[Federal Register Volume 76, Number 7 (Tuesday, January 11, 2011)]
[Proposed Rules]
[Pages 1890-1922]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2010-32189]
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Part IV
Department of the Treasury
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Office of the Comptroller of the Currency
12 CFR Part 3
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Federal Reserve System
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12 CFR Parts 208 and 225
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Federal Deposit Insurance Corporation
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12 CFR Part 325
Risk-Based Capital Guidelines: Market Risk; Proposed Rule
Federal Register / Vol. 76 , No. 7 / Tuesday, January 11, 2011 /
Proposed Rules
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DEPARTMENT OF THE TREASURY
Office of the Comptroller of the Currency
12 CFR Part 3
[Docket ID: OCC-2010-0003]
RIN 1557-AC99
FEDERAL RESERVE SYSTEM
12 CFR Parts 208 and 225
[Regulations H and Y; Docket No. R-1401]
RIN No. 7100-AD61
FEDERAL DEPOSIT INSURANCE CORPORATION
12 CFR Part 325
RIN 3064-AD70
Risk-Based Capital Guidelines: Market Risk
AGENCY: Office of the Comptroller of the Currency, Department of the
Treasury; Board of Governors of the Federal Reserve System; and Federal
Deposit Insurance Corporation.
ACTION: Notice of proposed rulemaking with request for public comment.
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SUMMARY: The Office of the Comptroller of the Currency (OCC), Board of
Governors of the Federal Reserve System (Board), and Federal Deposit
Insurance Corporation (FDIC) are requesting comment on a proposal to
revise their market risk capital rules to modify their scope to better
capture positions for which the market risk capital rules are
appropriate; reduce procyclicality in market risk capital requirements;
enhance the rules' sensitivity to risks that are not adequately
captured under the current regulatory measurement methodologies; and
increase transparency through enhanced disclosures. The proposal does
not include the methodologies adopted by the Basel Committee on Banking
Supervision for calculating the specific risk capital requirements for
debt and securitization positions due to their reliance on credit
ratings, which is impermissible under the Dodd-Frank Wall Street Reform
and Consumer Protection Act. The proposal, therefore, retains the
current specific risk treatment for these positions until the agencies
develop alternative standards of creditworthiness as required by the
Act. The proposed rules are substantively the same across the agencies.
DATES: Comments on this notice of proposed rulemaking must be received
by April 11, 2011.
ADDRESSES: Comments should be directed to:
OCC: Because paper mail in the Washington, DC area and at the
Agencies is subject to delay, commenters are encouraged to submit
comments by the Federal eRulemaking Portal or e-mail, if possible.
Please use the title ``Risk-Based Capital Guidelines: Market Risk'' to
facilitate the organization and distribution of the comments. You may
submit comments by any of the following methods:
Federal eRulemaking Portal--``regulations.gov'': Go to
http://www.regulations.gov. Select ``Document Type'' of ``Proposed
Rules,'' and in ``Enter Keyword or ID Box,'' enter Docket ID ``OCC-
2010-0003,'' and click ``Search.'' On ``View By Relevance'' tab at
bottom of screen, in the ``Agency'' column, locate the proposed rule
for OCC, in the ``Action'' column, click on ``Submit a Comment'' or
``Open Docket Folder'' to submit or view public comments and to view
supporting and related materials for this rulemaking action.
Click on the ``Help'' tab on the Regulations.gov home page
to get information on using Regulations.gov, including instructions for
submitting or viewing public comments, viewing other supporting and
related materials, and viewing the docket after the close of the
comment period.
E-mail: [email protected].
Mail: Office of the Comptroller of the Currency, 250 E
Street, SW., Mail Stop 2-3, Washington, DC 20219.
Fax: (202) 874-5274.
Hand Delivery/Courier: 250 E Street, SW., Mail Stop 2-3,
Washington, DC 20219.
Instructions: You must include ``OCC'' as the agency name and
``Docket ID OCC-2010-0003'' in your comment. In general, OCC will enter
all comments received into the docket and publish them on the
Regulations.gov Web site without change, including any business or
personal information that you provide such as name and address
information, e-mail addresses, or phone numbers. Comments received,
including attachments and other supporting materials, are part of the
public record and subject to public disclosure. Do not enclose any
information in your comment or supporting materials that you consider
confidential or inappropriate for public disclosure.
You may review comments and other related materials that pertain to
this proposed rule by any of the following methods:
Viewing Comments Electronically: Go to http://www.regulations.gov. Select ``Document Type'' of ``Public
Submissions,'' in ``Enter Keyword or ID Box,'' enter Docket ID ``OCC-
2010-0003,'' and click ``Search.'' Comments will be listed under ``View
By Relevance'' tab at bottom of screen. If comments from more than one
agency are listed, the ``Agency'' column will indicate which comments
were received by the OCC.
Viewing Comments Personally: You may personally inspect
and photocopy comments at the OCC, 250 E Street, SW., Washington, DC.
For security reasons, the OCC requires that visitors make an
appointment to inspect comments. You may do so by calling (202) 874-
4700. Upon arrival, visitors will be required to present valid
government-issued photo identification and to submit to security
screening in order to inspect and photocopy comments.
Docket: You may also view or request available background
documents and project summaries using the methods described above.
Board: You may submit comments, identified by Docket No. R-1401 and
RIN No. 7100-AD61, by any of the following methods:
Agency Web Site: http://www.federalreserve.gov. Follow the
instructions for submitting comments at 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.
Federal eRulemaking Portal: ``Regulations.gov'': Go to
http://www.regulations.gov and follow the instructions for submitting
comments.
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, unless modified 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 form in Room MP-500 of the Board's Martin Building (20th and C
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Street, NW.) between 9 a.m. and 5 p.m. on weekdays.
FDIC: You may submit comments by any of the following methods:
Federal eRulemaking Portal: http://www.regulations.gov.
Follow the instructions for submitting comments.
Agency Web site: http://www.FDIC.gov/regulations/laws/Federal/propose.html.
Mail: Robert E. Feldman, Executive Secretary, Attention:
Comments/Legal ESS, Federal Deposit Insurance Corporation, 550 17th
Street, NW., Washington, DC 20429.
Hand Delivered/Courier: 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.
E-mail: [email protected].
Instructions: Comments submitted must include ``FDIC'' and ``RIN
[3064-AD70].'' Comments received will be posted without change to
http://www.FDIC.gov/regulations/laws/Federal/propose.html, including
any personal information provided.
FOR FURTHER INFORMATION CONTACT:
OCC: Roger Tufts, Senior Economic Advisor, Capital Policy Division,
(202) 874-4925, or Ron Shimabukuro, Senior Counsel, Carl Kaminski,
Senior Attorney, or Hugh Carney, Attorney, Legislative and Regulatory
Activities Division, (202) 874-5090, Office of the Comptroller of the
Currency, 250 E Street, SW., Washington, DC 20219.
Board: Anna Lee Hewko, (202) 530-6260, Assistant Director, Capital
and Regulatory Policy, or Connie Horsley, (202) 452-5239, Senior
Supervisory Financial Analyst, Division of Banking Supervision and
Regulation; or April C. Snyder, Counsel, (202) 452-3099, or Benjamin W.
McDonough, Counsel, (202) 452-2036, Legal Division. For the hearing
impaired only, Telecommunication Device for the Deaf (TDD), (202) 263-
4869.
FDIC: Bobby R. Bean, Chief, Policy Section, (202) 898-6705; Karl
Reitz, Senior Capital Markets Specialist, (202) 898-6775; Jim
Weinberger, Senior Policy Analyst, (202) 898-7034, Division of
Supervision and Consumer Protection; or Mark Handzlik, Counsel, (202)
898-3990; or Michael Phillips, Counsel, (202) 898-3581, Supervision
Branch, Legal Division.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Introduction
A. Background
B. Summary of the Current Market Risk Capital Rule
1. Covered Positions
2. Capital Requirement for Market Risk
3. Internal Models-Based Capital Requirement
4. Specific Risk
5. Calculation of the Risk-Based Capital Ratio
II. Proposed Revisions to the Market Risk Capital Rule
A. Objectives of the Proposed Revisions
B. Description of the Proposed Revisions to the Market Risk
Capital Rule
1. Scope
2. Reservation of Authority
3. Modification of the Definition of Covered Position
4. Requirements for the Identification of Trading Positions and
Management of Covered Positions
5. General Requirements for Internal Models
Model Approval and Ongoing Use Requirements
Risks Reflected in Models
Control, Oversight, and Validation Mechanisms
Internal Assessment of Capital Adequacy
Documentation
6. Capital Requirement for Market Risk
Determination of the Multiplication Factor
7. VaR-Based Capital Requirement
Quantitative Requirements for VaR-based Measure
8. Stressed VaR-Based Capital Requirement
Quantitative Requirements for Stressed VaR-based Measure
9. Revised Modeling Standards for Specific Risk
10. Standardized Specific Risk Capital Requirement
Debt Positions
Equity Positions
Securitization Positions
11. Incremental Risk Capital Requirement
12. Comprehensive Risk Capital Requirement
13. Disclosure Requirements
III. Regulatory Flexibility Act Analysis
IV. OCC Unfunded Mandates Reform Act of 1995 Determination
V. Paperwork Reduction Act
VI. Plain Language
I. Introduction
A. Background
The first international capital framework for banks \1\ entitled
International Convergence of Capital Measurement and Capital Standards
(1988 Capital Accord) was developed by the Basel Committee on Banking
Supervision (BCBS) \2\ and endorsed by the G-10 governors in 1988. The
OCC, the Board, and the FDIC (collectively, the agencies) implemented
the 1988 Capital Accord in 1989 through the issuance of the general
risk-based capital rules.\3\ In 1996, the BCBS amended the 1988 Capital
Accord to require banks to measure and hold capital to cover their
exposure to market risk associated with foreign exchange and commodity
positions and positions located in the trading account (the Market Risk
Amendment (MRA) or market risk framework).\4\ The agencies implemented
the MRA with an effective date of January 1, 1997 (market risk capital
rule).\5\
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\1\ For simplicity, and unless otherwise indicated, the preamble
to this notice of proposed rulemaking uses the term ``bank'' to
include banks, savings associations, and bank holding companies
(BHCs). The terms ``bank holding company'' and ``BHC'' refer only to
bank holding companies regulated by the Board.
\2\ The BCBS is a committee of banking supervisory authorities,
which was established by the central bank governors of the G-10
countries in 1975. It consists of senior representatives of bank
supervisory authorities and central banks from Argentina, Australia,
Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR,
India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the
Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain,
Sweden, Switzerland, Turkey, the United Kingdom, and the United
States. Documents issued by the BCBS are available through the Bank
for International Settlements Web site at http://www.bis.org.
\3\ The agencies' general risk-based capital rules are at 12 CFR
part 3, Appendix A (OCC); 12 CFR part 208, Appendix A and 12 CFR
part 225, Appendix A (Board); and 12 CFR part 325, Appendix A
(FDIC).
\4\ In 1997, the BCBS modified the MRA to remove a provision
pertaining to the specific risk capital charge under the internal
models approach (see http://www.bis.org/press/p970918a.htm).
\5\ 61 FR 47358 (September 6, 1996). The agencies' market risk
capital rules are at 12 CFR part 3, Appendix B (OCC), 12 CFR part
208, Appendix E and 12 CFR part 225, Appendix E (Board), and 12 CFR
part 325, Appendix C (FDIC).
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In June 2004, the BCBS issued a document entitled International
Convergence of Capital Measurement and Capital Standards: A Revised
Framework (New Accord or Basel II), which was intended for use by
individual countries as the basis for national consultation and
implementation. The New Accord sets forth a ``three-pillar'' framework
that includes (i) risk-based capital requirements for credit risk,
market risk, and operational risk (Pillar 1); (ii) supervisory review
of capital adequacy (Pillar 2); and (iii) market discipline through
enhanced public disclosures (Pillar 3).
The New Accord retained much of the MRA; however, after its
release, the BCBS announced that it would develop improvements to the
market risk framework, especially with respect to the treatment of
specific risk, which refers to the risk of loss on a position due to
factors other than broad-based movements in market prices. As a result,
in July 2005, the BCBS and the International Organization of Securities
Commissions (IOSCO) published The Application of Basel II to Trading
Activities and the Treatment of Double Default Effects. The BCBS
incorporated the July 2005 changes into the June 2006 comprehensive
version of the New Accord and follow its ``three-pillar'' structure.
Specifically, the Pillar 1
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changes narrow the types of positions that are subject to the market
risk framework and revise modeling standards and procedures for
calculating minimum regulatory capital requirements; the Pillar 2
changes require banks to conduct internal assessments of their capital
adequacy with respect to market risk, taking into account the output of
their internal models, valuation adjustments, and stress tests; and the
Pillar 3 changes require banks to disclose certain quantitative and
qualitative information, including their valuation techniques for
covered positions, the soundness standard used for modeling purposes,
and their internal capital adequacy assessment methodologies.
In September 2006, the agencies issued a joint notice of proposed
rulemaking (2006 proposal) in which they proposed amendments to their
market risk capital rules that would implement the BCBS's changes to
the market risk framework.\6\ The BCBS began work on significant
changes to the market risk framework in 2007 due to issues highlighted
by the financial crisis. As a result, the agencies did not finalize the
2006 proposal. This joint notice of proposed rulemaking (proposed rule)
incorporates aspects of the agencies' 2006 proposal as well as further
revisions to the New Accord (and associated guidance) published by the
BCBS in July 2009. These publications include Revisions to the Basel II
Market Risk Framework, Guidelines for Computing Capital for Incremental
Risk in the Trading Book, and Enhancements to the Basel II Framework
(collectively, the 2009 revisions).
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\6\ 71 FR 55958, (September 25, 2006). The 2006 proposal was
issued jointly by the agencies and the Office of Thrift Supervision
(OTS). In the proposal, the OTS, which had not previously adopted
the MRA, proposed adopting a market risk capital rule.
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The 2009 revisions to the market risk framework place additional
prudential requirements on banks' internal models for measuring market
risk and require enhanced qualitative and quantitative disclosures,
particularly with respect to banks' securitization activities. The
revisions also introduce an incremental risk capital requirement to
capture default and credit quality migration risk for non-
securitization credit products. With respect to securitizations, the
2009 revisions require banks to apply the standardized measurement
method for specific risk to these positions, except for ``correlation
trading'' positions (described further below), for which banks may
choose to model all material price risks. The 2009 revisions also add a
stressed Value-at-Risk (VaR)-based capital requirement to banks' VaR-
based capital requirement under the existing framework. In June, 2010,
the BCBS published additional revisions to the market risk framework
that included establishing a floor on the risk-based capital
requirement for modeled correlation trading positions.\7\
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\7\ The June 2010 revisions can be found, in their entirety, at
http://bis.org/press/p100618/annex.pdf.
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These revisions to the market risk framework and other proposed
revisions are discussed more fully below. Part I.B. of this preamble
summarizes and provides background on the current market risk capital
rule. Part II describes the proposed revisions to the market risk
capital rule that incorporate aspects of the BCBS 2005 and 2009
revisions to the market risk framework.
Question 1: The agencies request comment on all aspects of the
proposed rule and specifically on whether and for what reasons certain
aspects of the proposed rule present particular implementation
challenges. Responses should be detailed as to the nature and impact of
such challenges. What, if any, specific approaches (for example,
transitional arrangements) should the agencies consider to address such
challenges and why?
B. Summary of the Current Market Risk Capital Rule
The current market risk capital rule supplements both the agencies'
general risk-based capital rules and the advanced capital adequacy
guidelines (advanced approaches rules) (collectively, the credit risk
capital rules) \8\ by requiring any bank subject to the market risk
capital rule to adjust its risk-based capital ratios to reflect market
risk in its trading activities. The rule applies to a bank with
worldwide, consolidated trading activity equal to 10 percent or more of
total assets, or $1 billion or more. The primary Federal supervisor of
a bank may apply the market risk capital rule to a bank if the
supervisor deems it necessary or appropriate for safe and sound banking
practices. In addition, the supervisor may exempt a bank that meets the
threshold criteria from application of the rule if the supervisor
determines the bank meets such criteria as a consequence of accounting,
operational, or similar considerations, and the supervisor deems such
an exemption to be consistent with safe and sound banking practices.
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\8\ The agencies' advanced approaches rules are at 12 CFR part
3, Appendix C (OCC); 12 CFR part 208, Appendix F and 12 CFR part
225, Appendix G (Board); and 12 CFR part 325, Appendix D (FDIC). For
purposes of this preamble, the term ``credit risk capital rules''
refers to the general risk-based capital rules and the advanced
approaches rules (that also apply to operational risk), as
applicable to the bank using the proposed rule.
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1. Covered Positions
The current market risk capital rule requires a bank to maintain
regulatory capital against the market risk of its covered positions.
Covered positions are defined as all on- and off-balance sheet
positions in the bank's trading account (as defined in the instructions
to the Consolidated Reports of Condition and Income (Call Report) or to
the FR Y-9C Consolidated Financial Statements for Bank Holding
Companies (FR Y-9C)), and all foreign exchange and commodity positions,
whether or not they are in the trading account. Covered positions
exclude all positions in the trading account that, in form or
substance, act as liquidity facilities that provide liquidity support
to asset-backed commercial paper.
2. Capital Requirement for Market Risk
The current market risk capital rule defines market risk as the
risk of loss resulting from movements in market prices. Market risk
consists of general market risk and specific risk components. General
market risk is defined as changes in the market value of positions
resulting from broad market movements, such as changes in the general
level of interest rates, equity prices, foreign exchange rates, or
commodity prices. Specific risk is defined as changes in the market
value of a position due to factors other than broad market movements
and includes event and default risk, as well as idiosyncratic risk.\9\
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\9\ Idiosyncratic risk is the risk of loss in the value of a
position that arises from changes in risk factors unique to that
position. Event risk is the risk of loss on a position that could
result from sudden and unexpected large changes in market prices or
specific events other than the default of the issuer. Default risk
is the risk of loss on a position that could result from the failure
of an obligor to make timely payments of principal or interest on
its debt obligation, and the risk of loss that could result from
bankruptcy, insolvency, or similar proceeding. For credit
derivatives, default risk means the risk of loss on a position that
could result from the default of the reference exposure(s).
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A bank that is subject to the market risk capital rule is required
to use an internal model to calculate a VaR-based measure of its
exposure to market risk. A bank's total risk-based capital requirement
for covered positions generally consists of a VaR-based capital
requirement plus an add-on for specific risk, if specific risk is not
captured in the bank's internal VaR model.\10\ The VaR-based capital
requirement is based
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on an estimate of the amount that the value of one or more positions
could decline over a stated time horizon and at a stated confidence
level. A bank may determine its capital requirement for specific risk
using a standardized method or, with supervisory approval, may use
internal models to measure its minimum capital requirement for specific
risk.
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\10\ The primary Federal supervisor of a bank may also permit
the use of alternative techniques to measure the market risk of de
minimis exposures, if the techniques adequately measure associated
market risk.
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3. Internal Models-Based Capital Requirement
In calculating the capital requirement for market risk, a bank is
required to use an internal model that meets specified qualitative and
quantitative criteria. The qualitative requirements reflect basic
components of sound market risk management. For example, the current
market risk capital rule requires an independent risk control unit that
reports directly to senior management and an internal risk measurement
model that is integrated into the daily management process. The
quantitative criteria include the use of a VaR-based measure based on a
99.0 percent, one-tailed confidence level. The VaR-based measure must
be based on a price shock equivalent to a 10-business-day movement in
rates or prices. Price changes estimated using shorter time periods
must be adjusted to the 10-business-day standard. The minimum effective
historical observation period for deriving the rate or price changes is
one year and data sets must be updated at least every three months or
more frequently if market conditions warrant. In all cases, under the
current rule, a bank must have the capability to update its data sets
more frequently than every three months in anticipation of market
conditions that would require such updating.
A bank need not use a single model to calculate its VaR-based
measure. A bank's internal model may use any generally accepted
approach, such as variance-covariance models, historical simulations,
or Monte Carlo simulations. However, the level of sophistication of the
bank's internal model must be commensurate with the nature and size of
the positions it covers. The 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, equity
price risk, foreign exchange rate risk, and commodity price risk.
The current market risk capital rule imposes backtesting
requirements that must be calculated quarterly. A bank must compare its
daily VaR-based measure for each of the preceding 250 business days to
its actual daily trading profit or loss, which typically includes
realized and unrealized gains and losses on portfolio positions as well
as fee income and commissions associated with trading activities. If
the quarterly backtesting shows that the bank's daily net trading loss
exceeded its corresponding daily VaR-based measure, a backtesting
exception has occurred. If a bank experiences more than four
backtesting exceptions over the preceding 250 business days, it is
generally required to apply a multiplication factor in excess of 3 when
it calculates its risk-based capital ratio (see section I.B.5 of this
preamble).
A bank subject to the market risk capital rule is also required to
conduct stress tests to assess the impact of adverse market events on
its positions. The market risk capital rule does not prescribe specific
stress-testing methodologies.
4. Specific Risk
Under the current market risk capital rule, a bank may use an
internal model to measure its exposure to specific risk if it has
demonstrated to its primary Federal supervisor that the model measures
the specific risk, including event and default risk, as well as
idiosyncratic risk, of its debt and equity positions. A bank that
incorporates specific risk in its internal model but fails to
demonstrate that the model adequately measures all aspects of specific
risk is subject to a specific risk add-on. In this case, if the bank
can validly separate its VaR-based measure into a specific risk portion
and a general market risk portion, the add-on is equal to the previous
day's specific risk portion. If the bank cannot separate the VaR-based
measure into a specific risk portion and a general market risk portion,
the add-on is equal to the sum of the previous day's VaR-based measures
for subportfolios of debt and equity positions that contain specific
risk.
If the bank does not model specific risk, it must calculate its
specific risk capital requirement, or ``add-on,'' using a standardized
method.\11\ Under this method, the specific risk add-on for debt
positions is calculated by multiplying the absolute value of the
current market value of each net long and net short position in a debt
instrument by the appropriate specific risk-weighting factor in the
rule. These specific risk-weighting factors range from zero to 8.0
percent and are based on the identity of the obligor and, in the case
of some positions, the credit rating and remaining contractual maturity
of the position. Derivative instruments are risk-weighted according to
the market value of the effective notional amount of the underlying
position. A bank may net long and short debt positions (including
derivatives) in identical debt issues or indices. A bank may also
offset a ``matched'' position in a derivative and its corresponding
underlying instrument.
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\11\ See section 5(c) of the agencies' market risk capital rules
for a description of this method.
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Under the standardized method, the specific risk add-on for equity
positions is the sum of the bank's net long and short positions in an
equity, multiplied by a specific risk-weighting factor. A bank may net
long and short positions (including derivatives) in identical equity
issues or equity indices in the same market. The specific risk add-on
is 8.0 percent of the net equity position, unless the bank's portfolio
is both liquid and well-diversified, in which case the specific risk
add-on is 4.0 percent. For positions that are index contracts
comprising a well-diversified portfolio of equities, the specific risk
add-on is 2.0 percent of the net long or net short position in the
index.\12\
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\12\ In addition, for futures contracts on broadly based indices
that are matched by offsetting equity baskets, a bank may apply a
2.0 percent specific risk requirement to the futures and stock
basket positions if the basket comprises at least 90 percent of the
capitalization of the index. The 2.0 percent specific risk
requirement applies to only one side of certain futures-related
arbitrage strategies when either: (i) The long and short positions
are in exactly the same index at different dates or in different
markets; or (ii) the long and short positions are in different but
similar indices at the same date.
