[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\
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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 of five supervisory rating
grades: Strong, Good, Satisfactory, Weak, and Default. In addition,
supervisory risk weights would be assigned to each of these supervisory
rating grades. To assist banking organizations in implementing these
supervisory rating grades, for reference purposes the New Accord
associates each with an explicit range of external rating grades. If
the SSC approach were allowed in the United States, the Agencies would
have to develop slotting criteria that would take into account factors
such as market conditions; financial ratios such as debt service
coverage or loan-to-value ratios; cash flow predictability; strength of
sponsor or developer; and other factors likely to affect the PD and/or
LGD of each loan.
The Agencies invite comment on the merits of the SSC approach in
the United States. The Agencies also invite comment on the specific
slotting criteria and associated risk weights that should be used by
organizations to map their internal rating grades to supervisory
rating grades if the SSC approach were to be adopted in the United
States.
Under the A-IRB approach, a banking organization would estimate the
risk inputs for each SL exposure and then calculate the A-IRB capital
charge for the exposure by substituting the estimated PD, LGD, EAD, and
M into one of two risk weight functions. The first risk weight function
is the wholesale risk weight function and applies to all PF, OF, and CF
exposures, as well as to all low-asset-correlation CRE exposures
(including in-place commercial properties). The second risk weight
function applies to all HVCRE exposures. It also is the same as the
wholesale risk weight function, except that it incorporates a higher
asset correlation parameter. The asset correlation equation for HVCRE
is as follows:
R = 0.12 x (1-EXP (-50 x PD)) + 0.30 x [EXP (-50 x PD)]
Where
R denotes asset correlation;
EXP denotes the natural exponential function; and
PD denotes probability of default.
The following table presents the A-IRB capital requirement (K) for
a range of values of both PD and M. In this table, LGD is assumed to
equal 45 percent. This LGD is used for consistency with the similar
table above for wholesale exposures and should not be construed as an
indication that 45 percent is a typical LGD for HVCRE exposures.
HVCRE Capital Requirements
[In percentage points]
----------------------------------------------------------------------------------------------------------------
Effective remaining maturity
PD -----------------------------------------------
1 year 3 years 5 years
----------------------------------------------------------------------------------------------------------------
0.05 percent.................................................... 1.24 2.46 3.68
0.10 percent.................................................... 2.05 3.61 5.16
0.25 percent.................................................... 3.74 5.76 7.77
0.50 percent.................................................... 5.52 7.79 10.07
1.00 percent.................................................... 7.53 9.89 12.25
2.00 percent.................................................... 9.55 11.79 14.02
5.00 percent.................................................... 13.12 15.12 17.11
10.00 percent................................................... 18.59 20.54 22.49
20.00 percent................................................... 26.84 28.65 30.47
----------------------------------------------------------------------------------------------------------------
All ADC loans would be treated as HVCRE exposures, unless the
borrower has ``substantial equity'' at risk or the property is pre-sold
or sufficiently pre-leased. In part, this reflects some empirical
evidence suggesting that most ADC loans have relatively high asset
correlations. It also, however, reflects a longstanding supervisory
concern that CRE lending to finance speculative construction and
development is vulnerable to, and may worsen, speculative swings in CRE
markets, especially when there is little borrower equity at risk. Such
lending was a major factor causing the stress experienced by many banks
in the early 1990s, not only in the United States but in other
countries as well.
Under the New Accord, SL loans financing the construction of one-
to four-family residential properties (single or in subdivisions) are
included with other ADC loans in the high asset correlation category.
However, loans financing the construction of pre-sold one- to four-
family residential properties would be eligible to be treated as low-
asset-correlation CRE exposures. In some cases the loans may finance
the construction of subdivisions or other groups of houses, some of
which are pre-sold while others are not.
Under the New Accord, each national supervisory authority is
directed to recognize and incorporate into its implementation of the
New Accord the high asset correlation determinations of other national
supervisory authorities for loans made in their respective
jurisdictions. Thus, when the Agencies designate certain CRE properties
as HVCRE, foreign banking organizations making extensions of credit to
those properties also would be expected to treat them as HVCRE.
Similarly, when non-U.S. supervisory authorities designate certain CRE
as HVCRE, U.S. banking organizations that extend credit to those
properties would be expected to treat them as HVCRE.
[[Page 45916]]
The Agencies invite the submission of empirical evidence
regarding the (relative or absolute) asset correlations
characterizing portfolios of ADC loans, as well as comments
regarding the circumstances under which such loans would
appropriately be categorized as HVCRE.
The Agencies also invite comment on the appropriateness of
exempting from the high-asset-correlation category ADC loans with
substantial equity or that are pre-sold or sufficiently pre-leased.
The Agencies invite comment on what standard should be used in
determining whether a property is sufficiently pre-leased when
prevailing occupancy rates are unusually low.
The Agencies invite comment on whether high-asset-correlation
treatment for one- to four-family residential construction loans is
appropriate, or whether they should be included in the low-asset-
correlation category. In cases where loans finance the construction
of a subdivision or other group of houses, some of which are pre-
sold while others are not, the Agencies invite comment regarding how
the ``pre-sold'' exception should be interpreted.
The Agencies invite comment on the competitive impact of
treating defined classes of CRE differently. What are commenters'
views on an alternative approach where there is only one risk weight
function for all CRE? If a single risk weight function for all CRE
is considered, what would be the appropriate asset correlation to
employ?
