Regulatory Capital Rule: Large Banking Organizations and Banking Organizations With Significant Trading Activity
| Court | Federal Deposit Insurance Corporation,The Comptroller Of The Currency Office |
| Citation | 88 FR 64028 |
| Published date | 18 September 2023 |
| Record Number | 2023-19200 |
Federal Register, Volume 88 Issue 179 (Monday, September 18, 2023)
[Federal Register Volume 88, Number 179 (Monday, September 18, 2023)]
[Proposed Rules]
[Pages 64028-64343]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2023-19200]
[[Page 64027]]
Vol. 88
Monday,
No. 179
September 18, 2023
Part IIDepartment of the Treasury-----------------------------------------------------------------------Office of the Comptroller of the Currency12 CFR Parts 3, 6, 32, et al.Federal Reserve System-----------------------------------------------------------------------Federal Deposit Insurance Corporation-----------------------------------------------------------------------Regulatory Capital Rule: Large Banking Organizations and Banking
Organizations With Significant Trading Activity; Proposed Rule
Federal Register / Vol. 88, No. 179 / Monday, September 18, 2023 /
Proposed Rules
[[Page 64028]]
DEPARTMENT OF THE TREASURY
Office of the Comptroller of the Currency
12 CFR Parts 3, 6, 32
[Docket ID OCC-2023-0008]
RIN 1557-AE78
FEDERAL RESERVE SYSTEM
12 CFR Parts 208, 217, 225, 238, 252
[Docket No. R-1813]
RIN 7100-AG64
FEDERAL DEPOSIT INSURANCE CORPORATION
12 CFR Part 324
RIN 3064-AF29
Regulatory Capital Rule: Large Banking Organizations and Banking
Organizations With Significant Trading Activity
AGENCY: Office of the Comptroller of the Currency, Treasury; the Board
of Governors of the Federal Reserve System; and the Federal Deposit
Insurance Corporation.
ACTION: Notice of proposed rulemaking.
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SUMMARY: The Office of the Comptroller of the Currency, the Board of
Governors of the Federal Reserve System, and the Federal Deposit
Insurance Corporation are inviting public comment on a notice of
proposed rulemaking (proposal) that would substantially revise the
capital requirements applicable to large banking organizations and to
banking organizations with significant trading activity. The revisions
set forth in the proposal would improve the calculation of risk-based
capital requirements to better reflect the risks of these banking
organizations' exposures, reduce the complexity of the framework,
enhance the consistency of requirements across these banking
organizations, and facilitate more effective supervisory and market
assessments of capital adequacy. The revisions would include replacing
current requirements that include the use of banking organizations'
internal models for credit risk and operational risk with standardized
approaches and replacing the current market risk and credit valuation
adjustment risk requirements with revised approaches. The proposed
revisions would be generally consistent with recent changes to
international capital standards issued by the Basel Committee on
Banking Supervision. The proposal would not amend the capital
requirements applicable to smaller, less complex banking organizations.
DATES: Comments must be received by November 30, 2023.
ADDRESSES: Comments should be directed to:
OCC: Commenters are encouraged to submit comments through the
Federal eRulemaking Portal, if possible. Please use the title
``Regulatory capital rule: Amendments applicable to large banking
organizations and to banking organizations with significant trading
activity'' 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 https://regulations.gov/. Enter ``Docket ID OCC-2023-0008''
in the Search Box and click ``Search.'' Public comments can be
submitted via the ``Comment'' box below the displayed document
information or by clicking on the document title and then clicking the
``Comment'' box on the top-left side of the screen. For help with
submitting effective comments, please click on ``Commenter's
Checklist.'' For assistance with the Regulations.gov site, please call
1-866-498-2945 (toll free) Monday-Friday, 9 a.m.-5 p.m. ET, or email
[email protected].
Mail: Chief Counsel's Office, Attention: Comment
Processing, Office of the Comptroller of the Currency, 400 7th Street
SW, Suite 3E-218, Washington, DC 20219.
Hand Delivery/Courier: 400 7th Street SW, Suite 3E-218,
Washington, DC 20219.
Instructions: You must include ``OCC'' as the agency name and
``Docket ID OCC-2023-0008'' in your comment. In general, the OCC will
enter all comments received into the docket and publish the comments on
the Regulations.gov website without change, including any business or
personal information provided such as name and address information,
email 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 include 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 action by the following method:
Viewing Comments Electronically--Regulations.gov:
Go to https://regulations.gov/. Enter ``Docket ID OCC-2023-0008''
in the Search Box and click ``Search.'' Click on the ``Dockets'' tab
and then the document's title. After clicking the document's title,
click the ``Browse All Comments'' tab. Comments can be viewed and
filtered by clicking on the ``Sort By'' drop-down on the right side of
the screen or the ``Refine Comments Results'' options on the left side
of the screen. Supporting materials can be viewed by clicking on the
``Browse Documents'' tab. Click on the ``Sort By'' drop-down on the
right side of the screen or the ``Refine Results'' options on the left
side of the screen checking the ``Supporting & Related Material''
checkbox. For assistance with the Regulations.gov site, please call 1-
866-498-2945 (toll free) Monday-Friday, 9 a.m.-5 p.m. ET, or email
[email protected].
The docket may be viewed after the close of the comment period in
the same manner as during the comment period.
Board: You may submit comments, identified by Docket No. R-1813,
RIN 7100-AG64 by any of the following methods:
Agency Website: https://www.federalreserve.gov. Follow the
instructions for submitting comments at https://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm.
Federal eRulemaking Portal: https://www.regulations.gov. Follow the
instructions for submitting comments.
Email: [email protected]. Include the docket number
and RIN in the subject line of the message.
Fax: (202) 452-3819 or (202) 452-3102.
Mail: Ann E. Misback, Secretary, Board of Governors of the Federal
Reserve System, 20th Street and Constitution Avenue NW, Washington, DC
20551.
In general, all public comments will be made available on the
Board's website at www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm as submitted, and will not be modified to remove
confidential, contact or any identifiable information. Public comments
may also be viewed electronically or in paper in Room M-4365A, 2001 C
St. NW, Washington, DC 20551, between 9 a.m. and 5 p.m. during Federal
business weekdays.
FDIC: The FDIC encourages interested parties to submit written
comments. Please include your name, affiliation, address, email
address, and telephone number(s) in your comment. You may submit
comments to the FDIC, identified by RIN 3064-AF29 by any of the
following methods:
Agency Website: https://www.fdic.gov/resources/regulations/
[[Page 64029]]
federal-register-publications. Follow instructions for submitting
comments on the FDIC's website.
Mail: James P. Sheesley, Assistant Executive Secretary, Attention:
Comments/Legal OES (RIN 3064-AF29), Federal Deposit Insurance
Corporation, 550 17th Street NW, Washington, DC 20429.
Hand Delivered/Courier: Comments may be hand-delivered to the guard
station at the rear of the 550 17th Street NW, building (located on F
Street NW) on business days between 7 a.m. and 5 p.m.
Email: [email protected]. Include the RIN 3064-AF29 on the subject
line of the message.
Public Inspection: Comments received, including any personal
information provided, may be posted without change to https://www.fdic.gov/resources/regulations/federal-register-publications.
Commenters should submit only information that the commenter wishes to
make available publicly. The FDIC may review, redact, or refrain from
posting all or any portion of any comment that it may deem to be
inappropriate for publication, such as irrelevant or obscene material.
The FDIC may post only a single representative example of identical or
substantially identical comments, and in such cases will generally
identify the number of identical or substantially identical comments
represented by the posted example. All comments that have been
redacted, as well as those that have not been posted, that contain
comments on the merits of this document will be retained in the public
comment file and will be considered as required under all applicable
laws. All comments may be accessible under the Freedom of Information
Act.
FOR FURTHER INFORMATION CONTACT:
OCC: Venus Fan, Risk Expert, Benjamin Pegg, Analyst, Andrew
Tschirhart, Risk Expert, or Diana Wei, Risk Expert, Capital Policy,
(202) 649-6370; Carl Kaminski, Assistant Director, Kevin Korzeniewski,
Counsel, Rima Kundnani, Counsel, Daniel Perez, Counsel, or Daniel
Sufranski, Senior Attorney, Chief Counsel's Office, (202) 649-5490,
Office of the Comptroller of the Currency, 400 7th Street SW,
Washington, DC 20219. If you are deaf, hard of hearing, or have a
speech disability, please dial 7-1-1 to access telecommunications relay
services.
Board: Anna Lee Hewko, Associate Director, (202) 530-6260; Brian
Chernoff, Manager, (202) 452-2952; Andrew Willis, Manager, (202) 912-
4323; Cecily Boggs, Lead Financial Institution Policy Analyst, (202)
530-6209; Marco Migueis, Principal Economist, (202) 452-6447; Diana
Iercosan, Principal Economist, (202) 912-4648; Nadya Zeltser, Senior
Financial Institution Policy Analyst, (202) 452-3164; Division of
Supervision and Regulation; or Jay Schwarz, Assistant General Counsel,
(202) 452-2970; Mark Buresh, Special Counsel, (202) 452-5270; Andrew
Hartlage, Special Counsel, (202) 452-6483; Gillian Burgess, Senior
Counsel, (202) 736-5564; Jonah Kind, Senior Counsel, (202) 452-2045,
Legal Division, Board of Governors of the Federal Reserve System, 20th
Street and Constitution Avenue NW, Washington, DC 20551. For users of
TTY-TRS, please call 711 from any telephone, anywhere in the United
States.
FDIC: Benedetto Bosco, Chief Capital Policy Section; Bob Charurat,
Corporate Expert; Irina Leonova, Corporate Expert; Andrew Carayiannis,
Chief, Policy and Risk Analytics Section; Brian Cox, Chief, Capital
Markets Strategies Section; Noah Cuttler, Senior Policy Analyst; David
Riley, Senior Policy Analyst; Michael Maloney, Senior Policy Analyst;
Richard Smith, Capital Markets Policy Analyst; Olga Lionakis, Capital
Markets Policy Analyst; Kyle McCormick, Senior Policy Analyst; Keith
Bergstresser, Senior Policy Analyst, Capital Markets and Accounting
Policy Branch, Division of Risk Management Supervision; Catherine Wood,
Counsel; Benjamin Klein, Counsel; Anjoly David, Honors Attorney, Legal
Division; [email protected], (202) 898-6888; Federal Deposit
Insurance Corporation, 550 17th Street NW, Washington, DC 20429.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Introduction
A. Overview of the Proposal
B. Use of Internal Models Under the Proposed Framework
II. Scope of Application
III. Proposed Changes to the Capital Rule
A. Calculation of Capital Ratios and Application of Buffer
Requirements
1. Standardized Output Floor
2. Stress Capital Buffer Requirement
B. Definition of Capital
1. Accumulated Other Comprehensive Income
2. Regulatory Capital Deductions
3. Additional Definition of Capital Adjustments
4. Changes to the Definition of Tier 2 Capital Applicable to
Large Banking Organizations
C. Credit Risk
1. Due Diligence
2. Proposed Risk Weights for Credit Risk
3. Off-Balance Sheet Exposures
4. Derivatives
5. Credit Risk Mitigation
D. Securitization Framework
1. Operational Requirements
2. Securitization Standardized Approach (SEC-SA)
3. Exceptions to the SEC-SA Risk-Based Capital Treatment for
Securitization Exposures
4. Credit Risk Mitigation for Securitization Exposures
E. Equity Exposures
1. Risk-Weighted Asset Amount
F. Operational Risk
1. Business Indicator
2. Business Indicator Component
3. Internal Loss Multiplier
4. Operational Risk Management and Data Collection Requirements
G. Disclosure Requirements
1. Proposed Disclosure Requirements
2. Specific Public Disclosure Requirements
H. Market Risk
1. Background
2. Scope and Application of the Proposed Rule
3. Market Risk Covered Position
4. Internal Risk Transfers
5. General Requirements for Market Risk
6. Measure for Market Risk
7. Standardized Measure for Market Risk
8. Models-Based Measure for Market Risk
9. Treatment of Certain Market Risk Covered Positions
10. Reporting and Disclosure Requirements
11. Technical Amendments
I. Credit Valuation Adjustment Risk
1. Background
2. Scope of Application
3. CVA Risk Covered Positions and CVA Hedges
4. General Risk Management Requirements
5. Measure for CVA Risk
IV. Transition Provisions
A. Transitions for Expanded Total Risk-Weighted Assets
B. AOCI Regulatory Capital Adjustments
V. Impact and Economic Analysis
A. Scope and Data
B. Impact on Risk-Weighted Assets and Capital Requirements
C. Economic Impact on Lending Activity
D. Economic Impact on Trading Activity
E. Additional Impact Considerations
VI. Technical Amendments to the Capital Rule
A. Additional OCC Technical Amendments
B. Additional FDIC Technical Amendments
VII. Proposed Amendments to Related Rules and Related Proposals
A. OCC Amendments
B. Board Amendments
C. Related Proposals
VIII. Administrative Law Matters
A. Paperwork Reduction Act
B. Regulatory Flexibility Act
C. Plain Language
D. Riegle Community Development and Regulatory Improvement Act
of 1994
E. OCC Unfunded Mandates Reform Act of 1995 Determination
F. Providing Accountability Through Transparency Act of 2023
I. Introduction
The Office of the Comptroller of the Currency (OCC), the Board of
Governors
[[Page 64030]]
of the Federal Reserve System (Board), and the Federal Deposit
Insurance Corporation (FDIC) (collectively, the agencies) are proposing
to modify the capital requirements applicable to banking organizations
\1\ with total assets of $100 billion or more and their subsidiary
depository institutions (large banking organizations) and to banking
organizations with significant trading activity. The revisions set
forth in the proposal would strengthen the calculation of risk-based
capital requirements to better reflect the risks of these banking
organizations' exposures. In addition, the proposed revisions would
enhance the consistency of requirements across large banking
organizations and facilitate more effective supervisory and market
assessments of capital adequacy.
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\1\ The term ``banking organizations'' includes national banks,
state member banks, state nonmember banks, Federal savings
associations, state savings associations, top-tier bank holding
companies domiciled in the United States not subject to the Board's
Small Bank Holding Company and Savings and Loan Holding Company
Policy Statement (12 CFR part 225, appendix C), U.S. intermediate
holding companies of foreign banking organizations, and top-tier
savings and loan holding companies domiciled in the United States,
except for certain savings and loan holding companies that are
substantially engaged in insurance underwriting or commercial
activities and savings and loan holding companies that are subject
to the Small Bank Holding Company and Savings and Loan Holding
Company Policy Statement.
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Following the 2007-09 financial crisis, the agencies adopted an
initial set of reforms to improve the effectiveness of and address
weaknesses in the regulatory capital framework. For example, in 2013,
the agencies adopted a final rule that increased the quantity and
quality of regulatory capital banking organizations must maintain.\2\
These changes were broadly consistent with an initial set of reforms
published by the Basel Committee on Banking Supervision (Basel
Committee) following the financial crisis.\3\ The Board also
implemented capital planning and stress testing requirements for large
bank holding companies and savings and loan holding companies \4\ and
an additional capital buffer requirement to mitigate the financial
stability risks posed by U.S. global systemically important banking
organizations (GSIBs),\5\ as well as other enhanced prudential
standards, consistent with the Dodd-Frank Wall Street Reform and
Consumer Protection Act of 2010 (Dodd-Frank Act).\6\
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\2\ The Board and the OCC issued a joint final rule on October
11, 2013 (78 FR 62018) and the FDIC issued a substantially identical
interim final rule on September 10, 2013 (78 FR 55340). In April
2014, the FDIC adopted the interim final rule as a final rule with
no substantive changes. 79 FR 20754 (April 14, 2014).
\3\ The Basel Committee is a committee composed of central banks
and banking supervisory authorities, which was established by the
central bank governors of the G-10 countries in 1975.
\4\ See 12 CFR 225.8; 12 CFR part 238, subparts N, O, P, R, S;
12 CFR part 252, subparts D, E, F, N, O.
\5\ 12 CFR part 217, subpart H.
\6\ See 12 CFR part 252; 12 U.S.C. 5365.
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The proposal would build on these initial reforms by making
additional changes developed in response to the 2007-09 financial
crisis and informed by experience since the crisis. Requirements under
the proposal would generally be consistent with international capital
standards issued by the Basel Committee, commonly known as the Basel
III reforms.\7\ Where appropriate, the proposal differs from the Basel
III reforms to reflect, for example, specific characteristics of U.S.
markets, requirements under U.S. generally accepted accounting
principles (GAAP),\8\ practices of U.S. banking organizations, and U.S.
legal requirements and policy objectives.
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\7\ See the consolidated Basel Framework at https://www.bis.org/basel_framework/.
\8\ GAAP often serve as a foundational measurement component for
U.S. capital requirements.
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The proposal would strengthen risk-based capital requirements for
large banking organizations by improving their comprehensiveness and
risk sensitivity. These proposed revisions, including removal of
certain internal models, would increase capital requirements in the
aggregate, in particular for those banking organizations with
heightened risk profiles. Increased capital requirements can produce
both economic costs and benefits. The agencies assessed the likely
effect of the proposal on economic activity and resilience, and expect
that the benefits of strengthening capital requirements for large
banking organizations outweigh the costs.\9\
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\9\ See the impact and economic analysis presented in section V
of this SUPPLEMENTARY INFORMATION.
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Historical experience has demonstrated the impact individual
banking organizations can have on the stability of the U.S. banking
system, in particular banking organizations that would have been
subject to the proposal. Large banking organizations that experience an
increase in their capital requirements resulting from the proposal
would be expected to be able to absorb losses with reduced disruption
to financial intermediation in the U.S. economy. Enhanced resilience of
the banking sector supports more stable lending through the economic
cycle and diminishes the likelihood of financial crises and their
associated costs.
The agencies seek comment on all aspects of the proposal.
A. Overview of the Proposal
The proposal would improve the risk capture and consistency of
capital requirements across large banking organizations and reduce
complexity and operational costs through changes across multiple areas
of the agencies' risk-based capital framework. For most parts of the
framework, the proposal would eliminate the use of banking
organizations' internal models to set regulatory capital requirements
and in their place apply a simpler and more consistent standardized
framework. For market risk, the proposal would retain banking
organizations' ability to use internal models, with an improved models-
based measure for market risk that better accounts for potential
losses. The use of internal models would be subject to enhanced
requirements for model approval and performance and a new ``output
floor'' to limit the extent to which a banking organization's internal
models may reduce its overall capital requirement. The proposal would
also adopt new standardized approaches for market risk and credit
valuation adjustment (CVA) risk that better reflect the risks of
banking organizations' exposures.
This new framework for calculating risk-weighted assets (the
expanded risk-based approach) would apply to banking organizations with
total assets of $100 billion or more and their subsidiary depository
institutions. The revised requirements for market risk would also apply
to other banking organizations with $5 billion or more in trading
assets plus trading liabilities or for which trading assets plus
trading liabilities exceed 10 percent of total assets.
The expanded risk-based approach would be more risk-sensitive than
the current U.S. standardized approach by incorporating more credit-
risk drivers (for example, borrower and loan characteristics) and
explicitly differentiating between more types of risk (for example,
operational risk, credit valuation adjustment risk). In this manner,
the expanded risk-based approach would better account for key risks
faced by large banking organizations. The proposed changes would also
enhance the alignment of capital requirements to the risks of banking
organizations' exposures and increase incentives for prudent risk
management.
To ensure that large banking organizations would not have lower
capital requirements than smaller, less complex banking organizations,
the
[[Page 64031]]
proposal would maintain the capital rule's dual-requirement structure.
Under this structure, a large banking organization would be required to
calculate its risk-based capital ratios under both the new expanded
risk-based approach and the standardized approach (including market
risk, as applicable), and use the lower of the two for each risk-based
capital ratio.\10\ All capital buffer requirements, including the
stress capital buffer requirement, would apply regardless of whether
the expanded risk-based approach or the existing standardized approach
produces the lower ratio.
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\10\ Banking organizations' risk-based capital ratios are the
common equity tier 1 capital ratio, tier 1 capital ratio, and total
capital ratio. See 12 CFR 3.10 (OCC), 12 CFR 217.10 (Board), and 12
CFR 324.10 (FDIC).
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For banking organizations subject to Category III or IV capital
standards,\11\ the proposal would align the calculation of regulatory
capital--the numerator of the regulatory capital ratios--with the
calculation for banking organizations subject to Category I or II
capital standards, providing the same approach for all large banking
organizations. Banking organizations subject to Category III or IV
capital standards would be subject to the same treatment of accumulated
other comprehensive income (AOCI), capital deductions, and rules for
minority interest as banking organizations subject to Category I or II
capital standards. This change would help ensure that the regulatory
capital ratios of these banking organizations better reflect their
capacity to absorb losses, including by taking into account unrealized
losses or gains on securities positions reflected in AOCI.
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\11\ In 2019, the agencies adopted rules establishing four
categories of capital standards for U.S. banking organizations with
$100 billion or more in total assets and foreign banking
organizations with $100 billion or more in combined U.S. assets.
Under this framework, Category I capital standards apply to U.S.
global systemically important bank holding companies and their
depository institution subsidiaries. Category II capital standards
apply to banking organizations with at least $700 billion in total
consolidated assets or at least $75 billion in cross-jurisdictional
activity and their depository institution subsidiaries. Category III
capital standards apply to banking organizations with total
consolidated assets of at least $250 billion or at least $75 billion
in weighted short-term wholesale funding, nonbank assets, or off-
balance sheet exposure and their depository institution
subsidiaries. Category IV capital standards apply to banking
organizations with total consolidated assets of at least $100
billion that do not meet the thresholds for a higher category and
their depository institution subsidiaries. See 12 CFR 3.2 (OCC), 12
CFR 252.5, 12 CFR 238.10 (Board), 12 CFR 324.2 (FDIC); ``Prudential
Standards for Large Bank Holding Companies, Savings and Loan Holding
Companies, and Foreign Banking Organizations,'' 84 FR 59032
(November 1, 2019); and ``Changes to Applicability Thresholds for
Regulatory Capital and Liquidity Requirements,'' 84 FR 59230
(November 1, 2019).
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The proposal would expand application of the supplementary leverage
ratio and the countercyclical capital buffer to banking organizations
subject to Category IV capital standards. This change would bring
further alignment of capital requirements across large banking
organizations and is consistent with the proposal's goal of
strengthening the resilience of large banking organizations.
The proposal would also introduce enhanced disclosure requirements
to facilitate market participants' understanding of a banking
organization's financial condition and risk management practices. Also,
the proposal would align Federal Reserve's regulatory reporting
requirements with the changes to capital requirements. The agencies
anticipate that revisions to the reporting forms of the Federal
Financial Institutions Examination Council (FFIEC) applicable to large
banking organizations and to banking organizations with significant
trading activity will be proposed in the near future, which would align
with the proposed revisions to the capital rule.
The proposed changes would take effect subject to the transition
provisions described in section IV of this SUPPLEMENTARY INFORMATION.
The revisions introduced by the proposal would interact with
several Board rules, including by modifying the risk-weighted assets
used to calculate total loss-absorbing capacity requirements, long-term
debt requirements, and the short-term wholesale funding score included
in the GSIB surcharge method 2 score. Also, the proposal would revise
the calculation of single-counterparty credit limits by removing the
option of using a banking organization's internal models to calculate
derivatives exposure amounts and requiring the use of the standardized
approach for counterparty credit risk for this purpose. The proposal
would also remove the exemption from calculating risk-weighted assets
under subpart E of the capital rule currently available to U.S.
intermediate holding companies of foreign banking organizations under
the Board's enhanced prudential standards.
In parallel, the Board is issuing a notice of proposed rulemaking
revising the GSIB surcharge calculation applicable to GSIBs and the
systemic risk report applicable to large banking organizations.\12\
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\12\ On October 24, 2019, the Board published in the Federal
Register a notice of proposed rulemaking inviting comment on a
proposal to establish risk-based capital requirements for depository
institution holding companies significantly engaged in insurance
activities. See 84 FR 57240 (October 24, 2019). The Board
anticipates that any final rule based on the proposal in this
Supplementary Information would include appropriate adjustments as
necessary to take into account any final insurance capital rule.
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Question 1: The Board invites comment on the interaction of the
revisions under the proposal with other existing rules and with the
other notice of proposed rulemaking. In particular, comment is invited
on the impact of the proposal on the single-counterparty credit limit
framework. What are the advantages and disadvantages of the proposed
approach? Which alternatives, if any, should the Board consider and
why?
B. Use of Internal Models Under the Proposed Framework
The proposal would remove the use of internal models to set credit
risk and operational risk capital requirements (the so-called advanced
approaches) for banking organizations subject to Category I or II
capital standards. These internal models rely on a banking
organization's choice of modeling assumptions and supporting data. Such
model assumptions include a degree of subjectivity, which can result in
varying risk-based capital requirements for similar exposures.
Moreover, empirical verification of modeling choices can require many
years of historical experience because severe credit risk and
operational risk losses can occur infrequently. In the agencies'
previous observations, the advanced approaches have produced
unwarranted variability across banking organizations in requirements
for exposures with similar risks.\13\ This unwarranted variability,
combined with the complexity of these models-based approaches, can
reduce confidence in the validity of the modeled outputs, lessen the
transparency of the risk-based capital ratios, and challenge
comparisons of capital adequacy across banking organizations.
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\13\ The Basel Committee has published analysis illustrating the
variability of credit-risk-weighted assets across banking
organizations. See https://www.bis.org/publ/bcbs256.pdf and https://www.bis.org/bcbs/publ/d363.pdf.
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Standardization of credit and operational risk capital requirements
would improve the consistency of requirements. Standardized
requirements, together with robust public disclosure and reporting
requirements, would enhance the transparency of capital requirements
and the ability of supervisors and market participants to make
independent assessments of a banking
[[Page 64032]]
organization's capital adequacy, individually and relative to its
peers.
The use of robust, risk-sensitive standardized approaches for
credit and operational risk would also improve the efficiency of the
capital framework by reducing operational costs. Under the advanced
approaches, banking organizations subject to Category I or II capital
standards must develop and maintain internal modeling systems to
determine capital requirements, which may differ from the risk
measurement approaches they use to monitor risk for internal
assessments. Further, any material changes to a banking organization's
internal models must be fully documented and presented to the banking
organization's primary Federal supervisor for review.\14\ Replacing the
use of internal models with standardized approaches would reduce costs
associated with maintaining such modeling systems and eliminate the
associated submissions to the agencies.
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\14\ See 12 CFR 3.123(a) (OCC); 12 CFR 217.123(a) (Board); 12
CFR 324.123(a) (FDIC).
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Eliminating the use of internal models to set credit and
operational risk capital requirements would not reduce the overall risk
capture of the regulatory framework. In addition to the calculation of
expanded risk-based approach and standardized approach capital
requirements, a large banking organization would continue to be
required to maintain capital commensurate with the level and nature of
all risks to which the banking organization is exposed,\15\ to have a
process for assessing its overall capital adequacy in relation to its
risk profile and a comprehensive strategy for maintaining an
appropriate level of capital,\16\ and, where applicable, to conduct
internal stress tests.\17\ Also, holding companies subject to the
Board's capital plan rule would continue to be subject to a stress
capital buffer requirement that is based on a supervisory stress test
of the holding company's exposures.\18\ Although the proposal would
remove use of internal models for calculating capital requirements for
credit and operational risk, internal models can provide valuable
information to a banking organization's internal stress testing,
capital planning, and risk management functions. Large banking
organizations should employ internal modeling capabilities as
appropriate for the complexity of their activities.
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\15\ See 12 CFR 3.10(e)(1) (OCC); 12 CFR 217.10(e)(1) (Board);
12 CFR 324.10(e)(1) (FDIC).
\16\ See 12 CFR 3.10(e)(2) (OCC); 12 CFR 217.10(e)(2) (Board);
12 CFR 324.10(e)(2) (FDIC).
\17\ See 12 CFR 46 (OCC); 12 CFR 252 subpart B and F (Board); 12
CFR 325 (FDIC).
\18\ See 12 CFR 225.8 and 12 CFR 238.170.
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The proposal would continue to allow use of internal models to set
market risk capital requirements for portfolios where modeling can be
demonstrated to be appropriate. In addition, the proposal would provide
for conservative but risk-sensitive standardized alternatives where
modeling is not supported. In contrast to credit and operational risk,
market risk data allows for daily feedback on model performance to
support empirical verification. The proposal would limit the use of
models to only those trading desks for which a banking organization has
received approval from its primary Federal supervisor. Ongoing use of
such models would depend upon a banking organization's ability to
demonstrate through robust testing that the models are sufficiently
conservative and accurate for purposes of calculating market risk
capital requirements. In cases where a banking organization cannot
demonstrate acceptable performance of its internal models for a given
trading desk, the banking organization would be required to use the
standardized measure for market risk which acts as a risk-sensitive
alternative.
II. Scope of Application
The proposal's expanded risk-based approach would apply to banking
organizations with total assets of $100 billion or more and their
subsidiary depository institutions.\19\ These banking organizations are
large and exhibit heightened complexity. Application of the expanded
risk-based approach to large banking organizations would provide
granular, generally standardized requirements that result in robust
risk capture and appropriate risk sensitivity. By strengthening the
requirements that apply to large banking organizations, the proposal
would enhance their resilience and reduce risks to U.S. financial
stability and costs they may pose to the Federal Deposit Insurance Fund
in case of material distress or failure. Relative to smaller, less
complex banking organizations, these banking organizations have greater
operational capacity to apply more sophisticated requirements.
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\19\ The proposal would also apply to depository institutions
with total assets of $100 billion or more that are not consolidated
subsidiaries of depository institution holding companies, and to
depository institutions with total assets of $100 billion or more
that are subsidiaries of depository institution holding companies
that are not assigned a category under the capital rule.
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Previously, the agencies determined that the advanced approaches
requirements should not apply to banking organizations subject to
Category III or IV capital standards, as the agencies considered such
requirements to be overly complex and burdensome relative to the safety
and soundness benefits that they would provide for these banking
organizations.\20\ The expanded risk-based approach generally is based
on standardized requirements, which would be less complex and costly.
In addition, recent events demonstrate the impact banking organizations
subject to Category III or IV capital standards can have on financial
stability. While the recent failure of banking organizations subject to
Category IV capital standards may be attributed to a variety of
factors, the effect of these failures on financial stability supports
further alignment of the regulatory capital framework across large
banking organizations.
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\20\ See ``Prudential Standards for Large Bank Holding
Companies, Savings and Loan Holding Companies, and Foreign Banking
Organizations,'' 84 FR 59032 (November 1, 2019).
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Banking organizations with significant trading activities are
subject to substantial market risk and, therefore, would be subject to
market risk capital requirements. Recognizing that the dollar-based
threshold for the application of market risk requirements was
established in 1996, the proposal would increase this dollar-based
threshold from $1 billion to $5 billion of trading assets plus trading
liabilities. Banking organizations would also continue to be subject to
market risk requirements if their trading assets plus trading
liabilities represent 10 percent or more of total assets. The proposal
would revise the calculation of the dollar-based threshold amount to be
based on four-quarter averages of trading assets and trading
liabilities instead of point-in-time amounts. Banking organizations
that would no longer meet these minimum thresholds for being subject to
market risk capital requirements would calculate risk-weighted assets
for trading exposures under the standardized approach. Additionally,
under the proposal, large banking organizations would be subject to
market risk capital requirements regardless of trading activities.
The proposal would expand application of the countercyclical
capital buffer to banking organizations subject to Category IV capital
standards. The countercyclical capital buffer is a macroprudential tool
that can be used to increase the resilience of the financial system by
increasing capital requirements for large banking organizations during
a period of
[[Page 64033]]
elevated risk of above-normal losses. Failure or distress of a banking
organization with assets of $100 billion or more during a time of
elevated risk or stress can have significant destabilizing effects for
other banking organizations and the broader financial system--even if
the banking organization does not meet the criteria for being subject
to Category II or III capital standards. Applying the countercyclical
capital buffer to banking organizations subject to Category IV capital
standards would increase the resilience of these banking organizations
and, in turn, improve the resilience of the broader financial system.
The proposed approach also has the potential to moderate fluctuations
in the supply of credit over time. The proposal would also modify how
the countercyclical capital buffer amount is determined to reflect the
proposed changes to market risk capital requirements. Specifically, the
risk-weighted asset amount for private sector credit exposures that are
market risk covered positions under the proposal would be determined
using the standardized default risk capital requirement for such
positions rather than using the specific risk add-on of the current
rule.
The proposal also would expand application of the supplementary
leverage ratio requirement to banking organizations subject to Category
IV capital standards. In contrast to the risk-based capital
requirements, a leverage ratio does not differentiate the amount of
capital required by exposure type. Rather, a leverage ratio puts a
simple and transparent limit on banking organization leverage. Leverage
requirements protect against underestimation of risk both by banking
organizations and by risk-based capital requirements and serve as a
complement to risk-based capital requirements. The supplementary
leverage ratio measures tier 1 capital relative to total leverage
exposure, which includes on-balance sheet assets and certain off-
balance sheet exposures. The proposed change would ensure that all
large banking organizations are subject to a consistent and robust
leverage requirement that serves as a complement to risk-based capital
requirements and takes into account on- and off-balance sheet
exposures.
Question 2: What are the advantages and disadvantages of applying
the expanded risk-based approach to banking organizations subject to
Category III or IV capital standards? To what extent is the expanded
risk-based approach appropriate for banking organizations with
different risk profiles, including from a cost and operational burden
perspective? Are there specific areas, such as the market risk capital
framework, for which the agencies should consider a materiality
threshold to better balance cost and operational burden and risk
sensitivity, and if so what should that threshold be and why? What
would the appropriate exposure treatment be for banking organizations
with such exposures beneath any materiality threshold, and how would
that treatment be consistent with the overall calibration of the
expanded risk-based approach? What alternatives, if any, should the
agencies consider to help ensure that the risks of large banking
organizations are appropriately captured under minimum risk-based
capital requirements and why?
Question 3: What are the advantages and disadvantages of
harmonizing the calculation of regulatory capital across large banking
organizations? What are any unintended consequences of the proposal and
what steps should the agencies consider to mitigate those consequences?
What are the advantages and disadvantages of harmonizing the
calculation of regulatory capital across large banking organizations
and using different approaches (for example, the expanded risk-based
approach and the U.S. standardized approach) for the calculation of
risk-weighted assets?
Question 4: What are the advantages and disadvantages of applying
the countercyclical capital buffer and supplementary leverage ratio to
banking organizations subject to Category IV capital standards?
III. Proposed Changes to the Capital Rule
A. Calculation of Capital Ratios and Application of Buffer Requirements
Under the proposal, large banking organizations would be required
to calculate total risk-weighted assets under two approaches: (1) the
expanded risk-based approach, and (2) the standardized approach. Total
risk-weighted assets under the expanded risk-based approach (expanded
total risk-weighted assets) would equal the sum of risk-weighted assets
for credit risk, equity risk, operational risk, market risk, and CVA
risk, as described in this proposal, minus any amount of the banking
organization's adjusted allowance for credit losses that is not
included in tier 2 capital and any amount of allocated transfer risk
reserves. For calculating standardized total risk-weighted assets, the
proposal would revise the methodology for determining market risk-
weighted assets and would require banking organizations subject to
Category III or IV capital standards to use the standardized approach
for counterparty credit risk (SA-CCR) for derivative exposures.\21\
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\21\ The proposed methodology for determining market risk-
weighted assets, in certain instances, would require a banking
organization that is subject to subpart E to apply risk weights from
subpart D for purposes of determining its standardized total risk-
weighted assets and from subpart E for purposes of determining its
expanded total risk-weighted assets. This approach would apply in
the case of: (i) capital add-ons for re-designations, (ii) term
repo-style transactions the banking organization elects to include
in market risk, (iii) the standardized default risk capital
requirement for securitization positions non-CTP, and (iv) the
standardized default risk capital requirement for correlation
trading positions, each as discussed further below.
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To determine its applicable risk-based capital ratios, a large
banking organization would calculate two sets of risk-based capital
ratios (common equity tier 1 capital ratio, tier 1 capital ratio, and
total capital ratio), one using expanded total risk-weighted assets and
one using standardized total risk-weighted assets. A banking
organization's common equity tier 1 capital ratio, tier 1 capital
ratio, and total capital ratio would be the lower of each ratio of the
two approaches.
The proposal would not change the minimum risk-based capital ratios
under the capital rule. Also, the capital conservation buffer would
continue to apply to risk-based capital ratios as under the capital
rule, except that the stress capital buffer requirement--a component of
the capital conservation buffer that is applicable to banking
organizations subject to the Board's capital plan rule--would apply to
a banking organization's risk-based capital ratios regardless of
whether the ratios result from the expanded risk-based approach or the
standardized approach.
Question 5: What are the advantages and disadvantages of banking
organizations being required to calculate risk-based capital ratios in
two different ways and what alternatives, such as a single calculation,
should the agencies consider and why? What modifications, if any, to
the proposed structure of the risk-based capital calculation should the
agencies consider?
1. Standardized Output Floor
To enhance the consistency of capital requirements and ensure that
the use of internal models for market risk does not result in
unwarranted reductions in capital requirements, the proposal would
introduce an ``output floor'' to the calculation of expanded total
risk-
[[Page 64034]]
weighted assets. This output floor would correspond to 72.5 percent of
the sum of a banking organization's credit risk-weighted assets, equity
risk-weighted assets, operational risk-weighted assets, and CVA risk-
weighted assets under the expanded risk-based approach and risk-
weighted assets calculated using the standardized measure for market
risk, minus any amount of the banking organization's adjusted allowance
for credit losses that is not included in tier 2 capital and any amount
of allocated transfer risk reserves.
The output floor would serve as a lower bound on the risk-weighted
assets under the expanded risk-based approach. In other words, if the
risk-weighted assets under the expanded risk-based approach were less
than the output floor, the output floor would have to be used as the
risk-weighted asset amount to determine the expanded risk-based
approach capital ratios.
The proposed calibration of the output floor aims to strike a
balance between allowing internal models to enhance the risk
sensitivity of market risk capital requirements and ensuring that these
models would not result in unwarranted reductions in capital
requirements. The output floor would be consistent with the Basel III
reforms, which would promote consistency in capital requirements for
large, complex, and internationally active banking organizations across
jurisdictions.
[GRAPHIC] [TIFF OMITTED] TP18SE23.000
Question 6: What are the advantages and disadvantages of the
proposed output floor?
2. Stress Capital Buffer Requirement
Under the current capital rule, each banking organization is
subject to one or more buffer requirements, and must maintain capital
ratios above the sum of its minimum requirements and buffer
requirements to avoid restrictions on capital distributions and certain
discretionary bonus payments.\22\ Banking organizations that are
subject to the Board's capital plan rule \23\ (bank holding companies,
U.S. intermediate holding companies, and savings and loan holding
companies that have over $100 billion or more in total consolidated
assets) are currently subject to a standardized approach capital
conservation buffer requirement, which is calculated as the sum of the
banking organization's stress capital buffer requirement, applicable
countercyclical capital buffer requirement, and applicable GSIB
surcharge. The standardized approach capital conservation buffer
requirement applies to a banking organization's standardized approach
risk-based capital ratios. In addition, banking organizations that are
subject to the capital plan rule and the advanced approaches
requirements are subject to an advanced approaches capital conservation
buffer requirement, which applies to their advanced approaches risk-
based capital ratios, and which is calculated in the same manner as the
standardized approach capital conservation buffer requirement, except
that the banking organization's stress capital buffer requirement is
replaced with a 2.5 percent buffer requirement.\24\
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\22\ 12 CFR 3.11 (OCC); 12 CFR 217.11 (Board); 12 CFR 324.11
(FDIC).
\23\ 12 CFR 225.8 (bank holding companies and U.S. intermediate
holding companies of foreign banking organizations); 12 CFR 238.170
(savings and loan holding companies).
\24\ See 12 CFR 217.11(c).
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The stress capital buffer requirement integrates the results of the
Board's supervisory stress tests with the risk-based requirements of
the capital rule to determine capital distribution limitations. As a
result, required capital levels for each banking organization more
closely align with the banking organization's risk profile and
projected losses as measured by the Board's stress test.\25\ The stress
capital buffer requirement is generally calculated as (1) the
difference between the banking organization's starting and minimum
projected common equity tier 1 capital ratios under the severely
adverse scenario in the supervisory stress test (stress test losses)
plus (2) the sum of the dollar amount of the banking organization's
planned common stock dividends for each of the fourth through seventh
quarters of the planning horizon as a percentage of risk-weighted
assets (dividend add-on).\26\ A banking organization's stress capital
buffer requirement cannot be less than 2.5 percent of standardized
total risk-weighted assets.
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\25\ See 85 FR 15576 (March 18, 2020).
\26\ 12 CFR 225.8(f)(2); 12 CFR 238.170(f)(2).
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Currently, the stress test losses and dividend add-on portion of
the stress capital buffer requirement are calculated using only the
standardized approach common equity tier 1 capital ratio. This is
consistent with the exclusion of the stress capital buffer requirement
from the advanced approaches capital conservation buffer requirement,
and with the Board's stress testing and capital plan rules, under which
banking organizations are not required to project capital ratios using
the advanced approaches.
The Board is proposing to amend its capital plan rule, stress
testing rule, and the buffer framework in its capital rule to take into
account capital ratios calculated under the expanded risk-based
approach, in addition to the standardized approach. Under the proposal,
banking organizations subject to the capital plan rule would be subject
to a single capital conservation buffer requirement, which would
include the stress capital buffer requirement, applicable
countercyclical capital buffer requirement, and applicable GSIB
surcharge, and would apply to the banking organization's risk-based
capital ratios, regardless of whether the ratios result from the
expanded risk-based approach or the standardized approach. In this
manner, the proposal would ensure that the stress capital buffer
requirement contributes to the robustness and risk-sensitivity of the
[[Page 64035]]
risk-based capital requirements of these banking organizations.
Application of the stress capital buffer requirement to the risk-based
capital ratios derived from the expanded risk-based approach would not
introduce complexity given the fixed balance sheet assumption currently
used in the Board stress tests and because the expanded risk-based
approach is based in mostly standardized requirements.\27\
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\27\ Initially, the Board did not incorporate the stress capital
buffer requirement into the advanced approaches capital conservation
buffer requirement owing to the complexity involved in doing so.
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Additionally, the proposal would revise the calculation of the
stress capital buffer requirement for large banking organizations.
Under the proposal, both the stress test losses and dividend add-on
components of the stress capital buffer requirement would be calculated
using the binding common equity tier 1 capital ratio, as of the final
quarter of the previous capital plan cycle, regardless of whether it
results from the expanded risk-based approach or the standardized
approach.\28\ The proposed calculation methodology would limit
complexity relative to potential alternatives, such as introducing two
stress capital buffer requirements for each banking organization (one
for each approach to calculating total risk-weighted assets). In
addition, the proposed approach recognizes that the binding approach
for a banking organization is unlikely to change within the period in
which a given stress capital buffer requirement is applicable.
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\28\ The Board's Stress Testing Policy Statement includes an
assumption that the magnitude of a banking organization's balance
sheet will be fixed throughout the projection horizon under the
supervisory stress test. 12 CFR part 252, appendix B. Under this
assumption, because the denominators of the common equity tier 1
capital ratios as calculated under the standardized approach and the
expanded risk-based approach would remain the same throughout the
stress test, the approach under which the binding common equity tier
1 capital ratio is calculated would remain the same throughout the
final quarter of the previous capital plan cycle and the projection
horizon.
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As part of the capital buffer framework, the stress capital buffer
requirement helps ensure that a banking organization can withstand
losses from a severely adverse scenario, while still meeting its
minimum regulatory capital requirements and thereby continuing to serve
as a viable financial intermediary. Because this proposal aims to
better reflect the risk of banking organizations' exposures in the
calculation of risk-weighted assets, without changing the targeted
level of conservatism of the minimum capital requirements, the Board is
not proposing associated changes to the targeted severity of the stress
capital buffer requirement. The Board evaluates the minimum risk-based
capital requirements, which are largely determined by risk-weighted
assets, and the stress capital buffer requirement individually for
their specific intended purposes in the capital framework, and
holistically as they determine the aggregate capital banking
organizations hold in the normal course of business.
In addition to revising the stress capital buffer requirement, the
proposal would amend the Board's stress testing and capital plan rules
to require banking organizations subject to Category I, II, or III
standards to project their risk-based capital ratios in their company-
run stress tests and capital plans using the calculation approach that
results in the binding ratios as of the start of the projection horizon
(generally, as of December 31 of a given year). Also, the proposal
would require banking organizations subject to Category IV standards to
project their risk-based capital ratios under baseline conditions in
their capital plans and FR Y-14A submissions using the risk-weighted
assets calculation approach that results in the binding ratios as of
the start of the projection horizon. The use of the binding approach to
calculating risk-based capital ratios aims to conform company-run
stress tests and capital plans with the binding risk-based capital
ratios in the proposed capital rule and promote simplicity relative to
possible alternatives (such as requiring that firms project ratios
under both the expanded risk-based approach and the standardized
approach).
Question 7: The Board invites comment on the appropriate level of
risk capture for the risk-weighted assets framework and the stress
capital buffer requirement, both for their respective roles in the
capital framework and for their joint determination of overall capital
requirements. How should the Board balance considerations of overall
capital requirements with the distinct roles of minimum requirements
and buffer requirements? What adjustments, if any, to either piece of
the framework should the Board consider? Which, if any, specific
portfolios or exposure classes merit particular attention and why?
Question 8: What are the advantages and disadvantages of applying
the same stress capital buffer requirement to a banking organization's
risk-based capital ratios regardless of whether they are determined
using the standardized or expanded risk-based approach? What would be
the advantages and disadvantages of applying different stress capital
buffer requirements for each set of risk-based capital ratios?
Question 9: What, if any, adjustments should the Board consider
with respect to the buffer requirements to account for the transitions
in this proposal, particularly related to expanded total risk-weighted
assets? For example, what would be the advantages and disadvantages of
the Board determining stress capital buffer requirements using fully
phased-in expanded total risk-weighted assets versus transitional
expanded total risk-weighted assets? What, if any, additional
adjustments to stress capital buffer requirements should the Board
consider during the expanded total risk-weighted assets transition?
B. Definition of Capital
The agencies regularly review their capital framework to help
ensure it is functioning as intended. Consistent with this ongoing
assessment, the agencies believe it is appropriate to align the
definition of capital for banking organizations subject to Category III
or IV capital standards with the definition currently applicable to
banking organizations subject to Category I or II capital standards.
The current definition of capital applicable to banking organizations
subject to Category I or II capital standards provides for risk
sensitivity and transparency that is commensurate with the size,
complexity, and risk profile of banking organizations subject to
Category III or IV capital standards. The proposed alignment of the
numerator and denominator of regulatory capital ratios of large banking
organizations would support the transparency of the capital rule as it
facilitates market participants' assessment of loss absorbency and
would promote consistency of requirements across large banking
organizations.
As described in more detail below, under the proposal, banking
organizations subject to Category III or IV capital standards would be
required to recognize most elements of AOCI in regulatory capital
consistent with the treatment for banking organizations subject to
Category I or II capital standards. Banking organizations subject to
Category III or IV capital standards would also apply the capital
deductions and minority interest treatments that are currently
applicable to banking organizations subject to Category I or II capital
standards. The proposal would also apply total loss absorbing capacity
(TLAC) holdings deduction treatments to banking organizations subject
to Category III or IV capital standards. The proposal
[[Page 64036]]
includes a three-year transition period for AOCI.
1. Accumulated Other Comprehensive Income
Under the current capital rule, banking organizations subject to
Category I or II capital standards are required to include most
elements of AOCI in regulatory capital; whereas all other banking
organizations including those subject to Category III or IV capital
standards were provided an opportunity to make a one-time election to
opt-out of recognizing most elements of AOCI and related deferred tax
assets (DTAs) and deferred tax liabilities within regulatory capital
(AOCI opt-out banking organizations).\29\ Under the proposal,
consistent with the treatment applicable to banking organizations
subject to Category I or II capital standards, banking organizations
subject to Category III or IV capital standards would be required to
include all AOCI components in common equity tier 1 capital, except
gains and losses on cash-flow hedges where the hedged item is not
recognized on a banking organization's balance sheet at fair value.
This would require all net unrealized holding gains and losses on
available-for-sale (AFS) debt securities \30\ from changes in fair
value to flow through to common equity tier 1 capital, including those
that result primarily from fluctuations in benchmark interest rates.
This treatment would better reflect the point in time loss-absorbing
capacity of banking organizations subject to Category III or IV capital
standards and would align with banking organizations subject to
Category I or II capital standards.
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\29\ See 12 CFR 3.22(b) (OCC); 12 CFR 217.22(b) (Board); 12 CFR
324.22(b) (FDIC). A banking organization that made an opt-out
election is currently required to adjust common equity tier 1
capital as follows: subtract any net unrealized holding gains and
add any net unrealized holding losses on available-for-sale
securities; subtract any accumulated net gains and add any
accumulated net losses on cash flow hedges; subtract any amounts
recorded in AOCI attributed to defined benefit postretirement plans
resulting from the initial and subsequent application of the
relevant GAAP standards that pertain to such plans (excluding, at
the banking organization's option, the portion relating to pension
assets deducted under Sec. __.22(a)(5) of the current capital
rule); and, subtract any net unrealized holding gains and add any
net unrealized holding losses on held-to-maturity securities that
are included in AOCI.
\30\ AFS securities refers to debt securities. ASC Subtopic 321-
10 eliminated the classification of equity securities with readily
determinable fair values not held for trading as available-for-sale
and generally requires investments in equity securities to be
measured at fair value with changes in fair value recognized in net
income. Changes in the fair value of (i.e., the unrealized gains and
losses on) a banking organization's equity securities are recognized
through net income rather than other comprehensive income.
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The agencies have previously observed that the requirement to
recognize elements of AOCI in regulatory capital has helped improve the
transparency of regulatory capital ratios, as it better reflects
banking organizations' actual loss-absorbing capacity at a specific
point in time, notwithstanding the potential volatility that such
recognition may pose for their regulatory capital ratios. The agencies
have also previously observed that AOCI is an important indicator used
by market participants to evaluate the capital strength of a banking
organization.\31\ More recently, the agencies have observed generally
higher levels of securities classified as held-to-maturity (HTM) among
banking organizations that recognize AOCI in regulatory capital.\32\
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\31\ 84 FR 59230, 59249 (November 1, 2019).
\32\ GAAP set forth restrictions on the classification of a debt
security as HTM, circumstances not consistent with the HTM
classification, and situations that call into question or taint a
banking organization's intent to hold securities in the HTM
category.
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Changes in interest rates have led to net unrealized losses for
banking organizations' investment portfolios and brought into focus the
importance of regulatory capital measures reflecting the loss absorbing
capacity of a banking organization. The agencies have observed that
adverse trends in a banking organization's GAAP equity can have
negative market perception and liquidity implications.\33\
Specifically, net unrealized losses on AFS securities included in AOCI
have reduced banking organizations' tangible book value and liquidity
buffers,\34\ which can adversely affect market participants'
assessments of capital adequacy and liquidity. Banking organizations
are often reluctant to sell these AFS securities as the unrealized
losses would become realized losses upon sale, thus reducing regulatory
capital. However, banking organizations may need to take such steps in
order to meet liquidity needs. Recognizing elements of AOCI in
regulatory capital thus achieves a better alignment of regulatory
capital with market participants' assessment of loss-absorbing
capacity.
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\33\ See Board of Governors of the Federal Reserve System,
Supervision and Regulation Report, at 11 (November 2022); Office of
the Comptroller of the Currency, Semiannual Risk Perspective, at 22
(Fall 2022); Federal Deposit Insurance Corporation, Fourth Quarter
2022 Quarterly Banking Profile, at 5, 22 (February 2023), Managing
Sensitivity to Market Risk in a Challenging Interest Rate
Environment (FIL-46-2013, October 8, 2013).
\34\ See 12 CFR part 50 (OCC); 12 CFR part 249 (Board); 12 CFR
part 329 (FDIC).
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Question 10: What complementary measures should the banking
agencies consider regarding the regulatory capital treatment for
securities held as HTM rather than AFS?
2. Regulatory Capital Deductions
The agencies have long limited the amount of intangible and higher-
risk assets, such as mortgage servicing assets (MSAs) and certain
temporary difference DTAs, included in regulatory capital and required
deduction of the amounts above the limits. This is due to the
relatively high level of uncertainty regarding the ability of banking
organizations to both accurately value and realize value from these
assets, especially under adverse financial conditions. The current
capital rule also limits the amount of investments in the capital
instruments of other banking organizations that can be reflected in
regulatory capital. Furthermore, the current capital rule limits the
inclusion of minority interest \35\ in regulatory capital in
recognition that minority interest is generally not available to absorb
losses at the banking organization's consolidated level and to prevent
highly capitalized subsidiaries from overstating the amount of capital
available to absorb losses at the consolidated organization.
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\35\ Minority interest, also referred to as non-controlling
interest, reflects investments in the capital instruments of
subsidiaries of banking organizations that are held by third
parties.
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Under the current capital rule, banking organizations subject to
Category I or II capital standards must deduct from common equity tier
1 capital amounts of MSAs, temporary difference DTAs that the banking
organization could not realize through net operating loss carrybacks,
and significant investments in the capital of unconsolidated financial
institutions in the form of common stock \36\ (collectively, threshold
items) that individually exceed 10 percent of the banking
organization's common equity tier 1 capital minus certain deductions
and adjustments.\37\ Banking organizations subject to Category I or II
capital standards must also deduct from common equity tier 1 capital
the aggregate amount of threshold items not deducted under the 10
percent
[[Page 64037]]
threshold deduction but that nevertheless exceeds 15 percent of the
banking organization's common equity tier 1 capital minus certain
deductions and adjustments. Under the current capital rule, banking
organizations subject to Category III or IV capital standards are
required to deduct from common equity tier 1 capital any amount of
MSAs, temporary difference DTAs that the banking organization could not
realize through net operating loss carrybacks, and investments in the
capital of unconsolidated financial institutions \38\ that individually
exceed 25 percent of common equity tier 1 capital of the banking
organization minus certain deductions and adjustments.
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\36\ A significant investment in the capital of an
unconsolidated financial institution is defined as an investment in
the capital of an unconsolidated financial institution where a
banking organization subject to Category I or II capital standards
owns more than 10 percent of the issued and outstanding common stock
of the unconsolidated financial institution. 12 CFR 3.2 (OCC); 12
CFR 217.2 (Board); 12 CFR 324.2 (FDIC).
\37\ See 12 CFR 3.22(c)(6), (d)(2) (OCC); 12 CFR 217.22(c)(6),
(d)(2) (Board); 12 CFR 324.22(c)(6), (d)(2) (FDIC).
\38\ For banking organizations that are not subject to Category
I or II capital standards, the current capital rule does not have
distinct treatments for significant and nonsignificant investments
in the capital of unconsolidated financial institutions. Rather, the
regulatory capital treatment for an investment in the capital of
unconsolidated financial institutions would be based on the type of
instrument underlying the investment.
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Under the proposal, banking organizations subject to Category III
or IV capital standards would be required to deduct threshold items
from common equity tier 1 capital and apply other capital deductions
that are currently applicable to banking organizations subject to
Category I or II capital standards instead of the deductions applicable
to all other banking organizations, thereby creating alignment across
all banking organizations subject to the proposal.
In addition to deductions for the threshold items, the current
capital rule requires that a banking organization subject to Category I
or II capital standards deduct from regulatory capital any amount of
the banking organization's nonsignificant investments \39\ in the
capital of unconsolidated financial institutions that exceeds 10
percent of the banking organization's common equity tier 1 capital
minus certain deductions and adjustments.\40\ Further, significant
investments in the capital of unconsolidated financial institutions not
in the form of common stock must be deducted from regulatory capital in
their entirety.\41\ Under the proposal, banking organizations subject
to Category III or IV capital standards would be required to make these
deductions.
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\39\ A non-significant investment in the capital of an
unconsolidated financial institution is defined as an investment in
the capital of an unconsolidated financial institution where a
banking organization subject to Category I or II capital standards
owns 10 percent or less of the issued and outstanding common stock
of the unconsolidated financial institution. 12 CFR 3.2 (OCC); 12
CFR 217.2 (Board); 12 CFR 324.2 (FDIC).
\40\ 12 CFR 3.22(c)(5) (OCC); 12 CFR 217.22(c)(5) (Board); 12
CFR 324.22(c)(5) (FDIC).
\41\ 12 CFR 3.22(c)(6) (OCC); 12 CFR 217.22(c)(6) (Board); 12
CFR 324.22(c)(6) (FDIC).
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Similar to the deductions for investments in the capital of
unconsolidated financial institutions, the current capital rule
requires banking organizations subject to Category I or II capital
standards to deduct covered debt instruments from regulatory
capital.\42\ Under the proposal, banking organizations subject to
Category III or IV capital standards would be required to apply the
deduction requirements for certain investments in unsecured debt
instruments issued by U.S. or foreign GSIBs (covered debt instruments)
that currently apply to banking organizations subject to Category I or
II capital standards.\43\ The current capital rule generally treats
investments in unsecured debt instruments issued by U.S. or foreign
GSIBs as tier 2 capital instruments for purposes of applying deduction
requirements.
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\42\ See 12 CFR 3.22(c) (OCC); 12 CFR 217.22(c) (Board); 12 CFR
324.22(c) (FDIC).
\43\ Similar to banking organizations subject to Category II
capital standards, the definition of excluded covered debt and the
applicable capital treatment, would not apply to banking
organizations subject to Category III and IV capital standards. See
12 CFR 3.2 (OCC); 12 CFR 217.2) (Board); 12 CFR 324.2 (FDIC).
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The current capital rule also limits the amount of minority
interest that banking organizations subject to Category I or II capital
standards may include in regulatory capital based on the amount of
capital held by a consolidated subsidiary, relative to the amount of
capital the subsidiary would have had to maintain to avoid any
restrictions on capital distributions and discretionary bonus payments
under capital conservation buffer requirements.\44\ Under the current
capital rule, banking organizations subject to Category III or IV
capital standards are allowed to include: (i) common equity tier 1
minority interest comprising up to 10 percent of the parent banking
organization's common equity tier 1 capital; (ii) tier 1 minority
interest comprising up to 10 percent of the parent banking
organization's tier 1 capital; and (iii) total capital minority
interest comprising up to 10 percent of the parent banking
organization's total capital.\45\ Under the proposal, the limitations
on minority interests that apply to banking organizations subject to
Category I or II capital standards would also apply to banking
organizations subject to Category III or IV capital standards.
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\44\ See 12 CFR 3.21(b) (OCC); 12 CFR 217.21(b) (Board); 12 CFR
324.21(b) (FDIC).
\45\ See 12 CFR 3.21(a) (OCC); 12 CFR 217.21(a) (Board); 12 CFR
324.21(a) (FDIC).
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3. Additional Definition of Capital Adjustments
The current capital rule applies an additional capital eligibility
criterion to banking organizations subject to Category I or II capital
standards for their additional tier 1 and tier 2 capital instruments.
The criterion requires that the governing agreement, offering circular
or prospectus for the instrument must disclose that the holders of the
instrument may be fully subordinated to interests held by the U.S.
government in the event the banking organization enters into a
receivership, insolvency, liquidation, or similar proceeding. Under the
proposal, this eligibility criterion would also apply to instruments
issued after the date on which the issuer becomes subject to the
proposed rule, which generally would be the effective date of a final
rule for banking organizations subject to Category III or IV capital
standards. Instruments issued by banking organizations subject to
Category III or IV capital standards prior to the effective date of a
final rule that currently count as regulatory capital would continue to
count as regulatory capital as long as those instruments remain
outstanding.
4. Changes to the Definition of Tier 2 Capital Applicable to Large
Banking Organizations
The current capital rule defines an element of tier 2 capital to
include the allowance for loan and lease losses (ALLL) or the adjusted
allowance for credit losses (AACL), as applicable, up to 1.25 percent
of standardized total risk-weighted assets not including any amount of
the ALLL or AACL, as applicable (and excluding in the case of a banking
organization subject to market risk requirements, its standardized
market risk-weighted assets). Further, as part of its calculations for
determining its total capital ratio, a banking organization subject to
Category I or II standards must determine its advanced-approaches-
adjusted total capital by (1) deducting from its total capital any ALLL
or AACL, as applicable, included in its tier 2 capital and; (2) adding
to its total capital any eligible credit reserves that exceed the
banking organization's total expected credit losses to the extent that
the excess reserve amount does not exceed 0.6 percent of credit-risk-
weighted assets. Due to changes in GAAP, all large banking
organizations are no longer using ALLL and must use AACL. In addition,
the concept of eligible credit reserves is related to use
[[Page 64038]]
of the internal ratings-based approach, which the proposal would
eliminate. Therefore, under the proposal, a large banking organization
would determine its expanded risk-based approach-adjusted total capital
by (1) deducting from its total capital AACL included in its tier 2
capital and; (2) adding to its total capital any AACL up to 1.25
percent of total credit risk-weighted assets. The proposal would define
total credit risk-weighted assets as the sum of total risk-weighted
assets for: (1) general credit risk as calculated under Sec. __.110;
(2) cleared transactions and default fund contributions as calculated
under Sec. __.114; (3) unsettled transactions as calculated under
Sec. __.115; and (4) securitization exposures as calculated under
Sec. __.132.
Question 11: The agencies seek comment on the proposed definition
of total credit risk-weighted assets in connection with determining a
banking organization's total capital ratio. What, if any, modifications
should the agencies consider making to this definition and why?
C. Credit Risk
Credit risk arises from the possibility that an obligor, including
a borrower or counterparty, will fail to perform on an obligation.
While loans are a significant source of credit risk, other products,
activities, and services also expose banking organizations to credit
risk, including investments in debt securities and other credit
instruments, credit derivatives, and cash management services. Off-
balance sheet activities, such as letters of credit, unfunded loan
commitments, and the undrawn portion of lines of credit, also expose
banking organizations to credit risk.
In this section of the Supplementary Information, subsection
III.C.1. describes expectations for completing due diligence on a
banking organization's credit risk portfolio; subsection III.C.2.
describes the risk-weight treatment for on-balance sheet exposures
under the proposal; subsection III.C.3. describes the proposed approach
to determine the exposure amount for off-balance sheet exposures; and
subsections III.C.4.-5 provide the available approaches for recognizing
the benefits of credit risk mitigants including certain guarantees,
certain credit derivatives and financial collateral.
1. Due Diligence
Banking organizations must maintain capital commensurate with the
level and nature of the risks to which they are exposed.\46\ The
agencies' safety and soundness guidelines establish standards for
banking organizations to have an adequate understanding of the impact
of their lending decisions on the banking organization's credit
risk.\47\ A banking organization's performance of due diligence on
their credit portfolios is central to meeting both of these
obligations. For example, under the safety and soundness guidelines, a
banking organization is expected to have established effective internal
policies, processes, systems, and controls to ensure that the banking
organization's regulatory reporting is accurate and reflects
appropriate risk weights assigned to credit exposures.\48\
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\46\ See 12 CFR 3.10(e) (OCC); 12 CFR 217.10(e) (Board); 12 CFR
324.10(e) (FDIC).
\47\ See 12 CFR part 30, appendix A (OCC); 12 CFR, appendix D-1
to part 208 (Board); 12 CFR, appendix A to part 364 (FDIC).
\48\ When performing due diligence, banking organizations must
adhere to the operational and managerial standards for loan
documentation and credit underwriting as set forth in the
Interagency Guidelines Establishing Standards for Safety and
Soundness (safety and soundness guidelines).
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When properly performed, due diligence may lead a banking
organization to conclude that the minimum regulatory capital
requirements for certain exposures do not sufficiently account for
their potential credit risk. In such instances, the banking
organization should take appropriate risk mitigating measures such as
allocating additional capital, establishing larger credit loss
allowances, or requiring additional collateral. Adherence to due
diligence standards, as established through the agencies' safety and
soundness guidelines, directly supports and facilitates requirements
for banking organizations to maintain capital commensurate with the
level and nature of the risks to which they are exposed.
Question 12: The agencies seek comment on whether due diligence
requirements should be directly integrated into the text of the final
rule. What would be the advantages and disadvantages of specifying
increases in risk weights that would be required to the extent that due
diligence requirements are not met, similar to the proposed risk-weight
treatment for securitization exposures as described in section III.D of
this Supplementary Information?
2. Proposed Risk Weights for Credit Risk
The proposal would replace the use of internal models to set
regulatory capital requirements for credit risk as set out in subpart E
of the current capital rule with a new expanded risk-based approach for
credit risk applicable to large banking organizations. The proposed
expanded risk-based approach for credit risk would retain many of the
same definitions Sec. __.2 of the current capital rule including among
others a sovereign, a sovereign exposure, certain supranational
entities, a multilateral development bank, a public sector entity
(PSE), a government-sponsored enterprise (GSE), other assets, and a
commitment. Some elements of the proposed expanded risk-based approach
for credit risk would apply the same risk-weight treatment provided in
subpart D of the current capital rule (current standardized approach)
for on-balance sheet exposures, including exposures to sovereigns,
certain supranational entities and multilateral development banks,
government sponsored entities (GSEs) in the form of senior debt and
guaranteed exposures, Federal Home Loan Bank (FHLB) and Federal
Agricultural Mortgage Corporation (Farmer Mac) equity exposures,\49\
public sector entities (PSEs), and other assets. The proposal would
also apply the same risk-weight treatment provided in the current
standardized approach to the following real estate exposures: pre-sold
construction loans, statutory multifamily mortgages, and high-
volatility commercial real estate (HVCRE) exposures.
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\49\ For treatment of other exposures to GSEs, see discussion
related to equity exposures in section III.E. and exposures to
subordinated debt instruments in section III.C.2.d. of this
Supplementary Information.
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Relative to the internal models-based approaches in the advanced
approaches under the current capital rule, the proposed expanded risk-
based approach would result in more transparent capital requirements
for credit risk exposures across banking organizations. The proposal
would also facilitate comparisons of capital adequacy across banking
organizations by reducing excessive, unwarranted variability in risk-
weighted assets for similar exposures. Relative to the current
standardized approach, the proposal would incorporate more granular
risk factors to allow for a broader range of risk weights.
Specifically, the proposal would introduce the expanded risk-based
approach for exposures to depository institutions, foreign banks, and
credit unions; exposures to subordinated debt instruments, including
those to GSEs; and real estate, retail, and corporate exposures. The
proposal would also increase risk capture for certain off-balance sheet
exposures through a new exposure methodology for commitments without
pre-set limits and would
[[Page 64039]]
modify the credit conversion factors applicable to commitments.
Additionally, the proposal would introduce new definitions for
defaulted exposures and defaulted real estate exposures.
Under the proposal, a banking organization would determine the
risk-weighted asset amount for an on-balance sheet exposure by
multiplying the exposure amount by the applicable risk weight,
consistent with the method used under the current standardized
approach. The on-balance sheet exposure amount would generally be the
banking organization's carrying value \50\ of the exposure, consistent
with the value of the asset on the balance sheet as determined in
accordance with GAAP, which is the same as under the current capital
rule. For all assets other than AFS securities and purchased credit-
deteriorated assets, the carrying value is not reduced by any
associated credit loss allowance that is determined in accordance with
GAAP. Using the value of an asset under GAAP to determine a banking
organization's exposure amount would reduce burden and provide a
consistent framework that can be easily applied across all banking
organizations of the proposal because, in most cases, GAAP serve as the
basis for the information presented in financial statements and
regulatory reports.\51\
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\50\ Carrying value under Sec. __. 2 of the current capital
rule means, with respect to an asset, the value of the asset on the
balance sheet of the banking organization as determined in
accordance with GAAP. For all assets other than available-for-sale
debt securities or purchased credit deteriorated assets, the
carrying value is not reduced by any associated credit loss
allowance that is determined in accordance with GAAP. See 12 CFR 3.2
(OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC). The exposure
amount arising from an OTC derivative contract; a repo-style
transaction or an eligible margin loan; a cleared transaction; a
default fund contribution; or a securitization exposure would be
calculated in accordance with Sec. Sec. __.113, 121, or 131 of the
proposal, respectively, as described in sections III.C.4, II.C.5.b.,
and III.D. of this Supplementary Information.
\51\ See 12 U.S.C. 1831n.
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The proposal would group credit risk exposures into the following
categories: sovereign exposures; exposures to certain supranational
entities and multilateral development banks; exposures to GSEs;
exposures to depository institutions, foreign banks, and credit unions;
exposures to PSEs; real estate exposures; retail exposures; corporate
exposures; defaulted exposures; exposures to subordinated debt
instruments; and off-balance sheet exposures.
The proposed categories with amended risk-weight treatments
relative to the current standardized approach include equity exposures
to GSEs and exposures to subordinated debt instruments issued by GSEs;
exposures to depository institutions, foreign banks, and credit unions;
exposures to subordinated debt instruments; real estate exposures;
retail exposures; corporate exposures; defaulted exposures; and some
off-balance sheet exposures such as commitments. The proposed risk
weight treatments for each of these categories are described in the
following sections of this Supplementary Information.
a. Defaulted Exposures
The proposal would introduce an enhanced definition of a defaulted
exposure that would be broader than the current capital rule's
definition of a defaulted exposure under subpart E. The proposed scope
and criteria of the defaulted exposure category is intended to
appropriately capture the elevated credit risk of exposures where the
banking organization's reasonable expectation of repayment has been
reduced, including exposures where the obligor is in default on an
unrelated obligation. Under the proposal, a defaulted exposure would be
any exposure that is a credit obligation and that meets the proposed
criteria related to reduced expectation of repayment, and that is not
an exposure to a sovereign entity,\52\ a real estate exposure,\53\ or a
policy loan.\54\ The proposal would define a credit obligation as any
exposure where the lender but not the obligor is exposed to credit
risk. In other words, for these exposures, the lender would have a
claim on the obligor that does not give rise to counterparty credit
risk \55\ and would exclude derivative contracts, cleared transactions,
default fund contributions, repo-style transactions, eligible margin
loans, equity exposures, and securitization exposures.
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\52\ Under the proposal, the expanded risk-based approach would
rely on the treatment of sovereign default in the current
standardized approach in the capital rule. See 12 CFR 3.32(a)(6)
(OCC); 12 CFR 217.32(a)(6) (Board); 12 CFR 324.32 (a)(6) (FDIC).
\53\ For the treatment of defaulted real estate exposures, see
section III.C.2.e.vii of this Supplementary Information.
\54\ A policy loan is defined under Sec. __.2 of the current
capital rule to mean means a loan by an insurance company to a
policy holder pursuant to the provisions of an insurance contract
that is secured by the cash surrender value or collateral assignment
of the related policy or contract. A policy loan includes: (1) A
cash loan, including a loan resulting from early payment benefits or
accelerated payment benefits, on an insurance contract when the
terms of contract specify that the payment is a policy loan secured
by the policy; and (2) An automatic premium loan, which is a loan
that is made in accordance with policy provisions which provide that
delinquent premium payments are automatically paid from the cash
value at the end of the established grace period for premium
payments. See 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2
(FDIC).
\55\ Counterparty credit risk is the risk that the counterparty
to a transaction could default before the final settlement of the
transaction where there is a bilateral risk of loss.
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For all other exposure categories (excluding an exposure to a
sovereign entity, real estate exposure, a retail exposure, or a policy
loan), the proposed definition of defaulted exposure would look to the
performance of the borrower with respect to credit obligations to any
creditor. Specifically, if the banking organization determines that an
obligor meets any of the of the defaulted criteria for exposures that
are not retail exposures, described further below, the proposal would
require the banking organization to treat all exposures that are credit
obligations of that obligor as defaulted exposures. Additionally, the
proposal would differentiate the criteria for determining whether an
exposure is a defaulted exposure between exposures that are retail
exposures and those that are not.
Retail exposures are originated to individuals or small- and
medium-sized businesses. Evaluating whether a retail borrower has other
exposures that are in default as defined by the proposal may be
difficult to operationalize for banking organizations given many unique
obligors. For other types of exposures that are not retail exposures,
evaluating default at the obligor level is appropriate because those
obligors are more likely to have additional credit obligations that are
large and held by multiple banking organizations. Default on one of
those credit obligations would be indicative of increased riskiness of
the exposure held by a banking organization, and hence a banking
organization should account for this in evaluating the risk profile of
the borrower.
Under the proposal, for a retail exposure, a credit obligation
would be considered a defaulted exposure if any of the following has
occurred: (1) the exposure is 90 days past due or in nonaccrual status;
(2) the banking organization has taken a partial charge-off, write-down
of principal, or negative fair value adjustment on the exposure for
credit-related reasons, until the banking organization has reasonable
assurance of repayment and performance for all contractual principal
and interest payments on the exposure; or (3) a distressed
restructuring of the exposure was agreed to by the banking
organization, until the banking organization has reasonable assurance
of repayment and performance for all contractual principal and interest
payments on the exposure as demonstrated by a
[[Page 64040]]
sustained period of repayment performance, provided that a distressed
restructuring includes the following made for credit-related reasons:
forgiveness or postponement of principal, interest, or fees, term
extension, or an interest rate reduction. A sustained period of
repayment performance by the borrower is generally a minimum of six
months in accordance with the contractual terms of the restructured
exposure.