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5. Calculation of the Risk-Based Capital Ratio
A bank subject to the current market risk capital rule must
calculate its adjusted risk-based capital ratios as follows. First, the
bank must calculate its adjusted risk-weighted assets, which equals its
risk-weighted assets calculated under the general risk-based capital
rule excluding the risk-weighted amounts of covered positions (except
foreign exchange positions outside the trading account and over-the-
counter derivative instruments) \13\ and cash-secured securities
borrowing receivables that meet the criteria of the market risk capital
rule.
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\13\ Foreign exchange positions outside the trading account and
all over-the-counter derivative positions, regardless of whether
they are in the trading account, must be included in a bank's risk-
weighted assets as determined under the general risk-based capital
rules.
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The bank then must calculate its measure for market risk, which
equals the sum of the VaR-based capital requirement for market risk,
the specific risk add-on (if any), and the capital
[[Page 1894]]
requirement for de minimis exposures (if any). The VaR-based capital
requirement equals the greater of (i) the previous day's VaR-based
measure; or (ii) the average of the daily VaR-based measures for each
of the preceding 60 business days multiplied by three, or such higher
multiplier as may be required under the backtesting requirements of the
market risk capital rule. The measure for market risk is multiplied by
12.5 to calculate market-risk-equivalent assets. The market-risk-
equivalent assets are added to adjusted risk-weighted assets to compute
the denominator of the bank's risk-based capital ratio.
To calculate the numerator, the bank must allocate tier 1 and tier
2 capital equal to 8.0 percent of adjusted risk-weighted assets, and
further allocate excess tier 1, excess tier 2, and tier 3 \14\ capital
equal to the measure for market risk. The sum of tier 2 and tier 3
capital allocated for market risk may not exceed 250 percent of tier 1
capital. As a result, tier 1 capital must equal at least 28.6 percent
of the measure for market risk. The sum of tier 2 (both allocated and
excess) and allocated tier 3 capital may not exceed 100 percent of tier
1 capital (both allocated and excess). Term subordinated debt and
intermediate-term preferred stock and related surplus included in tier
2 capital (both allocated and excess) may not exceed 50 percent of tier
1 capital (both allocated and excess). The sum of tier 1 and tier 2
capital (both allocated and excess) and allocated tier 3 capital is the
numerator of the bank's total risk-based capital ratio.
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\14\ Tier 1 and tier 2 capital are defined in the general risk-
based capital rules. 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 primary Federal supervisor, includes a lock-in clause
precluding payment of either interest or principal (even at
maturity) if the payment would cause the issuing bank's risk-based
capital ratio to fall or remain below the minimum required under the
credit risk capital rules, and does not contain and is not covered
by any covenants, terms, or restrictions that are inconsistent with
safe and sound banking practices.
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II. Proposed Revisions to the Market Risk Capital Rule
A. Objectives of the Proposed Revisions
The key objectives of the proposed revisions to the current market
risk capital rule are to enhance the rule's sensitivity to risks that
are not adequately captured by the current rule; to enhance modeling
requirements in a manner that is consistent with advances in risk
management since the initial implementation of the rule; to modify the
definition of covered position to better capture positions for which
treatment under the rule is appropriate; to address shortcomings in the
modeling of certain risks; to address certain procyclicality concerns;
and to increase transparency through enhanced disclosures. The
objective of enhancing the risk sensitivity of the rule is particularly
important because of banks' increased exposure to traded credit
products, such as credit default swaps (CDSs) and asset-backed
securities, in other structured products, and in less liquid products.
The risks of these products are generally not fully captured in current
VaR models, which rely on a 10-business-day, one-tail, 99.0 percent
confidence level soundness standard.
For example, the growth in traded credit products has increased
default and credit migration risks that should be captured in a
regulatory capital requirement for specific risk but have proved
difficult to capture adequately within current specific risk models.
The agencies did not contemplate risks associated with less liquid
credit products when the market risk capital rule was first adopted.
Therefore, the agencies propose to implement an incremental risk
capital requirement that would apply to a bank that models specific
risk for one or more portfolios of debt or, if applicable, equity
positions, and to incorporate explicit measures of liquidity.
In addition, to address the agencies' concerns about the
appropriate treatment of covered positions that have limited price
transparency, the agencies propose to require banks to have a well-
defined valuation process for all covered positions. The specific
proposals are discussed below.
B. Description of the Proposed Revisions to the Market Risk Capital
Rule
1. Scope
The proposed market risk capital rule does not change the set of
banks to which the rule applies. That is, the proposed rule continues
to apply to any bank with aggregate trading assets and trading
liabilities equal to 10 percent or more of total assets, or $1 billion
or more. The proposed rule applies to a bank that meets the market risk
capital rule applicability threshold regardless of whether the bank
uses the general risk-based capital rules or the advanced approaches
rules.
The primary Federal supervisor of a bank that does not meet the
threshold criteria may apply the market risk capital rule to the bank
if the supervisor deems it necessary or appropriate given the level of
market risk of the bank or to ensure safe and sound banking practices.
The primary Federal supervisor may also exclude a bank that meets the
threshold criteria from application of the rule if the supervisor
determines that the exclusion is appropriate based on the level of
market risk of the bank and is consistent with safe and sound banking
practices.
Question 2: The agencies seek comment on the appropriateness of the
proposed applicability thresholds. What, if any, alternative thresholds
should the agencies consider and why?
2. Reservation of Authority
The proposed rule contains a reservation of authority that affirms
the authority of a bank's primary Federal supervisor to require the
bank to hold an overall amount of capital greater than would otherwise
be required under the rule if the supervisor determines that the bank's
risk-based capital requirements under the rule are not commensurate
with the market risk of the bank's covered positions. In addition, the
agencies anticipate that there may be instances when the proposed rule
would generate a risk-based capital requirement for a specific covered
position or portfolio of covered positions that is not commensurate
with the risks of the covered position or portfolio. In these cases, a
bank's primary Federal supervisor may require the bank to assign a
different risk-based capital requirement to the covered position or
portfolio of covered positions that better reflects the risk of the
position or portfolio. The proposed rule also provides authority for a
bank's primary Federal supervisor to require the bank to calculate
capital requirements for specific positions or portfolios under the
market risk capital rule or under either the general risk-based capital
rules or advanced approaches rules, as appropriate, to more
appropriately reflect the risks of the positions.
3. Modification of the Definition of Covered Position
The proposed rule modifies the definition of a covered position to
include trading assets and trading liabilities (as reported on schedule
RC-D of the Call Report or Schedule HC-D of the Consolidated Financial
Statements for Bank Holding Companies) that are trading positions.
Under the proposal, a trading position is defined as a position that is
held by the bank for the purpose of short-term resale or with the
intent of benefiting from actual or expected short-term price
movements, or to lock in arbitrage profits. Thus, the characterization
of an
[[Page 1895]]
asset or liability as ``trading'' for purposes of U.S. Generally
Accepted Accounting Principles (GAAP) will not necessarily determine
whether the asset or liability is a ``trading position'' for purposes
of the proposed rule. Commenters on the 2006 proposal expressed
concerns that the proposed covered position definition would create
inconsistencies between the regulatory capital treatment of certain
trading assets and trading liabilities and the treatment of those
positions under GAAP. The agencies, however, continue to believe that
relying on the accounting definition of trading assets and trading
liabilities, without modification, would not be appropriate because it
includes positions that are not held with the intent or ability to
trade.
The proposed covered position definition includes trading assets
and trading liabilities that hedge covered positions. In addition, the
trading asset or trading liability must be free of any restrictive
covenants on its tradability or the bank must be able to hedge its
material risk elements in a two-way market. A trading asset or trading
liability that hedges a trading position is a covered position only if
the hedge is within the scope of the bank's hedging strategy (discussed
below). The agencies encourage the sound risk management of trading
positions. Therefore, the agencies include in the definition of a
covered position any hedges that offset the risk of trading positions.
The agencies are concerned, however, that a bank could craft its
hedging strategies in order to bring non-trading positions that are
more appropriately treated under the credit risk capital rules into the
bank's covered positions. The agencies will review a bank's hedging
strategies to ensure that they are not being manipulated in this
manner. For example, mortgage-backed securities that are not held with
the intent to trade, but that are hedged with interest rate swaps to
mitigate interest rate risk, would be subject to the credit risk
capital rules.
Consistent with the current definition of covered position, under
the proposed rule, a covered position also includes any foreign
exchange or commodity position, whether or not it is a trading asset or
trading liability. With prior supervisory approval, a bank may exclude
from its covered positions any structural position in a foreign
currency, which is defined as a position that is not a trading position
and that is (i) a subordinated debt, equity, or minority interest in a
consolidated subsidiary that is denominated in a foreign currency; (ii)
capital assigned to foreign branches that is denominated in a foreign
currency; (iii) a position related to an unconsolidated subsidiary or
another item that is denominated in a foreign currency and that is
deducted from the bank's tier 1 and tier 2 capital; or (iv) a position
designed to hedge a bank's capital ratios or earnings against the
effect of adverse exchange rate movements on (i), (ii), or (iii).
Also consistent with the current rule, the proposed definition of a
covered position explicitly excludes any position that, in form or
substance, acts as a liquidity facility that provides support to asset-
backed commercial paper. In addition, the definition of covered
position excludes all intangible assets, including servicing assets.
Intangible assets are excluded because their risks are explicitly
addressed in the credit risk capital rules, often through a deduction
from capital.
The proposed covered position definition excludes any equity
position that is not publicly traded, other than a derivative that
references a publicly traded equity; any direct real estate holding;
and any position that a bank holds with the intent to securitize.
Equity positions that are not publicly traded would include private
equity investments, most hedge fund investments, and other such
closely-held and non-liquid investments that are not easily marketable.
Direct real estate holdings include real estate for which the bank
holds title, such as ``other real estate owned'' held from foreclosure
activities, and bank premises used by a bank as part of its ongoing
business activities. With such real estate holdings, marketability and
liquidity are uncertain or even impractical as the assets are an
integral part of the bank's ongoing business. Indirect investments in
real estate, such as through real estate investment trusts or special
purpose vehicles, must meet the definition of a trading position in
order to be a covered position. Positions that a bank holds with the
intent to securitize include a ``pipeline'' or ``warehouse'' of loans
being held for securitization; the agencies do not view the intent to
securitize these positions as synonymous with the intent to trade them.
Consistent with the 2009 revisions, the agencies believe all of these
excluded positions have significant constraints in terms of a bank's
ability to liquidate them readily and value them reliably on a daily
basis.
The proposed covered position definition excludes a credit
derivative that the bank recognizes as a guarantee for purposes of
calculating the amount of risk-weighted assets under the credit risk
capital rules \15\ if it is used to hedge a position that is not a
covered position (for example, a credit derivative hedge of a loan that
is not a covered position). This requires the bank to include the
credit derivative in its risk-weighted assets for credit risk and
exclude it from its VaR-based measure for market risk. This proposed
treatment of a credit derivative hedge avoids the mismatch that arises
when the hedged position (for example, a loan) is not a covered
position and the credit derivative hedge is a covered position. This
mismatch has the potential to overstate the VaR-based measure of market
risk if only one side of the transaction were reflected in that
measure.
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\15\ See 12 CFR part 3, section 3 (OCC); 12 CFR part 208,
Appendix A, section II.B and 12 CFR part 225, Appendix A, section
II.B (Board); and 12 CFR part 325, Appendix A, section II.B.3
(FDIC). The treatment of guarantees is described in sections 33 and
34 of the advanced approaches rules.
---------------------------------------------------------------------------
Question 3: The agencies request comment on all aspects of the
proposed definition of covered position.
Under the proposed rule, in addition to commodities and foreign
exchange positions, covered positions include debt positions, equity
positions and securitization positions. The proposal defines a debt
position as a covered position that is not a securitization position or
a correlation trading position and that has a value that reacts
primarily to changes in interest rates or credit spreads. Examples of
debt positions include corporate and government bonds, certain
nonconvertible preferred stock, certain convertible bonds, and
derivatives (including written and purchased options) for which the
underlying instrument is a debt position.
The proposal defines an equity position as a covered position that
is not a securitization position or a correlation trading position and
that has a value that reacts primarily to changes in equity prices.
Examples of equity positions include voting or nonvoting common stock,
certain convertible bonds, commitments to buy or sell equity
instruments, equity indices, and a derivative for which the underlying
instrument is an equity position.
Under the proposal, a securitization is a transaction in which: (i)
All or a portion of the credit risk of one or more underlying exposures
is transferred to one or more third parties; (ii) the credit risk
associated with the underlying exposures has been separated into at
least two tranches that reflect different levels of seniority; (iii)
performance of the securitization exposures depends upon the
performance of the underlying exposures; (iv) all or substantially all
of
[[Page 1896]]
the underlying exposures are financial exposures (such as loans,
commitments, credit derivatives, guarantees, receivables, asset-backed
securities, mortgage-backed securities, other debt securities, or
equity securities); (v) for non-synthetic securitizations, the
underlying exposures are not owned by an operating company; \16\ (vi)
the underlying exposures are not owned by a small business investment
company described in section 302 of the Small Business Investment Act
of 1958 (15 U.S.C. 682); and (vii) the underlying exposures are not
owned by a firm an investment in which qualifies as a community
development investment under 12 U.S.C. 24 (Eleventh). Further, a bank's
primary Federal supervisor may determine that a transaction in which
the underlying exposures are owned by an investment firm that exercises
substantially unfettered control over the size and composition of its
assets, liabilities, and off-balance sheet exposures is not a
securitization based on the transaction's leverage, risk profile, or
economic substance. Generally, the agencies would consider investment
firms that can easily change the size and composition of their capital
structure, as well as the size and composition of their assets and off-
balance sheet exposures as eligible for exclusion from the
securitization definition under this provision. Based on a particular
transaction's leverage, risk profile, or economic substance, a bank's
primary Federal supervisor may deem an exposure to a transaction to be
a securitization exposure, even if the exposure does not meet the
criteria in provisions (v), (vi), or (vii) above. A securitization
position is a covered position that is (i) an on-balance sheet or off-
balance sheet credit exposure (including credit-enhancing
representations and warranties) that arises from a securitization
(including a resecuritization); or (ii) an exposure that directly or
indirectly references a securitization exposure described in (i) above.
---------------------------------------------------------------------------
\16\ In a synthetic securitization, a company uses credit
derivatives or guarantees to transfer a portion of the credit risk
of one or more underlying exposures to third-party protection
providers. The credit derivative or guarantee may be collateralized
or uncollateralized.
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A securitization position includes nth-to-default credit
derivatives and resecuritization positions. The proposal defines an
nth-to-default credit derivative as a credit derivative that provides
credit protection only for the nth-defaulting reference exposure in a
group of reference exposures. In addition, under the proposal, a
resecuritization is a securitization in which one or more of the
underlying exposures is a securitization exposure. A resecuritization
position is (i) an on- or off-balance sheet exposure to a
resecuritization; or (ii) an exposure that directly or indirectly
references a resecuritization exposure described in (i).
The proposal defines a correlation trading position as (i) a
securitization position for which all or substantially all of the value
of the underlying exposures is based on the credit quality of a single
company for which a two-way market exists, or on commonly traded
indices based on such exposures for which a two-way market exists on
the indices; or (ii) a position that is not a securitization position
and that hedges a position described in clause (i) above. Under the
proposed definition, a correlation trading position does not include a
resecuritization position, a derivative of a securitization position
that does not provide a pro rata share in the proceeds of a
securitization tranche, or a securitization position for which the
underlying assets or reference exposures are retail exposures,
residential mortgage exposures, or commercial mortgage exposures.
Correlation trading positions are typically not rated by external
credit rating agencies and may include CDO index tranches, bespoke CDO
tranches, and nth-to-default credit derivatives. Standardized CDS
indices and single-name CDSs are examples of instruments used to hedge
these positions. While banks typically hedge correlation trading
positions, hedging frequently does not reduce a bank's net exposure to
a position because the hedges often do not perfectly match the
position.
4. Requirements for the Identification of Trading Positions and
Management of Covered Positions
Section 3 of the proposal introduces new requirements for the
identification of trading positions and the management of covered
positions. The agencies believe that these new requirements are
warranted based on the inclusion of more credit risk-related, less
liquid, and less actively traded products in banks' covered positions.
The risks of these positions may not be fully reflected in the
requirements of the market risk capital rule and may be more
appropriately captured under credit risk capital rules.
The proposed rule requires a bank to have clearly defined policies
and procedures for determining which of its trading assets and trading
liabilities are trading positions as well as which of its trading
positions are correlation trading positions. In determining the scope
of trading positions, the bank must consider (i) the extent to which a
position (or a hedge of its material risks) can be marked-to-market
daily by reference to a two-way market; and (ii) possible impairments
to the liquidity of a position or its hedge.
In addition, the bank must have clearly defined trading and hedging
strategies. The bank's trading and hedging strategies for its trading
positions must be approved by senior management. The trading strategy
must articulate the expected holding period of, and the market risk
associated with, each portfolio of trading positions. The hedging
strategy must articulate for each portfolio the level of market risk
the bank is willing to accept and must detail the instruments,
techniques, and strategies the bank will use to hedge the risk of the
portfolio. The hedging strategy should be applied at the level at which
trading positions are risk managed at the bank (for example, trading
desk, portfolio levels).
The proposed rule requires a bank to have clearly defined policies
and procedures for actively managing all covered positions. In the
context of non-traded commodities and foreign exchange positions,
active management includes managing the risks of those positions within
the bank's risk limits. For all covered positions, these policies and
procedures, at a minimum, must require (i) marking positions to market
or model on a daily basis; (ii) assessing on a daily basis the bank's
ability to hedge position and portfolio risks and the extent of market
liquidity; (iii) establishment and daily monitoring of limits on
positions by a risk control unit independent of the trading business
unit; (iv) daily monitoring by senior management of the information
described in (i) through (iii) above; (v) at least annual reassessment
by senior management of established limits on positions; and (vi) at
least annual assessments by qualified personnel of the quality of
market inputs to the valuation process, the soundness of key
assumptions, the reliability of parameter estimation in pricing models,
and the stability and accuracy of model calibration under alternative
market scenarios.
The proposed rule introduces new requirements for the prudent
valuation of covered positions that include maintaining policies and
procedures for valuation, marking positions to market or to model,
independent price verification, and valuation adjustments or reserves.
The valuation process must consider, as appropriate, unearned credit
spreads, close-out costs, early termination costs, investing and
funding
[[Page 1897]]
costs, future administrative costs, liquidity, and model risk. These
new valuation requirements reflect the agencies' concerns about
deficiencies in banks' valuation of less liquid trading positions,
especially in light of the historical focus of the market risk capital
rule on a 10-business-day time horizon and a one-tail, 99.0 percent
confidence level, which has proved to be inadequate at times to reflect
the full extent of the risks of less liquid positions.
5. General Requirements for Internal Models
Model Approval and Ongoing Use Requirements. Under the proposed
rule, a bank must receive the prior written approval of its primary
Federal supervisor before using any internal model to calculate its
market risk capital requirement. The 2006 proposal included a
requirement that a bank receive prior written approval from its primary
Federal supervisor before extending the use of an approved model to an
additional business line or product type. Some commenters raised
concerns that this requirement might unduly impede a new product launch
pending regulatory approval. The agencies have not included this
requirement in the proposed rule. Instead, the proposal requires that a
bank promptly notify its primary Federal supervisor when the bank plans
to extend the use of a model that the primary Federal supervisor has
approved to an additional business line or product type.
The proposed rule also requires a bank to notify its primary
Federal supervisor promptly if it makes any change to its internal
models that would result in a material change in the bank's amount of
risk-weighted assets for a portfolio of covered positions or when the
bank makes any material change to its modeling assumptions. The bank's
primary Federal supervisor may rescind its approval, in whole or in
part, of the use of any internal model, and determine an appropriate
regulatory capital requirement for the covered positions to which the
model would apply, if it determines that the model no longer complies
with the market risk capital rule or fails to reflect accurately the
risks of the bank's covered positions. For example, if adverse market
events or other developments reveal that a material assumption in a
bank's approved model is flawed, the bank's primary Federal supervisor
may require the bank to revise its model assumptions and resubmit the
model specifications for review by the supervisor.
Financial markets evolve rapidly, and internal models that were
state-of-the-art at the time they were approved for use in risk-based
capital calculations can become less relevant as the risks of covered
positions evolve and as the industry develops more sophisticated
modeling techniques that better capture material risks. The proposed
rule therefore requires a bank to review its internal models
periodically, but no less frequently than annually, in light of
developments in financial markets and modeling technologies, and to
enhance those models as appropriate to ensure that they continue to
meet the agencies' standards for model approval and employ risk
measurement methodologies that are most appropriate for the bank's
covered positions. It is essential that a bank continually improve its
models to ensure that its market risk capital requirement reflects the
risk of the bank's covered positions. A bank's primary Federal
supervisor will closely scrutinize the bank's model review practices as
a matter of safety and soundness.
To support the model review and enhancement requirement discussed
above, the agencies are considering imposing a capital supplement in
circumstances in which a bank's internal model continues to meet the
qualification requirements of the rule, but develops specific
shortcomings in risk identification, risk aggregation and
representation, or validation. The regulatory capital supplement would
reflect the materiality of these shortcomings associated with the
bank's current model and could result in a risk-weighted assets
surcharge that would apply until such time that the bank enhances its
model to the satisfaction of its primary Federal supervisor. For
example, the capital supplement could take the form of a model risk
multiplier similar to the backtesting multiplier for VaR-type models in
section 4 of the proposed rule. Depending on the materiality of the
shortcomings, the supervisor could increase the multiplier on any model
above three, generally subject to the restriction that the resulting
capital requirement not exceed the capital requirement that would apply
under the proposed rule's standardized measurement method for specific
risk.
Question 4: Under what circumstances should the agencies require a
model-specific capital supplement? What criteria could the agencies use
to apply capital supplements consistently across banks? Aside from a
capital supplement or withdrawal of model approval, how else could the
agencies address concerns about outdated models?
Risks Reflected in Models. Under the proposed rule, a bank must
incorporate its internal models into its risk management process and
integrate the internal models used for calculating its VaR-based
measure into its daily risk management process. The level of
sophistication of a bank's models must be commensurate with the
complexity and amount of its covered positions. To measure market risk,
a bank's internal models may use any generally accepted modeling
approach, including but not limited to variance-covariance models,
historical simulations, or Monte Carlo simulations. A bank's internal
models must properly measure all material risks in the covered
positions to which they are applied. The proposed rule requires that
risks arising from less liquid positions and positions with limited
price transparency be modeled conservatively under realistic market
scenarios. The proposed rule also requires a bank to have a rigorous
process for reestimating, reevaluating and updating its models to
ensure continued applicability and relevance.
Control, Oversight, and Validation Mechanisms. The proposed rule
maintains the current requirement that a bank have a risk control unit
that reports directly to senior management and is independent of its
business trading units. In addition, the proposed rule provides
specific model validation standards that are similar to those in the
advanced approaches rules. Specifically, the proposal requires a bank
to validate its internal models initially and on an ongoing basis. The
validation process must be independent of the internal models'
development, implementation, and operation, or the validation process
must be subjected to an independent review of its adequacy and
effectiveness. The review personnel do not necessarily have to be
external to the bank in order to achieve the required independence. A
bank should ensure that individuals who perform the review are not
biased in their assessment due to their involvement in the development,
implementation, or operation of the models.
