[Federal Register Volume 70, Number 58 (Monday, March 28, 2005)]
[Notices]
[Pages 15681-15688]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 05-5982]


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DEPARTMENT OF THE TREASURY

Office of the Comptroller of the Currency

[Docket No. 05-08]

Office of Thrift Supervision

[No. 2005-14]

FEDERAL RESERVE SYSTEM

[Docket No. OP-1227]

FEDERAL DEPOSIT INSURANCE CORPORATION


Interagency Proposal on the Classification of Commercial Credit 
Exposures

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

ACTION: Joint notice and request for comment.

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SUMMARY: The OCC, Board, FDIC, and OTS (the agencies) request comment 
on their proposal to revise the classification system for commercial 
credit exposures.
    The proposal will replace the current commercial loan 
classification system categories ``special mention,'' ``substandard,'' 
and ``doubtful'' with a two-dimensional based framework. The proposed 
framework would be used by institutions and supervisors for the uniform 
classification of commercial and industrial loans; leases; receivables; 
mortgages; and other extensions of credit made for business purposes by 
federally insured depository institutions and their subsidiaries 
(institutions), based on an assessment of borrower creditworthiness and 
estimated loss severity. The proposed framework would not modify the 
interagency classification of retail credit as stated in the ``Uniform 
Retail Credit Classification and Account Management Policy Statement,'' 
issued in February 2000. However, by creating a new treatment for 
commercial loan exposures, the proposed framework would modify Part I 
of the ``Revised Uniform Agreement on the Classification of Assets and 
Appraisal of Securities Held by Banks and Thrifts' issued in June 2004.
    This proposal is intended to enhance the methodology used to 
systematically assess the level of credit risk posed by individual 
commercial extensions of credit and the level of an institution's 
aggregate commercial credit risk.

DATES: Comments must be received by June 30, 2005.

ADDRESSES: Interested parties are invited to submit written comments to 
any or all of the agencies. All comments will be shared among the 
agencies.
    Comments should be directed to:
    OCC: You should include OCC and Docket Number 05-08 in your 
comment. You may submit comments by any of the following methods:
     Federal eRulemaking Portal: http://www.regulations.gov. 
Follow the instructions for submitting comments.
     OCC Web Site: http://www.occ.treas.gov. Click on ``Contact 
the OCC,'' scroll down and click on ``Comments on Proposed 
Regulations.''
     E-mail address: [email protected].
     Fax: (202) 874-4448.
     Mail: Office of the Comptroller of the Currency, 250 E 
Street, SW., Mail Stop 1-5, Washington, DC 20219.
     Hand Delivery/Courier: 250 E Street, SW., Attn: Public 
Information Room, Mail Stop 1-5, Washington, DC 20219.
    Instructions: All submissions received must include the agency name 
(OCC) and docket number or Regulatory Information Number (RIN) for this 
notice of proposed rulemaking. In general, OCC will enter all comments 
received into the docket without change, including any business or 
personal information that you provide. You may review comments and 
other related materials by any of the following methods:
     Viewing Comments Personally: You may personally inspect 
and photocopy comments at the OCC's Public Information Room, 250 E 
Street, SW., Washington, DC. You can make an appointment to inspect 
comments by calling (202) 874-5043.
     Viewing Comments Electronically: You may request e-mail or 
CD-ROM

[[Page 15682]]

copies of comments that the OCC has received by contacting the OCC's 
Public Information Room at [email protected].
     Docket: You may also request available background 
documents and project summaries using the methods described above.
    Board: You may submit comments, identified by Docket Number OP-
1227, by any of the following methods:
     Agency Web Site: http://www.federalreserve.gov. Follow the 
instructions for submitting comments on the http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm.
     Federal eRulemaking Portal: http://www.regulations.gov. 
Follow the instructions for submitting comments.
     E-mail: [email protected]. Include docket 
number in the subject line of the message.
     FAX: 202-452-3819 or 202-452-3102.
     Mail: Jennifer J. Johnson, Secretary, Board of Governors 
of the Federal Reserve System, 20th Street and Constitution Avenue, 
NW., Washington, DC 20551.
    All public comments are available from the Board's Web site at 
http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm as 
submitted, except as necessary for technical reasons. Accordingly, your 
comments will not be edited to remove any identifying or contact 
information. Public comments may also be viewed electronically or in 
paper in Room MP-500 of the Board's Martin Building (20th and C 
Streets, N.W.) between 9 a.m. and 5 p.m. on weekdays.
    FDIC: You may submit comments by any of the following methods:
     Agency Web Site: http://www.fdic.gov/regulations/laws/federal/propose.html. Follow instructions for submitting comments on 
the Agency Web site.
     E-mail: [email protected].
     Mail: Robert E. Feldman, Executive Secretary, Attention: 
Comments, Federal Deposit Insurance Corporation, 550 17th Street, NW., 
Washington, DC 20429.
     Hand Delivery/Courier: 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.
    Instructions: All comments received will be posted without change 
to http://www.fdic.gov/regulations/laws/federal/propose.html including 
any personal information provided.
    OTS: You may submit comments, identified by No. 2005-14, by any of 
the following methods:
     Federal eRulemaking Portal: http://www.regulations.gov. 
Follow the instructions for submitting comments.
     E-mail: [email protected]. Please include No. 
2005-14 in the subject line of the message, and include your name and 
telephone number in the message.
     Fax: (202) 906-6518.
     Mail: Regulation Comments, Chief Counsel's Office, Office 
of Thrift Supervision, 1700 G Street, NW., Washington, DC 20552, 
Attention: No. 2005-14.
     Hand Delivery/Courier: Guard's Desk, East Lobby Entrance, 
1700 G Street, NW., from 9 a.m. to 4 p.m. on business days, Attention: 
Regulation Comments, Chief Counsel's Office, Attention: No. 2005-14.
    Instructions: All submissions received must include the agency name 
and document number or Regulatory Information Number (RIN) for this 
notice. All comments received will be posted without change to http://www.ots.treas.gov/pagehtml.cfm?catNumber=67&an=1, including any 
personal information provided.
    Docket: For access to the docket to read background documents or 
comments received, go to http://www.ots.treas.gov/pagehtml.cfm?catNumber=67&an=1. In addition, you may inspect comments 
at the Public Reading Room, 1700 G Street, NW., by appointment. To make 
an appointment for access, call (202) 906-5922, send an e-mail to 
public.info@ots.treas.gov">public.info@ots.treas.gov, or send a facsimile transmission to (202) 
906-7755. (Prior notice identifying the materials you will be 
requesting will assist us in serving you.) We schedule appointments on 
business days between 10 a.m. and 4 p.m. In most cases, appointments 
will be available the next business day following the date we receive a 
request.

