[Federal Register Volume 65, Number 46 (Wednesday, March 8, 2000)]
[Proposed Rules]
[Pages 12320-12352]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-4211]



[[Page 12319]]

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Part II





Department of the Treasury





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Office of the Comptroller of the Currency



Office of Thrift Supervision



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Federal Reserve System





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Federal Deposit Insurance Corporation





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12 CFR Parts 3, 208, 225, 325 and 567



Risk-Based Capital Standards; Recourse and Direct Credit Substitutes; 
Proposed Rule

  Federal Register / Vol. 65, No. 46 / Wednesday, March 8, 2000 / 
Proposed Rules  

[[Page 12320]]



DEPARTMENT OF THE TREASURY

Office of the Comptroller of the Currency

12 CFR Part 3

[Docket No. 00-06]
RIN 1557-AB14

FEDERAL RESERVE SYSTEM

12 CFR Parts 208 and 225

[Regulations H and Y; Docket No. R-1055]

FEDERAL DEPOSIT INSURANCE CORPORATION

12 CFR Part 325

RIN 3064-AB31

DEPARTMENT OF THE TREASURY

Office of Thrift Supervision

12 CFR Part 567

[Docket No. 2000-15]
RIN 1550-AB11


Risk-Based Capital Standards; Recourse and Direct Credit 
Substitutes

AGENCIES: Office of the Comptroller of the Currency, Treasury; Board of 
Governors of the Federal Reserve System; Federal Deposit Insurance 
Corporation; and Office of Thrift Supervision, Treasury.

ACTION: Joint notice of proposed rulemaking.

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SUMMARY: The Office of the Comptroller of the Currency (OCC), the Board 
of Governors of the Federal Reserve System (Board), the Federal Deposit 
Insurance Corporation (FDIC), and the Office of Thrift Supervision 
(OTS) (collectively, the agencies) are proposing changes to their risk-
based capital standards to address the regulatory capital treatment of 
recourse obligations and direct credit substitutes that expose banks, 
bank holding companies, and thrifts (collectively, banking 
organizations) to credit risk. The proposal treats recourse obligations 
and direct credit substitutes more consistently than under the 
agencies' current risk-based capital standards. In addition, the 
agencies would use credit ratings and certain alternative approaches to 
match the risk-based capital requirement more closely to a banking 
organization's relative risk of loss in asset securitizations. The 
proposal also requires the sponsor of a revolving credit securitization 
that involves an early amortization feature to hold capital against the 
amount of assets under management, i.e. the off-balance sheet 
securitized receivables.
    This proposal is intended to result in more consistent treatment of 
recourse obligations and similar transactions among the agencies, more 
consistent risk-based capital treatment for certain types of 
transactions involving similar risk, and capital requirements that more 
closely reflect a banking organization's relative exposure to credit 
risk.

DATES: Your comments must be received by June 7, 2000.

ADDRESSES: Comments should be directed to:
    OCC: You may send comments electronically to regs.comments@
occ.treas.gov or by mail to Docket No. 00-06, Communications Division, 
Third Floor, Office of the Comptroller of the Currency, 250 E Street, 
SW, Washington, DC 20219. In addition, you may send comments by 
facsimile transmission to (202) 874-5274. You can inspect and photocopy 
comments at that address.
    Board: Comments, which should refer to Docket No. R-1055, may be 
mailed to Jennifer J. Johnson, Secretary, Board of Governors of the 
Federal Reserve System, 20th Street and Constitution Avenue, NW, 
Washington, DC 20551. Comments may also be delivered to Room B-2222 of 
the Eccles Building between 8:45 a.m. and 5:15 p.m. weekdays, or to the 
guard station in the Eccles Building courtyard on 20th Street between 
Constitution Avenue and C Street, NW, at any time. Comments may be 
inspected in Room MP-500 of the Martin Building between 9 a.m. and 5 
p.m. weekdays, except as provided in 12 CFR 261.8 of the Board's Rules 
Regarding Availability of Information.
    FDIC: Written comments should be addressed to Robert E. Feldman, 
Executive Secretary, Attention: Comments/OES, Federal Deposit Insurance 
Corporation, 550 17th Street, NW, Washington, DC 20429. Comments may be 
hand delivered to the guard station at the rear of the 550 17th Street 
Building (located on F Street), on business days between 7 a.m. and 5 
p.m. (Fax number: (202) 898-3838; Internet address: [email protected]). 
Comments may be inspected and photocopied in the FDIC Public 
Information Center, Room 100, 801 17th Street, NW, Washington, DC, 
between 9 a.m. and 4:30 p.m. on business days.
    OTS: Send comments to Manager, Dissemination Branch, Records 
Management and Information Policy, Office of Thrift Supervision, 1700 G 
Street, NW, Washington, DC 20552, Attention Docket No. 2000-15. These 
submissions may be hand-delivered to 1700 G Street, NW, from 9 a.m. to 
5 p.m. on business days or may be sent by facsimile transmission to FAX 
number (202) 906-7755; or by e-mail: [email protected]. Those 
commenting by e-mail should include their name and telephone number. 
Comments will be available for inspection at 1700 G Street, NW, from 9 
to 4 p.m. on business days.

FOR FURTHER INFORMATION CONTACT: OCC: Roger Tufts, Senior Economic 
Advisor or Amrit Sekhon, Risk Specialist, Capital Policy Division, 
(202) 874-5070; Laura Goldman, Senior Attorney, Legislative and 
Regulatory Activities Division, (202) 874-5090, Office of the 
Comptroller of the Currency, 250 E Street, SW, Washington, DC 20219.
    Board: Thomas R. Boemio, Senior Supervisory Financial Analyst, 
(202) 452-2982, or Norah Barger, Assistant Director (202) 452-2402, 
Division of Banking Supervision and Regulation. For the hearing 
impaired only, Telecommunication Device for the Deaf (TDD), Diane 
Jenkins, (202) 452-3544, Board of Governors of the Federal Reserve 
System, 20th Street and Constitution Avenue, NW, Washington, DC 20551.
    FDIC: Robert F. Storch, Chief, Accounting Section, Division of 
Supervision, (202) 898-8906; or Jamey Basham, Counsel, Legal Division, 
(202) 898-7265, Federal Deposit Insurance Corporation, 550 17th Street, 
NW, Washington, DC 20429.
    OTS: Michael D. Solomon, Senior Program Manager for Capital Policy, 
Supervision Policy, (202) 906-5654; or Karen Osterloh, Assistant Chief 
Counsel (202) 906-6639, Office of Thrift Supervision, 1700 G Street, 
NW, Washington, DC 20552.

SUPPLEMENTARY INFORMATION:

I. Introduction

    The agencies are proposing to amend their risk-based capital 
standards to change the treatment of certain recourse obligations, 
direct credit substitutes, and securitized transactions that expose 
banking organizations to credit risk. This proposal amends the 
agencies' risk-based capital standards to align more closely the risk-
based capital treatment of recourse obligations and direct credit 
substitutes and to vary the capital requirements for positions in 
securitized transactions (and certain other credit exposures) according 
to their relative risk. The proposal also requires the sponsor of a 
revolving credit securitization that involves an early amortization 
feature to hold capital

[[Page 12321]]

against the amount of assets under management in that securitization.
    This proposal builds on the agencies' earlier work with respect to 
the appropriate risk-based capital treatment for recourse obligations 
and direct credit substitutes. On May 25, 1994, the agencies published 
in the Federal Register a proposal to reduce the capital requirement 
for banks for low-level recourse transactions, to treat first-loss (but 
not second-loss) direct credit substitutes like recourse, and to 
implement definitions of ``recourse,'' ``direct credit substitute,'' 
and related terms. 59 FR 27116 (May 25, 1994) (the 1994 Notice). The 
1994 Notice also contained, in an advance notice of proposed 
rulemaking, a proposal to use credit ratings to determine the capital 
treatment of certain recourse obligations and direct credit 
substitutes. The OCC, the Board, and the FDIC subsequently implemented 
the capital reduction for low-level recourse transactions, thereby 
satisfying the requirements of section 350 of the Riegle Community 
Development and Regulatory Improvement Act, Public Law 103-325, sec. 
350, 108 Stat. 2160, 2242 (1994) (CDRI Act).\1\ The OTS risk-based 
capital regulation already included the low-level recourse treatment 
required by the statute.\2\ The agencies did not issue a final 
regulation on the remaining elements of the 1994 Notice.
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    \1\ See 60 FR 17986 (April 10, 1995) (OCC); 60 FR 8177 (February 
13, 1995) (Board); 60 FR 15858 (March 28, 1995) (FDIC).
    \2\ See 60 FR 45618 (August 31, 1995.)
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    On November 5, 1997, the agencies published another notice of 
proposed rulemaking. 62 FR 59943 (1997 Proposal). In the 1997 Proposal, 
the agencies proposed to use credit ratings from nationally recognized 
statistical rating organizations to determine the capital requirement 
for recourse obligations, direct credit substitutes, and senior asset-
backed securities. Additionally, the 1997 Proposal requested comment on 
a series of options and alternatives to supplement or replace the 
ratings-based approach.
    In June 1999, the Basel Committee on Banking Supervision issued a 
consultative paper, ``A New Capital Adequacy Framework, that sets forth 
possible revisions to the 1988 Basel Accord.\3\ The Basel consultative 
paper discusses potential modifications to the current capital 
standards, including the capital treatment of securitizations. The 
suggested changes in the Basel consultative paper move in the same 
direction as this proposal by looking to external credit ratings issued 
by qualifying external credit assessment institutions as a basis for 
determining the credit quality and the resulting capital treatment of 
securitizations.
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    \3\ International Convergence of Capital Measurement and Capital 
Standards (July 1988).
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II. Background

A. Asset Securitization

    Asset securitization is the process by which loans or other credit 
exposures are pooled and reconstituted into securities, with one or 
more classes or positions, that may then be sold. Securitization \4\ 
provides an efficient mechanism for banking organizations to buy and 
sell loan assets or credit exposures and thereby to make them more 
liquid.
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    \4\ For purposes of this discussion, references to 
``securitization'' also include structured finance transactions or 
programs that generally create stratified credit risk positions, 
which may or may not be in the form of a security, whose performance 
is dependent upon a pool of loans or other credit exposures.
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    Securitizations typically carve up the risk of credit losses from 
the underlying assets and distribute it to different parties. The 
``first dollar,'' or subordinate, loss position is first to absorb 
credit losses; the most ``senior'' investor position is last; and there 
may be one or more loss positions in between (``second dollar'' loss 
positions). Each loss position functions as a credit enhancement for 
the more senior loss positions in the structure.
    For residential mortgages sold through certain Federally-sponsored 
mortgage programs, a Federal government agency or Federal government 
sponsored enterprise (GSE) guarantees the securities sold to investors. 
However, many of today's asset securitization programs involve 
nonmortgage assets or are not Federally supported in any way. Sellers 
of these privately securitized assets therefore often provide other 
forms of credit enhancement--first and second dollar loss positions--to 
reduce investors' risk of credit loss.
    A seller may provide this credit enhancement itself through 
recourse arrangements. As defined in this proposal, ``recourse'' refers 
to the risk of credit loss that a banking organization retains in 
connection with the transfer of its assets. Banking organizations have 
long provided recourse in connection with sales of whole loans or loan 
participations; today, recourse arrangements frequently are associated 
with asset securitization programs.
    A seller may also arrange for a third party to provide credit 
enhancement \5\ in an asset securitization. If the third-party 
enhancement is provided by another banking organization, that 
organization assumes some portion of the assets' credit risk. In this 
proposal, all forms of third-party enhancements, i.e., all arrangements 
in which a banking organization assumes risk of credit loss from third-
party assets or other claims that it has not transferred, are referred 
to as ``direct credit substitutes.'' The economic substance of a 
banking organization's risk of credit loss from providing a direct 
credit substitute can be identical to its risk of credit loss from 
transferring an asset with recourse.
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    \5\ As used in this proposal, the terms ``credit enhancement'' 
and ``enhancement'' refer to both recourse arrangements and direct 
credit substitutes.
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    Depending on the type of securitization transaction, the sponsor of 
a securitization may provide a portion of the total credit enhancement 
internally, as part of the securitization structure, through the use of 
spread accounts, overcollateralization, retained subordinated 
interests, or other similar forms of on-balance sheet assets. When 
these or other types of internal enhancements are provided, the 
enhancements are considered a form of recourse for risk-based capital 
purposes. Many asset securitizations use a combination of internal 
enhancement, recourse, and third-party enhancement to protect investors 
from risk of credit loss.

B. Risk Management of Exposures Arising From Securitization Activities

    While asset securitization can enhance both credit availability and 
a banking organization's profitability, managing the risks associated 
with this activity can pose significant challenges. This is because the 
risks involved, while not new to banking organizations, may be less 
obvious and more complex than the risks of traditional lending. 
Specifically, securitization can involve credit, liquidity, 
operational, legal, and reputational risks in concentrations and forms 
that may not be fully recognized by management or adequately 
incorporated into a banking organization's risk management systems.
    The risk-based capital treatment described in this proposal 
provides one important way of addressing the credit risk presented by 
securitization activities, but a banking organization's compliance with 
capital standards should be complemented by effective risk management 
strategies. The agencies expect that banking organizations will 
identify, measure, monitor and control the risks of their 
securitization activities (including

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synthetic securitizations \6\ using credit derivatives) and explicitly 
incorporate the full range of risks into their risk management systems. 
Management is responsible for having adequate policies and procedures 
in place to ensure that the economic substance of their risks is fully 
recognized and appropriately managed. Banking organizations should be 
able to measure and manage their risk exposure from risk positions in 
the securitizations, either retained or acquired, and should be able to 
assess the credit quality of the retained residual portfolio after the 
transfer of assets in a securitization transaction. The formality and 
sophistication with which the risks of these activities are 
incorporated into a banking organization's risk management system 
should be commensurate with the nature and volume of its securitization 
activities. Banking organizations with significant securitization 
activities, no matter what the size of their on-balance sheet assets, 
are expected to have more elaborate and formal approaches to manage the 
risks. Failure to understand the risks inherent in securitization 
activities and to incorporate them into risk management systems and 
internal capital allocations may constitute an unsafe or unsound 
banking practice.
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    \6\ ``Synthetic securitization'' refers to the bundling of 
credit risk associated with on-balance sheet assets and off-balance 
sheet items for subsequent sale into the market.
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    Banking organizations must have adequate systems that evaluate the 
effect of securitization transactions on the banking organization's 
risk profile and capital adequacy. Based on the complexity of 
transactions, these systems should be capable of differentiating 
between the nature and quality of the risk exposures transferred versus 
those that the banking organization retains. Adequate management 
systems usually:
     Have an internal system for grading credit risk exposures, 
including: (1) Adequate differentiation of risk among risk grades; (2) 
adequate controls to ensure the objectivity and consistency of the 
rating process; and (3) analysis or evidence supporting the accuracy or 
appropriateness of the risk-grading system.\7\
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    \7\ In this regard, the agencies note that one increasingly 
important component of the systems for controlling credit risk at 
larger banking organizations is the identification of the gradations 
in credit risk among their business loans and the assignment of 
internal credit risk ratings to loans that correspond to these 
gradations. The agencies believe that the use of such an internal 
rating process is appropriate--indeed, necessary--for sound risk 
management at large banking organizations. In particular, those 
banking organizations with significant involvement in securitization 
activities should have relatively elaborate and formal approaches 
for assessing and managing the associated credit risk.
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     Evaluate the effect of the transaction on the nature and 
distribution of the banking book exposures that have not been 
transferred in connection with securitization. This analysis should 
include a comparison of the banking book's risk profile before and 
after the transaction, including the mix of exposures by risk grade and 
by business or economic sector. The analysis should also include 
identification of any concentrations of credit risk.
     Perform rigorous, forward-looking stress testing \8\ on 
exposures that have not been transferred (that is, loans and 
commitments remaining in the banking book), transferred exposures, and 
exposures retained to facilitate transfers (that is, credit 
enhancements).
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    \8\ Stress testing usually involves identifying possible events 
or changes in market behavior that could have unfavorable effects on 
an banking organization and assessing the organization's ability to 
withstand them. Stress testing should not only consider the 
probability of adverse events, but also potential ``worst case'' 
scenarios. Such an analysis should be done on a consolidated basis 
and consider, for example, the effect of higher than expected levels 
of delinquencies and defaults. The analysis should also consider the 
consequences of early amortization events that could raise concerns 
regarding a banking organization's capital adequacy and its 
liquidity and funding capabilities. Stress test analyses should also 
include contingency plans regarding the actions management might 
take given certain situations.
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     Have an internal economic capital allocation methodology 
that provides the banking organization will have adequate 
capitalization to meet a specific probability that it will not become 
insolvent if unexpected credit losses occur and that readjusts, as 
necessary, the sponsoring bank's internal economic capital requirements 
to take into account the effect of the securitization transactions.
    Banking organizations should ensure that their capital positions 
are sufficiently strong to support all of the risks associated with 
these activities on a fully consolidated basis and should maintain 
adequate capital in all affiliated entities engaged in these 
activities.

C. Current Risk-Based Capital Treatment of Recourse and Direct Credit 
Substitutes

    Currently, the agencies' risk-based capital standards apply 
different treatments to recourse arrangements and direct credit 
substitutes. As a result, capital requirements applicable to credit 
enhancements do not consistently reflect credit risk. The current rules 
of the OCC, Board, and FDIC (the banking agencies) are also not 
entirely consistent with those of the OTS.
1. Recourse
    The agencies' risk-based capital guidelines prescribe a single 
treatment for assets transferred with recourse, regardless of whether 
the transaction is reported as a financing or a sale of assets in a 
bank's Consolidated Reports of Condition and Income (Call Report), a 
bank holding company's FR Y-9 reports, or a thrift's Thrift Financial 
Report.\9\ For a transaction reported as a financing, the transferred 
assets remain on the balance sheet and are risk-weighted. For a 
transaction reported as a sale, the entire outstanding amount of the 
assets sold (not just the contractual amount of the recourse 
obligation) is converted into an on-balance sheet credit equivalent 
amount using a 100% credit conversion factor. This credit equivalent 
amount (less any applicable recourse liability account recorded on the 
balance sheet) is then risk-weighted.\10\ If the seller's balance sheet 
includes as an asset any retained interest in the assets sold, the 
retained interest is not risk-weighted separately. Thus, regardless of 
the method used to account for the transfer, risk-based capital is held 
against the full, risk-weighted amount of the transferred assets, 
although the transaction is subject to the low-level recourse rule, 
which limits the maximum risk-based capital requirement to the banking 
organization's maximum contractual exposure. \11\
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    \9\ Assets transferred with any amount of recourse in a 
transaction reported as a financing in accordance with generally 
accepted accounting principles (GAAP) remain on the balance sheet 
and are risk-weighted in the same manner as any other on-balance 
sheet asset. Assets transferred with recourse in a transaction that 
is reported as a sale under GAAP are removed from the balance sheet 
and are treated as off-balance sheet exposures for risk-based 
capital purposes.
    \10\ Consistent with statutory requirements, the agencies' 
current rules also provide for special treatment of sales of small 
business loan obligations with recourse. See 12 CFR Part 3, appendix 
A, Section 3(c) (OCC); 12 CFR parts 208 and 225, appendix A, II.B.5 
(FRB); 12 CFR part 325, appendix A, II.B.6 (FDIC); 12 CFR 
567.6(E)(3) (OTS).
    \11\ Section 350 of the CDRI Act required the agencies to 
prescribe regulations providing that the risk-based capital 
requirement for assets transferred with recourse could not exceed a 
banking organization's maximum contractual exposure. The agencies 
may require a higher amount if necessary for safety and soundness 
reasons. See 12 U.S.C. 4808.
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    For leverage capital ratio purposes, if a transfer with recourse is 
reported as a financing, the transferred assets remain on the 
transferring banking organization's balance sheet and the banking 
organization must hold leverage capital against these assets. If a 
transfer with recourse is reported as a sale, the assets sold do not 
remain on the selling

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banking organization's balance sheet and the banking organization need 
not hold leverage capital against these assets. However, if the 
seller's balance sheet includes as an asset any retained interest in 
the assets sold, leverage capital must be held against the retained 
interest.
2. Direct Credit Substitutes
    Direct credit substitutes are treated differently from recourse 
under the current risk-based capital standards. Under the banking 
agencies' current standards, off-balance sheet direct credit 
substitutes, such as financial standby letters of credit provided for 
third-party assets, carry a 100% credit conversion factor. However, 
only the dollar amount of the direct credit substitute is converted 
into an on-balance sheet credit equivalent amount, so that capital is 
held only against the face amount of the direct credit substitute. The 
capital requirement for a recourse arrangement, in contrast, generally 
is based on the full amount of the assets enhanced.
    If a direct credit substitute covers less than 100% of the 
potential losses on the assets enhanced, the current capital treatment 
results in a lower capital charge for a direct credit substitute than 
for a comparable recourse arrangement. For example, if a direct credit 
substitute covers losses up to the first 20% of the assets enhanced, 
then the on-balance sheet credit equivalent amount equals that 20% 
amount, and risk-based capital is held against only the 20% amount. In 
contrast, required capital for a first-loss 20% recourse arrangement is 
higher because capital is held against the full outstanding amount of 
the assets enhanced, subject to the low-level recourse rule.
    Currently, under the banking agencies' guidelines, purchased 
subordinated interests receive the same capital treatment as off-
balance sheet direct credit substitutes. That is, the amount of the 
purchased subordinated interest is placed in the appropriate risk-
weight category. In contrast, a banking organization that retains a 
subordinated interest in connection with the transfer of its own assets 
is considered to have transferred the assets with recourse. As a 
result, the banking organization must hold capital against the carrying 
amount of the retained subordinated interest as well as the outstanding 
amount of all senior interests that it supports, subject to the low-
level recourse rule.
    The OTS risk-based capital regulation treats some forms of direct 
credit substitutes (e.g., financial standby letters of credit) in the 
same manner as the banking agencies' guidelines. However, unlike the 
banking agencies, the OTS treats purchased subordinated interests 
(except for certain high quality subordinated mortgage-related 
securities) under its general recourse provisions. The risk-based 
capital requirement is based on the carrying amount of the subordinated 
interest plus all senior interests, as though the thrift owned the full 
outstanding amount of the assets enhanced.
3. Concerns Raised by Current Risk-Based Capital Treatment
    The agencies' current risk-based capital standards raise 
significant concerns with respect to the treatment of recourse and 
direct credit substitutes. First, banking organizations are often 
required to hold different amounts of capital for recourse arrangements 
and direct credit substitutes that expose the banking organization to 
equivalent risk of credit loss. Banking organizations are taking 
advantage of this anomaly, for example, by providing first-loss letters 
of credit to asset-backed commercial paper conduits that lend directly 
to corporate customers. This results in a significantly lower capital 
requirement than if the loans had originally been carried on the 
banking organizations' balance sheets and then were sold. Moreover, the 
current capital standards do not recognize differences in risk 
associated with different loss positions in asset securitizations, nor 
do they provide uniform definitions of recourse, direct credit 
substitute, and associated terms.

III. Description of the Proposal

    This proposal would amend the agencies' risk-based capital 
standards as follows:
     The proposal defines ``recourse'' and revises the 
definition of ``direct credit substitute''; \12\
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    \12\ The OTS, which already defines the term ``recourse'' in its 
rules, would revise its definition so that it is consistent with the 
definition adopted by the other agencies. The OTS is also adding a 
definition of ``financial guarantee-type letter of credit'' to be 
consistent with the OCC and the Board.
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     It provides more consistent risk-based capital treatment 
for recourse obligations and direct credit substitutes;
     It varies the capital requirements for positions in 
securitized transactions according to their relative risk exposure, 
using credit ratings from nationally recognized statistical rating 
organizations \13\ (rating agencies) to measure the level of risk;
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    \13\ ``Nationally recognized statistical rating organization'' 
means an entity recognized by the Division of Market Regulation of 
the Securities and Exchange Commission as a nationally recognized 
statistical rating organization for various purposes, including the 
capital rules for broker-dealers. See SEC Rule 15c3-1(c)(2)(vi)(E), 
(F) and (H), 17 CFR 240.15c3-091(c)(2)(vi)(E), (F), and (H).
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     It permits the limited use of a banking organization's 
qualifying internal risk rating system, a rating agency's or other 
appropriate third party's review of the credit risk of positions in 
structured programs, and qualifying software to determine the capital 
requirement for certain unrated direct credit substitutes; and
     It requires the sponsor of a revolving credit 
securitization that involves an early amortization feature to hold 
capital against the amount of assets under management in that 
securitization.
    The use of credit ratings in this proposal is similar to the 1997 
Proposal. Although many commenters expressed concerns about specific 
details in the 1997 Proposal, commenters generally supported the goal 
of making the capital requirements associated with asset 
securitizations more rational and efficient, and viewed the 1997 
Proposal as a positive step toward achieving a more consistent, 
rational, and efficient regulatory capital framework. The agencies have 
made several changes to the 1997 Proposal in response to commenters' 
concerns and based on further agency consideration of the issues 
presented.
    Several options and alternatives in the 1997 Proposal have been 
eliminated: the modified gross-up approach, the ratings benchmark 
approach, and the historical losses approach.\14\ Commenters expressed 
numerous concerns about these approaches and the agencies agree that 
better alternatives exist.
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    \14\ For a description of these approaches, see 62 FR 59944, 
59952-59961 (November 5, 1997).
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    Commenters responding to the 1997 Proposal expressed a number of 
concerns about the use of ratings from rating agencies to determine 
capital requirements, especially in the case of unrated direct credit 
substitutes. Commenters noted that banking organizations actively 
involved in the securitization business have their own internal risk 
rating systems, that banking organizations know their assets better 
than third parties, and that a requirement that a banking organization 
obtain a rating from a rating agency solely for regulatory capital 
purposes is burdensome. Some commenters also expressed skepticism about 
the suitability of rating agency credit ratings for regulatory capital 
purposes.
    In the opinion of the agencies, ratings have the advantages of 
being relatively objective, widely used, and relied upon by investors 
and other participants in

[[Page 12324]]

the financial markets. Ratings provide a flexible, efficient, market-
oriented way to measure credit risk. The agencies recognize, however, 
that there are drawbacks to using credit ratings from rating agencies 
to set capital requirements. Moreover, the agencies agree with some 
commenters' observation that credit ratings are most useful with 
respect to publicly-traded positions that would be rated regardless of 
the agencies' risk-based capital requirements.
    To minimize the need for banking organizations to obtain ratings on 
otherwise unrated enhancements that are provided in asset-backed 
commercial paper securitizations, the proposal permits banking 
organizations to use their own qualifying internal risk rating systems 
in place of ratings from rating agencies for risk weighting certain 
direct credit substitutes. The use of internal risk ratings to assign 
direct credit substitutes in asset-backed commercial paper programs to 
rating categories under the ratings-based approach is dependent upon 
the existence of adequate internal risk rating systems. The adequacy of 
any internal risk rating system will depend upon a banking 
organization's incorporation of the prudential standards outlined in 
this proposal, as well as other factors recommended through supervisory 
guidance or on a case-by-case basis.
    Finally, the agencies are proposing an additional measure to 
address the risk associated with early amortization features in certain 
asset securitizations. The managed assets approach, described in 
Section III.D., would apply a 20% risk weight to the amount of off-
balance sheet securitized assets under management in such transactions.

