2023-09-18 | 2023-19200Added · Updated
The OCC, Federal Reserve Board, and FDIC propose substantially revised capital requirements for large banking organizations with $100 billion or more in total assets and those with significant trading activity. The rule eliminates most internal models for credit and operational risk in favor of standardized approaches, introduces an output floor to limit model-based capital reductions, and revises market and credit valuation adjustment risk calculations. These changes strengthen risk-sensitive capital ratios, reduce regulatory complexity, and align U.S. standards with Basel III to enhance the financial stability of systemically important institutions.
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DEPARTMENT OF THE TREASURY Office of the Comptroller of the Currency 12 CFR Parts 3, 6, 32 [Docket ID OCC–2023–0008] RIN 1557–AE78 FEDERAL RESERVE SYSTEM 12 CFR Parts 208, 217, 225, 238, 252 [Docket No. R–1813] RIN 7100–AG64 FEDERAL DEPOSIT INSURANCE CORPORATION 12 CFR Part 324 RIN 3064–AF29 Regulatory Capital Rule: Large Banking Organizations and Banking Organizations With Significant Trading Activity AGENCY: Office of the Comptroller of the Currency, Treasury; the Board of Governors of the Federal Reserve System; and the Federal Deposit Insurance Corporation. 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 inviting public comment on a notice of proposed rulemaking (proposal) that would substantially revise the capital requirements applicable to large banking organizations and to banking organizations with significant trading activity. The revisions set forth in the proposal would improve the calculation of risk-based capital requirements to better reflect the risks of these banking organizations’ exposures, reduce the complexity of the framework, enhance the consistency of requirements across these banking organizations, and facilitate more effective supervisory and market assessments of capital adequacy. The revisions would include replacing current requirements that include the use of banking organizations’ internal models for credit risk and operational risk with standardized approaches and replacing the current market risk and credit valuation adjustment risk requirements with revised approaches. The proposed revisions would be generally consistent with recent changes to international capital standards issued by the Basel Committee on Banking Supervision. The proposal would not amend the capital requirements applicable to smaller, less complex banking organizations. DATES: Comments must be received by November 30, 2023. ADDRESSES: Comments should be directed to:
OCC: Commenters are encouraged to submit comments through the Federal eRulemaking Portal, if possible. Please use the title ‘‘Regulatory capital rule:
Amendments applicable to large banking organizations and to banking organizations with significant trading activity’’ to facilitate the organization and distribution of the comments. You may submit comments by any of the following methods:
federal-register-publications. Follow instructions for submitting comments on the FDIC’s website. Mail: James P. Sheesley, Assistant 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, Analyst, Andrew Tschirhart, Risk Expert, or Diana Wei, Risk Expert, Capital Policy, (202) 649– 6370; Carl Kaminski, Assistant Director, Kevin Korzeniewski, Counsel, Rima Kundnani, Counsel, Daniel Perez, Counsel, or Daniel Sufranski, Senior Attorney, 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; Brian Chernoff, Manager, (202) 452–2952; Andrew Willis, Manager, (202) 912– 4323; 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, Senior Financial Institution Policy Analyst, (202) 452–3164; Division of Supervision and Regulation; or Jay Schwarz, Assistant General Counsel, (202) 452– 2970; Mark Buresh, Special Counsel, (202) 452–5270; Andrew Hartlage, Special Counsel, (202) 452–6483; 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; Brian Cox, Chief, Capital Markets Strategies
Section; Noah Cuttler, Senior Policy
Analyst; David Riley, Senior Policy Analyst; Michael Maloney, Senior Policy Analyst; Richard Smith, Capital Markets Policy Analyst; Olga Lionakis, Capital Markets Policy Analyst; Kyle McCormick, Senior Policy Analyst; Keith Bergstresser, Senior Policy Analyst, Capital Markets and Accounting Policy Branch, Division of Risk Management Supervision; Catherine Wood, Counsel; Benjamin Klein, Counsel; Anjoly David, Honors Attorney, 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. Overview of the Proposal B. Use of Internal Models Under the Proposed Framework
II. Scope of Application
III. Proposed Changes to the Capital Rule
A. Calculation of Capital Ratios and Application of Buffer Requirements
1The term ‘‘banking organizations’’ includes national banks, state member banks, state nonmember banks, Federal savings associations, state savings associations, top-tier bank holding companies domiciled in the United States not subject to the Board’s Small Bank Holding Company and Savings and Loan Holding Company Policy Statement (12 CFR part 225, appendix C), U.S. intermediate holding companies of foreign banking organizations, and top-tier savings and loan holding companies domiciled in the United States, except for certain savings and loan holding companies that are substantially engaged in insurance underwriting or commercial activities and savings and loan holding companies that are subject to the Small Bank Holding Company and Savings and Loan Holding Company Policy Statement. 2The Board and the OCC issued a joint final rule on October 11, 2013 (78 FR 62018) and the FDIC issued a substantially identical interim final rule on September 10, 2013 (78 FR 55340). In April 2014, the FDIC adopted the interim final rule as a final rule with no substantive changes. 79 FR 20754 (April 14, 2014). 3The 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. 4See 12 CFR 225.8; 12 CFR part 238, subparts N, O, P, R, S; 12 CFR part 252, subparts D, E, F, N, O. 5 12 CFR part 217, subpart H. 6See 12 CFR part 252; 12 U.S.C. 5365. 7See the consolidated Basel Framework at https://www.bis.org/basel_framework/. 8 GAAP often serve as a foundational measurement component for U.S. capital requirements. 9See the impact and economic analysis presented in section V of this SUPPLEMENTARY INFORMATION. of the Federal Reserve System (Board), and the Federal Deposit Insurance Corporation (FDIC) (collectively, the agencies) are proposing to modify the capital requirements applicable to banking organizations 1 with total assets of $100 billion or more and their subsidiary depository institutions (large banking organizations) and to banking organizations with significant trading activity. The revisions set forth in the proposal would strengthen the calculation of risk-based capital requirements to better reflect the risks of these banking organizations’ exposures. In addition, the proposed revisions would enhance the consistency of requirements across large banking organizations and facilitate more effective supervisory and market assessments of capital adequacy. Following the 2007–09 financial crisis, the agencies adopted an initial set of reforms to improve the effectiveness of and address weaknesses in the regulatory capital framework. For example, in 2013, the agencies adopted a final rule that increased the quantity and quality of regulatory capital banking organizations must maintain.2 These changes were broadly consistent with an initial set of reforms published by the Basel Committee on Banking Supervision (Basel Committee) following the financial
crisis.3 The Board also implemented capital planning and stress testing requirements for large bank holding companies and savings and loan holding companies 4 and an additional capital buffer requirement to mitigate the financial stability risks posed by U.S. global systemically important banking organizations (GSIBs),5 as well as other enhanced prudential standards, consistent with the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act).6 The proposal would build on these initial reforms by making additional changes developed in response to the 2007–09 financial crisis and informed by experience since the crisis. Requirements under the proposal would generally be consistent with international capital standards issued by the Basel Committee, commonly known as the Basel III reforms.7 Where appropriate, the proposal differs from the Basel III reforms to reflect, for example, specific characteristics of U.S. markets, requirements under U.S. generally accepted accounting principles (GAAP),8 practices of U.S. banking organizations, and U.S. legal requirements and policy objectives. The proposal would strengthen riskbased capital requirements for large banking organizations by improving their comprehensiveness and risk sensitivity. These proposed revisions, including removal of certain internal models, would increase capital requirements in the aggregate, in particular for those banking organizations with heightened risk profiles. Increased capital requirements can produce both economic costs and benefits. The agencies assessed the likely effect of the proposal on economic activity and resilience, and expect that the benefits of strengthening capital requirements for large banking organizations outweigh the costs.9 Historical experience has demonstrated the impact individual banking organizations can have on the stability of the U.S. banking system, in particular banking organizations that would have been subject to the proposal. Large banking organizations that experience an increase in their capital requirements resulting from the proposal would be expected to be able to absorb losses with reduced disruption to financial intermediation in the U.S. economy. Enhanced resilience of the banking sector supports more stable lending through the economic cycle and diminishes the likelihood of financial crises and their associated costs. The agencies seek comment on all aspects of the proposal. A. Overview of the Proposal The proposal would improve the risk capture and consistency of capital requirements across large banking organizations and reduce complexity and operational costs through changes across multiple areas of the agencies’ risk-based capital framework. For most parts of the framework, the proposal would eliminate the use of banking organizations’ internal models to set regulatory capital requirements and in their place apply a simpler and more consistent standardized framework. For market risk, the proposal would
retain banking organizations’ ability to use internal models, with an improved models-based measure for market risk that better accounts for potential losses. The use of internal models would be subject to enhanced requirements for model approval and performance and a new ‘‘output floor’’ to limit the extent to which a banking organization’s internal models may reduce its overall capital requirement. The proposal would also adopt new standardized approaches for market risk and credit valuation adjustment (CVA) risk that better reflect the risks of banking organizations’ exposures. This new framework for calculating risk-weighted assets (the expanded riskbased approach) would apply to banking organizations with total assets of $100 billion or more and their subsidiary depository institutions. The revised requirements for market risk would also apply to other banking organizations with $5 billion or more in trading assets plus trading liabilities or for which trading assets plus trading liabilities exceed 10 percent of total assets. The expanded risk-based approach would be more risk-sensitive than the current U.S. standardized approach by incorporating more credit-risk drivers (for example, borrower and loan characteristics) and explicitly differentiating between more types of risk (for example, operational risk, credit valuation adjustment risk). In this manner, the expanded risk-based approach would better account for key risks faced by large banking organizations. The proposed changes would also enhance the alignment of capital requirements to the risks of banking organizations’ exposures and increase incentives for prudent risk management. To ensure that large banking organizations would not have lower capital requirements than smaller, less complex banking organizations, the
10Banking organizations’ risk-based capital ratios are the common equity tier 1 capital ratio, tier 1 capital ratio, and total capital ratio. See 12 CFR 3.10 (OCC), 12 CFR 217.10 (Board), and 12 CFR 324.10 (FDIC). 11 In 2019, the agencies adopted rules establishing four categories of capital standards for U.S. banking organizations with $100 billion or more in total assets and foreign banking organizations with $100 billion or more in combined U.S. assets. Under this framework, Category I capital standards apply to U.S. global systemically important bank holding companies and their depository institution subsidiaries. Category II capital standards apply to banking organizations with at least $700 billion in total consolidated assets or at least $75 billion in cross-jurisdictional activity and their depository institution subsidiaries. Category III capital 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 exposure and their depository institution subsidiaries. Category IV capital 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 252.5, 12 CFR 238.10 (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 (November 1, 2019); and ‘‘Changes to Applicability Thresholds for Regulatory Capital and Liquidity Requirements,’’ 84 FR 59230 (November 1, 2019). 12On October 24, 2019, the Board published in the Federal Register a notice of proposed rulemaking inviting comment on a proposal to establish risk-based capital requirements for depository institution holding companies significantly engaged in insurance activities. See 84 FR 57240 (October 24, 2019). The Board anticipates that any final rule based on the proposal in this SUPPLEMENTARY INFORMATION would include appropriate adjustments as necessary to take into account any final insurance capital rule. 13The Basel Committee has published analysis illustrating the variability of credit-risk-weighted assets across banking organizations. See https:// www.bis.org/publ/bcbs256.pdf and https:// www.bis.org/bcbs/publ/d363.pdf. proposal would maintain the capital rule’s dual-requirement structure. Under this structure, a large banking organization would be required to calculate its risk-based capital ratios under both the new expanded riskbased approach and the standardized approach (including market risk, as applicable), and use the lower of the two for each risk-based capital ratio.10 All capital buffer requirements, including the stress capital buffer requirement, would apply regardless of whether the expanded risk-based approach or the existing standardized approach
produces the lower ratio. For banking organizations subject to Category III or IV capital standards,11 the proposal would align the calculation of regulatory capital—the numerator of the regulatory capital ratios—with the calculation for banking organizations subject to Category I or II capital standards, providing the same approach for all large banking organizations. Banking organizations subject to Category III or IV capital standards would be subject to the same treatment of accumulated other comprehensive income (AOCI), capital deductions, and rules for minority interest as banking organizations subject to Category I or II capital standards. This change would help ensure that the regulatory capital ratios of these banking organizations better reflect their capacity to absorb losses, including by taking into account unrealized losses or gains on securities positions reflected in AOCI. The proposal would expand application of the supplementary leverage ratio and the countercyclical capital buffer to banking organizations subject to Category IV capital standards. This change would bring further alignment of capital requirements across large banking organizations and is consistent with the proposal’s goal of strengthening the resilience of large banking organizations. The proposal would also introduce enhanced disclosure requirements to facilitate market participants’ understanding of a banking organization’s financial condition and risk management practices. Also, the proposal would align Federal Reserve’s regulatory reporting requirements with the changes to capital requirements. The agencies anticipate that revisions to the reporting forms of the Federal Financial Institutions Examination Council (FFIEC) applicable to large banking organizations and to banking organizations with significant trading activity will be proposed in the near future, which would align with the proposed revisions to the capital rule. The proposed changes would take effect subject to the transition provisions described in section IV of this SUPPLEMENTARY INFORMATION. The revisions introduced by the proposal would interact with several Board rules, including by modifying the risk-weighted assets used to calculate total loss-absorbing capacity requirements, long-term debt requirements, and the short-term wholesale funding score included in the GSIB surcharge method 2 score. Also, the proposal would revise the calculation of single-counterparty credit limits by removing the option of using a banking organization’s internal models to calculate derivatives exposure amounts and requiring the use of the standardized approach for counterparty credit risk for this purpose. The proposal would also remove the exemption from calculating riskweighted assets under subpart E of the capital rule currently available to U.S. intermediate holding companies of foreign banking organizations under the Board’s enhanced prudential standards. In parallel, the Board is issuing a notice of
proposed rulemaking revising the GSIB surcharge calculation applicable to GSIBs and the systemic risk report applicable to large banking organizations.12 Question 1: The Board invites comment on the interaction of the revisions under the proposal with other existing rules and with the other notice of proposed rulemaking. In particular, comment is invited on the impact of the proposal on the single-counterparty credit limit framework. What are the advantages and disadvantages of the proposed approach? Which alternatives, if any, should the Board consider and why? B. Use of Internal Models Under the Proposed Framework The proposal would remove the use of internal models to set credit risk and operational risk capital requirements (the so-called advanced approaches) for banking organizations subject to Category I or II capital standards. These internal models rely on a banking organization’s choice of modeling assumptions and supporting data. Such model assumptions include a degree of subjectivity, which can result in varying risk-based capital requirements for similar exposures. Moreover, empirical verification of modeling choices can require many years of historical experience because severe credit risk and operational risk losses can occur infrequently. In the agencies’ previous observations, the advanced approaches have produced unwarranted variability across banking organizations in requirements for exposures with similar risks.13 This unwarranted variability, combined with the complexity of these models-based approaches, can reduce confidence in the validity of the modeled outputs, lessen the transparency of the risk-based capital ratios, and challenge comparisons of capital adequacy across banking organizations. Standardization of credit and operational risk capital requirements would improve the consistency of requirements. Standardized requirements, together with robust public disclosure and reporting requirements, would enhance the transparency of capital requirements and the ability of supervisors and market participants to make independent assessments of a banking
14See 12 CFR 3.123(a) (OCC); 12 CFR 217.123(a) (Board); 12 CFR 324.123(a) (FDIC). 15See 12 CFR 3.10(e)(1) (OCC); 12 CFR 217.10(e)(1) (Board); 12 CFR 324.10(e)(1) (FDIC). 16See 12 CFR 3.10(e)(2) (OCC); 12 CFR 217.10(e)(2) (Board); 12 CFR 324.10(e)(2) (FDIC). 17See 12 CFR 46 (OCC); 12 CFR 252 subpart B and F (Board); 12 CFR 325 (FDIC). 18See 12 CFR 225.8 and 12 CFR 238.170. 19The proposal would also apply to depository institutions with total assets of $100 billion or more that are not consolidated subsidiaries of depository institution holding companies, and to depository institutions with total assets of $100 billion or more that are subsidiaries of depository institution holding companies that are not assigned a category under the capital rule. 20See ‘‘Prudential Standards for Large Bank Holding Companies, Savings and Loan Holding Companies, and Foreign Banking Organizations,’’ 84 FR 59032 (November 1, 2019). organization’s capital adequacy, individually and relative to its peers. The use of robust, risk-sensitive standardized approaches for credit and operational risk would also improve the efficiency of the capital framework by reducing operational costs. Under the advanced approaches, banking organizations subject to Category I or II capital standards must develop and maintain internal modeling systems to determine capital requirements, which may differ from the risk measurement approaches they use to monitor risk for internal assessments. Further, any material changes to a banking organization’s internal models must be fully documented and presented to the banking organization’s primary Federal supervisor for review.14 Replacing the use of internal models with standardized approaches would reduce costs associated with maintaining such modeling systems and eliminate the associated submissions to the agencies. Eliminating the use of internal models to set credit and operational risk capital requirements would not reduce the overall risk capture of the regulatory framework. In addition to the calculation of expanded risk-based approach and standardized approach capital requirements, a large banking organization would continue to be required to maintain capital commensurate with the level and nature of all risks to which the banking organization is exposed,15 to have a process for assessing its overall capital adequacy in relation to its risk profile and a comprehensive strategy for maintaining an appropriate level of capital,16 and, where applicable, to conduct internal stress tests.17 Also, holding companies subject to the Board’s capital plan rule would continue to be subject to a stress capital buffer requirement that is based on a supervisory stress test of the holding company’s exposures.18 Although the proposal would remove use of internal models for calculating capital requirements for credit and operational risk, internal models can provide valuable information to a banking organization’s internal stress testing, capital planning, and
risk management functions. Large banking organizations should employ internal modeling capabilities as appropriate for the complexity of their activities. The proposal would continue to allow use of internal models to set market risk capital requirements for portfolios where modeling can be demonstrated to be appropriate. In addition, the proposal would provide for conservative but risksensitive standardized alternatives where modeling is not supported. In contrast to credit and operational risk, market risk data allows for daily feedback on model performance to support empirical verification. The proposal would limit the use of models to only those trading desks for which a banking organization has received approval from its primary Federal supervisor. Ongoing use of such models would depend upon a banking organization’s ability to demonstrate through robust testing that the models are sufficiently conservative and accurate for purposes of calculating market risk capital requirements. In cases where a banking organization cannot demonstrate acceptable performance of its internal models for a given trading desk, the banking organization would be required to use the standardized measure for market risk which acts as a risk-sensitive alternative.
II. Scope of Application
The proposal’s expanded risk-based approach would apply to banking organizations with total assets of $100 billion or more and their subsidiary depository institutions.19 These banking organizations are large and exhibit heightened complexity. Application of the expanded risk-based approach to large banking organizations would provide granular, generally standardized requirements that result in robust risk capture and appropriate risk sensitivity. By strengthening the requirements that apply to large banking organizations, the proposal would enhance their resilience and reduce risks to U.S. financial stability and costs they may pose to the Federal Deposit Insurance Fund in case of material distress or failure. Relative to smaller, less complex banking organizations, these banking organizations have greater operational capacity to apply more sophisticated requirements. Previously, the agencies determined that the advanced approaches requirements should not apply to banking organizations subject to Category III or IV capital standards, as the agencies considered such requirements to be overly complex and burdensome relative to the safety and soundness benefits that they would provide for these banking organizations.20 The expanded riskbased approach generally is based on standardized requirements, which would be less complex and costly. In addition, recent events demonstrate the impact banking organizations subject to Category III or IV capital standards can have on financial stability. While the recent failure of banking organizations subject to Category IV capital standards may be attributed to a variety of factors, the effect of these failures on financial stability supports further alignment of the regulatory capital framework across large banking organizations. Banking organizations with significant trading activities are subject to substantial market risk and, therefore, would be subject to market risk capital requirements. Recognizing that the dollar-based threshold for the application of market risk requirements was established in 1996, the proposal would increase this dollar-based threshold from $1 billion to $5 billion of trading assets plus trading liabilities. Banking organizations would also continue to be subject to market risk requirements if their trading assets plus trading liabilities represent 10 percent or more of total assets. The proposal would revise the calculation of the dollar-based threshold amount to be based on four-quarter averages of trading assets and trading liabilities instead of point-in-time amounts. Banking organizations that would no longer meet these minimum thresholds for being subject to market risk capital requirements would calculate riskweighted assets for trading exposures under the standardized approach. Additionally, under the proposal, large banking organizations would be subject to market risk capital requirements regardless of trading activities. The proposal would expand application of the
countercyclical capital buffer to banking organizations subject to Category IV capital standards. The countercyclical capital buffer is a macroprudential tool that can be used to increase the resilience of the financial system by increasing capital requirements for large banking organizations during a period of
21The proposed methodology for determining market risk-weighted assets, in certain instances, would require a banking organization that is subject to subpart E to apply risk weights from subpart D for purposes of determining its standardized total risk-weighted assets and from subpart E for purposes of determining its expanded total riskweighted assets. This approach would apply in the case of: (i) capital add-ons for re-designations, (ii) term repo-style transactions the banking organization elects to include in market risk, (iii) the standardized default risk capital requirement for securitization positions non-CTP, and (iv) the standardized default risk capital requirement for correlation trading positions, each as discussed further below. elevated risk of above-normal losses. Failure or distress of a banking organization with assets of $100 billion or more during a time of elevated risk or stress can have significant destabilizing effects for other banking organizations and the broader financial system—even if the banking organization does not meet the criteria for being subject to Category II or III capital standards. Applying the countercyclical capital buffer to banking organizations subject to Category IV capital standards would increase the resilience of these banking organizations and, in turn, improve the resilience of the broader financial system. The proposed approach also has the potential to moderate fluctuations in the supply of credit over time. The proposal would also modify how the countercyclical capital buffer amount is determined to reflect the proposed changes to market risk capital requirements. Specifically, the riskweighted asset amount for private sector credit exposures that are market risk covered positions under the proposal would be determined using the standardized default risk capital requirement for such positions rather than using the specific risk add-on of the current rule. The proposal also would expand application of the supplementary leverage ratio requirement to banking organizations subject to Category IV capital standards. In contrast to the riskbased capital requirements, a leverage ratio does not differentiate the amount of capital required by exposure type. Rather, a leverage ratio puts a simple and transparent limit on banking organization leverage. Leverage requirements protect against underestimation of risk both by banking organizations and by risk-based capital requirements and serve as a complement to risk-based capital requirements. The supplementary leverage ratio measures tier 1 capital relative to total leverage exposure, which includes on-balance sheet assets and certain off-balance sheet exposures. The proposed change would ensure that all large banking organizations are subject to a consistent and robust leverage requirement that serves as a complement to risk-based capital requirements and takes into account onand off-balance sheet exposures. Question 2: What are the advantages and
disadvantages of applying the expanded risk-based approach to banking organizations subject to Category III or IV capital standards? To what extent is the expanded risk-based approach appropriate for banking organizations with different risk profiles, including from a cost and operational burden perspective? Are there specific areas, such as the market risk capital framework, for which the agencies should consider a materiality threshold to better balance cost and operational burden and risk sensitivity, and if so what should that threshold be and why? What would the appropriate exposure treatment be for banking organizations with such exposures beneath any materiality threshold, and how would that treatment be consistent with the overall calibration of the expanded risk-based approach? What alternatives, if any, should the agencies consider to help ensure that the risks of large banking organizations are appropriately captured under minimum risk-based capital requirements and why? Question 3: What are the advantages and disadvantages of harmonizing the calculation of regulatory capital across large banking organizations? What are any unintended consequences of the proposal and what steps should the agencies consider to mitigate those consequences? What are the advantages and disadvantages of harmonizing the calculation of regulatory capital across large banking organizations and using different approaches (for example, the expanded risk-based approach and the U.S. standardized approach) for the calculation of risk-weighted assets? Question 4: What are the advantages and disadvantages of applying the countercyclical capital buffer and supplementary leverage ratio to banking organizations subject to Category IV capital standards?
III. Proposed Changes to the Capital
Rule
A. Calculation of Capital Ratios and Application of Buffer Requirements Under the proposal, large banking organizations would be required to calculate total risk-weighted assets under two approaches: (1) the expanded risk-based approach, and (2) the standardized approach. Total riskweighted assets under the expanded risk-based approach (expanded total risk-weighted assets) would equal the sum of risk-weighted assets for credit risk, equity risk, operational risk, market risk, and CVA risk, as described in this proposal, minus any amount of the banking organization’s adjusted allowance for credit losses that is not included in tier 2 capital and any amount of allocated transfer risk reserves. For calculating standardized total risk-weighted assets, the proposal would revise the methodology for determining market risk-weighted assets and would require banking organizations subject to Category III or IV capital standards to use the standardized approach for counterparty credit risk (SA–CCR) for derivative exposures.21 To determine its applicable risk-based capital ratios, a large banking organization would calculate two sets of risk-based capital ratios (common equity tier 1 capital ratio, tier 1 capital ratio, and total capital ratio), one using expanded total risk-weighted assets and one using standardized total riskweighted assets. A banking organization’s common equity tier 1 capital ratio, tier 1 capital ratio, and total capital ratio would be the lower of each ratio of the two approaches. The proposal would not change the minimum risk-based capital ratios under the capital rule. Also, the capital conservation buffer would continue to apply to risk-based capital ratios as under the capital rule, except that the stress capital buffer requirement—a component of the capital conservation buffer that is applicable to banking organizations subject to the Board’s capital plan rule—would apply to a banking organization’s risk-based capital ratios regardless of whether the ratios result from the expanded riskbased approach or the standardized approach. Question 5: What are the advantages and disadvantages of banking organizations being required to calculate risk-based capital ratios in two different ways and what alternatives, such as a single calculation, should the agencies consider and why? What modifications, if any, to the proposed structure of the risk-based capital calculation should the agencies consider?
22 12 CFR 3.11 (OCC); 12 CFR 217.11 (Board); 12 CFR 324.11 (FDIC). 23 12 CFR 225.8 (bank holding companies and U.S. intermediate holding companies of foreign banking organizations); 12 CFR 238.170 (savings and loan holding companies). 24See 12 CFR 217.11(c). 25See 85 FR 15576 (March 18, 2020). 26 12 CFR 225.8(f)(2); 12 CFR 238.170(f)(2). weighted assets. This output floor would correspond to 72.5 percent of the sum of a banking organization’s credit risk-weighted assets, equity riskweighted assets, operational riskweighted assets, and CVA risk-weighted assets under the expanded risk-based approach and risk-weighted assets calculated using the standardized measure for market risk, minus any amount of the banking organization’s adjusted allowance for credit losses that is not included in tier 2 capital and any amount of allocated transfer risk reserves. The output floor would serve as a lower bound on the risk-weighted assets under the expanded risk-based approach. In other words, if the riskweighted assets under the expanded risk-based approach were less than the output floor, the output floor would have to be used as the risk-weighted asset amount to determine the expanded risk-based approach capital ratios. The proposed calibration of the output floor aims to strike a balance between allowing internal models to enhance the risk sensitivity of market risk capital requirements and ensuring that these models would not result in unwarranted reductions in capital requirements. The output floor would be consistent with the Basel III reforms, which would promote consistency in capital requirements for large, complex, and internationally active banking organizations across jurisdictions. Question 6: What are the advantages and disadvantages of the proposed output floor?
2. Stress Capital Buffer Requirement
Under the current capital rule, each banking organization is subject to one or more buffer requirements, and must maintain capital ratios above the sum of its minimum requirements and buffer requirements to avoid restrictions on capital distributions and certain discretionary bonus payments.22 Banking organizations that are subject to the Board’s capital plan rule 23 (bank holding companies, U.S. intermediate holding companies, and savings and loan holding companies that have over $100 billion or more in total consolidated assets) are currently subject to a standardized approach capital conservation buffer requirement, which is calculated as the sum of the banking organization’s stress capital buffer requirement, applicable countercyclical capital buffer requirement, and applicable GSIB surcharge. The standardized approach capital conservation buffer requirement applies to a banking organization’s standardized approach risk-based capital ratios. In addition, banking organizations that are subject to the capital plan rule and the advanced approaches requirements are subject to an advanced approaches capital conservation buffer requirement, which applies to their advanced approaches risk-based capital ratios, and which is calculated in the same manner as the standardized approach capital conservation buffer requirement, except that the banking organization’s stress capital buffer requirement is replaced with a 2.5 percent buffer requirement.24 The stress capital buffer requirement integrates the results of the Board’s supervisory stress tests with the riskbased requirements of the capital rule to determine capital distribution limitations. As a result, required capital levels for each banking organization more closely align with the banking organization’s risk profile and projected losses as measured by the Board’s stress test.25 The stress capital buffer requirement is generally calculated as (1) the difference between the banking organization’s starting and minimum projected common equity tier 1 capital ratios under the severely adverse scenario in the supervisory stress test (stress test losses) plus (2) the sum of the dollar amount of the banking organization’s planned common stock dividends for each of the fourth through seventh quarters of the planning horizon as a percentage of risk-weighted assets (dividend add-on).26 A banking organization’s stress capital buffer requirement cannot be less than 2.5 percent of standardized total riskweighted assets. Currently, the stress test losses and dividend add-on portion of the stress capital buffer requirement are calculated using only the standardized approach common equity tier 1 capital ratio. This is consistent with the exclusion of the stress capital buffer requirement from the advanced approaches capital conservation buffer requirement, and with the Board’s stress testing and capital plan rules, under which banking organizations are not required to project capital ratios using the advanced
approaches. The Board is proposing to amend its capital plan rule, stress testing rule, and the buffer framework in its capital rule to take into account capital ratios calculated under the expanded riskbased approach, in addition to the standardized approach. Under the proposal, banking organizations subject to the capital plan rule would be subject to a single capital conservation buffer requirement, which would include the stress capital buffer requirement, applicable countercyclical capital buffer requirement, and applicable GSIB surcharge, and would apply to the banking organization’s risk-based capital ratios, regardless of whether the ratios result from the expanded riskbased approach or the standardized approach. In this manner, the proposal would ensure that the stress capital buffer requirement contributes to the robustness and risk-sensitivity of the EP18SE23.000</GPH>
27 Initially, the Board did not incorporate the stress capital buffer requirement into the advanced approaches capital conservation buffer requirement owing to the complexity involved in doing so. 28The Board’s Stress Testing Policy Statement includes an assumption that the magnitude of a banking organization’s balance sheet will be fixed throughout the projection horizon under the supervisory stress test. 12 CFR part 252, appendix B. Under this assumption, because the denominators of the common equity tier 1 capital ratios as calculated under the standardized approach and the expanded risk-based approach would remain the same throughout the stress test, the approach under which the binding common equity tier 1 capital ratio is calculated would remain the same throughout the final quarter of the previous capital plan cycle and the projection horizon. risk-based capital requirements of these banking organizations. Application of the stress capital buffer requirement to the risk-based capital ratios derived from the expanded risk-based approach would not introduce complexity given the fixed balance sheet assumption currently used in the Board stress tests and because the expanded risk-based approach is based in mostly standardized requirements.27 Additionally, the proposal would revise the calculation of the stress capital buffer requirement for large banking organizations. Under the proposal, both the stress test losses and dividend add-on components of the stress capital buffer requirement would be calculated using the binding common equity tier 1 capital ratio, as of the final quarter of the previous capital plan cycle, regardless of whether it results from the expanded risk-based approach or the standardized approach.28 The proposed calculation methodology would limit complexity relative to potential alternatives, such as introducing two stress capital buffer requirements for each banking organization (one for each approach to calculating total risk-weighted assets). In addition, the proposed approach recognizes that the binding approach for a banking organization is unlikely to change within the period in which a given stress capital buffer requirement is applicable. As part of the capital buffer framework, the stress capital buffer requirement helps ensure that a banking organization can withstand losses from a severely adverse scenario, while still meeting its minimum regulatory capital requirements and thereby continuing to serve as a viable financial intermediary. Because this proposal aims to better reflect the risk of banking organizations’ exposures in the calculation of riskweighted assets, without changing the targeted level of conservatism of the minimum capital requirements, the Board is not proposing associated changes to the targeted severity of the stress capital buffer requirement. The Board evaluates the minimum riskbased capital requirements, which are largely determined by risk-weighted assets, and the stress capital buffer
requirement individually for their specific intended purposes in the capital framework, and holistically as they determine the aggregate capital banking organizations hold in the normal course of business. In addition to revising the stress capital buffer requirement, the proposal would amend the Board’s stress testing and capital plan rules to require banking organizations subject to Category I, II, or III standards to project their risk-based capital ratios in their company-run stress tests and capital plans using the calculation approach that results in the binding ratios as of the start of the projection horizon (generally, as of December 31 of a given year). Also, the proposal would require banking organizations subject to Category IV standards to project their risk-based capital ratios under baseline conditions in their capital plans and FR Y–14A submissions using the risk-weighted assets calculation approach that results in the binding ratios as of the start of the projection horizon. The use of the binding approach to calculating riskbased capital ratios aims to conform company-run stress tests and capital plans with the binding risk-based capital ratios in the proposed capital rule and promote simplicity relative to possible alternatives (such as requiring that firms project ratios under both the expanded risk-based approach and the standardized approach). Question 7: The Board invites comment on the appropriate level of risk capture for the risk-weighted assets framework and the stress capital buffer requirement, both for their respective roles in the capital framework and for their joint determination of overall capital requirements. How should the Board balance considerations of overall capital requirements with the distinct roles of minimum requirements and buffer requirements? What adjustments, if any, to either piece of the framework should the Board consider? Which, if any, specific portfolios or exposure classes merit particular attention and why? Question 8: What are the advantages and disadvantages of applying the same stress capital buffer requirement to a banking organization’s risk-based capital ratios regardless of whether they are determined using the standardized or expanded risk-based approach? What would be the advantages and disadvantages of applying different stress capital buffer requirements for each set of risk-based capital ratios? Question 9: What, if any, adjustments should the Board consider with respect to the buffer requirements to account for the transitions in this proposal, particularly related to expanded total risk-weighted assets? For example, what would be the advantages and disadvantages of the Board determining stress capital buffer requirements using fully phased-in expanded total riskweighted assets versus transitional expanded total risk-weighted assets? What, if any, additional adjustments to stress capital buffer requirements should the Board consider during the expanded total risk-weighted
assets transition? B. Definition of Capital The agencies regularly review their capital framework to help ensure it is functioning as intended. Consistent with this ongoing assessment, the agencies believe it is appropriate to align the definition of capital for banking organizations subject to Category III or IV capital standards with the definition currently applicable to banking organizations subject to Category I or II capital standards. The current definition of capital applicable to banking organizations subject to Category I or II capital standards provides for risk sensitivity and transparency that is commensurate with the size, complexity, and risk profile of banking organizations subject to Category III or IV capital standards. The proposed alignment of the numerator and denominator of regulatory capital ratios of large banking organizations would support the transparency of the capital rule as it facilitates market participants’ assessment of loss absorbency and would promote consistency of requirements across large banking organizations. As described in more detail below, under the proposal, banking organizations subject to Category III or IV capital standards would be required to recognize most elements of AOCI in regulatory capital consistent with the treatment for banking organizations subject to Category I or II capital standards. Banking organizations subject to Category III or IV capital standards would also apply the capital deductions and minority interest treatments that are currently applicable to banking organizations subject to Category I or II capital standards. The proposal would also apply total loss absorbing capacity (TLAC) holdings deduction treatments to banking organizations subject to Category III or IV capital standards. The proposal
29See 12 CFR 3.22(b) (OCC); 12 CFR 217.22(b) (Board); 12 CFR 324.22(b) (FDIC). A banking organization that made an opt-out election is currently required to adjust common equity tier 1 capital as follows: subtract any net unrealized holding gains and add any net unrealized holding losses on available-for-sale securities; subtract any accumulated net gains and add any accumulated net losses on cash flow hedges; subtract any amounts recorded in AOCI attributed to defined benefit postretirement plans resulting from the initial and subsequent application of the relevant GAAP standards that pertain to such plans (excluding, at the banking organization’s option, the portion relating to pension assets deducted under §ll.22(a)(5) of the current capital rule); and, subtract any net unrealized holding gains and add any net unrealized holding losses on held-tomaturity securities that are included in AOCI. 30AFS securities refers to debt securities. ASC Subtopic 321–10 eliminated the classification of equity securities with readily determinable fair values not held for trading as available-for-sale and generally requires investments in equity securities to be measured at fair value with changes in fair value recognized in net income. Changes in the fair value of (i.e., the unrealized gains and losses on) a banking organization’s equity securities are recognized through net income rather than other comprehensive income. 31 84 FR 59230, 59249 (November 1, 2019). 32 GAAP set forth restrictions on the classification of a debt security as HTM, circumstances not consistent with the HTM classification, and situations that call into question or taint a banking organization’s intent to hold securities in the HTM category. 33See Board of Governors of the Federal Reserve System, Supervision and Regulation Report, at 11 (November 2022); Office of the Comptroller of the Currency, Semiannual Risk Perspective, at 22 (Fall 2022); Federal Deposit Insurance Corporation, Fourth Quarter 2022 Quarterly Banking Profile, at 5, 22 (February 2023), Managing Sensitivity to Market Risk in a Challenging Interest Rate Environment (FIL–46–2013, October 8, 2013). 34See 12 CFR part 50 (OCC); 12 CFR part 249 (Board); 12 CFR part 329 (FDIC). 35 Minority interest, also referred to as noncontrolling interest, reflects investments in the capital instruments of subsidiaries of banking organizations that are held by third parties. 36A significant investment in the capital of an unconsolidated financial institution is defined as an investment in the capital of an unconsolidated financial institution where a banking organization subject to Category I or II capital standards owns more than 10 percent of the issued and outstanding common stock of the unconsolidated financial institution. 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC). 37See 12 CFR 3.22(c)(6), (d)(2) (OCC); 12 CFR 217.22(c)(6), (d)(2) (Board); 12 CFR 324.22(c)(6), (d)(2) (FDIC). includes a three-year transition period
for AOCI.
