2026-03-27 | 2026-05959Added · Updated
The OCC, Federal Reserve, and FDIC propose to modernize capital requirements for Category I and II banking organizations and revise the market risk framework for those with significant trading activity. The proposal aims to enhance risk sensitivity and consistency while simplifying core design elements, including the removal of internal models for credit and operational risk. These changes align U.S. standards with international Basel framework updates to support financial stability and lending activities across economic conditions.
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DEPARTMENT OF THE TREASURY Office of the Comptroller of the Currency 12 CFR Parts 3, 6, and 32 [Docket ID OCC–2026–0265] RIN 1557–AF52 FEDERAL RESERVE SYSTEM 12 CFR Parts 208, 217, 225, 238, and 252 [Docket No. 1887] RIN 7100–AH20 FEDERAL DEPOSIT INSURANCE CORPORATION 12 CFR Part 324 RIN 3064–AF29 Regulatory Capital Rule: Category I and II Banking Organizations, Banking Organizations With Significant Trading Activity, and Optional Adoption for Other Banking Organizations AGENCY: Office of the Comptroller of the Currency (OCC), Treasury; the Board of Governors of the Federal Reserve System (Board); and the Federal Deposit Insurance Corporation (FDIC). ACTION: Notice of proposed rulemaking. SUMMARY: The Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation are proposing to modernize the capital requirements applicable to Category I and II depository institution holding companies and depository institutions, as well as revise the market risk capital framework for banking organizations with significant trading activity (the proposal). The proposal would improve the regulatory capital framework for covered banking organizations by enhancing its risk sensitivity and consistency and by simplifying core components of its design. The agencies expect the proposal would support the safety and soundness of covered banking organizations and U.S. financial stability while promoting lending and other financial intermediation activities in the banking system over a range of economic conditions. DATES: Comments must be received by June 18, 2026. ADDRESSES: Comments should be directed to:
Mail: Jennifer M. Jones, Deputy Executive Secretary, Attention:
Comments/Legal OES (RIN 3064–AF29), Federal Deposit Insurance Corporation, 550 17th Street NW, Washington, DC 20429. Hand Delivered/Courier: Comments may be hand-delivered to the guard station at the rear of the 550 17th Street NW, building (located on F Street NW) on business days between 7 a.m. and 5 p.m. Email: comments@FDIC.gov. Include the RIN 3064–AF29 on the subject line of the message. Public Inspection: Comments received, including any personal information provided, may be posted without change to https://www.fdic.gov/ resources/regulations/federal-registerpublications. Commenters should submit only information that the commenter wishes to make available publicly. The FDIC may review, redact, or refrain from posting all or any portion of any comment that it may deem to be inappropriate for publication, such as irrelevant or obscene material. The FDIC may post only a single representative example of identical or substantially identical comments, and in such cases will generally identify the number of identical or substantially identical comments represented by the posted example. All comments that have been redacted, as well as those that have not been posted, that contain comments on the merits of this document will be retained in the public comment file and will be considered as required under all applicable laws. All comments may be accessible under the Freedom of Information Act. FOR FURTHER INFORMATION CONTACT:
OCC: Venus Fan, Risk Expert, Benjamin Pegg, Technical Expert, or Diana Wei, Risk Expert, Capital Policy, (202) 649–6370; Carl Kaminski, Assistant Director, Ron Shimabukuro, Senior Counsel, Kevin Korzeniewski, Counsel, Daniel Perez, Counsel, Christopher Rafferty, Counsel, or Joanne Phillips, Counsel, Chief Counsel’s Office, (202) 649–5490, Office of the Comptroller of the Currency, 400 7th Street SW, Washington, DC 20219. If you are deaf, hard of hearing, or have a speech disability, please dial 7–1–1 to access telecommunications relay services. Board: Anna Lee Hewko, Associate Director, (202) 530–6260; Andrew Willis, Manager, (202) 430–1667; Missaka Nuwan Warusawitharana, Manager, (202) 452–3461; Cecily Boggs, Lead Financial Institution Policy Analyst, (202) 530–6209; Marco Migueis, Principal Economist, (202) 452–6447; Diana Iercosan, Principal Economist, (202) 912–4648; Nadya Zeltser, Lead Financial Institution Policy Analyst, (202) 452–3164; Division of Supervision and Regulation; or Jay Schwarz, Deputy Associate General Counsel, (202) 452–2970; Mark Buresh, Senior Special Counsel, (202) 452–5270; Gillian Burgess, Senior Counsel, (202) 736–5564; Jonah Kind, Senior Counsel, (202) 452–2045, Legal Division, Board of Governors of the Federal Reserve System, 20th Street and Constitution Avenue NW, Washington, DC 20551. For users of TTY–TRS, please call 711 from any telephone, anywhere in the United States. FDIC: Benedetto Bosco, Chief Capital Policy Section; Bob Charurat, Corporate Expert; Irina Leonova, Corporate Expert; Andrew Carayiannis, Chief, Policy and Risk Analytics Section; Michael Maloney, Senior Policy Analyst; Iris Li, Senior Policy Analyst; Olga Lionakis, Senior Policy Analyst; Richard Smith, Capital Markets Policy Analyst; Ernest Barkett, Financial Analyst; Kyle McCormick, Senior Policy Analyst; Keith Bergstresser, Senior Policy Analyst; Lauren Brown, Senior Risk and Policy Analyst; Rachel Romm-Nisson, Risk Analytics Specialist; Jim Yu, Senior Policy Analyst, Peter Yen, Senior Policy Analyst; Huiyang Zhou, Senior Quantitative Risk Specialist; Soo Jeong Kim, Capital Markets Policy Analyst; Capital Markets and Accounting Policy Branch, Division of Risk Management Supervision; Catherine Wood, Counsel; Merritt Pardini, Counsel; Kevin Zhao, Senior Attorney; Nicholas Soyer, Attorney, Michael Overmyer, Special Counsel, Legal Division; regulatorycapital@fdic.gov, (202) 898– 6888; Federal Deposit Insurance Corporation, 550 17th Street NW, Washington, DC 20429. SUPPLEMENTARY INFORMATION:
Table of Contents
I. Introduction
A. Statutory Authority
B. Objectives of the Proposal
C. Overview of the Proposal
II. Scope, Design, and Other Overarching
Issues
A. Scope of Application B. Single Set of Risk-Based Requirements
C. Removal of Internal Models for Credit
and Operational Risk
D. Overlaps With the Stress Capital Buffer Requirement E. Indexing of Thresholds F. The Role of International Standards in Developing U.S. Capital Requirements G. Treatments Retained from the Current Standardized Approach
III. Definition of Capital
IV. Calculation of Risk-Weighted Assets
Under the Expanded Risk-Based Approach A. Credit Risk
1 In 2019, the agencies adopted rules establishing four categories of capital standards for U.S. banking organizations with $100 billion or more in total consolidated assets and foreign banking organizations with $100 billion or more in combined U.S. assets. Under this framework, Category I standards apply to U.S.-domiciled bank holding companies identified as global systemically important BHCs and their depository institution subsidiaries. Category II standards apply to banking organizations with at least $700 billion in total consolidated assets or at least $75 billion in crossjurisdictional activity and their depository institution subsidiaries. Category III standards apply to banking organizations with total consolidated assets of at least $250 billion or at least $75 billion in weighted short-term wholesale funding, nonbank assets, or off-balance sheet exposures and their depository institution subsidiaries. Category IV standards apply to banking organizations with total consolidated assets of at least $100 billion that do not meet the thresholds for a higher category and their depository institution subsidiaries. See 12 CFR 3.2 (OCC); 12 CFR 217.400, 238.10, 252.5, (Board); 12 CFR 324.2 (FDIC); ‘‘Prudential Standards for Large Bank Holding Companies, Savings and Loan Holding Companies, and Foreign Banking Organizations,’’ 84 FR 59032 (Nov. 1, 2019); ‘‘Changes to Applicability Thresholds for Regulatory Capital and Liquidity Requirements,’’ 84 FR 59230 (Nov. 1, 2019). 2The term covered banking organizations refers to Category I and II banking organizations, banking organizations with significant trading activity, and banking organizations that elect to use the expanded risk-based approach (as discussed further below). 3The agencies, together with the Federal Financial Institutions Examination Council, commenced a review under the Economic Growth and Regulatory Paperwork Reduction Act of 1996 in 2024 to identify outdated or otherwise unnecessary regulatory requirements. The agencies will continue reviewing and considering these comments as part of any final rulemaking. Public Law 104–208, Div. A, Title II, section 2222, 110 Stat. 3009–414, (1996) (codified at 12 U.S.C. 3311). See also Regulatory Publication and Review Under the Economic Growth and Regulatory Paperwork Reduction Act of 1996, 90 FR. 35241 (Jul. 25, 2025). 4Other recent initiatives to modernize the capital framework include the finalized changes to the enhanced supplementary leverage ratio standards, which would reinforce the role of leverage requirements as a backstop to risk-based capital requirements and address unintended incentive effects (see 90 FR 55248 (Dec. 1, 2025); the community bank leverage ratio proposal, which would reduce regulatory burden while continuing to ensure the safety and soundness of community banks (see 90 FR 55048 (Dec. 1, 2025); and recent proposals to revise the Board’s stress testing framework, which would improve its transparency and reduce excess
volatility in the stress capital buffer requirement (see 90 FR 16843 (Apr. 22, 2025) and 90 FR 51856 (Nov. 18, 2025)). 5The Basel Committee is a committee composed of central banks and banking supervisory authorities, which was established by the central bank governors of the G–10 countries in 1975. The consolidated Basel framework is available at https://www.bis.org/basel_framework/. For additional discussion of the revisions to the Basel framework with which this proposal would align, see also https://www.bis.org/bcbs/publ/d424.htm, https://www.bis.org/bcbs/publ/d457.htm, and https://www.bis.org/bcbs/publ/d507.htm.
6 GAAP often serve as a foundational measurement component for U.S. capital requirements. See also 12 U.S.C. 1831n (generally requiring that financial reports required by the agencies from banking organizations use U.S. GAAP). 7The revisions introduced by the proposal to the calculation of risk-weighted assets would also modify Category I bank holding companies’ total loss-absorbing capacity (TLAC) requirements and long-term debt requirements. 8See 90 FR 51856 (Nov. 18, 2025). 9A banking organization for which the Board is the primary Federal supervisor must maintain capital ratios above the sum of its minimum requirements and buffer requirements to avoid restrictions on capital distributions and discretionary bonus payments. 10 In 2023, the agencies published a proposal to revise the capital rule based on the Basel Committee framework. 88 FR 64028 (Sept. 18, 2023). The agencies are rescinding the 2023 proposal. Members of the public that seek to submit comments on the current proposal must submit comments in line with the procedures described in this proposal. 11 Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law 111–203, 124 Stat. 1376 (2010). 12Economic Growth, Regulatory Relief, and Consumer Protection Act, Public Law 115–174, 132 Stat. 1296 (2018). 13See 12 U.S.C. 5365(a)(1), (b)(1)(A)(i). Section 165 of the Dodd-Frank Act also provides that the Board may apply any prudential standard established under section 165 to any bank holding company with $100 billion or more in total consolidated assets to which the prudential standard does not otherwise apply, under certain circumstances. 12 U.S.C. 5365(a)(2)(C). Section 165, in relevant part, also applies to foreign banks or companies that are treated as a bank holding company for purposes of the Bank Holding Company Act. See 12 U.S.C. 3106(a), 5311(a)(1). See also section 401(g) of the Economic Growth, Regulatory Relief, and Consumer Protection Act (regarding the Board’s authority to establish enhanced prudential standards for foreign banking organizations with total consolidated assets of $100 billion or more). 12 U.S.C. 5365 note. 14See 12 U.S.C. 1831o(c)(1)(A), (c)(1)(B)(i). 15See 12 U.S.C. 93a (national banking associations); 12 U.S.C. 248(i), 324, 327, 329 (state member banks); 12 U.S.C. 1463 (savings associations); 12 U.S.C. 1467a(g)(1) (savings and loan holding companies); 12 U.S.C. 1844(b) (bank holding companies); 12 U.S.C. 3106 (certain U.S. operations of foreign banking organizations); 12 U.S.C. 3902(1)–(2), 3907(a), 3909(a), (c)(1)–(2) (depository institutions; affiliates of depository institutions, including holding companies; and certain U.S. operations of foreign banking organizations); 12 U.S.C. 5371 (insured depository institutions, depository institution holding companies, and nonbank financial companies supervised by the Board). Additional statutory authorities relevant to the agencies’ capital rule can be found in the authority citations in the capital rule.
See 12 CFR part 3 (OCC); 12 CFR part 217 (Board); 12 CFR part 324 (FDIC). principles (GAAP),6 practices of U.S. banking organizations, and U.S. statutory mandates and policy objectives. For example, the proposal would remove the current requirement to deduct mortgage servicing assets (MSAs) from regulatory capital and instead subject all MSAs to a 250 percent risk weight. This aspect of the proposal is intended to remove a regulatory disincentive for residential mortgage servicing and origination, reducing impacts on broader policy objectives regarding the U.S. housing market. The agencies expect that the proposal would increase the common equity tier 1 capital requirements of Category I and II holding companies by about 1.2 percent, while decreasing corresponding requirements for Category I and II subsidiary depository institutions by 5.1 percent.7 Together with the GSIB surcharge proposal and the stress testing changes proposed in October 2025,8 the Board expects that the common equity tier 1 capital requirements for Category I and II holding companies would decline by 5.0 percent (see section VII for additional discussion of capital impact).9 The agencies performed extensive economic analysis to assess the potential effects of the proposal, including together with related proposals (see section VIII). The improvements in risk sensitivity, simplicity, transparency and consistency of risk-based capital requirements expected to result from the proposal justify its expected costs. The agencies seek comment on all aspects of the proposal.10 A. Statutory Authority Congress has authorized the agencies to establish risk-based capital requirements and standards for banking organizations subject to this proposal.
Section 165 of the Dodd-Frank Wall
Street Reform and Consumer Protection Act (Dodd-Frank Act),11 as amended by
section 401 of the Economic Growth,
Regulatory Relief, and Consumer Protection Act,12 requires the Board to establish enhanced prudential standards that include risk-based capital requirements for bank holding companies with $250 billion or more in total consolidated assets.13 The prompt corrective action framework in section 38 of the Federal Deposit Insurance Act (FDI Act) requires the agencies to prescribe capital standards for insured depository institutions that include a risk-based capital requirement and provides that the agencies may establish any additional relevant capital measures to carry out the purpose of that
section.14 Various other statutory
authorities provide the agencies with broad discretionary authority to set capital requirements and standards for banking organizations supervised by the agencies, including national banking associations, state-chartered banks, savings associations, and depository institution holding companies.15 B. Objectives of the Proposal The proposal aims to improve the capital framework for covered banking organizations by enhancing its risk sensitivity, reducing complexity, and improving transparency and consistency. Risk sensitivity is a core feature of risk-based capital requirements. The proposed framework aims to improve the alignment of regulatory capital requirements with the risks presented by banking organizations’ exposures. Such alignment could help promote safe and sound banking organizations that can lend through a range of economic conditions. To further improve the capital framework, the proposal seeks to reduce complexity by simplifying its overall design. Redundant or unnecessarily complex requirements, such as multiple risk-based capital frameworks applying to the same banking organization, add costs that outweigh any incremental benefits presented by such an approach, whereas a simpler framework reduces compliance burden and strengthens transparency. Clear and transparent requirements support safety and soundness by making it easier for supervisors, investors, and other stakeholders to assess the financial condition of banking organizations. A central element of the proposal’s effort to reduce redundancy is better integration with the Board’s stress testing framework, which is achieved by considering jointly the calibrations of this proposal and the proposed stress test model changes that would inform stress capital buffer requirements. The proposal would also promote consistency. Consistent capital requirements hold banking organizations with similar risk profiles to similar standards, thereby reducing unwarranted divergence. Consistency is also valuable internationally. The proposal is generally aligned with the Basel standards, with some differences as discussed in section II.F of this Supplementary Information. Broadly consistent regulatory frameworks should reduce complexity and compliance costs for banking organizations with cross-border operations, including both U.S. banking organizations operating abroad and foreign banking organizations operating in the United States. By improving risk-based capital requirements, the proposal would bolster the role of large U.S. banking organizations in supporting the broader economy. The reforms that followed the 2007–09 financial crisis substantially increased the resilience of the U.S.
16According to the 2024 Financial Stability Oversight Council report on nonbank mortgage servicing, nonbank mortgage companies originated approximately two-thirds of mortgages in the United States and owned the servicing rights on 54 percent of mortgage balances in 2022. In 2008, nonbank mortgage companies only accounted for 39 percent of mortgage originations and owned the servicing rights on 4 percent of mortgage balances. See page 3 FSOC Report on Nonbank Mortgage Servicing 2024 at https://home.treasury.gov/system/ files/261/FSOC-2024-Nonbank-Mortgage-ServicingReport.pdf. 17See 12 CFR part 3, subparts D and E (OCC); 12 CFR part 217, subparts D and E (Board); 12 CFR part 324, subparts D and E (FDIC). 18For purposes of this discussion, unless otherwise noted, the revised market risk framework is inclusive of requirements for credit valuation adjustment risk, as applicable. 19Credit valuation adjustment risk is the exposure to changes in the valuation of derivative contracts driven by changes in counterparty credit risk. 20This definition of capital would include the requirement to reflect accumulated other comprehensive income in regulatory capital and to use the deductions framework that applies to Category I and II banking organizations. 21Certain thresholds in FDIC regulations are also indexed to reflect inflation. See 90 FR 55789 (Dec. 1, 2025). 22The disclosure requirements would only apply to the top tier of a consolidated banking organization. banking system. However, in some cases, these post-crisis reforms have imposed burdens that contributed to the migration of some activities, such as mortgage origination and servicing, outside of the regulated banking sector.16 Revising the regulatory capital framework to better align requirements with risks—and in so doing easing requirements on some lower-risk, traditional banking activities—would contribute to U.S. banking organizations becoming better positioned to support the economy.
C. Overview of the Proposal
The proposal would streamline the risk-based capital requirements applicable to Category I and II banking organizations. Currently, these banking organizations are subject to two sets of risk-based capital ratio requirements:
one based on the standardized approach (which also generally applies to other banking organizations) and the other based on an internal models framework, the advanced approaches.17 Under the proposal, Category I and II banking organizations would be subject to a single set of risk-based capital ratio requirements based on the ‘‘expanded risk-based approach’’—which would include requirements for credit risk, equity risk, and operational risk—and the revised market risk framework.18 The standardized approach would no longer apply to these banking organizations, and the advanced approaches would be removed from the regulatory capital framework. As discussed further below, other banking organizations could choose to adopt the expanded risk-based approach that would be required for Category I and II banking organizations. The expanded risk-based approach is a standardized framework that would promote the simplicity, risk sensitivity, transparency, and consistency objectives of the proposal. This approach would improve risk sensitivity relative to the current standardized approach by varying capital requirements according to several new risk factors, such as loan-to-value ratios for real estate exposures, repayment history for retail exposures, and assessed creditworthiness for corporate exposures. Unlike the current standardized approach, the expanded risk-based approach would include a specific operational risk capital requirement. This difference, in part, supports the different calibration of credit risk weights under the expanded risk-based approach relative to the risk weights under the standardized approach. The proposal would also revise the market risk framework, which would be applicable to Category I and II depository institution holding companies and to other banking organizations with significant trading activity. Significant trading activity would be defined to mean (1) more than $5 billion in trading activity or (2) trading activity equal to or higher than 10 percent of the banking organization’s total assets. The new framework would improve risk sensitivity and consistency by revising the models-based approach for market risk and introducing a standardized approach for market risk. To reduce burden without a meaningful loss in resilience, the proposal would raise the threshold for applicability of the market risk framework from having trading activity of at least $1 billion to having trading activity of at least $5 billion. As part of the revised market risk framework, the proposal would include a risk-sensitive and consistent framework for capturing the risks associated with credit valuation adjustment risk for derivative exposures.19 This framework would apply to (1) Category I and II depository institution holding companies, (2) depository institutions that are subsidiaries of Category I or II depository institution holding companies and have significant trading activity, and (3) other banking organizations with significant trading
activity that also have at least $1 trillion in notional derivative exposure. The proposal would retain banking organizations’ ability to use internal models, with supervisory approval, to calculate market risk capital requirements. Market risk is more effectively modeled than credit and operational risk because relevant data is observed at a much higher frequency and depth, providing the basis for both model calibration and empirical verification of model appropriateness. The agencies consider the proposed requirements under the expanded riskbased approach to be appropriate for Category I and II banking organizations given their risk profiles, complexity, risk management resources, and international activities. The agencies recognize that the risk-sensitive requirements under the expanded riskbased approach may appeal to other banking organizations with certain business models and risk management systems. Therefore, the proposal would allow other banking organizations to elect to use the expanded risk-based approach. Banking organizations that choose this option would also be subject to the definition of capital that applies to Category I and II banking organizations.20 In addition to the changes to the calculation of risk-weighted assets, the proposal would change the definition of regulatory capital applicable to Category I and II banking organizations by removing the threshold-based deduction for mortgage servicing assets. Thus, all mortgage servicing assets would receive a 250 percent risk weight under the proposal, consistent with the risk weight in the current capital rule for MSAs that do not exceed the deduction thresholds. This proposed revision would eliminate a strong disincentive for mortgage origination and mortgage servicing by banking organizations. The proposal would also amend certain dollar-based regulatory thresholds, where appropriate, to reflect inflation and ensure that such thresholds preserve their intended application in real terms over time.21 Consistent with this proposal, the agencies are reviewing other thresholds throughout out the regulatory framework. Finally, the proposal would revise disclosure requirements to facilitate market participants’ understanding of the financial condition and risk management practices of banking organizations subject to the expanded risk-based approach.22 In addition, to align with these revisions, the agencies anticipate proposing revisions to the
23This transition period would mirror the transition period under the standardized approach proposal provided to Category III and IV banking organizations that do not currently recognize accumulated other comprehensive income in regulatory capital. 24This revision would be consistent with comments received under EGRPRA as commenters requested that banking organizations be required to calculate risk-weighted assets under a single approach. reporting forms of the Federal Financial Institutions Examination Council (FFIEC) that would apply to covered banking organizations. In a separate rulemaking, the agencies are proposing modifications to the standardized approach risk-based capital requirements (standardized approach proposal), which would apply to banking organizations that do not use the expanded risk-based approach. Also, the Board is separately issuing a notice of proposed rulemaking that would revise the U.S. global systemically important banking holding company (GSIB) surcharge calculation applicable to Category I bank holding companies and the systemic risk report applicable to large holding companies (GSIB surcharge proposal). Question 1: The agencies invite comment on the interaction of the revisions in the proposal with other existing rules and with other notices of proposed rulemaking. Question 2: What would be an appropriate amount of time between the publication of any final rule and its effective date, and why?
II. Scope, Design, and Other
Overarching Issues
A. Scope of Application The proposal would require Category I and II banking organizations to use the expanded risk-based approach. These banking organizations present substantial systemic risks due to their size, complexity, interconnectedness, and cross-jurisdictional activity. Application of the expanded risk-based approach to them would provide granular, risk-sensitive, and standardized requirements that align with international standards. While the expanded risk-based approach was designed for application to banking organizations that operate globally across multiple business lines, such as Category I and II banking organizations, the agencies are aware that the more differentiated treatments for traditional banking exposures such as mortgage, corporate, and retail exposures may appeal to certain smaller banking organizations. Therefore, the proposal would provide all banking organizations subject to the capital rule with the option of adopting the expanded risk-based approach in its entirety. Under the proposal, a banking organization that chooses to adopt the expanded risk-based approach would become subject to the same definition of capital as Category I and II banking organizations and, therefore, be required to reflect most elements of accumulated other comprehensive income in regulatory capital even if it subsequently changes to the standardized approach. This is consistent with the one-time election to recognize accumulated other comprehensive income in regulatory capital in the current standardized approach and avoids changes in accumulated other comprehensive income recognition based on interest rate cycles. For a banking organization that chooses to adopt the proposed expanded risk-based approach, the inclusion of most elements of other accumulated other comprehensive income in regulatory capital would be subject to a transition period of five years from the effective date of any final rule.23 To align with a banking organization’s annual capital planning processes, any change in election between the expanded risk-based approach and the standardized approach would take effect 12 months after the date on which the banking organization provides written notice of the change in election to its primary Federal supervisor. This requirement would help ensure that any change in election reflects structural balance sheet considerations and not short-term capital reductions. Banking organizations with significant trading activities face an elevated level of market risk and, therefore, would continue to be subject to the market risk framework. The proposal would increase the current dollar-based threshold for the application of market risk capital requirements from $1 billion to $5 billion or more of trading assets and trading liabilities. The proposal would also revise the calculation of the dollarbased threshold amount to be based on four-quarter averages of trading assets and trading liabilities instead of pointin-time amounts. Banking
organizations would continue to be subject to market risk capital requirements if their trading assets and trading liabilities represent 10 percent or more of total assets. Banking organizations that do not meet the thresholds for being subject to market risk capital requirements would calculate risk-weighted assets for trading exposures under the standardized approach or the expanded risk-based approach, as applicable. Additionally, under the proposal, Category I and II depository institution holding companies would be subject to market risk capital requirements regardless of the amount of their trading activities. The proposal would apply capital requirements for credit valuation adjustment risk to all Category I and II depository institution holding companies, as well as to their subsidiary depository institutions that are subject to the market risk framework. In addition, capital requirements for credit valuation adjustment risk would apply to other banking organizations subject to the market risk framework that have over-the-counter derivative notional amounts of $1 trillion or more. Due to their substantial derivative portfolios, these banking organizations have meaningful exposure to losses resulting from changes to their credit valuation adjustment accounting reserve. This threshold aims to balance coverage of credit valuation adjustment risk and burden. According to data reported in the FR Y–9C form, depository institution holding companies above this threshold accounted for over 98 percent of the over-the-counter derivative exposures of depository institution holding companies as of 2025Q2. Question 3: What are the advantages and disadvantages of the proposed scope of application of the expanded risk-based approach? Question 4: What are the advantages and disadvantages of allowing all banking organizations to adopt the expanded risk-based approach? What are the challenges associated with adopting the expanded risk-based approach for Category III, IV, and smaller banking organizations? To what extent would this optionality limit the transparency and consistency of the risk-based capital requirements? What limitations or restrictions on how frequently a banking organization could switch from the expanded risk-based approach to the standardized approach and vice versa should the agencies include and why? B. Single Set of Risk-Based Requirements Under the proposal, banking organizations would be subject to a single set of risk-based capital ratio requirements.24 This contrasts with the current framework, which requires Category I and II banking organizations to calculate two sets of risk-based capital ratios: one using the standardized approach and the other
25See Risk-Based Capital Standards: Advanced Capital Adequacy Framework—Basel II, 72 FR 69288 (Dec. 7, 2007). The agencies subsequently revised certain aspects of the advanced approaches framework in the rulemakings that established the current capital rule. See 78 FR 62018 (Oct. 11, 2013). 26For both credit risk and operational risk, the advanced approaches capital requirements aimed to cover the risk of loss over a one-year window at the 99.9th percentile level. See 72 FR 69288 (Dec. 7, 2007); 12 CFR part 3 (OCC); part 217 (Board); part 324 (FDIC). 27See, e.g., Tobias Berg, and Philipp Koziol ‘‘An analysis of the consistency of banks’ internal ratings,’’ Journal of Banking and Finance 78, 27–41 (2017), https://dx.doi.org/10.1016/j.jbankfin. 2017.01.013; and Barbora Stepankova, and Petr Teply, ‘‘Consistency of Banks’ Internal Probability of Default Estimates: Empirical Evidence from the COVID–19 crisis,’’ Journal of Banking and Finance 154, 106969 (2023), https://doi.org/10.1016/ j.jbankfin.2023.106969. 28See Jon Danielsson, ‘‘Blame the Models,’’ Journal of Financial Stability, 321–28 (2008), https://doi.org/10.1016/j.jfs.2008.09.003. 29For example, horizontal supervisory reviews have found material deviations in loss rates at different banking organizations with respect to the same defaulted exposure. 30For example, banking organizations have followed different practices regarding whether to count technical defaults (which are situations where the borrower failed to uphold an aspect of the loan agreement but has not failed to make regularly scheduled payments) as defaults for purposes of modeling probability of default. 31 Various analyses conducted by the Basel Committee, to which the agencies contributed, demonstrated significant divergence across banking organizations in credit risk-weighted assets calculated under the internal models-based approaches that could not be explained by differences in the riskiness of banking organizations’ portfolios. See https://www.bis.org/ publ/bcbs256.pdf and https://www.bis.org/bcbs/ publ/d363.pdf. 32See G. Mignola, and R. Ugoccioni, ‘‘Sources of Uncertainty in Modeling Operational Risk Losses,’’ Journal of Operational Risk 1(2): 33–50 (2006); J. Nesˇlehova´, P. Embrechts, and V. Chavez-Demoulin, ‘‘Infinite Mean Models and the LDA for Operational Risk,’’ Journal of Operational Risk 1(1): 3–25 (2006); and E. Cope, G. Mignola, G. Antonini, and R. Ugoccioni, ‘‘Challenges and Pitfalls in Measuring Operational Risk from Loss Data,’’ Journal of Operational Risk 4(4): 3–27 (2009). 33See E. Cope, G. Mignola, G. Antonini, and R. Ugoccioni, ‘‘Challenges and Pitfalls in Measuring Operational Risk from Loss Data’’ Journal of Operational Risk 4(4): 3–27 (2009); and J. Opdyke, and A. Cavallo, ‘‘Estimating Operational Risk Capital: The Challenges of Truncation, the Hazards of Maximum Likelihood Estimation, and the Promise of Robust Statistics,’’ Journal of Operational Risk 7(3): 3–90 (2012). using the internal
models-based advanced approaches. By employing risk-sensitive, simplified, consistent, and transparent requirements, aligned with international standards, the expanded risk-based approach would result in an appropriate stand-alone requirement. The capital conservation buffer requirement would apply to the riskbased capital ratios of Category I and II banking organizations in the same manner as it currently applies to the standardized approach ratios. For Category I depository institution holding companies, the capital conservation buffer requirement would continue to consist of the stress capital buffer requirement, the countercyclical capital buffer (if activated), and the GSIB surcharge. For Category II depository institution holding companies, the capital conservation buffer would continue to consist of the stress capital buffer requirement plus the countercyclical capital buffer (if activated). For the subsidiary depository institutions of Category I or II depository institution holding companies, the capital conservation buffer requirement would continue to equal 2.5 percent plus the countercyclical capital buffer requirement (if activated).
C. Removal of Internal Models for Credit
and Operational Risk
The proposal would eliminate the advanced approaches framework and introduce in its place the expanded riskbased approach to improve the consistency and transparency of the risk-based capital requirements applicable to Category I and II banking organizations. This approach would help address many of the challenges associated with the use of internal models to calculate risk-based capital requirements for credit risk and operational risk. In 2007, the agencies jointly issued a final rule requiring large, internationally active banking organizations to calculate risk-based capital requirements for credit risk and operational risk under the advanced approaches.25 In seeking to ensure that these banking organizations are adequately capitalized, the advanced approaches require banking organizations to estimate their exposure to severe unexpected losses.26 However, available information since adoption of this rule suggests that the advanced approaches do not always result in consistent minimum requirements across U.S. banking organizations with similar risk profiles.27 While internal models to calculate risk-based capital requirements for credit risk and operational risk do provide valuable information and may be more accurate in some cases than standardized approaches, as discussed below the severity of the outcomes the advanced approaches rule requires banking organizations to model coupled with data limitations and the subjectivity embedded in modeling assumptions has presented substantial challenges. Financial risk models designed to capture severe loss events can suffer from substantial uncertainty.28 Such uncertainty can result in substantial and unwarranted differences in capital requirements across similar exposures that are unrelated to differences in risk. The advanced approaches require banking organizations to estimate loss given default conditional on an economic downturn. Ensuring that banking organizations’ loss given default estimates are consistent with the risk of their exposures has proven challenging for several reasons, including (1) limited data on loss given default and its drivers under downturn conditions; (2) inconsistencies in constructing the loss given default variables, arising from factors such as methodological differences and difficulties in capturing all cash inflows and outflows after default;29 and (3) difficulty in verifying certain modeling assumptions, such as the time window used to calculate loss given default in an economic downturn. To a lesser degree, verifying the appropriateness of banking organizations’ probability of default models is challenging in some cases due to limited data for certain low default portfolios and varying practices in identifying defaults across banking organizations.30 31 For operational risk, banking organizations subject to the advanced approaches are required to estimate the 99.9th percentile of the distribution of the aggregated annual operational losses under the advanced
measurement approaches (AMA). This requirement has presented substantial challenges for banking organizations and supervisors as a considerable amount of relevant data would be needed to empirically verify model performance. Given the severe outcome that the requirement is designed to estimate, model and parameter uncertainty can result in substantial divergence in model outcomes and, consequently, substantial divergence in capital requirements.32 In addition, infrequent large operational loss events tend to have substantial influence on model outcomes and can result in substantial volatility.33 Together, these factors result in substantial uncertainty in internally modeled operational risk capital requirements and likely inconsistent requirements across banking organizations with similar operational risk profiles. Taken together, the severe outcomes that the advanced approaches rule expects banking organizations to model, the limitations of available data, and the subjectivity of modeling assumptions
34See 12 CFR 3.10(e)(1) (OCC); 12 CFR 217.10(e)(1) (Board); 12 CFR 324.10(e)(1) (FDIC). 35See 12 CFR 3.10(e)(2) (OCC); 12 CFR 217.10(e)(2) (Board); 12 CFR 324.10(e)(2) (FDIC). 36See 12 CFR 225.8; 12 CFR 238.170. 37See 12 CFR part 46 (OCC); 12 CFR part 238, subparts P and R, and 12 CFR part 252, subparts B and F (Board); 12 CFR part 325 (FDIC). 38See Enhanced Transparency and Public Accountability of the Supervisory Stress Test Models and Scenarios; Modifications to the Capital Planning and Stress Capital Buffer Requirement Rule, Enhanced Prudential Standards Rule, and Regulation LL, 90 FR 51856 (Nov. 18, 2025). 39 ‘‘In addition, both the supervisory stress test and the advanced approaches are calibrated to reflect tail risks; thus it could be duplicative to require a firm to meet the requirements of the advanced approaches on a post-stress basis.’’ 83 FR 18160 (Apr. 25, 2018). 40As the Board noted in October 2025, in aggregate, the proposed stress test model and scenario changes inform the Board’s determination of a firm’s stress capital buffer requirement and are not expected materially change capital requirements for firms subject to the supervisory stress test, across various stress test scenarios and jump-off conditions at the start of the test. That proposal included illustrative analysis that considered the potential effects of the proposed stress test model changes, independent of other factors and components that inform the Board’s stress capital buffer determinations for specific firms, within the 2024 and 2025 supervisory stress tests. In that analysis, implementing the proposed model changes and proposed revisions to the global Continued contribute to concerns about the reliability of internal model outputs and unwarranted divergences in risk-based capital requirements for credit and operational risk across banking organizations. The application of the stress capital buffer requirement to Category I and II bank holding companies also reduces the usefulness of retaining the advanced approaches for these banking organizations. Under the proposal, the stress capital buffer requirement would apply to the single set of risk-based capital ratios to which these bank holding companies would be subject, providing risk-sensitive capital requirements that reflect a granular, forward-looking assessment of risks. In this context, removing the advanced approaches simplifies the framework without reducing the resilience of Category I and II bank holding companies. Under the current capital rule, banking organizations are required to maintain capital commensurate with the level and nature of all risks to which they are exposed 34 and to have a process for assessing their overall capital adequacy in relation to their risk profile and a comprehensive strategy for maintaining an appropriate level of capital.35 In addition, certain large banking organizations are required to develop and maintain a capital plan 36 and conduct internal stress tests.37 The
proposal would not change these requirements. As discussed above, the advanced approaches have limitations as a means to set consistent minimum risk-based capital requirements. However, internal models can provide valuable information to a banking organization’s internal risk management, stress testing, and planning functions and can be used to complement minimum capital requirements in assessing a banking organization’s capital adequacy. Category I and II banking organizations, as well as other banking organizations, should continue to employ internal modeling capabilities for sound risk management as appropriate for the complexity of their activities. The proposal would continue to allow the use of internal models to calculate market risk capital requirements, but only for trading desks where modeling can be demonstrated to be appropriate. Market risk is more easily and effectively modeled than credit and operational risk because data on trading positions are observed at a much higher frequency and depth, in particular for commonly traded instruments. Trading creates price observations, which in turn provide daily feedback on model calibration and performance to support empirical verification through techniques such as back-testing. For these reasons, the benefits of retaining models are larger for market risk than for other exposure types. Question 5: What are the advantages and disadvantages of removing internal models for credit risk and operational risk? Are there alternatives that the agencies should consider and if so, why? Question 6: The Basel standards include a floor to risk-weighted assets, the ‘‘output floor,’’ which corresponds to 72.5 percent of risk-weighted assets calculated only using standardized approaches. The proposal would not include this output floor because proposed requirements would be almost completely standardized and, therefore, the output floor would be unlikely to bind in most situations. What would be the advantages and disadvantages of including a floor to risk-weighted assets corresponding to 72.5 percent of the risk-weighted assets calculated using only the standardized approaches in the proposal. D. Overlaps With the Stress Capital Buffer Requirement In proposing these revised risk-based capital requirements for Category I and II banking organizations, the Board is mindful of the overlaps between the capital and stress testing frameworks. Together, this proposal and a recent proposal to enhance the transparency and public accountability of the Board’s stress test,38 which requested public comment on certain revisions to the Board’s stress test models, aim to improve risk sensitivity of requirements in a way that considers the cumulative effect of the entire capital framework. The stress capital buffer requirement represents an explicitly forward-looking element in the risk-based capital requirements of large bank holding companies. Informed by the Board’s stress testing framework, the stress capital buffer
requirement aims to capture exposures comprehensively and granularly under conditions of severe stress. Under the current rule, a bank holding company’s stress capital buffer requirement is applied to its risk-based capital ratios calculated under the standardized approach, which do not include a specific requirement for operational risk, and is not applied to the bank holding company’s requirements under the advanced approaches. This historical choice was motivated, in part, by the goal of limiting redundancy between the stress capital buffer requirement, based on the Board’s forward-looking assessment of stress risks, and the bank holding company’s modeling of tail risks under the advanced approaches.39 Consistent with international standards, the proposed expanded riskbased approach would include a specific measure of operational risk in risk-weighted assets. Also, the proposed changes to the market risk framework would improve the measurement of tail risks in ways that are expected to raise minimum market risk capital requirements for the most complex banking organizations. The outstanding Board stress testing proposal would introduce meaningful revisions to stress test models and scenarios, including the models for operational risk and trading positions. Operational risk modeling would be enhanced by focusing on the more robust historical simulation model. Similarly, the stress test proposal would improve the modeling of trading positions under the global market shock component of the severely adverse scenario by better measuring their liquidity horizons. Both proposed revisions, on their own and independent of other factors, are projected to somewhat reduce aggregate projected stress capital buffer requirements.40
market shock component of the severely adverse scenario in the 2024 and 2025 stress tests would have, independent of other factors, increased the aggregate projected common equity tier 1 (CET1) stress ratio, on average, by 29 basis points, which would have corresponded to a reduction in stress capital buffer requirements of approximately 23 basis points or approximately 2.2 percent of current required capital. See 90 Federal Register 51856, 51874–51877 (Nov. 18, 2025). The analysis estimates that the proposed model changes would reduce stress capital buffer requirements by approximately 13 basis points and that the proposed revisions to the global market shock scenario component would reduce stress capital buffer requirements by approximately 10 basis points. For U.S. GSIBs, the analysis estimates a decline of 25 basis points in stress capital buffer requirements. See also Federal Reserve Board— Federal Reserve Board requests comment on proposals to enhance the transparency and public accountability of its annual stress test; Dodd-Frank Act Stress Tests 2026 (Dec. 1, 2025). 41This revision would also be consistent with comments received under EGRPRA as commenters requested indexing of thresholds going forward to reflect inflation. 42The agencies’ regulations that implement the Community Reinvestment Act define small and intermediate-small banks by reference to asset-size criteria expressed in dollar amounts, which are adjusted annually based on the year-to-year change in inflation through a Federal Register notice. Specifically, this adjustment corresponds to the average of the Consumer Price Index for Urban Wage Earners and Clerical Workers, not seasonally adjusted, for each 12-month period ending in November, with rounding to the nearest million. See, e.g., Community Reinvestment Act Regulations Asset-Size Thresholds, 89 FR 106480, 106481 (Dec. 30, 2024). See also 12 CFR 229.11. 43See Adjusting and Indexing Certain Regulatory Thresholds, 90 FR 55789 (Dec. 1, 2025). 44Any periods of deflation would be reflected in future threshold increases, as threshold adjustments in the future would be based on the positive net cumulative change in CPI–W. 45For example, a threshold that would otherwise be calculated as $5.964 million would be rounded to $6.0 million, or the nearest $0.1 million. In summary, this proposal is projected to increase the minimum requirements for operational risk and market risk, while the stress test proposal’s analysis of the proposed model changes estimated a decrease in related requirements for these risks, as they inform the stress capital buffer requirement. The Board expects both sets of revisions to improve risk sensitivity and coherence of the capital framework, while the revisions in this proposal would contribute to international consistency. The capital impact of these revisions would largely offset each other, and the Board considers that the combined calibration of these risks would be appropriate (see
section VII for additional analysis of the
cumulative calibration of requirements by risk type). Question 7: The current Board stress testing methodology reflects a constant balance sheet assumption and assumes that a banking organization’s riskweighted assets generally remain unchanged over the nine-quarter projection horizon. What would be the advantages and disadvantages of adjusting the stress testing methodology to project changes in risk-weighted assets for banking organizations subject to the expanded risk-based approach and banking organizations subject to the market risk framework? For example, what would be the advantages and disadvantages of projecting changes in the risk-weighted assets applicable to credit exposures to better reflect deteriorations in obligors’ credit quality during a stress period (such as migrating corporate exposures in the investment grade 65 percent risk weight category into the general corporate category or from the general corporate category into the past due category)? What would be the advantages and disadvantages of adjusting riskweighted assets for operational risk by projecting lower income amounts during a stress period? What, if any, changes should the Board consider to better project risk-weighted assets for trading positions and derivatives during a stress period in light of the proposed market risk framework, including the proposed credit valuation adjustment risk requirement (these may include revisions to reflect changes in modelability of risk factors and volatility)? E. Indexing of Thresholds The proposal uses certain thresholds to differentiate requirements based on a banking organization’s size, risk profile, and complexity as well as on the characteristics of the exposures. However, static dollar-based thresholds can lead to unintended consequences if threshold levels are not periodically updated or indexed to inflation. For example, banking organizations can become subject to additional requirements and burden over time for reasons unrelated to changes in their risk profile. Under the proposal, certain dollar-based thresholds would be adjusted in the future to reflect inflation, pursuant to a pre-determined indexing methodology.41 Indexing dollar-based thresholds would preserve threshold levels in real terms, which would efficiently and transparently preserve the thresholds’ intended application and align with intended policy objectives over time. The proposed indexing methodology would adjust thresholds based on the consumer price index for urban wage earners and clerical workers (CPI–W) published by the U.S. Bureau of Labor Statistics. The use of CPI–W to index thresholds is consistent with other bank regulations, such as those relating to the Community Reinvestment Act and the Board’s Regulation CC.42 Further, the indexing methodology included under the proposal would generally align with the methodology used to adjust certain thresholds within FDIC regulations.43 Specifically, certain dollar thresholds would be adjusted at the
end of every consecutive two-year period based on the cumulative percent change of the non-seasonally adjusted CPI–W since the effective date of any final rule. This two-year period is intended to provide an appropriate cadence for capturing meaningful changes in inflation on a timely basis while minimizing the burden of adjustment. To address the possibility of periods of unusual inflation, the indexing methodology would also allow for discretionary adjustment to thresholds by the agencies during an off year. The proposal would also not lower thresholds in the event of deflation.44 Additionally, thresholds adjusted under the proposed indexing methodology would be rounded based on the size of the threshold (e.g., billions, millions, thousands), generally, to the nearest two significant digits, as appropriate.45 The proposal would index the following thresholds: (1) the $1 million threshold for a retail exposure to qualify as regulatory retail; (2) the $50 million annual revenue threshold for a borrower to qualify as a small or medium-sized entity; (3) the $10 million threshold used to determine whether a company in which a covered banking organization owns equity instruments meets the definition of financial institution; (4) the $1 billion and the $30 billion business indicator thresholds that determine the marginal coefficients applicable for the calculation of the business indicator component in the operational risk capital requirement; (5) the $20,000 threshold for mandatory collection of operational loss events; (6) the $5 billion trading activity threshold for application of the market risk framework; (7) the $1 trillion derivatives exposure threshold for application of the credit valuation adjustment risk requirement; (8) the $20 million threshold above which net short positions must be included in the market risk framework; and (9) the $2 billion threshold for an equity issuer to be classified as having large market capitalization in the market risk standardized approach. To effectuate threshold changes under the proposal, the agencies would announce threshold adjustments pursuant to the indexing methodology by publishing the updated thresholds.
46The U.S. Bureau of Labor Statistics publishes the CPI–W on a monthly basis. 47See, e.g., 12 U.S.C. 1828 note, 3901, 3907, 3911, and 5373; see also 22 U.S.C. 9522 note; Federal Deposit Insurance Corporation Improvement Act of 1991 § 305(b)(2), Public Law 102–242, 105 Stat. 2236, 2355. 48The Basel Committee was originally formed after the failure of Herstatt Bank in Germany in 1974, which contributed to serious disruptions to foreign currency and banking markets within and beyond Germany, demonstrating the need for better coordination among bank regulators in different jurisdictions. See https://www.bis.org/bcbs/ history.htm. 49See GAO Report ‘‘Bank Capital Requirements— Potential Effects of New Changes on Foreign Holding Companies and U.S. Banks Abroad’’ (Jan. 2012), https://www.gao.gov/assets/gao-12-235.pdf; see also GAO Report ‘‘International Banking— International Coordination of Bank Supervision:
The Record to Date’’ (Feb. 1986), https:// www.gao.gov/assets/nsiad-86-40.pdf. 50See, e.g., Board of Governors of the Federal Reserve System and U.S. Department of the Treasury, ‘‘Capital Equivalency Report’’ (June 1992), https://fraser.stlouisfed.org/title/capitalequivalency-report-9009; 12 U.S.C. 3105(j). 51See, e.g., 12 CFR 211.24, 225.2(r)(3). 52Public Law 111–203, 124 Stat. 1376 (2010). In applying section 165 to a foreign-based bank holding company, the Dodd-Frank Act directs the Board to give due regard to the principle of national treatment and equality of competitive opportunity, and to take into account the extent to which the foreign banking organization is subject, on a consolidated basis, to home country standards that are comparable to those applied to financial companies in the United States. See 12 U.S.C. 5365(b)(2). 53See, e.g., 12 CFR 252.143(a). Absent homecountry standards consistent with the Basel Capital Framework, a foreign banking organization would be required to demonstrate to the Board’s satisfaction that it would meet Basel Capital Framework standards at the consolidated level were those standards to apply. See 79 FR 17240 (Mar. 27, 2014). 54See GAO Report ‘‘International Banking— International Coordination of Bank Supervision:
The Record to Date’’ (Feb. 1986), https:// www.gao.gov/assets/nsiad-86-40.pdf. 55For example, the GSIB surcharge framework adopted by the Board includes a second method for calculating GSIB surcharges that is different from the Basel GSIB surcharge methodology. See 80 FR 49082 (Aug. 14, 2015). Additionally, alignment with the Basel standards can be achieved without using all methods specified in them and, in the past, the agencies have chosen not to adopt some methods included within the Basel standards. See, e.g., 61 FR 47358 (Sept. 6, 1996), 72 FR 69288 (Dec. 7, 2007), and 78 FR 62018 (Oct. 11, 2013). 56See 12 U.S.C. 1831n. 57See, e.g., 12 U.S.C. 1831bb and 5371; 15 U.S.C. 78o–7 note. Threshold adjustments would be calculated based on cumulative CPI–W data through August of the year in which the adjustment is made, relative to the same initial baseline.46 Question 8: What are the advantages and disadvantages of the proposed approach for indexing thresholds? What alternatives should the agencies consider and why? What are the advantages and disadvantages of using a different index for adjusting thresholds, such as nominal GDP or the GDP deflator, instead of CPI–W? Question 9: Are there specific thresholds within the proposal that can result in an increase in operational burden when indexed? If so, which are they and why? Question 10: What are the advantages and disadvantages of discretionary offyear adjustments for periods of unusual inflation? Should the agencies consider a framework for adjustment in off years, such as based on inflation or other threshold and, if so, why? F. The Role of International Standards in Developing U.S. Capital Requirements The agencies participate in international fora, including the Basel Committee, that support broadly aligned prudential financial regulation across major economies, consistent with the agencies’ mandates and various statutory authorizations.47 Standards issued by these international fora are not binding under U.S. law. The agencies routinely consider the potential benefits of such standards as
part of a reasoned decision-making
process when developing domestic rulemakings to implement prudential requirements. Where appropriate and consistent with the agencies’ statutory authorities and policy objectives, maintaining consistency between domestic financial regulatory policy and international standards can generate significant benefits, particularly regarding large, internationally active banking organizations. Large, internationally active banks and the U.S. financial system more broadly are highly interconnected with the global financial system. Promoting the application of suitable and robust prudential standards across jurisdictions can enhance the resilience of the U.S. financial system by reducing the likelihood of distress or other problems that arise in a foreign jurisdiction having negative effects in the United States.48 Comparability of standards across jurisdictions can also reduce complexity and compliance costs for banking organizations with significant crossborder operations or activities.49 In particular, similar prudential standards enable the agencies and foreign supervisors to look to home country capital regimes when such requirements are generally consistent with international standards.50 For example, similar prudential standards help to facilitate the Board’s assessment of the capital adequacy of foreign banking organizations in connection with applications to establish operations within the United States.51 In addition, consistent standards help ensure that foreign banking organizations with U.S. operations are subject to standards at the consolidated level that promote safety and soundness and competitive equity with U.S. banking organizations. The adoption of similar prudential standards across many jurisdictions means that, consistent with section 165 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (DoddFrank Act),52 the Board’s enhanced prudential standards for large foreign banking organizations may rely on the home country capital and stress testing regimes applicable to a foreign banking organization, avoiding unnecessary duplication of requirements.53 Additionally, comparability of standards across jurisdictions helps home country and host country supervisors, along with banking organization management and public markets, understand and monitor positions and risks across jurisdictions by providing all parties with a set of shared principles, concepts, and measuring tools.54 Notwithstanding these benefits, the agencies have, at various times, concluded that departures from international standards are appropriate and desirable in light of domestic requirements or considerations, or where U.S. regulators simply believe different standards are more appropriate. Consistent with previous rulemakings that implemented aspects of the Basel standards in the United States,55 the proposal may differ from the Basel standards in certain areas to reflect factors such as specific characteristics of U.S. markets, requirements under GAAP,56
practices of U.S. banking organizations, and U.S. legal requirements and policy objectives.57 G. Treatments Retained From the Current Standardized Approach Taking the current standardized approach as a starting point, the proposal would generally adopt treatments consistent with the Basel standards when they would improve the risk sensitivity and consistency of the requirements applicable to covered banking organizations, do not conflict with existing U.S. law, and are appropriate for U.S. banking organizations. Many elements of the expanded risk-based approach would be consistent with the Basel standards and different in some respects from the treatment under the current standardized approach. In some cases, the current standardized approach is
58For example, the expanded risk-based approach would treat sovereign exposures, certain exposures to government-sponsored entities, and exposures to public sector entities the same as the current standardized approach. 59An MSA arises when a banking organization sells a loan to a third party but retains the obligation to service the loan in exchange for a fee. Banking organizations may also purchase, sell, or transfer MSAs separately from the underlying mortgage loans. 60 In addition, the proposal would require a banking organization to deduct from common equity tier 1 capital any portion of a creditenhancing interest only strip that does not constitute an after-tax-gain-on sale, as discussed in
section IV.B.5.f. of this SUPPLEMENTARY
INFORMATION.
