requirements. 

7. Control and Oversight Mechanisms 

The consequences of an inaccurate or 

unreliable advanced system can be 

significant, particularly regarding the 

calculation of risk-based capital 

requirements. Accordingly, bank senior 

management is responsible for ensuring 

that all advanced systems function 

effectively and comply with the 

qualification requirements. 

Under the proposed rule, a bank’s 

board of directors (or a designated 

committee of the board) would at least 

annually evaluate the effectiveness of, 

and approve, the bank’s advanced 

systems. Multiple commenters objected 

to this requirement. Commenters 

suggested that a bank’s board of 

directors should have more narrowly 

defined responsibilities, and that 

evaluation of a bank’s advanced systems 

would be more effectively and 

appropriately accomplished by senior 

management. 

The agencies believe that a bank’s 

board of directors has ultimate 

accountability for the effectiveness of 

the bank’s advanced systems. However, 

the agencies agree that it is not 

necessarily the responsibility of a bank’s 

board of directors to conduct an 

evaluation of the effectiveness of a 

bank’s advanced systems. Evaluation 

may include transaction testing, 

validation, and audit activities more 

appropriately the responsibility of 

senior management. Accordingly, the 

final rule requires a bank’s board of 

directors to review the effectiveness of, 

and approve, the bank’s advanced 

systems at least annually. 

To support senior management’s and 

the board of directors’’ oversight 

responsibilities, a bank must have an 

effective system of controls and 

oversight that ensures ongoing 

compliance with the qualification 

requirements; maintains the integrity, 

reliability, and accuracy of the bank’s 

advanced systems; and includes 

adequate corporate governance and 

project management processes. Banks 

have flexibility to determine how to 

achieve integrity in their risk 

management systems. Banks are, 

however, expected to follow standard 

control principles in their systems such 

as checks and balances, separation of 

duties, appropriateness of incentives, 

and data integrity assurance, including 

that of information purchased from 

third parties. Moreover, the oversight 

process should be sufficiently 

independent of the advanced systems’’

development, implementation, and 

operation to ensure the integrity of the 

component systems. The objective of 

risk management system oversight is to 

ensure that the various systems used in 

determining risk-based capital 

requirements are operating as intended. 

The oversight process should draw 

conclusions on the soundness of the 

components of the risk management 

system, identify errors and flaws, and 

recommend corrective action as 

appropriate. 

Validation 

A bank must validate its advanced 

systems on an ongoing basis. Validation 

is the set of activities designed to give 

the greatest possible assurances of 

accuracy of the advanced systems. 

Validation includes three broad 

components: (i) Evaluation of the 

conceptual soundness of the advanced 

systems; (ii) ongoing monitoring that 

includes process verification and 

comparison of the bank’s internal 

estimates with relevant internal and 

external data sources or results from 

other estimation techniques 

(benchmarking); and (iii) outcomes 

analysis that includes back-testing. 

Each of these three components of 

validation must be applied to the bank’s 

risk rating and segmentation systems, 

risk parameter quantification processes, 

and internal models that are part of the 

bank’s advanced systems. A sound 

validation process should take business 

cycles into account, and any 

adjustments for stages of the economic 

cycle should be clearly specified in 

advance and fully documented as part 

of the validation policy. Senior 

management of the bank should be 

notified of the validation results and 

should take corrective action where 

appropriate. 

A bank’s validation process must be 

independent of the advanced systems’

development, implementation, and 

operation, or be subject to independent 

assessment of its adequacy and 

effectiveness. A bank should ensure that 

individuals who perform the review are 

not biased in their assessment due to 

their involvement in the development, 

implementation, or operation of the 

processes or products. For example, 

reviews of the internal risk rating and 

segmentation systems should be 

performed by individuals who were not 

part of the development, 

implementation, or maintenance of 

those systems. In addition, individuals 

performing the reviews should possess 

the requisite technical skills and 

expertise to fulfill their mandate. 

The first component of validation is 

evaluating conceptual soundness, which 

involves assessing the quality of the 

design and construction of a risk 

measurement or management system. 

This evaluation of conceptual 

soundness should include 

documentation and empirical evidence 

supporting the methods used and the 

variables selected in the design and 

quantification of the bank’s advanced 

systems. The documentation should 

also evidence an understanding of the 

systems’ limitations. The development 

of internal risk rating and segmentation 

systems and their quantification 

processes requires banks to exercise 

judgment. Validation should ensure that 

these judgments are well informed and 

considered, and generally include a 

body of expert opinion. A bank should 

review developmental evidence 

whenever the bank makes material 

changes in its advanced systems. 

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The second component of the 

validation process for a bank’s advanced 

systems is ongoing monitoring to 

confirm that the systems were 

implemented appropriately and 

continue to perform as intended. Such 

monitoring involves process verification 

and benchmarking. Process verification 

includes verifying that internal and 

external data are accurate and complete, 

as well as ensuring that: Internal risk 

rating and segmentation systems are 

being used, monitored, and updated as 

designed; ratings are assigned to 

wholesale obligors and exposures as 

intended; and appropriate remediation 

is undertaken if deficiencies exist. 

Benchmarking means the comparison 

of a bank’s internal estimates with 

relevant internal and external data or 

with estimates based on other 

estimation techniques. Banks are 

required to use alternative data sources 

or risk assessment approaches to draw 

inferences about the validity of their 

internal risk ratings, segmentations, risk 

parameter estimates, and model outputs 

on an ongoing basis. For credit risk 

ratings, examples of alternative data 

sources include independent internal 

raters (such as loan review), external 

rating agencies, wholesale and retail 

credit risk models developed 

independently, or retail credit bureau 

models. Because it may take 

considerable time before outcomes with 

which to conduct sufficiently robust 

backtesting are available, benchmarking 

will be a very important validation 

device. Benchmarking applies to all 

quantification processes and internal 

risk rating and segmentation activities. 

Benchmarking allows a bank to 

compare its estimates with those of 

other estimation techniques and data 

sources. Results of benchmarking 

exercises can be a valuable diagnostic 

tool in identifying potential weaknesses 

in a bank’s risk quantification system. 

While benchmarking activities allow for 

inferences about the appropriateness of 

the quantification processes and 

internal risk rating and segmentation 

systems, they are not the same as 

backtesting. Differences observed 

between the bank’s risk estimates and 

the benchmark do not necessarily 

indicate that the internal risk ratings, 

segmentation decisions, or risk 

parameter estimates are in error. The 

benchmark itself is an alternative 

prediction, and the difference may be 

due to different data or methods. As part 

of the benchmarking exercise, the bank 

should investigate the source of the 

differences and whether the extent of 

the differences is appropriate. 

The third component of the validation 

process is outcomes analysis, which is 

the comparison of the bank’s forecasts of 

risk parameters and other model outputs 

with actual outcomes. A bank’s 

outcomes analysis must include 

backtesting, which is the comparison of 

the bank’s forecasts generated by its 

internal models with actual outcomes 

during a sample period not used in 

model development. In this context, 

backtesting is one form of out-of-sample 

testing. The agencies note that in other 

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

not what the rule requires a bank to do 

as part of the advanced approaches 

validation process. 

Actual outcomes should be compared 

with expected ranges around the 

estimated values of the risk parameters 

and model results. Randomness and 

many other variables will make 

discrepancies between realized 

outcomes and the estimated risk 

parameters inevitable. Therefore the 

expected ranges should take into 

account relevant elements of a bank’s 

internal risk rating or segmentation 

processes. For example, depending on 

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

expected to differ significantly from the 

long-run one-year average. Also, 

changes in economic conditions 

between the historical data and current 

period can lead to differences between 

actual outcomes and estimates. 

One commenter asserted that 

requiring a bank to perform a 

statistically robust form of backtesting 

would be an impractically high standard 

for AMA qualification given the nature 

of operational risk. The commenter 

further claimed that validating an 

operational risk model must rely on the 

robustness of the logical structure of the 

model and the appropriateness of the 

resultant operational risk exposure 

when benchmarked against other 

established reference points. 

The agencies recognize that it may 

take considerable time before actual 

outcomes outside of the sample period 

used in model development are 

available that would allow a bank to 

backtest its operational risk models by 

comparing its internal estimates with 

these outcomes. The agencies also 

acknowledge that a bank may be unable 

to backtest an operational risk model 

with the same degree of statistical 

precision that it is able to backtest an 

internal market risk model. When a 

bank’s backtesting process is not 

sufficiently robust, a bank may need to 

rely more heavily on benchmarking and 

other alternative validation devices. The 

agencies maintain, however, that 

backtesting provides important feedback 

on the accuracy of model outputs and 

that a bank should be able to assess how 

actual losses compare with estimates 

previously generated by its model. 

Internal Audit 

A bank must have an internal audit 

function independent of business-line 

management that at least annually 

assesses the effectiveness of the controls 

supporting the bank’s advanced 

systems. Internal audit should review 

the validation process, including 

validation procedures, responsibilities, 

results, timeliness, and responsiveness 

to findings. Further, internal audit 

should evaluate the depth, scope, and 

quality of the risk management system 

review process and conduct appropriate 

testing to ensure that the conclusions of 

these reviews are well founded. Internal 

audit must report its findings at least 

annually to the bank’s board of directors 

(or a committee thereof). 

Stress Testing 

A bank must periodically stress test 

its advanced systems. Stress testing 

analysis is a means of understanding 

how economic cycles, especially 

downturns as described by stress 

scenarios, affect risk-based capital 

requirements, including migration 

across rating grades or segments and the 

credit risk mitigation benefits of double 

default treatment. Stress testing analysis 

consists of identifying stress scenarios 

and then assessing the effects of the 

scenarios on key performance measures, 

including risk-based capital 

requirements. Under the rule, changes 

in borrower credit quality will lead to 

changes in risk-based capital 

requirements. Because credit quality 

changes typically reflect changing 

economic conditions, risk-based capital 

requirements may also vary with the 

economic cycle. During an economic 

downturn, risk-based capital 

requirements will increase if wholesale 

obligors or retail exposures migrate 

toward lower credit quality rating 

grades or segments. 

Supervisors expect banks to manage 

their regulatory capital position so that 

they remain at least adequately 

capitalized during all phases of the 

economic cycle. A bank that credibly 

estimates regulatory capital levels 

during a downturn can be more 

confident of appropriately managing 

regulatory capital. 

Banks should use a range of plausible 

but severe scenarios and methods when 

stress testing to manage regulatory 

capital. Scenarios may be historical, 

hypothetical, or model-based. Key 

variables specified in a scenario may 

include, for example, interest rates, 

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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 subportfolios. The severity of the stress 

scenarios should be consistent with the 

periodic economic downturns 

experienced in the bank’s market areas. 

Such scenarios may be less severe than 

those used for other purposes, such as 

testing a bank’s solvency. 

The scope of stress testing analysis 

should be broad and include all material 

portfolios. The time horizon of the 

analysis should be consistent with the 

specifics of the scenario and should be 

long enough to measure the material 

effects of the scenario on key 

performance measures. For example, if 

a scenario such as a historical recession 

has material income and segment or 

ratings migration effects over two years, 

the appropriate time horizon is at least 

two years. 

8. Documentation 

A bank must adequately document all 

material aspects of its advanced 

systems, including but not limited to the 

internal risk rating and segmentation 

systems, risk parameter quantification 

processes, model design, assumptions, 

and validation results. The guiding 

principle governing documentation is 

that it should support the requirements 

for the quantification, validation, and 

control and oversight mechanisms as 

well as the bank’s broader risk 

management and reporting needs. 

Documentation is also critical to the 

supervisory oversight process. 

The bank should document the 

rationale for all material assumptions 

underpinning its chosen analytical 

frameworks, including the choice of 

inputs, distributional assumptions, and 

weighting of quantitative and qualitative 

elements. The bank also should 

document and justify any subsequent 

changes to these assumptions. 

C. Ongoing Qualification 

A bank using the advanced 

approaches must meet the qualification 

requirements on an ongoing basis. 

Banks are expected to improve their 

advanced systems as they improve data 

gathering capabilities and as industry 

practice evolves. To facilitate the 

supervisory oversight of systems 

changes, a bank must notify its primary 

Federal supervisor when it makes a 

change to its advanced systems that 

results in a material change in the 

bank’s risk-weighted asset amount for 

an exposure type, or when the bank 

makes any significant change to its 

modeling assumptions. 

If an agency determines that a bank 

that uses the advanced approaches to 

calculate its risk-based capital 

requirements has fallen out of 

compliance with one or more of the 

qualification requirements, the agency 

will notify the bank of its failure to 

comply. After receiving such notice, a 

bank must establish and submit a plan 

satisfactory to its primary Federal 

supervisor to return to compliance. If 

the bank’s primary Federal supervisor 

determines that the bank’s risk-based 

capital requirements are not 

commensurate with the bank’s credit, 

market, operational, or other risks, it 

may require the bank to calculate its 

risk-based capital requirements using 

the general risk-based capital rules or a 

modified form of the advanced 

approaches (for example, with fixed 

supervisory risk parameters). 

Under the proposed rule, a bank that 

fell out of compliance with the 

qualification requirements would also 

be required to disclose publicly its 

noncompliance with the qualification 

requirements promptly after receiving 

notice of noncompliance from its 

primary Federal supervisor. 

Commenters objected to this 

requirement, noting that it is not one of 

the public disclosure requirements of 

the New Accord. The agencies have 

determined that the public disclosure of 

noncompliance is not always necessary, 

because the disclosure may not reflect 

the degree of noncompliance. Therefore, 

the agencies are not including a general 

noncompliance disclosure requirement 

in the final rule. However, the agencies 

acknowledge that a bank’s significant 

noncompliance with the qualification 

requirements is an important factor in 

market participants’ assessments of the 

bank’s risk profile and, thus, a primary 

Federal supervisor may require public 

disclosure of noncompliance with the 

qualification requirements if such 

noncompliance is significant. 

D. Merger and Acquisition Transition 

Provisions 

Due to the advanced approaches’

rigorous systems requirements, a bank 

that merges with or acquires another 

company might not be able to quickly 

integrate the merged or acquired 

company’s exposures into its risk-based 

capital calculations. The proposed rule 

provided transition provisions that 

would allow the acquiring bank time to 

integrate the merged or acquired 

company into its advanced approaches, 

subject to an implementation plan 

submitted to the bank’s primary Federal 

supervisor. As proposed, the transition 

provisions applied only to banks that 

had already qualified to use the 

advanced approaches. The agencies 

recognize, however, that a bank in the 

process of qualifying to use the 

advanced approaches may merge with 

or acquire a company and need time to 

integrate the company into its advanced 

approaches on an implementation 

schedule distinct from its original 

implementation plan. In the final rule, 

the agencies are therefore allowing 

banks to take advantage of the proposed 

rule’s transition provisions for mergers 

and acquisitions both before and after 

they qualify to use the advanced 

approaches. 

Under the proposed rule, a bank 

could use the transition provisions for 

the merged or acquired company’s 

exposures for up to 24 months following 

the calendar quarter during which the 

merger or acquisition consummates. A 

bank’s primary Federal supervisor could 

extend the transition period for up to an 

additional 12 months. Commenters 

generally supported this timeframe and 

associated supervisory flexibility. 

Therefore, the final rule adopts the 

proposed rule’s merger and acquisition 

transition timeframe without change. 

To take advantage of the merger and 

acquisition transition provisions, the 

acquiring bank must submit to its 

primary Federal supervisor an 

implementation plan for using the 

advanced approaches for the merged or 

acquired company. The proposed rule 

required a bank to submit such a plan 

within 30 days of consummating the 

merger or acquisition. Many 

commenters asserted that the 30-day 

timeframe for submission of an 

implementation plan may be too short, 

particularly given the many integration 

activities that must take place 

immediately following the 

consummation of a merger or 

acquisition. These commenters 

generally suggested that banks instead 

be given 90 or 180 days to submit the 

implementation plan. The agencies 

agree with these commenters that the 

proposed timeframe for submitting an 

implementation plan may be too short. 

Accordingly, the final rule requires a 

bank to submit an implementation plan 

within 90 days of the consummation of 

a merger or acquisition. 

Under the final rule, if a bank that 

uses the advanced approaches to 

calculate risk-based capital 

requirements merges with or acquires a 

company that does not calculate riskbased capital requirements using the 

advanced approaches, the acquiring 

bank may use the general risk-based 

capital rules to compute the riskweighted assets and associated capital 

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41Any amount of the acquired company’s ALLL 

that was eliminated in accounting for the 

acquisition is not included in the acquiring bank’s 

regulatory capital. 

42See 12 CFR part 3, Appendix A, § 2 (national 

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

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

(bank holding companies); 12 CFR part 325, 

Appendix A, § I (state nonmember banks); and 12 

CFR 567.5 (savings associations). 

43 If the amount deductible from tier 2 capital 

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

the bank must deduct the shortfall amount from tier 

1 capital. 

44Any assets deducted from capital in computing 

the numerator of the risk-based capital ratios are 

also not included in risk-weighted assets in the 

denominator of the ratio. 

45See 12 CFR part 3, Appendix A, § 2 (national 

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

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

(bank holding companies); 12 CFR part 325, 

Appendix A, § I (state nonmember banks). OTS 

existing rules are formulated differently, but 

include similar deductions. Under OTS rules, for 

example, goodwill is included within the definition 

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

(core) capital along with other intangible assets. See 

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

purchased credit card relationships and mortgage 

and non-mortgage servicing assets are included in 

capital to the same extent as the other agencies’

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

deduction of deferred tax assets is discussed in 

Thrift Bulletin 56. 

for the merged or acquired company’s 

exposures during the merger and 

acquisition transition timeframe. Any 

ALLL (net of allocated transfer risk 

reserves) associated with the acquired 

company’s exposures may be included 

in the acquiring bank’s tier 2 capital up 

to 1.25 percent of the acquired 

company’s risk-weighted assets.41 Such 

ALLL is excluded from the acquiring 

bank’s eligible credit reserves. The riskweighted assets of the acquired 

company are not included in the 

acquiring bank’s credit-risk-weighted 

assets but are included in the acquiring 

bank’s total risk-weighted assets. If the 

acquiring bank uses the general riskbased capital rules for acquired 

exposures, it must disclose publicly the 

amounts of risk-weighted assets and 

qualifying capital calculated under the 

general risk-based capital rules with 

respect to the acquired company and 

under this rule for the acquiring bank. 

The primary Federal supervisor of the 

bank will monitor the merger or 

acquisition to determine whether the 

acquiring bank’s application of the 

general risk-based capital rules for the 

acquired company produces appropriate 

risk-based capital requirements for the 

assets of the acquired company in light 

of the overall risk profile of the 

acquiring bank. 

Similarly, a core or opt-in bank that 

merges with or acquires another core or 

opt-in bank might not be able to apply 

its systems for the advanced approaches 

immediately to the acquired bank’s 

exposures. Accordingly, the final rule 

permits a core or opt-in bank that 

merges with or acquires another core or 

opt-in bank to use the acquired bank’s 

advanced approaches to determine the 

risk-weighted asset amounts for, and 

deductions from capital associated with, 

the acquired bank’s exposures during 

the merger and acquisition transition 

timeframe. 

A third potential merger or 

acquisition scenario is a bank subject to 

the general risk-based capital rules that 

merges with or acquires a bank that uses 

the advanced approaches. If, after the 

merger or acquisition, the acquiring 

bank is not a core bank, it could choose 

to opt in to the advanced approaches or 

to apply the general risk-based capital 

rules to the consolidated bank. If the 

acquiring bank chooses to remain on the 

general risk-based capital rules, the 

bank must immediately apply the 

general risk-based capital rules to all its 

exposures, including those of the 

acquired bank. 

If the acquiring bank chooses or is 

required to move to the advanced 

approaches, however, it could apply the 

advanced approaches to the acquired 

exposures (provided that it continues to 

meet all of the qualification 

requirements for those exposures) for up 

to 24 months (with a potential 12-month 

extension) while it completes the 

process of qualifying to use the 

advanced approaches for the entire 

bank. If the acquiring bank has not 

begun implementing the advanced 

approaches at the time of the merger or 

acquisition, it may instead use the 

transition timeframes described in 

section III.A. of the preamble and 

section 21 of the final rule. In the latter 

case, the bank must consult with its 

primary Federal supervisor regarding 

the appropriate risk-based capital 

treatment of the acquired exposures. In 

no case may a bank permanently apply 

the advanced approaches only to an 

acquired bank’s exposures and not to 

the consolidated bank. 

Because eligible credit reserves and 

the ALLL are treated differently under 

the general risk-based capital rules and 

the advanced approaches, the final rule 

specifies how the acquiring bank must 

treat the general allowances associated 

with the merged or acquired company’s 

exposures during the period when the 

general risk-based capital rules apply to 

the acquiring bank. Specifically, ALLL 

associated with the exposures of the 

merged or acquired company may not 

be directly included in the acquiring 

bank’s tier 2 capital. Rather, any excess 

eligible credit reserves (that is, eligible 

credit reserves minus total expected 

credit losses) associated with the 

merged or acquired company’s 

exposures may be included in the 

acquiring bank’s tier 2 capital up to 0.6 

percent of the credit-risk-weighted 

assets associated with those exposures. 

IV. Calculation of Tier 1 Capital and 

Total Qualifying Capital 

The final rule maintains the minimum 

risk-based capital ratio requirements of 

4.0 percent tier 1 capital to total riskweighted assets and 8.0 percent total 

qualifying capital to total risk-weighted 

assets. A bank’s total qualifying capital 

is the sum of its tier 1 (core) capital 

elements and tier 2 (supplemental) 

capital elements, subject to various 

limits and restrictions, minus certain 

deductions (adjustments). The agencies 

are not restating the elements of tier 1 

and tier 2 capital in the final rule. Those 

capital elements generally remain as 

they are currently in the general riskbased capital rules.42 Consistent with 

the proposed rule, the final rule 

includes regulatory text for certain 

adjustments to the capital elements for 

purposes of the advanced approaches. 

Under the final rule, consistent with 

the proposal, after identifying the 

elements of tier 1 and tier 2 capital, a 

bank must make certain adjustments to 

determine its tier 1 capital and total 

qualifying capital (the numerator of the 

total risk-based capital ratio). Some of 

these adjustments are made only to the 

tier 1 portion of the capital base. Other 

adjustments are made 50 percent from 

tier 1 capital and 50 percent from tier 2 

capital.43 A bank must still have at least 

50 percent of its total qualifying capital 

in the form of tier 1 capital.44

Under the final rule, as under the 

proposal, a bank must deduct from tier 

1 capital goodwill, other intangible 

assets, and deferred tax assets to the 

same extent that those assets are 

deducted from tier 1 capital under the 

general risk-based capital rules. Thus, 

all goodwill is deducted from tier 1 

capital. Certain intangible assets—

including mortgage servicing assets, 

non-mortgage servicing assets, and 

purchased credit card relationships—

that meet the conditions and limits in 

the general risk-based capital rules do 

not have to be deducted from tier 1 

capital. Likewise, deferred tax assets 

that are dependent upon future taxable 

income and that meet the valuation 

requirements and limits in the general 

risk-based capital rules do not have to 

be deducted from tier 1 capital.45

Under the general risk-based capital 

rules, a bank also must deduct from its 

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46By contrast, OTS rules require the deduction of 

equity investments from total capital. 12 CFR 

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

include (i) investments in equity securities (other 

than investments in subsidiaries, equity 

investments that are permissible for national banks, 

indirect ownership interests in certain pools of 

assets (for example, mutual funds), Federal Home 

Loan Bank stock and Federal Reserve Bank stock); 

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

567.1. Savings associations applying the final rule 

are not required to deduct investments in equity 

securities. Instead, such investments are subject to 

the equity treatment in part VI of the final rule. 

Equity investments in real estate continue to be 

deducted to the same extent as under the general 

risk-based capital rules. 

47 12 U.S.C. 3904 does not apply to savings 

associations regulated by the OTS. As a result, the 

OTS final rule does not refer to allocated transfer 

risk reserves. 

tier 1 capital certain percentages of the 

adjusted carrying value of its 

nonfinancial equity investments. An 

advanced approaches bank is not 

required to make these deductions. 

Instead, the bank’s equity exposures 

generally are subject to the equity 

treatment in part VI of the final rule and 

described in section V.F. of this 

preamble.46

A number of commenters urged the 

agencies to revisit the existing 

definitions of tier 1 and tier 2 capital, 

including some of the deductions. Some 

offered specific suggestions, such as 

removing the requirement to deduct 

goodwill from tier 1 capital or revising 

the limitations on certain capital 

instruments that may be included in 

regulatory capital. Other commenters 

noted that the definition of regulatory 

capital and related deductions should 

be thoroughly debated internationally 

before changes are made in any one 

national jurisdiction. The agencies 

believe that the definition of regulatory 

capital should be as consistent as 

possible across national jurisdictions. 

The BCBS has formed a working group 

that is currently looking at issues related 

to the definition of regulatory capital. 

Accordingly, the agencies have not 

modified the existing definition of 

regulatory capital and related 

deductions at this time, other than with 

respect to implementation of the 

advanced approaches. 

Under the general risk-based capital 

rules, a bank is allowed to include in 

tier 2 capital its ALLL up to 1.25 percent 

of risk-weighted assets (net of certain 

deductions). Amounts of ALLL in 

excess of this limit are deducted from 

the gross amount of risk-weighted 

assets. 

Under the proposed rule, the ALLL 

was treated differently. The proposed 

rule included a methodology for 

adjusting risk-based capital 

requirements based on a comparison of 

the bank’s eligible credit reserves to its 

ECL. The proposed rule defined eligible 

credit reserves as all general allowances, 

including the ALLL, established through 

a charge against earnings to absorb 

credit losses associated with on-or offbalance sheet wholesale and retail 

exposures. As proposed, eligible credit 

reserves did not include allocated 

transfer risk reserves established 

pursuant to 12 U.S.C. 390447 and other 

specific reserves created against 

recognized losses. The final rule 

maintains the proposed definition of 

eligible credit reserves. 

The proposed rule defined a bank’s 

total ECL as the sum of ECL for all 

wholesale and retail exposures other 

than exposures to which the bank 

applied the double default treatment 

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

wholesale exposure to a non-defaulted 

obligor or a non-defaulted retail segment 

was equal to the product of PD, ELGD, 

and EAD for the exposure or segment. 

The ECL for non-defaulted exposures 

thus reflected expected economic losses, 

including the cost of carry and direct 

and indirect workout expenses. The 

bank’s ECL for a wholesale exposure to 

a defaulted obligor or a defaulted retail 

segment was equal to the bank’s 

impairment estimate for allowance 

purposes for the exposure or segment. 

The ECL for defaulted exposures thus 

was based on accounting measures of 

credit loss incorporated into a bank’s 

charge-off and reserving practices. 

In the proposal, the agencies solicited 

comment on a possible alternative 

treatment for determining ECL for a 

defaulted exposure that would be more 

consistent with the proposed treatment 

of ECL for non-defaulted exposures. 

That alternative approach calculated 

ECL as the bank’s current carrying value 

of the exposure multiplied by the bank’s 

best estimate of the expected economic 

loss rate associated with the exposure 

(measured relative to the current 

carrying value). Commenters on this 

issue generally supported the proposed 

treatment and expressed some concern 

about the added complexity of the 

alternative treatment. 

The agencies believe that, for 

defaulted exposures, any difference 

between a bank’s best estimate of 

economic losses and its impairment 

estimate for ALLL purposes is likely to 

be small. The agencies also believe that 

the proposed ALLL impairment 

approach is less burdensome for banks 

than the ‘‘best estimate of economic 

loss’’ approach. As a result, the agencies 

are retaining this aspect of the proposed 

definition of ECL for defaulted 

exposures. The agencies recognize that 

this treatment requires a bank to specify 

how much of its ALLL is attributable to 

defaulted exposures, and emphasize 

that a bank must capture all material 

economic losses on defaulted exposures 

when building its databases for 

estimating LGDs for non-defaulted 

exposures. 

The agencies also sought comment on 

the appropriate measure of ECL for 

assets held at fair value with gains and 

losses flowing through earnings. 

Commenters expressed the view that 

there should be no ECL for such assets 

because expected losses on such assets 

already have been removed from 

regulatory capital. The agencies agree 

with this position and, therefore, under 

the final rule, a bank may assign an ECL 

of zero to assets held at fair value with 

gains and losses flowing through 

earnings. The agencies are otherwise 

maintaining the proposed definition of 

ECL in the final rule, with the 

substitution of LGD for ELGD noted 

above. 

Under the final rule, consistent with 

the proposal, a bank must compare the 

total dollar amount of its ECL to its 

eligible credit reserves. If there is a 

shortfall of eligible credit reserves 

compared to total ECL, the bank must 

deduct 50 percent of the shortfall from 

tier 1 capital and 50 percent from tier 2 

capital. If eligible credit reserves exceed 

total ECL, the excess portion of eligible 

credit reserves may be included in tier 

2 capital up to 0.6 percent of credit-riskweighted assets. 

A number of commenters objected to 

the 0.6 percent limit on inclusion of 

excess reserves in tier 2 capital and 

suggested that there should be a higher 

or no limit on the amount of excess 

reserves that may be included in 

regulatory capital. While the 0.6 percent 

limit is part of the New Accord, some 

commenters asserted that this limitation 

would put U.S. banks at a competitive 

disadvantage because U.S. accounting 

practices (as compared to accounting 

practices in many other countries) lead 

to higher reserves that are more likely to 

exceed the limitation. Another 

commenter asserted that the proposed 

limitation on excess reserves is more 

restrictive than the current cap on ALLL 

in the general risk-based capital rules. 

Finally, several commenters suggested 

that because ALLL is the first buffer 

against credit losses, it should be 

included without limit in tier 1 capital. 

The agencies believe that the 

proposed 0.6 percent limit on inclusion 

of excess reserves in tier 2 capital is 

roughly equivalent to the 1.25 percent 

cap in the general risk-based capital 

rules and serves to maintain general 

consistency in the treatment of reserves 

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69324 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

48See 12 CFR part 3, Appendix A, § 2(c)(4) 

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

§ I.B.1.c. (state member banks); 12 CFR part 225, 

Appendix A, § I.B.1.c. (bank holding companies); 12 

CFR part 325, Appendix A, § I.B.5. (state 

nonmember banks); 12 CFR 567.5(a)(2)(iii) and 

567.12(d)(2) (savings associations). 

49See Public Law 106–102 (November 12, 1999), 

codified, among other places, at 12 U.S.C. 24a. See 

also 12 CFR 5.39(h)(1) (national banks); 12 CFR 

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

Appendix A, § I.B.2. (state nonmember banks). 

Again, OTS rules are formulated differently. For 

example, OTS rules do not use the terms 

‘‘unconsolidated banking and finance subsidiary’’

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

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

(HOLA), equity and debt investments in nonincludable subsidiaries (generally subsidiaries that 

are engaged in activities that are not permissible for 

a national bank) are deducted from assets and tier 

1 (core) capital. 12 CFR 567.5(a)(2)(iv) and (v). As 

required by HOLA, OTS will continue to deduct 

non-includable subsidiaries. Reciprocal holdings of 

bank capital instruments are deducted from a 

savings association’s total capital under 12 CFR 

567.5(c)(2). 

domestically and internationally. 

Accordingly, the agencies have included 

the 0.6 percent cap in the final rule. 

Under the proposed rule, a bank 

would deduct from tier 1 capital any 

after-tax gain-on-sale. Gain-on-sale was 

defined as an increase in a bank’s equity 

capital that resulted from a 

securitization, other than an increase in 

equity capital that resulted from the 

bank’s receipt of cash in connection 

with the securitization. The agencies 

designed this deduction to offset 

accounting treatments that produce an 

increase in a bank’s equity capital and 

tier 1 capital at the inception of a 

securitization—for example, a gain 

attributable to a CEIO that results from 

Financial Accounting Standard (FAS) 

140 accounting treatment for the sale of 

underlying exposures to a securitization 

special purpose entity (SPE). Over time, 

as the bank, from an accounting 

perspective, realizes the increase in 

equity capital and tier 1 capital booked 

at the inception of the securitization 

through actual receipt of cash flows, the 

amount of the required deduction 

would shrink accordingly. 

Under the general risk-based capital 

rules,48 a bank must deduct CEIOs, 

whether purchased or retained, from tier 

1 capital to the extent that the CEIOs 

exceed 25 percent of the bank’s tier 1 

capital. Under the proposed rule, a bank 

would deduct CEIOs from tier 1 capital 

to the extent they represent gain-on-sale, 

and would deduct any remaining CEIOs 

50 percent from tier 1 capital and 50 

percent from tier 2 capital. 

Under the proposed rule, certain other 

securitization exposures also would be 

deducted from tier 1 and tier 2 capital. 

These exposures included, for example, 

securitization exposures with an 

applicable external rating (defined 

below) that is more than one category 

below investment grade (for example, 

below BB-) and most subordinated 

unrated securitization exposures. When 

a bank deducted a securitization 

exposure (other than gain-on-sale) from 

regulatory capital, the bank would take 

the deduction 50 percent from tier 1 

capital and 50 percent from tier 2 

capital. Moreover, under the proposal, a 

bank could calculate any deductions 

from tier 1 and tier 2 capital with 

respect to a securitization exposure 

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

any deferred tax liabilities associated 

with the exposure. 

The agencies received a number of 

comments on the proposed 

securitization-linked deductions. In 

particular, some commenters urged the 

agencies to retain the general risk-based 

capital rule for deducting only CEIOs 

that exceed 25 percent of tier 1 capital. 

Some of these commenters noted that 

the ‘‘harsher’’ securitization-linked 

deductions under the advanced 

approaches could have a significant tier 

1 capital impact and, accordingly, could 

have an unwarranted effect on a bank’s 

tier 1 leverage ratio calculation. A few 

commenters encouraged the agencies to 

permit a bank to replace the deduction 

approach for certain securitization 

exposures with a 1,250 percent risk 

weight approach, in part to mitigate 

potential tier 1 leverage ratio effects. 

The agencies are retaining the 

securitization-related deductions as 

proposed. The proposed deductions are 

part of the New Accord’s securitization 

framework. The agencies believe that 

they should be retained to foster 

consistency among participants in the 

international securitization markets. 

The proposed rule also required a 

bank to deduct the bank’s exposure on 

certain unsettled and failed capital 

markets transactions 50 percent from 

tier 1 capital and 50 percent from tier 2 

capital. The agencies are retaining this 

deduction as proposed. 

The agencies are also retaining, as 

proposed, the deductions in the general 

risk-based capital rules for investments 

in unconsolidated banking and finance 

subsidiaries and reciprocal holdings of 

bank capital instruments. Further, the 

agencies are retaining the current 

treatment for national and state banks 

that control or hold an interest in a 

financial subsidiary. As required by the 

Gramm-Leach-Bliley Act, assets and 

liabilities of the financial subsidiary are 

not consolidated with those of the bank 

for risk-based capital purposes and the 

bank must deduct its equity investment 

(including retained earnings) in the 

financial subsidiary from regulatory 

capital—50 percent from tier 1 capital 

and 50 percent from tier 2 capital.49 A 

BHC generally does not deconsolidate 

the assets and liabilities of the financial 

subsidiaries of the BHC’s subsidiary 

banks and does not deduct from its 

regulatory capital the equity 

investments of its subsidiary banks in 

financial subsidiaries. Rather, a BHC 

generally fully consolidates the 

financial subsidiaries of its subsidiary 

banks. These treatments continue under 

the final rule. 

For BHCs with consolidated 

insurance underwriting subsidiaries that 

are functionally regulated by a State 

insurance regulator (or subject to 

comparable supervision and regulatory 

capital requirements in a non-U.S. 

jurisdiction), the proposed rule set forth 

the following treatment. The assets and 

liabilities of the subsidiary would be 

consolidated for purposes of 

determining the BHC’s risk-weighted 

assets. However, the BHC would deduct 

from tier 1 capital an amount equal to 

the insurance underwriting subsidiary’s 

minimum regulatory capital 

requirement as determined by its 

functional (or equivalent) regulator. For 

U.S. regulated insurance underwriting 

subsidiaries, this amount generally 

would be 200 percent of the subsidiary’s 

Authorized Control Level as established 

by the appropriate state insurance 

regulator. 

The proposal noted that its approach 

with respect to functionally regulated 

consolidated insurance underwriting 

subsidiaries was different from the New 

Accord, which broadly endorses a 

deconsolidation and deduction 

approach for insurance subsidiaries. 

The proposal acknowledged the Board’s 

concern that a full deconsolidation and 

deduction approach does not capture 

the credit risk in insurance 

underwriting subsidiaries at the 

consolidated BHC level. 

Several commenters objected to the 

proposed deduction from tier 1 capital 

and instead supported a deduction 50 

percent from tier 1 capital and 50 

percent from tier 2 capital. Others 

supported the full deduction and 

deconsolidation approach endorsed by 

the New Accord and maintained that, by 

contrast, the proposed approach was 

overly conservative and resulted in a 

double-count of capital requirements for 

insurance regulation and banking 

regulation. 

The Board continues to believe that a 

consolidated BHC risk-based capital 

measure should incorporate all credit, 

market, and operational risks to which 

the BHC is exposed, regardless of the 

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50The proposed rule excluded from the definition 

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

family residential construction loans and certain 

multifamily residential loans. The treatment of such 

loans under the final rule is discussed below in 

section V.B.5. of the preamble. 

51As described below, tranched guarantees (like 

most transactions that involve a tranching of credit 

risk) generally are securitization exposures under 

the final rule. The final rule defines a guarantee 

broadly to include almost any transaction (other 

than a credit derivative) that involves the transfer 

of the credit risk of an exposure from one party to 

another party. This definition of guarantee generally 

includes, for example, a credit spread option under 

which a bank has agreed to make payments to its 

counterparty in the event of an increase in the 

credit spread associated with a particular reference 

obligation issued by a company. 

52 12 CFR part 34, Subpart D (OCC); 12 CFR part 

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

Appendix A (FDIC); and 12 CFR 560.100–560.101 

(OTS). 

legal entity subsidiary where a risk 

exposure resides. The Board also 

believes that a fully consolidated 

approach minimizes the potential for 

regulatory capital arbitrage; it eliminates 

incentives to book individual exposures 

at a subsidiary that is deducted from the 

consolidated entity for capital purposes 

where a different, potentially more 

favorable, capital requirement is applied 

at the subsidiary. Moreover, the Board 

does not agree that the proposed 

approach results in a double-count of 

capital requirements. Rather, the capital 

requirements imposed by a functional 

regulator or other supervisory authority 

at the subsidiary level reflect the capital 

needs at the particular subsidiary. The 

consolidated measure of minimum 

capital requirements should reflect the 

consolidated organization. 

Thus, the Board is retaining the 

proposed requirement that assets and 

liabilities of insurance underwriting 

subsidiaries are consolidated for 

determining risk-weighted assets. The 

Board has modified the final rule for 

BHCs, however, to allow the associated 

capital deduction to be made 50 percent 

from tier 1 capital and 50 percent from 

tier 2 capital. 

V. Calculation of Risk-Weighted Assets 

Under the final rule, a bank’s total 

risk-weighted assets is the sum of its 

credit risk-weighted assets and riskweighted assets for operational risk, 

minus the sum of its excess eligible 

credit reserves (eligible credit reserves 

in excess of its total ECL) not included 

in tier 2 capital. Unlike under the 

proposal, allocated transfer risk reserves 

are not subtracted from total riskweighted assets under the final rule. 

Because the EAD of wholesale 

exposures and retail segments is 

calculated net of any allocated transfer 

risk reserves, a second subtraction of the 

reserves from risk-weighted assets is not 

appropriate. 

A. Categorization of Exposures 

To calculate credit risk-weighted 

assets, a bank must determine riskweighted asset amounts for exposures 

that have been grouped into four general 

categories: wholesale, retail, 

securitization, and equity. It must also 

identify and determine risk-weighted 

asset amounts for assets not included in 

an exposure category and any nonmaterial portfolios of exposures to 

which the bank elects not to apply the 

IRB approach. To exclude a portfolio 

from the IRB approach, a bank must 

demonstrate to the satisfaction of its 

primary Federal supervisor that the 

portfolio (when combined with all other 

portfolios of exposures that the bank 

seeks to exclude from the IRB approach) 

is not material to the bank. As described 

above, credit-risk-weighted assets is 

defined as 1.06 multiplied by the sum 

of total wholesale and retail riskweighted assets, risk-weighted assets for 

securitization exposures, and riskweighted assets for equity exposures. 

1. Wholesale Exposures 

Consistent with the proposed rule, the 

final rule defines a wholesale exposure 

as a credit exposure to a company, 

individual, sovereign entity, or other 

governmental entity (other than a 

securitization exposure, retail exposure, 

or equity exposure).50 The term 

‘‘company’’ is broadly defined to mean 

a corporation, partnership, limited 

liability company, depository 

institution, business trust, SPE, 

association, or similar organization. 

Examples of a wholesale exposure 

include: (i) A non-tranched guarantee 

issued by a bank on behalf of a 

company; 51 (ii) a repo-style transaction 

entered into by a bank with a company 

and any other transaction in which a 

bank posts collateral to a company and 

faces counterparty credit risk; (iii) an 

exposure that a bank treats as a covered 

position under the market risk rule for 

which there is a counterparty credit risk 

capital requirement; (iv) a sale of 

corporate loans by a bank to a third 

party in which the bank retains full 

recourse; (v) an OTC derivative contract 

entered into by a bank with a company; 

(vi) an exposure to an individual that is 

not managed by the bank as part of a 

segment of exposures with 

homogeneous risk characteristics; and 

(vii) a commercial lease. 

The agencies proposed two 

subcategories of wholesale exposures—

HVCRE exposures and non-HVCRE 

exposures. Under the proposed rule, 

HVCRE exposures would be subject to a 

separate IRB risk-based capital formula 

that would produce a higher risk-based 

capital requirement for a given set of 

risk parameters than the IRB risk-based 

capital formula for non-HVCRE 

wholesale exposures. Further, the 

agencies proposed that once an 

exposure was determined to be an 

HVCRE exposure, it would remain an 

HVCRE exposure until paid in full, sold, 

or converted to permanent financing. 

The proposed rule defined an HVCRE 

exposure as a credit facility that 

finances or has financed the acquisition, 

development, or construction of real 

property, excluding facilities that 

finance (i) one-to four-family residential 

properties or (ii) commercial real estate 

projects that meet the following 

conditions: (A) The exposure’s loan-tovalue (LTV) ratio is less than or equal 

to the applicable maximum supervisory 

LTV ratio in the real estate lending 

standards of the agencies; 52 (B) the 

borrower has contributed capital to the 

project in the form of cash or 

unencumbered readily marketable assets 

(or has paid development expenses outof-pocket) of at least 15 percent of the 

real estate’s appraised ‘‘as completed’’

value; and (C) the borrower contributed 

the amount of capital required before 

the bank advances funds under the 

credit facility, and the capital 

contributed by the borrower or 

internally generated by the project is 

contractually required to remain in the 

project throughout the life of the project. 

Several commenters raised issues 

related to the requirement that banks 

must separate HVCRE exposures from 

other wholesale exposures. One 

commenter asserted that a separate riskweight function for HVCRE exposures is 

unnecessary because the higher risk 

associated with such exposures would 

be reflected in higher PDs and LGDs. 

Other commenters stated that tracking 

the exception requirements for 

acquisition, development, or 

construction loans would be 

burdensome and expressed concern that 

all multifamily loans could be subject to 

the HVCRE treatment. Yet other 

commenters requested that the agencies 

exclude from the definition of HVCRE 

all multifamily acquisition, 

development, or construction loans; 

additional commercial real estate 

exposures; and other exposures with 

significant project equity and/or pre-sale 

commitments. A few commenters 

supported the proposed approach to 

HVCRE exposures. 

The agencies have determined that 

the proposed definition of HVCRE 

exposures strikes an appropriate balance 

between risk-sensitivity and simplicity. 

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69326 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

53The proposed rule excluded from the definition 

of a residential mortgage exposure certain pre-sold 

one- to-four family residential construction loans 

and certain multifamily residential loans. The 

treatment of such loans under the final rule is 

discussed below in section V.B.5. of the preamble. 

54The proposed rule excluded from the definition 

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

certain multifamily residential loans. The treatment 

of such loans under the final rule is discussed 

below in section V.B.5. of the preamble. 

Thus, the final rule retains the 

definition as proposed. If a bank does 

not want to track compliance with the 

definition for burden-related reasons, 

the bank may choose to apply the 

HVCRE risk-weight function to all credit 

facilities that finance the acquisition, 

construction, or development of 

multifamily and commercial real 

property. The agencies believe that this 

treatment would be an appropriate 

application of the principle of 

conservatism discussed in section II.D. 

of the preamble and set forth in section 

1(d) of the final rule. 

The New Accord identifies five subclasses of specialized lending for which 

the primary source of repayment of the 

obligation is the income generated by 

the financed asset(s) rather than the 

independent capacity of a broader 

commercial enterprise. The sub-classes 

are project finance, object finance, 

commodities finance, income-producing 

real estate, and HVCRE. The New 

Accord provides a methodology to 

accommodate banks that cannot meet 

the requirements for the estimation of 

PD for these exposure types. The 

proposed rule did not include a separate 

treatment for specialized lending 

beyond the separate IRB risk-based 

capital formula for HVCRE exposures 

specified in the New Accord. The 

agencies noted in the proposal that 

sophisticated banks that would be 

applying the advanced approaches in 

the United States should be able to 

estimate risk parameters for specialized 

lending. The agencies continue to 

believe that banks using the advanced 

approaches in the United States should 

be able to estimate risk parameters for 

specialized lending and, therefore, have 

not adopted a separate treatment for 

specialized lending in the final rule. 

In contrast to the New Accord, the 

agencies did not propose a separate riskbased capital function for exposures to 

small- and medium-size enterprises 

(SMEs). The SME function in the New 

Accord generates a lower risk-based 

capital requirement for an exposure to 

an SME than for an exposure to a larger 

firm that has the same risk parameter 

values. The agencies were not aware of 

compelling evidence that smaller firms 

are subject to less systematic risk than 

is already reflected in the wholesale 

exposure risk-based capital formula, 

which specifies lower AVCs as PDs 

increase. 

A number of commenters objected to 

this aspect of the proposal and urged the 

agencies to include in the final rule the 

SME risk-based capital function from 

the New Accord. Several commenters 

expressed concern about potential 

competitive disparities in the market for 

SME lending between U.S. banks and 

foreign banks subject to rules that 

include the New Accord’s treatment of 

SME exposures. Others asserted that 

lower AVCs and risk-based capital 

requirements were appropriate for SME 

exposures because the asset values of 

exposures to smaller firms are more 

idiosyncratic than those of exposures to 

larger firms. 

While commenters raised important 

issues related to SME exposures, the 

agencies have decided not to add a 

distinct risk-weight function for such 

exposures to the final rule. The agencies 

continue to believe that a distinct riskweight function with a lower AVC for 

SME exposures is not substantiated by 

sufficient empirical evidence and may 

give rise to a domestic competitive 

inequity between banks subject to the 

advanced approaches and banks subject 

to the general risk-based capital rules. 

2. Retail Exposures 

Under the final rule, as under the 

proposed rule, retail exposures 

generally include exposures (other than 

securitization exposures or equity 

exposures) to an individual and small 

exposures to businesses that are 

managed as part of a segment of similar 

exposures, not on an individualexposure basis. There are three 

subcategories of retail exposure: (i) 

Residential mortgage exposures; (ii) 

QREs; and (iii) other retail exposures. 

The final rule retains the proposed 

definitions of the retail exposure 

subcategories and, thus, defines 

residential mortgage exposure as an 

exposure that is primarily secured by a 

first or subsequent lien on one- to fourfamily residential property.53 This 

includes both term loans and HELOCs. 

An exposure primarily secured by a first 

or subsequent lien on residential 

property that is not one to four family 

also is included as a residential 

mortgage exposure as long as the 

exposure has both an original and 

current outstanding amount of no more 

than $1 million. There is no upper limit 

on the size of an exposure that is 

secured by one-to four-family 

residential properties. To be a 

residential mortgage exposure, the bank 

must manage the exposure as part of a 

segment of exposures with 

homogeneous risk characteristics. 

Residential mortgage loans that are 

managed on an individual basis, rather 

than managed as part of a segment, are 

categorized as wholesale exposures. 

QREs are defined as exposures to 

individuals that are (i) revolving, 

unsecured, and unconditionally 

cancelable by the bank to the fullest 

extent permitted by Federal law; (ii) 

have a maximum exposure amount 

(drawn plus undrawn) of up to 

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

of a segment of exposures with 

homogeneous risk characteristics. In 

practice, QREs typically include 

exposures where customers’ outstanding 

borrowings are permitted to fluctuate 

based on their decisions to borrow and 

repay, up to a limit established by the 

bank. Most credit card exposures to 

individuals and overdraft lines on 

individual checking accounts are QREs. 

The category of other retail exposures 

includes two types of exposures. First, 

all exposures to individuals for nonbusiness purposes (other than 

residential mortgage exposures and 

QREs) that are managed as part of a 

segment of similar exposures are other 

retail exposures. Such exposures may 

include personal term loans, margin 

loans, auto loans and leases, credit card 

accounts with credit lines above 

$100,000, and student loans. There is no 

upper limit on the size of these types of 

retail exposures to individuals. Second, 

exposures to individuals or companies 

for business purposes (other than 

residential mortgage exposures and 

QREs), up to a single-borrower exposure 

threshold of $1 million, that are 

managed as part of a segment of similar 

exposures are other retail exposures. For 

the purpose of assessing exposure to a 

single borrower, the bank must 

aggregate all business exposures to a 

particular legal entity and its affiliates 

that are consolidated under GAAP. If 

that borrower is a natural person, any 

consumer loans (for example, personal 

credit card loans or mortgage loans) to 

that borrower would not be part of the 

aggregate. A bank could distinguish a 

consumer loan from a business loan by 

the loan department through which the 

loan is made. Exposures to a borrower 

for business purposes primarily secured 

by residential property count toward the 

$1 million single-borrower other retail 

business exposure threshold.54

The residual value portion of a retail 

lease exposure is excluded from the 

definition of an other retail exposure. 

Consistent with the New Accord, a bank 

must assign the residual value portion 

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55Several commenters asked the agencies to 

confirm that the typical syndicated credit facility 

would not be a securitization exposure. The 

agencies confirm that a syndicated credit facility is 

not a securitization exposure so long as less than 

substantially all of the borrower’s assets are 

financial exposures. 

of a retail lease exposure a risk-weighted 

asset amount equal to its residual value 

as described in section 31 of the final 

rule. 

3. Securitization Exposures 

The proposed rule defined a 

securitization exposure as an on-balance 

sheet or off-balance sheet credit 

exposure that arises from a traditional or 

synthetic securitization (including 

credit-enhancing representations and 

warranties). A traditional securitization 

was defined as a transaction in which (i) 

all or a portion of the credit risk of one 

or more underlying exposures is 

transferred to one or more third parties 

other than through the use of credit 

derivatives or guarantees; (ii) the credit 

risk associated with the underlying 

exposures has been separated into at 

least two tranches reflecting different 

levels of seniority; (iii) performance of 

the securitization exposures depends on 

the performance of the underlying 

exposures; and (iv) all or substantially 

all of the underlying exposures are 

financial exposures. Examples of 

financial exposures are loans, 

commitments, receivables, asset-backed 

securities, mortgage-backed securities, 

other debt securities, equity securities, 

or credit derivatives. The proposed rule 

also defined mortgage-backed passthrough securities guaranteed by Fannie 

Mae or Freddie Mac (whether or not 

issued out of a structure that tranches 

credit risk) as securitization exposures. 

A synthetic securitization was defined 

as a transaction in which (i) all or a 

portion of the credit risk of one or more 

underlying exposures is transferred to 

one or more third parties through the 

use of one or more credit derivatives or 

guarantees (other than a guarantee that 

transfers only the credit risk of an 

individual retail exposure); (ii) the 

credit risk associated with the 

underlying exposures has been 

separated into at least two tranches 

reflecting different levels of seniority; 

(iii) performance of the securitization 

exposures depends on the performance 

of the underlying exposures; and (iv) all 

or substantially all of the underlying 

exposures are financial exposures. 

Accordingly, the proposed definition of 

a securitization exposure included 

tranched cover or guarantee 

arrangements—that is, arrangements in 

which an entity transfers a portion of 

the credit risk of an underlying 

exposure to one or more guarantors or 

credit derivative providers but also 

retains a portion of the credit risk, 

where the risk transferred and the risk 

retained are of different seniority levels. 

The preamble to the proposal noted 

that, provided there is a tranching of 

credit risk, securitization exposures 

could include, among other things, 

asset-backed and mortgage-backed 

securities; loans, lines of credit, 

liquidity facilities, and financial 

standby letters of credit; credit 

derivatives and guarantees; loan 

servicing assets; servicer cash advance 

facilities; reserve accounts; creditenhancing representations and 

warranties; and CEIOs. Securitization 

exposures also could include assets sold 

with retained tranched recourse. 

As explained in the proposal, if a 

bank purchases an asset-backed security 

issued by a securitization SPE and 

purchases a credit derivative to protect 

itself from credit losses associated with 

the asset-backed security, the purchase 

of the credit derivative by the investing 

bank does not turn the traditional 

securitization into a synthetic 

securitization. Instead, the investing 

bank would be viewed as having 

purchased a traditional securitization 

exposure and would reflect the CRM 

benefits of the credit derivative through 

the securitization CRM rules described 

later in the preamble and in section 46 

of the rule. Moreover, if a bank provides 

a guarantee or a credit derivative on a 

securitization exposure, that guarantee 

or credit derivative would also be a 

securitization exposure. 

Commenters raised several objections 

to the proposed definitions of 

traditional and synthetic securitizations. 

First, several commenters objected to 

the requirement that all or substantially 

all of the underlying exposures must be 

financial exposures. These commenters 

noted that the securitization market 

rapidly evolves and expands to cover 

new asset classes—such as intellectual 

property rights, project finance 

revenues, and entertainment royalties—

that may or may not be financial assets. 

Commenters expressed particular 

concern that the proposed definitions 

may exclude from the securitization 

framework leases that include a material 

lease residual component. 

The agencies believe that requiring all 

or substantially all of the underlying 

exposures for a securitization to be 

financial exposures creates an important 

boundary between the wholesale and 

retail frameworks, on the one hand, and 

the securitization framework, on the 

other hand. Accordingly, the agencies 

are maintaining this requirement in the 

final rule. The securitization framework 

was designed to address the tranching of 

the credit risk of financial exposures 

and was not designed, for example, to 

apply to tranched credit exposures to 

commercial or industrial companies or 

nonfinancial assets. Accordingly, under 

the final rule, a specialized loan to 

finance the construction or acquisition 

of large-scale projects (for example, 

airports and power plants), objects (for 

example, ships, aircraft, or satellites), or 

commodities (for example, reserves, 

inventories, precious metals, oil, or 

natural gas) generally is not a 

securitization exposure because the 

assets backing the loan typically are 

nonfinancial assets (the facility, object, 

or commodity being financed). In 

addition, although some structured 

transactions involving incomeproducing real estate or HVCRE can 

resemble securitizations, these 

transactions generally would not be 

securitizations because the underlying 

exposure would be real estate. 

Consequently, exposures resulting from 

the tranching of the risks of 

nonfinancial assets are not subject to the 

final rule’s securitization framework, 

but generally are subject to the rules for 

wholesale exposures. 

Based on their cash flow 

characteristics, for purposes of the final 

rule, the agencies would consider many 

of the asset classes identified by 

commenters including lease residuals 

and entertainment royalties—to be 

financial assets. Both the designation of 

exposures as securitization exposures 

and the calculation of risk-based capital 

requirements for securitization 

exposures will be guided by the 

economic substance of a transaction 

rather than its legal form.55

Some commenters asserted that the 

proposal generally to define as 

securitization exposures all exposures 

involving credit risk tranching of 

underlying financial assets was too 

broad. The proposed definition captured 

many exposures these commenters did 

not consider to be securitization 

exposures, including tranched 

exposures to a single underlying 

financial exposure and exposures to 

many hedge funds and private equity 

funds. Commenters requested flexibility 

to apply the wholesale or equity 

framework (depending on the exposure) 

rather than the securitization framework 

to these exposures. 

The agencies believe that a single, 

unified approach to dealing with the 

tranching of credit risk is important to 

create a level playing field across the 

securitization, credit derivative, and 

other financial markets, and therefore 

have decided to maintain the proposed 

treatment of tranched exposures to a 

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56Several commenters asked the agencies to 

clarify whether a special purpose entity that issues 

multiple classes of securities that have equal 

priority in the capital structure of the issuer but 

different maturities would be considered a 

securitization SPE. The agencies do not believe that 

maturity differentials alone constitute credit risk 

tranching for purposes of the definitions of 

traditional securitization and synthetic 

securitization. 

single underlying financial asset in the 

final rule. The agencies believe that 

basing the applicability of the 

securitization framework on the 

presence of some minimum number of 

underlying exposures would complicate 

the rule and would create a divergence 

from the New Accord, without any 

material improvement in risk 

sensitivity. The securitization 

framework is designed specifically to 

deal with tranched exposures to credit 

risk. Moreover, the principal risk-based 

capital approaches of the securitization 

framework take into account the 

effective number of underlying 

exposures. 

The agencies agree with commenters 

that the proposed definition for 

securitization exposures was quite 

broad and captured some exposures that 

would more appropriately be treated 

under the wholesale or equity 

frameworks. To limit the scope of the 

IRB securitization framework, the 

agencies have modified the definition of 

traditional securitization in the final 

rule to make clear that operating 

companies are not traditional 

securitizations (even if all or 

substantially all of their assets are 

financial exposures). For purposes of 

the final rule’s definition of traditional 

securitization, operating companies 

generally are companies that produce 

goods or provide services beyond the 

business of investing, reinvesting, 

holding, or trading in financial assets. 

Examples of operating companies are 

depository institutions, bank holding 

companies, securities brokers and 

dealers, insurance companies, and nonbank mortgage lenders. Accordingly, an 

equity investment in an operating 

company, such as a bank, generally 

would be an equity exposure under the 

final rule; a debt investment in an 

operating company, such as a bank, 

generally would be a wholesale 

exposure under the final rule. 

Investment firms, which generally do 

not produce goods or provide services 

beyond the business of investing, 

reinvesting, holding, or trading in 

financial assets, are not operating 

companies for purposes of the final rule 

and would not qualify for this general 

exclusion from the definition of 

traditional securitization. Examples of 

investment firms would include 

companies that are exempted from the 

definition of an investment company 

under section 3(a) of the Investment 

Company Act of 1940 (15 U.S.C. 80a–

3(a)) by either section 3(c)(1) (15 U.S.C. 

80a–3(c)(1)) or section 3(c)(7) (15 U.S.C. 

80a–3(c)(7)) of the Act. 

The final definition of a traditional 

securitization also provides the primary 

Federal supervisor of a bank with 

discretion to exclude from the definition 

of traditional securitization investment 

firms that exercise substantially 

unfettered control over the size and 

composition of their assets, liabilities, 

and off-balance sheet transactions. The 

agencies will consider a number of 

factors in the exercise of this discretion, 

including an assessment of the 

investment firm’s leverage, risk profile, 

and economic substance. This 

supervisory exclusion is intended to 

provide discretion to a bank’s primary 

Federal supervisor to distinguish 

structured finance transactions, to 

which the securitization framework was 

designed to apply, from more flexible 

investment firms such as many hedge 

funds and private equity funds. Only 

investment firms that can easily change 

the size and composition of their capital 

structure, as well as the size and 

composition of their assets and offbalance sheet exposures, would be 

eligible for this exclusion from the 

definition of traditional securitization 

under this new provision. The agencies 

do not consider managed collateralized 

debt obligation vehicles, structured 

investment vehicles, and similar 

structures, which allow considerable 

management discretion regarding asset 

composition but are subject to 

substantial restrictions regarding capital 

structure, to have substantially 

unfettered control. Thus, such 

transactions meet the final rule’s 

definition of traditional securitization. 

The agencies also have added two 

additional exclusions to the definition 

of traditional securitization for small 

business investment companies (SBICs) 

and community development 

investment vehicles. As a result, a 

bank’s equity investments in SBICs and 

community development equity 

investments generally are treated as 

equity exposures under the final rule. 

The agencies remain concerned that 

the line between securitization 

exposures and non-securitization 

exposures may be difficult to draw in 

some circumstances. In addition to the 

supervisory exclusion from the 

definition of traditional securitization 

described above, the agencies have 

added a new component to the 

definition of traditional securitization to 

specifically permit a primary Federal 

supervisor to scope certain transactions 

into the securitization framework if 

justified by the economics of the 

transaction. Similar to the analysis for 

excluding an investment firm from 

treatment as a traditional securitization, 

the agencies will consider the economic 

substance, leverage, and risk profile of 

transactions to ensure that the 

appropriate IRB classification is made. 

The agencies will consider a number of 

factors when assessing the economic 

substance of a transaction including, for 

example, the amount of equity in the 

structure, overall leverage (whether onor off-balance sheet), whether 

redemption rights attach to the equity 

investor, and the ability of the junior 

tranches to absorb losses without 

interrupting contractual payments to 

more senior tranches. 

One commenter asked whether a bank 

could ignore the credit protection 

provided by a tranched guarantee for 

risk-based capital purposes and instead 

calculate the risk-based capital 

requirement for the guaranteed exposure 

as if the guarantee did not exist. The 

agencies believe that this treatment 

would be an appropriate application of 

the principle of conservatism discussed 

in section II.D. of this preamble and set 

forth in section 1(d) of the final rule. 

As noted above, the proposed rule 

defined mortgage-backed pass-through 

securities guaranteed by Fannie Mae or 

Freddie Mac (whether or not issued out 

of a structure that tranches credit risk) 

as securitization exposures. The 

agencies have reconsidered this 

proposal and have concluded that a 

special treatment for these securities is 

inconsistent with the New Accord and 

would violate the fundamental credittranching-based nature of the definition 

of securitization exposures. The final 

rule therefore does not define all 

mortgage-backed pass-through securities 

guaranteed by Fannie Mae or Freddie 

Mac to be securitization exposures. As 

a result, those mortgage-backed 

securities that involve tranching of 

credit risk will be securitization 

exposures; those mortgage-backed 

securities that do not involve tranching 

of credit risk will not be securitization 

exposures.56

A few commenters asserted that OTC 

derivatives with a securitization SPE as 

the counterparty should be excluded 

from the definition of securitization 

exposure and treated as wholesale 

exposures. The agencies believe that the 

securitization framework is the most 

appropriate way to assess the 

counterparty credit risk of such 

exposures because this risk is a tranched 

exposure to the credit risk of the 

underlying financial assets of the 

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securitization SPE. The agencies are 

addressing specific commenter concerns 

about the burden of applying the 

securitization framework to these 

exposures in preamble section V.E. 

below and section 42(a)(5) of the final 

rule. 

4. Equity Exposures 

The proposed rule defined an equity 

exposure to mean: 

(i) A security or instrument whether 

voting or non-voting that represents a 

direct or indirect ownership interest in, 

and a residual claim on, the assets and 

income of a company, unless: (A) The 

issuing company is consolidated with 

the bank under GAAP; (B) the bank is 

required to deduct the ownership 

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

the ownership interest is redeemable; 

(D) the ownership interest incorporates 

a payment or other similar obligation on 

the part of the issuing company (such as 

an obligation to pay periodic interest); 

or (E) the ownership interest is a 

securitization exposure. 

(ii) A security or instrument that is 

mandatorily convertible into a security 

or instrument described in (i). 

(iii) An option or warrant that is 

exercisable for a security or instrument 

described in (i). 

(iv) Any other security or instrument 

(other than a securitization exposure) to 

the extent the return on the security or 

instrument is based on the performance 

of a security or instrument described in 

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

equity security or a total return equity 

swap would be characterized as an 

equity exposure. 

The proposal noted that 

nonconvertible term or perpetual 

preferred stock generally would be 

considered wholesale exposures rather 

than equity exposures. Financial 

instruments that are convertible into an 

equity exposure only at the option of the 

holder or issuer also generally would be 

considered wholesale exposures rather 

than equity exposures provided that the 

conversion terms do not expose the 

bank to the risk of losses arising from 

price movements in that equity 

exposure. Upon conversion, the 

instrument would be treated as an 

equity exposure. In addition, the 

agencies note that unfunded equity 

commitments, which are commitments 

to make equity investments at a future 

date, meet the definition of an equity 

exposure. 

Many commenters expressed support 

for the proposed definition of equity 

exposure, except for the proposed 

exclusion of equity investments in 

hedge funds and other leveraged 

investment vehicles, as discussed above. 

The agencies are adopting the proposed 

definition for equity exposures with one 

exception. They have eliminated in the 

final rule the exclusion of a redeemable 

ownership interest from the definition 

of equity exposure. The agencies believe 

that redeemable ownership interests, 

such as those in mutual funds and 

private equity funds, are most 

appropriately treated as equity 

exposures. 

The agencies anticipate that, as a 

general matter, each of a bank’s 

exposures will fit in one and only one 

exposure category. One exception to this 

principle is that equity derivatives 

generally will meet the definition of an 

equity exposure (because of the bank’s 

exposure to the underlying equity 

security) and the definition of a 

wholesale exposure (because of the 

bank’s credit risk exposure to the 

counterparty). In such cases, as 

discussed in more detail below, the 

bank’s risk-based capital requirement 

for the equity derivative generally is the 

sum of its risk-based capital 

requirement for the derivative 

counterparty credit risk and for the 

underlying exposure. 

5. Boundary Between Operational Risk 

and Other Risks 

With the introduction of an explicit 

risk-based capital requirement for 

operational risk, issues arise about the 

proper treatment of operational losses 

that also could be attributed to either 

credit risk or market risk. The agencies 

recognize that these boundary issues are 

important and have significant 

implications for how banks must 

compile loss data sets and compute riskbased capital requirements under the 

final rule. Consistent with the treatment 

in the New Accord and the proposed 

rule, banks must treat operational losses 

that are related to market risk as 

operational losses for purposes of 

calculating risk-based capital 

requirements under this final rule. For 

example, losses incurred from a failure 

of bank personnel to properly execute a 

stop loss order, from trading fraud, or 

from a bank selling a security when a 

purchase was intended, must be treated 

as operational losses. 

Under the proposed rule, banks 

would treat losses that are related to 

both operational risk and credit risk as 

credit losses for purposes of calculating 

risk-based capital requirements. For 

example, where a loan defaults (credit 

risk) and the bank discovers that the 

collateral for the loan was not properly 

secured (operational risk), the bank’s 

resulting loss would be attributed to 

credit risk (not operational risk). This 

general separation between credit and 

operational risk is supported by current 

U.S. accounting standards for the 

treatment of credit risk. 

To be consistent with prevailing 

practice in the credit card industry, the 

proposed rule included an exception to 

this standard for retail credit card fraud 

losses. Specifically, retail credit card 

losses arising from non-contractual, 

third party-initiated fraud (for example, 

identity theft) would be treated as 

external fraud operational losses under 

the proposed rule. All other third partyinitiated losses would be treated as 

credit losses. 

Generally, commenters urged the 

agencies not to be prescriptive on risk 

boundary issues and to give banks 

discretion to categorize risk as they 

deem appropriate, subject to 

supervisory review. Other commenters 

noted that boundary issues are so 

significant that the agencies should not 

contemplate any additional exceptions 

to treating losses related to both credit 

and operational risk as credit losses 

unless the exceptions are agreed to by 

the BCBS. Several commenters objected 

to specific aspects of the agencies’

proposal and suggested that additional 

types of losses related to credit risk and 

operational risk, including losses related 

to check fraud, overdraft fraud, and 

small business loan fraud, should be 

treated as operational losses for 

purposes of calculating risk-based 

capital requirements. One commenter 

expressly noted its support for the 

agencies’ proposal, which effectively 

requires banks to treat losses on 

HELOCs related to both credit risk and 

operational risk as credit losses for 

purposes of calculating risk-based 

capital requirements. 

Because of the substantial potential 

impact boundary issues have on riskbased capital requirements under the 

advanced approaches, there should be 

consistency across U.S. banks in how 

they categorize losses that relate to both 

credit risk and operational risk. 

Moreover, the agencies believe that 

international consistency on this issue 

is an important objective. Therefore, the 

final rule maintains the proposed 

boundaries for losses that relate to both 

credit risk and operational risk and does 

not incorporate any additional 

exemptions beyond that in the proposal. 

6. Boundary Between the Final Rule and 

the Market Risk Rule 

For banks subject to the market risk 

rule, the existing market risk rule 

applies to all positions classified as 

trading positions in regulatory reports. 

The New Accord establishes additional 

criteria for positions to be eligible for 

application of the market risk rule. The 

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69330 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

57 If the bank determines the EAD for eligible 

margin loans using the approach in section 32(b) of 

the rule, it must segment retail eligible margin loans 

for which the bank uses this approach separately 

from other retail exposures. 

agencies are incorporating these 

additional criteria into the market risk 

rule through a separate rulemaking that 

is expected to be finalized soon and 

published in the Federal Register. 

Under this final rule, as under the 

proposal, core and opt-in banks subject 

to the market risk rule must use the 

market risk rule for exposures that are 

covered positions under the market risk 

rule. Core and opt-in banks not subject 

to the market risk rule must use this 

final rule for all of their exposures. 

B. Risk-Weighted Assets for General 

Credit Risk (Wholesale Exposures, Retail 

Exposures, On-Balance Sheet Assets 

That Are Not Defined by Exposure 

Category, and Immaterial Credit 

Portfolios) 

Under the proposed rule, the 

wholesale and retail risk-weighted 

assets calculation consisted of four 

phases: (1) Categorization of exposures; 

(2) assignment of wholesale exposures 

to rating grades and segmentation of 

retail exposures; (3) assignment of risk 

parameters to wholesale obligors and 

exposures and segments of retail 

exposures; and (4) calculation of riskweighted asset amounts. The agencies 

did not receive any negative comments 

on the four phases for calculating 

wholesale and retail risk-weighted 

assets and, thus, are adopting the fourphase concept as proposed. Where 

applicable, the agencies have clarified 

particular issues within the four-phase 

process. 

1. Phase 1—Categorization of Exposures 

In phase 1, a bank must determine 

which of its exposures fall into each of 

the four principal IRB exposure 

categories—wholesale exposures, retail 

exposures, securitization exposures, and 

equity exposures. In addition, a bank 

must identify within the wholesale 

exposure category certain exposures that 

receive a special treatment under the 

wholesale framework. These exposures 

include HVCRE exposures, sovereign 

exposures, eligible purchased wholesale 

exposures, eligible margin loans, repostyle transactions, OTC derivative 

contracts, unsettled transactions, and 

eligible guarantees and eligible credit 

derivatives that are used as credit risk 

mitigants. 

The treatment of HVCRE exposures 

and eligible purchased wholesale 

receivables is discussed below in this 

section. The treatment of eligible margin 

loans, repo-style transactions, OTC 

derivative contracts, and eligible 

guarantees and eligible credit 

derivatives that are credit risk mitigants 

is discussed in section V.C. of the 

preamble. In addition, sovereign 

exposures and exposures to or directly 

and unconditionally guaranteed by the 

Bank for International Settlements, the 

International Monetary Fund, the 

European Commission, the European 

Central Bank, and multilateral 

development banks are exempt from the 

0.03 percent floor on PD discussed in 

the next section. 

The proposed rule recognized as 

multilateral development banks only 

those multilateral lending institutions or 

regional development banks in which 

the U.S. government is a shareholder or 

contributing member. The final rule 

adopts a slightly expanded definition of 

multilateral development bank. 

Specifically, under the final rule, 

multilateral development bank is 

defined to include the International 

Bank for Reconstruction and 

Development, the International Finance 

Corporation, the Inter-American 

Development Bank, the Asian 

Development Bank, the African 

Development Bank, the European Bank 

for Reconstruction and Development, 

the European Investment Bank, the 

European Investment Fund, the Nordic 

Investment Bank, the Caribbean 

Development Bank, the Islamic 

Development Bank, the Council of 

Europe Development Bank; any 

multilateral lending institution or 

regional development bank in which the 

U.S. government is a shareholder or 

contributing member; and any 

multilateral lending institution that a 

bank’s primary Federal supervisor 

determines poses comparable credit 

risk. 

In phase 1, a bank also must 

subcategorize its retail exposures as 

residential mortgage exposures, QREs, 

or other retail exposures. In addition, a 

bank must identify any on-balance sheet 

asset that does not meet the definition 

of a wholesale, retail, securitization, or 

equity exposure, as well as any nonmaterial portfolio of exposures to which 

it chooses, subject to supervisory 

review, not to apply the IRB risk-based 

capital formulas. 

2. Phase 2—Assignment of Wholesale 

Obligors and Exposures to Rating 

Grades and Retail Exposures to 

Segments 

In phase 2, a bank must assign each 

wholesale obligor to a single rating 

grade (for purposes of assigning an 

estimated PD) and may assign each 

wholesale exposure to loss severity 

rating grades (for purposes of assigning 

an estimated LGD). A bank that elects 

not to use a loss severity rating grade 

system for a wholesale exposure must 

directly assign an estimated LGD to the 

wholesale exposure in phase 3. As a 

part of the process of assigning 

wholesale obligors to rating grades, a 

bank must identify which of its 

wholesale obligors are in default. In 

addition, a bank must group its retail 

exposures within each retail 

subcategory into segments that have 

homogeneous risk characteristics. 57

Segmentation is the grouping of 

exposures within each subcategory 

according to the predominant risk 

characteristics of the borrower (for 

example, credit score, debt-to-income 

ratio, and delinquency) and the 

exposure (for example, product type and 

LTV ratio). In general, retail segments 

should not cross national jurisdictions. 

A bank has substantial flexibility to use 

the retail portfolio segmentation it 

believes is most appropriate for its 

activities, subject to the following broad 

principles: 

• Differentiation of risk—

Segmentation should provide 

meaningful differentiation of risk. 

Accordingly, in developing its risk 

segmentation system, a bank should 

consider the chosen risk drivers’ ability 

to separate risk consistently over time 

and the overall robustness of the bank’s 

approach to segmentation. 

• Reliable risk characteristics—

Segmentation should use borrowerrelated risk characteristics and 

exposure-related risk characteristics that 

reliably and consistently over time 

differentiate a segment’s risk from that 

of other segments. 

• Consistency—Risk drivers for 

segmentation should be consistent with 

the predominant risk characteristics 

used by the bank for internal credit risk 

measurement and management. 

• Accuracy—The segmentation 

system should generate segments that 

separate exposures by realized 

performance and should be designed so 

that actual long-run outcomes closely 

approximate the retail risk parameters 

estimated by the bank. 

A bank might choose to segment 

exposures by common risk drivers that 

are relevant and material in determining 

the loss characteristics of a particular 

retail product. For example, a bank may 

segment mortgage loans by LTV band, 

age from origination, geography, 

origination channel, and credit score. 

Statistical modeling, expert judgment, 

or some combination of the two may 

determine the most relevant risk drivers. 

Alternatively, a bank might segment by 

grouping exposures with similar loss 

characteristics, such as loss rates or 

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default rates, as determined by 

historical performance of segments with 

similar risk characteristics. 

A bank must segment defaulted retail 

exposures separately from nondefaulted retail exposures and should 

base the segmentation of defaulted retail 

exposures on characteristics that are 

most predictive of current loss and 

recovery rates. This segmentation 

should provide meaningful 

differentiation so that individual 

exposures within each defaulted 

segment do not have material 

differences in their expected loss 

severity. 

Banks commonly obtain tranched 

credit protection, for example first-loss 

or second-loss guarantees, on certain 

retail exposures such as residential 

mortgages. The proposal recognized that 

the securitization framework, which 

applies to tranched wholesale 

exposures, is not appropriate for 

individual retail exposures. Therefore, 

the agencies proposed to exclude 

tranched guarantees that apply only to 

an individual retail exposure from the 

securitization framework. The preamble 

to the proposal noted that an important 

result of this exclusion is that, in 

contrast to the treatment of wholesale 

exposures, a bank may recognize 

recoveries from both a borrower and a 

guarantor for purposes of estimating 

LGD for certain retail exposures. 

Most commenters who addressed the 

agencies’ proposed treatment for 

tranched retail guarantees supported the 

proposed approach. One commenter 

urged the agencies to extend the 

treatment of tranched guarantees of 

retail exposures to wholesale exposures. 

Another commenter asserted that the 

proposed treatment was inconsistent 

with the New Accord. 

The agencies have determined that 

while the securitization framework is 

the most appropriate risk-based capital 

treatment for most tranched guarantees, 

the regulatory burden associated with 

applying it to tranched guarantees of 

individual retail exposures exceeds the 

supervisory benefit. The agencies are 

therefore adopting the proposed 

treatment in the final rule and excluding 

tranched guarantees of individual retail 

exposures from the securitization 

framework. 

Some banks expressed concern about 

the treatment of eligible margin loans 

under the New Accord. Due to the 

highly collateralized nature and low 

loss frequency of margin loans, banks 

typically collect little customer-specific 

information that they could use to 

differentiate margin loans into 

segments. The agencies believe that a 

bank could appropriately segment its 

margin loan portfolio using only 

product-specific risk drivers, such as 

product type and origination channel. A 

bank could then use the definition of 

default to associate a PD and LGD with 

each segment. As described in section 

32 of the rule, a bank may adjust the 

EAD of eligible margin loans to reflect 

the risk-mitigating effect of financial 

collateral. If a bank elects this option to 

adjust the EAD of eligible margin loans, 

it must associate an LGD with the 

segment that does not reflect the 

presence of collateral. 

Under the proposal, if a bank was not 

able to estimate PD and LGD for an 

eligible margin loan, the bank could 

apply a 300 percent risk weight to the 

EAD of the loan. Commenters generally 

objected to this approach. As discussed 

in section III.B.3. of the preamble, 

several commenters asserted that the 

agencies should permit banks to treat 

margin loans and other portfolios that 

exhibit low loss frequency or for which 

a bank has limited data on a portfolio 

basis, by apportioning EL between PD 

and LGD for portfolios rather than 

estimating each risk parameter 

separately. Other commenters suggested 

that banks should be expected to 

develop sound practices for applying 

the IRB approach to such exposures and 

adopt an appropriate degree of 

conservatism to address the level of 

uncertainty in the estimation process. 

Several commenters added that if a bank 

simply is unable to estimate PD and 

LGD for eligible margin loans, they 

would support the agencies’ proposal to 

apply a flat risk weight to the EAD of 

eligible margin loans. However, they 

asserted that the risk weight should not 

exceed 100 percent given the low levels 

of loss associated with these types of 

exposures. 

As discussed in section III.B.3. of the 

preamble, the final rule provides 

flexibility and incentives for banks to 

develop and document sound practices 

for applying the IRB approach to 

portfolios with limited data or default 

history, which may include eligible 

margin loans. However, the agencies 

believe that for banks facing particular 

challenges with respect to estimating PD 

and LGD for eligible margin loans, the 

proposed application of a 300 percent 

risk weight to the EAD of an eligible 

margin loan is a reasonable alternative. 

The option balances pragmatism with 

the provision of appropriate incentives 

for banks to develop processes to apply 

the IRB approach to such exposures. 

Accordingly, the final rule continues to 

provide banks with the option of 

applying a 300 percent risk weight to 

the EAD of an eligible margin loan for 

which it cannot estimate PD and LGD. 

Purchased Wholesale Exposures 

A bank may also elect to use a topdown approach, similar to the treatment 

of retail exposures, for eligible 

purchased wholesale exposures. Under 

the final rule, as under the proposal, 

this approach may be used for 

exposures purchased directly by the 

bank. In addition, the final rule clarifies 

that this approach also may be used for 

exposures purchased by a securitization 

SPE in which the bank has invested and 

for which the bank calculates the capital 

requirement on the underlying 

exposures (KIRB) for purposes of the 

SFA (as defined in section V.E.4. of the 

preamble). Under this approach, in 

phase 2, a bank would group its eligible 

purchased wholesale exposures into 

segments that have homogeneous risk 

characteristics. To be an eligible 

purchased wholesale exposure, several 

criteria must be met: 

• The purchased wholesale exposure 

must be purchased from an unaffiliated 

seller and must not have been directly 

or indirectly originated by the 

purchasing bank or securitization SPE; 

• The purchased wholesale exposure 

must be generated on an arm’s-length 

basis between the seller and the obligor 

(intercompany accounts receivable and 

receivables subject to contra-accounts 

between firms that buy and sell to each 

other would not satisfy this criterion); 

• The purchasing bank must have a 

claim on all proceeds from the exposure 

or a pro rata interest in the proceeds; 

• The purchased wholesale exposure 

must have an effective remaining 

maturity of less than one year; and 

• The purchased wholesale exposure 

must, when consolidated by obligor, not 

represent a concentrated exposure 

relative to the portfolio of purchased 

wholesale exposures. 

Wholesale Lease Residuals 

The agencies proposed a treatment for 

wholesale lease residuals that differs 

from the New Accord. A wholesale lease 

residual typically exposes a bank to the 

risk of a decline in value of the leased 

asset and to the credit risk of the lessee. 

Although the New Accord provides for 

a flat 100 percent risk weight for 

wholesale lease residuals, the preamble 

to the proposal noted that the agencies 

believed this treatment was excessively 

punitive for leases to highly 

creditworthy lessees. Accordingly, the 

proposed rule required a bank to treat 

its net investment in a wholesale lease 

as a single exposure to the lessee. As 

proposed, there would not be a separate 

capital calculation for the wholesale 

lease residual. Commenters on this issue 

broadly supported the agencies’

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69332 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

58EAD for repo-style transactions and eligible 

margin loans may be calculated as described in 

section 32 of the final rule. EAD for OTC derivatives 

must be calculated as described in section 32 of the 

final rule. 

proposed approach. The agencies 

believe the proposed approach 

appropriately reflects current bank risk 

management practice and are adopting 

the proposed approach in the final rule. 

Commenters also requested this 

treatment for retail lease residuals. 

However, the agencies have determined 

that the proposal to apply a flat 100 

percent risk weight for retail lease 

residuals, consistent with the New 

Accord, appropriately balances risk 

sensitivity and complexity and are 

maintaining this treatment in the final 

rule. 

3. Phase 3—Assignment of Risk 

Parameters to Wholesale Obligors and 

Exposures and Retail Segments 

In phase 3, a bank associates a PD 

with each wholesale obligor rating 

grade; associates an LGD with each 

wholesale loss severity rating grade or 

assigns an LGD to each wholesale 

exposure; assigns an EAD and M to each 

wholesale exposure; and assigns a PD, 

LGD, and EAD to each segment of retail 

exposures. In some cases it may be 

reasonable to assign the same PD, LGD, 

or EAD to multiple segments of retail 

exposures. The quantification phase for 

PD, LGD, and EAD can generally be 

divided into four steps—obtaining 

historical reference data, estimating the 

risk parameters for the reference data, 

mapping the historical reference data to 

the bank’s current exposures, and 

determining the risk parameters for the 

bank’s current exposures. As discussed 

in more detail below, quantification of 

M is accomplished through direct 

computation based on the contractual 

characteristics of the exposure. 

A bank should base its estimation of 

the values assigned to PD, LGD, and 

EAD 58 on historical reference data that 

are a reasonable proxy for the bank’s 

current exposures and that provide 

meaningful predictions of the 

performance of such exposures. A 

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

exposures to defaulted wholesale 

obligors and defaulted retail exposures 

(in the case of LGD and EAD estimation) 

or to both defaulted and non-defaulted 

wholesale obligors and retail exposures 

(in the case of PD estimation). 

The reference data set should be 

described using a set of observed 

characteristics. Relevant characteristics 

might include debt ratings, financial 

measures, geographic regions, the 

economic environment and industry/ 

sector trends during the time period of 

the reference data, borrower and loan 

characteristics related to the risk 

parameters (such as loan terms, LTV 

ratio, credit score, income, debt-toincome ratio, or performance history), or 

other factors that are related in some 

way to the risk parameters. Banks may 

use more than one reference data set to 

improve the robustness or accuracy of 

the parameter estimates. 

A bank should then apply statistical 

techniques to the reference data to 

determine a relationship between risk 

characteristics and the estimated risk 

parameter. The result of this step is a 

model that ties descriptive 

characteristics to the risk parameter 

estimates. In this context, the term 

‘‘model’’ is used in the most general 

sense; a model may use simple 

concepts, such as the calculation of 

averages, or more complex ones, such as 

an approach based on rigorous 

regression techniques. This step may 

include adjustments for differences 

between this final rule’s definition of 

default and the default definition in the 

reference data set, or adjustments for 

data limitations. This step includes 

adjustments for seasoning effects related 

to retail exposures, if material. 

A bank may use more than one 

estimation technique to generate 

estimates of the risk parameters, 

especially if there are multiple sets of 

reference data or multiple sample 

periods. If multiple estimates are 

generated, the bank should have a clear 

and consistent policy on reconciling 

and combining the different estimates. 

Once a bank estimates PD, LGD, and 

EAD for its reference data sets, it should 

create a link between its portfolio data 

and the reference data based on 

corresponding characteristics. Variables 

or characteristics that are available for 

the existing portfolio should be mapped 

or linked to the variables used in the 

default, loss-severity, or exposure 

amount model. In order to effectively 

map the data, reference data 

characteristics need to allow for the 

construction of rating and segmentation 

criteria that are consistent with those 

used on the bank’s portfolio. An 

important element of mapping is 

making adjustments for differences 

between reference data sets and the 

bank’s exposures. 

Finally, a bank must apply the risk 

parameters estimated for the reference 

data to the bank’s actual portfolio data. 

As noted above, the bank must attribute 

a PD to each wholesale obligor risk 

grade, an LGD to each wholesale loss 

severity grade or wholesale exposure, an 

EAD and M to each wholesale exposure, 

and a PD, LGD, and EAD to each 

segment of retail exposures. If multiple 

data sets or estimation methods are 

used, the bank must adopt a means of 

combining the various estimates at this 

stage. 

The final rule, as noted above, permits 

a bank to elect to segment its eligible 

purchased wholesale exposures like 

retail exposures. A bank that chooses to 

apply this treatment must directly 

assign a PD, LGD, EAD, and M to each 

such segment. If a bank can estimate 

ECL (but not PD or LGD) for a segment 

of eligible purchased wholesale 

exposures, the bank must assume that 

the LGD of the segment equals 100 

percent and that the PD of the segment 

equals ECL divided by EAD. The bank 

must estimate ECL for the eligible 

purchased wholesale exposures without 

regard to any assumption of recourse or 

guarantees from the seller or other 

parties. The bank must then use the 

wholesale exposure formula in section 

31(e) of the final rule to determine the 

risk-based capital requirement for each 

segment of eligible purchased wholesale 

exposures. 

A bank may recognize the credit risk 

mitigation benefits of collateral that 

secures a wholesale exposure by 

adjusting its estimate of the LGD of the 

exposure and may recognize the credit 

risk mitigation benefits of collateral that 

secures retail exposures by adjusting its 

estimate of the PD and LGD of the 

segment of retail exposures. In certain 

cases, however, a bank may take 

financial collateral into account in 

estimating the EAD of repo-style 

transactions, eligible margin loans, and 

OTC derivative contracts (as provided in 

section 32 of the final rule). 

Consistent with the proposed rule, the 

final rule also provides that a bank may 

use an EAD of zero for (i) derivative 

contracts that are publicly traded on an 

exchange that requires the daily receipt 

and payment of cash-variation margin; 

(ii) derivative contracts and repo-style 

transactions that are outstanding with a 

qualifying central counterparty (defined 

below), but not for those transactions 

that the qualifying central counterparty 

has rejected; and (iii) credit risk 

exposures to a qualifying central 

counterparty that arise from derivative 

contracts and repo-style transactions in 

the form of clearing deposits and posted 

collateral. The final rule, like the 

proposed rule, defines a qualifying 

central counterparty as a counterparty 

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

Facilitates trades between 

counterparties in one or more financial 

markets by either guaranteeing trades or 

novating contracts; (ii) requires all 

participants in its arrangements to be 

fully collateralized on a daily basis; and 

(iii) the bank demonstrates to the 

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Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 69333 

satisfaction of its primary Federal 

supervisor is in sound financial 

condition and is subject to effective 

oversight by a national supervisory 

authority. 

Some repo-style transactions and OTC 

derivative contracts giving rise to 

counterparty credit risk may result, from 

an accounting point of view, in both onand off-balance sheet exposures. A bank 

that uses an EAD approach to measure 

the exposure amount of such 

transactions is not required to apply 

separately a risk-based capital 

requirement to an on-balance sheet 

receivable from the counterparty 

recorded in connection with that 

transaction. Because any exposure 

arising from the on-balance sheet 

receivable is captured in the risk-based 

capital requirement determined under 

the EAD approach, a separate capital 

requirement would double count the 

exposure for regulatory capital 

purposes. 

A bank may take into account the risk 

reducing effects of eligible guarantees 

and eligible credit derivatives in 

support of a wholesale exposure by 

applying the PD substitution approach 

or the LGD adjustment approach to the 

exposure as provided in section 33 of 

the final rule or, if applicable, applying 

the double default treatment to the 

exposure as provided in section 34 of 

the final rule. A bank may decide 

separately for each wholesale exposure 

that qualifies for the double default 

treatment whether to apply the PD 

substitution approach, the LGD 

adjustment approach, or the double 

default treatment. A bank may take into 

account the risk-reducing effects of 

guarantees and credit derivatives in 

support of retail exposures in a segment 

when quantifying the PD and LGD of the 

segment. 

The proposed rule imposed several 

supervisory limitations on risk 

parameters assigned to wholesale 

obligors and exposures and segments of 

retail exposures. First, the PD for each 

wholesale obligor or segment of retail 

exposures could not be less than 0.03 

percent, except for exposures to or 

directly and unconditionally guaranteed 

by a sovereign entity, the Bank for 

International Settlements, the 

International Monetary Fund, the 

European Commission, the European 

Central Bank, or a multilateral 

development bank, to which the bank 

assigns a rating grade associated with a 

PD of less than 0.03 percent. 

Second, the LGD of a segment of 

residential mortgage exposures (other 

than segments of residential mortgage 

exposures for which all or substantially 

all of the principal of the exposures is 

directly and unconditionally guaranteed 

by the full faith and credit of a sovereign 

entity) could not be less than 10 

percent. These supervisory floors on PD 

and LGD applied regardless of whether 

the bank recognized an eligible 

guarantee or eligible credit derivative as 

provided in sections 33 and 34 of the 

proposed rule. 

Commenters did not object to the 

floor on PD, and the agencies are 

including it in the final rule. A number 

of commenters, however, objected to the 

10 percent floor on LGD for segments of 

residential mortgage exposures. These 

commenters asserted that the floor 

would penalize low-risk mortgage 

lending and would provide a 

disincentive for obtaining high-quality 

collateral. The agencies continue to 

believe that the LGD floor is appropriate 

at least until banks and the agencies 

gain more experience with the advanced 

approaches. Accordingly, the agencies 

are maintaining the floor in the final 

rule. As the agencies gain more 

experience with the advanced 

approaches they will reconsider the 

need for the floor together with other 

calibration issues identified during the 

parallel run and transitional floor 

periods. The agencies also intend to 

address this issue and other calibration 

issues with the BCBS and other 

supervisory and regulatory authorities, 

as appropriate. 

The 10 percent LGD floor for 

residential mortgage exposures applies 

at the segment level. The agencies will 

not allow a bank to artificially group 

exposures into segments to avoid the 

LGD floor for mortgage products. A bank 

should use consistent risk drivers to 

determine its retail exposure 

segmentations and not artificially 

segment low LGD loans with higher 

LGD loans to avoid the floor. 

A bank also must calculate M for each 

wholesale exposure. Under the 

proposed rule, for wholesale exposures 

other than repo-style transactions, 

eligible margin loans, and OTC 

derivative contracts subject to a 

qualifying master netting agreement 

(defined in section V.C.2. of this 

preamble), M was defined as the 

weighted-average remaining maturity 

(measured in whole or fractional years) 

of the expected contractual cash flows 

from the exposure, using the 

undiscounted amounts of the cash flows 

as weights. A bank could use its best 

estimate of future interest rates to 

compute expected contractual interest 

payments on a floating-rate exposure, 

but it could not consider expected but 

noncontractually required returns of 

principal, when estimating M. A bank 

could, at its option, use the nominal 

remaining maturity (measured in whole 

or fractional years) of the exposure. The 

M for repo-style transactions, eligible 

margin loans, and OTC derivative 

contracts subject to a qualifying master 

netting agreement was the weightedaverage remaining maturity (measured 

in whole or fractional years) of the 

individual transactions subject to the 

qualifying master netting agreement, 

with the weight of each individual 

transaction set equal to the notional 

amount of the transaction. The M for 

netting sets for which the bank used the 

internal models methodology was 

calculated as described in section 32(c) 

of the proposed rule. 

Many commenters requested more 

flexibility in the definition of M, 

including the ability to estimate 

noncontractually required prepayments 

and the ability to use either discounted 

or undiscounted cash flows. However, 

the agencies believe that the proposed 

definition of M, which is consistent 

with the New Accord, is appropriately 

conservative and provides for a 

consistent definition of M across 

internationally active banks. The final 

rule therefore maintains the proposed 

definition of M. 

Under the final rule, as under the 

proposal, for most exposures M may be 

no greater than five years and no less 

than one year. For exposures that have 

an original maturity of less than one 

year and are not part of a bank’s ongoing 

financing of the obligor, however, a 

bank may set M as low as one day, 

consistent with the New Accord. An 

exposure is not part of a bank’s ongoing 

financing of the obligor if the bank (i) 

has a legal and practical ability not to 

renew or roll over the exposure in the 

event of credit deterioration of the 

obligor; (ii) makes an independent 

credit decision at the inception of the 

exposure and at every renewal or 

rollover; and (iii) has no substantial 

commercial incentive to continue its 

credit relationship with the obligor in 

the event of credit deterioration of the 

obligor. Examples of transactions that 

may qualify for the exemption from the 

one-year maturity floor include amounts 

due from other banks, including 

deposits in other banks; bankers’’

acceptances; sovereign exposures; shortterm self-liquidating trade finance 

exposures; repo-style transactions; 

eligible margin loans; unsettled trades 

and other exposures resulting from 

payment and settlement processes; and 

collateralized OTC derivative contracts 

subject to daily remargining. 