38For banking organizations that are not subject to Category I or II capital standards, the current capital rule does not have distinct treatments for significant and nonsignificant investments in the capital of unconsolidated financial institutions. Rather, the regulatory capital treatment for an investment in the capital of unconsolidated financial institutions would be based on the type of instrument underlying the investment. 39A non-significant investment in the capital of an unconsolidated financial institution is defined as an investment in the capital of an unconsolidated financial institution where a banking organization subject to Category I or II capital standards owns 10 percent or less of the issued and outstanding common stock of the unconsolidated financial institution. 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC). 40 12 CFR 3.22(c)(5) (OCC); 12 CFR 217.22(c)(5) (Board); 12 CFR 324.22(c)(5) (FDIC). 41 12 CFR 3.22(c)(6) (OCC); 12 CFR 217.22(c)(6) (Board); 12 CFR 324.22(c)(6) (FDIC). 42See 12 CFR 3.22(c) (OCC); 12 CFR 217.22(c) (Board); 12 CFR 324.22(c) (FDIC). 43Similar to banking organizations subject to Category II capital standards, the definition of excluded covered debt and the applicable capital treatment, would not apply to banking organizations subject to Category III and IV capital standards. See 12 CFR 3.2 (OCC); 12 CFR 217.2) (Board); 12 CFR 324.2 (FDIC). 44See 12 CFR 3.21(b) (OCC); 12 CFR 217.21(b) (Board); 12 CFR 324.21(b) (FDIC). 45See 12 CFR 3.21(a) (OCC); 12 CFR 217.21(a) (Board); 12 CFR 324.21(a) (FDIC). threshold deduction but that nevertheless exceeds 15 percent of the banking organization’s common equity tier 1 capital minus certain deductions and adjustments. Under the current capital rule, banking organizations subject to Category III or IV capital standards are required to deduct from common equity tier 1 capital any amount of MSAs, temporary difference DTAs that the banking organization could not realize through net operating loss carrybacks, and investments in the capital of unconsolidated financial institutions 38 that individually exceed 25 percent of common equity tier 1 capital of the banking organization minus certain deductions and adjustments. Under the proposal, banking organizations subject to Category III or IV capital standards would be required to deduct threshold items from common equity tier 1 capital and apply other capital deductions that are currently applicable to banking organizations subject to Category I or II capital standards instead of the deductions applicable to all other banking organizations, thereby creating alignment across all banking organizations subject to the proposal. In addition to deductions for the threshold items, the current capital rule requires that a banking organization subject to Category I or II capital standards deduct from regulatory capital any amount of the banking organization’s nonsignificant investments 39 in the capital of unconsolidated
financial institutions that exceeds 10 percent of the banking organization’s common equity tier 1 capital minus certain deductions and adjustments.40 Further, significant investments in the capital of unconsolidated financial institutions not in the form of common stock must be deducted from regulatory capital in their entirety.41 Under the proposal, banking organizations subject to Category III or IV capital standards would be required to make these deductions. Similar to the deductions for investments in the capital of unconsolidated financial institutions, the current capital rule requires banking organizations subject to Category I or II capital standards to deduct covered debt instruments from regulatory capital.42 Under the proposal, banking organizations subject to Category III or IV capital standards would be required to apply the deduction requirements for certain investments in unsecured debt instruments issued by U.S. or foreign GSIBs (covered debt instruments) that currently apply to banking organizations subject to Category I or II capital standards.43 The current capital rule generally treats investments in unsecured debt instruments issued by U.S. or foreign GSIBs as tier 2 capital instruments for purposes of applying deduction requirements. The current capital rule also limits the amount of minority interest that banking organizations subject to Category I or II capital standards may include in regulatory capital based on the amount of capital held by a consolidated subsidiary, relative to the amount of capital the subsidiary would have had to maintain to avoid any restrictions on capital distributions and discretionary bonus payments under capital conservation buffer requirements.44 Under the current capital rule, banking organizations subject to Category III or IV capital standards are allowed to include: (i) common equity tier 1 minority interest comprising up to 10 percent of the parent banking organization’s common equity tier 1 capital; (ii) tier 1 minority interest comprising up to 10 percent of the parent banking organization’s tier 1 capital; and (iii) total capital minority interest comprising up to 10 percent of the parent banking organization’s total capital.45 Under the proposal, the limitations on minority interests that apply to banking organizations subject to Category I or II capital standards would also apply to banking organizations subject to Category III or IV capital standards.
3. Additional Definition of Capital
Adjustments
The current capital rule applies an additional capital eligibility criterion to banking organizations subject to Category I or II capital standards for their additional tier 1 and tier 2 capital instruments. The criterion requires that the governing agreement, offering circular or prospectus for the instrument must disclose that the holders of the instrument may be fully subordinated to interests held by the U.S. government in the event the banking organization enters into a receivership, insolvency, liquidation, or similar proceeding. Under the proposal, this eligibility criterion would also apply to instruments issued after the date on which the issuer becomes subject to the proposed rule, which generally would be the effective date of a final rule for banking organizations subject to Category III or IV capital standards. Instruments issued by banking organizations subject to Category III or IV capital standards prior to the effective date of a final rule that currently count as regulatory capital would continue to count as regulatory capital as long as those instruments remain outstanding.
4. Changes to the Definition of Tier 2
Capital Applicable to Large Banking Organizations The current capital rule defines an element of tier 2 capital to include the allowance for loan and lease losses (ALLL) or the adjusted allowance for credit losses (AACL), as applicable, up to 1.25 percent of standardized total risk-weighted assets not including any amount of the ALLL or AACL, as applicable (and excluding in the case of a banking organization subject to market risk requirements, its standardized market risk-weighted assets). Further, as
part of its calculations for determining
its total capital ratio, a banking organization subject to Category I or II standards must determine its advancedapproaches-adjusted total capital by (1) deducting from its total capital any ALLL or AACL, as applicable, included in its tier 2 capital and; (2) adding to its total capital any eligible credit reserves that exceed the banking organization’s total expected credit losses to the extent that the excess reserve amount does not exceed 0.6 percent of credit-riskweighted assets. Due to changes in GAAP, all large banking organizations are no longer using ALLL and must use AACL. In addition, the concept of eligible credit reserves is related to use
46See 12 CFR 3.10(e) (OCC); 12 CFR 217.10(e) (Board); 12 CFR 324.10(e) (FDIC). 47See 12 CFR part 30, appendix A (OCC); 12 CFR,
appendix D–1 to part 208 (Board); 12 CFR,
appendix A to part 364 (FDIC).
48When performing due diligence, banking organizations must adhere to the operational and managerial standards for loan documentation and credit underwriting as set forth in the Interagency Guidelines Establishing Standards for Safety and Soundness (safety and soundness guidelines). 49For treatment of other exposures to GSEs, see discussion related to equity exposures in section III.E. and exposures to subordinated debt instruments in section III.C.2.d. of this SUPPLEMENTARY INFORMATION. of the internal ratings-based approach, which the proposal would eliminate. Therefore, under the proposal, a large banking organization would determine its expanded risk-based approachadjusted total capital by (1) deducting from its total capital AACL included in its tier 2 capital and; (2) adding to its total capital any AACL up to 1.25 percent of total credit risk-weighted assets. The proposal would define total credit risk-weighted assets as the sum of total risk-weighted assets for: (1) general credit risk as calculated under § ll.110; (2) cleared transactions and default fund contributions as calculated under §ll.114; (3) unsettled transactions as calculated under § ll.115; and (4) securitization exposures as calculated under § ll.132. Question 11: The agencies seek comment on the proposed definition of total credit risk-weighted assets in connection with determining a banking organization’s total capital ratio. What, if any, modifications should the agencies consider making to this definition and why?
C. 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. In this section of the SUPPLEMENTARY INFORMATION, subsection III.C.1. describes expectations for completing due diligence on a banking organization’s credit risk portfolio; subsection III.C.2. describes the riskweight treatment for on-balance sheet exposures under the proposal; subsection III.C.3. describes the proposed approach to determine the exposure amount for off-balance sheet exposures; and subsections III.C.4.–5 provide the available approaches for recognizing the benefits of credit risk mitigants including certain guarantees, certain credit derivatives and financial collateral.
50Carrying 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 III.C.4, II.C.5.b., and III.D. of this SUPPLEMENTARY INFORMATION. 51See 12 U.S.C. 1831n. 52Under the proposal, the expanded risk-based approach would rely on the treatment of sovereign default in the current standardized approach in the capital rule. See 12 CFR 3.32(a)(6) (OCC); 12 CFR 217.32(a)(6) (Board); 12 CFR 324.32 (a)(6) (FDIC). 53For the treatment of defaulted real estate exposures, see section III.C.2.e.vii of this SUPPLEMENTARY INFORMATION. 54A policy loan is defined under §ll.2 of the current capital rule to mean means a loan by an insurance company to a policy holder pursuant to the provisions of an insurance contract that is secured by the cash surrender value or collateral assignment of the related policy or contract. A policy loan includes: (1) A cash loan, including a loan resulting from early payment benefits or accelerated payment benefits, on an insurance contract when the terms of contract specify that the payment is a policy loan secured by the policy; and (2) An automatic premium loan, which is a loan that is made in accordance with policy provisions which provide that delinquent premium payments are automatically paid from the cash value at the end of the established grace period for premium payments. See 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC). 55Counterparty credit risk is the risk that the counterparty to a transaction could default before the final settlement of the transaction where there is a bilateral risk of loss. modify the credit conversion factors applicable to commitments. Additionally, the proposal would introduce new definitions for defaulted exposures and defaulted real estate exposures. Under the proposal, a banking organization would determine the riskweighted asset amount for an onbalance sheet exposure by multiplying the exposure amount by the applicable risk weight, consistent with the method used under the current standardized approach. The on-balance sheet exposure amount would generally be the banking organization’s carrying value 50 of the exposure, consistent with the value of the asset on the balance sheet as determined in accordance with GAAP, which is the same as under the current capital
rule. For all assets other than AFS securities and purchased credit-deteriorated assets, the carrying value is not reduced by any associated credit loss allowance that is determined in accordance with GAAP. Using the value of an asset under GAAP to determine a banking organization’s exposure amount would reduce burden and provide a consistent framework that can be easily applied across all banking organizations of the proposal because, in most cases, GAAP serve as the basis for the information presented in financial statements and regulatory reports.51 The proposal would group credit risk exposures into the following categories:
sovereign exposures; exposures to certain supranational entities and multilateral development banks; exposures to GSEs; exposures to depository institutions, foreign banks, and credit unions; exposures to PSEs; real estate exposures; retail exposures; corporate exposures; defaulted exposures; exposures to subordinated debt instruments; and off-balance sheet exposures. The proposed categories with amended risk-weight treatments relative to the current standardized approach include equity exposures to GSEs and exposures to subordinated debt instruments issued by GSEs; exposures to depository institutions, foreign banks, and credit unions; exposures to subordinated debt instruments; real estate exposures; retail exposures; corporate exposures; defaulted exposures; and some off-balance sheet exposures such as commitments. The proposed risk weight treatments for each of these categories are described in the following sections of this SUPPLEMENTARY INFORMATION. a. Defaulted Exposures The proposal would introduce an enhanced definition of a defaulted exposure that would be broader than the current capital rule’s definition of a defaulted exposure under subpart E. The proposed scope and criteria of the defaulted exposure category is intended to appropriately capture the elevated credit risk of exposures where the banking organization’s reasonable expectation of repayment has been reduced, including exposures where the obligor is in default on an unrelated obligation. Under the proposal, a defaulted exposure would be any exposure that is a credit obligation and that meets the proposed criteria related to reduced expectation of repayment, and that is not an exposure to a sovereign entity,52 a real estate exposure,53 or a policy loan.54 The proposal would define a credit obligation as any exposure where the lender but not the obligor is exposed to credit risk. In other words, for these exposures, the lender would have a claim on the obligor that does not give rise to counterparty credit risk 55 and would exclude derivative contracts, cleared transactions, default fund contributions, repo-style transactions, eligible margin loans, equity exposures, and securitization exposures. For all other exposure categories (excluding an exposure to a sovereign entity, real estate exposure, a retail exposure, or a policy loan), the proposed definition of defaulted exposure would look to the performance of the borrower with respect to credit obligations to any creditor. Specifically, if the banking organization determines that an obligor meets any of the of the defaulted criteria for exposures that are not retail exposures, described further below, the proposal would require the banking organization to treat all exposures that are credit obligations of that obligor as defaulted exposures. Additionally, the proposal would differentiate the criteria for determining whether an exposure is a defaulted exposure between exposures that are retail exposures and those that are
not. Retail exposures are originated to individuals or small- and medium-sized businesses. Evaluating whether a retail borrower has other exposures that are in default as defined by the proposal may be difficult to operationalize for banking organizations given many unique obligors. For other types of exposures that are not retail exposures, evaluating default at the obligor level is appropriate because those obligors are more likely to have additional credit obligations that are large and held by multiple banking organizations. Default on one of those credit obligations would be indicative of increased riskiness of the exposure held by a banking organization, and hence a banking organization should account for this in evaluating the risk profile of the borrower. Under the proposal, for a retail exposure, a credit obligation would be considered a defaulted exposure if any of the following has occurred: (1) the exposure is 90 days past due or in nonaccrual status; (2) 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 (3) 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
56Overdrafts are past due and are considered defaulted exposures once the obligor has breached an advised limit or been advised of a limit smaller than the current outstanding balance. 57Under §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. See 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC). 58The proposal would revise the definition of speculative grade to mean that the entity to which a 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 in the near term, but is vulnerable to adverse economic conditions, such that should economic conditions deteriorate, the issuer or the reference entity would present an elevated default risk. 59 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).
60Similar to the treatment of senior debt exposures to GSEs and GSE exposures that are not equity exposures or exposures to a subordinated debt instrument issued by a GSE, the proposal would apply the same 20 percent risk weight to all exposures to FHLB or Farmer Mac, including equity exposures and exposures to subordinated debt instruments, which continues the treatment under the current standardized approach. 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, term extension, or an interest rate reduction. A sustained period of repayment performance by the borrower is generally a minimum of six months in accordance with the contractual terms of the restructured exposure. For exposures that are not retail exposures (excluding an exposure to a sovereign entity, a real estate exposure, or a policy loan), a credit obligation would be considered a defaulted exposure if either of the following has occurred: (1) the obligor has a credit obligation to the banking organization that is 90 days or more past due 56 or in nonaccrual status; or (2) the banking organization determines that, based on ongoing credit monitoring, the obligor is unlikely to pay its credit obligations to the banking organization in full, without recourse by the banking organization. If a banking organization determines that an obligor meets these proposed criteria, the proposal would require the banking organization to treat all exposures that are credit obligations of that obligor as defaulted exposures. For purposes of the second criterion, the proposal would require a banking organization to consider an obligor as unlikely to pay its credit obligations if any of the following criteria apply: (1) the obligor has any credit obligation that is 90 days or more past due or in nonaccrual status with any creditor; (2) any credit obligation of the obligor has been sold at a credit-related loss; (3) a distressed restructuring of any credit obligation of the obligor was agreed to by any creditor, provided that a distressed restructuring includes the following made for credit-related reasons: forgiveness or postponement of principal, interest, or fees, term extension or an interest rate reduction; (4) the obligor is subject to a pending or active bankruptcy proceeding; or (5) any creditor has taken a full or partial charge-off, write-down of principal, or negative fair value adjustment on a credit obligation of the obligor for credit-related reasons. Under the proposal, banking organizations are expected to conduct ongoing credit monitoring regarding relevant obligors. The proposal would require banking organizations to continue to treat an exposure as a defaulted exposure until the exposure no longer meets the definition or until the banking organization determines that the obligor meets the definition of investment grade 57 or the proposed definition of speculative grade.58 The proposal would revise the definition of speculative grade, consistent with the current definition of investment grade, to allow the definition to apply to entities to which the banking organization is exposed through a loan or security. In addition, the proposal would make the same revision to the definition of sub-speculative grade. A banking organization would assign a 150 percent risk weight to a defaulted exposure including any exposure amount remaining on the balance sheet following a charge-off, and any
other non-retail exposure to the same obligor, to reflect the increased uncertainty as to the recovery of the remaining carrying value. The proposed risk weight is intended to reflect the impaired credit quality of defaulted exposures and to help ensure that banking organizations maintain sufficient regulatory capital for the increased probability of losses on these exposures. A banking organization may apply a risk weight to the guaranteed or secured portion of a defaulted exposure based on (1) the risk weight under § ll.120 of the proposal if the guarantee or credit derivative meets the applicable requirements or (2) the risk weight under §ll.121 of the proposal if the collateral meets the applicable requirements. Question 13: How does the defaulted exposure definition compare with banking organizations’ existing policies relating to the determination of the credit risk of a defaulted exposure and the creditworthiness of a defaulted obligor? What additional clarifications are necessary to determine the point at which retail and non-retail exposures should no longer be treated as defaulted exposures? Question 14: What operational challenges, if any, would a banking organization face in identifying which exposures meet the proposed definition of defaulted exposure? In particular, the agencies seek comment on the ability of a banking organization to obtain the necessary information to assess whether the credit obligations of a borrower to creditors other than the banking organization would meet the proposed criteria? What operational challenges, if any, would a banking organization face in identifying whether obligors on nonretail credit obligations are subject to a pending or active bankruptcy proceeding? Question 15: For the purposes of retail credit obligations, the agencies invite comment on the appropriateness of including a borrower’s bankruptcy as a criterion for a defaulted exposure. What operational challenges, if any, would a banking organization face in identifying whether obligors on retail credit obligations are subject to a pending or active bankruptcy proceeding? To what extent would criteria (1) through (3) in the proposed defaulted exposure definition for retail exposures sufficiently capture the risk of a borrower involved in a bankruptcy proceeding? Question 16: What alternatives to the proposed treatment should the agencies consider while maintaining a risksensitive treatment for credit risk of a defaulted borrower? For example, what would be the advantages and disadvantages of limiting the defaulted borrower scope to obligations of the borrower with the banking organization? b. Exposures to Government-Sponsored Enterprises The proposal would assign a 20 percent risk weight to GSE 59 exposures that are not equity exposures, securitization exposures or exposures to a subordinated debt instrument issued by a GSE, consistent with the current standardized approach.60 Under the proposal, an exposure to the common stock issued by a
GSE would be an
61Under §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 (October 11, 2013). 62The 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). 63See 12 CFR part 702 (National Credit Union Administration). 64See 12 CFR 3.12(a)(1) (OCC); 12 CFR 217.12(a)(1) (Board); 12 CFR 324.12(a)(1) (FDIC). 65See 12 CFR 6.4(b)(2) (OCC); 12 CFR 208.43(b)(2) (Board); 12 CFR 324.403(b)(2) (FDIC). 66The capital ratios used for this determination are the ratios on the depository institution’s most recent quarterly Call Report. 67See 12 CFR part 702 (National Credit Union Administration). equity exposure. An exposure to the preferred stock issued by a GSE would be an equity exposure or an exposure to a subordinated debt instrument, depending on the contractual terms of the preferred stock instrument. Equity exposures to a GSE must be assigned a risk-weighted asset amount as calculated under §§ ll.140 through ll.142 of subpart E. An exposure to a subordinated debt instrument issued by a GSE must be assigned a 150 percent risk weight, unless issued by a FHLB or Farmer Mac. As discussed later in sections III.E. and III.C.2.d. of this SUPPLEMENTARY INFORMATION, equity exposures and exposures to subordinated debt instruments would generally be subject to an increased riskbased capital requirement to reflect their heightened risk relative to exposures to senior debt.
c. Exposures to Depository Institutions,
Foreign Banks, and Credit Unions The proposal would define the scope of exposures to depository institutions, 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 any depository institution, foreign bank, or credit union.61 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 the bank exposure category would be based on 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,62 or under similar rules of the National Credit Union Administration.63 For example, an exposure to an investment grade depository institution could qualify as a Grade A bank exposure if the depository institution was not subject to limitations on distributions and discretionary bonus payments under the capital rules and had riskbased capital ratios that met the well capitalized thresholds under the agencies’ prompt corrective action framework. 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, even if the obligor depository institution were in the grace period under the CBLR framework.64 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. 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 requirements for the adequatelycapitalized category 65 under the agencies’ prompt corrective action framework,66 or under similar rules of the National Credit Union Administration.67 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 consistent with international capital standards issued by the Basel Committee. A Grade C bank exposure would mean a bank exposure that does not qualify as a Grade A or Grade B bank exposure. For example, a bank exposure would be a Grade C bank exposure if the obligor depository institution, foreign bank, or credit union has not publicly disclosed its capital ratios within the last six months. In addition, an exposure would be a Grade C bank exposure if 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. Under the proposal, a foreign bank exposure that is a Grade A or Grade B bank exposure and is a self-liquidating, 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. The proposal would also 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
68See §ll.111 for the proposed sovereign riskweight table, which is identical to Table 1 to §ll.32 in the current capital rule. 69Under §ll. 2 of the current capital rule, a Country Risk Classification (CRC) for a sovereign means the most recent consensus CRC published by the Organization for Economic Cooperation and Development (OECD) as of December 31st of the prior calendar year that provides a view of the likelihood that the sovereign will service its external debt. See 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC). For more information on the OECD country risk classification methodology, see OECD, ‘‘Country Risk Classification,’’ available at https://www.oecd.org/ trade/topics/export-credits/arrangement-andsector-understandings/financing-terms-andconditions/country-risk-classification/. 70The CRCs reflect an assessment of country risk, used to set interest rate charges for transactions covered by the OECD arrangement on export credits. The CRC methodology classifies countries into one of eight risk categories (0–7), with countries assigned to the zero category having the lowest possible risk assessment and countries assigned to the 7 category having the highest possible risk assessment. See 78 FR 62088 (October 11, 2018). 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) the exposure to a foreign bank branch that is not in the local currency of the jurisdiction in which the foreign branch operates (sovereign risk-weight floor).68 The risk weight floor would not apply to shortterm 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 40 percent to 150 percent. Question 17: What are the advantages and disadvantages of assigning a range of risk weights based on the bank’s creditworthiness? What alternatives, if any, should the agencies consider, including to address potential concerns around procyclicality? Question 18: What are the advantages and disadvantages of incorporating specific capital levels in the determination of each of the three categories of bank exposures? What, if any, other risk factors should the banking agencies consider to differentiate the credit risk of bank exposures? What concerns, if any, could limitations on available information about foreign banks raise in the context of determining the appropriate risk weights for exposures to such banks and how should the agencies consider addressing such concerns? Question 19: What is the impact of limiting the lower risk weight for selfliquidating, trade-related contingent items that arise from the movement of goods to those with a maturity of three months or less? What would be the advantages and disadvantages of expanding this risk weight treatment to include such exposures with a maturity of six
months or less? What would be the advantages and disadvantages of limiting this reduced risk weight treatment to only foreign banks whose home country has an Organization for Economic Cooperation and Development (OECD) Country Risk Classification (CRC) 69 of 0, 1, 2, or 3, or is an OECD member with no CRC, consistent with the current standardized approach? 70 d. Subordinated Debt Instruments The proposal would introduce a definition and an explicit risk weight treatment for exposures in the form of subordinated debt instruments. The proposed definition of a subordinated debt instrument would capture exposures that are financial instruments and present heightened credit risk but are not equity exposures, including: (1) any preferred stock that does not meet the definition of an equity exposure, (2) any covered debt instrument, including a TLAC debt instrument, that is not deducted from regulatory capital, and (3) any debt instrument that qualifies as tier 2 capital under the current capital rule or that would otherwise be treated as regulatory capital by the primary Federal supervisor of the issuer and that is not deducted from regulatory capital. The proposal would define a subordinated debt instrument as (1) a debt security that is a corporate exposure, a bank exposure, or an exposure to a GSE, including a note, bond, debenture, similar instrument, or other debt instrument as determined by the primary Federal supervisor, that is subordinated by its terms, or separate intercreditor agreement, to any creditor of the obligor, or (2) preferred stock that is not an equity exposure. For these purposes, a debt security would be subordinated if the documentation creating or evidencing such indebtedness (or a separate intercreditor agreement) provides for any of the issuer’s other creditors to rank senior to the payment of such indebtedness in the event the issuer becomes the subject of a bankruptcy or other insolvency proceeding, with the scope of applicable bankruptcy or other insolvency proceedings being defined in the applicable documentation. The scope of the definition of a subordinated debt instrument is meant to capture the types of entities that issue subordinated debt instruments and for which the level of subordination is a meaningful determinant of the credit risk of the instrument. EP18SE23.001</GPH>
71Covered debt instruments are subject to deduction by banking organizations subject to Category I or II capital standards similar to the deduction framework for exposures to capital instruments. See 12 CFR 3.22(c) (OCC); 12 CFR 217.22(c) (Board); 12 CFR 324.22(c) (FDIC). As noted in section III.B.3. of this SUPPLEMENTARY INFORMATION, under the proposal, this deduction framework will be expanded to banking organizations subject to Category III or IV capital standards. As discussed in section III.C.2.b. above, exposures to subordinated debt instruments issued by an FHLB or by Farmer Mac would be assigned a 20 percent risk weight. 72For purposes of the proposal, ‘‘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. 73The 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. 74The 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. 75Section 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. In addition, even though the provision of collateral typically reduces the risk of loss on indebtedness, the proposal includes secured as well as unsecured subordinated debt securities in the scope of subordinated debt instruments, since the effect of subordination may result in the collateral providing little or no real value to the subordinated debt holder in the event the issuer becomes to subject of a bankruptcy or other insolvency proceeding. A subordinated debt instrument would not include any loan, including a syndicated loan, a debt security issued by a sovereign, public sector entity, multilateral development bank, or supranational entity, or a security that would be captured under the securitization framework. Due to the contractual obligations and structures associated with subordinated debt instruments, such exposures generally pose increased risk relative to a senior loan, including a
syndicated loan, or a senior debt security to the same entity because investments in subordinated debt instruments are usually considered junior creditors and subordinate to obligations specified in the definition of senior debt in the document governing the junior creditors’ obligations. The proposal generally would apply a 150 percent risk weight for exposures that meet the definition of a subordinated debt instrument, including any preferred stock that is not an equity exposure, and any tier 2 instrument or covered debt instrument that is not deducted from regulatory capital, including TLAC debt instruments, and any debt instrument that would otherwise be treated as regulatory capital by the primary Federal supervisor of the issuer and that is not deducted from regulatory capital.71 The instruments included in the scope of subordinated debt instruments present a greater risk of loss to an investing banking organization relative to more senior debt exposures to the same issuer because subordinated debt instruments have a lower priority of repayment in the event of default. As a result, the proposal would apply an increased risk weight to recognize this increase in loss given default. Since a covered debt instrument that qualifies as a TLAC debt instrument shares similar risk characteristics with a subordinated debt instrument, the proposal would require banking organizations to apply the same 150 percent risk weight to any such exposures that are not otherwise deducted from regulatory capital. Question 20: The agencies seek comment on the scope of the proposed definition of a subordinated debt instrument. What, if any, operational challenges might the proposed definition pose for banking organizations, such as identifying the level of subordination in debt securities or similar instruments, and how should the agencies consider addressing such challenges? Question 21: Would expanding the definition of a subordinated debt instrument to include loans that are not securities more appropriately capture the types of exposures that pose elevated risk and, if so, why? Question 22: The agencies seek comment on applying a heightened 150 percent risk weight to exposures to subordinated debt instruments issued by GSEs. What would be the advantages and disadvantages of this proposed regulatory capital requirement? Would there be any challenges for banking organizations to be able to identify which GSE exposures would be subject to the 150 percent risk weight? Please provide specific examples of any challenges and supporting data. e. 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) secured by collateral in the form of real estate,72 (3) a pre-sold construction loan,73 (4) a statutory multifamily mortgage,74 (5) a high volatility commercial real estate (HVCRE) exposure,75 or (6) an acquisition, development, or
construction (ADC) exposure. A pre-sold 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 that are not defaulted real estate exposures would be consistent with the current standardized approach. The proposal would 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 nonstatutory 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, hotels); and (3) in the case of regulatory residential or regulatory commercial real estate exposures, the loan-to-value (LTV) ratio of the exposure. These 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. The criteria in these definitions generally align with existing Interagency Guidelines for Real Estate Lending Policies (real estate lending
76See 12 CFR part 34, appendix A to subpart D (OCC); 12 CFR part 208, appendix C (Board); 12 CFR part 365, appendix A (FDIC). 77Comparable exposures include loans secured by real estate where the repayment of the loan depends on non-real estate cash flows such as owner-occupied properties, revenue from manufacturing or retail sales. 78See Board of Governors of the Federal Reserve System, Financial Stability Report (November 2020), https://www.federalreserve.gov/publications/ files/financial-stability-report-20201109.pdf. 79 Id., at 30. 80The proposed LTV criterion measures the borrower’s use of debt (leverage) to finance a real estate purchase, with higher LTV reflecting greater leverage and thus higher credit risk. guidelines).76 Real estate loans in which repayment is dependent on the cash flows generated by the real estate can expose a banking organization to elevated credit risk relative to comparable exposures 77 as the borrower 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.78 In addition, LTV ratios can be a useful risk indicator because the amount of a borrower’s equity in a real estate property correlates inversely with default risk and provides banking organizations with a degree of protection against losses.79 Therefore, exposures with lower LTV ratios generally would receive a lower risk weight than comparable real estate exposures with higher LTV ratios under the proposal.80 The following chart illustrates how the proposal would require a banking organization to assign risk weights to various real estate exposures, as described in more detail below:
BILLING CODE 6210–01–P; 6714–01–P; 4810–33–P
81Consistent 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. BILLING CODE 6210–01–C; 6714–01–C; 4810–33–C
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) that is not a defaulted real estate exposure (as defined in § ll. 101), an ADC exposure, a pre-sold construction loan, a statutory multifamily mortgage, or an HVCRE exposure, provided the exposure meets certain prudential criteria.81 First, the loan would be required to be secured by a 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 loan amount as a percent of the value of the EP18SE23.002</GPH>
82For more information on value of the property, see section III.C.2.e.iv of this SUPPLEMENTARY INFORMATION. 83See 12 CFR part 30, appendix A (OCC); 12 CFR
part 208, appendix C (Board); 12 CFR parts 364 and
365 (FDIC).
84When 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 of the criteria for a regulatory commercial real estate exposure. 85For example, if (1) a borrower purchases a twounit 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. property.82 Third, during the underwriting process, the banking organization would be required to apply underwriting policies that account for the ability of the borrower to repay based on clear and measurable underwriting standards that enable the banking organization to evaluate these credit factors. The agencies would expect these underwriting standards to be consistent with the agencies’ safety and soundness and real estate lending guidelines.83 Fourth, the property must be valued in accordance with the proposed requirements included in the proposed LTV ratio calculation, as discussed below.
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, a defaulted 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 must be primarily secured by fully completed real estate. Second, the banking organization must hold a first priority security interest in the property that is legally enforceable in all relevant jurisdictions.84 Third, the exposure must be made in accordance with prudent underwriting standards, including standards relating to the loan amount as a percent of the value of the property. Fourth, during the underwriting process, the banking organization must apply underwriting policies that account for the ability of the borrower to repay in a timely manner based on clear and measurable underwriting standards that enable the banking organization to evaluate these credit factors. The agencies would expect that these underwriting standards would be consistent with the agencies’ safety and soundness and real estate lending guidelines. Finally, the property must be valued in accordance with the proposed requirements included in the proposed LTV ratio calculation, as discussed below. Question 23: The agencies seek comment on the application of prudent underwriting standards in the proposed definitions of regulatory residential and regulatory commercial real estate exposures, including standards relating to the loan amount as a percent of the value of the property. What, if any, further clarity is needed and why?