Under the proposed rule, validation must include an evaluation of
the conceptual soundness of the internal models. This evaluation should
include evaluation of empirical evidence and documentation supporting
the methodologies used; important model assumptions and their
limitations; adequacy and robustness of empirical data used in
parameter estimation and model calibration; and evidence of a model's
strengths and weaknesses.
[[Page 1898]]
Validation also must include an ongoing monitoring process that
includes a review and verification of processes and the comparison of
the bank's model outputs with relevant internal and external data
sources or estimation techniques. The results of this comparison
provide a valuable diagnostic tool for identifying potential weaknesses
in a bank's models. As part of this comparison, the bank should
investigate the source of any differences between the model estimates
and the relevant internal or external data or estimation techniques and
whether the extent of the differences is appropriate.
Validation of internal models must include an outcomes analysis
process that includes backtesting. Consistent with the 2009 revisions,
the proposed rule requires a bank's validation process for internal
models used to calculate its VaR-based measure to include an outcomes
analysis process that includes a comparison of the changes in the
bank's portfolio value that would have occurred were end-of-day
positions to remain unchanged (therefore, excluding fees, commissions,
reserves, net interest income, and intraday trading) with VaR-based
measures during a sample period not used in model development.
The proposed rule expands upon the current market risk rule's
stress-testing requirement. Specifically, the proposal requires a bank
to stress test the market risk of its covered positions at a frequency
appropriate to each portfolio, and in no case less frequently than
quarterly. The stress tests must take into account concentration risk,
illiquidity under stressed market conditions, and other risks arising
from the bank's trading activities that may not be captured adequately
in the bank's internal models. For example, it may be appropriate for a
bank to include in its stress testing the gapping of prices, one-way
markets, nonlinear or deep out-of-the-money products, jumps-to-default,
and significant changes in correlation. Relevant types of concentration
risk include concentration by name, industry, sector, country, and
market. Market concentration occurs when a bank holds a position that
represents a concentrated share of the market for a security, and thus
requires a longer than usual liquidity horizon to liquidate the
position without impacting the market. A bank's primary Federal
supervisor would evaluate the robustness and appropriateness of a
bank's stress tests through the supervisory review process.
The proposed rule requires a bank to have an internal audit
function independent of business-line management that at least annually
assesses the effectiveness of the controls supporting the bank's market
risk measurement systems, including the activities of the business
trading units and independent risk control unit, compliance with
policies and procedures, and the calculation of the bank's measure for
market risk. The internal audit function should review the bank's
validation processes, including validation procedures,
responsibilities, results, timeliness, and responsiveness to findings.
Further, the internal audit function should evaluate the depth, scope,
and quality of the risk management system review process and conduct
appropriate testing to ensure that the conclusions of these reviews are
well-founded. At least annually, the internal audit function must
report its findings to the bank's board of directors (or a committee
thereof).
Internal Assessment of Capital Adequacy. The proposed rule requires
that a bank have a rigorous process for assessing its overall capital
adequacy in relation to its market risk. The assessment must take into
account market concentration and liquidity risks under stressed market
conditions, as well as other risks that may not be captured fully in
the VaR-based measure.
Documentation. Under the proposal, a bank must document adequately
all material aspects of its internal models, the management and
valuation of covered positions, its control, oversight, validation and
review processes and results, and its internal assessment of capital
adequacy. This documentation would facilitate the supervisory review
process as well as the bank's internal audit or other review
procedures.
6. Capital Requirement for Market Risk
As under the current rule, the proposed rule requires a bank to
calculate its risk-based capital ratio denominator as the sum of its
adjusted risk-weighted assets and market risk equivalent assets. To
calculate market risk equivalent assets, a bank must multiply its
measure for market risk by 12.5. Under the proposed rule, a bank's
measure for market risk equals the sum of its VaR-based capital
requirement, its stressed VaR-based capital requirement, any specific
risk add-ons, any incremental risk capital requirement, any
comprehensive risk capital requirement, and any capital requirement for
de minimis exposures, each calculated according to the requirements of
the proposed rule as discussed further below. No adjustments are
permitted to address potential double counting among any of these
components of a bank's measure for market risk.
Also, consistent with the current rule, under the proposed rule a
bank's VaR-based capital requirement equals the greater of (i) the
previous day's VaR-based measure, or (ii) the average of the daily VaR-
based measures for each of the preceding 60 business days multiplied by
three, or such higher multiplication factor required based on
backtesting results determined according to section 4 of the proposed
rule and discussed further below. Similarly, under the proposed rule, a
bank's stressed VaR-based capital requirement equals the greater of (i)
the most recent stressed VaR-based measure; or (ii) the average of the
weekly VaR-based measures for each of the preceding 12 weeks multiplied
by three, or such higher multiplication factor as required based on
backtesting results determined according to section 4 of the proposed
rule. The multiplication factor applicable to the stressed-VaR based
measure for purposes of this calculation is based on the backtesting
results for its VaR-based measure; there is no separate backtesting
requirement for the stressed VaR-based measure for purposes of
calculating a bank's measure for market risk.
The proposed rule requires a bank to include in its measure for
market risk any specific risk add-on as required under section 7(c) of
the proposed rule, determined using the standardized measurement method
described in section 10 of the proposed rule. The proposed rule also
requires a bank to include in its measure for market risk any capital
requirement for de minimis exposures. Specifically, a bank must add to
its measure for market risk the absolute value of the market value of
those de minimis exposures that are not captured in the bank's VaR-
based measure unless the bank has obtained prior written approval from
its primary Federal supervisor to calculate a capital requirement for
the de minimis exposures using alternative techniques that
appropriately measure the market risk associated with those exposures.
With regard to a bank's total risk-based capital numerator, the
proposed rule eliminates tier 3 capital and the associated allocation
methodologies.
Determination of the Multiplication Factor. The proposed rule
modifies the current rule's regulatory backtesting framework for
determining the multiplication factor based on the number of
backtesting exceptions. Under the current market risk capital rule, a
bank must compare its daily VaR-based measure to its actual daily
trading profit or loss, which typically includes realized and
unrealized gains and losses
[[Page 1899]]
on portfolio positions as well as fee income and commissions associated
with trading activities. Under the proposed rule, each quarter, a bank
must compare each of its most recent 250 business days' trading losses
(excluding fees, commissions, reserves, intra-day trading, and net
interest income) with the corresponding daily VaR-based measure
calibrated to a one-day holding period and at a one-tail, 99.0 percent
confidence level. The excluded components of trading profit and loss
are not modeled as part of the VaR-based measure. Therefore, excluding
them from the regulatory backtesting framework will improve the
accuracy of the backtesting and provide a better assessment of the
bank's internal model. Some commenters on the 2006 proposal raised
concerns with this requirement; however, the agencies continue to
believe that banks' trading and reporting systems are sufficiently
sophisticated to allow this type of backtesting.
Question 5: The agencies request comment on any challenges banks
may face in formulating the measure of trading loss as proposed,
particularly for smaller portfolios. More specifically, which, if any,
of the items to be excluded from a bank's measure of trading loss
(fees, commissions, reserves, intra-day trading, or net interest
income) present difficulties and what is the nature of such
difficulties?
7. VaR-Based Capital Requirement
Consistent with the current rule, section 5 of the proposed rule
requires a bank to use one or more internal models to calculate a daily
VaR-based measure that reflects general market risk for all covered
positions. The daily VaR-based measure also may reflect the bank's
specific risk for one or more portfolios of debt or equity positions
and must reflect the specific risk for any portfolios of correlation
trading positions that are modeled under section 9 of the proposed
rule.
The proposal adds credit spread risk to the list of risk categories
required to be captured in a bank's VaR-based measure (that is, in
addition to interest rate risk, equity price risk, foreign exchange
rate risk, and commodity price risk). The VaR-based measure may
incorporate empirical correlations within and across risk categories,
provided the bank validates and justifies the reasonableness of its
process for measuring correlations. If the VaR-based measure does not
incorporate empirical correlations across risk categories, the bank
must add the separate measures from its internal models used to
calculate the VaR-based measure for the appropriate market risk
categories to determine the bank's aggregate VaR-based measure. The
proposed rule continues to require models to include risks arising from
the nonlinear price characteristics of option positions or positions
with embedded optionality.
Consistent with the 2009 revisions, under the proposed rule, a bank
must be able to justify to the satisfaction of its primary Federal
supervisor the omission of any risk factors from the calculation of its
VaR-based measure that the bank includes in its pricing models. In
addition, a bank must demonstrate to the satisfaction of its primary
Federal supervisor the appropriateness of any proxies it uses to
capture the risks of the bank's actual positions for which such proxies
are used.
Quantitative Requirements for VaR-based Measure. The proposed rule
includes the same quantitative requirements for the daily VaR-based
measure as the current market risk capital rule. These include the one-
tail, 99.0 percent confidence level, a ten-business-day holding period,
and a historical observation period of at least one year.
To calculate VaR-based measures using a 10-day holding period, the
bank may calculate 10-business-day measures directly, or may convert
VaR-based measures using holding periods other than 10 business days to
the equivalent of a 10-business-day holding period. A bank that
converts its VaR-based measure in this manner must be able to justify
the reasonableness of its approach to the satisfaction of its primary
Federal supervisor. For example, a bank that computes its VaR-based
measure by multiplying a daily VaR amount by the square root of 10
(that is, using the square root of time) should demonstrate that daily
changes in portfolio value do not exhibit significant mean reversion,
autocorrelation, or volatility clustering.\17\
---------------------------------------------------------------------------
\17\ Using the square root of time assumes that daily portfolio
returns are independent and identically distributed (IID). When the
IID assumption is violated, the square root of time approximation is
not appropriate.
---------------------------------------------------------------------------
The proposed rule requires a bank's VaR-based measure to be based
on data relevant to the bank's actual exposures and of sufficient
quality to support the calculation of risk-based capital requirements.
The bank must update data sets at least monthly, or more frequently as
changes in market conditions or portfolio composition warrant. For
banks that use a weighting scheme or other method for identifying the
historical observation period, the bank must either: (i) Use an
effective observation period of at least one year in which the average
time lag of the observations is at least six months; or (ii)
demonstrate to its primary Federal supervisor that the method used is
more effective than that described in (i) at representing the
volatility of the bank's trading portfolio over a full business cycle.
In the latter case, a bank must update its data more frequently than
monthly and in a manner appropriate for the type of weighting scheme.
In general, a bank using a weighting scheme should update its data
daily. Because the most recent observations typically are the most
heavily weighted it is important to include these observations in the
bank's VaR-based measure.
The proposed rule requires a bank to retain and make available to
its primary Federal supervisor model performance information on
significant subportfolios. Taking into account the value and
composition of a bank's covered positions, the subportfolios must be
sufficiently granular to inform a bank and its supervisor about the
ability of the bank's VaR model to reflect risk factors appropriately.
A bank's primary Federal supervisor must approve the number of
subportfolios it uses for subportfolio backtesting. While the proposed
rule does not prescribe the basis for determining significant
subportfolios, the primary Federal supervisor may consider the bank's
evaluation of certain factors such as trading volume, product types and
number of distinct traded products, business lines, and number of
traders or trading desks.
The proposed rule requires a bank to retain and make available to
its primary Federal supervisor, with no less than a 60 day lag,
information for each subportfolio for each business day over the
previous two years (500 business days) that includes (i) A daily VaR-
based measure for the subportfolio calibrated to a one-tail, 99.0
percent confidence level; (ii) the daily profit or loss for the
subportfolio (that is, the net change in price of the positions held in
the portfolio at the end of the previous business day); and (iii) the
p-value of the profit or loss on each day (that is, the probability of
observing a loss greater than reported in (ii) above, based on the
model used to calculate the VaR-based measure described in (i) above).
Daily information on the probability of observing a loss greater
than that which occurred on any day is a useful metric for banks and
supervisors to assess the quality of a bank's VaR model. For example,
if a bank that used a historical simulation VaR model using the most
recent 500 business days
[[Page 1900]]
experienced a loss equal to the second worst day of the 500, it would
assign a probability of 0.004 (2/500) to that loss based on its VaR
model. Applying this process over a given period provides information
about the adequacy of the VaR model's ability to characterize the whole
distribution of losses, including information on the size and number of
backtesting exceptions. The requirement to create and retain this
information at the subportfolio level may help identify particular
products or business lines for which the model is not adequately
measuring risk.
Question 6: The agencies request comment on what, if any,
challenges exist with the proposed subportfolio backtesting
requirements described above. How might banks determine significant
subportfolios of covered positions that would be subject to these
requirements? What basis could be used to determine an appropriate
number of subportfolios? Is the p-value a useful statistic for
evaluating the efficacy of a bank's VaR model in gauging market risk?
What, if any, other statistics should the agencies consider and why?
The current market risk capital rule requires a bank to include in
its VaR-based measure only covered positions. In contrast, the proposed
rule allows a bank to include term repo-style transactions in its VaR-
based measure even though these positions may not meet the definition
of a covered position, provided the bank includes all such term repo-
style transactions consistently over time. Under the proposed rule, a
term repo-style transaction is a repurchase or reverse repurchase
transaction, or a securities borrowing or securities lending
transaction, including a transaction in which the bank acts as agent
for a customer and indemnifies the customer against loss, that has an
original maturity in excess of one business day, provided that it meets
certain requirements, including being based solely on liquid and
readily marketable securities or cash and subject to daily marking-to-
market and daily margin maintenance requirements.\18\ While repo-style
transactions typically are close adjuncts to trading activities, GAAP
traditionally has not permitted companies to report them as trading
assets or trading liabilities. Repo-style transactions included in the
VaR-based measure will continue to be subject to the requirements of
the credit risk capital rules for calculating capital for counterparty
credit risk.
---------------------------------------------------------------------------
\18\ See Section 2, ``Definitions,'' of the proposed rule for a
full definition of a term repo-style transaction.
---------------------------------------------------------------------------
8. Stressed VaR-based Capital Requirement
Under section 6 of the proposed rule, a bank must calculate at
least weekly a stressed VaR-based measure using the same internal
model(s) used to calculate its VaR-based measure. The stressed VaR-
based measure supplements the VaR-based measure, which, due to inherent
limitations, proved inadequate in producing capital requirements
appropriate to the level of losses incurred at many banks during the
financial market crisis that began in mid-2007. The stressed VaR-based
measure mitigates the procyclicality of the minimum capital
requirements for market risk and contributes to a more appropriate
measure of the risks of a bank's covered positions.
Quantitative Requirements for Stressed VaR-based Measure. To
determine the stressed VaR-based measure, a bank must use the same
model(s) used to calculate its VaR-based measure, but with model inputs
calibrated to reflect historical data from a continuous 12-month period
that reflects a period of significant financial stress appropriate to
the bank's current portfolio. The stressed VaR-based measure must be
calculated at least weekly and be no less than the bank's VaR-based
measure. The agencies generally expect that a bank's stressed VaR-based
measure will be substantially greater than its VaR-based measure.
The proposed rule requires a bank to have policies and procedures
that describe how it determines the period of significant financial
stress used to calculate the bank's stressed VaR-based measure, and to
be able to provide empirical support for the period used. These
policies and procedures must address (i) how the bank links the period
of significant financial stress used to calculate the stressed VaR-
based measure to the composition and directional bias of the bank's
current portfolio; and (ii) the bank's process for selecting,
reviewing, and updating the period of significant financial stress used
to calculate the stressed VaR-based measure and for monitoring the
appropriateness of the 12-month period in light of the bank's current
portfolio. The bank must obtain the prior approval of its primary
Federal supervisor for, and notify its primary Federal supervisor if
the bank makes any material changes to, these policies and procedures.
A bank's primary Federal supervisor may require it to use a different
period of significant financial stress in the calculation of the bank's
stressed VaR-based measure.
9. Revised Modeling Standards for Specific Risk
The proposed rule more clearly specifies the modeling standards for
specific risk and eliminates the current option for a bank to model
some but not all material aspects of specific risk for an individual
portfolio of debt or equity positions. As under the current market risk
capital rule, a bank may use one or more internal models to measure the
specific risk of a portfolio of debt or equity positions with specific
risk. A bank must also use one or more internal models to measure the
specific risk of a portfolio of correlation trading positions with
specific risk that are modeled under section 9 of the proposed rule. A
bank may not, however, model the specific risk of securitization
positions that are not modeled under section 9 of the proposed rule.
This treatment addresses regulatory arbitrage opportunities as well as
deficiencies in the modeling of securitization positions that became
more evident during the course of the financial market crisis that
began in mid-2007.
Under the proposed rule, the internal models must explain the
historical price variation in the portfolio, be responsive to changes
in market conditions, be robust to an adverse environment, and capture
all material aspects of specific risk for the debt and equity
positions. Specifically, the proposed revisions require that a bank's
internal models capture event risk and idiosyncratic risk; capture and
demonstrate sensitivity to material differences between positions that
are similar but not identical; and capture and demonstrate sensitivity
to changes in portfolio composition and concentrations. If a bank
calculates an incremental risk measure for a portfolio of debt or
equity positions under section 8 of the proposed rule, the bank is not
required to capture default and credit migration risks in its internal
models used to measure the specific risk of those portfolios.
Under the current market risk capital rule, if a bank incorporates
specific risk in its internal model but fails to demonstrate to its
primary Federal supervisor that its internal model adequately measures
all aspects of specific risk for a portfolio of debt and equity
positions, the bank is subject to an internal models-based specific
risk add-on for that portfolio. In contrast, the proposed rule requires
a bank that does not have an approved internal model that captures all
material aspects of specific risk for a particular portfolio of
[[Page 1901]]
debt, equity, or correlation trading positions to use the standardized
measurement method (described in section 10 of the proposed rule) to
calculate a specific risk add-on for that portfolio. This proposed
change reflects the agencies' interest in creating incentives for more
robust specific risk modeling. Due to concerns about the ability of a
bank to model the specific risk of certain securitization positions,
the proposed rule requires a bank to calculate a specific risk add-on
under the standardized measurement method for all of its securitization
positions that are not correlation trading positions modeled under
section 9 of the proposed rule. The agencies note that not all debt,
equity, or securitization positions have specific risk (for example,
certain interest rate swaps). Under the proposed rule, there is no
specific risk capital requirement for positions without specific risk.
A bank should have clear policies and procedures for determining
whether a position has specific risk.
While the proposed rule continues to provide for flexibility and a
combination of approaches to measure market risk, including the use of
different models to measure the general market risk and the specific
risk of one or more portfolios of debt and equity positions, the
agencies strongly encourage banks to develop and implement models that
integrate the measurement of VaR for general market risk and specific
risk. A bank's use of a combination of approaches would be subject to
supervisory review to ensure that the overall capital requirement for
market risk is commensurate with the risks of the bank's covered
positions.
10. Standardized Specific Risk Capital Requirement
The proposed rule requires a bank to calculate a total specific
risk add-on for each portfolio of debt and equity positions for which
the bank's VaR-based measure does not capture all material aspects of
specific risk and for each of its securitization positions that is not
modeled under section 9 of the proposed rule. A bank must calculate
each specific risk add-on in accordance with the requirements of the
proposed rule. The bank must add the total specific risk add-on for
each portfolio of positions to the bank's measure for market risk. The
specific risk add-on for an individual debt or securitization position
that represents purchased credit protection is capped at the market
value of the protection.
For debt, equity, and securitization positions that are derivatives
with linear payoffs (for example, futures, equity swaps), a bank must
apply a risk weighting factor to the market value of the effective
notional amount of the underlying instrument or index portfolio. For
debt, equity, and securitization positions that are derivatives with
nonlinear payoffs (for example, options, interest rate caps, tranched
positions), a bank must apply a risk weighting factor to the market
value of the effective notional amount of the underlying instrument or
portfolio multiplied by the derivative's delta (that is, the change of
the derivative's value relative to changes in the price of the
reference exposure). For a standard interest rate derivative, the
effective notional amount refers to the apparent or stated notional
principal amount. If the contract contains a multiplier or other
leverage enhancement, the apparent or stated notional principal amount
must be adjusted to reflect the effect of the multiplier or leverage
enhancement in order to determine the effective notional amount. A swap
must be included as an effective notional position in the underlying
debt, equity, or securitization instrument or portfolio, with the
receiving side treated as a long position and the paying side treated
as a short position. Consistent with the current rules, a bank may net
long and short positions (including derivatives) in identical issues or
identical indices. A bank may also net positions in depositary receipts
against an opposite position in an identical equity in different
markets, provided that the bank includes the costs of conversion.
The proposed rule also expands the recognition of hedging effects
for debt and securitization positions. A set of transactions consisting
of either a debt position and its credit derivative hedge or a
securitization position and its credit derivative hedge has a specific
risk add-on of zero if the debt or securitization position is fully
hedged by a total return swap (or similar instrument where there is a
matching of payments and changes in market value of the position) and
there is an exact match between the reference obligation, the maturity,
and the currency of the swap and the debt or securitization position.
If a set of transactions consisting of either a debt position and
its credit derivative hedge or a securitization position and its credit
derivative hedge does not meet the criteria for no specific risk add-
on, the specific risk add-on for the set of transactions is equal to
20.0 percent of the specific risk add-on for the side of the
transaction with the higher specific risk add-on, provided that the
credit risk of the position is fully hedged by a credit default swap
(or similar instrument), and there is an exact match between the
reference obligation of the credit derivative hedge and the debt or
securitization position, the maturity of the credit derivative hedge
and the debt or securitization position, and the currency of the credit
derivative hedge and the debt or securitization position. For a set of
transactions that consists of either a debt position and its credit
derivative hedge or a securitization position and its credit derivative
hedge that does not meet the criteria for full offset or the 80.0
percent offset described above (for example, there is mismatch in the
maturity of the credit derivative hedge and that of the debt or
securitization position), but in which all or substantially all of the
price risk has been hedged, the specific risk add-on is equal to the
specific risk add-on for the side of the transaction with the larger
specific risk add-on.
Debt and Securitization Positions. While most securitization
positions are considered debt positions under the current market risk
capital rule, the agencies distinguish between securitization positions
and debt positions in the proposed rule because of new proposed
requirements that are uniquely applicable to securitization positions.
Under the proposed rule, the total specific risk add-on for a portfolio
of debt or securitization positions is the sum of the specific risk
add-ons for individual debt or securitization positions, which are
determined by multiplying the absolute value of the current market
value of each net long or net short debt or securitization position by
an appropriate risk-weighting factor for the position.
The 2005 revisions to the market risk framework incorporated
changes to the standardized measurement method used for calculating the
specific risk add-ons for debt positions. For example, the
``government'' category was expanded to include all sovereign debt, and
the specific risk-weighting factor for sovereign debt was changed from
zero percent to a range from zero to 12.0 percent based on the external
rating of the obligor and the remaining contractual maturity of the
debt position. Table 1 below provides an illustrative representation of
the specific risk-weighting factors applicable to debt positions in the
``government,'' ``qualifying,'' and ``other'' categories under the
market risk framework.
[[Page 1902]]
Table 1--Specific Risk-Weighting Factors for Debt Positions
----------------------------------------------------------------------------------------------------------------
Specific
Illustrative external rating Remaining contractual risk (%)
Category description maturity weight
factor
----------------------------------------------------------------------------------------------------------------
Government........................... Highest investment grade to ............................. 0.00
second highest investment
grade (for example, AAA to
AA-).