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69334 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

59Alternatively, as noted above, a bank may 

apply a 300 percent risk weight to the EAD of an 

eligible margin loan if the bank is not able to assign 

a rating grade to the obligor of the loan. 

4. Phase 4—Calculation of RiskWeighted Assets 

After a bank assigns risk parameters to 

each of its wholesale obligors and 

exposures and retail segments, the bank 

must calculate the dollar risk-based 

capital requirement for each wholesale 

exposure to a non-defaulted obligor and 

each segment of non-defaulted retail 

exposures (except eligible guarantees 

and eligible credit derivatives that 

hedge another wholesale exposure). 

Other than for exposures to which the 

bank applies the double default 

treatment in section 34 of the final rule, 

a bank makes this calculation by 

inserting the risk parameters for the 

wholesale obligor and exposure or retail 

segment into the appropriate IRB riskbased capital formula specified in Table 

B, and multiplying the output of the 

formula (K) by the EAD of the exposure 

or segment.59 Section 34 contains a 

separate double default risk-based 

capital requirement formula. Eligible 

guarantees and eligible credit 

derivatives that are hedges of a 

wholesale exposure are reflected in the 

risk-weighted assets amount of the 

hedged exposure (i) through 

adjustments made to the risk parameters 

of the hedged exposure under the PD 

substitution or LGD adjustment 

approach in section 33 of the final rule 

or (ii) through a separate double default 

risk-based capital requirement formula 

in section 34 of the final rule. 

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

6720–01–P 

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Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 69335 

The sum of the dollar risk-based 

capital requirements for wholesale 

exposures to non-defaulted obligors 

(including exposures subject to the 

double default treatment described 

below) and segments of non-defaulted 

retail exposures equals the total dollar 

risk-based capital requirement for those 

exposures and segments. The total 

dollar risk-based capital requirement 

multiplied by 12.5 equals the riskweighted asset amount. 

Under the proposed rule, to compute 

the risk-weighted asset amount for a 

wholesale exposure to a defaulted 

obligor, a bank would first have to 

compare two amounts: (i) The sum of 

0.08 multiplied by the EAD of the 

wholesale exposure plus the amount of 

any charge-offs or write-downs on the 

exposure; and (ii) K for the wholesale 

exposure (as determined in Table B 

immediately before the obligor became 

defaulted), multiplied by the EAD of the 

exposure immediately before the 

exposure became defaulted. If the 

amount calculated in (i) were equal to 

or greater than the amount calculated in 

(ii), the dollar risk-based capital 

requirement for the exposure would be 

0.08 multiplied by the EAD of the 

exposure. If the amount calculated in (i) 

were less than the amount calculated in 

(ii), the dollar risk-based capital 

requirement for the exposure would be 

K for the exposure (as determined in 

Table B immediately before the obligor 

became defaulted), multiplied by the 


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69336 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

60See 12 CFR part 3, Appendix A, section 

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

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

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

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

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

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

61See §§ 618(a) and (b) of the RTCRRI Act, Pub. 

L. 102–233. The first class includes loans for the 

construction of a residence consisting of 1-to-4 

family dwelling units that have been pre-sold under 

firm contracts to purchasers who have obtained 

firm commitments for permanent qualifying 

mortgages and have made substantial earnest 

money deposits. The second class includes loans 

that are secured by a first lien on a residence 

consisting of more than 4 dwelling units if the loan 

meets certain criteria outlined in the RTCRRI Act. 

62See §§ 618(a) and (b) of the RTCRRI Act. 

63See § 618(a)(1)((B) of the RTCRRI Act. 

64See § 618(b)(1)(B) of the RTCRRI Act. 

65See § 618(a)(2) of the RTCRRI Act. 

EAD of the exposure. The reason for this 

comparison was to ensure that a bank 

did not receive a regulatory capital 

benefit as a result of the exposure 

moving from non-defaulted to defaulted 

status. 

The proposed rule provided a simpler 

approach for segments of defaulted 

retail exposures. The dollar risk-based 

capital requirement for a segment of 

defaulted retail exposures was 0.08 

multiplied by the EAD of the segment. 

Some commenters objected to the 

proposed risk-based capital treatment of 

defaulted wholesale exposures, which 

differs from the approach in the New 

Accord. These commenters contended 

that it would be burdensome to track the 

pre-default risk-based capital 

requirements for purposes of the 

proposed comparison. These 

commenters also claimed that the cost 

and burden of the proposed treatment of 

defaulted wholesale exposures would 

subject banks to a competitive 

disadvantage relative to international 

counterparts subject to an approach 

similar to that in the New Accord. 

In view of commenters’ concerns 

about cost and regulatory burden, the 

final rule treats defaulted wholesale 

exposures the same as defaulted retail 

exposures. The dollar risk-based capital 

requirement of a wholesale exposure to 

a defaulted obligor equals 0.08 

multiplied by the EAD of the exposure. 

The agencies will review banks’

practices to ensure that banks are not 

moving exposures from non-defaulted to 

defaulted status for the primary purpose 

of obtaining a reduction in risk-based 

capital requirements. 

To convert the dollar risk-based 

capital requirements for defaulted 

exposures into a risk-weighted asset 

amount, the bank must sum the dollar 

risk-based capital requirements for all 

wholesale exposures to defaulted 

obligors and segments of defaulted retail 

exposures and multiply the sum by 

12.5. 

A bank may assign a risk-weighted 

asset amount of zero to cash owned and 

held in all offices of the bank or in 

transit, and for gold bullion held in the 

bank’s own vaults or held in another 

bank’s vaults on an allocated basis, to 

the extent the gold bullion assets are 

offset by gold bullion liabilities. The 

risk-weighted asset amount for an onbalance sheet asset that does not meet 

the definition of a wholesale, retail, 

securitization, or equity exposure—for 

example, property, plant, and 

equipment and mortgage servicing 

rights—is its carrying value. The riskweighted asset amount for a portfolio of 

exposures that the bank has 

demonstrated to its primary Federal 

supervisor’s satisfaction is, when 

combined with all other portfolios of 

exposures that the bank seeks to treat as 

immaterial for risk-based capital 

purposes, not material to the bank 

generally is its carrying value (for onbalance sheet exposures) or notional 

amount (for off-balance sheet 

exposures). For this purpose, the 

notional amount of an OTC derivative 

contract that is not a credit derivative is 

the EAD of the derivative as calculated 

in section 32 of the final rule. If an OTC 

derivative contract is a credit derivative, 

the notional amount is the notional 

amount of the credit derivative. 

Total wholesale and retail riskweighted assets are defined as the sum 

of risk-weighted assets for wholesale 

exposures to non-defaulted obligors and 

segments of non-defaulted retail 

exposures, wholesale exposures to 

defaulted obligors and segments of 

defaulted retail exposures, assets not 

included in an exposure category, nonmaterial portfolios of exposures (as 

calculated under section 31 of the final 

rule), and unsettled transactions (as 

calculated under section 35 of the final 

rule and described in section V.D. of the 

preamble) minus the amounts deducted 

from capital pursuant to the general 

risk-based capital rules (excluding those 

deductions reversed in section 12 of the 

final rule). 

5. Statutory Provisions on the 

Regulatory Capital Treatment of Certain 

Mortgage Loans 

The general risk-based capital rules 

assign 50 percent and 100 percent risk 

weights to certain one-to four-family 

residential pre-sold construction loans 

and multifamily residential loans.60 The 

agencies adopted these provisions as a 

result of the Resolution Trust 

Corporation Refinancing, Restructuring, 

and Improvement Act of 1991 (RTCRRI 

Act).61 The RTCRRI Act mandates that 

each agency provide in its capital 

regulations (i) A 50 percent risk weight 

for certain one-to four-family residential 

pre-sold construction loans and 

multifamily residential loans that meet 

specific statutory criteria in the RTCRRI 

Act and any other underwriting criteria 

imposed by the agencies; and (ii) a 100 

percent risk weight for one-to fourfamily residential pre-sold construction 

loans for residences for which the 

purchase contract is cancelled.62

When Congress enacted the RTCRRI 

Act in 1991, the agencies’ risk-based 

capital rules reflected the Basel I 

framework. Consequently, the risk 

weight treatment for certain categories 

of mortgage loans in the RTCRRI Act 

assumes a risk weight bucketing 

approach, instead of the more risksensitive IRB approach in the advanced 

approaches. 

In the proposed rule, the agencies 

identified three types of residential 

mortgage loans addressed by the 

RTCRRI Act that would continue to 

receive the risk weights provided in the 

Act. Consistent with the general riskbased capital rules, the proposed rule 

would apply the following risk weights 

(instead of the risk weights that would 

otherwise be produced under the IRB 

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

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

the residences have been pre-sold under 

firm contracts to purchasers who have 

obtained firm commitments for 

permanent qualifying mortgages and 

have made substantial earnest money 

deposits, and the loans meet the other 

underwriting characteristics established 

by the agencies in the general risk-based 

capital rules; 63 (ii) a 50 percent risk 

weight for multifamily residential loans 

that meet certain statutory loan-to-value, 

debt-to-income, amortization, and 

performance requirements, and meet the 

other underwriting characteristics 

established by the agencies in the 

general risk-based capital rules; 64 and 

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

construction loans for a residence for 

which the purchase contract is 

cancelled.65 Under the proposal, 

mortgage loans that did not meet the 

relevant criteria would not qualify for 

the statutory risk weights and would be 

risk-weighted according to the IRB riskbased capital formulas. 

Commenters generally opposed the 

proposed assignment of a 50 percent 

risk weight to multifamily and pre-sold 

single family residential construction 

exposures. Commenters maintained that 

the RTCRRI Act capital requirements do 

not align with risk, are contrary to the 

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Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 69337 

66See, e.g., Floor debate for the Resolution Trust 

Corporation Refinancing, Restructuring, and 

Improvement Act of 1991, p. H11853, House of 

Representatives, Nov. 26, 1991 (Rep. Wylie) 

67 12 U.S.C. 1828. 

intent of the New Accord and to its 

implementation in other jurisdictions, 

and would impose additional 

compliance burdens on banks without 

any associated benefit. 

The agencies agree with these 

concerns and have decided to adopt in 

the final rule an alternative described in 

the preamble to the proposed rule. The 

proposed rule’s preamble noted the 

tension between the statutory risk 

weights provided by the RTCRRI Act 

and the more risk-sensitive IRB 

approaches to risk-based capital 

requirements. The preamble observed 

that the RTCRRI Act permits the 

agencies to prescribe additional 

underwriting characteristics for 

identifying loans that are subject to the 

50 percent statutory risk weights, 

provided these underwriting 

characteristics are ‘‘consistent with the 

purposes of the minimum acceptable 

capital requirements to maintain the 

safety and soundness of financial 

institutions.’’ The agencies asked 

whether they should impose the 

following additional underwriting 

criteria as additional requirements for a 

core or opt-in bank to qualify for the 

statutory 50 percent risk weight for a 

particular mortgage loan: (i) That the 

bank has an IRB risk measurement and 

management system in place that 

assesses the PD and LGD of prospective 

residential mortgage exposures; and (ii) 

that the bank’s IRB system generates a 

50 percent risk weight for the loan 

under the IRB risk-based capital 

formula. If the bank’s IRB system does 

not generate a 50 percent risk weight for 

a particular loan, the loan would not 

qualify for the statutory risk weight and 

would receive the risk weight generated 

by the IRB system. 

A few commenters opposed this 

alternative approach and indicated that 

the additional underwriting criteria 

would increase operational burden. 

Other commenters, however, observed 

that compliance with the additional 

underwriting criteria would not be 

burdensome. 

After careful consideration of the 

comments and further analysis of the 

text, spirit and legislative history of the 

RTCRRI Act, the agencies have 

concluded that they should impose the 

additional underwriting criteria 

described in the preamble to the 

proposed rule as minimum 

requirements for a core or opt-in bank 

to use the statutory 50 percent risk 

weight for particular loans. The agencies 

believe that the imposition of these 

criteria is consistent with the plain 

language of the RTCRRI Act, which 

allows a bank to use the 50 percent risk 

weight only if it meets the additional 

underwriting characteristics established 

by the agencies. The agencies have 

concluded that the additional 

underwriting characteristics imposed in 

the final rule are ‘‘consistent with the 

purposes of the minimum acceptable 

capital requirements to maintain the 

safety and soundness of financial 

institution,’’ because the criteria will 

make the risk-based capital requirement 

for these loans a function of each bank’s 

historical loss experience for the loans 

and will therefore more accurately 

reflect the performance and risk of loss 

for these loans. The additional 

underwriting characteristics are also 

consistent with the purposes and 

legislative history of RTCRRI Act, which 

was designed to reflect the true level of 

risk associated with these types of 

mortgage loans and to do so in 

accordance with the Basel Accord.66

A capital-related provision of the 

Federal Deposit Insurance Corporation 

Improvement Act of 1991 (‘‘FDICIA’’), 

enacted by Congress just four days after 

its adoption of the RTCRRI Act, also 

supports the addition of the new 

underwriting characteristics. Section 

305(b)(1)(B) of FDICIA 67 directs each 

agency to revise its risk-based capital 

standards for insured depository 

institutions to ensure that those 

standards ‘‘reflect the actual 

performance and expected risk of loss of 

multifamily mortgages.’’ Although this 

addresses only multifamily mortgage 

loans (and not one-to four-family 

residential pre-sold construction loans), 

it provides the agencies with a 

Congressional mandate—equal in force 

and power to section 618 of the RTCRRI 

Act—to enhance the risk sensitivity of 

the regulatory capital treatment of 

multifamily mortgage loans. Crucially, 

the IRB approach required of core and 

opt-in banks will produce capital 

requirements that more accurately 

reflect both performance and risk of loss 

for multifamily mortgage loans than 

either the Basel I risk weight or the 

RTCRRI Act risk weight. 

As noted above, section 618(a)(2) of 

the RTCRRI Act mandates that each 

agency amend its capital regulations to 

provide a 100 percent risk weight to any 

single-family residential construction 

loan for which the purchase contract is 

cancelled. Because the statute does not 

authorize the agencies to establish 

additional underwriting characteristics 

for this small category of loans, the final 

rule, like the proposed rule, provides a 

100 percent risk weight for single-family 

residential construction loans for which 

the purchase contract is cancelled. 

C. Credit Risk Mitigation (CRM) 

Techniques 

Banks use a number of techniques to 

mitigate credit risk. This section of the 

preamble describes how the final rule 

recognizes the risk-mitigating effects of 

both financial collateral (defined below) 

and nonfinancial collateral, as well as 

guarantees and credit derivatives, for 

risk-based capital purposes. To 

recognize credit risk mitigants for riskbased capital purposes, a bank should 

have in place operational procedures 

and risk management processes that 

ensure that all documentation used in 

collateralizing or guaranteeing a 

transaction is legal, valid, binding, and 

enforceable under applicable law in the 

relevant jurisdictions. The bank should 

have conducted sufficient legal review 

to reach a well-founded conclusion that 

the documentation meets this standard 

and should reconduct such a review as 

necessary to ensure continuing 

enforceability. 

Although the use of CRM techniques 

may reduce or transfer credit risk, it 

simultaneously may increase other 

risks, including operational, liquidity, 

and market risks. Accordingly, it is 

imperative that banks employ robust 

procedures and processes to control 

risks, including roll-off risk and 

concentration of risks, arising from the 

bank’s use of CRM techniques and to 

monitor the implications of using CRM 

techniques for the bank’s overall credit 

risk profile. 

1. Collateral 

Under the final rule, a bank generally 

recognizes collateral that secures a 

wholesale exposure as part of the LGD 

estimation process and generally 

recognizes collateral that secures a retail 

exposure as part of the PD and LGD 

estimation process, as described above 

in section V.B.3. of the preamble. 

However, in certain limited 

circumstances described in the next 

section, a bank may adjust EAD to 

reflect the risk mitigating effect of 

financial collateral. 

Although the final rule does not 

contain specific regulatory requirements 

about how a bank incorporates collateral 

into PD or LGD estimates, a bank 

should, when reflecting the credit risk 

mitigation benefits of collateral in its 

estimation of the risk parameters of a 

wholesale or retail exposure: 

(i) Conduct sufficient legal review to 

ensure, at inception and on an ongoing 

basis, that all documentation used in the 

collateralized transaction is binding on 

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69338 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

68For purposes of the internal models 

methodology in section 32(d) of the rule, discussed 

below in section V.C.4. of this preamble, netting set 

also means a group of transactions with a single 

counterparty that are subject to a qualifying crossproduct master netting agreement. 

69Only repo-style transactions and eligible 

margin loans subject to a single-product qualifying 

master netting agreement are eligible for the simple 

VaR methodology. 

70 In conjunction with the current exposure 

methodology. 

all parties and legally enforceable in all 

relevant jurisdictions; 

(ii) Consider the correlation between 

obligor risk and collateral risk in the 

transaction; 

(iii) Consider any currency and/or 

maturity mismatch between the hedged 

exposure and the collateral; 

(iv) Ground its risk parameter 

estimates for the transaction in 

historical data, using historical recovery 

rates where available; and 

(v) Fully take into account the time 

and cost needed to realize the 

liquidation proceeds and the potential 

for a decline in collateral value over this 

time period. 

The bank also should ensure that: 

(i) The legal mechanism under which 

the collateral is pledged or transferred 

ensures that the bank has the right to 

liquidate or take legal possession of the 

collateral in a timely manner in the 

event of the default, insolvency, or 

bankruptcy (or other defined credit 

event) of the obligor and, where 

applicable, the custodian holding the 

collateral; 

(ii) The bank has taken all steps 

necessary to fulfill legal requirements to 

secure its interest in the collateral so 

that it has and maintains an enforceable 

security interest; 

(iii) The bank has clear and robust 

procedures to ensure observation of any 

legal conditions required for declaring 

the default of the borrower and prompt 

liquidation of the collateral in the event 

of default; 

(iv) The bank has established 

procedures and practices for (A) 

conservatively estimating, on a regular 

ongoing basis, the market value of the 

collateral, taking into account factors 

that could affect that value (for example, 

the liquidity of the market for the 

collateral and obsolescence or 

deterioration of the collateral), and (B) 

where applicable, periodically verifying 

the collateral (for example, through 

physical inspection of collateral such as 

inventory and equipment); and 

(v) The bank has in place systems for 

promptly requesting and receiving 

additional collateral for transactions 

whose terms require maintenance of 

collateral values at specified thresholds. 

2. Counterparty Credit Risk of RepoStyle Transactions, Eligible Margin 

Loans, and OTC Derivative Contracts 

This section describes two EAD-based 

methodologies—a collateral haircut 

approach and an internal models 

methodology—that a bank may use 

instead of an LGD estimation 

methodology to recognize the benefits of 

financial collateral in mitigating the 

counterparty credit risk associated with 

repo-style transactions, eligible margin 

loans, collateralized OTC derivative 

contracts, and single product groups of 

such transactions with a single 

counterparty subject to a qualifying 

master netting agreement (netting 

sets).68 A third methodology, the simple 

VaR methodology, is also available to 

recognize financial collateral mitigating 

the counterparty credit risk of single 

product netting sets of repo-style 

transactions and eligible margin loans. 

These methodologies are substantially 

the same as those in the proposal, 

except for a few differences identified 

below. 

One difference from the proposal is 

that, consistent with the New Accord, 

under the final rule these three 

methodologies may also be used to 

recognize the benefits of any collateral 

(not only financial collateral) mitigating 

the counterparty credit risk of repo-style 

transactions that are included in a 

bank’s VaR-based measure under the 

market risk rule. In response to 

comments requesting broader 

application of the EAD-based 

methodologies for recognizing the riskmitigating effect of collateral, the 

agencies added this flexibility to the 

final rule to enhance international 

consistency and reduce regulatory 

burden. 

A bank may use any combination of 

the three methodologies for collateral 

recognition; however, it must use the 

same methodology for similar 

exposures. This means that, as a general 

matter, the agencies expect a bank to use 

one of the three methodologies for all its 

repo-style transactions, one of the three 

methodologies for all its eligible margin 

loans, and one of the three 

methodologies for all its OTC derivative 

contracts. A bank may, however, apply 

a different methodology to subsets of 

repo-style transactions, eligible margin 

loans, or OTC derivatives by product 

type or geographical location if its 

application of different methodologies is 

designed to separate transactions that do 

not have similar risk profiles and is not 

designed to arbitrage the rule. For 

example, a bank may choose to use one 

methodology for agency securities 

lending transactions—that is, repo-style 

transactions in which the bank, acting 

as agent for a customer, lends the 

customer’s securities and indemnifies 

the customer against loss—and another 

methodology for all other repo-style 

transactions. 

This section also describes the 

methodology for calculating EAD for an 

OTC derivative contract or set of OTC 

derivative contracts subject to a 

qualifying master netting agreement. 

Table C illustrates which EAD 

estimation methodologies may be 

applied to particular types of exposure. 

TABLE C 

Current exposure methodology 

Collateral haircut approach 

Models approach 

Simple VaR 69

methodology 

Internal models methodology 

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

Recognition of collateral for OTC derivatives .................................................. ........................ 70X ........................ X 

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

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

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

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Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 69339 

69Only repo-style transactions and eligible 

margin loans subject to a single-product qualifying 

master netting agreement are eligible for the simple 

VaR methodology. 

70 In conjunction with the current exposure 

methodology. 

Qualifying Master Netting Agreement 

Under the final rule, consistent with 

the proposal, a qualifying master netting 

agreement is defined to mean any 

written, legally enforceable bilateral 

agreement, provided that: 

(i) The agreement creates a single 

legal obligation for all individual 

transactions covered by the agreement 

upon an event of default, including 

bankruptcy, insolvency, or similar 

proceeding, of the counterparty; 

(ii) The agreement provides the bank 

the right to accelerate, terminate, and 

close-out on a net basis all transactions 

under the agreement and to liquidate or 

set off collateral promptly upon an 

event of default, including upon an 

event of bankruptcy, insolvency, or 

similar proceeding, of the counterparty, 

provided that, in any such case, any 

exercise of rights under the agreement 

will not be stayed or avoided under 

applicable law in the relevant 

jurisdictions; 

(iii) The bank has conducted 

sufficient legal review to conclude with 

a well-founded basis (and has 

maintained sufficient written 

documentation of that legal review) that 

the agreement meets the requirements of 

paragraph (ii) of this definition and that 

in the event of a legal challenge 

(including one resulting from default or 

from bankruptcy, insolvency, or similar 

proceeding) the relevant court and 

administrative authorities would find 

the agreement to be legal, valid, binding, 

and enforceable under the law of the 

relevant jurisdictions; 

(iv) The bank establishes and 

maintains procedures to monitor 

possible changes in relevant law and to 

ensure that the agreement continues to 

satisfy the requirements of this 

definition; and 

(v) The agreement does not contain a 

walkaway clause (that is, a provision 

that permits a non-defaulting 

counterparty to make lower payments 

than it would make otherwise under the 

agreement, or no payment at all, to a 

defaulter or the estate of a defaulter, 

even if the defaulter or the estate of the 

defaulter is a net creditor under the 

agreement). 

The agencies consider the following 

jurisdictions to be relevant for a 

qualifying master netting agreement: the 

jurisdiction in which each counterparty 

is chartered or the equivalent location in 

the case of non-corporate entities, and if 

a branch of a counterparty is involved, 

then also the jurisdiction in which the 

branch is located; the jurisdiction that 

governs the individual transactions 

covered by the agreement; and the 

jurisdiction that governs the agreement. 

EAD for Repo-Style Transactions and 

Eligible Margin Loans 

Under the final rule, a bank may 

recognize the risk-mitigating effect of 

financial collateral that secures a repostyle transaction, eligible margin loan, 

or single-product netting set of such 

transactions and the risk-mitigating 

effect of any collateral that secures a 

repo-style transaction that is included in 

a bank’s VaR-based measure under the 

market risk rule through an adjustment 

to EAD rather than LGD. The bank may 

use a collateral haircut approach or one 

of two models approaches: a simple VaR 

methodology (for single-product netting 

sets of repo-style transactions or eligible 

margin loans) or an internal models 

methodology. Figure 2 illustrates the 

methodologies available for calculating 

EAD and LGD for eligible margin loans 

and repo-style transactions. 

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69340 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

71This requirement is met where all transactions 

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

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

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

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

or 559), qualified financial contracts under section 

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

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

among financial institutions under sections 401–

407 of the Federal Deposit Insurance Corporation 

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

the Federal Reserve Board’s Regulation EE (12 CFR 

part 231). 72 71 FR 8932, February 22, 2006. 

The proposed rule defined a repostyle transaction as a repurchase or 

reverse repurchase transaction, or a 

securities borrowing or securities 

lending transaction (including a 

transaction in which the bank acts as 

agent for a customer and indemnifies 

the customer against loss), provided 

that: 

(i) The transaction is based solely on 

liquid and readily marketable securities 

or cash; 

(ii) The transaction is marked to 

market daily and subject to daily margin 

maintenance requirements; 

(iii) The transaction is executed under 

an agreement that provides the bank the 

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

liquidate or set off collateral promptly 

upon an event of default (including 

upon an event of bankruptcy, 

insolvency, or similar proceeding) of the 

counterparty, provided that, in any such 

case, any exercise of rights under the 

agreement will not be stayed or avoided 

under applicable law in the relevant 

jurisdictions;71 and 

(iv) The bank has conducted and 

documented sufficient legal review to 

conclude with a well-founded basis that 

the agreement meets the requirements of 

paragraph (iii) of this definition and is 

legal, valid, binding, and enforceable 

under applicable law in the relevant 

jurisdictions. 

In the proposal, the agencies 

recognized that criterion (iii) above may 

pose challenges for certain transactions 

that would not be eligible for certain 

exemptions from bankruptcy or 

receivership laws because the 

counterparty—for example, a sovereign 

entity or a pension fund—is not subject 

to such laws. The agencies sought 

comment on ways this criterion could 

be crafted to accommodate such 

transactions when justified on 

prudential grounds, while ensuring that 

the requirements in criterion (iii) are 

met for transactions that are eligible for 

those exemptions. 

Several commenters responded to this 

question by urging the agencies to 

modify the third component of the repostyle transaction definition in 

accordance with the 2006 interagency 

securities borrowing rule.72 Under the 

securities borrowing rule, the agencies 

accorded preferential risk-based capital 

treatment for cash-collateralized 

securities borrowing transactions that 

either met a bankruptcy standard such 

as the standard in criterion (iii) above or 

were overnight or unconditionally 

cancelable at any time by the bank. 

Commenters maintained that banks are 

able to terminate promptly a repo-style 

transaction with a counterparty whose 

financial condition is deteriorating so 

long as the transaction is done on an 

overnight basis or is unconditionally 

cancelable by the bank. As a result, 

these commenters contended that events 

of default and losses on such 

transactions are very rare. 

The agencies have decided to modify 

the definition of repo-style transaction 

consistent with this suggestion by 

commenters and consistent with the 

2006 securities borrowing rule. The 

agencies believe that this modification 

will resolve, in a manner that preserves 

safety and soundness, technical 

difficulties that banks would have had 

in meeting the proposed rule’s 


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73This requirement is met under the 

circumstances described in footnote 73. Under the 

U.S. Bankruptcy Code, ‘‘margin loans’’ are a type 

of securities contract, but the term ‘‘margin loan’’

does not encompass all loans that happen to be 

secured by securities collateral. Rather, Congress 

intended the term ‘‘margin loan’’ to include only 

those loans commonly known in the industry as 

margin loans, such as credit permitted in an 

account under the Board’s Regulation T or where 

a financial intermediary extends credit for the 

purchase, sale, carrying, or trading of securities. See 

H.R. Rep. No. 109–131, at 119, 130 (2005). 

definition for a material proportion of 

their repo-style transactions. Consistent 

with the 2006 securities borrowing rule, 

a reasonably short notice period, 

typically no more than the standard 

settlement period associated with the 

securities underlying the repo-style 

transaction, would not detract from the 

unconditionality of the bank’s 

termination rights. With regard to 

overnight transactions, the counterparty 

generally should have no expectation, 

either explicit or implicit, that the bank 

will automatically roll over the 

transaction. The agencies are 

maintaining in substance all the other 

components of the proposed definition 

of repo-style transaction. 

The proposed rule defined an eligible 

margin loan as an extension of credit 

where: 

(i) The credit extension is 

collateralized exclusively by debt or 

equity securities that are liquid and 

readily marketable; 

(ii) The collateral is marked to market 

daily and the transaction is subject to 

daily margin maintenance requirements; 

(iii) The extension of credit is 

conducted under an agreement that 

provides the bank the right to accelerate 

and terminate the extension of credit 

and to liquidate or set off collateral 

promptly upon an event of default 

(including upon an event of bankruptcy, 

insolvency, or similar proceeding) of the 

counterparty, provided that, in any such 

case, any exercise of rights under the 

agreement will not be stayed or avoided 

under applicable law in the relevant 

jurisdictions; 73 and 

(iv) The bank has conducted and 

documented sufficient legal review to 

conclude with a well-founded basis that 

the agreement meets the requirements of 

paragraph (iii) of this definition and is 

legal, valid, binding, and enforceable 

under applicable law in the relevant 

jurisdictions. 

Commenters generally supported this 

definition, but some objected to the 

prescriptiveness of criterion (iii). 

Criterion (iii) is necessary to ensure that 

a bank is quickly able to realize the 

value of its collateral in the event of 

obligor default. Collateral stayed by 

bankruptcy and not liquidated until a 

date far in the future is more 

appropriately reflected as a discounted 

positive cash flow in LGD estimation. 

Criterion (iii) is satisfied when the bank 

has conducted sufficient legal review to 

conclude with a well-founded basis 

(and has maintained sufficient written 

documentation of that legal review) that 

a margin loan would be exempt from the 

bankruptcy auto-stay. The agencies are 

therefore maintaining substantially the 

same definition of eligible margin loan 

in the final rule. 

With the exception of repo-style 

transactions that are included in a 

bank’s VaR-based measure under the 

market risk rule (as discussed above), 

for purposes of determining EAD for 

repo-style transactions, eligible margin 

loans, and OTC derivatives, and 

recognizing collateral mitigating the 

counterparty credit risk of such 

exposures, the final rule (consistent 

with the proposed rule) allows banks to 

take into account only financial 

collateral. The proposed rule defined 

financial collateral as collateral in the 

form of any of the following instruments 

in which the bank has a perfected, first 

priority security interest or the legal 

equivalent thereof: (i) Cash on deposit 

with the bank (including cash held for 

the bank by a third-party custodian or 

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

debt securities that have an applicable 

external rating of one category below 

investment grade or higher (for example, 

at least BB–); (iv) short-term debt 

instruments that have an applicable 

external rating of at least investment 

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

equity securities that are publicly 

traded; (vi) convertible bonds that are 

publicly traded; and (vii) mutual fund 

shares and money market mutual fund 

shares if a price for the shares is 

publicly quoted daily. 

In connection with this definition, the 

agencies asked for comment on the 

appropriateness of requiring that a bank 

have a perfected, first priority security 

interest, or the legal equivalent thereof, 

in the definition of financial collateral. 

A couple of commenters supported this 

requirement, but several other 

commenters objected. The objecting 

commenters acknowledged that the 

requirement would generally be 

consistent with current U.S. collateral 

practices for repo-style transactions, 

eligible margin loans, and OTC 

derivatives, but they criticized the 

requirement on the grounds that: (i) 

Obtaining a perfected, first priority 

security interest may not be the current 

market practice outside the United 

States; (ii) U.S. practices may evolve in 

such a fashion as to not meet this 

requirement; and (iii) the requirement is 

not explicit in the New Accord. Other 

commenters asked the agencies to 

clarify that the requirement would be 

met for all or certain forms of collateral 

if the bank had possession and control 

of the collateral and a reasonable basis 

to believe it could promptly liquidate 

the collateral. 

The agencies believe that in order to 

use the EAD adjustment approaches for 

exposures within the United States, a 

bank must have a perfected, first 

priority security interest in collateral, 

with the exception of cash on deposit 

with the bank and certain custodial 

arrangements. The agencies have 

modified the proposed requirement to 

address a concern raised by several 

commenters that a bank could fail to 

satisfy the first priority security interest 

requirement because of the senior 

security interest of a third-party 

custodian involved as an intermediary 

in the transaction. Under the final rule, 

a bank meets the security interest 

requirement so long as the bank has a 

perfected, first priority security interest 

in the collateral notwithstanding the 

prior security interest of any custodial 

agent. Outside of the United States, the 

definition of financial collateral can be 

satisfied as long as the bank has the 

legal equivalent of a perfected, first 

priority security interest. For example, 

cash on deposit with the bank is an 

example of the legal equivalent of a 

perfected, first priority security interest. 

The agencies intend to apply this ‘‘legal 

equivalent’’ standard flexibly to deal 

with non-U.S. collateral access regimes. 

The agencies also invited comment on 

the extent to which assets that do not 

meet the definition of financial 

collateral are the basis of repo-style 

transactions engaged in by banks or are 

taken by banks as collateral for eligible 

margin loans or OTC derivatives. The 

agencies also inquired as to whether the 

definition of financial collateral should 

be expanded to reflect any other asset 

types. 

A substantial number of commenters 

asked the agencies to add asset types to 

the list of financial collateral. The 

principal recommended additions 

included: (i) Non-investment-grade 

externally rated bonds; (ii) bonds that 

are not externally rated; (iii) all financial 

instruments; (iv) letters of credit; (v) 

mortgages loans; and (vi) certificates of 

deposit. Some commenters that 

advocated inclusion of a wider range of 

bonds admitted that it may be 

reasonable to impose some sort of 

liquidity requirement on the additional 

bonds and to impose a 25–50 percent 

standard supervisory haircut for such 

additional bonds. Some of the 

commenters that advocated inclusion of 

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69342 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

74 11 U.S.C. 559. 

a broader range of bonds and mortgages 

asserted that such inclusion would be 

warranted by the exemption from 

bankruptcy auto-stay accorded to repostyle transactions involving such assets 

by the U.S. Bankruptcy Code.74

As described above, to enhance 

international consistency and conform 

the final rule more closely to the New 

Accord, the agencies have decided to 

permit a bank to use the EAD approach 

for all repo-style transactions that are 

included in a bank’s VaR-based measure 

under the market risk rule, regardless of 

the underlying collateral type. The 

agencies are satisfied that such repostyle transactions would be based on 

collateral that is sufficiently liquid to 

justify applying the EAD approach. 

The agencies have included 

conforming residential mortgages in the 

definition of financial collateral and as 

acceptable underlying instruments in 

the definitions of repo-style transaction 

and eligible margin loan based on the 

liquidity of such mortgages and their 

widespread use as collateral in repostyle transactions. However, because 

this inclusion goes beyond the New 

Accord’s recognition of financial 

collateral, the agencies decided to take 

a conservative approach and require 

banks to use the standard supervisory 

haircut approach, with a 25 percent 

haircut and minimum ten-business-day 

holding period, in order to recognize 

conforming residential mortgage 

collateral in EAD (other than for repostyle transactions that are included in a 

bank’s VaR-based measure under the 

market risk rule). Use of the standard 

supervisory haircut approach for repostyle transactions, eligible margin loans, 

and OTC derivatives collateralized by 

conforming mortgages does not preclude 

a bank’s use of the other EAD 

adjustment approaches for exposures 

collateralized by other types of financial 

collateral. Due to concerns about both 

competitive equity and the liquidity and 

price availability of other types of 

collateral, the agencies are not otherwise 

expanding the proposed definition of 

financial collateral in the final rule. 

Collateral Haircut Approach 

Under the collateral haircut approach 

of the final rule, similar to the proposed 

rule, a bank must set EAD equal to the 

sum of three quantities: (i) The value of 

the exposure less the value of the 

collateral; (ii) the absolute value of the 

net position in a given instrument or in 

gold (where the net position in a given 

instrument or in gold equals the sum of 

the current market values of the 

instrument or gold the bank has lent, 

sold subject to repurchase, or posted as 

collateral to the counterparty minus the 

sum of the current market values of that 

same instrument or gold the bank has 

borrowed, purchased subject to resale, 

or taken as collateral from the 

counterparty) multiplied by the market 

price volatility haircut appropriate to 

the instrument or gold; and (iii) the sum 

of the absolute values of the net position 

of any cash or instruments in each 

currency that is different from the 

settlement currency multiplied by the 

haircut appropriate to each currency 

mismatch. To determine the appropriate 

haircuts, a bank may choose to use 

standard supervisory haircuts or, with 

prior written approval from its primary 

Federal supervisor, its own estimates of 

haircuts. 

In the preamble to the proposed rule, 

for purposes of the collateral haircut 

approach, the agencies clarified that a 

given security would include, for 

example, all securities with a single 

Committee on Uniform Securities 

Identification Procedures (CUSIP) 

number and would not include 

securities with different CUSIP 

numbers, even if issued by the same 

issuer with the same maturity date. The 

agencies sought comment on alternative 

approaches for determining a given 

security for purposes of the collateral 

haircut approach. A few commenters 

expressed support for the proposed 

CUSIP approach to defining a given 

security, but one commenter asked the 

agencies to permit each bank the 

flexibility to define given security. The 

collateral haircut approach in the final 

rule is based on a bank’s net position in 

a ‘‘given instrument or gold’’ rather than 

in a ‘‘given security’’ to more precisely 

capture the positions to which a bank 

must apply the haircuts. To enhance 

safety and soundness and comparability 

across banks, the agencies believe that it 

is important to preserve the relatively 

clear CUSIP approach to defining a 

given instrument for purposes of the 

collateral haircut approach. 

Accordingly, the agencies are 

maintaining the CUSIP approach as 

appropriate for determining a given 

instrument for instruments that are 

securities. 

Standard supervisory haircuts. Under 

the final rule, as under the proposed 

rule, if a bank chooses to use standard 

supervisory haircuts, it must use an 8 

percent haircut for each currency 

mismatch and the haircut appropriate to 

each security in Table D below. These 

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

loans and must be multiplied by the 

square root of 1⁄2 to convert the standard 

supervisory haircuts to the fivebusiness-day minimum holding period 

for repo-style transactions. A bank must 

adjust the standard supervisory haircuts 

upward on the basis of a holding period 

longer than ten business days for 

eligible margin loans or five business 

days for repo-style transactions where 

and as appropriate to take into account 

the illiquidity of an instrument. 

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Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 69343 

75The proposed and final rules define a ‘‘main 

index’’ as the S&P 500 Index, the FTSE All-World 

Index, and any other index for which the bank 

demonstrates to the satisfaction of its primary 

Federal supervisor that the equities represented in 

the index have comparable liquidity, depth of 

market, and size of bid-ask spreads as equities in 

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

As an example, assume a bank that 

uses standard supervisory haircuts has 

extended an eligible margin loan of 

$100 that is collateralized by five-year 

U.S. Treasury notes with a market value 

of $100. The value of the exposure less 

the value of the collateral would be 

zero, and the net position in the security 

($100) times the supervisory haircut 

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

mismatch. Therefore, the EAD of the 

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

Own estimates of haircuts. Under the 

final rule, as under the proposal, with 

the prior written approval of the bank’s 

primary Federal supervisor, a bank may 

calculate security type and currency 

mismatch haircuts using its own 

internal estimates of market price 

volatility and foreign exchange 

volatility. The bank’s primary Federal 

supervisor would base approval to use 

internally estimated haircuts on the 

satisfaction of certain minimum 

qualitative and quantitative standards. 

These standards include: (i) The bank 

must use a 99th percentile one-tailed 

confidence interval and a minimum 

five-business-day holding period for 

repo-style transactions and a minimum 

ten-business-day holding period for all 

other transactions; (ii) the bank must 

adjust holding periods upward where 

and as appropriate to take into account 

the illiquidity of an instrument; (iii) the 

bank must select a historical observation 

period for calculating haircuts of at least 

one year; and (iv) the bank must update 

its data sets and recompute haircuts no 

less frequently than quarterly and 

reassess data sets and haircuts whenever 

market prices change materially. A bank 

must estimate individually the 

volatilities of the exposure, the 

collateral, and foreign exchange rates, 

and may not take into account the 

correlations between them. 

Under the final rule, as under the 

proposal, a bank that uses internally 

estimated haircuts must adhere to the 

following rules. The bank may calculate 

internally estimated haircuts for 

categories of debt securities that have an 

applicable external rating of at least 

investment grade. The haircut for a 

category of securities must be 

representative of the internal volatility 

estimates for securities in that category 

that the bank has lent, sold subject to 

repurchase, posted as collateral, 

borrowed, purchased subject to resale, 

or taken as collateral. In determining 


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69344 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

relevant categories, the bank must at a 

minimum take into account (i) the type 

of issuer of the security; (ii) the 

applicable external rating of the 

security; (iii) the maturity of the 

security; and (iv) the interest rate 

sensitivity of the security. A bank must 

calculate a separate internally estimated 

haircut for each individual debt security 

that has an applicable external rating 

below investment grade and for each 

individual equity security. In addition, 

a bank must internally estimate a 

separate currency mismatch haircut for 

each individual mismatch between each 

net position in a currency that is 

different from the settlement currency. 

One commenter recommended that 

the agencies permit banks to use 

category-based internal estimate 

haircuts for non-investment-grade bonds 

and equity securities. The agencies have 

decided to adopt the proposed rule’s 

provisions on category-based haircuts 

because they are consistent with the 

New Accord and because the volatilities 

of non-investment-grade bonds and of 

equity securities are more dependent on 

idiosyncratic, issuer-specific events 

than the volatility of investment-grade 

bonds. 

Under the final rule, as under the 

proposal, when a bank calculates an 

internally estimated haircut on a TN-day 

holding period, which is different from 

the minimum holding period for the 

transaction type, the bank must 

calculate the applicable haircut (HM) 

using the following square root of time 

formula: 

H H T

T M N

M

N

= ,

Where: 

(i) TM = five for repo-style transactions and 

ten for eligible margin loans; 

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

derive HN; and 

(iii) HN = haircut based on the holding period 

TN. 

Simple VaR Methodology 

As noted above, under the final rule, 

as under the proposal, a bank may use 

one of two internal models approaches 

to recognize the risk mitigating effects of 

financial collateral that secures a repostyle transaction or eligible margin loan. 

This section of the preamble describes 

the simple VaR methodology; a later 

section of the preamble describes the 

internal models methodology (which 

also may be used to determine the EAD 

for OTC derivative contracts). The 

agencies received no material comments 

on the simple VaR methodology and are 

adopting the methodology without 

change from the proposal. 

With the prior written approval of its 

primary Federal supervisor, a bank may 

estimate EAD for repo-style transactions 

and eligible margin loans subject to a 

single product qualifying master netting 

agreement using a VaR model. Under 

the simple VaR methodology, a bank’s 

EAD for the transactions subject to such 

a netting agreement is equal to the value 

of the exposures minus the value of the 

collateral plus a VaR-based estimate of 

potential future exposure (PFE). The 

value of the exposures is the sum of the 

current market values of all securities 

and cash the bank has lent, sold subject 

to repurchase, or posted as collateral to 

a counterparty under the netting set. 

The value of the collateral is the sum of 

the current market values of all 

securities and cash the bank has 

borrowed, purchased subject to resale, 

or taken as collateral from a 

counterparty under the netting set. The 

VaR-based estimate of PFE is an 

estimate of the bank’s maximum 

exposure on the netting set over a fixed 

time horizon with a high level of 

confidence. 

Specifically, the VaR model must 

estimate the bank’s 99th percentile, onetailed confidence interval for an 

increase in the value of the exposures 

minus the value of the collateral 

(SE¥SC) over a five-business-day 

holding period for repo-style 

transactions or over a ten-business-day 

holding period for eligible margin loans 

using a minimum one-year historical 

observation period of price data 

representing the instruments that the 

bank has lent, sold subject to 

repurchase, posted as collateral, 

borrowed, purchased subject to resale, 

or taken as collateral. 

The qualification requirements for the 

use of a VaR model are less stringent 

than the qualification requirements for 

the internal models methodology 

described below. The main ongoing 

qualification requirement for using a 

VaR model is that the bank must 

validate its VaR model by establishing 

and maintaining a rigorous and regular 

backtesting regime. 

3. EAD for OTC Derivative Contracts 

Under the final rule, as under the 

proposed rule, a bank may use either the 

current exposure methodology or the 

internal models methodology to 

determine the EAD for OTC derivative 

contracts. An OTC derivative contract is 

defined as a derivative contract that is 

not traded on an exchange that requires 

the daily receipt and payment of cashvariation margin. A derivative contract 

is defined to include interest rate 

derivative contracts, exchange rate 

derivative contracts, equity derivative 

contracts, commodity derivative 

contracts, credit derivatives, and any 

other instrument that poses similar 

counterparty credit risks. The rule also 

defines derivative contracts to include 

unsettled securities, commodities, and 

foreign exchange trades with a 

contractual settlement or delivery lag 

that is longer than the normal settlement 

period (which the rule defines as the 

lesser of the market standard for the 

particular instrument or five business 

days). This includes, for example, 

agency mortgage-backed securities 

transactions conducted in the To-BeAnnounced market. 

Figure 3 illustrates the treatment of 

OTC derivative contracts. 


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Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 69345 

76This requirement was found in footnote 8 of the 

proposed rule text (in section 32(b)(2)). 

Current Exposure Methodology 

The final rule’s current exposure 

methodology for determining EAD for 

single OTC derivative contracts is 

similar to the methodology in the 

general risk-based capital rules and is 

the same as the current exposure 

methodology in the proposal. Under the 

current exposure methodology, the EAD 

for an OTC derivative contract is equal 

to the sum of the bank’s current credit 

exposure and PFE on the derivative 

contract. The current credit exposure for 

a single OTC derivative contract is the 

greater of the mark-to-market value of 

the derivative contract or zero. 

The final rule’s current exposure 

methodology for OTC derivative 

contracts subject to qualifying master 

netting agreements is also similar to the 

treatment in the agencies’ general riskbased capital rules and, with one 

exception discussed below, is the same 

as the treatment in the proposal. Under 

the general risk-based capital rules and 

under the proposed rule, a bank could 

not recognize netting agreements for 

OTC derivative contracts for risk-based 

capital purposes unless it obtained a 

written and reasoned legal opinion 

representing that, in the event of a legal 

challenge, the bank’s exposure would be 

found to be the net amount in the 

relevant jurisdictions.76 The agencies 

asked for comment on methods banks 

would use to ensure enforceability of 

single product OTC derivative netting 

agreements in the absence of an explicit 

written legal opinion requirement. 

Although one commenter supported 

the proposed rule’s written legal 

opinion requirement, many other 

commenters asked the agencies to 

remove this requirement. These 

commenters maintained that, provided a 

transaction is conducted in a 

jurisdiction and with a counterparty 

type that is covered by a commissioned 

legal opinion, use of industry-developed 

standardized contracts for certain OTC 

derivative products and reliance on 

commissioned legal opinions as to the 

enforceability of these contracts should 

be a sufficient guarantor of 

enforceability. These commenters added 

that reliance on such commissioned 

legal opinions is standard market 

practice. 

The agencies continue to believe that 

the legal enforceability of netting 

agreements is a necessary condition for 

a bank to recognize netting effects in its 

capital calculation. However, the 

agencies have conducted additional 

analysis and agree that a unique, written 

legal opinion is not necessary in all 

cases to ensure the enforceability of an 

OTC derivative netting agreement. 

Accordingly, the agencies have removed 

the requirement that a bank obtain a 

written and well reasoned legal opinion 

for each of its qualifying master netting 

agreements that cover OTC derivatives. 

As a result, under the final rule, to 

obtain netting treatment for multiple 

OTC derivative contracts subject to a 

qualifying master netting agreement, a 


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69346 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

77The counterparty credit risk of a credit 

derivative that is used to hedge the credit risk of 

an exposure subject to an IRB credit risk capital 

requirement is captured in the IRB treatment of the 

hedged exposure, as detailed in sections 33 and 34 

of the proposed rule. 

78The agencies recognize that there are reasons 

why a bank’s credit portfolio might contain 

purchased credit protection on a reference name in 

a notional principal amount that exceeds the bank’s 

currently measured EAD to that obligor. If the 

protection amount of the credit derivative is 

materially greater than the EAD of the exposure 

being hedged, however, the bank generally must 

treat the credit derivative as two separate exposures 

and calculate a counterparty credit risk capital 

requirement for the exposure that is not providing 

credit protection to the hedged exposure. 

bank must conduct sufficient legal 

review to conclude with a well-founded 

basis (and maintain sufficient written 

documentation of that legal review) that 

the agreement would provide 

termination netting benefits and is legal, 

valid, binding, and enforceable. In some 

cases, this requirement could be met by 

reasoned reliance on a commissioned 

legal opinion or an in-house counsel 

analysis. In other cases, however—for 

example, involving certain new 

derivative transactions or derivative 

counterparties in unusual 

jurisdictions—the bank would need to 

obtain an explicit written legal opinion 

from external or internal legal counsel 

addressing the particular situation. 

The proposed rule’s conversion factor 

(CF) matrix used to compute PFE was 

based on the matrices in the general 

risk-based capital rules, with two 

exceptions. First, under the proposed 

rule, the CF for credit derivatives that 

are not used to hedge the credit risk of 

exposures subject to an IRB credit risk 

capital requirement was specified to be 

5.0 percent for contracts with 

investment-grade reference obligors and 

10.0 percent for contracts with noninvestment-grade reference obligors.77

The CF for a credit derivative contract 

did not depend on the remaining 

maturity of the contract. The second 

change was that floating/floating basis 

swaps were no longer exempted from 

the CF for interest rate derivative 

contracts. The exemption was put into 

place when such swaps were very 

simple, and the agencies believed it was 

no longer appropriate given the 

evolution of the product. The 

computation of the PFE of multiple OTC 

derivative contracts subject to a 

qualifying master netting agreement did 

not change from the general risk-based 

capital rules. The agencies received no 

material comment on these provisions 

of the proposed rule and have adopted 

them as proposed. 

Under the final rule, as under the 

proposed rule, if an OTC derivative 

contract is collateralized by financial 

collateral and a bank uses the current 

exposure methodology to determine 

EAD for the exposure, the bank must 

first determine an unsecured EAD as 

described above and in section 32(c) of 

the rule. To take into account the riskreducing effects of the financial 

collateral, the bank may either adjust 

the LGD of the contract or, if the 

transaction is subject to daily markingto-market and remargining, adjust the 

EAD of the contract using the collateral 

haircut approach for repo-style 

transactions and eligible margin loans 

described above and in section 32(b) of 

the rule. 

Under part VI of the final rule, and of 

the proposed rule, a bank must treat an 

equity derivative contract as an equity 

exposure and compute a risk-weighted 

asset amount for that exposure. If the 

bank is using the internal models 

approach for its equity exposures, it also 

must compute a risk-weighted asset 

amount for its counterparty credit risk 

exposure on the equity derivative 

contract. However, if the bank is using 

the simple risk weight approach for its 

equity exposures, it may choose not to 

hold risk-based capital against the 

counterparty credit risk of the equity 

derivative contract. Likewise, a bank 

that purchases a credit derivative that is 

recognized under section 33 or 34 of the 

rule as a credit risk mitigant for an 

exposure that is not a covered position 

under the market risk rule does not have 

to compute a separate counterparty 

credit risk capital requirement for the 

credit derivative.78 If a bank chooses not 

to hold risk-based capital against the 

counterparty credit risk of such equity 

or credit derivative contracts, it must do 

so consistently for all such equity 

derivative contracts or for all such credit 

derivative contracts. Further, where the 

contracts are subject to a qualifying 

master netting agreement, the bank must 

either include them all or exclude them 

all from any measure used to determine 

counterparty credit risk exposure to all 

relevant counterparties for risk-based 

capital purposes. 

In addition, where a bank provides 

protection through a credit derivative 

that is not treated as a covered position 

under the market risk rule, it must treat 

the credit derivative as a wholesale 

exposure to the reference obligor and 

compute a risk-weighted asset amount 

for the credit derivative under section 

31 of the rule. The bank need not 

compute a counterparty credit risk 

capital requirement for the credit 

derivative, so long as it does so 

consistently for all such credit 

derivatives and either includes all or 

excludes all such credit derivatives that 

are subject to a qualifying master netting 

agreement from any measure used to 

determine counterparty credit risk 

exposure to all relevant counterparties 

for risk-based capital purposes. Where 

the bank provides protection through a 

credit derivative treated as a covered 

position under the market risk rule, it 

must compute a counterparty credit risk 

capital requirement for the credit 

derivative under section 31 of the rule. 

4. Internal Models Methodology 

The final rule, like the proposed rule, 

includes an internal models 

methodology for the calculation of EAD 

for the counterparty credit exposure of 

OTC derivatives, eligible margin loans, 

and repo-style transactions. The internal 

models methodology requires a risk 

model that estimates EAD at the level of 

a netting set. A transaction not subject 

to a qualifying master netting agreement 

is considered to be its own netting set 

and a bank must calculate EAD for each 

such transaction individually. 

A bank may use the internal models 

methodology for OTC derivatives 

(collateralized or uncollateralized) and 

single-product netting sets thereof, for 

eligible margin loans and single-product 

netting sets thereof, or for repo-style 

transactions and single-product netting 

sets thereof. A bank that uses the 

internal models methodology for a 

particular transaction type (that is, OTC 

derivative contracts, eligible margin 

loans, or repo-style transactions) must 

use the internal models methodology for 

all transactions of that transaction type. 

However, a bank may choose whether or 

not to use the internal models 

methodology for each transaction type. 

A bank also may use the internal 

models methodology for OTC 

derivatives, eligible margin loans, and 

repo-style transactions subject to a 

qualifying cross-product master netting 

agreement if (i) the bank effectively 

integrates the risk mitigating effects of 

cross-product netting into its risk 

management and other information 

technology systems; and (ii) the bank 

obtains the prior written approval of its 

primary Federal supervisor. 

The final rule tracks the proposed rule 

by defining a qualifying cross-product 

master netting agreement as a qualifying 

master netting agreement that provides 

for termination and close-out netting 

across multiple types of financial 

transactions or qualifying master netting 

agreements in the event of a 

counterparty’s default, provided that: 

(i) The underlying financial 

transactions are OTC derivative 

contracts, eligible margin loans, or repostyle transactions; and 

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79BCBS, ‘‘The Application of Basel II to Trading 

Activities and the Treatment of Double Default 

Effects,’’ July 2005, ¶ 15. 

(ii) The bank obtains a written legal 

opinion verifying the validity and 

enforceability of the netting agreement 

under applicable law of the relevant 

jurisdictions if the counterparty fails to 

perform upon an event of default, 

including upon an event of bankruptcy, 

insolvency, or similar proceeding. 

As discussed in the proposal, banks 

use several measures to manage their 

exposure to the counterparty credit risk 

of repo-style transactions, eligible 

margin loans, and OTC derivatives, 

including PFE, expected exposure (EE), 

and expected positive exposure (EPE). 

PFE is the maximum exposure 

estimated to occur over a future horizon 

at a high level of statistical confidence. 

Banks often use PFE when measuring 

counterparty credit risk exposure 

against counterparty credit limits. EE is 

the expected value of the probability 

distribution of non-negative credit risk 

exposures to a counterparty at any 

specified future date, whereas EPE is the 

time-weighted average of individual 

expected exposures estimated for a 

given forecasting horizon (one year in 

the proposed rule). The final rule 

clarifies that, when estimating EE, a 

bank must set any negative market 

values in the probability distribution of 

market values to a counterparty at a 

specified future date to zero to convert 

the probability distribution of market 

values to the probability distribution of 

credit risk exposures. Banks typically 

compute EPE, EE, and PFE using a 

common stochastic model. 

A paper published by the BCBS in 

July 2005 titled ‘‘The Application of 

Basel II to Trading Activities and the 

Treatment of Double Default Effects’’

notes that EPE is an appropriate EAD 

measure for determining risk-based 

capital requirements for counterparty 

credit risk because transactions with 

counterparty credit risk ‘‘are given the 

same standing as loans with the goal of 

reducing the capital treatment’s 

influence on a firm’s decision to extend 

an on-balance sheet loan rather than 

engage in an economically equivalent 

transaction that involves exposure to 

counterparty credit risk.’’ 79 An 

adjustment to EPE, called ‘‘effective 

EPE’’ and described below, is used in 

the calculation of EAD under the 

internal models methodology. EAD is 

calculated as a multiple of effective EPE. 

To address the concern that EE and 

EPE may not capture risk arising from 

the replacement of existing short-term 

positions over the one-year horizon 

used for capital requirements (rollover 

risk) or may underestimate the 

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

with short maturities, the final rule, like 

the proposed rule, uses a netting set’s 

effective EPE as the basis for calculating 

EAD for counterparty credit risk. 

Consistent with the use of a one-year PD 

horizon, effective EPE is the timeweighted average of effective EE over 

one year where the weights are the 

proportion that an individual effective 

EE represents in a one-year time 

interval. If all contracts in a netting set 

mature before one year, effective EPE is 

the average of effective EE until all 

contracts in the netting set mature. For 

example, if the longest maturity contract 

in the netting set matures in six months, 

effective EPE would be the average of 

effective EE over six months. 

Effective EE is defined as: 

Effective EEtk = max(Effective EEtk-1, 

EEtk) 

where exposure is measured at future dates 

t1, t2, t3, * * * and effective EEt0 equals 

current exposure. Alternatively, a bank may 

use a measure that is more conservative than 

effective EPE for every counterparty (that is, 

a measure based on peak exposure) with 

prior approval of its primary Federal 

supervisor. 

The final rule clarifies that if a bank 

hedges some or all of the counterparty 

credit risk associated with a netting set 

using an eligible credit derivative, the 

bank may take the reduction in 

exposure to the counterparty into 

account when estimating EE. If the bank 

recognizes this reduction in exposure to 

the counterparty in its estimate of EE, it 

must also use its internal model to 

estimate a separate EAD for the bank’s 

exposure to the protection provider of 

the credit derivative. 

The EAD for instruments with 

counterparty credit risk must be 

determined assuming economic 

downturn conditions. To accomplish 

this determination in a prudent manner, 

the internal models methodology sets 

EAD equal to EPE multiplied by a 

scaling factor termed ‘‘alpha.’’ Alpha is 

set at 1.4; a bank’s primary Federal 

supervisor has the flexibility to raise 

this value based on the bank’s specific 

characteristics of counterparty credit 

risk. In addition, with supervisory 

approval, a bank may use its own 

estimate of alpha, subject to a floor of 

1.2. 

In the proposal, the agencies 

requested comment on all aspects of the 

effective EPE approach to counterparty 

credit risk and, in particular, on the 

appropriateness of the monotonically 

increasing effective EE function, the 

alpha constant of 1.4, and the floor on 

internal estimates of alpha of 1.2. 

Commenters expressed a number of 

objections to the proposed rule’s 

internal models methodology. 

Several commenters contended that 

banks that use the internal models 

methodology should be permitted to 

calculate effective EPE at the 

counterparty level and should not be 

required to calculate effective EPE at the 

netting set level. These commenters 

indicated that while the New Accord 

mandates calculation at the netting set 

level, those banks that currently use an 

EPE-style approach to measuring 

counterparty credit risk for internal risk 

management purposes typically use a 

counterparty-by-counterparty EPE 

approach. They asserted that forcing 

banks to use a netting-set-by-netting-set 

approach would be burdensome for 

banks and would provide the agencies 

no material regulatory benefits, as 

netting effects are taken into account in 

the calculation of EE. 

The agencies have retained the netting 

set focus of the calculation of effective 

EPE to preserve international 

consistency. The agencies will continue 

to review the implications, particularly 

with respect to the appropriate 

recognition of netting benefits, of 

allowing banks to calculate effective 

EPE at the counterparty level. 

One commenter objected to the 

proposed rule’s requirement that a bank 

use effective EE (as opposed to EE). This 

commenter contended that effective EE 

is an excessively conservative and 

imprecise mechanism to address 

rollover risk in a portfolio of short-term 

transactions. The commenter 

represented that rollover risk should be 

addressed under Pillar 2 rather than 

Pillar 1. The agencies continue to 

believe that rollover risk is a core credit 

risk that should be covered by explicit 

risk-based capital requirements. The 

agencies also remain concerned that EE 

and EPE (as opposed to effective EE and 

effective EPE) would not adequately 

incorporate rollover risk and do not 

believe that bank internal estimates of 

rollover risk are sufficiently reliable at 

this time to use for risk-based capital 

purposes. To ensure consistency with 

the New Accord and in light of the lack 

of alternative prudent mechanisms to 

incorporate rollover risk, the agencies 

continue to include effective EE and 

effective EPE in the final rule. 

Several commenters criticized the 

default alpha of 1.4 and the 1.2 floor on 

internal estimates of alpha. These 

commenters contended that these 

supervisory alphas were too 

conservative for many dealer banks with 

large, diverse, and granular portfolios of 

repo-style transactions, eligible margin 

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69348 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

loans, and OTC derivatives. Although 

the agencies acknowledge the 

possibility that certain banks with 

certain types of portfolios at certain 

times could warrant an alpha of less 

than 1.2, the agencies believe it is 

important to have a supervisory floor on 

alpha. This floor will ensure 

consistency with the New Accord, 

comparability among the various banks 

that use the internal models 

methodology, and sufficient capital 

through the economic cycle for 

securities financing transactions and 

OTC derivatives. Therefore, the agencies 

are retaining the alpha floor as 

proposed. 

Similar to the proposal, under the 

final rule a bank’s primary Federal 

supervisor must determine that the bank 

meets certain qualifying criteria before 

the bank may use the internal models 

methodology. These criteria consist of 

the following operational requirements, 

modeling standards, and model 

validation requirements. 

First, the bank must have the systems 

capability to estimate EE on a daily 

basis. While this requirement does not 

require the bank to report EE daily, or 

even estimate EE daily, the bank must 

demonstrate that it is capable of 

performing the estimation daily. 

Second, the bank must estimate EE at 

enough future time points to accurately 

reflect all future cash flows of contracts 

in the netting set. To accurately reflect 

the exposure arising from a transaction, 

the model should incorporate those 

contractual provisions, such as reset 

dates, that can materially affect the 

timing, probability, or amount of any 

payment. The requirement reflects the 

need for an accurate estimate of EPE. 

However, in order to balance the ability 

to calculate exposures with the need for 

information on timely basis, the number 

of time points is not specified. 

Third, the bank must have been using 

an internal model that broadly meets the 

minimum standards to calculate the 

distributions of exposures upon which 

the EAD calculation is based for a 

period of at least one year prior to 

approval. This requirement is to ensure 

that the bank has integrated the 

modeling into its counterparty credit 

risk management process. 

Fourth, the bank’s model must 

account for the non-normality of 

exposure distribution where 

appropriate. Non-normality of exposure 

distribution means high loss events 

occur more frequently than would be 

expected on the basis of a normal 

distribution, the statistical term for 

which is leptokurtosis. In many 

instances, there may not be a need to 

account for this. Expected exposures are 

much less likely to be affected by 

leptokurtosis than peak exposures or 

high percentile losses. However, the 

bank must demonstrate that its EAD 

measure is not affected by leptokurtosis 

or must account for it within the model. 

Fifth, the bank must measure, 

monitor, and control the exposure to a 

counterparty over the whole life of all 

contracts in the netting set, in addition 

to accurately measuring and actively 

monitoring the current exposure to 

counterparties. The bank should 

exercise active management of both 

existing exposure and exposure that 

could change in the future due to 

market moves. 

Sixth, the bank must be able to 

measure and manage current exposures 

gross and net of collateral held, where 

appropriate. The bank must estimate 

expected exposures for OTC derivative 

contracts both with and without the 

effect of collateral agreements. By 

contrast, under the proposed rule, a 

bank would have to measure and 

manage current exposure gross and net 

of collateral held. Some commenters 

criticized this requirement as 

inconsistent with the New Accord and 

bank internal risk management 

practices. The agencies agree and have 

revised the rule to only require a bank 

to ‘‘be able to’’ measure and manage 

current exposures gross and net of 

collateral. 

Seventh, the bank must have 

procedures to identify, monitor, and 

control specific wrong-way risk 

throughout the life of an exposure. In 

this context, wrong-way risk is the risk 

that future exposure to a counterparty 

will be high when the counterparty’s 

probability of default is also high. 

Wrong-way risk generally arises from 

events specific to the counterparty, 

rather than broad market downturns. 

Eighth, the data used by the bank 

should be adequate for the measurement 

and modeling of the exposures. In 

particular, the model must use current 

market data to compute current 

exposures. When a bank uses historical 

data to estimate model parameters, the 

bank must use at least three years of 

data that cover a wide range of 

economic conditions. This requirement 

reflects the longer horizon for 

counterparty credit risk exposures 

compared to market risk exposures. The 

data must be updated at least quarterly 

or more frequently if market conditions 

warrant. Banks should consider using 

model parameters based on forward 

looking measures, where appropriate. 

Ninth, the bank must subject its 

models used in the calculation of EAD 

to an initial validation and annual 

model review process. The model 

review should consider whether the 

inputs and risk factors, as well as the 

model outputs, are appropriate. The 

review of outputs should include a 

rigorous program of backtesting model 

outputs against realized exposures. 

Maturity Under the Internal Models 

Methodology 

Like corporate loan exposures, 

counterparty exposure on netting sets is 

susceptible to changes in economic 

value that stem from deterioration in the 

counterparty’s creditworthiness short of 

default. The effective maturity 

parameter (M) reflects the impact of 

these changes on capital. The formula 

used to compute M for netting sets with 

maturities greater than one year must be 

different than that generally applied to 

wholesale exposures in order to reflect 

how counterparty credit exposures 

change over time. The final rule’s 

definition of M under the internal 

models methodology is identical to that 

of the proposed rule and is based on a 

weighted average of expected exposures 

over the life of the transactions relative 

to their one year exposures. Consistent 

with the New Accord, the final rule 

expands upon the proposal by providing 

that a bank that uses an internal model 

to calculate a one-sided credit valuation 

adjustment may use the effective credit 

duration estimated by the model as 

M(EPE) in place of the formula in the 

paragraph below. 

If the remaining maturity of the 

exposure or the longest-dated contract 

contained in a netting set is greater than 

one year, the bank must set M for the 

exposure or netting set equal to the 

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

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and (ii) dfk is the risk-free discount 

factor for future time period tk. The cap 

of five years on M is consistent with the 

treatment of wholesale exposures under 

section 31 of the rule. 

If the remaining maturity of the 

exposure or the longest-dated contract 

in the netting set is one year or less, the 

bank must set M for the exposure or 

netting set equal to one year except as 

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

In this case, repo-style transactions, 

eligible margin loans, and collateralized 

OTC derivative transactions subject to 

daily remargining agreements may use 

the effective maturity of the longest 

maturity transaction in the netting set as 

M. 

Collateral Agreements Under the 

Internal Models Methodology 

The provisions of the final rule on 

collateral agreements under the internal 

models methodology are the same as 

those of the proposed rule. Under the 

final rule, if a bank has prior written 

approval from its primary Federal 

supervisor, it may capture within its 

internal model the effect on EAD of a 

collateral agreement that requires 

receipt of collateral when exposure to 

the counterparty increases. In no 

circumstances, however, may a bank 

take into account in EAD collateral 

agreements triggered by deterioration of 

counterparty credit quality. Several 

commenters asked the agencies to 

permit banks to incorporate in EAD 

collateral agreements that are dependent 

on a decline in the external rating of the 

counterparty. The agencies do not 

believe that banks are able to model the 

necessary correlations with sufficient 

reliability to accept these types of 

collateral agreements under the internal 

models methodology at this time. 

In the context of the internal models 

methodology, the rule defines a 

collateral agreement as a legal contract 

that: (i) Specifies the time when, and 

circumstances under which, the 

counterparty is required to exchange 

collateral with the bank for a single 

financial contract or for all financial 

contracts covered under a qualifying 

master netting agreement; and (ii) 

confers upon the bank a perfected, first 

priority security interest 

(notwithstanding the prior security 

interest of any custodial agent), or the 

legal equivalent thereof, in the collateral 

posted by the counterparty under the 

agreement. This security interest must 

provide the bank with a right to close 

out the financial positions and the 

collateral upon an event of default of or 

failure to perform by the counterparty 

under the collateral agreement. A 

contract would not satisfy this 

requirement if the bank’s exercise of 

rights under the agreement may be 

stayed or avoided under applicable law 

in the relevant jurisdictions. 

If a bank’s internal model does not 

capture the effects of collateral 

agreements, the final rule provides a 

‘‘shortcut’’ method to provide the bank 

with some benefit, in the form of a 

smaller EAD, for collateralized 

counterparties. Under the shortcut 

method, effective EPE is the lesser of a 

threshold amount (linked to the 

exposure amount at which a 

counterparty must post collateral) plus 

an add-on and effective EPE without a 

collateral agreement. Although any bank 

may use this ‘‘shortcut’’ method under 

the internal models methodology, the 

agencies expect banks that make 

extensive use of collateral agreements to 

develop the modeling capacity to 

measure the impact of such agreements 

on EAD. The shortcut method provided 

in the final rule is identical to the 

shortcut method provided in the 

proposed rule. 

Alternative Methods 

Under the final rule, consistent with 

the proposed rule, a bank using the 

internal models methodology may use 

an alternative method to determine EAD 

for certain transactions, provided that 

the bank can demonstrate to its primary 

Federal supervisor that the method’s 

output is more conservative than an 

alpha of 1.4 (or higher) times effective 

EPE. 

Use of an alternative method may be 

appropriate where a new product or 

business line is being developed, where 

a recent acquisition has occurred, or 

where the bank believes that other more 

conservative methods to measure 

counterparty credit risk for a category of 

transactions are prudent. The alternative 

method should be applied to all similar 

transactions. When an alternative 

method is used, the bank should either 

treat the particular transactions 

concerned as a separate netting set with 

the counterparty or apply the alternative 

model to the entire original netting set. 

The agencies recognize that for new 

OTC derivative products a bank may 

need a transition period during which to 

incorporate a new product into its 

internal models methodology or to 

demonstrate that an alternative method 

is more conservative than an alpha of 

1.4 (or higher) times effective EPE. The 

final rule therefore provides that for 

material portfolios of new OTC 

derivative products, a bank may assume 

that the current exposure methodology 

in section 32(c) of the rule meets the 

conservatism requirement for a period 

not longer than 180 days. As a general 

matter, the agencies expect that the 

current exposure methodology in 

section 32(c) of the rule would be an 

acceptable, more conservative method 

for immaterial portfolios of OTC 

derivatives. 

5. Guarantees and Credit Derivatives 

That Cover Wholesale Exposures 

The New Accord specifies that a bank 

may adjust either the PD or the LGD of 

a wholesale exposure to reflect the risk 

mitigating effects of a guarantee or 

credit derivative. Similarly, under the 

final rule, as under the proposed rule, 

a bank may choose either a PD 

substitution or an LGD adjustment 

approach to recognize the risk 

mitigating effects of an eligible 

guarantee or eligible credit derivative on 

a wholesale exposure (or in certain 

circumstances may choose to use a 

double default treatment, as discussed 

below). In all cases a bank must use the 

same risk parameters for calculating 

ECL for a wholesale exposure as it uses 

for calculating the risk-based capital 

requirement for the exposure. Moreover, 

in all cases, a bank’s ultimate PD and 

LGD for the hedged wholesale exposure 

may not be lower than the PD and LGD 

floors discussed above and described in 

section 31(d) of the rule. 

Eligible Guarantees and Eligible Credit 

Derivatives 

Under the proposed rule, guarantees 

and credit derivatives had to meet 

specific eligibility requirements to be 

recognized as CRM for a wholesale 

exposure. The proposed rule defined an 

eligible guarantee as a guarantee that: 


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80New Accord, ¶189. 

81This concern of the agencies is the same 

concern that led the agencies to exclude from the 

definition of tier 1 capital any instrument that has 

credit-sensitive features—such as an interest rate or 

dividend rate that increases as the credit quality of 

the bank issuer declines or an investor put right that 

is triggered by a decline in issuer credit quality. 

See, e.g., 12 CFR part 208, appendix A, section 

II.A.1.b. 

82Although the Board’s Regulation W places 

strict quantitative and qualitative limits on 

guarantees issued by a bank on behalf of an affiliate, 

it does not restrict all guarantees issued by an 

affiliate on behalf of a bank. See, e.g., 12 CFR 

223.3(e). 

(i) Is written and unconditional; 

(ii) Covers all or a pro rata portion of 

all contractual payments of the obligor 

on the reference exposure; 

(iii) Gives the beneficiary a direct 

claim against the protection provider; 

(iv) Is non-cancelable by the 

protection provider for reasons other 

than the breach of the contract by the 

beneficiary; 

(v) Is legally enforceable against the 

protection provider in a jurisdiction 

where the protection provider has 

sufficient assets against which a 

judgment may be attached and enforced; 

and 

(vi) Requires the protection provider 

to make payment to the beneficiary on 

the occurrence of a default (as defined 

in the guarantee) of the obligor on the 

reference exposure without first 

requiring the beneficiary to demand 

payment from the obligor. 

Commenters suggested a number of 

improvements to the proposed 

definition of eligible guarantee. One 

commenter asked the agencies to clarify 

that the unconditionality requirement in 

criterion (i) of the definition would be 

interpreted consistently with the New 

Accord’s requirement that ‘‘there should 

be no clause in the protection contract 

outside the direct control of the bank 

that could prevent the protection 

provider from being obliged to pay out 

in a timely manner in the event that the 

original counterparty fails to make the 

payment(s) due.’’ 80 The agencies are not 

providing the requested clarification. 

The agencies have acquired 

considerable experience in the intricate 

issue of the conditionality of guarantees 

under the general risk-based capital 

rules and intend to address the meaning 

of ‘‘unconditional’’ in the context of 

eligible guarantees under this final rule 

on a case-by-case basis going forward. 

This same commenter also asked the 

agencies to revise the second criterion of 

the definition from coverage of ‘‘all or 

a pro rata portion of all contractual 

payments of the obligor on the reference 

exposure’’ to coverage of ‘‘all or a pro 

rata portion of all principal or due and 

payable amounts on the reference 

exposure.’’ The agencies have decided 

to preserve the second criterion of the 

eligible guarantee definition without 

change to ensure that a bank only 

obtains CRM benefits from credit risk 

mitigants that cover all sources of credit 

exposure to the obligor. Although it is 

appropriate to provide partial CRM 

benefits under the wholesale framework 

for partial but pro rata guarantees of all 

contractual payments, the agencies are 

less comfortable with providing partial 

CRM benefits under the wholesale 

framework where the extent of the loss 

coverage of the credit exposure is not so 

easily quantifiable. Accordingly, for 

example, if a bank obtains a principalonly or interest-only guarantee of a 

corporate bond, the guarantee will not 

qualify as an eligible guarantee and the 

bank will not be able to obtain any CRM 

benefits from the guarantee. 

Some commenters asked the agencies 

to modify the fourth criterion of the 

eligible guarantee definition to clarify, 

consistent with the New Accord, that a 

guarantee that is terminable by the bank 

and the protection provider by mutual 

consent may qualify as an eligible 

guarantee. This is an appropriate 

clarification of the definition and, 

therefore, the agencies have amended 

the fourth criterion of the definition to 

require that the guarantee be noncancelable by the protection provider 

unilaterally. 

One commenter asked the agencies to 

modify the fifth criterion of the eligible 

guarantee definition, which requires the 

guarantee to be legally enforceable in a 

jurisdiction where the protection 

provider has sufficient assets, by 

deleting the word ‘‘sufficient.’’ The 

agencies have preserved the fifth 

criterion of the proposed definition 

intact. The agencies do not think that it 

would be consistent with safety and 

soundness to permit a bank to obtain 

CRM benefits under the rule if the 

guarantee were not legally enforceable 

against the protection provider in a 

jurisdiction where the protection 

provider has sufficient available assets. 

Finally, some commenters objected to 

the sixth and final criterion of the 

eligible guarantee definition, which 

requires the protection provider to make 

payments to the beneficiary upon 

default of the obligor without first 

requiring the beneficiary to demand 

payment from the obligor. The agencies 

have decided to modify this criterion to 

make it more consistent with the New 

Accord and actual market practice. The 

final rule’s sixth criterion requires only 

that the guarantee permit the bank to 

obtain payment from the protection 

provider in the event of an obligor 

default in a timely manner and without 

first having to take legal actions to 

pursue the obligor for payment. 

The agencies also have performed 

additional analysis and review of the 

definition of eligible guarantee and have 

decided to add two additional criteria to 

the definition. The first additional 

criterion prevents guarantees from 

certain affiliated companies from being 

eligible guarantees. Under the final rule, 

a guarantee will not be an eligible 

guarantee if the protection provider is 

an affiliate of the bank (other than an 

affiliated depository institution, bank, 

securities broker or dealer, or insurance 

company that does not control the bank 

and that is subject to consolidated 

supervision and regulation comparable 

to that imposed on U.S. depository 

institutions, securities broker-dealers, or 

insurance companies). For purposes of 

the definition, an affiliate of a bank is 

defined as a company that controls, is 

controlled by, or is under common 

control with, the bank. Control of a 

company is defined as (i) ownership, 

control, or holding with power to vote 

25 percent or more of a class of voting 

securities of the company; or (ii) 

consolidation of the company for 

financial reporting purposes. 

The strong correlations among the 

financial conditions of affiliated parties 

would typically render guarantees from 

affiliates of the bank of little value 

precisely when the bank would need 

them most—when the bank itself is in 

financial distress.81 For example, a 

guarantee that a bank might receive 

from its parent shell bank holding 

company would provide little credit risk 

mitigation to the bank as the bank 

approached insolvency because the 

financial condition of the holding 

company would depend critically on 

the financial health of the subsidiary 

bank. Moreover, the holding company 

typically would experience no increase 

in its regulatory capital requirement for 

issuing the guarantee because the 

guarantee would be on behalf of a 

consolidated subsidiary and would be 

eliminated in the consolidation of the 

holding company’s financial 

statements.82

The agencies have decided, however, 

that a bank should be able to recognize 

CRM benefits by obtaining a guarantee 

from an affiliated insured depository 

institution, bank, securities broker or 

dealer, or insurance company that does 

not control the bank and that is subject 

to consolidated supervision and 

regulation comparable to that imposed 

on U.S. depository institutions, 

securities broker-dealers, or insurance 

companies (as the case may be). A 

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83One commenter also asked the agencies to 

clarify that a bank should translate the phrase 

‘‘beneficiary’’ in the definition of eligible guarantee 

to ‘‘protection purchaser’’ when confirming that a 

credit derivative meets all the requirements of the 

definition of eligible guarantee. The agencies have 

not amended the rule to address this point, but do 

confirm that such translation is appropriate. 

depository institution for this purpose 

includes all subsidiaries of the 

depository institution except financial 

subsidiaries. The final rule recognizes 

guarantees from these types of affiliates 

because they are financial institutions 

subject to prudential regulation by 

national or state supervisory authorities. 

The agencies expect that the prudential 

regulation of the affiliate would help 

prevent the affiliate from exposing itself 

excessively to the credit exposures of 

the bank. Similarly, these affiliates 

would be subject to regulatory capital 

requirements of their own and should 

experience an increase in their 

regulatory capital requirements for 

issuing the guarantee. 

The second additional criterion 

precludes a guarantee from eligible 

guarantee status if the guarantee 

increases the beneficiary’s cost of credit 

protection in response to deterioration 

in the credit quality of the reference 

exposure. This additional criterion is 

consistent with the New Accord’s 

treatment of guarantees and with the 

proposed rule’s operational 

requirements for synthetic 

securitizations. 

The proposed rule defined an eligible 

credit derivative as a credit derivative in 

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

provided that: 

(i) The contract meets the 

requirements of an eligible guarantee 

and has been confirmed by the 

protection purchaser and the protection 

provider; 

(ii) Any assignment of the contract 

has been confirmed by all relevant 

parties; 

(iii) If the credit derivative is a credit 

default swap or nth-to-default swap, the 

contract includes the following credit 

events: 

(A) Failure to pay any amount due 

under the terms of the reference 

exposure (with a grace period that is 

closely in line with the grace period of 

the reference exposure); and 

(B) Bankruptcy, insolvency, or 

inability of the obligor on the reference 

exposure to pay its debts, or its failure 

or admission in writing of its inability 

generally to pay its debts as they 

become due, and similar events; 

(iv) The terms and conditions 

dictating the manner in which the 

contract is to be settled are incorporated 

into the contract; 

(v) If the contract allows for cash 

settlement, the contract incorporates a 

robust valuation process to estimate loss 

reliably and specifies a reasonable 

period for obtaining post-credit event 

valuations of the reference exposure; 

(vi) If the contract requires the 

protection purchaser to transfer an 

exposure to the protection provider at 

settlement, the terms of the exposure 

provide that any required consent to 

transfer may not be unreasonably 

withheld; 

(vii) If the credit derivative is a credit 

default swap or nth-to-default swap, the 

contract clearly identifies the parties 

responsible for determining whether a 

credit event has occurred, specifies that 

this determination is not the sole 

responsibility of the protection 

provider, and gives the protection 

purchaser the right to notify the 

protection provider of the occurrence of 

a credit event; and 

(viii) If the credit derivative is a total 

return swap and the bank records net 

payments received on the swap as net 

income, the bank records offsetting 

deterioration in the value of the hedged 

exposure (either through reductions in 

fair value or by an addition to reserves). 

Commenters generally supported the 

proposed rule’s definition of eligible 

credit derivative, but two commenters 

asked for a series of changes. These 

commenters asked that the final rule 

specifically reference contingent credit 

default swaps (CCDSs) in the list of 

eligible forms of credit derivatives. 

CCDS are a relatively new type of credit 

derivative, and the agencies are still 

considering their appropriate role 

within the risk-based capital rules. 

However, to enable the rule to adapt to 

future market innovations, the agencies 

have revised the definition of eligible 

credit derivative to add to the list of 

eligible credit derivative forms ‘‘any 

other form of credit derivative approved 

by’’ the bank’s primary Federal 

supervisor.83

One commenter asked that the 

agencies amend the third criterion of the 

eligible credit derivative definition, 

which applies to credit default swaps 

and nth-to-default swaps. The 

commenter indicated that standard 

practice in the credit derivatives market 

is for a credit default swap to contain 

provisions that exempt the protection 

provider from making default payments 

to the protection purchaser if the 

reference obligor’s failure to pay is in an 

amount below a de minimis threshold. 

The agencies do not believe that safety 

and soundness would be materially 

impaired by conforming this criterion of 

the eligible credit derivative definition 

to the current standard market practice. 

Under the final rule, therefore, a credit 

derivative will satisfy the definition of 

an eligible credit derivative if the 

protection provider’s obligation to make 

default payments to the protection 

purchaser is triggered only if the 

reference obligor’s failure to pay 

exceeds any applicable minimal 

payment threshold that is consistent 

with standard market practice. 

Finally, a commenter asked for 

clarification of the meaning of the sixth 

criterion of the definition of eligible 

credit derivative, which states that if the 

contract requires the protection 

purchaser to transfer an exposure to the 

protection provider at settlement, the 

terms of the exposure provide that any 

required consent to transfer may not be 

unreasonably withheld. To address any 

potential ambiguity about which 

exposure’s transferability must be 

analyzed, the agencies have amended 

the sixth component to read: ‘‘If the 

contract requires the protection 

purchaser to transfer an exposure to the 

protection provider at settlement, the 

terms of at least one of the exposures 

that is permitted to be transferred under 

the contract must provide that any 

required consent to transfer may not be 

unreasonably withheld.’’

The proposed rule also provided that 

a bank may recognize an eligible credit 

derivative that hedges an exposure that 

is different from the credit derivative’s 

reference exposure used for determining 

the derivative’s cash settlement value, 

deliverable obligation, or occurrence of 

a credit event only if: 

(i) The reference exposure ranks pari 

passu (that is, equal) or junior to the 

hedged exposure; and 

(ii) The reference exposure and the 

hedged exposure are exposures to the 

same legal entity, and legally 

enforceable cross-default or crossacceleration clauses are in place. 

One commenter acknowledged that 

the proposal’s pari passu ceiling is 

consistent with the New Accord but 

asked for clarification that the provision 

only requires reference exposure 

equality or subordination with respect 

to priority of payments. Although the 

agencies have concluded that it is not 

necessary to amend the rule to provide 

this clarification, the agencies agree that 

the pari passu ceiling relates to priority 

of payments only. 

Two commenters also asked the 

agencies to provide an exception to the 

cross-default/cross-acceleration 

requirement where the hedged exposure 

is an OTC derivative contract or a 

qualifying master netting agreement that 

covers OTC derivative contracts. 

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Although some parts of the debt markets 

have incorporated obligations from OTC 

derivative contracts in cross-default/ 

cross-acceleration clauses, the 

commenter asserted that the practice is 

not prevalent in many parts of the 

market. In addition, the commenter 

maintained that, unlike a failure to pay 

on a loan or a bond, failure to pay on 

an OTC derivative contract generally 

would not trigger a credit event with 

respect to the reference exposure of the 

credit default swap. The agencies have 

not made this change. The proposed 

cross-default/cross-acceleration 

requirement is consistent with the New 

Accord. In addition, the agencies are 

reluctant to permit a bank to obtain 

CRM benefits for an exposure hedged by 

a credit derivative whose reference 

exposure is different than the hedged 

exposure unless the hedged and 

reference exposures would default 

simultaneously. If the hedged exposure 

could default prior to the default of the 

reference exposure, the bank may suffer 

losses on the hedged exposure and not 

be able to collect default payments on 

the credit derivative. The final rule 

clarifies that, in order to recognize the 

credit risk mitigation benefits of an 

eligible credit derivative, cross-default/ 

cross-acceleration provisions must 

assure payments under the credit 

derivative are triggered if the obligor 

fails to pay under the terms of the 

hedged exposure. 

PD Substitution Approach 

Under the PD substitution approach 

of the final rule, as under the proposal, 

if the protection amount (as defined 

below) of the eligible guarantee or 

eligible credit derivative is greater than 

or equal to the EAD of the hedged 

exposure, a bank may substitute for the 

PD of the hedged exposure the PD 

associated with the rating grade of the 

protection provider. If the bank 

determines that full substitution leads to 

an inappropriate degree of risk 

mitigation, the bank may substitute a 

higher PD for that of the protection 

provider. 

If the guarantee or credit derivative 

provides the bank with the option to 

receive immediate payout on triggering 

the protection, then the bank must use 

the lower of the LGD of the hedged 

exposure (not adjusted to reflect the 

guarantee or credit derivative) and the 

LGD of the guarantee or credit 

derivative. If the guarantee or credit 

derivative does not provide the bank 

with the option to receive immediate 

payout on triggering the protection (and 

instead provides for the guarantor to 

assume the payment obligations of the 

obligor over the remaining life of the 

hedged exposure), the bank must use 

the LGD of the guarantee or credit 

derivative. 

If the protection amount of the 

eligible guarantee or eligible credit 

derivative is less than the EAD of the 

hedged exposure, however, the bank 

must treat the hedged exposure as two 

separate exposures (protected and 

unprotected) to recognize the credit risk 

mitigation benefit of the guarantee or 

credit derivative. The bank must 

calculate its risk-based capital 

requirement for the protected exposure 

under section 31 of the rule (using a PD 

equal to the protection provider’s PD, an 

LGD determined as described above, 

and an EAD equal to the protection 

amount of the guarantee or credit 

derivative). If the bank determines that 

full substitution leads to an 

inappropriate degree of risk mitigation, 

the bank may use a higher PD than that 

of the protection provider. The bank 

must calculate its risk-based capital 

requirement for the unprotected 

exposure under section 31 of the rule 

(using a PD equal to the obligor’s PD, an 

LGD equal to the hedged exposure’s 

LGD not adjusted to reflect the 

guarantee or credit derivative, and an 

EAD equal to the EAD of the original 

hedged exposure minus the protection 

amount of the guarantee or credit 

derivative). 

The protection amount of an eligible 

guarantee or eligible credit derivative is 

defined as the effective notional amount 

of the guarantee or credit derivative 

reduced by any applicable haircuts for 

maturity mismatch, lack of 

restructuring, and currency mismatch 

(each described below). The effective 

notional amount of a guarantee or credit 

derivative is the lesser of the contractual 

notional amount of the credit risk 

mitigant and the EAD of the hedged 

exposure, multiplied by the percentage 

coverage of the credit risk mitigant. For 

example, the effective notional amount 

of a guarantee that covers, on a pro rata 

basis, 40 percent of any losses on a $100 

bond would be $40. 

The agencies received no material 

comments on the above-described 

structure of the PD substitution 

approach, and the final rule’s PD 

substitution approach is substantially 

the same as that of the proposed rule. 

LGD Adjustment Approach 

Under the LGD adjustment approach 

of the final rule, as under the proposal, 

if the protection amount of the eligible 

guarantee or eligible credit derivative is 

greater than or equal to the EAD of the 

hedged exposure, the bank’s risk-based 

capital requirement for the hedged 

exposure is the greater of (i) the riskbased capital requirement for the 

exposure as calculated under section 31 

of the rule (with the LGD of the 

exposure adjusted to reflect the 

guarantee or credit derivative); or (ii) the 

risk-based capital requirement for a 

direct exposure to the protection 

provider as calculated under section 31 

of the rule (using the bank’s PD for the 

protection provider, the bank’s LGD for 

the guarantee or credit derivative, and 

an EAD equal to the EAD of the hedged 

exposure). 

If the protection amount of the 

eligible guarantee or eligible credit 

derivative is less than the EAD of the 

hedged exposure, however, the bank 

must treat the hedged exposure as two 

separate exposures (protected and 

unprotected) in order to recognize the 

credit risk mitigation benefit of the 

guarantee or credit derivative. The 

bank’s risk-based capital requirement 

for the protected exposure would be the 

greater of (i) the risk-based capital 

requirement for the protected exposure 

as calculated under section 31 of the 

rule (with the LGD of the exposure 

adjusted to reflect the guarantee or 

credit derivative and EAD set equal to 

the protection amount of the guarantee 

or credit derivative); or (ii) the riskbased capital requirement for a direct 

exposure to the protection provider as 

calculated under section 31 of the rule 

(using the bank’s PD for the protection 

provider, the bank’s LGD for the 

guarantee or credit derivative, and an 

EAD set equal to the protection amount 

of the guarantee or credit derivative). 

The bank must calculate its risk-based 

capital requirement for the unprotected 

exposure under section 31 of the rule 

using a PD set equal to the obligor’s PD, 

an LGD set equal to the hedged 

exposure’s LGD (not adjusted to reflect 

the guarantee or credit derivative), and 

an EAD set equal to the EAD of the 

original hedged exposure minus the 

protection amount of the guarantee or 

credit derivative. 

The agencies received no material 

comments on the above-described 

structure of the LGD adjustment 

approach, and the final rule’s LGD 

adjustment approach is substantially the 

same as that of the proposed rule. 

The PD substitution approach allows 

a bank to effectively assess risk-based 

capital against a hedged exposure as if 

it were a direct exposure to the 

protection provider, and the LGD 

adjustment approach produces a riskbased capital requirement for a hedged 

exposure that is never lower than that 

of a direct exposure to the protection 

provider. Accordingly, these approaches 

do not fully reflect the risk mitigation 

benefits certain types of guarantees and 

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84Under the final rule, if an eligible guarantee 

provides tranched credit protection to a group of 

hedged exposures—for example, the guarantee 

covers the first 2 percent of aggregate losses for the 

group—the bank must determine the risk-based 

capital requirements for the hedged exposures 

under the securitization framework. 

credit derivatives may provide because 

the resulting risk-based capital 

requirement does not consider the joint 

probability of default of the obligor of 

the hedged exposure and the protection 

provider, sometimes referred to as the 

‘‘double default’’ benefit. The agencies 

have decided, consistent with the New 

Accord and the proposed rule, to 

recognize double default benefits in the 

wholesale framework only for certain 

hedged exposures covered by certain 

guarantees and credit derivatives. A 

later section of the preamble describes 

which hedged exposures are eligible for 

the double default treatment and 

describes the double default treatment 

that is available to those exposures. 

Maturity Mismatch Haircut 

Under the final rule, a bank that seeks 

to reduce the risk-based capital 

requirement on a wholesale exposure by 

recognizing an eligible guarantee or 

eligible credit derivative must adjust the 

effective notional amount of the credit 

risk mitigant downward to reflect any 

maturity mismatch between the hedged 

exposure and the credit risk mitigant. A 

maturity mismatch occurs when the 

residual maturity of a credit risk 

mitigant is less than that of the hedged 

exposure(s). 

The proposed rule provided, 

consistent with the New Accord, that 

when the hedged exposures have 

different residual maturities, the longest 

residual maturity of any of the hedged 

exposures would be used as the residual 

maturity of all hedged exposures. One 

commenter criticized this provision as 

excessively conservative. The agencies 

agree and have decided to restrict the 

application of this provision to 

securitization CRM.84 Accordingly, 

under the final rule, to calculate the 

risk-based capital requirement for a 

group of hedged wholesale exposures 

that are covered by a single eligible 

guarantee under which the protection 

provider has agreed to backstop all 

contractual payments associated with 

each hedged exposure, a bank should 

treat each hedged exposure as if it were 

fully covered by a separate eligible 

guarantee. To determine whether any of 

the hedged wholesale exposures has a 

maturity mismatch with the eligible 

guarantee, the bank must assess whether 

the residual maturity of the eligible 

guarantee is less than that of the hedged 

exposure. 

