[Federal Register Volume 59, Number 100 (Wednesday, May 25, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-11513]


[[Page Unknown]]

[Federal Register: May 25, 1994]


_______________________________________________________________________

Part II

Department of the Treasury
Office of the Comptroller of the Currency



12 CFR Part 3

Office of Thrift Supervision



12 CFR Part 567

Federal Reserve System



12 CFR Parts 208 and 225

Federal Deposit Insurance Corporation



12 CFR Part 325




Risk-Based Capital Requirements--Recourse and Direct Credit 
Substitutes; Proposed Rule
DEPARTMENT OF THE TREASURY

Office of the Comptroller of the Currency

12 CFR Part 3

[DOCKET No. 94-07]
RIN 1557-AA91

FEDERAL RESERVE SYSTEM

12 CFR Parts 208 and 225

[Docket No. R-0835]
RIN 7100-AB77

FEDERAL DEPOSIT INSURANCE CORPORATION

12 CFR Part 325

RIN 3064-AB31

DEPARTMENT OF THE TREASURY

Office of Thrift Supervision

12 CFR Part 567

[Docket No. 93-238]
RIN 1550-AA70

 
Risk-Based Capital Requirements--Recourse and Direct Credit 
Substitutes

AGENCIES: Office of the Comptroller of the Currency (OCC), Department 
of the Treasury; Board of Governors of the Federal Reserve System 
(FRB); Federal Deposit Insurance Corporation (FDIC); Office of Thrift 
Supervision (OTS), Department of the Treasury.

ACTION: Notice of proposed rulemaking and advance notice of proposed 
rulemaking.

SUMMARY: The FDIC, FRB, OCC, and OTS (the Agencies) are proposing 
revisions to their risk-based capital standards to address the 
regulatory capital treatment of recourse arrangements and direct credit 
substitutes that expose banks, bank holding companies, and thrifts to 
credit risk. The proposal is intended to correct certain 
inconsistencies in the Agencies' risk-based capital standards and allow 
banks and bank holding companies (banking organizations) to maintain 
lower amounts of capital against low-level recourse transactions. The 
proposal would require higher amounts of risk-based capital to be 
maintained against certain direct credit substitutes, including, for 
banking organizations, purchased servicing rights that provide loss 
protection to the owners of the loans serviced and purchased 
subordinated interests that absorb the first dollars of losses from the 
underlying assets, and, for both banking organizations and thrifts, 
certain guarantee-type arrangements (such as standby letters of credit) 
provided for third-party assets that absorb the first dollars of losses 
from those assets.
    The OTS is proposing to change only the capital requirements for 
the treatment of guarantee-type arrangements that absorb first dollar 
losses. In all other respects, the OTS treatment of recourse and direct 
credit substitutes would continue to follow existing OTS capital 
regulations. The OTS regulations have been revised for clarity and now 
include language codifying agency regulatory guidance.
    In addition, the Agencies are publishing, in an advance notice of 
proposed rulemaking (ANPR), a preliminary proposal to use credit 
ratings to match the risk-based capital assessment more closely to an 
institution's relative risk of loss in certain asset securitizations. 
The Agencies are also requesting comment in the ANPR on the need for a 
similar system for unrated asset securitizations and on how such a 
system could be designed.
    The Agencies intend that any final rules adopted in connection with 
this notice of proposed rulemaking and ANPR that result in increased 
risk-based capital requirements for banking organizations or thrifts 
would apply only to transactions that are consummated after the 
effective date of such final rules.

DATES: Comments must be received on or before July 25, 1994.

ADDRESSES: Commenters may respond to any or all of the Agencies. All 
comments will be shared among all of the Agencies.
    OCC: Written comments should be submitted to Docket No. 94-07, 
Communications Division, Ninth Floor, Office of the Comptroller of the 
Currency, 250 E Street SW., Washington, DC 20219, Attention: Karen 
Carter. Comments will be available for inspection and photocopying at 
that address.
    FRB: Comments, which should refer to Docket No. R-0835, may be 
mailed to the Board of Governors of the Federal Reserve System, 20th 
Street and Constitution Avenue NW., Washington, DC 20551, to the 
attention of Mr. William Wiles, Secretary. Comments addressed to the 
attention of Mr. Wiles may be delivered to the FRB's mail room between 
8:45 a.m. and 5:15 p.m., and to the security control room outside of 
those hours. Both the mail room and the security control room are 
accessible from the courtyard entrance on 20th Street between 
Constitution Avenue and C Street NW. Comments may be inspected in room 
B-1122 between 9 a.m. and 5 p.m. weekdays, except as provided in 
Sec. 261.8 of the FRB's Rules Regarding Availability of Information, 12 
CFR 261.8.
    FDIC: Comments should be addressed to Robert E. Feldman, Acting 
Executive Secretary, Federal Deposit Insurance Corporation, 550 17th 
Street NW., Washington, DC 20429. Comments may also be hand-delivered 
to Room F-400, 1776 F Street NW., between the hours of 8:30 a.m. and 5 
p.m. on business days. They may be sent by facsimile transmission to 
FAX Number (202) 898-3838]. Comments will be available for inspection 
and photocopying in the FDIC's Reading Room, room 7118, 550 17th Street 
NW., between 9 a.m. and 4:30 p.m. on business days.
    OTS: Send comments to Director, Information Services Division, 
Public Affairs, Office of Thrift Supervision, 1700 G Street NW., 
Washington, DC 20552, Attention Docket No. [93-238]. These submissions 
may be hand-delivered to 1700 G Street NW., between 9 a.m. and 5 p.m. 
on business days; they may be sent by facsimile transmission to FAX 
Number (202) 906-7755. Submissions must be received by 5 p.m. on the 
day they are due in order to be considered by the OTS. Late-filed, 
misaddressed or misidentified submissions will not be considered in 
this rulemaking. Comments will be available for inspection at 1700 G 
Street NW., from 1 p.m. until 4 p.m. on business days. Visitors will be 
escorted to and from the Public Reading Room at established intervals.

FOR FURTHER INFORMATION CONTACT:
    OCC: Owen Carney, Senior Advisor for Investment Securities, Office 
of the Chief National Bank Examiner (202/874-5070); David Thede, Senior 
Attorney, Bank Operations and Assets Division (202/874-4460); 
Christopher Beshouri, Financial Economist, Economics and Evaluation 
(202/874-5220); Elizabeth Milor, Financial Economist, Regulatory and 
Statistical Analysis (202/874-5240).
    FRB: Rhoger H. Pugh, Assistant Director (202/728-5883); Thomas R. 
Boemio, Supervisory Financial Analyst (202/452-2982); or David A. 
Elkes, Financial Analyst (202/452-5218), Division of Banking 
Supervision and Regulation. Telecommunication Device for the Deaf 
(TDD), Dorothea Thompson (202/452-3544), Board of Governors of the 
Federal Reserve System, 20th and C Streets NW., Washington, DC 20551.
    FDIC: Robert F. Storch, Chief, Accounting Section, Division of 
Supervision, (202/898-8906), or Cristeena G. Naser, Attorney, Legal 
Division (202/898-3587).
    OTS: John F. Connolly, Senior Program Manager for Capital Policy 
(202/906-6465); Fred Phillips-Patrick, Senior Financial Economist (202/
906-7295); Robert Kazdin, Senior Project Manager (202/906-5759), 
Policy; Karen Osterloh, Counsel, Banking and Finance (202/906-6639); 
Deborah Dakin, Assistant Chief Counsel, Regulations and Legislation 
Division (202/906-6445), Office of Thrift Supervision, 1700 G Street 
NW., Washington, DC 20552.

SUPPLEMENTARY INFORMATION:

I. Introduction and Background

A. Overview

    Each of the Agencies is proposing to amend its risk-based capital 
standards to clarify and revise the treatment of recourse arrangements 
and certain direct credit substitutes that expose banking organizations 
(banks and bank holding companies) and thrifts to credit risk. The 
Banking Agencies (OCC, FRB, and FDIC) are also proposing to recommend 
that the FFIEC make conforming revisions to the regulatory reporting 
requirements applicable to asset transfers with recourse and direct 
credit substitutes for insured commercial banks and FDIC-supervised 
savings banks.
    This notice of proposed rulemaking would amend the Agencies' risk-
based capital standards to:
     Define the term ``recourse'' and expand the definition of 
the term ``direct credit substitute'';1
---------------------------------------------------------------------------

    \1\The OTS is adding definitions for ``public sector entity'' 
and ``standby-type letter of credit'' to be consistent with the 
Banking Agencies.
---------------------------------------------------------------------------

     Create an exception to the Banking Agencies' current 
guidelines that would reduce the amount of capital required for certain 
low-level recourse transactions;2
---------------------------------------------------------------------------

    \2\The OTS risk-based capital regulation already permits thrifts 
to hold reduced capital against low level recourse transactions and 
requires thrifts to treat purchased recourse servicing and certain 
purchased subordinated interests as recourse. 12 CFR 
567.6(a)(2)(i)(C). The OTS is not proposing to amend these existing 
treatments.
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     Require banking organizations that purchase loan servicing 
rights that provide loss protection to the owners of the loans serviced 
to hold capital against those loans;
     Require banking organizations that purchase subordinated 
interests in loans or pools of loans that absorb the first dollars of 
losses from those loans to hold capital against the subordinated 
interest plus all more senior interests; and
     Require banking organizations and thrifts that provide 
financial standby letters of credit or other guarantee-type 
arrangements for third-party assets that absorb the first dollars of 
losses from those assets to hold the same amount of capital that they 
would be required to hold under a recourse arrangement with equivalent 
risk exposure.
    The Agencies are also publishing as an advance notice of proposed 
rulemaking (ANPR) a preliminary ``multi-level approach,'' that would 
use credit ratings from nationally recognized statistical rating 
organizations to measure relative exposure to risk in rated securitized 
asset transactions and would allow the capital assessment to vary with 
the risk. The Agencies are also requesting comment in the ANPR on the 
need for a separate multi-level approach for unrated securitizations 
and on how such a system could be designed.

B. Purpose and Effect

    Implementation of all aspects of this proposal, including one or 
more multi-level approaches for securitization transactions, would 
result in more consistent treatments of recourse and similar 
transactions among the Agencies, more consistent risk-based capital 
treatments for transactions involving similar risk, and capital 
requirements that more closely reflect a banking organization or 
thrift's relative exposure to credit risk. In particular, the proposed 
treatments of low-level recourse transactions, purchased loan servicing 
rights that provide loss protection, and purchased subordinated 
interests that absorb the first dollars of losses from the underlying 
assets would bring the capital requirements of the Banking Agencies 
into greater conformity with those of the OTS.
    The proposal would allow banks and bank holding companies (banking 
organizations) to maintain lower amounts of capital against low-level 
recourse transactions. The proposal would also require higher amounts 
of risk-based capital to be maintained against certain direct credit 
substitutes, including, for banking organizations, purchased servicing 
rights that provide loss protection to the owners of the loans serviced 
and purchased subordinated interests that absorb the first dollars of 
losses from the underlying assets, and, for both banking organizations 
and thrifts, certain guarantee-type arrangements provided for third-
party assets that absorb the first dollars of losses from those assets.
    Additionally, the Agencies expect that a multi-level approach will 
provide a method for identifying participants in securitization 
transactions that are relatively insulated from credit risk and 
therefore eligible for reduced capital assessments.
    The Agencies intend that any final rules adopted in connection with 
this notice of proposed rulemaking and advance notice of proposed 
rulemaking that result in increased risk-based capital requirements for 
banking organizations or thrifts would apply only to transactions that 
are consummated after the effective date of such final rules. The 
Agencies intend that any final rules adopted in connection with this 
notice that result in reduced risk-based capital requirements for 
banking organizations or thrifts would apply to all transactions 
outstanding as of the effective date of such final rules and to all 
subsequent transactions.
    The Agencies believe that the proposed rule would satisfy the 
requirements of section 618(b)(3) of the Resolution Trust Corporation 
Refinancing, Restructuring, and Improvement Act, since the proposed 
rule would apply to multifamily residential property loans sold with 
recourse.

C. Background

1. Recourse and Direct Credit Substitutes
    Asset securitization is the process by which loans and other 
receivables are pooled, reconstituted into one or more classes or 
positions, and then sold. Securitizations typically carve up the risk 
of credit losses from the underlying assets and distribute it to 
different parties. The ``first dollar'' loss or subordinate position is 
first to absorb credit losses, the ``senior'' investor position is 
last, and there may be one or more loss positions in between (``second 
dollar'' loss positions). Each loss position functions as a credit 
enhancement for the more senior loss positions in the structure.
    For residential mortgages that are sold through the federally 
sponsored mortgage programs, a federal government agency or federally 
sponsored agency guarantees the securities sold to investors. However, 
many of today's asset securitization programs involve nonmortgage 
assets and are not supported in any way by the federal government. 
Sellers of these privately securitized assets therefore provide other 
forms of credit enhancement--first and second dollar loss positions--to 
reduce investors' risk of loss.
    Sellers may provide this credit enhancement themselves through 
recourse arrangements. For purposes of this notice, ``recourse'' refers 
to any risk of loss that an institution may retain in connection with 
the transfer of its assets. While banking organizations and thrifts 
have long provided recourse in connection with sales of whole loans or 
loan participations, recourse arrangements today are frequently 
associated with asset securitization programs.
    Sellers may also arrange for a third party to provide credit 
enhancement in an asset securitization. If the third-party enhancement 
is provided by another banking organization or thrift, that institution 
assumes some portion of the assets' credit risk. For purposes of this 
proposal, all forms of third-party enhancements, i.e., all arrangements 
in which an institution assumes risk of loss from third-party assets or 
other claims that it has not transferred, are referred to as ``direct 
credit substitutes.''3 In economic terms, an institution's risk of 
loss from providing a direct credit substitute can be identical to its 
risk of loss from transferring an asset with recourse.
---------------------------------------------------------------------------

    \3\As used in this preamble, the terms ``credit enhancement'' 
and ``enhancement'' refer to both recourse arrangements and direct 
credit substitutes.
---------------------------------------------------------------------------

    Depending upon the type of asset securitization, a portion of the 
total credit enhancement may also be provided internally, as part of 
the securitization structure, through the use of spread accounts, 
overcollateralization, or other forms of self-enhancement. Many asset 
securitizations use a combination of internal enhancement, recourse, 
and third-party enhancement to protect investors from risk of loss.
2. Prior History
    On June 29, 1990, the Federal Financial Institutions Examination 
Council (FFIEC) published a request for comment on recourse 
arrangements. See 55 FR 26766 (June 29, 1990). The publication 
announced the Agencies' intent to review the regulatory capital, 
reporting and lending limit treatments of assets transferred with 
recourse and similar transactions, and set out a broad range of issues 
for public comment. The FFIEC received approximately 150 comment 
letters in response. The FFIEC then narrowed the scope of the review to 
the reporting and capital treatments of recourse arrangements and 
direct credit substitutes that expose banking organizations and thrifts 
to credit-related risks.
    In July 1992, after receiving preliminary recommendations from an 
interagency staff working group, the FFIEC directed the staff to carry 
out a study of the likely impact of those recommendations on banking 
organizations and thrifts, financial markets and other affected 
parties. As part of that study, the staff held a series of meetings 
with representatives from thirteen organizations active in the 
securitization and credit enhancement markets. Summaries of the 
information provided to the staff and a copy of the staff's letter sent 
to participants prior to the meetings are in the FFIEC's public file on 
recourse arrangements and are available for public inspection and 
photocopying. Additional material provided to the Agencies from 
financial institutions and others since these meetings has also been 
placed in the FFIEC's public file.
    The FFIEC's offices are located at 2100 Pennsylvania Avenue, NW., 
suite 200, Washington, DC 20037. For public convenience, the Agencies 
have also placed copies of all of the above material in the FRB's 
public file, located at 20th Street and Constitution Avenue, NW., 
Washington, DC 20551, room B-1122.

D. Current Risk-Based Capital Treatments of Recourse and Direct Credit 
Substitutes

    Currently, the Agencies' risk-based capital standards apply 
different treatments to recourse arrangements and direct credit 
substitutes. As a result, capital requirements applicable to credit 
enhancements do not consistently reflect credit risk. The Banking 
Agencies' current rules are also not consistent with those of the OTS.
1. Recourse
    a. Banking agencies. The Banking Agencies' risk-based capital 
guidelines prescribe a single treatment for assets transferred with 
recourse whether the transaction is reported as a financing or a sale 
of assets in a bank's Consolidated Reports of Condition and Income 
(Call Report). In either case, risk-based capital is held against the 
full, risk-weighted amount of the transferred assets, regardless of the 
amount of recourse that is provided.4
---------------------------------------------------------------------------

    \4\The Banking Agencies provide a limited exception to this 
treatment for sales of mortgage loan pools where the bank or bank 
holding company retains only minimal risk and meets certain other 
conditions.
---------------------------------------------------------------------------

    Assets transferred with any amount of recourse in transactions 
reported as financings remain on the balance sheet and continue to be 
subject to the full risk-based capital charge (based on their risk-
weight).
    Assets transferred with recourse in transactions that are reported 
as sales create off-balance sheet exposures. The entire outstanding 
amount of the assets sold (not just the amount of the recourse) is 
converted into an on-balance sheet credit equivalent amount using a 
100% credit conversion factor.
    This capital treatment differs from the accounting treatment for 
recourse arrangements under generally accepted accounting principles 
(GAAP) and is intended to ensure that banking organizations that 
transfer assets and retain the credit risk inherent in the assets 
maintain adequate capital to support that risk. As is explained below, 
the Banking Agencies believe that the GAAP accounting treatment would 
not provide sufficient capital to support recourse arrangements.
    b. OTS. OTS follows GAAP in according sales treatment to sales with 
recourse for reporting purposes and for calculating the leverage ratios 
of thrifts. Under the OTS risk-based capital regulation, thrifts must 
also hold capital against the full value of assets transferred with 
recourse in computing their risk-based capital requirements, unless the 
capital charge would exceed the contractual maximum amount of the 
recourse provided. If the capital charge would exceed the amount of the 
recourse, then the thrift is only required to hold dollar-for-dollar 
capital against the contractual maximum amount of the recourse (the 
low-level recourse rule). (Footnote 17 below addresses the treatment of 
recourse liability accounts.)
2. Direct Credit Substitutes
    a. Banking agencies. Direct credit substitutes are treated 
differently from recourse under the current risk-based capital 
standards. Under the Banking Agencies' guidelines, off-balance sheet 
direct credit substitutes, such as financial standby letters of credit 
provided for third-party assets, carry a 100% credit conversion factor. 
However, only the dollar amount of the direct credit substitute is 
converted into an on-balance sheet credit equivalent so that capital is 
held only against the face amount of the direct credit substitute. The 
capital requirement for a recourse arrangement, in contrast, is based 
on the full amount of the assets enhanced.
    If a direct credit substitute covers less than 100% of the losses 
on the assets enhanced, the current capital treatment results in a 
lower capital charge for a direct credit substitute than for a 
comparable recourse arrangement. For example, if a direct credit 
substitute covers losses up to 20% of the amount of the assets 
enhanced, then the on-balance sheet credit equivalent amount equals 
that 20% amount. Risk-based capital is held against only the 20% 
amount. In contrast, required capital for a 20% recourse arrangement is 
higher because capital is held against the full outstanding amount of 
the assets enhanced.5
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    \5\If the direct credit substitute covers 100% of losses on the 
assets enhanced, then the current capital treatment results in the 
same capital charge for a direct credit substitute as for an asset 
sold with recourse. The direct credit substitute is converted into 
an on-balance sheet credit equivalent equal to 100% of the assets 
enhanced and capital is required against that amount.
---------------------------------------------------------------------------

    Under the Agencies' proposal, the definition of direct credit 
substitute would also be expanded to include some items that are 
already partially reflected on the balance sheet, such as purchased 
subordinated interests. Currently, under the Banking Agencies' 
guidelines, these interests receive the same capital treatment as off-
balance sheet direct credit substitutes. Purchased subordinated 
interests are placed in the appropriate risk-weight category and then 
added to the banking organization's risk-weighted assets. In contrast, 
if a banking organization retains a subordinated interest in connection 
with the transfer of its own assets, this is considered recourse. The 
institution must hold capital against the carrying amount of the 
subordinated interest as well as the outstanding amount of all senior 
interests that it supports.
    b. OTS. The OTS risk-based capital regulation treats some forms of 
direct credit substitutes (e.g., financial standby letters of credit) 
the same as the Banking Agencies' guidelines. However, unlike the 
Banking Agencies, the OTS treats purchased subordinated interests under 
its general recourse provisions (except for certain high quality 
subordinated mortgage-related securities). The risk-based capital 
requirement is based on the carrying amount of the subordinated 
interest plus all senior interests, as though the thrift owned the full 
outstanding amount of the assets enhanced.
3. Problems With Existing Risk-Based Capital Treatments of Recourse 
Arrangements and Direct Credit Substitutes
    The Agencies are proposing changes to the risk-based capital 
standards to address the following major concerns with the current 
treatments of recourse and direct credit substitutes:
     Different amounts of capital can be required for recourse 
arrangements and direct credit substitutes that expose a banking 
organization or thrift to equivalent risk of loss.
     The standards generally do not reduce the capital 
requirement for banking organizations that reduce their risk by 
transferring assets with low levels of recourse.
     The capital assessment rate does not recognize the 
difference in risk of loss between recourse or direct credit 
substitutes that absorb first losses and recourse or direct credit 
substitutes that absorb second losses from the underlying assets.
     The current standards do not provide uniform definitions 
of recourse, direct credit substitute, and associated terms.