Third highest investment Residual term to final 0.25
grade to lowest investment maturity 6 months or less.
grade (for example, A+ to
BBB-).
Residual term to final 1.00
maturity greater than 6 and
up to and including 24
months.
Residual term to final 1.60
maturity exceeding 24 months.
One category below investment ............................. 8.00
grade to two categories
below investment grade (for
example, BB+ to B-).
More than two categories ............................. 12.00
below investment grade.
Unrated...................... ............................. 8.00
Qualifying........................... Not applicable............... Residual term to final 0.25
maturity 6 months or less.
Residual term to final 1.00
maturity greater than 6 and
up to and including 24
months.
Residual term to final 1.60
maturity exceeding 24 months.
Other................................ One category below investment ............................. 8.00
grade to two categories
below investment grade (for
example, BB+ to B-).
More than two categories ............................. 12.00
below investment grade, or
equivalent based on a bank's
internal ratings.
Unrated...................... ............................. 8.00
----------------------------------------------------------------------------------------------------------------
The 2009 revisions to the market risk framework also incorporated
changes to the specific risk-weighting factors under the standardized
measurement method for rated securitization and re-securitization
positions as well as other treatments for unrated securitization and
re-securitization positions. For rated positions, the revisions apply
risk weights according to whether the positions' external rating
represents a long-term credit rating or a short-term credit rating and
generally apply higher risk weights to rated re-securitization
positions than to other rated securitization positions. Tables 2 and 3
below provide illustrative representations of the specific risk-
weighting factors applicable to rated securitization and re-
securitization position under the market risk framework. This treatment
was designed to address regulatory arbitrage opportunities as well as
deficiencies in the modeling of securitization positions that became
more evident during the course of the financial market crisis that
began in mid-2007. This revised treatment also assigns a more risk-
sensitive capital requirement to securitization positions than applied
previously.
Table 2--Long-Term Credit Rating Specific Risk-Weighting Factors for Securitization and Re-Securitization
Positions
----------------------------------------------------------------------------------------------------------------
Securitization
exposure (that is
not a Resecuritization
Illustrative external rating Example resecuritization exposure risk-
description exposure) risk- weighting factor
weighting factor (%)
(%)
----------------------------------------------------------------------------------------------------------------
Highest investment grade rating........ AAA............................ 1.60 3.20
Second-highest investment grade rating. AA............................. 1.60 3.20
Third-highest investment grade rating.. A.............................. 4.00 8.00
Lowest investment grade rating......... BBB............................ 8.00 18.00
One category below investment grade.... BB............................. 28.00 52.00
Two categories below investment grade.. B.............................. 100.00 100.00
Three categories or more below CCC............................ 100.00 100.00
investment grade.
----------------------------------------------------------------------------------------------------------------
[[Page 1903]]
Table 3--Short-Term Credit Rating Specific Risk-Weighting Factors for Securitization and Re-Securitization
Positions
----------------------------------------------------------------------------------------------------------------
Securitization
exposure (that is
not a Resecuritization
Illustrative external rating description Example resecuritization exposure risk-
exposure) risk- weighting factor
weighting factor (%)
(%)
----------------------------------------------------------------------------------------------------------------
Highest investment grade rating............. A-1/P-1................... 1.60 3.20
Second-highest investment grade rating...... A-2/P-2................... 4.00 8.00
Third-highest investment grade rating....... A-3/P-3................... 8.00 18.00
All other ratings........................... N/A....................... 100.00 100.00
----------------------------------------------------------------------------------------------------------------
As a result of the recent enactment in the United States of the
Dodd-Frank Wall Street Reform and Consumer Protection Act \19\ (the
Act), the agencies may not reference or require reliance on credit
ratings in the assessment of the creditworthiness of a security or
money market instrument. The Act provides that each Federal agency,
after a required review of its regulations, must remove from each of
its regulations any reference to or requirement of reliance on credit
ratings and substitute a standard of creditworthiness the agency
determines is appropriate for the regulation.\20\
---------------------------------------------------------------------------
\19\ See Public Law 111-203 (July 21, 2010).
\20\ See section 939A of the Act.
---------------------------------------------------------------------------
The 2005 and 2009 BCBS revisions include provisions that rely on
credit ratings for determining the specific risk-weighting factors for
debt, securitization, and re-securitization positions. These provisions
would need to be revised when implemented in the U.S. in order to
conform to the Act. The agencies acknowledge that the specific risk
treatment for debt, securitization and re-securitization positions
outlined in Tables 1 through 3 would provide a more risk-sensitive
treatment for these positions than exists under the current rule;
however, pending the agencies' development of appropriate standards of
creditworthiness to replace use of credit ratings as required by the
Act, the proposed rule retains as a placeholder the current rule's
method for determining specific risk add-ons applicable to debt and
securitization positions. More specifically, the ``government,''
``qualifying,'' and ``other'' categories as described in the current
market risk capital rule and associated risk-weighting factors would
continue to apply to a bank's debt and securitization positions until
the agencies develop a substitute standard of creditworthiness to
replace reliance on credit ratings. For completeness and to ensure
uniformity of regulatory text across the agencies' rules, the proposed
rule includes in section 10(b) the current standardized measurement
method for these positions. The agencies acknowledge the shortcomings
of the current treatment and recognize that it will have to be amended
in accordance with the requirements of the Act. To the extent possible,
the amended treatment would seek to establish comparable capital
requirements for the affected positions in order to ensure
international consistency and competitive equity. At the same time, the
agencies believe it is important to move forward with the revisions to
the market risk rules contained in this proposal.\21\
---------------------------------------------------------------------------
\21\ The agencies also note that certain other provisions of the
Act may affect the market risk capital rules. For example, the
credit risk retention requirements of the Act may affect whether a
securitization position retained by a bank pursuant to the
requirements meets the definition of a trading position or a covered
position.
---------------------------------------------------------------------------
When the agencies determine a substitute standard of
creditworthiness for external ratings as required by the Act, they
intend to incorporate the new standard into their capital rules,
including the market risk rule. The agencies are currently reviewing
alternative approaches to the use of credit ratings across all of the
agencies' regulations and requirements with the goal of establishing a
uniform alternative credit-worthiness standard. The agencies have asked
for public input on this process through an advance notice of proposed
rulemaking (ANPR).\22\ The agencies noted in the ANPR that in
evaluating any standard of creditworthiness for purpose of determining
risk-based capital requirements, the agencies will, to the extent
practicable and consistent with the other objectives, consider whether
the standard would:
---------------------------------------------------------------------------
\22\ 75 FR 52283 (August 25, 2010).
---------------------------------------------------------------------------
Appropriately distinguish the credit risk associated with
a particular exposure within an asset class;
Be sufficiently transparent, unbiased, replicable, and
defined to allow banking organizations of varying size and complexity
to arrive at the same assessment of creditworthiness for similar
exposures and to allow for appropriate supervisory review;
Provide for the timely and accurate measurement of
negative and positive changes in creditworthiness;
Minimize opportunities for regulatory capital arbitrage;
Be reasonably simple to implement and not add undue burden
on banking organizations; and
Foster prudent risk management.
Question 7: What specific standards of creditworthiness that meet
the agencies' suggested criteria for a creditworthiness standard
outlined above should the agencies consider for these positions?
Under the proposed rule, the total specific risk add-on for a
portfolio of nth-to-default credit derivatives is the sum of the
specific risk add-ons for individual nth-to-default credit derivatives,
as computed therein. A bank must calculate a specific risk add-on for
each nth-to-default credit derivative position regardless of whether
the bank is a net protection buyer or net protection seller.
For first-to-default credit derivatives, the specific risk add-on
is the lesser of (i) the sum of the specific risk add-ons for the
individual reference credit exposures in the group of reference
exposures, and (ii) the maximum possible credit event payment under the
credit derivative contract. Where a bank has a risk position in one of
the reference credit exposures underlying a first-to-default credit
derivative and this credit derivative hedges the bank's risk position,
the bank is allowed to reduce both the specific risk add-on for the
reference credit exposure and that part of the specific risk add-on for
the credit derivative that relates to this particular reference credit
exposure such that its specific risk add-on for the pair reflects the
bank's net position in the reference credit exposure. Where a bank has
multiple risk positions in reference credit exposures underlying a
first-to-default credit derivative, this offset is allowed only for the
underlying
[[Page 1904]]
reference credit exposure having the lowest specific risk add-on.
For second-or-subsequent-to-default credit derivatives, the
specific risk add-on is the lesser of: (i) The sum of the specific risk
add-ons for the individual reference credit exposures in the group of
reference exposures, but disregarding the (n-1) obligations with the
lowest specific risk add-ons; or (ii) the maximum possible credit event
payment under the credit derivative contract. For second-or-subsequent-
to-default credit derivatives, no offset of the specific risk add-on
with an underlying reference credit exposure is allowed under the
proposed rule.
Equity Positions. Under the proposed rule, the total specific risk
add-on for a portfolio of equity positions is the sum of the specific
risk add-ons of the individual equity positions, which are determined
by multiplying the absolute value of the current market value of each
net long or short equity position by an appropriate risk-weighting
factor.
The proposed rule retains the specific risk add-ons applicable to
equity positions under the current market risk capital rule, with one
exception. Consistent with the 2009 revisions, the proposed rule
eliminates the provision that allows a bank to apply a specific risk-
weighting factor of 4.0 to an equity position held in a portfolio that
is both liquid and well-diversified. Instead, a bank must multiply the
absolute value of the current market value of each net long or short
equity position by a risk-weighting factor of 8.0 percent. For equity
positions that are index contracts comprising a well-diversified
portfolio of equity instruments, the absolute value of the current
market value of each net long or short position is multiplied by a
risk-weighting factor of 2.0 percent. A portfolio is well-diversified
if it contains a large number of individual equity positions, with no
single position representing a substantial portion of the portfolio's
total market value.
The proposed rule retains the specific risk treatment in the
current market risk capital rule for equity positions arising from
futures-related arbitrage strategies where long and short positions are
in exactly the same index at different dates or in different market
centers, or where long and short positions are in index contracts at
the same date in different but similar indices. The proposed rule also
retains the current treatment for futures contracts on main indices
that are matched by offsetting positions in a basket of stocks
comprising the index.
Due Diligence Requirements for Securitization Positions. The
proposed rule incorporates requirements from the 2009 revisions that
banks perform due diligence on securitization positions. The due
diligence requirements apply to all securitization positions and
emphasize the need for banks to conduct their own due diligence of
borrower creditworthiness, in addition to any use of third-party
assessments, and not place undue reliance on external credit ratings.
In order to meet the proposed due diligence requirements, a bank
must be able to demonstrate, to the satisfaction of its primary Federal
supervisor, a comprehensive understanding of the features of a
securitization position that would materially affect the performance of
the bank's securitization position. The bank's analysis must be
commensurate with the complexity of the securitization position and the
materiality of the position in relation to capital.
To support the demonstration of its comprehensive understanding,
for each securitization position, the bank must conduct and document an
analysis of the risk characteristics of a securitization position prior
to acquiring the position, considering: (i) Structural features of the
securitization that would materially impact the performance of the
position, for example, the contractual cash flow waterfall, waterfall-
related triggers, credit enhancements, liquidity enhancements, market
value triggers, the performance of organizations that service the
position, and deal-specific definitions of default; (ii) relevant
information regarding the performance of the underlying credit
exposure(s), for example, the percentage of loans 30, 60, and 90 days
past due; default rates; prepayment rates; loans in foreclosure;
property types; occupancy; average credit score or other measures of
creditworthiness; average LTV ratio; and industry and geographic
diversification data on the underlying exposure(s); (iii) relevant
market data of the securitization, for example, bid-ask spreads, most
recent sales price and historical price volatility, trading volume,
implied market rating, and size, depth and concentration level of the
market for the securitization; and (iii) for resecuritization
positions, performance information on the underlying securitization
exposures, for example, the issuer name and credit quality, and the
characteristics and performance of the exposures underlying the
securitization exposures. On an on-going basis, but no less frequently
than quarterly, the bank must also evaluate, review, and update as
appropriate the analysis required above for each securitization
position.
Question 8: What, if any, specific challenges are involved with
meeting the proposed due diligence requirements and for what types of
securitization positions? How might the agencies address these
challenges while still ensuring that a bank conducts an appropriate
level of due diligence commensurate with the risks of its covered
positions? For example, would it be appropriate to scale the
requirements according to a position's expected holding period? How
would such scaling affect a bank's ability to demonstrate a
comprehensive understanding of the risk characteristics of a
securitization position? What are the benefits and drawbacks of
requiring public disclosures regarding a bank's processes for
performing due diligence on its securitization positions?
The agencies are considering alternative methodologies to the
standardized measurement method for determining the specific risk
capital requirement for securitization positions to better recognize
the risk reduction benefits of hedging. Conceptually, such a
methodology could recognize some degree of offsetting between positions
that reference the same pool of assets but have different levels of
seniority, or between positions that reference similar but not
identical assets. For example, it could use a formulaic approach to
determine a degree of offset between securitization positions that are
similar to an index. Inputs to the formula could include factors such
as the attachment and detachment points of an individual securitization
position, the aggregate capital requirement of its underlying
exposures, and the percentage of underlying obligors common to the
securitization exposure and the index.
Question 9: What alternative non-models-based methodologies could
the agencies use to determine the specific risk add-ons for
securitization positions? Please provide specific details on the
mechanics of and rationale for any suggested methodology. Please also
describe how the methodology conservatively recognizes some degree of
hedging benefits, yet captures the basis risk between non-identical
positions. To what types of securitization positions would such a
methodology apply and why?
11. Incremental Risk Capital Requirement
Under section 8 of the proposed rule, a bank that measures the
specific risk of a portfolio of debt positions using internal models
must calculate an incremental risk measure for that portfolio using an
internal model
[[Page 1905]]
(incremental risk model). Incremental risk consists of the default risk
of a position (that is, the risk of loss on the position upon an event
of default (for example, the failure of the obligor to make timely
payments of principal or interest), including bankruptcy, insolvency,
or similar proceeding) and the credit migration risk of a position
(that is, price risk that arises from significant changes in the
underlying credit quality of the position).
With the prior approval of its primary Federal supervisor, a bank
may also include portfolios of equity positions in its incremental risk
model, provided that it consistently includes such equity positions in
a manner that is consistent with how the bank internally measures and
manages the incremental risk for such positions at the portfolio level.
Default is deemed to occur with respect to any equity position that is
included in the bank's incremental risk model upon the default of any
debt of the issuer of the equity position. A bank may not include
correlation trading positions or securitization positions in its
incremental risk model.
Under the proposed rule, a bank's model to measure the incremental
risk of a portfolio of debt positions (and equity positions, if
applicable) must meet certain requirements and be approved by the
bank's primary Federal supervisor before the bank may use it to
calculate its risk-based capital requirement. The model must measure
incremental risk over a one-year time horizon and at a one-tail, 99.9
percent confidence level, either under the assumption of a constant
level of risk, or under the assumption of constant positions.
The liquidity horizon of a position is the time that would be
required for a bank to reduce its exposure to, or hedge all of the
material risks of, the position(s) in a stressed market. The liquidity
horizon for a position may not be less than the lower of three months
or the contractual maturity of the position.
A position's liquidity horizon is a key risk attribute for purposes
of calculating the incremental risk measure because it puts a bank's
overall risk exposure to an actively managed portfolio into context.
Positions with longer (that is, less liquid) liquidity horizons are
more difficult to hedge and result in more exposure to both default and
credit migration risk over any fixed time horizon. In particular, two
positions with differing liquidity horizons but exactly the same amount
of default risk if held in a static portfolio over a one-year horizon
may exhibit significantly different amounts of default risk if held in
a dynamic portfolio in which hedging can occur in response to
observable changes in credit quality. The position with the shorter
liquidity horizon can be hedged more rapidly and with less cost in the
event of a change in credit quality, which leads to a different
exposure to default risk over a one-year horizon than the position with
the longer liquidity horizon.
A constant level of risk assumption assumes that the bank
rebalances, or rolls over, its trading positions at the beginning of
each liquidity horizon over a one-year horizon in a manner that
maintains the bank's initial risk level. The bank must determine the
frequency of rebalancing in a manner consistent with the liquidity
horizons of the positions in the portfolio. A constant position
assumption assumes that a bank maintains the same set of positions
throughout the one-year horizon. If a bank uses this assumption, it
must do so consistently across all portfolios for which it models
incremental risk. A bank has flexibility in whether it chooses to use a
constant risk or constant position assumption in its incremental risk
model; however, the agencies expect that the assumption will remain
fairly constant once selected. As with any material change to modeling
assumptions, the proposed rule requires a bank must promptly notify its
primary Federal supervisor if the bank changes from a constant risk to
a constant position assumption or vice versa. Further, to the extent a
bank estimates a comprehensive risk measure under section 9 of the
proposed rule, the bank's selection of a constant position or a
constant risk assumption must be consistent between the bank's
incremental risk model and comprehensive risk model. Similarly, the
bank's treatment of liquidity horizons must be consistent between a
bank's incremental risk model and comprehensive risk model.
The proposed rule requires a bank's incremental risk model to meet
the conditions described below. The model must recognize the impact of
correlations between default and credit migration events among
obligors. In particular, the existence of an aggregate, economy-wide
credit cycle implies some degree of correlation between the default and
credit migration events across different issuers. The degree of
correlation between default and credit migration events of different
issuers may also depend on other issuer attributes such as industry
sector or region of domicile. The model must also reflect the effect of
issuer and market concentrations, as well as concentrations that can
arise within and across product classes during stressed conditions.
The bank's incremental risk model must reflect netting only of long
and short positions that reference the same financial instrument and
must also reflect any material mismatch between a position and its
hedge. Examples of such mismatches include maturity mismatches as well
as mismatches between an underlying position and its hedge, (for
example, the use of an index position to hedge a single name security).
The bank's incremental risk model must also recognize the effect
that liquidity horizons have on hedging strategies. When a bank's
hedging strategy requires continual rebalancing of the hedge position,
the constraints on rebalancing imposed by the liquidity horizon of the
hedge must be recognized. As an example, if a position is being hedged
with an instrument with a liquidity horizon of three months, no
rebalancing of the hedge can occur within a three month period.
Accordingly, any divergence in the value of the position and its hedge
that occurs because the hedge cannot be rebalanced within the three
month liquidity horizon must be recognized. Moreover, in order to
reflect the effect of hedging in the incremental risk measure, the bank
must (i) Choose to model the rebalancing of the hedge consistently over
the relevant set of trading positions; (ii) demonstrate that the
inclusion of rebalancing results in a more appropriate risk
measurement; (iii) demonstrate that the market for the hedge is
sufficiently liquid to permit rebalancing during periods of stress; and
(iv) capture in the incremental risk model any residual risks arising
from such hedging strategies.
The incremental risk model must reflect the nonlinear impact of
options and other positions with material nonlinear behavior with
respect to default and credit migration changes. In light of the one-
year horizon of the incremental risk measure and the extremely high
confidence level required, it is important that nonlinearities be
explicitly recognized. Price changes resulting from defaults or credit
migrations can be large and the resulting nonlinear behavior of the
position can be material. The bank's incremental risk model must also
maintain consistency with the bank's internal risk management
methodologies for identifying, measuring, and managing risk.
A bank that calculates an incremental risk measure under section 8
of the proposed rule must calculate its incremental risk capital
requirement at
[[Page 1906]]
least weekly. This capital requirement is the greater of: (i) The
average of the incremental risk measures over the previous 12 weeks; or
(ii) the most recent incremental risk measure.
12. Comprehensive Risk Capital Requirement
Under section 9 of the proposed rule, with its primary Federal
supervisor's prior approval, a bank may measure all material price
risks of one or more portfolios of correlation trading positions
(comprehensive risk measure) using a model (comprehensive risk model).
If the bank uses a comprehensive risk model for a portfolio of
correlation trading positions, the bank must also measure the specific
risk of that portfolio using internal models that meet the requirements
in section 7(b) of the proposed rule. If the bank does not use a
comprehensive risk model to calculate the price risk of a portfolio of
correlation trading positions, it must calculate a specific risk add-on
for the portfolio under section 7(c) of the proposed rule, determined
using the standardized measurement method for specific risk described
in section 10 of the proposed rule.
A bank's comprehensive risk model must meet several requirements
under the proposed rule. The model must measure comprehensive risk
(that is, all price risk) consistent with a one-year time horizon and
at a one-tail, 99.9 percent confidence level, under the assumption of
either a constant level of risk or constant positions. As mentioned
under the incremental risk measure discussion, while a bank has
flexibility in whether it chooses to use a constant risk or constant
position assumption, the agencies expect that the assumption will
remain fairly constant once selected. The bank's selection of a
constant position assumption or a constant risk assumption must be
consistent between the bank's comprehensive risk model and its
incremental risk model. Similarly, the bank's treatment of liquidity
horizons must be consistent between the bank's comprehensive risk model
and its incremental risk model.
The proposed rule requires that a bank's comprehensive risk model
capture all material price risk of included positions, including, but
not limited to: (i) The risk associated with the contractual structure
of cash flows of the position, its issuer, and its underlying exposures
(for example, the risk arising from multiple defaults, including the
ordering of defaults, in tranched products); (ii) credit spread risk,
including nonlinear price risks; (iii) volatility of implied
correlations, including nonlinear price risks such as the cross-effect
between spreads and correlations; (iv) basis risks (for example, the
basis between the spread of an index and the spread on its constituents
and the basis between implied correlation of an index tranche and that
of a bespoke tranche); (v) recovery rate volatility as it relates to
the propensity for recovery rates to affect tranche prices; and (vi) to
the extent the comprehensive risk measure incorporates benefits from
dynamic hedging, the static nature of the hedge over the liquidity
horizon.
The risks above have been identified as risks that are particularly
important for correlation trading positions; however, the comprehensive
risk model is intended to capture all material price risks related to
those correlation trading positions that are included in the
comprehensive risk model. Accordingly, additional risks that are not
explicitly discussed above but are a material source of price risk must
be included in the comprehensive risk model.
The proposed rule also requires that a bank have sufficient market
data to ensure that it fully captures the material price risks of the
correlation trading positions in its comprehensive risk measure.
Moreover, the bank must be able to demonstrate that its model is an
appropriate representation of comprehensive risk in light of the
historical price variation of its correlation trading positions. The
agencies will scrutinize the positions a bank identifies as correlation
trading positions and will also review whether the correlation trading
positions have sufficient market data available to support reliable
modeling of material risks. If there is insufficient market data to
support reliable modeling for certain positions (such as new products),
the agencies may require the bank to exclude these positions from the
comprehensive risk model and, instead, require the bank to calculate
specific risk add-ons for these positions under the standardized
measurement method for specific risk. Again, the proposed rule requires
a bank to promptly notify its primary Federal supervisor if the bank
plans to extend the use of a model that has been approved by the
supervisor to an additional business line or product type.
In addition to these requirements, a bank must at least weekly
apply to its portfolio of correlation trading positions a set of
specific, supervisory stress scenarios that capture changes in default
rates, recovery rates, and credit spreads; correlations of underlying
exposures; and correlations of a correlation trading position and its
hedge. A bank must retain and make available to its primary supervisor
the results of the supervisory stress testing, including comparisons
with the capital requirements generated by the bank's comprehensive
risk model. A bank also must promptly report to its primary Federal
supervisor any instances where the stress tests indicate any material
deficiencies in the comprehensive risk model.