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 borrower’s ability to service the loan is dependent on cash flows generated by the real estate. Exposures that are dependent on the cash flows generated by real estate to repay the loan can be affected by local market conditions and present elevated credit risk relative to exposures that are serviceable by the income, cash, or other assets of the borrower. For example, an increase in the supply of competitive rental property can lower demand and suppress cash flows needed to support repayment of the loan. 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 whether repayment of the exposure is dependent on cash flows generated from the real estate is a conservative and straightforward approach for differentiating the credit risk of real estate exposures. Given their increased credit risk, the proposal would assign relatively higher risk weights to exposures that are dependent on any proceeds or income generated from the real estate itself to service the debt. Under the proposal, additional loan characteristics can affect whether an exposure would be considered dependent on cash flows from the real estate. The proposal’s definition of dependence on the cash flows generated by the real estate would exclude any residential mortgage exposure that is secured by the borrower’s principal residence as such mortgage exposures present reduced credit risk relative to real estate exposures that are secured by the borrower’s non-principal residence.85 For residential properties that are not the borrower’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 borrower’s personal income and resources, rather than rental income (or resale or refinance of the property), to repay the loan. 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 dependent on the cash flows generated by the real estate for repayment of the loan. In the case of a loan to a borrower to purchase or refinance real estate where the borrower will operate a business such as a retail store or factory and rely solely on the revenues from the business or
resources of the borrower 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 borrower will rely solely on the sale of products from the farm or other resources of the borrower other than rental, resale, or other income from the real estate for repayment. Question 24: What, if any, alternative quantitative threshold should the agencies consider in determining whether a real estate exposure is dependent on cash flows from the real estate (for example, a threshold between 5 and 50 percent of the income)? Further, if the agencies decide to adopt an alternative quantitative threshold, either for regulatory residential or regulatory commercial real estate exposures, how should it be calibrated for regulatory residential and separately for regulatory commercial real estate exposures and what would be the appropriate calibration levels for each? Please provide specific examples of any
86See Garcia, Daniel (2019). ‘‘Second Home Buyers and the Housing Boom and Bust,’’ Finance and Economics Discussion Series 2019–029. Washington: Board of Governors of the Federal Reserve System, https://www.federalreserve.gov/ econres/feds/files/2019029pap.pdf. 87See 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). alternatives, including calculations and supporting data. Question 25: The agencies seek feedback on the proposed treatment of exposures secured by second homes, including vacation homes where repayment of the loan is not dependent on cash flows. What are the advantages and disadvantages of treating such exposures as regulatory residential real estate exposures? Would a different category be more appropriate for these exposures given their risk profile, and if so, describe which other category(s) of real estate exposures would be most similar and why. Please provide supporting data in your responses.86 Question 26: The agencies seek comment on the treatment of residential mortgage exposures where repayment is dependent on cash flows from overnight or short-term rentals, as such cash flows may not be as reliable as a source of repayment as cash flows from long-term rental contracts or the borrower’s other income sources. What would be the advantages or disadvantages of treating residential real estate exposures dependent on cash flows from shortterm rentals similar to commercial real estate exposures dependent on cash flows?
iv. Calculating the Loan-To-Value Ratio
The proposal would require a banking organization also to use LTV ratios to assign a risk weight to a regulatory residential or regulatory commercial real estate exposure. Under the proposal, LTV ratio would be calculated as the extension of credit divided by the value of the property. The proposed calculation of 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. The extension of credit would mean the total outstanding amount of the loan including 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 may allow a banking organization to assign a lower risk weight during the life of the loan. Similarly, if a loan balance increases, a banking organization would need to increase the risk weight if the increased LTV would result in a higher risk weight. For purposes of the LTV ratio calculation, 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 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) and also reflects the performance of private mortgage insurance during times of stress in the housing market. The agencies do not intend the proposed risk weights to be applied to LTVs that include private mortgage insurance. The value of the property would mean the value at the time of origination of all real estate properties securing or being improved by the extension of credit, plus 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 (combined, the appraisal rule),87 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 as 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 using prudently conservative valuation criteria that is separate from the banking organization’s origination and underwriting process. Supervisory experience has shown that market values of real estate properties can be temporarily impacted by local market forces and using a value figure including such volatility would not reflect the long-term value of the real estate. Therefore, the proposal would require that the value used for the LTV calculation be an amount that is more conservative than the market value of the property. Using the value of the 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 an 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 consistent with 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, on an auction or similarly available daily bid and ask price market. Readily marketable
88The 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. collateral should be appropriately discounted by the banking organization consistent with the banking organization’s usual practices for making loans secured by such collateral. 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. Other acceptable collateral should be appropriately discounted by the banking organization consistent with the banking organization’s usual practices for making loans secured by such collateral. Under the proposal, other acceptable collateral would include, among other items, unconditional irrevocable standby letters of credit for the benefit of the banking organization. The reasonableness of a banking organization’s underwriting criteria would be reviewed through the examination and supervisory process to help ensure its real estate lending policies are consistent with safe and sound banking practices. Question 27: What are the benefits and drawbacks of allowing readily marketable collateral and other acceptable collateral to be included in the value for purposes of calculating the LTV ratio? What are the advantages and disadvantages of providing specific discount factors to the value of acceptable collateral for purposes of calculating the LTV ratio such as the standard supervisory market price volatility haircuts contained in § ll.121 of the proposed rule? What alternatives should the agencies consider? Please provide specific examples and supporting data.
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 and whether the exposure is dependent on the cash flows generated by the real estate, as reflected in Tables 2 and 3 below. LTV ratios and dependence on cash flows generated by the real estate would factor into the riskweight treatment for real estate exposures under the proposal because these risk factors can be determinants of credit risk for real estate exposures. The proposed corresponding risk weights in each LTV ratio category are intended to appropriately reflect differences in the credit risk of these exposures. The risk weights that would apply under the proposal are provided below.88 While LTV ratios and dependency upon cash flows of the real estate are useful risk indicators, the agencies recognize that banking organizations consider a variety of factors when underwriting a residential real estate exposure and assessing a borrower’s ability to repay. For example, a banking organization may consider a borrower’s current and expected income, current and expected cash flows, net worth, other relevant financial resources, current financial obligations, employment status, credit history, or other relevant factors during the underwriting process. The agencies are supportive of home ownership and do not intend the proposal to diminish home affordability or homeownership opportunities, including for low- and moderate-income (LMI) home buyers or other historically underserved markets. The agencies are particularly interested in whether the proposed framework for regulatory residential real estate exposures should be modified in any way to avoid unintended impacts on the ability of otherwise credit-worthy borrowers who make a smaller down payment to purchase a home. For example, the agencies are considering whether a 50 percent risk weight would be appropriate for these loans, to the extent they are originated in accordance with prudent underwriting standards and originated through a home ownership program that the primary Federal regulatory agency determines provides a public benefit and includes risk mitigation features such as credit counseling and consideration of repayment ability. Question 28: The agencies seek comment on how the proposed treatment of regulatory residential real estate exposures will impact home affordability and home ownership opportunities, particularly for LMI borrowers or other historically underserved markets. What are the advantages and disadvantages of an alternative treatment that would assign a 50 percent risk weight to mortgage loans originated in accordance with EP18SE23.003</GPH> EP18SE23.004</GPH>
89See 12 CFR part 1026. prudent underwriting standards and originated through a home ownership program that the primary Federal regulatory agency determines provides a public benefit and includes risk mitigation features such as credit counseling and consideration of repayment ability? What, if any, additional or alternative risk indicators should the agencies consider, besides loan-to-value or dependency upon cash flow for risk-weighting regulatory residential real estate exposures? Please provide specific examples of mortgage lending programs where such factors were the basis for underwriting the loans and the historical repayment performance of the loans in such programs. Please comment on whether these risk indicators are already collected and maintained by banking organizations as part of their mortgage lending activities and underwriting practices. In addition, the agencies considered adopting an alternative risk-based capital treatment in subpart E that does not rely on loan-to-value ratios or dependency upon cash flow generated by the real estate. One such alternative would be to incorporate the same treatment for residential mortgage exposures as found in the current U.S. standardized risk-based capital framework. Under this alternative, the risk-based capital treatment for residential mortgage exposures in subpart D of the capital rule would be incorporated into the proposed subpart E. First-lien residential mortgage exposures that are prudently underwritten would receive a 50 percent risk weight consistent with the treatment contained in the U.S. standardized risk-based capital framework. Such an approach would allow banking organizations to continue to offer prudently underwritten products through lending programs with the flexibility to meet the needs of their communities without additional regulatory capital implications. The agencies note that current mortgage rules promulgated since the global financial crisis require lenders to consider each borrower’s ability to repay.89 As in subpart D, residential mortgage exposures that do not meet the requirements necessary to receive a 50 percent risk weight would receive a 100 percent risk weight. While such an approach would not use loan-to-value or dependency upon cash flow generated by the real estate to assign a risk-weight, it would provide for a simpler framework where all prudently underwritten first-lien residential mortgage exposures would receive the same risk-based capital treatment. Lastly and consistent with the treatment in subpart D, if a banking organization holds the first and junior lien(s) on a regulatory residential real estate exposure and no other party holds an intervening lien, the banking organization would be required to treat the combined exposure as a single loan secured by a first lien for purposes of assigning a risk weight. Question 29: The agencies seek comment on assigning risk weights to residential mortgage exposures, consistent with the current U.S.
standardized risk-based capital framework. What are the pros and cons of this alternative treatment?
vi. Risk Weights for Regulatory
Commercial Real Estate Exposures In a manner similar 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, as reflected in Tables 4 and 5 below. For regulatory commercial real estate exposures that are not dependent on cash flows for repayment, the main driver of risk to the banking organization is whether the commercial borrower would generate sufficient revenue through its non-real estate business activities to repay the loan to the banking organization. For this reason, under Table 4 the proposed risk weight for the exposure would be dependent on the risk weight assigned to the borrower. For the purposes of
Table 4, if the LTV ratio of the
exposures 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 borrower would be, the banking organization would be required to assign a 100 percent risk weight to the exposure. Question 30: What, if any, market effects could the proposed treatment have on residential and commercial real estate mortgage lending and why? What alternatives to the proposed treatment or calibration should the agencies consider? Please provide supporting data.
vii. Defaulted Real Estate Exposures
The proposal would require banking organizations to apply an elevated risk weight to defaulted real estate EP18SE23.005</GPH> EP18SE23.006</GPH>
90The U.S. Treasury’s Home Affordable Mortgage Program was created under the Troubled Asset Relief Program in response to the subprime mortgage crisis of 2008. See Emergency Economic Stabilization Act, Public Law 110–343, 122 Stat. 3765 (2008). 91Section 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. exposures, consistent with the approach to defaulted exposures described in
section III.C.2.a. of this SUPPLEMENTARY
INFORMATION. The proposal would introduce a definition of defaulted real estate exposure that would provide new criteria for determining whether a residential mortgage exposure or a nonresidential mortgage exposure is in default. These new criteria are indicative of a credit-related default for such exposures. For residential mortgage exposures, the definition of defaulted real estate exposure would require the banking organization to evaluate default at the exposure level. For other real estate exposures that are not residential mortgage exposures, the definition of defaulted real estate exposure would require the banking organization to evaluate default at the obligor level, consistent with the approach describe above for non-retail defaulted exposures. Since residential mortgage exposures are primarily originated to individuals for the purchase or refinancing of their primary residence, most obligors of residential real estate exposures do not have additional real estate exposures. Therefore, determining default at the exposure level would account for the material default risk of most residential mortgage exposures. Additionally, evaluating defaulted residential mortgage exposures at the obligor level may be difficult for banking organizations to operationalize, for example, if there are challenges collecting information on the payment status of other obligations of individual borrowers. In contrast, for other types of real estate exposures, such as regulatory commercial real estate and ADC exposures, evaluating default at the obligor level would be more appropriate and less challenging as those obligors frequently have other credit obligations that are large in value and potentially held by multiple banking organizations. Default by an obligor on other credit obligations, which a banking organization should account for when evaluating the risk profile of the borrower, would indicate increased credit risk of the exposure held by a banking organization. A defaulted real estate exposure that is a residential mortgage exposure would include an exposure (1) that is 90 days or more past due or in nonaccrual status; (2) where 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 (3) where the banking organization agreed to a distressed restructuring that includes the following credit-related reasons: forgiveness or postponement of principal, interest, or fees; term extension; or an interest rate reduction. Distressed restructuring would not include a loan modified or restructured solely pursuant to the U.S. Treasury’s Home Affordable Mortgage Program.90 To determine if a non-residential mortgage exposure would be a defaulted real estate exposure, banking organizations would apply the same
criteria as described above in section III.C.2.a. of this SUPPLEMENTARY INFORMATION that are used to determine if a non-retail exposure is a defaulted exposure. Banking organizations are expected to conduct ongoing credit reviews of relevant obligors. The proposal would require banking organizations to continue to treat nonresidential real estate exposures that meet this definition as defaulted real estate exposures until the nonresidential real estate exposure no longer meets the definition or until the banking organization determines that the obligor meets the definition of investment grade or speculative grade. Under the proposal, a defaulted real estate exposure that is a residential mortgage exposure not dependent on the cash flows generated by the real estate would receive a risk weight of 100 percent, regardless of whether the exposure qualifies as a regulatory real estate exposure, unless a portion of the real estate exposure is guaranteed under § ll.120 of the proposal. This treatment is consistent with the risk weight for past due residential mortgage exposures under the current standardized approach. Additionally, a residential mortgage guaranteed by the Federal Government through the Federal Housing Administration (FHA) or the Department of Veterans Affairs (VA) generally will be risk-weighted at 20 percent under the proposal, including a residential mortgage guaranteed by FHA or VA that meets the defaulted real estate exposure definition. Any other defaulted real estate exposure would receive a risk weight of 150 percent, including any other nonresidential real estate exposure to the same obligor, consistent with the proposed risk weight of other defaulted exposures described in section II.C.2.a. of this SUPPLEMENTARY INFORMATION. A banking organization may apply a risk weight to the guaranteed portion of defaulted real estate exposures based on the risk weight that applies under § ll.120 of the proposal if the guarantee or credit derivative meets the applicable requirements. Question 31: How does the defaulted real estate exposure definition compare with banking organizations’ existing policies relating to the determination of the credit risk of defaulted real estate exposures and the creditworthiness of defaulted real estate obligors? What, if any, additional clarifications are necessary to determine the point at which residential and non-residential mortgages should no longer be treated as defaulted exposures? Please provide specific examples and supporting data. Question 32: For purposes of commercial real estate exposures, the agencies invite comment on the extent to which obligors have outstanding other exposures with multiple banking organizations and other creditors. What would be the advantages and disadvantages of considering both the obligor and the parent company or other entity or individual that owns or controls the obligor when determining if the exposure meets the criteria for ‘‘defaulted real estate exposure’’?
Question 33: For purposes of residential mortgage exposures, the agencies invite comment on the appropriateness of including a borrower’s bankruptcy as a criterion for defaulted real estate exposure. Would criteria (1)(i) through (1)(iii) in the proposed defaulted real estate definition for residential mortgages sufficiently capture the risk of a borrower involved in a bankruptcy proceeding?
viii. 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.91 Real estate exposures that meet the
92An 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 III reforms and also corresponds with the maximum receiptsbased 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. 93For an exposure that qualifies as a real estate exposure and also meets conditions (1) and (2) of the definition of a retail exposure, the proposal would require a banking organization to treat the exposure as a real estate exposure and calculate risk-based requirements for the exposure as described in section III.C.2.e of this SUPPLEMENTARY INFORMATION. definition of ADC exposure but do not meet the criteria of an HVCRE exposure or a defaulted real estate exposure 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 LTV ratio criteria. 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 an amortizing permanent loan for completed residential or commercial real estate. Supervisory experience has shown that ADC exposures have heightened risk compared to permanent commercial real estate exposures, and these exposures generally have been subject to a risk weight of 100 percent or more under the current standardized approach. Repayment of ADC loans is often based on the expected completion of the construction or development of the property, which can be delayed or interrupted by many factors such as changes in market condition or financial difficulty of the obligor.
ix. Other Real Estate Exposures
The proposal would define other real estate exposures as real estate exposures that are not defaulted real estate exposures, 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 proposed prudential underwriting criteria included in 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 must 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. In other cases, if a banking organization does not adequately evaluate the creditworthiness of a borrower for an owner-occupied residential mortgage exposure, or if the borrower 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. The 100 percent risk weight would also apply to junior lien home equity lines of credit and other second mortgages given the elevated risk of these loans when compared to similar senior lien loans. f. Retail Exposures Relative to the current standardized approach, and as described in more detail below, 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 include an exposure to a natural person or persons, or an exposure to a small or
mediumsized entity (SME) 92 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 provides a benefit for small companies, such as smaller limited liability companies, which may have characteristics more similar to those of a natural person than of a larger corporation. 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 subpart E, which includes a broader range of exposures, including 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 only apply to a retail exposure that would not otherwise be a real estate exposure.93 The proposal would differentiate the risk-weight treatment for retail exposures based on whether (1) the exposure qualifies as a regulatory retail exposure, (2) further qualifies as a transactor exposure; or (3) does not qualify for either of the previous categories and is treated as an other retail exposure. 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 the 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) (collectively, eligible products). In addition, under the proposal, the amount of retail exposures that a banking organization could treat as regulatory retail exposures would be limited on an aggregate and granular basis. A banking organization would include all outstanding and committed but unfunded regulatory retail exposures accounting for any applicable credit conversion factor when aggregating the retail exposures. 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 offbalance sheet exposures, exceeds a combined total of $1 million (aggregate limit). In addition, for any single retail exposure, only the portion up to 0.2 percent of the banking organization’s total retail exposures that are eligible products (granularity limit) would be considered a regulatory retail exposure.
The portion of any single retail exposure that exceeds the granularity limit would not qualify as a regulatory retail exposure. For purposes of calculating the 0.2 percent granularity limit for a regulatory retail exposure, off-balance sheet exposures would be subject to the applicable credit conversion factors, as discussed in § ll.112(b), and defaulted exposures, as discussed in § ll.101(b) of the proposal, would be excluded. Under the proposal, if an exposure to an SME does not meet criteria (1) through (3) of the definition of a regulatory retail exposure, then none of the exposures to that SME would qualify as retail exposures and all of 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 each facility would meet the definition of a transactor exposure to be categorized as a transactor exposure. Under the proposal, a banking organization would assign a risk weight of 55 percent to a regulatory retail exposure that is a transactor exposure and an 85 percent risk weight to a regulatory retail exposure that is not a transactor exposure. All other retail exposures would be assigned a 110 percent risk weight. The proposed 55 percent risk weight for a transactor exposure is appropriate because obligors that demonstrate a historical repayment capacity generally exhibit less credit risk relative to other retail obligors. A regulatory retail exposure that is not a transactor exposure warrants the proposed 85 percent risk weight, which would be lower than the proposed 110 percent risk weight for all other retail exposures, due to mitigating factors related to size or concentration risk. The aggregate limit and granularity limit are intended to ensure that the regulatory retail portfolio consists of a set of small exposures to a diversified group of obligors, which would reduce credit risk to the banking organization. Conversely, banking organizations with a high aggregate amount of retail exposures to a single obligor, or exposures exceeding the granularity limit, have a heightened concentration of retail exposures. This concentration of retail exposures increases the level of credit risk the banking organization has to a single obligor, and the likelihood that the banking organization could face material losses if the obligor misses a payment or defaults. Therefore, any retail exposure that would not qualify as a regulatory retail or a transactor exposure warrants a risk weight of 110 percent. The following example describes how a banking
organization would identify the amount of retail exposures that could be treated as regulatory retail exposures. First, a banking organization would identify the amount of credit exposures that meet the eligible products criterion within the definition of a regulatory retail exposure. Assume a banking organization has $100 million in total retail exposures that meet the eligible regulatory retail product criterion described above. Next, for this set of exposures, the banking organization would identify any amounts to a single obligor and its affiliates that exceed $1 million. The banking organization in this example determines that a single obligor and its affiliates account for an aggregate of $20 million of the banking organization’s total retail exposures. Because this $20 million exceeds the $1 million threshold for amounts to a single obligor and its affiliates, this $20 million would be retail exposures that are not regulatory retail exposures and subject to a 110 percent risk weight, leaving $80 million that could be categorized as regulatory retail exposures. Also, assume that of the $80 million, $1 million of the exposures are considered defaulted exposures. This $1 million in defaulted exposures would be subtracted from the $80 million. The banking organization would multiply the remaining $79 million by the 0.2 percent granularity limit, with the resulting $158,000 representing the dollar amount equivalent of the granularity limit for this banking organization’s retail portfolio. Therefore, of the remaining $79 million, the portion of those retail exposures to a single obligor and its affiliates that do not exceed $158,000 would be considered regulatory retail exposures. Of the regulatory retail exposures, the portion of the exposure that would qualify as a transactor exposure would receive a 55 percent risk weight and the remaining portion would receive an 85 percent risk weight. Under the proposal, a banking organization would assign a 110 percent risk weight to the portion of a retail exposure that exceeds the granularity limit. Thus, the total amount of retail exposures to a single obligor exceeding $158,000 in this example would receive a 110 percent risk weight as other retail exposures. This example is also illustrated in the following decision tree.
Question 34: 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 35: What simplifications, if any, to the calculation described above for a regulatory retail exposure should the agencies consider to reduce operational complexity for banking organizations? For example, what operational challenges would arise from assigning differing risk weights to portions of retail exposures based on the regulatory retail eligibility criteria? Question 36: Is the requirement for repayment of a credit facility in full at each scheduled repayment date for the previous twelve months or lack of overdraft history an appropriate criterion to distinguish the credit risk of a transactor exposure from other retail exposures, and if not, what would be more appropriate and why? Is twelve months of full repayment history a sufficient amount of time to demonstrate a consistent repayment history of the credit or overdraft facility to meet the definition of a transactor and if not, what would be an appropriate amount of time? g. Risk-Weight Multiplier for Certain Retail and Residential Mortgage Exposures With Currency Mismatch The proposal would introduce a new requirement for banking organizations to apply a multiplier to the applicable risk weight assigned to certain exposures that contain currency mismatches between the banking organization’s lending currency and the borrower’s source of repayment. The multiplier would reflect the borrower’s increased risk of default due to the borrower’s exposure to foreign exchange risk. The multiplier would apply to exposure types where the borrower generally does not manage or hedge its foreign exchange risk. Exposures with such currency mismatches pose increased credit risk to the banking organization as the borrower’s repayment ability could be affected by exchange rate fluctuations. To capture this increased risk, the proposal would require banking organizations to apply a 1.5 multiplier to the applicable risk weight, subject to a maximum risk weight of 150 percent, for retail and residential mortgage exposures to a borrower that does not have a source of repayment in the currency of the loan equal to at least 90 percent of the annual payment from either income generated through ordinary business activities or from a contract with a financial institution that provides funds denominated in the currency of the loan, such as a forward exchange contract. Other types of exposures generally account for foreign exchange risk through hedging or other risk mitigants and would not be subject to the proposed multiplier. The proposed risk weight ceiling of 150 percent aligns with the maximum risk weight for credit exposures under the proposal. Question
37: What, if any, additional or alternative criteria of the proposed multiplier should the agencies consider and why? h. 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 corporation 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 a corporate exposure’s investment quality and the general creditworthiness of the borrower, level of subordination, as well as the nature and substance of the lending arrangement, and the degree of reliance on the borrower’s independent capacity for repayment of the obligation, or reliance on the income that the borrowing entity is expected to generate from the asset(s) or a project being financed. First, a banking organization would assign a 65 percent risk weight to a corporate exposure that is an exposure to a company that is investment grade, and that has a publicly traded security outstanding or that is controlled by a company that has EP18SE23.007</GPH>
94Under §ll.2 of the current capital rule, a person or company controls a company if it: (1) owns, controls, or holds with power to vote 25 percent or more of a class of voting securities of the company; or (2) consolidates the company for financial reporting purposes. See 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC). 95See 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). 96Under §ll.2 of the current capital rule, publicly-traded means traded on: (1) any exchange registered with the SEC as a national securities exchange under section 6 of the Securities Exchange Act; or (2) any non-U.S.-based securities exchange that: (i) is registered with, or approved by, a national securities regulatory authority; and (ii) provides a liquid, two-way market for the instrument in question. See 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC). 97Exposures 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. 98Although it is common for the banking organization to take a mortgage over the real property and a lien against other assets of the a publicly traded security outstanding.94 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.95 Third, as discussed further below, a banking organization would assign a 130 percent risk weight to a project finance exposure that is not a project finance operational phase exposure. Fourth, a banking organization would assign a 150 percent risk weight to a corporate exposure that is an exposure to a subordinated debt instrument or an exposure to a covered debt instrument unless a deduction treatment is provided as described in
section III.C.2.d. of this SUPPLEMENTARY
INFORMATION.
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 appropriately reflects the relative risk of such corporate exposures, as the repayment methods for these exposures pose greater risks than those of publiclytraded corporate exposures that are deemed investment grade. A banking organization would also assign a 100 percent risk weight to corporate exposures that finance incomeproducing assets or projects that engage in non-real estate activities where the obligor has no independent capacity to repay the loan. For example, corporate exposures subject to the 100 percent risk weight would include exposures (i) for the purpose of acquiring or financing equipment where repayment of the exposure is dependent on the cash flows generated by either the equipment being financed or acquired, (ii) for the purpose of acquiring or financing physical commodities where repayment of the exposure is dependent on the proceeds from the sale of the physical commodities, and (iii) project finance operational phase exposures, as further discussed below.
i. Investment Grade Companies With
Publicly Traded Securities Outstanding Under the proposal, a banking organization would assign a 65 percent risk weight to a corporate exposure that is both (1) an exposure to a company that is investment grade, and (2) where that company, or a parent that controls that company, has publicly traded securities outstanding.96 This twopronged test would serve as a reasonable basis for banking organizations to identify exposures to obligors of sufficient creditworthiness to be eligible for a reduced risk weight. The definition of investment grade directly addresses the credit quality of the exposure by requiring that the entity or reference entity have adequate capacity to meet financial commitments, which means that the risk of its default is low and the full and timely repayment of principal and interest is expected. A banking organization’s investment grade analysis is dependent upon the banking organization’s underwriting criteria, judgment, and assumptions. The proposed requirement that the company or its parent company have securities outstanding that are publicly traded, in contrast, would be a simple, objective criterion that would provide a degree of consistency across banking organizations. Further, publicly-traded corporate entities are subject to enhanced transparency and market discipline as a result of being listed publicly on an exchange. A banking organization would use these simple criteria, which complement a banking organization’s due diligence and internal credit analysis, to determine whether a corporate exposure qualifies as an investment grade exposure. Question 38: What, if any, alternative criteria should the agencies consider to identify corporate exposures that would warrant a risk weight of 65 percent or a risk weight between 65 percent and 100 percent? Question 39: For what reasons, if any, should the agencies consider applying a lower risk weight than 100 percent to exposures to companies that are not publicly traded but are companies that are ‘‘highly regulated?’’ What, if any, criteria should the agencies consider to identify companies that are ‘‘highly regulated?’’ Alternatively, what are the advantages and disadvantages of assigning lower risk weights to highly regulated entities (such as open-ended mutual funds, mutual insurance companies, pension funds, or registered investment companies)? Question 40: What are the advantages and disadvantages of applying a lower risk weight (such as between 85 and 100 percent), to entities based on size, such as companies with reported annual sales of less than or equal to $50 million for the most recent financial year? What alternative criteria, if any, should the agencies consider to identify small or medium-sized entities that present lower credit risk? For example, should the agencies consider asset size or number of employees to identify small or medium-sized entities? Please provide supporting data. Question 41: What criteria, if any, should the agencies consider to further
differentiate corporate exposures according to their risk profiles and what implications would such criteria have for the risk weighting of these exposures and why?
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 power plants, manufacturing plants, transportation infrastructure, telecommunications, or other similar installations), both as the source of repayment and as security for the loan. For example, 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. 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 obligor or the market value or sale of the project or the real estate on which the project sits.97 A project finance exposure also would be required to meet the following criteria:
(1) the exposure would need to be to a borrowing entity that was created specifically to finance the project, operate the physical assets of the project, or do both, and (2) the borrowing entity would need to have an immaterial amount of assets, activities, or sources of income apart from revenues from the activities of the project being financed. Under the proposal, an exposure that is deemed secured by real estate,98 would not be
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 III.C.2.e 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. 99See 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC). considered a project finance exposure and would be assigned a risk weight as described in section III.C.2.e. of this SUPPLEMENTARY INFORMATION. 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. The proposal would define a project finance operational phase exposure as a project finance exposure where 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 obligation, in accordance with the banking organization’s applicable loan underwriting criteria for permanent financings, and where the outstanding long-term debt of the project is declining. Prior to the operational phase classification, a banking organization would be required to treat a project finance exposure as being in the pre-operational phase and assign a 130 percent risk weight to the exposure. The pre-operational 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 cost-effective manner, 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 could disrupt timely completion of the project and the expected timing of the transition to the operational phase. These unanticipated changes could disrupt the completion of the project and delay it becoming operational, and thus impact the ability of the project to generate cash flows as projected and to repay creditors. Question 42: What additional exposures, if any, should be captured by the proposed definition of a project finance exposure? What exposures, if any, captured by the proposed definition of a project finance exposure should be excluded from the definition? Question 43: What clarifications or changes, if any, should the agencies consider to differentiate project finance exposures from exposures secured by real estate? What, if any, capital market effects
would the proposed treatment of project finance exposures have and why and what, if any, modifications should the agencies consider to address such effects? How material for banking organizations are project finance exposures that are not based on the creditworthiness of a Federal, state or local government?
3. Off-Balance Sheet Exposures
In addition to on-balance sheet exposures, banking organizations are exposed to credit risk associated with off-balance sheet exposures. Banking organizations often enter into contractual arrangements with borrowers or counterparties to provide credit or other support. Such arrangements generally are not recorded on-balance sheet under GAAP. These off-balance sheet exposures often include commitments, contingent items, guarantees, certain repo-style transactions, financial standby letters of credit, and forward agreements. The proposal would introduce a few updated credit conversion factors that a banking organization would apply to an off-balance sheet item’s notional amount (typically, the contractual amount) in order to calculate the exposure amount for an off-balance sheet exposure. Under the proposal, the credit conversion factors, which would range from 10 percent to 100 percent, would reflect the expected proportion of the off-balance sheet item that would become an onbalance sheet credit exposure to the borrower, taking into account the contractual features of the off-balance sheet item. For example, a guarantee provided by a banking organization would be subject to a 100 percent credit conversion factor because there generally is a high probability of the full amount of the guarantee becoming an on-balance sheet credit exposure. In contrast, under the terms of most commitments, banking organizations generally are not expected to extend the full amount of credit agreed to in the contract. After determining the offbalance sheet exposure amount, the banking organization would then multiply it by the appropriate risk weight, as provided under section III.C.2. of the SUPPLEMENTARY INFORMATION, to arrive at the riskweighted asset amount for the offbalance sheet exposure, consistent with the calculation method under the current standardized approach. a. Commitments The proposal would maintain the existing definition of commitment under the current capital rule. The current capital rule defines a commitment as any legally binding arrangement that obligates a banking organization to extend credit or to purchase assets.99 A commitment can exist even when the banking organization has the unilateral right to not extend credit at any time. Off-balance sheet exposures such as credit cards 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 and generally require obligors to pay their balance in full each month. For commitments with no 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 (off-balance sheet notional amount), based on an averaging formula over the previous two years (averaging methodology). A banking organization would first calculate the average total drawn amount of the commitment over the prior eight
quarters or, if the banking organization has offered such products to the obligor for fewer than eight quarters, the average total drawn amount since the commitment with no pre-set limit was first issued. The banking organization would then multiply the average total drawn amount by 10 to determine the offbalance sheet notional amount. Next, the banking organization would determine the applicable off-balance sheet exposure amount by first subtracting the current drawn amount from the calculated off-balance sheet notional amount and then multiplying this difference by the applicable credit conversion factor (10 percent for an unconditionally cancelable commitment, as described in more detail in the following section). The risk-weighted asset amount would be the off-balance sheet exposure amount multiplied by the applicable risk weight (e.g., 55 percent for a transactor retail exposure). For example, assume an obligor’s charge card had an average drawn amount of $4,000 over the prior eight quarters, and a drawn amount of $3,000 during the most recent reporting quarter. To determine the off-balance sheet exposure amount of the charge card, a banking organization would (1) multiply the average of $4,000 by 10
100As discussed in section III.C.2.f of this SUPPLEMENTARY INFORMATION, a retail exposure would need to meet certain criteria and be evaluated against the aggregate and granularity limits to qualify as a regulatory retail exposure. 101Under §ll. 2 of the current capital rule, unconditionally cancelable means a commitment that a banking organization may, at any time, with or without cause, refuse to extend credit (to the extent permitted under applicable law). See 12 CFR
3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2
(FDIC).
102Under the proposal, a 40 percent CCF would also apply to commitments that are not unconditionally cancelable commitments for purposes of calculating total leverage exposure for the supplementary leverage ratio. 103 85 FR 4362 (January 24, 2020). 104 12 CFR 3.34 (OCC); 12 CFR 217.34 (Board); 12 CFR 324.34 (FDIC). 105 Id. 106See 12 CFR 3.133(d) (OCC); 12 CFR 217.133(d) (Board); 12 CFR 324.133(d) (FDIC). ($40,000), (2) subtract the current drawn amount of $3,000 from $40,000 ($37,000), and (3) multiply $37,000 by the 10 percent credit conversion factor for unconditionally cancellable commitments ($3,700). For purposes of this example, assume the obligor’s charge card would qualify as a regulatory retail exposure 100 that is a transactor exposure. Applying the 55 percent risk weight for transactor exposures to the exposure amount of $3,700. would result in a risk-weighted asset amount of $2,035. The proposed averaging methodology would apply a multiplier of 10 to the average total drawn amount because supervisory experience suggests that obligors similar to those with charge cards have average credit utilization rates equal to approximately 10 percent. This approach uses an eight-quarter average balance, as opposed to a shorter period, to better reflect a borrower’s credit usage, notably by mitigating the impact of seasonality and of short-term trends in drawn balances from the total credit exposure estimate. Question 44: What are the advantages and disadvantages of the averaging methodology to calculate a proxy for the undrawn credit exposure amount for commitments with no pre-set limits? What, if any, adjustments should the agencies consider to better reflect a borrower’s credit usage when calculating the undrawn portion of the credit exposures for commitments that have less than eight quarters of data, particularly those with less than a full quarter of data? What, if any, alternative approaches should the agencies consider and why? Question 45: What adjustments, if any, should the agencies make to the proposed multiplier of 10 for calculating the total off-balance sheet notional amount of the obligor under the proposed methodology and why? b. Credit Conversion Factors The proposal would provide the same credit conversion factors in the current capital rule except with respect to commitments. The proposal would modify the credit conversion factors applicable to commitments and simplify the treatment relative to the current standardized approach by no longer differentiating such factors by maturity. Under the proposal, a commitment, regardless of the maturity of the facility, would be subject to a credit conversion factor of 40 percent, except for the unused portion of a commitment that is unconditionally cancelable 101 (to the extent permitted under applicable law) by the banking organization, which would be subject to a credit conversion factor of 10 percent.102 Although unconditionally cancellable commitments allow banking organizations to
cancel such commitments at any time without prior notice, in practice, banking organizations often extend credit or provide funding for reputational reasons or to support the viability of borrowers to which the banking organization has significant ongoing exposure, even when borrowers 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, for less substantial customer relationships, cause the banking organization to cancel a commitment. Relative to the current standardized approach, the proposal would simplify the applicable credit conversion factor for all other commitments given the 10 percent applicable credit conversion factor for unconditionally cancellable commitments. A 40 percent credit conversion factor for other commitments is appropriate because such commitments do not provide the banking organization the same flexibility to exit the commitment compared with unconditionally cancellable commitments. Question 46: What additional factors, if any, should the agencies consider for determining the applicable credit conversion factors for commitments?