FOR FURTHER INFORMATION CONTACT:
    OCC: Daniel Bailey, National Bank Examiner, Credit Risk Division, 
(202) 874-5170, Office of the Comptroller of the Currency, 250 E 
Street, SW., Washington, DC 20219.
    Board: Robert Walker, Senior Supervisory Financial Analyst, Credit 
Risk, (202) 452-3429, Division of Banking Supervision and Regulation, 
Board of Governors of the Federal Reserve System. For the hearing 
impaired only, Telecommunication Device for the Deaf (TDD), (202) 263-
4869, Board of Governors of the Federal Reserve System, 20th and C 
Streets NW., Washington, DC 20551.
    FDIC: Kenyon Kilber, Senior Examination Specialist, (202) 898-8935, 
Division of Supervision and Consumer Protection, Federal Deposit 
Insurance Corporation, 550 17th Street. NW., Washington, DC 20429.
    OTS: William J. Magrini, Senior Project Manager, (202) 906-5744, 
Supervision Policy, Office of Thrift Supervision, 1700 G Street, NW., 
Washington, DC 20552.

SUPPLEMENTARY INFORMATION:

Background Information

    The Uniform Agreement on the Classification of Assets and Appraisal 
of Securities Held by Banks (current classification system \1\) was 
originally issued in 1938. The current classification system was 
revised in 1949, again in 1979,\2\ and most recently in 2004. 
Separately in 1993, the agencies adopted a common definition of the 
special mention rating. The current classification system is used by 
both regulators and institutions to measure the level of credit risk in 
commercial loan portfolios, benchmark credit risk across institutions, 
assess the adequacy of an institution's capital and allowance for loan 
and lease losses (ALLL), and evaluate an institution's ability to 
accurately identify and evaluate the level of credit risk posed by 
commercial exposures.
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    \1\ The supervisory categories currently used by the agencies 
are:
    Special Mention: A ``special mention'' asset has potential 
weaknesses that deserve management's close attention. If left 
uncorrected, these potential weaknesses may result in deterioration 
of the repayment prospects for the asset or in the institution's 
credit position at some future date. Special mention assets are not 
adversely classified and do not expose an institution to sufficient 
risk to warrant adverse classification.
    Substandard: A ``substandard'' asset is inadequately protected 
by the current sound worth and paying capacity of the obligor or by 
the collateral pledged, if any. Assets so classified must have a 
well-defined weakness, or weaknesses that jeopardize the liquidation 
of the debt. They are characterized by the distinct possibility that 
the institution will sustain some loss if the deficiencies are not 
corrected.
    Doubtful: An asset classified ``doubtful'' has all the 
weaknesses inherent in one classified substandard with the added 
characteristic that the weaknesses make collection or liquidation in 
full, on the basis of currently known facts, conditions, and values, 
highly questionable and improbable.
    Loss: An asset classified ``loss'' is considered uncollectible, 
and of such little value that its continuance on the books is not 
warranted. This classification does not mean that the asset has 
absolutely no recovery or salvage value, but rather it is not 
practical or desirable to defer writing off this basically worthless 
asset event though partial recovery may be affected in the future.
    \2\ The Federal Home Loan Bank Board, the predecessor of the 
OTS, adopted the Uniform Agreement in 1987.
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    The current classification system focuses primarily on borrower 
weaknesses and the possibility of loss without specifying how factors 
that mitigate the loss, such as collateral and guarantees, should be 
considered in the

