[Federal Register: August 4, 2003 (Volume 68, Number 149)]
[Proposed Rules]
[Page 45899-45948]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr04au03-14]
[[Page 45899]]
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Part II
Department of the Treasury
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Office of the Comptroller of the Currency
12 CFR Part 3
Federal Reserve System
12 CFR Parts 208 and 225
Federal Deposit Insurance Corporation
12 CFR Part 325
Department of the Treasury
Office of Thrift Supervision
12 CFR Part 567
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Risk-Based Capital Guidelines; Implementation of New Basel Capital
Accord; Internal Ratings-Based Systems for Corporate Credit and
Operational Risk Advanced Measurement Approaches for Regulatory
Capital; Proposed Rule and Notice
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DEPARTMENT OF THE TREASURY
Office of the Comptroller of the Currency
12 CFR Part 3
[Docket No. 03-14]
RIN Number 1557-AC48
FEDERAL RESERVE SYSTEM
12 CFR Parts 208 and 225
[Regulations H and Y; Docket No. R-1154]
FEDERAL DEPOSIT INSURANCE CORPORATION
12 CFR Part 325
RIN 3064-AC73
DEPARTMENT OF THE TREASURY
Office of Thrift Supervision
12 CFR Part 567
[No. 2003-27]
RIN 1550-AB56
Risk-Based Capital Guidelines; Implementation of New Basel
Capital Accord
AGENCIES: Office of the Comptroller of the Currency, Treasury; Board of
Governors of the Federal Reserve System; Federal Deposit Insurance
Corporation; and Office of Thrift Supervision, Treasury.
ACTION: Advance notice of proposed rulemaking.
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SUMMARY: The Office of the Comptroller of the Currency (OCC), the Board
of Governors of the Federal Reserve System (Board), the Federal Deposit
Insurance Corporation (FDIC), and the Office of Thrift Supervision
(OTS) (collectively, the Agencies) are setting forth for industry
comment their current views on a proposed framework for implementing
the New Basel Capital Accord in the United States. In particular, this
advance notice of proposed rulemaking (ANPR) describes significant
elements of the Advanced Internal Ratings-Based approach for credit
risk and the Advanced Measurement Approaches for operational risk
(together, the advanced approaches). The ANPR specifies criteria that
would be used to determine banking organizations that would be required
to use the advanced approaches, subject to meeting certain qualifying
criteria, supervisory standards, and disclosure requirements. Other
banking organizations that meet the criteria, standards, and
requirements also would be eligible to use the advanced approaches.
Under the advanced approaches, banking organizations would use internal
estimates of certain risk components as key inputs in the determination
of their regulatory capital requirements.
DATES: Comments must be received no later than November 3, 2003.
ADDRESSES: Comments should be directed to: OCC: Please direct your
comments to: Office of the Comptroller of the Currency, 250 E Street,
SW., Public Information Room, Mailstop 1-5, Washington, DC 20219,
Attention: Docket No. 03-14; fax number (202) 874-4448; or Internet
address: regs.comments@occ.treas.gov. Due to delays in paper mail
delivery in the Washington area, we encourage the submission of
comments by fax or e-mail whenever possible. Comments may be inspected
and photocopied at the OCC's Public Information Room, 250 E Street,
SW., Washington, DC. You may make an appointment to inspect comments by
calling (202) 874-5043.
Board: Comments should refer to Docket No. R-1154 and may be mailed
to Ms. Jennifer J. Johnson, Secretary, Board of Governors of the
Federal Reserve System, 20th Street and Constitution Avenue, NW.,
Washington, DC 20551. However, because paper mail in the Washington
area and at the Board of Governors is subject to delay, please consider
submitting your comments by e-mail to
regs.comments@federalreserve.gov., or faxing them to the Office of the
Secretary at (202) 452-3819 or (202) 452-3102. Members of the public
may inspect comments in Room MP-500 of the Martin Building between 9
a.m. and 5 p.m. weekdays pursuant to Sec. 261.12, except as provided
by Sec. 261.14, of the Board's Rules Regarding Availability of
Information, 12 CFR 261.12 and 261.14.
FDIC: Written comments should be addressed to Robert E. Feldman,
Executive Secretary, Attention: Comments, Federal Deposit Insurance
Corporation, 550 17th Street, NW., Washington, DC 20429. Commenters are
encouraged to submit comments by facsimile transmission to (202) 898-
3838 or by electronic mail to Comments@FDIC.gov. Comments also may be
hand-delivered to the guard station at the rear of the 550 17th Street
Building (located on F Street) on business days between 8:30 a.m. and 5
p.m. Comments may be inspected and photocopied at the FDIC's Public
Information Center, Room 100, 801 17th Street, NW., Washington, DC
between 9 a.m. and 4:30 p.m. on business days.
OTS: Send comments to Regulation Comments, Chief Counsel's Office,
Office of Thrift Supervision, 1700 G Street, NW., Washington, DC 20552,
Attention: No. 2003-27. Delivery: Hand deliver comments to the Guard's
desk, east lobby entrance, 1700 G Street, NW., from 9 a.m. to 4 p.m. on
business days, Attention: Regulation Comments, Chief Counsel's Office,
Attention: No. 2003-27. Facsimiles: Send facsimile transmissions to FAX
Number (202) 906-6518, Attention: No. 2003-27. E-mail: Send e-mails to
regs.comments@ots.treas.gov, Attention: No. 2003-27, and include your
name and telephone number. Due to temporary disruptions in mail service
in the Washington, DC area, commenters are encouraged to send comments
by fax or e-mail, if possible.
FOR FURTHER INFORMATION CONTACT:
OCC: Roger Tufts, Senior Economic Advisor (202-874-4925 or
roger.tufts@occ.treas.gov), Tanya Smith, Senior International Advisor
(202-874-4735 or tanya.smith@occ.treas.gov), or Ron Shimabukuro,
Counsel (202-874-5090 or ron.shimabukuro@occ.treas.gov).
Board: Barbara Bouchard, Assistant Director (202/452-3072 or
barbara.bouchard@frb.gov), David Adkins, Supervisory Financial Analyst
(202/452-5259 or david.adkins@frb.gov), Division of Banking Supervision
and Regulation, or Mark Van Der Weide, Counsel (202/452-2263 or
mark.vanderweide@frb.gov), Legal Division. For users of
Telecommunications Device for the Deaf (``TDD'') only, contact 202/263-
4869.
FDIC: Keith Ligon, Chief (202/898-3618 or kligon@fdic.gov), Jason
Cave, Chief (202/898-3548 or jcave@fdic.gov), Division of Supervision
and Consumer Protection, or Michael Phillips, Counsel (202/898-3581 or
mphillips@fdic.gov).
OTS: Michael D. Solomon, Senior Program Manager for Capital Policy
(202/906-5654); David W. Riley, Project Manager (202/906-6669),
Supervision Policy; or Teresa A. Scott, Counsel (Banking and Finance)
(202/906-6478), Regulations and Legislation Division, Office of the
Chief Counsel, Office of Thrift Supervision, 1700 G Street, NW.,
Washington, DC 20552.
SUPPLEMENTARY INFORMATION:
I. Executive Summary
A. Introduction
B. Overview of the New Accord
C. Overview of U.S. Implementation
The A-IRB Approach for Credit Risk
The AMA for Operational Risk
Other Considerations
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D. Competitive Considerations
II. Application of the Advanced Approaches in the United States
A. Threshold Criteria for Mandatory Advanced Approach
Organizations
Application of Advanced Approaches at Individual Bank/Thrift
Levels
U.S. Banking Subsidiaries of Foreign Banking Organizations
B. Implementation for Advanced Approach Organizations
C. Other Considerations
General Banks
Majority-Owned or Controlled Subsidiaries
Transitional Arrangements
III. Advanced Internal Ratings-Based Approach (A-IRB)
A. Conceptual Overview
Expected Losses versus Unexpected Losses
B. A-IRB Capital Calculations
Wholesale Exposures: Definitions and Inputs
Wholesale Exposures: Formulas
Wholesale Exposures: Other Considerations
Retail Exposures: Definitions and Inputs
Retail Exposures: Formulas
A-IRB: Other Considerations
Purchased Receivables
Credit Risk Mitigation Techniques
Equity Exposures
C. Supervisory Assessment of A-IRB Framework
Overview of Supervisory Framework
U.S. Supervisory Review
IV. Securitization
A. General Framework
Operational Criteria
Differences Between the General A-IRB Framework and the A-IRB
Approach for Securitization Exposures
B. Determining Capital Requirements
General Considerations
Capital Calculation Approaches
Other Considerations
V. AMA Framework for Operational Risk
A. AMA Capital Calculation
Overview of the Supervisory Criteria
B. Elements of an AMA Framework
VI. Disclosure
A. Overview
B. Disclosure Requirements
VII. Regulatory Analysis
A. Executive Order 12866
B. Regulatory Flexibility Act
C. Unfunded Mandates Reform Act of 1995
D. Paperwork Reduction Act
List of Acronyms
I. Executive Summary
A. Introduction
In the United States, banks, thrifts, and bank holding companies
(banking organizations or institutions) are subject to minimum
regulatory capital requirements. Specifically, U.S. banking
organizations must maintain a minimum leverage ratio and two minimum
risk-based ratios.\1\ The current U.S. risk-based capital requirements
are based on an internationally agreed framework for capital
measurement that was developed by the Basel Committee on Banking
Supervision (Basel Supervisors Committee or BSC) and endorsed by the G-
10 Governors in 1988.\2\ The international framework (1988 Accord)
accomplished several important objectives. It strengthened capital
levels at large, internationally active banks and fostered
international consistency and coordination. The 1988 Accord also
reduced disincentives for banks to hold liquid, low-risk assets.
Moreover, by requiring banks to hold capital against off-balance-sheet
exposures, the 1988 Accord represented a significant step forward for
regulatory capital measurement.
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\1\ The leverage ratio measures regulatory capital as a
percentage of total on-balance-sheet assets as reported in
accordance with generally accepted accounting principles (GAAP)
(with certain adjustments). The risk-based ratios measure regulatory
capital as a percentage of both on- and off-balance-sheet credit
exposures with some gross differentiation based on perceived credit
risk. The Agencies' capital rules may be found at 12 CFR Part 3
(OCC), 12 CFR Parts 208 and 225 (Board), 12 CFR Part 325 (FDIC), and
12 CFR Part 567 (OTS).
\2\ The BSC was established in 1974 by the central-bank
governors of the Group of Ten (G-10) countries. Countries are
represented on the BSC by their central bank and also by authorities
with bank supervisory responsibilities. Current member countries are
Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the
Netherlands, Spain, Sweden, Switzerland, the United Kingdom, and the
United States. The 1988 Accord is described in a document entitled
``International Convergence of Capital Measurement and Capital
Standards.'' This document and other documents issued by the BSC are
available through the Bank for International Settlements website at
www.bis.org.