61The agencies’ standardized approach proposal would make the same modification to the definition of regulatory capital for all other banking organizations. 62 In the 2013 capital rule (78 FR 62069, Oct 11, 2013), in connection with section 475 of the Federal Deposit Insurance Corporation Improvement Act of 1991 (12 U.S.C. 1828 note), the agencies made a finding that the treatment under the capital rule of readily marketable purchased MSAs would not have an adverse effect on the Deposit Insurance Fund or the safety and soundness of insured depository institutions. The proposal would continue to apply a 250 percent risk weight to all MSAs, while removing the threshold deduction, and the agencies continue to consider the proposed treatment to not have an adverse effect on the Deposit Insurance Fund or the safety and soundness of insured depository institutions. appropriately risk sensitive for application to Category I and II banking organizations and, therefore, the agencies are retaining those treatments with minimal or no change.58
III. Definition of Capital
Under the proposal, all banking organizations required to apply the expanded risk-based approach, or that choose to adopt the expanded risk-based approach, would be subject to the same definition of capital. The proposal would broadly maintain the definition of capital for Category I and II banking organizations in the current capital rule, with one modification to eliminate the requirement to deduct MSAs 59 above a threshold from common equity tier 1 capital.60 Banking organizations that choose to adopt the expanded risk-based approach would, therefore, be required to include most components of accumulated other comprehensive income in regulatory capital. Under the current capital rule, Category I and II banking organizations must deduct from common equity tier 1 capital amounts of MSAs, temporary difference DTAs that the banking organization could not realize through net operating loss carrybacks, and significant investments in the capital of unconsolidated financial institutions in the form of common stock (collectively, threshold items) that individually exceed 10 percent of the banking organization’s common equity tier 1 capital minus certain deductions and adjustments. In addition, these banking organizations must deduct from common equity tier 1 capital the aggregate amount of the threshold items that exceeds 15 percent of common equity tier 1 capital. Under the proposal, Category I and II banking organizations would no longer be required to deduct any amount of MSAs from common equity tier 1 capital and would not consider MSAs when calculating the aggregate deduction amount for temporary difference DTAs and significant investments in the capital of unconsolidated financial institutions in the form of common stock. Instead, MSAs would be subject to a 250 percent risk weight, consistent with the treatment in the current capital rule for MSAs that do not exceed the deduction thresholds.61 MSAs can be a useful tool for banking organizations to manage interest rate risk. The value of MSAs generally increases when interest rates rise, which extends the expected duration of related servicing fees. As a result, they may provide a hedge against losses on other assets that decline in value in the same interest rate environment. Moreover, MSAs are important for banking organizations to maintain their relationship with borrowers by retaining customer-facing relationships even after transferring the underlying loans, allowing cross-selling of products. Banking organizations can also improve efficiency by increasing scale. A deduction approach for MSAs can discourage banking organizations from creating economies of scale, which can hinder their ability to compete in mortgage underwriting or servicing businesses and to manage risks. At the same time, MSAs have long been subject to elevated capital requirements because of the high level of uncertainty regarding the ability of banking organizations to realize value from these assets, especially under
adverse financial conditions. MSAs may face significant valuation risk, which mainly stems from prepayment risk, default risk, and liquidity risk. For example, increased refinancing of mortgage loans due to lower interest rates can quickly erode the value of MSA portfolios, as can increased incidents of mortgage defaults. MSAs can also be difficult to value, as banking organization portfolios of MSAs can be heterogeneous and MSA valuations rely on assessments of future economic variables. Maintaining the 250 percent risk weight for MSAs would promote regulatory capital requirements that are commensurate with the risk of these assets.62 Question 11: What are the advantages and disadvantages of the proposed treatment of MSAs? What are the implications of the proposed treatment of MSAs for banking organizations’ mortgage origination business? To what extent does the 250 percent risk weight appropriately reflect the risk of these assets throughout the economic cycle? Given the potential volatility of MSAs under certain circumstances, what are the advantages and disadvantages of the agencies imposing a higher limit on MSA as a percentage of common equity tier 1 capital (for example, 100 percent) and why? What are the advantages and disadvantages of differentiating the treatment of MSAs based on the size of the banking organization (for example, banking organizations with assets under $10 billion or over $100 billion) or applicable capital framework (for example, banking organizations that elect the community bank leverage ratio framework)?
IV. Calculation of Risk-Weighted Assets
Under the Expanded Risk-Based Approach A. Credit Risk Credit risk arises from the possibility that an obligor, including a borrower or counterparty, will fail to perform on an obligation. While loans are a significant source of credit risk, other products, activities, and services also expose banking organizations to credit risk, including investments in debt securities and other credit instruments, credit derivatives, and cash management services. Off-balance sheet activities, such as letters of credit, unfunded loan commitments, and the undrawn portion of lines of credit, also expose banking organizations to credit risk. Certain transactions give rise to counterparty credit risk, which generally refers to the risk that a counterparty to a transaction will default before the final settlement of the transaction and will fail to make all the payments required by the transaction. Transactions that give rise to counterparty credit risk include repostyle transactions, eligible margin loans, and derivatives transactions. Counterparty credit exposure is determined by the market value of the transaction, which fluctuates with market conditions. Thus, the current exposure to a counterparty’s default continuously changes and the future exposure is uncertain. Under the proposal, a banking organization subject to the expanded
63Carrying value under §ll. 2 of the current capital rule means, with respect to an asset, the value of the asset on the balance sheet of the banking organization as determined in accordance with GAAP. For all assets other than available-forsale debt securities or purchased credit deteriorated assets, the carrying value is not reduced by any associated credit loss allowance that is determined in accordance with GAAP. See 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC). The exposure amount arising from an OTC derivative contract; a repo-style transaction or an eligible margin loan; a cleared transaction; a default fund contribution; or a securitization exposure would be calculated in accordance with §§ll. 113, 121, or 131 of the proposal, respectively, as described in sections IV.A.4, IVA.5.b., and IV.B. of this Supplementary Information. The standardized approach proposal also includes a technical amendment that would modify the term adjusted allowance for credit losses (AACL) and carrying value to exclude allowance for credit losses (ACLs) on purchased seasoned loans (PSLs) in addition to those on purchased credit deteriorated (PCD) assets and available-for-sale (AFS) debt securities. The standardized approach proposal also amends the definition of AACL and carrying value to provide the same treatment as PCD assets to other assets that may in the future become subject to the gross approach following a change to GAAP by FASB. 64See 12 U.S.C. 1831n. risk-based approach would follow similar mechanics to those in the current standardized approach to determine its risk-weighted assets for credit risk. Such a banking organization would first determine the exposure amount of each on-balance sheet exposure, derivative contract, and offbalance sheet commitment, trade and transaction-related contingency, guarantee, repo-style transaction, financial standby letter of credit, forward agreement, or other similar transaction (excluding certain transaction types or exposures as specified in the proposed rule). In certain cases, exposure amount is measured at the netting-set level. The banking organization would then multiply the exposure amount by the risk weight appropriate to the exposure based on the exposure type or counterparty. In addition, the proposal would allow for the recognition of certain credit risk mitigants through adjustments to the risk-weighted asset amount for protected exposures.
Section IV.A.1. of this SUPPLEMENTARY
INFORMATION describes in general terms the approaches for determining exposure amount under the proposal;
section IV.A.2. of this SUPPLEMENTARY
INFORMATION describes the risk-weight treatment for credit exposures under the proposal; section IV.A.3. of this SUPPLEMENTARY INFORMATION describes the proposed exposure measurement of off-balance sheet exposures; section IV.A.4. of this SUPPLEMENTARY INFORMATION describes the proposed exposure measurement for counterparty credit risk-related exposures; and
section IV.A.5. of this SUPPLEMENTARY
INFORMATION describes the available approaches for recognizing the benefits of credit risk mitigants including certain guarantees, certain credit derivatives, financial collateral, and prepaid credit protection arrangements.
65Under the proposal, specified supranational entities would include the Bank for International Settlements, the European Central Bank, the European Commission, the International Monetary Fund, the European Stability Mechanism, and the European Financial Stability Facility. Consistent with the current capital rule, exposures to such entities would continue to be subject to a zero percent risk weight for the purposes of the expanded risk-based approach. 66Under the proposal, multilateral development bank would include International Bank for Reconstruction and Development, the Multilateral Investment Guarantee Agency, 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 primary Federal supervisor determines poses comparable credit risk. Consistent with the current capital rule, exposures to these entities would continue to be subject to a zero percent risk weight for the purposes of the expanded risk-based approach 67For treatment of other exposures to GSEs, see discussion related to equity exposures in section IV.C. and subordinated exposures in section IV.A.2.f. of this SUPPLEMENTARY INFORMATION. 68Certain residential mortgage exposures that are 90 days past due or in nonaccrual would receive a higher risk weight under the proposal. See section IV.A.2.c.v of this SUPPLEMENTARY INFORMATION. 69 Government-sponsored enterprise (GSE) under §ll. 2 of the current capital rule means an entity established or chartered by the U.S. government to serve public purposes specified by the U.S. Congress but whose debt obligations are not explicitly guaranteed by the full faith and credit of the U.S. government. See 12 CFR 3.2 (OCC); 12 CFR
217.2 (Board); 12 CFR 324.2 (FDIC).
and the potential for increased central clearing. The agencies are proposing to revise SA–CCR to permit the netting of collateralized-to-market and settled-tomarket client-facing derivative transactions and incorporate noncleared repo-style transactions. Specifically, the agencies are proposing to permit a banking organization to elect to treat as a derivative contract any noncleared repo-style transaction subject to a qualifying cross-product master netting agreement that also contains a derivative contract. These proposed amendments and other proposed technical revisions to SA–CCR are described below in section IV.A.4.b. of this SUPPLEMENTARY INFORMATION. As stated earlier, the proposal would increase simplicity, transparency, consistency, and comparability of capital requirements by reducing banking organization’s use of models. Therefore, the proposal does not include the internal models methodology (IMM) or the simple value-at-risk (VaR) methodology for measuring counterparty credit risk or the use of a banking organization’s own estimates of haircuts for purposes of the collateral haircut approach.
2. Proposed Risk Weights for Credit Risk
The proposed expanded risk-based approach would introduce credit risk weights that generally align with the Basel standards and use many of the same definitions in §ll.2 of the current capital rule. Some elements of the proposed expanded risk-based approach for credit risk would apply the same risk weights provided in the current standardized approach, including exposures to sovereigns, specified supranational entities 65 and multilateral development banks,66 government sponsored entities (GSEs) in the form of senior debt and guaranteed exposures, Federal Home Loan Bank (FHLB) and Federal Agricultural Mortgage Corporation (Farmer Mac) equity exposures,67 public sector entities (PSEs), exposures that are 90 days or more past due or in nonaccrual,68 and certain insurance assets. Consistent with statutory mandates, the proposal would also maintain the same risk-weight treatment provided in the current standardized approach to pre-sold construction loans, statutory multifamily mortgages, and high-volatility commercial real estate (HVCRE) exposures. Relative to the advanced approaches under the current capital rule, the proposed expanded risk-based approach would result in more consistent and transparent capital requirements for credit risk exposures across banking organizations. The proposal would also facilitate comparisons of capital adequacy across banking organizations by reducing excessive, unwarranted divergence in risk-weighted assets for similar exposures. Relative to the current standardized approach, the proposal would incorporate more granular risk factors to allow for a broader range of risk weights. Specifically, the expanded risk-based approach would introduce new risk weights for exposures to depository institutions, foreign banks, and credit unions; subordinated exposures, including those to GSEs; and real estate, retail, and corporate exposures. The proposed risk weights for each of these categories are described in the following sections of this SUPPLEMENTARY INFORMATION. Question 12: What are the pros and cons of continuing the risk-weights in the current standardized approach for sovereigns, specified supranational entities and multilateral development banks, GSEs in the form of senior debt and guaranteed exposures, FHLB and Farmer Mac equity exposures, PSEs, exposures that are 90 days or more past due or in nonaccrual, insurance assets, and other exposures? Question 13: To enhance the risk sensitivity of the rule, what alternatives to ‘‘exposures that are 90 days or more past due or in nonaccrual’’ should the agencies consider to identify exposures in or near default? What are the advantages and disadvantages of using an approach similar to the definition of defaulted exposures in the advanced approaches, that would include exposures where (a) the banking organization has taken a partial chargeoff, write-down of principal, or negative fair value adjustment on the exposure for credit-related reasons, until the banking
organization has reasonable assurance of repayment and performance for all contractual principal and interest payments on the exposure; or (b) a distressed restructuring of the exposure was agreed to by the banking organization, until the banking organization has reasonable assurance of repayment and performance for all contractual principal and interest payments on the exposure as demonstrated by a sustained period of repayment performance, provided that a distressed restructuring includes the following made for credit-related reasons:
forgiveness or postponement of principal, interest, or fees, or an interest rate reduction? a. Exposures to Government-Sponsored Enterprises The proposal would assign a 20 percent risk weight to most GSE 69 exposures, consistent with the current standardized approach. GSE exposures that are subordinated exposures or equity exposures, however, would receive higher risk weights. As discussed later in sections IV.C. and IV.A.2.f. of this SUPPLEMENTARY INFORMATION, equity exposures and subordinated exposures would generally be subject to an increased risk weight to reflect their heightened risk relative to senior credit exposures. As an exception to this general rule, the proposal would apply a 20 percent risk weight to all exposures to FHLB or Farmer Mac, including equity exposures and exposures to subordinated debt instruments, which is consistent with the treatment under the current standardized approach. b. Exposures to Depository Institutions, Foreign Banks, and Credit Unions The proposal would define the scope of exposures to depository institutions,
70Under §ll.2 of the current capital rule, a depository institution means a depository institution as defined in section 3 of the Federal Deposit Insurance Act, a foreign bank means a foreign bank as defined in section 211.2 of the Federal Reserve Board’s Regulation K (12 CFR 211.2) (other than a depository institution), and a credit union means an insured credit union as defined under the Federal Credit Union Act (12 U.S.C. 1751 et seq.). See 12 CFR 3.2 (OCC); 12 CFR
217.2 (Board); 12 CFR 324.2 (FDIC). Exposures to
other financial institutions, such as bank holding companies, savings and loans holding companies, and securities firms, generally would be considered corporate exposures. See 78 FR 62087 (Oct. 11, 2013). 71The proposal would require banking organizations to apply a 150 percent risk weight to bank exposures that are either subordinated exposures, as described in section IV.A.2.f. of this SUPPLEMENTARY INFORMATION, or covered debt instruments that are not deducted. 72The capital ratios used for this determination are the ratios on the depository institution’s most recent quarterly Consolidated Report of Condition and Income (Call Report). 73See 12 CFR part 702 (National Credit Union Administration). 74Under §ll.2 of the current capital rule, ‘‘investment grade’’ means that the entity to which the banking organization is exposed through a loan or security, or the reference entity with respect to a credit derivative, has adequate capacity to meet financial commitments for the projected life of the asset or exposure. Such an entity or reference entity has adequate capacity to meet financial commitments if the risk of its default is low and the full and timely repayment of principal and interest is expected. 75See 12 CFR 3.12(a)(1) (OCC); 12 CFR 217.12(a)(1) (Board); 12 CFR 324.12(a)(1) (FDIC). See also 90 FR 55048 (Dec. 1, 2025). 76An exposure to a depository institution that has not opted into the CBLR framework and is not required to calculate a common equity tier 1 ratio and a SLR or tier 1 leverage ratio, as applicable, under the agencies’ capital rule would not qualify for the 30 percent risk weight. 77The Grade A foreign bank would have to meet the five percent Basel leverage ratio level for the 30 percent risk weight, as implemented by the foreign bank’s home country. The Basel leverage ratio is substantially similar to the supplementary leverage ratio under the agencies’ capital rule. 78For comparison, a well-capitalized credit union must have a net worth ratio (NWR) of 7 percent or greater. A NWR of 9 percent was selected given that is the level used in their Complex Credit Union Leverage Ratio (CCULR) framework. The average NWR of Risk-Based Capital reporters was 9.83 percent as of 2025 Q2. See Quarterly Credit Union Data Summary 2025 Q2 (Page 20) and Risk-Based Capital Frequently Asked Questions | NCUA. foreign banks, and credit unions in a manner that is consistent with the definitions and scope of exposures covered under the current capital rule. Under the proposal, a bank exposure would mean an exposure (such as a receivable, guarantee, letter of credit, loan, OTC derivative contract, or senior debt instrument) to a depository institution, foreign bank, or credit union.70 71 The proposed treatment for bank exposures supports the simplicity, transparency, and consistency objectives of the proposal in a manner that is appropriately risk sensitive. The proposal would provide three categories for bank exposures that are ranked from the
highest to the lowest in terms of creditworthiness: Grade A, Grade B, and Grade C. The assignment of a bank exposure to a category would be based on the indicators of creditworthiness of the obligor depository institution, foreign bank, or credit union. As outlined below, the proposal would rely on the current capital rule’s definition of investment grade and the proposed definition of speculative grade for differentiating the credit risk of bank exposures. In addition, the proposal would incorporate publicly disclosed capital levels to differentiate the financial strength of a depository institution, foreign bank, or credit union in a manner that is both objective and transparent to supervisors and the public. More specifically, a Grade A bank exposure would mean a bank exposure for which the obligor depository institution, foreign bank, or credit union (1) is investment grade, and (2) whose most recent publicly disclosed capital ratios meet or exceed the higher of: (a) the minimum capital requirements and any additional amounts necessary to not be subject to limitations on distributions and discretionary bonus payments under the capital rules established by the prudential supervisor of the depository institution, foreign bank, or credit union, and (b) if applicable, the capital ratio requirements for the wellcapitalized category under the agencies’ prompt corrective action framework,72 or under similar rules of the National Credit Union Administration.73 For a bank exposure to be considered investment grade, a banking organization would have to determine that the obligor has adequate capacity to meet financial commitments, consistent with the current rule.74 Further, a bank exposure to a depository institution that had opted into the community bank leverage ratio (CBLR) framework and is investment grade would be considered to be a Grade A bank exposure, including if the obligor depository institution were in the grace period under the CBLR framework.75 As a result, under the proposal, a depository institution that uses the CBLR framework would not be required to calculate or disclose risk-based capital ratios for purposes of qualifying as a Grade A bank exposure. Additionally, as described further in the next paragraph, a Grade A exposure to depository institutions that have opted into the CBLR framework would receive a reduced risk weight relative to other Grade A exposures. Certain Grade A exposures to depository institutions, foreign banks, and credit unions would be subject to a 30 percent risk weight, whereas the others would be assigned a 40 percent risk weight. Specifically, a banking organization could assign a 30 percent risk weight to Grade A exposures to: (1) Category I, II, or III depository institutions with a common equity tier 1 capital ratio of 14 percent or higher and a supplementary leverage ratio (SLR) of five percent or higher; (2) depository institutions that have opted into the CBLR framework; and (3) depository
institutions not subject to the SLR or CBLR framework with a common equity tier 1 capital ratio of 14 percent or higher and a tier 1 leverage ratio of five percent or higher.76 To qualify for the 30 percent risk weight, a foreign bank obligor would have to meet the same requirements of having a 14 percent or higher common equity tier 1 capital ratio and a five percent or higher leverage ratio as determined by the applicable capital standards of the foreign bank’s home country jurisdiction.77 Under this proposed criteria, 68.3 percent of U.S. depository institutions would meet the criteria for a highly capitalized bank exposure and be assigned a 30 percent risk weight, based on Call Report data as of June 30,
2025. Grade A exposures to credit
unions would be subject to the 30 percent risk weight if the obligor credit union has a net worth ratio of 9 percent or higher.78 These requirements would be broadly consistent with those in the Basel standards and provide a preferential risk weight for institutions presenting a materially lower credit risk than other Grade A bank exposures. The 30 percent risk weight for exposures to banks with materially higher capital levels would increase risk sensitivity while maintaining competitive equity across various sizes of obligor institutions. A Grade B bank exposure would mean a bank exposure that is not a Grade A bank exposure and for which the obligor depository institution, foreign bank, or credit union (1) is speculative grade or investment grade, and (2) whose most recent publicly disclosed capital ratios meet or exceed the higher of: (a) the applicable minimum capital requirements under capital rules established by the prudential supervisor of the depository institution, foreign bank, or credit union, and (b) if applicable, the capital ratio
79See 12 CFR 6.4(b)(2) (OCC); 12 CFR 208.43(b)(2) (Board); 12 CFR 324.403(b)(2) (FDIC). 80See Table 1 in §ll.111 for the proposed sovereign risk-weight table, which is identical to
Table 1 to §ll.32 in the current capital rule.
capitalized category 79 under the agencies’ prompt corrective action framework, or under similar rules of the National Credit Union Administration. For a foreign bank to qualify as a Grade A or Grade B bank exposure, the proposal would require the applicable capital standards imposed by the home country supervisor to be broadly consistent with international capital standards issued by the Basel Committee. This requirement aims to maintain competitive equity and recognize creditworthiness of institutions subject to capital standards that are broadly consistent—the capital standards issued by the Basel Committee are comparable to U.S. capital rules. Under the proposal, an exposure to a foreign bank that is a Grade A or Grade B bank exposure and is a selfliquidating, trade-related contingent item that arises from the movement of goods and that has a maturity of three months or less may be assigned a risk weight that is lower than the risk weight applicable to other exposures to the same foreign bank. The proposed approach to providing a preferential risk weight for short-term self-liquidating, trade-related contingent items would be consistent with the current standardized approach. In addition, an exposure would not qualify as a Grade A or Grade B bank exposure if: (1) the obligor depository institution, foreign bank, or credit union does not have capital ratios that are publicly disclosed within the last six months; or (2) the external auditor of the depository institution, foreign bank, or credit union has issued an adverse audit opinion or has expressed substantial doubt about the ability of the depository institution, foreign bank, or credit union to continue as a going concern within the previous 12 months. A Grade C bank exposure would mean a bank exposure that does not qualify as a Grade A or Grade B bank exposure. The proposal would address the risk that capital and foreign exchange controls imposed by a sovereign entity in which a foreign bank is located could prevent or materially impede the ability of the foreign bank to convert its currency to meet its obligations or transfer funds. The proposal would, therefore, provide a risk weight floor for foreign bank exposures based on the risk weight applicable to a sovereign exposure for the jurisdiction where the foreign bank is incorporated when (1) the exposure is not in the local currency of the jurisdiction where the foreign bank is incorporated; or (2) for an exposure to a branch of a foreign bank in a foreign jurisdiction that is not the home country of the foreign bank, the exposure is in the local currency of the jurisdiction in which the foreign branch operates.80 The risk weight floor would not apply to short-term self-liquidating, trade-related contingent items that arise from the movement of goods. As provided in Table 1, the proposed risk weights for bank exposures generally would range from 20 percent to 150 percent. The proposal provides more granular and higher risk weights
for bank exposures compared to the standardized approach to better reflect the range of credit risks presented by these exposures. In addition, the proposal better accounts for financial system interconnectedness inherent in exposures to depository institutions, foreign banks, and credit unions, which can pose systemic risk to the financial system. The proposed risk weights in Table 1 for exposures to depository institutions, credit unions and foreign banks, especially those that are Grade A, reflect that those institutions present reduced credit risk relative to exposures to other types of financial institutions or companies. U.S. depository institutions and credit unions are subject to strong capital requirements, are subject to robust federal supervision, and have limitations in the types of riskier financial transactions in which they can engage. Foreign banks that qualify as Grade A would have broadly consistent capital standards as U.S. depository institutions and also would be subject to regulatory and supervisory frameworks broadly equivalent with those in the Basel standards. Additionally, the proposed risk weights for bank exposures under the expanded riskbased approach would be more risk sensitive than the current standardized EP27MR26.060</GPH>
81For purposes of the proposal, ‘‘primarily secured by collateral in the form of real estate’’ should be interpreted in a manner that is consistent with the current definition for ‘‘a loan secured by real estate’’ in the Call Report and Consolidated Financial Statements for Holding Companies (FR Y–9C) instructions. 82The Resolution Trust Corporation Refinancing, Restructuring, and Improvement Act of 1991 (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 that meet specific statutory criteria in the RTCRRI Act and any other underwriting criteria imposed by the agencies, and (ii) a 100 percent risk weight for one-to-four-family residential pre-sold construction loans for residences for which the purchase contract is cancelled. See 12 U.S.C. 1831n note. 83The RTCRRI Act mandates that each agency provide in its capital regulations a 50 percent risk weight for certain multifamily residential loans that meet specific statutory criteria in the RTCRRI Act and any other underwriting criteria imposed by the agencies. See 12 U.S.C. 1831n note. 84Section 214 of the Economic Growth, Regulatory Relief, and Consumer Protection Act imposes certain requirements on high volatility commercial real estate acquisition, development, or construction loans. Section 214 of Public Law 115– 174, 132 Stat. 1296 (2018). See 12 U.S.C. 1831bb. 85See ‘‘Charge Off Rates for Loans and Leases at Commercial Banks,’’ https:// www.federalreserve.gov/releases/chargeoff/ delallsa.htm. 86See sections IV.A.2.c.i. and ii of this SUPPLEMENTARY INFORMATION for more information about the prudential criteria differentiating regulatory residential and regulatory commercial real estate exposures. approach as the expanded risk-based approach incorporates more credit-risk indicators and characteristics of the obligor depository institution, foreign bank, or credit union. Question 14: What would be the advantages and disadvantages of the agencies treating an exposure to a nonbank financial institution such as foreign holding companies or broker dealer subsidiary institutions that are located in a foreign jurisdiction as a foreign bank exposure, when that foreign jurisdiction has determined that the given type of financial institution is regulated and supervised in that jurisdiction in a manner equivalent to banks? Question 15: What are the advantages and disadvantages of assigning a 30 percent risk weight to Grade A bank exposures meeting the additional criteria discussed above? To what extent would the lower 30 percent risk weight contribute to the pro-cyclicality of bank capital requirements? To what extent might the risk weight contribute to credit contraction during economic downturns and credit acceleration during economic expansions? Question 16: The agencies seek comment on the appropriateness of the additional requirements that must be met to for Grade A bank exposures
to qualify for a 30 percent risk weight. What alternative calibration of common equity tier 1 capital ratio and supplementary leverage ratio levels would be appropriate for Category I, II, and III Grade A depository institutions to receive a 30 percent risk weight? What alternative calibration of common equity tier 1 capital ratio and tier 1 leverage ratio levels would be appropriate for depository institutions not subject to the CBLR framework or SLR to receive a 30 percent risk weight? Please provide analytical support. Question 17: The agencies seek comment on whether the proposed treatment for exposures to depository institutions, foreign banks, and credit unions is appropriate for uninsured trust banks that do not have capital ratios that were publicly disclosed within the last six months, including such entities that issue payment stablecoins. What alternative calibrations or approaches should the agencies consider to differentiate the financial strength of uninsured trust banks that would be appropriately risksensitive and consistent with the objective of establishing simple, transparent, and consistent requirements? Question 18: What would be the advantages and disadvantages of the agencies requiring broadly consistent capital standards in the foreign jurisdiction, as well as robust regulatory and supervisory frameworks that are consistent with international capital standards issued by the Basel Committee for certain foreign banks to qualify as Grade A and Grade B? What are appropriate alternative indicators that could be used to determine whether a foreign bank qualifies for a Grade A classification? What are the advantages and disadvantages of looking to the applicable capital requirements in foreign jurisdictions for determining if a Grade A foreign bank meets the thresholds described above to be eligible to apply a 30 percent risk weight? What alternatives should the agencies consider to determine whether a foreign bank has sufficient capital to warrant applying a 30 percent risk weight to a Grade A foreign bank exposure?
c. Real Estate Exposures
The proposal would define a real estate exposure as an exposure that is neither a sovereign exposure nor an exposure to a PSE and that is (1) a residential mortgage exposure, (2) primarily secured by collateral in the form of real estate,81 (3) a pre-sold construction loan,82 (4) a statutory multifamily mortgage,83 (5) a high volatility commercial real estate (HVCRE) exposure,84 or (6) an acquisition, development, or construction (ADC) exposure. A presold construction loan, a statutory multifamily mortgage, and an HVCRE exposure are collectively referred to as statutory real estate exposures for purposes of this SUPPLEMENTARY INFORMATION. Under the proposal, the risk weight treatment for statutory real estate exposures would be unchanged from the current standardized approach. Risks related to exposures secured by real estate depend on what type of real estate secures the exposure. Residential real estate loans generally have lower historical charge off rates than commercial real estate exposures.85 Residential real estate exposures are generally amortizing, often have stricter underwriting standards for leverage than commercial real estate, and often are easier to value. In addition, residential and commercial real estate exposures that are deemed prudently underwritten reflect reduced credit risk relative to those real estate exposures that are not prudently underwritten.86 The proposal would therefore differentiate the credit risk of real estate exposures that are not statutory real estate exposures by introducing the following categories: regulatory residential real estate exposures, regulatory commercial real estate exposures, ADC exposures, and other real estate exposures. The applicable risk weight for these real estate exposures would depend on (1) whether the real estate exposure meets the definitions of regulatory residential real estate exposure, regulatory commercial real estate exposure, ADC exposure, or other real estate exposure, described below; (2) whether the repayment of such exposures is dependent on the cash flows generated by the underlying real estate (such as rental properties, leased properties, and hotels); and (3) in the case of regulatory residential or regulatory commercial real estate exposures, the loan-to-value (LTV) ratio of the exposure. The proposed criteria for differentiating the credit risk of real estate exposures would be based on information already collected and maintained by a banking organization as
part of its mortgage lending activities
and underwriting practices. Under the proposal, regulatory residential and regulatory commercial real estate exposures would be required to meet prudential criteria that are intended to reduce the likelihood of default relative to other real estate exposures. These criteria include a requirement that loans are made in accordance with prudent underwriting standards as described in
87See 12 CFR part 34, appendix A to subpart D (OCC); 12 CFR part 208, appendix C (Board); 12 CFR part 365, appendix A (FDIC). 88Loans secured by real estate where the repayment of the loan does not depend on cash flows generated by the real estate include owneroccupied properties, where repayment of the loan is generally based on the income or revenue of the borrower. See additional discussion of dependent on the cash flows generated by the real estate in
section IV.A.2.c.iii. of this SUPPLEMENTARY
INFORMATION.
89See Board of Governors of the Federal Reserve System, Financial Stability Report (November 2020), https://www.federalreserve.gov/publications/ files/financial-stability-report-20201109.pdf. 90 Id., at 30. For evidence on the correlation between LTV and loss rates in mortgage loans, see Laurie Goodman and Jun Zhu, ‘‘Bank Capital Notice of Proposed Rulemaking—A Look at the Provisions Affecting Mortgage Loans in Bank Portfolios,’’ Urban Institute (2023), https://www.urban.org/sites/ default/files/2023-09/BankCapitalNoticeofProposed Rulemaking.pdf; and Sewin Chan, Andrew Haughwout, Andrew Hayashi, and Wilbert van der Klaauw, ‘‘Determinants of Mortgage Default and Consumer Credit Use: The Effects of Foreclosure Laws and Foreclosure Delays,’’ Federal Reserve Bank of New York, Staff Report No. 732 (2015), https://www.newyorkfed.org/medialibrary/media/ research/staff_reports/sr732.pdf. 91See Avery et al, ‘‘Credit Risk, Credit Scoring, and the Performance of Home Mortgages,’’ Federal Reserve Board of Governors, Federal Reserve Bulletin (1996), https://www.federalreserve.gov/ pubs/bulletin/1996/796lead.pdf. See also 12 CFR
part 1240.
92Consistent with the standardized approach in the capital rule, under the proposal, when a banking organization holds the first-lien and juniorlien(s) residential mortgage exposures and no other party holds an intervening lien, the banking organization must combine the exposures and treat them as a single first-lien regulatory residential real estate exposure, if the first-lien meets all of the criteria for a regulatory residential real estate exposure. 93For more information on determining the value of the property, see section IV.A.2.c.iv. of this SUPPLEMENTARY INFORMATION. 94See 12 CFR part 30, appendix C and 12 CFR
part 34, appendix A to subpart D (OCC); 12 CFR
part 208, appendix C (Board); 12 CFR parts 364 and
365 (FDIC).
95Consistent with the current standardized approach, a residential real estate loan that is modified or restructured solely pursuant to the U.S. Treasury’s Home Affordable Mortgage Program is not modified or restructured under this criterion for regulatory residential real estate exposures. 96Commercial properties where the construction is complete and the property is ready for its intended use. 97When the banking organization also holds a junior security interest in the same property and no other party holds an intervening security interest, the banking organization must treat the exposures as a single first-lien regulatory commercial real estate exposure, if the first lien meets all the criteria for a regulatory commercial real estate exposure. the existing Interagency Guidelines for Real Estate Lending Policies (real estate lending guidelines).87 Loans that are prudently underwritten are less likely to lead to credit losses. Thus, the risk weights proposed for these exposures are lower than for other real estate exposures. Moreover, real estate loans for which repayment is dependent on the cash flows generated by the real estate can expose a banking organization to elevated credit risk relative to real estate exposures where repayment is not dependent on cash flows generated by the property,88 as the obligor may be unable to meet its financial commitments when cash flows from the property decrease, such as when tenants default or properties are unexpectedly vacant.89 Exposures that are dependent on the cash flows generated by real estate to repay the loan can also be affected by local market conditions and, thus, present elevated credit risk relative to exposures that are serviceable by the income, cash, or other assets of the obligor. For example, an increase in the supply of competitive rental property can lower demand and suppress cash flows needed to support repayment of a loan. In addition, LTV ratios are a meaningful risk indicator for the credit quality of a real estate exposure because the amount of an obligor’s equity in a real estate property is negatively correlated with default risk and provides banking organizations with a degree of protection against losses.90 LTV ratios are also one of several key factors that market participants, including banking organizations, consider for differentiating credit risk.91 Therefore, under the proposal, exposures with lower LTV ratios generally would receive a lower risk weight than comparable real estate exposures with higher LTV ratios. The proposed scope, risk drivers, and risk weights described below are generally consistent with those in the Basel standards.
i. Regulatory Residential Real Estate
Exposures
Under the proposal, a regulatory residential real estate exposure would be defined as a first-lien residential mortgage exposure (as defined in § ll.2 of the current capital rule) that is not an ADC exposure, a pre-sold construction loan, a statutory multifamily mortgage, or an HVCRE exposure, provided the exposure meets certain prudential criteria.92 First, the loan would be required to be secured by a residential property that is either owner-occupied or rented. Second, the exposure would be required to be made in accordance with prudent underwriting standards, including standards relating to the supervisory LTVs as described in the interagency real estate lending guidelines.93 Third, during the underwriting process, the banking organization would be required to apply underwriting policies that account for the ability of the obligor to repay based on clear and measurable underwriting standards that enable the banking organization to evaluate these credit factors. The agencies expect these underwriting standards to be consistent with the agencies’ safety and soundness and real estate lending guidelines.94 Fourth, the property must be valued in accordance with the proposed requirements included in the proposed LTV ratio calculation, as discussed below in section IV.A.2.c.iv. of this SUPPLEMENTARY INFORMATION. Finally, the loan must not have been modified or restructured.95 As discussed, residential real estate exposures that meet these criteria present relatively lower credit risk than other residential real estate exposures. Loans on property that are owneroccupied or rented have both a consistent expected flow of payments on the loan, as well as an occupant of the property that is present. Evaluating the ability of the obligor to repay using consistent and transparent metrics allows banking organizations and supervisors to more easily compare the obligor’s ability to repay with other borrowers in the banking organization’s loan portfolio. Modified or restructured loans reflect that there might be deterioration in the ability of the borrower to repay and, though not necessarily indications of likely default, merit higher applicable risk weights than those that have no such indications of potential deterioration in credit quality.
ii. Regulatory Commercial Real Estate
Exposures
The proposal would define a regulatory commercial real estate exposure as a real estate exposure that is not a regulatory residential real estate exposure, an ADC exposure, a pre-sold construction loan, a statutory multifamily mortgage, or an HVCRE exposure, provided the exposure meets several prudential criteria. First, the exposure would be required to be primarily secured by fully completed real estate.96 Second, the banking organization would be required to hold a first priority security interest in the property that is legally enforceable in all relevant jurisdictions.97 Third, the exposure would be required to be made in accordance with prudent underwriting standards, including standards relating to supervisory LTVs. Fourth, during the underwriting process, the banking organization would be required to apply underwriting policies that account for the ability of the obligor to repay in a timely manner
98See, e.g., https://www.occ.gov/publicationsand-resources/publications/comptrollershandbook/files/commercial-real-estate-lending/ pub-ch-commercial-real-estate.pdf. 99See, e.g., https://www.occ.treas.gov/static/ots/ exam-handbook/ots-exam-handbook-214aa.pdf. 100See Breck Robinson, Federal Reserve Bank of Richmond, and Richard M. Todd, Federal Reserve Bank of Minneapolis, ‘‘The Role of Non-OwnerOccupied Homes in the Current Housing and Foreclosure Cycle,’’ Pg. 6, which cites multiple studies that loans on non-owner occupied properties have higher loss rates on mortgages to non-occupant owners than on mortgages to owneroccupants, at least after controlling for credit scores and other standard underwriting criteria. https:// www.richmondfed.org/∼/media/richmondfedorg/ publications/research/working_papers/2010/pdf/ wp10-11.pdf. 101For example, if (1) a borrower purchases a two-unit property with the intention of making one unit their principal residence, (2) the borrower intends to rent out the second unit to a third party, and (3) the banking organization considered the cash flows from the rental unit as a source of repayment, the exposure would not meet the proposal’s definition of dependent on the cash flows generated by the real estate because the property securing the exposure is the borrower’s principal residence. based on clear and measurable underwriting standards that enable the banking organization to evaluate these credit factors. The agencies expect that these underwriting standards would be consistent with the agencies’ safety and soundness and real estate lending guidelines. The property would be required to be valued in accordance with the requirements included in the proposed LTV ratio calculation, as discussed below. Finally, the loan must not have been modified or restructured. As previously discussed, commercial real estate exposures that meet these criteria would present relatively lower credit risk than other commercial real estate exposures. Loans on property that is still under construction are reliant on the completion of the property for repayment of the loan, which can be delayed or interrupted by many factors such as changes in market condition or financial difficulty of the obligor.98 A perfected, first priority security interest would provide the banking organization with priority for repayment in the case of bankruptcy of the obligor.99 Evaluating the ability of the obligor to repay using consistent and transparent metrics allows banking organizations and supervisors to more easily compare the obligor’s ability to repay with other borrowers in the banking organization’s loan portfolio. As with residential exposures, permanent commercial real estate loans that have been modified or restructured indicate there might be a deterioration in the ability of the borrower to repay, meriting higher applicable risk weights than those that have no such indications. Question 19: What are the pros and cons of the proposed
requirements for real estate exposures to qualify as regulatory commercial real estate exposures? How would the requirement for the banking organization to hold a first-priority security interest in the property that is legally enforceable in all relevant jurisdictions impact loans to different types of commercial borrowers? For those commercial real estate exposures where banking organizations do not hold a first priority security interest in the underlying property, what, if any, alternatives should the agencies consider that would result in the same priority for repayment in the case of bankruptcy of the obligor?
iii. Exposures That Are Dependent on
the Cash Flows Generated by the Real Estate As noted above, the proposal would differentiate the risk weight of regulatory residential, regulatory commercial, and other real estate exposures based on whether the obligor’s ability to service the loan is dependent on cash flows generated by the real estate. If the underwriting process at origination of the real estate exposure considers any cash flows generated by the real estate securing the loan, such as from lease or rental payments or from the sale of the real estate, as a source of repayment, then the exposure would meet the proposal’s definition of dependent on the cash flows generated by the real estate. Evaluating the dependence on cash flows generated from the real estate is a conservative and straightforward measure of credit risk. Reliance on cash flows from the property for repayment of a loan indicates increased risk of nonpayment relative to when the borrower has sufficient funds from other sources, such as income or business profits, for full repayment of the loan. Given their increased credit risk, the proposal would assign higher risk weights to exposures that are dependent on proceeds or cash flows generated from the real estate itself to service the loan. Under the proposal, additional loan characteristics can affect whether an exposure would be considered dependent on cash flows generated by the real estate. The proposal’s definition of dependent on the cash flows generated by the real estate would exclude any residential mortgage exposure that is secured by the obligor’s principal residence, as such mortgage exposures present reduced credit risk relative to real estate exposures that are secured by the obligor’s non-principal residence.100 For residential properties that are not the obligor’s principal residence, including vacation homes and other second homes, such properties would be considered dependent on the cash flows generated by the real estate unless the banking organization has relied solely on the obligor’s personal income and resources, rather than rental income (or resale or refinance of the property), to ascertain the obligor’s capacity to repay the loan.101 For regulatory commercial real estate exposures, the applicable risk weights similarly would be determined based on whether repayment is dependent on the cash flows generated by the real estate. For example, the agencies would expect that rental office buildings, hotels, and shopping centers leased to tenants are often dependent on the cash flows generated by the real estate for repayment of the loan. In the case of a loan to an obligor to purchase or refinance real estate where the obligor will operate a business, such as a retail store or factory, and rely solely on the revenues from the business or resources of the obligor other than rental, resale, or other income from the real estate for repayment, the exposure would not be considered dependent on the cash flows generated by the real estate under the
proposal. Similarly, a loan to the owneroperator of a farm would not be considered dependent on the cash flows generated by the real estate under the proposal if the obligor will rely solely on the sale of products from the farm or other resources of the obligor other than rental, resale, or other income from the real estate for repayment. Question 20: What are the pros and cons of the agencies establishing a ‘‘materially’’ dependent on cash flows test that would consider the source of repayment to be partly from the borrower’s own resources and partly from the cash flows/income generated by the real estate? What, if any, quantitative threshold should the agencies consider in determining whether a real estate exposure is dependent on cash flows generated by the real estate (for example, the cash flows generated from real estate reflect between 5 and 50 percent of amount needed for repayment of the loan)? Further, if the agencies decide to adopt a quantitative threshold, either for regulatory residential or regulatory commercial real estate exposures, what should the agencies consider when calibrating such a threshold for regulatory residential, and separately for regulatory commercial real estate
102A guarantor is not an eligible guarantor under the current capital rule if the guarantor’s creditworthiness is positively correlated with the credit risk of the exposures for which it has provided guarantees. 78 FR 62141 (Oct.11, 2013). 103See Laurie Goodman and Karan Kuhl, ‘‘Sixty Years of Private Mortgage Insurance in the United States,’’ The Urban Institute Housing Finance Policy Center, August 2017. Pg. 7, https:// www.urban.org/sites/default/files/publication/ 92676/2017_08_18_sixty_years_of_pmi_ finalizedv3_3.pdf. 104As described in section IV.A.2.c.i. of this SUPPLEMENTARY INFORMATION, regulatory residential mortgage exposures must be made in accordance with prudent underwriting standards, including standards relating to supervisory LTVs, which allow for the consideration of private mortgage insurance for permanent mortgage or home equity loans on owner-occupied, 1- to 4-family residential properties. 105See 12 CFR part 34, subpart C or subpart G (OCC); 12 CFR part 208, subpart E or 12 CFR part 225, subpart G (Board); 12 CFR part 323 (FDIC). exposures, and what would be the appropriate calibration levels for each? Provide specific examples, including calculations and supporting data. Relatedly, please provide views on how to define cash flows and what expenses, if any, the agencies should consider.
iv. Calculating the Loan-to-Value Ratio
The proposal would require a banking organization to use LTV ratios to assign a risk weight to a regulatory residential or regulatory commercial real estate exposure. The proposed calculation of the LTV ratio would be generally consistent with the real estate lending guidelines except with respect to the recognition of private mortgage insurance, as described below. Under the proposal, an LTV ratio would be calculated as the extension of credit divided by the value of the property. The extension of credit would mean the total outstanding amount of the loan including the notional total of any undrawn committed amount of the loan. The total outstanding amount of the loan would reflect the current amortized balance as the loan pays down, which would allow a banking organization to assign a lower risk weight to a loan over time as the principal is repaid. Similarly, if an extension of credit increases, a banking organization would reflect that increase in the LTV ratio. For purposes of the LTV ratios in Tables 2, 3, 4, 5 below, a banking organization would calculate the loan amount without making any adjustments for credit loss provisions or private mortgage insurance. Not recognizing private mortgage insurance for these purposes would be consistent with the current capital rule’s definition of eligible guarantor, which does not recognize an insurance company engaged predominately in the business of providing credit protection (such as a monoline bond insurer or reinsurer).102 During the 2007–2009 housing market stress, the performance of private mortgage insurance deteriorated at the same time as the underlying exposures.103 Under the proposal and consistent with the current capital rule, private mortgage insurance is considered when banking organizations identify if a residential mortgage exposure is made in accordance with prudent underwriting standards. As discussed earlier, under the proposal a residential mortgage exposure must be made in accordance with prudent underwriting standards and must meet other requirements to be considered regulatory residential real estate exposures and therefore eligible to be risk weighted according to the LTV
table described below.104
The value of the property would mean the value at the time of origination of all real estate properties securing the extension of credit, including the increased estimated value of the property if the property is being improved by an extension of credit. The value of the property would also include the fair value of any readily marketable collateral and other acceptable collateral, as defined in the real estate lending guidelines, that secures the extension of credit. For exposures subject to the Real Estate Lending, Appraisal Standards, and Minimum Requirements for Appraisal Management Companies or Appraisal Standards for Federally Related Transactions (collectively, the appraisal rule),105 the market value of real estate would be a valuation that meets all requirements of that rule. For exposures not subject to the appraisal rule, the proposal would require that (1) the market value of real estate be obtained from an independent valuation of the property using prudently conservative valuation criteria; and (2) the valuation be done independently from the banking organization’s origination and underwriting process. Most real estate exposures held by insured depository institutions are subject to the agencies’ appraisal rule, which also provides for evaluations in some cases, and provides for certain exceptions, such as where a lien on real estate is taken out of an abundance of caution. To help ensure that the value of the real estate is determined in a prudently conservative manner, the proposal would also provide that, for exposures not subject to the appraisal rule, the valuations of the real estate properties would need to exclude expectations of price increases and be adjusted downward to take into account the potential for the current market prices to be significantly above the values that would be sustainable over the life of the loan. In addition, when the real estate exposure finances the purchase of the property, the value would be the lower of (1) the actual acquisition cost of the property and (2) the market value obtained from either (i) the valuation requirements under the appraisal rule (if applicable) or (ii) as described above, an independent valuation of the property using prudently conservative valuation criteria and that is separate from the banking organization’s origination and underwriting process. Using the value of a property at origination when calculating the LTV ratio protects against volatility risk or short-term market price inflation. For purposes of the LTV ratio calculation, the proposal would require banking organizations to use the value of the property at the time of origination, except under the following circumstances: (1) the banking organization’s primary Federal supervisor requires the banking organization to revise the property value downward; (2) an extraordinary event occurs resulting in a permanent reduction of the property value (for example, a natural disaster); or (3) modifications are made to the
property that increase its market value and are supported by a new appraisal or independent evaluation using prudently conservative criteria. These proposed exceptions are intended to constrain the use of values other than the value of the property at loan origination only to exceptional circumstances that are sufficiently material to warrant use of a revised valuation. For purposes of determining the value of the property, the proposal would use the definition of readily marketable collateral and other acceptable collateral from the real estate lending guidelines. Therefore, readily marketable collateral would mean insured deposits, financial instruments, and bullion in which the banking organization has a perfected security interest. Financial instruments and bullion would need to be salable under ordinary circumstances with reasonable promptness at a fair market value determined by quotations based on actual transactions, by an auction, or by a similarly available daily bid and ask price market. Other acceptable collateral would mean any collateral in which the banking organization has a perfected security interest that has a quantifiable value and is accepted by the banking organization in accordance with safe and sound lending practices.