The agencies are evaluating the appropriate bases for supervisory
stress scenarios to be applied to a bank's portfolio of correlation
trading positions. There are inherent difficulties in prescribing
stress scenarios that would be universally applicable and relevant
across all banks and across all products contained in banks'
correlation trading portfolios. The agencies believe a level of
comparability is important for assessing the sufficiency and
appropriateness of banks' comprehensive risk models, but also recognize
that specific scenarios may not be relevant for certain products or for
certain modeling approaches. The agencies are considering various
options for stress scenarios, including an approach that would involve
specifying stress scenarios based on credit spread shocks to certain
correlation trading positions (for example, single-name CDSs, CDS
indexes, index tranches), which may replicate historically observed
spreads. Another approach would require a bank to calibrate its
existing valuation model to certain specified stress periods by
adjusting credit-related risk factors to reflect a given stress period.
The credit-related risk factors, as adjusted, would then be used to
revalue the bank's correlation trading portfolio under one or more
stress scenarios.
Question 10: What are the benefits and drawbacks of the supervisory
stress scenario requirements described above and what other specific
stress scenario approaches for the correlation trading portfolio should
the agencies consider? For which products and model types are widely
applicable stress scenarios most appropriate, and for which product and
model types is a more tailored stress scenario most appropriate? What
other stress scenario approaches could consistently reflect the risks
of the entire portfolio of correlation trading positions?
The agencies have identified prudential challenges associated with
relying solely on banks' comprehensive risk models for determining
risk-based capital requirements for correlation trading positions. For
example, a bank's ability to perform robust validation of
[[Page 1907]]
its comprehensive risk model using standard backtesting methods is
limited in light of the proposed requirements for the model to measure
potential losses on correlation trading positions due to all price risk
at a one-year time horizon and high-percentile confidence level. As a
result, banks will need to use indirect model validation methods, such
as stress tests, scenario analysis or other methods to assess their
models. The agencies anticipate that banks' comprehensive risk model
validation approaches will evolve over time; however, to address near-
term modeling challenges while still giving consideration to sound risk
management practices, the agencies are proposing a floor on the modeled
correlation trading position capital requirements in the form of a
capital surcharge as described below.
A bank approved to measure comprehensive risk for one or more
portfolios of correlation trading positions must calculate at least
weekly a comprehensive risk measure. The comprehensive risk measure
equals the sum of the output from the bank's approved comprehensive
risk model plus a surcharge on the bank's modeled correlation trading
positions. The agencies propose setting the surcharge equal to 15.0
percent of the total specific risk add-on that would apply to the
bank's modeled correlation trading positions under the standardized
measurement method for specific risk in section 10 of the proposed
rule.
The agencies propose that banks initially be required to calculate
the comprehensive risk measure under the surcharge approach while banks
and supervisors gain experience with the banks' comprehensive risk
models. Over time, with approval from its primary Federal supervisor, a
bank may be permitted to use a floor approach to calculate its
comprehensive risk measure as the greater of: (1) The output from the
bank's approved comprehensive risk model; or (2) 8.0 percent of the
total specific risk add-on that would apply to the bank's modeled
correlation trading positions under the standardized measurement method
for specific risk, provided the bank has met the comprehensive risk
modeling requirements in the proposed rule for a period of at least one
year and can demonstrate the effectiveness of its comprehensive risk
model through the results of ongoing validation efforts, including
robust benchmarking. Such results may incorporate a comparison of the
banks' internal model results to those from an alternative model for
certain portfolios and other relevant data. The agencies may also
consider a benchmarking approach that uses banks' internal models to
determine capital requirements for a portfolio specified by the
supervisors to allow for a relative assessment of models across banks.
A bank's primary Federal supervisor will monitor the appropriateness of
the floor approach on an ongoing basis and may rescind its approval of
this approach if it determines that the bank's comprehensive risk model
may not sufficiently reflect the risks of the bank's modeled
correlation trading positions.
The agencies believe the proposed approach provides a prudential
backstop on modeled capital requirements as well as appropriate
incentives for ongoing model improvement. Another potential approach
would be a stress-test based floor that would, for instance, require a
bank to value its correlation trading positions using prescribed
instantaneous price and correlation shocks in the models it uses to
price its correlation trading positions. For example, such a floor
could require a bank's comprehensive risk capital requirement to be at
least as great as the largest loss the bank would experience for its
correlation trading positions under a scenario of instantaneous price
changes for the underlying positions within a range of plus and minus
15.0 percent combined with instantaneous correlation changes within a
range of plus or minus 5.0 percent.
Question 11: What, if any, specific challenges exist with respect
to the proposed modeling requirements for correlation trading
positions? What additional criteria and benchmarking methods should the
agencies consider that would provide an objective basis for evaluating
whether to allow a bank to apply a lower surcharge percentage in
calculating its comprehensive risk measure? What are the advantages and
disadvantages of the proposed floor approach and the other potential
floor approaches described above? What other alternatives should the
agencies consider to address the uncertainties identified above while
ensuring safe and sound risk-based capital requirements for correlation
trading positions?
A bank that calculates a comprehensive risk measure under section 9
of the proposed rule must calculate its comprehensive risk capital
requirement at least weekly. This capital requirement is the greater of
(i) the average of the comprehensive risk measures over the previous 12
weeks; or (ii) the most recent comprehensive risk measure. Separate
from the proposed requirements for calculating a comprehensive risk
measure, as discussed previously, the proposed rule contains an
explicit reservation of authority providing that a bank's primary
Federal supervisor may require a bank to assign a different risk-based
capital requirement than would otherwise apply to a covered position or
portfolio of covered positions that better reflects the risk of the
position or portfolio. For example, regardless of a modeled capital
requirement, a primary Federal supervisor may require a bank to
increase its risk-weighted asset amount for correlation trading
positions to ensure that it reflects the risk to which the bank is
exposed. Because banks' comprehensive risk models use many different
methodologies, there is no uniform appropriate supervisory adjustment
to risk-weighted assets. An adjustment may take the form of a
multiplier, a floor, a fixed add-on, or another adjustment consistent
with the risk of the portfolio and the bank's modeling practices.
13. Disclosure Requirements
The proposed rule imposes disclosure requirements designed to
increase transparency and improve market discipline on the top-tier
consolidated legal entity that is subject to the market risk capital
rule. The disclosure requirements, discussed further below, include a
breakdown of certain components of a bank's market risk capital
requirement, information on a bank's modeling approaches, and
qualitative and quantitative disclosures relating to a bank's
securitization activities.
The agencies recognize the importance of market discipline in
encouraging sound risk management practices and fostering financial
stability. With enhanced information, market participants can better
evaluate a bank's risk management performance, earnings potential, and
financial strength. Many of the proposed disclosure requirements
reflect information already disclosed publicly by the banking industry.
A bank is encouraged, but not required, to make these disclosures in a
central location on its web site.
Consistent with the advanced approaches rules, the proposed rule
requires a bank to comply with the disclosure requirements of section
11 of the proposed rule unless it is a consolidated subsidiary of
another depository institution or bank holding company that is subject
to the disclosure requirements. A bank subject to section 11 is
required to adopt a formal disclosure policy approved by its board of
directors that addresses the bank's approach for determining the
disclosures it makes. The policy must
[[Page 1908]]
address the associated internal controls and disclosure controls and
procedures. The board of directors and senior management must ensure
that appropriate verification of the bank's disclosures takes place and
that effective internal controls and disclosure controls and procedures
are maintained. One or more senior officers is required to attest that
the disclosures meet the requirements of the proposed rule, and the
board of directors and senior management are responsible for
establishing and maintaining an effective internal control structure
over financial reporting, including the information required under
section 11 of the proposed rule.
The proposed rule requires a bank, at least quarterly, to disclose
publicly for each portfolio of covered positions (i) The high, low,
median, and mean VaR-based measures over the reporting period and the
VaR-based measure at period-end; (ii) the high, low, median, and mean
stressed VaR-based measures over the reporting period and the stressed
VaR-based measure at period-end; (iii) the high, low, median, and mean
incremental risk capital requirements over the reporting period and the
incremental risk capital requirement at period-end; (iv) the high, low,
median, and mean comprehensive risk capital requirements over the
reporting period and the comprehensive risk capital requirement at
period-end; (v) separate measures for interest rate risk, credit spread
risk, equity price risk, foreign exchange rate risk, and commodity
price risk used to calculate the VaR-based measure; and (vi) a
comparison of VaR-based measures with actual results and an analysis of
important outliers. In addition, the bank must publicly disclose the
following information at least quarterly: (i) The aggregate amount of
on-balance sheet and off-balance sheet securitization positions by
exposure type; and (ii) the aggregate amount of correlation trading
positions.
A bank is required to make qualitative disclosures at least
annually, or more frequently in the event of material changes, of the
following information for each portfolio of covered positions: (i) The
composition of material portfolios of covered positions; (ii) the
bank's valuation policies, procedures, and methodologies for covered
positions including, for securitization positions, the methods and key
assumptions used for valuing such positions, any significant changes
since the last reporting period, and the impact of such change; (iii)
the characteristics of its internal models, including, for the bank's
incremental risk capital requirement and the comprehensive risk capital
requirement, the approach used by the bank to determine liquidity
horizons; the methodologies used to achieve a capital assessment that
is consistent with the required soundness standard; and the specific
approaches used in the validation of these models; (iv) a description
of its approaches for validating the accuracy of its internal models
and modeling processes; (v) a description of the stress tests applied
to each market risk category; (vi) the results of a comparison of the
bank's internal estimates with actual outcomes during a sample period
not used in model development; (vii) the soundness standard on which
its internal capital adequacy assessment is based, including a
description of the methodologies used to achieve a capital adequacy
assessment that is consistent with the soundness standard and the
requirements of the market risk capital rule; and (viii) a description
of the bank's processes for monitoring changes in the credit and market
risk of securitization positions, including how those processes differ
for resecuritization positions; and (ix) a description of the bank's
policy governing the use of credit risk mitigation to mitigate the
risks of securitization and resecuritization positions.
Question 12: The agencies seek comment on the effectiveness of the
proposed disclosure requirements. What, if any, changes to these
requirements would make the proposed disclosures more effective in
promoting market discipline?
III. Regulatory Flexibility Act Analysis
The Regulatory Flexibility Act, 5 U.S.C. 601 et seq. (RFA),
generally requires that, in connection with a notice of proposed
rulemaking, an agency prepare and make available for public comment an
initial regulatory flexibility analysis that describes the impact of a
proposed rule on small entities.\23\ Under regulations issued by the
Small Business Administration,\24\ a small entity includes a commercial
bank or bank holding company with assets of $175 million or less (a
small banking organization). As of June 30, 2010, there were
approximately 2,561 small bank holding companies, 690 small national
banks, 400 small state member banks, and 2,706 small state nonmember
banks.
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\23\ See 5 U.S.C. 603(a).
\24\ See 13 CFR 121.201.
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The proposed rule would apply only if the bank holding company or
bank has aggregated trading assets and trading liabilities equal to 10
percent or more of quarter-end total assets, or $1 billion or more. No
small banking organizations satisfy these criteria. Therefore, no small
entities would be subject to this rule.
IV. OCC Unfunded Mandates Reform Act of 1995 Determination
The Unfunded Mandates Reform Act of 1995 (UMRA) requires Federal
agencies to 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 (adjusted annually for
inflation) in any one year. The current inflation-adjusted expenditure
threshold is $126.4 million. If a budgetary impact statement is
required, section 205 of the UMRA also requires an agency to identify
and consider a reasonable number of regulatory alternatives before
promulgating a rule.
In conducting the regulatory analysis, UMRA requires each Federal
agency to provide:
The text of the draft regulatory action, together with a
reasonably detailed description of the need for the regulatory action
and an explanation of how the regulatory action will meet that need;
An assessment of the potential costs and benefits of the
regulatory action, including an explanation of the manner in which the
regulatory action is consistent with a statutory mandate and, to the
extent permitted by law, promotes the President's priorities and avoids
undue interference with State, local, and tribal governments in the
exercise of their governmental functions;
An assessment, including the underlying analysis, of
benefits anticipated from the regulatory action (such as, but not
limited to, the promotion of the efficient functioning of the economy
and private markets, the enhancement of health and safety, the
protection of the natural environment, and the elimination or reduction
of discrimination or bias) together with, to the extent feasible, a
quantification of those benefits;
An assessment, including the underlying analysis, of costs
anticipated from the regulatory action (such as, but not limited to,
the direct cost both to the government in administering the regulation
and to businesses and others in complying with the regulation, and any
adverse effects on the efficient functioning of the economy, private
markets (including productivity, employment, and competitiveness),
health, safety, and the natural environment), together with, to the
[[Page 1909]]
extent feasible, a quantification of those costs; and
An assessment, including the underlying analysis, of costs
and benefits of potentially effective and reasonably feasible
alternatives to the planned regulation, identified by the agencies or
the public (including improving the current regulation and reasonably
viable nonregulatory actions), and an explanation why the planned
regulatory action is preferable to the identified potential
alternatives.
An estimate of any disproportionate budgetary effects of
the Federal mandate upon any particular regions of the nation or
particular State, local, or tribal governments, urban or rural or other
types of communities, or particular segments of the private sector.
An estimate of the effect the rulemaking action may have
on the national economy, if the OCC determines that such estimates are
reasonably feasible and that such effect is relevant and material.
A. The Need for the Regulatory Action
The proposed rule would modify the current market risk capital rule
by adjusting the minimum risk-based capital calculation and adding
public disclosure requirements. The proposed rule would also (1) modify
the definition of covered positions to include assets that are in the
trading book and held with the intent to trade; (2) introduce new
requirements for the identification of trading positions and the
management of covered positions; and (3) require banks to have clearly
defined policies and procedures for actively managing all covered
positions, for the prudent valuation of covered positions and for
specific internal model validation standards. The proposed rule will
generally apply to any bank with aggregate trading assets and
liabilities that are at least 10 percent of total assets or at least $1
billion. These thresholds are the same as those currently used to
determine applicability of the market risk rule.
Under current rules, the measure for market risk is as follows:
\25\
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\25\ The following are the components of the current Market Risk
Measure. Value-at-Risk (VaR) is an estimate of the maximum amount
that the value of one or more positions could decline due to market
price or rate movements during a fixed holding period within a
stated confidence interval. Specific risk is the risk of loss on a
position that could result from factors other than broad market
movements and includes event risk, default risk, and idiosyncratic
risk. There may also be a capital requirement for de minimis
exposures, if any, that are not included in the bank's VaR models.
Market Risk Measure = (Value-at-Risk based capital requirement) +
(Specific risk capital requirement) + (Capital requirement for de
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minimis exposures)
Under the proposed rule, the new market risk measure would be as
follows (new risk measure components are underlined):
New Market Risk Measure = (Value-at-Risk based capital requirement) +
(Stressed Value-at-Risk based capital requirement) + (Specific risk
capital charge) + (Incremental risk capital requirement) +
(Comprehensive risk capital requirement) + (Capital charge for de
minimis exposures)
The Basel Committee and the Federal banking agencies designed the
new components of the market risk measure to capture key risks
overlooked by the current market risk measure.
B. Cost-Benefit Analysis of the Proposed Rule
1. Organizations Affected by the Proposed Rule \26\
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\26\ Unless otherwise noted, the population of banks used in
this analysis consists of all FDIC-insured national banks and
uninsured national bank and trust companies. Banking organizations
are aggregated to the top holding company level.
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According to September 30, 2010, Call Report data, 16 national
banking organizations \27\ had trading assets and liabilities that are
at least 10 percent of total assets or at least $1 billion.
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\27\ A national banking organization is any bank holding company
with a subsidiary national bank.
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2. Impact of the Proposed Rule
The key benefits of the proposed rule are the following qualitative
benefits:
Enhances sensitivity to market risk,
Enhances modeling requirements consistent with advances in
risk management,
Better captures trading positions for which market risk
capital treatment is appropriate,
Increases transparency through enhanced market
disclosures.
Increased market risk capital should lower the probability
of catastrophic losses to the bank occurring because of market risk.
Modified requirements should reduce the procyclicality of
market risk capital.
We derive our estimates of the proposed rule's effect on the market
risk measure from the third trading book impact study conducted by the
Basel Committee on Banking Supervision in 2009 and additional estimates
of the capital requirement for standardized securitization exposures
and correlation trading positions.\28\ Based on these two assessments,
we estimate that the market risk measure will increase 300 percent on
average. The market risk measure itself acts as an estimate of the
minimum regulatory capital requirement for an adequately capitalized
bank. Thus, quadrupling the market risk measure suggests that minimum
required capital will increase by approximately $50.7 billion under the
proposed rule. These new capital requirements would lead banks to
deleverage and lose the tax advantage of debt. We estimate that the
loss of these tax benefits would be approximately $334 million per
year.
---------------------------------------------------------------------------
\28\ The report, ``Analysis of the third trading book impact
study'', is available at http://www.bis.org/publ/bcbs163.htm. The
study gathered data from 43 banks in 10 countries, including six
banks from the United States.
---------------------------------------------------------------------------
We estimate that new disclosure requirements and the implementation
of calculations for the new market risk measures may involve some
additional system costs, but because the proposed rule will only affect
institutions already subject to the current market risk rule we expect
these additional system costs to be de minimis. We do not anticipate
that the proposed rule will create significant additional
administrative costs for the OCC. Based on our assessment of the
capital costs of the proposed rule; we estimate that the total cost of
the proposed rule will be approximately $334 million in 2010 dollars
over one year.
C. Comparison Between Proposed Rule and Baseline
Under the baseline scenario, the current market risk rule would
continue to apply. Thus, in the baseline scenario, required market risk
capital would remain at current levels and there would be no additional
cost associated with adding capital. However, the benefits of increased
sensitivity to market risk, increased transparency, the improved
targeting of trading positions, reduced procyclicality of market risk
capital, and the protective advantages of additional capital would be
lost under the baseline scenario.
D. Comparison Between Proposed Rule and Alternatives
The Unfunded Mandates Reform Act of 1995 (UMRA) requires a
comparison between the proposed rule and reasonable alternatives. In
this regulatory impact analysis, we compare the proposed rule with two
alternatives that modify the size thresholds for the rule.
Assessment of Alternative A
Under Alternative A, we consider a rule that has the same
provisions as the
[[Page 1910]]
proposed rule, but we alter the rule's trading book size threshold.
Because trading assets and liabilities are concentrated in six or seven
institutions, modest changes in the size thresholds have little impact
on the dollar volume of trading assets affected by the market risk rule
and thus little impact on the estimated cost of the rule. Changing the
size threshold does affect the number of institutions affected by the
rule, which suggests that the banking agencies' systemic concerns could
play a role in determining the appropriate size threshold for
applicability of the market risk rule.
Assessment of Alternative B
Under Alternative B, we consider a rule that has the same
provisions as the proposed rule, but we change the condition of the
size thresholds from ``or'' to ``and''. With this change, the proposed
rule would apply to institutions that have $1 billion or more in
trading assets and liabilities and a trading book to asset ratio of at
least 10 percent. Making the applicability of the market risk rule
contingent on meeting both size thresholds would reduce the number of
banks affected by the rule to four using the current thresholds of $1
billion and 10 percent. In order for the alternative B rule to apply to
the same number of institutions as the current rule, the alternative's
joint condition would have to be comparable to thresholds of between
$500 million and $1 billion in the trading book and a 1 percent
trading-book-to-assets ratio. However, under this alternative the list
of the 16 institutions subject to the rule would change slightly. Not
surprisingly, as this joint threshold alternative could excuse some
institutions with larger trading books, the estimated cost of the
alternative rule does decrease with the number of institutions affected
by the rule.
E. Overall Impact of Proposed Rule, Baseline and Alternatives
Under our baseline scenario, which reflects the current application
of the market risk rule, a market risk capital charge of approximately
$16.9 billion applies to 16 national banks. Under the proposed rule,
this capital charge would continue to apply to the same 16 banks but
the capital charge would likely quadruple. We estimate that the cost of
this additional capital would be approximately $334 million per year in
2010 dollars.
Our alternatives examine the impact of a market risk rule that uses
different size thresholds in order to determine which institutions are
subject to the rule. With alternative A we consider altering the $1
billion trading book threshold used currently and maintained under the
proposed rule. Although varying the size threshold changed the number
of institutions affected by the rule, the overall capital cost of the
rule did not significantly change. This reflects the high concentration
of trading assets and liabilities in seven banks with over $15 billion
in their trading books as of September 30, 2010. As long as the
proposed rule applies to these seven institutions, the additional
required capital and its corresponding cost will not change
considerably.
Alternative B did affect both the number of institutions subject to
the proposed rule and the cost of the proposed rule by limiting the
market risk rule to institutions that meet both size criteria, i.e., a
$1 billion trading book and a trading-book-to-assets ratio of at least
10 percent. Only four national banks currently meet both of these
criteria, and applying the proposed rule to these institutions would
require an additional $36.0 billion in market risk capital at a cost of
approximately $237 million. Clearly, the estimated cost of the proposed
rule would fall if the size thresholds determining applicability of the
market risk rule were to increase. However, the current size
thresholds, which continue to apply under the proposed rule, capture
those institutions that the regulatory agencies believe should be
subject to market risk capital rules. The proposed rule changes covered
positions, disclosure requirements, and methods relating to calculating
the market risk measure. These changes achieve the important objectives
of enhancing the banking system's sensitivity to market risk, increases
transparency of the trading book and market risk, and better captures
trading positions for which market risk capital treatment is
appropriate. The proposed rule carries over the current thresholds used
to determine the applicability of the market risk rule. The banking
agencies have determined that these size thresholds capture the
appropriate institutions; those most exposed to market risk.
The large increase in required market risk capital, which we
estimate to be approximately $51 billion under the proposed rule, will
provide a considerable buttress to the capital position of institutions
subject to the market risk rule. This additional capital should
dramatically lower the likelihood of catastrophic losses from market
risk occurring at these institutions, which will enhance the safety and
soundness of these institutions, the banking system, and world
financial markets. Although there is some concern regarding the burden
of the proposed increase in market risk capital and the effect this
could have on bank lending, in the OCC's opinion, the proposed rule
offers a better balance between costs and benefits than either the
baseline or the alternatives.
The OCC does not expect the revised risk-based capital guidelines
to have any disproportionate budgetary effect on any particular regions
of the nation or particular State, local, or tribal governments, urban
or rural or other types of communities, or particular segments of the
private sector.
V. Paperwork Reduction Act
A. Request for Comment on Proposed Information Collection
In accordance with the requirements of the Paperwork Reduction Act
of 1995 (44 U.S.C. 3501-3521), the agencies may not conduct or sponsor,
and the respondent is not required to respond to, an information
collection unless it displays a currently valid Office of Management
and Budget (OMB) control number. The information collection
requirements contained in this joint notice of proposed rulemaking have
been submitted by the OCC and FDIC to OMB for review and approval under
section 3506 of the PRA and section 1320.11 of OMB's implementing
regulations (5 CFR part 1320). The Board reviewed the proposed rule
under the authority delegated to the Board by OMB.