For exposures that are not retail exposures (excluding an exposure
to a sovereign entity, a real estate exposure, or a policy loan), a
credit obligation would be considered a defaulted exposure if either of
the following has occurred: (1) the obligor has a credit obligation to
the banking organization that is 90 days or more past due \56\ or in
nonaccrual status; or (2) the banking organization determines that,
based on ongoing credit monitoring, the obligor is unlikely to pay its
credit obligations to the banking organization in full, without
recourse by the banking organization. If a banking organization
determines that an obligor meets these proposed criteria, the proposal
would require the banking organization to treat all exposures that are
credit obligations of that obligor as defaulted exposures.
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\56\ Overdrafts are past due and are considered defaulted
exposures once the obligor has breached an advised limit or been
advised of a limit smaller than the current outstanding balance.
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For purposes of the second criterion, the proposal would require a
banking organization to consider an obligor as unlikely to pay its
credit obligations if any of the following criteria apply: (1) the
obligor has any credit obligation that is 90 days or more past due or
in nonaccrual status with any creditor; (2) any credit obligation of
the obligor has been sold at a credit-related loss; (3) a distressed
restructuring of any credit obligation of the obligor was agreed to by
any creditor, provided that a distressed restructuring includes the
following made for credit-related reasons: forgiveness or postponement
of principal, interest, or fees, term extension or an interest rate
reduction; (4) the obligor is subject to a pending or active bankruptcy
proceeding; or (5) any creditor has taken a full or partial charge-off,
write-down of principal, or negative fair value adjustment on a credit
obligation of the obligor for credit-related reasons. Under the
proposal, banking organizations are expected to conduct ongoing credit
monitoring regarding relevant obligors. The proposal would require
banking organizations to continue to treat an exposure as a defaulted
exposure until the exposure no longer meets the definition or until the
banking organization determines that the obligor meets the definition
of investment grade \57\ or the proposed definition of speculative
grade.\58\ The proposal would revise the definition of speculative
grade, consistent with the current definition of investment grade, to
allow the definition to apply to entities to which the banking
organization is exposed through a loan or security. In addition, the
proposal would make the same revision to the definition of sub-
speculative grade.
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\57\ Under Sec. __.2 of the current capital rule, investment
grade means that the entity to which the banking organization is
exposed through a loan or security, or the reference entity with
respect to a credit derivative, has adequate capacity to meet
financial commitments for the projected life of the asset or
exposure. Such an entity or reference entity has adequate capacity
to meet financial commitments if the risk of its default is low and
the full and timely repayment of principal and interest is expected.
See 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC).
\58\ The proposal would revise the definition of speculative
grade to mean that the entity to which a banking organization is
exposed through a loan or security, or the reference entity with
respect to a credit derivative, has adequate capacity to meet
financial commitments in the near term, but is vulnerable to adverse
economic conditions, such that should economic conditions
deteriorate, the issuer or the reference entity would present an
elevated default risk.
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A banking organization would assign a 150 percent risk weight to a
defaulted exposure including any exposure amount remaining on the
balance sheet following a charge-off, and any other non-retail exposure
to the same obligor, to reflect the increased uncertainty as to the
recovery of the remaining carrying value. The proposed risk weight is
intended to reflect the impaired credit quality of defaulted exposures
and to help ensure that banking organizations maintain sufficient
regulatory capital for the increased probability of losses on these
exposures. A banking organization may apply a risk weight to the
guaranteed or secured portion of a defaulted exposure based on (1) the
risk weight under Sec. __.120 of the proposal if the guarantee or
credit derivative meets the applicable requirements or (2) the risk
weight under Sec. __.121 of the proposal if the collateral meets the
applicable requirements.
Question 13: How does the defaulted exposure definition compare
with banking organizations' existing policies relating to the
determination of the credit risk of a defaulted exposure and the
creditworthiness of a defaulted obligor? What additional clarifications
are necessary to determine the point at which retail and non-retail
exposures should no longer be treated as defaulted exposures?
Question 14: What operational challenges, if any, would a banking
organization face in identifying which exposures meet the proposed
definition of defaulted exposure? In particular, the agencies seek
comment on the ability of a banking organization to obtain the
necessary information to assess whether the credit obligations of a
borrower to creditors other than the banking organization would meet
the proposed criteria? What operational challenges, if any, would a
banking organization face in identifying whether obligors on non-retail
credit obligations are subject to a pending or active bankruptcy
proceeding?
Question 15: For the purposes of retail credit obligations, the
agencies invite comment on the appropriateness of including a
borrower's bankruptcy as a criterion for a defaulted exposure. What
operational challenges, if any, would a banking organization face in
identifying whether obligors on retail credit obligations are subject
to a pending or active bankruptcy proceeding? To what extent would
criteria (1) through (3) in the proposed defaulted exposure definition
for retail exposures sufficiently capture the risk of a borrower
involved in a bankruptcy proceeding?
Question 16: What alternatives to the proposed treatment should the
agencies consider while maintaining a risk-sensitive treatment for
credit risk of a defaulted borrower? For example, what would be the
advantages and disadvantages of limiting the defaulted borrower scope
to obligations of the borrower with the banking organization?
b. Exposures to Government-Sponsored Enterprises
The proposal would assign a 20 percent risk weight to GSE \59\
exposures that are not equity exposures, securitization exposures or
exposures to a subordinated debt instrument issued by a GSE, consistent
with the current standardized approach.\60\ Under the proposal, an
exposure to the common stock issued by a GSE would be an
[[Page 64041]]
equity exposure. An exposure to the preferred stock issued by a GSE
would be an equity exposure or an exposure to a subordinated debt
instrument, depending on the contractual terms of the preferred stock
instrument. Equity exposures to a GSE must be assigned a risk-weighted
asset amount as calculated under Sec. Sec. __.140 through __.142 of
subpart E. An exposure to a subordinated debt instrument issued by a
GSE must be assigned a 150 percent risk weight, unless issued by a FHLB
or Farmer Mac. As discussed later in sections III.E. and III.C.2.d. of
this Supplementary Information, equity exposures and exposures to
subordinated debt instruments would generally be subject to an
increased risk-based capital requirement to reflect their heightened
risk relative to exposures to senior debt.
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\59\ Government-sponsored enterprise (GSE) under Sec. __. 2 of
the current capital rule means an entity established or chartered by
the U.S. government to serve public purposes specified by the U.S.
Congress but whose debt obligations are not explicitly guaranteed by
the full faith and credit of the U.S. government. See 12 CFR 3.2
(OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC).
\60\ Similar to the treatment of senior debt exposures to GSEs
and GSE exposures that are not equity exposures or exposures to a
subordinated debt instrument issued by a GSE, the proposal would
apply the same 20 percent risk weight to all exposures to FHLB or
Farmer Mac, including equity exposures and exposures to subordinated
debt instruments, which continues the treatment under the current
standardized approach.
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c. Exposures to Depository Institutions, Foreign Banks, and Credit
Unions
The proposal would define the scope of exposures to depository
institutions, foreign banks, and credit unions in a manner that is
consistent with the definitions and scope of exposures covered under
the current capital rule. Under the proposal, a bank exposure would
mean an exposure (such as a receivable, guarantee, letter of credit,
loan, OTC derivative contract, or senior debt instrument) to any
depository institution, foreign bank, or credit union.\61\
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\61\ Under Sec. __.2 of the current capital rule, a depository
institution means a depository institution as defined in section 3
of the Federal Deposit Insurance Act, a foreign bank means a foreign
bank as defined in section 211.2 of the Federal Reserve Board's
Regulation K (12 CFR 211.2) (other than a depository institution),
and a credit union means an insured credit union as defined under
the Federal Credit Union Act (12 U.S.C. 1751 et seq.). See 12 CFR
3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC). Exposures to
other financial institutions, such as bank holding companies,
savings and loans holding companies, and securities firms, generally
would be considered corporate exposures. See 78 FR 62087 (October
11, 2013).
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The proposed treatment for bank exposures supports the simplicity,
transparency, and consistency objectives of the proposal in a manner
that is appropriately risk sensitive. The proposal would provide three
categories for bank exposures that are ranked from the highest to the
lowest in terms of creditworthiness: Grade A, Grade B, and Grade C. The
assignment of the bank exposure category would be based on the obligor
depository institution, foreign bank, or credit union. As outlined
below, the proposal would rely on the current capital rule's definition
of investment grade and the proposed definition of speculative grade
for differentiating the credit risk of bank exposures. In addition, the
proposal would incorporate publicly disclosed capital levels to
differentiate the financial strength of a depository institution,
foreign bank, or credit union in a manner that is both objective and
transparent to supervisors and the public.
More specifically, a Grade A bank exposure would mean a bank
exposure for which the obligor depository institution, foreign bank, or
credit union (1) is investment grade, and (2) whose most recent
publicly disclosed capital ratios meet or exceed the higher of: (a) the
minimum capital requirements and any additional amounts necessary to
not be subject to limitations on distributions and discretionary bonus
payments under the capital rules established by the prudential
supervisor of the depository institution, foreign bank, or credit
union, and (b) if applicable, the capital ratio requirements for the
well-capitalized category under the agencies' prompt corrective action
framework,\62\ or under similar rules of the National Credit Union
Administration.\63\ For example, an exposure to an investment grade
depository institution could qualify as a Grade A bank exposure if the
depository institution was not subject to limitations on distributions
and discretionary bonus payments under the capital rules and had risk-
based capital ratios that met the well capitalized thresholds under the
agencies' prompt corrective action framework. Further, a bank exposure
to a depository institution that had opted into the community bank
leverage ratio (CBLR) framework and is investment grade would be
considered to be a Grade A bank exposure, even if the obligor
depository institution were in the grace period under the CBLR
framework.\64\ Under the proposal, a depository institution that uses
the CBLR framework would not be required to calculate or disclose risk-
based capital ratios for purposes of qualifying as a Grade A bank
exposure.
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\62\ The capital ratios used for this determination are the
ratios on the depository institution's most recent quarterly
Consolidated Report of Condition and Income (Call Report).
\63\ See 12 CFR part 702 (National Credit Union Administration).
\64\ See 12 CFR 3.12(a)(1) (OCC); 12 CFR 217.12(a)(1) (Board);
12 CFR 324.12(a)(1) (FDIC).
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A Grade B bank exposure would mean a bank exposure that is not a
Grade A bank exposure and for which the obligor depository institution,
foreign bank, or credit union (1) is speculative grade or investment
grade, and (2) whose most recent publicly disclosed capital ratios meet
or exceed the higher of: (a) the applicable minimum capital
requirements under capital rules established by the prudential
supervisor of the depository institution, foreign bank, or credit
union, and (b) if applicable, the capital ratio requirements for the
adequately-capitalized category \65\ under the agencies' prompt
corrective action framework,\66\ or under similar rules of the National
Credit Union Administration.\67\
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\65\ See 12 CFR 6.4(b)(2) (OCC); 12 CFR 208.43(b)(2) (Board); 12
CFR 324.403(b)(2) (FDIC).
\66\ The capital ratios used for this determination are the
ratios on the depository institution's most recent quarterly Call
Report.
\67\ See 12 CFR part 702 (National Credit Union Administration).
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For a foreign bank to qualify as a Grade A or Grade B bank
exposure, the proposal would require the applicable capital standards
imposed by the home country supervisor to be consistent with
international capital standards issued by the Basel Committee.
A Grade C bank exposure would mean a bank exposure that does not
qualify as a Grade A or Grade B bank exposure. For example, a bank
exposure would be a Grade C bank exposure if the obligor depository
institution, foreign bank, or credit union has not publicly disclosed
its capital ratios within the last six months. In addition, an exposure
would be a Grade C bank exposure if the external auditor of the
depository institution, foreign bank, or credit union has issued an
adverse audit opinion or has expressed substantial doubt about the
ability of the depository institution, foreign bank, or credit union to
continue as a going concern within the previous 12 months.
Under the proposal, a foreign bank exposure that is a Grade A or
Grade B bank exposure and is a self-liquidating, trade-related
contingent item that arises from the movement of goods and that has a
maturity of three months or less may be assigned a risk weight that is
lower than the risk weight applicable to other exposures to the same
foreign bank. The proposed approach to providing a preferential risk
weight for short-term self-liquidating, trade-related contingent items
would be consistent with the current standardized approach.
The proposal would also address the risk that capital and foreign
exchange controls imposed by a sovereign entity in which a foreign bank
is located could prevent or materially impede the ability of the
foreign bank to convert its currency to meet its obligations or
transfer funds. The proposal would, therefore, provide a risk weight
floor for foreign bank exposures based on the risk weight applicable to
a sovereign
[[Page 64042]]
exposure for the jurisdiction where the foreign bank is incorporated
when (1) the exposure is not in the local currency of the jurisdiction
where the foreign bank is incorporated; or (2) the exposure to a
foreign bank branch that is not in the local currency of the
jurisdiction in which the foreign branch operates (sovereign risk-
weight floor).\68\ The risk weight floor would not apply to short-term
self-liquidating, trade-related contingent items that arise from the
movement of goods.
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\68\ See Sec. __.111 for the proposed sovereign risk-weight
table, which is identical to Table 1 to Sec. __.32 in the current
capital rule.
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As provided in Table 1, the proposed risk weights for bank
exposures generally would range from 40 percent to 150 percent.
[GRAPHIC] [TIFF OMITTED] TP18SE23.001
Question 17: What are the advantages and disadvantages of assigning
a range of risk weights based on the bank's creditworthiness? What
alternatives, if any, should the agencies consider, including to
address potential concerns around procyclicality?
Question 18: What are the advantages and disadvantages of
incorporating specific capital levels in the determination of each of
the three categories of bank exposures? What, if any, other risk
factors should the banking agencies consider to differentiate the
credit risk of bank exposures? What concerns, if any, could limitations
on available information about foreign banks raise in the context of
determining the appropriate risk weights for exposures to such banks
and how should the agencies consider addressing such concerns?
Question 19: What is the impact of limiting the lower risk weight
for self-liquidating, trade-related contingent items that arise from
the movement of goods to those with a maturity of three months or less?
What would be the advantages and disadvantages of expanding this risk
weight treatment to include such exposures with a maturity of six
months or less? What would be the advantages and disadvantages of
limiting this reduced risk weight treatment to only foreign banks whose
home country has an Organization for Economic Cooperation and
Development (OECD) Country Risk Classification (CRC) \69\ of 0, 1, 2,
or 3, or is an OECD member with no CRC, consistent with the current
standardized approach? \70\
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\69\ Under Sec. __. 2 of the current capital rule, a Country
Risk Classification (CRC) for a sovereign means the most recent
consensus CRC published by the Organization for Economic Cooperation
and Development (OECD) as of December 31st of the prior calendar
year that provides a view of the likelihood that the sovereign will
service its external debt. See 12 CFR 3.2 (OCC); 12 CFR 217.2
(Board); 12 CFR 324.2 (FDIC). For more information on the OECD
country risk classification methodology, see OECD, ``Country Risk
Classification,'' available at https://www.oecd.org/trade/topics/export-credits/arrangement-and-sector-understandings/financing-terms-and-conditions/country-risk-classification/.
\70\ The CRCs reflect an assessment of country risk, used to set
interest rate charges for transactions covered by the OECD
arrangement on export credits. The CRC methodology classifies
countries into one of eight risk categories (0-7), with countries
assigned to the zero category having the lowest possible risk
assessment and countries assigned to the 7 category having the
highest possible risk assessment. See 78 FR 62088 (October 11,
2018).
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d. Subordinated Debt Instruments
The proposal would introduce a definition and an explicit risk
weight treatment for exposures in the form of subordinated debt
instruments. The proposed definition of a subordinated debt instrument
would capture exposures that are financial instruments and present
heightened credit risk but are not equity exposures, including: (1) any
preferred stock that does not meet the definition of an equity
exposure, (2) any covered debt instrument, including a TLAC debt
instrument, that is not deducted from regulatory capital, and (3) any
debt instrument that qualifies as tier 2 capital under the current
capital rule or that would otherwise be treated as regulatory capital
by the primary Federal supervisor of the issuer and that is not
deducted from regulatory capital.
The proposal would define a subordinated debt instrument as (1) a
debt security that is a corporate exposure, a bank exposure, or an
exposure to a GSE, including a note, bond, debenture, similar
instrument, or other debt instrument as determined by the primary
Federal supervisor, that is subordinated by its terms, or separate
intercreditor agreement, to any creditor of the obligor, or (2)
preferred stock that is not an equity exposure. For these purposes, a
debt security would be subordinated if the documentation creating or
evidencing such indebtedness (or a separate intercreditor agreement)
provides for any of the issuer's other creditors to rank senior to the
payment of such indebtedness in the event the issuer becomes the
subject of a bankruptcy or other insolvency proceeding, with the scope
of applicable bankruptcy or other insolvency proceedings being defined
in the applicable documentation. The scope of the definition of a
subordinated debt instrument is meant to capture the types of entities
that issue subordinated debt instruments and for which the level of
subordination is a meaningful determinant of the credit risk of the
instrument.
[[Page 64043]]
In addition, even though the provision of collateral typically
reduces the risk of loss on indebtedness, the proposal includes secured
as well as unsecured subordinated debt securities in the scope of
subordinated debt instruments, since the effect of subordination may
result in the collateral providing little or no real value to the
subordinated debt holder in the event the issuer becomes to subject of
a bankruptcy or other insolvency proceeding. A subordinated debt
instrument would not include any loan, including a syndicated loan, a
debt security issued by a sovereign, public sector entity, multilateral
development bank, or supranational entity, or a security that would be
captured under the securitization framework. Due to the contractual
obligations and structures associated with subordinated debt
instruments, such exposures generally pose increased risk relative to a
senior loan, including a syndicated loan, or a senior debt security to
the same entity because investments in subordinated debt instruments
are usually considered junior creditors and subordinate to obligations
specified in the definition of senior debt in the document governing
the junior creditors' obligations.
The proposal generally would apply a 150 percent risk weight for
exposures that meet the definition of a subordinated debt instrument,
including any preferred stock that is not an equity exposure, and any
tier 2 instrument or covered debt instrument that is not deducted from
regulatory capital, including TLAC debt instruments, and any debt
instrument that would otherwise be treated as regulatory capital by the
primary Federal supervisor of the issuer and that is not deducted from
regulatory capital.\71\
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\71\ Covered debt instruments are subject to deduction by
banking organizations subject to Category I or II capital standards
similar to the deduction framework for exposures to capital
instruments. See 12 CFR 3.22(c) (OCC); 12 CFR 217.22(c) (Board); 12
CFR 324.22(c) (FDIC). As noted in section III.B.3. of this
Supplementary Information, under the proposal, this deduction
framework will be expanded to banking organizations subject to
Category III or IV capital standards. As discussed in section
III.C.2.b. above, exposures to subordinated debt instruments issued
by an FHLB or by Farmer Mac would be assigned a 20 percent risk
weight.
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The instruments included in the scope of subordinated debt
instruments present a greater risk of loss to an investing banking
organization relative to more senior debt exposures to the same issuer
because subordinated debt instruments have a lower priority of
repayment in the event of default. As a result, the proposal would
apply an increased risk weight to recognize this increase in loss given
default. Since a covered debt instrument that qualifies as a TLAC debt
instrument shares similar risk characteristics with a subordinated debt
instrument, the proposal would require banking organizations to apply
the same 150 percent risk weight to any such exposures that are not
otherwise deducted from regulatory capital.
Question 20: The agencies seek comment on the scope of the proposed
definition of a subordinated debt instrument. What, if any, operational
challenges might the proposed definition pose for banking
organizations, such as identifying the level of subordination in debt
securities or similar instruments, and how should the agencies consider
addressing such challenges?
Question 21: Would expanding the definition of a subordinated debt
instrument to include loans that are not securities more appropriately
capture the types of exposures that pose elevated risk and, if so, why?
Question 22: The agencies seek comment on applying a heightened 150
percent risk weight to exposures to subordinated debt instruments
issued by GSEs. What would be the advantages and disadvantages of this
proposed regulatory capital requirement? Would there be any challenges
for banking organizations to be able to identify which GSE exposures
would be subject to the 150 percent risk weight? Please provide
specific examples of any challenges and supporting data.
e. Real Estate Exposures
The proposal would define a real estate exposure as an exposure
that is neither a sovereign exposure nor an exposure to a PSE and that
is (1) a residential mortgage exposure, (2) secured by collateral in
the form of real estate,\72\ (3) a pre-sold construction loan,\73\ (4)
a statutory multifamily mortgage,\74\ (5) a high volatility commercial
real estate (HVCRE) exposure,\75\ or (6) an acquisition, development,
or construction (ADC) exposure. A pre-sold construction loan, a
statutory multifamily mortgage, and an HVCRE exposure are collectively
referred to as statutory real estate exposures for purposes of this
Supplementary Information. Under the proposal, the risk weight
treatment for statutory real estate exposures that are not defaulted
real estate exposures would be consistent with the current standardized
approach.
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\72\ For purposes of the proposal, ``secured by collateral in
the form of real estate'' should be interpreted in a manner that is
consistent with the current definition for ``a loan secured by real
estate'' in the Call Report and Consolidated Financial Statements
for Holding Companies (FR Y-9C) instructions.
\73\ The Resolution Trust Corporation Refinancing,
Restructuring, and Improvement Act of 1991 (RTCRRI Act) mandates
that each agency provide in its capital regulations (i) a 50 percent
risk weight for certain one-to-four-family residential pre-sold
construction loans that meet specific statutory criteria in the
RTCRRI Act and any other underwriting criteria imposed by the
agencies, and (ii) a 100 percent risk weight for one-to-four-family
residential pre-sold construction loans for residences for which the
purchase contract is cancelled. See 12 U.S.C. 1831n, note.
\74\ The RTCRRI Act mandates that each agency provide in its
capital regulations a 50 percent risk weight for certain multifamily
residential loans that meet specific statutory criteria in the
RTCRRI Act and any other underwriting criteria imposed by the
agencies. See 12 U.S.C. 1831n, note.
\75\ Section 214 of the Economic Growth, Regulatory Relief, and
Consumer Protection Act imposes certain requirements on high
volatility commercial real estate acquisition, development, or
construction loans. Section 214 of Public Law 115-174, 132 Stat.
1296 (2018). See 12 U.S.C. 1831bb.
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The proposal would differentiate the credit risk of real estate
exposures that are not statutory real estate exposures by introducing
the following categories: regulatory residential real estate exposures,
regulatory commercial real estate exposures, ADC exposures, and other
real estate exposures. The applicable risk weight for these non-
statutory real estate exposures would depend on (1) whether the real
estate exposure meets the definitions of regulatory residential real
estate exposure, regulatory commercial real estate exposure, ADC
exposure, or other real estate exposure, described below; (2) whether
the repayment of such exposures is dependent on the cash flows
generated by the underlying real estate (such as rental properties,
leased properties, hotels); and (3) in the case of regulatory
residential or regulatory commercial real estate exposures, the loan-
to-value (LTV) ratio of the exposure.
These proposed criteria for differentiating the credit risk of real
estate exposures would be based on information already collected and
maintained by a banking organization as part of its mortgage lending
activities and underwriting practices. Under the proposal, regulatory
residential and regulatory commercial real estate exposures would be
required to meet prudential criteria that are intended to reduce the
likelihood of default relative to other real estate exposures. The
criteria in these definitions generally align with existing Interagency
Guidelines for Real Estate Lending Policies (real estate lending
[[Page 64044]]
guidelines).\76\ Real estate loans in which repayment is dependent on
the cash flows generated by the real estate can expose a banking
organization to elevated credit risk relative to comparable exposures
\77\ as the borrower may be unable to meet its financial commitments
when cash flows from the property decrease, such as when tenants
default or properties are unexpectedly vacant.\78\ In addition, LTV
ratios can be a useful risk indicator because the amount of a
borrower's equity in a real estate property correlates inversely with
default risk and provides banking organizations with a degree of
protection against losses.\79\ Therefore, exposures with lower LTV
ratios generally would receive a lower risk weight than comparable real
estate exposures with higher LTV ratios under the proposal.\80\ The
following chart illustrates how the proposal would require a banking
organization to assign risk weights to various real estate exposures,
as described in more detail below:
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\76\ See 12 CFR part 34, appendix A to subpart D (OCC); 12 CFR
part 208, appendix C (Board); 12 CFR part 365, appendix A (FDIC).
\77\ Comparable exposures include loans secured by real estate
where the repayment of the loan depends on non-real estate cash
flows such as owner-occupied properties, revenue from manufacturing
or retail sales.
\78\ See Board of Governors of the Federal Reserve System,
Financial Stability Report (November 2020), https://www.federalreserve.gov/publications/files/financial-stability-report-20201109.pdf.
\79\ Id., at 30.
\80\ The proposed LTV criterion measures the borrower's use of
debt (leverage) to finance a real estate purchase, with higher LTV
reflecting greater leverage and thus higher credit risk.
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BILLING CODE 6210-01-P; 6714-01-P; 4810-33-P
[[Page 64045]]
[GRAPHIC] [TIFF OMITTED] TP18SE23.002
BILLING CODE 6210-01-C; 6714-01-C; 4810-33-C
i. Regulatory Residential Real Estate Exposures
Under the proposal, a regulatory residential real estate exposure
would be defined as a first-lien residential mortgage exposure (as
defined in Sec. __.2) that is not a defaulted real estate exposure (as
defined in Sec. __. 101), an ADC exposure, a pre-sold construction
loan, a statutory multifamily mortgage, or an HVCRE exposure, provided
the exposure meets certain prudential criteria.\81\ First, the loan
would be required to be secured by a property that is either owner-
occupied or rented. Second, the exposure would be required to be made
in accordance with prudent underwriting standards, including standards
relating to the loan amount as a percent of the value of the
[[Page 64046]]
property.\82\ Third, during the underwriting process, the banking
organization would be required to apply underwriting policies that
account for the ability of the borrower to repay based on clear and
measurable underwriting standards that enable the banking organization
to evaluate these credit factors. The agencies would expect these
underwriting standards to be consistent with the agencies' safety and
soundness and real estate lending guidelines.\83\ Fourth, the property
must be valued in accordance with the proposed requirements included in
the proposed LTV ratio calculation, as discussed below.
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\81\ Consistent with the standardized approach in the capital
rule, under the proposal, when a banking organization holds the
first-lien and junior-lien(s) residential mortgage exposures and no
other party holds an intervening lien, the banking organization must
combine the exposures and treat them as a single first-lien
regulatory residential real estate exposure, if the first-lien meets
all of the criteria for a regulatory residential real estate
exposure.
\82\ For more information on value of the property, see section
III.C.2.e.iv of this Supplementary Information.
\83\ See 12 CFR part 30, appendix A (OCC); 12 CFR part 208,
appendix C (Board); 12 CFR parts 364 and 365 (FDIC).
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ii. Regulatory Commercial Real Estate Exposures
The proposal would define a regulatory commercial real estate
exposure as a real estate exposure that is not a regulatory residential
real estate exposure, a defaulted real estate exposure, an ADC
exposure, a pre-sold construction loan, a statutory multifamily
mortgage, or an HVCRE exposure, provided the exposure meets several
prudential criteria. First, the exposure must be primarily secured by
fully completed real estate. Second, the banking organization must hold
a first priority security interest in the property that is legally
enforceable in all relevant jurisdictions.\84\ Third, the exposure must
be made in accordance with prudent underwriting standards, including
standards relating to the loan amount as a percent of the value of the
property. Fourth, during the underwriting process, the banking
organization must apply underwriting policies that account for the
ability of the borrower to repay in a timely manner based on clear and
measurable underwriting standards that enable the banking organization
to evaluate these credit factors. The agencies would expect that these
underwriting standards would be consistent with the agencies' safety
and soundness and real estate lending guidelines. Finally, the property
must be valued in accordance with the proposed requirements included in
the proposed LTV ratio calculation, as discussed below.
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\84\ When the banking organization also holds a junior security
interest in the same property and no other party holds an
intervening security interest, the banking organization must treat
the exposures as a single first-lien regulatory commercial real
estate exposure, if the first-lien meets all of the criteria for a
regulatory commercial real estate exposure.
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Question 23: The agencies seek comment on the application of
prudent underwriting standards in the proposed definitions of
regulatory residential and regulatory commercial real estate exposures,
including standards relating to the loan amount as a percent of the
value of the property. What, if any, further clarity is needed and why?
iii. Exposures That Are Dependent on the Cash Flows Generated by the
Real Estate
As noted above, the proposal would differentiate the risk weight of
regulatory residential, regulatory commercial, and other real estate
exposures based on whether the borrower's ability to service the loan
is dependent on cash flows generated by the real estate. Exposures that
are dependent on the cash flows generated by real estate to repay the
loan can be affected by local market conditions and present elevated
credit risk relative to exposures that are serviceable by the income,
cash, or other assets of the borrower. For example, an increase in the
supply of competitive rental property can lower demand and suppress
cash flows needed to support repayment of the loan.
If the underwriting process at origination of the real estate
exposure considers any cash flows generated by the real estate securing
the loan, such as from lease or rental payments or from the sale of the
real estate as a source of repayment, then the exposure would meet the
proposal's definition of dependent on the cash flows generated by the
real estate. Evaluating whether repayment of the exposure is dependent
on cash flows generated from the real estate is a conservative and
straightforward approach for differentiating the credit risk of real
estate exposures. Given their increased credit risk, the proposal would
assign relatively higher risk weights to exposures that are dependent
on any proceeds or income generated from the real estate itself to
service the debt.
Under the proposal, additional loan characteristics can affect
whether an exposure would be considered dependent on cash flows from
the real estate. The proposal's definition of dependence on the cash
flows generated by the real estate would exclude any residential
mortgage exposure that is secured by the borrower's principal residence
as such mortgage exposures present reduced credit risk relative to real
estate exposures that are secured by the borrower's non-principal
residence.\85\ For residential properties that are not the borrower's
principal residence, including vacation homes and other second homes,
such properties would be considered dependent on the cash flows
generated by the real estate unless the banking organization has relied
solely on the borrower's personal income and resources, rather than
rental income (or resale or refinance of the property), to repay the
loan.
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\85\ For example, if (1) a borrower purchases a two-unit
property with the intention of making one unit their principal
residence, (2) the borrower intends to rent out the second unit to a
third party, and (3) the banking organization considered the cash
flows from the rental unit as a source of repayment, the exposure
would not meet the proposal's definition of dependent on the cash
flows generated by the real estate because the property securing the
exposure is the borrower's principal residence.
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For regulatory commercial real estate exposures, the applicable
risk weights similarly would be determined based on whether repayment
is dependent on the cash flows generated by the real estate. For
example, the agencies would expect that rental office buildings,
hotels, and shopping centers leased to tenants are dependent on the
cash flows generated by the real estate for repayment of the loan. In
the case of a loan to a borrower to purchase or refinance real estate
where the borrower will operate a business such as a retail store or
factory and rely solely on the revenues from the business or resources
of the borrower other than rental, resale, or other income from the
real estate for repayment, the exposure would not be considered
dependent on the cash flows generated by the real estate under the
proposal. Similarly, a loan to the owner-operator of a farm would not
be considered dependent on the cash flows generated by the real estate
under the proposal if the borrower will rely solely on the sale of
products from the farm or other resources of the borrower other than
rental, resale, or other income from the real estate for repayment.
Question 24: What, if any, alternative quantitative threshold
should the agencies consider in determining whether a real estate
exposure is dependent on cash flows from the real estate (for example,
a threshold between 5 and 50 percent of the income)? Further, if the
agencies decide to adopt an alternative quantitative threshold, either
for regulatory residential or regulatory commercial real estate
exposures, how should it be calibrated for regulatory residential and
separately for regulatory commercial real estate exposures and what
would be the appropriate calibration levels for each? Please provide
specific examples of any
[[Page 64047]]
alternatives, including calculations and supporting data.
Question 25: The agencies seek feedback on the proposed treatment
of exposures secured by second homes, including vacation homes where
repayment of the loan is not dependent on cash flows. What are the
advantages and disadvantages of treating such exposures as regulatory
residential real estate exposures? Would a different category be more
appropriate for these exposures given their risk profile, and if so,
describe which other category(s) of real estate exposures would be most
similar and why. Please provide supporting data in your responses.\86\
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\86\ See Garcia, Daniel (2019). ``Second Home Buyers and the
Housing Boom and Bust,'' Finance and Economics Discussion Series
2019-029. Washington: Board of Governors of the Federal Reserve
System, https://www.federalreserve.gov/econres/feds/files/2019029pap.pdf.
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Question 26: The agencies seek comment on the treatment of
residential mortgage exposures where repayment is dependent on cash
flows from overnight or short-term rentals, as such cash flows may not
be as reliable as a source of repayment as cash flows from long-term
rental contracts or the borrower's other income sources. What would be
the advantages or disadvantages of treating residential real estate
exposures dependent on cash flows from short-term rentals similar to
commercial real estate exposures dependent on cash flows?
iv. Calculating the Loan-To-Value Ratio
The proposal would require a banking organization also to use LTV
ratios to assign a risk weight to a regulatory residential or
regulatory commercial real estate exposure. Under the proposal, LTV
ratio would be calculated as the extension of credit divided by the
value of the property. The proposed calculation of LTV ratio would be
generally consistent with the real estate lending guidelines except
with respect to the recognition of private mortgage insurance, as
described below.
The extension of credit would mean the total outstanding amount of
the loan including any undrawn committed amount of the loan. The total
outstanding amount of the loan would reflect the current amortized
balance as the loan pays down, which may allow a banking organization
to assign a lower risk weight during the life of the loan. Similarly,
if a loan balance increases, a banking organization would need to
increase the risk weight if the increased LTV would result in a higher
risk weight. For purposes of the LTV ratio calculation, a banking
organization would calculate the loan amount without making any
adjustments for credit loss provisions or private mortgage insurance.
Not recognizing private mortgage insurance would be consistent with the
current capital rule's definition of eligible guarantor, which does not
recognize an insurance company engaged predominately in the business of
providing credit protection (such as a monoline bond insurer or re-
insurer) and also reflects the performance of private mortgage
insurance during times of stress in the housing market. The agencies do
not intend the proposed risk weights to be applied to LTVs that include
private mortgage insurance.
The value of the property would mean the value at the time of
origination of all real estate properties securing or being improved by
the extension of credit, plus the fair value of any readily marketable
collateral and other acceptable collateral, as defined in the real
estate lending guidelines, that secures the extension of credit.
For exposures subject to the Real Estate Lending, Appraisal
Standards, and Minimum Requirements for Appraisal Management Companies
or Appraisal Standards for Federally Related Transactions (combined,
the appraisal rule),\87\ the market value of real estate would be a
valuation that meets all requirements of that rule. For exposures not
subject to the appraisal rule, the proposal would require that (1) the
market value of real estate be obtained from an independent valuation
of the property using prudently conservative valuation criteria and (2)
the valuation be done independently from the banking organization's
origination and underwriting process. Most real estate exposures held
by insured depository institutions are subject to the agencies'
appraisal rule, which also provides for evaluations in some cases, and
provides for certain exceptions, such as where a lien on real estate is
taken as an abundance of caution. To help ensure that the value of the
real estate is determined in a prudently conservative manner, the
proposal would also provide that, for exposures not subject to the
appraisal rule, the valuations of the real estate properties would need
to exclude expectations of price increases and be adjusted downward to
take into account the potential for the current market prices to be
significantly above the values that would be sustainable over the life
of the loan.
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\87\ See 12 CFR part 34, subpart C or subpart G (OCC); 12 CFR
part 208, subpart E or 12 CFR part 225, subpart G (Board); 12 CFR
part 323 (FDIC).
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In addition, when the real estate exposure finances the purchase of
the property, the value would be the lower of (1) the actual
acquisition cost of the property and (2) the market value obtained from
either (i) the valuation requirements under the appraisal rule (if
applicable) or (ii) as described above, an independent valuation using
prudently conservative valuation criteria that is separate from the
banking organization's origination and underwriting process.
Supervisory experience has shown that market values of real estate
properties can be temporarily impacted by local market forces and using
a value figure including such volatility would not reflect the long-
term value of the real estate. Therefore, the proposal would require
that the value used for the LTV calculation be an amount that is more
conservative than the market value of the property.
Using the value of the property at origination when calculating the
LTV ratio protects against volatility risk or short-term market price
inflation. For purposes of the LTV ratio calculation, the proposal
would require banking organizations to use the value of the property at
the time of origination, except under the following circumstances: (1)
the banking organization's primary Federal supervisor requires the
banking organization to revise the property value downward; (2) an
extraordinary event occurs resulting in a permanent reduction of the
property value (for example, a natural disaster); or (3) modifications
are made to the property that increase its market value and are
supported by an appraisal or independent evaluation using prudently
conservative criteria. These proposed exceptions are intended to
constrain the use of values other than the value of the property at
loan origination only to exceptional circumstances that are
sufficiently material to warrant use of a revised valuation.
For purposes of determining the value of the property, the proposal
would use the definition of readily marketable collateral and other
acceptable collateral consistent with the real estate lending
guidelines. Therefore, readily marketable collateral would mean insured
deposits, financial instruments, and bullion in which the banking
organization has a perfected security interest. Financial instruments
and bullion would need to be salable under ordinary circumstances with
reasonable promptness at a fair market value determined by quotations
based on actual transactions, on an auction or similarly available
daily bid and ask price market. Readily marketable
[[Page 64048]]
collateral should be appropriately discounted by the banking
organization consistent with the banking organization's usual practices
for making loans secured by such collateral. Other acceptable
collateral would mean any collateral in which the banking organization
has a perfected security interest that has a quantifiable value and is
accepted by the banking organization in accordance with safe and sound
lending practices. Other acceptable collateral should be appropriately
discounted by the banking organization consistent with the banking
organization's usual practices for making loans secured by such
collateral. Under the proposal, other acceptable collateral would
include, among other items, unconditional irrevocable standby letters
of credit for the benefit of the banking organization. The
reasonableness of a banking organization's underwriting criteria would
be reviewed through the examination and supervisory process to help
ensure its real estate lending policies are consistent with safe and
sound banking practices.
Question 27: What are the benefits and drawbacks of allowing
readily marketable collateral and other acceptable collateral to be
included in the value for purposes of calculating the LTV ratio? What
are the advantages and disadvantages of providing specific discount
factors to the value of acceptable collateral for purposes of
calculating the LTV ratio such as the standard supervisory market price
volatility haircuts contained in Sec. __.121 of the proposed rule?
What alternatives should the agencies consider? Please provide specific
examples and supporting data.
v. Risk Weights for Regulatory Residential Real Estate Exposures
Under the proposal, a banking organization would assign a risk
weight to a regulatory residential real estate exposure based on the
exposure's LTV ratio and whether the exposure is dependent on the cash
flows generated by the real estate, as reflected in Tables 2 and 3
below. LTV ratios and dependence on cash flows generated by the real
estate would factor into the risk-weight treatment for real estate
exposures under the proposal because these risk factors can be
determinants of credit risk for real estate exposures. The proposed
corresponding risk weights in each LTV ratio category are intended to
appropriately reflect differences in the credit risk of these
exposures. The risk weights that would apply under the proposal are
provided below.\88\
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\88\ The risk weight assigned to loans does not impact the
appropriate treatment of loans under the agencies' other regulations
and guidance, such as the supervisory LTV limits under the real
estate lending guidelines.
[GRAPHIC] [TIFF OMITTED] TP18SE23.003
[GRAPHIC] [TIFF OMITTED] TP18SE23.004
While LTV ratios and dependency upon cash flows of the real estate
are useful risk indicators, the agencies recognize that banking
organizations consider a variety of factors when underwriting a
residential real estate exposure and assessing a borrower's ability to
repay. For example, a banking organization may consider a borrower's
current and expected income, current and expected cash flows, net
worth, other relevant financial resources, current financial
obligations, employment status, credit history, or other relevant
factors during the underwriting process. The agencies are supportive of
home ownership and do not intend the proposal to diminish home
affordability or homeownership opportunities, including for low- and
moderate-income (LMI) home buyers or other historically underserved
markets. The agencies are particularly interested in whether the
proposed framework for regulatory residential real estate exposures
should be modified in any way to avoid unintended impacts on the
ability of otherwise credit-worthy borrowers who make a smaller down
payment to purchase a home. For example, the agencies are considering
whether a 50 percent risk weight would be appropriate for these loans,
to the extent they are originated in accordance with prudent
underwriting standards and originated through a home ownership program
that the primary Federal regulatory agency determines provides a public
benefit and includes risk mitigation features such as credit counseling
and consideration of repayment ability.
Question 28: The agencies seek comment on how the proposed
treatment of regulatory residential real estate exposures will impact
home affordability and home ownership opportunities, particularly for
LMI borrowers or other historically underserved markets. What are the
advantages and disadvantages of an alternative treatment that would
assign a 50 percent risk weight to mortgage loans originated in
accordance with
[[Page 64049]]
prudent underwriting standards and originated through a home ownership
program that the primary Federal regulatory agency determines provides
a public benefit and includes risk mitigation features such as credit
counseling and consideration of repayment ability? What, if any,
additional or alternative risk indicators should the agencies consider,
besides loan-to-value or dependency upon cash flow for risk-weighting
regulatory residential real estate exposures? Please provide specific
examples of mortgage lending programs where such factors were the basis
for underwriting the loans and the historical repayment performance of
the loans in such programs. Please comment on whether these risk
indicators are already collected and maintained by banking
organizations as part of their mortgage lending activities and
underwriting practices.
In addition, the agencies considered adopting an alternative risk-
based capital treatment in subpart E that does not rely on loan-to-
value ratios or dependency upon cash flow generated by the real estate.
One such alternative would be to incorporate the same treatment for
residential mortgage exposures as found in the current U.S.
standardized risk-based capital framework. Under this alternative, the
risk-based capital treatment for residential mortgage exposures in
subpart D of the capital rule would be incorporated into the proposed
subpart E. First-lien residential mortgage exposures that are prudently
underwritten would receive a 50 percent risk weight consistent with the
treatment contained in the U.S. standardized risk-based capital
framework. Such an approach would allow banking organizations to
continue to offer prudently underwritten products through lending
programs with the flexibility to meet the needs of their communities
without additional regulatory capital implications. The agencies note
that current mortgage rules promulgated since the global financial
crisis require lenders to consider each borrower's ability to
repay.\89\
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\89\ See 12 CFR part 1026.
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As in subpart D, residential mortgage exposures that do not meet
the requirements necessary to receive a 50 percent risk weight would
receive a 100 percent risk weight. While such an approach would not use
loan-to-value or dependency upon cash flow generated by the real estate
to assign a risk-weight, it would provide for a simpler framework where
all prudently underwritten first-lien residential mortgage exposures
would receive the same risk-based capital treatment. Lastly and
consistent with the treatment in subpart D, if a banking organization
holds the first and junior lien(s) on a regulatory residential real
estate exposure and no other party holds an intervening lien, the
banking organization would be required to treat the combined exposure
as a single loan secured by a first lien for purposes of assigning a
risk weight.
Question 29: The agencies seek comment on assigning risk weights to
residential mortgage exposures, consistent with the current U.S.
standardized risk-based capital framework. What are the pros and cons
of this alternative treatment?
vi. Risk Weights for Regulatory Commercial Real Estate Exposures
In a manner similar to regulatory residential real estate exposure,
the proposal would require a banking organization to assign a risk
weight to a regulatory commercial real estate exposure based on the
exposure's LTV ratio and whether the exposure is dependent on the cash
flows generated by the real estate, as reflected in Tables 4 and 5
below. For regulatory commercial real estate exposures that are not
dependent on cash flows for repayment, the main driver of risk to the
banking organization is whether the commercial borrower would generate
sufficient revenue through its non-real estate business activities to
repay the loan to the banking organization. For this reason, under
Table 4 the proposed risk weight for the exposure would be dependent on
the risk weight assigned to the borrower. For the purposes of Table 4,
if the LTV ratio of the exposures is greater than 60 percent, and the
banking organization does not have sufficient information about the
exposure to determine what the risk weight applicable to the borrower
would be, the banking organization would be required to assign a 100
percent risk weight to the exposure.
[GRAPHIC] [TIFF OMITTED] TP18SE23.005
[GRAPHIC] [TIFF OMITTED] TP18SE23.006
Question 30: What, if any, market effects could the proposed
treatment have on residential and commercial real estate mortgage
lending and why? What alternatives to the proposed treatment or
calibration should the agencies consider? Please provide supporting
data.
vii. Defaulted Real Estate Exposures
The proposal would require banking organizations to apply an
elevated risk weight to defaulted real estate
[[Page 64050]]
exposures, consistent with the approach to defaulted exposures
described in section III.C.2.a. of this Supplementary Information. The
proposal would introduce a definition of defaulted real estate exposure
that would provide new criteria for determining whether a residential
mortgage exposure or a non-residential mortgage exposure is in default.
These new criteria are indicative of a credit-related default for such
exposures. For residential mortgage exposures, the definition of
defaulted real estate exposure would require the banking organization
to evaluate default at the exposure level. For other real estate
exposures that are not residential mortgage exposures, the definition
of defaulted real estate exposure would require the banking
organization to evaluate default at the obligor level, consistent with
the approach describe above for non-retail defaulted exposures.
Since residential mortgage exposures are primarily originated to
individuals for the purchase or refinancing of their primary residence,
most obligors of residential real estate exposures do not have
additional real estate exposures. Therefore, determining default at the
exposure level would account for the material default risk of most
residential mortgage exposures. Additionally, evaluating defaulted
residential mortgage exposures at the obligor level may be difficult
for banking organizations to operationalize, for example, if there are
challenges collecting information on the payment status of other
obligations of individual borrowers.
In contrast, for other types of real estate exposures, such as
regulatory commercial real estate and ADC exposures, evaluating default
at the obligor level would be more appropriate and less challenging as
those obligors frequently have other credit obligations that are large
in value and potentially held by multiple banking organizations.
Default by an obligor on other credit obligations, which a banking
organization should account for when evaluating the risk profile of the
borrower, would indicate increased credit risk of the exposure held by
a banking organization.
A defaulted real estate exposure that is a residential mortgage
exposure would include an exposure (1) that is 90 days or more past due
or in nonaccrual status; (2) where the banking organization has taken a
partial charge-off, write-down of principal, or negative fair value
adjustment on the exposure for credit-related reasons, until the
banking organization has reasonable assurance of repayment and
performance for all contractual principal and interest payments on the
exposure; or (3) where the banking organization agreed to a distressed
restructuring that includes the following credit-related reasons:
forgiveness or postponement of principal, interest, or fees; term
extension; or an interest rate reduction. Distressed restructuring
would not include a loan modified or restructured solely pursuant to
the U.S. Treasury's Home Affordable Mortgage Program.\90\
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\90\ The U.S. Treasury's Home Affordable Mortgage Program was
created under the Troubled Asset Relief Program in response to the
subprime mortgage crisis of 2008. See Emergency Economic
Stabilization Act, Public Law 110-343, 122 Stat. 3765 (2008).
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To determine if a non-residential mortgage exposure would be a
defaulted real estate exposure, banking organizations would apply the
same criteria as described above in section III.C.2.a. of this
Supplementary Information that are used to determine if a non-retail
exposure is a defaulted exposure. Banking organizations are expected to
conduct ongoing credit reviews of relevant obligors. The proposal would
require banking organizations to continue to treat non-residential real
estate exposures that meet this definition as defaulted real estate
exposures until the non-residential real estate exposure no longer
meets the definition or until the banking organization determines that
the obligor meets the definition of investment grade or speculative
grade.
Under the proposal, a defaulted real estate exposure that is a
residential mortgage exposure not dependent on the cash flows generated
by the real estate would receive a risk weight of 100 percent,
regardless of whether the exposure qualifies as a regulatory real
estate exposure, unless a portion of the real estate exposure is
guaranteed under Sec. __.120 of the proposal. This treatment is
consistent with the risk weight for past due residential mortgage
exposures under the current standardized approach. Additionally, a
residential mortgage guaranteed by the Federal Government through the
Federal Housing Administration (FHA) or the Department of Veterans
Affairs (VA) generally will be risk-weighted at 20 percent under the
proposal, including a residential mortgage guaranteed by FHA or VA that
meets the defaulted real estate exposure definition.
Any other defaulted real estate exposure would receive a risk
weight of 150 percent, including any other non-residential real estate
exposure to the same obligor, consistent with the proposed risk weight
of other defaulted exposures described in section II.C.2.a. of this
Supplementary Information. A banking organization may apply a risk
weight to the guaranteed portion of defaulted real estate exposures
based on the risk weight that applies under Sec. __.120 of the
proposal if the guarantee or credit derivative meets the applicable
requirements.
Question 31: How does the defaulted real estate exposure definition
compare with banking organizations' existing policies relating to the
determination of the credit risk of defaulted real estate exposures and
the creditworthiness of defaulted real estate obligors? What, if any,
additional clarifications are necessary to determine the point at which
residential and non-residential mortgages should no longer be treated
as defaulted exposures? Please provide specific examples and supporting
data.
Question 32: For purposes of commercial real estate exposures, the
agencies invite comment on the extent to which obligors have
outstanding other exposures with multiple banking organizations and
other creditors. What would be the advantages and disadvantages of
considering both the obligor and the parent company or other entity or
individual that owns or controls the obligor when determining if the
exposure meets the criteria for ``defaulted real estate exposure''?
Question 33: For purposes of residential mortgage exposures, the
agencies invite comment on the appropriateness of including a
borrower's bankruptcy as a criterion for defaulted real estate
exposure. Would criteria (1)(i) through (1)(iii) in the proposed
defaulted real estate definition for residential mortgages sufficiently
capture the risk of a borrower involved in a bankruptcy proceeding?
viii. ADC Exposures That Are Not HVCRE Exposures
Under the proposal, the agencies would define an ADC exposure as an
exposure secured by real estate for the purpose of acquiring,
developing, or constructing residential or commercial real estate
properties, as well as all land development loans, and all other land
loans. Some ADC exposures meet the definition of HVCRE exposure in
Sec. __.2 of the capital rule and would be assigned a 150 percent risk
weight.\91\ Real estate exposures that meet the
[[Page 64051]]
definition of ADC exposure but do not meet the criteria of an HVCRE
exposure or a defaulted real estate exposure would be assigned a 100
percent risk weight under the proposal. The proposed regulatory
treatment for ADC exposures would not take into consideration cash flow
dependency or LTV ratio criteria. ADC exposures are mostly short-term
or bridge loans to cover construction or development, or lease up or
sales phases of a real estate project, rather than an amortizing
permanent loan for completed residential or commercial real estate.
Supervisory experience has shown that ADC exposures have heightened
risk compared to permanent commercial real estate exposures, and these
exposures generally have been subject to a risk weight of 100 percent
or more under the current standardized approach. Repayment of ADC loans
is often based on the expected completion of the construction or
development of the property, which can be delayed or interrupted by
many factors such as changes in market condition or financial
difficulty of the obligor.
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\91\ Section 214 of the Economic Growth, Regulatory Relief, and
Consumer Protection Act (EGRRCPA) imposes certain requirements on
high volatility commercial real estate acquisition, development, or
construction loans. Section 214 of Public Law 115-174, 132 Stat.
1296 (2018); 12 U.S.C. 1831bb.
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ix. Other Real Estate Exposures
The proposal would define other real estate exposures as real
estate exposures that are not defaulted real estate exposures,
regulatory commercial real estate exposures, regulatory residential
real estate exposures, ADC exposures, or any of the statutory real
estate exposures.
An exposure meeting the proposed definition of other real estate
exposure poses heightened credit risk as a result of not meeting the
proposed prudential underwriting criteria included in the definitions
of regulatory residential and regulatory commercial real estate,
respectively, and accordingly would be assigned a higher risk weight.
Specifically, the proposal would require a banking organization to
assign a 150 percent risk weight to an other real estate exposure,
unless the exposure is a residential mortgage exposure that is not
dependent on the cash flows generated by the real estate, which must be
assigned a 100 percent risk weight.
For example, a banking organization would assign a 150 percent risk
weight to real estate exposures that are dependent on the cash flows
generated by the underlying real estate, such as a rental property, and
that do not meet the regulatory residential or regulatory commercial
real estate exposure definitions. Loans for the purpose of acquiring
real estate and reselling it at higher value that do not qualify as ADC
loans and do not meet the definition of regulatory residential real
estate exposures would be assigned a 150 percent risk weight as other
real estate exposures. The proposed 150 percent risk weight also would
provide a regulatory capital incentive for banking organizations to
originate real estate exposures in accordance with the prudential
qualification requirements for regulatory residential and commercial
real estate exposures, respectively.
In other cases, if a banking organization does not adequately
evaluate the creditworthiness of a borrower for an owner-occupied
residential mortgage exposure, or if the borrower has inadequate
creditworthiness or capacity to repay the loan, the exposure would not
be considered prudently underwritten and would be assigned a 100
percent risk weight instead of the lower risk weights included in Table
2 for regulatory residential mortgage exposures not dependent on the
cash flows generated by the real estate. The 100 percent risk weight
would also apply to junior lien home equity lines of credit and other
second mortgages given the elevated risk of these loans when compared
to similar senior lien loans.
f. Retail Exposures
Relative to the current standardized approach, and as described in
more detail below, the proposal would increase the credit risk-
sensitivity of the capital requirements applicable to retail exposures
by assigning risk weights that would vary depending on product type and
the degree of portfolio diversification. The proposal would introduce a
new definition of retail exposure, which would include an exposure to a
natural person or persons, or an exposure to a small or medium-sized
entity (SME) \92\ that meets the proposed definition of a regulatory
retail exposure described below. Including an exposure to an SME in the
definition of a retail exposure provides a benefit for small companies,
such as smaller limited liability companies, which may have
characteristics more similar to those of a natural person than of a
larger corporation. The proposed definition of a retail exposure would
be narrower in scope than the current capital rule's existing
definition of a retail exposure under subpart E, which includes a
broader range of exposures, including real estate-related exposures.
Because the proposal would include separate risk-weight treatments for
real estate exposures that account for the underlying collateral, the
proposed definition of a retail exposure would only apply to a retail
exposure that would not otherwise be a real estate exposure.\93\
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\92\ An SME would mean an entity in which the reported annual
revenues or sales for the consolidated group of which the entity is
a part are less than or equal to $50 million for the most recent
fiscal year. This scope is generally consistent with the definition
of an SME under the Basel III reforms and also corresponds with the
maximum receipts-based size standard for small businesses set by the
Small Business Administration, which varies by industry and does not
exceed $47 million per year. See 13 CFR part 121.
\93\ For an exposure that qualifies as a real estate exposure
and also meets conditions (1) and (2) of the definition of a retail
exposure, the proposal would require a banking organization to treat
the exposure as a real estate exposure and calculate risk-based
requirements for the exposure as described in section III.C.2.e of
this Supplementary Information.
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The proposal would differentiate the risk-weight treatment for
retail exposures based on whether (1) the exposure qualifies as a
regulatory retail exposure, (2) further qualifies as a transactor
exposure; or (3) does not qualify for either of the previous categories
and is treated as an other retail exposure. The proposed definitions of
a regulatory retail exposure and a transactor exposure outlined below
include key criteria for broadly categorizing the relative credit risk
of retail exposures.
To qualify as a regulatory retail exposure, the proposal would
require the exposure to be in the form of any of the following credit
products: a revolving credit or line of credit (such as a credit card,
charge card, or overdraft) or a term loan or lease (such as an
installment loan, auto loan or lease, or student or educational loan)
(collectively, eligible products). In addition, under the proposal, the
amount of retail exposures that a banking organization could treat as
regulatory retail exposures would be limited on an aggregate and
granular basis. A banking organization would include all outstanding
and committed but unfunded regulatory retail exposures accounting for
any applicable credit conversion factor when aggregating the retail
exposures. Specifically, the regulatory retail exposure category would
exclude any retail exposure to a single obligor and its affiliates
that, in the aggregate with any other retail exposures to that obligor
or its affiliates, including both on- and off-balance sheet exposures,
exceeds a combined total of $1 million (aggregate limit).
In addition, for any single retail exposure, only the portion up to
0.2 percent of the banking organization's total retail exposures that
are eligible products (granularity limit) would be considered a
regulatory retail exposure.
[[Page 64052]]
The portion of any single retail exposure that exceeds the granularity
limit would not qualify as a regulatory retail exposure. For purposes
of calculating the 0.2 percent granularity limit for a regulatory
retail exposure, off-balance sheet exposures would be subject to the
applicable credit conversion factors, as discussed in Sec. __.112(b),
and defaulted exposures, as discussed in Sec. __.101(b) of the
proposal, would be excluded. Under the proposal, if an exposure to an
SME does not meet criteria (1) through (3) of the definition of a
regulatory retail exposure, then none of the exposures to that SME
would qualify as retail exposures and all of the exposures to that SME
would be treated as corporate exposures.
The proposal would define a transactor exposure as a regulatory
retail exposure that is a credit facility where the balance has been
repaid in full at each scheduled repayment date for the previous twelve
months or an overdraft facility where there has been no drawdown over
the previous twelve months. If a single obligor had both a credit
facility and an overdraft facility from the same banking organization,
the banking organization would separately evaluate each facility to
determine whether each facility would meet the definition of a
transactor exposure to be categorized as a transactor exposure.
Under the proposal, a banking organization would assign a risk
weight of 55 percent to a regulatory retail exposure that is a
transactor exposure and an 85 percent risk weight to a regulatory
retail exposure that is not a transactor exposure. All other retail
exposures would be assigned a 110 percent risk weight. The proposed 55
percent risk weight for a transactor exposure is appropriate because
obligors that demonstrate a historical repayment capacity generally
exhibit less credit risk relative to other retail obligors. A
regulatory retail exposure that is not a transactor exposure warrants
the proposed 85 percent risk weight, which would be lower than the
proposed 110 percent risk weight for all other retail exposures, due to
mitigating factors related to size or concentration risk. The aggregate
limit and granularity limit are intended to ensure that the regulatory
retail portfolio consists of a set of small exposures to a diversified
group of obligors, which would reduce credit risk to the banking
organization. Conversely, banking organizations with a high aggregate
amount of retail exposures to a single obligor, or exposures exceeding
the granularity limit, have a heightened concentration of retail
exposures. This concentration of retail exposures increases the level
of credit risk the banking organization has to a single obligor, and
the likelihood that the banking organization could face material losses
if the obligor misses a payment or defaults. Therefore, any retail
exposure that would not qualify as a regulatory retail or a transactor
exposure warrants a risk weight of 110 percent.
The following example describes how a banking organization would
identify the amount of retail exposures that could be treated as
regulatory retail exposures. First, a banking organization would
identify the amount of credit exposures that meet the eligible products
criterion within the definition of a regulatory retail exposure. Assume
a banking organization has $100 million in total retail exposures that
meet the eligible regulatory retail product criterion described above.
Next, for this set of exposures, the banking organization would
identify any amounts to a single obligor and its affiliates that exceed
$1 million. The banking organization in this example determines that a
single obligor and its affiliates account for an aggregate of $20
million of the banking organization's total retail exposures. Because
this $20 million exceeds the $1 million threshold for amounts to a
single obligor and its affiliates, this $20 million would be retail
exposures that are not regulatory retail exposures and subject to a 110
percent risk weight, leaving $80 million that could be categorized as
regulatory retail exposures.
Also, assume that of the $80 million, $1 million of the exposures
are considered defaulted exposures. This $1 million in defaulted
exposures would be subtracted from the $80 million. The banking
organization would multiply the remaining $79 million by the 0.2
percent granularity limit, with the resulting $158,000 representing the
dollar amount equivalent of the granularity limit for this banking
organization's retail portfolio. Therefore, of the remaining $79
million, the portion of those retail exposures to a single obligor and
its affiliates that do not exceed $158,000 would be considered
regulatory retail exposures. Of the regulatory retail exposures, the
portion of the exposure that would qualify as a transactor exposure
would receive a 55 percent risk weight and the remaining portion would
receive an 85 percent risk weight. Under the proposal, a banking
organization would assign a 110 percent risk weight to the portion of a
retail exposure that exceeds the granularity limit. Thus, the total
amount of retail exposures to a single obligor exceeding $158,000 in
this example would receive a 110 percent risk weight as other retail
exposures. This example is also illustrated in the following decision
tree.
[[Page 64053]]
[GRAPHIC] [TIFF OMITTED] TP18SE23.007
Question 34: What, if any, additional criteria or alternatives
should the agencies consider to help ensure that the regulatory retail
treatment is limited to a group of diversified retail obligors? What
alternative thresholds or calibrations should the agencies consider for
purposes of retail exposures? Please provide supporting data in your
response.
Question 35: What simplifications, if any, to the calculation
described above for a regulatory retail exposure should the agencies
consider to reduce operational complexity for banking organizations?
For example, what operational challenges would arise from assigning
differing risk weights to portions of retail exposures based on the
regulatory retail eligibility criteria?
Question 36: Is the requirement for repayment of a credit facility
in full at each scheduled repayment date for the previous twelve months
or lack of overdraft history an appropriate criterion to distinguish
the credit risk of a transactor exposure from other retail exposures,
and if not, what would be more appropriate and why? Is twelve months of
full repayment history a sufficient amount of time to demonstrate a
consistent repayment history of the credit or overdraft facility to
meet the definition of a transactor and if not, what would be an
appropriate amount of time?
g. Risk-Weight Multiplier for Certain Retail and Residential Mortgage
Exposures With Currency Mismatch
The proposal would introduce a new requirement for banking
organizations to apply a multiplier to the applicable risk weight
assigned to certain exposures that contain currency mismatches between
the banking organization's lending currency and the borrower's source
of repayment. The multiplier would reflect the borrower's increased
risk of default due to the borrower's exposure to foreign exchange
risk. The multiplier would apply to exposure types where the borrower
generally does not manage or hedge its foreign exchange risk. Exposures
with such currency mismatches pose increased credit risk to the banking
organization as the borrower's repayment ability could be affected by
exchange rate fluctuations.
To capture this increased risk, the proposal would require banking
organizations to apply a 1.5 multiplier to the applicable risk weight,
subject to a maximum risk weight of 150 percent, for retail and
residential mortgage exposures to a borrower that does not have a
source of repayment in the currency of the loan equal to at least 90
percent of the annual payment from either income generated through
ordinary business activities or from a contract with a financial
institution that provides funds denominated in the currency of the
loan, such as a forward exchange contract. Other types of exposures
generally account for foreign exchange risk through hedging or other
risk mitigants and would not be subject to the proposed multiplier. The
proposed risk weight ceiling of 150 percent aligns with the maximum
risk weight for credit exposures under the proposal.
Question 37: What, if any, additional or alternative criteria of
the proposed multiplier should the agencies consider and why?
h. Corporate Exposures
A corporate exposure under the proposal would be an exposure to a
company that does not fall under any other exposure category under the
proposal. This scope would be consistent with the definition found in
Sec. __.2 of the current capital rule. For example, an exposure to a
corporation that also meets the proposed definition of a real estate
exposure would be a real estate exposure rather than a corporate
exposure for purposes of the proposal.
As described in more detail below, the proposal would differentiate
the risk weights of corporate exposures based on credit risk by
considering such factors as a corporate exposure's investment quality
and the general creditworthiness of the borrower, level of
subordination, as well as the nature and substance of the lending
arrangement, and the degree of reliance on the borrower's independent
capacity for repayment of the obligation, or reliance on the income
that the borrowing entity is expected to generate from the asset(s) or
a project being financed. First, a banking organization would assign a
65 percent risk weight to a corporate exposure that is an exposure to a
company that is investment grade, and that has a publicly traded
security outstanding or that is controlled by a company that has
[[Page 64054]]
a publicly traded security outstanding.\94\ Second, consistent with the
current standardized approach, a banking organization would assign risk
weights of 2 percent or 4 percent to certain exposures to a qualifying
central counterparty.\95\ Third, as discussed further below, a banking
organization would assign a 130 percent risk weight to a project
finance exposure that is not a project finance operational phase
exposure. Fourth, a banking organization would assign a 150 percent
risk weight to a corporate exposure that is an exposure to a
subordinated debt instrument or an exposure to a covered debt
instrument unless a deduction treatment is provided as described in
section III.C.2.d. of this Supplementary Information.
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\94\ Under Sec. __.2 of the current capital rule, a person or
company controls a company if it: (1) owns, controls, or holds with
power to vote 25 percent or more of a class of voting securities of
the company; or (2) consolidates the company for financial reporting
purposes. See 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2
(FDIC).
\95\ See 12 CFR 3.32(f)(2) and (3) (OCC); 12 CFR 217.32(f)(2)
and (3) (Board); 12 CFR 324.32(f)(2) and (3) (FDIC).
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Finally, a banking organization would assign a 100 percent risk
weight to all other corporate exposures. Assigning a 100 percent risk
weight to all other corporate exposures appropriately reflects the
relative risk of such corporate exposures, as the repayment methods for
these exposures pose greater risks than those of publicly-traded
corporate exposures that are deemed investment grade. A banking
organization would also assign a 100 percent risk weight to corporate
exposures that finance income-producing assets or projects that engage
in non-real estate activities where the obligor has no independent
capacity to repay the loan. For example, corporate exposures subject to
the 100 percent risk weight would include exposures (i) for the purpose
of acquiring or financing equipment where repayment of the exposure is
dependent on the cash flows generated by either the equipment being
financed or acquired, (ii) for the purpose of acquiring or financing
physical commodities where repayment of the exposure is dependent on
the proceeds from the sale of the physical commodities, and (iii)
project finance operational phase exposures, as further discussed
below.
i. Investment Grade Companies With Publicly Traded Securities
Outstanding
Under the proposal, a banking organization would assign a 65
percent risk weight to a corporate exposure that is both (1) an
exposure to a company that is investment grade, and (2) where that
company, or a parent that controls that company, has publicly traded
securities outstanding.\96\ This two-pronged test would serve as a
reasonable basis for banking organizations to identify exposures to
obligors of sufficient creditworthiness to be eligible for a reduced
risk weight. The definition of investment grade directly addresses the
credit quality of the exposure by requiring that the entity or
reference entity have adequate capacity to meet financial commitments,
which means that the risk of its default is low and the full and timely
repayment of principal and interest is expected. A banking
organization's investment grade analysis is dependent upon the banking
organization's underwriting criteria, judgment, and assumptions.
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\96\ Under Sec. __.2 of the current capital rule, 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; 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. See 12 CFR 3.2 (OCC); 12 CFR 217.2
(Board); 12 CFR 324.2 (FDIC).
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The proposed requirement that the company or its parent company
have securities outstanding that are publicly traded, in contrast,
would be a simple, objective criterion that would provide a degree of
consistency across banking organizations. Further, publicly-traded
corporate entities are subject to enhanced transparency and market
discipline as a result of being listed publicly on an exchange. A
banking organization would use these simple criteria, which complement
a banking organization's due diligence and internal credit analysis, to
determine whether a corporate exposure qualifies as an investment grade
exposure.
Question 38: What, if any, alternative criteria should the agencies
consider to identify corporate exposures that would warrant a risk
weight of 65 percent or a risk weight between 65 percent and 100
percent?
Question 39: For what reasons, if any, should the agencies consider
applying a lower risk weight than 100 percent to exposures to companies
that are not publicly traded but are companies that are ``highly
regulated?'' What, if any, criteria should the agencies consider to
identify companies that are ``highly regulated?'' Alternatively, what
are the advantages and disadvantages of assigning lower risk weights to
highly regulated entities (such as open-ended mutual funds, mutual
insurance companies, pension funds, or registered investment
companies)?
Question 40: What are the advantages and disadvantages of applying
a lower risk weight (such as between 85 and 100 percent), to entities
based on size, such as companies with reported annual sales of less
than or equal to $50 million for the most recent financial year? What
alternative criteria, if any, should the agencies consider to identify
small or medium-sized entities that present lower credit risk? For
example, should the agencies consider asset size or number of employees
to identify small or medium-sized entities? Please provide supporting
data.
Question 41: What criteria, if any, should the agencies consider to
further differentiate corporate exposures according to their risk
profiles and what implications would such criteria have for the risk
weighting of these exposures and why?
ii. Project Finance Exposures
The proposal would define a project finance exposure as a corporate
exposure for which the banking organization relies on the revenues
generated by a single project (typically a large and complex
installation, such as power plants, manufacturing plants,
transportation infrastructure, telecommunications, or other similar
installations), both as the source of repayment and as security for the
loan. For example, a project finance exposure could take the form of
financing the construction of a new installation, or a refinancing of
an existing installation, with or without improvements. The primary
determinant of credit risk for a project finance exposure is the
variability of the cash flows expected to be generated by the project
being financed rather than the general creditworthiness of the obligor
or the market value or sale of the project or the real estate on which
the project sits.\97\ A project finance exposure also would be required
to meet the following criteria: (1) the exposure would need to be to a
borrowing entity that was created specifically to finance the project,
operate the physical assets of the project, or do both, and (2) the
borrowing entity would need to have an immaterial amount of assets,
activities, or sources of income apart from revenues from the
activities of the project being financed. Under the proposal, an
exposure that is deemed secured by real estate,\98\ would not be
[[Page 64055]]
considered a project finance exposure and would be assigned a risk
weight as described in section III.C.2.e. of this Supplementary
Information.
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\97\ Exposures that are guaranteed by the government or
considered a general obligation or revenue obligation exposure to a
PSE would not qualify as a project finance exposure.
\98\ Although it is common for the banking organization to take
a mortgage over the real property and a lien against other assets of
the project for security and lender control purposes, a project
finance exposure would not be considered a real estate exposure
because the banking organization does not rely on real estate
collateral to grant credit. As noted in section III.C.2.e of this
Supplementary Information, for purposes of the proposal, ``secured
by collateral in the form of real estate'' in the context of the
proposed real estate exposure definition should be interpreted in a
manner that is consistent with the current definition for ``a loan
secured by real estate'' in the Call Report and FR Y-9C
instructions.
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Under the proposal, a project finance exposure would receive a 130
percent risk weight during the pre-operational phase and a 100 percent
risk weight during the operational phase. The proposal would define a
project finance operational phase exposure as a project finance
exposure where the project has a positive net cash flow that is
sufficient to support the debt service and expenses of the project and
any other remaining contractual obligation, in accordance with the
banking organization's applicable loan underwriting criteria for
permanent financings, and where the outstanding long-term debt of the
project is declining. Prior to the operational phase classification, a
banking organization would be required to treat a project finance
exposure as being in the pre-operational phase and assign a 130 percent
risk weight to the exposure. The pre-operational phase would be the
period between the origination of the loan and the time at which the
banking organization determines that the project has entered the
operational phase. Relative to the operational phase, the pre-
operational phase presents increased uncertainty that the project will
be completed in a timely and cost-effective manner, which warrants the
application of a higher risk weight. For example, market conditions
could change significantly between commencement and completion of the
project. In addition, unanticipated supply shortages could disrupt
timely completion of the project and the expected timing of the
transition to the operational phase. These unanticipated changes could
disrupt the completion of the project and delay it becoming
operational, and thus impact the ability of the project to generate
cash flows as projected and to repay creditors.
Question 42: What additional exposures, if any, should be captured
by the proposed definition of a project finance exposure? What
exposures, if any, captured by the proposed definition of a project
finance exposure should be excluded from the definition?
Question 43: What clarifications or changes, if any, should the
agencies consider to differentiate project finance exposures from
exposures secured by real estate? What, if any, capital market effects
would the proposed treatment of project finance exposures have and why
and what, if any, modifications should the agencies consider to address
such effects? How material for banking organizations are project
finance exposures that are not based on the creditworthiness of a
Federal, state or local government?
3. Off-Balance Sheet Exposures
In addition to on-balance sheet exposures, banking organizations
are exposed to credit risk associated with off-balance sheet exposures.
Banking organizations often enter into contractual arrangements with
borrowers or counterparties to provide credit or other support. Such
arrangements generally are not recorded on-balance sheet under GAAP.
These off-balance sheet exposures often include commitments, contingent
items, guarantees, certain repo-style transactions, financial standby
letters of credit, and forward agreements.
The proposal would introduce a few updated credit conversion
factors that a banking organization would apply to an off-balance sheet
item's notional amount (typically, the contractual amount) in order to
calculate the exposure amount for an off-balance sheet exposure. Under
the proposal, the credit conversion factors, which would range from 10
percent to 100 percent, would reflect the expected proportion of the
off-balance sheet item that would become an on-balance sheet credit
exposure to the borrower, taking into account the contractual features
of the off-balance sheet item. For example, a guarantee provided by a
banking organization would be subject to a 100 percent credit
conversion factor because there generally is a high probability of the
full amount of the guarantee becoming an on-balance sheet credit
exposure. In contrast, under the terms of most commitments, banking
organizations generally are not expected to extend the full amount of
credit agreed to in the contract. After determining the off-balance
sheet exposure amount, the banking organization would then multiply it
by the appropriate risk weight, as provided under section III.C.2. of
the Supplementary Information, to arrive at the risk-weighted asset
amount for the off-balance sheet exposure, consistent with the
calculation method under the current standardized approach.
a. Commitments
The proposal would maintain the existing definition of commitment
under the current capital rule. The current capital rule defines a
commitment as any legally binding arrangement that obligates a banking
organization to extend credit or to purchase assets.\99\ A commitment
can exist even when the banking organization has the unilateral right
to not extend credit at any time.