4. Derivatives
The current capital rule requires banking organizations to calculate riskweighted assets based on the exposure amount of their derivative contracts and prescribes different approaches for measuring the exposure amount of derivative contracts based on the size and risk profile of the banking organization. The proposal would expand the scope of banking organizations that would be required to use one of the approaches, SA–CCR, which was adopted in January 2020 (the SA–CCR final rule),103 and make certain technical revisions to that approach. The current capital rule requires banking organizations subject to Category I or II capital standards to utilize SA–CCR or the internal models methodology to calculate their advanced approaches total risk-weighted assets and to utilize SA–CCR to calculate standardized total risk-weighted assets.104 The current capital rule permits banking organizations subject to Category III or IV capital standards to utilize the current exposure methodology or SA–CCR to calculate standardized total risk-weighted assets.105 As discussed in section II of this SUPPLEMENTARY INFORMATION, the proposal would require institutions subject to Category III or IV capital standards to use the expanded riskbased approach, which includes the requirement to use SA–CCR, and would eliminate the internal models methodology as an available approach to calculate the exposure amount of derivative contracts. Therefore, under the proposal, large banking organizations would be required to use SA–CCR to calculate regulatory capital ratios under the standardized approach, expanded risk-based approach, and supplementary leverage ratio. The agencies are also proposing technical revisions to SA–CCR to assist banking organizations in implementing SA–CCR in a consistent manner and with an exposure measurement that more appropriately reflects the counterparty credit risks posed by derivative transactions. a. 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.106 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 SA–CCR final 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
107 12 CFR 3.133(c)(4)(i) (OCC); 12 CFR 217.133(c)(4)(i) (Board); 12 CFR 324.133(c)(4)(i) (FDIC). 108For 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. 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, in which collateral is not subtracted from the exposure amount but is instead a component of the calculations of both the replacement cost (RC) and potential future exposure (PFE). The proposal would 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, which is more sensitive to the risk-reducing benefits of collateral, would allow the proper 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 RC 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 supervisory haircuts under
Table 1 to §ll.121 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 derivative contracts transacted through a central counterparty (CCP). When calculating its trade exposure amount for a cleared transaction, a banking organization under both the standardized and advanced approaches under the 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 final 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.107 The expanded risk-based approach does not include these heightened requirements and would align the requirements for the exclusion of collateral from the trade exposure amount of banking organizations under both the standardized and expanded risk-based approach.
iii. Supervisory Delta for Collateralized
Debt Obligation (CDO) Tranches Under the SA–CCR final 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.108 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 SA–CCR final 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 purchasing or selling 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 that would result in a proper aggregation of CDO tranches with linear credit derivative contracts in PFE calculations, the proposal would revise the sign specification for the supervisory delta adjustment for CDO tranches as follows: positive if the CDO tranches were used to purchase credit protection by the banking organization and negative if the CDO tranches were used to sell credit protection by the banking organization.
iv. Supervisory Delta for Options
Contracts
Under the SA–CCR final rule, the supervisory delta adjustment for option contracts is calculated based on the Black-Scholes formulas for delta sensitivity of European call and put option contracts. The original BlackScholes 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. The SA– CCR final rule uses modified BlackScholes 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 SA–CCR final 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. However, negative values of the instrument or risk factor underlying an option contract can occur in other asset classes as well. For example, whenever EP18SE23.008</GPH>
109See 12 CFR 3.132(c)(5)(vi) (OCC); 12 CFR 217.132(c)(5)(vi) (Board); 12 CFR 324.132(c)(5)(vi) (FDIC). 110Consistent with the current capital rule, the proposal would not require banking organizations to recognize any instrument as a credit risk mitigant. 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. 111Credit 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. 112See 12 CFR 3.2, 217.2, and 324.2 for the definition of financial collateral. 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 are commonly traded in the OTC derivatives market, including 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 SA–CCR final 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 SA–CCR final rule: to set the lowest possible value of the underlying instrument or risk factor slightly below the lowest observed value. Because it is challenging to determine a universal additive offset value for all values of non-interest-rate instruments and risk factors, 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 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 appropriate, considering the range of values for the instrument or risk factor underlying option contracts. This flexibility would allow a banking organization to use a specific value for l, rather than the value resulting from the proposed formula described above, in the event that a different value for l is more appropriate than the value resulting from the formula. 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 47: 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 the capital rule, 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.109 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 (e.g., 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.110 Credit derivatives and guarantees can reduce the credit risk of an exposure by placing a legal obligation on a third-party protection provider to compensate the banking organization for losses in the event of a borrower default.111 Similarly, the use of collateral 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 thereby reduce the riskbased 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 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.112 As stated earlier, the proposal would eliminate the use of models for credit risk under the current capital rule.
113See section III.D.3.a of this SUPPLEMENTARY INFORMATION. 114Under subpart D, banking organizations also are permitted to use their own estimates of market price volatility haircuts, with prior written approval from the primary Federal supervisors. The proposal would not include this option in subpart E as the agencies have found it to introduce unwarranted variability in banking organizations’ risk-weighted assets. 115See 12 CFR 3.2, 217.2, and 324.2 for the definition of qualifying master netting agreement. 116Under subpart E in the current capital rule, an eligible guarantee need not be issued by an eligible guarantor unless the exposure is a securitization exposure. The proposal would require all eligible guarantees to be issued by an eligible guarantor. Therefore, the proposal would replace certain methodologies for recognizing the risk-reducing benefits of financial collateral and eligible guarantees and credit derivatives—namely, the internal models methodology, simple VaR approach, PD substitution approach, LGD adjustment approach, and double default treatment—with the standardized approaches described below. For eligible guarantees and eligible credit derivatives, the proposal would permit banking organizations to use the substitution approach from subpart D of the current capital rule with a modification for eligible credit derivatives that do not include restructuring as a credit event. Further, the proposal would no longer permit the recognition of credit protection from nth-to-default credit derivatives.113 For all collateralized transactions, the corporate issuer of any financial collateral in the form of a corporate debt security must have an outstanding publicly traded security or the corporate issuer must be controlled by a company that has an outstanding publicly traded security in order to be recognized. For collateralized transactions where financial collateral secures exposures that are not derivative contracts or netting sets of derivative contracts, the proposal would permit banking organizations to use the simple approach from subpart D without any modification. For eligible margin loans and repo-style transactions, the proposal would also permit banking organizations to use the collateral haircut approach with standard supervisory market price volatility haircuts 114 from subpart D with two proposed modifications to increase risk sensitivity: (1) adjustments to the market price volatility haircuts and (2) a modified formula for netting sets of eligible margin loans or repo-style transactions that reflects netting and diversification benefits within netting sets. Finally, the proposal would introduce minimum haircut floors for certain eligible margin loan and repostyle transactions with unregulated financial institutions that banking organizations must meet in order to recognize the risk-mitigation benefits of financial collateral. In connection with the removal of the internal models methodology, the proposal would
make corresponding revisions to reflect this change in the definition of a netting set. Compared to the current capital rule, the proposal would exclude cross-product netting sets from the definition of a netting set, as none of the proposed approaches under the revised framework would recognize cross-product netting. This would be consistent with the current capital rule, which also does not recognize cross-product netting. Therefore, the proposal would define a netting set as a group of single-product transactions with a single counterparty that are subject to a qualifying master netting agreement (QMNA) 115 and that consist only of one of the following:
derivative contracts, repo-style transactions, or eligible margin loans. For purposes of the proposed netting set definition, the netting set must include the same product (i.e., all derivative contracts or all repo-style transactions or all eligible margin loans). Consistent with the current capital rule, for derivative contracts, the proposed definition of netting set would also include a single derivative contract between a banking organization and a single counterparty. Question 48: What would be the impact of requiring that certain debt securities must be issued by a publiclytraded company, or issued by a company controlled by a publiclytraded company, in order to qualify as financial collateral and what, if any, alternatives should the agencies consider to this requirement? a. Guarantees and Credit Derivatives
i. Substitution Approach
As under subpart D in the current capital rule, under the proposal a banking organization would be permitted to recognize the credit-riskmitigation benefits of eligible guarantees and eligible credit derivatives by substituting the risk weight applicable to the eligible guarantor or protection provider for the risk weight applicable to the hedged exposure.116
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 result 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 (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 would 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 add 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 application of 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 requirements would 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, are afforded similar recognition under the capital framework. Question 49: The agencies seek comment on the appropriateness of 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. Is the exemption from the 40 percent haircut overly broad? If so, why, and how might the exemption be narrowed to only capture the types of credit derivatives that provide protection similar to credit derivatives that include restructuring as a credit event? Question 50: 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? b. Collateralized Transactions The proposal would only allow a banking organization to recognize the risk-mitigating benefits of a corporate debt security that meets the definition of financial collateral in expanded riskweighted assets if the corporate issuer of the debt security has a publicly traded security outstanding or is controlled by a company that has a publicly traded security outstanding. Corporations with publicly traded securities typically are subject to mandatory regulatory and public reporting and disclosure requirements, and therefore debt securities issued by such corporations may be a more stable and liquid form of collateral.
i. Simple Approach
Subpart D of the current capital rule includes the simple approach, which allows a banking organization to recognize the risk-mitigating benefits of financial collateral received 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. The proposal generally would maintain the simple approach of the current capital rule, including restrictions on collateral eligibility and the risk-weight floor, except for the proposed requirement for certain corporate debt securities.
ii. Collateral Haircut Approach
Under the current capital rule, a banking organization may recognize the credit risk-mitigation benefits of repostyle transactions, eligible margin loans, and netting sets of such transactions by adjusting its exposure amount to its counterparty to recognize any financial collateral received and any collateral posted to the counterparty. Subpart E of the current capital rule includes several approaches that a banking organization may use and some of those approaches include the use of models that contribute to variability in risk-weighted assets. For this reason, under the proposal a banking organization would no longer be allowed to use the simple VaR approach or the internal models methodology to calculate the exposure amount, nor would a banking organization be permitted to use its own internal estimates for calculating haircuts. The proposal would broadly retain the collateral haircut approach with standard supervisory market volatility haircuts with some modifications. This approach would 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 differences in currency. To increase the risk-sensitivity of the collateral haircut approach, the proposal would modify certain market price volatility haircuts. The proposal would also introduce a new method to calculate the exposure amount of eligible transactions in a netting set and simplify the existing exposure calculation method for individual transactions that are not part of a netting set.
I. Exposure Amount
The proposal would provide two methods for calculating the exposure amount under the collateral haircut approach for eligible margin loans and repo-style transactions. One method would apply to individual eligible margin loans and repo-style transactions, the other to single-product netting sets of such transactions, as described below. The new formula for netting sets would allow for the recognition of the risk-mitigating benefits of netting and portfolio diversification and is intended to provide for increased risk-sensitivity of the capital requirement for such transactions relative to the current capital rule. A. Exposure Amount for Transactions Not in a Netting Set Under the collateral haircut approach, the proposed exposure amount for an individual eligible margin loan or repostyle transaction that is not part of a netting set would yield the same result as the exposure amount equation in the current capital rule. However, the proposal would change the variables and structure to provide a simplified calculation for an individual eligible margin loan or repo-style transaction in comparison with transactions that are
part of a netting set. Specifically, the
proposal would require a banking organization to calculate the exposure amount as the greater of zero and the difference of the following two quantities: (1) the value of the exposure, adjusted by the market price volatility haircut applicable to the exposure for a potential increase in the exposure amount; and (2) the value of the collateral, adjusted by the market price volatility haircut applicable to the collateral for a potential decrease in the collateral value and the currency mismatch haircut applicable where the currency of the collateral is different from the settlement currency. The banking organization would use the market price volatility haircuts and a standard 8 percent currency mismatch haircut, subject to adjustments, as described in the following section. Specifically, the exposure amount for an individual eligible margin loan or repostyle transaction that is not in a netting set would be based on the following formula:
E* = max{0; E × (1 + He)¥C × (1¥Hc¥Hfx)} Where:
117Systematic risk represents risks that are impacted by broad market variables (such as economy, region, and sector). Idiosyncratic risk represents risks that are endemic to a specific asset, borrower, or counterparty.
118This category also would include public sector entities that are treated as sovereigns by the national supervisor. 119 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. methodology for calculating the exposure amount for eligible margin loans and repo-style transactions covered by a QMNA? Question 52: What would be the advantages and disadvantages of an alternative method to calculate the number of instruments N based on the number of legal entities that issued or guaranteed the instruments?
II. Market Price Volatility Haircuts
Under the proposal, a banking organization would apply the market price volatility haircut appropriate for the type of collateral, as provided in
Table 1 to §ll.121 below, in the
exposure amount calculation for repostyle transactions, eligible margin loans, and netting sets thereof using the collateral haircut approach and in the calculation of the net independent collateral amount and the variation margin amount for collateralized derivative transactions using SA–CCR. Consistent with the current capital rule, the proposal would require banking organizations to apply an 8 percent supervisory haircut, subject to adjustments, to the absolute value of the net position in each currency that is different from the settlement currency.118 119 BILLING CODE 6210–01–P; 6714–01–P; 4810–33–P BILLING CODE 6210–01–C; 6714–01–C; 4810–33–C 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 EP18SE23.010</GPH>
120See Basel Committee, ‘‘Strengthening the resilience of the banking sector—consultative document,’’ December 2009; https://www.bis.org/ publ/bcbs164.pdf. 121 If the mutual fund qualifies for the full lookthrough approach described in section III.E.1.c.ii of this SUPPLEMENTARY INFORMATION but would be treated as a market risk covered position as described in section III.H.3 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. 122See ‘‘Strengthening Oversight and Regulation of Shadow Banking,’’ Financial Stability Board, August 2013 https://www.fsb.org/wp-content/ uploads/r_130829b.pdf. 123 In this example, the banking organization would be permitted to calculate the exposure amount using the collateral haircut approach but would be required to exclude any collateral received from the calculation. Alternatively, the banking organization could choose not to use the collateral haircut approach but to risk weight any on-balance sheet or off-balance sheet portions of the exposure as demonstrated in the example below. prominently in the instrument’s market price volatility, as described below. The proposal would apply haircuts based solely on residual maturity, rather than a combination of residual maturity and underlying risk weight as under the current capital rule for investment grade debt securities other than sovereign 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 future changes in both interest rates and the creditworthiness of the issuer. Because securitization exposures tend to be more volatile than corporate debt,120 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. Since senior securitization exposures absorb losses only after more junior securitization exposures, these exposures have an added layer of security and different 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, as 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 collateral haircut approach provided in the current capital rule in which a banking organization would apply the highest haircut applicable to any security in which the fund can invest. The proposal also would include an alternative method available to a banking organization if the mutual fund qualifies for the full lookthrough approach described in section III.E.1.c.ii. of this SUPPLEMENTARY INFORMATION. This alternative method would provide a more risk-sensitive calculation of the haircut on mutual fund shares collateral by using the weighted average of haircuts applicable to the instruments held by the mutual fund.121 This aspect of the proposal reflects the agencies’ observation that, while certain mutual funds may be authorized to hold a wide range of investments, the actual holdings of mutual funds are often more limited. In addition, the proposal would maintain the requirement for 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.121. Question 53: What are the advantages and disadvantages of allowing banking organizations to apply the full lookthrough approach for certain collateral in the form of mutual fund shares? What alternative approaches should the agencies consider for banking organizations to determine the market price volatility haircuts for collateral in the form of mutual fund shares?
III. Minimum Haircut Floors for Certain
Eligible Margin Loans and Repo-Style Transactions The proposed framework for minimum haircuts on non-centrally cleared securities financing transactions would reflect the risk exposure of banking organizations to non-bank financial entities that employ leverage and engage in maturity transformation but that are not subject to prudential regulation. The absence of prudential regulation makes such entities more vulnerable to runs, leading to an increase in the credit risk of these entities in the form of a greater risk of default in stress periods.122 Episodes of non-bank financial entities’ distress, such as the 2008 financial crisis, have highlighted banking organizations’ exposure to nonbank financial entities through securities financing transactions, which may give rise to credit and liquidity risks. Securities financing transactions may include repo-style transactions and eligible margin loans. The motivation behind a specific securities financing transaction can be either to lend or borrow cash, or to lend or borrow a security. Securities financing transactions can be used by a counterparty to achieve significant leverage—for example, through transactions where the primary purpose is to finance a counterparty through the lending of cash—and result in elevated counterparty credit risk. The proposal would require a banking organization to receive a minimum amount of collateral when undertaking certain repo-style transactions and eligible margin loans (in-scope transactions) with such entities (unregulated financial institutions). The application of haircut floors would determine the minimum amount of collateral exchanged. A banking organization would treat in-scope transactions with unregulated financial institutions that do not meet the proposed haircut floors as repo-style transactions or eligible margin loans where the banking organization did not receive any collateral from its counterparty.123 The proposed treatment is intended to limit the buildup of excessive leverage outside the banking system and reduce the cyclicality of such leverage, thereby limiting risk to the lending banking organization and the banking system. A. Unregulated Financial Institutions Consistent with the definition in § ll. 2 of the current capital rule, the proposal would define unregulated financial institution as a financial institution that is not a regulated financial institution, including any
124 If a netting set contains both in-scope and outof-scope transactions, the banking organization would apply a portfolio-based floor for the entire netting set. financial institution that would meet the definition of ‘‘financial institution’’ under §ll.2 of the current capital rule but for the ownership interest thresholds set forth in paragraph (4)(i) of that definition. Unregulated financial institutions would include hedge funds and private equity firms. This definition would capture non-bank financial entities that employ leverage and engage in maturity transformation but that are not subject to prudential regulation. Question 54: What entities should be included or excluded from the scope of entities subject to the minimum haircut floors and why? For example, what would be the advantages and disadvantages of expanding the definition of entities that are scoped-in to include all counterparties, or all counterparties other than QCCPs? What impact would expanding the scope of entities subject to the minimum haircut floors have on banking organizations’ business models, competitiveness, or ability to intermediate in funding markets and in U.S. Treasury securities markets? B. In-Scope Transactions Under the proposal, an in-scope transaction generally would include the following non-centrally cleared transactions: (1) an eligible margin loan or a repo-style transaction in which a banking organization lends cash to an unregulated financial institution in exchange for securities, unless all of the securities are non-defaulted sovereign exposures, and (2) certain security-forsecurity repo-style transactions that are collateral upgrade transactions with an unregulated financial institution. Under the proposal, a collateral upgrade transaction would include a transaction in which the banking organization lends one or more securities that, in aggregate, are subject to a lower haircut floor in
Table 2 to §ll.121 than the securities
received from the unregulated financial institution. The proposal would exempt the following types of transactions and netting sets of such transactions with unregulated financial institutions from the minimum haircut floor requirements: (1) transactions in which an unregulated financial institution lends, sells subject to repurchase, or posts as collateral securities to a banking organization in exchange for cash and the unregulated financial institution reinvests the cash at the same or a shorter maturity than the original transaction with the banking organization; (2) collateral upgrade transactions in which the unregulated financial institution is unable to rehypothecate, or contractually agrees that it will not re-hypothecate, the securities it receives as collateral; or (3) transactions in which a banking organization borrows securities from an unregulated financial institution for the purpose of meeting current or anticipated demand, such as for delivery obligations, customer demand, or segregation requirements, and not to provide financing to the unregulated financial institution. For transactions that are cash-collateralized in which an unregulated financial institution lends securities to the banking organization, banking organizations could rely on representations made by the unregulated financial institution as to whether the unregulated financial institution reinvests the cash at the same or a shorter maturity than the maturity of the transaction. For transactions in which a banking organization is seeking to borrow securities from an unregulated financial institution to meet a current or anticipated demand, banking organizations must maintain sufficient written documentation that such transactions are for the purpose of meeting a current or anticipated demand and not for providing financing to an unregulated financial institution. The proposal would exclude these inscope transactions from the minimum haircut floors as these transactions do not pose the same credit and liquidity risks as other in-scope transactions and serve as important liquidity and intermediation services provided by banking organizations. Question 55: What alternative definitions of ‘‘in-scope transactions’’ should the agencies consider? For example, what would be the pros and cons of an expanded definition of ‘‘inscope transactions’’ to include all eligible margin loan or repo-style transactions in which a banking organization lends cash, including those involving sovereign exposures as collateral? How would the inclusion of sovereign exposures affect the market for those securities? What, if any, additional factors should the agencies consider concerning this alternative definition? Question 56: What, if any, difficulties would banking organizations have in identifying transactions that would be exempt from the minimum haircut floor? Question 57: What, if any, operational burdens would be imposed by the proposal to require banking organizations to maintain
sufficient written documentation to exempt transactions with an unregulated financial institution where the banking organization is seeking to borrow securities from an unregulated financial institution to meet a current or anticipated demand?
C. Application of the Minimum Haircut
Floors
For in-scope transactions, the proposal would establish minimum haircut floors that would be applied on a single-transaction or a portfolio basis depending on whether the in-scope transaction is part of a netting set. The proposed haircut floors are derived from observed historical price volatilities as well as existing market and central bank haircut conventions. If the in-scope transaction is a single transaction, then the banking organization would apply the corresponding single-transaction haircut floor. If the in-scope transaction is part of a netting set, the banking organization would apply a portfoliobased floor to the entire netting set.124 In-scope transactions that do not meet the applicable minimum haircut floor would be treated as uncollateralized exposures. The minimum haircut floors are intended to reflect the minimum amount of collateral banking organizations should receive when undertaking in-scope transactions with unregulated financial institutions. Banking organizations should require an appropriate amount of collateral to be provided to account for the risks of the transaction and counterparty. Figure 1 provides a summary of the process for determining whether an in-scope transaction meets the applicable minimum haircut floor. BILLING CODE 6210–01–P; 6714–01–P; 4810–33–P
BILLING CODE 6210–01–C; 6714–01–C; 4810–33–C The proposal would require a banking organization to compare the haircut (H) and a single-transaction or portfolio haircut floor (ƒ), as calculated below, to determine whether an in-scope transaction or a netting set of in-scope transactions meets the relevant floor. If H is less than f, then the banking organization may not recognize the riskmitigating effects of any financial collateral that secures the exposure. For a single cash-lent-for-security inscope transaction, H would be defined as the ratio of the fair value of financial collateral borrowed, purchased subject to resale, or taken as collateral from the counterparty to the fair value of cash lent, minus one, and ƒ would be the corresponding haircut applicable to the collateral in Table 2 to § ll.121. For example, for an in-scope transaction in which a banking organization lends $100 in cash to an unregulated financial institution and receives $102 in investment-grade corporate bonds with a residual maturity of 10 years as collateral, the haircut would be calculated as H = (102/100)¥1 = 2 percent. The single-transaction haircut floor for an investment grade corporate bond with a residual maturity of 10 years or less under Table 2 to § ll.121 would be ƒ= 3 percent Since the haircut is less than the single-transaction haircut floor (H = 2 percent < 3 percent = ƒ), the proposal would not allow the banking organization to recognize the risk-mitigating benefits of the collateral and would require the banking organization to calculate the exposure amount of its repo-style transaction or eligible margin loan as if it had not received any collateral from its counterparty. For a single security-for-security repostyle transaction, H would be defined as the ratio of the fair value of financial collateral borrowed, purchased subject to resale, or taken as collateral from the counterparty (B) relative to the fair value of the financial collateral the banking organization has lent, sold subject to repurchase, or posted as EP18SE23.011</GPH> EP18SE23.012</GPH>
125For a given security or cash, a banking organization may collect the security or cash in one transaction and post it in another. Thus, at the portfolio level, the banking organization may, after netting across all transactions in the same portfolio, be either collecting the security or cash (that is, net borrowed) or posting the security or cash (that is, net lent). collateral to the counterparty (L), minus one. The single-transaction haircut floor (f) of the transaction would incorporate the corresponding haircut applicable to the collateral received (fB) and collateral lent (ƒL) in Table 2 to §ll.121. The single-transaction haircut floor for the two types of collateral would be computed as follows:
The single transaction floor then would be compared to the haircut of the transaction, determined as follows:
where CB denotes the fair value of collateral received and CL the fair value of collateral lent. For example, for a securities lending transaction in which a banking organization lends $100 in investment grade corporate bonds with a residual maturity of 10 years (which correspond to a haircut floor of 3 percent) and receives $102 in main index equity securities (which correspond to a haircut floor of 6 percent) as collateral, the haircut would be:
The single-transaction haircut floor would be:
Since the haircut is less than the single-transaction haircut floor (H = 2 percent < 2.9126 percent = ƒ), the banking organization would not be able to recognize the risk-mitigating benefits of the collateral received and would be required to calculate the exposure amount of its repo-style transaction or eligible margin loan as if it had not received any collateral from its counterparty. For a netting set of in-scope transactions, the haircut floor of the netting set would be computed as follows:
In the above formula, (CL) would be the fair value of the net position in each security or in cash that is net lent, sold subject to repurchase, or posted as collateral to the counterparty; CB is the fair value of the net position that is net borrowed, purchased subject to resale, or taken as collateral from the counterparty; and ƒL and ƒB would be the haircut floors for the securities or cash, as applicable, that are net lent and net borrowed, respectively.125 This calculation would be the weighted average haircut floor of the portfolio. The portfolio haircut H would be calculated as:
The portfolio would satisfy the minimum haircut floor requirement where the following condition is satisfied: H ≥ fPortfolio. If the portfolio does not satisfy the minimum haircut floor, the banking organization would not be able to recognize the risk-mitigating benefits of the collateral received. In the following example, there are two in-scope repo-style transactions that are in the same netting set: (1) a reverse repo transaction in which a banking organization lends $100 in cash to an unregulated financial institution and receives $102 in investment grade corporate bonds with a residual maturity of 10 years (which correspond to a haircut floor of 3 percent) as collateral; and (2) a securities lending transaction in which a banking organization lends $100 of different investment grade corporate bonds also with a residual maturity of 10 years and receives $104 in main index equity securities (which correspond to a haircut floor of 6 percent) as collateral. For this set of in-scope repo-style transactions, the portfolio haircut would be:
The portfolio haircut floor would be:
The banking organization would be able to recognize the risk-mitigating benefits of the collateral received, because the portfolio haircut is higher than the portfolio haircut floor:
H = 3 percent > 2.971 percent = fPortfolio) To calculate the exposure amount for this transaction, the banking organization would use the collateral haircut approach formula in § ll.121(c) and the standard market price volatility haircuts in Table 1 to § ll.121 and set N to 3:
EP18SE23.013</GPH> EP18SE23.014</GPH> EP18SE23.015</GPH> EP18SE23.016</GPH> EP18SE23.017</GPH> EP18SE23.018</GPH> EP18SE23.019</GPH> EP18SE23.020</GPH>
126The transaction would also result in credit (reduction) of $100 cash, but this would have no impact on the banking organization’s risk-weighted assets as cash is assigned a 0 percent risk weight under §ll.111. 127See proposed §ll.112(b)(5)(iv). 128 If the transaction is a securities borrowing transaction from the perspective of the banking organization, and if the equity securities received are sold or if the counterparty defaults, the banking organization would be required to record an obligation to return the securities. 129See proposed §ll.112(b)(5)(v) 130 In all cases, the $100 of investment grade corporate bonds the banking organization has lent would continue to remain on the banking organization’s balance sheet and the banking organization would continue to maintain risk-based capital against these bonds. Where:
exposurenet = |(100 × 0%) + (100 × 12%) + (102 × (¥ 12%)) + (104 × (¥20%))| = 21.04 and exposuregross = (100 × |0%|) + (100 × |12%| + (102 × |¥ 12% |) + (104 × |¥ 20%|) = 45.04 In a similar example, there are also two in-scope repo-style transactions that are in the same netting set: (1) a reverse repo transaction in which a banking organization lends $100 in cash to an unregulated financial institution and receives $101 in investment grade corporate bonds with a residual maturity of 10 years (which correspond to a haircut floor of 3 percent) as collateral; and (2) a securities lending transaction in which a banking organization lends $100 of different investment grade corporate bonds and receives $102 in main index equity securities (which correspond to a haircut floor of 6 percent) as collateral. For this set of in-scope repo-style transactions, the portfolio haircut would be:
and the portfolio haircut floor would be:
Since the portfolio haircut is less than the portfolio haircut floor (H= 1.5 percent < 2.9642 percent = ƒPortfolio), the banking organization would not be able to recognize the risk-mitigating benefits of the collateral received. Instead, the banking organization would be required to separately riskweight the on-balance sheet and offbalance sheet portion of each individual transaction. In this example, assuming that both individual transactions are treated as secured borrowings instead of sales under GAAP, the first transaction in which a banking organization lends $100 in cash to an unregulated financial institution and receives $101 in investment grade corporate bonds would result in an on-balance sheet receivable of $100.126 If the second transaction is a securities lending transaction from the perspective of the banking organization and the banking organization is permitted to sell or repledge the equity securities, the transaction results in an increase in the banking organization’s balance sheet of $102 for the equity securities received from the counterparty. The banking organization would be required to apply a 100 percent credit conversion factor (CCF) to the off-balance sheet exposure to its counterparty for the return of the investment grade corporate bonds. In this case, the off-balance sheet exposure to the counterparty would be the $100 of lent investment grade corporate bonds.127 The total exposure amount for the two transactions would be ($100 receivable + $102 equity exposure + $100 off-balance sheet exposure) = $302. If the banking organization is not permitted to sell or repledge the equity securities in the second transaction, or if that transaction is a securities borrowing transaction from the perspective of the banking organization, the equity securities received by the banking organization would not be recognized on the banking organization’s balance sheet.128 The banking organization would still be required to apply a 100 percent CCF to the off-balance sheet exposure to its counterparty,129 so the total exposure amount would be ($100 receivable + $100 off-balance sheet exposure) = $200.130 Question 58: What alternative minimum haircut floors should the agencies consider and why? What would be the advantages and disadvantages of setting the minimum haircuts at a higher level, such as at the proposed market price volatility haircuts used for recognition of collateral for eligible margin loans and repo-style transactions, or at levels between the proposed minimum haircut floors and the proposed market price volatility haircuts? Question 59: Where a banking organization has exchanged multiple securities for multiple other securities under a QMNA with an unregulated financial institution, what would be the costs and benefits of providing banking organizations the flexibility to apply a single-transaction haircut floor on a transaction-by-transaction basis for inscope transactions within the netting set, rather than applying
a portfoliobased floor? Under this approach, each in-scope transaction within a netting set would be evaluated separately. Banking organizations would be permitted to recognize the risk-mitigation benefits of collateral for individual transactions that meet the single-transaction haircut floor, even if the netting set did not meet the portfolio-based floor. Question 60: How can the proposed formulas used for determining whether an in-scope transaction or in-scope set of transactions breaches the minimum haircut floors be improved or further clarified? Question 61: What are the advantages and disadvantages of the proposed approach to minimum collateral haircuts for in-scope transactions with unregulated financial institutions? How might the proposal change the behavior of banking organizations and their counterparties, including changes in funding practices and potential migration of funding transactions to other counterparties? Commenters are encouraged to provide data and supporting analysis. D. Securitization Framework The securitization framework is designed to provide the capital requirement for exposures that involve the tranching of credit risk of one or more underlying financial exposures. The risk and complexity posed by securitizations differ relative to direct exposure to the underlying assets in the securitization because the credit risk of those assets is divided into different levels of loss prioritization using a wide EP18SE23.021</GPH> EP18SE23.022</GPH> EP18SE23.023</GPH>
131To segment a reference portfolio into different levels of risks for different investors, the securitization process divides the reference portfolio into different slices, called tranches, which receive cash flows or absorb losses based on a predetermined order of priority. This payment structure is known as the ‘‘cash flow waterfall,’’ or simply the ‘‘waterfall.’’ The waterfall schedule prioritizes the manner in which interest or principal payments from the reference portfolio must be allocated, creating different risk-return profiles for each tranche. 132The proposal generally would use the same approaches to determine the exposure amount of securitization exposures. 133The exceptions to the current 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. range of structural mechanisms.131 The performance of a securitization depends not only on the structure, but also on the performance of the underlying assets and certain parties to the securitization structure, including the asset servicer and any liquidity facility provider. The involvement of these parties makes securitization exposures susceptible to additional risks as compared to direct credit exposures. The proposed securitization framework would draw on many features of the framework in subpart E of the current capital rule with the following modifications: (1) additional operational requirements for synthetic securitizations; (2) a modified treatment for resecuritizations that meet the operational requirements; (3) a new securitization standardized approach (SEC–SA), as a replacement to the supervisory formula approach and 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 higher p-factor, a lower risk-weight floor for securitization exposures that are not resecuritization exposures, and a higher risk-weight floor for resecuritization exposures; (4) a prohibition on using the securitization framework for nth-to-default credit derivatives; (5) a new treatment for derivative contracts that do not provide credit enhancement; (6) a modified treatment for overlapping exposures; (7) new maximum capital requirements and eligibility criteria for certain senior securitization exposures (the ‘‘lookthrough approach’’); (8) a modification to the treatment for credit-enhancing interest only strips (CEIOs); and (9) a new framework for non-performing loan (NPL) securitizations.132
134For example, if a securitization SPE has assets denominated in U.S. Dollars and liabilities denominated in Euros, and if the securitization SPE executes a USD–EUR foreign exchange swap, the swap hedges the foreign exchange risk between the SPE’s assets and liabilities but does not provide credit enhancement to any of the tranches of the securitization. 135The proposal would define nonrefundable purchase price discount to mean the difference between the initial outstanding balance of the exposures in the underlying pool and the price at which these exposures are sold by the originator to the securitization SPE, when neither originator nor the original lender are reimbursed for this difference. In cases where the originator underwrites tranches of a NPL securitization for subsequent sale, the NRPPD may include the differences between the notional amount of the tranches and the price at which these tranches are first sold to unrelated third parties. For any given piece of a securitization tranche, only its initial sale from the originator to investors is taken into account in the determination of NRPPD. The purchase prices of subsequent re-sales are not considered. See proposed definition in §ll.101. 136For the sake of consistency, the proposal would also use the term ‘‘outstanding balance’’ in the calculation of W and KG. 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. A minimum payment threshold is a contractual minimum amount that must be delinquent before a credit event is deemed to have occurred. The proposed minimum payment threshold criterion is intended to prohibit an originating banking organization from recognizing the capital reducing benefits of 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 65: 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 that is a traditional securitization, if the operational requirements have been met, an originating banking organization would be required to exclude the transferred exposures from the 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, the proposal would not allow a banking organization the option to elect to treat a resecuritization as if the underlying exposures had not been re-securitized. While a securitization of nonsecuritized 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 exposures it retains in connection with the synthetic securitization.
2. 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 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 assets, with adjustments to reflect (1) delinquencies in such assets, (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 credit exposures. To calculate the risk weight for a securitization exposure using the SEC– SA, a banking organization must 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 exposure. a. Definition of Attachment Point and Detachment Point Under the current capital rule, the attachment point (parameter A) of a securitization exposure equals the ratio of the current dollar amount of underlying exposures that are subordinated to the exposure of the banking organization to the current dollar amount of underlying exposures. Any reserve account funded by the accumulated cash flows from the underlying exposures that is subordinated to the banking organization’s securitization exposure may be included in the calculation of parameter A to the extent that cash is present in the account. The calculation in the current capital rule does not permit a banking organization to recognize noncash assets in a reserve account in the calculation of parameter A. In contrast, the proposal would permit a banking organization to recognize all assets, cash or noncash, that are included in a reserve account in the calculation of parameter A. However, a banking organization would not be allowed to include interest rate derivative contracts and exchange rate derivative contracts, or the cash collateral accounts related to these instruments, in the calculation of parameters A and D. The agencies are proposing this treatment because assets held in a funded reserve account, whether cash or noncash, can provide credit enhancement to a securitization exposure, whereas interest rate and foreign exchange derivatives (and any cash collateral held against these derivatives) do not.134 The proposal would modify the definition of attachment point so that it refers to the outstanding balance of the underlying assets in the pool rather than the current dollar value of the underlying exposures. By referencing the outstanding balance of the underlying assets instead of the current dollar amount of the underlying exposures, the revised definition would clarify that a banking organization may recognize a nonrefundable purchase price discount 135 when calculating
the attachment point of a securitization exposure. A similar modification would be made to the definition of detachment point.136 b. Definition of W Parameter Under the current capital rule, parameter W, which is expressed as a decimal value between zero and one, reflects the proportion of underlying exposures that are not performing or are delinquent, according to criteria outlined in the rule. The proposal would apply a similar definition of parameter W for subpart E, but clarify that for resecuritization exposures, any
137See sections III.C.2 and III.D.2.d of this SUPPLEMENTARY INFORMATION for a more detailed discussion of the reduced risk weights applicable to certain underlying assets and the risk-weight floor, respectively. 138 Default correlation is the likelihood that two or more exposures will default at the same time. 139 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 underlying exposure that is a securitization exposure would only be included in the denominator of the ratio and would be excluded from the numerator of the ratio. That is, for resecuritization exposures, parameter W would be the ratio of the sum of the outstanding balance of any underlying exposures of the securitization 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 outstanding balance of all underlying exposures. Underlying securitization exposures need not be included in the numerator of parameter W because the risk weight of the underlying securitization exposure as calculated by the SEC–SA already reflects 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 would be true regardless of the delinquency status of any of the securitization exposures.