E. GAAP Treatment of Recourse Arrangements

    As was mentioned above, the Banking Agencies' regulatory capital 
treatment of asset transfers with recourse differs from the accounting 
treatment of asset transfers with recourse under generally accepted 
accounting principles (GAAP).6 The Banking Agencies do not believe 
it would be appropriate to conform the regulatory capital treatment of 
recourse arrangements to GAAP.
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    \6\The OTS requires thrifts to account for assets sold with 
recourse in accordance with GAAP for reporting purposes and leverage 
capital requirements, but assesses capital against assets sold with 
recourse in computing the risk-based capital requirement for 
thrifts.
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    Under GAAP, a transfer of receivables with recourse is accounted 
for as a sale if the transferor (1) surrenders control of the future 
economic benefits of the assets, (2) is able to reasonably estimate its 
obligations under the recourse provision, and (3) is not obligated to 
repurchase the assets except pursuant to the recourse provision. These 
provisions indicate that GAAP focuses on the transfer of benefits 
rather than the retention of risk in determining whether an asset 
transfer should be accounted for as a sale.
    The transferor must accrue, as a separate liability, an amount 
sufficient to absorb all estimated probable losses under the recourse 
provision over the life of the assets transferred. This accrued amount 
is referred to as the GAAP recourse liability. If a banking 
organization reported assets transferred with recourse in accordance 
with GAAP, and no regulatory capital were required for the transaction, 
then the institution's only protection against losses would be the GAAP 
recourse liability account. For a number of reasons, the Banking 
Agencies are of the opinion that the GAAP recourse liability account 
would be an inadequate substitute for an appropriate level of 
regulatory capital.
    First, the GAAP recourse liability account is intended to cover 
only an institution's probable expected losses under the recourse 
provision. In contrast, regulatory capital is intended to provide a 
cushion against unexpected losses. In recognition of the distinctly 
different purposes of the GAAP recourse liability account and 
regulatory capital, the Banking Agencies explicitly exclude the GAAP 
recourse liability account from regulatory capital.
    Second, the amount of credit risk that is typically retained in a 
recourse transaction greatly exceeds the normal, expected losses 
associated with the transferred assets. Even though a transferor may 
reduce its exposure to potential catastrophic losses by limiting the 
amount of recourse it provides, in many cases the transferor still 
retains the bulk of the risk inherent in the assets.
    For example, if an institution transfers high quality assets with 
10% recourse that have a reasonably estimated loss rate of 1%, the 
transferor retains the risk of default up to a maximum of 10% of the 
total amount of the assets transferred. Because the recourse provision 
represents exposure to such a high amount of losses relative to the 
expected losses, in the normal course of business the transferor will 
sustain the same amount of losses as if the assets had not been sold. 
Consequently, the Banking Agencies take the position that the 
transferor in this example has not significantly reduced its risk for 
purposes of assessing regulatory capital and should continue to be 
assessed regulatory capital as though the assets have not been 
transferred.
    Third, the GAAP reliance on reasonable estimates of all probable 
credit losses over the life of the receivables transferred poses 
additional concerns for the Banking Agencies. While it may be possible 
to make such estimates for pools of consumer loans or residential 
mortgages, the Banking Agencies are of the view that it is difficult to 
do so for other types of loans. Even if it is possible to make a 
reasonable estimate of probable credit losses at the time an asset or 
asset pool is transferred, the ability of an institution to make a 
reasonable estimate may change over the life of the transferred assets.
    Finally, the Banking Agencies are concerned that an institution 
transferring assets with recourse might estimate that it would not have 
any losses under the recourse provision, in which case it would not 
establish any GAAP recourse liability account for the exposure. If the 
transferor recorded either no liability or only a nominal liability in 
the GAAP recourse liability account for a succession of asset 
transfers, a cumulation of credit risk would occur that would not be 
reflected, or would be only partially reflected, on the balance sheet.

II. Notice of Proposed Rulemaking

    The Agencies' proposal to amend the risk-based capital standards 
would do the following:
     Define the term ``recourse,'' expand the definition of the 
existing term ``direct credit substitute,'' and define the associated 
terms ``standard representations and warranties'' and ``servicer cash 
advance'';
     Reduce the Banking Agencies' risk-based capital assessment 
for certain low-level recourse arrangements; and
     Require equivalent treatment of recourse arrangements and 
certain direct credit substitutes that present equivalent risk of loss, 
including

--requiring banking organizations that purchase certain loan servicing 
rights which provide loss protection to the owners of the loans 
serviced to hold capital against those loans,
--requiring banking organizations that purchase subordinated interests 
which absorb the first dollars of losses from the underlying assets to 
hold capital against the subordinated interest plus all more senior 
interests, and
--requiring banking organizations and thrifts that provide financial 
standby letters of credit or other guarantee-like arrangements for 
third-party assets that absorb the first dollars of losses from those 
assets to hold capital against the outstanding amount of the assets 
enhanced.7
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    \7\The OTS currently treats purchased loan servicing rights and 
purchased subordinated interests as recourse. This treatment would 
not change under this proposal.
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A. Definitions of Recourse and Direct Credit Substitute

1. Recourse
    The proposal defines ``recourse'' to mean any risk of loss that a 
banking organization or thrift retains in connection with an asset 
transfer, if the risk of loss exceeds a pro rata share of the 
institution's claim on the assets.8 The proposed definition of 
recourse is consistent with the Banking Agencies' longstanding use of 
this term, and is intended to incorporate into the risk-based capital 
standards existing Agency practices regarding retention of risk in 
asset transfers.9
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    \8\If the institution transfers an asset or pool of assets in 
whole or in part but shares the total credit risk from the assets on 
a pro rata basis with the purchaser, this is not considered 
recourse. In such transactions, capital is required only against the 
transferor's pro rata share. Recourse exists when the transferor 
retains a disproportionate amount of the credit risk relative to its 
retained interest (if any) in the assets.
    \9\The OTS currently defines the term ``recourse'' more broadly 
than the proposal to include credit risk that a thrift assumes or 
accepts from third-party assets as well as risk that it retains in 
an asset transfer. Under the proposal, as explained below, credit 
risk that a banking organization or thrift assumes from third-party 
assets would fall under the definition of ``direct credit 
substitute'' rather than ``recourse.''
---------------------------------------------------------------------------

    Currently, the term ``recourse'' is not explicitly defined in the 
Banking Agencies' risk-based capital guidelines. Instead, the 
guidelines use the term ``sale of assets with recourse,'' which is 
defined by reference to the Call Report instructions. See Call Report 
instructions, Glossary (entry for ``Sales of Assets''). Once a 
definition of recourse is adopted in the risk-based capital guidelines, 
the Banking Agencies would delete the cross-reference to the Call 
Report instructions and would recommend to the FFIEC that these 
instructions be revised to incorporate the risk-based capital 
definition of recourse. The OTS capital regulation currently provides a 
definition of the term ``recourse,'' which would also be replaced once 
a final definition of recourse is adopted.
2. Direct Credit Substitute
    The proposed definition of ``direct credit substitute'' is intended 
to mirror the definition of recourse. The term ``direct credit 
substitute'' would refer to any arrangement in which an institution 
assumes risk of loss from assets or other claims it has not 
transferred, if the risk of loss exceeds the institution's pro rata 
share of the assets or other claims. Currently, under the Banking 
Agencies' guidelines, this term covers guarantees and guarantee-type 
arrangements. As revised, it would also explicitly include items such 
as purchased subordinated interests and agreements to cover credit 
losses that arise from purchased loan servicing rights.
3. Risks Other Than Credit Risks
    These definitions cover arrangements that create exposure to all 
types of risk. However, a capital charge would be assessed only against 
arrangements that create exposure to credit or credit-related risks. 
This continues the Agencies' current practice and is consistent with 
the risk-based capital standards' current, primary focus on credit 
risk.
4. Implicit Recourse
    The definitions cover all arrangements that are recourse or direct 
credit substitutes, in form or in substance. This continues the Banking 
Agencies' current treatment of recourse under the Call Report 
instructions.10 Recourse exists in substance, or implicitly, when 
an institution demonstrates a pattern of providing recourse even though 
it has no legal obligation to do so. For example, an institution that 
regularly buys back or replaces problem assets when it is not required 
to do so under the terms of the sale agreement may be providing 
recourse. The Agencies will continue their current practice of 
requiring institutions that demonstrate a pattern of providing implicit 
recourse to treat those transactions and all similar outstanding 
transactions as recourse for risk-based capital purposes. The Agencies 
will follow the same approach, as appropriate, for direct credit 
substitutes. Decisions concerning implicit recourse or implicit direct 
credit substitute arrangements will be made on a case-by-case basis.
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    \1\0See Call Report Instructions, Glossary--Sales of Assets: 
Interpretations and illustrations of the general rule 1, A-49 (May 
1989) (retention of risk depends on the substance of the 
transaction, not the form).
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5. Subordinated Interests in Loans or Pools of Loans
    The definitions explicitly cover an institution's ownership of 
subordinated interests in loans or pools of loans. This continues the 
Banking Agencies' longstanding treatment of retained subordinated 
interests as recourse and recognizes that purchased subordinated 
interests can also function as credit enhancements. Subordinated 
interests generally absorb more than their pro rata share of losses 
(principal or interest) from the underlying assets in the event of 
default.11 For example, a multi-class asset securitization may 
have several classes of subordinated securities, each of which provides 
credit enhancement for the more senior classes. Generally, the holder 
of any class that absorbs more than its pro rata share of losses from 
the total underlying assets is providing recourse or a direct credit 
substitute for all more senior classes.12
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    \1\1A class of securities that receives payments of principal 
(and, in some cases, interest) only after another class or classes 
from the same issue is completely paid is generally not considered 
recourse or a credit substitute, provided that losses are shared on 
a pro rata basis in the event of default.
    \1\2Current OTS risk-based capital guidelines exclude certain 
high-quality subordinated mortgage-related securities from treatment 
as recourse arrangements due to their credit quality. OTS is not 
proposing to change this treatment.
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6. Second Mortgages
    Second mortgages or home equity loans would generally not be 
considered recourse or direct credit substitutes, unless they actually 
functioned as credit enhancements by facilitating the sale of the first 
mortgage. This is most likely to occur if a lender originates first and 
second mortgages contemporaneously on the same property and then sells 
the first mortgage and retains the second. In such a transaction, the 
second mortgage would function as a substitute for a recourse 
arrangement because it is intended that the second mortgage will absorb 
losses before the first mortgage does if the borrower fails to make all 
payments due on both loans. Under the proposal, a second mortgage that 
is originated at or about the same time as the first mortgage would be 
presumed to be a recourse arrangement or direct credit substitute 
unless the holder was able to demonstrate that the second mortgage was 
granted for some purpose other than providing credit enhancement for 
the first mortgage (e.g., home improvement loans).
    (Question 1) The Agencies specifically request comment on this 
proposed treatment and on whether additional factors should be 
considered in determining whether a second mortgage provides recourse 
or a direct credit substitute.
7. Representations and Warranties
    When a banking organization or thrift transfers assets, including 
servicing rights, it customarily makes representations and warranties 
concerning those assets. When a banking organization or thrift 
purchases loan servicing rights, it may also assume representations and 
warranties made by the seller or a prior servicer. These 
representations and warranties give certain rights to other parties and 
impose obligations upon the seller or servicer of the assets. The 
definitions would treat as recourse or direct credit substitutes any 
representations or warranties that create exposure to default risk or 
any other form of open-ended, credit-related risk from the assets that 
is not controllable by the seller or servicer. This reflects the 
Agencies' current practice with respect to recourse arising out of 
representations and warranties, and explicitly recognizes that a 
servicer with purchased loan servicing rights can also take on risk 
through servicer representations and warranties.
    The Agencies recognize, however, that the market requires asset 
transferors and servicers to make certain representations and 
warranties, and that most of these present only normal, operational 
risk. Currently, the Agencies have no formal standard for 
distinguishing between these types of representations and warranties 
and those that create recourse or direct credit substitutes. The 
proposal therefore defines the term ``standard representations and 
warranties'' and provides that seller or servicer representations or 
warranties that meet this definition would not be considered recourse 
or direct credit substitutes.
    Under the proposal, ``standard representations and warranties'' are 
those that refer to an existing state of facts that the seller or 
servicer can either control or verify with reasonable due diligence at 
the time the assets are sold or the servicing rights are transferred. 
These representations and warranties will not be considered recourse or 
direct credit substitutes, provided that the seller or servicer 
performs due diligence prior to the transfer of the assets or servicing 
rights to ensure that it has a reasonable basis for making the 
representation or warranty. The term ``standard representations and 
warranties'' would also cover contractual provisions that permit the 
return of transferred assets in the event of fraud or documentation 
deficiencies, (i.e., if the assets are not what the seller represented 
them to be), consistent with the current Call Report instructions 
governing the reporting of asset transfers. After a final definition of 
``standard representations and warranties'' is adopted for the risk-
based capital standards, the Banking Agencies would recommend to the 
FFIEC that the Call Report instructions be changed to conform to the 
capital guidelines and the OTS would similarly amend the instructions 
for the Thrift Financial Report (TFR).
    Examples of ``standard representations and warranties'' include 
seller representations that the transferred assets are current (i.e., 
not past due) at the time of sale; that the assets meet specific, 
agreed-upon credit standards at the time of sale; or that the assets 
are free and clear of any liens (provided that the seller has exercised 
due diligence to verify these facts). An example of a nonstandard 
representation and warranty would be a contractual provision stating 
that all properties underlying a pool of transferred mortgages are free 
of environmental hazards. This representation is not verifiable by the 
seller or servicer with reasonable due diligence because it is not 
possible to absolutely verify that a property is, in fact, free of all 
environmental hazards. Such an open-ended guarantee against the risk 
that unknown but currently existing hazards might be discovered in the 
future would be considered recourse or a direct credit substitute. 
However, a seller's representation that all properties underlying a 
pool of transferred mortgages have undergone environmental studies and 
that the studies revealed no known environmental hazards would be a 
``standard representation and warranty'' (assuming that the seller 
performed the requisite due diligence). This is a verifiable statement 
of facts that would not be considered recourse or a direct credit 
substitute.
8. Loan Servicing Arrangements
    The definitions cover loan servicing arrangements if the servicer 
is responsible for credit losses associated with the loans being 
serviced. However, cash advances made by servicers to ensure an 
uninterrupted flow of payments to investors or the timely collection of 
the loans would be specifically excluded from the definitions of 
recourse and direct credit substitute, provided that the servicer is 
entitled to reimbursement for any significant advances.13 Such 
advances are assessed risk-based capital only against the amount of the 
cash advance, and are assigned to the risk-weight category appropriate 
to the party that is obligated to reimburse the servicer.
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    \1\3Servicer cash advances would include disbursements made to 
cover foreclosure costs or other expenses arising from a loan in 
order to facilitate its timely collection (but not to protect 
investors from incurring these expenses).
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    If the servicer is not entitled to full reimbursement, then the 
maximum possible amount of any nonreimbursed advances on any one loan 
must be contractually limited to an insignificant amount of the 
outstanding principal on that loan in order for the cash advance to be 
excluded from the definitions of recourse and direct credit substitute. 
This treatment reflects the Agencies' traditional view that servicer 
cash advances meeting these criteria are part of the normal servicing 
function and do not constitute credit enhancements.

B. Low-level recourse rule

    The Banking Agencies are proposing to reduce the capital 
requirement for all recourse transactions in which a banking 
organization contractually limits its exposure to less than the full, 
effective risk-based capital requirement for the assets transferred 
(referred to as ``low-level recourse transactions'').14 This 
proposal would apply to low-level recourse transactions involving all 
types of assets, including small business loans, commercial loans and 
residential mortgages.
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    \1\4The ``full effective risk-based capital charge'' is 8% for 
100% risk-weighted assets and 4% for 50% risk-weighted assets.
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1. ``Dollar-for-dollar'' Capital Requirement Up to the Amount of the 
Recourse Obligation for Low-Level Recourse
    Under the proposed low-level recourse rule, a banking organization 
that contractually limits its maximum recourse obligation to less than 
the full effective risk-based capital requirement for the transferred 
assets would be required to hold risk-based capital equal to the 
contractual maximum amount of its recourse obligation. This would be a 
``dollar-for-dollar'' capital requirement for the low-level recourse 
exposure. For example, the risk-based capital requirement for a 100% 
risk-weighted asset transferred with 3% recourse would be only 3% of 
the value of the transferred assets rather than the currently required 
8%. This would prevent a banking organization's capital requirement 
from exceeding the contractual maximum amount that it could lose under 
a recourse obligation.15 In addition, adoption of this proposal 
would bring the Banking Agencies into conformity with the OTS, which 
already applies the low-level recourse rule to thrifts.
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    \1\5The proposed low-level recourse rule would supersede the 
Banking Agencies' current risk-based capital treatment of mortgage 
transfers with ``insignificant'' recourse. Under that treatment, the 
sale of a residential mortgage with recourse is excluded from risk-
weighted assets if the institution does not retain significant risk 
of loss, i.e., the institution's maximum contractual recourse 
exposure does not exceed its reasonably estimated probable losses on 
the transferred mortgages, and the institution establishes and 
maintains a recourse liability account equal to the amount of its 
recourse obligation.
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    The Agencies will continue to evaluate the need for full capital 
support for low-level recourse transactions and will consider, in 
connection with development of the multi-level approaches that are 
discussed in Section III, whether even greater reductions in the 
capital requirement for low-level recourse transactions should be 
proposed.
2. Low-level Recourse Arrangements for Mortgage-Related Securities or 
Participation Certificates Retained in a Mortgage Loan Swap
    When an institution swaps mortgage loans for mortgage-related 
securities or participation certificates and retains low-level 
recourse, the Banking Agencies currently base the capital requirement 
on the underlying loans as if the loans were held as on-balance sheet 
assets. The OTS bases the capital requirement for these arrangements on 
its existing low-level recourse rule, with a minimum capital level of 
1.6% of the mortgage-related securities or participation certificates. 
(These certificates would include only high-quality mortgage related 
securities.)
    To recognize the risks related to such a participation certificate 
and the retained recourse, the Agencies propose to change their capital 
requirement for this arrangement. The requirement would equal the sum 
of the amount of risk-based capital required for the portion of the 
mortgage-related security or participation certificate not covered by 
the institution's recourse obligation and the risk-based capital 
required for the low-level recourse obligation retained on the 
underlying loans, limited to the capital requirement for the underlying 
loans as if the loans were held as on-balance sheet assets.
    For example, if an institution swaps $1,000 of qualifying single-
family mortgage loans for a Freddie Mac participation certificate and 
retains 1% recourse, the proposed capital requirement would equal the 
sum of the following:
(1) $1,000 times (100% minus 1%)16 times 20% risk-weight times 8% 
= $15.84, and
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    \1\6This 99% piece is the portion of the loan pool not covered 
by the institution's recourse obligation, which is guaranteed by 
Freddie Mac. For operational simplicity, 100% may be used to 
determine an institution's capital requirement.
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(2) $1,000 times 1% = $10

This sum, $25.84, is limited by the capital requirement on the 
underlying loans as if they were held by the institution. This limit is 
4% of $1,000 or $40. Thus, since the sum, $25.84, is less than the 
limit, $40, the capital requirement is $25.84.
3. Reporting of Low-Level Recourse Transactions
    The Banking Agencies are also proposing to recommend to the FFIEC 
that banks be permitted to report low-level recourse transactions as 
sales of assets (rather than financings) in the Call Report, if they 
establish and maintain a recourse liability account for the contractual 
maximum amount of the recourse obligation. (Otherwise, these 
transactions would continue to be reported as financings in the Call 
Report.) The recourse liability account could be established either by 
a charge to expense or to the allowance for loan and lease losses, as 
appropriate. The recourse liability account would not be part of the 
allowance for loan and lease losses and would therefore be excluded 
from the bank's capital base. Banks that fully reserve against their 
recourse exposure in this manner would not be assessed any risk-based 
capital for the transaction, which would be consistent with the current 
treatment of such transactions for thrifts. The accounting entries 
which permit the removal of the assets from a bank's balance sheet on 
the condition that the low-level risk exposures are either expensed or 
fully reserved for (either of which produces a change in the bank's 
equity capital position) result in an appropriately adjusted leverage 
capital ratio.
    The Banking Agencies currently permit banks to report as sales in 
the Call Report certain residential and agricultural mortgage transfers 
with recourse that qualify as sales under GAAP. The FRB requires bank 
holding companies to report all asset sales with recourse in accordance 
with GAAP on the consolidated financial statement for bank holding 
companies (Form FR Y-9C). The OTS requires thrifts to report all 
transfers of receivables with recourse in accordance with GAAP on their 
TFRs. The Agencies are not proposing to change these existing 
regulatory reporting treatments.
4. GAAP Recourse Liability Account
    As previously explained, under GAAP, when a transfer of receivables 
with recourse qualifies to be recognized as a sale, the seller must 
establish a recourse liability account at the date of sale that covers 
all probable credit losses under the recourse provision over the life 
of the receivables transferred.
    (Question 2) The Banking Agencies request comment on how the GAAP 
recourse liability account should be treated under the proposed low-
level recourse rule for transfers of receivables with recourse that are 
currently reported as sales in the Call Report and FR Y-9C.17 That 
is, when a banking organization transfers assets in such transactions, 
should the amount of capital required under the low-level recourse rule 
be adjusted to take account of the institution's GAAP recourse 
liability account?
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    \1\7The OTS is not proposing to change its current policy, which 
permits a thrift to deduct the amount of its GAAP recourse liability 
account (1) from the contractual maximum amount of its recourse 
obligation in applying the low-level recourse rule, and (2) from the 
amount of loans sold with recourse in assessing the full effective 
risk-based capital requirement for all loans.
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    The two options are: (1) Not taking the GAAP recourse liability 
account into consideration at all; or (2) requiring risk-based capital 
equal to the amount of the banking organization's low-level recourse 
obligation minus the balance of its GAAP recourse liability account so 
that the recourse liability account plus required capital would equal 
the banking organization's contractual maximum exposure under the 
recourse obligation.18 The latter option would conform the Banking 
Agencies' treatment to that of the OTS in this area.
---------------------------------------------------------------------------

    \1\8The GAAP recourse liability account must be excluded from an 
institution's risk-based and leverage capital base.
---------------------------------------------------------------------------

    The Banking Agencies' existing risk-based capital guidelines also 
do not indicate how the GAAP recourse liability account should be taken 
into account in general when determining the credit equivalent amounts 
of assets transferred with recourse that are currently reported as 
sales in the Call Report or FR Y-9C. The Banking Agencies expect to 
apply the GAAP recourse liability account treatment that they adopt for 
low-level recourse transactions that are reported as sales in the Call 
Report or FR Y-9C to all asset transfers with recourse that are 
currently reported as sales in the Call Report or FR Y-9C, and to 
clarify their risk-based capital guidelines accordingly.