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\99\ See 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2
(FDIC).
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Off-balance sheet exposures such as credit cards allow obligors to
borrow up to a specified amount. However, some off-balance sheet
exposures such as charge cards do not have an explicit contractual pre-
set credit limit and generally require obligors to pay their balance in
full each month. For commitments with no express contractual maximum
amount or pre-set limit, the proposal would include an approach to
calculate a proxy for the committed but undrawn amount of the
commitment (off-balance sheet notional amount), based on an averaging
formula over the previous two years (averaging methodology). A banking
organization would first calculate the average total drawn amount of
the commitment over the prior eight quarters or, if the banking
organization has offered such products to the obligor for fewer than
eight quarters, the average total drawn amount since the commitment
with no pre-set limit was first issued. The banking organization would
then multiply the average total drawn amount by 10 to determine the
off-balance sheet notional amount. Next, the banking organization would
determine the applicable off-balance sheet exposure amount by first
subtracting the current drawn amount from the calculated off-balance
sheet notional amount and then multiplying this difference by the
applicable credit conversion factor (10 percent for an unconditionally
cancelable commitment, as described in more detail in the following
section). The risk-weighted asset amount would be the off-balance sheet
exposure amount multiplied by the applicable risk weight (e.g., 55
percent for a transactor retail exposure).
For example, assume an obligor's charge card had an average drawn
amount of $4,000 over the prior eight quarters, and a drawn amount of
$3,000 during the most recent reporting quarter. To determine the off-
balance sheet exposure amount of the charge card, a banking
organization would (1) multiply the average of $4,000 by 10
[[Page 64056]]
($40,000), (2) subtract the current drawn amount of $3,000 from $40,000
($37,000), and (3) multiply $37,000 by the 10 percent credit conversion
factor for unconditionally cancellable commitments ($3,700). For
purposes of this example, assume the obligor's charge card would
qualify as a regulatory retail exposure \100\ that is a transactor
exposure. Applying the 55 percent risk weight for transactor exposures
to the exposure amount of $3,700. would result in a risk-weighted asset
amount of $2,035.
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\100\ As discussed in section III.C.2.f of this Supplementary
Information, a retail exposure would need to meet certain criteria
and be evaluated against the aggregate and granularity limits to
qualify as a regulatory retail exposure.
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The proposed averaging methodology would apply a multiplier of 10
to the average total drawn amount because supervisory experience
suggests that obligors similar to those with charge cards have average
credit utilization rates equal to approximately 10 percent. This
approach uses an eight-quarter average balance, as opposed to a shorter
period, to better reflect a borrower's credit usage, notably by
mitigating the impact of seasonality and of short-term trends in drawn
balances from the total credit exposure estimate.
Question 44: What are the advantages and disadvantages of the
averaging methodology to calculate a proxy for the undrawn credit
exposure amount for commitments with no pre-set limits? What, if any,
adjustments should the agencies consider to better reflect a borrower's
credit usage when calculating the undrawn portion of the credit
exposures for commitments that have less than eight quarters of data,
particularly those with less than a full quarter of data? What, if any,
alternative approaches should the agencies consider and why?
Question 45: What adjustments, if any, should the agencies make to
the proposed multiplier of 10 for calculating the total off-balance
sheet notional amount of the obligor under the proposed methodology and
why?
b. Credit Conversion Factors
The proposal would provide the same credit conversion factors in
the current capital rule except with respect to commitments. The
proposal would modify the credit conversion factors applicable to
commitments and simplify the treatment relative to the current
standardized approach by no longer differentiating such factors by
maturity. Under the proposal, a commitment, regardless of the maturity
of the facility, would be subject to a credit conversion factor of 40
percent, except for the unused portion of a commitment that is
unconditionally cancelable \101\ (to the extent permitted under
applicable law) by the banking organization, which would be subject to
a credit conversion factor of 10 percent.\102\ Although unconditionally
cancellable commitments allow banking organizations to cancel such
commitments at any time without prior notice, in practice, banking
organizations often extend credit or provide funding for reputational
reasons or to support the viability of borrowers to which the banking
organization has significant ongoing exposure, even when borrowers are
under economic stress. For example, banking organizations may have
incentives to preserve substantial or core customer relationships when
there is a deterioration in creditworthiness that may, for less
substantial customer relationships, cause the banking organization to
cancel a commitment. Relative to the current standardized approach, the
proposal would simplify the applicable credit conversion factor for all
other commitments given the 10 percent applicable credit conversion
factor for unconditionally cancellable commitments. A 40 percent credit
conversion factor for other commitments is appropriate because such
commitments do not provide the banking organization the same
flexibility to exit the commitment compared with unconditionally
cancellable commitments.
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\101\ Under Sec. __. 2 of the current capital rule,
unconditionally cancelable means a commitment that a banking
organization may, at any time, with or without cause, refuse to
extend credit (to the extent permitted under applicable law). See 12
CFR 3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC).
\102\ Under the proposal, a 40 percent CCF would also apply to
commitments that are not unconditionally cancelable commitments for
purposes of calculating total leverage exposure for the
supplementary leverage ratio.
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Question 46: What additional factors, if any, should the agencies
consider for determining the applicable credit conversion factors for
commitments?
4. Derivatives
The current capital rule requires banking organizations to
calculate risk-weighted assets based on the exposure amount of their
derivative contracts and prescribes different approaches for measuring
the exposure amount of derivative contracts based on the size and risk
profile of the banking organization. The proposal would expand the
scope of banking organizations that would be required to use one of the
approaches, SA-CCR, which was adopted in January 2020 (the SA-CCR final
rule),\103\ and make certain technical revisions to that approach. The
current capital rule requires banking organizations subject to Category
I or II capital standards to utilize SA-CCR or the internal models
methodology to calculate their advanced approaches total risk-weighted
assets and to utilize SA-CCR to calculate standardized total risk-
weighted assets.\104\ The current capital rule permits banking
organizations subject to Category III or IV capital standards to
utilize the current exposure methodology or SA-CCR to calculate
standardized total risk-weighted assets.\105\
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\103\ 85 FR 4362 (January 24, 2020).
\104\ 12 CFR 3.34 (OCC); 12 CFR 217.34 (Board); 12 CFR 324.34
(FDIC).
\105\ Id.
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As discussed in section II of this Supplementary Information, the
proposal would require institutions subject to Category III or IV
capital standards to use the expanded risk-based approach, which
includes the requirement to use SA-CCR, and would eliminate the
internal models methodology as an available approach to calculate the
exposure amount of derivative contracts. Therefore, under the proposal,
large banking organizations would be required to use SA-CCR to
calculate regulatory capital ratios under the standardized approach,
expanded risk-based approach, and supplementary leverage ratio.
The agencies are also proposing technical revisions to SA-CCR to
assist banking organizations in implementing SA-CCR in a consistent
manner and with an exposure measurement that more appropriately
reflects the counterparty credit risks posed by derivative
transactions.
a. Proposed Technical Revisions
i. Treatment of Collateral Held by a Qualifying Central Counterparty
(QCCP)
Under the current capital rule, a clearing member banking
organization using SA-CCR must determine its capital requirement for a
default fund contribution to a QCCP based on the hypothetical capital
requirement for the QCCP (KCCP) using SA-CCR.\106\ The
calculation of KCCP requires calculating the exposure amount
of the QCCP to each of its clearing members. In the calculation of the
exposure amount, the SA-CCR final rule allows the exposure amount of
the QCCP to each clearing member to be reduced by all collateral held
by the QCCP posted by the clearing member and by the amount of
[[Page 64057]]
prefunded default fund contributions provided by the clearing member to
the QCCP. However, this treatment is inconsistent with the calculation
of the exposure amount for a netting set, in which collateral is not
subtracted from the exposure amount but is instead a component of the
calculations of both the replacement cost (RC) and potential future
exposure (PFE).
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\106\ See 12 CFR 3.133(d) (OCC); 12 CFR 217.133(d) (Board); 12
CFR 324.133(d) (FDIC).
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The proposal would change how collateral posted to a QCCP by
clearing members and the amount of clearing members' prefunded default
fund contributions factor into the calculation of KCCP. This
treatment, which is more sensitive to the risk-reducing benefits of
collateral, would allow the proper recognition of collateral in
calculating the exposure amount of a QCCP to its clearing members and
would be consistent with the calculation of the exposure amount for a
netting set. Specifically, for the purpose of calculating the exposure
amount of a QCCP to a clearing member, the net independent collateral
amount that appears in the RC and PFE calculations would be replaced by
the sum of:
(1) the fair value amount of the independent collateral posted to a
QCCP by a clearing member;
(2) the fair value amount of the independent collateral posted to a
QCCP by a clearing member on behalf of a client, in connection with
derivative contracts for which the clearing member has provided a
guarantee to the QCCP; and
(3) the amount of the prefunded default fund contribution of the
clearing member to the QCCP.
Both the amount of independent collateral and the prefunded default
fund contribution would be adjusted by the standard supervisory
haircuts under Table 1 to Sec. __.121 of the proposal, as applicable.
ii. Treatment of Collateral Held in a Bankruptcy-Remote Manner
Both the standardized approach and the advanced approaches under
the current capital rule require a banking organization to determine
the trade exposure amount for derivative contracts transacted through a
central counterparty (CCP).
When calculating its trade exposure amount for a cleared
transaction, a banking organization under both the standardized and
advanced approaches under the capital rule may exclude collateral
posted to the CCP that is held in a bankruptcy-remote manner by the CCP
or a custodian. In the SA-CCR final rule, the agencies inadvertently
imposed heightened requirements for the exclusion of collateral from
the trade exposure amount posted by a clearing member banking
organizations to a CCP under the advanced approaches.\107\ The expanded
risk-based approach does not include these heightened requirements and
would align the requirements for the exclusion of collateral from the
trade exposure amount of banking organizations under both the
standardized and expanded risk-based approach.
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\107\ 12 CFR 3.133(c)(4)(i) (OCC); 12 CFR 217.133(c)(4)(i)
(Board); 12 CFR 324.133(c)(4)(i) (FDIC).
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iii. Supervisory Delta for Collateralized Debt Obligation (CDO)
Tranches
Under the SA-CCR final rule, a banking organization must apply a
supervisory delta adjustment to account for the sensitivity of a
derivative contract (scaled to unit size) to the underlying primary
risk factor, including the correct sign (positive or negative) to
account for the direction of the derivative contract amount relative to
the primary risk factor.\108\
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\108\ For the supervisory delta adjustment, a banking
organization applies a positive sign to the derivative contract
amount if the derivative contract is long the risk factor and a
negative sign if the derivative contract is short the risk factor. A
derivative contract is long the primary risk factor if the fair
value of the instrument increases when the value of the primary risk
factor increases. A derivative contract is short the primary risk
factor if the fair value of the instrument decreases when the value
of the primary risk factor increases.
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For a derivative contract that is a CDO tranche, the supervisory
delta adjustment is calculated using the formula below:
[GRAPHIC] [TIFF OMITTED] TP18SE23.008
where A is the attachment point and D is the detachment point.
The SA-CCR final rule applies a positive sign to the resulting
amount if the banking organization purchased the CDO tranche and
applies a negative sign if the banking organization sold the CDO
tranche. However, the appropriate sign to account for the purchasing or
selling of CDO tranches can be ambiguous: purchasing a CDO tranche can
be interpreted as selling credit protection, while selling a CDO
tranche can be interpreted as purchasing credit protection. In order to
ensure the correct sign of the supervisory delta adjustment for CDO
tranches that would result in a proper aggregation of CDO tranches with
linear credit derivative contracts in PFE calculations, the proposal
would revise the sign specification for the supervisory delta
adjustment for CDO tranches as follows: positive if the CDO tranches
were used to purchase credit protection by the banking organization and
negative if the CDO tranches were used to sell credit protection by the
banking organization.
iv. Supervisory Delta for Options Contracts
Under the SA-CCR final rule, the supervisory delta adjustment for
option contracts is calculated based on the Black-Scholes formulas for
delta sensitivity of European call and put option contracts. The
original Black-Scholes formula for a European option contract's delta
sensitivity assumes a lognormal probability distribution for the value
of the instrument or risk factor underlying the option contract, thus
precluding negative values for both the current value of the underlying
instrument or risk factor and the strike price of the option contract.
The SA-CCR final rule uses modified Black-Scholes formulas that are
based on a shifted lognormal probability distribution, which allows
negative values of the underlying instrument or risk factor with the
magnitude not exceeding the value of a shift parameter [lambda]
(lambda). The SA-CCR final rule sets [lambda] to zero (thus precluding
negative values) for all asset classes except the interest rate asset
class, which has exhibited negative values in some currencies in recent
years. For the interest rate asset class, a banking organization must
set the value of [lambda] for a given currency equal to the greater of
(i) the negative of the lowest value of the strike prices and the
current values of the interest rate underlying all interest rate
options in a given currency that the banking organization has with all
counterparties plus 0.1 percent; and (ii) zero.
However, negative values of the instrument or risk factor
underlying an option contract can occur in other asset classes as well.
For example, whenever
[[Page 64058]]
an option contract references the difference between the values of two
instruments or risk factors, the underlying spread of this option
contract can be negative. Such option contracts are commonly traded in
the OTC derivatives market, including option contracts on the spread
between two commodity prices and on the difference in performance
across two equity indices. Under the current capital rule, banking
organizations cannot calculate the supervisory delta adjustment for any
option contract other than an interest rate derivative contract if the
strike price or the current value of the underlying instrument or risk
factor is negative because the SA-CCR final rule only allows a non-zero
value for [lambda] for interest rate derivative contracts. To ensure
that a banking organization is able to calculate the supervisory delta
adjustment for option contracts when the underlying instrument or risk
factor has a negative value, the proposal would extend the use of the
shift parameter [lambda] to all asset classes. More specifically, for
non-interest-rate asset classes, the proposal would require a banking
organization to use the same value of [lambda] for all option contracts
that reference the same underlying instrument or risk factor. If the
value of the underlying instrument or risk factor cannot be negative,
the value of [lambda] would be set to zero. Otherwise, to determine the
value of [lambda] for a given risk factor or instrument, the proposal
would require a banking organization to find the lowest value L of the
strike price and the current value of the underlying instrument or risk
factor of all option contracts that reference this instrument or risk
factor with all counterparties. The proposal would require a banking
organization to set [lambda] for this instrument or risk factor
according to the formula [lambda]=max{-1.1[middot]L,0{time} . The
purpose of multiplying negative L by 1.1 (thus, resulting in -
1.1[middot]L) is the same as that for adding 0.1 percent in the case of
interest rate derivative contracts under the SA-CCR final rule: to set
the lowest possible value of the underlying instrument or risk factor
slightly below the lowest observed value. Because it is challenging to
determine a universal additive offset value for all values of non-
interest-rate instruments and risk factors, the offset would be
performed via multiplication for asset classes other than the interest
rate asset class.
The proposal would also permit a banking organization, with the
approval of its primary Federal supervisor, to specify a different
value for [lambda] for purposes of the supervisory delta adjustment for
option contracts other than interest rate option contracts, if a
different value for [lambda] would be appropriate, considering the
range of values for the instrument or risk factor underlying option
contracts. This flexibility would allow a banking organization to use a
specific value for [lambda], rather than the value resulting from the
proposed formula described above, in the event that a different value
for [lambda] is more appropriate than the value resulting from the
formula. A banking organization that specifies a different value for
[lambda] would be required to assign the same value for [lambda] to all
option contracts with the same underlying instrument or risk factor, as
applicable, with all counterparties. This proposed provision is
intended to permit a banking organization, with approval from its
primary Federal supervisor, to account for unanticipated outcomes in
the supervisory delta adjustment of certain asset classes while
avoiding arbitrage between assets in that class.
Question 47: What other approaches should the agencies consider to
calibrate the lambda parameter for non-interest-rate asset classes,
such as a formula that is different from the proposed formula of
[lambda]=max{-1.1[middot]L,0{time} , and why? What values besides 1.1,
if any, should the agencies consider for the value of the multiplier in
the proposed formula? Why?
v. Decomposition of Credit, Equity, and Commodity Indices
Under the capital rule, banking organizations are permitted to
decompose indices within credit, equity, and commodity asset classes,
such that a banking organization would treat each component of the
index as a separate single-name derivative contract.\109\ The capital
rule requires that if a banking organization elects to decompose
indices within the credit, equity, and commodity asset classes, the
banking organization must perform all calculations in determining the
exposure amount based on the underlying instrument rather than the
index. While this is possible for linear indices, for non-linear index
contracts (e.g., those with optionality and CDS index tranches) it is
not mathematically possible to calculate the supervisory delta for an
underlying component, as the delta associated with the non-linear index
applies at the instrument level. In recognition of this fact, the
agencies are clarifying that the option to decompose a non-linear index
is not available under SA-CCR. Additionally, the agencies are
clarifying that if electing to decompose a linear index, banking
organizations must apply the weights used by the index when determining
the exposure amounts for the underlying instrument.
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\109\ See 12 CFR 3.132(c)(5)(vi) (OCC); 12 CFR 217.132(c)(5)(vi)
(Board); 12 CFR 324.132(c)(5)(vi) (FDIC).
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5. Credit Risk Mitigation
The current capital rule permits banking organizations to recognize
certain types of credit risk mitigants, such as guarantees, credit
derivatives, and collateral, for risk-based capital purposes provided
the credit risk mitigants satisfy the qualification standards under the
rule.\110\ Credit derivatives and guarantees can reduce the credit risk
of an exposure by placing a legal obligation on a third-party
protection provider to compensate the banking organization for losses
in the event of a borrower default.\111\ Similarly, the use of
collateral can reduce the credit risk of an exposure by creating the
right of a banking organization to take ownership of and liquidate the
collateral in the event of a default by the counterparty. Prudent use
of such mitigants can help a banking organization reduce the credit
risk of an exposure and thereby reduce the risk-based capital
requirement associated with that exposure.
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\110\ Consistent with the current capital rule, the proposal
would not require banking organizations to recognize any instrument
as a credit risk mitigant. Credit derivatives that a banking
organization cannot or chooses not to recognize as a credit risk
mitigant would be subject to a separate counterparty credit risk
capital requirement.
\111\ Credit events are defined in the documents governing the
credit risk mitigant and often include events such as failure to pay
principal and interest and entry into insolvency or similar
proceedings.
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Credit risk mitigants recognized for risk-based capital purposes
must be of sufficiently high quality to effectively reduce credit risk.
For guarantees and credit derivatives, the current capital rule
primarily looks to the creditworthiness of the guarantor and the
features of the underlying contract to determine whether these forms of
credit risk mitigation may be recognized for risk-based capital
purposes (eligible guarantee or eligible credit derivative). With
respect to collateralized transactions, the current capital rule
primarily looks to the liquidity profile and quality of the collateral
received and the nature of the banking organization's security interest
to determine whether the collateral qualifies as financial collateral
that may be recognized for purposes of risk-based capital.\112\
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\112\ See 12 CFR 3.2, 217.2, and 324.2 for the definition of
financial collateral.
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As stated earlier, the proposal would eliminate the use of models
for credit risk under the current capital rule.
[[Page 64059]]
Therefore, the proposal would replace certain methodologies for
recognizing the risk-reducing benefits of financial collateral and
eligible guarantees and credit derivatives--namely, the internal models
methodology, simple VaR approach, PD substitution approach, LGD
adjustment approach, and double default treatment--with the
standardized approaches described below. For eligible guarantees and
eligible credit derivatives, the proposal would permit banking
organizations to use the substitution approach from subpart D of the
current capital rule with a modification for eligible credit
derivatives that do not include restructuring as a credit event.
Further, the proposal would no longer permit the recognition of credit
protection from nth-to-default credit derivatives.\113\ For all
collateralized transactions, the corporate issuer of any financial
collateral in the form of a corporate debt security must have an
outstanding publicly traded security or the corporate issuer must be
controlled by a company that has an outstanding publicly traded
security in order to be recognized. For collateralized transactions
where financial collateral secures exposures that are not derivative
contracts or netting sets of derivative contracts, the proposal would
permit banking organizations to use the simple approach from subpart D
without any modification. For eligible margin loans and repo-style
transactions, the proposal would also permit banking organizations to
use the collateral haircut approach with standard supervisory market
price volatility haircuts \114\ from subpart D with two proposed
modifications to increase risk sensitivity: (1) adjustments to the
market price volatility haircuts and (2) a modified formula for netting
sets of eligible margin loans or repo-style transactions that reflects
netting and diversification benefits within netting sets. Finally, the
proposal would introduce minimum haircut floors for certain eligible
margin loan and repo-style transactions with unregulated financial
institutions that banking organizations must meet in order to recognize
the risk-mitigation benefits of financial collateral.
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\113\ See section III.D.3.a of this Supplementary Information.
\114\ Under subpart D, banking organizations also are permitted
to use their own estimates of market price volatility haircuts, with
prior written approval from the primary Federal supervisors. The
proposal would not include this option in subpart E as the agencies
have found it to introduce unwarranted variability in banking
organizations' risk-weighted assets.
---------------------------------------------------------------------------
In connection with the removal of the internal models methodology,
the proposal would make corresponding revisions to reflect this change
in the definition of a netting set. Compared to the current capital
rule, the proposal would exclude cross-product netting sets from the
definition of a netting set, as none of the proposed approaches under
the revised framework would recognize cross-product netting. This would
be consistent with the current capital rule, which also does not
recognize cross-product netting. Therefore, the proposal would define a
netting set as a group of single-product transactions with a single
counterparty that are subject to a qualifying master netting agreement
(QMNA) \115\ and that consist only of one of the following: derivative
contracts, repo-style transactions, or eligible margin loans. For
purposes of the proposed netting set definition, the netting set must
include the same product (i.e., all derivative contracts or all repo-
style transactions or all eligible margin loans). Consistent with the
current capital rule, for derivative contracts, the proposed definition
of netting set would also include a single derivative contract between
a banking organization and a single counterparty.
---------------------------------------------------------------------------
\115\ See 12 CFR 3.2, 217.2, and 324.2 for the definition of
qualifying master netting agreement.
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Question 48: What would be the impact of requiring that certain
debt securities must be issued by a publicly-traded company, or issued
by a company controlled by a publicly-traded company, in order to
qualify as financial collateral and what, if any, alternatives should
the agencies consider to this requirement?
a. Guarantees and Credit Derivatives
i. Substitution Approach
As under subpart D in the current capital rule, under the proposal
a banking organization would be permitted to recognize the credit-risk-
mitigation benefits of eligible guarantees and eligible credit
derivatives by substituting the risk weight applicable to the eligible
guarantor or protection provider for the risk weight applicable to the
hedged exposure.\116\
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\116\ Under subpart E in the current capital rule, an eligible
guarantee need not be issued by an eligible guarantor unless the
exposure is a securitization exposure. The proposal would require
all eligible guarantees to be issued by an eligible guarantor.
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ii. Adjustment for Credit Derivatives Without Restructuring as a Credit
Event
Credit derivative contracts in certain jurisdictions include debt
restructuring as a credit event that triggers a payment obligation by
the protection provider to the protection purchaser. Such
restructurings of the hedged exposure may involve forgiveness or
postponement of principal, interest, or fees that result in a loss to
investors. Consistent with the current capital rule, the proposal would
generally require a banking organization that seeks to recognize the
credit risk-mitigation benefits of an eligible credit derivative that
does not include a restructuring of the reference exposure as a credit
event to reduce the effective notional amount of the credit derivative
by 40 percent to account for any unmitigated losses that could occur as
a result of a restructuring of the hedged exposure.
Under the proposal, however, the 40 percent adjustment would not
apply to eligible credit derivatives without restructuring as a credit
event if both of the following requirements are satisfied: (1) the
terms of the hedged exposure (and the reference exposure, if different
from the hedged exposure) allow the maturity, principal, coupon,
currency, or seniority status to be amended outside of receivership,
insolvency, liquidation, or similar proceeding only by unanimous
consent of all parties; and (2) the banking organization has conducted
sufficient legal review to conclude with a well-founded basis (and
maintains sufficient written documentation of that legal review) that
the hedged exposure is subject to the U.S. Bankruptcy Code or a
domestic or foreign insolvency regime with similar features that allows
for a company to reorganize or restructure and provides for an orderly
settlement of creditor claims.
The unanimous consent requirement would mean that, for
restructurings occurring outside of an insolvency proceeding, all
holders of the hedged exposure (and the reference exposure, if
different from the hedged exposure) must agree to any restructuring for
the restructuring to occur, and no holder can vote against the
restructuring or abstain. This unanimous consent requirement would
reduce the risk that a banking organization would suffer a credit loss
on the hedged exposure that would not be offset by a payment under the
eligible credit derivative. Banking organizations generally would only
be incentivized to vote for a restructuring if the terms of the
restructuring would provide a more beneficial outcome to the banking
organization relative to insolvency proceedings that would trigger
payment under the eligible credit derivative. Additionally, the
unanimous consent requirement for the reference exposure, if different
from the hedged exposure, would add an additional layer of security by
significantly reducing the
[[Page 64060]]
probability of reaching a restructuring agreement that results in a
loss of principal or interest for creditors without triggering payment
under the eligible credit derivative. The unanimous consent requirement
would need to be satisfied through the terms of the hedged exposure
(and the reference exposure, if different from the hedged exposure),
which could be accomplished through a contractual provision of the
exposure or the application of law.
The requirement that the hedged exposure be subject to the U.S.
Bankruptcy Code or a similar domestic or foreign insolvency regime
would help to ensure that any restructuring is done in an orderly,
predictable, and regulated process. In the event that the obligor of
the hedged exposure defaults and the default is not cured, the obligor
would either be required to enter insolvency proceedings, which would
trigger payment under the credit derivative, or the obligor would be
required to pursue restructuring outside of insolvency, which could not
occur without the banking organization's consent. Together, the
proposed requirements would ensure that credit derivatives that do not
include restructuring as a credit event but provide similarly effective
protection as those that do contain such provisions, are afforded
similar recognition under the capital framework.
Question 49: The agencies seek comment on the appropriateness of
allowing banking organizations to recognize in full the effective
notional amount of credit derivatives that do not include restructuring
as a credit event, if certain conditions are met. Is the exemption from
the 40 percent haircut overly broad? If so, why, and how might the
exemption be narrowed to only capture the types of credit derivatives
that provide protection similar to credit derivatives that include
restructuring as a credit event?
Question 50: To what extent is the proposed treatment of eligible
credit derivatives that do not include restructuring of the reference
exposure as a credit event relevant outside of the United States?
b. Collateralized Transactions
The proposal would only allow a banking organization to recognize
the risk-mitigating benefits of a corporate debt security that meets
the definition of financial collateral in expanded risk-weighted assets
if the corporate issuer of the debt security has a publicly traded
security outstanding or is controlled by a company that has a publicly
traded security outstanding. Corporations with publicly traded
securities typically are subject to mandatory regulatory and public
reporting and disclosure requirements, and therefore debt securities
issued by such corporations may be a more stable and liquid form of
collateral.
i. Simple Approach
Subpart D of the current capital rule includes the simple approach,
which allows a banking organization to recognize the risk-mitigating
benefits of financial collateral received by substituting the risk
weight applicable to an exposure with the risk weight applicable to the
financial collateral securing the exposure, generally subject to a 20
percent floor. The proposal generally would maintain the simple
approach of the current capital rule, including restrictions on
collateral eligibility and the risk-weight floor, except for the
proposed requirement for certain corporate debt securities.
ii. Collateral Haircut Approach
Under the current capital rule, a banking organization may
recognize the credit risk-mitigation benefits of repo-style
transactions, eligible margin loans, and netting sets of such
transactions by adjusting its exposure amount to its counterparty to
recognize any financial collateral received and any collateral posted
to the counterparty. Subpart E of the current capital rule includes
several approaches that a banking organization may use and some of
those approaches include the use of models that contribute to
variability in risk-weighted assets. For this reason, under the
proposal a banking organization would no longer be allowed to use the
simple VaR approach or the internal models methodology to calculate the
exposure amount, nor would a banking organization be permitted to use
its own internal estimates for calculating haircuts. The proposal would
broadly retain the collateral haircut approach with standard
supervisory market volatility haircuts with some modifications. This
approach would require a banking organization to adjust the fair value
of the collateral received and posted to account for any potential
market price volatility in the value of the collateral during the
margin period of risk, as well as to address any differences in
currency. To increase the risk-sensitivity of the collateral haircut
approach, the proposal would modify certain market price volatility
haircuts. The proposal would also introduce a new method to calculate
the exposure amount of eligible transactions in a netting set and
simplify the existing exposure calculation method for individual
transactions that are not part of a netting set.
I. Exposure Amount
The proposal would provide two methods for calculating the exposure
amount under the collateral haircut approach for eligible margin loans
and repo-style transactions. One method would apply to individual
eligible margin loans and repo-style transactions, the other to single-
product netting sets of such transactions, as described below. The new
formula for netting sets would allow for the recognition of the risk-
mitigating benefits of netting and portfolio diversification and is
intended to provide for increased risk-sensitivity of the capital
requirement for such transactions relative to the current capital rule.
A. Exposure Amount for Transactions Not in a Netting Set
Under the collateral haircut approach, the proposed exposure amount
for an individual eligible margin loan or repo-style transaction that
is not part of a netting set would yield the same result as the
exposure amount equation in the current capital rule. However, the
proposal would change the variables and structure to provide a
simplified calculation for an individual eligible margin loan or repo-
style transaction in comparison with transactions that are part of a
netting set. Specifically, the proposal would require a banking
organization to calculate the exposure amount as the greater of zero
and the difference of the following two quantities: (1) the value of
the exposure, adjusted by the market price volatility haircut
applicable to the exposure for a potential increase in the exposure
amount; and (2) the value of the collateral, adjusted by the market
price volatility haircut applicable to the collateral for a potential
decrease in the collateral value and the currency mismatch haircut
applicable where the currency of the collateral is different from the
settlement currency. The banking organization would use the market
price volatility haircuts and a standard 8 percent currency mismatch
haircut, subject to adjustments, as described in the following section.
Specifically, the exposure amount for an individual eligible margin
loan or repo-style transaction that is not in a netting set would be
based on the following formula:
E* = max{0; E x (1 + He)-C x (1-Hc-Hfx){time}
Where:
[[Page 64061]]
E* is the exposure amount of the transaction after credit
risk mitigation.
E is the current fair value of the specific instrument,
cash, or gold the banking organization has lent, sold subject to
repurchase, or posted as collateral to the counterparty.
He is the haircut appropriate to E as described in Table 1
to Sec. __.121, as applicable.
C is the current fair value of the specific instrument,
cash, or gold the banking organization has borrowed, purchased
subject to resale, or taken as collateral from the counterparty.
Hc is the haircut appropriate to C as described in Table 1
to Sec. __.121, as applicable.
Hfx is the haircut appropriate for currency mismatch
between the collateral and exposure.
The first component in the above formula, E x (1 + He), would
capture the current value of the specific instrument, cash, or gold the
banking organization has lent, sold subject to repurchase, or posted as
collateral to the counterparty by the banking organization in the
eligible margin loan or repo-style transaction, while accounting for
the market price volatility of the instrument type. The second
component in the above formula, C x (1-Hc-Hfx), would capture the
current value of the specific instrument, cash, or gold the banking
organization has borrowed, purchased subject to resale, or taken as
collateral from the counterparty in the eligible margin loan or repo-
style transaction, while accounting for the market price volatility of
the specific instrument as well as any adjustment to reflect currency
mismatch, if applicable.
B. Exposure Amount for Transactions in a Netting Set
Under the collateral haircut approach, the proposal would provide a
new, more risk-sensitive equation that recognizes diversification
benefits by taking into consideration the number of securities included
in a netting set of eligible margin loans or repo-style transactions.
Under this approach, the exposure amount for a netting set of eligible
margin loans or repo-style transactions would equal:
[GRAPHIC] [TIFF OMITTED] TP18SE23.009
Where:
E* is the exposure amount of the netting set after credit
risk mitigation.
Ei is the current fair value of the instrument, cash, or
gold the banking organization has lent, sold subject to repurchase,
or posted as collateral to the counterparty.
Ci is the current fair value of the instrument, cash, or
gold the banking organization has borrowed, purchased subject to
resale, or taken as collateral from the counterparty.
netexposure = [verbar][Sigma]s Es Hs[verbar].
grossexposure = [Sigma]s Es [verbar]Hs[verbar].
Es is the absolute value of the net position in a given
instrument or in gold (where the net position in a given instrument
or gold equals the sum of the current fair values of the instrument
or gold the banking organization has lent, sold subject to
repurchase, or posted as collateral to the counterparty, minus the
sum of the current fair values of that same instrument or gold the
banking organization has borrowed, purchased subject to resale, or
taken as collateral from the counterparty).
Hs is the haircut appropriate to Es as described in Table 1
to Sec. __.121, as applicable. Hs has a positive sign if the
instrument or gold is net lent, sold subject to repurchase, or
posted as collateral to the counterparty; Hs has a negative sign if
the instrument or gold is net borrowed, purchased subject to resale,
or taken as collateral from the counterparty.
N is the number of instruments in the netting set with a
unique Committee on Uniform Securities Identification Procedures
(CUSIP) designation or foreign equivalent, with certain exceptions.
N would include any instrument with a unique CUSIP that the banking
organization lends, sells subject to repurchase, or posts as
collateral, as well as any instrument with a unique CUSIP that the
banking organization borrows, purchases subject to resale, or takes
as collateral. However, N would not include collateral instruments
that the banking organization is not permitted to include within the
credit risk mitigation framework (such as nonfinancial collateral
that is not part of a repo-style transaction included in the banking
organization's market risk weighted assets) or elects not to include
within the credit risk mitigation framework. The number of
instruments for N would also not include any instrument (or gold)
for which the value Es is less than one-tenth of the value of the
largest Es in the netting set. Any amount of gold would be given a
value of one.
Efx is the absolute value of the net position in each
currency fx different from the settlement currency.
Hfx is the haircut appropriate for currency mismatch of
currency fx.
The first component in the above formula, ([Sigma]i Ei-[Sigma]iCi)
would capture the baseline exposure of a netting set of eligible margin
loans or repo-style transactions after accounting for the value of any
collateral. The second, (0.4 x netexposure), and third, (0.6
x (\grossexposure\/[radic]N)) components in the above
formula would reflect the systematic risk (based on the net exposure)
and the idiosyncratic risk \117\ (based on the gross exposure) of the
netting set of eligible margin loans or repo-style transactions covered
by a QMNA. Under the proposal, the net exposure component would allow
the formula to recognize netting at the level of the netting set and
correlations in the movement of market prices for instruments lent and
received. Additionally, because the contribution from the gross
exposure component to the exposure amount would decrease proportionally
with an increase in the number of unique instruments by CUSIP
designations or foreign equivalent, the gross exposure would capture
the impact of portfolio diversification. The fourth component,
([Sigma]fx (Efx x Hfx)) would capture any adjustment to reflect
currency mismatch, if applicable.
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\117\ Systematic risk represents risks that are impacted by
broad market variables (such as economy, region, and sector).
Idiosyncratic risk represents risks that are endemic to a specific
asset, borrower, or counterparty.
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When determining the market price volatility and currency mismatch
haircuts, the banking organization would use the market price
volatility haircuts described in the following section and a standard 8
percent currency mismatch haircut, subject to certain adjustments.
Question 51: What are the advantages and disadvantages of the
proposed
[[Page 64062]]
methodology for calculating the exposure amount for eligible margin
loans and repo-style transactions covered by a QMNA?
Question 52: What would be the advantages and disadvantages of an
alternative method to calculate the number of instruments N based on
the number of legal entities that issued or guaranteed the instruments?
II. Market Price Volatility Haircuts
Under the proposal, a banking organization would apply the market
price volatility haircut appropriate for the type of collateral, as
provided in Table 1 to Sec. __.121 below, in the exposure amount
calculation for repo-style transactions, eligible margin loans, and
netting sets thereof using the collateral haircut approach and in the
calculation of the net independent collateral amount and the variation
margin amount for collateralized derivative transactions using SA-CCR.
Consistent with the current capital rule, the proposal would require
banking organizations to apply an 8 percent supervisory haircut,
subject to adjustments, to the absolute value of the net position in
each currency that is different from the settlement
currency.118 119
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\118\ This category also would include public sector entities
that are treated as sovereigns by the national supervisor.
\119\ Includes senior securitization exposures with a risk
weight greater than or equal to 100 percent and sovereign exposures
with a risk weight greater than 100 percent.
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BILLING CODE 6210-01-P; 6714-01-P; 4810-33-P
[GRAPHIC] [TIFF OMITTED] TP18SE23.010
BILLING CODE 6210-01-C; 6714-01-C; 4810-33-C
The proposed haircuts would strike a balance between simplicity and
risk sensitivity relative to the supervisory haircuts in the current
capital rule by introducing additional granularity with respect to
residual maturity, which is a meaningful driver for distinguishing
between the market price volatility of different instruments, and by
streamlining other aspects of the collateral haircut approach where the
exposure's risk weight figures less
[[Page 64063]]
prominently in the instrument's market price volatility, as described
below.
The proposal would apply haircuts based solely on residual
maturity, rather than a combination of residual maturity and underlying
risk weight as under the current capital rule for investment grade debt
securities other than sovereign debt securities. These haircuts are
derived from observed stress volatilities during 10-business day
periods during the 2008 financial crisis. Debt securities with longer
maturities are subject to higher price volatility from future changes
in both interest rates and the creditworthiness of the issuer.
Because securitization exposures tend to be more volatile than
corporate debt,\120\ the proposal would provide a distinct category of
market price volatility haircuts for certain securitization exposures
consistent with the current capital rule. The proposal would
distinguish between non-senior and senior securitization exposures to
enhance risk sensitivity. Since senior securitization exposures absorb
losses only after more junior securitization exposures, these exposures
have an added layer of security and different market price volatility.
Therefore, the proposal would only specify term-based haircuts for
investment grade senior securitization exposures that receive a risk
weight of less than 100 percent under the securitization framework.
Other securitization exposures would receive the 30 percent market
price volatility haircut applicable to ``other'' exposure types.
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\120\ See Basel Committee, ``Strengthening the resilience of the
banking sector--consultative document,'' December 2009; https://www.bis.org/publ/bcbs164.pdf.
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The proposal would require a banking organization to apply market
price volatility haircuts of 20 percent for main index equities
(including convertible bonds) and gold, 30 percent for other publicly
traded equities and convertible bonds, and 30 percent for other
exposure types. Equities in a main index typically are more liquid than
those that are not included in a main index, as investors may seek to
replicate the index by purchasing the referenced equities or engaging
in derivative transactions involving the index or equities within the
index. The lower haircuts for equities included in a main index under
the proposal would reflect the higher liquidity of those securities
compared to other publicly traded equities or exposure types, which
would generally help to reduce losses to banking organizations when
liquidating those securities during stress conditions.
For collateral in the form of mutual fund shares, the proposal
would be consistent with the collateral haircut approach provided in
the current capital rule in which a banking organization would apply
the highest haircut applicable to any security in which the fund can
invest. The proposal also would include an alternative method available
to a banking organization if the mutual fund qualifies for the full
look-through approach described in section III.E.1.c.ii. of this
Supplementary Information. This alternative method would provide a more
risk-sensitive calculation of the haircut on mutual fund shares
collateral by using the weighted average of haircuts applicable to the
instruments held by the mutual fund.\121\ This aspect of the proposal
reflects the agencies' observation that, while certain mutual funds may
be authorized to hold a wide range of investments, the actual holdings
of mutual funds are often more limited.
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\121\ If the mutual fund qualifies for the full look-through
approach described in section III.E.1.c.ii of this Supplementary
Information but would be treated as a market risk covered position
as described in section III.H.3 of this Supplementary Information if
the banking organization held the mutual fund directly, the banking
organization is permitted to apply the alternative method to
calculate the haircut.
---------------------------------------------------------------------------
In addition, the proposal would maintain the requirement for a
banking organization to apply a market price volatility haircut of 30
percent to address the potential market price volatility for any
instruments that the banking organization has lent, sold subject to
repurchase, or posted as collateral that is not of a type otherwise
specified in Table 1 to Sec. __.121.
Question 53: What are the advantages and disadvantages of allowing
banking organizations to apply the full look-through approach for
certain collateral in the form of mutual fund shares? What alternative
approaches should the agencies consider for banking organizations to
determine the market price volatility haircuts for collateral in the
form of mutual fund shares?
III. Minimum Haircut Floors for Certain Eligible Margin Loans and Repo-
Style Transactions
The proposed framework for minimum haircuts on non-centrally
cleared securities financing transactions would reflect the risk
exposure of banking organizations to non-bank financial entities that
employ leverage and engage in maturity transformation but that are not
subject to prudential regulation.
The absence of prudential regulation makes such entities more
vulnerable to runs, leading to an increase in the credit risk of these
entities in the form of a greater risk of default in stress
periods.\122\ Episodes of non-bank financial entities' distress, such
as the 2008 financial crisis, have highlighted banking organizations'
exposure to non-bank financial entities through securities financing
transactions, which may give rise to credit and liquidity risks.
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\122\ See ``Strengthening Oversight and Regulation of Shadow
Banking,'' Financial Stability Board, August 2013 https://www.fsb.org/wp-content/uploads/r_130829b.pdf.
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Securities financing transactions may include repo-style
transactions and eligible margin loans. The motivation behind a
specific securities financing transaction can be either to lend or
borrow cash, or to lend or borrow a security. Securities financing
transactions can be used by a counterparty to achieve significant
leverage--for example, through transactions where the primary purpose
is to finance a counterparty through the lending of cash--and result in
elevated counterparty credit risk.
The proposal would require a banking organization to receive a
minimum amount of collateral when undertaking certain repo-style
transactions and eligible margin loans (in-scope transactions) with
such entities (unregulated financial institutions). The application of
haircut floors would determine the minimum amount of collateral
exchanged. A banking organization would treat in-scope transactions
with unregulated financial institutions that do not meet the proposed
haircut floors as repo-style transactions or eligible margin loans
where the banking organization did not receive any collateral from its
counterparty.\123\ The proposed treatment is intended to limit the
build-up of excessive leverage outside the banking system and reduce
the cyclicality of such leverage, thereby limiting risk to the lending
banking organization and the banking system.
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\123\ In this example, the banking organization would be
permitted to calculate the exposure amount using the collateral
haircut approach but would be required to exclude any collateral
received from the calculation. Alternatively, the banking
organization could choose not to use the collateral haircut approach
but to risk weight any on-balance sheet or off-balance sheet
portions of the exposure as demonstrated in the example below.
---------------------------------------------------------------------------
A. Unregulated Financial Institutions
Consistent with the definition in Sec. __. 2 of the current
capital rule, the proposal would define unregulated financial
institution as a financial institution that is not a regulated
financial institution, including any
[[Page 64064]]
financial institution that would meet the definition of ``financial
institution'' under Sec. __.2 of the current capital rule but for the
ownership interest thresholds set forth in paragraph (4)(i) of that
definition. Unregulated financial institutions would include hedge
funds and private equity firms. This definition would capture non-bank
financial entities that employ leverage and engage in maturity
transformation but that are not subject to prudential regulation.
Question 54: What entities should be included or excluded from the
scope of entities subject to the minimum haircut floors and why? For
example, what would be the advantages and disadvantages of expanding
the definition of entities that are scoped-in to include all
counterparties, or all counterparties other than QCCPs? What impact
would expanding the scope of entities subject to the minimum haircut
floors have on banking organizations' business models, competitiveness,
or ability to intermediate in funding markets and in U.S. Treasury
securities markets?
B. In-Scope Transactions
Under the proposal, an in-scope transaction generally would include
the following non-centrally cleared transactions: (1) an eligible
margin loan or a repo-style transaction in which a banking organization
lends cash to an unregulated financial institution in exchange for
securities, unless all of the securities are non-defaulted sovereign
exposures, and (2) certain security-for-security repo-style
transactions that are collateral upgrade transactions with an
unregulated financial institution. Under the proposal, a collateral
upgrade transaction would include a transaction in which the banking
organization lends one or more securities that, in aggregate, are
subject to a lower haircut floor in Table 2 to Sec. __.121 than the
securities received from the unregulated financial institution.
The proposal would exempt the following types of transactions and
netting sets of such transactions with unregulated financial
institutions from the minimum haircut floor requirements: (1)
transactions in which an unregulated financial institution lends, sells
subject to repurchase, or posts as collateral securities to a banking
organization in exchange for cash and the unregulated financial
institution reinvests the cash at the same or a shorter maturity than
the original transaction with the banking organization; (2) collateral
upgrade transactions in which the unregulated financial institution is
unable to re-hypothecate, or contractually agrees that it will not re-
hypothecate, the securities it receives as collateral; or (3)
transactions in which a banking organization borrows securities from an
unregulated financial institution for the purpose of meeting current or
anticipated demand, such as for delivery obligations, customer demand,
or segregation requirements, and not to provide financing to the
unregulated financial institution. For transactions that are cash-
collateralized in which an unregulated financial institution lends
securities to the banking organization, banking organizations could
rely on representations made by the unregulated financial institution
as to whether the unregulated financial institution reinvests the cash
at the same or a shorter maturity than the maturity of the transaction.
For transactions in which a banking organization is seeking to borrow
securities from an unregulated financial institution to meet a current
or anticipated demand, banking organizations must maintain sufficient
written documentation that such transactions are for the purpose of
meeting a current or anticipated demand and not for providing financing
to an unregulated financial institution. The proposal would exclude
these in-scope transactions from the minimum haircut floors as these
transactions do not pose the same credit and liquidity risks as other
in-scope transactions and serve as important liquidity and
intermediation services provided by banking organizations.
Question 55: What alternative definitions of ``in-scope
transactions'' should the agencies consider? For example, what would be
the pros and cons of an expanded definition of ``in-scope
transactions'' to include all eligible margin loan or repo-style
transactions in which a banking organization lends cash, including
those involving sovereign exposures as collateral? How would the
inclusion of sovereign exposures affect the market for those
securities? What, if any, additional factors should the agencies
consider concerning this alternative definition?
Question 56: What, if any, difficulties would banking organizations
have in identifying transactions that would be exempt from the minimum
haircut floor?
Question 57: What, if any, operational burdens would be imposed by
the proposal to require banking organizations to maintain sufficient
written documentation to exempt transactions with an unregulated
financial institution where the banking organization is seeking to
borrow securities from an unregulated financial institution to meet a
current or anticipated demand?
C. Application of the Minimum Haircut Floors
For in-scope transactions, the proposal would establish minimum
haircut floors that would be applied on a single-transaction or a
portfolio basis depending on whether the in-scope transaction is part
of a netting set. The proposed haircut floors are derived from observed
historical price volatilities as well as existing market and central
bank haircut conventions. If the in-scope transaction is a single
transaction, then the banking organization would apply the
corresponding single-transaction haircut floor. If the in-scope
transaction is part of a netting set, the banking organization would
apply a portfolio-based floor to the entire netting set.\124\ In-scope
transactions that do not meet the applicable minimum haircut floor
would be treated as uncollateralized exposures.
---------------------------------------------------------------------------
\124\ If a netting set contains both in-scope and out-of-scope
transactions, the banking organization would apply a portfolio-based
floor for the entire netting set.
---------------------------------------------------------------------------
The minimum haircut floors are intended to reflect the minimum
amount of collateral banking organizations should receive when
undertaking in-scope transactions with unregulated financial
institutions. Banking organizations should require an appropriate
amount of collateral to be provided to account for the risks of the
transaction and counterparty. Figure 1 provides a summary of the
process for determining whether an in-scope transaction meets the
applicable minimum haircut floor.
BILLING CODE 6210-01-P; 6714-01-P; 4810-33-P
[[Page 64065]]
[GRAPHIC] [TIFF OMITTED] TP18SE23.011
[GRAPHIC] [TIFF OMITTED] TP18SE23.012
BILLING CODE 6210-01-C; 6714-01-C; 4810-33-C
The proposal would require a banking organization to compare the
haircut (H) and a single-transaction or portfolio haircut floor
([fnof]), as calculated below, to determine whether an in-scope
transaction or a netting set of in-scope transactions meets the
relevant floor. If H is less than f, then the banking organization may
not recognize the risk-mitigating effects of any financial collateral
that secures the exposure.
For a single cash-lent-for-security in-scope transaction, H would
be defined as the ratio of the fair value of financial collateral
borrowed, purchased subject to resale, or taken as collateral from the
counterparty to the fair value of cash lent, minus one, and [fnof]
would be the corresponding haircut applicable to the collateral in
Table 2 to Sec. __.121. For example, for an in-scope transaction in
which a banking organization lends $100 in cash to an unregulated
financial institution and receives $102 in investment-grade corporate
bonds with a residual maturity of 10 years as collateral, the haircut
would be calculated as H = (102/100)-1 = 2 percent. The single-
transaction haircut floor for an investment grade corporate bond with a
residual maturity of 10 years or less under Table 2 to Sec. __.121
would be [fnof]= 3 percent Since the haircut is less than the single-
transaction haircut floor (H = 2 percent = fPortfolio.
If the portfolio does not satisfy the minimum haircut floor, the
banking organization would not be able to recognize the risk-mitigating
benefits of the collateral received.
In the following example, there are two in-scope repo-style
transactions that are in the same netting set: (1) a reverse repo
transaction in which a banking organization lends $100 in cash to an
unregulated financial institution and receives $102 in investment grade
corporate bonds with a residual maturity of 10 years (which correspond
to a haircut floor of 3 percent) as collateral; and (2) a securities
lending transaction in which a banking organization lends $100 of
different investment grade corporate bonds also with a residual
maturity of 10 years and receives $104 in main index equity securities
(which correspond to a haircut floor of 6 percent) as collateral. For
this set of in-scope repo-style transactions, the portfolio haircut
would be:
[GRAPHIC] [TIFF OMITTED] TP18SE23.019
The portfolio haircut floor would be:
[GRAPHIC] [TIFF OMITTED] TP18SE23.020
The banking organization would be able to recognize the risk-
mitigating benefits of the collateral received, because the portfolio
haircut is higher than the portfolio haircut floor:
H = 3 percent > 2.971 percent = fPortfolio)
To calculate the exposure amount for this transaction, the banking
organization would use the collateral haircut approach formula in Sec.
__.121(c) and the standard market price volatility haircuts in Table 1
to Sec. __.121 and set N to 3:
[[Page 64067]]
[GRAPHIC] [TIFF OMITTED] TP18SE23.021
Where:
exposurenet = [verbar](100 x 0%) + (100 x 12%) + (102 x (- 12%)) +
(104 x (-20%))[verbar] = 21.04
and
exposuregross = (100 x [verbar]0%[verbar]) + (100 x
[verbar]12%[verbar] + (102 x [verbar]- 12% [verbar]) + (104 x
[verbar]- 20%[verbar]) = 45.04
In a similar example, there are also two in-scope repo-style
transactions that are in the same netting set: (1) a reverse repo
transaction in which a banking organization lends $100 in cash to an
unregulated financial institution and receives $101 in investment grade
corporate bonds with a residual maturity of 10 years (which correspond
to a haircut floor of 3 percent) as collateral; and (2) a securities
lending transaction in which a banking organization lends $100 of
different investment grade corporate bonds and receives $102 in main
index equity securities (which correspond to a haircut floor of 6
percent) as collateral. For this set of in-scope repo-style
transactions, the portfolio haircut would be:
[GRAPHIC] [TIFF OMITTED] TP18SE23.022
and the portfolio haircut floor would be:
[GRAPHIC] [TIFF OMITTED] TP18SE23.023
Since the portfolio haircut is less than the portfolio haircut
floor (H= 1.5 percent 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2
(FDIC).
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1. Risk-Weighted Asset Amount
The proposal would retain the risk-weighted asset amount
calculation under the current capital rule. Consistent with the current
capital rule, the proposal would require a banking organization to
determine the risk-weighted asset amount for each equity exposure,
except for equity exposures to investment funds, by multiplying the
adjusted carrying value of the exposure by the lowest applicable risk
weight, as described below in section III.E.1.b. of this Supplementary
Information. A banking organization would determine the risk-weighted
asset amount for an equity exposure to an investment fund by
multiplying the adjusted carrying value of the exposure by either the
risk weight calculated under one of the look-through approaches or by a
risk weight of 1,250 percent, as described below in section III.E.1.c.
of this Supplementary Information. A banking organization would
calculate its aggregate risk-weighted asset amount for equity exposures
as the sum of the risk-weighted asset amount calculated for each equity
exposure.\150\
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\150\ The proposal would exclude from the proposed equity
framework equity exposures that a banking organization would be
required to deduct from regulatory capital under Sec.
__.22(d)(2)(i)(C) of the proposal. The proposal would require a
banking organization to assign a 250 percent risk weight to the
amount of the significant investments in the common stock of
unconsolidated financial institutions that is not deducted from
common equity tier 1 capital.
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a. Adjusted Carrying Value
Under the proposal, the adjusted carrying value of an equity
exposure, including equity exposures to investment funds, would be
based on the type of exposure, as described in Table 6 below.
BILLING CODE 6210-01-P; 6714-01-P; 4810-33-P
[[Page 64075]]
[GRAPHIC] [TIFF OMITTED] TP18SE23.024
The proposal would maintain the current capital rule's methods for
calculating the adjusted carrying value for equity exposures, with one
exception. The proposal would simplify the treatment of conditional
commitments to acquire an equity exposure to remove the differentiation
of conversion factors by maturity. The proposal would require a banking
organization to multiply the effective notional principal amount of a
conditional commitment by a 40 percent conversion factor to calculate
its adjusted carrying value. The 40 percent conversion factor is meant
to appropriately account for the risk of conditional equity
commitments, which provide the banking organization more flexibility to
exit the commitment relative to unconditional equity commitments.
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\151\ Consistent with the current capital rule, the proposal
would allow a banking organization to choose not to hold risk-based
capital against the counterparty credit risk of equity derivative
contracts, as long as it does so for all such contracts. Where the
equity derivative contracts are subject to a qualified master
netting agreement, the proposal would require the banking
organization to either include all or exclude all of the contracts
from any measure used to determine counterparty credit risk
exposure. See Sec. __.113(d) of the proposal.
\152\ Consistent with the current capital rule, the proposal
includes the concept of the effective notional principal amount of
the off-balance sheet portion of an equity exposure to provide a
uniform method for banking organizations to measure the on-balance
sheet equivalent of an off-balance sheet exposure. For example, if
the value of a derivative contract referencing the common stock of
company X changes the same amount as the value of 150 shares of
common stock of company X, for a small change (for example, 1.0
percent) in the value of the common stock of company X, the
effective notional principal amount of the derivative contract is
the current value of 150 shares of common stock of company X,
regardless of the number of shares the derivative contract
references. The adjusted carrying value of the off-balance sheet
component of the derivative is the current value of 150 shares of
common stock of company X minus the adjusted carrying value of any
on-balance sheet amount associated with the derivative.
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b. Expanded Simple Risk-Weight Approach (ESRWA)
Under the proposal, the risk-weighted asset amount for an equity
exposure, except for equity exposures to investment funds, would be the
product of the adjusted carrying value of the equity exposure
multiplied by the lowest applicable risk weight in Table 7.
[[Page 64076]]
[GRAPHIC] [TIFF OMITTED] TP18SE23.025
BILLING CODE 6210-01-C; 6714-01-C; 4810-33-C
Except for the proposed zero, 20, and 400 percent risk-weight
buckets and the 250 percent risk weight for significant investments in
the capital of an unconsolidated financial institution in the form of
common stock that are not deducted from regulatory capital, the
proposal would revise the risk weights applicable to other types of
equity exposures relative to those in the current capital rule's simple
risk-weight approach. Specifically, to enhance risk sensitivity and
simplify the equity framework, the proposal would eliminate the
following risk weights within the current capital rule's simple risk-
weight approach: (1) the 100 percent risk weight for non-significant
equity exposures whose aggregate adjusted carrying value does not
exceed 10 percent of the banking organization's total capital, and (2)
the 100 and 300 percent risk weights for the effective and ineffective
portion of hedge pairs, respectively. Given the removal of the 100
percent risk weight threshold category for non-significant equity
exposures and the revised scope of equity exposures subject to the
proposed equity framework, the proposal would (1) assign a 100 percent
risk weight to equity exposures to Small Business Investment Companies
and (2) generally assign a 250 percent risk weight to publicly traded
equity exposures with restrictions on tradability,\155\ as described in
more
[[Page 64077]]
detail below. Finally, the proposal would introduce a 1,250 percent
risk weight to replace the 600 percent risk weight in the simple risk-
weight approach under subpart E of the current capital rule for equity
exposures to investment firms that have greater than immaterial
leverage and that the primary Federal supervisor has determined do not
qualify as a traditional securitization exposure, as described in more
detail below.
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\153\ The proposal would rely on the existing definition of
publicly traded under the current capital rule. See 12 CFR 3.2
(OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC).
\154\ Consistent with the current capital rule, the proposal
would require banking organizations to apply the 250 percent risk
weight to the net long position, as calculated under Sec. __.22(h),
that is not deducted from capital pursuant to Sec.
__.22(d)(2)(i)(C).
\155\ Banking organizations that would be subject to the
proposed enhanced risk-based capital framework but not the proposed
market risk capital requirements would be required to assign a 250
percent risk weight to all publicly traded equity positions that are
not equity exposures to investment funds.
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Removing the 100 percent risk weight for non-significant equity
exposures is intended to increase the risk sensitivity of the equity
framework by requiring banking organizations to apply a risk weight
based on the characteristics of each equity exposure, rather than only
for those in excess of 10 percent of the banking organization's total
capital. Given that primarily illiquid or infrequently traded equity
positions would be subject to the proposed equity framework, the
proposal would remove the 100 and 300 percent risk weights under the
current capital rule for the effective and ineffective portions of
hedge pairs. The hedge pair treatment under the current capital rule is
only available if each of the equity exposures is publicly traded or
has a return that is primarily based on a publicly traded equity
exposure. As such positions would generally be subject to the proposed
market risk capital framework under the proposal, the agencies are
proposing to eliminate the hedge pair treatment to simplify the risk-
weighting framework under the proposal.
i. Community Development Investments and Small Business Investment
Companies
The current capital rule assigns a 100 percent risk weight to
equity exposures that either (1) qualify as a community development
investment under section 24 (Eleventh) of the National Bank Act, or (2)
represent non-significant equity exposures to the extent that the
aggregate adjusted carrying value of the exposures does not exceed 10
percent of the banking organization's total capital. Under the current
capital rule, when determining which equity exposures are ``non-
significant'' and thus eligible for a 100 percent risk weight, a
banking organization first must include equity exposures to an
unconsolidated small business investment company or held through a
consolidated small business investment company described in section 302
of the Small Business Investment Act of 1958 (15 U.S.C. 682).\156\ As
depository institutions are limited by statute to only invest up to 5
percent of total capital in the equity exposures and debt instruments
of small business investment companies, the current capital rule
effectively assigns a 100 percent risk weight to all equity exposures
to such programs.
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\156\ See 12 CFR 3.152(b)(3)(iii)(B) (OCC); 12 CFR
217.152(b)(3)(iii)(B) (Board); 12 CFR 324.152(b)(3)(iii)(B) (FDIC).
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Equity exposures to community development investments and small
business investment companies generally receive favorable tax treatment
and/or investment subsidies that make their risk and return
characteristics different than equity investments in general.
Recognizing this more favorable risk-return structure and the
importance of these investments to promoting important public welfare
goals, the proposal would effectively retain the treatment of equity
exposures that qualify as community development investments and equity
exposures to small business investment companies under the current
capital rule and assign such exposures a 100 percent risk weight.
ii. Publicly Traded Equity With Tradability Restrictions \157\
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\157\ The proposal would require banking organizations that are
not subject to the proposed market risk capital framework to
calculate risk-weighted assets for all publicly traded equity
exposures under the proposed equity framework.
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To appropriately capture the risk of publicly traded equity
exposures with restrictions on tradability, the proposal would (1)
eliminate the 100 percent risk weight for non-significant equity
exposures up to 10 percent of total capital under the current capital
rule; and (2) introduce a 250 percent risk weight to replace the
current capital rule's 300 percent risk weight applicable to publicly
traded exposures.\158\ The revised calibration of the risk-weight for
publicly traded equity exposures with restrictions on tradability is
intended to take into account the removal of the non-significant equity
exposures treatment. Under the proposal, banking organizations would no
longer assign separate risk weights (100 percent and 300 percent) to
publicly traded equity exposures based on factors that are unrelated to
the underlying risk of the exposure. Instead, the proposal would assign
an identical 250 percent risk weight to all publicly traded equity
exposures with restrictions on tradability, improving the consistency
and risk-sensitivity of the framework.
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\158\ Equity exposures, including preferred stock exposures, to
the FHLBs and Farmer Mac would continue to receive a 20 percent risk
weight.
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iii. Equity Exposures to Investment Firms With Greater Than Immaterial
Leverage and That Would Meet the Definition of a Traditional
Securitization Were It Not for the Application of Paragraph (8) of That
Definition
Consistent with the current capital rule, the proposed
securitization framework generally would apply to exposures to
investment firms with material liabilities that are not operating
companies,\159\ unless the primary Federal supervisor determines the
exposure is not a traditional securitization based on its leverage,
risk profile or economic substance.160 161 For an equity
exposure to an investment firm that has greater than immaterial
leverage and that the primary Federal supervisor has determined does
not qualify as a traditional securitization exposure, the proposal
would increase the 600 percent risk weight in the simple risk-weight
approach under subpart E of the current capital rule to 1,250 percent
under the proposed expanded simple risk-weight approach.
[[Page 64078]]
As under the current capital rule, the applicable risk weight for
equity exposures to such investment firms with greater than immaterial
liabilities under the proposed securitization framework would depend on
the size of the first loss tranche.\162\ For investment firms that have
greater than immaterial leverage, their capital structure may result in
a large first loss tranche that understates the risk of the exposure to
the investment firm. Unlike most traditional securitization structures,
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) may pose additional risks not
covered by the securitization framework. For example, the performance
of an equity exposure to an investment firm with greater than
immaterial liabilities may depend in part on management discretion
regarding asset composition and capital structure. To appropriately
capture the additional risks posed by equity exposures to investment
firms with greater than immaterial liabilities that may not be
reflected within the proposed securitization framework, the proposal
would permit the primary Federal supervisor to determine that the
exposure is not a traditional securitization and require the banking
organization to apply a 1,250 percent risk weight to the adjusted
carrying value of equity exposures to such investment firms.\163\
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\159\ Operating companies generally refer to companies that are
established to conduct business with clients with the intention of
earning a profit in their own right and generally produce goods or
provide services beyond the business of investing, reinvesting,
holding, or trading in financial assets. Accordingly, an equity
investment in an operating company generally would be an equity
exposure under the proposal and subject to the proposed enhanced
simple risk-weight approach. Consistent with the current capital
rule, under the proposal, banking organizations would be operating
companies and would not fall under the definition of a traditional
securitization. However, investment firms that generally do not
produce goods or provide services beyond the business of investing,
reinvesting, holding, or trading in financial assets, would not be
operating companies, and would not qualify for the general exclusion
from the definition of traditional securitization.
\160\ In general, such entities qualify as ``traditional
securitizations'' unless explicitly scoped out by criterion (10) of
that definition (for example collective investment funds, as defined
in 12 CFR 208.34, as well as entities registered with the SEC under
the Investment Company Act of 1940, 15 U.S.C. 80a-1, or foreign
equivalents thereof). As the definition of ``traditional
securitization'' does not include exposures to entities where all or
substantially all of the underlying exposures are not financial
exposures, equity exposures to Real Estate Investment Trusts (REITs)
generally would be treated in a similar manner to equity exposures
to operating companies and, unless they qualify as market risk
covered positions, would be subject to the proposed expanded simple
risk-weight approach of the equity framework.
\161\ For example, for an equity security issued by a qualifying
venture capital fund, as defined under Sec. __.10(c)(16) of each
agency's regulations implementing section 13 of the BHC Act, that
also has outstanding debt securities, the proposal would generally
require a banking organization to treat the exposure as a
traditional securitization exposure if the exposure would meet all
of the criteria of the definition of traditional securitization
under Sec. __.2 of the current capital rule unless the primary
Federal supervisor determines the exposure is not a traditional
securitization.
\162\ Consistent with the current capital rule, under the
proposal, an equity exposure to an investment firm that is treated
as a traditional securitization would be subject to due diligence
requirements. If a banking organization is unable to demonstrate to
the satisfaction of the primary Federal supervisor a comprehensive
understanding of the features of an equity exposure that would
materially affect the performance of the exposure, the proposal
would require the banking organization to assign a risk weight of
1,250 percent to the equity exposure to the investment firm.
\163\ Consistent with the current capital rule, the agencies
will consider the economic substance, leverage, and risk profile of
a transaction to ensure that an appropriate risk-based capital
treatment is applied. The agencies will consider a number of factors
when assessing the economic substance of a transaction including,
for example, the amount of equity in the structure, overall leverage
(whether on or off-balance sheet), whether redemption rights attach
to the equity investor, and the ability of the junior tranches to
absorb losses without interrupting contractual payments to more
senior tranches.
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Question 68: The agencies request comment on the proposed
application of a 1,250 percent risk weight to equity exposures to
investment firms with greater than immaterial leverage and that would
meet the definition of a traditional securitization were it not for the
application of paragraph (8) of that definition. For what, if any,
types of exposures would requiring banking organizations to apply a
1,250 percent risk weight be inappropriate and why? What are the
advantages and disadvantages of the proposed 1,250 percent risk weight
relative to expanding the proposed look-through approaches for
investment funds to include such exposures?
Question 69: The agencies seek comment on the advantages and
disadvantages of requiring banking organizations to calculate risk-
based capital requirements for equity exposures to investment firms
with greater than immaterial leverage under the proposed securitization
framework relative to the proposed look-through approaches under the
equity framework. What, if any, types of equity exposures to investment
firms with greater than immaterial leverage may not be appropriately
captured by the securitization framework--such as equity exposures to
investment firms where all the exposures of the investment firm are
pari passu in the event of a bankruptcy or other insolvency proceeding?
Between the proposed securitization framework and the proposed look-
through approaches under the equity framework, which approach would be
more operationally burdensome or challenging and why? Which approach
would produce a more appropriate capital requirement and why? Provide
supporting data and examples.
c. Risk Weights for Equity Exposures to Investment Funds
The separate risk-based capital treatment for equity exposures to
investment funds under the current capital rule reflects that the risk
of equity exposures to investment fund structures depends primarily on
the nature of the underlying assets held by the fund and the degree of
leverage employed by the fund. Consistent with the current capital
rule, the proposal would require banking organizations to determine the
risk weight applicable to the adjusted carrying value of each equity
exposure to an investment fund using a look-through approach in the
equity framework. When more detailed information is available about the
investment fund's characteristics, a banking organization is in a
better position to evaluate the risk profile of its equity exposure to
the fund and calculate a risk weight commensurate with that risk.
Conversely, equity exposures to investment funds that provide less
transparency or are not subject to regular independent verification
could present elevated risk to banking organizations. Accordingly, the
proposal would specify a hierarchy that banking organizations would be
required to use to identify the applicable look-through approach for
each equity exposure to an investment fund based on the nature and
quality of the information available to the banking organization.
The proposal would also enhance the risk sensitivity of the current
capital rule's look-through approaches under subpart E by modifying the
full look-through and the alternative look-through approaches to
explicitly capture off-balance sheet exposures held by an investment
fund, the counterparty credit risk and CVA risk of any underlying
derivatives held by the investment fund, and the leverage of an
investment fund. The proposal would also replace the simple modified
look-through approach under subpart E with a flat 1,250 percent risk-
weight.
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\164\ The proposal would require banking organizations subject
to the market risk capital requirements to apply the proposed market
risk capital framework to determine the risk-weighted asset amount
for equity exposures to investment funds that would otherwise be
subject to the full look-through approach under the proposed equity
framework. See Sec. __.202 for the proposed definition of market
risk covered position.
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i. Hierarchy of Look-Through Approaches
The proposal would require a banking organization that is not
subject to the proposed market risk capital framework to use the full
look-through approach if the banking organization has sufficient
verified information about the underlying exposures of the investment
fund to calculate a risk-weighted asset amount for each of the
exposures held by the investment fund.\164\ If a banking organization
is unable to meet the criteria to use the full look-through approach,
the proposal would require the banking organization to apply the
alternative modified look-through approach and determine a risk-
weighted asset amount for the exposures of the investment fund based on
the information contained in the investment fund's prospectus,
partnership agreement, or similar contract that defines the investment
fund's permissible investments. If the banking organization is unable
to apply either the full look-through approach or the alternative
modified look-through approach, the proposal would require the banking
organization to assign a 1,250 percent risk weight to the adjusted
carrying value of the equity exposure to the investment fund. Banking
organizations generally would not be permitted to apply a combination
of the
[[Page 64079]]
above approaches to determine the risk-weighted asset amount applicable
to the adjusted carrying value of an equity exposure to an investment
fund, except for equity exposures to investment funds with underlying
securitizations, or equity exposures to other investment funds, as
described in section III.E.1.c.v. of this Supplementary Information.
ii. Full Look-Through Approach
Since the full look-through approach is the most granular and risk-
sensitive approach, the proposal would require banking organizations
that are not subject to the proposed market risk capital framework to
use the full look-through approach when verified, detailed information
about the underlying exposures of the investment fund is available to
enhance risk-sensitivity of the risk-based capital requirements. Under
the proposed hierarchy, such banking organizations would be required to
use the full look-through approach if the banking organization is able
to calculate a risk-weighted asset amount for each of the underlying
exposures of the investment fund as if the exposures were held directly
by the banking organization, with the exception of securitization
exposures, derivative exposures, and equity exposures to other
investment funds, as described in section III.E.1.c.v. of this
Supplementary Information.
Specifically, the proposal would require banking organizations that
are not subject to the proposed market risk capital framework to apply
the full look-through approach when there is sufficient and frequent
information provided to the banking organization regarding the
underlying exposures of the investment fund. To satisfy this criterion,
the frequency of financial reporting of the investment fund must be at
least quarterly, and the financial information must be sufficient for
the banking organization to calculate the risk-weighted asset amount
for each exposure held by the investment fund as if each exposure were
held directly by the banking organization (except for securitization
exposures, derivatives exposures, and equity exposures to other
investment funds). In addition, such information would be required to
be verified on at least a quarterly basis by an independent third
party, such as a custodian bank or management fund.\165\
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\165\ As externally licensed auditors typically express their
opinions on investment funds' accounts rather than on the accuracy
of the data used for the purposes of applying the full look-through
approach, an external audit would not be required.
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The proposal would largely maintain the same risk-weight treatment
as provided under the full look-through approach in the advanced
approaches of the current capital rule, with five exceptions. First, to
facilitate application of the full look-through approach, the proposal
would allow banking organizations the option to use conservative
alternative methods to those provided under the proposed expanded risk-
weighted asset approach to calculate the risk-weighted asset amount
attributable to any underlying exposures that are securitizations,
derivatives, or equity exposures to another investment fund, as
described in section III.E.1.c.v. of this Supplementary Information.
Second, to increase comparability across banking organizations, the
proposal would clarify that the total risk-weighted asset amount for
the investment fund under the full look-through approach must include
any off-balance sheet exposures of the investment fund and the
counterparty credit risk and, where applicable, the CVA risk of any
underlying derivative exposures held by the investment fund.
Accordingly, under the proposal, the total risk-weighted asset amount
for the investment fund under the full look-through approach would
equal the sum of the risk-weighted asset amount for (1) the on-balance
sheet exposures, including any equity exposures to other investment
funds and securitization exposures; (2) the off-balance sheet
exposures; and (3) the counterparty credit risk and CVA risk, if
applicable, of any underlying derivative exposures held by the
investment fund, as described in section III.E.1.c.v. of this
Supplementary Information. A banking organization would calculate the
average risk weight for an equity exposure to the investment fund by
dividing the total risk-weighted asset amount for the investment fund
by the total assets of the investment fund.
Third, to capture the risk of equity exposures to investment funds
with leverage, the full look-through approach under the proposal would
explicitly require banking organizations to adjust the average risk
weight for its equity exposure to the investment fund upwards to
reflect the leverage of the investment fund.\166\ Specifically, the
proposal would require banking organizations to multiply the average
risk weight for its equity exposure to the investment fund by the ratio
of the total assets of the investment fund to the total equity of the
investment fund.
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\166\ While not done explicitly, the full look-through approach
under the current capital rule does capture the leverage of an
investment fund.
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Fourth, to avoid disincentivizing banking organizations from
obtaining the necessary information to apply the full-look through
approach, the proposal would cap the risk weight for an equity exposure
to an investment fund under the full look-through approach at no more
than 1,250 percent.