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Although the 1988 Accord has been a stabilizing force for the
international banking system, the world financial system has become
increasingly more complex over the past fifteen years. The BSC has been
working for several years to develop a new regulatory capital framework
that recognizes new developments in financial products, incorporates
advances in risk measurement and management practices, and more
precisely assesses capital charges in relation to risk. On April 29,
2003, the BSC released for public consultation a document entitled
``The New Basel Capital Accord'' (New Accord) that sets forth proposed
revisions to the 1988 Accord. The BSC will accept industry comment on
the New Accord through July 31, 2003 and expects to issue a final
revised Accord by the end of 2003. The BSC expects that the New Accord
would have an effective date for implementation of December 31, 2006.
Accordingly, the Agencies are soliciting comment on all aspects of
this ANPR, which is based on certain proposals in the New Accord.
Comments will assist the Agencies in reaching a determination on a
number of issues related to how the New Accord would be proposed to be
implemented in the United States. In addition, in light of the public
comments submitted on the ANPR, the Agencies will seek appropriate
modifications to the New Accord.
B. Overview of the New Accord
The New Accord encompasses three pillars: minimum regulatory
capital requirements, supervisory review, and market discipline. Under
the first pillar, a banking organization must calculate capital
requirements for exposure to both credit risk and operational risk (and
market risk for institutions with significant trading activity). The
New Accord does not change the definition of what qualifies as
regulatory capital, the minimum risk-based capital ratio, or the
methodology for determining capital charges for market risk. The New
Accord provides several methodologies for determining capital
requirements for both credit and operational risk. For credit risk
there are two general approaches; the standardized approach
(essentially a package of modifications to the 1988 Accord) and the
internal ratings-based (IRB) approach (which uses an institution's
internal estimates of key risk drivers to derive capital requirements).
Within the IRB approach there is a foundation methodology, in which
certain risk component inputs are provided by supervisors and others
are supplied by the institutions, and an advanced methodology (A-IRB),
where institutions themselves provide more risk inputs.
The New Accord provides three methodologies for determining capital
requirements for operational risk; the basic indicator approach, the
standardized approach, and the advanced measurement approaches (AMA).
Under the first two methodologies, capital requirements for operational
risk are fixed percentages of specified, objective risk measures (for
example, gross income). The AMA provides the flexibility for an
institution to develop its own individualized approach for measuring
operational risk, subject to supervisory oversight.
The second pillar of the New Accord, supervisory review, highlights
the need for banking organizations to assess their capital adequacy
positions relative to overall risk (rather than solely to the minimum
capital requirement), and the need for supervisors to review and take
appropriate actions in response to those assessments. The third pillar
of the New Accord imposes public disclosure requirements on
institutions that are intended to allow market participants to
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assess key information about an institution's risk profile and its
associated level of capital.
The Agencies do not expect the implementation of the New Accord to
result in a significant decrease in aggregate capital requirements for
the U.S. banking system. Individual banking organizations may, however,
face increases or decreases in their minimum risk-based capital
requirements because the New Accord is more risk sensitive than the
1988 Accord and the Agencies' existing risk-based capital rules
(general risk-based capital rules). The Agencies will continue to
analyze the potential impact of the New Accord on both systemic and
individual bank capital levels.
C. Overview of U.S. Implementation
The Agencies believe that the advanced risk and capital measurement
methodologies of the New Accord are the most appropriate approaches for
large, internationally active banking organizations. As a result,
large, internationally active banking organizations in the United
States would be required to use the A-IRB approach to credit risk and
the AMA to operational risk. The Agencies are proposing to identify
three types of banking organizations: institutions subject to the
advanced approaches on a mandatory basis (core banks); institutions not
subject to the advanced approaches on a mandatory basis, but that
choose voluntarily to apply those approaches (opt-in banks); and
institutions that are not mandatorily subject to and do not apply the
advanced approaches (general banks). Core banks would be those with
total banking (and thrift) assets of $250 billion or more or total on-
balance-sheet foreign exposure of $10 billion or more. Both core banks
and opt-in banks (advanced approach banks) would be required to meet
certain infrastructure requirements (including complying with specified
supervisory standards for credit risk and operational risk) and make
specified public disclosures before being able to use the advanced
approaches for risk-based regulatory capital calculation purposes.\3\
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\3\ The Agencies continue to reserve the right to require higher
minimum capital levels for individual institutions, on a case-by-
case basis, if necessary to address particular circumstances.
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General banks would continue to apply the general risk-based
capital rules. Because the general risk-based capital rules include a
buffer for risks not easily quantified (for example, operational risk
and concentration risk), general banks would not be subject to an
additional direct capital charge for operational risk.
Under this proposal, some U.S. banking organizations would use the
advanced approaches while others would apply the general risk-based
capital rules. As a result, the United States would have a bifurcated
regulatory capital framework. That is, U.S. capital rules would provide
two distinct methodologies for institutions to calculate risk-weighted
assets (the denominator of the risk-based capital ratios). Under the
proposed framework, all U.S. institutions would continue to calculate
regulatory capital, the numerator of the risk-based capital ratios, as
they do now. Importantly, U.S. banking organizations would continue to
be subject to a leverage ratio requirement under existing regulations,
and Prompt Corrective Action (PCA) legislation and implementing
regulations would remain in effect.\4\ It is recognized that in some
cases, under the proposed framework, the leverage ratio would serve as
the most binding regulatory capital constraint.
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\4\ Thus, for example, to be in the well-capitalized PCA
category a bank must have at least a 10 percent total risk-based
capital ratio, a 6 percent Tier I risk-based capital ratio, and a 5
percent leverage ratio. The other PCA categories also would not
change.
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Implementing the capital framework described in this ANPR would
raise a number of significant practical and conceptual issues about the
role of economic capital calculations relative to regulatory capital
requirements. The capital formulas described in this ANPR, as well as
the economic capital models used by banking organizations, assume the
ability to assign precisely probabilities to future credit and
operational losses that might occur. The term ``economic capital'' is
often used to refer to the amount of capital that should be allocated
to an activity according to the results of such an exercise. For
example, a banking organization might compute the amount of income,
reserves, and capital that it would need to cover the 99.9th percentile
of possible credit losses associated with a given type of lending. The
desired degree of certainty of covering losses is related to several
factors including, for example, the banking organization's target
credit rating. The higher the loss percentile the institution wishes to
provide protection against, the less likely the capital held by the
institution would be insufficient to cover losses, and the higher would
be the institution's credit rating.
While the Agencies intend to move to a framework where regulatory
capital is more closely aligned to economic capital, the Agencies do
not intend to place sole reliance on the results of economic capital
calculations for purposes of computing minimum regulatory capital
requirements. Banking organizations face risks other than credit and
operational risks, and the assumed loss distributions underlying
banking organizations' economic capital calculations are subject to the
risk of error. Consequently, the Agencies continue to view the leverage
ratio tripwires contained in existing PCA and other regulations as
important components of the regulatory capital framework.
The A-IRB Approach for Credit Risk
Under the A-IRB approach for credit risk, an institution's internal
assessment of key risk drivers for a particular exposure (or pool of
exposures) would serve as the primary inputs in the calculation of the
institution's minimum risk-based capital requirements. Formulas, or
risk weight functions, specified by supervisors would use the banking
organization's estimated inputs to derive a specific dollar amount
capital requirement for each exposure (or pool of exposures). This
dollar capital requirement would be converted into a risk-weighted
assets equivalent by multiplying the dollar amount of the capital
requirement by 12.5--the reciprocal of the 8 percent minimum risk-based
capital requirement. Generally, banking organizations using the A-IRB
approach would assign assets and off-balance-sheet exposures into one
of three portfolios: wholesale (corporate, interbank, and sovereign),
retail (residential mortgage, qualifying revolving, and other), and
equities. There also would be specific treatments for securitization
exposures and purchased receivables. Certain assets that do not
constitute a direct credit exposure (for example, premises, equipment,
or mortgage servicing rights) would continue to be subject to the
general risk-based capital rules and risk weighted at 100 percent. A
brief overview of each A-IRB portfolio follows.
Wholesale (Corporate, Interbank, and Sovereign) Exposures
Wholesale credit exposures comprise three types of exposures:
corporate, interbank, and sovereign. Generally, the meaning of
interbank and sovereign would be consistent with the general risk-based
capital rules. Corporate exposures are exposures to private-sector
companies; interbank exposures are primarily exposures to banks and
securities firms; and sovereign exposures are those to central
governments, central banks, and certain
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other public-sector entities (PSEs). Within the wholesale exposure
category, in addition to the treatment for general corporate lending,
there would be four sub-categories of specialized lending (SL). These
are project finance (PF), object finance (OF), commodities finance
(CF), and commercial real estate (CRE). CRE is further subdivided into
low-asset-correlation CRE, and high-volatility CRE (HVCRE).
For each wholesale exposure, an institution would assign four
quantitative risk drivers (inputs): (1) Probability of default (PD),
which measures the likelihood that the borrower will default over a
given time horizon; (2) loss given default (LGD), which measures the
proportion of the exposure that will be lost if a default occurs; (3)
exposure at default (EAD), which is the estimated amount owed to the
institution at the time of default; and (4) maturity (M), which
measures the remaining economic maturity of the exposure. Institutions
generally would be able to take into account credit risk mitigation
techniques (CRM), such as collateral and guarantees (subject to certain
criteria), by adjusting their estimates for PD or LGD. The wholesale A-
IRB risk weight function would use all four risk inputs to produce a
specific capital requirement for each wholesale exposure. There would
be a separate, more conservative risk weight function for certain
acquisition, development, and construction loans (ADC) in the HVCRE
category.
Retail Exposures
Within the retail category, three distinct risk weight functions
are proposed for three product areas that exhibit different historical
loss experiences and different asset correlations.\5\ The three retail
sub-categories would be: (1) Exposures secured by residential mortgages
and related exposures; (2) qualifying revolving exposures (QRE); and
(3) other retail exposures. QRE would include unsecured revolving
credits (such as credit cards and overdraft lines), and other retail
would include most other types of exposures to individuals, as well as
certain exposures to small businesses. The key inputs to the three
retail risk weight functions would be a banking organization's
estimates of PD, LGD, and EAD. There would be no explicit M component
to the retail A-IRB risk weight functions. Unlike wholesale exposures,
for retail exposures, an institution would assign a common set of
inputs (PD, LGD, and EAD) to predetermined pools of exposures, which
are typically referred to as segments, rather than to individual
exposures.\6\ The inputs would be used in the risk weight functions to
produce a capital charge for the associated pool of exposures.
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\5\ Asset correlation is a measure of the tendency for the
financial condition of a borrower in a banking organization's
portfolio to improve or degrade at the same time as the financial
condition of other borrowers in the portfolio improve or degrade.
\6\ When the PD, LGD, and EAD parameters are assigned separately
to individual exposures, it may be referred to as a ``bottom-up''
approach. When those parameters are assigned to predetermined sets
of exposures (pools or segments), it may be referred to as a ``top-
down'' approach.