C. Treatment of Direct Credit Substitutes

    The Agencies are proposing to extend the current risk-based capital 
treatment of asset transfers with recourse (including the proposed low-
level recourse rule) to certain direct credit substitutes. As 
previously explained, the current risk-based capital assessment for a 
direct credit substitute may be dramatically lower than the assessment 
for a recourse provision that creates an identical exposure to risk. 
Based on the Agencies' conclusion that asset transfers with recourse 
should be assessed risk-based capital against the full amount of the 
assets enhanced19 (except in low-level recourse transactions), the 
Agencies are of the opinion that direct credit substitutes that present 
equivalent risk should be subject to an equivalent risk-based capital 
treatment.
---------------------------------------------------------------------------

    \1\9See earlier comparison to GAAP accounting requirements.
---------------------------------------------------------------------------

    Under this proposal, the general treatment of direct credit 
substitutes would be to assess capital against the amount of the asset 
or pool of assets that is enhanced, rather than the face amount of the 
direct credit substitute. Like low-level recourse arrangements, direct 
credit substitutes that cover only losses below the full effective 
risk-based capital requirement for the assets would be assessed a 
dollar-for-dollar capital requirement.20
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    \2\0As indicated in Section II(B), the Agencies are continuing 
to evaluate the need for a dollar-for-dollar capital requirement on 
low-level recourse transactions. Any modification to the proposed 
treatment of low level recourse transactions would also apply to low 
level direct credit substitutes (i.e., those that cover losses below 
the full, effective risk-based capital charge for the total 
outstanding amount of the assets enhanced). See Section III for 
additional discussion.
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    The proposed treatment of direct credit substitutes would not 
affect the current treatment of purchased subordinated interests and 
financial standby letters of credit that absorb only the second dollars 
of losses from the assets enhanced.21 The Agencies intend to 
determine the appropriate risk-based capital treatment of these second 
dollar loss direct credit substitutes as part of the development of the 
multi-level approaches discussed in Section III. In the event that the 
Agencies do not proceed with implementation of one or more multi-level 
approaches, the Agencies would expect to propose amendments to the 
risk-based capital standards that would assess risk-based capital 
against all second dollar loss direct credit substitutes based on their 
face amounts plus the face amounts of all more senior outstanding 
positions.
---------------------------------------------------------------------------

    \2\1For purposes of this proposal, and until the Agencies 
implement one or more multi-level approaches, a direct credit 
substitute absorbs the second dollars of losses from assets if there 
is prior credit enhancement that absorbs first dollars of losses 
from those assets. For OTS only, purchased subordinated interests 
whether in the first or second loss position will continue to be 
treated as recourse.
---------------------------------------------------------------------------

    The currently proposed change to the treatment of direct credit 
substitutes would primarily affect the following transactions:
     Loan servicing rights purchased by banking organizations 
if they embody a direct credit substitute,
     Subordinated interests purchased by banking organizations 
that absorb the first dollars of losses from the underlying loans or 
pools of loans, and
     Financial standby letters of credit and other guarantee-
like arrangements provided by banking organizations or thrifts that 
absorb the first dollars of losses from third-party assets.

Each of these is discussed below.
1. Purchased Loan Servicing Rights That Embody a Direct Credit 
Substitute
    Banking organizations and thrifts that sell receivables often 
retain the servicing rights on the transferred assets. Banking 
organizations and thrifts may also acquire loan servicing rights as 
separate assets such as purchased mortgage servicing rights. The terms 
of some loan servicing agreements require the servicer to absorb credit 
losses on the loans, so that the servicer effectively extends a credit 
enhancement (in the form of recourse or a direct credit substitute) to 
the owners of the loans.
    Currently, all of the Agencies treat as recourse retained loan 
servicing rights that embody an obligation to provide credit or other 
loss protection to the owners of the loans. Accordingly, risk-based 
capital is required against the full amount of the assets serviced.
    Under the Banking Agencies' proposal, banking organizations with 
purchased loan servicing rights that extend credit protection (a direct 
credit substitute) to the owners of the loans being serviced would also 
be required to hold capital against the total outstanding amount of 
those loans.22 Thus, banking organizations that purchase such 
servicing rights would be required to apply the 100% credit conversion 
factor to the amount of assets enhanced (the amount of the loans 
serviced) to convert this off-balance sheet exposure into an on-balance 
sheet credit equivalent amount.23
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    \2\2The OTS already requires thrifts to hold capital against the 
total outstanding amount of these loans.
    \2\3The risk-based capital requirement for the servicer's 
exposure to credit risk from the loans would be in addition to the 
separate risk-based capital requirement that is currently required 
to support qualifying intangible assets under the risk-based capital 
standards.
---------------------------------------------------------------------------

    The proposed low-level recourse rule would apply if the servicer's 
maximum retained recourse obligation is contractually limited to an 
amount that is less than the amount of capital that would be required 
against the total amount of the loans serviced.
    (Question 3) The Agencies request comment on whether purchased loan 
servicing rights agreements exist that obligate the servicer to provide 
credit loss protection for only the second dollars of losses from the 
loans. In determining a servicer's loss position, the Agencies do not 
consider access to loan collateral upon default to place the servicer 
in a second loss position.
    Adoption of the proposal would align the Banking Agencies' 
treatment of purchased loan servicing rights that embody a direct 
credit substitute with that of the OTS, which already explicitly 
requires capital support for these arrangements.24 Currently, the 
FDIC and OCC do not explicitly require capital support for these 
arrangements.25 (Capital is required for the allowed portion of 
the intangible asset generated by the purchase of mortgage servicing 
rights, but not for the servicer's separate risk of loss on the 
underlying loans). The FRB considers purchased mortgage servicing 
rights that provide credit protection to be a direct credit substitute 
and requires capital support for the risk associated with the 
underlying mortgage loans. Thus, the proposal would make this treatment 
explicit in the FRB's guidelines.
---------------------------------------------------------------------------

    \2\4The OTS capital regulation provides that ``loans serviced by 
associations where the association is subject to losses on the 
loans, commonly known as recourse servicing,'' are to be converted 
at 100% to an on-balance sheet credit equivalent. 12 CFR 
567.6(a)(2)(i)(C).
    \2\5The Agencies are not at this time addressing the risk-based 
capital treatment of servicing rights associated with mortgage pools 
that back securities guaranteed by the Government National Mortgage 
Association.
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2. Purchased Subordinated Interests
    The proposal would extend the current risk-based capital treatment 
of retained subordinated interests to purchased subordinated interests 
that absorb the first dollars of losses from the underlying loans or 
loan pools. Currently, banking organizations with purchased 
subordinated interests are required to hold risk-based capital only 
against the carrying value of the subordinated interest. In contrast, 
the OTS currently treats purchased subordinated interests in the same 
manner as retained subordinated interests, i.e., as recourse, except 
for certain high quality subordinated interests.26
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    \2\6The OTS will continue to recognize the 20 percent risk-
weight for high quality residential mortgage-backed senior and 
subordinated interests that qualify under the Secondary Mortgage 
Market Enhancement Act of 1984 (SMMEA), Section 3(a)(41) of the 
Securities Exchange Act of 1934, 15 U.S.C. 78c(a)(41), except as 
discussed in Regulatory Bulletin 26. These types of securities are 
commonly referred to as ``SMMEA securities.''
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    Under this proposal, banking organizations with direct credit 
substitutes in the form of purchased subordinated interests that absorb 
the first dollars of losses from the underlying assets would be 
required to hold risk-based capital against the carrying value of the 
subordinated interest plus the outstanding amount of all more senior 
interests that the subordinated interest supports.27 If the 
carrying value of the most subordinated portion of the loan, or pool of 
loans, is less than the full, effective risk-based capital requirement 
for the total underlying loan, or pool of loans, then the low-level 
treatment would apply, i.e., the subordinated portion would be assessed 
risk-based capital dollar-for-dollar against its carrying value. For 
example, if the most subordinated portion of a pool of mortgage assets 
that qualifies for the 50% risk-weight is held by a banking 
organization and its carrying value represents only 3% of the total 
pool, the capital requirement for the subordinated portion would be 3% 
of the total pool rather than 4% (i.e., the carrying value of the 
subordinated portion rather than the full effective capital requirement 
for the pool).
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    \2\7If the subordinated portion of the loan, or pool of loans, 
is held by several banking organizations or thrifts, each 
institution would be required to hold risk-based capital against the 
carrying value of its subordinated interest plus its proportionate 
share of all more senior interests that the subordinated interest 
supports.
---------------------------------------------------------------------------

    The Banking Agencies' risk-based capital treatment of purchased 
subordinated interests that represent middle or mezzanine level loss 
positions in terms of exposure to total losses from the assets (i.e., 
purchased subordinated interests that absorb losses only after prior 
enhancements that absorb the first dollars of losses have been fully 
exhausted) would not be affected by this proposal.28 Risk-based 
capital would continue to be assessed at the 100% risk-weight against 
the carrying value of this type of purchased subordinated interest.
---------------------------------------------------------------------------

    \2\8The OTS would continue to treat such purchased subordinated 
interests (except for SMMEA securities) as recourse.
---------------------------------------------------------------------------

3. Financial Standby Letters of Credit and Guarantee-Like Arrangements
    The proposal would extend the risk-based capital treatment that is 
currently applied to asset transfers with recourse to financial standby 
letters of credit and guarantee-like arrangements that absorb the first 
dollars of losses from third-party assets. The risk-based capital 
assessment for this form of credit enhancement would be based on the 
full amount of the assets enhanced rather than the face amount of the 
standby letter of credit or guarantee-like arrangement.
    The risk-based capital treatment of standby letters of credit or 
guarantee-like arrangements that represent second dollar loss 
enhancements provided for third-party assets would not be affected by 
this proposal. For purposes of this part of the proposal, a second 
dollar loss standby letter of credit or guarantee-like arrangement is 
one that covers any percentage portion of loss after some level of the 
first dollars of loss is covered by another party or through internal 
enhancement (e.g., losses from 6 to 20% of the asset value when another 
party provides first dollar loss enhancement that covers losses from 0 
to 6% of the asset value\29\). These second dollar loss direct credit 
substitutes would continue to be assessed risk-based capital based on 
their risk-weighted face amounts.
---------------------------------------------------------------------------

    \29\If the enhancement is a back-up for the 0 to 6% coverage 
(i.e., the first party covers the first 6% of losses and the second 
party covers the first 20% of losses but expects to absorb losses at 
the 0 to 6% level only if the first party fails to perform), then 
this is not a ``second dollar loss'' enhancement. The second party 
has exposure to the risk that the first party will not perform and 
would be charged capital for that exposure at the risk-weight 
appropriate for claims against the first party.
---------------------------------------------------------------------------

    The proposed rule also addresses participations in financial 
standby letters of credit and guarantee-like arrangements.

D. Summary

    The proposal would increase capital requirements for first dollar 
loss financial standby letters of credit and guarantee-like 
arrangements that cover less than 100% of the face value of the total 
assets enhanced. There would be no change, however, in the risk-based 
capital requirement for arrangements that cover the entire amount of 
losses from a third party's assets, because the current guidelines 
already require capital to be held against the full asset amount in 
such direct credit substitute transactions. Based on Agency staff 
discussions with market participants, the Agencies believe that the 
majority of first dollar loss financial standby letters of credit and 
similar arrangements that are provided by banking organizations and 
thrifts in the current market are of this latter type. Thus, the 
Agencies do not expect that many banking organizations or thrifts would 
face increased risk-based capital requirements as a result of this 
aspect of the proposal.
    Moreover, as was previously mentioned, the Agencies are considering 
options for matching the risk-based capital requirement more closely to 
the risk associated with second dollar loss subordinated interests and 
financial standby letters of credit and guarantee-like arrangements in 
connection with the development of one or more multi-level approaches. 
The multi-level approaches, in conjunction with the proposed rules 
above, would ensure that banking organizations maintain adequate 
capital against the risks associated with credit enhancements, would 
recognize when an institution has reduced its risk, and make capital 
treatment more consistent across the various types of depository 
institutions.

III. Advance Notice of Proposed Rulemaking

    Many asset securitizations carve up the risk of credit losses from 
the underlying assets and distribute it to different parties. The first 
dollar loss or subordinate position is first to absorb credit losses, 
the senior investor position is last, and there may be one or more loss 
positions in between. Each loss position functions as a credit 
enhancement for the more senior loss positions in the structure. 
Currently, the risk-based capital standards do not vary the rate of 
capital assessment with differences in credit risk represented by 
different credit enhancement or loss positions.
    To address this issue, the Agencies are requesting comment on a 
preliminary proposal to adopt a multi-level approach that would assess 
risk-based capital against all banking organization and thrift 
participants in certain asset securitizations (i.e., recourse 
providers, direct credit substitute providers and investors) based on 
their relative exposure to risk of loss from the underlying assets. 
Credit ratings from nationally recognized statistical rating 
organizations would be used to determine relative exposure to risk of 
loss. This proposal, referred to as the ratings-based multi-level 
approach, would permit reduced risk-based capital assessments for 
second dollar loss credit enhancers (both recourse and direct credit 
substitute providers) and for senior investors in eligible 
securitization transactions.\30\ The Agencies also seek comment on 
whether a multi-level approach is needed for unrated securitization 
transactions and, if so, on how such a system could be designed.
---------------------------------------------------------------------------

    \30\The reduction in the risk-based capital charge for second 
dollar loss enhancements would be in relation to the treatment that 
the Agencies are considering proposing for second dollar loss direct 
credit substitutes that do not qualify for the ratings-based multi-
level approach (see discussion below).
---------------------------------------------------------------------------

A. Ratings-Based Multi-Level Approach

1. Threshold Criteria
    The ratings-based multi-level approach would be restricted to 
transactions involving the securitization of large, diversified asset 
pools in which all forms of first dollar loss credit enhancement are 
either completely free of third-party performance risk (i.e., the 
inability of the credit enhancer to perform) or are provided internally 
as part of the securitization structure, as specified below. The 
diversification requirement and the requirement that all first dollar 
loss credit enhancement be free from third-party performance risk are 
intended to protect the first dollar loss enhancement from default risk 
associated with any single party. For purposes of applying a multi-
level approach, it is important to minimize the possibility that the 
first dollar loss enhancement will be exhausted because the presence of 
this prior enhancement will be the basis, in most transactions, for 
allowing lower risk-based capital assessments on the second dollar loss 
and senior positions.
    For a transaction to qualify for the ratings-based multi-level 
approach, the first dollar loss credit enhancement could be provided in 
any of the following four ways:
     Cash collateral accounts;\31\
---------------------------------------------------------------------------

    \31\A cash collateral account is a separate account funded with 
a loan from the provider of the enhancement. Funds in the account 
are available to cover potential losses.
---------------------------------------------------------------------------

     Subordinated interests or classes of securities;
     Spread accounts, including those that are funded initially 
with a loan that is repaid from excess cash flows;\32\ and
---------------------------------------------------------------------------

    \32\A spread account is typically a trust or special account 
that the issuer establishes to retain interest rate payments in 
excess of the amounts due investors from the underlying assets, plus 
a normal servicing fee rate. The excess spread serves as a cushion 
to cover potential losses on the underlying loans.
---------------------------------------------------------------------------

     Other forms of overcollateralization involving excess cash 
flows, e.g., placing excess receivables into the pool so that total 
cash flows expected to be received exceed cash flows needed to pay 
investors.
    Cash collateral accounts and subordinated interests are free of 
third-party performance risk because they stand ready to absorb a given 
percentage of total losses from the underlying assets regardless of the 
financial condition of the party that funds the cash collateral account 
or holds the subordinated interest. Spread accounts and other forms of 
overcollateralization can provide a similar type of insulation from 
exposure to any one party if the asset securitization is based on a 
large, well diversified pool of assets. These forms of internal credit 
enhancement depend on expected excess cash flows from the underlying 
assets and thus are subject to the risk that the excess cash may not 
materialize if default rates among the underlying borrowers exceed 
expectations. Restricting application of the ratings-based multi-level 
approach to large, well diversified asset pools is intended to minimize 
this risk.
    Transactions with first dollar loss credit enhancements that are 
subject to third-party performance risk, such as financial standby 
letters of credit or repurchase obligations (which are subject to the 
risk that the provider fails to perform), and transactions that do not 
involve the securitization of large, well diversified asset pools would 
not be eligible for the ratings-based multi-level approach. Banking 
organizations and thrifts that participate as credit enhancers or 
investors in these types of securitization transactions would not be 
eligible for the reduced risk-based capital assessments available under 
this approach.
2. Risk-Based Capital Treatment of First Dollar Loss Positions
    The risk-based capital treatment of credit enhancements provided by 
banking organizations or thrifts in transactions that qualify for the 
ratings-based multi-level approach would depend on the loss position of 
the credit enhancement. First dollar loss enhancements, whether 
provided as recourse or direct credit substitutes, would be required to 
hold capital dollar-for-dollar against their face amount, up to the 
full, effective risk-based capital requirement for the outstanding 
amount of the assets enhanced.\33\ This would essentially incorporate 
the proposed low-level recourse rule into the treatment of first dollar 
loss enhancements under the ratings-based multi-level approach. The 
dollar-for-dollar capital requirement would apply to the holders of 
subordinated interests as well as against the providers of loans used 
to fund either cash collateral accounts or spread accounts.\34\
---------------------------------------------------------------------------

    \33\See note 13. In no event would a single institution be 
required to hold capital in excess of the amount that would be 
required for the full amount of the assets underlying the 
securitization.
    \34\First dollar loss enhancement provided through 
overcollateralization or a spread account (after any banking 
organization or thrift's initial loan to that account is repaid) 
does not impose risk of loss on any banking organization or thrift 
(assuming it is not capitalized in any fashion) and would therefore 
not be subject to an explicit risk-based capital charge.
---------------------------------------------------------------------------