106Residential real estate exposures that are 90 days past due or in nonaccrual would be assigned a 150 percent risk weight, unless the exposure is a residential mortgage exposure that is not dependent on the cash flows generated by the real estate, which would be assigned a 100 percent risk weight. 107The risk weight assigned to loans does not impact the appropriate treatment of loans under the agencies’ other regulations and guidance, such as the supervisory LTV limits under the real estate lending guidelines. 108For purposes of the LTV ratio calculation, the proposal would require banking organizations to use the value of the property at the time of origination, except under limited circumstances. See also Luis Otero Gonza´lez, Pablo Dura´n Santomil, Milagros Vivel Bu´ a and Rube´n Lado Sestayo, ‘‘The Impact of Loan-to-Value on The Default Rate of Residential MBS’’ Journal of Credit Risk (July 2016), https://www.risk.net/journal-ofcredit-risk/2465626/the-impact-of-loan-to-value-onthe-default-rate-of-residential-mortgage-backedsecurities. Under the proposal, other acceptable collateral would include, among other items, unconditional irrevocable standby letters of credit for the benefit of the banking organization. Readily marketable collateral and other acceptable collateral must be appropriately discounted by the banking organization consistent with the banking organization’s usual practices for making loans secured by such collateral. The reasonableness of a banking organization’s underwriting criteria would continue to be reviewed through the supervisory process to help ensure its real estate lending policies are consistent with safe and sound banking practices. Question 21: What other approaches should the agencies consider to recognize private mortgage insurance in the determination of the risk weight of residential mortgage exposures? What would be the pros and cons of providing explicit recognition of private mortgage insurance in the calculation of LTV ratio for purposes of determining the risk weights for regulatory real estate exposures? What, if any, increases in procyclicality and incentives for increased risk-taking by banking organizations might such recognition create? What conditions could the agencies impose on such recognition to mitigate concerns about the wrong-way risk of monoline credit insurance? In recognition that private mortgage insurance may not provide protection under all relevant stress events, what are the advantages and disadvantages of recognizing a portion (such as 50 percent) of the value of the private mortgage insurance in determining the total outstanding amount of the loan in the calculation of the LTV ratio? Please provide any data and analysis supporting alternative approaches.
v. Risk Weights for Regulatory
Residential Real Estate Exposures Under the proposal, a banking organization would assign a risk weight to a regulatory residential real estate exposure based on the exposure’s LTV ratio without PMI and whether the exposure is dependent on the cash flows generated by the real estate, in accordance with Tables 2 and 3 below.106 LTV ratios and dependence on cash flows generated by the real estate would factor into the risk-weight treatment for real estate exposures under the proposal because these risk factors are meaningful determinants of credit risk for real estate exposures. The proposed risk weights in each LTV ratio category are intended to reflect differences in the credit risk of these exposures.107 The proposed risk weights in Tables 2 and 3 would appropriately balance the benefits of risk sensitivity, transparency, and consistency in the risk weight for real estate exposures across banking organizations subject to the expanded risk-based approach. Applying lower risk weights to loans with lower LTVs aligns the credit risk of the loan with the applicable risk weight, and relying on cash flows from the property for repayment has historically indicated increased credit risk that merits higher risk weights. The proposal would also recognize the reduction in credit risk of regulatory residential real estate exposures due to amortization, as the obligor pays down principal and builds equity.108 The risk weights for such exposures could decrease throughout the life of the respective loans as obligors make payments. For example, analysis by the agencies indicates that residential mortgage loans issued in the 90 percent to 100 percent LTV ratio category would have a lifetime average risk weight approximately five percentage points EP27MR26.061</GPH> EP27MR26.062</GPH>
109See section VII of this SUPPLEMENTARY INFORMATION for more information explaining the analysis of the estimated ‘‘effective’’ risk weights applicable to residential mortgage exposures under the proposal. 110According to agency analysis, effective risk weights, which reflect both credit risk weights and estimated add-ons to reflect operational risk, are relatively constant or falling for almost all types of mortgage obligors relative to the applicable 50 percent risk weight for prudently underwritten residential mortgage exposures in the current standardized framework. For instance, for low-tomoderate income obligors, the total equivalent risk weight under the proposal is estimated to be 46 percent (42 percent from credit risk and 4 percent from operational risk). See the economic analysis presented in section VIII.D.2 of this SUPPLEMENTARY INFORMATION. 111Commercial real estate exposures that are 90 days past due or in nonaccrual would be assigned a 150 percent risk weight. lower than the applicable risk weight at origination.109 The agencies recognize that some home buyers, especially low- and moderate-income home buyers or those in historically underserved markets, are more likely to be obligors of loans with higher LTV ratios and thus higher risk weights under the approach described above. As a result, borrowing costs for some low- and moderate-income home buyers could be higher relative to obligors with lower LTV ratios. However, many low-to-moderate income borrowers obtain mortgages through loan programs administered by the Federal Housing Administration (FHA) or Department of Veterans Affairs (VA). Consistent with the current capital rule, banking organizations generally would apply a 20 percent risk weight to real estate exposures guaranteed by the U.S. government through the FHA or VA under the proposal. In addition, the proposed risk weights applicable to regulatory residential real estate exposures that have high LTV ratios would be generally consistent with the applicable risk weights under the current standardized approach for residential real estate exposures. The agencies estimate that the proposed riskbased capital requirements for regulatory residential real estate exposures that are not dependent on the cash flows of the real estate—reflecting both credit risk weights and estimated operational risk requirements—would be lower than the applicable risk-based capital requirements for residential real estate mortgages exposures under the current standardized approach for exposures with LTV ratios at or below 90 percent and very similar for such exposures with LTV ratios between 90 and 99 percent.110 Question 22: Given the proposed treatment of residential real estate exposures, how, if at all, would the proposed risk weights impact home affordability and home ownership opportunities, particularly for low-tomoderate income obligors or customers in other historically underserved markets? Please provide supporting data. Question
23: What alternative approaches for determining applicable risk weights to residential real estate exposures should the agencies consider and why? Please provide data supporting alternative approaches, including factors that were the basis for underwriting the loans and the historical repayment performance of the loans.
vi. Risk Weights for Regulatory
Commercial Real Estate Exposures Similar to the proposed approach to regulatory residential real estate exposure, the proposal would require a banking organization to assign a risk weight to a regulatory commercial real estate exposure based on the exposure’s LTV ratio and whether the exposure is dependent on the cash flows generated by the real estate, in accordance with Tables 4 and 5 below. Further, in the case of a regulatory commercial real estate exposure that is not dependent on cash flows generated by the real estate for repayment, a banking organization would be required to assign the risk weight applicable to the obligor, as reflected in Table 4. If the LTV ratio of such an exposure is greater than 60 percent, and the banking organization does not have sufficient information about the exposure to determine what the risk weight applicable to the obligor would be, the banking organization would be required to assign a 100 percent risk weight to the exposure unless the exposures is 90 days more past due or in nonaccrual.111 Regulatory commercial real estate exposures not dependent on cash flows generated by the real estate often involve situations where the borrowing entity occupies the property or the obligor has significant other cash flows to repay the loan that the banking organization considered when underwriting the loan. While these exposures generally present lower credit risk relative to exposures to commercial real estate dependent on cash flows EP27MR26.063</GPH> EP27MR26.064</GPH>
112Section 214 of the Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA) imposes certain requirements on high volatility commercial real estate acquisition, development, or construction loans. Section 214 of Public Law 115–174, 132 Stat. 1296 (2018); 12 U.S.C. 1831bb. 113OCC Commercial Real Estate Lending Handbook 2.0, https://www.occ.gov/publicationsand-resources/publications/comptrollershandbook/files/commercial-real-estate-lending/ pub-ch-commercial-real-estate.pdf. 114Under the proposal, an SME would mean an entity in which the reported annual revenues or sales for the consolidated group of which the entity is a part are less than or equal to $50 million for the most recent fiscal year. This scope is generally consistent with the definition of an SME under the Basel standards and also corresponds with the maximum receipts-based size standard for small businesses set by the Small Business Administration, which varies by industry and does not exceed $47 million per year. See 13 CFR part 121. generated by the real estate, or other types of corporate exposures where real estate collateral is not present, the risk profile of the obligor impacts the applicable risk weight to appropriately reflect the credit quality of the obligor in addition to the real estate collateral. Therefore, the applicable risk weights in
Table 4 for regulatory commercial real
estate exposures not dependent on cash flows generated by the real estate reflect both the LTV ratio and the risk profile of the obligor. In contrast, because the risks of commercial real estate exposures dependent on cash flows generated by the real estate are more dependent on the property, the risk weights in Table 5 reflect only the LTV ratio as a risk driver and generally are higher relative to Table 4.
vii. ADC Exposures That Are Not
HVCRE Exposures
Under the proposal, the agencies would define an ADC exposure as an exposure secured by real estate for the purpose of acquiring, developing, or constructing residential or commercial real estate properties, as well as all land development loans, and all other land loans. Some ADC exposures meet the definition of HVCRE exposure in § ll.2 of the capital rule and would be assigned a 150 percent risk weight.112 Real estate exposures that meet the definition of ADC exposure but do not meet the definition of HVCRE exposure and are not 90 days past due or in nonaccrual would be assigned a 100 percent risk weight under the proposal. The proposed regulatory treatment for ADC exposures would not take into consideration cash flow dependency or the LTV ratio. ADC exposures are mostly short-term or bridge loans to cover construction or development, or lease up or sales phases of a real estate project, rather than amortizing permanent loans for completed residential or commercial real estate. ADC exposures have heightened risk compared to permanent commercial real estate exposures, reflecting uncertainty for unforeseen issues with construction or market conditions, compared to the expected cash flow on a fully leased and constructed commercial property. The proposal would be consistent with the current standardized approach, as ADC exposures are generally subject to a risk weight of 100 percent or more under the current standardized approach.113
viii. Other Real Estate Exposures
The proposal would define other real estate exposures as real estate exposures that are not regulatory commercial real estate exposures, regulatory residential real estate exposures, ADC exposures, or any of the statutory real estate exposures. An exposure meeting the proposed definition of other real estate exposure poses heightened credit risk as a result of not meeting the definitions of regulatory residential and regulatory commercial real estate, respectively, and accordingly would be assigned a higher risk weight. Specifically, the proposal would require a banking organization to assign a 150 percent risk weight to an other real estate exposure, unless the exposure is a residential mortgage exposure that is not dependent on the cash flows generated by the real estate, which would be assigned a 100 percent risk weight. For example, a banking organization would assign a 150 percent risk weight to real estate exposures that are dependent on the cash flows generated by the underlying real estate, such as a rental property, and that do not meet the regulatory residential or regulatory commercial real estate exposure definitions. Loans for the purpose of acquiring real estate and reselling it at higher value that do not qualify as ADC loans and do not meet the definition of regulatory residential real estate exposures would be assigned a 150 percent risk weight as other real estate exposures. The proposed 150 percent risk weight also would provide a regulatory capital incentive for banking organizations to originate real estate exposures in accordance with the prudential qualification requirements for regulatory residential and commercial real estate exposures, respectively. The 100 percent risk weight would apply to other real estate exposures that are a residential mortgage exposure that is not dependent on the cash flows generated by the real estate, which could include junior lien home equity lines of credit (where the banking organization does not also hold the first lien) and other second mortgages, as these exposures reflect heightened credit risk compared to first-lien exposures because the banking organization would receive repayment only after more senior creditors in the instance of the obligor defaulting. In addition, if a banking organization does not adequately evaluate the creditworthiness of an obligor for an owner-occupied residential mortgage exposure, or if the obligor has inadequate creditworthiness or capacity to repay the loan, the exposure would not be considered prudently underwritten and would be assigned a 100 percent risk weight instead of the lower risk weights included in Table 2 for regulatory residential mortgage exposures not dependent on the cash flows generated by the real estate. d. Retail Exposures The proposal would increase the credit risk sensitivity of the capital requirements applicable to retail exposures by assigning risk weights that would vary depending on product type and the degree of portfolio
diversification. The proposal would introduce a new definition of retail exposure, which would be defined as an exposure that is not a real estate exposure, and is an exposure to a natural person or persons or an exposure to a small or medium-sized entity (SME) 114 that meets the proposed definition of a regulatory retail exposure described below. Including an exposure to an SME in the definition of a retail exposure recognizes that many small companies have characteristics more similar to those of a natural person than of a larger corporation with respect to financial resources and the time horizon under which it operates. The proposed definition of a retail exposure would be narrower in scope than the current capital rule’s existing definition of a retail exposure under the advanced approaches, which includes a broader range of exposures, including residential real estate-related exposures. Because the proposal would include separate risk-weight treatments for real estate exposures that account for the underlying collateral, the proposed definition of a retail exposure would not include real estate exposures. The proposal would differentiate the risk-weight treatment for retail exposures based on whether the exposure (1) qualifies as a regulatory
115The $1 million threshold for a retail exposure to qualify as regulatory retail would be indexed using CPI–W. See section II.E. of this SUPPLEMENTARY INFORMATION. For an off-balance sheet exposure, the full notional amount of the exposure would apply towards the $1 million threshold. If a retail exposure to a single obligor and its affiliates does exceed the $1 million threshold, then none of the exposures to that obligor would qualify as regulatory retail exposures. 116The proposal would require banking organizations to apply a 150 percent risk weight to corporate exposures that are either subordinated exposures, as described in section IV.A.2.f. of this SUPPLEMENTARY INFORMATION, or covered debt instruments that are not deducted. See the Federal Reserve Board’s rule on ‘‘Total Loss-Absorbing Capacity, Long-Term Debt, and Clean Holding Company Requirements for Systemically Important U.S. Bank Holding Companies and Intermediate Holding Companies of Systemically Important Foreign Banking Organizations’’ 12 CFR part 252. 117See 12 CFR 3.32(f)(2) and (3) (OCC); 12 CFR 217.32(f)(2) and (3) (Board); 12 CFR 324.32(f)(2) and (3) (FDIC). retail exposure, (2) further qualifies as a transactor exposure; or (3) does not qualify for either of the previous categories and therefore is treated as an other retail exposure. The proposed risk weights assigned to retail exposures consider characteristics such as payment history and exposure size the latter of which is individually generally small in dollar-per-loan volume for exposures captured within the scope of the proposal’s retail exposure definition. The proposed definitions of a regulatory retail exposure and a transactor exposure outlined below include key criteria for broadly categorizing the relative credit risk of retail exposures. To qualify as a regulatory retail exposure, the proposal would require an exposure to be in the form of any of the following credit products: a revolving credit or line of credit (such as a credit card, charge card, or overdraft) or a term loan or lease (such as an installment loan, auto loan or lease, or student or educational loan). In addition, under the proposal, the amount of retail exposures to a single obligor and its affiliates that a banking organization could treat as regulatory retail exposures would be limited. Specifically, the regulatory retail exposure category would exclude any retail exposure to a single obligor and its affiliates that, in the aggregate with any other retail exposures to that obligor or its affiliates, including both on- and off-balance sheet exposures, exceeds a combined total of $1 million (aggregate limit).115 Limiting the types of products and the dollar amount of exposures to a single obligor that would qualify as regulatory retail exposures under the proposal would help ensure that the regulatory retail treatment applies only to a set of small exposures to a diversified group of obligors. A banking organization would include all
outstanding and committed but unfunded regulatory retail exposures in determining the aggregated total to a single obligor and its affiliates. Under the proposal, if an exposure to an SME does not meet the eligible product criterion and the aggregate limit criterion described above, then none of the exposures to that SME would qualify as retail exposures and all the exposures to that SME would be treated as corporate exposures. The proposal would define a transactor exposure as a regulatory retail exposure that is a credit facility where the balance has been repaid in full at each scheduled repayment date for the previous twelve months or an overdraft facility where there has been no drawdown over the previous twelve months. If a single obligor had both a credit facility and an overdraft facility from the same banking organization, the banking organization would separately evaluate each facility to determine whether it meets the definition of a transactor exposure. An exposure would not be a transactor exposure if the credit facility has a balance or the facility includes installment payments, even if the obligor was not required to make a payment, including when the credit facility had a promotional offer such as a zero percent interest. Under the proposal, a banking organization would assign a risk weight of 45 percent to a regulatory retail exposure that is a transactor exposure and a 75 percent risk to a regulatory retail exposure that is not a transactor exposure. All other retail exposures would be assigned a 100 percent risk weight. The proposed relatively low 45 percent risk weight for a transactor exposure is appropriate because such obligors have a demonstrated history of full and timely repayment. A regulatory retail exposure that is not a transactor exposure warrants the proposed 75 percent risk weight, which would be lower than the proposed 100 percent risk weight for all other retail exposures, due to mitigating factors related to size or concentration risk. Any retail exposure that would not qualify as a regulatory retail or a transactor exposure warrants a risk weight of 100 percent. The proposed retail categories, risk weights, and risk indicators are largely consistent with the Basel standards. Question 24: What, if any, additional criteria or alternatives should the agencies consider to help ensure that the regulatory retail treatment is limited to a group of diversified retail obligors? What alternative thresholds or calibrations should the agencies consider for purposes of retail exposures? Please provide supporting data in your response. Question 25: What, if any, changes to the methodology for the aggregate limit calculation should the agencies consider? What are the pros and cons of treating the amount of retail exposures to a single obligor, when aggregated, below $1 million as regulatory retail exposures, while the amount of exposures above $1 million to the same obligor in aggregate would be treated as other retail
exposures? The agencies seek comment on whether there is a differentiation of risk to the same obligor for exposures above and below the aggregate limit. e. Corporate Exposures A corporate exposure under the proposal would be an exposure to a company that does not fall under any other exposure category under the proposal. This scope would be consistent with the definition found in § ll.2 of the current capital rule. For example, an exposure to a company that also meets the proposed definition of a real estate exposure would be a real estate exposure rather than a corporate exposure for purposes of the proposal. As described in more detail below, the proposal would differentiate the risk weights of corporate exposures based on credit risk by considering such factors as the general creditworthiness of the obligor; each exposure’s level of subordination and the expected source of repayment.116 First, a banking organization would be permitted to assign a 65 percent risk weight to a corporate exposure that is an exposure to a company that is investment grade based on the banking organization’s internal ratings system, subject to the criteria outlined further below. Second, consistent with the current standardized approach, a banking organization would assign risk weights of 2 percent or 4 percent to certain exposures to a qualifying central counterparty.117 Third, a banking organization would assign a 100 percent risk weight to a project finance exposure that is in the operational phase; otherwise, such an exposure would receive a 130 percent risk weight. Fourth, a banking organization would assign a 100 percent risk weight to a corporate exposure that is for the purpose of acquiring or financing equipment or physical commodities where repayment of the exposure is dependent on the physical assets being financed or acquired. This would include exposures that finance incomeproducing assets or projects that engage in non-real estate activities where the
118See 12 CFR 3.2 (definition of investment grade) (OCC); 12 CFR 217.2 (definition of investment grade) (Board); 12 CFR 324.2 (definition of investment grade) (FDIC). 119The use of the investment grade definition in the current capital rule was expanded in 2013 as
part of a set of alternatives to external credit ratings
for calculating risk-weighted assets for certain exposures, to implement section 939A of the Dodd Frank Act. These alternative creditworthiness standards were designed to be consistent with safety and soundness while also exhibiting risk sensitivity similar to external credit rating categories. See 15 U.S.C. 78o–7 note. Prior to the 2013 capital rule, investment grade was used in several areas of the capital rule, including in the market risk framework, the treatment of securitization and equity exposures, and in the requirements for recognizing certain guarantees and collateral in the calculation of risk-weighted assets. See Risk-Based Capital Guidelines: Market Risk, 77 FR 53060 (Aug. 30, 2012) (when the concept was initially introduced). In the now-superseded capital rule that contained such references, a long-term credit rating of BBB- or better and a short-term credit rating of A3 or better were provided as examples of credit ratings considered to be investment grade. See Risk-Based Capital Standards: Advanced Capital Adequacy Framework—Basel II, 72 FR 69288, (Dec. 7, 2007). 120Under the proposal, credit risk mitigation techniques could not be used to support investment grade determinations. See section IV.A.5. of this SUPPLEMENTARY INFORMATION for a description of how credit risk mitigants, such as guarantees and collateral, can reduce the risk-weighted asset amount for certain exposures. obligor entity itself has no independent capacity to repay the loan. Finally, a banking organization would assign a 100 percent risk weight to all other corporate exposures. Assigning a 100 percent risk weight to all other corporate exposures broadly reflects the relative risk of such corporate exposures, as exposures not deemed investment grade generally pose greater credit risk than that of investment grade corporate exposures.
i. Investment Grade Companies
Under the proposal, a banking organization would be permitted to assign a 65 percent risk weight to a corporate exposure that is not a subordinated exposure and is an exposure to a company that the banking organization, using one or more internal credit risk rating systems that meet certain requirements, determines is investment grade, as that term is defined in §ll.2 of the capital rule. The definition of investment grade, which would remain unchanged under the proposal, requires that the entity has adequate capacity to meet its financial commitments for the projected life of the asset or exposure.118 The rule further provides that an entity has adequate capacity to meet financial commitments if the risk of its default is low and the full and timely repayment of principal and interest is expected. Thus, the investment grade classification is intended to apply to companies of high credit quality.119 Corporate exposures typically exhibit significant differences in default probabilities, loss severities, and correlation with broader economic conditions based on many factors including the financial strength and stability of the obligor. An investment grade designation would provide a mechanism to increase risk sensitivity in the capital framework by subdividing corporate exposures by credit risk. Further, assigning separate risk weights for corporate exposures to investment grade companies and non-investment grade companies would align capital requirements more closely with actual risk. To help promote the consistency and reliability of a banking organization’s investment grade determinations for purposes of assigning a 65 percent risk weight to a corporate exposure and to promote comparability in such determinations across banking organizations, the proposal would set forth requirements for any internal credit risk rating system used by banking organizations for such purposes. Additionally, a banking organization would have to meet proposed requirements when validating such systems. The proposal would require that the internal credit risk rating system that a banking organization would rely upon to make investment grade determinations also be used to inform material business or risk management decisions, such as those related to accounting, regulatory reporting, risk management and measurement, loan loss reserve estimation, capital planning, loan pricing, or supporting board of directors’ decision making. Using existing systems would allow banking organizations to leverage existing data on obligors that are used for other purposes to support their investment grade determinations under the proposal, thus reducing regulatory burden. In addition, given their importance in fundamental business processes, such systems are subject to internal controls, oversight, and validation processes that help ensure their reliability. The banking organization would be required to define which obligor rating grades within its internal credit risk rating system(s) are
considered to be investment grade, as that term is defined in §ll.2 of the capital rule. Because the rating assessment and the corresponding determination of investment grade would occur at the obligor level, such determinations would not include exposure level loss given default factors, such as credit enhancements, transaction structure, and collateral.120 The proposal would require the internal credit risk rating system to assign a rating grade for each obligor in an accurate and timely manner, no less frequently than annually and whenever the banking organization receives new material information regarding the creditworthiness of the obligor. The proposal would also require the internal credit risk rating system to incorporate both quantitative and qualitative factors relating to the historical and projected patterns of payment behaviors, the financial situation and performance of each obligor, and any relevant developments that affect the investment grade determination. Examples of quantitative risk factors fitting these characteristics include, but are not limited to, metrics relating to cash flow available to cover debt obligations, levels of equity relative to debt, and quantities of liquid assets relative to liabilities. Qualitative risk factors could include the business model and economic sector of the obligor, the obligor’s willingness to repay, and market conditions. A banking organization would not be permitted to rely solely on third-party assessments of credit risk in its rating of obligors for purposes of determining investment grade status. The proposal would require a banking organization, at least annually, to validate the robustness, consistency, and reliability of its internal credit risk rating system, using data from at least one full credit cycle and taking care to ensure that benign and stressful periods are appropriately represented. As part of the validation of the internal credit rating system, the proposal would require a banking organization to evaluate whether the performance of the obligors identified by the internal credit risk rating system as investment grade is consistent with the definition of investment grade in § ll.2 of the capital rule, including by benchmarking the investment grade ratings resulting from the internal credit risk rating system with external information relating to the creditworthiness of obligors. Such benchmarking may include comparisons to external credit ratings of obligors produced by third parties. Using external information as part of validating the internal credit risk rating system could identify areas for improvement in the system and may enhance consistency in investment
121Exposures that are guaranteed by the government or considered a general obligation or revenue obligation exposure to a PSE would not qualify as a project finance exposure. 122Although it is common for the banking organization to take a mortgage over the real property and a lien against other assets of the project for security and lender control purposes, a project finance exposure would not be considered a real estate exposure because the banking organization does not rely on real estate collateral to grant credit. As noted in section IV.A.2.c of this Supplementary Information, for purposes of the proposal, ‘‘secured by collateral in the form of real estate’’ in the context of the proposed real estate exposure definition should be interpreted in a manner that is consistent with the current definition for ‘‘a loan secured by real estate’’ in the Call Report and FR Y–9C instructions. grade determinations across banking organizations. Also, as part of the validation, the proposal would require a banking organization to assess the reliability, accuracy, completeness, timeliness, and appropriateness of the data sources used as part of the investment grade determinations. The proposal would require a banking organization to incorporate available information that is reasonably expected to support a robust evaluation of the internal credit rating system, including information regarding the performance of companies that have ceased operations or that have been sold to a third party to address potential survivorship bias. Properly accounting for obligors that are sold to a third party or that cease operations would reduce the likelihood of rating grades being skewed. The proposal also would require a banking organization to ensure that the validation process is independent of the internal credit risk system’s development, implementation, and operation, or subject the validation process to an independent review of its adequacy and effectiveness. These requirements around independence would help ensure the objectivity, reliability, and integrity of the validation process. Consistent with requirements under the current advanced approaches, the proposal would require the validation process to incorporate default data covering a period of at least five years and include a period of stress. If the banking organization has relevant data that extends beyond the five-year period, it would be required to incorporate that data into the validation process. The banking organization also would not be permitted to place undue weight on data from periods of favorable or benign economic conditions relative to economic downturn conditions. Appropriately reflecting and balancing all relevant data over at least five years would help support an accurate credit assessment. Question 26: The agencies seek comment on the proposed treatment of corporate exposures to companies that the banking organization determines are investment grade. What, if any, operational challenges
might the proposed approach pose for banking organizations? How should the agencies consider addressing such challenges? Question 27: The agencies seek comment on the pros and cons of an alternative approach to determining eligibility for the 65 percent risk weight that would include requirements that banking organizations demonstrate that the obligors meet certain quantitative thresholds using commonly defined metrics such as probability of default in order to demonstrate if the obligor merits an investment grade rating. What, if any, operational challenges or limitations might numerical threshold requirements pose for banking organizations in meeting the proposed ratings criteria? Question 28: What would be the pros and cons of requiring a banking organization to receive prior approval of its internal credit risk rating system from its primary Federal supervisor before applying the preferential 65 percent risk weight compared to evaluation of its compliance with the capital rule requirements by its primary Federal supervisor during routine supervisory review processes? The agencies are seeking feedback on the benefits that a preapproval process may provide versus the operational burden imposed by such a process.
ii. Project Finance Exposures
The proposal would define a project finance exposure as a corporate exposure for which the banking organization relies on the revenues generated by a single project (typically a large and complex installation, such as a power plant, manufacturing plant, transportation infrastructure, telecommunications installation, or other similar installation), both as the source of repayment and as security for the exposure. A project finance exposure could take the form of financing the construction of a new installation or a refinancing of an existing installation, with or without improvements. In addition, a project finance exposure also must: (1) be to an obligor entity that was created specifically to finance the project, operate the physical assets of the project, or do both, and (2) the borrowing entity must only have an immaterial amount of assets, activities, or sources of income, apart from revenues from the activities of the project being financed. The primary determinant of credit risk for a project finance exposure is the variability of the cash flows expected to be generated by the project being financed rather than the general creditworthiness of the borrowing entity or the market value or sale of the project or the real estate on which the project sits.121 Under the proposal, a project finance exposure would receive a 130 percent risk weight during the pre-operational phase and a 100 percent risk weight during the operational phase of the project. The proposal would define a project finance operational phase exposure as a project finance exposure for which the project has a positive net cash flow that is sufficient to support the debt service and expenses of the project and any other remaining contractual obligations, in accordance with the banking organization’s applicable loan underwriting criteria for permanent financings, and for which the outstanding long-term debt of the project is declining. Prior to the operational phase classification, the proposal would require a banking organization to treat a project finance exposure as being in the pre-operational phase and assign a 130 percent risk weight to the exposure. The preoperational phase would be the period between the origination of the loan and the time at which the banking organization determines that the project has entered the operational phase. Relative to the operational phase, the pre-operational phase presents increased uncertainty that the project will be completed in a timely and costeffective manner, and produce expected revenue, which warrants the application of a higher risk weight. For example, market conditions could change significantly between commencement and completion of the project. In addition, unanticipated supply shortages or other challenges could disrupt timely completion of the project and the expected timing of the transition to the operational phase. These unanticipated changes could impact the ability of the project to generate cash flows as projected and
to repay creditors. Under the proposal, an exposure that is considered to be secured by collateral in the form of real estate 122 where the banking organization relies on real estate collateral to grant credit, would not be considered a project finance exposure and would be assigned a risk weight as described in section IV.A.2.c. of this SUPPLEMENTARY INFORMATION.
123See 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC). 124The proposal would remove the definition of ‘‘unconditionally cancelable,’’ and revise the definition of ‘‘commitment’’ to indicate which commitments are considered unconditionally cancelable. f. Subordinated Exposures The proposal would introduce a definition and risk weight treatment for subordinated exposures. Subordinated exposures present a greater risk of loss to an investing banking organization relative to more senior exposures to the same issuer or borrower because subordinated exposures have a lower priority of repayment in the event of default. The proposed definition of a subordinated exposure would capture exposures that are financial instruments, such as debt securities and loans, and present heightened credit risk but are not equity exposures, as outlined in section IV.C. of this SUPPLEMENTARY INFORMATION. The proposal would define a subordinated exposure as a corporate exposure, a bank exposure, or an exposure to a GSE, that is subordinated by its terms or separate intercreditor agreement to the general creditors of the obligor, or an exposure to preferred stock that is not an equity exposure. A subordinated exposure would not include a retail exposure or a debt security issued by a sovereign, public sector entity, multilateral development bank, or supranational entity, or an exposure that would be captured under the securitization framework. For these purposes, an exposure would be subordinated if the documentation creating or evidencing such indebtedness (or a separate intercreditor agreement) provides for the issuer’s or obligor’s general creditors to rank senior to the payment of such indebtedness in the event the issuer or obligor becomes the subject of a bankruptcy or other insolvency proceeding. The scope of the definition of a subordinated exposure is meant to capture the types of entities that issue subordinated instruments and for which the level of subordination is a meaningful determinant of the credit risk of the instrument. The definition also captures instances where a banking organization makes or purchases a loan that is subordinated to the general creditors of the obligor. Limiting the scope of subordinated exposures to those junior to general creditors, as proposed, would apply a heightened risk weight to only those exposures for which subordination results in a heightened credit risk relative to general creditors. The proposal would apply a 150 percent risk weight to exposures that meet the definition of a subordinated exposure, consistent with the Basel standards. Relative to the current standardized approach, the proposal provides more risk-sensitive approaches for several exposure categories, including bank exposures, corporate exposures, and exposures to GSEs, as described above in sections IV.A.2.a.–c. of this SUPPLEMENTARY INFORMATION. The relative risk associated with those exposures and the applicable risk weights for those exposures
are based on those exposures being in a senior loss position. Therefore, the applicable risk weights for a subordinated exposure should reflect the heightened credit risk of such exposures. Question 29: The agencies seek comment on the scope of the proposed definition of a subordinated exposure. What, if any, operational challenges might the proposed definition pose for banking organizations, and how should the agencies consider addressing such challenges? The agencies seek comment on what, if any, exposures the proposed definition would capture that commenters believe would not reflect heightened credit risk that merits a heightened risk weight? The agencies also seek comment on what, if any, subordinated exposures the agencies have excluded from the proposed definition that merit a heightened risk weight?
3. Off-Balance Sheet Exposures
The proposal would better capture the risk of certain off-balance sheet exposures relative to the current standardized approach by revising the definition of commitment to clarify the off-balance sheet exposures that would be subject to risk-based capital requirements, modifying the credit conversion factors applicable to commitments, and introducing an exposure methodology for commitments without pre-set limits. a. Definition of Commitment The current capital rule defines a commitment as any legally binding arrangement that obligates a banking organization to extend credit or to purchase assets.123 Such an arrangement is treated as a commitment even when the banking organization has the unilateral right to cancel the arrangement at any time. The agencies have received questions from banking organizations regarding whether certain types of arrangements, such as advised credit lines and uncommitted lines, would be commitments even if they are unconditionally cancelable. In addition, the agencies have observed an inconsistent application of the current definition of commitment. The proposal would revise the definition of commitment to clarify that any contractual arrangement under which a banking organization and an obligor agree to the terms applicable to one or more future extensions of credit, purchases of assets, or issuances of credit substitutes by the banking organization is a commitment, whether or not the arrangement is unconditionally cancelable. Consistent with the current capital rule, an unconditionally cancelable commitment would include a commitment that permits a banking organization to, at any time, with or without cause, refuse to extend credit, purchase assets, or issue credit substitutes under the arrangement (to the extent permitted under applicable law). Similarly, the proposal clarifies that a contractual arrangement to extend credit, purchase assets, or issue credit substitutes, but which does not obligate the banking organization to do so, is also considered a commitment that is unconditionally cancelable.124 This approach would promote comparable treatment across banking organizations subject to the capital rule. Commitments represent an arrangement where the banking organization could expect to purchase assets or to extend credit to an obligor, in which case the credit becomes an onbalance sheet asset. The scope of the definition is, therefore, not intended to be limited to those situations in which the banking organization is obligated to provide some amount of credit to an obligor. The agencies do not, however, intend for the definition of commitment to include arrangements where a banking organization has merely offered potential terms to a potential obligor or that continue to be subject to negotiation between the parties. For the purpose of the regulatory capital rule, a commitment does not and would not include pre-approval letters for residential mortgage loans, credit card offers, or other offers that have not
yet been agreed upon by both parties to the transaction. Examples of arrangements that would generally be considered commitments under the proposal include fronting commitments, where a banking organization agrees to fund the obligations of other members of a syndicate of lenders, and commitment letters, where a banking organization agrees to provide financing in connection with an acquisition or other transaction to be entered into by the
125See section IV.A.3.c. of this SUPPLEMENTARY INFORMATION for the proposed methodology to determine the exposure amount for retail exposures with no pre-set limit. 126Note issuance facilities and revolving underwriting facilities are forms of revolving credit. Notes issued under note issuance facilities and revolving underwriting facilities are short-term instruments issued under a legally binding medium-term contractual arrangement. Under a revolving underwriting facility, the underwriting banking organization agrees to provide loans should the issue fail, but under a note issuance facility the banking organization could either lend to the issuer or purchase the outstanding notes. Consistent with the current rule and with the Basel standards, the proposal would require banking organizations to apply a 50 percent credit conversion factor to the off-balance sheet amount of note issuance facilities and revolving underwriting facilities, regardless of whether a lower credit conversion factor would otherwise apply. 127Currently, commitments that are not unconditionally cancelable with an original maturity of one year or less receive a 20 percent credit conversion factor and those with an original maturity of more than one year receive a 50 percent credit conversion factor. 12 CFR 3.33(b)(2) (OCC); 12 CFR 217.33(b)(2) (Board); 12 CFR 324.33(b)(2) (FDIC). 128Under the proposal, a 40 percent CCF would also apply to commitments that are not unconditionally cancelable commitments for purposes of calculating the total leverage exposure for the supplementary leverage ratio framework and for the calculation of the Size Category of the FR Y–15 Systemic Risk Report form. 129The FR Y–9C indicates (see HC–R Part II items 18.a and b) that prior to application of the credit conversion factor, as of Q2 2025, 84 percent of the exposure and 85 percent of the standardized riskweighted assets of Category I and II bank holding companies have original maturity exceeding one year. 130As discussed in section IV.A.3.a. of this SUPPLEMENTARY INFORMATION, the proposal would provide that a commitment is unconditionally cancelable if by its terms, it either: (a) provides that a banking organization is not obligated to extend credit, purchase assets, or issue credit substitutes; or (b) permits a banking organization to, at any time, with or without cause, refuse to extend credit, purchase assets, or issue credit substitutes under the arrangement (to the extent permitted under applicable law). 131See, e.g., 12 CFR 1002.9 (adverse action notices), 12 CFR 1026.9(c) (subsequent disclosure requirements for open-end credit), and 12 CFR 1026.40(f) (limitations on changes to home equity lines of credit). obligor. The proposal would also include other off-balance sheet activities such as advised lines or ‘‘uncommitted’’ facilities as commitments (even if they are unconditionally cancelable or provide that the banking organization is not obligated to perform). For example, an
arrangement under which a banking organization retains full discretion as to whether to extend credit to a potential borrower, but under which the banking organization and the potential borrower have agreed to the material terms on which such lending would take place if the banking organization chose to extend credit, is an unconditionally cancelable commitment under the proposal. An unconditionally cancelable commitment also includes an arrangement where a banking organization provides an initial line of credit with an additional amount that the banking organization may extend in the future subject to prior approval by the banking organization, with the agreed upon terms of the future unconditionally cancelable line. Exposures without pre-set limits on the amount of credit that can be extended would also be unconditionally cancelable commitments under the proposal. With some retail products, such as with charge cards, the banking organization does not disclose a pre-set credit limit to its obligors. For charge cards, or similar types of off-balance sheet exposures, each attempt to borrow by an obligor is individually underwritten at the time of purchase and requires the approval of the banking organization. Nevertheless, because the banking organization and the borrower have agreed to the material terms on which such lending would take place, such arrangements meet the definition of commitment and, therefore, should be treated as unconditionally cancelable commitments for regulatory capital purposes.125 Question 30: The agencies seek comment on the proposed definition of commitment. Does the proposal appropriately capture as off-balance sheet exposures arrangements where the banking organization is not legally obligated to extend credit, purchase assets, or issue credit substitutes but which nonetheless arise out of a contractual arrangement to extend credit or purchase assets? To what extent would the proposed definition affect a banking organization’s business practices regarding commitments and similar arrangements, including how banking organizations treat such arrangements for regulatory capital and reporting purposes? Please provide any rationale or data that may be helpful for the agencies to consider. b. Credit Conversion Factors Consistent with the current rule, under the proposed rule a banking organization would calculate the exposure amount of an off-balance sheet exposure by multiplying the off-balance sheet component, which is usually the contractual amount, by the applicable credit conversion factor. The resulting exposure amount would then be assigned to the relevant risk-weight category for the exposure. The proposed expanded risk-based approach would incorporate the same credit conversion factors from the current capital rule, except with respect to commitments.126 Relative to the current standardized approach and consistent with the Basel standards, the proposal would simplify the credit conversion factors applicable to the
unused portion of a commitment that is not unconditionally cancelable relative to the current standardized approach. For these commitments, the proposal would no longer differentiate credit conversion factors by original maturity of one year or less and greater than one year.127 Under the proposal, a commitment that is not unconditionally cancelable would be subject to a credit conversion factor of 40 percent regardless of the maturity of the facility.128 This would remove the oneyear mark as a dividing line between substantially different treatments, which would remove any regulatory incentive to structure transactions around that line. The 40 percent credit conversion factor would align with international standards and reflect that most outstanding commitments that are not unconditionally cancelable have a maturity greater than one year.129 For the unused portion of a commitment that is unconditionally cancelable 130 by the banking organization, the proposal would require a banking organization to apply a credit conversion factor of 10 percent. Under the current capital rule, unconditionally cancelable commitments receive a credit conversion factor of zero percent. Although unconditionally cancelable commitments allow banking organizations to cancel such commitments at any time without prior notice, subject to compliance with consumer protection laws, in practice, risk management practices of the banking organization may constrain the organization’s willingness to cancel such commitments.131 In addition, banking organizations may extend credit or provide funding to support the viability of obligors to which the banking organization has significant ongoing exposure, even when obligors are under economic stress. For example, banking organizations may have incentives to preserve substantial or core customer relationships when there is a deterioration in creditworthiness that may otherwise, such as for less substantial customer relationships, cause the banking organization to cancel a commitment. For these reasons, the agencies are proposing nonzero credit conversion factors for unconditionally cancelable commitments. Under the proposal, certain retail credit card exposures would be subject to reduced risk-weights relative to the current standardized approach, as
132For additional considerations of the proposed approach, data on credit conversion factors, and on the impact of the proposal on credit cards, see the economic analysis presented in section VIII.E.1. of this SUPPLEMENTARY INFORMATION. 133Under the proposal, the methodology for calculating the undrawn exposures amount for retail commitments with no explicit contractual pre-set limit would also apply for purposes of calculating total leverage exposure for the supplementary leverage ratio. 134The maximum balance would reflect the highest drawn amount on any date during the previous 24 months for the retail account with no pre-set limit over the period. 135 If a multiplier of two were applied to the maximum drawn amount over the prior 24 months, under the example presented above, the off-balance sheet exposure amount would equal $5,000, which corresponds to $4,000 times two minus $3,000. The other steps of the process would remain unchanged and would result in a risk-weight asset amount of $225 for the off-balance sheet exposure. discussed in section IV.A.2.d. of this SUPPLEMENTARY INFORMATION. However, the overall risk-weighted asset amount associated with such exposures may be higher relative to the current standardized approach due to the increase in the credit conversion factors described above.132 Question 31: What additional factors, if any, should the agencies consider for determining the applicable credit conversion factors for commitments? Question 32: What other approaches to setting a credit conversion factor for unconditionally cancelable commitments should the agencies consider and why? To what extent and under what circumstances should an obligor’s historical usage patterns for unconditionally cancelable commitments that are transactor exposures affect the credit conversion factor for such exposures? What average utilization rate (for example, 10 percent) over what time period (for example, 24 months) would support a credit conversion factor lower than 10 percent? Please include any relevant data. Question 33: What are the advantages and disadvantages relative to the proposal of using the current treatment for commitments, that are not unconditionally cancelable which differentiates credit conversion factors based on maturity, and would apply a 20 percent credit conversion factor to those commitments with an original maturity of one year or less, and a 50 percent credit conversion factor to those with an original maturity of more than one year? Question 34: What are the advantages and disadvantages of applying the proposed 40 percent credit conversion factor for commitments regardless of maturity that are not unconditionally cancelable to the supplementary leverage ratio framework and to the Size Category of the FR Y–15?
c. Commitments With No Pre-Set Limit
Most off-balance sheet exposures, such as credit card lines, allow obligors to borrow up to a specified amount. However, some off-balance sheet exposures such as charge cards do not have an explicit contractual pre-set credit limit. For commitments that are retail exposures that do not have an express contractual maximum amount or pre-set limit, the proposal would include an approach to calculate a proxy for the committed but undrawn amount of the commitment (undrawn exposure amount). For commitments that are retail exposures, the undrawn exposure amount would be calculated by using the exposure’s highest drawn amount over the previous 24 months as an indicator of the amount of credit a banking organization is likely to extend to an obligor in the future. Specifically, under the proposal, a banking organization would first identify the largest drawn amount by a retail obligor over the prior 24 months or, if the banking organization has offered the product to the obligor for fewer than 24 months, the largest drawn amount since the commitment was first issued. The off-balance sheet exposure amount would be calculated by first subtracting the current drawn amount from the largest drawn amount and then multiplying this difference by the applicable credit conversion factor.133 The risk-weighted asset amount would be the off-balance sheet exposure amount multiplied by the applicable risk weight for the obligor. A substantial share of uncapped commitments are in the form of retail charge cards, and these exposures have characteristics that suggest the highest drawn balance method described above is a reasonable proxy to estimate the undrawn exposure amount. A charge card does not have a pre-set credit limit, its balance is generally required to be paid in full at the end of each statement period, and charge card transactions are generally underwritten separately and reviewed by the issuing banking organization for approval or denial. Therefore, a charge card obligor’s spending pattern, which reflects a banking organization’s approval of the charge card obligor’s usage, is indicative of the off-balance sheet exposure amount for a retail charge card. As an example of the proposed treatment, assume a retail obligor’s charge card had a maximum drawn amount of $4,000 during the period of the prior 24 months and a current drawn amount of $3,000.134 To determine the off-balance sheet exposure amount of the charge card, a banking organization would (1) identify the maximum drawn amount over the prior 24 months ($4,000), (2) subtract the applicable drawn amount of $3,000 from $4,000 ($1,000), and (3) multiply $1,000 by the applicable credit conversion factor (assuming a credit conversion factor of 10 percent, $100). For this example, assume the obligor’s charge card would qualify as a regulatory retail exposure that is a transactor exposure. Applying the proposed 45 percent risk weight for transactor exposures to the off-balance sheet exposure amount of $100
would result in a risk-weighted asset amount of $45, which would apply in addition to the risk-weighted asset amount of $1,350 for the on-balance sheet exposure (the drawn amount of $3,000). Question 35: What are the advantages and disadvantages of the proposed treatment for commitments to retail obligors with no express contractual maximum amount or pre-set limit? What other time period or approach should the agencies consider for calculating the highest drawn amount (for example, using month-end balance or statement balances), and why? Question 36: What would be the advantages and disadvantages of applying a multiplier to the highest drawn amount to calculate the offbalance sheet exposure amount (for example, multiplying the highest drawn balance by a figure between 1.5 and 3) to calculate the off-balance sheet exposure amount? 135 If applied, how should such multiplier be calibrated? What data should the agencies use to calibrate such a multiplier? Question 37: The agencies seek feedback on commitments that contain no express contractual maximum amount but also contain features such as a ‘‘pay over time’’ limit, which allows a borrower to carry a balance with interest on certain charges. What would be the advantages and disadvantages of incorporating the ‘‘pay over time’’ limit as a floor when calculating the highest drawn amount under the proposal? For example, assume the maximum drawn amount over the prior 24 months is $4,000 and the ‘‘pay over time’’ limit is $5,000. Under this alternative, the applicable drawn amount would be subtracted from $5,000 instead of $4,000. Question 38: The proposal would apply the specific treatment described above to commitments to retail obligors with no contractual maximum or pre-set
limit. The agencies seek comment on the appropriate treatment for commitments to non-retail obligors with no contractual maximum amount or pre-set limit. The agencies request comment on the product types, structures, risks, materiality, and loss history of commitments to non-retail obligors with no contractual maximum amount or pre-set limit. Please provide specific product examples and relevant data. What would be the advantages and disadvantages of applying the proposed treatment for commitments to retail obligors with no pre-set limit to such commitments to non-retail obligors? What would be the advantages and disadvantages of using the average total drawn amount over the period since the commitment to a non-retail obligor was created or the prior 24 months, whichever period is shorter, for the committed but undrawn amount? What would be the advantages and disadvantages of applying a multiplier to the highest drawn amount (for example, multiplying the highest drawn balance by a figure between 1.5 and 3) to calculate the off-balance sheet exposure amount? If applied, how should such multiplier be calibrated? What other alternative treatments should the agencies consider, and why? Please provide any rationale or data that may be helpful for the agencies to consider.