The residual maturity of a hedged 

exposure is the longest possible 

remaining time before the obligor is 

scheduled to fulfil its obligation on the 

exposure. When determining the 

residual maturity of the guarantee or 

credit derivative, embedded options that 

may reduce the term of the credit risk 

mitigant must be taken into account so 

that the shortest possible residual 

maturity for the credit risk mitigant is 

used to determine the potential maturity 

mismatch. Where a call is at the 

discretion of the protection provider, 

the residual maturity of the guarantee or 

credit derivative is the first call date. If 

the call is at the discretion of the bank 

purchasing the protection, but the terms 

of the arrangement at inception of the 

guarantee or credit derivative contain a 

positive incentive for the bank to call 

the transaction before contractual 

maturity, the remaining time to the first 

call date is the residual maturity of the 

credit risk mitigant. For example, where 

there is a step-up in the cost of credit 

protection in conjunction with a call 

feature or where the effective cost of 

protection increases over time even if 

credit quality remains the same or 

improves, the residual maturity of the 

credit risk mitigant is the remaining 

time to the first call. 

Eligible guarantees and eligible credit 

derivatives with maturity mismatches 

may only be recognized if their original 

maturities are equal to or greater than 

one year. As a result, a guarantee or 

credit derivative is not recognized for a 

hedged exposure with an original 

maturity of less than one year unless the 

credit risk mitigant has an original 

maturity of equal to or greater than one 

year or an effective residual maturity 

equal to or greater than that of the 

hedged exposure. In all cases, credit risk 

mitigants with maturity mismatches 

may not be recognized when they have 

an effective residual maturity of three 

months or less. 

When a maturity mismatch exists, a 

bank must apply the following maturity 

mismatch adjustment to determine the 

effective notional amount of the 

guarantee or credit derivative adjusted 

for maturity mismatch: Pm = E × 

(t¥0.25)/(T¥0.25), where: 

(i) Pm = effective notional amount of the 

credit risk mitigant adjusted for maturity 

mismatch; 

(ii) E = effective notional amount of the 

credit risk mitigant; 

(iii) t = lesser of T or effective residual 

maturity of the credit risk mitigant, expressed 

in years; and 

(iv) T = lesser of 5 or effective residual 

maturity of the hedged exposure, expressed 

in years. 

Other than as discussed above with 

respect to pools of hedged exposures 

with different residual maturities, the 

final rule’s provisions on maturity 

mismatch do not differ from those of the 

proposed rule. 

Restructuring Haircut 

Under the final rule, as under the 

proposed rule, a bank that seeks to 

recognize an eligible credit derivative 

that does not include a distressed 

restructuring as a credit event that 

triggers payment under the derivative 

must reduce the recognition of the 

credit derivative by 40 percent. A 

distressed restructuring is a 

restructuring of the hedged exposure 

involving forgiveness or postponement 

of principal, interest, or fees that results 

in a charge-off, specific provision, or 

other similar debit to the profit and loss 

account. 

In other words, the effective notional 

amount of the credit derivative adjusted 

for lack of restructuring credit event 

(and maturity mismatch, if applicable) 

is: Pr = Pm × 0.60, where: 

(i) Pr = effective notional amount of the 

credit risk mitigant, adjusted for lack of 

restructuring credit event (and maturity 

mismatch, if applicable); and 

(ii) Pm = effective notional amount of the 

credit risk mitigant adjusted for maturity 

mismatch (if applicable). 

Two commenters opposed the 40 

percent restructuring haircut. One 

commenter contended that the 40 

percent haircut is too punitive. The 

other commenter contended that the 40 

percent haircut should not apply when 

the hedged exposure is an OTC 

derivative contract or a qualifying 

master netting agreement that covers 

OTC derivative contracts. The 40 

percent haircut is a rough estimate of 

the reduced CRM benefits that accrue to 

a bank that purchases a credit derivative 

without restructuring coverage. 

Nonetheless, the agencies recognize that 

restructuring events could result in 

substantial economic losses to a bank. 

Moreover, the 40 percent haircut is 

consistent with the New Accord and is 

a reasonably prudent mechanism for 

ensuring that banks do not receive 

excessive CRM benefits for purchasing 

credit protection that does not cover all 

material sources of economic loss to the 

bank on the hedged exposure. 

The final rule’s provisions on lack of 

restructuring as a credit event do not 

differ from those of the proposed rule. 

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69354 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

85New Accord, ¶206. 

86 Id. 

87The New Accord permits certain retail small 

business exposures to be eligible for double default 

treatment. Under the final rule, however, a bank 

must effectively desegment a retail small business 

exposure (thus rendering it a wholesale exposure) 

to make it eligible for double default treatment. 

Currency Mismatch Haircut 

Under the final rule, as under the 

proposed rule, where the eligible 

guarantee or eligible credit derivative is 

denominated in a currency different 

from that in which any hedged exposure 

is denominated, the effective notional 

amount of the guarantee or credit 

derivative must be adjusted for currency 

mismatch (and maturity mismatch and 

lack of restructuring credit event, if 

applicable). The adjusted effective 

notional amount is calculated as: Pc = 

Pr × (1¥Hfx), where: 

(i) Pc = effective notional amount of the 

credit risk mitigant, adjusted for currency 

mismatch (and maturity mismatch and lack 

of restructuring credit event, if applicable); 

(ii) Pr = effective notional amount of the 

credit risk mitigant (adjusted for maturity 

mismatch and lack of restructuring credit 

event, if applicable); and 

(iii) Hfx = haircut appropriate for the 

currency mismatch between the credit risk 

mitigant and the hedged exposure. 

A bank may use a standard 

supervisory haircut of 8 percent for Hfx 

(based on a ten-business-day holding 

period and daily marking-to-market and 

remargining). Alternatively, a bank may 

use internally estimated haircuts for Hfx 

based on a ten-business-day holding 

period and daily marking-to-market and 

remargining if the bank qualifies to use 

the own-estimates haircuts in paragraph 

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

methodology in paragraph (b)(3) of 

section 32, or the internal models 

methodology in paragraph (d) of section 

32 of the rule. The bank must scale 

these haircuts up using a square root of 

time formula if the bank revalues the 

guarantee or credit derivative less 

frequently than once every ten business 

days. 

The agencies received no comments 

on the currency mismatch provisions 

discussed above, and the final rule’s 

provisions on currency mismatch do not 

differ from those of the proposed rule. 

Example 

Assume that a bank holds a five-year $100 

corporate exposure, purchases a $100 credit 

derivative to mitigate its credit risk on the 

exposure, and chooses to use the PD 

substitution approach. The unsecured LGD of 

the corporate exposure is 30 percent; the LGD 

of the credit derivative is 80 percent. The 

credit derivative is an eligible credit 

derivative, has the bank’s exposure as its 

reference exposure, has a three-year maturity, 

no restructuring provision, no currency 

mismatch with the bank’s hedged exposure, 

and the protection provider assumes the 

payment obligations of the obligor upon 

default. The effective notional amount and 

initial protection amount of the credit 

derivative would be $100. The maturity 

mismatch would reduce the protection 

amount to $100 × (3¥.25)÷(5¥.25) or $57.89. 

The haircut for lack of restructuring would 

reduce the protection amount to $57.89 × 0.6 

or $34.74. So the bank would treat the $100 

corporate exposure as two exposures: (i) An 

exposure of $34.74 with the PD of the 

protection provider, an LGD of 80 percent, 

and an M of five; and (ii) an exposure of 

$65.26 with the PD of the obligor, an LGD of 

30 percent, and an M of five. 

Multiple Credit Risk Mitigants 

The New Accord provides that if 

multiple credit risk mitigants (for 

example, two eligible guarantees) cover 

a single exposure, a bank must 

disaggregate the exposure into portions 

covered by each credit risk mitigant (for 

example, the portion covered by each 

guarantee) and must calculate separately 

the risk-based capital requirement of 

each portion.85 The New Accord also 

indicates that when credit risk mitigants 

provided by a single protection provider 

have differing maturities, they should be 

subdivided into separate layers of 

protection.86 In the proposal, the 

agencies invited comment on whether 

and how the agencies should address 

these and other similar situations in 

which multiple credit risk mitigants 

cover a single exposure. 

Commenters generally agreed that the 

agencies should provide additional 

guidance about how to address 

situations where multiple credit risk 

mitigants cover a single exposure. 

Although one commenter recommended 

that the agencies permit banks 

effectively to recognize triple default 

benefits in situations where two credit 

risk mitigants cover a single exposure, 

commenters did not provide material 

specific suggestions as to their preferred 

approach to addressing these situations. 

Thus, the agencies have decided to 

adopt the New Accord’s principles for 

dealing with multiple credit risk 

mitigant situations. The agencies have 

added several additional provisions to 

section 33(a) of the final rule to provide 

clarity in this area. 

Double Default Treatment 

As noted above, the final rule, like the 

proposed rule, contains a separate riskbased capital methodology for hedged 

exposures eligible for double default 

treatment. The final rule’s double 

default provisions are identical to those 

of the proposed rule, with the exception 

of some limited changes to the 

definition of an eligible double default 

guarantor discussed below. 

To be eligible for double default 

treatment, a hedged exposure must be 

fully covered or covered on a pro rata 

basis (that is, there must be no tranching 

of credit risk) by an uncollateralized 

single-reference-obligor credit derivative 

or guarantee (or certain nth-to-default 

credit derivatives) provided by an 

eligible double default guarantor (as 

defined below). Moreover, the hedged 

exposure must be a wholesale exposure 

other than a sovereign exposure.87 In 

addition, the obligor of the hedged 

exposure must not be an eligible double 

default guarantor, an affiliate of an 

eligible double default guarantor, or an 

affiliate of the guarantor. 

The proposed rule defined eligible 

double default guarantor to include a 

depository institution (as defined in 

section 3 of the Federal Deposit 

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

holding company (as defined in section 

2 of the Bank Holding Company Act (12 

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

holding company (as defined in 12 

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

substantially all of the holding 

company’s activities are permissible for 

a financial holding company under 12 

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

dealer registered (under the Securities 

Exchange Act of 1934) with the 

Securities and Exchange Commission 

(SEC); an insurance company in the 

business of providing credit protection 

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

a state insurance regulator; a foreign 

bank (as defined in section 211.2 of the 

Federal Reserve Board’s Regulation K 

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

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

company in the business of providing 

credit protection. The proposal required 

an eligible double default guarantor to 

(i) have a bank-assigned PD that, at the 

time the guarantor issued the guarantee 

or credit derivative, was equal to or 

lower than the PD associated with a 

long-term external rating of at least the 

third highest investment-grade rating 

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

than the PD associated with a long-term 

external rating of at least investment 

grade. In addition, the proposal 

permitted a non-U.S. based bank, 

securities firm, or insurance company to 

qualify as an eligible double default 

guarantor only if the firm were subject 

to consolidated supervision and 

regulation comparable to that imposed 

on U.S. depository institutions, 

securities firms, or insurance companies 

(as the case may be) or had issued an 

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outstanding and unsecured long-term 

debt security without credit 

enhancement that had a long-term 

applicable external rating in one of the 

three highest investment-grade rating 

categories. 

Commenters expressed two principal 

criticisms of the proposed definition of 

an eligible double default guarantor. 

First, commenters asked the agencies to 

conform the definition to the New 

Accord by permitting a foreign financial 

firm to qualify so long as it had an 

outstanding long-term debt security 

with an external rating of investment 

grade or higher (for example, BBB¥ or 

higher) instead of in one of the three 

highest investment-grade rating 

categories (for example, A¥ or higher). 

In light of the other eligibility criteria, 

the agencies have concluded that it 

would be appropriate to conform this 

provision of the definition to the New 

Accord. 

Commenters also requested that the 

agencies conform the definition of 

eligible double default guarantor to the 

New Accord by permitting a financial 

firm to qualify so long as it had a bankassigned PD, at the time the guarantor 

issued the guarantee or credit derivative 

or at any time thereafter, that was equal 

to or lower than the PD associated with 

a long-term external rating of at least the 

third highest investment-grade rating 

category. In light of the other eligibility 

criteria, the agencies have concluded 

that it would be appropriate to conform 

this provision of the definition to the 

New Accord. 

Effectively, under the final rule, the 

scope of an eligible double default 

guarantor is limited to financial firms 

whose normal business includes the 

provision of credit protection, as well as 

the management of a diversified 

portfolio of credit risk. This restriction 

arises from the agencies’ concern to 

limit double default recognition to 

financial institutions that have a high 

level of credit risk management 

expertise and that provide sufficient 

market disclosure. The restriction is also 

designed to limit the risk of excessive 

correlation between the 

creditworthiness of the guarantor and 

the obligor of the hedged exposure due 

to their performance depending on 

common economic factors beyond the 

systematic risk factor. As a result, 

hedged exposures to potential credit 

protection providers or affiliates of 

credit protection providers are not 

eligible for the double default treatment. 

In addition, the agencies have excluded 

hedged exposures to sovereign entities 

from eligibility for double default 

treatment because of the potential high 

correlation between the 

creditworthiness of a sovereign and that 

of a guarantor. 

One commenter urged the agencies to 

delete the requirement that the obligor 

of a hedged exposure that qualifies for 

double default treatment not be an 

eligible double default guarantor or an 

affiliate of such an entity. This 

commenter represented that this 

requirement significantly constrained 

the scope of application of double 

default treatment and assumed 

inappropriately that there is an 

excessive amount of correlation among 

all financial firms. The agencies 

acknowledge that this requirement is a 

crude mechanism to prevent excessive 

wrong-way risk, but the agencies have 

decided to retain the requirement in 

light of its consistency with the New 

Accord and the limited ability of banks 

to measure accurately correlations 

among obligors. 

In addition to limiting the types of 

guarantees, credit derivatives, 

guarantors, and hedged exposures 

eligible for double default treatment, the 

rule limits wrong-way risk further by 

requiring a bank to implement a process 

to detect excessive correlation between 

the creditworthiness of the obligor of 

the hedged exposure and the protection 

provider. The bank must receive prior 

written approval from its primary 

Federal supervisor for this process in 

order to recognize double default 

benefits for risk-based capital purposes. 

To apply double default treatment to a 

particular hedged exposure, the bank 

must determine that there is not 

excessive correlation between the 

creditworthiness of the obligor of the 

hedged exposure and the protection 

provider. For example, the 

creditworthiness of an obligor and a 

protection provider would be 

excessively correlated if the obligor 

derives a high proportion of its income 

or revenue from transactions with the 

protection provider. If excessive 

correlation is present, the bank may not 

use the double default treatment for the 

hedged exposure. 

The risk-based capital requirement for 

a hedged exposure subject to double 

default treatment is calculated by 

multiplying a risk-based capital 

requirement for the hedged exposure (as 

if it were unhedged) by an adjustment 

factor that considers the PD of the 

protection provider (see section 34 of 

the rule). Thus, the PDs of both the 

obligor of the hedged exposure and the 

protection provider are factored into the 

hedged exposure’s risk-based capital 

requirement. In addition, as under the 

PD substitution treatment in section 33 

of the rule, the bank is allowed to set 

LGD equal to the lower of the LGD of 

the hedged exposure (not adjusted to 

reflect the guarantee or credit 

derivative) or the LGD of the guarantee 

or credit derivative if the guarantee or 

credit derivative provides the bank with 

the option to receive immediate payout 

on the occurrence of a credit event. 

Otherwise, the bank must set LGD equal 

to the LGD of the guarantee or credit 

derivative. Accordingly, in order to 

apply the double default treatment, the 

bank must estimate a PD for the 

protection provider and an LGD for the 

guarantee or credit derivative. Finally, a 

bank using the double default treatment 

must make applicable adjustments to 

the protection amount of the guarantee 

or credit derivative to reflect maturity 

mismatches, currency mismatches, and 

lack of restructuring coverage (as under 

the PD substitution and LGD adjustment 

approaches in section 33 of the rule). 

One commenter objected that the 

calibration of the double default formula 

under the proposed rule was too 

conservative because it assumed an 

excessive amount of correlation between 

the obligor of the hedged exposure and 

the protection provider. The agencies 

have decided to leave the calibration 

unaltered in light of its consistency with 

the New Accord. The agencies will 

evaluate this decision over time and 

will raise this issue with the BCBS if 

appropriate. 

6. Guarantees and Credit Derivatives 

That Cover Retail Exposures 

Like the proposal, the final rule 

provides a different treatment for 

guarantees and credit derivatives that 

cover retail exposures than for those 

that cover wholesale exposures. The 

approach set forth above for guarantees 

and credit derivatives that cover 

wholesale exposures is an exposure-byexposure approach consistent with the 

overall exposure-by-exposure approach 

the rule takes to wholesale exposures. 

The agencies believe that a different 

treatment for guarantees that cover retail 

exposures is necessary and appropriate 

because of the rule’s segmentation 

approach to retail exposures. The 

approaches to retail guarantees 

described in this section generally apply 

only to guarantees of individual retail 

exposures. Guarantees of multiple retail 

exposures (such as pool private 

mortgage insurance (PMI)) are typically 

tranched (that is, they cover less than 

the full amount of the hedged 

exposures) and, therefore, are 

securitization exposures under the final 

rule. 

The rule does not specify the ways in 

which guarantees and credit derivatives 

may be taken into account in the 

segmentation of retail exposures. 

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69356 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

88The agencies consider a qualifying central 

counterparty to be the functional equivalent of an 

exchange, and have long exempted exchange-traded 

contracts from risk-based capital requirements. 

Likewise, the rule does not explicitly 

limit the extent to which a bank may 

take into account the credit risk 

mitigation benefits of guarantees and 

credit derivatives in its estimation of the 

PD and LGD of retail segments, except 

by the application of overall floors on 

certain PD and LGD assignments. This 

approach has the principal advantage of 

being relatively easy for banks to 

implement—the approach generally 

would not disrupt the existing retail 

segmentation practices of banks and 

would not interfere with banks’

quantification of PD and LGD for retail 

segments. 

In the proposal, the agencies 

expressed some concern, however, that 

this approach would provide banks with 

substantial discretion to incorporate 

double default and double recovery 

effects. To address these concerns, the 

preamble to the proposed rule described 

two possible alternative treatments for 

guarantees of retail exposures. The first 

alternative distinguished between 

eligible retail guarantees and all other 

(non-eligible) guarantees of retail 

exposures. Under this alternative, an 

eligible retail guarantee would be an 

eligible guarantee that applies to a 

single retail exposure and is (i) PMI 

issued by a highly creditworthy 

insurance company; or (ii) issued by a 

sovereign entity or a political 

subdivision of a sovereign entity. 

Under this alternative, a bank would 

be able to recognize the credit risk 

mitigation benefits of eligible retail 

guarantees that cover retail exposures in 

a segment by adjusting its estimates of 

LGD for the segment to reflect recoveries 

from the guarantor. However, the bank 

would have to estimate the PD of a 

segment without reflecting the benefit of 

guarantees. Specifically, a segment’s PD 

would be an estimate of the stand-alone 

probability of default for the retail 

exposures in the segment, before taking 

account of any guarantees. Accordingly, 

for this limited set of traditional 

guarantees of retail exposures by high 

credit quality guarantors, a bank would 

be allowed to recognize the benefit of 

the guarantee when estimating LGD but 

not when estimating PD. 

This alternative approach would 

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

within the retail framework, a bank 

would not be able to recognize noneligible retail guarantees when 

estimating PD and LGD for any segment 

of retail exposures. A bank would be 

required to estimate PD and LGD for 

segments containing retail exposures 

with non-eligible guarantees as if the 

exposures were not guaranteed. 

However, a bank would be permitted to 

recognize non-eligible retail guarantees 

provided by a wholesale guarantor by 

treating the hedged retail exposure as a 

direct exposure to the guarantor and 

applying the appropriate wholesale IRB 

risk-based capital formula. In other 

words, for retail exposures covered by 

non-eligible retail guarantees, a bank 

would be permitted to reflect the 

guarantee by ‘‘desegmenting’’ the retail 

exposures (which effectively would 

convert the retail exposures into 

wholesale exposures) and then applying 

the rules set forth above for guarantees 

that cover wholesale exposures. Thus, 

under this approach, a bank would not 

be allowed to recognize either double 

default or double recovery effects for 

non-eligible retail guarantees. 

A second alternative that the agencies 

described in the preamble to the 

proposed rule would permit a bank to 

recognize the credit risk mitigation 

benefits of all eligible guarantees 

(whether eligible retail guarantees or 

not) that cover retail exposures by 

adjusting its estimates of LGD for the 

relevant segments, but would subject a 

bank’s risk-based capital requirement 

for a segment of retail exposures that are 

covered by one or more non-eligible 

retail guarantees to a floor. Under this 

second alternative, the agencies could 

impose a floor on risk-based capital 

requirements of between 2 percent and 

6 percent on such a segment of retail 

exposures. 

A substantial number of commenters 

supported the flexible approach in the 

text of the proposed rule. A few 

commenters also supported the first 

alternative approach in the preamble of 

the proposed rule. Commenters 

uniformly urged the agencies not to 

adopt the second alternative approach. 

The agencies have decided to adopt the 

approach to retail guarantees in the text 

of the proposed rule and not to adopt 

either alternative approach described in 

the proposed rule preamble. Although 

the first alternative approach addresses 

prudential concerns, the agencies have 

concluded that it is excessively 

conservative and prescriptive and 

would not harmonize with banks’

internal risk measurement and 

management practices. The agencies 

also have determined that the second 

alternative approach is insufficiently 

risk sensitive and is not consistent with 

the New Accord. In light of the final 

rule’s flexible approach to retail 

guarantees, the agencies expect banks to 

limit their use of guarantees in the retail 

segmentation process and retail risk 

parameter estimation process to 

situations where the bank has 

particularly reliable data about the CRM 

benefits of such guarantees. 

D. Unsettled Securities, Foreign 

Exchange, and Commodity Transactions 

Section 35 of the final rule describes 

the risk-based capital requirements for 

unsettled and failed securities, foreign 

exchange, and commodities 

transactions. The agencies did not 

receive any material comments on this 

aspect of the proposed rule and are 

adopting it as proposed. 

Under the final rule, certain 

transaction types are excluded from the 

scope of section 35, including: 

(i) Transactions accepted by a 

qualifying central counterparty that are 

subject to daily marking-to-market and 

daily receipt and payment of variation 

margin (which do not have a risk-based 

capital requirement); 88

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

determined under sections 31 and 32 of 

the final rule); 

(iii) One-way cash payments on OTC 

derivative contracts (the risk-based 

capital requirements of which are 

determined under sections 31 and 32 of 

the final rule); and 

(iv) Transactions with a contractual 

settlement period that is longer than the 

normal settlement period (defined 

below), which transactions are treated 

as OTC derivative contracts and 

assessed a risk-based capital 

requirement under sections 31 and 32 of 

the final rule. The final rule also 

provides that, in the case of a systemwide failure of a settlement or clearing 

system, the bank’s primary Federal 

supervisor may waive risk-based capital 

requirements for unsettled and failed 

transactions until the situation is 

rectified. 

The final rule contains separate 

treatments for delivery-versus-payment 

(DvP) and payment-versus-payment 

(PvP) transactions with a normal 

settlement period, on the one hand, and 

non-DvP/non-PvP transactions with a 

normal settlement period, on the other 

hand. The final rule provides the 

following definitions of a DvP 

transaction, a PvP transaction, and a 

normal settlement period. A DvP 

transaction is a securities or 

commodities transaction in which the 

buyer is obligated to make payment only 

if the seller has made delivery of the 

securities or commodities and the seller 

is obligated to deliver the securities or 

commodities only if the buyer has made 

payment. A PvP transaction is a foreign 

exchange transaction in which each 

counterparty is obligated to make a final 

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89Although the IAA described below does allow 

a bank to use an internal-ratings-based approach to 

determine its risk-based capital requirement for an 

exposure to an ABCP program, banks are required 

to follow NRSRO rating criteria and therefore are 

required implicitly to use the NRSRO’s 

determination of the correlation of the underlying 

exposures in the ABCP program. 

transfer of one or more currencies only 

if the other counterparty has made a 

final transfer of one or more currencies. 

A transaction has a normal settlement 

period if the contractual settlement 

period for the transaction is equal to or 

less than the market standard for the 

instrument underlying the transaction 

and equal to or less than five business 

days. 

A bank must hold risk-based capital 

against a DvP or PvP transaction with a 

normal settlement period if the bank’s 

counterparty has not made delivery or 

payment within five business days after 

the settlement date. The bank must 

determine its risk-weighted asset 

amount for such a transaction by 

multiplying the positive current 

exposure of the transaction for the bank 

by the appropriate risk weight in Table 

E. The positive current exposure of a 

transaction of a bank is the difference 

between the transaction value at the 

agreed settlement price and the current 

market price of the transaction, if the 

difference results in a credit exposure of 

the bank to the counterparty. 

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

Number of business 

days after contractual 

settlement date 

Risk weight to be 

applied to positive 

current exposure 

(percent) 

From 5 to 15 ............... 100 

From 16 to 30 ............. 625 

From 31 to 45 ............. 937 .5 

46 or more .................. 1,250 

A bank must hold risk-based capital 

against any non-DvP/non-PvP 

transaction with a normal settlement 

period if the bank has delivered cash, 

securities, commodities, or currencies to 

its counterparty but has not received its 

corresponding deliverables by the end 

of the same business day. The bank 

must continue to hold risk-based capital 

against the transaction until the bank 

has received its corresponding 

deliverables. From the business day 

after the bank has made its delivery 

until five business days after the 

counterparty delivery is due, the bank 

must calculate its risk-based capital 

requirement for the transaction by 

treating the current market value of the 

deliverables owed to the bank as a 

wholesale exposure. 

For purposes of computing a bank’s 

risk-based capital requirement for 

unsettled non-DvP/non-PvP 

transactions, a bank may assign an 

internal obligor rating to a counterparty 

for which it is not otherwise required 

under the final rule to assign an obligor 

rating on the basis of the applicable 

external rating of any outstanding 

unsecured long-term debt security 

without credit enhancement issued by 

the counterparty. A bank may estimate 

a loss severity rating or LGD for the 

exposure, or may use a 45 percent LGD 

for the exposure provided the bank uses 

the 45 percent LGD for all such 

exposures (that is, for all non-DvP/nonPvP transactions subject to a risk-based 

capital requirement other than 

deduction under section 35 of the final 

rule). Alternatively, a bank may use a 

100 percent risk weight for all non-DvP/ 

non-PvP transactions subject to a riskbased capital requirement other than 

deduction under section 35 of the final 

rule. 

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

with a normal settlement period, the 

bank has not received its deliverables by 

the fifth business day after counterparty 

delivery was due, the bank must deduct 

the current market value of the 

deliverables owed to the bank 50 

percent from tier 1 capital and 50 

percent from tier 2 capital. 

The total risk-weighted asset amount 

for unsettled transactions equals the 

sum of the risk-weighted asset amount 

for each DvP and PvP transaction with 

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

settlement period. 

E. Securitization Exposures 

This section describes the framework 

for calculating risk-based capital 

requirements for securitization 

exposures (the securitization 

framework). In contrast to the 

framework for wholesale and retail 

exposures, the securitization framework 

does not permit a bank to rely on its 

internal assessments of the risk 

parameters of a securitization 

exposure.89 For securitization 

exposures, which typically are tranched 

exposures to a pool of underlying 

exposures, such assessments would 

require implicit or explicit estimates of 

correlations among the losses on the 

underlying exposures and estimates of 

the credit risk-transfering consequences 

of tranching. Such correlation and 

tranching effects are difficult to estimate 

and validate in an objective manner and 

on a going-forward basis. Instead, the 

securitization framework relies 

principally on two sources of 

information, where available, to 

determine risk-based capital 

requirements: (i) An assessment of the 

securitization exposure’s credit risk 

made by a nationally recognized 

statistical rating organization (NRSRO); 

or (ii) the risk-based capital requirement 

for the underlying exposures as if the 

exposures had not been securitized 

(along with certain other objective 

information about the securitization 

exposure, such as the size and relative 

seniority of the exposure). 

1. Hierarchy of Approaches 

The securitization framework 

contains three general approaches for 

determining the risk-based capital 

requirement for a securitization 

exposure: a ratings-based approach 

(RBA), an internal assessment approach 

(IAA), and a supervisory formula 

approach (SFA). Consistent with the 

New Accord and the proposal, under 

the final rule a bank generally must 

apply the following hierarchy of 

approaches to determine the risk-based 

capital requirement for a securitization 

exposure. 

Gains-on-Sale and CEIOs 

Under the proposed rule, a bank 

would deduct from tier 1 capital any 

after-tax gain-on-sale resulting from a 

securitization and would deduct from 

total capital any portion of a CEIO that 

does not constitute a gain-on-sale, as 

described in section 42(a)(1) and (c) of 

the proposed rule. Thus, if the after-tax 

gain-on-sale associated with a 

securitization equaled $100 while the 

amount of CEIOs associated with that 

same securitization equaled $120, the 

bank would deduct $100 from tier 1 

capital and $20 from total capital ($10 

from tier 1 capital and $10 from tier 2 

capital). 

Several commenters asserted that the 

proposed deductions of gains-on-sale 

and CEIOs were excessively 

conservative, because such deductions 

are not reflected in an originating bank’s 

maximum risk-based capital 

requirement associated with a single 

securitization transaction (described 

below). Commenters noted that while 

securitization does not increase an 

originating bank’s overall risk exposure 

to the securitized assets, in some 

circumstances the proposal would result 

in a securitization transaction increasing 

an originating bank’s risk-based capital 

requirement. To address this concern, 

some commenters suggested deducting 

CEIOs from total capital only when the 

CEIOs constitute a gain-on-sale. Others 

urged adopting the treatment of CEIOs 

in the general risk-based capital rules. 

Under this treatment, the entire amount 

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69358 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

90A securitization exposure held by an 

originating bank must have two or more external 

ratings or inferred ratings to qualify for the RBA. 

of CEIOs beyond a concentration 

threshold is deducted from total capital 

and there is no separate gain-on-sale 

deduction. 

The final rule retains the proposed 

deduction of gains-on-sale and CEIOs. 

These deductions are consistent with 

the New Accord, and the agencies 

believe they are warranted given 

historical supervisory concerns with the 

subjectivity involved in valuations of 

gains-on-sale and CEIOs. Furthermore, 

although the treatments of gains-on-sale 

and CEIOs can increase an originating 

bank’s risk-based capital requirement 

following a securitization, the agencies 

believe that such anomalies will be rare 

where a securitization transfers 

significant credit risk from the 

originating bank to third parties. 

Ratings-Based Approach (RBA) 

If a securitization exposure is not a 

gain-on-sale or CEIO, a bank must apply 

the RBA to a securitization exposure if 

the exposure qualifies for the RBA. As 

a general matter, an exposure qualifies 

for the RBA if the exposure has an 

external rating from an NRSRO or has 

an inferred rating (that is, the exposure 

is senior to another securitization 

exposure in the transaction that has an 

external rating from an NRSRO).90 For 

example, a bank generally must use the 

RBA approach to determine the riskbased capital requirement for an assetbacked security that has an applicable 

external rating of AA+ from an NRSRO 

and for another tranche of the same 

securitization that is unrated but senior 

in all respects to the asset-backed 

security that was rated. In this example, 

the senior unrated tranche would be 

treated as if it were rated AA+. 

Internal Assessment Approach (IAA) 

If a securitization exposure does not 

qualify for the RBA but the exposure is 

to an ABCP program—such as a credit 

enhancement or liquidity facility—the 

bank may apply the IAA (if the bank, 

the exposure, and the ABCP program 

qualify for the IAA) or the SFA (if the 

bank and the exposure qualify for the 

SFA) to the exposure. As a general 

matter, a bank will qualify to use the 

IAA if the bank establishes and 

maintains an internal risk rating system 

for exposures to ABCP programs that 

has been approved by the bank’s 

primary Federal supervisor. 

Alternatively, a bank may use the SFA 

if the bank is able to calculate a set of 

risk factors relating to the securitization, 

including the risk-based capital 

requirement for the underlying 

exposures as if they were held directly 

by the bank. A bank that qualifies for 

and chooses to use the IAA must use the 

IAA for all exposures that qualify for the 

IAA. 

A number of commenters asserted 

that a bank should be permitted to use 

the IAA for a securitization exposure to 

an ABCP conduit even when the 

exposure has an inferred rating, 

provided all other IAA eligibility 

criteria were met. The commenters 

maintained that the RBA would produce 

an excessive risk-based capital 

requirement for an unrated 

securitization exposure, such as a 

liquidity facility, when the inferred 

rating is based on a rated security that 

is very junior to the unrated exposure. 

Commenters suggested that allowing a 

bank to use the IAA instead of the RBA 

in such circumstances would lead to a 

risk-based capital requirement that was 

better aligned with the unrated 

exposure’s actual risk. 

Like the New Accord, the final rule 

does not allow a bank to use the IAA for 

securitization exposures that qualify for 

the RBA based on an inferred rating. 

While in some cases the IAA might 

produce a more risk-sensitive capital 

treatment relative to an inferred rating 

under the RBA, the agencies—as well as 

the majority of commenters—believe 

that it is important to retain as much 

consistency as possible with the New 

Accord to provide a level international 

playing field for financial services 

providers in a competitive line of 

business. The commenters’ concerns 

relating to inferred ratings apply only to 

a small proportion of outstanding ABCP 

liquidity facilities. In many cases, a 

bank may mitigate such concerns by 

having the ABCP program issue an 

additional, intermediate layer of 

externally rated securities, which would 

provide a more accurate reference for 

inferring a rating on the unrated 

liquidity facility. The agencies intend to 

monitor developments in this area and, 

as appropriate, will coordinate any 

reassessment of the hierarchy of 

securitization approaches with the 

BCBS and other supervisory and 

regulatory authorities. 

Supervisory Formula Approach (SFA) 

If a securitization exposure is not a 

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

for the RBA, and is not an exposure to 

an ABCP program for which the bank is 

applying the IAA, the bank may apply 

the SFA to the exposure if the bank is 

able to calculate the SFA risk 

parameters for the securitization. In 

many cases, an originating bank would 

use the SFA to determine its risk-based 

capital requirements for retained 

securitization exposures. 

Deduction 

If a securitization exposure is not a 

gain-on-sale or a CEIO and does not 

qualify for the RBA, the IAA, or the 

SFA, the bank must deduct the exposure 

from total capital. 

Numerous commenters requested an 

alternative to deducting the 

securitization exposure from capital. 

Some of these commenters noted that if 

a bank does not service the underlying 

assets, the bank may not be able to 

produce highly accurate estimates of a 

key SFA risk parameter, KIRB, which is 

the risk-based capital requirement as if 

the underlying assets were held directly 

by the bank. Commenters expressed 

concern that, under the proposal, a bank 

would be required to deduct from 

capital some structured lending 

products that have long histories of low 

credit losses. Commenters maintained 

that a bank should be allowed to 

calculate the securitization exposure’s 

risk-based capital requirement using the 

rules for wholesale exposures or using 

an IAA-like approach under which the 

bank’s internal risk rating for the 

exposure would be mapped into an 

NRSRO’s rating category. 

Like the proposal, the final rule 

contains only those securitization 

approaches in the New Accord. As 

already noted, the agencies—and most 

commenters—believe that it is 

important to minimize substantive 

differences between the final rule and 

the New Accord to foster international 

consistency. Furthermore, the agencies 

believe that the hierarchy of 

securitization approaches is sufficiently 

comprehensive to accommodate 

demonstrably low-risk structured 

lending arrangements in a risk-sensitive 

manner. As described in greater detail 

below, for securitization exposures that 

are not eligible for the RBA or the IAA, 

a bank has flexibility under the SFA to 

tailor its procedures for estimating KIRB

to the data that are available. The 

agencies recognize that, in light of data 

shortcomings, a bank may have to use 

approaches to estimating KIRB that are 

less sophisticated than what the bank 

might use for similar assets that it 

originates, services, and holds directly. 

Supervisors generally will review the 

reasonableness of KIRB estimates in the 

context of available data, and will 

expect estimates of KIRB to incorporate 

appropriate conservatism to address any 

data shortcomings. 

Total risk-weighted assets for 

securitization exposures equals the sum 

of risk-weighted assets calculated under 

the RBA, IAA, and SFA, plus any riskmstockstill on PROD1PC66 with RULES2

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weighted asset amounts calculated 

under the early amortization provisions 

in section 47 of the final rule. 

Exceptions to the General Hierarchy of 

Approaches 

Consistent with the New Accord and 

the proposed rule, the final rule 

includes a mechanism that generally 

prevents a bank’s effective risk-based 

capital requirement from increasing as a 

result of the bank securitizing its assets. 

Specifically, the rule limits a bank’s 

effective risk-based capital requirement 

for all of its securitization exposures to 

a single securitization to the applicable 

risk-based capital requirement if the 

underlying exposures were held directly 

by the bank. Under the rule, unless one 

or more of the underlying exposures 

does not meet the definition of a 

wholesale, retail, securitization, or 

equity exposure, the total risk-based 

capital requirement for all securitization 

exposures held by a single bank 

associated with a single securitization 

(including any regulatory capital 

requirement that relates to an early 

amortization provision, but excluding 

any capital requirements that relate to 

the bank’s gain-on-sale or CEIOs 

associated with the securitization) 

cannot exceed the sum of (i) the bank’s 

total risk-based capital requirement for 

the underlying exposures as if the bank 

directly held the underlying exposures; 

and (ii) the bank’s total ECL for the 

underlying exposures. 

One commenter urged the agencies to 

delete the reference to ECL in the capital 

calculation. However, the agencies 

believe it is appropriate to include the 

ECL of the underlying exposures in this 

calculation because ECL is included in 

the New Accord’s limit, and because the 

bank would have had to estimate the 

ECL of the exposures and hold reserves 

or capital against the ECL if the bank 

held the underlying exposures on its 

balance sheet. 

This maximum risk-based capital 

requirement is different from the general 

risk-based capital rules. Under the 

general risk-based capital rules, banks 

generally are required to hold a dollar 

in capital for every dollar in residual 

interest, regardless of the effective riskbased capital requirement on the 

underlying exposures. The agencies 

adopted this dollar-for-dollar capital 

treatment for a residual interest to 

recognize that in many instances the 

relative size of the residual interest 

retained by the originating bank reveals 

market information about the quality of 

the underlying exposures and 

transaction structure that may not have 

been captured under the general riskbased capital rules. Given the 

significantly heightened risk sensitivity 

of the IRB approach, the agencies 

believe that the maximum risk-based 

capital requirement in the final rule is 

appropriate. 

The securitization framework also 

includes provisions to limit the double 

counting of risks in situations involving 

overlapping securitization exposures. 

While the proposal addressed only 

those overlapping exposures arising in 

the context of exposures to ABCP 

programs and mortgage loan swaps with 

recourse, the final rule addresses 

overlapping exposures for 

securitizations more generally. If a bank 

has multiple securitization exposures 

that provide duplicative coverage of the 

underlying exposures of a securitization 

(such as when a bank provides a 

program-wide credit enhancement and 

multiple pool-specific liquidity facilities 

to an ABCP program), the bank is not 

required to hold duplicative risk-based 

capital against the overlapping position. 

Instead, the bank would apply to the 

overlapping position the applicable riskbased capital treatment under the 

securitization framework that results in 

the highest capital requirement. If 

different banks have overlapping 

exposures to a securitization, however, 

each bank must hold capital against the 

entire maximum amount of its exposure. 

Although duplication of capital 

requirements will not occur for 

individual banks, some systemic 

duplication may occur where multiple 

banks have overlapping exposures to the 

same securitization. 

The proposed rule also addressed the 

risk-based capital treatment of a 

securitization of non-IRB assets. Claims 

to future music concert and film 

receivables are examples of financial 

assets that are not wholesale, retail, 

securitization, or equity exposures. In 

these cases, the SFA cannot be used 

because of the absence of a risksensitive measure of the credit risk of 

the underlying exposures. Specifically, 

under the proposed rule, if a bank had 

a securitization exposure and any 

underlying exposure of the 

securitization was not a wholesale, 

retail, securitization or equity exposure, 

the bank would (i) apply the RBA if the 

securitization exposure qualifies for the 

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

or (ii) otherwise, deduct the exposure 

from total capital. 

Numerous commenters asserted that a 

bank should be allowed to use the IAA 

in these situations since, unlike the 

SFA, the IAA is tied to NRSRO rating 

methodologies rather than to the riskbased capital requirement for the 

underlying exposures. The agencies 

believe that this is a reasonable 

approach for exposures to ABCP 

conduits. The final rule permits a bank 

to use the IAA for a securitization 

exposure for which any underlying 

exposure of the securitization is not a 

wholesale, retail, securitization or 

equity exposure, provided the 

securitization exposure is not gain-onsale, not a CEIO, and not eligible for the 

RBA, and all of the IAA qualification 

criteria are met. 

As described in section V.A.3. of this 

preamble, a few commenters asserted 

that OTC derivatives with a 

securitization SPE as the counterparty 

should be excluded from the definition 

of securitization exposure. These 

commenters objected to the burden of 

using the securitization framework to 

calculate a capital requirement for 

counterparty credit risk for OTC 

derivatives with a securitization SPE. 

The agencies continue to believe that 

the securitization framework is the most 

appropriate way to assess the 

counterparty credit risk of such 

exposures, and that in many cases the 

relatively simple RBA will apply to 

such exposures. In response to 

commenter concerns about burden, the 

agencies have decided to add an 

optional simple risk weight approach 

for certain OTC derivatives. Under the 

final rule, if a securitization exposure is 

an OTC derivative contract (other than 

a credit derivative) that has a first 

priority claim on the cash flows from 

the underlying exposures 

(notwithstanding amounts due under 

interest rate or currency derivative 

contracts, fees due, or other similar 

payments), a bank may choose to apply 

an effective 100 percent risk weight to 

the exposure rather than the general 

securitization hierarchy of approaches. 

This treatment is subject to supervisory 

approval. 

Like the proposed rule, the final rule 

contains three additional exceptions to 

the general hierarchy. Each exception 

parallels the general risk-based capital 

rules. First, an interest-only mortgagebacked security must be assigned a risk 

weight that is no less than 100 percent. 

Although a number of commenters 

objected to this risk weight floor on the 

grounds that it was not risk sensitive, 

the agencies believe that a minimum 

risk weight of 100 percent is prudent in 

light of the uncertainty implied by the 

substantial price volatility of these 

securities. Second, a sponsoring bank 

that qualifies as a primary beneficiary 

and must consolidate an ABCP program 

as a variable interest entity under GAAP 

generally may exclude the consolidated 

ABCP program assets from riskmstockstill on PROD1PC66 with RULES2

69360 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

91See Financial Accounting Standards Board, 

Interpretation No. 46: Consolidation of Variable 

Interest Entities (January 2003). 

92See 12 U.S.C. 1835, which places a cap on the 

risk-based capital requirement applicable to a wellcapitalized DI that transfers small business loans 

with recourse. The final rule does not expressly 

state that the agencies may permit adequately 

capitalized banks to use the small business recourse 

rule on a case-by-case basis because the agencies 

may do this under the general reservation of 

authority contained in section 1 of the rule. 

weighted assets.91 In such cases, the 

bank must hold risk-based capital 

against any securitization exposures of 

the bank to the ABCP program. Third, 

as required by Federal statute, a special 

set of rules applies to transfers of small 

business loans and leases with recourse 

by well-capitalized depository 

institutions.92

Servicer Cash Advances 

A traditional securitization typically 

employs a servicing bank that—on a 

day-to-day basis—collects principal, 

interest, and other payments from the 

underlying exposures of the 

securitization and forwards such 

payments to the securitization SPE or to 

investors in the securitization. Such 

servicing banks often provide to the 

securitization a credit facility under 

which the servicing bank may advance 

cash to ensure an uninterrupted flow of 

payments to investors in the 

securitization (including advances made 

to cover foreclosure costs or other 

expenses to facilitate the timely 

collection of the underlying exposures). 

These servicer cash advance facilities 

are securitization exposures. 

Under the final rule, as under the 

proposed rule, a servicing bank must 

determine its risk-based capital 

requirement for any advances under 

such a facility using the hierarchy of 

securitization approaches described 

above. The treatment of the undrawn 

portion of the facility depends on 

whether the facility is an ‘‘eligible’’

servicer cash advance facility. An 

eligible servicer cash advance facility is 

a servicer cash advance facility in which 

(i) the servicer is entitled to full 

reimbursement of advances (except that 

a servicer may be obligated to make 

non-reimburseable advances for a 

particular underlying exposure if any 

such advance is limited to an 

insignificant amount of the outstanding 

principal balance of that exposure); (ii) 

the servicer’s right to reimbursement is 

senior in right of payment to all other 

claims on the cash flows from the 

underlying exposures of the 

securitization; and (iii) the servicer has 

no legal obligation to, and does not, 

make advances to the securitization if 

the servicer concludes the advances are 

unlikely to be repaid. Consistent with 

the general risk-based capital rules with 

respect to residential mortgage servicer 

cash advances, a servicing bank is not 

required to hold risk-based capital 

against the undrawn portion of an 

eligible servicer cash advance facility. A 

bank that provides a non-eligible 

servicer cash advance facility must 

determine its risk-based capital 

requirement for the undrawn portion of 

the facility in the same manner as the 

bank would determine its risk-based 

capital requirement for any other 

undrawn securitization exposure. 

Amount of a Securitization Exposure 

Under the proposed rule, the amount 

of an on-balance sheet securitization 

exposure was the bank’s carrying value, 

if the exposure was held-to-maturity or 

for trading, or the bank’s carrying value 

minus any unrealized gains and plus 

any unrealized losses on the exposure, 

if the exposure was available-for-sale. In 

general, the amount of an off-balance 

sheet securitization exposure was the 

notional amount of the exposure. For an 

OTC derivative contract that was not a 

credit derivative, the notional amount 

was the EAD of the derivative contract 

(as calculated in section 32). 

In the final rule the agencies are 

maintaining the substance of the 

proposed provision on the amount of a 

securitization exposure with one 

exception. The final rule provides that 

the amount of a securitization exposure 

that is a repo-style transaction, eligible 

margin loan, or OTC derivative (other 

than a credit derivative) is the EAD of 

the exposure as calculated in section 32 

of the final rule. The agencies believe 

this change is consistent with the way 

banks manage these exposures, more 

appropriately reflects the collateral that 

directly supports these exposures, and 

recognizes the credit risk mitigation 

benefits of netting where these 

exposures are part of a cross-product 

netting set. Because the collateral 

associated with a repo-style transaction 

or eligible margin loan is reflected in the 

determination of exposure amount 

under section 32 of the rule, these 

transactions are not eligible for the 

general securitization collateral 

approach in section 46(b) of the final 

rule. Similarly, if a bank chooses to 

reflect collateral associated with an OTC 

derivative contract in its determination 

of exposure amount under section 32 of 

the rule, it may not also apply the 

general securitization collateral 

approach in section 46(b) of the final 

rule. Similar to the definition of EAD for 

on-balance sheet exposures, the 

agencies are clarifying that the amount 

of an on-balance sheet securitization 

exposure is based on whether or not the 

exposure is classified as an available for 

sale security. 

Under the proposal, when a 

securitization exposure to an ABCP 

program takes the form of a 

commitment, such as a liquidity facility, 

the notional amount could be reduced 

to the maximum potential amount that 

the bank currently would be required to 

fund under the arrangement’s 

documentation (the maximum potential 

amount that could be drawn given the 

assets currently held by the program). 

Within some ABCP programs, however, 

certain commitments, such as liquidity 

facilities, may be dynamic in that the 

maximum amount that can be drawn at 

any moment depends on the current 

credit quality of the program’s 

underlying assets. That is, if the 

underlying assets were to remain fixed, 

but their credit quality deteriorated, the 

maximum amount that could be drawn 

against the liquidity facility could 

increase. 

The final rule clarifies that in such 

circumstances the notional amount of 

an off-balance sheet securitization 

exposure to an ABCP program may be 

reduced to the maximum potential 

amount that the bank could be required 

to fund given the program’s current 

assets (calculated without regard to the 

current credit quality of these assets). 

Thus, if $100 is the maximum amount 

that could be drawn given the current 

volume and current credit quality of the 

program’s assets, but the maximum 

potential draw against these same assets 

could increase to as much as $200 if 

their credit quality were to deteriorate, 

then the exposure amount is $200. 

Some commenters recommended 

capping the securitization amount for an 

ABCP liquidity facility at the amount of 

the outstanding commercial paper 

covered by that facility. The agencies 

believe, however, that this would be 

inappropriate if the liquidity provider 

could be required to advance a larger 

amount. The agencies note that when 

calculating the exposure amount of a 

liquidity facility, a bank may take into 

account any limits on advances—

including limits based on the amount of 

commercial paper outstanding—that are 

contained in the program’s 

documentation. 

Implicit Support 

Like the proposed rule, the final rule 

sets forth the regulatory capital 

consequences if a bank provides support 

to a securitization in excess of the 

bank’s predetermined contractual 

obligation to provide credit support to 

the securitization. First, consistent with 

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Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 69361 

93 Interagency Guidance on Implicit Recourse in 

Asset Securitizations, May 23, 2002. 

94See, e.g., OCC Bulletin 99–46 (Dec. 13, 1999) 

(OCC); FDIC Financial Institution Letter 109–99 

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

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

(OTS). 

the general risk-based capital rules,93 a 

bank that provides such implicit 

support must hold regulatory capital 

against all of the underlying exposures 

associated with the securitization as if 

the exposures had not been securitized, 

and must deduct from tier 1 capital any 

after-tax gain-on-sale resulting from the 

securitization. Second, the bank must 

disclose publicly (i) that it has provided 

implicit support to the securitization, 

and (ii) the regulatory capital impact to 

the bank of providing the implicit 

support. The bank’s primary Federal 

supervisor also may require the bank to 

hold regulatory capital against all the 

underlying exposures associated with 

some or all the bank’s other 

securitizations as if the exposures had 

not been securitized, and to deduct from 

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

resulting from such securitizations. 

Operational Requirements for 

Traditional Securitizations 

In a traditional securitization, an 

originating bank typically transfers a 

portion of the credit risk of exposures to 

third parties by selling them to a 

securitization SPE. Under the final rule, 

consistent with the proposed rule, banks 

engaging in a traditional securitization 

may exclude the underlying exposures 

from the calculation of risk-weighted 

assets only if each of the following 

conditions is met: (i) The transfer is a 

sale under GAAP; (ii) the originating 

bank transfers to third parties credit risk 

associated with the underlying 

exposures; and (iii) any clean-up calls 

relating to the securitization are eligible 

clean-up calls (as discussed below). 

Originating banks that meet these 

conditions must hold regulatory capital 

against any securitization exposures 

they retain in connection with the 

securitization. Originating banks that 

fail to meet these conditions must hold 

regulatory capital against the transferred 

exposures as if they had not been 

securitized and must deduct from tier 1 

capital any gain-on-sale resulting from 

the transaction. The operational 

requirements for synthetic securitization 

are described in preamble section 

V.E.7., below. 

Consistent with the general risk-based 

capital rules, the above operational 

requirements refer specifically to GAAP 

for the purpose of determining whether 

a securitization transaction should be 

treated as an asset sale or a financing. 

In contrast, the New Accord stipulates 

guiding principles for use in 

determining whether sale treatment is 

warranted. One commenter requested 

that the agencies conform the proposed 

operational requirements for traditional 

securitizations to those in the New 

Accord. The agencies believe that the 

current conditions to qualify for sale 

treatment under GAAP are broadly 

consistent with the guiding principles 

enumerated in the New Accord. 

However, if GAAP in this area were to 

change materially in the future, the 

agencies would reassess, and possibly 

revise, the operational standards. 

Clean-Up Calls 

To satisfy the operational 

requirements for securitizations and 

enable an originating bank to exclude 

the underlying exposures from the 

calculation of its risk-based capital 

requirements, any clean-up call 

associated with a securitization must be 

an eligible clean-up call. The proposal 

defined a clean-up call as a contractual 

provision that permits a servicer to call 

securitization exposures (for example, 

asset-backed securities) before the stated 

(or contractual) maturity or call date. 

The preamble to the proposed rule 

explained that, in the case of a 

traditional securitization, a clean-up call 

is generally accomplished by 

repurchasing the remaining 

securitization exposures once the 

amount of underlying exposures or 

outstanding securitization exposures 

falls below a specified level. In the case 

of a synthetic securitization, the cleanup call may take the form of a clause 

that extinguishes the credit protection 

once the amount of underlying 

exposures has fallen below a specified 

level. 

Under the proposed rule, an eligible 

clean-up call would be a clean-up call 

that: 

(i) Is exercisable solely at the 

discretion of the servicer; 

(ii) Is not structured to avoid 

allocating losses to securitization 

exposures held by investors or 

otherwise structured to provide credit 

enhancement to the securitization (for 

example, to purchase non-performing 

underlying exposures); and 

(iii) (A) For a traditional 

securitization, is only exercisable when 

10 percent or less of the principal 

amount of the underlying exposures or 

securitization exposures (determined as 

of the inception of the securitization) is 

outstanding. 

(B) For a synthetic securitization, is 

only exercisable when 10 percent or less 

of the principal amount of the reference 

portfolio of underlying exposures 

(determined as of the inception of the 

securitization) is outstanding. 

A number of comments addressed the 

proposed definitions of clean-up call 

and eligible clean-up call. One 

commenter observed that prudential 

concerns would also be satisfied if the 

call were at the discretion of the 

originator of the underlying exposures. 

The agencies concur with this view and 

have modified the final rule to state that 

a clean-up call may permit the servicer 

or originating bank to call the 

securitization exposures before the 

stated maturity or call date, and that an 

eligible clean-up call must be 

exercisable solely at the discretion of 

the servicer or the originating bank. 

Commenters also requested clarification 

whether, for a securitization that 

involves a master trust, the 10 percent 

requirement described above in criteria 

(iii)(A) and (iii)(B) would be interpreted 

as applying to each series or tranche of 

securities issued from the master trust. 

The agencies believe this is a reasonable 

interpretation. Thus, where a 

securitization SPE is structured as a 

master trust, a clean-up call with respect 

to a particular series or tranche issued 

by the master trust would meet criteria 

(iii)(A) and (iii)(B) so long as the 

outstanding principal amount in that 

series was 10 percent or less of its 

original amount at the inception of the 

series. 

Additional Supervisory Guidance 

Over the last several years, the 

agencies have published a significant 

amount of supervisory guidance to 

assist banks with assessing the extent to 

which they have transferred credit risk 

and, consequently, may recognize any 

reduction in required regulatory capital 

as a result of a securitization or other 

form of credit risk transfer. 94 In general, 

the agencies expect banks to continue to 

use this guidance, most of which 

remains applicable to the advanced 

approaches securitization framework. 

Banks are encouraged to consult with 

their primary Federal supervisor about 

transactions that require additional 

guidance. 

2. Ratings-Based Approach (RBA) 

Under the final rule, as under the 

proposal, a bank must determine the 

risk-weighted asset amount for a 

securitization exposure that is eligible 

for the RBA by multiplying the amount 

of the exposure by the appropriate riskweight provided in the tables in section 

43 of the rule. Under the proposal, 

whether a securitization exposure was 

eligible for the RBA would depend on 

whether the bank holding the 

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69362 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

securitization exposure is an originating 

bank or an investing bank. An 

originating bank would be eligible to 

use the RBA for a securitization 

exposure if (i) the exposure had two or 

more external ratings, or (ii) the 

exposure had two or more inferred 

ratings. In contrast, an investing bank 

would be eligible to use the RBA for a 

securitization exposure if the exposure 

has one or more external or inferred 

ratings. A bank would be an originating 

bank if it (i) directly or indirectly 

originated or securitized the underlying 

exposures included in the 

securitization, or (ii) serves as an ABCP 

program sponsor to the securitization. 

The proposed rule defined an external 

rating as a credit rating assigned by a 

NRSRO to an exposure, provided (i) the 

credit rating fully reflects the entire 

amount of credit risk with regard to all 

payments owed to the holder of the 

exposure, and (ii) the external rating is 

published in an accessible form and is 

included in the transition matrices 

made publicly available by the NRSRO 

that summarize the historical 

performance of positions it has rated. 

For example, if a holder is owed 

principal and interest on an exposure, 

the credit rating must fully reflect the 

credit risk associated with timely 

repayment of principal and interest. 

Under the proposed rule, an exposure’s 

applicable external rating was the 

lowest external rating assigned to the 

exposure by any NRSRO. 

The proposed two-rating requirement 

for originating banks was the only 

material difference between the 

treatment of originating banks and 

investing banks under the proposed 

securitization framework. Although the 

two-rating requirement is not included 

in the New Accord, it is generally 

consistent with the treatment of 

originating and investing banks in the 

general risk-based capital rules. The 

agencies sought comment on whether 

this treatment was appropriate, and on 

possible alternative mechanisms that 

could be employed to ensure the 

reliability of external and inferred 

ratings on securitization exposures 

retained by originating banks. 

Commenters generally objected to the 

two-rating requirement for originating 

banks. Many asserted that since the 

credit risk of a given securitization 

exposure was the same regardless of the 

holder, the risk-based capital treatments 

also should be the same. Because 

external ratings would be publicly 

available, some commenters contended 

that NRSROs will have strong 

reputational reasons to give unbiased 

ratings—even to non-traded 

securitization exposures retained by 

originating banks. The agencies 

continue to believe that external ratings 

for securitization exposures retained by 

an originating bank, which typically are 

not traded, are subject to less market 

discipline than ratings for exposures 

sold to third parties. This disparity in 

market discipline warrants more 

stringent conditions on use of the 

former for risk-based capital purposes. 

Accordingly, the final rule retains the 

two-rating requirement for originating 

banks. 

Consistent with the New Accord, the 

final rule states that an unrated 

securitization exposure has an inferred 

rating if another securitization exposure 

issued by the same issuer and secured 

by the same underlying exposures has 

an external rating and this rated 

reference exposure (i) is subordinate in 

all respects to the unrated securitization 

exposure; (ii) does not benefit from any 

credit enhancement that is not available 

to the unrated securitization exposure; 

and (iii) has an effective remaining 

maturity that is equal to or longer than 

the unrated securitization exposure. 

Under the RBA, securitization 

exposures with an inferred rating are 

treated the same as securitization 

exposures with an identical external 

rating. This definition does not permit 

a bank to assign an inferred rating based 

on the ratings of the underlying 

exposures in a securitization, even 

when the unrated securitization 

exposure is secured by a single, 

externally rated security. In particular, 

such a look-through approach would 

fail to meet the requirements that the 

rated reference exposure must be issued 

by the same issuer, secured by the same 

underlying assets, and subordinated in 

all respects to the unrated securitization 

exposure. 

The agencies sought comment on 

whether they should consider other 

bases for inferring a rating for an 

unrated securitization position, such as 

using an applicable credit rating on 

outstanding long-term debt of the issuer 

or guarantor of the securitization 

exposure. In situations where an 

unrated securitization exposure 

benefited from a guarantee that covered 

all contractual payments associated 

with the securitization exposure, several 

commenters advocated allowing an 

inferred rating to be assigned based on 

the long-term rating of the guarantor. In 

addition, some commenters 

recommended that if a senior, unrated 

securitization exposure is secured by a 

single externally rated underlying 

security, a bank should be permitted to 

assign an inferred rating for the unrated 

exposure using a look-through 

approach. 

The agencies do not believe there is 

a compelling need at this time to 

supplement the New Accord’s methods 

for determining an inferred rating. 

However, if a need develops in the 

future, the agencies will seek to revise 

the New Accord in coordination with 

the BCBS and other supervisory and 

regulatory authorities. In the situations 

cited above, the framework already 

provides simplified methods for 

calculating a securitization exposure’s 

risk-based capital requirement. For 

example, when a securitization 

exposure benefits from a full guarantee, 

such as from an externally rated 

monoline insurance company, the 

exposure’s external rating often will 

reflect that guarantee. When the 

guaranteed securitization exposure is 

not externally rated, subject to the rules 

for recognition of guarantees of 

securitization exposures in section 46, 

the unrated securitization exposure may 

be treated as a direct (wholesale) 

exposure to the guarantor. In addition, 

when a securitization exposure to an 

ABCP program is secured by a single, 

externally rated asset, a look-through 

approach may be possible under the 

IAA provided that such a look-through 

is no less conservative than the 

applicable NRSRO rating 

methodologies. 

Under the proposal, if a securitization 

exposure had multiple external ratings 

or multiple inferred ratings, a bank 

would be required to use the lowest 

rating (the rating that would produce 

the highest risk-based capital 

requirement). Commenters objected that 

this treatment was significantly more 

conservative than required by the New 

Accord, which permits use of the 

second most favorable rating, and would 

unfairly penalize banks in situations 

where the lowest rating was unsolicited 

or an outlier. The agencies recognize 

commenters’ concerns regarding 

unsolicited ratings, and note that the 

New Accord states banks should use 

solicited ratings. To maintain 

consistency with the general risk-based 

capital rules, the final rule defines the 

applicable external rating of a 

securitization exposure to be its lowest 

solicited external rating and the 

applicable inferred rating of a 

securitization exposure to be the 

inferred rating based on its lowest 

solicited external rating. 

For securitization exposures eligible 

for the RBA, the risk-based capital 

requirement per dollar of securitization 

exposure depends on four factors: (i) 

The applicable rating of the exposure; 

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

exposure’s credit risk; (iii) whether the 

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Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 69363 

exposure is a ‘‘senior’’ exposure; and 

(iv) a measure of the effective number 

(‘‘N’’) of underlying exposures. In 

response to a specific question posed by 

the agencies, commenters generally 

supported linking risk weights under 

the RBA to these factors. 

In the proposed rule, a ‘‘senior 

securitization exposure’’ was defined as 

a securitization exposure that has a first 

priority claim on the cash flows from 

the underlying exposures, disregarding 

the claims of a service provider (such as 

a swap counterparty or trustee, 

custodian, or paying agent for the 

securitization) to fees from the 

securitization. Generally, only the most 

senior tranche of a securitization would 

be a senior securitization exposure. For 

example, if multiple tranches of a 

securitization share the transaction’s 

highest rating, only the tranche with the 

shortest remaining maturity would be 

treated as senior, since other tranches 

with the same rating would not have a 

first claim to cash flows throughout 

their lifetimes. A liquidity facility that 

supports an ABCP program would be a 

senior securitization exposure if the 

liquidity facility provider’s right to 

reimbursement of the drawn amounts 

was senior to all claims on the cash 

flows from the underlying exposures 

except claims of a service provider to 

fees. 

In the final rule, the agencies 

modified this definition to clarify two 

points. First, in the context of an ABCP 

program, the final rule specifically 

states that both the most senior 

commercial paper issued by the 

program and a liquidity facility 

supporting the program may be ‘‘senior’’

exposures if the liquidity facility 

provider’s right to reimbursement of any 

drawn amounts is senior to all claims on 

the cash flow from the underlying 

exposures. Second, the final rule 

clarifies that when determining whether 

a securitization exposure is senior, a 

bank is not required to consider any 

amounts due under interest rate or 

currency derivative contracts, fees due, 

or other similar payments. 

Consistent with the New Accord, a 

bank must use Table F below when a 

securitization exposure qualifies for the 

RBA based on a long-term external 

rating or an inferred rating based on a 

long-term external rating. A bank may 

apply the risk weights in column 1 of 

Table F to the securitization exposure 

only if the N is six or more and the 

securitization exposure is a senior 

securitization exposure. If N is six or 

more but the securitization exposure is 

not a senior securitization exposure, the 

bank must apply the risk weights in 

column 2 of Table F. Applying the 

principle of conservatism, however, if N 

is six or more a bank may use the risk 

weights in column 2 of Table F without 

determining whether the exposure is 

senior. A bank must apply the risk 

weights in column 3 of Table F to the 

securitization exposure if N is less than 

six. 

In certain situations the rule provides 

a simplified approach for determining 

N. If the notional number of underlying 

exposures of a securitization is 25 or 

more or if all the underlying exposures 

are retail exposures, a bank may assume 

that N is six or more (unless the bank 

knows or has reason to know that N is 

less than six). However, if the notional 

number of underlying exposures of a 

securitization is less than 25 and one or 

more of the underlying exposures is a 

non-retail exposure, the bank must 

compute N as described in the SFA 

section below. 

A few commenters wanted to 

determine N only at the inception of a 

securitization transaction, due to the 

burden of tracking N over time. The 

agencies believe that a bank must track 

N over time to ensure an appropriate 

risk-based capital requirement. The 

number of underlying exposures in a 

securitization typically changes over 

time as some underlying exposures are 

repaid or default. As the number of 

underlying exposures changes, the risk 

profile of the associated securitization 

exposures changes, and a bank must 

reflect this change in risk profile in its 

risk-based capital requirement. 

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

Applicable external or inferred rating 

(illustrative rating example) 

Column 1 Column 2 Column 3 

Risk weights for 

senior 

securitization exposures backed 

by granular pools 

(percent) 

Risk weights for 

non-senior 

securitization exposures backed 

by granular pools 

(percent) 

Risk weights for 

securitization exposures backed 

by non-granular 

pools 

(percent) 

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

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

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

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

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

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

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

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

One category below investment grade—positive designation (for example, 

BB+) ........................................................................................................... 250 

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

One category below investment grade—negative designation (for example, 

BB¥) .......................................................................................................... 650 

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95See Vladislav Peretyatkin and William 

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

Bank of England, February 2003. 

96See, e.g., Michael Pykhtin and Ashish Dev, 

‘‘Credit Risk in Asset Securitizations: An Analytical 

Model,’’ Risk (May 2002) S16–S20. 

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

Applicable external or inferred rating 

(illustrative rating example) 

Column 1 Column 2 Column 3 

Risk weights for 

senior 

securitization exposures backed 

by granular pools 

(percent) 

Risk weights for 

non-senior 

securitization exposures backed 

by granular pools 

(percent) 

Risk weights for 

securitization exposures backed 

by non-granular 

pools 

(percent) 

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

A bank must apply the risk weights in 

Table G when the securitization 

exposure qualifies for the RBA based on 

a short-term external rating or an 

inferred rating based on a short-term 

external rating. A bank must apply the 

decision rules outlined in the previous 

paragraph to determine which column 

of Table G applies. 

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

Applicable external or inferred rating 

(illustrative rating example) 

Column 1 Column 2 Column 3 

Risk weights for 

senior 

securitization exposures backed 

by granular pools 

(percent) 

Risk weights for 

non-senior 

securitization exposures backed 

by granular pools 

(percent) 

Risk weights for 

securitization exposures backed 

by non-granular 

pools 

(percent) 

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

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

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

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

Within Tables G and H, risk weights 

increase as rating grades decline. Under 

column 2 of Table F, for example, the 

risk weights range from 12 percent for 

exposures with the highest investmentgrade rating to 650 percent for 

exposures rated one category below 

investment grade with a negative 

designation. This pattern of risk weights 

is broadly consistent with analyses 

employing standard credit risk models 

and a range of assumptions regarding 

correlation effects and the types of 

exposures being securitized.95 These 

analyses imply that, compared with a 

corporate bond having a given level of 

stand-alone credit risk (for example, as 

measured by its expected loss rate), a 

securitization tranche having the same 

level of stand-alone credit risk—but 

backed by a reasonably granular and 

diversified pool—will tend to exhibit 

more systematic risk.96 This effect is 

most pronounced for below-investmentgrade tranches and is the primary reason 

why the RBA risk-weights increase 

rapidly as ratings deteriorate over this 

range—much more rapidly than for 

similarly rated corporate bonds. 

Under the RBA, a securitization 

exposure that has an investment-grade 

rating and has fewer than six effective 

underlying exposures generally receives 

a higher risk weight than a similarly 

rated securitization exposure with six or 

more effective underlying exposures. 

This treatment is intended to discourage 

a bank from engaging in regulatory 

capital arbitrage by securitizing very 

high-quality wholesale exposures 

(wholesale exposures with a low PD and 

LGD), obtaining external ratings on the 

securitization exposures issued by the 

securitization, and retaining essentially 

all the credit risk of the pool of 

underlying exposures. 

A bank must deduct from regulatory 

capital any securitization exposure with 

an external or inferred rating lower than 

one category below investment grade for 

long-term ratings or below investment 

grade for short-term ratings. Although 

this treatment is more conservative than 

suggested by credit risk modeling 

analyses, the agencies believe that 

deducting such exposures from 

regulatory capital is appropriate in light 

of significant modeling uncertainties for 

such low-rated securitization tranches. 

Moreover, external ratings of these 

tranches are subject to less market 

discipline because these positions 

generally are retained by the bank and 

are not traded. 

The most senior tranches of granular 

securitizations with long-term 

investment-grade external ratings 

receive a more favorable risk weight as 

compared to more subordinated 

tranches of the same securitizations. To 

be considered granular, a securitization 

must have an N of at least six. 

Consistent with the New Accord, the 

lowest possible risk-weight, 7 percent, 

applies only to senior securitization 

exposures receiving the highest external 

rating (for example, AAA) and backed 

by a granular asset pool. 

The agencies sought comment on how 

well the risk weights in Tables G and H 

capture the most important risk factors 

for securitization exposures of varying 

degrees of seniority and granularity. A 

number of commenters contended that, 

in the interest of competitive equity, the 

risk weight for senior securitization 

exposures having the highest rating and 

backed by a granular asset pool should 

be 6 percent, the level specified in the 

European Union’s Capital Requirements 

Directive (CRD). The agencies decided 

against making this change. There is no 

compelling empirical evidence to 

support a 6 percent risk weight for all 

exposures satisfying these conditions 

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and, further, a 6 percent risk weight is 

inconsistent with the New Accord. 

Moreover, estimates of the credit risk 

associated with such positions tend to 

be highly sensitive to subjective 

modeling assumptions and to the 

specific types of underlying assets and 

structure of the transaction, which 

supports the use of the more 

conservative approach in the New 

Accord. 

3. Internal Assessment Approach (IAA) 

Under the final rule, as under the 

proposal, a bank is permitted to 

compute its risk-based capital 

requirement for a securitization 

exposure to an ABCP program (such as 

a liquidity facility or credit 

enhancement) using the bank’s internal 

assessment of the credit quality of the 

securitization exposure. The ABCP 

program may be sponsored by the bank 

itself or by a third party. To apply the 

IAA, the bank’s internal assessment 

process and the ABCP program must 

meet certain qualification requirements 

in section 44 of the final rule, and the 

securitization exposure must initially be 

internally rated at least equivalent to 

investment grade. A bank that elects to 

use the IAA for any securitization 

exposure to an ABCP program must use 

the IAA to compute risk-based capital 

requirements for all securitization 

exposures that qualify for the IAA. 

Under the IAA, a bank maps its internal 

credit assessment of a securitization 

exposure to an equivalent external 

credit rating from an NRSRO. The bank 

must determine the risk-weighted asset 

amount for a securitization exposure by 

multiplying the amount of the exposure 

(using the methodology set forth above 

in the RBA section) by the appropriate 

risk weight provided in Table F or G 

above. 

Under the proposal, a bank required 

prior written approval from its primary 

Federal supervisor before it could use 

the IAA. Several commenters objected 

to this requirement maintaining that 

approval is not required under the New 

Accord and would likely delay a bank 

being authorized to use the IAA for new 

ABCP programs. Instead, commenters 

requested a submission and nonobjection approach, under which a bank 

would be allowed to use the IAA in the 

absence of any objection from its 

supervisor based on examination 

findings. The final rule retains the 

requirement for prior written approval 

before a bank can use the IAA. Like 

other optional approaches in the final 

rule (for example, the double default 

treatment and the internal models 

methodology), it is important that the 

primary Federal supervisor have an 

opportunity to review a bank’s practices 

relative to the final rule before allowing 

a bank to use the optional approach. If 

a bank chooses to implement the IAA at 

the same time that it implements the 

advanced approaches, the IAA review 

and approval process will be part of the 

overall qualification process. If a bank 

chooses to implement the IAA after it 

has qualified for the advanced 

approaches, prior written approval is a 

necessary safeguard for ensuring 

appropriate application of the IAA. 

Furthermore, the agencies believe this 

requirement can be implemented 

without impeding future innovations in 

ABCP programs. 

Similar to the proposed rule, under 

the final rule a bank must demonstrate 

that its internal credit assessment 

process satisfies all the following 

criteria in order to receive approval to 

use the IAA. 

The bank’s internal credit assessments 

of securitization exposures to ABCP 

programs must be based on publicly 

available rating criteria used by an 

NRSRO for evaluating the credit risk of 

the underlying exposures. The 

requirement that an NRSRO’s rating 

criteria be publicly available does not 

mean that these criteria must be 

published formally by the NRSRO. 

While the agencies expect banks to rely 

on published rating criteria when these 

criteria are available, an NRSRO often 

delays publication of rating criteria for 

securitizations involving new asset 

types until the NRSRO builds sufficient 

experience with such assets. Similarly, 

as securitization structures evolve over 

time, published criteria may be revised 

with some lag. Especially for 

securitizations involving new structures 

or asset types, the requirement that 

rating criteria be publicly available 

should be interpreted broadly to 

encompass not only published criteria, 

but also criteria that are obtained 

through written correspondence or other 

communications with an NRSRO. In 

such cases, these communications 

should be documented and available for 

review by the bank’s primary Federal 

supervisor. The agencies believe this 

flexibility is appropriate only for unique 

situations when published rating 

criteria are not generally applicable. 

A commenter asked whether the 

applicable NRSRO rating criteria must 

cover all contractual payments owed to 

the bank holding the exposure, or only 

contractual principal and interest. For 

example, liquidity facilities typically 

obligate the seller to make certain future 

fee and indemnity payments directly to 

the liquidity bank. These ancillary 

obligations, however, are not an 

exposure to the ABCP program and 

would not normally be covered by 

NRSRO rating criteria, which focus on 

the risks of the underlying assets and 

the exposure’s vulnerability to those 

risks. The agencies agree that such 

ancillary obligations of the seller need 

not be covered by the applicable NRSRO 

rating criteria for an exposure to be 

eligible for the IAA. 

To be eligible for the IAA, a bank 

must also demonstrate that its internal 

credit assessments of securitization 

exposures used for regulatory capital 

purposes are consistent with those used 

in its internal risk management process, 

capital adequacy assessment process, 

and management information reporting 

systems. The bank must also 

demonstrate that its internal credit 

assessment process has sufficient 

granularity to identify gradations of risk. 

Each of the bank’s internal credit 

assessment categories must correspond 

to an external credit rating of an 

NRSRO. In addition, the bank’s internal 

credit assessment process, particularly 

the stress test factors for determining 

credit enhancement requirements, must 

be at least as conservative as the most 

conservative of the publicly available 

rating criteria of the NRSROs that have 

provided external credit ratings to the 

commercial paper issued by the ABCP 

program. In light of recent events in the 

securitization market, the agencies 

emphasize that if an NRSRO that 

provides an external rating to an ABCP 

program’s commercial paper changes its 

methodology, the bank must evaluate 

whether to revise its internal assessment 

process. 

Moreover, the bank must have an 

effective system of controls and 

oversight that ensures compliance with 

these operational requirements and 

maintains the integrity and accuracy of 

the internal credit assessments. The 

bank must also have an internal audit 

function independent from the ABCP 

program business line and internal 

credit assessment process that assesses 

at least annually whether the controls 

over the internal credit assessment 

process function as intended. The bank 

must review and update each internal 

credit assessment whenever new 

material information is available, but no 

less frequently than annually. The bank 

must also validate its internal credit 

assessment process on an ongoing basis, 

but not less frequently than annually. 

Under the proposed rule, in order for 

a bank to use the IAA on a specific 

exposure to an ABCP program, the 

program had to satisfy the following 

requirements: 

(i) All commercial paper issued by the 

ABCP program must have an external 

rating. 

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69366 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

(ii) The ABCP program must have 

robust credit and investment guidelines 

(underwriting standards). 

(iii) The ABCP program must perform 

a detailed credit analysis of the asset 

sellers’ risk profiles. 

(iv) The ABCP program’s 

underwriting policy must establish 

minimum asset eligibility criteria that 

include a prohibition of the purchase of 

assets that are significantly past due or 

defaulted, as well as limitations on 

concentrations to an individual obligor 

or geographic area and the tenor of the 

assets to be purchased. 

(v) The aggregate estimate of loss on 

an asset pool that the ABCP program is 

considering purchasing must consider 

all sources of potential risk, such as 

credit and dilution risk. 

(vi) The ABCP program must 

incorporate structural features into each 

purchase of assets to mitigate potential 

credit deterioration of the underlying 

exposures. Such features may include 

wind-down triggers specific to a pool of 

underlying exposures. 

Commenters suggested that the 

program-level eligibility criteria should 

apply only to those elements of the 

ABCP program that are relevant to the 

securitization exposure held by the bank 

in order to prevent an ABCP program’s 

purchase of a single asset pool that does 

not meet the above criteria from 

disallowing the IAA for securitization 

exposures to that program that are 

unrelated to the non-qualifying asset 

pool. The agencies agree that this is a 

reasonable approach. Accordingly, the 

final rule applies criteria (ii) through 

(vi) to the exposures underlying a 

securitization exposure, rather than to 

the entire ABCP program. For a 

program-wide credit enhancement 

facility, all of the separate seller-specific 

arrangements benefiting from that 

facility must meet the above 

requirements for the facility to be 

eligible for the IAA. 

Several commenters objected to the 

requirement that the ABCP program 

prohibit purchases of significantly pastdue or defaulted assets. Commenters 

contended that such purchases should 

be allowed so long as the applicable 

NRSRO rating criteria permit and deal 

appropriately with such assets. Like the 

New Accord, the final rule prohibits the 

ABCP program from purchasing 

significantly past-due or defaulted 

assets in order to ensure that the IAA is 

applied only to securitization exposures 

that are relatively low-risk at inception. 

This criterion would be met if the ABCP 

program does not fund underlying 

assets that are significantly past due or 

defaulted when placed into the program 

(that is, the program’s advance rate 

against such assets is 0 percent) and the 

securitization exposure is not subject to 

potential losses associated with these 

assets. The agencies observe that the 

rule does not set a specific number-ofdays-past due criterion. In addition, the 

term ‘defaulted assets’ in criterion (iv) 

does not refer to the wholesale and 

retail definitions of default in the final 

rule, but rather may be interpreted as 

referring to assets that have been 

charged off or written down by the 

seller prior to being placed into the 

ABCP program or to assets that would 

be charged off or written down under 

the program’s governing contracts. 

In addition, commenters asked the 

agencies to clarify that a bank may 

ignore one or more of the eligibility 

requirements where the requirement is 

not relevant to a particular exposure. 

For example, in the case of a liquidity 

facility supporting a static pool of term 

loans, it may not be possible to 

incorporate features into the transaction 

that mitigate against a potential 

deterioration in these assets, and there 

may be no use for detailed credit 

analyses of the seller following the 

securitization if the seller has no further 

involvement with the transaction. The 

agencies have modified the final 

criterion for determining whether an 

exposure qualifies for the IAA, to 

specify that where relevant, the ABCP 

program must incorporate structural 

features into each purchase of exposures 

underlying the securitization exposure 

to mitigate potential credit deterioration 

of the underlying exposures. 

4. Supervisory Formula Approach (SFA) 

General Requirements 

Under the proposed rule, a bank using 

the SFA would determine the riskweighted asset amount for a 

securitization exposure by multiplying 

the SFA risk-based capital requirement 

for the exposure (as determined by the 

supervisory formula set forth below) by 

12.5. If the SFA risk weight for a 

securitization exposure was 1,250 

percent or greater, however, the bank 

would deduct the exposure from total 

capital rather than risk weight the 

exposure. The agencies noted that 

deduction is consistent with the 

treatment of other high-risk 

securitization exposures, such as CEIOs. 

The SFA capital requirement for a 

securitization exposure depends on the 

following seven inputs: 

(i) The amount of the underlying 

exposures (UE); 

(ii) The securitization exposure’s 

proportion of the tranche that contains 

the securitization exposure (TP); 

(iii) The sum of the risk-based capital 

requirement and ECL for the underlying 

exposures (as determined under the 

final rule as if the underlying exposures 

were held directly on the bank’s balance 

sheet) divided by the amount of the 

underlying exposures (KIRB); 

(iv) The tranche’s credit enhancement 

level (L); 

(v) The tranche’s thickness (T); 

(vi) The securitization’s effective 

number of underlying exposures (N); 

and 

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

(EWALGD). 

A bank may only use the SFA to 

determine its risk-based capital 

requirement for a securitization 

exposure if the bank can calculate each 

of these seven inputs on an ongoing 

basis. In particular, if a bank cannot 

compute KIRB because the bank cannot 

compute the risk-based capital 

requirement for all underlying 

exposures, the bank may not use the 

SFA to compute its risk-based capital 

requirement for the securitization 

exposure. In those cases, the bank must 

deduct the exposure from regulatory 

capital. 

The SFA capital requirement for a 

securitization exposure is UE multiplied 

by TP multiplied by the greater of (i) 

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

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97New Accord, Annex 7. 

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

to the cumulative beta distribution with 

parameters a and b evaluated at Y. In 

the case where N = 1 and EWALGD = 

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

calculated with K[Y] set equal to the 

product of KIRB and Y, and d set equal 

to 1–KIRB. The major inputs to the SFA 

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

and N) are defined below and in section 

45 of the final rule. 

The agencies are modifying the SFA 

treatment of certain high risk 

securitization exposures in the final 

rule. Under the proposed treatment 

described above, a bank would have to 

deduct from total capital any 

securitization exposure with a SFA risk 

weight equal to 1,250 percent. Under 

certain circumstances, however, a slight 

increase in the thickness of the tranche 

that contains the securitization exposure 

(T), holding other SFA risk parameters 

fixed, could cause the exposure’s SFA 

risk-weight to fall below 1,250 percent. 

As a result, the bank would not deduct 

any part of the exposure from capital 

and would, instead, reflect the entire 

amount of the SFA risk-based capital 

requirement in its risk-weighted assets. 

Consistent with the New Accord,97 the 

agencies have removed this anomaly 

from the final rule. Under the final rule 

a bank must deduct from total capital 

any part of a securitization exposure 

that incurs a 1,250 percent risk weight 

under the SFA (that is, any part of a 

securitization exposure covering loss 

rates on the underlying assets between 

zero and KIRB). Any part of a 

securitization exposure that incurs less 

than a 1,250 percent risk weight must be 

risk weighted rather than deducted. 

To illustrate, suppose that an 

exposure’s SFA capital requirement 

equaled $15, and UE, TP, KIRB, and L 

equaled $1000, 1.0, 0.10, and 0.095, 

respectively. The bank must deduct 

from total capital $5 (UE × TP × (KIRB

–L)), and the exposure’s risk-weighted 

asset amount would be $125 (($15–$5) 

× 12.5). 

The specific securitization exposures 

that are subject to this deduction 

treatment under the SFA may change 

over time in response to variations in 

the credit quality of the underlying 

exposures. For example, if the pool’s 

IRB capital requirement were to increase 

after the inception of a securitization, 

additional portions of unrated 

securitization exposures may fall below 

KIRB and thus become subject to 

deduction under the SFA. Therefore, if 

at the inception of a securitization a 

bank owns an unrated securitization 

exposure well in excess of KIRB, the 

capital requirement on the exposure 

could climb rapidly in the event of 

marked deterioration in the credit 

quality of the underlying exposures and 


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69368 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

98The conceptual basis for specification of K[x] 

is developed in Michael B. Gordy and David Jones, 

‘‘Random Tranches,’’ Risk (March 2003), 16(3), 78–

83. 

99See Michael Pykhtin and Ashish Dev, ‘‘Coarsegrained CDOs,’’ Risk (January 2003), 16(1), 113–116. 

the bank may be required to deduct the 

exposure. 

The SFA formula effectively imposes 

a 56 basis point minimum risk-based 

capital requirement (8 percent of the 7 

percent risk weight) per dollar of 

securitization exposure. Although such 

a floor may impose a capital 

requirement that is too high for some 

securitization exposures, the agencies 

continue to believe that some minimum 

prudential capital requirement is 

appropriate in the securitization 

context. This 7 percent risk-weight floor 

is also consistent with the lowest capital 

requirement available under the RBA 

and, thus, should reduce incentives for 

regulatory capital arbitrage. 

The SFA formula is a blend of credit 

risk modeling results and supervisory 

judgment. The function S[Y] 

incorporates two distinct features. The 

first is a pure model-based estimate of 

the pool’s aggregate systematic or nondiversifiable credit risk that is 

attributable to a first loss position 

covering losses up to and including Y. 

Because the tranche of interest covers 

losses over a specified range (defined in 

terms of L and T), the tranche’s 

systematic risk can be represented as 

S[L+T] ¥ S[L]. The second feature 

involves a supervisory add-on primarily 

intended to avoid behavioral distortions 

associated with what would otherwise 

be a discontinuity in capital 

requirements for relatively thin 

mezzanine tranches lying just below 

and just above the KIRB boundary. 

Without this add-on, all tranches at or 

below KIRB would be deducted from 

capital, whereas a very thin tranche just 

above KIRB would incur a pure modelbased percentage capital requirement 

that could vary between zero and one, 

depending on the number of effective 

underlying exposures (N). The 

supervisory add-on applies primarily to 

positions just above KIRB, and its 

quantitative effect diminishes rapidly as 

the distance from KIRB widens. 

Apart from the risk-weight floor and 

other supervisory adjustments described 

above, the supervisory formula attempts 

to be as consistent as possible with the 

parameters and assumptions of the IRB 

approach that would apply to the 

underlying exposures if held directly by 

a bank.98 The specification of S[Y] 

assumes that KIRB is an accurate 

measure of the total systematic credit 

risk of the pool of underlying exposures 

and that a securitization merely 

redistributes this systematic risk among 

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

embodies precisely the same asset 

correlations as are assumed elsewhere 

within the IRB approach. In addition, 

this specification embodies the result 

that a pool’s systematic risk (KIRB) tends 

to be redistributed toward more senior 

tranches as N declines.99 The 

importance of pool granularity depends 

on the pool’s average loss severity rate, 

EWALGD. For small values of N, the 

framework implies that, as EWALGD 

increases, systematic risk is shifted 

toward senior tranches. For highly 

granular pools, such as securitizations 

of retail exposures, EWALGD would 

have no influence on the SFA capital 

requirement. 

Inputs to the SFA Formula 

Consistent with the proposal, the final 

rule defines the seven inputs into the 

SFA formula as follows: 

(i) Amount of the underlying 

exposures (UE). This input (measured in 

dollars) is the EAD of any underlying 

wholesale and retail exposures plus the 

amount of any underlying exposures 

that are securitization exposures (as 

defined in section 42(e) of the proposed 

rule) plus the adjusted carrying value of 

any underlying equity exposures (as 

defined in section 51(b) of the proposed 

rule). UE also includes any funded 

spread accounts, cash collateral 

accounts, and other similar funded 

credit enhancements. 

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

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

securitization exposure to (ii) the 

amount of the securitization tranche 

that contains the bank’s securitization 

exposure. 

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

risk-based capital requirement for the 

underlying exposures plus the ECL of 

the underlying exposures (all as 

determined as if the underlying 

exposures were directly held by the 

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

includes the ECL of the underlying 

exposures in the numerator because if 

the bank held the underlying exposures 

on its balance sheet, the bank also 

would hold reserves against the 

exposures. 

The calculation of KIRB must reflect 

the effects of any credit risk mitigant 

applied to the underlying exposures 

(either to an individual underlying 

exposure, a group of underlying 

exposures, or to the entire pool of 

underlying exposures). In addition, all 

assets related to the securitization must 

be treated as underlying exposures for 

purposes of the SFA, including assets in 

a reserve account (such as a cash 

collateral account). 

In practice, a bank’s ability to 

calculate KIRB will often determine 

whether it can use the SFA or whether 

it must instead deduct an unrated 

securitization exposure from total 

capital. As noted above, there is a need 

for flexibility when the estimation of 

KIRB is constrained by data 

shortcomings, such as when the bank 

holding the securitization exposure is 

not the servicer of the underlying assets. 

The final rule clarifies that the 

simplified approach for eligible 

purchased wholesale exposures (Section 

31) may be used for calculating KIRB. 

To reduce the operational burden of 

estimating KIRB, several commenters 

urged the agencies to develop a simple 

look-through approach such that when 

all of the assets held by the SPE are 

externally rated, KIRB could be 

determined directly from the external 

ratings of theses assets. The agencies 

believe that a look-through approach for 

estimating KIRB would be inconsistent 

with the New Accord and would 

increase the potential for capital 

arbitrage. The agencies note that several 

simplified methods for estimating riskweighted assets for the underlying 

exposures for the purposes of 

computing KIRB are provided in other 

parts of the framework. For example, the 

simplified approach for eligible 

purchased wholesale exposures in 

section 31 may be available when a 

bank can estimate risk parameters for 

segments of underlying wholesale 

exposures but not for each of the 

individual exposures. If the assets held 

by the SPE are securitization exposures 

with external ratings, the RBA would be 

used to determine risk-weighted assets 

for the underlying exposures based on 

these ratings. If the assets held by the 

SPE represent shares in an investment 

company (that is, unleveraged, pro rata 

ownership interests in a pool of 

financial assets), the bank may be 

eligible to determine risk-weighted 

assets for the underlying exposures 

using the Alternative Modified LookThrough Approach of Section 54 (d) 

based on investment limits specified in 

the program’s prospectus or similar 

documentation. 

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

the ratio of (i) the amount of all 

securitization exposures subordinated to 

the securitization tranche that contains 

the bank’s securitization exposure to (ii) 

UE. Banks must determine L before 

considering the effects of any tranchespecific credit enhancements (such as 

third-party guarantees that benefit only 

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Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 69369 

sale or CEIOs associated with the 

securitization may not be included in L. 

Any reserve account funded by 

accumulated cash flows from the 

underlying exposures that is 

subordinated to the tranche that 

contains the bank’s securitization 

exposure may be included in the 

numerator and denominator of L to the 

extent cash has accumulated in the 

account. Unfunded reserve accounts 

(reserve accounts that are to be funded 

from future cash flows from the 

underlying exposures) may not be 

included in the calculation of L. 

In some cases, the purchase price of 

receivables will reflect a discount that 

provides credit enhancement (for 

example, first loss protection) for all or 

certain tranches. When this arises, L 

should be calculated inclusive of this 

discount if the discount provides credit 

enhancement for the securitization 

exposure. 

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

ratio of (i) the size of the tranche that 

contains the bank’s securitization 

exposure to (ii) UE. 

(vi) Effective number of exposures (N). 

As a general matter, the effective 

number of exposures is calculated as 

follows: 

where EADi represents the EAD 

associated with the ith instrument in the 

pool of underlying exposures. For 

purposes of computing N, multiple 

exposures to one obligor must be treated 

as a single underlying exposure. In the 

case of a re-securitization (a 

securitization in which some or all of 

the underlying exposures are 

themselves securitization exposures), a 

bank must treat each underlying 

securitization exposure as a single 

exposure and must not look through to 

the exposures that secure the underlying 

securitization exposures. 

N represents the granularity of a pool 

of underlying exposures using an 

‘‘effective’’ number of exposures 

concept rather than a ‘‘gross’’ number of 

exposures concept to appropriately 

assess the diversification of pools that 

have individual underlying exposures of 

different sizes. An approach that simply 

counts the gross number of underlying 

exposures in a pool treats all exposures 

in the pool equally. This simplifying 

assumption could radically overestimate 

the granularity of a pool with numerous 

small exposures and one very large 

exposure. The effective exposure 

approach captures the notion that the 

risk profile of such an unbalanced pool 

is more like a pool of several mediumsized exposures than like a pool of a 

large number of equally sized small 

exposures. 

For example, suppose Pool A contains 

four loans with EADs of $100 each. 

Under the formula set forth above, N for 

Pool A would be four, precisely equal to 

the actual number of exposures. 

Suppose Pool B also contains four loans: 

One loan with an EAD of $100 and three 

loans with an EAD of $1. Although both 

pools contain four loans, Pool B is much 

less diverse and granular than Pool A 

because Pool B is dominated by the 

presence of a single $100 loan. 

Intuitively, therefore, N for Pool B 

should be closer to one than to four. 

Under the formula in the rule, N for 

Pool B is calculated as follows: 

N = ( ) +++

+++ = = 100 1 1 1100 1 1 1

10 609

10 003

1 06

2

2222

,

, .

As noted above, when calculating N 

for a re-securitization, a bank must treat 

each underlying securitization exposure 

as an exposure to a single obligor. This 

conservative treatment addresses the 

concern that AVCs among securitization 

exposures can be much greater than the 

AVCs among the underlying individual 

assets securing these securitization 

exposures. Because the framework’s 

simple approach to re-securitizations 

may result in the differential treatment 

of economically similar securitization 

exposures, the agencies sought comment 

on alternative approaches for 

determining the N of a re-securitization. 

While a number of commenters urged 

that a bank be permitted to calculate N 

for re-securitizations of asset-backed 

securities by looking through to the 

underlying pools of assets securing 

these securities, none provided 

theoretical or empirical evidence to 

support this recommendation. Absent 

such evidence, the final rule remains 

consistent with New Accord’s 

measurement of N for re-securitizations. 

(vii) Exposure-weighted average loss 

given default (EWALGD). The EWALGD 

is calculated as: 

where LGDi represents the average LGD 

associated with all exposures to the ith

obligor. In the case of a re-securitization, 

an LGD of 100 percent must be assumed 

for any underlying exposure that is a 

securitization exposure. 

Although this treatment of EWALGD 

is consistent with the New Accord, 

several commenters asserted that 

assigning an LGD of 100 percent to all 

securitization exposures in the 

underlying pool was excessively 

conservative, particularly for underlying 

exposures that are senior, highly rated 

asset-backed securities. The agencies 

acknowledge that in many situations an 

LGD significantly lower than 100 

percent may be appropriate. However, 

determination of the appropriate LGD 

depends on many complex factors, 

including the characteristics of the 

underlying assets and structural features 

of the securitization, such as the 

securitization exposure’s thickness. 

Moreover, for thin securitization 

exposures or certain mezzanine 

positions backed by low-quality assets, 

the LGD may in fact be close to 100 

percent. In this light, the agencies 

believe that any simple alternative to 

the New Accord’s measurement of 

EWALGD would increase the potential 

for capital arbitrage, and any more risksensitive alternative would take 

considerable time to develop. Thus, the 

agencies have retained the proposed 

treatment, consistent with the New 

Accord. 

