[Federal Register Volume 61, Number 174 (Friday, September 6, 1996)]
[Rules and Regulations]
[Pages 47358-47378]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-22546]
[[Page 47357]]
_______________________________________________________________________
Part IV
Department of the Treasury
Office of the Comptroller of the Currency
12 CFR Part 3
Federal Reserve System
12 CFR Parts 208 and 225
Federal Deposit Insurance Corporation
12 CFR Part 325
_______________________________________________________________________
Risk-Based Capital Standards: Market Risk; Joint Final Rule
Federal Register / Vol. 61, No. 174 / Friday, September 6, 1996 /
Rules and Regulations
[[Page 47358]]
DEPARTMENT OF THE TREASURY
Office of the Comptroller of the Currency
12 CFR Part 3
[Docket No. 96-18]
RIN 1557-AB14
FEDERAL RESERVE SYSTEM
12 CFR Parts 208 and 225
[Regulations H and Y; Docket No. R-0884]
FEDERAL DEPOSIT INSURANCE CORPORATION
12 CFR Part 325
RIN 3064-AB64
Risk-Based Capital Standards: Market Risk
AGENCIES: Office of the Comptroller of the Currency, Treasury; Board of
Governors of the Federal Reserve System; and Federal Deposit Insurance
Corporation.
ACTION: Joint final rule.
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SUMMARY: The Office of the Comptroller of the Currency (OCC), the Board
of Governors of the Federal Reserve System (Board), and the Federal
Deposit Insurance Corporation (FDIC) (collectively, the Agencies) are
amending their respective risk-based capital standards to incorporate a
measure for market risk to cover all positions located in an
institution's trading account and foreign exchange and commodity
positions wherever located. The final rule implements an amendment to
the Basle Capital Accord that sets forth a supervisory framework for
measuring market risk. The effect of the final rule is that any bank or
bank holding company (institution) regulated by the OCC, the Board, or
the FDIC, with significant exposure to market risk must measure that
risk using its own internal value-at-risk model, subject to the
parameters contained in this final rule, and must hold a commensurate
amount of capital.
DATES: Effective date: January 1, 1997.
Compliance date: Mandatory compliance January 1, 1998.
FOR FURTHER INFORMATION CONTACT:
OCC: Margot Schwadron, Financial Analyst, Roger Tufts, Senior
Economic Advisor, or Christina Benson, Capital Markets Specialist,
Office of the Chief National Bank Examiner (202/874-5070). For legal
issues, Andrew Gutierrez, Attorney, or Ron Shimabukuro, Senior
Attorney, Legislative and Regulatory Activities Division (202/874-
5090), Office of the Comptroller of the Currency, 250 E Street, SW,
Washington, D.C. 20219.
Board: Roger Cole, Deputy Associate Director (202/452-2618), James
Houpt, Assistant Director (202/452-3358), Barbara Bouchard, Supervisory
Financial Analyst (202/452-3072), Division of Banking Supervision and
Regulation; or Stephanie Martin, Senior Attorney (202/452-3198), Legal
Division. For the Hearing impaired only, Telecommunication Device for
the Deaf (TDD), Dorothea Thompson (202/452-3544), Federal Reserve
Board, 20th and C Streets, NW, Washington, D.C. 20551.
FDIC: William A. Stark, Assistant Director (202/898-6972), Miguel
Browne, Deputy Assistant Director (202/898-6789), Kenton Fox, Senior
Capital Markets Specialist (202/898-7119), Division of Supervision;
Jamey Basham, Counsel (202/898-7265), Legal Division, Federal Deposit
Insurance Corporation, 550 17th Street, NW, Washington, D.C. 20429.
SUPPLEMENTARY INFORMATION:
I. Background
The Agencies' risk-based capital standards are based upon
principles contained in the July 1988 agreement entitled
``International Convergence of Capital Measurement and Capital
Standards'' (Accord). The Accord, developed by the Basle Committee on
Banking Supervision (Committee) and endorsed by the central bank
governors of the Group of Ten (G-10) countries,1 provides a
framework for assessing an institution's capital adequacy by weighting
its assets and off-balance-sheet exposures on the basis of counterparty
credit risk. In April 1995, the Committee issued a consultative
proposal to amend the Accord and require institutions to measure and
hold capital to cover their exposure to market risk, specifically,
market risk associated with foreign exchange and commodity positions,
and with debt and equity positions located in the trading
account.2
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\1\ The G-10 countries are Belgium, Canada, France, Germany,
Italy, Japan, Netherlands, Sweden, Switzerland, the United Kingdom,
and the United States. The Committee is comprised of representatives
of the central banks and supervisory authorities from the G-10
countries and Luxembourg. The Agencies each adopted risk-based
capital standards implementing the Accord in 1989.
\2\ Market risk consists of general market risk and specific
risk. General market risk refers to changes in the market value of
on-balance-sheet assets and liabilities and off-balance-sheet items
resulting from broad market movements, such as changes in the
general level of interest rates, equity prices, foreign exchange
rates, and commodity prices. Specific risk refers to changes in the
market value of individual positions due to factors other than broad
market movements and includes such risks as the credit risk of an
instrument's issuer.
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Market Risk Proposal
On July 25, 1995, the Agencies published a joint proposal to amend
their respective risk-based capital standards in accordance with the
Committee's consultative proposal (60 FR 38082) (market risk proposal).
Under the market risk proposal, an institution with significant trading
activity must calculate a capital charge for market risk using either
its own internal risk measurement model (internal models approach) or a
risk-weighting process developed by the Committee (standardized
approach). The market risk proposal requires an institution to
integrate the market risk capital charge into its risk-based capital
ratios used for supervisory purposes no later than year-end 1997.
The proposed internal models approach requires an institution to
employ an internal model to calculate daily value-at-risk (VAR)
measures 3 for each of four risk categories: interest rates,
equity prices, foreign exchange rates, and commodity prices, including
related options in each category. For regulatory capital purposes, the
market risk proposal requires an institution to calibrate VAR measures
to a ten-day movement in rates and prices and a 99 percent confidence
level. An institution must base its VAR measures upon rates and prices
observed over a period of at least one year. In deriving the overall
VAR measure, an institution could take into account historical
correlations within a risk category (e.g., between interest rates), but
not across risk categories (e.g., not between interest rates and equity
prices); in other words, the overall VAR measure equals the sum of the
VAR measures for each risk category. An institution's capital charge
for general market risk equals the greater of (1) the previous day's
overall VAR measure, or (2) the average of the preceding 60 days'
overall VAR measures multiplied by a factor of three (the
multiplication factor). Moreover, the market risk proposal requires an
institution to hold additional capital for specific risk associated
with debt and equity positions in the trading account to the extent
that its internal model does not incorporate that risk.
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\3\ The VAR measure represents an estimate of the amount by
which an institution's positions in a risk category could decline
due to general market movements during a given holding period,
measured with a specified confidence level.
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Under the market risk proposal, an institution's supervisor
evaluates its internal modeling and risk management process to ensure
that the institution is,
[[Page 47359]]
in fact, using its internal model for risk management purposes, that
the calculation of VAR for capital purposes conforms with the specified
quantitative criteria, and that the risk management process meets
certain qualitative criteria, such as requiring independent model
validations 4 and having an independent risk management unit. The
market risk proposal allows an institution's supervisor to increase its
multiplication factor (which applies to the 60-day VAR average) if
backtesting results suggest problems with the institution's internal
model or risk management process.
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\4\ The proposed qualitative criteria identify backtesting and
stress testing as two model validation techniques. Backtests provide
information about the accuracy of an internal model by comparing an
institution's daily VAR measures to its corresponding daily trading
profits and losses. Stress tests provide information about the
impact of adverse market events on an institution's positions.
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The standardized approach, the market risk proposal's alternative
to the internal models approach, requires an institution to apply
certain uniform techniques to calculate a capital charge for the
general market risk of positions in the four risk categories, as well
as for the specific risk of debt and equity positions located in the
trading account. The total capital charge is the sum of the capital
charges for each risk category.
An institution supports its market risk capital charges using a
combination of Tier 1 and Tier 2 capital instruments (as defined in the
credit risk-based capital standards), as well as a proposed new type of
capital (Tier 3). Generally, Tier 3 capital consists of short-term
subordinated debt subject to certain criteria, including a lock-in
provision that prevents the issuer from repaying the debt even at
maturity if the issuer's risk-based capital ratio is less than 8.0
percent following the payment.
In December 1995, the G-10 Governors endorsed a final amendment to
the Accord adopting, with some modification, the Committee's market
risk consultative proposal. At that same time, the Committee issued
supervisory guidance specifying the effect of backtesting results on an
institution's multiplication factor.
Backtesting Proposal
On March 7, 1996, the Agencies published for public comment a joint
proposal on backtesting (61 FR 9114) (backtesting proposal) that
reflected the Committee's backtesting guidance. The backtesting
proposal requires an institution to compare its daily net profits and
losses for the most recent 250 business days to the corresponding daily
VAR measures generated for internal risk management purposes, using a
99 percent confidence level and a one-day period of rate and price
movement. Each day for which a net trading loss exceeds the
corresponding VAR measure is counted as an exception. An institution
with five or more exceptions is presumed to have an inaccurate internal
model and must increase its multiplication factor from three up to a
maximum of four, depending on the number of exceptions. The backtesting
proposal requires an institution to begin backtesting one year after it
begins to calculate market risk capital charges. The delayed effective
date for backtesting provides an institution with sufficient time to
accumulate the required data for 250 business days.
II. Comment Summary
Market Risk Proposal
Together, the Agencies received 33 public comments on the market
risk proposal. Commenters strongly supported the proposed internal
models approach.5 Most commenters believed that approach provides
greater accuracy in measuring market risk than the standardized
approach and creates incentives for institutions to continue improving
their risk modeling and management techniques. Nevertheless, most
commenters stated that the proposed modeling constraints were
unnecessarily rigid and, especially when combined with the
multiplication factor of three, result in excessive capital charges.
The following discussion summarizes the responses to the Agencies'
specific questions about the proposal.
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\5\ Early versions of the Basle Committee's market risk
amendment did not allow for the use of internal models to determine
capital charges.
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General Topics
The Agencies asked commenters about the proposed criteria for
determining which institutions must calculate capital charges for
market risk. As proposed, the rule applied to: (1) Any institution with
total assets exceeding $5 billion and either trading activity totaling
at least 3 percent of total assets or the notional amount of trading
account derivative contracts in excess of $5 billion; and (2) any
institution with total assets of $5 billion or less and trading
activity representing at least 10 percent of total assets. Commenters
generally agreed that an institution with significant exposure to
market risk should hold capital against that exposure. However, some
believed it inappropriate to use the notional amount of trading account
derivative contracts as a criterion. Further, some objected to
different criteria for institutions of different asset size.
The Agencies asked about the burden associated with applying the
market risk measure to both banks and bank holding companies and, with
regard to bank holding companies, the burden associated with applying
the measure both with and without Section 20 subsidiaries. The Agencies
received mixed comments on the bank and bank holding company issue.
Some believed the measure should apply only at the bank holding company
level, pointing out that market risk usually is managed on a
consolidated basis at the bank holding company level. Some favored
applying the measure at the bank level. Others believed that an
institution should have a choice, depending on how it manages risk.
Most commenters discussing the Section 20 subsidiary issue supported
applying the rule on a fully consolidated basis (i.e., including
Section 20 subsidiaries).
The Agencies also asked whether to allow an institution to choose
either the standardized or internal models approaches, whether to allow
an institution to combine the two approaches for different risk
categories, and whether the two approaches result in similar capital
charges. While some commenters supported the flexibility of choosing
between the internal models and standardized approaches, those
commenters who anticipated that they would be subject to the market
risk capital requirements indicated that they intend to use only the
internal models approach. Other commenters thought that a choice of
approaches could be useful in certain situations, for example, when an
institution suddenly meets the applicability criteria but does not have
a completely developed internal model. Several commenters expressed
concerns about the accuracy of the standardized approach and urged its
elimination. The few commenters that addressed the question about
combining the two approaches supported the flexibility that this could
provide. A few commenters stated that capital charges would be higher
under the internal models approach than under the standardized
approach.6
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\6\ The summary does not include comments on particular issues
that might arise in applying the standardized approach (other than
comments on specific risk) because, as discussed below, the Agencies
have decided not to adopt the standardized approach in the final
rule. Public comments are available from the Board's and OCC's
Freedom of Information Office and the FDIC's Reading Room.
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[[Page 47360]]
The Internal Models Approach
The market risk proposal imposed several quantitative standards on
VAR measures used for regulatory capital purposes. The Agencies asked
about the potential burden associated with these standards and whether
the resulting capital charge sufficiently covered market risk.
Commenters overwhelmingly responded that the proposed modeling
constraints were unnecessarily rigid and would result in an excessive
capital charge. Many commenters suggested the Agencies allow an
institution to use the same internal modeling parameters for regulatory
capital purposes as for internal risk management.
Modeling Constraints. With regard to the proposed modeling
constraints, a few commenters supported basing capital charges on a
ten-day period of rate and price movements. Others indicated that the
period was too long, with most suggesting a one-day period. Some
commenters objected to any specified period. Several commenters opposed
the proposed 99 percent confidence level, noting that many institutions
use lower confidence levels. Others supported the proposed level and
still others suggested that regulators should not specify a confidence
level.
Many commenters strongly asserted that the proposed multiplication
factor of three was too high and suggested, instead, a minimum factor
of one. Most of these commenters believed that the proposal did not
adequately explain the rationale for a multiplication factor greater
than one. Several asked for clarification about how the Agencies will
measure a model's accuracy and adjust an institution's multiplication
factor. They advocated objective, well-defined criteria to ensure that
the Agencies apply the rules consistently.
Commenters strongly opposed the proposal's requirement that an
institution aggregate VAR measures by simple summation across the risk
categories. They asserted that ignoring the effects of cross
correlation among risk categories overstates exposure and understates
the merits of diversified portfolios.
The Agencies asked whether to require an institution to calculate
VARs using two observation periods. Specifically, the Agencies asked
about the tradeoff between enhanced prudential coverage and additional
burden associated with requiring an institution to make two VAR
measures, one based on a short observation period and one based on a
longer (over one year) period. Most commenters believed dual
observation periods would result in unnecessary costs and operational
burden. Commenters had varying opinions about the optimal length of
time for an observation period. Some commenters suggested that the
Agencies allow an institution to choose an appropriate observation
period.
Backtesting. The Agencies asked for comments about the potential
burden associated with backtesting to evaluate the accuracy of an
institution's internal model. Commenters generally viewed backtesting
as a useful tool for model validation purposes. Most believed that
backtesting should compare an institution's VAR calculated for internal
risk management purposes (rather than for regulatory capital purposes)
with actual profits and losses. A few commenters, noting the developing
nature of backtesting generally, urged regulators not to prescribe
specific regulations, guidelines, or methodologies for backtesting.
The Agencies also asked for comment about the types of stress tests
institutions should perform as part of their internal risk management
process. Several commenters recognized generally the importance of
stress testing. These and other commenters responded that the Agencies
should allow an institution to choose its methodology. Other commenters
questioned whether a stress testing requirement was necessary.
Specific Risk. The Agencies noted that the internal models approach
requires an institution to add a specific risk capital charge
calculated using the standardized approach if its internal model does
not adequately capture specific risk, and asked what modeling
techniques the Agencies should consider when evaluating an
institution's model for specific risk. While commenters generally
agreed that an institution should integrate specific risk into its
internal model, several objected to using capital charges calculated
under the standardized approach as the benchmark for specific risk
under the internal models approach. A few commenters asked for
clarification about what constitutes sufficient integration of specific
risk into a model to avoid the add-on capital charge. Some commenters
noted that internal models that incorporate specific risk elements are
still in the development stage, and stated that the Agencies should not
include a specific risk requirement in the internal models approach.
The Agencies asked whether they should specifically define the term
``liquid and well-diversified,'' as applied to specific risk in
equities, entitling an institution to a lower capital charge under the
standardized approach. Commenters differed as to the appropriate degree
of specificity. Some preferred a qualitative definition, as proposed,
and others supported a more explicit and objective definition.
Other Issues
Some commenters raised issues not directly addressed in the
Agencies' specific questions on the market risk proposal. One commenter
suggested that an institution could determine internally whether to
classify a debt instrument as qualifying or non-qualifying for purposes
of determining the applicable specific risk weight factor (qualifying
instruments receive a lower specific risk charge than non-qualifying
instruments). Another commenter recommended a zero percent specific
risk charge for debt instruments issued by local and regional
governments. Another recommended a zero percent specific risk charge
for instruments tracking an equity index.
Several commenters said that the proposed qualitative standards for
an institution's risk management system were reasonable. One
institution noted the qualitative standards provided a comprehensive
set of guidelines. Some commenters questioned the marketability of
short-term subordinated debt included as Tier 3 capital. A few
commenters discussed the relationship between market risk and credit
risk, with some arguing that when aggregating capital charges for
credit and market risk the Agencies should permit an institution to
recognize correlations between the two types of risk.
Backtesting Proposal
Together, the Agencies received 17 public comments on the
backtesting proposal. Commenters to that proposal generally supported
backtesting as a useful component of risk management. Several expressed
concern that the proposal was unnecessarily rigid, noting that
backtesting techniques are evolving, and suggested that the Agencies
reexamine backtesting prior to implementation of the final rule. A few
commenters questioned linking backtesting results to capital
requirements. Some commenters expressed the view that the Agencies
should take into account the severity of an exception, not just the
number of exceptions. Other commenters believed that the Agencies
should base capital requirements on an overall evaluation of an
institution's risk management process and not merely on the number of
exceptions. A few commenters suggested that the Agencies retain the
[[Page 47361]]
flexibility to adjust the multiplication factor below three if an
institution's model exhibits superior performance.