    As previously noted, the Agencies are continuing to evaluate the 
risk-based capital requirements for low-level recourse arrangements and 
low-level direct credit substitutes. Because the proposed treatment of 
first dollar loss positions under the ratings-based multi-level 
approach incorporates the low-level recourse rule, any modification of 
the low-level recourse rule would also affect the proposed treatment of 
first dollar loss positions. The capital requirement for these 
positions should reflect the fact that they generally carry a higher 
probability of loss relative to other loss positions in the 
securitization. However, the Agencies also recognize that the capital 
requirement for these positions may appear to be excessive because the 
probability of total loss for low-level recourse positions is unlikely 
to be 100 percent.
    Consequently, the Agencies request comment on the proposed 
treatment of low-level recourse and direct credit substitute 
transactions and of first dollar loss positions. In particular, the 
Agencies invite comment on the following questions:
    (Question 4) Is the proposed dollar-for-dollar capital requirement 
(up to the full, effective risk-based capital requirement for the 
underlying assets) too high for low-level recourse and direct credit 
substitute transactions or for first dollar loss positions? If so, why?
    (Question 5) If this proposed capital requirement is too high, how 
can this be demonstrated or quantified? What methodology could be used 
to reduce the capital requirement without jeopardizing safety and 
soundness?
    (Question 6) If less than dollar-for-dollar capital is required for 
low-level or other first dollar loss positions, then the probability of 
loss to the insurance funds increases. How should the Agencies deal 
with this increased probability of loss?
3. Risk-Based Capital Treatment of Second Dollar Loss Positions
    Second dollar loss enhancements that qualify for the ratings-based 
multi-level approach, whether provided as recourse or direct credit 
substitutes, would be assessed risk-based capital only against the 
amount of the enhancement, and not against the more senior portions of 
the pool. This would continue the Banking Agencies' current risk-based 
capital treatment of direct credit substitutes and would significantly 
reduce the amount of capital that is currently required for second 
dollar loss recourse positions. All qualifying second dollar loss 
enhancements, including subordinated mortgage-backed securities, would 
be assigned to the 100% risk-weight category. This would continue the 
Banking Agencies' current treatment of purchased subordinated 
positions.
    To qualify for treatment as a second dollar loss enhancement under 
the ratings-based multi-level approach, two requirements must be 
satisfied:\35\
---------------------------------------------------------------------------

    \35\The Agencies intend that any position in a securitization 
that meets these requirements would qualify for treatment as a 
``second dollar loss enhancement'' under the ratings-based multi-
level approach.
---------------------------------------------------------------------------

     The securitization transaction itself would have to 
qualify for this approach (i.e., it would involve a large, well 
diversified pool of assets and all forms of first dollar loss 
enhancement would be limited to the four types that are described 
above), and
     The enhancement would have to meet specified minimum 
credit rating requirements, as explained below.
    For second dollar loss enhancements in the form of middle level or 
subordinated interests or securities, the interest or security would 
need a formal credit rating of at least investment grade from a 
nationally recognized statistical rating organization. The rating would 
be acceptable only if the same rating organization also provided the 
credit rating for each rated portion or security of the securitization. 
Risk-based capital would be assessed against qualifying middle level or 
subordinated interests or securities at the 100% risk-weight, based on 
the carrying value of the interest or security. No additional risk-
based capital would be required for these qualifying interests or 
securities to support the more senior interests in the pool. See 
Example 1.
    For second dollar loss enhancements in the form of financial 
standby letters of credit or other guarantee-type arrangements, the 
Agencies are considering two alternatives. One alternative would 
require that the portion of the underlying asset pool covered by the 
standby letter of credit must receive a formal credit rating of at 
least investment grade from a nationally recognized statistical rating 
organization. See Example 2A. The second alternative would require that 
the entire asset pool receive a formal credit rating of investment 
grade prior to the addition of the standby letter of credit.\36\ See 
Example 2B.
---------------------------------------------------------------------------

    \36\The credit ratings required under both alternatives are not 
the same as the credit rating that would be obtained for purposes of 
marketing the senior investment portions of the pool, which would 
represent an evaluation of the credit quality of the top portion of 
the asset pool, after the second dollar loss enhancement (and any 
other enhancement) is added.
---------------------------------------------------------------------------

    (Question 7) The Agencies request comment on which of these 
alternatives would be more appropriate for purposes of applying the 
ratings-based multi-level approach.
    (Question 8) The Agencies request comment on whether the above-
described credit rating requirement for second dollar loss enhancements 
should be established at a higher level than investment grade. In 
particular, the Agencies seek information on the extent to which 
banking organizations and thrifts currently purchase subordinated 
interests (including middle level subordinated interests) and on the 
typical credit ratings for such purchased subordinated interests.
    (Question 9) The Agencies request comment on how application of the 
ratings-based multi-level approach to second dollar loss enhancements 
would affect banking organizations or thrifts that provide financial 
standby letters of credit for asset-backed commercial paper programs 
and other asset securitizations.
    A second dollar loss enhancement could qualify for this treatment 
even if it were not free of third-party performance risk. For example, 
a financial standby letter of credit, which has third party performance 
risk, could qualify for this preferential capital treatment if it had 
qualifying first-loss protection. That is, even though a financial 
standby letter of credit would not be considered to qualify for first 
loss protection for purposes of determining the capital requirement of 
more senior loss positions, the standby letter of credit itself could 
qualify for the treatment described above. Risk-based capital would be 
assessed at the 100% risk-weight against the face amount of the standby 
letter of credit.
    It is possible that an asset securitization involving a large, 
well-diversified asset pool might satisfy the above credit rating 
requirements simply on the basis of asset quality, without the addition 
of any credit enhancement. In this circumstance, the risk of loss 
associated with providing credit enhancement for investment grade 
assets should be the same, regardless of whether the investment grade 
rating is based solely on asset quality or on some combination of asset 
quality plus first dollar loss credit enhancement. Therefore, the 
Agencies are considering whether to treat ``first dollar loss'' 
enhancements that provide credit support to pools or portions of pools 
(depending on which alternative is selected, as explained above) that 
have a formal credit rating of at least investment grade rating on a 
stand-alone basis in the same manner that qualifying second dollar loss 
enhancements would be treated under the ratings-based multi-level 
approach. See Example 3.
    (Question 10) The Agencies request comment on this possible 
treatment of ``first dollar loss'' enhancements of investment grade 
assets.
    Second dollar loss credit enhancements that are rated below 
investment grade or do not meet the other criteria stated above would 
not qualify for reduced capital requirements under the ratings-based 
multi-level approach.\37\ The Agencies are considering requiring risk-
based capital for such second dollar loss enhancements based on the 
amount of the enhancement plus all more senior positions, up to the 
lower of the size of the enhancement or the full risk-based capital 
requirement. (The provider of the second dollar loss enhancement would 
not be required to hold risk-based capital against the portion of the 
asset pool that is covered by the first dollar loss enhancement.)
---------------------------------------------------------------------------

    \37\Because banks and thrifts are generally restricted from 
purchasing corporate debt securities rated below investment grade, 
this discussion primarily applies to second dollar loss positions, 
such as financial standby letters of credit, that are not in the 
form of subordinated securities.
---------------------------------------------------------------------------

    The Agencies are concerned that assigning a single capital 
treatment to all second dollar loss positions rated below investment 
grade may not adequately reflect the variation in credit risk of assets 
rated below investment grade.
    (Question 11) The Agencies request comment on modifications to the 
capital requirement for second dollar loss enhancements rated below 
investment grade to better reflect different levels of credit risk.
    In the event that the Agencies do not proceed with implementation 
of a multi-level approach, the Agencies would expect to propose 
amendments to the risk-based capital standards that would assess risk-
based capital against all second dollar loss positions based on their 
face amounts plus the face amounts of all more senior outstanding 
positions (up to the maximum size of the second dollar loss position). 
For this reason the Agencies are particularly interested in receiving 
comment on all aspects of the ratings-based multi-level approach.
4. Risk-Based Capital Treatment of Senior Securities
    Under the ratings-based multi-level approach, a senior security 
could qualify for a 20 percent risk weight, regardless of the risk-
weight of the underlying assets, if:
     The securitization involves a large, well diversified pool 
of assets,
     All prior credit enhancement is limited to the permissible 
forms, and
     The security has received the highest possible rating from 
the same rating organization that provided the credit rating (if any) 
associated with the second dollar loss enhancement.
    This preferential risk-based capital treatment for qualifying 
senior securities would apply regardless of whether a second dollar 
loss enhancement for the same transaction also qualifies for 
preferential treatment under the ratings-based multi-level approach. 
Senior securities that do not meet all of the specified conditions 
would be required to hold capital at the risk-weight appropriate to the 
pooled assets, in accordance with the current risk-based capital 
standards.
    The term ``senior security'' would mean that no class of securities 
has a prior claim to payment from the underlying assets. Securities 
that do not have the first claim to payment would be treated as first 
or second dollar loss enhancements under the ratings-based multi-level 
approach (regardless of their credit rating).\38\
---------------------------------------------------------------------------

    \38\Senior securities that are not paid out until after another 
class or classes of securities from the same issue is completely 
paid out would be considered ``senior securities'' for purposes of 
the ratings-based multi-level approach, provided that they do not 
provide credit enhancement for another class of securities and that 
losses are shared on a pro rata basis in the event of default.
---------------------------------------------------------------------------

    (Question 12) The Agencies request comment on whether a class of 
securities that receives the highest investment grade rating but is not 
the most senior class in a qualifying transaction should also be 
eligible for the 20% risk-weight category under the ratings-based 
multi-level approach.
    (Question 13) The Agencies request comment on whether the ratings-
based multi-level approach should be further adjusted to reflect the 
reduced risk of loss associated with positions rated above the minimum 
investment grade rating but below the highest investment grade rating.
    The proposed favorable risk-based capital treatment of senior 
securities would be restricted to transactions in which all of the 
credit enhancement, including all second dollar loss credit 
enhancements, is either completely free of third-party performance risk 
or is provided internally through the securitization structure. Thus, 
to be eligible for the reduced risk-based capital assessment, a senior 
security would have to be supported solely by cash collateral accounts, 
subordinated interests (including middle level subordinated positions), 
spread accounts, or other forms of overcollateralization. If any part 
of the total credit enhancement provided is subject to third-party 
performance risk, then the senior portion of the issue would not be 
eligible for a reduced risk-based capital requirement under the 
ratings-based multi-level approach, regardless of its rating.\39\ For 
example, if a financial standby letter of credit provides second dollar 
loss enhancement for an asset securitization, then the senior portion 
of that securitization would not be eligible for the 20% risk-weight. 
Risk-based capital would be held against the amount of the standby 
letter of credit and all portions of the transaction that are senior to 
the standby letter of credit in accordance with the current risk-based 
capital standards. See Example 4.
---------------------------------------------------------------------------

    \39\The OTS would continue to apply the 20% risk-weight to any 
SMMEA security regardless of the type of credit enhancement provided 
in the transaction.
---------------------------------------------------------------------------

5. Maintenance of Minimum Ratings
    The proposed favorable risk-based capital treatments for second 
dollar loss enhancements and senior securities under the ratings-based 
multi-level approach would be contingent upon maintenance of the 
required minimum ratings. If second dollar loss enhancement is 
downgraded below investment grade, if the senior securities are 
downgraded below the highest possible rating, or if either rating is 
withdrawn by the rating organization that provided the initial ratings, 
then the capital requirement would be adjusted accordingly.\40\
---------------------------------------------------------------------------

    \40\The incorporation of the ratings-based multi-level approach 
into the risk-based capital standards would also not affect the 
Agencies' authority to require banking organizations and thrifts to 
hold additional capital beyond the minimum regulatory requirements, 
when warranted.
---------------------------------------------------------------------------

6. Conclusion
    The Agencies believe that this preliminary proposal for a ratings-
based multi-level approach could eliminate or reduce many of the 
concerns with the current treatment of recourse and direct credit 
substitutes. This approach would:
     Incorporate the proposed low-level recourse rule, so that 
an institution's capital would never exceed the contractual maximum 
amount of its exposure;
     Equalize the treatment of recourse arrangements and direct 
credit substitutes that present equivalent risk of loss; and
     Add flexibility to the regulatory capital requirements for 
recourse arrangements and direct credit substitutes by taking into 
account the different degrees of credit risk associated with first 
dollar loss and second dollar loss credit enhancements and senior 
positions for those asset securitizations where formal credit ratings 
are provided for the various positions.
    The use of credit ratings would provide a way for the Agencies to 
use market determinations of credit quality to identify different loss 
positions for capital purposes in an asset securitization structure. 
The use of ratings could also enable the approach to be applied to 
large, well diversified pools of non-homogeneous assets, such as small 
business loans, because the market would determine the level of credit 
support necessary to obtain the various credit ratings. This may permit 
the Agencies to give more equitable treatment to a wide variety of 
transactions and structures in administering the risk-based capital 
system.
    The flexibility of such a system would be particularly apparent in 
transactions that use overcollateralization to provide first dollar 
loss credit enhancement because the amount of the excess collateral 
will vary based on factors such as the quality of the underlying 
assets. One pool of assets may require 5% overcollateralization and 
another may require 20% overcollateralization to raise the credit 
quality of the pools to the investment grade level. Even though the 
second pool in this example has a greater amount of 
overcollateralization, the provider of second dollar loss enhancement 
for this transaction would not necessarily be in a safer loss position 
than the provider of second dollar loss enhancement for the pool that 
required only 5% overcollateralization. The use of credit ratings to 
determine the amount of first dollar loss protection could provide the 
Agencies with an inherently flexible method for identifying when an 
adequate first dollar loss position has been reached and when the 
second dollar loss position begins.
    (Question 14) While the agencies believe that a ratings-based 
multi-level approach may be less costly for banking organizations and 
thrifts than a multi-level approach that depends more heavily on 
quantitative and qualitative analysis of individual securitizations and 
the positions within them, the agencies request comment on the costs of 
obtaining and monitoring ratings over time and on how these costs might 
compare with the cost of having to examine each position for purposes 
of determining its risk-based capital requirement.

B. Multi-Level Approach for Unrated Securitizations

    The ratings-based multi-level approach relies on credit ratings to 
permit reduced risk-based capital requirements for qualifying credit 
enhancements and senior securities in certain asset securitizations. 
However, not all asset securitizations are rated and, in some 
securitizations, certain portions may be rated while others may be 
unrated. The Agencies recognize that there could be a need for a 
separate multi-level approach to establish capital requirements for 
unrated securitizations and unrated portions of rated securitizations. 
In theory, there are several ways to proceed.
    The ideal multi-level approach for unrated securitizations would 
set capital requirements roughly equivalent to those for rated 
securitizations. To determine whether the credit quality of an unrated 
credit enhancement or security is similar to a rated credit enhancement 
or security, banking organizations and thrifts would need to: (1) Know 
the current loss position of the credit enhancement or security being 
evaluated, and (2) have current information on the credit quality of 
the underlying assets. This information could then be used in 
conjunction with a formula that relates the capital requirement for a 
credit enhancement or security to its loss position and the credit 
quality of the underlying assets.
    Alternatively, the Agencies could develop a multi-level approach 
for unrated securitizations that assigns capital requirements based 
purely on a quantitative measure of sequential loss exposure (that is, 
the amount of loss protection provided by more junior positions), 
without regard to underlying asset quality. A refinement in this 
approach would be to develop quantitative measures for each asset type 
to reflect each type's default characteristics.
    These alternatives represent two of the possible ways to establish 
a multi-level approach for unrated securitizations. The Agencies 
request comment on these and any other options.
    If the Agencies do not proceed with a multi-level approach for 
unrated securitizations, they expect to extend the current risk-based 
capital treatment of recourse transactions to all unrated credit 
enhancements (i.e., capital would be required against the face amount 
of the credit enhancement plus all more senior positions).
    The Agencies request comment on the following questions:
    (Question 15) Is there a need for a multi-level approach for 
unrated securitizations and unrated portions of rated securitizations?
    (Question 16) Should the credit quality of the underlying loans be 
given additional consideration (beyond that present in the current 
risk-based capital requirements) in the capital requirements for 
unrated transactions? If so, how would this be accomplished? What other 
information, if any, should be considered in determining the capital 
requirements?
    (Question 17) Should the loss position of the credit enhancement or 
security be taken into account in determining capital requirements for 
unrated transactions? If so, how would the loss position be determined? 
In particular, how should forms of prior enhancement such as 
overcollateralization and spread accounts be treated?
    (Question 18) If the Agencies were to develop a multi-level 
approach that incorporates both qualitative and quantitative elements 
(the first alternative presented above), what problems might banking 
organizations and thrifts encounter in obtaining and maintaining the 
necessary information on loss positions and credit quality? How could 
the Agencies ensure consistent use of this information in determining 
loss positions and assigning capital requirements?
    (Question 19) If the Agencies were to develop a multi-level 
approach based solely on quantitative measurement of loss positions 
(the second alternative presented above), how should such an approach 
be designed?
    (Question 20) How might a multi-level approach be designed so that 
positions that would not, if rated, qualify for reduced capital 
requirements under the ratings-based approach, also would not qualify 
for reduced capital requirements under the multi-level approach for 
unrated transactions?
    (Question 21) How can a multi-level approach for unrated 
securitizations be designed so it does not create an unreasonable bias 
toward or away from obtaining ratings?

IV. Application of Any Final Rules

    The Agencies intend that any final rules adopted in connection with 
this notice of proposed rulemaking and advance notice of proposed 
rulemaking that result in increased risk-based capital requirements for 
banking organizations or thrifts would apply only to transactions that 
are consummated after the effective date of such final rules. The 
Agencies intend that any final rules adopted in connection with this 
notice that result in reduced risk-based capital requirements for 
banking organizations or thrifts would apply to all transactions 
outstanding as of the effective date of such final rules and to all 
subsequent transactions.

V. Sample Applications of the Ratings-Based Multi-Level Approach

Example 1A--Senior/Subordinated Structure

    Bank A issues three classes of securities that are backed by a $212 
million, well-diversified pool of residential mortgage loans that 
individually qualify for the 50% risk-weight category--a bottom-level 
subordinated class of $12 million, a middle-level subordinated class of 
$20 million and a senior class of $180 million. Bank A retains the 
bottom-level class and sells the other two classes to banking 
organizations or thrifts.
    Bank A, retaining the bottom-level subordinated class, would be 
required to hold risk-based capital equal to 4% of the $212 million 
pool (i.e., the full effective risk-based capital requirement for the 
outstanding amount of the assets enhanced). Because this subordinated 
class provides sufficient first dollar loss enhancement, a nationally 
recognized statistical rating organization gives the $20 million middle 
class an investment grade rating. Since this class is rated investment 
grade, risk-based capital would be held against it at the 100% risk-
weight, based solely on its carrying value. That is, the holder of the 
middle-level class would not be required to hold any capital against 
the senior class it supports. The same rating organization gives its 
highest credit rating to the $180 million senior class. Since this is 
the most senior class, has the highest possible credit rating, and all 
prior enhancements are performance risk-free, risk-based capital would 
be calculated at the 20% risk-weight. Table 1 summarizes this example.

                                     Table 1.--Senior-Subordinated Structure                                    
                  [Underlying Assets--Type: Residential Mortgage Loans; Amount: $212 million]                   
----------------------------------------------------------------------------------------------------------------
                                                                                          Current               
                                                                             Current     treatment     Ratings  
      Loss position          Size ($              Credit rating             treatment       for      proposal ($
                              mill)                                        for thrifts  banks\1\ ($     mill)   
                                                                             ($ mill)      mill)                
----------------------------------------------------------------------------------------------------------------
1st......................          $12  No IG rating.....................        $8.48        $8.48        $8.48
2nd......................           20  IG...............................         8.00         1.60         1.60
3rd......................          180  Highest IG rating................         2.88         7.20         2.88
TOTAL CAPITAL: In Dollars  ...........  .................................        19.36        17.28        12.96
    As Percent Of Pool...  ...........  .................................         9.1%         8.2%        6.1% 
----------------------------------------------------------------------------------------------------------------
IG=Investment Grade                                                                                             
\1\Under the Banking Agencies' existing capital rules the capital charges for retained first and second loss    
  positions differ from the capital requirements for purchased first and second loss positions. For example, a  
  bank must hold regulatory capital equal to 8 percent of the carrying value of a purchased subordinated        
  position at the 100% risk-weight, whereas a retained subordinated position is subject to a capital requirement
  against the full value of all the assets enhanced. (In contrast, the OTS treats both of these positions in the
  same way, requiring capital against the full value of the assets enhanced.) The proposed new rules would      
  eliminate such disparate capital treatment by focusing the capital charge on the risk of recourse arrangements
  or credit substitutes, rather than the manner in which they are acquired. Note, however, that other rules     
  restricting banks from purchasing or holding securities that are of less than investment grade quality already
  limit the opportunities to exploit the disparities present in existing capital rules.                         