Fifth, consistent with the standardized approach under the current
capital rule, to reflect the agencies' and banking organizations'
experience with money market fund investments and similar investment
funds during the 2008 financial crisis and the 2020 coronavirus
response, the proposal would floor the minimum risk weight that may be
assigned to the adjusted carrying value of any equity exposure to an
investment fund under the proposed look-through approaches at 20
percent. Accordingly, under the proposal, a banking organization would
be required to calculate the total risk-weighted asset amount for an
equity exposure to an investment fund under the full look-through
approach by multiplying the adjusted carrying value of the equity
exposure by the applicable risk weight, as calculated according to the
following formula provided under Sec. __.142(b) of the proposed rule:
[GRAPHIC] [TIFF OMITTED] TP18SE23.026
Where:
RWAon is the aggregate risk-weighted asset
amount of the on-balance sheet exposures of the investment fund,
including any equity exposures to other investment funds and
securitization exposures, calculated as if each exposure were held
directly on balance sheet by the banking organization;
RWAoff is the aggregate risk-weighted asset
amount of the off-balance sheet exposures of the investment fund,
calculated for each exposure as if it were
[[Page 64080]]
held under the same terms by the banking organization;
RWAderivatives is the aggregate risk-weighted
asset amount for the counterparty credit risk and CVA risk, if
applicable, of the derivative contracts held by the investment fund,
calculated as if each derivative contract were held directly by the
banking organization, unless the banking organization applies the
alternative approach described in section III.E.1.c.v. of this
Supplementary Information; \167\
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\167\ Under the proposal, a banking organization may exclude
equity derivative contracts held by the investment fund for purposes
of calculating the RWAderivatives component of the full
and alternative modified look-through approaches, if the banking
organization has elected to exclude equity derivative contracts for
purposes of Sec. __.113(d) of the proposal.
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Total AssetsIF is the balance sheet total assets of the
investment fund; and
Total EquityIF is the balance sheet total equity of the
investment fund.
Question 70: What would be the advantages and disadvantages of
allowing a banking organization that does not have adequate data or
information to determine the risk weight associated with its equity
exposure to an investment fund to rely on information from a source
other than the investment fund itself, if the risk weight would be
increased (for example by a factor of 1.2)? For what types of
investment funds would a banking organization rely on a source other
than the investment fund itself to obtain this information and what
types of entities would it rely on to obtain this information?
iii. Alternative Modified Look-Through Approach
If a banking organization is unable to meet the criteria to use the
full look-through approach, the proposal would require the banking
organization to use the alternative modified look-through approach,
provided that the information contained in the investment fund's
prospectus, partnership agreement, or similar contract is sufficient to
determine the risk weight applicable to each exposure type in which the
investment fund is permitted to invest.\168\ To account for the
uncertain accuracy of risk assessments when banking organizations have
limited information about the underlying exposures of an investment
fund or such information is not verified on at least a quarterly basis
by an independent third party, the alternative modified look-through
approach in the current capital rule requires banking organizations to
use conservative assumptions when calculating total risk-weighted
assets for equity exposures to investment funds.
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\168\ Under the proposal, banking organizations subject to the
proposed market risk capital requirements would only apply the
alternative modified look-through approach to such equity exposures
to investment funds if the banking organization is unable to obtain
daily quotes for the equity exposure to the investment fund. See
Sec. __.202 for the proposed definition of market risk covered
position.
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The proposal would largely maintain the same risk-weight treatment
as provided under the alternative modified look-through approach in the
advanced approaches of the current capital rule, with five exceptions.
First, to increase comparability of the risk-based capital requirements
applicable to equity exposures to investment funds with investment
policies that permit the investment fund to hold equity exposures to
other investment funds or securitization exposures, the proposed
alternative modified look-through approach would specify the methods
that banking organizations would be required to use to calculate risk-
weighted assets for such underlying exposures, as described in section
III.E.1.c.v. of this Supplementary Information.
Second, to capture the risk of equity exposures to investment funds
with investment policies that permit the use of off-balance sheet
transactions or derivative contracts, the proposal would require
banking organizations to include the off-balance sheet transactions as
well as the counterparty credit risk and CVA risk, if applicable, of
the derivative contracts, when calculating the total risk-weighted
asset amount for the investment fund. Specifically, the proposal would
require banking organizations to assume that the investment fund
invests to the maximum extent permitted under its investment limits in
off-balance sheet transactions with the highest applicable credit
conversion factor and risk weight.\169\ The proposal would also require
banking organizations to assume that the investment fund has the
maximum volume of derivative contracts permitted under its investment
limits. Under the proposal, the total risk-weighted asset amount for
the investment fund under the alternative modified look-through
approach would equal the sum of the following risk-weighted asset
amounts: (1) the on-balance sheet exposures, including any equity
exposures to other investment funds and securitization exposures; (2)
the off-balance sheet exposures, and (3) the counterparty credit risk
and CVA risk, if applicable, for derivative exposures, as described in
section III.E.1.c.v. of this Supplementary Information. A banking
organization would calculate the average risk weight for an equity
exposure to the investment fund by dividing the total risk-weighted
asset amount for the investment fund by the total assets of the
investment fund.
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\169\ For example, if the mandate of an investment entity
permits the use of unconditional equity commitments, the proposal
would require the banking organization to multiply the notional
amount of the commitment by a 100 percent credit conversion factor
and the risk weight applicable to the underlying reference exposure
of the commitment. If the banking organization does not know the
type of equity underlying the commitment, the banking organization
would be required to use the highest applicable risk-weight to
equity exposures.
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Third, to capture the risk of equity exposures to investment funds
with leverage, the alternative modified look-through approach under the
proposal would require a banking organization to adjust the average
risk weight for its equity exposure to the investment fund upwards by
the ratio of the total assets of the investment fund to the total
equity of the investment fund.
Fourth, to avoid disincentivizing banking organizations from
obtaining the necessary information to apply the alternative modified
look-through approach, the proposal would cap the risk weight
applicable to an equity exposure to an investment fund under the
alternative modified look-through approach at no more than 1,250
percent.
Fifth, consistent with the standardized approach under the current
capital rule, to reflect the agencies' and banking organizations'
experience with money market fund investments and similar investment
funds during the 2008 financial crisis and the 2020 coronavirus
response, the proposal would floor the minimum risk weight that may be
assigned to the adjusted carrying value of any equity exposure to an
investment fund under the proposed look-through approaches at 20
percent.
Accordingly, under the proposal, a banking organization's risk-
weighted asset amount for an equity exposure to an investment fund
under the alternative modified look-through approach would be equal to
the adjusted carrying value of the equity exposure multiplied by the
lesser of 1,250 percent or the greater of either (1) the product of the
average risk weight of the investment fund multiplied by the leverage
of the investment fund or (2) 20 percent.
iv. 1,250 Percent Risk Weight
When banking organizations have limited information on the
underlying exposures or the leverage of the investment fund, they have
limited ability to appropriately capture and manage the risk and price
volatility of such equity exposures. Accordingly, if a
[[Page 64081]]
banking organization does not have the necessary information to apply
the full look-through approach or the alternative modified look-through
approach, the proposal would require the banking organization to assign
a 1,250 percent risk weight to the adjusted carrying value of its
equity exposure to the investment fund.
v. Risk Weights for Equity Exposures to Investment Funds With
Underlying Securitizations, Derivatives, or Equity Exposures to Other
Investment Funds
Banking organizations may not always be able to obtain the
necessary information to calculate risk-weighted asset amounts under
the full look-though approach or the alternative modified look-through
approach for certain types of underlying exposures held by an
investment fund. For example, even if an investment fund provides
detailed quarterly disclosures on all its underlying assets and
liabilities, such disclosures may not identify the actual counterparty
to each underlying derivative exposure of the investment fund or which
of the underlying derivative exposures of the investment fund are
subject to the same qualified master netting agreement. Furthermore,
the information contained in an investment fund's prospectus,
partnership agreement, or similar contract may not always allow banking
organizations to calculate risk-weighted asset amounts for such
underlying exposures under the alternative modified look-through
approach.
To facilitate application of the look-through approaches, the
proposal would allow banking organizations to use conservative
assumptions to calculate risk-weighted asset amounts under the full
look-through approach for underlying exposures that are securitization
exposures, derivative exposures, or equity exposures to another
investment fund. For purposes of the alternative modified look-through
approach, the proposal would require banking organizations to use these
alternative assumptions for such underlying exposures.
I. Securitization Exposures
For any securitization exposures held by an investment fund, the
proposal would allow a banking organization using the full look-through
approach to apply a 1,250 percent risk weight to the exposure, if it
cannot or chooses not to calculate the applicable risk weight under the
securitization standardized approach (SEC-SA), as described in section
III.D. of this Supplementary Information. The proposal would require a
banking organization applying the alternative modified look-through
approach to apply a 1,250 percent risk weight to any securitization
exposures held by an investment fund.
II. Derivative Exposures
For derivative exposures held by an investment fund, the proposal
would require a banking organization to calculate the risk-weighted
asset amount for each derivative netting set by multiplying the
exposure amount of the netting set by the risk weight applicable to the
derivative counterparty under the proposed credit risk framework. To
the extent a banking organization cannot determine the counterparty,
the proposal would require the banking organization to multiply the
resulting exposure amount by a 100 percent risk weight, as a
conservative approach to reflect the highest risk-weight that would be
likely to apply to a counterparty to such transactions.\170\
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\170\ Relatedly, to the extent a banking organization is unable
to determine the netting sets of the underlying derivative
exposures, the proposal would require each single derivative to be
its own netting set.
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For banking organizations using the full look-through approach, the
proposal would require a banking organization to use the replacement
cost and the potential future exposure as calculated under SA-CCR to
determine the exposure amount for each netting set of underlying
derivative exposures (including single derivative contracts) \171\ held
by the investment fund, where possible.\172\ If a banking organization
using the full look-through approach does not have sufficient
information to calculate the replacement cost or the potential future
exposure for each derivative netting set using SA-CCR or is using the
alternative modified look-through approach, the proposal would require
the banking organization to use the notional amount of each netting set
and 15 percent of the notional amount of each netting set for the
replacement cost and potential future exposure, respectively. The
proposal would require banking organizations using the alternative
modified look-through approach to use the notional amount of each
netting set and 15 percent of the notional amount of each netting set
to determine the replacement cost and potential future exposure,
respectively. A banking organization would multiply the resulting
exposure amount by a factor of 1.4 if the banking organization
determines that the counterparty is not a commercial end-user or cannot
determine whether the counterparty is a commercial end-user.\173\
Additionally, the proposal would require a banking organization to
further multiply the exposure amount by a factor of 1.5 for each
derivative netting set that either qualifies (or for which the banking
organization cannot determine whether the exposure qualifies) as a CVA
risk covered position, as defined in section III.I.3 of this
Supplementary Information. Accordingly, the proposal would require
banking organizations to calculate the exposure amount for derivative
exposures held by an investment fund as described in the following
formula:
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\171\ The proposal would rely on the existing definition of
netting set under the current capital rule, which is defined to
include a single derivative contract between a banking organization
and a single counterparty. See 12 CFR 3.2 (OCC); 12 CFR 217.2
(Board); 12 CFR 324.2 (FDIC).
\172\ Under the proposal, a banking organization may exclude
equity derivative contracts held by the investment fund for purposes
of calculating the RWAderivatives component of the full
and alternative modified look-through approaches, if the banking
organization has elected to exclude equity derivative contracts for
purposes of Sec. __.113(d) of the proposal.
\173\ The proposal would rely on the existing definition of
commercial end-user under the current capital rule. See 12 CFR 3.2
(OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC).
Exposure Amount = C * [alpha] (Replacement Cost + Potential Future
---------------------------------------------------------------------------
Exposure)
Where:
C would equal 1.5 if at least one of the derivative
contracts in the netting set is a CVA risk covered position or if the
banking organization cannot determine whether one or more of the
derivative contracts within the netting set is a CVA risk covered
position; C would equal 1 if all of the derivative contracts within the
netting set are not CVA risk covered positions;
[alpha] would equal 1.4 if the banking organization
determines that the counterparty is not a commercial end-user or cannot
determine whether the counterparty is a commercial end-user, or 1
otherwise;
Replacement Cost would equal:
[rtarr8] The replacement cost as calculated under SA-CCR for
purposes of the full look-through approach, where possible; or
[rtarr8] The notional amount of the derivative contract if the
banking organization cannot determine replacement cost under SA-CCR or
is using the alternative modified look-through approach;
Potential Future Exposure would equal:
[rtarr8] The potential future exposure as calculated under SA-CCR
\174\ for
[[Page 64082]]
purposes of the full look-through approach, where possible; or
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\174\ If the banking organization is not able to calculate the
replacement cost of the netting set under SA-CCR but is able to
calculate the PFE aggregated amount, the banking organization must
set the PFE multiplier equal to 1.
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[rtarr8] 15 percent of the notional amount of the derivative
contract if the banking organization cannot determine the potential
future exposure under SA-CCR or is using the alternative modified look-
through approach.
The proposal is intended to provide a conservative approach for
banking organizations to calculate risk-weighted asset amounts for the
underlying derivative exposures held by an investment fund in a manner
that appropriately captures the risk of such positions. For example,
using 100 percent of the notional amount of the derivative contract as
a proxy for the replacement cost is intended to provide a standardized
and simple input to the exposure amount calculation when the necessary
information about the replacement cost is not available. The notional
amount of the derivative contract is typically larger than the fair
value or replacement cost of the contract and thus providing a
conservative estimate of the maximum exposure that could arise for a
derivative contract. Similarly, setting potential future exposure equal
to 15 percent of the notional amount of the derivative contract is
intended to provide a conservative estimate of the potential losses
that could arise from a counterparty credit risk exposure when the
likelihood of significant changes in the value of the exposure
increases over the longer term.
III. Equity Exposures to Other Investment Funds
For an equity exposure to an investment fund (e.g., Investment Fund
A) that itself has a direct equity exposure to another investment fund
(e.g., Investment Fund B), the proposal would require a banking
organization to determine the proportional amount of risk-weighted
assets of Investment Fund A attributable to the underlying equity
exposure to Investment Fund B using the hierarchy of approaches
described in section III.E.1.c.i. of this Supplementary Information.
That is, the banking organization may be required to apply the same or
another approach to determine the risk-weighted asset amount for
Investment Fund A's equity exposure to Investment Fund B than was used
for the banking organization's equity exposure to Investment Fund A,
based on the nature and quality of the information available to the
banking organization regarding the underlying assets and liabilities of
Investment Fund B.
For all subsequent indirect equity exposure layers (e.g.,
Investment Fund B's equity exposure to Investment Fund C and so forth),
the proposal would generally require the banking organization to assign
a 1,250 percent risk weight, with one exception. If the banking
organization applied the full look-through approach to calculate risk-
weighted assets for the equity exposure to the investment fund at the
previous layer, the banking organization would be required to apply the
full look-through approach to any subsequent layer when there is
sufficient and frequent information provided to the banking
organization regarding the underlying exposures of that particular
investment fund. If there is not sufficient and frequent information to
apply the full look-through approach to the subsequent layer, then the
banking organization would be required to assign a 1,250 percent risk
weight to the subsequent layer.
Question 71: The agencies invite comment on the impact of the
proposed expanded risk-based framework for equity exposures. What are
the pros and cons of the proposal and what, if any, unintended
consequences might the proposed treatment pose with respect to a
banking organization's equity exposures? Provide data to support the
response.
Question 72: The agencies solicit comment on all aspects of the
proposed treatment of equity exposures to investment funds. What, if
any, challenges could implementing the full look-through approach, the
alternative modified look-through approach, or the 1,250 percent risk
weight pose for banking organizations? What, if any, clarifications or
modifications should the agencies consider making to the proposed look-
through approaches and why? To what extent would equity exposures to
investment funds be captured under the proposed look-through approaches
in equity exposure framework as opposed to the market risk framework?
Which type(s) of investment funds would present challenges under the
proposed methods? What other methods should the agencies consider to
more accurately capture such exposures' risk that would still help
promote simplicity and transparency of risk-based capital requirements?
Question 73: What, if any, modifications should the agencies
consider to more appropriately capture the risk of underlying
derivatives exposures held by an investment fund and why? The agencies
seek comment on the appropriateness of the proposed alternative method
for banking organizations to calculate risk-weighted asset amounts for
derivative exposures held by an investment fund if the banking
organization does not have sufficient information to use SA-CCR. What
would be the benefits and drawbacks of excluding derivative contracts
that are used for hedging rather than speculative purposes and that do
not constitute a material portion of the investment entity's exposures?
F. Operational Risk
The proposal would introduce a capital requirement for operational
risk based on a standardized approach (standardized approach for
operational risk). The current capital rule defines operational risk as
the risk of loss resulting from inadequate or failed internal
processes, people, and systems, or from external events. Operational
risk includes legal risk but excludes strategic and reputational
risk.\175\ Experience shows that operational risk is inherent in all
banking products, activities, processes, and systems.
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\175\ See 12 CFR 3.101 (OCC), 217.101 (Board), and 12 CFR
324.101 (FDIC).
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Under the current capital rule, banking organizations subject to
Category I or II capital standards are required to calculate risk-
weighted assets for operational risk using the advanced measurement
approaches (AMA),\176\ which are based on a banking organization's
internal models. The AMA results in significant challenges for banking
organizations, market participants, and the supervisory process. AMA
exposure estimates can present substantial uncertainty and volatility,
which introduces challenges to capital planning processes.\177\ In
addition, the AMA's reliance on internal models has resulted in a lack
of transparency and comparability across banking organizations. As a
result, supervisors and market participants experience challenges in
assessing the relative magnitude of operational risk across banking
organizations, evaluating the adequacy of operational risk capital, and
determining the effectiveness of operational risk management practices.
To address these concerns, the proposal would remove the AMA and
introduce a standardized approach for operational
[[Page 64083]]
risk that seeks to address the operational risks currently covered by
the AMA.
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\176\ The agencies adopted the AMA for operational risk as part
of the advanced approaches capital framework in 2007. See 72 FR
69288 (December 7, 2007).
\177\ See, e.g., Cope, E., G. Mignola, G. Antonini, and R.
Ugoccioni. 2009. Challenges and Pitfalls in Measuring Operational
Risk from Loss Data. Journal of Operational Risk 4(4): 3-27; and
Opdyke, J., and A. Cavallo. 2012. Estimating Operational Risk
Capital: The Challenges of Truncation, the Hazards of Maximum
Likelihood Estimation, and the Promise of Robust Statistics. Journal
of Operational Risk 7(3): 3-90.
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The operational risk capital requirements under the standardized
approach for operational risk would be a function of a banking
organization's business indicator component and internal loss
multiplier. The business indicator component would provide a measure of
the operational risk exposure of the banking organization and would be
calculated based on its business indicator multiplied by scaling
factors that increase with the business indicator. The business
indicator would serve as a proxy for a banking organization's business
volume and would be based on inputs compiled from a banking
organization's financial statements. The internal loss multiplier would
be based on the ratio of a banking organization's historical
operational losses to its business indicator component and would
increase the operational risk capital requirement as historical
operational losses increase. To help ensure the robustness of the
operational risk capital requirement, the proposal would require that
the internal loss multiplier be no less than one.
A banking organization's operational risk capital requirement would
be equal to its business indicator component multiplied by its internal
loss multiplier. Similar to the current capital rule, risk-weighted
assets for operational risk would be equal to 12.5 times the
operational risk capital requirement.
1. Business Indicator
Under the proposal, the business indicator would be based on the
sum of the following three components: an interest, lease, and dividend
component; a services component; and a financial component. Each
component would serve as a measure of a broad category of activities in
which banking organizations typically engage. Given that operational
risk is inherent in all banking products, activities, processes, and
systems, these components aim to capture comprehensively the volume of
a banking organization's financial activities and thus serve as a proxy
for a banking organization's business volume. The interest, lease, and
dividend component aims to capture lending and investment activities
through measures of interest income, interest expense, interest-earning
assets, and dividends. The services component aims to capture fee and
commission-based activities as well as other banking activities, such
as those resulting in other operating income and other operating
expense. Lastly, the financial component aims to capture trading
activity and other activities that are associated with a banking
organization's assets and liabilities.
Banking organizations with higher overall business volume are
larger and more complex, which likely results in exposure to higher
operational risk.\178\ Higher business volumes present more
opportunities for operational risk to manifest. In addition, the
complexities associated with a higher business volume can give rise to
gaps or other deficiencies in internal controls that result in
operational losses. Therefore, higher overall business volume would
correlate with higher operational risk capital requirements under the
proposal.
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\178\ Recent research connecting operational risk to higher
business volume includes Frame, McLemore, and Mihov (2020), Haste
Makes Waste: Banking Organization Growth and Operational Risk,
Federal Reserve Bank of Dallas, https://www.dallasfed.org/research/papers/2020/wp2023; Curti, Frame, and Mihov (2019), Are the Largest
Banking Organizations Operationally More Risky?, Journal of Money,
Credit and Banking Vol. 54, Issue 5, 1223-1259, https://doi.org/10.1111/jmcb.12933; and Abdymomunov and Curti (2020), Quantifying
and Stress Testing Operational Risk with Peer Banks' Data, Journal
of Financial Services Research Vol. 57, 287-313, https://link.springer.com/article/10.1007/s10693-019-00320-w.
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Under the proposal, all inputs to the business indicator would be
based on three-year rolling averages. For example, when calculating the
three-year average for a business indicator input reported at the end
of the third calendar quarter of 2023, the values of the item for the
fourth quarter of 2020 through the third quarter of 2021, the fourth
quarter of 2021 through the third quarter of 2022, and the fourth
quarter of 2022 through the third quarter of 2023 would be averaged.
The one exception is interest-earning assets, which would be calculated
as the average of the quarterly values of interest-earning assets for
the previous 12 quarters.\179\
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\179\ Unlike the other inputs used to calculate the business
indicator, interest-earning assets are balance-sheet items, rather
than income statement items, and thus their use in the business
indicator does not represent a flow over a one-year period, but
rather a point-in-time value. The use of average interest-earning
assets for the previous 12 quarters instead of, for example, the
average interest-earning assets for the ending quarter of the last
three years aims to increase the robustness of the average used in
the calculation.
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The use of three-year averages would capture a banking
organization's activities over time and help reduce the impact of
temporary fluctuations. Basing the business indicator on a shorter time
period, such as a single year of data, would likely result in a more
volatile capital requirement, which could make it more difficult for
banking organizations to incorporate the operational risk capital
requirement into capital planning processes and could result in unduly
low or high operational risk capital requirements given temporary
changes in a banking organization's activities. Alternatively, basing
the business indicator on too many years of data could reduce its
responsiveness to changes in a banking organization's activities, which
could in turn weaken the relationship between the capital requirements
and the banking organization's risk profile. Based on these
considerations, the use of three-year averages aims to balance the
stability and responsiveness of a banking organization's operational
risk capital requirement.
As described below, the inputs used in each component of the
business indicator would, in most cases, use information contained in
line items from schedules RI and RC of the Call Report and schedules HI
and HC of the FR Y-9C report, as applicable. The agencies are planning
to separately propose modifications to the FFIEC 101 report so that all
inputs to the business indicator (described below) as well as total net
operational losses (described further below) would be publicly reported
as separate inputs to the applicable calculations.
The inputs to each component of the business indicator would not be
meant to overlap. Income and expenses would not be counted in more than
one component of the business indicator, consistent with instructions
to the regulatory reports and the principles of accounting. The inputs
used to calculate the business indicator would include data relative to
entities that have been acquired by, or merged with, the banking
organization over the period prior to the acquisition or merger that is
relevant to the calculation of the business indicator.
a. The Interest, Lease, and Dividend Component
Under the proposal, the interest, lease, and dividend component
would account for activities that produce interest, lease, and dividend
income and would be calculated as follows:
Interest, Lease, and Dividend Component = min (Avg3y (Abs(total
interest income - total interest expense)), 0.0225 * Avg3y (interest
earning assets)) + Avg3y (dividend income)
The proposal includes the following definitions:
Total interest income would mean interest income from all
financial assets and other interest income; \180\
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\180\ Total interest income would correspond to total interest
income in the FR Y-9C (holding companies) and Call Report, excluding
dividend income as defined in the proposal.
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[[Page 64084]]
Total interest expense would mean interest expenses
related to all financial liabilities and other interest expenses; \181\
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\181\ Total interest expense would correspond to total interest
expense in the FR Y-9C (holding companies) and Call Report.
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Dividend income would mean all dividends received on
securities not consolidated in the banking organization's financial
statements; \182\ and
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\182\ Dividend income is currently included in total interest
income in the FR Y-9C (holding companies) and Call Report.
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Interest-earning assets would mean the sum of all gross
outstanding loans and leases, securities that pay interest, interest-
bearing balances, Federal funds sold, and securities purchased under
agreements to resell.\183\
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\183\ Interest-earning assets would equal the sum of interest-
bearing balances in U.S. offices, interest-bearing balances in
foreign offices, Edge and agreement subsidiaries, and IBFs, Federal
funds sold in domestic offices, securities purchased under
agreements to resell, loans and leases held for sale, loans and
leases, held for investment, total held-to-maturity securities at
amortized cost (only including securities that pay interest), total
available-for-sale securities at fair value (only including
securities that pay interest), and total trading assets (only
including trading assets that pay interest) in the FR Y-9C (holding
companies) and Call Report.
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The interest, lease, and dividend component aims to capture a
banking organization's interest income and expenses from financial
assets and liabilities, as well as dividend income from investments in
stocks and mutual funds.
The interest income and expenses portion is calculated as the
absolute value of the difference between total interest income and
total interest expense (which constitutes net interest income) and is
subject to a ceiling equal to 2.25 percent of the banking
organization's total interest-earning assets. Net interest income is a
useful indicator of a banking organization's operational risk because a
higher volume of business is associated with higher operational risk.
Because operational risk does not necessarily increase proportionally
to increases in net interest income, the net interest income input
would be capped at 2.25 percent of interest-earning assets.
The proposal would add dividend income to the net interest income
input to capture investment activities that do not produce interest
income (for example, investment in equities and mutual funds).
b. The Services Component
Under the proposal, the services component would account for
activities that result in fees and commissions and other financial
activities not captured by the other components of the business
indicator. The services component would be calculated as follows:
Services component = max (Avg3y (fee and commission income),
Avg3y(fee and commission expense)) + max (Avg3y
(other operating income), Avg3y(other operating expense))
The proposal includes the following definitions:
Fee and commission income would mean income received from
providing advisory and financial services, including insurance income;
\184\
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\184\ Fee and commission income would include the sum of income
from fiduciary activities, service charges on deposit accounts in
domestic offices; fees and commissions from securities brokerage;
investment banking, advisory, and underwriting fees and commissions;
fees and commissions from annuity sales; income and fees from
printing and sale of checks; income and fees from automated teller
machines; safe deposit box rent; bank card and credit card
interchange fees; income and fees from wire transfers; underwriting
income from insurance and reinsurance activities; and income from
other insurance activities in the FR Y-9C (holding companies) and
Call Report. Fee and commission income would also include servicing
fees on a gross basis, which would correspond to net servicing fees
in the FR Y-9C (holding companies) and Call Report, with the
modification that expenses should not be netted, because fee and
commission expenses should not be netted in the calculation of fee
and commission income. In addition, fee and commission income would
include other income received from providing advice and financial
services that is not currently itemized in the regulatory reports.
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Fee and commission expense would mean expenses paid by the
banking organization for advisory and financial services received;
\185\
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\185\ Fee and commission expense would include consulting and
advisory expenses and automated teller machine and interchange
expenses in the FR Y-9C (holding companies) and Call Report. Fee and
commission expense would also include any other expenses paid for
advice and financial services received that are not currently
itemized in the regulatory reports.
Note that fee and commission expense would include fees paid by
the banking organization as a result of outsourcing financial
services, but not fees paid for outsourced non-financial services
(e.g., logistical, information technology, human resources).
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Other operating income would mean income not included in
other elements of the business indicator and not excluded from the
business indicator; \186\ and
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\186\ Other operating income would include rent and other income
from other real estate owned in the FR Y-9C (holding companies) and
Call Report. Other operating income would also include all other
income items not currently itemized in the regulatory reports, which
are not included in other business indicator items and are not
specifically excluded from the business indicator.
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Other operating expense would mean expenses associated
with financial services not included in other elements of the business
indicator and all expenses associated with operational loss events
(expenses associated with operational loss events would not be included
in other business indicator items).\187\ Other operating expense would
not include expenses excluded from the business indicator.
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\187\ Note that expenses with operational loss events in ``other
operating expense'' would not exclude expenses associated with
operational loss events that result in less than $20,000 in net loss
amount.
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The services component would reflect a banking organization's
income and expenses from fees and commissions as well as its other
operating income and expenses.
The fee and commission elements and the other operating elements of
the services component would be calculated as gross amounts, reflecting
the larger of either income or expense. This approach would account for
the different business models of banking organizations better than a
netting approach, which may lead to variances in the services component
that exaggerate differences in operational risk. For example, using
income net of expense as the indicator would result in the services
component for banking organizations that only distribute products
bought from third parties, for which expenses would be netted from
income, being substantially lower than the services component of
banking organizations that originate products to distribute, which
would generally not have many financial expenses to net from income.
Therefore, a netting approach would likely exaggerate the difference in
operational risk between these two business models.
The proposal would include in the services component the income and
expense of a banking organization's insurance activities. The agencies
intend for the operational risk capital requirement to reflect all
operational risks to which a banking organization is exposed,
regardless of the activity or legal entity in which the operational
risk resides.
Question 74: What are the advantages and disadvantages of the
proposed approach to calculating the services component, including any
impacts on specific business models? Which alternatives, if any, should
the agencies consider and why? Similarly, should the agencies consider
any adjustments or limits related to specific business lines, such as
underwriting, wealth management, or custody, or to specific fee types,
such as interchange fees, and if so what adjustment or limits should
they consider? For example, should the agencies consider adjusting or
limiting how the services component contributes
[[Page 64085]]
to the business indicator and, if so, how? What would be the advantages
and disadvantages of any alternative approach and what impact would
such an alternative approach have on operational risk capital
requirements? For example, under the proposal, fee income and expenses
of charge cards are included under the services component. Would it be
more appropriate for fee income and expenses of charge cards to be
included in net interest income of the interest, lease, and dividend
component (and excluded from the services component) and for charge
card exposures to be included in interest earning assets of the
interest, lease, and dividend component and why? Please provide
supporting data with your response.
c. The Financial Component
Under the proposal, the financial component would capture trading
activities and other activities associated with a banking
organization's assets and liabilities. The financial component would be
calculated as follows:
Financial Component = Avg3y (Abs (trading revenue)) +
Avg3y (Abs (net profit or loss on assets and liabilities not
held for trading))
The proposal includes the following definitions:
Trading revenue would mean the net gain or loss from
trading cash instruments and derivative contracts (including commodity
contracts); \188\ and
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\188\ Trading revenue would correspond to trading revenue in the
FR Y-9C (holding companies) and Call Report.
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Net profit or loss on assets and liabilities not held for
trading would mean the sum of realized gains (losses) on held-to-
maturity securities, realized gains (losses) on available-for-sale
securities, net gains (losses) on sales of loans and leases, net gains
(losses) on sales of other real estate owned, net gains (losses) on
sales of other assets, venture capital revenue, net securitization
income, and mark-to-market profit or loss on bank liabilities.\189\
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\189\ Realized gains (losses) on held-to-maturity securities,
realized gains (losses) on available-for-sale securities, net gains
(losses) on sales of loans and leases, net gains (losses) on sales
of other real estate owned, net gains (losses) on sales of other
assets, venture capital revenue, and net securitization income
correspond to their current definitions in the FR Y-9C (holding
companies) and Call Report.
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The financial component aims to capture trading activities and
other activities that are associated with a banking organization's
assets and liabilities. Trading revenue, which reflects net income or
loss from trading activities, would be a proxy for the business volume
associated with trading and related activities. Net profit or loss on
assets and liabilities not held for trading would reflect the profit or
loss of activities associated with assets and liabilities that are not
included by other components of the business indicator and therefore
ensures that the business indicator comprehensively captures these
activities. The use of net values for these inputs would align with
current regulatory reporting, thereby reducing data gathering and
calculation burden. Both of these inputs would be measured in terms of
their absolute value to better capture business volume (for example,
negative trading revenue would not imply that a banking organization's
trading activities are small in volume), which is associated with
higher operational risk.
d. Exclusions From the Business Indicator
Under the proposal, the business indicator would reflect the volume
of financial activities of a banking organization; therefore, the
business indicator would exclude expenses that do not relate to
financial services received by the banking organization. Excluded
expenses would include staff expenses, expenses to outsource non-
financial services (such as logistical, human resources, and
information technology), administrative expenses (such as utilities,
telecommunications, travel, office supplies, and postage), expenses
relating to premises and fixed assets, and depreciation of tangible and
intangible assets. Still, the proposal would include expenses related
to operational loss events in the services component even when they
relate to these otherwise-excluded categories of expenses because the
objective of the operational risk capital requirement is to support a
banking organization's resilience to operational risk, and observed
operational loss expenses are a meaningful indicator of a banking
organization's exposure to operational risk.
The proposal also would not include loss provisions and reversal of
provisions (except for those related to operational loss events) or
changes in goodwill in the business indicator, as these items do not
reflect business volume of the banking organization. In addition, the
business indicator would not include applicable income taxes as an
expense, as they reflect obligations to the government for which the
operational risk capital framework should be neutral.
With prior supervisory approval, the proposal would allow banking
organizations to exclude activities that they have ceased to conduct,
whether directly or indirectly, from the calculation of the business
indicator, provided that the banking organization demonstrates that
such activities do not carry legacy legal exposure. Supervisory
approval would not be granted when, for example, legacy business
activities are subject to potential or pending legal or regulatory
enforcement action. The supervisory approval requirement would help
ensure that a banking organization's operational risk capital
requirement aligns with its existing operational risk exposure.
2. Business Indicator Component
Under the proposal, the business indicator component would be a
function of the business indicator, with three linear segments. The
business indicator component would increase at a rate of: (a) 12
percent per unit of business indicator for levels of business indicator
up to $1 billion; (b) 15 percent per unit of business indicator for
levels of business indicator above $1 billion and up to $30 billion;
and (c) 18 percent per unit of business indicator for levels of
business indicator above $30 billion. Table 8 below presents the
formulas that can be used to calculate the business indicator component
given a banking organization's business indicator.
[[Page 64086]]
[GRAPHIC] [TIFF OMITTED] TP18SE23.027
The higher rate of increase of the business indicator component as
a banking organization's business indicator rises above $1 billion and
$30 billion would reflect exposure to operational risk generally
increasing more than proportionally with a banking organization's
overall business volume, in part due to the increased complexity of
large banking organizations. This approach is supported by analysis
undertaken by the Basel Committee.\191\ Similarly, academic studies
have found that larger U.S. bank holding companies have higher
operational losses per dollar of total assets.\192\
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\190\ $120 million is equal to 0.12 * $1 billion. $4.47 billion
is equal to 0.12 * $1 billion + 0.15 * ($30 billion-$1 billion).
\191\ See Basel Committee (2014), ``Operational risk--Revisions
to the simpler approaches,'' https://www.bis.org/publ/bcbs291.htm
and Basel Committee (2016), ``Standardized Measurement Approach for
operational risk,'' https://www.bis.org/bcbs/publ/d355.htm.
\192\ See Curti, Mih, and Mihov (2022), ``Are the Largest
Banking Organizations Operationally More Risky?, Journal of Money,
Credit and Banking,'' DOI: 10.111/jmcb.12933; and Frame, McLemore,
and Mihov (2020), ``Haste Makes Waste: Banking Organization Growth
and Operational Risk,'' Federal Reserve Bank of Dallas, https://www.dallasfed.org/research/papers/2020/wp2023.
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3. Internal Loss Multiplier
Higher historical operational losses are associated with higher
future operational risk exposure.\193\ Supervisory experience also
suggests that operational risk management deficiencies can be
persistent, which can often result in operational losses. Accordingly,
under the proposal, the operational risk capital requirement would be
higher for banking organizations that experienced larger operational
losses in the past. To this effect, the proposal would include a
scalar, the internal loss multiplier, that increases operational risk
capital requirements based on a banking organization's historical
operational loss experience. This multiplier would depend on the ratio
of a banking organization's average annual total net operational losses
to its business indicator component.
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\193\ See Curti and Migueis (2023), ``The Information Value of
Past Losses in Operational Risk, Finance and Economics Discussion
Series,'' Board of Governors of the Federal Reserve System, https://doi.org/10.17016/FEDS.2023.003.
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The proposal would require the internal loss multiplier to be no
less than one. This floor would ensure that the operational risk
capital requirement provides a robust minimum amount of coverage to the
potential future operational risks a banking organization may be
exposed to, as reflected by its overall business volume through the
business indicator component, even in situations where historical
operational losses have been low in relative terms.
The internal loss multiplier would be calculated as follows:
[GRAPHIC] [TIFF OMITTED] TP18SE23.028
Where:
Average annual total net operational losses would
correspond to the average of annual total net operational losses
over the previous ten years (on a rolling quarter basis).\194\ In
this calculation, the total net operational losses of a quarter
would equal the sum of any portions of losses or recoveries of any
material operational losses allocated to the quarter. Material
operational loss would mean an operational loss incurred by the
banking organization that resulted in a net loss greater than or
equal to $20,000 after taking into account all subsequent recoveries
related to the operational loss.
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\194\ For example, when calculating average annual total net
operational losses for the second calendar quarter of 2023, total
net operational losses from the third calendar quarter of 2013
through the second calendar quarter of 2023 would be included.
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exp(1) is the Euler's number, which is approximately equal
to 2.7183.
ln is the natural logarithm.
Average annual total net operational losses would be multiplied by
15 in the internal loss multiplier formula. This multiplication
extrapolates from average annual total net operational losses the
potential for unusually large losses and, therefore, aims to ensure
that a banking organization maintains sufficient capital given its
operational loss history and risk profile. The constant used is
consistent with the Basel III reforms.
[[Page 64087]]
The natural log function (ln) combined with an exponent of 0.8
would limit the effect that large operational losses have on a banking
organization's operational risk capital requirement. This feature of
the internal loss multiplier formula is intended to constrain the
volatility of the operational risk capital requirement. As a result,
increases in average annual total net operational losses would increase
the operational risk capital requirement at a decreasing rate.\195\
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\195\ The internal loss multiplier variation depends on the
ratio of the product of 15 and the average annual total operational
losses to the business indicator component. The 0.8 exponent applied
to this ratio reduces the effect of the variation of this ratio on
the internal loss multiplier. For example, a ratio of 2 becomes
approximately 1.74 after application of the exponent, and a ratio of
0.5 becomes approximately 0.57 after application of the exponent.
Similarly, the application of a logarithmic function further reduces
the variability of the internal loss multiplier for values above 1.
Taken together, these two transformations mitigate the reaction of
the operational risk capital requirement to large historical
operational losses.
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The calculation of average annual total net operational losses
would be based on an average of ten years of data. The use of a ten-
year average for annual total net operational losses would balance
recognition that a banking organization's operational risk exposure
changes over time with limiting the volatility that would result from
using a shorter time horizon and the importance of the calculation
window providing sufficient information regarding the banking
organization's operational risk profile.
The proposal would define an ``operational loss'' as all losses
(excluding insurance or tax effects) resulting from an operational loss
event, including any reduction in previously reported capital levels
attributable to restatements or corrections of financial statements. An
operational loss includes all expenses associated with an operational
loss event except for opportunity costs, forgone revenue, and costs
related to risk management and control enhancements implemented to
prevent future operational losses. Operational loss would not include
losses that are also credit losses and are related to exposures within
the scope of the credit risk risk-weighted assets framework (except for
retail credit card losses arising from non-contractual, third-party-
initiated fraud, which are operational losses).
``Operational loss event'' would be defined as an event that
results in loss due to inadequate or failed internal processes, people,
or systems or from external events. This definition includes legal loss
events and restatements or corrections of financial statements that
result in a reduction of capital relative to amounts previously
reported. The proposal would retain the current classification of
operational loss events according to seven event types:
1--Internal fraud, which means the operational loss event type that
comprises operational losses resulting from an act involving at least
one internal party of a type intended to defraud, misappropriate
property, or circumvent regulations, the law, or company policy
excluding diversity and discrimination noncompliance events.
2--External fraud, which means the operational loss event type that
comprises operational losses resulting from an act by a third party of
a type intended to defraud, misappropriate property, or circumvent the
law. Retail credit card losses arising from non-contractual, third-
party-initiated fraud (for example, identity theft) are external fraud
operational losses.
3--Employment practices and workplace safety, which means the
operational loss event type that comprises operational losses resulting
from an act inconsistent with employment, health, or safety laws or
agreements, payment of personal injury claims, or payment arising from
diversity and discrimination noncompliance events.
4--Clients, products, and business practices, which means the
operational loss event type that comprises operational losses resulting
from the nature or design of a product or from an unintentional or
negligent failure to meet a professional obligation to specific clients
(including fiduciary and suitability requirements).
5--Damage to physical assets, which means the operational loss
event type that comprises operational losses resulting from the loss of
or damage to physical assets from natural disasters or other events.
6--Business disruption and system failures, which means the
operational loss event type that comprises operational losses resulting
from disruption of business or system failures, including hardware,
software, telecommunications, or utility outage or disruptions.
7--Execution, delivery, and process management, which means the
operational loss event type that comprises operational losses resulting
from failed transaction processing or process management or losses
arising from relations with trade counterparties and vendors.
By ensuring consistency, the classification of operational loss
events according to these event types would continue to assist banking
organizations and the agencies in understanding the causal factors
driving operational losses.
The proposal would include a $20,000 net loss threshold (that is,
$20,000 after taking into account all subsequent recoveries related to
the operational loss) for inclusion of an operational loss in the
calculation of average annual total net operational losses. This
threshold aims to balance comprehensiveness against the materiality of
the operational losses.
The proposal would require a banking organization to group losses
with a common underlying trigger into the same operational loss event.
For example, losses that occur in multiple locations or over a period
of time resulting from the same natural disaster would be grouped into
a single operational loss event. This grouping requirement aims to
ensure comprehensive inclusion of operational loss events that result
in $20,000 or more of net loss in the calculation of the internal loss
multiplier and to facilitate understanding of operational risk exposure
by banking organizations and supervisors.
There are two main differences in how the proposal would treat
operational losses relative to typical practice under the AMA. First,
total net operational losses would include operational losses in the
quarter in which their accounting impacts were recorded, rather than
aggregated into a single event date.\196\ Second, operational losses
would enter the internal loss multiplier calculation net of related
recoveries, including insurance recoveries.\197\ Recoveries would be
included in the quarter in which they are paid to the banking
organization. Insurance receivables would not be accounted for in the
calculation as recoveries. Reductions in the legal reserves associated
with an ongoing legal event would be treated as recoveries for the
calculation of total net operational losses. Also, a recovery would
only offset a loss arising from a related operational loss event. This
proposed treatment would ensure that only applicable recoveries are
recognized.
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\196\ For example, if an operation loss event results in a loss
impact of $500,000 in the first quarter of 2020 and a loss impact of
$400,000 in the second quarter of 2021, the banking organization
would add $500,000 to the total gross operational losses of first
quarter of 2020 and add $400,000 to the total gross operational
losses of the second quarter of 2021.
\197\ A recovery is an inflow of funds or economic benefits
received from a third party in relation to an operational loss
event.
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Under the proposal, a negative financial impact that a banking
organization books in its financial
[[Page 64088]]
statement due to having incorrectly booked a positive financial impact
in a previous financial statement would constitute an operational loss
(these losses are generally known as ``timing losses''). Examples of an
incorrectly booked positive financial impact would include revenue
overstatement, overbilling, accounting errors, and mark-to-market
errors. Corrections that would constitute operational losses include
refunds and restatements that result in a reduction in equity capital.
If the initial overstatement and its correction occur in the same
financial statement period, there would be no operational loss under
the proposal.
The proposal's definition of operational loss includes a
clarification regarding the boundary between operational risk and
credit risk, which aims to ensure that all losses experienced by a
banking organization in its financial statements are within the scope
of the credit risk, market risk, or operational risk frameworks. Losses
resulting from events that meet the definition of an operational loss
event which are also credit losses and are related to exposures within
the scope of the credit risk risk-weighted assets framework would
continue to be excluded from total operational losses for purposes of
the operational risk capital requirement. In keeping with the current
framework and prevailing industry practice, retail credit card losses
arising from non-contractual, third-party-initiated fraud would
continue to be operational losses under the proposal. In addition,
operational losses related to products that are outside of the scope of
the credit risk-weighted asset framework (for example, losses due to
representations and warranties unrelated to credit risk that require
the banking organization to repurchase an asset) would be operational
losses even if they are associated with obligor default events.
Operational losses that result from boundary events with market risk
(for example, losses that are the result of failed or inadequate model
validation processes) would also continue to be treated as operational
losses in the proposal.
The proposal includes revisions to the FR Y-14Q report, which is
applicable to large banking organizations subject to the Board's
capital plan rule, to conform with the revisions to the definitions of
operational loss and operational loss event introduced by the proposal.
Under the proposal, a banking organization would include in its
calculation of total net operational losses any operational loss events
incurred by an entity that has been acquired by or merged with the
banking organization. In cases where historical loss data meeting the
collection requirements is not available for a merged or acquired
entity for certain years in the calculation window of the internal loss
multiplier, the proposal would provide a formula for calculating annual
total net operational losses for this merged or acquired entity for
these missing years. Annual total net operational losses of the merged
or acquired entity for the missing years would be such that the ratio
of average annual total net operational losses to the business
indicator contribution of this merged or acquired entity \198\ is the
same as the ratio of the average annual total net operational losses to
business indicator of the remainder of the banking organization:
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\198\ The business indicator contribution of a merged or
acquired entity would be the business indicator of the banking
organization inclusive of the merged or acquired entity minus the
business indicator of the banking organization when the merged or
acquired entity is excluded.
Annual total net operational losses for a merged or acquired business
that lacks loss data = Business indicator contribution of merged or
acquired business that lacks loss data * Average annual total net
operational losses of the banking organization excluding amounts
attributable to the merged or acquired business/Business indicator of
the banking organization excluding amounts attributable to the merged
---------------------------------------------------------------------------
or acquired business.
This approach would recognize that historical data for operational
losses may be difficult to obtain in certain circumstances,
particularly if an acquired or merged entity had not previously been
required to track operational losses.\199\
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\199\ In contrast, the business indicator includes only three
years of financial statement data, which should be readily
available.
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Banking organizations that only have five to nine years of loss
data meeting the operational loss event data collection requirements in
Sec. __.150(f)(2) of the proposal (for example, when transitioning
into the standardized approach for operational risk) would be expected
to use as many years of loss data meeting the internal loss event data
collection requirements as are available in the calculation of average
annual total net operational losses. In cases where a banking
organization's loss collection practices are deficient, its primary
Federal supervisor may require higher capital requirements under the
capital rule's reservation of authority.
Under the proposal, the internal loss multiplier would equal one in
cases where the number of years of loss data meeting the internal loss
event data collection requirements is less than five years. In cases
where the banking organization's primary Federal supervisor determines
that an internal loss multiplier of one results in insufficient
operational risk capital, the primary Federal supervisor may require
higher capital requirements under the capital rule's reservation of
authority.
Under the proposal, a banking organization would be able to request
supervisory approval to exclude operational loss events that are no
longer relevant to their risk profile from the internal loss multiplier
calculation. The agencies expect the exclusion of operational loss
events would generally be rare, and a banking organization would be
required to provide adequate justification for why operational loss
events are no longer relevant to its risk profile when requesting
supervisory approval for exclusion. In evaluating the relevance of
operational loss events to the banking organization's risk profile, the
primary Federal supervisor would consider various factors, including
whether the cause or causes of the loss events could occur in other
areas of the banking organization's operations. The banking
organization would need to demonstrate, for example, that there is no
similar or residual legal exposure and that the excluded operational
loss events have no relevance to other continuing activities or
products.
In the case of divestitures, a banking organization would be able
to request supervisory approval to remove historical operational loss
events associated with an activity that the banking organization has
ceased to directly or indirectly conduct--either through full sale of
the business or closing of the business--from the calculation of the
internal loss multiplier. Given that divestiture has occurred,
exclusion of operational losses relating to legal events would
generally depend on whether the divested activities carry legacy legal
exposure, as would be the case, for example, where such activities are
the subject of a potential or pending legal or regulatory enforcement
action.
Except in the case of divestitures, the agencies would only
consider providing supervisory approval for exclusions after
operational losses have been included in a banking organization's total
net operational losses for at least three years. This retention period
would aim to ensure prudence in the calculation of operational risk
capital requirements, as operational risk
[[Page 64089]]
exposure is unlikely to be fully eliminated over a short time frame.
Finally, to ensure that requests for operational loss exclusions
are of a substantive nature, the agencies would only consider a request
for exclusion when the total net operational losses to be excluded are
equal to five percent or more of the banking organization's average
annual total net operational losses.
Question 75: What are the advantages and disadvantages of flooring
the internal loss multiplier at one? Which alternatives, if any, should
the agencies consider and why?
Question 76: What are the advantages and disadvantages of including
the internal loss multiplier as opposed to setting it equal to one?
Question 77: What are the advantages and disadvantages of the
treatment proposed for losses of merged or acquired businesses? Which
alternatives, if any, should the agencies consider and why? What impact
would any alternatives have on the conservatism of the proposal?
Question 78: What are the advantages and disadvantages of an
alternative threshold for the operational losses for which banking
organizations may request supervisory approval to exclude?
4. Operational Risk Management and Data Collection Requirements
Under the proposal, banking organizations would continue to be
required to collect operational loss event data. As discussed above, a
banking organization would be required to include operational losses,
net of recoveries, of $20,000 or more in the calculation of the
internal loss multiplier. To assist the identification of operational
loss events that result in an operational loss, net of recoveries, of
$20,000 or more, the proposal would require banking organizations to
collect operational loss event data for all operational loss events
that result in $20,000 or more of gross operational loss.
Operational loss event data would include the gross loss amount,
recovery amounts, the date when the event occurred or began (date of
occurrence), the date when the banking organization became aware of the
event (date of discovery), and the date when the loss event resulted in
a loss, provision, or recovery being recognized in the banking
organization's profit and loss accounts (date of accounting). These
loss data collection requirements are similar to the loss reporting
requirements currently in place for banking organizations subject to
the FR Y-14 reporting and are similar to the data that banking
organizations subject to the AMA have typically collected.
To ensure the validity of its operational loss event data, a
banking organization would be required to document the procedures used
for the identification and collection of operational loss event data.
Additionally, the banking organization would be required to have
processes to independently review the comprehensiveness and accuracy of
operational loss data, and the banking organization would be required
to subject the aforementioned procedures and processes to regular
independent reviews by internal or external audit functions.
The proposal would introduce a requirement that banking
organizations collect descriptive information about the drivers or
causes of operational loss events that result in a gross operational
loss of $20,000 or more. This requirement would facilitate the efforts
of banking organizations and the agencies to understand the sources of
operational risk and the drivers of operational loss events. The
agencies would expect that the level of detail of any descriptive
information be commensurate with the size of the gross loss amount of
the operational loss event.
The proposal would not include certain data requirements included
in the AMA. Specifically, banking organizations would not be required
to estimate their operational risk exposure or to collect external
operational loss event data, scenario analysis, and business,
environment, and internal control factors.
The agencies consider effective operational risk management to be
critical to ensuring the financial and operational resilience of
banking organizations, particularly for large banking
organizations.\200\ Thus, consistent with the current advanced
approaches qualification requirements applicable to banking
organizations subject to Category I or II capital standards, the
proposal would include the requirement that large banking organizations
have an operational risk management function that is independent of
business line management. This independent operational risk management
function would be expected to design, implement, and oversee the
comprehensiveness and accuracy of operational loss event data and
operational loss event data collection processes, and oversee other
aspects of the banking organization's operational risk management.
Large banking organizations would also be required to have and document
processes to identify, measure, monitor, and control operational risk
in their products, activities, processes, and systems. In addition,
large banking organizations would be required to report operational
loss events and other relevant operational risk information to business
unit management, senior management, and the board of directors (or a
designated committee of the board).
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\200\ The interagency paper titled ``Sound Practices to
Strengthen Operational Resilience'' (November 2, 2020) notes that
operational resilience ``is the outcome of effective operational
risk management combined with sufficient financial and operational
resources to prepare, adapt, withstand, and recover from
disruptions.''
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Question 79: The proposal would require a banking organization to
collect information on the drivers of operational loss events, with the
level of detail of any descriptive information commensurate with the
size of the gross loss amount. What are the advantages and
disadvantages of this requirement? Which alternatives should the
agencies consider--for example, introducing a higher dollar threshold
for such a requirement--and why?
G. Disclosure Requirements
1. Proposed Disclosure Requirements
Meaningful public disclosures of a banking organization's
activities and the features of its risk profile, including risk
appetite, work in tandem with the regulatory and supervisory frameworks
applicable to banking organizations by helping to support robust market
discipline. In this way, meaningful public disclosures help to support
the safety and soundness of banking organizations and the financial
system more broadly.
The proposal would revise certain existing qualitative disclosure
requirements and introduce new and enhanced qualitative disclosure
requirements related to the proposed revisions described in this
Supplementary Information. The proposal would also remove from the
disclosure tables most of the existing quantitative disclosures, which
would instead be included in regulatory reporting forms. Therefore, the
agencies anticipate separately proposing revisions to the Consolidated
Reports of Condition and Income, the Regulatory Capital Reporting for
Institutions Subject to the Advanced Capital Adequacy Framework (FFIEC
101), and the Market Risk Regulatory Report for Institutions Subject to
the Market Risk Capital Rule (FFIEC 102). The Board similarly
anticipates proposing
[[Page 64090]]
corresponding revisions to the Consolidated Financial Statements for
Holding Companies (FR Y-9C), the Capital Assessments and Stress Testing
(FR Y-14A and FR Y-14Q), and the Systemic Risk Report (FR Y-15) to
reflect the changes to the capital rule that would be required under
this proposal. The proposal would also remove disclosures related to
internal ratings-based systems and internal models, consistent with the
broader objectives of this proposal.
Under the current capital rule, banking organizations subject to
Category I or II capital standards are subject to enhanced public
disclosure and reporting requirements in comparison to the disclosure
and reporting requirements applicable to banking organizations subject
to Category III or IV capital standards. Under the proposal, the
enhanced public disclosure requirements would apply to all large
banking organizations. Applying enhanced disclosure and reporting
requirements to banking organizations subject to Category III or IV
capital standards would bring consistency across large banking
organizations and promote transparency for market participants.
Consistent with the current capital rule, the top-tier entity
(including a depository institution, if applicable), would be subject
to both the qualitative and quantitative enhanced disclosure and
reporting requirements.\201\
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\201\ In the case of a depository institution that is not a
consolidated subsidiary of a depository institution holding company
that is assigned a category under the capital rule, the depository
institution would be considered the top-tier entity for purposes of
the qualitative and quantitative enhanced disclosure and reporting
requirements.
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The current capital rule does not subject a banking organization
that is a consolidated subsidiary of a bank holding company, a covered
savings and loan holding company that is a banking organization as
defined in 12 CFR 238.2, or depository institution that is subject to
public disclosure requirements, or a subsidiary of a non-U.S. banking
organization that is subject to comparable public disclosure
requirements in its home jurisdiction to the qualitative disclosure
requirements described in the current capital rule. The proposal would
not change the current capital rule's requirements regarding public
disclosure policy and attestation, the frequency of required
disclosures, the location of disclosures, or the treatment of
proprietary information.
2. Specific Public Disclosure Requirements
The proposed changes to disclosure requirements pertaining to the
risk-based capital framework are described below.\202\ Disclosure
tables 1,\203\ 2,\204\ 3,\205\ 4,\206\ 11 \207\ (table 9 to Sec.
__.162 in the proposal), and 12 \208\ (table 10 to Sec. __.162 in the
proposal) in Sec. __.173 of the current capital rule have been
retained without material modification, although the table numbers
would change.
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\202\ The table numbers refer to the table numbers included in
the proposed rule.
\203\ See Table 1 to Sec. 3.173 (OCC); Sec. 217.173 (Board);
Sec. 324.173 (FDIC)--Scope of Application.
\204\ See Table 2 to Sec. 3.173 (OCC); Sec. 217.173 (Board);
Sec. 324.173 (FDIC)--Capital Structure.
\205\ See Table 3 to Sec. 3.173 (OCC); Sec. 217.173 (Board);
Sec. 324.173 (FDIC)--Capital Adequacy.
\206\ See Table 4 to Sec. 3.173 (OCC); Sec. 217.173 (Board);
Sec. 324.173 (FDIC)--Capital Conservation and Countercyclical
Capital Buffers.
\207\ See Table 11 to Sec. 3.173 (OCC); Sec. 217.173 (Board);
Sec. 324.173 (FDIC)--Equities Not Subject to Subpart F of This
Part.
\208\ See Table 12 to 3.173 (OCC); Sec. 217.173 (Board); Sec.
324.173 (FDIC)--Interest Rate Risk for Non-Trading Activities.
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The proposal would retain the requirement that a banking
organization disclose its risk management objectives as they relate to
specific risk areas (e.g., credit risk). The proposal would revise the
risk areas to which these disclosure requirements apply to help ensure
consistency with the broader proposal. In addition, the proposal would
require a banking organization to describe its risk management
objectives as they relate to the organization overall. The required
disclosures would include information regarding how the banking
organization's business model determines and interacts with the overall
risk profile; how this risk profile interacts with the risk tolerance
approved by its board; the banking organization's risk governance
structure; channels to communicate, define, and enforce the risk
culture within the banking organization; scope and features of risk
measurement systems; risk information reporting; qualitative
information on stress testing; and the strategies and processes to
manage, hedge, and mitigate risks. These disclosures are intended to
allow market participants to evaluate the adequacy of a banking
organization's approach to risk management.
Table 5 to Sec. __.162, ``Credit Risk: General Disclosures,''
would include the disclosures a banking organization is required to
make under the current capital rule regarding its approach to general
credit risk.\209\ In addition, the proposal would require a banking
organization to disclose certain additional information regarding its
risk management policies and objectives for credit risk. Specifically,
the proposal would require a banking organization to enhance its
existing disclosures by describing how its business model translates
into the components of the banking organization's credit risk profile
and how it defines credit risk management policy and sets credit
limits. Additionally, a banking organization would be required to
disclose the organizational structure of its credit risk management and
control function as well as interactions with other functions. A
banking organization would also be required to disclose information on
its policies related to reporting of credit risk exposure and the
credit risk management function that are provided to the banking
organization's leadership.
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\209\ See Table 5 to Sec. 3.173 (OCC); Sec. 217.173 (Board);
Sec. 324.173 (FDIC)--Credit Risk--General Disclosures.
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Table 6 to Sec. __.162, ``General Disclosure for Counterparty
Credit Risk-Related Exposures,'' would include the disclosures a
banking organization is required to make under the current capital rule
regarding its approach to managing counterparty credit risk.\210\ The
proposal would also include new disclosure requirements regarding a
banking organization's methodology for assigning economic capital for
counterparty credit risk exposures as well as its policies regarding
wrong-way risk exposures. Additionally, the proposal would further
require a banking organization to disclose its risk management
objectives and policies related to counterparty credit risk, including
the method used to assign the operating limits defined in terms of
internal capital for counterparty credit risk exposures and for CCP
exposures, policies relating to guarantees and other risk mitigants and
assessments concerning counterparty credit risk (including exposures to
CCPs), and the increase in the amount of collateral that the banking
organization would be required to provide in the event of a credit
rating downgrade.
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\210\ See Table 7 to Sec. 3.173 (OCC); Sec. 217.173 (Board);
Sec. 324.173 (FDIC)--General Disclosure for Counterparty Credit
Risk of OTC Derivative Contracts, Repo-Style Transactions, and
Eligible Margin Loans.
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Table 7 to Sec. __.162, ``Credit Risk Mitigation,'' would include
the disclosures a banking organization is required to make under the
current rule regarding its approach to credit risk mitigation.\211\ In
addition, the proposal would specify that a banking organization must
provide a meaningful
[[Page 64091]]
breakdown of its credit derivative providers, including a breakdown by
rating class or by type of counterparty (e.g., banking organizations,
other financial institutions, and non-financial institutions). These
disclosures would apply to eligible credit risk mitigants under the
proposal,\212\ although a banking organization would be encouraged to
also disclose information about other mitigants. The credit risk
mitigation disclosures in Table 7 to Sec. __.162 of the proposal would
not apply to synthetic securitization exposures, which would be
included in Table 8 to Sec. __.162 as part of the banking
organization's disclosures related to securitization exposures.
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\211\ See Table 8 to Sec. 3.173 (OCC); Sec. 217.173 (Board);
Sec. 324.173 (FDIC)--Credit Risk Mitigation.
\212\ See section III.C.5 of this Supplementary Information for
a more detailed discussion on the types of credit risk mitigants
that a banking organization would be allowed to recognize for
purposes of calculating risk-based capital requirements.
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Table 8 to Sec. __.162, ``Securitization,'' would include the
disclosures a banking organization is required to make under the
current capital rule regarding its approach to securitization.\213\ In
addition to the existing qualitative disclosures related to
securitization, the proposal would require disclosure of whether the
banking organization provides implicit support to a securitization and
the risk-based capital impact of such support.
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\213\ See Table 9 to Sec. 3.173 (OCC); Sec. 217.173 (Board);
Sec. 324.173 (FDIC)--Securitization.
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Table 11 to Sec. __.162, ``Additional Disclosure Related to the
Credit Quality of Assets,'' is a new disclosure table that would
require banking organizations to provide further information on the
scope of ``past due'' exposures used for accounting purposes, including
the differences, if any, between the banking organization's scope of
exposures treated as past due for accounting purposes and those treated
as past due for regulatory capital purposes. Table 11 to Sec. __.162
would also describe the scope of exposures that qualify as ``defaulted
exposures'' or ``defaulted real estate exposures'' that are not
exposures for which credit losses are measured under ASC \214\ Topic
326 and for which the banking organization has recorded a partial
write-off or write-down. Additionally, a banking organization would be
required to disclose the scope of exposures that qualify as a ``loan
modification to borrowers experiencing financial difficulty'' for
accounting purposes under ASC Topic 310 \215\ and the difference, if
any, between the scope of exposures treated as ``defaulted exposures''
or ``defaulted real estate exposures.''
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\214\ The Accounting Standards Codification is promulgated by
the Financial Accounting Standards Board for GAAP.
\215\ See ASC 310-10-50-36.
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Table 12 to Sec. __.162, ``General Qualitative Disclosure
Requirements Related to CVA'' is a new disclosure table that would
require a banking organization to disclose certain information
pertaining to CVA risk, including its risk management objectives and
policies for CVA risk and information related to a banking
organization's CVA risk management framework, including processes
implemented to identify, measure, monitor, and control CVA risks and
effectiveness of CVA hedges. Table 13 to Sec. __.162, ``Qualitative
Disclosures for Banks Using the SA-CVA'' is a new disclosure table that
would require a banking organization that has approval to use the
standardized CVA approach (SA-CVA) to make disclosures related to the
banking organization's risk management framework, including a
description of the banking organization's risk management framework, a
description of how senior management is involved in the CVA risk
management framework, and an overview of the governance of the CVA risk
management framework such as documentation, independent risk control
unit, independent review, and independence of data acquisition from
lines of business.
Table 14 to Sec. __.162, ``General Qualitative Information on a
Banking Organization's Operational Risk Framework,'' is a new
disclosure table that would require a banking organization to disclose
information regarding its operational risk management processes,
including its policies, frameworks, and guidelines for operational risk
management; the structure and organization of its operational risk
management and control function; its operational risk measurement
system (the systems and data used to measure operational risk in order
to estimate the operational risk capital requirement); the scope and
context of its reporting framework on operational risk to executive
management and to the board of directors; and the risk mitigation and
risk transfer used in the management of operational risk.
Table 15 to Sec. __.162, ``Main Features of Regulatory Capital
Instruments and of other TLAC-Eligible Instruments,'' is a new
disclosure table that would require a banking organization to disclose
information regarding the terms and features of its regulatory capital
instruments and other instruments eligible for TLAC.\216\ In addition,
the proposal would require a banking organization to describe the main
features of its regulatory capital instruments and provide disclosures
of the full terms and conditions of all instruments included in
regulatory capital. A banking organization that is also a GSIB would
also be required to describe the main features of its covered debt
positions and provide disclosures of the full terms and conditions of
all covered debt positions.
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\216\ For purposes of Table 15, unique identifiers associated
with regulatory capital instruments and other instruments eligible
for TLAC may include Committee on Uniform Security Identification
Procedures number, Bloomberg identifier for private placement,
International Securities Identification Number, or others.
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H. Market Risk
1. Background
a. Description of Market Risk
Market risk for a banking organization results from exposure to
price movements caused by changes in market conditions, market events,
and issuer events that affect asset prices. Losses resulting from
market risk can affect a banking organization's capital strength,
liquidity, and profitability. To help ensure that a banking
organization maintains a sufficient amount of capital to withstand
adverse market risks and consistent with amendments to the Basel
Capital Accord, the agencies adopted risk-based capital standards for
market risk in 1996 (1996 rule).\217\ Although adoption of the 1996
rule was a constructive step in capturing market risk, the 1996 rule
did not sufficiently capture the risks associated with financial
instruments that became prevalent in the years following its adoption.
This became evident during the 2007-2009 financial crisis, when the
1996 rule did not fully capture banking organizations' increased
exposures to traded credit and other structured products, such as
collateralized debt obligations (CDO), credit default swaps (CDS),
mortgage-related securitizations, and exposures to other less liquid
products.
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\217\ 61 FR 47358 (September 6, 1996). The agencies' market risk
capital rules were located 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 August 2012, the agencies issued a final rule that modified the
1996 rule to address these deficiencies.\218\ Specifically, the rule
added a stressed value-at-risk (VaR) measure, a capital requirement for
default and migration risk (the incremental risk capital
[[Page 64092]]
requirement), a comprehensive risk measurement for correlation trading
portfolio, a modified definition of covered position, a definition of
trading position, an expanded set of requirements for internal models
to reflect advances in risk management, and revised requirements for
regulatory backtesting. These changes enhanced the calibration of
market risk capital requirements by incorporating stressed conditions
into VaR and by increasing the comprehensiveness and quality of the
standards for internal models used to calculate market risk capital
requirements.\219\
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\218\ Risk-Based Capital Guidelines: Market Risk, 77 FR 53059
(August 30, 2012).
\219\ The rule was subsequently modified in 2013 with changes
that included moving the market risk requirements from the agencies'
respective appendices to subpart F of the capital rule; making
savings associations and savings and loan holding companies with
material exposure to market risk subject to the market risk rule, 78
FR 62018 (October 11, 2013); addressing changes to the country risk
classifications, clarifying the treatment of certain traded
securitization positions; revising the definition of covered
position, and clarifying the timing of the market risk disclosure
requirements, 78 FR 76521 (December 18, 2013).
---------------------------------------------------------------------------
While these updates to the rule addressed certain pressing
deficiencies in the calculation of market risk capital requirements, a
number of structural shortcomings that came to light during the crisis
remained unaddressed (such as an inability of a VaR metric to capture
tail risks). To address these shortcomings, the Basel Committee
conducted a fundamental review of the market risk capital
framework.\220\ Following this review, the Basel Committee in January
2016 published a new, more robust framework, which established minimum
capital requirements for market risk.\221\ The new framework also
included enhanced templates and qualitative disclosure requirements to
increase the transparency of banking organizations' market-risk-
weighted assets. In January 2019, the Basel Committee published an
amended framework for market risk capital requirements that revised the
calibration of certain risk weights to more appropriately capture the
potential losses for certain types of risks.\222\ The proposal would
modify subpart F of the capital rule to increase risk sensitivity,
transparency, and consistency of the market risk capital requirements
in a manner generally consistent with the revised framework of the
Basel Committee.
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\220\ The Basel Committee has published three consultative
documents on the review and to address the structural shortcomings
identified. ``Fundamental review of the trading book,'' May 2012,
www.bis.org/publ/bcbs219.pdf; ``Fundamental review of the trading
book: A revised market risk framework,'' October 2013, www.bis.org/publ/bcbs265.pdf; and, ``Fundamental review of the trading book:
Outstanding issues,'' December 2014, www.bis.org/bcbs/publ/d305.pdf.
\221\ Basel Committee, ``Minimum capital requirements for market
risk,'' January 2016, www.bis.org/bcbs/publ/d352.pdf.
\222\ Basel Committee, Explanatory note on the minimum capital
requirements for market risk, January 2019, www.bis.org/bcbs/publ/d457.pdf.
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b. Overview of the Proposal
The proposal would improve the risk-sensitivity and calibration of
market risk capital requirements relative to the current capital rule.
The proposal would introduce a risk-sensitive standardized methodology
for calculating risk-weighted assets for market risk (standardized
measure for market risk) and a new models-based methodology (models-
based measure for market risk) to replace the framework in subpart F of
the current capital rule. The standardized measure for market risk
would be the default methodology for calculating market risk capital
requirements for all banking organizations subject to market risk
requirements. A banking organization would be required to obtain prior
approval from its primary Federal supervisor to use the models-based
measure for market risk to determine its market risk capital
requirements.\223\
---------------------------------------------------------------------------
\223\ A banking organization that has regulatory approval to use
internal models to measure market risk would be required to obtain
new approvals to use the models-based measure for market risk under
the proposed framework.
---------------------------------------------------------------------------
In contrast to the current framework which, subject to approval,
allows the use of internal models at the banking organization level,
the proposal would provide for enhanced risk-sensitivity by introducing
the concept of a trading desk and restricting application of the
proposed models-based approach to the trading desk level. The trading
desk-level approach would limit use of the internal models approach to
only those trading desks that can appropriately capture the risk of
market risk covered positions in banking organizations' internal
models. Notably, the proposal would also improve the current capital
rule's models-based measure for market risk. Specifically, the proposal
would replace the VaR-based measure of market risk with an expected
shortfall-based measure that better accounts for extreme losses.\224\
In addition, the proposal would replace the fixed ten-business-day
liquidity horizon in the current capital rule with liquidity horizons
that vary based on the underlying risk factors to adequately capture
the market risk of less liquid positions.\225\
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\224\ The proposal would define expected shortfall as a measure
of the average of all potential losses exceeding the VaR at a given
confidence level and over a specified horizon.
\225\ The proposal would define liquidity horizon as the time
required to exit or hedge a market risk covered position without
materially affecting market prices in stressed market conditions.
---------------------------------------------------------------------------
If after receiving approval from the primary Federal supervisor to
use the models-based measure for market risk, a banking organization's
trading desk fails to satisfy either the proposed desk-level
backtesting requirements \226\ or the proposed desk-level profit and
loss attribution testing requirements,\227\ the proposal would require
the banking organization to use the standardized measure for market
risk to calculate market risk capital requirements for the trading
desk. This requirement would limit the use of internal models to only
those trading desks for which the models are sufficiently conservative
and accurate for purposes of calculating market risk capital
requirements for the trading desk.
---------------------------------------------------------------------------
\226\ The proposed desk-level backtesting requirements are
intended to measure the conservatism of the forecasting assumptions
and valuation methods used in the desk's expected shortfall models.
\227\ The proposed desk-level profit and loss attribution (PLA)
testing requirements are intended to measure the accuracy of the
potential future profits or losses estimated by the expected
shortfall models relative to those produced by the front office
models. For purposes of this Supplementary Information, the term
``front office model'' refers to the valuation methods used to
report actual profits and losses for financial reporting purposes.
---------------------------------------------------------------------------
The proposed standardized measure for market risk (as illustrated
in Figure 2 below) would consist of three main components: (1) a
sensitivities-based capital requirement that would capture non-default
market risk based on the estimated losses produced by risk factor
sensitivities \228\ under regulatorily determined stress conditions;
\229\ (2) a standardized default risk capital requirement that would
capture losses on credit and equity positions in the event of issuer
default; and (3) a residual risk capital requirement (a residual risk
add-on) that would address in a simple, conservative manner any other
known risks that are not already captured by the first two components,
such as gap risk, correlation risk, and behavioral risks. The proposed
[[Page 64093]]
standardized measure for market risk would also include three
additional components that would apply in limited instances to specific
positions: (1) a fallback capital requirement for instances where a
banking organization is unable to calculate market risk capital
requirements under the sensitivities-based method or the standardized
default risk capital requirement; (2) a capital add-on for re-
designations for instances where a banking organization re-classifies
an instrument after initial designation as being subject either to the
market risk capital requirements under subpart F or to the capital
requirements under either subpart D or E of the capital rule,
respectively, and (3) any additional capital requirement established by
the primary Federal supervisor. Specifically, as part of the proposal's
reservation of authority provisions, the primary Federal supervisor may
require a banking organization to maintain an overall amount of capital
that differs from the amount otherwise required under the proposal, if
the primary Federal supervisor determines that the banking
organization's market risk capital requirements under the proposal are
not commensurate with the risk of the banking organization's market
risk covered positions, a specific market risk covered position, or
categories of positions, as applicable. The standardized measure for
market risk would equal the simple sum of the above components as shown
in Figure 2.