[[Page 15683]]

rating assignment. This has led to differing applications of the 
current classification system by institutions and the agencies.
    Under the current classification system, rating differences between 
an institution and its supervisor commonly arise when, despite a 
borrower's well-defined credit weaknesses, risk mitigants such as 
collateral and the facility's structure reduce the institution's risk 
of incurring a loss. The current classification system does not 
adequately address how, when rating an asset, to reconcile the risk of 
the borrower's default with the estimated loss severity of the 
particular facility. As a result, the system dictates that transactions 
with significantly different levels of expected loss receive the same 
rating. This limits the effectiveness of the current classification 
system in measuring an institution's credit risk exposure.
    To address these limitations, the agencies are proposing a two-
dimensional rating framework (proposed framework) that considers a 
borrower's capacity to meet its debt obligations separately from the 
facility characteristics that influence loss severity. By 
differentiating between these two factors, a more precise measure of an 
institution's level of credit risk is achieved.
    The proposal includes three borrower rating categories, 
``marginal,'' ``weak'' and ``default.'' Facility ratings would be 
required only for those borrowers rated default (i.e. borrowers with a 
facility placed on nonaccrual or fully or partially charged off). 
Typically, this is a very small proportion of all commercial exposures. 
For borrowers not rated default, institutions would have the option of 
assigning the facility ratings as discussed in the proposed framework.
    The agencies believe that this flexibility will allow institutions 
with both one-dimensional and two-dimensional internal risk rating 
systems to adopt the proposed framework. Under the current 
classification system, institutions with two-dimensional internal 
credit rating systems have encountered problems translating their 
internal ratings into the supervisory categories.
    The agencies also propose to adopt common definitions for the 
``criticized'' and ``classified'' asset quality benchmarks.
    In this proposed framework, the agencies have sought to minimize 
complexity and supervisory burden. The agencies believe that the 
proposed framework attains these goals and that institutions of all 
sizes will be able to apply the approach.
    The proposed framework aligns the determination of a facility's 
accrual status, partial charge-off and ALL treatment with the rating 
assignment process. The current framework does not provide a link 
between these important determinations and a facility's assignment to a 
supervisory category. The proposed framework leverages off many 
determinations and estimates management must already make to comply 
with generally accepted accounting principles (GAAP). As a result, 
financial institutions should benefit from a more efficient assessment 
process and improved clarity.
    This proposed framework, if adopted, would apply to all regulated 
financial institutions and their operating subsidiaries supervised by 
the agencies. Institutions will be provided transition time to become 
familiar with the proposal and to implement the framework for their 
commercial loan portfolios. In addition, the agencies will need to 
review the existing classification guidance for specialized lending 
activities, such as commercial real estate lending, to reflect the 
proposed rating framework. The text of the proposed framework statement 
follows below.

Uniform Agreement on the Classification of Commercial Credit Exposures

    This agreement applies to the assessment of all commercial credit 
exposures both on and off an institution's balance sheet. An 
institution's management is encouraged to differentiate borrowers and 
facilities beyond the requirements of this framework by developing its 
own risk rating system. Institutions may incorporate this framework 
into their internal risk rating systems or, alternatively, they may map 
their internal rating system into the supervisory framework. Note that 
this framework does not apply to commercial credit exposures in the 
form of securities.
    The framework is built upon two distinct ratings:
     Borrower \3\ rating--rates the borrower's capacity to meet 
financial obligations.
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    \3\ Borrower means any obligor or counterparty in a credit 
exposure, both on and off the balance sheet.
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     Facility rating--rates a facility's estimated loss 
severity.
    When combined, these two ratings determine whether the exposure 
will be a ``criticized'' or ``classified'' asset, as those asset 
quality benchmarks are defined.

Borrower Ratings

Marginal
    A ``marginal'' borrower exhibits material negative financial trends 
due to company-specific or systemic conditions. If these potential 
weaknesses are not mitigated, they threaten the borrower's capacity to 
meet its debt obligations. Marginal borrowers still demonstrate 
sufficient financial flexibility to react to and positively address the 
root cause of the adverse financial trends without significant 
deviations from their current business strategy. Their potential 
weaknesses deserve institution management's close attention and warrant 
enhanced monitoring.
    A marginal borrower exhibits potential weaknesses, which may, if 
not checked or corrected, negatively affect the borrower's financial 
capacity and threaten its ability to fulfill its debt obligations.
    The existence of adverse economic or market conditions that are 
likely to affect the borrower's future financial capacity may support a 
``marginal'' borrower rating. An adverse trend in the borrower's 
operations or balance sheet, which has not reached a point where 
default is likely, may warrant a ``marginal'' borrower rating. The 
rating should also be used for borrowers that have made significant 
progress in resolving their financial weaknesses but still exhibit 
characteristics inconsistent with a ``pass'' rating.
Weak
    A ``weak'' borrower does not possess the current sound worth and 
payment capacity of a creditworthy borrower. Borrowers rated weak 
exhibit well-defined credit weaknesses that jeopardize their continued 
performance. The weaknesses are of a severity that the distinct 
possibility of the borrower defaulting exists.
    Borrowers included in this category are those with weaknesses that 
are beyond the requirements of routine lender oversight. These 
weaknesses affect the ability of the borrower to fulfill its 
obligations. Weak borrowers exhibit adverse trends in their operations 
or balance sheets of a severity that makes it questionable that they 
will be able to fulfill their obligations, thus making default likely. 
Illustrative adverse conditions that may warrant a borrower rating of 
``weak'' include an insufficient level of cash flow compared to debt 
service needs; a highly leveraged balance sheet; a loss of

