[Federal Register Volume 66, Number 184 (Friday, September 21, 2001)]
[Rules and Regulations]
[Pages 48532-48535]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-55528]


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FEDERAL RESERVE SYSTEM

12 CFR Part 225


Bank Holding Companies and Change in Bank Control (Regulation Y)

CFR Correction

    In Title 12 of the Code of Federal Regulations, parts 220 to 299, 
revised as of January 1, 2001, in part 225, appendix E is corrected to 
read as follows:

[[Page 48533]]

Appendix E to Part 225--Capital Adequacy Guidelines for Bank Holding 
Companies: Market Risk Measure

Section 1. Purpose, Applicability, Scope, and Effective Date

    (a) Purpose. The purpose of this appendix is to ensure that bank 
holding companies (organizations) with significant exposure to 
market risk maintain adequate capital to support that 
exposure.1 This appendix supplements and adjusts the 
risk-based capital ratio calculations under appendix A of this part 
with respect to those organizations.
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    \1\ This appendix is based on a framework developed jointly by 
supervisory authorities from the countries represented on the Basle 
Committee on Banking Supervision and endorsed by the Group of Ten 
Central Bank Governors. The framework is described in a Basle 
Committee paper entitled ``Amendment to the Capital Accord to 
Incorporate Market Risks,'' January 1996. Also see modifications 
issued in September 1997.
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    (b) Applicability. (1) This appendix applies to any bank holding 
company whose trading activity 2 (on a worldwide 
consolidated basis) equals:
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    \2\ Trading activity means the gross sum of trading assets and 
liabilities as reported in the bank holding company's most recent 
quarterly Y-9C Report.
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    (i) 10 percent or more of total assets; 3 or
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    \3\ Total assets means quarter-end total assets as reported in 
the bank holding company's most recent Y-9C Report.
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    (ii) $1 billion or more.
    (2) The Federal Reserve may additionally apply this appendix to 
any bank holding company if the Federal Reserve deems it necessary 
or appropriate for safe and sound banking practices.
    (3) The Federal Reserve may exclude a bank holding company 
otherwise meeting the criteria of paragraph (b)(1) of this section 
from coverage under this appendix if it determines the organization 
meets such criteria as a consequence of accounting, operational, or 
similar considerations, and the Federal Reserve deems it consistent 
with safe and sound banking practices.
    (c) Scope. The capital requirements of this appendix support 
market risk associated with an organization's covered positions.
    (d) Effective date. This appendix is effective as of January 1, 
1997. Compliance is not mandatory until January 1, 1998. Subject to 
supervisory approval, a bank holding company may opt to comply with 
this appendix as early as January 1, 1997.4
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    \4\ A bank holding company that voluntarily complies with the 
final rule prior to January 1, 1998, must comply with all of its 
provisions.
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Section 2. Definitions

    For purposes of this appendix, the following definitions apply:
    (a) Covered positions means all positions in an organization's 
trading account, and all foreign exchange 5 and commodity 
positions, whether or not in the trading account.6 
Positions include on-balance-sheet assets and liabilities and off-
balance-sheet items. Securities subject to repurchase and lending 
agreements are included as if still owned by the lender.
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    \5\ Subject to supervisory review, a bank may exclude structural 
positions in foreign currencies from its covered positions.
    \6\ The term trading account is defined in the instructions to 
the Call Report.
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    (b) Market risk means the risk of loss resulting from movements 
in market prices. Market risk consists of general market risk and 
specific risk components.
    (1) General market risk means changes in the market value of 
covered positions resulting from broad market movements, such as 
changes in the general level of interest rates, equity prices, 
foreign exchange rates, or commodity prices.
    (2) Specific risk means changes in the market value of specific 
positions due to factors other than broad market movements and 
includes event and default risk as well as idiosyncratic variations.
    (c) Tier 1 and Tier 2 capital are defined in appendix A of this 
part.
    (d) Tier 3 capital is subordinated debt that is unsecured; is 
fully paid up; has an original maturity of at least two years; is 
not redeemable before maturity without prior approval by the Federal 
Reserve; includes a lock-in clause precluding payment of either 
interest or principal (even at maturity) if the payment would cause 
the issuing organization's risk-based capital ratio to fall or 
remain below the minimum required under appendix A of this part; and 
does not contain and is not covered by any covenants, terms, or 
restrictions that are inconsistent with safe and sound banking 
practices.
    (e) Value-at-risk (VAR) means the estimate of the maximum amount 
that the value of covered positions could decline due to market 
price or rate movements during a fixed holding period within a 
stated confidence level, measured in accordance with section 4 of 
this appendix.