Example 1B--A First Loss Position That Qualifies for the Low-Level 
Recourse Rule

    Bank A issues three classes of securities that are backed by a $212 
million, well-diversified pool of consumer loans that individually 
qualify for the 100% risk-weight category--a bottom-level subordinated 
class of $12 million, a middle-level subordinated class of $20 million 
and a senior class of $180 million. Bank A retains the bottom-level 
class and sells the other two classes to banking organizations or 
thrifts.
    Without the proposed low-level recourse rule, Bank A's capital 
requirement for the $12 million bottom-level subordinated class would 
be $16.96 million, i.e., a full risk-based capital requirement of 8% 
against the $212 million mortgage pool enhanced by this class. The low-
level recourse rule, however, would allow the risk-based capital 
requirement to fall below the full effective capital requirement when 
the recourse obligation falls below the full effective capital 
requirement. Thus, the capital requirement would be the lesser of 
either the maximum contractual recourse obligation or the full 
effective capital requirement. Consequently, the bottom-level class in 
this example would be assessed dollar-for-dollar capital up to its $12 
million carrying value, for a capital requirement of $12 million.
    Because the bottom-level subordinated class provides sufficient 
first dollar loss enhancement, a nationally recognized statistical 
rating organization gives the $20 million middle class an investment 
grade rating. Since this class is rated investment grade, risk-based 
capital would be assessed against it at the 100% risk-weight, based 
solely on its carrying value. That is, the holder of the middle-level 
class would not be assessed any capital against the senior class it 
supports. The same rating organization gives its highest credit rating 
to the $180 million senior class. Since this is the most senior class, 
has the highest possible credit rating, and all prior enhancements are 
performance risk-free, risk-based capital would be assessed against 
this class at the 20% risk-weight. Table 2 summarizes this example.

                             Table 2.--An Application of the Low-Level Recourse Rule                            
                        [Underlying Assets--Type: Consumer Loans; Amount: $212 million]                         
----------------------------------------------------------------------------------------------------------------
                                                                             Current      Current               
                                                                            treatment    Treatment     Ratings  
      Loss position          Size ($              Credit rating                for          for      proposal ($
                              mill)                                         thrifts\1\  Banks\2\ ($     mill)   
                                                                             ($ mill)      mill)                
----------------------------------------------------------------------------------------------------------------
1st......................          $12  No IG rating.....................       $12.00       $16.96       $12.00
2nd......................           20  IG...............................        16.00         1.60         1.60
3rd......................          180  Highest IG rating................        14.40        14.40         2.88
TOTAL CAPITAL: In Dollars  ...........  .................................        42.40        32.96        16.48
    As Percent Of Pool...  ...........  .................................        20.0%        15.6%        7.8% 
----------------------------------------------------------------------------------------------------------------
IG=Investment Grade                                                                                             
\1\OTS already has a low-level recourse rule in place for thrifts.                                              
\2\See note 1 to Table 1.                                                                                       

Example 2A--Investment Grade Rating Applied to Portion of Pool Covered 
by Standby Letter of Credit

    The XYZ Company is seeking the highest possible credit rating on an 
asset-backed commercial paper issuance that is backed by a large, well-
diversified pool of trade receivables. A total of $200 million of 
commercial paper is issued against the pool, which contains $212 
million worth of trade receivables. Thus, there is $12 million of 
overcollateralization available to provide loss protection.
    To obtain the highest rating for the commercial paper, the XYZ 
Company also purchases a standby letter of credit from Bank B that 
covers the next $20 million of losses after the $12 million of 
overcollateralization. This letter of credit provides loss protection 
analogous to the middle-level subordinated class of securities in 
Examples 1A and 1B above. A nationally recognized statistical rating 
organization provides a formal credit rating of investment grade for 
the position, i.e., that portion of pool losses that represents the 
exposure to be covered by the $20 million letter of credit. As a 
result, under the Agencies' first alternative for application of the 
ratings-based multi-level approach to this type of transaction, risk-
based capital would be assessed against the $20 million standby letter 
of credit at the 100% risk-weight, based on its credit equivalent 
amount. That is, Bank B would not be required to hold capital against 
the additional $180 million supported by the standby letter of credit. 
If the rating given to the letter of credit was not at least investment 
grade, then Bank B would be required to hold capital at the 100% risk-
weight against the credit equivalent amount of its letter of credit and 
all senior classes that it supports (in this case, against $200 
million).

Example 2B--Investment Grade Rating Applied to the Entire Pool of 
Assets

    The details of the transaction here are identical to those of 
example 2A, except that the investment grade rating provided by a 
nationally recognized statistical rating organization is not on the 
second loss position, but on the entire $212 million pool, prior to the 
addition of Bank B's standby letter of credit. As a result, under the 
Agencies' second alternative for application of the ratings-based 
multi-level approach to this type of transaction, risk-based capital 
would be assessed against the $20 million standby letter of credit at 
the 100% risk-weight, based on its credit equivalent amount. That is, 
Bank B would not be required to hold capital against the $180 million 
of the pool that the standby letter of credit supports, but does not 
cover. If the rating given to the entire pool prior to the addition of 
the letter of credit were not at least investment grade, then Bank B 
would be required to hold capital at the 100% risk-weight against the 
credit equivalent amount of its letter of credit and all the senior 
classes that it supports (in this case, against $200 million).

Example 3--Investment Grade Rating on First Loss Position

    If the Agencies adopt the proposed alternative to treat certain 
``first dollar loss'' enhancements that have a formal credit rating of 
at least investment grade in the same manner as qualifying second 
dollar loss enhancements, the following example would apply:
    Bank C issues two classes of securities that are backed by a $212 
million, well-diversified pool of auto loans--a subordinated class of 
$12 million and a senior class of $200 million. Bank C retains the 
bottom-level class and sells the other class to either a banking 
organization or thrift.
    Because of the high credit quality of the underlying loans, a 
nationally-recognized statistical rating organization gives the $212 
million pool of auto loans a rating equal to one level above investment 
grade on a stand-alone basis. The $12 million subordinated class is 
given an investment grade rating. Since this class is rated investment 
grade, risk-based capital would be assessed against it at the 100 
percent risk-weight, based solely on its carrying value. That is, Bank 
C would not be assessed any capital against the senior class it 
supports. On the basis of the high credit quality of the underlying 
loans, and the loss protection provided by the subordinated class, the 
same rating organization gives its highest credit rating to the $200 
million senior class. Since this is the most senior class, has the 
highest possible credit rating, and all prior enhancements are 
performance risk-free, risk-based capital would be assessed against 
this class at the 20 percent risk-weight. Table 3 summarizes this 
example.

                          Table 3.--Investment Grade Rating on the First Loss Position                          
                          [Underlying Assets--Type: Auto Loans; Amount: $212 million]                           
----------------------------------------------------------------------------------------------------------------
                                                                                          Current               
                                                                             Current     treatment     Ratings  
      Loss position          Size ($              Credit rating             treatment       for      proposal ($
                              mill)                                        for thrifts  banks\1\ ($     mill)   
                                                                             ($ mill)      mill)                
----------------------------------------------------------------------------------------------------------------
1st......................          $12  IG...............................       $12.00       $16.96        $0.96
2nd......................          200  Highest IG rating................        16.00        16.00         3.20
TOTAL CAPITAL: In Dollars  ...........  .................................        28.00        32.96         4.16
    As Percent Of Pool...  ...........  .................................        13.2%        15.6%         2.0%
----------------------------------------------------------------------------------------------------------------
IG = Investment Grade                                                                                           
\1\See note 1 to Table 1.                                                                                       

Example 4--Nonqualifying Senior Position

    Bank D issues two classes of securities backed by a $212 million, 
well-diversified pool of consumer loans--a subordinated class of $12 
million, which would be rated below investment grade, and a senior 
class of $200 million. Bank D retains the bottom-level class and sells 
the other class to a banking organization or thrift. In the absence of 
additional credit enhancements, a nationally recognized statistical 
rating organization will rate the senior class one grade below its 
highest credit rating as a result of the first dollar loss enhancement 
from the subordinated class.
    Bank D obtains a letter of credit to provide additional enhancement 
to the transaction from a company whose obligations have the highest 
possible credit rating from the same credit rating organization. The 
credit rating organization now gives its highest possible credit rating 
to the senior class in this transaction. However, since this credit 
rating is a result of a prior enhancement that is provided in the form 
of a standby letter of credit, which has performance risk, risk-based 
capital would be assessed against the senior class at the 100% risk-
weight rather than at the 20% risk-weight. Under the ratings-based 
multi-level approach, the 20% risk-weight would only be applied to 
qualifying senior interests that are supported by prior credit 
enhancements that are in the form of overcollateralization, spread 
accounts, cash collateral accounts, or subordinated interests. Table 4 
summarizes this example. 

                                    Table 4.--Non-Qualifying Senior Position                                    
                        [Underlying Assets--Type: Consumer Loans; Amount: $212 million]                         
----------------------------------------------------------------------------------------------------------------
                                                                                      Current                   
                                                                         Current     treatment                  
    Loss position        Size ($              Credit rating             treatment       for      Ratingsproposal
                          mill)                                        for thrifts  banks\1\ ($     ($ mill)    
                                                                         ($ mill)      mill)                    
----------------------------------------------------------------------------------------------------------------
1st..................          $12  No IG rating.....................       $12.00       $16.96         $12.00  
2nd..................          200  Highest IG rating\2\.............        16.00        16.00          16.00  
TOTAL CAPITAL: In      ...........  .................................        28.00        32.96          28.00  
 Dollars.                                                                                                       
    As Percent Of      ...........  .................................        13.2%        15.6%         13.2%   
     Pool.                                                                                                      
----------------------------------------------------------------------------------------------------------------
IG = Investment Grade                                                                                           
\1\See note 1 to Table 1.                                                                                       
\2\Highest credit rating achieved because of a standby letter of credit issued on the senior class by a company 
  whose obligations have the highest credit rating.                                                             

VI. Additional Issues for Comment

    The Agencies request comment on all aspects of the proposed 
amendments to the risk-based capital treatment of recourse and direct 
credit substitutes and on all aspects of the proposal to adopt a multi-
level approach. In addition to the questions set out above, the 
agencies request comment on the following:

A. Proposal

1. Definitions of Recourse and Direct Credit Substitutes
    (Question 22) Does the proposed definition of the term ``standard 
representations and warranties'' provide a workable definition for 
determining whether a representation or warranty will be considered 
recourse or a direct credit substitute?
    (Question 23) Does the proposed definition of a ``servicer cash 
advance'' provide a workable definition for determining whether a cash 
advance will be considered recourse or a direct credit substitute?
2. Low-Level Recourse Rule
    (Question 24) Would the low-level recourse rule lower transaction 
costs or otherwise help facilitate the sale or securitization of 
banking organization assets?
3. Treatment of Direct Credit Substitutes
    (Question 25) For banking organizations and thrifts in general, or 
for your particular institution, please answer the following questions:
    (a) For securitized or pooled transactions, and separately for non-
securitized transactions, approximately what portion of third-party 
financial standby letters of credit provides less than 100% loss 
protection for the underlying assets? What are the typical 
circumstances of such arrangements?
    (b) For securitized or pooled transactions, and separately for non-
securitized transactions, do financial standby letters of credit 
typically absorb the first dollars of losses or the second dollars of 
losses from third-party assets, as defined in this section of the 
proposal? What is the approximate dollar amount of financial standby 
letters of credit provided by banking organizations and thrifts that 
absorb the first dollars of losses from third-party assets?
    (c) What is the approximate dollar amount of purchased subordinated 
interests that absorb the first dollars of losses from third-party 
assets, as defined in this section of the proposal?

B. Advance Notice of Proposed Rulemaking--Ratings-Based Multi-Level 
Approach

    (Question 26) Should the Agencies require that prior credit 
enhancements be free of performance risk in order for second dollar 
loss enhancements and senior positions to qualify for reduced risk-
based capital requirements?
    (Question 27) The discussion of the multi-level approach deals with 
varying the capital requirement in asset securitizations based on an 
institution's degree of exposure to credit risk. Does a multi-level 
approach have any applicability to sales or participations of 
individual, secured, unrated loans (including multifamily loans) with 
recourse under various loss sharing arrangements?

VII. Regulatory Flexibility Act

    It is hereby certified that the proposed changes to the Agencies' 
risk-based capital standards will not have a significant economic 
impact on a substantial number of small entities, in accord with the 
spirit and purposes of the Regulatory Flexibility Act (5 U.S.C. 601 et 
seq.). Most of the transactions that will be affected by the proposed 
changes are conducted by large banking organizations and large thrifts. 
In addition, consistent with current policy, the FRB's revised 
guidelines generally will not apply to bank holding companies with 
consolidated assets of less than $150 million. The intent of the 
proposal is to correct certain inconsistencies in the Agencies' risk-
based capital standards and to allow banking organizations to maintain 
lower amounts of capital against low-level recourse obligations by 
adopting the current OTS capital treatment of those transactions. 
Accordingly, a Regulatory Flexibility Act Analysis is not required.

VIII. Executive Order 12866

    OCC and OTS have determined that the proposed rule described in 
this notice is not a significant regulatory action under Executive 
Order 12866. Accordingly, a regulatory impact analysis is not required. 
The intent of the proposal is to correct certain inconsistencies in the 
Agencies' risk-based capital standards and to allow banking 
organizations to maintain lower amounts of capital against low-level 
recourse obligations by adopting the current OTS capital treatment of 
those transactions. Under the proposal, each institution's measured 
risk-based capital ratio may change. However, this change in measured 
capital ratios should have no material effect on the safety and 
soundness of the banking and thrift industries. Most banks and thrifts 
have capital ratios much in excess of minimum requirements. Of the 
11,071 commercial banks in operation at the end of September 1993, 
10,824 were well-capitalized (risk-based capital ratios in excess of 10 
percent). For the thrift industry, as of June 30, 1993, 1,561 of 1,752 
savings associations were similarly well-capitalized. Given the high 
level of capitalization in the industry, the net effect on the safety 
and soundness of the banking industry and the overall economy should be 
minimal.

IX. Paperwork Reduction Act

    The following information about paperwork relates only to Federal 
Reserve (FR) reports, which are approved by the Federal Reserve Board 
under delegated authority from the Office of Management and Budget 
(OMB).
    The proposed amendments to the Capital Adequacy Guidelines may 
require reporting revisions to the Consolidated Financial Statements 
for Bank Holding Companies With Total Consolidated Assets of $150 
Million or More or With More Than One Subsidiary Bank (FR Y-9C; OMB No. 
7100-0128). Any revisions will be determined by the Federal Reserve 
Board under delegated authority from OMB.

Description of Affected Report

    Report Title: Consolidated Financial Statements for Bank Holding 
Companies With Total Consolidated Assets of $150 Million or More, or 
With More than One Subsidiary Bank.
    This report is filed by all bank holding companies that have total 
consolidated assets of $150 million or more and by all multibank 
holding companies regardless of size. The following bank holding 
companies are exempt from filing the FR Y-9C, unless the FRB 
specifically requires an exempt company to file the report: bank 
holding companies that are subsidiaries of another bank holding company 
and have total consolidated assets of less than $1 billion; bank 
holding companies that have been granted a hardship exemption by the 
FRB under section 4(d) of the Bank Holding Company Act, 12 U.S.C. 
1843(d); and foreign banking organizations as defined by section 
211.23(b) of Regulation K.

List of Subjects

12 CFR Part 3

    Administrative practice and procedure, Capital risk, National 
banks, Reporting and recordkeeping requirements.

12 CFR Part 208

    Accounting, Agriculture, Banks, Banking, Branches, Capital 
adequacy, Confidential business information, Currency, Reporting and 
recordkeeping requirements, Securities, State member banks.

12 CFR Part 225

    Administrative practice and procedure, Banks, Banking, Capital 
adequacy, Holding companies, Reporting and recordkeeping requirements, 
Securities.

12 CFR Part 325

    Bank deposit insurance, Banks, Banking, Capital adequacy, Reporting 
and recordkeeping requirements, Savings associations, State nonmember 
banks.

12 CFR Part 567

    Capital, Reporting and recordkeeping requirements, Savings 
associations.

DEPARTMENT OF THE TREASURY

COMPTROLLER OF THE CURRENCY

12 CFR Chapter I

Authority and Issuance

    For the reasons set out in the preamble, part 3 of chapter I of 
title 12 of the Code of Federal Regulations is proposed to be amended 
as follows:

PART 3--MINIMUM CAPITAL RATIOS; ISSUANCE OF DIRECTIVES

    1. The authority citation for part 3 continues to read as follows:

    Authority: 12 U.S.C. 93a, 161, 1818, 1828(n), 1828 note, 1831n 
note, 3907 and 3909.


Appendix A  [Amended]

    2. In appendix A, section 1, paragraphs (c)(10) through (c)(29) are 
redesignated as follows: 

------------------------------------------------------------------------
            Oldparagraph                         Newparagraph           
------------------------------------------------------------------------
(c)(10)............................  (c)(11)                            
(c)(11)............................  (c)(13)                            
(c)(12)............................  (c)(14)                            
(c)(13)............................  (c)(15)                            
(c)(14)............................  (c)(16)                            
(c)(15)............................  (c)(17)                            
(c)(16)............................  (c)(18)                            
(c)(17)............................  (c)(19)                            
(c)(18)............................  (c)(21)                            
(c)(19)............................  (c)(22)                            
(c)(20)............................  (c)(23)                            
(c)(21)............................  (c)(25)                            
(c)(22)............................  (c)(26)                            
(c)(23)............................  (c)(27)                            
(c)(24)............................  (c)(30)                            
(c)(25)............................  (c)(31)                            
(c)(26)............................  (c)(32)                            
(c)(27)............................  (c)(33)                            
(c)(28)............................  (c)(34)                            
(c)(29)............................  (c)(35)                            
------------------------------------------------------------------------

    3. In appendix A, section 1, new paragraphs (c)(10), (12), (20), 
(24), (28) and (29) are added and paragraph (c)(22) is revised, to read 
as follows:

Appendix A to Part 3--Risk-Based Capital Guidelines

* * * * *

Section 1. Purpose, Applicability of Guidelines, and Definitions.

