Bank capital performs several important functions. Among other things, capital acts as a financial cushion to absorb unexpected losses, promotes public confidence in the solvency of the institution and the stability of the banking sector, and provides protection to depositors and deposit insurance funds. Because of capital’s role in absorbing losses, promoting confidence, and protecting depositors, federal banking regulations require banking organizations to maintain adequate capital, and regulators set minimum capital levels to help ensure that institutions do so, including a target total minimum risk-based capital ratio—that is, the ratio of capital to risk-weighted assets. Federal law authorizes banking regulators to take a variety of actions to ensure capital adequacy, including informal and formal enforcement actions. Federal banking regulators generally expect institutions to hold capital at levels higher than regulatory minimums. Capital rules in the United States generally follow a framework of measures adopted by the Basel Committee. U.S. federal banking regulators have adopted various risk-based capital regimes over the past decades. Under these frameworks, assets and off-balance-sheet exposures are assigned to one of several broad risk categories according to the obligor (for example, the person or legal entity contractually obligated on an exposure), or if relevant, the guarantor or the nature of the collateral. Banking organizations multiply the aggregate dollar amount or exposure amount in each risk category by the risk weight associated with that category. The resulting risk-weighted amounts from each of the risk categories are added together, and generally this sum is the banking organization’s total risk-weighted assets, which comprises the denominator of the risk-based capital ratio. For example, a $1,000 on- balance-sheet asset at a 20 percent risk weight would equal $200 in risk- weighted assets. An additional $1,000 on-balance-sheet asset at a 50 percent risk weight would equal $500 in risk-weighted assets, for a total of $700 in risk-weighted assets (compared to the $2,000 in total assets). The risk weights enable one to calculate the amount of capital a banking organization would need to hold for a given asset—its “capital charge”—in order to meet the minimum risk-based capital ratio requirements. To meet an 8 percent minimum total capital ratio requirement, the organization with the $700 in risk-weighted assets in the previous example would need to hold $56 in capital ($700×0.08). The minimum total capital charge for the $1,000 on-balance-sheet asset that was risk-weighted at 20 percent would be $16 ($1,000×0.2×0.08), while the minimum capital charge for the $1,000 on-balance-sheet asset that was risk-weighted at 50 percent would be $40 ($1,000×0.5×0.08). Risk weights for mortgages and other mortgage-related assets have been included in a number of these regulatory capital frameworks over the years, including the following: The Basel Capital Accord (Basel I), which was adopted in 1988 and implemented in the United States in the early 1990s, established a system of generally applicable risk weights for specific assets (including mortgage-related assets) to calculate total risk-weighted assets and defined a minimum total risk-based capital ratio (the ratio of regulatory capital to risk-weighted assets) of 8 percent with limited exceptions. Under this system, all assets of a certain category—for example, commercial loans—were assigned a flat risk weight without regard for differences in credit quality among the assets in that category (simple risk-bucket approach). Asset categories were classified into one of four risk-weight buckets—0 percent, 20 percent, 50 percent, or 100 percent. Amendments to the U.S. federal banking regulators’ rules adopted in 2001 implemented a multilevel, ratings-based approach to assess capital requirements on asset securitizations— including mortgage- backed securities (MBS)—based on their relative exposure to credit risk. The approach used credit ratings from nationally recognized statistical rating organizations (NRSRO) to measure relative exposure to credit risk and determine the associated risk-based capital requirement. In 2007, U.S. federal banking regulators adopted capital rules for large internationally active banking organizations that were based on a revised framework published by the Basel Committee in 2006 (Basel II). Only large, internationally active banks—banks 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 on-balance-sheet foreign exposure of $10 billion or more—were required to adopt the advanced approaches for measuring risk (including mortgage-related credit risk) established in the Basel II-based rules. Under these rules, the advanced internal ratings-based approach used risk parameters determined by a bank’s internal systems as inputs into a formula developed by supervisors for calculating minimum regulatory capital and expanded the use of credit ratings to measure credit risk. U.S. federal banking regulators promulgated a final rule in 2013 to incorporate many of the changes included in the Basel III framework. Among other changes, the final rule