Section 3. Adjustments to the Risk-Based Capital Ratio Calculations

    (a) Risk-based capital ratio denominator. An organization 
subject to this appendix shall calculate its risk-based capital 
ratio denominator as follows:
    (1) Adjusted risk-weighted assets. Calculate adjusted risk-
weighted assets, which equals risk-weighted assets (as determined in 
accordance with appendix A of this part), excluding the risk-
weighted amounts of all covered positions (except foreign exchange 
positions outside the trading account and over-the-counter 
derivative positions) 7 and receivables arising from the 
posting of cash collateral that is associated with securities 
borrowing transactions to the extent the receivables are 
collateralized by the market value of the borrowed securities, 
provided that the following conditions are met:
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    \7\ Foreign exchange positions outside the trading account and 
all over-the-counter derivative positions, whether or not in the 
trading account, must be included in the adjusted risk weighted 
assets as determined in appendix A of this part.
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    (i) The transaction is based on securities includable in the 
trading book that are liquid and readily marketable,
    (ii) The transaction is marked to market daily,
    (iii) The transaction is subject to daily margin maintenance 
requirements,
    (iv) The transaction is a securities contract for the purposes 
of section 555 of the Bankruptcy Code (11 U.S.C. 555), a qualified 
financial contract for the purposes of section 11(e)(8) of the 
Federal Deposit Insurance Act (12 U.S.C. 1821(e)(8)), or a netting 
contract between or among financial institutions for the purposes of 
sections 401-407 of the Federal Deposit Insurance Corporation 
Improvement Act of 1991 (12 U.S.C. 4401-4407), or the Board's 
Regulation EE (12 CFR Part 231).
    (2) Measure for market risk. Calculate the measure for market 
risk, which equals the sum of the VAR-based capital charge, the 
specific risk add-on (if any), and the capital charge for de minimis 
exposures (if any).
    (i) VAR-based capital charge. The VAR-based capital charge 
equals the higher of:
    (A) The previous day's VAR measure; or
    (B) The average of the daily VAR measures for each of the 
preceding 60 business days multiplied by three, except as provided 
in section 4(e) of this appendix;
    (ii) Specific risk add-on. The specific risk add-on is 
calculated in accordance with section 5 of this appendix; and
    (iii) Capital charge for de minimis exposure. The capital charge 
for de minimis exposure is calculated in accordance with section 
4(a) of this appendix.
    (3) Market risk equivalent assets. Calculate market risk 
equivalent assets by multiplying the measure for market risk (as 
calculated in paragraph (a)(2) of this section) by 12.5.
    (4) Denominator calculation. Add market risk equivalent assets 
(as calculated in paragraph (a)(3) of this section) to adjusted 
risk-weighted assets (as calculated in paragraph (a)(1) of this 
section). The resulting sum is the organization's risk-based capital 
ratio denominator.
    (b) Risk-based capital ratio numerator. An organization subject 
to this appendix shall calculate its risk-based capital ratio 
numerator by allocating capital as follows:
    (1) Credit risk allocation. Allocate Tier 1 and Tier 2 capital 
equal to 8.0 percent of adjusted risk-weighted assets (as calculated 
in paragraph (a)(1) of this section).8
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    \8\ An institution may not allocate Tier 3 capital to support 
credit risk (as calculated under appendix A of this part).
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    (2) Market risk allocation. Allocate Tier 1, Tier 2, and Tier 3 
capital equal to the measure for market risk as calculated in 
paragraph (a)(2) of this section. The sum of Tier 2 and Tier 3 
capital allocated for market risk must not exceed 250 percent of 
Tier 1 capital allocated for market risk. (This requirement means 
that Tier 1 capital allocated in this paragraph (b)(2) must equal at 
least 28.6 percent of the measure for market risk.)
    (3) Restrictions. (i) The sum of Tier 2 capital (both allocated 
and excess) and Tier 3 capital (allocated in paragraph (b)(2) of 
this section) may not exceed 100 percent of Tier 1 capital (both 
allocated and excess).9
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    \9\ Excess Tier 1 capital means Tier 1 capital that has not been 
allocated in paragraphs (b)(1) and (b)(2) of this section. Excess 
Tier 2 capital means Tier 2 capital that has not been allocated in 
paragraph (b)(1) and (b)(2) of this section, subject to the 
restrictions in paragraph (b)(3) of this section.
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    (ii) Term subordinated debt (and intermediate-term preferred 
stock and related surplus) included in Tier 2 capital (both