* * * * *
    (c) * * *
    (10) Direct credit substitute means the assumption, in form or 
in substance (other than through providing recourse), of any risk of 
loss directly or indirectly associated with an asset or other claim, 
that exceeds the national bank's pro rata share of the asset or 
claim. If a national bank has no claim on the asset, then the 
assumption of any risk of loss is a direct credit substitute. Direct 
credit substitutes include, but are not limited to:
    (i) Financial guarantee-type standby letters of credit that 
support financial claims on the account party;
    (ii) Guarantees and guarantee-type instruments backing financial 
claims;
    (iii) Purchased subordinated interests or securities that absorb 
more than their pro rata share of losses from the underlying assets; 
and
    (iv) Purchased loan servicing rights if the servicer is 
responsible for losses associated with the loans being serviced 
(other than servicer cash advances as defined in this section 1(c) 
of this appendix A), or if the servicer makes or assumes 
representations and warranties about the loans other than standard 
representations and warranties as defined in this section 1(c) of 
this appendix A).
* * * * *
    (12) Financial guarantee-type standby letter of credit means any 
letter of credit or similar arrangement, however named or described, 
which represents an irrevocable obligation to the beneficiary on the 
part of the issuer (1) to repay money borrowed by or advanced to or 
for the account of the account party, or (2) to make payment on 
account of any indebtedness undertaken by the account party, in the 
event that the account party fails to fulfill its obligation to the 
beneficiary.
* * * * *
    (20) Performance-based standby letter of credit means any letter 
of credit, or similar arrangement, however named or described, which 
represents an irrevocable obligation to the beneficiary on the part 
of the issuer to make payment on account of any default by the 
account party in the performance of a nonfinancial or commercial 
obligation.
* * * * *
    (22) Public-sector entities includes states, local authorities 
and governmental subdivisions below the central government level in 
an OECD country. In the United States, this definition encompasses a 
state, county, city, town or other municipal corporation, a public 
authority, and generally any publicly-owned entity that is an 
instrumentality of a state or municipal corporation. This definition 
does not include commercial companies owned by the public sector.
* * * * *
    (24) Recourse means the retention, in form or substance, of any 
risk of loss directly or indirectly associated with a transferred 
asset that exceeds a pro rata share of a national bank's claim on 
the asset. If a national bank has no claim on a transferred asset, 
then the retention of any risk of loss is recourse. A recourse 
arrangement typically arises when an institution transfers assets 
and retains an obligation to repurchase the assets or absorb losses 
due to a default of principal or interest or any other deficiency in 
the performance of the underlying obligor or some other party. 
Recourse arrangements include, but are not limited to:
    (i) Representations and warranties about the transferred assets 
other than standard representations and warranties as defined in 
this section 1(c) of this appendix A;
    (ii) Retained loan servicing rights if the servicer is 
responsible for losses associated with the loans being serviced 
(other than servicer cash advances as defined in this section 1(c) 
of this appendix A;
    (iii) Retained subordinated interests or securities that absorb 
more than their pro rata share of losses from the underlying assets;
    (iv) Assets sold under an agreement to repurchase; and
    (v) Loan strips sold without direct recourse where the maturity 
of the participation is shorter than the maturity of the underlying 
loan.
* * * * *
    (28) Servicer cash advance means funds that a loan servicer 
advances to ensure an uninterrupted flow of payments or the timely 
collection of loans, including disbursements made to cover 
foreclosure costs or other expenses arising from a loan to 
facilitate its timely collection. A servicer cash advance is not 
recourse or a direct credit substitute if the servicer is entitled 
to full reimbursement, or for any one loan, nonreimbursable amounts 
are contractually limited to an insignificant amount of the 
outstanding principal on that loan.
    (29) Standard representations and warranties means contractual 
provisions that a national bank extends when it transfers assets 
(including loan servicing rights), or assumes when it purchases loan 
servicing rights, that refer to existing facts at the time the 
assets are transferred or servicing rights are acquired and that 
have been verified with reasonable due diligence by the transferor 
or servicer. Standard representations and warranties also include 
contractual provisions for the return of assets in the event of 
fraud or documentation deficiencies. Standard representations and 
warranties do not constitute recourse or direct credit substitutes.
* * * * *


Appendix A  [Amended]

    4. In appendix A, section 3, a new paragraph is added after the 
second paragraph of the introductory text and prior to paragraph (a), 
paragraphs (b)(1)(i) and (ii) are revised, paragraph (b)(1)(iii) is 
removed and reserved, a new paragraph (c) is added, and footnotes 16, 
17, and 18 are revised, to read as follows:
* * * * *

Section 3. Risk Categories/Weights for On-Balance Sheet Assets and 
Off-Balance Sheet Items

* * * * *
    Assets transferred with recourse are treated in accordance with 
section 3(c) of this appendix A.
* * * * *
    (b) * * *
    (1) * * * (i) Recourse arrangements and direct credit 
substitutes,\13\ in accordance with section 3(c) of this appendix 
A.\14\
---------------------------------------------------------------------------

    \13\[Reserved]
    \14\Mortgage loans sold in transactions in which the bank 
retains only an insignificant amount of risk and makes concurrent 
provision for that risk are not considered assets sold with recourse 
under section 3. In order to qualify for sales treatment, such 
transactions must meet three conditions: (1) The bank has not 
retained any significant risk of loss, either directly or 
indirectly; (2) The bank's maximum contractual exposure under the 
recourse provision (or through the retention of a subordinated 
interest in the mortgages) at the time of the transfer is equal to 
or less than the amount of probable loss that the bank has 
reasonably estimated that it will incur on the transferred 
mortgages; and (3) The bank must have created a liability account or 
other special reserve in an amount equal to its maximum exposure. 
The amount of this liability account or other special reserve may 
not be included in capital for the purpose of determining compliance 
with either the risk-based capital requirement or the leverage 
ratio; nor may it be included in the allowance for loan and lease 
losses.
---------------------------------------------------------------------------

    (ii) Risk participations purchased in bankers acceptances.
    (iii) [Reserved]
* * * * *
    (2) * * *
    (i) * * *\16\ * * *
---------------------------------------------------------------------------

    \16\Participations in performance-based standby letters of 
credit are treated in accordance with section 3(c) of this appendix 
A.
---------------------------------------------------------------------------

    (ii) * * *\17\ * * *
---------------------------------------------------------------------------

    \17\Participations in commitments are treated in accordance with 
section 3(c) of this appendix A.
---------------------------------------------------------------------------

* * * * *
    (4) * * *
    (ii) * * *\18\ * * *
---------------------------------------------------------------------------

    \18\See definition of ``unconditionally cancelable'' in section 
1(c) of this appendix A.
---------------------------------------------------------------------------

    (c) Recourse arrangements and direct credit substitutes--(1) 
Risk-weighted asset amount--on-balance sheet assets. To calculate 
the risk-weighted asset amount for a recourse arrangement that is an 
on-balance sheet asset, multiply the amount of assets from which 
risk of loss is directly or indirectly retained by the appropriate 
risk weight using the criteria regarding obligors, guarantors, and 
collateral listed in section 3(a) of this appendix A.
    (2) Risk-weighted asset amount--off-balance sheet items. To 
calculate the risk-weighted asset amount for a recourse arrangement 
or direct credit substitute that is not an on-balance sheet asset, 
multiply the on-balance sheet credit equivalent amount by the 
appropriate risk weight using the criteria regarding obligors, 
guarantors, and collateral listed in section 3(a) of this appendix 
A.
    (3) On-balance sheet credit equivalent amount. Except as 
otherwise provided by this paragraph, the on-balance sheet credit 
equivalent amount for a recourse arrangement or direct credit 
substitute is the amount of assets from which risk of loss is 
directly or indirectly retained or assumed. For purposes of this 
section 3(c) of this appendix A, the amount of assets from which 
risk of loss is directly or indirectly retained or assumed means:
    (i) For a financial guarantee-type standby letter of credit, 
guarantee, or other guarantee-type arrangement, the assets that the 
direct credit substitute fully or partially supports;
    (ii) For a subordinated interest or security, the amount of the 
subordinated interest or security plus all more senior interests or 
securities;
    (iii) For mortgage servicing rights that are recourse 
arrangements or direct credit substitutes, the outstanding amount of 
the loans serviced;
    (iv) For representations and warranties (other than standard 
representations and warranties), the amount of the loans subject to 
the representations or warranties; and
    (v) For loans strips that are recourse arrangements or direct 
credit substitutes, the amount of the loans.
    (4) Second-loss position direct credit substitutes. The on-
balance sheet credit equivalent amount for a direct credit 
substitute is the face amount of the direct credit substitute if:
    (i) There is a prior credit enhancement that absorbs the first 
dollars of loss from the underlying assets that the direct credit 
substitute fully or partially supports; and
    (ii) The direct credit substitute is either:
    (A) A financial guarantee-type standby letter of credit, 
guarantee or other guarantee-type arrangement that absorbs the 
second dollars of loss from the underlying assets; or
    (B) A purchased subordinated interest or security that absorbs 
the second dollars of loss from the underlying assets.
    (5) Participations. The on-balance sheet credit equivalent 
amount for a participation interest in a standby letter of credit, 
guarantee, or other guarantee-type arrangement is calculated as 
follows:
    (i) Determine the on-balance sheet credit equivalent amount as 
if the bank held all of the interests in the participation.
    (ii) Multiply the on-balance sheet credit equivalent amount 
determined under section 3(c)(5)(i) of this appendix A by the 
percentage of the bank's participation interest.
    (iii) If the bank is exposed to more than its pro rata share of 
the risk of loss on the direct credit substitute (e.g., the bank 
remains secondarily liable on participations held by others), add to 
the amount computed under section 3(c)(5)(ii) of this appendix A an 
amount computed as follows: multiply the amount computed under 
3(c)(5)(i) by the percentage of the direct credit substitute held by 
others and then multiply the result by the risk-weight appropriate 
for the holders of those interests. (Note that this risk-weighting 
is in addition to the risk-weighting done to convert the on-balance 
sheet credit equivalent amount to the risk-weighted asset amount 
under section 3(c)(2) of this appendix A.)
    (6) Limitations on risk-based capital requirements--(i) Low-
level exposure. If the maximum contractual liability or exposure to 
loss retained or assumed by a bank in connection with a recourse 
arrangement or a direct credit substitute is less than the risk-
based capital required to support the recourse obligation or direct 
credit substitute, the risk-based capital requirement is limited to 
the maximum contractual liability or exposure to loss.
    (ii) Mortgage-related securities or participation certificates 
retained in a mortgage loan swap. If a bank holds a mortgage-related 
security or a participation certificate as a result of a mortgage 
loan swap with recourse, capital is required to support the recourse 
obligation and that percentage of the mortgage-related security or 
participation certificate that is not covered by the recourse 
obligation. The total amount of capital required for the on-balance 
sheet asset and the recourse obligation, however, is limited to the 
capital requirement for the underlying loans, calculated as if the 
bank continued to hold these loans as an on-balance sheet asset.
* * * * *


Appendix A  [Amended]

    4. In appendix A, Table 2, paragraph 1 under ``100 Percent 
Conversion Factor'' is revised to read as follows:
Table 2--Credit Conversion Factors for Off-Balance Sheet Items

100 Percent Conversion Factor

    1. Direct credit substitutes (arrangements to assume risk of 
loss from assets other than through providing recourse, including 
purchased subordinated interests and general guarantees of 
indebtedness and guarantee-type instruments, such as standby letters 
of credit serving as financial guarantees for, or supporting, loans 
and securities).
* * * * *

FEDERAL RESERVE SYSTEM

12 CFR Chapter II

Authority and Issuance

    For the reasons set out in the preamble, parts 208 and 225 of 
chapter II of title 12 of the Code of Federal Regulations are proposed 
to be amended as follows:

PART 208--MEMBERSHIP OF STATE BANKING INSTITUTIONS IN THE FEDERAL 
RESERVE SYSTEM (REGULATION H)

    1. The authority citation for part 208 is revised to read as 
follows:

    Authority: 12 U.S.C. 248(a) and 248(c), 321-328, 461, 481-486, 
601, 611, 1814, 1818, 1823(j), and 1831o.

    2. Section III of appendix A to part 208 is amended by adding a new 
paragraph B.5, and by revising the introductory text to paragraph D and 
paragraph D.1 to read as follows:

Appendix A to Part 208--Capital Adequacy Guidelines For State Member 
Banks: Risk-Based Measure

* * * * *

III. Procedures for Computing Weighted Risk Assets and Off-Balance 
Sheet Items

* * * * *
    B. * * *
    5. Recourse arrangements and direct credit substitutes. Banks 
may engage in activities--such as securitizing pools of assets, 
selling single assets, and entering into certain off-balance sheet 
transactions--that result in the provision of a credit enhancement 
in the form of a recourse arrangement or a direct credit substitute. 
The risk-based capital treatment of recourse arrangements and direct 
credit substitutes is discussed in section III.D of this appendix A. 
The following definitions of the terms ``recourse'' and ``direct 
credit substitute'' apply for risk-based capital purposes.
    Recourse is the retention, in form or in substance, of any risk 
of loss directly or indirectly associated with an asset a bank has 
transferred that is in excess of the bank's pro rata share of the 
asset. A recourse arrangement typically arises when an institution 
transfers an asset and retains an obligation to repurchase the asset 
or to absorb losses on the asset arising from a default of principal 
or interest or any other deficiencies in the performance of the 
underlying obligor or some other party.
    A direct credit substitute is the assumption, in form or 
substance through a nonrecourse arrangement, of any risk of loss 
directly or indirectly associated with an asset or other claim in 
excess of the bank's pro rata share of the asset or other claim. A 
direct credit substitute arrangement typically arises when an 
institution issues a standby letter of credit, purchases a 
subordinated security that provides loss protection to more senior 
securities, or purchases servicing rights, such as mortgage 
servicing rights, that obligate the servicer to provide credit 
protection to the third-party owners of the assets being serviced.
    For most direct credit substitutes, the amount of the bank's 
exposure to be converted to an on-balance sheet credit equivalent 
typically is the full face value of the item. However, for direct 
credit substitutes, such as purchased subordinated securities that 
are carried on the balance sheet and directly or indirectly absorb 
the first losses from a third-party asset, pool of assets, or other 
claim, the full amount of the bank's off-balance sheet exposure that 
is to be converted is the entire outstanding principal amount of the 
asset, pool of assets, or other claim, less the amount of the on-
balance sheet direct credit substitute against which capital is 
already held. This treatment applies regardless of whether the 
direct credit substitute fully or partially supports the asset, pool 
of assets, or other claim. The full amount of the bank's off-balance 
sheet exposure to be converted may be the same or greater than the 
face value of the direct credit substitute. For instance, in the 
case of purchased subordinated securities that absorb first losses, 
the entire outstanding principal amount of all more senior 
securities that are supported by that subordinated interest (to the 
extent they are not already reported on the bank's balance sheet) 
are converted to an on-balance sheet credit-equivalent amount.
    For risk-based capital purposes, non-standard representations or 
warranties a bank may extend in transferring assets (including the 
transfer of servicing rights), or may assume in other transactions, 
including the acquisition of loan servicing rights, are treated as 
recourse or direct credit substitutes.24a Standard 
representations and warranties, which normally do not constitute 
recourse or direct credit substitutes for risk-based capital 
purposes, are contractual provisions referring to an existing set of 
facts that has been verified with reasonable due diligence by the 
seller or servicer at the time the assets are transferred or loan 
servicing rights are acquired. Standard representations and 
warranties also include contractual provisions that provide for the 
return of the assets to the seller in instances of fraud or upon 
determination by the purchaser that the assets transferred are not 
fully and properly documented or otherwise as represented by the 
seller.
---------------------------------------------------------------------------

    \2\4aRepresentations are statements, express or implied, 
regarding a past or existing fact, circumstance, or state of facts 
pertinent to the contract, which is influential in bringing about 
the agreement. Warranties are promises that certain facts are truly 
as they are represented to be and that they will remain so, subject 
to specified limitations.
---------------------------------------------------------------------------

    A cash advance by a loan servicer does not constitute recourse 
or a direct credit substitute if the servicer is entitled to full 
reimbursement, or for any one loan, nonreimbursable amounts are 
contractually limited to an insignificant amount of the outstanding 
principal on that loan. A servicer cash advance is an arrangement 
under which the servicer advances funds to ensure an uninterrupted 
flow of payments to investors or the timely collection of loans. 
Funds advanced to ensure the timely collection of loans include 
disbursements made to cover foreclosure costs or other expenses 
incurred to facilitate the timely collection of a loan.
* * * * *
    D. * * *
    Before an off-balance sheet item can be incorporated into the 
risk-based capital ratio, the on-balance sheet credit-equivalent 
amount of the item must be determined. Once the credit-equivalent 
amount is determined, the amount is then assigned to the appropriate 
risk category according to the obligor, or if relevant, the 
guarantor or the nature of the collateral.40 The method for 
determining the credit-equivalent amount of an interest-rate or 
exchange-rate contract is set forth in section III.E.2 of this 
appendix A. For most other types of off-balance sheet items, the on-
balance sheet credit-equivalent amount is determined by multiplying 
the full amount of the bank's exposure under the item by the 
applicable credit conversion factor as set forth below and in 
Attachment IV to this appendix A.
---------------------------------------------------------------------------

    \4\0The sufficiency of collateral and guarantees for off-balance 
sheet items is determined by the market value of the collateral or 
the amount of the guarantee in relation to the face amount of the 
item, except for interest- and exchange-rate contracts, for which 
this determination is made in relation to the credit-equivalent 
amount. Collateral and guarantees are subject to the same provisions 
noted under section III.B of this appendix A.
---------------------------------------------------------------------------

    However, in the case of direct credit substitutes--which are 
described in detail in section III.B.5 of this appendix A and 
section III.D.1 of this appendix A--that directly or indirectly 
absorb the first losses from an asset, pool of assets, or other 
claim, the full amount of a bank's exposure that is to be converted 
is the entire outstanding principal amount of the asset, pool of 
assets, or other claim, less the amount of any on-balance sheet 
exposure associated with the item against which capital is already 
held. This treatment applies regardless of whether the direct credit 
substitute fully or partially supports the asset, pool of assets, or 
other claim. The full amount of the bank's exposure to be converted 
may be the same or greater than the face value of the direct credit 
substitute. For instance, in the case of standby letters of credit 
that absorb first losses, the entire outstanding principal amount of 
a customer's loan or debt instrument that is supported by the letter 
of credit is converted to an on-balance sheet credit-equivalent 
amount.
    Generally, the full face value of an off-balance sheet item is 
converted to an on-balance sheet credit-equivalent amount and 
incorporated in weighted risk assets and, thus, is subject to a full 
effective risk-based capital requirement. However, the aggregate 
capital requirement on a first loss direct credit substitute or a 
recourse transaction (including a transaction reported as a 
financing on a bank's balance sheet) is limited to the maximum 
contractual amount of loss to which the direct credit substitute or 
recourse arrangement exposes the institution if this amount is less 
than the effective risk-based capital charge for the asset, pool of 
assets, or other claim supported by the direct credit substitutes or 
recourse arrangement.
    1. Items with a 100 percent conversion factor. A 100 percent 
conversion factor applies to direct credit substitutes, which 
include guarantees, or equivalent instruments, backing financial 
claims such as outstanding securities, loans, and other financial 
liabilities, or that back off-balance sheet items that require 
capital under the risk-based capital framework. Direct credit 
substitutes include, for example, financial standby letters of 
credit, or other equivalent irrevocable undertakings or surety 
arrangements, that guarantee repayment of financial obligations such 
as: commercial paper, tax-exempt securities, commercial or 
individual loans or debt obligations, or standby or commercial 
letters of credit. As described in section III.B.5 of this appendix 
A, purchases of subordinated securities or of servicing rights may 
give rise to a direct credit substitute. Direct credit substitutes 
also include the acquisition of risk participations in bankers 
acceptances and standby letters of credit, since both of these 
transactions, in effect, constitute a guarantee by the acquiring 
bank that the underlying account party (obligor) will repay its 
obligation to the originating, or issuing, institution.41 
(Standby letters of credit that are performance-related are 
discussed below and have a credit conversion factor of 50 percent.)
---------------------------------------------------------------------------

    \4\1Credit-equivalent amounts of acquisitions of risk 
participations are assigned to the risk category appropriate to the 
account party obligor, or if relevant, the guarantor or the nature 
of the collateral.
---------------------------------------------------------------------------

    The full amount of a bank's exposure under a direct credit 
substitute is converted at 100 percent and the resulting credit 
equivalent amount is assigned to the risk category appropriate to 
the obligor or, if relevant, the guarantor or the nature of the 
collateral. In the case of a direct credit substitute in which a 
risk participation42 has been conveyed, the full amount of the 
bank's exposure is still converted at 100 percent. However, the 
credit equivalent amount that has been conveyed is assigned to 
whichever risk category is lower: the risk category appropriate to 
the obligor, after giving effect to any relevant guarantees or 
collateral, or the risk category appropriate to the institution 
acquiring the participation. Any remainder is assigned to the risk 
category appropriate to the obligor, guarantor, or collateral. For 
example, the portion of a direct credit substitute conveyed as a 
risk participation to a U.S. domestic depository institution or 
foreign bank is assigned to the risk category appropriate to claims 
guaranteed by those institutions, that is, the 20 percent risk 
category.43 This approach recognizes that such conveyances 
replace the originating bank's exposure to the obligor with an 
exposure to the institutions acquiring the risk 
participations.44
---------------------------------------------------------------------------

    \4\2That is, a participation in which the originating banking 
organization remains liable to the beneficiary for the full amount 
of the direct credit substitute if the party that has acquired the 
participation fails to pay when the instrument is drawn.
    \4\3Risk participations with a remaining maturity of over one 
year that are conveyed to non-OECD banks are to be assigned to the 
100 percent risk category, unless a lower risk category is 
appropriate to the obligor, guarantor, or collateral.
    \4\4A risk participation in bankers acceptances conveyed to 
other institutions is also assigned to the risk category appropriate 
to the institution acquiring the participation or, if relevant, the 
guarantor or nature of the collateral.
---------------------------------------------------------------------------

    In the case of direct credit substitutes that take the form of a 
syndication as defined in the instructions to the commercial bank 
Call Report, that is, where each bank is obligated only for its pro 
rata share of the risk and there is no recourse to the originating 
bank, each bank will only include its pro rata share of its exposure 
under the direct credit substitute in its risk-based capital 
calculation.
    Financial standby letters of credit are distinguished from loan 
commitments (discussed below) in that standbys are irrevocable 
obligations of the bank to pay a third-party beneficiary when a 
customer (account party) fails to repay an outstanding loan or debt 
instrument (direct credit substitute). Performance standby letters 
of credit (performance bonds) are irrevocable obligations of the 
bank to pay a third-party beneficiary when a customer (account 
party) fails to perform some other contractual non-financial 
obligation.
    The distinguishing characteristics of a standby letter of credit 
for risk-based capital purposes is the combination of irrevocability 
with the fact that funding is triggered by some failure to repay or 
perform an obligation. Thus, any commitment (by whatever name) that 
involves an irrevocable obligation to make a payment to the customer 
or to a third-party in the event the customer fails to repay an 
outstanding debt obligation or fails to perform a contractual 
obligation is treated, for risk-based capital purposes, as 
respectively, a financial guarantee standby letter of credit or a 
performance standby.
    A loan commitment, on the other hand, involves an obligation 
(with or without a material adverse change or similar clause) of the 
bank to fund its customer in the normal course of business should 
the customer seek to draw down the commitment.
    Sale and repurchase agreements and asset sales with recourse (to 
the extent not included on the balance sheet) and forward agreements 
also are converted at 100 percent. Accordingly, the entire amount of 
any assets transferred with recourse that are not already included 
on the balance sheet, including pools of 1- to 4-family residential 
mortgages, is to be converted at 100 percent and assigned to the 
risk category appropriate to the obligor, or if relevant, the 
guarantor or the nature of the collateral. In certain recourse 
transactions (including those that are reported as a financing on a 
bank's balance sheet) the amount of the institution's contractual 
liability may be limited to an amount less than the effective risk-
based capital requirement for the assets being transferred with 
recourse. In such cases, the amount of total capital that must be 
maintained against the transaction is equal to the maximum amount of 
possible loss under the recourse provision. So-called ``loan 
strips'' (that is, short-term advances sold under long-term 
commitments without direct recourse) are defined in the instructions 
to the commercial bank Call Report and for risk-based capital 
purposes as assets sold with recourse. The definition of the term 
``recourse'' is set forth in section III.B.5 of this appendix A.
    Forward agreements are legally binding contractual obligations 
to purchase assets with certain drawdown at a specified future date. 
Such obligations include forward purchases, forward forward deposits 
placed,45 and partly-paid shares and securities; they do not 
include commitments to make residential mortgage loans or forward 
foreign exchange contracts.
---------------------------------------------------------------------------

    \4\5Forward forward deposits accepted are treated as interest 
rate contracts.
---------------------------------------------------------------------------

    Securities lent by a bank are treated in one of two ways, 
depending upon whether the lender is at risk of loss. If a bank, as 
agent for a customer, lends the customer's securities and does not 
indemnify the customer against loss, then the transaction is 
excluded from the risk-based capital calculation. If, alternatively, 
a bank lends its own securities, or acting as agent for a customer, 
lends the customer's securities and indemnifies the customer against 
loss, the transaction is converted at 100 percent and assigned to 
the risk weight category appropriate to the obligor, to any 
collateral delivered to the lending bank, or, if applicable, to the 
independent custodian acting on the lender's behalf. Where a bank is 
acting as agent for a customer in a transaction involving the 
lending or sale of securities that is collateralized by cash 
delivered to the bank, the transaction is deemed to be 
collateralized by cash on deposit in the bank for purposes of 
determining the appropriate risk weight category, provided that any 
indemnification is limited to no more than the difference between 
the market value of the securities and the cash collateral received 
and any reinvestment risk associated with that cash collateral is 
borne by the customer.
* * * * *

PART 225--BANK HOLDING COMPANIES AND CHANGE IN BANK CONTROL 
(REGULATION Y)

    3. The authority citation for part 225 is revised to read as 
follows:

    Authority: 12 U.S.C. 1817(j)(13), 1818, 1831i, 1831p-1, 
1843(c)(8), 1844(b), 1972(l), 3106, 3108, 3310, 3331-3351, 3907, and 
3909.