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 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 outstanding balance used as the weight for each exposure), calculated using the risk weights according to subpart E of the proposed rule. The agencies are proposing two modifications to the definition of KG for SEC–SA compared to the current KG as used in the SSFA. First, for interest rate derivative contracts and exchange rate derivative contracts, the positive current exposure times the risk weight of the counterparty multiplied by 0.08 would be included in the numerator of KG but excluded from the denominator of KG. 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, if a banking organization transfers credit risk via a synthetic securitization to a securitization SPE and if the securitization SPE issues funded obligations to investors, the banking organization would include the total capital requirement (exposure amount multiplied by risk weight multiplied by 0.08) of any collateral held by the securitization SPE in the numerator of KG. The denominator of KG is calculated without recognition of the collateral. This ensures that if collateral held at the SPE is invested in credit-sensitive assets, the credit risk associated with those assets will be included in the banking organization’s capital calculation. Consistent with subpart D of the current capital rule, under the proposal, the value of KG for a resecuritization exposure would equal the weighted average of two distinct KG values, one for the underlying securitization (which equals the capital requirement calculated using the SEC– SA), the other for the underlying exposures (which equals the weighted average capital requirement of the underlying exposures). Question 66: Recognizing that banking organizations may not always know the delinquency status of all underlying exposures, 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, it could (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 should the agencies consider and why? d. Supervisory Calibration Parameter (Supervisory Parameter p) Under the proposal, a banking organization would apply a supervisory parameter p of 1.0 to securitization exposures that are not resecuritization exposures and a supervisory parameter p of 1.5 to resecuritization exposures. The proposed increase to the supervisory parameter p for securitizations that are not resecuritization exposures from 0.5 to
1.0 would help to ensure that the
framework produces appropriately conservative risk-based capital requirements when combined with the reduced risk weights applicable to certain underlying assets under the proposal that would be reflected in lower values of KG and the proposed reduction in the risk-weight floor under SEC–SA for securitization exposures that are not resecuritization exposures.137 e. Supervisory Risk-Weight Floors The SEC–SA would require banking organizations to apply a risk weight floor to all securitization exposures. The SEC–SA is based on assumptions and the risk weight floor ensures a minimum level of capital is held to account for modelling risks and correlation risks.138 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 risk, senior tranches are still exposed to some amount of credit risk on the underlying exposures. Therefore, a minimum prudential capital requirement continues to be appropriate in the securitization context. For resecuritization exposures, the proposed SEC–SA approach would require banking organizations to apply a risk-weight floor of at least 100 percent. The proposed 100 percent supervisory risk-weight floor for resecuritization exposures is intended to capture the greater complexity of such exposures and heightened correlation risks inherent in the underlying securitization exposures.139
correlated; therefore, resecuritizations typically have higher default correlations than other types of securitizations. 140An overlapping exposure occurs when a banking organization is exposed to the same risk to the same obligor through multiple direct or indirect exposures to that obligor. The proposal would also apply a minimum risk weight of 100 percent to NPL securitization exposures. Compared to other securitizations, the performance of NPL securitizations depends more heavily on the servicer’s ability to generate cashflows from the workout of the underlying exposures, typically through renegotiation of the defaulted loans with the borrower or enforcement against the collateral. These idiosyncratic risks associated with NPL securitizations merit a higher minimum risk weight.
3. Exceptions to the SEC–SA Risk-Based
Capital Treatment for Securitization Exposures Securitization exposures sometimes contain unique 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. Thus, notwithstanding the general application of SEC–SA, the proposal would include additional approaches to account for certain types of securitization exposures, which would more appropriately align the capital requirement with the risk of the exposure. a. Nth-to-Default Credit Derivatives Under the current capital rule, a banking organization that has purchased credit protection in the form of an nthto-default credit derivative is permitted to recognize the risk mitigating benefits of that derivative. The proposal would not permit banking organizations to recognize any risk-mitigating benefit for nth-to-default credit derivatives in which the banking organization is the protection purchaser under either the proposed credit risk mitigation framework or under the proposed securitization framework. Purchased credit protection through nth-to-default derivatives often does not correlate with the hedged exposure which inhibits the risk mitigating benefits of the instrument. For nth-to-default credit derivatives in which the banking organization is the protection provider, the proposal would prohibit use of the securitization framework and instead would require banking organizations to calculate the risk-weighted asset amount by multiplying the aggregate risk weights of the assets included in the basket up to a maximum of 1,250 percent by the notional amount of the protection provided by the credit derivative. In aggregating the risk weights, the (n-1) assets with the lowest risk weight may be excluded from the calculation. This approach would require banking organizations to maintain capital based on the risk characteristics of all the underlying assets in the basket on which it is providing protection, while accounting for the fact that the banking organization is not required to make a payment unless ‘‘n’’ names in the basket default. b. Derivative Contracts That Do Not Provide Credit Enhancements The proposal would provide a new treatment for certain interest rate or foreign exchange derivative contracts that qualify as securitization exposures. Some securitizations either make payments to investors in a different currency from the underlying exposures or make fixed payments to investors when the cash flows received on the securitized assets are linked to a floating interest rate. To neutralize these foreign exchange or interest rate risks, the securitization SPE may enter into a derivative contract that mirrors the currency or interest rate mismatch between the exposures and the tranches. Cash flows required to be made to the derivative counterparty tend to have a senior claim to the principal and interest payment of the collateral, and therefore tend not to provide credit enhancement. The
proposal would require a banking organization that acts as a counterparty to these types of interest rate and foreign exchange derivatives to set the risk weight on such derivatives equal to the risk weight calculated under the SEC– SA for a securitization exposure that is pari passu to the derivative contract or, if such an exposure does not exist, the risk weight of the next subordinated tranche of the securitization exposure. A banking organization may otherwise not be able to calculate a risk weight for these derivative contracts using the SEC–SA because the attachment and detachment points under the proposed formula could equal one another, rendering the formula inoperable. The proposed treatment is intended to appropriately reflect how the credit risk associated with these derivative contracts would be commensurate with or less than the credit risk associated with a pari passu tranche or the next subordinated tranche of a securitization exposure. The current capital rule permits banking organizations to assign a riskweighted asset amount for certain derivative contracts that are securitization exposures equal to the exposure amount of the derivative contract (i.e., a risk weight of 100 percent). The proposal would eliminate this option. The approaches for derivative contracts described in sections III.C.4. of this SUPPLEMENTARY INFORMATION (including the treatment for derivative contracts that do not provide credit enhancement described above) are more risk-sensitive and reflective of the risks than a flat 100 percent risk weight.
i. Overlapping Exposures
The proposal would introduce new provisions for overlapping exposures.140 First, the proposal would allow a banking organization to treat two nonoverlapping securitization exposures as overlapping to the degree that the banking organization assumes that obligations with respect to one of the exposures covers obligations with respect to the other exposure. For example, if a banking organization provides a full liquidity facility to an ABCP program that is not contractually required to fund defaulted assets and the banking organization also holds commercial paper issued by the ABCP program, a banking organization would be permitted to calculate risk-weighted assets only for the liquidity facility if the banking organization assumes, for purposes of calculating risk-based capital requirements, that the liquidity facility would be required to fund the defaulted assets. In this case, the banking organization would be maintaining capital to cover losses on the commercial paper when calculating capital requirements for the liquidity facility, so there is no need to assign a separate capital requirement for the commercial paper held by the banking organization. Second, the proposal would also allow a banking organization to recognize an overlap between relevant risk-based requirements for securitization exposures under subpart E and market risk covered positions under subpart F, provided the banking organization is able to calculate and compare the capital requirements for the relevant exposures. For example, a banking organization could hold a correlation trading position that would be subject to the proposed requirements under subpart F but would preclude losses in all circumstances on a separate securitization exposure held by the banking organization that would be subject to requirements under subpart E under the proposal. In such cases, the
141A servicer cash advance facility means a facility under which the servicer of the underlying exposures of a securitization may advance cash to ensure an uninterrupted flow of payments to investors in the securitization, including advances made to cover foreclosure costs or other expenses to facilitate the timely collection of the underlying exposures. 142See §ll.2 for the definition of creditenhancing interest-only strip. 143Cut-off date is the date on which the composition of the asset pool collateralizing a securitization transaction is established. This means that all assets to be included in a securitization must already be in existence and meet the NPL criteria as of that date. proposal would allow the banking organization to calculate the risk-based requirement for the overlapping portion of the exposures based on the greater of the requirement under subpart E or under subpart F. Question 67: 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?
ii. Look-Through Approach for Senior
Securitization Exposures The proposal would introduce a provision that would allow a banking organization to cap the risk weight applied to a senior securitization exposure that is not a resecuritization exposure at 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 unpaid principal balance would be used as the weight for each exposure. 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, exchange rate derivative contracts, and servicer cash advance facility contracts,141 or any fees and other similar payments to be made by the securitization SPE 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 drawn amounts is senior to all claims on the cash flows from the underlying exposures, except amounts due under interest rate derivative contracts, exchange rate derivative contracts, and servicer cash advance facility contracts, fees due, and other similar payments. Accordingly, under the proposed look-through approach, if a senior securitization exposure’s underlying pool of assets consists solely of loans with a weighted average risk weight of 100 percent, the risk weight for the senior securitization exposure would be the lower of the risk weight calculated under the SEC–SA and 100 percent. The proposed risk-weight cap is intended to recognize that the credit risk associated with each dollar of a senior securitization exposure generally will not be greater than the credit risk associated with each dollar of the underlying assets, because the nonsenior tranches of a securitization provide credit enhancement to the senior tranche. Notwithstanding the proposed risk weight cap, the proposal would require banking organizations to floor the total risk-based capital requirement under the look-through approach at 15 percent, consistent with the proposed 15 percent floor under the SEC–SA. The proposed 15 percent floor, even if it results in a risk weight amount greater than the risk weight cap, is intended to appropriately reflect the minimum amount of riskbased capital that a banking organization should maintain for such exposures given that the process of securitization can introduce additional risks that are not present in the underlying exposures such as modelling risks and correlation risks.
iii. Credit-Enhancing Interest Only
Strips
The proposal would require a banking organization to deduct from common equity tier 1 capital any portion of a CEIO strip 142 that does not constitute an after-tax-gain-on sale, regardless of whether the securitization exposure meets the proposed operational requirements. The proposed treatment for CEIOs would be different than under subpart D of the current capital rule, which requires a risk weight of 1,250 percent for these items. The agencies are proposing to require deduction from common equity tier 1 capital because valuations of CEIOs 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 CEIOs 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 capital ratio, given the various capital ratios, buffers, and add-ons applicable to banking organizations subject to subpart E, applying a deduction provides a more consistent treatment across ratios and banking organizations.
iv. NPL Securitizations
The proposal would define an NPL securitization as a securitization whose underlying exposures consist solely of loans where parameter W for the underlying pool is greater than or equal to 90 percent at the origination cut-off date 143 and at any subsequent date on which assets are added to or removed from the pool due to replenishment or restructuring. A securitization exposure that meets the definition of a resecuritization exposure would be excluded from the definition of an NPL securitization. In a typical NPL securitization, the originating banking organization sells the non-performing loans to a securitization SPE at a significant discount to the outstanding loan balances (reflecting the nonperforming nature of the underlying exposures) and this discount acts as a credit enhancement to investors. Unlike the performance of securitizations of performing loans, which principally depend on the cash flows of the underlying loans, the performance of NPL securitizations depends in part on the performance of workouts on defaulted loans, which are uncertain and could be volatile, and on the liquidation of underlying collateral for those loans which are unable to be cured. The proposal would introduce a specific approach for NPL securitization exposures as the proposed SEC–SA may be inappropriate for the unique risks of such exposures. The proposal would require a banking organization to assign a risk weight of 100 percent to a securitization exposure to an NPL securitization if the following conditions are satisfied: (1) the transaction structure meets the definition of a traditional securitization; (2) the securitization has 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 pool of exposures; and (3) the banking organization’s exposure is a senior
144 If the banking organization is an originating banking organization with respect to the NPL 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 gain-on-sale. 145While originator typically refers to the party originating the underlying loans, in the NPL context it refers to the party arranging the NPL securitization (i.e., the securitizer). 146 In particular, the proposal would eliminate references to model-based approaches that are currently contained in subpart E. The proposal would also eliminate the formula for collateral recognition under subpart E, which includes standard supervisory haircuts calibrated to a 65-day holding period and permits banking organizations to calculate their own estimates of haircuts with prior supervisory approval. securitization exposure as described in
section III.D.3.b.ii. of this
SUPPLEMENTARY INFORMATION.144 Using the SEC–SA for senior securitizations of NPLs that meet these criteria would result in capital requirements that do not reflect the nonrefundable purchase price discount associated with these transactions. The SEC–SA is calibrated on the basis that the loans in the pool at origination are generally performing and is therefore inappropriate for senior exposures to securitizations of NPLs that meet these criteria. If the NPL securitization exposure is not a senior securitization exposure or the purchase price discount is less than 50 percent, the banking organization would be required to use the SEC–SA to calculate the risk weight (subject to a risk weight floor of 100 percent and reflecting all delinquent exposures in calculating parameter W). If the exposure does not meet the requirements of the SEC–SA, the banking organization must assign a risk weight of 1,250 to the exposure.
I. Attachment and Detachment Points
for NPL Securitizations Under the proposal, the nonrefundable purchase price discount would equal the difference between the outstanding balance of the underlying exposures and the price at which these exposures are sold by the originator 145 to investors on a final basis without recourse through the securitization SPE, when neither the originator nor the original lender are eligible for future reimbursement for this difference (that is, that the purchase price discount is ‘‘non-refundable’’). In cases where the originator underwrites tranches of the NPL securitization for subsequent sale, a banking organization may include in the calculation of the nonrefundable purchase price discount the differences between the outstanding balance of the underlying nonperforming loans and the price at which the tranches are first sold to third parties unrelated to the originator. For any given piece of a securitization tranche, a banking organization may only take into account the initial sale from the originator to investors in the determination of the nonrefundable purchase price discount and may not account for any subsequent secondary re-sales. Since the calculation of parameters A and D both depend on the outstanding balance of the assets in the underlying pool, 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 transfers a pool of mortgage loans with an outstanding balance of $100 million to a securitization SPE at a price of $60 million. The nonrefundable purchase price discount would be the difference between the unpaid principal balances on the underlying mortgages at the time of sale to the securitization SPE and the price at which the originating banking organization sold these mortgages to the securitization SPE (that is, $40 million). Assume that the securitization SPE issues $60 million in securitization tranches of which the banking organization retains the senior $50 million tranche and an investing banking organization purchases the $10 million first-loss tranche. Parameter A for the investing banking organization’s exposure would equal 40 percent (that is, the ratio of $40 million to $100 million). Thus, the discount paid for the underlying assets is effectively the ‘‘first loss’’ position in the securitization. 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, the originating bank sells both tranches and each tranche is sold at a 20 percent discount (that is, the $10 million first loss tranche is sold for a price of $8 million and the $50 million senior tranche is sold for a price of $40 million), the investing banking organization that purchases the first-loss tranche would be permitted to assign an
attachment point of 52 percent to its exposure, because the nonrefundable purchase price discount would be the difference between the original outstanding amount of the exposures ($100 million) and the total notional value of all the securitization tranches ($48 million). The investing banking organization that purchases the senior tranche would be permitted to assign an attachment point of 60 percent to the exposure.
4. Credit Risk Mitigation for
Securitization Exposures The proposal would replace the existing credit risk mitigation framework under subpart E with a framework that is consistent with the credit risk mitigation framework under subpart D of the current capital rule,146 with one exception. 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 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. Since the former transaction would not be considered a senior securitization exposure eligible for the look-through approach, the agencies believe that 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 which case, the banking organization may treat the securitization exposure (which attaches at 20 percent and detaches at 100 percent) as a senior securitization exposure. E. 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
147While the proposal would require banking organizations that are not subject to the proposed market risk capital framework to calculate riskweighted assets for all publicly traded equity exposures under the proposed equity framework, such entities typically do not have material equity exposures. 148See §ll.202 for the proposed definition of market risk covered position. 149See 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC). 150The proposal would exclude from the proposed equity framework equity exposures that a banking organization would be required to deduct from regulatory capital under §ll.22(d)(2)(i)(C) of the proposal. The proposal would require a banking organization to assign a 250 percent risk weight to the amount of the significant investments in the common stock of unconsolidated financial institutions that is not deducted from common equity tier 1 capital. equity instrument and have a lower priority of payment or reimbursement in the event that the issuing entity fails to meet its credit obligations. For example, an equity exposure entitles a banking organization to no more than the prorata residual value of a company after all other creditors, including subordinated debt holders, are repaid. 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. The current capital rule’s advanced approaches equity framework permits use of an internal models approach for publicly traded and non-publicly traded equity exposures and equity derivative contracts. The proposal would not include an internal models approach because of the types of equity exposures that would likely be subject to the equity framework. Under the proposal, material publicly traded equity exposures would generally be subject to the proposed market risk framework described in section III.H of this SUPPLEMENTARY INFORMATION, unless there are restrictions on the tradability of such exposures.147 Similarly, equity exposures to investment funds for which 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 is either able to (1) calculate a market risk capital requirement for its proportional ownership share of each exposure held by the investment fund, or (2) obtain daily price quotes—would generally be subject to the proposed market risk framework.148 As the proposed equity framework would primarily cover illiquid or infrequently traded equity exposures, the proposal would require banking organizations to use a standardized approach to determine capital requirements for such equity exposures. This is intended to increase the transparency of the capital framework and facilitate comparisons of capital adequacy across banking organizations. The proposed framework would largely maintain those
sections of the current capital rule’s equity framework that do not rely on models, including the definition of equity exposure,149 the definition of investment fund, the treatment of stable value protection, and the methods for measuring the exposure amount for equity exposures. The proposal would make certain modifications to improve the risk sensitivity and robustness of the riskbased capital requirements for equity exposures relative to the current capital rule. Specifically, the proposal would:
(1) eliminate the 100 percent risk weight threshold category under the simple risk-weight approach for non-significant equity exposures; (2) eliminate the effective and ineffective hedge pair treatment under the simple risk-weight approach; (3) align the conversion factors for conditional commitments to acquire an equity exposure, consistent with the proposed off-balance sheet treatment for exposures subject to the proposed credit risk framework, and (4) increase the risk weight applicable to equity exposures to investment firms with greater than immaterial leverage that the primary Federal supervisor has determined do not qualify as a traditional securitization. Additionally, the proposal would enhance the risksensitivity of the current capital rule’s look-through approaches for equity exposures to investment funds by (1) specifying a hierarchy of approaches that a banking organization would be required to use based on the nature and quality of the information available to the banking organization concerning the investment fund’s underlying assets and liabilities; (2) modifying the full lookthrough and the alternative lookthrough approaches to explicitly capture off-balance sheet exposures held by an investment fund, the counterparty credit risk and CVA risk of any underlying derivatives held by the investment fund, and the leverage of the investment fund; (3) replacing the simple modified lookthrough approach with a flat 1,250 percent risk weight, and (4) flooring the risk weight applicable to an equity exposure to an investment fund at 20 percent, consistent with the standardized approach in the current capital rule.
151Consistent 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.113(d) of the proposal. 152Consistent 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 the derivative is the current value of 150 shares of common stock of company X minus the adjusted carrying value of any on-balance sheet amount associated with the derivative. The proposal would maintain the current capital rule’s methods for calculating the adjusted carrying value for equity exposures, with one exception. The proposal would simplify the treatment of conditional commitments to acquire an equity exposure to remove the differentiation of conversion factors by maturity. The proposal would require a banking organization to multiply the effective notional principal amount of a conditional commitment by a 40 percent conversion factor to calculate its adjusted carrying value. The 40 percent conversion factor is meant to appropriately account for the risk of conditional equity commitments, which provide the banking organization more flexibility to exit the commitment relative to unconditional equity commitments. b. Expanded Simple Risk-Weight Approach (ESRWA) 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 in Table 7. EP18SE23.024</GPH>
153The 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). 154Consistent with the current capital rule, the proposal would require banking organizations to apply the 250 percent risk weight to the net long position, as calculated under §ll.22(h), that is not deducted from capital pursuant to §ll.22(d)(2)(i)(C). 155Banking organizations that would be subject to the proposed enhanced risk-based capital framework but not the proposed market risk capital requirements would be required to assign a 250 BILLING CODE 6210–01–C; 6714–01–C; 4810–33–C Except for the proposed zero, 20, and 400 percent risk-weight buckets and the 250 percent risk weight for significant investments in the capital of an unconsolidated financial institution in the form of common stock that are not deducted from regulatory capital, the proposal would revise the risk weights applicable to other types of equity exposures relative to those in the current capital rule’s simple risk-weight approach. Specifically, to enhance risk sensitivity and simplify the equity framework, the proposal would eliminate the following risk weights within the current capital rule’s simple risk-weight approach: (1) the 100 percent risk weight for non-significant equity exposures whose aggregate adjusted carrying value does not exceed 10 percent of the banking organization’s total capital, and (2) the 100 and 300 percent risk weights for the effective and ineffective portion of hedge pairs, respectively. Given the removal of the 100 percent risk weight threshold category for non-significant equity exposures and the revised scope of equity exposures subject to the proposed equity framework, the proposal would (1) assign a 100 percent risk weight to equity exposures to Small Business Investment Companies and (2) generally assign a 250 percent risk weight to publicly traded equity exposures with restrictions on tradability,155 as described in more EP18SE23.025</GPH>
percent risk weight to all publicly traded equity positions that are not equity exposures to investment funds. 156See 12 CFR 3.152(b)(3)(iii)(B) (OCC); 12 CFR 217.152(b)(3)(iii)(B) (Board); 12 CFR 324.152(b)(3)(iii)(B) (FDIC). 157The proposal would require banking organizations that are not subject to the proposed market risk capital framework to calculate riskweighted assets for all publicly traded equity exposures under the proposed equity framework. 158Equity exposures, including preferred stock exposures, to the FHLBs and Farmer Mac would continue to receive a 20 percent risk weight. 159Operating companies generally refer to companies that are established to conduct business with clients with the intention of earning a profit in their own right and generally produce goods or provide services beyond the business of investing, reinvesting, holding, or trading in financial assets. Accordingly, an equity investment in an operating company generally would be an equity exposure under the proposal and subject to the proposed enhanced simple risk-weight approach. Consistent with the current capital rule, under the proposal, banking organizations would be operating companies and would not fall under the definition of a traditional securitization. However, investment firms that generally do not produce goods or provide services beyond the business of investing, reinvesting, holding, or trading in financial assets, would not be operating companies, and would not qualify for the general exclusion from the definition of traditional securitization. 160 In general, such entities qualify as ‘‘traditional securitizations’’ unless explicitly scoped out by criterion (10) of that definition (for example collective investment funds, as defined in 12 CFR 208.34, as well as entities registered with the SEC under the Investment Company Act of 1940, 15 U.S.C. 80a–1, or foreign equivalents thereof). As the definition of ‘‘traditional securitization’’ does not include exposures to entities where all or substantially all of the underlying exposures are not financial exposures, equity exposures to Real Estate Investment Trusts (REITs) generally would be treated in a similar manner to equity exposures to operating companies and, unless they qualify as market risk covered positions, would be subject to the proposed expanded simple risk-weight approach of the equity framework. 161For example, for an equity security issued by a qualifying venture capital fund, as defined under §ll.10(c)(16) of each agency’s regulations implementing section 13 of the BHC Act, that also has outstanding debt securities, the proposal would generally require a banking organization to treat the exposure as a traditional securitization exposure if the exposure would meet all of the criteria of the definition of traditional securitization under §ll.2 of the current capital rule unless the primary Federal supervisor determines the exposure is not a traditional securitization. detail below. Finally,
the proposal would introduce a 1,250 percent risk weight to replace the 600 percent risk weight in the simple risk-weight approach under subpart E of the current capital rule for equity exposures to investment firms that have greater than immaterial leverage and that the primary Federal supervisor has determined do not qualify as a traditional securitization exposure, as described in more detail below. Removing the 100 percent risk weight for non-significant equity exposures is intended to increase the risk sensitivity of the equity framework 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. Given that primarily illiquid or infrequently traded equity positions would be subject to the proposed equity framework, the proposal would remove the 100 and 300 percent risk weights under the current capital rule for the effective and ineffective portions of hedge pairs. The hedge pair treatment under the current capital rule is only available if each of the equity exposures is publicly traded or has a return that is primarily based on a publicly traded equity exposure. As such positions would generally be subject to the proposed market risk capital framework under the proposal, the agencies are proposing to eliminate the hedge pair treatment to simplify the risk-weighting framework under the proposal.
i. Community Development Investments
and Small Business Investment Companies The current capital rule assigns a 100 percent risk weight to equity exposures that either (1) qualify as a community development investment under section 24 (Eleventh) of the National Bank Act, or (2) represent non-significant equity exposures to the extent that the aggregate adjusted carrying value of the exposures does not exceed 10 percent of the banking organization’s total capital. Under the current capital rule, when determining which equity exposures are ‘‘non-significant’’ 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).156 As depository institutions are limited by statute to only invest up to 5 percent of total capital in the equity exposures and debt instruments of small business investment companies, the current capital rule effectively assigns a 100 percent risk weight to all equity exposures to such programs. Equity exposures to community development investments and small business investment companies generally receive favorable tax treatment and/or investment subsidies that make their risk and return characteristics different than equity investments in general. Recognizing this more favorable risk-return structure and the importance of these investments to promoting important public welfare goals, the proposal would effectively retain the treatment of equity exposures that qualify as community development investments and equity exposures to small business investment companies under the current capital rule and assign such exposures a 100 percent risk weight.
ii. Publicly Traded Equity With
Tradability Restrictions 157 To appropriately capture the risk of publicly traded equity exposures with restrictions on tradability, the proposal would (1) eliminate the 100 percent risk weight for non-significant equity exposures up to 10 percent of total capital under the current capital rule; and (2) introduce a 250 percent risk weight to replace the current capital rule’s 300 percent risk weight applicable to publicly traded exposures.158 The revised calibration of the risk-weight for publicly traded equity exposures with restrictions on tradability is intended to take into account the removal of the non-significant equity exposures treatment. Under the proposal, banking organizations would no longer assign separate risk weights (100 percent and 300 percent) to publicly traded equity exposures based on factors that are unrelated to the underlying risk of the exposure. Instead, the proposal would assign an identical 250 percent risk weight to all publicly traded equity exposures with restrictions on tradability, improving the consistency and risk-sensitivity of the framework.
iii. Equity Exposures to Investment
Firms With Greater Than Immaterial Leverage and That Would Meet the Definition of a Traditional Securitization Were It Not for the Application of Paragraph (8) of That Definition Consistent with the current capital rule, the proposed securitization framework generally would apply to exposures to investment firms with material liabilities that are not operating companies,159 unless the primary Federal supervisor determines the exposure is not a traditional securitization based on its leverage, risk profile or economic substance.160 161 For an equity exposure to an investment firm that has greater than immaterial leverage and that the primary Federal supervisor has determined does not qualify as a traditional securitization exposure, the proposal would increase the 600 percent risk weight in the simple risk-weight approach under subpart E of the current capital rule to 1,250 percent under the proposed expanded simple risk-weight approach.
162Consistent with the current capital rule, under the proposal, an equity exposure to an investment firm that is treated as a traditional securitization would be subject to due diligence requirements. If a banking organization is unable to demonstrate to the satisfaction of the primary Federal supervisor a comprehensive understanding of the features of an equity exposure that would materially affect the performance of the exposure, the proposal would require the banking organization to assign a risk weight of 1,250 percent to the equity exposure to the investment firm. 163Consistent with the current capital rule, the agencies will consider the economic substance, leverage, and risk profile of a transaction to ensure that an appropriate risk-based capital treatment is applied. The agencies will consider a number of factors when assessing the economic substance of a transaction including, for example, the amount of equity in the structure, overall leverage (whether on or off-balance sheet), whether redemption rights attach to the equity investor, and the ability of the junior tranches to absorb losses without interrupting contractual payments to more senior tranches. 164The proposal would require banking organizations subject to the market risk capital requirements to apply the proposed market risk capital framework to determine the risk-weighted asset amount for equity exposures to investment funds that would otherwise be subject to the full look-through approach under the proposed equity framework. See §ll.202 for the proposed definition of market risk covered position. As under the current capital rule, the applicable risk weight for equity exposures to such investment firms with greater than immaterial liabilities under the proposed securitization framework would depend on the size of the first loss tranche.162 For investment firms that have greater than immaterial leverage, their capital structure may result in a large first loss tranche that understates the risk of the exposure to the investment firm. Unlike most traditional securitization structures, investment firms that can easily change the size and composition of their capital structure (as well as the size and composition of their assets and offbalance sheet exposures) may pose additional risks not covered by the securitization framework. For example, the performance of an equity exposure to an investment firm with greater than immaterial liabilities may depend in
part on management discretion
regarding asset composition and capital structure. To appropriately capture the additional risks posed by equity exposures to investment firms with greater than immaterial liabilities that may not be reflected within the proposed securitization framework, the proposal would permit the primary Federal supervisor to determine that the exposure is not a traditional securitization and require the banking organization to apply a 1,250 percent risk weight to the adjusted carrying value of equity exposures to such investment firms.163 Question 68: The agencies request comment on the proposed application of a 1,250 percent risk weight to equity exposures to investment firms with greater than immaterial leverage and that would meet the definition of a traditional securitization were it not for the application of paragraph (8) of that definition. For what, if any, types of exposures would requiring banking organizations to apply a 1,250 percent risk weight be inappropriate and why? What are the advantages and disadvantages of the proposed 1,250 percent risk weight relative to expanding the proposed look-through approaches for investment funds to include such exposures? Question 69: The agencies seek comment on the advantages and disadvantages of requiring banking organizations to calculate risk-based capital requirements for equity exposures to investment firms with greater than immaterial leverage under the proposed securitization framework relative to the proposed look-through approaches under the equity framework. What, if any, types of equity exposures to investment firms with greater than immaterial leverage may not be appropriately captured by the securitization framework—such as equity exposures to investment firms where all the exposures of the investment firm are pari passu in the event of a bankruptcy or other insolvency proceeding? Between the proposed securitization framework and the proposed look-through approaches under the equity framework, which approach would be more operationally burdensome or challenging and why? Which approach would produce a more appropriate capital requirement and why? Provide supporting data and examples.
c. Risk Weights for Equity Exposures to
Investment Funds
The separate risk-based capital treatment for equity exposures to investment funds under the current capital rule reflects that the risk of equity exposures to investment fund structures depends primarily on the nature of the underlying assets held by the fund and the degree of leverage employed by the fund. Consistent with the current capital rule, the proposal would require banking organizations to determine the risk weight applicable to the adjusted carrying value of each equity exposure to an investment fund using a look-through approach in the equity framework. When more detailed information is available about the investment fund’s characteristics, a banking organization is in a better position to evaluate the risk profile of its equity exposure to the fund and calculate a risk weight commensurate with that risk. Conversely, equity exposures to investment funds that provide less transparency or are not subject to regular independent verification could present elevated risk to banking organizations. Accordingly, the proposal would specify a hierarchy that banking organizations would be required to use to identify the applicable look-through approach for each equity exposure to an investment fund based on the nature and quality of the information available to the banking organization. The proposal would also enhance the risk sensitivity of the current capital rule’s look-through approaches under subpart E by modifying the full lookthrough and the alternative lookthrough approaches to explicitly capture off-balance sheet exposures held by an investment fund, the counterparty credit risk and CVA risk of any underlying derivatives held by the investment fund, and the leverage of an investment fund. The proposal would also replace the simple modified look-through approach under subpart E with a flat 1,250 percent risk-weight.
i. Hierarchy of Look-Through
Approaches
The proposal would require a banking organization that is not subject to the proposed market risk capital framework to use the full look-through approach if the banking organization has sufficient verified information about the underlying exposures of the investment fund to calculate a risk-weighted asset amount for each of the exposures held by the investment fund.164 If a banking organization is unable to meet the criteria to use the full look-through approach, the proposal would require the banking organization to apply the alternative modified look-through approach and determine a risk-weighted asset amount for the exposures of the investment fund based on the information contained in the investment fund’s prospectus, partnership agreement, or similar contract that defines the investment fund’s permissible investments. If the banking organization is unable to apply either the full look-through approach or the alternative modified look-through approach, the proposal would require the banking organization to assign a 1,250 percent risk weight to the adjusted carrying value of the equity exposure to the investment fund. Banking organizations generally would not be permitted to apply a combination of the
165As externally licensed auditors typically express their opinions on investment funds’ accounts rather than on the accuracy of the data used for the purposes of applying the full lookthrough approach, an external audit would not be required. 166While not done explicitly, the full lookthrough approach under the current capital rule does capture the leverage of an investment fund. above approaches to determine the riskweighted asset amount applicable to the adjusted carrying value of an equity exposure to an investment fund, except for equity exposures to investment funds with underlying securitizations, or equity exposures to other investment funds, as described in section III.E.1.c.v. of this SUPPLEMENTARY INFORMATION.
ii. Full Look-Through Approach
Since the full look-through approach is the most granular and risk-sensitive approach, the proposal would require banking organizations that are not subject to the proposed market risk capital framework to use the full lookthrough approach when verified, detailed information about the underlying exposures of the investment fund is available to enhance risksensitivity of the risk-based capital requirements. Under the proposed hierarchy, such banking organizations would be required to use the full lookthrough approach if the banking organization is able to calculate a riskweighted asset amount for each of the underlying exposures of the investment fund as if the exposures were held directly by the banking organization, with the exception of securitization exposures, derivative exposures, and equity exposures to other investment funds, as described in section III.E.1.c.v. of this SUPPLEMENTARY INFORMATION. Specifically, the proposal would require banking organizations that are not subject to the proposed market risk capital framework to apply the full lookthrough approach when there is sufficient and frequent information provided to the banking organization regarding the underlying exposures of the investment fund. To satisfy this criterion, the frequency of financial reporting of the investment fund must be at least quarterly, and the financial information must be sufficient for the banking organization to calculate the risk-weighted asset amount for each exposure held by the investment fund as if each exposure were held directly by the banking organization (except for securitization exposures, derivatives exposures, and equity exposures to other investment funds). In addition, such information would be required to be verified on at least a quarterly basis by an independent third party, such as a custodian bank or management fund.165 The proposal would largely maintain the same risk-weight treatment as provided under the full look-through approach in the advanced approaches of the current capital rule, with five exceptions. First, to facilitate application of the full look-through approach, the proposal would allow banking organizations the option to use conservative alternative methods to those provided under the proposed expanded risk-weighted asset approach to calculate the risk-weighted asset amount attributable to any underlying exposures that are securitizations, derivatives, or equity exposures to another investment fund, as described in section III.E.1.c.v. of this SUPPLEMENTARY INFORMATION. Second, to increase comparability across banking organizations, the proposal would clarify that the total risk-weighted asset amount for the investment fund under the full lookthrough approach must include any offbalance sheet exposures of the investment fund and the counterparty credit risk and, where applicable, the CVA risk of any underlying derivative exposures held by the investment fund. Accordingly, under the proposal, the total
risk-weighted asset amount for the investment fund under the full lookthrough approach would equal the sum of the risk-weighted asset amount for (1) the on-balance sheet exposures, including any equity exposures to other investment funds and securitization exposures; (2) the off-balance sheet exposures; and (3) the counterparty credit risk and CVA risk, if applicable, of any underlying derivative exposures held by the investment fund, as described in section III.E.1.c.v. of this SUPPLEMENTARY INFORMATION. A banking organization would calculate the average risk weight for an equity exposure to the investment fund by dividing the total risk-weighted asset amount for the investment fund by the total assets of the investment fund. Third, to capture the risk of equity exposures to investment funds with leverage, the full look-through approach under the proposal would explicitly require banking organizations to adjust the average risk weight for its equity exposure to the investment fund upwards to reflect the leverage of the investment fund.166 Specifically, the proposal would require banking organizations to multiply the average risk weight for its equity exposure to the investment fund by the ratio of the total assets of the investment fund to the total equity of the investment fund. Fourth, to avoid disincentivizing banking organizations from obtaining the necessary information to apply the full-look through approach, the proposal would cap the risk weight for an equity exposure to an investment fund under the full look-through approach at no more than 1,250 percent. Fifth, consistent with the standardized approach under the current capital rule, to reflect the agencies’ and banking organizations’ experience with money market fund investments and similar investment funds during the 2008 financial crisis and the 2020 coronavirus response, the proposal would floor the minimum risk weight that may be assigned to the adjusted carrying value of any equity exposure to an investment fund under the proposed look-through approaches at 20 percent. Accordingly, under the proposal, a banking organization would be required to calculate the total riskweighted asset amount for an equity exposure to an investment fund under the full look-through approach by multiplying the adjusted carrying value of the equity exposure by the applicable risk weight, as calculated according to the following formula provided under § ll.142(b) of the proposed rule:
Where:
167Under the proposal, a banking organization may exclude equity derivative contracts held by the investment fund for purposes of calculating the RWAderivatives component of the full and alternative modified look-through approaches, if the banking organization has elected to exclude equity derivative contracts for purposes of §ll.113(d) of the proposal. 168Under the proposal, banking organizations subject to the proposed market risk capital requirements would only apply the alternative modified look-through approach to such equity exposures to investment funds if the banking organization is unable to obtain daily quotes for the equity exposure to the investment fund. See §ll.202 for the proposed definition of market risk covered position. 169For example, if the mandate of an investment entity permits the use of unconditional equity commitments, the proposal would require the banking organization to multiply the notional amount of the commitment by a 100 percent credit conversion factor and the risk weight applicable to the underlying reference exposure of the commitment. If the banking organization does not know the type of equity underlying the commitment, the banking organization would be required to use the highest applicable risk-weight to equity exposures. held under the same terms by the banking organization;
170Relatedly, to the extent a banking organization is unable to determine the netting sets of the underlying derivative exposures, the proposal would require each single derivative to be its own netting set. 171The proposal would rely on the existing definition of netting set under the current capital rule, which is defined to include a single derivative contract between a banking organization and a single counterparty. See 12 CFR 3.2 (OCC); 12 CFR
217.2 (Board); 12 CFR 324.2 (FDIC).