Among other specific questions, the Agencies asked about the merits
and problems associated with backtesting hypothetical trading outcomes
(profits and losses) versus backtesting actual trading outcomes.7
Almost all commenters supported using actual trading outcomes for
backtesting purposes rather than hypothetical outcomes. One commenter
supported giving an institution the option of what type of outcomes it
will backtest. Commenters who supported using actual trading outcomes
believed that these results appropriately included such factors as
gains and losses from trading activity, fee income, net interest
income, and management responses to changing portfolio conditions.
Commenters who objected to using hypothetical results noted that costs
associated with creating and operating a system for determining
hypothetical results were significant. Other commenters discussed the
potential burden of requiring an institution to calculate daily profits
and losses with an unreasonable degree of exactness. They noted that
global VARs are calculated by simulating changes in all market factors
and calculating resulting changes in portfolio values. They suggested
letting an institution estimate daily profit and losses using a
consistent, reasonable methodology.
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\7\ Generally, hypothetical outcomes are trading outcomes that
would result if the trading position as of the end of one business
day went unchanged during the next business day. Hypothetical
outcomes differ from actual outcomes because of the effects of such
items as changes in portfolio composition over the holding period,
fee income, commissions, and income from trading.
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The Agencies asked for comment on what types of events or regime
shifts (i.e., dramatic changes in market conditions that result in
numerous exceptions in a short period of time for the same reason)
might generate exceptions that do not warrant an increase in an
institution's multiplication factor. Several commenters asserted that
the Agencies should not list the types of regime shifts in advance. Two
commenters suggested that the Agencies should treat any market-wide or
asset-class event affecting a large number of institutions as a regime
shift. Commenters suggested the following examples of regime shifts:
sudden abnormal changes in interest or exchange rates, major political
events, and natural disasters. Some commenters suggested that the
Agencies should take into account an institution's reaction to
unanticipated trading results, such as how it adapts its internal model
to take into account changed conditions. A few commenters stated the
Agencies should not penalize an institution for exceptions after it
adjusts its model.
The Agencies asked about the proposed sample size of 250
independent observations. While several commenters on this question
responded that the proposed sample size was appropriate, some believed
that an institution should have flexibility to increase or decrease the
sample size. A few commenters asserted that all institutions should use
the same sample size.
Finally, the Agencies asked whether to require an institution to
backtest against its VAR measures generated for internal risk
management purposes, or against VAR measures calculated for market risk
capital requirements. Most commenters supported the former approach.
III. Final Rule
The Agencies believe it is important for an institution with
significant market risk to measure its exposure and hold commensurate
amounts of capital. The Agencies support the market risk amendment to
the Accord and are now issuing uniform market risk standards that will
implement that amendment for institutions regulated by the Agencies.
The final rule incorporates a measure for exposure to market risk into
the Agencies' credit risk-based capital standards. By January 1, 1998,
an institution that meets the applicability criteria must use its
internal model to measure its exposure to market risk and hold capital
in support of that exposure. The Agencies concur with commenters that
an institution with significant exposure to market risk can most
accurately measure that risk using detailed information available to
the institution about its particular portfolio processed by its own
risk measurement model. The final rule does not include the proposed
standardized approach for measuring general market risk. The final rule
does retain, however, the standardized approach methodologies for
determining capital charges for specific risk, which an institution
must use as the basis for its specific risk charge for debt and equity
positions in its trading account.
The final rule supplements the existing credit risk-based capital
standards by requiring an affected institution to adjust its risk-based
capital ratio to reflect market risk. Specifically, an institution must
adjust its risk-based capital ratio to take into account the general
market risk of all positions located in its trading account and of
foreign exchange and commodity positions, wherever located.
Additionally, the institution must account for the specific risk of
debt and equity positions located in its trading account. The positions
covered by this final rule (except for foreign exchange positions
outside the trading account and over-the-counter (OTC) derivatives) are
excluded from the credit risk capital charge. Foreign exchange
positions outside the trading account and OTC derivatives are subject
to the market risk capital charge, as well as the credit risk capital
charge.
Thus, the minimum capital charge for an institution that meets the
applicability criteria is its credit risk capital charge as calculated
under the Agencies' credit risk-based capital standards (excluding the
positions previously noted) plus its measure for market risk as
calculated under this final rule. The institution's risk-based capital
ratio adjusted for market risk is its risk-based capital ratio for
purposes of prompt corrective action and other statutory and regulatory
purposes.
Subject to supervisory approval that its internal model and risk
management processes meet the final rule's regulatory criteria, an
institution may choose to comply with the final rule as early as
January 1, 1997. Any institution that voluntarily complies with the
final rule prior to January 1, 1998, must comply with all of its
provisions, except for the backtesting provisions, which apply one year
after the institution begins to comply with the other provisions of the
final rule.
Institutions Subject to the Final Rule (Section 1(b))
The Agencies agree with commenters that all institutions with
significant market risk, regardless of size, should measure their
exposure and hold appropriate levels of capital. Thus, the Agencies
have revised the applicability criteria to eliminate the differential
criteria based on total asset size. The Agencies believe that the
capital requirements are appropriate both for an institution whose
trading activity is large relative to its total assets, and for an
institution with a substantial volume of trading activity.
The final rule applies to any bank or bank holding company whose
trading activity equals 10 percent or more of its total assets, or
whose trading activity equals $1 billion or more.8 For purposes
[[Page 47362]]
of these criteria, an institution's trading activity is defined as the
sum of its trading assets and trading liabilities as reported in its
most recent Consolidated Report of Condition and Income (Call Report)
for a bank, or its most recent Y-9C Report for a bank holding company.
Total assets means quarter-end total assets as most recently reported
by the institution.
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\8\ The Federal Reserve agrees with commenters that since market
risk usually is managed on a consolidated basis at the bank holding
company level, market risk should be measured at that level for
risk-based capital purposes. Thus, the final rule applies to bank
holding companies on a fully consolidated basis. In addition,
because the Accord applies to internationally active banks, the
final rule applies to consolidated banks. The Agencies may monitor
the market risk exposure of institutions on a non-consolidated basis
to ensure that significant imbalances within an organization do not
avoid supervision.
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In addition, on a case-by-case basis, an Agency may require an
institution that does not meet the applicability criteria to comply
with the final rule if the Agency deems it necessary for safety and
soundness purposes, or may exclude an institution that meets the
applicability criteria. For example, an Agency may require an
institution with trading activity less than $1 billion and less than 10
percent of total assets, but with significant foreign exchange exposure
outside of its trading account to comply with the provisions of the
final rule. On the other hand, an Agency may exempt an institution with
trading activity that exceeds 10 percent of its total assets as a
result of accounting, operational, or similar considerations, provided
this does not raise safety and soundness concerns.
An institution that does not meet the applicability criteria may,
subject to supervisory approval, comply voluntarily with the market
risk rule, but only if it complies with all of the final rule's
provisions (e.g., the backtesting requirements, after accumulating
sufficient trading outcomes).
Covered Positions (Section 2(a))
An institution subject to the final rule must hold capital to
support its exposure to general market risk arising from fluctuations
in interest rates, equity prices, foreign exchange rates, and commodity
prices and its exposure to specific risk associated with certain debt
and equity positions. Covered positions include all positions in an
institution's trading account and foreign exchange and commodity
positions throughout the institution (whether or not in the trading
account).
For market risk capital purposes, an institution's trading account
is defined in the instructions to the Call Report. For example, the
trading account includes on- and off-balance-sheet positions in
financial instruments acquired with the intent to resell in order to
profit from short-term price or rate movements (or other price or rate
variations). An institution may include in its measure for general
market risk certain non-trading account instruments that it
deliberately uses to hedge trading positions. Those instruments are not
subject to a specific risk capital charge, but instead, remain subject
to the credit risk capital requirements. An institution may not include
items in, or exclude items from, its trading account to manipulate
associated capital charges. All positions included in the trading
account must be marked to market and reflected in an institution's
earnings statement.
The market risk capital charge applies to all of an institution's
foreign exchange and commodities positions. An institution's foreign
exchange positions include, for each currency, such items as its net
spot position (including ordinary assets and liabilities denominated in
a foreign currency), forward positions, guarantees that are certain to
be called and likely to be unrecoverable, and any other items that
react primarily to changes in exchange rates. An institution may,
subject to supervisory approval, exclude from the market risk measure
any structural positions in foreign currencies. For this purpose,
structural positions include transactions designed to hedge an
institution's capital ratios against the effect of adverse exchange
rate movements on (1) subordinated debt, equity, or minority interests
in consolidated subsidiaries and capital assigned to foreign branches
that are denominated in foreign currencies, and (2) any positions
related to unconsolidated subsidiaries and other items that are
deducted from an institution's capital when calculating its capital
base. An institution's commodity positions include all positions that
react primarily to changes in commodity prices.
Adjustment to the Risk-Based Capital Ratio Calculation (Section 3)
An institution subject to the final rule must measure its market
risk and hold capital on a daily basis to maintain an overall minimum
8.0 percent ratio of total qualifying capital to risk-weighted assets
adjusted for market risk.
Risk-Based Capital Ratio Denominator (Section 3(a))
An institution's risk-based capital ratio denominator equals its
adjusted risk-weighted assets plus its market risk equivalent assets.
Adjusted risk-weighted assets are risk-weighted assets, as determined
under the credit risk-based capital standards, less the risk-weighted
amounts of all covered positions other than foreign exchange positions
outside the trading account and OTC derivatives. Covered positions
(except for foreign exchange positions outside the trading account and
OTC derivatives) are no longer subject to a credit risk capital charge.
An institution's market risk equivalent assets equals the measure for
market risk, as determined under this final rule, multiplied by 12.5
(the reciprocal of the minimum 8.0 percent capital ratio).
Measure for Market Risk (Section 3(a)(2))
The measure for market risk consists of an institution's VAR-based
capital charge plus an add-on capital charge for specific risk.\9\ The
VAR-based capital charge is the larger of either (1) the average VAR
measure for the last 60 business days, calculated under the regulatory
criteria and increased by a multiplication factor of between three and
four; or (2) the previous day's VAR, calculated under the regulatory
criteria but without the multiplication factor. An institution's
multiplication factor is three unless its backtesting results indicate
that a higher factor is appropriate or unless the institution's
supervisor determines that another action is appropriate.
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\9\ The final rule also provides that, on a case-by-case basis,
an Agency may permit an institution to measure de minimis exposures
to market risk using other techniques, provided the exposure is
truly de minimis, the associated risk is adequately measured, and
integration of the exposure into the institution's internal model
would impose an unnecessary regulatory burden.
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The Agencies believe this comparative approach will result in an
institution holding capital sufficient to cover peak levels of market
volatility. While the Agencies acknowledge some commenters' concerns
that a multiplication factor of three (or higher) imposes excessive
capital charges, the Agencies believe that adjustments in the final
rule to the internal models approach (e.g., requiring only a single
observation period and recognizing cross correlations among risk
categories) result in capital charges that are appropriate, given
existing industry practices. As institutions implement the final rule,
the Agencies will monitor resulting capital charges, will continue to
evaluate the appropriateness of the multiplication factor, and may
consider further refinements or adjustments to the final rule.
[[Page 47363]]
Risk-Based Capital Ratio Numerator (Section 3(b))
An institution's risk-based capital ratio numerator consists of a
combination of core (Tier 1) capital, supplemental (Tier 2) capital\10\
and a third tier of capital (Tier 3), which consists of short-term
subordinated debt that meets certain conditions. Specifically, Tier 3
capital must have an original maturity of at least two years; it must
be unsecured and fully paid up; it must be subject to a lock-in clause
that prevents the issuer from repaying the debt even at maturity if the
issuer's capital ratio is, or with repayment would become, less than
the minimum 8.0 percent risk-based capital ratio; it must not be
redeemable before maturity without the prior approval of the
institution's supervisor; and it must not contain or be covered by any
covenants, terms, or restrictions that may be inconsistent with safe
and sound banking practices. An institution may use Tier 3 capital only
to meet market risk capital requirements.
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\10\ Tier 1 and Tier 2 capital components are discussed in the
Agencies' credit risk capital standards. Generally, Tier 1 includes
common stockholder's equity, noncumulative perpetual preferred
stock, and minority equity interests in consolidated subsidiaries,
less goodwill and other deductions. Bank holding companies may
include certain amounts of cumulative perpetual preferred stock in
Tier 1. Tier 2 includes the allowance for loan and lease losses,
other preferred stock, and subordinated debt with an original
average maturity of at least five years.
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To determine its risk-based capital ratio numerator, an institution
should first allocate Tier 1 and Tier 2 capital equal to 8.0 percent of
its risk-weighted assets (adjusted for the positions that are no longer
subject to the credit risk rules). Next, the institution should
allocate Tier 1, Tier 2, and Tier 3 capital to support its measure for
market risk. The risk-based capital ratio numerator (i.e., total
qualifying capital), is the sum of Tier 1 capital (whether or not
allocated for credit risk or market risk), Tier 2 capital (whether or
not allocated for credit risk or market risk and subject to certain
limits), and Tier 3 capital (allocated for market risk and subject to
certain limits).
The Agencies continue to believe that Tier 1 capital should
constitute a substantial proportion of an institution's total capital.
Thus, the final rule includes the existing credit risk-based capital
constraints that at least 50 percent of an institution's total
qualifying capital must be Tier 1 capital, and that term subordinated
debt (and intermediate-term preferred stock and related surplus) may
not exceed 50 percent of Tier 1 capital. In addition, the sum of Tier 2
and Tier 3 capital allocated for market risk must not exceed 250
percent of Tier 1 capital allocated for market risk. This requirement
means that an institution must support at least 28.6 percent of its
measure for market risk with Tier 1 capital.
Internal Models (Section 4)
The Agencies recognize that institutions can and will use different
assumptions and modeling techniques and that such differences often
reflect distinct business strategies and approaches to risk management.
For example, an institution may calculate VAR using internal models
based on variance-covariance matrices, historical simulations, Monte
Carlo simulations, or other statistical approaches. In all cases,
however, the model must cover the institution's material risks.\11\
While the Agencies are not specifying modeling parameters for internal
risk management purposes, the final rule does include minimum
qualitative requirements for internal risk management processes, as
well as certain quantitative requirements for the parameters and
assumptions for internal models used to measure market risk exposure
for regulatory capital purposes.
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\11\ For an institution using an externally developed or
outsource risk measurement model, the model may be used for risk-
based capital purposes provided it complies with the requirements of
the final rule, management fully understands the model, the model is
integrated into the institution's daily risk management, and the
institution's overall risk management process is sound.
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Qualitative Requirements (Section 4(b))
The qualitative requirements reiterate several basic components of
sound risk management. For example, one of the final rule's qualitative
requirements is that an institution must have a risk control unit that
reports directly to senior management and that is independent from
business trading functions. The Agencies expect that a risk control
unit will conduct regular backtests to evaluate the model's accuracy
and stress tests to identify the impact of adverse market events on the
institution's portfolio.
The other qualitative requirements in the final rule are also
elements of sound risk management practices. For example, an
institution must have an internal model that is integrated into its
daily management, must have policies and procedures for conducting
appropriate stress tests and backtests and for responding to the
results of those tests, and must conduct independent reviews of its
risk measurement and management systems at least annually.
The Agencies agree with commenters that an institution should
develop and use stress tests appropriate to its particular situation.
Thus, the final rule does not require specific stress test
methodologies. The Agencies expect an institution to conduct stress
tests that are rigorous and comprehensive and that cover a range of
factors that could create extraordinary losses in a trading portfolio,
or make the control of risk in a portfolio difficult. The Agencies
believe stress tests should be both qualitative and quantitative,
should incorporate both market risk and liquidity aspects of market
disturbances, and should reflect the impact of an event on positions
with linear and non-linear price characteristics. Where stress tests
reveal a particular vulnerability, the institution should take
effective steps to appropriately manage those risks.
An institution's independent review of its risk management process
should include both the activities of business trading units and the
risk control unit. For example, the Agencies expect that an
institution's review would include assessing whether its risk
management system is fully integrated into the daily management process
and whether its risk management system is adequately documented. The
review should evaluate the organizational structure of the risk control
unit and analyze the approval process for risk pricing models and
valuation systems. The review should also consider the scope of market
risks captured by the risk measurement model, the accuracy and
completeness of position data, the verification of the consistency,
timeliness, and reliability of data sources used to run the internal
model, the accuracy and appropriateness of volatility and correlation
assumptions, and the validity of valuation and risk transformation
calculations.
Market Risk Factors (Section 4(c))
The final rule provides that an institution's internal model must
use risk factors that address market risk associated with interest
rates, equity prices, exchange rates, and commodity prices, including
the market risk associated with options in each of these risk
categories. Although an institution has discretion to use market risk
factors that it has determined affect the value of its positions and
the risks to which it is exposed, the Agencies expect an institution to
use sufficient risk factors to cover the risks inherent in its
portfolio.
[[Page 47364]]
For example, the Agencies believe that interest rate risk factors
should correspond to interest rates in each currency in which the
institution has interest-rate-sensitive positions. The risk measurement
system should model the yield curve using one of a number of generally
accepted approaches, such as by estimating forward rates or zero coupon
yields, and should incorporate risk factors to capture spread risk. The
yield curve should be divided into various maturity segments to capture
variation in the volatility of rates along the yield curve. For
material exposures to interest rate movements in the major currencies
and markets, modeling techniques should capture at least six segments
of the yield curve.