[[Page 48534]]

allocated and excess) may not exceed 50 percent of Tier 1 capital 
(both allocated and excess).
    (4) Numerator calculation. Add Tier 1 capital (both allocated 
and excess), Tier 2 capital (both allocated and excess), and Tier 3 
capital (allocated under paragraph (b)(2) of this section). The 
resulting sum is the organization's risk-based capital ratio 
numerator.

Section 4. Internal Models

    (a) General. For risk-based capital purposes, a bank holding 
company subject to this appendix must use its internal model to 
measure its daily VAR, in accordance with the requirements of this 
section.10 The Federal Reserve may permit an organization 
to use alternative techniques to measure the market risk of de 
minimis exposures so long as the techniques adequately measure 
associated market risk.
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    \10\ An organization's internal model may use any generally 
accepted measurement techniques, such as variance-covariance models, 
historical simulations, or Monte Carlo simulations. However, the 
level of sophistication and accuracy of an organization's internal 
model must be commensurate with the nature and size of its covered 
positions. An organization that modifies its existing modeling 
procedures to comply with the requirements of this appendix for 
risk-based capital purposes should, nonetheless, continue to use the 
internal model it considers most appropriate in evaluating risks for 
other purposes.
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    (b) Qualitative requirements. A bank holding company subject to 
this appendix must have a risk management system that meets the 
following minimum qualitative requirements:
    (1) The organization must have a risk control unit that reports 
directly to senior management and is independent from business 
trading units.
    (2) The organization's internal risk measurement model must be 
integrated into the daily management process.
    (3) The organization's policies and procedures must identify, 
and the organization must conduct, appropriate stress tests and 
backtests.11 The organization's policies and procedures 
must identify the procedures to follow in response to the results of 
such tests.
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    \11\ Stress tests provide information about the impact of 
adverse market events on a bank's covered positions. Backtests 
provide information about the accuracy of an internal model by 
comparing an organization's daily VAR measures to its corresponding 
daily trading profits and losses.
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    (4) The organization must conduct independent reviews of its 
risk measurement and risk management systems at least annually.
    (c) Market risk factors. The organization's internal model must 
use risk factors sufficient to measure the market risk inherent in 
all covered positions. The risk factors must address interest rate 
risk,12 equity price risk, foreign exchange rate risk, 
and commodity price risk.
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    \12\ For material exposures in the major currencies and markets, 
modeling techniques must capture spread risk and must incorporate 
enough segments of the yield curve--at least six--to capture 
differences in volatility and less than perfect correlation of rates 
along the yield curve.
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    (d) Quantitative requirements. For regulatory capital purposes, 
VAR measures must meet the following quantitative requirements:
    (1) The VAR measures must be calculated on a daily basis using a 
99 percent, one-tailed confidence level with a price shock 
equivalent to a ten-business day movement in rates and prices. In 
order to calculate VAR measures based on a ten-day price shock, the 
organization may either calculate ten-day figures directly or 
convert VAR figures based on holding periods other than ten days to 
the equivalent of a ten-day holding period (for instance, by 
multiplying a one-day VAR measure by the square root of ten).
    (2) The VAR measures must be based on an historical observation 
period (or effective observation period for an organization using a 
weighting scheme or other similar method) of at least one year. The 
organization must update data sets at least once every three months 
or more frequently as market conditions warrant.
    (3) The VAR measures must include the risks arising from the 
non-linear price characteristics of options positions and the 
sensitivity of the market value of the positions to changes in the 
volatility of the underlying rates or prices. An organization with a 
large or complex options portfolio must measure the volatility of 
options positions by different maturities.
    (4) The VAR measures may incorporate empirical correlations 
within and across risk categories, provided that the organization's 
process for measuring correlations is sound. In the event that the 