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\228\ A risk factor sensitivity is the change in value of an
instrument given a small movement in a risk factor that affects the
instrument's value.
\229\ Under the proposal, the market risk capital requirement
for the sensitivities-based method would equal the sum of the
capital requirements for a given risk factor for delta (a measure of
impact on a market risk covered position's value from small changes
in underlying risk factors), vega (a measure of the impact on a
market risk covered position's value from small changes in
volatility) and curvature (a measure of the additional change in the
positions' value not captured by delta arising from changes in the
value of an option or an embedded option).
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BILLING CODE 6210-01-P; 6714-01-P; 4810-33-P
[GRAPHIC] [TIFF OMITTED] TP18SE23.029
BILLING CODE 6210-01-C; 6714-01-C; 4810-33-C
The core components of the models-based measure for market risk
would consist of (1) the internal models approach capital requirements
for model-eligible trading desks; \230\ (2) the standardized approach
capital requirements for model-ineligible trading desks; and (3) the
additional capital requirement applied to model-eligible trading desks
with shortcomings in the internal models used for determining risk-
based capital requirements in the form of a PLA add-on,\231\ if
applicable. To limit the increase in capital requirements arising due
to differences in calculating risk-based capital requirements
separately \232\ between market risk covered positions held by trading
desks subject to the internal models approach and those held by trading
desks subject to the standardized approach, the models-based measure
for market risk would cap the sum of these three
[[Page 64094]]
components at the capital required for all trading desks under the
standardized approach.
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\230\ The internal models approach capital requirements for
model-eligible trading desks would itself consist of four
components: (1) the internally modelled capital requirement for
modellable risk factors, (2) the stressed expected shortfall for
non-modellable risk factors, (3) the standardized default risk
capital requirement, and (4) the aggregate trading portfolio
backtesting capital multiplier. See section III.H.8.a of this
Supplementary Information.
\231\ The PLA add-on would be an additional capital requirement
for model deficiencies in model-eligible trading desks based on the
profit and loss attribution test results. See section III.H.8.b of
this Supplementary Information.
\232\ Separate capital calculations could unnecessarily increase
capital requirement because they ignore the offsetting benefits
between market risk covered positions held by trading desks subject
to the internal models approach and those held by trading desks
subject to the standardized approach.
---------------------------------------------------------------------------
There are four other components of the models-based measure for
market risk; however, these would only apply in limited circumstances.
These components include: (1) the capital requirement for instances
where the capital requirements for model-eligible desks under the
internal models approach exceed those under the standardized approach;
\233\ (2) the fallback capital requirement for instances where a
banking organization is not able to apply the standardized approach to
market risk covered positions on model-ineligible trading desks or the
internal models approach to market risk covered positions on model-
eligible trading desks, as well as all securitization positions and
correlation trading positions that are excluded from the capital add-on
for ineligible positions on model-eligible trading desks; (3) the
capital add-on for re-designations for instances where a banking
organization re-classifies an instrument after initial designation as
being subject either to the market risk capital requirements under
subpart F or to the capital requirements under either subpart D or
subpart E of the capital rule, respectively, or from including
securitization positions, correlation trading positions, or certain
equity positions in investment funds \234\ on a model-eligible trading
desk, provided such positions are not included in the fallback capital
requirement; and (4) any additional capital requirement established by
the primary Federal supervisor. Specifically, as part of the proposal's
reservation of authority provisions, and similar to the standardize
measure for market risk, the primary Federal supervisor may require the
banking organization to maintain an overall amount of capital that
differs from the amount otherwise required under the proposal.
---------------------------------------------------------------------------
\233\ As the standardized approach is less risk-sensitive than
the internal models approach, to the extent that the capital
requirement under the internal models approach exceeds that under
the standardized approach for model-eligible desks, the proposal
would require this difference to be reflected in the aggregate
capital requirement under the models-based measure for market risk.
\234\ Specifically, the capital add-on would apply to equity
positions in an investment fund on model-eligible trading desks
where the banking organization cannot identify the underlying
positions held by the investment fund on a quarterly basis or there
is no daily price of the fund available.
---------------------------------------------------------------------------
Under the proposal, the market risk capital requirements for a
banking organization under the models-based measure for market risk
would equal the sum of the following components as shown in Figure 3.
[GRAPHIC] [TIFF OMITTED] TP18SE23.030
The proposal would also revise the criteria for determining whether
a banking organization is subject to the market risk-based capital
requirements to (1) reflect the significant growth in capital markets
since adoption of the 1996 rule; (2) provide a more reliable and stable
measure of banking organizations' trading activity by introducing a
four-quarter average requirement, and (3) incorporate measures of risk
identified as part of the agencies' 2019 regulatory tiering rule.\235\
In general, the revised criteria would take into account the prudential
benefits of the proposed market risk capital requirements and the
potential costs, including compliance costs.
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\235\ See 84 FR 59230, 59249 (November 1, 2019).
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In addition, the proposal would help promote consistency and
comparability in market risk capital requirements across banking
organizations by strengthening the criteria for identifying positions
subject to the proposed market risk capital requirement and by
proposing a risk-based capital treatment of transfers of risk between a
trading
[[Page 64095]]
desk and another unit within the same banking organization (internal
risk transfers). The proposal would also improve the transparency of
market risk capital requirements through enhanced disclosures.
2. Scope and Application of the Proposed Rule
a. Scope of the Proposed Rule
Currently, any banking organization with aggregate trading assets
and trading liabilities that, as of the most recent calendar quarter,
equal to $1 billion or more, or 10 percent or more of the banking
organization's total consolidated assets, is required to calculate
market risk capital requirements under subpart F of the current capital
rule.
The proposal would revise the criteria for determining whether a
banking organization is subject to subpart F of the capital rule. Under
the proposal, large banking organizations, as well as those with
significant trading activity, would be required to calculate market
risk capital requirements under subpart F of the capital rule.
Specifically, a banking organization with significant trading activity
would be any banking organization with average aggregate trading assets
and trading liabilities, excluding customer and proprietary broker-
dealer reserve bank accounts,\236\ over the previous four calendar
quarters equal to $5 billion or more, or equal to 10 percent or more of
total consolidated assets at quarter end as reported on the most recent
quarterly regulatory report. Under the proposal, any holding company
subject to Category I, II, III, or IV standards or any subsidiary
thereof, if the subsidiary engaged in any trading activity over any of
the four most recent quarters, would be subject to subpart F of the
capital rule.
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\236\ The proposal would define customer and proprietary broker-
dealer reserve bank accounts as segregated accounts established by a
subsidiary of a banking organization that fulfill the requirements
of 17 CFR 240.15c3-3 (SEC Rule 15c3-3) or 17 CFR 1.20 (CFTC
Regulation 1.20).
---------------------------------------------------------------------------
The proposed scope is designed to apply market risk capital
requirements to all large banking organizations. As the agencies noted
in the preamble to the final regulatory tiering rule, due to their
operational scale or global presence, banking organizations subject to
Category I or II capital standards pose heightened risks to U.S.
financial stability which would benefit from more stringent capital
requirements being applied to such banking organizations.\237\ As
banking organizations subject to Category I or II capital standards are
generally subject to rules based on the standards published by the
Basel Committee, the proposed scope would help promote competitive
equity among U.S. banking organizations and their foreign peers and
competitors, and reduce opportunities for regulatory arbitrage across
jurisdictions. In addition, given the increasing size and complexity of
activities of banking organizations subject to Category III and IV
capital standards and the risks such banking organizations pose to U.S.
financial stability, it would be appropriate to require such banking
organizations to be subject to the proposed market risk capital
requirements, which provide for enhanced risk sensitivity.
---------------------------------------------------------------------------
\237\ See 84 FR 59230, 59249 (November 1, 2019).
---------------------------------------------------------------------------
In addition to applying subpart F of the capital rule to large
banking organizations, the proposed rule would retain a trading
activity threshold. To reflect inflation since 1996 and growth in the
capital markets, the agencies are proposing to increase the trading
activity dollar threshold from $1 billion to $5 billion. A banking
organization whose trading assets and trading liabilities are equal to
10 percent or more of its total assets would continue to be subject to
subpart F of the capital rule under the proposal. This means that a
banking organization that is not subject to Category I, II, III, or IV
capital standards may still be subject to subpart F if it exceeds
either of these quantitative thresholds. The proposed trading activity
dollar threshold would be measured using the average aggregate trading
assets and trading liabilities of a banking organization, calculated in
accordance with the instructions to the FR Y-9C or Call Report, as
applicable, over the prior four consecutive quarters, rather than using
only the single most recent quarter.\238\ This approach would provide a
more reliable and stable measure of the banking organization's trading
activities than the current capital rule's quarter-end measure.\239\
Furthermore, for purposes of determining applicability of subpart F of
the capital rule, a banking organization would exclude from its
calculation of aggregate trading assets and trading liabilities
securities related to certain segregated accounts established by a
subsidiary of a banking organization pursuant to SEC Rule 15c3-3 and
CFTC Regulation 1.20 (customer and proprietary broker-dealer reserve
bank accounts). To protect customers against losses arising from a
broker-dealer's use of customer assets and cash, the SEC's and CFTC's
requirements for customer and proprietary broker-dealer reserve bank
accounts limit the ability of a banking organization to benefit from
short-term price movements on the assets held in such accounts. When
such accounts constitute the vast majority of a banking organization's
trading activities, the prudential benefit of requiring the banking
organization to measure risk-weighted assets for market risk would be
limited. The proposal would only allow a banking organization to
exclude these amounts from proposed trading activity thresholds for the
purpose of determining whether the banking organization is subject to
market risk capital requirements. If a banking organization exceeds
either of the proposed trading threshold criteria after excluding such
accounts, the proposal would require the banking organization to
include such accounts when calculating market risk capital
requirements.
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\238\ For purposes of the proposed scoping criteria, aggregate
average trading assets and trading liabilities would mean the sum of
the amount of trading assets and the amount of trading liabilities
as reported by the banking organization on the Consolidated
Financial Statements for Holding Companies (sum of line items 5 and
15 on schedule HC of the Y-9C) or on the Consolidated Reports of
Condition and Income (i.e., the sum of line items 5 and 15 on
schedule RC of the FFIEC 031, the FFIEC 041, or the FFIEC 051), as
applicable.
\239\ If the banking organization has not reported trading
assets and trading liabilities for each of the preceding four
calendar quarters, the threshold would be based on the average
amount of trading assets and trading liabilities over the quarters
that the banking organization has reported, unless the primary
Federal supervisor notifies the banking organization in writing to
use an alternative method.
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b. Application of Proposed Rule
The proposal would require a banking organization to comply with
the market risk capital requirements beginning the quarter after the
banking organization meets any of the proposed scoping criteria. To
avoid volatility in requirements, a banking organization would remain
subject to market risk capital requirements unless and until (1) it
falls below the trading activity threshold criteria for each of four
consecutive quarters or is no longer a banking organization subject to
Category I, II, III, or IV capital standards, as applicable, and (2)
has provided notice to its primary Federal supervisor.
Implementing the proposed market risk capital requirements would
require significant operational preparation. Therefore, the agencies
expect that that a banking organization would monitor its aggregate
trading assets and trading liabilities on an ongoing basis and work
with its primary Federal supervisor as it approaches any of the
proposed scoping criteria to prepare for compliance. To facilitate
supervisory oversight, the proposal would require a banking
[[Page 64096]]
organization to notify its primary Federal supervisor after falling
below the relevant scope thresholds.
While the proposed threshold criteria for application of market
risk capital requirements would help reasonably identify a banking
organization with significant levels of trading activity given the
current risk profile of the banking organization, there may be unique
instances where a banking organization either should or should not be
required to reflect market risk in its risk-based capital requirements.
To continue to allow the agencies to address such instances on a case-
by-case basis, the proposal would retain, without modification, the
authority under subpart F of the capital rule for the primary Federal
supervisor to either: (1) require a banking organization that does not
meet the proposed threshold criteria to calculate the proposed market
risk capital requirements, or (2) exclude a banking organization that
meets the proposed threshold criteria from such calculation, as
appropriate. To allow the agencies to address such instances on a case-
by-case basis, the proposal would retain such existing authority under
subpart F of the capital rule.
Question 80: The agencies seek comment on the appropriateness of
the proposed scope of application thresholds. Given the compliance
costs associated with the proposal, what, if any, alternative
thresholds should the agencies consider and why?
Question 81: What are the advantages or disadvantages of using a
four-quarter rolling average for the $5 billion aggregate trading
assets and trading liabilities scope of application threshold? What
different methodologies and time periods should the agencies consider
for purposes of this threshold?
3. Market Risk Covered Position
Subpart F of the capital rule applies to a banking organization's
covered positions, which are defined to include, subject to certain
restrictions: (i) any trading asset or trading liability as reported on
a banking organization's regulatory reports that is a trading position
\240\ or that hedges another covered position and is free of any
restrictive covenants on its tradability or for which the material risk
elements may be hedged by the banking organization in a two-way market,
and (ii) any foreign exchange \241\ or commodity position regardless of
whether such position is a trading asset or trading liability. The
definition of a covered position also explicitly excludes certain
positions. Thus, the definition is structured into three broad
categories, each subject to certain conditions: trading assets or
liabilities that are covered positions, positions that are covered
positions regardless of whether they are trading assets or trading
liabilities, and exclusions.
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\240\ The current capital rule defines a trading position as one
that is held by a 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.
\241\ With prior approval from its primary Federal supervisor, a
banking organization may exclude from its market risk 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 banking organization's tier 1 or tier 2
capital, or (iv) a position designed to hedge a banking
organization's capital ratios or earnings against the effect of
adverse exchange rate movements on (i), (ii), or (iii).
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The proposal would retain the structure and major elements of the
existing definition of covered position (re-designated as ``market risk
covered position'') with several modifications intended to better align
the definition of market risk covered position with those positions the
agencies believe should be subject to the market risk capital
requirements as well as to reflect other proposed changes to the
framework (for example, to incorporate the proposed treatment of
internal risk transfers). The proposed revisions would also help
promote consistency and comparability in the risk-based capital
treatment of positions across banking organizations.
a. Trading Assets and Trading Liabilities That Would Be Market Risk
Covered Positions Under the Proposal
The proposed definition of market risk covered position would
expand to explicitly include any trading asset or trading liability
that is held for the purpose of regular dealing or making a market in
securities or other instruments.242 243 In general, such
positions are held to facilitate sales to customers or otherwise to
support the banking organization's trading activities, for example by
hedging its trading positions, and therefore expose a banking
organization to significant market risk.
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\242\ The proposal also would require such a position to be free
of any restrictive covenants on its tradability or for the banking
organization to be able to hedge the material risk elements of such
a position in a two-way market.
\243\ The proposed definition of market risk covered position
would include correlation trading positions and instruments
resulting from securities underwriting commitments where the
securities are purchased by the banking organization on the
settlement date, excluding purchases that are held to maturity or
available for sale purposes.
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b. Positions That Would Be Market Risk Covered Positions Under the
Proposal Regardless of Whether They Are Trading Assets or Trading
Liabilities
The proposal would include as market risk covered positions certain
positions or hedges of such positions \244\ regardless of whether the
position is a trading asset or trading liability.\245\ Consistent with
subpart F of the current capital rule, such positions would continue to
include foreign exchange and commodity positions with certain
exclusions. In particular, the proposal would continue to allow a
banking organization to exclude structural positions in a foreign
currency from market risk covered positions with prior approval from
its primary Federal supervisor. In addition, the proposal would exclude
from market risk covered positions foreign exchange and commodity
positions that are eligible CVA hedges that mitigate the exposure
component of CVA risk.\246\
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\244\ A position that hedges a trading position must be within
the scope of the banking organization's hedging strategy as
described in Sec. __.203(a)(2) of the proposed rule.
\245\ Extending market risk covered positions to also include
such hedges is intended to encourage sound risk management by
allowing a banking organization to capture both the underlying
market risk covered position and any associated hedge(s) when
calculating its market risk capital requirements. Consistent with
current practice, the agencies would review a banking organization's
hedging strategies to ensure the appropriate designation of
positions subject to subpart F of the capital rule.
\246\ An eligible CVA hedge generally would include an external
CVA hedge or a CVA hedge that is the CVA segment of an internal risk
transfer. See section III.I.3.b. of this Supplementary Information
for more detail on the treatment and recognition of CVA hedges
either under the proposed CVA risk framework or the market risk
framework.
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The proposal would also expand the types of positions that would be
market risk covered positions, even if not categorized as trading
assets or trading liabilities, to include the following, each discussed
further below: (i) certain equity positions in an investment fund; (ii)
net short risk positions; (iii) certain publicly traded equity
positions; \247\ (iv) embedded derivatives on instruments issued by the
banking organization that relate to credit or equity risk and that the
banking organization bifurcates for accounting purposes; \248\ and (v)
certain
[[Page 64097]]
positions associated with internal risk transfer under the
proposal.\249\
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\247\ Equity positions arising from deferred compensation plans,
employee stock ownership plans, and retirement plans would not be
included in the scope of market risk covered position.
\248\ This would apply to hybrid contracts containing an
embedded derivative that must be separated from the host contract
and accounted for as a derivative instrument under ASC Topic 815,
Derivatives and Hedging (formerly FASB Statement No. 133
``Accounting for Derivative Instruments and Hedging Activities,'' as
amended).
\249\ See section III.H.4 of this Supplementary Information for
further detail on eligible internal risk transfer positions.
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First, the proposal would include as a market risk covered position
an equity position in an investment fund for which the banking
organization has access to the fund's prospectus, partnership
agreement, or similar contract that defines the fund's permissible
investments and investment limits, and which meets one of two
conditions. Specifically, the banking organization would either need to
(i) be able to use the look-through approach to calculate a market risk
capital requirement for its proportional ownership share of each
exposure held by the investment fund, or (ii) obtain daily price quotes
for the investment fund.
In contrast to the current covered position definition, which in
part relies on the legal form of the investment fund by referencing the
Investment Company Act to determine whether an equity position in such
a fund is a covered position, the proposed criteria would capture
equity positions for which there is sufficient transparency to be
reliably valued on a daily basis, either from an observable market
price for the equity position in the investment fund itself or from the
banking organization's ability to identify the underlying positions
held by the investment fund.
Second, the proposal would introduce a new term, net short risk
positions, to describe over-hedges of credit and equity exposures that
are not market risk covered positions. As the hedged exposures from
which such positions originate are not traded, net short risk positions
would not meet the definition of trading position even though they
expose the banking organization to market risk.\250\ The agencies
propose to include net short risk positions in market risk covered
positions in order to help ensure that such exposures are appropriately
reflected in banking organizations' risk-based capital requirements.
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\250\ The proposal would retain, without modification, the
existing definition of trading position in subpart F of the current
capital rule. See 12 CFR 3.202 (OCC); 12 CFR 217.202 (Board); 12 CFR
324.202 (FDIC).
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For example, assume a banking organization purchases an eligible
credit derivative (for example, a credit default swap) to mitigate the
credit risk arising from a loan that is not a market risk covered
position and the notional amount of protection provided by the credit
default swap exceeds the loan exposure amount. The banking organization
is exposed to additional market risk on the exposure arising from the
difference between the amount of protection purchased and the amount of
protected exposure because the value of the protection would fall if
the credit spread of the credit default swap narrows. Neither subpart D
nor E \251\ of the capital rule would require the banking organization
to reflect this risk in risk-weighted assets. To capture the market
risk arising from net short risk positions, the proposal would require
the banking organization to treat such positions as market risk covered
positions.
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\251\ Under the proposal, subpart D would cover a Standardized
Approach and subpart E would cover an Expanded Risk-Based Approach
for Risk-Weighted Assets.
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To calculate the exposure amount of a net short risk position, the
proposal would require a banking organization to compare the notional
amounts of its long and short credit positions and the adjusted
notional amounts of its long and short equity positions that are not
market risk covered positions.\252\ For purposes of this calculation,
the notional amounts would include the total funded and unfunded
commitments for loans that are not market risk covered positions.
Additionally, as a banking organization may hedge exposures at either
the single-name level or the portfolio level, the proposal would
require a banking organization to identify separately net short risk
positions for single name exposures and for index hedges. For single-
name exposures, the proposal would require a banking organization to
evaluate its long and short equity and credit exposures for all
positions referencing a single exposure to determine if it has a net
short risk position in a single-name exposure. For index hedges, the
proposal would require a banking organization to evaluate its long and
short equity and credit exposures for all positions in the portfolio
(aggregating across all relevant individual exposures) to determine if
it has a net short risk position for any given portfolio.
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\252\ For equity derivatives, the adjusted notional amount would
be the product of the current price of one unit of the stock (for
example, a share of equity) and the number of units referenced by
the trade.
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The proposal would limit the application of the proposed market
risk capital requirements to positions arising from exposures for which
the notional amount of a short position exceeds the notional amount of
a long position by $20 million or more at either the single-name or
index hedge level. Exposures arising from net short risk positions are
a potential area where a banking organization may maintain insufficient
capital relative to the market risk and should be monitored at the
single name or portfolio level rather than in the aggregate. The
agencies nonetheless recognize that it could be burdensome to require a
banking organization to capture every net short exposure that may
arise, regardless of size or duration, when calculating their market
risk capital requirements. Accordingly, the proposed $20 million
threshold is intended to help ensure that individual net short risk
exposures that could materially impact the risk-based capital
requirements of a banking organization would be appropriately reflected
in the proposed market risk capital requirements. Additionally, the
proposed $20 million threshold is intended to strike a balance between
over-hedging concerns and aligning incentives for banking organizations
to prudently hedge and manage risk while capturing positions for which
a market risk capital requirement would be appropriate. For example, if
a loan amortizes more quickly than expected, due to a borrower making
additional payments to pay down principal, the amount of notional
protection would only constitute a net short risk position if it
exceeds the amount of the total committed loan balance by $20 million
or more. The operational burden of requiring a banking organization to
capture temporary or small differences due to accelerated amortization
within its market risk capital requirements could inhibit the banking
organization from engaging in prudential hedging and sound risk
management. The proposal would require a banking organization to
calculate net short risk positions on a spot, quarter-end basis,
consistent with regulatory reporting, in order to reduce the
operational burden of identifying such positions subject to the
proposed market risk capital requirements.
Third, the proposal generally would include as market risk covered
positions all publicly traded equity positions \253\
[[Page 64098]]
regardless of whether they are trading assets or trading liabilities
and provided that there are no restrictions on the tradability of such
positions.
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\253\ The proposal would not change the current capital rule's
definition of publicly traded as 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 is registered with,
or approved by, a national securities regulatory authority and that
provides a liquid, two-way market for the instrument in question.
Consistent with the current capital rule, the proposal would define
a two-way market as 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 a relatively short time frame conforming to trade
custom.
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Fourth, a banking organization may issue hybrid instruments that
contain an embedded derivative related to credit or equity risk and a
host contract and bifurcate the derivative and the host contract for
accounting purposes under GAAP. Under such circumstances, the proposal
would include the embedded derivative in the definition of market risk
covered position regardless of whether GAAP treats the derivative as a
trading asset or a trading liability. If the banking organization
elected to report the entire hybrid instrument at fair value under the
fair value option rather than bifurcating the accounting, it would be a
market risk covered position only if it otherwise met the proposed
definition, such as held with trading intent or to hedge another market
risk covered position.\254\ This approach would capture the market risk
of embedded derivatives a banking organization faces when it issues
such hybrid instruments while being sensitive to the operational
challenges of requiring banking organizations to calculate the fair
value such derivatives on a daily basis, and also appropriately
excluding conventional instruments with an embedded derivative for
which the capital requirements under subpart D or E of the capital rule
would be appropriate.\255\
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\254\ For purposes of regulatory reporting, the instructions to
the Y-9C and Call Report require a banking organization to classify
as trading securities all debt securities that a banking
organization has elected to report at fair value under a fair value
option with changes in fair value reported in current earnings,
regardless of whether such positions are held with trading intent.
ASC 815-15-25-4 permits both issuers of and investors in hybrid
financial instruments that would otherwise require bifurcation of an
embedded derivative to elect at acquisition, issuance or a new basis
event to carry such instrument at fair value with all changes in
fair value reported in earnings.
\255\ For example, a conventional mortgage loan contains an
embedded prepayment or call option.
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Fifth, the proposed definition of market risk covered position
would include certain transactions of internal risk transfers, as
described in section III.H.4 of this Supplementary Information, based
in certain cases on the eligibility of the internal risk transfers. The
market risk covered position would explicitly include (1) the trading
desk segment of an eligible internal risk transfer of credit risk or
interest rate risk and the trading desk segment of an internal risk
transfer of CVA risk; (2) certain external transactions based on
eligibility of the risk transfers, executed by a trading desk related
to an internal risk transfer of CVA, credit, or interest rate risk, and
(3) both external and internal ineligible CVA hedges (an internal CVA
hedge is the CVA segment of an internal transfer of CVA risk). This
aspect of the proposal is intended to help promote consistency and
comparability in the risk-based capital treatment of such positions
across banking organizations and ensure the appropriate capitalization
of such positions under subparts D, E, or F of the capital rule.
c. Exclusions From the Proposed Definition of Market Risk Covered
Position
The definition of a covered position under subpart F of the current
capital rule explicitly excludes certain positions.\256\ These excluded
instruments and positions generally reflect the fact that they are
either deducted from regulatory capital, explicitly addressed under
subpart D or E of the current capital rule, have significant
constraints in terms of a banking organization's ability to liquidate
them readily and value them reliably on a daily basis, or are not held
with trading intent.
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\256\ See 77 FR 53060, 53064-53065 (August 30, 2012) for a more
detailed discussion on these exclusions under the market risk
capital rule.
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Consistent with subpart F of the current capital rule, the proposal
would continue to exclude from the definition of market risk covered
positions any intangible asset, including any servicing asset; any
hedge of a trading position that the banking organization's primary
Federal supervisor determines to be outside the scope of the banking
organization's trading and hedging strategy; any instrument that, in
form or substance, acts as a liquidity facility that provides support
to asset-backed commercial paper, and any position a banking
organization holds with the intent to securitize.
The proposed definition would also continue to exclude from market
risk covered positions any direct real estate holdings.\257\ Consistent
with past guidance from the agencies, indirect investments in real
estate, such as through REITs or special purpose vehicles, would not be
direct real estate holdings and could be market risk covered positions
if they meet the proposed definition.\258\
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\257\ Direct real estate holdings include real estate for which
the banking organization holds title, such as ``other real estate
owned'' held from foreclosure activities, and bank premises used by
the bank as part of its ongoing business activities.
\258\ See 77 FR 53060, 53065 (August 30, 2012) for the agencies'
interpretive guidance on the treatment of such indirect holdings
under subpart F of the capital rule.
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The proposed definition would also exclude from market risk covered
positions any non-publicly traded equity positions, other than certain
equity positions in investment funds, and would additionally exclude:
(1) a publicly traded equity position that has restrictions on
tradability; (2) a publicly traded equity position that is a
significant investment in the capital of an unconsolidated financial
institution in the form of common stock not deducted from regulatory
capital, and (3) any equity position in an investment fund that is not
a trading asset or trading liability or that otherwise does not meet
the requirements to be a market risk covered position. The proposed
definition would add an exclusion for any derivative instrument or
exposure to an investment fund that has material exposures to any of
the preceding excluded instruments or positions discussed in this
section.
To provide additional clarity, the proposal would also exclude from
market risk covered positions debt securities for which the banking
organization elects the fair value option for purposes of asset and
liability management, as such positions are not reflective of a banking
organization's trading activity. The proposal would also add an
exclusion for instruments held for the purpose of hedging a particular
risk of a position in any of the preceding excluded types of
instruments discussed in this section.
With respect to internal risk transfers of CVA risks, the proposed
definition would exclude from market risk covered positions the CVA
segment of an internal risk transfer that is an eligible CVA hedge. In
addition, consistent with the Basel III reforms, only positions
recognized as eligible external CVA hedges under either the basic or
standardized capital requirements for CVA risk would be excluded from
the market risk capital requirements.\259\ To the extent a banking
organization enters into one or more external hedges that hedge CVA
variability but do not qualify as eligible hedges under the revised CVA
capital standards, the banking organization would need to capture such
hedges in its market risk capital
[[Page 64099]]
requirements and would not be able to recognize the benefit of the
external hedge when calculating risk-based capital requirements for CVA
risk.
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\259\ External transactions executed by a trading desk as
matching transactions to all internal transfers of CVA risk would be
market risk covered positions under the proposal. See section
III.H.3.b of this Supplementary Information for a more detailed
discussion on the treatment of eligible and ineligible internal risk
transfers of CVA risk.
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Question 82: The agencies seek comment on the appropriateness of
the proposed definition of market risk covered position. What, if any,
practical challenges might the proposed definition pose for banking
organizations, such as the ability to fair value daily any of the
proposed instruments that would be captured by the definition? \260\
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\260\ For banking organizations subject to subpart F of the
capital rule, the Volcker Rule defines the scope of instruments
subject to the proprietary trading prohibition (trading account)
based on two prongs: market risk capital rule covered positions that
are trading positions, and instruments purchased or sold in
connection with the business of a dealer, swap dealer, or
securities-based swap dealer that require it to be licensed or
registered as such. The proposed revisions to the definition of
covered positions under subpart F of the capital rule could alter
the scope of financial instruments deemed to be in the trading
account under the Volcker Rule, but only to the extent that a market
risk covered position is also a trading position and the position is
not otherwise excluded from the Volcker rule definition of trading
account.
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Question 83: The agencies seek comment on the extent to which
limiting the proposed definition of market risk covered position to
include equity positions in investment funds only for which a banking
organization has access to the fund's investments limits (as specified
in the fund's prospectus, partnership agreement, or similar contract
that define the fund's permissible investments) appropriately captures
the types of positions that should be subject to regulatory capital
requirements under the proposed market risk framework. What types of
investment funds, if any, would a banking organization have the ability
to value reliably on a daily basis that do not meet this condition?
Question 84: The agencies seek comment on whether the agencies
should consider allowing a banking organization to exclude from the
definition of market risk covered position investments in capital
instruments or covered debt instruments of financial institutions that
have been deducted from tier 1 capital, including investments in
publicly-traded common stock of financial institutions, and hedges of
these investments that meet the requirements to offset such positions
for purposes of determining deductions. What would the benefits and
drawbacks be of not providing such an optionality?
Question 85: For the purposes of determining whether certain
positions are within the definition of market risk covered position, is
the proposed definition of net short risk position appropriate, and
why? What, if any, alternative measures should the agencies consider to
identify net short risk positions and why would these be more
appropriate?
Question 86: The agencies seek comment on whether the proposed $20
million threshold is an appropriate measure for identifying significant
net short risk exposures that warrant capitalization under the market
risk framework. What alternative thresholds or methods should the
agencies consider for identifying significant net short risk positions,
and why would these alternatives be more appropriate than the proposed
$20 million threshold?
Question 87: What, if any, challenges might banking organizations
face in calculating the market risk capital requirement for net short
risk positions? In particular, what, if any, alternatives to the total
commitment for loans should the agencies consider using to calculate
notional amount--for example, delta notional values rather than
notional amount, present value, sensitivities--and why would any such
alternatives be a better metric? Please provide specific details on the
mechanics of and rationale for any suggested methodology. In addition,
which, if any, of the items to be included in a banking organization's
net short credit or equity risk position may present operational
difficulties and what is the nature of such difficulties? How could
such concerns be mitigated?
Question 88: The agencies seek comment on whether to modify the
exclusion for debt instruments for which a banking organization has
elected to apply the fair value option that are used for asset and
liability management purposes. Would such an exclusion be overly
restrictive, and, if so, why and how should the exclusion be expanded?
Please specify the types and amounts of debt instruments for which
banking organizations apply the fair value option that should be
covered under this exclusion, and the capital implications of expanding
the exclusion relative to the proposal.
Question 89: The agencies seek comment on whether to modify the
criteria for including external CVA hedges in the scope of market risk
covered position. What are the benefits and drawbacks of requiring a
banking organization to include ineligible external CVA hedges in the
market risk capital requirements, provided a banking organization has
effective risk management and an effective hedging program?
4. Internal Risk Transfers
A banking organization may choose to hedge the risks of certain
positions \261\ held by a banking unit or a CVA desk by having one of
its trading desks obtain the hedge and subsequently transfer the hedge
position through an internal transaction to the banking unit or the CVA
desk. The current capital rule does not address the transfers of risk
from a banking unit or a CVA desk (or a functional equivalent thereof)
to a trading desk within the same banking organization \262\ (internal
risk transfers), for example between a mortgage banking unit and a
rates trading desk. Thus, market risk-weighted assets do not reflect
the market risk of such internal transactions and capture only the
external portion of the hedge, potentially misrepresenting the risk
position of the banking organization.
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\261\ Such risks can include credit, interest rate, or CVA risk
arising from exposures that are subject to risk-based requirements
under subpart D or E of the capital rule.
\262\ For example, if the banking organization is a depository
institution within a holding company structure, transactions
conducted between the depository institution and an affiliated
broker-dealer entity would not qualify as transactions within the
same banking organization for the depository institution. Such
transactions would qualify as transactions within the same banking
organization for the consolidated holding company.
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Accordingly, the proposal would define internal risk transfers and
establish a set of requirements including documentation and other
conditions for a banking organization to recognize certain types of
internal risk transfers in risk-based capital requirements. The
proposal would define internal risk transfers as a transfer executed
through internal derivatives trades of credit risk or interest rate
risk arising from an exposure capitalized under subparts D or E of the
capital rule to a trading desk, or a transfer of CVA risk arising from
a CVA desk (or the functional equivalent if the banking organization
does not have any CVA desks) to a trading desk.\263\ The proposed
definition of internal risk transfer would not include transfers of
risk from a trading desk to a banking unit or between trading desks
because such transactions present the types of risks appropriately
captured in market risk-weighted assets.\264\
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\263\ An internal risk transfer transaction would comprise two
perfectly offsetting segments--one segment for each of two parties
to the transaction.
\264\ As described in section III.H.7.c.ii of this Supplementary
Information, for transfers of risk between a trading desk that uses
the standardized measure and a trading desk that uses the internal
models approach, a banking organization may exclude the leg of the
transaction acquired by the trading desk using the standardized
approach from the residual risk add-on.
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In practice, for internal risk management purposes, most banking
[[Page 64100]]
organizations already document the source of risk being hedged and the
trading desk providing the hedge. As a result, the agencies do not
expect the proposed documentation requirements for such transactions to
qualify as eligible internal risk transfers, as described in more
detail below, to pose a significant compliance burden on banking
organizations. The agencies encourage prudent risk management and
believe this aspect of the proposal will help promote consistency and
comparability in the risk-based capital treatment of such internal
transactions across banking organizations and ensure the appropriate
capitalization of such positions.
a. Internal Risk Transfers of Credit Risk
The Basel III reforms introduce risk-based capital treatment of
internal transfers of credit risk executed from a banking unit to a
trading desk to hedge the credit risk arising from exposures in the
banking unit. The proposal is generally consistent with the Basel III
reforms by specifying the criteria for internal risk transfer
eligibility and clarifying the scope of exposures subject to market
risk capital requirements. Specifically, the banking organization would
be required to maintain documentation identifying the underlying
exposure under subpart D or E of the capital rule being hedged and its
sources of credit risk. In addition, a trading desk would be required
to enter into an external hedge that meets the requirements of Sec.
__.36 of the current capital rule or Sec. __.120 of the proposed rule
and matches the terms, other than amount, of the internal credit risk
transfer.
When these requirements are met, the transaction would qualify as
an eligible internal risk transfer, for which the banking unit would be
allowed to recognize the amount of the hedge position received from the
trading desk as a credit risk mitigant when calculating the risk-based
capital requirements for the underlying exposure under subpart D or E
of the capital rule. Since the trading desk enters into external hedges
to manage credit risk arising from banking unit exposures, such
external hedges would be included in the scope of market risk covered
positions along with the internal risk transfer (the trading desk
segment), where they would cancel each other provided the amounts and
terms of both transactions match. Nevertheless, if the internal risk
transfer results in a net short credit position for the banking unit,
the trading desk would be required to calculate risk-based capital
requirements for such positions under subpart F of the capital rule. A
net short risk credit position results when the external hedge exceeds
the amount required by the banking unit to hedge the underlying
exposure under subpart D or E of the capital rule.
For transactions that do not meet these requirements, the proposal
would require a banking organization to disregard the internal risk
transfer (the trading desk segment) from the market risk covered
positions. The proposal would subject the entire amount of the external
hedge acquired by the trading desk to the proposed market risk capital
requirements and disallow any recognition of risk mitigation benefits
of the internal credit risk transfer under subpart D or E of the
capital rule.
b. Internal Risk Transfers of Interest Rate Risk
The proposal would specify the risk-based capital treatment of
internal transfers of interest rate risk from a banking unit to the
trading desk to hedge the interest rate risk arising from the banking
unit. When a banking organization executes an internal interest rate
risk transfer between a banking unit and a trading desk, the
transferred interest rate risk exposure would be considered an eligible
risk transfer that the banking organization may treat as a market risk
covered position only if such internal risk transfer meets a set of
requirements. Specifically, the banking organization would be required
to maintain documentation of the underlying exposure being hedged and
its sources of interest rate risk. In addition, given the complexity of
tracking the direction of internal transfers of interest rate risk, the
proposal would allow a banking organization to establish a dedicated
notional trading desk for conducting internal risk transfers to hedge
interest rate risk. The proposal would require such a desk to receive
approval from its primary Federal supervisor to execute such internal
risk transfers.\265\ The proposal would require the capitalization of
trading desks that engage in such transactions on a standalone basis,
without regard to other market risks generated by activities on the
trading desk.
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\265\ The proposal would not require banking organizations to
purchase the hedge from a third party for such transactions to
qualify as an internal risk transfer.
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When these requirements are met, the transaction would qualify as
an eligible internal interest rate risk transfer, for which the banking
organization may recognize the hedge benefit of an internal derivative
transaction. A trading desk that conducts internal risk transfers of
interest rate risk may enter into external hedges to mitigate the risk
but would not be required to do so under the proposal. As the amount
transferred to the trading desk from the banking unit to hedge the
underlying exposure under subpart D or E of the capital rule would be a
market risk covered position, any such external hedges would also be
market risk covered positions and thus also subject to the proposed
market risk capital requirements.\266\
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\266\ As the trading desk segments of eligible internal risk
transfers of interest rate risk would be market risk covered
positions, to the extent a trading desk enters into external hedges
to mitigate the risk of such positions, the external hedge would
also be subject to the market risk capital rule and could in whole
or in part offset the market risk of the eligible internal risk
transfer.
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For transactions that do not meet these requirements, a banking
organization would be required to exclude the internal interest rate
risk transfer (the trading desk segment) from its market risk covered
positions. The entire amount of any external hedge of an ineligible
internal risk transfer would be a market risk covered position.
c. Internal Risk Transfers of CVA Risk
The proposal would specify the capital treatment of internal CVA
risk transfers executed between a CVA desk (or the functional
equivalent thereof) and a trading desk to hedge CVA risk arising from
exposures that are subject to the proposed capital requirements for CVA
risk.
Under the proposal, an internal CVA risk transfer would involve two
perfectly offsetting positions of a derivative transaction executed
between a CVA desk and a trading desk. For the CVA desk to recognize
the risk mitigation benefits of the internal risk transfer under the
risk-based capital requirements for CVA risk, the proposal would
require the banking organization to have a dedicated CVA desk or the
functional equivalent thereof that, along with other functions
performed by the desk, manages internal risk transfers of CVA risk. In
either case, such a desk would not need to satisfy the proposed trading
desk definition, given the proposed risk-based capital requirements for
CVA risk are not calibrated at the trading desk level. Additionally,
the proposal would require a banking organization to maintain an
internal written record of each internal derivative transaction
executed between the CVA desk and the trading desk, including
identifying the underlying exposure being hedged by the CVA desk and
the sources of such
[[Page 64101]]
risk. Furthermore, if the internal risk transfer from the CVA desk to
the trading desk is subject to curvature risk, default risk, or the
residual risk add-on under the proposed market risk capital rule, as
described in sections III.H.7.a.ii.III., III.H.7.b., and III.H.7.c of
this Supplementary Information, respectively, the trading desk would
have to execute an external transaction with a third party that is
identical in its terms to the risk transferred by the CVA desk to the
trading desk. This external transaction would be included in market
risk covered positions; therefore, there would be no impact to the
market risk capital required for the trading desk as the external
transaction would perfectly offset the risk from the internal risk
transfer. Given the difference in recognizing the curvature risk, the
default risk, or the residual risk add-on under the proposed market
risk capital requirements and the CVA risk capital requirements, as
well as complexity of tracking and ensuring the appropriateness of
internal transfers of CVA risk, the external matching transaction
requirement is intended to ensure the complete offsetting of the above
mentioned risks at the time the trades are originated, facilitate the
identification by the primary Federal supervisor of the underlying
position or sources of risk being hedged by the internal risk transfer,
and thus the determination of whether the transfer is an eligible
internal CVA risk transfer.
In addition to the above-mentioned requirements for the internal
transaction and the related external matching transaction to qualify as
an eligible internal risk transfer of CVA risk, the proposal sets forth
general requirements for the recognition of CVA hedges that would be
applicable to both internal transfers of CVA risk and external CVA
hedges. The proposal specifies these requirements for both the basic
approach for CVA risk and standardized approach for CVA risk, as
described in section III.I.3 of this Supplementary Information.\267\
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\267\ While the basic approach for CVA applies certain
restrictions on eligible instrument types for hedges to be
recognized as eligible, the standardized approach for CVA risk
allows for a broader set of hedging instruments. Moreover, the
standardized approach for CVA risk would also recognize as eligible
hedges instruments that are used to hedge the exposure component of
CVA risk.
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For eligible internal risk transfers of CVA risk, the banking
organization would be required to treat the transfers of risk from the
CVA desk or the functional equivalent to the trading desk as market
risk covered positions. In this way, the proposal would allow the CVA
desk to recognize the risk-mitigating benefit of the hedge position
received from the trading desk when calculating risk-based capital
requirements for CVA risk. As the overall risk profile of the banking
organization would not have changed, the proposed treatment would
require the trading desk to reflect the impact of the risk transferred
from the CVA desk as part of the transaction in the proposed market
risk capital requirements.
For transactions that do not meet these requirements or the general
hedge eligibility requirements under the basic approach for CVA risk or
the standardized approach for CVA risk, a banking organization would be
required to include both the trading desk segment and the CVA segment
of the internal transfer of CVA risk in market risk-weighted assets.
This is equivalent to disregarding the internal CVA risk transfer. The
entire amount of the external matching transaction executed by the non-
CVA trading desk in the context of an internal CVA risk transfer would
be deemed a market risk covered position. In addition, the CVA desk
would not be able to recognize any risk mitigation or offsetting
benefit from the ineligible internal risk transfer in its capital
requirements for CVA risk.
d. Internal Risk Transfers of Equity Risk
The agencies are not proposing to allow a banking organization to
recognize any risk mitigation benefits for internal equity risk
transfers executed between a trading desk and a banking unit to hedge
exposures that are subject to either subpart D or E of the capital
rule. The proposed definition of market risk covered position would
include equity positions that are publicly traded with no restrictions
on tradability. Given the expanded scope of equity positions that would
be subject to the proposed market risk capital requirements as
discussed above, the agencies believe that primarily illiquid or
irregularly traded equity positions would remain subject to subparts D
or E of the capital rule. As a banking organization would not be able
to hedge the material risk elements of such equity positions in a
liquid, two-way market, consistent with the current framework, the
proposal would not allow a banking organization to recognize internal
transfers of equity risk of such positions for risk-based capital
purposes.
Question 90: The agencies seek comment on any operational
challenges of the proposed internal risk transfer framework, in
particular any potential difficulties related to internal risk
transfers executed before implementation of the proposed market risk
capital rule. What is the nature of such difficulties and how could
they be mitigated?
Question 91: The agencies seek comment on the extent to which the
proposed internal risk transfer framework would incentivize hedging and
prudent risk management and/or provide opportunity to misrepresent the
risk profile of a banking organization. What, if any, additional
requirements or other modifications should the agencies consider?
Question 92: The agencies seek comment on the appropriateness of
the proposed eligibility requirements for a banking unit to recognize
the risk mitigation benefit of an eligible internal risk transfer of
credit risk. What, if any, additional requirements or other
modifications should the agencies consider, and why?
Question 93: What, if any, operational burden might the proposed
exclusion for the credit risk segment of internal risk transfers pose
for banking organizations? What, if any, alternatives should the
agencies consider to appropriately exclude the types of positions that
should be captured under subpart D or E of the capital rule, but would
impose less operational burden relative to the proposal?
Question 94: The agencies seek comment on subjecting the internal
risk transfers of interest rate risk to the market risk capital
requirements on a standalone basis. What are the benefits and costs
associated with this requirement?
Question 95: The agencies seek comment on the matching external
transaction requirements for internal transfer of CVA risk. Should such
external matching transactions be subject to additional requirements,
such as those applicable to external hedges of credit risk, and if so,
why?
Question 96: The agencies seek comment on limiting an eligible
internal risk transfer of CVA risk to only internal transactions for
which the external transaction perfectly offsets the internal risk
transfer. What, if any, challenges might this requirement pose and what
should the agencies consider to mitigate such challenges?
Question 97: The agencies seek comment on the proposed requirement
that a banking organization's trading desk execute a matching
transaction with a third party if the internal risk transfer of CVA
risk is subject to curvature risk, default risk, or the residual risk
add-on? What other risk mitigation techniques would the banking
organization implement?
Question 98: The agencies seek comment on the proposed
documentation requirements for an
[[Page 64102]]
internal risk transfer of credit risk, interest rate risk, and CVA risk
to qualify as an eligible internal risk transfer. What, if any,
alternatives should the agencies consider that would appropriately
capture the types of positions that should be recognized under subpart
D or E of the capital rule?
5. General Requirements for Market Risk
Subpart F of the current capital rule requires a banking
organization to satisfy certain general risk management requirements
related to the identification of trading positions, active management
of covered positions, stress testing, control and oversight, and
documentation. The proposal would maintain these requirements, as well
as introduce additional requirements. The additional requirements are
designed to further strengthen a banking organization's risk management
of market risk covered positions and to appropriately reflect other
changes under the proposal such as the definition of market risk
covered position and the introduction of the trading desk concept, as
described in sections III.H.3 and III.H.5.b of this Supplementary
Information. The proposal would also make certain related technical
corrections to the requirements around valuation of market risk covered
positions.\268\
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\268\ Specifically, to align with the GAAP considerations for
valuation of market risk covered positions, the proposal would
eliminate the market risk capital rule requirement that a banking
organization's process for valuing covered positions must consider,
as appropriate, unearned credit spreads, close-out costs, early
termination costs, investing and funding costs, liquidity, and model
risk. See 12 CFR 3.203(b)(2) (OCC); 12 CFR 217.203(b)(2) (Board); 12
CFR 324.203(b)(2) (FDIC).
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a. Identification of Market Risk Covered Positions
Subpart F of the current capital rule requires a banking
organization to have clearly defined policies and procedures for
determining which trading assets and trading liabilities are trading
positions and which trading positions are correlation trading
positions, as well as for actively managing all positions subject to
the rule.
The proposal would expand these requirements to reflect the
proposed scope and definition of market risk covered position as
described in section III.H.3 of this Supplementary Information. A
banking organization also would be required to update its policies and
procedures for identifying market risk covered positions at least
annually and to identify positions that must be excluded from market
risk covered positions. In addition, the proposal would introduce a new
requirement for a banking organization to establish a formal framework
for re-designating a position after its initial designation as being
subject to subpart F or to subparts D and, as applicable, E of the
capital rule. Specifically, the proposal would require a banking
organization to establish policies and procedures that describe the
events or circumstances under which a re-designation would be
considered, a process for identifying such events or circumstances, any
restrictions on re-designations, and the process for obtaining senior
management approval as well as for notifying the primary Federal
supervisor of material re-designations. These proposed requirements are
intended to complement the proposed capital requirement for re-
designations described in section III.H.6.d of this Supplementary
Information by ensuring re-designations would occur in only those
circumstances identified by the banking organization's senior
management as appropriate to merit re-designation.\269\
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\269\ As described in further detail in section III.H.6.d of
this Supplementary Information, the proposal would introduce a
capital requirement (the capital add-on for re-designations) to
offset any potential capital benefit that a banking organization
otherwise might have received from re-classifying an instrument
previously treated under subparts D or E of the capital rule as a
market risk covered position.
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In addition to the requirements for identifying market risk covered
positions, the proposal would require a banking organization to have
clearly defined trading and hedging strategies for its market risk
covered positions that are approved by the banking organization's
senior management. Consistent with the capital rule, the trading
strategy would need to specify the expected holding period and the
market risk of each portfolio of market risk covered positions, and the
hedging strategy would need to specify the level of market risk that
the banking organization would be willing to accept for each portfolio
of market risk covered positions, along with the instruments,
techniques, and strategies for hedging such risk.
b. Trading Desk
i. Trading Desk Definition
To limit overreliance on internal models, support more prudent
market risk management practices, and better align operational
requirements with the level at which trading activity is conducted, the
proposal would introduce the concept of a trading desk and apply the
proposed internal models approach at the trading desk level. Regardless
of whether a banking organization uses the standardized or the models-
based measure for market risk, the proposal would require the banking
organization to satisfy certain general operational requirements for
each trading desk, as described below in section III.H.5.c of this
Supplementary Information. The proposal would require the banking
organization to satisfy certain additional operational requirements, as
described below in section III.H.5.d of this Supplementary Information,
in order for the banking organization to calculate the market risk
capital requirements for trading desks under the internal models
approach.
The proposal would define trading desk as a unit of organization of
a banking organization that purchases or sells market risk covered
positions and satisfies three requirements. First, the proposal would
require a banking organization to structure a trading desk pursuant to
a well-defined business strategy. In general, a well-defined business
strategy would include a written description of the trading desk's
general strategy, including the economics behind the business strategy,
the trading and hedging strategies and a list of the types of
instruments and activities that the desk will use to accomplish its
objectives. The proposal would require a trading desk to be organized
to ensure the appropriate setting, monitoring, and management review of
the desk's trading and hedging limits and strategies. Third, the
proposal would require that a trading desk be characterized by a
clearly-defined unit of organization that: (1) engages in coordinated
trading activity with a unified approach to the key elements of the
proposed rule's requirements for trading desk policies and active
management of market risk covered positions; (2) operates subject to a
common and calibrated set of risk metrics, risk levels, and joint
trading limits; (3) submits compliance reports and other information as
a unit for monitoring by management; and (4) books its trades together.
The proposed trading desk definition is intended to help ensure
that a banking organization structures its trading desks to capture the
level at which trading activities are managed and operated and at which
the profit and loss of the trading strategy is attributed.\270\ This
approach would recognize the different strategies and objectives of
discrete units in a banking
[[Page 64103]]
organization's trading operations. The proposed parameters provide
sufficient specificity to enable more precise measures of market risk
for the purpose of determining risk-based capital requirements, while
taking into account the potential variation in trading practices across
banking organizations. In this regard, the proposal aims to reduce the
regulatory compliance burden for banking organizations by providing
flexibility to align the proposed trading desk definition with the
organizational structure that banking organizations may already have in
place to carry out their trading activities.
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\270\ The proposal would define trading desk in a manner
generally consistent with the Volcker Rule. See 12 CFR 44.3(e)(14)
(OCC); 12 CFR 248.3(e)(14) (Board); 12 CFR 351.3(e)(14) (FDIC).
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Question 99: What, if any, changes should the agencies consider
making to the definition of a trading desk and why? Are there any other
key factors that banking organizations typically use to define trading
desks for business purposes that the agencies should consider including
in the trading desk definition to clarify the designation of trading
desks for purposes of the market risk capital framework?
Question 100: The agencies seek comment on any implementation
challenges banking organizations with cross-border operations could
face in applying the proposed trading desk definition. What are the
advantages and disadvantages of permitting a U.S. subsidiary of a
foreign banking organization to apply trading desk designations
consistent with its home country's regulatory requirements, provided
those requirements are consistent with the Basel III reforms?
ii. Notional Trading Desk Definition
The proposed definition of market risk covered position would
include certain types of instruments and positions that may not arise
from, and may be unrelated to, a banking organization's trading
activities, such as net short risk positions, certain embedded
derivatives that are bifurcated for accounting purposes, as well as
foreign exchange and commodity exposures that are not trading assets or
trading liabilities.\271\ When a banking organization enters into such
positions, it may do so in a manner that causes these positions to
appear not to originate from a banking organization's existing trading
desks.
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\271\ As noted in section III.H.3.c of this Supplementary
Information, identifying these positions for treatment under the
proposed rule is necessary to enhance the rule's sensitivity to
risks that might not otherwise be captured or adequately captured by
subparts D or E of the capital rule.
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To address the issue that certain trading desk-level requirements
are not applicable to these types of activities and positions, the
proposal would introduce the concept of a notional trading desk \272\
to which such positions would be allocated. Under the proposal,
notional trading desks would be subject to only a subset of the general
risk management requirements applicable to trading desks. Specifically,
the proposal would require a banking organization to identify any such
positions and activities allocated to notional trading desks, as
described in section III.H.5.b.iii of this Supplementary Information,
but would not require a banking organization to establish policies and
procedures describing the trading strategy or risk management for the
notional trading desks or require a notional trading desk to satisfy
the requirements for active management of market risk covered
positions. Nevertheless, to qualify for use of the internal models
approach, the proposal would require a notional trading desk to satisfy
all of the general requirements for trading desks, as well as those
applicable for the models-based measure.\273\
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\272\ The proposal would define a notional trading desk as a
trading desk created for regulatory capital purposes to account for
market risk covered positions arising under subpart D or subpart E
such as net short risk positions, embedded derivatives on
instruments that the banking organization issued that relate to
credit or equity risk that it bifurcates for accounting purposes,
and foreign exchange positions and commodity positions. Notional
trading desks would be exempt from certain requirements applicable
to other trading desks, as discussed in this section III.H.5.b.iv.
\273\ See section III.H.5.d of this Supplementary Information
for further discussion on the requirements applicable to model-
eligible trading desks.
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The agencies are proposing to require a banking organization to
identify any notional trading desks as part of the trading desk
structure requirement, described in section III.H.5.b.iii of this
Supplementary Information, to help ensure that a banking organization
appropriately treats all market risk covered positions under the
capital rule. The agencies would review a banking organization's
trading desk structure, including notional trading desks and trading
desks used for internal risk transfers, to help ensure that they have
been appropriately identified.
Question 101: What, if any, additional requirements should apply to
notional trading desks to clarify the level at which market risk
capital requirements must be calculated? What, if any, additional types
of positions should be assigned to the notional trading desk and why?
iii. Trading Desk Structure
The proposal would require a banking organization to define its
trading desk structure, subject to the requirement that the structure
must define each constituent trading desk and identify: (1) model-
eligible trading desks that are used in the models-based measure for
market risk, (2) model-ineligible trading desks used in both the
standardized measure and model-based measure for market risk,\274\ (3)
trading desks that are used for internal risk transfers (as
applicable), and (4) notional trading desks (as applicable).\275\
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\274\ The list of model-eligible trading desks should include
both those for which the banking organization has elected to
calculate market risk capital requirements under the standardized
approach as well as any trading desks that previously received
approval to use the internal models approach but subsequently
reported one or both PLA test metrics in the red zone, as described
in more detail in section III.H.8.b.ii of this Supplementary
Information. A banking organization should maintain a list of all
trading desks and make it available for the primary Federal
supervisor for review upon request.
\275\ A banking organization could also seek approval for a
notional trading desk to be a model-eligible trading desk. Any such
desk that is approved would be subject to backtesting and profit and
loss attribution testing at the trading desk level.
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Additionally, before calculating market risk capital requirements
under the models-based measure for market risk, the proposal would
require a banking organization to receive prior written approval from
the primary Federal supervisor of its trading desk structure. As part
of the model approval process described in section III.H.5.d.iv of this
Supplementary Information, the agencies would consider whether the
level at which a banking organization is proposing to establish its
trading desks is consistent with the level at which trading activities
are actively managed and operated. The agencies would also consider
whether the level at which the banking organization defines each
trading desk is sufficiently granular to allow the banking organization
and the primary Federal supervisor to assess the adequacy of the
internal models used by the trading desk. For example, a banking
organization's proposed trading desk structure may be considered
insufficiently detailed if it reflects risk limits, internal controls,
and ongoing management at one or more organizational levels above the
routine management of the trading desk (for example, at the division-
wide or entity level).
iv. Trading Desk Policies
Subpart F of the current capital rule requires a banking
organization to have clearly defined trading and hedging strategies for
their trading positions that are approved by senior management. In
addition to applying these requirements at the trading desk level for
trading desks that are not notional trading
[[Page 64104]]
desks, the proposal would require policies and procedures for each
trading desk to describe the strategy and risk management framework
established for overseeing the risk-taking activities of the trading
desk.
For each trading desk that is not a notional trading desk, the
proposal would require a banking organization to have a clearly defined
policy, approved by senior management, that describes the general
strategy of the trading desk, the risk and position limits established
for the trading desk, and the internal controls and governance
structure established to oversee the risk-taking activities of the
trading desk.\276\ At a minimum, this would include the business
strategy for each trading desk; \277\ the clearly defined trading
strategy that details the market risk covered positions in which the
trading desk is permitted to trade, identifies the main types of market
risk covered positions purchased and sold by the trading desk, and
articulates the expected holding period of, and market risk associated
with, each portfolio of market risk covered positions held by the
trading desk; the clearly defined hedging strategy that articulates the
acceptable level of market risk and details the instruments,
techniques, and strategies that the trading desk will use to hedge the
risks of the portfolio; a brief description of the general strategy of
the trading desk that addresses the economics of its business strategy,
primary activities, and trading and hedging strategies; and the risk
scope applicable to the trading desk that is consistent with its
business strategy, including the overall risk classes and permitted
risk factors.\278\
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\276\ Under the proposal, these requirements would generally not
apply to any notional trading desk, except those with prior approval
from the primary Federal supervisor to use the internal models
approach.
\277\ Under the proposal, the business strategy must include
regular reports on the revenue, costs and market risk capital
requirements of the trading desk.
\278\ See section III.H.7.a.i of this Supplementary Information
for further discussion on risk factors.
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Together, the proposed requirements are intended to help ensure
that each trading desk engages only in those activities that are
permitted by senior management and that any exceptions would be
elevated to the appropriate organizational level. For example, the
proposed requirement for a banking organization to document trading,
hedging, and business strategies, including the internal controls
established to manage the risks arising from the trading strategy, at
the level of the organization responsible for implementing the general
business strategy, is intended to help ensure appropriate monitoring of
the risk limits set by senior management. Additionally, the proposed
requirements would help to assist the primary Federal supervisor in
monitoring compliance, particularly when assessing whether the trading
activities conducted by a trading desk are consistent with the general
strategy of the desk and the appropriateness of the limits established
for the desk. For example, the requirement for a trading desk to list
the types of instruments traded by the desk to hedge risks arising from
its business strategy would help to assist the primary Federal
supervisor in providing effective supervisory oversight of the trading
desk's activities.
c. Operational Requirements
Subpart F of the current capital rule requires a banking
organization to satisfy certain operational requirements for active
management of market risk covered positions, stress testing, control
and oversight, and documentation. The proposal would maintain these
requirements and introduce revisions designed to complement changes
under the proposed standardized and models-based measures for market
risk (including the application of calculations at the trading desk
level in the case of the models-based measure for market risk), and to
support the proposed requirements described in section III.H.5.a of
this Supplementary Information that would help ensure a banking
organization maintains robust risk management processes for identifying
and appropriately managing its market risk covered positions.
A key assumption of the proposed market risk framework is that the
internal risk management models \279\ used by banking organizations
provide an adequate basis for determining risk-based capital
requirements for market risk covered positions.\280\ To help ensure
such adequacy, the proposal also would strengthen a banking
organization's prudent valuation practices by incorporating
requirements that build on the agencies' overall regulatory framework
for market risk management, including the regulatory guidance set forth
in the Board's Supervision and Regulation (SR) Letter 11-7 and OCC's
Bulletin 2011-12, Regulatory Guidance on Model Risk Management. In
addition to facilitating the regulatory review process, the proposed
revisions are intended to assist a banking organization's independent
risk control unit and audit functions in providing appropriate review
of and challenge to model risk management, thereby promoting effective
model risk management.
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\279\ The proposal would define internal risk management model
as a valuation model that the independent risk control unit within
the banking organization uses to report market risks and risk-
theoretical profits and losses to senior management. See Sec.
__.202 of the proposed rule.
\280\ Additionally, as described in more detail in section
III.H.7.a.ii of this Supplementary Information, the proposal also
assumes that the valuation models used to report actual profits and
losses for purposes of financial reporting would provide an adequate
basis for purposes of calculating regulatory capital requirements.
As such models are already subject to additional requirements to
enhance the accuracy of the financial data produced, the proposed
requirements would only apply to those internal risk management
models that the primary Federal supervisor has approved the banking
organization to use in calculating regulatory capital requirements.
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The general risk management requirements described in this section
would apply to all banking organizations subject to the proposed market
risk capital framework regardless of whether they use the standardized
measure for market risk or models-based measure for market risk.
i. Active Management of Market Risk Covered Positions
Subpart F of the current capital rule requires a banking
organization to have clearly defined policies and procedures for
actively managing all positions subject to the market risk capital
rule, including establishing and conducting daily monitoring of
position limits.\281\ These requirements are appropriate to support
active management and monitoring under the current framework; the
proposal adds enhancements to support active management and monitoring
at the trading desk level.
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\281\ The proposal would retain certain other requirements with
modifications such as policies and procedures for active management
of trading positions subject to the market risk requirements which
include, but are not limited to, ongoing assessment of the ability
to hedge market risk covered positions and portfolio risks. See 12
CFR 3.203(b)(1) or 12 CFR 217.203(b)(1).
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Accordingly, the proposal would require a banking organization to
have clearly defined policies and procedures that describe its internal
controls, as well as its ongoing monitoring, management, and
authorization procedures, including escalation procedures, for the
active management of all market risk covered positions. At a minimum,
these policies and procedures must identify key groups and personnel
responsible for overseeing the activities of the banking organization's
trading desks that are not notional trading desks.
Further, the proposal would specify a broader set of risk metrics
for the monitoring requirement, which would
[[Page 64105]]
apply at the trading desk level. Specifically, at a minimum, the
proposal would require that a banking organization establish and
conduct daily monitoring by trading desks of: (1) trading limits,
including intraday trading limits, limit usage, and remedial actions
taken in response to limit breaches; (2) sensitivities to risk factors;
and (3) market risk covered positions and transaction volumes; and, as
applicable, (4) VaR and expected shortfall; (5) backtesting and p-
values \282\ at the trading desk level and at the aggregate level for
all model-eligible trading desks; and (6) comprehensive profit-and-loss
attribution (each as described in sections III.H.7 and III.H.8 of this
Supplementary Information). These risk metrics are the minimum elements
necessary to support adequate daily monitoring of market risk covered
positions at the trading desk level.
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\282\ P-value is the probability, when using the VaR-based
measure for purposes of backtesting, of observing a profit that is
less than, or a loss that is greater than, the profit or loss that
actually occurred on a given date.
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Consistent with subpart F of the capital rule, for a banking
organization that has approval for at least one model-eligible trading
desk, the proposal would require the banking organization's policies
and procedures to describe the establishment and monitoring of
backtesting and p-values at the trading desk level and at the aggregate
level for all model-eligible trading desks. Daily information on the
probability of observing a loss greater than that which occurred on any
given day is a useful metric for a banking organization and supervisors
to assess the quality of a banking organization's VaR model. For
example, if a banking organization that used a historical simulation
VaR model using the most recent 500 business days 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 many times over a long interval provides information about the
adequacy of the VaR model's ability to characterize the entire
distribution of losses, including information on the size and number of
backtesting exceptions. The requirement to create and retain this
information at the entity-wide and trading desk level may help identify
particular products or business lines for which a model does not
adequately measure risk. The agencies view active management of model
risk at the trading desk level as the best mechanism to address
potential risks of reliance on models, such as the possible adverse
consequences (including financial loss) of decisions based on models
that are incorrect or misused.
ii. Stress Testing and Internal Assessment of Capital Adequacy
Subpart F of the capital rule requires a banking organization to
have a rigorous process for assessing its overall capital adequacy in
relation to its market risk. The process must take into account market
concentration and liquidity risks under stressed market conditions as
well as other risks arising from the banking organization's trading
activities that may not be fully captured by a banking organization's
internal models. At least quarterly, a banking organization must
conduct stress tests at the entity-wide level of the market risk of its
covered positions.
The proposal would enhance the stress testing and internal
assessment of capital adequacy requirements in subpart F of the capital
rule to reflect both the entity-wide and the trading-desk level
elements within the proposed market risk capital requirement
calculation. Specifically, the proposal would require a banking
organization to stress-test the market risk of its market risk covered
positions at both the entity-wide and trading-desk level on at least a
quarterly basis. The proposal also would require that results of such
stress testing be reviewed by senior management of the banking
organization and reflected in the policies and limits set by the
banking organization's management and the board of directors, or a
committee thereof. In addition to concentration and liquidity risks,
the proposal would require stress tests to take into account risks
arising from a banking organization's trading activities that may not
be adequately captured in the standardized measure for market risk or
in the models-based measure for market risk, as applicable.
The proposed requirements are intended to help ensure that each
trading desk only engages in those activities that are permitted by the
banking organization's senior management, and that any weaknesses
revealed by the stress testing results would be elevated to the
appropriate management levels of the banking organization and addressed
in a timely manner.
iii. Control and Oversight
Subpart F of the capital rule requires a banking organization to
maintain a risk control unit that reports directly to senior management
and is independent of the business trading units. The internal audit
function is responsible for assessing, at least annually, 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 the banking organization's policies and procedures, and the
calculation of the banking organization's market risk capital
requirements. At least annually, the internal audit function must
report its findings to the banking organization's board of directors
(or a committee thereof).
The proposal largely would retain the control, oversight, and
validation requirements in subpart F of the capital rule, including the
requirement that a banking organization maintain an independent risk
control unit. The proposal would expand the required oversight
responsibilities of the independent risk control unit to include the
design and implementation of market risk management systems that are
used for identifying, measuring, monitoring, and managing market risk.
The proposed change is intended to complement other changes under the
proposal, in particular allowing a banking organization to calculate
risk-based requirements using standardized and models-based measures
for market risk (for example, the inclusion of more rigorous model
eligibility tests that apply at the trading desk level), as well as the
introduction of a capital add-on requirement for re-designations.
Further, the proposal would enhance the internal review and
challenge responsibilities of a banking organization by requiring it to
maintain conceptually sound systems and processes for identifying,
measuring, monitoring, and managing market risk. In addition to its
current requirements under subpart F of the capital rule, the banking
organization's internal audit function would have to assess at least
annually the effectiveness of the designations and re-designations of
market risk covered positions, and its assessment of the calculation of
the banking organization's measures for market risk under subpart F,
including the mapping of risk factors to liquidity horizons, as
applicable. The proposal would enhance the validation requirements by
requiring a banking organization to maintain independent validation of
its valuation models and valuation adjustments or reserves.
The agencies intend for these elements of the proposal to enhance
the accountability of the banking organization's independent risk
control unit and internal audit function and provide banking
organizations with sufficient flexibility to incorporate the
[[Page 64106]]
risk management processes required for regulatory capital purposes
within those daily risk management processes used by the banking
organization, such that managing market risk would be more consistent
with the banking organization's overall risk profile and business
model. A banking organization's primary Federal supervisor would
evaluate the robustness and appropriateness of the banking
organization's internal stress-testing methods, risk management
processes, and capital adequacy.
iv. Documentation
Similar to the enhancements to policies and procedures described
above, the proposal would enhance the documentation requirements under
subpart F of the capital rule to reflect the proposed market risk
capital framework. Specifically, a banking organization would be
required to adequately document all material aspects of its
identification, management, and valuation of its market risk covered
positions, including internal risk transfers and any re-designations of
positions between subpart F and subparts D and E of the capital rule.
Consistent with subpart of F of the current capital rule, the proposal
would require a banking organization to adequately document all
material aspects of its internal models, and its control, oversight,
validation, and review processes and results, as well as its internal
assessment of capital adequacy. The proposal also would require a
banking organization to document an explanation of the empirical
techniques used to measure market risk. Further, a banking organization
would be required to establish and document its trading desk structure,
including identifying which trading desks are model-eligible, model-
ineligible, used for internal risk transfers, or constitute notional
trading desks, as well as document policies describing how each trading
desk satisfies applicable requirements. These enhancements would
support the banking organization's ability to distinguish between
positions subject to subpart F of the capital rule and those that are
not.
d. Additional Operational Requirements for the Models-Based Measure for
Market Risk
Under subpart F of the capital rule, a banking organization must
use an internal VaR based model to calculate risk-based capital
requirements for its covered positions. The proposal would not require
a banking organization to use an internal model but would allow a
banking organization that has approval from its primary Federal
supervisor for at least one model-eligible trading desk to use the
internal models approach to calculate market risk capital requirements.
As a condition for use of the internal models approach, the
proposal would require a trading desk to satisfy certain additional
operational requirements, which are intended to help ensure that a
banking organization has allocated sufficient resources for the desk to
develop and rely on internal models that appropriately capture the
market risk of its market risk covered positions. Specifically, the
additional operational requirements, as well as the proposed profit and
loss attribution and backtesting requirements, as described in sections
III.H.8.b and III.H.8.c of this Supplementary Information, would help
ensure that the losses estimated by the internal models used to
calculate a trading desk's risk-based capital requirements are
sufficiently accurate and sufficiently conservative relative to the
profits and losses that are reported in the general ledger. These
general ledger reported profits and losses are produced by front-office
models.\283\ In this way, the additional operational requirements are
intended to help ensure that the internal models of a trading desk
properly measure all material risks of the market risk covered
positions to which they are applied, and the sophistication of the
internal models is commensurate with the complexity and extent of
trading activity conducted by the trading desk.
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\283\ The proposed backtesting requirements are intended to
measure the conservatism of the forecasting assumptions and
valuation methods in the expected shortfall models used for
determining risk-based capital requirements while the proposed PLA
testing requirements are intended to measure the accuracy of the
potential future profits or losses estimated by the expected
shortfall models relative to those produced by the front office
models. If a trading desk fails to satisfy either the proposed PLA
or backtesting requirements, it would no longer be able to calculate
risk-based capital requirements using the internal models approach.
In this way, the proposal would only allow trading desks for which
the internal models are sufficiently conservative and accurate to
use the internal models approach to calculate its market risk
capital requirements.
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As described above, the proposal would require eligibility for use
of the internal models approach to be determined at the trading desk
level, rather than for the entire banking organization. By aligning the
level at which a banking organization may be permitted to model market
risk capital requirements with the level at which the banking
organization applies its front office controls, the proposed
requirements would enhance prudent capital management for banking
organizations that use the models-based measure for market risk.
Additionally, the proposed trading desk-level framework would provide a
prudential backstop to the internal models approach by requiring the
use of the standardized approach for trading desks with risks that are
not adequately captured by a banking organization's internal models.
This avoids the risk of an abrupt or severe change in a banking
organization's overall market risk capital requirement in the event
that a particular trading desk ceases to be eligible to use the
internal models approach.
i. Trading Desk Identification
As part of the model approval process, the proposal would require a
banking organization to identify all trading desks within its trading
desk structure that it would designate as model-eligible and for which
it would seek approval to use internal models from the primary Federal
supervisor. When identifying which trading desks to designate as model-
eligible, the banking organization would be required to consider
whether the standardized or internal models approach would more
appropriately reflect the market risk of the desk's market risk covered
positions.
Additionally, the proposal generally would prohibit a banking
organization from seeking model approval for trading desks that hold
securitization positions or correlation trading positions, with one
exception. Given the operational difficulties of requiring a banking
organization to bifurcate trading desks that hold an insignificant
amount of securitization or correlation trading positions pursuant to
their trading or hedging strategy, the proposal would allow the banking
organization to designate such desks as model-eligible. If the primary
Federal supervisor were to approve the use of internal models for such
desks, the proposal would require the banking organization to
separately calculate market risk capital requirements for such
securitization or correlation trading positions held by a model-
eligible trading desk under either the standardized approach or the
fallback capital requirement, and otherwise treat such positions as if
they were not held by the desk.\284\
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\284\ Specifically, the proposal would require a banking
organization to exclude any insignificant amount of securitization
positions and/or correlation trading positions held by the model-
eligible trading desk from (1) the aggregate trading portfolio
backtesting; and (2) from the relevant desk-level backtesting and
profit and loss attribution metrics, except with the approval of the
banking organization's primary Federal supervisor.