    4. Section III of appendix A to part 225 is amended by adding a new 
paragraph B.5 and by revising the introductory text of paragraph D and 
paragraph D.1 to read as follows:

Appendix A to Part 225--Capital Adequacy Guidelines for Bank Holding 
Companies: Risked-Based Measure

* * * * *

III. Procedures for Computing Weighted Risk Assets and Off-Balance 
Sheet Items

* * * * *
    B. * * *
    5. Recourse Arrangements and Direct Credit Substitutes. Banking 
organizations may engage in activities--such as securitizing pools 
of assets, selling single assets, and entering into certain off-
balance sheet transactions--that result in the provision of a credit 
enhancement in the form of a recourse arrangement or a direct credit 
substitute. The risk-based capital treatment of recourse 
arrangements and direct credit substitutes is discussed in section 
III.D of this appendix A. The following definitions of the terms 
``recourse'' and ``direct credit substitute'' apply for risk-based 
capital purposes.
    Recourse is the retention, in form or in substance, of any risk 
of loss directly or indirectly associated with an asset a banking 
organization has transferred that is in excess of the banking 
organization's pro rata share of the asset. A recourse arrangement 
typically arises when an institution transfers an asset and retains 
an obligation to repurchase the asset or to absorb losses on the 
asset arising from (a) a default of principal or interest or (b) any 
other deficiencies in the performance of the underlying obligor or 
some other party.
    A direct credit substitute is the assumption, in form or 
substance through a nonrecourse arrangement, of any risk of loss 
directly or indirectly associated with an asset or other claim in 
excess of the banking organization's pro rata share of the asset or 
other claim. A direct credit substitute arrangement typically arises 
when an institution issues a standby letter of credit, purchases a 
subordinated security that provides loss protection to more senior 
securities, or purchases servicing rights, such as mortgage 
servicing rights, that obligate the servicer to provide credit 
protection to the third-party owners of the assets being serviced.
    For most direct credit substitutes, the amount of the banking 
organization's exposure to be converted to an on-balance sheet 
credit equivalent typically is the full face value of the item. 
However, for direct credit substitutes, such as purchased 
subordinated securities that are carried on the balance sheet that 
directly or indirectly absorb the first losses from a third-party 
asset, pool of assets, or other claim, the full amount of the 
banking organization's off-balance sheet exposure that is to be 
converted is the entire outstanding principal amount of the asset, 
pool of assets, or other claim, less the amount of the on-balance 
sheet direct credit substitute against which capital is already 
held. This treatment applies regardless of whether the direct credit 
substitute fully or partially supports the asset, pool of assets, or 
other claim. The full amount of the banking organization's off-
balance sheet exposure may be the same or greater than the face 
amount of the direct credit substitute. For instance, in the case of 
purchased subordinated securities that absorb first losses, the 
entire outstanding principal amount of all more senior securities 
that are supported by that subordinated interest (to the extent they 
are not already reported on the banking organization's balance 
sheet) are converted to an on-balance sheet credit equivalent 
amount.
    For risk-based capital purposes, non-standard representations or 
warranties a banking organization may extend in transferring assets 
(including the transfer of servicing rights), or may assume in other 
transactions, including the acquisition of loan servicing rights, 
are treated as recourse or direct credit substitutes.27a 
Standard representations and warranties, which normally do not 
constitute recourse or direct credit substitutes for risk-based 
capital purposes, are contractual provisions referring to an 
existing set of facts that has been verified with reasonable due 
diligence by the seller or servicer at the time the assets are 
transferred or loan servicing rights are acquired. Standard 
representations and warranties also include contractual provisions 
that provide for the return of the assets to the seller in instances 
of fraud or upon determination by the purchaser that the assets 
transferred are not fully and properly documented or otherwise as 
represented by the seller.
---------------------------------------------------------------------------

    \2\7aRepresentations are statements, express or implied, 
regarding a past or existing fact, circumstance, or state of facts 
pertinent to a contract, which is influential in bringing about the 
agreement. Warranties are promises that certain facts are truly as 
they are represented to be and that they will remain so, subject to 
specified limitations.
---------------------------------------------------------------------------

    A cash advance by a loan servicer does not constitute recourse 
or a direct credit substitute if the servicer is entitled to full 
reimbursement, or for any one loan, nonreimbursable amounts are 
contractually limited to an insignificant amount of the outstanding 
principal on that loan. A servicer cash advance is an arrangement 
under which the servicer advances funds to ensure an uninterrupted 
flow of payments to investors or the timely collection of loans. 
Funds advanced to ensure the timely collection of loans include 
disbursements made to cover foreclosure costs or other expenses 
incurred to facilitate the timely collection of a loan.
* * * * *
    D. * * *
    Before an off-balance sheet item can be incorporated into the 
risk-based capital ratio, the on-balance sheet credit-equivalent 
amount of the item must be determined. Once the credit-equivalent is 
determined, the amount is then assigned to the appropriate risk 
category according to the obligor, or, if relevant, the guarantor or 
the nature of the collateral.43 The method for determining the 
credit-equivalent amount of an interest-rate or exchange-rate 
contract is set forth in section III.E.2 of this appendix A. For 
most other types of off-balance sheet items, the on-balance sheet 
credit-equivalent amount is determined by multiplying the full 
amount of the banking organization's exposure under the item by the 
applicable credit conversion factor as set forth below and in 
Attachment IV to this appendix A.
---------------------------------------------------------------------------

    \4\3The sufficiency of collateral and guarantees for off-balance 
sheet items is determined by the market value of the collateral or 
the amount of the guarantee in relation to the face amount of the 
item, except for interest- and exchange-rate contracts, for which 
this determination is made in relation to the credit-equivalent 
amount. Collateral and guarantees are subject to the same provisions 
noted under section III.B of this Appendix A.
---------------------------------------------------------------------------

    However, in the case of direct credit substitutes--which are 
described in detail in sections III.B.5 and III.D.1 of this appendix 
A--that directly or indirectly absorb the first losses from an 
asset, pool of assets, or other claim, the full amount of a banking 
organization's exposure that is to be converted is the entire 
outstanding principal amount of the asset, pool of assets, or other 
claim, less the amount of any on-balance sheet exposure associated 
with the item against which capital is already held. This treatment 
applies regardless of whether the direct credit substitute fully or 
partially supports the asset, pool of assets, or other claim. The 
full amount of banking organization's exposure may be the same or 
greater than the face amount of the direct credit substitute. For 
instance, in the case of standby letters of credit that absorb first 
losses, the entire outstanding principal amount of a customer's loan 
or debt instrument that is supported by the letter of credit is 
converted to an on-balance sheet credit equivalent amount.
    Generally, the full face value of an off-balance sheet item is 
converted to an on-balance sheet credit equivalent amount and 
incorporated in weighted risk assets and, thus, is subject to a full 
effective risk-based capital requirement. However, the aggregate 
capital requirement on a first loss direct credit substitute or a 
recourse transaction is limited to the maximum contractual amount of 
loss to which the direct credit substitute or recourse arrangement 
exposes the institution if this amount is less than the effective 
risk-based capital charge for the asset, pool of assets, or other 
claim supported by the direct credit substitute or recourse 
arrangement.
    1. Items with a 100 percent conversion factor. A 100 percent 
conversion factor applies to direct credit substitutes, which 
include guarantees, or equivalent instruments, backing financial 
claims such as outstanding securities, loans, and other financial 
liabilities, or that back off-balance sheet items that require 
capital under the risk-based capital framework. Direct credit 
substitutes include, for example, financial standby letters of 
credit, or other equivalent irrevocable undertakings or surety 
arrangements, that guarantee repayment of financial obligations such 
as: commercial paper, tax-exempt securities, commercial or 
individual loans or debt obligations, or standby or commercial 
letters of credit. As described in section III.B.5 of this appendix 
A, purchases of subordinated securities or of servicing rights may 
give rise to a direct credit substitute. Direct credit substitutes 
also include the acquisition of risk participations in bankers 
acceptances and standby letters of credit, since both of these 
transactions, in effect, constitute a guarantee by the acquiring 
banking organization that the underlying account party (obligor) 
will repay its obligation to the originating, or issuing, 
institution.44 (Standby letters of credit that are performance-
related are discussed below and have a credit conversion factor of 
50 percent.)
---------------------------------------------------------------------------

    \4\4Credit-equivalent amounts of acquisitions of risk 
participations are assigned to the risk category appropriate to the 
account party obligor, or if relevant, the guarantor or nature of 
the collateral.
---------------------------------------------------------------------------

    The full amount of a banking organization's exposure under a 
direct credit substitute is converted at 100 percent and the 
resulting credit-equivalent amount is assigned to the risk category 
appropriate to the obligor or, if relevant, the guarantor or the 
nature of the collateral. In the case of a direct credit substitute 
in which a risk participation45 has been conveyed, the full 
amount of the banking organization's exposure is still converted at 
100 percent. However, the credit-equivalent amount that has been 
conveyed is assigned to whichever risk category is lower: the risk 
category appropriate to the obligor, after giving effect to any 
relevant guarantees or collateral, or the risk category appropriate 
to the institution acquiring the participation. Any remainder is 
assigned to the risk category appropriate to the obligor, guarantor, 
or collateral. For example, the portion of a direct credit 
substitute conveyed as a risk participation to a U.S. domestic 
depository institution or foreign bank is assigned to the risk 
category appropriate to claims guaranteed by those institutions, 
that is, the 20 percent risk category.46 This approach 
recognizes that such conveyances replace the originating banking 
organization's exposure to the obligor with an exposure to the 
institutions acquiring the risk participations.47
---------------------------------------------------------------------------

    \4\5That is, a participation in which the originating banking 
organization remains liable to the beneficiary for the full amount 
of the direct credit substitute if the party that has acquired the 
participation fails to pay when the instrument is drawn.
    \4\6Risk participations with a remaining maturity of over one 
year that are conveyed to non-OECD banks are to be assigned to the 
100 percent risk category, unless a lower risk category is 
appropriate to the obligor, guarantor, or collateral.
    \4\7A risk participation in bankers acceptances conveyed to 
other institutions is also assigned to the risk category appropriate 
to the institution acquiring the participation or, if relevant, the 
guarantor or nature of the collateral.
---------------------------------------------------------------------------

    In the case of direct credit substitutes that take the form of a 
syndication, that is, where each banking organization is obligated 
only for its pro rata share of the risk and there is no recourse to 
the originating banking organization, each banking organization will 
only include its pro rata share of its exposure under the direct 
credit substitute in its risk-based capital calculation.
    Financial standby letters of credit are distinguished from loan 
commitments (discussed below) in that standbys are irrevocable 
obligations of the banking organization to pay a third-party 
beneficiary when a customer (account party) fails to repay an 
outstanding loan or debt instrument (direct credit substitute). 
Performance standby letters of credit (performance bonds) are 
irrevocable obligations of the banking organization to pay a third-
party beneficiary when a customer (account party) fails to perform 
some other contractual non-financial obligation.
    The distinguishing characteristics of a standby letter of credit 
for risk-based capital purposes is the combination of irrevocability 
with the fact that funding is triggered by some failure to repay or 
perform an obligation. Thus, any commitment (by whatever name) that 
involves an irrevocable obligation to make a payment to the customer 
or to a third-party in the event the customer fails to repay an 
outstanding debt obligation or fails to perform a contractual 
obligation is treated, for risk-based capital purposes, as 
respectively, a financial guarantee standby letter of credit or a 
performance standby.
    A loan commitment, on the other hand, involves an obligation 
(with or without a material adverse change or similar clause) of the 
banking organization to fund its customer in the normal course of 
business should the customer seek to draw down the commitment.
    Sale and repurchase agreements and asset sales with recourse (to 
the extent not included on the balance sheet) and forward agreements 
also are converted at 100 percent.\48\ So-called ``loan strips'' 
(that is, short-term advances sold under long-term commitments 
without direct recourse) are treated for risk-based capital purposes 
as assets sold with recourse and, accordingly, are also converted at 
100 percent. The definition of the term ``recourse'' is set forth in 
section III.B.5 of this appendix A.
---------------------------------------------------------------------------

    \48\In the regulatory reports and under GAAP, bank holding 
companies are permitted to treat some asset sales with recourse as 
``true'' sales. For risk-based capital purposes, however, such 
assets sold with recourse and reported as ``true'' sales by bank 
holding companies are converted at 100 percent and assigned to the 
risk category appropriate to the underlying obligor or, if relevant 
the guarantor or nature of the collateral, provided that the 
transactions meet the definition of assets sold with recourse, 
including the sale of 1- to 4-family residential mortgages, that is 
contained in the instructions to the commercial bank Consolidated 
Reports of Condition and Income (Call Report). Accordingly, the 
entire amount of any assets transferred with recourse that are not 
already included on the balance sheet, including pools of 1- to 4-
family residential mortgages, is to be converted at 100 percent and 
assigned to the risk category appropriate to the obligor, or if 
relevant, the guarantor or the nature of the collateral. In certain 
recourse transactions the amount of the institution's contractual 
liability may be limited to an amount less than the effective risk-
based capital requirement for the assets being transferred with 
recourse. In such cases, the amount of total capital that must be 
maintained against the transaction is equal to the maximum amount of 
possible loss under the recourse provision.
---------------------------------------------------------------------------

    Forward agreements are legally binding contractual obligations 
to purchase assets with certain drawdown at a specified future date. 
Such obligations include forward purchases, forward deposits 
placed,\49\ and partly-paid shares and securities; they do not 
include commitments to make residential mortgage loans or forward 
foreign exchange contracts.
---------------------------------------------------------------------------

    \49\Forward forward deposits accepted are treated as interest 
rate contracts.
---------------------------------------------------------------------------

    Securities lent by a banking organization are treated in one of 
two ways, depending upon whether the lender is at risk of loss. If a 
banking organization, as agent for a customer, lends the customer's 
securities and does not indemnify the customer against loss, then 
the transaction is excluded from the risk-based capital calculation. 
If, alternatively, a banking organization lends its own securities, 
or acting as agent for a customer, lends the customer's securities 
and indemnifies the customer against loss, the transaction is 
converted at 100 percent and assigned to the risk weight category 
appropriate to the obligor, to any collateral delivered to the 
lending banking organization, or, if applicable, to the independent 
custodian acting on the lender's behalf. Where a banking 
organization is acting as agent for a customer in a transaction 
involving the lending or sale of securities that is collateralized 
by cash delivered to the banking organization, the transaction is 
deemed to be collateralized by cash on deposit in the banking 
organization for purposes of determining the appropriate risk weight 
category, provided that any indemnification is limited to no more 
than the difference between the market value of the securities and 
the cash collateral received and any reinvestment risk associated 
with that cash collateral is borne by the customer.
* * * * *

FEDERAL DEPOSIT INSURANCE CORPORATION

12 CFR Chapter III

Authority and Issuance

    For the reasons set forth in the preamble, the Board of Directors 
of the Federal Deposit Insurance Corporation proposes to amend part 325 
of title 12 of the Code of Federal Regulations as follows:

PART 325--CAPITAL MAINTENANCE

    1. The authority citation for part 325 continues to read as 
follows:

    Authority: 12 U.S.C. 1815(a), 1815(b), 1816, 1818(a), 1818(b), 
1818(c), 1818(t), 1819(Tenth), 1828(c), 1828(d), 1828(i), 1828(n), 
1828(o), 1831o, 3907, 3909; Pub. L. 102-233, 105 Stat. 1761, 1789, 
1790 (12 U.S.C. 1831n note); Pub. L. 102-242, 105 Stat. 2236, 2355, 
2386 (12 U.S.C. 1828 note).