The risk measurement system should incorporate risk factors
corresponding to individual foreign currencies in which the
institution's positions are denominated, to each of the equity markets
in which the institution has significant positions (at a minimum, a
risk factor should capture market-wide movements in equity prices), and
to each of the commodity markets in which the institution has
significant positions. Risk factors should measure the volatilities of
rates and prices underlying option positions. An institution with a
large or complex options portfolio should measure the volatilities of
options positions by different maturities. The sophistication and
nature of the modeling techniques should correspond to the level of the
institution's exposure.
Quantitative Requirements (Section 4(d))
While an institution has flexibility in developing the precise
nature of its model for internal risk management purposes, the Agencies
continue to believe that when determining capital charges for exposure
to market risk an institution's VAR measures should meet certain
quantitative requirements. Such requirements are designed to ensure
that an institution with significant market risk holds prudential
levels of capital and that capital charges are sufficiently consistent
across institutions with similar exposures. The Agencies have
considered commenters' concerns that the proposed modeling constraints,
when combined, would result in excessive capital charges. The Agencies
believe that certain of the proposed constraints, such as a 99 percent
(one-tailed) confidence level and a ten-day movement in rates and
prices, are appropriate and therefore they have been retained in the
final rule. However, the Agencies agree with commenters that other
proposed or considered requirements are not necessary. For example, the
Agencies have determined that a dual observation period would
unnecessarily increase regulatory burden without providing a
substantial benefit. Thus, the final rule employs a single observation
period.
The Agencies also agree with commenters that, for regulatory
capital purposes, an institution should be permitted to use models that
recognize cross correlations among risk categories. The final rule
permits an institution to recognize cross correlations. The Agencies
believe this revision eliminates a significant source of rigidity in
the market risk proposal and should result in internal modeling for
capital purposes that is more consistent with observed industry
practice. The Agencies also believe this revision will appropriately
recognize and reward portfolio diversification. These adjustments to
the quantitative requirements are consistent with the final amendment
to the Accord.
The final rule contains the following quantitative requirements for
an institution's VAR measures, upon which regulatory capital
requirements are based:
(1) VAR measures must be computed each business day based on a 99
percent (one-tailed) confidence level of estimated maximum loss.
(2) VAR measures must be based on a price shock equivalent to a
ten-day movement in rates or prices. An institution may adjust VAR
measures (including VAR measures for options) based on shorter periods
to a ten-day standard (e.g., by multiplying by the square root of
time).12 The Agencies do not believe that a price or rate movement
period less than ten days is sufficient to reflect the risk associated
with options positions (or other instruments with non-linear price
characteristics), but recognize that it may be overly burdensome for an
institution to apply a ten-day price or rate movement to such positions
at this time. The Agencies expect an institution with concentrations of
options to make substantive progress in developing a modeling system
that measures the non-linear price characteristics of options positions
(or other instruments with non-linear price characteristics), over a
full ten-day period.
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\12\ For example, under certain statistical assumptions, an
institution can estimate the ten-day price volatility of an
instrument by multiplying the volatility calculated on one-day
changes by the square root of ten (approximately 3.16).
---------------------------------------------------------------------------
(3) Internal models must include the non-linear price
characteristics of options positions and the sensitivity of the market
value of those positions to changes in the volatility of the option's
underlying rates and prices.
(4) VAR measures must be based on a minimum historical observation
period of at least one year for estimating future price and rate
changes. A model that uses a weighting scheme or other method for the
historical observation period must use an effective observation period
of at least one year. That is, the weighted average time lag of the
individual observations must be at least six months, the figure that
would prevail in an equally weighted one-year observation period.
(5) An institution must update its model data at least once every
three months and more frequently if market conditions warrant.
(6) VAR measures may incorporate empirical correlations (calculated
from historical data on rates and prices) both within broad risk
categories and across broad risk categories, subject to agreement by
the institution's supervisor that the model's system for measuring such
correlation is sound. If an institution's model does not incorporate
empirical correlations across risk categories, then the bank must
calculate the VAR measures used for regulatory capital purposes by
summing the separate VAR measures for the four broad risk categories
(i.e., interest rates, equity prices, foreign exchange rates, and
commodity prices).
The Agencies believe that, taken together, the modeling parameters
are appropriate for regulatory capital purposes and also that they are
compatible, as much as practicable, with existing modeling procedures.
During the examination process, the Agencies will review an
institution's risk management process and internal model to ensure that
the model processes all relevant data and that modeling and risk
management practices conform to the parameters and requirements of the
final rule.13
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\13\ When reviewing an institution's internal model for risk-
based capital purposes, the Agencies may consider reports and
opinions about the accuracy of the model that have been generated by
external auditors or qualified consultants.
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Backtesting (Section 4(e))
The Agencies have considered commenters' responses to the
backtesting proposal. The Agencies believe backtesting can be a useful
tool for internal model validation, and have determined to include the
backtesting provisions in the final rule, as proposed. An institution
subject to the final rule must perform backtests of its VAR measures as
calculated for internal risk management purposes. The backtests must
compare daily VAR measures
[[Page 47365]]
calibrated to a one-day movement in rates and prices and a 99 percent
(one-tailed) confidence level against the institution's actual daily
net trading profit or loss (trading outcome) for each of the preceding
250 business days. The backtests must be performed once each
quarter.14 Net trading outcomes include such items as fees and
commissions associated with trading activities, as well as changes in
market valuations associated with changing portfolio positions.
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\14\ An institution's obligation to backtest for regulatory
capital purposes does not arise until the institution has been
subject to the final rule for 250 business days (approximately one
year) and, thus, has accumulated the requisite number of
observations to be used in backtesting.
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An institution must identify the number of occurrences when its net
trading loss (if any) for a particular day exceeds the corresponding
daily VAR measure. In general, an institution's multiplication factor
increases incrementally beginning with five or more exceptions during
the previous 250 business days, and rises to a multiplication factor of
four for an institution with 10 or more exceptions during the period.
While the number of exceptions creates a presumption as to an
institution's multiplication factor, the institution's supervisor may
make other adjustments to the multiplication factor or may take other
appropriate actions. For example, the supervisor may exclude exceptions
that result from regime shifts, such as sudden abnormal changes in
interest rates or exchange rates, major political events, or natural
disasters. The supervisor may also consider such other factors as the
magnitude of an exception (that is, the extent of the difference
between the VAR measure and the actual trading loss), and an
institution's reaction in response to an exception.
The Agencies recognize that backtesting is evolving and acknowledge
commenters' concerns that it may not be appropriate to penalize an
institution by applying a higher multiplication factor if the
institution has refined the accuracy of its model in response to an
exception or has taken other action to improve its risk management
processes. The Agencies emphasize that they will implement the
backtesting requirements of the final rule with significant flexibility
and examiner judgment. The Agencies will continue to monitor industry
progress in developing backtesting methodologies and may consider
adjusting the backtesting requirements in the near future.
Specific Risk (Section 5)
The Agencies agree with the provisions in the final amendment to
the Accord that require an institution to hold capital in support of
the specific risk associated with debt and equity positions in an
institution's trading account. Thus, the final rule provides that an
institution must measure and hold capital in support of specific risk
associated with those positions. The capital charge for specific risk
is determined either by an institution's internal model or by the
standardized risk measurement techniques specified by the Agencies (the
standardized approach).
Standardized Approach
Under the standardized approach, the specific risk charge for debt
positions is calculated by multiplying the current market value of each
net long or short position in a trading account debt instrument by the
appropriate specific risk weighting factor as set forth in the final
rule, based on the identity of the obligor, and in the case of some
instruments such as corporate debt, on the credit rating and remaining
maturity of the instrument. An institution must risk weight derivatives
(e.g., swaps, futures, forwards, or options on certain debt
instruments) according to the relevant underlying instrument. For
example, for a forward contract, an institution must risk weight the
market value of the effective notional amount of the underlying
instrument (or index portfolio). An institution may net long and short
positions in identical debt instruments with exactly the same issuer,
coupon, currency, and maturity. An institution may also offset a
matched position in a derivative instrument and its corresponding
underlying instrument. The specific risk weighting factor for debt
instruments of OECD 15 central governments is zero percent. Other
debt instruments with qualifying ratings (essentially investment grade
corporate securities) receive risk weights ranging from 0.25 percent to
1.6 percent, depending on remaining maturity. Nonqualifying debt
instruments receive a risk weight of 8.0 percent.
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\15\ The Organization for Economic Cooperation and Development
(OECD) is defined in the credit risk-based capital standards.
---------------------------------------------------------------------------
The specific risk charge for equity positions is based on an
institution's gross equity position for each national market. The gross
equity position is defined as the sum of all long and short equity
positions, including positions arising from derivatives such as equity
swaps, forwards, futures, and options. An institution must risk weight
the current market value of each gross equity position by the
appropriate factor. An institution must risk weight derivatives
according to the relevant underlying equity instrument. An institution
may net long and short positions in identical equity issues or indices
in each national market. An institution may also offset a matched
position in a derivative instrument and its corresponding underlying
instrument.
The specific risk charge is 8.0 percent of the gross equity
position, unless the institution's portfolio is both liquid and well-
diversified, in which case the capital charge is 4.0 percent. A
portfolio is liquid and well-diversified if: (1) it is characterized by
a limited sensitivity to price changes of any single equity or closely
related group of equity issues held in a portfolio; (2) the volatility
of the portfolio's value is not dominated by the volatility of any
individual equity issue or by equity issues from any single industry or
economic sector; (3) it contains a large number of individual equity
positions, with no single position representing a substantial portion
of the portfolio's total market value; and (4) it consists mainly of
issues traded on organized exchanges or in well-established over-the-
counter markets.
For positions in an index comprising a diversified portfolio of
equities, the specific risk charge is 2.0 percent of the net long or
short position in the index. In addition, a 2.0 percent specific risk
charge applies to only one side (long or short) in the case of certain
futures-related arbitrage strategies (for instance, long and short
positions in the same index at different dates or different market
centers, and long and short positions at the same date in different,
but similar indices). Finally, under certain conditions, futures
positions on a broadly-based index that are matched against positions
in the equities comprising the index are subject to a specific risk
charge of 2.0 percent against each side of the transaction.
Internal Models Approach
The final rule permits an institution to use its internal model to
determine capital charges for specific risk if it can demonstrate to
its supervisor that the modeling process adequately addresses elements
of specific risk for debt and/or equity positions. In particular, an
institution may use the model-based estimates of specific risk in place
of the standardized capital charge. However, if the specific risk
component of the institution's VAR measure (when multiplied by the
backtesting multiplication factor, with respect to a
[[Page 47366]]
60-day average VAR figure) is not equal to at least 50 percent of the
specific risk charge resulting from the standardized calculation, then
the institution has a specific risk add-on in the amount of the
difference. For example, if the standardized approach indicates a
specific risk charge of $100, but the institution's 60-day average VAR
figure includes only $10 for specific risk, then the institution has a
specific risk add-on of $20 (that is, 50 percent of $100 minus three
times $10). However, if the 60-day average VAR figure includes $20 from
specific risk, then the institution would have no specific risk add-on
because the VAR-based charge (three times $20) exceeds 50 percent of
$100.
An institution (in conjunction with its supervisor) must separately
determine whether its model incorporates specific risk for debt
positions and equity positions. For instance, if the model addresses
the specific risk of debt positions but not equity positions, then the
institution can use the model-based specific risk charge (subject to
the limitations described earlier) for debt positions, but must use the
full standard specific risk charge for equity positions. If, however,
the model addresses the specific risk of both debt and equity
positions, then the institution must make the comparison based on the
total specific risk figure for debt and equity positions, taking into
account any correlations between the specific risk of debt and equity
positions that are built into the model.
This treatment provides an institution with an incentive to
incorporate specific risk into its internal model, while maintaining an
overall floor on the amount of capital it must hold against specific
risk. The Agencies believe that a minimum requirement for specific risk
is useful, at least for an initial period, since methods for
incorporating specific risk into VAR models are still in a process of
development at many institutions. The Agencies will continue to study
these developments and likely will issue further guidance on these
procedures as institutions implement this final rule in the coming
months.
IV. Regulatory Flexibility Act Analysis
OCC Regulatory Flexibility Act Analysis
Pursuant to section 605(b) of the Regulatory Flexibility Act, the
OCC certifies that this final rule will not have a significant impact
on a substantial number of small business entities in accord with the
spirit and purposes of the Regulatory Flexibility Act (5 U.S.C. 601 et
seq.). Accordingly, a regulatory flexibility analysis is not required.
The impact of this final rule on banks regardless of size is expected
to be minimal. Further, the OCC's comparison of the applicability
section of this final rule to Call Report data on all existing banks
shows that application of the rule to small banks will be the rare
exception.
Board Regulatory Flexibility Act Analysis
Pursuant to section 605(b) of the Regulatory Flexibility Act, the
Board does not believe this final rule will have a significant impact
on a substantial number of small business entities in accord with the
spirit and purposes of the Regulatory Flexibility Act (5 U.S.C. 601 et
seq.). The Board's comparison of the applicability section of this
final rule to Call Report data on all existing banks shows that
application of the rule to small entities will be the rare exception.
Accordingly, a regulatory flexibility analysis is not required. In
addition, because the risk-based capital standards generally do not
apply to bank holding companies with consolidated assets of less than
$150 million, this rule will not affect such companies.
FDIC Regulatory Flexibility Act Analysis
Pursuant to section 605(b) of the Regulatory Flexibility Act (Pub.
L. 96-354, 5 U.S.C. 601 et seq.), it is certified that the final rule
will not have a significant impact on a substantial number of small
entities. The FDIC's comparison of the applicability section of this
final rule to Call Report data on all existing banks shows that
application of the rule to small entities will be the rare exception.
V. Paperwork Reduction Act
OCC Paperwork Reduction Act
The OCC has determined that his final rule does not increase the
regulatory paperwork burden of banking organizations pursuant to the
provisions of the Paperwork Reduction Act (44 U.S.C. 3501 et seq.).
Board Paperwork Reduction Act
In accordance with the Paperwork Reduction Act of 1995 (44 U.S.C.
Ch. 3506; 5 CFR 1320 Appendix A.1), the Board reviewed the proposed
rule under the authority delegated to the Board by the Office of
Management and Budget. No collections of information pursuant to the
Paperwork Reduction Act are contained in the final rule.
FDIC Paperwork Reduction Act
The FDIC has determined that this final rule does not contain any
collections of information as defined by the Paperwork Reduction Act
(44 U.S.C. 3501 et seq.).
VI. OCC Executive Order 12866 Determination
The OCC has determined that this final rule is not a significant
regulatory action under Executive Order 12866.
VII. OCC Unfunded Mandates Reform Act of 1995 Determination
The OCC has determined that this final rule will not result in
expenditures by state, local, and tribal governments, or by the private
sector, of $100 million or more in any one year. Accordingly, a
budgetary impact statement is not required under section 202 of the
Unfunded Mandates Reform Act of 1995. This final rule will apply only
to a small number of national banks. Moreover, most (if not all) of
those banks already have internal VAR models that measure market risk,
thus reducing this final rule's implementation costs.
List of Subjects
12 CFR Part 3
Administrative practice and procedure, Capital, National banks,
Reporting and recordkeeping requirements, Risk.
12 CFR Part 208
Accounting, Agriculture, Banks, banking, Confidential business
information, Crime, Currency, Federal Reserve System, Mortgages,
Reporting and recordkeeping requirements, Securities.
12 CFR Part 225
Administrative practice and procedure, Banks, banking, Federal
Reserve System, Holding companies, Reporting and recordkeeping
requirements, Securities.
12 CFR Part 325
Administrative practice and procedure, Banks, banking, Capital
adequacy, Reporting and recordkeeping requirements, Savings
associations, State non-member banks.
Office of the Comptroller of the Currency
12 CFR CHAPTER I
Authority and Issuance
For the reasons set out in the joint preamble, part 3 of title 12,
chapter I of the Code of Federal Regulations is amended as follows:
PART 3--[AMENDED]
1. The authority citation for part 3 continues to read as follows:
[[Page 47367]]
Authority: 12 U.S.C. 93a, 161, 1818, 1828(n), 1828 note, 1831n
note, 1835, 3907, and 3909.
2. Section 3.6 is amended by revising paragraph (a) to read as
follows:
Sec. 3.6 Minimum capital ratios.
(a) Risk-based capital ratio. All national banks must have and
maintain the minimum risk-based capital ratio as set forth in appendix
A (and, for certain banks, in appendix B).
* * * * *
3. A new appendix B is added to part 3 to read as follows:
Appendix B to Part 3--Risk-Based Capital Guidelines; Market Risk
Adjustment
Section 1. Purpose, Applicability, Scope, and Effective Date
(a) Purpose. The purpose of this appendix is to ensure that
banks with significant exposure to market risk maintain adequate
capital to support that exposure.1 This appendix supplements
and adjusts the risk-based capital ratio calculations under appendix
A of this part with respect to those banks.
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\1\ This appendix is based on a framework developed jointly by
supervisory authorities from the countries represented on the Basle
Committee on Banking Supervision and endorsed by the Group of Ten
Central Bank Governors. The framework is described in a Basle
Committee paper entitled ``Amendment to the Capital Accord to
Incorporate Market Risk,'' January 1996.
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(b) Applicability. (1) This appendix applies to any national
bank whose trading activity 2 (on a worldwide consolidated
basis) equals:
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\2\ Trading activity means the gross sum of trading assets and
liabilities as reported in the bank's most recent quarterly
Consolidated Report of Condition and Income (Call Report).