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Equity Exposures
Banking organizations would use a market-based internal model for
determining capital requirements for equity exposures in the banking
book. The internal model approach would assess capital based on an
estimate of loss under extreme market conditions. Some equity
exposures, such as holdings in entities whose debt obligations qualify
for a zero percent risk weight, would continue to receive a zero
percent risk weight under the A-IRB approach to equities. Certain other
equity exposures, such as those made through a small business
investment company (SBIC) under the Small Business Investment Act or a
community development corporation (CDC) or a community and economic
development entity (CEDE), generally would be risk weighted at 100
percent under the A-IRB approach to equities. Banking organizations
that are subject to the Agencies' market risk capital rules would
continue to apply those rules to assess capital against equity
positions held in the trading book.\7\ Banking organizations that are
not subject to the market risk capital rules would treat equity
positions in the trading account as if they were in the banking book.
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\7\ The market risk capital rules were implemented by the
banking agencies in 1996. The market risk capital rules apply to any
banking organization whose trading activity (on a consolidated
worldwide basis) equals 10 percent or more of total assets, or $1
billion or more. The market risk capital rules are found at 12 CFR
Part 3, Appendix B (OCC), 12 CFR Parts 208 and 225, Appendix E
(Board), and 12 CFR Part 325, Appendix C (FDIC). The OTS, to date,
has not adopted the market risk capital rules.
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Securitization Exposures
Under the A-IRB treatment for securitization exposures, a banking
organization that originates a securitization would first calculate the
A-IRB capital charge that would have been assessed against the
underlying exposures as if the exposures had not been securitized. This
capital charge divided by the size of the exposure pool is referred to
as KIRB. If an originating banking organization retains a position in a
securitization that obligates the banking organization to absorb losses
up to or less than KIRB, the banking organization would deduct the
retained position from capital as is currently required under the
general risk-based capital rules. The general risk-based capital rules,
however, require a dollar-for-dollar risk-based capital deduction for
certain residual interests retained by originating banking
organizations in asset securitization transactions regardless of
amount. The A-IRB framework would no longer require automatic deduction
of such residual interests. The amount to be deducted would be capped
at KIRB for most exposures. For a position in excess of the KIRB
threshold, the originating banking organization would use an external-
ratings-based approach (if the position has been rated by an external
rating agency or a rating can be inferred) or a supervisory formula to
determine the capital charge for the position.
Non-originating banking organizations that invest in a
securitization exposure generally would use an external-ratings-based
approach (if the exposure has been rated by an external rating agency
or a rating can be inferred). For unrated liquidity facilities that
banking organizations provide to securitizations, capital requirements
would be based on several factors, including the asset quality of the
underlying pool and the degree to which other credit enhancements are
available. These factors would be used as inputs to a supervisory
formula. Under the A-IRB approach to securitization exposures, banking
organizations also would be required in some cases to hold regulatory
capital against securitizations of revolving exposures that have early
amortization features.
Purchased Receivables
Purchased receivables, that is, those that are purchased from
another institution either through a one-off transaction or as part of
an ongoing program, would be subject to a two-part capital charge: one
part is for the credit risk arising from the underlying receivables and
the second part is for dilution risk. Dilution risk refers to the
possibility that contractual amounts payable by the underlying obligors
on the receivables may be reduced through future cash payments or other
credits to the accounts made by the seller of the receivables. The
framework for determining the capital charge for credit risk permits a
purchasing organization to use a top-down (pool) approach to estimating
PDs and LGDs when the
[[Page 45904]]
purchasing organization is unable to assign an internal risk rating to
each of the purchased accounts. The capital charge for dilution risk
would be calculated using the wholesale risk weight function with some
additional specified risk inputs.
The AMA for Operational Risk
Under the A-IRB approach, capital charges for credit risk would be
directly calibrated solely for such risk and, thus, unlike the 1988
Accord, would not implicitly include a charge for operational risk. As
a result, the Agencies are proposing that banking organizations
operating under the A-IRB approach also would have to hold regulatory
capital for exposure to operational risk. The Agencies are proposing to
define operational risk as the risk of losses resulting from inadequate
or failed internal processes, people, and systems, or external events.
Under the AMA, each banking organization would be able to use its own
methodology for assessing exposure to operational risk, provided the
methodology is comprehensive and results in a capital charge that is
reflective of the operational risk experience of the organization. The
operational risk exposure would be multiplied by 12.5 to determine a
risk-weighted assets equivalent, which would be added to the comparable
amounts for credit and market risk in the denominator of the risk-based
capital ratios. The Agencies will be working closely with institutions
over the next few years as operational risk measurement and management
techniques continue to evolve.
Other Considerations
Boundary Issues
With the introduction of an explicit regulatory capital charge for
operational risk, an issue arises about the proper treatment of losses
that can be attributed to more than one risk factor. For example, where
a loan defaults and the banking organization discovers that the
collateral for the loan was not properly secured, the banking
organization's resulting losses would be attributable to both credit
and operational risk. The Agencies recognize that these types of
boundary issues are important and have significant implications for how
banking organizations would compile loss data sets and compute
regulatory capital charges.
The Agencies are proposing the following standard to govern the
boundary between credit and operational risk: A loss event that has
characteristics of credit risk would be incorporated into the credit
risk calculations for regulatory capital (and would not be incorporated
into operational risk capital calculations). This would include credit-
related fraud losses. Thus, in the above example, the loss from the
loan would be attributed to credit risk (not operational risk) for
regulatory capital purposes. This separation between credit and
operational risk is supported by current U.S. accounting standards for
the treatment of credit risks.
With regard to the boundary between the trading book and the
banking book, for institutions subject to the market risk rules,
positions currently subject to those rules include all positions held
in the trading account consistent with GAAP. The New Accord proposed
additional criteria for positions includable in the trading book for
purposes of market risk capital requirements. The Agencies encourage
comment on these additional criteria and whether the Agencies should
consider adopting such criteria (in addition to the GAAP criteria) in
defining the trading book under the Agencies' market risk capital
rules. The Agencies are seeking comment on the proposed treatment of
the boundaries between credit, operational, and market risk.
Supervisory Considerations
The advanced approaches introduce greater complexity to the
regulatory capital framework and would require a high level of
sophistication in the banking organizations that implement the advanced
approaches. As a result, the Agencies propose to require core and opt-
in banks to meet certain infrastructure requirements and comply with
specific supervisory standards for credit risk and for operational
risk. In addition, banking organizations would have to satisfy a set of
public disclosure requirements as a prerequisite for approval to using
the advanced approaches. Supervisory guidance for each credit risk
portfolio type, as well as for operational risk, is being developed to
ensure a sufficient degree of consistency within the supervisory
framework, while also recognizing that internal systems will differ
between banking organizations. The goal is to establish a supervisory
framework within which all institutions must develop their internal
systems, leaving exact details to each institution. In the case of
operational risk in particular, the Agencies recognize that measurement
methodologies are still evolving and flexibility is needed.
It is important to note that supervisors would not look at
compliance with requirements, or standards alone. Supervisors also
would evaluate whether the components of an institution's advanced
approaches are consistent with the overall objective of sound risk
management and measurement. An institution would have to use
appropriately the advanced approaches across all material business
lines, portfolios, and geographic regions. Exposures in non-significant
business units as well as asset classes that are immaterial in terms of
size and perceived risk profile may be exempted from the advanced
approaches with supervisory approval. These immaterial portfolios would
be subject to the general risk-based capital rules.
Proposed supervisory guidance for corporate credit exposures and
for operational risk is provided separately from this ANPR in today's
Federal Register. The draft supervisory guidance for corporate credit
exposures is entitled ``Supervisory Guidance on Internal-Ratings-Based
Systems for Corporate Credit.'' The guidance includes specified
supervisory standards that an institution's internal rating system for
corporate exposures would have to satisfy for the institution to be
eligible to use the A-IRB approach for credit risk. The draft
operational risk guidance is entitled ``Supervisory Guidance on
Operational Risk Advanced Measurement Approaches for Regulatory
Capital.'' The operational risk guidance includes identified
supervisory standards for an institution's AMA framework for
operational risk. The Agencies encourage commenters to review and
comment on the draft guidance pieces in conjunction with this ANPR. The
Agencies intend to issue for public comment supervisory guidance on
retail credit exposures, equity exposures, and securitization exposures
over the next several months.
Supervisory Review
As mentioned above, the second pillar of the New Accord focuses on
supervisory review to ensure that an institution holds sufficient
capital given its overall risk profile. The concepts of Pillar 2 are
not new to U.S. banking organizations. U.S. institutions already are
required to hold capital sufficient to meet their risk profiles, and
supervisors may require that an institution hold more capital if its
current levels are deficient or some element of its business practices
suggest the need for more capital. The Agencies also have the right to
intervene when capital levels fall to an unacceptable level. Given
these long-standing elements of the U.S. supervisory framework, the
Agencies
[[Page 45905]]
are not proposing to introduce specific requirements or guidelines to
implement Pillar 2. Instead, existing guidance, rules, and regulations
would continue to be enforced and supplemented as necessary as part of
this proposed new regulatory capital framework. However, all
institutions operating under the advanced approaches would be expected
by supervisors to address specific assumptions embedded in the advanced
approaches (such as diversification in credit portfolios), and would be
evaluated for their ability to account for deviations from the
underlying assumptions in their own portfolios.
Disclosure
An integral part of the advanced approaches is enhanced public
disclosure practices and improved transparency. Under the Agencies'
proposal, specific disclosure requirements would be applicable to all
institutions using the advanced approaches. These disclosure
requirements would encompass capital, credit risk, equities, credit
risk mitigation, securitization, market risk, operational risk, and
interest rate risk in the banking book.
D. Competitive Considerations
It is essential that the Agencies gain a full appreciation of the
possible competitive equity concerns that may be presented by the
establishment of a new capital framework. The creation of a bifurcated
capital framework in the United States--one set of capital standards
applicable to large, internationally active banking organizations (and
those that choose to apply the advanced approaches), and another set of
standards applicable to all other institutions--has created concerns
among some parties about the potential impact on competitive equity
between the two sets of banking organizations. Similarly, differences
in supervisory application of the advanced approaches (both within the
United States and abroad) among large, internationally active
institutions may pose competitive equity issues among such
institutions.
The New Accord relies upon compliance with certain minimum
operational and supervisory requirements to promote consistent
interpretation and uniformity in application of the advanced
approaches. Nevertheless, independent supervisory judgment will be
applied on a case-by-case basis. These processes, albeit subject to
detailed and explicit supervisory guidance, contain an inherent amount
of subjectivity and must be assessed by supervisors on an ongoing
basis. This supervisory assessment of the internal processes and
controls leading to an institution's internal ratings and other
estimates must maintain the high level of internal risk measurement and
management processes contemplated in this ANPR.
The BSC's Accord Implementation Group (AIG), in which the Agencies
play an active role, will seek to ensure that all jurisdictions
uniformly apply the same high qualitative and quantitative standards to
internationally active banking institutions. However, to the extent
that different supervisory regimes implement these standards
differently, there may be competitive dislocations. One concern is that
the U.S. supervisory regime will impose greater scrutiny in its
implementation standards, particularly given the extensive on-site
presence of bank examiners in the United States.