A. Definitions and Scope of the Proposal

1. Recourse
    The proposal defines the term ``recourse'' to mean an arrangement 
in which a banking organization retains risk of credit loss in 
connection with an asset transfer, if the risk of credit loss exceeds a 
pro rata share of the banking organization's claim on the assets. The 
proposed definition of recourse is consistent with the banking 
agencies' longstanding use of this term, and incorporates existing 
agency practices regarding retention of risk in asset transfers into 
the risk-based capital standards.\15\
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    \15\ The OTS currently defines the term ``recourse'' more 
broadly than the proposal to include arrangements involving credit 
risk that a thrift assumes or accepts from third-party assets as 
well as risk that it retains in an asset transfer. Under the 
proposal, credit risk that a banking organization assumes from 
third-party assets falls under the definition of ``direct credit 
substitute'' rather than ``recourse.''
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    Currently, the term ``recourse'' is not defined explicitly in the 
banking agencies' risk-based capital guidelines. Instead, the 
guidelines use the term ``sale of assets with recourse,'' which is 
defined by reference to the Call Report Instructions. See Call Report 
Instructions, Glossary (entry for ``Sales of Assets for Risk-Based 
Capital Purposes''). Once a definition of recourse is adopted in the 
risk-based capital guidelines, the banking agencies would remove the 
cross-reference to the Call Report instructions from the guidelines. 
The OTS capital regulation currently provides a definition of the term 
``recourse,'' which would also be replaced once a final definition of 
recourse is adopted.
2. Direct Credit Substitute
    The proposed definition of ``direct credit substitute'' complements 
the definition of recourse. The term ``direct credit substitute'' would 
refer to any arrangement in which a banking organization assumes risk 
of credit-related losses from assets or other claims it has not 
transferred, if the risk of credit loss exceeds the banking 
organization's pro rata share of the assets or other claims. Currently, 
under the banking agencies' guidelines, this term covers guarantee-type 
arrangements. As revised, it would also include explicitly items such 
as purchased subordinated interests, agreements to cover credit losses 
that arise from purchased loan servicing rights, credit derivatives and 
lines of credit that provide credit enhancement.
    Some commenters responding to the 1997 Proposal suggested that the 
definition of ``direct credit substitute'' should exclude risk 
positions that are not part of an asset securitization. Although direct 
credit substitutes commonly are used in asset securitizations, 
enhancements involving similar credit risk exposure can arise in other 
contexts and should receive the same capital treatment as enhancements 
associated with securitizations.
    Several commenters objected to the 1997 Proposal's treatment of 
direct credit substitutes as recourse. Commenters asserted that the 
business of providing third-party credit enhancements has historically 
been safe and profitable for banks and objected that the proposed 
capital treatment would impair the competitive position of U.S. banks 
and thrifts. As has been previously described, however, the current 
treatment of direct credit substitutes is not consistent with the 
treatment of recourse obligations. The agencies have concluded that the 
difference in treatment between the two forms of credit enhancement 
invites banking organizations to obtain direct credit substitutes in 
place of recourse obligations in order to avoid the capital requirement 
applicable to recourse obligations and on-balance-sheet assets. For 
this reason, the agencies are again proposing, as a general rule, to 
extend the current risk-based capital treatment of asset transfers with 
recourse, including the low-level recourse rule, to direct credit 
substitutes.
    In an effort to address competitive inequities at the international 
level, however, the agencies have raised this issue with the bank 
supervisory authorities from the other countries represented on the 
Basel Committee on Banking Supervision. The Basel Committee's 
consultative paper, ``A New Capital Adequacy Framework,'' acknowledges 
that the current Basel Capital Accord, upon which the agencies' risk-
based capital standards are based, lacks consistency in its treatment 
of credit enhancements.
3. Lines of Credit
    One commenter requested clarification that a line of credit that 
provides credit enhancement for the financial obligations of an account 
party could be a direct credit substitute only if it represented an 
irrevocable obligation to the beneficiary. A revocable line of credit 
would not be a direct credit substitute because the issuer could 
protect itself against credit losses at any time prior to a draw on the 
line of credit. However, an irrevocable line of credit could expose the 
issuer to credit losses and would constitute a direct credit 
substitute, if it met the criteria in the definitions. Also, any 
conditions attached to the issuer's ability to revoke the undrawn 
portion of a line of credit, or that interfere with the issuer's 
ability to protect itself against credit loss prior to a draw, will 
cause the line of credit to constitute a direct credit substitute.
4. Credit Derivatives
    The proposed definitions of ``recourse'' and ``direct credit 
substitute'' cover credit derivatives to the extent that a banking 
organization's credit risk exposure exceeds its pro rata interest in 
the underlying obligation. The ratings-based approach therefore applies 
to rated instruments such as credit-linked notes issued as part of a

[[Page 12325]]

synthetic securitization. \16\ The agencies request comment on the 
inclusion of credit derivatives in the definitions of ``recourse'' and 
``direct credit substitute,'' as well as on the definition of ``credit 
derivative'' contained in the proposal.
---------------------------------------------------------------------------

    \16\ ``Synthetic securitization'' refers to the bundling of 
credit risk associated with on-balance sheet assets and off-balance 
sheet items for subsequent sale into the market. Credit derivatives, 
and in particular credit-linked notes, are used to structure a 
synthetic securitization. For more information on synthetic 
securitizations see, Joint OCC and Federal Reserve Board Issuance on 
Credit Derivatives, ``Capital Interpretations--Synthetic 
Collateralized Loan Obligations,'' dated November 15, 1999.
---------------------------------------------------------------------------

5. Risks Other Than Credit Risks
    A capital charge would be assessed only against arrangements that 
create exposure to credit or credit-related risks. This continues the 
agencies' current practice and is consistent with the risk-based 
capital standards' traditional focus on credit risk. The agencies have 
undertaken other initiatives to ensure that the risk-based capital 
standards take interest rate risk and other non-credit related market 
risks into account.
6. Implicit Recourse
    The definitions cover all arrangements that are recourse or direct 
credit substitutes in form or in substance. Recourse may also exist 
when a banking organization assumes risk of loss without an explicit 
contractual agreement or, if there is a contractual limit, when the 
banking organization assumes risk of loss in an amount exceeding the 
limit. The existence of implicit recourse is often a complex and fact-
specific issue, usually demonstrated by a banking organization's 
actions to support a securitization beyond any contractual obligation. 
Actions that may constitute implicit recourse include: providing 
voluntary support for a securitization by selling assets to a trust at 
a discount from book value; exchanging performing for non-performing 
assets; or other actions that result in a significant transfer of value 
in response to deterioration in the credit quality of a securitized 
asset pool.
    To date, the agencies have taken the position that when a banking 
organization provides implicit recourse, it generally should hold 
capital in the same amount as for assets sold with recourse. However, 
the complexity of many implicit recourse arrangements and the variety 
of circumstances under which implicit recourse may be provided raise 
issues about whether recourse treatment is always the most appropriate 
way to address the level of risk that a banking organization has 
effectively retained or whether a different capital requirement would 
be warranted in some circumstances. Accordingly, the 1997 Proposal 
requested comment on the types of actions that should be considered 
implicit recourse and how the agencies should treat those actions for 
regulatory capital purposes.
    Commenters responding to the 1997 Proposal generally supported the 
view that implicit recourse is best handled on a case-by-case basis, 
guided by the general rule that actions that demonstrate retention of 
risk will trigger recourse treatment of affected transactions. The 
agencies intend to continue to address implicit recourse case-by-case, 
but may issue additional guidance if needed to clarify further the 
circumstances in which a banking organization will be considered to 
have provided implicit recourse.
7. Subordinated Interests in Loans or Pools of Loans
    The definitions of recourse and direct credit substitute explicitly 
cover a banking organization's ownership of subordinated interests in 
loans or pools of loans. This continues the banking agencies' 
longstanding treatment of retained subordinated interests as recourse 
and recognizes that purchased subordinated interests can also function 
as credit enhancements. (The OTS currently treats both retained and 
purchased subordinated securities as recourse obligations.) 
Subordinated interests generally absorb more than their pro rata share 
of losses (principal and interest) from the underlying assets in the 
event of default. For example, a multi-class asset securitization may 
have several classes of subordinated securities, each of which provides 
credit enhancement for the more senior classes. Generally, the holder 
of any class that absorbs more than its pro rata share of losses from 
the total underlying assets is providing credit protection for all of 
the more senior classes. \17\
---------------------------------------------------------------------------

    \17\ Current OTS risk-based capital guidelines exclude certain 
high-quality subordinated mortgage-related securities from treatment 
as recourse arrangements due to their credit quality.
---------------------------------------------------------------------------

    Some commenters questioned the treatment of purchased subordinated 
interests as recourse. Subordinated interests expose holders to 
comparable risk regardless of whether the interests are retained or 
purchased. If purchased subordinated interests were not treated as 
recourse, banking organizations could avoid recourse treatment by 
swapping retained subordinated interests with other banking 
organizations or by purchasing subordinated interests in assets 
originated by a conduit. The proposal would mitigate the effect of 
treating purchased subordinated interests as recourse by reducing the 
capital requirement on interests that qualify under the multi-level 
approach described in section III.B.
8. Representations and Warranties
    When a banking organization transfers assets, including servicing 
rights, it customarily makes representations and warranties concerning 
those assets. When a banking organization purchases loan servicing 
rights, it may also assume representations and warranties made by the 
seller or a prior servicer. These representations and warranties give 
certain rights to other parties and impose obligations upon the seller 
or servicer of the assets. The proposal addresses those particular 
representations and warranties that function as credit enhancements, 
i.e. those where, typically, a banking organization agrees to protect 
purchasers or some other party from losses due to the default or non-
performance of the obligor or insufficiency in the value of collateral. 
Therefore, to the extent a banking organization's representations and 
warranties function as credit enhancements to protect asset purchasers 
or investors from credit risk by obligating the banking organization to 
protect another party from losses due to credit risk in the transferred 
assets, the proposal treats them as recourse or direct credit 
substitutes.
    The 1997 Proposal treated as recourse or a direct credit substitute 
any representation or warranty other than a standard representation or 
warranty. Standard representations and warranties were those referring 
to facts verified by the seller or servicer with reasonable due 
diligence or conditions within the control of the seller or servicer 
and those providing for the return of assets in the event of fraud or 
documentation deficiencies. Some commenters objected that the 1997 
Proposal would treat as recourse many industry-standard warranties that 
impose only minor operational risk instead of true credit risk. Other 
commenters objected that the due diligence requirement was burdensome, 
and that it would impose compliance costs on banking organizations 
disproportionate to the risk assumed.
    The current proposal focuses on whether a warranty allocates credit 
risk to the banking organization, rather than whether the warranty is 
somehow standard or customary within the industry. Several commenters 
suggested

[[Page 12326]]

that the agencies expressly take accepted mortgage banking industry 
practice into account in determining whether a warranty should receive 
recourse treatment. However, the agencies are aware of warranties 
sometimes characterized as ``standard'' that effectively function as 
credit enhancements. These include warranties that transferred loans 
will remain of investment quality, or that no circumstances exist 
involving the loan collateral or borrower's credit standing that could 
cause the loan to become delinquent. They may also include warranties 
that, for seasoned mortgages, the value of the loan collateral still 
equals the original appraised value and the borrower's ability to pay 
has not changed adversely.
    The proposal is consistent with the agencies' longstanding recourse 
treatment of representations and warranties that effectively guaranty 
performance or credit quality of transferred loans. However, the 
proposal and the agencies' longstanding practice also recognize that 
banking organizations typically make a number of factual warranties 
unrelated to ongoing performance or credit quality. These warranties 
entail operational risk, as opposed to the open-ended credit risk 
inherent in a financial guaranty. Warranties that create operational 
risk include: warranties that assets have been underwritten or 
collateral appraised in conformity with identified standards, and 
warranties that provide for the return of assets in instances of 
incomplete documentation or fraud.
    Warranties can impose varying degrees of operational risk. For 
example, a warranty that asset collateral has not suffered damage from 
hazard entails risk that is offset to some extent by prudent 
underwriting practices requiring the borrower to provide hazard 
insurance to the banking organization. A warranty that asset collateral 
is free of environmental hazards may present acceptable operational 
risk for certain types of properties that have been subject to 
environmental assessment, depending on the circumstances. The agencies 
address appropriate limits for these operational risks through 
supervision of a banking organization's loan underwriting, sale, and 
servicing practices. Also, a banking organization that provides 
warranties to loan purchasers and investors must include associated 
operational risks in its risk management of exposures arising from loan 
sale or securitization-related activities. Banking organizations should 
be prepared to demonstrate to examiners that the operational risks are 
effectively managed.
    The proposal continues the agencies' current practice of imposing 
recourse treatment on ``early-default'' clauses. Early-default clauses 
typically warrant that transferred loans will not become more than 30 
days delinquent within a stated period, such as four months. Once the 
stated period has run, the early-default clause will no longer trigger 
recourse treatment, provided that there is no other provision that 
constitutes recourse. One commenter to the 1997 Proposal stated that 
early-default clauses carry minimal risk, and are intended to deal with 
inadvertent transfers of loans that are already 30-day delinquencies, 
or to guard against unsound originations by the loan seller. Another 
commenter found recourse treatment of early-default clauses to be an 
appropriate response to the transfer of credit risk that takes place 
under these clauses.
    The agencies find that early-default clauses are often drafted so 
broadly that they are indistinguishable from a guaranty of financial 
assets. The agencies have even found recent examples in which early-
default clauses have been expanded to cover the first year after loan 
transfer. Industry concerns about assets delinquent at the time of 
transfer or unsound originations could be dealt with by warranties 
directly addressing the condition of the asset at the time of transfer 
and compliance with stated underwriting standards or, failing that, 
exposure caps permitting the banking organization to take advantage of 
the low-level recourse rule. The proposal also requires recourse 
treatment for warranties providing assurances about the actual value of 
asset collateral, including that the market value corresponds to its 
appraised value or that the appraised value will be realized in the 
event of foreclosure and sale.
    The agencies invite further comment on these issues. The agencies 
also invite comment on whether ``premium refund'' clauses should 
receive recourse treatment under any final rule. These clauses require 
the seller to refund the premium paid by the investor for any loan that 
prepays within a stated period after the loan is transferred. The 
agencies are aware of premium refund clauses with terms ranging from 90 
days to 36 months.
9. Loan Servicing Arrangements
    The proposed definitions of ``recourse'' and ``direct credit 
substitute'' cover loan servicing arrangements if the servicer is 
responsible for credit losses associated with the loans being serviced. 
However, cash advances made by residential mortgage servicers to ensure 
an uninterrupted flow of payments to investors or the timely collection 
of the mortgage loans are specifically excluded from the definitions of 
recourse and direct credit substitute, provided that the residential 
mortgage servicer is entitled to reimbursement for any significant 
advances.\18\ This type of advance is assessed risk-based capital only 
against the amount of the cash advance, and is assigned to the risk-
weight category appropriate to the party obligated to reimburse the 
servicer.
---------------------------------------------------------------------------

    \18\ Servicer cash advances include disbursements made to cover 
foreclosure costs or other expenses arising from a loan in order to 
facilitate its timely collection (but not to protect investors from 
incurring these expenses).
---------------------------------------------------------------------------

    If a residential mortgage servicer is not entitled to full 
reimbursement, then the maximum possible amount of any nonreimbursed 
advances on any one loan must be contractually limited to an 
insignificant amount of the outstanding principal on that loan in order 
for the servicer's obligation to make cash advances to be excluded from 
the definitions of recourse and direct credit substitute. This 
treatment reflects the agencies' traditional view that servicer cash 
advances meeting these criteria are part of the normal mortgage 
servicing function and do not constitute credit enhancements.
    Commenters responding to the 1997 Proposal generally supported the 
proposed definition of servicer cash advances. Some commenters asked 
for clarification of the term ``insignificant'' and whether 
``reimbursement'' includes reimbursement payable out of subsequent 
collections or reimbursement in the form of a general claim on the 
party obligated to reimburse the servicer. Nonreimbursed advances on 
any one loan that are generally contractually limited to no more than 
one percent of the amount of the outstanding principal on that loan 
would be considered insignificant. Reimbursement includes reimbursement 
payable from subsequent collections and reimbursement in the form of a 
general claim on the party obligated to reimburse the servicer, 
provided that the claim is not subordinated to other claims on the cash 
flows from the underlying asset pool.
    Some commenters responding to the 1997 Proposal suggested that the 
agencies treat servicer cash advances as any advances that the servicer 
reasonably expects will be repaid. The agencies believe that a clear, 
specific standard is needed to prevent the use of servicer cash 
advances to circumvent the proposed risk-based capital

[[Page 12327]]

treatment of recourse obligations and direct credit substitutes.
10. Spread Accounts and Overcollateralization
    Several commenters requested that the agencies state in their rules 
that spread accounts and overcollateralization do not impose a risk of 
loss on a banking organization and are, therefore, not recourse. By its 
terms, the definition of recourse covers only the retention of risk in 
a sale of assets. Overcollateralization does not ordinarily impose a 
risk of loss on a banking organization, so it normally would not fall 
within the proposed definition of recourse. However, a retained 
interest in a spread account that is reflected as an asset on a selling 
banking organization's balance sheet (directly as an asset or 
indirectly as a receivable) is a form of recourse and is treated 
accordingly for risk-based capital purposes.
11. Interaction With Market Risk Rule
    Some commenters responding to the 1997 Proposal asked for 
clarification of the treatment of a transaction covered by both the 
market risk rule and the recourse rule. Under the market risk rule,\19\ 
a position properly located in the trading account is excluded from 
risk-weighted assets. The banking agencies are not proposing to modify 
this treatment, so a position that is properly held in the trading 
account would not be included in risk-weighted assets, even if the 
position otherwise met the criteria for a recourse obligation or a 
direct credit substitute.
---------------------------------------------------------------------------

    \19\ The OTS does not have a market risk rule.
---------------------------------------------------------------------------

12. Participations in Direct Credit Substitutes
    If a direct credit substitute is originated by a banking 
organization which then sells a participation in that direct credit 
substitute to another entity, the originating banking organization must 
apply a 100% conversion factor to the full amount of the assets 
supported by the direct credit substitute. The originating banking 
organization would then risk weight the credit equivalent amount of the 
participant's pro rata share of the direct credit substitute at the 
lower of the risk category appropriate to the obligor in the underlying 
transaction, after considering any relevant guaranties or collateral, 
or the risk category appropriate to the participant entity. The 
remaining pro rata share of the credit equivalent amount is assigned to 
the risk-weight category appropriate to the obligor in the underlying 
transaction, guarantor or collateral.
    A banking organization that acquires a risk participation in a 
direct credit substitute must apply a 100% conversion factor to its 
percentage share of the direct credit substitute multiplied by the full 
amount of the assets supported by the credit enhancement. The credit 
equivalent amount is then assigned to the risk category appropriate to 
the obligor or, if relevant, the nature of the collateral or guaranty.
    Finally, in the case of the syndication of a direct credit 
substitute where each banking organization is obligated only for its 
pro rata share of the risk and there is no recourse to the originating 
banking organization, each banking organization must hold risk-based 
capital against its pro rata share of the assets supported by the 
direct credit substitute.
13. Reservation of Authority
    The agencies are proposing to add language to the risk-based 
capital standards that will provide greater flexibility in 
administering the standards. Banking organizations are developing novel 
transactions that do not fit well into the risk-weight categories and 
credit conversion factors set forth in the standards. Banking 
organizations also are devising novel instruments that nominally fit 
into a particular risk-weight category or credit conversion factor, but 
that impose risks on the banking organization at levels that are not 
commensurate with the nominal risk-weight or credit conversion factor 
for the asset, exposure or instrument. Accordingly, the agencies are 
proposing to add language to the standards to clarify their authority, 
on a case-by-case basis, to determine the appropriate risk-weight for 
assets and credit equivalent amounts and the appropriate credit 
conversion factor for off-balance sheet items in these circumstances. 
Exercise of this authority by the agencies may result in a higher or 
lower risk weight for an asset or credit equivalent amount or a higher 
or lower credit conversion factor for an off-balance sheet item. This 
reservation of authority explicitly recognizes the agencies retention 
of sufficient discretion to ensure that banking organizations, as they 
develop novel financial assets, will be treated appropriately under the 
risk-based capital standards.\20\ In addition, the agencies reserve the 
right to assign risk positions in securitizations to appropriate risk 
categories if the credit rating of the risk position is deemed to be 
inappropriate.
---------------------------------------------------------------------------

    \20\ The Board is also proposing to add language to its risk-
based capital standards that would permit the Board to adjust the 
treatment of a capital instrument that does not fit into the 
existing capital categories or that provides capital to a banking 
organization at levels that are not commensurate with the nominal 
capital treatment of the instrument. The other agencies already have 
this flexibility under their existing rules.
---------------------------------------------------------------------------

14. Privately-Issued Mortgage-Backed Securities
    Currently, the agencies assign privately-issued mortgage-backed 
securities to the 20% risk-weight category if the underlying pool is 
composed entirely of mortgage-related securities issued by the Federal 
National Mortgage Association (Fannie Mae), Federal Loan Mortgage 
Corporation (Freddie Mac), or Government National Mortgage Association 
(Ginnie Mae). Privately-issued mortgage-backed securities backed by 
whole residential mortgages are now assigned to the 50% risk-weight 
category. The agencies propose to eliminate this ``pass-through'' 
treatment in favor of a ratings based approach. Because most mortgage-
backed securities usually also receive the highest or second highest 
credit rating, the agencies believe that ``pass-through'' treatment 
will be redundant once the ratings-based approach is implemented and, 
therefore, propose to eliminate it.

B. Proposed Treatment for Rated Positions

    As described in section II.A., each loss position in an asset 
securitization structure functions as a credit enhancement for the more 
senior loss positions in the structure. Currently, the risk-based 
capital standards do not vary the rate of capital requirement for 
different credit enhancements or loss positions to reflect differences 
in the relative risk of credit loss represented by the positions.
    To address this issue, the agencies are proposing a multi-level, 
ratings-based approach to assess capital requirements on recourse 
obligations, direct credit substitutes, and senior and subordinated 
securities in asset securitizations based on their relative exposure to 
credit risk. The approach uses credit ratings from the rating agencies 
and, to a limited extent, banking organization's internal risk ratings 
and other alternatives, to measure relative exposure to credit risk and 
to determine the associated risk-based capital requirement. The use of 
credit ratings provides a way for the agencies to use determinations of 
credit quality relied upon by investors and other market participants 
to differentiate the regulatory capital treatment for loss

[[Page 12328]]

positions representing different gradations of risk. This use permits 
the agencies to give more equitable treatment to a wide variety of 
transactions and structures in administering the risk-based capital 
system.
    The fact that investors rely on these ratings to make investment 
decisions exerts market discipline on the rating agencies and gives 
their ratings market credibility. The market's reliance on ratings, in 
turn, gives the agencies confidence that it is appropriate to consider 
ratings as a major factor in the risk weighting of assets for 
regulatory capital purposes. The agencies, however, would retain their 
authority to override the use of certain ratings or the ratings on 
certain instruments, either on a case-by-case basis or through broader 
supervisory policy, if necessary or appropriate to address the risk to 
banking organizations.
    Under the ratings-based approach, the capital requirement for a 
recourse obligation, direct credit substitute, or traded asset-backed 
security would be determined as follows: \21\
---------------------------------------------------------------------------

    \21\ The example rating designations (``AAA,'' ``BBB,'' etc.) 
are illustrative and do not indicate any preference for, or 
endorsement of, any particular rating agency designation system.

------------------------------------------------------------------------
         Rating category               Examples           Risk weight
------------------------------------------------------------------------
Highest or second highest         AAA or AA.........  20%.
 investment grade.
Third highest investment grade..  A.................  50%.
Lowest investment grade.........  BBB...............  100%.
One category below investment     BB................  200%.
 grade.
More than one category below      B or unrated......  ''Gross-up''
 investment grade, or unrated.                         treatment.
------------------------------------------------------------------------

    Many commenters expressed concerns about the so-called ``cliff 
effect'' that would arise because of the small number of rating 
categories--three--contained in the 1997 Proposal. To reduce the cliff 
effect, which causes relatively small differences in risk to result in 
disproportionately large differences in the capital requirement for a 
risk position, the agencies are proposing to add two additional rating 
categories, for a total of five.
    Under the proposal, the ratings-based approach is available for 
traded asset-backed securities \22\ and for traded and non-traded 
recourse obligations and direct credit substitutes. A position is 
considered ``traded'' if, at the time it is rated by an external rating 
agency, there is a reasonable expectation that in the near future: (1) 
The position may be sold to investors relying on the rating; or (2) a 
third party may enter into a transaction (e.g., a loan or repurchase 
agreement) involving the position in which the third party relies on 
the rating of the position. If external rating agencies rate a traded 
position differently, the single highest rating applies.
---------------------------------------------------------------------------

    \22\ Similar to the current approach under which ``stripped'' 
mortgage-backed securities are not eligible for risk weighting at 
50% on a ``pass-through'' basis, stripped mortgage-backed securities 
are ineligible for the 20% or 50% risk categories under the ratings 
based approach.
---------------------------------------------------------------------------

    An unrated position that is senior (in all respects, including 
access to collateral) to a rated position that is traded is treated as 
if it had the rating given the rated position, subject to the banking 
organization satisfying its supervisory agency that such treatment is 
appropriate.
    Recourse obligations and direct credit substitutes not qualifying 
for a reduced capital charge and positions rated more than one category 
below investment grade receive ``gross-up'' treatment, that is, the 
banking organization holding the position would hold capital against 
the amount of the position plus all more senior positions, subject to 
the low-level recourse rule.\23\ This grossed-up amount is placed into 
risk-weight categories according to the obligor and collateral.
---------------------------------------------------------------------------

    \23\ ``Gross-up'' treatment means that a position is combined 
with all more senior positions in the transaction. The result is 
then risk-weighted based on the nature of the underlying assets. For 
example, if a banking organization retains a first-loss position in 
a pool of mortgage loans that qualify for a 50% risk weight, the 
banking organization would include the full amount of the assets in 
the pool, risk-weighted at 50% in its risk-weighted assets for 
purposes of determining its risk-based capital ratio. The low level 
recourse rule provides that the dollar amount of risk-based capital 
required for assets transferred with recourse should not exceed the 
maximum dollar amount for which a banking organization is 
contractually liable. See, 12 CFR part 3, appendix A, Section 3(d) 
(OCC); 12 CFR 208 and 225, appendix A, III.D.1(g) (FRB); 12 CFR part 
325, appendix A, II.D.1 (FDIC); 12 CFR 567.6(a)(2)(i)(C) (OTS).
---------------------------------------------------------------------------

    The ratings-based approach is based on current ratings, so that a 
rating downgrade or withdrawal of a rating could change the treatment 
of a position under the proposal. However, a downgrade of a position by 
a single rating agency would not affect the capital treatment of a 
position if the position still qualified for the previous capital 
treatment under one or more ratings from a different rating agency.