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Question 102: The agencies seek comment on the benefits and
drawbacks
[[Page 64107]]
of requiring trading desks that hold an insignificant amount of
securitization positions and correlation trading positions to exclude
from the internal models approach such positions and any related
hedges, if applicable, in order for such desks to request approval to
calculate market risk capital requirements under the models-based for
market risk. Commenters are encouraged to provide data to support their
responses.
ii. Review, Risk Management, and Validation
To help ensure that the internal models appropriately capture a
model-eligible trading desk's market risk exposure on an ongoing basis,
the proposal would require a banking organization to satisfy additional
model review and validation standards for model-eligible trading desks
in order to calculate market risk capital requirements under the
models-based measure for market risk.
Specifically, a banking organization that uses the models-based
measure for market risk would be required to (1) review its internal
models at least annually and enhance them, as appropriate, to help
ensure the models continue to satisfy the initial approval requirements
and employ risk measurement methodologies that are the most appropriate
for the banking organization's market risk covered positions, (2)
integrate its internal models used for calculating the expected
shortfall-based measure for market risk into its daily risk management
process, and (3) independently \285\ validate its internal models both
initially and on an ongoing basis, and revalidate them when there is a
material change to a model, a significant structural change in the
market, or changes in the composition of its market risk covered
positions that might result in the internal models no longer adequately
capturing the market risk of the market risk covered positions held by
the model-eligible trading desk.
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\285\ Either the validation process itself would have to be
independent, or the validation process would have to be subjected to
independent review of its adequacy and effectiveness. The
independence of the banking organization's validation process would
be characterized by separateness from and impartiality to the
development, implementation, and operation of the banking
organization's internal models, or otherwise by independent review
of its adequacy and effectiveness, though the personnel conducting
the validation would not necessarily be required to be external to
the banking organization.
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The proposal also would require banking organizations to establish
a validation process that at a minimum includes an evaluation of the
internal models' (1) conceptual soundness \286\ and (2) adequacy in
appropriately capturing and reflecting all material risks, including
that the assumptions are appropriate and do not underestimate risks.
Additionally, the proposal would require a banking organization to
perform ongoing monitoring to review and verify processes, including by
comparing the outputs of the internal models 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 banking organization's models. As part of this
comparison, a banking organization would be expected to investigate the
source of differences between the model estimates and the relevant
internal or external data or estimation techniques and whether the
extent of the differences is appropriate.
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\286\ The process should include evaluation of empirical
evidence supporting the methodologies used and evidence of a model's
strengths and weaknesses.
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In addition, the proposal would expand on the outcomes analysis
requirements in subpart F of the capital rule by requiring validation
to include not only any outcomes analysis that includes backtesting at
the aggregated level of all model-eligible trading desks, but also
backtesting and profit and loss attribution testing at the trading desk
level for each model-eligible trading desk. The agencies recognize that
financial markets and modeling technologies undergo continual
development. Accordingly, a banking organization needs to continually
ensure that its models are appropriate. The ongoing review, risk
management, and validation requirements in the proposal are intended to
help ensure that the internal models used accurately reflect the risks
of market risk covered positions in evolving markets.
iii. Documentation
In addition to the general documentation requirements applicable to
all banking organizations as described in section III.H.5.c.iv of this
Supplementary Information, the proposal would require a banking
organization that uses the models-based measure for market risk to
document policies and procedures regarding the determination of which
risk factors are modellable and which are not modellable (risk factor
eligibility test), including a description of how the banking
organization maps real price observations to risk factors; the data
alignment of the profit and loss systems used by front office and by
the internal risk management models; the assignment of risk factors to
liquidity horizons, and any empirical correlations recognized with
respect to risk factor classes.
As with the other enhanced operational requirements applicable to a
banking organization that uses the models-based measure for market
risk, these requirements are designed to help ensure the use of the
internal models approach under the models-based measure for market risk
only applies to those trading desks for which the banking organization
is able to demonstrate that the internal models appropriately capture
the market risk of the market risk covered positions held by the desk.
iv. Model Eligibility
For the banking organization to use the models-based measure for
market risk, the proposal would require a banking organization to
receive the prior written approval from its primary Federal supervisor
for at least one trading desk to apply the internal models approach.
Accordingly, the proposal would establish a framework for such
approval.
I. Initial Approval
Under the proposal, the approval for a banking organization to use
internal models would be granted at the individual trading desk
level.\287\ For the primary Federal supervisor to approve an internal
model, the proposal would require a banking organization to demonstrate
that (1) the internal model properly measures all the material risks of
the market risk covered positions to which it would be applied; (2) the
internal model has been properly validated in accordance with the
validation process and requirements; (3) the level of sophistication of
the internal model is commensurate with the complexity and amount of
the market risk covered positions to which it would be applied; and (4)
the internal model meets all applicable requirements.
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\287\ The proposal would require a banking organization to
receive written approval from the primary Federal supervisor for
both the expected shortfall internal model and the stressed expected
shortfall methodology used by the trading desk. As the initial
approval process for each would be the same, for simplicity, the
term ``internal models'' used throughout this section is intended to
refer to both.
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To receive approval as a model-eligible trading desk, the proposal
would require a trading desk to satisfy one of the following criteria.
The banking organization could provide to the primary Federal
supervisor at least 250 business days of backtesting and PLA test
results for the trading desk.
[[Page 64108]]
Alternatively, the banking organization could either (1) provide at
least 125 business days of backtesting and PLA test results for the
trading desk and demonstrate to the satisfaction of the primary Federal
supervisor that the internal models would be able to satisfy the
backtesting and PLA requirements on an ongoing basis; (2) demonstrate
that the trading desk consists of market risk covered positions similar
to those of another trading desk that has received approval from the
primary Federal supervisor and such other trading desk has provided at
least 250 business days of backtesting and PLA results, or (3) subject
the trading desk to the PLA add-on until the desk provides at least 250
business days of backtesting and PLA test results that pass the
trading-desk level backtesting requirements and produce PLA metrics in
the green zone, as further described in sections III.H.8.b and
III.H.8.c of this Supplementary Information.
The proposed criteria would hold trading desks to robust modeling
requirements, while providing a banking organization sufficient
flexibility to satisfy the standard over time and as the banking
organization adapts its business structure. The agencies recognize that
when initially requesting approval and in subsequent requests (for
example, after a reorganization or upon entering into a new business),
a banking organization may not always be able to provide a full year of
backtesting and PLA results for each trading desk, even if the internal
models used by the desk provide an adequate basis for determining risk-
based capital requirements. The proposed criteria would allow a banking
organization to seek model approval for trading desks with at least a
six-month track record demonstrating the accuracy and conservatism of
the internal models used by the desk (PLA and backtesting results) as
well as for trading desks that consist of similar market risk covered
positions to another trading desk, for which the banking organization
has provided at least 250 business days of trading desk level profit
and loss attribution test and backtesting results and has received
approval from its primary Federal supervisor. Given the difficulty in
evaluating the appropriateness of the internal models used by trading
desks that provide less than six months of profit and loss attribution
test and backtesting results and that do not consist of market risk
covered positions similar to those of another trading desk that has
received approval, the agencies are proposing to allow a banking
organization to designate such desks as model-eligible, but to subject
any such trading desk approved by the primary Federal supervisor to the
PLA add-on until the desk produces one year of satisfactory profit and
loss attribution test and backtesting results in the green zone. Thus,
the trading desk would remain subject to an additional capital
requirement until it provides sufficient evidence demonstrating the
appropriateness of the internal models, at which time application of
the PLA add-on would automatically cease.
II. Ongoing Eligibility and Changes to Trading Desk Structure or
Internal Models
Subpart F of the current capital rule requires a banking
organization to promptly notify the primary Federal supervisor when (1)
extending the use of a model that the primary Federal supervisor has
approved to an additional business line or product type, (2) making any
change to an internal model that would result in a material change in
the banking organization's total risk-weighted asset amount for market
risk for a portfolio of covered positions, or (3) making any material
change to its modelling assumptions.
The proposal would expand on these requirements to require a
banking organization to receive prior written approval from its primary
Federal supervisor before implementing any change to its trading desk
structure or internal models (including any material change to its
modelling assumptions) that would (1) in the case of trading desk
structure, materially impact the risk-weighted asset amount for a
portfolio of market risk covered positions; or (2) in the case of
internal models, result in a material change in the banking
organization's internally modelled capital calculation for a trading
desk under the internal models approach. Additionally, the proposal
would require a banking organization to promptly notify its primary
Federal supervisor of any change, including non-material changes, to
its internal models, modelling assumptions, or trading desk
structure.\288\ Whether a banking organization would be required to
receive prior written approval or promptly notify the primary Federal
supervisor before extending the use of an approved model to an
additional business line or product type would depend on the nature of
and impact of such a change.
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\288\ In such cases, a banking organization should notify the
primary Federal supervisor in writing, in a manner acceptable to the
supervisor (such as through email, where appropriate).
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The proposal also would require a model-eligible trading desk to
perform and successfully pass quarterly backtesting and the PLA testing
requirements on an ongoing basis in order to maintain its approval
status.\289\ As banking organizations' quarterly review of backtesting
and PLA results would take place after a quarter is over, the proposal
would permit a banking organization to rely on the internal models
approach for model-eligible trading desks that previously received
approval from the primary Federal supervisor during the 20-day period
following quarter end while updating its use of internal models based
on the results of the quarterly review.
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\289\ See sections III.H.8.b and III.H.8.c of this Supplementary
Information.
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Even if a model-eligible trading desk were to satisfy the above
requirements, a banking organization's primary Federal supervisor could
determine that the desk no longer complies with any of the proposed
applicable requirements for use of the models-based measure for market
risk or that the banking organization's internal model for the trading
desk fails to either comply with any of the applicable requirements or
to accurately reflect the risks of the desk's market risk covered
positions. In such cases, the primary Federal supervisor could (1)
rescind the desk's model approval and require the desk to calculate
market risk capital requirements under the standardized approach, or
(2) subject the desk to a PLA add-on capital requirement until it
restores the desk's full approval, in the case of trading desk
noncompliance.
The agencies recognize that even if a banking organization's
expected shortfall model for a trading desk satisfies the proposed
backtesting, PLA testing, and operational requirements, the model may
not appropriately capture the risk of the market risk covered positions
held by the desk (for example, if the model develops specific
shortcomings in risk identification, risk aggregation and
representation, or validation). Thus, as an alternative to requiring a
trading desk to use the standardized approach, the proposal would allow
the primary Federal supervisor to subject the trading desk to the PLA
add-on if the desk were to continue to satisfy all of the proposed
backtesting, PLA testing, and operational requirements for use of the
models-based measure for market risk. In this way, the proposal would
help to ensure that the market risk capital requirements for the
trading desk appropriately reflect the materiality of the shortcomings
of the expected
[[Page 64109]]
shortfall model, as the PLA add-on would apply until such time that the
banking organization enhances the accuracy and conservatism of the
trading desk's expected shortfall model to the satisfaction of its
primary Federal supervisor.
Similarly, after approving a banking organization's stressed
expected shortfall methodology to capture non-modellable risk factors
for use by one or more trading desks, as described in section
III.H.8.a.i of this Supplementary Information, the primary Federal
supervisor may subsequently determine that the methodology no longer
complies with the operational requirements for use of the models-based
measure for market risk or that the methodology fails to accurately
reflect the risks of the market risk covered positions held by the
trading desk. In such cases, the proposal would allow the primary
Federal supervisor to rescind its approval of the banking
organization's methodology and require the affected trading desk(s) to
calculate market risk capital requirements for the trading desk under
the standardized approach. As the methodologies used to capture the
market risk of non-modellable risk factors would not be subject to the
proposed PLA testing requirements, which inform the calibration of the
PLA add-on as described in section III.H.8.b of this Supplementary
Information, the PLA add-on would not be an alternative if the primary
Federal supervisor rescinds its approval of such a methodology.
6. Measure for Market Risk
Under subpart F of the current capital rule, a banking organization
must use one or more internal models to calculate market risk capital
requirements for its covered positions.\290\ A banking organization's
market risk-weighted assets equal the sum of the VaR-based capital
requirement, the stressed VaR-based capital requirement, specific risk
add-ons, the incremental risk capital requirement, the comprehensive
risk capital requirement, and the capital requirement for de minimis
exposures, plus any additional capital requirement established by the
primary Federal supervisor, multiplied by 12.5. The primary Federal
supervisor may require the banking organization to maintain an overall
amount of capital that differs from the amount otherwise required under
the rule, if the regulator determines that the banking organization's
market risk-based capital requirements under the rule are not
commensurate with the risk of the banking organization's covered
positions, a specific covered position, or portfolios of such
positions, as applicable.
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\290\ Notably, for securitization positions subject to subpart
F, the current capital rule provides a standardized measurement
method for capturing specific risks and a models-based measure
capturing general risks for calculating market risk-weighted assets.
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As noted in section III.H.1.b. of this Supplementary Information,
the proposal would introduce a standardized methodology for calculating
market risk capital requirements and a new methodology for the internal
models approach to replace the framework in subpart F of the current
capital rule. Under the proposal, a banking organization that has one
or more model-eligible trading desks would be required to calculate
market risk capital requirements under both the standardized and the
models-based measures for market risk. Furthermore, if required by the
primary Federal supervisor, a banking organization that has one or more
model-eligible trading desk would be required to calculate the
standardized measure for market risk for each model-eligible trading
desk as if that trading desk were a standalone regulatory portfolio. A
banking organization with no model-eligible trading desks would only
calculate market risk capital requirements under the standardized
measure for market risk.
The agencies would have the authority to require a banking
organization to calculate capital requirements for specific positions
or categories of positions under either subpart D or E instead of under
subpart F of the capital rule, or under subpart F instead of under
subpart D or E of the capital rule, or under both subpart F and subpart
D or E, as applicable, to more appropriately reflect the risks of the
positions. Alternatively, under the proposal, the primary Federal
supervisor may require a banking organization to apply a capital add-on
for re-designations of specific positions or portfolios. These proposed
provisions would help the primary Federal supervisor ensure that a
banking organization's risk-based capital requirements appropriately
reflect the risks of such positions.
Additionally, for a banking organization that uses the models-based
measure for market risk, the agencies would reserve the authority to
require a banking organization to modify its observation period or
methodology (including the stress period) used to measure market risk,
when calculating the expected shortfall measure or stressed expected
shortfall. In this way, the proposal would help the primary Federal
supervisor ensure that a banking organization's internal models remain
sufficiently robust to capture risks in a dynamic market environment
and appropriately reflect the risks of such positions.
a. Standardized Measure for Market Risk
Under the proposal, the standardized measure for market risk would
consist of three main components: a sensitivities-based method, a
standardized default risk capital requirement, and a residual risk add-
on (together, the standardized approach). The proposed standardized
measure for market risk also would include three additional components
that would apply in more limited instances to specific positions: the
fallback capital requirement, the capital add-on requirement for re-
designations, and any additional capital requirement established by the
primary Federal supervisor as part of the proposal's reservation of
authority provisions.
The core component of the standardized approach is the
sensitivities-based capital requirement, which would capture non-
default market risk based on the estimated losses produced by risk
factor sensitivities \291\ under regulatorily determined stressed
conditions. The standardized default risk capital requirement captures
losses on credit and equity positions in the event of obligor default,
while the residual risk add-on serves to produce a simple, conservative
capital requirement for any other known risks that are not already
captured by first two components (sensitivities-based measure and the
standardized default risk capital), such as gap risk, correlation risk,
and behavioral risks such as prepayments. The fallback capital
requirement would apply in cases where a banking organization is unable
to calculate either the sensitivities-based capital requirement, such
as when a sensitivity is not available, or the standardized default
risk capital requirement.\292\ Additionally, the capital add-on
requirement for re-designations would apply in cases where a banking
organization re-classifies an instrument after initial designation as
being subject either to the market risk capital requirements under
subpart F or to capital requirements under subpart D or
[[Page 64110]]
E of the capital rule, respectively.\293\ Each of these components is
intended to help ensure the standardized measure for market risk
provides a simple, transparent, and risk-sensitive measure for
determining a banking organization's market risk capital requirements.
The standardized measure for market risk equals the sum of the above
components and any additional capital requirement established by the
primary Federal supervisor, as described in more detail in section
III.H.7 of this Supplementary Information.
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\291\ A risk factor sensitivity is the change in value of an
instrument given a small movement in a risk factor that affects the
instrument's value.
\292\ See section III.H.6.c of this Supplementary Information
for a more detailed discussion on the fallback capital requirement.
\293\ See section III.H.6.d of this Supplementary Information
for a more detailed discussion of the capital add-on for re-
designations.
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The agencies view the proposed standardized measure for market risk
as sufficiently risk sensitive to serve as a credible floor to the
models-based measure for market risk. If a trading desk does not
receive approval to use the internal models approach or fails to meet
the operational requirements of the models-based measure for market
risk on an on-going basis, the desk would be required to continue to
use the standardized approach to calculate its market risk capital
requirements. The conservative calibration of the risk weights and
correlations applied to a banking organization's market risk covered
positions would help ensure that risk-based capital requirements under
the standardized approach appropriately capture the market risks to
which a banking organization is exposed. Additionally, by relying on a
banking organization's models to produce risk factor sensitivities, the
proposed standardized measure for market risk would help ensure market
risk capital requirements appropriately capture a banking
organization's actual market risk exposure in a manner that minimizes
compliance burden and enhances risk-capture. Furthermore, the proposed
standardized measure for market risk would also promote comparability
in market risk capital requirements across banking organizations
subject to the proposal.
b. Models-Based Measure for Market Risk
To limit use of the internal models approach to only those trading
desks that can appropriately capture the risks of market risk covered
positions in internal models, model-eligible trading desks would be
required to satisfy the model eligibility criteria and processes (for
example, profit and loss attribution testing) introduced under the
proposal, as described in section III.H.5.d of this Supplementary
Information. Thus, under the proposal, a banking organization with
prior regulatory approval to use the models-based measure for market
risk could have some trading desks that are eligible for the internal
models approach and others that use the standardized approach.
Specifically, if the primary Federal supervisor were to approve a
banking organization to calculate market risk capital requirements for
one or more trading desks under the internal models approach, the
banking organization would be required to calculate the entity-wide
market risk capital requirement under the models-based measure for
market risk (IMAtotal), which would incorporate the capital
requirements under the standardized approach for model-ineligible
trading desks, according to the following formula, as provided under
Sec. __.204(c) of the proposed rule:
IMATotal = min ((IMAG,A + PLA add-on + SAU), SAall desks) + max
((IMAG,A-SAG,A),0) + fallback capital requirement + capital add-ons
Under the proposal, the core components of the models-based measure
for market risk capital requirements are the internal models approach
capital requirements for model-eligible trading desks, which capture
non-default market risks and the standardized default risk capital
requirement for model-eligible desks (IMAG,A), the standardized
approach capital requirements for model-ineligible trading desks (SAU),
the standardized approach capital requirement for market risk covered
positions and term repo-style transactions the banking organization
elects to include in model-eligible trading desks (SG,A) and the
additional capital requirements applied to model-eligible trading desks
with shortcomings in the internal models used for determining
regulatory capital requirements, (PLA addon) if applicable.
To limit the increase in capital requirements arising due to
differences in calculating risk-based capital requirements separately
\294\ between market risk covered positions held by trading desks
subject to the internal models approach and those held by trading desks
subject to the standardized approach, the models-based measure for
market risk would cap the sum of IMAG,A, the PLA add-on, and
SAU at the capital required for all trading desks under the
standardized approach:
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\294\ Separate capital calculations could unnecessarily increase
capital requirement because they ignore the offsetting benefits
between market risk covered positions held by trading desks subject
to the internal models approach and those held by trading desks
subject to the standardized approach.
---------------------------------------------------------------------------
(min((IMAG,A + PLA add-on + SAU), SAall desks))
The other components of the models-based measure for market risk
include four other components that would only apply in more limited
circumstances; these include the capital requirement for instances
where the capital requirements for model-eligible desks under the
internal models approach exceed those under the standardized approach,
(max((IMAG,A-SAG,A), 0)),\295\ the fallback capital
requirement for instances where a banking organization is not able to
apply the standardized approach and the internal models approach, if
eligible,\296\ and the capital add-on to offset any potential capital
benefit that otherwise might have been received either from re-
designating an instrument or from including ineligible positions on a
model-eligible trading desk,\297\ as well as any additional capital
requirement established by the primary Federal supervisor pursuant to
the proposal's reservation of authority provisions.
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\295\ As the standardized approach is less risk-sensitive than
the internal models approach, to the extent that the capital
requirement under the internal models approach exceeds that under
the standardized approach for model-eligible desks, the proposal
would require this difference to be reflected in the aggregate
capital requirement under the models-based measure for market risk.
\296\ See section III.H.6.c of this Supplementary Information
for a more detailed discussion on the fallback capital requirement.
\297\ See section III.H.6.d of this Supplementary Information
for a more detailed discussion on the capital add-on requirement for
re-designations.
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The proposed models-based measure for market risk would provide
important improvements to the risk sensitivity and calibration of risk-
weighted assets for market risk. In addition to replacing the VaR-based
measure with an expected shortfall measure to capture tail risk, the
models-based measure for market risk would replace the fixed ten
business-day liquidity horizon in subpart F of the current capital rule
with ones that vary based on the underlying risk factors in order to
adequately capture the market risk of less liquid positions. The
proposal also would limit the regulatory capital benefit of hedging and
portfolio diversification across different asset classes, which
generally dissipates in stress periods.
Question 103: The agencies seek comment on all aspects of the
models-based measure for market risk calculation, including the capital
requirement for instances where the capital requirement under the
internal models approach for model-eligible
[[Page 64111]]
desks exceeds the amount required for such desks under the standardized
approach. What would be the benefits or drawbacks of capping the total
capital requirement under the models-based measure for market risk at
that required for all trading desks under the standardized approach?
c. Fallback Capital Requirement
The agencies recognize that a banking organization may not be able
to calculate market risk capital requirements for one or more of its
market risk covered positions in situations when a banking organization
is unable to calculate market risk requirements under the standardized
approach and the internal models approach, if eligible. For example, a
banking organization may not be able to calculate some risk factor
sensitivities or components for one or more market risk covered
positions due to an operational issue or a calculation failure. Such
issues could arise when a new market product is introduced and the
banking organization has not had sufficient time to develop models and
analytics to produce the required sensitivities or the new data feeds
for the proposed market risk capital calculations. In such cases, the
proposal would require a banking organization to apply the fallback
capital requirement to the affected market risk covered positions, as
further described below.
For purposes of calculating the standardized measure for market
risk, the proposal would require a banking organization to apply the
fallback capital requirement to each of the affected positions and
exclude such positions from the standardized approach capital
requirement.\298\
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\298\ The respective components of the standardized approach
capital requirement are the sensitivities-based method capital
requirement, the standardized default risk capital requirement, and
the residual risk add-on.
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For purposes of calculating the models-based measure for market
risk, unless the banking organization receives prior written approval
from its primary Federal supervisor, the proposal would require the
banking organization to exclude each market risk covered position for
which it is not able to apply the standardized approach or the internal
models approach, as applicable, from the respective components of
IMATotal \299\ As the fallback capital requirement would only apply in
instances where a banking organization is not able to apply the
internal models approach and the standardized approach to calculate
market risk capital requirements, the agencies consider that applying a
separate capital treatment for such positions is appropriate to ensure
that they are conservatively incorporated into the market risk capital
requirement.
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\299\ The respective components of IMAtotal are: IMAG,A, SAU,
SAall desks, SAG,A, SAi (as part of the PLA add-on calculation), the
capital add-on for certain securitization and correlation trading
positions or equity positions in an investment fund on model-
eligible trading desks, and any additional capital requirement
established by the primary Federal supervisor. See section
III.H.8.b. of this Supplementary Information for further discussion
of each of these components. Also, see section III.H.6.d of this
Supplementary Information for further discussion on the capital add-
on for certain securitization and correlation trading positions held
on model-eligible desks.
---------------------------------------------------------------------------
Similar to the capital requirement for de minimis exposures in
subpart F of the capital rule, the fallback capital requirement would
equal the sum of the absolute fair value of each position subject to
the fallback capital requirement, unless the banking organization
receives prior written approval from its primary Federal supervisor to
use an alternative method to quantify the market risk capital
requirement for such positions.
Question 104: The fair value for derivative positions may
materially underestimate the exposure since the fair value of
derivatives is generally lower than the derivatives' potential exposure
(for example, fair value of a derivative swap contract is generally
zero at origination). Is the fallback capital requirement based on the
absolute fair value of the derivative positions appropriate? What could
be alternative methodologies for the fallback capital requirements for
derivatives (for example, the absolute value of the adjusted notional
amount or the effective notional amount of derivatives as defined in
the standardized approach for counterparty credit risk (SA-CCR)? What,
if any, alternative techniques would more appropriately measure the
market risk associated with market risk covered positions for which the
standardized approach cannot be applied?
d. Re-Designations and Other Capital Add-Ons
To reflect the proposed definition of market risk covered position,
the proposal would require a banking organization to have clearly
defined policies and procedures for identifying positions that are
market risk covered positions and those that are not, as well as for
determining whether, after such initial designation, a position needs
to be re-designated.\300\
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\300\ See section III.H.5.a of this Supplementary Information.
---------------------------------------------------------------------------
A position's effect on risk-weighted assets can vary based on
whether it is a market risk covered position. Therefore, to offset any
potential capital benefit that otherwise might be received from re-
classifying a position, the proposal would introduce the capital add-on
requirement as a penalty for any re-designation. With prior written
approval from its primary Federal supervisor, the proposal would not
require a banking organization to apply the penalty to re-designations
arising from circumstances that are outside of the banking
organization's control (for example, changes in accounting standards or
in the characteristics of the instrument itself, such as an equity
being listed or de-listed). The agencies expect re-designations to be
extremely rare, and recognize that re-designations could occur, for
example, due to the termination of a business activity applicable to
the instrument. Given the very limited circumstances under which re-
designations would occur, any re-designation would be irrevocable,
unless the banking organization receives prior approval from its
primary Federal supervisor.
To calculate the capital add-on for a re-designation, a banking
organization would be required to calculate the total capital
requirements for the re-designated positions under subparts D, E (if
applicable), and F of the capital rule before and immediately after the
re-designation of a position. The proposal would require a banking
organization that is subject to subpart D of the capital rule to
calculate its total capital requirements separately under subpart D of
the capital rule and under the market risk capital requirements before
and immediately after the re-designation. If the total capital
requirement is lower as a result of the re-designation, then the
difference between the two would be the capital add-on for the re-
designation. In cases when a banking organization is also subject to
subpart E of the capital rule, the proposal would require the banking
organization to calculate total capital requirements separately under
subpart D of the capital rule and subpart E of the capital rule and
under the market risk capital requirements before and immediately after
the re-designation. If the total capital requirement is lower as a
result of the re-designation, then the difference would be the capital
add-on for the re-designation. As such, the proposal would require the
banking organization to apply a capital add-on for re-designated
positions in situations when such re-designations result in any
[[Page 64112]]
capital reduction under the market risk capital requirements.
The proposal would require a banking organization to calculate the
capital add-on requirement at the time of the re-designation. A banking
organization could reduce or eliminate the capital add-on as the
instrument matures, pays down, amortizes, or expires, or the banking
organization sells or exits (in whole or in parts) the position.
Under the standardized measure for market risk, the capital add-on
would include the capital add-on for re-designations. Under the models-
based measure for market risk, the capital add-on would include the
capital add-on for re-designations, as well as add-ons for any
securitization and correlation trading positions, or equity positions
in an investment fund, where a banking organization is not able to
identify the underlying positions held by an investment fund on a
quarterly basis on model-eligible trading desks, provided such
positions are not subject to the fallback capital requirement.
Specifically, for securitization and correlation trading positions and
equity positions in an investment fund, where a banking organization
cannot identify the underlying positions, on model-eligible trading
desks, the models-based measure for market risk includes a capital add-
on equal to the risk-based capital requirement for such positions
calculated under the standardized approach.
Question 105: What, if any, operational challenges could the
proposed capital add-on calculation pose? What, if any, changes should
the agencies consider making to the proposed exceptions to the capital
add-on, such as to address additional circumstances in which the
capital add-ons for re-designations should not apply, and why?
7. Standardized Measure for Market Risk
Under the proposal, the standardized measure for market risk would
consist of the standardized approach capital requirement and three
additional components that would apply in more limited instances to
specific positions: the fallback capital requirement, the capital add-
on requirement for re-designations and any additional capital
requirement established by the primary Federal supervisor.\301\ The
proposal would require a banking organization to calculate the
standardized measure for market risk at least weekly.
---------------------------------------------------------------------------
\301\ See sections III.H.6.c and III.H.6.d of this Supplementary
Information for a more detailed discussion on the fallback capital
requirement and the capital add-on requirement for re-designations,
respectively.
---------------------------------------------------------------------------
a. Sensitivities-Based Method (SBM)
Conceptually, the proposed sensitivities-based method is similar to
a simple stress test where a banking organization estimates the change
in value of its market risk covered positions by applying standardized
shocks to relevant market risk covered positions. The sensitivities-
based method uses risk weights that represent the standardized shocks
with each prescribed risk weight calibrated to a defined liquidity time
horizon consistent with the expected shortfall measurement framework
under stressed conditions. To help ensure consistency in the
application of risk-based capital requirements across banking
organizations, the proposal would establish the following process to
determine the sensitivities-based capital requirement for the
portfolio: (1) assign market risk covered positions to risk classes and
establish the risk factors for market risk covered positions within the
same risk class; (2) describe the method to calculate the sensitivity
of a market risk covered position for each of the prescribed risk
factors; (3) describe the shock applied to each risk factor, and (4)
describe the process for aggregating the weighted sensitivities within
each risk class and across risk classes.
Under the proposal, a banking organization would assign each market
risk covered position to one or more risk buckets within appropriate
risk classes for the position. The seven prescribed risk classes, based
on standard industry classifications, are interest rate risk, credit
spread risk for non-securitization positions, credit spread risk for
correlation trading positions, credit spread risk for securitization
positions that are not correlation trading positions, equity risk,
commodity risk, and foreign exchange risk. The risk buckets represent
common risk characteristics of a given risk class in recognition that
positions sharing such risk characteristics are highly correlated and
therefore affect the value of a market risk covered position in
substantially the same manner. Further, the proposed risk buckets
correspond to common industry practice as large trading banking
organizations often use bucketing structures similar to those set forth
in the proposal.
Once the risk buckets are identified for a position, the bank would
have to map the positions to the appropriate risk factors within the
risk bucket. For example, the price of a typical corporate bond
fluctuates primarily due to changes in interest rates and issuer credit
spreads. Therefore, a position in a corporate bond would be placed in
two separate risk classes, one for interest rate risk and one for
credit spread risk for non-securitization positions.\302\ For positions
within the credit spread risk class, a banking organization would group
the corporate bond position and other positions with similar credit
quality and operating in the same sector together in one risk bucket.
Further, the banking organization would apply the proposed risk factors
to each position within that bucket based on credit spread curves and
tenors of each position. All market risk covered positions would be
assigned to risk buckets within risk classes and mapped to risk factors
based on that assignment.
---------------------------------------------------------------------------
\302\ Under the proposal, a banking organization would have to
separately calculate the potential losses arising from the
position's sensitivity to changes in interest rates and changes in
the issuer's credit spread.
---------------------------------------------------------------------------
For each risk bucket, the proposed risk factors reflect the
specific market variables that impact the value of a position. The risk
factors are separately defined to measure their individual impact on
market risk covered positions' value from small changes in the value of
a risk factor (the movement in price (delta) and, where applicable, the
movement in volatility (vega)), and the additional change in the
positions' value not captured by delta for each relevant risk factor
(curvature) in stress.\303\
---------------------------------------------------------------------------
\303\ Vega and curvature risk estimates are required for
instruments with optionality or embedded prepayment option risk. For
example, for an equity option, the proposed delta risk factor
(equity spot price) would capture the impact on the option's value
from changes in the equity spot price, the proposed vega risk factor
(implied volatility) would capture the impact from changes in the
implied volatility, and the proposed curvature risk factors (equity
spot prices for the issuer) would capture other higher-order factors
from nonlinear risks.
---------------------------------------------------------------------------
Under the proposal, a banking organization would calculate the
sensitivity of a market risk covered position as prescribed under the
proposal to each of the proposed risk factors for delta, vega, and
curvature, as applicable. The proposed sensitivity calculations for
delta, vega, and curvature risk factors are intended to estimate how
much a market risk covered position's value might change as a result of
a specified change in the risk factor, assuming all other relevant risk
factors remain constant. For each risk factor, the banking organization
would sum the resulting delta sensitivities (and separately the vega
and curvature sensitivities) for all market risk covered positions
within the same risk bucket to produce a net sensitivity for each risk
factor, which is
[[Page 64113]]
the potential value impact on all of the banking organization's market
risk covered positions in the risk bucket as a result of a uniform
change in a risk factor.\304\
---------------------------------------------------------------------------
\304\ The proposed risk factors are intended to be sufficiently
granular such that only long and short exposures without basis risk
would be able to fully offset for purposes of calculating the net
sensitivity to a risk factor. For example, by defining the risk
factors for equity risk at the issuer level, the proposal would
allow long and short equity risk exposures to the same issuer to
fully offset for purposes of calculating the net equity risk factor
sensitivity, but only partially offset (correlations less than one)
for exposures to different issuers with the same level of market
capitalization, the same type of economy, and the same market sector
(such as those within the same equity risk bucket).
---------------------------------------------------------------------------
To capture how much the risk factor might change over a defined
time horizon in stress conditions and how that would change the value
of the market risk covered position, a banking organization would
multiply the net delta sensitivity and the net vega sensitivity,
respectively, to each risk factor within the risk bucket by the
proposed standardized risk weight for the risk bucket. The proposed
risk weights are intended to capture the amount that a risk factor
would be expected to move during the liquidity horizon of the risk
factor in stress conditions.\305\ To capture curvature risk, a banking
organization would be required to aggregate the incremental loss above
the delta capital requirement from applying larger upward and downward
shock scenarios to each risk factor.
---------------------------------------------------------------------------
\305\ The prescribed risk weights represent the estimated change
in the value of the market risk covered position as a result of a
standardized shock to the risk factor based on characteristics of
the position and historic price movements. Additionally, the
proposed risk weights are intended to help ensure comparability with
the proposed internal models approach described in section III.H.8
of this Supplementary Information, which generally would require
banking organizations' internal models to follow a methodology
similar to the one used to calibrate the risk weights when
determining risk-based requirements for market risk covered
positions under the standardized approach.
---------------------------------------------------------------------------
To account for the potential price impact of interactions between
the risk factors, the proposal would prescribe aggregation formulas for
calculating the total delta, vega, and curvature capital requirements
within risk buckets and across risk buckets. Specifically, the risk-
weighted sensitivities for delta, vega, and curvature risk,
respectively, first would be summed for a risk factor, then aggregated
across risk factors with common characteristics within their respective
risk buckets to arrive at bucket-level risk positions. These bucket-
level risk positions would then be aggregated for each risk class using
the prescribed aggregation formulas to produce the respective delta,
vega, and curvature risk capital requirements.
The aggregation formulas prescribe offsetting and diversification
benefits via correlation parameters. Under the proposal, the
correlation parameters specified for each risk factor pair are intended
to limit the risk-mitigating benefit of hedges and diversification,
given that the hedge relationship between an underlying position and
its hedge, as well as the relationship between different types of
positions, could decrease or become less effective in a time of stress.
Specifically, taking into account prescribed correlation parameters,
the banking organization would need to calculate the aggregate
requirements first within a risk bucket and then across risk buckets
within one risk class to produce the risk class-level capital
requirement for delta, vega, and curvature risk. The resulting capital
requirements for delta, vega, and curvature risk then would be summed
across risk classes, respectively, with no recognition of any
diversification benefits because in stress diversification across
different risk classes may become less effective.
To capture the potential for risk factor correlations to increase
or decrease in periods of stress, the calculation of risk bucket-level
capital requirements and risk class-level capital requirements for each
risk class would be repeated corresponding to three different
correlation scenarios--assuming high, medium and low correlations
between risk factor shocks--in order to calculate the overall delta,
vega, and curvature capital requirements for all risk classes to
determine the overall capital requirement for each scenario. The
prescribed correlation parameters in the intra-bucket and inter-bucket
aggregation formulas would be those used in the medium correlation
scenario. For the high and low correlation scenarios, a banking
organization generally would increase and decrease the medium
correlation parameters by 25 percent, respectively, to appropriately
reflect the potential changes in the historical correlations during a
crisis.\306\
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\306\ As the degree to which a pair of variables are linearly
related (the correlation) can only range from negative one to one,
the proposal would cap the correlation parameters under the high
scenario at no more than one (100 percent) and floor those under the
low scenario at no less than negative one. For highly correlated
positions, the low correlation scenario also would not always reduce
the correlation parameter by 25 percent.
---------------------------------------------------------------------------
Finally, to determine the overall capital requirements for each of
the three correlation scenarios, the banking organization would sum the
separately calculated delta, vega, and curvature capital requirements
for all risk classes without recognition of any diversification
benefits, given that delta, vega, and curvature are intended to
separately capture different risks. The sensitivities-based capital
requirement would be the largest capital requirement resulting from the
three scenarios.
Question 106: The agencies seek comment on the sensitivities-based
method for market risk. To what extent does the sensitivities-based
method appropriately capture the risks of positions subject to the
market risk capital requirement? What additional features, adjustments
(such as to the treatment of diversification of risks), or alternative
methodology could the sensitivities-based method include to reflect
these risks more appropriately and why? Commenters are encouraged to
provide supporting data.
i. Risk Factors
Under the proposal, a banking organization would be required to map
all market risk covered positions within each risk class to the
specified risk factors in order to calculate the capital requirements
for delta, vega, and curvature. The proposed risk factors differ for
each risk class to reflect the specific market risk variables relevant
for each risk class (for example, no tenor is specified for the delta
risk factor for equity risk as equities do not have a stated maturity,
whereas the proposed tenors for credit spread delta risk reflect the
common maturities of positions within those risk classes). The granular
level at which the proposed risk factors would be defined is intended
to promote consistency and comparability in regulatory capital
requirements across banking organizations and to help ensure the
appropriate capitalization of market risk covered positions.
For risk classes that include specific tenors or maturities as risk
factors (for example, delta risk factors for interest rate risk), the
proposal would require a banking organization to assign the risk
factors to the proposed tenors through linear interpolation or a method
that is most consistent with the pricing functions used by the internal
risk management models. The banking organization's internal risk
management models, which are used by risk control units and reviewed by
auditors and regulators, would provide an appropriate basis for
determining regulatory capital requirements, without imposing the
operational burden of the time-consuming methods used by the front-
office models. Additionally, relying on banking organizations'
[[Page 64114]]
internal risk management models, rather than the front-office models,
to identify the relevant risk factors would help ensure that a control
function that is independent of business-line management would
determine the regulatory capital requirement for market risk.
I. Interest Rate Risk
Under the proposal, the delta risk factors for interest rate risk
would be separately defined for each currency along two dimensions:
tenor and interest rate curve. To value market risk covered positions
with interest rate risk, the proposal would require a banking
organization to construct and use interest rate curves for the currency
in which interest rate-sensitive market risk covered positions are
denominated (for example, interest rate curves from the overnight index
swap curve (OIS) or an alternative reference rate curve). The proposal
would require each of these curves to be treated as a distinct interest
rate curve due to the basis risk between them. Similarly, under the
proposal, a banking organization would be required to treat an onshore
currency curve (for example, locally traded contracts) and an offshore
currency curve (for example, contracts with the same maturity that are
traded outside the local jurisdiction) as two distinct curves. A
banking organization would be allowed to treat such curves as a single
curve only with the prior written approval from its primary Federal
supervisor.
As interest rate curves incorporate nominal inflation, an
additional delta risk factor would be required for instruments with
cash flows that are functionally dependent on a measure of inflation
(such as TIPS) to appropriately account for inflation risk.
Furthermore, the proposal would require an additional delta risk factor
for instruments with cash flows in different currencies to
appropriately reflect the cross-currency basis risk of each currency
over USD or EUR.\307\ Under the proposal, a banking organization would
not recognize the term structure when measuring delta capital
requirements for inflation risk and cross-currency basis risk.
Additionally, a banking organization would be required to consider the
inflation risk factor and the cross-currency basis risk factor, if
applicable, in addition to the sensitivity for the other delta risk
factors for the interest rate risk (currency, tenor and interest rate
curve) of the market risk covered position. Accordingly, a banking
organization would be required to allocate the sensitivities for
inflation risk and cross-currency basis risk in the relevant interest
rate curve for the same currency as other interest rate risk factors.
---------------------------------------------------------------------------
\307\ Cross-currency basis is a basis added to a yield curve in
order to evaluate a swap for which the two legs are paid in two
different currencies. Market participants use cross currency basis
to price cross currency interest rate swaps paying a fixed or a
floating leg in one currency, receiving a fixed or a floating leg in
a second currency, and including an exchange of the notional amount
in the two currencies at the start date and at the end date of the
swap.
---------------------------------------------------------------------------
The vega risk factors for interest rate risk would be the implied
volatilities of options referencing the interest rate of the underlying
instrument. The implied volatilities of inflation rate risk-sensitive
options and cross-currency basis risk-sensitive options would be
defined along the maturity of the option, whereas the implied
volatilities of interest-rate risk-sensitive options would be defined
along two dimensions: the maturity of the option and the residual
maturity of the underlying instrument at the expiration date of the
option. For example, a banking organization would calculate the vega
sensitivity of a European interest rate swaption that expires in 12
months referring to a one-year swap based on the maturity of the option
(12 months) as well as the residual maturity of the underlying
instrument (the swap's maturity of 12 months).
The proposal would define the curvature risk factors for interest
rate risk along one dimension: the interest rate curve of each currency
(no term structure would be considered).
Question 107: The agencies seek comment on the appropriateness of
requiring banking organizations with material exposure to emerging
market currencies to construct distinct onshore and offshore curves.
What, if any, operational burden may arise from such requirement and
why?
II. Credit Spread Risk
The proposal would separately define the credit spread risk factors
for non-securitization positions,\308\ securitization positions that
are not correlation trading positions (securitization positions non-
CTP), and correlation trading positions. The proposal would define the
delta risk factors for credit spread risk for non-securitization
positions along two dimensions: the credit spread curve of a relevant
issuer and the tenor of the position; the delta risk factors for credit
spread risk for securitization positions non-CTP would be defined also
along two dimensions: the credit spread curve of the tranche and the
tenor of the tranche; and the delta risk factors for credit spread risk
for correlation trading positions would be defined along two
dimensions: the credit spread curve of the underlying name and the
tenor of the underlying name. Under the proposal, the vega risk factors
for credit spread risk are the implied volatilities of options
referencing the credit spreads,\309\ defined along one dimension: the
option's maturity.
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\308\ Under the proposal, a non-securitization position would be
defined as a market risk 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.
\309\ When calculating the sensitivity for securitization
positions non-CTP, a banking organization would calculate the
sensitivities for credit spread risk based on the embedded
subordination of the position, such as the spread of the tranche.
For correlation trading positions, the credit spread risk
sensitivity would be based on the underlying names in the
securitization position, or nth-to-default position.
---------------------------------------------------------------------------
The proposal would define the curvature risk factors for credit
spread risk for non-securitization positions along one dimension: the
credit spread curves of the issuer. The curvature risk factors for
credit spread risk for securitization positions non-CTP would be
defined along the relevant tranche credit spread curves of bond and
CDS, while for correlation trading positions along the bond and CDS
credit spread curve of each underlying name. The agencies recognize
that requiring a banking organization to estimate the bond-CDS basis
for each issuer would impose a significant operational burden with
limited benefit in terms of risk capture. To simplify the
sensitivities-based-method calculation for curvature risk in these
cases, the proposal would require banking organizations to ignore any
bond-CDS basis that may exist between the bond and CDS spreads and to
calculate the credit spread risk sensitivity as a single spread curve
across the relevant tenor points.
III. Equity Risk
Similar to interest rate risk, the delta risk factors for equity
risk would be separately defined for each issuer as the spot prices of
each equity (for example, for cash equity positions) and an equity repo
rate (for example, for term repo-style transactions), as appropriate.
Under the proposal, the vega risk factors for equity risk would be the
implied volatilities of options referencing the equity spot price,
defined along the maturity of the option. The curvature risk factors
for equity risk would be the equity spot price. There are no curvature
risk factors for equity repo rates.
[[Page 64115]]
IV. Commodity Risk
Similar to interest rate and equity risk, the delta risk factors
for commodity risk would be separately defined for each commodity type
\310\ along two dimensions: the contracted delivery location of the
commodity and the remaining maturity of the contract. A banking
organization could only treat separate contracts as having the same
delivery location if both contracts allow delivery in all of the same
locations.\311\ Additionally, the proposal would follow the established
pricing convention for commodities and require a banking organization
to use the remaining maturity of the contract to measure the delta
sensitivity for instruments with commodity risk. As the price impact of
risk factor changes varies significantly between different types of
commodities, the proposal would define the delta risk factors for each
commodity type to limit offsetting across commodity types, as such
offsetting could drastically understate the potential losses arising
from those positions.
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\310\ Under the proposal, any two commodities would be
considered distinct if the underlying commodity to be delivered
would cause the market to treat the two contracts as distinct (e.g.,
West Texas Intermediate oil and Brent oil).
\311\ For example, a contract that can be delivered in four
ports may have less sensitivity to each location defined risk factor
than a contract that can only be delivered in three of those ports.
If a banking organization has entered into a contract to deliver
1000 barrels of oil in port A, B, C or D, and a hedge contract to
receive 1000 barrels of oil on the same date in port A, B or C, if
on delivery day ports A, B and C are closed, the banking
organization is exposed to commodity risk in that it must deliver
1000 barrels of oil to port D without receiving 1000 barrels. As a
result, the two contracts would have different sensitivity to
location defined risk factors.
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To measure the price sensitivity of a commodity market risk covered
position, the proposal would require a banking organization to use
either the spot price or the forward price, depending on which risk
factor is used by the internal risk management models to price
commodity transactions. For example, if the internal risk management
model typically values electricity contracts based on forward prices
(rather than spot prices), the proposal would require the banking
organization to compute the delta capital requirement using the current
prices for futures and forward contracts. Similar to equity risk, the
proposal would define the commodity vega risk factors based on the
implied volatilities of commodity-sensitive options as defined along
the maturity of the option and the curvature risk factors based on the
constructed curve per commodity spot price.
Question 108: What, if any, risk factors would better serve to
appropriately capture the delta sensitivity for positions within the
commodity risk class and why?
V. Foreign Exchange Risk
The proposal would define the delta risk factors for foreign
exchange risk as the exchange rate between the currency in which the
market risk covered position is denominated and the reporting currency
of the banking organization. For market risk covered positions that
reference two currencies other than the reporting currency, the banking
organization generally would be required to calculate the delta risk
factors for foreign exchange risk using the exchange rates between each
of the non-reporting currencies and the reporting currency. For
example, for a foreign exchange forward referencing EUR/JPY, the
relevant risk factors for a USD-reporting banking organization to
consider would be the exchange rates for USD/EUR and USD/JPY.
To reduce operational burden and help ensure the delta capital
requirements reflect foreign exchange risk, the proposal would also
allow a banking organization to calculate delta risk factors for
foreign exchange risk relative to a base currency instead of the
reporting currency, if approved by the primary Federal supervisor.\312\
In this case, after designating a single currency as the base currency,
a banking organization would calculate the foreign exchange risk for
all currencies relative to the base currency, and then convert the
foreign exchange risk into the reporting currency using the spot
exchange rate (reporting currency/base currency). For example, if a
USD-reporting banking organization receives approval to calculate
foreign exchange risk using JPY as the base currency, for a foreign
exchange forward referencing EUR/JPY, the banking organization would
consider separate deltas for the EUR/JPY exchange rate risk and USD/JPY
foreign exchange translation risk and then translate the resulting
capital requirement to USD at the USD/JPY spot exchange rate.
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\312\ A banking organization would have to demonstrate to its
primary Federal supervisor that calculating foreign exchange risk
relative to its base currency provides an appropriate risk
representation of the banking organization's market risk covered
positions and that the foreign exchange risk between the base
currency and the reporting currency is addressed. In general, the
base currency would be the functional currency in which the banking
organization generates or expends cash. For example, a multinational
banking organization headquartered in the United States that
primarily transacts in and uses EUR to value its assets and
liabilities for internal accounting and risk management purposes
could use EUR as its base currency. As its consolidated financial
statement must be reported in USD, this multinational banking
organization would need to translate the value of those assets and
liabilities from the base currency (EUR) to the reporting currency
(USD). Since exchange rates fluctuate continuously, this conversion
could increase or decrease the value of those assets and liabilities
and thus generate foreign exchange gains (or losses) from non-
operating activity.
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The proposal would define the vega risk factors for foreign
exchange risk as the implied volatility of options that reference
exchange rates between currency pairs along one dimension: the maturity
of the option. For curvature, the foreign exchange risk factors would
be all exchange rates between the currency in which a market risk
covered position is denominated and the reporting currency (or the base
currency, if approved by the primary Federal supervisor).
The proposal would allow (but not require) a banking organization
to treat a currency's onshore exchange rate and an offshore exchange
rate as two distinct risk factors in the delta, vega and curvature
calculations for foreign exchange risk. While in stress the foreign
exchange risk posed by a currency's onshore exchange rate and an
offshore exchange rate may differ, as U.S. banking organizations
generally do not have material exposure to foreign exchange risk from a
currency's onshore and offshore basis, the prudential benefit of
requiring banking organizations to capture risk posed by such basis
would be limited, relative to the potential compliance burden.
Therefore, the agencies are proposing to allow, but not require,
banking organizations with material exposure to emerging market
currencies to recognize the different foreign exchange risks posed by
onshore and offshore exchange rate curves when calculating risk-based
capital requirements under the sensitivities-based method.
ii. Risk Factor Sensitivities
A fundamental element of the sensitivities-based method is the
sensitivity calculation, which estimates the change in the value of a
market risk covered position as a result of a regulatorily prescribed
change in the value of a risk factor, assuming all other risk factors
are held constant. To help ensure consistency and conservatism across
banking organizations, the proposal would set requirements on the
valuation models, currency, inputs, and sensitivity calculation, as
applicable, that a banking organization could use to measure the risk
factor sensitivity of a market risk covered position.
In general, the proposal would require a banking organization to
calculate risk factor sensitivities using the valuation
[[Page 64116]]
models used to report actual profits and losses for financial reporting
purposes.\313\ The valuation methods used by such models would provide
an appropriate basis for determining risk-based capital requirements
because such models are subject to requirements intended to enhance the
accuracy of the financial data produced by the models.\314\ The
agencies recognize that a banking organization can calculate risk
sensitivities for delta and vega or estimate curvature using valuation
methods and systems from equivalent internal risk management models.
The proposal would permit a banking organization with prior approval of
the primary Federal supervisor to calculate delta and vega
sensitivities and curvature scenarios using the valuation methods used
in its internal risk management models.
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\313\ Banking organizations would be required to have a prudent
valuation process, including the independent validations of the
valuation models used in the standardized approach.
\314\ Such requirements include the requirements from the
Sarbanes-Oxley Act of 2002. Public Law 107-204.
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For consistency and comparability in risk-based capital
requirements across banking organizations, the proposal would require
each banking organization to calculate all risk factor sensitivities in
the reporting currency of the banking organization, except for the
foreign exchange risk class where, with prior approval of the primary
Federal supervisor, the banking organization may calculate the
sensitivities relative to a base currency instead of the reporting
currency. To appropriately capture a banking organization's exposure to
market risk, the proposal would require banking organizations to use
fair values that exclude CVA in the calculation of risk factor
sensitivities.
I. Delta
Under the proposal, a banking organization would calculate the
delta capital requirement using the steps previously outlined in
section III.H.7.a of this Supplementary Information for its market risk
covered positions except those whose value exclusively depends on risk
factors not captured by any of the proposed risk classes (exotic
exposures).\315\ The proposal would require a banking organization to
separately calculate the market risk capital requirements for such
positions under the residual risk add-on as described in section
III.H.7.c of this SUPPLEMENTARY INFORMATION.
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\315\ Examples of exotic exposures not captured by any of the
proposed risk classes include but are not limited to longevity,
weather, and natural disasters derivatives.
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For purposes of calculating the delta capital requirement, the
proposal would require a banking organization to calculate the delta
sensitivity of a position using the sensitivity definitions provided in
the proposal for each risk factor and the valuation models used for
financial reporting, unless a banking organization receives prior
written approval to define delta sensitivities based on internal risk
management models.\316\ Based on the proposed sensitivity definitions,
the delta sensitivity would reflect the change in the value of a market
risk covered position resulting from a small specified shift of one
basis point or one percent change to a risk factor, assuming all other
relevant risk factors are held at the current level, divided by the
same specified shift to the risk factor.
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\316\ The proposal would define internal risk management models
as the valuation models that the independent risk control unit
within the banking organization uses to report market risks and
risk-theoretical profits and losses to senior management.
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For the equity spot price, commodity, and foreign exchange risk
factors, the delta sensitivity would equal the change in value of a
market risk covered position due to a one percentage point increase in
the risk factor divided by one percentage point. For the interest rate,
credit spread, and equity repo rate risk factors, the delta sensitivity
would equal the change in value of a market risk covered position due
to a one basis point increase in the risk factor divided by one basis
point. In the case of credit spread risk for securitizations non-CTP, a
banking organization would calculate the delta sensitivity for the
positions with respect to the credit spread of the tranche rather than
the credit spread of the underlying positions. For credit spread risk
for correlation trading positions, the delta sensitivity for credit
spread risk would be computed using a one basis point shift in the
credit spreads of the individual underlying names of the securitization
position or nth-to-default position.
When calculating the delta sensitivity for positions with
optionality, a banking organization would apply either the sticky
strike rule,\317\ the sticky delta rule,\318\ or, with the prior
approval from its primary Federal supervisor, another assumption.\319\
Each of these methods, or various combinations of such methods, would
measure appropriately the sensitivity of a risk factor within any of
the risk classes.
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\317\ Under the sticky strike rule, a banking organization would
assume that the implied volatility for an option remains unaffected
by changes in the underlying asset price for any given strike pprice.
\318\ Under the sticky delta rule, the banking organization
would assume that the implied volatility for a particular maturity
depends only on the ratio of the price of the underlying asset to
the strike price (sometimes called the moneyness of the option).
\319\ With prior approval from the primary Federal supervisor, a
banking organization could calculate risk factor sensitivities based
on internal risk management models provided the method would be most
consistent with the valuation methods.
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II. Vega
For market risk covered positions with optionality, the vega
sensitivity to a risk factor would equal the vega of an option
multiplied by the volatility of the option, which represents
approximately the change in the option's value as the result of a one
percentage point increase in the value of the option's volatility. To
measure the vega sensitivity of a market risk covered position, the
proposal would require a banking organization to use either the at-the-
money volatility of an option or the implied volatility of an option,
depending on which is used by the valuation models used for financial
reporting \320\ to determine the intrinsic value of volatility in the
price of the option.
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\320\ With the prior approval of the primary Federal supervisor,
a banking organization could use the type of volatility used in the
internal risk management models.
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The vega capital requirement would only apply to options or
instruments with embedded optionality, including instruments with
material prepayment risk. For purposes of calculating the vega capital
requirement, a banking organization would follow the steps previously
outlined and use the same risk buckets applied in the delta capital
calculation and the proposed vega risk weights.
Callable and puttable bonds that are priced based on the yield to
maturity of the instrument would not be subject to the vega capital
requirement. The agencies recognize that in practice a banking
organization may not be able to calculate vega risk for callable and
puttable bonds, as implied volatility for credit spread typically is
not used as an input for the pricing of such instruments, and thus
implied volatility is not captured by the internal models. Therefore,
the agencies are proposing to allow banking organizations to exclude
from the vega capital requirement callable and puttable bonds that are
priced based on the yield to maturity of the instrument, as the delta
capital requirement in these cases would be sufficiently conservative
to capture the potential vega risk arising from such exposures.
To calculate the vega sensitivity, the proposal would require a
banking
[[Page 64117]]
organization to assign options to buckets based on their maturity. As
the proposal defines the vega risk factors for interest rate risk along
two dimensions: the maturity (or expiry) of the option and the maturity
of the option's underlying instrument--a banking organization would be
required to group options within the interest rate risk class along
both of these two dimensions. To help ensure appropriately conservative
capital requirements, the proposal would require a banking organization
to (1) assign instruments with optionality that either do not have a
stated maturity (for example, cancellable swaps) or that have an
undefined maturity to the longest prescribed maturity tenor for vega,
and (2) subject such instruments to the residual risk add-on, as
described in section III.H.7.c of this SUPPLEMENTARY INFORMATION.
Similarly, for options that do not have a stated strike price or that
have multiple strike prices, or that are barrier options, the proposal
would require a banking organization to apply the maturity and strike
price used in its valuation models for financial reporting, unless the
banking organization has received approval to use internal risk
management models, to value the position and apply a residual risk add-
on.\321\ The agencies are proposing these constraints as a simple and
conservative approach for market risk covered positions that are
difficult to value in practice.
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\321\ Tranches of correlation trading positions that do not have
an implied volatility would not be subject to the vega risk capital
requirement. Such instruments would not be exempt from delta and
curvature capital requirements.
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Question 109: As the pricing conventions for certain products (for
example, callable and puttable bonds) do not explicitly use an implied
volatility, the agencies seek comment on the merits of allowing banking
organizations to ignore the optionality of callable and puttable bonds
that are priced using yield-to-maturity of the instrument if the option
is not exercised relative to the merits of specifying a value for
implied volatility (for example, 35 percent) to be used in calculating
the vega capital requirement for credit spread risk positions when the
implied volatility cannot be measured or is not readily available in
the market. What are the benefits and drawbacks of specifying a value
for the implied volatility for such products and what should the
specified value be set to and why? What, if any, alternative approaches
would better serve to appropriately capture the vega sensitivity for
positions within the credit spread risk class when the implied
volatility is not available?
Question 110: The agencies solicit comment on the appropriateness
of relying on a banking organization's internal pricing methods for
determining the maturity and strike price of positions without a stated
strike price or with multiple strike prices. What, if any, alternative
approaches (such as using the average maturity of options with multiple
exercise dates) would better serve to promote consistency and
comparability in risk-based capital requirements across banking
organizations? What are the benefits and drawbacks of such alternatives
compared to the proposed reliance on the internal pricing models of
banking organizations?
III. Curvature
The proposed curvature capital requirements are intended to capture
the price risks inherent in instruments with optionality that are not
already captured by delta (for example, the change in the value of an
option that exceeds what can be explained by the delta of the option
alone). Under the proposal, only options or positions that contain
embedded optionality, including positions with material prepayment
risk, which present material price risks not captured by delta, would
be subject to the curvature capital requirement. While linear
instruments may also exhibit a certain degree of non-linearity, it is
not always material for such instruments. Therefore, to allow for a
more accurate representation of risk, the proposal would permit a
banking organization, at its discretion, to make an election for a
trading desk \322\ to include instruments without optionality risk in
the curvature capital requirement, provided that the trading desk
consistently includes such positions through time.
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\322\ For a banking organization that has established a trading
desk structure with a single trading desk that uses the standardized
measure to calculate market risk capital requirements, the proposal
would allow such banking organization to make such an election for
the entire organization rather than on a trading desk by trading
desk basis. If such an election is made at the enterprise-wide
level, the proposal would require the banking organization to
consistently include positions without optionality within the
curvature calculation.
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The proposal would require a banking organization to use the same
risk buckets applied in the delta capital calculation to calculate
curvature capital requirements. To calculate the risk-weighted
sensitivity for each curvature risk factor within a risk bucket, the
proposal would require a banking organization to fully revalue all of
its market risk covered positions with optionality or that a banking
organization has elected to include in the calculation of its curvature
capital requirement after applying an upward shock and a downward shock
to the current value of the market risk covered position. To avoid
double counting, the banking organization would calculate the
incremental loss in excess of that already captured by the delta
capital requirement for all market risk covered positions subject to
the curvature capital requirements. The larger incremental loss
resulting from the upward and the downward shock would be the curvature
risk-weighted sensitivity.\323\ The below graphic provides a conceptual
illustration of the calculation of the curvature risk-weighted
sensitivity based on the upward and the downward shock scenarios.
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\323\ To promote consistency and comparability in regulatory
capital requirements across banking organizations, the proposal
would require that in cases where the incremental loss resulting
from the upward and the downward shock is the same, the banking
organization must select the scenario in which the sum of the
capital requirements of the curvature risk factors is greater.
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[[Page 64118]]
[GRAPHIC] [TIFF OMITTED] TP18SE23.031
In calculating the curvature risk-weighted sensitivity for the
interest rate, credit spread, and commodity risk classes, the banking
organization would apply the upward and downward shocks assuming a
parallel shift of all tenors for each curve based on the highest
prescribed delta risk weight for the applicable risk
bucket.324 325 The proposal would require a banking
organization to apply the highest risk weight across risk buckets to
each tenor point along the curve (parallel shift assumption) for
conservatism and to help ensure the curvature capital requirements
reflect incremental losses from curvature and not those due to changes
in the shape or slope of the curve. The proposal would require a
banking organization to perform this calculation at the risk bucket
level (not the risk class level). To the extent that applying the
downward shocks results in negative credit spreads, the proposal would
allow banking organizations to floor credit spreads at zero, which is
the natural floor for credit spreads given that negative CDS spreads
are not meaningful.
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\324\ As described in section III.H.7.a.iii.I of this
SUPPLEMENTARY INFORMATION, the proposed risk bucket structure used
to group the delta risk factors for interest rate risk (and the
corresponding risk weight for each risk bucket) is solely based on
the tenor of market risk covered position. For purposes of
calculating the curvature sensitivity for interest rate risk, the
proposal would require a banking organization to disregard the
bucketing structure and apply the highest prescribed delta risk
weight (the 1.7 percent risk weight applicable to the 0.25-year
tenor, or 1.7 percent divided by [radic]2 if the interest rate curve
references a currency that is eligible for a reduced risk weight) to
all tenors simultaneously for each yield curve.
\325\ As the curvature capital requirements would capture an
option's change in the value above that captured by delta, a banking
organization would calculate the curvature sensitivity to credit
spread risk for securitization positions non-CTP and correlation
trading positions using the spread of the tranche and the spread of
the underlying names, respectively.
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For the foreign exchange and equity risk classes, the upward and
downward shocks represent a relative shift of the foreign exchange spot
prices or equity spot prices, respectively, equal to the delta risk
weight prescribed for the risk factor. The agencies recognize that the
conversion of other currencies into either the reporting currency or
base currency, if applicable, would capture exchange rate fluctuations,
and thus overstate the sensitivity for foreign exchange risk. Thus, for
options that do not reference the reporting or base currency of the
banking organization as an underlying exposure, the proposal would
allow the banking organization to divide the net curvature risk
positions by a scalar of 1.5. The proposal would allow a banking
organization to apply the scalar of 1.5 to all market risk covered
positions subject to foreign exchange risk, provided that the banking
organization consistently applies the scalar to all market risk covered
positions with foreign exchange risk through time.
To aggregate the risk bucket-level capital requirements and risk
class-level capital requirements for curvature, a banking organization
would bifurcate positions into those with positive curvature and those
with negative curvature. For the purposes of calculating risk-based
capital requirements for curvature, positions with negative curvature
represent a capital benefit--as they reduce rather than increase risk
and thus risk-based capital requirements. For example, the downward
shock as depicted in the above graphic produces less of an estimated
price reduction under the curvature scenario than under the linear
delta shock (negative curvature). To prevent negative curvature capital
requirements from decreasing the overall capital required under the
sensitivities-based method, both the intra-bucket and inter-bucket
aggregation formulas would floor the curvature capital requirement at
zero. Additionally, both formulas include a variable \326\ to allow a
banking organization to recognize the risk-reducing benefits of market
risk covered positions with negative curvature in offsetting those with
positive curvature, while preventing the aggregation of market risk
covered positions with negative curvature from resulting in an overall
reduction in capital.
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\326\ Specifically, this refers to the psi variable ([Psi])
within the intra and inter-bucket aggregation formulas in Sec.
__.206(d)(2) and Sec. __.206(d)(3) of the proposed rule.
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Question 111: The agencies solicit comment on the appropriateness
of calculating the curvature risk-weighted sensitivity for the
commodity risk class using the upward and downward shocks assuming a
parallel shift of all tenors for each curve. Would a relative shift be
more appropriate for calculating risk-weighted sensitivity for the
commodity risk class and why?
iii. Risk Buckets and Corresponding Risk Weights
After determining the net sensitivity for each of the proposed risk
factors within each risk class, a banking organization would calculate
the risk-weighted sensitivity by multiplying the
[[Page 64119]]
net sensitivity for each risk factor by the risk weight prescribed for
each risk bucket.\327\ The proposed risk buckets and corresponding risk
weights are largely consistent with the framework issued by the Basel
Committee. However, to reflect the potential systematic risks that
positions may experience in a time of stress and avoid reliance on
external ratings in accordance with U.S. law, the agencies are
proposing to use alternative criteria to define the bucketing structure
for risk factors related to credit spread risk and to clarify the
application of the credit spread risk buckets for certain U.S.
products, as described in section III.H.7.a.iii.II of this
SUPPLEMENTARY INFORMATION.\328\ Additionally, to appropriately reflect
a jurisdiction's stage of economic development, the agencies are
proposing to use objective market economy criteria to define the
bucketing structure for risk factors related to equity risk, as
described in section III.H.7.a.iii.III of this SUPPLEMENTARY
INFORMATION. Furthermore, the agencies are proposing to include
electricity in the same risk bucket as gaseous combustibles in view of
the inherent relationship between the price of electricity and natural
gas and to simplify the proposal, as described in section
III.H.7.a.iii.IV of this SUPPLEMENTARY INFORMATION.
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\327\ Vega and curvature capital requirements would use the same
risk buckets as prescribed for delta. See Sec. __.209(c) and (d) of
the proposed rule. Table 11 to Sec. __.209 of the proposed rule
provides the proposed vega risk weights for each risk class, which
incorporate the liquidity horizons for each risk class (risk of
market illiquidity) from the Basel III reforms.
\328\ See 15 U.S.C. 78o-7 note.
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The proposed risk weight buckets and associated risk weights would
be appropriate to capture the specific, idiosyncratic risks of market
risk covered positions (for example, negative betas or variations in
capital structure). These components of the proposal also are largely
consistent with the Basel III reforms and would promote consistency and
comparability in market risk capital requirements among banking
organizations domestically and across jurisdictions. The sections that
follow describe the proposed risk buckets and associated risk weights
for each risk factor.
I. Interest Rate Risk
Table 1 to Sec. __.209 of the proposed rule sets forth the ten
proposed risk buckets for the interest rate risk factors of market risk
covered positions and the corresponding risk weight applicable to each
risk bucket.\329\ The proposal would require a banking organization to
use separate risk buckets for each currency, for each of ten proposed
tenors to capture most commonly traded instruments across market risk
covered positions held by a banking organization and align with
bucketing structures used by trading firms.
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\329\ The buckets reflect that interest rates at a longer tenor
have less uncertainty and thus lower volatility than interest rates
at a shorter tenor that are more receptive to changes in interest
rate risk.
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By delineating interest rate risk factors based on currency \330\
and tenor, the granularity of the proposed risk buckets is intended to
appropriately balance the risk sensitivity of the proposed framework
with providing consistency in risk-based requirements across banking
organizations by assigning similar risk weights to similar kinds of
positions.
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\330\ As noted in section III.H.7.a.i.I of this SUPPLEMENTARY
INFORMATION, under the proposal, each currency would represent a
separate risk factor for interest rate risk.
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Factors such as the stage of the economic cycle and the role of
exchange rates can cause interest rate risk to diverge significantly
across different currencies, particularly in stress periods.
Accordingly, the proposal would require banking organizations to
establish separate interest rate risk buckets for each currency.
OTC interest rate derivatives for liquid currencies have
significant trading activity relative to non-liquid currencies, which
means a banking organization faces a shorter liquidity horizon to
offload exposure to interest rate risk factors in liquid currencies.
Therefore, the proposal would allow a banking organization to divide
the proposed risk weight applicable to each interest rate risk factor
bucket by the square root of two if the interest rate risk factor
relates to a liquid currency listed in Sec. __.209(b)(1)(i) of the
proposed rule or any other currencies specified by the primary Federal
supervisor. This approach would allow a banking organization to apply a
lower risk weight for purposes of the delta capital requirements for
interest rate risk factors for the listed liquid currencies and any
other currencies specified by the primary Federal supervisor.
II. Credit Spread Risk
Tables 3, 5, and 7 to Sec. __.209 of the proposed rule set forth
the risk buckets and corresponding risk weights for the credit spread
risk factors of non-securitization positions, correlation trading
positions, and securitization positions non-CTP, respectively. Under
the proposal, a banking organization would group the credit spread risk
factors for non-securitization positions, correlation trading
positions, and securitization positions non-CTP into one of nineteen,
seventeen, or twenty-five proposed risk buckets, respectively, based on
market sector and credit quality. The credit quality of a market risk
covered position in a given sector is inversely related to its credit
spread. Accordingly, the risk buckets for credit spread risk consider
the credit quality of a given market risk covered position.
More specifically with respect to the consideration of credit
quality, the agencies are proposing to generally use the same approach
to delta credit spread risk buckets and corresponding risk weights
provided in the Basel III reforms for non-securitization positions,
correlation trading positions, and securitization positions non-CTP,
but to define the risk buckets using alternative criteria to capture
the creditworthiness of the obligor. The delta credit spread risk
buckets in the Basel III reforms are defined based on the applicable
credit ratings of the reference entity. Section 939A of the Dodd-Frank
Act required the agencies to remove references to credit ratings in
Federal regulations.\331\ Therefore, the agencies are proposing an
approach that would allow for a level of risk sensitivity in the delta
credit spread risk buckets and corresponding risk weights applicable to
non-securitizations, correlation trading positions, and securitization
positions non-CTP that would be generally consistent with the Basel III
reforms and not rely on external credit ratings. Specifically, the
agencies are proposing to define the delta credit spread risk buckets
and corresponding risk weights for non-securitizations, correlation
trading positions, and securitization positions non-CTP based on the
definitions for investment grade as defined in the agencies' existing
capital rule \332\ and the definitions of speculative grade \333\ and
sub-speculative grade \334\ as defined in the proposal.
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\331\ 15 U.S.C. 78o-7 note.
\332\ See 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); and 12 CFR
324.2 (FDIC).
\333\ The proposal would define speculative grade to mean that
the entity to which a banking organization is exposed through a loan
or security, or the reference entity with respect to a credit
derivative, has adequate capacity to meet financial commitments in
the near term, but is vulnerable to adverse economic conditions,
such that should economic conditions deteriorate, the issuer or the
reference entity would present an elevated default risk.
\334\ The proposal would define sub-speculative grade to mean
that the entity to which a banking organization is exposed through a
loan or a security, or the reference entity with respect to a credit
derivative, depends on favorable economic conditions to meet its
financial commitments, such that should economic conditions
deteriorate, the issuer or the reference entity likely would default
on its financial commitments.
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[[Page 64120]]
The credit spread risks of industries within the proposed sectors
react similarly to the same market or economic events by principle of
shared economic risk factors (for example, technology and
telecommunications). Furthermore, the proposal would provide sectors
similar to those contained in the Basel III reforms and specify a
treatment for certain U.S.-specific sectors (for example, GSE debt and
public sector entities). Specifically, the proposal would include GSE
debt and public sector entities in the sector for government-backed
non-financials, education, and public administration to appropriately
reflect the potential variability in the credit spreads of such
positions in the industry. Accordingly, assigning the same risk weight
to these positively correlated sectors would reduce administrative
burden and not have a material effect on risk sensitivity.
Some proposed sectors consist of different industries, for example
basic materials, energy, industrials, agriculture, manufacturing, and
mining and quarrying. Positions within the same industry that are
investment grade would be assigned to the same risk bucket because from
a market risk perspective an economic event causing volatility in an
industry tends to similarly affect all positions in the industry, even
if there may be differences in credit quality between individual
issuers within an industry.
The agencies recognize that there may be sectors that are not
expressly categorized by the proposed risk buckets, and that specifying
all sectors for such purpose may not be possible. The proposed risk
buckets would include an ``other sector'' category for market risk
covered positions that do not belong to any of the other risk buckets.
The proposed risk weights are based on empirical data which reflect
the historical stress period for which the risk factors within the risk
bucket caused the largest cumulative loss at various liquidity
horizons. As such, for speculative grade sovereigns and multilateral
development banks, the agencies are proposing a 3 percent risk weight
for such positions that are non-securitization positions (Table 3 to
Sec. __.209) and a 13 percent risk weight for such positions that are
correlation trading positions (Table 5 to Sec. __.209). Based on the
agencies' quantitative analysis of the historical data, the credit
spreads of speculative grade sovereign bonds have typically widened
more than 2 percent after a downgrade, and significantly more for sub-
speculative grade sovereigns.\335\ Additionally, for non-securitization
positions and correlation trading positions, the agencies are proposing
a separate risk bucket with higher risk weights (7 percent and 16
percent, respectively) for sub-speculative grade sovereigns and
multilateral development banks than for those of speculative grade,
because of the additional risk posed by sub-speculative exposures.