Under certain conditions, a bank may 

employ the following simplifications to 

the SFA. First, for securitizations all of 

whose underlying exposures are retail 

exposures, a bank may set h=0 and v=0. 

In addition, if the share of a 

securitization corresponding to the 

largest underlying exposure (C1) is no 

more than 0.03 (or 3 percent of the 

underlying exposures), then for 

purposes of the SFA the bank may set 

N equal to the following amount: 


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

the amounts of the largest ‘‘m’’

underlying exposures of the 

securitization; to (ii) UE. A bank may 

select the level of ‘‘m’’ using its 

discretion. For example, if the three 

largest underlying exposures of a 

securitization represent 15 percent of 

the pool of underlying exposures, C3 for 

the securitization is 0.15. As an 

alternative simplification option, if only 

C1 is available, and C1 is no more than 

0.03, then the bank may set N=1/C1. 

Under both simplification options a 

bank may set EWALGD=0.50 unless one 

or more of the underlying exposures is 

a securitization exposure. If one or more 

of the underlying exposures is a 

securitization exposure, a bank using a 

simplification option must set 

EWALGD=1. 

5. Eligible Market Disruption Liquidity 

Facilities 

Under the proposed SFA, there was 

no special treatment provided for ABCP 

liquidity facilities that could be drawn 

upon only during periods of general 

market disruption. In contrast, the New 

Accord provides a more favorable 

capital treatment within the SFA for 

eligible market disruption liquidity 

facilities than for other liquidity 

facilities. Under the New Accord, an 

eligible market disruption liquidity 

facility is a liquidity facility that 

supports an ABCP program and that (i) 

is subject to an asset quality test that 

precludes funding of underlying 

exposures that are in default; (ii) can be 

used to fund only those exposures that 

have an investment-grade external 

rating at the time of funding, if the 

underlying exposures that the facility 

must fund against are externally rated 

exposures at the time that the exposures 

are sold to the program; and (iii) may 

only be drawn in the event of a general 

market disruption. 

The agencies sought comment on the 

prevalence of eligible market disruption 

liquidity facilities that might be subject 

to the SFA and, by implication, whether 

the final rule should incorporate the 

treatment provided in the New Accord. 

Commenters responded that eligible 

market disruption liquidity facilities 

currently are not a material product line 

for U.S. banks, but urged international 

consistency in this area. To limit 

additional complexity in the final rule, 

and because U.S. banks have limited 

exposure to eligible market disruption 

liquidity facilities, the agencies are not 

including a separate treatment of 

eligible market disruption liquidity 

facilities in the final rule. The agencies 

believe that the final rule provides 

adequate flexibility to determine an 

appropriate capital requirement for 

market disruption liquidity facilities. 

6. CRM for Securitization Exposures 

The treatment of CRM for 

securitization exposures differs from 

that applicable to wholesale and retail 

exposures, and is largely unchanged 

from the proposal. An originating bank 

that has obtained a credit risk mitigant 

to hedge its securitization exposure to a 

synthetic or traditional securitization 

that satisfies the operational criteria in 

section 41 of the final rule may 

recognize the credit risk mitigant, but 

only as provided in section 46 of the 

final rule. An investing bank that has 

obtained a credit risk mitigant to hedge 

a securitization exposure also may 

recognize the credit risk mitigant, but 

only as provided in section 46. A bank 

that has used the RBA or IAA to 

calculate its risk-based capital 

requirement for a securitization 

exposure whose external or inferred 

rating (or equivalent internal rating 

under the IAA) reflects the benefits of a 

particular credit risk mitigant provided 

to the associated securitization or that 

supports some or all of the underlying 

exposures, however, may not use the 

securitization credit risk mitigation 

rules to further reduce its risk-based 

capital requirement for the exposure 

based on that credit risk mitigant. For 

example, a bank that owns a AAA-rated 

asset-backed security that benefits from 

an insurance wrap that is part of the 

securitization transaction must calculate 

its risk-based capital requirement for the 

security strictly under the RBA. No 

additional credit is given for the 

presence of the insurance wrap. On the 

other hand, if a bank owns a BBB-rated 

asset-backed security and obtains a 

credit default swap from a AAA-rated 

counterparty to protect the bank from 

losses on the security, the bank would 

be able to apply the securitization CRM 

rules to recognize the risk mitigating 

effects of the credit default swap and 

determine the risk-based capital 

requirement for the position. 

As under the proposal, the final rule 

contains a treatment of CRM for 

securitization exposures separate from 

the treatment for wholesale and retail 

exposures because the wholesale and 

retail exposure CRM approaches rely on 

substitutions of, or adjustments to, the 

risk parameters of the hedged exposure. 

Because the securitization framework 

does not rely on risk parameters to 

determine risk-based capital 

requirements for securitization 

exposures, a different treatment of CRM 

for securitization exposures is 

necessary. 

The securitization CRM rules, like the 

wholesale and retail CRM rules, address 

collateral separately from guarantees 

and credit derivatives. A bank is not 

permitted to recognize collateral other 

than financial collateral as a credit risk 

mitigant for securitization exposures. A 

bank may recognize financial collateral 

in determining the bank’s risk-based 

capital requirement for a securitization 

exposure that is not a repo-style 

transaction, an eligible margin loan, or 

an OTC derivative for which the bank 

has reflected collateral in its 

determination of exposure amount 

under section 32 of the rule by using a 

collateral haircut approach. The bank’s 

risk-based capital requirement for a 

collateralized securitization exposure is 

equal to the risk-based capital 

requirement for the securitization 

exposure as calculated under the RBA 

or the SFA multiplied by the ratio of 

adjusted exposure amount (SE*) to 

original exposure amount (SE), 

Where: 

(i) SE* = max {0, [SE¥C × (1¥Hs¥Hfx)]}; 

(ii) SE = the amount of the securitization 

exposure (as calculated under section 

42(e) of the rule); 

(iii) C = the current market value of the 

collateral; 

(iv) Hs = the haircut appropriate to the 

collateral type; and 

(v) Hfx = the haircut appropriate for any 

currency mismatch between the 

collateral and the exposure. 

Where the collateral is a basket of 

different asset types or a basket of assets 

denominated in different currencies, the 

haircut on the basket is 

H aHi i

i

= ∑ ,

where ai is the current market value of 

the asset in the basket divided by the 

current market value of all assets in the 

basket and Hi is the haircut applicable 

to that asset. 

With the prior written approval of its 

primary Federal supervisor, a bank may 

calculate haircuts using its own internal 

estimates of market price volatility and 

foreign exchange volatility, subject to 

the requirements for use of ownestimates haircuts contained in section 

32 of the rule. Banks that use ownestimates haircuts for collateralized 

securitization exposures must assume a 

minimum holding period (TM) for 

securitization exposures of 65 business 

days. 

A bank that does not qualify for and 

use own-estimates haircuts must use the 

collateral type haircuts (Hs) in Table 3 

of the final rule and must use a currency 

mismatch haircut (Hfx) of 8 percent if 

the exposure and the collateral are 

denominated in different currencies. To 


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reflect the longer-term nature of 

securitization exposures as compared to 

securities financing transactions, 

however, these standard supervisory 

haircuts (which are based on a tenbusiness-day holding period and daily 

marking-to-market and remargining) 

must be adjusted to a 65-business-day 

holding period (the approximate 

number of business days in a calendar 

quarter) by multiplying them by the 

square root of 6.5 (2.549510). A bank 

also must adjust the standard 

supervisory haircuts upward on the 

basis of a holding period longer than 65 

business days where and as appropriate 

to take into account the illiquidity of the 

collateral. 

A bank may only recognize an eligible 

guarantee or eligible credit derivative 

provided by an eligible securitization 

guarantor in determining the bank’s 

risk-based capital requirement for a 

securitization exposure. The definitions 

of eligible guarantee and eligible credit 

derivative apply to both the wholesale 

and retail frameworks and the 

securitization framework. An eligible 

securitization guarantor is defined to 

mean (i) a sovereign entity, the Bank for 

International Settlements, the 

International Monetary Fund, the 

European Central Bank, the European 

Commission, a Federal Home Loan 

Bank, the Federal Agricultural Mortgage 

Corporation (Farmer Mac), a multilateral 

development bank, a depository 

institution (as defined in section 3 of the 

Federal Deposit Insurance Act (12 

U.S.C. 1813)), a bank holding company 

(as defined in section 2 of the Bank 

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

a savings and loan holding company (as 

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

or substantially all of the holding 

company’s activities are permissible for 

a financial holding company under 12 

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

defined in section 211.2 of the Federal 

Reserve Board’s Regulation K (12 CFR 

211.2)), or a securities firm; (ii) any 

other entity (other than a securitization 

SPE) that has issued and outstanding an 

unsecured long-term debt security 

without credit enhancement that has a 

long-term applicable external rating in 

one of the three highest investmentgrade rating categories; or (iii) any other 

entity (other than a securitization SPE) 

that has a PD assigned by the bank that 

is lower than or equivalent to the PD 

associated with a long-term external 

rating in the third-highest investmentgrade rating category. 

A bank must use the following 

procedures if the bank chooses to 

recognize an eligible guarantee or 

eligible credit derivative provided by an 

eligible securitization guarantor in 

determining the bank’s risk-based 

capital requirement for a securitization 

exposure. If the protection amount of 

the eligible guarantee or eligible credit 

derivative equals or exceeds the amount 

of the securitization exposure, the bank 

must set the risk-weighted asset amount 

for the securitization exposure equal to 

the risk-weighted asset amount for a 

direct exposure to the eligible 

securitization guarantor (as determined 

in the wholesale risk weight function 

described in section 31 of the final rule), 

using the bank’s PD for the guarantor, 

the bank’s LGD for the guarantee or 

credit derivative, and an EAD equal to 

the amount of the securitization 

exposure (as determined in section 42(e) 

of the final rule). 

If the protection amount of the 

eligible guarantee or eligible credit 

derivative is less than the amount of the 

securitization exposure, the bank must 

divide the securitization exposure into 

two exposures in order to recognize the 

guarantee or credit derivative. The riskweighted asset amount for the 

securitization exposure is equal to the 

sum of the risk-weighted asset amount 

for the covered portion and the riskweighted asset amount for the 

uncovered portion. The risk-weighted 

asset amount for the covered portion is 

equal to the risk-weighted asset amount 

for a direct exposure to the eligible 

securitization guarantor (as determined 

in the wholesale risk weight function 

described in section 31 of the rule), 

using the bank’s PD for the guarantor, 

the bank’s LGD for the guarantee or 

credit derivative, and an EAD equal to 

the protection amount of the credit risk 

mitigant. The risk-weighted asset 

amount for the uncovered portion is 

equal to the product of (i) 1.0 minus the 

ratio of the protection amount of the 

eligible guarantee or eligible credit 

derivative divided by the amount of the 

securitization exposure; and (ii) the riskweighted asset amount for the 

securitization exposure without the 

credit risk mitigant (as determined in 

sections 42–45 of the final rule). 

For any hedged securitization 

exposure, the bank must make 

applicable adjustments to the protection 

amount as required by the maturity 

mismatch, currency mismatch, and lack 

of restructuring provisions in 

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

of the final rule. The agencies have 

clarified in the final rule that the 

mismatch provisions apply to any 

hedged securitization exposure and any 

more senior securitization exposure that 

benefits from the hedge. In the context 

of a synthetic securitization, when an 

eligible guarantee or eligible credit 

derivative covers multiple hedged 

exposures that have different residual 

maturities, the bank must use the 

longest residual maturity of any of the 

hedged exposures as the residual 

maturity of all the hedged exposures. If 

the risk-weighted asset amount for a 

guaranteed securitization exposure is 

greater than the risk-weighted asset 

amount for the securitization exposure 

without the guarantee or credit 

derivative, a bank may elect not to 

recognize the guarantee or credit 

derivative. 

When a bank recognizes an eligible 

guarantee or eligible credit derivative 

provided by an eligible securitization 

guarantor in determining the bank’s 

risk-based capital requirement for a 

securitization exposure, the bank also 

must (i) calculate ECL for the protected 

portion of the exposure using the same 

risk parameters that it uses for 

calculating the risk-weighted asset 

amount of the exposure (that is, the PD 

associated with the guarantor’s rating 

grade, the LGD of the guarantee, and an 

EAD equal to the protection amount of 

the credit risk mitigant); and (ii) add 

this ECL to the bank’s total ECL. 

7. Synthetic Securitizations 

Background 

In a synthetic securitization, an 

originating bank uses credit derivatives 

or guarantees to transfer the credit risk, 

in whole or in part, of one or more 

underlying exposures to third-party 

protection providers. The credit 

derivative or guarantee may be either 

collateralized or uncollateralized. In the 

typical synthetic securitization, the 

underlying exposures remain on the 

balance sheet of the originating bank, 

but a portion of the originating bank’s 

credit exposure is transferred to the 

protection provider or covered by 

collateral pledged by the protection 

provider. 

In general, the final rule’s treatment of 

synthetic securitizations is identical to 

that of traditional securitizations and to 

that described in the proposal. The 

operational requirements for synthetic 

securitizations are more detailed than 

those for traditional securitizations and 

are intended to ensure that the 

originating bank has truly transferred 

credit risk of the underlying exposures 

to one or more third-party protection 

providers. 

Although synthetic securitizations 

typically employ credit derivatives, 

which might suggest that such 

transactions would be subject to the 

CRM rules in section 33 of the final rule, 

banks must apply the securitization 

framework when calculating risk-based 

capital requirements for a synthetic 

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69372 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

securitization exposure. Banks may 

ultimately be redirected to the 

securitization CRM rules to adjust the 

securitization framework capital 

requirement for an exposure to reflect 

the CRM technique used in the 

transaction. 

Operational Requirements for Synthetic 

Securitizations 

For synthetic securitizations, an 

originating bank may recognize for riskbased capital purposes the use of CRM 

to hedge, or transfer credit risk 

associated with, underlying exposures 

only if each of the following conditions 

is satisfied: 

(i) The credit risk mitigant is financial 

collateral, an eligible credit derivative 

from an eligible securitization guarantor 

(defined above), or an eligible guarantee 

from an eligible securitization 

guarantor. 

(ii) The bank transfers credit risk 

associated with the underlying 

exposures to third-party investors, and 

the terms and conditions in the credit 

risk mitigants employed do not include 

provisions that: 

(A) Allow for the termination of the 

credit protection due to deterioration in 

the credit quality of the underlying 

exposures; 

(B) Require the bank to alter or 

replace the underlying exposures to 

improve the credit quality of the 

underlying exposures; 

(C) Increase the bank’s cost of credit 

protection in response to deterioration 

in the credit quality of the underlying 

exposures; 

(D) Increase the yield payable to 

parties other than the bank in response 

to a deterioration in the credit quality of 

the underlying exposures; or 

(E) Provide for increases in a retained 

first loss position or credit enhancement 

provided by the bank after the inception 

of the securitization. 

(iii) The bank obtains a well-reasoned 

opinion from legal counsel that 

confirms the enforceability of the credit 

risk mitigant in all relevant 

jurisdictions. 

(iv) Any clean-up calls relating to the 

securitization are eligible clean-up calls 

(as discussed above). 

Failure to meet the above operational 

requirements for a synthetic 

securitization prevents the originating 

bank from using the securitization 

framework and requires the originating 

bank to hold risk-based capital against 

the underlying exposures as if they had 

not been synthetically securitized. A 

bank that provides credit protection to 

a synthetic securitization must use the 

securitization framework to compute 

risk-based capital requirements for its 

exposures to the synthetic securitization 

even if the originating bank failed to 

meet one or more of the operational 

requirements for a synthetic 

securitization. 

Consistent with the treatment of 

traditional securitization exposures, a 

bank must use the RBA for synthetic 

securitization exposures that have an 

appropriate number of external or 

inferred ratings. For an originating bank, 

the RBA will typically be used only for 

the most senior tranche of the 

securitization, which often has an 

inferred rating. If a bank has a synthetic 

securitization exposure that does not 

have an external or inferred rating, the 

bank must apply the SFA to the 

exposure (if the bank and the exposure 

qualify for use of the SFA) without 

considering any CRM obtained as part of 

the synthetic securitization. Then, if the 

bank has obtained a credit risk mitigant 

on the exposure as part of the synthetic 

securitization, the bank may apply the 

securitization CRM rules to reduce its 

risk-based capital requirement for the 

exposure. For example, if the credit risk 

mitigant is financial collateral, the bank 

may use the standard supervisory or 

own-estimates haircuts to reduce its 

risk-based capital requirement. If the 

bank is a protection provider to a 

synthetic securitization and has 

obtained a credit risk mitigant on its 

exposure, the bank may also apply the 

securitization CRM rules in section 46 

of the final rule to reduce its risk-based 

capital requirement on the exposure. If 

neither the RBA nor the SFA is 

available, a bank must deduct the 

exposure from regulatory capital. 

First-Loss Tranches 

If a bank has a first-loss position in a 

pool of underlying exposures in 

connection with a synthetic 

securitization, the bank must deduct the 

position from regulatory capital unless 

(i) the position qualifies for use of the 

RBA or (ii) the bank and the position 

qualify for use of the SFA and KIRB is 

greater than L. 

Mezzanine Tranches 

In a typical synthetic securitization, 

an originating bank obtains credit 

protection on a mezzanine, or secondloss, tranche of a synthetic 

securitization by either (i) obtaining a 

credit default swap or financial 

guarantee from a third-party financial 

institution; or (ii) obtaining a credit 

default swap or financial guarantee from 

an SPE whose obligations are secured by 

financial collateral. 

For a bank that creates a synthetic 

mezzanine tranche by obtaining an 

eligible credit derivative or guarantee 

from an eligible securitization 

guarantor, the bank generally will treat 

the notional amount of the credit 

derivative or guarantee (as adjusted to 

reflect any maturity mismatch, lack of 

restructuring coverage, or currency 

mismatch) as a wholesale exposure to 

the protection provider and use the IRB 

approach for wholesale exposures to 

determine the bank’s risk-based capital 

requirement for the exposure. A bank 

that creates the synthetic mezzanine 

tranche by obtaining from a non-eligible 

securitization guarantor a guarantee or 

credit derivative that is collateralized by 

financial collateral generally will (i) first 

use the SFA to calculate the risk-based 

capital requirement on the exposure 

(ignoring the guarantee or credit 

derivative and the associated collateral); 

and (ii) then use the securitization CRM 

rules to calculate any reductions to the 

risk-based capital requirement resulting 

from the associated collateral. The bank 

may look only to the protection provider 

from which it obtains the guarantee or 

credit derivative when determining its 

risk-based capital requirement for the 

exposure (that is, if the protection 

provider hedges the guarantee or credit 

derivative with a guarantee or credit 

derivative from a third party, the bank 

may not look through the protection 

provider to that third party when 

calculating its risk-based capital 

requirement for the exposure). 

For a bank providing credit protection 

on a mezzanine tranche of a synthetic 

securitization, the bank must use the 

RBA to determine the risk-based capital 

requirement for the exposure if the 

exposure has an external or inferred 

rating. If the exposure does not have an 

external or inferred rating and the 

exposure qualifies for use of the SFA, 

the bank may use the SFA to calculate 

the risk-based capital requirement for 

the exposure. If neither the RBA nor the 

SFA are available, the bank must deduct 

the exposure from regulatory capital. If 

a bank providing credit protection on 

the mezzanine tranche of a synthetic 

securitization obtains a credit risk 

mitigant to hedge its exposure, the bank 

may apply the securitization CRM rules 

to reflect the risk reduction achieved by 

the credit risk mitigant. 

Super-Senior Tranches 

A bank that has the most senior 

position in a pool of underlying 

exposures in connection with a 

synthetic securitization must use the 

RBA to calculate its risk-based capital 

requirement for the exposure if the 

exposure has at least one external or 

inferred rating (in the case of an 

investing bank) or at least two external 

or inferred ratings (in the case of an 

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100The final rule defines excess spread for a 

period as gross finance charge collections and other 

income received by the securitization SPE 

(including market interchange fees) over the period 

minus interest paid to holders of securitization 

exposures, servicing fees, charge-offs, and other 

senior trust similar expenses of the securitization 

SPE over the period, divided by the principal 

balance of the underlying exposures at the end of 

the period. 

originating bank). If the super-senior 

tranche does not have an external or 

inferred rating and the bank and the 

exposure qualify for use of the SFA, the 

bank may use the SFA to calculate the 

risk-based capital requirement for the 

exposure. If neither the RBA nor the 

SFA are available, the bank must deduct 

the exposure from regulatory capital. If 

an investing bank in the super-senior 

tranche of a synthetic securitization 

obtains a credit risk mitigant to hedge 

its exposure, however, the investing 

bank may apply the securitization CRM 

rules to reflect the risk reduction 

achieved by the credit risk mitigant. 

8. Nth-to-Default Credit Derivatives 

Credit derivatives that provide credit 

protection only for the nth defaulting 

reference exposure in a group of 

reference exposures (nth-to-default 

credit derivatives) are similar to 

synthetic securitizations that provide 

credit protection only after the first-loss 

tranche has defaulted or become a loss. 

A simplified treatment is available to 

banks that purchase and provide such 

credit protection. A bank that obtains 

credit protection on a group of 

underlying exposures through a first-todefault credit derivative must determine 

its risk-based capital requirement for the 

underlying exposures as if the bank had 

synthetically securitized only the 

underlying exposure with the lowest 

capital requirement and had obtained 

no credit risk mitigant on the other 

(higher capital requirement) underlying 

exposures. If the bank purchases credit 

protection on a group of underlying 

exposures through an nth-to-default 

credit derivative (other than a first-todefault credit derivative), it may only 

recognize the credit protection for riskbased capital purposes either if it has 

obtained credit protection on the same 

underlying exposures in the form of 

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

derivatives, or if n-1 of the underlying 

exposures have already defaulted. In 

such a case, the bank must again 

determine its risk-based capital 

requirement for the underlying 

exposures as if the bank had only 

synthetically securitized the n-1 

underlying exposures with the lowest 

capital requirement and had obtained 

no credit risk mitigant on the other 

underlying exposures. 

A bank that provides credit protection 

on a group of underlying exposures 

through a first-to-default credit 

derivative must determine its riskweighted asset amount for the derivative 

by applying the RBA (if the derivative 

qualifies for the RBA) or, if the 

derivative does not qualify for the RBA, 

by setting its risk-weighted asset amount 

for the derivative equal to the product 

of (i) the protection amount of the 

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

the risk-based capital requirements of 

the individual underlying exposures, up 

to a maximum of 100 percent. If a bank 

provides credit protection on a group of 

underlying exposures through an nth-todefault credit derivative (other than a 

first-to-default credit derivative), the 

bank must determine its risk-weighted 

asset amount for the derivative by 

applying the RBA (if the derivative 

qualifies for the RBA) or, if the 

derivative does not qualify for the RBA, 

by setting the risk-weighted asset 

amount for the derivative equal to the 

product of (i) the protection amount of 

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

of the risk-based capital requirements of 

the individual underlying exposures 

(excluding the n-1 underlying exposures 

with the lowest risk-based capital 

requirements), up to a maximum of 100 

percent. 

For example, a bank provides credit 

protection in the form of a second-todefault credit derivative on a basket of 

five reference exposures. The derivative 

is unrated and the protection amount of 

the derivative is $100. The risk-based 

capital requirements of the underlying 

exposures are 2.5 percent, 5.0 percent, 

10.0 percent, 15.0 percent, and 20 

percent. The risk-weighted asset amount 

of the derivative would be $100 × 12.5 

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

derivative were externally rated in the 

lowest investment-grade rating category 

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

0.50 or $50. 

9. Early Amortization Provisions 

Background 

Many securitizations of revolving 

credit facilities (for example, credit card 

receivables) contain provisions that 

require the securitization to be wound 

down and investors to be repaid if the 

excess spread falls below a certain 

threshold.100 This decrease in excess 

spread may, in some cases, be caused by 

deterioration in the credit quality of the 

underlying exposures. An early 

amortization event can increase a bank’s 

capital needs if new draws on the 

revolving credit facilities need to be 

financed by the bank using on-balance 

sheet sources of funding. The payment 

allocations used to distribute principal 

and finance charge collections during 

the amortization phase of these 

transactions also can expose a bank to 

greater risk of loss than in other 

securitization transactions. The final 

rule, consistent with the proposed rule, 

assesses a risk-based capital 

requirement that, in general, is linked to 

the likelihood of an early amortization 

event to address the risks that early 

amortization of a securitization poses to 

originating banks. 

Consistent with the proposed rule, the 

final rule defines an early amortization 

provision as a provision in a 

securitization’s governing 

documentation that, when triggered, 

causes investors in the securitization 

exposures to be repaid before the 

original stated maturity of the 

securitization exposure, unless the 

provision is solely triggered by events 

not related to the performance of the 

underlying exposures or the originating 

bank (such as material changes in tax 

laws or regulations). 

Under the proposed rule, a bank 

would not be required to hold 

regulatory capital against the investors’

interest if early amortization is solely 

triggered by events not related to the 

performance of the underlying 

exposures or the originating bank, such 

as material changes in tax laws or 

regulation. Under the New Accord, a 

bank is also not required to hold 

regulatory capital against the investors’

interest if (i) the securitization has a 

replenishment structure in which the 

individual underlying exposures do not 

revolve and the early amortization ends 

the ability of the originating bank to add 

new underlying exposures to the 

securitization; (ii) the securitization 

involves revolving assets and contains 

early amortization features that mimic 

term structures; or (iii) investors in the 

securitization remain fully exposed to 

future draws by borrowers on the 

underlying exposures even after the 

occurrence of early amortization. The 

agencies sought comment on the 

appropriateness of these additional 

exemptions in the U.S. markets for 

revolving securitizations. Most 

commenters asserted that the 

exemptions provided in the New 

Accord are prudent and should be 

adopted by the agencies in order to 

avoid placing U.S. banking 

organizations at a competitive 

disadvantage relative to foreign 

competitors. The agencies generally 

agree with this view of exemption (iii), 

above, and the definition of early 

amortization provision in the final rule 

incorporates this exemption. The 

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69374 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

agencies have not included exemption 

(i) or (ii). The agencies do not believe 

that the exemption for non-revolving 

exposures is meaningful because the 

early amortization provisions apply 

only to securitizations with revolving 

underlying exposures. The agencies also 

do not believe that the exemption for 

early amortization features that mimic 

term structures is meaningful in the U.S. 

market. 

Under the final rule, as under the 

proposed rule, an originating bank must 

generally hold risk-based capital against 

the sum of the originating bank’s 

interest and the investors’ interest 

arising from a securitization that 

contains an early amortization 

provision. An originating bank must 

compute its capital requirement for its 

interest using the hierarchy of 

approaches for securitization exposures 

as described above. The originating 

bank’s risk-weighted asset amount for 

the investors’ interest in the 

securitization is equal to the product of 

the following five quantities: (i) The 

EAD associated with the investors’

interest; (ii) the appropriate CF as 

determined below; (iii) KIRB; (iv) 12.5; 

and (v) the proportion of the underlying 

exposures in which the borrower is 

permitted to vary the drawn amount 

within an agreed limit under a line of 

credit. The agencies added (v) to the 

final rule because, for securitizations 

containing both revolving and nonrevolving underlying exposures, only 

the revolving underlying exposures give 

rise to the risk of early amortization. 

Under the final rule, consistent with 

the proposal, the investors’ interest with 

respect to a revolving securitization 

captures both the drawn balances and 

undrawn lines of the underlying 

exposures that are allocated to the 

investors in the securitization. The EAD 

associated with the investors’ interest is 

equal to the EAD of the underlying 

exposures multiplied by the ratio of: 

(i) The total amount of securitization 

exposures issued by the securitization 

SPE to investors; divided by 

(ii) The outstanding principal amount 

of underlying exposures. 

In general, the applicable CF depends 

on whether the early amortization 

provision repays investors through a 

controlled or non-controlled mechanism 

and whether the underlying exposures 

are revolving retail credit facilities that 

are uncommitted (unconditionally 

cancelable by the bank to the fullest 

extent of Federal law, such as credit 

card receivables) or are other revolving 

credit facilities (for example, revolving 

corporate credit facilities). Consistent 

with the New Accord, under the 

proposed rule a controlled early 

amortization provision would meet each 

of the following conditions: 

(i) The originating bank has 

appropriate policies and procedures to 

ensure that it has sufficient capital and 

liquidity available in the event of an 

early amortization; 

(ii) Throughout the duration of the 

securitization (including the early 

amortization period) there is the same 

pro rata sharing of interest, principal, 

expenses, losses, fees, recoveries, and 

other cash flows from the underlying 

exposures, based on the originating 

bank’s and the investors’ relative shares 

of the underlying exposures outstanding 

measured on a consistent monthly basis; 

(iii) The amortization period is 

sufficient for at least 90 percent of the 

total underlying exposures outstanding 

at the beginning of the early 

amortization period to have been repaid 

or recognized as in default; and 

(iv) The schedule for repayment of 

investor principal is not more rapid 

than would be allowed by straight-line 

amortization over an 18-month period. 

An early amortization provision that 

does not meet any of the above criteria 

is a non-controlled early amortization 

provision. 

The agencies solicited comment on 

the distinction between controlled and 

non-controlled early amortization 

provisions and on the extent to which 

banks use controlled early amortization 

provisions. The agencies also invited 

comment on the proposed definition of 

a controlled early amortization 

provision, including in particular the 

18-month period set forth above. 

Commenters generally believed that 

very few, if any, revolving 

securitizations would meet the criteria 

needed to qualify for treatment as a 

controlled early amortization structure. 

One commenter maintained that a fixed 

18-month straight-line amortization 

period was too long for certain 

exposures, such as prime credit cards. 

The final rule is unchanged from the 

proposal with respect to controlled and 

non-controlled early amortization 

provisions. The agencies believe that the 

proposed eligibility criteria for a 

controlled early amortization are 

important indicators of the risks to 

which an originating bank would be 

exposed in the event of any early 

amortization. While a fixed 18-month 

straight-line amortization period is 

unlikely to be the most appropriate 

period in all cases, it is a reasonable 

period for the vast majority of cases. The 

lower operational burden of using a 

single, fixed amortization period 

warrants the potential diminution in 

risk-sensitivity. 

Controlled Early Amortization 

Under the proposed rule, to calculate 

the appropriate CF for a securitization of 

uncommitted revolving retail exposures 

that contains a controlled early 

amortization provision, a bank would 

compare the three-month average 

annualized excess spread for the 

securitization to the point at which the 

bank is required to trap excess spread 

under the securitization transaction. In 

securitizations that do not require 

excess spread to be trapped, or that 

specify a trapping point based primarily 

on performance measures other than the 

three-month average annualized excess 

spread, the excess spread trapping point 

was 4.5 percent. The bank would divide 

the three-month average annualized 

excess spread level by the excess spread 

trapping point and apply the 

appropriate CF from Table H. 

TABLE H.—CONTROLLED EARLY AMORTIZATION PROVISIONS

Uncommitted Committed 

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

133.33% of trapping point or more, 0% CF.

less than 133.33% to 100% of trapping point, 1% CF.

less than 100% to 75% of trapping point, 2% CF.

less than 75% to 50% of trapping point, 10% CF.

less than 50% to 25% of trapping point, 20% CF less than 25% of trapping point, 

40% CF.

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

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A bank would apply a 90 percent CF 

for all other revolving underlying 

exposures (committed exposures and 

nonretail exposures) in securitizations 

containing a controlled early 

amortization provision. The proposed 

CFs for uncommitted revolving retail 

credit lines were much lower than for 

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

demonstrated ability of banks to 

monitor and, when appropriate, to 

curtail promptly uncommitted retail 

credit lines for customers of 

deteriorating credit quality. Such 

account management tools are 

unavailable for committed lines, and 

banks may be less proactive about using 

such tools in the case of uncommitted 

non-retail credit lines owing to lender 

liability concerns and the prominence of 

broad-based, longer-term customer 

relationships. 

Non-controlled Early Amortization 

Under the proposed rule, to calculate 

the appropriate CF for securitizations of 

uncommitted revolving retail exposures 

that contain a non-controlled early 

amortization provision, a bank would 

perform the excess spread calculations 

described in the controlled early 

amortization section above and then 

apply the CFs in Table I. 

TABLE I.—NON-CONTROLLED EARLY AMORTIZATION PROVISIONS

Uncommitted Committed 

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

133.33% of trapping point or more, 0% CF.

less than 133.33% to 100% of trapping point, 5% CF.

less than 100% to 75% of trapping point, 15% CF.

less than 75% to 50% of trapping point, 50% CF.

less than 50% of trapping point, 100% CF.

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

A bank would use a 100 percent CF 

for all other revolving underlying 

exposures (committed exposures and 

nonretail exposures) in securitizations 

containing a non-controlled early 

amortization provision. In other words, 

no risk transference would be 

recognized for these transactions; an 

originating bank’s IRB capital 

requirement would be the same as if the 

underlying exposures had not been 

securitized. 

A few commenters asserted that the 

proposed CFs were too high. The 

agencies believe, however, that the 

proposed CFs appropriately capture the 

risk to the bank of a potential early 

amortization event. The agencies also 

believe that the proposed CFs, which 

are consistent with the New Accord, 

foster consistency across national 

jurisdictions. Therefore, the agencies are 

maintaining the proposed CFs in the 

final rule with one exception, discussed 

below. 

In circumstances where a 

securitization contains a mix of retail 

and nonretail exposures or a mix of 

committed and uncommitted exposures, 

a bank may take a pro rata approach to 

determining the CF for the 

securitization’s early amortization 

provision. If a pro rata approach is not 

feasible, a bank must treat the 

securitization as a securitization of 

nonretail exposures if a single 

underlying exposure is a nonretail 

exposure and must treat the 

securitization as a securitization of 

committed exposures if a single 

underlying exposure is a committed 

exposure. 

Securitizations of Revolving Residential 

Mortgage Exposures 

The agencies sought comment on the 

appropriateness of the proposed 4.5 

percent excess spread trapping point 

and on whether there were other types 

and levels of early amortization triggers 

used in securitizations of revolving 

retail exposures that should be 

addressed by the agencies. Although 

some commenters believed the 4.5 

percent trapping point assumption was 

reasonable, others believed that it was 

inappropriate for securitizations of 

HELOCs. Unlike credit card 

securitizations, U.S. HELOC 

securitizations typically do not generate 

material excess spread and typically are 

structured with credit enhancements 

and early amortization triggers based on 

other factors, such as portfolio loss 

rates. Under the proposed treatment, 

banks would be required to hold capital 

against the potential early amortization 

of most U.S. HELOC securitizations at 

their inception, rather than only if the 

credit quality of the underlying 

exposures deteriorated. Although the 

New Accord does not provide an 

alternative methodology, the agencies 

concluded that the features of the U.S. 

HELOC securitization market warrant an 

alternative approach. Accordingly, the 

final rule allows a bank the option of 

applying either (i) the CFs in Tables I 

and J, as appropriate, or (ii) a fixed CF 

equal to 10 percent to its securitizations 

for which all or substantially all of the 

underlying exposures are revolving 

residential mortgage exposures. If a 

bank chooses the fixed CF of 10 percent, 

it must use that CF for all securitizations 

for which all or substantially all of the 

underlying exposures are revolving 

residential mortgage exposures. The 

agencies will monitor the 

implementation of this alternative 

approach to ensure that it is consistent 

with safety and soundness. 

F. Equity Exposures 

1. Introduction and Exposure 

Measurement 

This section describes the final rule’s 

risk-based capital treatment for equity 

exposures. Consistent with the proposal, 

under the final rule, a bank has the 

option to use either a simple risk-weight 

approach (SRWA) or an internal models 

approach (IMA) for equity exposures 

that are not exposures to an investment 

fund. A bank must use a look-through 

approach for equity exposures to an 

investment fund. 

Although the New Accord provides 

national supervisors the option to 

provide a grandfathering period for 

equity exposures—whereby for a 

maximum of ten years, supervisors 

could permit banks to exempt from the 

IRB treatment equity investments held 

at the time of the publication of the New 

Accord—the proposed rule did not 

include such a grandfathering provision. 

A number of commenters asserted that 

the proposal was inconsistent with the 

New Accord and would subject banks 

using the agencies’ advanced 

approaches to significant competitive 

inequity. 

The agencies continue to believe that 

it is not appropriate or necessary to 

incorporate the New Accord’s optional 

ten-year grandfathering period for 

equity exposures. The grandfathering 

concept would reduce the risk 

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69376 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

101The potential downward adjustment to the 

carrying value of an equity exposure reflects the fact 

that 100 percent of the unrealized gains on 

available-for-sale equity exposures are included in 

carrying value but only up to 45 percent of any such 

unrealized gains are included in regulatory capital. 

sensitivity of the SRWA and IMA. 

Moreover, the IRB approach does not 

provide grandfathering for other types of 

exposures, and the agencies see no 

compelling reason to do so for equity 

exposures. Further, the agencies believe 

that the overall final rule approach to 

equity exposures sufficiently mitigates 

potential competitive issues. 

Accordingly, the final rule does not 

provide a grandfathering period for 

equity exposures. 

Under the proposed SRWA, a bank 

generally would assign a 300 percent 

risk weight to publicly traded equity 

exposures and a 400 percent risk weight 

to non-publicly traded equity exposures. 

Certain equity exposures to sovereigns, 

multilateral institutions, and public 

sector enterprises would have a risk 

weight of 0 percent, 20 percent, or 100 

percent; and certain community 

development equity exposures, hedged 

equity exposures, and, up to certain 

limits, non-significant equity exposures 

would receive a 100 percent risk weight. 

Alternatively, under the proposed 

rule, a bank that met certain minimum 

quantitative and qualitative 

requirements on an ongoing basis and 

obtained the prior written approval of 

its primary Federal supervisor could use 

the IMA to determine its risk-based 

capital requirement for all modeled 

equity exposures. A bank that qualified 

to use the IMA could apply the IMA to 

its publicly traded and non-publicly 

traded equity exposures, or could apply 

the IMA only to its publicly traded 

equity exposures. However, if the bank 

applied the IMA to its publicly traded 

equity exposures, it would be required 

to apply the IMA to all such exposures. 

Similarly, if a bank applied the IMA to 

both publicly traded and non-publicly 

traded equity exposures, it would be 

required to apply the IMA to all such 

exposures. If a bank did not qualify to 

use the IMA, or elected not to use the 

IMA, to compute its risk-based capital 

requirements for equity exposures, the 

bank would apply the SRWA to assign 

risk weights to its equity exposures. 

Several commenters objected to the 

proposed restrictions on the use of the 

IMA. Commenters asserted that banks 

should be able to apply the SRWA and 

the IMA for different portfolios or 

subsets of equity exposures, provided 

that banks’ choices are consistent with 

internal risk management practices. 

The agencies have not relaxed the 

proposed restrictions regarding use of 

the SRWA and IMA. The agencies 

remain concerned that if banks are 

permitted to employ either the SRWA or 

IMA to different equity portfolios, banks 

could choose one approach over the 

other to manipulate their risk-based 

capital requirements and not for risk 

management purposes. In addition, 

because of concerns about lack of 

transparency, it is not prudent to allow 

a bank to apply the IMA only to its nonpublicly traded equity exposures and 

not its publicly traded equity exposures. 

The proposed rule defined publicly 

traded to mean traded on (i) any 

exchange registered with the SEC as a 

national securities exchange under 

section 6 of the Securities Exchange Act 

of 1934 (15 U.S.C. 78f) or (ii) any nonU.S.-based securities exchange that is 

registered with, or approved by, a 

national securities regulatory authority 

and that provides a liquid, two-way 

market for the exposure (that is, there 

are enough independent bona fide offers 

to buy and sell so that a sales price 

reasonably related to the last sales price 

or current bona fide competitive bid and 

offer quotations can be determined 

promptly and a trade can be settled at 

such a price within five business days). 

Several commenters explicitly 

supported the proposed definition of 

publicly traded, noting that it is 

reasonable and consistent with industry 

practice. Other commenters requested 

that the agencies revise the proposed 

definition by eliminating the 

requirement that a non-U.S.-based 

securities exchange provide a liquid, 

two-way market for the exposure. 

Commenters asserted that this 

requirement goes beyond the definition 

in the New Accord, which defines a 

publicly traded equity exposure as any 

equity security traded on a recognized 

security exchange. They asserted that 

registration with or approval by the 

national securities regulatory authority 

should suffice, as registration or 

approval generally would be predicated 

on the existence of a two-way market. 

The agencies have retained the 

definition of publicly traded as 

proposed. The agencies believe that the 

liquid, two-way market requirement is 

not in addition to the requirements of 

the New Accord. Rather, this 

requirement clarifies the intent of 

‘‘traded’’ in the New Accord and helps 

to ensure that a sales price reasonably 

related to the last sales price or 

competitive bid and offer quotations can 

be determined promptly and settled 

within five business days. 

A bank using either the IMA or the 

SRWA must determine the adjusted 

carrying value for each equity exposure. 

The proposed rule defined the adjusted 

carrying value of an equity exposure as: 

(i) For the on-balance sheet 

component of an equity exposure, the 

bank’s carrying value of the exposure 

reduced by any unrealized gains on the 

exposure that are reflected in such 

carrying value but excluded from the 

bank’s tier 1 and tier 2 capital; 101 and 

(ii) For the off-balance sheet 

component of an equity exposure, the 

effective notional principal amount of 

the exposure, the size of which is 

equivalent to a hypothetical on-balance 

sheet position in the underlying equity 

instrument that would evidence the 

same change in fair value (measured in 

dollars) for a given small change in the 

price of the underlying equity 

instrument, minus the adjusted carrying 

value of the on-balance sheet 

component of the exposure as 

calculated in (i). 

Commenters generally supported the 

proposed definition of adjusted carrying 

value and the agencies are adopting the 

definition as proposed with one minor 

clarification regarding unfunded equity 

commitments (discussed below). 

The agencies created the definition of 

the effective notional principal amount 

of the off-balance sheet portion of an 

equity exposure to provide a uniform 

method for banks to measure the onbalance sheet equivalent of an offbalance sheet exposure. For example, if 

the value of a derivative contract 

referencing the common stock of 

company X changes the same amount as 

the value of 150 shares of common stock 

of company X, for a small (for example, 

1 percent) change in the value of the 

common stock of company X, the 

effective notional principal amount of 

the derivative contract is the current 

value of 150 shares of common stock of 

company X regardless of the number of 

shares the derivative contract 

references. The adjusted carrying value 

of the off-balance sheet component of 

the derivative is the current value of 150 

shares of common stock of company X 

minus the adjusted carrying value of 

any on-balance sheet amount associated 

with the derivative. 

The final rule clarifies the 

determination of the effective notional 

principal amount of unfunded equity 

commitments. Under the final rule, for 

an unfunded equity commitment that is 

unconditional, a bank must use the 

notional amount of the commitment. If 

the unfunded equity commitment is 

conditional, the bank must use its best 

estimate of the amount that would be 

funded during economic downturn 

conditions. 

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Hedge Transactions 

The agencies proposed specific rules 

for recognizing hedged equity 

exposures; they received no substantive 

comment on these rules and are 

adopting these rules as proposed. For 

purposes of determining risk-weighted 

assets under both the SRWA and the 

IMA, a bank may identify hedge pairs, 

which the final rule defines as two 

equity exposures that form an effective 

hedge provided each equity exposure is 

publicly traded or has a return that is 

primarily based on a publicly traded 

equity exposure. A bank may risk 

weight only the effective and ineffective 

portions of a hedge pair rather than the 

entire adjusted carrying value of each 

exposure that makes up the pair. Two 

equity exposures form an effective 

hedge if the exposures either have the 

same remaining maturity or each has a 

remaining maturity of at least three 

months; the hedge relationship is 

documented formally before the bank 

acquires at least one of the equity 

exposures; the documentation specifies 

the measure of effectiveness (E) (defined 

below) the bank will use for the hedge 

relationship throughout the life of the 

transaction; and the hedge relationship 

has an E greater than or equal to 0.8. A 

bank must measure E at least quarterly 

and must use one of three alternative 

measures of E—the dollar-offset method, 

the variability-reduction method, or the 

regression method. 

It is possible that only part of a bank’s 

exposure to a particular equity 

instrument is part of a hedge pair. For 

example, assume a bank has an equity 

exposure A with a $300 adjusted 

carrying value and chooses to hedge a 

portion of that exposure with an equity 

exposure B with an adjusted carrying 

value of $100. Also assume that the 

combination of equity exposure B and 

$100 of the adjusted carrying value of 

equity exposure A form an effective 

hedge with an E of 0.8. In this situation 

the bank would treat $100 of equity 

exposure A and $100 of equity exposure 

B as a hedge pair, and the remaining 

$200 of its equity exposure A as a 

separate, stand-alone equity position. 

The effective portion of a hedge pair 

is E multiplied by the greater of the 

adjusted carrying values of the equity 

exposures forming the hedge pair, and 

the ineffective portion is (1-E) 

multiplied by the greater of the adjusted 

carrying values of the equity exposures 

forming the hedge pair. In the above 

example, the effective portion of the 

hedge pair would be 0.8 × $100 = $80 

and the ineffective portion of the hedge 

pair would be (1¥0.8) × $100 = $20. 

Measures of Hedge Effectiveness 

Under the dollar-offset method of 

measuring effectiveness, the bank must 

determine the ratio of the cumulative 

sum of the periodic changes in the value 

of one equity exposure to the 

cumulative sum of the periodic changes 

in the value of the other equity 

exposure, termed the ratio of value 

change (RVC). If the changes in the 

values of the two exposures perfectly 

offset each other, the RVC will be ¥1. 

If RVC is positive, implying that the 

values of the two equity exposures move 

in the same direction, the hedge is not 

effective and E = 0. If RVC is negative 

and greater than or equal to ¥1 (that is, 

between zero and ¥1), then E equals the 

absolute value of RVC. If RVC is 

negative and less than ¥1, then E 

equals 2 plus RVC. 

The variability-reduction method of 

measuring effectiveness compares 

changes in the value of the combined 

position of the two equity exposures in 

the hedge pair (labeled X) to changes in 

the value of one exposure as though that 

one exposure were not hedged (labeled 

A). This measure of E expresses the 

time-series variability in X as a 

proportion of the variability of A. As the 

variability described by the numerator 

becomes small relative to the variability 

described by the denominator, the 

measure of effectiveness improves, but 

is bounded from above by a value of 

one. E is computed as: 

Xt = At ¥ Bt

At = the value at time t of the one exposure 

in a hedge pair, and 

Bt = the value at time t of the other exposure 

in the hedge pair. 

The value of t will range from zero to 

T, where T is the length of the 

observation period for the values of A 

and B, and is comprised of shorter 

values each labeled t. 

The regression method of measuring 

effectiveness is based on a regression in 

which the change in value of one 

exposure in a hedge pair is the 

dependent variable and the change in 

value of the other exposure in the hedge 

pair is the independent variable. E 

equals the coefficient of determination 

of this regression, which is the 

proportion of the variation in the 

dependent variable explained by 

variation in the independent variable. 

However, if the estimated regression 

coefficient is positive, then the value of 

E is zero. The closer the relationship 

between the values of the two 

exposures, the higher E will be. 

2. Simple Risk-Weight Approach 

(SRWA) 

Under the SRWA in section 52 of the 

proposed rule, a bank would determine 

the risk-weighted asset amount for each 

equity exposure, other than an equity 

exposure to an investment fund, by 

multiplying the adjusted carrying value 

of the equity exposure, or the effective 

portion and ineffective portion of a 

hedge pair as described above, by the 

lowest applicable risk weight in Table J. 

A bank would determine the riskweighted asset amount for an equity 

exposure to an investment fund under 

section 54 of the proposed rule. 

If a bank exclusively uses the SRWA 

for its equity exposures, the bank’s 

aggregate risk-weighted asset amount for 

its equity exposures (other than equity 

exposures to investment funds) would 

be equal to the sum of the risk-weighted 

asset amounts for each of the bank’s 

individual equity exposures. 

TABLE J 

Risk weight Equity exposure 

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


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69378 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

TABLE J—Continued 

Risk weight Equity exposure 

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

a condition of membership in that entity. 

100 Percent ...... • Community development equity exposures. 

• An equity exposure to a Federal Home Loan Bank or Farmer Mac not subject to a 20 percent risk weight. 

• The effective portion of a hedge pair. 

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

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

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

Several commenters addressed the 

proposed risk weights under the SRWA. 

A few commenters asserted that the 100 

percent risk weight for the effective 

portion of a hedge pair is too high. 

These commenters suggested that the 

risk weight for such exposures should 

be zero or no more than 7 percent 

because the effectively hedged portion 

of a hedge pair involves negligible credit 

risk. One commenter remarked that it 

does not believe there is an economic 

basis for the different risk weight for an 

equity exposure to a Federal Home Loan 

Bank depending on whether the equity 

exposure is held as a condition of 

membership. 

The agencies do not agree with 

commenters’ assertion that the effective 

portion of a hedge pair entails negligible 

credit risk. The agencies believe the 100 

percent risk weight under the proposal 

is an appropriate and prudential 

safeguard; thus, it is maintained in the 

final rule. Banks that seek to more 

accurately account for equity hedging in 

their risk-based capital requirements 

should use the IMA. 

The agencies agree that different risk 

weights for an equity exposure to a 

Federal Home Loan Bank or Farmer Mac 

depending on whether the equity 

exposure is held as a condition of 

membership do not have an economic 

justification, given the similar risk 

profile of the exposures. Accordingly, 

under the final rule SRWA, all equity 

exposures to a Federal Home Loan Bank 

or to Farmer Mac receive a 20 percent 

risk weight. 

Non-significant Equity Exposures 

Under the SRWA, a bank may apply 

a 100 percent risk weight to nonsignificant equity exposures. The 

proposed rule defined non-significant 

equity exposures as equity exposures to 

the extent that the aggregate adjusted 

carrying value of the exposures did not 

exceed 10 percent of the bank’s tier 1 

capital plus tier 2 capital. 

Several commenters objected to the 10 

percent materiality threshold for 

determining significance. They asserted 

that this standard is more conservative 

than the 15 percent threshold under the 

OCC, FDIC, and Board general riskbased capital rules for nonfinancial 

equity investments. 

The agencies note that the applicable 

general risk-based capital rules address 

only nonfinancial equity investments; 

that the 15 percent threshold is a 

percentage only of tier 1 capital; and 

that the 15 percent threshold was 

designed for that particular rule. The 

proposed materiality threshold of 10 

percent of tier 1 plus tier 2 capital is 

consistent with the New Accord and is 

intended to identify non-significant 

holdings of equity exposures under a 

different type of capital framework. 

Thus, the two threshold limits are not 

directly comparable. The agencies 

believe that the proposed 10 percent 

threshold for determining nonsignificant equity exposures is 

appropriate for the advanced 

approaches and, thus, are adopting it as 

proposed. 

As discussed above in preamble 

section V.A.3., the agencies have 

discretion under the final rule to 

exclude from the definition of a 

traditional securitization those 

investment firms that exercise 

substantially unfettered control over the 

size and composition of their assets, 

liabilities, and off-balance sheet 

exposures. Equity exposures to 

investment firms that would otherwise 

be a traditional securitization were it 

not for the specific agency exclusion are 

leveraged exposures to the underlying 

financial assets of the investment firm. 

The agencies believe that equity 

exposure to such firms with greater than 

immaterial leverage warrant a 600 

percent risk weight under the SRWA, 

due to their particularly high risk. 

Moreover, the agencies believe that the 

100 percent risk weight assigned to nonsignificant equity exposures is 

inappropriate for equity exposures to 

investment firms with greater than 

immaterial leverage. 

Under the final rule, to compute the 

aggregate adjusted carrying value of a 

bank’s equity exposures for determining 

non-significance, the bank may exclude 

(i) equity exposures that receive less 

than a 300 percent risk weight under the 

SRWA (other than equity exposures 

determined to be non-significant); (ii) 

the equity exposure in a hedge pair with 

the smaller adjusted carrying value; and 

(iii) a proportion of each equity 

exposure to an investment fund equal to 

the proportion of the assets of the 

investment fund that are not equity 

exposures or that qualify as community 

development equity exposures. If a bank 

does not know the actual holdings of the 

investment fund, the bank may calculate 

the proportion of the assets of the fund 

that are not equity exposures based on 

the terms of the prospectus, partnership 

agreement, or similar contract that 

defines the fund’s permissible 

investments. If the sum of the 

investment limits for all exposure 

classes within the fund exceeds 100 

percent, the bank must assume that the 

investment fund invests to the 

maximum extent possible in equity 

exposures. 

When determining which of a bank’s 

equity exposures qualify for a 100 

percent risk weight based on nonsignificance, a bank first must include 

equity exposures to unconsolidated 

small business investment companies or 

held through consolidated small 

business investment companies 

described in section 302 of the Small 

Business Investment Act of 1958 (15 

U.S.C. 682), then must include publicly 

traded equity exposures (including 

those held indirectly through 

investment funds), and then must 

include non-publicly traded equity 

exposures (including those held 

indirectly through investment funds). 

The SRWA is summarized in Table K: 

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TABLE K 

Risk weight Equity exposure 

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

20 Percent ........ An equity exposure to a Federal Home Loan Bank or Farmer Mac. 

100 Percent ...... • Community development equity exposures.102

• The effective portion of a hedge pair. 

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

300 Percent ...... A publicly traded equity exposure (other than an equity exposure that receives a 600 percent risk weight and including the ineffective portion of a hedge pair). 

400 Percent ...... An equity exposure that is not publicly traded (other than an equity exposure that receives a 600 percent risk weight). 

600 percent ...... An equity exposure to an investment firm that (1) would meet the definition of a traditional securitization were it not for the primary Federal supervisor’s application of paragraph (8) of that definition and (2) has greater than immaterial leverage. 

102The final rule generally defines these exposures as exposures that would qualify as community development investments under 12 U.S.C. 

24(Eleventh), excluding equity exposures to an unconsolidated small business investment company and equity exposures held through a consolidated small business investment company described in section 302 of the Small Business Investment Act of 1958 (15 U.S.C. 682). For savings 

associations, community development investments would be defined to mean equity investments that are designed primarily to promote community welfare, including the welfare of low- and moderate-income communities or families, such as by providing services or jobs, and excluding equity exposures to an unconsolidated small business investment company and equity exposures held through a consolidated small business investment company described in section 302 of the Small Business Investment Act of 1958 (15 U.S.C. 682). 

3. Internal Models Approach (IMA) 

The IMA is designed to provide banks 

with a more sophisticated and risksensitive mechanism for calculating 

risk-based capital requirements for 

equity exposures. To qualify to use the 

IMA, a bank must receive prior written 

approval from its primary Federal 

supervisor. To receive such approval, 

the bank must demonstrate to its 

primary Federal supervisor’s 

satisfaction that the bank meets the 

quantitative and qualitative criteria 

discussed below. As noted earlier, a 

bank may model both publicly traded 

and non-publicly traded equity 

exposures or model only publicly traded 

equity exposures. 

In the final rule, the agencies clarify 

that under the IMA, a bank may use 

more than one model, as appropriate for 

its equity exposures, provided that it 

has received supervisory approval for 

use of the IMA, and each model meets 

the qualitative and quantitative criteria 

specified below and in section 53 of the 

rule. 

IMA Qualification 

The bank must have one or more 

models that (i) assess the potential 

decline in value of its modeled equity 

exposures; (ii) are commensurate with 

the size, complexity, and composition of 

the bank’s modeled equity exposures; 

and (iii) adequately capture both general 

market risk and idiosyncratic risks. The 

bank’s models must produce an estimate 

of potential losses for its modeled equity 

exposures that is no less than the 

estimate of potential losses produced by 

a VaR methodology employing a 99.0 

percent one-tailed confidence interval of 

the distribution of quarterly returns for 

a benchmark portfolio of equity 

exposures comparable to the bank’s 

modeled equity exposures using a longterm sample period. Banks with equity 

portfolios containing equity exposures 

with values that are highly nonlinear in 

nature (for example, equity derivatives 

or convertibles) must employ an 

internal model designed to 

appropriately capture the risks 

associated with these instruments. 

In addition, the number of risk factors 

and exposures in the sample and the 

data period used for quantification in 

the bank’s models and benchmarking 

exercise must be sufficient to provide 

confidence in the accuracy and 

robustness of the bank’s estimates. The 

bank’s model and benchmarking 

exercise also must incorporate data that 

are relevant in representing the risk 

profile of the bank’s modeled equity 

exposures, and must include data from 

at least one equity market cycle 

containing adverse market movements 

relevant to the risk profile of the bank’s 

modeled equity exposures. In addition, 

for the reasons described below, the 

final rule adds that the bank’s 

benchmarking exercise must be based 

on daily market prices for the 

benchmark portfolio. If the bank’s 

model uses a scenario methodology, the 

bank must demonstrate that the model 

produces a conservative estimate of 

potential losses on the bank’s modeled 

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

risk factor models, the bank must 

demonstrate through empirical analysis 

the appropriateness of the risk factors 

used. 

Under the proposed rule, the agencies 

also required that daily market prices be 

available for all modeled equity 

exposures. The proposed requirement 

applied to either direct holdings or 

proxies. Several commenters objected to 

the requirement of daily market prices. 

A few asserted that proxies for private 

equity investments are more relevant 

than public market proxies and should 

be permitted even if they are only 

available on a monthly basis. The 

agencies agree with commenters on this 

issue. Accordingly, under the final rule, 

banks are not required to have daily 

market prices for all modeled equity 

exposures, either direct holdings or 

proxies. However, to ensure sufficient 

rigor in the modeling process, the final 

rule requires that a bank’s 

benchmarking exercise be based on 

daily market prices for the benchmark 

portfolio, as noted above. 

Finally, the bank must be able to 

demonstrate, using theoretical 

arguments and empirical evidence, that 

any proxies used in the modeling 

process are comparable to the bank’s 

modeled equity exposures, and that the 

bank has made appropriate adjustments 

for differences. The bank must derive 

any proxies for its modeled equity 

exposures or benchmark portfolio using 

historical market data that are relevant 

to the bank’s modeled equity exposures 

or benchmark portfolio (or, where not, 

must use appropriately adjusted data), 

and such proxies must be robust 

estimates of the risk of the bank’s 

modeled equity exposures. 

In evaluating whether a bank has met 

the criteria described above, the bank’s 

primary Federal supervisor may 

consider, among other factors, (i) the 

nature of the bank’s equity exposures, 

including the number and types of 

equity exposures (for example, publicly 

traded, non-publicly traded, long, 

short); (ii) the risk characteristics and 

makeup of the bank’s equity exposures, 

including the extent to which publicly 

available price information is obtainable 

on the exposures; and (iii) the level and 

degree of concentration of, and 

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correlations among, the bank’s equity 

exposures. 

The agencies do not intend to dictate 

the form or operational details of a 

bank’s internal model for equity 

exposures. Accordingly, the agencies are 

not prescribing any particular type of 

model for determining risk-based capital 

requirements. Although the final rule 

requires a bank that uses the IMA to 

ensure that its internal model produces 

an estimate of potential losses for its 

modeled equity exposures that is no less 

than the estimate of potential losses 

produced by a VaR methodology 

employing a 99.0 percent one-tailed 

confidence interval of the distribution of 

quarterly returns for a benchmark 

portfolio of equity exposures, the rule 

does not require a bank to use a VaRbased model. The agencies recognize 

that the type and sophistication of 

internal models will vary across banks 

due to differences in the nature, scope, 

and complexity of business lines in 

general and equity exposures in 

particular. The agencies also recognize 

that some banks employ models for 

internal risk management and capital 

allocation purposes that can be more 

relevant to the bank’s equity exposures 

than some VaR models. For example, 

some banks employ rigorous historical 

scenario analysis and other techniques 

for assessing the risk of their equity 

portfolios. 

Banks that choose to use a VaR-based 

internal model under the IMA should 

use a historical observation period that 

includes a sufficient amount of data 

points to ensure statistically reliable and 

robust loss estimates relevant to the 

long-term risk profile of the bank’s 

specific holdings. The data used to 

represent return distributions should 

reflect the longest sample period for 

which data are available and should 

meaningfully represent the risk profile 

of the bank’s specific equity holdings. 

The data sample should be long-term in 

nature and, at a minimum, should 

encompass at least one complete equity 

market cycle containing adverse market 

movements relevant to the risk profile of 

the bank’s modeled exposures. The data 

used should be sufficient to provide 

conservative, statistically reliable, and 

robust loss estimates that are not based 

purely on subjective or judgmental 

considerations. 

The parameters and assumptions used 

in a VaR model should be subject to a 

rigorous and comprehensive regime of 

stress-testing. Banks utilizing VaR 

models should subject their internal 

model and estimation procedures, 

including volatility computations, to 

either hypothetical or historical 

scenarios that reflect worst-case losses 

given underlying positions in both 

publicly traded and non-publicly traded 

equities. At a minimum, banks that use 

a VaR model should employ stress tests 

to provide information about the effect 

of tail events beyond the level of 

confidence assumed in the IMA. 

Banks using non-VaR internal models 

that are based on stress tests or scenario 

analyses should estimate losses under 

worst-case modeled scenarios. These 

scenarios should reflect the composition 

of the bank’s equity portfolio and 

should produce risk-based capital 

requirements at least as large as those 

that would be required to be held 

against a representative market index or 

other relevant benchmark portfolio 

under a VaR approach. For example, for 

a portfolio consisting primarily of 

publicly held equity securities that are 

actively traded, risk-based capital 

requirements produced using historical 

scenario analyses should be greater than 

or equal to risk-based capital 

requirements produced by a baseline 

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

holdings. 

The loss estimate derived from the 

bank’s internal model constitutes the 

risk-based capital requirement for the 

modeled equity exposures (subject to 

the supervisory floors described below). 

The equity capital requirement is 

incorporated into a bank’s risk-based 

capital ratio through the calculation of 

risk-weighted equivalent assets. To 

convert the equity capital requirement 

into risk-weighted equivalent assets, a 

bank must multiply the capital 

requirement by 12.5. 

Risk-Weighted Assets Under the IMA 

Under the proposed and final rules, as 

noted above, a bank may apply the IMA 

only to its publicly traded equity 

exposures or may apply the IMA to its 

publicly traded and non-publicly traded 

equity exposures. In either case, a bank 

is not allowed to apply the IMA to 

equity exposures that receive a 0 or 20 

percent risk weight under the SRWA, 

community development equity 

exposures, and equity exposures to 

investment funds (collectively, 

excluded equity exposures). Unlike the 

SRWA, the IMA does not provide for a 

10 percent materiality threshold for 

non-significant equity exposures. 

Several commenters objected to the 

fact that the IMA does not provide a 100 

percent risk weight for non-significant 

equity exposures up to a 10 percent 

materiality threshold. These 

commenters maintained that the lack of 

a materiality threshold under the IMA 

will discourage use of this methodology 

relative to the SRWA. Commenters 

suggested that the agencies incorporate 

a materiality threshold into the IMA. 

The agencies do not believe that it is 

necessary or appropriate to incorporate 

such a threshold under the IMA. The 

agencies are concerned that a bank 

could manipulate significantly its riskbased capital requirements based on the 

exposures it chooses to model and those 

which it would deem immaterial (and to 

which it would apply a 100 percent risk 

weight). The agencies also believe that 

a flat 100 percent risk weight is 

inconsistent with the risk sensitivity of 

the IMA. 

Under the proposal, if a bank applied 

the IMA to both publicly traded and 

non-publicly traded equity exposures, 

the bank’s aggregate risk-weighted asset 

amount for its equity exposures would 

be equal to the sum of the risk-weighted 

asset amount of excluded equity 

exposures (calculated outside of the 

IMA) and the risk-weighted asset 

amount of the non-excluded equity 

exposures (calculated under the IMA). 

The risk-weighted asset amount of the 

non-excluded equity exposures 

generally would be set equal to the 

estimate of potential losses on the 

bank’s non-excluded equity exposures 

generated by the bank’s internal model 

multiplied by 12.5. To ensure that a 

bank holds a minimum amount of riskbased capital against its modeled equity 

exposures, however, the proposed rule 

contained a supervisory floor on the 

risk-weighted asset amount of the nonexcluded equity exposures. As a result 

of this floor, the risk-weighted asset 

amount of the non-excluded equity 

exposures could not fall below the sum 

of (i) 200 percent multiplied by the 

aggregate adjusted carrying value or 

ineffective portion of hedge pairs, as 

appropriate, of the bank’s non-excluded 

publicly traded equity exposures; and 

(ii) 300 percent multiplied by the 

aggregate adjusted carrying value of the 

bank’s non-excluded non-publicly 

traded equity exposures. 

Also under the proposal, if a bank 

applied the IMA only to its publicly 

traded equity exposures, the bank’s 

aggregate risk-weighted asset amount for 

its equity exposures would be equal to 

the sum of (i) the risk-weighted asset 

amount of excluded equity exposures 

(calculated outside of the IMA); (ii) 400 

percent multiplied by the aggregate 

adjusted carrying value of the bank’s 

non-excluded non-publicly traded 

equity exposures; and (iii) the aggregate 

risk-weighted asset amount of its nonexcluded publicly traded equity 

exposures. The risk-weighted asset 

amount of the non-excluded publicly 

traded equity exposures would be equal 

to the estimate of potential losses on the 

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bank’s non-excluded publicly traded 

equity exposures generated by the 

bank’s internal model multiplied by 

12.5. Under the proposed rule, the riskweighted asset amount for the nonexcluded publicly traded equity 

exposures would be subject to a floor of 

200 percent multiplied by the aggregate 

adjusted carrying value or ineffective 

portion of hedge pairs, as appropriate, of 

the bank’s non-excluded publicly traded 

equity exposures. 

Several commenters did not support 

the concept of floors in a risk-sensitive 

approach that requires a comparison to 

estimates of potential losses produced 

by a VaR methodology. If floors are 

required in the final rule, however, 

these commenters noted that the 

calculation at the aggregate level would 

not pose significant operational issues. 

A few commenters, in contrast, objected 

to the proposed aggregate floors, 

asserting that it would be operationally 

difficult to determine compliance with 

such floors. 

The agencies believe that it is prudent 

to retain the floor requirements in the 

IMA and, thus, are adopting the floor 

requirements as described above. The 

agencies note that the New Accord also 

imposes a 200 percent and 300 percent 

floor for publicly traded and nonpublicly traded equity exposures, 

respectively. Regarding the proposal to 

calculate the floors on an aggregate 

basis, the agencies believe it is 

appropriate to maintain this approach, 

given that for most banks it does not 

seem to pose significant operational 

issues. 

4. Equity Exposures to Investment 

Funds 

The proposed rule included a separate 

treatment for equity exposures to 

investment funds. As proposed, a bank 

would determine the risk-weighted asset 

amount for equity exposures to 

investment funds using one of three 

approaches: the full look-through 

approach, the simple modified lookthrough approach, or the alternative 

modified look-through approach, unless 

the equity exposure to an investment 

fund is a community development 

equity exposure. Such equity exposures 

would be subject to a 100 percent risk 

weight. If an equity exposure to an 

investment fund is part of a hedge pair, 

a bank could use the ineffective portion 

of the hedge pair as the adjusted 

carrying value for the equity exposure to 

the investment fund. The risk-weighted 

asset amount of the effective portion of 

the hedge pair is equal to its adjusted 

carrying value. A bank could choose to 

apply a different approach among the 

three alternatives to different equity 

exposures to investment funds. 

The agencies proposed a separate 

treatment for equity exposures to an 

investment fund to prevent banks from 

arbitraging the proposed rule’s riskbased capital requirements for certain 

high-risk exposures and to ensure that 

banks do not receive a punitive riskbased capital requirement for equity 

exposures to investment funds that hold 

only low-risk assets. Under the 

proposal, the agencies defined an 

investment fund as a company (i) all or 

substantially all of the assets of which 

are financial assets and (ii) that has no 

material liabilities. 

Generally, commenters supported the 

separate treatment for equity exposures 

to investment funds. However, several 

commenters objected to the exclusion of 

investment funds with material 

liabilities from this separate treatment, 

observing that it would exclude equity 

exposures to hedge funds. Several 

commenters suggested that investment 

funds with material liabilities should be 

eligible for the look-through approaches. 

One commenter suggested that the 

agencies should adopt the following 

definition of investment fund: ‘‘A 

company in which all or substantially 

all of the assets are pooled financial 

assets that are collectively managed in 

order to generate a financial return, 

including investment companies or 

funds with material liabilities.’’ A few 

commenters suggested that equity 

exposures to investment funds with 

material liabilities should be treated 

under the SRWA or IMA as nonpublicly traded equity exposures rather 

than the separate treatment developed 

for equity exposures to investment 

funds. 

The agencies do not agree with 

commenters that the look-through 

approaches for investment funds should 

apply to investment vehicles with 

material liabilities. The look-through 

treatment is designed to capture the 

risks of an indirect holding of the 

underlying assets of the investment 

fund. Investment vehicles with material 

liabilities provide a leveraged exposure 

to the underlying financial assets and 

have a risk profile that may not be 

appropriately captured by a lookthrough approach. 

Under the proposal, each of the 

approaches to equity exposures to 

investment funds imposed a 7 percent 

minimum risk weight on such 

exposures. This proposed minimum risk 

weight was similar to the minimum 7 

percent risk weight under the RBA for 

securitization exposures and the 

effective 56 basis point minimum riskbased capital requirement per dollar of 

securitization exposure under the SFA. 

Several commenters objected to the 

proposed 7 percent risk weight floor. A 

few commenters suggested that the floor 

should be decreased or eliminated, 

particularly for low-risk investment 

funds that receive the highest rating 

from an NRSRO. Others recommended 

that the 7 percent risk weight floor 

should be applied on an aggregate basis 

rather than on a fund-by-fund basis. 

The agencies proposed the 7 percent 

risk weight floor as a minimum riskbased capital requirement for exposures 

not directly held by a bank. However, 

the agencies believe the comments on 

this issue have merit and recognize that 

the floor would provide banks with an 

incentive to invest in higher-risk 

investment funds. Consistent with the 

New Accord, the final rule does not 

impose a 7 percent risk weight floor on 

equity exposures to investment funds, 

on either an individual or aggregate 

basis. 

Full Look-Through Approach 

A bank may use the full look-through 

approach only if the bank is able to 

compute a risk-weighted asset amount 

for each of the exposures held by the 

investment fund. Under the proposed 

rule, a bank would be required to 

calculate the risk-weighted asset amount 

for each of the exposures held by the 

investment fund as if the exposures 

were held directly by the bank. 

Depending on whether the exposures 

were wholesale, retail, securitization, or 

equity exposures, a bank would apply 

the appropriate IRB risk-based capital 

treatment. 

Several commenters suggested that 

the agencies should allow a bank with 

supervisory approval to use the IMA to 

model the underlying assets of an 

investment fund by including the bank’s 

pro rata share of the investment fund’s 

assets in its equities model. The 

commenters believed there is no basis 

for preventing a bank from using the 

IMA, a sophisticated and risk-sensitive 

approach, when a bank has full position 

data for an investment fund. 

The agencies agree with commenters’

views in this regard. If a bank has full 

position data for an investment fund 

and has been approved by its primary 

Federal supervisor for use of the IMA, 

it may include the underlying equity 

exposures held by an investment fund, 

after adjustment for proportional 

ownership, in its equities model under 

the IMA. Therefore, in the final rule, 

under the full look-through approach, a 

bank must either (i) set the riskweighted asset amount of the bank’s 

equity exposure to the investment fund 

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equal to product of (A) the aggregate 

risk-weighted asset amounts of the 

exposures held by the fund as if they 

were held directly by the bank and (B) 

the bank’s proportional ownership share 

of the fund; or (ii) include the bank’s 

proportional ownership share of each 

exposure held by the fund in the bank’s 

IMA. If the bank chooses (ii), the riskweighted asset amount for the equity 

exposure to the investment fund is 

determined together with the riskweighted asset amount for the bank’s 

other non-excluded equity exposures 

and is subject to the aggregate floors 

under this approach. 

Simple Modified Look-Through 

Approach 

Under the proposed simple modified 

look-through approach, a bank would 

set the risk-weighted asset amount for 

its equity exposure to an investment 

fund equal to the adjusted carrying 

value of the equity exposure multiplied 

by the highest risk weight in Table L 

that applies to any exposure the fund is 

permitted to hold under its prospectus, 

partnership agreement, or similar 

contract that defines the fund’s 

permissible investments. The bank 

could exclude derivative contracts that 

are used for hedging, not speculative 

purposes, and do not constitute a 

material portion of the fund’s exposures. 

Commenters generally supported the 

simple modified look-through approach 

as a low-burden yet moderately risksensitive way of treating equity 

exposures to an investment fund. 

However, several commenters objected 

to the large jump in risk weights (from 

a 400 percent to a 1,250 percent risk 

weight) between investment funds 

permitted to hold non-publicly traded 

equity exposures and investment funds 

permitted to hold OTC derivative 

contracts and/or exposures that must be 

deducted from regulatory capital or 

receive a risk weight greater than 400 

percent under the IRB approach. In 

addition, one commenter objected to the 

proposed 20 percent risk weight for the 

most highly rated money market mutual 

funds that are subject to SEC rule 2a-7 

governing portfolio maturity, quality, 

diversification and liquidity. This 

commenter asserted that a 7 percent risk 

weight for such exposures would be 

appropriate. 

The agencies agree that the proposed 

risk-weighting for highly-rated money 

market mutual funds subject to SEC rule 

2a-7 is conservative, given the generally 

low risk of such funds. Accordingly, the 

agencies added a new investment fund 

approach—the Money Market Fund 

Approach—which applies a 7 percent 

risk weight to a bank’s equity exposure 

to a money market fund that is subject 

to SEC rule 2a-7 and that has an 

applicable external rating in the highest 

investment-grade rating category. 

The agencies have made no changes 

to address commenters’ concerns about 

a lack of intermediate risk weights 

between 400 percent and 1,250 percent. 

The agencies believe the range of risk 

weights is sufficiently granular to 

accommodate most equity exposures to 

investment funds. 

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

Risk weight Exposure class or investment fund type 

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

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

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

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

bankers’ acceptances. 

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

rating in the second-highest investment-grade rating category. 

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

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

300 Percent ............... Publicly traded equity exposures. 

400 Percent ............... Non-publicly traded equity exposures; exposures with a long-term external rating two or more rating categories below investment grade; and unrated exposures (excluding publicly traded equity exposures). 

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

than 400 percent under this appendix. 

Alternative Modified Look-Through 

Approach 

Under this approach, a bank may 

assign the adjusted carrying value of an 

equity exposure to an investment fund 

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

the investment limits in the fund’s 

prospectus, partnership agreement, or 

similar contract that defines the fund’s 

permissible investments. If the sum of 

the investment limits for all exposure 

classes within the fund exceeds 100 

percent, the bank must assume that the 

fund invests to the maximum extent 

permitted under its investment limits in 

the exposure class with the highest risk 

weight under Table L, and continues to 

make investments in the order of the 

exposure class with the next highest 

risk-weight under Table L until the 

maximum total investment level is 

reached. If more than one exposure class 

applies to an exposure, the bank must 

use the highest applicable risk weight. 

A bank may exclude derivative 

contracts held by the fund that are used 

for hedging, not speculative, purposes 

and do not constitute a material portion 

of the fund’s exposures. Other than 

comments addressing the risk weight 

table and the 7 percent floor (addressed 

above), the agencies did not receive 

significant comment on this approach 

and have adopted it without significant 

change. 

VI. Operational Risk 

This section describes features of the 

AMA framework for determining the 

risk-based capital requirement for 

operational risk. A bank meeting the 

AMA qualifying criteria uses its internal 

operational risk quantification system to 

calculate its risk-based capital 

requirement for operational risk. 

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

explicit capital charge for operational 

risk. Rather, the existing risk-based 

capital rules were designed to broadly 

cover all risks, and therefore implicitly 

cover operational risk. With the 

adoption of the more risk-sensitive 

treatment under the IRB approach for 

credit risk in this final rule, there no 

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103 103 New Accord, ¶669(b). 

longer is an implicit capital buffer for 

other risks. 

The agencies recognize that 

operational risk is a key risk in banks, 

and evidence indicates that a number of 

factors are driving increases in 

operational risk. These factors include 

greater use of automated technology, 

proliferation of new and highly complex 

products, growth of e-banking 

transactions and related business 

applications, large-scale acquisitions, 

mergers, and consolidations, and greater 

use of outsourcing arrangements. 

Furthermore, the experience of a 

number of high-profile, high-severity 

operational losses across the banking 

industry, including those resulting from 

legal settlements, highlight operational 

risk as a major source of unexpected 

losses. Because the implicit regulatory 

capital buffer for operational risk is 

removed under the final rule, the 

agencies are requiring banks using the 

IRB approach for credit risk to use the 

AMA to address operational risk when 

computing their risk-based capital 

requirement. 

As discussed previously, operational 

risk exposure is the 99.9th percentile of 

the distribution of potential aggregate 

operational losses as generated by the 

bank’s operational risk quantification 

system over a one-year horizon. EOL is 

the expected value of the same 

distribution of potential aggregate 

operational losses. Under the proposal, 

a bank’s risk-based capital requirement 

for operational risk would be the sum of 

EOL and UOL. A bank would be 

allowed to recognize (i) certain offsets 

for EOL (such as certain reserves and 

other internal business practices), and 

(ii) the effect of risk mitigants such as 

insurance in calculating its regulatory 

capital requirement for operational risk. 

Under the proposed rule, the agencies 

recognized that a bank’s risk-based 

capital requirement for operational risk 

could be based on UOL alone if the bank 

could demonstrate it has offset EOL 

with eligible operational risk offsets. 

Eligible operational risk offsets were 

defined as amounts, not to exceed EOL, 

that (i) are generated by internal 

business practices to absorb highly 

predictable and reasonably stable 

operational losses, including reserves 

calculated in a manner consistent with 

GAAP; and (ii) are available to cover 

EOL with a high degree of certainty over 

a one-year horizon. Eligible operational 

risk offsets could only be used to offset 

EOL, not UOL. 

The preamble to the proposed rule 

stated that in determining whether to 

accept a proposed EOL offset, the 

agencies would consider whether the 

proposed offset would be available to 

cover EOL with a high degree of 

certainty over a one-year horizon. 

Supervisory recognition of EOL offsets 

would be limited to those business lines 

and event types with highly predictable, 

routine losses. The preamble noted that 

based on discussions with the industry 

and supervisory experience, highly 

predictable and routine losses appear to 

be limited to those relating to securities 

processing and to credit card fraud. 

The majority of commenters on this 

issue recommended that the agencies 

should allow banks to present evidence 

of additional areas with highly 

predictable and reasonably stable losses 

for which eligible operational risk 

offsets could be considered. These 

commenters identified fraud losses 

pertaining to debit or ATM cards, 

commercial or business credit cards, 

HELOCs, and external checks in retail 

banking as additional events that have 

highly predictable and reasonably stable 

losses. Commenters also identified legal 

reserves set aside for small, predictable 

legal loss events, budgeted funds, and 

forecasted funds as other items that 

should be considered eligible 

operational risk offsets. Several 

commenters also highlighted that the 

proposed rule was inconsistent with the 

New Accord regarding the ability of 

budgeted funds to serve as EOL offsets. 

One commenter proposed eliminating 

EOL altogether because the commenter 

already factors it into its pricing 

practices. 

The New Accord permits a supervisor 

to accept expected loss offsets provided 

a bank is ‘‘able to demonstrate to the 

satisfaction of its national supervisor 

that it has measured and accounted for 

its EL exposure.’’ 103 To the extent a 

bank is permitted to adjust its estimate 

of operational risk exposure to reflect 

potential operational risk offsets, it is 

appropriate to consider the degree to 

which such offsets meet U.S. accounting 

standards and can be viewed as 

regulatory capital substitutes. The final 

rule retains the proposed definition 

described above. The agencies believe 

that this definition allows for the 

supervisory consideration of EOL offsets 

in a flexible and prudent manner. 

In determining its operational risk 

exposure, the bank may also take into 

account the effects of qualifying 

operational risk mitigants such as 

insurance. To recognize the effects of 

qualifying operational risk mitigants 

such as insurance for risk-based capital 

purposes, the bank must estimate its 

operational risk exposure with and 

without such effects. The reduction in a 

bank’s risk-based capital requirement 

for operational risk due to qualifying 

operational risk mitigants may not 

exceed 20 percent of the bank’s riskbased capital requirement for 

operational risk, after approved 

adjustments for EOL offsets. 

A risk mitigant must be able to absorb 

losses with sufficient certainty to 

warrant inclusion as a qualifying 

operational risk mitigant. For insurance 

to meet this standard, it must: 

(i) be provided by an unaffiliated 

company that has a claims paying 

ability that is rated in one of the three 

highest rating categories by an NRSRO; 

(ii) have an initial term of at least one 

year and a residual term of more than 

90 days; 

(iii) have a minimum notice period for 

cancellation of 90 days; 

(iv) have no exclusions or limitations 

based upon regulatory action or for the 

receiver or liquidator of a failed bank; 

and 

(v) be explicitly mapped to an actual 

operational risk exposure of the bank. 

A bank must receive prior written 

approval from its primary Federal 

supervisor to recognize an operational 

risk mitigant other than insurance as a 

qualifying operational risk mitigant. In 

evaluating an operational risk mitigant 

other than insurance, a primary Federal 

supervisor will consider whether the 

operational risk mitigant covers 

potential operational losses in a manner 

equivalent to holding regulatory capital. 

The bank’s methodology for 

incorporating the effects of insurance 

must capture, through appropriate 

discounts in the amount of risk 

mitigation, the residual term of the 

policy, where less than one year; the 

policy’s cancellation terms, where less 

than one year; the policy’s timeliness of 

payment; and the uncertainty of 

payment as well as mismatches in 

coverage between the policy and the 

hedged operational loss event. The bank 

may not recognize for regulatory capital 

purposes insurance with a residual term 

of 90 days or less. 

Several commenters criticized the 

proposal for limiting recognition of noninsurance operational risk mitigants to 

those mitigants that would cover 

potential operational losses in a manner 

equivalent to holding regulatory capital. 

The commenters noted that similar 

limitations are not included in the New 

Accord. Other commenters asserted that 

qualifying operational risk mitigants 

should be broader than insurance. 

The New Accord discusses the use of 

insurance explicitly as an operational 

risk mitigant and notes that the BCBS 

‘‘in due course, may consider revising 

the criteria for and limits on the 

recognition of operational risk mitigants 

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104New Accord, footnote 110. 

on the basis of growing experience.’’ 104

Similarly, under the proposed rule, the 

agencies provided flexibility that 

recognizes the potential for developing 

operational risk mitigants other than 

insurance over time. The agencies 

continue to believe it is appropriate to 

consider the degree to which such 

mitigants can be viewed as regulatory 

capital substitutes. Therefore, under the 

final rule, in evaluating such mitigants, 

the agencies will consider whether the 

operational risk mitigant covers 

potential operational losses in a manner 

equivalent to holding regulatory capital. 

Under the final rule, as under the 

proposal, if a bank does not qualify to 

use or does not have qualifying 

operational risk mitigants, the bank’s 

dollar risk-based capital requirement for 

operational risk is its operational risk 

exposure minus eligible operational risk 

offsets (if any). If a bank qualifies to use 

operational risk mitigants and has 

qualifying operational risk mitigants, 

the bank’s dollar risk-based capital 

requirement for operational risk is the 

greater of: (i) The bank’s operational risk 

exposure adjusted for qualifying 

operational risk mitigants minus eligible 

operational risk offsets (if any); and (ii) 

0.8 multiplied by the difference between 

the bank’s operational risk exposure and 

its eligible operational risk offsets (if 

any). The dollar risk-based capital 

requirement for operational risk is 

multiplied by 12.5 to convert it into an 

equivalent risk-weighted asset amount. 

The resulting amount is added to the 

comparable amount for credit risk in 

calculating the institution’s risk-based 

capital denominator. 

VII. Disclosure 

1. Overview 

The agencies have long supported 

meaningful public disclosure by banks 

with the objective of improving market 

discipline. The agencies recognize the 

importance of market discipline in 

encouraging sound risk management 

practices and fostering financial 

stability. 

Pillar 3 of the New Accord, market 

discipline, complements the minimum 

capital requirements and the 

supervisory review process by 

encouraging market discipline through 

enhanced and meaningful public 

disclosure. The public disclosure 

requirements in the final rule are 

intended to allow market participants to 

assess key information about a bank’s 

risk profile and its associated level of 

capital. 

The agencies view public disclosure 

as an important complement to the 

advanced approaches to calculating 

minimum regulatory risk-based capital 

requirements, which will be heavily 

based on internal systems and 

methodologies. With enhanced 

transparency regarding banks’

experiences with the advanced 

approaches, investors can better 

evaluate a bank’s capital structure, risk 

exposures, and capital adequacy. With 

sufficient and relevant information, 

market participants can better evaluate 

a bank’s risk management performance, 

earnings potential and financial 

strength. 

Improvements in public disclosures 

come not only from regulatory 

standards, but also through efforts by 

bank management to improve 

communications to public shareholders 

and other market participants. In this 

regard, improvements to risk 

management processes and internal 

reporting systems provide opportunities 

to significantly improve public 

disclosures over time. Accordingly, the 

agencies strongly encourage the 

management of each bank to regularly 

review its public disclosures and 

enhance these disclosures, where 

appropriate, to clearly identify all 

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

on the bank’s financial condition and 

performance, cash flow, and earnings 

potential. 

Comments on the Proposed Rule 

Many commenters expressed concern 

that the proposed disclosures were 

excessive, burdensome and overly 

prescriptive and would hinder—rather 

than facilitate—market discipline by 

requiring banks to disclose items that 

would not be well understood or 

provide useful information to market 

participants. In particular, commenters 

were concerned that the differences 

between the proposed rule and the New 

Accord (such as the proposed ELGD risk 

parameter and proposed wholesale 

definition of default) would not be 

meaningful for cross-border comparative 

purposes, and would increase 

compliance burden for banks subject to 

the agencies’ risk-based capital rules. 

Some commenters also believed that the 

information provided in the disclosures 

would not be comparable across banks 

because each bank would use distinct 

internal methodologies to generate the 

disclosures. Several commenters 

suggested that the agencies should delay 

the disclosure requirements until U.S. 

implementation of the IRB approach has 

gained some maturity. This would allow 

the agencies and banking industry 

sufficient time to ensure usefulness of 

the public disclosure requirements and 

comparability across banks. 

The agencies believe that it is 

important to retain the vast majority of 

the proposed disclosures, which are 

consistent with the New Accord. These 

disclosures will enable market 

participants to gain key insights 

regarding a bank’s capital structure, risk 

exposures, risk assessment processes, 

and ultimately, the capital adequacy of 

the institution. The agencies also note 

that many of the disclosure 

requirements are already required by, or 

are consistent with, existing GAAP, SEC 

disclosure requirements, or regulatory 

reporting requirements for banks. More 

generally, the agencies view the public 

disclosure requirements as an integral 

part of the advanced approaches and the 

New Accord and are continuing to 

require their implementation beginning 

with a bank’s first transitional floor 

period. 

The agencies are sympathetic, 

however, to commenters’ concerns 

about cross-border comparability. The 

agencies believe that many of the 

changes they have made to the final rule 

(such as eliminating the ELGD risk 

parameter and adopting the New 

Accord’s definition of default for 

wholesale exposures, as discussed 

above) will address commenters’

concerns regarding comparability. In 

addition, the agencies have made 

several changes to the disclosure 

requirements to make them more 

consistent with the New Accord. These 

changes should increase cross-border 

comparability and reduce 

implementation and compliance 

burden. These changes are discussed in 

the relevant sections below. 

2. General Requirements 

Under the proposed rule, the public 

disclosure requirements would apply to 

the top-tier legal entity that is a core or 

opt-in bank within a consolidated 

banking group—the top-tier U.S. BHC or 

DI that is a core or opt-in bank. 

Several commenters objected to this 

proposal, noting that it is inconsistent 

with the New Accord, which requires 

such disclosures at the global top 

consolidated level of a banking group to 

which the framework applies. 

Commenters asserted that public 

disclosure at the U.S. BHC or DI level 

for U.S. banking organizations owned by 

a foreign banking organization is not 

meaningful and could generate 

confusion or misunderstanding in the 

market. 

The agencies agree that commenters’

concerns have merit and believe that it 

is important to be consistent with the 

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105Alternatively, banks may provide the 

disclosures in more than one place, as some of them 

Continued 

New Accord. Accordingly, under the 

final rule, the public disclosure 

requirements will generally be required 

only at the top-tier global consolidated 

level. Under exceptional circumstances, 

a primary Federal supervisor may 

require some or all of the public 

disclosures at the top-tier U.S. level if 

the primary Federal supervisor 

determines that such disclosures are 

important for market participants to 

form appropriate insights regarding the 

bank’s risk profile and associated level 

of capital. A factor the agencies will 

consider, for example, is whether a U.S. 

subsidiary of a foreign banking 

organization has debt or equity 

registered and actively traded in the 

United States. 

In addition, the proposed rule stated 

that, in general, a DI that is a subsidiary 

of a BHC or another DI would not be 

subject to the disclosure requirements 

except that every DI would be required 

to disclose total and tier 1 capital ratios 

and their components, similar to current 

requirements. Nonetheless, these 

entities must file applicable bank 

regulatory reports and thrift financial 

reports. In addition, as described below 

in the regulatory reporting section, the 

agencies will require certain additional 

regulatory reporting from banks 

applying the advanced approaches, and 

a limited amount of the reported 

information will be publicly disclosed. 

If a DI that is a core or opt-in bank and 

is not a subsidiary of a BHC or another 

DI that must make the full set of 

disclosures, the DI would be required to 

make the full set disclosures. 

One commenter objected to the 

supervisory flexibility provided to 

require additional disclosures at the 

subsidiary level. The commenter 

maintained that in all cases DIs that are 

a subsidiary of a BHC or another DI 

should not be subject to the disclosure 

requirements beyond disclosing their 

total and tier 1 capital ratios and the 

ratio components, as proposed. The 

commenter suggested that the agencies 

clarify this issue in the final rule. 

The agencies do not believe, however, 

that these changes are appropriate. The 

agencies believe that it is important to 

preserve some flexibility in the event 

that the primary Federal supervisor 

believes that disclosures from such a DI 

are important for market participants to 

form appropriate insights regarding the 

bank’s risk profile and associated level 

of capital. 

The risks to which a bank is exposed, 

and the techniques that it uses to 

identify, measure, monitor, and control 

those risks are important factors that 

market participants consider in their 

assessment of the bank. Accordingly, 

under the proposed and final rules, each 

bank that is subject to the disclosure 

requirements must have a formal 

disclosure policy approved by its board 

of directors that addresses the bank’s 

approach for determining the 

disclosures it should make. The policy 

should address the associated internal 

controls and disclosure controls and 

procedures. The board of directors and 

senior management must ensure that 

appropriate review of the disclosures 

takes place and that effective internal 

controls and disclosure controls and 

procedures are maintained. 

A bank should decide which 

disclosures are relevant for it based on 

the materiality concept. Information 

would be regarded as material if its 

omission or misstatement could change 

or influence the assessment or decision 

of a user relying on that information for 

the purpose of making investment 

decisions. 

To the extent applicable, a bank may 

fulfill its disclosure requirements under 

this final rule by relying on disclosures 

made in accordance with accounting 

standards or SEC mandates that are very 

similar to the disclosure requirements in 

this final rule. In these situations, a 

bank must explain material differences 

between the accounting or other 

disclosure and the disclosures required 

under this final rule. 

Frequency/Timeliness 

Under the proposed rule, the agencies 

required that quantitative disclosures be 

made quarterly. Several commenters 

objected to this requirement. These 

commenters asserted that banks subject 

to the U.S. public disclosure 

requirements would be placed at a 

competitive disadvantage because the 

New Accord requires banks to make 

Pillar 3 public disclosures on a 

semiannual basis. 

The agencies believe that quarterly 

public disclosure requirements are 

important to ensure that the market has 

access to timely and relevant 

information and therefore have decided 

to retain quarterly quantitative 

disclosure requirements in the final 

rule. This disclosure frequency is 

consistent with longstanding 

requirements in the United States for 

robust quarterly disclosures in financial 

and regulatory reports, and is 

appropriate considering the potential for 

rapid changes in risk profiles. Moreover, 

many of the existing SEC, regulatory 

reporting, and other disclosure 

requirements that a bank may use to 

help meet its public disclosure 

requirements in the final rule are 

already required on a quarterly basis. 

The proposal stated that the 

disclosures must be timely and that the 

agencies would consider a disclosure to 

be timely if it was made no later than 

the reporting deadlines for regulatory 

reports (for example, FR Y–9C) and 

financial reports (for example, SEC 

Forms 10–Q and 10–K). When these 

deadlines differ, the later deadline 

should be used. 

Several commenters expressed 

concern that the tight timeframe for 

public disclosure requirements would 

be a burden and requested that the 

agencies provide greater flexibility, such 

as by setting the deadline for public 

disclosures at 60 days after quarter-end. 

The agencies believe commenters’

concerns must be balanced against the 

importance of allowing market 

participants to have access to timely 

information that is reflective of a bank’s 

risk profile and associated capital levels. 

Accordingly, the agencies have decided 

to interpret the requirement for timely 

public disclosures for purposes of this 

final rule to mean within 45 days after 

calendar quarter-end. 

In some cases, management may 

determine that a significant change has 

occurred, such that the most recent 

reported amounts do not reflect the 

bank’s capital adequacy and risk profile. 

In those cases, banks should disclose 

the general nature of these changes and 

briefly describe how they are likely to 

affect public disclosures going forward. 

These interim disclosures should be 

made as soon as practicable after the 

determination that a significant change 

has occurred. 

Location of Disclosures and Audit/ 

Attestation Requirements 

Under the proposed and final rules, 

the disclosures must be publicly 

available (for example, included on a 

public Web site) for each of the latest 

three years (12 quarters) or such shorter 

time period since the bank entered its 

first transitional floor period. Except as 

discussed below, management has 

discretion to determine the appropriate 

medium and location of the disclosures 

required by this final rule. Furthermore, 

banks have flexibility in formatting their 

public disclosures. The agencies are not 

specifying a fixed format for these 

disclosures. 