[[Page 15684]]

access to the capital markets; adverse industry and/or economic 
conditions that the borrower is poorly positioned to withstand; or a 
substantial deterioration in the borrower's operating margins. A 
``weak'' rating is inappropriate for any borrower that meets the 
conditions described in the definition of a ``default'' rating.
Default
    A borrower is rated ``default'' when one or more of the 
institution's material \4\ credit exposures to the borrower satisfies 
one of the following conditions:
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    \4\ The materiality of credit exposures is measured relative to 
the institution's overall exposure to the borrower. Charge-offs and 
write-downs on material credit exposures include credit-related 
write-downs on securities of distressed borrowers for other than 
temporary impairment, as well as material write-downs on exposures 
to distressed borrowers that are sold or transferred to held-for-
sale, the trading account, or other reporting categories.
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    (1) the supervisory reporting definition of non-accrual,\5\ or
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    \5\ An asset should be reported as being in nonaccrual status if 
(1) it is being maintained on a cash basis because of deterioration 
in the financial condition of the borrower, (2) payment in full of 
principal and interest is not expected, or (3) principal or interest 
has been in default for a period of 90 days or more unless the asset 
is both well secured and in the process of collection.
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    (2) the institution has made a full or partial charge-off or write-
down for credit-related reasons or determined that an exposure is 
impaired for credit-related reasons.
    Borrowers rated ``default'' may be upgraded if they have met their 
contractual debt service requirements for six consecutive months and 
their financial condition supports management's assessment that they 
will recover their recorded book value(s) in full.

Facility Ratings

    Facilities to borrowers with a rating of default must be further 
differentiated based upon their estimated loss severity. The framework 
contains additional applications of facility ratings; however, 
institutions may choose not to utilize them. An institution can 
estimate how severe losses may be for either individual loans or pooled 
loans (provided the pooled transactions have similar risk 
characteristics), mirroring the institution's allowance for loan and 
lease losses (ALLL) methodologies. Institutions may use their ALLL 
impairment analysis as a basis for their loss severity estimates.
    The four facility ratings are:

------------------------------------------------------------------------
        Loss severity category               Loss severity estimate
------------------------------------------------------------------------
Remote Risk of Loss...................  0%.
Low...................................  <=5% of recorded investment \6\.
Moderate..............................  >5% and <=30% of recorded
                                         investment.
High..................................  >30% of recorded investment.
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\6\ Recorded investment means the exposure amount reported on the
  financial institution's balance sheet per the Call Report or Thrift
  Financial Report instructions.

Remote Risk of Loss
    Management has the option to expand the use of the ``remote risk of 
loss'' facility rating to borrowers rated ``marginal'' and ``weak.'' 
Facilities or portions of facilities that represent a remote risk of 
loss include those secured by cash, marketable securities, commodities, 
or livestock. In the event of the borrower's contractual default, 
management must be capable of liquidating the collateral and applying 
the funds against the facility's balance. The balance reflected in this 
category should be adequately margined to reflect fluctuations in the 
collateral's market price.
    Loans for the purpose of financing production expenses associated 
with agricultural crops may be rated ``remote risk of loss'' if 
management can demonstrate that the loan will be self-liquidating at 
the end of the production cycle. That is, based upon current estimates 
of yields and market prices for the crops securing the loan, the 
borrower should be expected to yield sufficient cash from the sale to 
repay the loan in full.
    Facilities guaranteed by the U.S. government or a government-
sponsored entity (GSE) that have a high investment grade external 
rating might be included in this category. If the guaranty is 
conditional, the ``remote risk of loss'' rating should be used only 
when the institution can satisfy the conditions and qualify for payment 
under the terms of the guaranty.
    Asset-based lending facilities may be rated ``remote risk of loss'' 
only if certain criteria are met, as described below (see ``Treatment 
of Asset-Based Lending Activities.'')
Low Loss Severity
    The ``low loss severity'' rating applies to exposures to borrowers 
rated default. Loss severity is estimated to be 5 percent or less of 
the institution's recorded investment. Asset-based lending facilities 
to Weak borrowers may be rated ``low loss severity'' only if certain 
criteria are met, as described below (see ``Treatment of Asset-Based 
Lending Activities.'')
Moderate Loss Severity
    The ``moderate loss severity'' rating only applies to exposures to 
borrowers rated default. Loss severity is estimated to be greater than 
5 percent and at most 30 percent of the institution's recorded 
investment. Recovery in full is not likely.
High Loss Severity
    The ``high loss severity'' rating only applies to exposures to 
borrowers rated default. Loss severity is estimated to be greater than 
30 percent of the institution's recorded investment. Recovery in full 
is not likely.
Loss
    Assets rated ``loss'' are considered uncollectible and of such 
little value that their continuance on the institution's balance sheet 
is not warranted. This rating does not mean that the asset has 
absolutely no recovery or salvage value (it may indeed have some 
fractional future value), but rather that it is not practical or 
desirable to defer writing off this basically worthless asset.
    Portions of facilities rated ``low loss severity'' and ``moderate 
loss severity'' must be rated loss when they satisfy this definition. 
Entire facilities or portions thereof rated ``high loss severity'' must 
be rated loss if they satisfy the definition. Balances rated loss are 
charged off and netted from the facility's balance and the 
institution's loss severity estimate must be updated to reflect the 
uncertainty in collecting the remaining recorded investment.
    A loss rating for an exposure does not imply that the institution 
has no prospects to recover the amount charged off. However, 
institutions should not maintain an asset or a portion thereof on their 
balance sheet if realizing its value would require long-term litigation 
or other lengthy recovery efforts. A facility should be partially rated 
``loss'' if there is a remote prospect of collecting a portion of the 
facility's balance. When the collectibility of the loan becomes highly 
questionable, it should be charged off or written down to a balance 
equal to a conservative estimate of its net realizable value under a 
realistic workout strategy. When access to the collateral is impeded, 
regardless of the collateral's value, the institution's management 
should carefully consider whether the facility should remain a bankable 
asset. Furthermore, institutions need to recognize losses in the period 
in which the asset is identified as uncollectible.