C. Proposed Treatment for Non-Traded and Unrated Positions

1. Ratings on Non-Traded Positions
    In the 1994 Notice, the agencies proposed to permit a banking 
organization to obtain a rating for a non-traded recourse obligation or 
direct credit substitute in order to permit that position to qualify 
for a favorable risk-weight. In response to the 1994 Notice, one rating 
agency expressed concern that use of ratings by the agencies for 
regulatory purposes could undermine the integrity of the rating 
process. Ordinarily, according to the commenter, there is a tension 
between the interests of the investors who rely on ratings and the 
interests of the issuers who pay rating agencies to generate ratings. 
Under the ratings-based approach in the 1994 Notice, however, the 
holder of a recourse obligation or direct credit substitute that was 
not traded or sold could, in some cases, seek a rating for the sole 
purposes of permitting the credit enhancement to qualify for a 
favorable risk weight. The rating agency expressed a strong concern 
that, without the counterbalancing interest of investors to rely on 
ratings, rating agencies may have an incentive to issue inflated 
ratings.
    In response to this concern, the 1997 Proposal included criteria to 
reduce the possibility of inflated ratings and inappropriate risk 
weights if ratings are used for a position that is not traded. A non-
traded position could qualify for the ratings-based approach only if: 
(1) It qualified under ratings obtained from two different rating 
agencies; (2) the ratings were publicly available; (3) the ratings were 
based on the same criteria used to rate securities sold to the public; 
and (4) at least one position in the securitization was traded. In 
comments responding to the 1997 Proposal, banking organizations 
expressed concern about the cost and delay associated with obtaining 
ratings, particularly for direct credit substitutes, that they would 
not need absent the agencies' adoption of a ratings-based approach for 
risk-based capital purposes.
    In this proposal, the agencies continue to permit a non-traded

[[Page 12329]]

recourse obligation or direct credit substitute to qualify for the 
ratings-based approach if the banking organization obtains ratings for 
the position. The agencies have retained the first three of the 1997 
Proposal's four criteria for non-traded positions, but have eliminated 
the fourth criterion, i.e., the requirement that one position in the 
securitization be traded.
    To address concerns expressed by commenters on the 1997 Proposal, 
however, the agencies have developed, and are also proposing, 
alternative approaches for determining the capital requirements for 
unrated direct credit substitutes, which are discussed in the following 
sections. Under each of these approaches, the banking organization must 
satisfy its supervisory agency that use of the approach is appropriate 
for the particular banking organization.
2. Use of Banking Organizations' Internal Risk Ratings
    The proposal would permit a banking organization with a qualifying 
internal risk rating system to use that system to apply the ratings-
based approach to the banking organization's unrated direct credit 
substitutes in asset-backed commercial paper programs. Internal risk 
ratings could be used to qualify a credit enhancement (other than a 
retained recourse position) for a risk weight of 100% or 200% under the 
ratings-based approach, but not for a risk weight of less than 100%. 
This relatively limited use of internal risk ratings for risk-based 
capital purposes is a step towards potential adoption of broader use of 
internal risk ratings as discussed in the Basel Committee's June 1999 
Consultative Paper. Limiting the approach to these types of credit 
enhancements reflects the agencies' view, based on industry research 
and empirical evidence, that these positions are more likely than 
recourse positions to be of investment-grade credit quality, and that 
the banking organizations providing them are more likely to have 
internal risk rating systems for these credit enhancements that are 
sufficiently accurate to be relied on for risk-based capital 
calculations.
    Most sophisticated banking organizations that participate 
extensively in the asset securitization business assign internal risk 
ratings to their credit exposures, regardless of the form of the 
exposure. Usually, internal risk ratings more finely differentiate the 
credit quality of a banking organization's exposures than the 
categories that the agencies use to evaluate credit risk during 
examinations of banking organizations (pass, substandard, doubtful, 
loss). Individual banking organizations' internal risk ratings may be 
associated with a certain probability of default, loss in the event of 
default, and loss volatility.
    The credit enhancements that sponsors obtain for their commercial 
paper conduits are rarely rated. If an internal risk ratings approach 
were not available for these unrated credit enhancements, the provider 
of the enhancement would have to obtain two ratings solely to avoid the 
gross-up treatment that would otherwise apply to unrated positions in 
asset securitizations for risk-based capital purposes. However, before 
a provider of an enhancement decides whether to provide a credit 
enhancement for a particular transaction (and at what price), the 
provider will generally perform its own analysis of the transaction to 
evaluate the amount of risk associated with the enhancement.
    Allowing banking organizations to use internal credit ratings 
harnesses information and analyses that they already generate rather 
than requiring them to obtain independent but redundant ratings from 
outside rating agencies. An internal risk ratings approach therefore 
has the potential to be less costly than a ratings-based approach that 
relies exclusively on ratings by the rating agencies for the risk-
weighting of these positions.
    Internal risk ratings that correspond to the rating categories of 
the rating agencies could be mapped to risk weights under the agencies' 
capital standards in a way that would make it possible to differentiate 
the riskiness of various unrated direct credit substitutes based on 
credit risk. However, the use of internal risk ratings raises concerns 
about the accuracy and consistency of the ratings, especially because 
the mapping of ratings to risk-weight categories will give banking 
organizations an incentive to rate their risk exposures in a way that 
minimizes the effective capital requirement. Banking organizations 
engaged in securitization activities that wish to use the internal risk 
ratings approach must ensure that their internal risk rating systems 
are adequate. Adequate internal risk rating systems usually:
    (1) Are an integral part of an effective risk management system 
that explicitly incorporates the full range of risks arising from an 
organization's participation in securitization activities. The system 
must also fully take into account the effect of such activities on the 
organization's risk profile and capital adequacy as discussed in 
Section II.B.
    (2) Link their ratings to measurable outcomes, such as the 
probability that a position will experience any losses, the expected 
losses on that position in the event of default, and the degree of 
variance in losses given default on that position.
    (3) Separately consider the risk associated with the underlying 
loans and borrowers and the risk associated with the specific positions 
in a securitization transaction.
    (4) Identify gradations of risk among ``pass'' assets, not just 
among assets that have deteriorated to the point that they fall into 
``watch'' grades. Although it is not necessary for a banking 
organization to use the same categories as the rating agencies, its 
internal ratings must correspond to the ratings of the rating agencies 
so that agencies can determine which internal risk rating corresponds 
to each rating category of the rating agencies. A banking organization 
would have the responsibility to demonstrate to the satisfaction of its 
primary regulator how these ratings correspond with the rating agency 
standards used as the framework for this proposal. This is necessary so 
that the mapping of credit ratings to risk weight categories in the 
ratings-based approach can be applied to internal ratings.
    (5) Classify assets into each risk grade, using clear, explicit 
criteria, even for subjective factors.
    (6) Have independent credit risk management or loan review 
personnel assign or review credit risk ratings. These personnel should 
have adequate training and experience to ensure that they are fully 
qualified to perform this function.
    (7) Periodically verify, through an internal audit procedure, that 
internal risk ratings are assigned in accordance with the banking 
organization's established criteria.
    (8) Track the performance of its internal ratings over time to 
evaluate how well risk grades are being assigned, make adjustments to 
its rating system when the performance of its rated positions diverges 
from assigned ratings, and adjust individual ratings accordingly.
    (9) Make credit risk rating assumptions that are consistent with, 
or more conservative than, the credit risk rating assumptions and 
methodologies of the rating agencies.
    The agencies also are considering whether to develop review and 
approval procedures governing their respective determinations of 
whether a particular banking organization may use the internal risk 
rating process. The agencies request comment on the appropriate scope 
and nature of that process.

[[Page 12330]]

    If a banking organization's rating system is found to no longer be 
adequate, the banking organization's primary regulator may preclude it 
from applying the internal risk ratings approach to new transactions 
for risk-based capital purposes until it has remedied the deficiencies. 
Additionally, depending on the severity of the problems identified, the 
primary regulator may also decline to rely on the internal risk ratings 
that the banking organization has applied to previous transactions that 
remain outstanding for purposes of determining the banking 
organization's regulatory capital requirements.
3. Ratings of Specific Positions in Structured Financing Programs
    The agencies also propose to authorize a banking organization to 
use a rating obtained from a rating agency or other appropriate third 
party of unrated direct credit substitutes in securitizations that 
satisfy specifications set by the rating agency. The banking 
organization would need to demonstrate that the rating meets the same 
rating standards generally used by the rating agency for rating 
publicly-issued securities. In addition, the banking organization must 
also demonstrate to its primary regulator's satisfaction that the 
criteria underlying the rating agency's assignment of ratings for the 
program are satisfied for the particular direct credit substitute 
issued by the banking organization.
    The proposal would also allow banking organizations to demonstrate 
to the agencies that it is reasonable and consistent with the standards 
of this proposal to rely on the rating of positions in a securitization 
structure under a program in which the banking organization 
participates if the sponsor of that program has obtained a rating. This 
aspect of the proposal is most likely to be useful to banking 
organizations with limited involvement in securitization activities. In 
addition, some banking organizations extensively involved in 
securitization activities already rely on ratings of the credit risk 
positions under their securitization programs as part of their risk 
management practices. Such banking organizations also could rely on 
such ratings under this proposal if the ratings are part of a sound 
overall risk management process and the ratings reflect the risk of 
non-traded positions to the banking organizations.
    This approach could be used to qualify a direct credit substitute 
(but not a retained recourse position) for a risk weight of 100% or 
200% of the face value of the position under the ratings-based 
approach, but not for a risk weight of less than 100%.
4. Use of Qualifying Rating Software Mapped to Public Rating Standards
    The agencies are also proposing to allow banking organizations, 
particularly those with limited involvement in securitization 
activities, to rely on qualifying credit assessment computer programs 
that the rating agencies or other appropriate third parties have 
developed for rating otherwise unrated direct credit substitutes in 
asset securitizations. To qualify for use by banking organizations for 
risk-based capital purposes, the computer programs must be tracked to 
the rating standards of the rating agencies. Banking organizations must 
demonstrate the credibility of these programs in the financial markets, 
which would generally be shown by the significant use of the computer 
program by investors and market participants for risk assessment 
purposes. Banking organizations also would need to demonstrate the 
reliability of the programs in assessing credit risk. Banking 
organizations may use these programs for purposes of applying the 
ratings-based approach under this proposal only if the banking 
organization satisfies its primary regulator that the programs result 
in credit assessments that credibly and reliably correspond with the 
rating of publicly issued securities by the rating agencies. 
Sophisticated banking organizations with extensive securitization 
activities generally should use this approach only if it is an integral 
part of their risk management systems and their systems fully capture 
the risks from the banking organizations' securitization activities.
    This approach could be used to qualify a direct credit substitute 
(but not a retained recourse position) for a risk weight of 100% or 
200% of the face value of the position under the ratings-based 
approach, but not for a risk weight of less than 100%.

D. Managed Assets Approach

    When assets are securitized, the extent to which the selling or 
sponsoring entity transfers the risks associated with the assets 
depends on the structure of the securitization and the revolving nature 
of the assets involved. To the extent the sponsoring institution is 
dependent on future securitizations as a funding source, as a practical 
matter, the amount of risk transferred often will be limited. Revolving 
credits include credit card and home equity line securitizations as 
well as commercial loans drawn down under long-term commitments that 
are securitized as collateralized loan obligations (CLOs).
    The early amortization feature present in some revolving credit 
securitizations ensures that investors will be repaid before being 
subject to any risk of significant credit losses. For example, if a 
securitized asset pool begins to experience credit deterioration to the 
point where the early amortization feature is triggered, then the 
asset-backed securities held by investors begin to rapidly pay down. 
This occurs because, after an early amortization feature is triggered, 
new receivables that are generated from the accounts designated to the 
securitization trust are no longer sold to investors, but are instead 
retained on the sponsoring banking organization's balance sheet.
    Early amortization features raise several distinct concerns about 
risks to the seller. First, the seller's interest in the securitized 
assets is effectively subordinated to the interests of the investors by 
the payment allocation formula applied during early amortization. 
Investors effectively get paid first, and the seller's residual 
interest will therefore absorb a disproportionate share of credit 
losses.
    Second, early amortization can create liquidity problems for the 
seller. For example, a credit card issuer must fund a steady stream of 
new credit card receivables. When a securitization trust is no longer 
able to purchase new receivables due to early amortization, the seller 
must either find an alternative buyer for the receivables or else the 
receivables will accumulate on the seller's balance sheet, creating the 
need for another source of funding.
    Third, the first two risks to the seller can create an incentive 
for the seller to provide implicit recourse--credit enhancement beyond 
any pre-existing contractual obligation--to prevent early amortization. 
Incentives to provide implicit recourse are to some extent present in 
other securitizations, because of concerns about damage to the seller's 
reputation and its ability to securitize assets going forward if one of 
its securitizations performs poorly. However, the early amortization 
feature creates additional and more direct financial incentives to 
prevent early amortization through implicit recourse.
    Because of their concerns about these risks, the agencies are 
proposing to apply a managed assets approach to securitization 
transactions that incorporate early amortization provisions. The 
approach would require a sponsoring banking organization's securitized 
(off-balance sheet) receivables to be included in risk-

[[Page 12331]]

weighted assets when determining its risk-based capital requirements. 
The securitized, off-balance sheet assets would be assigned to the 20 
percent risk category, thereby effectively applying a 1.6% risk-based 
capital charge to those assets.
    The 1.6% capital charge against securitized assets could be limited 
in certain cases. If the sponsoring banking organization in a revolving 
credit securitization provides credit protection to investors, either 
in the form of retained recourse or a direct credit substitute, the sum 
of the regulatory capital requirements for the credit protection and 
the 1.6% charge on the off-balance sheet securitized assets may not 
exceed 8% of securitized assets for that particular securitization 
transaction.
    A managed assets approach would require a banking organization to 
hold additional capital against the potential credit and liquidity 
risks stemming from the early amortization provisions of revolving 
credit securitization structures. This proposed capital charge would 
ensure that a banking organization maintain at least a minimum level of 
capital against the risks that arise when early amortization provisions 
are present in securitizations of revolving credits.
    The agencies request comment on the purpose of early amortization 
provisions, the proposed managed assets approach, and on any potential 
effects that the approach will have on current industry practices 
involving revolving credit securitizations. The agencies also recognize 
that there may be concerns that the managed assets approach may not 
produce safety and soundness benefits commensurate with the additional 
regulatory burden that would result from a 20% risk weight on managed 
assets, and they request comment on possible alternative measures that 
would address more effectively the risks arising from early 
amortization provisions in revolving securitizations. For example, one 
alternative to the managed assets approach described here would be to 
require greater public disclosure of securitization performance. This 
additional information could allow market participants and regulators 
to better assess the risks inherent in revolving securitizations with 
early amortization provisions and the capital level appropriate for 
those risks. The agencies also request comment on whether the benefits 
of greater public disclosure outweigh the costs associated with 
increased reporting.

IV. Effective Date of a Final Rule Resulting From This Proposal

    The agencies intend that any final rules adopted as a result of 
this proposal that result in increased risk-based capital requirements 
for banking organizations will apply only to securitization activities 
(as defined in the proposal) entered into or acquired after the 
effective date of those final rules. Conversely, any final rules that 
result in reduced risk-based capital requirements for banking 
organizations may be applied to all transactions outstanding as of the 
effective date of those final rules and to all subsequent transactions. 
Because some ongoing securitization conduits may need additional time 
to adapt to any new capital treatments, the agencies intend to permit 
banking organizations to apply the existing capital rules to asset 
securitizations with no fixed term, e.g., asset-backed commercial paper 
conduits, for up to two years after the effective date of any final 
rule.

V. Request for Comment

    The agencies request comment on all aspects of this proposal, as 
well as on the specific issues described in the preamble.

VI. Regulatory Flexibility Act

    OCC: Pursuant to section 605(b) of the Regulatory Flexibility Act, 
the OCC certifies that this proposal will not have a significant impact 
on a substantial number of small entities. 5 U.S.C. 601 et seq. The 
provisions of this proposal that increase capital requirements are 
likely to affect large national banks almost exclusively. Small 
national banks rarely sponsor or provide direct credit substitutes in 
asset securitizations. Accordingly, a regulatory flexibility analysis 
is not required.
    Board: Pursuant to section 605(b) of the Regulatory Flexibility 
Act, the Board has determined that this proposal will not have a 
significant impact on a substantial number of small business entities 
within the meaning of the Regulatory Flexibility Act (5 U.S.C. 601 et 
seq.). The Board's comparison of the applicability section of this 
proposal with Call Report Data on all existing banks shows that 
application of the proposal 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 proposal will not affect such 
companies.
    FDIC: Pursuant to section 605(b) of the Regulatory Flexibility Act 
(Public Law 96-354, 5 U.S.C. 601 et seq.), the FDIC certifies that the 
proposed rule will not have a significant impact on a substantial 
number of small entities. Comparison of Call Report data on FDIC-
supervised banks to the items covered by the proposal that result in 
increased capital requirements shows that application of the proposal 
to small entities will be the infrequent exception.
    OTS: Pursuant to section 605(b) of the Regulatory Flexibility Act, 
the OTS certifies that this proposal will not have a significant impact 
on a substantial number of small entities. A comparison of TFR data on 
OTS-supervised thrifts shows that the proposed rule would have little 
impact on the overall level of capital required at small thrifts, since 
capital requirements (other than the risk-based capital standards) are 
typically more binding on smaller thrifts. Moreover, the provisions of 
this proposal that may increase capital requirements are unlikely to 
affect small savings associations. Small thrifts rarely provide direct 
credit substitutes in asset securitizations and do not serve as 
sponsors of revolving securitizations. Accordingly, a regulatory 
flexibility analysis is not required.

VII. Paperwork Reduction Act

    The Agencies have determined that this proposal does not involve a 
collection of information pursuant to the provisions of the Paperwork 
Reduction Act of 1995 (44 U.S.C. 3501, et seq.).

VIII. Executive Order 12866

    OCC: The OCC has determined that this proposal is not a significant 
regulatory action for purposes of Executive Order 12866. The OCC 
expects that any increase in national banks' risk-based capital 
requirement, resulting from the proposed treatment of direct credit 
substitutes largely will be offset by the ability of those banks to 
reduce their capital requirement in accordance with the ratings-based 
approach. The managed assets position of the proposal may require a 
limited number of national banks to raise additional capital in order 
to remain in the category to which they are assigned currently under 
the OCC's prompt corrective action framework. The OCC believes that the 
costs associated with raising this new capital are below the thresholds 
prescribed in the Executive Order. Nonetheless, the impact of any final 
rule resulting from this proposal will depend on factors for which the 
agencies do not currently collect industry-wide information, such as 
the

[[Page 12332]]

proportion of bank-provided direct credit substitutes that would be 
rated below investment grade. The OCC, therefore, welcomes any 
quantitative information national banks wish to provide about the 
impact they expect the various portions of this proposal to have if 
issued in final form.
    OTS: The Director of the OTS has determined that this proposal does 
not constitute a ``significant regulatory action'' under Executive 
Order 12866. Since OTS already applies a ``gross up'' treatment for 
recourse obligations and for most direct credit substitutes, the 
proposal generally is likely to reduce the risk-based capital 
requirements for thrifts. The proposed rule would increase capital 
requirements only for certain direct credit substitutes issued in 
connection with asset securitizations or for thrifts that may serve as 
sponsors of revolving securitization programs. Currently, thrifts 
rarely participate in such activities. As a result, OTS has concluded 
that the proposal will have only minor effects on the thrift industry.

IX. OCC and OTS--Unfunded Mandates Reform Act of 1995

    Section 202 of the Unfunded Mandates Reform Act of 1995, Public Law 
104-4, (Unfunded Mandates Act), requires that an agency prepare a 
budgetary impact statement before promulgating a rule that includes a 
Federal mandate that may result in the expenditure by state, local, and 
tribal governments, in the aggregate, or by the private sector, of $100 
million or more in any one year. If a budgetary impact statement is 
required, section 205 of the Unfunded Mandates Act also requires an 
agency to identify and consider a reasonable number of regulatory 
alternatives before promulgating a rule. The OCC and OTS have 
determined that this proposed rule will not result in expenditures by 
state, local, and tribal governments, or by the private sector, of more 
than $100 million or more in any one year. Therefore, the OCC and OTS 
have not prepared a budgetary impact statement or specifically 
addressed the regulatory alternatives considered. As discussed in the 
preamble, this proposal will reduce inconsistencies in the agencies' 
risk-based capital standards and, in certain circumstances, will allow 
banking organizations to maintain lower amounts of capital against 
certain rated recourse obligations and direct credit substitutes.

X. Plain Language Requirement

    Section 722 of the Gramm-Leach-Bliley Act of 1999 requires the 
federal banking agencies to use ``plain language'' in all proposed and 
final rules published after January 1, 2000. We invite your comments on 
how to make this proposal easier to understand. For example:
    (1) Have we organized the material to suit your needs?
    (2) Are the requirements in the rule clearly stated?
    (3) Does the rule contain technical language or jargon that isn't 
clear?
    (4) Would a different format (grouping and order of sections, use 
of headings, paragraphing) make the rule easier to understand?
    (5) Would more (but shorter) sections be better?
    (6) What else could we do to make the rule easier to understand?

XI. FDIC Assessment of Impact of Federal Regulation on Families

    The FDIC has determined that this proposed rule will not affect 
family well-being within the meaning of section 654 of the Treasury and 
General Government Appropriations Act of 1999 (Pub. Law 105-277).

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

12 CFR Part 567

    Capital, Reporting and recordkeeping requirements, Savings 
associations.

Department of the Treasury

Office of the Comptroller of the Currency

12 CFR Chapter I

Authority and Issuance

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

PART 3--MINIMUM CAPITAL RATIOS; ISSUANCE OF DIRECTIVES

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


    Authority: 12 U.S.C. 93a, 161, 1818, 1828(n), 1828 note, 1831n 
note, 1835, 3907, and 3909.


Sec. 3.4  [Amended]

    2. In Sec. 3.4:
    A. The undesignated paragraph is designated as paragraph (a);
    B. The second sentence in the newly designated paragraph (a) is 
revised; and
    C. New paragraph (b) is added to read as follows:


Sec. 3.4  Reservation of authority.

    (a) * * * Similarly, the OCC may find that a particular intangible 
asset need not be deducted from Tier 1 or Tier 2 capital. * * *
    (b) Notwithstanding the risk categories in section 3 of appendix A 
to this part, the OCC may find that the assigned risk weight for any 
asset or the credit equivalent amount or credit conversion factor for 
any off-balance sheet item does not appropriately reflect the risks 
imposed on a bank and may require another risk weight, credit 
equivalent amount, or credit conversion factor that the OCC deems 
appropriate. Similarly, if no risk weight, credit equivalent amount, or 
credit conversion factor is specifically assigned, the OCC may assign 
any risk weight, credit equivalent amount, or credit conversion factor 
that the OCC deems appropriate. In making its determination, the OCC 
considers risks associated with the asset or off-balance sheet item as 
well as other relevant factors.