Quite distinct from the need for a level playing field among
internationally active institutions are the competitive concerns of
those institutions that do not elect to adopt or may not qualify for
the advanced approaches. Some banking organizations have expressed
concerns that small or regional banks would become more likely to be
acquired by larger organizations seeking to lever capital efficiencies.
There also is a qualitative concern about the impact of being
considered a ``second tier'' institution (one that does not implement
the advanced approaches) by the market, rating agencies, or
sophisticated customers such as government or municipal depositors and
borrowers. Finally, there is the question of what, if any, competitive
distortions might be introduced by differences in regulatory capital
minimums between the advanced approaches and the general risk-based
capital rules for loans or securities with otherwise similar risk
characteristics, and the extent to which such distortions may be
mitigated in an environment in which well-managed banking organizations
continue to hold excess capital.\8\
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\8\ The Agencies note that under the general risk-based capital
rules some institutions currently are able to hold less capital than
others on some types of assets (for example, through innovative
financing structures or use of credit risk mitigation techniques).
In addition, some institutions may hold lower amounts of capital
because the market perceives them as highly diversified, while
others hold higher amounts of capital because of concentrations of
credit risk or other factors.
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Because the advanced framework described in this ANPR is more risk-
sensitive than the 1988 Accord and the general risk-based capital
rules, banking organizations under the advanced approaches would face
increases in their minimum risk-based capital charges on some assets
and decreases on others. The results of a Quantitative Impact Study
(QIS3) the BSC conducted in late 2002 indicated the potential for the
advanced approaches described in this document to produce significant
changes in risk-based capital requirements for specific activities; the
results also varied on an institution-by-institution basis. The results
of QIS3 can be found at http://www.bis.org and various results of QIS3
are noted at pertinent places in this ANPR.
The Agencies do not believe the results of QIS3 are sufficiently
reliable to form the basis of a competitive impact analysis, both
because the inputs to the study were provided on a best-efforts basis
and because the proposals in this ANPR are in some cases different than
those that formed the basis of QIS3. The Agencies are nevertheless
interested in views on how changes in regulatory capital (for the total
of credit and operational risk) of the magnitude described in QIS3, if
such changes were in fact realized, would affect the competitive
landscape for domestic banking organizations.
The Agencies plan to conduct at least one more QIS, and potentially
other economic impact analyses, to better understand the potential
impact of the proposed framework on the capital requirements for
individual U.S. banking organizations and U.S. banking organizations as
a whole. This may affect the Agencies' further proposals through
recalibrating the A-IRB risk weight formulas and making other
modifications to the proposed approaches if the capital requirements do
not seem consistent with the overall risk profiles of banking
organizations or safe and sound banking practices.
If competitive effects of the New Accord are determined to be
significant, the Agencies would need to consider potential ways to
address those effects while continuing to seek to achieve the
objectives of the current proposal. Alternatives could potentially
include modifications to the proposed approaches, as well as
fundamentally different approaches. The Agencies recognize that an
optimal capital system must strike a balance between the objectives of
simplicity and regulatory consistency across banking organizations on
the one hand, and the degree of risk sensitivity of the regulation on
the other. There are many criteria that must be evaluated in achieving
this balance, including the resulting incentives for improving risk
measurement and management practices, the ease of supervisory and
regulatory enforcement, the degree to
[[Page 45906]]
which the overall level of regulatory capital in the banking system is
broadly preserved, and the effects on domestic and international
competition. The Agencies are interested in commenters' views on
alternatives to the advanced approaches that could achieve this
balance, and in particular on alternatives that could do so without a
bifurcated approach.\9\
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\9\ In this regard, alternative approaches would take time to
develop, but might present fewer implementation challenges.
Additional work would be necessary to advance the goal of
competitive equity among internationally active banking
organizations. If consensus on alternative approaches could not be
reached at the BSC, a departure from the Basel framework also could
raise significant international and domestic issues.
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The Agencies are committed to investigate the full scope of
possible competitive impact and welcome all comments in this regard.
Some questions are suggested below that may serve to focus commenters'
general reactions. More specific questions also are suggested
throughout this ANPR. These questions should not be viewed as limiting
the Agencies' areas of interest or commenters' submissions on the
proposals. The Agencies encourage commenters to provide supporting data
and analysis, if available.
What are commenters' views on the relative pros and cons of a
bifurcated regulatory capital framework versus a single regulatory
capital framework? Would a bifurcated approach lead to an increase
in industry consolidation? Why or why not? What are the competitive
implications for community and mid-size regional banks? Would
institutions outside of the core group be compelled for competitive
reasons to opt-in to the advanced approaches? Under what
circumstances might this occur and what are the implications? What
are the competitive implications of continuing to operate under a
regulatory capital framework that is not risk sensitive?
If regulatory minimum capital requirements declined under the
advanced approaches, would the dollar amount of capital held by
advanced approach banking organizations also be expected to decline?
To the extent that advanced approach institutions have lower capital
charges on certain assets, how probable and significant are concerns
that those institutions would realize competitive benefits in terms
of pricing credit, enhanced returns on equity, and potentially
higher risk-based capital ratios? To what extent do similar effects
already exist under the current general risk-based capital rules
(for example, through securitization or other techniques that lower
relative capital charges on particular assets for only some
institutions)? If they do exist now, what is the evidence of
competitive harm?
Apart from the approaches described in this ANPR, are there
other regulatory capital approaches that are capable of ameliorating
competitive concerns while at the same time achieving the goal of
better matching regulatory capital to economic risks? Are there
specific modifications to the proposed approaches or to the general
risk-based capital rules that the Agencies should consider?
II. Application of the Advanced Approaches in the United States
By its terms, the 1988 Accord applied only to internationally
active banks. Under the New Accord, the scope of application has been
broadened also to encompass bank holding companies that are parents of
internationally active ``banking groups.''
A. Threshold Criteria for Mandatory Advanced Approach Organizations
The Agencies believe that for large, internationally active U.S.
institutions only the advanced approaches are appropriate. Accordingly,
the Agencies intend to identify three groups of banking organizations:
(1) Large, internationally active banking organizations that would be
subject to the A-IRB approach and AMA on a mandatory basis (core
banks); (2) organizations not subject to the advanced approaches on a
mandatory basis, but that voluntarily choose to adopt those approaches
(opt-in banks); and all remaining organizations that are not
mandatorily subject to and do not apply the advanced approaches
(general banks).
For purposes of identifying core banks, the Agencies are proposing
a set of objective criteria for industry consideration. Specifically,
the Agencies are proposing to treat as a core bank any banking
organization that has (1) total commercial bank (and thrift) assets of
$250 billion or more, as reported on year-end regulatory reports (with
banking assets of consolidated groups aggregated at the U.S. bank
holding company level); \10\ or (2) total on-balance-sheet foreign
exposure of $10 billion or more, as reported on the year-end Country
Exposure Report (FFIEC 009) (with foreign exposure of consolidated
groups aggregated at the U.S. bank holding company level). These
threshold criteria are independent; meeting either condition would mean
an institution is a core bank.
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\10\ For banks this means the December Consolidated Report of
Condition and Income (Call Report). For thrifts this means the
December Thrift Financial Report.
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Once an institution becomes a core bank it would remain subject to
the advanced approaches on a going forward basis. If, in subsequent
years, such an institution were to drop below both threshold levels it
would continue to be a core bank unless it could demonstrate to its
primary Federal supervisor that it has substantially and permanently
downsized and should no longer be a core bank. The Agencies are
proposing an annual test for assessing banking organizations in
reference to the threshold levels. However, as a banking organization
approaches either of the threshold levels the Agencies would expect to
have ongoing dialogue with that organization to ensure that appropriate
practices are in place or are actively being developed to prepare the
organization for implementation of the advanced approaches.
Institutions that by expansion or merger meet the threshold levels
must qualify for use of the advanced approaches and would be subject to
the same implementation plan requirements and minimum risk-based
capital floors applicable to core and opt-in banks as described below.
Institutions that seek to become opt-in banks would be expected to
notify their primary Federal supervisors well in advance of the date by
which they expect to qualify for the advanced approaches. Based on the
aforementioned threshold levels, the Agencies anticipate at this time
that approximately ten U.S. institutions would be core banks.
Application of Advanced Approaches at Individual Bank/Thrift Levels
The Agencies are aware that some institutions might, on a
consolidated basis, exceed one of the threshold levels for mandatory
application of the A-IRB approach and AMA and, yet, might be comprised
of distinct bank and thrift charters whose respective sizes fall well
below the thresholds. In those cases, the Agencies believe that all
bank and thrift institutions that are members of a consolidated group
that is itself a core bank or an opt-in bank should calculate and
report their risk-based capital requirements under the advanced
approaches. However, recognizing that separate bank and thrift charters
may, to a large extent, be independently managed and have different
systems and portfolios, the Agencies are interested in comment on the
efficacy and burden of a framework that requires the advanced
approaches to be implemented by (or pushed down to) each of the
separate subsidiary banks and thrifts that make up the consolidated
group.
U.S. Banking Subsidiaries of Foreign Banking Organizations
Any U.S. bank or thrift that is a subsidiary of a foreign bank
would have to comply with the prevailing U.S. regulatory capital
requirements applied to U.S. banks. Thus, if a U.S. bank or
[[Page 45907]]
thrift that is owned by a foreign bank meets the threshold levels for
mandatory application of the advanced approaches, the U.S. bank or
thrift would be a core bank. If it does not meet those thresholds, it
would have the choice to opt-in to the advanced approaches (and be
subject to the same supervisory framework as other U.S. banking
organizations) or to remain a general bank. A top-tier U.S. bank
holding company that is owned by a foreign bank also would be subject
to the same threshold levels for core bank determination and would be
subject to the applicable U.S. bank holding company capital rules.
However, Federal Reserve SR Letter 01-1 (January 5, 2001) would remain
in effect. Thus, subject to the conditions in SR Letter 01-1, a top-
tier U.S. bank holding company that is owned or controlled by a foreign
bank that is a qualifying financial holding company generally would not
be required to comply with the Board's capital adequacy guidelines.
The Agencies are interested in comment on the extent to which
alternative approaches to regulatory capital that are implemented
across national boundaries might create burdensome implementation
costs for the U.S. subsidiaries of foreign banks.
B. Implementation for Advanced Approach Organizations
As noted earlier, U.S. banking organizations that apply the
advanced approaches would be required to comply with supervisory
standards prior to use.
The BSC has targeted December 31, 2006 as the effective date for
the international capital rules based on the New Accord. The Agencies
are proposing an implementation date of January 1, 2007. The
establishment of a final effective date in the United States, however,
would be contingent on the issuance for public comment of a Notice of
Proposed Rulemaking, and subsequent finalization of any changes in
capital regulations that the Agencies ultimately decide to adopt.
Because of the need to pre-qualify for the advanced approaches,
banking organizations would need to take a number of steps upon the
finalization of any changes to the capital regulations. These steps
would include developing detailed written implementation plans for the
A-IRB approach and the AMA and keeping their primary supervisors
advised of these implementation plans and schedules. Implementation
plans would need to address all supervisory standards for the A-IRB
approach and the AMA, include objectively measurable milestones, and
demonstrate that adequate resources would be realistically budgeted and
made available. An institution's board of directors would need to
approve its implementation plans.