---------------------------------------------------------------------------
(i) 10 percent or more of total assets; 3 or
---------------------------------------------------------------------------
\3\ Total assets means quarter-end total assets as reported in
the bank's most recent Call Report.
---------------------------------------------------------------------------
(ii) $1 billion or more.
(2) The OCC may apply this appendix to any national bank if the
OCC deems it necessary or appropriate for safe and sound banking
practices.
(3) The OCC may exclude a national bank otherwise meeting the
criteria of paragraph (b)(1) of this section from coverage under
this appendix if it determines the bank meets such criteria as a
consequence of accounting, operational, or similar considerations,
and the OCC deems it consistent with safe and sound banking
practices.
(c) Scope. The capital requirements of this appendix support
market risk associated with a bank's covered positions.
(d) Effective date. This appendix is effective as of January 1,
1997. Compliance is not mandatory until January 1, 1998. Subject to
supervisory approval, a bank may opt to comply with this appendix as
early as January 1, 1997.4
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\4\ A bank that voluntarily complies with the final rule prior
to January 1, 1998, must comply with all of its provisions.
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Section 2. Definitions
For purposes of this appendix, the following definitions apply:
(a) Covered positions means all positions in a bank's trading
account, and all foreign exchange 5 and commodity positions,
whether or not in the trading account.6 Positions include on-
balance-sheet assets and liabilities and off-balance-sheet items.
Securities subject to repurchase and lending agreements are included
as if they are still owned by the lender.
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\5\ Subject to supervisory review, a bank may exclude structural
positions in foreign currencies from its covered positions.
\6\ The term trading account is defined in the instructions to
the Call Report.
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(b) Market risk means the risk of loss resulting from movements
in market prices. Market risk consists of general market risk and
specific risk components.
(1) General market risk means changes in the market value of
covered positions resulting from broad market movements, such as
changes in the general level of interest rates, equity prices,
foreign exchange rates, or commodity prices.
(2) Specific risk means changes in the market value of specific
positions due to factors other than broad market movements and
includes such risk as the credit risk of an instrument's issuer.
(c) Tier 1 and Tier 2 capital are the same as defined in
appendix A of this part.
(d) Tier 3 capital is subordinated debt that is unsecured; is
fully paid up; has an original maturity of at least two years; is
not redeemable before maturity without prior approval by the OCC;
includes a lock-in clause precluding payment of either interest or
principal (even at maturity) if the payment would cause the issuing
bank's risk-based capital ratio to fall or remain below the minimum
required under appendix A of this part; and does not contain and is
not covered by any covenants, terms, or restrictions that are
inconsistent with safe and sound banking practices.
(e) Value-at-risk (VAR) means the estimate of the maximum amount
that the value of covered positions could decline during a fixed
holding period within a stated confidence level, measured in
accordance with section 4 of this appendix.
Section 3. Adjustments to the Risk-Based Capital Ratio Calculations
(a) Risk-based capital ratio denominator. A bank subject to this
appendix shall calculate its risk-based capital ratio denominator as
follows:
(1) Adjusted risk-weighted assets. Calculate adjusted risk-
weighted assets, which equals risk-weighted assets (as determined in
accordance with appendix A of this part), excluding the risk-
weighted amounts of all covered positions (except foreign exchange
positions outside the trading account and over-the-counter
derivative positions).7
---------------------------------------------------------------------------
\7\ Foreign exchange positions outside the trading account and
all over-the-counter derivative positions, whether or not in the
trading account, must be included in adjusted risk-weighted assets
as determined in appendix A of this part.
---------------------------------------------------------------------------
(2) Measure for market risk. Calculate the measure for market
risk, which equals the sum of the VAR-based capital charge, the
specific risk add-on (if any), and the capital charge for de minimis
exposure (if any).
(i) VAR-based capital charge. The VAR-based capital charge
equals the higher of:
(A) The previous day's VAR measure; or
(B) The average of the daily VAR measures for each of the
preceding 60 business days multiplied by three, except as provided
in section 4(e) of this appendix;
(ii) Specific risk add-on. The specific risk add-on is
calculated in accordance with section 5 of this appendix; and
(iii) Capital charge for de minimis exposure. The capital charge
for de minimis exposure is calculated in accordance with section
4(a) of this appendix.
(3) Market risk equivalent assets. Calculate market risk
equivalent assets by multiplying the measure for market risk (as
calculated in paragraph (a)(2) of this section) by 12.5.
(4) Denominator calculation. Add market risk equivalent assets
(as calculated in paragraph (a)(3) of this section) to adjusted
risk-weighted assets (as calculated in paragraph (a)(1) of this
section). The resulting sum is the bank's risk-based capital ratio
denominator.
(b) Risk-based capital ratio numerator. A bank subject to this
appendix shall calculate its risk-based capital ratio numerator by
allocating capital as follows:
(1) Credit risk allocation. Allocate Tier 1 and Tier 2 capital
equal to 8.0 percent of adjusted risk-weighted assets (as calculated
in paragraph (a)(1) of this section).8
---------------------------------------------------------------------------
\8\ A bank may not allocate Tier 3 capital to support credit
risk (as calculated under appendix A).
---------------------------------------------------------------------------
(2) Market risk allocation. Allocate Tier 1, Tier 2, and Tier 3
capital equal to the measure for market risk as calculated in
paragraph (a)(2) of this section. The sum of Tier 2 and Tier 3
capital allocated for market risk must not exceed 250 percent of
Tier 1 capital allocated for market risk. (This requirement means
that Tier 1 capital allocated in this paragraph (b)(2) must equal at
least 28.6 percent of the measure for market risk.)
(3) Restrictions. (i) The sum of Tier 2 capital (both allocated
and excess) and Tier 3 capital (allocated in paragraph (b)(2) of
this section) may not exceed 100 percent of Tier 1 capital (both
allocated and excess).9
---------------------------------------------------------------------------
\9\ Excess Tier 1 capital means Tier 1 capital that has not been
allocated in paragraphs (b)(1) and (b)(2) of this section. Excess
Tier 2 capital means Tier 2 capital that has not been allocated in
paragraph (b)(1) and (b)(2) of this section, subject to the
restrictions in paragraph (b)(3) of this section.
---------------------------------------------------------------------------
(ii) Term subordinated debt (and intermediate-term preferred
stock and related surplus) included in Tier 2 capital (both
allocated and excess) may not exceed 50 percent of Tier 1 capital
(both allocated and excess).
(4) Numerator calculation. Add Tier 1 capital (both allocated
and excess), Tier 2 capital (both allocated and excess), and Tier 3
capital (allocated under paragraph (b)(2) of this section). The
resulting sum is the bank's risk-based capital ratio numerator.
Section 4. Internal Models
(a) General. For risk-based capital purposes, a bank subject to
this appendix
[[Page 47368]]
must use its internal model to measure its daily VAR, in accordance
with the requirements of this section.10 The OCC may permit a
bank to use alternative techniques to measure the market risk of de
minimis exposures so long as the techniques adequately measure
associated market risk.
---------------------------------------------------------------------------
\10\ A bank's internal model may use any generally accepted
measurement techniques, such as variance-covariance models,
historical simulations, or Monte Carlo simulations. However, the
level of sophistication and accuracy of a bank's internal model must
be commensurate with the nature and size of its covered positions. A
bank that modifies its existing modeling procedures to comply with
the requirements of this appendix for risk-based capital purposes
should, nonetheless, continue to use the internal model it considers
most appropriate in evaluating risks for other purposes.
---------------------------------------------------------------------------
(b) Qualitative requirements. A bank subject to this appendix
must have a risk management system that meets the following minimum
qualitative requirements:
(1) The bank must have a risk control unit that reports directly
to senior management and is independent from business trading units.
(2) The bank's internal risk measurement model must be
integrated into the daily management process.
(3) The bank's policies and procedures must identify, and the
bank must conduct, appropriate stress tests and backtests.11
The bank's policies and procedures must identify the procedures to
follow in response to the results of such tests.
---------------------------------------------------------------------------
\11\ Stress tests provide information about the impact of
adverse market events on a bank's covered positions. Backtests
provide information about the accuracy of an internal model by
comparing a bank's daily VAR measures to its corresponding daily
trading profits and losses.
---------------------------------------------------------------------------
(4) The bank must conduct independent reviews of its risk
measurement and risk management systems at least annually.
(c) Market risk factors. The bank's internal model must use risk
factors sufficient to measure the market risk inherent in all
covered positions. The risk factors must address interest rate
risk,12 equity price risk, foreign exchange rate risk, and
commodity price risk.
---------------------------------------------------------------------------
\12\ For material exposures in the major currencies and markets,
modeling techniques must capture spread risk and must incorporate
enough segments of the yield curve--at least six--to capture
differences in volatility and less than perfect correlation of rates
along the yield curve.
---------------------------------------------------------------------------
(d) Quantitative requirements. For regulatory capital purposes,
VAR measures must meet the following quantitative requirements:
(1) The VAR measures must be calculated on a daily basis using a
99 percent, one-tailed confidence level with a price shock
equivalent to a ten-business day movement in rates and prices. In
order to calculate VAR measures based on a ten-day price shock, the
bank may either calculate ten-day figures directly or convert VAR
figures based on holding periods other than ten days to the
equivalent of a ten-day holding period (for instance, by multiplying
a one-day VAR measure by the square root of ten).
(2) The VAR measures must be based on an historical observation
period (or effective observation period for a bank using a weighting
scheme or other similar method) of at least one year. The bank must
update data sets at least once every three months or more frequently
as market conditions warrant.
(3) The VAR measures must include the risks arising from the
non-linear price characteristics of options positions and the
sensitivity of the market value of the positions to changes in the
volatility of the underlying rates or prices. A bank with a large or
complex options portfolio must measure the volatility of options
positions by different maturities.
(4) The VAR measures may incorporate empirical correlations
within and across risk categories, provided that the bank's process
for measuring correlations is sound. In the event that the VAR
measures do not incorporate empirical correlations across risk
categories, then the bank must add the separate VAR measures for the
four major risk categories to determine its aggregate VAR measure.
(e) Backtesting. (1) Beginning one year after a bank starts to
comply with this appendix, a bank must conduct backtesting by
comparing each of its most recent 250 business days' actual net
trading profit or loss 13 with the corresponding daily VAR
measures generated for internal risk measurement purposes and
calibrated to a one-day holding period and a 99 percent, one-tailed
confidence level.
---------------------------------------------------------------------------
\13\ Actual net trading profits and losses typically include
such things as realized and unrealized gains and losses on portfolio
positions as well as fee income and commissions associated with
trading activities.
---------------------------------------------------------------------------
(2) Once each quarter, the bank must identify the number of
exceptions, that is, the number of business days for which the
magnitude of the actual daily net trading loss, if any, exceeds the
corresponding daily VAR measure.
(3) A bank must use the multiplication factor indicated in Table
1 of this appendix in determining its capital charge for market risk
under section 3(a)(2)(i)(B) of this appendix until it obtains the
next quarter's backtesting results, unless the OCC determines that a
different adjustment or other action is appropriate.
Table 1.--Multiplication Factor Based on Results of Backtesting
------------------------------------------------------------------------
Multiplication
Number of exceptions factor
------------------------------------------------------------------------
4 or fewer.............................................. 3.00
5....................................................... 3.40
6....................................................... 3.50
7....................................................... 3.65
8....................................................... 3.75
9....................................................... 3.85
10 or more.............................................. 4.00
------------------------------------------------------------------------
Section 5. Specific Risk
(a) Specific risk add-on. For purposes of section 3(a)(2)(ii) of
this appendix, a bank's specific risk add-on equals the standard
specific risk capital charge calculated under paragraph (c) of this
section. If, however, a bank can demonstrate to the OCC that its
internal model measures the specific risk of covered debt and/or
equity positions and that those measures are included in the VAR-
based capital charge in section 3(a)(2)(i) of this appendix, then
the bank may reduce or eliminate its specific risk add-on under this
section. The determination as to whether a model incorporates
specific risk must be made separately for covered debt and equity
positions.
(1) If a model includes the specific risk of covered debt
positions but not covered equity positions (or vice versa), then the
bank can reduce its specific risk charge for the included positions
under paragraph (b) of this section. The specific risk charge for
the positions not included equals the standard specific risk capital
charge under paragraph (c) of this section.
(2) If a model addresses the specific risk of both covered debt
and equity positions, then the bank can reduce its specific risk
charge for both covered debt and equity positions under paragraph
(b) of this section. In this case, the comparison described in
paragraph (b) of this section must be based on the total VAR-based
figure for the specific risk of debt and equity positions, taking
into account any correlations that are built into the model.
(b) VAR-based specific risk capital charge. In all cases where a
bank measures specific risk in its internal model, the total capital
charge for specific risk (i.e., the VAR-based specific risk capital
charge plus the specific risk add-on) must equal at least 50 percent
of the standard specific risk capital charge (this amount is the
minimum specific risk charge).
(1) If the portion of a bank's VAR measure that is attributable
to specific risk (multiplied by the bank's multiplication factor if
required in section 3(a)(2) of this appendix) is greater than or
equal to the minimum specific risk charge, then the bank has no
specific risk add-on and its capital charge for specific risk is the
portion included in the VAR measure.
(2) If the portion of a bank's VAR measure that is attributable
to specific risk (multiplied by the bank's multiplication factor if
required in section 3(a)(2) of this appendix) is less than the
minimum specific risk charge, then the bank's specific risk add-on
is the difference between the minimum specific risk charge and the
specific risk portion of the VAR measure (multiplied by the bank's
multiplication factor if required in section 3(a)(2) of this
appendix).
(c) Standard specific risk capital charge. The standard specific
risk capital charge equals the sum of the components for covered
debt and equity positions as follows:
(1) Covered debt positions. (i) For purposes of this section 5,
covered debt positions means fixed-rate or floating-rate debt
instruments located in the trading account and instruments located
in the trading account with values that react primarily to changes
in interest rates, including certain non-convertible preferred
stock, convertible bonds, and instruments subject to repurchase and
lending agreements. Also included are derivatives (including written
and purchased options) for which the underlying instrument is a
covered debt instrument that is subject to a non-zero specific risk
capital charge.
(A) For covered debt positions that are derivatives, a bank must
risk-weight (as
[[Page 47369]]
described in paragraph (c)(1)(iii) of this section) the market value
of the effective notional amount of the underlying debt instrument
or index portfolio. Swaps must be included as the notional position
in the underlying debt instrument or index portfolio, with a
receiving side treated as a long position and a paying side treated
as a short position; and
(B) For covered debt positions that are options, whether long or
short, a bank must risk-weight (as described in paragraph
(c)(1)(iii) of this section) the market value of the effective
notional amount of the underlying debt instrument or index
multiplied by the option's delta.
(ii) A bank may net long and short covered debt positions
(including derivatives) in identical debt issues or indices.
(iii) A bank must multiply the absolute value of the current
market value of each net long or short covered debt position by the
appropriate specific risk weighting factor indicated in Table 2 of
this appendix. The specific risk capital charge component for
covered debt positions is the sum of the weighted values.
Table 2--Specific Risk Weighting Factors for Covered Debt Positions
------------------------------------------------------------------------
Weighting
Remaining maturity factor
Category (contractual) (in
percent)
------------------------------------------------------------------------
Government \1\...................... N/A.................... 0.00
Qualifying \2\...................... 6 months or less....... 0.25
Over 6 months to 24 1.00
months.
Over 24 months......... 1.60
Other \3\........................... N/A.................... 8.00
------------------------------------------------------------------------
\1\ The ``government'' category includes all debt instruments of central
governments of OECD countries (as defined in appendix A of this part)
including bonds, Treasury bills, and other short-term instruments, as
well as local currency instruments of non-OECD central governments to
the extent the bank has liabilities booked in that currency.
\2\ The ``qualifying'' category includes debt instruments of U.S.
government-sponsored agencies (as defined in appendix A of this part),
general obligation debt instruments issued by states and other
political subdivisions of OECD countries, multilateral development
banks (as defined in appendix A of this part), and debt instruments
issued by U.S. depository institutions or OECD-banks (as defined in
appendix A of this part) that do not qualify as capital of the issuing
institution. This category also includes other debt instruments,
including corporate debt and revenue instruments issued by states and
other political subdivisions of OECD countries, that are: (1) Rated
investment grade by at least two nationally recognized credit rating
services; (2) rated investment grade by one nationally recognized
credit rating agency and not rated less than investment grade by any
other credit rating agency; or (3) unrated, but deemed to be of
comparable investment quality by the reporting bank and the issuer has
instruments listed on a recognized stock exchange, subject to review
by the OCC.
\3\ The ``other'' category includes debt instruments that are not
included in the government or qualifying categories.
(2) Covered equity positions. (i) For purposes of this section
5, covered equity positions means equity instruments located in the
trading account and instruments located in the trading account with
values that react primarily to changes in equity prices, including
voting or non-voting common stock, certain convertible bonds, and
commitments to buy or sell equity instruments. Also included are
derivatives (including written and purchased options) for which the
underlying is a covered equity position.
(A) For covered equity positions that are derivatives, a bank
must risk weight (as described in paragraph (c)(2)(iii) of this
section) the market value of the effective notional amount of the
underlying equity instrument or equity portfolio. Swaps must be
included as the notional position in the underlying equity
instrument or index portfolio, with a receiving side treated as a
long position and a paying side treated as a short position; and
(B) For covered equity positions that are options, whether long
or short, a bank must risk weight (as described in paragraph
(c)(2)(iii) of this section) the market value of the effective
notional amount of the underlying equity instrument or index
multiplied by the option's delta.