VAR measures do not incorporate empirical correlations across risk 
categories, then the organization must add the separate VAR measures 
for the four major risk categories to determine its aggregate VAR 
measure.
    (e) Backtesting. (1) Beginning one year after a bank holding 
company starts to comply with this appendix, it must conduct 
backtesting by comparing each of its most recent 250 business days' 
actual net trading profit or loss 13 with the 
corresponding daily VAR measures generated for internal risk 
measurement purposes and calibrated to a one-day holding period and 
a 99th percentile, one-tailed confidence level.
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    \13\ Actual net trading profits and losses typically include 
such things as realized and unrealized gains and losses on portfolio 
positions as well as fee income and commissions associated with 
trading activities.
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    (2) Once each quarter, the organization must identify the number 
of exceptions, that is, the number of business days for which the 
magnitude of the actual daily net trading loss, if any, exceeds the 
corresponding daily VAR measure.
    (3) A bank holding company must use the multiplication factor 
indicated in Table 1 of this appendix in determining its capital 
charge for market risk under section 3(a)(2)(i)(B) of this appendix 
until it obtains the next quarter's backtesting results, unless the 
Federal Reserve determines that a different adjustment or other 
action is appropriate.

     Table 1.--Multiplication Factor Based on Results of Backtesting
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                                                          Multiplication
                  Number of exceptions                        factor
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4 or fewer..............................................          3.00
5.......................................................          3.40
6.......................................................          3.50
7.......................................................          3.65
8.......................................................          3.75
9.......................................................          3.85
10 or more..............................................          4.00
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Section 5. Specific Risk

    (a) Modeled specific risk. A bank holding company may use its 
internal model to measure specific risk. If the organization has 
demonstrated to the Federal Reserve that its internal model measures 
the specific risk, including event and default risk as well as 
idiosyncratic variation, of covered debt and equity positions and 
includes the specific risk measures in the VAR-based capital charge 
in section 3(a)(2)(i) of this appendix, then the organization has no 
specific risk add-on for purposes of section 3(a)(2)(ii) of this 
appendix. The model should explain the historical price variation in 
the trading portfolio and capture concentration, both magnitude and 
changes in composition. The model should also be robust to an 
adverse environment and have been validated through backtesting 
which assesses whether specific risk is being accurately captured.
    (b) Partially modeled specific risk. (1) A bank holding company 
that incorporates specific risk in its internal model but fails to 
demonstrate to the Federal Reserve that its internal model 
adequately measures all aspects of specific risk for covered debt 
and equity positions, including event and default risk, as provided 
by section 5(a) of this appendix, must calculate its specific risk 
add-on in accordance with one of the following methods:
    (i) If the model is susceptible to valid separation of the VAR 
measure into a specific risk portion and a general market risk 
portion, then the specific risk add-on is equal to the previous 
day's specific risk portion.
    (ii) If the model does not separate the VAR measure into a 
specific risk portion and a general market risk portion, then the 
specific risk add-on is the sum of the previous day's VAR measures 
for subportfolios of covered debt and equity positions that contain 
specific risk.
    (2) If a bank holding company models the specific risk of 
covered debt positions but not covered equity positions (or vice 
versa), then the bank holding company may determine its specific 
risk charge for the included positions under section 5(a) or 5(b)(1) 
of this appendix, as appropriate. The specific risk charge for the 
positions not included equals the standard specific risk capital 
charge under paragraph (c) of this section.
    (c) Specific risk not modeled. If a bank holding company does 
not model specific risk in accordance with section 5(a) or 5(b) of 
this appendix, then the organization's specific risk capital charge 
shall equal the standard specific risk capital charge, calculated as 
follows:

[[Page 48535]]

    (1) Covered debt positions. (i) For purposes of this section 5, 
covered debt positions means fixed-rate or floating-rate debt 
instruments located in the trading account or instruments located in 
the trading account with values that react primarily to changes in 
interest rates, including certain non- convertible preferred stock, 
convertible bonds, and instruments subject to repurchase and lending 
agreements. Also included are derivatives (including written and 
purchased options) for which the underlying instrument is a covered 
debt instrument that is subject to a non-zero specific risk capital 
charge.
    (A) For covered debt positions that are derivatives, an 
organization must risk-weight (as described in paragraph (c)(1)(iii) 
of this section) the market value of the effective notional amount 
of the underlying debt instrument or index portfolio. Swaps must be 
included as the notional position in the underlying debt instrument 
or index portfolio, with a receiving side treated as a long position 
and a paying side treated as a short position; and
    (B) For covered debt positions that are options, whether long or 
short, an organization must risk-weight (as described in paragraph 
(c)(1)(iii) of this section) the market value of the effective 
notional amount of the underlying debt instrument or index 
multiplied by the option's delta.
    (ii) An organization may net long and short covered debt 
positions (including derivatives) in identical debt issues or 
indices.
    (iii) An organization must multiply the absolute value of the 
current market value of each net long or short covered debt position 
by the appropriate specific risk weighting factor indicated in Table 
2 of this appendix. The specific risk capital charge component for 
covered debt positions is the sum of the weighted values.