The Agencies expect core banks to make every effort to meet the
supervisory standards as soon as practicable. In this regard, it is
possible that some core banks would not qualify to use the advanced
approaches in time to meet the effective date that is ultimately
established. For those banking organizations, the implementation plan
would need to identify when the supervisory standards would be met and
when the institution would be ready for implementation. The Agencies
note that developing an appropriate infrastructure to support the
advanced approaches for regulatory capital that fully complies with
supervisory conditions and expectations and the associated supervisory
guidance will be challenging. The Agencies believe, however, that
institutions would need to be fully prepared before moving to the
advanced approaches.
Use of the advanced approaches would require the primary Federal
supervisor's approval. Core banks unable to qualify for the advanced
approaches in time to meet the effective date would remain subject to
the general risk-based capital rules existing at that time. The
Agencies would consider the effort and progress made to meet the
qualifying standards and would consider whether, under the
circumstances, supervisory action should be taken against or penalties
imposed on individual core banks that have not adhered to the schedule
outlined in the implementation plan they submitted to their primary
Federal supervisor.
Opt-in banks meeting the supervisory standards could seek to
qualify for the advanced approaches in time to meet the ultimate final
effective date or any time thereafter. Institutions contemplating
opting-in to the advanced approaches would need to provide notice to,
and submit an implementation plan and schedule to be approved by, their
primary Federal supervisor. As is true of core banks, opt-in banks
would need to allow ample time for developing and executing
implementation plans.
An institution's primary Federal supervisor would have
responsibility for determining the institution's readiness for an
advanced approach and would be ultimately responsible, after
consultation with other relevant supervisors, for determining whether
the institution satisfies the supervisory expectations for the advanced
approaches. The Agencies recognize that a consistent and transparent
process to oversee implementation of the advanced approaches would be
crucial. The Agencies intend to develop interagency validation
standards and procedures to help ensure consistency. The Agencies would
consult with each other on significant issues raised during the
validation process and ongoing implementation.
C. Other Considerations
General Banks
The Agencies expect that the vast majority of U.S. institutions
would be neither core banks nor opt-in banks. Most institutions would
remain subject to the general risk-based capital rules. However, as has
been the case since the 1988 Accord was initially implemented in the
United States, the Agencies will continue to make necessary
modifications to the general risk-based capital rules as appropriate.
In the event changes are warranted, the Agencies could implement
revisions through notice and comment procedures prior to the proposed
effective date of the advanced approaches in 2007.
The Agencies seek comment on whether changes should be made to the
existing general risk-based capital rules to enhance their risk-
sensitivity or to reflect changes in the business lines or activities
of banking organizations without imposing undue regulatory burden or
complication. In particular, the Agencies seek comment on whether any
changes to the general risk-based capital rules are necessary or
warranted to address any competitive equity concerns associated with
the bifurcated framework.
Majority-Owned or Controlled Subsidiaries
The New Accord generally applies to internationally active banking
organizations on a fully consolidated basis. Thus, consistent with the
Agencies' general risk-based capital rules, subsidiaries that are
consolidated under U.S. generally accepted accounting principles (GAAP)
typically should be consolidated for regulatory capital calculation
purposes under the advanced approaches as well.\11\ With regard to
investments in consolidated insurance underwriting subsidiaries, the
New Accord notes that deconsolidation of assets and deduction of
capital is an
[[Page 45908]]
appropriate approach. The Federal Reserve is actively considering
several approaches to the capital treatment for investments by bank
holding companies in insurance underwriting subsidiaries. For example,
the Federal Reserve is currently assessing the merits and weaknesses of
an approach that would consolidate an insurance underwriting
subsidiary's assets at the holding company level and permit excess
capital of the subsidiary to be included in the consolidated regulatory
capital of the holding company. A deduction would be required for
capital that is not readily available at the holding company level for
general use throughout the organization.
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\11\ One notable exception exists at the bank level where there
is an investment in a financial subsidiary as defined in the Gramm-
Leach-Bliley Act of 1999. For such a subsidiary, assets would
continue to be deconsolidated from the bank's on-balance-sheet
assets, and capital at the subsidiary level would be deducted from
the bank's capital.
The Federal Reserve specifically seeks comment on the
appropriate regulatory capital treatment for investments by bank
holding companies in insurance underwriting subsidiaries as well as
other nonbank subsidiaries that are subject to minimum regulatory
capital requirements.
Transitional Arrangements
Core and opt-in banks would be required to calculate their capital
ratios using the A-IRB and AMA methodologies, as well as the general
risk-based capital rules, for one year prior to using the advanced
approaches on a stand-alone basis. In order to begin this parallel-run
year, however, the institution would have to demonstrate to its
supervisor that it meets the supervisory standards. Therefore, banking
organizations planning to meet the January 1, 2007 target effective
date for implementation of the advanced approaches would have to
receive approval from their primary Federal supervisor before year-end
2005. Banking organizations that later adopt the advanced approaches
also would have a one-year dual calculation period prior to moving to
stand-alone usage of the advanced approaches.
An institution would be subject to a minimum risk-based capital
floor for two years following moving to the advanced approaches on a
stand-alone basis. Specifically, in the first year of stand-alone usage
of the advanced approaches, an institution's calculated risk-weighted
assets could not be less than 90 percent of risk-weighted assets
calculated under the general risk-based capital rules. In the following
year, an institution's minimum calculated risk-weighted assets could
not be less than 80 percent of risk-weighted assets calculated under
the general risk-based capital rules.\12\
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\12\ The agencies note that the text above differs from the
floor text in the New Accord, which is based on 90 and 80 percent of
the minimum capital requirements under the 1988 Accord, rather than
on risk-weighted assets. The Agencies expect that the final language
of the New Accord would need to be consistent with this approach.
The following example reflects how the floor in the first year would
be applied by a U.S. banking organizaiton. If the banking
organization's general risk-based capital calculation produced risk-
weighted assets of $100 billion in its first year of implementation
of the advanced approaches, then its risk weighted assets in that
year could not be less than $90 billion. If the advanced approach
calculation produced risk-weighted assets of $75 billion (a decrease
of one quarter compared to the general risk-based capital rules),
the organization would not calculate risk-based capital ratios on
the basis of that $75 billion; rather, its risk-weighted assets
would be $90 billion. Consequently, its minimum total risk-based
capital charge would be $7.2 billion, and it would need $9 billion
to satisfy PCA well-capitalized criteria.
As a consequence, advanced approach banking organizations would
need to conduct two sets of capital calculations for at least three
years. The pre-implementation calculation of A-IRB and AMA capital
would not need to be made public, but the banking organization would be
required to disclose risk-based capital ratios calculated under both
advanced and general risk-based approaches during the two-year post-
implementation period. The Agencies would not propose to eliminate the
floors after the two-year transition period for any institution
applying the advanced approaches until the Agencies are fully satisfied
that the institution's systems are sound and accurately assess risk and
that resulting capital levels are prudent.
These transitional arrangements and the floors established above
relate only to risk-based capital ratios and do not affect the
continued applicability to all advanced banking organizations of the
leverage ratio and associated PCA regulations for banks and thrifts.
Importantly, the minimum capital requirements and the PCA thresholds
would not be changed. Furthermore, during the implementation period and
before removal of the floors the Agencies intend to closely monitor the
effect that the advanced approaches would have on capital levels at
individual institutions and industry-wide capital levels. Once the
results of this monitoring process are assessed, the Agencies may
consider modifications to the advanced approaches to ensure that
capital levels remain prudent.
Given the general principle that the advanced approaches are
expected to be implemented at the same time across all material
portfolios, business lines, and geographic regions, to what degree
should the Agencies be concerned that, for example, data may not be
available for key portfolios, business lines, or regions? Is there a
need for further transitional arrangements? Please be specific,
including suggested durations for such transitions.
Do the projected dates provide an adequate timeframe for core
banks to be ready to implement the advanced approaches? What other
options should the Agencies consider?
The Agencies seek comment on appropriate thresholds for
determining whether a portfolio, business line, or geographic
exposure would be material. Considerations should include relative
asset size, percentages of capital, and associated levels of risk
for a given portfolio, business line, or geographic region.
III. Advanced Internal Ratings-Based (A-IRB) Approach
This section describes the proposed A-IRB framework for the
measurement of capital requirements for credit risk. Under this
framework, banking organizations that meet the A-IRB infrastructure
requirements and supervisory standards would incorporate internal
estimates of risk inputs into supervisor-provided capital formulas for
the various debt and equity portfolios to calculate the capital
requirements for each portfolio. The discussion below provides
background on the conceptual basis of the A-IRB approach and then
describes the specific details of the capital formulas for two of the
main exposure categories, wholesale and retail. Separate sections
follow that describe the A-IRB treatments of loan loss reserves and
partial charge-offs, the A-IRB treatment of purchased receivables, the
A-IRB treatment of equity exposures, and the A-IRB treatment of
securitization exposures. The A-IRB supervisory requirements and the A-
IRB approach to credit risk mitigation techniques also are discussed in
separate sections.
A. Conceptual Overview
The A-IRB framework has as its conceptual foundation the belief
that any range of possible losses on a portfolio of credit exposures
can be represented by a probability density function (PDF) of possible
losses over a one-year time horizon. If known, the parameters of a PDF
can be used to specify a particular level of capital that will lower
the probability of the institution's insolvency due to adverse credit
risk outcomes to a stated confidence level. With a known or estimated
PDF, the probability of insolvency can be measured or estimated
directly, based on the level of reserves and capital available to an
institution.
The A-IRB framework builds off this concept and reflects an effort
to develop a common set of risk-sensitive formulas for the calculation
of required capital for credit risk. To a large extent, this framework
resembles more systematic quantitative approaches to the
[[Page 45909]]
measurement of credit risk that many banking organizations have been
developing. These approaches being developed by banking organizations
generally rely on a statistical or probability-based assessment of
credit risk and use inputs broadly similar to those required under the
A-IRB approach. Like the value-at-risk (VaR) model that forms the basis
for the market risk capital rules, the output of these statistical
approaches to credit risk is typically an estimate of loss threshold on
a credit exposure or pool of credit exposures that is highly unlikely
to be exceeded by actual credit-related losses on the exposure or pool.
Many banking organizations now use such a credit VaR amount as the
basis for an internal assessment of the economic capital necessary to
cover credit risk. In this context, it is common for banking
organizations' internal credit risk models to consider a one-year loss
horizon, and to focus on a high loss threshold confidence level (that
is, a loss threshold that has a small probability of being exceeded),
such as the 99.95th percentile. This is because banking organizations
typically seek to hold an amount of economic capital for credit risk
whose probability of being exceeded is broadly consistent with the
institution's external credit rating and its associated default
probability. For example, the one-year historical probability of
default for AA-rated firms is less than 5 basis points (0.05 percent).