4. Counterparty Credit Risk-Related
Exposures
Under the current capital rule, a covered banking organization is required to use the standardized approach to counterparty credit risk (SA–CCR) to calculate the exposure amount of derivative contracts. The proposal would retain this treatment, with the following modification. For noncleared repo-style transactions that are included in a qualifying crossproduct netting set that includes derivatives, a banking organization may elect to use SA–CCR to calculate the exposure amount of the netting set. Where a banking organization does not make such an election, it would use the collateral haircut approach to calculate the exposure amount for a repo-style transaction. Consistent with the current capital rule, the proposal would continue to allow banking organizations to use either the collateral haircut approach or the simple approach to calculate the exposure amount for eligible margin loans and repo-style transactions, provided that the banking organization uses the same approach for similar exposures or transactions. a. Collateral Haircut Approach Under the proposal, as under the current capital rule, a banking organization would be permitted to recognize the credit risk-mitigation benefits of collateral supporting repostyle transactions, eligible margin loans, and netting sets of such transactions by adjusting its exposure amount to its counterparty to recognize financial collateral received and any collateral posted to the counterparty. The expanded risk-based approach would incorporate the collateral haircut approach in the current standardized approach with some modifications that are generally consistent with the Basel standards. The collateral haircut approach would continue to require a banking organization to adjust the fair value of the collateral received and posted to account for any potential market price volatility in the value of the collateral during the margin period of risk, as well as to address any currency mismatch. To increase the risk-sensitivity of the collateral haircut approach, the proposal would modify certain of the standard market price volatility haircuts. At the same time, to reduce unwarranted divergence in riskweighted assets, the proposal would no longer allow a banking organization to use its own internal estimates for calculating haircuts.
i. Formula for Determining Exposure
Amount
The proposal would introduce a new formula for calculating the exposure amount of eligible margin loans, repostyle transactions, or netting sets thereof. The proposed exposure amount equation is revised from the current formula to improve the recognition of the risk-mitigating benefits of netting and portfolio diversification. The proposed formula would revert to the current collateral haircut approach formula in cases where there are no variables to populate the second and the third components as described below. The modification would increase the risk sensitivity of the capital requirement for such transactions relative to the current collateral haircut approach. Under the proposal, the exposure amount (E*) of a netting set of eligible margin loans or repo-style transactions or an individual transaction that is not part of a netting set would be determined according to the following formula:
Where:
136 Includes a foreign PSE that receives a zero percent risk weight. 137 Includes senior securitization exposures with a risk weight greater than or equal to 100 percent and sovereign exposures with a risk weight greater than 100 percent. resale, or taken as collateral from the counterparty.
The proposed haircuts would strike a balance between simplicity and risk sensitivity relative to the supervisory haircuts in the current capital rule by introducing additional granularity with respect to residual maturity, which is a meaningful driver for distinguishing between the market price volatility of different instruments, and by streamlining other aspects of the collateral haircut approach where the exposure’s risk weight figures less EP27MR26.066</GPH>
138 If the mutual fund qualifies for the full lookthrough approach under the proposed equity framework, as described in section IV.C. of this SUPPLEMENTARY INFORMATION, but would be treated as a market risk covered position as described in
section V.A.4. of this SUPPLEMENTARY INFORMATION
if the banking organization held the mutual fund directly, the banking organization is permitted to apply the alternative method to calculate the haircut. 139 85 FR 4362 (Jan. 24, 2020). 140 12 CFR 3.10(c)(2)(ii)–(iii), 12 CFR 3.34(a) (OCC); 12 CFR 217.10(c)(2)(ii)–(iii), 12 CFR 217.34(a) (Board); 12 CFR 324.10(c)(2)(ii)–(iii), 12 CFR 324.34(a)(a) (FDIC). prominently in the instrument’s market price volatility, as described below. The proposal would apply haircuts primarily based on residual maturity, rather than a combination of residual maturity and underlying risk weight as under the current capital rule, for nonsovereign investment grade debt securities. These haircuts are derived from observed stress volatilities during 10-business day periods during the 2008 financial crisis. Debt securities with longer maturities are subject to higher price volatility from changes in both interest rates and the creditworthiness of the issuer. Because securitization exposures tend to be more volatile than corporate debt, the proposal would provide a distinct category of market price volatility haircuts for certain securitization exposures consistent with the current capital rule. The proposal would distinguish between non-senior and senior securitization exposures to enhance risk sensitivity. Because senior securitization exposures absorb losses only after more junior securitization exposures, these exposures have an added layer of security and distinct market price volatility. Therefore, the proposal would only specify term-based haircuts for investment grade senior securitization exposures that receive a risk weight of less than 100 percent under the securitization framework. Other securitization exposures would receive the 30 percent market price volatility haircut applicable to ‘‘other’’ exposure types. The proposal would require a banking organization to apply market price volatility haircuts of 20 percent for main index equities (including convertible bonds) and gold, 30 percent for other publicly traded equities and convertible bonds, and 30 percent for other exposure types. Equities in a main index typically are more liquid than those that are not included in a main index, in part because investors may seek to replicate the index by purchasing the referenced equities or engaging in derivative transactions involving the index or equities within the index. The lower haircuts for equities included in a main index under the proposal would reflect the higher liquidity of those securities compared to other publicly traded equities or exposure types, which would generally help to reduce losses to banking organizations when liquidating those securities during stress conditions. For collateral in the form of mutual fund shares, the proposal would be consistent with the current collateral haircut approach in which a banking organization would apply the highest haircut applicable to any security in which the fund can invest. Under the proposal, a banking
organization could treat exchange traded fund (ETF) shares in the same manner as mutual fund shares and apply haircuts based on the underlying instruments in the fund. Given that ETFs (like mutual funds) benefit from diversification and tend to have lower levels of price volatility compared to non-pooled investment vehicles, a look-through approach is more risk sensitive than applying the publicly traded equities haircut for ETF shares. The proposal also would include an alternative method available to a banking organization if the mutual fund or ETF qualifies for the full lookthrough approach described in section IV.C. of this SUPPLEMENTARY INFORMATION. This alternative method would provide a more risk-sensitive calculation of the haircut on fund shares collateral by using the weighted average of haircuts applicable to the instruments held by the fund.138 In addition, consistent with the Basel standards, the proposal would require a banking organization to apply a market price volatility haircut of 30 percent to address the potential market price volatility for any instruments that the banking organization has lent, sold subject to repurchase, or posted as collateral that is not of a type otherwise specified in Table 1 to § ll.115. b. Standardized Approach to Counterparty Credit Risk The agencies incorporated SA–CCR for calculating the exposure amount of derivative contracts into the capital rule in 2020.139 This change required advanced approaches banking organizations to use SA–CCR instead of the current exposure methodology when calculating standardized total riskweighted assets and total leverage exposure. Similarly, the proposal would require a covered banking organization to use SA–CCR to determine the exposure amount for derivatives under the expanded risk-based approach and the supplementary leverage ratio.140 The proposal would also revise SA–CCR in certain ways to better reflect risks associated with evolving market practices. Specifically, for risk-based capital purposes, the proposal would revise SA–CCR to recognize qualifying cross-product master netting agreements for non-cleared transactions and incorporate certain non-cleared (such as client-facing) repo-style transactions. Additionally, the proposal would revise SA–CCR to permit the netting of collateralized-to-market and settled-tomarket client-facing derivative transactions. The agencies are also proposing technical revisions to assist banking organizations in implementing SA–CCR in a consistent manner and more appropriately reflect the counterparty credit risk posed by derivative transactions. Question 40: Consistent with the current rule, the proposal would require a banking organization to multiply the sum of the replacement cost of a netting set, calculated as stipulated by the SA– CCR framework, and the potential future exposure of a netting set by a factor of 1.4 if the relevant counterparty is not a commercial end-user, versus a factor of 1.0 if the counterparty is a
commercial end-user. Currently, the SA–CCR framework of the capital rule requires banking organizations to identify whether counterparties are commercial end-users. What would be the advantages or disadvantages of allowing banking organizations to apply the higher factor of 1.4 for all derivative transactions, rather than having to distinguish based on whether the counterparty qualifies as a commercial end-user? Please provide any rationale or data that may be helpful for the agencies to consider. Question 41: For purposes of the supplementary leverage ratio, the proposal would not modify SA–CCR to recognize qualifying cross-product master netting agreements for noncleared transactions or to incorporate certain non-cleared (including clientfacing) repo-style transactions, given that it is meant to serve as a non-riskbased measure. What are the advantages and disadvantages of modifying the supplementary leverage ratio to recognize such cross-product netting? If the agencies were to consider such recognition, what if any adjustments to the measure should be considered to align with the supplementary leverage ratio’s non-riskbased nature and why?
141Under the proposal, cross-product netting sets would be governed by qualifying cross-product master netting agreements as described below. 142Client-facing transactions are not considered cleared transactions under the capital rule. See 12 CFR 3.2 cleared transaction, (2) (OCC); 12 CFR
217.2 cleared transaction, (2) (Board); 12 CFR 324.2
cleared transaction, (2) (FDIC).
143Under the current capital rule, a qualifying cross-product master netting agreement is generally defined, as a qualifying master netting agreement that provides for termination and close-out netting rights across multiple types of financial transactions. As a type of qualifying master netting agreement, a qualifying cross-product master netting agreement would be required, among other provisions, to create, upon an event of default, a single legal obligation for all individual transactions covered by the agreement and to provide the banking organization with the right to liquidate or set-off any collateral provided in respect of any of the transactions covered by the agreement against the net amount owed across all the individual transactions. Accordingly, if a banking organization’s rights upon an event of default to net certain transaction types (e.g., derivatives) against other transaction types (e.g., repo-style transactions), or to apply collateral provided in respect of one type of transaction against amounts owed on other types of transactions, were restricted or limited under the relevant contractual agreements or applicable law, a banking organization would not be permitted recognize cross-product netting. 144The SA–CCR framework allows for offsetting positions to net for purposes of measuring exposure. In general, such netting can occur at a particular moment in time, so no short-term transaction can have any impact on exposure at long time horizons. Because of this, time averaging for the purposes of exposure calculation should be performed after exposure contributions of individual transactions are aggregated to the netting set exposure for each future time point. However, to simplify calculations, SA–CCR performs time averaging for each transaction in the netting set prior to the aggregation. This leads to a possibility of short-term transactions materially offsetting the risk of long-term transactions. This is not a major concern for netting sets of derivatives, which often have medium and long-term durations. However, because repo-style transactions are primarily shortterm (often overnight), applying SA–CCR to a crossproduct netting set would likely overstate the impact of repo-style transactions on the netting set exposure. The proposed maturity mismatch restriction on cross-product netting would mitigate this overstatement.
i. Amend SA–CCR To Recognize the
Netting of Non-Cleared Repo-Style Transactions and Derivative Transactions A netting set refers to a group of transactions between a banking organization and a single counterparty governed by a qualifying master netting agreement. Qualifying master netting agreements create a single net legal obligation for all individual transactions covered by the agreement and allow for close-out netting upon the event of default. By treating all transactions under the agreement as one combined obligation, these agreements recognize risk-offsets between transactions. Cross-product netting is a risk management technique that involves the inclusion of multiple types of financial products in one netting set. Generally, cross-product netting reduces risk exposure by allowing banking organizations to recognize offsets between positive and negative exposures across different financial product types and to calculate a single net exposure amount for collateral and default management. Cross-product netting sets allow the benefits of qualifying master netting agreements (such as close-out netting) to apply for a broader set of transactions than those included in a single-product netting set.141 For example, if a banking organization has a $5 million positive exposure to a counterparty under one swap transaction and a $2 million negative exposure to the same counterparty under a repo-style transaction, cross-product netting would allow for a net exposure of only $3 million to be recognized, rather than two separate exposures of $5 million and $2 million. Recognizing the riskmitigating benefits of cross-product netting better aligns capital requirements with risk because it allows offsetting risks between products to be recognized and capitalized jointly rather than separately. Consolidating exposures across products into a single netting set can also simplify risk management processes for banking organizations and reduce operational burden. The quantity of netting sets would generally be reduced, as banking organizations would be able to net transactions with multiple products together. Thus, a banking organization’s net exposure to a single counterparty typically would be lower, reducing counterparty credit risk. Additionally, cross-product netting allows banking organizations to improve collateral management and expand liquidity efficiency across different product types. Instead of calculating collateral requirements and posting collateral for transactions of each product type (such as derivative and repo-style transactions) separately, cross-product netting allows for collateral requirements to be determined on a net basis for all transaction types in the same netting set. The capital rule currently recognizes cross-product netting in the advanced approaches, under which banking organizations can measure counterparty credit exposure of a cross-product netting set using the internal models methodology (IMM). Since the agencies’ are proposing to remove the IMM from the
capital rule, the proposed revisions to SA–CCR to recognize qualifying cross-product master netting agreements and incorporate certain repo-style transactions for risk-based capital purposes would provide an avenue for banking organizations to recognize the benefits of cross-product netting in a standardized, transparent manner rather than through a banking organization’s internal model. The proposed modifications to the exposure amount calculation in SA–CCR would recognize the risk-mitigating benefits of crossproduct netting for banking organizations helping to facilitate market liquidity. Recognizing the benefits of crossproduct netting in SA–CCR would also allow banking organizations to better serve in their role as clearing members. Many clients of clearing members do not meet the requirements to become a clearing member of a central counterparty. As a result, without a clearing member stepping in to act as an intermediary, money market funds, pension funds, insurance funds, hedge funds, and other clients may not have access to central counterparty services and market access more broadly. The proposed revision to permit the netting of derivatives and non-cleared repostyle transactions would include clearing members’ intermediationrelated transactions, which are typically considered client-facing transactions under the capital rule.142 Permitting cross-product netting for derivative transactions and repo-style transactions in SA–CCR promotes smooth market functioning and liquidity and better aligns the risk-based capital treatment of intermediation-related transactions with their economics. To incorporate non-cleared repo-style transactions subject to a qualifying cross-product master netting agreement in SA–CCR, the proposal would treat them as forward derivative transactions with the security underlying the repostyle transaction determining the SA– CCR asset class.143 The agencies are proposing to include a restriction on the amount of offsetting for recognized between derivatives and repo-style transactions within SA–CCR to capture the mismatch between maturities of repo-style transactions and those of derivative contracts.144 In addition, for an entire cross-product netting set, banking organizations would have to calculate the exposure amount for the subset of the cross-product netting set that includes only derivative contracts and the exposure amount for the subset of the cross-product netting set that includes only repo-style transactions. The exposure amount for the entire cross-product netting set
145 12 CFR 3.132(c)(5)(v) (OCC); 12 CFR 217.132(c)(5)(v) (Board); 12 CFR 324.132(c)(5)(v) (FDIC). This would also be consistent with comments received under EGRPRA as commenters requested allowance of netting of settled-to-market and collateralized-to-market. would be a weighted average of two exposure numbers. One exposure amount would be the combined exposure for repo-style transactions and derivatives in the cross-product netting set using SA–CCR, weighted by a maturity ratio (MR). The other exposure amount would be the sum of the exposure amounts of the repo-style transactions in the netting set using the collateral haircut approach and the exposure amounts of derivatives transactions in the netting set using SA– CCR, weighted by (1–MR). MR would be the maturity ratio factor determined by the ratio of the notional average weighted maturity of the repo-style transactions to the notional average weighted maturity of the derivatives contracts or repo-style transactions within the cross-product netting set, whichever is longer. The maturities calculated this way would be floored by 10 business days and capped by 1 year. The MR would be capped at 1. Permitting the netting of repo-style transactions and derivative transactions subject to qualifying cross-product master netting agreements in SA–CCR and the proposed limitation on offsetting transactions promotes responsible counterparty credit risk mitigation and ensures the capital requirement better reflects such transactions’ risk profile and economic relationship. Recognizing cross-product netting in SA–CCR would create capital efficiency for banking organizations, align with banking organizations’ risk management practices for counterparty credit risk, and promote smooth market functioning and liquidity. The agencies have proposed to permit the netting of repo-style transactions and derivative transactions subject to qualifying master netting agreements in SA–CCR, and not to recognize cross product netting of eligible margin loans. Although eligible margin loans have similarities to repo-style transactions, such as both being collateralized by liquid and readily marketable securities, they differ from repo-style and derivative transactions in that eligible margin loans are not typically included in qualifying master netting arrangements. The agencies are seeking input on whether and how crossproduct netting should be recognized for eligible margin loans. The proposal also would not permit cross-product netting for cleared transactions, as cleared transactions are typically not included in netting sets with noncleared transactions. The agencies are seeking feedback on the scope of the proposed recognition of cross-product netting, including whether the scope of cross-product netting should be expanded to include cleared transactions. Question 42: The agencies seek comment on what, if any, challenges banking organizations may face in using SA–CCR to determine exposure amounts for counterparty
credit risk (e.g., whether SA–CCR could underestimate or overstate the exposure amount for some portfolios). What are the advantages and disadvantages of retaining the IMM for counterparty credit risk? If the IMM were retained, what corresponding modifications should the agencies make to the current version of the IMM to maintain appropriate alignment between SA–CCR and IMM? Question 43: What, if any, additional changes should be made to the scope of cross-product netting recognition under SA–CCR? For example, if the scope of cross-product netting recognition in SA– CCR were expanded to eligible margin loans, what would be the advantages and disadvantages of this expanded scope? What are the advantages and disadvantages of extending crossproduct netting recognition in SA–CCR to cleared transactions? Question 44: Are there any modifications to the operational requirements for qualifying crossproduct master netting agreements that the agencies should consider in connection with the recognition of netting of certain repo-style transactions in SA–CCR?
ii. Netting of Collateralized-to-Market
(CTM) and Settled-to-Market (STM) Client-Facing Derivative Transactions Under SA–CCR in the current capital rule, the exposure amount of a derivative netting set is calculated as the sum of replacement cost and potential future exposure (PFE) multiplied by an alpha factor. While the capital rule allows netting of all derivative contracts within a netting set in the replacement cost calculations, netting across margined and unmargined derivative contracts in the same netting set is limited to cleared transactions for purposes of the PFE calculations. Settled-to-market derivative contracts are those in which daily payments are made to settle the mark-to-market exposure. These payments are made on a periodic basis to reflect changes in exposure that arise from marking a derivative contract to fair value, and they are similar to traditional exchanges of variation margin, except that, in a settled-to-market contract, the payment to the receiving party extinguishes the amount owed to the receiving party arising from the change in fair value and thus effectively settles the outstanding amount due on the contract. In contrast, a collateralized-to-market derivative contract is a form of derivative transaction for which exchanges of variation margin that occur on a periodic (often daily) basis collateralize any outstanding payment obligation of a counterparty. The counterparties in a collateralized-to-market contract secure, but do not settle, mark-to-market exposures as they arise. Settled-tomarket derivative contracts and collateralized-to-market derivative contracts are functionally and economically similar from a counterparty credit risk perspective. SA–CCR therefore allows a clearing member banking organization to elect, at the netting set level, to treat all cleared settled-to-market derivative contracts within the netting set as subject to a variation margin agreement and receive the benefits of netting with cleared collateralized-to-market derivative contracts for the purposes of PFE calculations, provided that both sets of contracts share the same margin period of risk.145 The exposure of a clearing member to its client when facilitating a client’s cleared transaction (a client-facing derivative transaction) is treated as a non-cleared transaction under the capital rule because the clearing member’s exposure is to the client, not the central counterparty. Because some clearing members enter into clientfacing derivative transactions in the form of settled-to-market and collateralized-to-market transactions, there can be situations where both types of derivatives are a part of the same netting set. Because client-facing derivative transactions are not cleared transactions, banking organizations currently do not have the option to treat client-facing derivative transactions that are settled-to-market contracts as if subject to a variation margin agreement, and clearing member banking organizations therefore cannot net client-facing
settled-to-market derivative contracts and collateralized-to-market derivative contracts for purposes of SA– CCR. The proposal would amend SA–CCR to allow clearing member banking organizations the option to treat clientfacing settled-to-market derivative contracts as collateralized-to-market (i.e., margined) derivative contracts, thus permitting netting between clientfacing settled-to-market and
146See https://www.dtcc.com/news/2025/ december/15/dtcc-files-to-expand-cme-group-crossmargining-arrangement. 147See https://investor.cmegroup.com/newsreleases/news-release-details/cme-group-and-dtcclaunch-enhanced-treasury-cross-margining. collateralized-to-market contracts for the purposes of PFE calculations. This proposed approach would align the netting treatment of cleared derivative exposures with the netting treatment of their related client-facing derivative exposures, as well as facilitate efficient hedging. This proposed revision is also important for cross-product netting, as certain derivative transactions are settled-to-market, whereas repo-style transactions are often collateralized-tomarket. Question 45: What are the advantages and disadvantages of permitting banking organizations to treat bilateral settled-to-market derivative transactions as collateralized-to-market derivative transactions for purposes of SA–CCR?
iii. Potential Change to the Hypothetical
Capital Requirement for QCCP Default Fund Contribution Calculation Financial market participants are increasingly exploring cross-margining arrangements, which facilitate the aggregation of positions across multiple central counterparties and allow for initial margin to be determined on a net basis, with recognition of risk-offsets that exist among different positions.146 Cross-margining agreements generally allow a clearing member to post initial margin to multiple central counterparties on a net basis, taking into account offsetting positions the clearing member holds with each central counterparty. As a result, crossmargining agreements may more accurately reflect the economic risk of the transactions associated with each central counterparty subject to the relevant cross-margining agreement. Although cross-margining has historical precedent, in recent years there have been significant developments, refinements, and increased adoption of cross-margining practices across the financial industry. Cross-margining arrangements may involve netting sets that contain multiple products, as central counterparties in the United States generally specialize in clearing a single specific product type such as repo-style transactions or derivatives.147 For example, under a cross-margining agreement, a clearing member with an agreement to sell a U.S. Treasury security at one QCCP could recognize risk-offsets that exist with an interest rate future at a different QCCP in determining the margin it posts at each QCCP. Cross-margining agreements also generally include policies and procedures for QCCPs participating in such agreements to manage the default of a clearing member. Central counterparties use default funds, to which clearing members contribute, to cover potential losses that may arise if a clearing member defaults. Clearing members are generally required to contribute to the default funds in proportion to each clearing member’s share of the central counterparty’s transactions, whether in the form of bilateral transactions or clearing member client transactions guaranteed by the clearing member. The capital rule defines such default fund contributions as the funds contributed to, or commitments made by a clearing member, to a central counterparty’s mutualized loss sharing arrangement. Banking organizations that are clearing members are required to include in riskweighted assets an amount representing the risk of their default fund contributions. For contributions to qualifying central counterparties (QCCPs), the risk-weighted asset amount is derived using the hypothetical capital requirement of a qualifying central counterparty, Kccp, representing its counterparty credit risk exposures to all its clearing members and their clients. Kccp incorporates an exposure amount for each transaction cleared by the QCCP, reduced by initial margin, variation margin, and funded default fund contributions. Under the current capital rule, clearing member banking
organizations are not able to reflect the risk-offsets recognized by cross-margining programs in their Kccp calculations. Together with lower margin requirements resulting from cross-margining programs, this may result in banking organizations being required to hold additional capital when engaging in offsetting activities. As cross-margining arrangements are increasingly adopted, this potential misalignment could become increasingly consequential. Without revisions to the default fund contribution framework’s Kccp formula, clearing member banking organizations would not be able to reflect potential risk-reductions recognized by crossmargining arrangements in their hypothetical capital requirement calculation. A consequence could be that banking organizations may be less likely to intermediate transactions as clearing members, which could be problematic for money market funds, pension funds, insurance funds, hedge funds, and other clients that may not have direct access to central counterparty services and market access more broadly. The agencies are therefore seeking comment on potential modifications to the capital rule’s requirements related to default fund contributions to recognize cross-margining arrangements among QCCPs that meet certain criteria. QCCPs are either regulated and supervised as designated financial market utilities, or, if the QCCP is located outside of the United States, in a manner equivalent to a designated financial market utility. Such supervision and regulations can include evaluation of margining practices. Accordingly, the agencies are seeking feedback on proposed revisions to the Kccp formula described below, if a QCCP’s cross-margining arrangements are subject to appropriate oversight by the QCCP’s primary regulators. More specifically, the agencies are requesting comment on the below potential approach for calculating the exposure amount for derivatives and repo-style transactions that are subject to a valid cross-margining agreement for purposes of Kccp. The formula used in this approach would allow for the recognition of the risk-mitigating benefits of cross-margining programs and portfolio diversification relative to the current Kccp formula. KCCPi = Sj exposureQCCPi,j * 1.6% exposureQCCPi,j = exposureNon-XMi,j + Allocation Factori,j * exposureXMi,j Where:
exposureQCCPi,j represents the exposure amount of QCCPi to each of its clearing members j, exposureNon-XMi,j represents the exposure amount for positions not subject to a cross-margining agreement at QCCPi for clearing member j, exposureXMi,j represents the exposure amount for positions subject to a cross-margining agreement at QCCPi for clearing member j. Allocation Factori,j is the allocation factor for clearing member j at QCCPi which is assigned based on the ratio of gross notional positions held at QCCPi divided by the sum of all gross notional positions held across all QCCPs subject to the cross-margining agreement. This allocation factor must be between 0 and 1. Question 46: What are the advantages and disadvantages of recognizing the benefits of cross-margining arrangements, for Kccp purposes, under the capital rule? Question 47: If the agencies were to permit recognition of offsetting positions that are facilitated by cross-margining agreements among QCCPs that satisfy certain criteria, what criteria and operational requirements should the agencies establish for a qualifying crossmargining agreement? For example, should the agencies require that a qualifying cross-margining agreement be
148See 12 CFR 3.133(d) (OCC); 12 CFR 217.133(d) (Board); 12 CFR 324.133(d) (FDIC). 149 12 CFR 3.133(c)(4)(i) (OCC); 12 CFR 217.133(c)(4)(i) (Board); 12 CFR 324.133(c)(4)(i) (FDIC). 150For the supervisory delta adjustment, a banking organization applies a positive sign to the derivative contract amount if the derivative contract is long the risk factor and a negative sign if the derivative contract is short the risk factor. A derivative contract is long the primary risk factor if the fair value of the instrument increases when the value of the primary risk factor increases. A derivative contract is short the primary risk factor if the fair value of the instrument decreases when the value of the primary risk factor increases. approved by the QCCPs’ primary regulator or regulators? Alternatively, should the agencies require that banking organizations receive a legal opinion verifying the validity and enforceability of the agreement under applicable law of the relevant jurisdictions, or that banking organizations conduct sufficient legal review, including ongoing due diligence, to have a well-founded basis for concluding the agreement would be enforceable under applicable law? Question 48: What revisions, if any, should the agencies make to the cleared transactions framework in consideration of cross-margining agreements? What are the advantages and disadvantages of extending recognition of crossmargining agreements for default fund contribution capital requirements to cleared transaction capital requirements? Question 49: What alternatives to the allocation factor described in the proposed formula for the hypothetical capital requirement for cross-margined portfolios should the agencies consider and why?
iv. Proposed Technical Revisions
I. Treatment of Collateral Held by a
Qualifying Central Counterparty (QCCP) Under the current capital rule, a clearing member banking organization using SA–CCR must determine its capital requirement for a default fund contribution to a QCCP based on the hypothetical capital requirement for the QCCP (KCCP) using SA–CCR.148 The calculation of KCCP requires calculating the exposure amount of the QCCP to each of its clearing members. In the calculation of the exposure amount, the capital rule allows the exposure amount of the QCCP to each clearing member to be reduced by all collateral held by the QCCP posted by the clearing member and by the amount of prefunded default fund contributions provided by the clearing member to the QCCP. However, this treatment is inconsistent with the calculation of the exposure amount for a netting set, because collateral is a component of the calculations of both the replacement cost and PFE. It does not make sense to reduce that exposure amount further by subtracting collateral held by the QCCP. The proposal would therefore change how collateral posted to a QCCP by clearing members and the amount of clearing members’ prefunded default fund contributions factor into the calculation of KCCP. This treatment would allow for the appropriate recognition of collateral in calculating the exposure amount of a QCCP to its clearing members and would be consistent with the calculation of the exposure amount for a netting set. Specifically, for the purpose of calculating the exposure amount of a QCCP to a clearing member, the net independent collateral amount that appears in the replacement cost and PFE calculations would be replaced by the sum of:
(1) the fair value amount of the independent collateral posted to a QCCP by a clearing member; (2) the fair value amount of the independent collateral posted to a QCCP by a clearing member on behalf of a client, in connection with derivative contracts for which the clearing member has provided a guarantee to the QCCP; and (3) the amount of the prefunded default fund contribution of the clearing member to the QCCP. Both the amount of independent collateral and the prefunded default fund contribution would be adjusted by the standard market price volatility haircuts under Table 1 to § ll.115 of the proposal, as applicable.
II. Treatment of Collateral Held in a
Bankruptcy-Remote Manner Both the standardized approach and the advanced approaches under the current capital rule require a banking organization to determine the trade exposure amount for cleared derivative transactions. When calculating its trade exposure amount for a cleared transaction, a banking organization under the current capital rule may exclude collateral posted to the CCP that is held in a bankruptcy-remote manner by the CCP or a custodian. In the SA–CCR framework of the capital rule, the agencies inadvertently imposed heightened requirements for the exclusion of collateral from the trade exposure amount posted by a clearing member banking organizations to a CCP under the advanced approaches.149 The expanded risk-based approach would not include these heightened requirements and would align the requirements for the exclusion of collateral from the trade exposure amount of banking organizations under the expanded risk-based approach with the standardized approach.
III. Supervisory Delta for Collateralized
Debt Obligation (CDO) Tranches Under the capital rule, a banking organization must apply a supervisory delta adjustment to account for the sensitivity of a derivative contract (scaled to unit size) to the underlying primary risk factor, including the correct sign (positive or negative) to account for the direction of the derivative contract amount relative to the primary risk factor.150 For a derivative contract that is a CDO tranche, the supervisory delta adjustment is calculated using the formula below:
where A is the attachment point and D is the detachment point. The capital rule applies a positive sign to the resulting amount if the banking organization purchased the CDO tranche and applies a negative sign if the banking organization sold the CDO tranche. However, the appropriate sign to account for the purchase or sale of CDO tranches can be ambiguous:
purchasing a CDO tranche can be interpreted as selling credit protection, while selling a CDO tranche can be interpreted as purchasing credit protection. In order to ensure the correct sign of the supervisory delta adjustment for CDO tranches the proposal would revise the sign specification for the EP27MR26.067</GPH>
151See 12 CFR 3.132(c)(5)(vi) (OCC); 12 CFR 217.132(c)(5)(vi) (Board); 12 CFR 324.132(c)(5)(vi) (FDIC). 152Consistent with the current capital rule, the proposal would not require banking organizations to recognize a credit risk mitigant that it has obtained. Credit derivatives that a banking organization cannot or chooses not to recognize as a credit risk mitigant would be subject to a separate counterparty credit risk capital requirement. supervisory delta adjustment for CDO tranches as follows: positive if the CDO tranches were used by the banking organization to purchase credit protection and negative if the CDO tranches were used by the banking organization to sell credit protection.
IV. Supervisory Delta for Options
Contracts
The supervisory delta adjustment for option contracts in SA–CCR is calculated based on the Black-Scholes formulas for delta sensitivity of European call and put option contracts. The original Black-Scholes formula for a European option contract’s delta sensitivity assumes a lognormal probability distribution for the value of the instrument or risk factor underlying the option contract, thus precluding negative values for both the current value of the underlying instrument or risk factor and the strike price of the option contract. SA–CCR uses modified Black-Scholes formulas that are based on a shifted lognormal probability distribution, which allows negative values of the underlying instrument or risk factor with the magnitude not exceeding the value of a shift parameter l (lambda). The capital rule sets l to zero (thus precluding negative values) for all asset classes except the interest rate asset class, which has exhibited negative values in some currencies in recent years. For the interest rate asset class, a banking organization must set the value of l for a given currency equal to the greater of (i) the negative of the lowest value of the strike prices and the current values of the interest rate underlying all interest rate options in a given currency that the banking organization has with all counterparties plus 0.1 percent; and (ii) zero. Negative values of the instrument or risk factor underlying an option contract can occur in other asset classes as well. For example, whenever an option contract references the difference between the values of two instruments or risk factors, the underlying spread of this option contract can be negative. Such option contracts include option contracts on the spread between two commodity prices and on the difference in performance across two equity indices. Under the current capital rule, banking organizations cannot calculate the supervisory delta adjustment for any option contract other than an interest rate derivative contract if the strike price or the current value of the underlying instrument or risk factor is negative because the capital rule only allows a non-zero value for l for interest rate derivative contracts. To ensure that a banking organization is able to calculate the supervisory delta adjustment for option contracts when the underlying instrument or risk factor has a negative value, the proposal would extend the use of the shift parameter l to all asset classes. More specifically, for non-interest-rate asset classes, the proposal would require a banking organization to use the same value of l for all option contracts that reference the same underlying instrument or risk factor. If the value of the underlying instrument or risk factor cannot be negative, the value of l would be set to zero. Otherwise, to determine the value of l for a given risk factor or instrument, the proposal would require a banking organization to find the lowest value L of the strike price and the current value of
the underlying instrument or risk factor of all option contracts that reference this instrument or risk factor with all counterparties. The proposal would require a banking organization to set l for this instrument or risk factor according to the formula l=max{¥1.1·L,0}. The purpose of multiplying negative L by 1.1 (thus, resulting in ¥1.1·L) is the same as that for adding 0.1 percent in the case of interest rate derivative contracts under the capital rule: to set the lowest possible value of the underlying instrument or risk factor slightly below the lowest observed value. Because noninterest-rate instruments and risk factors can have vastly different magnitudes and, moreover, be expressed in different units (e.g., different currencies), it is challenging to determine a universal additive offset value for all values of non-interest-rate instruments and risk factors. Because of this, the offset would be performed via multiplication for asset classes other than the interest rate asset class. The proposal would also permit a banking organization, with the prior approval of its primary Federal supervisor, to specify a different value for l for purposes of the supervisory delta adjustment for option contracts other than interest rate option contracts, if a different value for l would be more appropriate, considering the range of values for the instrument or risk factor underlying option contracts. A banking organization that specifies a different value for l would be required to assign the same value for l to all option contracts with the same underlying instrument or risk factor, as applicable, with all counterparties. This proposed provision is intended to permit a banking organization, with approval from its primary Federal supervisor, to account for unanticipated outcomes in the supervisory delta adjustment of certain asset classes while avoiding arbitrage between assets in that class. Question 50: What other approaches should the agencies consider to calibrate the lambda parameter for noninterest-rate asset classes, such as a formula that is different from the proposed formula of l=max{¥1.1·L,0}, and why? What values besides 1.1, if any, should the agencies consider for the value of the multiplier in the proposed formula? Why?
V. Decomposition of Credit, Equity, and
Commodity Indices
Under SA–CCR, banking organizations are permitted to decompose indices within credit, equity, and commodity asset classes, such that a banking organization would treat each component of the index as a separate single-name derivative contract.151 The capital rule requires that if a banking organization elects to decompose indices within the credit, equity, and commodity asset classes, the banking organization must perform all calculations in determining the exposure amount based on the underlying instrument rather than the index. While this is possible for linear indices, for non-linear index contracts (for example, those with optionality and CDS index tranches) it is not mathematically possible to calculate the supervisory delta for an underlying component, as the delta associated with the non-linear index applies at the instrument level. In recognition of this fact, the agencies are clarifying that the option to decompose a non-linear index is not available under SA–CCR. Additionally, the agencies are clarifying that if electing to decompose a linear index, banking organizations must apply the weights used by the index when determining the exposure amounts for the underlying instrument.
5. Credit Risk Mitigation
The current capital rule permits banking organizations to recognize certain types of credit risk mitigants, such as guarantees, credit derivatives, and collateral, for risk-based capital purposes provided the credit risk mitigants satisfy the qualification standards under the rule.152 Credit derivatives and guarantees can reduce
153Credit events are defined in the documents governing the credit risk mitigant and often include events such as failure to pay principal and interest and entry into insolvency or similar proceedings. 154See 12 CFR 3.2, 217.2, and 324.2 for the definition of financial collateral. 155See section IV.B.5.b. of this Supplementary Information. 156The collateral haircut approach also would be available to banking organizations to recognize the benefits of collateral for eligible margin loans and for repo-style transactions. For netting sets containing certain repo-style transactions and derivative contracts that are subject to a qualifying cross product master netting agreement, a banking organization also would be able to determine its exposure amount using SA–CCR as described in
section IV.A.4.b. of this SUPPLEMENTARY
INFORMATION. 157Under the advanced approaches framework in the current capital rule, an eligible guarantee need not be issued by an eligible guarantor unless the exposure is a securitization exposure. Under the proposal, an eligible guarantee would need to be issued by an eligible guarantor. 158A banking organization would not have to apply the proposed internal credit risk rating system criteria, as described in section IV.A.2.e. of this SUPPLEMENTARY INFORMATION, in order to determine whether an entity satisfies the investment grade requirement included in in the definition of eligible guarantor. The proposed internal credit risk rating system criteria would be required in order for the 65 percent risk weight to be available for purposes of the substitution approach. the credit risk of an exposure by placing a legal obligation on a third-party protection provider to compensate the banking organization for losses associated with a credit event of the original obligor.153 Similarly, the use of collateral often can reduce the credit risk of an exposure by creating the right of a banking organization to take ownership of and liquidate the collateral in the event of a default by the counterparty. Prudent use of such mitigants can help a banking organization reduce the credit risk of an exposure and in some circumstances reduce the risk-based capital requirement associated with that exposure. Credit risk mitigants recognized for risk-based capital purposes must be of sufficiently high quality to effectively reduce credit risk. For guarantees and credit derivatives, the current capital rule primarily looks to the creditworthiness of the guarantor and the features of the underlying contract to determine whether these forms of credit risk mitigation may be recognized for risk-based capital purposes (eligible guarantee or eligible credit derivative). With respect to collateralized transactions, the current capital rule primarily looks to the liquidity profile and quality of the collateral received (such as the creditworthiness of the issuer of the collateral) and the nature of the banking organization’s security interest to determine whether the collateral qualifies as financial collateral that may be recognized for purposes of risk-based capital.154 The proposal would largely incorporate the treatments for collateralized transactions, guarantees, and credit derivatives from the current capital rule’s standardized approach with enhancements to increase risk sensitivity. For eligible guarantees and eligible credit derivatives, the proposal would generally retain the substitution approach from the standardized approach of the current capital rule with two modifications. Specifically, the proposal would modify the treatment for eligible credit derivatives that do not include restructuring as a credit event and no longer permit the recognition of credit protection from nth-to-default credit derivatives.155 For collateralized transactions where financial
collateral secures exposures that are not derivative contracts or netting sets of derivative contracts, the proposal would generally retain the simple approach from the current capital rule’s standardized approach with the following two modifications.156 First, the proposal would replace the requirement that financial collateral be subject to a collateral agreement with conditions including the requirement that the banking organization have the right to liquidate or take legal possession of the collateral upon an event of default. Second, the proposal would permit banking organizations to recognize, under the simple approach, the credit risk mitigation benefits of financial collateral with a maturity or currency mismatch, after applying certain adjustments. The proposal would also introduce eligible prepaid credit protection arrangements as a credit risk mitigant available to all exposure types, including securitizations, and permit banking organizations to recognize the credit risk mitigation benefits of the protection amount of the prepaid credit protection arrangement, discounted to reflect any applicable maturity and currency mismatch adjustments. a. Guarantees and Credit Derivatives
i. Substitution Approach
Consistent with the standardized approach in the current capital rule, the proposal would permit a banking organization to recognize the credit-riskmitigation benefits of eligible guarantees and eligible credit derivatives by substituting the risk weight applicable to the eligible guarantor or counterparty to the eligible credit derivative (protection provider) for the risk weight applicable to the hedged exposure. To recognize the risk mitigating benefits of a guarantee or credit derivative for riskbased capital purposes, the proposal would continue to require the issuer of or counterparty to the eligible guarantee or eligible credit derivative, respectively, to be an eligible guarantor.157 The proposal would rely on the definition of eligible guarantor in § ll.2 of the capital rule, which, among other criteria, requires an entity to have issued and outstanding an unsecured debt security without credit enhancement that is investment grade at the time the guarantee is issued or anytime thereafter.158 Question 51: The agencies seek comment on the requirement that the entity has issued and outstanding an unsecured debt security without credit enhancement that is investment grade to meet the definition of an eligible guarantor. What, if any, alternatives to this requirement should the agencies consider to help to ensure that eligible guarantors can be expected to perform on guarantees and what would the pros and cons of those alternatives be?
ii. Adjustment for Credit Derivatives
Without Restructuring as a Credit Event Credit derivative contracts in certain jurisdictions include debt restructuring as a credit event that triggers a payment obligation by the protection provider to the protection purchaser. Such restructurings of the hedged exposure may involve forgiveness or postponement of principal, interest, or fees that results in a loss to investors. Consistent with the current capital rule, the proposal would generally require a banking organization that seeks to recognize the credit risk-mitigation benefits of an eligible credit derivative that does not include a restructuring of the reference exposure as a credit event to reduce the effective notional amount of the credit derivative by 40 percent to account for any unmitigated losses that could occur as a result of a restructuring of the hedged exposure. Under the proposal, however, the 40 percent adjustment would not apply to eligible credit derivatives without restructuring as a credit event if both of the following requirements are satisfied:
(1) the terms of the hedged exposure (and the reference exposure, if different from the hedged exposure) allow the maturity, principal, coupon, currency, or seniority status to be amended outside of receivership, insolvency, liquidation, or similar proceeding only by unanimous consent of all parties; and (2) the banking organization has conducted sufficient legal review to conclude with a well-founded basis
159A banking organization would not have to apply the proposed internal credit risk rating system criteria in order to determine whether the issuer of long-term or short-term debt securities that are not resecuritization exposures is investment grade and are eligible to be considered financial collateral under the capital rule. However, the proposed internal credit risk rating system criteria would be required in order for the 65 percent risk weight to be available for purposes of risk weight substitution. See definition of financial collateral in §ll.2 of the capital rule. 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC). (and maintains sufficient written documentation of that legal review) that the hedged exposure is subject to the U.S. Bankruptcy Code or a domestic or foreign insolvency regime with similar features that allows for a company to reorganize or restructure and provides for an orderly settlement of creditor claims. The unanimous consent requirement would mean that, for restructurings occurring outside of an insolvency proceeding, all holders of the hedged exposure (and the reference exposure, if different from the hedged exposure) must agree to any restructuring for the restructuring to occur, and no holder can vote against the restructuring or abstain. This unanimous consent requirement would reduce the risk that a banking organization would suffer a credit loss on the hedged exposure that would not be offset by a payment under the eligible credit derivative. Banking organizations generally would only be incentivized to vote for a restructuring if the terms of the restructuring provide a more beneficial outcome to the banking organization relative to insolvency proceedings that would trigger payment under the eligible credit derivative. Additionally, the unanimous consent requirement for the reference exposure, if different from the hedged exposure, would provide an additional layer of security by significantly reducing the probability of reaching a restructuring agreement that results in a loss of principal or interest for creditors without triggering payment under the eligible credit derivative. The unanimous consent requirement would need to be satisfied through the terms of the hedged exposure (and the reference exposure, if different from the hedged exposure), which could be accomplished through a contractual provision of the exposure or the operation of the applicable law. The requirement that the hedged exposure be subject to the U.S. Bankruptcy Code or a similar domestic or foreign insolvency regime would help to ensure that any restructuring is done in an orderly, predictable, and regulated process. In the event that the obligor of the hedged exposure defaults and the default is not cured, the obligor would either be required to enter insolvency proceedings, which would trigger payment under the credit derivative, or the obligor would be required to pursue restructuring outside of insolvency, which could not
occur without the banking organization’s consent. Together, the proposed conditions are intended to ensure that credit derivatives that do not include restructuring as a credit event but provide similarly effective protection as those that do contain such provisions would be afforded similar recognition under the capital framework. Question 52: The agencies seek comment on allowing banking organizations to recognize in full the effective notional amount of credit derivatives that do not include restructuring as a credit event, if certain conditions are met. What are the cost and benefits of this approach? What, if any, less restrictive conditions for receiving full recognition should the agencies consider that would more appropriately capture credit derivatives that provide similar protection as those that include restructuring as a credit event receive and why? For example, what would be the advantages and disadvantages of requiring the consent of all parties directly and adversely affected by a restructuring, rather than the unanimous consent of all parties? What would be the advantages and disadvantages of requiring the consent of all parties affected by any change in lien position or priority in the hedged or referenced exposure? Question 53: To what extent is the proposed treatment of eligible credit derivatives that do not include restructuring of the reference exposure as a credit event relevant outside of the United States and how should this be considered for purposes of the proposal? Question 54: In order for a banking organization to recognize the credit risk mitigation benefits of an eligible credit derivative, the current capital rule requires that legally-enforceable crossdefault or cross-acceleration clauses be in place and that the reference exposure and the hedged exposure be to the same legal entity. What would be the advantages and disadvantages of allowing recognition of credit derivatives where (1) the reference exposure is to a different legal entity than the hedged exposure, (2) the reference exposure’s legal entity is guaranteed by its parent company, and (3) the parent company is subject to a binding cross-default or crossacceleration provision related to the hedged exposure’s debt. b. Collateralized Transactions Consistent with the current capital rule, a banking organization would be permitted to recognize the riskmitigating benefits of financial collateral using the simple approach by substituting the risk weight applicable to an exposure with the risk weight applicable to the financial collateral securing the exposure, generally subject to a 20 percent floor.159 Under the current capital rule, a requirement for recognizing the credit risk mitigation benefit of financial collateral under the simple approach is that the collateral must be subject to a collateral agreement for at least the life of the exposure. The proposal would not include this requirement under the simple approach because the requirement is overly
broad and not relevant for certain transaction types. For example, while the right to close out a transaction would be relevant with respect to a repurchase agreement, it may not be relevant with respect to a loan. Instead, the proposal would require that the legal mechanism by which the financial collateral is pledged or transferred be enforceable and provide the banking organization with an ability to exercise its applicable legal rights with respect to the collateral in a timely manner upon an event of default. Depending on the characteristics of the type of exposure and the financial collateral in question, those rights may include the right to liquidate or take legal possession of the financial collateral, to set off amounts owed by the banking organization against amounts owed by the obligor, and to close out the underlying transaction. However, not all of these rights may be applicable with respect to all types of exposures and financial collateral, and a banking organization would only be required to have those rights that are applicable for the type of exposure and financial collateral in question. This requirement, in combination with the definition of financial collateral— which, in part, requires a banking organization to have a perfected, firstpriority security interest (or the legal equivalent thereof) in the collateral— and the other requirements of § ll.121(b)(1) would provide a sufficient basis for recognizing the collateral under the simple approach. The requirement under the current capital rule that financial collateral be subject to a collateral agreement often prevents a banking organization from recognizing financial collateral as a credit risk mitigant under the simple
approach if the banking organization’s exercise of its rights may be stayed in a bankruptcy of the obligor. This has generally meant that a banking organization could not use the simple approach to recognize financial collateral in respect of collateralized loans because the exercise of a banking organization’s collateral rights with respect to a loan would often be subject to a stay in the bankruptcy or insolvency of a borrower under the applicable law. Under the proposal, the fact that a banking organization’s rights may be subject to a stay in the event of an obligor’s bankruptcy would not preclude the banking organization from recognizing the credit risk mitigation benefits of financial collateral, provided the banking organization has a wellfounded basis for concluding that it will be able to exercise its rights in a timely manner. The proposed change would permit banking organizations to recognize the credit risk mitigation benefits of financial collateral that protects exposures arising from many types of loans and traditional credit products. Other elements of the simple approach, such as the 20 percent riskweight floor, help to address the risk of declines in the value of collateral. Typically, financial collateral in respect of a collateralized transaction is pledged by the obligor of that exposure. In some cases, collateral may be pledged or transferred by a party other than the obligor. A third-party pledgor may be the parent or an affiliate of an obligor or an unrelated party that is providing credit risk protection to the banking organization. While collateral provided by a third party may be an effective credit risk mitigant, it may also pose unique risks. In particular, depending on the laws of the applicable jurisdictions and the terms of the relevant legal agreements, the bankruptcy or insolvency of a pledgor prior to an event of default of the obligor may terminate or impair the banking organization’s rights to the collateral. In these circumstances, financial collateral does not provide an effective credit risk mitigant. Consequently, the proposal would require that the bankruptcy or insolvency of a third-party pledgor not result in the termination or impairment of the banking organization’s rights in respect of the financial collateral. There may be situations where obligors have the ability to remove collateral that they are contractually obligated to maintain when a banking organization is experiencing stress. This risk is most apparent when financial collateral takes the form of cash on deposit at a banking organization, where a banking organization’s deposit systems may not reflect the obligor’s contractual obligation to maintain the deposit at the banking organization. It may also arise, in respect of other types of financial collateral, depending on the custody arrangement and associated controls in respect of the collateral. Financial collateral is not an effective credit risk mitigant if a banking organization
cannot appropriately safeguard its rights in respect of such financial collateral. Consequently, the proposal would also require a banking organization to be able to reasonably demonstrate the ability to protect and enforce its rights in respect of any financial collateral. Other safeguards relating to the simple approach are intended to sufficiently calibrate the benefits of the proposal’s recognition of financial collateral for a broader scope of products. For example, the maturity mismatch adjustment, which is described in greater detail below, reduces the benefit of financial collateral based on the difference between the residual maturity of the legal mechanism by which financial collateral is pledged and that of the secured exposure. Additionally, for a situation with a maturity mismatch, the proposal would only allow for recognition of the credit risk mitigant where the original maturity of the legal mechanism is greater than or equal to one year and the residual maturity of the legal mechanism is greater than three months. These requirements, taken together with the other requirements in section ll.121 of the proposal, would incentivize banking organizations to utilize credit risk mitigants that provide effective credit risk transfer. Question 55: Under the simple approach, the current capital rule requires that collateral be revalued at least every six months. The agencies recognize that, in practice, most collateral agreements for liquid collateral provide for more frequent valuation. The proposal would remove the requirement for collateral agreements. Given that financial collateral is generally liquid, what would be the advantages and disadvantages of requiring a more frequent minimum revaluation interval—such as quarterly—under the simple approach? Please provide rationale supporting or opposing a more frequent revaluation requirement. Question 56: The proposal would maintain the current capital rule’s definition of financial collateral and allow banking organizations to recognize the risk-mitigating benefits of cash on deposit, including cash held by a third-party custodian or trustee. The agencies invite comment on whether the definition of financial collateral is sufficiently clear with respect to cash collateral held for a banking organization by a third-party custodian or trustee. What would be the advantages or disadvantages of revising the ‘‘cash on deposit’’ prong of the definition of financial collateral to explicitly recognize cash on deposit at any third-party depository institution, regardless of whether it is a custodian or trustee? In addition, what would be the appropriate risk weight for the collateralized exposure where the financial collateral is, directly or indirectly, in the form of a deposit claim on a third-party depository institution and why? What would be the advantages and disadvantages of subjecting the collateralized exposure to the 20 percent risk weight floor? What, if any, other alternative approaches
should the agencies consider and why? Question 57: The agencies seek comment on the appropriateness of the calibration of the market price volatility haircuts. Commenters are encouraged to submit data with their response.