Appendix A to Part 3--[Amended]

    3. In section 3 of appendix A:
    A. Footnote 11a in paragraph (a)(3)(v) is revised;
    B. Paragraph (b) introductory text is amended by adding a new 
sentence at its end;
    C. Paragraph (b)(1)(i) and footnote 13 are removed and reserved;
    D. Paragraph (b)(1)(ii) is revised;
    E. Paragraph (b)(1)(iii) and footnote 14 are removed and 
reserved;

[[Page 12333]]

    F. Footnotes 16 and 17 in paragraphs (b)(2)(i) and (ii), 
respectively, are revised; and
    G. Paragraph (d) is revised to read as follows:

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

* * * * *

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

* * * * *
    (a) * * *
    (3) * * *
    (v) * * * \11a\
---------------------------------------------------------------------------

    \11a\ The portion of multifamily residential property loans that 
is sold subject to a pro rata loss sharing arrangement may be 
treated by the selling bank as sold to the extent that the sales 
agreement provides for the purchaser of the loan to share in any 
loss incurred on the loan on a pro rata basis with the selling bank. 
The portion of multifamily residential property loans sold subject 
to any loss sharing arrangement other than pro rata sharing of the 
loss shall be accorded the same treatment as any other asset sold 
under an agreement to repurchase or sold with recourse under section 
3(d)(2) of this appendix A.
---------------------------------------------------------------------------

* * * * *
    (b) * * * However, direct credit substitutes, recourse 
obligations, and securities issued in connection with asset 
securitizations are treated as described in section 3(d) of this 
appendix A.
    (1) * * *
    (ii) Risk participations purchased in bankers' acceptances.
* * * * *
    (2) * * *
    (i) * * * \16\ * * *
---------------------------------------------------------------------------

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

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

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

* * * * *
    (d) Recourse obligations, direct credit substitutes, and asset-
backed securities--(1) Definitions. For purposes of this section 3 
of this appendix A:
    (i) Covered representations and warranties means representations 
and warranties that are made or assumed in connection with a 
transfer of assets (including loan servicing assets) and that 
obligate a bank to absorb losses arising from credit risk in the 
assets transferred or the loans serviced. Covered representations 
and warranties include promises to protect a party from losses 
resulting from the default or nonperformance of another party or 
from an insufficiency in the value of the collateral.
    (ii) Credit derivative means a contract that allows one party 
(the beneficiary) to transfer the credit risk of an asset or off-
balance sheet credit exposure to another party (the guarantor). The 
value of a credit derivative is dependent, at least in part, on the 
credit performance of a ``reference asset.''
    (iii) Direct credit substitute means an arrangement in which a 
bank assumes credit risk associated with an on-or off-balance sheet 
asset that was not previously owned by the bank (third-party asset) 
and the risk assumed by the bank exceeds the pro rata share of the 
bank's interest in the third-party asset. If a bank has no claim on 
the third-party asset, then the bank's assumption of any risk of 
credit loss is a direct credit substitute. Direct credit substitutes 
include:
    (A) Financial guarantee-type standby letters of credit that 
support financial claims on a third party that exceed a bank's pro 
rata share in the financial claim;
    (B) Guarantees, surety arrangements, credit derivatives and 
similar instruments backing financial claims that exceed a bank's 
pro rata share in the financial claim;
    (C) Purchased subordinated interests that absorb more than their 
pro rata share of losses from the underlying assets;
    (D) Entering into a credit derivative contract under which the 
bank assumes more than its pro rata share of credit risk on a third-
party asset;
    (E) Loans or lines of credit that provide credit enhancement for 
the securitization activities of a third party; and
    (F) Purchased loan servicing assets if the servicer is 
responsible for credit losses or if the servicer makes or assumes 
covered representations and warranties with respect to the loans 
serviced. Cash advances described in section 4(d)(1)(vii) of this 
appendix A are not direct credit substitutes.
    (iv) Externally rated means that an instrument or obligation has 
received a credit rating from at least one nationally recognized 
statistical rating organization.
    (v) Face amount means the notional principal, or face value, 
amount of an off-balance sheet item; the amortized cost of an asset 
not held for trading purposes; and the fair value of a trading 
asset.
    (vi) Financial guarantee-type standby letter of credit means a 
letter of credit or similar arrangement that represents an 
irrevocable obligation to a third-party beneficiary:
    (A) To repay money borrowed by, or advanced to, or for the 
account of, a second party (the account party); or
    (B) To make payment on behalf of the account party, in the event 
that the account party fails to fulfill its obligation to the 
beneficiary.
    (vii) Mortgage servicer cash advance means funds that a mortgage 
servicer advances to ensure an uninterrupted flow of payments, 
including advances made to cover foreclosure costs or other expenses 
to facilitate the timely collection of the loan. A mortgage servicer 
cash advance is not a recourse obligation or a direct credit 
substitute if:
    (A) The servicer is entitled to full reimbursement and this 
right is not subordinated to other claims on the cash flows from the 
underlying asset pool; or
    (B) For any one loan, the servicer's obligation to make 
nonreimbursable advances is contractually limited to an 
insignificant amount.
    (viii) Nationally recognized statistical rating organization 
(NRSRO) means an entity recognized by the Division of Market 
Regulation of the Securities and Exchange Commission (or any 
successor Division) (Commission) as a nationally recognized 
statistical rating organization for various purposes, including the 
Commission's uniform net capital requirements for brokers and 
dealers.
    (ix) Recourse means the retention, by a bank, of any risk of 
credit loss directly or indirectly associated with a transferred 
asset that exceeds a pro rata share of that bank's claim on the 
asset. If a bank has no claim on a transferred asset, then the 
retention of any risk of credit loss is recourse. A recourse 
obligation typically arises when a bank transfers assets and retains 
an explicit obligation to repurchase assets or to absorb losses due 
to a default on the payment of principal or interest or any other 
deficiency in the performance of the underlying obligor or some 
other party. Recourse may also exist implicitly if a bank provides 
credit enhancement beyond any contractual obligation to support 
assets it has sold. The following are examples of recourse 
arrangements:
    (A) Making covered representations and warranties on transferred 
assets;
    (B) Retaining loan servicing assets pursuant to an agreement 
under which the bank will be responsible for losses associated with 
the loans serviced. Mortgage servicer cash advances, as defined in 
section 4(d)(1)(vii) of this appendix A, are not recourse 
arrangements;
    (C) Retaining a subordinated interest that absorbs more than its 
pro rata share of losses from the underlying assets;
    (D) Selling assets under an agreement to repurchase, if the 
assets are not already included on the balance sheet; and
    (E) Selling loan strips without contractual recourse where the 
maturity

[[Page 12334]]

of the transferred portion of the loan is shorter than the maturity 
of the whole loan.
    (x) Risk participation means a participation in which the 
originating bank remains liable to the beneficiary for the full 
amount of an obligation (e.g. a direct credit substitute) 
notwithstanding that another party has acquired a participation in 
that obligation.
    (xi) Securitization means the pooling and repackaging of assets 
or other credit exposures into securities that can be sold to 
investors, including transactions that create stratified credit risk 
positions.
    (xii) Traded position means a recourse obligation, direct credit 
substitute or asset-backed security retained, assumed or issued in 
connection with a securitization that is externally rated, where 
there is an expectation that, in the near future, the rating will be 
relied upon by:
    (A) Investors to purchase the position; or
    (B) A third party to enter into a transaction involving the 
position, such as a purchase, loan or repurchase agreement.
    (2) Credit equivalent amounts and risk weights of recourse 
obligations and direct credit substitutes--(i) Credit-equivalent 
amount. Except as provided in sections 3(d)(3) and (4) of this 
appendix A, the credit-equivalent amount for a recourse obligation 
or direct credit substitute is the full amount of the credit-
enhanced assets for which the bank directly or indirectly retains or 
assumes credit risk multiplied by a 100% conversion factor.
    (ii) Risk-weight factor. To determine the bank's risk-weighted 
assets for off-balance sheet recourse obligations and direct credit 
substitutes, the credit equivalent amount is assigned to the risk 
category appropriate to the obligor in the underlying transaction, 
after considering any associated guarantees or collateral. For a 
direct credit substitute that is an on-balance sheet asset (e.g., a 
purchased subordinated security), a bank must calculate risk-
weighted assets using the amount of the direct credit substitute and 
the full amount of the assets it supports, i.e., all the more senior 
positions in the structure.
    (3) Credit equivalent amount and risk weight of participations 
in, and syndications of, direct credit substitutes. The credit 
equivalent amount for a participation interest in, or syndication 
of, a direct credit substitute is calculated and risk weighted as 
follows:
    (i) In the case of a direct credit substitute in which a bank 
has conveyed a risk participation, the full amount of the assets 
that are supported by the direct credit substitute is converted to a 
credit equivalent amount using a 100% conversion factor. The pro 
rata share of the credit equivalent amount that has been conveyed 
through a risk participation is then assigned to whichever risk-
weight category is lower: The risk-weight category appropriate to 
the obligor in the underlying transaction, after considering any 
associated guarantees or collateral, or the risk-weight category 
appropriate to the institution acquiring the participation. The pro 
rata share of the credit equivalent amount that has not been 
participated out is assigned to the risk-weight category appropriate 
to the obligor, guarantor, or collateral.
    (ii) In the case of a direct credit substitute in which the bank 
has acquired a risk participation, the acquiring bank's percentage 
share of the direct credit substitute is multiplied by the full 
amount of the assets that are supported by the direct credit 
substitute and converted using a 100% credit conversion factor. The 
resulting credit equivalent amount is then assigned to the risk-
weight category appropriate to the obligor in the underlying 
transaction, after considering any associated guarantees or 
collateral.
    (iii) In the case of a direct credit substitute that takes the 
form of a syndication where each bank is obligated only for its pro 
rata share of the risk and there is no recourse to the originating 
bank, each bank's credit equivalent amount will be calculated by 
multiplying only its pro rata share of the assets supported by the 
direct credit substitute by a 100% conversion factor. The resulting 
credit equivalent amount is then assigned to the risk-weight 
category appropriate to the obligor in the underlying transaction, 
after considering any associated guarantees or collateral.
    (4) Externally rated positions: Credit-equivalent amounts and 
risk weights.--(i) Traded positions. With respect to a recourse 
obligation, direct credit substitute, or asset-backed security that 
is a ``traded position'' and that has received an external rating 
that is one grade below investment grade or better, the bank shall 
multiply the face amount of the position by the appropriate risk 
weight, determined in accordance with Table B. \24\
---------------------------------------------------------------------------

    \24\ Stripped mortgage-backed securities, such as interest-only 
or principal-only strips, may be assigned only, at a minimum, to the 
100% risk category.

                                 Table B
------------------------------------------------------------------------
                                                             Risk weight
          Rating category                   Examples          (percent)
------------------------------------------------------------------------
Highest or second highest            AAA, AA...............           20
 investment grade.
Third highest investment grade.....  A.....................           50
Lowest investment grade............  BBB...................          100
One category below investment grade  BB....................          200
------------------------------------------------------------------------

    (ii) Non-traded positions. A recourse obligation or direct 
credit substitute extended in connection with a securitization that 
is not a ``traded position'' is assigned a risk weight in accordance 
with section 3(d)(4)(i) of this appendix A if:
    (A) It has been externally rated one category below investment 
grade or better by two NRSROs;
    (B) The ratings are publicly available; and
    (C) The ratings are based on the same criteria used to rate 
securities sold to the public. If the two ratings are different, the 
lower rating will determine the risk category to which the recourse 
obligation or direct credit substitute will be assigned.
    (5) Senior positions not externally rated. For a recourse 
obligation, direct credit substitute, or asset-backed security that 
is not externally rated but is senior in all credit-risk related 
features to a traded position (including collateralization), a bank 
may apply a risk weight to the face amount of the senior position in 
accordance with section 3(d)(4)(i) of this appendix A, based upon 
the traded position, subject to the bank satisfying the OCC that 
this treatment is appropriate.
    (6) Direct credit substitutes that are not externally rated. A 
direct credit substitute extended in connection with a 
securitization that is not externally rated may risk weight the face 
amount of the direct credit substitute based on the bank's 
determination of the credit rating of the position, as specified in 
Table C. In order to qualify for this treatment, the bank's system 
for determining the credit rating of the direct credit substitute 
must meet one of the three alternative standards set out in section 
3(d)(6)(i) through (iii) of this appendix A.

[[Page 12335]]



                                 Table C
------------------------------------------------------------------------
                                                             Risk weight
          Rating category                   Examples          (percent)
------------------------------------------------------------------------
Highest or second highest            AAA, AA...............          100
 investment grade.
Third highest investment grade.....  A.....................          100
Lowest investment grade............  BBB...................          100
One category below investment grade  BB....................          200
------------------------------------------------------------------------

    (i) Internal risk rating used for asset-backed programs. The 
direct credit substitute is issued in connection with an asset-
backed commercial paper program sponsored by the bank and the bank's 
internal credit risk rating system is adequate. Adequate internal 
credit risk rating systems usually contain the following criteria: 
\25\
---------------------------------------------------------------------------

    \25\ The adequacy of a bank's use of its internal credit risk 
rating system must be demonstrated to the OCC considering the 
criteria listed in this section and the size and complexity of the 
credit exposures assumed by the bank.
---------------------------------------------------------------------------

    (A) The internal credit risk system is an integral part of the 
bank's risk management system that explicitly incorporates the full 
range of risks arising from a bank's participation in securitization 
activities;
    (B) Internal credit ratings are linked to measurable outcomes, 
such as the probability that the position will experience any loss, 
the position's expected loss given default, and the degree of 
variance in losses given default on that position;
    (C) The bank's internal credit risk system must separately 
consider the risk associated with the underlying loans or borrowers, 
and the risk associated with the structure of a particular 
securitization transaction;
    (D) The bank's internal credit risk system must identify 
gradations of risk among ``pass'' assets and other risk positions;
    (E) The bank must have clear, explicit criteria that are used to 
classify assets into each internal risk grade, including subjective 
factors;
    (F) The bank must have independent credit risk management or 
loan review personnel assigning or reviewing the credit risk 
ratings;
    (G) An internal audit procedure should periodically verify that 
internal risk ratings are assigned in accordance with the banking 
organization's established criteria.
    (H) The bank must monitor the performance of the internal credit 
risk ratings assigned to nonrated, nontraded direct credit 
substitutes over time to determine the appropriateness of the 
initial credit risk rating assignment and adjust individual credit 
risk ratings, or the overall internal credit risk ratings system, as 
needed; and
    (I) The internal credit risk system must make credit risk rating 
assumptions that are consistent with, or more conservative than, the 
credit risk rating assumptions and methodologies of NRSROs.
    (ii) Program ratings. The direct credit substitute is issued in 
connection with a securitization program and a NRSRO (or other 
entity satisfactory to the OCC) has reviewed the terms of the 
securitization and stated a rating for positions associated with the 
program. If the program has options for different combinations of 
assets, standards, internal credit enhancements and other relevant 
factors, and the NRSRO or other entity specifies ranges of rating 
categories to them, the bank may apply the rating category 
applicable to the option that corresponds to the bank's position. 
The bank must demonstrate to the OCC's satisfaction that the credit 
risk rating assigned to the program meets the same standards 
generally used by NRSROs for rating traded positions. In addition, 
the bank must also demonstrate to the OCC's satisfaction that the 
criteria underlying the NRSRO's assignment of ratings for the 
program are satisfied for the particular direct credit substitute 
issued by the bank. If a bank participates in a securitization 
sponsored by another party, the OCC may authorize the bank to use 
this approach based on a program rating obtained by the sponsor of 
the program.
    (iii) Computer program. The bank is using an acceptable credit 
assessment computer program to determine the rating of a direct 
credit substitute extended in connection with a securitization. A 
NRSRO (or another entity approved by the OCC) must have developed 
the computer program and the bank must demonstrate to the OCC's 
satisfaction that ratings under the program correspond credibly and 
reliably with the rating of traded positions.
    (7) Off-balance sheet securitized assets subject to early 
amortization. An asset that is sold by a bank into a revolving 
securitization sponsored by the bank, notwithstanding such sale, 
shall be converted to an on-balance sheet credit equivalent using a 
100% conversion factor, and assigned to the 20 percent risk-weight 
category, if the securitization has an early amortization 
feature.\26\ The total capital requirement for these assets, 
including capital charges arising from any retained recourse or 
direct credit substitute, may not exceed 8% of the amount of the 
assets in the securitization.
---------------------------------------------------------------------------

    \26\ This requirement does not apply to interests that the 
seller has retained.
---------------------------------------------------------------------------

    (8) Limitations on risk-based capital requirements--(i) Low-
level exposure rule. If the maximum contractual liability or 
exposure to loss retained or assumed by a bank is less than the 
effective risk-based capital requirement for the asset supported by 
the bank's position, the risk based capital required under this 
appendix A is limited to the bank's contractual liability, less any 
recourse liability account established in accordance with generally 
accepted accounting principles.
    (ii) Related on-balance sheet assets. If an asset is included in 
the calculation of the risk-based capital requirement under this 
section 3(d) of this appendix A and also appears as an asset on a 
bank's balance sheet, the asset is risk-weighted only under this 
section 3(d) of this appendix A, except in the case of loan 
servicing assets and similar arrangements with embedded recourse 
obligations or direct credit substitutes. In that case, both the on-
balance sheet servicing assets and the related recourse obligations 
or direct credit substitutes are incorporated into the risk-based 
capital calculation.
* * * * *
    4. In appendix A, Table 2, ``100 Percent Conversion Factor,'' 
Item 1 is revised to read as follows:
* * * * *

Table 2--Credit Conversion Factors for Off-Balance Sheet Items

100 Percent Conversion Factor

    1. [Reserved]
* * * * *

    Dated: February 9, 2000.
John D. Hawke, Jr.,
Comptroller of the Currency.

Federal Reserve System

12 CFR Chapter II

Authority and Issuance

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

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

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


    Authority: 12 U.S.C. 24, 36, 92(a), 93(a), 248(a), 248(c), 321-
338a, 371d, 461, 481-486,

[[Page 12336]]

601, 611, 1814, 1816, 1818, 1820(d)(9), 1823(j), 1828(o), 1831, 
1831o, 1831p-1, 1831r-1, 1835(a), 1882, 2901-2907, 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. In appendix A to part 208:
    A. The three introductory paragraphs to section II. are revised;
    B. A new undesignated fifth paragraph is added at the end of 
section III.A;
    C. In section III.B., paragraph 3 is revised and footnote 23 is 
removed, and in paragraph 4, footnote 24 is removed;
    D. In section III.C., paragraphs 1 through 3, footnotes 25 through 
37 are redesignated as footnotes 23 through 35, and paragraph 4 is 
revised;
    E. In section III.D., the introductory paragraph and paragraph 1 
are revised;
    F. In sections III.D. and III.E., footnote 46 is removed and 
footnotes 47 through 51 are redesignated as footnotes 44 through 48; 
and
    G. In section IV.B., footnote 52 is removed.

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

* * * * *

II. * * *

    A bank's qualifying total capital consists of two types of 
capital components: ``core capital elements'' (comprising Tier 1 
capital) and ``supplementary capital elements'' (comprising Tier 2 
capital). These capital elements and the various limits, 
restrictions, and deductions to which they are subject, are 
discussed below and are set forth in Attachment II.
    The Federal Reserve will, on a case-by-case basis, determine 
whether and, if so, how much of any liability that does not fit 
wholly within the terms of one of the capital categories set forth 
below or that does not have an ability to absorb losses commensurate 
with the capital treatment otherwise specified below will be counted 
as an element of Tier 1 or Tier 2 capital. In making such a 
determination, the Federal Reserve will consider the similarity of 
the liability to liabilities explicitly treated in the guidelines, 
the ability of the liability to absorb losses while the bank 
operates as a going concern, the maturity and redemption features of 
the liability, and other relevant terms and factors. To qualify as 
an element of Tier 1 or Tier 2 capital, a capital instrument may not 
contain or be covered by any covenants, terms, or restrictions that 
are inconsistent with safe and sound banking practices.
    Redemptions of permanent equity or other capital instruments 
before stated maturity could have a significant impact on a bank's 
overall capital structure. Consequently, a bank considering such a 
step should consult with the Federal Reserve before redeeming any 
equity or debt capital instrument (prior to maturity) if such 
redemption could have a material effect on the level or composition 
of the institution's capital base.\4\
---------------------------------------------------------------------------

    \4\ Consultation would not ordinarily be necessary if an 
instrument were redeemed with the proceeds of, or replaced by, a 
like amount of a similar or higher quality capital instrument and 
the organization's capital position is considered fully adequate by 
the Federal Reserve.
---------------------------------------------------------------------------

* * * * *
    III. * * *
    A. * * *
    The Federal Reserve will, on a case-by-case basis, determine the 
appropriate risk weight for any asset or the credit equivalent 
amount of an off-balance sheet item that does not fit wholly within 
the terms of one of the risk weight categories set forth below or 
that imposes risks on a bank that are incommensurate with the risk 
weight otherwise specified below for the asset or off-balance sheet 
item. In addition, the Federal Reserve will, on a case-by-case 
basis, determine the appropriate credit conversion factor for any 
off-balance sheet item that does not fit wholly within the terms of 
one of the credit conversion factors set forth below or that imposes 
risks on a bank that are incommensurate with the credit conversion 
factors otherwise specified below for the off-balance sheet item. In 
making such a determination, the Federal Reserve will consider the 
similarity of the asset or off-balance sheet item to assets or off-
balance sheet items explicitly treated in the guidelines, as well as 
other relevant factors.
* * * * *
    B. * * *
    3. Recourse obligations, direct credit substitutes, and asset- 
and mortgage-backed securities. Direct credit substitutes, assets 
transferred with recourse, and securities issued in connection with 
asset securitizations and structured financings are treated as 
described below. Use of the term ``asset securitizations'' or 
``securitizations'' in this rule includes structured financings, as 
well as asset securitization transactions.
    a. Definitions--(i) Credit derivatives are on-or off-balance 
sheet notes or contracts that allow one party (the ``beneficiary'') 
to transfer the credit risk of a ``reference asset,'' which it often 
owns, to another party (the ``guarantor''). The value of a credit 
derivative is dependent, at least in part, on the credit performance 
of the reference asset, which typically is a publicly traded loan or 
corporate bond.
    (ii) Credit-enhancing representations and warranties means 
representations and warranties extended by a bank when it transfers 
assets (including loan servicing assets) or assumed by the bank when 
it purchases loan servicing assets that obligate the bank to absorb 
credit losses on transferred assets or serviced loans. These 
representations and warranties typically arise when the bank agrees 
to protect purchasers or some other party from losses due to the 
default or nonperformance of the obligor on the transferred assets 
or serviced loans, or insufficiency in the value of collateral 
supporting the transferred assets or serviced loans.
    (iii) Direct credit substitute means an arrangement in which a 
bank assumes, in form or in substance, any risk of credit loss 
directly or indirectly associated with a third-party asset or other 
financial claim, that exceeds the bank's pro rata share of the asset 
or claim. If the bank has no claim on the asset, then the assumption 
of any risk of loss is a direct credit substitute. Direct credit 
substitutes include, but are not limited to:
    (1) Financial guarantee-type standby letters of credit that 
support financial claims on the account party;
    (2) Guarantees, surety arrangements, credit derivatives, and 
irrevocable guarantee-type instruments backing financial claims such 
as outstanding securities, loans, or other financial liabilities, or 
that back off-balance sheet items against which risk-based capital 
must be maintained;
    (3) Purchased subordinated interests or securities that absorb 
more than their pro rata share of losses from the underlying assets;
    (4) Loans or lines of credit that provide credit enhancement for 
the financial obligations of an account party; and
    (5) Purchased loan servicing assets if the servicer is 
responsible for credit losses associated with the loans being 
serviced (other than mortgage servicer cash advances as defined in 
paragraph III.B.3.a.(vi) of this section), or if the servicer makes 
or assumes credit-enhancing representations and warranties with 
respect to the serviced loans.
    (iv) Externally rated means, with respect to an instrument or 
obligation, that the instrument or obligation has received a credit 
rating from a nationally-recognized statistical rating organization.
    (v) Financial guarantee-type standby letter of credit means any 
letter of credit or similar arrangement, however named or described, 
that represents an irrevocable obligation to the beneficiary on the 
part of the issuer:
    (1) To repay money borrowed by, advanced to, or for the account 
of, the account party; or
    (2) To make payment on account of any indebtedness undertaken by 
the account party in the event that the account party fails to 
fulfill its obligation to the beneficiary.
    (vi) Mortgage servicer cash advance means funds that a 
residential mortgage loan servicer advances to ensure an 
uninterrupted flow of payments or the timely collection of 
residential mortgage loans, including disbursements made to cover 
foreclosure costs or other expenses arising from a mortgage loan to 
facilitate its timely collection. A mortgage servicer cash advance 
is not a recourse obligation or a direct credit substitute if the 
mortgage servicer is entitled to full reimbursement or, for any one 
residential mortgage loan, nonreimbursable advances are 
contractually limited to an insignificant amount of the outstanding 
principal on that loan.
    (vii) Nationally recognized statistical rating organization 
means an entity recognized by the Division of Market Regulation of 
the Securities and Exchange Commission as a nationally recognized 
statistical rating organization for various purposes, including the 
Commission's uniform net capital requirements for brokers and 
dealers (17 CFR 240.15c3-1(c)(2)(vi)(E), (F), and (H)).
    (viii) Recourse means an arrangement in which a bank retains, in 
form or in