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\335\ The agencies are applying a similar methodology for
calibration of credit spread risk weight for sovereigns as the Basel
Committee used for calibrating risk weights for other asset classes,
which aligns the sensitivities-based method risk weight calibration
to the liquidity horizon adjusted stressed expected shortfall
specified in the internal model approach. The Basel Committee used
IHS Markit Credit Default Swap (CDS) data and calculated ten day
overlapping returns (such as absolute changes in CDS spreads of
sovereigns). For the period of stress, the agencies used the
European sovereign crisis as it was more representative of stress
risk for these exposures. The standard deviation obtained was
multiplied by 2.34 to reflect the expected shortfall quantile of
97.5. In the last step, the estimate was adjusted to meet the
sovereign liquidity horizon specified for internal models.
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For non-securitization positions, the agencies are proposing a 2.5
percent risk weight for all investment grade covered bonds \336\ to
reduce variability in risk-based capital requirements across banking
organizations and appropriately account for the preferential treatment
provided in the standardized default risk capital requirement.\337\ As
most U.S. banking organizations hold limited or no covered bonds, the
proposed 2.5 percent risk weight should have an immaterial impact on
the sensitivities-based capital requirement.
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\336\ As defined in Sec. __.201 of proposed subpart F of the
capital rule, a covered bond would mean a bond issued by a financial
institution that is subject to a specific regulatory regime under
the law of the jurisdiction governing the bond designed to protect
bond holders and satisfies certain other criteria.
\337\ See section III.H.7.b of this Supplementary Information
for a more detailed description of the preferential treatment
applied to covered bonds under the proposed standardized default
risk capital requirement.
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For securitization positions non-CTP (Table 7 to Sec. __.209), the
proposal would clarify the treatment of personal loans and dealer
floorplan loans within the delta credit spread risk buckets.
Specifically, the proposal would require a banking organization to
include personal loans within the risk bucket for credit card
securitizations and dealer floorplans within the risk bucket for auto
securitizations in order to appropriately reflect the lower credit
spread risk of these positions relative to those within the other
sector risk bucket.\338\
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\338\ The other sector risk bucket refers to bucket 25 in Table
7 to Sec. __.209 of the proposed rule.
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For securitization positions non-CTP, the proposal would also
clarify the delta credit spread risk buckets for residential mortgage-
backed securities to help ensure consistency in bucketing assignments
across banking organizations. Specifically, the agencies are proposing
to define prime residential mortgage-backed securities based on the
definition of qualified residential mortgages in the credit risk
retention rule \339\ and to define sub-prime residential mortgage-
backed securities based on the definitions of higher-priced mortgage
loans and high-cost mortgages in Regulation Z,\340\ respectively.
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\339\ The credit risk retention rule generally requires a
securitizer to retain not less than 5 percent of the credit risk of
certain assets that the securitizer, through the issuance of an
asset-backed security, transfers, sells, or conveys to a third
party. See 12 CFR part 43 (OCC); 12 CFR part 244 (Board); 12 CFR
part 373 (FDIC).
\340\ To help ensure that credit terms are disclosed in a
meaningful way so consumers can compare credit terms more readily
and knowledgeably, Regulation Z mandates regulations on how lenders
may calculate and disclose loan costs. See 12 CFR part 1026.
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Under the proposal, prime residential mortgage-backed securities
would be defined as securities in which the underlying exposures
consist primarily of qualified residential mortgages as defined under
the credit risk retention rule. The eligibility criteria of the
qualified residential mortgage definition are designed to help ensure
the borrower's ability to repay.\341\ Residential mortgage-backed
securities that are primarily backed by qualified residential mortgage
loans carry significantly lower credit risk than those backed primarily
by non-qualifying loans. Therefore, the agencies are proposing to use
the existing definition of qualified residential mortgage in the credit
risk retention rule, which refers to the Regulation Z definition of
qualified mortgage to identify residential mortgage-backed securities
that are primarily backed by underlying loans with sufficiently low
credit risk to be classified as prime.
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\341\ Under the general definition for qualified mortgages in 12
CFR 1026.43(e)(2), a creditor must satisfy the statutory criteria
restricting certain product features and points and fees on the
loan, consider and verify certain underwriting requirements that are
part of the general ability-to-repay standard, and meet certain
other requirements.
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Similarly, the proposal would define a sub-prime residential
mortgage-backed security as a security in which the underlying
exposures consist primarily of higher-priced mortgage loans as defined
under Regulation Z (12 CFR 1026.35), high-cost mortgages as defined
under Regulation Z (12 CFR 1026.32), or both. In general, Regulation Z
defines
[[Page 64121]]
higher-priced mortgage loans \342\ and high-cost mortgages \343\ to
include consumer credit transactions secured by the consumer's
principal dwelling with an annual percentage rate \344\ that exceeds
the average prime offer rate (APOR) \345\ for a comparable transaction.
Consistent with Regulation Z, the best way to identify the subprime
market is by loan price rather than by borrower characteristics, which
could present operational difficulties and other problems. Therefore,
the agencies are proposing to use the existing definitions in
Regulation Z, which rely on a loan's annual percentage rate and other
characteristics, to identify residential mortgage-backed securities
that are primarily backed by underlying loans with sufficiently high
credit risk to be classified as sub-prime. In addition, the proposal
would reduce compliance burden for banking organizations by allowing
them to leverage criteria already being used to evaluate mortgage loans
for coverage under the prescribed Regulation Z thresholds.
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\342\ Under Regulation Z, a higher-priced mortgage loan is
defined as a closed-end consumer credit transaction secured by the
consumer's principal dwelling with an annual percentage rate that
exceeds the average prime offer rate for a comparable transaction as
of the date the interest rate is set by a certain amount of
percentage points depending on the type of loan. See 12 CFR
1026.35(a)(1).
\343\ Under Regulation Z, a high-cost mortgage is defined as a
closed- or open-end consumer credit transaction secured by the
consumer's principal dwelling and in which the annual percentage
rate exceeds the average prime offer rate for a comparable
transaction by a certain amount, or the transaction's total points
and fees exceed a certain amount, or under the terms of the loan
contract or open-end credit agreement, the creditor can charge a
prepayment penalty more than 36 months after consummation or account
opening, or prepayment penalties that can exceed, in total, more
than 2 percent of the amount prepaid. See 12 CFR 1026.32(a).
\344\ Annual percentage rates are derived from average interest
rates, points, and other loan pricing terms currently offered to
consumers by a representative sample of creditors for mortgage
transactions that have low-risk pricing characteristics. Other
pricing terms include commonly used indices, margins, and initial
fixed-rate periods for variable-rate transactions. Relevant pricing
characteristics include a consumer's credit history and transaction
characteristics such as the loan-to-value ratio, owner-occupant
status, and purpose of the transaction.
\345\ Loans with higher annual percentage rates or that have
higher points and fees or prepayment penalties generally are
extended to less creditworthy borrowers (for example, weaker
borrower credit histories, higher borrower debt-to-income ratios,
higher loan-to-value ratios, less complete income or asset
documentation, less traditional loan terms or payment schedules, or
combinations of these or other risk factors) and thus pose higher
credit risk.
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The agencies recognize that a securitization vehicle that holds
residential mortgage-backed securities may hold assets other than the
residential mortgage loans, such as interest rate swaps, to support its
liabilities. Furthermore, not all mortgage loans that satisfy the
requirements of the proposed definitions when the securitization
vehicle acquires the residential mortgage-backed securities will
continue to do so throughout the lifecycle of the position. To minimize
variability in risk-based capital requirements, reduce the operational
burdens imposed on banking organizations and help ensure consistency
and comparability in risk-based capital requirements across banking
organizations, the agencies are proposing to define prime and sub-prime
as those vehicles that primarily hold qualified residential mortgages
or high-priced mortgage loans and high-cost mortgages, respectively.
All other mortgage-backed securities would be defined as mid-prime
mortgage-backed securities.
Question 112: The agencies seek comment on the appropriateness of
adding the sub-speculative grade category for non-securitizations and
for correlation trading positions. What, if any, operational challenges
might the proposed bucketing structure pose for banking organizations
and why? What, if any, alternatives should the agencies consider to
better capture the risk of these positions?
Question 113: The agencies seek comment on the risk weight for
covered bonds. What, if any, alternative approaches would better serve
to differentiate the credit quality of highly rated covered bonds
without referring to credit ratings and why?
Question 114: The agencies seek comment on whether the proposed
definitions for each sector bucket appropriately capture the
characteristics to distinguish between the categories of residential
mortgage-backed securities. What would be the benefits and drawbacks of
using the definition of qualified residential mortgage in the credit
risk retention rule? What, if any, alternative approaches should the
agencies consider to more appropriately distinguish between the
categories of residential mortgage-backed securities?
Question 115: The agencies seek comment on whether the proposed
sector bucket definitions for residential mortgage-backed securities
are sufficiently clear. What, if any, additional criteria should the
agencies consider to define ``primarily'' in the context of residential
mortgage-backed securities (for example, quantitative limits or other
thresholds) and what are the associated benefits and drawbacks of doing
so?
Question 116: What, if any, operational challenges might the
proposed sector bucket definitions pose for banking organizations in
allocating the credit spread risk sensitivities of existing mortgage
exposures to the respective buckets and why? To what extent would using
one metric (for example, average prime offer rate) to define the sector
buckets address any such concerns?
Question 117: What, if any, other sector buckets require additional
clarification, and why?
III. Equity Risk
Table 8 to Sec. __.209 of the proposed rule provides the proposed
delta risk buckets and corresponding risk weights for market risk
covered positions with equity risk, which would be generally consistent
with those in the Basel III reforms.\346\ Under the proposal, a banking
organization would group the equity risk factors for market risk
covered positions into one of thirteen risk buckets based on market
capitalization, market economy, and sector.
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\346\ Vega and curvature capital requirements use the same risk
buckets as prescribed for delta. See Sec. __.209(c)(1), (d)(1) of
the proposed rule.
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The proposed risk buckets and associated risk weights for market
capitalization would differentiate between large and small market
capitalization issuers to appropriately reflect the relatively higher
volatility and increased equity risk of small market capitalization
issuers.\347\ Under the proposal, issuers with a consolidated market
capitalization equal to or greater than $2 billion would be classified
as large market capitalization issuers, and all other issuers would be
classified as small market capitalization issuers. The proposed large
market capitalization designation would help ensure an amount of
information and trading activity related to an issuer that is suitable
for the assignment of different risk weights relative to small market
capitalization issuers. The market capitalization data of publicly-
traded firms is readily available and
[[Page 64122]]
therefore would not be burdensome to identify.
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\347\ Relative to large market capitalization issuers,
instruments issued by those with small market capitalization are
typically less liquid and thus pose greater equity risk, as
investors holding these instruments may encounter difficulty in
buying or selling shares particularly during a stress event. Small
market capitalization issuers also typically have less access to
capital (such that they are less capable of obtaining sufficient
financing to bridge gaps in cash flow) and have a relatively shorter
operational history and thereby less evidence of a durable business
model. During downturns in the economic cycle, such complications
can increase the volatility (and therefore the equity risk) of
investments in such issuers.
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For purposes of the market economy criteria, the agencies are
proposing to differentiate between ``liquid market economy'' countries
and territorial entities and emerging market economy countries and
territorial entities to appropriately reflect the higher volatility
associated with emerging market equities. Under the proposal, a banking
organization would use the following criteria to identify annually a
country or territorial entity with a liquid market economy: $10,000 or
more in per capita income, $95 billion or more in market capitalization
of all domestic stock markets, no single export sector or commodity
comprises more than 50 percent of the country or entity's total annual
exports, no material controls on liquidation of direct investment, and
free of sanctions imposed by the U.S. Office of Foreign Assets Control
against a sovereign entity, public sector entity, or sovereign-
controlled enterprise of the country or territorial entity.\348\
Countries or territorial entities that satisfy all five criteria or
that are in a currency union \349\ with at least one country or
territorial entity that satisfies all five criteria would be classified
as liquid market economies, and all others would be classified as
emerging market economies.
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\348\ According to the agencies' analysis of the data, the
initial list of ``Liquid Market Economies'' would include: United
States, Canada, Mexico, the 19 Euro area countries (Austria,
Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland,
Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands,
Portugal, Slovakia, Slovenia, and Spain), non-Eurozone, western
European nations (the United Kingdom, Sweden, Denmark and
Switzerland), Japan, Australia, New Zealand, Singapore, Israel,
South Korea, Taiwan, Chile, and Malaysia.
\349\ The proposal would define a currency union as an agreement
by treaty among countries or territorial entities, under which the
members agree to use a single currency, where the currency used is
described in Sec. __.209(b)(1)(i) of the proposed rule.
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In relying on a set of objective criteria, the proposed approach
for market economy risk buckets is designed to increase risk
sensitivity by delineating equities with lower volatility or higher
volatility in a manner consistent with the Basel III reforms while also
providing sufficient flexibility to a banking organization to reflect
changes to the list of market economies as more data become available.
For market risk trading positions with exposure to large market
capitalization issuers, the proposal would group trading positions into
one of four sectors for equity risk for each of the emerging market and
liquid market economy categories: (1) consumer goods and services,
transportation and storage, administrative and support service
activities, healthcare, and utilities; (2) telecommunications and
industrials; (3) basic materials, energy, agriculture, manufacturing,
and mining and quarrying; and (4) financials including government-
backed financials, real estate activities, and technology.
The proposed equity risk buckets are intended to reflect
differences in the extent to which equity prices in varying sectors are
affected by the business cycle (such as GDP growth). Differentiating
sectors for purposes of assigning risk weights to exposures to large
market capitalization issuers is relevant because some sectors are more
sensitive than others to the given phase in a business cycle. The
proposal groups together industries into sectors that tend to have
similar economic sensitivities, and therefore are sufficiently
homogenous from a risk perspective.
Conversely, among small market capitalization issuers, volatility
is more attributable to whether the trading position is related to an
emerging market economy or liquid market economy, regardless of the
sector. Therefore, the proposed risk buckets for small market
capitalization issuers delineate emerging market economies from liquid
market economies but do not delineate sectors.
In addition, the proposal includes three risk buckets representing
other sectors; equity indices that are both large market capitalization
and liquid market economy (non-sector specific); and other equity
indices (non-sector specific). As is the case with credit spread risk
buckets, the agencies recognize that specifying all sectors for the
purpose of applying risk buckets is infeasible. Accordingly, the last
three risk buckets set forth in Table 8 to Sec. __.209 are intended to
strike a balance between the risk sensitivity of these risk buckets and
operational burden. Equity indices aggregate risk across different
sectors, and accordingly require separate treatment from sector-
specific risk buckets. Nonetheless, equity indices that are both large
market capitalization and liquid market economy are relatively less
risky than other equity indices and can be identified in the course of
determining large market capitalization issuers and liquid market
economies, such that it would not impose a great burden to delineate
them as a separate risk bucket.
Question 118: The agencies solicit comment on the proposed
definition of liquid market economy. Specifically, would the proposed
criteria sufficiently differentiate between economies that have liquid
and deep equity markets? What, if any, alternative criteria should the
agencies consider and why? What, if any, of the proposed criteria
should the agencies consider eliminating and why?
Question 119: The agencies solicit comment related to the proposed
risk bucket structure for equity risk. What, if any, other
relationships should the agencies consider for highly correlated risks
among different equity types that are currently in different risk
buckets and why? Please describe the historical correlations between
such equities, and historical price shocks for purposes of assigning
the appropriate risk weight.
IV. Commodity Risk
Table 9 to Sec. __.209 of the proposed rule provides the proposed
delta risk buckets and corresponding risk weights for positions with
commodity risk. Under the proposal, a banking organization would group
commodity risk factors into one of eleven risk buckets based on the
following commodity classes: energy--solid combustibles; energy--liquid
combustibles; energy--carbon trading; freight; metals--non-precious;
gaseous combustibles and electricity; precious metals (including gold);
grains and oilseed; livestock and dairy; forestry and agriculturals;
and other commodity.
The proposed risk buckets and associated risk weights for commodity
risk would be distinguished by the underlying commodity types described
above to appropriately reflect differences in volatility (and therefore
market risk) between those commodity types. In general, the price
sensitivity of a commodity to changes in global supply and demand can
vary between commodity types due to production and storage cycles,
along with other factors. For example, energy commodities are generally
delivered year-round, whereas grain production is seasonal such that
deliverable futures contracts are available on dates to coincide with
harvest. Further, commodities within the proposed commodity types have
historically similar levels of volatility. The proposed commodity risk
buckets are intended to strike a balance between the risk sensitivity
of measuring market risk for the delineated commodity groups and the
operational burden of capturing the market risk of all commodities. As
is the case with credit spread risk buckets and equity risk buckets,
the agencies recognize that specifying all commodities for the purpose
of applying risk buckets is operationally difficult. Accordingly, the
proposal includes an additional ``other commodity'' risk bucket to
include commodities that do not fall into the prescribed categories.
[[Page 64123]]
As is the case with other risk buckets, the proposed risk weights
for commodity risk factors are based on empirical data during
historical periods of stress. The agencies are proposing to align the
delta risk factor buckets and corresponding risk weights with those
provided in the Basel III reforms, with one exception. The Basel III
reforms prescribe separate risk buckets with different risk weights for
electricity and gaseous combustibles. The agencies are proposing to
move electricity into the risk bucket for gaseous combustibles to allow
for greater recognition of hedges between these two commodities. The
proposed bucketing structure would reflect appropriately the inherent
relationship between the price of electricity and natural gas, as
empirical evidence demonstrates a strong correlation between price
movements of natural gas and electricity contracts.\350\
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\350\ The agencies are proposing to include electricity and gas
in the same bucket based on an analysis of correlations between
natural gas and electricity futures prices pairs across multiple
geographical regions. The analysis shows that pairwise correlations
between gas and electricity prices within the same region are high
and stable and in excess of the inter bucket correlation that would
be applied if the two financial instruments were bucketed
separately.
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Question 120: The agencies solicit comment related to the proposed
risk bucket structure and risk weights for commodities. What, if any,
other relationships should the agencies consider for highly correlated
risks among different commodity types that are currently in different
risk buckets and why? Please describe the historical correlations
between such commodities, and historical price shocks for purposes of
assigning the appropriate risk weight.
Question 121: The agencies solicit comment on the risk bucket for
energy--carbon trading. To what extent is the proposed 60 percent risk
weight reflective of the risk in carbon trading under stressed
conditions?
V. Foreign Exchange Risk
The proposal would require a banking organization to establish
separate risk buckets for each exchange rate between the currency in
which a market risk covered position is denominated and the reporting
currency (or, as applicable, alternative base currency). To calculate
the risk-weighted delta sensitivity for foreign exchange risk, the
proposal would require a banking organization to apply a 15 percent
risk weight to each currency pair, with one exception. Similar to the
proposed risk weights for interest rate risk, the proposal would allow
a banking organization to divide the proposed 15 percent risk weight by
the square root of two for certain liquid currency pairs specified
under the proposal,\351\ as well as any additional currencies specified
by the primary Federal supervisor. Given high trading activity and use
of such liquid currency pairs relative to non-liquid pairs, the
proposal incorporates the effect of a shorter liquidity horizon for
liquid currency pairs and would allow a banking organization to
appropriately reflect the lower foreign exchange risk posed by such
liquid currency pairs.
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\351\ The proposal would allow a banking organization to apply a
lower risk weight for any currency pair formed of the following
currencies: USD, EUR, JPY, GBP, AUD, CAD, CHF, MXN, CNY, NZD, HKD,
SGD, TRY, KRW, SEK, ZAR, INR, NOK, and BRL.
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iv. Correlation Parameters
In general, the proposed correlation parameters closely follow
those in the Basel III reforms, which are calibrated to capture market
correlations observed over a long time horizon that included a period
of stress based on empirical data.\352\ To appropriately reflect the
risk-mitigating benefits of hedges and diversification, the proposal
would prescribe the correlation parameters that a banking organization
would be required to use for each risk factor pair when calculating the
aggregate risk bucket and risk class level capital requirements for
delta, vega, and curvature.\353\ To determine the applicable
correlation parameter for purposes of calculating the risk bucket or
risk class level capital requirements, a banking organization would
apply the same criteria used to define the risk factors within each
risk class, as described in section III.H.7.a.i of this Supplementary
Information, with two exceptions.
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\352\ For example, the correlation parameters for vega,
curvature, delta interest rate risk, and delta equity risk are
identical to those in the Basel III reforms.
\353\ As there is only one risk factor prescribed for foreign
exchange risk, the proposal does not specify an intra-bucket
correlation parameter.
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First, in addition to the proposed risk factors for credit spread
risk of non-securitizations, securitization positions non-CTP, and
correlation trading positions,\354\ the proposal would require a
banking organization to consider the name (in the case of non-
securitization positions and correlation trading positions) and tranche
(in the case of securitization positions non-CTP) to determine the
applicable correlation parameters for risk factors within the same risk
bucket when calculating the aggregate risk bucket level capital
requirements for delta and vega.
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\354\ As described in section III.H.7.a.i.II of this
Supplementary Information, the proposal would define the delta risk
factors for credit spread risk along two dimensions: the credit
spread curve of the reference entity and the tenor of the position.
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In the case of credit spread risk for securitization positions non-
CTP, the agencies generally are proposing to require a 100 percent
intra-bucket correlation parameter for securitization positions in the
same bucket and related to the same securitization tranche with more
than 80 percent overlap in notional terms and a 40 percent intra-bucket
correlation parameter otherwise. Furthermore, in the case of credit
spread risk for non-securitization and correlation trading positions,
banking organizations would need to apply a 35 percent intra-bucket
correlation factor for Uniform Mortgage-Backed Securities (UMBS) as
such positions would be treated as a separate name from Fannie Mae and
Freddie Mac.\355\
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\355\ In the to-be-announced (TBA) market, Freddie Mac and
Fannie Mae securities are not interchangeable and would be treated
as separate names under the proposal. As part of the single security
initiative, UMBS allows for either Fannie Mae or Freddie Mac to
deliver, thus creating the basis risk between the GSEs for such
securities.
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Second, for risk factors allocated to the ``other sector'' bucket
within the credit spread and equity risk classes,\356\ the risk bucket
level capital requirement would equal the sum of the absolute values of
the risk-weighted sensitivities for both the delta capital requirement
and the vega capital requirement (no correlation parameters would apply
to such exposures). Additionally, the proposal would require a banking
organization to assign a zero percent correlation parameter when
aggregating the delta risk-weighted sensitivity of exposures within the
``other sector'' risk bucket with those in any of the other bucket-
level capital requirements for credit spread and equity risk.
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\356\ The other sector buckets refer to buckets 17 in Tables 3
and 5 as well as buckets 25 and 11 in Tables 7 and 8, respectively,
of Sec. __.209 of the proposed rule.
---------------------------------------------------------------------------
By requiring a banking organization to determine the maximum
possible loss under three correlation scenarios, the proposed
correlation parameters are sufficiently conservative to appropriately
capture the potential interactions between risk factors that the market
risk covered positions may experience in a time of stress.
Question 122: Related to securitization positions non-CTP, the
agencies seek comments on requiring banking organizations to apply a
100 percent delta correlation parameter for cases where the
securitization positions are in the same bucket, are related to the
same securitization tranche, and have more than 80 percent overlap in
notional terms. What, if any, alternative criteria should the agencies
consider for
[[Page 64124]]
application of the 100 percent correlation parameter and why? For
example, what are benefits and drawbacks of allowing a banking
organization to apply a 100 percent delta correlation parameter if the
securitization tranches can offset all or substantially all of the
price risk of the position? What challenges exist, if any, with respect
to banking organizations' ability to implement such criteria? What
quantitative measures can be used to implement these criteria? How
would a market stress impact the basis risk between securitization
tranches within the same risk buckets, and the ability to adequately
hedge all or substantially all of the price risk using similar but
unrelated securitized tranches?
Question 123: The agencies request comment on the appropriateness
of allowing banking organizations to apply a higher intra-bucket
correlation parameter of 99.5 percent to 99.9 percent for energy--
carbon trading. What would be the benefits and drawbacks of such a
higher correlation parameter relative to the correlation parameter of
40 percent currently contained in the proposal?
Question 124: The agencies request comment on requiring banking
organizations to apply a 35 percent correlation parameter for Uniform
Mortgage Backed Securities. What alternative correlation parameter
should the agencies consider for Uniform Mortgage Backed Securities and
why?
b. Standardized Default Risk Capital Requirement
The standardized default risk capital requirement is intended to
capture the incremental loss if the issuer of an equity or credit
position were to immediately default (the additional losses from jump-
to-default risk), which are not captured by the credit spread or equity
shocks under the sensitivities-based method. Thus, the proposed
standardized default risk capital requirement would apply only to non-
securitization debt or equity positions (except for U.S. sovereigns and
multilateral development banks), securitization positions non-CTP, and
correlation trading positions.
Under the proposal, a banking organization would be required to
separately calculate the standardized default risk capital requirement
for each of the three default risk categories (three risk classes that
could incur default risk) using the following five steps.
First, for each of the three default risk categories, the banking
organization would be required to group instruments with similar risk
characteristics throughout an economic cycle into the defined default
risk buckets as described in more detail below.
Second, to estimate the position-level losses from an immediate
issuer default, the banking organization would be required to calculate
the gross default exposure separately for each default risk position.
Additionally, the banking organization would be required to determine
the long and short direction of the gross default exposure based on
whether it would experience a loss (long) or gain (short) in the event
of a default.
Third, to estimate the portfolio-level losses of a trading desk
from an immediate issuer default, the banking organization would be
required to calculate the net default exposure for each obligor by
offsetting the gross long and short default exposures to the same
obligor, where permitted.
Fourth, to estimate and recognize hedging benefit between net long
and net short position of different issuers within the same default
bucket, the banking organization would be required to calculate the
hedge benefit ratio and apply the prescribed risk weights \357\ to the
net default exposures within the same default risk bucket for the class
of instruments.\358\ In general, the proposed risk buckets and
associated risk weights closely follow those in the Basel III reforms,
which are calibrated to reflect a through-the-cycle probability of
default. The hedge benefit ratio is calculated based on the aggregate
net long default positions and the aggregate net short default
positions. It is intended to recognize the partial hedging of net long
and net short default positions in distinct obligors due to systematic
credit risk. The bucket-level default risk capital requirement would
equal (1) the sum of the risk-weighted net long default positions minus
(2) the product of the hedge benefit ratio and the sum of the risk-
weighted absolute value of the net short default positions. For non-
securitization debt and equity positions and securitization positions
non-CTP, the results of this calculation would be floored at zero.
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\357\ The proposal would require a banking organization to apply
the highest risk weight that is applicable under the investment
limits of an equity position in an investment fund that may invest
in primarily high-yield or distressed names under the fund's mandate
by first applying the highest risk weight that is applicable under
the fund's investment limits to defaulted instruments, followed by
sub-speculative grade, then speculative grade, then investment grade
securities. A banking organization may not recognize any offsetting
or diversification benefit when calculating the average risk weight
of the fund. See Sec. __.205(e)(3)(iii) of the proposed rule.
\358\ Specifically, a banking organization would first calculate
the hedge benefit ratio (the total net long jump-to-default risk
positions (numerator) divided by the sum of the total net long jump-
to-default risk positions and the sum of the absolute value of the
total net short positions (denominator), and then calculate the
risk-weighted exposure for each risk bucket by multiplying the
aggregate total net jump-to-default exposure by the risk weight
prescribed for the applicable risk bucket.
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Fifth, to calculate the default risk capital requirement for each
default risk category, the banking organization would sum the risk
bucket-level capital requirements (except for correlation trading
positions). The aggregation for correlation trading positions is not
the simple sum but is the sum of the risk-bucket level capital
requirements for the net long default exposures plus half of the sum of
the risk-weighted exposures for the net short default exposures as
further described in in section III.H.7.b.iii of this Supplementary
Information. For conservatism, the proposal would require a banking
organization to calculate the total standardized default risk capital
requirement as the sum of each of the default risk category level
capital requirements without recognizing any diversification benefits
across different types of default risk categories.
i. Non-Securitization Debt or Equity Positions
I. Gross Default Exposure
Under the proposal, the standardized default risk capital
requirement for non-securitization debt or equity positions would
generally follow the calculation steps described above. To calculate
the gross default exposure for each non-securitization debt or equity
position, the proposal would require a banking organization to multiply
the notional amount (face value) of the instrument and the prescribed
loss given default (LGD) rate \359\ to determine the total potential
loss of principal at default and then add the cumulative profits
(losses) already realized on the position to avoid double-counting
realized losses, with one exception.\360\ For defaulted positions, the
proposal would require a banking organization to multiply the current
market value and the prescribed LGD rate to determine the gross default
exposure for the position. The proposed calculation methodology is
intended to appropriately quantify the gross default risk for most
securities, including those that are less common.
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\359\ The loss rate from default is one minus the recovery rate.
\360\ As losses are recorded as a negative value, effectively
they would be subtracted from the overall exposure amount.
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For the purpose of calculating the gross default exposure for each
non-securitization debt or equity position, the agencies are proposing
the following
[[Page 64125]]
LGD rates, which are generally consistent with those in the Basel III
reforms: 100 percent for equity and non-senior debt instruments and
defaulted positions, 75 percent for senior debt instruments, 75 percent
for GSE debt issued but not guaranteed by the GSEs, 25 percent for GSE
debt guaranteed by the GSEs, 25 percent for covered bonds, and zero
percent for instruments whose value is not linked to the recovery rate
of the issuer.\361\ GSE debt issued and guaranteed by the GSEs is
secured by residential properties that satisfy the rigorous
underwriting standards of the GSEs (for example, loan-to-value ratios
of less than 80 percent), and include a guarantee on the repayment of
principal by the GSE. As these characteristics are economically similar
to the requirements for covered bonds, the agencies are proposing to
extend the LGD rate applied to covered bonds to GSE debt issued and
guaranteed by the GSEs to appropriately capture the expected losses of
such positions in the event of default. As GSE debt instruments issued
but not guaranteed by the GSEs are similarly secured by high-quality
residential mortgages, the proposal would allow banking organizations
to treat such exposures as senior debt (subject to a 75 percent LGD
rate) rather than apply the higher proposed risk weight for equity and
non-senior debt instruments. For credit derivatives, a banking
organization would be required to use the LGD rate of the reference
exposure.
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\361\ For example, in the case of a call option on a bond, the
notional amount to be used in the jump-to-default calculation would
be zero given that in the event of default the call option would not
be exercised (the default would extinguish the call option's value,
with the loss captured through the reduced fair value of the
position).
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For consistency across banking organizations, the proposal
specifies that a banking organization would be required to reflect the
notional amount of a non-securitization debt or equity position that
gives rise to a long gross default exposure as a positive value and the
corresponding loss as a negative value, and those that produce a short
exposure as a negative value and the corresponding gain as a positive
value. If the contractual or legal terms of a derivative contract allow
for the unwinding of the instrument, with no exposure to default risk,
the gross default exposure would equal zero.
Question 125: The agencies request comment on whether the proposed
formula for calculating gross default exposure appropriately captures
the gross default risk for all types of non-securitization debt and
equity instruments. What, if any, positions exist for which the formula
cannot be applied? What is the nature of such difficulties and how
could such concerns be mitigated? In particular, the agencies seek
comment on whether the proposed formula appropriately captures the
gross default risk of convertible instruments.
Question 126: The agencies request comment on the appropriateness
of the proposed LGD rates for non-securitization debt or equity
positions. What, if any, changes should the agencies consider making to
the categories to appropriately differentiate the LGD rates for various
instruments or for instruments with different seniority (for example,
senior versus non-senior)?
II. Net Default Exposure
To calculate the net default exposure for non-securitization debt
or equity positions, the proposal would permit a banking organization
to recognize either full or partial offsetting of the gross default
exposures for long and short positions if both reference the same
obligor and the short positions have the same or lower seniority as the
long positions.\362\ To appropriately reflect the net default risk, the
proposed calculation would not allow a banking organization to
recognize any offsetting of the gross default exposure for market risk
covered positions where the obligor is not identified, such as equity
positions in an investment fund, index instruments, and multi-
underlying options for which a banking organization elects to calculate
a single risk factor sensitivity (not to apply the look-through
approach).
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\362\ For a market risk covered position that has an eligible
guarantee, to determine if the exposure is to the underlying obligor
or an exposure to the eligible guarantor, the credit risk mitigation
requirements set out in the capital rule would apply. See 12 CFR
3.36, 3.134 and 3.135 (OCC); 12 CFR 217.36, 217.134 and 217.135
(Board); 12 CFR 324.36, 324.134 and 324.135 (FDIC).
---------------------------------------------------------------------------
As the GSEs can default independently of one another, the agencies
are clarifying that banking organizations should treat Federal National
Mortgage Association (Fannie Mae), Federal Home Loan Mortgage
Corporation (Freddie Mac), and the Federal Home Loan Bank System as
separate obligors. As the single security initiative led by Fannie Mae
and Freddie Mac has homogenized the mortgage pool and security
characteristics for Uniform Mortgage-Backed Securities (UMBS), the
proposal would allow the banking organization to fully offset Uniform
Mortgage Backed Securities that are issued by two different obligors.
Full offsetting would be permitted for short and long market risk
covered positions with maturities greater than one year or positions
with perfectly matching maturities provided other criteria are met such
as if both long and short positions reference the same obligor and the
short positions have the same or lower seniority as the long positions.
To determine the offsetting treatment for market risk covered positions
with maturities of one year or less, a banking organization would be
required to scale the gross default exposure by the fraction of a year
corresponding to the maturity of the instrument, subject to a three-
month floor. In the case where long and short gross default exposures
both have maturities of one year or less, scaling would apply to both
the long and short gross default exposure. By allowing only partial
offsetting, the proposed scaling approach is intended to appropriately
reflect the risk posed by maturity mismatch between exposures and their
hedges within the one-year capital horizon. For example, under the
proposal, the gross default exposure for an instrument with a six-month
maturity would be weighted by one-half, whereas that for a one-week
repurchase agreement would be prescribed a three-month maturity and
weighted by one-fourth.
The proposal would permit a banking organization to assign a
maturity of either three months or one year to cash equity positions
that do not have a stated maturity. For derivative transactions, the
proposal would require a banking organization to use the maturity of
the derivative contract, rather than that of the underlying, to
determine the applicable scaling factor. To prevent broken hedges for
equity and derivative positions, the proposal would allow banking
organizations to assign the same maturity to a cash equity position as
the maturity of the derivative contract it hedges (permit full
offsetting). Similarly, the proposal would allow a banking organization
to align the maturity of an instrument with that of a derivative
contract for which that instrument could be delivered to satisfy the
derivative contract, and thus permit full offsetting between the
instrument and the derivative. For example, a banking organization may
assign the maturity of a derivative contract in the to-be-announced
(TBA) market that is hedging a security interest in a pool of mortgages
to that security interest provided that the delivery of the security
interest would satisfy the delivery terms of the TBA derivative
contract.
[[Page 64126]]
The net default exposure to an issuer would be the sum of the
maturity-weighted default exposures to the issuer.
Question 127: The agencies request comment on the appropriateness
of allowing banking organizations to net the gross default exposures of
derivative contracts and the underlying positions that are deliverable
to satisfy the derivative contract. What, if any, additional criteria
should the agencies consider to further clarify the netting of gross
default exposures and why? What, if any, positions should the agencies
consider allowing to net that would not exhibit default risk? For
example, what are the advantages and disadvantages of the agencies
allowing Uniform Mortgage Backed Securities that are issued by two
different obligors to fully offset, even though such a treatment would
not eliminate the default risk of either obligor independently?
Question 128: The agencies seek comment on the appropriateness of
the proposed treatment of GSE exposures. What, if any, alternative
methods should the agencies consider to measure more appropriately the
default risk associated with such positions? What would be the benefits
and drawbacks of such alternatives compared to the proposed treatment?
Question 129: The agencies seek comment on the appropriateness of
not allowing banking organizations to recognize any offsetting benefit
for market risk covered positions where the obligor is not identified.
What, if any, alternative methods should the agencies consider to
measure more appropriately the default risk associated with such
positions? What would be the benefits and drawbacks of such
alternatives compared to the proposed treatment?
III. Risk Buckets and Corresponding Risk Weights
Table 1 to Sec. __.210 of the proposed rule provides the proposed
default risk buckets and corresponding risk weights for non-
securitization debt or equity positions, which reflect counterparty
type and credit quality, respectively. Under the proposal, the risk
buckets and applicable risk weights would distinguish between the type
of obligor based on whether the exposure is to a non-U.S. sovereign, a
public sector entity or GSE, or a corporate and include a single bucket
for defaulted positions.
To capture the credit quality of the obligor, the agencies are
proposing default risk buckets that are generally consistent with those
provided in the Basel III reforms but defined using alternative
criteria. The default risk buckets for non-securitization positions in
the Basel III reforms are defined based on the applicable credit
ratings of the reference entity. As discussed previously in section
III.H.7.a.iii.II of this Supplementary Information, the agencies are
proposing an approach that does not rely on external credit ratings but
allows for a level of granularity in the default risk buckets (and
corresponding risk weights) applicable to non-securitization positions
and that is also generally consistent with the Basel III reforms.
Specifically, the agencies are proposing to define the default risk
buckets and corresponding risk weights for non-securitization positions
based on the definition for Investment Grade in the agencies' existing
capital rule and the proposed definitions of Speculative Grade and Sub-
speculative Grade.\363\
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\363\ Specifically, the agencies are proposing to apply a
methodology similar to prior rules, where the risk weights in the
Basel III reforms are adjusted based on a weighted average risk
weight calculated from the notional amount of issuance since 2007
for each category. For this analysis, the agencies used the Mergent
Fixed Income Securities database to identify notional issuance
amounts for several lookback periods. The weighted average risk
weight for each category was then slightly modified to account for
rounding, to reflect internal consistency (so that a corporate or
PSE exposure would not have a lower risk weight than a sovereign)
and to help ensure risk weights were stable through an entire credit
cycle. The agencies believe the amended risk weight table
appropriately satisfies the requirements of the Dodd-Frank Act,
while also meeting the intent of the Basel III reforms. See 15
U.S.C. 78o-7 note.
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Question 130: The agencies solicit comment on the appropriateness
of the proposed risk weights and granularity in Table 1 to Sec.
__.210. What, if any, alternative approaches should the agencies
consider for assigning risk weights that would be consistent with the
prohibition on the use of credit ratings? Commenters are encouraged to
provide specific details on the mechanics of and rationale for any
suggested methodology.
ii. Securitization Positions Non-CTP
For securitization positions non-CTP, the process to calculate the
standardized default risk capital requirement would be identical to
that for non-securitization positions, except for the gross default
exposure calculation, the offsetting of long and short exposures in the
net default exposure calculation, and the proposed risk buckets and
corresponding risk weights.
I. Gross Default Exposure
Under the proposal, the gross default exposure for a securitization
position non-CTP equals the position's fair value. As the proposed
bucket-level risk weights described in section III.H.7.a.iii of this
Supplementary Information would already reflect the LGD rates for such
positions, a banking organization would not apply an LGD rate to
calculate the gross default exposure.
II. Net Default Exposure
First, the proposal would allow offsetting between securitization
exposures with the same underlying asset pool and belonging to the same
tranche. No offsetting would be permitted between securitization
exposures with different underlying asset pools, even where the
attachment and detachment points are the same.
Second, the proposal would permit a banking organization to offset
the gross default exposure of a securitization position non-CTP with
one or more non-securitization positions by decomposing the exposure of
non-tranched index instruments and replicating the exposures that make
up the entire capital structure of the securitized position.
Additionally, a banking organization would be required to exclude non-
securitization positions that are recognized as offsetting the gross
default exposure of a securitization position non-CTP from the
calculation of the standardized default risk capital requirement for
non-securitization debt and equity positions.
Third, the proposal would allow a banking organization to offset
the gross default exposure of a securitization position non-CTP through
decomposition if a collection of short securitization positions non-CTP
replicates a collection of long securitization positions non-CTP. For
example, if a banking organization holds a long position in the
securitization, and a short position in a mezzanine tranche that
attaches at 3 percent and detaches at 10 percent, the proposal would
permit the banking organization to decompose the securitization into
three tranches and offset the gross default exposures for the common
portion of the securitization (3-10 percent). In this case, the net
default exposure would reflect the long positions in the 0-3 percent
tranche and in the 10-100 percent tranche.
Question 131: The agencies seek comment on the proposed netting and
decomposition criteria for calculating the net default exposure for
securitization positions non-CTP. What, if any, alternative non-model-
based methodologies should the agencies consider that would
conservatively recognize some hedging benefits but still capture the
basis risk between non-identical positions?
[[Page 64127]]
III. Risk Buckets and Corresponding Risk Weights
To promote consistency and comparability in risk-based capital
requirements across banking organizations, the proposal would define
the risk bucket structure that a banking organization would be required
to use to group securitization positions non-CTP. Specifically, the
proposal would require a banking organization to classify
securitization positions non-CTP as corporate positions or based on the
asset class and the region of the underlying assets, following market
convention.\364\ Under the proposal, a banking organization would
assign each position to one risk bucket, and those with underlying
exposures in the same asset class and region to the same risk bucket.
Additionally, the proposal would require a banking organization to
assign any position that is not a corporate position and that it cannot
assign to a specific asset class or region to one of the ``other''
buckets.\365\
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\364\ The proposal would define the asset class buckets along
two dimensions: asset class and region. The region risk buckets
would include Asia, Europe, North America, and other. The asset
class risk buckets would include asset-backed commercial paper, auto
loans/leases, residential mortgage-backed securities, credit cards,
commercial mortgage-backed securities, collateralized loan
obligations, collateralized debt obligations squared, small and
medium enterprises, student loans, other retail, and other
wholesale.
\365\ Under the proposal, the other buckets would include other
retail and other wholesale (for asset class) and other (for region).
---------------------------------------------------------------------------
For consistency in the capital requirements for securitizations
under either subpart D or subpart E of the capital rule and to
recognize credit subordination,\366\ the proposed risk weights for
securitization positions non-CTP are based on the risk weights
calculated for securitization exposures under either subpart D or
subpart E of the capital rule.\367\
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\366\ For example, the general credit risk framework would apply
the SSFA to calculate the risk weight. The SSFA calculates the risk
weight based on characteristics of the tranche, such as the
attachment and detachment points and quality of the underlying
collateral.
\367\ 12 CFR 3.43, 3.143, 3.144 (OCC); 12 CFR 217.43, 217.143,
217.144 (Board); 12 CFR 324.43, 324.143, 324.144 (FDIC).
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To calculate the standardized default risk capital requirement for
securitization positions non-CTP, a banking organization would sum the
risk bucket-level capital requirements, except that a banking
organization could cap the standardized default risk capital
requirement for an individual cash securitization position non-CTP at
its fair value. For cash positions, the maximum loss on the exposure
would not exceed the fair value of the position even if each of the
underlying assets of the securitization were to immediately default.
Furthermore, the proposed treatment would align with the maximum
potential capital requirement for securitizations under either subpart
D or the proposed subpart E of the capital rule.\368\
---------------------------------------------------------------------------
\368\ 12 CFR 3.44(a) (OCC); 12 CFR 217.44(a) (Board); 12 CFR
324.44(a) (FDIC).
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Question 132: The agencies request comment on the proposed risk
buckets. What are the potential benefits and drawbacks of aligning the
default risk bucketing structure with the proposed delta risk buckets
for securitization positions non-CTP in the sensitivities-based method?
Commenters are encouraged to provide information regarding any
associated burden, complexity, and capital impact of such an alignment.
iii. Correlation Trading Positions
The process to calculate the standardized default risk capital
requirement for correlation trading positions would be the same as that
for non-securitization debt and equity positions, except for the
metrics used to measure gross default exposure, the offsetting of long
and short exposures in the net default exposure calculation, the risk
buckets, and the aggregation of the bucket level exposures across risk
buckets.
I. Gross Default Exposure
Under the proposal, the gross default exposure for a correlation
trading position equals the position's market value. To calculate the
gross default exposure for correlation trading positions that are nth-
to-default positions, the proposal would require a banking organization
to treat such positions as tranched positions and to calculate the
attachment point as (N-1) divided by the total number of single names
in the underlying basket or pool and the detachment point as N divided
by the total number of single names in the underlying basket or pool.
The proposed calculation is intended to appropriately reflect the
credit subordination of such positions.
II. Net Default Exposure
Similar to securitization positions non-CTP, to increase risk
sensitivity and permit greater offsetting of substantially similar
exposures, the proposal would permit banking organizations to offset
gross long and short default exposures in specific cases.
First, the proposal would allow a banking organization to offset
the gross default exposure of correlation trading positions that are
otherwise identical except for maturity, including index tranches of
the same series. This means the offsetting positions would need to have
the same underlying index family of the same series, and the same
attachment and detachment points.
Second, the proposal would allow a banking organization to offset
the gross default exposure of long and short exposures of tranches that
are perfect replications of non-tranched correlation trading positions.
For example, the proposal would allow a banking organization to offset
the gross default exposure of a long position in the CDX.NA.IG.24 index
with short positions that together comprise the entire index position
(for example, three distinct tranches that attach and detach at 0-3
percent, 3-10 percent, and 10-100 percent, respectively).
Third, the proposal would allow a banking organization to offset
the gross default exposure of indices and single-name constituents in
the indices through decomposition when the long and the short gross
default exposures are otherwise equivalent except for a residual
component. Under the proposal, a banking organization would account for
the residual exposure in the calculation of the net default exposure.
In such cases, the proposal would require that the decomposition into
single-name equivalent exposures account for the effect of marginal
defaults of the single names in the tranched correlation trading
position, where in particular the sum of the decomposed single name
amounts would be required to be consistent with the undecomposed value
of the tranched correlation trading position. Such decomposition
generally would be permissible for correlation trading positions (for
example, vanilla CDOs, index tranches or bespoke indices), but would be
prohibited for exotic securitizations (for example, CDO squared).
Fourth, the proposal would allow a banking organization to offset
the gross default exposure of different series (non-tranched) of the
same index through decomposition when the long and the short gross
default exposures are otherwise equivalent except for a residual
component. Under the proposal, a banking organization would account for
the residual exposure in the calculation of the net default exposure.
For example, assume that a banking organization holds a long position
in a CDS index that references 125 underlying credits and a short
position in the next series of the index that also references 125
credits. The two indices share the same 123 reference credits,
[[Page 64128]]
such that there are two unique credits in each index. Under the
proposal, a banking organization could offset the 123 names through
decomposition, in which case the net default exposure would reflect
only the two unique credits for the long index position and the two
unique credits for the short index position. Similarly, a banking
organization could offset the long exposure in 125 credits by selling
short an index that contains 123 of those same credits. In this case,
only the two residual names would be reflected in the net default
exposure.
Fifth, the proposal would allow a banking organization to offset
different tranches of the same index and series through replication and
decomposition and calculate a net default exposure on the unique
component only, if the residual component has the attachment and
detachment point nested with the original tranche or the combination of
tranches. For example, assume that a banking organization holds long
positions in two tranches, one that attaches at 5 percent and detaches
at 10 percent and another that attaches at 10 percent and detaches at
15 percent. To hedge this position, the banking organization holds a
short position in a tranche on the same index that attaches at 5
percent and detaches at 20 percent. In this case, the banking
organization's net default exposure would only be for the residual
portion of the tranche that attaches at 15 percent and detaches at 20
percent.
III. Risk Buckets and Corresponding Risk Weights
For correlation trading positions, the proposal would define risk
buckets by index, each index would comprise its own risk bucket.\369\
Under the proposal, a bespoke correlation trading position would be
assigned to its own unique bucket, unless it is substantially similar
to an index instrument, in which case the bespoke position would be
assigned to the risk bucket corresponding to the index. For a non-
securitization position that hedges a correlation trading position, a
banking organization would be required to assign such position and the
correlation trading position to the same bucket.
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\369\ A non-exhaustive list of indices include: the CDX North
America IG, iTraxx Europe IG, CDX HY, iTraxx XO, LCDX (loan index),
iTraxx LevX (loan index), Asia Corp, Latin America Corp, Other
Regions Corp, Major Sovereign (G7 and Western Europe) and Other
Sovereign.
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For consistency in the capital requirements for securitizations
under either subpart D or subpart E of the capital rule and to
recognize credit subordination,\370\ the proposed risk weights
corresponding to the proposed risk buckets for correlation trading
positions are based on the treatment under either subpart D or subpart
E of the capital rule.\371\
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\370\ For example, the general credit risk framework would apply
the SSFA to calculate the risk weight. The SSFA calculates the risk
weight based on characteristics of the tranche, such as the
attachment and detachment points and quality of the underlying
collateral.
\371\ 12 CFR 3.43, 3.143, 3.144 (OCC); 12 CFR 217.43, 217.143,
217.144 (Board); 12 CFR 324.43, 324.143, 324.144 (FDIC).
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The agencies recognize that the granularity of the proposed risk
bucket structure could result in several individual risk buckets
containing only net short exposures and thus overstate the offsetting
benefits of non-identical exposures if the total standardized default
risk capital requirement for correlation trading positions was
calculated as a sum of the bucket-level capital requirements. To
appropriately limit the benefit of risk buckets with short default
exposures offsetting those with long exposures, the total standardized
default risk capital requirement for correlation trading positions
would be calculated as the sum of the risk-bucket level capital
requirements for the net long default exposures plus half of the sum of
the risk-weighted exposures for the net short default exposures.
c. Residual Risk Capital Requirement
It is not possible in a standardized approach to sufficiently
specify all relevant distinctions between different market risks to
capture appropriately existing and future financial products.
Accordingly, the agencies are proposing the residual risk add-on
capital requirement (residual risk add-on) to reflect risks that would
not be fully reflected in the sensitivities-based capital requirement
or the standardized default risk capital requirement. Specifically, the
residual risk add-on is intended to capture exotic risks, such as
weather, longevity, and natural disasters, as well as other residual
risks, such as gap risk, correlation risk, and behavioral risks such as
prepayments.
To calculate the residual risk add-on, the proposal would require a
banking organization to risk weight the gross effective notional amount
of a market risk covered position by 1 percent for market risk covered
positions that are not subject to the standardized default risk capital
requirement and that have an exotic exposure and by 0.1 percent for
other market risk covered positions with residual risks (described in
the next section). The total residual risk add-on capital requirement
would equal the sum of such capital requirements across subject market
risk covered positions.
i. Positions Subject to the Residual Risk Add-On
The proposal would require a banking organization to calculate a
residual risk add-on for market risk covered positions that have an
exotic exposure, and certain market risk covered positions that carry
residual risks. As the potential losses of market risk covered
positions with exotic exposures (longevity risk, weather, natural
disaster, among many) would not be adequately captured under the
sensitivities-based method, the agencies are proposing a capital
requirement equal to 1 percent of the gross effective notional amount
of the market risk covered position, as an appropriately conservative
capital requirement for such exposures.
In contrast, market risk covered positions with other residual
risks would include those for which the primary risk factors are mostly
captured under the sensitivities-based method, but for which there are
additional, known risks that are not quantified in the sensitivities-
based method. Specifically, the proposal would include: (1) correlation
trading positions with three or more underlying exposures that are not
hedges of correlation trading positions; (2) options or positions with
embedded optionality, where the payoffs could not be replicated by a
finite linear combination of vanilla options or the underlying
instrument; and (3) options or positions with embedded optionality that
do not have a stated maturity or strike price or barrier, or that have
multiple strike prices or barriers.\372\ As the residual risk add-on is
intended as a supplement to the capital requirement under the
sensitivities-based method for these known risks, the agencies are
proposing a capital requirement equal to 0.1 percent of the gross
effective notional amount for market risk covered positions with other
residual risks.
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\372\ As proposed, the criteria are intended to capture (1)
correlation risks for basket options, best of options, basis
options, Bermudan options, and quanto options; (2) gap risks for
path dependent options, barrier options, Asian options and digital
options; and (3) behavior risks that might arise from early exercise
(call or put features, or pre-payment).
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In addition to positions with exotic or other residual risks, a
primary Federal supervisor may require a banking organization to
subject other market risk covered positions to the residual risk add-
on, if the proposed framework would not otherwise appropriately
[[Page 64129]]
capture the material risks of such positions. While the agencies
believe that the proposed definitions would reasonably identify
positions with risks not appropriately captured by other aspects of the
proposed framework, there could be instances where a market risk
covered position should be subject to the residual risk add-on in order
to capture appropriately the associated market risk of the exposure in
risk-based capital requirements. To allow the agencies to address such
instances on a case-by-case basis, the proposal would allow the primary
Federal supervisor to make such determinations, as appropriate.
ii. Excluded Positions
To promote appropriate capitalization of risk, the proposal would
allow certain positions to be excluded from the calculation of the
residual risk add-on if such positions would meet the following set of
exclusions. Specifically, the proposal would permit a banking
organization to exclude positions, other than those that have an exotic
exposure, from the residual risk add-on, if the position is either (1)
listed on an exchange; (2) eligible to be cleared by a CCP or QCCP; or
(3) an option that has two or fewer underlying positions and does not
contain path dependent pay-offs. The proposed exclusions would permit a
banking organization to exclude simple options, such as spread options,
which have two underlying positions, but not those for which the
payoffs cannot be replicated by a combination of traded financial
instruments. As spread options would be subject to the vega and
curvature requirements under the sensitivities-based method, the
agencies believe that subjecting spread options to the residual risk
add-on would be incommensurate with the risks of such positions and
could increase inappropriately the cost of hedging without a
corresponding reduction in risk. Additionally, as most agency mortgage-
backed securities and certain convertible instruments (for example,
callable bonds) are eligible to be cleared, the proposal would allow a
banking organization to exclude these instruments that are eligible to
be cleared from the residual risk add-on, despite the pre-payment risk
of such instruments.\373\
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\373\ As discussed in section III.H.7.c.ii of this Supplementary
Information, callable bonds that are priced as yield-to-maturity
would not be subject vega risk, as the risk factors for such
instruments would already be sufficiently captured under the
sensitivities-based method.
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The proposal would also allow a banking organization to exclude
positions, including those with exotic exposures, from the residual
risk add-on if the banking organization has entered into a third-party
transaction that exactly matches the market risk covered position (a
back-to-back transaction). As the long position and short position of
two identical trades would completely offset, excluding such
transactions from the residual risk add-on would appropriately reflect
the lack of residual risk inherent in such transactions.
Furthermore, the proposal would allow a banking organization to
exclude certain offsetting positions that may exhibit insignificant
residual risks and for which the residual risk add-on would be overly
punitive. Specifically, the proposal would allow a banking organization
to exclude the following from the residual risk add-on: (1) positions
that can be delivered into a derivative contract where the positions
are held as hedges of the banking organization's obligation to fulfill
the derivative contract (for example, TBA and security interests in
associated mortgage pools) as well as the associated derivative
exposure; (2) any GSE debt issued or guaranteed by GSEs or any
securities issued and guaranteed by the U.S. government; (3) internal
transactions between two trading desks, if only one trading desk is
model-eligible; (4) positions subject to the fallback capital
requirement; and (5) any other types of positions that the primary
Federal supervisor determines are not required to be subject to the
residual risk add-on, as the material risks would be sufficiently
captured under other aspects of the proposed market risk framework. For
example, the agencies consider the following risks sufficiently
captured under the proposed market risk framework such that banking
organizations would not need to calculate a residual risk add-on for
positions that exhibit these risks: risks from cheapest-to-deliver
options; volatility smile risk; correlation risk arising from multi-
underlying European or American plain vanilla options; dividend risk;
and index and multi-underlying options that are well-diversified or
listed on exchanges for which sensitivities are captured by the capital
requirement under the sensitivities-based method.
Question 133: The agencies seek comment on all aspects of the
proposed residual risk add-on. Specifically, the agencies request
comment on whether there are alternative methods to identify more
precisely exotic exposures and other residual risks for which the
residual risk capital requirement is appropriate. What, if any,
additional instruments and offsetting positions should be excluded from
the residual risk add-on and why? What, if any, quantitative measures
should the agencies consider to identify or distinguish residual risks
and why?
Question 134: Would characterizing volatility and variance swaps as
bearing other residual risk more appropriately reflect the risks of
such exposures and why?
d. Treatment of Certain Market Risk Covered Positions
To promote consistency in risk-based capital requirements across
banking organizations and to help ensure appropriate capitalization
under the market risk capital rule, the proposal would prescribe the
treatment of market risk covered positions that are hybrid instruments,
index instruments, and multi-underlying options under the standardized
approach, as described below.
i. Hybrid Instruments
Hybrid instruments are instruments that have characteristics in
common with both debt and equity instruments, including traditional
convertible bonds. As hybrid instruments primarily react to changes in
interest rates, issuer credit spreads, and equity prices, the proposal
would require a banking organization to assign risk sensitivities for
these instruments into the interest rate risk class, credit spread risk
class for non-securitization positions, and equity risk class, as
applicable, when calculating the delta, curvature, and vega under the
sensitivities-based method. For the standardized default risk capital
requirement, the proposal would require a banking organization to
decompose a hybrid instrument into a non-securitization position and an
equity position and calculate default risk capital for each position
respectively. For example, a convertible bond can be decomposed into a
vanilla bond and an equity call option. The notional amount to be used
in the default risk capital calculation for the vanilla bond is the
notional amount of the convertible bond. The notional amount to be used
in the default risk capital calculation for the call option is zero
(because, in the event of default, the call option will not be
exercised). In this case, a default of an issuer of the convertible
bond would extinguish the call option's value and this loss would be
captured through the profit and loss component of the gross default
exposure amount calculation. The standardized default risk capital
requirement for the convertible bond would be the sum of the default
risk capital of the vanilla bond and the default risk capital
requirement for the equity option.
[[Page 64130]]
ii. Index Instruments and Multi-Underlying Options
When calculating the delta and curvature capital requirements under
the sensitivities-based method for index instruments and multi-
underlying options, the proposal generally would require a banking
organization to apply a look-through approach. However, it could treat
listed and well-diversified credit or equity indices \374\ as a single
position. The look-through approach would require a banking
organization to identify the underlying positions of the index
instrument or multi-underlying option and calculate market risk capital
requirements as if the banking organization directly held the
underlying exposures. Under the proposal, a banking organization would
be required to apply consistently the look-through approach through
time and consistently for all positions that reference the same index.
The proposed look-through approach would align the treatment of such
instruments with that of single-name positions and thus provide greater
hedging recognition by allowing such instruments to net with single-
name positions issued by the same company. Specifically, a banking
organization would be able to net the risk factor sensitivities of such
positions of the index instrument or multi-underlying option and
single-name positions without restriction when calculating delta and
curvature capital requirements under the sensitivities-based method.
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\374\ An equity or credit index would be considered well
diversified if it contains a large number of individual equity or
credit positions, with no single position representing a substantial
portion of the index's total market value.
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In certain situations, a banking organization may choose not to
apply a look-through approach to listed and well-diversified indices,
in which case a single sensitivity for the index would be used to
calculate the delta and curvature capital requirements. To assign the
sensitivity of the index to the relevant sector or index bucket, the
agencies are proposing a waterfall approach as a simple and risk-
sensitive method to appropriately capture the risk of such positions
based on the risk and diversification of the underlying assets. For
indices where at least 75 percent of the notional value of the
underlying constituents relate to the same sector (sector-specific
indices), taking into account the weightings of the index, the
sensitivity would be assigned to the corresponding sector bucket. For
equity indices that are not sector specific, the sensitivity would be
assigned to the large market cap and liquid market economy (non-sector
specific) bucket if least 75 percent of the market value of the index
constituents met both the large market cap and liquid market economy
criteria, and to the other equity indices (non-sector specific) bucket
otherwise. For credit indices that are not sector specific, the
sensitivity would be assigned to the investment grade indices bucket if
the credit quality of at least 75 percent of the notional value of the
underlying constituents was investment grade, and to the speculative
grade and sub-speculative grade indices bucket otherwise.\375\ To the
extent a credit or an equity index spans multiple risk classes, the
proposal would require the banking organization to allocate the index
proportionately to the relevant risk classes following the above
methodology.
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\375\ See section III.H.7.a of this SUPPLEMENTARY INFORMATION
for a more detailed description on the assignment of delta
sensitivities to the prescribed risk buckets under the proposed
sensitivities-based method.
---------------------------------------------------------------------------
When calculating vega capital requirements for multi-underlying
options (including index options), the proposal would permit, but not
require, a banking organization to apply the look-through approach
required for delta and calculate the vega capital requirements based on
the implied volatility of options on the underlying constituents.
Alternatively, under the proposal, a banking organization could
calculate the vega capital requirement for multi-underlying options
based on the implied volatility of the option, which typically is the
method used by banking organizations' financial reporting valuation
models for multi-underlying options. For indices, the proposal would
require a banking organization to calculate vega capital requirements
based on the implied volatility of the underlying options by applying
the same approach used for delta and curvature and using the same
sector-specific bucket or index bucket.
The default risk of multi-underlying options that are non-
securitization debt or equity positions is primarily a function of the
idiosyncratic default risk of the underlying constituents. Accordingly,
to capture appropriately the default risk of such positions, the
proposal would require a banking organization to apply the look-through
approach when calculating the standardized default risk capital
requirement for multi-underlying options that are non-securitization
debt or equity positions. When decomposing multi-underlying exposures
or index options, a banking organization would be required to set the
gross default exposure assigned to a single name, referenced by the
instrument, equal to the difference between the value of the instrument
assuming only the single name defaults (with zero recovery) and the
value of the instrument assuming none of the single names referenced by
the instrument default.
Similarly, for positions in credit and equity indices, the proposal
would allow a banking organization to decompose the index position when
calculating the standardized default risk capital requirement. By
aligning the treatment of positions in credit and equity indices with
that of single-name positions, the proposal would provide greater
hedging recognition as the banking organization would be able to offset
the gross default exposure of long and short positions in indices with
that of single-name positions included in the index. Alternatively, as
the underlying assets of credit and equity indices could react
differently to the same market or economic event, the proposal would
also allow a banking organization to treat such indices as a single
position for purposes of calculating the standardized default risk
capital requirement.
Question 135: The agencies seek comment on the proposed threshold
of 75 percent for assigning a credit or equity index to the
corresponding sector or the investment grade indices bucket. What would
be the benefits and drawbacks of the proposed threshold? What, if any,
alternative thresholds should the agencies consider that would more
appropriately measure the majority of constituents in listed and well-
diversified credit and equity indices?
Question 136: The agencies seek comment on all aspects of the
proposed treatment of index instruments and multi-underlying options
under the standardized measure for market risk. Specifically, the
agencies request comment on any potential challenges from requiring the
look-through approach for all index instruments and multi-underlying
options that are non-securitization debt or equity positions for the
standardized default risk capital calculation. What, if any,
alternative methods should the agencies consider that would more
appropriately measure the default risk associated with such positions?
What would be the benefits and drawbacks of such alternatives compared
to the proposed look-through requirement?
8. Models-Based Measure for Market Risk
The core components of the proposed models-based measure for market
risk capital requirements are internal models
[[Page 64131]]
approach capital requirements for model-eligible trading desks
(IMAG,A), the standardized approach capital requirements for model-
ineligible trading desks (SAU), and the PLA add-on that addresses
deficiencies in the banking organization's internal models, if
applicable.
a. Internal Models Approach
The internal models approach capital requirements for model-
eligible trading desks (IMAG,A) would consist of four components: (1)
the internally modelled capital calculation for modellable risk factors
(IMCC); (2) the stressed expected shortfall for non-modellable risk
factors (SES); (3) the standardized default risk capital requirement as
described in section III.H.7.b of this SUPPLEMENTARY INFORMATION; and
(4) the aggregate trading portfolio backtesting capital multiplier.
The first two components, IMCC and SES, would capture risk and
distinguish between risk factors for which there are sufficient real
price observations to qualify as modellable risk factors and those for
which there are not (non-modellable risk factors or NMRFs).\376\ The
proposal would require banking organizations to separately calculate
the capital requirement for both types of risk factors using an
expected shortfall methodology. Under the proposal, the capital
requirement for both modellable and non-modellable risk factors would
reflect the losses calibrated to a 97.5 percent threshold over a period
of substantial market stress and incorporate the prescribed liquidity
horizons applicable to each risk factor.
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\376\ To be deemed modellable, a risk factor must pass the Risk
Factor Eligibility Test (RFET) and satisfy data quality
requirements, as described in more detail in section III.H.8.a.i of
this SUPPLEMENTARY INFORMATION.
---------------------------------------------------------------------------
Relative to the IMCC for modellable risk factors, the SES
calculation for non-modellable risk factors would provide significantly
less recognition for hedging and portfolio diversification due to the
lower quality inputs to the model; for example, limited data are
available to estimate the correlations between non-modellable risk
factors used by the model. These data limitations also increase the
possibility that a banking organization's internal models overstate the
diversification benefits (and therefore, understate the magnitude of
potential losses), as correlations increase during periods of stress
relative to levels in normal market conditions. Furthermore, the
conservative treatment of non-modellable risk factors under the SES
calculation would provide appropriate incentives for banking
organizations to enhance the quality of model inputs.
The third component of the internal models approach is the
standardized default risk capital requirement, as described in section
III.H.7.b of this SUPPLEMENTARY INFORMATION.
To calculate the overall capital required under the internal models
approach at the trading desk level, a banking organization would add
the standardized default risk capital requirement (DRCSA) to the
greater of (i) the sum of the capital requirements for modellable and
non-modellable risk factors as of the most recent reporting date
(IMCCt-1 and SESt-1, respectively), or (ii) the sum of the average
capital requirements for non-modellable risk factors over the prior 60
business days (SESaverage) and the product of the average capital
requirements for modellable risk factors over the prior 60 business
days (IMCCaverage) and a multiplication factor (mc) of at least 1.5,
which serves to capture model risk (the aggregate trading portfolio
backtesting multiplier).\377\ The overall capital requirement under the
internal models approach can be expressed by the following formula:
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\377\ The size of the multiplication factor could vary from 1.5
to 2 based on the results of the entity-wide backtesting. See
section III.H.8.c. of this SUPPLEMENTARY INFORMATION for further
discussion on the entity-wide backtesting, otherwise known as the
aggregate trading portfolio backtesting multiplier.
IMAG,A = DRCSA + (max ((IMCCt-1 + SESt-1), ((mc x
---------------------------------------------------------------------------
IMCCaverage) + SESaverage)))
Due to the capital multiplier (mc), the agencies generally expect
the capital requirements for modellable and non-modellable risk factors
to reflect those based on the prior 60 business day average, which
would reduce quarterly variation. The proposal would require a banking
organization to take into account the capital requirements as of the
most recent reporting date to capture situations where the banking
organization has significantly increased its risk taking. Thus, the max
function in the above formula would capture cases where risk has risen
significantly throughout the quarter so that the average over the
quarter is significantly less than the risk the banking organization
faces at the end of the quarter.
Question 137: The agencies seek comment on the internal models
approach for market risk. To what extent does the approach
appropriately capture the risks of positions subject to the market risk
capital requirement? What additional features, adjustments (such as to
the treatment of diversification of risks), or alternative methodology
could the approach include to reflect these risks more appropriately
and why? Commenters are encouraged to provide supporting data.
i. Risk Factor Identification and Model Eligibility
Under the proposal, a banking organization that intends to use the
internal models approach would be required to identify an appropriate
set of risk factors that is sufficiently representative of the risks
inherent in all of the market risk covered positions held by model-
eligible trading desks. Specifically, the proposal would require a
banking organization's expected shortfall models to include all the
applicable risk factors specified in the sensitivities-based method
under the standardized approach, with one exception, as well as those
used in either the banking organization's internal risk management
models or in the internal valuation models it uses to report actual
profits and losses for financial reporting purposes. If the risk
factors specified in the sensitivities-based method are not included in
the expected shortfall models used to calculate risk-based capital for
market risk under the internal models approach, the banking
organization would be required to justify the exclusions to the
satisfaction of its primary Federal supervisor. As a check on the
greater flexibility provided under the internal models approach,\378\
in comparison to the proposed sensitivities-based method, model-
eligible trading desks would be subject to PLA add-on and backtesting
requirements, which would help ensure the accuracy and conservativism
of the risk-based capital requirements estimated by the expected
shortfall models.
---------------------------------------------------------------------------
\378\ Unlike the proposed standardized approach, which would
require a banking organization to obtain a prior written approval of
its primary Federal supervisor to calculate risk factor
sensitivities using the banking organization's internal risk
management models, as described in section III.H.7.a.ii of this
SUPPLEMENTARY INFORMATION, the internal models approach would allow
a banking organization to use either the banking organization's
internal risk management models or the internal valuation models
used to report actual profits and losses for financial reporting
purposes.
---------------------------------------------------------------------------
For the identified risk factors, the proposal would require a
banking organization to conduct the risk factor eligibility test to
determine which risk factors are modellable, and thus subject to the
IMCC, and which are non-
[[Page 64132]]
modellable, and thus subject to the SES capital requirements. For a
risk factor to be classified as a modellable risk factor, a banking
organization would be required to identify a sufficient number of real
prices that are representative of the risk factor (those that could be
used to infer the value of the risk factor), as described in section
III.H.8.a.i.I of this SUPPLEMENTARY INFORMATION. Evidence of a
sufficient number of real prices demonstrates the liquidity of the
underlying risk factor and helps to ensure there is a sufficient
quantity of historical data to appropriately capture the risk factor
under expected shortfall models used in the IMCC calculation.
Question 138: The agencies request comment on the appropriateness
of the proposed requirements for the risk factors included in the
internal models approach. What, if any, alternative requirements should
the agencies consider, such as requiring risk factor coverage to align
with the front office models, and why? Specifically, please describe
any operational challenges and impact on banking organizations' minimum
capital requirements that requiring the expected shortfall model to
align with the front-office models would create relative to the
proposal.
I. Real Price
To perform the risk factor eligibility test, a banking organization
would be required to map real prices observed to the risk factors that
affect the value of the market risk covered positions held by model-
eligible trading desks. For example, a banking organization could map
the price of a corporate bond to a credit spread risk factor. The
proposal would define a real price as a price at which the banking
organization has executed a transaction, a verifiable price for an
actual transaction between third parties transacting at arm's length,
or a price obtained from a committed quote made by the banking
organization itself or another party, subject to certain conditions
discussed below. Prices obtained from collateral reconciliations or
valuations would not be considered real price observations for purposes
of the risk factor eligibility test because these transactions do not
indicate market liquidity of the position.
The agencies recognize that a banking organization may need to
obtain pricing information from third parties to demonstrate the market
liquidity of the underlying risk factors, and this may pose unique
challenges for validation and other model risk management activities.
Therefore, the proposed definition of a real price would limit
recognition of prices obtained from third-party providers to prices (1)
from a transaction or committed quote that has been processed through a
third-party provider \379\ or (2) for which there is an agreement
between the banking organization and the third party that the third
party would provide evidence of the transaction or committed quote to
the banking organization upon request.
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\379\ Prices from a transaction or quote processed through a
trading platform or exchange would satisfy this requirement for
purposes of the proposed definition of real price.
---------------------------------------------------------------------------
In certain cases, obtaining information on the prices of individual
transactions from third parties may raise legal concerns for the
banking organization, the third-party provider, or both.\380\
Therefore, the proposal would allow a banking organization to consider
information obtained from a third party on the number of corresponding
real prices observed and the dates at which they have been observed in
determining the model eligibility of risk factors, if the banking
organization is able to appropriately map this information to the risk
factors relevant to the market risk covered positions held by model-
eligible trading desks. For a banking organization to be able to use
such information for determining the model eligibility of risk factors,
the proposal would require that either the third-party provider's
internal audit function or another external party audit the validity of
the third-party provider's pricing information. Additionally, the
proposal would require the results and reports of the audit to either
be made public or available upon request to the banking
organization.\381\
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\380\ Banking organizations must ensure that exchanges of price
information among competitors or with third parties are not likely
to include acts or omissions that could result in a violation of
Federal antitrust laws, including the Sherman Act, 15 U.S.C. 1 et
seq., and the Federal Trade Commission Act, 15 U.S.C. 41 et seq.
\381\ If the audit on the third-party provider is not
satisfactory to the primary Federal supervisor (for example, the
auditor does not meet the independence or expertise standards of
U.S. securities exchanges), the supervisor may determine that data
from the third-party provider may not be used for purposes of the
risk factor eligibility test.
---------------------------------------------------------------------------
The additional requirements for prices or other information
obtained from third parties to qualify as a real price under the
proposed definition would allow banking organizations to appropriately
demonstrate the market liquidity of a risk factor, while also ensuring
there is sufficient documentation for the banking organization and the
primary Federal supervisor to assess the validity of the prices or
other information obtained from a third party.