Comments are invited on:
(a) Whether the collection of information is necessary for the
proper performance of the agencies' functions, including whether the
information has practical utility;
(b) The accuracy of the estimates of the burden of the information
collection, including the validity of the methodology and assumptions
used;
(c) Ways to enhance the quality, utility, and clarity of the
information to be collected;
(d) Ways to minimize the burden of the information collection on
respondents, including through the use of automated collection
techniques or other forms of information technology; and
(e) Estimates of capital or start up costs and costs of operation,
maintenance, and purchase of services to provide information.
Comments should be addressed to:
OCC: Communications Division, Office of the Comptroller of the
Currency, Public Information Room, Mail stop 1-5, Attention: 1557-NEW,
[[Page 1911]]
250 E Street, SW., Washington, DC 20219. In addition, comments may be
sent by fax to 202-874-5274, or by electronic mail to
[email protected]. You can inspect and photocopy the comments
at the OCC's Public Information Room, 250 E Street, SW., Washington, DC
20219. For security reasons, OCC requires that visitors make an
appointment to inspect the comments. You may do so by calling 202-874-
4700. Upon arrival, visitors will be required to present valid
government-issued photo identification and submit to security screening
in order to inspect and photocopy comments.
Board: You may submit comments, identified by the Docket number, 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, unless modified 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 form in Room MP-500 of the Board's Martin Building (20th and C
Streets, NW) between 9 a.m. and 5 p.m. on weekdays.
FDIC: You may submit written comments, which should refer to 3064-
--------, by any of the following methods:
Agency Web Site: http://www.fdic.gov/regulations/laws/
federal/propose.html. Follow the instructions for submitting comments
on the FDIC Web site.
Federal eRulemaking Portal: http://www.regulations.gov.
Follow the instructions for submitting comments.
E-mail: [email protected]. Include RIN on the subject line
of the message.
Mail: Robert E. Feldman, Executive Secretary, Attention:
Comments, FDIC, 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.
Public Inspection: All comments received will be posted without
change to http://www.fdic.gov/regulations/laws/federal/propose/html
including any personal information provided. Comments may be inspected
at 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.
A copy of the comments may also be submitted to the OMB desk
officer for the agencies: By mail to U.S. Office of Management and
Budget, 725 17th Street, NW., 10235, Washington, DC 20503 or
by facsimile to 202-395-6974, Attention: Federal Banking Agency Desk
Officer.
B. Proposed Information Collection
Title of Information Collection: Risk-Based Capital Standards:
Market Risk
Frequency of Response: Varied--some requirements are done at least
quarterly and some at least annually.
Affected Public:
OCC: National banks and Federal branches and agencies of foreign
banks.
Board: State member banks and bank holding companies.
FDIC: Insured non-member banks, insured state branches of foreign
banks, and certain subsidiaries of these entities.
Abstract: The information collection requirements are found in
sections 3, 4, 5, 6, 7, 8, 9, 10, and 11 of the proposed rule. They
will enhance risk sensitivity and introduce requirements for public
disclosure of certain qualitative and quantitative information about a
bank's or bank holding companies' market risk. The collection of
information is necessary to ensure capital adequacy according to the
level of market risk.
Section-by-Section Analysis
Section 3 sets forth the requirements for applying the market risk
framework. Section 3(a)(1) requires clearly defined policies and
procedures for determining which trading assets and trading liabilities
are trading positions, which of its trading positions are correlation
trading positions, and specifies what must be taken into account.
Section 3(a)(2) requires a clearly defined trading and hedging strategy
for trading positions approved by senior management and specifies what
each strategy must articulate. Section 3(b)(1) requires clearly defined
policies and procedures for actively managing all covered positions and
specifies the minimum that they must require. Sections 3(c)(4) through
3(c)(10) require the annual review of internal models and include
certain requirements that the models must meet. Section 3(d)(4)
requires an annual report to the board of directors on the
effectiveness of controls supporting market risk measurement systems.
Section 4(b) requires quarterly backtesting. Section 5(a)(5)
requires institutions to demonstrate to the agencies the
appropriateness of proxies used to capture risks within value-at- risk
models. Section 5(c) requires institutions to retain value-at-risk and
profit and loss information on subportfolios for two years. Section
6(b)(3) requires policies and procedures for stressed value-at-risk
models and prior approvals on determining periods of significant
financial stress.
Section 7(b)(1) specifies what internal models for specific risk
must include and address. Section 8(a) requires prior written approval
for incremental risk. Section 9(a) requires prior approval for
comprehensive risk models. Section 9(c)(2) requires retaining and
making available the results of supervisory stress testing on a
quarterly basis. Section 10(d) requires documentation quarterly for
analysis of risk characteristics of each securitization position it
holds. Section 11 requires quarterly quantitative disclosures, annual
qualitative disclosures, and a formal disclosure policy approved by the
board of directors that addresses the bank's approach for determining
the market risk disclosures it makes.
Estimated Burden
The burden associated with this collection of information may be
summarized as follows:
OCC
Number of Respondents: 15.
Estimated Burden Per Respondent: 1,964 hours.
Total Estimated Annual Burden: 29,460 hours.
Board
Number of Respondents: 26.
Estimated Burden Per Respondent: 2,204 hours.
Total Estimated Annual Burden: 51,064 hours.
FDIC
Number of Respondents: 2.
Estimated Burden Per Respondent: 1,964.
Total Estimated Annual Burden: 3,928.
[[Page 1912]]
VI. Plain Language
Section 722 of the GLBA required the agencies to use plain language
in all proposed and final rules published after January 1, 2000. The
agencies invite comment on how to make this proposed rule easier to
understand. For example:
Have the agencies organized the material to suit your
needs? If not, how could they present the rule more clearly?
Are the requirements in the rule clearly stated? If not,
how could the rule be more clearly stated?
Do the regulations contain technical language or jargon
that is not clear? If so, which language requires clarification?
Would a different format (grouping and order of sections,
use of headings, paragraphing) make the regulation easier to
understand? If so, what changes would achieve that?
Is this section format adequate? If not, which of the
sections should be changed and how?
What other changes can the agencies incorporate to make
the regulation easier to understand?
Text of the Proposed Common Rules (All Agencies)
The text of the proposed common rules appears below:
Appendix ---- to Part ------Risk-Based Capital Guidelines; Market Risk
Adjustment
Section 1 Purpose, Applicability, and Reservation of Authority
Section 2 Definitions
Section 3 Requirements for Application of the Market Risk Capital
Rule
Section 4 Adjustments to the Risk-Based Capital Ratio Calculations
Section 5 VaR-based Measure
Section 6 Stressed VaR-Based Measure
Section 7 Specific Risk
Section 8 Incremental Risk
Section 9 Comprehensive Risk
Section 10 Standardized Measurement Method for Specific Risk
Section 11 Market Risk Disclosures
Section 1. Purpose, Applicability, and Reservation of Authority
(a) Purpose. This appendix establishes risk-based capital
requirements for [banking organizations] with significant exposure
to market risk and provides methods for these [banking
organizations] to calculate their risk-based capital requirements
for market risk. This appendix supplements and adjusts the risk-
based capital calculations under [the general risk-based capital
rules] and [the advanced capital adequacy framework] and establishes
public disclosure requirements.
(b) Applicability--(1) This appendix applies to any [banking
organization] with aggregate trading assets and trading liabilities
(as reported in the [banking organization]'s most recent quarterly
[regulatory report]), equal to:
(i) 10 percent or more of quarter-end total assets as reported
on the most recent quarterly [Call Report or FR Y-9C]; or
(ii) $1 billion or more.
(2) The [Agency] may apply this appendix to any [banking
organization] if the [Agency] deems it necessary or appropriate
because of the level of market risk of the [banking organization] or
to ensure safe and sound banking practices.
(3) The [Agency] may exclude a [banking organization] that meets
the criteria of paragraph (b)(1) of this appendix from application
of this appendix if the [Agency] determines that the exclusion is
appropriate based on the level of market risk of the [banking
organization] and is consistent with safe and sound banking
practices.
(c) Reservation of authority--(1) The [Agency] may require a
[banking organization] to hold an amount of capital greater than
otherwise required under this appendix if the [Agency] determines
that the [banking organization]'s capital requirement for market
risk as calculated under this appendix is not commensurate with the
market risk of the [banking organization]'s covered positions. In
making determinations under this paragraph, the [Agency] will apply
notice and response procedures generally in the same manner as the
notice and response procedures described in [12 CFR 3.12, 12 CFR
263.202, 12 CFR 325.6(c), 12 CFR 567.3(d)].
(2) If the [Agency] determines that the risk-based capital
requirement calculated under this appendix by the [banking
organization] for one or more covered positions or portfolios of
covered positions is not commensurate with the risks associated with
those positions or portfolios, the [Agency] may require the [banking
organization] to assign a different risk-based capital requirement
to the positions or portfolios that more accurately reflects the
risk of the positions or portfolios.
(3) The [Agency] may also require a [banking organization] to
calculate risk-based capital requirements for specific positions or
portfolios under this appendix, or under [the advanced capital
adequacy framework] or [the general risk-based capital rules], as
appropriate, to more accurately reflect the risks of the positions.
(4) Nothing in this appendix limits the authority of the
[Agency] under any other provision of law or regulation to take
supervisory or enforcement action, including action to address
unsafe or unsound practices or conditions, deficient capital levels,
or violations of law.
Section 2. Definitions
For purposes of this appendix, the following definitions apply:
Backtesting means the comparison of a [banking organization]'s
internal estimates with actual outcomes during a sample period not
used in model development. For purposes of this appendix,
backtesting is one form of out-of-sample testing.
Bank holding company is defined in section 2(a) of the Bank
Holding Company Act of 1956 (12 U.S.C. 1841(a)).
Commodity position means a position for which price risk arises
from changes in the price of a commodity.
Company means a corporation, partnership, limited liability
company, depository institution, business trust, special purpose
entity, association, or similar organization.
Correlation trading position means:
(1) A securitization position for which all or substantially all
of the value of the underlying exposures is based on the credit
quality of a single company for which a two-way market exists, or on
commonly traded indices based on such exposures for which a two-way
market exists on the indices; or
(2) A position that is not a securitization position and that
hedges a position described in paragraph (1) of this definition; and
(3) A correlation trading position does not include:
(i) A resecuritization position;
(ii) A derivative of a securitization position that does not
provide a pro rata share in the proceeds of a securitization
tranche; or
(iii) A securitization position for which the underlying assets
or reference exposures are retail exposures, residential mortgage
exposures, or commercial mortgage exposures.
Covered position means the following positions:
(1) A trading asset or trading liability (whether on- or off-
balance sheet),\1\ as reported on Schedule RC-D of the Call Report
or Schedule HC-D of the FR Y-9C, that meets the following
conditions:
---------------------------------------------------------------------------
\1\ Securities subject to repurchase and lending agreements are
included as if they are still owned by the lender.
---------------------------------------------------------------------------
(i) The position is a trading position or hedges another covered
position \2\ and
---------------------------------------------------------------------------
\2\ A position that hedges a trading position must be within the
scope of the bank's hedging strategy as described in paragraph
(a)(2) of section (3) of this appendix.
---------------------------------------------------------------------------
(ii) The position is free of any restrictive covenants on its
tradability or the [banking organization] is able to hedge the
material risk elements of the position in a two-way market.
(2) A foreign exchange or commodity position, regardless of
whether the position is a trading asset or trading liability
(excluding any structural foreign currency positions that the
[banking organization] chooses to exclude with prior supervisory
approval).
(3) Notwithstanding paragraphs (1) and (2) of this definition, a
covered position does not include:
(i) An intangible asset, including any servicing asset;
(ii) Any hedge of a trading position that the [Agency]
determines to be outside the scope of the [banking organization]'s
hedging strategy required in paragraph (a)(2) of section 3 of this
appendix;
(iii) Any position that, in form or substance, acts as a
liquidity facility that provides support to asset-backed commercial
paper;
(iv) A credit derivative the [banking organization] recognizes
as a guarantee for risk-weighted asset amount calculation purposes
under [the advanced capital adequacy framework] or [the general
risk-based capital rules];
[[Page 1913]]
(v) Any equity position that is not publicly traded other than a
derivative that references a publicly traded equity;
(vi) Any position a [banking organization] holds with the intent
to securitize; or
(vii) Any direct real estate holding.
Credit derivative means a financial contract executed under
standard industry documentation that allows one party (the
protection purchaser) to transfer the credit risk of one or more
exposures (reference exposure(s)) to another party (the protection
provider).
Debt position means a covered position that is not a
securitization position or a correlation trading position and that
has a value that reacts primarily to changes in interest rates or
credit spreads.
Depository institution is defined in section 3 of the Federal
Deposit Insurance Act (12 U.S.C. 1813).
Equity position means a covered position that is not a
securitization position or a correlation trading position and that
has a value that reacts primarily to changes in equity prices.
Event risk means the risk of loss on a position that could
result from sudden and unexpected large changes in market prices or
specific events other than default and credit migration of the
issuer.
Financial firm means a depository institution, a bank holding
company, a savings and loan holding company (as defined in section
10(a)(1)(D) of the Home Owners' Loan Act (12 U.S.C. 1467a(a)(1)(D)),
a securities broker or dealer registered with the SEC, or a banking
or securities firm that the [banking organization] has determined is
subject to consolidated supervision and regulation comparable to
that imposed on U.S. [banking organizations] or securities broker-
dealers.
Foreign exchange position means a position for which price risk
arises from changes in foreign exchange rates.
General market risk means the risk of loss that could result
from broad market movements, such as changes in the general level of
interest rates, credit spreads, equity prices, foreign exchange
rates, or commodity prices.
Hedge means a position or positions that offset all, or
substantially all, of one or more material risk factors of another
position.
Idiosyncratic risk means the risk of loss in the value of a
position that arises from changes in risk factors unique to that
position.
Incremental risk means the default risk and credit migration
risk of a position. Default risk means the risk of loss on a
position that could result from the failure of an obligor to make
timely payments of principal or interest on its debt obligation, and
the risk of loss that could result from bankruptcy, insolvency, or
similar proceeding. Credit migration risk means the price risk that
arises from significant changes in the underlying credit quality of
the position.
Investing bank means, with respect to a securitization, a
[banking organization] that assumes the credit risk of a
securitization exposure (other than an originating bank of the
securitization).
Market risk means the risk of loss on a position that could
result from movements in market prices.
Nth-to-default credit derivative means a credit derivative that
provides credit protection only for the nth-defaulting reference
exposure in a group of reference exposures.
Originating bank, with respect to a securitization, means a
[banking organization] that:
(1) Directly or indirectly originated or securitized the
underlying exposures included in the securitization; or
(2) Serves as an asset-backed commercial paper (ABCP) program
sponsor to the securitization.
Over-the-counter (OTC) derivative means a derivative contract
that is not traded on an exchange that requires the daily receipt
and payment of cash-variation margin.
Publicly traded means traded on:
(1) Any exchange registered with the SEC as a national
securities exchange under section 6 of the Securities Exchange Act
of 1934 (15 U.S.C. 78f); or
(2) Any non-U.S.-based securities exchange that:
(i) Is registered with, or approved by, a national securities
regulatory authority; and
(ii) Provides a liquid, two-way market for the instrument in
question.
Qualifying securities borrowing transaction means a cash-
collateralized securities borrowing transaction that meets the
following conditions:
(1) The transaction is based on liquid and readily marketable
securities;
(2) The transaction is marked-to-market daily;
(3) The transaction is subject to daily margin maintenance
requirements; and
(4)(i) 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); or
(ii) If the transaction does not meet the criteria in paragraph
(4)(i) of this definition, either:
(A) The [banking organization] has conducted sufficient legal
review to reach a well-founded conclusion that:
(1) The securities borrowing agreement executed in connection
with the transaction provides the [banking organization] the right
to accelerate, terminate, and close-out on a net basis all
transactions under the agreement and to liquidate or set off
collateral promptly upon an event of counterparty default, including
in a bankruptcy, insolvency, or other similar proceeding of the
counterparty; and
(2) Under applicable law of the relevant jurisdiction, its
rights under the agreement are legal, valid, binding, and
enforceable and any exercise of rights under the agreement will not
be stayed or avoided; or
(B) The transaction is either overnight or unconditionally
cancelable at any time by the [banking organization], and the
[banking organization] has conducted sufficient legal review to
reach a well-founded conclusion that:
(1) The securities borrowing agreement executed in connection
with the transaction provides the [banking organization] the right
to accelerate, terminate, and close-out on a net basis all
transactions under the agreement and to liquidate or set off
collateral promptly upon an event of counterparty default; and
(2) Under the law governing the agreement, its rights under the
agreement are legal, valid, binding, and enforceable.
Resecuritization means a securitization in which one or more of
the underlying exposures is a securitization position.
Resecuritization position means:
(1) An on- or off-balance sheet exposure to a resecuritization;
or
(2) An exposure that directly or indirectly references a
resecuritization exposure in paragraph (1) of this definition.
SEC means the U.S. Securities and Exchange Commission.
Securitization means a transaction in which:
(1) All or a portion of the credit risk of one or more
underlying exposures is transferred to one or more third parties;
(2) The credit risk associated with the underlying exposures has
been separated into at least two tranches that reflect different
levels of seniority;
(3) Performance of the securitization exposures depends upon the
performance of the underlying exposures;
(4) All or substantially all of the underlying exposures are
financial exposures (such as loans, commitments, credit derivatives,
guarantees, receivables, asset-backed securities, mortgage-backed
securities, other debt securities, or equity securities);
(5) For non-synthetic securitizations, the underlying exposures
are not owned by an operating company;
(6) The underlying exposures are not owned by a small business
investment company described in section 302 of the Small Business
Investment Act of 1958 (15 U.S.C. 682); and
(7) The underlying exposures are not owned by a firm an
investment in which qualifies as a community development investment
under 12 U.S.C. 24(Eleventh).
(8) The [Agency] may determine that a transaction in which the
underlying exposures are owned by an investment firm that exercises
substantially unfettered control over the size and composition of
its assets, liabilities, and off-balance sheet exposures is not a
securitization based on the transaction's leverage, risk profile, or
economic substance.
(9) The [Agency] may deem an exposure to a transaction that
meets the definition of a securitization, notwithstanding paragraph
(5), (6), or (7) of this definition, to be a securitization based on
the transaction's leverage, risk profile, or economic substance.
Securitization position means a covered position that is:
(1) An on-balance sheet or off-balance sheet credit exposure
(including credit-enhancing representations and warranties) that
arises from a securitization (including a resecuritization); or
[[Page 1914]]
(2) An exposure that directly or indirectly references a
securitization exposure described in paragraph (1) of this
definition.
Sovereign entity means a central government (including the U.S.
government) or an agency, department, ministry, or central bank of a
central government.
Specific risk means the risk of loss on a position that could
result from factors other than broad market movements and includes
event risk, default risk, and idiosyncratic risk.
Structural position in a foreign currency means a position that
is not a trading position and that is:
(1) Subordinated debt, equity, or minority interest in a
consolidated subsidiary that is denominated in a foreign currency;
(2) Capital assigned to foreign branches that is denominated in
a foreign currency;
(3) A position related to an unconsolidated subsidiary or
another item that is denominated in a foreign currency and that is
deducted from the [banking organization]'s tier 1 and tier 2
capital, or
(4) A position designed to hedge a [banking organization]'s
capital ratios or earnings against the effect on paragraphs (1),
(2), or (3) of this definition of adverse exchange rate movements.
Term repo-style transaction means a repurchase or reverse
repurchase transaction, or a securities borrowing or securities
lending transaction, including a transaction in which the [banking
organization] acts as agent for a customer and indemnifies the
customer against loss, that has an original maturity in excess of
one business day, provided that:
(1) The transaction is based solely on liquid and readily
marketable securities or cash;
(2) The transaction is marked-to-market daily and subject to
daily margin maintenance requirements;
(3) The transaction is executed under an agreement that provides
the [banking organization] the right to accelerate, terminate, and
close-out the transaction on a net basis and to liquidate or set off
collateral promptly upon an event of default (including bankruptcy,
insolvency, or similar proceeding) of the counterparty, provided
that, in any such case, any exercise of rights under the agreement
will not be stayed or avoided under applicable law in the relevant
jurisdictions; \3\ and
---------------------------------------------------------------------------
\3\ This requirement is met where all transactions under the
agreement are (i) executed under U.S. law and (ii) constitute
``securities contracts'' or ``repurchase agreements'' under section
555 or 559, respectively, of the Bankruptcy Code (11 U.S.C. 555 or
559), qualified financial contracts under section 11(e)(8) of the
Federal Deposit Insurance Act (12 U.S.C. 1821(e)(8)), or netting
contracts between or among financial institutions under sections
401-407 of the Federal Deposit Insurance Corporation Improvement Act
of 1991 (12 U.S.C. 4407), or the Federal Reserve Board's Regulation
EE (12 CFR part 231).
---------------------------------------------------------------------------
(4) The [banking organization] has conducted and documented
sufficient legal review to conclude with a well-founded basis that
the agreement meets the requirements of paragraph (3) of this
definition and is legal, valid, binding, and enforceable under
applicable law in the relevant jurisdictions.
Tier 1 capital is defined in [the general risk-based capital
rules] or [the advanced capital adequacy framework], as applicable.
Tier 2 capital is defined in [the general risk-based capital
rules] or [the advanced capital adequacy framework], as applicable.
Trading position means a position that is held by the [banking
organization] for the purpose of short-term resale or with the
intent of benefiting from actual or expected short-term price
movements, or to lock in arbitrage profits.
Two-way market means a market where there are independent bona
fide offers to buy and sell so that a price reasonably related to
the last sales price or current bona fide competitive bid and offer
quotations can be determined within one day and settled at that
price within five business days.
Value-at-Risk (VaR) means the estimate of the maximum amount
that the value of one or more positions could decline due to market
price or rate movements during a fixed holding period within a
stated confidence interval.
Section 3. Requirements for Application of the Market Risk Capital Rule
(a) Trading positions--(1) Identification of trading positions.
A [banking organization] must have clearly defined policies and
procedures for determining which of its trading assets and trading
liabilities are trading positions and which of its trading positions
are correlation trading positions. These policies and procedures
must take into account:
(i) The extent to which a position, or a hedge of its material
risks, can be marked-to-market daily by reference to a two-way
market; and
(ii) Possible impairments to the liquidity of a position or its
hedge.
(2) Trading and hedging strategies. A [banking organization]
must have clearly defined trading and hedging strategies for its
trading positions that are approved by senior management of the
[banking organization].
(i) The trading strategy must articulate the expected holding
period of, and the market risk associated with, each portfolio of
trading positions.
(ii) The hedging strategy must articulate for each portfolio of
trading positions the level of market risk the [banking
organization] is willing to accept and must detail the instruments,
techniques, and strategies the [banking organization] will use to
hedge the risk of the portfolio.
(b) Management of covered positions-- (1) Active management. A
[banking organization] must have clearly defined policies and
procedures for actively managing all covered positions. At a
minimum, these policies and procedures must require:
(i) Marking positions to market or to model on a daily basis;
(ii) Daily assessment of the [banking organization]'s ability to
hedge position and portfolio risks, and of the extent of market
liquidity;
(iii) Establishment and daily monitoring of limits on positions
by a risk control unit independent of the trading business unit;
(iv) Daily monitoring by senior management of information
described in paragraphs (b)(1)(i) through (b)(1)(iii) of this
section;
(v) At least annual reassessment of established limits on
positions by senior management; and
(vi) At least annual assessments by qualified personnel of the
quality of market inputs to the valuation process, the soundness of
key assumptions, the reliability of parameter estimation in pricing
models, and the stability and accuracy of model calibration under
alternative market scenarios.