172Under the proposal, a banking organization may exclude equity derivative contracts held by the investment fund for purposes of calculating the RWAderivatives component of the full and alternative modified look-through approaches, if the banking organization has elected to exclude equity derivative contracts for purposes of §ll.113(d) of the proposal. 173The proposal would rely on the existing definition of commercial end-user under the current capital rule. See 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC). 174 If the banking organization is not able to calculate the replacement cost of the netting set under SA–CCR but is able to calculate the PFE aggregated amount, the banking organization must set the PFE multiplier equal to 1. banking organization does not have the necessary information to apply the full look-through approach or the alternative modified look-through approach, the proposal would require the banking organization to assign a 1,250 percent risk weight to the adjusted carrying value of its equity exposure to the investment fund.
v. Risk Weights for Equity Exposures to
Investment Funds With Underlying Securitizations, Derivatives, or Equity Exposures to Other Investment Funds Banking organizations may not always be able to obtain the necessary information to calculate risk-weighted asset amounts under the full lookthough approach or the alternative modified look-through approach for certain types of underlying exposures held by an investment fund. For example, even if an investment fund provides detailed quarterly disclosures on all its underlying assets and liabilities, such disclosures may not identify the actual counterparty to each underlying derivative exposure of the investment fund or which of the underlying derivative exposures of the investment fund are subject to the same qualified master netting agreement. Furthermore, the information contained in an investment fund’s prospectus, partnership agreement, or similar contract may not always allow banking organizations to calculate risk-weighted asset amounts for such underlying exposures under the alternative modified look-through approach. To facilitate application of the lookthrough approaches, the proposal would allow banking organizations to use conservative assumptions to calculate risk-weighted asset amounts under the full look-through approach for underlying exposures that are securitization exposures, derivative exposures, or equity exposures to another investment fund. For purposes of the alternative modified look-through approach, the proposal would require banking organizations to use these alternative assumptions for such underlying exposures.
I. Securitization Exposures
For any securitization exposures held by an investment fund, the proposal would allow a banking organization using the full look-through approach to apply a 1,250 percent risk weight to the exposure, if it cannot or chooses not to calculate the applicable risk weight under the securitization standardized approach (SEC–SA), as described in
section III.D. of this SUPPLEMENTARY
INFORMATION. The proposal would require a banking organization applying the alternative modified look-through approach to apply a 1,250 percent risk weight to any securitization exposures held by an investment fund.
II. Derivative Exposures
For derivative exposures held by an investment fund, the proposal would require a banking organization to calculate the risk-weighted asset amount for each derivative netting set by multiplying the exposure amount of the netting set by the risk weight applicable to the derivative counterparty under the proposed credit risk framework. To the extent a banking organization cannot determine the counterparty, the proposal would require the banking organization to multiply the resulting exposure amount by a 100 percent risk weight, as a conservative approach to reflect the highest risk-weight that would be likely to apply to a counterparty to such transactions.170 For banking organizations using the full look-through approach, the proposal would require a banking organization to use the replacement cost and the potential future exposure as calculated under SA–CCR to determine the exposure amount for each netting set of underlying derivative exposures (including single derivative contracts) 171 held by the investment fund, where possible.172 If a banking organization using the full look-through approach does not have sufficient information to calculate the replacement cost or the potential future exposure for each derivative netting set using SA– CCR or is using the alternative modified look-through approach, the proposal would require the banking organization to use the notional amount of each netting set and 15 percent of the notional amount of each netting set for the replacement cost and potential future exposure, respectively. The proposal would require banking organizations using the alternative modified look-through approach to use the notional amount of each netting set and 15 percent of the notional amount of each netting set to determine the replacement cost and potential future exposure, respectively. A banking organization would multiply the resulting exposure amount by a factor of
1.4 if the banking organization
determines that the counterparty is not a commercial end-user or cannot determine whether the counterparty is a commercial end-user.173 Additionally, the proposal would require a banking organization to further multiply the exposure amount by a factor of 1.5 for each derivative netting set that either qualifies (or for which the banking organization cannot determine whether the exposure qualifies) as a CVA risk covered position, as defined in section III.I.3 of this SUPPLEMENTARY INFORMATION. Accordingly, the proposal would require banking organizations to calculate the exposure amount for derivative exposures held by an investment fund as described in the following formula:
Exposure Amount = C * a (Replacement Cost + Potential Future Exposure) Where:
175See 12 CFR 3.101 (OCC), 217.101 (Board), and 12 CFR 324.101 (FDIC). 176The agencies adopted the AMA for operational risk as part of the advanced approaches capital framework in 2007. See 72 FR 69288 (December 7, 2007). 177See, 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. purposes of the full look-through approach, where possible; or
178Recent 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/ 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. 179Unlike 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. 180Total interest income would correspond to total interest income in the FR Y–9C (holding Continued risk that seeks to address the operational risks currently covered by the AMA. The operational risk capital requirements under the standardized approach for operational risk would be a function of a banking organization’s business indicator component and internal loss multiplier. 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. The internal loss multiplier would be based on the ratio of a banking organization’s historical operational losses to its business indicator component and would increase the operational risk capital requirement as historical operational losses increase. To help ensure the robustness of the operational risk capital requirement, the proposal would require that the internal loss multiplier be no less than one. A banking organization’s operational risk capital requirement would be equal to its business indicator component multiplied by its internal loss multiplier. Similar to the current capital rule, risk-weighted assets for operational risk would be equal to 12.5 times the operational risk capital requirement.
companies) and Call Report, excluding dividend income as defined in the proposal. 181Total interest expense would correspond to total interest expense in the FR Y–9C (holding companies) and Call Report. 182 Dividend income is currently included in total interest income in the FR Y–9C (holding companies) and Call Report. 183 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. 184Fee and commission income would include the sum of income from fiduciary activities, service charges on deposit accounts in domestic offices; fees and commissions from securities brokerage; investment banking, advisory, and underwriting fees and commissions; fees and commissions from annuity sales; income and fees from printing and sale of checks; income and fees from automated teller machines; safe deposit box rent; bank card and credit card interchange fees; income and fees from wire transfers; underwriting income from insurance and reinsurance activities; and income from other insurance activities in the FR Y–9C (holding companies) and Call Report. Fee and commission income would also include servicing fees on a gross basis, which would correspond to net servicing fees in the FR Y–9C (holding companies) and Call Report, with the modification that expenses should not be netted, because fee and commission expenses should not be netted in the calculation of fee and commission income. In addition, fee and commission income would include other income received from providing advice and financial services that is not currently itemized in the regulatory reports. 185Fee and commission expense would include consulting and advisory expenses and automated teller machine and interchange expenses in the FR Y–9C (holding companies) and Call Report. Fee and commission expense would also include any other expenses paid for advice and financial services received that are not currently itemized in the regulatory reports. Note that fee and commission expense would include fees paid by the banking organization as a result of outsourcing financial services, but not fees paid for outsourced non-financial services (e.g., logistical, information technology, human resources). 186Other operating income would include rent and other income from other real estate owned in the FR Y–9C (holding companies) and Call Report. Other operating income would also include all other income items not currently
itemized in the regulatory reports, which are not included in other business indicator items and are not specifically excluded from the business indicator. 187Note that expenses with operational loss events in ‘‘other operating expense’’ would not exclude expenses associated with operational loss events that result in less than $20,000 in net loss amount.
188Trading revenue would correspond to trading revenue in the FR Y–9C (holding companies) and Call Report. 189Realized gains (losses) on held-to-maturity securities, realized gains (losses) on available-forsale securities, net gains (losses) on sales of loans and leases, net gains (losses) on sales of other real estate owned, net gains (losses) on sales of other assets, venture capital revenue, and net securitization income correspond to their current definitions in the FR Y–9C (holding companies) and Call Report. to the business indicator and, if so, how? What would be the advantages and disadvantages of any alternative approach and what impact would such an alternative approach have on operational risk capital requirements? For example, under the proposal, fee income and expenses of charge cards are included under the services component. Would it be more appropriate for fee income and expenses of charge cards to be included in net interest income of the interest, lease, and dividend component (and excluded from the services component) and for charge card exposures to be included in interest earning assets of the interest, lease, and dividend component and why? Please provide supporting data with your response.
c. The Financial Component
Under the proposal, the financial component would capture trading activities and other activities associated with a banking organization’s assets and liabilities. The financial component would be calculated as follows:
Financial Component = Avg3y (Abs (trading revenue)) + Avg3y (Abs (net profit or loss on assets and liabilities not held for trading)) The proposal includes the following definitions:
190 $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). 191See 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. 192See 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. 193See Curti and Migueis (2023), ‘‘The Information Value of Past Losses in Operational Risk, Finance and Economics Discussion Series,’’ Board of Governors of the Federal Reserve System, https://doi.org/10.17016/FEDS.2023.003. 194For example, when calculating average annual total net operational losses for the second calendar quarter of 2023, total net operational losses from the third calendar quarter of 2013 through the second calendar quarter of 2023 would be included. The higher rate of increase of the business indicator component as a banking organization’s business indicator rises above $1 billion and $30 billion would reflect exposure to 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.191 Similarly, academic studies have found that larger U.S. bank holding companies have higher operational losses per dollar of total assets.192
3. Internal Loss Multiplier
Higher historical operational losses are associated with higher future operational risk exposure.193 Supervisory experience also suggests that operational risk management deficiencies can be persistent, which can often result in operational losses. Accordingly, under the proposal, the operational risk capital requirement would be higher for banking organizations that experienced larger operational losses in the past. To this effect, the proposal would include a scalar, the internal loss multiplier, that increases operational risk capital requirements based on a banking organization’s historical operational loss experience. This multiplier would depend on the ratio of a banking organization’s average annual total net operational losses to its business indicator component. The proposal would require the internal loss multiplier to be no less than one. This floor would ensure that the operational risk capital requirement provides a robust minimum amount of coverage to the potential future operational risks a banking organization may be exposed to, as reflected by its overall business volume through the business indicator component, even in situations where historical operational losses have been low in relative terms. The internal loss multiplier would be calculated as follows:
Where:
195The internal loss multiplier variation depends on the ratio of the product of 15 and the average annual total operational losses to the business indicator component. The 0.8 exponent applied to this ratio reduces the effect of the variation of this ratio on the internal loss multiplier. For example, a ratio of 2 becomes approximately 1.74 after application of the exponent, and a ratio of 0.5 becomes approximately 0.57 after application of the exponent. Similarly, the application of a logarithmic function further reduces the variability of the internal loss multiplier for values above 1. Taken together, these two transformations mitigate the reaction of the operational risk capital requirement to large historical operational losses. 196For example, if an operation loss event results in a loss impact of $500,000 in the first quarter of 2020 and a loss impact of $400,000 in the second quarter of 2021, the banking organization would add $500,000 to the total gross operational losses of first quarter of 2020 and add $400,000 to the total gross operational losses of the second quarter of 2021. 197A recovery is an inflow of funds or economic benefits received from a third party in relation to an operational loss event. The natural log function (ln) combined with an exponent of 0.8 would limit the effect that large operational losses have on a banking organization’s operational risk capital requirement. This feature of the internal loss multiplier formula is intended to constrain the volatility of the operational risk capital requirement. As a result, increases in average annual total net operational losses would increase the operational risk capital requirement at a decreasing rate.195 The calculation of average annual total net operational losses would be based on an average of ten years of data. The use of a ten-year average for annual total net operational losses would balance recognition that a banking organization’s operational risk exposure changes over time with limiting the volatility that would result from using a shorter time horizon and the importance of the calculation window providing sufficient information regarding the banking organization’s operational risk profile. The proposal would define an ‘‘operational loss’’ as all losses (excluding insurance or tax effects) resulting from an operational loss event, including any reduction in previously reported capital levels attributable to restatements or corrections of financial statements. An operational loss includes all expenses associated with an operational loss event except for opportunity costs, forgone revenue, and costs related to risk management and control enhancements implemented to prevent future operational losses. Operational loss would not include losses that are also credit losses and are related to exposures within the scope of the credit risk risk-weighted assets framework (except for retail credit card losses arising from non-contractual, third-party-initiated fraud,
which are operational losses). ‘‘Operational loss event’’ would be defined as an event that results in loss due to inadequate or failed internal processes, people, or systems or from external events. This definition includes legal loss events and restatements or corrections of financial statements that result in a reduction of capital relative to amounts previously reported. The proposal would retain the current classification of operational loss events according to seven event types:
1—Internal fraud, which means the operational loss event type that comprises operational losses resulting from an act involving at least one internal party of a type intended to defraud, misappropriate property, or circumvent regulations, the law, or company policy excluding diversity and discrimination noncompliance events. 2—External fraud, which means the operational loss event type that comprises operational losses resulting from an act by a third party of a type intended to defraud, misappropriate property, or circumvent the law. Retail credit card losses arising from noncontractual, third-party-initiated fraud (for example, identity theft) are external fraud operational losses. 3—Employment practices and workplace safety, which means the operational loss event type that comprises operational losses resulting from an act inconsistent with employment, health, or safety laws or agreements, payment of personal injury claims, or payment arising from diversity and discrimination noncompliance events. 4—Clients, products, and business practices, which means the operational loss event type that comprises operational losses resulting from the nature or design of a product or from an unintentional or negligent failure to meet a professional obligation to specific clients (including fiduciary and suitability requirements). 5—Damage to physical assets, which means the operational loss event type that comprises operational losses resulting from the loss of or damage to physical assets from natural disasters or other events. 6—Business disruption and system failures, which means the operational loss event type that comprises operational losses resulting from disruption of business or system failures, including hardware, software, telecommunications, or utility outage or disruptions. 7—Execution, delivery, and process management, which means the operational loss event type that comprises operational losses resulting from failed transaction processing or process management or losses arising from relations with trade counterparties and vendors. By ensuring consistency, the classification of operational loss events according to these event types would continue to assist banking organizations and the agencies in understanding the causal factors driving operational losses. The proposal would include a $20,000 net loss threshold (that is, $20,000 after taking into account all subsequent recoveries related to the operational loss) for inclusion of an operational loss in the calculation of average annual total net operational losses. This threshold aims to balance comprehensiveness against the materiality of the operational losses. The proposal would require a banking organization to group losses with a common underlying trigger into the same operational loss event. For example, losses that occur in multiple locations or over a period of time resulting from the same natural disaster would be grouped into a single operational loss event. This grouping requirement
aims to ensure comprehensive inclusion of operational loss events that result in $20,000 or more of net loss in the calculation of the internal loss multiplier and to facilitate understanding of operational risk exposure by banking organizations and supervisors. There are two main differences in how the proposal would treat operational losses relative to typical practice under the AMA. First, total net operational losses would include operational losses in the quarter in which their accounting impacts were recorded, rather than aggregated into a single event date.196 Second, operational losses would enter the internal loss multiplier calculation net of related recoveries, including insurance recoveries.197 Recoveries would be included in the quarter in which they are paid to the banking organization. Insurance receivables would not be accounted for in the calculation as recoveries. Reductions in the legal reserves associated with an ongoing legal event would be treated as recoveries for the calculation of total net operational losses. Also, a recovery would only offset a loss arising from a related operational loss event. This proposed treatment would ensure that only applicable recoveries are recognized. Under the proposal, a negative financial impact that a banking organization books in its financial
198The business indicator contribution of a merged or acquired entity would be the business indicator of the banking organization inclusive of the merged or acquired entity minus the business indicator of the banking organization when the merged or acquired entity is excluded. 199 In contrast, the business indicator includes only three years of financial statement data, which should be readily available. statement due to having incorrectly booked a positive financial impact in a previous financial statement would constitute an operational loss (these losses are generally known as ‘‘timing losses’’). Examples of an incorrectly booked positive financial impact would include revenue overstatement, overbilling, accounting errors, and mark-to-market errors. Corrections that would constitute operational losses include refunds and restatements that result in a reduction in equity capital. If the initial overstatement and its correction occur in the same financial statement period, there would be no operational loss under the proposal. The proposal’s definition of operational loss includes a clarification regarding the boundary between operational risk and credit risk, which aims to ensure that all losses experienced by a banking organization in its financial statements are within the scope of the credit risk, market risk, or operational risk frameworks. Losses resulting from events that meet the definition of an operational loss event which are also credit losses and are related to exposures within the scope of the credit risk risk-weighted assets framework would continue to be excluded from total operational losses for purposes of the operational risk capital requirement. In keeping with the current framework and prevailing industry practice, retail credit card losses arising from non-contractual, third-party-initiated fraud would continue to be operational losses under the proposal. In addition, operational losses related to products that are outside of the scope of the credit riskweighted asset framework (for example, losses due to representations and warranties unrelated to credit risk that require the banking organization to repurchase an asset) would be operational losses even if they are associated with obligor default events. Operational losses that result from boundary events with market risk (for example, losses that are the result of failed or inadequate model validation processes) would also continue to be treated as operational losses in the proposal. The proposal includes revisions to the FR Y–14Q report, which is applicable to large banking organizations subject to the Board’s capital plan rule, to conform with the revisions to the definitions of operational loss and operational loss event introduced by the proposal. Under the proposal, a banking organization would include in its calculation of total net operational losses any operational loss events incurred by an entity that has been acquired by or merged with the banking organization.
In cases where historical loss data meeting the collection requirements is not available for a merged or acquired entity for certain years in the calculation window of the internal loss multiplier, the proposal would provide a formula for calculating annual total net operational losses for this merged or acquired entity for these missing years. Annual total net operational losses of the merged or acquired entity for the missing years would be such that the ratio of average annual total net operational losses to the business indicator contribution of this merged or acquired entity 198 is the same as the ratio of the average annual total net operational losses to business indicator of the remainder of the banking organization:
Annual total net operational losses for a merged or acquired business that lacks loss data = Business indicator contribution of merged or acquired business that lacks loss data * Average annual total net operational losses of the banking organization excluding amounts attributable to the merged or acquired business/Business indicator of the banking organization excluding amounts attributable to the merged or acquired business. This approach would recognize that historical data for operational losses may be difficult to obtain in certain circumstances, particularly if an acquired or merged entity had not previously been required to track operational losses.199 Banking organizations that only have five to nine years of loss data meeting the operational loss event data collection requirements in § ll.150(f)(2) of the proposal (for example, when transitioning into the standardized approach for operational risk) would be expected to use as many years of loss data meeting the internal loss event data collection requirements as are available in the calculation of average annual total net operational losses. In cases where a banking organization’s loss collection practices are deficient, its primary Federal supervisor may require higher capital requirements under the capital rule’s reservation of authority. Under the proposal, the internal loss multiplier would equal one in cases where the number of years of loss data meeting the internal loss event data collection requirements is less than five years. In cases where the banking organization’s primary Federal supervisor determines that an internal loss multiplier of one results in insufficient operational risk capital, the primary Federal supervisor may require higher capital requirements under the capital rule’s reservation of authority. Under the proposal, a banking organization would be able to request supervisory approval to exclude operational loss events that are no longer relevant to their risk profile from the internal loss multiplier calculation. The agencies expect the exclusion of operational loss events would generally be rare, and a banking organization would be required to provide adequate justification for why operational loss events are no longer relevant to its risk profile when requesting supervisory approval for exclusion. In evaluating the relevance of operational loss events to the banking organization’s risk profile, the primary Federal supervisor would consider various factors, including whether the cause or causes of the loss events could occur in other areas of the banking organization’s operations. The banking organization would need to demonstrate, for example, that there is no similar or residual legal exposure and that the excluded operational loss events have no relevance to other continuing activities or products. In the case of divestitures, a banking organization would be able to request supervisory approval to remove historical operational loss events associated with an
activity that the banking organization has ceased to directly or indirectly conduct—either through full sale of the business or closing of the business—from the calculation of the internal loss multiplier. Given that divestiture has occurred, exclusion of operational losses relating to legal events would generally depend on whether the divested activities carry legacy legal exposure, as would be the case, for example, where such activities are the subject of a potential or pending legal or regulatory enforcement action. Except in the case of divestitures, the agencies would only consider providing supervisory approval for exclusions after operational losses have been included in a banking organization’s total net operational losses for at least three years. This retention period would aim to ensure prudence in the calculation of operational risk capital requirements, as operational risk
200The interagency paper titled ‘‘Sound Practices to Strengthen Operational Resilience’’ (November 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.’’ exposure is unlikely to be fully eliminated over a short time frame. Finally, to ensure that requests for operational loss exclusions are of a substantive nature, the agencies would only consider a request for exclusion when the total net operational losses to be excluded are equal to five percent or more of the banking organization’s average annual total net operational losses. Question 75: What are the advantages and disadvantages of flooring the internal loss multiplier at one? Which alternatives, if any, should the agencies consider and why? Question 76: What are the advantages and disadvantages of including the internal loss multiplier as opposed to setting it equal to one? Question 77: What are the advantages and disadvantages of the treatment proposed for losses of merged or acquired businesses? Which alternatives, if any, should the agencies consider and why? What impact would any alternatives have on the conservatism of the proposal? Question 78: What are the advantages and disadvantages of an alternative threshold for the operational losses for which banking organizations may request supervisory approval to exclude?
4. Operational Risk Management and
Data Collection Requirements Under the proposal, banking organizations would continue to be required to collect operational loss event data. As discussed above, a banking organization would be required to include operational losses, net of recoveries, of $20,000 or more in the calculation of the internal loss multiplier. To assist the identification of operational loss events that result in an operational loss, net of recoveries, of $20,000 or more, the proposal would require banking organizations to collect operational loss event data for all operational loss events that result in $20,000 or more of gross operational loss. Operational loss event data would include the gross loss amount, recovery amounts, the date when the event occurred or began (date of occurrence), the date when the banking organization became aware of the event (date of discovery), and the date when the loss event resulted in a loss, provision, or recovery being recognized in the banking organization’s profit and loss accounts (date of accounting). These loss data collection requirements are similar to the loss reporting requirements currently in place for banking organizations subject to the FR Y–14 reporting and are similar to the data that banking organizations subject to the AMA have typically collected. To ensure the validity of its operational loss event data, a banking organization would be required to document the procedures used for the identification and collection of operational loss event data. Additionally, the banking organization would be required to have processes to independently review the comprehensiveness and accuracy of operational loss data, and the banking organization would be required to subject the aforementioned procedures and processes to regular independent reviews by internal or external audit functions. The proposal would introduce a requirement that banking organizations collect descriptive information about the drivers or causes of operational loss events that result in a gross operational loss of $20,000 or more. This requirement would facilitate the efforts of banking organizations and the agencies to understand the sources of operational risk and the drivers of operational loss events. The agencies would expect that the level of detail of any descriptive information be commensurate with the size of the gross loss amount of the operational loss event. The proposal would not include certain data requirements included in the AMA. Specifically, banking organizations would not be required to estimate their operational risk exposure or to collect external operational loss event data, scenario analysis, and business, environment, and internal control factors. 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.200 Thus, consistent with the current advanced approaches qualification requirements
applicable to banking organizations subject to Category I or II capital standards, the proposal would include the requirement that large banking organizations have an operational risk management function that is independent of business line management. This independent operational risk management function would be expected to design, implement, and oversee the comprehensiveness and accuracy of operational loss event data and operational loss event data collection processes, and oversee other aspects of the banking organization’s operational risk management. Large banking organizations would also be required to have and document processes to identify, measure, monitor, and control operational risk in their products, activities, processes, and systems. In addition, large banking organizations 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). Question 79: The proposal would require a banking organization to collect information on the drivers of operational loss events, with the level of detail of any descriptive information commensurate with the size of the gross loss amount. What are the advantages and disadvantages of this requirement? Which alternatives should the agencies consider—for example, introducing a higher dollar threshold for such a requirement—and why? G. Disclosure Requirements
201 In the case of a depository institution that is not a consolidated subsidiary of a depository institution holding company that is assigned a category under the capital rule, the depository institution would be considered the top-tier entity for purposes of the qualitative and quantitative enhanced disclosure and reporting requirements. 202The table numbers refer to the table numbers included in the proposed rule. 203See Table 1 to § 3.173 (OCC); § 217.173 (Board); § 324.173 (FDIC)—Scope of Application. 204See Table 2 to § 3.173 (OCC); § 217.173 (Board); § 324.173 (FDIC)—Capital Structure. 205See Table 3 to § 3.173 (OCC); § 217.173 (Board); § 324.173 (FDIC)—Capital Adequacy. 206See Table 4 to § 3.173 (OCC); § 217.173 (Board); § 324.173 (FDIC)—Capital Conservation and Countercyclical Capital Buffers. 207See Table 11 to § 3.173 (OCC); § 217.173 (Board); § 324.173 (FDIC)—Equities Not Subject to Subpart F of This Part. 208See Table 12 to 3.173 (OCC); § 217.173 (Board); § 324.173 (FDIC)—Interest Rate Risk for Non-Trading Activities. 209See Table 5 to § 3.173 (OCC); § 217.173 (Board); § 324.173 (FDIC)—Credit Risk—General Disclosures. 210See Table 7 to § 3.173 (OCC); § 217.173 (Board); § 324.173 (FDIC)—General Disclosure for Counterparty Credit Risk of OTC Derivative Contracts, Repo-Style Transactions, and Eligible Margin Loans. 211See Table 8 to § 3.173 (OCC); § 217.173 (Board); § 324.173 (FDIC)—Credit Risk Mitigation. corresponding revisions to the Consolidated Financial Statements for Holding Companies (FR Y–9C), the Capital Assessments and Stress Testing (FR Y–14A and FR Y–14Q), and the Systemic Risk Report (FR Y–15) to reflect the changes to the capital rule that would be required under this proposal. The proposal would also remove disclosures related to internal ratings-based systems and internal models, consistent with the broader objectives of this proposal. Under the current capital rule, banking organizations subject to Category I or II capital standards are subject to enhanced public disclosure and reporting requirements in comparison to the disclosure and reporting requirements applicable to banking organizations subject to Category III or IV capital standards. Under the proposal, the enhanced public disclosure requirements would apply to all large banking organizations. Applying enhanced disclosure and reporting requirements to banking organizations subject to Category III or IV capital standards would bring consistency across large banking organizations and promote transparency for market participants. Consistent with the current capital rule, the top-tier entity (including a depository institution, if applicable), would be subject to both the qualitative and quantitative enhanced disclosure and reporting requirements.201 The current capital rule does not subject a banking organization that is a consolidated subsidiary of a bank holding company, a covered savings and loan holding company that is a banking organization as defined in 12
CFR 238.2, or depository institution that is subject to public disclosure requirements, or a subsidiary of a non-U.S. banking organization that is subject to comparable public disclosure requirements in its home jurisdiction to the qualitative disclosure requirements described in the current capital rule. The proposal would not change the current capital rule’s requirements regarding public disclosure policy and attestation, the frequency of required disclosures, the location of disclosures, or the treatment of proprietary information.
2. Specific Public Disclosure
Requirements
The proposed changes to disclosure requirements pertaining to the riskbased capital framework are described below.202 Disclosure tables 1,203 2,204 3,205 4,206 11 207 (table 9 to §ll.162 in the proposal), and 12 208 (table 10 to § ll.162 in the proposal) in § ll.173 of the current capital rule have been retained without material modification, although the table numbers would change. The proposal would retain the requirement that a banking organization disclose its risk management objectives as they relate to specific risk areas (e.g., credit risk). The proposal would revise the risk areas to which these disclosure requirements apply to help ensure consistency with the broader proposal. In addition, the proposal would require a banking organization to describe its risk management objectives as they relate to the organization overall. The required disclosures would include information regarding how the banking organization’s business model determines and interacts with the overall risk profile; how this risk profile interacts with the risk tolerance approved by its board; the banking organization’s risk governance structure; channels to communicate, define, and enforce the risk culture within the banking organization; scope and features of risk measurement systems; risk information reporting; qualitative information on stress testing; and the strategies and processes to manage, hedge, and mitigate risks. These disclosures are intended to allow market participants to evaluate the adequacy of a banking organization’s approach to risk management.
Table 5 to §ll.162, ‘‘Credit Risk:
General Disclosures,’’ would include the disclosures a banking organization is required to make under the current capital rule regarding its approach to general credit risk.209 In addition, the proposal would require a banking organization to disclose certain additional information regarding its risk management policies and objectives for credit risk. Specifically, the proposal would require a banking organization to enhance its existing disclosures by describing how its business model translates into the components of the banking organization’s credit risk profile and how it defines credit risk management policy and sets credit limits. Additionally, a banking organization would be required to disclose the organizational structure of its credit risk management and control function as well as interactions with other functions. A banking organization would also be required to disclose information on its policies related to reporting of credit risk exposure and the credit risk management function that are provided to the banking organization’s leadership.
Table 6 to §ll.162, ‘‘General
Disclosure for Counterparty Credit RiskRelated Exposures,’’ would include the disclosures a banking organization is required to make under the current capital rule regarding its approach to managing counterparty credit risk.210 The proposal would also include new disclosure requirements regarding a banking organization’s methodology for assigning economic capital for counterparty credit risk exposures as well as its policies regarding wrong-way risk exposures. Additionally, the proposal would further require a banking organization to disclose its risk management objectives and policies related to counterparty credit risk, including the method used to assign the operating limits defined in terms of internal capital for counterparty credit risk exposures and for CCP exposures, policies relating to guarantees and other risk mitigants and assessments concerning counterparty credit risk (including exposures to CCPs), and the increase in the amount of collateral that the banking organization would be required to provide in the event of a credit rating downgrade.
Table 7 to §ll.162, ‘‘Credit Risk
Mitigation,’’ would include the disclosures a banking organization is required to make under the current rule regarding its approach to credit risk mitigation.211 In addition, the proposal would specify that a banking organization must provide a meaningful
212See section III.C.5 of this SUPPLEMENTARY INFORMATION for a more detailed discussion on the types of credit risk mitigants that a banking organization would be allowed to recognize for purposes of calculating risk-based capital requirements. 213See Table 9 to § 3.173 (OCC); § 217.173 (Board); § 324.173 (FDIC)—Securitization. 214The Accounting Standards Codification is promulgated by the Financial Accounting Standards Board for GAAP. 215See ASC 310–10–50–36. 216For purposes of Table 15, unique identifiers associated with regulatory capital instruments and other instruments eligible for TLAC may include Committee on Uniform Security Identification Procedures number, Bloomberg identifier for private placement, International Securities Identification Number, or others. 217 61 FR 47358 (September 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). 218Risk-Based Capital Guidelines: Market Risk, 77 FR 53059 (August 30, 2012). breakdown of its credit derivative providers, including a breakdown by rating class or by type of counterparty (e.g., banking organizations, other financial institutions, and non-financial institutions). These disclosures would apply to eligible credit risk mitigants under the proposal,212 although a banking organization would be encouraged to also disclose information about other mitigants. The credit risk mitigation disclosures in Table 7 to § ll.162 of the proposal would not apply to synthetic securitization exposures, which would be included in
Table 8 to §ll.162 as part of the
banking organization’s disclosures related to securitization exposures.
Table 8 to §ll.162,
‘‘Securitization,’’ would include the disclosures a banking organization is required to make under the current capital rule regarding its approach to securitization.213 In addition to the existing qualitative disclosures related to securitization, the proposal would require disclosure of whether the banking organization provides implicit support to a securitization and the riskbased capital impact of such support.
Table 11 to §ll.162, ‘‘Additional
Disclosure Related to the Credit Quality of Assets,’’ is a new disclosure table that would require banking organizations to provide further information on the scope of ‘‘past due’’ exposures used for accounting purposes, including the differences, if any, between the banking organization’s scope of exposures treated as past due for accounting purposes and those treated as past due for regulatory capital purposes. Table 11 to §ll.162 would also describe the scope of exposures that qualify as ‘‘defaulted exposures’’ or ‘‘defaulted real estate exposures’’ that are not exposures for which credit losses are measured under ASC214 Topic 326 and for which the banking organization has recorded a partial write-off or writedown. Additionally, a banking organization would be required to disclose the scope of exposures that qualify as a ‘‘loan modification to borrowers experiencing financial difficulty’’ for accounting purposes under ASC Topic 310 215 and the difference, if any, between the scope of exposures treated as ‘‘defaulted exposures’’ or ‘‘defaulted real estate exposures.’’
Table 12 to §ll.162, ‘‘General
Qualitative Disclosure Requirements Related to CVA’’ is a new disclosure
table that would require a banking
organization to disclose certain information pertaining to CVA risk, including its risk management objectives and policies for CVA risk and information related to a banking organization’s CVA risk management framework, including processes implemented to identify, measure, monitor, and control CVA risks and effectiveness of CVA hedges. Table 13 to § ll.162, ‘‘Qualitative Disclosures for Banks Using the SA–CVA’’ is a new disclosure table that would require a banking organization that has approval to use the standardized CVA approach (SA–CVA) to make disclosures related to the banking organization’s risk management framework, including a description of the banking organization’s risk management framework, a description of how senior management is involved in the CVA risk management framework, and an overview of the governance of the CVA risk management framework such as documentation, independent risk control unit, independent review, and independence of data acquisition from lines of business.