[[Page 15685]]

Treatment of Asset-Based Lending Facilities
    Institutions with asset-based lending (ABL) activities can utilize 
the following facility ratings for qualifying exposures; however, this 
treatment is not required. Some ABL facilities, including some debtor-
in-possession (DIP) loans, may be included in the ``remote risk of 
loss'' category if they are well-secured by highly liquid collateral 
and the institution exercises strong controls over the collateral and 
the facility. ABL facilities secured by accounts receivable or other 
collateral that readily generates sufficient cash to repay the loan may 
be included in this category. In addition, the institution must have 
dominion over the cash generated from the conversion of collateral, 
prudent advance rates, strong monitoring controls, such as frequent 
borrowing base audits, and the expertise to liquidate sufficient 
collateral to repay the loan. Facilities that do not possess these 
characteristics are excluded from the category.
    ABL facilities and the lending institution must meet certain 
characteristics for the exposure to be rated ``remote risk of loss.''

 Convertibility
    --Institution is able to liquidate the collateral within 90 days of 
the borrower's contractual default.
    --Collateral is readily convertible to cash.
 Coverage
    --Loan is substantially over-collateralized such that full recovery 
of the exposure is expected.
    --Collateral has been valued within 60 days.
 Control
    --Collateral is under the institution's control.
    --Active lender management and credit administration can mitigate 
all loss through disbursement practices and collateral controls.

    For ABL facilities whose borrower is rated weak, management may 
assign the ``low loss severity'' rating if the conditions set forth 
below are satisfied:

 Convertibility
    --Institution is able to liquidate collateral within 180 days of 
the borrower's contractual default.
    --Substantial amount of the collateral is self-liquidating or 
marketable.
 Coverage
    --Loss severity is estimated to be 5 percent or less.
    --Collateral has been valued within 60 days.
 Control
    --Collateral is under the institution's control.
    --Active lender management and credit administration can minimize 
loss through disbursement practices and collateral controls.

    The institution's ABL controls and capabilities are the same as 
those described in the ``remote risk of loss'' description above. This 
category simply lengthens the period it would likely take the 
institution to liquidate the collateral from 90 days to 180 days and 
increases the loss severity estimate from full recovery of the exposure 
to 5 percent or less.
    Commercial Credit Risk Benchmarks:
    Criticized Assets = All loans to borrowers rated marginal, 
excluding those facilities, or portions thereof, rated ``remote risk of 
loss''

plus

    ABL transactions to borrowers rated weak, if they satisfy the ``low 
loss severity'' definition.
    Classified Assets = All loans to borrowers rated default, excluding 
those facilities, or portions thereof, rated ``remote risk of loss''

plus

    All loans to borrowers rated weak, excluding those facilities, or 
portions thereof, rated ``remote risk of loss'' and ABL transactions 
rated ``low loss severity.''
    When calculating a financial institution's criticized and 
classified assets, the institution's recorded investment plus any 
undrawn commitment that is reported on the institution's Call Report or 
Thrift Financial Report is included in the total, excluding any 
balances rated ``remote risk of loss.'' In the cases of lines of credit 
with borrowing bases or any other contractual restrictions that prevent 
the borrower from drawing on the entire committed amount, only the 
amount outstanding and available under the facility is included--not 
the full amount of the commitment. However, the lower amount should be 
used only if it is management's intent and practice to exert the 
institution's contractual rights to limit its exposure.
Framework Principles
    The borrower ratings should be utilized for both improving and 
deteriorating borrowers. Management should refresh ratings with 
adequate frequency to avoid significant jumps across their internal 
rating scale.
    When a facility is unconditionally guaranteed, the guarantor's 
rating can be substituted for that of the borrower to determine whether 
a facility should be criticized or classified. If the guarantor does 
not perform its obligations under the guarantee, the guarantor is rated 
default and the facility is included in the institution's classified 
assets.
    Loss severity estimates must relate to the institution's recorded 
investment, net of prior charge-offs, borrower payments, application of 
collateral proceeds, or any other funds attributable to the facility.
    Each loss severity estimate for borrowers rated default must 
reflect the institution's estimate of the asset's net realizable value 
or its estimate of projected future cash flows and the uncertainty of 
their timing and amount. For this purpose, financial institutions may 
use their impairment analysis for determining the adequacy of their 
ALLL. Facilities may be analyzed individually or in a pool with similar 
facilities.
    The ``default'' borrower rating in no way implies that the borrower 
has triggered an event of default as specified in the loan 
agreement(s). The rating indicates only that management has placed one 
or more of the borrower's facilities on non-accrual or recognized a 
full or partial charge-off. Legal determinations and collection 
strategies are the responsibility of management. If a borrower is rated 
default, it does not imply that the lender must take any particular 
action to collect from the borrower.
    When management recognizes a partial charge-off, the loss severity 
estimate and facility rating should be updated. For example, after a 
facility is partly charged off, its loss severity may improve and 
warrant a better rating.
    Estimating loss severity for many exposures to defaulted borrowers 
is difficult. If borrowers have filed for bankruptcy protection, there 
is normally significant uncertainty regarding their intent and ability 
to reorganize, to sell assets, to sell divisions, or, if it comes to 
that, to liquidate the firm. In addition, there is considerable 
uncertainty regarding the timing and amount of cash flows that these 
various strategies will produce for creditors. As a result, the loss 
severity estimates for facilities to borrowers rated default should be 
conservative and based upon the most probable outcome given current 
circumstances and the institution's loss experience on similar assets. 
The financial institution should be able to credibly support recovery 
rates on facilities in excess of the underlying collateral's net 
realizable value. Supervisors will focus on estimates where institution 
management has estimated recovery rates in excess of a loan's 
collateral value. Market prices for a borrower's similar exposures are 
one indication of a claim's intrinsic value. However, distressed debt 
prices may not