There is a great deal of variation across banking organizations in
the specifics of their credit risk measurement approaches. It is
important to recognize that the A-IRB approach is not intended to allow
banking organizations to use all aspects of their own models to
estimate regulatory capital for credit risk. The A-IRB approach has
been developed as a single, common methodology that all advanced
approach banking organizations would use, and consists of a set of
formulas (or functions) and a single set of assumptions regarding
critical parameters for the formulas. The A-IRB approach draws on the
same conceptual underpinnings as the credit VaR approaches that banking
organizations have developed individually, but likely differs in many
specifics from the approach used by any individual institution.
The specific A-IRB formulas require the banking organization first
to estimate certain risk inputs, which the organization may do using a
variety of techniques. The formulas themselves, into which the
estimated risk inputs are inserted, are broadly consistent with the
most common statistical approaches for measuring credit risk, but also
are more straightforward to calculate than those typically employed by
banking organizations (which often require computer simulations). In
particular, an important property of the A-IRB formulas is portfolio
invariance. That is, the A-IRB capital requirement for a particular
exposure generally does not depend on the other exposures held by the
banking organization; as with the general risk-based capital rules, the
total credit risk capital requirement for a banking organization is
simply the sum of the credit risk capital requirements on individual
exposures or pools of exposures.\13\
---------------------------------------------------------------------------
\13\ The theoretical underpinnings for obtaining portfolio-
invariant capital charges within credit VaR models are provided in
the paper ``A Risk-Factor Model Foundation for Ratings-Based Bank
Capital Rules,'' by Michael Gordy, forthcoming in the Journal of
Financial Intermediation. The A-IRB formulas are derived as an
application of these results to a single-factor CreditMetrics-style
mode. For mathematical details of this model, see M. Gordy, ``A
comparative Anatomy of Credit Risk Models.'' Journal of Banking and
Finance, January 2000, or H.R. Koyluogu and A. Hickman,
``Reconcilable Differences.'' Risk, October 1998.
---------------------------------------------------------------------------
As with the existing credit VaR models, the output of the A-IRB
formulas is an estimate of the amount of credit losses over a one-year
period that would only be exceeded a small percentage of the time. In
the case of the A-IRB formulas, this nominal confidence level is set to
99.9 percent. This means that within the context of the A-IRB modeling
assumptions a banking organization's overall credit portfolio capital
requirement can be thought of as an estimate of the 99.9th percentile
of potential losses on that portfolio over a one-year period. In
practice, however, this 99.9 percent nominal target likely overstates
the actual level of confidence because the A-IRB framework does not
explicitly address portfolio concentration issues or the possibility of
errors in estimating PDs, LGDs, or EADs. The choice of the 99.9th
percentile reflects a desire on the part of the Agencies to align the
regulatory capital standard with the default probabilities typically
associated with maintaining low investment grade ratings (that is, BBB)
even in periods of economic adversity and to ensure neither a
substantial increase or decrease in overall required capital levels
among A-IRB banking organizations compared with the capital levels that
would be required under the general risk-based capital rules. It also
recognizes that the risk-based capital rules count a broader range of
instruments as eligible capital (for example, certain subordinated
debt) than do internal economic capital methodologies.
Expected Losses Versus Unexpected Losses
The diagram below shows a hypothetical loss distribution for a
portfolio of credit exposures over a one-year horizon. The loss
distribution is represented by the curve, and is drawn in such a way
that it depicts a higher proportion of losses falling below the mean
value than falling above the mean. The average value of credit losses
is referred to as expected loss (EL). The losses that exceed the
expected level are labeled unexpected loss (UL). An overarching policy
question concerns whether the proposed design of the A-IRB capital
requirements should reflect an expectation that institutions would
allocate capital to cover both EL and a substantial portion of the
range of possible UL outcomes, or only the UL portion of the range of
possible losses (that is, from the EL point out to the 99.9th
percentile).
The Agencies recognize that some institutions, in their comment
letters on earlier BSC proposals and in discussion with supervisory
staffs, have highlighted the view that regulatory capital should not be
allocated for EL. They emphasize that EL is normally incorporated into
the interest rate and spreads charged on specific products, such that
EL is covered by net interest margin and provisioning. The implication
is that supervisors would review provisioning policies and the adequacy
of reserves as part of a supervisory review, much as they do today, and
would require additional reserves and/or regulatory capital for EL in
cases where reserves were deemed insufficient. However, the Agencies
are concerned that the accounting definition of general reserves
differs significantly across countries, and that banking practices with
respect to the recognition of impairment also are very different. Thus,
the Agencies are proposing to include EL in the calibration of the risk
weight functions.
The Agencies also note that the current regulatory definition of
capital includes a portion of general reserves. That is, general
reserves up to 1.25 percent of risk-weighted assets are included in the
Tier 2 portion of total capital. If the risk weight functions were
calibrated solely to UL, it could be argued that the definition of
capital would also need to be revisited. In the United States, such a
discussion would require a review of the provisioning practices of
institutions under GAAP and of the distinctions drawn between specific
and general provisions.
[[Page 45910]]
[GRAPHIC] [TIFF OMITTED] TP04AU03.000
The framework described in this ANPR calibrates the risk-based
capital requirements to the sum of EL plus UL, which raises significant
calibration issues. Those calibration issues would be treated
differently if the calibration were based only on the estimate of UL.
That is, decisions with respect to significant policy variables that
are described below hinge crucially on the initial decision to base the
calibration on EL plus UL, rather than UL only. These issues include,
for example, the appropriate mechanism for incorporating any future
margin income (FMI) that is associated with particular business lines,
as well as the appropriate method for incorporating general and
specific reserves into the risk-based capital ratios.
A final overarching assumption of the A-IRB framework is the role
of asset correlations. Within the A-IRB capital formulas (as in the
credit VaR models of many banking organizations), asset correlation
parameters provide a measure of the extent to which changes in the
economic value of separate exposures are presumed to move together. A
higher asset correlation between a particular asset and other assets in
the same portfolio implies a greater likelihood that the asset will
decline in value at the same time as the portfolio as a whole declines
in value. Because this means a greater chance that the asset will be a
contributor to high loss scenarios, its capital requirement under the
A-IRB framework also is higher.
Specifically, the A-IRB capital formulas described in detail below
are based on the assumption that correlation in defaults across
borrowers is attributable to their common dependence on one or more
systematic risk factors. The basis for this assumption is the
observation that a banking organization's borrowers are generally
susceptible to adverse changes in the global economy. These systematic
factors are distinct from the borrower-specific, or idiosyncratic, risk
factors that determine the probability that a specific loan will be
repaid. Like other risk-factor models, the A-IRB framework assumes that
these borrower-specific factors represent idiosyncratic sources of
risk, and thus (unlike the systematic risk-factors) are diversified in
a large lending portfolio.
The A-IRB approach allows for much improved sensitivity to many of
the loan-level determinants of economic capital (such as PD and LGD),
but does not explicitly address how an exposure's economic capital
might vary with the degree of concentration in the overall portfolio to
specific industries or regions, or even to specific borrowers. That is,
it neither rewards nor penalizes differences across banking
organizations in diversification or concentration across industry,
geography, and names. To introduce such rewards and penalties in an
appropriate manner would necessarily entail far greater operational
complexity for both regulatory and financial institutions.
In contrast, the portfolio models of credit risk employed by many
banking organizations are quite sensitive to all forms of
diversification. That is, the economic capital charge assigned to a
loan within such a model will depend on the portfolio as a whole. In
order to apply a portfolio model to the calibration of A-IRB capital
charges, it would be necessary to identify the assumptions needed so
that a portfolio model would yield economic capital charges that do not
depend on portfolio characteristics. Recent advances in the finance
literature demonstrate that economic capital charges are portfolio-
invariant if (and only if) two assumptions are imposed.\14\ First, the
portfolio must be infinitely fine-grained. Second, there must be only a
single systematic risk factor.
---------------------------------------------------------------------------
\14\ See forthcoming paper by M. Gordy referenced in footnot
number 12 above.
---------------------------------------------------------------------------
Infinite granularity, while never literally attained, is satisfied
in an approximate sense by the portfolios of large, internationally
active banks. Analysis of data provided by such institutions shows that
taking account of single-name concentrations in such portfolios would
lead to only trivial changes in the total capital requirement. The
single risk-factor assumption would appear, at first glance, more
troublesome. As an empirical matter, there undoubtedly are distinct
cyclical factors for different industries and different geographic
regions. From a substantive perspective, however, the
[[Page 45911]]
relevant question is whether portfolios at large financial institutions
are diversified across the various sub-sectors of the economy in a
reasonably similar manner. If so, then the portfolio can be modeled as
if there were only a single factor, namely, the credit cycle as a
---------------------------------------------------------------------------
whole.
The Agencies seek comment on the conceptual basis of the A-IRB
approach, including all of the aspects just described. What are the
advantages and disadvantages of the A-IRB approach relative to
alternatives, including those that would allow greater flexibility
to use internal models and those that would be more cautious in
incorporating statistical techniques (such as greater use of credit
ratings by external rating agencies)? The Agencies also encourage
comment on the extent to which the necessary conditions of the
conceptual justification for the A-IRB approach are reasonably met,
and if not, what adjustments or alternative approach would be
warranted.
Should the A-IRB capital regime be based on a framework that
allocates capital to EL plus UL, or to UL only? Which approach would
more closely align the regulatory framework to the internal capital
allocation techniques currently used by large institutions? If the
framework were recalibrated solely to UL, modifications to the rest
of the A-IRB framework would be required. The Agencies seek
commenters' views on issues that would arise as a result of such
recalibration.
B. A-IRB Capital Calculations
A common characteristic of the A-IRB capital formulas is that they
calculate the actual dollar value of the minimum capital requirement
associated with an exposure (or, in the case of retail exposures, a
pool of exposures). This capital requirement must be converted to an
equivalent amount of risk-weighted assets in order to be inserted into
the denominator of a banking organization's risk-based capital ratios.
Because the minimum risk-based capital ratio in the United States is 8
percent, the minimum capital requirement on any asset would be equal to
8 percent of the risk-weighted asset amount associated with that asset.
Therefore, in order to determine the amount of risk-weighted assets to
associate with a given minimum capital requirement, it would be
necessary to multiply the dollar capital requirement generated by the
A-IRB formulas by the reciprocal of 8 percent, or 12.5.
The following subsections of the ANPR detail the specific features
of the A-IRB capital formulas for two principal categories of credit
exposure: wholesale and retail. Both of these subsections include a
proposed definition of the exposure category, a description of the
banking organization-estimated inputs required to complete the capital
calculations, a description of the specific calculations required to
determine the A-IRB capital requirement, and tables depicting a range
of representative results.
Wholesale Exposures: Definitions and Inputs
The Agencies propose that a single credit exposure category--
wholesale exposures--would encompass most non-retail credit exposures
in the A-IRB framework. The wholesale category would include the sub-
categories of corporate, sovereign, and interbank exposures as well as
all types of specialized lending exposures. Wholesale exposures would
include debt obligations of corporations, partnerships, limited
liability companies, proprietorships, and special-purpose entities
(including those created specifically to finance and/or operate
physical assets). Wholesale exposures also would include debt
obligations of banks and securities firms (interbank exposures), and
debt obligations of central governments, central banks, and certain
public-sector entities (sovereign exposures). The wholesale exposure
category would not include securitization exposures, or certain small-
business exposures that are eligible to be treated as retail exposures.