c. Prepaid Credit Protection
The proposal would introduce eligible prepaid credit protection arrangements as an additional type of credit risk mitigant. The proposal would define a prepaid credit protection arrangement as a contractual agreement in which a protection purchaser receives an initial amount in cash from a protection provider that the protection purchaser is required to repay, less any losses that the protection purchaser incurs due to a credit event on the protected exposures, such as borrower default on the protected exposures. In this type of arrangement, the amount paid by the protection provider is not collateral that secures a future obligation of the protection provider; rather, it is consideration for a right to future payments, contingent on the performance of the protected exposure(s), from the protection purchaser. This form of credit risk mitigant effectively transfers credit risk to the protection provider, as the banking organization’s liability created by the prepaid credit protection arrangement generally would be reduced at the same time the banking organization incurs a loss on the protected exposure(s). A common example of a prepaid credit protection arrangement are fully funded creditlinked notes issued by a banking organization that transfer the credit risk of a reference exposure or portfolio of
160See, e.g., Frequently Asked Questions, 12 CFR
part 217, Q2 and Q3, https://
www.federalreserve.gov/supervisionreg/ legalinterpretations/reg-q-frequently-askedquestions.htm. This revision would also be consistent with comments received under EGRPRA as commenters requested recognition of the riskmitigation benefits of credit-linked notes. 161Exposures on which there is a tranching of credit risk (reflecting at least two different levels of seniority) generally are securitization exposures, as described in section IV.B. of this SUPPLEMENTARY INFORMATION. reference exposures to third party investors.160 Under the proposal, a prepaid credit protection arrangement would be required to meet specific requirements to be recognized for risk-based capital purposes as an eligible prepaid credit protection arrangement. Specifically, the proposal would define an eligible prepaid credit protection arrangement as a prepaid credit protection arrangement that:
(1) Is written;
(2) Is unconditional;
(3) Covers all or a pro rata portion of all contractual payments due to be paid on the reference exposure or reference exposures; (4) Provides that the amount and timing of payments due from the protection purchaser to the protection provider are incorporated into the arrangement and the arrangement only allows these terms to change in the event of a breach of the arrangement by the protection purchaser; (5) Provides that entry of the protection provider into receivership, insolvency, liquidation, conservatorship, or similar proceeding does not change the amounts or timing of payments due by the protection purchaser under the arrangement; (6) Is legally valid and enforceable under applicable law of the relevant jurisdictions; (7) Upon a failure by the obligor on the one or more reference exposures to make a contractually required payment, or the occurrence of other credit events as described in the arrangement, allows the protection purchaser promptly to reduce the outstanding balance of the initial principal amount due to the protection provider by the loss of the protection purchaser on the reference exposures without input from the protection provider; and (8) Does not increase the protection purchaser’s cost of credit protection in response to deterioration in the credit quality of any of the reference exposures. The protection amount of an eligible prepaid credit protection arrangement would be the effective notional amount of the prepaid credit protection, reduced to reflect any currency mismatch or maturity mismatch. The effective notional amount for an eligible prepaid credit protection arrangement would be the lesser of the contractual notional amount of the credit risk mitigant and the exposure amount of the reference exposure(s), multiplied by the percentage coverage of the credit risk mitigant. Under the proposal, if the protection amount of the eligible prepaid credit protection arrangement is greater than or equal to the exposure amount of the reference exposure, a banking organization would be allowed to assign a zero percent risk weight to the exposure. If the protection amount of the eligible prepaid credit protection arrangement is less than the exposure amount of the reference exposure(s) and any losses are shared on a pro rata basis between the banking organization and the protection provider,161 the proposal would require the banking organization to treat the reference exposure(s) as two separate exposures, protected and unprotected, in order to recognize the credit risk mitigation benefit of the eligible prepaid credit protection arrangement. In such cases, a banking organization would apply a zero percent risk weight to the protected exposure. The banking organization would calculate its risk-weighted asset amount for the unprotected exposure under the expanded risk-based approach using the risk weight assigned to the exposure and an exposure amount equal to the exposure amount of the original reference exposure minus the
protection amount. Question 58: Under the definition of eligible prepaid credit protection arrangement, the proposal would require that a protection purchaser be able to reduce the outstanding balance due to the protection provider promptly upon realizing or otherwise recognizing a loss on the reference exposure, in the event that the obligor on one or more reference exposures fails to make a contractually required payment, or the occurrence of other credit events as described in the arrangement. What, if any, are the exposure types in respect of which, or circumstances when, a protection purchaser may be exposed to losses before such losses are manifested in a way that would permit a reduction in the protection purchaser’s repayment obligation? For example, what would be the instances where nonpayment or other loss on the reference exposure may not always result in an accounting write-down of the eligible prepaid credit protection arrangement at the same time? What, if any, changes to the proposed definitions of prepaid credit protection arrangement and eligible prepaid credit protection arrangement should the agencies consider to further ensure that a protection purchaser would be able to reduce its repayment obligation on a prepaid credit protection arrangement as contemporaneously as possible with the manifestation of losses in respect of a reference exposure? Question 59: The proposal would define the protection amount of an eligible prepaid credit protection arrangement to mean the effective notional amount of the prepaid credit protection. Certain credit-linked notes that may qualify as eligible prepaid credit protection under the proposal, are sometimes accounted for on a fair value basis. The fair value of such creditlinked notes may be affected by factors other than losses or credit events (for example, a change in interest rates) in respect of the reference exposure. As a result, at the time that credit losses in respect of the reference exposure are realized, the fair value of the creditlinked note, and the amount by which the banking organization may set off its losses in respect of the reference exposure, may be less than the notional amount of the note. What, if any, modifications to the proposal should the agencies consider to address the risk that a banking organization may not be able to set off losses on a reference exposure against the full notional amount of a prepaid credit protection instrument? What would be the advantages and disadvantages of defining the protection amount of an eligible prepaid credit protection instrument to be the instrument’s carrying value (For example, the fair value if the banking organizations elects this accounting treatment)? Question 60: The definition of prepaid credit protection requires that the protection purchaser is obligated to repay the initial principal amount to the protection provider on or before the maturity date of the transaction, less any losses that the protection purchaser
realizes or otherwise recognizes due to nonpayment of all contractual payments due to be paid on the reference exposure by the obligors. The agencies seek comment as to whether the definition is sufficiently broad to capture the types of prepaid credit protection arrangements that banking organizations may enter into to transfer credit risk. For example, may prepaid credit protection arrangements be structured to allow for a reduction in the initial principal amount of the arrangement upon the recognition of losses on one or more reference
162For determining maturity mismatch, the comparison is between the remaining maturity of the protected exposure against the remaining maturity of the legal mechanism by which financial collateral is pledged. For example, if the legal mechanism by which financial collateral is pledged to a 5-year loan has a 5-year term, even if the remaining maturity of the collateral is 2 years, there would be no maturity mismatch under the proposal as long as the security interest transfers without any breaks to the proceeds of the matured collateral or replacement collateral. 163The proposal would define residual maturity as the longest possible remaining time before the obligated party of the secured exposure is scheduled to fulfill its obligation on the reference exposure. If a contract has embedded options that may reduce its term, the proposal would require the banking organization to adjust the residual maturity of the contract. If a call is at the discretion of the protection provider, the residual maturity of the contract would be at the first call date. If the call is at the discretion of the banking organization, but the terms of the arrangement at origination of the contract contain a positive incentive for the banking organization to cancel the contract before contractual maturity, the remaining time to the first call date would be the residual maturity of the contract. exposures due to credit quality deterioration of the exposures, even in the absence of any nonpayment. If so, what if any changes to the definition of prepaid credit protection should the agencies consider? d. Maturity and Currency Mismatch Adjustment The simple approach in the current capital rule does not permit a banking organization to recognize credit risk mitigation benefits where the transaction is subject to a collateral agreement that has a shorter tenor than that of the secured exposure.162 To improve the risk-sensitivity of the simple approach, the proposal would permit banking organizations to recognize financial collateral and prepaid credit protection with a maturity mismatch after adjusting the fair value of the financial collateral or the effective notional amount of the eligible prepaid credit protection arrangement to reflect any maturity mismatch.163 Under the proposal, the residual maturity of an eligible prepaid credit protection arrangement would be determined in the same manner as applies to eligible credit derivatives and eligible guarantees under the current capital rule. For financial collateral that is not cash on deposit at the banking organization, but including cash held for the banking organization by a thirdparty custodian or trustee, the residual maturity of any amount of such financial collateral would be the earliest date on which the banking organization’s rights in respect of such amount of financial collateral may be terminated without the pledgor being subject to a contemporaneous requirement to pledge additional financial collateral. For
financial collateral that is cash on deposit at the banking organization, the residual maturity of any amount of such collateral would be the earliest date on which a depositor may withdraw such amount, notwithstanding any notice requirements or early withdrawal fees or penalties. For example, if an obligor is subject to a loan covenant requiring the obligor to maintain a certain deposit balance at the banking organization until the maturity of the loan, the residual maturity of the cash on deposit would be the remaining maturity of the loan. Any amount of a deposit balance that an obligor is contractually permitted to withdraw, however, would have a residual maturity of the earliest date on which the deposit may be withdrawn. If an obligor may withdraw a deposit at any time, including where an obligor may be subject to a notice period or an early withdrawal fee or penalty, the residual maturity would be zero, notwithstanding any stated maturity date of the deposit instrument. Under the proposal, a banking organization would be required to apply the same adjustment to reduce the fair value of the financial collateral or the effective notional amount of the prepaid credit protection arrangement as currently applies to eligible credit derivatives and eligible guarantees under the substitution approach:
Pm = E × [(t¥0.25)/(T¥0.25)] Where:
164To segment the credit risk of the underlying financial exposures (‘‘reference portfolio’’), securitization exposures divide the reference portfolio into different slices (known as ‘‘tranches’’) such that any cash flows or losses are allocated to the various tranches based on a predetermined order of priority. This payment structure is sometimes referred to as the cash flow waterfall (or simply the ‘‘waterfall’’) and dictates the manner in which interest or principal payments from the reference portfolio must be allocated, creating different risk-return profiles for each tranche. 165For example, assume a banking organization extends a loan to a bankruptcy remote special purpose entity which holds financial exposures (including equity securities) and the fair value of the underlying financial assets exceeds that of the loan. Under this transaction, the underlying financial exposures are pledged as collateral to the lender. As the excess collateral would initially absorb any losses arising from non-payment on the loan (after which the banking organization would be exposed to any subsequent losses), the loan would generally be viewed as tranched and could qualify as a securitization exposure under the proposal, if the transaction satisfies all of the other applicable requirements. Consistent with the current capital rule, to the extent the fair value of the collateral declines such that it no longer exceeds the outstanding principal balance of the banking organization’s exposure to the borrower, the transaction would no longer involve tranching of credit or equity risk—and thus would not qualify as a securitization exposure under the proposal. Rather, the banking organization would be required to calculate risk-based capital requirements for the exposure using the general credit risk framework as described in section IV.A. of this SUPPLEMENTARY INFORMATION. 166Consistent with the current capital rule, the proposal would define equity exposure to include exposures to equity instruments that do not have mandatory contractual payments, among other requirements. Accordingly, under the proposal, the performance of underlying equity exposures would refer to both changes in the fair value of the equity exposures and whether the issuer(s) of the equity exposures is subject to a bankruptcy or insolvency proceeding. arrangement? Please provide supporting data and analysis. B. Securitization Framework The securitization framework is designed to produce capital requirements for exposures that involve tranching of the credit risk of one or more underlying financial exposures.164 The risk and complexity posed by securitizations differ relative to direct exposures to the underlying financial exposures because the credit risk of those exposures is divided into different levels of risk using a wide range of structural mechanisms.165 The performance of a securitization exposure depends not only on the structure of the securitization, but also on the performance of
the underlying exposures 166 and certain parties to the securitization structure, including the asset servicer and any liquidity facility provider. Such structural features and the involvement of these parties makes securitization exposures susceptible to additional risks as compared to direct exposures to the underlying financial exposures. The proposed securitization framework would incorporate the securitization framework in the current standardized approach with the following modifications: (1) a revised definition of and additional operational requirements for synthetic securitizations; (2) a modified treatment for resecuritizations that meet the operational requirements; (3) a modified definition of an eligible clean-up call; (4) a new securitization standardized approach (SEC–SA), as a replacement to the standardized supervisory formula approach (SSFA), which includes, relative to the SSFA, modified definitions of attachment point and detachment point, a modified definition of the W parameter, modifications to the definition of KG, a lower risk-weight floor for securitization exposures that are not resecuritization exposures, and a higher risk-weight floor for resecuritization exposures; (5) a revised treatment for purchased and sold nth-todefault credit derivatives that would prohibit banking organizations from recognizing any risk-mitigating benefit for such exposures; (6) a revised treatment for certain derivative contracts that are not credit derivatives and a new treatment for derivative contracts that do not provide credit enhancement; (7) new provisions to expand the scope of securitization exposures for which a banking organization may apply the overlapping exposure treatment; (8) a new treatment and eligibility criteria for certain senior securitization exposures (the ‘‘lookthrough approach’’); (9) a modification to the treatment for credit-enhancing interest only strips; and (10) a new framework for non-performing loan securitizations. The proposal would also introduce certain minor technical edits to the definitions of traditional securitization and synthetic securitization to clarify the existing scope of exposures subject to the securitization framework under the current capital rule.
167See 78 FR 62018, 62112 (Oct. 11, 2013). 168Consistent with the current capital rule, under the proposal, a banking organization would use the equity framework to calculate risk-based capital requirements for equity exposures to companies where all or substantially all of the underlying assets are financial assets and that have no material liabilities. See definition of investment fund in §ll.2 of the current capital rule and the treatment of equity exposures to investment funds in §ll.142 of the proposed rule. 169 In the case of non-performing loan securitizations, as described in section IV.B.5.g. of this SUPPLEMENTARY INFORMATION, the proposal would allow a banking organization that meets the operational requirements to choose to hold riskbased capital against the transferred exposures as if they had not been securitized and deduct from common equity tier 1 capital any after-tax gain-onsale resulting from the transaction. 170Under the capital rule, an originating banking organization, with respect to a securitization, means a banking organization 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. See 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC). enhancement such as a guarantee on a portion of the losses not protected by the seller over-collateralization. Consistent with the current capital rule, under the proposal, commercial paper issued by the ABCP conduit with a pool-specific liquidity facility generally would be a securitization exposure because the pool-specific liquidity facility represents a tranche of the credit risk of the underlying exposures (that is the repayment of the liquidity facility depends upon the underlying exposures) and losses are allocated through subordination. Conversely, if the sponsor provides a program-wide credit enhancement that covers all credit losses across multiple asset pools without reference to asset-level performance (not just those above the seller-provided credit enhancement) or seller-specific subordination, the commercial paper generally would not be a securitization exposure, as the commercial paper holders are primarily exposed to the default risk of the sponsor instead of the underlying exposures and the commercial paper does not represent a tranched risk position. The proposed modification is intended to clarify that a securitization exposure to such program-wide guarantees, including guarantees provided by an operating company to a special purpose entity it establishes, generally would not satisfy the definition of traditional or synthetic securitization. Additionally, the proposal would modify paragraph (1) of the definition of traditional securitization to clarify that a transaction transferring equity risk could be subject to the securitization framework if all of the other definitional criteria are satisfied. The securitization framework generally
applies to exposures to companies with material liabilities that are not operating companies,167 and whose underlying exposures are primarily financial exposures (including when all or substantially all of the underlying assets are equity exposures). For exposures to companies with material liabilities that are not operating companies and whose underlying exposures are all or substantially all financial exposures, the risk-based capital treatment under the current capital rule reflects how the risk of exposures to such entities depends primarily on the degree of leverage employed by the company. Accordingly, the current capital rule generally requires banking organizations to apply the securitization framework to determine the risk-weighted asset amount for exposures to non-operating companies with material liabilities, unless the primary Federal supervisor determines that the exposure is not a traditional securitization based on the transaction’s leverage, risk profile or economic substance. The proposal would modify paragraph (1) of definition of traditional securitization to clarify that this treatment would also apply to exposures to such companies with material liabilities, where all or a portion of the credit or equity 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 or prepaid credit protection arrangements).168 As a result, the proposed definition of traditional securitization would continue to include exposures to companies with material liabilities that are not operating companies, where all or substantially all of the underlying assets are financial exposures, and whose funding structure results in the risk associated with the underlying exposures being separated into at least two tranches with different levels of seniority. Question 62: What additional clarifications, if any, should the agencies consider for the proposed modification to paragraph (3) of the definition of traditional and synthetic securitization and why? Question 63: What additional clarifications, if any, should the agencies consider for the proposed modification to paragraph (1) of the definition of traditional securitization and why? What would be the advantages and disadvantages of making similar changes to paragraph (1) of the definition of synthetic securitization? Question 64: The agencies seek comment on the appropriateness of requiring covered banking organizations to use the general risk-weight framework for certain overcollateralized exposures if the fair value of underlying equity exposures declines such that there is no longer overcollateralization? What would be the advantages and disadvantages of requiring covered banking organizations to use the general risk-weight framework (rather than the securitization framework) to determine the applicable risk weight for securitization exposures where the underlying exposures are primarily equity exposures and the
fair value of the underlying equity exposures has significantly declined? What criteria should the agencies consider to capture only those securitization exposures for which such an approach would more appropriately capture the risk and why?
2. Operational Requirements
The proposed operational requirements would be consistent with the operational requirements in the standardized approach of the current capital rule, with five exceptions as described below and directly above in
section IV.A.1.a. of this SUPPLEMENTARY
INFORMATION. In addition, for resecuritization exposures that meet the operational requirements, the proposal would eliminate the option for banking organizations to treat the exposures as if they had not been securitized.169 a. Early Amortization Provisions Early amortization provisions cause investors in securitization exposures to be repaid before the original stated maturity when certain conditions are triggered. For example, many securitizations of revolving credit facilities, most commonly credit-card receivable securitizations, contain provisions that require the securitization to be wound down and investors repaid on an accelerated basis if excess spread falls below a certain threshold. This decrease in excess spread would typically be caused by credit deterioration in the underlying exposures. Such provisions can expose the originating banking organization to increased credit and liquidity risk and potentially increased capital requirements after the early amortization is triggered as the banking organization could be obligated to fund the borrowers’ future draws on the revolving lines of credit.170 In such an instance, the originating banking organization may have to either find a new funding source, whether internal or external, to cover the new draws or
171Under the capital rule, the exceptions to the definition of early amortization provision are a provision that: (1) is triggered solely by events not directly related to the performance of the underlying exposures or the originating banking organization (such as material changes in tax laws or regulations); or (2) leaves investors fully exposed to future draws by borrowers on the underlying exposures even after the provision is triggered. See definition of early amortization provision in §ll.2 of the capital rule. 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC). 172For example, for derivative contracts written under ISDA Master Agreement documentation, standard market practice for contractual minimum payment thresholds would generally be $1 million (or the equivalent in other currencies), such as established in ISDA Credit Derivatives Definitions. See ISDA Credit Derivatives Definitions Section 4.5 ‘‘Failure to Pay’’ and Section 4.9(d) ‘‘Payment Requirement.’’ reduce the borrowers’ credit line availability. The proposal would expand the applicability of the operational requirements regarding early amortization provisions to synthetic securitizations, similar to their application to traditional securitizations under the standardized approach of the current capital rule. The current capital rule defines an early amortization provision as 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, with certain exceptions.171 Under the proposal, if a synthetic securitization includes an early amortization provision and references 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, the banking organization would be required to hold risk-based capital against the underlying exposures as if they had not been synthetically securitized. Aligning this treatment for both traditional and synthetic securitizations would provide greater consistency within the securitization framework and reduce the likelihood that a banking organization would provide implicit support for synthetic securitization exposures. Question 65: What, if any, additional exceptions to the early amortization provision definition should the agencies consider and why, provided such exceptions would not incentivize a banking organization to provide implicit support to a securitization exposure? In particular, is the current rule’s exception where early amortization ‘‘is triggered solely by events not directly related to the performance of the underlying exposures or the originating institution (such as material changes in tax laws or regulations)’’ sufficiently clear? What types of early termination events should qualify as events not directly related to either the performance of the underlying exposures or the originating banking
organization? Should events not directly related to the performance of the underlying exposures or the originating banking organization include customary provisions designed to protect against non-performance of various contractual obligations by one of the parties facilitating the securitization (including the originating banking organization, if it has such a transaction facilitating role, for example by acting as a servicer)? Commenters are also asked to describe under what circumstances could a provision in a revolving loan securitization that, when triggered, causes investors in the securitization exposures to be repaid before the original stated maturity of the securitization exposures, leaves investors ‘‘fully exposed to future draws by borrowers on the underlying exposures even after the provision is triggered’’, or otherwise should be deemed not to be an early amortization provision. What are the advantages and disadvantages of ‘‘fully exposed’’ encompassing only cash-funded exposures versus also including exposures in the form of contractual commitments to provide funding? b. Synthetic Excess Spread The proposal would prohibit an originating banking organization from recognizing the risk-mitigating benefits of a synthetic securitization that includes synthetic excess spread. Synthetic excess spread would be defined as any contractual provision in a synthetic securitization that is designed to absorb losses prior to any of the tranches of the securitization structure. Synthetic excess spread is a form of credit enhancement provided by the originating banking organization to the investors in the synthetic securitization; therefore, the originating banking organization should maintain capital against the credit exposure represented by the synthetic excess spread. However, a risk-based capital requirement for synthetic excess spread may not be determinable with sufficient precision to promote comparability across banking organizations because the amount of synthetic excess spread made available to investors in the synthetic securitization would depend upon the maturity of the underlying exposures, which itself depends on whether any of the underlying exposures have defaulted or prepaid. In particular, the total amount of synthetic excess spread made available at inception to investors over the life of the transaction may not be known ex ante, as the outstanding balance of the securitization in future years is unknown. Therefore, if a synthetic securitization structure includes synthetic excess spread, the proposal would require the banking organization to maintain capital against all the underlying exposures as if they had not been synthetically securitized. Question 66: What clarifications or modifications should the agencies consider for the above proposed definition of synthetic excess spread and why? Question 67: What are the advantages and disadvantages of the proposed treatment of synthetic securitizations with synthetic excess
spread? If the agencies were to permit originating banking organizations to recognize the credit risk-mitigation benefits of securitizations with synthetic excess spread, how should the exposure amount of the synthetic excess spread be calculated, and what would be the appropriate capital requirement for synthetic excess spread?
c. Minimum Payment Threshold
Under the proposal, the operational requirements for synthetic securitizations would include a new requirement that any applicable minimum payment threshold for the credit risk mitigant be consistent with standard market practice.172 A contractual minimum payment threshold refers to the delinquency condition that must exist before a credit event is deemed to have occurred under the terms of the credit protection. The proposed minimum payment threshold criterion is intended to prohibit an originating banking organization from recognizing any risk mitigating benefit for a synthetic securitization whose minimum payment threshold is so large that it allows for material losses to occur without triggering the credit protection acquired by the protection purchaser, as such provisions would interfere with an effective transfer of credit risk. Question 68: What are the benefits and drawbacks of the proposed minimum payment threshold criterion? What, if any, additional criteria or clarifications should the agencies consider and why? d. Resecuritization Exposures For a resecuritization exposure arising from a traditional securitization, if the operational requirements have been met, an originating banking organization would be required to exclude the transferred exposures from the
173The proposal would generally maintain the current capital rule’s treatment for off-balance sheet securitization exposures to ABCP programs, with certain exceptions. The proposal would not include the specific treatments provided for such exposures in ll.42(c)(3)(ii)–(iii) and ll.44 in the current capital rule. The other elements of the proposed securitization framework (for example, the look through approach for senior securitization exposures) are intended to better reflect the risk of such exposures. calculation of its risk-weighted assets and maintain risk-based capital against any credit risk it retains in connection with the resecuritization. Unlike in the case of a securitization exposure that is not a resecuritization exposure, the proposal would not provide the option for a banking organization to elect to treat a resecuritization exposure as if the underlying exposures had not been resecuritized. While a securitization of non-securitized assets can be used to diversify or transfer credit risk of those exposures, a resecuritization might not offer similar risk reduction or diversification benefits, particularly if the underlying exposures reflect similar high-risk tranches of other securitizations. Therefore, these resecuritization exposures warrant a higher regulatory capital requirement than that applicable to the underlying exposures. Similarly, for a resecuritization that is a synthetic securitization, if the operational requirements have been met, an originating banking organization would be required to recognize for riskbased capital purposes the use of a credit risk mitigant to hedge the underlying exposures and must hold capital against any credit risk of the resecuritization exposures it retains in connection with the synthetic securitization. These proposed operational requirements for resecuritization exposures are consistent with the Basel standards. e. Clean-Up Calls The proposal would use the definition of a clean-up call in the current capital rule without change. The capital rule defines a clean-up call as a contractual provision that permits an originating banking organization or servicer to call securitization exposures before their stated maturity date or call date. For an originating banking organization to exclude the underlying exposures from its risk-based capital calculation, any clean-up call associated with a securitization must be an eligible cleanup call. The proposal would expand the definition of an eligible clean-up call. Under the current capital rule, an eligible clean-up call is defined as a clean-up call that is exercisable solely at the discretion of the originator or servicer, is not structured to avoid allocating losses to securitization exposures held by investors or otherwise structured to provide credit enhancement to the securitization, and is only exercisable when 10 percent or less of the principal amount of the initial pool of underlying or reference exposures is outstanding. The proposal
would expand the definition of an eligible clean-up call to also include clean-up calls exercisable when certain regulatory and tax events occur, in addition to the existing criteria under the current capital rule. Specifically, the modification would permit the exercise of a clean-up call upon the occurrence of (1) a regulatory event that significantly changes the risk-weighted asset amount for the securitization exposure under applicable riskweighted asset standards of the agencies, or (2) a tax event that significantly changes the tax treatment of the securitization exposure under applicable tax laws. The events must represent final actions, such as a final rule adopted by the agencies or taxing authority, or a law enacted by Congress. Proposed rules or legislative bills would not satisfy this requirement. Question 69: What, if any, other modifications should the agencies consider for the definition of an eligible clean-up call and why?
3. Exposure Amount of a Securitization
Exposure
The proposal would maintain the exposure calculation methodology in the current capital rule for both onbalance-sheet and off-balance-sheet securitization exposures. The exposure amount for an on-balance-sheet securitization exposure that is not a repo-style transaction, an eligible margin loan, or a derivative contract (other than a credit derivative) would equal the carrying value of the exposure. For off-balance- sheet securitization exposures that are not a repo-style transaction, eligible margin loan, or derivative contract (other than a credit derivative), the exposure amount would equal the notional amount of the exposure.173 For a securitization exposure that is a repo-style transaction, eligible margin loan, or derivative contract (other than a credit derivative), the exposure amount would be calculated based on the proposed counterparty credit risk framework, described in section IV.A.4. of this SUPPLEMENTARY INFORMATION. Question 70: What, if any, clarifications should the agencies consider regarding the determination of the exposure amount for securitization exposures where one or more of the underlying exposures are off-balance sheet exposures (such as unfunded commitments)? Specifically, what are the advantages and disadvantages of a modification that would clarify that banking organizations could apply the same credit conversion factors described in section IV.A.1.b. of this SUPPLEMENTARY INFORMATION when calculating the components of the SEC– SA (GG, W parameter, attachment point A and detachment point D) for a securitization exposure where one or more of the underlying exposures are off-balance sheet exposures? What would be the effect of such a clarification on the volatility of the capital requirements?
4. Securitization Standardized
Approach (SEC–SA)
Under the proposal, a banking organization would determine the capital requirements for most securitization exposures under the SEC– SA, which is generally consistent with the Basel standards. The SEC–SA would be substantively similar to the SSFA in the current capital rule except for certain changes as discussed below. Under the SEC–SA, a banking organization would determine the risk weight for a securitization exposure based on the risk weight of the underlying exposures that are adjusted to reflect (1) delinquencies in such exposures, (2) the securitization exposure’s subordination level in the allocation of losses, and (3) the heightened correlation and additional risks inherent in securitizations relative to direct exposures to the underlying financial exposures. To calculate the risk weight for a securitization exposure using the SEC– SA, a banking organization would be required to have accurate information on the parameters used in the SEC–SA calculation. If the banking organization cannot, or chooses not to, apply the SEC–SA, the banking organization would be required to apply a 1,250 percent risk weight to the securitization exposure. For synthetic securitizations, the proposal would permit banking organizations to choose not to recognize the credit risk mitigant and hold riskbased capital against the underlying exposures as if they had not been synthetically securitized. Under the proposed SEC–SA, the risk weight assigned to a securitization exposure, or portion of a securitization
174Consistent with the current capital rule, the proposal would require banking organizations to treat any assets that are included in a reserve account as underlying exposures of the securitization exposure, which must be reflected in parameters A and D as well as KG and the W parameter. 175For example, assume a securitization has assets denominated in U.S. dollars and liabilities denominated in euros, and that the securitization executes a USD–EUR foreign exchange swap with a banking organization. The transaction would serve to hedge the foreign exchange risk of the securitization’s assets and liabilities, but would not provide credit enhancement to any of the tranches of the securitization. 176Consistent with the current capital rule, the proposal would define equity exposure to include exposures to equity instruments that do not have mandatory contractual payments, among other requirements. Accordingly, under the proposal, for purposes of determining the W parameter for a securitization exposure, a banking organization would not treat an underlying equity exposure as being past due or in default on payments, but could treat an underlying equity exposure as subject to a bankruptcy or insolvency proceeding if the issuer of the equity exposure were subject to such a proceeding. See definition of equity exposure in §ll.2 of the capital rule. 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC). exposure, would be determined according to the formula under § ll.133(a) of the proposed rule, expressed as:
Where:
Under the proposal, a banking organization would exclude from the calculation of parameter W any exposure that is directly and unconditionally guaranteed by the U.S. government, its central bank, or a U.S. government agency, up to the amount of the guarantee. By allowing banking organizations to reflect the risk mitigation effects of the U.S. government’s guarantee, the proposed modification is intended to more appropriately align the capital requirement with the risk of such securitization exposures. For example, when a banking organization invests in a securitization exposure where all of the underlying exposures are unconditionally guaranteed by the U.S. government, the banking organization may set parameter W equal to zero. For resecuritization exposures, parameter W would be the ratio of the sum of the current dollar amount of any underlying exposures of the resecuritization that meet any of the criteria in paragraphs ll.133(b)(1)(i) through (vi) of the proposal that are not securitization exposures to the current dollar amount of all underlying exposures. Underlying securitization exposures do not need to be included in the numerator of parameter W because the risk weight of the underlying securitization exposure as calculated by the SEC–SA would already reflect the impact of any delinquent or otherwise nonperforming loans within the underlying securitization exposure. For example, if a resecuritization with a notional amount of $10 million includes underlying securitization exposures with a notional amount of $5 million and underlying non-securitization exposures with a notional amount of $5 million, and if $500,000 of the nonsecuritization exposures are delinquent, the numerator for the W parameter would be $500,000 while the denominator for the W parameter would be $10 million. This reflects the fact that the risk associated with securitization exposures generally arises from the underlying assets failing to perform as expected, resulting in investors receiving less cashflow than expected from the securitization exposure, rather than from securitization exposure itself failing to make payments due to investors. Question 71: The agencies seek comment on the appropriateness of requiring banking organizations to only include equity exposures when the issuer is subject to a bankruptcy or insolvency proceeding in the W parameter calculation. What, if any, alternative approaches (such as requiring banking organizations to include equity exposures when the issuer has an obligation to the banking organization that is 90-days or more past due) should the agencies consider that would more appropriately capture the proportion of underlying exposures that are not performing or are delinquent and why? What, if any, operational concerns could such alternatives pose?
c. Delinquency-Adjusted (KA) and NonAdjusted (KG) Weighted-Average Capital
Requirement of the Underlying Exposures Under the proposal, KA would reflect the delinquency-adjusted, weightedaverage capital requirement of the underlying exposures and would be a function of KG and parameter W. Under this approach, in order to calculate parameter W, and thus KA, the banking organization must know the delinquency status of all underlying exposures in the securitization. KG would equal the weighted average total capital requirement of the underlying exposures (with the unpaid principal used as the weight for each exposure), calculated using the proposed risk weights in the expanded risk-based approach, as described in section IV.A.2. of this SUPPLEMENTARY INFORMATION. The proposal would retain the current capital rule’s definition of KG, with two modifications. First, for interest rate derivative contracts and exchange rate derivative contracts, the proposal would require banking organizations to include in the numerator of KG (and exclude from the denominator of KG) the product of (1) the positive current exposure, (2) the risk weight of the counterparty, and (3) by 0.08, consistent with the Basel standards. This accounts for the issue where, if amounts related to interest rate and exchange rate derivative contracts were included in both the numerator and denominator of KG, these contracts could reduce the capital requirement of securitization exposures even though interest rate and exchange rate derivative contracts do not provide any credit enhancement to a securitization. Second, the proposal would clarify the existing requirement that banking organizations must determine the risk weight applicable to an underlying equity exposure under the simple riskweight approach, as described in section IV.C.2. of this SUPPLEMENTARY INFORMATION, based on the characteristics of the underlying equity exposure. Consistent with the treatment under the current capital rule, banking organizations would not be able to consider the underlying equity exposures as a non-significant equity exposure that receive a 100 percent risk weight when determining KG. Unlike equity exposures to investment funds (as defined), traditional securitizations can include transactions with companies that have material liabilities and structures that allocate losses based on a predetermined order of priority (rather than on a pro-rata basis). Accordingly, unlike the look-through approaches applicable to underlying equity securities held by investment funds, the proposal would clarify that banking organizations may not calculate risk-based capital requirements for securitization exposures with underlying equity exposures as though the underlying equity exposures were on the banking organization’s balance sheet. This clarification to the current capital rule promotes the risk sensitivity of the securitization framework by requiring banking organizations to reflect a risk weight based on the underlying exposure’s risk characteristics and appropriately differentiates
between the risk-based capital treatment applicable to investment funds and to securitization exposures. Question 72: Recognizing that banking organizations may not always know the delinquency status of each underlying exposure, what would be the benefits and drawbacks of allowing a banking organization to use the SEC–SA if the banking organization knows the delinquency status for most, but not all, of the underlying exposures? For example, if the banking organization knew the delinquency status of 95 percent of the exposures, what would be the benefits and drawbacks of allowing the banking organization to (1) split the underlying exposures into two subpools, (2) calculate a weighted average of the KA of the subpool comprising the underlying exposures for which the delinquency status is known, (3) assign a value of 1 for KA of the other subpool comprising exposures for which the delinquency status is unknown, and (4) assign a KA for the entire pool equal to the weighted average of the KA for each subpool? What other approaches, if any, should the agencies consider and why? Question 73: The agencies seek comment on the appropriateness of requiring banking organizations to reflect underlying past due exposures in both the KG and the W parameter components when calculating KA. To what extent could including past due exposures in both components result in overly punitive capital requirements for such exposures under SEC–SA? What, if any, alternatives (such as not applying the heightened 150 risk weight for past
177 In a typical securitization exposure that is not a resecuritization, each underlying exposure is subject to idiosyncratic default risks (for example, the employment status of each obligor) which may exhibit lower relative default correlation. In a resecuritization exposure, the underlying exposures, which are typically tranches of securitizations, usually have credit enhancement from more junior tranches that protects against many idiosyncratic risks. Systematic risks are more likely to generate defaults in the underlying exposures of resecuritizations than idiosyncratic risks, but systematic risks are also much more likely to be correlated due to their system-wide nature; therefore, resecuritizations can be expected to have higher default correlations than other types of securitizations. 178Securitization SPE under §ll. 2 of the current capital rule 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. See 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC). 179The proposal would retain the existing definition of securitization exposure under the current capital rule. Under §ll. 2 of the current capital rule, securitization exposure means (1) an on-balance sheet or off-balance sheet credit exposure (including credit-enhancing representations and warranties) that arises from a traditional securitization or synthetic securitization (including a resecuritization), or (2) an exposure that directly or indirectly references a securitization exposure described in paragraph (1) of this definition. See 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC). 180Consistent with the current capital rule, the proposal would define an nth-to-default credit derivative as a credit derivative the provides credit protection only for the nth-defaulting reference exposure in a group of reference exposures. See 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC). due exposures for purposes of calculating KG) should the agencies consider and why? Commenters are encouraged to provide specific examples, including calculations and supporting data. d. Supervisory Risk-Weight Floors Consistent with the SSFA in the current capital rule, the SEC–SA would require banking organizations to apply a risk-weight floor to all securitization exposures. The proposed risk-weight floor is intended to ensure that banking organizations maintain a minimum level of capital to account for risks that may not otherwise be captured by SEC–SA, such as modeling risks and correlation. The proposal would apply a risk-weight floor of 15 percent for securitization exposures that are not resecuritization exposures. The 15 percent risk-weight
floor is most relevant for more senior securitization exposures. While junior tranches can absorb a significant amount of credit or equity risk, senior tranches are still exposed to some amount of credit or equity risk on the underlying exposures. Therefore, a minimum capital requirement continues to be appropriate for all securitization exposures. For resecuritization exposures, the proposed SEC–SA approach would require banking organizations to apply a risk-weight floor of 100 percent. The proposed 100 percent supervisory riskweight floor for resecuritization exposures is intended to capture the greater complexity of such exposures and heightened correlation risks inherent in the underlying securitization exposures.177 Question 74: The agencies seek comment on the proposed 100 percent risk-weight floor for resecuritization exposures. What modifications, if any, should the agencies consider to the 100 percent risk-weight floor for resecuritization exposures and why? For example, what would be the pros and cons of excluding certain types of resecuritization exposures—such as resecuritizations of servicer cash advance receivables—from the 100 percent risk-weight floor and why? Commenters are encouraged to provide data (such as loss history) to support their recommendations.
5. Exceptions to the SEC–SA Risk-Based
Capital Treatment for Securitization Exposures Securitization exposures sometimes contain features that, if not accounted for, could produce inconsistent outcomes under the SEC–SA, or in some cases make the calculation of the risk weight inoperable. Therefore, the proposal would include additional approaches for certain types of securitization exposures to more appropriately align the capital requirement with the risk of such securitization exposures. a. Purchased Credit Derivatives As discussed previously in section IV.B.1.b. of this SUPPLEMENTARY INFORMATION, the proposal would modify paragraph (1) of the definition of traditional securitization to clarify that the securitization framework generally applies to exposures to companies with material liabilities that are not operating companies, and whose underlying exposures are primarily financial exposures. To further clarify the scope of exposures subject to the securitization framework under the current capital rule, the proposal would also remove the definition of securitization special purpose entity (SPE). Under the current capital rule, if a banking organization purchases a credit derivative (other than an nth-to-default credit derivative) that is recognized as a credit risk mitigant (including via recognized collateral) under the securitization framework, the banking organization is not required to compute a separate counterparty credit risk capital requirement. For purchased credit derivatives that a banking organization cannot or chooses not to recognize as a credit risk mitigant under the securitization framework, the current capital rule requires the banking organization to calculate an exposure amount using SA–CCR and to determine the applicable risk weight based on whether or not the counterparty is a securitization SPE.178 Specifically, if the counterparty is a securitization SPE, the banking organization must determine the risk weight based on the securitization framework; if the counterparty is not a securitization SPE, the banking organization must apply the risk weight applicable to the counterparty under the general credit risk framework. Consistent with the proposed technical modification to the definition of traditional securitization,179 the proposal would (1) remove the definition of securitization SPE, and (2) clarify that the risk weight applicable to purchased credit derivatives that a banking organization cannot or chooses not to recognize as a credit risk mitigant would be based on whether the counterparty is a securitization (that is, a non-operating company that holds the underlying exposures of a securitization transaction). b. Nth-to-Default Credit Derivatives Nth-to-default credit derivatives provide credit protection on a group of reference exposures only after a specific number (n) of the reference exposures default.180 As nth-to-default credit derivatives tranche the credit risk of the reference exposures based on the order in which defaults occur within the
group of reference exposures, such credit derivatives would generally qualify as securitization exposures under the proposal, consistent with the current capital rule. Under the current capital rule, banking organizations that have purchased credit protection in the form of an nth-to-default credit derivative may recognize the riskmitigating benefit of that derivative under the credit risk mitigation framework applicable to securitization exposures if certain conditions are met. If a banking organization sells protection in the form of an nth-todefault credit derivative, the current capital rule requires the banking
181As a standardized approach, the SEC–SA calculation does not explicitly capture default correlation among the underlying exposures (such as the possibility that multiple underlying exposures will default simultaneously or that the default of one underlying exposure may affect the likelihood of another underlying exposure defaulting). Instead, default correlation effects are implicitly incorporated through the supervisory parameter (p) in the SEC–SA calculation, which serves as a proxy for the concentration and correlation of the underlying exposures. 182For example, assume a banking organization sells a first-to-default credit derivative that provides protection on three underlying corporate entities, two of which would be subject to a 65 percent risk weight and one to a 100 percent risk weight under the proposal. The proposal would require the banking organization to multiply the sum of the three risk-weights (230 percent) by the notional amount of protection provided by the first-todefault credit derivative. If the banking organization sold a second-to-default credit derivative that provided protection on the same three corporate entities, the proposal would require the banking organization to multiply the sum of the two highest applicable risk-weights (165 percent) by the notional amount of protection provided by the second-to-default credit derivative. organization to calculate risk-weighted assets as the product of (1) the exposure amount produced by SA–CCR, and (2) either the risk weight produced by the SSFA or a 1,250 percent risk weight. Nth-to-default credit derivatives provide protection only for a limited number of default event(s) and, therefore, do not provide continuous or comprehensive coverage of credit risk for the entire basket of reference exposures. Furthermore, the current capital treatment of nth-to-default credit derivatives may not appropriately capture the default correlation among the reference exposures. For example, assume a banking organization with exposure to five corporate entities purchases an nth-to-default credit derivative that pays out upon the default of the second of the five corporate entities. In such a case, the banking organization would remain exposed to any losses incurred upon the first corporate entity default, as well as losses from any defaults beyond the second corporate entity default, if applicable. Conversely, a banking organization that sells an nth-to-default credit derivative that provides protection against the default of the second corporate entity could incur losses exceeding the premiums collected from the protection purchaser if the defaults of the underlying corporates are highly correlated. Furthermore, the risk weight produced by the SEC–SA may not appropriately capture the risk of sold nth-to-default credit derivatives, which are priced based on the expected default correlation among the reference exposures.181 Accordingly, consistent with the Basel standards, while
nth-to-default credit derivatives would continue to be securitization exposures, the proposal would not permit banking organizations to recognize any risk-mitigating benefit for nth-to-default credit derivatives for which the banking organization is the protection purchaser under the proposed securitization framework. Rather, the proposal would require banking organizations to calculate riskweighted assets for counterparty credit risk using the exposure amount produced by SA–CCR, as described in
section IV.A.4.b. of this SUPPLEMENTARY
INFORMATION and the risk weight applicable to the protection provider under the general credit risk framework. Similarly, consistent with the Basel standards, while nth-to-default credit derivatives in which the banking organization is the seller of protection would continue to be securitization exposures, the proposal would prohibit the banking organization from using the SEC–SA to determine the applicable risk weight. Rather, the proposal would generally require banking organizations to calculate the risk-weighted asset amount by multiplying the notional amount of the protection provided by the nth-to-default credit derivative by the sum of the risk weights applicable to each of the underlying reference exposures, up to a maximum of 1,250 percent. In aggregating the risk weights for second-or-later-to-default credit derivatives, the proposal would permit banking organizations to exclude the (n–
183For example, typically in the case of multiseller ABCP conduits, each seller provides first-loss protection by over-collateralizing the conduit to which it sells loans. 184For example, the proposed market risk capital framework would require banking organizations to calculate risk-based capital requirements at the trading desk level. Thus, the cost associated with requiring banking organizations to calculate market risk capital requirements for an individual securitization exposure may outweigh any improvement in risk sensitivity associated with the proposed treatment for overlapping exposures described above. 185As discussed in section IV.B.4.c. of this SUPPLEMENTARY INFORMATION, the non-significant equity exposure treatment does not apply to equity securities underlying a securitization. 186Consistent with the current capital rule, the proposal would define a servicer cash advance facility as 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 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC). option to assign a 100 percent risk weight to securitization exposures that are derivative contracts (other than protection provided by a banking organization in the form of a credit derivative) that have a first priority claim on the cash flows from the underlying exposures (notwithstanding amounts due under interest rate or currency derivative contracts, fees, or other similar payments). The agencies seek comment on the advantages and disadvantages of retaining this option. What, if any, operational burden would banking organizations face if this option were retained or eliminated? What, if any, clarifications should the agencies consider regarding the determination of the attachment point and detachment point for such securitization exposures, and why? d. Overlapping Exposures To enhance the risk sensitivity of the securitization framework, the proposal would introduce new provisions to address instances where one of the banking organization’s securitization exposures would preclude the banking organization from incurring losses under all circumstances on one or more separate securitization exposures also held by the banking organization (overlapping exposures). The standardized approach of the current capital rule includes provisions to limit the double counting of risks in situations involving overlapping securitization exposures. If a banking organization has multiple securitization exposures that provide duplicative coverage to the underlying exposures of a securitization (such as when a banking organization provides a program-wide credit enhancement and multiple poolspecific liquidity facilities to an ABCP program), the banking organization is not required to hold
duplicative riskbased capital against the overlapping position. Instead, the banking organization may apply to the overlapping position the applicable riskbased capital treatment under the securitization framework that results in the highest risk-based capital requirement. Consistent with the Basel standards, the proposal would expand the treatment of overlapping exposures to allow banking organizations to also apply this treatment (1) where one or more of the overlapping securitization exposures would be subject to the expanded risk-based approach and other(s) to the proposed market risk framework, and (2) to securitization exposures that partially overlap for purposes of the expanded risk-based approach. First, to the extent that one or more of the such securitization exposures would be subject to the expanded riskbased approach and others to the revised market risk framework, the proposal would allow banking organizations to reflect only the greater of the risk-based capital requirement produced by the expanded risk-based approach or the market risk capital framework, provided the banking organization is able to calculate and compare the capital requirements for the relevant exposures. Second, if a banking organization has two or more securitization exposures that partially overlap, the proposal would permit the banking organization to treat the exposures as overlapping exposures, provided the banking organization can demonstrate that one of its securitization exposures can fully absorb losses arising from its other securitization exposures. For example, if a banking organization provides a program-wide credit enhancement to an ABCP conduit that covers only the portion of the losses above the sellerprovided protection 183 and the banking organization also holds commercial paper issued by the ABCP conduit, the banking organization would be permitted to reflect the risk-weighted asset amount only for the program-wide credit enhancement, provided the banking organization demonstrates, for purposes of calculating risk-based capital requirements, that the programwide credit enhancement would require the banking organization to fully absorb any losses arising from the ABCP conduit. As the risk-based capital requirement for the program-wide credit enhancement would be treated as covering any losses on the commercial paper, the proposal would not require the banking organization to also maintain additional risk-based capital against the securitization exposure(s) arising from the commercial paper. In this regard, the proposal aims to increase risk-sensitivity by allowing banking organizations to appropriately reflect the risk of such overlapping exposures within the calculation of riskweighted assets while also providing sufficient flexibility if doing so would impose significant burden.184 Question 76: What challenges, if any, would the option to recognize an overlap between market risk covered and noncovered positions introduce? To what degree
do banking organizations anticipate recognizing overlaps between market risk covered and noncovered positions? e. Look-Through Approach for Senior Securitization Exposures Consistent with the Basel standards, the proposal would introduce a provision that would allow a banking organization to assign to a senior securitization exposure that is not a resecuritization exposure a risk weight equal to the weighted average risk weight of the underlying exposures, provided that the banking organization has knowledge of the composition of all of the underlying exposures (also referred to as the ‘‘look-through approach’’). For purposes of calculating the weighted-average risk weight, the proposal would require a banking organization to use (1) the unpaid principal amount of underlying exposures as the weight for each exposure, and (2) determine the risk weight applicable to an underlying equity exposure based on the characteristics of the underlying equity exposure.185 The proposal would define a senior securitization exposure as an 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 banking organization would not be required to consider amounts due under interest rate derivative contracts, currency derivative contracts, and servicer cash advance facility contracts,186 or any fees and other similar payments to be made by the securitization to other parties. 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
187Consistent with the current capital rule, the proposal would define a credit-enhancing interestonly strip as 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 of the CEIO 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. See 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC). 188Cut-off date is the date on which the composition of the underlying exposures collateralizing a securitization transaction is established. This means that all exposures to be included in a securitization must already be in existence and meet the non-performing loan criteria as of that date. 189 If the banking organization is an originating banking organization with respect to the nonperforming loan securitization, the banking organization may maintain risk-based capital against the transferred exposures as if they had not been securitized and must deduct from common equity tier 1 capital any after-tax gain-on-sale resulting from the transaction and any portion of a CEIO strip that does not constitute an after-tax gainon-sale. drawn amounts is senior to all claims on the cash flows from the underlying exposures, except amounts due under interest rate derivative contracts, currency derivative contracts, and servicer cash advance facility contracts, fees due, and other similar payments. Accordingly, under the proposed lookthrough approach, if a senior securitization exposure’s underlying exposures consists solely of past due loans with a weighted-average risk weight of 150 percent, the risk weight for the senior securitization exposure would be no more than 150 percent. Consistent with the proposed 15 percent floor under the SEC–SA, the proposal would require banking organizations to floor the total riskbased capital requirement under the look-through approach at 15 percent. The proposed 15 percent floor is intended to appropriately reflect the minimum amount of risk-based capital that a banking organization should maintain for senior securitization exposures given that the process of securitization can introduce risks that are not present in directly holding the underlying exposures. For example, the transformation of risk profiles through the securitization process and the introduction of payment waterfalls, among other structural features, can add complexity to modeling and correlation assumptions. Question 77: What are the advantages and disadvantages of the proposed 15 percent risk weight floor in the lookthrough approach and why? f. Credit-Enhancing Interest Only Strips The proposal would require a banking organization to deduct from common equity tier 1
capital any portion of a credit-enhancing interest-only strip187 that does not constitute an after-taxgain-on sale, regardless of whether the securitization exposure meets the proposed operational requirements. The proposed treatment for credit-enhancing interest-only strips would be different than under standardized approach in the current capital rule, which requires a risk weight of 1,250 percent for these items. The proposal would require banking organizations to deduct creditenhancing interest-only strips from common equity tier 1 capital because valuations of credit-enhancing interestonly strips can include a high degree of subjectivity and, just like assets subject to deduction under the current capital rule such as goodwill and other intangible assets, banking organizations may not be able to fully realize value from credit-enhancing interest-only strips based on their balance sheet carrying amounts. While a deduction is generally equivalent to a 1,250 percent risk weight when the banking organization maintains an 8 percent risk-based capital ratio, given the various capital ratios, buffers, and addons applicable to banking organizations subject to the proposed expanded riskbased approach, applying a deduction provides a more consistent treatment across capital ratios and greater consistency with the Basel standards. g. Non-Performing Loan Securitizations The proposal would define a nonperforming loan securitization as a traditional securitization, that is not a resecuritization, where parameter W for the underlying exposures is greater than or equal to 90 percent at the origination cut-off date 188 and at any subsequent date on which exposures are added to or removed from the pool of underlying exposures due to replenishment or restructuring. A securitization exposure that meets the definition of a resecuritization exposure would be excluded from the definition of a nonperforming loan securitization. In a typical non-performing loan securitization, the originating banking organization sells non-performing loans to a securitization at a significant discount to the outstanding loan balances, reflecting the nonperforming nature of the underlying exposures. This nonrefundable purchase price discount functions as a form of credit enhancement to investors. Unlike securitizations of performing loans, which principally depend on the cash flows of the underlying loans, the performance of non-performing loan securitizations depends in part on the performance of workouts on defaulted loans and on the liquidation of underlying collateral for those loans which are unable to be cured, both which are uncertain and could be volatile. Consistent with the Basel standards, the proposal would introduce a specific capital treatment for non-performing loan securitization exposures. A banking organization would assign a risk weight of 100 percent to a nonperforming loan securitization exposure if the following conditions are satisfied:
(1) the transaction structure meets the definition of a traditional securitization; (2) the securitization contains a credit enhancement in the form of a nonrefundable purchase price discount greater than or equal to 50 percent of the outstanding balance of the underlying exposures at inception of the transaction; and (3) the banking organization’s securitization exposure is a senior securitization exposure, as described in section IV.B.5.e. of this SUPPLEMENTARY INFORMATION.189 Applying the SEC–SA to senior securitizations of non-performing loans that meet these criteria would result in capital requirements that do not appropriately reflect the nonrefundable purchase price discount associated with these transactions. The SEC–SA is calibrated on the assumption that the underlying exposures at origination of the securitization are generally performing and is therefore inappropriate for senior exposures to securitizations of non-performing loans that meet these criteria. If the non-performing loan securitization exposure is not a senior securitization exposure or the nonrefundable purchase price discount is less than 50 percent, the banking organization would be required to apply the SEC–SA to determine the applicable risk weight (including by reflecting all delinquent exposures in the calculation of parameter W), subject to a risk weight floor of 100 percent. Compared to other securitizations, the higher supervisory risk-weight floor of 100 percent for nonperforming loan securitization exposures reflects the greater dependence of non-performing loan securitizations on the servicer’s ability to generate recovery cashflows through loan workouts, borrower renegotiations, or enforcement against collateral. If the securitization exposure does not meet the requirements for use of the SEC–SA, the proposal would require the banking
190While originator typically refers to the party originating the underlying loans, in the nonperforming loan context it refers to the party arranging the non-performing loan securitization (that is, the securitizer). 191Under the proposal, a purchase price discount would only qualify as a non-refundable purchase price discount if neither the securitization originator nor the original lender receive reimbursement of the discount. If, in the above example, the securitization company repays the originating banking organization, acting in its role as underwriter, for the purchase price discount from the sale of the tranches to third-party investors, the purchase price discount would not qualify as a non-refundable purchase price discount and the investing banking organizations would not be permitted to recognize such a discount in the calculation of parameters A and D. 192As discussed in section IV.A.4. of this SUPPLEMENTARY INFORMATION, the proposal would increase consistency and comparability of capital requirements by reducing the use of bank models. Therefore, the proposal does not include the modelbased approaches currently contained in the credit risk mitigation framework under the advanced approaches (such as allowing banking organizations to use their own internal estimates for calculating haircuts under the collateral haircut approach and allowing the use of the internal models methodology or simple value at risk methodology for measuring counterparty credit risk). Instead, consistent with the standardized approach in the current capital rule, the proposed credit risk mitigation framework for securitization exposures would permit the recognition of a credit risk mitigant only to the extent consistent with the requirements of §ll.120 or 121, as applicable, as well as the requirements of the proposed securitization framework. organization to assign a risk weight of 1,250 to the securitization exposure. Question 78: The agencies seek comment on the proposed 100 percent risk-weight floor for non-performing loan securitization exposures. What modifications, if any, should the agencies consider to the 100 percent risk-weight floor for non-performing loan securitization exposures and why? Commenters are encouraged to provide data (such as loss history) to support their recommendations.