Table 14 to §ll.162, ‘‘General
Qualitative Information on a Banking Organization’s Operational Risk Framework,’’ is a new disclosure table that would require a banking organization to disclose information regarding its operational risk management processes, including its policies, frameworks, and guidelines for operational risk management; the structure and organization of its operational risk management and control function; its operational risk measurement system (the systems and data used to measure operational risk in order to estimate the operational risk capital requirement); the scope and context of its reporting framework on operational risk to executive management and to the board of directors; and the risk mitigation and risk transfer used in the management of operational risk.
Table 15 to §ll.162, ‘‘Main
Features of Regulatory Capital Instruments and of other TLAC-Eligible Instruments,’’ is a new disclosure table that would require a banking organization to disclose information regarding the terms and features of its regulatory capital instruments and other instruments eligible for TLAC.216 In addition, the proposal would require a banking organization to describe the main features of its regulatory capital instruments and provide disclosures of the full terms and conditions of all instruments included in regulatory capital. A banking organization that is also a GSIB would also be required to describe the main features of its covered debt positions and provide disclosures of the full terms and conditions of all covered debt positions. H. Market Risk
219The 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 savings and loan holding companies with material exposure to market risk subject to the market risk rule, 78 FR 62018 (October 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 (December 18, 2013). 220The 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. 221Basel Committee, ‘‘Minimum capital requirements for market risk,’’ January 2016, www.bis.org/bcbs/publ/d352.pdf. 222Basel Committee, Explanatory note on the minimum capital requirements for market risk, January 2019, www.bis.org/bcbs/publ/d457.pdf. 223A banking organization that has regulatory approval to use internal models to measure market risk would be required to obtain new approvals to use the models-based measure for market risk under the proposed framework. 224The 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. 225The 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. 226The proposed desk-level backtesting requirements are intended to measure the conservatism of the forecasting assumptions and valuation methods used in the desk’s expected shortfall models. 227The proposed desk-level profit and loss attribution (PLA) testing requirements are intended to measure the accuracy of the potential future profits or losses estimated by the expected shortfall models relative to those produced by the front office models. For purposes of this SUPPLEMENTARY INFORMATION, the term ‘‘front office model’’ refers to the valuation methods used to report actual profits and losses for financial reporting purposes. 228A 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. 229Under 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). requirement), a comprehensive risk measurement for correlation trading portfolio, a modified definition of covered position, a definition of trading position, an expanded set of requirements for internal models to reflect advances in risk management, and revised requirements for regulatory backtesting. These changes enhanced the calibration of market risk capital requirements by incorporating stressed conditions into VaR and by increasing the comprehensiveness and quality of the standards for internal models used to calculate market risk capital requirements.219 While these updates to the rule addressed certain pressing deficiencies in the calculation of market risk capital requirements, a number of structural shortcomings that came to light during the crisis remained unaddressed (such as an inability of a VaR metric to capture tail risks). To address these shortcomings, the Basel Committee conducted a fundamental review of the market risk capital framework.220 Following this review, the Basel Committee in January 2016 published a new, more robust framework, which established minimum capital requirements for market risk.221 The new framework also included enhanced templates and qualitative disclosure requirements to increase the transparency of banking organizations’ market-risk-weighted assets. In January 2019, the Basel Committee published an amended framework for market risk capital requirements that revised the calibration of certain risk weights to more appropriately capture the potential losses for certain types of risks.222 The proposal would modify subpart F of the capital rule to increase risk sensitivity, transparency, and consistency of the market risk capital requirements in a manner generally consistent with the revised framework of the Basel Committee. b. Overview of the Proposal The proposal would improve the risksensitivity and calibration of market risk capital requirements relative to the current capital rule. The proposal would introduce a risk-sensitive standardized methodology for calculating riskweighted assets for market risk (standardized measure for market risk) and a new models-based methodology (models-based measure for market risk) to replace the framework in subpart F of the current capital rule. The standardized measure for market risk would be the default methodology for calculating market risk capital requirements for all banking organizations subject to market risk requirements. A banking organization would be required to obtain prior approval from its primary Federal supervisor to use the models-based measure for market risk to determine its market risk capital requirements.223 In contrast to the current framework which, subject to approval, allows
the use of internal models at the banking organization level, the proposal would provide for enhanced risk-sensitivity by introducing the concept of a trading desk and restricting application of the proposed models-based approach to the trading desk level. The trading desklevel approach would limit use of the internal models approach to only those trading desks that can appropriately capture the risk of market risk covered positions in banking organizations’ internal models. Notably, the proposal would also improve the current capital rule’s models-based measure for market risk. Specifically, the proposal would replace the VaR-based measure of market risk with an expected shortfallbased measure that better accounts for extreme losses.224 In addition, the proposal would replace the fixed tenbusiness-day liquidity horizon in the current capital rule with liquidity horizons that vary based on the underlying risk factors to adequately capture the market risk of less liquid positions.225 If after receiving approval from the primary Federal supervisor to use the models-based measure for market risk, a banking organization’s trading desk fails to satisfy either the proposed desk-level backtesting requirements 226 or the proposed desk-level profit and loss attribution testing requirements,227 the proposal would require the banking organization to use the standardized measure for market risk to calculate market risk capital requirements for the trading desk. This requirement would limit the use of internal models to only those trading desks for which the models are sufficiently conservative and accurate for purposes of calculating market risk capital requirements for the trading desk. The proposed standardized measure for market risk (as illustrated in Figure 2 below) would consist of three main components: (1) a sensitivities-based capital requirement that would capture non-default market risk based on the estimated losses produced by risk factor sensitivities 228 under regulatorily determined stress conditions; 229 (2) a standardized default risk capital requirement that would capture losses on credit and equity positions in the event of issuer default; and (3) a residual risk capital requirement (a residual risk add-on) that would address in a simple, conservative manner any other known risks that are not already captured by the first two components, such as gap risk, correlation risk, and behavioral risks. The proposed
230The internal models approach capital requirements for model-eligible trading desks would itself consist of four components: (1) the internally modelled capital requirement for modellable risk factors, (2) the stressed expected shortfall for non-modellable risk factors, (3) the standardized default risk capital requirement, and (4) the aggregate trading portfolio backtesting capital multiplier. See section III.H.8.a of this SUPPLEMENTARY INFORMATION. 231The PLA add-on would be an additional capital requirement for model deficiencies in model-eligible trading desks based on the profit and loss attribution test results. See section III.H.8.b of this SUPPLEMENTARY INFORMATION. 232Separate capital calculations could unnecessarily increase capital requirement because they ignore the offsetting benefits between market risk covered positions held by trading desks subject to the internal models approach and those held by trading desks subject to the standardized approach. standardized measure for market risk would also include three additional components that would apply in limited instances to specific positions: (1) a fallback capital requirement for instances where a banking organization is unable to calculate market risk capital requirements under the sensitivitiesbased method or the standardized default risk capital requirement; (2) a capital add-on for re-designations for instances where a banking organization re-classifies an instrument after initial designation as being subject either to the market risk capital requirements under subpart F or to the capital requirements under either subpart D or E of the capital rule, respectively, and (3) any additional capital requirement established by the primary Federal supervisor. Specifically, 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 standardized measure for market risk would equal the simple sum of the above components as shown in Figure 2. BILLING CODE 6210–01–P; 6714–01–P; 4810–33–P BILLING CODE 6210–01–C; 6714–01–C; 4810–33–C The core components of the modelsbased measure for market risk would consist of (1) the internal models approach capital requirements for model-eligible trading desks; 230 (2) the standardized approach capital requirements for model-ineligible trading desks; and (3) the additional capital requirement applied to modeleligible trading desks with shortcomings in the internal models used for determining risk-based capital requirements in the form of a PLA addon,231 if
applicable. To limit the increase in capital requirements arising due to differences in calculating riskbased capital requirements separately 232 between market risk covered positions held by trading desks subject to the internal models approach and those held by trading desks subject to the standardized approach, the models-based measure for market risk would cap the sum of these three EP18SE23.029</GPH>
233As the standardized approach is less risksensitive than the internal models approach, to the extent that the capital requirement under the internal models approach exceeds that under the standardized approach for model-eligible desks, the proposal would require this difference to be reflected in the aggregate capital requirement under the models-based measure for market risk. 234Specifically, the capital add-on would apply to equity positions in an investment fund on modeleligible trading desks where the banking organization cannot identify the underlying positions held by the investment fund on a quarterly basis or there is no daily price of the fund available. 235See 84 FR 59230, 59249 (November 1, 2019). components at the capital required for all trading desks under the standardized approach. There are four other components of the models-based measure for market risk; however, these would only apply in limited circumstances. These components include: (1) the capital requirement for instances where the capital requirements for model-eligible desks under the internal models approach exceed those under the standardized approach; 233 (2) the fallback capital requirement for instances where a banking organization is not able to apply the standardized approach to market risk covered positions on model-ineligible trading desks or the internal models approach to market risk covered positions on model-eligible trading desks, as well as all securitization positions and correlation trading positions that are excluded from the capital add-on for ineligible positions on model-eligible trading desks; (3) the capital add-on for re-designations for instances where a banking organization re-classifies an instrument after initial designation as being subject either to the market risk capital requirements under subpart F or to the capital requirements under either subpart D or subpart E of the capital rule, respectively, or from including securitization positions, correlation trading positions, or certain equity positions in investment funds 234 on a model-eligible trading desk, provided such positions are not included in the fallback capital requirement; and (4) any additional capital requirement established by the primary Federal supervisor. Specifically, as part of the proposal’s reservation of authority provisions, and similar to the standardize measure for market risk, 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 proposal. Under the proposal, the market risk capital requirements for a banking organization under the models-based measure for market risk would equal the sum of the following components as shown in Figure 3. The proposal would also revise the criteria for determining whether a banking organization is subject to the market risk-based capital requirements to (1) reflect the significant growth in capital markets since
adoption of the 1996 rule; (2) provide a more reliable and stable measure of banking organizations’ trading activity by introducing a four-quarter average requirement, and (3) incorporate measures of risk identified as part of the agencies’ 2019 regulatory tiering rule.235 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 EP18SE23.030</GPH>
236The 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). 237See 84 FR 59230, 59249 (November 1, 2019).
238For 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. 239 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. 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 Currently, any banking organization with aggregate trading assets and trading liabilities that, as of the most recent calendar quarter, equal to $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 under subpart F of the current capital rule. The proposal would revise the criteria for determining whether a banking organization is subject to subpart F of the capital rule. Under the proposal, large banking organizations, as well as those with significant trading activity, would be required to calculate market risk capital requirements under subpart F of the capital rule. Specifically, a banking organization with significant trading activity would be any banking organization with average aggregate trading assets and trading liabilities, excluding customer and proprietary broker-dealer reserve bank accounts,236 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. Under the proposal, any holding company subject to Category I, II, III, or IV standards or any subsidiary thereof, if the subsidiary engaged in any trading activity over any of the four most recent quarters, would be subject to subpart F of the capital rule. The proposed scope is designed to apply market risk capital requirements to all large banking organizations. As the agencies noted in the preamble to the final regulatory tiering 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 would benefit from more stringent capital requirements being applied to such banking organizations.237 As banking organizations subject to Category I or II capital standards are generally subject to rules based on the standards published by the Basel Committee, the proposed scope would 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, given the increasing size and complexity of activities of banking organizations subject to Category III and IV capital standards and the risks such banking organizations pose to U.S. financial stability, it would be appropriate to require such banking organizations to be subject to the proposed market risk capital requirements, which provide for enhanced risk sensitivity. In addition to applying subpart F of the capital rule to large banking organizations, the proposed rule would retain a trading activity threshold. To reflect inflation since 1996 and growth in the capital markets, the agencies are proposing to increase the trading activity dollar threshold from $1 billion to $5 billion. 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 subpart F of the capital rule under the proposal. This means that a banking organization that is not subject to Category I, II, III, or IV capital standards may still be subject to subpart F if it 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.238 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.239 Furthermore, for purposes of determining applicability of subpart F of the capital rule, 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 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 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 market risk capital requirements. b. Application of Proposed Rule The proposal would require a banking organization to comply with the market risk capital requirements beginning the quarter after the banking organization meets any of the proposed scoping criteria. To avoid volatility in requirements, a banking organization would remain subject to market risk capital requirements unless and until (1) it falls below the trading activity threshold criteria for each of four consecutive quarters or is no longer a banking organization subject to Category I, II, III, or IV capital standards, as applicable, and (2) has provided notice to its primary Federal supervisor. Implementing the proposed market
risk capital requirements would require significant operational preparation. Therefore, the agencies expect that 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. To facilitate supervisory oversight, the proposal would require a banking
240The 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. 241With prior approval from its primary Federal supervisor, a banking organization may 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). 242The 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. 243The proposed definition of market risk covered position would include correlation trading positions and instruments resulting from securities underwriting commitments where the securities are purchased by the banking organization on the settlement date, excluding purchases that are held to maturity or available for sale purposes. 244A position that hedges a trading position must be within the scope of the banking organization’s hedging strategy as described in §ll.203(a)(2) of the proposed rule. 245Extending 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 subpart F of the capital rule. 246An eligible CVA hedge generally would include an external CVA hedge or a CVA hedge that is the CVA segment of an internal risk transfer. See
section III.I.3.b. of this SUPPLEMENTARY INFORMATION
for more detail on the treatment and recognition of CVA hedges either under the proposed CVA risk framework or the market risk framework. 247Equity positions arising from deferred compensation plans, employee stock ownership plans, and retirement plans would not be included in the scope of market risk covered position. 248This would apply to hybrid contracts containing an embedded derivative that must be separated from the host contract and accounted for organization to notify its primary Federal supervisor after falling below the relevant scope thresholds. 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 subpart F of the capital rule for the primary Federal supervisor to either:
(1) require a banking organization that does not meet the proposed threshold criteria to calculate the proposed market risk capital requirements, or (2) exclude a banking organization that meets the proposed threshold criteria from such calculation, as appropriate. To allow the agencies to address such instances on a case-by-case basis, the proposal would retain such existing authority under subpart F of the capital rule. Question 80: 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 81: 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. Market Risk Covered Position
Subpart F of the capital rule applies to a banking organization’s covered positions, which are defined to include, subject to certain restrictions: (i) any trading asset or trading liability as reported on a banking organization’s regulatory reports that is a trading position 240 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 241 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 intended to better align the definition of market risk covered position with those positions the agencies believe 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 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 expand to 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.242 243 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 significant 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 244 regardless of whether the position is a trading asset or trading liability.245 Consistent with subpart F of 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. In addition, the proposal would exclude from
market risk covered positions foreign exchange and commodity positions that are eligible CVA hedges that mitigate the exposure component of CVA risk.246 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; (ii) net short risk positions; (iii) certain publicly traded equity positions; 247 (iv) 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; 248 and (v) certain
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). 249See section III.H.4 of this SUPPLEMENTARY INFORMATION for further detail on eligible internal risk transfer positions. 250The proposal would retain, without modification, the existing definition of trading position in subpart F of the current capital rule. See 12 CFR 3.202 (OCC); 12 CFR 217.202 (Board); 12 CFR 324.202 (FDIC). 251Under the proposal, subpart D would cover a Standardized Approach and subpart E would cover an Expanded Risk-Based Approach for RiskWeighted Assets. 252For 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. 253The 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 Continued positions associated with internal risk transfer under the proposal.249 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. In contrast to the current covered position definition, which in part relies on the legal form of the investment fund by referencing the Investment Company Act to determine whether an equity position in such a fund is a covered position, the proposed criteria would capture equity positions for which there is sufficient transparency to be reliably valued on a daily basis, either from an observable market price for the equity position in the investment fund itself or 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 over-hedges 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.250 The agencies propose to include net short risk positions in market risk covered positions in order to help ensure that such exposures are appropriately reflected in banking organizations’ risk-based capital requirements. 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 subpart D nor E 251 of the capital rule would require the banking organization to reflect this risk in risk-weighted assets. To capture the market risk arising from net short risk positions, the proposal would require the banking organization to treat such positions 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.252 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, the proposal would require a banking organization to evaluate its long and short equity and credit exposures for all positions referencing a single exposure to determine if it has a net short risk position in a single-name exposure. For index hedges, the proposal would require a banking organization to evaluate its long and short equity and credit exposures for all positions in the portfolio (aggregating across all relevant individual exposures) to determine if it has a net short risk position for any given portfolio. The proposal would limit the application of the proposed market risk capital requirements to positions arising from exposures for which the notional amount of a short position exceeds the notional amount of a long position by $20 million or more at either the singlename or index hedge level. Exposures arising from net short risk positions are a potential area where a banking organization may maintain insufficient capital relative
to the market risk and should be monitored at the single name or portfolio level rather than in the aggregate. The agencies nonetheless recognize that it could be burdensome to require a banking organization to capture every net short exposure that may arise, regardless of size or duration, when calculating their market risk capital requirements. 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. Third, the proposal generally would include as market risk covered positions all publicly traded equity positions 253
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. 254For purposes of regulatory reporting, the instructions to the 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 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. 255For example, a conventional mortgage loan contains an embedded prepayment or call option. 256See 77 FR 53060, 53064–53065 (August 30,
2012) for a more detailed discussion on these
exclusions under the market risk capital rule. 257 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.
258See 77 FR 53060, 53065 (August 30, 2012) for the agencies’ interpretive guidance on the treatment of such indirect holdings under subpart F of the capital rule. 259External transactions executed by a trading desk as matching transactions to all internal transfers of CVA risk would be market risk covered positions under the proposal. See section III.H.3.b of this SUPPLEMENTARY INFORMATION for a more detailed discussion on the treatment of eligible and ineligible internal risk transfers of CVA risk. regardless of whether they are trading assets or trading liabilities and 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. 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. If the banking organization elected to report the entire hybrid instrument at fair value under the fair value option rather than bifurcating the accounting, it would be a market risk covered position only if it otherwise met the proposed definition, such as held with trading intent or to hedge another market risk covered position.254 This approach 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 such derivatives on a daily basis, and also appropriately excluding conventional instruments with an embedded derivative for which the capital requirements under subpart D or E of the capital rule would be appropriate.255 Fifth, the proposed definition of market risk covered position would include certain transactions of internal risk transfers, as described in section III.H.4 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 or interest rate risk and the trading desk segment of an internal risk transfer of CVA risk; (2) certain external transactions based on eligibility of the risk transfers, executed by a trading desk related to an internal risk transfer of CVA, credit, or interest rate risk, and (3) both external and internal ineligible CVA hedges (an internal CVA hedge is the CVA segment of an internal transfer of CVA 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 subparts D, E, or F of the
capital rule.
c. Exclusions From the Proposed
Definition of Market Risk Covered Position The definition of a covered position under subpart F of the current capital rule explicitly excludes certain positions.256 These excluded instruments and positions generally reflect the fact that they are either deducted from regulatory capital, explicitly addressed under subpart D or E 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 subpart F of the current capital rule, the proposal would continue to exclude from the definition of market risk covered positions any intangible asset, including any servicing asset; 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; any instrument that, in form or substance, acts as a liquidity facility that provides support to asset-backed commercial paper, and any position a banking organization holds with the intent to securitize. The proposed definition would also continue to exclude from market risk covered positions any direct real estate holdings.257 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.258 The proposed definition would also exclude from market risk covered positions any non-publicly traded equity positions, other than certain equity positions in investment funds, and would additionally exclude: (1) a publicly traded equity position that has restrictions on tradability; (2) a 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, and (3) 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. 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. To provide additional clarity, the proposal would also exclude from market risk covered positions debt securities for which the banking organization elects the fair value option for purposes of asset and liability management, as such positions are not reflective of a banking organization’s trading activity. 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. With respect to internal risk transfers of CVA risks, the proposed definition
would exclude from market risk covered positions the CVA segment of an internal risk transfer that is an eligible CVA hedge. In addition, consistent with the Basel III reforms, only positions recognized as eligible external CVA hedges under either the basic or standardized capital requirements for CVA risk would be excluded from the market risk capital requirements.259 To the extent a banking organization enters into one or more external hedges that hedge CVA variability but do not qualify as eligible hedges under the revised CVA capital standards, the banking organization would need to capture such hedges in its market risk capital
260For banking organizations subject to subpart F of 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 under subpart F of the capital rule 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. 261Such risks can include credit, interest rate, or CVA risk arising from exposures that are subject to risk-based requirements under subpart D or E of the capital rule. 262For 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 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. 263An internal risk transfer transaction would comprise two perfectly offsetting segments—one segment for each of two parties to the transaction. 264As described in section III.H.7.c.ii of this SUPPLEMENTARY INFORMATION, for transfers of risk between a trading desk that uses the standardized measure and a trading desk that uses the internal models approach, a banking organization may exclude the leg of the transaction acquired by the trading desk using the standardized approach from the residual risk add-on. requirements and would not be able to recognize the benefit of the external hedge when calculating risk-based capital requirements for CVA risk. Question 82: 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? 260 Question 83: 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? Question 84: The agencies seek comment on whether the agencies should consider allowing a banking organization to exclude from the definition of market risk covered position investments in capital instruments or covered debt instruments of financial institutions that have been deducted from tier 1 capital, including investments in publicly-traded common stock of financial institutions, and hedges of these investments that meet the requirements to offset such positions for purposes of determining deductions. What would the benefits and drawbacks be of not providing such an optionality? Question 85: 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 86: 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 87: 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? Question 88: The agencies seek comment on whether to modify the exclusion for debt instruments for which a banking organization has elected to apply the fair value option that are used for asset and liability management purposes. Would such an exclusion be overly restrictive, and, if so, why and how should the exclusion be expanded? Please specify the types and amounts of debt instruments for which banking organizations apply the fair value option that should be covered under this exclusion, and the capital implications of expanding the exclusion relative to the proposal. Question 89: The agencies seek comment on whether to modify the criteria for including external CVA hedges in the scope of
market risk covered position. What are the benefits and drawbacks of requiring a banking organization to include ineligible external CVA hedges in the market risk capital requirements, provided a banking organization has effective risk management and an effective hedging program?
4. Internal Risk Transfers
A banking organization may choose to hedge the risks of certain positions 261 held by a banking unit or a CVA desk by having one of its trading desks obtain the hedge and subsequently transfer the hedge position through an internal transaction to the banking unit or the CVA desk. 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 262 (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 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 a transfer executed through internal derivatives trades of credit risk or interest rate risk arising from an exposure capitalized under subparts D or E of the capital rule 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.263 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.264 In practice, for internal risk management purposes, most banking
265The proposal would not require banking organizations to purchase the hedge from a third party for such transactions to qualify as an internal risk transfer. 266As 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. organizations already document the source of risk being hedged and the trading desk providing the hedge. 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 believe 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 III reforms introduce riskbased capital treatment of 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 III reforms by specifying the criteria for internal risk transfer eligibility and clarifying the scope of exposures subject to market risk capital requirements. Specifically, the banking organization would be required to maintain documentation identifying the underlying exposure under subpart D or E of the capital rule 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. 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 subpart D or E of the capital rule. Since 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 each other provided the amounts and terms of both transactions match. Nevertheless, if the internal risk transfer results in a net short credit position for the banking unit, the trading desk would be required to
calculate riskbased capital requirements for such positions under subpart F of the capital rule. 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 subpart D or E of the capital rule. 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 subpart D or E of the capital rule. 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. 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. The proposal would require such a desk to receive approval from its primary Federal supervisor to execute such internal risk transfers.265 The proposal would require the capitalization of trading desks that engage in such transactions on a standalone basis, without regard to other market risks generated by activities on the trading desk. When these requirements are met, the transaction 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 subpart D or E of the capital rule 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.266 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
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. 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. 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 an internal written record of each internal derivative transaction executed between the CVA desk and the trading desk, including identifying the underlying exposure being hedged by the CVA desk and the sources of such
267While 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. risk. Furthermore, if the internal risk transfer from the CVA desk to the trading desk is subject to curvature risk, default risk, or the residual risk add-on under the proposed market risk capital rule, as described in sections III.H.7.a.ii.III., III.H.7.b., and III.H.7.c of this SUPPLEMENTARY INFORMATION, respectively, the trading desk would have to execute an external transaction with a third party that is identical in its terms to the risk transferred by the CVA desk to the trading desk. This external transaction would be included in market risk covered positions; therefore, there would be no impact to the market risk capital required for the trading desk as the external transaction would perfectly offset the risk from the internal risk transfer. Given the difference in recognizing the curvature risk, the default risk, or the residual risk add-on under the proposed market risk capital requirements and the CVA risk capital requirements, as well as complexity of tracking and ensuring the appropriateness of internal transfers of CVA risk, the external matching transaction requirement is intended to ensure the complete offsetting of the above mentioned risks at the time the trades are originated, facilitate the identification by the primary Federal supervisor of the underlying position or sources of risk being hedged by the internal risk transfer, and thus the determination of whether the transfer is an eligible internal CVA risk transfer. In addition to the above-mentioned requirements for the internal transaction and the related external matching 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 III.I.3 of this SUPPLEMENTARY
INFORMATION.267
For eligible internal risk transfers of CVA risk, the banking organization would be required to treat the transfers of risk from the CVA desk or the functional equivalent to the trading desk as market risk covered positions. 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. As the overall risk profile of the banking organization would not have changed, the proposed treatment would require the trading desk to reflect the impact of the risk transferred from the CVA desk as part of the transaction in the proposed market risk capital requirements. 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 include both the trading desk segment and the CVA segment of the internal transfer of CVA risk in market risk-weighted assets. This is equivalent to disregarding the internal CVA risk transfer. The entire amount of the external matching transaction executed by the non-CVA trading desk in the context of an internal CVA risk transfer would be deemed a market risk covered position. 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 subpart D or E of the capital rule. The proposed definition of market risk covered position would include equity positions that are publicly traded with no restrictions on tradability. Given the expanded scope of equity positions that would be subject to the proposed market risk capital requirements as discussed above, the agencies believe that primarily illiquid or irregularly traded equity positions would remain subject to subparts D or E of the capital rule. As a banking organization would not be able to hedge the material risk elements of such equity positions in a liquid, two-way market, consistent with the current framework, the proposal would not allow a banking organization to recognize internal transfers of equity risk of such positions for risk-based capital purposes. Question 90: The agencies seek comment on any operational challenges 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 91: The agencies seek comment on the extent to which the proposed internal risk
transfer framework would incentivize hedging and prudent risk management and/or provide opportunity to misrepresent the risk profile of a banking organization. What, if any, additional requirements or other modifications should the agencies consider? Question 92: 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 93: 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 to appropriately exclude the types of positions that should be captured under subpart D or E of the capital rule, but would impose less operational burden relative to the proposal? Question 94: 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? Question 95: The agencies seek comment on the matching external transaction requirements for internal transfer of CVA risk. Should such external matching transactions be subject to additional requirements, such as those applicable to external hedges of credit risk, and if so, why? Question 96: The agencies seek comment on limiting an eligible internal risk transfer of CVA risk to only internal transactions for which the external transaction perfectly offsets the internal risk transfer. What, if any, challenges might this requirement pose and what should the agencies consider to mitigate such challenges? Question 97: The agencies seek comment on the proposed requirement that a banking organization’s trading desk execute a matching transaction with a third party if the internal risk transfer of CVA risk is subject to curvature risk, default risk, or the residual risk add-on? What other risk mitigation techniques would the banking organization implement? Question 98: The agencies seek comment on the proposed documentation requirements for an
268Specifically, 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). 269As described in further detail in section III.H.6.d 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 subparts D or E of the capital rule as a market risk covered position. 270The proposal would define trading desk in a manner generally consistent with 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). internal risk transfer of credit risk, interest rate risk, and CVA risk to qualify as an eligible internal risk transfer. What, if any, alternatives should the agencies consider that would appropriately capture the types of positions that should be recognized under subpart D or E of the capital rule?
5. General Requirements for Market Risk
Subpart F of 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 III.H.3 and III.H.5.b of this SUPPLEMENTARY INFORMATION. The proposal would also make certain related technical corrections to the requirements around valuation of market risk covered positions.268 a. Identification of Market Risk Covered Positions Subpart F of 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 III.H.3 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 subpart F or to subparts D and, as applicable, E 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 III.H.6.d 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.269 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 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 the level of market risk that the banking organization would be 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 internal models approach 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 III.H.5.c of this SUPPLEMENTARY
INFORMATION. The proposal would require the banking organization to satisfy certain additional operational requirements, as described below in
section III.H.5.d of this SUPPLEMENTARY
INFORMATION, in order for the banking organization to calculate the market risk capital requirements for trading desks under the internal models approach. The proposal would define 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. 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.270 This approach would recognize the different strategies and objectives of discrete units in a banking
271As noted in section III.H.3.c of this SUPPLEMENTARY INFORMATION, identifying these positions for treatment under the proposed rule is necessary to enhance the rule’s sensitivity to risks that might not otherwise be captured or adequately captured by subparts D or E of the capital rule. 272The 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 subpart D or subpart E such as net short risk positions, embedded derivatives on instruments that the banking organization issued that relate to credit or equity risk that it bifurcates for accounting purposes, and foreign exchange positions and commodity positions. Notional trading desks would be exempt from certain requirements applicable to other trading desks, as discussed in this section III.H.5.b.iv. 273See section III.H.5.d of this SUPPLEMENTARY INFORMATION for further discussion on the requirements applicable to model-eligible trading desks. 274The list of model-eligible trading desks should include both those for which the banking organization has elected to calculate market risk capital requirements under the standardized approach as well as any trading desks that previously received approval to use the internal models approach but subsequently reported one or both PLA test metrics in the red zone, as described in more detail in section III.H.8.b.ii 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. 275A 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. 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 99: What, if any, changes should the agencies consider making to the definition of a trading desk and why? Are there any other key factors that 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 100: 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 III reforms?
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 that are bifurcated for accounting purposes, as well as foreign exchange and commodity exposures that are not trading assets or trading liabilities.271 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 272 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 III.H.5.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 internal models approach, 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.273 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 III.H.5.b.iii of this SUPPLEMENTARY INFORMATION, to help 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 101: 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, subject to the requirement that 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 model-based measure for market risk,274 (3) trading desks that are used for internal risk transfers (as applicable), and (4) notional trading desks (as applicable).275 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 written approval from the primary Federal supervisor of its trading desk structure. As part of the model approval process described in section III.H.5.d.iv of this SUPPLEMENTARY INFORMATION, the agencies 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 agencies 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
Subpart F of the current capital rule requires a banking organization to have clearly defined trading and hedging strategies for their 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
276Under the proposal, these requirements would generally not apply to any notional trading desk, except those with prior approval from the primary Federal supervisor to use the internal models approach. 277Under the proposal, the business strategy must include regular reports on the revenue, costs and market risk capital requirements of the trading desk. 278See section III.H.7.a.i of this SUPPLEMENTARY INFORMATION for further discussion on risk factors. 279The proposal would define internal risk management model as a valuation model that the independent risk control unit within the banking organization uses to report market risks and risktheoretical profits and losses to senior management. See §ll.202 of the proposed rule. 280Additionally, as described in more detail in
section III.H.7.a.ii of this SUPPLEMENTARY
INFORMATION, the proposal also assumes that the valuation models used to report actual profits and losses for purposes of financial reporting would provide an adequate basis for purposes of calculating regulatory capital requirements. As such models are already subject to additional requirements to enhance the accuracy of the financial data produced, the proposed requirements would only apply to those internal risk management models that the primary Federal supervisor has approved the banking organization to use in calculating regulatory capital requirements. 281The 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) or 12 CFR 217.203(b)(1). 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.276 At a minimum, this would include the business strategy for each trading desk; 277 the 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; the 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; 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; and the risk scope applicable to the trading desk that is consistent with its business strategy, including the overall risk classes and permitted risk factors.278 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
Subpart F of the current capital rule requires a banking organization to satisfy certain operational requirements for active management of market risk covered positions, stress testing, 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 III.H.5.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 internal risk management models 279 used by banking organizations provide an adequate basis for determining riskbased capital requirements for market risk covered positions.280 To help ensure such adequacy, the proposal also would strengthen a banking organization’s prudent valuation practices by incorporating requirements that build on the agencies’ overall regulatory framework for market risk management, including the regulatory guidance set forth in the Board’s Supervision and Regulation (SR) Letter 11–7 and OCC’s Bulletin 2011–12, Regulatory Guidance on Model Risk Management. 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 regardless of whether they use the standardized measure for market risk or models-based measure for market risk.
i. Active Management of Market Risk
Covered Positions
Subpart F of the current capital rule requires a banking organization to have clearly defined policies and procedures for actively managing all positions subject to the market risk capital rule, including establishing and conducting daily monitoring of position limits.281 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
282P-value is 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. 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, including intraday trading limits, limit usage, and remedial actions taken in response to limit breaches; (2) sensitivities to risk factors; and (3) market risk covered positions and transaction volumes; and, as applicable, (4) VaR and expected shortfall; (5) backtesting and p-values 282 at the trading desk level and at the aggregate level for all model-eligible trading desks; and (6) comprehensive profit-and-loss attribution (each as described in sections III.H.7 and III.H.8 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 subpart F of the capital rule, for a banking organization that has approval for at least one modeleligible 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 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 Subpart F of the 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 stress testing and internal assessment of capital adequacy requirements in subpart F of the capital rule to reflect both the entity-wide and the tradingdesk level elements 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 entitywide and trading-desk level 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 measure for market risk or in 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 management levels of the banking organization and addressed in a timely manner.
iii. Control and Oversight
Subpart F of the 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 subpart F of 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 its current requirements under subpart F of 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 its assessment of the calculation of the banking organization’s measures for market risk under subpart F, 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. 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
283The proposed backtesting requirements are intended to measure the conservatism of the forecasting assumptions and valuation methods in the expected shortfall models used for determining risk-based capital requirements while the proposed PLA testing requirements are intended to measure the accuracy of the potential future profits or losses estimated by the expected shortfall models relative to those produced by the front office models. If a trading desk fails to satisfy either the proposed PLA or backtesting requirements, it would no longer be able to calculate risk-based capital requirements using the internal models approach. In this way, the proposal would only allow trading desks for which the internal models are sufficiently conservative and accurate to use the internal models approach to calculate its market risk capital requirements. 284Specifically, the proposal would require a banking organization to exclude any insignificant amount of securitization positions and/or correlation trading positions held by the modeleligible trading desk from (1) the aggregate trading portfolio backtesting; and (2) from the relevant desk-level backtesting and profit and loss attribution metrics, except with the approval of the banking organization’s primary Federal supervisor. 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. A banking organization’s primary Federal supervisor would evaluate the robustness and appropriateness of the banking organization’s internal stresstesting methods, risk management processes, and capital adequacy.
iv. Documentation
Similar to the enhancements to policies and procedures described above, the proposal would enhance the documentation requirements under subpart F of the capital rule to reflect the proposed market risk capital framework. Specifically, a banking organization would be required to adequately document all material aspects of its identification, management, and valuation of its market risk covered positions, including internal risk transfers and any redesignations of positions between subpart F and subparts D and E of the capital rule. Consistent with subpart of F of the current capital rule, the proposal would require a banking organization to adequately document 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, modelineligible, used for internal risk transfers, or constitute notional trading desks, as well as document policies describing how each trading desk satisfies applicable requirements. These enhancements would support the banking organization’s ability to distinguish between positions subject to subpart F of the capital rule and those that are not. d. Additional Operational Requirements for the Models-Based Measure for Market Risk Under subpart F of the capital rule, a banking organization must use an internal VaR based model to calculate risk-based capital requirements for its covered positions. The proposal would not require a banking organization to use an internal model but would allow a banking organization that has approval from its primary Federal supervisor for at least one model-eligible trading desk to use the internal models approach to calculate market risk capital requirements. As a condition for use of the internal models approach, the proposal would require a trading desk to satisfy certain additional operational requirements, which are intended to help ensure that a 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, as described in sections III.H.8.b and III.H.8.c of this SUPPLEMENTARY INFORMATION, would help ensure that the losses estimated by the internal models used to calculate a trading desk’s risk-based capital requirements are sufficiently accurate and sufficiently conservative relative to the profits and losses that are reported in the general ledger. These general ledger reported profits and losses are produced by
front-office models.283 In this way, the additional operational requirements are intended 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 internal models approach 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 its front office controls, the proposed requirements would enhance prudent capital management for banking organizations that use the models-based measure for market risk. Additionally, the proposed trading desk-level framework would provide a prudential backstop to the internal models approach by requiring the use of the standardized approach for trading desks with risks that are not adequately captured by a banking organization’s internal models. This avoids the risk of an abrupt or severe change in a banking organization’s overall market risk capital requirement in the event that a particular trading desk ceases to be eligible to use the internal models approach.