  Table 2.--Specific Risk Weighting Factors for Covered Debt Positions
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                                                               Weighting
                                         Remaining maturity      factor
              Category                     (contractual)          (in
                                                                percent)
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Government..........................  N/A....................       0.00
Qualifying..........................  6 months or less.......       0.25
                                      Over 6 months to 24           1.00
                                       months.
                                      Over 24 months.........       1.60
Other...............................  N/A....................       8.00
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    (A) The government category includes all debt instruments of 
central governments of OECD-based countries 14 including 
bonds, Treasury bills, and other short-term instruments, as well as 
local currency instruments of non-OECD central governments to the 
extent the organization has liabilities booked in that currency.
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    \14\ Organization for Economic Cooperation and Development 
(OECD)-based countries is defined in appendix A of this part.
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    (B) The qualifying category includes debt instruments of U.S. 
government-sponsored agencies, general obligation debt instruments 
issued by states and other political subdivisions of OECD-based 
countries, multilateral development banks, and debt instruments 
issued by U.S. depository institutions or OECD banks that do not 
qualify as capital of the issuing institution.15 This 
category also includes other debt instruments, including corporate 
debt and revenue instruments issued by states and other political 
subdivisions of OECD countries, that are:
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    \15\ U.S. government-sponsored agencies, multilateral 
development banks, and OECD banks are defined in appendix A of this 
part.
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    (1) Rated investment-grade by at least two nationally recognized 
credit rating services;
    (2) Rated investment grade by one nationally recognized credit 
rating agency and not rated less than investment grade by any other 
credit rating agency; or
    (3) Unrated, but deemed to be of comparable investment quality 
by the reporting organization and the issuer has instruments listed 
on a recognized stock exchange, subject to review by the Federal 
Reserve.
    (C) The other category includes debt instruments that are not 
included in the government or qualifying categories.
    (2) Covered equity positions. (i) For purposes of this section 
5, covered equity positions means equity instruments located in the 
trading account and instruments located in the trading account with 
values that react primarily to changes in equity prices, including 
voting or non-voting common stock, certain convertible bonds, and 
commitments to buy or sell equity instruments. Also included are 
derivatives (including written or purchased options) for which the 
underlying is a covered equity position.
    (A) For covered equity positions that are derivatives, an 
organization must risk weight (as described in paragraph (c)(2)(iii) 
of this section) the market value of the effective notional amount 
of the underlying equity instrument or equity portfolio. Swaps must 
be included as the notional position in the underlying equity 
instrument or index portfolio, with a receiving side treated as a 
long position and a paying side treated as a short position; and
    (B) For covered equity positions that are options, whether long 
or short, an organization must risk weight (as described in 
paragraph (c)(2)(iii) of this section) the market value of the 
effective notional amount of the underlying equity instrument or 
index multiplied by the option's delta.
    (ii) An organization may net long and short covered equity 
positions (including derivatives) in identical equity issues or 
equity indices in the same market.16
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    \16\ An organization may also net positions in depository 
receipts against an opposite position in the underlying equity or 
identical equity in different markets, provided that the 
organization includes the costs of conversion.
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    (iii)(A) An organization must multiply the absolute value of the 
current market value of each net long or short covered equity 
position by a risk weighting factor of 8.0 percent, or by 4.0 
percent if the equity is held in a portfolio that is both liquid and 
well-diversified.17 For covered equity positions that are 
index contracts comprising a well-diversified portfolio of equity 
instruments, the net long or short position is to be multiplied by a 
risk weighting factor of 2.0 percent.
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    \17\ A portfolio is liquid and well-diversified if: (1) it is 
characterized by a limited sensitivity to price changes of any 
single equity issue or closely related group of equity issues held 
in the portfolio; (2) the volatility of the portfolio's value is not 
dominated by the volatility of any individual equity issue or by 
equity issues from any single industry or economic sector; (3) it 
contains a large number of individual equity positions, with no 
single position representing a substantial portion of the 
portfolio's total market value; and (4) it consists mainly of issues 
traded on organized exchanges or in well-established over-the-
counter markets.
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    (B) For covered equity positions from the following futures-
related arbitrage strategies, an organization may apply a 2.0 
percent risk weighting factor to one side (long or short) of each 
equity position with the opposite side exempt from charge, subject 
to review by the Federal Reserve:
    (1) Long and short positions in exactly the same index at 
different dates or in different market centers; or
    (2) Long and short positions in index contracts at the same date 
in different but similar indices.
    (C) For futures contracts on broadly-based indices that are 
matched by offsetting positions in a basket of stocks comprising the 
index, an organization may apply a 2.0 percent risk weighting factor 
to the futures and stock basket positions (long and short), provided 
that such trades are deliberately entered into and separately 
controlled, and that the basket of stocks comprises at least 90 
percent of the capitalization of the index.
    (iv) The specific risk capital charge component for covered 
equity positions is the sum of the weighted values.

[61 FR 47373, Sept. 6, 1996, as amended at 62 FR 68068, Dec. 30, 
1997; 64 FR 19038, Apr. 19, 1999; 65 FR 75859, Dec. 5, 2000]

[FR Doc. 01-55528 Filed 9-20-01; 8:45 am]
BILLING CODE 1505-01-D