(ii) A bank may net long and short covered equity positions
(including derivatives) in identical equity issues or equity indices
in the same market.14
---------------------------------------------------------------------------
\14\ A bank may also net positions in depository receipts
against an opposite position in the underlying equity or identical
equity in different markets, provided that the bank includes the
costs of conversion.
---------------------------------------------------------------------------
(iii)(A) A bank must multiply the absolute value of the current
market value of each net long or short covered equity position by a
risk weighting factor of 8.0 percent, or by 4.0 percent if the
equity is held in a portfolio that is both liquid and well-
diversified.15 For covered equity positions that are index
contracts comprising a well-diversified portfolio of equity
instruments, the net long or short position is multiplied by a risk
weighting factor of 2.0 percent.
---------------------------------------------------------------------------
\15\ A portfolio is liquid and well-diversified if: (1) It is
characterized by a limited sensitivity to price changes of any
single equity issue or closely related group of equity issues held
in the portfolio; (2) the volatility of the portfolio's value is not
dominated by the volatility of any individual equity issue or by
equity issues from any single industry or economic sector; (3) it
contains a large number of individual equity positions, with no
single position representing a substantial portion of the
portfolio's total market value; and (4) it consists mainly of issues
traded on organized exchanges or in well-established over-the-
counter markets.
---------------------------------------------------------------------------
(B) For covered equity positions from the following futures-
related arbitrage strategies, a bank may apply a 2.0 percent risk
weighting factor to one side (long or short) of each position with
the opposite side exempt from charge:
(1) Long and short positions in exactly the same index at
different dates or in different market centers; or
(2) Long and short positions in index contracts at the same date
in different but similar indices.
(C) For futures contracts on broadly-based indices that are
matched by offsetting positions in a basket of stocks comprising the
index, a bank may apply a 2.0 percent risk weighting factor to the
futures and stock basket positions (long and short), provided that
such trades are deliberately entered into and separately controlled,
and that the basket of stocks comprises at least 90 percent of the
capitalization of the index.
(iv) The specific risk capital charge component for covered
equity positions is the sum of the weighted values.
Section 6. Reservation of Authority
The OCC reserves the authority to modify the application of any
of the provisions in this appendix to any bank, upon reasonable
justification.
Dated: August 6, 1996.
Eugene A. Ludwig,
Comptroller of the Currency.
Federal Reserve System
12 CFR CHAPTER II
For the reasons set out in the joint preamble, parts 208 and 225 of
title 12 of chapter II of the Code of Federal Regulations are 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. 36, 248(a), 248(c), 321-338a, 371d, 461,
481-486, 601, 611, 1814, 1823(j), 1828(o), 1831o, 1831p-1, 3105,
3310, 3331-3351, and 3906-3909; 15 U.S.C. 78b, 78l(b), 78l(g),
78l(i), 78o-4(c)(5), 78q, 78q-1, and 78w; 31 U.S.C. 5318; 42 U.S.C.
4012a, 4104a, 4104b, 4106, and 4128.
2. Section 208.13 is revised to read as follows:
Sec. 208.13 Capital Adequacy.
The standards and guidelines by which the capital adequacy of state
member banks will be evaluated by the Board are set forth in appendix A
and appendix E for risk-based capital purposes, and, with respect to
the ratios relating capital to total assets, in appendix B to part 208
and in appendix B to the Board's Regulation Y, 12 CFR part 225.
3. Appendix A is amended in the introductory text by adding a new
paragraph after the second undesignated paragraph to read as follows:
[[Page 47370]]
Appendix A to Part 208--Capital Adequacy Guidelines for State Member
Banks; Risk Based Measure
* * * * *
In addition, when certain banks that engage in trading activities
calculate their risk-based capital ratio under this appendix A, they
must also refer to appendix E of this part, which incorporates capital
charges for certain market risks into the risk-based capital ratio.
When calculating their risk-based capital ratio under this appendix A,
such banks are required to refer to appendix E of this part for
supplemental rules to determine qualifying and excess capital,
calculate risk-weighted assets, calculate market risk equivalent
assets, and calculate risk-based capital ratios adjusted for market
risk.
* * * * *
4. A new appendix E is added to read as follows:
Appendix E to Part 208--Capital Adequacy Guidelines for State Member
Banks; Market Risk Measure
Section 1. Purpose, Applicability, Scope, and Effective Date
(a) Purpose. The purpose of this appendix is to ensure that
banks with significant exposure to market risk maintain adequate
capital to support that exposure.1 This appendix supplements
and adjusts the risk-based capital ratio calculations under appendix
A of this part with respect to those banks.
---------------------------------------------------------------------------
\1\ This appendix is based on a framework developed jointly by
supervisory authorities from the countries represented on the Basle
Committee on Banking Supervision and endorsed by the Group of Ten
Central Bank Governors. The framework is described in a Basle
Committee paper entitled ``Amendment to the Capital Accord to
Incorporate Market Risk,'' January 1996.
---------------------------------------------------------------------------
(b) Applicability. (1) This appendix applies to any insured
state member bank whose trading activity 2 (on a worldwide
consolidated basis) equals:
---------------------------------------------------------------------------
\2\ Trading activity means the gross sum of trading assets and
liabilities as reported in the bank's most recent quarterly
Consolidated Report of Condition and Income (Call Report).
---------------------------------------------------------------------------
(i) 10 percent or more of total assets; 3 or
---------------------------------------------------------------------------
\3\ Total assets means quarter-end total assets as reported in
the bank's most recent Call Report.
---------------------------------------------------------------------------
(ii) $1 billion or more.
(2) The Federal Reserve may additionally apply this appendix to
any insured state member bank if the Federal Reserve deems it
necessary or appropriate for safe and sound banking practices.
(3) The Federal Reserve may exclude an insured state member bank
otherwise meeting the criteria of paragraph (b)(1) of this section
from coverage under this appendix if it determines the bank meets
such criteria as a consequence of accounting, operational, or
similar considerations, and the Federal Reserve deems it consistent
with safe and sound banking practices.
(c) Scope. The capital requirements of this appendix support
market risk associated with a bank's covered positions.
(d) Effective date. This appendix is effective as of January 1,
1997. Compliance is not mandatory until January 1, 1998. Subject to
supervisory approval, a bank may opt to comply with this appendix as
early as January 1, 1997.4
---------------------------------------------------------------------------
\4\ A bank that voluntarily complies with the final rule prior
to January 1, 1998, must comply with all of its provisions.
---------------------------------------------------------------------------
Section 2. Definitions
For purposes of this appendix, the following definitions apply:
(a) Covered positions means all positions in a bank's trading
account, and all foreign exchange 5 and commodity positions,
whether or not in the trading account.6 Positions include on-
balance-sheet assets and liabilities and off-balance-sheet items.
Securities subject to repurchase and lending agreements are included
as if they are still owned by the lender.
---------------------------------------------------------------------------
\5\ Subject to supervisory review, a bank may exclude structural
positions in foreign currencies from its covered positions.
\6\ The term trading account is defined in the instructions to
the Call Report.
---------------------------------------------------------------------------
(b) Market risk means the risk of loss resulting from movements
in market prices. Market risk consists of general market risk and
specific risk components.
(1) General market risk means changes in the market value of
covered positions resulting from broad market movements, such as
changes in the general level of interest rates, equity prices,
foreign exchange rates, or commodity prices.
(2) Specific risk means changes in the market value of specific
positions due to factors other than broad market movements and
includes such risk as the credit risk of an instrument's issuer.
(c) Tier 1 and Tier 2 capital are defined in appendix A of this
part.
(d) Tier 3 capital is subordinated debt that is unsecured; is
fully paid up; has an original maturity of at least two years; is
not redeemable before maturity without prior approval by the Federal
Reserve; includes a lock-in clause precluding payment of either
interest or principal (even at maturity) if the payment would cause
the issuing bank's risk-based capital ratio to fall or remain below
the minimum required under appendix A of this part; and does not
contain and is not covered by any covenants, terms, or restrictions
that are inconsistent with safe and sound banking practices.
(e) Value-at-risk (VAR) means the estimate of the maximum amount
that the value of covered positions could decline during a fixed
holding period within a stated confidence level, measured in
accordance with section 4 of this appendix.
Section 3. Adjustments to the Risk-Based Capital Ratio Calculations
(a) Risk-based capital ratio denominator. A bank subject to this
appendix shall calculate its risk-based capital ratio denominator as
follows:
(1) Adjusted risk-weighted assets. Calculate adjusted risk-
weighted assets, which equals risk-weighted assets (as determined in
accordance with appendix A of this part), excluding the risk-
weighted amounts of all covered positions (except foreign exchange
positions outside the trading account and over-the-counter
derivative positions).7
---------------------------------------------------------------------------
\7\ Foreign exchange positions outside the trading account and
all over-the-counter derivative positions, whether or not in the
trading account, must be included in adjusted risk weighted assets
as determined in appendix A of this part.
---------------------------------------------------------------------------
(2) Measure for market risk. Calculate the measure for market
risk, which equals the sum of the VAR-based capital charge, the
specific risk add-on (if any), and the capital charge for de minimis
exposures (if any).
(i) VAR-based capital charge. The VAR-based capital charge
equals the higher of:
(A) The previous day's VAR measure; or
(B) The average of the daily VAR measures for each of the
preceding 60 business days multiplied by three, except as provided
in section 4(e) of this appendix;
(ii) Specific risk add-on. The specific risk add-on is
calculated in accordance with section 5 of this appendix; and
(iii) Capital charge for de minimis exposure. The capital charge
for de minimis exposure is calculated in accordance with section
4(a) of this appendix.
(3) Market risk equivalent assets. Calculate market risk
equivalent assets by multiplying the measure for market risk (as
calculated in paragraph (a)(2) of this section) by 12.5.
(4) Denominator calculation. Add market risk equivalent assets
(as calculated in paragraph (a)(3) of this section) to adjusted
risk-weighted assets (as calculated in paragraph (a)(1) of this
section). The resulting sum is the bank's risk-based capital ratio
denominator.
(b) Risk-based capital ratio numerator. A bank subject to this
appendix shall calculate its risk-based capital ratio numerator by
allocating capital as follows:
(1) Credit risk allocation. Allocate Tier 1 and Tier 2 capital
equal to 8.0 percent of adjusted risk-weighted assets (as calculated
in paragraph (a)(1) of this section).8
---------------------------------------------------------------------------
\8\ A bank may not allocate Tier 3 capital to support credit
risk (as calculated under appendix A of this part).
---------------------------------------------------------------------------
(2) Market risk allocation. Allocate Tier 1, Tier 2, and Tier 3
capital equal to the measure for market risk as calculated in
paragraph (a)(2) of this section. The sum of Tier 2 and Tier 3
capital allocated for market risk must not exceed 250 percent of
Tier 1 capital allocated for market risk. (This requirement means
that Tier 1 capital allocated in this paragraph (b)(2) must equal at
least 28.6 percent of the measure for market risk.)
(3) Restrictions. (i) The sum of Tier 2 capital (both allocated
and excess) and Tier 3 capital (allocated in paragraph (b)(2) of
this section) may not exceed 100 percent of Tier 1 capital (both
allocated and excess).9
---------------------------------------------------------------------------
\9\ Excess Tier 1 capital means Tier 1 capital that has not been
allocated in paragraphs (b)(1) and (b)(2) of this section. Excess
Tier 2 capital means Tier 2 capital that has not been allocated in
paragraph (b)(1) and (b)(2) of this section, subject to the
restrictions in paragraph (b)(3) of this section.
---------------------------------------------------------------------------
(ii) Term subordinated debt (and intermediate-term preferred
stock and related
[[Page 47371]]
surplus) included in Tier 2 capital (both allocated and excess) may
not exceed 50 percent of Tier 1 capital (both allocated and excess).
(4) Numerator calculation. Add Tier 1 capital (both allocated
and excess), Tier 2 capital (both allocated and excess), and Tier 3
capital (allocated under paragraph (b)(2) of this section). The
resulting sum is the bank's risk-based capital ratio numerator.
Section 4. Internal Models.
(a) General. For risk-based capital purposes, a bank subject to
this appendix must use its internal model to measure its daily VAR,
in accordance with the requirements of this section.10 The
Federal Reserve may permit a bank to use alternative techniques to
measure the market risk of de minimis exposures so long as the
techniques adequately measure associated market risk.
---------------------------------------------------------------------------
\10\ A bank's internal model may use any generally accepted
measurement techniques, such as variance-covariance models,
historical simulations, or Monte Carlo simulations. However, the
level of sophistication and accuracy of a bank's internal model must
be commensurate with the nature and size of its covered positions. A
bank that modifies its existing modeling procedures to comply with
the requirements of this appendix for risk-based capital purposes
should, nonetheless, continue to use the internal model it considers
most appropriate in evaluating risks for other purposes.
---------------------------------------------------------------------------
(b) Qualitative requirements. A bank subject to this appendix
must have a risk management system that meets the following minimum
qualitative requirements:
(1) The bank must have a risk control unit that reports directly
to senior management and is independent from business trading units.
(2) The bank's internal risk measurement model must be
integrated into the daily management process.
(3) The bank's policies and procedures must identify, and the
bank must conduct, appropriate stress tests and backtests.11
The bank's policies and procedures must identify the procedures to
follow in response to the results of such tests.
---------------------------------------------------------------------------
\11\ Stress tests provide information about the impact of
adverse market events on a bank's covered positions. Backtests
provide information about the accuracy of an internal model by
comparing a bank's daily VAR measures to its corresponding daily
trading profits and losses.
---------------------------------------------------------------------------
(4) The bank must conduct independent reviews of its risk
measurement and risk management systems at least annually.
(c) Market risk factors. The bank's internal model must use risk
factors sufficient to measure the market risk inherent in all
covered positions. The risk factors must address interest rate
risk,12 equity price risk, foreign exchange rate risk, and
commodity price risk.
---------------------------------------------------------------------------
\12\ For material exposures in the major currencies and markets,
modeling techniques must capture spread risk and must incorporate
enough segments of the yield curve--at least six--to capture
differences in volatility and less than perfect correlation of rates
along the yield curve.
---------------------------------------------------------------------------
(d) Quantitative requirements. For regulatory capital purposes,
VAR measures must meet the following quantitative requirements:
(1) The VAR measures must be calculated on a daily basis using a
99 percent, one-tailed confidence level with a price shock
equivalent to a ten-business day movement in rates and prices. In
order to calculate VAR measures based on a ten-day price shock, the
bank may either calculate ten-day figures directly or convert VAR
figures based on holding periods other than ten days to the
equivalent of a ten-day holding period (for instance, by multiplying
a one-day VAR measure by the square root of ten).
(2) The VAR measures must be based on an historical observation
period (or effective observation period for a bank using a weighting
scheme or other similar method) of at least one year. The bank must
update data sets at least once every three months or more frequently
as market conditions warrant.
(3) The VAR measures must include the risks arising from the
non-linear price characteristics of options positions and the
sensitivity of the market value of the positions to changes in the
volatility of the underlying rates or prices. A bank with a large or
complex options portfolio must measure the volatility of options
positions by different maturities.
(4) The VAR measures may incorporate empirical correlations
within and across risk categories, provided that the bank's process
for measuring correlations is sound. In the event that the VAR
measures do not incorporate empirical correlations across risk
categories, then the bank must add the separate VAR measures for the
four major risk categories to determine its aggregate VAR measure.
(e) Backtesting. (1) Beginning one year after a bank starts to
comply with this appendix, a bank must conduct backtesting by
comparing each of its most recent 250 business days' actual net
trading profit or loss 13 with the corresponding daily VAR
measures generated for internal risk measurement purposes and
calibrated to a one-day holding period and a 99 percent, one-tailed
confidence level.
---------------------------------------------------------------------------
\13\ Actual net trading profits and losses typically include
such things as realized and unrealized gains and losses on portfolio
positions as well as fee income and commissions associated with
trading activities.
---------------------------------------------------------------------------
(2) Once each quarter, the bank must identify the number of
exceptions, that is, the number of business days for which the
magnitude of the actual daily net trading loss, if any, exceeds the
corresponding daily VAR measure.
(3) A bank must use the multiplication factor indicated in Table
1 of this appendix in determining its capital charge for market risk
under section 3(a)(2)(i)(B) of this appendix until it obtains the
next quarter's backtesting results, unless the Federal Reserve
determines that a different adjustment or other action is
appropriate.
Table 1.--Multiplication Factor Based on Results of Backtesting
------------------------------------------------------------------------
Multiplication
Number of exceptions factor
------------------------------------------------------------------------
4 or fewer.............................................. 3.00
5....................................................... 3.40
6....................................................... 3.50
7....................................................... 3.65
8....................................................... 3.75
9....................................................... 3.85
10 or more.............................................. 4.00
------------------------------------------------------------------------
Section 5. Specific Risk
(a) Specific risk add-on. For purposes of section 3(a)(2)(ii) of
this appendix, a bank's specific risk add-on equals the standard
specific risk capital charge calculated under paragraph (c) of this
section. If, however, a bank can demonstrate to the Federal Reserve
that its internal model measures the specific risk of covered debt
and/or equity positions and that those measures are included in the
VAR-based capital charge in section 3(a)(2)(i) of this appendix,
then the bank may reduce or eliminate its specific risk add-on under
this section. The determination as to whether a model incorporates
specific risk must be made separately for covered debt and equity
positions.
(1) If a model includes the specific risk of covered debt
positions but not covered equity positions (or vice versa), then the
bank can reduce its specific risk charge for the included positions
under paragraph (b) of this section. The specific risk charge for
the positions not included equals the standard specific risk capital
charge under paragraph (c) of this section.