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 internal models from the primary Federal supervisor. When identifying which trading desks to designate as model-eligible, the banking organization would be required to consider whether the standardized or internal models approach would more appropriately reflect the market risk of the desk’s market risk covered positions. Additionally, the proposal generally would prohibit a banking organization from seeking model approval for trading desks that hold securitization positions or correlation trading positions, with one exception. Given the operational difficulties of requiring a banking organization to bifurcate trading desks that hold an insignificant amount of securitization or correlation trading 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 internal models for such desks, the proposal would require the banking organization to separately calculate market risk capital requirements for such securitization or correlation trading positions held by a model-eligible trading desk under either the standardized approach or the fallback capital requirement, and otherwise treat such positions as if they were not held by the desk.284 Question 102: The agencies seek comment on the benefits and drawbacks
285Either 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. 286The process should include evaluation of empirical evidence supporting the methodologies used and evidence of a model’s strengths and weaknesses. 287The proposal would require a banking organization to receive written approval from the primary Federal supervisor for both the expected shortfall internal model and the stressed expected shortfall methodology used by the trading desk. As the initial approval process for each would be the same, for simplicity, the term ‘‘internal models’’ used throughout this section is intended to refer to both. of requiring trading desks that hold an insignificant amount of securitization positions and correlation trading positions to exclude from the internal models approach 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 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 in order to calculate market risk capital requirements under the models-based measure for market risk. 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 initial approval 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 285 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 its 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 banking organizations to establish a validation process that at a minimum includes an evaluation of the internal models’ (1) conceptual soundness 286 and (2) adequacy in appropriately capturing and reflecting all material risks, including 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 in subpart F of the 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.
iii. Documentation
In addition to the general documentation requirements applicable to all banking organizations as described in section III.H.5.c.iv of this SUPPLEMENTARY INFORMATION, the proposal would require a banking organization that uses the models-based measure for market risk to document policies and procedures regarding the determination of which risk factors are modellable and which are not modellable (risk factor eligibility test), including a description of how the banking organization maps real price observations to risk factors; the data alignment of the profit and loss systems used by front office and by the internal risk management models; the assignment of risk factors to liquidity horizons, and any empirical correlations recognized with respect to risk factor classes. As with the other enhanced operational requirements applicable to a banking organization that uses the models-based measure for market risk, these requirements are designed to help ensure the use of the internal models approach under the models-based measure for market risk only applies to those trading desks for which the banking organization is able to demonstrate that the internal models appropriately capture the market risk of the market risk covered positions held by the desk.
iv. Model Eligibility
For the banking organization to use the models-based measure for market risk, the proposal would require a banking organization to receive the prior written approval from its primary Federal supervisor for at least one trading desk to apply the internal models approach. Accordingly, the proposal would establish a framework for such approval.
I. Initial Approval
Under the proposal, the approval for a banking organization to use internal models would be granted at the individual trading desk level.287 For the primary Federal supervisor to approve an internal model, the proposal would require a banking organization to demonstrate that (1) the internal model properly measures all the material risks of the market risk covered positions to which it would be applied; (2) the internal model has been properly validated in accordance with the validation process and requirements; (3) the level of sophistication of the internal model is commensurate with the complexity and amount of the market risk covered positions to which it would be applied; and (4) the internal model meets all applicable requirements. To receive approval as a modeleligible trading desk, the proposal would require a trading desk to satisfy one of the following criteria. The banking organization could provide to the primary Federal supervisor at least 250 business days of backtesting and PLA test results for the trading desk.
288 In such cases, a banking organization should notify the primary Federal supervisor in writing, in a manner acceptable to the supervisor (such as through email, where appropriate). 289See sections III.H.8.b and III.H.8.c of this SUPPLEMENTARY INFORMATION. Alternatively, the banking organization could either (1) provide at least 125 business days of backtesting and PLA test results for the trading desk and demonstrate to the satisfaction of the primary Federal supervisor that the internal models would be able to satisfy the backtesting and PLA requirements on an ongoing basis; (2) demonstrate that the trading desk consists of market risk covered positions similar to those of another trading desk that has received approval from the primary Federal supervisor and such other trading desk has provided at least 250 business days of backtesting and PLA results, or (3) subject the trading desk to the PLA addon until the desk provides at least 250 business days of backtesting and PLA test results that pass the trading-desk level backtesting requirements and produce PLA metrics in the green zone, as further described in sections III.H.8.b and III.H.8.c of this SUPPLEMENTARY INFORMATION. The proposed criteria would hold trading desks to robust modeling requirements, while providing a banking organization sufficient flexibility to satisfy the standard over time and as the banking organization adapts its business structure. The agencies recognize that when initially requesting approval and in subsequent requests (for example, after a reorganization or upon entering into a new business), a banking organization may not always be able to provide a full year of backtesting and PLA results for each trading desk, even if the internal models used by the desk provide an adequate basis for determining riskbased capital requirements. The proposed criteria would allow a banking organization to seek model approval for trading desks with at least a six-month track record demonstrating the accuracy and conservatism of the internal models used by the desk (PLA and backtesting results) as well as for trading desks that consist of similar market risk covered positions to another trading desk, for which the banking organization has provided at least 250 business days of trading desk level profit and loss attribution test and backtesting results and has received approval from its primary Federal supervisor. Given the difficulty in evaluating the appropriateness of the internal models used by trading desks that provide less than six months of profit and loss attribution test and backtesting results and that do not consist of market risk covered positions similar to those of another trading desk that has received approval, the agencies are proposing to allow a banking organization to designate such desks as model-eligible, but to subject any such trading desk approved by the primary Federal supervisor to the PLA add-on until the desk produces one year of satisfactory profit
and loss attribution test and backtesting results in the green zone. Thus, the trading desk would remain subject to an additional capital requirement until it provides sufficient evidence demonstrating the appropriateness of the internal models, at which time application of the PLA add-on would automatically cease.
II. Ongoing Eligibility and Changes to
Trading Desk Structure or Internal Models Subpart F of the current capital rule requires a banking organization to promptly notify the primary Federal supervisor when (1) extending the use of a model that the primary Federal supervisor has approved to an additional business line or product type, (2) making any change to an internal model that would result in a material change in the banking organization’s total risk-weighted asset amount for market risk for a portfolio of covered positions, or (3) making any material change to its modelling assumptions. The proposal would expand on these requirements to require a banking organization to receive prior written approval from its primary Federal supervisor before implementing any change to its trading desk structure or internal models (including any material change to its modelling assumptions) that would (1) in the case of trading desk structure, materially impact the risk-weighted asset amount for a portfolio of market risk covered positions; or (2) in the case of internal models, result in a material change in the banking organization’s internally modelled capital calculation for a trading desk under the internal models approach. Additionally, the proposal would require a banking organization to promptly notify its primary Federal supervisor of any change, including non-material changes, to its internal models, modelling assumptions, or trading desk structure.288 Whether a banking organization would be required to receive prior written approval or promptly notify the primary Federal supervisor before extending the use of an approved model to an additional business line or product type would depend on the nature of and impact of such a change. The proposal also would require a model-eligible trading desk to perform and successfully pass quarterly backtesting and the PLA testing requirements on an ongoing basis in order to maintain its approval status.289 As banking organizations’ quarterly review of backtesting and PLA results would take place after a quarter is over, the proposal would permit a banking organization to rely on the internal models approach for model-eligible trading desks that previously received approval from the primary Federal supervisor during the 20-day period following quarter end while updating its use of internal models based on the results of the quarterly review. Even if a model-eligible trading desk were to satisfy the above requirements, a banking organization’s primary Federal supervisor could determine that the desk no longer complies with any of the proposed applicable requirements for use of the models-based measure for market risk or that the banking organization’s internal model for the trading desk fails to either comply with any of the applicable requirements or to accurately reflect the risks of the desk’s market risk covered positions. In such cases, the primary Federal supervisor could (1) rescind the desk’s model approval and require the desk to calculate
market risk capital requirements under the standardized approach, or (2) subject the desk to a PLA add-on capital requirement until it restores the desk’s full approval, in the case of trading desk noncompliance. The agencies recognize that even if a banking organization’s expected shortfall model for a trading desk satisfies the proposed backtesting, PLA testing, and operational requirements, the model may not appropriately capture the risk of the market risk covered positions held by the desk (for example, if the model develops specific shortcomings in risk identification, risk aggregation and representation, or validation). Thus, as an alternative to requiring a trading desk to use the standardized approach, the proposal would allow the primary Federal supervisor to subject the trading desk to the PLA add-on if the desk were to continue to satisfy all of the proposed backtesting, PLA testing, and operational requirements for use of the models-based measure for market risk. In this way, the proposal would help to ensure that the market risk capital requirements for the trading desk appropriately reflect the materiality of the shortcomings of the expected
290Notably, for securitization positions subject to subpart F, the current capital rule provides a standardized measurement method for capturing specific risks and a models-based measure capturing general risks for calculating market riskweighted assets. 291A 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. 292See section III.H.6.c of this SUPPLEMENTARY INFORMATION for a more detailed discussion on the fallback capital requirement. shortfall model, as the PLA add-on would apply until such time that the banking organization enhances the accuracy and conservatism of the trading desk’s expected shortfall model to the satisfaction of its primary Federal supervisor. Similarly, after approving a banking organization’s stressed expected shortfall methodology to capture nonmodellable risk factors for use by one or more trading desks, as described in
section III.H.8.a.i of this SUPPLEMENTARY
INFORMATION, the primary Federal supervisor may subsequently determine that the methodology no longer complies with the operational requirements for use of the modelsbased measure for market risk or that the methodology fails to accurately reflect the risks of the market risk covered positions held by the trading desk. In such cases, the proposal would allow the primary Federal supervisor to rescind its approval of the banking organization’s methodology and require the affected trading desk(s) to calculate market risk capital requirements for the trading desk under the standardized approach. As the methodologies used to capture the market risk of nonmodellable risk factors would not be subject to the proposed PLA testing requirements, which inform the calibration of the PLA add-on as described in section III.H.8.b of this SUPPLEMENTARY INFORMATION, the PLA add-on would not be an alternative if the primary Federal supervisor rescinds its approval of such a methodology.
6. Measure for Market Risk
Under subpart F of the current capital rule, a banking organization must use one or more internal models to calculate market risk capital requirements for its covered positions.290 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 regulator 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. As noted in section III.H.1.b. of this SUPPLEMENTARY INFORMATION, the proposal would introduce a standardized methodology for calculating market risk capital requirements and a new methodology for the internal models approach to replace the framework in subpart F of the current capital rule. Under the proposal, a banking organization that has one or more model-eligible trading desks would be required to calculate market risk capital requirements under both the standardized and the modelsbased measures for market risk. Furthermore, if required by the primary Federal supervisor, a banking organization that has one or more model-eligible trading desk would be required to calculate the standardized measure for market risk for each modeleligible trading desk as if that trading desk were a standalone regulatory portfolio. A banking organization with no model-eligible trading desks would only calculate market risk capital requirements under the standardized measure for market risk. The agencies would have the authority to require a banking organization to calculate capital requirements for specific positions or categories of positions under either subpart D or E instead of under subpart F of the capital rule, or under subpart F instead of under subpart D or E of the capital rule, or under both subpart F and subpart D or E, 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 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. a. Standardized Measure for Market Risk Under the proposal, the standardized measure for market risk would consist of three main components: a sensitivities-based method, a standardized default risk capital requirement, and a residual risk add-on (together, the standardized approach). The proposed standardized measure for market risk also would include three additional components that would apply in more limited instances to specific positions: the fallback capital requirement, the capital add-on requirement for re-designations, and any additional capital requirement established by the primary Federal supervisor as part of the proposal’s reservation of authority provisions. The core component of the standardized approach is the sensitivities-based capital requirement, which would capture non-default market risk based on the estimated losses produced by risk factor sensitivities 291 under regulatorily determined stressed conditions. The standardized default risk capital requirement captures losses on credit and equity positions in the event of obligor default, while the residual risk add-on serves to produce a simple, conservative capital requirement for any other known risks that are not already captured by first two components (sensitivities-based measure and the standardized default risk capital), such as gap risk, correlation risk, and behavioral risks such as prepayments. The fallback capital requirement would apply in cases where a banking organization is unable to calculate either the sensitivities-based capital requirement, such as when a sensitivity is not available, or the standardized default risk capital requirement.292 Additionally, 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 under subpart F or to capital requirements under subpart D or
293See section III.H.6.d of this SUPPLEMENTARY INFORMATION for a more detailed discussion of the capital add-on for re-designations. 294Separate capital calculations could unnecessarily increase capital requirement because they ignore the offsetting benefits between market risk covered positions held by trading desks subject to the internal models approach and those held by trading desks subject to the standardized approach. 295As the standardized approach is less risksensitive than the internal models approach, to the extent that the capital requirement under the internal models approach exceeds that under the standardized approach for model-eligible desks, the proposal would require this difference to be reflected in the aggregate capital requirement under the models-based measure for market risk. 296See section III.H.6.c of this SUPPLEMENTARY INFORMATION for a more detailed discussion on the fallback capital requirement. 297See section III.H.6.d of this SUPPLEMENTARY INFORMATION for a more detailed discussion on the capital add-on requirement for re-designations. E of the capital rule, respectively.293 Each of these components is intended to help ensure the standardized measure for market risk provides a simple, transparent, and risk-sensitive measure for determining a banking organization’s market risk capital requirements. The standardized measure for market risk equals the sum of the above components and any additional capital requirement established by the primary Federal supervisor, as described in more detail in section III.H.7 of this SUPPLEMENTARY INFORMATION. The agencies view the proposed standardized measure for market risk as sufficiently risk sensitive to serve as a credible floor to the models-based measure for market risk. If a trading desk does not receive approval to use the internal models approach or fails to meet the operational requirements of the models-based measure for market risk on an on-going basis, the desk would be required to continue to use the standardized approach to calculate its market risk capital requirements. The conservative calibration of the risk weights and correlations applied to a banking organization’s market risk covered positions would help ensure that risk-based capital requirements under the standardized approach appropriately capture the market risks to which a banking organization is exposed. Additionally, by relying on a banking organization’s models to produce risk factor sensitivities, the proposed standardized measure for market risk 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 also promote comparability in market risk capital requirements across banking organizations subject to the proposal. b. Models-Based Measure for Market Risk To limit use of the internal models
approach to only those trading desks that can appropriately capture the risks of market risk covered positions in internal models, model-eligible trading desks would be required to satisfy the model eligibility criteria and processes (for example, profit and loss attribution testing) introduced under the proposal, as described in section III.H.5.d of this SUPPLEMENTARY INFORMATION. Thus, under the proposal, a banking organization with prior regulatory approval to use the models-based measure for market risk could have some trading desks that are eligible for the internal models approach and others that use the standardized approach. Specifically, if the primary Federal supervisor were to approve a banking organization to calculate market risk capital requirements for one or more trading desks under the internal models approach, the banking organization would be required to calculate the entity-wide market risk capital requirement under the models-based measure for market risk (IMAtotal), which would incorporate the capital requirements under the standardized approach for model-ineligible trading desks, according to the following formula, as provided under §ll.204(c) of the proposed rule:
IMATotal = min ((IMAG,A + PLA add-on
298The respective components of the standardized approach capital requirement are the sensitivities-based method capital requirement, the standardized default risk capital requirement, and the residual risk add-on. 299The respective components of IMAtotal are:
IMAG,A, SAU, SAall desks, SAG,A, SAi (as part of the PLA add-on calculation), the capital add-on for certain securitization and correlation trading positions or equity positions in an investment fund on model-eligible trading desks, and any additional capital requirement established by the primary Federal supervisor. See section III.H.8.b. of this SUPPLEMENTARY INFORMATION for further discussion of each of these components. Also, see section III.H.6.d of this SUPPLEMENTARY INFORMATION for further discussion on the capital add-on for certain securitization and correlation trading positions held on model-eligible desks. 300See section III.H.5.a of this SUPPLEMENTARY INFORMATION. desks exceeds the amount required for such desks under the standardized approach. What would be the benefits or drawbacks of capping the total capital requirement under the models-based measure for market risk at that required for all trading desks under the standardized approach?
c. 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 in situations when a banking organization is unable to calculate market risk requirements under the standardized approach and the internal models approach, if eligible. 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 approach capital requirement.298 For purposes of calculating the models-based measure for market risk, unless the banking organization receives prior written approval from its primary Federal supervisor, the proposal would require the banking organization to exclude each market risk covered position for which it is not able to apply the standardized approach or the internal models approach, as applicable, from the respective components of IMATotal 299 As the fallback capital requirement would only apply in instances where a banking organization is not able to apply the internal models approach and the standardized approach to calculate market risk capital requirements, 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. Similar to the capital requirement for de minimis exposures in subpart F of the capital rule, the fallback capital requirement would equal the sum of the absolute fair value of each position subject to the fallback capital requirement, unless the banking organization receives prior written approval from its primary Federal supervisor to use an alternative method to quantify the market risk capital requirement for such positions. Question 104: The fair value for derivative positions may materially underestimate the exposure since 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). Is the fallback capital requirement based on the absolute fair value of the derivative positions appropriate? What could be alternative methodologies for the fallback capital
requirements for derivatives (for example, the absolute value of the adjusted notional amount or the effective notional amount of derivatives as defined in the standardized approach for counterparty credit risk (SA–CCR)? What, if any, alternative techniques would more appropriately measure the market risk associated with market risk covered positions for which the standardized approach cannot be applied? d. Re-Designations and Other Capital Add-Ons To reflect the proposed definition of market risk covered position, 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.300 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-classifying a position, the proposal would introduce the capital add-on requirement as a penalty for any re-designation. With prior written approval from its primary Federal supervisor, the proposal would not require a banking organization to apply the penalty to 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 de-listed). The agencies expect re-designations 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 the total capital requirements for the redesignated positions under subparts D, E (if applicable), and F of the capital rule before and immediately after the redesignation of a position. The proposal would require a banking organization that is subject to subpart D of the capital rule to calculate its total capital requirements separately under subpart D of the capital rule and under the market risk capital requirements before and immediately after the redesignation. 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. In cases when a banking organization is also subject to subpart E of the capital rule, the proposal would require the banking organization to calculate total capital requirements separately under subpart D of the capital rule and subpart E of the capital rule and under the market risk capital requirements before and
immediately after the re-designation. If the total capital requirement is lower as a result of the re-designation, then the difference would be the capital add-on for the re-designation. As such, the proposal would require the banking organization to apply a capital add-on for re-designated positions in situations when such re-designations result in any
301See sections III.H.6.c and III.H.6.d of this SUPPLEMENTARY INFORMATION for a more detailed discussion on the fallback capital requirement and the capital add-on requirement for re-designations, respectively. 302Under the proposal, a banking organization would have to separately calculate the potential losses arising from the position’s sensitivity to changes in interest rates and changes in the issuer’s credit spread. 303 Vega and curvature risk estimates are required for instruments with optionality or embedded prepayment option risk. For example, for an equity option, the proposed delta risk factor (equity spot price) would capture the impact on the option’s value from changes in the equity spot price, the proposed vega risk factor (implied volatility) would capture the impact from changes in the implied volatility, and the proposed curvature risk factors (equity spot prices for the issuer) would capture other higher-order factors from nonlinear risks. capital reduction under the market risk capital requirements. The proposal would require a banking organization to calculate the capital add-on requirement at the time of the redesignation. A banking organization could reduce or eliminate the capital add-on as the instrument matures, pays down, amortizes, or expires, or the banking organization sells or exits (in whole or in parts) the position. Under the standardized measure for market risk, the capital add-on would include the capital add-on for redesignations. Under the models-based measure for market risk, the capital addon would include the capital add-on for re-designations, as well as add-ons for any securitization and correlation trading positions, or equity positions in an investment fund, where a banking organization is not able to identify the underlying positions held by an investment fund on a quarterly basis on model-eligible trading desks, provided such positions are not subject to the fallback capital requirement. Specifically, for securitization and correlation trading positions and equity positions in an investment fund, where a banking organization cannot identify the underlying positions, on modeleligible trading desks, the models-based measure for market risk includes a capital add-on equal to the risk-based capital requirement for such positions calculated under the standardized approach. Question 105: 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?
7. Standardized Measure for Market
Risk
Under the proposal, the standardized measure for market risk would consist of the standardized approach capital requirement and three additional components that would apply in more limited instances to specific positions:
the fallback capital requirement, the capital add-on requirement for redesignations and any additional capital requirement established by the primary Federal supervisor.301 The proposal would require a banking organization to calculate the standardized measure for market risk at least weekly. a. Sensitivities-Based Method (SBM) Conceptually, the proposed sensitivities-based method is similar to a simple stress test where a banking organization estimates the change in value of its market risk covered positions by applying standardized shocks to relevant market risk covered positions. The sensitivities-based method uses risk weights that represent the standardized shocks with each prescribed risk weight calibrated to a defined liquidity time horizon consistent with the expected shortfall measurement framework under stressed conditions. To help ensure consistency in the application of risk-based capital requirements across banking organizations, the proposal would establish the following process to determine the sensitivities-based capital requirement for the portfolio: (1) assign market risk covered positions to risk classes and establish the risk factors for market risk covered positions within the same risk class; (2) describe the method to calculate the sensitivity of a market risk covered position for each of the prescribed risk factors; (3) describe the shock applied to each risk factor, and (4) describe the process for aggregating the weighted sensitivities within each risk class and across risk classes. Under the proposal, a banking organization would assign each market risk covered position to one or more risk buckets within appropriate risk classes for the position. The seven prescribed risk classes, based on standard industry classifications, are interest rate risk, credit spread risk for non-securitization positions, credit spread risk for correlation trading positions, credit spread risk for securitization positions that are not correlation trading positions, equity risk, commodity risk, and foreign exchange risk. The risk buckets represent common risk characteristics of a given risk class in recognition that positions sharing such risk characteristics are highly correlated and therefore affect the value of a market risk covered position in substantially the same manner. Further, the proposed risk buckets correspond to common industry practice as large trading banking organizations often use bucketing structures similar to those set forth in the proposal. Once the risk buckets are identified for a position, the bank would have to map the positions to the appropriate risk factors within the risk bucket. For example, the price of a typical corporate bond fluctuates primarily due to changes in interest rates and issuer credit spreads. Therefore, a position in a corporate bond would be placed in two separate risk classes, one for interest rate risk and one for credit spread risk for non-securitization positions.302 For positions within the
credit spread risk class, a banking organization would group the corporate bond position and other positions with similar credit quality and operating in the same sector together in one risk bucket. Further, the banking organization would apply the proposed risk factors to each position within that bucket based on credit spread curves and tenors of each position. All market risk covered positions would be assigned to risk buckets within risk classes and mapped to risk factors based on that assignment. For each risk bucket, the proposed risk factors reflect the specific market variables that impact the value of a position. The risk factors are separately defined to measure their individual impact on market risk covered positions’ value from small changes in the value of a risk factor (the movement in price (delta) and, where applicable, the movement in volatility (vega)), and the additional change in the positions’ value not captured by delta for each relevant risk factor (curvature) in stress.303 Under the proposal, a banking organization would calculate the sensitivity of a market risk covered position as prescribed under the proposal to each of the proposed risk factors for delta, vega, and curvature, as applicable. The proposed sensitivity calculations for delta, vega, and curvature risk factors are intended to estimate how much a market risk covered position’s value might change as a result of a specified change in the risk factor, assuming all other relevant risk factors remain constant. For each risk factor, the banking organization would sum the resulting delta sensitivities (and separately the vega and curvature sensitivities) for all market risk covered positions within the same risk bucket to produce a net sensitivity for each risk factor, which is
304The proposed risk factors are intended to be sufficiently granular such that only long and short exposures without basis risk would be able to fully offset for purposes of calculating the net sensitivity to a risk factor. For example, by defining the risk factors for equity risk at the issuer level, the proposal would allow long and short equity risk exposures to the same issuer to fully offset for purposes of calculating the net equity risk factor sensitivity, but only partially offset (correlations less than one) for exposures to different issuers with the same level of market capitalization, the same type of economy, and the same market sector (such as those within the same equity risk bucket). 305The prescribed risk weights represent the estimated change in the value of the market risk covered position as a result of a standardized shock to the risk factor based on characteristics of the position and historic price movements. Additionally, the proposed risk weights are intended to help ensure comparability with the proposed internal models approach described in
section III.H.8 of this SUPPLEMENTARY INFORMATION,
which generally would require banking organizations’ internal models to follow a methodology similar to the one used to calibrate the risk weights when determining risk-based requirements for market risk covered positions under the standardized approach. 306As the degree to which a pair of variables are linearly related (the correlation) can only range from negative one to one, the proposal would cap the correlation parameters under the high scenario at no more than one (100 percent) and floor those under the low scenario at no less than negative one. For highly correlated positions, the low correlation scenario also would not always reduce the correlation parameter by 25 percent. the potential value impact on all of the banking organization’s market risk covered positions in the risk bucket as a result of a uniform change in a risk factor.304 To capture how much the risk factor might change over a defined time horizon in stress conditions and how that would change the value of the market risk covered position, a banking organization would multiply the net delta sensitivity and the net vega sensitivity, respectively, to each risk factor within the risk bucket by the proposed standardized risk weight for the risk bucket. The proposed risk weights are intended to capture the amount that a risk factor would be expected to move during the liquidity horizon of the risk factor in stress conditions.305 To capture curvature risk, a banking organization would be required to aggregate the incremental loss above the delta capital requirement from applying larger upward and downward shock scenarios to each risk factor. To account for the potential price impact of interactions between the risk factors, the proposal would prescribe aggregation formulas for calculating the total delta, vega, and curvature capital requirements within risk buckets and across risk buckets. Specifically, the risk-weighted sensitivities for delta, vega, and curvature risk, respectively, first would be summed for a risk factor, then aggregated across risk factors with common characteristics within their respective risk buckets to arrive at bucket-level risk positions. These bucket-level risk positions would then be aggregated for each risk class using the prescribed aggregation formulas to produce the respective delta, vega, and curvature risk capital requirements. The aggregation formulas prescribe offsetting and diversification benefits via correlation parameters. Under the proposal, the correlation parameters specified for each risk factor pair are intended to limit the risk-mitigating benefit of hedges and diversification, given that the hedge relationship between an underlying position and its hedge, as well as the relationship between different types of positions, could decrease or become less effective in a time of stress. Specifically, taking into account prescribed correlation parameters, the banking organization would need to calculate the aggregate requirements first
within a risk bucket and then across risk buckets within one risk class to produce the risk class-level capital requirement for delta, vega, and curvature risk. The resulting capital requirements for delta, vega, and curvature risk then would be summed across risk classes, respectively, with no recognition of any diversification benefits because in stress diversification across different risk classes may become less effective. To capture the potential for risk factor correlations to increase or decrease in periods of stress, the calculation of risk bucket-level capital requirements and risk class-level capital requirements for each risk class would be repeated corresponding to three different correlation scenarios—assuming high, medium and low correlations between risk factor shocks—in order to calculate the overall delta, vega, and curvature capital requirements for all risk classes to determine the overall capital requirement for each scenario. The prescribed correlation parameters in the intra-bucket and inter-bucket aggregation formulas would be those used in the medium correlation scenario. For the high and low correlation scenarios, a banking organization generally would increase and decrease the medium correlation parameters by 25 percent, respectively, to appropriately reflect the potential changes in the historical correlations during a crisis.306 Finally, to determine the overall capital requirements for each of the three correlation scenarios, the banking organization would sum the separately calculated delta, vega, and curvature capital requirements for all risk classes without recognition of any diversification benefits, given that delta, vega, and curvature are intended to separately capture different risks. The sensitivities-based capital requirement would be the largest capital requirement resulting from the three scenarios. Question 106: The agencies seek comment on the sensitivities-based method for market risk. To what extent does the sensitivities-based method appropriately capture the risks of positions subject to the market risk capital requirement? What additional features, adjustments (such as to the treatment of diversification of risks), or alternative methodology could the sensitivities-based method include to reflect these risks more appropriately and why? Commenters are encouraged to provide supporting data.
i. Risk Factors
Under the proposal, a banking organization would be required to map all market risk covered positions within each risk class to the specified risk factors in order to calculate the capital requirements for delta, vega, and curvature. The proposed risk factors differ for each risk class to reflect the specific market risk variables relevant for each risk class (for example, no tenor is specified for the delta risk factor for equity risk as equities do not have a stated maturity, whereas the proposed tenors for credit spread delta risk reflect the common maturities of positions within those risk classes). The granular level at which the proposed risk factors would be defined is intended to promote consistency and comparability in regulatory capital requirements across banking organizations and to help ensure the appropriate capitalization of market risk covered positions. For risk classes that include specific tenors or maturities as risk factors (for example, delta risk factors for interest rate risk), the proposal would require a banking organization to assign the risk factors to the proposed tenors through linear interpolation or a method that is most consistent with the pricing functions used by the internal risk management models. The banking organization’s internal risk management models, which are used by risk control units and reviewed by auditors and regulators, would provide an appropriate basis for determining regulatory capital requirements, without imposing the operational burden of the time-consuming methods used by the front-office models. Additionally, relying on banking organizations’
307Cross-currency basis is a basis added to a yield curve in order to evaluate a swap for which the two legs are paid in two different currencies. Market participants use cross currency basis to price cross currency interest rate swaps paying a fixed or a floating leg in one currency, receiving a fixed or a floating leg in a second currency, and including an exchange of the notional amount in the two currencies at the start date and at the end date of the swap. 308Under the proposal, a non-securitization position would be defined as a market risk covered position that is not a securitization position or a correlation trading position and that has a value that reacts primarily to changes in interest rates or credit spreads. 309When calculating the sensitivity for securitization positions non-CTP, a banking organization would calculate the sensitivities for credit spread risk based on the embedded subordination of the position, such as the spread of the tranche. For correlation trading positions, the credit spread risk sensitivity would be based on the underlying names in the securitization position, or nth-to-default position. internal risk management models, rather than the front-office models, to identify the relevant risk factors would help ensure that a control function that is independent of business-line management would determine the regulatory capital requirement for market risk.
I. Interest Rate Risk
Under the proposal, the delta risk factors for interest rate risk would be separately defined for each currency along two dimensions: tenor and interest rate curve. To value market risk covered positions with interest rate risk, the proposal would require a banking organization to construct and use interest rate curves for the currency in which interest rate-sensitive market risk covered positions are denominated (for example, interest rate curves from the overnight index swap curve (OIS) or an alternative reference rate curve). The proposal would require each of these curves to be treated as a distinct interest rate curve due to the basis risk between them. Similarly, under the proposal, a banking organization would be required to treat an onshore currency curve (for example, locally traded contracts) and an offshore currency curve (for example, contracts with the same maturity that are traded outside the local jurisdiction) as two distinct curves. A banking organization would be allowed to treat such curves as a single curve only with the prior written approval from its primary Federal supervisor. As interest rate curves incorporate nominal inflation, an additional delta risk factor would be required for instruments with cash flows that are functionally dependent on a measure of inflation (such as TIPS) to appropriately account for inflation risk. Furthermore, the proposal would require an additional delta risk factor for instruments with cash flows in different currencies to appropriately reflect the cross-currency basis risk of each currency over USD or EUR.307 Under the proposal, a banking organization would not recognize the term structure when measuring delta capital requirements for inflation risk and cross-currency basis risk. Additionally, a banking organization would be required to consider the inflation risk factor and the cross-currency basis risk factor, if applicable, in addition to the sensitivity for the other delta risk factors for the interest rate risk (currency, tenor and interest rate curve) of the market risk covered position. Accordingly, a banking organization would be required to allocate the sensitivities for inflation risk and cross-currency basis risk in the relevant interest rate curve for the same currency as other interest rate risk factors. The vega risk factors for interest rate risk would be the implied volatilities of options referencing the interest rate of the underlying instrument. The implied volatilities of inflation rate risk-sensitive options and cross-currency basis risksensitive options would be defined along the maturity of the option, whereas the implied volatilities of interest-rate risk-sensitive options would be defined along two dimensions: the maturity of the option and the residual maturity of the underlying instrument at the expiration date of the option. For example, a banking organization would calculate the vega sensitivity of a European interest rate swaption that expires in 12 months
referring to a one-year swap based on the maturity of the option (12 months) as well as the residual maturity of the underlying instrument (the swap’s maturity of 12 months). The proposal would define the curvature risk factors for interest rate risk along one dimension: the interest rate curve of each currency (no term structure would be considered). Question 107: The agencies seek comment on the appropriateness of requiring banking organizations with material exposure to emerging market currencies to construct distinct onshore and offshore curves. What, if any, operational burden may arise from such requirement and why?
II. Credit Spread Risk
The proposal would separately define the credit spread risk factors for nonsecuritization positions,308 securitization positions that are not correlation trading positions (securitization positions non-CTP), and correlation trading positions. The proposal would define the delta risk factors for credit spread risk for nonsecuritization positions along two dimensions: the credit spread curve of a relevant issuer and the tenor of the position; the delta risk factors for credit spread risk for securitization positions non-CTP would be defined also along two dimensions: the credit spread curve of the tranche and the tenor of the tranche; and the delta risk factors for credit spread risk for correlation trading positions would be defined along two dimensions: the credit spread curve of the underlying name and the tenor of the underlying name. Under the proposal, the vega risk factors for credit spread risk are the implied volatilities of options referencing the credit spreads,309 defined along one dimension: the option’s maturity. The proposal would define the curvature risk factors for credit spread risk for non-securitization positions along one dimension: the credit spread curves of the issuer. The curvature risk factors for credit spread risk for securitization positions non-CTP would be defined along the relevant tranche credit spread curves of bond and CDS, while for correlation trading positions along the bond and CDS credit spread curve of each underlying name. The agencies recognize that requiring a banking organization to estimate the bond-CDS basis for each issuer would impose a significant operational burden with limited benefit in terms of risk capture. To simplify the sensitivitiesbased-method calculation for curvature risk in these cases, the proposal would require banking organizations to ignore any bond-CDS basis that may exist between the bond and CDS spreads and to calculate the credit spread risk sensitivity as a single spread curve across the relevant tenor points.
III. Equity Risk
Similar to interest rate risk, the delta risk factors for equity risk would be separately defined for each issuer as the spot prices of each equity (for example, for cash equity positions) and an equity repo rate (for example, for term repostyle transactions), as appropriate. Under the proposal, the vega risk factors for equity risk would be the implied volatilities of options referencing the equity spot price, defined along the maturity of the option. The curvature risk factors for equity risk would be the equity spot price. There are no curvature risk factors for equity repo rates.
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Source: Federal Deposit Insurance Corporation — 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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