[[Page 12337]]

substance, any risk of credit loss directly or indirectly associated 
with a transferred asset that exceeds a pro rata share of the bank's 
claim on the asset. If a bank has no claim on a transferred asset, 
then the retention of any risk of loss is recourse. A recourse 
obligation typically arises when an institution transfers assets and 
retains an obligation to repurchase the assets or absorb losses due 
to a default of principal or interest or any other deficiency in the 
performance of the underlying obligor or some other party. Recourse 
may exist implicitly where a bank provides credit enhancement beyond 
any contractual obligation to support assets it has sold. Recourse 
obligations include, but are not limited to:
    (1) Credit-enhancing representations and warranties on the 
transferred assets that obligate the servicer to absorb credit 
losses, including early-default clauses;
    (2) Retained loan servicing assets if the servicer is 
responsible for losses associated with the loans being serviced 
other than mortgage servicer cash advances as defined in paragraph 
III.B.3.a.(vi) of this section.
    (3) Retained subordinated interests or securities or credit 
derivatives that absorb more than their pro rata share of losses 
from the underlying assets;
    (4) Assets sold under an agreement to repurchase if the assets 
are not already included on the balance sheet; and
    (5) Loan strips sold without direct recourse where the maturity 
of the transferred loan that is drawn is shorter than the maturity 
of the commitment.
    (ix) Securitization means the pooling and repackaging of loans 
or other credit exposures into securities that can be sold to 
investors. For purposes of this appendix A, securitization also 
includes structured finance transactions or programs that generally 
create stratified credit risk positions whose performance is 
dependent upon an underlying pool of credit exposures, including 
loans and commitments.
    (x) Traded position means a recourse obligation, direct credit 
substitute, or asset-or mortgage-backed security that is retained, 
assumed, or issued in connection with an asset securitization and 
that is rated with a reasonable expectation that, in the near 
future:
    (1) The position would be sold to investors relying on the 
rating; or
    (2) A third party would, in reliance on the rating, enter into a 
transaction such as a purchase, loan, or repurchase agreement 
involving the position.
    b. Amount of position to be included in risk-weighted assets. 
Other types of recourse obligations or direct credit substitutes, 
other than those listed in section III.B.3.b.(i)(1) through (7) of 
this appendix A, should be treated in accordance with the principles 
contained in section III.B.3. of this appendix A. The treatment of 
direct credit substitutes that have been syndicated or in which risk 
participations have been conveyed or acquired is set forth in 
section III.D.1 of this appendix A.
    (i) General rule for determining the credit equivalent amount 
and risk weight of recourse obligations and direct credit 
substitutes. Except as otherwise provided in section III of this 
appendix A, the risk weighted asset amount or the credit equivalent 
amount for a recourse obligation or direct credit substitute is the 
full amount of the credit enhanced assets from which risk of credit 
loss is directly or indirectly retained or assumed. This credit 
equivalent amount is assigned to the risk weight category 
appropriate to the obligor or, if relevant, the guarantor or nature 
of any collateral. Thus, a bank that extends a partial direct credit 
substitute, e.g., a financial standby letter of credit, that absorbs 
the first 10 percent of loss on a transaction, must maintain capital 
against the full amount of the assets being supported. Furthermore, 
for direct credit substitutes that are on-balance sheet assets, 
e.g., purchased subordinated securities, banks must maintain capital 
against the amount of the direct credit substitutes and the full 
amount of the assets being supported, i.e., all more senior 
positions. This treatment is subject to the low-level capital rule 
discussed in section III.B.3.c.i. of this appendix A. For purposes 
of this appendix A, the full amount of the credit enhanced assets 
from which risk of credit loss is directly or indirectly retained or 
assumed means for:
    (1) A financial guarantee-type standby letter of credit, surety 
arrangement, credit derivative, guarantee, or irrevocable guarantee-
type instruments, the full amount of the assets that the direct 
credit substitute fully or partially supports;
    (2) A subordinated interest or security, the amount of the 
subordinated interest or security plus all more senior interests or 
securities;
    (3) Mortgage servicing assets that are recourse obligations or 
direct credit substitutes, the outstanding amount of the loans 
serviced;
    (4) Credit-enhancing representations and warranties, the amount 
of the assets subject to the representations or warranties;
    (5) Loans or lines of credit that provide credit enhancement for 
the financial obligations of an account party, the full amount of 
the enhanced financial obligations;
    (6) Loans strips, the amount of the loans; and
    (7) For assets sold with recourse, the amount of assets for 
which risk of loss is directly or indirectly retained, less any 
applicable recourse liability account established in accordance with 
generally accepted accounting principles.
    (ii) Determining the credit risk weight of recourse obligations, 
direct credit substitutes, and asset- and mortgage-backed securities 
that are rated within one of the five highest rating categories. (1) 
A traded position is eligible for the risk-based capital treatment 
described in this paragraph if its external rating is within one of 
the five highest rating categories, e.g., AAA through BB, used by a 
nationally-recognized statistical rating organization. A recourse 
obligation, direct credit substitute, or asset- or mortgage-backed 
security which is not externally rated but is senior in all respects 
to a traded position that is externally rated, including access to 
any collateral, is also eligible for the risk-based capital 
treatment described in this paragraph III.B.3.b.(ii) as if it had 
the same rating as the traded position. This treatment for the 
unrated senior position is subject to current and prospective 
supervisory guidance on a case-by-case basis.
    (A) Two highest investment grades. Except as otherwise provided 
in section III. of this appendix A, the face amount of a recourse 
obligation, direct credit substitute, or an asset- or mortgage-
backed security that is rated in either of the two highest 
investment grade categories, e.g., AAA or AA, is assigned to the 20 
percent risk category.
    (B) Third highest investment grade. Except as otherwise provided 
in this section III. of this appendix A, the face amount of a 
recourse obligation, direct credit substitute, or an asset-or 
mortgage-backed security that is rated in the third highest 
investment grade category, e.g., A, is assigned to the 50 percent 
risk category.
    (C) Lowest investment grade. Except as otherwise provided in 
this section III. of this appendix A, the face amount of a recourse 
obligation, direct credit substitute, or an asset-or mortgage-backed 
security that is rated in the lowest investment grade category, 
e.g., BBB, is assigned to the 100 percent risk category.
    (D) One category below investment grade. Except as otherwise 
provided in this section III. of this appendix A, the face amount of 
a recourse obligation, direct credit substitute, or an asset-or 
mortgage-backed security that is rated in the next lower category 
below the lowest investment grade category, e.g., BB, is assigned a 
200 percent risk weight.
    (2) Nontraded recourse obligations, direct credit substitutes, 
or asset-or mortgage-backed securities that are retained, assumed or 
issued in connection with an asset securitization also are eligible 
for the treatment described in this paragraph III.B.3.b.(ii) if they 
are externally rated within one of the five highest rating 
categories by two nationally-recognized statistical rating 
organizations, the ratings are publicly available, and the ratings 
are based on the same criteria used to rate securities sold to the 
public.
    (3) A direct credit substitute extended in connection with an 
asset securitization that is not a traded position and is not 
externally rated by a nationally-recognized statistical rating 
organization (such as a letter of credit) may be eligible for the 
treatment described in section III.B.3.b.(ii)(1)(C) and (D) of this 
appendix A, i.e., a minimum risk weight of 100 percent, if it 
satisfies the criteria of one of the following approaches deemed 
appropriate for the institution by the Federal Reserve:
    (A) A bank, under its qualifying internal risk rating system, 
assigns an internal rating to a direct credit substitute extended to 
an asset-backed commercial paper program that is equivalent to an 
external credit rating one category below investment grade or higher 
provided by a nationally recognized statistical rating organization. 
A qualifying internal risk rating system must be reviewed and deemed 
appropriate by the Federal Reserve and must satisfy the following 
criteria and any other prudential standards that the Federal Reserve 
determines are necessary. Qualifying internal risk rating systems at 
a minimum must:

[[Page 12338]]

    (i) Be an integral part of an effective risk management system 
that explicitly incorporates the full range of risks arising from a 
bank's participation in securitization activities;
    (ii) Link the internal ratings to measurable outcomes, such as 
the probability that the position will experience any loss, the 
position's expected loss given default, and the degree of variance 
in losses given default on that position;
    (iii) Separately consider the risk associated with the 
underlying loans or borrowers, and the risk associated with the 
structure of a particular securitization transaction;
    (iv) Identify gradations of risk among ``pass'' assets and other 
risk positions;
    (v) Have clear, explicit criteria that are used to classify 
assets into each internal risk grade, including subjective factors;
    (vi) Have independent credit risk management or loan review 
personnel assigning or reviewing the credit risk ratings;
    (vii) Have an internal audit procedure that periodically 
verifies that the internal credit risk ratings are assigned in 
accordance with the established criteria;
    (viii) Monitor the performance of the internal ratings assigned 
to nonrated nontraded direct credit substitutes over time to 
determine the appropriateness of the initial rating assignment and 
adjust individual ratings accordingly; and
    (ix) Be consistent with, or more conservative than, the rating 
assumptions and methodologies of nationally recognized statistical 
rating organizations.
    (B) A bank's direct credit substitute extended to a 
securitization or structured finance program is reviewed by a 
nationally recognized statistical rating organization, in 
conjunction with a review of the overall program, and is assigned a 
rating or its equivalent. If the program has options for different 
combinations of assets, standards, internal credit enhancements, and 
other relevant factors, the rating organization may specify ranges 
of rating categories that may apply premised on which options are 
utilized by the bank's risk position. The bank must demonstrate to 
the Federal Reserve that the nationally recognized statistical 
rating organization's programmatic rating for its risk position 
generally meets the same standards used by the rating organization 
for rating traded positions, and that the rating organization's 
underlying premises are satisfied for particular direct credit 
substitutes issued by the bank. If a bank participates in a 
securitization or structured finance program sponsored by another 
party, the Federal Reserve may authorize the bank to use this 
approach based on a programmatic rating obtained by the sponsor of 
the program.
    (C) A bank may rate its credit risk exposure to direct credit 
substitutes by relying on a qualifying credit assessment computer 
program. A nationally recognized statistical rating agency or other 
acceptable third party must have developed such a credit assessment 
system for determining the credit risk of direct credit substitutes 
and other stratified credit positions. Banks must demonstrate to the 
Federal Reserve that ratings under such a credit assessment computer 
program correspond credibly and reliably with the ratings assigned 
by the rating agencies to publicly traded securities.
    (iii) Determining the credit risk weight for off-balance sheet 
securitized assets that are subject to early amortization 
provisions. If a bank securitizes revolving assets, such as credit 
cards, home equity lines, or commercial loans issued under lines of 
credit, in a securitization transaction that it has sponsored and 
which includes early amortization provisions, then the sponsoring 
bank must maintain risk-based capital against the off-balance sheet 
securitized assets from the inception of the transaction. An early 
amortization feature is a provision that, under specified 
conditions, returns principal to investors prior to the expected 
payment dates and generally is a result of a deteriorating 
portfolio. The securitized, off-balance sheet assets are to be 
converted to an on-balance sheet credit equivalent amount using the 
100 percent conversion factor and assigned to the 20 percent risk 
category. However, this capital requirement, when combined with the 
capital requirements for any retained recourse or direct credit 
substitute associated with the securitized assets, is limited to a 
total of 8 percent of the off-balance sheet securitized assets.
    c. Limitations on risk-based capital requirements. (i) Low-level 
exposure. If the maximum contractual liability or exposure to loss 
retained or assumed by a bank in connection with a recourse 
obligation or a direct credit substitute is less than the effective 
risk-based capital requirement for the enhanced assets, the risk-
based capital requirement is limited to the maximum contractual 
liability or exposure to loss, less any liability account 
established in accordance with generally accepted accounting 
principles. This limitation does not apply to assets sold with 
implicit recourse.
    (ii) Mortgage-related securities or participation certificates 
retained in a mortgage loan swap. If a bank holds a mortgage-related 
security or a participation certificate as a result of a mortgage 
loan swap with recourse, capital is required to support the recourse 
obligation plus the percentage of the mortgage-related security or 
participation certificate that is not covered by the recourse 
obligation. The total amount of capital required for the on-balance 
sheet asset and the recourse obligation, however, is limited to the 
capital requirement for the underlying loans, calculated as if the 
bank continued to hold these loans as an on-balance sheet asset.
    (iii) Related on-balance sheet assets. If a recourse obligation 
or direct credit substitute subject to section III.B.3. of this 
appendix A also appears as a balance sheet asset, the balance sheet 
asset is not included in a bank's risk-weighted assets to the extent 
the value of the balance sheet asset is already included in the off-
balance sheet credit equivalent amount for the recourse obligation 
or direct credit substitute, except in the case of loan servicing 
assets and similar arrangements with embedded recourse obligations 
or direct credit substitutes. In the latter cases, both the on-
balance sheet assets and the related recourse obligations and direct 
credit substitutes are incorporated into the risk-based capital 
calculation.
* * * * *
    C. * * *
    4. Category 4: 100 percent. a. All assets not included in the 
categories above are assigned to this category, which comprises 
standard risk assets. The bulk of the assets typically found in a 
loan portfolio would be assigned to the 100 percent category.
    b. This category includes long-term claims on, and the portions 
of long-term claims that are guaranteed by, non-OECD banks, and all 
claims on non-OECD central governments that entail some degree of 
transfer risk.\36\ This category includes all claims on foreign and 
domestic private-sector obligors not included in the categories 
above (including loans to nondepository financial institutions and 
bank holding companies); claims on commercial firms owned by the 
public sector; customer liabilities to the bank on acceptances 
outstanding involving standard risk claims; \37\ investments in 
fixed assets, premises, and other real estate owned; common and 
preferred stock of corporations, including stock acquired for debts 
previously contracted; all stripped mortgage-backed securities and 
similar instruments; and commercial and consumer loans (except those 
assigned to lower risk categories due to recognized guarantees or 
collateral and loans secured by residential property that qualify 
for a lower risk weight).
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    \36\ Such assets include all nonlocal currency claims on, and 
the portions of claims that are guaranteed by, non-OECD central 
governments and those portions of local currency claims on, or 
guaranteed by, non-OECD central governments that exceed the local 
currency liabilities held by subsidiary depository institutions.
    \37\ Customer liabilities on acceptances outstanding involving 
nonstandard risk claims, such as claims on U.S. depository 
institutions, are assigned to the risk category appropriate to the 
identity of the obligor or, if relevant, the nature of the 
collateral or guarantees backing the claims. Portions of acceptances 
conveyed as risk participations to U.S. depository institutions or 
foreign banks are assigned to the 20 percent risk category 
appropriate to short-term claims guaranteed by U.S. depository 
institutions and foreign banks.
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    c. Also included in this category are industrial-development 
bonds and similar obligations issued under the auspices of state or 
political subdivisions of the OECD-based group of countries for the 
benefit of a private party or enterprise where that party or 
enterprise, not the government entity, is obligated to pay the 
principal and interest, and all obligations of states or political 
subdivisions of countries that do not belong to the OECD-based 
group.
    d. The following assets also are assigned a risk weight of 100 
percent if they have not been deducted from capital: Investments in 
unconsolidated companies, joint ventures, or associated companies; 
instruments that qualify as capital issued by other banking 
organizations; and any intangibles, including those that may have 
been grandfathered into capital.
    D. * * *
    The face amount of an off-balance sheet item is generally 
incorporated into risk-weighted assets in two steps. The face amount 
is first multiplied by a credit

[[Page 12339]]

conversion factor, except for direct credit substitutes and recourse 
obligations as discussed in section III.D.1. of this appendix A. The 
resultant credit equivalent amount is assigned to the appropriate 
risk category according to the obligor or, if relevant, the 
guarantor or the nature of the collateral.\38\ Attachment IV to this 
appendix A sets forth the conversion factors for various types of 
off-balance sheet items.
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    \38\ The sufficiency of collateral and guarantees for off-
balance-sheet items is determined by the market value of the 
collateral or the amount of the guarantee in relation to the face 
amount of the item, except for derivative contracts, for which this 
determination is generally made in relation to the credit equivalent 
amount. Collateral and guarantees are subject to the same provisions 
noted under section III.B. of this appendix A.
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    1. Items with a 100 percent conversion factor. a. Except as 
otherwise provided in section III.B.3. of this appendix A, the full 
amount of an asset or transaction supported, in whole or in part, by 
a direct credit substitute or a recourse obligation. Direct credit 
substitutes and recourse obligations are defined in section III.B.3. 
of this appendix A.
    b. Sale and repurchase agreements and forward agreements. 
Forward agreements are legally binding contractual obligations to 
purchase assets with certain drawdown at a specified future date. 
Such obligations include forward purchases, forward forward deposits 
placed,\39\ and partly-paid shares and securities; they do not 
include commitments to make residential mortgage loans or forward 
foreign exchange contracts.
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    \39\ Forward forward deposits accepted are treated as interest 
rate contracts.
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    c. Securities lent by a bank are treated in one of two ways, 
depending upon whether the lender is at risk of loss. If a bank, as 
agent for a customer, lends the customer's securities and does not 
indemnify the customer against loss, then the transaction is 
excluded from the risk-based capital calculation. If, alternatively, 
a bank lends its own securities or, acting as agent for a customer, 
lends the customer's securities and indemnifies the customer against 
loss, the transaction is converted at 100 percent and assigned to 
the risk weight category appropriate to the obligor, or if 
applicable to any collateral delivered to the lending bank, or, the 
independent custodian acting on the lending bank's behalf. Where a 
bank is acting as agent for a customer in a transaction involving 
the lending or sale of securities that is collateralized by cash 
delivered to the bank, the transaction is deemed to be 
collateralized by cash on deposit in the bank for purposes of 
determining the appropriate risk-weight category, provided that any 
indemnification is limited to no more than the difference between 
the market value of the securities and the cash collateral received 
and any reinvestment risk associated with that cash collateral is 
borne by the customer.
    d. In the case of direct credit substitutes in which a risk 
participation \40\ has been conveyed, the full amount of the assets 
that are supported, in whole or in part, by the credit enhancement 
are converted to a credit equivalent amount at 100 percent. However, 
the pro rata share of the credit equivalent amount that has been 
conveyed through a risk participation is assigned to whichever risk 
category is lower: the risk category appropriate to the obligor, 
after considering any relevant guarantees or collateral, or the risk 
category appropriate to the institution acquiring the 
participation.\41\ Any remainder is assigned to the risk category 
appropriate to the obligor, guarantor, or collateral. For example, 
the pro rata share of the full amount of the assets supported, in 
whole or in part, by a direct credit substitute conveyed as a risk 
participation to a U.S. domestic depository institution or foreign 
bank is assigned to the 20 percent risk category.\42\
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    \40\ That is, a participation in which the originating bank 
remains liable to the beneficiary for the full amount of the direct 
credit substitute if the party that has acquired the participation 
fails to pay when the instrument is drawn.
    \41\ A risk participation in bankers acceptances conveyed to 
other institutions is also assigned to the risk category appropriate 
to the institution acquiring the participation or, if relevant, the 
guarantor or nature of the collateral.
    \42\ Risk participations with a remaining maturity of over one 
year that are conveyed to non-OECD banks are to be assigned to the 
100 percent risk category, unless a lower risk category is 
appropriate to the obligor, guarantor, or collateral.
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    e. In the case of direct credit substitutes in which a risk 
participation has been acquired, the acquiring bank's percentage 
share of the direct credit substitute is multiplied by the full 
amount of the assets that are supported, in whole or in part, by the 
credit enhancement and converted to a credit equivalent amount at 
100 percent. The credit equivalent amount of an acquisition of a 
risk participation in a direct credit substitute is assigned to the 
risk category appropriate to the account party obligor or, if 
relevant, the nature of the collateral or guarantees.
    f. In the case of direct credit substitutes that take the form 
of a syndication where each bank is obligated only for its pro rata 
share of the risk and there is no recourse to the originating bank, 
each bank will only include its pro rata share of the assets 
supported, in whole or in part, by the direct credit substitute in 
its risk-based capital calculation.\43\
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    \43\ For example, if a bank has a 10 percent share of a $10 
syndicated direct credit substitute that provides credit support to 
a $100 loan, then the bank's $1 pro rata share in the enhancement 
means that a $10 pro rata share of the loan is included in risk 
weighted assets.
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* * * * *

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, 1828(o), 1831i, 1831p-1, 
1843(c)(8), 1844(b), 1972(1), 3106, 3108, 3310, 3331-3351, 3907, and 
3909.

    2. In appendix A to part 225:
    A. The three introductory paragraphs to section II. are revised;
    B. A new fifth undesignated paragraph is added to section III.A.;
    C. In section III.B., paragraph 3 is revised and footnote 26 is 
removed, and in paragraph 4 footnote 27 is removed;
    D. In section III.C., paragraphs 1 through 3, footnotes 28 through 
40 are redesignated as footnotes 26 through 38, and paragraph 4 is 
revised;
    E. In section III.D., the introductory paragraph and paragraph 1 
are revised; and
    F. In section III.D. and III.E., footnote 50 is removed and 
footnotes 51 through 57 are redesignated as footnotes 47 through 53.

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

* * * * *
    II. * * *
    An institution's qualifying total capital consists of two types 
of capital components: ``core capital elements'' (comprising Tier 1 
capital) and ``supplementary capital elements'' (comprising Tier 2 
capital). These capital elements and the various limits, 
restrictions, and deductions to which they are subject, are 
discussed below and are set forth in Attachment II.
    The Federal Reserve will, on a case-by-case basis, determine 
whether, and if so how much of, any liability that does not fit 
wholly within the terms of one of the capital categories set forth 
below or that does not have an ability to absorb losses commensurate 
with the capital treatment otherwise specified below will be counted 
as an element of Tier 1 or Tier 2 capital. In making such a 
determination, the Federal Reserve will consider the similarity of 
the liability to liabilities explicitly treated in the guidelines, 
the ability of the liability to absorb losses while the institution 
operates as a going concern, the maturity and redemption features of 
the liability, and other relevant terms and factors. To qualify as 
an element of Tier 1 or Tier 2 capital, a capital instrument may not 
contain or be covered by any covenants, terms, or restrictions that 
are inconsistent with safe and sound banking practices.
    Redemptions of permanent equity or other capital instruments 
before stated maturity could have a significant impact on a 
organization's overall capital structure. Consequently, an 
organization considering such a step should consult with the Federal 
Reserve before redeeming any equity or debt capital instrument 
(prior to maturity) if such redemption could have a material effect 
on the level or composition of the organization's capital base.\5\
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    \5\ Consultation would not ordinarily be necessary if an 
instrument were redeemed with the proceeds of, or replaced by, a 
like amount of a similar or higher quality capital instrument and 
the organization's capital position is considered fully adequate by 
the Federal Reserve. In the case of limited-life Tier 2 instruments, 
consultation would generally be obviated if the new security is of 
equal or greater maturity than the one it replaces.
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* * * * *
    III. * * *
    A. * * *

[[Page 12340]]

    The Federal Reserve will, on a case-by-case basis, determine the 
appropriate risk weight for any asset or the credit equivalent 
amount of an off-balance sheet item that does not fit wholly within 
the terms of one of the risk weight categories set forth below or 
that imposes risks on a bank that are incommensurate with the risk 
weight otherwise specified below for the asset or off-balance sheet 
item. In addition, the Federal Reserve will, on a case-by-case 
basis, determine the appropriate credit conversion factor for any 
off-balance sheet item that does not fit wholly within the terms of 
one of the credit conversion factors set forth below or that imposes 
risks on an institution that are incommensurate with the credit 
conversion factors otherwise specified below for the off-balance 
sheet item. In making such a determination, the Federal Reserve will 
consider the similarity of the asset or off-balance sheet item to 
assets or off-balance sheet items explicitly treated in the 
guidelines, as well as other relevant factors.
    B. * * *
    3. Recourse obligations, direct credit substitutes, and asset-
and mortgage-backed securities. Direct credit substitutes, assets 
transferred with recourse, and securities issued in connection with 
asset securitizations and structured financings are treated as 
described below. Use of the term ``asset securitizations'' or 
``securitizations'' in this rule includes structured financings, as 
well as asset securitization transactions.
    a. Definitions. (i) Credit derivatives are on-or off-balance 
sheet notes or contracts that allow one party (the ``beneficiary'') 
to transfer the credit risk of a ``reference asset,'' which it often 
owns, to another party (the ``guarantor''). The value of a credit 
derivative is dependent, at least in part, on the credit performance 
of the reference asset, which typically is a publicly traded loan or 
corporate bond.
    (ii) Credit-enhancing representations and warranties means 
representations and warranties extended by a bank when it transfers 
assets (including loan servicing assets) or assumed by the bank when 
it purchases loan servicing assets that obligate the bank to absorb 
credit losses on transferred assets or serviced loans. These 
representations and warranties typically arise when the bank agrees 
to protect purchasers or some other party from losses due to the 
default or nonperformance of the obligor on the transferred assets 
or serviced loans, or insufficiency in the value of collateral 
supporting the transferred assets or serviced loans.
    (iii) Direct credit substitute means an arrangement in which a 
banking organization assumes, in form or in substance, any risk of 
credit loss directly or indirectly associated with a third-party 
asset or other financial claim, that exceeds the banking 
organization's pro rata share of the asset or claim. If the banking 
organization has no claim on the asset, then the assumption of any 
risk of loss is a direct credit substitute. Direct credit 
substitutes include, but are not limited to:
    (1) Financial guarantee-type standby letters of credit that 
support financial claims on the account party;
    (2) Guarantees, surety arrangements, credit derivatives, and 
irrevocable guarantee-type instruments backing financial claims such 
as outstanding securities, loans, or other financial liabilities, or 
that back off-balance sheet items against which risk-based capital 
must be maintained;
    (3) Purchased subordinated interests or securities that absorb 
more than their pro rata share of losses from the underlying assets;
    (4) Loans or lines of credit that provide credit enhancement for 
the financial obligations of an account party; and
    (5) Purchased loan servicing assets if the servicer is 
responsible for credit losses associated with the loans being 
serviced (other than mortgage servicer cash advances as defined in 
paragraph III.B.3.a.(vi) of this appendix A), or if the servicer 
makes or assumes credit-enhancing representations and warranties 
with respect to the serviced loans.
    (iv) Externally rated means, with respect to an instrument or 
obligation, that the instrument or obligation has received a credit 
rating from a nationally-recognized statistical rating organization.
    (v) Financial guarantee-type standby letter of credit means any 
letter of credit or similar arrangement, however named or described, 
that represents an irrevocable obligation to the beneficiary on the 
part of the issuer:
    (1) To repay money borrowed by, advanced to, or for the account 
of, the account party; or
    (2) To make payment on account of any indebtedness undertaken by 
the account party in the event that the account party fails to 
fulfill its obligation to the beneficiary.
    (vi) Mortgage servicer cash advance means funds that a 
residential mortgage loan servicer advances to ensure an 
uninterrupted flow of payments or the timely collection of 
residential mortgage loans, including disbursements made to cover 
foreclosure costs or other expenses arising from a mortgage loan to 
facilitate its timely collection. A mortgage servicer cash advance 
is not a recourse obligation or a direct credit substitute if the 
mortgage servicer is entitled to full reimbursement or, for any one 
residential mortgage loan, nonreimbursable advances are 
contractually limited to an insignificant amount of the outstanding 
principal on that loan.
    (vii) Nationally recognized statistical rating organization 
means an entity recognized by the Division of Market Regulation of 
the Securities and Exchange Commission as a nationally recognized 
statistical rating organization for various purposes, including the 
Commission's uniform net capital requirements for brokers and 
dealers (17 CFR 240.15c3-1(c)(2)(vi)(E), (F), and (H)).
    (viii) Recourse means an arrangement in which a banking 
organization retains, in form or in substance, any risk of credit 
loss directly or indirectly associated with a transferred asset that 
exceeds a pro rata share of the banking organization's claim on the 
asset. If a banking organization has no claim on a transferred 
asset, then the retention of any risk of loss is recourse. A 
recourse obligation typically arises when an institution transfers 
assets and retains an obligation to repurchase the assets or absorb 
losses due to a default of principal or interest or any other 
deficiency in the performance of the underlying obligor or some 
other party. Recourse may exist implicitly where a banking 
organization provides credit enhancement beyond any contractual 
obligation to support assets it has sold. Recourse obligations 
include, but are not limited to:
    (1) Credit-enhancing representations and warranties on the 
transferred assets that obligate the servicer to absorb credit 
losses, including early-default clauses;
    (2) Retained loan servicing assets if the servicer is 
responsible for losses associated with the loans being serviced 
other than mortgage servicer cash advances as defined in paragraph 
III.B.3.a.(v) of this appendix A.
    (3) Retained subordinated interests or securities or credit 
derivatives that absorb more than their pro rata share of losses 
from the underlying assets;
    (4) Assets sold under an agreement to repurchase if the assets 
are not already included on the balance sheet; and
    (5) Loan strips sold without direct recourse where the maturity 
of the transferred loan that is drawn is shorter than the maturity 
of the commitment.
    (ix) Securitization means the pooling and repackaging of loans 
or other credit exposures into securities that can be sold to 
investors. For purposes of this appendix A, securitization also 
includes structured finance transactions or programs that generally 
create stratified credit risk positions, whether in the form of a 
security or not, whose performance is dependent upon an underlying 
pool of credit exposures, including loans and commitments.
    (x) Traded position means a recourse obligation, direct credit 
substitute, or asset- or mortgage-backed security that is retained, 
assumed, or issued in connection with an asset securitization and 
that is rated with a reasonable expectation that, in the near 
future:
    (1) The position would be sold to investors relying on the 
rating; or
    (2) A third party would, in reliance on the rating, enter into a 
transaction such as a purchase, loan, or repurchase agreement 
involving the position.
    b. Amount of position to be included in risk-weighted assets. 
Types of recourse obligations or direct credit substitutes, other 
than those listed in section III.B.3.b.(i)(1) through (7) of this 
appendix A, should be treated in accordance with the principles 
contained in section III.B.3 of this appendix A. The treatment of 
direct credit substitutes that have been syndicated or in which risk 
participations have been conveyed or acquired is set forth in 
section III.D.1 of this appendix A.
    (i) General rule for determining the credit equivalent amount 
and risk weight of recourse obligations and direct credit 
substitutes. Except as otherwise provided in section III of this 
appendix A, the risk weighted asset amount or the credit equivalent 
amount for a recourse obligation or direct credit substitute is the 
full amount of the credit enhanced assets from which risk of credit 
loss is directly or indirectly retained or assumed. This credit 
equivalent amount is