The agencies encourage management 

to provide all of the required disclosures 

in one place on the entity’s public Web 

site. The public Web site addresses are 

reported in the regulatory reports (for 

example, the FR Y–9C).105

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may be included in public financial reports (for 

example, in Management’s Discussion and Analysis 

included in SEC filings) or other regulatory reports 

(for example, FR Y–9C Reports). Banks must 

provide a summary table on their public Web site 

that specifically indicates where all the disclosures 

may be found (for example, regulatory report 

schedules or page numbers in annual reports). 

106These ratios are required to be disclosed in the 

footnotes to the audited financial statements 

pursuant to existing GAAP requirements in Chapter 

17 of the ‘‘AICPA Audit and Accounting Guide for 

Depository and Lending Institutions: Banks, 

Savings institutions, Credit unions, Finance 

companies and Mortgage companies.’’

107Proprietary information encompasses 

information that, if shared with competitors, would 

render a bank’s investment in these products/ 

systems less valuable, and, hence, could undermine 

its competitive position. Information about 

customers is often confidential, in that it is 

provided under the terms of a legal agreement or 

counterparty relationship. 

Disclosure of tier 1 and total capital 

ratios must be provided in the footnotes 

to the year-end audited financial 

statements.106 Accordingly, these 

disclosures must be tested by external 

auditors as part of the financial 

statement audit. Disclosures that are not 

included in the footnotes to the audited 

financial statements are not subject to 

external audit reports for financial 

statements or internal control reports 

from management and the external 

auditor. 

The preamble to the proposed rule 

stated that due to the importance of 

reliable disclosures, the agencies would 

require the chief financial officer to 

certify that the disclosures required by 

the proposed rule were appropriate and 

that the board of directors and senior 

management were responsible for 

establishing and maintaining an 

effective internal control structure over 

financial reporting, including the 

information required by the proposed 

rule. 

Several commenters expressed 

uncertainty regarding the proposed 

certification requirement for the chief 

financial officer. One commenter asked 

the agencies to articulate the standard of 

acceptance required for the certification 

of disclosure standards compared with 

what is required for financial reporting 

purposes. Another commenter 

questioned whether the chief financial 

officer would have sufficient familiarity 

with the risk management disclosures to 

make such a certification. 

To address commenter uncertainty, 

the agencies have simplified and 

clarified the final rule’s accountability 

requirements. Specifically, the final rule 

modifies the certification requirement 

and instead requires one or more senior 

officers of the bank to attest that the 

disclosures meet the requirements of the 

final rule. The senior officer may be the 

chief financial officer, the chief risk 

officer, an equivalent senior officer, or a 

combination thereof. 

Proprietary and Confidential 

Information 

The agencies stated in the preamble to 

the proposed rule that they believed the 

proposed requirements strike an 

appropriate balance between the need 

for meaningful disclosure and the 

protection of proprietary and 

confidential information.107 Many 

commenters, however, expressed 

concern that the required disclosures 

would result in the release of 

proprietary information. Commenters 

expressed particular concerns about the 

granularity of the credit loss history and 

securitization disclosures, as well as 

disclosures for portfolios subject to the 

IRB risk-based capital formulas. 

As noted above, the final rule 

provides banks with considerable 

discretion with regard to public 

disclosure requirements. Bank 

management determines which 

disclosures are relevant based on a 

materiality concept. In addition, bank 

management has flexibility regarding 

formatting and the level of granularity of 

disclosures, provided they meet certain 

minimum requirements. Accordingly, 

the agencies believe that banks generally 

can provide these disclosures without 

revealing proprietary and confidential 

information. Only in rare circumstances 

might disclosure of certain items of 

information required in the final rule 

compel a bank to reveal confidential 

and proprietary information. In these 

unusual situations, the final rule 

requires that if a bank believes that 

disclosure of specific commercial or 

financial information would prejudice 

seriously the position of the bank by 

making public information that is either 

proprietary or confidential in nature, the 

bank need not disclose those specific 

items, but must disclose more general 

information about the subject matter of 

the requirement, together with the fact 

that, and the reason why, the specific 

items of information have not been 

disclosed. This provision of the final 

rule applies only to those disclosures 

required by the final rule and does not 

apply to disclosure requirements 

imposed by accounting standards or 

other regulatory agencies. 

3. Summary of Specific Public 

Disclosure Requirements 

As in the proposed rule, the public 

disclosure requirements are comprised 

of 11 tables that provide important 

information to market participants on 

the scope of application, capital, risk 

exposures, risk assessment processes, 

and, hence, the capital adequacy of the 

institution. The agencies are adopting 

the tables as proposed, with the 

exceptions noted below. Again, the 

agencies note that the substantive 

content of the tables is the focus of the 

disclosure requirements, not the tables 

themselves. The table numbers below 

refer to the table numbers in the final 

rule. 

Table 11.1 disclosures (Scope of 

Application) include a description of 

the level in the organization to which 

the disclosures apply and an outline of 

any differences in consolidation for 

accounting and regulatory capital 

purposes, as well as a description of any 

restrictions on the transfer of funds and 

capital within the organization. These 

disclosures provide the basic context 

underlying regulatory capital 

calculations. 

One commenter questioned item (e) in 

Table 11.1, which would require the 

disclosure of the aggregate amount of 

capital deficiencies in all subsidiaries 

and the name(s) of such subsidiaries. 

The commenter asserted that the scope 

of this item should be limited to those 

legal subsidiaries that are subject to 

banking, securities, or insurance 

regulators’ capital adequacy rules and 

should not include unregulated entities 

that are consolidated into the top 

corporate entity or unconsolidated 

affiliate and joint ventures. 

As stated in a footnote to Table 11.1 

in the proposed rule, the agencies 

limited the proposed requirement to 

legal subsidiaries that are subject to 

banking, securities, or insurance 

regulators’ capital adequacy rules. The 

agencies are further clarifying this 

disclosure in Table 11.1. 

Table 11.2 disclosures (Capital 

Structure) provide information on 

various components of regulatory 

capital available to absorb losses and 

allow for an evaluation of the quality of 

the capital available to absorb losses 

within the bank. 

Table 11.3 disclosures (Capital 

Adequacy) provide information about 

how a bank assesses the adequacy of its 

capital and require that the bank 

disclose its minimum capital 

requirements for significant risk areas 

and portfolios. The table also requires 

disclosure of the regulatory capital 

ratios of the consolidated group and 

each DI subsidiary. Such disclosures 

provide insight into the overall 

adequacy of capital based on the risk 

profile of the organization. 

Tables 11.4, 11.5, and 11.7 disclosures 

(Credit Risk) provide market 

participants with insight into different 

types and concentrations of credit risk 

to which the bank is exposed and the 

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techniques the bank uses to measure, 

monitor, and mitigate those risks. These 

disclosures are intended to enable 

market participants to assess the credit 

risk exposures under the IRB approach, 

without revealing proprietary 

information. 

Several commenters made suggestions 

related to Table 11.4. One commenter 

addressed item (b), which requires the 

disclosure of total and average gross 

credit risk exposures over the period 

broken down by major types of credit 

exposure. The commenter asked the 

agencies to clarify that methods used for 

financial reporting purposes are allowed 

for determining averages. Another 

commenter requested that the agencies 

clarify what is meant by ‘‘gross’’ in item 

(b), given that a related footnote 

describes net credit risk exposures in 

accordance with GAAP. 

As with most of the disclosure 

requirements, the agencies are not 

prescriptive regarding the 

methodologies a bank must use for 

determining averages. Rather, the bank 

must choose whatever methodology it 

believes to be most reflective of its risk 

position. That methodology may be the 

one the bank uses for financial reporting 

purposes. The agencies have deleted 

‘‘gross’’ and otherwise simplified the 

wording of item (b) in Table 11.4 to 

enhance clarity. Item (b) now reads 

‘‘total credit risk exposures and average 

credit risk exposures, after accounting 

offsets in accordance with GAAP, and 

without taking into account the effects 

of credit risk mitigation techniques (for 

example collateral and netting not 

included in GAAP for disclosure), over 

the period broken down by major types 

of credit exposure.’’

In addition, a commenter noted that 

the requirements in Table 11.4 regarding 

the breakdown of disclosures by ‘‘major 

types of credit exposure’’ in items (b) 

through (e) and by ‘‘counterparty type’’

for items (d) and (f) are unclear. 

Moreover, with respect to items (d), (e), 

and (f), the commenter recommended 

that disclosures should be provided on 

an annual rather than quarterly basis. 

The same commenter also asserted that 

the disclosure of remaining contractual 

maturity breakdown in item (e) should 

be required annually. Finally, regarding 

items (f) and (g), a few commenters 

wanted clarification of the definition of 

impaired and past due loans. 

The agencies are not prescriptive with 

regard to what is meant by ‘‘major types 

of credit exposure,’’ disclosure by 

counterparty type, or impaired and past 

due loans. Bank management has the 

discretion to determine the most 

appropriate disclosure for the bank’s 

risk profile consistent with internal 

practice, GAAP or regulatory reports 

(such as the FR Y–9C). As noted in the 

proposal, for major types of credit 

exposure a bank could apply a 

breakdown similar to that used for 

accounting purposes, such as (a) loans, 

off-balance sheet commitments, and 

other non-derivative off-balance sheet 

exposures, (b) debt securities, and (c) 

OTC derivatives. The agencies do not 

believe it is appropriate to make an 

exception to the general quarterly 

requirement for quantitative disclosures 

for the disclosure in Table 11.4. 

Commenters provided extensive 

feedback on several aspects of Table 

11.5 (Disclosures for Portfolios Subject 

to IRB Risk-Based Capital Formulas). 

Several commenters were concerned 

that the required level of detail may 

compel banks to disclose proprietary 

information. With respect to item (c), a 

couple of commenters noted that the 

proposal differs from the New Accord in 

requiring exposure-weighted average 

capital requirements instead of risk 

weight percentages for groups of 

wholesale and retail exposures. One 

commenter also suggested that the term 

‘‘actual losses’’ required in item (d) 

needs to be defined. Finally, several 

commenters objected to the proposal in 

item (e) to disclose backtesting results, 

asserting that such results would not be 

understood by the market. Commenters 

suggested that disclosure of this item be 

delayed beyond the proposed 

commencement date of year-end 2010, 

to commence instead ten years after a 

bank exits from the parallel run period. 

As discussed above, the agencies 

believe that, in most cases, a bank can 

make the required disclosures without 

revealing proprietary information and 

that the rule contains appropriate 

provisions to deal with specific bank 

concerns. With regard to item (c), the 

agencies agree that there is no strong 

policy reason to differ from the New 

Accord and have changed item (c) to 

require the specified disclosures in risk 

weight percentages rather than 

weighted-average capital requirements. 

With respect to item (d), the agencies 

are not imposing a prescriptive 

definition of actual losses and believe 

that banks should determine actual 

losses consistent with internal practice. 

Finally, regarding item (e), the agencies 

believe that public disclosure of 

backtesting results provides important 

information to the market and should 

not be delayed. However, the agencies 

have slightly modified the requirement, 

consistent with the New Accord, to 

reinforce that disclosure of individual 

risk parameter backtesting is not always 

required. 

Commenters provided feedback on a 

few aspects of Table 11.7 (Credit Risk 

Mitigation). One commenter asserted 

that the table appears to overlap with 

the information on credit risk mitigation 

required in Table 11.5, item (a) and 

requested that the agencies consolidate 

and simplify the requirements. In 

addition, several commenters objected 

to Table 11.7 item (b), which would 

require public disclosure of the riskweighted asset amount associated with 

credit risk exposures that are covered by 

credit risk mitigation in the form of 

guarantees and credit derivatives. The 

commenter noted that this requirement 

is not contained in the New Accord, 

which only requires the total exposure 

amount of such credit risk exposures. 

The agencies recognize that there is 

some duplication between Tables 11.7 

and 11.5. At the same time, both 

requirements are part of the New 

Accord. The agencies have decided to 

address this issue by inserting in Table 

11.5, item (a), a note that the disclosures 

can be met by completing the 

disclosures in Table 11.7. With regard to 

Table 11.7, item (b), the agencies have 

decided that there is no strong policy 

reason for requiring banks to disclose 

risk-weighted assets associated with 

credit risk exposures that are covered by 

credit risk mitigation in the form of 

guarantees and credit derivatives. The 

agencies have removed this requirement 

from the final rule, consistent with the 

New Accord. 

Table 11.6 (General Disclosure for 

Counterparty Credit Risk of OTC 

Derivative Contracts, Repo-Style 

Transaction, and Eligible Margin Loans) 

provides the disclosure requirements 

related to credit exposures from 

derivatives. See the July 2005 BCBS 

publication entitled ‘‘The Application of 

Basel II to Trading Activities and the 

Treatment of Double Default Effects.’’

Commenters raised a few issues with 

respect to Table 11.6. One commenter 

requested that the agencies clarify item 

(a), which requires a discussion of the 

impact of the amount of collateral the 

bank would have to provide given a 

credit rating downgrade. The 

commenter asked whether this 

disclosure refers to credit downgrade of 

the bank, the counterparty, or some 

other entity. Another commenter 

objected to item (b), which would 

require the breakdown of counterparty 

credit exposure by type of exposure. 

The commenter asserted that this 

proposed requirement is burdensome, 

infeasible for netted exposures and 

duplicative of other information 

generally available in existing GAAP 

and U.S. bank regulatory financial 

statements. 

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The agencies have decided to clarify 

that item (a) refers in part to the credit 

rating downgrade of the bank making 

the disclosure. This is consistent with 

the intent of this disclosure requirement 

in the New Accord. With respect to item 

(b), the agencies recognize that this 

proposed requirement may be 

problematic for banks that have 

implemented the internal models 

methodology. Accordingly, the agencies 

have decided to modify the rule to note 

that this disclosure item is only required 

for banks not using the internal models 

methodology in section 32(d). 

Table 11.8 disclosures (Securitization) 

provide information to market 

participants on the amount of credit risk 

transferred and retained by the 

organization through securitization 

transactions and the types of products 

securitized by the organization. These 

disclosures provide users a better 

understanding of how securitization 

transactions impact the credit risk of the 

bank. 

One commenter asked the agencies to 

explicitly acknowledge that they will 

accept the definitions and 

interpretations of the components of 

securitization exposures that a bank 

uses for financial reporting purposes 

(FAS 140 reporting disclosures). 

Generally, as noted above, the 

agencies expect that a bank will be able 

to fulfill some of its disclosure 

requirements by relying on disclosures 

made in accordance with accounting 

standards, SEC mandates, or regulatory 

reports. In these situations, a bank must 

explain any material differences 

between the accounting or other 

disclosure and the disclosures required 

under the final rule. The agencies do not 

believe any changes to the rule are 

necessary to accommodate the 

commenter’s concern. 

Table 11.9 disclosures (Operational 

Risk) provide insight into the bank’s 

application of the AMA for operational 

risk and what internal and external 

factors are considered in determining 

the amount of capital allocated to 

operational risk. 

Table 11.10 disclosures (Equities Not 

Subject to Market Risk Rule) provide 

market participants with an 

understanding of the types of equity 

securities held by the bank and how 

they are valued. The table also provides 

information on the capital allocated to 

different equity products and the 

amount of unrealized gains and losses. 

Table 11.11 disclosures (Interest Rate 

Risk in Non-Trading Activities) provide 

information about the potential risk of 

loss that may result from changes in 

interest rates and how the bank 

measures such risk. 

4. Regulatory Reporting 

In addition to the public disclosures 

required by the consolidated banking 

organization subject to the advanced 

approaches, the agencies will require 

certain additional regulatory reporting 

from BHCs, their subsidiary DIs, and DIs 

applying the advanced approaches that 

are not subsidiaries of BHCs. The 

agencies believe that the reporting of 

key risk parameter estimates by each DI 

applying the advanced approaches will 

provide the primary Federal supervisor 

and other relevant supervisors with data 

important for assessing the 

reasonableness and accuracy of the 

bank’s calculation of its minimum 

capital requirements under this final 

rule and the adequacy of the 

institution’s capital in relation to its 

risks. This information will be collected 

through regulatory reports. The agencies 

believe that requiring certain common 

reporting across banks will facilitate 

comparable application of the final rule. 

The agencies will publish in the 

Federal Register reporting schedules 

based on the reporting templates issued 

for comment in September 2006. 

Consistent with the proposed reporting 

schedules, these reporting schedules 

will include a summary schedule with 

aggregate data that will be available to 

the general public. It also will include 

supporting schedules that will be 

viewed as confidential supervisory 

information. These schedules will be 

broken out by exposure category and 

will collect risk parameter and other 

pertinent data in a systematic manner. 

Under the final rule, banks must begin 

reporting this information during their 

parallel run on a confidential basis. The 

agencies will share this information 

with each other for calibration and other 

analytical purposes. 

One commenter expressed concerns 

that some of the confidential 

information requested in the proposed 

reporting templates was also contained 

in the public disclosure requirements 

under the proposal. As a result, some 

information would be classified as 

confidential in the reporting templates 

and public under the disclosure 

requirements in the final rule. 

The agencies recognize that there may 

be some overlap between confidential 

information required in the regulatory 

reports and public information required 

in the disclosure requirements of the 

final rule. The agencies will address 

specific comments on the reporting 

templates separately. In general, the 

agencies believe that given the different 

purposes of the regulatory reporting and 

public disclosure requirements under 

the final rule, there may be some 

instances where the same or similar 

disclosures may be required by both sets 

of requirements. Many of the public 

disclosures cover only a subset of the 

information sought in the proposed 

regulatory reporting templates. For 

instance, banks are required only to 

disclose publicly information ‘‘across a 

sufficient number of PD grades to allow 

a meaningful differentiation of credit 

risk,’’ whereas the proposed reporting 

templates contemplate a much more 

granular collection of data by specified 

PD bands. Such aggregation of data so 

as to mask the confidential nature of 

more granular information that is 

reported to regulators is not unique to 

the advanced approaches reporting. In 

addition, the agencies believe that a 

bank may be able to comply with some 

of the public disclosure requirements 

under this final rule by publicly 

disclosing, at the bank’s discretion and 

judgment, certain information found in 

the reporting templates that otherwise 

would be held confidential by the 

agencies. A bank could disclose this 

information on its Web site (as 

described in ‘‘location and audit 

requirements’’ above) if it believes that 

such disclosures will meet the public 

disclosure requirements required by the 

rule. 

List of Acronyms 

ABCP Asset-Backed Commercial Paper 

ALLL Allowance for Loan and Lease Losses 

AMA Advanced Measurement Approaches 

ANPR Advance Notice of Proposed 

Rulemaking 

AVC Asset Value Correlation 

BCBS Basel Committee on Banking 

Supervision 

BHC Bank Holding Company 

CCDS Contingent Credit Default Swap 

CF Conversion Factor 

CEIO Credit-Enhancing Interest-Only Strip 

CRM Credit Risk Mitigation 

CUSIP Committee on Uniform Securities 

Identification Procedures 

DI Depository Institution 

DvP Delivery versus Payment 

E Measure of Effectiveness 

EAD Exposure at Default 

ECL Expected Credit Loss 

EE Expected Exposure 

EL Expected Loss 

ELGD Expected Loss Given Default 

EOL Expected Operational Loss 

EPE Expected Positive Exposure 

EWALGD Exposure-Weighted Average Loss 

Given Default 

FAS Financial Accounting Standard 

FDIC Federal Deposit Insurance 

Corporation 

FFIEC Federal Financial Institutions 

Examination Council 

GAAP Generally Accepted Accounting 

Principles 

GAO Government Accountability Office 

HELOC Home Equity Line of Credit 

HOLA Home Owners’ Loan Act 

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HVCRE High-Volatility Commercial Real 

Estate 

IAA Internal Assessment Approach 

ICAAP Internal Capital Adequacy 

Assessment Process 

IMA Internal Models Approach 

IRB Internal Ratings-Based 

KIRB Capital Requirement for Underlying 

Pool of Exposures (securitizations) 

LGD Loss Given Default 

LTV Loan-to-Value Ratio 

M Effective Maturity 

NRSRO Nationally Recognized Statistical 

Rating Organization 

OCC Office of the Comptroller of the 

Currency 

OTC Over-the-Counter 

OTS Office of Thrift Supervision 

PCA Prompt Corrective Action 

PD Probability of Default 

PFE Potential Future Exposure 

PMI Private Mortgage Insurance 

PvP Payment versus Payment 

QIS–3 Quantitative Impact Study 3 

QIS–4 Quantitative Impact Study 4 

QIS–5 Quantitative Impact Study 5 

QRE Qualifying Revolving Exposure 

RBA Ratings-Based Approach 

RVC Ratio of Value Change 

SEC Securities and Exchange Commission 

SFA Supervisory Formula Approach 

SME Small- and Medium-Size Enterprise 

SPE Special Purpose Entity 

SRWA Simple Risk-Weight Approach 

TFR Thrift Financial Report 

UL Unexpected Loss 

UOL Unexpected Operational Loss 

VaR Value-at-Risk 

Regulatory Flexibility Act Analysis 

The Regulatory Flexibility Act (RFA) 

requires an agency that is issuing a final 

rule to prepare and make available a 

regulatory flexibility analysis that 

describes the impact of the final rule on 

small entities. 5 U.S.C. 603(a). The RFA 

provides that an agency is not required 

to prepare and publish a regulatory 

flexibility analysis if the agency certifies 

that the final rule will not have a 

significant economic impact on a 

substantial number of small entities. 5 

U.S.C. 605(b). 

Pursuant to section 605(b) of the RFA 

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

that this final rule will not have a 

significant economic impact on a 

substantial number of small entities. 

Pursuant to regulations issued by the 

Small Business Administration (13 CFR 

121.201), a ‘‘small entity’’ includes a 

bank holding company, commercial 

bank, or savings association with assets 

of $165 million or less (collectively, 

small banking organizations). The final 

rule requires a bank holding company, 

national bank, state member bank, state 

nonmember bank, or savings association 

to calculate its risk-based capital 

requirements according to certain 

internal-ratings-based and internal 

model approaches if the bank holding 

company, bank, or savings association 

(i) has consolidated total assets (as 

reported on its most recent year-end 

regulatory report) equal to $250 billion 

or more; (ii) has consolidated total onbalance sheet foreign exposures at the 

most recent year-end equal to $10 

billion or more; or (iii) is a subsidiary 

of a bank holding company, bank, or 

savings association that would be 

required to use the proposed rule to 

calculate its risk-based capital 

requirements. 

The agencies estimate that zero small 

bank holding companies (out of a total 

of approximately 2,919 small bank 

holding companies), 16 small national 

banks (out of a total of approximately 

948 small national banks), one small 

state member bank (out of a total of 

approximately 468 small state member 

banks), one small state nonmember bank 

(out of a total of approximately 3,242 

small state nonmember banks), and zero 

small savings associations (out of a total 

of approximately 419 small savings 

associations) would be subject to the 

final rule on a mandatory basis. In 

addition, each of the small banking 

organizations subject to the final rule on 

a mandatory basis is a subsidiary of a 

bank holding company with over $250 

billion in consolidated total assets or 

over $10 billion in consolidated total 

on-balance sheet foreign exposure. 

Therefore, the agencies believe that the 

final rule will not result in a significant 

economic impact on a substantial 

number of small entities. 

Paperwork Reduction Act 

In accordance with the requirements 

of the Paperwork Reduction Act of 1995, 

the agencies may not conduct or 

sponsor, and respondents are not 

required to respond to, an information 

collection unless it displays a currently 

valid Office of Management and Budget 

(OMB) control number. OMB assigned 

the following control numbers to the 

collections of information: 1557–0234 

(OCC), 3064–0153 (FDIC), and 1550–

0115 (OTS). The Board assigned control 

number 7100–0313. 

In September 2006 the OCC, FDIC, 

and OTS submitted the information 

collections contained in this rule to 

OMB for review and approval once the 

proposed rule was published. The 

Board, under authority delegated to it by 

OMB, also submitted the proposed 

information collection to OMB. 

The agencies (OCC, FDIC, the Board, 

and OTS) determined that sections 21–

24, 42, 44, 53, and 71 of the final rule 

contain collections of information. The 

final rule sets forth a new risk-based 

capital adequacy framework that would 

require some banks and allow other 

qualifying banks to use an internal 

ratings-based approach to calculate 

regulatory credit risk capital 

requirements and advanced 

measurement approaches to calculate 

regulatory operational risk capital 

requirements. The collections of 

information are necessary in order to 

implement the proposed advanced 

capital adequacy framework. The 

agencies received approximately ninety 

public comments. None of the comment 

letters specifically addressed the 

proposed burden estimates; therefore, 

the burden estimates will remain 

unchanged, as published in the notice of 

proposed rulemaking (71 FR 55830). 

The affected public are: national 

banks and Federal branches and 

agencies of foreign banks (OCC); state 

member banks, bank holding 

companies, affiliates and certain nonbank subsidiaries of bank holding 

companies, uninsured state agencies 

and branches of foreign banks, 

commercial lending companies owned 

or controlled by foreign banks, and Edge 

and agreement corporations (Board); 

insured nonmember banks, insured state 

branches of foreign banks, and certain 

subsidiaries of these entities (FDIC); and 

savings associations and certain of their 

subsidiaries (OTS). 

Comment Request 

The agencies have an ongoing interest 

in your comments. They should be sent 

to [Agency] Desk Officer, [OMB No.], by 

mail to U.S. Office of Management and 

Budget, 725 17th Street, NW., #10235, 

Washington, DC 20503, or by fax to 

(202) 395–6974. 

Comments submitted in response to 

this notice will be shared among the 

agencies. All comments will become a 

matter of public record. Written 

comments should address the accuracy 

of the burden estimates and ways to 

minimize burden including the use of 

automated collection techniques or the 

use of other forms of information 

technology as well as other relevant 

aspects of the information collection 

request. 

OCC Executive Order 12866 

Executive Order 12866 requires 

Federal agencies to prepare a regulatory 

impact analysis for agency actions that 

are found to be ‘‘significant regulatory 

actions.’’ ‘‘Significant regulatory 

actions’’ include, among other things, 

rulemakings that ‘‘have an annual effect 

on the economy of $100 million or more 

or adversely affect in a material way the 

economy, a sector of the economy, 

productivity, competition, jobs, the 

environment, public health or safety, or 

State, local, or tribal governments or 

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69390 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

108 108 Executive Order 12866 (September 30, 

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

by Executive Order 13258 (February 26, 2002), 67 

FR 9385 (February 28, 2002) and by Executive 

Order 13422 (January 18, 2007), 72 FR 2763 

(January 23, 2007). For the complete text of the 

definition of ‘‘significant regulatory action,’’ see 

E.O. 12866 at § 3(f). A ‘‘regulatory action’’ is ‘‘any 

substantive action by an agency (normally 

published in the Federal Register) that promulgates 

or is expected to lead to the promulgation of a final 

rule or regulation, including notices of inquiry, 

advance notices of proposed rulemaking, and 

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

§ 3(e). 

109Operational risk is the risk of loss resulting 

from inadequate or failed processes, people, and 

systems or from external events. It includes legal 

risk, but excludes strategic risk and reputation risk. 

communities.’’108 Regulatory actions 

that satisfy one or more of these criteria 

are referred to as ‘‘economically 

significant regulatory actions.’’

The OCC anticipates that the final 

rule will meet the $100 million criterion 

and therefore is an economically 

significant regulatory action. In 

conducting the regulatory analysis for 

an economically significant regulatory 

action, Executive Order 12866 requires 

each Federal agency to provide to the 

Administrator of the Office of 

Management and Budget’s (OMB) Office 

of Information and Regulatory Affairs 

(OIRA): 

• The text of the draft regulatory 

action, together with a reasonably 

detailed description of the need for the 

regulatory action and an explanation of 

how the regulatory action will meet that 

need; 

• An assessment of the potential costs 

and benefits of the regulatory action, 

including an explanation of the manner 

in which the regulatory action is 

consistent with a statutory mandate and, 

to the extent permitted by law, promotes 

the President’s priorities and avoids 

undue interference with State, local, 

and tribal governments in the exercise 

of their governmental functions; 

• An assessment, including the 

underlying analysis, of benefits 

anticipated from the regulatory action 

(such as, but not limited to, the 

promotion of the efficient functioning of 

the economy and private markets, the 

enhancement of health and safety, the 

protection of the natural environment, 

and the elimination or reduction of 

discrimination or bias) together with, to 

the extent feasible, a quantification of 

those benefits; 

• An assessment, including the 

underlying analysis, of costs anticipated 

from the regulatory action (such as, but 

not limited to, the direct cost both to the 

government in administering the 

regulation and to businesses and others 

in complying with the regulation, and 

any adverse effects on the efficient 

functioning of the economy, private 

markets (including productivity, 

employment, and competitiveness), 

health, safety, and the natural 

environment), together with, to the 

extent feasible, a quantification of those 

costs; and 

• An assessment, including the 

underlying analysis, of costs and 

benefits of potentially effective and 

reasonably feasible alternatives to the 

planned regulation, identified by the 

agencies or the public (including 

improving the current regulation and 

reasonably viable nonregulatory 

actions), and an explanation why the 

planned regulatory action is preferable 

to the identified potential alternatives. 

Set forth below is a summary of the 

OCC’s regulatory impact analysis, which 

can be found in its entirety at http:// 

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

the link of ‘‘Regulatory Impact Analysis 

for Risk-Based Capital Standards: 

Revised Capital Adequacy Guidelines 

(Basel II: Advanced Approach) 2007’’. 

I. The Need for the Regulatory Action 

Federal banking law directs Federal 

banking agencies including the Office of 

the Comptroller of the Currency (OCC) 

to require banking organizations to hold 

adequate capital. The law authorizes 

Federal banking agencies to set 

minimum capital levels to ensure that 

banking organizations maintain 

adequate capital. The law also gives 

Federal banking agencies broad 

discretion with respect to capital 

regulation by authorizing them to also 

use any other methods that they deem 

appropriate to ensure capital adequacy. 

Capital regulation seeks to address 

market failures that stem from several 

sources. Asymmetric information about 

the risk in a bank’s portfolio creates a 

market failure by hindering the ability 

of creditors and outside monitors to 

discern a bank’s actual risk and capital 

adequacy. Moral hazard creates market 

failure in which the bank’s creditors fail 

to restrain the bank from taking 

excessive risks because deposit 

insurance either fully or partially 

protects them from losses. Public policy 

addresses these market failures because 

individual banks fail to adequately 

consider the positive externality or 

public benefit that adequate capital 

brings to financial markets and the 

economy as a whole. 

Capital regulations cannot be static. 

Innovation in and transformation of 

financial markets require periodic 

reassessments of what may count as 

capital and what amount of capital is 

adequate. Continuing changes in 

financial markets create both a need and 

an opportunity to refine capital 

standards in banking. The Basel 

Committee on Banking Supervision’s 

‘‘International Convergence of Capital 

Measurement and Capital Standards: A 

Revised Framework’’ (New Accord), and 

its implementation in the United States, 

reflects an appropriate step forward in 

addressing these changes. 

II. Regulatory Background 

The capital regulation examined in 

this analysis will apply to commercial 

banks and savings associations 

(collectively, banks). Three banking 

agencies, the OCC, the Board of 

Governors of the Federal Reserve 

System (Board), and the FDIC regulate 

commercial banks, while the Office of 

Thrift Supervision (OTS) regulates all 

federally chartered and many statechartered savings associations. 

Throughout this document, the four are 

jointly referred to as the Federal banking 

agencies. 

The New Accord comprises three 

mutually reinforcing ‘‘pillars’’ as 

summarized below. 

1. Minimum Capital Requirements 

(Pillar 1) 

The first pillar establishes a method 

for calculating minimum regulatory 

capital. It sets new requirements for 

assessing credit risk and operational risk 

while retaining the approach to market 

risk as developed in the 1996 

amendments to the 1988 Accord. 

The New Accord offers banks a choice 

of three methodologies for calculating a 

capital charge for credit risk. The first 

approach, called the Standardized 

Approach, essentially refines the riskweighting framework of the 1988 

Accord. The other two approaches are 

variations on an internal ratings-based 

(IRB) approach that leverages banks’

internal credit-rating systems: a 

‘‘foundation’’ methodology in which 

banks estimate the probability of 

borrower or obligor default, and an 

‘‘advanced’’ approach in which banks 

also supply other inputs needed for the 

capital calculation. In addition, the new 

framework uses more risk-sensitive 

methods for dealing with collateral, 

guarantees, credit derivatives, 

securitizations, and receivables. 

The New Accord also introduces an 

explicit capital requirement for 

operational risk.109 The New Accord 

offers banks a choice of three 

methodologies for calculating their 

capital charge for operational risk. The 

first method, called the Basic Indicator 

Approach, requires banks to hold 

capital for operational risk equal to 15 

percent of annual gross income 

(averaged over the most recent three 

years). The second option, called the 

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Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 69391 

Standardized Approach, uses a formula 

that divides a bank’s activities into eight 

business lines, calculates the capital 

charge for each business line as a fixed 

percentage of gross income (12 percent, 

15 percent, or 18 percent depending on 

the nature of the business, again 

averaged over the most recent three 

years), and then sums across business 

lines. The third option, called the 

Advanced Measurement Approaches 

(AMA), uses an bank’s internal 

operational risk measurement system to 

determine the capital requirement. 

2. Supervisory Review Process (Pillar 2) 

The second pillar calls upon banks to 

have an internal capital assessment 

process and banking supervisors to 

evaluate each bank’s overall risk profile 

as well as its risk management and 

internal control processes. This pillar 

establishes an expectation that banks 

hold capital beyond the minimums 

computed under Pillar 1, including 

additional capital for any risks that are 

not adequately captured under Pillar 1. 

It encourages banks to develop better 

risk management techniques for 

monitoring and managing their risks. 

Pillar 2 also charges supervisors with 

the responsibility to ensure that banks 

using advanced Pillar 1 techniques, 

such as the IRB approach to credit risk 

and the AMA for operational risk 

(collectively, advanced approaches), 

comply with the minimum standards 

and disclosure requirements of those 

methods, and take action promptly if 

capital is not adequate. 

3. Market Discipline (Pillar 3) 

The third pillar of the New Accord 

sets minimum disclosure requirements 

for banks. The disclosures, covering the 

composition and structure of the bank’s 

capital, the nature of its risk exposures, 

its risk management and internal control 

processes, and its capital adequacy, are 

intended to improve transparency and 

strengthen market discipline. By 

establishing a common set of disclosure 

requirements, Pillar 3 seeks to provide 

a consistent and understandable 

disclosure framework that market 

participants can use to assess key pieces 

of information on the risks and capital 

adequacy of a bank. 

4. U.S. Implementation 

The rule for implementing the New 

Accord’s advanced approaches in the 

United States will apply the new 

framework to the largest and most 

internationally active banks. All banks 

will fall into one of three regulatory 

categories. The first category, called 

‘‘mandatory’’ banks, consists of banks 

with consolidated assets of at least $250 

billion or consolidated on-balance-sheet 

foreign exposures of $10 billion or more. 

Mandatory banks will have to use the 

New Accord’s most advanced methods 

only: the Advanced IRB approach to 

determine capital for credit risk and the 

AMA to determine capital for 

operational risk. A second category of 

banks, called ‘‘opt-in’’ banks, includes 

banks that do not meet either size 

criteria of a mandatory bank but choose 

voluntarily to comply with the 

advanced approaches specified under 

the New Accord. The third category, 

called ‘‘general’’ banks, encompasses all 

other banks, and these will continue to 

operate under existing risk-based capital 

rules, subject to any amendments. 

Various changes to the rules that 

apply to non-mandatory banks are 

under consideration. The Federal 

banking agencies have decided to issue 

for comment a proposal that would 

allow the voluntary adoption of the 

standardized approach for credit risk 

and the basic indicator approach for 

operational risk for non-mandatory 

banks (referred to hereafter as the 

Standardized Option). Because the 

Standardized Option would be a 

separate rulemaking, our analysis will 

focus just on the implementation of the 

Advanced Approaches. However, we 

will note how the Standardized Option 

might affect the outcome of our analysis 

if we anticipate the possibility that its 

adoption could lead to a significantly 

different outcome. 

While introducing many significant 

changes, the U.S. implementation of the 

New Accord retains many components 

of the capital rules currently in effect. 

For example, it preserves existing 

Prompt Corrective Action provisions for 

all banks. The U.S. implementation of 

the New Accord also keeps intact most 

elements of the definition of what 

comprises regulatory capital. 

III. Costs and Benefits of the Rule 

This analysis considers the costs and 

benefits of the fully phased-in rule. 

Under the rule, current capital rules will 

remain in effect in 2008 during a 

parallel run using both old and new 

capital rules. For three years following 

the parallel run, the final rule will apply 

limits on the amount by which 

minimum required capital may 

decrease. This analysis, however, 

considers the costs and benefits of the 

rule as fully phased in. 

Cost and benefit analysis of changes 

in minimum capital requirements entail 

considerable measurement problems. 

On the cost side, it can be difficult to 

attribute particular expenditures 

incurred by banks to the costs of 

implementation because banks would 

likely incur some of these costs as part 

of their ongoing efforts to improve risk 

measurement and management systems. 

On the benefits side, measurement 

problems are even greater because the 

benefits of the rule are more qualitative 

than quantitative. Measurement 

problems exist even with an apparently 

measurable effect such as lower 

minimum capital because lower 

minimum requirements do not 

necessarily mean lower capital levels 

held by banks. Healthy banks generally 

hold capital well above regulatory 

minimums for a variety of reasons, and 

the effect of reducing the regulatory 

minimum is uncertain and may vary 

across regulated banks. 

Benefits of the Rule 

1. Better allocation of capital and 

reduced impact of moral hazard 

through reduction in the scope for 

regulatory arbitrage: By assessing the 

amount of capital required for each 

exposure or pool of exposures, the 

advanced approaches do away with the 

simplistic risk buckets of current capital 

rules. Getting rid of categorical risk 

weighting and assigning capital based 

on measured risk instead greatly curtails 

or eliminates the ability of troubled 

banks to ‘‘game’’ regulatory capital 

requirements by finding ways to comply 

technically with the requirements while 

evading their intent and spirit. 

2. Improved signal quality of capital 

as an indicator of solvency: The 

advanced approaches are designed to 

more accurately align regulatory capital 

with risk, which should improve the 

signal quality of capital as an indicator 

of solvency. The improved signaling 

quality of capital will enhance banking 

supervision and market discipline. 

3. Encourages banks to improve credit 

risk management: One of the principal 

objectives of the rule is to more closely 

align capital charges and risk. For any 

type of credit, risk increases as either 

the probability of default or the loss 

given default increases. Under the final 

rule, the capital charge for credit risk 

depends on these risk parameter 

measures and consequently capital 

requirements will more closely reflect 

risk. This enhanced link between capital 

requirements and risk will encourage 

banks to improve credit risk 

management. 

4. More efficient use of required bank 

capital: Increased risk sensitivity and 

improvements in risk measurement will 

allow prudential objectives to be 

achieved more efficiently. If capital 

rules can better align capital with risk 

across the system, a given level of 

capital will be able to support a higher 

level of banking activity while 

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69392 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

110For more information on QIS–4, see Office of 

the Comptroller of the Currency, Board of 

Governors of the Federal Reserve System, Federal 

Deposit Insurance Corporation, and Office of Thrift 

Supervision, ‘‘Summary Findings of the Fourth 

Quantitative Impact Study,’’ February 2006, 

available online at http://www.occ.treas.gov/ftp/ 

release/2006-23a.pdf. 

maintaining the same degree of 

confidence regarding the safety and 

soundness of the banking system. Social 

welfare is enhanced by either the 

stronger condition of the banking 

system or the increased economic 

activity the additional banking services 

facilitate. 

5. Incorporates and encourages 

advances in risk measurement and risk 

management: The rule seeks to improve 

upon existing capital regulations by 

incorporating advances in risk 

measurement and risk management 

made over the past 15 years. An 

objective of the rule is to speed adoption 

of new risk management techniques and 

to promote the further development of 

risk measurement and management 

through the regulatory process. 

6. Recognizes new developments and 

accommodates continuing innovation in 

financial products by focusing on risk: 

The rule also has the benefit of 

facilitating recognition of new 

developments in financial products by 

focusing on the fundamentals behind 

risk rather than on static product 

categories. 

7. Better aligns capital and 

operational risk and encourages banks 

to mitigate operational risk: Introducing 

an explicit capital calculation for 

operational risk eliminates the implicit 

and imprecise ‘‘buffer’’ that covers 

operational risk under current capital 

rules. Introducing an explicit capital 

requirement for operational risk 

improves assessments of the protection 

capital provides, particularly at banks 

where operational risk dominates other 

risks. The explicit treatment also 

increases the transparency of 

operational risk, which could encourage 

banks to take further steps to mitigate 

operational risk. 

8. Enhanced supervisory feedback: 

Although U.S. banks have long been 

subject to close supervision, aspects of 

all three pillars of the rule aim to 

enhance supervisory feedback from 

Federal banking agencies to managers of 

banks. Enhanced feedback could further 

strengthen the safety and soundness of 

the banking system. 

9. Enhanced disclosure promotes 

market discipline: The rule seeks to aid 

market discipline through the regulatory 

framework by requiring specific 

disclosures relating to risk measurement 

and risk management. Market discipline 

could complement regulatory 

supervision to bolster safety and 

soundness. 

10. Preserves the benefits of 

international consistency and 

coordination achieved with the 1988 

Basel Accord: An important objective of 

the 1988 Accord was competitive 

consistency of capital requirements for 

banks competing in global markets. The 

New Accord continues to pursue this 

objective. Because achieving this 

objective depends on the consistency of 

implementation in the United States 

and abroad, the Basel Committee on 

Banking Supervision (BCBS) has 

established an Accord Implementation 

Group to promote consistency in the 

implementation of the New Accord. 

11. Ability to opt in offers long-term 

flexibility to nonmandatory banks: The 

U.S. implementation of the New Accord 

allows non-mandatory banks to 

individually judge when the benefits 

they expect to realize from adopting the 

advanced approaches outweigh their 

costs. Even though the cost and 

complexity of adopting the advanced 

methods may present non-mandatory 

banks with a substantial hurdle to 

opting in at present, the potential longterm benefits of allowing nonmandatory banks to partake in the 

benefits described above may be 

similarly substantial. 

Costs of the Rule 

Because banks are constantly 

developing programs and systems to 

improve how they measure and manage 

risk, it is difficult to distinguish 

between expenditures explicitly caused 

by adoption of this final rule and costs 

that would have occurred irrespective of 

any new regulation. In an effort to 

identify how much banks expect to 

spend to comply with the U.S. 

implementation of the New Accord’s 

advanced approaches, the Federal 

banking agencies included several 

questions related to compliance costs in 

the fourth Quantitative Impact Study 

(QIS–4).110

1. Overall Costs: According to the 19 

out of 26 QIS–4 questionnaire 

respondents that provided estimates of 

their implementation costs, banks will 

spend roughly $42 million on average to 

adapt to capital requirements 

implementing the New Accord’s 

advanced approaches. Not all of these 

respondents are likely mandatory banks. 

Counting just the likely mandatory 

banks, the average is approximately $46 

million, so there is little difference 

between banks that meet a mandatory 

threshold and those that do not. 

Aggregating estimated expenditures 

from all 19 respondents indicates that 

these banks will spend a total of $791 

million over several years to implement 

the rule. Estimated costs for nine 

respondents meeting one of the 

mandatory thresholds come to $412 

million. 

2. Estimate of costs specific to the 

rule: Ten QIS–4 respondents provided 

estimates of the portion of costs they 

would have incurred even if current 

capital rules remain in effect. Those ten 

indicated that they would have spent 45 

percent on average, or roughly half of 

their advanced approaches expenditures 

on improving risk management anyway. 

This suggests that of the $42 million 

banks expect to spend on 

implementation, approximately $21 

million may represent expenditures 

each bank would have undertaken even 

without the New Accord. Thus, pure 

implementation costs may be closer to 

roughly $395 million for the 19 QIS–4 

respondents. 

3. Ongoing costs: Seven QIS–4 

respondents were able to estimate what 

their recurring costs might be under the 

U.S implementation of the New Accord. 

On average, the seven banks estimate 

that annual recurring expenses 

attributable to the revised capital 

framework will be $2.4 million per 

bank. Banks indicated that the ongoing 

costs to maintain related technology 

reflect costs for increased personnel and 

system maintenance. The larger onetime expenditures to adopt this final 

rule primarily involve money for system 

development and software purchases. 

4. Implicit costs: In addition to 

explicit setup and recurring costs, banks 

may also face implicit costs arising from 

the time and inconvenience of having to 

adapt to new capital regulations. At a 

minimum this involves the increased 

time and attention required of senior 

bank management to introduce new 

programs and procedures and the need 

to closely monitor the new activities 

during the inevitable rough patches 

when the rule first takes effect. 

5. Government Administrative Costs: 

OCC expenditures fall into three broad 

categories: training, guidance, and 

supervision. Training includes expenses 

for AMA and IRB workshops, and other 

training courses and seminars for 

examiners. Guidance expenses reflect 

expenditures on the development of IRB 

and AMA guidance. Supervision 

expenses reflect bank-specific 

supervisory activities related to the 

development and implementation of the 

New Accord. The largest OCC 

expenditures have been on the 

development of IRB and AMA policy 

guidance. The $5.4 million spent on 

guidance represents 54 percent of the 

estimated total OCC advanced 

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Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 69393 

111Patrick de Fontnouvelle, Victoria Garrity, 

Scott Chu, and Eric Rosengren, ‘‘The Potential 

Impact of Explicit Basel II Operational Risk Capital 

Charges on the Competitive Environment of 

Processing Banks in the United States,’’ manuscript, 

Federal Reserve Bank of Boston, January 12, 2005. 

Available at http://www.federalreserve.gov/ 

generalinfo/basel2/whitepapers.htm. 

112Paul S. Calem and James R. Follain, 

‘‘Regulatory Capital Arbitrage and the Potential 

Competitive Impact of Basel II in the Market for 

Residential Mortgages’’, The Journal of Real Estate 

Finance and Economics, Vol. 35, pp. 197–219, 

August 2007. 

113 Diana Hancock, Andreas Lennert, Wayne 

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

the Potential Competitive Impact of Basel II Capital 

Standards on U.S. Mortgage Rates and Mortgage 

Securitization’’, manuscript, Federal Reserve Board, 

April 2005. Available at http:// 

www.federalreserve.gov/generalinfo/basel2/ 

whitepapers.htm. 

114Allen N. Berger, ‘‘Potential Competitive Effects 

of Basel II on Banks in SME Credit Markets in the 

United States,’’ Journal of Financial Services 

Research, 29:1, pp. 5–36, 2006. Also available at 

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

whitepapers.htm. 

115Timothy H. Hannan and Steven J. Pilloff, 

‘‘Will the Proposed Application of Basel II in the 

United States Encourage Increased Bank Merger 

Activity? Evidence from Past Merger Activity,’’

Federal Reserve Board Finance and Economics 

Discussion Series, 2004–13, February 2004. 

Available at http://www.federalreserve.gov/ 

generalinfo/basel2/whitepapers.htm. 

approaches-related expenditure of $10.0 

million through the 2006 fiscal year. In 

part, this large share reflects the absence 

of data for training and supervision 

costs for several years, but it also is 

indicative of the large guidance 

expenses in 2002 and 2003 when the 

New Accord was in development. To 

date, New Accord expenditures have 

not been a large part of overall OCC 

expenditures. The $3 million spent on 

the advanced approaches in fiscal year 

2006 represents less than one percent of 

the OCC’s $579 million budget for the 

year. 

6. Total Cost: The OCC’s estimate of 

the total cost of the rule includes 

expenditures by banks and the OCC 

from the present through 2011, the final 

year of the transition period. Combining 

expenditures by mandatory banks and 

the OCC provides a present value 

estimate of $498.9 million for the total 

cost of the rule. 

7. Procyclicality: Procyclicality refers 

to the possibility that banks may reduce 

lending during economic downturns 

and increase lending during economic 

expansions as a consequence of 

minimum capital requirements. There is 

some concern that the risk-sensitivity of 

the Advanced IRB approach may cause 

capital requirements for credit risk to 

increase during an economic downturn. 

Although procyclicality may be inherent 

in banking to some extent, elements of 

the advanced approaches could reduce 

inherent procyclicality. Risk 

management and information systems 

may provide bank managers with more 

forward-looking information about risk 

that will allow them to adjust portfolios 

gradually and with more foresight as the 

economic outlook changes over the 

business cycle. Regulatory stress-testing 

requirements included in the rule also 

will help ensure that banks anticipate 

cyclicality in capital requirements to the 

greatest extent possible, reducing the 

potential economic impact of changes in 

capital requirements. 

IV. Competition Among Providers of 

Financial Services 

One potential concern with any 

regulatory change is the possibility that 

it might create a competitive advantage 

for some banks relative to others, a 

possibility that certainly applies to a 

change with the scope of this final rule. 

However, measurement difficulties 

described in the preceding discussion of 

costs and benefits also extend to any 

consideration of the impact on 

competition. Despite the inherent 

difficulty of drawing definitive 

conclusions, this section considers 

various ways in which competitive 

effects might be manifest, as well as 

available evidence related to those 

potential effects. 

1. Explicit Capital for Operational 

Risk: Some have noted that the explicit 

computation of required capital for 

operational risk could lead to an 

increase in total minimum regulatory 

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

generally defined as banks that tend to 

engage in a variety of activities related 

to securities clearing, asset management, 

and custodial services. Some have 

suggested that the increase in required 

capital could place such firms at a 

competitive disadvantage relative to 

competitors that do not face a similar 

capital requirement. A careful analysis 

by Fontnouvelle et al.111 considers the 

potential competitive impact of the 

explicit capital requirement for 

operational risk. Overall, the study 

concludes that competitive effects from 

an explicit operational risk capital 

requirement should be, at most, 

extremely modest. 

2. Residential Mortgage Lending: The 

issue of competitive effects has received 

substantial attention with respect to the 

residential mortgage market. The focus 

on the residential mortgage market 

stems from the size and importance of 

the market in the United States, and the 

fact that the rule may lead to substantial 

reductions in credit-risk capital for 

residential mortgages. To the extent that 

corresponding operational-risk capital 

requirements do not offset these creditrisk-related reductions, overall capital 

requirements for residential mortgages 

could decline under the rule. Studies by 

Calem and Follain112 and Hancock, 

Lennert, Passmore, and Sherlund 113

suggest that banks operating under rules 

based on the New Accord’s advance 

approaches may increase their holdings 

of residential mortgages. Calem and 

Follain argue that the increase would be 

significant and come at the expense of 

general banks. Hancock et al. foresee a 

more modest increase in residential 

mortgage holdings at banks operating 

under the advanced approaches rule, 

and they see this increase primarily as 

a shift away from the large government 

sponsored mortgage enterprises. 

3. Small Business Lending: One 

potential avenue for competitive effects 

is small-business lending. Smaller 

banks—those that are less likely to 

adopt the advanced approaches to 

regulatory capital under the rule—tend 

to rely more heavily on smaller loans 

within their commercial loan portfolios. 

To the extent that the rule reduces 

required capital for such loans, general 

banks not operating under the rule 

might be placed at a competitive 

disadvantage. A study by Berger114 finds 

some potential for a relatively small 

competitive effect on smaller banks in 

small business lending. However, Berger 

concludes that the small business 

market for large banks is very different 

from the small business market for 

smaller banks. For instance, a ‘‘small 

business’’ at a larger bank is usually 

much larger than small businesses at 

community banks. 

4. Mergers and Acquisitions: Another 

concern related to potential changes in 

competitive conditions under the rule is 

that bifurcation of capital standards 

might change the landscape with regard 

to mergers and acquisitions in banking 

and financial services. For example, 

banks operating under this final rule 

might be placed in a better position to 

acquire banks operating under the old 

rules, possibly leading to an undesirable 

consolidation of the banking sector. 

Research by Hannan and Pilloff 115

suggests that the rule is unlikely to have 

a significant impact on merger and 

acquisition activity in banking. 

5. Credit Card Competition: The U.S. 

implementation of the New Accord 

might also affect competition in the 

credit card market. Overall capital 

requirements for credit card loans could 

increase under the rule. This raises the 

possibility of a change in the 

competitive environment among banks 

subject to the new rules, nonbank credit 

card issuers, and banks not subject to 

this final rule. A study by Lang, Mester, 

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69394 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

116William W. Lang, Loretta J. Mester, and Todd 

A. Vermilyea, ‘‘Potential Competitive Effects on 

U.S. Bank Credit Card Lending from the Proposed 

Bifurcated Application of Basel II,’’ manuscript, 

Federal Reserve Bank of Philadelphia, December 

2005. Available at http://www.philadelphiafed.org/ 

files/wps/2005/wp05–29.pdf. 

117The full text of the Regulatory Impact Analysis 

describes the factors that the interagency study will 

consider. 

118 In addition to the United States, members of 

the BCBS implementing Basel II are Belgium, 

Canada, France, Germany, Italy, Japan, 

Luxembourg, the Netherlands, Spain, Sweden, 

Switzerland, and the United Kingdom. 

119Cost estimates for adopting a rule that might 

result from the Standardized Option are not 

currently available. 

and Vermilyea116 finds that 

implementation of a rule based on the 

New Accord will not affect credit card 

competition at most community and 

regional banks. The authors also suggest 

that higher capital requirements for 

credit cards may only pose a modest 

disadvantage to banks that are subject to 

this final rule. 

Overall, the evidence regarding the 

impact of this final rule on competitive 

equity is mixed. The body of recent 

economic research discussed in the 

body of this report does not reveal 

persuasive evidence of any sizeable 

competitive effects. Nonetheless, the 

Federal banking agencies recognize the 

need to closely monitor the competitive 

landscape subsequent to any regulatory 

change. In particular, the OCC and other 

Federal banking agencies will be alert 

for early signs of competitive inequities 

that might result from this final rule. A 

multi-year transition period before full 

implementation of this final rule should 

provide ample opportunity for the 

Federal banking agencies to identify any 

emerging problems. In particular, after 

the end of the second transition year, 

the agencies will conduct and publish a 

study that evaluates the advanced 

approaches to determine if there are any 

material deficiencies.117 The Federal 

banking agencies will consider any 

egregious competitive effects associated 

with New Accord implementation, 

whether domestic or international in 

context, to be a material deficiency. To 

the extent that undesirable competitive 

inequities emerge, the agencies have the 

power to respond to them through many 

channels, including but not limited to 

suitable changes to the capital adequacy 

regulations. 

V. Analysis of Baseline and 

Alternatives 

In order to place the costs and 

benefits of the rule in context, Executive 

Order 12866 requires a comparison 

between this final rule, a baseline of 

what the world would look like without 

this final rule, and several reasonable 

alternatives to the rule. In this 

regulatory impact analysis, we analyze a 

baseline and three alternatives to the 

rule. The baseline analyzes the situation 

where the Federal banking agencies do 

not adopt this final rule, but other 

countries with internationally active 

banks do adopt the New Accord.118

1. Baseline Scenario: Current capital 

standards based on the 1988 Basel 

Accord continue to apply to banks 

operating in the United States, but the 

rest of the world adopts the New 

Accord: Abandoning the New Accord in 

favor of current capital rules would 

eliminate essentially all of the benefits 

of the rule described earlier. In place of 

these lost or diminished benefits, the 

only advantage of continuing to apply 

current capital rules to all banks is that 

maintaining the status quo should 

alleviate concerns regarding 

competition among domestic financial 

service providers. Although the effect of 

the rule on competition is uncertain in 

our estimation, staying with current 

capital rules (or universally applying a 

revised rule that might emerge from the 

Standardized Option) eliminates 

bifurcation. Concerns regarding 

competition usually center on this 

characteristic of the rule. However, the 

emergence of different capital rules 

across national borders would at least 

partially offset this advantage. Thus, 

while concerns regarding competition 

among U.S. financial service providers 

might diminish in this scenario, 

concerns regarding cross-border 

competition would likely increase. 

While continuing to use current capital 

rules eliminates most of the benefits of 

adopting the capital rule, it does not 

eliminate many costs associated with 

the New Accord. Because the New 

Accord-related costs are difficult to 

separate from the bank’s ordinary 

development costs and ordinary 

supervisory costs at the Federal banking 

agencies, not implementing the New 

Accord would reduce but not eliminate 

many of these costs associated with the 

final rule.119 Furthermore, because 

banks in the United States would be 

operating under a set of capital rules 

different from the rest of the world, U.S. 

banks that are internationally active 

may face higher costs because they will 

have to track and comply with more 

than one set of capital requirements. 

2. Alternative A: Permit U.S. banks to 

choose among all three New Accord 

credit risk approaches: The principal 

benefit of Alternative A that the rule 

does not achieve is the increased 

flexibility of the regulation for banks 

that would be mandatory banks under 

the final rule. Banks that are not 

prepared for the adoption of the 

advanced approach to credit risk under 

the final rule could choose to use the 

Foundation IRB methodology or even 

the Standardized Approach. How 

Alternative A might affect benefits 

depends entirely on how many banks 

select each of the three available 

options. The most significant drawback 

to Alternative A is the increased cost of 

applying a new set of capital rules to all 

U.S. banks. The vast majority of banks 

in the United States would incur no 

direct costs from new capital rules. 

Under Alternative A, direct costs would 

increase for every U.S. bank that would 

have continued with current capital 

rules. Although it is not clear how high 

these costs might be, general banks 

would face higher costs because they 

would be changing capital rules 

regardless of which option they choose 

under Alternative A. 

3. Alternative B: Permit U.S. banks to 

choose among all three New Accord 

operational risk approaches: The 

operational risk approach that banks 

ultimately selected would determine 

how the overall benefits of the new 

capital regulations would change under 

Alternative B. Just as Alternative A 

increases the flexibility of credit risk 

rules for mandatory banks, Alternative B 

is more flexible with respect to 

operational risk. Because the 

Standardized Approach tries to be more 

sensitive to variations in operational 

risk than the Basic Indicator Approach 

and AMA is more sensitive than the 

Standardized Approach, the effect of 

implementing Alternative B depends on 

how many banks select the more risk 

sensitive approaches. As was the case 

with Alternative A, the most significant 

drawback to Alternative B is the 

increased cost of applying a new set of 

capital rules to all U.S. banks. 

Under Alternative B, direct costs 

would increase for every U.S. bank that 

would have continued with current 

capital rules. It is not clear how much 

it might cost banks to adopt these 

capital measures for operational risk, 

but general banks would face higher 

costs because they would be changing 

capital rules regardless of which option 

they choose under Alternative B. 

4. Alternative C: Use a different asset 

amount to determine a mandatory bank: 

The number of mandatory banks 

decreases slowly as the size thresholds 

increase, and the number of banks 

grows more quickly as the thresholds 

decrease. Under Alternative C, the 

framework of the final rule would 

remain the same and only the number 

of mandatory banks would change. 

Because the structure of the 

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Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 69395 

120The leverage ratio is the ratio of core capital 

to adjusted total assets. Under prompt corrective 

action requirements, savings associations must 

maintain a leverage ratio of at least five percent to 

be well capitalized and at least four percent to be 

adequately capitalized. Basel II will primarily affect 

the calculation of risk-weighted assets, rather than 

the calculation of total assets and will have only a 

modest impact on the calculation of core capital. 

Thus, the proposed Basel II changes should not 

significantly affect the calculated leverage ratio and 

a savings association that is currently constrained 

by the leverage ratio would not significantly benefit 

from the Basel II changes. 

implementation would remain intact, 

Alternative C would capture all of the 

benefits of the final rule. However, 

because these benefits derive from 

applying the final rule to individual 

banks, changing the number of banks 

affected by the rule will change the 

cumulative level of the benefits 

achieved. Generally, the benefits 

associated with the rule will rise and 

fall with the number of mandatory 

banks. Because Alternative C would 

change the number of mandatory banks 

subject to the rule, aggregate costs will 

also rise or fall with the number of 

mandatory banks. 

Overall Comparison of the Rule With 

Baselines and Alternatives 

The New Accord and its U.S. 

implementation seek to incorporate risk 

measurement and risk management 

advances into capital requirements. 

Risk-sensitive capital requirements are 

integral to ensuring an adequate capital 

cushion to absorb financial losses at 

large complex financial banks. In 

implementing the New Accord’s 

advanced approaches in the United 

States, the agencies’ intent is to achieve 

risk-sensitivity while maintaining a 

regulatory capital regime that is as 

rigorous as the current system. Total 

capital requirements under the 

advanced approaches, including capital 

for operational risk, will better allocate 

capital in the system. This will occur 

regardless of whether the minimum 

required capital at a particular bank is 

greater or less than it would be under 

current capital rules. In order to ensure 

that we achieve our goal of increased 

risk sensitivity without loss of rigor, the 

final rule provides a means for the 

agencies to identify and address 

deficiencies in the capital requirements 

that may become apparent during the 

transition period. 

Although the anticipated benefits of 

the final rule are difficult to quantify in 

dollar terms because of measurement 

problems, the OCC is confident that the 

anticipated benefits well exceed the 

anticipated costs of this regulation. On 

the basis of our analysis, we believe that 

the benefits of the final rule are 

significant, durable, and hold the 

potential to increase with time. The 

offsetting costs of implementing the 

final rule are also significant, but appear 

to be largely because of considerable 

start-up costs. However, much of the 

apparent start-up costs reflect activities 

that the banks would undertake as part 

of their ongoing efforts to improve the 

quality of their internal risk 

measurement and management, even in 

the absence of the New Accord and this 

final rule. The advanced approaches 

seem to have fairly modest ongoing 

expenses. Against these costs, the 

significant benefits of the New Accord 

suggest that the final rule offers an 

improvement over the baseline scenario. 

With regard to the three alternative 

approaches we consider, the final rule 

offers an important degree of flexibility 

while significantly restricting costs by 

limiting its application to large, 

internationally active banks. 

Alternatives A and B introduce more 

flexibility from the perspective of the 

large mandatory banks, but each is less 

flexible with respect to other banks. 

Either Alternative A or B would compel 

these non-mandatory banks to select a 

new set of capital rules and require 

them to undertake the time and expense 

of adjusting to this final rule. 

Alternative C would change the number 

of mandatory banks. If the number of 

mandatory banks increases, then the 

new rule would lose some of the 

flexibility it achieves with the opt-in 

option. Furthermore, costs would 

increase as the final rule would compel 

more banks to incur the expense of 

adopting the advanced approaches. 

Decreasing the number of mandatory 

banks would decrease the aggregate 

social good of each benefit achieved 

with the final rule. The final rule offers 

a better balance between costs and 

benefits than any of the three 

alternatives. 

OTS Executive Order 12866 

Determination 

OTS commented on the development 

of, and concurs with, OCC’s RIA. Rather 

than replicate that analysis, OTS drafted 

an RIA incorporating OCC’s analysis by 

reference and adding appropriate 

material reflecting the unique aspects of 

the thrift industry. The full text of OTS’s 

RIA is available at the locations for 

viewing the OTS docket indicated in the 

ADDRESSES section above. OTS believes 

that its analysis meets the requirements 

of Executive Order 12866. 

The following discussion 

supplements OCC’s summary of its RIA. 

The final rule will apply to 

approximately six mandatory and 

potential opt-in savings associations 

representing approximately 52 percent 

of total thrift industry assets. 

Approximately 76 percent of the total 

assets in these six institutions are 

concentrated in residential mortgagerelated assets. By contrast, national 

banks tend to concentrate their assets in 

commercial loans and other kinds of 

non-mortgage loans. Only about 35 

percent of national bank’s total assets 

are residential mortgage-related assets. 

As a result, the costs and benefits of the 

final rule for OTS-regulated savings 

associations will differ in important 

ways from OCC-regulated national 

banks. These differences are the focus of 

OTS’s analysis. 

Benefits. Among the benefits of the 

final rule, OCC cites: (i) Better allocation 

of capital and reduced impact of moral 

hazard through reduction in the scope 

for regulatory arbitrage; (ii) improved 

signal quality of capital as an indicator 

of institution solvency; and (iii) more 

efficient use of required bank capital. 

From OTS’s perspective, however, the 

final rule may not provide the degree of 

benefits anticipated by OCC from these 

sources. 

Because of the typically low credit 

risk associated with residential 

mortgage-related assets, OTS believes 

that the risk-insensitive leverage ratio, 

rather than the risk-based capital ratio, 

may be more binding on savings 

association institutions.120 As a result, 

these institutions may be required to 

hold more capital than would be 

required under Basel II risk-based 

standards alone. Therefore, the final 

rule may cause these institutions to 

incur much the same implementation 

costs as banks with riskier assets, but 

with reduced benefits. 

Costs. OTS adopts the OCC cost 

analysis with the following 

supplemental information on OTS’s 

administrative costs. OTS did not incur 

a meaningful amount of direct 

expenditures until 2002 when it 

transitioned from a monitoring role to 

active involvement in Basel II. 

Thereafter, expenditures increased 

rapidly. The OTS expenditures fall into 

two broad categories: policymaking 

expenses incurred in the development 

of the ANPR, the NPR, the final rule and 

related guidance; and supervision 

expenses that reflect institution-specific 

supervisory activities. OTS estimates 

that it incurred total expenses of 

$6,420,000 for fiscal years 2002 through 

2006, including $4,080,000 in 

policymaking expenses and $2,340,000 

in supervision expenses. OTS 

anticipates that supervision expenses 

will continue to grow as a percentage of 

the total expense as it moves from 

policy development to implementation 

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69396 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

121Paul S. Calem and James R. Follain, ‘‘An 

Examination of How the Proposed Bifurcated 

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

Competition Among Banking Organizations for 

Residential Mortgages,’’ manuscript, January 14, 

2005. 

122 Diana Hancock, Andreas Lenhert, Wayne 

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

the Competitive Impacts of Basel II Capital 

Standards on U.S. Mortgage Rates and Mortgage 

Securitization, March 7, 2005, Board of Governors 

of the Federal Reserve System, working paper. 

and training. To date, Basel II 

expenditures have not been a large part 

of overall expenditures. 

Competition. OTS agrees with OCC’s 

analysis of competition among 

providers of financial services. OTS 

adds, however, that some institutions 

with low credit risk portfolios face an 

existing competitive disadvantage 

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

ratio. Thus, the agencies regulate a class 

of institutions that currently receive 

fewer capital benefits from risk-based 

capital rules because they are bound by 

the risk-insensitive leverage ratio. This 

anomaly will likely continue under the 

final rule. 

In addition, the results from QIS–3 

and QIS–4 suggest that the largest 

reductions in regulatory credit-risk 

capital requirements from the 

application of revised rules would occur 

in the residential mortgage loan area. 

Thus, to the extent regulatory credit-risk 

capital requirements affect pricing of 

such loans, it is possible that core and 

opt-in institutions who are not 

constrained by the leverage ratio may 

experience an improvement in their 

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

bound by the leverage ratio. Two 

research papers—one by Calem and 

Follain,121 and another by Hancock, 

Lenhert, Passmore, and Sherlund122

addressed this topic. The Calem and 

Follain paper argues that Basel II will 

significantly affect the competitive 

environment in mortgage lending; 

Hancock, et al. argue that it will not. 

Both papers are predicated, however, on 

the current capital regime for nonadopters. The agencies recently 

announced that they have agreed to 

issue a proposed rule that would 

provide non-core banks with the option 

to adopt an approach consistent with 

the standardized approach included in 

the Basel II framework. The 

standardized proposal will replace the 

earlier proposed rule (the Basel IA 

proposed rule), and would be available 

as an alternative to the existing riskbased capital rules for all U.S. banks 

other than banks that adopt the final 

Basel II rule. Such modifications, if 

implemented, would likely reduce the 

competitive advantage of Basel II 

adopters. 

The final rule also has a ten percent 

floor on loss given default parameter 

estimates for residential mortgage 

segments that persists beyond the twoyear period articulated in the 

international Basel II framework, 

providing a disincentive for core 

institutions to hold the least risky 

residential mortgages. This may have 

the effect of reducing the core banks’’

advantage vis-a`-vis both non-adopters 

and their international competitors. 

Further, residential mortgages are 

subject to substantial interest rate risk. 

The agencies will retain the authority to 

require additional capital to cover 

interest rate risk. If regulatory capital 

requirements affect asset pricing, a 

substantial regulatory capital interest 

rate risk component could mitigate any 

competitive advantages of the proposed 

rule. Moreover, the capital requirement 

for interest rate risk would be subject to 

interpretation by each agency. A 

consistent evaluation of interest rate risk 

by the supervisory agencies would 

present a level playing field among the 

adopters—an important consideration 

given the potential size of the capital 

requirement. 

OCC Unfunded Mandates Reform Act of 

1995 Determination 

The Unfunded Mandates Reform Act 

of 1995 (Pub. L. 104–4) (UMRA) 

requires cost-benefit and other analyses 

for a rule that would include any 

Federal mandate that may result in the 

expenditure by State, local, and tribal 

governments, in the aggregate, or by the 

private sector of $100 million or more 

(adjusted annually for inflation) in any 

one year. The current inflation-adjusted 

expenditure threshold is $119.6 million. 

The requirements of the UMRA include 

assessing a rule’s effects on future 

compliance costs; particular regions or 

State, local, or tribal governments; 

communities; segments of the private 

sector; productivity; economic growth; 

full employment; creation of productive 

jobs; and the international 

competitiveness of U.S. goods and 

services. The final rule qualifies as a 

significant regulatory action under the 

UMRA because its Federal mandates 

may result in the expenditure by the 

private sector of $119.6 million or more 

in any one year. As permitted by section 

202(c) of the UMRA, the required 

analyses have been prepared in 

conjunction with the Executive Order 

12866 analysis document titled 

Regulatory Impact Analysis for RiskBased Capital Standards: Revised 

Capital Adequacy Guidelines. The 

analysis is available on the Internet at 

http://www.occ.treas.gov/law/basel.htm 

under the link of ‘‘Regulatory Impact 

Analysis for Risk-Based Capital 

Standards: Revised Capital Adequacy 

Guidelines (Basel II: Advanced 

Approach) 2007’’. 

OTS Unfunded Mandates Reform Act of 

1995 Determination 

The Unfunded Mandates Reform Act 

of 1995 (Pub. L. 104–4) (UMRA) 

requires cost-benefit and other analyses 

for a rule that would include any 

Federal mandate that may result in the 

expenditure by State, local, and tribal 

governments, in the aggregate, or by the 

private sector of $100 million or more 

(adjusted annually for inflation) in any 

one year. The current inflation-adjusted 

expenditure threshold is $119.6 million. 

The requirements of the UMRA include 

assessing a rule’s effects on future 

compliance costs; particular regions or 

State, local, or tribal governments; 

communities; segments of the private 

sector; productivity; economic growth; 

full employment; creation of productive 

jobs; and the international 

competitiveness of U.S. goods and 

services. The final rule qualifies as a 

significant regulatory action under the 

UMRA because its Federal mandates 

may result in the expenditure by the 

private sector of $119.6 or more in any 

one year. As permitted by section 202(c) 

of the UMRA, the required analyses 

have been prepared in conjunction with 

the Executive Order 12866 analysis 

document titled Regulatory Impact 

Analysis for Risk-Based Capital 

Standards: Revised Capital Adequacy 

Guidelines. The analysis is available at 

the locations for viewing the OTS 

docket indicated in the ADDRESSES

section above. 

Text of Common Appendix (All 

Agencies) 

The text of the agencies’’ common 

appendix appears below: 

[Appendix l to Part l]—Capital Adequacy 

Guidelines for [Banks]: Internal-RatingsBased and Advanced Measurement 

Approaches 

Part I General Provisions 

Section 1 Purpose, Applicability, 

Reservation of Authority, and Principle 

of Conservatism 

Section 2 Definitions 

Section 3 Minimum Risk-Based Capital 

Requirements 

Part II Qualifying Capital 

Section 11 Additional Deductions 

Section 12 Deductions and Limitations 

Not Required 

Section 13 Eligible Credit Reserves 

Part III Qualification 

Section 21 Qualification Process 

Section 22 Qualification Requirements 

Section 23 Ongoing Qualification 

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Section 24 Merger and Acquisition 

Transitional Arrangements 

Part IV Risk-Weighted Assets for General 

Credit Risk 

Section 31 Mechanics for Calculating 

Total Wholesale and Retail RiskWeighted Assets 

Section 32 Counterparty Credit Risk of 

Repo-Style Transactions, Eligible Margin 

Loans, and OTC Derivative Contracts 

Section 33 Guarantees and Credit 

Derivatives: PD Substitution and LGD 

Adjustment Approaches 

Section 34 Guarantees and Credit 

Derivatives: Double Default Treatment 

Section 35 Risk-Based Capital 

Requirement for Unsettled Transactions 

Part V Risk-Weighted Assets for 

Securitization Exposures 

Section 41 Operational Criteria for 

Recognizing the Transfer of Risk 

Section 42 Risk-Based Capital 

Requirement for Securitization 

Exposures 

Section 43 Ratings-Based Approach 

(RBA) 

Section 44 Internal Assessment Approach 

(IAA) 

Section 45 Supervisory Formula 

Approach (SFA) 

Section 46 Recognition of Credit Risk 

Mitigants for Securitization Exposures 

Section 47 Risk-Based Capital 

Requirement for Early Amortization 

Provisions 

Part VI Risk-Weighted Assets for Equity 

Exposures 

Section 51 Introduction and Exposure 

Measurement 

Section 52 Simple Risk Weight Approach 

(SRWA) 

Section 53 Internal Models Approach 

(IMA) 

Section 54 Equity Exposures to 

Investment Funds 

Section 55 Equity Derivative Contracts 

Part VII Risk-Weighted Assets for 

Operational Risk 

Section 61 Qualification Requirements 

for Incorporation of Operational Risk 

Mitigants 

Section 62 Mechanics of Risk-Weighted 

Asset Calculation 

Part VIII Disclosure 

Section 71 Disclosure Requirements 

Part I. General Provisions 

Section 1. Purpose, Applicability, 

Reservation of Authority, and Principle of 

Conservatism 

(a) Purpose. This appendix establishes: 

(1) Minimum qualifying criteria for [banks] 

using [bank]-specific internal risk 

measurement and management processes for 

calculating risk-based capital requirements; 

(2) Methodologies for such [banks] to 

calculate their risk-based capital 

requirements; and 

(3) Public disclosure requirements for such 

[banks]. 

(b) Applicability. (1) This appendix applies 

to a [bank] that: 

(i) Has consolidated total assets, as 

reported on the most recent year-end 

Consolidated Report of Condition and 

Income (Call Report) or Thrift Financial 

Report (TFR), equal to $250 billion or more; 

(ii) Has consolidated total on-balance sheet 

foreign exposure at the most recent year-end 

equal to $10 billion or more (where total onbalance sheet foreign exposure equals total 

cross-border claims less claims with head 

office or guarantor located in another country 

plus redistributed guaranteed amounts to the 

country of head office or guarantor plus local 

country claims on local residents plus 

revaluation gains on foreign exchange and 

derivative products, calculated in accordance 

with the Federal Financial Institutions 

Examination Council (FFIEC) 009 Country 

Exposure Report); 

(iii) Is a subsidiary of a depository 

institution that uses 12 CFR part 3, Appendix 

C, 12 CFR part 208, Appendix F, 12 CFR part 

325, Appendix D, or 12 CFR part 567, 

Appendix C, to calculate its risk-based 

capital requirements; or 

(iv) Is a subsidiary of a bank holding 

company that uses 12 CFR part 225, 

Appendix G, to calculate its risk-based 

capital requirements. 

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

appendix to calculate its risk-based capital 

requirements. 

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

must use this appendix unless the [AGENCY] 

determines in writing that application of this 

appendix is not appropriate in light of the 

[bank]’s asset size, level of complexity, risk 

profile, or scope of operations. In making a 

determination under this paragraph, the 

[AGENCY] will apply notice and response 

procedures in the same manner and to the 

same extent as the notice and response 

procedures in 12 CFR 3.12 (for national 

banks), 12 CFR 263.202 (for bank holding 

companies and state member banks), 12 CFR 

325.6(c) (for state nonmember banks), and 12 

CFR 567.3(d) (for savings associations). 

(c) Reservation of authority—(1) Additional 

capital in the aggregate. The [AGENCY] may 

require a [bank] to hold an amount of capital 

greater than otherwise required under this 

appendix if the [AGENCY] determines that 

the [bank]’s risk-based capital requirement 

under this appendix is not commensurate 

with the [bank]’s credit, market, operational, 

or other risks. In making a determination 

under this paragraph, the [AGENCY] will 

apply notice and response procedures in the 

same manner and to the same extent as the 

notice and response procedures in 12 CFR 

3.12 (for national banks), 12 CFR 263.202 (for 

bank holding companies and state member 

banks), 12 CFR 325.6(c) (for state nonmember 

banks), and 12 CFR 567.3(d) (for savings 

associations). 

(2) Specific risk-weighted asset amounts. (i) 

If the [AGENCY] determines that the riskweighted asset amount calculated under this 

appendix by the [bank] for one or more 

exposures is not commensurate with the risks 

associated with those exposures, the 

[AGENCY] may require the [bank] to assign 

a different risk-weighted asset amount to the 

exposures, to assign different risk parameters 

to the exposures (if the exposures are 

wholesale or retail exposures), or to use 

different model assumptions for the 

exposures (if relevant), all as specified by the 

[AGENCY]. 

(ii) If the [AGENCY] determines that the 

risk-weighted asset amount for operational 

risk produced by the [bank] under this 

appendix is not commensurate with the 

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

may require the [bank] to assign a different 

risk-weighted asset amount for operational 

risk, to change elements of its operational 

risk analytical framework, including 

distributional and dependence assumptions, 

or to make other changes to the [bank]’s 

operational risk management processes, data 

and assessment systems, or quantification 

systems, all as specified by the [AGENCY]. 

(3) Other supervisory authority. Nothing in 

this appendix limits the authority of the 

[AGENCY] under any other provision of law 

or regulation to take supervisory or 

enforcement action, including action to 

address unsafe or unsound practices or 

conditions, deficient capital levels, or 

violations of law. 

(d) Principle of conservatism. 

Notwithstanding the requirements of this 

appendix, a [bank] may choose not to apply 

a provision of this appendix to one or more 

exposures, provided that: 

(1) The [bank] can demonstrate on an 

ongoing basis to the satisfaction of the 

[AGENCY] that not applying the provision 

would, in all circumstances, unambiguously 

generate a risk-based capital requirement for 

each such exposure greater than that which 

would otherwise be required under this 

appendix; 

(2) The [bank] appropriately manages the 

risk of each such exposure; 

(3) The [bank] notifies the [AGENCY] in 

writing prior to applying this principle to 

each such exposure; and 

(4) The exposures to which the [bank] 

applies this principle are not, in the 

aggregate, material to the [bank]. 

Section 2. Definitions 

Advanced internal ratings-based (IRB) 

systems means a [bank]’s internal risk rating 

and segmentation system; risk parameter 

quantification system; data management and 

maintenance system; and control, oversight, 

and validation system for credit risk of 

wholesale and retail exposures. 

Advanced systems means a [bank]’s 

advanced IRB systems, operational risk 

management processes, operational risk data 

and assessment systems, operational risk 

quantification systems, and, to the extent the 

[bank] uses the following systems, the 

internal models methodology, double default 

excessive correlation detection process, IMA 

for equity exposures, and IAA for 

securitization exposures to ABCP programs. 

Affiliate with respect to a company means 

any company that controls, is controlled by, 

or is under common control with, the 

company. 

Applicable external rating means: 

(1) With respect to an exposure that has 

multiple external ratings assigned by 

NRSROs, the lowest solicited external rating 

assigned to the exposure by any NRSRO; and 

(2) With respect to an exposure that has a 

single external rating assigned by an NRSRO, 

the external rating assigned to the exposure 

by the NRSRO. 

Applicable inferred rating means: 

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1Overdrafts are past due once the obligor has 

breached an advised limit or been advised of a limit 

smaller than the current outstanding balance. 

(1) With respect to an exposure that has 

multiple inferred ratings, the lowest inferred 

rating based on a solicited external rating; 

and 

(2) With respect to an exposure that has a 

single inferred rating, the inferred rating. 

Asset-backed commercial paper (ABCP) 

program means a program that primarily 

issues commercial paper that: 

(1) Has an external rating; and 

(2) Is backed by underlying exposures held 

in a bankruptcy-remote SPE. 

Asset-backed commercial paper (ABCP) 

program sponsor means a [bank] that: 

(1) Establishes an ABCP program; 

(2) Approves the sellers permitted to 

participate in an ABCP program; 

(3) Approves the exposures to be 

purchased by an ABCP program; or 

(4) Administers the ABCP program by 

monitoring the underlying exposures, 

underwriting or otherwise arranging for the 

placement of debt or other obligations issued 

by the program, compiling monthly reports, 

or ensuring compliance with the program 

documents and with the program’s credit and 

investment policy. 

Backtesting means the comparison of a 

[bank]’s internal estimates with actual 

outcomes during a sample period not used in 

model development. In this context, 

backtesting is one form of out-of-sample 

testing. 

Bank holding company is defined in 

section 2 of the Bank Holding Company Act 

(12 U.S.C. 1841). 

Benchmarking means the comparison of a 

[bank]’s internal estimates with relevant 

internal and external data or with estimates 

based on other estimation techniques. 

Business environment and internal control 

factors means the indicators of a [bank]’s 

operational risk profile that reflect a current 

and forward-looking assessment of the 

[bank]’s underlying business risk factors and 

internal control environment. 

Carrying value means, with respect to an 

asset, the value of the asset on the balance 

sheet of the [bank], determined in accordance 

with GAAP. 

Clean-up call means a contractual 

provision that permits an originating [bank] 

or servicer to call securitization exposures 

before their stated maturity or call date. See 

also eligible clean-up call. 

Commodity derivative contract means a 

commodity-linked swap, purchased 

commodity-linked option, forward 

commodity-linked contract, or any other 

instrument linked to commodities that gives 

rise to similar counterparty credit risks. 

Company means a corporation, 

partnership, limited liability company, 

depository institution, business trust, special 

purpose entity, association, or similar 

organization. 

Control. A person or company controls a 

company if it: 

(1) Owns, controls, or holds with power to 

vote 25 percent or more of a class of voting 

securities of the company; or 

(2) Consolidates the company for financial 

reporting purposes. 

Controlled early amortization provision 

means an early amortization provision that 

meets all the following conditions: 

(1) The originating [bank] has appropriate 

policies and procedures to ensure that it has 

sufficient capital and liquidity available in 

the event of an early amortization; 

(2) Throughout the duration of the 

securitization (including the early 

amortization period), there is the same pro 

rata sharing of interest, principal, expenses, 

losses, fees, recoveries, and other cash flows 

from the underlying exposures based on the 

originating [bank]’s and the investors’

relative shares of the underlying exposures 

outstanding measured on a consistent 

monthly basis; 

(3) The amortization period is sufficient for 

at least 90 percent of the total underlying 

exposures outstanding at the beginning of the 

early amortization period to be repaid or 

recognized as in default; and 

(4) The schedule for repayment of investor 

principal is not more rapid than would be 

allowed by straight-line amortization over an 

18-month period. 

Credit derivative means a financial contract 

executed under standard industry credit 

derivative documentation that allows one 

party (the protection purchaser) to transfer 

the credit risk of one or more exposures 

(reference exposure) to another party (the 

protection provider). See also eligible credit 

derivative. 

Credit-enhancing interest-only strip (CEIO) 

means an on-balance sheet asset that, in form 

or in substance: 

(1) Represents a contractual right to receive 

some or all of the interest and no more than 

a minimal amount of principal due on the 

underlying exposures of a securitization; and 

(2) Exposes the holder to credit risk 

directly or indirectly associated with the 

underlying exposures that exceeds a pro rata 

share of the holder’s claim on the underlying 

exposures, whether through subordination 

provisions or other credit-enhancement 

techniques. 

Credit-enhancing representations and 

warranties means representations and 

warranties that are made or assumed in 

connection with a transfer of underlying 

exposures (including loan servicing assets) 

and that obligate a [bank] to protect another 

party from losses arising from the credit risk 

of the underlying exposures. Creditenhancing representations and warranties 

include provisions to protect a party from 

losses resulting from the default or 

nonperformance of the obligors of the 

underlying exposures or from an 

insufficiency in the value of the collateral 

backing the underlying exposures. Creditenhancing representations and warranties do 

not include: 

(1) Early default clauses and similar 

warranties that permit the return of, or 

premium refund clauses that cover, first-lien 

residential mortgage exposures for a period 

not to exceed 120 days from the date of 

transfer, provided that the date of transfer is 

within one year of origination of the 

residential mortgage exposure; 

(2) Premium refund clauses that cover 

underlying exposures guaranteed, in whole 

or in part, by the U.S. government, a U.S. 

government agency, or a U.S. government 

sponsored enterprise, provided that the 

clauses are for a period not to exceed 120 

days from the date of transfer; or 

(3) Warranties that permit the return of 

underlying exposures in instances of 

misrepresentation, fraud, or incomplete 

documentation. 

Credit risk mitigant means collateral, a 

credit derivative, or a guarantee. 

Credit-risk-weighted assets means 1.06 

multiplied by the sum of: 

(1) Total wholesale and retail risk-weighted 

assets; 

(2) Risk-weighted assets for securitization 

exposures; and 

(3) Risk-weighted assets for equity 

exposures. 

Current exposure means, with respect to a 

netting set, the larger of zero or the market 

value of a transaction or portfolio of 

transactions within the netting set that would 

be lost upon default of the counterparty, 

assuming no recovery on the value of the 

transactions. Current exposure is also called 

replacement cost. 

Default—(1) Retail. (i) A retail exposure of 

a [bank] is in default if: 

(A) The exposure is 180 days past due, in 

the case of a residential mortgage exposure or 

revolving exposure; 

(B) The exposure is 120 days past due, in 

the case of all other retail exposures; or 

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

charge-off, write-down of principal, or 

material negative fair value adjustment of 

principal on the exposure for credit-related 

reasons. 

(ii) Notwithstanding paragraph (1)(i) of this 

definition, for a retail exposure held by a 

non-U.S. subsidiary of the [bank] that is 

subject to an internal ratings-based approach 

to capital adequacy consistent with the Basel 

Committee on Banking Supervision’s 

‘‘International Convergence of Capital 

Measurement and Capital Standards: A 

Revised Framework’’ in a non-U.S. 

jurisdiction, the [bank] may elect to use the 

definition of default that is used in that 

jurisdiction, provided that the [bank] has 

obtained prior approval from the [AGENCY] 

to use the definition of default in that 

jurisdiction. 

(iii) A retail exposure in default remains in 

default until the [bank] has reasonable 

assurance of repayment and performance for 

all contractual principal and interest 

payments on the exposure. 

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

obligor is in default if: 

(A) The [bank] determines that the obligor 

is unlikely to pay its credit obligations to the 

[bank] in full, without recourse by the [bank] 

to actions such as realizing collateral (if 

held); or 

(B) The obligor is past due more than 90 

days on any material credit obligation(s) to 

the [bank].1

(ii) An obligor in default remains in default 

until the [bank] has reasonable assurance of 

repayment and performance for all 

contractual principal and interest payments 

on all exposures of the [bank] to the obligor 

(other than exposures that have been fully 

written-down or charged-off). 

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Dependence means a measure of the 

association among operational losses across 

and within units of measure. 

Depository institution is defined in section 

3 of the Federal Deposit Insurance Act (12 

U.S.C. 1813). 

Derivative contract means a financial 

contract whose value is derived from the 

values of one or more underlying assets, 

reference rates, or indices of asset values or 

reference rates. Derivative contracts include 

interest rate derivative contracts, exchange 

rate derivative contracts, equity derivative 

contracts, commodity derivative contracts, 

credit derivatives, and any other instrument 

that poses similar counterparty credit risks. 

Derivative contracts also include unsettled 

securities, commodities, and foreign 

exchange transactions with a contractual 

settlement or delivery lag that is longer than 

the lesser of the market standard for the 

particular instrument or five business days. 

Early amortization provision means a 

provision in the documentation governing a 

securitization that, when triggered, causes 

investors in the securitization exposures to 

be repaid before the original stated maturity 

of the securitization exposures, unless the 

provision: 

(1) Is triggered solely by events not directly 

related to the performance of the underlying 

exposures or the originating [bank] (such as 

material changes in tax laws or regulations); 

or 

(2) Leaves investors fully exposed to future 

draws by obligors on the underlying 

exposures even after the provision is 

triggered. 

Economic downturn conditions means, 

with respect to an exposure held by the 

[bank], those conditions in which the 

aggregate default rates for that exposure’s 

wholesale or retail exposure subcategory (or 

subdivision of such subcategory selected by 

the [bank]) in the exposure’s national 

jurisdiction (or subdivision of such 

jurisdiction selected by the [bank]) are 

significantly higher than average. 

Effective maturity (M) of a wholesale 

exposure means: 

(1) For wholesale exposures other than 

repo-style transactions, eligible margin loans, 

and OTC derivative contracts described in 

paragraph (2) or (3) of this definition: 

(i) The weighted-average remaining 

maturity (measured in years, whole or 

fractional) of the expected contractual cash 

flows from the exposure, using the 

undiscounted amounts of the cash flows as 

weights; or 

(ii) The nominal remaining maturity 

(measured in years, whole or fractional) of 

the exposure. 

(2) For repo-style transactions, eligible 

margin loans, and OTC derivative contracts 

subject to a qualifying master netting 

agreement for which the [bank] does not 

apply the internal models approach in 

paragraph (d) of section 32 of this appendix, 

the weighted-average remaining maturity 

(measured in years, whole or fractional) of 

the individual transactions subject to the 

qualifying master netting agreement, with the 

weight of each individual transaction set 

equal to the notional amount of the 

transaction. 

(3) For repo-style transactions, eligible 

margin loans, and OTC derivative contracts 

for which the [bank] applies the internal 

models approach in paragraph (d) of section 

32 of this appendix, the value determined in 

paragraph (d)(4) of section 32 of this 

appendix. 

Effective notional amount means, for an 

eligible guarantee or eligible credit 

derivative, the lesser of the contractual 

notional amount of the credit risk mitigant 

and the EAD of the hedged exposure, 

multiplied by the percentage coverage of the 

credit risk mitigant. For example, the 

effective notional amount of an eligible 

guarantee that covers, on a pro rata basis, 40 

percent of any losses on a $100 bond would 

be $40. 

Eligible clean-up call means a clean-up call 

that: 

(1) Is exercisable solely at the discretion of 

the originating [bank] or servicer; 

(2) Is not structured to avoid allocating 

losses to securitization exposures held by 

investors or otherwise structured to provide 

credit enhancement to the securitization; and 

(3) (i) For a traditional securitization, is 

only exercisable when 10 percent or less of 

the principal amount of the underlying 

exposures or securitization exposures 

(determined as of the inception of the 

securitization) is outstanding; or 

(ii) For a synthetic securitization, is only 

exercisable when 10 percent or less of the 

principal amount of the reference portfolio of 

underlying exposures (determined as of the 

inception of the securitization) is 

outstanding. 

Eligible credit derivative means a credit 

derivative in the form of a credit default 

swap, nth-to-default swap, total return swap, 

or any other form of credit derivative 

approved by the [AGENCY], provided that: 

(1) The contract meets the requirements of 

an eligible guarantee and has been confirmed 

by the protection purchaser and the 

protection provider; 

(2) Any assignment of the contract has 

been confirmed by all relevant parties; 

(3) If the credit derivative is a credit default 

swap or nth-to-default swap, the contract 

includes the following credit events: 

(i) Failure to pay any amount due under 

the terms of the reference exposure, subject 

to any applicable minimal payment threshold 

that is consistent with standard market 

practice and with a grace period that is 

closely in line with the grace period of the 

reference exposure; and 

(ii) Bankruptcy, insolvency, or inability of 

the obligor on the reference exposure to pay 

its debts, or its failure or admission in 

writing of its inability generally to pay its 

debts as they become due, and similar events; 

(4) The terms and conditions dictating the 

manner in which the contract is to be settled 

are incorporated into the contract; 

(5) If the contract allows for cash 

settlement, the contract incorporates a robust 

valuation process to estimate loss reliably 

and specifies a reasonable period for 

obtaining post-credit event valuations of the 

reference exposure; 

(6) If the contract requires the protection 

purchaser to transfer an exposure to the 

protection provider at settlement, the terms 

of at least one of the exposures that is 

permitted to be transferred under the contract 

provides that any required consent to transfer 

may not be unreasonably withheld; 

(7) If the credit derivative is a credit default 

swap or nth-to-default swap, the contract 

clearly identifies the parties responsible for 

determining whether a credit event has 

occurred, specifies that this determination is 

not the sole responsibility of the protection 

provider, and gives the protection purchaser 

the right to notify the protection provider of 

the occurrence of a credit event; and 

(8) If the credit derivative is a total return 

swap and the [bank] records net payments 

received on the swap as net income, the 

[bank] records offsetting deterioration in the 

value of the hedged exposure (either through 

reductions in fair value or by an addition to 

reserves). 

Eligible credit reserves means all general 

allowances that have been established 

through a charge against earnings to absorb 

credit losses associated with on- or offbalance sheet wholesale and retail exposures, 

including the allowance for loan and lease 

losses (ALLL) associated with such exposures 

but excluding allocated transfer risk reserves 

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

other specific reserves created against 

recognized losses. 