[[Page 15686]]

be a realistic indication of value if trading volume is low compared to 
the magnitude of the institution's exposure.
    Split facility ratings should be used only when part of the 
facility meets the criteria for the ``remote risk of loss'' category. 
When a portion of a facility is rated ``remote risk of loss,'' 
management's loss severity estimate should only reflect the risk 
associated with the remaining portion of the facility.
    To eliminate the need for split facility ratings and further 
simplify the framework, institutions have the option to disregard the 
``remote risk of loss'' category for loans partially secured by 
collateral that qualify for the treatment. In that case, the 
institution would reflect the loss characteristics of the loan in its 
entirety when estimating the loan's loss severity and slot the loan in 
one of the three remaining facility ratings.
    Because individually rating every borrower would be labor-intensive 
and costly, institutions may use an alternative rating approach for 
borrowers with an aggregate exposure below a specified threshold. 
Examiners will evaluate the appropriateness of the alternative rating 
approach and aggregate exposure threshold by considering factors such 
as the size of the institution, the risk profile of the subject 
exposures, and management's portfolio management capabilities.
    The following chart summarizes the structure of the proposed 
framework:
BILLING CODE 4810-33-P; 6210-01-P; 6714-01-P; 6720-01-P

Chart 1--Framework Overview
[GRAPHIC] [TIFF OMITTED] TN28MR05.018

Appendix A. Application of Framework

    The following examples highlight how certain loan facilities 
should be rated under the ``Uniform Agreement on the Assessment of 
Commercial Credit Risk.''

Example 1. Marginal Borrower Rating

    Credit Facility: $100 line of credit for working capital, $50 
outstanding
    Source of Repayment:
    Primary: Cash flow from conversion of assets
    Secondary: Security interest in all corporate assets
    Collateral: Accounts receivable with a net book value of $70 
from large hospitals, nursing care facilities, and other health care 
providers. Receivables turn slowly, 120-150 days, but with a low 
level of uncollectible accounts. No customer concentrations exceed 5 
percent of sales. Modest inventory levels consist of products to 
fill specific orders.
    Situation: The borrower is a distributor of health care 
products. Consolidation of health care providers in the firm's 
market area has had a negative effect on its revenues, 
profitability, and cash flow. The borrower's balance sheet exhibits 
moderate leverage and liquidity. The firm is currently operating at 
break-even. The firm has developed a new relationship with a 
hospital chain that operates in adjacent markets to the firm's 
traditional trade area. The new client is expected to increase sales 
by 10 percent in the coming fiscal year. If this expectation 
materializes, the borrower should return to profitability. Line 
utilization has increased over the last fiscal year; however, the 
remaining availability should provide sufficient liquidity during 
this slow period.
    Borrower Rating: The borrower has shown material negative 
financial trends; however, it appears that there is sufficient 
financial flexibility to positively address the cause of the 
concerns without significant deviation from its original business 
plan. Accordingly, the borrower is rated marginal.
    The loan is included in criticized assets.

Example 2. Weak Borrower Rating

    Credit Facility: $100 line of credit for working capital 
purposes, $100 outstanding. Borrowing base equal to 70 percent of 
eligible accounts receivable.
    Sources of Repayment:
    Primary: Cash flow from conversion of assets
    Secondary: Security interest in all unencumbered corporate 
assets

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    Situation: The borrower is a regional truck transportation firm. 
A sustained increase in fuel prices over the last six months led to 
operating losses. The borrower has been unable to increase prices to 
offset the higher fuel prices.
    The borrower's interest payments have been running 15 to 30 days 
late over the last several months. Net cash flow from operations is 
breakeven, but sufficient to meet lease payments on its truck fleet. 
The borrower leases all of its trucks from the manufacturer's 
leasing company. The line was recently fully drawn to pay 
registration fees and insurance premiums for the fleet. The borrower 
is moderately leveraged and has minimal levels of liquid assets. 
Borrower continues to maintain its customer base and generate new 
business, but pricing pressures are forcing it to run unprofitably.
    The most recent borrowing base certificate indicates the 
borrower is in compliance with the advance rate.
    Borrower and
    Facility rating: The borrower's unprofitable operations and lack 
of liquidity constitute well-defined credit weaknesses. As a result, 
the borrower is rated weak.
    The loan is included in classified assets.