[[Page 12341]]

assigned to the risk weight category appropriate to the obligor or, 
if relevant, the guarantor or nature of any collateral. Thus, a 
banking organization that extends a partial direct credit 
substitute, e.g., a financial standby letter of credit, that absorbs 
the first 10 percent of loss on a transaction, must maintain capital 
against the full amount of the assets being supported. Furthermore, 
for direct credit substitutes that are on-balance sheet assets, 
e.g., purchased subordinated securities, banking organizations must 
maintain capital against the amount of the direct credit substitutes 
and the full amount of the assets being supported, i.e., all more 
senior positions. This treatment is subject to the low-level capital 
rule discussed in section III.B.3.c.(i) of this appendix A. For 
purposes of this appendix A, the full amount of the credit enhanced 
assets from which risk of credit loss is directly or indirectly 
retained or assumed means for:
    (1) A financial guarantee-type standby letter of credit, surety 
arrangement, credit derivative, guarantee, or irrevocable guarantee-
type instruments, the full amount of the assets that the direct 
credit substitute fully or partially supports;
    (2) A subordinated interest or security, the amount of the 
subordinated interest or security plus all more senior interests or 
securities;
    (3) Mortgage servicing assets that are recourse obligations or 
direct credit substitutes, the outstanding amount of the loans 
serviced;
    (4) Credit-enhancing representations and warranties, the amount 
of the assets subject to the representations or warranties;
    (5) Loans or lines of credit that provide credit enhancement for 
the financial obligations of an account party, the full amount of 
the enhanced financial obligations;
    (6) Loans strips, the amount of the loans; and
    (7) For assets sold with recourse, the amount of assets for 
which risk of loss is directly or indirectly retained, less any 
applicable recourse liability account established in accordance with 
generally accepted accounting principles.
    (ii) Determining the credit risk weight of recourse obligations, 
direct credit substitutes, and asset- and mortgage-backed securities 
that are rated within one of the five highest rating categories. (1) 
A traded position is eligible for the risk-based capital treatment 
described in this paragraph if its external rating is within one of 
the five highest rating categories, e.g. AAA through BB, used by a 
nationally-recognized statistical rating organization. A recourse 
obligation, direct credit substitute, or asset- or mortgage-backed 
security which is not externally rated but is senior in all respects 
to a traded position that is externally rated, including access to 
any collateral, is also eligible for the risk-based capital 
treatment described in this paragraph III.B.3.b.(ii) as if it had 
the same rating as the traded position. This treatment for the 
unrated senior position is subject to current and prospective 
supervisory guidance on a case-by-case basis.
    (A) Two highest investment grades. Except as otherwise provided 
in this section III. of this appendix A, the face amount of a 
recourse obligation, direct credit substitute, or an asset- or 
mortgage-backed security that is rated in either of two highest 
investment grade categories, e.g., AAA or AA, is assigned to the 20 
percent risk category.
    (B) Third highest investment grade. Except as otherwise provided 
in this section III. of this appendix A, the face amount of a 
recourse obligation, direct credit substitute, or an asset- or 
mortgage-backed security that is rated in the third highest 
investment grade category, e.g., A, is assigned to the 50 percent 
risk category.
    (C) Lowest investment grade. Except as otherwise provided in 
this section III. of this appendix A, the face amount of a recourse 
obligation, direct credit substitute, or an asset- or mortgage-
backed security that is rated in the lowest investment grade 
category, e.g., BBB, is assigned to the 100 percent risk category.
    (D) One category below investment grade. Except as otherwise 
provided in this section III. of this appendix A, the face amount of 
a recourse obligation, direct credit substitute, or an asset- or 
mortgage-backed security that is rated in the next lower category 
below the lowest investment grade category, e.g., BB, is assigned to 
the 200 percent risk category.
    (2) Nontraded recourse obligations, direct credit substitutes, 
or asset- or mortgage-backed securities that are retained, assumed, 
or issued in connection with an asset securitization are also 
eligible for the treatment described in this paragraph 
III.B.3.b.(ii) if they are externally rated within one of the five 
highest rating categories by two nationally-recognized statistical 
rating organizations, the ratings are publicly available, and the 
ratings are based on the same criteria used to rate securities sold 
to the public.
    (3) A direct credit substitute extended in connection with an 
asset securitization that is not a traded position and is not 
externally rated by a nationally-recognized statistical rating 
organization (such as a letter of credit) may be eligible for the 
treatment described in paragraph III.B.3.b.ii(1)(C) and (D), i.e., a 
minimum risk weight of 100 percent, if it satisfies the criteria of 
one of the following approaches deemed appropriate for the 
organization by the Federal Reserve:
    (A) A banking organization, under its qualifying internal risk 
rating system, assigns an internal rating to a direct credit 
substitute extended to an asset-backed commercial paper program that 
is equivalent to an external credit rating one category below 
investment grade or higher provided by a nationally recognized 
statistical rating organization. A qualifying internal risk rating 
system must be reviewed and deemed appropriate by the Federal 
Reserve and must satisfy the following criteria and any other 
prudential standards that the Federal Reserve determines are 
necessary. Qualifying internal risk rating systems at a minimum 
must:
    (i) Be an integral part of an effective risk management system 
that explicitly incorporates the full range of risks arising from a 
banking organization's participation in securitization activities;
    (ii) Link the internal ratings to measurable outcomes, such as 
the probability that the position will experience any loss, the 
position's expected loss given default, and the degree of variance 
in losses given default on that position;
    (iii) Separately consider the risk associated with the 
underlying loans or borrowers, and the risk associated with the 
structure of a particular securitization transaction;
    (iv) Identify gradations of risk among ``pass'' assets and other 
risk positions;
    (v) Have clear, explicit criteria that are used to classify 
assets into each internal risk grade, including subjective factors;
    (vi) Have independent credit risk management or loan review 
personnel assigning or reviewing the credit risk ratings;
    (vii) Have an internal audit procedure that periodically 
verifies that the internal credit risk ratings are assigned in 
accordance with the established criteria;
    (viii) Monitor the performance of the internal ratings assigned 
to nonrated nontraded direct credit substitutes over time to 
determine the appropriateness of the initial rating assignment and 
adjust individual ratings accordingly; and,
    (ix) Be consistent with, or more conservative than, the rating 
assumptions and methodologies of nationally recognized statistical 
rating organizations.
    (B) A banking organization's direct credit substitute extended 
to a securitization or structured finance program is reviewed by a 
nationally recognized statistical rating organization, in 
conjunction with a review of the overall program, and is assigned a 
rating or its equivalent. If the program has options for different 
combinations of assets, standards, internal credit enhancements, and 
other relevant factors, the rating organization may specify ranges 
of rating categories that may apply premised on which options are 
utilized by the bank's risk position. The banking organization must 
demonstrate to the Federal Reserve that the nationally recognized 
statistical rating organization's programmatic rating for its risk 
position generally meets the same standards used by the rating 
organization for rating traded positions, and that the rating 
organization's underlying premises are satisfied for particular 
direct credit substitutes issued by the institution. If a banking 
organization participates in a securitization or structured finance 
program sponsored by another party, the Federal Reserve may 
authorize the institution to use this approach based on a 
programmatic rating obtained by the sponsor of the program.
    (C) An institution may rate its credit risk exposure to direct 
credit substitutes by relying on a qualifying credit assessment 
computer program. A nationally recognized statistical rating agency 
or other acceptable third party must have developed such a credit 
assessment system for determining the credit risk of direct credit 
substitutes and other stratified credit positions. Institutions must 
demonstrate to the Federal Reserve that ratings under such a credit 
assessment computer program correspond credibly and reliably with 
the ratings assigned by the rating agencies to publicly traded 
securities.
    (iii) Determining the credit risk weight for off-balance sheet 
securitized assets that are subject to early amortization 
provisions. If a

[[Page 12342]]

bank securitizes revolving assets, such as credit cards, home equity 
lines, or commercial loans issued under lines of credit, in a 
securitization transaction that it has sponsored and which includes 
early amortization provisions, then the sponsoring bank must 
maintain risk-based capital against the off-balance sheet 
securitized assets from the inception of the transaction. An early 
amortization feature is a provision that, under specified 
conditions, returns principal to investors prior to the expected 
payment dates and generally is a result of a deteriorating 
portfolio. The securitized, off-balance sheet assets are to be 
converted to an on-balance sheet credit equivalent amount using the 
100 percent conversion factor and assigned to the 20 percent risk 
category. However, this capital requirement, when conbined with the 
capital requirements for any retained recourse or direct credit 
substitute associated with the securitized assets, is limited to a 
toal of 8 percent of the off-balance sheet securitized assets.
    c. Limitations on risk-based capital requirements. (i) Low-level 
exposure. If the maximum contractual liability or exposure to loss 
retained or assumed by a banking organization in connection with a 
recourse obligation or a direct credit substitute is less than the 
effective risk-based capital requirement for the enhanced assets, 
the risk-based capital requirement is limited to the maximum 
contractual liability or exposure to loss, less any recourse 
liability account established in accordance with generally accepted 
accounting principles. This limitation does not apply to assets sold 
with implicit recourse.
    (ii) Mortgage-related securities or participation certificates 
retained in a mortgage loan swap. If a banking organization holds a 
mortgage-related security or a participation certificate as a result 
of a mortgage loan swap with recourse, capital is required to 
support the recourse obligation plus the percentage of the mortgage-
related security or participation certificate that is not covered by 
the recourse obligation. The total amount of capital required for 
the on-balance sheet asset and the recourse obligation, however, is 
limited to the capital requirement for the underlying loans, 
calculated as if the banking organization continued to hold these 
loans as an on-balance sheet asset.
    (iii) Related on-balance sheet assets. If a recourse obligation 
or direct credit substitute subject to section III.B.3. of this 
appendix A also appears as a balance sheet asset, the balance sheet 
asset is not included in a banking organization's risk-weighted 
assets to the extent the value of the balance sheet asset is already 
included in the off-balance sheet credit equivalent amount for the 
recourse obligation or direct credit substitute, except in the case 
of loan servicing assets and similar arrangements with embedded 
recourse obligations or direct credit substitutes. In the latter 
cases, both the on-balance sheet assets and the related recourse 
obligations and direct credit substitutes are incorporated into the 
risk-based capital calculation.
* * * * *
    C. * * *
    4. Category 4: 100 percent. a. All assets not included in the 
categories above are assigned to this category, which comprises 
standard risk assets. The bulk of the assets typically found in a 
loan portfolio would be assigned to the 100 percent category.
    b. This category includes long-term claims on, and the portions 
of long-term claims that are guaranteed by, non-OECD banks, and all 
claims on non-OECD central governments that entail some degree of 
transfer risk.\39\ This category includes all claims on foreign and 
domestic private-sector obligors not included in the categories 
above (including loans to nondepository financial institutions and 
bank holding companies); claims on commercial firms owned by the 
public sector; customer liabilities to the bank on acceptances 
outstanding involving standard risk claims; \40\ investments in 
fixed assets, premises, and other real estate owned; common and 
preferred stock of corporations, including stock acquired for debts 
previously contracted; all stripped mortgage-backed securities and 
similar instruments; and commercial and consumer loans (except those 
assigned to lower risk categories due to recognized guarantees or 
collateral and loans secured by residential property that qualify 
for a lower risk weight).
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    \39\ Such assets include all nonlocal currency claims on, and 
the portions of claims that are guaranteed by, non-OECD central 
governments and those portions of local currency claims on, or 
guaranteed by, non-OECD central governments that exceed the local 
currency liabilities held by subsidiary depository institutions.
    \40\ Customer liabilities on acceptances outstanding involving 
nonstandard risk claims, such as claims on U.S. depository 
institutions, are assigned to the risk category appropriate to the 
identity of the obligor or, if relevant, the nature of the 
collateral or guarantees backing the claims. Portions of acceptances 
conveyed as risk participations to U.S. depository institutions or 
foreign banks are assigned to the 20 percent risk category 
appropriate to short-term claims guaranteed by U.S. depository 
institutions and foreign banks.
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    c. Also included in this category are industrial-development 
bonds and similar obligations issued under the auspices of state or 
political subdivisions of the OECD-based group of countries for the 
benefit of a private party or enterprise where that party or 
enterprise, not the government entity, is obligated to pay the 
principal and interest, and all obligations of states or political 
subdivisions of countries that do not belong to the OECD-based 
group.
    d. The following assets also are assigned a risk weight of 100 
percent if they have not been deducted from capital: investments in 
unconsolidated companies, joint ventures, or associated companies; 
instruments that qualify as capital issued by other banking 
organizations; and any intangibles, including those that may have 
been grandfathered into capital.
    D. * * *
    The face amount of an off-balance sheet item is generally 
incorporated into risk-weighted assets in two steps. The face amount 
is first multiplied by a credit conversion factor, except for direct 
credit substitutes and recourse obligations as discussed in section 
III.D.1. of this appendix A. The resultant credit equivalent amount 
is assigned to the appropriate risk category according to the 
obligor or, if relevant, the guarantor or the nature of the 
collateral.\41\ Attachment IV to this appendix A sets forth the 
conversion factors for various types of off-balance sheet items.
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    \41\ The sufficiency of collateral and guarantees for off-
balance-sheet items is determined by the market value of the 
collateral of the amount of the guarantee in relation to the face 
amount of the item, except for derivative contracts, for which this 
determination is generally made in relation to the credit equivalent 
amount. Collateral and guarantees are subject to the same provisions 
noted under section III.B. of this appendix A.
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    1. Items with a 100 percent conversion factor. a. Except as 
otherwise provided in section III.B.3. of this appendix A, the full 
amount of an asset or transaction supported, in whole or in part, by 
a direct credit substitute or a recourse obligation. Direct credit 
substitutes and recourse obligations are defined in section III.B.3. 
of this appendix A. b. Sale and repurchase agreements and forward 
agreements. Forward agreements are legally binding contractual 
obligations to purchase assets with certain drawdown at a specified 
future date. Such obligations include forward purchases, forward 
forward deposits placed,\42\ and partly-paid shares and securities; 
they do not include commitments to make residential mortgage loans 
or forward foreign exchange contracts.
---------------------------------------------------------------------------

    \42\ Forward forward deposits accepted are treated as interest 
rate contracts.
---------------------------------------------------------------------------

    c. Securities lent by a banking organization are treated in one 
of two ways, depending upon whether the lender is at risk of loss. 
If a banking organization, as agent for a customer, lends the 
customer's securities and does not indemnify the customer against 
loss, then the transaction is excluded from the risk-based capital 
calculation. If, alternatively, a banking organization lends its own 
securities or, acting as agent for a customer, lends the customer's 
securities and indemnifies the customer against loss, the 
transaction is converted at 100 percent and assigned to the risk 
weight category appropriate to the obligor, or if applicable to any 
collateral delivered to the lending bank, or, the independent 
custodian acting on the lending banking organization's behalf. Where 
a banking organization is acting as agent for a customer in a 
transaction involving the lending or sale of securities that is 
collateralized by cash delivered to the banking organization, the 
transaction is deemed to be collateralized by cash on deposit in the 
banking organization for purposes of determining the appropriate 
risk-weight category, provided that any indemnification is limited 
to no more than the difference between the market value of the 
securities and the cash collateral received and any reinvestment 
risk associated with that cash collateral is borne by the customer.
    d. In the case of direct credit substitutes in which a risk 
participation \43\ has been conveyed, the full amount of the assets 
that

[[Page 12343]]

are supported, in whole or in part, by the credit enhancement are 
converted to a credit equivalent amount at 100 percent. However, the 
pro rata share of the credit equivalent amount that has been 
conveyed through a risk participation is assigned to whichever risk 
category is lower: the risk category appropriate to the obligor, 
after considering any relevant guarantees or collateral, or the risk 
category appropriate to the institution acquiring the 
participation.\44\ Any remainder is assigned to the risk category 
appropriate to the obligor, guarantor, or collateral. For example, 
the pro rata share of the full amount of the assets supported, in 
whole or in part, by a direct credit substitute conveyed as a risk 
participation to a U.S. domestic depository institution or foreign 
bank is assigned to the 20 percent risk category.\45\
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    \43\ That is, a participation in which the originating banking 
organization remains liable to the beneficiary for the full amount 
of the direct credit substitute if the party that has acquired the 
participation fails to pay when the instrument is drawn.
    \44\ A risk participation in bankers acceptances conveyed to 
other institutions is also assigned to the risk category appropriate 
to the institution acquiring the participation or, if relevant, the 
guarantor or nature of the collateral.
    \45\ Risk participations with a remaining maturity of over one 
year that are conveyed to non-OECD banks are to be assigned to the 
100 percent risk category, unless a lower risk category is 
appropriate to the obligor, guarantor, or collateral.
---------------------------------------------------------------------------

    e. In the case of direct credit substitutes in which a risk 
participation has been acquired, the acquiring banking 
organization's percentage share of the direct credit substitute is 
multiplied by the full amount of the assets that are supported, in 
whole or in part, by the credit enhancement and converted to a 
credit equivalent amount at 100 percent. The credit equivalent 
amount of an acquisition of a risk participation in a direct credit 
substitute is assigned to the risk category appropriate to the 
account party obligor or, if relevant, the nature of the collateral 
or guarantees.
    f. In the case of direct credit substitutes that take the form 
of a syndication where each banking organization is obligated only 
for its pro rata share of the risk and there is no recourse to the 
originating banking organization, each banking organization will 
only include its pro rata share of the assets supported, in whole or 
in part, by the direct credit substitute in its risk-based capital 
calculation.\46\
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    \46\ For example, if a banking organization has a 10 percent 
share of a $10 syndicated direct credit substitute that provides 
credit support to a $100 loan, then the banking organization's $1 
pro rata share in the enhancement means that a $10 pro rata share of 
the loan is included in risk weighted assets.
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* * * * *

    By order of the Board of Governors of the Federal Reserve 
System, February 10, 2000.
Jennifer J. Johnson,
Secretary of the Board.

Federal Deposit Insurance Corporation

12 CFR Chapter III

Authority and Issuance

    For the reasons set forth in the joint preamble, part 325 of 
chapter III of title 12 of the Code of Federal Regulations is proposed 
to be amended as follows:

PART 325--CAPITAL MAINTENANCE

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

    Authority:  12 U.S.C. 1815(a), 1815(b), 1816, 1818(a), 1818(b), 
1818(c), 1818(t), 1819(Tenth), 1828(c), 1828(d), 1828(i), 1828(n), 
1828(o), 1831o, 1835, 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, as amended by Pub. L. 103-325, 108 Stat. 2160, 2233 (12 
U.S.C. 1828 note); Pub. L. 102-242, 105 Stat. 2236, 2386, as amended 
by Pub. L. 102-550, 106 Stat. 3672, 4089 (12 U.S.C. 1828 note).

    2. In appendix A to part 325, section II:
    A. In paragraph A., the first two undesignated paragraphs are 
designated 1. and 2. respectively;
    B. A new paragraph A.3. is added;
    C. Paragraph B. is amended by revising paragraph B.5.;
    D. In paragraph C., Category 1--Zero Percent Risk Weight through 
Category 3--50 Percent Risk Weight, footnotes 15 through 31 are 
redesignated as footnotes 19 through 34;
    E. In paragraph C., Category 2--20 Percent Risk Weight, the three 
undesignated paragraphs are designated as paragraphs a. through c., 
respectively, and a new paragraph d. is added;
    F. In paragraph C., Category 3--50 Percent Risk Weight, the third 
undesignated paragraph is removed and the remaining three undesignated 
paragraphs are designated as paragraphs a. through c., respectively;
    G. In paragraph C., Category 3--50 Percent Risk Weight, newly 
designated footnote 32 is revised;
    H. In paragraph C., Category 4--100 Percent Risk Weight is revised;
    I. In paragraph C., following the paragraph titled Category 4--100 
Percent Risk Weight, a new paragraph titled Category 5--200 Percent 
Risk Weight is added;
    J. In paragraph D., the undesignated introductory paragraph is 
revised;
    K. Paragraph D.1. is revised;
    L. In paragraph D.2., footnote 38 is removed; and
    M. In paragraphs D.2. and E., footnotes 39 through 42 are 
redisignated as footnotes 38 through 41.

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

* * * * *

II. * * *

    A. * * *
    3. The Director of the Division of Supervision may, on a case-
by-case basis, determine the appropriate risk weight for any asset 
or credit equivalent amount that does not fit wholly within one of 
the risk categories set forth below or that imposes risks on a bank 
that are not commensurate with the risk weight otherwise specified 
below for the asset or credit equivalent amount. In addition, the 
Director of the Division of Supervision may, on a case-by-case 
basis, determine the appropriate credit conversion factor for any 
off-balance sheet item that does not fit wholly within one of the 
credit conversion factors set forth below or that imposes risks on a 
bank that are not commensurate with the credit conversion factor 
otherwise specified below for the off-balance sheet item. In making 
such a determination, the Director of the Division of Supervision 
will consider the similarity of the asset or off-balance sheet item 
to assets or off-balance sheet items explicitly treated in the 
guidelines, as well as other relevant factors.
    B. * * *
    5. Recourse obligations, direct credit substitutes, and asset-
and mortgage-backed securities. Direct credit substitutes, assets 
sold with recourse, and securities issued in connection with asset 
securitizations are treated as described below.
    (a) Definitions. (i) Credit derivative means an on-or off-
balance sheet note or contract that allows one party (the 
``beneficiary'') to transfer the credit risk of a ``reference 
asset,'' which the beneficiary often owns, to another party (the 
``guarantor''). The value of a credit derivative is dependent, at 
least in part, on the credit performance of the reference asset, 
which typically is a publicly traded loan or corporate bond.
    (ii) Credit-enhancing representations and warranties means 
representations and warranties, extended by a bank when it transfers 
assets (including loan servicing assets) or assumed by the bank when 
it purchases loan servicing assets, that obligate the bank to 
protect another party from losses due to credit risk in the 
transferred assets or serviced loans. These representations and 
warranties typically arise when the bank agrees to protect 
purchasers or some other party from losses due to:
    (1) The default or nonperformance of the obligor on the 
transferred assets or serviced loans; or
    (2) Insufficiency in the value of collateral supporting the 
transferred assets or serviced loans.
    (iii) Direct credit substitute means an arrangement in which a 
bank assumes, in form or in substance, any risk of credit loss 
directly or indirectly associated with a third-party asset or other 
financial claim, that exceeds the bank's pro rata share of the asset 
or claim. If the bank has no claim on the asset, then the assumption 
of any risk of loss is a direct credit substitute. Direct credit 
substitutes include, but are not limited to:
    (1) Financial standby letters of credit, which includes any 
letter of credit or similar arrangement, however named or described, 
that represents an irrevocable obligation to the beneficiary on the 
part of the issuer:
    (a) To repay money borrowed by, advanced to, or for the account 
of, the account party, or
    (b) To make payment on account of any indebtedness undertaken by 
the account party in the event that the account party fails to 
fulfill its obligation to the beneficiary.
    (2) Guarantees, surety arrangements, credit derivatives, and 
irrevocable guarantee-type