Eligible double default guarantor, with 

respect to a guarantee or credit derivative 

obtained by a [bank], means: 

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

institution, a bank holding company, a 

savings and loan holding company (as 

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

substantially all of the holding company’s 

activities are permissible for a financial 

holding company under 12 U.S.C. 1843(k), a 

securities broker or dealer registered with the 

SEC under the Securities Exchange Act of 

1934 (15 U.S.C. 78o et seq.), or an insurance 

company in the business of providing credit 

protection (such as a monoline bond insurer 

or re-insurer) that is subject to supervision by 

a State insurance regulator, if: 

(i) At the time the guarantor issued the 

guarantee or credit derivative or at any time 

thereafter, the [bank] assigned a PD to the 

guarantor’s rating grade that was equal to or 

lower than the PD associated with a longterm external rating in the third-highest 

investment-grade rating category; and 

(ii) The [bank] currently assigns a PD to the 

guarantor’s rating grade that is equal to or 

lower than the PD associated with a longterm external rating in the lowest investmentgrade rating category; or 

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

(as defined in § 211.2 of the Federal Reserve 

Board’s Regulation K (12 CFR 211.2)), a nonU.S.-based securities firm, or a non-U.S.- 

based insurance company in the business of 

providing credit protection, if: 

(i) The [bank] demonstrates that the 

guarantor is subject to consolidated 

supervision and regulation comparable to 

that imposed on U.S. depository institutions, 

securities broker-dealers, or insurance 

companies (as the case may be), or has issued 

and outstanding an unsecured long-term debt 

security without credit enhancement that has 

a long-term applicable external rating of at 

least investment grade; 

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2This requirement is met where all transactions 

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

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

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

qualified financial contracts under section 11(e)(8) 

of the Federal Deposit Insurance Act (12 U.S.C. 

1821(e)(8)), or netting contracts between or among 

financial institutions under sections 401–407 of the 

Federal Deposit Insurance Corporation 

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

the Federal Reserve Board’s Regulation EE (12 CFR 

part 231). 

(ii) At the time the guarantor issued the 

guarantee or credit derivative or at any time 

thereafter, the [bank] assigned a PD to the 

guarantor’s rating grade that was equal to or 

lower than the PD associated with a longterm external rating in the third-highest 

investment-grade rating category; and 

(iii) The [bank] currently assigns a PD to 

the guarantor’s rating grade that is equal to 

or lower than the PD associated with a longterm external rating in the lowest investmentgrade rating category. 

Eligible guarantee means a guarantee that: 

(1) Is written and unconditional; 

(2) Covers all or a pro rata portion of all 

contractual payments of the obligor on the 

reference exposure; 

(3) Gives the beneficiary a direct claim 

against the protection provider; 

(4) Is not unilaterally cancelable by the 

protection provider for reasons other than the 

breach of the contract by the beneficiary; 

(5) Is legally enforceable against the 

protection provider in a jurisdiction where 

the protection provider has sufficient assets 

against which a judgment may be attached 

and enforced; 

(6) Requires the protection provider to 

make payment to the beneficiary on the 

occurrence of a default (as defined in the 

guarantee) of the obligor on the reference 

exposure in a timely manner without the 

beneficiary first having to take legal actions 

to pursue the obligor for payment; 

(7) Does not increase the beneficiary’s cost 

of credit protection on the guarantee in 

response to deterioration in the credit quality 

of the reference exposure; and 

(8) Is not provided by an affiliate of the 

[bank], unless the affiliate is an insured 

depository institution, bank, securities broker 

or dealer, or insurance company that: 

(i) Does not control the [bank]; and 

(ii) Is subject to consolidated supervision 

and regulation comparable to that imposed 

on U.S. depository institutions, securities 

broker-dealers, or insurance companies (as 

the case may be). 

Eligible margin loan means an extension of 

credit where: 

(1) The extension of credit is collateralized 

exclusively by liquid and readily marketable 

debt or equity securities, gold, or conforming 

residential mortgages; 

(2) The collateral is marked to market 

daily, and the transaction is subject to daily 

margin maintenance requirements; 

(3) The extension of credit is conducted 

under an agreement that provides the [bank] 

the right to accelerate and terminate the 

extension of credit and to liquidate or set off 

collateral promptly upon an event of default 

(including upon an event of bankruptcy, 

insolvency, or similar proceeding) of the 

counterparty, provided that, in any such 

case, any exercise of rights under the 

agreement will not be stayed or avoided 

under applicable law in the relevant 

jurisdictions; 2 and 

(4) The [bank] has conducted sufficient 

legal review to conclude with a well-founded 

basis (and maintains sufficient written 

documentation of that legal review) that the 

agreement meets the requirements of 

paragraph (3) of this definition and is legal, 

valid, binding, and enforceable under 

applicable law in the relevant jurisdictions. 

Eligible operational risk offsets means 

amounts, not to exceed expected operational 

loss, that: 

(1) Are generated by internal business 

practices to absorb highly predictable and 

reasonably stable operational losses, 

including reserves calculated consistent with 

GAAP; and 

(2) Are available to cover expected 

operational losses with a high degree of 

certainty over a one-year horizon. 

Eligible purchased wholesale exposure 

means a purchased wholesale exposure that: 

(1) The [bank] or securitization SPE 

purchased from an unaffiliated seller and did 

not directly or indirectly originate; 

(2) Was generated on an arm’s-length basis 

between the seller and the obligor 

(intercompany accounts receivable and 

receivables subject to contra-accounts 

between firms that buy and sell to each other 

do not satisfy this criterion); 

(3) Provides the [bank] or securitization 

SPE with a claim on all proceeds from the 

exposure or a pro rata interest in the 

proceeds from the exposure; 

(4) Has an M of less than one year; and 

(5) When consolidated by obligor, does not 

represent a concentrated exposure relative to 

the portfolio of purchased wholesale 

exposures. 

Eligible securitization guarantor means: 

(1) A sovereign entity, the Bank for 

International Settlements, the International 

Monetary Fund, the European Central Bank, 

the European Commission, a Federal Home 

Loan Bank, Federal Agricultural Mortgage 

Corporation (Farmer Mac), a multilateral 

development bank, a depository institution, a 

bank holding company, a savings and loan 

holding company (as defined in 12 U.S.C. 

1467a) provided all or substantially all of the 

holding company’s activities are permissible 

for a financial holding company under 12 

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

§ 211.2 of the Federal Reserve Board’s 

Regulation K (12 CFR 211.2)), or a securities 

firm; 

(2) Any other entity (other than a 

securitization SPE) that has issued and 

outstanding an unsecured long-term debt 

security without credit enhancement that has 

a long-term applicable external rating in one 

of the three highest investment-grade rating 

categories; or 

(3) Any other entity (other than a 

securitization SPE) that has a PD assigned by 

the [bank] that is lower than or equal to the 

PD associated with a long-term external 

rating in the third highest investment-grade 

rating category. 

Eligible servicer cash advance facility 

means a servicer cash advance facility in 

which: 

(1) The servicer is entitled to full 

reimbursement of advances, except that a 

servicer may be obligated to make nonreimbursable advances for a particular 

underlying exposure if any such advance is 

contractually limited to an insignificant 

amount of the outstanding principal balance 

of that exposure; 

(2) The servicer’s right to reimbursement is 

senior in right of payment to all other claims 

on the cash flows from the underlying 

exposures of the securitization; and 

(3) The servicer has no legal obligation to, 

and does not, make advances to the 

securitization if the servicer concludes the 

advances are unlikely to be repaid. 

Equity derivative contract means an equitylinked swap, purchased equity-linked option, 

forward equity-linked contract, or any other 

instrument linked to equities that gives rise 

to similar counterparty credit risks. 

Equity exposure means: 

(1) A security or instrument (whether 

voting or non-voting) that represents a direct 

or indirect ownership interest in, and is a 

residual claim on, the assets and income of 

a company, unless: 

(i) The issuing company is consolidated 

with the [bank] under GAAP; 

(ii) The [bank] is required to deduct the 

ownership interest from tier 1 or tier 2 capital 

under this appendix; 

(iii) The ownership interest incorporates a 

payment or other similar obligation on the 

part of the issuing company (such as an 

obligation to make periodic payments); or 

(iv) The ownership interest is a 

securitization exposure; 

(2) A security or instrument that is 

mandatorily convertible into a security or 

instrument described in paragraph (1) of this 

definition; 

(3) An option or warrant that is exercisable 

for a security or instrument described in 

paragraph (1) of this definition; or 

(4) Any other security or instrument (other 

than a securitization exposure) to the extent 

the return on the security or instrument is 

based on the performance of a security or 

instrument described in paragraph (1) of this 

definition. 

Excess spread for a period means: 

(1) Gross finance charge collections and 

other income received by a securitization 

SPE (including market interchange fees) over 

a period minus interest paid to the holders 

of the securitization exposures, servicing 

fees, charge-offs, and other senior trust or 

similar expenses of the SPE over the period; 

divided by 

(2) The principal balance of the underlying 

exposures at the end of the period. 

Exchange rate derivative contract means a 

cross-currency interest rate swap, forward 

foreign-exchange contract, currency option 

purchased, or any other instrument linked to 

exchange rates that gives rise to similar 

counterparty credit risks. 

Excluded mortgage exposure means any 

one-to four-family residential pre-sold 

construction loan for a residence for which 

the purchase contract is cancelled that would 

receive a 100 percent risk weight under 

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section 618(a)(2) of the Resolution Trust 

Corporation Refinancing, Restructuring, and 

Improvement Act and under 12 CFR part 3, 

Appendix A, section 3(a)(3)(iii) (for national 

banks), 12 CFR part 208, Appendix A, section 

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

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

holding companies), 12 CFR part 325, 

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

nonmember banks), or 12 CFR 567.1 

(definition of ‘‘qualifying residential 

construction loan’’) and 12 CFR 

567.6(a)(1)(iv) (for savings associations). 

Expected credit loss (ECL) means: 

(1) For a wholesale exposure to a nondefaulted obligor or segment of non-defaulted 

retail exposures that is carried at fair value 

with gains and losses flowing through 

earnings or that is classified as held-for-sale 

and is carried at the lower of cost or fair 

value with losses flowing through earnings, 

zero. 

(2) For all other wholesale exposures to 

non-defaulted obligors or segments of nondefaulted retail exposures, the product of PD 

times LGD times EAD for the exposure or 

segment. 

(3) For a wholesale exposure to a defaulted 

obligor or segment of defaulted retail 

exposures, the [bank]’s impairment estimate 

for allowance purposes for the exposure or 

segment. 

(4) Total ECL is the sum of expected credit 

losses for all wholesale and retail exposures 

other than exposures for which the [bank] 

has applied the double default treatment in 

section 34 of this appendix. 

Expected exposure (EE) means the 

expected value of the probability distribution 

of non-negative credit risk exposures to a 

counterparty at any specified future date 

before the maturity date of the longest term 

transaction in the netting set. Any negative 

market values in the probability distribution 

of market values to a counterparty at a 

specified future date are set to zero to convert 

the probability distribution of market values 

to the probability distribution of credit risk 

exposures. 

Expected operational loss (EOL) means the 

expected value of the distribution of 

potential aggregate operational losses, as 

generated by the [bank]’s operational risk 

quantification system using a one-year 

horizon. 

Expected positive exposure (EPE) means 

the weighted average over time of expected 

(non-negative) exposures to a counterparty 

where the weights are the proportion of the 

time interval that an individual expected 

exposure represents. When calculating riskbased capital requirements, the average is 

taken over a one-year horizon. 

Exposure at default (EAD). (1) For the onbalance sheet component of a wholesale 

exposure or segment of retail exposures 

(other than an OTC derivative contract, or a 

repo-style transaction or eligible margin loan 

for which the [bank] determines EAD under 

section 32 of this appendix), EAD means: 

(i) If the exposure or segment is a security 

classified as available-for-sale, the [bank]’s 

carrying value (including net accrued but 

unpaid interest and fees) for the exposure or 

segment less any allocated transfer risk 

reserve for the exposure or segment, less any 

unrealized gains on the exposure or segment, 

and plus any unrealized losses on the 

exposure or segment; or 

(ii) If the exposure or segment is not a 

security classified as available-for-sale, the 

[bank]’s carrying value (including net 

accrued but unpaid interest and fees) for the 

exposure or segment less any allocated 

transfer risk reserve for the exposure or 

segment. 

(2) For the off-balance sheet component of 

a wholesale exposure or segment of retail 

exposures (other than an OTC derivative 

contract, or a repo-style transaction or 

eligible margin loan for which the [bank] 

determines EAD under section 32 of this 

appendix) in the form of a loan commitment, 

line of credit, trade-related letter of credit, or 

transaction-related contingency, EAD means 

the [bank]’s best estimate of net additions to 

the outstanding amount owed the [bank], 

including estimated future additional draws 

of principal and accrued but unpaid interest 

and fees, that are likely to occur over a oneyear horizon assuming the wholesale 

exposure or the retail exposures in the 

segment were to go into default. This 

estimate of net additions must reflect what 

would be expected during economic 

downturn conditions. Trade-related letters of 

credit are short-term, self-liquidating 

instruments that are used to finance the 

movement of goods and are collateralized by 

the underlying goods. Transaction-related 

contingencies relate to a particular 

transaction and include, among other things, 

performance bonds and performance-based 

letters of credit. 

(3) For the off-balance sheet component of 

a wholesale exposure or segment of retail 

exposures (other than an OTC derivative 

contract, or a repo-style transaction or 

eligible margin loan for which the [bank] 

determines EAD under section 32 of this 

appendix) in the form of anything other than 

a loan commitment, line of credit, traderelated letter of credit, or transaction-related 

contingency, EAD means the notional 

amount of the exposure or segment. 

(4) EAD for OTC derivative contracts is 

calculated as described in section 32 of this 

appendix. A [bank] also may determine EAD 

for repo-style transactions and eligible 

margin loans as described in section 32 of 

this appendix. 

(5) For wholesale or retail exposures in 

which only the drawn balance has been 

securitized, the [bank] must reflect its share 

of the exposures’ undrawn balances in EAD. 

Undrawn balances of revolving exposures for 

which the drawn balances have been 

securitized must be allocated between the 

seller’s and investors’ interests on a pro rata 

basis, based on the proportions of the seller’s 

and investors’ shares of the securitized 

drawn balances. 

Exposure category means any of the 

wholesale, retail, securitization, or equity 

exposure categories. 

External operational loss event data 

means, with respect to a [bank], gross 

operational loss amounts, dates, recoveries, 

and relevant causal information for 

operational loss events occurring at 

organizations other than the [bank]. 

External rating means a credit rating that 

is assigned by an NRSRO to an exposure, 

provided: 

(1) The credit rating fully reflects the entire 

amount of credit risk with regard to all 

payments owed to the holder of the exposure. 

If a holder is owed principal and interest on 

an exposure, the credit rating must fully 

reflect the credit risk associated with timely 

repayment of principal and interest. If a 

holder is owed only principal on an 

exposure, the credit rating must fully reflect 

only the credit risk associated with timely 

repayment of principal; and 

(2) The credit rating is published in an 

accessible form and is or will be included in 

the transition matrices made publicly 

available by the NRSRO that summarize the 

historical performance of positions rated by 

the NRSRO. 

Financial collateral means collateral: 

(1) In the form of: 

(i) Cash on deposit with the [bank] 

(including cash held for the [bank] by a thirdparty custodian or trustee); 

(ii) Gold bullion; 

(iii) Long-term debt securities that have an 

applicable external rating of one category 

below investment grade or higher; 

(iv) Short-term debt instruments that have 

an applicable external rating of at least 

investment grade; 

(v) Equity securities that are publicly 

traded; 

(vi) Convertible bonds that are publicly 

traded; 

(vii) Money market mutual fund shares and 

other mutual fund shares if a price for the 

shares is publicly quoted daily; or (viii) 

Conforming residential mortgages; and 

(2) In which the [bank] has a perfected, 

first priority security interest or, outside of 

the United States, the legal equivalent thereof 

(with the exception of cash on deposit and 

notwithstanding the prior security interest of 

any custodial agent). 

GAAP means generally accepted 

accounting principles as used in the United 

States. 

Gain-on-sale means an increase in the 

equity capital (as reported on Schedule RC of 

the Call Report, Schedule HC of the FR Y–

9C Report, or Schedule SC of the Thrift 

Financial Report) of a [bank] that results from 

a securitization (other than an increase in 

equity capital that results from the [bank]’s 

receipt of cash in connection with the 

securitization). 

Guarantee means a financial guarantee, 

letter of credit, insurance, or other similar 

financial instrument (other than a credit 

derivative) that allows one party (beneficiary) 

to transfer the credit risk of one or more 

specific exposures (reference exposure) to 

another party (protection provider). See also 

eligible guarantee. 

High volatility commercial real estate 

(HVCRE) exposure means a credit facility 

that finances or has financed the acquisition, 

development, or construction (ADC) of real 

property, unless the facility finances: 

(1) One- to four-family residential 

properties; or 

(2) Commercial real estate projects in 

which: 

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

equal to the applicable maximum 

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supervisory loan-to-value ratio in the 

[AGENCY]’s real estate lending standards at 

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

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

365, Subpart D (FDIC); and 12 CFR 560.100–

560.101 (OTS); 

(ii) The borrower has contributed capital to 

the project in the form of cash or 

unencumbered readily marketable assets (or 

has paid development expenses out-ofpocket) of at least 15 percent of the real 

estate’s appraised ‘‘as completed’’ value; and 

(iii) The borrower contributed the amount 

of capital required by paragraph (2)(ii) of this 

definition before the [bank] advances funds 

under the credit facility, and the capital 

contributed by the borrower, or internally 

generated by the project, is contractually 

required to remain in the project throughout 

the life of the project. The life of a project 

concludes only when the credit facility is 

converted to permanent financing or is sold 

or paid in full. Permanent financing may be 

provided by the [bank] that provided the 

ADC facility as long as the permanent 

financing is subject to the [bank]’s 

underwriting criteria for long-term mortgage 

loans. 

Inferred rating. A securitization exposure 

has an inferred rating equal to the external 

rating referenced in paragraph (2)(i) of this 

definition if: 

(1) The securitization exposure does not 

have an external rating; and 

(2) Another securitization exposure issued 

by the same issuer and secured by the same 

underlying exposures: 

(i) Has an external rating; 

(ii) Is subordinated in all respects to the 

unrated securitization exposure; 

(iii) Does not benefit from any credit 

enhancement that is not available to the 

unrated securitization exposure; and 

(iv) Has an effective remaining maturity 

that is equal to or longer than that of the 

unrated securitization exposure. 

Interest rate derivative contract means a 

single-currency interest rate swap, basis 

swap, forward rate agreement, purchased 

interest rate option, when-issued securities, 

or any other instrument linked to interest 

rates that gives rise to similar counterparty 

credit risks. 

Internal operational loss event data means, 

with respect to a [bank], gross operational 

loss amounts, dates, recoveries, and relevant 

causal information for operational loss events 

occurring at the [bank]. 

Investing [bank] means, with respect to a 

securitization, a [bank] that assumes the 

credit risk of a securitization exposure (other 

than an originating [bank] of the 

securitization). In the typical synthetic 

securitization, the investing [bank] sells 

credit protection on a pool of underlying 

exposures to the originating [bank]. 

Investment fund means a company: 

(1) All or substantially all of the assets of 

which are financial assets; and 

(2) That has no material liabilities. 

Investors’ interest EAD means, with respect 

to a securitization, the EAD of the underlying 

exposures multiplied by the ratio of: 

(1) The total amount of securitization 

exposures issued by the securitization SPE to 

investors; divided by 

(2) The outstanding principal amount of 

underlying exposures. 

Loss given default (LGD) means: 

(1) For a wholesale exposure, the greatest 

of: 

(i) Zero; 

(ii) The [bank]’s empirically based best 

estimate of the long-run default-weighted 

average economic loss, per dollar of EAD, the 

[bank] would expect to incur if the obligor (or 

a typical obligor in the loss severity grade 

assigned by the [bank] to the exposure) were 

to default within a one-year horizon over a 

mix of economic conditions, including 

economic downturn conditions; or 

(iii) The [bank]’s empirically based best 

estimate of the economic loss, per dollar of 

EAD, the [bank] would expect to incur if the 

obligor (or a typical obligor in the loss 

severity grade assigned by the [bank] to the 

exposure) were to default within a one-year 

horizon during economic downturn 

conditions. 

(2) For a segment of retail exposures, the 

greatest of: 

(i) Zero; 

(ii) The [bank]’s empirically based best 

estimate of the long-run default-weighted 

average economic loss, per dollar of EAD, the 

[bank] would expect to incur if the exposures 

in the segment were to default within a oneyear horizon over a mix of economic 

conditions, including economic downturn 

conditions; or 

(iii) The [bank]’s empirically based best 

estimate of the economic loss, per dollar of 

EAD, the [bank] would expect to incur if the 

exposures in the segment were to default 

within a one-year horizon during economic 

downturn conditions. 

(3) The economic loss on an exposure in 

the event of default is all material creditrelated losses on the exposure (including 

accrued but unpaid interest or fees, losses on 

the sale of collateral, direct workout costs, 

and an appropriate allocation of indirect 

workout costs). Where positive or negative 

cash flows on a wholesale exposure to a 

defaulted obligor or a defaulted retail 

exposure (including proceeds from the sale of 

collateral, workout costs, additional 

extensions of credit to facilitate repayment of 

the exposure, and draw-downs of unused 

credit lines) occur after the date of default, 

the economic loss must reflect the net 

present value of cash flows as of the default 

date using a discount rate appropriate to the 

risk of the defaulted exposure. 

Main index means the Standard & Poor’s 

500 Index, the FTSE All-World Index, and 

any other index for which the [bank] can 

demonstrate to the satisfaction of the 

[AGENCY] that the equities represented in 

the index have comparable liquidity, depth 

of market, and size of bid-ask spreads as 

equities in the Standard & Poor’s 500 Index 

and FTSE All-World Index. 

Multilateral development bank means the 

International Bank for Reconstruction and 

Development, the International Finance 

Corporation, the Inter-American 

Development Bank, the Asian Development 

Bank, the African Development Bank, the 

European Bank for Reconstruction and 

Development, the European Investment 

Bank, the European Investment Fund, the 

Nordic Investment Bank, the Caribbean 

Development Bank, the Islamic Development 

Bank, the Council of Europe Development 

Bank, and any other multilateral lending 

institution or regional development bank in 

which the U.S. government is a shareholder 

or contributing member or which the 

[AGENCY] determines poses comparable 

credit risk. 

Nationally recognized statistical rating 

organization (NRSRO) means an entity 

registered with the SEC as a nationally 

recognized statistical rating organization 

under section 15E of the Securities Exchange 

Act of 1934 (15 U.S.C. 78o–7). 

Netting set means a group of transactions 

with a single counterparty that are subject to 

a qualifying master netting agreement or 

qualifying cross-product master netting 

agreement. For purposes of the internal 

models methodology in paragraph (d) of 

section 32 of this appendix, each transaction 

that is not subject to such a master netting 

agreement is its own netting set. 

Nth-to-default credit derivative means a 

credit derivative that provides credit 

protection only for the nth-defaulting 

reference exposure in a group of reference 

exposures. 

Obligor means the legal entity or natural 

person contractually obligated on a 

wholesale exposure, except that a [bank] may 

treat the following exposures as having 

separate obligors: 

(1) Exposures to the same legal entity or 

natural person denominated in different 

currencies; 

(2) (i) An income-producing real estate 

exposure for which all or substantially all of 

the repayment of the exposure is reliant on 

the cash flows of the real estate serving as 

collateral for the exposure; the [bank], in 

economic substance, does not have recourse 

to the borrower beyond the real estate 

collateral; and no cross-default or crossacceleration clauses are in place other than 

clauses obtained solely out of an abundance 

of caution; and 

(ii) Other credit exposures to the same legal 

entity or natural person; and 

(3) (i) A wholesale exposure authorized 

under section 364 of the U.S. Bankruptcy 

Code (11 U.S.C. 364) to a legal entity or 

natural person who is a debtor-in-possession 

for purposes of Chapter 11 of the Bankruptcy 

Code; and 

(ii) Other credit exposures to the same legal 

entity or natural person. 

Operational loss means a loss (excluding 

insurance or tax effects) resulting from an 

operational loss event. Operational loss 

includes all expenses associated with an 

operational loss event except for opportunity 

costs, forgone revenue, and costs related to 

risk management and control enhancements 

implemented to prevent future operational 

losses. 

Operational loss event means an event that 

results in loss and is associated with any of 

the following seven operational loss event 

type categories: 

(1) Internal fraud, which means the 

operational loss event type category that 

comprises operational losses resulting from 

an act involving at least one internal party of 

a type intended to defraud, misappropriate 

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property, or circumvent regulations, the law, 

or company policy, excluding diversity- and 

discrimination-type events. 

(2) External fraud, which means the 

operational loss event type category that 

comprises operational losses resulting from 

an act by a third party of a type intended to 

defraud, misappropriate property, or 

circumvent the law. Retail credit card losses 

arising from non-contractual, third-party 

initiated fraud (for example, identity theft) 

are external fraud operational losses. All 

other third-party initiated credit losses are to 

be treated as credit risk losses. 

(3) Employment practices and workplace 

safety, which means the operational loss 

event type category that comprises 

operational losses resulting from an act 

inconsistent with employment, health, or 

safety laws or agreements, payment of 

personal injury claims, or payment arising 

from diversity- and discrimination-type 

events. 

(4) Clients, products, and business 

practices, which means the operational loss 

event type category that comprises 

operational losses resulting from the nature 

or design of a product or from an 

unintentional or negligent failure to meet a 

professional obligation to specific clients 

(including fiduciary and suitability 

requirements). 

(5) Damage to physical assets, which 

means the operational loss event type 

category that comprises operational losses 

resulting from the loss of or damage to 

physical assets from natural disaster or other 

events. 

(6) Business disruption and system 

failures, which means the operational loss 

event type category that comprises 

operational losses resulting from disruption 

of business or system failures. 

(7) Execution, delivery, and process 

management, which means the operational 

loss event type category that comprises 

operational losses resulting from failed 

transaction processing or process 

management or losses arising from relations 

with trade counterparties and vendors. 

Operational risk means the risk of loss 

resulting from inadequate or failed internal 

processes, people, and systems or from 

external events (including legal risk but 

excluding strategic and reputational risk). 

Operational risk exposure means the 99.9th

percentile of the distribution of potential 

aggregate operational losses, as generated by 

the [bank]’s operational risk quantification 

system over a one-year horizon (and not 

incorporating eligible operational risk offsets 

or qualifying operational risk mitigants). 

Originating [bank], with respect to a 

securitization, means a [bank] that: 

(1) Directly or indirectly originated or 

securitized the underlying exposures 

included in the securitization; or 

(2) Serves as an ABCP program sponsor to 

the securitization. 

Other retail exposure means an exposure 

(other than a securitization exposure, an 

equity exposure, a residential mortgage 

exposure, an excluded mortgage exposure, a 

qualifying revolving exposure, or the residual 

value portion of a lease exposure) that is 

managed as part of a segment of exposures 

with homogeneous risk characteristics, not 

on an individual-exposure basis, and is 

either: 

(1) An exposure to an individual for nonbusiness purposes; or 

(2) An exposure to an individual or 

company for business purposes if the [bank]’s 

consolidated business credit exposure to the 

individual or company is $1 million or less. 

Over-the-counter (OTC) derivative contract 

means a derivative contract that is not traded 

on an exchange that requires the daily receipt 

and payment of cash-variation margin. 

Probability of default (PD) means: 

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

based best estimate of the long-run average 

one-year default rate for the rating grade 

assigned by the [bank] to the obligor, 

capturing the average default experience for 

obligors in the rating grade over a mix of 

economic conditions (including economic 

downturn conditions) sufficient to provide a 

reasonable estimate of the average one-year 

default rate over the economic cycle for the 

rating grade. 

(2) For a segment of non-defaulted retail 

exposures, the [bank]’s empirically based 

best estimate of the long-run average one-year 

default rate for the exposures in the segment, 

capturing the average default experience for 

exposures in the segment over a mix of 

economic conditions (including economic 

downturn conditions) sufficient to provide a 

reasonable estimate of the average one-year 

default rate over the economic cycle for the 

segment and adjusted upward as appropriate 

for segments for which seasoning effects are 

material. For purposes of this definition, a 

segment for which seasoning effects are 

material is a segment where there is a 

material relationship between the time since 

origination of exposures within the segment 

and the [bank]’s best estimate of the long-run 

average one-year default rate for the 

exposures in the segment. 

(3) For a wholesale exposure to a defaulted 

obligor or segment of defaulted retail 

exposures, 100 percent. 

Protection amount (P) means, with respect 

to an exposure hedged by an eligible 

guarantee or eligible credit derivative, the 

effective notional amount of the guarantee or 

credit derivative, reduced to reflect any 

currency mismatch, maturity mismatch, or 

lack of restructuring coverage (as provided in 

section 33 of this appendix). 

Publicly traded means traded on: 

(1) Any exchange registered with the SEC 

as a national securities exchange under 

section 6 of the Securities Exchange Act of 

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

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

that: 

(i) Is registered with, or approved by, a 

national securities regulatory authority; and 

(ii) Provides a liquid, two-way market for 

the instrument in question, meaning that 

there are enough independent bona fide 

offers to buy and sell so that a sales price 

reasonably related to the last sales price or 

current bona fide competitive bid and offer 

quotations can be determined promptly and 

a trade can be settled at such a price within 

five business days. 

Qualifying central counterparty means a 

counterparty (for example, a clearinghouse) 

that: 

(1) Facilitates trades between 

counterparties in one or more financial 

markets by either guaranteeing trades or 

novating contracts; 

(2) Requires all participants in its 

arrangements to be fully collateralized on a 

daily basis; and 

(3) The [bank] demonstrates to the 

satisfaction of the [AGENCY] is in sound 

financial condition and is subject to effective 

oversight by a national supervisory authority. 

Qualifying cross-product master netting 

agreement means a qualifying master netting 

agreement that provides for termination and 

close-out netting across multiple types of 

financial transactions or qualifying master 

netting agreements in the event of a 

counterparty’s default, provided that: 

(1) The underlying financial transactions 

are OTC derivative contracts, eligible margin 

loans, or repo-style transactions; and 

(2) The [bank] obtains a written legal 

opinion verifying the validity and 

enforceability of the agreement under 

applicable law of the relevant jurisdictions if 

the counterparty fails to perform upon an 

event of default, including upon an event of 

bankruptcy, insolvency, or similar 

proceeding. 

Qualifying master netting agreement means 

any written, legally enforceable bilateral 

agreement, provided that: 

(1) The agreement creates a single legal 

obligation for all individual transactions 

covered by the agreement upon an event of 

default, including bankruptcy, insolvency, or 

similar proceeding, of the counterparty; 

(2) The agreement provides the [bank] the 

right to accelerate, terminate, and close-out 

on a net basis all transactions under the 

agreement and to liquidate or set off 

collateral promptly upon an event of default, 

including upon an event of bankruptcy, 

insolvency, or similar proceeding, of the 

counterparty, provided that, in any such 

case, any exercise of rights under the 

agreement will not be stayed or avoided 

under applicable law in the relevant 

jurisdictions; 

(3) The [bank] has conducted sufficient 

legal review to conclude with a well-founded 

basis (and maintains sufficient written 

documentation of that legal review) that: 

(i) The agreement meets the requirements 

of paragraph (2) of this definition; and 

(ii) In the event of a legal challenge 

(including one resulting from default or from 

bankruptcy, insolvency, or similar 

proceeding) the relevant court and 

administrative authorities would find the 

agreement to be legal, valid, binding, and 

enforceable under the law of the relevant 

jurisdictions; 

(4) The [bank] establishes and maintains 

procedures to monitor possible changes in 

relevant law and to ensure that the agreement 

continues to satisfy the requirements of this 

definition; and 

(5) The agreement does not contain a 

walkaway clause (that is, a provision that 

permits a non-defaulting counterparty to 

make a lower payment than it would make 

otherwise under the agreement, or no 

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payment at all, to a defaulter or the estate of 

a defaulter, even if the defaulter or the estate 

of the defaulter is a net creditor under the 

agreement). 

Qualifying revolving exposure (QRE) 

means an exposure (other than a 

securitization exposure or equity exposure) 

to an individual that is managed as part of 

a segment of exposures with homogeneous 

risk characteristics, not on an individualexposure basis, and: 

(1) Is revolving (that is, the amount 

outstanding fluctuates, determined largely by 

the borrower’s decision to borrow and repay, 

up to a pre-established maximum amount); 

(2) Is unsecured and unconditionally 

cancelable by the [bank] to the fullest extent 

permitted by Federal law; and 

(3) Has a maximum exposure amount 

(drawn plus undrawn) of up to $100,000. 

Repo-style transaction means a repurchase 

or reverse repurchase transaction, or a 

securities borrowing or securities lending 

transaction, including a transaction in which 

the [bank] acts as agent for a customer and 

indemnifies the customer against loss, 

provided that: 

(1) The transaction is based solely on 

liquid and readily marketable securities, 

cash, gold, or conforming residential 

mortgages; 

(2) The transaction is marked-to-market 

daily and subject to daily margin 

maintenance requirements; 

(3)(i) The transaction is a ‘‘securities 

contract’’ or ‘‘repurchase agreement’’ under 

section 555 or 559, respectively, of the 

Bankruptcy Code (11 U.S.C. 555 or 559), a 

qualified financial contract under section 

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

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

between or among financial institutions 

under sections 401–407 of the Federal 

Deposit Insurance Corporation Improvement 

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

Federal Reserve Board’s Regulation EE (12 

CFR part 231); or 

(ii) If the transaction does not meet the 

criteria set forth in paragraph (3)(i) of this 

definition, then either: 

(A) The transaction is executed under an 

agreement that provides the [bank] the right 

to accelerate, terminate, and close-out the 

transaction on a net basis and to liquidate or 

set off collateral promptly upon an event of 

default (including upon an event of 

bankruptcy, insolvency, or similar 

proceeding) of the counterparty, provided 

that, in any such case, any exercise of rights 

under the agreement will not be stayed or 

avoided under applicable law in the relevant 

jurisdictions; or 

(B) The transaction is: 

(1) Either overnight or unconditionally 

cancelable at any time by the [bank]; and 

(2) Executed under an agreement that 

provides the [bank] the right to accelerate, 

terminate, and close-out the transaction on a 

net basis and to liquidate or set off collateral 

promptly upon an event of counterparty 

default; and 

(4) The [bank] has conducted sufficient 

legal review to conclude with a well-founded 

basis (and maintains sufficient written 

documentation of that legal review) that the 

agreement meets the requirements of 

paragraph (3) of this definition and is legal, 

valid, binding, and enforceable under 

applicable law in the relevant jurisdictions. 

Residential mortgage exposure means an 

exposure (other than a securitization 

exposure, equity exposure, or excluded 

mortgage exposure) that is managed as part 

of a segment of exposures with homogeneous 

risk characteristics, not on an individualexposure basis, and is: 

(1) An exposure that is primarily secured 

by a first or subsequent lien on one- to fourfamily residential property; or 

(2) An exposure with an original and 

outstanding amount of $1 million or less that 

is primarily secured by a first or subsequent 

lien on residential property that is not one to 

four family. 

Retail exposure means a residential 

mortgage exposure, a qualifying revolving 

exposure, or an other retail exposure. 

Retail exposure subcategory means the 

residential mortgage exposure, qualifying 

revolving exposure, or other retail exposure 

subcategory. 

Risk parameter means a variable used in 

determining risk-based capital requirements 

for wholesale and retail exposures, 

specifically probability of default (PD), loss 

given default (LGD), exposure at default 

(EAD), or effective maturity (M). 

Scenario analysis means a systematic 

process of obtaining expert opinions from 

business managers and risk management 

experts to derive reasoned assessments of the 

likelihood and loss impact of plausible highseverity operational losses. Scenario analysis 

may include the well-reasoned evaluation 

and use of external operational loss event 

data, adjusted as appropriate to ensure 

relevance to a [bank]’s operational risk 

profile and control structure. 

SEC means the U.S. Securities and 

Exchange Commission. 

Securitization means a traditional 

securitization or a synthetic securitization. 

Securitization exposure means an onbalance sheet or off-balance sheet credit 

exposure that arises from a traditional or 

synthetic securitization (including creditenhancing representations and warranties). 

Securitization special purpose entity 

(securitization SPE) means a corporation, 

trust, or other entity organized for the 

specific purpose of holding underlying 

exposures of a securitization, the activities of 

which are limited to those appropriate to 

accomplish this purpose, and the structure of 

which is intended to isolate the underlying 

exposures held by the entity from the credit 

risk of the seller of the underlying exposures 

to the entity. 

Senior securitization exposure means a 

securitization exposure that has a first 

priority claim on the cash flows from the 

underlying exposures. When determining 

whether a securitization exposure has a first 

priority claim on the cash flows from the 

underlying exposures, a [bank] is not 

required to consider amounts due under 

interest rate or currency derivative contracts, 

fees due, or other similar payments. Both the 

most senior commercial paper issued by an 

ABCP program and a liquidity facility that 

supports the ABCP program may be senior 

securitization exposures if the liquidity 

facility provider’s right to reimbursement of 

the drawn amounts is senior to all claims on 

the cash flows from the underlying exposures 

except amounts due under interest rate or 

currency derivative contracts, fees due, or 

other similar payments. 

Servicer cash advance facility means a 

facility under which the servicer of the 

underlying exposures of a securitization may 

advance cash to ensure an uninterrupted 

flow of payments to investors in the 

securitization, including advances made to 

cover foreclosure costs or other expenses to 

facilitate the timely collection of the 

underlying exposures. See also eligible 

servicer cash advance facility. 

Sovereign entity means a central 

government (including the U.S. government) 

or an agency, department, ministry, or central 

bank of a central government. 

Sovereign exposure means: 

(1) A direct exposure to a sovereign entity; 

or 

(2) An exposure directly and 

unconditionally backed by the full faith and 

credit of a sovereign entity. 

Subsidiary means, with respect to a 

company, a company controlled by that 

company. 

Synthetic securitization means a 

transaction in which: 

(1) All or a portion of the credit risk of one 

or more underlying exposures is transferred 

to one or more third parties through the use 

of one or more credit derivatives or 

guarantees (other than a guarantee that 

transfers only the credit risk of an individual 

retail exposure); 

(2) The credit risk associated with the 

underlying exposures has been separated into 

at least two tranches reflecting different 

levels of seniority; 

(3) Performance of the securitization 

exposures depends upon the performance of 

the underlying exposures; and 

(4) All or substantially all of the underlying 

exposures are financial exposures (such as 

loans, commitments, credit derivatives, 

guarantees, receivables, asset-backed 

securities, mortgage-backed securities, other 

debt securities, or equity securities). 

Tier 1 capital is defined in [the general 

risk-based capital rules], as modified in part 

II of this appendix. 

Tier 2 capital is defined in [the general 

risk-based capital rules], as modified in part 

II of this appendix. 

Total qualifying capital means the sum of 

tier 1 capital and tier 2 capital, after all 

deductions required in this appendix. 

Total risk-weighted assets means: 

(1) The sum of: 

(i) Credit risk-weighted assets; and 

(ii) Risk-weighted assets for operational 

risk; minus 

(2) Excess eligible credit reserves not 

included in tier 2 capital. 

Total wholesale and retail risk-weighted 

assets means the sum of risk-weighted assets 

for wholesale exposures to non-defaulted 

obligors and segments of non-defaulted retail 

exposures; risk-weighted assets for wholesale 

exposures to defaulted obligors and segments 

of defaulted retail exposures; risk-weighted 

assets for assets not defined by an exposure 

category; and risk-weighted assets for nonmstockstill on PROD1PC66 with RULES2

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material portfolios of exposures (all as 

determined in section 31 of this appendix) 

and risk-weighted assets for unsettled 

transactions (as determined in section 35 of 

this appendix) minus the amounts deducted 

from capital pursuant to [the general riskbased capital rules] (excluding those 

deductions reversed in section 12 of this 

appendix). 

Traditional securitization means a 

transaction in which: 

(1) All or a portion of the credit risk of one 

or more underlying exposures is transferred 

to one or more third parties other than 

through the use of credit derivatives or 

guarantees; 

(2) The credit risk associated with the 

underlying exposures has been separated into 

at least two tranches reflecting different 

levels of seniority; 

(3) Performance of the securitization 

exposures depends upon the performance of 

the underlying exposures; 

(4) All or substantially all of the underlying 

exposures are financial exposures (such as 

loans, commitments, credit derivatives, 

guarantees, receivables, asset-backed 

securities, mortgage-backed securities, other 

debt securities, or equity securities); 

(5) The underlying exposures are not 

owned by an operating company; 

(6) The underlying exposures are not 

owned by a small business investment 

company described in section 302 of the 

Small Business Investment Act of 1958 (15 

U.S.C. 682); and 

(7) The underlying exposures are not 

owned by a firm an investment in which 

qualifies as a community development 

investment under 12 U.S.C. 24(Eleventh). 

(8) The [AGENCY] may determine that a 

transaction in which the underlying 

exposures are owned by an investment firm 

that exercises substantially unfettered control 

over the size and composition of its assets, 

liabilities, and off-balance sheet exposures is 

not a traditional securitization based on the 

transaction’s leverage, risk profile, or 

economic substance. 

(9) The [AGENCY] may deem a transaction 

that meets the definition of a traditional 

securitization, notwithstanding paragraph 

(5), (6), or (7) of this definition, to be a 

traditional securitization based on the 

transaction’s leverage, risk profile, or 

economic substance. 

Tranche means all securitization exposures 

associated with a securitization that have the 

same seniority level. 

Underlying exposures means one or more 

exposures that have been securitized in a 

securitization transaction. 

Unexpected operational loss (UOL) means 

the difference between the [bank]’s 

operational risk exposure and the [bank]’s 

expected operational loss. 

Unit of measure means the level (for 

example, organizational unit or operational 

loss event type) at which the [bank]’s 

operational risk quantification system 

generates a separate distribution of potential 

operational losses. 

Value-at-Risk (VaR) means the estimate of 

the maximum amount that the value of one 

or more exposures could decline due to 

market price or rate movements during a 

fixed holding period within a stated 

confidence interval. 

Wholesale exposure means a credit 

exposure to a company, natural person, 

sovereign entity, or governmental entity 

(other than a securitization exposure, retail 

exposure, excluded mortgage exposure, or 

equity exposure). Examples of a wholesale 

exposure include: 

(1) A non-tranched guarantee issued by a 

[bank] on behalf of a company; 

(2) A repo-style transaction entered into by 

a [bank] with a company and any other 

transaction in which a [bank] posts collateral 

to a company and faces counterparty credit 

risk; 

(3) An exposure that a [bank] treats as a 

covered position under [the market risk rule] 

for which there is a counterparty credit risk 

capital requirement; 

(4) A sale of corporate loans by a [bank] to 

a third party in which the [bank] retains full 

recourse; 

(5) An OTC derivative contract entered into 

by a [bank] with a company; 

(6) An exposure to an individual that is not 

managed by a [bank] as part of a segment of 

exposures with homogeneous risk 

characteristics; and 

(7) A commercial lease. 

Wholesale exposure subcategory means the 

HVCRE or non-HVCRE wholesale exposure 

subcategory. 

Section 3. Minimum Risk-Based Capital 

Requirements 

(a) Except as modified by paragraph (c) of 

this section or by section 23 of this appendix, 

each [bank] must meet a minimum ratio of: 

(1) Total qualifying capital to total riskweighted assets of 8.0 percent; and 

(2) Tier 1 capital to total risk-weighted 

assets of 4.0 percent. 

(b) Each [bank] must hold capital 

commensurate with the level and nature of 

all risks to which the [bank] is exposed. 

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

risk rule] calculates its risk-based capital 

requirements under this appendix, the [bank] 

must also refer to [the market risk rule] for 

supplemental rules to calculate risk-based 

capital requirements adjusted for market risk. 

Part II. Qualifying Capital 

Section 11. Additional Deductions 

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

appendix must make the same deductions 

from its tier 1 capital and tier 2 capital 

required in [the general risk-based capital 

rules], except that: 

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

certain equity investments and CEIOs (as 

provided in section 12 of this appendix); and 

(2) A [bank] also must make the deductions 

from capital required by paragraphs (b) and 

(c) of this section. 

(b) Deductions from tier 1 capital. A [bank] 

must deduct from tier 1 capital any gain-onsale associated with a securitization exposure 

as provided in paragraph (a) of section 41 

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

section 42 of this appendix. 

(c) Deductions from tier 1 and tier 2 

capital. A [bank] must deduct the exposures 

specified in paragraphs (c)(1) through (c)(7) 

in this section 50 percent from tier 1 capital 

and 50 percent from tier 2 capital. If the 

amount deductible from tier 2 capital 

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

however, the [bank] must deduct the excess 

from tier 1 capital. 

(1) Credit-enhancing interest-only strips 

(CEIOs). In accordance with paragraphs (a)(1) 

and (c) of section 42 of this appendix, any 

CEIO that does not constitute gain-on-sale. 

(2) Non-qualifying securitization 

exposures. In accordance with paragraphs 

(a)(4) and (c) of section 42 of this appendix, 

any securitization exposure that does not 

qualify for the Ratings-Based Approach, the 

Internal Assessment Approach, or the 

Supervisory Formula Approach under 

sections 43, 44, and 45 of this appendix, 

respectively. 

(3) Securitizations of non-IRB exposures. In 

accordance with paragraphs (c) and (g)(4) of 

section 42 of this appendix, certain 

exposures to a securitization any underlying 

exposure of which is not a wholesale 

exposure, retail exposure, securitization 

exposure, or equity exposure. 

(4) Low-rated securitization exposures. In 

accordance with section 43 and paragraph (c) 

of section 42 of this appendix, any 

securitization exposure that qualifies for and 

must be deducted under the Ratings-Based 

Approach. 

(5) High-risk securitization exposures 

subject to the Supervisory Formula 

Approach. In accordance with paragraphs (b) 

and (c) of section 45 of this appendix and 

paragraph (c) of section 42 of this appendix, 

certain high-risk securitization exposures (or 

portions thereof) that qualify for the 

Supervisory Formula Approach. 

(6) Eligible credit reserves shortfall. In 

accordance with paragraph (a)(1) of section 

13 of this appendix, any eligible credit 

reserves shortfall. 

(7) Certain failed capital markets 

transactions. In accordance with paragraph 

(e)(3) of section 35 of this appendix, the 

[bank]’s exposure on certain failed capital 

markets transactions. 

Section 12. Deductions and Limitations Not 

Required 

(a) Deduction of CEIOs. A [bank] is not 

required to make the deductions from capital 

for CEIOs in 12 CFR part 3, Appendix A, 

section 2(c) (for national banks), 12 CFR part 

208, Appendix A, section II.B.1.e. (for state 

member banks), 12 CFR part 225, Appendix 

A, section II.B.1.e. (for bank holding 

companies), 12 CFR part 325, Appendix A, 

section II.B.5. (for state nonmember banks), 

and 12 CFR 567.5(a)(2)(iii) and 567.12(e) (for 

savings associations). 

(b) Deduction of certain equity 

investments. A [bank] is not required to make 

the deductions from capital for nonfinancial 

equity investments in 12 CFR part 3, 

Appendix A, section 2(c) (for national banks), 

12 CFR part 208, Appendix A, section II.B.5. 

(for state member banks), 12 CFR part 225, 

Appendix A, section II.B.5. (for bank holding 

companies), and 12 CFR part 325, Appendix 

A, section II.B. (for state nonmember banks). 

Section 13. Eligible Credit Reserves 

(a) Comparison of eligible credit reserves to 

expected credit losses—(1) Shortfall of 

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eligible credit reserves. If a [bank]’s eligible 

credit reserves are less than the [bank]’s total 

expected credit losses, the [bank] must 

deduct the shortfall amount 50 percent from 

tier 1 capital and 50 percent from tier 2 

capital. If the amount deductible from tier 2 

capital exceeds the [bank]’s actual tier 2 

capital, the [bank] must deduct the excess 

amount from tier 1 capital. 

(2) Excess eligible credit reserves. If a 

[bank]’s eligible credit reserves exceed the 

[bank]’s total expected credit losses, the 

[bank] may include the excess amount in tier 

2 capital to the extent that the excess amount 

does not exceed 0.6 percent of the [bank]’s 

credit-risk-weighted assets. 

(b) Treatment of allowance for loan and 

lease losses. Regardless of any provision in 

[the general risk-based capital rules], the 

ALLL is included in tier 2 capital only to the 

extent provided in paragraph (a)(2) of this 

section and in section 24 of this appendix. 

Part III. Qualification 

Section 21. Qualification Process 

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

in paragraph (b)(1) of section 1 of this 

appendix must adopt a written 

implementation plan no later than six 

months after the later of April 1, 2008, or the 

date the [bank] meets a criterion in that 

section. The implementation plan must 

incorporate an explicit first floor period start 

date no later than 36 months after the later 

of April 1, 2008, or the date the [bank] meets 

at least one criterion under paragraph (b)(1) 

of section 1 of this appendix. The [AGENCY] 

may extend the first floor period start date. 

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

appendix under paragraph (b)(2) of section 1 

of this appendix must adopt a written 

implementation plan. 

(b) Implementation plan. (1) The [bank]’s 

implementation plan must address in detail 

how the [bank] complies, or plans to comply, 

with the qualification requirements in 

section 22 of this appendix. The [bank] also 

must maintain a comprehensive and sound 

planning and governance process to oversee 

the implementation efforts described in the 

plan. At a minimum, the plan must: 

(i) Comprehensively address the 

qualification requirements in section 22 of 

this appendix for the [bank] and each 

consolidated subsidiary (U.S. and foreignbased) of the [bank] with respect to all 

portfolios and exposures of the [bank] and 

each of its consolidated subsidiaries; 

(ii) Justify and support any proposed 

temporary or permanent exclusion of 

business lines, portfolios, or exposures from 

application of the advanced approaches in 

this appendix (which business lines, 

portfolios, and exposures must be, in the 

aggregate, immaterial to the [bank]); 

(iii) Include the [bank]’s self-assessment of: 

(A) The [bank]’s current status in meeting 

the qualification requirements in section 22 

of this appendix; and 

(B) The consistency of the [bank]’s current 

practices with the [AGENCY]’s supervisory 

guidance on the qualification requirements; 

(iv) Based on the [bank]’s self-assessment, 

identify and describe the areas in which the 

[bank] proposes to undertake additional work 

to comply with the qualification 

requirements in section 22 of this appendix 

or to improve the consistency of the [bank]’s 

current practices with the [AGENCY]’s 

supervisory guidance on the qualification 

requirements (gap analysis); 

(v) Describe what specific actions the 

[bank] will take to address the areas 

identified in the gap analysis required by 

paragraph (b)(1)(iv) of this section; 

(vi) Identify objective, measurable 

milestones, including delivery dates and a 

date when the [bank]’s implementation of the 

methodologies described in this appendix 

will be fully operational; 

(vii) Describe resources that have been 

budgeted and are available to implement the 

plan; and 

(viii) Receive approval of the [bank]’s 

board of directors. 

(2) The [bank] must submit the 

implementation plan, together with a copy of 

the minutes of the board of directors’

approval, to the [AGENCY] at least 60 days 

before the [bank] proposes to begin its 

parallel run, unless the [AGENCY] waives 

prior notice. 

(c) Parallel run. Before determining its riskbased capital requirements under this 

appendix and following adoption of the 

implementation plan, the [bank] must 

conduct a satisfactory parallel run. A 

satisfactory parallel run is a period of no less 

than four consecutive calendar quarters 

during which the [bank] complies with the 

qualification requirements in section 22 of 

this appendix to the satisfaction of the 

[AGENCY]. During the parallel run, the 

[bank] must report to the [AGENCY] on a 

calendar quarterly basis its risk-based capital 

ratios using [the general risk-based capital 

rules] and the risk-based capital requirements 

described in this appendix. During this 

period, the [bank] is subject to [the general 

risk-based capital rules]. 

(d) Approval to calculate risk-based capital 

requirements under this appendix. The 

[AGENCY] will notify the [bank] of the date 

that the [bank] may begin its first floor period 

if the [AGENCY] determines that: 

(1) The [bank] fully complies with all the 

qualification requirements in section 22 of 

this appendix; 

(2) The [bank] has conducted a satisfactory 

parallel run under paragraph (c) of this 

section; and 

(3) The [bank] has an adequate process to 

ensure ongoing compliance with the 

qualification requirements in section 22 of 

this appendix. 

(e) Transitional floor periods. Following a 

satisfactory parallel run, a [bank] is subject to 

three transitional floor periods. 

(1) Risk-based capital ratios during the 

transitional floor periods—(i) Tier 1 riskbased capital ratio. During a [bank]’s 

transitional floor periods, the [bank]’s tier 1 

risk-based capital ratio is equal to the lower 

of: 

(A) The [bank]’s floor-adjusted tier 1 riskbased capital ratio; or 

(B) The [bank]’s advanced approaches tier 

1 risk-based capital ratio. 

(ii) Total risk-based capital ratio. During a 

[bank]’s transitional floor periods, the 

[bank]’s total risk-based capital ratio is equal 

to the lower of: 

(A) The [bank]’s floor-adjusted total riskbased capital ratio; or 

(B) The [bank]’s advanced approaches total 

risk-based capital ratio. 

(2) Floor-adjusted risk-based capital ratios. 

(i) A [bank]’s floor-adjusted tier 1 risk-based 

capital ratio during a transitional floor period 

is equal to the [bank]’s tier 1 capital as 

calculated under [the general risk-based 

capital rules], divided by the product of: 

(A) The [bank]’s total risk-weighted assets 

as calculated under [the general risk-based 

capital rules]; and 

(B) The appropriate transitional floor 

percentage in Table 1. 

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

period is equal to the sum of the [bank]’s tier 

1 and tier 2 capital as calculated under [the 

general risk-based capital rules], divided by 

the product of: 

(A) The [bank]’s total risk-weighted assets 

as calculated under [the general risk-based 

capital rules]; and 

(B) The appropriate transitional floor 

percentage in Table 1. 

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

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

appendix as of April 1, 2008, must use [the 

general risk-based capital rules] during the 

parallel run and as the basis for its 

transitional floors. 

TABLE 1.—TRANSITIONAL FLOORS

Transitional floor period Transitional floor percentage 

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

Second floor period ... 90 percent. 

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

(3) Advanced approaches risk-based 

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

approaches tier 1 risk-based capital ratio 

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

ratio as calculated under this appendix (other 

than this section on transitional floor 

periods). 

(ii) A [bank]’s advanced approaches total 

risk-based capital ratio equals the [bank]’s 

total risk-based capital ratio as calculated 

under this appendix (other than this section 

on transitional floor periods). 

(4) Reporting. During the transitional floor 

periods, a [bank] must report to the 

[AGENCY] on a calendar quarterly basis both 

floor-adjusted risk-based capital ratios and 

both advanced approaches risk-based capital 

ratios. 

(5) Exiting a transitional floor period. A 

[bank] may not exit a transitional floor period 

until the [bank] has spent a minimum of four 

consecutive calendar quarters in the period 

and the [AGENCY] has determined that the 

[bank] may exit the floor period. The 

[AGENCY]’s determination will be based on 

an assessment of the [bank]’s ongoing 

compliance with the qualification 

requirements in section 22 of this appendix. 

(6) Interagency study. After the end of the 

second transition year (2010), the Federal 

banking agencies will publish a study that 

evaluates the advanced approaches to 

determine if there are any material 

deficiencies. For any primary Federal 

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Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 69407 

supervisor to authorize any institution to exit 

the third transitional floor period, the study 

must determine that there are no such 

material deficiencies that cannot be 

addressed by then-existing tools, or, if such 

deficiencies are found, they are first 

remedied by changes to this appendix. 

Notwithstanding the preceding sentence, a 

primary Federal supervisor that disagrees 

with the finding of material deficiency may 

not authorize any institution under its 

jurisdiction to exit the third transitional floor 

period unless it provides a public report 

explaining its reasoning. 

Section 22. Qualification Requirements 

(a) Process and systems requirements. (1) A 

[bank] must have a rigorous process for 

assessing its overall capital adequacy in 

relation to its risk profile and a 

comprehensive strategy for maintaining an 

appropriate level of capital. 

(2) The systems and processes used by a 

[bank] for risk-based capital purposes under 

this appendix must be consistent with the 

[bank]’s internal risk management processes 

and management information reporting 

systems. 

(3) Each [bank] must have an appropriate 

infrastructure with risk measurement and 

management processes that meet the 

qualification requirements of this section and 

are appropriate given the [bank]’s size and 

level of complexity. Regardless of whether 

the systems and models that generate the risk 

parameters necessary for calculating a 

[bank]’s risk-based capital requirements are 

located at any affiliate of the [bank], the 

[bank] itself must ensure that the risk 

parameters and reference data used to 

determine its risk-based capital requirements 

are representative of its own credit risk and 

operational risk exposures. 

(b) Risk rating and segmentation systems 

for wholesale and retail exposures. (1) A 

[bank] must have an internal risk rating and 

segmentation system that accurately and 

reliably differentiates among degrees of credit 

risk for the [bank]’s wholesale and retail 

exposures. 

(2) For wholesale exposures: 

(i) A [bank] must have an internal risk 

rating system that accurately and reliably 

assigns each obligor to a single rating grade 

(reflecting the obligor’s likelihood of default). 

A [bank] may elect, however, not to assign to 

a rating grade an obligor to whom the [bank] 

extends credit based solely on the financial 

strength of a guarantor, provided that all of 

the [bank]’s exposures to the obligor are fully 

covered by eligible guarantees, the [bank] 

applies the PD substitution approach in 

paragraph (c)(1) of section 33 of this 

appendix to all exposures to that obligor, and 

the [bank] immediately assigns the obligor to 

a rating grade if a guarantee can no longer be 

recognized under this appendix. The [bank]’s 

wholesale obligor rating system must have at 

least seven discrete rating grades for nondefaulted obligors and at least one rating 

grade for defaulted obligors. 

(ii) Unless the [bank] has chosen to directly 

assign LGD estimates to each wholesale 

exposure, the [bank] must have an internal 

risk rating system that accurately and reliably 

assigns each wholesale exposure to a loss 

severity rating grade (reflecting the [bank]’s 

estimate of the LGD of the exposure). A 

[bank] employing loss severity rating grades 

must have a sufficiently granular loss 

severity grading system to avoid grouping 

together exposures with widely ranging 

LGDs. 

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

an internal system that groups retail 

exposures into the appropriate retail 

exposure subcategory, groups the retail 

exposures in each retail exposure 

subcategory into separate segments with 

homogeneous risk characteristics, and 

assigns accurate and reliable PD and LGD 

estimates for each segment on a consistent 

basis. The [bank]’s system must identify and 

group in separate segments by subcategories 

exposures identified in paragraphs (c)(2)(ii) 

and (iii) of section 31 of this appendix. 

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

for wholesale exposures must describe the 

[bank]’s rating philosophy (that is, must 

describe how wholesale obligor rating 

assignments are affected by the [bank]’s 

choice of the range of economic, business, 

and industry conditions that are considered 

in the obligor rating process). 

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

for wholesale exposures must provide for the 

review and update (as appropriate) of each 

obligor rating and (if applicable) each loss 

severity rating whenever the [bank] receives 

new material information, but no less 

frequently than annually. The [bank]’s retail 

exposure segmentation system must provide 

for the review and update (as appropriate) of 

assignments of retail exposures to segments 

whenever the [bank] receives new material 

information, but generally no less frequently 

than quarterly. 

(c) Quantification of risk parameters for 

wholesale and retail exposures. (1) The 

[bank] must have a comprehensive risk 

parameter quantification process that 

produces accurate, timely, and reliable 

estimates of the risk parameters for the 

[bank]’s wholesale and retail exposures. 

(2) Data used to estimate the risk 

parameters must be relevant to the [bank]’s 

actual wholesale and retail exposures, and of 

sufficient quality to support the 

determination of risk-based capital 

requirements for the exposures. 

(3) The [bank]’s risk parameter 

quantification process must produce 

appropriately conservative risk parameter 

estimates where the [bank] has limited 

relevant data, and any adjustments that are 

part of the quantification process must not 

result in a pattern of bias toward lower risk 

parameter estimates. 

(4) The [bank]’s risk parameter estimation 

process should not rely on the possibility of 

U.S. government financial assistance, except 

for the financial assistance that the U.S. 

government has a legally binding 

commitment to provide. 

(5) Where the [bank]’s quantifications of 

LGD directly or indirectly incorporate 

estimates of the effectiveness of its credit risk 

management practices in reducing its 

exposure to troubled obligors prior to default, 

the [bank] must support such estimates with 

empirical analysis showing that the estimates 

are consistent with its historical experience 

in dealing with such exposures during 

economic downturn conditions. 

(6) PD estimates for wholesale obligors and 

retail segments must be based on at least five 

years of default data. LGD estimates for 

wholesale exposures must be based on at 

least seven years of loss severity data, and 

LGD estimates for retail segments must be 

based on at least five years of loss severity 

data. EAD estimates for wholesale exposures 

must be based on at least seven years of 

exposure amount data, and EAD estimates for 

retail segments must be based on at least five 

years of exposure amount data. 

(7) Default, loss severity, and exposure 

amount data must include periods of 

economic downturn conditions, or the [bank] 

must adjust its estimates of risk parameters 

to compensate for the lack of data from 

periods of economic downturn conditions. 

(8) The [bank]’s PD, LGD, and EAD 

estimates must be based on the definition of 

default in this appendix. 

(9) The [bank] must review and update (as 

appropriate) its risk parameters and its risk 

parameter quantification process at least 

annually. 

(10) The [bank] must at least annually 

conduct a comprehensive review and 

analysis of reference data to determine 

relevance of reference data to the [bank]’s 

exposures, quality of reference data to 

support PD, LGD, and EAD estimates, and 

consistency of reference data to the definition 

of default contained in this appendix. 

(d) Counterparty credit risk model. A 

[bank] must obtain the prior written approval 

of the [AGENCY] under section 32 of this 

appendix to use the internal models 

methodology for counterparty credit risk. 

(e) Double default treatment. A [bank] must 

obtain the prior written approval of the 

[AGENCY] under section 34 of this appendix 

to use the double default treatment. 

(f) Securitization exposures. A [bank] must 

obtain the prior written approval of the 

[AGENCY] under section 44 of this appendix 

to use the Internal Assessment Approach for 

securitization exposures to ABCP programs. 

(g) Equity exposures model. A [bank] must 

obtain the prior written approval of the 

[AGENCY] under section 53 of this appendix 

to use the Internal Models Approach for 

equity exposures. 

(h) Operational risk—(1) Operational risk 

management processes. A [bank] must: 

(i) Have an operational risk management 

function that: 

(A) Is independent of business line 

management; and 

(B) Is responsible for designing, 

implementing, and overseeing the [bank]’s 

operational risk data and assessment systems, 

operational risk quantification systems, and 

related processes; 

(ii) Have and document a process (which 

must capture business environment and 

internal control factors affecting the [bank]’s 

operational risk profile) to identify, measure, 

monitor, and control operational risk in 

[bank] products, activities, processes, and 

systems; and 

(iii) Report operational risk exposures, 

operational loss events, and other relevant 

operational risk information to business unit 

management, senior management, and the 

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board of directors (or a designated committee 

of the board). 

(2) Operational risk data and assessment 

systems. A [bank] must have operational risk 

data and assessment systems that capture 

operational risks to which the [bank] is 

exposed. The [bank]’s operational risk data 

and assessment systems must: 

(i) Be structured in a manner consistent 

with the [bank]’s current business activities, 

risk profile, technological processes, and risk 

management processes; and 

(ii) Include credible, transparent, 

systematic, and verifiable processes that 

incorporate the following elements on an 

ongoing basis: 

(A) Internal operational loss event data. 

The [bank] must have a systematic process 

for capturing and using internal operational 

loss event data in its operational risk data 

and assessment systems. 

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

assessment systems must include a historical 

observation period of at least five years for 

internal operational loss event data (or such 

shorter period approved by the [AGENCY] to 

address transitional situations, such as 

integrating a new business line). 

(2) The [bank] must be able to map its 

internal operational loss event data into the 

seven operational loss event type categories. 

(3) The [bank] may refrain from collecting 

internal operational loss event data for 

individual operational losses below 

established dollar threshold amounts if the 

[bank] can demonstrate to the satisfaction of 

the [AGENCY] that the thresholds are 

reasonable, do not exclude important internal 

operational loss event data, and permit the 

[bank] to capture substantially all the dollar 

value of the [bank]’s operational losses. 

(B) External operational loss event data. 

The [bank] must have a systematic process 

for determining its methodologies for 

incorporating external operational loss event 

data into its operational risk data and 

assessment systems. 

(C) Scenario analysis. The [bank] must 

have a systematic process for determining its 

methodologies for incorporating scenario 

analysis into its operational risk data and 

assessment systems. 

(D) Business environment and internal 

control factors. The [bank] must incorporate 

business environment and internal control 

factors into its operational risk data and 

assessment systems. The [bank] must also 

periodically compare the results of its prior 

business environment and internal control 

factor assessments against its actual 

operational losses incurred in the intervening 

period. 

(3) Operational risk quantification systems. 

(i) The [bank]’s operational risk 

quantification systems: 

(A) Must generate estimates of the [bank]’s 

operational risk exposure using its 

operational risk data and assessment systems; 

(B) Must employ a unit of measure that is 

appropriate for the [bank]’s range of business 

activities and the variety of operational loss 

events to which it is exposed, and that does 

not combine business activities or 

operational loss events with demonstrably 

different risk profiles within the same loss 

distribution; 

(C) Must include a credible, transparent, 

systematic, and verifiable approach for 

weighting each of the four elements, 

described in paragraph (h)(2)(ii) of this 

section, that a [bank] is required to 

incorporate into its operational risk data and 

assessment systems; 

(D) May use internal estimates of 

dependence among operational losses across 

and within units of measure if the [bank] can 

demonstrate to the satisfaction of the 

[AGENCY] that its process for estimating 

dependence is sound, robust to a variety of 

scenarios, and implemented with integrity, 

and allows for the uncertainty surrounding 

the estimates. If the [bank] has not made such 

a demonstration, it must sum operational risk 

exposure estimates across units of measure to 

calculate its total operational risk exposure; 

and 

(E) Must be reviewed and updated (as 

appropriate) whenever the [bank] becomes 

aware of information that may have a 

material effect on the [bank]’s estimate of 

operational risk exposure, but the review and 

update must occur no less frequently than 

annually. 

(ii) With the prior written approval of the 

[AGENCY], a [bank] may generate an estimate 

of its operational risk exposure using an 

alternative approach to that specified in 

paragraph (h)(3)(i) of this section. A [bank] 

proposing to use such an alternative 

operational risk quantification system must 

submit a proposal to the [AGENCY]. In 

determining whether to approve a [bank]’s 

proposal to use an alternative operational 

risk quantification system, the [AGENCY] 

will consider the following principles: 

(A) Use of the alternative operational risk 

quantification system will be allowed only 

on an exception basis, considering the size, 

complexity, and risk profile of the [bank]; 

(B) The [bank] must demonstrate that its 

estimate of its operational risk exposure 

generated under the alternative operational 

risk quantification system is appropriate and 

can be supported empirically; and 

(C) A [bank] must not use an allocation of 

operational risk capital requirements that 

includes entities other than depository 

institutions or the benefits of diversification 

across entities. 

(i) Data management and maintenance. (1) 

A [bank] must have data management and 

maintenance systems that adequately support 

all aspects of its advanced systems and the 

timely and accurate reporting of risk-based 

capital requirements. 

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

electronic format that allows timely retrieval 

of data for analysis, validation, reporting, and 

disclosure purposes. 

(3) A [bank] must retain sufficient data 

elements related to key risk drivers to permit 

adequate monitoring, validation, and 

refinement of its advanced systems. 

(j) Control, oversight, and validation 

mechanisms. (1) The [bank]’s senior 

management must ensure that all 

components of the [bank]’s advanced systems 

function effectively and comply with the 

qualification requirements in this section. 

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

designated committee of the board) must at 

least annually review the effectiveness of, 

and approve, the [bank]’s advanced systems. 

(3) A [bank] must have an effective system 

of controls and oversight that: 

(i) Ensures ongoing compliance with the 

qualification requirements in this section; 

(ii) Maintains the integrity, reliability, and 

accuracy of the [bank]’s advanced systems; 

and 

(iii) Includes adequate governance and 

project management processes. 

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

basis, its advanced systems. The [bank]’s 

validation process must be independent of 

the advanced systems’ development, 

implementation, and operation, or the 

validation process must be subjected to an 

independent review of its adequacy and 

effectiveness. Validation must include: 

(i) An evaluation of the conceptual 

soundness of (including developmental 

evidence supporting) the advanced systems; 

(ii) An ongoing monitoring process that 

includes verification of processes and 

benchmarking; and 

(iii) An outcomes analysis process that 

includes back-testing. 

(5) The [bank] must have an internal audit 

function independent of business-line 

management that at least annually assesses 

the effectiveness of the controls supporting 

the [bank]’s advanced systems and reports its 

findings to the [bank]’s board of directors (or 

a committee thereof). 

(6) The [bank] must periodically stress test 

its advanced systems. The stress testing must 

include a consideration of how economic 

cycles, especially downturns, affect riskbased capital requirements (including 

migration across rating grades and segments 

and the credit risk mitigation benefits of 

double default treatment). 

(k) Documentation. The [bank] must 

adequately document all material aspects of 

its advanced systems. 

Section 23. Ongoing Qualification 

(a) Changes to advanced systems. A [bank] 

must meet all the qualification requirements 

in section 22 of this appendix on an ongoing 

basis. A [bank] must notify the [AGENCY] 

when the [bank] makes any change to an 

advanced system that would result in a 

material change in the [bank]’s risk-weighted 

asset amount for an exposure type, or when 

the [bank] makes any significant change to its 

modeling assumptions. 

(b) Failure to comply with qualification 

requirements. (1) If the [AGENCY] 

determines that a [bank] that uses this 

appendix and has conducted a satisfactory 

parallel run fails to comply with the 

qualification requirements in section 22 of 

this appendix, the [AGENCY] will notify the 

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

comply. 

(2) The [bank] must establish and submit 

a plan satisfactory to the [AGENCY] to return 

to compliance with the qualification 

requirements. 

(3) In addition, if the [AGENCY] 

determines that the [bank]’s risk-based 

capital requirements are not commensurate 

with the [bank]’s credit, market, operational, 

or other risks, the [AGENCY] may require 

such a [bank] to calculate its risk-based 

capital requirements: 

(i) Under [the general risk-based capital 

rules]; or 

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(ii) Under this appendix with any 

modifications provided by the [AGENCY]. 

Section 24. Merger and Acquisition 

Transitional Arrangements 

(a) Mergers and acquisitions of companies 

without advanced systems. If a [bank] merges 

with or acquires a company that does not 

calculate its risk-based capital requirements 

using advanced systems, the [bank] may use 

[the general risk-based capital rules] to 

determine the risk-weighted asset amounts 

for, and deductions from capital associated 

with, the merged or acquired company’s 

exposures for up to 24 months after the 

calendar quarter during which the merger or 

acquisition consummates. The [AGENCY] 

may extend this transition period for up to 

an additional 12 months. Within 90 days of 

consummating the merger or acquisition, the 

[bank] must submit to the [AGENCY] an 

implementation plan for using its advanced 

systems for the acquired company. During 

the period when [the general risk-based 

capital rules] apply to the merged or acquired 

company, any ALLL, net of allocated transfer 

risk reserves established pursuant to 12 

U.S.C. 3904, associated with the merged or 

acquired company’s exposures may be 

included in the acquiring [bank]’s tier 2 

capital up to 1.25 percent of the acquired 

company’s risk-weighted assets. All general 

allowances of the merged or acquired 

company must be excluded from the [bank]’s 

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

company are not included in the [bank]’s 

credit-risk-weighted assets but are included 

in total risk-weighted assets. If a [bank] relies 

on this paragraph, the [bank] must disclose 

publicly the amounts of risk-weighted assets 

and qualifying capital calculated under this 

appendix for the acquiring [bank] and under 

[the general risk-based capital rules] for the 

acquired company. 

(b) Mergers and acquisitions of companies 

with advanced systems—(1) If a [bank] 

merges with or acquires a company that 

calculates its risk-based capital requirements 

using advanced systems, the [bank] may use 

the acquired company’s advanced systems to 

determine the risk-weighted asset amounts 

for, and deductions from capital associated 

with, the merged or acquired company’s 

exposures for up to 24 months after the 

calendar quarter during which the 

acquisition or merger consummates. The 

[AGENCY] may extend this transition period 

for up to an additional 12 months. Within 90 

days of consummating the merger or 

acquisition, the [bank] must submit to the 

[AGENCY] an implementation plan for using 

its advanced systems for the merged or 

acquired company. 

(2) If the acquiring [bank] is not subject to 

the advanced approaches in this appendix at 

the time of acquisition or merger, during the 

period when [the general risk-based capital 

rules] apply to the acquiring [bank], the 

ALLL associated with the exposures of the 

merged or acquired company may not be 

directly included in tier 2 capital. Rather, any 

excess eligible credit reserves associated with 

the merged or acquired company’s exposures 

may be included in the [bank]’s tier 2 capital 

up to 0.6 percent of the credit-risk-weighted 

assets associated with those exposures. 

Part IV. Risk-Weighted Assets for General 

Credit Risk 

Section 31. Mechanics for Calculating Total 

Wholesale and Retail Risk-Weighted Assets 

(a) Overview. A [bank] must calculate its 

total wholesale and retail risk-weighted asset 

amount in four distinct phases: 

(1) Phase 1—categorization of exposures; 

(2) Phase 2—assignment of wholesale 

obligors and exposures to rating grades and 

segmentation of retail exposures; 

(3) Phase 3—assignment of risk parameters 

to wholesale exposures and segments of retail 

exposures; and 

(4) Phase 4—calculation of risk-weighted 

asset amounts. 

(b) Phase 1—Categorization. The [bank] 

must determine which of its exposures are 

wholesale exposures, retail exposures, 

securitization exposures, or equity exposures. 

The [bank] must categorize each retail 

exposure as a residential mortgage exposure, 

a QRE, or an other retail exposure. The [bank] 

must identify which wholesale exposures are 

HVCRE exposures, sovereign exposures, OTC 

derivative contracts, repo-style transactions, 

eligible margin loans, eligible purchased 

wholesale exposures, unsettled transactions 

to which section 35 of this appendix applies, 

and eligible guarantees or eligible credit 

derivatives that are used as credit risk 

mitigants. The [bank] must identify any onbalance sheet asset that does not meet the 

definition of a wholesale, retail, equity, or 

securitization exposure, as well as any nonmaterial portfolio of exposures described in 

paragraph (e)(4) of this section. 

(c) Phase 2—Assignment of wholesale 

obligors and exposures to rating grades and 

retail exposures to segments—(1) Assignment 

of wholesale obligors and exposures to rating 

grades. 

(i) The [bank] must assign each obligor of 

a wholesale exposure to a single obligor 

rating grade and must assign each wholesale 

exposure to which it does not directly assign 

an LGD estimate to a loss severity rating 

grade. 

(ii) The [bank] must identify which of its 

wholesale obligors are in default. 

(2) Segmentation of retail exposures. (i) 

The [bank] must group the retail exposures 

in each retail subcategory into segments that 

have homogeneous risk characteristics. 

(ii) The [bank] must identify which of its 

retail exposures are in default. The [bank] 

must segment defaulted retail exposures 

separately from non-defaulted retail 

exposures. 

(iii) If the [bank] determines the EAD for 

eligible margin loans using the approach in 

paragraph (b) of section 32 of this appendix, 

the [bank] must identify which of its retail 

exposures are eligible margin loans for which 

the [bank] uses this EAD approach and must 

segment such eligible margin loans 

separately from other retail exposures. 

(3) Eligible purchased wholesale 

exposures. A [bank] may group its eligible 

purchased wholesale exposures into 

segments that have homogeneous risk 

characteristics. A [bank] must use the 

wholesale exposure formula in Table 2 in 

this section to determine the risk-based 

capital requirement for each segment of 

eligible purchased wholesale exposures. 

(d) Phase 3—Assignment of risk 

parameters to wholesale exposures and 

segments of retail exposures—(1) 

Quantification process. Subject to the 

limitations in this paragraph (d), the [bank] 

must: 

(i) Associate a PD with each wholesale 

obligor rating grade; 

(ii) Associate an LGD with each wholesale 

loss severity rating grade or assign an LGD to 

each wholesale exposure; 

(iii) Assign an EAD and M to each 

wholesale exposure; and 

(iv) Assign a PD, LGD, and EAD to each 

segment of retail exposures. 

(2) Floor on PD assignment. The PD for 

each wholesale obligor or retail segment may 

not be less than 0.03 percent, except for 

exposures to or directly and unconditionally 

guaranteed by a sovereign entity, the Bank for 

International Settlements, the International 

Monetary Fund, the European Commission, 

the European Central Bank, or a multilateral 

development bank, to which the [bank] 

assigns a rating grade associated with a PD 

of less than 0.03 percent. 

(3) Floor on LGD estimation. The LGD for 

each segment of residential mortgage 

exposures (other than segments of residential 

mortgage exposures for which all or 

substantially all of the principal of each 

exposure is directly and unconditionally 

guaranteed by the full faith and credit of a 

sovereign entity) may not be less than 10 

percent. 

(4) Eligible purchased wholesale 

exposures. A [bank] must assign a PD, LGD, 

EAD, and M to each segment of eligible 

purchased wholesale exposures. If the [bank] 

can estimate ECL (but not PD or LGD) for a 

segment of eligible purchased wholesale 

exposures, the [bank] must assume that the 

LGD of the segment equals 100 percent and 

that the PD of the segment equals ECL 

divided by EAD. The estimated ECL must be 

calculated for the exposures without regard 

to any assumption of recourse or guarantees 

from the seller or other parties. 

(5) Credit risk mitigation—credit 

derivatives, guarantees, and collateral. (i) A 

[bank] may take into account the risk 

reducing effects of eligible guarantees and 

eligible credit derivatives in support of a 

wholesale exposure by applying the PD 

substitution or LGD adjustment treatment to 

the exposure as provided in section 33 of this 

appendix or, if applicable, applying double 

default treatment to the exposure as provided 

in section 34 of this appendix. A [bank] may 

decide separately for each wholesale 

exposure that qualifies for the double default 

treatment under section 34 of this appendix 

whether to apply the double default 

treatment or to use the PD substitution or 

LGD adjustment treatment without 

recognizing double default effects. 

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

reducing effects of guarantees and credit 

derivatives in support of retail exposures in 

a segment when quantifying the PD and LGD 

of the segment. 

(iii) Except as provided in paragraph (d)(6) 

of this section, a [bank] may take into 

account the risk reducing effects of collateral 

in support of a wholesale exposure when 

quantifying the LGD of the exposure and may 

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take into account the risk reducing effects of 

collateral in support of retail exposures when 

quantifying the PD and LGD of the segment. 

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

(i) A [bank] must calculate its EAD for an 

OTC derivative contract as provided in 

paragraphs (c) and (d) of section 32 of this 

appendix. A [bank] may take into account the 

risk-reducing effects of financial collateral in 

support of a repo-style transaction or eligible 

margin loan and of any collateral in support 

of a repo-style transaction that is included in 

the [bank]’s VaR-based measure under [the 

market risk rule] through an adjustment to 

EAD as provided in paragraphs (b) and (d) of 

section 32 of this appendix. A [bank] that 

takes collateral into account through such an 

adjustment to EAD under section 32 of this 

appendix may not reflect such collateral in 

LGD. 

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

to: 

(A) Derivative contracts that are publicly 

traded on an exchange that requires the daily 

receipt and payment of cash-variation 

margin; 

(B) Derivative contracts and repo-style 

transactions that are outstanding with a 

qualifying central counterparty (but not for 

those transactions that a qualifying central 

counterparty has rejected); and 

(C) Credit risk exposures to a qualifying 

central counterparty in the form of clearing 

deposits and posted collateral that arise from 

transactions described in paragraph 

(d)(6)(ii)(B) of this section. 

(7) Effective maturity. An exposure’s M 

must be no greater than five years and no less 

than one year, except that an exposure’s M 

must be no less than one day if the exposure 

has an original maturity of less than one year 

and is not part of a [bank]’s ongoing 

financing of the obligor. An exposure is not 

part of a [bank]’s ongoing financing of the 

obligor if the [bank]: 

(i) Has a legal and practical ability not to 

renew or roll over the exposure in the event 

of credit deterioration of the obligor; 

(ii) Makes an independent credit decision 

at the inception of the exposure and at every 

renewal or roll over; and 

(iii) Has no substantial commercial 

incentive to continue its credit relationship 

with the obligor in the event of credit 

deterioration of the obligor. 

(e) Phase 4—Calculation of risk-weighted 

assets—(1) Non-defaulted exposures. (i) A 

[bank] must calculate the dollar risk-based 

capital requirement for each of its wholesale 

exposures to a non-defaulted obligor (except 

eligible guarantees and eligible credit 

derivatives that hedge another wholesale 

exposure and exposures to which the [bank] 

applies the double default treatment in 

section 34 of this appendix) and segments of 

non-defaulted retail exposures by inserting 

the assigned risk parameters for the 

wholesale obligor and exposure or retail 

segment into the appropriate risk-based 

capital formula specified in Table 2 and 

multiplying the output of the formula (K) by 

the EAD of the exposure or segment. 

Alternatively, a [bank] may apply a 300 

percent risk weight to the EAD of an eligible 

margin loan if the [bank] is not able to meet 

the agencies’’ requirements for estimation of 

PD and LGD for the margin loan. 

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

6720–01–P 

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BILLING CODE 4810–33–C; 6210–01–C; 6714–01–C; 

6720–01–C 

(ii) The sum of all the dollar risk-based 

capital requirements for each wholesale 

exposure to a non-defaulted obligor and 

segment of non-defaulted retail exposures 

calculated in paragraph (e)(1)(i) of this 

section and in paragraph (e) of section 34 of 

this appendix equals the total dollar riskbased capital requirement for those 

exposures and segments. 

(iii) The aggregate risk-weighted asset 

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

dollar risk-based capital requirement 

calculated in paragraph (e)(1)(ii) of this 

section multiplied by 12.5. 

(2) Wholesale exposures to defaulted 

obligors and segments of defaulted retail 

exposures. (i) The dollar risk-based capital 

requirement for each wholesale exposure to 

a defaulted obligor equals 0.08 multiplied by 

the EAD of the exposure. 

(ii) The dollar risk-based capital 

requirement for a segment of defaulted retail 

exposures equals 0.08 multiplied by the EAD 

of the segment. 

(iii) The sum of all the dollar risk-based 

capital requirements for each wholesale 

exposure to a defaulted obligor calculated in 

paragraph (e)(2)(i) of this section plus the 

dollar risk-based capital requirements for 

each segment of defaulted retail exposures 

calculated in paragraph (e)(2)(ii) of this 

section equals the total dollar risk-based 

capital requirement for those exposures and 

segments. 

(iv) The aggregate risk-weighted asset 

amount for wholesale exposures to defaulted 

obligors and segments of defaulted retail 

exposures equals the total dollar risk-based 

capital requirement calculated in paragraph 

(e)(2)(iii) of this section multiplied by 12.5. 


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(3) Assets not included in a defined 

exposure category. (i) A [bank] may assign a 

risk-weighted asset amount of zero to cash 

owned and held in all offices of the [bank] 

or in transit and for gold bullion held in the 

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

[bank]’s vaults on an allocated basis, to the 

extent the gold bullion assets are offset by 

gold bullion liabilities. 

(ii) The risk-weighted asset amount for the 

residual value of a retail lease exposure 

equals such residual value. 

(iii) The risk-weighted asset amount for 

any other on-balance-sheet asset that does 

not meet the definition of a wholesale, retail, 

securitization, or equity exposure equals the 

carrying value of the asset. 

(4) Non-material portfolios of exposures. 

The risk-weighted asset amount of a portfolio 

of exposures for which the [bank] has 

demonstrated to the [AGENCY]’s satisfaction 

that the portfolio (when combined with all 

other portfolios of exposures that the [bank] 

seeks to treat under this paragraph) is not 

material to the [bank] is the sum of the 

carrying values of on-balance sheet exposures 

plus the notional amounts of off-balance 

sheet exposures in the portfolio. For 

purposes of this paragraph (e)(4), the notional 

amount of an OTC derivative contract that is 

not a credit derivative is the EAD of the 

derivative as calculated in section 32 of this 

appendix. 

Section 32. Counterparty Credit Risk of RepoStyle Transactions, Eligible Margin Loans, 

and OTC Derivative Contracts 

(a) In General. (1) This section describes 

two methodologies—a collateral haircut 

approach and an internal models 

methodology—that a [bank] may use instead 

of an LGD estimation methodology to 

recognize the benefits of financial collateral 

in mitigating the counterparty credit risk of 

repo-style transactions, eligible margin loans, 

collateralized OTC derivative contracts, and 

single product netting sets of such 

transactions and to recognize the benefits of 

any collateral in mitigating the counterparty 

credit risk of repo-style transactions that are 

included in a [bank]’s VaR-based measure 

under [the market risk rule]. A third 

methodology, the simple VaR methodology, 

is available for single product netting sets of 

repo-style transactions and eligible margin 

loans. 

(2) This section also describes the 

methodology for calculating EAD for an OTC 

derivative contract or a set of OTC derivative 

contracts subject to a qualifying master 

netting agreement. A [bank] also may use the 

internal models methodology to estimate 

EAD for qualifying cross-product master 

netting agreements. 

(3) A [bank] may only use the standard 

supervisory haircut approach with a 

minimum 10-business-day holding period to 

recognize in EAD the benefits of conforming 

residential mortgage collateral that secures 

repo-style transactions (other than repo-style 

transactions included in the [bank]’s VaRbased measure under [the market risk rule]), 

eligible margin loans, and OTC derivative 

contracts. 

(4) A [bank] may use any combination of 

the three methodologies for collateral 

recognition; however, it must use the same 

methodology for similar exposures. 

(b) EAD for eligible margin loans and repostyle transactions—(1) General. A [bank] may 

recognize the credit risk mitigation benefits 

of financial collateral that secures an eligible 

margin loan, repo-style transaction, or singleproduct netting set of such transactions by 

factoring the collateral into its LGD estimates 

for the exposure. Alternatively, a [bank] may 

estimate an unsecured LGD for the exposure, 

as well as for any repo-style transaction that 

is included in the [bank]’s VaR-based 

measure under [the market risk rule], and 

determine the EAD of the exposure using: 

(i) The collateral haircut approach 

described in paragraph (b)(2) of this section; 

(ii) For netting sets only, the simple VaR 

methodology described in paragraph (b)(3) of 

this section; or 

(iii) The internal models methodology 

described in paragraph (d) of this section. 

(2) Collateral haircut approach—(i) EAD 

equation. A [bank] may determine EAD for 

an eligible margin loan, repo-style 

transaction, or netting set by setting EAD 

equal to max {0, [(SE¥SC) + S(Es × Hs) + 

S(Efx × Hfx)]}, where: 

(A) SE equals the value of the exposure (the 

sum of the current market values of all 

instruments, gold, and cash the [bank] has 

lent, sold subject to repurchase, or posted as 

collateral to the counterparty under the 

transaction (or netting set)); 

(B) SC equals the value of the collateral 

(the sum of the current market values of all 

instruments, gold, and cash the [bank] has 

borrowed, purchased subject to resale, or 

taken as collateral from the counterparty 

under the transaction (or netting set)); 

(C) Es equals the absolute value of the net 

position in a given instrument or in gold 

(where the net position in a given instrument 

or in gold equals the sum of the current 

market values of the instrument or gold the 

[bank] has lent, sold subject to repurchase, or 

posted as collateral to the counterparty 

minus the sum of the current market values 

of that same instrument or gold the [bank] 

has borrowed, purchased subject to resale, or 

taken as collateral from the counterparty); 

(D) Hs equals the market price volatility 

haircut appropriate to the instrument or gold 

referenced in Es; 

(E) Efx equals the absolute value of the net 

position of instruments and cash in a 

currency that is different from the settlement 

currency (where the net position in a given 

currency equals the sum of the current 

market values of any instruments or cash in 

the currency the [bank] has lent, sold subject 

to repurchase, or posted as collateral to the 

counterparty minus the sum of the current 

market values of any instruments or cash in 

the currency the [bank] has borrowed, 

purchased subject to resale, or taken as 

collateral from the counterparty); and 

(F) Hfx equals the haircut appropriate to 

the mismatch between the currency 

referenced in Efx and the settlement 

currency. 

(ii) Standard supervisory haircuts. (A) 

Under the standard supervisory haircuts 

approach: 

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

market price volatility (Hs) in Table 3, as 

adjusted in certain circumstances as 

provided in paragraph (b)(2)(ii)(A)(3) and (4) 

of this section; 

TABLE 3.—STANDARD SUPERVISORY MARKET PRICE VOLATILITY HAIRCUTS 1

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

securities 

Issuers exempt 

from the 3 basis 

point floor 

Other issuers 

Two highest investment-grade rating categories for long-term ratings/highest investment-grade rating category for short-term ratings.≤ 1 year ............................

>1 year, ≤ 5 years ............

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

0.005 

0.02 

0.04 

0.01 

0.04 

0.08 

Two lowest investment-grade rating categories for both short- and longterm ratings.≤ 1 year ............................

> 1 year, ≤ 5 years ...........

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

0.01 

0.03 

0.06 

0.02 

0.06 

0.12 

One rating category below investment grade .............................................. All ...................................... 0.15 0.25 

Main index equities (including convertible bonds) and gold ....................................................................... 0.15 

Other publicly traded equities (including convertible bonds), conforming residential mortgages, and 

nonfinancial collateral.

0.25 

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Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 69413 

TABLE 3.—STANDARD SUPERVISORY MARKET PRICE VOLATILITY HAIRCUTS 1—Continued 

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

securities 

Issuers exempt 

from the 3 basis 

point floor 

Other issuers 

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

security in which the fund can invest. 

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

1The market price volatility haircuts in Table 3 are based on a ten-business-day holding period. 

(2) For currency mismatches, a [bank] must 

use a haircut for foreign exchange rate 

volatility (Hfx) of 8 percent, as adjusted in 

certain circumstances as provided in 

paragraph (b)(2)(ii)(A)(3) and (4) of this 

section. 

(3) For repo-style transactions, a [bank] 

may multiply the supervisory haircuts 

provided in paragraphs (b)(2)(ii)(A)(1) and (2) 

of this section by the square root of 1⁄2 (which 

equals 0.707107). 

(4) A [bank] must adjust the supervisory 

haircuts upward on the basis of a holding 

period longer than ten business days (for 

eligible margin loans) or five business days 

(for repo-style transactions) where and as 

appropriate to take into account the 

illiquidity of an instrument. 

(iii) Own internal estimates for haircuts. 

With the prior written approval of the 

[AGENCY], a [bank] may calculate haircuts 

(Hs and Hfx) using its own internal estimates 

of the volatilities of market prices and foreign 

exchange rates. 

(A) To receive [AGENCY] approval to use 

its own internal estimates, a [bank] must 

satisfy the following minimum quantitative 

standards: 

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

one-tailed confidence interval. 

(2) The minimum holding period for a 

repo-style transaction is five business days 

and for an eligible margin loan is ten 

business days. When a [bank] calculates an 

own-estimates haircut on a TN-day holding 

period, which is different from the minimum 

holding period for the transaction type, the 

applicable haircut (HM) is calculated using 

the following square root of time formula: 

H H T

T M N

M

N

= , where

(i) TM equals 5 for repo-style transactions and 

10 for eligible margin loans; 

(ii) TN equals the holding period used by the 

[bank] to derive HN; and 

(iii) HN equals the haircut based on the 

holding period TN. 

(3) A [bank] must adjust holding periods 

upwards where and as appropriate to take 

into account the illiquidity of an instrument. 

(4) The historical observation period must 

be at least one year. 

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

recompute haircuts no less frequently than 

quarterly and must also reassess data sets and 

haircuts whenever market prices change 

materially. 

(B) With respect to debt securities that 

have an applicable external rating of 

investment grade, a [bank] may calculate 

haircuts for categories of securities. For a 

category of securities, the [bank] must 

calculate the haircut on the basis of internal 

volatility estimates for securities in that 

category that are representative of the 

securities in that category that the [bank] has 

lent, sold subject to repurchase, posted as 

collateral, borrowed, purchased subject to 

resale, or taken as collateral. In determining 

relevant categories, the [bank] must at a 

minimum take into account: 

(1) The type of issuer of the security; 

(2) The applicable external rating of the 

security; 

(3) The maturity of the security; and 

(4) The interest rate sensitivity of the 

security. 

(C) With respect to debt securities that 

have an applicable external rating of below 

investment grade and equity securities, a 

[bank] must calculate a separate haircut for 

each individual security. 

(D) Where an exposure or collateral 

(whether in the form of cash or securities) is 

denominated in a currency that differs from 

the settlement currency, the [bank] must 

calculate a separate currency mismatch 

haircut for its net position in each 

mismatched currency based on estimated 

volatilities of foreign exchange rates between 

the mismatched currency and the settlement 

currency. 

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

price and foreign exchange rate volatilities 

may not take into account the correlations 

among securities and foreign exchange rates 

on either the exposure or collateral side of a 

transaction (or netting set) or the correlations 

among securities and foreign exchange rates 

between the exposure and collateral sides of 

the transaction (or netting set). 

(3) Simple VaR methodology. With the 

prior written approval of the [AGENCY], a 

[bank] may estimate EAD for a netting set 

using a VaR model that meets the 

requirements in paragraph (b)(3)(iii) of this 

section. In such event, the [bank] must set 

EAD equal to max {0, [(SE—SC) + PFE]}, 

where: 

(i) SE equals the value of the exposure (the 

sum of the current market values of all 

instruments, gold, and cash the [bank] has 

lent, sold subject to repurchase, or posted as 

collateral to the counterparty under the 

netting set); 

(ii) SC equals the value of the collateral 

(the sum of the current market values of all 

instruments, gold, and cash the [bank] has 

borrowed, purchased subject to resale, or 

taken as collateral from the counterparty 

under the netting set); and 

(iii) PFE (potential future exposure) equals 

the [bank]’s empirically based best estimate 

of the 99th percentile, one-tailed confidence 

interval for an increase in the value of (SE—

SC) over a five-business-day holding period 

for repo-style transactions or over a tenbusiness-day holding period for eligible 

margin loans using a minimum one-year 

historical observation period of price 

data representing the instruments that the 

[bank] has lent, sold subject to 

repurchase, posted as collateral, 

borrowed, purchased subject to resale, or 

taken as collateral. The [bank] must 

validate its VaR model, including by 

establishing and maintaining a rigorous and 

regular back-testing regime. 