Example 3. Remote Risk of Loss Facility Rating

    Credit Facilities: $100 line of credit to fund seasonal 
fluctuations in cash flow
    $100 mortgage for the acquisition of farmland
    Sources of Repayment:
    Primary: Cash flow from operations
    Secondary: Security interest in collateral
    Collateral: The line of credit is secured by livestock and crops 
with a market value of $110. The mortgage is secured by a lien on 
acreage valued at $75. A U.S. government agency guarantee was 
obtained on the mortgage loan. The guarantee covers 75% of any 
principal deficiency the institution suffers on the mortgage.
    Situation: Borrower's financial information reflects the 
negative effect of low commodity prices and a reduction in the value 
of the livestock. The borrower does not have adequate sources of 
liquidity to remain operating. Both loans have been placed on 
nonaccrual since they are delinquent in excess of 90 days. 
Institution management has completed a recent inspection of the 
livestock and crops securing their loan. The borrower has placed its 
operations up for sale, including all of the collateral securing 
both loans. The farmland is under contract with a purchase price of 
$75. Management expects to realize after selling expenses $100 from 
the sale of livestock and crops and $70 from the sale of the 
farmland. As a result, management expects to collect approximately 
$20 (75% of $30) under the government guarantee. Management 
estimates that the mortgage has impairment of $10 based on the fair 
value of the collateral and the guarantee.
    Borrower and Facility rating: The borrower is rated default 
because the loans are on nonaccrual.
    Because the line of credit is adequately collateralized by 
marketable collateral, the facility is rated ``remote risk of 
loss.'' The portion of the mortgage supported by the sale of the 
property and proceeds from the government guarantee, $90, is also 
considered ``remote risk of loss.'' The remaining $10 balance is 
rated loss due to the collateral shortfall and the unlikely 
prospects of collecting additional amounts.
    The line of credit and the portion of the mortgage supported by 
the government guarantee are included in pass assets.

Example 4. Rating Assignments for Multiple Loans to a Single Borrower

    Credit Facilities: $100 mortgage for permanent financing of an 
office building located at One Main Street.
    $100 mortgage for permanent financing of an office building 
located at One Central Avenue.
    Sources of Repayment:
    Primary: Rental income
    Secondary:Sale of real estate
    Collateral: Each loan is secured by a perfected first mortgage 
on the financed property. The values of the Main Street and Central 
Avenue properties are $85 and $110, respectively.
    Situation: The borrower is a real estate holding company for the 
two commercial office buildings. The Main Street building is not 
performing well and is generating insufficient cash flow to maintain 
the building, renovate vacant space for new tenants, and service the 
debt. The borrower is more than 90 days delinquent on the building's 
mortgage. Because the building's rents have declined and its vacancy 
rate has increased, the fair market value of the troubled property 
has declined to $85 from $120 at the time of loan origination. 
Market conditions do not favor better performance of the Main Street 
property in the short run. As a result, management has placed the 
loan on nonaccrual.
    The Central Avenue property is performing adequately, but is not 
generating sufficient excess cash flow to meet the debt service 
requirements of the first loan. The property is currently estimated 
to be worth $110. Since the loan's primary source of repayment 
remains adequate to service the debt, the credit remains on accrual 
basis.
    According to institution management's estimates, foreclosing on 
the troubled Main Street building and selling it would realize $75, 
net of brokerage fees and other selling expenses. However, the 
institution is exploring other workout strategies exclusive of 
foreclosure. These strategies may mitigate the amount of loss to the 
institution. To be conservative, the institution bases its loss 
severity estimate on the foreclosure scenario. If the Central Avenue 
building continues to generate sufficient cash flow to service the 
loan and maintains its fair market value, the institution does not 
expect to incur any loss on the second loan. Therefore, management 
assigns a 5 percent loss severity estimate to the facility, which is 
equal to its impairment estimate for a pool of similar facilities 
and borrowers.
    Borrower and Facility Ratings: The borrower is rated default 
because the one mortgage is on non-accrual.
    The mortgage on the Main Street property is rated ``moderate 
loss severity'' (>5% and <=30%) because management's estimate is a 
25 percent loss severity. The mortgage on the Central Avenue 
property is rated ``low loss severity'' (<=5%) because management's 
estimate is a 5 percent loss severity.
    Both facilities are included in classified assets.

Example 5. Loss Recognition

    Credit Facility: $100 term loan
    Source of Repayment:
    Primary: Cash flow from business
    Secondary: Security interest in collateral
    Collateral: The institution has a blanket lien on all business 
assets with an estimated value of $60.
    Situation: The borrower is seriously delinquent on its loan 
payments and has filed for bankruptcy protection. Because the 
borrower's business prospects are poor, liquidation of collateral is 
the only means by which the institution will receive repayment. 
Management estimates net realizable value ranges between $50 and 
$60. As a result, management charges off $40 and places the loan on 
nonaccrual. Management also assigns a 10 percent loss severity 
estimate to the remaining balance, which is equal to its impairment 
estimate for a pool of similar facilities and borrowers.
    Borrower and Facility Rating: Since the borrower's facility was 
placed on nonaccrual and partially charged off, the borrower is 
rated default.
    After recognizing a loss in the amount of $40, the facility's 
remaining balance is rated ``moderate loss severity'' (>5% and <30%) 
because management's analysis indicates impairment of 10 percent of 
the loan balance.
    The loan is included in classified assets.