(2) Valuation of covered positions. The [banking organization]
must have a process for prudent valuation of its covered positions
that includes policies and procedures on the valuation of positions,
marking positions to market or to model, independent price
verification, and valuation adjustments or reserves. The valuation
process must consider, as appropriate, unearned credit spreads,
close-out costs, early termination costs, investing and funding
costs, future administrative costs, liquidity, and model risk.
(c) Requirements for internal models. (1) A [banking
organization] must obtain the prior written approval of the [Agency]
before using any internal model to calculate its risk-based capital
requirement under this appendix.
(2) A [banking organization] must meet all of the requirements
of this section on an ongoing basis. The [banking organization] must
promptly notify the [Agency] when:
(i) The [banking organization] plans to extend the use of a
model that the [Agency] has approved under this appendix to an
additional business line or product type;
(ii) The [banking organization] makes any change to any internal
model approved by the [Agency] under this appendix that would result
in a material change in the [banking organization]'s risk-weighted
asset amount for a portfolio of covered positions; or
(iii) The [banking organization] makes any material change to
its modeling assumptions.
(3) The [Agency] may rescind its approval of the use of any
internal model (in whole or in part) or of the surcharge applicable
to a [banking organization]'s modeled correlation trading positions
as determined under section 9(d)(2) of this appendix, and determine
an appropriate capital requirement for the covered positions to
which the model would apply, if the [Agency] determines that the
model no longer complies with this appendix or fails to reflect
accurately the risks of the [banking organization]'s covered
positions.
(4) The [banking organization] must periodically, but no less
frequently than annually, review its internal models in light of
developments in financial markets and modeling technologies, and
enhance those models as appropriate to ensure that they continue to
meet the [Agency]'s standards for model approval and employ risk
measurement methodologies that are most appropriate for the [banking
organization]'s covered positions.
(5) The [banking organization] must incorporate its internal
models into its risk management process and integrate the internal
models used for calculating its VaR-based measure into its daily
risk management process.
[[Page 1915]]
(6) The level of sophistication of a [banking organization]'s
internal models must be commensurate with the complexity and amount
of its covered positions. A [banking organization]'s internal models
may use any of the generally accepted approaches, including but not
limited to variance-covariance models, historical simulations, or
Monte Carlo simulations, to measure market risk.
(7) The [banking organization]'s internal models must properly
measure all of the material risks in the covered positions to which
they are applied.
(8) The [banking organization]'s internal models must
conservatively assess the risks arising from less liquid positions
and positions with limited price transparency under realistic market
scenarios.
(9) The [banking organization] must have a rigorous and well-
defined process for reestimating, reevaluating, and updating its
internal models to ensure continued applicability and relevance.
(10) If a [banking organization] uses internal models to measure
specific risk, the internal models must also satisfy the
requirements in paragraph (b)(1) of section 7 of this appendix.
(d) Control, oversight, and validation mechanisms. (1) The
[banking organization] must have a risk control unit that reports
directly to senior management and is independent from the business
trading units.
(2) The [banking organization] must validate its internal models
initially and on an ongoing basis. The [banking organization]'s
validation process must be independent of the internal models'
development, implementation, and operation, or the validation
process must be subjected to an independent review of its adequacy
and effectiveness. Validation must include:
(i) An evaluation of the conceptual soundness of (including
developmental evidence supporting) the internal models;
(ii) An ongoing monitoring process that includes verification of
processes and the comparison of the [banking organization]'s model
outputs with relevant internal and external data sources or
estimation techniques; and
(iii) An outcomes analysis process that includes backtesting.
For internal models used to calculate the VaR-based measure, this
process must include a comparison of the changes in the [banking
organization]'s portfolio value that would have occurred were end-
of-day positions to remain unchanged (therefore, excluding fees,
commissions, reserves, net interest income, and intraday trading)
with VaR-based measures during a sample period not used in model
development.
(3) The [banking organization] must stress-test the market risk
of its covered positions at a frequency appropriate to each
portfolio, and in no case less frequently than quarterly. The stress
tests must take into account concentration risk (including but not
limited to concentrations in single issuers, industries, sectors, or
markets), illiquidity under stressed market conditions, and risks
arising from the [banking organization]'s trading activities that
may not be adequately captured in its internal models.
(4) The [banking organization] must have an internal audit
function independent of business-line management that at least
annually assesses the effectiveness of the controls supporting the
[banking organization]'s market risk measurement systems, including
the activities of the business trading units and independent risk
control unit, compliance with policies and procedures, and
calculation of the [banking organization]'s measure for market risk
under this appendix. At least annually, the internal audit function
must report its findings to the [banking organization]'s board of
directors (or a committee thereof).
(e) Internal assessment of capital adequacy. The [banking
organization] must have a rigorous process for assessing its overall
capital adequacy in relation to its market risk. The assessment must
take into account risks that may not be captured fully in the VaR-
based measure, including concentration and liquidity risk under
stressed market conditions.
(f) Documentation. The [banking organization] must adequately
document all material aspects of its internal models, management and
valuation of covered positions, control, oversight, validation and
review processes and results, and internal assessment of capital
adequacy.
Section 4. Adjustments to the Risk-Based Capital Ratio Calculations
(a) Risk-based capital ratio denominator. The [banking
organization] must calculate its risk-based capital ratio
denominator as follows:
(1) Adjusted risk-weighted assets. The [banking organization]
must calculate adjusted risk-weighted assets, which equal risk-
weighted assets (as determined in accordance with [the advanced
capital adequacy framework] or [the general risk-based capital
rules], as applicable), with the following adjustments:
(i) The [banking organization] must exclude the risk-weighted
asset amounts of all covered positions (except foreign exchange
positions that are not trading positions and over-the-counter
derivative positions).
(ii) A [banking organization] subject to [the general risk-based
capital rules] may exclude receivables that arise from the posting
of cash collateral and are associated with qualifying securities
borrowing transactions to the extent the receivable is
collateralized by the market value of the borrowed securities;
(2) Measure for market risk. The [banking organization] must
calculate the measure for market risk, which equals the sum of the
VaR-based capital requirement, stressed VaR-based capital
requirement, any specific risk add-ons, any incremental risk capital
requirement, any comprehensive risk capital requirement, and any
capital requirement for de minimis exposures as defined under this
paragraph.
(i) VaR-based capital requirement. The VaR-based capital
requirement equals the greater of:
(A) The previous day's VaR-based measure as calculated under
section 5 of this appendix; or
(B) The average of the daily VaR-based measures as calculated
under section 5 of this appendix for each of the preceding 60
business days multiplied by three, except as provided in paragraph
(b) of this section.
(ii) Stressed VaR-based capital requirement. The stressed VaR-
based capital requirement equals the greater of:
(A) The most recent stressed VaR-based measure as calculated
under section 6 of this appendix; or
(B) The average of the stressed VaR-based measures as calculated
under section 6 of this rule for each of the preceding 60 business
days multiplied by three, except as provided in paragraph (b) of
this section.
(iii) Any specific risk add-ons. Any specific risk add-ons that
are required under section 7 and are calculated in accordance with
section 10 of this appendix.
(iv) Any incremental risk capital requirement. Any incremental
risk capital requirement as calculated under section 8 of this
appendix.
(v) Any comprehensive risk capital requirement. Any
comprehensive risk capital requirement as calculated under section 9
of this appendix.
(vi) Any capital requirement for de minimis exposures. The
[banking organization] must add to its measure for market risk the
absolute value of the market value of those de minimis exposures
that are not captured in the [banking organization]'s VaR-based
measure unless the [banking organization] has obtained prior written
approval from the [Agency] to calculate a capital requirement for de
minimis exposures using alternative techniques that appropriately
measure the market risk associated with those exposures.
(3) Market risk equivalent assets. The [banking organization]
must calculate market risk equivalent assets as the measure for
market risk (as calculated in paragraph (a)(2) of this section)
multiplied by 12.5.
(4) Denominator calculation. The [banking organization] must 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 [banking
organization]'s risk-based capital ratio denominator.
(b) Backtesting. A [banking organization] must compare each of
its most recent 250 business days' trading losses (excluding fees,
commissions, reserves, intra-day trading, and net interest income)
with the corresponding daily VaR-based measures calibrated to a one-
day holding period and at a one-tail, 99.0 percent confidence level.
(1) Once each quarter, the [banking organization] must identify
the number of exceptions (that is, the number of business days for
which the actual daily net trading loss, if any, exceeds the
corresponding daily VaR-based measure) that have occurred over the
preceding 250 business days.
(2) A [banking organization] must use the multiplication factor
in Table 1 of this appendix that corresponds to the number of
exceptions identified in paragraph (b)(1) of this section to
determine its VaR-based capital requirement for market risk under
paragraph (a)(2)(i) of this section and to determine its stressed
VaR-based capital requirement for market risk under paragraph
[[Page 1916]]
(a)(2)(ii) of this section until it obtains the next quarter's
backtesting results, unless the [Agency] notifies the [banking
organization] in writing that a different adjustment or other action
is appropriate.
Table 1--Multiplication Factors Based on Results of Backtesting
------------------------------------------------------------------------
Multiplication
Number of exceptions factor
------------------------------------------------------------------------
4 or fewer.............................................. 3.00
5....................................................... 3.40
6....................................................... 3.50
7....................................................... 3.65
8....................................................... 3.75
9....................................................... 3.85
10 or more.............................................. 4.00
------------------------------------------------------------------------
Section 5. VaR-Based Measure
(a) General requirement. A [banking organization] must use one
or more internal models to calculate daily a VaR-based measure of
the general market risk of all covered positions. The daily VaR-
based measure also may reflect the [banking organization]'s specific
risk for one or more portfolios of debt and equity positions, if the
internal models meet the requirements of paragraph (b)(1) of section
7. The daily VaR-based measure must also reflect the [banking
organization]'s specific risk for any portfolio of correlation
trading positions that is modeled under section 9 of this appendix.
A [banking organization] may elect to include term repo-style
transactions in its VaR-based measure, provided that the [banking
organization] includes all such term repo-style transactions
consistently over time.
(1) The [banking organization]'s internal models for calculating
its VaR-based measure must use risk factors sufficient to measure
the market risk inherent in all covered positions. The market risk
categories must include, as appropriate, interest rate risk, credit
spread risk, equity price risk, foreign exchange risk, and commodity
price risk. For material positions in the major currencies and
markets, modeling techniques must incorporate enough segments of the
yield curve--in no case less than six--to capture differences in
volatility and less than perfect correlation of rates along the
yield curve.
(2) The VaR-based measure may incorporate empirical correlations
within and across risk categories, provided the [banking
organization] validates and demonstrates the reasonableness of its
process for measuring correlations. If the VaR-based measure does
not incorporate empirical correlations across risk categories, the
[banking organization] must add the separate measures from its
internal models used to calculate the VaR-based measure for the
appropriate market risk categories (interest rate risk, credit
spread risk, equity price risk, foreign exchange rate risk, and/or
commodity price risk) to determine its aggregate VaR-based measure.
(3) The VaR-based measure must include the risks arising from
the nonlinear price characteristics of options positions or
positions with embedded optionality and the sensitivity of the
market value of the positions to changes in the volatility of the
underlying rates, prices, or other material risk factors. A [banking
organization] with a large or complex options portfolio must measure
the volatility of options positions or positions with embedded
optionality by different maturities and/or strike prices, where
material.
(4) The [banking organization] must be able to justify to the
satisfaction of the [Agency] the omission of any risk factors from
the calculation of its VaR-based measure that the [banking
organization] uses in its pricing models.
(5) The [banking organization] must demonstrate to the
satisfaction of the [Agency] the appropriateness of any proxies used
to capture the risks of the [banking organization]'s actual
positions for which such proxies are used.
(b) Quantitative requirements for VaR-based measure. (1) The
VaR-based measure must be calculated on a daily basis using a one-
tail, 99.0 percent confidence level, and a holding period equivalent
to a 10-business-day movement in underlying risk factors, such as
rates, spreads, and prices. To calculate VaR-based measures using a
10-business-day holding period, the [banking organization] may
calculate 10-business-day measures directly or may convert VaR-based
measures using holding periods other than 10 business days to the
equivalent of a 10-business-day holding period. A [banking
organization] that converts its VaR-based measure in such a manner
must be able to justify the reasonableness of its approach to the
satisfaction of the [Agency].
(2) The VaR-based measure must be based on a historical
observation period of at least one year. Data used to determine the
VaR-based measure must be relevant to the [banking organization]'s
actual exposures and of sufficient quality to support the
calculation of risk-based capital requirements. The [banking
organization] must update data sets at least monthly or more
frequently as changes in market conditions or portfolio composition
warrant. For a [banking organization] that uses a weighting scheme
or other method for the historical observation period, the [banking
organization] must either:
(i) Use an effective observation period of at least one year in
which the average time lag of the observations is at least six
months; or
(ii) Demonstrate to the [Agency] that its weighting scheme is
more effective than a weighting scheme with an average time lag of
at least six months at representing the volatility of the [banking
organization]'s trading portfolio over a full business cycle. A
[banking organization] using this option must update its data more
frequently than monthly and in a manner appropriate for the type of
weighting scheme.
(c) A [banking organization] must divide its portfolio into a
number of significant subportfolios approved by the [Agency] for
subportfolio backtesting purposes. These subportfolios must be
sufficient to allow the [banking organization] and the [Agency] to
assess the adequacy of the VaR model at the risk factor level; the
[Agency] will evaluate the appropriateness of these subportfolios
relative to the value and composition of the [banking
organization]'s covered positions. The [banking organization] must
retain and make available to the [Agency] the following information
for each subportfolio for each business day over the previous two
years (500 business days), with no more than a 60 day lag:
(1) A daily VaR-based measure for the subportfolio calibrated to
a one-tail, 99.0 percent confidence level;
(2) The daily profit or loss for the subportfolio (that is, the
net change in price of the positions held in the portfolio at the
end of the previous business day); and
(3) The p-value of the profit or loss on each day (that is, the
probability of observing a profit that is less than, or a loss that
is greater than, the amount reported for purposes of paragraph
(c)(2) of this section based on the model used to calculate the VaR-
based measure described in paragraph (c)(1) of this section).
Section 6. Stressed VaR-Based Measure
(a) General requirement. At least weekly, a [banking
organization] must use the same internal model(s) used to calculate
its VaR-based measure to calculate a stressed VaR-based measure.
(b) Quantitative requirements for stressed VaR-based measure.
(1) A [banking organization] must calculate a stressed VaR-based
measure for its covered positions using the same model(s) used to
calculate the VaR-based measure, subject to the same confidence
level and holding period applicable to the VaR-based measure under
section 5, but with model inputs calibrated to historical data from
a continuous 12-month period that reflects a period of significant
financial stress appropriate to the [banking organization]'s current
portfolio.
(2) The stressed VaR-based measure must be calculated at least
weekly and be no less than the [banking organization]'s VaR-based
measure.
(3) A [banking organization] must have policies and procedures
that describe how it determines the period of significant financial
stress used to calculate the [banking organization]'s stressed VaR-
based measure under this section and must be able to provide
empirical support for the period used. The [banking organization]
must obtain the prior approval of the [Agency] for, and notify the
[Agency] if the [banking organization] makes any material changes
to, these policies and procedures. The policies and procedures must
address:
(i) How the [banking organization] links the period of
significant financial stress used to calculate the stressed VaR-
based measure to the composition and directional bias of its current
portfolio; and
(ii) The [banking organization]'s process for selecting,
reviewing, and updating the period of significant financial stress
used to calculate the stressed VaR-based measure and for monitoring
the appropriateness of the period to the [banking organization]'s
current portfolio.
(4) Nothing in this section prevents the [Agency] from requiring
a [banking organization] to use a different period of significant
financial stress in the calculation of the stressed VaR-based
measure.
[[Page 1917]]
Section 7. Specific Risk
(a) General requirement. A [banking organization] must use one
of the methods in this section to measure the specific risk for each
of its debt, equity, and securitization positions with specific
risk.
(b) Modeled specific risk. A [banking organization] may use
models to measure the specific risk of covered positions as provided
in paragraph (a) of section 5 (therefore, excluding securitization
positions that are not modeled under section 9 of this appendix). A
[banking organization] must use models to measure the specific risk
of correlation trading positions that are modeled under section 9 of
this appendix.
(1) Requirements for specific risk modeling. (i) If a [banking
organization] uses internal models to measure the specific risk of a
portfolio, the internal models must:
(A) Explain the historical price variation in the portfolio;
(B) Be responsive to changes in market conditions;
(C) Be robust to an adverse environment, including signaling
rising risk in an adverse environment; and
(D) Capture all material components of specific risk for the
debt and equity positions in the portfolio. Specifically, the
internal models must:
(1) Capture event risk and idiosyncratic risk;
(2) Capture and demonstrate sensitivity to material differences
between positions that are similar but not identical; and
(3) Capture and demonstrate sensitivity to changes in portfolio
composition and concentrations.
(ii) If a [banking organization] calculates an incremental risk
measure for a portfolio of debt or equity positions under section 8
of this appendix, the [banking organization] is not required to
capture default and credit migration risks in its internal models
used to measure the specific risk of those portfolios.
(2) Specific risk fully modeled for one or more portfolios. If
the [banking organization]'s VaR-based measure captures all material
aspects of specific risk for one or more of its portfolios of debt,
equity, or correlation trading positions, the [banking organization]
has no specific risk add-on for those portfolios for purposes of
paragraph (a)(2)(iii) of section 4 of this appendix.
(c) Specific risk not modeled. (1) If the [banking
organization]'s VaR-based measure does not capture all material
aspects of specific risk for a portfolio of debt, equity, or
correlation trading positions, the [banking organization] must
calculate a specific-risk add-on for the portfolio under the
standardized measurement method as described in section 10 of this
appendix.
(2) A [banking organization] must calculate a specific risk add-
on under the standardized measurement method as described in section
10 of this appendixfor all of its securitization positions that are
not modeled under section 9 of this appendix.
Section 8. Incremental Risk
(a) General requirement. A [banking organization] that measures
the specific risk of a portfolio of debt positions under section
7(b) using internal models must calculate at least weekly an
incremental risk measure for that portfolio according to the
requirements in this section. The incremental risk measure is the
[banking organization]'s measure of potential losses due to
incremental risk over a one-year time horizon at a one-tail, 99.9
percent confidence level, either under the assumption of a constant
level of risk, or under the assumption of constant positions. With
the prior approval of the [Agency], a [banking organization] may
choose to include portfolios of equity positions in its incremental
risk model, provided that it consistently includes such equity
positions in a manner that is consistent with how the [banking
organization] internally measures and manages the incremental risk
of such positions at the portfolio level. If equity positions are
included in the model, for modeling purposes default is considered
to have occurred upon the default of any debt of the issuer of the
equity position. A [banking organization] may not include
correlation trading positions or securitization positions in its
incremental risk measure.
(b) Requirements for incremental risk modeling. For purposes of
calculating the incremental risk measure, the incremental risk model
must:
(1) Measure incremental risk over a one-year time horizon and at
a one-tail, 99.9 percent confidence level, either under the
assumption of a constant level of risk, or under the assumption of
constant positions.
(i) A constant level of risk assumption means that the [banking
organization] rebalances, or rolls over, its trading positions at
the beginning of each liquidity horizon over the one-year horizon in
a manner that maintains the [banking organization]'s initial risk
level. The [banking organization] must determine the frequency of
rebalancing in a manner consistent with the liquidity horizons of
the positions in the portfolio. The liquidity horizon of a position
or set of positions is the time required for a [banking
organization] to reduce its exposure to, or hedge all of its
material risks of, the position(s) in a stressed market. The
liquidity horizon for a position or set of positions may not be less
than the lower of three months or the contractual maturity of the
position.
(ii) A constant position assumption means that the [banking
organization] maintains the same set of positions throughout the
one-year horizon. If a [banking organization] uses this assumption,
it must do so consistently across all portfolios.
(iii) A [banking organization]'s selection of a constant
position or a constant risk assumption must be consistent between
the [banking organization]'s incremental risk model and its
comprehensive risk model described in section 9, if applicable.
(iv) A [banking organization]'s treatment of liquidity horizons
must be consistent between the [banking organization]'s incremental
risk model and its comprehensive risk model described in section 9,
if applicable.
(2) Recognize the impact of correlations between default and
migration events among obligors.
(3) Reflect the effect of issuer and market concentrations, as
well as concentrations that can arise within and across product
classes during stressed conditions.
(4) Reflect netting only of long and short positions that
reference the same financial instrument.
(5) Reflect any material mismatch between a position and its
hedge.
(6) Recognize the effect that liquidity horizons have on dynamic
hedging strategies. In such cases, a [banking organization] must:
(i) Choose to model the rebalancing of the hedge consistently
over the relevant set of trading positions;
(ii) Demonstrate that the inclusion of rebalancing results in a
more appropriate risk measurement;
(iii) Demonstrate that the market for the hedge is sufficiently
liquid to permit rebalancing during periods of stress; and
(iv) Capture in the incremental risk model any residual risks
arising from such hedging strategies.
(7) Reflect the nonlinear impact of options and other positions
with material nonlinear behavior with respect to default and
migration changes.
(8) Maintain consistency with the [banking organization]'s
internal risk management methodologies for identifying, measuring,
and managing risk.
(c) Calculation of incremental risk capital requirement. The
incremental risk capital requirement is the greater of:
(1) The average of the incremental risk measures over the
previous 12 weeks; or
(2) The most recent incremental risk measure.
Section 9. Comprehensive Risk
(a) General requirement. (1) Subject to the prior approval of
the [Agency], a [banking organization] may use the method in this
section to measure comprehensive risk, that is, all price risk, for
one or more portfolios of correlation trading positions.
(2) A [banking organization] that measures the price risk of a
portfolio of correlation trading positions using internal models
must calculate at least weekly a comprehensive risk measure that
captures all price risk according to the requirements of this
section. The comprehensive risk measure is either:
(i) The sum of:
(A) The [banking organization]'s modeled measure of all price
risk determined according to the requirements in paragraph (b) of
this section; and
(B) A surcharge for the [banking organization]'s modeled
correlation trading positions equal to the total specific risk add-
on for such positions as calculated under section 10 of this
appendix multiplied by 15.0 percent; or
(ii) With approval of the [Agency] and provided the [banking
organization] has met the requirements of this section for a period
of at least one year and can demonstrate the effectiveness of the
model through the results of ongoing model validation efforts
including robust benchmarking, the greater of:
(A) The [banking organization]'s modeled measure of all price
risk determined according to the requirements in paragraph (b) of
this section; or
(B) The total specific risk add-on that would apply to the
bank's modeled correlation trading positions as calculated under
section 10 of this appendix multiplied by 8.0 percent.
[[Page 1918]]
(b) Requirements for modeling all price risk. If a [banking
organization] uses an internal model to measure the price risk of a
portfolio of correlation trading positions:
(1) The internal model must measure comprehensive risk over a
one-year time horizon at a one-tail, 99.9 percent confidence level,
either under the assumption of a constant level of risk, or under
the assumption of constant positions.