(2) If a model addresses the specific risk of both covered debt
and equity positions, then the bank can reduce its specific risk
charge for both covered debt and equity positions under paragraph
(b) of this section. In this case, the comparison described in
paragraph (b) of this section must be based on the total VAR-based
figure for the specific risk of debt and equity positions, taking
into account any correlations that are built into the model.
(b) VAR-based specific risk capital charge. In all cases where a
bank measures specific risk in its internal model, the total capital
charge for specific risk (i.e., the VAR-based specific risk capital
charge plus the specific risk add-on) must equal at least 50 percent
of the standard specific risk capital charge (this amount is the
minimum specific risk charge).
(1) If the portion of a bank's VAR measure that is attributable
to specific risk (multiplied by the bank's multiplication factor if
required in section 3(a)(2) of this appendix) is greater than or
equal to the minimum specific risk charge, then the bank has no
specific risk add-on and its capital charge for specific risk is the
portion included in the VAR measure.
(2) If the portion of a bank's VAR measure that is attributable
to specific risk (multiplied by the bank's multiplication factor if
required in section 3(a)(2) of this appendix) is less than the
minimum specific risk charge, then the bank's specific risk add-on
is the difference between the minimum specific risk charge and the
specific risk portion of the VAR measure (multiplied by the bank's
multiplication factor if required in section 3(a)(2) of this
appendix).
[[Page 47372]]
(c) Standard specific risk capital charge. The standard specific
risk capital charge equals the sum of the components for covered
debt and equity positions as follows:
(1) Covered debt positions. (i) For purposes of this section 5,
covered debt positions means fixed-rate or floating-rate debt
instruments located in the trading account and instruments located
in the trading account with values that react primarily to changes
in interest rates, including certain non-convertible preferred
stock, convertible bonds, and instruments subject to repurchase and
lending agreements. Also included are derivatives (including written
and purchased options) for which the underlying instrument is a
covered debt instrument that is subject to a non-zero specific risk
capital charge.
(A) For covered debt positions that are derivatives, a bank must
risk-weight (as described in paragraph (c)(1)(iii) of this section)
the market value of the effective notional amount of the underlying
debt instrument or index portfolio. Swaps must be included as the
notional position in the underlying debt instrument or index
portfolio, with a receiving side treated as a long position and a
paying side treated as a short position; and
(B) For covered debt positions that are options, whether long or
short, a bank must risk-weight (as described in paragraph
(c)(1)(iii) of this section) the market value of the effective
notional amount of the underlying debt instrument or index
multiplied by the option's delta.
(ii) A bank may net long and short covered debt positions
(including derivatives) in identical debt issues or indices.
(iii) A bank must multiply the absolute value of the current
market value of each net long or short covered debt position by the
appropriate specific risk weighting factor indicated in Table 2 of
this appendix. The specific risk capital charge component for
covered debt positions is the sum of the weighted values.
Table 2.--Specific Risk Weighting Factors for Covered Debt Positions
------------------------------------------------------------------------
Weighting
Remaining maturity factor
Category (contractual) (in
percent)
------------------------------------------------------------------------
Government.......................... N/A.................... 0.00
Qualifying.......................... 6 months or less....... 0.25
Over 6 months to 24 1.00
months.
Over 24 months......... 1.60
Other............................... N/A.................... 8.00
------------------------------------------------------------------------
(A) The government category includes all debt instruments of
central governments of OECD-based countries 14 including bonds,
Treasury bills, and other short-term instruments, as well as local
currency instruments of non-OECD central governments to the extent
the bank has liabilities booked in that currency.
---------------------------------------------------------------------------
\14\ Organization for Economic Cooperation and Development
(OECD)-based countries is defined in appendix A of this part.
---------------------------------------------------------------------------
(B) The qualifying category includes debt instruments of U.S.
government-sponsored agencies, general obligation debt instruments
issued by states and other political subdivisions of OECD-based
countries, multilateral development banks, and debt instruments
issued by U.S. depository institutions or OECD-banks that do not
qualify as capital of the issuing institution.15 This category
also includes other debt instruments, including corporate debt and
revenue instruments issued by states and other political
subdivisions of OECD countries, that are:
---------------------------------------------------------------------------
\15\ U.S. government-sponsored agencies, multilateral
development banks, and OECD banks are defined in appendix A of this
part.
---------------------------------------------------------------------------
(1) Rated investment-grade by at least two nationally recognized
credit rating services;
(2) Rated investment-grade by one nationally recognized credit
rating agency and not rated less than investment-grade by any other
credit rating agency; or
(3) Unrated, but deemed to be of comparable investment quality
by the reporting bank and the issuer has instruments listed on a
recognized stock exchange, subject to review by the Federal Reserve.
(C) The other category includes debt instruments that are not
included in the government or qualifying categories.
(2) Covered equity positions. (i) For purposes of this section
5, covered equity positions means equity instruments located in the
trading account and instruments located in the trading account with
values that react primarily to changes in equity prices, including
voting or non-voting common stock, certain convertible bonds, and
commitments to buy or sell equity instruments. Also included are
derivatives (including written and purchased options) for which the
underlying is a covered equity position.
(A) For covered equity positions that are derivatives, a bank
must risk weight (as described in paragraph (c)(2)(iii) of this
section) the market value of the effective notional amount of the
underlying equity instrument or equity portfolio. Swaps must be
included as the notional position in the underlying equity
instrument or index portfolio, with a receiving side treated as a
long position and a paying side treated as a short position; and
(B) For covered equity positions that are options, whether long
or short, a bank must risk weight (as described in paragraph
(c)(2)(iii) of this section) the market value of the effective
notional amount of the underlying equity instrument or index
multiplied by the option's delta.
(ii) A bank may net long and short covered equity positions
(including derivatives) in identical equity issues or equity indices
in the same market.16
---------------------------------------------------------------------------
\16\ A bank may also net positions in depository receipts
against an opposite position in the underlying equity or identical
equity in different markets, provided that the bank includes the
costs of conversion.
---------------------------------------------------------------------------
(iii)(A) A bank must multiply the absolute value of the current
market value of each net long or short covered equity position by a
risk weighting factor of 8.0 percent, or by 4.0 percent if the
equity is held in a portfolio that is both liquid and well-
diversified.17 For covered equity positions that are index
contracts comprising a well-diversified portfolio of equity
instruments, the net long or short position is multiplied by a risk
weighting factor of 2.0 percent.
---------------------------------------------------------------------------
\17\ A portfolio is liquid and well-diversified if: (1) It is
characterized by a limited sensitivity to price changes of any
single equity issue or closely related group of equity issues held
in the portfolio; (2) the volatility of the portfolio's value is not
dominated by the volatility of any individual equity issue or by
equity issues from any single industry or economic sector; (3) it
contains a large number of individual equity positions, with no
single position representing a substantial portion of the
portfolio's total market value; and (4) it consists mainly of issues
traded on organized exchanges or in well-established over-the-
counter markets.
---------------------------------------------------------------------------
(B) For covered equity positions from the following futures-
related arbitrage strategies, a bank may apply a 2.0 percent risk
weighting factor to one side (long or short) of each position with
the opposite side exempt from charge, subject to review by the
Federal Reserve:
(1) Long and short positions in exactly the same index at
different dates or in different market centers; or
(2) Long and short positions in index contracts at the same date
in different but similar indices.
(C) For futures contracts on broadly-based indices that are
matched by offsetting positions in a basket of stocks comprising the
index, a bank may apply a 2.0 percent risk weighting factor to the
futures and stock basket positions (long and short), provided that
such trades are deliberately entered into and separately controlled,
and that the basket of stocks comprises at least 90 percent of the
capitalization of the index.
(iv) The specific risk capital charge component for covered
equity positions is the sum of the weighted values.
PART 225--BANK HOLDING COMPANIES AND CHANGE IN BANK CONTROL
(REGULATION Y)
1. The authority citation for part 225 continues to read as
follows:
Authority: 12 U.S.C. 1817(j)(13), 1818, 1831i, 1831p-1,
1843(c)(8), 1844(b), 1972(l), 3106, 3108, 3310, 3331-3351, 3907, and
3909.
2. Appendix A is amended in the introductory text, by adding a new
paragraph after the second undesignated paragraph to read as follows:
Appendix A to Part 225--Capital Adequacy Guidelines for Bank Holding
Companies: Risk-Based Measure
* * * * *
In addition, when certain organizations that engage in trading
activities calculate their risk-based capital ratio under this
appendix A, they must also refer to appendix E of this part, which
incorporates capital charges for certain market risks into the risk-
based capital ratio. When calculating their risk-based capital ratio
under this appendix A, such organizations are required to refer to
[[Page 47373]]
appendix E of this part for supplemental rules to determine
qualifying and excess capital, calculate risk-weighted assets,
calculate market risk equivalent assets, and calculate risk-based
capital ratios adjusted for market risk.
* * * * *
3. A new appendix E is added to read as follows:
Appendix E to Part 225--Capital Adequacy Guidelines for Bank Holding
Companies: Market Risk Measure
Section 1. Purpose, Applicability, Scope, and Effective Date
(a) Purpose. The purpose of this appendix is to ensure that bank
holding companies (organizations) with significant exposure to
market risk maintain adequate capital to support that
exposure.1 This appendix supplements and adjusts the risk-based
capital ratio calculations under appendix A of this part with
respect to those organizations.
---------------------------------------------------------------------------
\1\ This appendix is based on a framework developed jointly by
supervisory authorities from the countries represented on the Basle
Committee on Banking Supervision and endorsed by the Group of Ten
Central Bank Governors. The framework is described in a Basle
Committee paper entitled ``Amendment to the Capital Accord to
Incorporate Market Risk,'' January 1996.
---------------------------------------------------------------------------
(b) Applicability. (1) This appendix applies to any bank holding
company whose trading activity 2 (on a worldwide consolidated
basis) equals:
---------------------------------------------------------------------------
\2\ Trading activity means the gross sum of trading assets and
liabilities as reported in the bank holding company's most recent
quarterly Y-9C Report.
---------------------------------------------------------------------------
(i) 10 percent or more of total assets; 3 or
---------------------------------------------------------------------------
\3\ Total assets means quarter-end total assets as reported in
the bank holding company's most recent Y-9C Report.
---------------------------------------------------------------------------
(ii) $1 billion or more.
(2) The Federal Reserve may additionally apply this appendix to
any bank holding company if the Federal Reserve deems it necessary
or appropriate for safe and sound banking practices.
(3) The Federal Reserve may exclude a bank holding company
otherwise meeting the criteria of paragraph (b)(1) of this section
from coverage under this appendix if it determines the organization
meets such criteria as a consequence of accounting, operational, or
similar considerations, and the Federal Reserve deems it consistent
with safe and sound banking practices.
(c) Scope. The capital requirements of this appendix support
market risk associated with an organization's covered positions.
(d) Effective date. This appendix is effective as of January 1,
1997. Compliance is not mandatory until January 1, 1998. Subject to
supervisory approval, a bank holding company may opt to comply with
this appendix as early as January 1, 1997.4
---------------------------------------------------------------------------
\4\ A bank holding company that voluntarily complies with the
final rule prior to January 1, 1998, must comply with all of its
provisions.
---------------------------------------------------------------------------
Section 2. Definitions
For purposes of this appendix, the following definitions apply:
(a) Covered positions means all positions in an organization's
trading account, and all foreign exchange 5 and commodity
positions, whether or not in the trading account.6 Positions
include on-balance-sheet assets and liabilities and off-balance-
sheet items. Securities subject to repurchase and lending agreements
are included as if still owned by the lender.
---------------------------------------------------------------------------
\5\ Subject to supervisory review, a bank may exclude structural
positions in foreign currencies from its covered positions.
\6\ The term trading account is defined in the instructions to
the Call Report.
---------------------------------------------------------------------------
(b) Market risk means the risk of loss resulting from movements
in market prices. Market risk consists of general market risk and
specific risk components.
(1) General market risk means changes in the market value of
covered positions resulting from broad market movements, such as
changes in the general level of interest rates, equity prices,
foreign exchange rates, or commodity prices.
(2) Specific risk means changes in the market value of specific
positions due to factors other than broad market movements and
includes such risk as the credit risk of an instrument's issuer.
(c) Tier 1 and Tier 2 capital are defined in appendix A of this
part.
(d) Tier 3 capital is subordinated debt that is unsecured; is
fully paid up; has an original maturity of at least two years; is
not redeemable before maturity without prior approval by the Federal
Reserve; includes a lock-in clause precluding payment of either
interest or principal (even at maturity) if the payment would cause
the issuing organization's risk-based capital ratio to fall or
remain below the minimum required under appendix A of this part; and
does not contain and is not covered by any covenants, terms, or
restrictions that are inconsistent with safe and sound banking
practices.
(e) Value-at-risk (VAR) means the estimate of the maximum amount
that the value of covered positions could decline due to market
price or rate movements during a fixed holding period within a
stated confidence level, measured in accordance with section 4 of
this appendix.
Section 3. Adjustments to the Risk-Based Capital Ratio Calculations
(a) Risk-based capital ratio denominator. An organization
subject to this appendix shall calculate its risk-based capital
ratio denominator as follows:
(1) Adjusted risk-weighted assets. Calculate adjusted risk-
weighted assets, which equals risk-weighted assets (as determined in
accordance with appendix A of this part) excluding the risk-weighted
amounts of all covered positions (except foreign exchange positions
outside the trading account and over-the-counter derivative
positions).7
---------------------------------------------------------------------------
\7\ Foreign exchange positions outside the trading account and
all over-the-counter derivative positions, whether or not in the
trading account, must be included in adjusted risk weighted assets
as determined in appendix A of this part.
---------------------------------------------------------------------------
(2) Measure for market risk. Calculate the measure for market
risk, which equals the sum of the VAR-based capital charge, the
specific risk add-on (if any), and the capital charge for de minimis
exposures (if any).
(i) VAR-based capital charge. The VAR-based capital charge
equals the higher of:
(A) The previous day's VAR measure; or
(B) The average of the daily VAR measures for each of the
preceding 60 business days multiplied by three, except as provided
in section 4(e) of this appendix;
(ii) Specific risk add-on. The specific risk add-on is
calculated in accordance with section 5 of this appendix; and
(iii) Capital charge for de minimis exposure. The capital charge
for de minimis exposure is calculated in accordance with section
4(a) of this appendix.
(3) Market risk equivalent assets. Calculate market risk
equivalent assets by multiplying the measure for market risk (as
calculated in paragraph (a)(2) of this section) by 12.5.
(4) Denominator calculation. Add market risk equivalent assets
(as calculated in paragraph (a)(3) of this section) to adjusted
risk-weighted assets (as calculated in paragraph (a)(1) of this
section). The resulting sum is the organization's risk-based capital
ratio denominator.
(b) Risk-based capital ratio numerator. An organization subject
to this appendix shall calculate its risk-based capital ratio
numerator by allocating capital as follows:
(1) Credit risk allocation. Allocate Tier 1 and Tier 2 capital
equal to 8.0 percent of adjusted risk-weighted assets (as calculated
in paragraph (a)(1) of this section).8
---------------------------------------------------------------------------
\8\ An institution may not allocate Tier 3 capital to support
credit risk (as calculated under appendix A of this part).
---------------------------------------------------------------------------
(2) Market risk allocation. Allocate Tier 1, Tier 2, and Tier 3
capital equal to the measure for market risk as calculated in
paragraph (a)(2) of this section. The sum of Tier 2 and Tier 3
capital allocated for market risk must not exceed 250 percent of
Tier 1 capital allocated for market risk. (This requirement means
that Tier 1 capital allocated in this paragraph (b)(2) must equal at
least 28.6 percent of the measure for market risk.)
(3) Restrictions. (i) The sum of Tier 2 capital (both allocated
and excess) and Tier 3 capital (allocated in paragraph (b)(2) of
this section) may not exceed 100 percent of Tier 1 capital (both
allocated and excess).9
---------------------------------------------------------------------------
\9\ Excess Tier 1 capital means Tier 1 capital that has not been
allocated in paragraphs (b)(1) and (b)(2) of this section. Excess
Tier 2 capital means Tier 2 capital that has not been allocated in
paragraph (b)(1) and (b)(2) of this section, subject to the
restrictions in paragraph (b)(3) of this section.
---------------------------------------------------------------------------
(ii) Term subordinated debt (and intermediate-term preferred
stock and related surplus) included in Tier 2 capital (both
allocated and excess) may not exceed 50 percent of Tier 1 capital
(both allocated and excess).
(4) Numerator calculation. Add Tier 1 capital (both allocated
and excess), Tier 2 capital (both allocated and excess), and Tier 3
capital (allocated under paragraph (b)(2) of this section). The
resulting sum is the organization's risk-based capital ratio
numerator.
Section 4. Internal Models
(a) General. For risk-based capital purposes, a bank holding
company subject to this appendix must use its internal model to
measure its daily VAR, in accordance with
[[Page 47374]]
the requirements of this section.10 The Federal Reserve may
permit an organization to use alternative techniques to measure the
market risk of de minimis exposures so long as the techniques
adequately measure associated market risk.
---------------------------------------------------------------------------
\10\ An organization's internal model may use any generally
accepted measurement techniques, such as variance-covariance models,
historical simulations, or Monte Carlo simulations. However, the
level of sophistication and accuracy of an organization's internal
model must be commensurate with the nature and size of its covered
positions. An organization that modifies its existing modeling
procedures to comply with the requirements of this appendix for
risk-based capital purposes should, nonetheless, continue to use the
internal model it considers most appropriate in evaluating risks for
other purposes.
---------------------------------------------------------------------------
(b) Qualitative requirements. A bank holding company subject to
this appendix must have a risk management system that meets the
following minimum qualitative requirements:
(1) The organization must have a risk control unit that reports
directly to senior management and is independent from business
trading units.