(c) EAD for OTC derivative contracts. (1) A 

[bank] must determine the EAD for an OTC 

derivative contract that is not subject to a 

qualifying master netting agreement using the 

current exposure methodology in paragraph 

(c)(5) of this section or using the internal 

models methodology described in paragraph 

(d) of this section. 

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

multiple OTC derivative contracts that are 

subject to a qualifying master netting 

agreement using the current exposure 

methodology in paragraph (c)(6) of this 

section or using the internal models 

methodology described in paragraph (d) of 

this section. 

(3) Counterparty credit risk for credit 

derivatives. Notwithstanding the above, (i) A 

[bank] that purchases a credit derivative that 

is recognized under section 33 or 34 of this 

appendix as a credit risk mitigant for an 

exposure that is not a covered position under 

[the market risk rule] need not compute a 

separate counterparty credit risk capital 

requirement under this section so long as the 

[bank] does so consistently for all such credit 

derivatives and either includes all or 

excludes all such credit derivatives that are 

subject to a master netting agreement from 

any measure used to determine counterparty 

credit risk exposure to all relevant 

counterparties for risk-based capital 

purposes. 

(ii) A [bank] that is the protection provider 

in a credit derivative must treat the credit 

derivative as a wholesale exposure to the 

reference obligor and need not compute a 

counterparty credit risk capital requirement 

for the credit derivative under this section, so 

long as it does so consistently for all such 

credit derivatives and either includes all or 

excludes all such credit derivatives that are 

subject to a master netting agreement from 

any measure used to determine counterparty 

credit risk exposure to all relevant 

counterparties for risk-based capital purposes 

(unless the [bank] is treating the credit 

derivative as a covered position under [the 


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market risk rule], in which case the [bank] 

must compute a supplemental counterparty 

credit risk capital requirement under this 

section). 

(4) Counterparty credit risk for equity 

derivatives. A [bank] must treat an equity 

derivative contract as an equity exposure and 

compute a risk-weighted asset amount for the 

equity derivative contract under part VI 

(unless the [bank] is treating the contract as 

a covered position under [the market risk 

rule]). In addition, if the [bank] is treating the 

contract as a covered position under [the 

market risk rule] and in certain other cases 

described in section 55 of this appendix, the 

[bank] must also calculate a risk-based 

capital requirement for the counterparty 

credit risk of an equity derivative contract 

under this part. 

(5) Single OTC derivative contract. Except 

as modified by paragraph (c)(7) of this 

section, the EAD for a single OTC derivative 

contract that is not subject to a qualifying 

master netting agreement is equal to the sum 

of the [bank]’s current credit exposure and 

potential future credit exposure (PFE) on the 

derivative contract. 

(i) Current credit exposure. The current 

credit exposure for a single OTC derivative 

contract is the greater of the mark-to-market 

value of the derivative contract or zero. 

(ii) PFE. The PFE for a single OTC 

derivative contract, including an OTC 

derivative contract with a negative mark-tomarket value, is calculated by multiplying 

the notional principal amount of the 

derivative contract by the appropriate 

conversion factor in Table 4. For purposes of 

calculating either the PFE under this 

paragraph or the gross PFE under paragraph 

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

contracts and other similar contracts in 

which the notional principal amount is 

equivalent to the cash flows, notional 

principal amount is the net receipts to each 

party falling due on each value date in each 

currency. For any OTC derivative contract 

that does not fall within one of the specified 

categories in Table 4, the PFE must be 

calculated using the ‘‘other’’ conversion 

factors. A [bank] must use an OTC derivative 

contract’s effective notional principal amount 

(that is, its apparent or stated notional 

principal amount multiplied by any 

multiplier in the OTC derivative contract) 

rather than its apparent or stated notional 

principal amount in calculating PFE. PFE of 

the protection provider of a credit derivative 

is capped at the net present value of the 

amount of unpaid premiums. 

TABLE 4.—CONVERSION FACTOR MATRIX FOR OTC DERIVATIVE CONTRACTS 1

Remaining maturity 2 Interest rate 

Foreign exchange rate 

and gold 

Credit (investment-grade 

reference obligor)3

Credit (non-investmentgrade reference obligor) 

Equity 

Precious metals (except 

gold) 

Other 

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

Over one to five 

years ..................... 0 .005 0 .05 0.05 0.10 0.08 0.07 0.12 

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

1For an OTC derivative contract with multiple exchanges of principal, the conversion factor is multiplied by the number of remaining payments 

in the derivative contract. 2For an OTC derivative contract that is structured such that on specified dates any outstanding exposure is settled and the terms are reset so 

that the market value of the contract is zero, the remaining maturity equals the time until the next reset date. For an interest rate derivative contract with a remaining maturity of greater than one year that meets these criteria, the minimum conversion factor is 0.005. 3A [bank] must use the column labeled ‘‘Credit (investment-grade reference obligor)’’ for a credit derivative whose reference obligor has an 

outstanding unsecured long-term debt security without credit enhancement that has a long-term applicable external rating of at least investment 

grade. A [bank] must use the column labeled ‘‘Credit (non-investment-grade reference obligor)’’ for all other credit derivatives. 

(6) Multiple OTC derivative contracts 

subject to a qualifying master netting 

agreement. Except as modified by paragraph 

(c)(7) of this section, the EAD for multiple 

OTC derivative contracts subject to a 

qualifying master netting agreement is equal 

to the sum of the net current credit exposure 

and the adjusted sum of the PFE exposure for 

all OTC derivative contracts subject to the 

qualifying master netting agreement. 

(i) Net current credit exposure. The net 

current credit exposure is the greater of: 

(A) The net sum of all positive and 

negative mark-to-market values of the 

individual OTC derivative contracts subject 

to the qualifying master netting agreement; or 

(B) zero. 

(ii) Adjusted sum of the PFE. The adjusted 

sum of the PFE, Anet, is calculated as Anet 

= (0.4×Agross)+(0.6×NGR×Agross), where: 

(A) Agross = the gross PFE (that is, the sum 

of the PFE amounts (as determined under 

paragraph (c)(5)(ii) of this section) for each 

individual OTC derivative contract subject to 

the qualifying master netting agreement); and 

(B) NGR = the net to gross ratio (that is, the 

ratio of the net current credit exposure to the 

gross current credit exposure). In calculating 

the NGR, the gross current credit exposure 

equals the sum of the positive current credit 

exposures (as determined under paragraph 

(c)(5)(i) of this section) of all individual OTC 

derivative contracts subject to the qualifying 

master netting agreement. 

(7) Collateralized OTC derivative contracts. 

A [bank] may recognize the credit risk 

mitigation benefits of financial collateral that 

secures an OTC derivative contract or singleproduct netting set of OTC derivatives by 

factoring the collateral into its LGD estimates 

for the contract or netting set. Alternatively, 

a [bank] may recognize the credit risk 

mitigation benefits of financial collateral that 

secures such a contract or netting set that is 

marked to market on a daily basis and subject 

to a daily margin maintenance requirement 

by estimating an unsecured LGD for the 

contract or netting set and adjusting the EAD 

calculated under paragraph (c)(5) or (c)(6) of 

this section using the collateral haircut 

approach in paragraph (b)(2) of this section. 

The [bank] must substitute the EAD 

calculated under paragraph (c)(5) or (c)(6) of 

this section for SE in the equation in 

paragraph (b)(2)(i) of this section and must 

use a ten-business-day minimum holding 

period (TM = 10). 

(d) Internal models methodology. (1) With 

prior written approval from the [AGENCY], a 

[bank] may use the internal models 

methodology in this paragraph (d) to 

determine EAD for counterparty credit risk 

for OTC derivative contracts (collateralized 

or uncollateralized) and single-product 

netting sets thereof, for eligible margin loans 

and single-product netting sets thereof, and 

for repo-style transactions and single-product 

netting sets thereof. A [bank] that uses the 

internal models methodology for a particular 

transaction type (OTC derivative contracts, 

eligible margin loans, or repo-style 

transactions) must use the internal models 

methodology for all transactions of that 

transaction type. A [bank] may choose to use 

the internal models methodology for one or 

two of these three types of exposures and not 

the other types. A [bank] may also use the 

internal models methodology for OTC 

derivative contracts, eligible margin loans, 

and repo-style transactions subject to a 

qualifying cross-product netting agreement if: 

(i) The [bank] effectively integrates the risk 

mitigating effects of cross-product netting 

into its risk management and other 

information technology systems; and 

(ii) The [bank] obtains the prior written 

approval of the [AGENCY]. A [bank] that uses 

the internal models methodology for a 

transaction type must receive approval from 

the [AGENCY] to cease using the 

methodology for that transaction type or to 

make a material change to its internal model. 

(2) Under the internal models 

methodology, a [bank] uses an internal model 

to estimate the expected exposure (EE) for a 

netting set and then calculates EAD based on 

that EE. 

(i) The [bank] must use its internal model’s 

probability distribution for changes in the 

market value of a netting set that are 

attributable to changes in market variables to 

determine EE. 

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3Alternatively, a [bank] that uses an internal 

model to calculate a one-sided credit valuation 

adjustment may use the effective credit duration estimated by the model as M(EPE) in place of the 

formula in paragraph (d)(4). 

(ii) Under the internal models 

methodology, EAD = a x effective EPE, or, 

subject to [AGENCY] approval as provided in 

paragraph (d)(7), a more conservative 

measure of EAD. 

( ) A EffectiveEE t t k

k

n

k EffectiveEPEtk = × =

∑ ∆ 1

(that is, effective EPE is the time-weighted 

average of effective EE where the weights are 

the proportion that an individual effective EE 

represents in a one-year time interval) where: 

(1) Effective EEtk = max (Effective EEtk−1, 

EEtk) (that is, for a specific datetk, effective EE 

is the greater of EE at that date or the 

effective EE at the previous date); and 

(2) tk represents the kth future time period 

in the model and there are n time periods 

represented in the model over the first year; 

and 

(B) a = 1.4 except as provided in paragraph 

(d)(6), or when the [AGENCY] has 

determined that the [bank] must set a higher 

based on the [bank]’s specific characteristics 

of counterparty credit risk. 

(iii) A [bank] may include financial 

collateral currently posted by the 

counterparty as collateral (but may not 

include other forms of collateral) when 

calculating EE. 

(iv) If a [bank] hedges some or all of the 

counterparty credit risk associated with a 

netting set using an eligible credit derivative, 

the [bank] may take the reduction in 

exposure to the counterparty into account 

when estimating EE. If the [bank] recognizes 

this reduction in exposure to the 

counterparty in its estimate of EE, it must 

also use its internal model to estimate a 

separate EAD for the [bank]’s exposure to the 

protection provider of the credit derivative. 

(3) To obtain [AGENCY] approval to 

calculate the distributions of exposures upon 

which the EAD calculation is based, the 

[bank] must demonstrate to the satisfaction of 

the [AGENCY] that it has been using for at 

least one year an internal model that broadly 

meets the following minimum standards, 

with which the [bank] must maintain 

compliance: 

(i) The model must have the systems 

capability to estimate the expected exposure 

to the counterparty on a daily basis (but is 

not expected to estimate or report expected 

exposure on a daily basis). 

(ii) The model must estimate expected 

exposure at enough future dates to reflect 

accurately all the future cash flows of 

contracts in the netting set. 

(iii) The model must account for the 

possible non-normality of the exposure 

distribution, where appropriate. 

(iv) The [bank] must measure, monitor, and 

control current counterparty exposure and 

the exposure to the counterparty over the 

whole life of all contracts in the netting set. 

(v) The [bank] must be able to measure and 

manage current exposures gross and net of 

collateral held, where appropriate. The 

[bank] must estimate expected exposures for 

OTC derivative contracts both with and 

without the effect of collateral agreements. 

(vi) The [bank] must have procedures to 

identify, monitor, and control specific wrongway risk throughout the life of an exposure. 

Wrong-way risk in this context is the risk that 

future exposure to a counterparty will be 

high when the counterparty’s probability of 

default is also high. 

(vii) The model must use current market 

data to compute current exposures. When 

estimating model parameters based on 

historical data, at least three years of 

historical data that cover a wide range of 

economic conditions must be used and must 

be updated quarterly or more frequently if 

market conditions warrant. The [bank] 

should consider using model parameters 

based on forward-looking measures, where 

appropriate. 

(viii) A [bank] must subject its internal 

model to an initial validation and annual 

model review process. The model review 

should consider whether the inputs and risk 

factors, as well as the model outputs, are 

appropriate. 

(4) Maturity. (i) If the remaining maturity 

of the exposure or the longest-dated contract 

in the netting set is greater than one year, the 

[bank] must set M for the exposure or netting 

set equal to the lower of five years or 

M(EPE),3 where: 

(B) dfk is the risk-free discount factor for 

future time period tk; and 

(C) Dtk = tk¥tk¥1. 

(ii) If the remaining maturity of the 

exposure or the longest-dated contract in the 

netting set is one year or less, the [bank] must 

set M for the exposure or netting set equal 

to one year, except as provided in paragraph 

(d)(7) of section 31 of this appendix. 

(5) Collateral agreements. A [bank] may 

capture the effect on EAD of a collateral 

agreement that requires receipt of collateral 

when exposure to the counterparty increases 

but may not capture the effect on EAD of a 

collateral agreement that requires receipt of 

collateral when counterparty credit quality 

deteriorates. For this purpose, a collateral 

agreement means a legal contract that 

specifies the time when, and circumstances 

under which, the counterparty is required to 

pledge collateral to the [bank] for a single 

financial contract or for all financial 

contracts in a netting set and confers upon 

the [bank] a perfected, first priority security 

interest (notwithstanding the prior security 

interest of any custodial agent), or the legal 

equivalent thereof, in the collateral posted by 

the counterparty under the agreement. This 

security interest must provide the [bank] 

with a right to close out the financial 

positions and liquidate the collateral upon an 

event of default of, or failure to perform by, 

the counterparty under the collateral 

agreement. A contract would not satisfy this 

requirement if the [bank]’s exercise of rights 

under the agreement may be stayed or 

avoided under applicable law in the relevant 

jurisdictions. Two methods are available to 

capture the effect of a collateral agreement: 

(i) With prior written approval from the 

[AGENCY], a [bank] may include the effect of 

a collateral agreement within its internal 

model used to calculate EAD. The [bank] may 

set EAD equal to the expected exposure at the 

end of the margin period of risk. The margin 

period of risk means, with respect to a 

netting set subject to a collateral agreement, 

the time period from the most recent 

exchange of collateral with a counterparty 

until the next required exchange of collateral 

plus the period of time required to sell and 

realize the proceeds of the least liquid 

collateral that can be delivered under the 

terms of the collateral agreement and, where 

applicable, the period of time required to rehedge the resulting market risk, upon the 

default of the counterparty. The minimum 

margin period of risk is five business days for 

repo-style transactions and ten business days 

for other transactions when liquid financial 

collateral is posted under a daily margin 

maintenance requirement. This period 

should be extended to cover any additional 

time between margin calls; any potential 

closeout difficulties; any delays in selling 

collateral, particularly if the collateral is 

illiquid; and any impediments to prompt rehedging of any market risk. 

(ii) A [bank] that can model EPE without 

collateral agreements but cannot achieve the 

higher level of modeling sophistication to 

model EPE with collateral agreements can set 

effective EPE for a collateralized netting set 

equal to the lesser of: 

(A) The threshold, defined as the exposure 

amount at which the counterparty is required 

to post collateral under the collateral 

agreement, if the threshold is positive, plus 

an add-on that reflects the potential increase 

in exposure of the netting set over the margin 

period of risk. The add-on is computed as the 


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expected increase in the netting set’s 

exposure beginning from current exposure of 

zero over the margin period of risk. The 

margin period of risk must be at least five 

business days for netting sets consisting only 

of repo-style transactions subject to daily remargining and daily marking-to-market, and 

ten business days for all other netting sets; 

or 

(B) Effective EPE without a collateral 

agreement. 

(6) Own estimate of alpha. With prior 

written approval of the [AGENCY], a [bank] 

may calculate alpha as the ratio of economic 

capital from a full simulation of counterparty 

exposure across counterparties that 

incorporates a joint simulation of market and 

credit risk factors (numerator) and economic 

capital based on EPE (denominator), subject 

to a floor of 1.2. For purposes of this 

calculation, economic capital is the 

unexpected losses for all counterparty credit 

risks measured at a 99.9 percent confidence 

level over a one-year horizon. To receive 

approval, the [bank] must meet the following 

minimum standards to the satisfaction of the 

[AGENCY]: 

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

capture in the numerator the effects of: 

(A) The material sources of stochastic 

dependency of distributions of market values 

of transactions or portfolios of transactions 

across counterparties; 

(B) Volatilities and correlations of market 

risk factors used in the joint simulation, 

which must be related to the credit risk factor 

used in the simulation to reflect potential 

increases in volatility or correlation in an 

economic downturn, where appropriate; and 

(C) The granularity of exposures (that is, 

the effect of a concentration in the proportion 

of each counterparty’s exposure that is driven 

by a particular risk factor). 

(ii) The [bank] must assess the potential 

model uncertainty in its estimates of alpha. 

(iii) The [bank] must calculate the 

numerator and denominator of alpha in a 

consistent fashion with respect to modeling 

methodology, parameter specifications, and 

portfolio composition. 

(iv) The [bank] must review and adjust as 

appropriate its estimates of the numerator 

and denominator of alpha on at least a 

quarterly basis and more frequently when the 

composition of the portfolio varies over time. 

(7) Other measures of counterparty 

exposure. With prior written approval of the 

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

measure of counterparty credit risk exposure, 

such as peak EAD, that is more conservative 

than an alpha of 1.4 (or higher under the 

terms of paragraph (d)(2)(ii)(B) of this 

section) times EPE for every counterparty 

whose EAD will be measured under the 

alternative measure of counterparty 

exposure. The [bank] must demonstrate the 

conservatism of the measure of counterparty 

credit risk exposure used for EAD. For 

material portfolios of new OTC derivative 

products, the [bank] may assume that the 

current exposure methodology in paragraphs 

(c)(5) and (c)(6) of this section meets the 

conservatism requirement of this paragraph 

for a period not to exceed 180 days. For 

immaterial portfolios of OTC derivative 

contracts, the [bank] generally may assume 

that the current exposure methodology in 

paragraphs (c)(5) and (c)(6) of this section 

meets the conservatism requirement of this 

paragraph. 

Section 33. Guarantees and Credit 

Derivatives: PD Substitution and LGD 

Adjustment Approaches 

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

wholesale exposures for which: 

(i) Credit risk is fully covered by an eligible 

guarantee or eligible credit derivative; or 

(ii) Credit risk is covered on a pro rata basis 

(that is, on a basis in which the [bank] and 

the protection provider share losses 

proportionately) by an eligible guarantee or 

eligible credit derivative. 

(2) Wholesale exposures on which there is 

a tranching of credit risk (reflecting at least 

two different levels of seniority) are 

securitization exposures subject to the 

securitization framework in part V. 

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

credit risk mitigation benefits of an eligible 

guarantee or eligible credit derivative 

covering an exposure described in paragraph 

(a)(1) of this section by using the PD 

substitution approach or the LGD adjustment 

approach in paragraph (c) of this section or, 

if the transaction qualifies, using the double 

default treatment in section 34 of this 

appendix. A [bank]’s PD and LGD for the 

hedged exposure may not be lower than the 

PD and LGD floors described in paragraphs 

(d)(2) and (d)(3) of section 31 of this 

appendix. 

(4) If multiple eligible guarantees or 

eligible credit derivatives cover a single 

exposure described in paragraph (a)(1) of this 

section, a [bank] may treat the hedged 

exposure as multiple separate exposures each 

covered by a single eligible guarantee or 

eligible credit derivative and may calculate a 

separate risk-based capital requirement for 

each separate exposure as described in 

paragraph (a)(3) of this section. 

(5) If a single eligible guarantee or eligible 

credit derivative covers multiple hedged 

wholesale exposures described in paragraph 

(a)(1) of this section, a [bank] must treat each 

hedged exposure as covered by a separate 

eligible guarantee or eligible credit derivative 

and must calculate a separate risk-based 

capital requirement for each exposure as 

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

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

parameters for calculating ECL as it uses for 

calculating the risk-based capital requirement 

for the exposure. 

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

only recognize the credit risk mitigation 

benefits of eligible guarantees and eligible 

credit derivatives. 

(2) A [bank] may only recognize the credit 

risk mitigation benefits of an eligible credit 

derivative to hedge an exposure that is 

different from the credit derivative’s 

reference exposure used for determining the 

derivative’s cash settlement value, 

deliverable obligation, or occurrence of a 

credit event if: 

(i) The reference exposure ranks pari passu 

(that is, equally) with or is junior to the 

hedged exposure; and 

(ii) The reference exposure and the hedged 

exposure are exposures to the same legal 

entity, and legally enforceable cross-default 

or cross-acceleration clauses are in place to 

assure payments under the credit derivative 

are triggered when the obligor fails to pay 

under the terms of the hedged exposure. 

(c) Risk parameters for hedged exposures—

(1) PD substitution approach—(i) Full 

coverage. If an eligible guarantee or eligible 

credit derivative meets the conditions in 

paragraphs (a) and (b) of this section and the 

protection amount (P) of the guarantee or 

credit derivative is greater than or equal to 

the EAD of the hedged exposure, a [bank] 

may recognize the guarantee or credit 

derivative in determining the [bank]’s riskbased capital requirement for the hedged 

exposure by substituting the PD associated 

with the rating grade of the protection 

provider for the PD associated with the rating 

grade of the obligor in the risk-based capital 

formula applicable to the guarantee or credit 

derivative in Table 2 and using the 

appropriate LGD as described in paragraph 

(c)(1)(iii) of this section. If the [bank] 

determines that full substitution of the 

protection provider’s PD leads to an 

inappropriate degree of risk mitigation, the 

[bank] may substitute a higher PD than that 

of the protection provider. 

(ii) Partial coverage. If an eligible guarantee 

or eligible credit derivative meets the 

conditions in paragraphs (a) and (b) of this 

section and the protection amount (P) of the 

guarantee or credit derivative is less than the 

EAD of the hedged exposure, the [bank] must 

treat the hedged exposure as two separate 

exposures (protected and unprotected) in 

order to recognize the credit risk mitigation 

benefit of the guarantee or credit derivative. 

(A) The [bank] must calculate its risk-based 

capital requirement for the protected 

exposure under section 31 of this appendix, 

where PD is the protection provider’s PD, 

LGD is determined under paragraph (c)(1)(iii) 

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

determines that full substitution leads to an 

inappropriate degree of risk mitigation, the 

[bank] may use a higher PD than that of the 

protection provider. 

(B) The [bank] must calculate its risk-based 

capital requirement for the unprotected 

exposure under section 31 of this appendix, 

where PD is the obligor’s PD, LGD is the 

hedged exposure’s LGD (not adjusted to 

reflect the guarantee or credit derivative), and 

EAD is the EAD of the original hedged 

exposure minus P. 

(C) The treatment in this paragraph 

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

a wholesale exposure is covered on a partial 

pro rata basis or when an adjustment is made 

to the effective notional amount of the 

guarantee or credit derivative under 

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

(iii) LGD of hedged exposures. The LGD of 

a hedged exposure under the PD substitution 

approach is equal to: 

(A) The lower of the LGD of the hedged 

exposure (not adjusted to reflect the 

guarantee or credit derivative) and the LGD 

of the guarantee or credit derivative, if the 

guarantee or credit derivative provides the 

[bank] with the option to receive immediate 

payout upon triggering the protection; or 

(B) The LGD of the guarantee or credit 

derivative, if the guarantee or credit 

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derivative does not provide the [bank] with 

the option to receive immediate payout upon 

triggering the protection. 

(2) LGD adjustment approach—(i) Full 

coverage. If an eligible guarantee or eligible 

credit derivative meets the conditions in 

paragraphs (a) and (b) of this section and the 

protection amount (P) of the guarantee or 

credit derivative is greater than or equal to 

the EAD of the hedged exposure, the [bank]’s 

risk-based capital requirement for the hedged 

exposure is the greater of: 

(A) The risk-based capital requirement for 

the exposure as calculated under section 31 

of this appendix, with the LGD of the 

exposure adjusted to reflect the guarantee or 

credit derivative; or 

(B) The risk-based capital requirement for 

a direct exposure to the protection provider 

as calculated under section 31 of this 

appendix, using the PD for the protection 

provider, the LGD for the guarantee or credit 

derivative, and an EAD equal to the EAD of 

the hedged exposure. 

(ii) Partial coverage. If an eligible guarantee 

or eligible credit derivative meets the 

conditions in paragraphs (a) and (b) of this 

section and the protection amount (P) of the 

guarantee or credit derivative is less than the 

EAD of the hedged exposure, the [bank] must 

treat the hedged exposure as two separate 

exposures (protected and unprotected) in 

order to recognize the credit risk mitigation 

benefit of the guarantee or credit derivative. 

(A) The [bank]’s risk-based capital 

requirement for the protected exposure 

would be the greater of: 

(1) The risk-based capital requirement for 

the protected exposure as calculated under 

section 31 of this appendix, with the LGD of 

the exposure adjusted to reflect the guarantee 

or credit derivative and EAD set equal to P; 

or 

(2) The risk-based capital requirement for 

a direct exposure to the guarantor as 

calculated under section 31 of this appendix, 

using the PD for the protection provider, the 

LGD for the guarantee or credit derivative, 

and an EAD set equal to P. 

(B) The [bank] must calculate its risk-based 

capital requirement for the unprotected 

exposure under section 31 of this appendix, 

where PD is the obligor’s PD, LGD is the 

hedged exposure’s LGD (not adjusted to 

reflect the guarantee or credit derivative), and 

EAD is the EAD of the original hedged 

exposure minus P. 

(3) M of hedged exposures. The M of the 

hedged exposure is the same as the M of the 

exposure if it were unhedged. 

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

recognizes an eligible guarantee or eligible 

credit derivative in determining its risk-based 

capital requirement for a hedged exposure 

must adjust the effective notional amount of 

the credit risk mitigant to reflect any maturity 

mismatch between the hedged exposure and 

the credit risk mitigant. 

(2) A maturity mismatch occurs when the 

residual maturity of a credit risk mitigant is 

less than that of the hedged exposure(s). 

(3) The residual maturity of a hedged 

exposure is the longest possible remaining 

time before the obligor is scheduled to fulfill 

its obligation on the exposure. If a credit risk 

mitigant has embedded options that may 

reduce its term, the [bank] (protection 

purchaser) must use the shortest possible 

residual maturity for the credit risk mitigant. 

If a call is at the discretion of the protection 

provider, the residual maturity of the credit 

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

is at the discretion of the [bank] (protection 

purchaser), but the terms of the arrangement 

at origination of the credit risk mitigant 

contain a positive incentive for the [bank] to 

call the transaction before contractual 

maturity, the remaining time to the first call 

date is the residual maturity of the credit risk 

mitigant. For example, where there is a stepup in cost in conjunction with a call feature 

or where the effective cost of protection 

increases over time even if credit quality 

remains the same or improves, the residual 

maturity of the credit risk mitigant will be 

the remaining time to the first call. 

(4) A credit risk mitigant with a maturity 

mismatch may be recognized only if its 

original maturity is greater than or equal to 

one year and its residual maturity is greater 

than three months. 

(5) When a maturity mismatch exists, the 

[bank] must apply the following adjustment 

to the effective notional amount of the credit 

risk mitigant: Pm = E × (t – 0.25)/(T – 0.25), 

where: 

(i) Pm = effective notional amount of the 

credit risk mitigant, adjusted for maturity 

mismatch; 

(ii) E = effective notional amount of the 

credit risk mitigant; 

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

maturity of the credit risk mitigant, expressed 

in years; and 

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

maturity of the hedged exposure, expressed 

in years. 

(e) Credit derivatives without restructuring 

as a credit event. If a [bank] recognizes an 

eligible credit derivative that does not 

include as a credit event a restructuring of 

the hedged exposure involving forgiveness or 

postponement of principal, interest, or fees 

that results in a credit loss event (that is, a 

charge-off, specific provision, or other similar 

debit to the profit and loss account), the 

[bank] must apply the following adjustment 

to the effective notional amount of the credit 

derivative: Pr = Pm × 0.60, where: 

(1) Pr = effective notional amount of the 

credit risk mitigant, adjusted for lack of 

restructuring event (and maturity mismatch, 

if applicable); and 

(2) Pm = effective notional amount of the 

credit risk mitigant adjusted for maturity 

mismatch (if applicable). 

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

recognizes an eligible guarantee or eligible 

credit derivative that is denominated in a 

currency different from that in which the 

hedged exposure is denominated, the [bank] 

must apply the following formula to the 

effective notional amount of the guarantee or 

credit derivative: Pc = Pr × (1 – HFX), where: 

(i) Pc = effective notional amount of the 

credit risk mitigant, adjusted for currency 

mismatch (and maturity mismatch and lack 

of restructuring event, if applicable); 

(ii) Pr = effective notional amount of the 

credit risk mitigant (adjusted for maturity 

mismatch and lack of restructuring event, if 

applicable); and 

(iii) HFX = haircut appropriate for the 

currency mismatch between the credit risk 

mitigant and the hedged exposure. 

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

percent unless it qualifies for the use of and 

uses its own internal estimates of foreign 

exchange volatility based on a ten-businessday holding period and daily marking-tomarket and remargining. A [bank] qualifies 

for the use of its own internal estimates of 

foreign exchange volatility if it qualifies for: 

(i) The own-estimates haircuts in 

paragraph (b)(2)(iii) of section 32 of this 

appendix; 

(ii) The simple VaR methodology in 

paragraph (b)(3) of section 32 of this 

appendix; or 

(iii) The internal models methodology in 

paragraph (d) of section 32 of this appendix. 

(3) A [bank] must adjust HFX calculated in 

paragraph (f)(2) of this section upward if the 

[bank] revalues the guarantee or credit 

derivative less frequently than once every ten 

business days using the square root of time 

formula provided in paragraph 

(b)(2)(iii)(A)(2) of section 32 of this appendix. 

Section 34. Guarantees and Credit 

Derivatives: Double Default Treatment 

(a) Eligibility and operational criteria for 

double default treatment. A [bank] may 

recognize the credit risk mitigation benefits 

of a guarantee or credit derivative covering 

an exposure described in paragraph (a)(1) of 

section 33 of this appendix by applying the 

double default treatment in this section if all 

the following criteria are satisfied. 

(1) The hedged exposure is fully covered 

or covered on a pro rata basis by: 

(i) An eligible guarantee issued by an 

eligible double default guarantor; or 

(ii) An eligible credit derivative that meets 

the requirements of paragraph (b)(2) of 

section 33 of this appendix and is issued by 

an eligible double default guarantor. 

(2) The guarantee or credit derivative is: 

(i) An uncollateralized guarantee or 

uncollateralized credit derivative (for 

example, a credit default swap) that provides 

protection with respect to a single reference 

obligor; or 

(ii) An nth-to-default credit derivative 

(subject to the requirements of paragraph (m) 

of section 42 of this appendix). 

(3) The hedged exposure is a wholesale 

exposure (other than a sovereign exposure). 

(4) The obligor of the hedged exposure is 

not: 

(i) An eligible double default guarantor or 

an affiliate of an eligible double default 

guarantor; or 

(ii) An affiliate of the guarantor. 

(5) The [bank] does not recognize any 

credit risk mitigation benefits of the 

guarantee or credit derivative for the hedged 

exposure other than through application of 

the double default treatment as provided in 

this section. 

(6) The [bank] has implemented a process 

(which has received the prior, written 

approval of the [AGENCY]) to detect 

excessive correlation between the 

creditworthiness of the obligor of the hedged 

exposure and the protection provider. If 

excessive correlation is present, the [bank] 

may not use the double default treatment for 

the hedged exposure. 

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(b) Full coverage. If the transaction meets 

the criteria in paragraph (a) of this section 

and the protection amount (P) of the 

guarantee or credit derivative is at least equal 

to the EAD of the hedged exposure, the 

[bank] may determine its risk-weighted asset 

amount for the hedged exposure under 

paragraph (e) of this section. 

(c) Partial coverage. If the transaction 

meets the criteria in paragraph (a) of this 

section and the protection amount (P) of the 

guarantee or credit derivative is less than the 

EAD of the hedged exposure, the [bank] must 

treat the hedged exposure as two separate 

exposures (protected and unprotected) in 

order to recognize double default treatment 

on the protected portion of the exposure. 

(1) For the protected exposure, the [bank] 

must set EAD equal to P and calculate its 

risk-weighted asset amount as provided in 

paragraph (e) of this section. 

(2) For the unprotected exposure, the 

[bank] must set EAD equal to the EAD of the 

original exposure minus P and then calculate 

its risk-weighted asset amount as provided in 

section 31 of this appendix. 

(d) Mismatches. For any hedged exposure 

to which a [bank] applies double default 

treatment, the [bank] must make applicable 

adjustments to the protection amount as 

required in paragraphs (d), (e), and (f) of 

section 33 of this appendix. 

(e) The double default dollar risk-based 

capital requirement. The dollar risk-based 

capital requirement for a hedged exposure to 

which a [bank] has applied double default 

treatment is KDD multiplied by the EAD of 

the exposure. KDD is calculated according to 

the following formula: KDD = Ko × (0.15 + 160 

× PDg), 

Where: 

(1) 

(2) PDg = PD of the protection provider. 

(3) PDo = PD of the obligor of the hedged 

exposure. 

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

hedged exposure (not adjusted to reflect 

the guarantee or credit derivative) and 

the LGD of the guarantee or credit 

derivative, if the guarantee or credit 

derivative provides the [bank] with the 

option to receive immediate payout on 

triggering the protection; or 

(ii) The LGD of the guarantee or credit 

derivative, if the guarantee or credit 

derivative does not provide the [bank] 

with the option to receive immediate 

payout on triggering the protection. 

(5) rOS (asset value correlation of the obligor) 

is calculated according to the 

appropriate formula for (R) provided in 

Table 2 in section 31 of this appendix, 

with PD equal to PDo. 

(6) b (maturity adjustment coefficient) is 

calculated according to the formula for b 

provided in Table 2 in section 31 of this 

appendix, with PD equal to the lesser of 

PDo and PDg. 

(7) M (maturity) is the effective maturity of 

the guarantee or credit derivative, which 

may not be less than one year or greater 

than five years. 

Section 35. Risk-Based Capital Requirement 

for Unsettled Transactions 

(a) Definitions. For purposes of this 

section: 

(1) Delivery-versus-payment (DvP) 

transaction means a securities or 

commodities transaction in which the buyer 

is obligated to make payment only if the 

seller has made delivery of the securities or 

commodities and the seller is obligated to 

deliver the securities or commodities only if 

the buyer has made payment. 

(2) Payment-versus-payment (PvP) 

transaction means a foreign exchange 

transaction in which each counterparty is 

obligated to make a final transfer of one or 

more currencies only if the other 

counterparty has made a final transfer of one 

or more currencies. 

(3) Normal settlement period. A transaction 

has a normal settlement period if the 

contractual settlement period for the 

transaction is equal to or less than the market 

standard for the instrument underlying the 

transaction and equal to or less than five 

business days. 

(4) Positive current exposure. The positive 

current exposure of a [bank] for a transaction 

is the difference between the transaction 

value at the agreed settlement price and the 

current market price of the transaction, if the 

difference results in a credit exposure of the 

[bank] to the counterparty. 

(b) Scope. This section applies to all 

transactions involving securities, foreign 

exchange instruments, and commodities that 

have a risk of delayed settlement or delivery. 

This section does not apply to: 

(1) Transactions accepted by a qualifying 

central counterparty that are subject to daily 

marking-to-market and daily receipt and 

payment of variation margin; 

(2) Repo-style transactions, including 

unsettled repo-style transactions (which are 

addressed in sections 31 and 32 of this 

appendix); 

(3) One-way cash payments on OTC 

derivative contracts (which are addressed in 

sections 31 and 32 of this appendix); or 

(4) Transactions with a contractual 

settlement period that is longer than the 

normal settlement period (which are treated 

as OTC derivative contracts and addressed in 

sections 31 and 32 of this appendix). 

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

system-wide failure of a settlement or 

clearing system, the [AGENCY] may waive 

risk-based capital requirements for unsettled 

and failed transactions until the situation is 

rectified. 

(d) Delivery-versus-payment (DvP) and 

payment-versus-payment (PvP) transactions. 

A [bank] must hold risk-based capital against 

any DvP or PvP transaction with a normal 

settlement period if the [bank]’s counterparty 

has not made delivery or payment within five 

business days after the settlement date. The 

[bank] must determine its risk-weighted asset 

amount for such a transaction by multiplying 

the positive current exposure of the 

transaction for the [bank] by the appropriate 

risk weight in Table 5. 

TABLE 5.—RISK WEIGHTS FOR UNSETTLED DVP AND PVP TRANSACTIONS

Number of business 

days after contractual 

settlement date 

Risk weight to be 

applied to positive 

current exposure 

(percent) 

From 5 to 15 ................. 100 

From 16 to 30 ............... 625 

From 31 to 45 ............... 937 .5 

46 or more .................... 1,250 

(e) Non-DvP/non-PvP (non-delivery-versuspayment/non-payment-versus-payment) 

transactions. (1) A [bank] must hold riskbased capital against any non-DvP/non-PvP 

transaction with a normal settlement period 

if the [bank] has delivered cash, securities, 

commodities, or currencies to its 

counterparty but has not received its 

corresponding deliverables by the end of the 

same business day. The [bank] must continue 

to hold risk-based capital against the 

transaction until the [bank] has received its 

corresponding deliverables. 

(2) From the business day after the [bank] 

has made its delivery until five business days 

after the counterparty delivery is due, the 

[bank] must calculate its risk-based capital 

requirement for the transaction by treating 

the current market value of the deliverables 

owed to the [bank] as a wholesale exposure. 

(i) A [bank] may assign an obligor rating to 

a counterparty for which it is not otherwise 

required under this appendix to assign an 

obligor rating on the basis of the applicable 

external rating of any outstanding unsecured 

long-term debt security without credit 

enhancement issued by the counterparty. 

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

the transaction rather than estimating LGD 

for the transaction provided the [bank] uses 

the 45 percent LGD for all transactions 

described in paragraphs (e)(1) and (e)(2) of 

this section. 

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

weight for the transaction provided the 

[bank] uses this risk weight for all 

transactions described in paragraphs (e)(1) 

and (e)(2) of this section. 


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

deliverables by the fifth business day after 

the counterparty delivery was due, the [bank] 

must deduct the current market value of the 

deliverables owed to the [bank] 50 percent 

from tier 1 capital and 50 percent from tier 

2 capital. 

(f) Total risk-weighted assets for unsettled 

transactions. Total risk-weighted assets for 

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

non-DvP/non-PvP transactions. 

Part V. Risk-Weighted Assets for 

Securitization Exposures 

Section 41. Operational Criteria for 

Recognizing the Transfer of Risk 

(a) Operational criteria for traditional 

securitizations. A [bank] that transfers 

exposures it has originated or purchased to 

a securitization SPE or other third party in 

connection with a traditional securitization 

may exclude the exposures from the 

calculation of its risk-weighted assets only if 

each of the conditions in this paragraph (a) 

is satisfied. A [bank] that meets these 

conditions must hold risk-based capital 

against any securitization exposures it retains 

in connection with the securitization. A 

[bank] that fails to meet these conditions 

must hold risk-based capital against the 

transferred exposures as if they had not been 

securitized and must deduct from tier 1 

capital any after-tax gain-on-sale resulting 

from the transaction. The conditions are: 

(1) The transfer is considered a sale under 

GAAP; 

(2) The [bank] has transferred to third 

parties credit risk associated with the 

underlying exposures; and 

(3) Any clean-up calls relating to the 

securitization are eligible clean-up calls. 

(b) Operational criteria for synthetic 

securitizations. For synthetic securitizations, 

a [bank] may recognize for risk-based capital 

purposes the use of a credit risk mitigant to 

hedge underlying exposures only if each of 

the conditions in this paragraph (b) is 

satisfied. A [bank] that fails to meet these 

conditions must hold risk-based capital 

against the underlying exposures as if they 

had not been synthetically securitized. The 

conditions are: 

(1) The credit risk mitigant is financial 

collateral, an eligible credit derivative from 

an eligible securitization guarantor or an 

eligible guarantee from an eligible 

securitization guarantor; 

(2) The [bank] transfers credit risk 

associated with the underlying exposures to 

third parties, and the terms and conditions in 

the credit risk mitigants employed do not 

include provisions that: 

(i) Allow for the termination of the credit 

protection due to deterioration in the credit 

quality of the underlying exposures; 

(ii) Require the [bank] to alter or replace 

the underlying exposures to improve the 

credit quality of the pool of underlying 

exposures; 

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

protection in response to deterioration in the 

credit quality of the underlying exposures; 

(iv) Increase the yield payable to parties 

other than the [bank] in response to a 

deterioration in the credit quality of the 

underlying exposures; or 

(v) Provide for increases in a retained first 

loss position or credit enhancement provided 

by the [bank] after the inception of the 

securitization; 

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

opinion from legal counsel that confirms the 

enforceability of the credit risk mitigant in all 

relevant jurisdictions; and 

(4) Any clean-up calls relating to the 

securitization are eligible clean-up calls. 

Section 42. Risk-Based Capital Requirement 

for Securitization Exposures 

(a) Hierarchy of approaches. Except as 

provided elsewhere in this section: 

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

any after-tax gain-on-sale resulting from a 

securitization and must deduct from total 

capital in accordance with paragraph (c) of 

this section the portion of any CEIO that does 

not constitute gain-on-sale. 

(2) If a securitization exposure does not 

require deduction under paragraph (a)(1) of 

this section and qualifies for the RatingsBased Approach in section 43 of this 

appendix, a [bank] must apply the RatingsBased Approach to the exposure. 

(3) If a securitization exposure does not 

require deduction under paragraph (a)(1) of 

this section and does not qualify for the 

Ratings-Based Approach, the [bank] may 

either apply the Internal Assessment 

Approach in section 44 of this appendix to 

the exposure (if the [bank], the exposure, and 

the relevant ABCP program qualify for the 

Internal Assessment Approach) or the 

Supervisory Formula Approach in section 45 

of this appendix to the exposure (if the [bank] 

and the exposure qualify for the Supervisory 

Formula Approach). 

(4) If a securitization exposure does not 

require deduction under paragraph (a)(1) of 

this section and does not qualify for the 

Ratings-Based Approach, the Internal 

Assessment Approach, or the Supervisory 

Formula Approach, the [bank] must deduct 

the exposure from total capital in accordance 

with paragraph (c) of this section. 

(5) If a securitization exposure is an OTC 

derivative contract (other than a credit 

derivative) that has a first priority claim on 

the cash flows from the underlying exposures 

(notwithstanding amounts due under interest 

rate or currency derivative contracts, fees 

due, or other similar payments), with 

approval of the [AGENCY], a [bank] may 

choose to set the risk-weighted asset amount 

of the exposure equal to the amount of the 

exposure as determined in paragraph (e) of 

this section rather than apply the hierarchy 

of approaches described in paragraphs (a) (1) 

through (4) of this section. 

(b) Total risk-weighted assets for 

securitization exposures. A [bank]’s total 

risk-weighted assets for securitization 

exposures is equal to the sum of its riskweighted assets calculated using the RatingsBased Approach in section 43 of this 

appendix, the Internal Assessment Approach 

in section 44 of this appendix, and the 

Supervisory Formula Approach in section 45 

of this appendix, and its risk-weighted assets 

amount for early amortization provisions 

calculated in section 47 of this appendix. 

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

a securitization exposure from total capital, 

the [bank] must take the deduction 50 

percent from tier 1 capital and 50 percent 

from tier 2 capital. If the amount deductible 

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

2 capital, the [bank] must deduct the excess 

from tier 1 capital. 

(2) A [bank] may calculate any deduction 

from tier 1 capital and tier 2 capital for a 

securitization exposure net of any deferred 

tax liabilities associated with the 

securitization exposure. 

(d) Maximum risk-based capital 

requirement. Regardless of any other 

provisions of this part, unless one or more 

underlying exposures does not meet the 

definition of a wholesale, retail, 

securitization, or equity exposure, the total 

risk-based capital requirement for all 

securitization exposures held by a single 

[bank] associated with a single securitization 

(including any risk-based capital 

requirements that relate to an early 

amortization provision of the securitization 

but excluding any risk-based capital 

requirements that relate to the [bank]’s gainon-sale or CEIOs associated with the 

securitization) may not exceed the sum of: 

(1) The [bank]’s total risk-based capital 

requirement for the underlying exposures as 

if the [bank] directly held the underlying 

exposures; and 

(2) The total ECL of the underlying 

exposures. 

(e) Amount of a securitization exposure. (1) 

The amount of an on-balance sheet 

securitization exposure that is not a repostyle transaction, eligible margin loan, or 

OTC derivative contract (other than a credit 

derivative) is: 

(i) The [bank]’s carrying value minus any 

unrealized gains and plus any unrealized 

losses on the exposure, if the exposure is a 

security classified as available-for-sale; or 

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

exposure is not a security classified as 

available-for-sale. 

(2) The amount of an off-balance sheet 

securitization exposure that is not an OTC 

derivative contract (other than a credit 

derivative) is the notional amount of the 

exposure. For an off-balance-sheet 

securitization exposure to an ABCP program, 

such as a liquidity facility, the notional 

amount may be reduced to the maximum 

potential amount that the [bank] could be 

required to fund given the ABCP program’s 

current underlying assets (calculated without 

regard to the current credit quality of those 

assets). 

(3) The amount of a securitization exposure 

that is a repo-style transaction, eligible 

margin loan, or OTC derivative contract 

(other than a credit derivative) is the EAD of 

the exposure as calculated in section 32 of 

this appendix. 

(f) Overlapping exposures. If a [bank] has 

multiple securitization exposures that 

provide duplicative coverage of the 

underlying exposures of a securitization 

(such as when a [bank] provides a programwide credit enhancement and multiple poolspecific liquidity facilities to an ABCP 

program), the [bank] is not required to hold 

duplicative risk-based capital against the 

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69420 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

overlapping position. Instead, the [bank] may 

apply to the overlapping position the 

applicable risk-based capital treatment that 

results in the highest risk-based capital 

requirement. 

(g) Securitizations of non-IRB exposures. If 

a [bank] has a securitization exposure where 

any underlying exposure is not a wholesale 

exposure, retail exposure, securitization 

exposure, or equity exposure, the [bank] 

must: 

(1) If the [bank] is an originating [bank], 

deduct from tier 1 capital any after-tax gainon-sale resulting from the securitization and 

deduct from total capital in accordance with 

paragraph (c) of this section the portion of 

any CEIO that does not constitute gain-onsale; 

(2) If the securitization exposure does not 

require deduction under paragraph (g)(1), 

apply the RBA in section 43 of this appendix 

to the securitization exposure if the exposure 

qualifies for the RBA; 

(3) If the securitization exposure does not 

require deduction under paragraph (g)(1) and 

does not qualify for the RBA, apply the IAA 

in section 44 of this appendix to the exposure 

(if the [bank], the exposure, and the relevant 

ABCP program qualify for the IAA); and 

(4) If the securitization exposure does not 

require deduction under paragraph (g)(1) and 

does not qualify for the RBA or the IAA, 

deduct the exposure from total capital in 

accordance with paragraph (c) of this section. 

(h) Implicit support. If a [bank] provides 

support to a securitization in excess of the 

[bank]’s contractual obligation to provide 

credit support to the securitization (implicit 

support): 

(1) The [bank] must hold regulatory capital 

against all of the underlying exposures 

associated with the securitization as if the 

exposures had not been securitized and must 

deduct from tier 1 capital any after-tax gainon-sale resulting from the securitization; and 

(2) The [bank] must disclose publicly: 

(i) That it has provided implicit support to 

the securitization; and 

(ii) The regulatory capital impact to the 

[bank] of providing such implicit support. 

(i) Eligible servicer cash advance facilities. 

Regardless of any other provisions of this 

part, a [bank] is not required to hold riskbased capital against the undrawn portion of 

an eligible servicer cash advance facility. 

(j) Interest-only mortgage-backed 

securities. Regardless of any other provisions 

of this part, the risk weight for a non-creditenhancing interest-only mortgage-backed 

security may not be less than 100 percent. 

(k) Small-business loans and leases on 

personal property transferred with recourse. 

(1) Regardless of any other provisions of this 

appendix, a [bank] that has transferred smallbusiness loans and leases on personal 

property (small-business obligations) with 

recourse must include in risk-weighted assets 

only the contractual amount of retained 

recourse if all the following conditions are 

met: 

(i) The transaction is a sale under GAAP. 

(ii) The [bank] establishes and maintains, 

pursuant to GAAP, a non-capital reserve 

sufficient to meet the [bank]’s reasonably 

estimated liability under the recourse 

arrangement. 

(iii) The loans and leases are to businesses 

that meet the criteria for a small-business 

concern established by the Small Business 

Administration under section 3(a) of the 

Small Business Act (15 U.S.C. 632). 

(iv) The [bank] is well capitalized, as 

defined in the [AGENCY]’s prompt corrective 

action regulation—12 CFR part 6 (for national 

banks), 12 CFR part 208, subpart D (for state 

member banks or bank holding companies), 

12 CFR part 325, subpart B (for state 

nonmember banks), and 12 CFR part 565 (for 

savings associations). For purposes of 

determining whether a [bank] is well 

capitalized for purposes of this paragraph, 

the [bank]’s capital ratios must be calculated 

without regard to the capital treatment for 

transfers of small-business obligations with 

recourse specified in paragraph (k)(1) of this 

section. 

(2) The total outstanding amount of 

recourse retained by a [bank] on transfers of 

small-business obligations receiving the 

capital treatment specified in paragraph 

(k)(1) of this section cannot exceed 15 

percent of the [bank]’s total qualifying 

capital. 

(3) If a [bank] ceases to be well capitalized 

or exceeds the 15 percent capital limitation, 

the preferential capital treatment specified in 

paragraph (k)(1) of this section will continue 

to apply to any transfers of small-business 

obligations with recourse that occurred 

during the time that the [bank] was well 

capitalized and did not exceed the capital 

limit. 

(4) The risk-based capital ratios of the 

[bank] must be calculated without regard to 

the capital treatment for transfers of smallbusiness obligations with recourse specified 

in paragraph (k)(1) of this section as provided 

in 12 CFR part 3, Appendix A (for national 

banks), 12 CFR part 208, Appendix A (for 

state member banks), 12 CFR part 225, 

Appendix A (for bank holding companies), 

12 CFR part 325, Appendix A (for state 

nonmember banks), and 12 CFR 

567.6(b)(5)(v) (for savings associations). 

(l) Consolidated ABCP programs. (1) A 

[bank] that qualifies as a primary beneficiary 

and must consolidate an ABCP program as a 

variable interest entity under GAAP may 

exclude the consolidated ABCP program 

assets from risk-weighted assets if the [bank] 

is the sponsor of the ABCP program. If a 

[bank] excludes such consolidated ABCP 

program assets from risk-weighted assets, the 

[bank] must hold risk-based capital against 

any securitization exposures of the [bank] to 

the ABCP program in accordance with this 

part. 

(2) If a [bank] either is not permitted, or 

elects not, to exclude consolidated ABCP 

program assets from its risk-weighted assets, 

the [bank] must hold risk-based capital 

against the consolidated ABCP program 

assets in accordance with this appendix but 

is not required to hold risk-based capital 

against any securitization exposures of the 

[bank] to the ABCP program. 

(m) N th-to-default credit derivatives—(1) 

First-to-default credit derivatives—(i) 

Protection purchaser. A [bank] that obtains 

credit protection on a group of underlying 

exposures through a first-to-default credit 

derivative must determine its risk-based 

capital requirement for the underlying 

exposures as if the [bank] synthetically 

securitized the underlying exposure with the 

lowest risk-based capital requirement and 

had obtained no credit risk mitigant on the 

other underlying exposures. 

(ii) Protection provider. A [bank] that 

provides credit protection on a group of 

underlying exposures through a first-todefault credit derivative must determine its 

risk-weighted asset amount for the derivative 

by applying the RBA in section 43 of this 

appendix (if the derivative qualifies for the 

RBA) or, if the derivative does not qualify for 

the RBA, by setting its risk-weighted asset 

amount for the derivative equal to the 

product of: 

(A) The protection amount of the 

derivative; 

(B) 12.5; and 

(C) The sum of the risk-based capital 

requirements of the individual underlying 

exposures, up to a maximum of 100 percent. 

(2) Second-or-subsequent-to-default credit 

derivatives—(i) Protection purchaser. (A) A 

[bank] that obtains credit protection on a 

group of underlying exposures through a nthto-default credit derivative (other than a firstto-default credit derivative) may recognize 

the credit risk mitigation benefits of the 

derivative only if: 

(1) The [bank] also has obtained credit 

protection on the same underlying exposures 

in the form of first-through-(n-1)-to-default 

credit derivatives; or 

(2) If n-1 of the underlying exposures have 

already defaulted. 

(B) If a [bank] satisfies the requirements of 

paragraph (m)(2)(i)(A) of this section, the 

[bank] must determine its risk-based capital 

requirement for the underlying exposures as 

if the [bank] had only synthetically 

securitized the underlying exposure with the 

nth lowest risk-based capital requirement and 

had obtained no credit risk mitigant on the 

other underlying exposures. 

(ii) Protection provider. A [bank] that 

provides credit protection on a group of 

underlying exposures through a nth-to-default 

credit derivative (other than a first-to-default 

credit derivative) must determine its riskweighted asset amount for the derivative by 

applying the RBA in section 43 of this 

appendix (if the derivative qualifies for the 

RBA) or, if the derivative does not qualify for 

the RBA, by setting its risk-weighted asset 

amount for the derivative equal to the 

product of: 

(A) The protection amount of the 

derivative; 

(B) 12.5; and 

(C) The sum of the risk-based capital 

requirements of the individual underlying 

exposures (excluding the n-1 underlying 

exposures with the lowest risk-based capital 

requirements), up to a maximum of 100 

percent. 

Section 43. Ratings-Based Approach (RBA) 

(a) Eligibility requirements for use of the 

RBA—(1) Originating [bank]. An originating 

[bank] must use the RBA to calculate its riskbased capital requirement for a securitization 

exposure if the exposure has two or more 

external ratings or inferred ratings (and may 

not use the RBA if the exposure has fewer 

than two external ratings or inferred ratings). 

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(2) Investing [bank]. An investing [bank] 

must use the RBA to calculate its risk-based 

capital requirement for a securitization 

exposure if the exposure has one or more 

external or inferred ratings (and may not use 

the RBA if the exposure has no external or 

inferred rating). 

(b) Ratings-based approach. (1) A [bank] 

must determine the risk-weighted asset 

amount for a securitization exposure by 

multiplying the amount of the exposure (as 

defined in paragraph (e) of section 42 of this 

appendix) by the appropriate risk weight 

provided in Table 6 and Table 7. 

(2) A [bank] must apply the risk weights in 

Table 6 when the securitization exposure’s 

applicable external or applicable inferred 

rating represents a long-term credit rating, 

and must apply the risk weights in Table 7 

when the securitization exposure’s 

applicable external or applicable inferred 

rating represents a short-term credit rating. 

(i) A [bank] must apply the risk weights in 

column 1 of Table 6 or Table 7 to the 

securitization exposure if: 

(A) N (as calculated under paragraph (e)(6) 

of section 45 of this appendix) is six or more 

(for purposes of this section only, if the 

notional number of underlying exposures is 

25 or more or if all of the underlying 

exposures are retail exposures, a [bank] may 

assume that N is six or more unless the 

[bank] knows or has reason to know that N 

is less than six); and 

(B) The securitization exposure is a senior 

securitization exposure. 

(ii) A [bank] must apply the risk weights 

in column 3 of Table 6 or Table 7 to the 

securitization exposure if N is less than six, 

regardless of the seniority of the 

securitization exposure. 

(iii) Otherwise, a [bank] must apply the 

risk weights in column 2 of Table 6 or Table 

7. 

TABLE 6.—LONG-TERM CREDIT RATING RISK WEIGHTS UNDER RBA AND IAA 

Applicable external or inferred rating 

(Illustrative rating example) 

Column 1 Column 2 Column 3 

Risk weights 

for senior 

securitization 

exposures 

backed by 

granular pools 

Risk weights 

for non-senior 

securitization 

exposures 

backed by 

granular pools 

Risk weights 

for 

securitization 

exposures 

backed by 

non-granular 

pools 

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

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

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

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

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

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

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

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

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

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

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

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

TABLE 7.—SHORT-TERM CREDIT RATING RISK WEIGHTS UNDER RBA AND IAA 

Applicable external or inferred rating 

(Illustrative rating example) 

Column 1 Column 2 Column 3 

Risk weights 

for senior 

securitization 

exposures 

backed by 

granular pools 

Risk weights 

for non-senior 

securitization 

exposures 

backed by 

granular pools 

Risk weights 

for 

securitization 

exposures 

backed by 

non-granular 

pools 

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

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

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

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

Section 44. Internal Assessment Approach 

(IAA) 

(a) Eligibility requirements. A [bank] may 

apply the IAA to calculate the risk-weighted 

asset amount for a securitization exposure 

that the [bank] has to an ABCP program (such 

as a liquidity facility or credit enhancement) 

if the [bank], the ABCP program, and the 

exposure qualify for use of the IAA. 

(1) [Bank] qualification criteria. A [bank] 

qualifies for use of the IAA if the [bank] has 

received the prior written approval of the 

[AGENCY]. To receive such approval, the 

[bank] must demonstrate to the [AGENCY]’s 

satisfaction that the [bank]’s internal 

assessment process meets the following 

criteria: 

(i) The [bank]’s internal credit assessments 

of securitization exposures must be based on 

publicly available rating criteria used by an 

NRSRO. 

(ii) The [bank]’s internal credit assessments 

of securitization exposures used for riskbased capital purposes must be consistent 

with those used in the [bank]’s internal risk 

management process, management 

information reporting systems, and capital 

adequacy assessment process. 

(iii) The [bank]’s internal credit assessment 

process must have sufficient granularity to 

identify gradations of risk. Each of the 

[bank]’s internal credit assessment categories 

must correspond to an external rating of an 

NRSRO. 

(iv) The [bank]’s internal credit assessment 

process, particularly the stress test factors for 

determining credit enhancement 

requirements, must be at least as conservative 

as the most conservative of the publicly 

available rating criteria of the NRSROs that 

have provided external ratings to the 

commercial paper issued by the ABCP 

program. 

(A) Where the commercial paper issued by 

an ABCP program has an external rating from 

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69422 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

two or more NRSROs and the different 

NRSROs’’ benchmark stress factors require 

different levels of credit enhancement to 

achieve the same external rating equivalent, 

the [bank] must apply the NRSRO stress 

factor that requires the highest level of credit 

enhancement. 

(B) If any NRSRO that provides an external 

rating to the ABCP program’s commercial 

paper changes its methodology (including 

stress factors), the [bank] must evaluate 

whether to revise its internal assessment 

process. 

(v) The [bank] must have an effective 

system of controls and oversight that ensures 

compliance with these operational 

requirements and maintains the integrity and 

accuracy of the internal credit assessments. 

The [bank] must have an internal audit 

function independent from the ABCP 

program business line and internal credit 

assessment process that assesses at least 

annually whether the controls over the 

internal credit assessment process function 

as intended. 

(vi) The [bank] must review and update 

each internal credit assessment whenever 

new material information is available, but no 

less frequently than annually. 

(vii) The [bank] must validate its internal 

credit assessment process on an ongoing 

basis and at least annually. 

(2) ABCP-program qualification criteria. 

An ABCP program qualifies for use of the 

IAA if all commercial paper issued by the 

ABCP program has an external rating. 

(3) Exposure qualification criteria. A 

securitization exposure qualifies for use of 

the IAA if the exposure meets the following 

criteria: 

(i) The [bank] initially rated the exposure 

at least the equivalent of investment grade. 

(ii) The ABCP program has robust credit 

and investment guidelines (that is, 

underwriting standards) for the exposures 

underlying the securitization exposure. 

(iii) The ABCP program performs a detailed 

credit analysis of the sellers of the exposures 

underlying the securitization exposure. 

(iv) The ABCP program’s underwriting 

policy for the exposures underlying the 

securitization exposure establishes minimum 

asset eligibility criteria that include the 

prohibition of the purchase of assets that are 

significantly past due or of assets that are 

defaulted (that is, assets that have been 

charged off or written down by the seller 

prior to being placed into the ABCP program 

or assets that would be charged off or written 

down under the program’s governing 

contracts), as well as limitations on 

concentration to individual obligors or 

geographic areas and the tenor of the assets 

to be purchased. 

(v) The aggregate estimate of loss on the 

exposures underlying the securitization 

exposure considers all sources of potential 

risk, such as credit and dilution risk. 

(vi) Where relevant, the ABCP program 

incorporates structural features into each 

purchase of exposures underlying the 

securitization exposure to mitigate potential 

credit deterioration of the underlying 

exposures. Such features may include winddown triggers specific to a pool of underlying 

exposures. 

(b) Mechanics. A [bank] that elects to use 

the IAA to calculate the risk-based capital 

requirement for any securitization exposure 

must use the IAA to calculate the risk-based 

capital requirements for all securitization 

exposures that qualify for the IAA approach. 

Under the IAA, a [bank] must map its 

internal assessment of such a securitization 

exposure to an equivalent external rating 

from an NRSRO. Under the IAA, a [bank] 

must determine the risk-weighted asset 

amount for such a securitization exposure by 

multiplying the amount of the exposure (as 

defined in paragraph (e) of section 42 of this 

appendix) by the appropriate risk weight in 

Table 6 and Table 7 in paragraph (b) of 

section 43 of this appendix. 

Section 45. Supervisory Formula Approach 

(SFA) 

(a) Eligibility requirements. A [bank] may 

use the SFA to determine its risk-based 

capital requirement for a securitization 

exposure only if the [bank] can calculate on 

an ongoing basis each of the SFA parameters 

in paragraph (e) of this section. 

(b) Mechanics. Under the SFA, a 

securitization exposure incurs a deduction 

from total capital (as described in paragraph 

(c) of section 42 of this appendix) and/or an 

SFA risk-based capital requirement, as 

determined in paragraph (c) of this section. 

The risk-weighted asset amount for the 

securitization exposure equals the SFA riskbased capital requirement for the exposure 

multiplied by 12.5. 

(c) The SFA risk-based capital 

requirement. (1) If KIRB is greater than or 

equal to L + T, the entire exposure must be 

deducted from total capital. 

(2) If KIRB is less than or equal to L, the 

exposure’s SFA risk-based capital 

requirement is UE multiplied by TP 

multiplied by the greater of: 

(i) 0.0056 * T; or 

(ii) S[L + T] ¥ S[L]. 

(3) If KIRB is greater than L and less than 

L + T, the [bank] must deduct from total 

capital an amount equal to UE*TP*(KIRB ¥ 

L), and the exposure’s SFA risk-based capital 

requirement is UE multiplied by TP 

multiplied by the greater of: 

(i) 0.0056 * (T ¥ (KIRB ¥ L)); or 

(ii) S[L + T] ¥ S[KIRB]. 

(d) The supervisory formula: 

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(11) In these expressions, b[Y; a, b] refers 

to the cumulative beta distribution with 

parameters a and b evaluated at Y. In the case 

where N = 1 and EWALGD = 100 percent, 

S[Y] in formula (1) must be calculated with 

K[Y] set equal to the product of KIRB and Y, 

and d set equal to 1 ¥ KIRB. 

(e) SFA parameters—(1) Amount of the 

underlying exposures (UE). UE is the EAD of 

any underlying exposures that are wholesale 

and retail exposures (including the amount of 

any funded spread accounts, cash collateral 

accounts, and other similar funded credit 

enhancements) plus the amount of any 

underlying exposures that are securitization 

exposures (as defined in paragraph (e) of 

section 42 of this appendix) plus the adjusted 

carrying value of any underlying exposures 

that are equity exposures (as defined in 

paragraph (b) of section 51 of this appendix). 

(2) Tranche percentage (TP). TP is the ratio 

of the amount of the [bank]’s securitization 

exposure to the amount of the tranche that 

contains the securitization exposure. 

(3) Capital requirement on underlying 

exposures (KIRB). (i) KIRB is the ratio of: 

(A) The sum of the risk-based capital 

requirements for the underlying exposures 

plus the expected credit losses of the 

underlying exposures (as determined under 

this appendix as if the underlying exposures 

were directly held by the [bank]); to 

(B) UE. 

(ii) The calculation of KIRB must reflect the 

effects of any credit risk mitigant applied to 

the underlying exposures (either to an 

individual underlying exposure, to a group of 

underlying exposures, or to the entire pool of 

underlying exposures). 

(iii) All assets related to the securitization 

are treated as underlying exposures, 

including assets in a reserve account (such as 

a cash collateral account). 

(4) Credit enhancement level (L). (i) L is the 

ratio of: 

(A) The amount of all securitization 

exposures subordinated to the tranche that 

contains the [bank]’s securitization exposure; 

to 

(B) UE. 

(ii) A [bank] must determine L before 

considering the effects of any tranchespecific credit enhancements. 

(iii) Any gain-on-sale or CEIO associated 

with the securitization may not be included 

in L. 

(iv) Any reserve account funded by 

accumulated cash flows from the underlying 

exposures that is subordinated to the tranche 

that contains the [bank]’s securitization 

exposure may be included in the numerator 

and denominator of L to the extent cash has 

accumulated in the account. Unfunded 

reserve accounts (that is, reserve accounts 

that are to be funded from future cash flows 

from the underlying exposures) may not be 

included in the calculation of L. 

(v) In some cases, the purchase price of 

receivables will reflect a discount that 

provides credit enhancement (for example, 

first loss protection) for all or certain 

tranches of the securitization. When this 

arises, L should be calculated inclusive of 

this discount if the discount provides credit 

enhancement for the securitization exposure. 


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(5) Thickness of tranche (T). T is the ratio 

of: 

(i) The amount of the tranche that contains 

the [bank]’s securitization exposure; to 

(ii) UE. 

(6) Effective number of exposures (N). (i) 

Unless the [bank] elects to use the formula 

provided in paragraph (f) of this section, 

where EADi represents the EAD associated 

with the ith instrument in the pool of 

underlying exposures. 

(ii) Multiple exposures to one obligor must 

be treated as a single underlying exposure. 

(iii) In the case of a re-securitization (that 

is, a securitization in which some or all of 

the underlying exposures are themselves 

securitization exposures), the [bank] must 

treat each underlying exposure as a single 

underlying exposure and must not look 

through to the originally securitized 

underlying exposures. 

(7) Exposure-weighted average loss given 

default (EWALGD). EWALGD is calculated 

as: 

where LGDi represents the average LGD 

associated with all exposures to the ith 

obligor. In the case of a re-securitization, an 

LGD of 100 percent must be assumed for the 

underlying exposures that are themselves 

securitization exposures. 

(f) Simplified method for computing N and 

EWALGD. (1) If all underlying exposures of 

a securitization are retail exposures, a [bank] 

may apply the SFA using the following 

simplifications: 

(i) h = 0; and 

(ii) v = 0. 

(2) Under the conditions in paragraphs 

(f)(3) and (f)(4) of this section, a [bank] may 

employ a simplified method for calculating N 

and EWALGD. 

(3) If C1 is no more than 0.03, a [bank] may 

set EWALGD = 0.50 if none of the underlying 

exposures is a securitization exposure or 

EWALGD = 1 if one or more of the 

underlying exposures is a securitization 

exposure, and may set N equal to the 

following amount: 

where: 

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

of the ‘m’ largest underlying exposures to UE; 

and 

(ii) The level of m is to be selected by the 

[bank]. 

(4) Alternatively, if only C1 is available and 

C1 is no more than 0.03, the [bank] may set 

EWALGD = 0.50 if none of the underlying 

exposures is a securitization exposure or 

EWALGD = 1 if one or more of the 

underlying exposures is a securitization 

exposure and may set N = 1/C1. 

Section 46. Recognition of Credit Risk 

Mitigants for Securitization Exposures 

(a) General. An originating [bank] that has 

obtained a credit risk mitigant to hedge its 

securitization exposure to a synthetic or 

traditional securitization that satisfies the 

operational criteria in section 41 of this 

appendix may recognize the credit risk 

mitigant, but only as provided in this section. 

An investing [bank] that has obtained a credit 

risk mitigant to hedge a securitization 

exposure may recognize the credit risk 

mitigant, but only as provided in this section. 

A [bank] that has used the RBA in section 43 

of this appendix or the IAA in section 44 of 

this appendix to calculate its risk-based 

capital requirement for a securitization 

exposure whose external or inferred rating 

(or equivalent internal rating under the IAA) 

reflects the benefits of a credit risk mitigant 

provided to the associated securitization or 

that supports some or all of the underlying 

exposures may not use the credit risk 

mitigation rules in this section to further 

reduce its risk-based capital requirement for 

the exposure to reflect that credit risk 

mitigant. 

(b) Collateral—(1) Rules of recognition. A 

[bank] may recognize financial collateral in 

determining the [bank]’s risk-based capital 

requirement for a securitization exposure 

(other than a repo-style transaction, an 

eligible margin loan, or an OTC derivative 

contract for which the [bank] has reflected 

collateral in its determination of exposure 

amount under section 32 of this appendix) as 

follows. The [bank]’s risk-based capital 

requirement for the collateralized 

securitization exposure is equal to the riskbased capital requirement for the 

securitization exposure as calculated under 

the RBA in section 43 of this appendix or 

under the SFA in section 45 of this appendix 

multiplied by the ratio of adjusted exposure 

amount (SE*) to original exposure amount 

(SE), where: 

(i) SE* = max {0, [SE—C x (1¥Hs¥Hfx)]}; 

(ii) SE = the amount of the securitization 

exposure calculated under paragraph (e) of 

section 42 of this appendix; 

(iii) C = the current market value of the 

collateral; 

(iv) Hs = the haircut appropriate to the 

collateral type; and 

(v) Hfx = the haircut appropriate for any 

currency mismatch between the collateral 

and the exposure. 

(2) Mixed collateral. Where the collateral is 

a basket of different asset types or a basket 

of assets denominated in different currencies, 

the haircut on the basket will be 

H aHi i

i

= ∑ ,

where ai is the current market value of the 

asset in the basket divided by the current 

market value of all assets in the basket and 

Hi is the haircut applicable to that asset. 

(3) Standard supervisory haircuts. Unless a 

[bank] qualifies for use of and uses ownestimates haircuts in paragraph (b)(4) of this 

section: 

(i) A [bank] must use the collateral type 

haircuts (Hs) in Table 3; 

(ii) A [bank] must use a currency mismatch 

haircut (Hfx) of 8 percent if the exposure and 

the collateral are denominated in different 

currencies; 

(iii) A [bank] must multiply the 

supervisory haircuts obtained in paragraphs 

(b)(3)(i) and (ii) by the square root of 6.5 

(which equals 2.549510); and 

(iv) A [bank] must adjust the supervisory 

haircuts upward on the basis of a holding 

period longer than 65 business days where 

and as appropriate to take into account the 

illiquidity of the collateral. 

(4) Own estimates for haircuts. With the 

prior written approval of the [AGENCY], a 

[bank] may calculate haircuts using its own 

internal estimates of market price volatility 

and foreign exchange volatility, subject to 

paragraph (b)(2)(iii) of section 32 of this 

appendix. The minimum holding period 

(TM) for securitization exposures is 65 

business days. 

(c) Guarantees and credit derivatives—(1) 

Limitations on recognition. A [bank] may 

only recognize an eligible guarantee or 

eligible credit derivative provided by an 

eligible securitization guarantor in 

determining the [bank]’s risk-based capital 

requirement for a securitization exposure. 

(2) ECL for securitization exposures. When 

a [bank] recognizes an eligible guarantee or 

eligible credit derivative provided by an 

eligible securitization guarantor in 

determining the [bank]’s risk-based capital 

requirement for a securitization exposure, the 

[bank] must also: 

(i) Calculate ECL for the protected portion 

of the exposure using the same risk 

parameters that it uses for calculating the 

risk-weighted asset amount of the exposure 

as described in paragraph (c)(3) of this 

section; and 

(ii) Add the exposure’s ECL to the [bank]’s 

total ECL. 

(3) Rules of recognition. A [bank] may 

recognize an eligible guarantee or eligible 

credit derivative provided by an eligible 

securitization guarantor in determining the 


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[bank]’s risk-based capital requirement for 

the securitization exposure as follows: 

(i) Full coverage. If the protection amount 

of the eligible guarantee or eligible credit 

derivative equals or exceeds the amount of 

the securitization exposure, the [bank] may 

set the risk-weighted asset amount for the 

securitization exposure equal to the riskweighted asset amount for a direct exposure 

to the eligible securitization guarantor (as 

determined in the wholesale risk weight 

function described in section 31 of this 

appendix), using the [bank]’s PD for the 

guarantor, the [bank]’s LGD for the guarantee 

or credit derivative, and an EAD equal to the 

amount of the securitization exposure (as 

determined in paragraph (e) of section 42 of 

this appendix). 

(ii) Partial coverage. If the protection 

amount of the eligible guarantee or eligible 

credit derivative is less than the amount of 

the securitization exposure, the [bank] may 

set the risk-weighted asset amount for the 

securitization exposure equal to the sum of: 

(A) Covered portion. The risk-weighted 

asset amount for a direct exposure to the 

eligible securitization guarantor (as 

determined in the wholesale risk weight 

function described in section 31 of this 

appendix), using the [bank]’s PD for the 

guarantor, the [bank]’s LGD for the guarantee 

or credit derivative, and an EAD equal to the 

protection amount of the credit risk mitigant; 

and 

(B) Uncovered portion. (1) 1.0 minus the 

ratio of the protection amount of the eligible 

guarantee or eligible credit derivative to the 

amount of the securitization exposure); 

multiplied by 

(2) The risk-weighted asset amount for the 

securitization exposure without the credit 

risk mitigant (as determined in sections 42–

45 of this appendix). 

(4) Mismatches. The [bank] must make 

applicable adjustments to the protection 

amount as required in paragraphs (d), (e), and 

(f) of section 33 of this appendix for any 

hedged securitization exposure and any more 

senior securitization exposure that benefits 

from the hedge. In the context of a synthetic 

securitization, when an eligible guarantee or 

eligible credit derivative covers multiple 

hedged exposures that have different residual 

maturities, the [bank] must use the longest 

residual maturity of any of the hedged 

exposures as the residual maturity of all the 

hedged exposures. 

Section 47. Risk-Based Capital Requirement 

for Early Amortization Provisions 

(a) General. (1) An originating [bank] must 

hold risk-based capital against the sum of the 

originating [bank]’s interest and the 

investors’ interest in a securitization that: 

(i) Includes one or more underlying 

exposures in which the borrower is permitted 

to vary the drawn amount within an agreed 

limit under a line of credit; and 

(ii) Contains an early amortization 

provision. 

(2) For securitizations described in 

paragraph (a)(1) of this section, an originating 

[bank] must calculate the risk-based capital 

requirement for the originating [bank]’s 

interest under sections 42–45 of this 

appendix, and the risk-based capital 

requirement for the investors’ interest under 

paragraph (b) of this section. 

(b) Risk-weighted asset amount for 

investors’ interest. The originating [bank]’s 

risk-weighted asset amount for the investors’

interest in the securitization is equal to the 

product of the following 5 quantities: 

(1) The investors’ interest EAD; 

(2) The appropriate conversion factor in 

paragraph (c) of this section; 

(3) KIRB (as defined in paragraph (e)(3) of 

section 45 of this appendix); 

(4) 12.5; and 

(5) The proportion of the underlying 

exposures in which the borrower is permitted 

to vary the drawn amount within an agreed 

limit under a line of credit. 

(c) Conversion factor. (1) (i) Except as 

provided in paragraph (c)(2) of this section, 

to calculate the appropriate conversion 

factor, a [bank] must use Table 8 for a 

securitization that contains a controlled early 

amortization provision and must use Table 9 

for a securitization that contains a noncontrolled early amortization provision. In 

circumstances where a securitization 

contains a mix of retail and nonretail 

exposures or a mix of committed and 

uncommitted exposures, a [bank] may take a 

pro rata approach to determining the 

conversion factor for the securitization’s 

early amortization provision. If a pro rata 

approach is not feasible, a [bank] must treat 

the mixed securitization as a securitization of 

nonretail exposures if a single underlying 

exposure is a nonretail exposure and must 

treat the mixed securitization as a 

securitization of committed exposures if a 

single underlying exposure is a committed 

exposure. 

(ii) To find the appropriate conversion 

factor in the tables, a [bank] must divide the 

three-month average annualized excess 

spread of the securitization by the excess 

spread trapping point in the securitization 

structure. In securitizations that do not 

require excess spread to be trapped, or that 

specify trapping points based primarily on 

performance measures other than the threemonth average annualized excess spread, the 

excess spread trapping point is 4.5 percent. 

TABLE 8.—CONTROLLED EARLY AMORTIZATION PROVISIONS

Uncommitted Committed 

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

133.33% of trapping point or more, 0% CF.

less than 133.33% to 100% of trapping point, 1% CF.

less than 100% to 75% of trapping point, 2% CF.

less than 75% to 50% of trapping point, 10% CF.

less than 50% to 25% of trapping point, 20% CF.

less than 25% of trapping point, 40% CF.

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

TABLE 9.—NON-CONTROLLED EARLY AMORTIZATION PROVISIONS

Uncommitted Committed 

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

133.33% of trapping point or more, 0% CF.

less than 133.33% to 100% of trapping point, 5% CF.

less than 100% to 75% of trapping point, 15% CF.

less than 75% to 50% of trapping point, 50% CF.

less than 50% of trapping point, 100% CF.

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

(2) For a securitization for which all or 

substantially all of the underlying exposures 

are residential mortgage exposures, a [bank] 

may calculate the appropriate conversion 

factor using paragraph (c)(1) of this section or 

may use a conversion factor of 10 percent. If 

the [bank] chooses to use a conversion factor 

of 10 percent, it must use that conversion 

factor for all securitizations for which all or 

substantially all of the underlying exposures 

are residential mortgage exposures. 

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69426 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

Part VI. Risk-Weighted Assets for Equity 

Exposures 

Section 51. Introduction and Exposure 

Measurement 

(a) General. To calculate its risk-weighted 

asset amounts for equity exposures that are 

not equity exposures to investment funds, a 

[bank] may apply either the Simple Risk 

Weight Approach (SRWA) in section 52 of 

this appendix or, if it qualifies to do so, the 

Internal Models Approach (IMA) in section 

53 of this appendix. A [bank] must use the 

look-through approaches in section 54 of this 

appendix to calculate its risk-weighted asset 

amounts for equity exposures to investment 

funds. 

(b) Adjusted carrying value. For purposes 

of this part, the adjusted carrying value of an 

equity exposure is: 

(1) For the on-balance sheet component of 

an equity exposure, the [bank]’s carrying 

value of the exposure reduced by any 

unrealized gains on the exposure that are 

reflected in such carrying value but excluded 

from the [bank]’s tier 1 and tier 2 capital; and 

(2) For the off-balance sheet component of 

an equity exposure, the effective notional 

principal amount of the exposure, the size of 

which is equivalent to a hypothetical onbalance sheet position in the underlying 

equity instrument that would evidence the 

same change in fair value (measured in 

dollars) for a given small change in the price 

of the underlying equity instrument, minus 

the adjusted carrying value of the on-balance 

sheet component of the exposure as 

calculated in paragraph (b)(1) of this section. 

For unfunded equity commitments that are 

unconditional, the effective notional 

principal amount is the notional amount of 

the commitment. For unfunded equity 

commitments that are conditional, the 

effective notional principal amount is the 

[bank]’s best estimate of the amount that 

would be funded under economic downturn 

conditions. 

Section 52. Simple Risk Weight Approach 

(SRWA) 

(a) General. Under the SRWA, a [bank]’s 

aggregate risk-weighted asset amount for its 

equity exposures is equal to the sum of the 

risk-weighted asset amounts for each of the 

[bank]’s individual equity exposures (other 

than equity exposures to an investment fund) 

as determined in this section and the riskweighted asset amounts for each of the 

[bank]’s individual equity exposures to an 

investment fund as determined in section 54 

of this appendix. 

(b) SRWA computation for individual 

equity exposures. A [bank] must determine 

the risk-weighted asset amount for an 

individual equity exposure (other than an 

equity exposure to an investment fund) by 

multiplying the adjusted carrying value of 

the equity exposure or the effective portion 

and ineffective portion of a hedge pair (as 

defined in paragraph (c) of this section) by 

the lowest applicable risk weight in this 

paragraph (b). 

(1) 0 percent risk weight equity exposures. 

An equity exposure to an entity whose credit 

exposures are exempt from the 0.03 percent 

PD floor in paragraph (d)(2) of section 31 of 

this appendix is assigned a 0 percent risk 

weight. 

(2) 20 percent risk weight equity exposures. 

An equity exposure to a Federal Home Loan 

Bank or Farmer Mac is assigned a 20 percent 

risk weight. 

(3) 100 percent risk weight equity 

exposures. The following equity exposures 

are assigned a 100 percent risk weight: 

(i) Community development equity 

exposures. An equity exposure that qualifies 

as a community development investment 

under 12 U.S.C. 24 (Eleventh), excluding 

equity exposures to an unconsolidated small 

business investment company and equity 

exposures held through a consolidated small 

business investment company described in 

section 302 of the Small Business Investment 

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

(ii) Effective portion of hedge pairs. The 

effective portion of a hedge pair. 

(iii) Non-significant equity exposures. 

Equity exposures, excluding exposures to an 

investment firm that would meet the 

definition of a traditional securitization were 

it not for the [AGENCY]’s application of 

paragraph (8) of that definition and has 

greater than immaterial leverage, to the 

extent that the aggregate adjusted carrying 

value of the exposures does not exceed 10 

percent of the [bank]’s tier 1 capital plus tier 

2 capital. 

(A) To compute the aggregate adjusted 

carrying value of a [bank]’s equity exposures 

for purposes of this paragraph (b)(3)(iii), the 

[bank] may exclude equity exposures 

described in paragraphs (b)(1), (b)(2), (b)(3)(i), 

and (b)(3)(ii) of this section, the equity 

exposure in a hedge pair with the smaller 

adjusted carrying value, and a proportion of 

each equity exposure to an investment fund 

equal to the proportion of the assets of the 

investment fund that are not equity 

exposures or that meet the criterion of 

paragraph (b)(3)(i) of this section. If a [bank] 

does not know the actual holdings of the 

investment fund, the [bank] may calculate 

the proportion of the assets of the fund that 

are not equity exposures based on the terms 

of the prospectus, partnership agreement, or 

similar contract that defines the fund’s 

permissible investments. If the sum of the 

investment limits for all exposure classes 

within the fund exceeds 100 percent, the 

[bank] must assume for purposes of this 

paragraph (b)(3)(iii) that the investment fund 

invests to the maximum extent possible in 

equity exposures. 

(B) When determining which of a [bank]’s 

equity exposures qualify for a 100 percent 

risk weight under this paragraph, a [bank] 

first must include equity exposures to 

unconsolidated small business investment 

companies or held through consolidated 

small business investment companies 

described in section 302 of the Small 

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

682), then must include publicly traded 

equity exposures (including those held 

indirectly through investment funds), and 

then must include non-publicly traded equity 

exposures (including those held indirectly 

through investment funds). 

(4) 300 percent risk weight equity 

exposures. A publicly traded equity exposure 

(other than an equity exposure described in 

paragraph (b)(6) of this section and including 

the ineffective portion of a hedge pair) is 

assigned a 300 percent risk weight. 

(5) 400 percent risk weight equity 

exposures. An equity exposure (other than an 

equity exposure described in paragraph (b)(6) 

of this section) that is not publicly traded is 

assigned a 400 percent risk weight. 

(6) 600 percent risk weight equity 

exposures. An equity exposure to an 

investment firm that: 

(i) Would meet the definition of a 

traditional securitization were it not for the 

[AGENCY]’s application of paragraph (8) of 

that definition; and 

(ii) Has greater than immaterial leverage is 

assigned a 600 percent risk weight. 

(c) Hedge transactions—(1) Hedge pair. A 

hedge pair is two equity exposures that form 

an effective hedge so long as each equity 

exposure is publicly traded or has a return 

that is primarily based on a publicly traded 

equity exposure. 

(2) Effective hedge. Two equity exposures 

form an effective hedge if the exposures 

either have the same remaining maturity or 

each has a remaining maturity of at least 

three months; the hedge relationship is 

formally documented in a prospective 

manner (that is, before the [bank] acquires at 

least one of the equity exposures); the 

documentation specifies the measure of 

effectiveness (E) the [bank] will use for the 

hedge relationship throughout the life of the 

transaction; and the hedge relationship has 

an E greater than or equal to 0.8. A [bank] 

must measure E at least quarterly and must 

use one of three alternative measures of E: 

(i) Under the dollar-offset method of 

measuring effectiveness, the [bank] must 

determine the ratio of value change (RVC). 

The RVC is the ratio of the cumulative sum 

of the periodic changes in value of one equity 

exposure to the cumulative sum of the 

periodic changes in the value of the other 

equity exposure. If RVC is positive, the hedge 

is not effective and E equals 0. If RVC is 

negative and greater than or equal to ¥1 (that 

is, between zero and ¥1), then E equals the 

absolute value of RVC. If RVC is negative and 

less than ¥1, then E equals 2 plus RVC. 

(ii) Under the variability-reduction method 

of measuring effectiveness: 

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(A) Xt = At ¥ Bt; 

(B) At = the value at time t of one exposure 

in a hedge pair; and 

(C) Bt = the value at time t of the other 

exposure in a hedge pair. 

(iii) Under the regression method of 

measuring effectiveness, E equals the 

coefficient of determination of a regression in 

which the change in value of one exposure 

in a hedge pair is the dependent variable and 

the change in value of the other exposure in 

a hedge pair is the independent variable. 

However, if the estimated regression 

coefficient is positive, then the value of E is 

zero. 

(3) The effective portion of a hedge pair is 

E multiplied by the greater of the adjusted 

carrying values of the equity exposures 

forming a hedge pair. 

(4) The ineffective portion of a hedge pair 

is (1–E) multiplied by the greater of the 

adjusted carrying values of the equity 

exposures forming a hedge pair. 

Section 53. Internal Models Approach (IMA) 

(a) General. A [bank] may calculate its riskweighted asset amount for equity exposures 

using the IMA by modeling publicly traded 

and non-publicly traded equity exposures (in 

accordance with paragraph (c) of this section) 

or by modeling only publicly traded equity 

exposures (in accordance with paragraph (d) 

of this section). 

(b) Qualifying criteria. To qualify to use the 

IMA to calculate risk-based capital 

requirements for equity exposures, a [bank] 

must receive prior written approval from the 

[AGENCY]. To receive such approval, the 

[bank] must demonstrate to the [AGENCY]’s 

satisfaction that the [bank] meets the 

following criteria: 

(1) The [bank] must have one or more 

models that: 

(i) Assess the potential decline in value of 

its modeled equity exposures; 

(ii) Are commensurate with the size, 

complexity, and composition of the [bank]’s 

modeled equity exposures; and 

(iii) Adequately capture both general 

market risk and idiosyncratic risk. 

(2) The [bank]’s model must produce an 

estimate of potential losses for its modeled 

equity exposures that is no less than the 

estimate of potential losses produced by a 

VaR methodology employing a 99.0 percent, 

one-tailed confidence interval of the 

distribution of quarterly returns for a 

benchmark portfolio of equity exposures 

comparable to the [bank]’s modeled equity 

exposures using a long-term sample period. 

(3) The number of risk factors and 

exposures in the sample and the data period 

used for quantification in the [bank]’s model 

and benchmarking exercise must be 

sufficient to provide confidence in the 

accuracy and robustness of the [bank]’s 

estimates. 

(4) The [bank]’s model and benchmarking 

process must incorporate data that are 

relevant in representing the risk profile of the 

[bank]’s modeled equity exposures, and must 

include data from at least one equity market 

cycle containing adverse market movements 

relevant to the risk profile of the [bank]’s 

modeled equity exposures. In addition, the 

[bank]’s benchmarking exercise must be 

based on daily market prices for the 

benchmark portfolio. If the [bank]’s model 

uses a scenario methodology, the [bank] must 

demonstrate that the model produces a 

conservative estimate of potential losses on 

the [bank]’s modeled equity exposures over 

a relevant long-term market cycle. If the 

[bank] employs risk factor models, the [bank] 

must demonstrate through empirical analysis 

the appropriateness of the risk factors used. 

(5) The [bank] must be able to demonstrate, 

using theoretical arguments and empirical 

evidence, that any proxies used in the 

modeling process are comparable to the 

[bank]’s modeled equity exposures and that 

the [bank] has made appropriate adjustments 

for differences. The [bank] must derive any 

proxies for its modeled equity exposures and 

benchmark portfolio using historical market 

data that are relevant to the [bank]’s modeled 

equity exposures and benchmark portfolio 

(or, where not, must use appropriately 

adjusted data), and such proxies must be 

robust estimates of the risk of the [bank]’s 

modeled equity exposures. 

(c) Risk-weighted assets calculation for a 

[bank] modeling publicly traded and nonpublicly traded equity exposures. If a [bank] 

models publicly traded and non-publicly 

traded equity exposures, the [bank]’s 

aggregate risk-weighted asset amount for its 

equity exposures is equal to the sum of: 

(1) The risk-weighted asset amount of each 

equity exposure that qualifies for a 0 percent, 

20 percent, or 100 percent risk weight under 

paragraphs (b)(1) through (b)(3)(i) of section 

52 (as determined under section 52 of this 

appendix) and each equity exposure to an 

investment fund (as determined under 

section 54 of this appendix); and 

(2) The greater of: 

(i) The estimate of potential losses on the 

[bank]’s equity exposures (other than equity 

exposures referenced in paragraph (c)(1) of 

this section) generated by the [bank]’s 

internal equity exposure model multiplied by 

12.5; or 

(ii) The sum of: 

(A) 200 percent multiplied by the aggregate 

adjusted carrying value of the [bank]’s 

publicly traded equity exposures that do not 

belong to a hedge pair, do not qualify for a 

0 percent, 20 percent, or 100 percent risk 

weight under paragraphs (b)(1) through 

(b)(3)(i) of section 52 of this appendix, and 

are not equity exposures to an investment 

fund; 

(B) 200 percent multiplied by the aggregate 

ineffective portion of all hedge pairs; and 

(C) 300 percent multiplied by the aggregate 

adjusted carrying value of the [bank]’s equity 

exposures that are not publicly traded, do not 

qualify for a 0 percent, 20 percent, or 100 

percent risk weight under paragraphs (b)(1) 

through (b)(3)(i) of section 52 of this 

appendix, and are not equity exposures to an 

investment fund. 

(d) Risk-weighted assets calculation for a 

[bank] using the IMA only for publicly traded 

equity exposures. If a [bank] models only 

publicly traded equity exposures, the [bank]’s 

aggregate risk-weighted asset amount for its 

equity exposures is equal to the sum of: 

(1) The risk-weighted asset amount of each 

equity exposure that qualifies for a 0 percent, 

20 percent, or 100 percent risk weight under 

paragraphs (b)(1) through (b)(3)(i) of section 

52 (as determined under section 52 of this 

appendix), each equity exposure that 

qualifies for a 400 percent risk weight under 

paragraph (b)(5) of section 52 or a 600 

percent risk weight under paragraph (b)(6) of 

section 52 (as determined under section 52 

of this appendix), and each equity exposure 

to an investment fund (as determined under 

section 54 of this appendix); and 

(2) The greater of: 

(i) The estimate of potential losses on the 

[bank]’s equity exposures (other than equity 

exposures referenced in paragraph (d)(1) of 

this section) generated by the [bank]’s 

internal equity exposure model multiplied by 

12.5; or 

(ii) The sum of: 

(A) 200 percent multiplied by the aggregate 

adjusted carrying value of the [bank]’s 

publicly traded equity exposures that do not 

belong to a hedge pair, do not qualify for a 

0 percent, 20 percent, or 100 percent risk 

weight under paragraphs (b)(1) through 

(b)(3)(i) of section 52 of this appendix, and 

are not equity exposures to an investment 

fund; and 

(B) 200 percent multiplied by the aggregate 

ineffective portion of all hedge pairs. 

Section 54. Equity Exposures to Investment 

Funds 

(a) Available approaches. (1) Unless the 

exposure meets the requirements for a 

community development equity exposure in 

paragraph (b)(3)(i) of section 52 of this 

appendix, a [bank] must determine the riskweighted asset amount of an equity exposure 

to an investment fund under the Full LookThrough Approach in paragraph (b) of this 

section, the Simple Modified Look-Through 

Approach in paragraph (c) of this section, the 

Alternative Modified Look-Through 

Approach in paragraph (d) of this section, or, 

if the investment fund qualifies for the 

Money Market Fund Approach, the Money 

Market Fund Approach in paragraph (e) of 

this section. 

(2) The risk-weighted asset amount of an 

equity exposure to an investment fund that 


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69428 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

meets the requirements for a community 

development equity exposure in paragraph 

(b)(3)(i) of section 52 of this appendix is its 

adjusted carrying value. 

(3) If an equity exposure to an investment 

fund is part of a hedge pair and the [bank] 

does not use the Full Look-Through 

Approach, the [bank] may use the ineffective 

portion of the hedge pair as determined 

under paragraph (c) of section 52 of this 

appendix as the adjusted carrying value for 

the equity exposure to the investment fund. 

The risk-weighted asset amount of the 

effective portion of the hedge pair is equal to 

its adjusted carrying value. 