Example 6. Asset-Backed Loan

    Credit Facility: $100 revolving credit facility, $50 outstanding 
with $20 available under the borrowing base
    Sources of Repayment:
    Primary: Conversion of accounts receivable
    Secondary: Liquidation of collateral
    Collateral: Accounts receivable from companies with investment 
grade external ratings.
    Situation: The borrower manufactures patio furniture. Because 
the prices of aluminum and other raw materials have increased, the 
borrower's profit margin has compressed significantly. As a result, 
the borrower's financial condition exhibits well-defined credit 
weaknesses.
    Despite the borrower's financial weakness, the financial 
institution is well-positioned to recover its loan balance and 
interest. The institution controls all cash receipts of the company 
through a lock-box and applies excess funds daily against the loan 
balance. The institution also controls the borrower's cash 
disbursements. The facility has a borrowing base that allows the 
borrower to draw 70 percent of eligible receivables. Eligibility is 
based on restrictive requirements designed to exclude low-quality or 
disputed receivables. Management monitors adherence to the 
requirements by conducting periodic on-site audits of the borrower's 
accounts receivable. Management estimates that the facility is not 
impaired because the collateral is liquid and has ample coverage, 
the account receivables

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counterparties are highly creditworthy, and the institution's 
management not only has tight controls on the loan but also has a 
favorable track record of managing similar loans. In the event of 
the borrower's contractual default, the institution's management 
believes that it would recover sufficient cash to repay the loan 
within 60 days.
    Borrower and Facility Rating: The borrower is rated weak due to 
its well-defined credit weaknesses.
    The facility is rated ``remote risk of loss'' because of 
institutional management's expertise; the facility's strong controls 
and high quality; and the collateral's liquidity and ample coverage.
    The facility is included in pass assets.

Example 7. Debtor-in-Possession

    Credit Facility: $100 debtor-in-possession (DIP) facility, $70 
outstanding with $10 available
    $100 term loan
    Sources of Repayment:
    Primary: Cash flow from operations
    Secondary: Liquidation of collateral
    Collateral: The DIP facility is secured by receivables from 
several investment grade companies and underwritten with a 
conservative advance rate to protect against dilution risk.
    The term loan is secured by equipment.
    Situation: The borrower has filed for Chapter 11 bankruptcy 
protection because the recall of one of the company's products has 
precipitated a substantial decline in sales. The product liability 
litigation resulted in substantial legal expenses and settlements. 
Because collecting the term loan in full is very unlikely, the 
financial institution's management placed the term loan on 
nonaccrual prior to the borrower's bankruptcy filing. Management 
estimates the institution will collect 70 percent to 80 percent on 
their secured claim under the borrower's bankruptcy reorganization 
plan. Based on this estimate, management charges off $20 and 
estimates impairment of $10 for the remaining balance. The DIP 
facility repaid the pre-petition asset-based line of credit. 
Management has expertise in asset-based lending and strong controls 
over the activity.
    Borrower and Facility Rating: The borrower is rated default 
since one of its facilities was placed on nonaccrual.
    The DIP facility is rated ``remote risk of loss'' not only 
because it is secured by high-quality receivables with ample 
coverage, but also because the financial institution's management 
has performed frequent borrowing-base audits and has strong controls 
over cash disbursements and collections. The term loan is rated 
``moderate loss severity'' (>5% and <=30%) because management's 
impairment estimate for the remaining loan balance falls within this 
range.
    The DIP facility is included in pass assets.
    The term loan is included in classified assets.

Request for Comment

    The agencies request comments on all aspects of the proposed 
policy statement. In addition, the agencies also are asking for 
comment on a number of issues affecting the policy and will consider 
the answers before developing the final policy statement. In 
particular, your comments are needed on the following issues:
    1. The agencies intend to implement this framework for all sizes 
of institutions. Could your institution implement the approach?
    2. If not, please provide the reasons.
    3. What types of implementation expenses would financial 
institutions likely incur? The agencies welcome financial data 
supporting the estimated cost of implementing the framework.
    4. Which provisions of this proposal, if any, are likely to 
generate significant training and systems programming costs?
    5. Are the examples clear and the resultant ratings reasonable?
    6. Would additional parts of the framework benefit from 
illustrative examples?
    7. Is the proposed treatment of guarantors reasonable?
    Please provide any other information that the agencies should 
consider in determining the final policy statement, including the 
optimal implementation date for the proposed changes.

    Dated: March 17, 2005.
Julie L. Williams,
Acting Comptroller of the Currency.

    Board of Governors of the Federal Reserve System, March 21, 
2005.
Jennifer J. Johnson,
Secretary of the Board.

Federal Deposit Insurance Corporation.

    By order of the Board of Directors.

    Dated at Washington, DC, this 18th day of March, 2005.
Robert E. Feldman,
Executive Secretary.

    Dated: March 18, 2005.

    By the Office of Thrift Supervision.
James E. Gilleran,
Director.

[FR Doc. 05-5982 Filed 3-25-05; 8:45 am]
BILLING CODE 4810-33-C; 6210-01-C; 6714-01-C; 6720-01-C