(2) The organization's internal risk measurement model must be
integrated into the daily management process.
(3) The organization's policies and procedures must identify,
and the organization must conduct, appropriate stress tests and
backtests.11 The organization's policies and procedures must
identify the procedures to follow in response to the results of such
tests.
---------------------------------------------------------------------------
\11\ Stress tests provide information about the impact of
adverse market events on a bank's covered positions. Backtests
provide information about the accuracy of an internal model by
comparing an organization's daily VAR measures to its corresponding
daily trading profits and losses.
---------------------------------------------------------------------------
(4) The organization must conduct independent reviews of its
risk measurement and risk management systems at least annually.
(c) Market risk factors. The organization's internal model must
use risk factors sufficient to measure the market risk inherent in
all covered positions. The risk factors must address interest rate
risk,12 equity price risk, foreign exchange rate risk, and
commodity price risk.
---------------------------------------------------------------------------
\12\ For material exposures in the major currencies and markets,
modeling techniques must capture spread risk and must incorporate
enough segments of the yield curve--at least six--to capture
differences in volatility and less than perfect correlation of rates
along the yield curve.
---------------------------------------------------------------------------
(d) Quantitative requirements. For regulatory capital purposes,
VAR measures must meet the following quantitative requirements:
(1) The VAR measures must be calculated on a daily basis using a
99 percent, one-tailed confidence level with a price shock
equivalent to a ten-business day movement in rates and prices. In
order to calculate VAR measures based on a ten-day price shock, the
organization may either calculate ten-day figures directly or
convert VAR figures based on holding periods other than ten days to
the equivalent of a ten-day holding period (for instance, by
multiplying a one-day VAR measure by the square root of ten).
(2) The VAR measures must be based on an historical observation
period (or effective observation period for an organization using a
weighting scheme or other similar method) of at least one year. The
organization must update data sets at least once every three months
or more frequently as market conditions warrant.
(3) The VAR measures must include the risks arising from the
non-linear price characteristics of options positions and the
sensitivity of the market value of the positions to changes in the
volatility of the underlying rates or prices. An organization with a
large or complex options portfolio must measure the volatility of
options positions by different maturities.
(4) The VAR measures may incorporate empirical correlations
within and across risk categories, provided that the organization's
process for measuring correlations is sound. In the event that the
VAR measures do not incorporate empirical correlations across risk
categories, then the organization must add the separate VAR measures
for the four major risk categories to determine its aggregate VAR
measure.
(e) Backtesting. (1) Beginning one year after a bank holding
company starts to comply with this appendix, it must conduct
backtesting by comparing each of its most recent 250 business days'
actual net trading profit or loss 13 with the corresponding
daily VAR measures generated for internal risk measurement purposes
and calibrated to a one-day holding period and a 99th percentile,
one-tailed confidence level.
---------------------------------------------------------------------------
\13\ Actual net trading profits and losses typically include
such things as realized and unrealized gains and losses on portfolio
positions as well as fee income and commissions associated with
trading activities.
---------------------------------------------------------------------------
(2) Once each quarter, the organization must identify the number
of exceptions, that is, the number of business days for which the
magnitude of the actual daily net trading loss, if any, exceeds the
corresponding daily VAR measure.
(3) A bank holding company must use the multiplication factor
indicated in Table 1 of this appendix in determining its capital
charge for market risk under section 3(a)(2)(i)(B) of this appendix
until it obtains the next quarter's backtesting results, unless the
Federal Reserve determines that a different adjustment or other
action is appropriate.
Table 1.--Multiplication Factor Based on Results of Backtesting
------------------------------------------------------------------------
Multiplication
Number of exceptions factor
------------------------------------------------------------------------
4 or fewer.............................................. 3.00
5....................................................... 3.40
6....................................................... 3.50
7....................................................... 3.65
8....................................................... 3.75
9....................................................... 3.85
10 or more.............................................. 4.00
------------------------------------------------------------------------
Section 5. Specific Risk
(a) Specific risk add-on. For purposes of section 3(a)(2)(ii) of
this appendix, a bank holding company's specific risk add-on equals
the standard specific risk capital charge calculated under paragraph
(c) of this section. If, however, an organization can demonstrate to
the Federal Reserve that its internal model measures the specific
risk of covered debt and/or equity positions and that those measures
are included in the VAR-based capital charge in section 3(a)(2)(i)
of this appendix, then it may reduce or eliminate its specific risk
add-on under this section. The determination as to whether a model
incorporates specific risk must be made separately for covered debt
and equity positions.
(1) If a model includes the specific risk of covered debt
positions but not covered equity positions (or vice versa), then the
organization can reduce its specific risk charge for the included
positions under paragraph (b) of this section. The specific risk
charge for the positions not included equals the standard specific
risk capital charge under paragraph (c) of this section.
(2) If a model addresses the specific risk of both covered debt
and equity positions, then the organization can reduce its specific
risk charge for both covered debt and equity positions under
paragraph (b) of this section. In this case, the comparison
described in paragraph (b) of this section must be based on the
total VAR-based figure for the specific risk of debt and equity
positions, taking account of any correlations that are built into
the model.
(b) VAR-based specific risk capital charge. In all cases where a
bank holding company measures specific risk in its internal model,
the total capital charge for specific risk (i.e., the VAR-based
specific risk capital charge plus the specific risk add-on) must
equal at least 50 percent of the standard specific risk capital
charge (this amount is the minimum specific risk charge).
(1) If the portion of an organization's VAR measure that is
attributable to specific risk (multiplied by the organization's
multiplication factor if required in section 3(a)(2) of this
appendix) is greater than or equal to the minimum specific risk
charge, then the organization has no specific risk add-on and its
capital charge for specific risk is the portion included in the VAR
measure.
(2) If the portion of an organization's VAR measure that is
attributable to specific risk (multiplied by the organization's
multiplication factor if required in section 3(a)(2) of this
appendix) is less than the minimum specific risk charge, then the
organization's specific risk add-on is the difference between the
minimum specific risk charge and the specific risk portion of the
VAR measure (multiplied by the multiplication factor if required in
section 3(a)(2) of this appendix).
(c) Standard specific risk capital charge. The standard specific
risk capital charge equals the sum of the components for covered
debt and equity positions as follows:
(1) Covered debt positions. (i) For purposes of this section 5,
covered debt positions means fixed-rate or floating-rate debt
instruments located in the trading account or instruments located in
the trading account with values that react primarily to changes in
interest rates, including certain non-
[[Page 47375]]
convertible preferred stock, convertible bonds, and instruments
subject to repurchase and lending agreements. Also included are
derivatives (including written and purchased options) for which the
underlying instrument is a covered debt instrument that is subject
to a non-zero specific risk capital charge.
(A) For covered debt positions that are derivatives, an
organization must risk-weight (as described in paragraph (c)(1)(iii)
of this section) the market value of the effective notional amount
of the underlying debt instrument or index portfolio. Swaps must be
included as the notional position in the underlying debt instrument
or index portfolio, with a receiving side treated as a long position
and a paying side treated as a short position; and
(B) For covered debt positions that are options, whether long or
short, an organization must risk-weight (as described in paragraph
(c)(1)(iii) of this section) the market value of the effective
notional amount of the underlying debt instrument or index
multiplied by the option's delta.
(ii) An organization may net long and short covered debt
positions (including derivatives) in identical debt issues or
indices.
(iii) An organization must multiply the absolute value of the
current market value of each net long or short covered debt position
by the appropriate specific risk weighting factor indicated in Table
2 of this appendix. The specific risk capital charge component for
covered debt positions is the sum of the weighted values.
Table 2.--Specific Risk Weighting Factors for Covered Debt Positions
------------------------------------------------------------------------
Weighting
Remaining maturity factor
Category (contractual) (in
percent)
------------------------------------------------------------------------
Government.......................... N/A.................... 0.00
Qualifying.......................... 6 months or less....... 0.25
Over 6 months to 24 1.00
months.
Over 24 months......... 1.60
Other............................... N/A.................... 8.00
------------------------------------------------------------------------
(A) The government category includes all debt instruments of
central governments of OECD-based countries 14 including bonds,
Treasury bills, and other short-term instruments, as well as local
currency instruments of non-OECD central governments to the extent
the organization has liabilities booked in that currency.
---------------------------------------------------------------------------
\14\ Organization for Economic Cooperation and Development
(OECD)-based countries is defined in appendix A of this part.
---------------------------------------------------------------------------
(B) The qualifying category includes debt instruments of U.S.
government-sponsored agencies, general obligation debt instruments
issued by states and other political subdivisions of OECD-based
countries, multilateral development banks, and debt instruments
issued by U.S. depository institutions or OECD banks that do not
qualify as capital of the issuing institution.15 This category
also includes other debt instruments, including corporate debt and
revenue instruments issued by states and other political
subdivisions of OECD countries, that are:
---------------------------------------------------------------------------
\15\ U.S. government-sponsored agencies, multilateral
development banks, and OECD banks are defined in appendix A of this
part.
---------------------------------------------------------------------------
(1) Rated investment-grade by at least two nationally recognized
credit rating services;
(2) Rated investment grade by one nationally recognized credit
rating agency and not rated less than investment grade by any other
credit rating agency; or
(3) Unrated, but deemed to be of comparable investment quality
by the reporting organization and the issuer has instruments listed
on a recognized stock exchange, subject to review by the Federal
Reserve.
(C) The other category includes debt instruments that are not
included in the government or qualifying categories.
(2) Covered equity positions. (i) For purposes of this section
5, covered equity positions means equity instruments located in the
trading account and instruments located in the trading account with
values that react primarily to changes in equity prices, including
voting or non-voting common stock, certain convertible bonds, and
commitments to buy or sell equity instruments. Also included are
derivatives (including written or purchased options) for which the
underlying is a covered equity position.
(A) For covered equity positions that are derivatives, an
organization must risk weight (as described in paragraph (c)(2)(iii)
of this section) the market value of the effective notional amount
of the underlying equity instrument or equity portfolio. Swaps must
be included as the notional position in the underlying equity
instrument or index portfolio, with a receiving side treated as a
long position and a paying side treated as a short position; and
(B) For covered equity positions that are options, whether long
or short, an organization must risk weight (as described in
paragraph (c)(2)(iii) of this section) the market value of the
effective notional amount of the underlying equity instrument or
index multiplied by the option's delta.
(ii) An organization may net long and short covered equity
positions (including derivatives) in identical equity issues or
equity indices in the same market.16
---------------------------------------------------------------------------
\16\ An organization may also net positions in depository
receipts against an opposite position in the underlying equity or
identical equity in different markets, provided that the
organization includes the costs of conversion.
---------------------------------------------------------------------------
(iii)(A) An organization must multiply the absolute value of the
current market value of each net long or short covered equity
position by a risk weighting factor of 8.0 percent, or by 4.0
percent if the equity is held in a portfolio that is both liquid and
well-diversified.17 For covered equity positions that are index
contracts comprising a well-diversified portfolio of equity
instruments, the net long or short position is to be multiplied by a
risk weighting factor of 2.0 percent.
---------------------------------------------------------------------------
\17\ A portfolio is liquid and well-diversified if: (1) it is
characterized by a limited sensitivity to price changes of any
single equity issue or closely related group of equity issues held
in the portfolio; (2) the volatility of the portfolio's value is not
dominated by the volatility of any individual equity issue or by
equity issues from any single industry or economic sector; (3) it
contains a large number of individual equity positions, with no
single position representing a substantial portion of the
portfolio's total market value; and (4) it consists mainly of issues
traded on organized exchanges or in well-established over-the-
counter markets.
---------------------------------------------------------------------------
(B) For covered equity positions from the following futures-
related arbitrage strategies, an organization may apply a 2.0
percent risk weighting factor to one side (long or short) of each
equity position with the opposite side exempt from charge, subject
to review by the Federal Reserve:
(1) Long and short positions in exactly the same index at
different dates or in different market centers; or
(2) Long and short positions in index contracts at the same date
in different but similar indices.
(C) For futures contracts on broadly-based indices that are
matched by offsetting positions in a basket of stocks comprising the
index, an organization may apply a 2.0 percent risk weighting factor
to the futures and stock basket positions (long and short), provided
that such trades are deliberately entered into and separately
controlled, and that the basket of stocks comprises at least 90
percent of the capitalization of the index.
(iv) The specific risk capital charge component for covered
equity positions is the sum of the weighted values.
By order of the Board of Governors of the Federal Reserve
System, August 29, 1996.
William W. Wiles,
Secretary of the Board.
Federal Deposit Insurance Corporation
12 CFR CHAPTER III
For the reasons indicated in the preamble, the FDIC Board of
Directors hereby amends part 325 of chapter III of title 12 of the Code
of Federal Regulations as follows.
PART 325--[AMENDED]
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, 4808; Pub. L. 102-233, 105 Stat. 1761,
1789, 1790 (12 U.S.C. 1831n note); Pub. L. 102-242, 105 Stat. 2236,
2355, 2386 (12 U.S.C. 1828 note).
2. Appendix A to part 325 is amended in the introductory text, by
adding a new paragraph after the third undesignated paragraph to read
as follows:
Appendix A to Part 325--Statement of Policy on Risk-Based Capital
* * * * *
In addition, when certain banks that engage in trading
activities calculate their risk-based capital ratio under this
appendix A, they must also refer to appendix C of this
[[Page 47376]]
part, which incorporates capital charges for certain market risks
into the risk-based capital ratio. When calculating their risk-based
capital ratio under this appendix A, such banks are required to
refer to appendix C of this part for supplemental rules to determine
qualifying and excess capital, calculate risk-weighted assets,
calculate market risk equivalent assets and add them to risk-
weighted assets, and calculate risk-based capital ratios as adjusted
for market risk.
* * * * *
3. A new appendix C is added to part 325 to read as follows:
Appendix C to Part 325--Risk-Based Capital for State Non-Member
Banks; Market Risk
Section 1. Purpose, Applicability, Scope, and Effective Date
(a) Purpose. The purpose of this appendix is to ensure that
banks with significant exposure to market risk maintain adequate
capital to support that exposure.1 This appendix supplements
and adjusts the risk-based capital ratio calculations under appendix
A of this part with respect to those banks.
---------------------------------------------------------------------------
\1\ This appendix is based on a framework developed jointly by
supervisory authorities from the countries represented on the Basle
Committee on Banking Supervision and endorsed by the Group of Ten
Central Bank Governors. The framework is described in a Basle
Committee paper entitled ``Amendment to the Capital Accord to
Incorporate Market Risk,'' January 1996.
---------------------------------------------------------------------------
(b) Applicability. (1) This appendix applies to any insured
state nonmember bank whose trading activity 2 (on a worldwide
consolidated basis) equals:
---------------------------------------------------------------------------
\2\ Trading activity means the gross sum of trading assets and
liabilities as reported in the bank's most recent quarterly
Consolidated Report of Condition and Income (Call Report).
---------------------------------------------------------------------------
(i) 10 percent or more of total assets; 3 or
---------------------------------------------------------------------------
\3\ Total assets means quarter-end total assets as reported in
the bank's most recent Call Report.
---------------------------------------------------------------------------
(ii) $1 billion or more.
(2) The FDIC may additionally apply this appendix to any insured
state nonmember bank if the FDIC deems it necessary or appropriate
for safe and sound banking practices.
(3) The FDIC may exclude an insured state nonmember bank
otherwise meeting the criteria of paragraph (b)(1) of this section
from coverage under this appendix if it determines the bank meets
such criteria as a consequence of accounting, operational, or
similar considerations, and the FDIC deems it consistent with safe
and sound banking practices.
(c) Scope. The capital requirements of this appendix support
market risk associated with a bank's covered positions.
(d) Effective date. This appendix is effective as of January 1,
1997. Compliance is not mandatory until January 1, 1998. Subject to
supervisory approval, a bank may opt to comply with this appendix as
early as January 1, 1997.4
---------------------------------------------------------------------------
\4\ A bank that voluntarily complies with the final rule prior
to January 1, 1998, must comply with all of its provisions.
---------------------------------------------------------------------------
Section 2. Definitions
For purposes of this appendix, the following definitions apply:
(a) Covered positions means all positions in a bank's trading
account, and all foreign exchange 5 and commodity positions,
whether or not in the trading account.6 Positions include on-
balance-sheet assets and liabilities and off-balance-sheet items.
Securities subject to repurchase and lending agreements are included
as if they are still owned by the lender.
---------------------------------------------------------------------------
\5\ Subject to FDIC review, a bank may exclude structural
positions in foreign currencies from its covered positions.
\6\ The term trading account is defined in the instructions to
the Call Report.
---------------------------------------------------------------------------
(b) Market risk means the risk of loss resulting from movements
in market prices. Market risk consists of general market risk and
specific risk components.
(1) General market risk means changes in the market value of
covered positions resulting from broad market movements, such as
changes in the general level of interest rates, equity prices,
foreign exchange rates, or commodity prices.
(2) Specific risk means changes in the market value of specific
positions due to factors other than broad market movements and
includes such risk as the credit risk of an instrument's issuer.
(c) Tier 1 and Tier 2 capital are defined in appendix A of this
part.
(d) Tier 3 capital is subordinated debt that is unsecured; is
fully paid up; has an original maturity of at least two years; is
not redeemable before maturity without prior approval by the FDIC;
includes a lock-in clause precluding payment of either interest or
principal (even at maturity) if the payment would cause the issuing
bank's risk-based capital ratio to fall or remain below the minimum
required under appendix A of this part; and does not contain and is
not covered by any covenants, terms, or restrictions that are
inconsistent with safe and sound banking practices.