[[Page 12344]]

instruments backing financial claims such as outstanding securities, 
loans, or other financial claims, or that back off-balance-sheet 
items against which risk-based capital must be maintained;
    (3) Purchased subordinated interests or securities that absorb 
more than their pro rata share of credit losses from the underlying 
assets;
    (4) Loans or lines of credit that provide credit enhancement for 
the financial obligations of an account party; and
    (5) Purchased loan servicing assets if the servicer is 
responsible for credit losses associated with the loans being 
serviced (other than mortgage servicer cash advances as defined in 
paragraph B.5(a)(vi) of this section), or if the servicer makes or 
assumes credit-enhancing representations and warranties on the 
serviced loans.
    (iv) Externally rated means, with respect to an instrument or 
obligation, that the instrument or obligation has received a credit 
rating from a nationally-recognized statistical rating organization.
    (v) Face amount means the notional principal, or face value, 
amount of an off-balance sheet item; the amortized cost of an asset 
not held for trading purposes; and the fair value of a trading 
asset.
    (vi) Mortgage servicer cash advance means funds that a 
residential mortgage loan servicer advances to ensure an 
uninterrupted flow of payments or the timely collection of 
residential mortgage loans, including disbursements made to cover 
foreclosure costs or other expenses arising from a mortgage loan to 
facilitate its timely collection, so long as the mortgage servicer 
is entitled to full reimbursement or nonreimbursable advances are 
contractually limited to an insignificant amount of the outstanding 
principal for any one residential mortgage loan, and the servicer's 
entitlement to reimbursement is not subordinated.
    (vii) Nationally recognized statistical rating organization 
means an entity recognized by the Division of Market Regulation of 
the Securities and Exchange Commission as a nationally recognized 
statistical rating organization for various purposes, including the 
Commission's uniform net capital requirements for brokers and 
dealers (17 CFR 240.15c3-1(c)(2)(vi)(E), (F), and (H)).
    (viii) Recourse means an arrangement in which a bank retains, in 
form or in substance, any risk of credit loss directly or indirectly 
associated with an asset it has transferred and sold that exceeds a 
pro rata share of the bank's claim on the asset. If a bank has no 
claim on an asset it has transferred and sold, then the retention of 
any risk of credit loss is recourse. A recourse obligation typically 
arises when an institution transfers assets in a sale and retains an 
obligation to repurchase the assets or absorb losses due to a 
default of principal or interest or any other deficiency in the 
performance of the underlying obligor or some other party. Recourse 
may exist implicitly where a bank provides credit enhancement beyond 
any contractual obligation to support assets it has sold. Recourse 
obligations include, but are not limited to:
    (1) Credit-enhancing representations and warranties on the 
transferred assets;
    (2) Retained loan servicing assets if the servicer is 
responsible for credit losses associated with the loans being 
serviced (including credit-enhancing representations and 
warranties), other than mortgage servicer cash advances as defined 
in paragraph B.5(a)(vi) of this section;
    (3) Retained subordinated interests or securities, or credit 
derivatives that absorb more than their pro rata share of credit 
losses from the underlying assets;
    (4) Assets sold under an agreement to repurchase, if the assets 
are not already included on the balance sheet; and
    (5) Loan strips sold without direct recourse where the maturity 
of the transferred loan that is drawn is shorter than the maturity 
of the commitment.
    (ix) Securitization means the pooling and repackaging of loans 
or other credit exposures into securities that can be sold to 
investors. For purposes of this section II.B.5, securitization also 
includes transactions or programs that generally create stratified 
credit risk positions, whether in the form of a security or not, 
whose performance is dependent upon an underlying pool of loans or 
other credit exposures.
    (x) Traded position means a recourse obligation, direct credit 
substitute, or asset-or mortgage-backed security that is retained, 
assumed, or issued in connection with an asset securitization and 
that is externally rated with a reasonable expectation that, in the 
near future:
    (1) The position would be sold to investors relying on the 
external rating; or
    (2) A third party would, in reliance on the external rating, 
enter into a transaction such as a purchase, loan, or repurchase 
agreement involving the position.
    (b) Amount of position to be included in risk-weighted assets--
(i) General rule for determining the credit equivalent amount and 
risk weight of recourse obligations and direct credit substitutes. 
Except as otherwise provided in this section II.B. of this appendix 
A, the credit equivalent amount for a recourse obligation or direct 
credit substitute is the full amount of the credit enhanced assets 
from which risk of credit loss is directly or indirectly retained or 
assumed by the bank. This credit equivalent amount is assigned to 
the risk category appropriate to the obligor, or if relevant, the 
guarantor or nature of any collateral. Thus, a bank that extends a 
partial direct credit substitute, e.g., a financial standby letter 
of credit that absorbs the first 10 percent of loss on a 
transaction, must maintain capital against the full amount of the 
assets being supported. Furthermore, for a direct credit substitute 
that is an on-balance sheet asset, e.g., a purchased subordinated 
security, a bank must maintain capital against the amount of the 
direct credit substitute and the full amount of the assets being 
supported, i.e., all more senior positions. This treatment is 
subject to the low-level exposure rule discussed in section 
II.B.5(c)(i) of this appendix A. For purposes of this appendix A, 
the full amount of the credit enhanced assets from which risk of 
credit loss is directly or indirectly retained or assumed means for:
    (1) A financial standby letter of credit, surety arrangement, 
credit derivative, guarantee, or irrevocable guarantee-type 
instrument, the full amount of the assets that the direct credit 
substitute fully or partially supports;
    (2) A subordinated interest or security, the amount of the 
subordinated interest or security plus all more senior interests or 
securities;
    (3) Loan servicing assets that are recourse obligations or 
direct credit substitutes, the outstanding amount of the loans 
serviced;
    (4) Credit-enhancing representations and warranties, the amount 
of the assets subject to the representations or warranties;
    (5) Loans or lines of credit that provide credit enhancement for 
the financial obligations of an account party, the full amount of 
the enhanced financial obligations;
    (6) Loans strips, the amount of the loans sold; and
    (7) Assets sold with recourse, the full amount of the assets 
from which risk of credit loss is directly or indirectly retained, 
less any applicable recourse liability account established in 
accordance with generally accepted accounting principles.
    (ii) Participations in and syndications of direct credit 
substitutes. Subject to the low-level exposure rule discussed in 
section II.B.5(c)(i) of this appendix A:
    (1) In the case of a direct credit substitute in which the bank 
has conveyed a risk participation,\14\ the full amount of the assets 
that are supported, in whole or in part, by the direct credit 
substitute are converted to a credit equivalent amount at 100 
percent. However, the pro rata share of the credit equivalent amount 
that has been conveyed through a risk participation is assigned to 
whichever risk category is lower: The risk category appropriate to 
the obligor, after considering any relevant guarantees or 
collateral, or the risk category appropriate to the institution 
acquiring the participation.\15\ Any remainder is assigned to the 
risk category appropriate to the obligor, guarantor, or collateral. 
For example, the pro rata share of the full amount of the assets 
supported, in whole or in part, by a direct credit substitute 
conveyed as a risk participation to a U.S. domestic depository 
institution or an OECD bank is assigned to the 20 percent risk 
category.\16\
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    \14\ That is, a participation in which the originating bank 
remains liable to the beneficiary for the full amount of the direct 
credit substitute if the party that has acquired the participation 
fails to pay when the instrument is drawn.
    \15\ A risk participation in a bankers acceptance conveyed to 
another institution is also assigned to the risk category 
appropriate to the institution acquiring the participation or, if 
relevant, the guarantor or nature of the collateral.
    \16\ A risk participation with a remaining maturity of one year 
or less that is conveyed to a non-OECD bank is also assigned to the 
20 percent risk category.
---------------------------------------------------------------------------

    (2) In the case of a direct credit substitute in which the bank 
has acquired a risk participation, the acquiring bank's percentage 
share of the direct credit substitute is multiplied by the full 
amount of the assets that are supported, in whole or in part, by the 
direct credit substitute and converted to a credit equivalent amount 
at 100 percent. The resulting credit equivalent amount is

[[Page 12345]]

assigned to the risk category appropriate to the account party 
obligor, guarantor, or collateral.
    (3) In the case of a direct credit substitute that takes the 
form of a syndication where each bank is obligated only for its pro 
rata share of the risk and there is no recourse to the originating 
bank, each bank's credit equivalent amount will be only its pro rata 
share of the assets supported, in whole or in part, by the direct 
credit substitute. The resulting credit equivalent amount is 
assigned to the risk category appropriate to the obligor, guarantor, 
or collateral. \17\
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    \17\ For example, if a bank has a 10 percent share of a $10 
syndicated direct credit substitute that provides credit support to 
a $100 loan to a private obligor, then the bank's $1 pro rata share 
in the enhancement means that a $10 pro rata share of the loan is 
included in the bank's risk weighted assets.
---------------------------------------------------------------------------

    (iii) Face-amount treatment for externally rated recourse 
obligations, direct credit substitutes, and asset-and mortgage-
backed securities. (1) A traded position is eligible for the risk-
based capital treatment described in this paragraph II.B.5(b)(iii) 
if its external rating is within one of the five highest rating 
categories, e.g., AAA through BB, used by a nationally-recognized 
statistical rating organization.
    (a) Two highest investment grades. The face amount of a recourse 
obligation, direct credit substitute, or an asset-or mortgage-backed 
security that is rated in either of the two highest investment grade 
categories, e.g., AAA or AA, is assigned to the 20 percent risk 
category.
    (b) Third highest investment grade. The face amount of a 
recourse obligation, direct credit substitute, or an asset-or 
mortgage-backed security that is rated in the third highest 
investment grade category, e.g., A, is assigned to the 50 percent 
risk category.
    (c) Lowest investment grade. The face amount of a recourse 
obligation, direct credit substitute, or an asset-or mortgage-backed 
security that is rated in the lowest investment grade category, 
e.g., BBB, is assigned to the 100 percent risk category.
    (d) One category below investment grade. The face amount of a 
recourse obligation, direct credit substitute, or an asset- or 
mortgage-backed security that is rated in the next lower category 
below the lowest investment grade category, e.g., BB, is assigned to 
the 200 percent risk category.
    (2) Other recourse obligations and direct credit substitutes 
that are retained, assumed, or issued in connection with an asset 
securitization are also eligible for the risk-based capital 
treatment described in this paragraph II.B.5(b)(iii) if they are 
externally rated by two nationally-rated statistical rating 
organizations as falling within one of the five highest rating 
categories used by the organizations, the ratings are publicly 
available, and the ratings are based on the same criteria used to 
rate traded positions.\18\ If the two ratings differ, the lower 
rating will determine the risk category to which the recourse 
obligation or direct credit substitute will be assigned.
---------------------------------------------------------------------------

    \18\ The bank must demonstrate to the FDIC's satisfaction that 
the ratings are based on the same criteria that the ratings 
organizations use to rate traded positions.
---------------------------------------------------------------------------

    (3) Stripped mortgage-backed securities (such as interest-only 
or principal-only strips) may not be assigned to the 20 percent or 
50 percent risk category under section II.B.5(b)(iii)(1)(a)-(b) of 
this appendix A.
    (4) A position which is not externally rated but is senior in 
all respects to a traded position eligible for the risk-based 
capital treatment described in section II.B.5(b)(iii)(1) of this 
appendix A, including access to any collateral, will be eligible for 
the risk-based capital treatment described in this paragraph 
II.B.5(b)(iii) as if it had the same rating as the traded position, 
if the bank can demonstrate to the FDIC's satisfaction that such 
treatment is appropriate.
    (iv) Face-amount treatment for direct credit substitutes which 
are not externally rated. A direct credit substitute assumed or 
issued in connection with an asset securitization which does not 
qualify for face amount treatment under section II.B.5(b)(iii) of 
this appendix A because it is not externally rated may still qualify 
for face amount treatment, if the bank determines that the credit 
risk of the direct credit substitute is equivalent to or better than 
the external rating category set out at section II.B.5(b)(iii)(1)(d) 
of this appendix A (e.g., BB). The face amount of a position which 
the bank determines is equivalent to or better than the external 
rating category set out at section II.B.5(b)(iii)(1)(c) of this 
appendix A (e.g., BBB) must be assigned to the 100 percent risk 
category, and a position equivalent to the external rating category 
set out in section II.B.5(b)(iii)(1)(d) of this appendix A (e.g., 
BB) must be assigned to the 200 percent risk category. The bank's 
determination may only be made pursuant to the following three 
approaches, the use of which must be satisfactory to the FDIC:
    (1) Internal risk ratings for asset-backed commercial paper 
programs. A bank, under its internal risk rating system, assigns an 
internal rating to a direct credit substitute the bank extends to 
the asset-backed commercial paper program it sponsors, and the 
rating is equivalent to or better than the rating category set out 
at section B.5(b)(iii)(1)(d) of this appendix A (e.g., BB). The 
internal risk rating system must be satisfactory to the FDIC and 
must be prudent and appropriate for the size and complexity of the 
bank's program. Adequate internal risk rating systems typically:
    (a) are an integral part of an effective risk management system 
that explicitly incorporates the full range of risks arising from a 
bank's participation in securitization activities;
    (b) link the internal ratings to measurable outcomes, such as 
the probability that the position will experience any loss, the 
position's expected loss given default, and the degree of variance 
in losses given default on that position;
    (c) separately consider the risk associated with the underlying 
loans or borrowers and the risk associated with the structure of a 
particular securitization transaction;
    (d) identify gradations of risk among ``pass'' assets and other 
risk positions;
    (e) have clear, explicit criteria that are used to classify 
assets into each internal risk grade, including criteria for 
subjective factors;
    (f) have independent credit risk management or loan review 
personnel with adequate training assigning or reviewing the credit 
risk ratings, subject to internal audit review to verify that 
ratings are assigned in accordance with the bank's criteria;
    (g) track the performance of the internal ratings over time and 
make adjustments to the ratings system when the performance of rated 
positions has a tendency to diverge from assigned ratings, and 
adjust individual ratings accordingly; and,
    (h) are consistent with, or more conservative than, the rating 
assumptions and methodologies of nationally recognized statistical 
rating organizations.
    (2) Program ratings. If a nationally recognized statistical 
rating organization or other entity satisfactory to the FDIC has 
reviewed the terms of a securitization program and stated a rating 
for direct credit substitutes to be issued under the program 
equivalent to or better than the external rating category set out at 
section II.B.5(b)(iii)(1)(d) of this appendix A (e.g., BB), a bank 
may use such a rating for a direct credit substitute the bank issues 
under the program. If the program has options for different 
combinations of assets, standards, internal credit enhancements, and 
other relevant factors, the rating organization or other entity may 
specify ranges of rating categories that will apply premised on 
which options correspond to the bank's position. The bank must 
demonstrate to the FDIC's satisfaction that the program rating meets 
the same standards generally used by nationally recognized 
statistical rating organizations for rating traded positions, and 
that the rating organization's or other entity's underlying premises 
are satisfied for the particular direct credit substitute issued by 
the bank.
    (3) Credit assessment computer program. A bank may use an 
acceptable credit assessment computer program to determine that a 
direct credit substitute is equivalent to or better than the 
external rating category set out at section II.B.5(b)(iii)(1)(d) of 
this appendix A (e.g., BB). A nationally recognized statistical 
rating organization or other party satisfactory to the FDIC must 
have developed the credit assessment system for determining the 
credit risk of direct credit substitutes and other stratified credit 
positions. The bank must demonstrate to the FDIC's satisfaction that 
ratings under such a credit assessment computer program correspond 
credibly and reliably with the rating of traded positions.
    (v) Determining the credit risk weight for off-balance sheet 
securitized assets that are subject to early amortization 
provisions. If a bank securitizes revolving assets, such as credit 
cards, home equity lines, or commercial lines of credit, in a 
transaction that it has sponsored and which includes early 
amortization provisions, then the bank must maintain risk-based 
capital against the off-balance sheet securitized assets from the 
inception of the transaction. An early amortization feature is a 
provision that, under specified conditions, returns principal to 
investors prior to the expected payment

[[Page 12346]]

dates, generally as a result of a deterioration in the portfolio of 
securitized revolving assets. The securitized, off-balance sheet 
assets are to be converted to an on-balance sheet credit equivalent 
amount using the 100 percent conversion factor and the resulting 
amount is to be assigned to the 20 percent risk category. However, 
this capital requirement, when combined with the capital 
requirements for any retained recourse or direct credit substitute 
associated with the securitized assets, is limited to a total of 8 
percent of the managed assets.
    (c) Limitations on risk-based capital requirements--(i) Low-
level exposure. If the maximum contractual liability or exposure to 
loss retained or assumed by a bank in connection with a recourse 
obligation or a direct credit substitute is less than the effective 
risk-based capital requirement for the enhanced assets, the risk-
based capital requirement is limited to the maximum contractual 
liability or exposure to loss, less any recourse liability account 
established in accordance with generally accepted accounting 
principles. This limitation does not apply to assets sold with 
implicit recourse.
    (ii) Mortgage-related securities or participation certificates 
retained in a mortgage loan swap. If a bank holds a mortgage-related 
security or a participation certificate as a result of a mortgage 
loan swap with recourse, capital is required to support the recourse 
obligation plus the percentage of the mortgage-related security or 
participation certificate that is not covered by the recourse 
obligation. The total amount of capital required for the on-balance 
sheet asset and the recourse obligation, however, is limited to the 
capital requirement for the underlying loans, calculated as if the 
bank continued to hold these loans as an on-balance sheet asset.
    (iii) Related on-balance sheet assets. If a recourse obligation 
or direct credit substitute subject to paragraph B.5. of this 
section also appears as a balance sheet asset, the balance sheet 
asset is not included in a bank's risk-weighted assets to the extent 
the value of the balance-sheet asset is already included in the 
credit equivalent amount for the recourse obligation or direct 
credit substitute, except in the case of loan servicing assets and 
similar arrangements with embedded recourse obligations or direct 
credit substitutes. In such a case, both the on-balance sheet 
servicing assets and the related recourse obligations or direct 
credit substitutes are incorporated into the risk-based capital 
calculation.
* * * * *
    C. * * *
    Category 2--20 Percent Risk Weight.
* * * * *
    d. This category also includes the credit equivalent amount of 
off-balance sheet securitized revolving assets in transactions which 
include early amortization provisions that were sponsored by the 
bank.
    Category 3--50 Percent Risk Weight.
* * * * *
    b. * * * \32\ * * *
---------------------------------------------------------------------------

    \32\ The types of loans that qualify as loans secured by 
multifamily residential properties are listed in the instructions 
for preparation of the Consolidated Reports of Condition and Income. 
In addition, from the standpoint of the selling bank, when a 
multifamily residential property loan is sold subject to a pro rata 
loss sharing arrangement which provides for the purchaser of the 
loan to share in any loss incurred on the loan on a pro rata basis 
with the selling bank, that portion of the loan is not subject to 
the risk-based capital standards. In connection with sales of 
multifamily residential property loans in which the purchaser of the 
loan shares in any loss incurred on the loan with the selling 
institution on other than a pro rata basis, the selling bank must 
treat these other loss sharing arrangements in accordance with 
section II.B.5. of this appendix A.
---------------------------------------------------------------------------

* * * * *
    Category 4--100 Percent Risk Weight. (a) All assets not included 
in the categories above, except the assets specifically included in 
the 200 percent category below, are assigned to this category, which 
comprises standard risk assets. The bulk of the assets typically 
found in a loan portfolio would be assigned to the 100 percent 
category.
    (b) This category includes:
    (1) Long-term claims on, and the portions of long-term claims 
that are guaranteed by, non-OECD banks, and all claims on non-OECD 
central governments that entail some degree of transfer risk; \35\
---------------------------------------------------------------------------

    \35\ Such assets include all nonlocal currency claims on, and 
the portions of claims that are guaranteed by, non-OECD central 
governments and those portions of local currency claims on, or 
guaranteed by, non-OECD central governments that exceed the local 
currency liabilities held by the bank.
---------------------------------------------------------------------------

    (2) All claims on foreign and domestic private-sector obligors 
not included in the categories above (including loans to 
nondepository financial institutions and bank holding companies);
    (3) Claims on commercial firms owned by the public sector;
    (4) Customer liabilities to the bank on acceptances outstanding 
involving standard risk claims; \36\
---------------------------------------------------------------------------

    \36\ Customer liabilities on acceptances outstanding involving 
nonstandard risk claims, such as claims on U.S. depository 
institutions, are assigned to the risk category appropriate to the 
identity of the obligor or, if relevant, the nature of the 
collateral or guarantees backing the claims. Portions of acceptances 
conveyed as risk participations to U.S. depository institutions or 
foreign banks are assigned to the 20 percent risk category 
appropriate to short-term claims guaranteed by U.S. depository 
institutions and foreign banks.
---------------------------------------------------------------------------

    (5) Investments in fixed assets, premises, and other real estate 
owned;
    (6) Common and preferred stock of corporations, including stock 
acquired for debts previously contracted;
    (7) Commercial and consumer loans (except those assigned to 
lower risk categories due to recognized guarantees or collateral and 
loans secured by residential property that qualify for a lower risk 
weight);
    (8) Mortgage- and asset-backed securities that do not meet the 
criteria for assignment to a lower risk category;
    (9) Industrial-development bonds and similar obligations issued 
under the auspices of states or political subdivisions of the OECD-
based group of countries for the benefit of a private party or 
enterprise where that party or enterprise, not the government 
entity, is obligated to pay the principal and interest; and
    (10) All obligations of states or political subdivisions of 
countries that do not belong to the OECD-based group.
    (c) The following assets also are assigned a risk weight of 100 
percent if they have not already been deducted from capital: 
investments in unconsolidated companies, joint ventures, or 
associated companies; instruments that qualify as capital issued by 
other banks; deferred tax assets; and mortgage servicing assets, 
nonmortgage servicing assets, and other allowed intangibles.
    Category 5--200 Percent Risk Weight. This category includes:
    (a) The face amount of externally rated recourse obligations, 
direct credit substitutes, and asset- and mortgage-backed securities 
that are rated in the next lower category below the lowest 
investment grade category, e.g., BB, to the extent permitted in 
section II.B.5(b)(iii) of this appendix A; and
    (b) The face amount of direct credit substitutes for which the 
bank determines that the credit risk is equivalent to one category 
below investment grade, e.g., BB, to the extent permitted in section 
II.B.5.(b)(iii) of this appendix A.
    D. * * *
    The face amount of an off-balance sheet item is generally 
incorporated into the risk-weighted assets in two steps. The face 
amount is first multiplied by a credit conversion factor, except for 
direct credit substitutes and recourse obligations as discussed in 
section II.B.5. of this appendix A. The resultant credit equivalent 
amount is assigned to the appropriate risk category according to the 
obligor or, if relevant, the guarantor or the nature of the 
collateral.\37\ Table III to this appendix A sets forth the 
conversion factors for various types of off-balance-sheet items.
---------------------------------------------------------------------------

    \37\ The sufficiency of collateral and guarantees for off-
balance-sheet items is determined by the market value of the 
collateral or the amount of the guarantee in relation to the face 
amount of the item, except for derivative contracts, for which this 
determination is generally made in relation to the credit equivalent 
amount. Collateral and guarantees are subject to the same provisions 
noted under section II.B. of this appendix A.
---------------------------------------------------------------------------

    1. Items with a 100 percent conversion factor. (a) Except as 
otherwise provided in section II.B.5. of this appendix A, the full 
amount of an asset or transaction supported, in whole or in part, by 
a direct credit substitute or a recourse obligation. Direct credit 
substitutes and recourse obligations are defined in section II.B.5. 
of this appendix A.
    (b) Sale and repurchase agreements, if not already included on 
the balance sheet, and forward agreements. Forward agreements are 
legally binding contractual obligations to purchase assets with 
drawdown which is certain at a specified future date. Such 
obligations include forward purchases, forward forward deposits 
placed,\38\ and partly-paid shares and securities; they do not 
include commitments to make residential mortgage loans or forward 
foreign exchange contracts.
---------------------------------------------------------------------------

    \38\ Forward forward deposits accepted are treated as interest 
rate contracts.
---------------------------------------------------------------------------

    (c) Securities lent by a bank are treated in one of two ways, 
depending upon whether

[[Page 12347]]

the lender is exposed to risk of loss. If a bank, as agent for a 
customer, lends the customer's securities and does not indemnify the 
customer against loss, then the securities transaction is excluded 
from the risk-based capital calculation. On the other hand, if a 
bank lends its own securities or, acting as agent for a customer, 
lends the customer's securities and indemnifies the customer against 
loss, the transaction is converted at 100 percent and assigned to 
the risk weight category appropriate to the obligor or, if 
applicable, to the collateral delivered to the lending bank or the 
independent custodian acting on the lending bank's behalf.
* * * * *
    3. In the tables at the end of appendix A to part 325, Table II.--
Summary of Risk Weights and Risk Categories:
    A. In Category 2--20 Percent Risk Weight, paragraph (11) is 
removed, paragraph (12) is redesignated as paragraph (11), and new 
paragraphs (12) and (13) are added;
    B. In Category 3--50 Percent Risk Weight, paragraph (3) is revised;
    C. In Category 4--100 Percent Risk Weight, paragraph (9) is revised 
and a new paragraph (10) is added; and
    D. Following the paragraph titled Category 4--100 Percent Risk 
Weight, a new paragraph titled, Category 5--200 Percent Risk Weight, is 
added to read as follows:
* * * * *
    Table II.--Summary of Risk Weights and Risk Categories.
* * * * *
    Category 2--20 Percent Risk Weight.
* * * * *
    (12) Asset- or mortgage-backed securities (or recourse 
obligations or direct credit substitutes issued in connection with 
such securitizations) rated in either of the two highest investment 
grade categories, e.g., AAA or AA.
    (13) The credit equivalent amount of off-balance sheet revolving 
assets in securitization transactions featuring early amortization 
provisions sponsored by the bank.
    Category 3--50 Percent Risk Weight.
* * * * *
    (3) Asset- or mortgage-backed securities (or recourse 
obligations or direct credit substitutes issued in connection with 
such securitizations) rated in the third-highest investment grade 
category, e.g., A.
* * * * *
    Category 4--100 Percent Risk Weight.
* * * * *
    (9) Asset- or mortgage-backed securities (or recourse 
obligations or direct credit substitutes issued in connection with 
such securitizations) rated in the lowest investment grade category, 
e.g., BBB, as well as certain direct credit substitutes which the 
bank rates as the equivalent of the lowest investment grade 
category, e.g., BBB, or above through an internal assessment 
satisfactory to the FDIC.
    (10) All other assets, including any intangible assets that are 
not deducted from capital, and the credit equivalent amounts \4\ of 
off-balance sheet items not assigned to a different risk category.
---------------------------------------------------------------------------

    \4\ For each off-balance sheet item, a conversion factor (see 
Table III) must be applied to determine the ``credit equivalent 
amount'' prior to assigning the off-balance sheet time to a risk 
weight category.
---------------------------------------------------------------------------

    Category 5--200 Percent Risk Weight.
    Asset- or mortgage-backed securities (or recourse obligations or 
direct credit substitutes issued in connection with such 
securitizations) rated one category below investment grade, e.g., 
BB, as well as certain direct credit substitutes which the bank 
rates as the equivalent of one category below investment grade, 
e.g., BB, through an internal assessment satisfactory to the FDIC.

    4. In the tables at the end of appendix A to part 325, Table III.--
Credit Conversion Factors for Off-Balance Sheet Items:
    A. In this table, references to footnote 1 are removed each time 
they appear and footnote 1 is removed.
    B. In 100 Percent Conversion Factor, paragraphs (1) through (3) are 
revised, and a new paragraph (6) is added, to read as follows:

    Table III.--Credit Conversion Factors for Off-Balance Sheet 
Items.
    100 Percent Conversion Factor.
    (1) The full amount of assets supported by direct credit 
substitutes or recourse obligations (unless a different treatment is 
otherwise specified). For risk participations in such arrangements 
and acquired by the bank, the full amount of assets supported by the 
main obligation multiplied by the acquiring bank's percentage share 
of the risk participation.
    (2) Acquisitions of risk participations in bankers acceptances.
    (3) Sale and repurchase agreements, if not already included on 
the balance sheet.
* * * * *
    (6) Off-balance sheet revolving assets in securitization 
transactions featuring early amortization provisions sponsored by 
the bank.
* * * * *

    By Order of the Board of Directors.