Question 139: What, if any, other information should the agencies
consider in defining a real price that would better demonstrate the
market liquidity for risk factors, such as valuations provided by an
exchange or central counterparty or valuations of individual derivative
contracts for the purpose of exchanging variation margin? What, if any,
conditions or limitations should the agencies consider applying to help
ensure the validity of such information, such as only allowing
information related to individual derivative transactions to qualify as
a real price and not information provided on a pooled basis?
II. Bucketing Approach
To determine whether a risk factor satisfies the risk factor
eligibility test, a banking organization would be required to (1) map
real prices to each relevant risk factor or set of risk factors, such
as a curve, and (2) define risk buckets at the risk factor level. Under
the proposal, a banking organization could choose either its own
bucketing approach or the standard bucketing approach. As the choice of
approach is at the risk factor level, the proposal would allow a
banking organization to adopt its own bucketing approach for some risk
factors and the standard bucketing approach for others. The number of
risk factor buckets should be driven by the banking organization's
trading strategies. For example, a banking organization with a complex
portfolio across many points on the yield curve could elect to define
more granular risk factor buckets for interest rate risk, such as
separate 3-month and 6-month buckets, than those prescribed under the
standard bucketing approach, which puts all maturities of less than 9
months in one bucket. Conversely, a banking organization with less
complex products could elect to use the less granular standard
bucketing approach.
Table 1 to Sec. __.214 of the proposal provides the proposed risk
factor buckets a banking organization would be required to use to group
real prices under the standard bucketing approach. The proposal would
define the risk factor buckets under the standard bucketing approach
based on the type of risk factor, the maturity of the instruments used
for the real prices, and the probability that an option has value (is
``in the money'') at the maturity of the instrument.\382\ The proposed
buckets are intended to balance between
[[Page 64133]]
the granularity of the risk factors allocated to each standardized
bucket and the compliance burden of tracking and mapping the allocation
of real prices to more granular buckets, especially as market
conditions change. Too frequent re-allocation of real prices may lead
to artificial and unwarranted regulatory capital requirement
volatility.
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\382\ Whether an option has value (is ``in the money'') at the
maturity of the instrument depends on the relationship between the
strike price of the option and the market price for the underlying
instrument (the spot price). A call option has value at maturity if
the strike price is below the spot price. A put option has value at
maturity if the strike price is above the spot price.
---------------------------------------------------------------------------
When using its own bucketing approach, a banking organization would
be able to define more granular risk factor buckets than those
prescribed under the standard bucketing approach, provided that the
internal risk management model uses the same buckets or segmentation of
risk factors to calculate profits and losses for purposes of the PLA
test.\383\ While the use of more granular buckets could facilitate a
model-eligible trading desk's ability to pass the proposed PLA test, it
would also render the risk factor eligibility test more challenging as
the banking organization would need to source a sufficient number of
real prices for each additional risk factor bucket. Therefore, the
proposal would provide the banking organization the flexibility to
define its own bucketing structures and would place an additional
operational burden on the banking organization to demonstrate the
appropriateness of using a more granular bucketing structure.
---------------------------------------------------------------------------
\383\ Sec. __.213(c) of the proposed rule describes trading
desk-level profit and loss attribution test requirements.
---------------------------------------------------------------------------
As positions mature, a banking organization could continue to
allocate real prices identified within the prior 12 months to the risk
factor bucket that the banking organization initially used to reflect
the maturity of such positions. Alternatively, the banking organization
could re-allocate the real prices for maturing positions to the
adjacent (shorter) maturity bucket. To avoid overstating the market
liquidity of a risk factor, the proposal would allow the banking
organization to count a real price observation only once, either in the
initial bucket or the adjacent bucket to which it was re-allocated, but
not in both.
To enable banking organizations' internal models to capture market-
wide movements for a given economy, region, or sector, the proposal
would allow, but not require, a banking organization to decompose risks
associated with credit or equity indices into systematic risk factors
\384\ within its internal models.\385\ The proposal would only allow
the banking organization to include idiosyncratic risk factors \386\
related to the credit spread or equity risk of a specific issuer if
there are a sufficient number of real prices to pass the risk factor
eligibility test. Otherwise, such idiosyncratic risk factors would be a
non-modellable risk factor. The proposal would allow a banking
organization, where possible, to consider real prices of market indices
(for example, CDX.NA.IG and S&P 500 Index) and instruments of
individual issuers as representative for a systematic risk factor as
long as they share the same attributes (for example, economy, region,
sector, and rating) as the systematic risk factor. The proposed
treatment would allow the banking organization to align the treatment
of real prices for market indices with those for single-name positions
and, thus, provide greater hedging recognition.
---------------------------------------------------------------------------
\384\ The proposal would define systematic risk factors as
categories of risk factors that present systematic risk, such as
economy, region, and sector. Systematic risk would be defined as the
risk of loss that could arise from changes in risk factors that
represent broad market movements and that are not specific to an
issue or issuer.
\385\ As a banking organization may not always be able to model
each constituent of the index, the agencies are not proposing to
require the banking organization to always decompose credit spread
and equity risk factors.
\386\ Idiosyncratic risk factors would be defined as categories
of risk factors that present idiosyncratic risk. Idiosyncratic risk
would be defined as the risk of loss in the value of a position that
arise from changes in risk factors unique to the issuer. These risks
would include the inherent risks associated with a specific issuance
or issuer that would change a position's value but are not
correlated with broader market movements (for example, the impact on
the position's value from departure of senior management or
litigation).
---------------------------------------------------------------------------
To determine whether the risk factors in a bucket pass the risk
factor eligibility test, the proposal would require a banking
organization to allocate a real price to any risk bucket for which the
price is representative of the risk factors within the bucket and to
count all real prices mapped to a risk bucket. A real price may often
be used to infer values for multiple risk factors. By requiring real
prices to evidence the model eligibility of all risk factors related
with the observation, the proposal would more accurately capture the
market liquidity for the relevant risk factors.
Question 140: The agencies request comment on what, if any,
modifications to the proposed bucketing structure should be considered
to better reflect the risk factors used to price certain classes of
products. What would be the benefits or drawbacks of such alternatives
compared to the proposed bucketing structure?
III. Model Eligibility of Risk Factors
For a risk factor to pass the risk factor eligibility test, a
banking organization would be required on a quarterly basis to either
identify for each risk factor (i) at least 100 real prices in the
previous twelve-month period or (ii) at least 24 real prices in the
previous twelve-month period, if each 90-day period contains at least
four real prices.\387\ The proposed criteria are intended to help
ensure real prices capture products that exhibit either a minimum level
of trading activity throughout the year, or seasonal periods of
liquidity, such as commodities.
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\387\ As described in section III.H.8.a.i.I of this
SUPPLEMENTARY INFORMATION, in certain cases, a banking organization
would be allowed to obtain information on the prices of individual
transactions from third parties in determining the model eligibility
of risk factors.
---------------------------------------------------------------------------
For any market risk covered position, the banking organization
could not count more than one real price observation in any single day
and would be required to count the real price as an observation for all
of the risk factors for which it is representative. Together, these
requirements are intended to help ensure that real prices capture more
accurately the market liquidity for the relevant risk factors and
prevent outdated prices from being used as model inputs.\388\
---------------------------------------------------------------------------
\388\ For example, if several transactions occur on day one,
followed by a long period for which there are no real price
observations, the proposal would prevent a banking organization from
using the outdated day-one prices to estimate the fair value of its
current holdings.
---------------------------------------------------------------------------
The agencies recognize that the banking organization may use a
combination of internal and external data for the risk factor
eligibility test. When a banking organization relies on external data,
the real prices may be provided with a time lag. Therefore, the
proposal would allow the banking organization to use a different time
period for purposes of the risk factor eligibility test than that used
to calibrate the current expected shortfall model, if such difference
is not greater than one month. For consistency in the time periods used
for internal and external data, the proposal would also allow the
period used for internal data for purposes of the risk factor
eligibility test to differ from that used to calibrate the expected
shortfall model, but only if the period used for internal data is
exactly the same as that used for external data.
For risk factors associated with new issuances, the observation
period for the risk factor eligibility test would begin on the issuance
date and the number of real prices required to pass the risk factor
eligibility test would be pro-rated until
[[Page 64134]]
12 months after the issuance date. For example, a bond that was issued
six months prior would require 50 real prices over the prior six-month
period to pass the risk factor eligibility test or at least 12 real
price observations with no 90-day period in which fewer than four real
price observations were identified for the risk factor. For market risk
covered positions that reference new reference rates, the proposal
would allow the banking organization to use quotes of discontinued
reference rates that the new reference rate is replacing to pass the
risk factor eligibility test until the new reference rate liquidity
improves.
If a standard or own bucket for risk factor eligibility contains a
sufficient number of real prices to pass the risk factor eligibility
test and the risk factors also satisfy the data quality requirements
for modellable risk factors described in the following section, all
risk factors within the bucket would be deemed modellable. Risk factors
within a bucket that fail to pass the risk factor eligibility test or
that do not satisfy the data qualify requirements would be classified
as non-modellable risk factors.
Question 141: What, if any, restrictions on the minimum observation
period for new issuances should the agencies consider and why?
Question 142: The agencies request comment on whether certain types
of risk factors should be considered to pass the risk factor
eligibility test based on sustained volume over time and through crisis
periods. What if any conditions should be met before these can be
considered real price observations and why?
IV. Data Quality Requirements
Under the proposal, once a risk factor has passed the risk factor
eligibility test, the banking organization would be required to choose
the most appropriate data for calculating the IMCC for modellable risk
factors. In calculating the IMCC, a banking organization could use
other data than that used to demonstrate the market liquidity of a risk
factor for purposes of the risk factor eligibility test, provided that
such data meet the data quality requirements listed below. Alternative
sources may provide updated data more frequently than would otherwise
be available from those used to obtain real prices. For example,
banking organizations may be able to obtain updated data more
frequently from internal systems than from third-party providers.
Additionally, in certain cases, a banking organization may not be able
to use the real prices to calculate the IMCC. For example, a banking
organization may receive data from a third-party provider on the dates
and number of real prices, as described in section III.H.8.a.i.I of
this SUPPLEMENTARY INFORMATION. While such data demonstrates the
liquidity of a risk factor for purposes of the risk factor eligibility
test, without the transaction prices, such real prices would not
provide any value to calibrate potential losses for a particular risk
factor.
To help ensure the appropriateness of the data and other
information used to calibrate the expected shortfall models for IMCC,
the proposal would establish data quality requirements for risk factors
to be deemed modellable risk factors. Under the proposal, any risk
factor that passes the risk factor eligibility test but subsequently
fails to meet any of the following seven proposed data quality
requirements would be a non-modellable risk factor.
First, the proposal would generally require that the data reflect
prices observed or quoted in the market. For any data not derived from
real prices, the proposal would require the banking organization to
demonstrate that such data are reasonably representative of real
prices. A banking organization should periodically reconcile the price
data used to calibrate its expected shortfall models for IMCC with that
used by the front office and internal risk management models, to
confirm the validity of the price data used to calculate the IMCC under
the internal models approach.\389\
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\389\ If real prices are not widely available, a banking
organization may use the prices estimated by the front office and
risk management models for this comparison.
---------------------------------------------------------------------------
Second, the proposal would require the data used in the expected
shortfall models for IMCC to capture both the systematic risk and
idiosyncratic risk (as applicable) of modellable risk factors so that
the IMCC appropriately reflects the potential losses arising from
modellable risk factors.
Third, the proposal would require the data used to calibrate the
IMCC expected shortfall model to appropriately reflect the volatility
and correlation of risk factors of market risk covered positions.
Different data sources can provide dramatically different volatility
and correlation estimates for asset prices. When selecting the data
sources to be used in calculating the IMCC, a banking organization
should assess the quality and relevance of the data to ensure it would
be appropriately representative of real prices, not understate price
volatility, and accurately reflect the correlation of asset prices,
rates across yield curves, and volatilities within volatility surfaces.
Fourth, the proposal would allow the data used to calibrate the
IMCC expected shortfall model to include combinations of other
modellable risk factors. However, a risk factor derived from a
combination of modellable risk factors would be modellable only if this
risk factor also passes the risk factor eligibility test.
Alternatively, banking organizations may decompose the derived risk
factor into two components: a modellable component and a non-modellable
component that represents the basis between the modellable component
and the non-modellable risk factor. To derive modellable risk factors
from combinations of other modellable risk factors, banking
organizations could use common approaches, such as interpolation or
principal component analysis, if such approaches are conceptually
sound. In connection with implementation of any final rule based on
this proposal, the agencies would intend to use the supervisory process
to supplement the proposal through horizontal reviews to evaluate the
appropriateness of banking organizations' use of combinations of risk
factors to determine whether a risk factor is modellable. For example,
the agencies could require risk factors to be treated as non-modellable
if the banking organization were to use unsound extrapolation or
irregular bucketing approaches for modellable risk factors.
Fifth, the proposal would require a banking organization to update
the data inputs at a sufficient frequency and on at least a weekly
basis. While generally the banking organization should strive to update
the data inputs as frequently as possible, the agencies would require
the data to be updated weekly as requiring large data sets to be
updated more frequently may pose significant operational challenges.
For example, a banking organization that relies on a third-party
provider may not be able to receive updated data on a real time or
daily basis. The proposal would require a banking organization that
uses regressions to estimate risk factor parameters to re-estimate the
parameters on a regular basis. In addition, the agencies would expect a
banking organization to calibrate its expected shortfall models to
current market prices at a sufficient frequency, ideally no less
frequently than the calibration of front office models. A banking
organization would be required to have clear policies and procedures
for backfilling and gap-filling missing data.
Sixth, in determining the liquidity horizon-adjusted expected
shortfall-based measure, a banking organization
[[Page 64135]]
would be required to use data that are reflective of market prices
observed or quoted in periods of stress. Under the proposal, banking
organizations should source the data directly from the historical
period, whenever possible. Even if the characteristics of the market
risk covered positions currently being traded differ from those traded
during the historical stress period, the proposal would require a
banking organization to empirically justify the use of any prices in
the expected shortfall calculation in a stress period that differ from
those actually observed during a historical stress period. For market
risk covered positions that did not exist during a period of
significant financial stress, the proposal would require banking
organizations to demonstrate that the prices used match changes in the
prices or spreads of similar instruments during the stress period.
Seventh, the data for modellable risk factors could include proxies
if the banking organization were able to demonstrate the
appropriateness of such proxies to the satisfaction of the primary
Federal supervisor. At a minimum, a banking organization would be
required to have sufficient evidence demonstrating the appropriateness
of the proxies, such as an appropriate track record for their
representation of a market risk covered position. Additionally, any
proxies used would be required to (1) exhibit sufficiently similar
characteristics to the transactions they represent in terms of
volatility level and correlations and (2) be appropriate for the
region, credit spread cohort, quality, and type of instrument they are
intended to represent. Under the proposal, a banking organization's
proxying of new reference rates would be required to appropriately
capture the risk-free rate as well as credit spread, if applicable.
Even if a risk factor passes the risk factor eligibility test and
satisfies each of the seven proposed data quality requirements, the
primary Federal supervisor may determine the data inputs to be
unsuitable for use in calculating the IMCC. In such cases, the proposal
would require a banking organization to exclude the risk factor from
the expected shortfall model and subject it to the SES capital
requirements for non-modellable risk factors.
Question 143: The agencies request comment on the appropriateness
of the proposed data quality requirements for modellable risk factors.
What, if any, challenges might the proposed requirements pose for
banking organizations? What, if any, additional requirements should the
agencies consider to help ensure the data used to calculate the IMCC
appropriately capture the potential losses arising from modellable risk
factors?
Question 144: The agencies request comment on the appropriateness
of requiring banking organizations to update the data inputs used in
calculating the IMCC on at least a weekly basis. What, if any,
challenges might this pose for banking organizations? How could such
concerns be mitigated while ensuring the integrity of the data inputs
used to calculate regulatory capital requirements for modellable risk
factors?
Question 145: The agencies request comment on the appropriateness
of requiring banking organizations to re-estimate parameters in line
with the frequency specified in their policies and procedures. What, if
any, challenges might this pose for banking organizations?
Question 146: The agencies request comment on the operational
burden of requiring banking organizations to model the idiosyncratic
risk of an issuer that satisfies the risk factor eligibility test and
data quality requirements using data inputs for that issuer. What, if
any, alternative approaches should the agencies consider such as
allowing banking organizations to use data from similar names that
would appropriately capture the idiosyncratic risk of the issuer? What
would be the benefits and drawbacks of such alternatives relative to
the proposal?
ii. Internally Modelled Capital Calculation (IMCC) for Modellable Risk
Factors
The IMCC for modellable risk factors is intended to capture the
estimated losses for market risk covered positions on model-eligible
trading desks arising from changes in modellable risk factors during a
period of substantial market stress. As described in this section, the
IMCC for modellable risk factors would begin with the calculation each
business day of the expected shortfall-based measure for an entity-wide
level for each risk class and across risk classes for all model-
eligible trading desks, and also for a trading desk level throughout a
twelve-month period of stress, which then would be adjusted using risk-
factor specific liquidity horizons.
The proposal would require a banking organization to use one or
more internal models to calculate on an entity-wide level for each risk
class and across risk classes a daily expected shortfall-based measure
under stressed market conditions.\390\ While the proposal would allow a
banking organization's expected shortfall internal models to use any
generally accepted modelling approach (for example, variance-covariance
models, historical simulations,\391\ or Monte Carlo simulations) to
measure the expected shortfall for modellable risk factors, the
proposal would require the models to satisfy the proposed backtesting
and PLA testing requirements to demonstrate on an on-going basis that
such models are functioning effectively and to assess their performance
over time as conditions and model applications change.\392\
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\390\ As discussed in section III.H.8.a.ii.I of this
Supplementary Information, a banking organization may elect to
either use (1) the full set of risk factors employed by its internal
risk management models and directly calculate the daily expected
shortfall measure under the selected twelve-month period of stress
or (2) an appropriate subset of modellable risk factors to estimate
the potential losses that would be incurred throughout the selected
stress period, which would require the banking organization to
estimate a daily expected shortfall measure for both the current and
stress period.
\391\ The proposal would allow a banking organization to use
filtered historical simulation, as the approach generally reflects
current volatility and would maintain equal weighting of the
observations by rescaling all of the observations.
\392\ See sections III.H.8.b and III.H.8.c of this Supplementary
Information for further discussion on the PLA testing and
backtesting requirements, respectively.
---------------------------------------------------------------------------
Additionally, the proposal would require a banking organization's
expected shortfall internal models to appropriately capture the risks
associated with options, including non-linear price characteristics,
within each of the risk classes as well as correlation and relevant
basis risks, such as basis risks between credit default swaps and
bonds. For options, at a minimum, the proposal would require a banking
organization's expected shortfall internal models to have a set of risk
factors that capture the volatilities of the underlying rates and
prices and model the volatility surface across both strike price and
maturity, which are necessary inputs for appropriately valuing the
options.
I. Expected Shortfall-Based Measure
To reflect the potential losses arising from modellable risk
factors on model-eligible trading desks throughout an appropriately
severe twelve-month period of stress (as described in section
III.H.8.a.ii.III of this Supplementary Information), the proposal would
require a banking organization to use one or more internal models to
calculate each business day an expected shortfall-based measure using a
one-tail, 97.5th percentile confidence interval at the
[[Page 64136]]
entity-wide level for each risk class and across all risk classes for
all model-eligible trading desks.\393\
---------------------------------------------------------------------------
\393\ The proposal would also require banking organizations to
calculate a daily expected shortfall-based measure at the trading
desk level for the purposes of backtesting and PLA testing to
determine whether a model-eligible trading desk is subject to the
PLA add-on. See sections III.H.8.b and III.H.8.c of this
Supplementary Information for further discussion.
---------------------------------------------------------------------------
Under the proposal, the requirement to exclude non-modellable risk
factors from expected shortfall-based internal models used to calculate
the IMCC could pose significant operational burden for entity-wide
backtesting and may also cause anomalies in the expected shortfall-
based calculation that render the IMCC relatively unstable.\394\
Accordingly, the proposal would allow a banking organization, with
approval from its primary Federal supervisor, to also capture in its
internal models the non-modellable risk factors on model-eligible
trading desks, though such positions would still be required to be
included in the SES measure for non-modellable risk factors, described
in section III.H.8.a.iii of this Supplementary Information. The
agencies view that this will provide a banking organization an
appropriate incentive to integrate the expected shortfall-based
internal models used to calculate the IMCC into its daily risk
management processes,\395\ which may not distinguish between modellable
and non-modellable risk factors.
---------------------------------------------------------------------------
\394\ For example, when a single tenor point is excluded from
the shock to an interest rate curve, the resulting shock across the
curve may be unrealistic.
\395\ As described in more detail in section III.H.5.d.ii of
this Supplementary Information, the proposal would require a banking
organization that calculates the market risk capital requirements
under the models-based measure for market risk to incorporate its
internal models, including its expected shortfall internal models,
into its daily risk management process.
---------------------------------------------------------------------------
To calculate the daily expected shortfall-based measure, a banking
organization would apply a base liquidity horizon of 10 days (the
shortest liquidity horizon for any risk factor bucket in each risk
factor class) to either the full set of modellable risk factors on its
model-eligible trading desks or an appropriate subset of modellable
risk factors throughout a twelve-month stress period (base expected
shortfall).
The agencies view that requiring a banking organization to directly
estimate the potential change in value of each of its market risk
covered positions held by model-eligible trading desks arising from the
full set of modellable risk factors throughout a twelve-month period of
stress may pose significant operational challenges. For example, a
banking organization may not be able to source sufficient data for all
modellable risk factors during the identified twelve-month stress
period. Thus, the proposal would allow a banking organization to use
either the full set of modellable risk factors employed by the expected
shortfall model (direct approach) or an appropriate subset (indirect
approach) of the entire portfolio of modellable risk factors for the
stress period.
Under the direct approach, the banking organization would directly
calculate the expected shortfall measure at the entity-wide level for
each risk class and across all risk classes throughout a twelve-month
period of stress and then apply the liquidity horizon adjustments
discussed in the following section.
Under the indirect approach, a banking organization would use a
reduced set of modellable risk factors to estimate the losses that
would be incurred throughout the stress period for the full set of
modellable risk factors. The proposal would require a banking
organization using the indirect approach to perform three separate
expected shortfall calculations at the entity-wide level for each risk
class and at the entity-wide level across risk classes: one using a
reduced set of risk factors for the stress period, one using the same
reduced set of risk factors for the current period, and one using the
full set of risk factors for the current period. Similar to the direct
approach, the proposal would require the banking organization to apply
the liquidity horizon adjustments discussed in the following section to
each of the three expected shortfall calculations to approximate the
entity-wide liquidity horizon-adjusted expected shortfall-based
measures for the full set of risk factors in stress.
Under the proposal, the banking organization would multiply the
liquidity horizon-adjusted expected shortfall-based measure for the
stress period based on the reduced set of risk factors (ESR,S) by the
ratio of the liquidity horizon-adjusted expected shortfall-based
measure in the current period based on the full set of risk factors
(ESF,C) to the lesser of the current liquidity-horizon adjusted
expected shortfall-based measure using the reduced set of risk factors
or ESF,C (ESR,C), as provided according to the following formula under
Sec. __.215(b)(6)(ii)(B) of the proposed rule, ES:
[GRAPHIC] [TIFF OMITTED] TP18SE23.032
The proposal would floor this ratio at one to prevent a reduction in
capital requirements due to using the reduced set of risk factors.
Additionally, the proposal would require the entity-wide liquidity
horizon-adjusted expected shortfall-based measure for the current
period based on the reduced set of risk factors (ESR,C),to explain at
least 75 percent of the variability of the losses estimated by the
liquidity horizon-adjusted expected shortfall-based measure in the
current period for the full set of risk factors (ESF,C) over the
preceding 60 business days. Under the proposal, compliance with the 75
percent variation requirement would be determined based on an out-of-
sample R\2\ measure, as defined according to the following formula
under Sec. __.215(b)(5)(ii)(C) of the proposed rule:
[GRAPHIC] [TIFF OMITTED] TP18SE23.033
Mean(ESF,C) would be the mean of ESF,C over the previous 60 business
days. This formula is intended to help ensure that the potential losses
estimated under the indirect approach appropriately reflect those that
would be produced by the full set of modellable risk factors, if such a
stress were to occur in the current period.
Furthermore, to help ensure the accuracy of this comparison, the
proposal would require a banking organization that uses the indirect
approach to update the reduced set of
[[Page 64137]]
risk factors whenever it updates its twelve-month stress period, as
described in section III.H.8.a.ii.III of this Supplementary
Information. The proposal would also require the reduced set of
modellable risk factors used to calculate the liquidity horizon-
adjusted expected shortfall-based measure for the stress period to have
a sufficiently long history of observations that satisfies the data
quality requirements for modellable risk factors, as described in
section III.H.8.a.i.IV of this Supplementary Information. In this
manner, the proposal would hold the inputs used for the indirect
approach to the same data quality requirements as those required of the
inputs used in the direct approach.
Question 147: What operational difficulties, if any, would be posed
by requiring banking organizations to exclude non-modellable risk
factors from the expected shortfall models for the purpose of the IMCC
calculation and entity-wide daily backtesting requirement?
Question 148: The agencies request comment on the appropriateness
of requiring the election of either the direct or the indirect approach
to apply to the entire portfolio of modellable risk factors for market
risk covered positions on model-eligible trading desks. What, if any,
alternatives should the agencies consider that would enable banking
organizations' expected shortfall models to more accurately measure
potential losses under the selected stress period, such as allowing
banking organizations to make this election at the level of the trading
desk, risk class, or risk factor? If this election is allowed at a more
granular level, how should the agencies consider addressing the
operational challenges associated with aggregating the various direct
and indirect expected shortfall measures into a single entity-wide
expected shortfall measure? What would be the benefits and drawbacks of
such alternatives compared to the proposed entity-wide election?
II. Liquidity Horizon Adjustments
To capture appropriately the potential losses from the longer
periods of time needed to reduce the exposure to certain risk factors
(for example, by selling assets or entering into hedges), a banking
organization would assign each modellable risk factor to the proposed
liquidity horizons specified in Table 2 to Sec. __.215 of the proposed
rule.
BILLING CODE 6210-01-P; 6714-01-P; 4810-33-P
[[Page 64138]]
[GRAPHIC] [TIFF OMITTED] TP18SE23.034
BILLING CODE 6210-01-C; 6714-01-C; 4810-33-C
The proposed liquidity horizons (10, 20, 40, 60, and 120 days)
would vary across risk factors, with longer horizons assigned to those
that would require longer periods of time to sell or hedge, except for
instruments with a maturity shorter than the respective liquidity
horizon. For instruments with a maturity shorter than the respective
liquidity horizon assigned to the risk factor, the banking organization
would be required to use the next longer liquidity horizon compared to
the maturity of the market risk covered position. For example, if an
investment grade corporate bond matures in 19 days, the proposal would
require a banking organization to assign the associated credit spread
risk factor a liquidity horizon of 20 days rather than the proposed 40-
day liquidity horizon. To map liquidity horizons for multi-underlying
instruments, such as credit and equity indices, the proposal would
require a banking organization to take a weighted average of the
liquidity horizons of risk factors corresponding to the underlying
constituents and the respective weighting of each within the index and
use the shortest liquidity horizon that is equal to or longer than the
weighted average.\397\ Furthermore, the proposal would require a
banking organization to apply a consistent liquidity horizon to both
the inflation risk factors and interest rate risk factors for a given
currency.
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\396\ Any currency pair formed by the following list of
currencies: USD, EUR, JPY, GBP, AUD, CAD, CHF, MXN, CNY, NZD, HKD,
SGD, TRY, KRW, SEK, ZAR, INR, NOK, BRL, and any additional
currencies specified by the primary Federal supervisor.
\397\ A weighted average would be based on the market value of
the instruments with the same liquidity horizon.
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In general, the proposed liquidity horizons closely follow the
Basel III reforms. The proposal would clarify the applicable liquidity
horizon for non-securitization positions issued or guaranteed by the
GSEs. Under the proposal, a banking organization would assign a
liquidity horizon of 20 days to GSE debt guaranteed by a GSE, and a
liquidity horizon of 40 days to all other
[[Page 64139]]
positions issued by the GSEs. The proposed 20-day liquidity horizon
would recognize that GSE debt instruments guaranteed by the GSEs
consistently trade in very large volumes and, similar to U.S. Treasury
securities, have historically been able to rapidly generate liquidity
for a banking organization, including during periods of severe market
stress. Consistent with the agencies' current capital rule, the
proposal would assign a longer 40-day liquidity horizon to all other
positions issued by the GSEs, as such positions are not as liquid or
readily marketable as those that are guaranteed by the GSEs. Together,
the proposed treatment is intended to promote consistency and
comparability in regulatory capital requirements across banking
organizations and to help ensure appropriate capitalization of such
positions under subpart F of the capital rule.
To encourage sound risk management and enable a banking
organization and the agencies to appropriately evaluate the conceptual
soundness of the expected shortfall models used to calculate the IMCC,
the proposal would require a banking organization to establish and
document procedures for performing risk factor mappings consistently
over time. Additionally, the proposal would require a banking
organization to map each of its risk factors to one of the risk factor
categories and the corresponding liquidity horizon in a consistent
manner on a quarterly basis to help ensure that the selected stress
period continues to appropriately reflect potential losses for the risk
factors of model-eligible trading desks over time.
To conservatively recognize empirical correlations across risk
factor classes, the proposal would require a banking organization to
calculate the liquidity horizon-adjusted expected shortfall-based
measure both at the entity-wide level for each risk class and across
risk classes for all model-eligible trading desks. To calculate the
entity-wide liquidity horizon-adjusted expected shortfall-based measure
for each risk class, the banking organization would be required to
scale up the 10-day base expected shortfall measure using the longer
proposed liquidity horizons for modellable risk factors within the same
risk class and assign either the same or a longer liquidity horizon;
all other modellable risk factors, including those within the same risk
class but assigned a shorter liquidity horizon, would be held constant
to appropriately reflect the incremental losses attributable to the
specific risk factors over the longer proposed liquidity horizon. The
banking organization would calculate separately the liquidity horizon-
adjusted expected shortfall-based measure for modellable risk factors
within the same risk class at each proposed liquidity horizon
consecutively, starting with the shortest (10 days). Specifically, a
banking organization would first compute the potential loss over the 0-
to 10-day period,\398\ then the potential loss over the subsequent 10-
to 20-day period--assuming that its exposure to risk factors within the
10-day liquidity horizon has been eliminated--and continue this
calculation for each of the proposed liquidity horizons, as described
in Table 1 to Sec. __.215 of the proposed rule. A banking organization
would then aggregate the losses for each period to determine the total
liquidity horizon-adjusted expected shortfall-based measure for the
risk class.
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\398\ When computing losses over the 0- to 10-day period, the
proposal would require a banking organization to floor the time
period for extinguishing its exposure to a risk factor exposure at
10 days. For example, if an instrument would mature in two days, the
banking organization must still calculate the potential losses
assuming a 10-day liquidity horizon.
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The liquidity horizon-adjusted expected shortfall-based measure for
each risk class would reflect both the losses under the expected
shortfall-based measure and the incremental losses at each proposed
liquidity horizon, according to the following formula, as provided
under Sec. __.215(b)(3) of the proposed rule:
[GRAPHIC] [TIFF OMITTED] TP18SE23.035
Where:
ES is the regulatory liquidity horizon-adjusted expected shortfall;
T is the length of the base liquidity horizon, 10 days;
EST(P) is the ES at base liquidity horizon T of a portfolio with
market risk covered positions P;
EST(P,j) is the ES at base liquidity horizon T of a portfolio with
market risk covered positions P for all risk factors whose liquidity
horizon corresponds to the index value, j, specified in Table 1 to
Sec. __.215 of the proposed rule;
LHj is the liquidity horizon corresponding to the index value, j,
specified in Table 1 to Sec. __.215 of the proposed rule.
To calculate the liquidity horizon-adjusted expected shortfall-
based measure at the entity-wide level across risk classes, the banking
organization would scale up the 10-day expected shortfall-based measure
for all modellable risk factors assigned either the same or a longer
liquidity horizon, without distinguishing between risk classes.
Otherwise, the process to calculate the entity-wide liquidity horizon-
adjusted expected shortfall-based measure would be the same as the
risk-class level calculation.
---------------------------------------------------------------------------
\399\ The incremental increase in time is represented by the
difference in the liquidity horizons, LHj-LHj-1. In the example,
from liquidity horizon 20 days to 40 days, this amount is 20 days,
or 40 days-20 days. The incremental increase in time is divided by
the base horizon of 10 days. Thus, the time scaling factor for
credit spread risk is the square root of 2.
---------------------------------------------------------------------------
For example, assume that a banking organization would be required
to calculate the liquidity horizon-adjusted expected shortfall-based
measure for a single, USD denominated, investment grade corporate bond,
whose price is only driven by two risk factors, interest rate risk and
credit spread risk. Under the proposal, the banking organization would
calculate the expected shortfall-based measure for both interest rate
risk and credit risk factors using the 10-day liquidity horizon, as
expressed by EST(P) in the above formula. According to Table 2 to Sec.
__.215 in the proposed rule, the liquidity horizon for interest rate
risk denominated in USD is 10 days and the liquidity horizon for credit
spread risk of investment grade issuers is 40 days. Therefore, the
banking organization would not extend the liquidity horizon for
interest rate risk but would for the credit spread risk. To determine
the liquidity horizon-adjusted expected shortfall-based measure for
credit spread risk, the banking organization would (1) scale the credit
spread risk by the square root of
[[Page 64140]]
the incremental increase in time (1 for liquidity horizon from 10 days
to 20 days and the square root of 2 for liquidity horizon from 20 days
to 40 days),\399\ (2) add the resulting liquidity horizon adjustment
for credit spread risk, as expressed by the second term in the above
formula and repeated below, to the base 10-day liquidity horizon
squared, and (3) calculate the square root of the sum of (1) and (2):
[GRAPHIC] [TIFF OMITTED] TP18SE23.036
As described above, the proposal would require the banking
organization to perform this calculation at the aggregate level, which
combines the risk factors for all risk classes and separately for each
risk class, such as interest rate risk and credit spread risk. The
proposal would require the banking organization to use the results of
these calculations as inputs into the overall capital calculation,
described in more detail below in section III.H.8.a.ii.IV of this
Supplementary Information.
Question 149: What, if any, risk factors exist that would not be
captured by the proposal for which the agencies should consider
designating a specific liquidity horizon and why?
Question 150: The agencies request comment on the appropriateness
of assigning a liquidity horizon for multi-underlying instruments based
on the weighted average of the liquidity horizons for the risk factors
corresponding to the underlying constituents and the respective
weighting of each within the index. What, if any, alternative
methodologies should the agencies consider, such as assigning the
liquidity horizon for credit and equity indices based on the longest
liquidity horizon applicable to the risk factors corresponding to the
underlying constituents? What would be the benefits and drawbacks of
such alternatives compared to the proposal? Commenters are encouraged
to provide data to support their responses.
Question 151: The agencies request comment on the appropriateness
of requiring banking organizations to use the next longer liquidity
horizon for instruments with a maturity shorter than the respective
liquidity horizon assigned to the risk factor. What, if any,
operational challenges might this pose for banking organizations? How
could such concerns be mitigated while still ensuring consistency and
comparability in regulatory capital requirements across banking
organizations?
III. Stress Period
To appropriately account for potential losses in stress, the
proposal would require a banking organization to calculate the entity-
wide expected shortfall-based measures for each risk class and across
risk classes described in section III.H.8.a.ii.I of this Supplementary
Information using the twelve-month period of stress for which its
market risk covered positions on model-eligible trading desks would
experience the largest cumulative loss. To identify the appropriate
period of stress, the proposal would require a banking organization to
consider all twelve-month periods spanning back to at least 2007 and,
depending on whether the banking organization elected to employ the
direct or indirect approach, select that in which either the full or
reduced set of risk factors would incur the largest cumulative
loss.\400\ The proposal would require a banking organization to equally
weight observations within each twelve-month stress period when
selecting the appropriate stress period.
---------------------------------------------------------------------------
\400\ Under the proposal, a banking organization that has
elected to use the direct approach would select the relevant stress
period using the full set of modellable risk factors, while that
using the indirect approach would use the reduced set of risk
factors to select the stress period.
---------------------------------------------------------------------------
To help ensure that the stress period continues to appropriately
reflect potential losses for the modellable risk factors of model-
eligible trading desks over time, the proposal would require a banking
organization to review and update, if appropriate, the twelve-month
stress period on at least a quarterly basis or whenever there are
material changes in the risk factors of model-eligible trading desks.
Question 152: The agencies seek comment on the appropriateness of
requiring banking organizations to use the same reduced set of risk
factors to both identify the appropriate stress period and calculate
the IMCCs. To what extent does the proposed approach provide banking
organizations sufficient flexibility to appropriately capture the risk
factors that may be present in some, but not all stress periods? What,
if any, alternative approaches should the agencies consider that would
better serve to capture such risk factors relative to the proposal?
IV. Total Internal Models Capital Calculations (IMCC)
The proposal would require a banking organization to use the
liquidity horizon-adjusted expected shortfall-based measures calculated
throughout the stress period at the entity-wide level for each risk
(IMCC(Ci)) and at the entity-wide level across risk classes (IMCC(C))
to calculate the IMCC for the modellable risk factors of model-eligible
trading desks. To constrain the empirical correlations and provide an
appropriate balance between perfect diversification and no
diversification between risk factor classes, the IMCC would equal half
of the entity-wide liquidity horizon-adjusted expected shortfall-based
measure across all risk classes plus half of the sum of the liquidity
horizon-adjusted expected shortfall measures for each risk class,
according to the following formula, as provided under Sec.
__.215(c)(4) of the proposed rule:
[GRAPHIC] [TIFF OMITTED] TP18SE23.037
Where:
i indexes the following risk classes: interest rate risk, credit
spread risk, equity risk, commodity risk and foreign exchange risk.
iii. Stressed Expected Shortfall (SES) for Non-Modellable Risk Factors
Under the proposal, the SES capital requirement for non-modellable
risk factors would be similar to the IMCC for modellable risk factors,
except that the SES calculation would provide significantly less
recognition for hedging and portfolio diversification relative to the
IMCC.
Under the proposal, a banking organization would have to use a
stress scenario that is calibrated to be at least as prudent as the
expected shortfall-
[[Page 64141]]
based measure for modellable risk factors and calculate the liquidity
horizon-adjusted expected shortfall-based measure for non-modellable
risk factors in stress using the same general process as proposed for
modellable risk factors, with three key differences. First, the
proposal would require a banking organization to separately carry out
such calculation for each non-modellable risk factor, as opposed to at
the risk class level. Second, the proposal would require a banking
organization to apply a minimum liquidity horizon adjustment of at
least 20 days, rather than 10 days. Third, the proposal would require a
banking organization to separately identify for each risk class the
stress period for which its market risk covered positions on model-
eligible trading desks would experience the largest cumulative loss,
except that a common twelve-month period of stress could be used for
all non-modellable risk factors arising from idiosyncratic credit
spread or equity risk due to spot, futures and forward prices, equity
repo rates, dividends and volatilities.
To calculate the aggregate SES capital requirement for non-
modellable risk factors, the proposal would require a banking
organization to separate non-modellable risk factors (the
ESNMRF) into those with idiosyncratic credit spread risk,
those with idiosyncratic equity risk, and those with systematic risk,
according to the following formula as provided under Sec. __.215(d)(2)
of the proposed rule:
[GRAPHIC] [TIFF OMITTED] TP18SE23.038
Where:
ISESNM,i is the stress scenario capital measure for non-modellable
idiosyncratic credit spread risk, i, aggregated with zero
correlation, and where I is a non-modellable idiosyncratic credit
spread risk factor;
ISESNM,j is the stress scenario capital measure for non-modellable
idiosyncratic equity risk, j, aggregated with zero correlation, and
where J is a non-modellable idiosyncratic equity risk factor;
SESNM,k is the stress scenario capital measure for the remaining
non-modellable systematic risk factors, k, and where K is the
remaining non-modellable risk factors in a model-eligible trading
desk; and
[rho] is equal to 0.6.
For non-modellable risk factors with systematic risk, the third
term would allow for a limited and appropriate diversification benefit
that depends on the level of [rho] parameter. For idiosyncratic non-
modellable risk factors that the banking organization demonstrates are
not related to broader market movements,\401\ the proposal would
provide greater diversification benefit by allowing such non-modellable
risk factors to be aggregated with zero correlation.
---------------------------------------------------------------------------
\401\ One way to show this is to regress equity return or
changes in credit spreads on systematic risk factors and show that
the residuals of these regressions are uncorrelated with each other.
---------------------------------------------------------------------------
Given the limited data available for non-modellable risk factors
from which to estimate correlations between such factors, the proposed
conservative capital treatment would address the potential risk of
lower quality inputs being used in calculating market risk capital
requirements for non-modellable risk factors (for example, the limited
data set overstates the diversification benefits and, therefore,
understates the magnitude of potential losses of non-modellable risk
factors).
In recognition of the data limitations of non-modellable risk
factors, the proposal would allow a banking organization to use proxies
in designing the stress scenario for each risk class of non-modellable
risk factors, as long as such proxies satisfy the data quality
requirements for modellable risk factors. Additionally, with approval
from its primary Federal supervisor, a banking organization may use an
alternative approach to design the stress scenario for each risk class
of non-modellable risk factors. However, when a banking organization is
not able to model a stress scenario for a risk factor class, or a
smaller subset of non-modellable risk factors, that is acceptable to
the primary Federal supervisor, the proposal would require the banking
organization to use a methodology that produces the maximum possible
loss.
Question 153: The agencies seek comment on the treatment of non-
modellable risk factors. Specifically, is the treatment for non-
modellable risk factors appropriate and commensurate with their risks?
What other treatments should the agencies consider and why? Should the
agencies consider scaling the resulting aggregate SES capital
requirement for non-modellable risk factors by a multiplier to better
reflect the risk profile of these risk factors and, if so, how should
that multiplier be calibrated and why?
iv. Aggregate Trading Portfolio Backtesting Capital Multiplier
Under subpart F of the current capital rule, each quarter, a
banking organization must compare each of its most recent 250 business
days of entity-wide trading losses (excluding fees, commissions,
reserves, net interest income, and intraday trading) with the
corresponding daily VaR-based measure calibrated to a one-day holding
period and at a one-tail, 99.0 percent confidence level. Depending on
the number of exceptions in the entity-wide backtesting results, a
banking organization must apply a multiplication factor, which can
range from 3 to 4, to a banking organization's VaR-based and stressed
VaR-based capital requirements for market risk.
The proposal generally would retain the backtesting requirements in
subpart F of the current capital rule, with two modifications. First,
the proposal would require backtesting of VaR-based measures against
both actual profit and loss as well as against hypothetical profit and
loss.\402\ Specifically, for the most recent 250 business days,\403\ a
banking organization would be required to separately compare each
business day's aggregate actual profit and loss for transactions on
model-eligible trading desks and aggregate hypothetical profit and loss
for transactions on model-eligible trading desks with the corresponding
aggregate VaR-based measures for that business day
[[Page 64142]]
calibrated to a one-day holding period at a one-tail, 99.0 percent
confidence level for market risk covered positions on all model-
eligible trading desks. Second, the proposal generally would require a
banking organization to apply a lower capital multiplier (mc), that
could range from a factor of 1.5 to 2, to the 60-day average estimated
capital required for modellable risk factors, based on the number of
exceptions in the entity-wide backtesting results.\404\
---------------------------------------------------------------------------
\402\ The proposal would define hypothetical profit and loss as
the change in the value of the market risk covered positions that
would have occurred due to changes in the market data at end of
current day if the end-of-previous-day market risk covered positions
remained unchanged. Valuation adjustments that are updated daily
would have to be included, unless the banking organization receives
approval from its primary Federal Supervisor to exclude them.
Valuation adjustments for which separate regulatory capital
requirements have been otherwise specified, commissions, fees,
reserves, net interest income, intraday trading, and time effects
would have to be excluded. See Sec. __.202 of the proposed rule.
\403\ In its first year of backtesting, a banking organization
would count the number of exceptions that have occurred since it
began backtesting.
\404\ The mechanics of the backtesting requirements for the
aggregate trading portfolio backtesting multiplier would be the same
as those at the trading desk level. Consistent with the trading desk
level backtesting requirements, the proposal would allow banking
organizations to disregard backtesting exceptions related to
official holidays and, in certain instances, those related to non-
modellable risk factors and technical issues. See section III.H.8.c
of this Supplementary Information for a detailed description of the
mechanics of the proposed backtesting requirements, including
circumstances in which a banking organization may disregard a
backtesting exemption.
CA = max((IMCCt-1 + SESt-1), ((mc x IMCCaverage)
---------------------------------------------------------------------------
+ SESaverage))
The proposed backtesting requirements would measure the
conservatism of the forecasting assumptions and the valuation methods
in the expected shortfall models used for determining risk-based
capital requirements by comparing the daily VaR-based measure against
the actual and hypothetical profits and losses. Such comparisons are a
critical part of a banking organization's ongoing risk management, as
they improve a banking organization's ability to make prompt
adjustments to the internal models used for determining risk-based
capital requirements to address factors such as changing market
conditions and model deficiencies. A high number of exceptions could
indicate modeling issues (for example, insufficiently conservative risk
factor shocks) and warrant increased capital requirements.
The proposed PLA add-on, as described in section III.H.8.b of this
Supplementary Information, would require a banking organization's
market risk capital requirement to reflect an additional capital
requirement for deficiencies in the accuracy of a banking
organization's internal models. Accordingly, the backtesting
requirements and associated multiplication factor provide appropriate
incentives for banking organizations to regularly update the internal
models used for determining regulatory capital requirements.
Question 154: What, if any, alternative techniques should the
agencies consider that would render the capital multiplier a more
appropriate measure of the robustness of a banking organization's
internal models? What are the benefits and drawbacks of such
alternatives compared to the proposed calculation for the aggregate
trading portfolio backtesting capital multiplier?
v. Default Risk Capital Requirement Under the Internal Models Approach
The agencies propose to require all banking organizations to use
the standardized default risk capital requirement regardless of whether
they use the IMCC plus SES or the sensitivities-based method plus the
residual risk add-on for non-default market risk factors. The agencies
propose this simplification to the internally modelled approach for
market risk in order to reduce the operational burden for a banking
organization and to further promote consistency in risk-based capital
requirements across banking organizations and within the capital rule.
b. PLA Add-On
Under the proposal, use of the internal models approach for a
model-eligible trading desk fundamentally would depend on the accuracy
of the potential future profits or losses estimated under the banking
organization's expected shortfall models relative to those produced by
the valuation methods used to report actual profits and losses for
financial reporting purposes (front office models). The proposed profit
and loss attribution test metrics \405\ would help ensure that the
theoretical changes in a model-eligible trading desk's revenue produced
by the internal risk management models are sufficiently close to the
hypothetical changes produced by valuation methods used by the banking
organization in the end-of-day valuation process and adequately capture
the risk factors used in such models. Thus, the proposed PLA test
metrics would measure the materiality of the simplifications of the
internal risk management models used by a model-eligible trading desk
relative to the front-office models and remove the eligibility of any
trading desk for which such simplifications are deemed material from
using the internal models approach to calculate its regulatory capital
requirement for market risk.
---------------------------------------------------------------------------
\405\ The proposed PLA test metrics include (1) the Spearman
correlation metric which assesses the correlation between the risk-
theoretical profit and loss and the hypothetical profit and loss;
and (2) the Kolmogorov-Smirnov metric which assesses the similarity
of the distributions of the risk-theoretical profit and loss and the
hypothetical profit and loss.
---------------------------------------------------------------------------
The proposal would impose an additional capital requirement (the
PLA add-on) on model-eligible trading desks for which either or both of
the two desk-level PLA test metrics demonstrate deficiencies in the
ability of the banking organization's internal models to appropriately
capture the market risk of a model-eligible trading desk's market risk
covered positions. The PLA add-on would help ensure that model-eligible
trading desks with model deficiencies, but not disqualifying failures
of the PLA test metrics, are subject to more conservative capital
requirements relative to model-eligible trading desks without model
deficiencies. Additionally, the PLA add-on provides appropriate
incentives for such trading desks to address the potential gaps in data
and model deficiencies. However, a model-eligible trading desk that
passes both of the PLA test metrics could still be subject to the PLA
add-on if the primary Federal supervisor determines that the trading
desk no longer complies with all applicable requirements, as described
in section III.H.5.d of this Supplementary Information.
i. PLA Test
To measure the materiality of the simplifications (for example,
missing risk factors and differences in the way positions are valued)
within the expected shortfall models used by each model-eligible
trading desk, the PLA test would require a banking organization, for
each model-eligible trading desk, to compare the daily profit and loss
values produced by its internal risk management models (risk-
theoretical profit and loss) \406\ against the hypothetical profit and
loss produced by the front office models.
---------------------------------------------------------------------------
\406\ The proposal would define risk-theoretical profit and loss
as the daily trading desk-level profit and loss on the end-of-
previous-day market risk covered positions generated by the banking
organization's internal risk management models. The risk-theoretical
profit and loss would have to take into account all risk factors,
including non-modellable risk factors, in the banking organization's
internal risk management models.
---------------------------------------------------------------------------
I. Data Input Requirements
For the sole purpose of the PLA test, the proposal would permit a
banking organization to align the risk factor input data used in the
valuations calculated by the internal risk management models with that
used in the front office models, if the banking organization
demonstrates that such an alignment would be appropriate. If the input
data for a given risk factor that is common to both the front office
models and the internal risk management models differs due to data
acquisition complications (specifically, different market data sources,
time fixing of market data sources, or transformations of market data
into input data suitable
[[Page 64143]]
for the risk factors of the underlying valuation engines), a banking
organization may adjust the input data used by the front office models
into a format that can be used by the internal risk management models.
When transforming the input data of the front office models into a
format that can be applied to the risk factors used in internal risk
management models, the banking organization would be required to
demonstrate that no differences in the risk factors or in the valuation
models have been omitted. The proposal would require a banking
organization to assess the effect of these input data alignments on
both the valuations produced by the internal risk management models and
the PLA test when designing or changing the input data alignment
process, or at the request of the primary Federal supervisor.
Additionally, the proposal would require a banking organization to
treat time effects \407\ in a consistent manner in the hypothetical
profit and loss and the risk-theoretical profit and loss.\408\
---------------------------------------------------------------------------
\407\ Time effects can include various elements such as the
sensitivity to time, or theta effect, and carry or costs of funding.
\408\ In particular, when time effects are included in (or
excluded from) the hypothetical profit and loss, they must also be
included in (or excluded from) the risk-theoretical profit and loss.
---------------------------------------------------------------------------
The proposed flexibility would allow the results of the PLA test
metrics to more accurately assess the consistency of the risk-
theoretical and hypothetical profit and loss for a particular model-
eligible trading desk, by focusing on differences due to the pricing
function and risk factor coverage rather than those arising from use of
different data inputs.
Furthermore, the proposal would allow, subject to approval by the
primary Federal supervisor, a banking organization, for a model-
eligible trading desk that holds a limited amount of securitization
positions or correlation trading positions pursuant to its trading or
hedging strategy, to include such positions for the purposes of the PLA
tests. Allowing such positions to be included would enable
securitization positions held as hedges to be recognized with the
underlying positions they are intended to hedge and thus minimize the
potential of PLA testing to incorrectly identify model deficiencies for
model-eligible trading desks due solely to the bi-furcation of such
hedges. For model-eligible trading desks with approval of the primary
Federal supervisor to incorporate securitization positions in their PLA
test metrics, the proposal would require the banking organization to
calculate the market risk capital requirements for such positions using
the more conservative capital treatment under the standardized approach
or the fallback capital requirement, as described in sections III.H.7
and III.H.6.c of this Supplementary Information, respectively.
II. PLA Test Metrics
For the PLA test, the banking organization, for each model-eligible
trading desk, would be required to compare, for the most recent 250
business days, the risk-theoretical profit and loss and the
hypothetical profit and loss using two test metrics: the Spearman
correlation and the Kolmogorov-Smirnov metric.
To calculate the Spearman correlation metric, the banking
organization, for each model-eligible trading desk, must compute, for
each of the most recent 250 business days, the rank order of the daily
hypothetical profit and loss, (RHPL), and the rank order of the daily
risk-theoretical profit and loss, (RRTPL), with the lowest profit and
loss value in the time series receiving a rank of 1, the next lowest
value receiving a rank of 2, etc. The Spearman correlation coefficient
for the two rank orders, RHPL and RRTPL, would be based on the
following formula:
[GRAPHIC] [TIFF OMITTED] TP18SE23.039
where cov(RHPL, RRTPL) is the covariance between RHPL and RRTPL and
[sigma]RHPL and [sigma]RRTPL are the standard
deviations of rank orders RHPL and RRTPL, respectively.
As a testing metric, the Spearman correlation coefficient is
intended to support sound risk management by assessing the correlation
between the daily risk-theoretical profit and loss and the hypothetical
profit and loss for a model-eligible trading desk. A high degree of
correlation would indicate directional consistency between the two
measures.
To calculate the Kolmogorov-Smirnov metric, the banking
organization, for each model-eligible trading desk, would identify the
number of daily observations over the most recent 250 business days
where the risk-theoretical profit and loss or separately the
hypothetical profit and loss is less than or equal to the specified
value. To appropriately weight the probability of each daily
observation,\409\ the proposal would define the empirical cumulative
distribution function as the number of daily observations multiplied by
0.004 (1/250). Under the proposal, the Kolmogorov-Smirnov metric would
be the largest absolute difference observed between these two empirical
cumulative distributions of profit and loss at any value, which could
be expressed as:
---------------------------------------------------------------------------
\409\ For example, if the internal risk management model
generates the same value for the model-eligible trading desk's
portfolio on two separate days, the proposal would require the
banking organization to assign a larger probability by requiring
each daily observation to be weighted at 0.004.
---------------------------------------------------------------------------
KS = max(abs(DHPL-DRTPL))
where DHPL is the empirical cumulative distribution of
hypothetical profit and loss produced by the front office models and
DRTPL the empirical cumulative distribution of risk-
theoretical profit and loss produced by the internal risk management
models.
As a testing metric, the Kolmogorov-Smirnov metric is intended to
support good risk management by requiring banking organizations to
assess the similarity of the distribution of the daily portfolio values
for a model-eligible trading desk generated by the internal risk
management models and the front office models. The closeness of the
distributions would indicate how accurately the internal risk-
management models capture the range of losses experienced by the model-
eligible trading desk across different market conditions with closer
distributions indicating greater accuracy with respect to pricing and
risk factor coverage. Applying this process over a given period would
provide information about the accuracy of the internal risk management
model's ability to appropriately reflect the shape of the whole
distribution of values for the model-eligible trading desk's portfolio
compared to the distribution of values generated by the front office
models, including information on the size and number of valuation
differences.
Based on the PLA test results for the two above metrics, a banking
organization would be required to allocate each model-eligible trading
desk to a PLA test zone as set out in Table 1 to Sec. __.213 of the
proposed rule.
The proposal would permit a banking organization to consider a
model-eligible trading desk to be in the green zone only if both of the
PLA test metrics fall into the green zone. Conversely, a banking
organization would consider a model-eligible trading desk to be in the
red zone if either of the PLA test metrics fall within the red zone.
The proposal would require a banking organization to consider all other
model-eligible trading desks (such as those with both metrics in the
amber zone or one metric in the amber zone and the other in the green
zone) in the amber zone. Additionally, under the proposal, the primary
Federal
[[Page 64144]]
supervisor could require a banking organization to assign a different
PLA test zone to a model-eligible trading desk than that based on PLA
test metrics of the model-eligible trading desk.\410\
---------------------------------------------------------------------------
\410\ As discussed in more detail in section III.H.5.d.iv. of
this Supplementary Information, if for initial or on-going model
eligibility, the primary Federal supervisor subjects a model-
eligible trading desk to the PLA add-on, the model-eligible trading
desk would remain subject to the PLA add-on until either the model-
eligible trading desk (1) provides at least 250 business days of
backtesting and PLA test results that pass the trading-desk level
backtesting requirements and produce PLA metrics in the green zone,
or (2) receives written approval from the primary Federal supervisor
that the PLA add-on no longer applies.
---------------------------------------------------------------------------
Question 155: The agencies seek comment on all aspects of the PLA
test metrics. What, if any, modifications should the agencies consider
that would enable the PLA tests to more appropriately measure the
robustness of a banking organization's internal models?
Question 156: The agencies seek comment on the appropriateness of
allowing banking organizations to align the risk input data between the
internal risk management models and the front-office models. What other
instances, if any, should the agencies consider to ensure accurate and
consistent assessment of the profit and losses produced by the internal
risk management models with those produced by the front office models
for a particular model-eligible trading desk?
Question 157: The agencies request comment on the benefits and
drawbacks of allowing banking organizations, with regulatory approval,
to include non-modellable risk factors for purposes of the PLA tests.
Should non-modellable risk factors be excluded from the PLA tests? Why
or why not? What, if any, further conditions should the agencies
consider including to appropriately limit the inclusion of non-
modellable risk factors for purposes of the PLA tests? Commenters are
encouraged to provide data to support their responses.
ii. Calculation of the PLA Add-On
Under the proposal, a banking organization would consider model-
eligible trading desks in the green zone or amber zone as passing the
PLA test for model eligibility purposes but would be required to apply
the PLA add-on to model-eligible trading desks within the amber zone.
The proposal would require a banking organization to calculate the PLA
add-on as the greater of zero and the aggregate capital benefit to the
banking organization from the internal models approach (the difference
between the capital requirements for all model-eligible trading desks
\411\ in the green or amber zone under the standardized approach
(SAG,A) and those under the internal models approach
(IMAG,A)), multiplied by a multiplication factor of k, as
defined according to the following formula under Sec. __.213(c)(4) of
the proposed rule:
---------------------------------------------------------------------------
\411\ In calculating the PLA add-on, a banking organization must
exclude any securitization positions, including correlation trading
positions, held by a model-eligible desk, as such positions must be
subject to either the standardized approach or the fallback capital
requirement.
---------------------------------------------------------------------------
PLA add-on = k x max ((SAG,A-IMAG,A),0)
Under the proposal, the value of k would equal half of the ratio of
the sum of the standardized approach capital requirements for each
model-eligible trading desk within the amber zone and those for each of
the model-eligible trading desks within either the green or amber zone
as defined according to the following formula under Sec.
__.213(c)(4)(i) of the proposed rule:
[GRAPHIC] [TIFF OMITTED] TP18SE23.040
Thus, the value of k would gradually increase from 0 to 0.5 as the
number of model-eligible trading desks within the amber zone increases,
which is intended to mitigate the potential cliff effect of
significantly increasing market risk capital requirements as a model-
eligible trading desk transitions from using the internal models
approach to the standardized approach.
iii. Application of the PLA Add-On
If, in the most recent 250 business day period, a trading desk that
the primary Federal supervisory previously approved to use the internal
models approach produces results in the PLA test red zone, the proposal
would require the banking organization to use the standardized approach
and calculate market risk capital requirements for the positions held
by the trading desk together with all other trading desks subject to
the standardized approach.\412\ Under the proposal, since deficiencies
identified by the PLA test metrics relate solely to the expected
shortfall models, if the expected shortfall model used by a trading
desk subsequently fails the PLA test, the banking organization would
calculate the market risk capital requirement for the trading desk
using the sensitivities-based method and the residual risk add-on, as
applicable. The proposal would not permit the banking organization to
use the internal models approach to calculate market risk capital
requirements for the trading desk until the trading desk (i) produces
PLA test results in either the green or amber zone and passes specific
trading desk level backtesting requirements over the most recent 250
business days, or (ii) receives approval from the primary Federal
supervisor.
---------------------------------------------------------------------------
\412\ As discussed in section III.H.5.d.i of this Supplementary
Information, model-eligible trading desks that hold limited amounts
of securitization and correlation trading positions must calculate
regulatory capital requirements for such positions under the
standardized approach or fallback capital requirement, as
applicable. With regulatory approval, a banking organization may
include such positions within its internal models for the purposes
of the PLA tests and backtesting.
---------------------------------------------------------------------------
c. Backtesting Requirements for Model-Eligible Trading Desks
Under the proposal, a banking organization may treat a trading desk
that conducts and successfully passes both backtesting and the PLA test
at the trading desk level on an ongoing quarterly basis as a model-
eligible trading desk. For determining the model eligibility of a
trading desk, the proposal would require the banking organization to
perform backtesting at the trading desk level. For the purpose of desk-
level backtesting, for each trading desk, a banking organization would
be required to compare each of its most recent 250 business days'
actual profit and loss and hypothetical profit and loss produced by the
front office models with the corresponding daily VaR-based measure
calculated by the banking organization's expected shortfall model under
the internal models approach. The proposal would require the banking
organization, for each trading desk, to calibrate the VaR-based measure
to a one-day holding period and at both the 97.5th percentile and the
99.0th percentile one-tail confidence levels.
Under the proposal, a backtesting exception would occur when the
daily actual profit and loss or the daily hypothetical profit and loss
of the trading desk exceeds the corresponding daily VaR-based measure
calculated by the banking organization's expected shortfall model. A
banking organization must count separately the number of backtesting
exceptions that occurred in the most recent 250 business days for
actual profit and loss at each confidence level and those that occurred
for hypothetical profit and loss at each confidence level. A trading
desk would become model-ineligible if, in the most recent 250 business
day period, the trading desk experiences any of the following: (1) 13
or more exceptions for actual profit and loss at the 99.0th percentile;
(2) 13 or more exceptions for hypothetical profit and loss at the
99.0th percentile; (3) 31 or more exceptions for
[[Page 64145]]
actual profit and loss at the 97.5th percentile; or (4) 31 or more
exceptions for hypothetical profit and loss at the 97.5th percentile.
In the event that either the daily actual or hypothetical profit and
loss is unavailable or the banking organization is unable to compute
them, or the banking organization is unable to compute the VaR-based
measure for a particular business day, the proposal would require the
banking organization to treat such an occurrence as a backtesting
exception unless related to an official holiday, in which case the
banking organization may disregard the backtesting exception. In
addition, with approval of the primary Federal supervisor, the banking
organization must disregard the backtesting exception if the banking
organization could demonstrate that the backtesting exception is due to
technical issues that are unrelated to the banking organization's
internal model; or if the banking organization could show that a
backtesting exception relates to one or more non-modellable risk
factors and the market risk capital requirement for these non-
modellable risk factors exceeds either (a) the difference between the
banking organization's VaR-based measure and actual loss or (b) the
difference between the banking organization's VaR-based measure and
hypothetical loss for that business day. In these cases, the banking
organization must demonstrate to the primary Federal supervisor that
the non-modellable risk factor has caused the relevant loss.
If in the most recent 250 business day period a trading desk
experiences either 13 or more backtesting exceptions at the 99.0th
percentile, or 31 or more backtesting exceptions at the 97.5th
percentile, the proposal would require the banking organization to use
the standardized approach to determine the market risk capital
requirements for the market risk covered positions held by the trading
desk. If a model-eligible trading desk is approved with less than 250
business days of trading desk level backtesting and PLA test results,
the proposal would require a banking organization to use all
backtesting data for the model-eligible trading desk and to prorate the
number of allowable exceptions by the number of business days for which
backtesting data are available for the model-eligible trading desk. The
proposal would allow the banking organization to return to using the
full internal models approach to calculate market risk capital
requirements for the trading desk if the banking organization (1)
remediates the internal model deficiencies such that the trading desk
successfully passes trading desk-level backtesting and reports PLA test
metrics in the green or amber zone or (2) receives approval of the
primary Federal supervisor.
Question 158: Should non-modellable risk factors be excluded from
the proposed backtesting requirements? Why or why not? What, if any,
further conditions should the agencies consider including to limit
appropriately the inclusion of non-modellable risk factors for purposes
of the backtesting requirements? Commenters are encouraged to provide
data to support their responses.
Question 159: The agencies invite comment on what, if any,
challenges requiring banking organizations to directly calculate the
internally modelled capital requirement for modellable risk factors
using a 10-day liquidity horizon for the purposes of the daily expected
shortfall-based measure for modellable risk factors could pose and a 1-
day VaR for the purposes of backtesting could pose. What, if any,
alternative methodologies should the agencies consider?
9. Treatment of Certain Market Risk Covered Positions
To promote consistency and comparability in the risk-based capital
requirements across banking organizations and to help ensure
appropriate capitalization of positions subject to subpart F of the
capital rule, the proposal would clarify the treatment of certain
market risk covered positions under the standardized and models-based
measures for market risk.
a. Net Short Risk Positions
The proposal would require a banking organization to calculate on a
quarterly basis its exposure arising from any net short credit or
equity position.\413\ A banking organization would be required to
include net short risk positions exceeding $20 million in its total
market risk capital requirement for the entire quarter, under both the
standardized measure for market risk and the models-based measure for
market risk, as applicable.
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\413\ See section III.H.3.c of this Supplementary Information
for a more detailed discussion on net short risk positions.
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The proposed quarterly approach is intended to reduce operational
burden of requiring a banking organization to capture temporary or
small differences arising from fluctuations in the value of positions
subject to the credit risk framework. Further, the proposed quarterly
calculation requirement should help ensure that banking organizations
are appropriately managing and monitoring net short risk positions
arising from exposures subject to subpart D or E of the capital rule at
intervals of sufficient frequency to prevent the formation of non-
negligible net short risk positions.
As proposed it may be difficult for a banking organization to apply
the standardized approach or internal models approach to net short risk
positions given that the composition of any particular net short
position could contain a different combination of various underlying
instruments. Therefore, if unable to calculate a risk factor
sensitivity for a net short risk position, the proposal would require
the banking organization to calculate market risk capital requirements
using the fallback capital requirement as described in section
III.H.6.c of this Supplementary Information.
b. Securitization Positions and Defaulted and Distressed Market Risk
Covered Positions
The proposal would require a banking organization to calculate
market risk capital requirements for securitization positions using the
standardized approach or the fallback capital requirement, as
applicable. The proposed treatment would address regulatory arbitrage
concerns as well as deficiencies in the modelling of securitization
positions that became more evident during the course of the financial
crisis that began in mid-2007.
The proposal would require a banking organization to include
defaulted and distressed market risk covered positions in only the
standardized default risk capital requirement. Such positions are not
required to be included in the sensitivities-based method or the
residual risk add-on of the standardized approach, or in the non-
default capital requirement for modellable and non-modellable risk
factors. Generally, distressed and defaulted positions trade based on
recovery, which is not driven by or reflective of the credit spread of
the issuer. Therefore, in addition to being operationally difficult,
requiring a banking organization to calculate the sensitivity of such
positions to changes in credit spreads may not be appropriate for the
purposes of quantifying the risk posed by such positions. Additionally,
subjecting defaulted and distressed positions to capital requirements
under the sensitivities-based method, residual risk add-on, or expected
shortfall measures for modellable and non-modellable risk factors would
increase the capital requirements for such positions beyond the maximum
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potential loss of such holdings, as the standardized default risk
capital requirement already assigns a 100 percent risk weight and LGD
to such exposures. If unable to calculate the standardized default risk
capital requirement for such positions, the proposal would require the
banking organization to calculate market risk capital requirements
using the fallback capital requirement.\414\
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\414\ As described in more detail in section III.H.6.c of this
Supplementary Information, the fallback capital requirement would
apply in instances where a banking organization is unable to apply
the internal models approach and the standardized approach to
calculate market risk capital requirements.
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As the amount of regulatory capital required under the fallback
capital requirement would equal the absolute fair value of the
position, the proposal would cap the overall market risk capital
requirement for defaulted, distressed, and securitization positions at
the maximum loss of the position. By capping the amount of regulatory
capital requirement for such positions at the total potential loss that
a banking organization could incur from holding such positions, the
proposal would align the risk-based requirements under the standardized
and internal models approaches, as applicable, with those under the
fallback capital requirement.
c. Equity Positions in an Investment Fund
i. Standardized Approach
For equity positions in an investment fund for which the banking
organization is able to use the look-through approach to calculate a
market risk capital requirement for its proportional ownership share of
each exposure held by the investment fund, the proposal would require a
banking organization to apply the look-through approach under the
standardized measure for market risk. Alternatively, a banking
organization could elect not to apply the look-through approach for
such positions if the investment fund closely tracks an index benchmark
or holds a listed and well-diversified index position. Generally, the
agencies would consider an equity position in an investment fund to
closely track the index if the standard deviation of the returns of the
investment fund (ignoring fees and commissions) over the prior year
differs from those of the index by only a small percentage (for
example, less than 1 percent). For an equity position in an investment
fund that closely tracks an index benchmark, the proposal would allow a
banking organization to treat the equity position in the investment
fund as if it was the tracked index in calculating the delta, vega, and
curvature capital requirements, given the high correlation of the
equity position with that of the index.\415\ Further, for equity
positions in an investment fund that holds a listed and well-
diversified index, the proposal would allow a banking organization to
calculate the delta, vega, and curvature capital requirements for the
underlying index position using the treatment for indices \416\ and
apply the look-through approach to the other underlying exposures of
the investment fund.
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\415\ In this situation, the banking organization would apply
the treatment for index instruments described in section
III.H.7.d.ii of this Supplementary Information.
\416\ In this situation, the banking organization would apply
the treatment for index instruments described in section
III.H.7.d.ii of this Supplementary Information.
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For equity positions in an investment fund for which the banking
organization is not able to use the look-through approach to calculate
a market risk capital requirement for its proportional ownership share
of each exposure held by the investment fund, but where the banking
organization has access to daily price quotes for the investment fund
and to the information contained in the fund's mandate, the proposal
would allow the banking organization to calculate capital requirements
in one of three ways under the standardized measure for market risk.
For equity positions in an investment fund that closely tracks an index
benchmark, the banking organization could assume that the investment
fund is the tracked index and treat the equity position as an index
instrument when calculating the delta, vega, and curvature capital
requirement.\417\ Alternatively, the proposal would allow the banking
organization to calculate the delta, vega, and curvature capital
requirements for the equity position based on the hypothetical
portfolio of the investment fund or allocate the equity position in the
investment fund to the other sector risk bucket.
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\417\ In this situation, the banking organization would apply
the treatment for index instruments described in section
III.H.7.d.ii of this Supplementary Information.
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Under the proposed hypothetical portfolio approach, the banking
organization would need to assume that the investment fund invests to
the maximum extent permitted under its mandate in those exposures with
the highest applicable risk weight and continues to make investments in
the order of the exposure type with the next highest applicable risk
weight until the maximum total investment level is reached. If more
than one risk weight can be applied to a given exposure, the proposal
would require the banking organization to use the maximum applicable
risk weight in calculating the sensitivities-based method requirement.
Alternatively, the banking organization may assume that the investment
fund invests based on the most recent quarterly disclosure of the
fund's historical holdings of underlying positions. The proposal would
require a banking organization to weight the constituents of the
investment fund based on the hypothetical portfolio. Further, the
proposal would require a banking organization to calculate market risk-
based capital requirements for the hypothetical portfolio on a stand-
alone basis for all positions in the fund, separate from any other
position subject to market risk capital requirements.
Alternatively, the proposal's fallback method would allow a banking
organization to allocate equity positions in an investment fund to the
applicable other sector risk bucket.\418\ Under this approach, the
banking organization would determine whether, given the mandate of the
investment fund, to apply a higher risk weight in calculating the
standardized default risk capital requirement and whether to apply the
residual risk add-on. For example, if a banking organization determines
that the residual risk add-on applies, the banking organization must
assume that the investment fund has invested in such exposures to the
maximum extent permitted under its mandate. For equity positions in
publicly traded real estate investment trusts, the proposal would
require a banking organization to treat such exposures as a single
exposure and apply the risk weight applicable to exposures allocated to
the other sector risk bucket when calculating the delta, vega, and
curvature capital requirements under the sensitivities-based
method.\419\ While equity positions in publicly traded real estate
investment trusts are traded on the market, the underlying assets of
such trusts generally are not. Thus, often a banking organization will
not be able to calculate the risk factor sensitivity for each of the
underlying assets of the real estate investment trust. Requiring a
banking organization to treat equity positions in real estate
investment trusts as a single position would help ensure that market
risk capital requirements appropriately capture a banking
organization's market
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risk exposure arising from such positions in a manner that minimizes
compliance burden and enhances risk-capture. As each of the proposed
alternative approaches would reflect a highly conservative capital
requirement, the agencies consider that the proposed alternatives would
help ensure a banking organization maintains sufficient capital against
potential losses arising from equity positions in an investment fund
for which the banking organization is unable to identify the underlying
positions held by the fund.
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\418\ Table 8 to Sec. __.209 of the proposed rule provides the
proposed delta risk buckets and corresponding risk weights for
positions within the equity risk class.
\419\ Under the proposal, such exposures would receive the 70
percent risk weight applicable to equity risk factors allocated to
bucket 11 in Table 8. See Sec. __.209(b)(5) of the proposed rule.
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Similar to index instruments and multi-underlying options that are
non-securitization debt or equity positions, the default risk of equity
positions in an investment fund is primarily a function of the
idiosyncratic default risk of the underly