(2) The model must capture all material price risk, including
but not limited to the following:
(i) The risks associated with the contractual structure of cash
flows of the position, its issuer, and its underlying exposures;
(ii) Credit spread risk, including nonlinear price risks;
(iii) The volatility of implied correlations, including
nonlinear price risks such as the cross-effect between spreads and
correlations;
(iv) Basis risk;
(v) Recovery rate volatility as it relates to the propensity for
recovery rates to affect tranche prices; and
(vi) To the extent the comprehensive risk measure incorporates
the benefits of dynamic hedging, the static nature of the hedge over
the liquidity horizon must be recognized. In such cases, a [banking
organization] must:
(A) Choose to model the rebalancing of the hedge consistently
over the relevant set of trading positions;
(B) Demonstrate that the inclusion of rebalancing results in a
more appropriate risk measurement;
(C) Demonstrate that the market for the hedge is sufficiently
liquid to permit rebalancing during periods of stress; and
(D) Capture in the comprehensive risk model any residual risks
arising from such hedging strategies;
(3) The [banking organization] must use market data that are
relevant in representing the risk profile of the [banking
organization]'s correlation trading positions in order to ensure
that the [banking organization] fully captures the material risks of
the correlation trading positions in its comprehensive risk measure
in accordance with this section; and
(4) The [banking organization] must be able to demonstrate that
its model is an appropriate representation of comprehensive risk in
light of the historical price variation of its correlation trading
positions.
(c) Requirements for stress testing.
(1) A [banking organization] must at least weekly apply
specific, supervisory stress scenarios to its portfolio of
correlation trading positions that capture changes in:
(i) Default rates;
(ii) Recovery rates;
(iii) Credit spreads;
(iv) Correlations of underlying exposures; and
(v) Correlations of a correlation trading position and its
hedge.
(2) Other requirements. (i) A [banking organization] must retain
and make available to the [Agency] the results of the supervisory
stress testing, including comparisons with the capital requirements
generated by the [banking organization]'s comprehensive risk model.
(ii) A [banking organization] must report to the [Agency]
promptly any instances where the stress tests indicate any material
deficiencies in the comprehensive risk model.
(d) Calculation of comprehensive risk capital requirement. The
comprehensive risk capital requirement is the greater of:
(1) The average of the comprehensive risk measures over the
previous 12 weeks; or
(2) The most recent comprehensive risk measure.
Section 10. Standardized Measurement Method for Specific Risk
(a) General requirement. A [banking organization] must calculate
a total specific risk add-on for each portfolio of debt and equity
positions for which the [banking organization]'s VaR-based measure
does not capture all material aspects of specific risk and for all
securitization positions that are not modeled under section 9 of
this appendix. A [banking organization] must calculate each specific
risk add-on in accordance with the requirements of this section.
(1) The specific risk add-on for an individual debt or
securitization position that represents purchased credit protection
is capped at the market value of the protection.
(2) For debt, equity, or securitization positions that are
derivatives with linear payoffs, a [banking organization] must risk
weight the market value of the effective notional amount of the
underlying instrument or index portfolio. A swap must be included as
an effective notional position in the underlying instrument or
portfolio, with the receiving side treated as a long position and
the paying side treated as a short position. For debt, equity, or
securitization positions that are derivatives with nonlinear
payoffs, a [banking organization] must risk weight the market value
of the effective notional amount of the underlying instrument or
portfolio multiplied by the derivative's delta.
(3) For debt, equity, or securitization positions, a [banking
organization] may net long and short positions (including
derivatives) in identical issues or identical indices. A [banking
organization] may also net positions in depositary receipts against
an opposite position in an identical equity in different markets,
provided that the [banking organization] includes the costs of
conversion.
(4) A set of transactions consisting of either a debt position
and its credit derivative hedge or a securitization position and its
credit derivative hedge has a specific risk add-on of zero if the
debt or securitization position is fully hedged by a total return
swap (or similar instrument where there is a matching of payments
and changes in market value of the position) and there is an exact
match between the reference obligation of the swap and the debt or
securitization position, the maturity of the swap and the debt or
securitization position, and the currency of the swap and the debt
or securitization position.
(5) The specific risk add-on for a set of transactions
consisting of either a debt position and its credit derivative hedge
or a securitization position and its credit derivative hedge that
does not meet the criteria of paragraph (a)(4) of this section is
equal to 20.0 percent of the capital requirement for the side of the
transaction with the higher capital requirement when the credit risk
of the position is fully hedged by a credit default swap or similar
instrument and there is an exact match between the reference
obligation of the credit derivative hedge and the debt or
securitization position, the maturity of the credit derivative hedge
and the debt or securitization position, and the currency of the
credit derivative hedge and the debt or securitization position.
(6) The specific risk add-on for a set of transactions
consisting of either a debt position and its credit derivative hedge
or a securitization position and its credit derivative hedge that
does not meet the criteria of either paragraph (a)(4) or (a)(5) of
this section, but in which all or substantially all of the price
risk has been hedged, is equal to the specific risk add-on for the
side of the transaction with the higher specific risk add-on.
(b) Debt and securitization positions. (1) Unless otherwise
provided in paragraph (b)(2) of this section, the total specific
risk add-on for a portfolio of debt or securitization positions is
the sum of the specific risk add-ons for individual debt or
securitization positions, as computed under this section. To
determine the specific risk add-on for individual debt or
securitization positions, a [banking organization] must multiply the
absolute value of the current market value of each net long or net
short debt or securitization position in the portfolio by the
appropriate risk-weighting factor in Table 2. The following
definitions apply to this paragraph, including Table 2:
Table 2--Specific Risk Weighting Factors for Debt and Securitization
Positions
------------------------------------------------------------------------
Risk-weighting
Category Remaining maturity factor (in
(contractual) percent)
------------------------------------------------------------------------
Government..................... N/A.................... 0.00
Qualifying..................... 6 months or less....... 0.25
Over 6 months to 24 1.00
months.
Over 24 months......... 1.60
[[Page 1919]]
Other.......................... N/A.................... 8.00
------------------------------------------------------------------------
(i) The government category includes all debt instruments of
central governments of OECD-based countries \4\ including bonds,
Treasury bills, and other short-term instruments, as well as local
currency instruments of non-OECD central governments to the extent
the bank has liabilities booked in that currency.
---------------------------------------------------------------------------
\4\ Organization for Economic Cooperation and Development
(OECD)-based countries is defined in [the general risk-based capital
rules].
---------------------------------------------------------------------------
(ii) 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.\5\ 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:
---------------------------------------------------------------------------
\5\ U.S. government-sponsored agencies, multilateral development
banks, and OECD banks are defined in [the general risk-based capital
rules].
---------------------------------------------------------------------------
(A) Rated investment-grade by at least two nationally recognized
credit rating services;
(B) Rated investment-grade by one nationally recognized credit
rating agency and not rated less than investment-grade by any other
credit rating agency; or
(C) Unrated, but deemed to be of comparable investment quality
by the reporting bank and the issuer has instruments listed on a
recognized stock exchange, subject to review by the [Agency].
(iii) The other category includes debt instruments that are not
included in the government or qualifying categories.
(2) Nth-to-default credit derivatives. The total
specific risk add-on for a portfolio of nth-to-default
credit derivatives is the sum of the specific risk add-ons for
individual nth-to-default credit derivatives, as computed
under this paragraph. The specific risk add-on for each
nth-to-default credit derivative position applies
irrespective of whether a [banking organization] is a net protection
buyer or net protection seller. A [banking organization] must
calculate the specific risk add-on for each nth-to-
default credit derivative as follows:
(i) First-to-default credit derivatives.
(A) The specific risk add-on for a first-to-default credit
derivative is the lesser of:
(1) The sum of the specific risk add-ons for the individual
reference credit exposures in the group of reference exposures; or
(2) The maximum possible credit event payment under the credit
derivative contract.
(B) Where a [banking organization] has a risk position in one of
the reference credit exposures underlying a first-to-default credit
derivative and this credit derivative hedges the [banking
organization]'s risk position, the [banking organization] is allowed
to reduce both the specific risk add-on for the reference credit
exposure and that part of the specific risk add-on for the credit
derivative that relates to this particular reference credit exposure
such that its specific risk add-on for the pair reflects the bank's
net position in the reference credit exposure. Where a [banking
organization] has multiple risk positions in reference credit
exposures underlying a first-to-default credit derivative, this
offset is allowed only for the underlying reference credit exposure
having the lowest specific risk add-on.
(ii) Second-or-subsequent-to-default credit derivatives.
(A) The specific risk add-on for a second-or-subsequent-to-
default credit derivative is the lesser of:
(1) The sum of the specific risk add-ons for the individual
reference credit exposures in the group of reference exposures, but
disregarding the (n-1) obligations with the lowest specific risk
add-ons; or
(2) The maximum possible credit event payment under the credit
derivative contract.
(B) For second-or-subsequent-to-default credit derivatives, no
offset of the specific risk add-on with an underlying reference
credit exposure is allowed.
(c) Equity positions. The total specific risk add-on for a
portfolio of equity positions is the sum of the specific risk add-
ons of the individual equity positions, as computed under this
section. To determine the specific risk add-on of individual equity
positions, a [banking organization] must multiply the absolute value
of the current market value of each net long or net short equity
position by the appropriate risk-weighting factor as determined
under this paragraph.
(1) The [banking organization] must multiply the absolute value
of the current market value of each net long or net short equity
position by a risk-weighting factor of 8.0 percent. For equity
positions that are index contracts comprising a well-diversified
portfolio of equity instruments, the absolute value of the current
market value of each net long or net short position is multiplied by
a risk-weighting factor of 2.0 percent.\6\
---------------------------------------------------------------------------
\6\ A portfolio is well-diversified if it contains a large
number of individual equity positions, with no single position
representing a substantial portion of the portfolio's total market
value.
---------------------------------------------------------------------------
(2) For equity positions arising from the following futures-
related arbitrage strategies, a [banking organization] may apply a
2.0 percent risk-weighting factor to one side (long or short) of
each position with the opposite side exempt from an additional
capital requirement:
(i) Long and short positions in exactly the same index at
different dates or in different market centers; or
(ii) Long and short positions in index contracts at the same
date in different, but similar indices.
(3) For futures contracts on main indices that are matched by
offsetting positions in a basket of stocks comprising the index, a
[banking 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 is comprised of stocks
representing at least 90.0 percent of the capitalization of the
index. A main index refers to the Standard & Poor's 500 Index, the
FTSE All-World Index, and any other index for which the [banking
organization] can demonstrate to the satisfaction of the [AGENCY]
that the equities represented in the index have liquidity, depth of
market, and size of bid-ask spreads comparable to equities in the
Standard & Poor's 500 Index and FTSE All-World Index.
(d)(1) A [banking organization] must be able to demonstrate to
the satisfaction of the [Agency] a comprehensive understanding of
the features of a securitization position that would materially
affect the performance of the position. The [banking organization]'s
analysis must be commensurate with the complexity of the
securitization position and the materiality of the position in
relation to capital.
(2) To support the demonstration of its comprehensive
understanding, for each securitization position a [banking
organization] must:
(i) Conduct and document an analysis of the risk characteristics
of a securitization position prior to acquiring the position,
considering:
(A) Structural features of the securitization that would
materially impact the performance of the position, for example, the
contractual cash flow waterfall, waterfall-related triggers, credit
enhancements, liquidity enhancements, market value triggers, the
performance of organizations that service the position, and deal-
specific definitions of default;
(B) Relevant information regarding the performance of the
underlying credit exposure(s), for example, the percentage of loans
30, 60, and 90 days past due; default rates; prepayment rates; loans
in foreclosure; property types; occupancy; average credit score or
other measures of creditworthiness; average LTV ratio; and industry
and geographic diversification data on the underlying exposure(s);
(C) Relevant market data of the securitization, for example,
bid-ask spreads, most recent sales price and historical price
volatility, trading volume, implied market
[[Page 1920]]
rating, and size, depth and concentration level of the market for
the securitization; and
(D) For resecuritization positions, performance information on
the underlying securitization exposures, for example, the issuer
name and credit quality, and the characteristics and performance of
the exposures underlying the securitization exposures; and
(ii) On an on-going basis (no less frequently than quarterly),
evaluate, review, and update as appropriate the analysis required
under paragraph (d)(1) of this section for each securitization
position.
Section 11. Market Risk Disclosures
(a) Scope. A [banking organization] must comply with this
section unless it is a consolidated subsidiary of a bank holding
company or a depository institution that is subject to these
requirements or of a non-U.S. banking organization that is subject
to comparable public disclosure requirements in its home
jurisdiction. Quantitative disclosures must be made publicly each
calendar quarter. If a significant change occurs, such that the most
recent reporting amounts are no longer reflective of the [banking
organization]'s capital adequacy and risk profile, then a brief
discussion of this change and its likely impact must be provided as
soon as practicable thereafter. Qualitative disclosures that
typically do not change each quarter may be disclosed annually,
provided any significant changes are disclosed in the interim. If a
[banking organization] believes that disclosure of specific
commercial or financial information would prejudice seriously its
position by making public certain information that is either
proprietary or confidential in nature, the [banking organization]
need not disclose these specific items, but must disclose more
general information about the subject matter of the requirement,
together with the fact that, and the reason why, the specific items
of information have not been disclosed.
(b) Disclosure policy. The [banking organization] must have a
formal disclosure policy approved by the board of directors that
addresses the [banking organization]'s approach for determining the
market risk disclosures it makes. The policy must address the
associated internal controls and disclosure controls and procedures.
The board of directors and senior management must ensure that
appropriate verification of the disclosures takes place and that
effective internal controls and disclosure controls and procedures
are maintained. One or more senior officers of the [banking
organization] must attest that the disclosures meet the requirements
of this appendix, and the board of directors and senior management
are responsible for establishing and maintaining an effective
internal control structure over financial reporting, including the
disclosures required by this section.
(c) Quantitative disclosures.
(1) For each portfolio of covered positions, the [banking
organization] must publicly disclose the following information at
least quarterly:
(i) The high, low, median, and mean VaR-based measures over the
reporting period and the VaR-based measure at period-end;
(ii) The high, low, median, and mean stressed VaR-based measures
over the reporting period and the stressed VaR-based measure at
period-end;
(iii) The high, low, median, and mean incremental risk capital
requirements over the reporting period and the incremental risk
capital requirement at period-end;
(iv) The high, low, median, and mean comprehensive risk capital
requirements over the reporting period and the comprehensive risk
capital requirement at period-end, with the period-end requirement
broken down into appropriate risk classifications (for example,
default risk, migration risk, correlation risk);
(v) Separate measures for interest rate risk, credit spread
risk, equity price risk, foreign exchange risk, and commodity price
risk used to calculate the VaR-based measure; and
(vi) A comparison of VaR-based estimates with actual gains or
losses experienced by the [banking organization], with an analysis
of important outliers.
(2) In addition, the [banking organization] must publicly
disclose the following information at least quarterly:
(i) The aggregate amount of on-balance sheet and off-balance
sheet securitization positions by exposure type; and
(ii) The aggregate amount of correlation trading positions.
(d) Qualitative disclosures.
(1) For each portfolio of covered positions, the [banking
organization] must publicly disclose the following information at
least annually, or more frequently in the event of material changes
for each portfolio:
(i) The composition of material portfolios of covered positions;
(ii) The [banking organization]'s valuation policies,
procedures, and methodologies for covered positions including, for
securitization positions, the methods and key assumptions used for
valuing such positions, any significant changes since the last
reporting period, and the impact of such change;
(iii) The characteristics of the internal models used for
purposes of this appendix. For the incremental risk capital
requirement and the comprehensive risk capital requirement, this
must include:
(A) The approach used by the [banking organization] to determine
liquidity horizons;
(B) The methodologies used to achieve a capital assessment that
is consistent with the required soundness standard; and
(C) The specific approaches used in the validation of these
models;
(iv) A description of the approaches used for validating and
evaluating the accuracy of internal models and modeling processes
for purposes of this appendix;
(v) For each market risk category (that is, interest rate risk,
credit spread risk, equity price risk, foreign exchange risk, and
commodity price risk), a description of the stress tests applied to
the positions subject to the factor;
(vi) The results of the comparison of the [banking
organization]'s internal estimates for purposes of this appendix
with actual outcomes during a sample period not used in model
development;
(vii) The soundness standard on which the [banking
organization]'s internal capital adequacy assessment under this
appendix is based, including a description of the methodologies used
to achieve a capital adequacy assessment that is consistent with the
soundness standard;
(2) A description of the [banking organization]'s processes for
monitoring changes in the credit and market risk of securitization
positions, including how those processes differ for resecuritization
positions; and
(3) A description of the [banking organization]'s policy
governing the use of credit risk mitigation to mitigate the risks of
securitization and resecuritization positions.
[End of Common Text]
List of Subjects
12 CFR Part 3
Administrative practices and procedure, Capital, National banks,
Reporting and recordkeeping requirements, Risk.
12 CFR Part 208
Confidential business information, Crime, Currency, Federal Reserve
System, Mortgages, reporting and recordkeeping requirements,
Securities.
12 CFR Part 225
Administrative practice and procedure, Banks, banking, Federal
Reserve System, Holding companies, Reporting and recordkeeping
requirements, Securities.
12 CFR Part 325
Administrative practice and procedure, Banks, banking, Capital
Adequacy, Reporting and recordkeeping requirements, Savings
associations, State non-member banks.
Adoption of Proposed Common Rule
The adoption of the proposed common rules by the agencies, as
modified by agency-specific text, is set forth below:
Department of the Treasury
Office of the Comptroller of the Currency
12 CFR Chapter I
Authority and Issuance
For the reasons set forth in the common 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, 3907 and 3909.
[[Page 1921]]
2. Appendix B to part 3 is revised to read as set forth at the end
of the common preamble.
Appendix B to Part 3--Risk-Based Capital Guidelines; Market Risk
Adjustment
3. Appendix B to part 3 is further amended by:
a. Removing ``[the advanced capital adequacy framework]'' wherever
it appears and adding in its place ``Appendix C to this part'';
b. Removing ``[Agency]'' wherever it appears and adding in its
place ``OCC'';
c. Removing ``[Agency's]'' wherever it appears and adding in its
place ``OCC's'';
d. Removing ``[banking organization]'' wherever it appears and
adding in its place ``bank'';
e. Removing ``[banking organizations]'' wherever it appears and
adding in its place ``banks'';
f. Removing ``[Call Report or FR Y-9C]'' wherever it appears and
adding in its place ``Call Report'';
g. Removing ``[regulatory report]'' wherever it appears and adding
in its place ``Consolidated Reports of Condition and Income (Call
Report)'';
h. Removing ``[the general risk-based capital rules]'' wherever it
appears and adding in its place ``Appendix A to this part''.
Board of Governors of the Federal Reserve System
12 CFR Chapter II
Authority and Issuance
For the reasons set forth in the common 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)
4. The authority citation for part 208 continues to read as
follows:
Authority: 12 U.S.C. 24, 36, 92a, 93a, 248(a), 248(c), 321-
338a, 371d, 461, 481-486, 601, 611, 1814, 1816, 1818, 1820(d)(9),
1833(j), 1828(o), 1831, 1831o, 1831p-1, 1831r-1, 1831w, 1831x,
1835a, 1882, 2901-2907, 3105, 3310, 3331-3351, and 3905-3909; 15
U.S.C. 78b, 78I(b), 78l(i), 780-4(c)(5), 78q, 78q-1, and 78w, 1681s,
1681w, 6801, and 6805; 31 U.S.C. 5318; 42 U.S.C. 4012a, 4104a,
4104b, 4106 and 4128.
5. Appendix E to part 208 is revised to read as set forth at the
end of the common preamble.
Appendix E to Part 208--Capital Adequacy Guidelines for State Member
Banks: Market Risk Measure
6. Appendix E to part 208 is amended by:
a. Removing ``[the advanced capital adequacy framework]'' wherever
it appears and adding in its place ``Appendix F to this part'';
b. Removing ``[Agency]'' wherever it appears and adding in its
place ``Board'';
c. Removing ``[Agency's]'' wherever it appears and adding in its
place ``Board's'';
d. Removing ``[banking organization]'' wherever it appears and
adding in its place ``bank'';
e. Removing ``[banking organizations]'' wherever it appears and
adding in its place ``banks'';
f. Removing ``[Call Report or FR Y-9C]'' wherever it appears and
adding in its place ``Call Report'';
g. Removing ``[regulatory report]'' wherever it appears and adding
in its place ``Consolidated Reports of Condition and Income (Call
Report)'';
h. Removing ``[the general risk-based capital rules]'' wherever it
appears and adding in its place ``Appendix A to this part''.
PART 225--BANK HOLDING COMPANIES AND CHANGE IN BANK CONTROL
(REGULATION Y)
7. 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; 15 U.S.C. 1681s, 1681w, 6801 and 6805.
8. Appendix E to part 225 is revised to read as set forth at the
end of the common preamble.
Appendix E to Part 225--Capital Adequacy Guidelines for Bank Holding
Companies: Market Risk Measure
9. Appendix E is amended by:
a. Removing ``[the advanced capital adequacy framework]'' wherever
it appears and adding in its place ``Appendix G to this part'';
b. Removing ``[Agency]'' wherever it appears and adding in its
place ``Board'';
c. Removing ``[Agency's]'' wherever it appears and adding in its
place ``Board's'';
d. Removing ``[banking organization]'' wherever it appears and
adding in its place ``bank holding company'';
e. Removing ``[banking organizations]'' wherever it appears and
adding in its place ``bank holding companies'';
f. Removing ``[Call Report or FR Y-9C]'' wherever it appears and
adding in its place ``FR Y-9C'';
g. Removing ``[regulatory report]'' wherever it appears and adding
in its place ``Consolidated Financial Statements for Bank Holding
Companies (FR Y-9C)''; and
h. Removing ``[the general risk-based capital rules]'' wherever it
appears and adding in its place ``Appendix A to this part''.
Federal Deposit Insurance Corporation
12 CFR Chapter III
Authority and Issuance
For the reasons set forth in the common 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
10. 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).
11. Appendix C to part 325 is revised to read as set forth at the
end of the common preamble.
Appendix C to Part 325--Risk-Based Capital for State Nonmember Banks:
Market Risk
12. Appendix C is further amended by:
a. Removing ``[Agency]'' wherever it appears and adding in its
place ``FDIC'';
b. Removing ``[Agency's]'' wherever it appears and adding in its
place ``FDIC's'';
c. Removing ``[banking organization]'' wherever it appears and
adding in its place ``bank'';
d. Removing ``[banking organizations]'' wherever it appears and
adding in its place ``banks'';
e. Removing [Call Report or FR Y-9C] wherever it appears and adding
in its place ``Call Report'';
f. Removing ``[the advanced capital adequacy framework]'' wherever
it appears and adding in its place ``Appendix D to this part'';
g. Removing ``[regulatory report]'' wherever it appears and adding
in its place ``Consolidated Reports of Condition and Income (Call
Report)'';
h. Removing ``[the general risk-based capital rules]'' wherever it
appears and adding in its place ``Appendix A to this part''.
[[Page 1922]]
Dated: December 15, 2010.
John Walsh,
Acting Comptroller of the Currency.
By order of the Board of Governors of the Federal Reserve
System, December 14, 2010.
Robert deV. Frierson,
Deputy Secretary of the Board.
Dated at Washington, DC, this 14th of December 2010. By order of
the Board of Directors. Federal Deposit Insurance Corporation.
Robert E. Feldman,
Executive Secretary.
[FR Doc. 2010-32189 Filed 1-10-11; 8:45 am]
BILLING CODE 4810-33-P; 6210-01-P; 6714-01-P; 6720-01-P