The Agencies propose that advanced approach banking organizations
would use the same A-IRB capital formula to compute capital
requirements on all wholesale exposures with two exceptions. First,
wholesale exposures to small- and medium-sized enterprises (SMEs) would
use a downward adjustment to the wholesale A-IRB capital formula
typically based on borrower size. Second, the A-IRB capital formula for
HVCRE loans (generally encompassing certain speculative ADC loans)
would use a higher asset correlation assumption than other wholesale
exposures.
The proposed A-IRB capital framework for wholesale exposures would
require banking organizations to assign four key risk inputs for each
individual wholesale exposure: (1) Probability of default (PD); (2)
loss given default (LGD); (3) exposure at default (EAD); and (4)
effective remaining maturity (M). In addition, to use the proposed
downward adjustment for wholesale SMEs described in more detail below,
banking organizations would be required to provide an additional input
for borrower size (S).
Probability of Default
The first principal input to the wholesale A-IRB calculation is the
measure of PD. Under the A-IRB approach, a banking organization would
assign an internal rating to each of its wholesale obligors (or in
other words, assign each wholesale exposure to an internal rating grade
applicable to the obligor). The internal rating would have to be
produced by a rating system that meets the A-IRB infrastructure
requirements and supervisory standards for wholesale exposures, which
are intended to ensure (among other things) that the rating system
results in a meaningful differentiation of risk among exposures. For
each internal rating, the banking organization must associate a
specific one-year PD value. Various approaches may be used to develop
estimates of PDs; however, regardless of the specific approach, banking
organizations would be expected to satisfy the supervisory standards.
The minimum PD that may be assigned to most wholesale exposures is 3
basis points (0.03 percent). Certain wholesale exposures are exempt
from this floor, including exposures to sovereign governments, their
central banks, the BIS, IMF, European Central Bank, and high quality
multilateral development banks (MDBs) with strong shareholder support.
The Agencies intend to apply standards to the PD quantification
process that are consistent with the broad guidance outlined in the New
Accord. More detailed discussion of those points is provided in the
draft supervisory guidance on IRB approaches for corporate exposures
published elsewhere in today's Federal Register.
Loss Given Default
The second principal input to the A-IRB capital formula for
wholesale exposures is LGD. Under the A-IRB approach, banking
organizations would estimate an LGD for each wholesale exposure. An LGD
estimate for a wholesale exposure should provide an assessment of the
expected loss in the event of default of the obligor, expressed as a
percentage of the institution's estimated total exposure at default.
The LGD for a defaulted exposure would be estimated as the expected
economic loss rate on that exposure taking into account, where
appropriate, recoveries, workout costs, and the time value of money.
Banking organizations would estimate LGDs as the loss severities
expected to prevail when default rates are high, unless they have
information indicating that recoveries on a particular
[[Page 45912]]
class of exposure are unlikely to be affected to an appreciable extent
by cyclical factors. As with estimates of other A-IRB inputs, banking
organizations would be expected to be conservative in assigning LGDs.
Although estimated LGDs should be grounded in historical recovery
rates, the A-IRB approach is structured to allow banking organizations
to assess the differential impact of various factors, including, for
example, the presence of collateral or differences in loan terms and
covenants. The Agencies expect to impose limitations on the use of
guarantees and credit derivatives in a banking organization's LGD
estimates. These limitations are discussed in the separate section of
this ANPR on the A-IRB treatment of credit risk mitigation techniques.
Exposure at Default
The third principal input to the wholesale A-IRB capital formula is
EAD. The Agencies are proposing that banking organizations would
provide their own estimate of EAD for each exposure. The EAD for an
exposure would be defined as the amount legally owed to the banking
organization (net of any charge-offs) in the event that the borrower
defaults on the exposure. For on-balance-sheet items, banking
organizations would estimate EAD as no less than the current drawn
amount. For off-balance-sheet items, except over-the-counter (OTC)
derivative transactions, banking organizations would assign an EAD
equal to an estimate of the long-run default-weighted average EAD for
similar facilities and borrowers or, if EADs are highly cyclical, the
EAD expected to prevail when default rates are high. The EAD associated
with OTC derivative transactions would continue to be estimated using
the ``add-on'' approach contained in the general risk-based capital
rules.\15\ In addition, there would be a specific EAD calculation for
the recognition of collateral in the context of repo-style transactions
subject to a master netting agreement, the features of which are
outlined below in the section on the A-IRB treatment of credit risk
mitigation techniques.\16\
---------------------------------------------------------------------------
\15\ Under the add-on approach, an institution would determine
its EAD for an OTC derivative contract by adding the current value
of the contract (zero if the current value is negative) and an
estimate of potential future exposure (PFE) on the contract. The
estimated PFE would be equal to the notional amount of the
derivative multiplied by a supervisor-provided add-on factor that
takes into account the type of instrument and its maturity.
\16\ Repo-style transactions include reverse repurchase
agreements and repurchase agreements and securities lending and
borrowing.
---------------------------------------------------------------------------
Definition of Default and Loss
A banking organization would estimate inputs relative to the
following definition of default and loss. A default is considered to
have occurred with respect to a particular borrower when either or both
of the following two events has taken place: (1) The banking
organization determines that the borrower is unlikely to pay its
obligations to the organization in full, without recourse to actions by
the organization such as the realization of collateral; or (2) the
borrower is more than 90 days past due on principal or interest on any
material obligation to the organization. The Agencies believe that the
use of the concept of ``unlikely to pay'' is largely consistent with
the practice of U.S. banking organizations in assessing whether a loan
is on non-accrual status.
Maturity
The fourth principal input to the A-IRB capital formula is
effective remaining maturity (M), measured in years. If a wholesale
exposure is subject to a determinable cash flow schedule, the banking
organization would calculate M as the weighted-average remaining
maturity of the expected cash flows, using the amounts of the cash
flows as the relevant weights. The banking organization also would be
able to use the nominal remaining maturity of the exposure if the
weighted-average remaining maturity of the exposure cannot be
calculated. For OTC derivatives and repo-style transactions subject to
master netting agreements, the institution would set M equal to the
weighted-average remaining maturity of the individual transactions,
using the notional amounts of the individual transactions as the
relevant weights.
In all cases, M would be set no greater than five years and, with
few exceptions, M would be set no lower than one year. The exceptions
apply to certain transactions that are not part of a banking
organization's ongoing financing of a borrower. For wholesale exposures
that have an original maturity of less than three months--including
repo-style transactions, money market transactions, trade finance-
related transactions, and exposures arising from payment and settlement
processes--M may be set as low as one day. For OTC derivatives and
repo-style transactions subject to a master netting agreement, M would
be set at no less than five days.
As with the assignment of PD estimates, the Agencies propose to
apply supervisory standards for the estimation of LGD, EAD, and M that
are consistent with the broad guidance contained in the New Accord.
More detailed discussion of these issues is provided in the draft
supervisory guidance on IRB approaches for corporate exposures
published elsewhere in today's Federal Register.
The Agencies seek comment on the proposed definition of
wholesale exposures and on the proposed inputs to the wholesale A-
IRB capital formulas. What are views on the proposed definitions of
default, PD, LGD, EAD, and M? Are there specific issues with the
standards for the quantification of PD, LGD, EAD, or M on which the
Agencies should focus?
Wholesale Exposures: Formulas
The calculation of the A-IRB capital requirement for a
particular wholesale exposure would be accomplished in three steps:
(1) Calculation of the relevant asset correlation parameter,
which would be a function of PD (as well as borrower size (S) for
SMEs);
(2) Calculation of a preliminary capital requirement assuming a
maturity of one year, which would be a function of PD, LGD, EAD, and
the asset correlation parameter calculated in the first step; and
(3) Application of a maturity adjustment for differences between
the actual effective remaining maturity of the exposure and the one-
year maturity assumption in the second step, where the adjustment
would be a function of both PD and M.
These calculations result in the A-IRB capital requirement,
expressed in dollars, for a particular wholesale exposure. As noted
earlier, this amount would be converted to a risk-weighted assets
equivalent by multiplying the amount by 12.5, and the risk-weighted
assets equivalent would be included in the denominator of the risk-
based capital ratios.
Asset Correlation
The first step in the calculation of the A-IRB capital
requirement for a wholesale exposure is the calculation of the asset
correlation parameter, which is denoted by the letter ``R'' in the
formulas below. This asset correlation parameter is not a fixed
amount; rather, the parameter varies as an inverse function of PD.
For all wholesale exposures except HVCRE exposures, the asset
correlation parameter approaches an upper bound value of 24 percent
for very low PD values and approaches a lower bound value of 12
percent for very high PD values. This reflects the Agencies' view
that borrowers with lower credit quality (that is, higher PDs) are
likely to be more idiosyncratic in the factors affecting their
likelihood of default than borrowers with higher credit quality
(lower PDs). Therefore, the higher PD borrowers are proportionately
less influenced by systematic (sector-wide or economy-wide) factors
common to all borrowers.\17\
---------------------------------------------------------------------------
\17\ See Jose Lopez, ``The Empirical Relationship between
Average Asset Correlation, Firm Probability of Default, and Asset
Size.'' Federal Reserve Bank of San Francisco Working Paper 02-05
(June 2002).
---------------------------------------------------------------------------
An important practical impact of having asset correlation
decline with increases in PD
[[Page 45913]]
is to reduce the speed with which capital requirements increase as
PDs increase, and to increase the speed with which EL dominates the
total capital charge, thereby tending to reduce procyclicality in
the application of the wholesale A-IRB capital formulas. The
specific formula for determining the asset correlation parameter for
---------------------------------------------------------------------------
all wholesale exposures except HVCRE exposures is as follows:
R = 0.12 * (1-EXP(-50 * PD)) + 0.24 * [1-(1-EXP(-50 * PD))]
Where:
R denotes asset correlation;
EXP(x) denotes the natural exponential function; and
PD denotes probability of default.
Capital Requirement With Assumed One-Year Maturity Adjustment
The second step in the calculation of the A-IRB capital
requirement for a particular wholesale exposure is the calculation
of the capital requirement that would apply to the exposure assuming
a one-year effective remaining maturity. The specific formula to
calculate this one-year-maturity capital requirement is as follows:
K1 = EAD * LGD * N[(1-R)[caret]-0.5 * G(PD) + (R/(1-
R))[caret]0.5 * G(0.999)]
Where:
K1 denotes the one-year-maturity capital requirement;
EAD denotes exposure at default;
LGD denotes loss given default;
N(x) denotes the standard normal cumulative distribution function;
R denotes asset correlation;
G(x) denotes the inverse of the standard normal cumulative
distribution function; and \18\
---------------------------------------------------------------------------
\18\ The N(x) and G(x) functions are widely used in statistics
and are commonly available in computer spreadsheet programs. A
description of these functions may be found in the Help function of
most spreadsheet programs or in basic statistical textbooks.