i. Attachment and Detachment Points
for NPL Securitizations Subject to the SEC–SA Under the proposal, the nonrefundable purchase price discount would equal the difference between the outstanding principal balance of the underlying exposures at the time of sale and the price at which these exposures are sold by the securitization originator 190 on a final basis, without recourse, to a company the activities of which are limited to those appropriate for the specific purpose of holding the underlying exposures of a securitization. The purchase price discount would be considered nonrefundable when neither the securitization originator nor the original lender are reimbursed with respect to that difference. For any given tranche of the securitization, a banking organization may take into account only the initial sale from the securitization originator in the determination of the non-refundable purchase price discount. In cases where the securitization originator underwrites tranches of a non-performing loan securitization for subsequent sale, an investing banking organization may include in the calculation of the nonrefundable purchase price discount the difference between the outstanding principal balance of the underlying exposures at time of sale and the price at which the securitization originator subsequently sells all of the underwritten tranches to unrelated third parties. Because the calculation of both parameters A and D depend on the current dollar amount of the underlying exposures, any nonrefundable purchase price discount associated with a securitization would be included in both the numerator and denominator of parameters A and D. For example, assume an originating banking organization sells on a final basis, without recourse, a pool of mortgage loans with an outstanding principal balance of $100 million to a securitization at a price of $60 million. The nonrefundable purchase price discount would be the difference between the outstanding principal balances of the underlying mortgages at the time of sale to the securitization and the price at which the originating banking organization sold these mortgages to the securitization company (that is, $40 million). Assume that the securitization company issues $60 million in securitization tranches of which the originating banking organization purchases the senior $50 million tranche and an investing banking organization purchases the $10 million subordinate tranche. Parameter A for the investing banking organization’s exposure would equal 40 percent (that is, the ratio of $40 million to $100 million). In this case, the purchase price discount functions as the effective first-loss position in the securitization structure. Likewise, the originating banking organization would treat both the nonrefundable purchase price discount and the investing banking organization’s tranche as subordinate and would set parameter A at 50 percent. If, in the example above, after selling the $100 million pool of mortgage loans to a securitization
company at a price of $60 million, the originating banking organization underwrites both the senior tranche and the subordinate tranche and later sells both tranches to third parties at a 20 percent discount (that is, the $10 million subordinated tranche is sold for a price of $8 million and the $50 million senior tranche is sold for a price of $40 million), the proposal would allow the investing banking organizations to assign an attachment point that reflects the extent to which losses have effectively been absorbed by the non-refundable purchase price discount, as measured by the difference between the outstanding principal amount of the underlying exposures ($100 million) and the aggregate price at which the originating bank subsequently sells those securitization tranches to unrelated third parties ($48 million). The originating banking organization as underwriter absorbs the additional 20 percent price discount at the sale of the tranches.191 Thus, the investing banking organization that purchases the $8 million subordinate tranche would be permitted to assign an attachment point of 52 percent and a detachment point of 60 percent to its securitization exposure; the investing banking organization that purchases the $40 million senior tranche would be permitted to assign an attachment point of 60 percent and a detachment point of 100 percent to its securitization exposure.
6. Credit Risk Mitigation for
Securitization Exposures The proposal would incorporate the credit risk mitigation framework for securitization exposures in the current standardized approach, with one exception.192 A banking organization that purchases or sells tranched credit protection, whether hedged or unhedged, referencing part of a senior tranche would not be allowed to treat the lower-priority portion that the credit protection does not reference as a senior securitization exposure. For example, if a banking organization holds a securitization exposure with an attachment point of 20 percent and a detachment point of 100 percent and the banking organization purchases an eligible guarantee with an attachment point of 50 percent and a detachment point of 100 percent, the banking organization’s residual exposure, which attaches at 20 percent and detaches at 50 percent, would be considered a nonsenior securitization exposure, and the banking organization would not be permitted to apply the look-through approach to this exposure. A banking organization that purchases a mezzanine tranche that attaches at 20 percent and detaches at 50 percent has a similar economic exposure to a banking organization that purchases a senior
193For example, exposures that could be characterized as an equity exposure under the current capital rule and under the proposal include a short position in an equity security or an equity total return swap. See 12 CFR 3.2 (OCC); 12 CFR
217.2 (Board); 12 CFR 324.2 (FDIC) for the
definition of equity exposure.
194See §ll.202 for the proposed definition of market risk covered position. 195See 78 FR 62124. tranche that attaches at 20 percent and detaches at 100 percent and then purchases credit protection that attaches at 50 percent and detaches at 100 percent. Because the former transaction would not be considered a senior securitization exposure eligible for the look-through approach, the latter transaction likewise should not be eligible for the look-through approach. Alternatively, the banking organization may choose not to recognize the tranched credit protection. In this case, the proposal would allow the banking organization to treat the securitization exposure (which attaches at 20 percent and detaches at 100 percent) as a senior securitization exposure.
C. Equity Exposures
Equity exposures present a greater risk of loss relative to credit exposures, as equity exposures represent an ownership interest in the issuer of an equity instrument and is a residual claim on the assets and income of the issuer. An equity exposure entitles a banking organization to no more than the pro-rata residual value of a company after all other creditors are repaid.193 As a result, consistent with the current capital rule, the proposal would generally assign higher risk weights to equity exposures than exposures subject to the proposed credit risk framework. Under the proposal, for banking organizations subject to the market risk framework, material publicly traded equity exposures would generally be subject to the proposed market risk framework 194 described in section V.A. of this SUPPLEMENTARY INFORMATION, unless restrictions exist on the tradability of such exposures. Similarly, equity exposures to investment funds would be subject to the proposed market risk framework when the following conditions are met: (1) the banking organization has access to the investment fund’s prospectus, partnership agreement, or similar contract that defines the fund’s permissible investments and investment limits, and (2) the banking organization is either able to calculate a market risk capital requirement for its proportional ownership share of each exposure held by the investment fund, or obtain daily price quotes. For banking organizations with significant trading activity, the proposed equity framework would therefore primarily cover illiquid or infrequently traded equity exposures. For banking organizations without significant trading activity, the proposed equity framework would be used to calculate risk-weighted assets for all equity exposures. The proposed framework would largely maintain the current standardized approach equity framework. The proposal would make one targeted modification to align the treatment of commitments within the expanded risk-based approach. Specifically, the proposal would simplify the current rule’s conversion factors for conditional commitments to acquire an equity exposure.
196Consistent with the current capital rule, the proposal includes the concept of the effective notional principal amount of the off-balance sheet portion of an equity exposure to provide a uniform method for banking organizations to measure the on-balance sheet equivalent of an off-balance sheet exposure. For example, if the value of a derivative contract referencing the common stock of company X changes the same amount as the value of 150 shares of common stock of company X, for a small change (for example, 1.0 percent) 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 this derivative is the current value of shares of common stock of company X minus the adjusted carrying value of any on-balance sheet amount associated with the derivative. 197Consistent with the current capital rule, the proposal would allow a banking organization to 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, the proposal would require the banking organization to either include all or exclude all of the contracts from any measure used to determine counterparty credit risk exposure. See §ll.114(d) of the proposal.
2. Simple Risk-Weight Approach
(SRWA)
Under the proposal, the risk-weighted asset amount for an equity exposure, except for equity exposures to investment funds, would be the product of the adjusted carrying value of the equity exposure multiplied by the lowest applicable risk weight, as described in Table 2 below. The proposed simple risk-weight approach maintains the same risk weights applicable to equity exposures under the current capital rule. EP27MR26.071</GPH>
198Under the proposal, specified supranational entities would include the Bank for International Settlements, the European Central Bank, the European Commission, the International Monetary Fund, the European Stability Mechanism, and the European Financial Stability Facility. Consistent with the current capital rule, equity exposures to such entities would continue to be subject to a zero percent risk weight for the purposes of the simple risk weight approach. 199See 78 FR 62124 (Oct. 11, 2013). 200The proposal would rely on the existing definition of publicly traded under the current capital rule. See 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC). 201See ll.141(b). 202Under the current capital rule, when determining which equity exposures are ‘‘nonsignificant’’ and thus eligible for a 100 percent risk weight, a banking organization first must include equity exposures to an unconsolidated small business investment company or 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). 203The 250 percent risk weight for publicly traded equities would be consistent with the Basel standards. a. Alternative Approach The proposal would maintain the current capital rule’s treatment of nonsignificant equity exposures. Nonsignificant equity exposures means equity exposures to the extent that the aggregate adjusted carrying value of the banking organization’s equity exposure does not exceed 10 percent of the banking organization’s total capital.201 Non-significant equity exposures receive a 100 percent risk weight under the current capital rule. To increase the risk sensitivity of the proposed equity framework, the agencies considered the following alternative approach: (1) remove the 100 percent risk weight for non-significant equity exposures, (2) introduce a 100 percent risk weight for certain tax equity financing transactions and equity exposures to Small Business Investment Companies,202 (3) lower the risk weight for publicly traded equity exposures from 300 percent to 250 percent,203 and (4) increase the risk weight applicable to equity exposures to investment firms with greater than immaterial leverage EP27MR26.072</GPH>
204A significant portion of publicly traded equity exposures and equity investment in funds exposures will be considered market risk covered positions. See §ll.202 for the proposed definition of market risk covered position. 205See 12 CFR 3.101 (OCC); 217.101 (Board); 12 CFR 324.101 (FDIC). Under the proposal, the definition of operational risk would include legal risk, but exclude strategic risk. 206There are several examples of large banking organizations experiencing severe operational losses. Multiple banking organizations have suffered substantial losses due to rogue trading. Large U.S. banking organizations have also experienced billions of dollars in operational losses from legal settlements relating to improper loan origination, securitization, and foreclosure practices associated with the 2007–09 global financial crisis. Some banking organizations have experienced substantial losses from legal settlements relating to the violation of sanctions put in place by the United States. Additionally, a large banking organization experienced substantial operational losses due to a fake-accounts scandal. See, e.g., M. Jeremy, ‘‘Leeson pleads guilty to two charges in Barings collapse, and may cooperate,’’ The Wall Street Journal (Dec. 1, 1995); and Nicola Clark and David Jolly, ‘‘French Bank Says Rogue Trader Lost $7 Billion,’’ The New York Times, (Jan. 25, 2008). See, e.g., U.S. Dep’t of Justice, Press Release, Federal Government and State Attorneys General Reach $25 Billion Agreement with Five Largest Mortgage Servicers to Address Mortgage Loan Servicing and Foreclosure Abuses (Feb. 9, 2012), https://www.justice.gov/opa/pr/federal-governmentand-state-attorneys-general-reach-25-billionagreement-five-largest; U.S. Dep’t of Justice, Press Release, Justice Department, Federal and State Partners Secure Record $13 Billion Global Settlement with JPMorgan for Misleading Investors About Securities Containing Toxic Mortgages (Nov. 9, 2013), https://www.justice.gov/opa/pr/justicedepartment-federal-and-state-partners-securerecord-13-billion-global-settlement; FHFA, Press Release, FHFA Announces $9.3 Billion Settlement With Bank of America Corporation (Mar. 26, 2014), https://www.fhfa.gov/news/news-release/fhfaannounces-9.3-billion-settlement-with-bank-ofamerica-corporation; U.S. Dep’t of Justice, Press Release, Bank of America to Pay $16.65 Billion in Historic Justice Department Settlement for Financial Fraud Leading up to and During the Financial Crisis (Aug. 21, 2014), 21, 2014), https:// www.justice.gov/opa/pr/bank-america-pay-1665- billion-historic-justice-department-settlementfinancial-fraud-leadinghttps://www.justice.gov/opa/ pr/bank-america-pay-1665-billion-historic-justicedepartment-settlement-financial-fraud-leading; U.S. Dept’ of Justice, Press Release, Justice Department, Federal and State Partners Secure Record $7 Billion Global Settlement with Citigroup for Misleading Investors About Securities Containing Toxic Mortgages (July 14, 2014),
https://www.justice.gov/ opa/pr/justice-department-federal-and-statepartners-secure-record-7-billion-globalsettlementhttps://www.justice.gov/opa/pr/justicedepartment-federal-and-state-partners-securerecord-7-billion-global-settlement; U.S. Dep’t of Justice, Press Release, BNP Paribas Sentenced for Conspiring to Violate the International Emergency Economic Powers Act and the Trading with the Enemy Act (May 1, 2015), https://www.justice.gov/ opa/pr/bnp-paribas-sentenced-conspiring-violateinternational-emergency-economic-powers-actand;U.S. Dep’t of Justice, Press Release, Morgan Stanley Agrees to Pay $2.6 Billion Penalty in Connection with Its Sale of Residential Mortgage Backed Securities (Feb. 11, 2016), https:// www.justice.gov/opa/pr/morgan-stanley-agrees-pay26-billion-penalty-connection-its-sale-residentialmortgage-backed; U.S. Dep’t of Justice, Press Release, Deutsche Bank Agrees to Pay $7.2 Billion for Misleading Investors in its Sale of Residential Mortgage-Backed Securities (Jan. 17, 2017), https:// www.justice.gov/opa/pr/deutsche-bank-agrees-pay72-billion-misleading-investors-its-sale-residentialmortgage-backed; U.S. Dep’t of Justice, Press Release, Credit Suisse Agrees to Pay $5.28 Billion in Connection with its Sale of Residential MortgageBacked Securities (Jan. 18, 2017), https:// www.justice.gov/opa/pr/deutsche-bank-agrees-pay72-billion-misleading-investors-its-sale-residentialmortgage-backed; U.S. Dep’t of Justice, Press Release, Credit Suisse Agrees to Pay $5.28 Billion in Connection with its Sale of Residential MortgageBacked Securities (Jan. 18, 2017), https:// www.justice.gov/opa/pr/credit-suisse-agrees-pay528-billion-connection-its-sale-residentialmortgage-backed; and U.S. Dep’t of Treasury, Office of Foreign Assets Control, Press Release, Settlement Agreement between the U.S. Department of the Treasury’s Office of Foreign Assets Control and JPMorgan Chase Bank, N.A. (JPMC), and Finding of Violation issued to JPMC (Oct. 5, 2018), https:// ofac.treasury.gov/recent-actions/20181005 (each and that would meet the definition of a traditional securitization were it not for the application of paragraph (8) of that definition from 600 percent to 1,250 percent. Outside of those changes under consideration, the agencies would retain the current capital rule’s risk weights for equity exposures, the hedge pair treatment, and look-through approaches for equity investment in funds. This alternative approach would increase risk sensitivity by requiring banking organizations to apply a risk weight based on the characteristics of each equity exposure, rather than only for those in excess of 10 percent of the banking organization’s total capital. Conversely, the agencies recognize that implementing this alternative approach would increase the operational burden associated with the proposal as banking organizations have developed internal reporting systems and processes to apply the current capital rule’s 100 percent risk weight for
non-significant equity exposures. Given that the proposed equity framework captures a more limited set of exposures compared to the current rule,204 the agencies determined that the cost associated with replacing the current treatment for non-significant equity exposures may be higher than the improvement in risk sensitivity associated with the alternative approach described above. As such, to balance risk sensitivity with burden, the proposed simple risk weight approach retains the current capital rule’s treatment for non-significant equity exposures. Question 79: What are the advantages and disadvantages of the proposed 40 percent conversion factor for calculating the adjusted carrying value of conditional equity commitments? How appropriate is this proposed conversion factor for capturing the risk that such commitments will become on-balance sheet equity exposures? What alternative approaches or conversion factor values might better reflect the risk profile of conditional equity commitments, and what would be the potential costs and benefits of such alternatives? Question 80: What are the advantages and disadvantages of using a treatment for conditional commitments which differentiates conversion factors based on maturity, and would apply a 20 percent credit conversion factor to those commitments with an original maturity of one year or less, and a 50 percent conversion factor to those with an original maturity of more than one year? Question 81: The agencies request comment on the proposed 100 percent risk weight for non-significant equity exposures. What are the advantages or disadvantages of replacing the proposed treatment of equity exposures with the alternative approach described above? What other alternatives should the agencies consider, and what would be the advantages and disadvantages of such alternatives? Question 82: For what, if any, types of exposures would a 100 percent risk weight and classification as nonsignificant equity exposure be inappropriate and why? What specific characteristics of these exposures would warrant a different risk weight treatment? Question 83: Certain equity exposures, such as certain tax equity financing transactions, may have a different risk profile than general equity exposures. What types of equity exposures have risk profiles that differ materially from general equity exposures? What risk weights would be appropriate for such exposures, and what are the benefits and costs of applying different risk weight treatments? Please provide relevant data to support your views, including historical loss data and information on risk characteristics of these exposures. D. Operational Risk The proposal would include an operational risk capital requirement. Operational risk is defined in the current capital rule as the risk of loss resulting from inadequate or failed internal processes, people, and systems, or from external events.205 It includes a wide range of risks, such as fraud, system failures, business
disruptions, damage to physical assets, cyberattacks, and litigation. Operational risk is present across banking products, activities, processes, and systems and has resulted in substantial financial losses for large banking organizations in the United States.206
describing a settlement between the U.S. government and large banking organizations involving substantial payments by banking organizations to resolve allegations of misconduct). See, e.g., Jackie Wattles, Ben Geir, Matt Egan, and Danielle Wiener-Bronner, ‘‘Wells Fargo’s 20-Month Nightmare,’’ CNN Money (Apr. 24, 2018). 207The $308 billion figure was calculated by adding together all operational loss events that resulted in a net loss amount of $20,000 or more and were reported in the FR Y–14Q form. 208Using a summary measure for the macroeconomic environment, Abdymomunov et al. (2020) find that operational losses increase by 16.5 percent for a one standard deviation decrease in the macroeconomic measure. Similarly, Allen and Bali (2007) find that operational risk is cyclical and relates to measures of the macroeconomy and systemic risk. Chernobai et al. (2011) find that operational risk is higher for firms with higher credit risk. Hess (2011) finds that measures of operational risk for several business lines increased meaningfully after the 2007–09 financial crisis. Cope and Carrivick (2013) find that operational loss frequency and severity increased due to the 2007– 09 financial crisis. And Aldosoro et al. (2023) find that operational losses peaked during the 2007–09 financial crisis and that operational losses increase after periods of accommodative monetary policy. Relatedly, Berger et al. (2022) find that operational losses increase the systemic risk posed by large U.S. banking organizations. See Abdymomunov, Azamat, Filippo Curti, and Atanas Mihov, ‘‘U.S Banking Sector Operational Losses and the Macroeconomic Environment,’’ Journal of Money, Credit, and Banking, Vol. 52, No.1, pages 115–144 (2020); Allen, Linda, and Turan G. Bali, ‘‘Cyclicality in catastrophic and operational risk measurements,’’ Journal of Banking & Finance 31, pages 1191–1235 (2007); Chernobai, Anna, Phillippe Jorion, and Fan Yu, ‘‘The Determinants of Operational Risk in U.S. Financial Institutions,’’ Journal of Financial and Quantitative Analysis, Vol. 46, No. 6, pages 1683–1725 (2011); Hess, Christian, ‘‘The impact of the financial crisis on operational risk in the financial services industry: empirical evidence,’’ The Journal of Operational Risk, Volume 6, Number 1, pages 23–35 (2011); Cope, Eric W., and Luke Carrivick, ‘‘Effects of the financial crisis on banking operational losses,’’ Journal of Operational Risk 8(3), pages 3–29 (2013); Aldosoro, Inaki, Leonardo Gambacorta, Paolo Giudici, and Thomas Leach, ‘‘Operational and Cyber Risks in the Financial Sector,’’ International Journal of Central Banking Vol. 19, No. 5, pages 341–402 (2023); Berger, Allen N., Filippo Curti, Atanas Mihov, and John Sedunov, ‘‘Operational Risk is More Systemic than You Think: Evidence from U.S. Bank Holding Companies;’’ Journal of Banking and Finance 143, 106619 (2022). 209See Paul Povel, Rajdeep Singh, and Andrew Winton, ‘‘Booms, Busts, and Fraud’’ The Review of Financial Studies,
1219–1254 (2007); and Robert T. Stewart, ‘‘Bank fraud and the macroeconomy,’’ Journal of Operational Risk 11(1), 71–82 (2016). 210The inclusion of operational risk in the Basel II standards was driven in part by Barings Bank’s failure in 1995. Barings Bank, originally founded in 1762, collapsed after discovering that one of its Singapore branch traders lost $1.3 billion in unauthorized derivatives trades made through the bank’s error accounts. One of the lessons from the failure of Barings Bank is that a bank’s capital could be depleted through rogue traders and other operational events, not just through credit and market losses. See Michael S. Barr, Howell E. Jackson, Margaret E. Tahyar, Financial Regulation:
Law and Policy (2021).
211On the operational losses caused by the Enron scandal, see https://www.nytimes.com/2005/06/15/ business/jp-morgan-chase-to-pay-enron-investors22-billion.html; https://www.nytimes.com/2005/06/ 15/business/jp-morgan-chase-to-pay-enroninvestors-22-billion.html; https:// www.nytimes.com/2008/03/27/business/ 27enron.html; https://www.nytimes.com/2008/03/ 27/business/27enron.html; and Vaugh K. Reynolds, ‘‘The Citigroup and J.P Morgan Chase Enron Settlements: The Impact on the Financial Industry’’ North Carolina Banking Institute—Financial Accounting and Derivatives (2004), https:// scholarship.law.unc.edu/cgi/viewcontent. cgi?article=1143&context=ncbi. On the operational losses caused by the WorldCom scandal, see https://www.nytimes.com/ 2005/03/13/business/yourmoney/worldcomteaches-a-pricey-lesson.html and https:// www.wsj.com/articles/SB110985786525469459. 212On the operational losses caused by the Bernard Madoff scandal, see https:// www.justice.gov/usao-sdny/pr/manhattan-usattorney-and-fbi-assistant-director-chargeannounce-filing-criminal. On operational losses resulting from mortgage servicing abuses, see https://www.justice.gov/opa/pr/federal-governmentand-state-attorneys-general-reach-25-billionagreement-five-largest. 213The agencies adopted the AMA for operational risk as part of the advanced approaches capital framework in 2007. See 72 FR 69288 (Dec. 7, 2007). 214See, e.g., Cope, E., G. Mignola, G. Antonini, and R. Ugoccioni. 2009. Challenges and Pitfalls in Measuring Operational Risk from Loss Data. Journal of Operational Risk 4(4): 3–27; and Opdyke, J., and A. Cavallo. 2012. Estimating Operational Risk Capital: The Challenges of Truncation, the Hazards of Maximum Likelihood Estimation, and the Promise of Robust Statistics. Journal of Operational Risk 7(3): 3–90. 215 12.5 is the amount by which the measure of operational risk exposure needs to be multiplied so that the risk-weighted assets it generates are equivalent to an 8 percent total capital requirement. 216The proposal would not include the internal loss multiplier that was included under the agencies 2023 proposal, which is equivalent to setting the internal loss multiplier equal to one. 217Recent research connecting operational risk to higher business volume includes Frame, McLemore, and Mihov (2020), Haste Makes Waste: Banking Organization Growth and Operational Risk, Federal Reserve Bank of Dallas, https://www.dallasfed.org/ Continued In total, Category I and II holding companies have experienced over $308 billion in operational losses between 2007Q1 and 2025Q2.207 These totals include large operational losses from activities that typically do not result in substantial credit or market riskweighted assets, such as certain feebased activities, indicating that operational risk can represent the main source of risk for activities that have a limited balance sheet footprint. In addition to their substantial standalone materiality, empirical academic research supports that
operational losses tend to increase during economic downturns.208 In some cases, operational losses only become apparent once a banking organization is otherwise under stress, with economic downturns and reductions in asset values exposing previous operational failures and fraud.209 For example, the operational failures and fraud of a rogue trader within Barings Bank only became known after the fall in asset values within Asian financial markets following the 1995 Kobe earthquake. These operational losses ultimately resulted in the bank’s failure.210 Similarly, substantial operational losses followed from the Enron and Worldcom fraud scandals, which coincided with a stock market downturn in the early 2000s.211 The fall in asset values during the 2007–09 financial crisis was a key factor in exposing Bernard Madoff’s ponzi scheme and mortgage servicing abuses, which led to severe operational losses for certain large banking organizations.212 For these reasons, the agencies are proposing to account for operational risk together with credit risk and market risk in the capital framework applicable to Category I and II banking organizations to help ensure their safety and soundness and bolster U.S. financial stability. Under the current capital rule, Category I and II banking organizations are required to calculate risk-weighted assets for operational risk using the AMA,213 which is based on a banking organization’s internal models. The AMA results in significant challenges for banking organizations, market participants, and the supervisory process. AMA exposure estimates can present substantial uncertainty and volatility, introducing challenges to capital planning processes.214 In addition, the AMA’s reliance on internal models has resulted in a lack of transparency and comparability across banking organizations. As a result, supervisors and market participants experience challenges in evaluating the adequacy of operational risk capital across banking organizations. To address these concerns, the proposal would remove the AMA and introduce a standardized approach for operational risk that seeks to address the operational risks currently covered by the AMA. Consistent with the Basel standards, risk-weighted assets for operational risk would be equal to 12.5 times the business indicator component.215,216 The business indicator component would provide a measure of the operational risk exposure of the banking organization and would be calculated based on its business indicator multiplied by scaling factors that increase with the business indicator. The business indicator would serve as a proxy for a banking organization’s business volume and would be based on inputs compiled from a banking organization’s financial statements. Banking organizations with higher overall business volume are larger and more complex, which is likely to result in more operational risk exposure.217
research/papers/2020/wp2023; Curti, Frame, and Mihov (2019), Are the Largest Banking Organizations Operationally More Risky?, Journal of Money, Credit and Banking Vol. 54, Issue 5, 1223– 1259, https://doi.org/10.1111/jmcb.12933; and Abdymomunov and Curti (2020), Quantifying and Stress Testing Operational Risk with Peer Banks’ Data, Journal of Financial Services Research Vol. 57, 287–313, https://link.springer.com/article/ 10.1007/s10693-019-00320-w. 218Unlike the other inputs used to calculate the business indicator, interest-earning assets are balance-sheet items, rather than income statement items, and thus their use in the business indicator does not represent a flow over a one-year period, but rather a point-in-time value. The use of average interest-earning assets for the previous 12 quarters instead of, for example, the average interest-earning assets for the ending quarter of the last three years aims to increase the robustness of the average used in the calculation. 219Total interest income would correspond to total interest income in the FR Y–9C (holding companies) and Call Report, excluding dividend income as defined in the proposal. 220Total interest expense would correspond to total interest expense in the FR Y–9C (holding companies) and Call Report. 221 Interest-earning assets would equal the sum of interest-bearing balances in U.S. offices, interestbearing balances in foreign offices, Edge and agreement subsidiaries, and IBFs, Federal funds sold in domestic offices, securities purchased under agreements to resell, loans and leases held for sale, loans and leases held for investment, total held-tomaturity securities at amortized cost (only including securities that pay interest), total available-for-sale securities at fair value (only including securities that pay interest), and total trading assets (only including trading assets that pay interest) in the FR Y–9C (holding companies) and Call Report. Higher business volumes present more opportunities for operational risk to manifest. In addition, the complexities associated with a higher business volume can give rise to gaps or other deficiencies in internal controls that result in operational losses. Therefore, the proposal would set a banking organization’s operational risk capital requirement in line with its business volume. Question 84: The Basel standards includes an optional scalar called the internal loss multiplier, which is calculated based on a banking organization’s historical internal operational losses. The internal loss multiplier would scale the business indicator component in the calculation of risk-weighted assets for operational risk. The internal loss multiplier is calculated as follows:
Internal loss multiplier = ln(exp(1)¥1 + (15 * average annual total net operational losses/business indicator component)0.8) where ln is the natural logarithm and exp(1) is the Euler’s number, which is approximately equal to 2.7183. Should the agencies include the internal loss multiplier in the calculation of operational risk-weighted assets and, if so, why? If the internal loss multiplier is included in the calculation of the operational riskweighted assets, should the ‘‘15’’ factor included in its calculation be adjusted to better reflect the operational risks of U.S. Category I and II banking organizations, within a range between 5 and 15? Please provide any analysis justifying a recommendation.
222 Dividend income is currently included in total interest income in the FR Y–9C (holding companies) and Call Report. 223The total noninterest income, realized gains (losses) on held-to-maturity securities, and realized gains (losses) on available-for-sale debt securities to be used in the calculation of the noninterest component align with the corresponding values in the banking organization’s Call Report or FR Y–9C report. Ahead of the implementation of any final rule, the agencies plan to issue an update to the FFIEC 101 report, which would include reporting instructions for all items relevant to the calculation of risk-weighted assets for operational risk. 224Other noninterest expense is as reported in the consolidated financial statements of the banking organization. 225Contra revenues are reductions to a revenue account in an accounting statement (typically, most expenses are included in accounting statements through expense accounts). 226Operational loss data was obtained from FR Y–14Q Schedule E. Income data was obtained from FR Y–14Q Schedule G. Only observations for which both the operational losses and the necessary Continued received on securities not consolidated in the banking organization’s financial statements.222 The interest, lease, and dividend component would capture a banking organization’s interest income and expenses from financial assets and liabilities, as well as dividend income from investments in stocks and mutual funds. The interest income and expense portion of the interest, lease, and dividend component would be calculated as the absolute value of the difference between total interest income and total interest expense (which constitutes net interest income) and be subject to a ceiling equal to 2.25 percent of the banking organization’s interestearning assets. Net interest income is a useful indicator of a banking organization’s operational risk because a higher volume of business is associated with higher operational risk. Given that operational risk is unlikely to increase proportionally to increases in net interest margin, the net interest income input would be capped at 2.25 percent of interest-earning assets, consistent with the Basel standards. The proposal would add dividend income to the net interest income input to capture investment activities that produce dividends instead of interest income (for example, investment in equities and mutual funds). Question 85: The proposal would include interest income and expenses in the interest component and noninterest income and certain noninterest expenses in the noninterest component. Income and expenses relating to operating leases are typically characterized as noninterest income and noninterest expenses, respectively, in regulatory reports. However, income and certain expenses relating to operating leases are included in the interest component under the Basel standards. What would be the advantages and disadvantages of including (1) income from operating leases
and (2) depreciation and impairments relating to operating leased assets in the interest component rather than the noninterest component? b. The Noninterest Component Under the proposal, the noninterest component would account for fee and commission-based activities, trading activity, and other activities that are associated with a banking organization’s assets and liabilities and would be calculated as follows:
Noninterest component = Avg3y(Abs(total noninterest income
income elements were reported are included in this analysis. 227The definition of treasury services currently employed in the FR Y–14 includes certain lending activities such as trade finance and corporate and commercial credit cards. To ensure that lending activities are treated consistently by the operational risk framework, the proposal would not include lending activities within treasury services in the scope of activities whose contribution to the noninterest component would be reduced by 70 percent. This analysis shows that the aggregate ratio of historical operational losses to income for investment management activities, investment services, and treasury services is approximately 32 percent of the same ratio for the Category I and II holding companies as a whole. Considering the findings of this analysis, the proposal would reduce by 70 percent the noninterest income and expenses from investment management, investment services, and non-lending treasury services used in the calculation of the noninterest income component and, thereby, reflect the lower operational risk that these activities have presented historically.227 There are substantial practical difficulties in designing and implementing scalars to differentiate the contribution of business lines to the operational risk capital requirement. The existing segmentation of business lines for purposes of reporting operational losses, income, and expenses does not align in all cases. Also, banking organizations’ practices around classification of operational losses and income vary, and there may be meaningful variability across banking organizations with respect to the ratio of operational losses to income at the business line level. In addition, introducing differentiated scalars across multiple business lines could introduce inconsistency across banking organizations, as the business line classification of income or expense would have risk-based capital consequences. Addressing such potential inconsistency would necessitate significant supervisory review of business line income and expense classification, which would result in additional compliance costs for banking organizations. Further, differentiation of operational risk requirements across business lines would introduce additional inconsistencies relative to the Basel standards. Given these considerations, the proposal would only differentiate EP27MR26.073</GPH>
228See Filippo Curti and Marco Migueis, ‘‘The Information Value of Past Losses in Operational Risk,’’ Journal of Operational Risk Volume 18, Number 2, 1–36 (2023), https://doi.org/10.21314/ JOP.2022.033. 229Subtracting operational losses from the noninterest component (and thereby the business indicator)—as would occur if operational losses were retained within noninterest expense for BI— would not be appropriate because operational losses would generally be reducing risk-weighted assets for operational risk. the contribution of investment management, investment services, and non-lending treasury services activities to the noninterest component. The proposal would reflect operational losses within the business indicator. Empirical research suggests observed operational losses are a meaningful indicator of a banking organization’s operational risk exposure.228 Including expenses related to operational loss events in the business indicator is therefore consistent with the operational risk requirement’s objective of supporting a banking organization’s resilience to operational risk. Specifically, the proposal would add total operational losses within the noninterest component. This approach is consistent with how operational losses contribute positively to other operating expense under the Basel standards and, therefore, would contribute positively to the business indicator under the Basel standards when other operating expense is higher than other operating income.229 The proposed noninterest component, including the downscaling of income net of expenses from investment management, investment services, and non-lending treasury services activities, would improve the consistency of requirements across Category I and II banking organizations and better reflect the operational risk of their activities. Question 86: What are the advantages and disadvantages of the proposed design of the noninterest component, including any impact on specific business models? Which alternatives, if any, should the agencies consider and why? Please provide supporting data with your response. Question 87: What are the advantages and disadvantages of the proposed downscaling of the income and expense from investment management, investment services, and non-lending treasury services activities? What are the advantages and disadvantages of the proposed calibration approach? Should the agencies consider differentiated scalars (both increasing and decreasing requirements) across multiple business lines and why? What alternatives, if any, should the agencies consider and why? Please include data to support your views.
C. Exclusions From the Business
Indicator
Consistent with the Basel standards, the business indicator under the proposal would reflect the volume of financial activities of a banking organization; therefore, the business indicator would exclude expenses that do not relate to financial services received by the banking organization. Excluded expenses would include staff expenses, expenses to outsource nonfinancial services (such as logistical, human resources, and information technology), administrative expenses (such as utilities, telecommunications, travel, office supplies, and postage), expenses relating to premises and fixed assets, and depreciation of tangible and intangible assets. Also consistent with the Basel standards, the proposal would exclude loss provisions and reversal of provisions (except for those related to operational loss events) or changes in goodwill from the business indicator, as these items reflect accounting adjustments rather than financial transactions. In addition, the business indicator would be neutral relative to applicable income taxes by excluding them from the expense considered. With prior supervisory approval, the proposal would allow banking organizations to exclude activities that they have ceased to conduct, whether directly or indirectly, from the calculation of the business indicator, provided that the banking organization demonstrates that such activities do not carry legacy legal exposure. Supervisory approval would not be granted when, for example, legacy business activities are subject to potential or pending legal or regulatory enforcement action. The supervisory approval requirement would help ensure that a banking organization’s operational risk capital requirement aligns with its existing operational risk exposure. Question 88: Under what circumstances, if any, would it be appropriate for the business indicator to also exclude income relating to nonfinancial activities provided by a banking organization, such as an exclusion for income relating to nonfinancial activities provided to foreign affiliates or parents (recharge income)? What are the advantages and disadvantages of such exclusion, and what distinguishes such potentially excluded income from other income relating to non-financial activities? Please provide any data that would be useful to consider on this issue, including data that would allow the agencies to estimate the impact of such exclusion.
2. Business Indicator Component
Under the proposal, the business indicator component would rise with the size of the business indicator, but at three different rates. It would increase by 12 percent for each unit of business indicator up to $1 billion, by 15 percent for each unit above $1 billion and up to $30 billion, and by 18 percent for each unit above $30 billion. As described in
section II.E., these thresholds would be
indexed to inflation over time. Table 3 below presents the formulas that can be used to calculate the business indicator component given a banking organization’s business indicator.
230 $120 million is equal to 0.12 * $1 billion. $4.47 billion is equal to 0.12 * $1 billion + 0.15 * ($30 billion ¥ $1 billion). 231See Basel Committee (2014), ‘‘Operational risk—Revisions to the simpler approaches,’’ https:// www.bis.org/publ/bcbs291.htm and Basel Committee (2016), ‘‘Standardized Measurement Approach for operational risk,’’ https:// www.bis.org/bcbs/publ/d355.htm. 232See Curti, Mih, and Mihov (2022), ‘‘Are the Largest Banking Organizations Operationally More Risky?, Journal of Money, Credit and Banking,’’ DOI: 10.111/jmcb.12933; and Frame, McLemore, and Mihov (2020), ‘‘Haste Makes Waste: Banking Organization Growth and Operational Risk,’’ Federal Reserve Bank of Dallas, https:// www.dallasfed.org/research/papers/2020/wp2023. 233See Basel Committee on Banking Supervision (2006): ‘‘International Convergence of Capital Measurement and Capital Standards,’’ https:// www.bis.org/publ/bcbs128.htm. Upon the adoption of the new approach for calculating operational risk capital to the Basel standards, the basic indicator approach is no longer part of the Basel framework. The agencies have previously considered simple options for operational risk, including the basic indicator approach. See 73 FR 43982, https:// www.govinfo.gov/content/pkg/FR-2008-07-29/pdf/ E8-16262.pdf. 234The basic indicator approach specifies that gross income should (1) be gross of any provisions (for example, for unpaid interest), (2) be gross of operating expenses, including fees paid to outsourcing service providers, (3) exclude realized gains or losses from the sale of securities in the banking book such as from securities classified as ‘‘held to maturity’’ and ‘‘available for sale,’’ and (4) exclude extraordinary or irregular items as well as income derived from insurance. 235Based on data from form FR Y–9C, Schedule HI, between 2022Q3 to 2025Q2. Net-interest income would correspond to line 3 from Schedule HI, noninterest income to line 5.m, and noninterest expense excluding salaries and employee benefits, expenses of premises and fixed assets, goodwill impairment losses, and amortization expense and impairment losses for other intangible assets to line 7.d. The proposed higher rate of increase of the business indicator component as a banking organization’s business indicator rises above $1 billion and $30 billion reflects operational risk generally increasing more than proportionally with a banking organization’s overall business volume, in part due to the increased complexity of large banking organizations. This approach is supported by analysis undertaken by the Basel Committee.231 Similarly, academic studies have found that larger U.S. bank holding companies have higher operational losses per dollar of total assets.232
3. Alternative Simple Approaches
In developing the proposal, the agencies considered alternative approaches to the proposed framework for determining a banking organization’s operational risk capital requirement. These alternatives would rely on simpler measures of size and complexity that may provide an appropriate proxy for operational risk exposure. Specifically, the agencies considered an income-based approach and an asset-based approach as alternatives. Each of these approaches could provide a simple alternative for determining operational risk capital, which could easily be measured from existing regulatory reporting. Under an income-based approach, size and complexity—and associated operational risk exposure—could be measured using a broad measure of income, such as gross income, similar to the Basel Committee’s basic indicator approach.233 Under the Basel Committee’s basic indicator approach, risk-weighted assets for operational risk equal 15 percent of average annual gross income, defined as net interest income plus net noninterest income, over the previous three years where annual gross income is positive, multiplied by 12.5. Notably, the definition of gross income under the basic indicator approach excludes certain income statement items.234 In an income-based alternative closest to the Basel Committee’s basic indicator approach, the agencies would define gross income in a given year as netinterest income plus noninterest income minus noninterest expense, where noninterest expense excludes salaries and employee benefits, expenses of premises and fixed assets, goodwill impairment losses, and amortization expense and impairment losses for other intangible assets. Like in the Basel Committee’s basic indicator approach, the calculation of risk-weighted assets for operational risk under this approach would equal the product of the gross income scalar and average annual gross income over the previous three years where annual gross income is positive, multiplied by 12.5. To appropriately calibrate an operational risk capital requirement based on gross income, the agencies considered two alternatives. In the first alternative, the scalar determining the capital requirement would be calibrated to result in a similar amount of aggregate required capital as under the proposed standardized approach for operational risk. Analysis by the agencies suggests that a scalar between 15 and 20 percent would be necessary to achieve the target calibration.235 As a second alternative, the gross income scalar could be set to cover the operational risk exposure of Category I and II banking organizations demonstrated by their historical operational losses. The agencies also considered potential modifications to gross income. For example, gross income could be defined solely as net-interest income plus net-noninterest income, with no exclusions for noninterest expenses. Based on agency analysis of FR Y–9C data between 2022Q3 to 2025Q2, such an approach would require a grossincome scalar
between 35 and 45 percent to result in a similar amount of aggregate required capital as under the proposed standardized approach for operational risk. Separately, both gross income definitions discussed above could be modified to add operational losses (similar to the methodology within the noninterest component under the proposal’s operational risk standardized approach). Such a modification would ensure that operational losses are positively reflected in operational risk capital requirements and could incentivize better operational risk management. Under such a EP27MR26.074</GPH>
236The current capital rule applies certain adjustments to capture off-balance sheet activities. For example, the standardized approach for credit risk utilizes credit conversion factors to incorporate off-balance sheet activities into risk-weighted assets. Similarly, the supplementary leverage ratio incorporates off-balance sheet activities into the calculation of total leverage exposure. 237The interagency paper titled ‘‘Sound Practices to Strengthen Operational Resilience’’ (Nov. 2,
2020) notes that operational resilience ‘‘is the
outcome of effective operational risk management combined with sufficient financial and operational resources to prepare, adapt, withstand, and recover from disruptions.’’ modification, operational losses would be excluded from noninterest expense. The agencies also considered an alternative that would use an institution’s balance sheet, rather than income, for calculating the operational risk capital requirement. Such an approach could use total consolidated assets as an alternative, simple measure of size and complexity and, therefore, as a proxy for operational risk exposure. Asset size is a common proxy for size and complexity in the agencies’ regulatory framework. In an asset-based approach, a scalar would be applied to total assets to determine the operational risk capital requirement. To result in a similar aggregate amount of required capital as under the proposed standardized approach for operational risk, analysis by the agencies suggests that a scalar between 0.4 percent and 0.5 percent would be appropriate. Similar to the income-based approach, the scalar in an asset-based approach could be calibrated to cover the operational risk exposure of Category I and II banking organizations demonstrated by their historical operational losses. An approach based on total assets could be modified to capture off-balance sheet activities, which may improve how the requirement captures operational risk exposure at the cost of some additional complexity.236 Relative to an approach based on income, an approach based on the balance sheet of a banking organization may not appropriately capture the operational risks associated with activities with small footprint in terms of on-balance sheet assets and few quantifiable off-balance sheet exposures. Using gross income or total assets instead of the business indicator to set the operational risk capital requirement would result in a simpler method for calculating the operational risk requirement than the proposal. However, such approaches may be less risk sensitive than the proposed requirement based on the business indicator. Also, use of the business indicator as a proxy for operational risk exposure provides for greater alignment with the Basel standard than these alternatives, consistent with a broader objective of the proposal. Still, the agencies welcome comments on all aspects of these potential alternatives and on alternative calibrations. Question 89: The agencies invite comments on the use of a simple approach for determining a banking organization’s operational risk capital requirement. Are there any aspects associated with using a simple approach that should be considered? What are the advantages and disadvantages of a simple approach relative to the proposed standardized approach for operational risk? Which aspects of the proposed standardized approach for operational risk would provide for greater risk sensitivity relative to the simple approaches discussed above? To what extent should risk
sensitivity be an objective for the operational risk capital requirement, and how should that be weighed against complexity? Question 90: The agencies invite comments on an approach based on gross income for determining a banking organization’s operational risk capital requirement. What are the advantages and disadvantages of such an approach? What are the advantages and disadvantages of excluding salaries and employee benefits, expenses of premises and fixed assets, goodwill impairment losses, and amortization expense and impairment losses for other intangible assets from the definition of gross income? What are the advantages and disadvantages of adding operational losses to gross income in the calculation of the operational risk capital requirement? Provide any analysis supporting your recommendation. Question 91: The agencies invite comments on an asset-based approach for determining a banking organization’s operational risk capital requirement. What are the advantages and disadvantages of such an approach? What are the advantages and disadvantages of including off-balance sheet exposures on the size proxy used in such an approach? How should offbalance sheet exposures be measured under such an alternative? Provide any analysis supporting your recommendation. Question 92: The agencies invite comments on how to calibrate an income-based or an assets-based approach, if such an approach were to be adopted. What are the advantages and disadvantages of using projected requirements under the proposed standardized approach as the basis for calibration? For calibration of an income-based approach: (1) In a gross income variant where salaries and employee benefits, expenses of premises and fixed assets, goodwill impairment losses, and amortization expense and impairment losses for other intangible assets are excluded from the calculation, would a scalar between 15 percent and 20 percent be appropriate and why?(2) In a gross income variant where gross income does not have the exclusions under (1), would a scalar between 35 and percent and 45 be appropriate and why? For the calibration of an asset-based approach would a scalar between 0.4 percent and 0.5 percent be appropriate and why? What are the advantages and disadvantages of calibrating the operational risk capital requirement such that it would capture operational risk exposure as demonstrated by banking organizations’ historical operational losses? If the agencies were to follow such a calibration approach, which methodology should be used to estimate operational risk exposure and why? Provide any analysis supporting your recommendations.