(e) Value-at-risk (VAR) means the estimate of the maximum amount
that the value of covered positions could decline during a fixed
holding period within a stated confidence level, measured in
accordance with section 4 of this appendix.
Section 3. Adjustments to the Risk-Based Capital Ratio
Calculations.
(a) Risk-based capital ratio denominator. A bank subject to this
appendix shall calculate its risk-based capital ratio denominator as
follows:
(1) Adjusted risk-weighted assets. Calculate adjusted risk-
weighted assets, which equals risk-weighted assets (as determined in
accordance with appendix A of this part), excluding the risk-
weighted amounts of all covered positions (except foreign exchange
positions outside the trading account and over-the-counter
derivative positions).7
---------------------------------------------------------------------------
\7\ Foreign exchange positions outside the trading account and
all over-the-counter derivative positions, whether or not in the
trading account, must be included in adjusted risk weighted assets
as determined in appendix A of this part.
---------------------------------------------------------------------------
(2) Measure for market risk. Calculate the measure for market
risk, which equals the sum of the VAR-based capital charge, the
specific risk add-on (if any), and the capital charge for de minimis
exposures (if any).
(i) VAR-based capital charge. The VAR-based capital charge
equals the higher of:
(A) The previous day's VAR measure; or
(B) The average of the daily VAR measures for each of the
preceding 60 business days multiplied by three, except as provided
in section 4(e) of this appendix;
(ii) Specific risk add-on. The specific risk add-on is
calculated in accordance with section 5 of this appendix; and
(iii) Capital charge for de minimis exposure. The capital charge
for de minimis exposure is calculated in accordance with section
4(a) of this appendix.
(3) Market risk equivalent assets. Calculate market risk
equivalent assets by multiplying the measure for market risk (as
calculated in paragraph (a)(2) of this section) by 12.5.
(4) Denominator calculation. Add market risk equivalent assets
(as calculated in paragraph (a)(3) of this section) to adjusted
risk-weighted assets (as calculated in paragraph (a)(1) of this
section). The resulting sum is the bank's risk-based capital ratio
denominator.
(b) Risk-based capital ratio numerator. A bank subject to this
appendix shall calculate its risk-based capital ratio numerator by
allocating capital as follows:
(1) Credit risk allocation. Allocate Tier 1 and Tier 2 capital
equal to 8.0 percent of adjusted risk-weighted assets (as calculated
in paragraph (a)(1) of this section).8
---------------------------------------------------------------------------
\8\ A bank may not allocate Tier 3 capital to support credit
risk (as calculated under appendix A of this part).
---------------------------------------------------------------------------
(2) Market risk allocation. Allocate Tier 1, Tier 2, and Tier 3
capital equal to the measure for market risk as calculated in
paragraph (a)(2) of this section. The sum of Tier 2 and Tier 3
capital allocated for market risk must not exceed 250 percent of
Tier 1 capital allocated for market risk. (This requirement means
that Tier 1 capital allocated in this paragraph (b)(2) must equal at
least 28.6 percent of the measure for market risk.)
(3) Restrictions. (i) The sum of Tier 2 capital (both allocated
and excess) and Tier 3 capital (allocated in paragraph (b)(2) of
this section) may not exceed 100 percent of Tier 1 capital (both
allocated and excess).9
---------------------------------------------------------------------------
\9\ Excess Tier 1 capital means Tier 1 capital that has not been
allocated in paragraphs (b)(1) and (b)(2) of this section. Excess
Tier 2 capital means Tier 2 capital that has not been allocated in
paragraph (b)(1) and (b)(2) of this section, subject to the
restrictions in paragraph (b)(3) of this section.
---------------------------------------------------------------------------
(ii) Term subordinated debt (and intermediate-term preferred
stock and related surplus) included in Tier 2 capital (both
allocated and excess) may not exceed 50 percent of Tier 1 capital
(both allocated and excess).
(4) Numerator calculation. Add Tier 1 capital (both allocated
and excess), Tier 2 capital (both allocated and excess), and Tier 3
capital (allocated under paragraph (b)(2) of this section). The
resulting sum is the bank's risk-based capital ratio numerator.
Section 4. Internal Models
(a) General. For risk-based capital purposes, a bank subject to
this appendix
[[Page 47377]]
must use its internal model to measure its daily VAR, in accordance
with the requirements of this section.10 The FDIC may permit a
bank to use alternative techniques to measure the market risk of de
minimis exposures so long as the techniques adequately measure
associated market risk.
---------------------------------------------------------------------------
\10\ A bank's internal model may use any generally accepted
measurement techniques, such as variance-covariance models,
historical simulations, or Monte Carlo simulations. However, the
level of sophistication and accuracy of a bank's internal model must
be commensurate with the nature and size of its covered positions. A
bank that modifies its existing modeling procedures to comply with
the requirements of this appendix for risk-based capital purposes
should, nonetheless, continue to use the internal model it considers
most appropriate in evaluating risks for other purposes.
---------------------------------------------------------------------------
(b) Qualitative requirements. A bank subject to this appendix
must have a risk management system that meets the following minimum
qualitative requirements:
(1) The bank must have a risk control unit that reports directly
to senior management and is independent from business trading units.
(2) The bank's internal risk measurement model must be
integrated into the daily management process.
(3) The bank's policies and procedures must identify, and the
bank must conduct, appropriate stress tests and backtests.11
The bank's policies and procedures must identify the procedures to
follow in response to the results of such tests.
---------------------------------------------------------------------------
\11\ Stress tests provide information about the impact of
adverse market events on a bank's covered positions. Backtests
provide information about the accuracy of an internal model by
comparing a bank's daily VAR measures to its corresponding daily
trading profits and losses.
---------------------------------------------------------------------------
(4) The bank must conduct independent reviews of its risk
measurement and risk management systems at least annually.
(c) Market risk factors. The bank's internal model must use risk
factors sufficient to measure the market risk inherent in all
covered positions. The risk factors must address interest rate
risk,12 equity price risk, foreign exchange rate risk, and
commodity price risk.
---------------------------------------------------------------------------
\12\ For material exposures in the major currencies and markets,
modeling techniques must capture spread risk and must incorporate
enough segments of the yield curve--at least six--to capture
differences in volatility and less than perfect correlation of rates
along the yield curve.
---------------------------------------------------------------------------
(d) Quantitative requirements. For regulatory capital purposes,
VAR measures must meet the following quantitative requirements:
(1) The VAR measures must be calculated on a daily basis using a
99 percent, one-tailed confidence level with a price shock
equivalent to a ten-business day movement in rates and prices. In
order to calculate VAR measures based on a ten-day price shock, the
bank may either calculate ten-day figures directly or convert VAR
figures based on holding periods other than ten days to the
equivalent of a ten-day holding period (for instance, by multiplying
a one-day VAR measure by the square root of ten).
(2) The VAR measures must be based on an historical observation
period (or effective observation period for a bank using a weighting
scheme or other similar method) of at least one year. The bank must
update data sets at least once every three months or more frequently
as market conditions warrant.
(3) The VAR measures must include the risks arising from the
non-linear price characteristics of options positions and the
sensitivity of the market value of the positions to changes in the
volatility of the underlying rates or prices. A bank with a large or
complex options portfolio must measure the volatility of options
positions by different maturities.
(4) The VAR measures may incorporate empirical correlations
within and across risk categories, provided that the bank's process
for measuring correlations is sound. In the event that the VAR
measures do not incorporate empirical correlations across risk
categories, then the bank must add the separate VAR measures for the
four major risk categories to determine its aggregate VAR measure.
(e) Backtesting. (1) Beginning one year after a bank starts to
comply with this appendix, a bank must conduct backtesting by
comparing each of its most recent 250 business days' actual net
trading profit or loss 13 with the corresponding daily VAR
measures generated for internal risk measurement purposes and
calibrated to a one-day holding period and a 99 percent, one-tailed
confidence level.
---------------------------------------------------------------------------
\13\ Actual net trading profits and losses typically include
such things as realized and unrealized gains and losses on portfolio
positions as well as fee income and commissions associated with
trading activities.
---------------------------------------------------------------------------
(2) Once each quarter, the bank must identify the number of
exceptions, that is, the number of business days for which the
magnitude of the actual daily net trading loss, if any, exceeds the
corresponding daily VAR measure.
(3) A bank must use the multiplication factor indicated in Table
1 of this appendix in determining its capital charge for market risk
under section 3(a)(2)(i)(B) of this appendix until it obtains the
next quarter's backtesting results, unless the FDIC determines that
a different adjustment or other action is appropriate.
Table 1.--Multiplication Factor Based on Results of Backtesting
------------------------------------------------------------------------
Multiplication
Number of exceptions factor
------------------------------------------------------------------------
4 or fewer.............................................. 3.00
5....................................................... 3.40
6....................................................... 3.50
7....................................................... 3.65
8....................................................... 3.75
9....................................................... 3.85
10 or more.............................................. 4.00
------------------------------------------------------------------------
Section 5. Specific Risk
(a) Specific risk add-on. For purposes of section 3(a)(2)(ii) of
this appendix, a bank's specific risk add-on equals the standard
specific risk capital charge calculated under paragraph (c) of this
section. If, however, a bank can demonstrate to the FDIC that its
internal model measures the specific risk of covered debt and/or
equity positions and that those measures are included in the VAR-
based capital charge in section 3(a)(2)(i) of this appendix, then
the bank may reduce or eliminate its specific risk add-on under this
section. The determination as to whether a model incorporates
specific risk must be made separately for covered debt and equity
positions.
(1) If a model includes the specific risk of covered debt
positions but not covered equity positions (or vice versa), then the
bank can reduce its specific risk charge for the included positions
under paragraph (b) of this section. The specific risk charge for
the positions not included equals the standard specific risk capital
charge under paragraph (c) of this section.
(2) If a model addresses the specific risk of both covered debt
and equity positions, then the bank can reduce its specific risk
charge for both covered debt and equity positions under paragraph
(b) of this section. In this case, the comparison described in
paragraph (b) of this section must be based on the total VAR-based
figure for the specific risk of debt and equity positions, taking
into account any correlations that are built into the model.
(b) VAR-based specific risk capital charge. In all cases where a
bank measures specific risk in its internal model, the total capital
charge for specific risk (i.e., the VAR-based specific risk capital
charge plus the specific risk add-on) must equal at least 50 percent
of the standard specific risk capital charge (this amount is the
minimum specific risk charge).
(1) If the portion of a bank's VAR measure that is attributable
to specific risk (multiplied by the bank's multiplication factor if
required in section 3(a)(2) of this appendix) is greater than or
equal to the minimum specific risk charge, then the bank has no
specific risk add-on and its capital charge for specific risk is the
portion included in the VAR measure.
(2) If the portion of a bank's VAR measure that is attributable
to specific risk (multiplied by the bank's multiplication factor if
required in section 3(a)(2) of this appendix) is less than the
minimum specific risk charge, then the bank's specific risk add-on
is the difference between the minimum specific risk charge and the
specific risk portion of the VAR measure (multiplied by the bank's
multiplication factor if required in section 3(a)(2) of this
appendix).
(c) Standard specific risk capital charge. The standard specific
risk capital charge equals the sum of the components for covered
debt and equity positions as follows:
(1) Covered debt positions. (i) For purposes of this section 5,
covered debt positions means fixed-rate or floating-rate debt
instruments located in the trading account and instruments located
in the trading account with values that react primarily to changes
in interest rates, including certain non-convertible preferred
stock, convertible bonds, and instruments subject to repurchase and
lending agreements. Also included are derivatives (including written
and purchased options) for which the underlying instrument is a
covered debt instrument that is subject to a non-zero specific risk
capital charge.
(A) For covered debt positions that are derivatives, a bank must
risk-weight (as
[[Page 47378]]
described in paragraph (c)(1)(iii) of this section) the market value
of the effective notional amount of the underlying debt instrument
or index portfolio. Swaps must be included as the notional position
in the underlying debt instrument or index portfolio, with a
receiving side treated as a long position and a paying side treated
as a short position; and
(B) For covered debt positions that are options, whether long or
short, a bank must risk-weight (as described in paragraph
(c)(1)(iii) of this section) the market value of the effective
notional amount of the underlying debt instrument or index
multiplied by the option's delta.
(ii) A bank may net long and short covered debt positions
(including derivatives) in identical debt issues or indices.
(iii) A bank must multiply the absolute value of the current
market value of each net long or short covered debt position by the
appropriate specific risk weighting factor indicated in Table 2 of
this appendix. The specific risk capital charge component for
covered debt positions is the sum of the weighted values.
Table 2.--Specific Risk Weighting Factors for Covered Debt Positions
------------------------------------------------------------------------
Weighting
Category Remaining maturity factor (in
(contractual) percent)
------------------------------------------------------------------------
Government......................... N/A.................... 0.00
Qualifying......................... 6 months or less....... 0.25
Over 6 months to 24 1.00
months.
Over 24 months......... 1.60
Other.............................. N/A.................... 8.00
------------------------------------------------------------------------
(A) The government category includes all debt instruments of
central governments of OECD-based countries 14 including bonds,
Treasury bills, and other short-term instruments, as well as local
currency instruments of non-OECD central governments to the extent
the bank has liabilities booked in that currency.
---------------------------------------------------------------------------
\14\ Organization for Economic Cooperation and Development
(OECD)-based countries is defined in appendix A of this part.
---------------------------------------------------------------------------
(B) The qualifying category includes debt instruments of U.S.
government-sponsored agencies, general obligation debt instruments
issued by states and other political subdivisions of OECD-based
countries, multilateral development banks, and debt instruments
issued by U.S. depository institutions or OECD-banks that do not
qualify as capital of the issuing institution.15 This category
also includes other debt instruments, including corporate debt and
revenue instruments issued by states and other political
subdivisions of OECD countries, that are:
---------------------------------------------------------------------------
\15\ U.S. government-sponsored agencies, multilateral
development banks, and OECD banks are defined in appendix A of this
part.
---------------------------------------------------------------------------
(1) Rated investment-grade by at least two nationally recognized
credit rating services;
(2) Rated investment-grade by one nationally recognized credit
rating agency and not rated less than investment-grade by any other
credit rating agency; or
(3) Unrated, but deemed to be of comparable investment quality
by the reporting bank and the issuer has instruments listed on a
recognized stock exchange, subject to review by the FDIC.
(C) The other category includes debt instruments that are not
included in the government or qualifying categories.
(2) Covered equity positions. (i) For purposes of this section
5, covered equity positions means equity instruments located in the
trading account and instruments located in the trading account with
values that react primarily to changes in equity prices, including
voting or non-voting common stock, certain convertible bonds, and
commitments to buy or sell equity instruments. Also included are
derivatives (including written and purchased options) for which the
underlying is a covered equity position.
(A) For covered equity positions that are derivatives, a bank
must risk weight (as described in paragraph (c)(2)(iii) of this
section) the market value of the effective notional amount of the
underlying equity instrument or equity portfolio. Swaps must be
included as the notional position in the underlying equity
instrument or index portfolio, with a receiving side treated as a
long position and a paying side treated as a short position; and
(B) For covered equity positions that are options, whether long
or short, a bank must risk weight (as described in paragraph
(c)(2)(iii) of this section) the market value of the effective
notional amount of the underlying equity instrument or index
multiplied by the option's delta.
(ii) A bank may net long and short covered equity positions
(including derivatives) in identical equity issues or equity indices
in the same market.16
---------------------------------------------------------------------------
\16\ A bank may also net positions in depository receipts
against an opposite position in the underlying equity or identical
equity in different markets, provided that the bank includes the
costs of conversion.
---------------------------------------------------------------------------
(iii)(A) A bank must multiply the absolute value of the current
market value of each net long or short covered equity position by a
risk weighting factor of 8.0 percent, or by 4.0 percent if the
equity is held in a portfolio that is both liquid and well-
diversified.17 For covered equity positions that are index
contracts comprising a well-diversified portfolio of equity
instruments, the net long or short position is multiplied by a risk
weighting factor of 2.0 percent.
---------------------------------------------------------------------------
\17\ A portfolio is liquid and well-diversified if: (1) it is
characterized by a limited sensitivity to price changes of any
single equity issue or closely related group of equity issues held
in the portfolio; (2) the volatility of the portfolio's value is not
dominated by the volatility of any individual equity issue or by
equity issues from any single industry or economic sector; (3) it
contains a large number of individual equity positions, with no
single position representing a substantial portion of the
portfolio's total market value; and (4) it consists mainly of issues
traded on organized exchanges or in well-established over-the-
counter markets.
---------------------------------------------------------------------------
(B) For covered equity positions from the following futures-
related arbitrage strategies, a bank may apply a 2.0 percent risk
weighting factor to one side (long or short) of each position with
the opposite side exempt from charge, subject to review by the FDIC:
(1) Long and short positions in exactly the same index at
different dates or in different market centers; or
(2) Long and short positions in index contracts at the same date
in different but similar indices.
(C) For futures contracts on broadly-based indices that are
matched by offsetting positions in a basket of stocks comprising the
index, a bank may apply a 2.0 percent risk weighting factor to the
futures and stock basket positions (long and short), provided that
such trades are deliberately entered into and separately controlled,
and that the basket of stocks comprises at least 90 percent of the
capitalization of the index.
(iv) The specific risk capital charge component for covered
equity positions is the sum of the weighted values.
By Order of the Board of Directors.
Dated at Washington, D.C., this 13th day of August, 1996.
Federal Deposit Insurance Corporation.
Jerry L. Langley,
Executive Secretary.
[FR Doc. 96-22546 Filed 9-5-96; 8:45 am]
BILLING CODE 4810-33-P; 6210-01-P; 6714-01-P