    2. Section II of appendix A to part 325 is amended by:
    a. Adding paragraph 6 to section II.B;
    b. Removing the undesignated introductory paragraph in section II.D 
and adding in its place three new paragraphs; and
    c. Revising the first and the second through fifth paragraphs under 
paragraph 1 in section II.D, to read as follows:

Appendix A to Part 325--Statement of Policy on Risk-Based Capital

* * * * *

II. Procedures For Computing Risk-Weighted Assets

* * * * *
    B. * * *
    6. Recourse Arrangements and Direct Credit Substitutes. For 
purposes of determining the risk-based capital treatment of 
securitized pools of assets, sales of single assets, and certain 
off-balance sheet transactions in which a bank provides credit 
enhancement, the following definitions of the terms ``recourse'' and 
``direct credit substitute'' apply. The risk-based capital treatment 
of recourse arrangements and direct credit substitutes is discussed 
in section II.D of this appendix A.
    Recourse is the retention, in form or in substance, of any risk 
of loss directly or indirectly associated with an asset a bank has 
transferred that is in excess of the bank's pro rata share of the 
asset. A recourse arrangement typically arises when an institution 
transfers an asset and retains an obligation to repurchase the asset 
or to absorb losses on the asset arising from: (a) a default of 
principal or interest or (b) any other deficiencies in the 
performance of the underlying obligor or some other party.
    A direct credit substitute is the assumption, in form or in 
substance through a nonrecourse arrangement, of any risk of loss 
directly or indirectly associated with an asset or other claim in 
excess of the bank's pro rata share of the asset or other claim. A 
direct credit substitute arrangement typically arises when an 
institution issues a financial standby letter of credit, purchases a 
subordinated security that provides loss protection to more senior 
securities, or purchases servicing rights, such as mortgage 
servicing rights, that obligate the servicer to provide credit 
protection to the third party owners of the assets being serviced.
    For most direct credit substitutes, the amount of the bank's 
exposure to be converted into an on-balance sheet credit equivalent 
amount typically is the full face value of the direct credit 
substitute. However, for direct credit substitutes carried on the 
balance sheet that directly or indirectly absorb the first losses 
from an asset, pool of assets, or other claim, the full amount of 
the bank's off-balance sheet exposure that is to be converted is the 
entire outstanding principal amount of the asset, pool of assets, or 
other claim, less the amount of the on-balance sheet direct credit 
substitute which is itself being assigned to one of the four broad 
risk weight categories. This treatment applies regardless of whether 
the direct credit substitute fully or partially supports the asset, 
pool of assets, or other claim. The full amount of the bank's 
exposure to be converted may be the same or greater than the face 
value of the direct credit substitute. For instance, in the case of 
purchased subordinated securities that absorb first losses, the 
entire outstanding principal amount of all more senior securities 
that are supported by that subordinated interest (to the extent they 
are not already reported on the bank's balance sheet) are converted 
to an on-balance sheet credit equivalent amount.
    For risk-based capital purposes, nonstandard representations or 
warranties that a bank may extend in transferring assets (including 
the transfer of servicing rights) or assume in other transactions 
(including the acquisition of loan servicing rights) are treated as 
recourse or direct credit substitutes. Standard representations and 
warranties, which normally do not constitute recourse or direct 
credit substitutes for risk-based capital purposes, are contractual 
provisions referring to an existing set of facts that has been 
verified with reasonable due diligence by the seller or servicer at 
the time the assets are transferred or loan servicing rights are 
acquired. Standard representations and warranties are also generally 
accompanied by contractual provisions that provide for the return of 
the assets to the seller in instances of fraud or upon determination 
by the purchaser that the assets transferred are not fully and 
properly documented or otherwise as represented by the seller.
    A servicer cash advance is an arrangement under which the 
servicer of a loan advances funds to ensure an uninterrupted flow of 
payments to investors or the timely collection of loans. Funds 
advanced to ensure the timely collection of loans include 
disbursements made to cover foreclosure costs or other expenses 
incurred to facilitate the timely collection of a loan. A servicer 
cash advance does not constitute recourse or a direct credit 
substitute if: (a) the servicer is entitled to full reimbursement 
for the amount of the advance or (b) for any one loan, 
nonreimbursable amounts are contractually limited to an 
insignificant amount of the outstanding principal on that loan.
* * * * *
    D. * * *
    In order for an off-balance sheet item to be incorporated into a 
bank's risk-weighted assets, the on-balance sheet credit equivalent 
amount of the item must first be determined. Once the credit 
equivalent amount is determined, this amount is assigned to the 
appropriate risk category according to the obligor or, if relevant, 
the guarantor or the nature of the collateral. The method for 
determining the credit equivalent amount of an interest rate or 
foreign exchange rate contract is set forth in section II.E.1 of 
this appendix A. For most other types of off-balance sheet items, 
the on-balance sheet credit equivalent amount is determined by 
multiplying the full amount of the bank's exposure under the item by 
the applicable credit conversion factor as set forth below.
    However, in the case of direct credit substitutes--which are 
described in detail in sections II.B.6 and II.D.1 of this appendix 
A--that directly or indirectly absorb the first losses from an 
asset, pool of assets, or other claim, the full amount of the bank's 
exposure that must be converted to a credit equivalent amount is the 
entire outstanding principal amount of the asset, pool of assets, or 
other claim, less the amount of any on-balance sheet exposure 
associated with the item which is itself being assigned to one of 
the four risk weight categories. This treatment applies regardless 
of whether the direct credit substitute fully or partially supports 
the asset, pool of assets, or other claim. The full amount of the 
bank's exposure that must be converted to a credit equivalent amount 
may be the same as or greater than the face value of the direct 
credit substitute. For instance, in the case of financial standby 
letters of credit that absorb first losses, the entire outstanding 
principal amount of the customer's loan or debt instrument that is 
supported by the letter of credit is converted to an on-balance 
sheet credit equivalent amount.
    Generally, the full amount of the bank's exposure under an off-
balance sheet item is converted to an on-balance sheet credit 
equivalent amount and then incorporated in risk-weighted assets and, 
thus, is subject to a full effective risk-based capital charge. 
However, the aggregate capital requirement on a first loss direct 
credit substitute or a recourse transaction (including a transaction 
reported as a financing on a bank's balance sheet) is limited to the 
maximum contractual amount of loss to which the direct credit 
substitute or recourse arrangement exposes the bank if this amount 
is less than the full effective risk-based capital charge for the 
asset, pool of assets, or other claim that is supported by the bank.
    1. Items With a 100 Percent Conversion Factor. A 100 percent 
conversion factor applies to direct credit substitutes, which 
include guarantees, or equivalent instruments, backing financial 
claims, such as outstanding securities, loans, and other financial 
obligations, or backing off-balance sheet items that require capital 
under the risk-based capital framework. These direct credit 
substitutes include, for example, financial standby letters of 
credit, or other equivalent irrevocable undertakings or surety 
arrangements, that effectively guarantee repayment of financial 
obligations such as: commercial paper, tax-exempt securities, 
commercial or individual loans or other debt obligations, or standby 
or commercial letters of credit. As described in section II.B.6 of 
this appendix A, purchases of subordinated securities or of 
servicing rights may give rise to a direct credit substitute. The 
full amount of a bank's exposure under a direct credit substitute is 
converted at 100 percent and the resulting credit equivalent amount 
is assigned to the risk category appropriate to the obligor or, if 
relevant, the guarantor or the nature of the collateral.
* * * * *
    Therefore, the distinguishing characteristics of a financial 
standby letter of credit for risk-based capital purposes is the 
combination of irrevocability with the notion that funding is 
triggered by some failure to repay or perform on a financial 
obligation. Thus, any commitment (by whatever name) that involves an 
irrevocable obligation to make a payment to the customer or to a 
third party in the event the customer fails to repay an outstanding 
debt obligation will be treated, for risk-based capital purposes, as 
a financial standby letter of credit and the full amount of the 
bank's exposure under the letter of credit will be assigned a 100 
percent conversion factor. (Performance-related standby letters of 
credit are assigned a conversion factor of 50 percent.)
    A bank that has conveyed a risk participation\35\ in a direct 
credit substitute to a third party should convert the full amount of 
its exposure under the direct credit substitute at a 100 percent 
conversion factor without deducting the risk participations 
conveyed. However, portions of direct credit substitutes that have 
been conveyed as risk participations to U.S. depository institutions 
and OECD banks may then be assigned to the 20 percent risk category 
that is appropriate for claims guaranteed by U.S. depository 
institutions and OECD banks, rather than to the risk category 
appropriate to the account party obligor.\36\ A bank acquiring a 
risk participation in a direct credit substitute or bankers 
acceptance should convert the full amount of its exposure under the 
participation at 100 percent and then assign the credit equivalent 
amount to the risk category that is appropriate to the account party 
obligor or, if relevant, the guarantor or the nature of the 
collateral.
---------------------------------------------------------------------------

    \35\That is, participations in which the originating bank 
remains liable to the beneficiary for the full amount of the direct 
credit substitute if the party that has acquired the participation 
fails to pay when the instrument is drawn upon.
    \36\Risk participations with a remaining maturity of one year or 
less that are conveyed to non-OECD banks are also assigned to the 20 
percent risk weight category.
---------------------------------------------------------------------------

    In the case of direct credit substitutes that are structured in 
the form of a syndication as defined in the instructions for the 
preparation of the Consolidated Reports of Condition and Income 
(that is, where each bank is obligated only for its pro rata share 
of the risk and there is no recourse to the originating bank), each 
bank will only include its pro rata share of its exposure under the 
direct credit substitute in its risk-based capital calculation.
    Sale and repurchase agreements and asset sales with recourse, if 
not already included on the balance sheet, and forward agreements 
are also converted at 100 percent. Accordingly, the entire amount of 
any assets transferred with recourse that are not already included 
on the balance sheet, including pools of one-to-four family 
residential mortgages, is to be converted at 100 percent and 
assigned to the risk category appropriate to the obligor or, if 
relevant, the guarantor or the nature of the collateral. In certain 
recourse transactions (including those that are reported as 
financings on a bank's balance sheet) the amount of the bank's 
contractual liability may be limited to an amount less than the full 
effective risk-based capital requirement for the assets being 
transferred with recourse. In such cases, the amount of capital that 
must be maintained against the transaction is limited to the maximum 
amount of possible loss under the recourse provision. So-called 
``loan strips'' and similar arrangements involving short-term loans 
sold by a bank without direct recourse but subject to long-term loan 
commitments by the bank are accorded the same treatment for risk-
based capital purposes as assets sold with recourse. The definition 
of the term ``recourse'' is set forth in section II.B.6 of this 
appendix A. Forward agreements are legally binding contractual 
obligations to purchase assets with drawdown which is certain at a 
specified future date. These obligations include forward purchases, 
forward deposits placed, and partly paid shares and securities but 
do not include forward foreign exchange rate contracts or 
commitments to make residential mortgage loans.
* * * * *

DEPARTMENT OF THE TREASURY

Office of Thrift Supervision

12 CFR Chapter V

Authority and Issuance

    For the reasons set out in the preamble, part 567 of chapter V of 
title 12 of the Code of Federal Regulations is proposed to be amended 
as follows:
SUBCHAPTER D--REGULATIONS APPLICABLE TO ALL SAVINGS ASSOCIATIONS

PART 567--CAPITAL

    1. The authority citation for part 567 continues to read as 
follows:

    Authority: 12 U.S.C. 1462, 1462a, 1463, 1464, 1476a, 1828(note).

    2. Section 567.1 is amended by revising paragraphs (f) and (kk) and 
by adding new paragraphs (mm), (nn), (oo) and (pp) to read as follows:


Sec. 567.1  Definitions.

* * * * *
    (f) Direct credit substitute. The term direct credit substitute 
means the assumption, in form or substance (other than recourse 
obligations as defined in Sec. 567.1(kk)), of any risk of loss directly 
or indirectly associated with an asset or other claim, that exceeds the 
savings association's pro rata share of the asset or claim. If a 
savings association has no claim on an asset, the assumption of any 
risk of loss is a direct credit substitute. Direct credit substitutes 
include, but are not limited to:
    (1) Financial guarantee-type standby letters of credit that support 
financial claims on the account party;
    (2) Guarantees and guarantee-type instruments backing financial 
claims;
    (3) Purchased subordinated interests or securities that absorb more 
than their pro rata share of losses from the underlying assets; and
    (4) Purchased loan servicing rights if the servicer is responsible 
for losses associated with the loans being serviced (other than 
servicer cash advances as defined in Sec. 567.1(nn)), or if the 
servicer makes or assumes representations or warranties about the loans 
(other than standard representations and warranties as defined in 
Sec. 567.1(oo)).
* * * * *
    (kk) Recourse. The term recourse means the retention, in form or 
substance, of any risk of loss directly or indirectly associated with a 
transferred asset, that exceeds a pro rata share of the savings 
association's claim on the asset. If the savings association has no 
claim on a transferred asset, the retention of any risk of loss is 
recourse. A recourse obligation typically arises when an institution 
transfers assets and retains an obligation to repurchase the assets, or 
to absorb losses due to: a default of principal or interest; or any 
other deficiency in the performance of the underlying obligor or some 
other party. Recourse arrangements include, but are not limited to:
    (1) Representations or warranties about the transferred assets 
other than standard representations and warranties as defined in 
Sec. 567.1(oo);
    (2) Retained loan servicing rights if the servicer is responsible 
for losses associated with the loans serviced (other than servicer cash 
advances as defined in Sec. 567.1(nn));
    (3) Retained subordinated interests or securities that absorb more 
than a pro rata share of losses from the underlying assets;
    (4) Assets sold under an agreement to repurchase; and
    (5) Loan strips sold without direct recourse where the maturity of 
the participation is shorter than the maturity of the underlying loan.
* * * * *
    (mm) Public-sector entities. The term public-sector entities 
includes states, local authorities and governmental subdivisions below 
the central government level in an OECD-based country. In the United 
States, this definition encompasses a state, county, city, town or 
other municipal corporation, a public authority, and generally any 
publicly-owned entity that is an instrumentality of a state or 
municipal corporation. This definition does not include commercial 
companies owned by the public sector.
    (nn) Servicer cash advances. The term servicer cash advances means 
funds that a loan servicer advances to ensure an uninterrupted flow of 
payments or the timely collection of loans, including disbursements 
made to cover foreclosure costs or other expenses arising from a loan 
to facilitate its timely collection. A servicer cash advance is not a 
recourse arrangement (as defined in Sec. 567.1(kk)) or a direct credit 
substitute (as defined in Sec. 567.1(ff)), if:
    (1) The servicer is entitled to full reimbursement; or
    (2) For any one loan, nonreimbursed advances are contractually 
limited to an insignificant amount of the outstanding principal on that 
loan.
    (oo) Standard representations and warranties. The term standard 
representations and warranties means contractual provisions that a 
savings association extends when it transfers assets (including loan 
servicing rights) or assumes when it purchases loan servicing rights, 
that refer to existing facts at the time the assets are transferred or 
the servicing rights are acquired, and that have been verified with 
reasonable due diligence by the transferor or servicer. Standard 
representations and warranties also include contractual provisions for 
the return of assets in the event of fraud or documentation 
deficiencies. Standard representations and warranties are not recourse 
obligations as defined in Sec. 567.1(kk) or direct credit substitutes 
as defined in Sec. 567.1(ff).
    (pp) Standby letters of credit. (1) A financial guarantee-type 
standby letter of credit is any letter of credit, or similar 
arrangement, however named or described, which represents an 
irrevocable obligation to the beneficiary on the part of the issuer:
    (i) To repay money borrowed by or advanced to or for the account of 
the account party; or
    (ii) To make payment on account of any indebtedness undertaken by 
the account party, in the event that the account party fails to fulfill 
its obligation to the beneficiary.
    (2) A performance-based standby letter of credit is any letter of 
credit, or similar arrangement, however named or described, which 
represents an irrevocable obligation to the beneficiary on the part of 
the issuer to make payment on account of any default by the account 
party in the performance of a nonfinancial or commercial obligation.
    3. In Sec. 567.6, the first sentence of paragraph (a)(2) 
introductory text is revised, the fifth sentence of paragraph (a)(2) 
introductory text is removed, paragraph (a)(2)(i)(A) and (C) are 
removed and reserved, paragraph (a)(2)(i)(B) is revised, and a new 
paragraph (a)(3) is added to read as follows:


Sec. 567.6  Risk-based capital credit risk weight categories.

    (a) * * *
    (2) Off-balance sheet activities. Except for recourse obligations 
and direct credit substitutes which are specifically discussed in 
paragraph (a)(3) of this section, risk weights for off-balance sheet 
items are determined by the following two-step process. * * *
    (i) * * *
    (A) [Reserved]
    (B) Risk participations purchased in bankers acceptances;
    (C) [Reserved]
* * * * *
    (3) Recourse arrangements and direct credit substitutes--(i) Risk-
weighted asset amounts. To calculate the risk-weighted asset amount for 
a recourse arrangement or for a direct credit substitute, multiply the 
on-balance sheet credit equivalent amount by the appropriate risk 
weight using the criteria regarding obligors, guarantors, and 
collateral listed in paragraph (a)(1) of this section.
    (ii) On-balance sheet credit equivalent amount. Except as otherwise 
provided by this paragraph (a)(3), the on-balance sheet credit 
equivalent amount for a recourse arrangement or direct credit 
substitute is the amount of assets from which risk of loss is directly 
or indirectly retained or assumed. For the purposes of this paragraph 
(a)(3), the amount of assets from which risk of loss is directly or 
indirectly assumed or retained means:
    (A) For a financial guarantee-type standby letter of credit, 
guarantee, or other guarantee-type arrangement, the assets that the 
direct credit substitute fully or partially supports;
    (B) For a subordinated interest or security, the amount of the 
subordinated interest or security plus all more senior interests or 
securities;
    (C) For mortgage servicing rights that are recourse arrangements or 
direct credit substitutes, the outstanding amount of the loans 
serviced;
    (D) For representations and warranties (other than standard 
representations and warranties), the amount of the loans subject to the 
representations or warranties;
    (E) For assets sold with recourse, the amount of assets from which 
risk of loss is directly or indirectly retained excluding the amount of 
the recourse liability account established in accordance with GAAP 
standards; and
    (F) For loans strips that are recourse arrangements or direct 
credit substitutes, the amount of the loans.
    (iii) Second-loss position direct credit substitutes. The on-
balance sheet credit equivalent amount for certain direct credit 
substitutes is the face amount of the direct credit substitute if:
    (A) There is a prior credit enhancement that absorbs the first 
dollars of loss from the underlying assets that the direct credit 
substitute fully or partially supports; and
    (B) The direct credit substitute is a financial guarantee-type 
standby letter of credit, a guarantee or other guarantee-type 
arrangement that absorbs the second dollars of loss from the underlying 
assets.
    (iv) Participations. The on-balance sheet credit equivalent amount 
for a participation interest in a financial guarantee-type standby 
letter of credit, a guarantee or other guarantee-type is calculated as 
follows:
    (A) Determine the on-balance credit sheet equivalent amount as if 
the savings association held all of interests in the participation. See 
paragraph (a)(3)(ii) of this section (direct credit substitute in the 
first loss position) and paragraph (a)(3)(iii) of this section (direct 
credit substitute in the second loss position).
    (B) Multiply the on-balance sheet credit equivalent amount 
determined under paragraph (a)(3)(iv)(A) of this section by the 
percentage of the savings association's participation interest.
    (C) If the savings association is exposed to more than its pro rata 
share of the risk of loss on the direct credit substitute (e.g., the 
savings association remains secondarily liable on participations held 
by others), add to the amount computed under paragraph (a)(3)(iv)(B) of 
this section, an amount computed as follows: multiply the amount 
computed under paragraph (a)(3)(iv)(A) of this section, by the percent 
of the direct credit substitute held by others and the multiply the 
result by the risk weight appropriate for other holders of those 
interest. (Note: This risk-weighting is in addition to the risk-
weighting done to convert the on-balance sheet credit equivalent amount 
to the risk-weighted asset amount under paragraph (a)(3)(i) of this 
section.)
    (v) Related on-balance sheet assets. To the extent that an asset is 
included in the calculation of the capital requirement for a recourse 
arrangement or direct credit substitute under this paragraph (a)(3), 
and may also be included as an on-balance sheet asset under paragraph 
(a)(1) of this section, the asset shall be risk-weighted only under 
this paragraph (a)(3) except:
    (A) Excess mortgage servicing rights that are recourse 
arrangements, and purchased mortgage servicing rights and purchased 
credit card relationships that are direct credit substitutes are risk 
weighted as on-balance sheet assets under paragraph (a)(1) of this 
section, and the related recourse arrangements and direct credit 
substitutes are risk weighted under this paragraph (a)(3).
    (B) Purchased subordinated interests that are high quality 
mortgage-related securities are not subject to risk-weighting under 
this paragraph (a)(3). Rather, these assets are risk weighted as on-
balance sheet assets under paragraph (a)(1)(ii)(H) of this section.
    (vi) Limitations on risk-based capital requirement--(A) Low-level 
exposure. If the maximum contractual liability or exposure to loss 
retained or assumed by a savings association in connection with a 
recourse arrangement or direct credit substitute is less than the 
capital required to support the recourse obligation or direct credit 
substitute, the capital requirement is limited to the maximum 
contractual liability or exposure to loss. For assets sold with 
recourse, the amount of capital required to support the recourse 
obligation is limited to the maximum contractual liability or exposure 
to loss less the amount of the recourse liability account established 
in accordance with GAAP standards.
    (B) Mortgage-related securities or participation certificates 
retained in a mortgage loan swap. If a savings association holds a 
mortgage related security or a participation certificate as a result of 
a mortgage loan swap with recourse, capital is required to support that 
percentage of the mortgage related security or participation 
certificate that is not covered by the recourse obligation, and the 
recourse obligation. The total amount of capital required for the on-
balance sheet asset and the recourse obligation, however, is limited to 
the capital requirement for the underlying loans, calculated as if the 
savings association continued to hold these loans as an on-balance 
sheet asset.
    (vii) Obligations of subsidiaries. If a savings association retains 
a recourse arrangement or assumes a direct credit substitute on the 
obligation of a subsidiary that is not an includable subsidiary and the 
recourse obligation or direct credit substitute is an equity investment 
in the subsidiary under GAAP standards, the face amount of the recourse 
obligation or direct credit substitute is deducted from capital under 
Secs. 567.5(a)(2) and 567.9(c). All other recourse obligations and 
direct credit substitutes retained or assumed by a savings association 
on the obligations of a subsidiary are risk-weighted in accordance with 
paragraphs (a)(3) (i) through (vi) of this section.
* * * * *
    Dated: December 8, 1993.

Eugene A. Ludwig,
Comptroller of the Currency.
    By order of the Board of Directors.

    Dated at Washington, DC, this 12th day of April, 1994.

Federal Deposit Insurance Corporation.
Robert E. Feldman,
Acting Executive Secretary.
    Dated: May 4, 1994.

Board of Governors of the Federal Reserve System.
William W. Wiles,
Secretary of the Board.
    Dated: December 15, 1993.

    By the Office of Thrift Supervision.
Jonathan L. Fiechter,
Acting Director.
[FR Doc. 94-11513 Filed 5-24-94; 8:45 am]
BILLING CODE 4810-33-P, 6210-01-P, 6714-01-P, 6720-01-P