4. Operational Risk Management
The agencies consider effective operational risk management to be critical to ensuring the financial and operational resilience of banking organizations, particularly for large banking organizations.237 Thus, consistent with the current advanced approaches qualification requirements applicable to Category I and II banking organizations, the proposal would require that banking organizations subject to the expanded risk-based approach have an operational risk management function that is independent of business line management. This independent operational risk management function would design, implement, and oversee the comprehensiveness and accuracy of operational loss event data and its collection processes and oversee other aspects of the banking organization’s operational risk management. In addition, banking organizations subject to the expanded risk-based approach would be required to report operational loss events and other relevant operational risk information to business unit management, senior management, and the board of directors (or a designated committee of the board). Lastly, the proposal would require banking organizations subject to the expanded risk-based approach to have
238Risk-Based Capital Standards: Market Risk, 61 FR 47358 (Sept. 6, 1996). The agencies’ market risk capital rules were located at 12 CFR part 3,
appendix B (OCC), 12 CFR part 208, appendix E
and 12 CFR part 225, appendix E (Board), and 12 CFR part 325, appendix C (FDIC). 239Risk-Based Capital Guidelines: Market Risk, 77 FR 53059 (Aug. 30, 2012). 240The rule was subsequently modified in 2013 with changes that included moving the market risk requirements from the agencies’ respective appendices to subpart F of the capital rule; making savings associations and covered savings and loan holding companies with material exposure to market risk subject to the market risk rule, 78 FR 62018 (Oct. 11, 2013); addressing changes to the country risk classifications, clarifying the treatment of certain traded securitization positions; revising the definition of covered position, and clarifying the timing of the market risk disclosure requirements, 78 FR 76521 (Dec. 18, 2013). 241The Basel Committee has published three consultative documents on the review and to address the structural shortcomings identified. ‘‘Fundamental review of the trading book,’’ May 2012, www.bis.org/publ/bcbs219.pdf; ‘‘Fundamental review of the trading book: A revised market risk framework,’’ October 2013, www.bis.org/publ/bcbs265.pdf; and, ‘‘Fundamental review of the trading book: Outstanding issues,’’ December 2014, www.bis.org/bcbs/publ/d305.pdf. The Basel Committee published a new, more robust framework, which established minimum capital requirements for market risk, ‘‘Minimum capital requirements for market risk,’’ January 2016, www.bis.org/bcbs/publ/d352.pdf. 242The proposal would define expected shortfall as a measure of the average of all potential losses exceeding the VaR at a given confidence level and over a specified horizon. The risk weights within the standardized measure were calibrated based on the expected shortfall-based measure in the modelsbased measure for market risk. 243The proposal would define liquidity horizon as the time required to exit or hedge a market risk covered position without materially affecting market prices in stressed market conditions. 244A banking organization that has regulatory approval to use internal models to measure market risk under the current rule would be required to obtain new approval to use the models-based measure for market risk under the proposed framework. 245The proposed desk-level backtesting requirements are intended to measure the accuracy and conservatism of the forecasting assumptions and valuation methods used in the desk’s internal models. 246The proposed desk-level PLA testing requirements are intended to measure the accuracy of the potential future profits or losses estimated by the valuation models used for internal risk management purposes relative to those produced by the financial reporting models. For purposes of this SUPPLEMENTARY INFORMATION, the term ‘‘financial reporting model’’ refers to the valuation methods used to report actual profits and losses for financial reporting purposes. operational loss event data collection processes that meet certain requirements.
V. Calculation of Risk-Weighted Assets
Under the Market Risk Framework A. Market Risk
247See 84 FR 59230, 59249 (Nov. 1, 2019). 248The proposal would define customer and proprietary broker-dealer reserve bank accounts as segregated accounts established by a subsidiary of a banking organization that fulfill the requirements of 17 CFR 240.15c3–3 (SEC Rule 15c3–3) or 17 CFR
1.20 (CFTC Regulation 1.20). 249See section II.E. of this SUPPLEMENTARY
INFORMATION for a more detailed discussion on indexing nominal thresholds in the proposal going forward to reflect CPI–W. 250See 84 FR 59230, 59249 (Nov. 1, 2019). 251For purposes of the proposed scoping criteria, aggregate average trading assets and trading liabilities would mean the sum of the amount of trading assets and the amount of trading liabilities as reported by the banking organization on the Consolidated Financial Statements for Holding Companies (sum of line items 5 and 15 on schedule HC of the Y–9C) or on the Consolidated Reports of Condition and Income (i.e., the sum of line items 5 and 15 on schedule RC of the FFIEC 031, the FFIEC 041, or the FFIEC 051), as applicable. 252 If the banking organization has not reported trading assets and trading liabilities for each of the preceding four calendar quarters, the threshold would be based on the average amount of trading assets and trading liabilities over the quarters that the banking organization has reported, unless the primary Federal supervisor notifies the banking organization in writing to use an alternative method. agencies recognize the potential difficulties that a banking organization could experience when performing the proposed desk-level PLA test. To improve the ability of banking organizations to use more risk-sensitive modeled approaches, where appropriate, the proposal would provide a three-year transition period during which there would be no automatic consequences based on PLA test results. This extended transition period for implementation of the PLA test would allow banking organizations to gain experience with the test, provide time to improve their systems and processes, and address any potential gaps in data and model performance. The delayed transition would also provide the agencies an additional opportunity to monitor the effectiveness of the PLA test metric and thresholds. The proposal would also revise the criteria for determining whether a banking organization is subject to the market risk capital requirements to (1) reflect the inflation since 1996 and growth in the capital markets as well as to reflect CPI–W going forward; (2) provide a more reliable and stable measure of banking organizations’ trading activity by introducing a fourquarter average requirement, and (3) incorporate measures of risk identified as part of the agencies’ 2019 regulatory tailoring rule.247 In general, the revised criteria would take into account the prudential benefits of the proposed market risk capital requirements and the potential costs, including compliance costs. In addition, the proposal would help promote consistency and comparability in market risk capital requirements across banking organizations by strengthening the criteria for identifying positions subject to the proposed market risk capital requirement and by proposing a risk-based capital treatment of transfers of risk between a trading desk and another unit within the same banking organization (internal risk
transfers). The proposal would also improve the transparency of market risk capital requirements through enhanced disclosures.
2. Scope and Application of the
Proposed Rule a. Scope of the Proposed Rule Under the current capital rule, any banking organization with aggregate trading assets and trading liabilities that, as of the most recent calendar quarter, equal $1 billion or more, or 10 percent or more of the banking organization’s total consolidated assets, is required to calculate market risk capital requirements. The proposal would revise the criteria for determining whether a banking organization is subject to market risk capital requirements. Under the proposal, a Category I or Category II depository institution holding company would be subject to market risk capital requirements. In addition, a banking organization with average aggregate trading assets and trading liabilities, excluding customer and proprietary broker-dealer reserve bank accounts,248 over the previous four calendar quarters equal to $5 billion or more or equal to 10 percent or more of total consolidated assets at quarter end as reported on the most recent quarterly regulatory report would be subject to market risk capital requirements.249 The proposed scope is designed to apply market risk capital requirements to the largest and most complex banking organizations. As the agencies noted in the preamble to the final tailoring rule, due to their operational scale or global presence, banking organizations subject to Category I or II capital standards pose heightened risks to U.S. financial stability which necessitate more stringent capital requirements.250 Further, because such banking organizations are generally the most internationally active and interconnected banking organizations, the proposed scope of the market risk capital requirements (which are based largely on the international framework adopted by the Basel Committee), should help promote competitive equity among U.S. banking organizations and their foreign peers and competitors, and reduce opportunities for regulatory arbitrage across jurisdictions. In addition to applying market risk capital requirements to the largest banking organizations, the proposed rule would retain and increase the trading activity threshold from $1 billion to $5 billion to reflect inflation since 1996 and growth in the capital markets. The agencies are also proposing to index the $5 billion trading activity threshold based on the CPI–W going forward. Additionally, a banking organization whose trading assets and trading liabilities are equal to 10 percent or more of its total assets would continue to be subject to market risk capital requirements under the proposal. This means that any subsidiary depository institution of a Category I and II depository institution holding company or any banking organization that is not a Category I or II banking organization would be subject to market risk capital requirements if it has trading activity that exceeds either of these quantitative thresholds. The proposed trading activity dollar threshold would be measured using the average aggregate trading
assets and trading liabilities of a banking organization, calculated in accordance with the instructions to the FR Y–9C or Call Report, as applicable, over the prior four consecutive quarters, rather than using only the single most recent quarter.251 This approach would provide a more reliable and stable measure of the banking organization’s trading activities than the current capital rule’s quarter-end measure.252 Furthermore, for purposes of determining applicability of market risk capital requirements, a banking organization would exclude from its calculation of aggregate trading assets and trading liabilities securities related to certain segregated accounts established by a subsidiary of a banking organization pursuant to SEC Rule 15c3–3 and CFTC Regulation 1.20 (customer and proprietary broker-dealer reserve bank accounts). To protect customers against losses arising from a broker-dealer’s use of customer assets and cash, the SEC’s and CFTC’s requirements for customer and proprietary broker-dealer reserve bank accounts limit the ability of a banking organization to benefit or suffer loss from short-term price movements on the assets held in such accounts. When such accounts constitute the vast majority of a banking organization’s trading activities, the prudential benefit of requiring the banking organization to
253Notably, for securitization positions subject to the market risk capital framework, the current capital rule provides a standardized measurement method for capturing specific risks and a modelsbased measure for capturing general risks for purposes of calculating market risk-weighted assets. 254The proposal would require a banking organization to calculate the standardized measure for market risk on a weekly basis and the modelsbased measure for market risk, if applicable, on a daily basis. measure risk-weighted assets for market risk would be limited. The proposal would only allow a banking organization to exclude these amounts from proposed trading activity thresholds for the purpose of determining whether the banking organization is subject to market risk capital requirements. If a banking organization exceeds either of the proposed trading threshold criteria after excluding such accounts, the proposal would require the banking organization to include such accounts when calculating its market risk capital requirements. b. Application of Proposed Rule The proposal would require a banking organization to comply with the market risk capital requirements (as well as the related reporting and public disclosure requirements) beginning the quarter after the banking organization meets any of the proposed scoping criteria. To avoid volatility in requirements, a banking organization that is not a Category I or II depository institution holding company would remain subject to market risk capital requirements unless and until its trading activity falls below the threshold criteria for each of the prior four consecutive quarters. Implementing the proposed market risk capital requirements would require significant operational preparation. Therefore, the agencies expect that a banking organization would monitor its aggregate trading assets and trading liabilities on an ongoing basis and work with its primary Federal supervisor as it approaches any of the proposed scoping criteria to prepare for compliance. While the proposed threshold criteria for application of market risk capital requirements would help reasonably identify a banking organization with significant levels of trading activity given the current risk profile of the banking organization, there may be unique instances where a banking organization either should or should not be required to reflect market risk in its risk-based capital requirements. To continue to allow the agencies to address such instances on a case-by-case basis, the proposal would retain, without modification, the authority under the market risk framework of the current capital rule for the primary Federal supervisor to either: (1) require a banking organization that does not meet the proposed criteria to calculate a market risk capital requirement, or (2) exclude a banking organization that meets the proposed criteria from such calculation, as appropriate. Question 93: The agencies seek comment on the appropriateness of the
proposed scope of application thresholds. Given the compliance costs associated with the proposal, what, if any, alternative thresholds should the agencies consider and why? Question 94: What are the advantages or disadvantages of using a four-quarter rolling average for the $5 billion aggregate trading assets and trading liabilities scope of application threshold? What different methodologies and time periods should the agencies consider for purposes of this threshold?
3. Measure for Market Risk
Under the current capital rule, a banking organization subject to market risk capital requirements must use one or more internal models to calculate market risk capital requirements for its covered positions.253 A banking organization’s market risk-weighted assets equal the sum of the VaR-based capital requirement, the stressed VaRbased capital requirement, specific risk add-ons, the incremental risk capital requirement, the comprehensive risk capital requirement, and the capital requirement for de minimis exposures, plus any additional capital requirement established by the primary Federal supervisor, multiplied by 12.5. The primary Federal supervisor may require the banking organization to maintain an overall amount of capital that differs from the amount otherwise required under the rule, if the supervisor determines that the banking organization’s market risk-based capital requirements under the rule are not commensurate with the risk of the banking organization’s covered positions, a specific covered position, or portfolios of such positions, as applicable. The proposal would introduce a standardized methodology for calculating market risk capital requirements (standardized measure for market risk) and a new models-based methodology (models-based measure for market risk) to replace the market risk capital framework of the current capital rule. A banking organization with no model-eligible trading desks would calculate market risk capital requirements under the standardized measure for market risk. Alternatively, with prior approval from its primary Federal supervisor, a banking organization that has one or more model-eligible trading desks would be required to calculate market risk capital requirements under the models-based measure for market risk.254 If a trading desk does not receive approval to use the models-based nondefault capital requirement or fails to meet the operational requirements of the models-based non-default capital requirement on an on-going basis, the desk would be required to use the standardized non-default capital requirement to calculate its market risk capital requirements. The agencies view the proposed standardized non-default capital requirement as sufficiently risk sensitive to serve as a credible alternative to the models-based nondefault capital requirement given the conservative calibration of the risk weights and correlations applied to market risk covered positions under the standardized non-default capital requirement. Additionally, by relying in
part on inputs a banking organization
uses for its own internal risk management or financial reporting purposes, the proposed standardized non-default capital requirement would help ensure market risk capital requirements appropriately capture a banking organization’s actual market risk exposure in a manner that minimizes compliance burden and enhances risk-capture. Furthermore, the proposed standardized measure for market risk would promote comparability in market risk capital requirements across banking organizations subject to the proposal. The proposed models-based measure for market risk would provide important improvements to the risk sensitivity and calibration of risk-weighted assets for market risk. In addition to replacing the VaR-based measure with an expected shortfall measure to capture tail risk better, the models-based measure for market risk would replace the fixed ten business-day liquidity horizon in the market risk capital framework of the current capital rule with liquidity horizons that vary based on the underlying risk factors in order to adequately capture the market risk of less liquid positions. The proposal also would limit the regulatory capital benefit of hedging and portfolio diversification across different asset classes, which may dissipate in stress periods. At a high level, both the proposed standardized measure and the modelsbased measure for market risk would consist of a non-default capital
requirement specific to each measure; a default risk capital requirement, which would be the same under both the standardized and models-based measures for market risk; a fallback capital requirement; and a capital addon for re-designations. Each measure would include any additional capital requirement established by the primary Federal supervisor. Figure 1 illustrates the components of the standardized measure for market risk and Figure 2 illustrates the components of the models-based measure for market risk. Each of the components is described below in this section. EP27MR26.075</GPH> EP27MR26.076</GPH>
255A risk factor sensitivity is the change in value of an instrument given a small movement in a risk factor that affects the instrument’s value. 256Under the proposal, the market risk capital requirement for the sensitivities-based method would equal the sum of the capital requirements for a given risk factor for delta (a measure of impact on a market risk covered position’s value from small changes in underlying risk factors), vega (a measure of the impact on a market risk covered position’s value from small changes in volatility) and curvature (a measure of the additional change in the positions’ value not captured by delta arising from changes in the value of an option or an embedded option). As discussed further in section V.A.6.d.i. of this SUPPLEMENTARY INFORMATION, model-eligible trading desk would be allowed to hold insignificant amounts of model-ineligible positions such as securitization positions, correlation trading positions, or certain equity positions in investment funds. The proposal would require a banking organization to calculate the nondefault capital requirement for model-ineligible positions using the standardized non-default capital requirement. 257As discussed further in section V.A.6.d.i. of this SUPPLEMENTARY INFORMATION, model-eligible trading desk would be allowed to hold insignificant amounts of model-ineligible positions such as securitization positions, correlation trading positions, or certain equity positions in investment funds. The proposal would require a banking organization to calculate the non-default capital requirement for model-ineligible positions using the standardized non-default capital requirement. 258For example, periods of sudden and extreme market volatility (such as the COVID pandemic) may significantly increase the number of aggregate trading portfolio backtesting exceptions, which can result in models-based non-default capital requirement being unduly conservative relative to the market risk to which the banking organization is exposed. a. Standardized Non-Default Capital Requirement Under the proposal, the standardized non-default capital requirement would consist of two components: a sensitivities-based method capital requirement and a residual risk add-on, each further described in section V.A.7. of this SUPPLEMENTARY INFORMATION. The sensitivities-based capital requirement captures non-default market risk based on the estimated losses produced by risk factor sensitivities 255 under regulatorily determined stressed conditions.256 The residual risk add-on serves to produce a simple, conservative capital requirement for any other known risks that are not already captured by the sensitivities-based method capital requirement or the default risk capital requirement, including gap risk, correlation risk, and behavioral risks, such as prepayments. b. Non-Default Capital Requirement Under the Models-Based Measure Under the proposal, a banking organization that has received prior supervisory
approval to use the modelsbased measure for market risk could have some trading desks that are eligible for the models-based non-default capital requirement (model-eligible trading desks) and others that are not (modelineligible trading desks).257 The proposal would limit use of the modelsbased non-default capital requirement to those trading desks that can appropriately capture the risks of market risk covered positions in internal models and that satisfy the model eligibility criteria and processes (for example, desk-level backtesting) introduced under the proposal, as described in section V.A.6.d. of this SUPPLEMENTARY INFORMATION. Specifically, if the primary Federal supervisor were to approve a banking organization to calculate market risk capital requirements for one or more model-eligible trading desks under the models-based non-default capital requirement, the banking organization would be required to calculate the entity-wide market risk capital requirement under the models-based measure for market risk, which would incorporate the capital requirements for model-eligible and model-ineligible positions, according to the following formula, as provided under §ll.204(c) of the proposed rule:
Models-based measure for market risk = NDCR + DRC + fallback capital requirement + capital add-on for redesignations Consistent with the standardized nondefault capital requirement as discussed above, the non-default capital requirement under the models-based measure (NDCR) is intended to capture potential losses arising from changes in risk factors under severe stress conditions. More specifically, the proposal would set the non-default capital requirement under the modelsbased measure equal to the sum of (1) the models-based non-default capital requirement for model-eligible positions (IMAG,A) and (2) the difference between the standardized non-default capital requirement for all trading desks (SAall desks) and the standardized nondefault capital requirement for modeleligible positions (SAG,A). NDCR = IMAG,A + (SAall desks¥SAG,A) The agencies recognize that simply adding the standardized non-default capital requirements for modelineligible positions and the modelsbased non-default capital requirements for model-eligible positions (IMAG,A) together would disregard potential diversification effects between these two types of market risk covered positions. In order to appropriately reflect the marginal contribution of modelineligible positions subject to the standardized non-default capital requirement, the proposal would require a banking organization to calculate the standardized non-default capital requirement for all market risk covered positions on all trading desks (SAall desks) and subtract the amount required under the standardized non-default capital requirement for model-eligible positions (SAG,A). To appropriately capture implied diversification benefits between model-eligible and model-ineligible positions across trading desks, the proposal would require a banking organization to calculate the non-default capital requirement as the sum of the models-based non-default capital requirement for model-eligible positions (IMAG,A) and the adjusted standardized non-default capital requirement for model ineligible positions (SAall desks¥SAG,A). In some circumstances, non-default capital requirement for model-eligible positions (IMAG,A) may exceed the standardized non-default capital requirement for model-eligible positions (SAG,A). In such cases, the non-default capital requirement under the modelsbased measure (NDCR) would exceed the standardized non-default capital requirement for all market risk covered positions on all trading desks (SAall desks). While there can be merit in requiring a banking organization to reflect higher capital requirements produced by the models-based nondefault capital requirement for modeleligible positions, there could be instances when the higher capital requirements are not commensurate with the risk profile of the banking organization’s market risk covered positions. To address such situations, the proposal would allow a banking organization, with prior approval from the primary Federal supervisor, to
cap the amount of capital required under the non-default capital requirement of the models-based measure (NDCR) at the standardized non-default capital requirement for all trading desks (SAall desks). To receive approval to cap the non-default capital requirement under the models-based measure, a banking organization would be required to demonstrate to the primary Federal supervisor that the aggregate market risk capital requirement with the cap would be adequate with respect to the risk profile of the banking organization’s market risk covered positions and consistent with safety and soundness.258 Question 95: The agencies seek comment on the recognition of diversification benefits between modeleligible and model-ineligible positions across trading desks. What are the advantages and disadvantages of
259The respective components of the standardized non-default capital requirement are the sensitivities-based method capital requirement and the residual risk add-on. requiring a banking organization to calculate the models-based non-default capital requirement as the sum of the models-based non-default capital requirement for model-eligible positions (IMAG,A) and the adjusted standardized non-default capital requirement for model ineligible positions (SAall desks¥SAG,A), and why? If the agencies were to consider not recognizing any diversification benefits between modeleligible and model-ineligible positions across trading desks, should the agencies consider adopting the following formula:
Models Based Non ¥Default Capital Requirement = min ((IMAG,A + PLA add-on + SAU), SAall desks) + max ((IMAG,A¥SAG,A),0) Where, SAu would be the standardized approach capital requirement for market risk covered positions for modelineligible trading desks. What are the advantages and disadvantages of calculating the models-based non-default capital requirement as the sum of the modelsbased non-default capital requirement for model-eligible trading desks and the standardized non-default capital requirement for model-ineligible trading desks, capped at the capital requirement for all trading desks under the standardized non-default capital requirement, plus the difference between the models-based non-default capital requirement for model-eligible desks and the standardized non-default capital requirement for model-eligible desks? If the agencies were to consider this alternative, what adjustments should be made? Why? Please include any supporting empirical data, including during periods of market stress, and rationale that would be helpful for evaluating this alternative. Question 96: The agencies seek comment on allowing a banking organization to cap the non-default risk capital requirement under the modelsbased measure at the amount required by the standardized non-default capital requirement for all trading desks upon approval by the primary Federal supervisor. What are the advantages and disadvantages of the proposed cap, and why? If the agencies were to consider allowing the cap to be in effect in all circumstances, without prior approval, what are the advantages and disadvantages of the proposed supervisory approval requirement, and why? Commenters are encouraged to provide supporting rationale and data. Question 97: In order to provide appropriate incentives for banking organizations to use internal models, what, if any, alternatives to capping the amount of capital required under the non-default risk capital requirement within the models-based measure at the amount required by the standardized non-default capital requirement for all trading desks should the agencies consider, and why?
c. Default Risk Capital Requirement
The default risk capital requirement, further described in section V.A.9. of this SUPPLEMENTARY INFORMATION, would capture losses on credit and equity positions in the event of issuer default for purposes of both the standardized measure for market risk and the modelsbased measure for market risk. To recognize offsetting of long and short positions across model-eligible and model-ineligible positions, the modelsbased measure for market risk would require banking organizations to perform a single calculation of the default risk capital requirement that includes all market risk covered positions. d. Fallback Capital Requirement The agencies recognize that a banking organization may not be able to calculate market risk capital requirements for one or more of its market risk covered positions under the standardized non-default capital requirement, the models-based nondefault capital requirement, or the default risk capital requirement. For example, a banking organization may not be able to calculate some risk factor sensitivities or components for one or more market risk covered positions due to an operational issue or a calculation failure. Such issues could arise when a new market product is introduced and the banking organization has not had sufficient time to develop models and analytics to produce the required sensitivities or the new data feeds for the proposed market risk capital calculations. In such cases, the proposal would require a banking organization to apply the fallback capital requirement to the affected market risk covered positions, as further described below. For purposes of calculating the standardized measure for market risk, the proposal would require a banking organization to apply the fallback capital requirement to each of the affected positions and exclude such positions from the standardized nondefault capital requirement and the default risk capital requirement.259 For purposes of calculating the models-based measure for market risk, the proposal would require the banking organization to apply the fallback capital requirement to each market risk covered position for which it is not able to apply the models-based non-default capital requirement, the standardized non-default capital requirement, or the default risk capital requirement, as applicable, and exclude such positions from the respective components of models-based measure for market risk. The fallback capital requirement would equal the sum of the absolute value of the fair value of each position subject to the fallback capital requirement, unless the banking organization receives prior approval from its primary Federal supervisor to use an alternative method to quantify the market risk capital requirement for such positions. The fallback capital requirement would only apply in instances where a banking organization is not able to capture all relevant risks of market risk covered positions under the standardized non-default capital requirement, the models-based
nondefault capital requirement, or the default risk capital requirement. As such, the agencies consider that applying a separate capital treatment for such positions is appropriate to ensure that they are conservatively incorporated into the market risk capital requirement. The agencies also recognize that using the fair value for derivatives can materially underestimate the exposure to the derivative positions given the fair market value of any given derivatives can change daily, often with a magnitude much greater than their current fair value. Therefore, for derivative positions that represent more than de-minimis exposure, the banking organizations should notify their primary Federal supervisor. In such cases, the banking organization can propose an alternative methodology (subject to approval from the primary Federal supervisor) or the primary Federal supervisor can mandate a methodology for the banking organization to adopt for the fallback capital requirement. Question 98: The fair value for derivative positions may materially underestimate the exposure because the fair value of derivatives is generally lower than the derivatives’ potential exposure (for example, fair value of a derivative swap contract is generally zero at origination). What are the advantages and disadvantages of using the absolute fair value of the derivative positions for the calculation of the fallback capital requirement? What could be alternative methodologies for the fallback capital requirements for
derivative positions? What, if any, alternative techniques would more appropriately measure the market risk associated with market risk covered positions for which the standardized non-default capital requirement cannot be applied? Question 99: What are the advantages and disadvantages of asking a banking organization to notify its primary Federal supervisor if the banking organization has derivative positions that represent more than de-minimis exposure and it plans to use an alternative methodology to calculate the fallback capital requirement, and why? What are the advantages and disadvantages of requiring a banking organization to notify its primary Federal supervisor, and why? e. Capital Add-On for Re-Designations The proposal would require a banking organization to have clearly defined policies and procedures for identifying positions that are market risk covered positions and those that are not, as well as for determining whether, after such initial designation, a position needs to be re-designated as being a market risk covered position or not. A position’s effect on risk-weighted assets can vary based on whether it is a market risk covered position. Therefore, to offset any potential capital benefit that otherwise might be received from re-designating a position, the proposal would introduce the capital add-on requirement to compensate for any re-designation. The capital add-on requirement for re-designations would apply in cases where a banking organization re-classifies an instrument after initial designation as being subject either to the market risk capital requirements or to the capital requirements under the standardized approach or the expanded risk-based approach, respectively. With prior notification to the primary Federal supervisor, the proposal would not require a banking organization to apply the capital add-on for re-designations arising from circumstances that are outside of the banking organization’s control (for example, changes in accounting standards or in the characteristics of the instrument itself, such as an equity being listed or delisted). The agencies expect redesignations to be extremely rare, and recognize that re-designations could occur, for example, due to the termination of a business activity applicable to the instrument. Given the very limited circumstances under which re-designations would occur, any redesignation would be irrevocable, unless the banking organization receives prior approval from its primary Federal supervisor. To calculate the capital add-on for a re-designation, a banking organization would be required to calculate its total capital requirements for the redesignated positions separately under the standardized approach or the expanded risk-based approach, as applicable, and under market risk capital framework before and immediately after the re-designation of a position. If the total capital requirement is lower as a result of the re-designation, then the difference between the two
would be the capital add-on for the re-designation to avoid any resultant reduction in market risk capital requirements. The proposal would require a banking organization to calculate the capital add-on requirement at the time of the redesignation. The capital add-on requirement would decline proportionate to the balance sheet value relative to the time of the re-designation. This could occur when an instrument matures, pays down, amortizes, or expires, or the banking organization sells or exits (in whole or in parts) the position. Question 100: What, if any, operational challenges could the proposed capital add-on calculation pose? What, if any, changes should the agencies consider making to the proposed exceptions to the capital addon, such as to address additional circumstances in which the capital addons for re-designations should not apply, and why? For example, what would be advantages and disadvantages of exempting transactions in high quality liquid assets (HQLA) between a business unit of a banking organization that engages in asset-liability management and internal trading desk from the re-designation framework, and why? Question 101: The agencies seek comment on whether the re-designation framework should include a grace period (for example, 10 business days) that would allow a banking organization to identify and correct any errors during the initial re-designation process. What are the advantages and disadvantages of the grace period and why? f. Additional Capital Requirement and Other Provisions As part of the proposal’s reservation of authority provisions, the primary Federal supervisor may require a banking organization to maintain an overall amount of capital that differs from the amount otherwise required under the proposal, if the primary Federal supervisor determines that the banking organization’s market risk capital requirements under the proposal are not commensurate with the risk of the banking organization’s market risk covered positions, a specific market risk covered position, or categories of positions, as applicable. The primary Federal supervisor also would have the authority to require a banking organization to calculate capital requirements for specific positions or categories of positions under either the standardized approach or the expanded risk-based approach instead of under the market risk capital framework, or under the market risk capital framework instead of under the standardized approach or the expanded risk-based approach, as applicable, to more appropriately reflect the risks of the positions. Alternatively, under the proposal, the primary Federal supervisor may require a banking organization to apply a capital add-on for re-designations of specific positions or portfolios. These proposed provisions would help the primary Federal supervisor ensure that a banking organization’s risk-based capital requirements appropriately reflect the risks of such positions. Additionally, for a banking organization
that uses the models-based measure for market risk, the agencies would reserve the authority to require such a banking organization to modify its observation period or methodology (including the stress period) used to measure market risk, when calculating the expected shortfall measure or stressed expected shortfall. In this way, the proposal would help the primary Federal supervisor ensure that a banking organization’s internal models remain sufficiently robust to capture risks in a dynamic market environment and appropriately reflect the risks of such positions. Furthermore, the primary Federal supervisor could require a banking organization that has one or more model-eligible trading desks to calculate the standardized non-default risk capital requirement for each modeleligible trading desk as if that trading desk were a standalone regulatory portfolio. This situation could arise when, for example, a banking organization is unable to empirically justify the correlation of a trading desk’s losses with other model-eligible trading desks.
4. Market Risk Covered Position
Market risk capital requirements under the current capital rule apply to a banking organization’s covered positions, which are defined to include, subject to certain restrictions: (i) any trading asset or trading liability as
260The current capital rule defines a trading position as one that is held by a banking organization for the purpose of short-term resale or with the intent of benefiting from actual or expected short-term price movements or to lock-in arbitrage profits. 261With prior approval from its primary Federal supervisor, the proposal would allow a banking organization to exclude from its market risk covered positions any structural position in a foreign currency, which is defined as a position that is not a trading position and that is (i) a subordinated debt, equity or minority interest in a consolidated subsidiary that is denominated in a foreign currency; (ii) capital assigned to foreign branches that is denominated in a foreign currency; (iii) a position related to an unconsolidated subsidiary or another item that is denominated in a foreign currency and that is deducted from the banking organization’s tier 1 or tier 2 capital, or (iv) a position designed to hedge a banking organization’s capital ratios or earnings against the effect of adverse exchange rate movements on (i), (ii), or (iii). 262Consistent with the current capital rule, the proposal also would require such a position to be free of any restrictive covenants on its tradability or for the banking organization to be able to hedge the material risk elements of such a position in a two-way market. 263A position that hedges a trading position would be required to be within the scope of the banking organization’s hedging strategy as described in §ll.203(a)(2) of the proposed rule. Extending market risk covered positions to also include such hedges is intended to encourage sound risk management by allowing a banking organization to capture both the underlying market risk covered position and any associated hedge(s) when calculating its market risk capital requirements. Consistent with current practice, the agencies would review a banking organization’s hedging strategies to ensure the appropriate designation of positions subject to market risk capital requirements. 264The proposal would define CVA hedge as a transaction that a banking organization enters into with a third party or an internal trading desk and manages for the purpose of mitigating CVA risk. Thus, the proposal would exclude from market risk capital requirements any CVA hedge—regardless of whether or not a banking organization is subject to CVA risk capital requirements. 265Equity positions in investment funds arising from bank-owned life insurance, corporate ownedlife insurance owned by an affiliate, or that the banking organization has acquired for the purpose of providing such fund with sufficient initial equity to permit the fund to attract unaffiliated investors and held for less than five years (‘‘seed capital investments’’) and any hedges of such positions that qualify for effective hedge pair treatment under §ll.52(c) of the current rule or §ll.141(c) of the proposal would not be included in the scope of market risk
covered position. 266Equity positions arising from deferred compensation plans and hedges of such positions that qualify for effective hedge pair treatment under §ll.52(c) of the current rule or §ll.141(c) of the proposal would not be included in the scope of market risk covered position. 267With prior approval from its primary Federal supervisor, the proposal would allow a banking organization to include in the scope of market risk covered positions an entire instrument with an embedded derivative issued by the banking organization and that relates to credit or equity risk and for which the banking organization elects the fair value option for purposes of financial reporting. 268See section V.A.5. of this SUPPLEMENTARY INFORMATION for further detail on eligible internal risk transfer positions. 269 15 U.S.C. 80a–1 et seq. reported on a banking organization’s regulatory reports that is a trading position 260 or that hedges another covered position and is free of any restrictive covenants on its tradability or for which the material risk elements may be hedged by the banking organization in a two-way market, and (ii) any foreign exchange 261 or commodity position regardless of whether such position is a trading asset or trading liability. The definition of a covered position also explicitly excludes certain positions. Thus, the definition is structured into three broad categories, each subject to certain conditions: trading assets or liabilities that are covered positions, positions that are covered positions regardless of whether they are trading assets or trading liabilities, and exclusions. The proposal would retain the structure and major elements of the existing definition of covered position (re-designated as ‘‘market risk covered position’’) with several modifications. These modifications aim to better align the definition of market risk covered position with those positions the agencies consider should be subject to the market risk capital requirements, as well as to reflect other proposed changes to the framework (for example, to incorporate the proposed treatment of internal risk transfers). The proposed revisions would capture positions that have exposures to market risk and also help promote consistency and comparability in the risk-based capital treatment of positions across banking organizations. a. Trading Assets and Trading Liabilities That Would Be Market Risk Covered Positions Under the Proposal The proposed definition of market risk covered position would explicitly include any trading asset or trading liability that is held for the purpose of regular dealing or making a market in securities or other instruments.262 In general, such positions are held to facilitate sales to customers or otherwise to support the banking organization’s trading activities, for example by hedging its trading positions, and, therefore, expose a banking organization to market risk. b. Positions That Would Be Market Risk Covered Positions Under the
Proposal Regardless of Whether They are Trading Assets or Trading Liabilities The proposal would include as market risk covered positions certain positions or hedges of such positions regardless of whether the position is a trading asset or trading liability.263 Consistent with the current capital rule, such positions would continue to include foreign exchange and commodity positions with certain exclusions. In particular, the proposal would continue to allow a banking organization to exclude structural positions in a foreign currency from market risk covered positions with prior approval from its primary Federal supervisor. To incentivize prudent hedging and sound risk management, the proposal would also exclude foreign exchange and commodity positions that are CVA hedges from the definition of market risk covered position.264 The proposal would also expand the types of positions that would be market risk covered positions, even if not categorized as trading assets or trading liabilities, to include the following, each discussed further below: (i) certain equity positions in an investment fund; 265 (ii) net short risk positions; (iii) certain publicly traded equity positions; 266 (iv) certain embedded derivatives on instruments issued by the banking organization that relate to credit or equity risk and that the banking organization bifurcates for accounting purposes or elects the fair value option for purposes of financial reporting; 267 (v) certain positions associated with internal risk transfer under the proposal; 268 and (vi) certain instruments resulting from securities underwriting commitments. First, the proposal would include as a market risk covered position an equity position in an investment fund for which the banking organization has access to the fund’s prospectus, partnership agreement, or similar contract that defines the fund’s permissible investments and investment limits, and which meets one of two conditions. Specifically, the banking organization would either need to (i) be able to use the look-through approach to calculate a market risk capital requirement for its proportional ownership share of each exposure held by the investment fund, or (ii) obtain daily price quotes for the investment fund. The current covered position definition relies in part on the legal form of the investment fund by referencing the Investment Company Act of 1940 269 to determine whether an equity position in such a fund is a covered position. In contrast, the proposed criteria would capture equity positions for which there is sufficient transparency for the positions to be reliably valued on a daily basis. This valuation could come either from an observable market price for the equity position in the investment fund itself or
270The proposal would retain, without modification, the existing definition of trading position in the market risk capital framework of the current capital rule. See 12 CFR 3.202 (OCC); 12 CFR 217.202 (Board); 12 CFR 324.202 (FDIC). 271As discussed in section II.E. of this SUPPLEMENTARY INFORMATION, the proposal would index the $20 million threshold for net short risk positions going forward on an annual basis to reflect CPI–W. 272For equity derivatives, the adjusted notional amount would be the product of the current price of one unit of the stock (for example, a share of equity) and the number of units referenced by the trade. 273For net short-risk positions, banking organizations may use their spot, quarter-end calculations for the purposes of their weekly calculations of the standardized measure for market risk or daily calculations of the models-based measure for market risk. 274The proposal would not change the current capital rule’s definition of publicly traded as 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 is registered with, or approved by, a national securities regulatory authority and that provides a liquid, two-way market for the instrument in question. Consistent with the current capital rule, the proposal would define a two-way market as a market where there are independent bona fide offers to buy and sell so that a price reasonably related to the last sales price or current bona fide competitive bid and offer quotations can be determined within one day and settled at that price within a relatively short time frame conforming to trade custom. 275This would apply to hybrid contracts containing an embedded derivative that must be separated from the host contract and accounted for as a derivative instrument under ASC Topic 815, Derivatives and Hedging (formerly FASB Statement No. 133 ‘‘Accounting for Derivative Instruments and Hedging Activities,’’ as amended). 276For purposes of regulatory reporting, the instructions to the FR Y–9C and Call Report require a banking organization to classify as trading securities all debt securities that a banking organization has elected to report at fair value under a fair value option with changes in fair value reported in current earnings, regardless of whether such positions are held with trading intent. ASC 815–15–25–4 permits both issuers of and investors in hybrid financial instruments that would from the banking organization’s ability to identify the underlying positions held by the investment fund. Second, the proposal would introduce a new term, net short risk positions, to describe credit and equity exposures that are outright short positions or overhedges of credit and equity exposures that are not market risk covered positions. As the hedged exposures from which such positions originate are not traded, net short risk
positions would not meet the definition of trading position even though they expose the banking organization to market risk.270 The agencies propose to include any net short risk position of at least $20 million, adjusted to reflect CPI–W, in market risk covered positions in order to help ensure that such exposures are appropriately reflected in banking organizations’ risk-based capital requirements.271 For example, assume a banking organization purchases an eligible credit derivative (for example, a credit default swap) to mitigate the credit risk arising from a loan that is not a market risk covered position and the notional amount of protection provided by the credit default swap exceeds the loan exposure amount. The banking organization is exposed to additional market risk on the exposure arising from the difference between the amount of protection purchased and the amount of protected exposure because the value of the protection would fall if the credit spread of the credit default swap narrows. Neither the standardized approach nor the expanded risk-based approach would require the banking organization to reflect this risk in riskweighted assets. To capture the market risk arising from net short risk positions, the proposal would require the banking organization to treat such positions that meet or exceed the proposed dollar threshold described above as market risk covered positions. To calculate the exposure amount of a net short risk position, the proposal would require a banking organization to compare the notional amounts of its long and short credit positions and the adjusted notional amounts of its long and short equity positions that are not market risk covered positions.272 For purposes of this calculation, the notional amounts would include the total funded and unfunded commitments for loans that are not market risk covered positions. Additionally, as a banking organization may hedge exposures at either the single-name level or the portfolio level, the proposal would require a banking organization to identify separately net short risk positions for single-name exposures and for index hedges. For single-name exposures, a banking organization would need to evaluate its long and short equity and credit exposures for all positions referencing a single name or obligor to determine if it has a net short risk position. For index hedges, a banking organization would need to evaluate its long and short equity and credit exposures for all positions that are not market risk covered positions in the hedged portfolio (aggregating across all relevant individual exposures) to determine if it has a net short risk position for any hedged portfolio. Exposures arising from net short risk positions are a potential area where a banking organization may maintain insufficient capital relative to the market risk. The agencies nonetheless recognize that requiring a banking organization to capture every net short exposure that may arise, regardless of size
or duration, when calculating its market risk capital requirements could be burdensome. Accordingly, the proposed $20 million threshold is intended to help ensure that individual net short risk exposures that could materially impact the risk-based capital requirements of a banking organization would be appropriately reflected in the proposed market risk capital requirements. Additionally, the proposed $20 million threshold is intended to strike a balance between over-hedging concerns and aligning incentives for banking organizations to prudently hedge and manage risk while capturing positions for which a market risk capital requirement would be appropriate. For example, if a loan amortizes more quickly than expected, due to a borrower making additional payments to pay down principal, the amount of notional protection would only constitute a net short risk position if it exceeds the amount of the total committed loan balance by $20 million or more. The operational burden of requiring a banking organization to capture temporary or small differences due to accelerated amortization within its market risk capital requirements could inhibit the banking organization from engaging in prudential hedging and sound risk management. The proposal would require a banking organization to calculate net short risk positions on a spot, quarter-end basis, consistent with regulatory reporting, in order to reduce the operational burden of identifying such positions subject to the proposed market risk capital requirements.273 Third, the proposal generally would include as market risk covered positions all publicly traded equity positions 274 regardless of whether they are trading assets or trading liabilities, provided that there are no restrictions on the tradability of such positions. Fourth, a banking organization may issue hybrid instruments that contain an embedded derivative related to credit or equity risk and a host contract, and bifurcate the derivative and the host contract for accounting purposes under GAAP or elect the fair value option for such an embedded derivative for purposes of financial reporting.275 Under such circumstances, the proposal would include the embedded derivative in the definition of market risk covered position regardless of whether GAAP treats the derivative as a trading asset or a trading liability.276 This approach
otherwise require bifurcation of an embedded derivative to elect at acquisition, issuance or a new basis event to carry such instrument at fair value with all changes in fair value reported in earnings. 277For example, a conventional mortgage loan contains an embedded prepayment or call option. 278For example, a banking organization can choose to hedge structured notes issued by a banking organization that are linked to credit or equity risk with trading instruments even if the banking organization does not view the structured note as a trading position. 279The agencies anticipate that such approval would be granted in limited circumstances such as where the instrument or associated hedges trade or may be hedged in liquid, two-way markets. 280Under the proposal, only banking organizations subject to CVA risk capital requirements would be required to treat the trading desk segment of an eligible internal risk transfer of CVA risk as a market risk covered position, as described in section V.B.2. of this SUPPLEMENTARY INFORMATION. The proposed definition of market risk covered position would not include the trading desk segment of an eligible internal risk transfer of CVA risk for banking organizations subject to the market risk framework but not CVA risk framework. 281An external transaction generally refers to a transaction between a banking organization and an unaffiliated third party (except that in the case of a banking organization that is a depository institution, a transaction with an affiliate that is not a direct or indirect subsidiary of the depository institution would also be an external transaction for purposes of the depository institution’s stand-alone capital requirement). 282See 77 FR 53060, 53064–65 (Aug. 30, 2012) for a more detailed discussion on these exclusions under the market risk capital rule. 283See definition of ‘‘CVA hedge’’ and ‘‘market risk covered position’’ under §ll.202 of the proposal rule. 284 Direct real estate holdings include real estate for which the banking organization holds title, such as ‘‘other real estate owned’’ held from foreclosure activities, and bank premises used by the bank as
part of its ongoing business activities.