(b) Full Look-Through Approach. A [bank] 

that is able to calculate a risk-weighted asset 

amount for its proportional ownership share 

of each exposure held by the investment fund 

(as calculated under this appendix as if the 

proportional ownership share of each 

exposure were held directly by the [bank]) 

may either: 

(1) Set the risk-weighted asset amount of 

the [bank]’s exposure to the fund equal to the 

product of: 

(i) The aggregate risk-weighted asset 

amounts of the exposures held by the fund 

as if they were held directly by the [bank]; 

and 

(ii) The [bank]’s proportional ownership 

share of the fund; or 

(2) Include the [bank]’s proportional 

ownership share of each exposure held by 

the fund in the [bank]’s IMA. 

(c) Simple Modified Look-Through 

Approach. Under this approach, the riskweighted asset amount for a [bank]’s equity 

exposure to an investment fund equals the 

adjusted carrying value of the equity 

exposure multiplied by the highest risk 

weight in Table 10 that applies to any 

exposure the fund is permitted to hold under 

its prospectus, partnership agreement, or 

similar contract that defines the fund’s 

permissible investments (excluding 

derivative contracts that are used for hedging 

rather than speculative purposes and that do 

not constitute a material portion of the fund’s 

exposures). 

TABLE 10.—MODIFIED LOOK-THROUGH APPROACHES FOR EQUITY EXPOSURES TO INVESTMENT FUNDS

Risk weight Exposure class 

0 percent ........................... Sovereign exposures with a long-term applicable external rating in the highest investment-grade rating category and 

sovereign exposures of the United States. 

20 percent ......................... Non-sovereign exposures with a long-term applicable external rating in the highest or second-highest investmentgrade rating category; exposures with a short-term applicable external rating in the highest investment-grade rating category; and exposures to, or guaranteed by, depository institutions, foreign banks (as defined in 12 CFR 

211.2), or securities firms subject to consolidated supervision and regulation comparable to that imposed on U.S. 

securities broker-dealers that are repo-style transactions or bankers’ acceptances. 

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

short-term applicable external rating in the second-highest investment-grade rating category. 

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

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

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

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

more below investment grade; and exposures without an external rating (excluding publicly traded equity exposures). 

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

greater than 400 percent under this appendix. 

(d) Alternative Modified Look-Through 

Approach. Under this approach, a [bank] 

may assign the adjusted carrying value of an 

equity exposure to an investment fund on a 

pro rata basis to different risk weight 

categories in Table 10 based on the 

investment limits in the fund’s prospectus, 

partnership agreement, or similar contract 

that defines the fund’s permissible 

investments. The risk-weighted asset amount 

for the [bank]’s equity exposure to the 

investment fund equals the sum of each 

portion of the adjusted carrying value 

assigned to an exposure class multiplied by 

the applicable risk weight. If the sum of the 

investment limits for exposure classes within 

the fund exceeds 100 percent, the [bank] 

must assume that the fund invests to the 

maximum extent permitted under its 

investment limits in the exposure class with 

the highest risk weight under Table 10, and 

continues to make investments in order of 

the exposure class with the next highest risk 

weight under Table 10 until the maximum 

total investment level is reached. If more 

than one exposure class applies to an 

exposure, the [bank] must use the highest 

applicable risk weight. A [bank] may exclude 

derivative contracts held by the fund that are 

used for hedging rather than for speculative 

purposes and do not constitute a material 

portion of the fund’s exposures. 

(e) Money Market Fund Approach. The 

risk-weighted asset amount for a [bank]’s 

equity exposure to an investment fund that 

is a money market fund subject to 17 CFR 

270.2a–7 and that has an applicable external 

rating in the highest investment-grade rating 

category equals the adjusted carrying value of 

the equity exposure multiplied by 7 percent. 

Section 55. Equity Derivative Contracts 

Under the IMA, in addition to holding riskbased capital against an equity derivative 

contract under this part, a [bank] must hold 

risk-based capital against the counterparty 

credit risk in the equity derivative contract 

by also treating the equity derivative contract 

as a wholesale exposure and computing a 

supplemental risk-weighted asset amount for 

the contract under part IV. Under the SRWA, 

a [bank] may choose not to hold risk-based 

capital against the counterparty credit risk of 

equity derivative contracts, as long as it does 

so for all such contracts. Where the equity 

derivative contracts are subject to a qualified 

master netting agreement, a [bank] using the 

SRWA must either include all or exclude all 

of the contracts from any measure used to 

determine counterparty credit risk exposure. 

Part VII. Risk-Weighted Assets for 

Operational Risk 

Section 61. Qualification Requirements for 

Incorporation of Operational Risk Mitigants 

(a) Qualification to use operational risk 

mitigants. A [bank] may adjust its estimate of 

operational risk exposure to reflect qualifying 

operational risk mitigants if: 

(1) The [bank]’s operational risk 

quantification system is able to generate an 

estimate of the [bank]’s operational risk 

exposure (which does not incorporate 

qualifying operational risk mitigants) and an 

estimate of the [bank]’s operational risk 

exposure adjusted to incorporate qualifying 

operational risk mitigants; and 

(2) The [bank]’s methodology for 

incorporating the effects of insurance, if the 

[bank] uses insurance as an operational risk 

mitigant, captures through appropriate 

discounts to the amount of risk mitigation: 

(i) The residual term of the policy, where 

less than one year; 

(ii) The cancellation terms of the policy, 

where less than one year; 

(iii) The policy’s timeliness of payment; 

(iv) The uncertainty of payment by the 

provider of the policy; and 

(v) Mismatches in coverage between the 

policy and the hedged operational loss event. 

(b) Qualifying operational risk mitigants. 

Qualifying operational risk mitigants are: 

(1) Insurance that: 

(i) Is provided by an unaffiliated company 

that has a claims payment ability that is rated 

in one of the three highest rating categories 

by a NRSRO; 

(ii) Has an initial term of at least one year 

and a residual term of more than 90 days; 

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Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 69429 

4Other public disclosure requirements continue 

to apply—for example, Federal securities law and 

regulatory reporting requirements. 

(iii) Has a minimum notice period for 

cancellation by the provider of 90 days; 

(iv) Has no exclusions or limitations based 

upon regulatory action or for the receiver or 

liquidator of a failed depository institution; 

and 

(v) Is explicitly mapped to a potential 

operational loss event; and 

(2) Operational risk mitigants other than 

insurance for which the [AGENCY] has given 

prior written approval. In evaluating an 

operational risk mitigant other than 

insurance, the [AGENCY] will consider 

whether the operational risk mitigant covers 

potential operational losses in a manner 

equivalent to holding regulatory capital. 

Section 62. Mechanics of Risk-Weighted 

Asset Calculation 

(a) If a [bank] does not qualify to use or 

does not have qualifying operational risk 

mitigants, the [bank]’s dollar risk-based 

capital requirement for operational risk is its 

operational risk exposure minus eligible 

operational risk offsets (if any). 

(b) If a [bank] qualifies to use operational 

risk mitigants and has qualifying operational 

risk mitigants, the [bank]’s dollar risk-based 

capital requirement for operational risk is the 

greater of: 

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

adjusted for qualifying operational risk 

mitigants minus eligible operational risk 

offsets (if any); or 

(2) 0.8 multiplied by the difference 

between: 

(i) The [bank]’s operational risk exposure; 

and 

(ii) Eligible operational risk offsets (if any). 

(c) The [bank]’s risk-weighted asset amount 

for operational risk equals the [bank]’s dollar 

risk-based capital requirement for operational 

risk determined under paragraph (a) or (b) of 

this section multiplied by 12.5. 

Part VIII. Disclosure 

Section 71. Disclosure Requirements 

(a) Each [bank] must publicly disclose each 

quarter its total and tier 1 risk-based capital 

ratios and their components (that is, tier 1 

capital, tier 2 capital, total qualifying capital, 

and total risk-weighted assets).4

[Disclosure paragraph (b)] 

[Disclosure paragraph 

(c)] 

END OF COMMON RULE 

[END OF COMMON TEXT] 

List of Subjects 

12 CFR Part 3 

Administrative practices and 

procedure, Capital, National banks, 

Reporting and recordkeeping 

requirements, Risk. 

12 CFR Part 208 

Confidential business information, 

Crime, Currency, Federal Reserve 

System, Mortgages, reporting and 

recordkeeping requirements, Securities. 

12 CFR Part 225 

Administrative practice and 

procedure, Banks, banking, Federal 

Reserve System, Holding companies, 

Reporting and recordkeeping 

requirements, Securities. 

12 CFR Part 325 

Administrative practice and 

procedure, Banks, banking, Capital 

Adequacy, Reporting and recordkeeping 

requirements, Savings associations, 

State nonmember banks. 

12 CFR Part 559 

Reporting and recordkeeping 

requirements, Savings associations, 

Subsidiaries. 

12 CFR Part 560 

Consumer protection, Investments, 

Manufactured homes, Mortgages, 

Reporting and recordkeeping 

requirements, Savings associations, 

Securities. 

12 CFR Part 563 

Accounting, Administrative practice 

and procedure, Advertising, Conflict of 

interest, Crime, Currency, Holding 

companies, Investments, Mortgages, 

Reporting and recordkeeping 

requirements, Savings associations, 

Securities, Surety bond. 

12 CFR Part 567 

Capital, Reporting and recordkeeping 

requirements, Savings associations. 

Adoption of Common Appendix 

■ The adoption of the final common 

rules by the agencies, as modified by 

agency-specific text, is set forth below: 

DEPARTMENT OF THE TREASURY 

Office of the Comptroller of the 

Currency 

12 CFR Chapter I 

Authority and Issuance 

For the reasons stated in the common 

preamble, the Office of the Comptroller 

of the Currency amends part 3 of 

chapter I of Title 12, Code of Federal 

Regulations as follows: 

PART 3—MINIMUM CAPITAL RATIOS; 

ISSUANCE OF DIRECTIVES 

■ 1. The authority citation for part 3 

continues to read as follows: 

Authority: 12 U.S.C. 93a, 161, 1818, 

1828(n), 1828 note, 1831n note, 1835, 3907, 

and 3909. 

■ 2. New Appendix C to part 3 is added 

as set forth at the end of the common 

preamble. 

■ 3. Appendix C to part 3 is amended 

as set forth below: 

■ a. Remove ‘‘[AGENCY]’’ and add 

‘‘OCC’’ in its place wherever it appears. 

■ b. Remove ‘‘[bank]’’ and add ‘‘bank’’

in its place wherever it appears, remove 

‘‘[banks]’’ and add ‘‘banks’’ in its place 

wherever it appears, remove ‘‘[Banks]’’

and add ‘‘Banks’’ in its place wherever 

it appears, and remove ‘‘[Bank]’’ and 

add ‘‘Bank’’ in its place wherever it 

appears. 

■ c. Remove ‘‘[Appendixl to Part l]’’

and add ‘‘Appendix C to Part 3’’ in its 

place wherever it appears. 

■ d. Remove ‘‘[the general risk-based 

capital rules]’’ and add ‘‘12 CFR part 3, 

Appendix A’’ in its place wherever it 

appears. 

■ e. Remove ‘‘[the market risk rule]’’ and 

add ‘‘12 CFR part 3, Appendix B’’ in its 

place wherever it appears. 

■ f. In section 1, revise paragraph 

(b)(1)(i), the last sentence in paragraph 

(b)(3), and the last sentence in 

paragraph (c)(1) to read as follows: 

Section 1. Purpose, Applicability, 

Reservation of Authority, and Principle 

of Conservatism 

* * * * * 

(b) Applicability. (1) * * * 

(i) Has consolidated assets, as 

reported on the most recent year-end 

Consolidated Report of Condition and 

Income (Call Report) equal to $250 

billion or more; * * * 

(3) * * * In making a determination 

under this paragraph, the OCC will 

apply notice and response procedures in 

the same manner and to the same extent 

as the notice and response procedures 

in 12 CFR 3.12. 

(c) Reservation of authority—(1) 

* * * In making a determination under 

this paragraph, the OCC will apply 

notice and response procedures in the 

same manner and to the same extent as 

the notice and response procedures in 

12 CFR 3.12. 

* * * * * 

■ g. In section 2, revise the definition of 

excluded mortgage exposure, the 

definition of gain-on-sale, and 

paragraph (2)(i) of the definition of high 

volatility commercial real estate 

(HVCRE) exposure to read as follows: 

Section 2. Definitions 

* * * * * 

Excluded mortgage exposure means 

any one- to four-family residential presold construction loan for a residence 

for which the purchase contract is 

cancelled that would receive a 100 

percent risk weight under section 

618(a)(2) of the Resolution Trust 

Corporation Refinancing, Restructuring, 

and Improvement Act and under and 12 

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69430 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

CFR part 3, Appendix A, section 

3(a)(3)(iii). 

* * * * * 

Gain-on-sale means an increase in the 

equity capital (as reported on Schedule 

RC of the Call Report) of a bank that 

results from a securitization (other than 

an increase in equity capital that results 

from the bank’s receipt of cash in 

connection with the securitization). 

* * * * * 

High volatility commercial real estate 

(HVCRE) exposure * * * 

(2) * * * 

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

or equal to the applicable maximum 

supervisory loan-to-value ratio in the 

OCC’s real estate lending standards at 

12 CFR part 34, Subpart D; 

* * * * * 

■ h. Revise section 12 to read as follows: 

Section 12. Deductions and Limitations 

Not Required 

(a) Deduction of CEIOs. A bank is not 

required to make the deductions from 

capital for CEIOs in 12 CFR part 3, 

Appendix A, section 2(c). 

(b) Deduction of certain equity 

investments. A bank is not required to 

make the deductions from capital for 

nonfinancial equity investments in 12 

CFR part 3, Appendix A, section 2(c). 

* * * * * 

■ i. Revise the first sentence of 

paragraph (k)(1)(iv) and paragraph (k)(4) 

of section 42 to read as follows: 

Section 42. Risk-Based Capital 

Requirement for Securitization 

Exposures 

* * * * * 

(k) * * * 

(1) * * * 

(iv) The bank is well capitalized, as 

defined in the OCC’s prompt corrective 

action regulation at 12 CFR part 6. 

* * * 

* * * * * 

(4) The risk-based capital ratios of the 

bank must be calculated without regard 

to the capital treatment for transfers of 

small-business obligations with recourse 

specified in paragraph (k)(1) of this 

section as provided in 12 CFR part 3, 

Appendix A. 

* * * * * 

■ j. Remove ‘‘[Disclosure paragraph 

(b)]’’ and add in its place ‘‘(b) A bank 

must comply with paragraph (b) of 

section 71 of appendix G to the Federal 

Reserve Board’s Regulation Y (12 CFR 

part 225, appendix G) unless it is a 

consolidated subsidiary of a bank 

holding company or depository 

institution that is subject to these 

requirements.’’

■ k. Remove ‘‘[Disclosure paragraph 

(c)].’’

BOARD OF GOVERNORS OF THE 

FEDERAL RESERVE SYSTEM 

12 CFR Chapter II 

Authority and Issuance 

■ For the reasons stated in the common 

preamble, the Board of Governors of the 

Federal Reserve System amends parts 

208 and 225 of chapter II of title 12 of 

the Code of Federal Regulations as 

follows: 

PART 208—MEMBERSHIP OF STATE 

BANKING INSTITUTIONS IN THE 

FEDERAL RESERVE SYSTEM 

(REGULATION H) 

■ 1. The authority citation for part 208 

continues to read as follows: 

Authority: 12 U.S.C. 24, 36, 92a, 93a, 

248(a), 248(c), 321–338a, 371d, 461, 481–486, 

601, 611, 1814, 1816, 1818, 1820(d)(9), 

1823(j), 1828(o), 1831, 1831o, 1831p–1, 

1831r–1, 1835a, 1882, 2901–2907, 3105, 

3310, 3331–3351, and 3906–3909; 15 U.S.C. 

78b, 78l(b), 78l(g), 78l(i), 78o–4(c)(5), 78q, 

78q–1, and 78w, 6801, and 6805; 31 U.S.C. 

5318; 42 U.S.C. 4012a, 4104a, 4104b, 4106, 

and 4128. 

■ 2. New Appendix F to part 208 is 

added as set forth at the end of the 

common preamble. 

■ 3. Appendix F to part 208 is amended 

as set forth below: 

■ a. Remove ‘‘[AGENCY]’’ and add 

‘‘Federal Reserve’’ in its place wherever 

it appears. 

■ b. Remove ‘‘[bank]’’ and add ‘‘bank’’

in its place wherever it appears, remove 

‘‘[banks]’’ and add ‘‘banks’’ in its place 

wherever it appears, remove ‘‘[Banks]’’

and add ‘‘Banks’’ in its place wherever 

it appears, and remove ‘‘[Bank]’’ and 

add ‘‘Bank’’ in its place wherever it 

appears. 

■ c. Remove ‘‘[Appendix l to Part l]’’

and add ‘‘Appendix F to part 208’’ in its 

place wherever it appears. 

■ d. Remove ‘‘[the general risk-based 

capital rules]’’ and add ‘‘12 CFR part 

208, Appendix A’’ in its place wherever 

it appears. 

■ e. Remove ‘‘[the market risk rule]’’ and 

add ‘‘12 CFR part 208, Appendix E’’ in 

its place wherever it appears. 

■ f. In section 1, revise paragraph 

(b)(1)(i), the last sentence in paragraph 

(b)(3), and the last sentence in 

paragraph (c)(1) to read as follows: 

Section 1. Purpose, Applicability, 

Reservation of Authority, and Principle 

of Conservatism 

* * * * * 

(b) Applicability. (1) * * * 

(i) Has consolidated assets, as 

reported on the most recent year-end 

Consolidated Report of Condition and 

Income (Call Report) equal to $250 

billion or more; * * * 

(3) * * * In making a determination 

under this paragraph, the Federal 

Reserve will apply notice and response 

procedures in the same manner and to 

the same extent as the notice and 

response procedures in 12 CFR 263.202. 

(c) Reservation of authority—(1) 

* * * In making a determination under 

this paragraph, the Federal Reserve will 

apply notice and response procedures in 

the same manner and to the same extent 

as the notice and response procedures 

in 12 CFR 263.202. 

* * * * * 

■ g. In section 2, revise the definition of 

excluded mortgage exposure, the 

definition of gain-on-sale, and 

paragraph (2)(i) of the definition of high 

volatility commercial real estate 

(HVCRE) exposure to read as follows: 

Section 2. Definitions 

* * * * * 

Excluded mortgage exposure means 

any one- to four-family residential presold construction loan for a residence 

for which the purchase contract is 

cancelled that would receive a 100 

percent risk weight under section 

618(a)(2) of the Resolution Trust 

Corporation Refinancing, Restructuring, 

and Improvement Act and under and 12 

CFR part 208, Appendix A, section 

III.C.3. 

* * * * * 

Gain-on-sale means an increase in the 

equity capital (as reported on Schedule 

RC of the Call Report) of a bank that 

results from a securitization (other than 

an increase in equity capital that results 

from the bank’s receipt of cash in 

connection with the securitization). 

* * * * * 

High volatility commercial real estate 

(HVCRE) exposure * * * 

(2) * * * 

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

or equal to the applicable maximum 

supervisory loan-to-value ratio in the 

Federal Reserve’s real estate lending 

standards at 12 CFR part 208, Appendix 

C; 

* * * * * 

■ h. Revise section 12 to read as follows: 

Section 12. Deductions and Limitations 

Not Required 

(a) Deduction of CEIOs. A bank is not 

required to make the deductions from 

capital for CEIOs in 12 CFR part 208, 

Appendix A, section II.B.1.e. 

(b) Deduction of certain equity 

investments. A bank is not required to 

make the deductions from capital for 

nonfinancial equity investments in 12 

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Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 69431 

CFR part 208, Appendix A, section 

II.B.5. 

* * * * * 

■ i. Revise the first sentence of 

paragraph (k)(1)(iv) and paragraph (k)(4) 

of section 42 to read as follows: 

Section 42. Risk-Based Capital 

Requirement for Securitization 

Exposures 

* * * * * 

(k) * * * 

(1) * * * 

(iv) The bank is well capitalized, as 

defined in the Federal Reserve’s prompt 

corrective action regulation at 12 CFR 

part 208, Subpart D.* * * 

* * * * * 

(4) The risk-based capital ratios of the 

bank must be calculated without regard 

to the capital treatment for transfers of 

small-business obligations with recourse 

specified in paragraph (k)(1) of this 

section as provided in 12 CFR part 208, 

Appendix A. 

* * * * * 

■ j. Remove ‘‘[Disclosure paragraph 

(b)]’’ and add in its place ‘‘(b) A bank 

must comply with paragraph (b) of 

section 71 of appendix G to the Federal 

Reserve Board’s Regulation (12 CFR part 

225, appendix G) unless it is a 

consolidated subsidiary of a bank 

holding company or depository 

institution that is subject to these 

requirements.’’

■ k. Remove ‘‘[Disclosure paragraph 

(c)].’’

PART 225—BANK HOLDING 

COMPANIES AND CHANGE IN BANK 

CONTROL (REGULATION Y) 

■ 1. The authority citation for part 225 

continues to read as follows: 

Authority: 12 U.S.C. 1817(j)(13), 1818, 

1828(o), 1831i, 1831p–1, 1843(c)(8), 1844(b), 

1972(1), 3106, 3108, 3310, 3331–3351, 3907, 

and 3909; 15 U.S.C. 6801 and 6805. 

■ 2. New Appendix G to part 225 is 

added as set forth at the end of the 

common preamble. 

■ 3. Appendix G to part 225 is amended 

as set forth below: 

■ a. Remove ‘‘[AGENCY]’’ and add 

‘‘Federal Reserve’’ in its place wherever 

it appears. 

■ b. Remove ‘‘[bank]’’ and add in its 

place ‘‘bank holding company’’

wherever it appears, remove ‘‘[banks]’’

and add ‘‘bank holding companies’’ in 

its place wherever it appears, remove 

‘‘[Banks]’’ and add ‘‘Bank holding 

companies’’ in its place wherever it 

appears, and remove ‘‘[Bank]’’ and add 

‘‘Bank holding company’’ in its place 

wherever it appears. 

■ c. Remove ‘‘[Appendixlto Partl]’’

and add ‘‘Appendix G to Part 225’’ in its 

place wherever it appears. 

■ d. Remove ‘‘[the general risk-based 

capital rules]’’ and add ‘‘12 CFR part 

225, Appendix A’’ in its place wherever 

it appears. 

■ e. Remove ‘‘[the market risk rule]’’ and 

add ‘‘12 CFR part 225, Appendix E’’ in 

its place wherever it appears. 

■ f. In section 1, revise paragraph (b)(1), 

the last sentence in paragraph (b)(3), 

and the last sentence in paragraph (c)(1) 

to read as follows: 

Section 1. Purpose, Applicability, 

Reservation of Authority, and Principle 

of Conservatism 

* * * * * 

(b) * * * 

(1) This appendix applies to a bank 

holding company that: 

(i) Is not a consolidated subsidiary of 

another bank holding company that uses 

this appendix to calculate its risk-based 

capital requirements; and 

(ii) That: 

(A) Is a U.S.-based bank holding 

company that has total consolidated 

assets (excluding assets held by an 

insurance underwriting subsidiary), as 

reported on the most recent year-end FR 

Y–9C Report, equal to $250 billion or 

more; 

(B) Has consolidated total on-balance 

sheet foreign exposure at the most 

recent year-end equal to $10 billion or 

more (where total on-balance sheet 

foreign exposure equals total crossborder claims less claims with head 

office or guarantor located in another 

country plus redistributed guaranteed 

amounts to the country of head office or 

guarantor plus local country claims on 

local residents plus revaluation gains on 

foreign exchange and derivative 

products, calculated in accordance with 

the Federal Financial Institutions 

Examination Council (FFIEC) 009 

Country Exposure Report); or 

(C) Has a subsidiary depository 

institution that is required, or has 

elected, to use 12 CFR part 3, Appendix 

C, 12 CFR part 208, Appendix F, 12 CFR 

part 325, Appendix F, or 12 CFR part 

567, Appendix C to calculate its riskbased capital requirements. 

* * * * * 

(3) * * * In making a determination 

under this paragraph, the Federal 

Reserve will apply notice and response 

procedures in the same manner and to 

the same extent as the notice and 

response procedures in 12 CFR 263.202. 

(c) Reservation of authority—(1) 

* * * In making a determination under 

this paragraph, the Federal Reserve will 

apply notice and response procedures in 

the same manner and to the same extent 

as the notice and response procedures 

in 12 CFR 263.202. 

* * * * * 

■ g. In section 2, revise the definition of 

excluded mortgage exposure, the 

definition of gain-on-sale, and 

paragraph (2)(i) of the definition of high 

volatility commercial real estate 

(HVCRE) exposure to read as follows: 

Section 2. Definitions 

* * * * * 

Excluded mortgage exposure means 

any one- to four-family residential presold construction loan for a residence 

for which the purchase contract is 

cancelled that would receive a 100 

percent risk weight under section 

618(a)(2) of the Resolution Trust 

Corporation Refinancing, Restructuring, 

and Improvement Act and under 12 CFR 

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

* * * * * 

Gain-on-sale means an increase in the 

equity capital (as reported on Schedule 

HC of the FR Y–9C Report) of a bank 

holding company that results from a 

securitization (other than an increase in 

equity capital that results from the bank 

holding company’s receipt of cash in 

connection with the securitization). 

* * * * * 

High volatility commercial real estate 

(HVCRE) exposure * * * 

(2) * * * 

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

or equal to the applicable maximum 

supervisory loan-to-value ratio in the 

relevant agency’s real estate lending 

standards at 12 CFR part 34, Subpart D 

(OCC), 12 CFR part 208, Appendix C 

(Federal Reserve); 12 CFR part 365, 

Subpart D (FDIC); and 12 CFR 560.100–

560.101 (OTS). 

* * * * * 

■ h. Add a new paragraph (c)(8) to 

section 11 to read as follows: 

Section 11. Additional Deductions. 

* * * * * 

(c) * * * 

(8) A bank holding company must 

also deduct an amount equal to the 

minimum regulatory capital 

requirement established by the regulator 

of any insurance underwriting 

subsidiary of the holding company. For 

U.S.-based insurance underwriting 

subsidiaries, this amount generally 

would be 200 percent of the subsidiary’s 

Authorized Control Level as established 

by the appropriate state regulator of the 

insurance company. 

* * * * * 

■ i. Revise section 12 to read as follows: 

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5Alternatively, a bank holding company may 

provide the disclosures in more than one place, as 

some of them may be included in public financial 

reports (for example, in Management’s Discussion 

and Analysis included in SEC filings) or other 

regulatory reports. The bank holding company must 

provide a summary table on its public Web site that 

specifically indicates where all the disclosures may 

be found (for example, regulatory report schedules, 

page numbers in annual reports). 

6Entities include securities, insurance and other 

financial subsidiaries, commercial subsidiaries 

(where permitted), and significant minority equity 

investments in insurance, financial and commercial 

entities. 

Section 12. Deductions and Limitations 

Not Required. 

(a) Deduction of CEIOs. A bank 

holding company is not required to 

make the deductions from capital for 

CEIOs in 12 CFR part 225, Appendix A, 

section II.B.1.e. 

(b) Deduction for certain equity 

investments. A bank holding company 

is not required to make the deductions 

from capital for nonfinancial equity 

investments in 12 CFR part 225, 

Appendix A, section II.B.5. 

* * * * * 

■ j. Remove and reserve section 

22(h)(3)(ii). 

■ k. In section 31(e)(3)(i), remove ‘‘A 

[bank] may assign a risk-weighted asset 

amount of zero to cash owned and held 

in all offices of the [bank] or in transit 

and to gold bullion held in the [bank]’s 

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

vaults on an allocated basis, to the 

extent the gold bullion assets are offset 

by gold bullion liabilities’’ and add in 

its place ‘‘A bank holding company may 

assign a risk-weighted asset amount of 

zero to cash owned and held in all 

offices of subsidiary depository 

institutions or in transit and for gold 

bullion held in either a subsidiary 

depository institution’s own vaults, or 

held in another depository institution’s 

vaults on an allocated basis, to the 

extent the gold bullion assets are offset 

by gold bullion liabilities.’’

* * * * * 

■ l. Revise the first sentence of 

paragraph (k)(1)(iv) and revise 

paragraph (k)(4) of section 42 to read as 

follows: 

Section 42. Risk-Based Capital 

Requirement for Securitization 

Exposures 

* * * * * 

(k) * * * 

(1) * * * 

(iv) The bank holding company is 

well capitalized, as defined in the 

Federal Reserve’s prompt corrective 

action regulation at 12 CFR part 208, 

Subpart D.* * * 

* * * * * 

(4) The risk-based capital ratios of the 

bank holding company must be 

calculated without regard to the capital 

treatment for transfers of small-business 

obligations with recourse specified in 

paragraph (k)(1) of this section as 

provided in 12 CFR part 225, Appendix 

A. 

* * * * * 

■ m. In section 71, remove ‘‘[Disclosure 

paragraph (b)].’’

■ n. In section 71, remove ‘‘[Disclosure 

paragraph (c)].’’

■ o. In section 71, add new paragraph 

(b) and Tables 11.1 through 11.11 to 

read as follows: 

Section 71. Disclosure Requirements 

* * * * * 

(b)(1) Each consolidated bank holding 

company that is not a subsidiary of a 

non-U.S. banking organization that is 

subject to comparable public disclosure 

requirements in its home jurisdiction 

and has successfully completed its 

parallel run must provide timely public 

disclosures each calendar quarter of the 

information in tables 11.1–11.11 below. 

If a significant change occurs, such that 

the most recent reported amounts are no 

longer reflective of the bank holding 

company’s capital adequacy and risk 

profile, then a brief discussion of this 

change and its likely impact must be 

provided as soon as practicable 

thereafter. Qualitative disclosures that 

typically do not change each quarter (for 

example, a general summary of the bank 

holding company’s risk management 

objectives and policies, reporting 

system, and definitions) may be 

disclosed annually, provided any 

significant changes to these are 

disclosed in the interim. Management is 

encouraged to provide all of the 

disclosures required by this appendix in 

one place on the bank holding 

company’s public Web site.5 The bank 

holding company must make these 

disclosures publicly available for each 

of the last three years (that is, twelve 

quarters) or such shorter period since it 

began its first floor period. 

(2) Each bank holding company is 

required to have a formal disclosure 

policy approved by the board of 

directors that addresses its approach for 

determining the disclosures it makes. 

The policy must address the associated 

internal controls and disclosure controls 

and procedures. The board of directors 

and senior management are responsible 

for establishing and maintaining an 

effective internal control structure over 

financial reporting, including the 

disclosures required by this appendix, 

and must ensure that appropriate review 

of the disclosures takes place. One or 

more senior officers of the bank holding 

company must attest that the 

disclosures meet the requirements of 

this appendix. 

(3) If a bank holding company 

believes that disclosure of specific 

commercial or financial information 

would prejudice seriously its position 

by making public information that is 

either proprietary or confidential in 

nature, the bank holding company need 

not disclose those specific items, but 

must disclose more general information 

about the subject matter of the 

requirement, together with the fact that, 

and the reason why, the specific items 

of information have not been disclosed. 

TABLE 11.1.—SCOPE OF APPLICATION

Qualitative Disclosures ................... (a) The name of the top corporate entity in the group to which the appendix applies. 

(b) An outline of differences in the basis of consolidation for accounting and regulatory purposes, with a 

brief description of the entities 6 within the group that are fully consolidated; that are deconsolidated and 

deducted; for which the regulatory capital requirement is deducted; and that are neither consolidated nor 

deducted (for example, where the investment is risk-weighted). 

(c) Any restrictions, or other major impediments, on transfer of funds or regulatory capital within the group. 

Quantitative Disclosures ................. (d) The aggregate amount of surplus capital of insurance subsidiaries (whether deducted or subjected to 

an alternative method) included in the regulatory capital of the consolidated group. 

(e) The aggregate amount by which actual regulatory capital is less than the minimum regulatory capital 

requirement in all subsidiaries with regulatory capital requirements and the name(s) of the subsidiaries 

with such deficiencies. 

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7Representing 50 percent of the amount, if any, 

by which total expected credit losses as calculated 

within the IRB approach exceed eligible credit 

reserves, which must be deducted from tier 1 

capital. 

8 Including 50 percent of the amount, if any, by 

which total expected credit losses as calculated 

within the IRB approach exceed eligible credit 

reserves, which must be deducted from tier 2 

capital. 

9Risk-weighted assets determined under [the 

market risk rule] are to be disclosed only for the 

approaches used. 

10Total risk-weighted assets should also be 

disclosed. 

TABLE 11.2.—CAPITAL STRUCTURE

Qualitative Disclosures ................... (a) Summary information on the terms and conditions of the main features of all capital instruments, especially in the case of innovative, complex or hybrid capital instruments. 

Quantitative Disclosures ................. (b) The amount of tier 1 capital, with separate disclosure of: 

• Common stock/surplus; 

• Retained earnings; 

• Minority interests in the equity of subsidiaries; 

• Restricted core capital elements as defined in 12 CFR part 225, Appendix A; 

• Regulatory calculation differences deducted from tier 1 capital; 7 and 

• Other amounts deducted from tier 1 capital, including goodwill and certain intangibles. 

(c) The total amount of tier 2 capital. 

(d) Other deductions from capital. 8

(e) Total eligible capital. 

TABLE 11.3.—CAPITAL ADEQUACY

Qualitative disclosures .................... (a) A summary discussion of the bank holding company’s approach to assessing the adequacy of its capital to support current and future activities. 

Quantitative disclosures .................. (b) Risk-weighted assets for credit risk from: 

• Wholesale exposures; 

• Residential mortgage exposures; 

• Qualifying revolving exposures; 

• Other retail exposures; 

• Securitization exposures; 

• Equity exposures 

• Equity exposures subject to the simple risk weight approach; and 

• Equity exposures subject to the internal models approach. 

(c) Risk-weighted assets for market risk as calculated under [the market risk rule]: 9

• Standardized approach for specific risk; and 

• Internal models approach for specific risk. 

(d) Risk-weighted assets for operational risk. 

(e) Total and tier 1 risk-based capital ratios: 10

• For the top consolidated group; and 

• For each DI subsidiary. 

General Qualitative Disclosure 

Requirement 

For each separate risk area described 

in tables 11.4 through 11.11, the bank 

holding company must describe its risk 

management objectives and policies, 

including: 

• Strategies and processes; 

• The structure and organization of 

the relevant risk management function; 

• The scope and nature of risk 

reporting and/or measurement systems; 

• Policies for hedging and/or 

mitigating risk and strategies and 

processes for monitoring the continuing 

effectiveness of hedges/mitigants. 

TABLE 11.4.11—CREDIT RISK: GENERAL DISCLOSURES

Qualitative Disclosures ................... (a) The general qualitative disclosure requirement with respect to credit risk (excluding counterparty credit 

risk disclosed in accordance with Table 11.6), including: 

• Definitions of past due and impaired (for accounting purposes); 

• Description of approaches followed for allowances, including statistical methods used where applicable; and 

• Discussion of the bank holding company’s credit risk management policy. 

Quantitative Disclosures ................. (b) Total credit risk exposures and average credit risk exposures, after accounting offsets in accordance 

with GAAP,12 and without taking into account the effects of credit risk mitigation techniques (for example, collateral and netting), over the period broken down by major types of credit exposure.13

(c) Geographic 14 distribution of exposures, broken down in significant areas by major types of credit exposure. 

(d) Industry or counterparty type distribution of exposures, broken down by major types of credit exposure. 

(e) Remaining contractual maturity breakdown (for example, one year or less) of the whole portfolio, broken down by major types of credit exposure. 

(f) By major industry or counterparty type: 

• Amount of impaired loans; 

• Amount of past due loans; 15

• Allowances; and 

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11Table 4 does not include equity exposures. 12For example, FASB Interpretations 39 and 41. 13For example, bank holding companies could 

apply a breakdown similar to that used for 

accounting purposes. Such a breakdown might, for 

instance, be (a) loans, off-balance sheet 

commitments, and other non-derivative off-balance 

sheet exposures, (b) debt securities, and (c) OTC 

derivatives. 

14 Geographical areas may comprise individual 

countries, groups of countries, or regions within 

countries. A bank holding company might choose 

to define the geographical areas based on the way 

the company’s portfolio is geographically managed. 

The criteria used to allocate the loans to 

geographical areas must be specified. 

15A bank holding company is encouraged also to 

provide an analysis of the aging of past-due loans. 

16The portion of general allowance that is not 

allocated to a geographical area should be disclosed 

separately. 

17The reconciliation should include the 

following: A description of the allowance; the 

opening balance of the allowance; charge-offs taken 

against the allowance during the period; amounts 

provided (or reversed) for estimated probable loan 

losses during the period; any other adjustments (for 

example, exchange rate differences, business 

combinations, acquisitions and disposals of 

subsidiaries), including transfers between 

allowances; and the closing balance of the 

allowance. Charge-offs and recoveries that have 

been recorded directly to the income statement 

should be disclosed separately. 

18This disclosure does not require a detailed 

description of the model in full—it should provide 

the reader with a broad overview of the model 

approach, describing definitions of the variables 

and methods for estimating and validating those 

variables set out in the quantitative risk disclosures 

below. This should be done for each of the four 

category/subcategories. The bank holding company 

should disclose any significant differences in 

approach to estimating these variables within each 

category/subcategories. 

19The PD, LGD and EAD disclosures in Table 

11.5(c) should reflect the effects of collateral, 

qualifying master netting agreements, eligible 

guarantees and eligible credit derivatives as defined 

in part I. Disclosure of each PD grade should 

include the exposure-weighted average PD for each 

grade. Where a bank holding company aggregates 

PD grades for the purposes of disclosure, this 

should be a representative breakdown of the 

distribution of PD grades used for regulatory capital 

purposes. 

20Outstanding loans and EAD on undrawn 

commitments can be presented on a combined basis 

for these disclosures. 

21These disclosures are a way of further 

informing the reader about the reliability of the 

information provided in the ‘‘quantitative 

disclosures: risk assessment’’ over the long run. The 

disclosures are requirements from year-end 2010; in 

the meantime, early adoption is encouraged. The 

phased implementation is to allow a bank holding 

company sufficient time to build up a longer run 

of data that will make these disclosures meaningful. 

22This regulation is not prescriptive about the 

period used for this assessment. Upon 

implementation, it might be expected that a bank 

holding company would provide these disclosures 

for as long run of data as possible—for example, if 

a bank holding company has 10 years of data, it 

might choose to disclose the average default rates 

for each PD grade over that 10-year period. Annual 

amounts need not be disclosed. 

TABLE 11.4.11—CREDIT RISK: GENERAL DISCLOSURES—Continued 

• Charge-offs during the period. 

(g) Amount of impaired loans and, if available, the amount of past due loans broken down by significant 

geographic areas including, if practical, the amounts of allowances related to each geographical area.16

(h) Reconciliation of changes in the allowance for loan and lease losses.17

TABLE 11.5.—CREDIT RISK: DISCLOSURES FOR PORTFOLIOS SUBJECT TO IRB RISK-BASED CAPITAL FORMULAS

Qualitative disclosures .................... (a) Explanation and review of the: 

• Structure of internal rating systems and relation between internal and external ratings; 

• Use of risk parameter estimates other than for regulatory capital purposes; 

• Process for managing and recognizing credit risk mitigation (see table 11.7); and 

• Control mechanisms for the rating system, including discussion of independence, accountability, and 

rating systems review. 

(b) Description of the internal ratings process, provided separately for the following: 

• Wholesale category; 

• Retail subcategories; 

• Residential mortgage exposures; 

• Qualifying revolving exposures; and 

• Other retail exposures. 

For each category and subcategory the description should include: 

• The types of exposure included in the category/subcategories; and 

• The definitions, methods and data for estimation and validation of PD, LGD, and EAD, including assumptions employed in the derivation of these variables.18

Quantitative disclosures: Risk assessment.(c) For wholesale exposures, present the following information across a sufficient number of PD grades 

(including default) to allow for a meaningful differentiation of credit risk: 19

• Total EAD; 20

• Exposure-weighted average LGD (percentage); 

• Exposure-weighted average risk weight; and 

• Amount of undrawn commitments and exposure-weighted average EAD for wholesale exposures. 

For each retail subcategory, present the disclosures outlined above across a sufficient number of segments to allow for a meaningful differentiation of credit risk. 

Quantitative disclosures: Historical 

results.

(d) Actual losses in the preceding period for each category and subcategory and how this differs from past 

experience. A discussion of the factors that impacted the loss experience in the preceding period—for 

example, has the bank holding company experienced higher than average default rates, loss rates or 

EADs. 

(e) Bank holding company’s estimates compared against actual outcomes over a longer period.21 At a 

minimum, this should include information on estimates of losses against actual losses in the wholesale 

category and each retail subcategory over a period sufficient to allow for a meaningful assessment of 

the performance of the internal rating processes for each category/subcategory.22 Where appropriate, 

the bank holding company should further decompose this to provide analysis of PD, LGD, and EAD outcomes against estimates provided in the quantitative risk assessment disclosures above.23

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23A bank holding company should provide this 

further decomposition where it will allow users 

greater insight into the reliability of the estimates 

provided in the ‘‘quantitative disclosures: risk 

assessment.’’ In particular, it should provide this 

information where there are material differences 

between its estimates of PD, LGD or EAD compared 

to actual outcomes over the long run. The bank 

holding company should also provide explanations 

for such differences. 

24Net unsecured credit exposure is the credit 

exposure after considering the benefits from legally 

enforceable netting agreements and collateral 

arrangements, without taking into account haircuts 

for price volatility, liquidity, etc. 

25This may include interest rate derivative 

contracts, foreign exchange derivative contracts, 

equity derivative contracts, credit derivatives, 

commodity or other derivative contracts, repo-style 

transactions, and eligible margin loans. 

26At a minimum, a bank holding company must 

provide the disclosures in Table 11.7 in relation to 

credit risk mitigation that has been recognized for 

the purposes of reducing capital requirements 

under this appendix. Where relevant, bank holding 

companies are encouraged to give further 

information about mitigants that have not been 

recognized for that purpose. 

27Credit derivatives that are treated, for the 

purposes of this appendix, as synthetic 

securitization exposures should be excluded from 

the credit risk mitigation disclosures and included 

within those relating to securitization. 

28Counterparty credit risk-related exposures 

disclosed pursuant to Table 11.6 should be 

excluded from the credit risk mitigation disclosures 

in Table 11.7. 

TABLE 11.6.—GENERAL DISCLOSURE FOR COUNTERPARTY CREDIT RISK OF OTC DERIVATIVE CONTRACTS, REPO-STYLE

TRANSACTIONS, AND ELIGIBLE MARGIN LOANS

Qualitative Disclosures ................... (a) The general qualitative disclosure requirement with respect to OTC derivatives, eligible margin loans, 

and repo-style transactions, including: 

• Discussion of methodology used to assign economic capital and credit limits for counterparty credit 

exposures; 

• Discussion of policies for securing collateral, valuing and managing collateral, and establishing credit 

reserves; 

• Discussion of the primary types of collateral taken; 

• Discussion of policies with respect to wrong-way risk exposures; and 

• Discussion of the impact of the amount of collateral the bank holding company would have to provide 

if the bank holding company were to receive a credit rating downgrade. 

Quantitative Disclosures ................. (b) Gross positive fair value of contracts, netting benefits, netted current credit exposure, collateral held (including type, for example, cash, government securities), and net unsecured credit exposure.24 Also report measures for EAD used for regulatory capital for these transactions, the notional value of credit derivative hedges purchased for counterparty credit risk protection, and, for bank holding companies not 

using the internal models methodology in section 32(d) of this appendix, the distribution of current credit 

exposure by types of credit exposure.25

(c) Notional amount of purchased and sold credit derivatives, segregated between use for the bank holding 

company’s own credit portfolio and for its intermediation activities, including the distribution of the credit 

derivative products used, broken down further by protection bought and sold within each product group. 

(d) The estimate of alpha if the bank holding company has received supervisory approval to estimate 

alpha. 

TABLE 11.7.—CREDIT RISK MITIGATION 26 27 28

Qualitative Disclosures ................... (a) The general qualitative disclosure requirement with respect to credit risk mitigation including: 

• Policies and processes for, and an indication of the extent to which the bank holding company uses, 

on- and off-balance sheet netting; 

• Policies and processes for collateral valuation and management; 

• A description of the main types of collateral taken by the bank holding company; 

• The main types of guarantors/credit derivative counterparties and their creditworthiness; and 

• Information about (market or credit) risk concentrations within the mitigation taken. 

Quantitative Disclosures ................. (b) For each separately disclosed portfolio, the total exposure (after, where applicable, on-or off-balance 

sheet netting) that is covered by guarantees/credit derivatives. 

TABLE 11.8.—SECURITIZATION

Qualitative disclosures .................... (a) The general qualitative disclosure requirement with respect to securitization (including synthetics), including a discussion of: 

• The bank holding company’s objectives relating to securitization activity, including the extent to which 

these activities transfer credit risk of the underlying exposures away from the bank holding company 

to other entities; 

• The roles played by the bank holding company in the securitization process 29 and an indication of the 

extent of the bank holding company’s involvement in each of them; and 

• The regulatory capital approaches (for example, RBA, IAA and SFA) that the bank holding company 

follows for its securitization activities. 

(b) Summary of the bank holding company’s accounting policies for securitization activities, including: 

• Whether the transactions are treated as sales or financings; 

• Recognition of gain-on-sale; 

• Key assumptions for valuing retained interests, including any significant changes since the last reporting period and the impact of such changes; and 

• Treatment of synthetic securitizations. 

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29For example: originator, investor, servicer, 

provider of credit enhancement, sponsor of asset 

backed commercial paper facility, liquidity 

provider, or swap provider. 

30Underlying exposure types may include, for 

example, one- to four-family residential loans, 

home equity lines, credit card receivables, and auto 

loans. 

31Securitization transactions in which the 

originating bank holding company does not retain 

any securitization exposure should be shown 

separately but need only be reported for the year 

of inception. 

32Where relevant, a bank holding company is 

encouraged to differentiate between exposures 

resulting from activities in which they act only as 

sponsors, and exposures that result from all other 

bank holding company securitization activities. 

33For example, charge-offs/allowances (if the 

assets remain on the bank holding company’s 

balance sheet) or write-downs of I/O strips and 

other residual interests. 

34Unrealized gains (losses) recognized in the 

balance sheet but not through earnings. 

35Unrealized gains (losses) not recognized either 

in the balance sheet or through earnings. 

36This disclosure should include a breakdown of 

equities that are subject to the 0 percent, 20 percent, 

100 percent, 300 percent, 400 percent, and 600 

percent risk weights, as applicable. 

TABLE 11.8.—SECURITIZATION—Continued 

(c) Names of NRSROs used for securitizations and the types of securitization exposure for which each 

agency is used. 

Quantitative disclosures .................. (d) The total outstanding exposures securitized by the bank holding company in securitizations that meet 

the operational criteria in section 41 of this appendix (broken down into traditional/synthetic), by underlying exposure type.30 31 32

(e) For exposures securitized by the bank holding company in securitizations that meet the operational criteria in Section 41 of this appendix: 

• Amount of securitized assets that are impaired/past due; and 

• Losses recognized by the bank holding company during the current period 33 broken down by exposure type. 

(f) Aggregate amount of securitization exposures broken down by underlying exposure type. 

(g) Aggregate amount of securitization exposures and the associated IRB capital requirements for these 

exposures broken down into a meaningful number of risk weight bands. Exposures that have been deducted from capital should be disclosed separately by type of underlying asset. 

(h) For securitizations subject to the early amortization treatment, the following items by underlying asset 

type for securitized facilities: 

• The aggregate drawn exposures attributed to the seller’s and investors’ interests; and 

• The aggregate IRB capital charges incurred by the bank holding company against the investors’

shares of drawn balances and undrawn lines. 

(i) Summary of current year’s securitization activity, including the amount of exposures securitized (by exposure type), and recognized gain or loss on sale by asset type. 

TABLE 11.9.—OPERATIONAL RISK

Qualitative disclosures .................... (a) The general qualitative disclosure requirement for operational risk. 

(b) Description of the AMA, including a discussion of relevant internal and external factors considered in 

the bank holding company’s measurement approach. 

(c) A description of the use of insurance for the purpose of mitigating operational risk. 

TABLE 11.10.—EQUITIES NOT SUBJECT TO MARKET RISK RULE

Qualitative Disclosures ................... (a) The general qualitative disclosure requirement with respect to equity risk, including: 

• Differentiation between holdings on which capital gains are expected and those held for other objectives, including for relationship and strategic reasons; and 

• Discussion of important policies covering the valuation of and accounting for equity holdings in the 

banking book. This includes the accounting techniques and valuation methodologies used, including 

key assumptions and practices affecting valuation as well as significant changes in these practices. 

Quantitative Disclosures ................. (b) Value disclosed in the balance sheet of investments, as well as the fair value of those investments; for 

quoted securities, a comparison to publicly-quoted share values where the share price is materially different from fair value. 

(c) The types and nature of investments, including the amount that is: 

• Publicly traded; and 

• Non-publicly traded. 

(d) The cumulative realized gains (losses) arising from sales and liquidations in the reporting period. 

(e) • Total unrealized gains (losses) 34

• Total latent revaluation gains (losses) 35

• Any amounts of the above included in tier 1 and/or tier 2 capital. 

(f) Capital requirements broken down by appropriate equity groupings, consistent with the bank holding 

company’s methodology, as well as the aggregate amounts and the type of equity investments subject 

to any supervisory transition regarding regulatory capital requirements.36

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TABLE 11.11.—INTEREST RATE RISK FOR NON-TRADING ACTIVITIES

Qualitative disclosures .................... (a) The general qualitative disclosure requirement, including the nature of interest rate risk for non-trading 

activities and key assumptions, including assumptions regarding loan prepayments and behavior of nonmaturity deposits, and frequency of measurement of interest rate risk for non-trading activities. 

Quantitative disclosures .................. (b) The increase (decline) in earnings or economic value (or relevant measure used by management) for 

upward and downward rate shocks according to management’s method for measuring interest rate risk 

for non-trading activities, broken down by currency (as appropriate). 

* * * * * 

FEDERAL DEPOSIT INSURANCE 

CORPORATION 

12 CFR Chapter III 

Authority and Issuance 

■ For the reasons stated in the common 

preamble, the Federal Deposit Insurance 

Corporation amends part 325 of chapter 

III of title 12 of the Code of Federal 

Regulations as follows: 

PART 325—CAPITAL MAINTENANCE 

■ 1. The authority citation for part 325 

continues to read as follows: 

Authority: 12 U.S.C. 1815(a), 1815(b), 

1816, 1818(a), 1818(b), 1818(c), 1818(t), 

1819(Tenth), 1828(c), 1828(d), 1828(i), 

1828(n), 1828(o), 1831o, 1835, 3907, 3909, 

4808; Pub. L. 102–233, 105 Stat. 1761, 1789, 

1790 (12 U.S.C. 1831n note); Pub. L. 102–

242, 105 Stat. 2236, 2355, 2386 (12 U.S.C. 

1828 note). 

■ 2. New Appendix D to part 325 is 

added as set forth at the end of the 

common preamble. 

■ 3. Appendix D to part 325 is amended 

as set forth below: 

■ a. Remove ‘‘[AGENCY]’’ and add 

‘‘FDIC’’ in its place wherever it appears. 

■ b. Remove ‘‘[bank]’’ and add ‘‘bank’’

in its place wherever it appears, remove 

‘‘[banks]’’ and add ‘‘banks’’ in its place 

wherever it appears, remove ‘‘[Banks]’’

and add ‘‘Banks’’ in its place wherever 

it appears, and remove ‘‘[Bank]’’ and 

add ‘‘Bank’’ in its place wherever it 

appears. 

■ c. Remove ‘‘[Appendix l to Part l]’’

and add ‘‘Appendix D to Part 325’’ in its 

place wherever it appears. 

■ d. Remove ‘‘[the general risk-based 

capital rules]’’ and add ‘‘12 CFR part 

325, Appendix A’’ in its place wherever 

it appears. 

■ e. Remove ‘‘[the market risk rule]’’ and 

add ‘‘12 CFR part 325, Appendix C’’ in 

its place wherever it appears. 

■ f. In section 1, revise paragraph 

(b)(1)(i), the last sentence in paragraph 

(b)(3), and the last sentence in 

paragraph (c)(1) to read as follows: 

Section 1. Purpose, Applicability, 

Reservation of Authority, and Principle 

of Conservatism 

* * * * * 

(b) Applicability. (1) * * * 

(i) Has consolidated assets, as 

reported on the most recent year-end 

Consolidated Report of Condition and 

Income (Call Report) equal to $250 

billion or more; 

* * * * * 

(3) * * * In making a determination 

under this paragraph, the FDIC will 

apply notice and response procedures in 

the same manner and to the same extent 

as the notice and response procedures 

in 12 CFR 325.6(c). 

(c) Reservation of authority—(1) 

* * * In making a determination under 

this paragraph, the FDIC will apply 

notice and response procedures in the 

same manner and to the same extent as 

the notice and response procedures in 

12 CFR 325.6(c). 

* * * * * 

■ g. In section 2, revise the definition of 

excluded mortgage exposure, the 

definition of gain-on-sale, and 

paragraph (2)(i) of the definition of high 

volatility commercial real estate 

(HVCRE) exposure to read as follows: 

Section 2. Definitions 

* * * * * 

Excluded mortgage exposure means 

any one- to four-family residential presold construction loan for a residence 

for which the purchase contract is 

cancelled that would receive a 100 

percent risk weight under section 

618(a)(2) of the Resolution Trust 

Corporation Refinancing, Restructuring, 

and Improvement Act and under 12 CFR 

part 325, Appendix A, section II.C. 

* * * * * 

Gain-on-sale means an increase in the 

equity capital (as reported on Schedule 

RC of the Call Report) of a bank that 

results from a securitization (other than 

an increase in equity capital that results 

from the bank’s receipt of cash in 

connection with the securitization). 

* * * * * 

High volatility commercial real estate 

(HVCRE) exposure * * * 

(2) * * * 

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

or equal to the applicable maximum 

supervisory loan-to-value ratio in the 

FDIC’s real estate lending standards at 

12 CFR part 365, Appendix A. 

* * * * * 

■ h. Revise section 12 to read as follows: 

Section 12. Deductions and Limitations 

Not Required 

(a) Deduction of CEIOs. A bank is not 

required to make the deductions from 

capital for CEIOs in 12 CFR part 325, 

Appendix A, section II.B.5. 

(b) Deduction for certain equity 

investments. A bank is not required to 

make the deductions from capital for 

nonfinancial equity investments in 12 

CFR part 325, Appendix A, section II.B. 

* * * * * 

■ i. Revise the first sentence of 

paragraph (k)(1)(iv) and paragraph (k)(4) 

of section 42 to read as follows: 

Section 42. Risk-Based Capital 

Requirement for Securitization 

Exposures 

* * * * * 

(k) * * * 

(1) * * * 

(iv) The bank is well capitalized, as 

defined in the FDIC ’s prompt corrective 

action regulation at 12 CFR part 325, 

Subpart B. For purposes of determining 

whether a bank is well capitalized for 

purposes of this paragraph, the bank’s 

capital ratios must be calculated 

without regard to the capital treatment 

for transfers of small-business 

obligations with recourse specified in 

paragraph (k)(1) of this section. * * * 

* * * * * 

(4) The risk-based capital ratios of the 

bank must be calculated without regard 

to the capital treatment for transfers of 

small-business obligations with recourse 

specified in paragraph (k)(1) of this 

section as provided in 12 CFR part 325, 

Appendix A. 

* * * * * 

■ j. Remove ‘‘[Disclosure paragraph 

(b)]’’ and add in its place ‘‘(b) A bank 

must comply with paragraph (b) of 

section 71 of appendix G to the Federal 

Reserve Board’s Regulation Y (12 CFR 

part 225, appendix G) unless it is a 

consolidated subsidiary of a bank 

holding company or depository 

institution that is subject to these 

requirements.’’

■ k. Remove ‘‘[Disclosure paragraph 

(c)].’’

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69438 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

DEPARTMENT OF THE TREASURY 

Office of Thrift Supervision 

12 CFR Chapter V 

Authority and Issuance 

■ For the reasons set out in the 

preamble, the Office of Thrift 

Supervision amends Chapter V of title 

12 of the Code of Federal Regulations to 

read as follows: 

PART 559—SUBORDINATE 

ORGANIZATIONS 

■ 1. The authority citation for part 559 

continues to read as follows: 

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

1464, 1467a, 1828. 

■ 2. Revise § 559.5(b)(1) to read as 

follows: 

§ 559.5 How much may a savings 

association invest in service corporations 

or lower tier entities? 

* * * * * 

(b) * * * 

(1) You and your GAAP-consolidated 

subsidiaries may, in the aggregate, make 

loans of up to 15% of your total capital, 

as described in part 567 of this chapter 

to each subordinate organization that 

does not qualify as a GAAPconsolidated subsidiary. All loans made 

under this paragraph (b)(1) may not, in 

the aggregate, exceed 50% of your total 

capital, as described in part 567 of this 

chapter. 

* * * * * 

PART 560—LENDING AND 

INVESTMENT 

■ 3. The authority citation for part 560 

continues to read as follows: 

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

1464, 1467a, 1701j–3, 1828, 3803, 3806, 42 

U.S.C. 4106. 

§ 560.101 [Amended] 

■ 4. In footnote 2 to the appendix to 

§ 560.101, remove the phrase ‘‘as 

defined at 12 CFR 567.5(c)’’ and add the 

phrase ‘‘as described in part 567 of this 

chapter’’ in its place. 

PART 563—SAVINGS 

ASSOCIATIONS—OPERATIONS 

■ 5. The authority citation for part 563 

continues to read as follows: 

Authority: 12 U.S.C. 375b, 1462, 1462a, 

1463, 1464, 1467a, 1468, 1817, 1820, 1828, 

1831o, 3806; 31 U.S.C. 5318; 42 U.S.C. 4106. 

§ 563.74 [Amended] 

■ 6. Amend § 563.74 as follows: 

■ a. In paragraph (i)(2)(iv), remove the 

phrase ‘‘regulatory capital requirement 

under § 567.2 of this chapter’’ and add 

the phrase ‘‘regulatory capital 

requirements under part 567 of this 

chapter’’ in its place. 

■ b. In paragraph (i)(2)(v) remove the 

phrase ‘‘regulatory capital requirement 

under § 567.2 of this chapter’’ and add 

the phrase ‘‘regulatory capital 

requirements under part 567 of this 

chapter’’ in its place. 

§ 563.81 [Amended] 

■ 7. Amend § 563.81 as follows: 

■ a. In paragraph (a), remove the phrase 

‘‘in supplementary capital under 12 CFR 

567.5(b)’’ and add the phrase ‘‘in 

supplementary capital (tier 2 capital) 

under part 567 of this chapter’’ in its 

place. 

■ b. In paragraph (d)(2)(ii), remove the 

phrase ‘‘regulatory capital requirements 

at § 567.2 of this chapter’’ and add the 

phrase ‘‘regulatory capital requirements 

at part 567 of this chapter’’ in its place. 

§ 563.141 [Amended] 

■ 8. In § 563.141(b), remove the phrase 

‘‘in your total capital under § 567.5 of 

this chapter’’ and add the phrase ‘‘in 

your total capital under part 567 of this 

chapter’’ in its place. 

§ 563.142 [Amended] 

■ 9. In § 563.142, amend the definition 

of ‘‘capital’’ by removing the phrase 

‘‘total capital, as described under 

§ 567.5(c) of this chapter’’ and adding 

the phrase ‘‘total capital, as computed 

under part 567 of this chapter’’ in its 

place. 

PART 567—CAPITAL 

■ 10. The authority citation for part 567 

continues to read as follows: 

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

1464, 1467a, 1828(note). 

■ 11. Add a new subpart A to read as 

follows: 

Subpart A—Scope 

§ 567.0 Scope. 

(a) This part prescribes the minimum 

regulatory capital requirements for 

savings associations. Subpart B of this 

part applies to all savings associations, 

except as described in paragraph (b) of 

this section. 

(b)(1) A savings association that uses 

Appendix C of this part must comply 

with the minimum qualifying criteria 

for internal risk measurement and 

management processes for calculating 

risk-based capital requirements, utilize 

the methodologies for calculating riskbased capital requirements, and make 

the required disclosures described in 

that appendix. 

(2) Subpart B of this part does not 

apply to the computation of risk-based 

capital requirements by a savings 

association that uses Appendix C of this 

part. However, these savings 

associations: 

(i) Must compute the components of 

capital under § 567.5, subject to the 

modifications in sections 11 and 12 of 

Appendix C of this part. 

(ii) Must meet the leverage ratio 

requirement at §§ 567.2(a)(2) and 567.8 

with tier 1 capital, as computed under 

sections 11 and 12 of Appendix C of this 

part. 

(iii) Must meet the tangible capital 

requirement described at §§ 567.2(a)(3) 

and 567.9. 

(iv) Are subject to §§ 567.3 (individual 

minimum capital requirement), 567.4 

(capital directives); and 567.10 

(consequences of failure to meet capital 

requirements). 

(v) Are subject to the reservations of 

authority at § 567.11, which supplement 

the reservations of authority at section 

1 of Appendix C of this part. 

■ 12. Designate §§ 567.1 through 567.6 

and §§ 567.8 through 567.12 as subpart 

B and add a heading for subpart B to 

read as follows: 

Subpart B—Regulatory Capital 

Requirements 

■ 13. Revise the introductory sentence 

to § 567.1 to read as follows: 

§ 567.1 Definitions. 

For the purposes of this subpart: 

* * * * * 

■ 14. In § 567.3, revise paragraphs (a), 

(b) introductory text, and (d)(1) to read 

as follows: 

§ 567.3 Individual minimum capital 

requirements. 

(a) Purpose and scope. The rules and 

procedures specified in this section 

apply to the establishment of an 

individual minimum capital 

requirement for a savings association 

that varies from the risk-based capital 

requirement, the leverage ratio 

requirement or the tangible capital 

requirement that would otherwise apply 

to the savings association under this 

part. 

(b) Appropriate considerations for 

establishing individual minimum 

capital requirements. Minimum capital 

levels higher than the risk-based capital 

requirement, the leverage ratio 

requirement or the tangible capital 

requirement required under this part 

may be appropriate for individual 

savings associations. Increased 

individual minimum capital 

requirements may be established upon a 

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Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 69439 

determination that the savings 

association’s capital is or may become 

inadequate in view of its circumstances. 

For example, higher capital levels may 

be appropriate for: 

* * * * * 

(d) Procedures—(1) Notification. 

When the OTS determines that a 

minimum capital requirement is 

necessary or appropriate for a particular 

savings association, it shall notify the 

savings association in writing of its 

proposed individual minimum capital 

requirement; the schedule for 

compliance with the new requirement; 

and the specific causes for determining 

that the higher individual minimum 

capital requirement is necessary or 

appropriate for the savings association. 

The OTS shall forward the notifying 

letter to the appropriate state supervisor 

if a state-chartered savings association 

would be subject to an individual 

minimum capital requirement. 

* * * * * 

■ 15. Revise paragraph (a)(1) 

introductory text of § 567.4 to read as 

follows: 

§ 567.4 Capital directives. 

(a) Issuance of a Capital Directive—(1) 

Purpose. In addition to any other action 

authorized by law, the Office, may issue 

a capital directive to a savings 

association that does not have an 

amount of capital satisfying its 

minimum capital requirement. Issuance 

of such a capital directive may be based 

on a savings association’s 

noncompliance with the risk-based 

capital requirement, the leverage ratio 

requirement, the tangible capital 

requirement, or individual minimum 

capital requirement established under 

this part, by a written agreement under 

12 U.S.C. 1464(s), or as a condition for 

approval of an application. A capital 

directive may order a savings 

association to: 

* * * * * 

■ 16. Revise paragraph (e) introductory 

text of § 567.10 to read as follows: 

§ 567.10 Consequences of failure to meet 

capital requirements. 

* * * * * 

(e) If a savings association fails to 

meet the risk-based capital requirement, 

the leverage ratio requirement, or the 

tangible capital requirement established 

under this part, the Director may, 

through enforcement proceedings or 

otherwise, require such savings 

association to take one or more of the 

following corrective actions: 

* * * * * 

■ 17. Appendices A and B are added to 

part 567, and are reserved. 

■ 18. Appendix C is added to part 567 

as set forth at the end of the common 

preamble. 

■ 19. Amend Appendix C of part 567 as 

follows: 

■ a. Revise the heading of Appendix C 

to read as follows: 

Risk-Based Capital Requirements—

Internal-Ratings-Based and Advanced 

Measurement Approaches 

■ b. Remove [AGENCY] and add ‘‘OTS’’

in its place wherever it appears. 

■ c. Remove ‘‘[bank]’’ and add ‘‘savings 

association’’ in its place wherever it 

appears, remove ‘‘[banks]’’ and add 

‘‘savings associations’’ in its place 

wherever it appears, remove ‘‘[Banks]’’

and add ‘‘Savings associations’’ in its 

place wherever it appears, and remove 

‘‘[Bank]’’ and add ‘‘Savings association’’

in its place wherever it appears. 

■ d. Remove ‘‘[Appendixlto Partl]’’

and add ‘‘Appendix C to Part 567’’ in its 

place wherever it appears. 

■ e. Remove ‘‘[the general risk-based 

capital rules]’’ and add ‘‘subpart B of 

part 567’’ in its place wherever it 

appears. 

■ f. Remove ‘‘[the market risk rule]’’ and 

add ‘‘any applicable market risk rule’’ in 

its place wherever it appears. 

■ g. In section 1, revise paragraph 

(b)(1)(i), the last sentence in paragraph 

(b)(3), and the last sentence in 

paragraph (c)(1) to read as follows: 

Section 1 Purpose, Applicability, 

Reservation of Authority, and Principle 

of Conservatism 

* * * * * 

(b) Applicability. (1) * * * 

(i) Has consolidated assets, as 

reported on the most recent year-end 

Thrift Financial Report (TFR) equal to 

$250 billion or more; 

* * * * * 

(3) * * * In making a determination 

under this paragraph, the OTS will 

apply notice and response procedures in 

the same manner and to the same extent 

as the notice and response procedures 

in § 567.3(d). 

(c) Reservation of authority—(1) 

* * * In making a determination under 

this paragraph, the OTS will apply 

notice and response procedures in the 

same manner and to the same extent as 

the notice and response procedures in 

§ 567.3(d). 

* * * * * 

■ h. In section 2, revise the definition of 

eligible credit reserves, the definition of 

excluded mortgage exposure, paragraph 

(1) of the definition of exposure at 

default (EAD), the definition of gain-onsale, paragraph (2)(i) of the definition of 

high volatility commercial real estate 

(HVCRE) exposure, and paragraph (7) of 

the definition of traditional 

securitization, to read as follows: 

Section 2 Definitions 

* * * * * 

Eligible credit reserves means all 

general allowances that have been 

established through a charge against 

earnings to absorb credit losses 

associated with on- or off-balance sheet 

wholesale and retail exposures, 

including the allowance for loan and 

lease losses (ALLL) associated with such 

exposures but excluding specific 

reserves created against recognized 

losses. 

* * * * * 

Excluded mortgage exposure means 

any one- to four-family residential presold construction loan for a residence 

for which the purchase contract is 

cancelled that would receive a 100 

percent risk weight under section 

618(a)(2) of the Resolution Trust 

Corporation Refinancing, Restructuring, 

and Improvement Act and under 12 CFR 

567.1 (definition of ‘‘qualifying 

residential construction loan’’) and 12 

CFR 567.6(a)(1)(iv). 

* * * * * 

Exposure at default (EAD). (1) For the 

on-balance sheet component of a 

wholesale exposure or segment of retail 

exposures (other than an OTC derivative 

contract, or a repo-style transaction, or 

eligible margin loan for which the 

savings association determines EAD 

under section 32 of this appendix), EAD 

means: 

(i) If the exposure or segment is a 

security classified as available-for-sale, 

the savings associations carrying value 

(including net accrued but unpaid 

interest and fees) for the exposure or 

segment less any unrealized gains on 

the exposure or segment and plus any 

unrealized losses on the exposure or 

segment; or 

(ii) If the exposure or segment is not 

a security classified as available-for-sale, 

the savings association’s carrying value 

(including net accrued but unpaid 

interest and fees) for the exposure or 

segment. 

* * * * * 

Gain-on-sale means an increase in the 

equity capital (as reported on Schedule 

SC of the Thrift Financial Report) of a 

savings association that results from a 

securitization (other than an increase in 

equity capital that results from the 

savings association’s receipt of cash in 

connection with the securitization). 

* * * * * 

High volatility commercial real estate 

(HVCRE) exposure * * * 

(2) * * * 

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69440 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

5Alternatively, a savings association may provide 

the disclosures in more than one place, as some of 

them may be included in public financial reports 

(for example, in Management’s Discussion and 

Analysis included in SEC filings) or other 

regulatory reports. The savings association must 

provide a summary table on its public Web site that 

specifically indicates where all the disclosures may 

be found (for example, regulatory report schedules, 

page numbers in annual reports). 

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

or equal to the applicable maximum 

supervisory loan-to-value ratio in the 

OTS’s real estate lending standards at 12 

CFR 560.100–560.101; 

* * * * * 

Traditional securitization * * * 

(7) The underlying exposures are not 

owned by a firm an investment in which 

is designed primarily to promote 

community welfare, including the 

welfare of low- and moderate-income 

communities or families, such as by 

providing services or jobs. 

* * * * * 

■ i. Revise section 12 to read as follows: 

Section 12 Deductions and limitations 

not required 

(a) Deduction of CEIOs. A savings 

association is not required to make the 

deduction from capital for CEIOs in 12 

CFR 567.5(a)(2)(iii) and 567.12(e). 

(b) Deduction for certain equity 

investments. A savings association is 

not required to deduct equity securities 

from capital under 12 CFR 

567.5(c)(2)(ii). However, it must 

continue to deduct equity investments 

in real estate under that section. See 12 

CFR 567.1, which defines equity 

investments, including equity securities 

and equity investments in real estate. 

■ j. Revise the fourth sentence of section 

24(a) to read as follows: 

Section 24 Merger and Acquisition 

Transition Arrangements 

(a) Mergers and acquisitions of 

companies without advanced systems. 

* * * During the period when subpart 

A of this part applies to the merged or 

acquired company, any ALLL associated 

with the merged or acquired company’s 

exposures may be included in the 

savings association’s tier 2 capital up to 

1.25 percent of the acquired company’s 

risk-weighted assets. * * * 

* * * * * 

■ k. Revise the first sentence of 

paragraph (k)(1)(iv) and paragraph (k)(4) 

of section 42 to read as follows: 

Section 42 Risk-Based Capital 

Requirement for Securitization 

Exposures 

* * * * * 

(k) * * * 

(1) * * * 

(iv) The savings association is well 

capitalized, as defined in the OTS’s 

prompt corrective action regulation at 

12 CFR part 565. * * * 

* * * * * 

(4) The risk-based capital ratios of the 

savings association must be calculated 

without regard to the capital treatment 

for transfers of small-business 

obligations with recourse specified in 

paragraph (k)(1) of this section as 

provided in 12 CFR 567.6(b)(5)(v). 

* * * * * 

■ l. Revise paragraph (b)(3)(i) of section 

52 to read as follows: 

Section 52 Simple Risk Weight 

Approach (SRWA) 

* * * * * 

(b) * * * 

(3) * * * 

(i) An equity exposure that is 

designed primarily to promote 

community welfare, including the 

welfare of low- and moderate-income 

communities or families, such as by 

providing services or jobs, excluding 

equity exposures to an unconsolidated 

small business investment company and 

equity exposures held through a 

consolidated small business investment 

company described in section 302 of the 

Small Business Investment Act of 1958 

(15 U.S.C. 682). 

* * * * * 

■ m. Remove ‘‘[Disclosure paragraph 

(b)]’’ and add in its place ‘‘(b) A savings 

association must comply with paragraph 

(c) of section 71 of this appendix unless 

it is a consolidated subsidiary of a 

depository institution or bank holding 

company that is subject to these 

requirements.’’

■ n. Remove ‘‘[Disclosure paragraph 

(c)].’’

■ o. In section 71, add new paragraph 

(c) and Tables 11.1 through 11.11 to 

read as follows: 

Section 71 Disclosure Requirements 

* * * * * 

(c)(1) Each consolidated savings 

association described in paragraph (b) of 

this section that is not a subsidiary of a 

non-U.S. banking organization that is 

subject to comparable public disclosure 

requirements in its home jurisdiction 

and has successfully completed its 

parallel run must provide timely public 

disclosures each calendar quarter of the 

information in tables 11.1–11.11 below. 

If a significant change occurs, such that 

the most recent reported amounts are no 

longer reflective of the savings 

association’s capital adequacy and risk 

profile, then a brief discussion of this 

change and its likely impact must be 

provided as soon as practicable 

thereafter. Qualitative disclosures that 

typically do not change each quarter (for 

example, a general summary of the 

savings association’s risk management 

objectives and policies, reporting 

system, and definitions) may be 

disclosed annually, provided any 

significant changes to these are 

disclosed in the interim. Management is 

encouraged to provide all of the 

disclosures required by this appendix in 

one place on the savings association’s 

public Web site.5 The savings 

association must make these disclosures 

publicly available for each of the last 

three years (twelve quarters) or such 

shorter period since it began its first 

floor period. 

(2) Each savings association is 

required to have a formal disclosure 

policy approved by the board of 

directors that addresses its approach for 

determining the disclosures it makes. 

The policy must address the associated 

internal controls and disclosure controls 

and procedures. The board of directors 

and senior management are responsible 

for establishing and maintaining an 

effective internal control structure over 

financial reporting, including the 

disclosures required by this appendix, 

and must ensure that appropriate review 

of the disclosures takes place. One or 

more senior officers of the savings 

association must attest that the 

disclosures required by this appendix 

meet the requirements of this appendix. 

(3) If a savings association believes 

that disclosure of specific commercial or 

financial information would prejudice 

seriously its position by making public 

information that is either proprietary or 

confidential in nature, the savings 

association need not disclose those 

specific items, but must disclose more 

general information about the subject 

matter of the requirement, together with 

the fact that, and the reason why, the 

specific items of information have not 

been disclosed. 

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Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 69441 

6Entities include securities, insurance and other 

financial subsidiaries, commercial subsidiaries 

(where permitted), and significant minority equity 

investments in insurance, financial and commercial 

entities. 

7Representing 50 percent of the amount, if any, 

by which total expected credit losses as calculated 

within the IRB approach exceed eligible credit 

reserves, which must be deducted from tier 1 

capital. 

8 Including 50 percent of the amount, if any, by 

which total expected credit losses as calculated 

within the IRB approach exceed eligible credit 

reserves, which must be deducted from tier 2 

capital. 

9Risk-weighted assets determined under [the 

market risk rule] are to be disclosed only for the 

approaches used. 

10Total risk-weighted assets should also be 

disclosed. 

TABLE 11.1.—SCOPE OF APPLICATION

Qualitative Disclosures ................... (a) The name of the top corporate entity in the group to which the appendix applies. 

(b) An outline of differences in the basis of consolidation for accounting and regulatory purposes, with a 

brief description of the entities6 within the group that are fully consolidated; that are deconsolidated and 

deducted; for which the regulatory capital requirement is deducted; and that are neither consolidated nor 

deducted (for example, where the investment is risk-weighted). 

(c) Any restrictions, or other major impediments, on transfer of funds or regulatory capital within the group. 

Quantitative Disclosures ................. (d) The aggregate amount of surplus capital of insurance subsidiaries (whether deducted or subjected to 

an alternative method) included in the regulatory capital of the consolidated group. 

(e) The aggregate amount by which actual regulatory capital is less than the minimum regulatory capital 

requirement in all subsidiaries with regulatory capital requirements and the name(s) of the subsidiaries 

with such deficiencies. 

TABLE 11.2.—CAPITAL STRUCTURE

Qualitative Disclosures ................... (a) Summary information on the terms and conditions of the main features of all capital instruments, especially in the case of innovative, complex or hybrid capital instruments. 

Quantitative Disclosures ................. (b) The amount of tier 1 capital, with separate disclosure of: 

• Common stock/surplus; 

• Retained earnings; 

• Minority interests in the equity of subsidiaries; 

• Regulatory calculation differences deducted from tier 1 capital;7 and 

• Other amounts deducted from tier 1 capital, including goodwill and certain intangibles. 

(c) The total amount of tier 2 capital. 

(d) Other deductions from capital.8

(e) Total eligible capital. 

TABLE 11.3.—CAPITAL ADEQUACY

Qualitative disclosures .................... (a) A summary discussion of the savings association’s approach to assessing the adequacy of its capital to 

support current and future activities. 

Quantitative disclosures .................. (b) Risk-weighted assets for credit risk from: 

• Wholesale exposures; 

• Residential mortgage exposures; 

• Qualifying revolving exposures; 

• Other retail exposures; 

• Securitization exposures; 

• Equity exposures 

• Equity exposures subject to the simple risk weight approach; and 

• Equity exposures subject to the internal models approach. 

(c) Risk-weighted assets for market risk as calculated under [the market risk rule]:9

• Standardized approach for specific risk; and 

• Internal models approach for specific risk. 

(d) Risk-weighted assets for operational risk. 

(e) Total and tier 1 risk-based capital ratios:10

• For the top consolidated group; and 

• For each DI subsidiary. 

General qualitative disclosure 

requirement 

For each separate risk area described 

in tables 11.4 through 11.11, the savings 

association must describe its risk 

management objectives and policies, 

including: 

• strategies and processes; 

• the structure and organization of 

the relevant risk management function; 

• the scope and nature of risk 

reporting and/or measurement systems; 

• policies for hedging and/or 

mitigating risk and strategies and 

processes for monitoring the continuing 

effectiveness of hedges/mitigants. 

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69442 Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 

11Table 4 does not include equity exposures. 12For example, FASB Interpretations 39 and 41. 13For example, savings associations could apply 

a breakdown similar to that used for accounting 

purposes. 

Such a breakdown might, for instance, be (a) 

loans, off-balance sheet commitments, and other 

non-derivative off-balance sheet exposures, (b) debt 

securities, and (c) OTC derivatives. 

14 Geographical areas may comprise individual 

countries, groups of countries, or regions within 

countries. 

A savings association might choose to define the 

geographical areas based on the way the company’s 

portfolio is geographically managed. The criteria 

used to allocate the loans to geographical areas 

must be specified. 

15A savings association is encouraged also to 

provide an analysis of the aging of past-due loans. 

16The portion of general allowance that is not 

allocated to a geographical area should be disclosed 

separately. 

17The reconciliation should include the 

following: a description of the allowance; the 

opening balance of the allowance; charge-offs taken 

against the allowance during the period; amounts 

provided (or reversed) for estimated probable loan 

losses during the period; any other adjustments (for 

example, exchange rate differences, business 

combinations, acquisitions and disposals of 

subsidiaries), including transfers between 

allowances; and the closing balance of the 

allowance. Charge-offs and recoveries that have 

been recorded directly to the income statement 

should be disclosed separately. 

TABLE 11.4.11—CREDIT RISK: GENERAL DISCLOSURES

Qualitative Disclosures ................... (a) The general qualitative disclosure requirement with respect to credit risk (excluding counterparty credit 

risk disclosed in accordance with Table 11.6), including: 

• Definitions of past due and impaired (for accounting purposes); 

• Description of approaches followed for allowances, including statistical methods used where applicable; and 

• Discussion of the savings association’s credit risk management policy. 

Quantitative Disclosures ................. (b) Total credit risk exposures and average credit risk exposures, after accounting offsets in accordance 

with GAAP,12 and without taking into account the effects of credit risk mitigation techniques (for example, collateral and netting), over the period broken down by major types of credit exposure.13

(c) Geographic14 distribution of exposures, broken down in significant areas by major types of credit exposure. 

(d) Industry or counterparty type distribution of exposures, broken down by major types of credit exposure. 

(e) Remaining contractual maturity breakdown (for example, one year or less) of the whole portfolio, broken down by major types of credit exposure. 

(f) By major industry or counterparty type: 

• Amount of impaired loans; 

• Amount of past due loans; 15

• Allowances; and 

• Charge-offs during the period. 

(g) Amount of impaired loans and, if available, the amount of past due loans broken down by significant 

geographic areas including, if practical, the amounts of allowances related to each geographical area.16

(h) Reconciliation of changes in the allowance for loan and lease losses.17

TABLE 11.5.—CREDIT RISK: DISCLOSURES FOR PORTFOLIOS SUBJECT TO IRB RISK-BASED CAPITAL FORMULAS

Qualitative disclosures .................... (a) Explanation and review of the: 

• Structure of internal rating systems and relation between internal and external ratings; 

• Use of risk parameter estimates other than for regulatory capital purposes; 

• Process for managing and recognizing credit risk mitigation (see table 11.7); and 

• Control mechanisms for the rating system, including discussion of independence, accountability, and 

rating systems review. 

(b) Description of the internal ratings process, provided separately for the following: 

• Wholesale category; 

• Retail subcategories; 

• Residential mortgage exposures; 

• Qualifying revolving exposures; and 

• Other retail exposures. 

For each category and subcategory the description should include: 

• The types of exposure included in the category/subcategories; and 

• The definitions, methods and data for estimation and validation of PD, LGD, and EAD, including assumptions employed in the derivation of these variables.18

Quantitative disclosures: risk assessment.(c) For wholesale exposures, present the following information across a sufficient number of PD grades 

(including default) to allow for a meaningful differentiation of credit risk:19

• Total EAD; 20

• Exposure-weighted average LGD (percentage); 

• Exposure-weighted average risk weight; and 

• Amount of undrawn commitments and exposure-weighted average EAD for wholesale exposures. 

For each retail subcategory, present the disclosures outlined above across a sufficient number of segments to allow for a meaningful differentiation of credit risk. 

Quantitative disclosures: historical 

results.

(d) Actual losses in the preceding period for each category and subcategory and how this differs from past 

experience. A discussion of the factors that impacted the loss experience in the preceding period—for 

example, has the savings association experienced higher than average default rates, loss rates or 

EADs. 

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18This disclosure does not require a detailed 

description of the model in full—it should provide 

the reader with a broad overview of the model 

approach, describing definitions of the variables 

and methods for estimating and validating those 

variables set out in the quantitative risk disclosures 

below. This should be done for each of the four 

category/subcategories. The savings association 

should disclose any significant differences in 

approach to estimating these variables within each 

category/subcategories. 

19The PD, LGD and EAD disclosures in Table 

11.5(c) should reflect the effects of collateral, 

qualifying master netting agreements, eligible 

guarantees and eligible credit derivatives as defined 

in part I. Disclosure of each PD grade should 

include the exposure-weighted average PD for each 

grade. Where a savings association aggregates PD 

grades for the purposes of disclosure, this should 

be a representative breakdown of the distribution of 

PD grades used for regulatory capital purposes. 

20Outstanding loans and EAD on undrawn 

commitments can be presented on a combined basis 

for these disclosures. 

21These disclosures are a way of further 

informing the reader about the reliability of the 

information provided in the ‘‘quantitative 

disclosures: risk assessment’’ over the long run. The 

disclosures are requirements from year-end 2010; in 

the meantime, early adoption is encouraged. The 

phased implementation is to allow a savings 

association sufficient time to build up a longer run 

of data that will make these disclosures meaningful. 

22This regulation is not prescriptive about the 

period used for this assessment. Upon 

implementation, it might be expected that a savings 

association would provide these disclosures for as 

long a run of data as possible—for example, if a 

savings association has 10 years of data, it might 

choose to disclose the average default rates for each 

PD grade over that 10-year period. Annual amounts 

need not be disclosed. 

23A savings association should provide this 

further decomposition where it will allow users 

greater insight into the reliability of the estimates 

provided in the ‘‘quantitative disclosures: risk 

assessment.’’ In particular, it should provide this 

information where there are material differences 

between its estimates of PD, LGD or EAD compared 

to actual outcomes over the long run. The savings 

association should also provide explanations for 

such differences. 

24Net unsecured credit exposure is the credit 

exposure after considering the benefits from legally 

enforceable netting agreements and collateral 

arrangements, without taking into account haircuts 

for price volatility, liquidity, etc. 

25This may include interest rate derivative 

contracts, foreign exchange derivative contracts, 

equity derivative contracts, credit derivatives, 

commodity or other derivative contracts, repo-style 

transactions, and eligible margin loans. 

TABLE 11.5.—CREDIT RISK: DISCLOSURES FOR PORTFOLIOS SUBJECT TO IRB RISK-BASED CAPITAL FORMULAS—

Continued 

(e) Savings association’s estimates compared against actual outcomes over a longer period.21 At a minimum, this should include information on estimates of losses against actual losses in the wholesale category and each retail subcategory over a period sufficient to allow for a meaningful assessment of the 

performance of the internal rating processes for each category/subcategory.22 Where appropriate, the 

savings association should further decompose this to provide analysis of PD, LGD, and EAD outcomes 

against estimates provided in the quantitative risk assessment disclosures above.23

TABLE 11.6.—GENERAL DISCLOSURE FOR COUNTERPARTY CREDIT RISK OF OTC DERIVATIVE CONTRACTS, REPO-STYLE

TRANSACTIONS, AND ELIGIBLE MARGIN LOANS

Qualitative Disclosures ................... (a) The general qualitative disclosure requirement with respect to OTC derivatives, eligible margin loans, 

and repo-style transactions, including: 

• Discussion of methodology used to assign economic capital and credit limits for counterparty credit 

exposures; 

• Discussion of policies for securing collateral, valuing and managing collateral, and establishing credit 

reserves; 

• Discussion of the primary types of collateral taken; 

• Discussion of policies with respect to wrong-way risk exposures; and 

• Discussion of the impact of the amount of collateral the savings association would have to provide if 

the savings association were to receive a credit rating downgrade. 

Quantitative Disclosures ................. (b) Gross positive fair value of contracts, netting benefits, netted current credit exposure, collateral held (including type, for example, cash, government securities), and net unsecured credit exposure.24 Also report measures for EAD used for regulatory capital for these transactions, the notional value of credit derivative hedges purchased for counterparty credit risk protection, and, for savings associations not using 

the internal models methodology in section 32(d) of this appendix, the distribution of current credit exposure by types of credit exposure.25

(c) Notional amount of purchased and sold credit derivatives, segregated between use for the savings association’s own credit portfolio and for its intermediation activities, including the distribution of the credit 

derivative products used, broken down further by protection bought and sold within each product group. 

(d) The estimate of alpha if the savings association has received supervisory approval to estimate alpha. 

TABLE 11.7.—CREDIT RISK MITIGATION 26 27 28

Qualitative Disclosures ................... (a) The general qualitative disclosure requirement with respect to credit risk mitigation including: 

• Policies and processes for, and an indication of the extent to which the savings association uses, onand off-balance sheet netting; 

• Policies and processes for collateral valuation and management; 

• A description of the main types of collateral taken by the savings association; 

• The main types of guarantors/credit derivative counterparties and their creditworthiness; and 

• Information about (market or credit) risk concentrations within the mitigation taken. 

Quantitative Disclosures ................. (b) For each separately disclosed portfolio, the total exposure (after, where applicable, on-or off-balance 

sheet netting) that is covered by guarantees/credit derivatives. 

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26At a minimum, a savings associagtion must 

provide the disclosures in Table 11.7 in relation to 

credit risk mitigation that has been recognized for 

the purposes of reducing capital requirements 

under this appendix. Where relevant, savings 

associations are encouraged to give further 

information about mitigants that have not been 

recognized for that purpose. 

27Credit derivatives that are treated, for the 

purposes of this appendix, as synthetic 

securitization exposures should be excluded from 

the credit risk mitigation disclosures and included 

within those relating to securitization. 

28Counterparty credit risk-related exposures 

disclosed pursuant to Table 11.6 should be 

excluded from the credit risk mitigation disclosures 

in Table 11.7. 

29For example: originator, investor, servicer, 

provider of credit enhancement, sponsor of asset 

backed commercial paper facility, liquidity 

provider, or swap provider. 

30Underlying exposure types may include, for 

example, one- to four-family residential loans, 

home equity lines, credit card receivables, and auto 

loans. 

31Securitization transactions in which the 

originating savings association does not retain any 

securitization exposure should be shown separately 

but need only be reported for the year of inception. 

32Where relevant, a savings association is 

encouraged to differentiate between exposures 

resulting from activities in which they act only as 

sponsors, and exposures that result from all other 

savings association securitization activities. 

33For example, charge-offs/allowances (if the 

assets remain on the savings association’s balance 

sheet) or write-downs of I/O strips and other 

residual interests. 

TABLE 11.8.—SECURITIZATION

Qualitative Disclosures ................... (a) The general qualitative disclosure requirement with respect to securitization (including synthetics), including a discussion of: 

• The savings association’s objectives relating to securitization activity, including the extent to which 

these activities transfer credit risk of the underlying exposures away from the savings association to 

other entities; 

• The roles played by the savings association in the securitization process 29 and an indication of the 

extent of the savings association’s involvement in each of them; and 

• The regulatory capital approaches (for example, RBA, IAA and SFA) that the savings association follows for its securitization activities. 

(b) Summary of the savings association’s accounting policies for securitization activities, including: 

• Whether the transactions are treated as sales or financings; 

• Recognition of gain-on-sale; 

• Key assumptions for valuing retained interests, including any significant changes since the last reporting period and the impact of such changes; and 

• Treatment of synthetic securitizations. 

(c) Names of NRSROs used for securitizations and the types of securitization exposure for which each 

agency is used. 

Quantitative Disclosures ................. (d) The total outstanding exposures securitized by the savings association in securitizations that meet the 

operational criteria in section 41 of this appendix (broken down into traditional/synthetic), by underlying 

exposure type.30 31 32

(e) For exposures securitized by the savings association in securitizations that meet the operational criteria 

in Section 41 of this appendix: 

• Amount of securitized assets that are impaired/past due; and 

• Losses recognized by the savings association during the current period 33 broken down by exposure 

type. 

(f) Aggregate amount of securitization exposures broken down by underlying exposure type. 

(g) Aggregate amount of securitization exposures and the associated IRB capital requirements for these 

exposures broken down into a meaningful number of risk weight bands. Exposures that have been deducted from capital should be disclosed separately by type of underlying asset. 

(h) For securitizations subject to the early amortization treatment, the following items by underlying asset 

type for securitized facilities: 

• The aggregate drawn exposures attributed to the seller’s and investors’ interests; and 

• The aggregate IRB capital charges incurred by the savings association against the investors’ shares 

of drawn balances and undrawn lines. 

(i) Summary of current year’s securitization activity, including the amount of exposures securitized (by exposure type), and recognized gain or loss on sale by asset type. 

TABLE 11.9.—OPERATIONAL RISK

Qualitative Disclosures ................... (a) The general qualitative disclosure requirement for operational risk. 

(b) Description of the AMA, including a discussion of relevant internal and external factors considered in 

the savings association’s measurement approach. 

(c) A description of the use of insurance for the purpose of mitigating operational risk. 

TABLE 11.10.—EQUITIES NOT SUBJECT TO MARKET RISK RULE

Qualitative Disclosures ................... (a) The general qualitative disclosure requirement with respect to equity risk, including: 

• Differentiation between holdings on which capital gains are expected and those held for other objectives, including for relationship and strategic reasons; and 

• Discussion of important policies covering the valuation of and accounting for equity holdings in the 

banking book. This includes the accounting techniques and valuation methodologies used, including 

key assumptions and practices affecting valuation as well as significant changes in these practices. 

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Federal Register / Vol. 72, No. 235 / Friday, December 7, 2007 / Rules and Regulations 69445 

34Unrealized gains (losses) recognized in the 

balance sheet but not through earnings. 

35Unrealized gains (losses) not recognized either 

in the balance sheet or through earnings. 

36This disclosure should include a breakdown of 

equities that are subject to the 0 percent, 20 percent, 

100 percent, 300 percent, 400 percent, and 600 

percent risk weights, as applicable. 

TABLE 11.10.—EQUITIES NOT SUBJECT TO MARKET RISK RULE—Continued 

Quantitative Disclosures ................. (b) Value disclosed in the balance sheet of investments, as well as the fair value of those investments; for 

quoted securities, a comparison to publicly-quoted share values where the share price is materially different from fair value. 

(c) The types and nature of investments, including the amount that is: 

• Publicly traded; and 

• Non-publicly traded. 

(d) The cumulative realized gains (losses) arising from sales and liquidations in the reporting period. 

(e) • Total unrealized gains (losses)34

• Total latent revaluation gains (losses)35

• Any amounts of the above included in tier 1 and/or tier 2 capital. 

(f) Capital requirements broken down by appropriate equity groupings, consistent with the savings association’s methodology, as well as the aggregate amounts and the type of equity investments subject to any 

supervisory transition regarding regulatory capital requirements.36

TABLE 11.11.—INTEREST RATE RISK FOR NON-TRADING ACTIVITIES

Qualitative Disclosures ................... (a) The general qualitative disclosure requirement, including the nature of interest rate risk for non-trading 

activities and key assumptions, including assumptions regarding loan prepayments and behavior of nonmaturity deposits, and frequency of measurement of interest rate risk for non-trading activities. 

Quantitative Disclosures ................. (b) The increase (decline) in earnings or economic value (or relevant measure used by management) for 

upward and downward rate shocks according to management’s method for measuring interest rate risk 

for non-trading activities, broken down by currency (as appropriate). 

* * * * * 

Dated: November 8, 2007. 

John C. Dugan, 

Comptroller of the Currency. 

By order of the Board of Governors of the 

Federal Reserve System, November 13, 2007. 

Robert deV. Frierson, 

Deputy Secretary of the Board. 

Dated at Washington, DC, this 5th day of 

November, 2007. 

By Order of the Board of Directors. Federal 

Deposit Insurance Corporation. 

Valerie J. Best, 

Assistant Executive Secretary. 

Dated: October 29, 2007. 

By the Office of Thrift Supervision. 

John M. Reich, 

Director. 

[FR Doc. 07–5729 Filed 12–6–07; 8:45 am] 

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

6720–01–P 

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