    Dated at Washington, DC this 9th day of February, 2000.

Federal Deposit Insurance Corporation.
Robert E. Feldman,
Executive Secretary.

Department of the Treasury

Office of Thrift Supervision

12 CFR Chapter V

Authority and Issuance

    For the reasons set out in the preamble, part 567 of chapter V of 
title 12 of the Code of Federal Regulations is proposed to be amended 
as follows:

PART 567--CAPITAL

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

    Authority: 12 U.S.C. 1462, 1462a, 1463, 1464, 1467a, 1828 
(note).

    2. Section 567.1 is amended by revising the definitions of direct 
credit substitute and recourse and adding definitions of covered 
representations and warranties, credit derivative, financial guarantee-
type standby letter of credit, nationally recognized statistical rating 
organization, performance-based standby letter of credit, rated, 
securitization, servicer cash advance, standby letter of credit and 
traded position, to read as follows:


Sec. 567.1  Definitions.

* * * * *
    Covered representations and warranties. The term covered 
representations and warranties means representations and warranties 
extended by a savings association when it transfers assets (including 
loan servicing assets) or assumed by a savings association when it 
purchases loan servicing assets, that obligate the savings association 
to protect another party from losses due to credit risk in the 
transferred assets or serviced loans.
    Credit derivative. The term credit derivative means on- or off-
balance sheet notes or contracts that allow one party to transfer the 
credit risk of a referenced asset, that it may own, to another party. 
The value of a credit derivative is dependent, at least in part, on the 
credit performance of the referenced asset.
* * * * *
    Direct credit substitute. The term direct credit substitute means 
an arrangement in which a savings association assumes, in form or in 
substance, any risk of credit loss directly or indirectly associated 
with an asset or other financial claim owned in whole or in part by 
another party, that exceeds the association's pro rata share of the 
asset or claim. If the savings association has no claim on the asset, 
then the assumption of any risk of loss is a direct credit substitute. 
Direct credit substitutes include:
    (1) Financial guarantee-type standby letters of credit that support 
financial claims on the account party;
    (2) Guarantees, surety arrangements, credit derivatives, and 
irrevocable guarantee-type instruments backing financial claims;
    (3) Purchased subordinated interests or securities that absorb more 
than their pro rata share of losses from the underlying assets;

[[Page 12348]]

    (4) Loans or lines of credit that provide credit enhancement for 
the financial obligations of an account party; and
    (5) Purchased loan servicing assets if the servicer is responsible 
for credit losses associated with the loans being serviced (other than 
a servicer cash advance), or if the servicer makes or assumes covered 
representations and warranties with respect to such loans.
* * * * *
    Financial guarantee-type standby letter of credit. The term 
financial guarantee-type standby letter of credit means any letter of 
credit or similar arrangement, however named or described, that 
represents an irrevocable obligation to the beneficiary on the part of 
the issuer:
    (1) To repay money borrowed by, advanced to, or for the account of, 
the account party; or
    (2) To make payment on account of any indebtedness undertaken by 
the account party in the event that the account party fails to fulfill 
its obligation to the beneficiary.
* * * * *
    Nationally recognized statistical rating organization. The term 
nationally recognized statistical rating organization means an entity 
recognized by the Division of Market Regulation of the Securities and 
Exchange Commission as a nationally recognized statistical rating 
organization for various purposes, including the uniform net capital 
regulations for broker-dealers.
* * * * *
    Performance-based standby letter of credit. The term performance-
based standby letter of credit means any letter of credit, or similar 
arrangement, however named or described, which represents an 
irrevocable obligation to the beneficiary on the part of the issuer to 
make payment on account of any default by a third party in the 
performance of a nonfinancial or commercial obligation. Such letters of 
credit include arrangements backing subcontractors' and suppliers' 
performance, labor and materials contracts, and construction bids.
* * * * *
    Rated. The term rated means, with respect to an instrument or 
obligation, that the instrument or obligation has received a credit 
rating from a nationally recognized statistical rating organization. An 
instrument or obligation is rated investment grade if it has received a 
credit rating that falls within one of the four highest rating 
categories used by the organization. An instrument or obligation is 
rated in the highest investment grade if it has received a credit 
rating that falls within the highest rating category used by the 
organization.
* * * * *
    Recourse. The term recourse means an arrangement in which a savings 
association retains, in form or in substance, any risk of credit loss 
directly or indirectly associated with a transferred asset that exceeds 
the pro rata share of the association's claim on the asset. If a 
savings association has no claim on a transferred asset, then the 
retention of any risk of loss is recourse. A recourse obligation 
typically arises when an institution transfers assets and retains an 
obligation to repurchase the assets or to absorb losses due to a 
default of principal or interest or any other deficiency in the 
performance of the underlying obligor or some other party. Recourse may 
exist implicitly where a savings association provides credit 
enhancement beyond any contractual obligation to support assets it has 
sold. Recourse obligations include:
    (1) Covered representations and warranties on transferred assets;
    (2) Retained loan servicing assets if the servicer is responsible 
for losses associated with the loans being serviced (other than a 
servicer cash advance);
    (3) Retained subordinated interests or securities, or credit 
derivatives that absorb more than their pro rata share of losses from 
the underlying assets;
    (4) Assets sold under an agreement to repurchase; and
    (5) Loan strips sold without direct recourse where the maturity of 
the transferred loan is shorter than the maturity of the commitment.
* * * * *
    Securitization. The term securitization means the pooling and 
repackaging of loans or other credit exposures into securities that can 
be sold to investors. For purposes of Sec. 567.6(b) of this part, the 
term securitization also includes transactions or programs that 
generally create stratified credit risk positions, whether in the form 
of a security or not, whose performance is dependent upon an underlying 
pool of loans or other credit exposures.
    Servicer cash advance. The term servicer cash advance means funds 
that a residential mortgage loan servicer advances to ensure an 
uninterrupted flow of payments or the timely collection of residential 
mortgage loans, including disbursements made to cover foreclosure costs 
or other expenses arising from a mortgage loan to facilitate its timely 
collection. A servicer cash advance is not a recourse obligation or a 
direct credit substitute if the servicer is entitled to full 
reimbursement or, for any single residential mortgage loan, 
nonreimbursable advances are contractually limited to an insignificant 
amount of the outstanding principal on that loan.
    Standby letter of credit. The term standby letter of credit means 
any financial guarantee-type standby letter of credit or performance-
based standby letter of credit.
* * * * *
    Traded position. The term traded position means a recourse 
obligation, direct credit substitute, or asset- or mortgage-backed 
security that is retained, assumed, or issued in connection with an 
asset securitization and that is rated with a reasonable expectation 
that, in the near future:
    (1) The position would be sold to investors relying on the rating; 
or
    (2) A third party would, in reliance on the rating, enter into a 
transaction such as a purchase, loan, or repurchase agreement involving 
the position.
* * * * *
    3. Section 567.2 is amended by revising paragraph (a)(1)(i) to read 
as follows:


Sec. 567.2  Minimum regulatory capital requirement.

    (a) * * *
    (1) Risk-based capital requirement. (i) A savings associations' 
minimum risk-based capital requirement shall be an amount equal to 8% 
of its risk-weighted assets as measured under Sec. 567.6 of this part.
* * * * *
    4. Section 567.6 is amended by:
    A. Revising paragraph (a) introductory text;
    B. Revising paragraph (a)(1) introductory text;
    C. Revising paragraph (a)(2) introductory text;
    D. Removing and reserving paragraphs (a)(2)(i)(A) and (C);
    E. Revising paragraph (a)(2)(i)(B);
    F. Revising paragraph (a)(2)(ii)(A);
    G. Removing paragraph (a)(3); and
    H. Adding paragraph (b) to read as follows:


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

    (a) Risk-weighted assets. Risk-weighted assets equal risk-weighted 
on-balance-sheet assets (as computed under paragraph (a)(1) of this 
section), plus risk-weighted off-balance-sheet activities (as computed 
under paragraph (a)(2) of this section), plus risk-weighted recourse 
obligations, direct credit substitutes and asset- and mortgage-backed 
securities (as computed under

[[Page 12349]]

paragraph (b) of this section). Assets not included for purposes of 
calculating capital under Sec. 567.5 are not included in calculating 
risk-weighted assets.
    (1) On-balance-sheet assets. Except as provided in paragraph (b) of 
this section, risk-weighted on-balance-sheet assets are computed by 
multiplying the on-balance-sheet asset amounts times the appropriate 
risk weight categories. The risk weight categories for on-balance-sheet 
assets are:
* * * * *
    (2) Off-balance-sheet activities. Except as provided in paragraph 
(b) of this section, risk-weighted off-balance-sheet items are 
determined by the following two-step process. First, the face amount of 
the off-balance-sheet item must be multiplied by the appropriate credit 
conversion factor listed in this paragraph (a)(2). This calculation 
translates the face amount of an off-balance-sheet exposure into an on-
balance-sheet credit-equivalent amount. Second, the credit-equivalent 
amount must be assigned to the appropriate risk weight category using 
the criteria regarding obligors, guarantors, and collateral listed in 
paragraph (a)(1) of this section, provided that the maximum risk weight 
assigned to the credit-equivalent amount of an interest-rate or 
exchange-rate contract is 50 percent. The following are the credit 
conversion factors and the off-balance-sheet items to which they apply.
    (i) * * *
    (B) Risk participations purchased in bank acceptances.
* * * * *
    (ii) * * *
    (A) Transaction-related contingencies, including, among other 
things, performance bonds and performance-based standby letters of 
credit related to a particular transaction;
* * * * *
    (b) Recourse obligations, direct credit substitutes, and asset-and 
mortgage-backed securities--(1) In general. Except as otherwise 
provided in this paragraph (b), to calculate the risk-weighted asset 
amount for a recourse obligation, direct credit substitute, or asset- 
or mortgage-backed security, multiply the amount of assets from which 
risk of credit loss is directly or indirectly retained or assumed, by 
the appropriate risk weight using the criteria regarding obligors, 
guarantors, and collateral listed in paragraph (a)(1) of this section. 
For purposes of this paragraph (b), the amount of assets from which 
risk of credit loss is directly or indirectly retained or assumed 
means:
    (i) For a financial guarantee-type standby letter of credit, surety 
arrangement, credit derivative, guarantee, or irrevocable guarantee-
type instruments, the amount of the assets that the direct credit 
substitute fully or partially supports;
    (ii) For a subordinated interest or security, the amount of the 
subordinated interest or security plus all more senior interests or 
securities;
    (iii) For mortgage servicing assets that are recourse obligations 
or direct credit substitutes, the outstanding amount of unpaid 
principal of the loans serviced;
    (iv) For covered representations and warranties, the amount of the 
assets subject to the representations or warranties;
    (v) For loans or lines of credit that provide credit enhancement 
for the financial obligations of an account party, the amount of the 
enhanced financial obligations;
    (vi) For loans strips, the amount of the loans;
    (vii) For assets sold with recourse, the amount of assets from 
which risk of loss is directly or indirectly retained, less any 
applicable recourse liability account established in accordance with 
generally accepted accounting principles; and
    (viii) Other types of recourse obligations and direct credit 
substitutes should be treated in accordance with the principles 
contained in this paragraph (b).
    (2) Ratings-based approach--(i) Calculation. As an alternative to 
the calculation described in paragraph (b)(1) of this section, a 
savings association may calculate the risk-weighted asset amount for 
eligible recourse obligations, direct credit substitutes, or asset- or 
mortgage-backed securities described in paragraph (b)(2)(ii) of this 
section by multiplying the face amount of the position by the risk-
weight associated with the applicable rating under the following chart.

------------------------------------------------------------------------
               Rating category                        Risk weight
------------------------------------------------------------------------
Highest or second highest investment grade...  20%.
Third highest investment grade...............  50%.
Fourth highest investment grade..............  100%.
One grade below investment grade.............  200%.
More than one grade below investment grade or  Risk weight the asset
 not rated.                                     under paragraph (b)(1)
                                                of this section.
------------------------------------------------------------------------

    (ii) Eligibility. To be eligible for the treatment described in 
this paragraph (b)(2), a recourse obligation, direct credit substitute, 
or asset- or mortgage-backed security must meet one of the following 
criteria:
    (A) Traded position rated by a rating organization. (1) A traded 
position is eligible for the risk-based capital treatment described in 
this paragraph (b)(2), if a nationally recognized statistical rating 
organization rates the position in one of its five highest grades. If 
two or more nationally recognized statistical rating organizations 
assign different ratings to a position, the savings association may use 
the highest rating as the rating of the position for the purposes of 
this paragraph (b)(2). If a rating changes, the savings association 
must use the new rating.
    (2) If a recourse obligation, direct credit substitute, or asset- 
or mortgage-backed security or other credit risk position is not rated 
but is senior in all credit risk related features (including access to 
any collateral) to a rated, traded position, the savings association 
may risk weight the position under this paragraph (b)(2) using the 
rating of the traded position. The savings association must satisfy OTS 
that this treatment is appropriate.
    (B) Non-traded position rated by two rating organizations. (1) A 
recourse obligation or direct credit substitute that is not a traded 
position is eligible for the treatment described in this paragraph 
(b)(2), if two nationally recognized statistical rating organizations 
rate the recourse obligation or direct credit substitute in one of 
their five highest grades. The organizations must apply the same 
criteria that they use to rate securities that are traded positions and 
must make the rating publicly available.
    (2) If two or more national recognized statistical rating 
organizations assign different ratings to the recourse obligation or 
direct credit substitute, the savings association must use the second 
highest rating as the rating of the position for the purposes of this 
paragraph (b)(2). If a rating changes, the

[[Page 12350]]

savings association must use the new rating.
    (3) Internal ratings, qualified structured transactions, and credit 
assessment computer programs--(i) Calculation. As an alternative to the 
calculation described in paragraph (b)(1) of this section, a savings 
association may calculate the risk-weighted asset amount for eligible 
direct credit substitutes described in paragraph (b)(3)(ii) of this 
section by multiplying the face amount of the position by the risk-
weight associated with the applicable rating under the following chart:

------------------------------------------------------------------------
               Rating category                        Risk weight
------------------------------------------------------------------------
Investment grade.............................  100%.
One grade below investment grade.............  200%.
More than one grade below investment grade or  Risk weight the asset
 not rated.                                     under paragraph (b)(1)
                                                of this section.
------------------------------------------------------------------------

    (ii) Eligibility. To be eligible for the treatment described in 
this paragraph (b)(3), a direct credit substitute must meet one of the 
following criteria.
    (A) Non-traded position rated internally. A direct credit 
substitute assumed or issued in connection with an asset-backed 
commercial paper program and that is not a traded position is eligible 
for the treatment described in this paragraph (b)(3), if a savings 
association that is the sponsor of the program rates the direct credit 
substitute as investment grade or one category immediately below 
investment grade. The savings association must use an internal risk 
weighting system that is satisfactory to OTS. Adequate internal risk 
rating systems typically:
    (1) Are an integral part of an effective risk management system 
that explicitly incorporates the full range of risks arising from the 
institution's securitization activities.
    (2) Link ratings to measurable outcomes, such as the probability 
that the position will experience loss, the expected loss on the 
position in the event of default, and variance of losses in the event 
of default on that position;
    (3) Separately consider the risk associated with the underlying 
loans or borrowers, and the risk associated with the structure of the 
particular securitization transaction;
    (4) Identify gradations of risk even among those assets where no 
loss is likely as well as other risk positions;
    (5) Use clear, explicit criteria to classify assets into each 
internal rating category;
    (6) Employ independent credit risk management or loan review 
personnel to assign or review the internal ratings;
    (7) Include an internal audit procedure to periodically verify that 
internal risk ratings are assigned in accordance with the savings 
association's established criteria;
    (8) Monitor the performance of the assigned internal ratings to 
determine if the system correctly identified individual ratings and, if 
appropriate, adjust the rating system and individual ratings; and
    (9) Use assumptions and methodologies that are consistent with, or 
more conservative than, the rating assumptions and methodologies used 
by nationally recognized statistical rating organizations.
    (B) Non-traded positions in approved securitization or structured 
financing programs. A direct credit substitute that is not a traded 
position is eligible for the treatment described in this paragraph 
(b)(3), if the position is generated through a securitization or 
structured financing program that is approved by OTS. OTS will not 
approve the use of a securitization or structured financing program 
unless the program meets the following minimum criteria and other 
appropriate prudential standards:
    (1) A nationally recognized statistical rating organization (or 
other entity approved by OTS) must review the terms of the program, and 
state a rating for the direct credit substitutes to be issued under the 
program. If the program has options for different combinations of 
assets, standards, internal or external credit enhancements and other 
relevant factors, the rating organization or other approved entity may 
specify ranges of rating categories that will be applied based on the 
options that are utilized in the position.
    (2) The savings association must demonstrate to OTS' satisfaction 
that the rating corresponds credibly and reliably with the ratings 
issued by nationally recognized statistical rating organizations for 
traded positions, and that the rating organization's or other entity's 
underlying premises are satisfied by the direct credit substitute.
    (3) If a savings association participates in a securitization or 
structured financing program sponsored by another party, OTS may 
authorize the savings association to use this approach based on the 
program rating obtained by the sponsor of the program.
    (C) Non-traded position in a structured financing program rated by 
using qualifying credit assessment computer software. A direct credit 
substitute that is not a traded position is eligible for the treatment 
described in this paragraph (b)(3), if the position is generated 
through a structured financing program and the position is rated using 
credit assessment computer software that has been approved by OTS. OTS 
will not approve the use of credit assessment computer software unless 
the software meets the following minimum criteria and other appropriate 
prudential standards:
    (1) A nationally recognized statistical rating organization (or 
other entity approved by OTS) developed the computer software for 
determining the credit ratings of direct credit substitutes and other 
stratified positions; and
    (2) The savings association must demonstrate that the ratings 
generated using the computer software correspond credibly and reliably 
with the ratings issued by nationally recognized statistical rating 
organizations for traded positions.
    (4) Alternative capital computation for small business 
obligations--(i) Definitions. For the purposes of this paragraph 
(b)(4):
    (A) Qualified savings association means a savings association that:
    (1) Is well capitalized as defined in Sec. 565.4 of this chapter 
without applying the capital treatment described in paragraph 
(b)(4)(ii) of this section; or
    (2) Is adequately capitalized as defined in Sec. 565.4 of this 
chapter without applying the capital treatment described in paragraph 
(b)(4)(ii) of this section and has received written permission from the 
OTS to apply that capital calculation.
    (B) Small business means a business that meets the criteria for a 
small business concern established by the Small Business Administration 
in 13 CFR part 121 pursuant to 15 U.S.C. 632.
    (ii) Capital requirement. With respect to a transfer of a small 
business loan or lease of personal property with recourse that is a 
sale under generally accepted accounting principles, a qualified 
savings association may elect to include

[[Page 12351]]

only the amount of its retained recourse in its risk-weighted assets 
for the purposes of paragraph (b)(1) of this section. To qualify for 
this election, the savings association must establish and maintain a 
reserve under generally accepted accounting principles sufficient to 
meet the reasonable estimated liability of the savings association 
under the recourse obligation.
    (iii) Aggregate amount of recourse. The total outstanding amount of 
recourse retained by a qualified savings association with respect to 
transfers of small business loans and leases of personal property and 
included in the risk-weighted assets of the savings association as 
described in paragraph (b)(4)(ii) of this section, may not exceed 15 
percent of the association's total capital computed under 
Sec. 567.5(c)(4).
    (iv) Savings association that ceases to be a qualified savings 
association or that exceeds aggregate limits. If a savings association 
ceases to be a qualified savings association or exceeds the aggregate 
limit described in paragraph (b)(4)(iii) of this section, the savings 
association may continue to apply the capital treatment described in 
paragraph (b)(4)(ii) of this section to transfers of small business 
loans and leases of personal property that occurred when the 
association was a qualified savings association and did not exceed the 
limit.
    (v) Prompt corrective action not affected. (A) A savings 
association shall compute its capital without regard to this paragraph 
(b)(4) of this section for purposes of prompt corrective action (12 
U.S.C. 1831o), unless the savings association is adequately or well 
capitalized without applying the capital treatment described in this 
paragraph (b)(4) and would be well capitalized after applying that 
capital treatment.
    (B) A savings association shall compute its capital requirement 
without regard to this paragraph (b)(4) for the purposes of applying 12 
U.S.C. 1381o(g), regardless of the association's capital level.
    (5) Risk participations and syndications of direct credit 
substitutes. Except as otherwise provided in this paragraph (b) and 
subject to the low level recourse rule, a savings association must 
calculate the risk-weighted asset amount for a risk participation in, 
or syndication of, a direct credit substitute as described below. For 
the purposes of this paragraph (b)(5), in a risk participation the 
originator of the participation remains liable to the beneficiary for 
the full amount of the direct credit substitute, even though another 
party may have acquired a participation in the obligation:
    (i) Where a savings association conveys a risk participation, the 
savings association must risk weight the full amount the assets 
supported, in whole or in part, by the direct credit substitute. The 
savings association must assign a percentage share (i.e., the 
percentage of the direct credit substitute that is conveyed) of these 
assets to the lower of: the risk-weight category appropriate to the 
obligor in the underlying transaction, after considering any associated 
guarantees or collateral; or the risk-weight category appropriate to 
the entity acquiring the participation. The remainder of the assets 
supported, in whole or in part, by the direct credit substitute, must 
be assigned to the risk-weight category appropriate to the obligor, 
guarantor or collateral.
    (ii) If a savings association acquires a risk participation in a 
direct credit substitute, the savings association must multiply a 
percentage share (i.e. the percentage of the direct credit substitute 
that is acquired) by the full amount the assets supported, in whole or 
in part, by the direct credit substitute. The savings association must 
assign this amount to the risk-weight category appropriate to the 
account party obligor, guarantor or collateral.
    (iii) If the savings association holds a direct credit substitute 
as a part of a syndication and it is obligated only for its pro rata 
share of the risk of loss on the direct credit substitute and there is 
no recourse to the originating entity, the savings association must 
assign its share of the assets supported, in whole or in part, by the 
direct credit substitute to the risk-weight category appropriate to the 
obligor, guarantor or collateral.
    (6) Limitations on risk-based capital requirements--(i) Low-level 
recourse. If the maximum contractual liability or exposure to credit 
loss retained or assumed by a savings association in connection with a 
recourse obligation or a direct credit substitute calculated under 
paragraphs (b)(1) through (5) of this section is less than the 
effective risk-based capital requirement for the enhanced assets, the 
risk-based capital requirement is limited to the maximum contractual 
liability or exposure to loss, less any recourse liability account 
established in accordance with generally accepted accounting 
principles. This limitation does not apply to assets sold with implicit 
recourse.
    (ii) Mortgage-related securities or participation certificates 
retained in a mortgage loan swap. If a savings association holds a 
mortgage-related security or a participation certificate as a result of 
a mortgage loan swap with recourse, capital is required to support the 
recourse obligation plus the percentage of the mortgage-related 
security or participation certificate that is not covered by the 
recourse obligation. The total amount of capital required for the on-
balance-sheet asset and the recourse obligation, however, is limited to 
the capital requirement for the underlying loans, calculated as if the 
savings association continued to hold these loans as an on-balance-
sheet asset.
    (iii) Related on-balance-sheet assets. To the extent that an asset 
may be included in the calculation of risk-weighted on-balance-sheet 
assets under paragraph (a)(1) of this section and may also be included 
in the calculation of risk-weighted assets under this paragraph (b), 
the savings association should risk-weight the asset only under this 
paragraph (b), except mortgage servicing assets and similar 
arrangements with embedded recourse obligations or direct credit 
substitutes. In such cases, the mortgage servicing asset is risk 
weighted as an on-balance-sheet asset under paragraph (a)(1) of this 
section and the related recourse obligations and direct credit 
substitutes are risk-weighted under this paragraph (b).
    (7) Obligations of subsidiaries. If a savings association retains a 
recourse obligation or assumes a direct credit substitute on the 
obligation of a subsidiary that is not an includable subsidiary, and 
the recourse obligation or direct credit substitute is an equity or 
debt investment in that subsidiary under generally accepted accounting 
principles, the face amount of the recourse obligation or direct credit 
substitute is deducted for capital under Secs. 567.5(a)(2) and 
567.9(c). All other recourse obligations and direct credit substitutes 
retained or assumed by a savings association on the obligations of an 
entity in which the savings association has an equity investment are 
risk-weighted in accordance with this paragraph (b).
    (8) Addition to risk-weighted assets--managed assets. (i) A savings 
association must include an additional amount in the risk-weighted 
asset amount calculated under this paragraph (b), if:
    (A) The savings association sells assets to a revolving 
securitization (e.g., credit card receivables or home equity line 
securitizations) with an early amortization feature. An early 
amortization feature is a provision that, under specified conditions, 
terminates the ability of the savings association to add new 
receivables or debt to the securitization, and requires the savings

[[Page 12352]]

association to use any payments received from the debtors to pay down 
the receivables or debts previously included in the securitization; and
    (B) The savings association is the sponsor of the revolving 
securitization.
    (ii) The additional amount is equal to the face amount of the 
assets that the savings association sells to the revolving 
securitization less the face amount of any recourse obligation or 
direct credit substitute that the savings association retains or 
assumes in connection with the sale of the asset, multiplied by a 20 
percent risk weight.
    5. Section 567.11 is amended by redesignating paragraph (c) as 
paragraph (c)(1) and adding a new paragraph (c)(2) to read as follows:


Sec. 567.11  Reservations of authority.

* * * * *
    (c) * * *
    (2) If a savings association has calculated the risk-weighted asset 
amount for a recourse obligation, a direct credit substitute or an 
asset under Sec. 567.6(b), OTS may determine that risk-weighted asset 
amount does not adequately reflect the credit risk that the savings 
association assumed or retained in the transaction and require the 
institution to revise the risk-weighted asset amount to reflect the 
risk of, and other relevant factors associated with, the recourse 
obligation, direct credit substitute or asset.

    Dated: February 9, 2000.

    By the Office of Thrift Supervision.
Ellen Seidman,
Director.
[FR Doc. 00-4211 Filed 3-7-00; 8:45 am]
BILLING CODE 4810-33-P, 6210-01-P, 6714-01-P, 6720-01-P