285See 77 FR 53060, 53065 (August 30, 2012) for the agencies’ interpretive guidance on the treatment of such indirect holdings under the market risk capital framework of the capital rule. 286For example, the proposal would exclude equity positions in investment funds arising from Continued would capture the market risk of embedded derivatives a banking organization faces when it issues such hybrid instruments while being sensitive to the operational challenges of requiring banking organizations to calculate the fair value of such derivatives on a daily basis, and also appropriately exclude conventional instruments with an embedded derivative for which the capital requirements under the standardized approach or the expanded risk-based approach, as applicable, would be appropriate.277 If a banking organization elects to report the entire hybrid instrument at fair value under the fair value option for accounting purposes (rather than bifurcating the derivative and host contract), the proposal would allow the banking organization to treat the entire instrument (and any associated hedges) as a market risk covered position with prior approval from the primary Federal supervisor. The agencies recognize such hybrid instruments can also present market risk, which banking organizations may choose to hedge either at the level of the embedded derivative or the entire instrument. To encourage sound risk management without unduly increasing operational burden or decreasing the overall capital required under the market risk framework,278 the proposal would allow banking organizations to treat the entire instrument (as well as any associated hedges) as a market risk covered position with prior approval from the primary Federal supervisor.279 Fifth, the proposed definition of market risk covered position would include certain transactions of internal risk transfers, as described in section V.A.5. of this SUPPLEMENTARY INFORMATION, based in certain cases on the eligibility of the internal risk transfers. The market risk covered position would explicitly include (1) the trading desk segment of an eligible internal risk transfer of credit risk, interest rate risk, or CVA risk; 280 and (2) certain external transactions 281 based on eligibility of the risk transfers, executed by a trading desk related to an internal risk transfer of credit or interest rate risk. This aspect of the proposal is intended to help promote consistency and comparability in the risk-based capital treatment of such positions across banking organizations and ensure the appropriate capitalization of such positions under the standardized approach, the expanded risk-based approach, or the market risk capital framework of the capital rule. Sixth, the proposed definition of market risk covered position would include instruments resulting from securities underwriting commitments where the securities are expected to be purchased by the banking organization on the settlement date, except those that a
banking organization expects to classify as held to maturity or available for sale upon purchase. In general, such positions are held for sale or otherwise to support the banking organization’s trading activities and, therefore, expose a banking organization to significant market risk. The agencies recognize that there may be circumstances under which the banking organization, as underwriter, might hold securities for investment purposes that it could not sell in the distribution. As such securities are not reflective of a banking organization’s trading activity, the proposal would exclude instruments that a banking organization expects to purchase for held to maturity or available for sale purposes from the definition of market risk covered position.
c. Exclusions From the Proposed
Definition of Market Risk Covered Position The definition of a covered position in the current capital rule explicitly excludes certain positions.282 These excluded instruments and positions generally reflect the fact that they are either deducted from regulatory capital, explicitly addressed under the standardized approach and advanced approaches of the current capital rule, have significant constraints in terms of a banking organization’s ability to liquidate them readily and value them reliably on a daily basis, or are not held with trading intent. Consistent with the current capital rule, the proposal would continue to exclude from the definition of market risk covered positions: (1) any intangible asset, including any servicing asset; (2) any hedge of a trading position that the banking organization’s primary Federal supervisor determines to be outside the scope of the banking organization’s trading and hedging strategy; (3) any instrument that, in form or substance, acts as a liquidity facility that provides support to asset-backed commercial paper; (4) any position a banking organization holds with the intent to securitize; and (5) any CVA hedge.283 The proposed definition would also continue to exclude from market risk covered positions any direct real estate holdings.284 Consistent with past guidance from the agencies, indirect investments in real estate, such as through REITs or special purpose vehicles, would not be direct real estate holdings and could be market risk covered positions if they meet the proposed definition.285 The proposed definition would also exclude the following from the definition of market risk covered position: (1) any non-publicly traded equity positions, other than certain equity positions in investment funds, (2) any publicly traded equity position that has restrictions on tradability; (3) any publicly traded equity position that is a significant investment in the capital of an unconsolidated financial institution in the form of common stock not deducted from regulatory capital, as applicable, (4) any equity position in an investment fund that is not a trading asset or trading liability or that otherwise does not meet the requirements to be a market risk covered position,286 and (5) equity positions that
bank-owned life insurance and corporate ownedlife insurance owned by an affiliate from the scope of market risk covered position. Such positions are held for the purpose of covering the cost of providing benefits to employees and retirement planning, and not with trading intent. Similarly, the proposal would exclude equity positions in investment funds arising from seed capital investments from the definition of market risk covered position. A banking organization typically invests a limited amount of its own capital as part of organizing the fund to produce investment performance as a record of the fund’s investment strategy (‘‘track record’’). Only once a track record is established would the banking organization market the fund to investors with trading intent. As investors may demand a track record of at least five years before investing in the fund, the proposal would exclude equity positions in investment funds arising from seed capital investments, if the banking organization has held the fund for less than five years from the date on which the investment adviser or similar entity to the fund begins making initial investments pursuant to the written strategy of the fund upon its establishment. The exclusion is not intended to be used in situations where an investment manager provides additional capital to a fund after the fund has developed a track record. See (2)(x) and (2)(xiv) within the definition of market risk covered position under §ll.202 of the proposal. 287For banking organizations subject to market risk capital requirements under the capital rule, the Volcker Rule defines the scope of instruments subject to the proprietary trading prohibition (trading account) based on two prongs: market risk capital rule covered positions that are trading positions, and instruments purchased or sold in connection with the business of a dealer, swap dealer, or securities-based swap dealer that require it to be licensed or registered as such. The proposed revisions to the definition of covered positions (redesignated as ‘‘market risk covered position’’), as described in section V.A.4. of this SUPPLEMENTARY INFORMATION, could alter the scope of financial instruments deemed to be in the trading account under the Volcker Rule, but only to the extent that a market risk covered position is also a trading position and the position is not otherwise excluded from the Volcker rule definition of trading account. See 12 CFR 44.3(b) (OCC); 12 CFR 248.3(b) (Board); 12 CFR 351.3(b) (FDIC). 288Such risks can include credit, interest rate, or CVA risk arising from exposures that are subject to risk-based requirements under the standardized approach, the expanded risk-based approach, or the market risk capital framework of the capital rule. 289For example, if the banking organization is a depository institution within a holding company structure, transactions conducted between the depository institution and an affiliated brokerdealer entity that is not a
subsidiary of the depository institution would not qualify as transactions within the same banking organization for the depository institution. Such transactions would qualify as transactions within the same banking organization for the consolidated holding company. qualify as effective hedges pursuant to § ll.52(c) of the current capital rule or § ll.141(c) of the proposal. The proposed definition would add an exclusion for any derivative instrument or exposure to an investment fund that has material exposures to any of the preceding excluded instruments or positions discussed in this section. The proposal would also add an exclusion for instruments held for the purpose of hedging a particular risk of a position in any of the preceding excluded types of instruments discussed in this section. Question 102: The agencies seek comment on the appropriateness of the proposed definition of market risk covered position. What, if any, practical challenges might the proposed definition pose for banking organizations, such as the ability to fair value daily any of the proposed instruments that would be captured by the definition? 287 Question 103: The proposal would include as a market risk covered position an equity position in an investment fund that satisfies the conditions described in the definition of ‘‘market risk covered position’’ in § ll.202. Consistent with the definition of ‘‘investment fund’’ under the current capital rule, to be an eligible market risk covered position, an equity position must be in a company (1) where all or substantially all of the assets of the company are financial assets, and (2) that has no material liabilities. The agencies seek comment on whether a more specific definition of eligible ‘‘investment fund’’ would be appropriate for market risk covered positions. For example, what other vehicles that do not meet the criteria of the ‘‘investment fund’’ definition but would be subject to market risk capital requirements, in a manner that such positions would be most appropriately subject to market risk capital requirements, such as an investment fund with material liabilities? What are the advantages and disadvantages of subjecting such investment funds to market risk capital requirements, and why? Alternatively, what additional conditions or limitations should the agencies consider to place on investment funds eligible for being a market risk covered position, beyond those currently in the proposal? Question 104: The agencies seek comment on the extent to which limiting the proposed definition of market risk covered position to include equity positions in investment funds only for which a banking organization has access to the fund’s investments limits (as specified in the fund’s prospectus, partnership agreement, or similar contract that define the fund’s permissible investments) appropriately captures the types of positions that should be subject to regulatory capital requirements under the proposed market risk
framework. What types of investment funds, if any, would a banking organization have the ability to value reliably on a daily basis that do not meet this condition? In addition, what are the advantages and disadvantages of excluding equity positions in investment funds arising from bank-owned life insurance or corporate-owned life insurance from the definition of market risk covered positions? Question 105: For the purposes of determining whether certain positions are within the definition of market risk covered position, is the proposed definition of net short risk position appropriate, and why? What, if any, alternative measures should the agencies consider to identify net short risk positions and why would these be more appropriate? Question 106: The agencies seek comment on whether the proposed $20 million threshold is an appropriate measure for identifying significant net short risk exposures that warrant capitalization under the market risk framework. What alternative thresholds or methods should the agencies consider for identifying significant net short risk positions, and why would these alternatives be more appropriate than the proposed $20 million threshold? Question 107: What, if any, challenges might banking organizations face in calculating the market risk capital requirement for net short risk positions? In particular, what, if any, alternatives to the total commitment for loans should the agencies consider using to calculate notional amount—for example, delta notional values rather than notional amount, present value, sensitivities—and why would any such alternatives be a better metric? Please provide specific details on the mechanics of and rationale for any suggested methodology. In addition, which, if any, of the items to be included in a banking organization’s net short credit or equity risk position may present operational difficulties and what is the nature of such difficulties? How could such concerns be mitigated?
5. Internal Risk Transfers
A banking organization may choose to hedge the risks of certain positions 288 held by a banking unit or a CVA desk by having one of its trading desks obtain the hedge for a banking unit or a CVA desk exposure. The current capital rule does not address the transfers of risk from a banking unit or a CVA desk (or a functional equivalent thereof) to a trading desk within the same banking organization 289 (internal risk transfers), for example between a mortgage banking unit and a rates trading desk. Thus, market risk-weighted assets do not reflect the market risk of such internal transactions and capture only
290An internal risk transfer transaction would comprise two perfectly offsetting segments—one segment for each of two parties to the transaction. 291As described in section V.A.7.b.ii. of this SUPPLEMENTARY INFORMATION, for transfers of risk between a trading desk that uses the standardized non-default capital requirement and a trading desk that uses the models-based non-default capital requirement, a banking organization may exclude the leg of the transaction acquired by the trading desk using the standardized non-default capital requirement from the residual risk add-on. 292The agencies recognize that some internal risk transfers will be executed by means of legally binding contracts entered into between affiliates, while others will be executed between business units within the same legal entity under other arrangements, and that the form of documentation used by a banking organization may vary accordingly. 293The proposal would not require a banking organization to purchase the hedge from a third party for such transactions to qualify as an internal risk transfer, because tracking interest rate risk transfers can be operationally burdensome. the external portion of the hedge, potentially misrepresenting the risk position of the banking organization. Accordingly, the proposal would define internal risk transfers and establish a set of requirements including documentation and other conditions for a banking organization to recognize certain types of internal risk transfers in risk-based capital requirements. The proposal would define internal risk transfers as transfers executed through internal derivatives trades of credit risk or interest rate risk arising from an exposure capitalized under the standardized approach of the capital rule or the proposed expanded riskbased approach to a trading desk, or a transfer of CVA risk arising from a CVA desk (or the functional equivalent if the banking organization does not have any CVA desks) to a trading desk.290 The proposed definition of internal risk transfer would not include transfers of risk from a trading desk to a banking unit or between trading desks because such transactions present the types of risks appropriately captured in market risk-weighted assets.291 In practice, for internal risk management purposes, most banking organizations already document the source of risk being hedged and the trading desk providing the hedge.292 As a result, the agencies do not expect the proposed documentation requirements for such transactions to qualify as eligible internal risk transfers, as described in more detail below, to pose a significant compliance burden on banking organizations. The agencies encourage prudent risk management and view that this aspect of the proposal will help promote consistency and comparability in the risk-based capital treatment of such internal transactions across banking organizations and ensure the appropriate capitalization of such positions. a. Internal Risk Transfers of
Credit Risk The Basel standards introduce a riskbased capital treatment for internal transfers of credit risk executed from a banking unit to a trading desk to hedge the credit risk arising from exposures in the banking unit. The proposal is generally consistent with the Basel standards in specifying the criteria for internal risk transfer eligibility and clarifying the scope of exposures subject to market risk capital requirements. Specifically, a banking organization would be required to maintain documentation identifying the underlying exposure under the standardized approach or the expanded risk-based approach, as applicable, being hedged and its sources of credit risk. In addition, a trading desk would be required to enter into an external hedge that meets the requirements of § ll.36 of the current capital rule or § ll.120 of the proposed rule and matches the terms, other than amount, of the internal credit risk transfer at trade initiation. The agencies recognize that under certain circumstances a banking organization could choose to novate to a CCP an external transaction entered into in connection with an internal risk transfer. Because such transactions could be subject to compression, the terms of the internal risk transfer, aside from amount, would not be identical to the terms of the external hedge of credit risk post trade initiation. As such, the proposal would require the terms of the external hedge and the internal risk transfer to be identical only at trade initiation. When these requirements are met, the transaction would qualify as an eligible internal risk transfer, for which the banking unit would be allowed to recognize the amount of the hedge position received from the trading desk as a credit risk mitigant when calculating the risk-based capital requirements for the underlying exposure under the standardized approach or the expanded risk-based approach. Because the trading desk enters into external hedges to manage credit risk arising from banking unit exposures, such external hedges would be included in the scope of market risk covered positions along with the internal risk transfer (the trading desk segment), where they would cancel out each other provided the amounts and terms of both transactions match. Nevertheless, if the internal risk transfer results in a net short credit position greater than $20 million for the banking unit, the trading desk would be required to calculate market risk-based capital requirements for such positions. A net short risk credit position results when the external hedge exceeds the amount required by the banking unit to hedge the underlying exposure under the standardized approach or the expanded risk-based approach. For transactions that do not meet these requirements, the proposal would require a banking organization to disregard the internal risk transfer (the trading desk segment) from the market risk covered positions. The proposal would subject the entire amount of the external
hedge acquired by the trading desk to the proposed market risk capital requirements and disallow any recognition of risk mitigation benefits of the internal credit risk transfer under the standardized approach or the expanded risk-based approach, as applicable. b. Internal Risk Transfers of Interest Rate Risk The proposal would specify the riskbased capital treatment of internal transfers of interest rate risk from a banking unit to the trading desk to hedge the interest rate risk arising from the banking unit. When a banking organization executes an internal interest rate risk transfer between a banking unit and a trading desk, the transferred interest rate risk exposure would be considered an eligible risk transfer that the banking organization may treat as a market risk covered position only if such internal risk transfer meets a set of requirements. Specifically, the banking organization would be required to maintain documentation of the underlying exposure being hedged and its sources of interest rate risk.293 In addition, given the complexity of tracking the direction of internal transfers of interest rate risk, the proposal would allow a banking organization to establish a dedicated notional trading desk for conducting internal risk transfers to hedge interest rate risk. If a banking organization conducts internal transfers of interest rate risk on a dedicated notional trading desk, the proposal would require a banking organization to calculate market risk capital requirements for such positions on the dedicated notional trading desk on a standalone basis apart from all other market risk covered positions. Specifically, a banking organization would be required to calculate either the standardized measure for market risk or the modelsbased measure for market risk, if
294As the trading desk segments of eligible internal risk transfers of interest rate risk would be market risk covered positions, to the extent a trading desk enters into external hedges to mitigate the risk of such positions, the external hedge would also be subject to the market risk capital rule and could in whole or in part offset the market risk of the eligible internal risk transfer. 295Under the proposal, the requirements for internal CVA risk transfers would not apply to banking organizations that are not subject to the proposed CVA risk capital requirement. See section V.B.2. of this SUPPLEMENTARY INFORMATION for the scope of banking organizations that would be subject to CVA risk capital requirements under the proposal. 296While the basic approach for CVA applies certain restrictions on eligible instrument types for hedges to be recognized as eligible, the standardized approach for CVA risk allows for a broader set of hedging instruments. Moreover, the standardized approach for CVA risk would also recognize as eligible hedges instruments that are used to hedge the exposure component of CVA risk. 297For example, the proposed market risk covered position would exclude equity positions arising from deferred compensation plans and hedges of such positions that qualify for effective hedge pair treatment under §ll.52(c) of the current capital rule and under §ll.141(c) of the proposed rule. See section V.A.4.b. of this SUPPLEMENTARY INFORMATION for the proposed definition of market risk covered position. 298Consistent with the current capital rule, the proposed equity risk framework under the expanded risk-based approach would allow firms to apply the effective hedge pair treatment to equity exposures not subject to market risk capital requirements for which the banking organization can demonstrate that the hedge transaction at initiation satisfies one of the three hedge effectiveness tests. applicable, for the internal risk transfer positions on the dedicated notional trading desk separate from all other market risk covered positions. When these requirements are met, the internal risk transfer would qualify as an eligible internal interest rate risk transfer, for which the banking organization may recognize the hedge benefit of an internal derivative transaction. A trading desk that conducts internal risk transfers of interest rate risk may enter into external hedges to mitigate the risk but would not be required to do so under the proposal. As the amount transferred to the trading desk from the banking unit to hedge the underlying exposure under the standardized approach or the expanded risk-based approach, as applicable, would be a market risk covered position, any such external hedges would also be market risk covered positions and thus also subject to the proposed market risk capital requirements.294 For transactions that do not meet these requirements, a banking organization would be required to exclude the internal interest rate risk
transfer (the trading desk segment) from its market risk covered positions. The entire amount of any external hedge of an ineligible internal risk transfer would be a market risk covered position.
c. Internal Risk Transfers of CVA Risk
For banking organizations that are subject to CVA risk capital requirements, the proposal would specify the capital treatment of internal CVA risk transfers executed between a CVA desk (or the functional equivalent thereof) and a trading desk to hedge CVA risk arising from exposures that are subject to the proposed capital requirements for CVA risk.295 Under the proposal, an internal CVA risk transfer would involve two perfectly offsetting positions of a derivative transaction executed between a CVA desk and a trading desk: the position of the CVA desk (the CVA segment) and the position of the trading desk (the trading desk segment). For the CVA desk to recognize the risk mitigation benefits of the internal risk transfer under the risk-based capital requirements for CVA risk, the proposal would require the banking organization to have a dedicated CVA desk or the functional equivalent thereof that, along with other functions performed by the desk, manages internal risk transfers of CVA risk. In either case, such a desk would not need to satisfy the proposed trading desk definition, given the proposed risk-based capital requirements for CVA risk are not calibrated at the trading desk level. Additionally, the proposal would require a banking organization to maintain, at either the desk or portfolio level, an internal written record of internal derivative transaction(s) executed between the CVA desk and the trading desk, including identifying the underlying exposure(s) being hedged by the CVA desk and the sources of such risk. In addition to the above-mentioned requirements for the internal transaction to qualify as an eligible internal risk transfer of CVA risk, the proposal sets forth general requirements for the recognition of CVA hedges that would be applicable to both internal transfers of CVA risk and external CVA hedges. The proposal specifies these requirements for both the basic approach for CVA risk and standardized approach for CVA risk, as described in
section V.B.3. of this SUPPLEMENTARY
INFORMATION.296
For eligible internal risk transfers of CVA risk, the banking organization would be required to treat the CVA segment as an eligible CVA hedge when calculating the CVA risk capital requirement and treat the trading desk segment as a market risk covered position. In this way, the proposal would allow the CVA desk to recognize the risk-mitigating benefit of the hedge position received from the trading desk when calculating risk-based capital requirements for CVA risk. For transactions that do not meet these requirements or the general hedge eligibility requirements under the basic approach for CVA risk or the standardized approach for CVA risk, a banking organization would be required to exclude both the trading desk segment and the CVA segment of the internal transfer of CVA risk from market risk-weighted assets, thus disregarding the ineligible internal CVA risk transfer. In addition, the CVA desk would not be able to recognize any risk mitigation or offsetting benefit from the ineligible internal risk transfer in its capital requirements for CVA risk. d. Internal Risk Transfers of Equity Risk The agencies are not proposing to allow a banking organization to recognize any risk mitigation benefits for internal equity risk transfers executed between a trading desk and a banking unit to hedge exposures that are subject to either the standardized approach or the expanded risk-based approach, as applicable. The proposed definition of market risk covered position would generally include equity positions that are publicly traded with no restrictions on tradability, with a few exceptions.297 Given the expanded scope of equity positions that would be subject to the proposed market risk capital requirements, primarily illiquid or irregularly traded equity positions would remain subject to the standardized approach or the expanded risk-based approach, as applicable.298 In general, banking organizations would not be able to hedge the material risk elements of illiquid or irregularly traded equity positions in a liquid, two-way market. For publicly traded equity exposures still subject to the standardized approach or the expanded risk-based approach, as applicable, banking organizations may apply the hedge pair treatment, which allows for the recognition of risk-mitigating benefits of hedged transactions. Given the narrower scope of equity positions subject to the standardized approach or the expanded risk-based approach, as applicable, and the option to apply hedge pair treatment for publicly traded exposures, the proposal would not allow a banking organization to recognize internal transfers of equity risk of such positions. Question 108: The agencies seek comment on any operational challenges
299Specifically, to align with the GAAP considerations for valuation of market risk covered positions, the proposal would eliminate the market risk capital rule requirement that a banking organization’s process for valuing covered positions must consider, as appropriate, unearned credit spreads, close-out costs, early termination costs, investing and funding costs, liquidity, and model risk. See 12 CFR 3.203(b)(2) (OCC); 12 CFR 217.203(b)(2) (Board); 12 CFR 324.203(b)(2) (FDIC). 300As described in further detail in section V.A.3.e. of this SUPPLEMENTARY INFORMATION, the proposal would introduce a capital requirement (the capital add-on for re-designations) to offset any potential capital benefit that a banking organization otherwise might have received from re-classifying an instrument previously treated under the standardized approach or the expanded risk-based approach of the capital rule, as applicable, as a market risk covered position. of the proposed internal risk transfer framework, in particular any potential difficulties related to internal risk transfers executed before implementation of the proposed market risk capital rule. What is the nature of such difficulties and how could they be mitigated? Question 109: The agencies seek comment on the extent to which the proposed internal risk transfer framework would incentivize hedging and prudent risk management and/or potentially misrepresent the risk profile of a banking organization. What, if any, additional requirements or other modifications should the agencies consider? Question 110: The agencies seek comment on the appropriateness of the proposed eligibility requirements for a banking unit to recognize the risk mitigation benefit of an eligible internal risk transfer of credit risk. What, if any, additional requirements or other modifications should the agencies consider, and why? Question 111: What, if any, operational burden might the proposed exclusion for the credit risk segment of internal risk transfers pose for banking organizations? What, if any, alternatives should the agencies consider that would appropriately exclude the types of positions that should be captured under the standardized approach or the expanded risk-based approach, as applicable, and also impose less operational burden relative to the proposal? Question 112: The agencies seek comment on subjecting the internal risk transfers of interest rate risk to the market risk capital requirements on a standalone basis. What are the benefits and costs associated with this requirement? What would be an alternative approach for calculating a standalone capital requirement for internal transfers of interest rate risk? What would be the advantages and disadvantages of allowing a banking organization to calculate the market risk capital requirements for the internal risk transfers of interest rate risk together with other market risk exposures, and why? Question 113: The agencies seek comment on the proposed documentation
requirements for an internal risk transfer of credit risk, interest rate risk, or CVA risk to qualify as an eligible internal risk transfer. What, if any, changes to the proposed documentation requirements should the agencies consider, particularly in cases in which CVA risk is hedged on a portfolio basis? What, if any, alternatives should the agencies consider that would appropriately capture the types of positions that should be recognized under the standardized approach or the expanded risk-based approach, as applicable? Question 114: The agencies seek comment on not allowing a banking organization to recognize any risk mitigation benefits for internal equity risk transfers executed between a trading desk and a banking unit to hedge exposures that are subject to either the standardized approach or the expanded risk-based approach, as applicable. Given the proposed scope of equity positions that would be subject to the proposed market risk capital requirements and the retention of effective hedge pair treatment, under what circumstances would there be a need for internal equity risk transfers? What would be advantages and disadvantages of including the concept of internal risk transfer to equity risk and why?
6. General Requirements for Market Risk
The current capital rule requires a banking organization to satisfy certain general risk management requirements related to the identification of trading positions, active management of covered positions, stress testing, control and oversight, and documentation. The proposal would maintain these requirements, as well as introduce additional requirements. The additional requirements are designed to further strengthen a banking organization’s risk management of market risk covered positions and to appropriately reflect other changes under the proposal such as the definition of market risk covered position and the introduction of the trading desk concept, as described in sections V.A.4. and V.A.6.b. of this SUPPLEMENTARY INFORMATION. The proposal would also make certain technical corrections related to the requirements around valuation of market risk covered positions.299 a. Identification of Market Risk Covered Positions The current capital rule requires a banking organization to have clearly defined policies and procedures for determining which trading assets and trading liabilities are trading positions and which trading positions are correlation trading positions, as well as for actively managing all positions subject to the rule. The proposal would expand these requirements to reflect the proposed scope and definition of market risk covered position as described in section V.A.4. of this SUPPLEMENTARY INFORMATION. A banking organization also would be required to update its policies and procedures for identifying market risk covered positions at least annually and to identify positions that must be excluded from market risk covered positions. In addition, the proposal would introduce a new requirement for a banking organization to establish a formal framework for redesignating a position after its initial designation as being subject to the market risk capital framework or to the standardized approach or the expanded risk-based approach, as applicable, of the capital rule. Specifically, the proposal would require a banking organization to establish policies and procedures that describe the events or circumstances under which a redesignation would be considered, a process for identifying such events or circumstances, any restrictions on redesignations, and the process for obtaining senior management approval as well as for notifying the primary Federal supervisor of material redesignations. These proposed requirements are intended to complement the proposed capital requirement for re-designations described in section V.A.3.e. of this SUPPLEMENTARY INFORMATION by ensuring re-designations would occur in only those circumstances identified by the banking organization’s senior management as appropriate to merit redesignation.300 In addition to the requirements for identifying market risk covered positions, the proposal would require a banking organization to have clearly defined trading and hedging strategies for its market risk covered
positions that are approved by the banking organization’s senior management. Consistent with the current capital rule, the trading strategy would need to specify the expected holding period and the market risk of each portfolio of market risk covered positions, and the hedging strategy would need to specify
301A banking organization subject to the market risk capital requirements under the proposal would be required to use the same trading desk structure it establishes pursuant to the proposed market risk capital framework to demonstrate compliance with the prohibitions and restrictions on proprietary trading under the Volcker Rule. See 12 CFR 44.3(e)(14) (OCC); 12 CFR 248.3(e)(14) (Board); 12 CFR 351.3(e)(14) (FDIC). 302The proposal would define a notional trading desk as a trading desk created for regulatory capital purposes to account for market risk covered positions arising under the standardized approach or the expanded risk-based approach of the capital rule, as applicable, such as net short risk positions, certain embedded derivatives on instruments that the banking organization issued that relate to credit or equity risk, instruments with an embedded derivative that the banking organization issued that relate to credit or equity risk that it elects the fair value option for purposes of financial reporting, and foreign exchange positions and commodity positions that are not trading assets or trading liabilities. 303See section V.A.6.d. of this SUPPLEMENTARY INFORMATION for further discussion on the additional operational requirements applicable to modeleligible trading desks. the level of market risk that the banking organization is willing to accept for each portfolio of market risk covered positions, along with the instruments, techniques, and strategies for hedging such risk. b. Trading Desk
i. Trading Desk Definition
To limit overreliance on internal models, support more prudent market risk management practices, and better align operational requirements with the level at which trading activity is conducted, the proposal would introduce the concept of a trading desk and apply the proposed models-based non-default capital requirement at the trading desk level. Regardless of whether a banking organization uses the standardized or the models-based measure for market risk, the proposal would require the banking organization to satisfy certain general operational requirements for each trading desk, as described below in section V.A.6.c. of this SUPPLEMENTARY INFORMATION. The proposal would also require the banking organization to satisfy certain additional operational requirements, as described below in section V.A.6.d. of this SUPPLEMENTARY INFORMATION, in order for the banking organization to calculate the market risk capital requirements for trading desks under the models-based non-default capital requirement. The proposal would define a trading desk as a unit of organization of a banking organization that purchases or sells market risk covered positions and satisfies three requirements. First, the proposal would require a banking organization to structure a trading desk pursuant to a well-defined business strategy. In general, a well-defined business strategy would include a written description of the trading desk’s general strategy, including the economics behind the business strategy, the trading and hedging strategies and a list of the types of instruments and activities that the desk will use to accomplish its objectives. Second, the proposal would require a trading desk to be organized to ensure the appropriate setting, monitoring, and management review of the desk’s trading and hedging limits and strategies. Third, the proposal would require that a trading desk be characterized by a clearly-defined unit of organization that: (1) engages in coordinated trading activity with a unified approach to the key elements of the proposed rule’s requirements for trading desk policies and active management of market risk covered positions; (2) operates subject to a common and calibrated set of risk metrics, risk levels, and joint trading limits; (3) submits compliance reports and other information as a unit for monitoring by management; and (4) books its trades together. The proposed trading desk definition is intended to help ensure that a banking organization structures its trading desks to capture the level at which trading activities are managed and operated and at which the profit and loss of the trading strategy is attributed.301 This approach would recognize the different strategies and objectives of discrete units in a banking organization’s trading operations. The proposed parameters provide sufficient specificity to enable more precise measures of market risk for the purpose of determining risk-based capital requirements, while taking into account the
potential variation in trading practices across banking organizations. In this regard, the proposal aims to reduce the regulatory compliance burden for banking organizations by providing flexibility to align the proposed trading desk definition with the organizational structure that banking organizations may already have in place to carry out their trading activities. Question 115: What, if any, changes should the agencies consider making to the definition of a trading desk and why? What, if any, other key factors do banking organizations typically use to define trading desks for business purposes that the agencies should consider including in the trading desk definition to clarify the designation of trading desks for purposes of the market risk capital framework? Question 116: The agencies seek comment on any implementation challenges banking organizations with cross-border operations could face in applying the proposed trading desk definition. What are the advantages and disadvantages of permitting a U.S. subsidiary of a foreign banking organization to apply trading desk designations consistent with its home country’s regulatory requirements, provided those requirements are consistent with the Basel standards?
ii. Notional Trading Desk Definition
The proposed definition of market risk covered position would include certain types of instruments and positions that may not arise from, and may be unrelated to, a banking organization’s trading activities, such as net short risk positions, certain embedded derivatives on instruments issued by the banking organization that relate to credit or equity risk, as well as foreign exchange and commodity exposures that are not trading assets or trading liabilities. When a banking organization enters into such positions, it may do so in a manner that causes these positions to appear not to originate from a banking organization’s existing trading desks. To address the issue that certain trading desk-level requirements are not applicable to these types of activities and positions, the proposal would introduce the concept of a notional trading desk 302 to which such positions would be allocated. Under the proposal, notional trading desks would be subject to only a subset of the general risk management requirements applicable to trading desks. Specifically, the proposal would require a banking organization to identify any such positions and activities allocated to notional trading desks, as described in section V.A.6.b.iii. of this SUPPLEMENTARY INFORMATION, but would not require a banking organization to establish policies and procedures describing the trading strategy or risk management for the notional trading desks or require a notional trading desk to satisfy the requirements for active management of market risk covered positions. Nevertheless, to qualify for use of the models-based non-default capital requirement, the proposal would require a notional trading desk to satisfy all of the general requirements for trading desks, as well as those applicable for the models-based measure.303 The agencies are proposing to require a banking organization to identify any notional trading desks as part of the trading desk structure requirement, described in section V.A.6.b.iii. of this SUPPLEMENTARY INFORMATION, to help
304The list of model-ineligible trading desks should include both those for which the banking organization has elected to calculate market risk capital requirements under the standardized nondefault capital requirement as well as any trading desks that previously received approval to use the models-based non-default capital requirement but subsequently reported the PLA test metric in the red zone, as described in more detail in section V.A.8.e. of this SUPPLEMENTARY INFORMATION. A banking organization should maintain a list of all trading desks and make it available for the primary Federal supervisor for review upon request. 305A banking organization could also seek approval for a notional trading desk to be a modeleligible trading desk. Any such desk that is approved would be subject to backtesting and profit and loss attribution testing at the trading desk level. 306Under the proposal, these requirements would generally not apply to notional trading desks, except those with prior approval from the primary Federal supervisor to use the models-based nondefault capital requirement. 307Under the proposal, the business strategy must include regular reports on the revenue, costs, and market risk capital requirements of the trading desk. 308The proposal would define internal risk management model as a valuation model that the independent risk control unit within the banking Continued ensure that a banking organization appropriately treats all market risk covered positions under the capital rule. The agencies would review a banking organization’s trading desk structure, including notional trading desks and trading desks used for internal risk transfers, to help ensure that they have been appropriately identified. Question 117: What, if any, additional requirements should apply to notional trading desks to clarify the level at which market risk capital requirements must be calculated? What, if any, additional types of positions should be assigned to the notional trading desk and why?
iii. Trading Desk Structure
The proposal would require a banking organization to define its trading desk structure. Specifically, the structure must define each constituent trading desk and identify: (1) model-eligible trading desks that are used in the models-based measure for market risk, (2) model-ineligible trading desks used in both the standardized measure and models-based measure for market risk,304 (3) trading desks that are used for internal risk transfers (as applicable), and (4) notional trading desks (as applicable).305 Additionally, before calculating market risk capital requirements under the models-based measure for market risk, the proposal would require a banking organization to receive prior approval from the primary Federal supervisor of its trading desk structure. As part of the model approval process described in section V.A.6.d.iv. of this SUPPLEMENTARY INFORMATION, the primary Federal supervisor would consider whether the level at which a banking organization is proposing to establish its trading desks is consistent with the level at which trading activities are actively managed and operated. The primary Federal supervisor would also consider whether the level at which the banking organization defines each trading desk is sufficiently granular to allow the banking organization and the primary Federal supervisor to assess the adequacy of the internal models used by the trading desk. For example, a banking organization’s proposed trading desk structure may be considered insufficiently detailed if it reflects risk limits, internal controls, and ongoing management at one or more organizational levels above the routine management of the trading desk (for example, at the division-wide or entity level).
iv. Trading Desk Policies
The current capital rule requires a banking organization to have clearly defined trading and hedging strategies for its trading positions that are approved by senior management. In addition to applying these requirements at the trading desk level for trading desks that are not notional trading desks, the proposal would require policies and procedures for each trading desk to describe the strategy and risk management framework established for overseeing the risk-taking activities of the trading desk. For each trading desk that is not a notional trading desk, the proposal would require a banking organization to have a clearly defined policy, approved by senior management, that describes the general strategy of the trading desk, the risk and position limits established for the trading desk, and the internal controls and governance structure established to oversee the risk-taking activities of the trading desk.306 At a minimum, this would include the business strategy for each trading desk; 307 a clearly defined trading strategy that details the market risk covered positions in which the trading desk is permitted to trade, identifies the main types of market risk covered positions purchased and sold by the trading desk, and articulates the expected holding period of, and market risk associated with, each portfolio of market risk covered positions held by the trading desk; a clearly defined hedging strategy that articulates the acceptable level of market risk and details the instruments, techniques, and strategies that the trading desk will use to hedge the risks of the portfolio; and a brief description of the general strategy of the trading desk that addresses the economics of its business strategy, primary activities, and trading and hedging strategies. Together, the proposed requirements are intended to help ensure that each trading desk engages only in those activities that are permitted by senior management and that any exceptions would be elevated to the appropriate organizational level. For example, the proposed requirement for a banking organization to document trading, hedging, and business strategies, including the internal controls established to manage the risks arising from the trading strategy, at the level of the organization responsible for implementing the general business strategy, is intended to help ensure appropriate monitoring of the risk limits set by senior management. Additionally, the proposed requirements would help to assist the primary Federal supervisor in monitoring compliance, particularly when assessing whether the trading activities conducted by a trading desk are consistent with the general strategy of the desk and the appropriateness of the limits established for the desk. For example, the requirement for a trading desk to list the types of instruments traded by the desk to hedge risks arising from its business strategy would help to assist the primary Federal supervisor in providing effective supervisory oversight
of the trading desk’s activities.
c. Operational Requirements
The current capital rule requires a banking organization to satisfy certain operational requirements for active management of market risk covered positions, stress testing and internal assessment of capital adequacy, control and oversight, and documentation. The proposal would maintain these requirements and introduce revisions designed to complement changes under the proposed standardized and modelsbased measures for market risk (including the application of calculations at the trading desk level in the case of the models-based measure for market risk), and to support the proposed requirements described in
section V.A.6.a. of this SUPPLEMENTARY
INFORMATION that would help ensure a banking organization maintains robust risk management processes for identifying and appropriately managing its market risk covered positions. A key assumption of the proposed market risk framework is that the financial reporting and internal risk management models 308 used by banking
organization uses to report market risks and risktheoretical profits and losses to senior management. See §ll.202 of the proposed rule. 309As a banking organization’s financial reporting models are already subject to requirements to support the accuracy of the financial data produced (such as the requirements from the Sarbanes-Oxley Act of 2002, Pub. L. 107–204), such models would satisfy the proposed independent validation requirements described in more detail in section V.A.6.c.iii. of this SUPPLEMENTARY INFORMATION. 310The supervisory guidance set forth in the Board’s Supervision and Regulation (SR) Letter 11– 7 and OCC’s Bulletin 2011–12, Supervisory Guidance on Model Risk Management includes prudent valuation practices for banking organizations subject to market risk capital requirements. 311The proposal would retain certain other requirements with modifications such as policies and procedures for active management of trading positions subject to the market risk requirements which include, but are not limited to, ongoing assessment of the ability to hedge market risk covered positions and portfolio risks. See 12 CFR 3.203(b)(1) (OCC); 12 CFR 217.203(b)(1) (Board); 12 CFR 324.203(b)(1) (FDIC). 312Under the proposal, p-value would be defined as the probability, when using the VaR-based measure for purposes of backtesting, of observing a profit that is less than, or a loss that is greater than, the profit or loss that actually occurred on a given date. organizations provide an adequate basis for determining risk-based capital requirements for market risk covered positions.309 To help ensure such adequacy, the proposal would reinforce a banking organization’s prudent valuation practices by incorporating requirements that build on the agencies’ overall framework for market risk management.310 including In addition to facilitating the regulatory review process, the proposed revisions are intended to assist a banking organization’s independent risk control unit and audit functions in providing appropriate review of and challenge to model risk management, thereby promoting effective model risk management. The general risk management requirements described in this section would apply to all banking organizations subject to the proposed market risk capital framework.
i. Active Management of Market Risk
Covered Positions
The current capital rule requires a banking organization to have clearly defined policies and procedures for actively managing all positions subject to market risk capital requirements, including establishing and conducting daily monitoring of position limits.311 These requirements are appropriate to support active management and monitoring under the current framework; the proposal adds enhancements to support active management and monitoring at the trading desk level. Accordingly, the proposal would require a banking organization to have clearly defined policies and procedures that describe its internal controls, as well as its ongoing monitoring, management, and authorization procedures, including escalation procedures, for the active management of all market risk covered positions. At a minimum, these policies and procedures must identify key groups and personnel responsible for overseeing the activities of the banking organization’s trading desks that are not notional trading desks. Further, the proposal would specify a broader set of risk metrics for the monitoring requirement, which would apply at the trading desk level. Specifically, at a minimum, the proposal would require that a banking organization establish and conduct daily monitoring by trading desks of: (1) trading limits, limit usage, and remedial actions taken in response to limit breaches; (2) sensitivities to risk factors; (3) market risk covered positions and transaction volumes; and, as applicable, (4) VaR and expected shortfall; (5) backtesting and p-values 312 at the trading desk level and at the aggregate level for all model-eligible trading desks; and (6) comprehensive profitand-loss attribution (each as described in sections V.A.8.d.–f. of this SUPPLEMENTARY INFORMATION). These risk metrics are the minimum elements necessary to support adequate daily monitoring of market risk covered positions at the trading desk level. Consistent with the current capital rule, for a banking organization that has approval for at least one model-eligible trading desk, the proposal would require the banking organization’s policies and procedures to describe the establishment and monitoring of backtesting and p-values at the trading desk level and at the aggregate level for all model-eligible trading desks. Daily information on the probability of observing a loss greater than that which occurred on any given day is a useful metric for a banking organization and supervisors to assess the quality of a banking organization’s VaR model. For example, if a banking organization that used a historical simulation VaR model using the most recent 500 business days experienced a loss equal to the second worst day of the 500, it would assign a probability of 0.004 (2/500) to that loss based on its VaR model. Applying this process many times over a long interval provides information about the adequacy of the VaR model’s ability to characterize the entire distribution of losses, including information on
the size and number of backtesting exceptions. The requirement to create and retain this information at the entity-wide and trading desk level for model-eligible trading desks may help identify particular products or business lines for which a model does not adequately measure risk. The agencies view active management of model risk at the trading desk level as the best mechanism to address potential risks of reliance on models, such as the possible adverse consequences (including financial loss) of decisions based on models that are incorrect or misused.
ii. Stress Testing and Internal
Assessment of Capital Adequacy The current capital rule requires a banking organization to have a rigorous process for assessing its overall capital adequacy in relation to its market risk. The process must take into account market concentration and liquidity risks under stressed market conditions as well as other risks arising from the banking organization’s trading activities that may not be fully captured by a banking organization’s internal models. At least quarterly, a banking organization must conduct stress tests at the entity-wide level of the market risk of its covered positions. The proposal would enhance the current stress testing and internal assessment of capital adequacy requirements to reflect both the entitywide and the trading-desk level elements for model-eligible positions within the proposed market risk capital requirement calculation. Specifically, the proposal would require a banking organization to stress-test the market risk of its market risk covered positions at both the entity-wide and trading-desk level for model-eligible positions on at least a quarterly basis. The proposal also would require that results of such stress testing be reviewed by senior management of the banking organization and reflected in the policies and limits set by the banking organization’s management and the board of directors, or a committee thereof. In addition to concentration and liquidity risks, the proposal would require stress tests to take into account risks arising from a banking organization’s trading activities that may not be adequately captured in the standardized or the models-based measure for market risk, as applicable. The proposed requirements are intended to help ensure that each trading desk only engages in those activities that are permitted by the banking organization’s senior management, and that any weaknesses revealed by the stress testing results would be elevated to the appropriate
313A banking organization’s financial reporting models provide an appropriate basis for determining risk-based capital requirements because such models are subject to requirements intended to enhance the accuracy of the financial data produced by the models, such as the requirements from the Sarbanes-Oxley Act of 2002. Pub. L. 107–204. Accordingly, banking organizations that rely on financial reporting models for purposes of calculating risk-based capital requirements would satisfy the proposed prudent valuation requirement. 314The proposed backtesting requirements are intended to measure the conservatism of the forecasting assumptions and valuation methods in the internal models used to determine risk-based capital requirements relative to those used in the financial reporting models. The proposed PLA testing requirement is intended to measure the accuracy of the potential future profits or losses estimated by the valuation models used for internal risk management purposes (internal risk management models) relative to those produced by the valuation models used for financial reporting. If a trading desk fails to satisfy either the backtesting requirements or, after the three-year transition period, the proposed PLA test requirements, it would no longer be able to calculate risk-based capital requirements using the models-based non-default capital requirement. In this way, the proposal would only allow trading desks for which the internal models are sufficiently conservative and accurate to use the models-based non-default capital requirement to calculate market risk capital requirements. management levels of the banking organization and addressed in a timely manner.
iii. Control and Oversight
The current capital rule requires a banking organization to maintain a risk control unit that reports directly to senior management and is independent of the business trading units. The internal audit function is responsible for assessing, at least annually, the effectiveness of the controls supporting the banking organization’s market risk measurement systems (including the activities of the business trading units and independent risk control unit), compliance with the banking organization’s policies and procedures, and the calculation of the banking organization’s market risk capital requirements. At least annually, the internal audit function must report its findings to the banking organization’s board of directors (or a committee thereof). The proposal largely would retain the control, oversight, and validation requirements in the capital rule, including the requirement that a banking organization maintain an independent risk control unit. The proposal would expand the required oversight responsibilities of the independent risk control unit to include the design and implementation of market risk management systems that are used for identifying, measuring, monitoring, and managing market risk. The proposed change is intended to complement other changes under the proposal, in particular allowing a banking organization to calculate riskbased requirements using standardized and models-based measures for market risk (for example, the inclusion of more rigorous model eligibility tests that apply at the trading desk level), as well as the introduction of a capital add-on requirement for re-designations. Further, the proposal would enhance the internal review and challenge responsibilities of a banking organization by requiring it to maintain conceptually sound systems and processes for identifying, measuring, monitoring, and managing market risk. In addition to the current requirements in the capital rule, the banking organization’s internal audit function would have to assess at least annually the effectiveness of the designations and re-designations of market risk covered positions, and the calculation of the banking organization’s measures for market risk, including the mapping of risk factors to liquidity horizons, as applicable. The proposal would enhance the validation requirements by requiring a banking organization to maintain independent validation of its valuation models and valuation adjustments or reserves.313 The agencies intend for these elements of the proposal to enhance the accountability of the banking organization’s independent risk control unit and internal audit function and provide banking organizations with sufficient flexibility to incorporate the risk management processes required for regulatory capital purposes within those daily risk management processes used by the banking organization, such that managing market risk would be more consistent with the banking organization’s overall risk profile and business model.
iv. Documentation
Similar to the enhancements to policies and procedures described above, the proposal would enhance the documentation requirements in the capital rule to reflect the proposed market risk capital framework. Specifically, a banking organization would be required to document adequately all material aspects of its identification, management, and valuation of market risk covered positions, including internal risk transfers and any re-designations of positions between the market risk capital framework and the standardized approach or the expanded risk-based approach of the capital rule, as applicable. Consistent with the current capital rule, the proposal would require a banking organization to document adequately all material aspects of its internal models, and its control, oversight, validation, and review processes and results, as well as its internal assessment of capital adequacy. The proposal also would require a banking organization to document an explanation of the empirical techniques used to measure market risk. Further, a banking organization would be required to establish and document its trading desk structure, including identifying which trading desks are model-eligible, model-ineligible, used for internal risk transfers, or constitute notional trading desks, as well as document policies describing how each desk satisfies applicable requirements. These enhancements would help ensure that a banking organization appropriately treats all market risk covered positions under the capital rule. d. Additional Operational Requirements for the Models-Based Measure for Market Risk Under the current capital rule, a banking organization must use an internal VaR-based model to calculate risk-based capital requirements for its covered positions. Under the proposal, only a banking organization that receives approval from its primary Federal supervisor to use the modelsbased non-default capital requirement for at least one model-eligible trading desk would be required to calculate market risk capital requirements under the models-based measure for market risk. As a condition for use of the modelsbased non-default capital requirement, the proposal would require a trading desk to satisfy certain additional operational requirements, which are intended to help ensure that the banking organization has allocated sufficient resources for the desk to develop and rely on internal models that appropriately capture the market risk of its market risk covered positions. Specifically, the additional operational requirements, as well as the proposed profit and loss attribution and backtesting requirements described in sections V.A.8.e. and V.A.8.f. of this SUPPLEMENTARY INFORMATION, would help ensure that the internal models used to calculate a trading desk’s riskbased capital requirements are sufficiently accurate and conservative relative to the models used to report actual profits and losses for financial reporting purposes (financial reporting models).314 In this
way, the additional operational requirements are intended
315As described in section V.A.10.e.ii. of this SUPPLEMENTARY INFORMATION, an equity position in an investment fund could be a model-eligible position to the extent a banking organization is able to identify the underlying positions held by an investment fund on a quarterly basis. 316Specifically, the proposal would require a banking organization to exclude any insignificant amount of model-ineligible positions held by the model-eligible trading desk from the aggregate trading portfolio backtesting and the relevant desklevel backtesting and profit and loss attribution metric, unless the banking organization receives approval from its primary Federal supervisor to include such positions. 317Either the validation process itself would have to be independent, or the validation process would have to be subjected to independent review of its adequacy and effectiveness. The independence of the banking organization’s validation process would be characterized by separateness from and impartiality to the development, implementation, and operation of the banking organization’s internal models, or otherwise by independent review of its adequacy and effectiveness, though the personnel conducting the validation would not necessarily be required to be external to the banking organization. As a banking organization’s financial reporting models provide an appropriate basis for determining risk-based capital requirements because such models are subject to the requirements of the Sarbanes-Oxley Act of 2002, including external audit, banking organizations that rely on financial reporting models for purposes of calculating risk-based capital requirements would satisfy the proposed prudent valuation requirement. 318The process should include evaluation of empirical evidence supporting the methodologies used and evidence of a model’s strengths and weaknesses. to help ensure that the internal models of a trading desk properly measure all material risks of the market risk covered positions to which they are applied, and the sophistication of the internal models is commensurate with the complexity and extent of trading activity conducted by the trading desk. As described above, the proposal would require eligibility for use of the models-based non-default capital requirement to be determined at the trading desk level, rather than for the entire banking organization. By aligning the level at which a banking organization may be permitted to model market risk capital requirements with the level at which the banking organization applies the controls used for financial reporting, the proposed requirements would enhance prudent capital management for banking organizations that use the models-based measure for market risk.
i. Trading Desk Identification
As part of the model approval process, the proposal would require a banking organization to identify all trading desks within its trading desk structure that it would designate as model-eligible and for which it would seek approval to use the models-based non-default capital requirement from the primary Federal supervisor. Additionally, the proposal generally would prohibit a banking organization from seeking model approval for trading desks that hold securitization positions, correlation trading positions, or certain equity positions in investment funds (together ‘‘model-ineligible positions’’), with one exception.315 Given the operational difficulties of requiring a banking organization to bifurcate trading desks that hold an insignificant amount of model-ineligible positions pursuant to their trading or hedging strategy, the proposal would allow the banking organization to designate such desks as model-eligible. If the primary Federal supervisor were to approve the use of models-based non-default capital requirement for such desks, the proposal would require the banking organization to separately calculate market risk capital requirements for such model-ineligible positions held by a model-eligible trading desk under either the standardized non-default capital requirement or the fallback capital requirement, and otherwise treat such positions as if they were not held by the desk.316 Question 118: The agencies seek comment on the benefits and drawbacks of requiring trading desks that hold an insignificant amount of model-ineligible positions to exclude from the modelsbased non-default capital requirement such positions and any related hedges, if applicable, in order for such desks to request approval to calculate market risk capital requirements under the models-based measure for market risk. Commenters are encouraged to provide data to support their responses.
ii. Review, Risk Management, and
Validation
To help ensure that the internal models appropriately capture a modeleligible trading desk’s market risk exposure on an ongoing basis, the proposal would require a banking organization to satisfy additional model review and validation standards for model-eligible trading desks to use the models-based non-default risk capital requirement to calculate market risk capital requirements. Specifically, a banking organization that uses the models-based measure for market risk would be required to (1) review its internal models at least annually and enhance them, as appropriate, to help ensure the models continue to satisfy the regulatory requirements and employ risk measurement methodologies that are the most appropriate for the banking organization’s market risk covered positions, (2) integrate its internal models used for calculating the expected shortfall-based measure for market risk into its daily risk management process, and (3) independently 317 validate its internal models both initially and on an ongoing basis, and revalidate them when there is a material change to a model, a significant structural change in the market, or changes in the composition of the banking organization’s market risk covered positions that might result in the internal models no longer adequately capturing the market risk of the market risk covered positions held by the model-eligible trading desk. The proposal also would require a banking organization to establish a validation process that, at a minimum, includes an evaluation of the internal models’ (1) conceptual soundness 318 and (2) adequacy in appropriately capturing and reflecting all material risks, including ensuring that the assumptions are appropriate and do not underestimate risks. Additionally, the proposal would require a banking organization to perform ongoing monitoring to review and verify processes, including by comparing the outputs of the internal models with relevant internal and external data sources or estimation techniques. The results of this comparison provide a valuable diagnostic tool for identifying potential weaknesses in a banking organization’s models. As part of this comparison, a banking organization would be expected to investigate the source of differences between the model estimates and the relevant internal or external data or estimation techniques and whether the extent of the differences is appropriate. In addition, the proposal would expand on the outcomes analysis requirements of the current capital rule by requiring validation to include not only any outcomes analysis that includes backtesting at the aggregated level of all model-eligible trading desks, but also backtesting and profit and loss attribution testing at the trading desk level for each model-eligible trading desk. The agencies recognize that financial markets and modeling technologies undergo continual development. Accordingly, a banking organization needs to continually ensure that its models are appropriate. The
ongoing review, risk management, and validation requirements in the proposal are intended to help ensure that the internal models used accurately reflect the risks of market risk covered positions in evolving markets.
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Source: Federal Reserve Board — original document · Summary generated with machine assistance and reviewed before publication; the authoritative text is the regulator's original document. How RegAlert works
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