includes a new standardized approach for credit risk to replace the Basel I generally applicable risk-based capital rule. The final rule also removed references to credit ratings that were in the Basel I generally applicable rule and the advanced internal ratings-based approach, consistent with requirements in Section 939A of the Dodd-Frank Act. Other entities that hold mortgages and mortgage-related assets have different capital requirements. For example, in 1992 the Office of Federal Housing Enterprise Oversight, which at the time was the regulator for the enterprises, adopted minimum capital requirements based on the enterprises’ on-balance-sheet assets and off-balance-sheet obligations. Nonbank financial institutions that service mortgages for the enterprises and Ginnie Mae must comply with minimum capital and net worth requirements those entities have issued. The Basel III final rule adopted in 2013 by the U.S. federal banking regulators and generally effective as of January 2015 incorporates higher risk weights for certain mortgage-related exposures while leaving others unchanged (see table 1). For example, the risk weights for most single- family residential mortgages are largely unchanged by the final rule. However, the final rule changed the risk weights for some mortgage- related securitization exposures and for mortgage servicing assets. Risk weights for residential first-lien mortgages on one-to-four family properties that are held in banks’ portfolios have remained largely unchanged since the adoption of the Basel I-based rules. Under the standardized approach outlined in the Basel III-based final rule, the portions of mortgages that are conditionally guaranteed by U.S. government agencies, such as the Federal Housing Administration or the Department of Veterans Affairs, are assigned 20 percent risk weights under the standardized approach—essentially unchanged since Basel I. Other mortgages—and the portions of mortgages not guaranteed by U.S. government agencies—secured by one-to-four family residential properties are assigned a 50 percent risk weight, provided that such loans are: secured by a property that is either owner-occupied or rented; made in accordance with prudent underwriting standards, including standards relating to the loan amount as a percentage of the appraised value of the property; not 90 days or more past due or carried in nonaccrual status; and not restructured or modified (other than through the Department of the Treasury’s Home Affordable Modification Program). Also, if a banking organization holds the first-lien and junior-lien residential mortgage exposures, and no other party holds an intervening lien, the institution must combine the exposures and treat them as a single loan secured by a first lien to determine the loan-to-value ratio and assign a risk weight. Banking organizations are required to assign a 100 percent risk weight to a first-lien residential mortgage exposure that does not meet the criteria previously listed and to junior-lien residential mortgage exposures if the banking organization does not hold the first lien on the property. The advanced internal ratings-based approach requires banking organizations to use a formula defined in regulation to determine the capital requirements for residential mortgage exposures, which are grouped into segments that have similar (homogeneous) risk characteristics. The formula for the capital charge for nondefaulted residential mortgage exposures uses values for the probability of default and loss given default that each bank derives from its internal systems (see app. I). For example, applying a probability of default of 3 percent and losses given default of 20 percent to a segment of nondefaulted residential mortgages would result in a risk weight of about 50 percent using this formula. This formula is unchanged since it went into effect in 2008. Under this advanced approach, defaulted residential mortgage exposures that are covered by an eligible U.S. government guarantee have a capital charge of 1.6 percent for the portion that is covered by the guarantee—an implicit 20 percent risk weight (0.016 ÷ 0.08 = 0.2). The previous rules did not include a separate provision for defaulted residential mortgage exposures covered by a government guarantee. Defaulted residential mortgage exposures not covered by an eligible U.S. government guarantee have a capital charge of 8 percent, which implies a risk weight of 100 percent. The standardized approach and the advanced approach both assign a risk weight of 50 percent to pre-sold construction loans with a legally binding sales contract unless the purchase contract is cancelled, in which case a banking organization must assign a 100 percent risk weight. The Basel III-based final rule keeps the risk weights for government- and enterprise-guaranteed MBS outlined under the previous rules but changes how the risk weights for private-label securities are calculated. Under the standardized approach, residential MBS guaranteed by Ginnie Mae have a risk weight of 0 percent, while residential MBS issued and guaranteed by Fannie Mae and Freddie Mac have a risk weight of 20 percent—unchanged since Basel I.