---------------------------------------------------------------------------
PD denotes probability of default.
There are several important aspects of this formula. First, it
rises in a straight-line fashion with increases in EAD, meaning that
a doubling of the exposure amount would result in a doubling of the
capital requirement. It also rises in a straight-line fashion with
increases in LGD, which similarly implies that a loan with an LGD
estimate twice that of an otherwise identical loan would have twice
the capital requirement of the other loan. This also implies that as
LGD or EAD estimates approach zero, the capital requirement would
likewise approach zero. The remainder of the formula is a function
of PD, asset correlation (R), which is itself a function of PD, and
the target loss percentile amount of 99.9 percent discussed earlier.
Maturity Adjustment
The third stage in the calculation of the A-IRB capital
requirement for a particular wholesale exposure is the application
of a maturity adjustment to reflect the exposure's actual effective
remaining maturity (M). The A-IRB maturity adjustment multiplies the
one-year-maturity capital requirement (K1) by a factor
that depends on both M and PD. The fact that the A-IRB maturity
adjustment depends on PD reflects the Agencies' view that there is a
greater proportional need for maturity adjustments for high-quality
exposures (those with low PDs) because there is a greater potential
for such exposures to deteriorate in credit quality than for
exposures whose credit quality is lower. The specific formula for
applying the maturity adjustment and generating the A-IRB capital
requirement is as follows:
K = K1 * [1 + (M-2.5) * b]/[(1-1.5 * b)], where b =
(0.08451-0.05898 * LN(PD))\2\
and:
K denotes the A-IRB capital requirement;
K1 denotes the one-year-maturity capital requirement;
M denotes effective remaining maturity;
LN(x) denotes the natural logarithm; and
PD denotes probability of default.
In this formula, the value ``b'' effectively determines the
slope of the maturity adjustment and is itself a function of PD.
Note that if M is set equal to one, the maturity adjustment also
equals one and K will therefore equal K1.
To provide a more concrete sense of the range of capital
requirements under the wholesale A-IRB framework, the following
table presents the A-IRB capital requirements (K) for a range of
values of both PD and M. In this table LGD is assumed to equal 45
percent. For comparison purposes, the general risk-based capital
rules assign a capital requirement of 8 percent for most commercial
loans.
Capital Requirements
[In percentage points]
----------------------------------------------------------------------------------------------------------------
Effective remaining maturity (M)
PD ---------------------------------------------------------------
1 month 1 year 3 years 5 years
----------------------------------------------------------------------------------------------------------------
0.05 percent.................................... 0.50 0.92 1.83 2.74
0.10 percent.................................... 1.00 1.54 2.71 3.88
0.25 percent.................................... 2.17 2.89 4.44 5.99
0.50 percent.................................... 3.57 4.40 6.21 8.03
1.00 percent.................................... 5.41 6.31 8.29 10.27
2.00 percent.................................... 7.65 8.56 10.56 12.56
5.00 percent.................................... 11.91 12.80 14.75 16.69
10.00 percent................................... 17.67 18.56 20.50 22.45
20.00 percent................................... 26.01 26.84 28.65 30.47
----------------------------------------------------------------------------------------------------------------
The impact of the A-IRB capital formulas on minimum risk-based
capital requirements for wholesale exposures would, of course, depend
on the actual values of PD, LGD, EAD, and M that banking organizations
would use as inputs to the wholesale formulas. Subject to the caveats
noted earlier, evidence from QIS3 suggested an average reduction in
credit risk capital requirements for corporate exposures of about 26
percent for twenty large U.S. banking organizations.
SME Adjustment
For loans to SMEs not eligible for retail A-IRB treatment, the
proposed calculation of the A-IRB capital requirement has one
additional element--a downward adjustment based on borrower size (S).
This adjustment would effectively lower the A-IRB capital requirement
on wholesale exposures to SMEs with annual sales (or total assets) of
less than $50 million. The Agencies believe the measure of borrower
size should be based on annual sales (rather than total assets), unless
the banking organization can demonstrate that it would be more
appropriate for the banking organization to use the total assets of the
borrower as its measure of borrower size. The borrower size adjustment
would be made to the asset correlation parameter (R), as shown in the
following formula:
RSME = R-0.04 * [1-(S- 5)/45]
Where
RSME denotes the size-adjusted asset correlation;
R denotes asset correlation; and
[[Page 45914]]
S denotes borrower size (expressed in millions of dollars).
The maximum reduction in the asset correlation parameter based on
this formula is 4 percent, and is achieved when borrower size is $5
million. For all borrower sizes below $5 million, borrower size would
be set equal to $5 million. The adjustment shrinks to zero as borrower
size approaches $50 million. The broad rationale for this adjustment is
the view that the credit condition of SMEs will be influenced
relatively more by idiosyncratic factors than is the case for larger
firms, and, thus, SMEs would be less likely to deteriorate
simultaneously with other exposures. This greater susceptibility to
idiosyncratic factors would imply lower asset correlation. The evidence
in favor of this view is mixed, particularly after considering that the
A-IRB framework already incorporates a negative relationship between
asset correlation and PD. The following table illustrates the practical
effect of the SME adjustment by depicting the capital requirements (K)
across a range of PDs and borrower sizes. As in the previous table, LGD
is assumed to equal 45 percent. For this table, M is assumed to be
equal to three years. Note that the last column is identical to the
three-year maturity column in the preceding table because the SME
adjustment is phased out for borrowers of $50 million or more in size.
Capital Requirements
[In percentage points]
----------------------------------------------------------------------------------------------------------------
Borrower size (S)
----------------------------------------------------------------
PD =
$5 million $20 million $35 million $50 million
----------------------------------------------------------------------------------------------------------------
0.05 percent................................... 1.44 1.57 1.70 1.83
0.10 percent................................... 2.14 2.33 2.51 2.71
0.25 percent................................... 3.54 3.83 4.13 4.44
0.50 percent................................... 4.97 5.37 5.79 6.21
1.00 percent................................... 6.63 7.17 7.72 8.29
2.00 percent................................... 8.40 9.11 9.83 10.56
5.00 percent................................... 11.70 12.73 13.74 14.75
10.00 percent.................................. 16.76 18.05 19.30 20.50
20.00 percent.................................. 24.67 26.08 27.40 28.65
----------------------------------------------------------------------------------------------------------------
Subject to the caveats mentioned above, evidence from QIS3
suggested an average reduction in credit risk-based capital
requirements for corporate SME exposures of about 39 percent for twenty
large U.S. banking organizations.
If the Agencies include a SME adjustment, are the $50 million
threshold and the proposed approach to measurement of borrower size
appropriate? What standards should be applied to the borrower size
measurement (for example, frequency of measurement, use of size
buckets rather than precise measurements)?
Does the proposed borrower size adjustment add a meaningful
element of risk sensitivity sufficient to balance the costs
associated with its computation? The Agencies are interested in
comments on whether it is necessary to include an SME adjustment in
the A-IRB approach. Data supporting views is encouraged.
Wholesale Exposures: Other Considerations
Specialized Lending
The specialized lending (SL) asset class encompasses exposures
for which the primary source of repayment is the income generated by
the specific asset(s) being financed, rather than the financial
capacity of a broader commercial enterprise. The SL category
encompasses four broad exposure types:
[sbull] Project finance (PF) exposures finance large, complex,
expensive installations that produce goods or services for sale,
such as power plants, chemical processing plants, mines, or
transportation infrastructure, where the source of repayment is
primarily the revenues generated by sale of the goods or services by
the installations.
[sbull] Object finance (OF) exposures finance the acquisition of
(typically moveable) physical assets, such as ships or aircraft, where
the source of repayment is primarily the revenues generated by the
assets being financed, often through rental or lease contracts with
third parties.
[sbull] Commodities finance (CF) exposures are structured short-
term financings of reserves, inventories, or receivables of exchange-
traded commodities, such as crude oil, metals, or agricultural
commodities, where the source of repayment is the proceeds of the sale
of the commodity.
[sbull] Commercial real estate (CRE) exposures finance the
construction or acquisition of real estate (including land as well as
improvements) where the prospects for repayment and recovery depend
primarily on the cash flows generated by the lease, rental, or sale of
the real estate.\19\ The broad CRE category is further divided into two
groups: low-asset-correlation CRE and HVCRE.\20\
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\19\ CRE exposures are typically non-recourse exposures, often
to special purpose vehicles, and are distinguishable from corporate
exposures that are collateralized by real estate for which the
prospects for repayment and recovery depend primarily on the
financial performance of the broader commercial enterprise that is
the obligor.
\20\ To describe a loan portfolio as having a relatively high
asset correlation means that any defaults that occur in that
portfolio are relatively likely to occur at the same time, and for
this reason the portfolio is likely to exhibit greater variability
in aggregate default rates. For two portfolios with the same EL, the
portfolio with more highly variable aggregate default rates warrants
higher capital to cover UL (``bad-tail events'') with the same level
of confidence. Describing a portfolio as having a relatively high
asset correlation does not imply that loans in that portfolio have
relatively high PD, LGD, or EL. In particular, loans in high asset
correlation portfolios may well have very low PDs and LGDs and
therefore ELs); conversely, loans in low asset correlation
portfolios may have very high PDs and LGDs (and ELs). For any two
loans from a portfolio with a given asset correlation (or from two
different portfolios with the same asset correlation), the loan with
the lower EL should be assigned a lower risk weight. For any two
loans with the same EL, the loan from the portfolio with the lower
asset correlation should incur a lower capital charge, because bad-
tail events are less likely to occur in that portfolio.
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Most of the issues raised below for comment are described in
substantially greater detail, in the context of CRE exposures, in a
white paper entitled ``Loss Characteristics of CRE Loan Portfolios,''
released by the Federal Reserve Board on June 10, 2003. Commenters are
encouraged to read the white paper in conjunction with this section.
A defining characteristic of SL exposures (including CRE) is that
the risk factors influencing actual default rates are likely to
influence LGDs as well. This is because both the borrower's ability to
repay an exposure and the banking organization's recovery on an
exposure in the event of default are likely to depend on the same
underlying factors, such as the net cash flows of the property being
financed.
[[Page 45915]]
This suggests a positive correlation between observed default
frequencies and observed loss rates on defaulted loans, with both
declining during periods of favorable economic conditions and both
increasing during unfavorable economic periods. While cyclicality in
LGDs may be significant for a number of lending activities, the
Agencies believe that cyclicality is likely to be the norm for SL
portfolios, and that a banking organization's procedures for estimating
LGD inputs for SL exposures should assess and quantify this cyclicality
in a comprehensive and systematic fashion.
The Agencies invite comment on ways to deal with cyclicality in
LGDs. How can risk sensitivity be achieved without creating undue
burden?
For core and opt-in banks that may not be able to provide
sufficiently reliable estimates of PD, LGD, and M for each SL exposure,
the New Accord offers a Supervisory Slotting Criteria (SSC) approach.
Under this approach, rather than estimating the loan-level risk
parameters, banking organizations would use slotting criteria to map
their internal risk rating grades to one o |