Lease Financings
Under the wholesale A-IRB framework, some lease financings require
special consideration. A distinction is made for leases that expose the
lessor to residual value risk, namely the risk of the fair value of the
assets declining below the banking organization's estimate of residual
risk at lease inception. If a banking organization has exposure to
residual value risk, it would assign a 100 percent risk weight to the
residual value amount and determine a risk-weighted asset equivalent
for the lease's remaining net investment (net of residual value amount)
using the same methodology as for any other wholesale exposure. The sum
of these components would be the risk-weighted asset amount for a
particular lease. Where a banking organization does not have exposure
to residual value risk, the lease's net investment would be subject to
a capital charge using the same methodology applied to any other
wholesale exposure.
This approach would be used regardless of accounting classification
as a direct finance, operating or leveraged lease. For leveraged
leases, when the banking organization is the equity participant it
would net the balance of the non-recourse debt against the discounted
lease payment stream prior to applying the risk weight. If the banking
organization is the debt participant, the exposure would be treated as
any other wholesale exposure.
The Agencies are seeking comment on the wholesale A-IRB capital
formulas and the resulting capital requirements. Would this approach
provide a meaningful and appropriate increase in risk sensitivity in
the sense that the results are consistent with alternative
assessments of the credit risks associated with such exposures or
the capital needed to support them? If not, where are there material
inconsistencies?
Does the proposed A-IRB maturity adjustment appropriately
address the risk differences between loans with differing
maturities?
Retail Exposures: Definitions and Inputs
The second major exposure category in the A-IRB framework is the
retail exposure category. This category encompasses the vast majority
of credit exposures to individual consumers. The Agencies also are
considering whether certain SME exposures should be eligible for retail
A-IRB treatment. The retail exposure category has three distinct sub-
categories: (1) Residential mortgages (and related exposures); (2)
qualifying revolving exposures (QREs); and (3) other retail exposures.
There are separate A-IRB capital formulas for each of these three sub-
categories to reflect different levels of associated risk.
The Agencies propose that the residential mortgage exposure sub-
category be defined to include loans secured by first or subsequent
liens on one-to four-family residential properties, including term
loans and revolving lines of credit secured by home equity. There would
be no upper limit on the size of the exposure that could be included in
the residential mortgage exposure sub-category, but the borrower would
have to be an individual and the banking organization should generally
manage the exposure as part of a pool of similar exposures. Residential
mortgage exposures that are individually internally rated and managed
similarly to commercial exposures, rather than managed and internally
rated as pools, would be treated under the wholesale A-IRB framework.
The second sub-category of retail exposures is qualifying revolving
exposures (QREs). The Agencies propose to define QREs as exposures to
individuals that are revolving, unsecured, uncommitted, less than
$100,000, and managed as part of a pool of similar exposures. In
practice, QREs will include primarily exposures where customers'
outstanding borrowings are permitted to fluctuate based on their own
decisions to borrow and repay, up to a limit established by the banking
organization. Most credit card exposures to individuals and overdraft
lines on individual checking accounts would be QREs.
The third sub-category of retail exposures, other retail exposures,
includes two types of exposures. First, it encompasses all exposures to
individuals for non-business purposes that are generally managed as
part of a pool of similar exposures and that do not meet the conditions
for inclusion in the first two sub-categories of retail exposures. The
Agencies are not proposing to establish a fixed upper limit on the size
of exposures to individuals that are eligible for the other retail
treatment. In addition, the Agencies are proposing that the other
retail sub-category include certain SME exposures that are managed on a
pool basis similar to retail exposures. These exposures could be to a
company or to an individual. The Agencies are considering an individual
borrower exposure threshold of $1 million for such exposures. For the
purpose of assessing compliance with the individual borrower exposure
threshold, the banking organization would aggregate all exposures to a
particular borrower on a fully consolidated basis. Credit card accounts
with balances between $100,000 and $1 million would be considered other
retail exposures rather than QRE, even if the accounts are extended to
or guaranteed by an individual and used exclusively for small business
purposes.
The Agencies are interested in comment on whether the proposed
$1 million threshold provides the appropriate dividing line between
those SME exposures that banking organizations should be allowed to
treat on a pooled basis under the retail A-IRB framework and those
SME exposures that should be rated individually and treated under
the wholesale A-IRB framework.
One of the most significant differences between the wholesale and
retail A-IRB categories is that the risk inputs for retail exposures do
not have to be assigned at the level of an individual exposure. The
Agencies recognize that banking organizations typically manage retail
exposures on a portfolio or pool basis, where each portfolio or pool
contains exposures with similar risk characteristics. Therefore, a key
characteristic of the retail A-IRB framework is that the risk inputs
for retail exposures would be assigned to portfolios or pools of
exposures rather than to individual exposures.
It is important to highlight that within each of the three sub-
categories of retail
[[Page 45917]]
exposures, the retail A-IRB framework is intended to provide banking
organizations with substantial flexibility to use the retail portfolio
segmentation that they believe is most appropriate for their
activities. In determining how to group their retail exposures within
each sub-category into portfolio segments for the purpose of assigning
A-IRB risk inputs, the Agencies believe that banking organizations
should use a segmentation approach that is consistent with their
approach for internal risk assessment purposes and that classifies
exposures according to predominant risk characteristics.
As general principles for segmentation, banking organizations
should group exposures in each of the three retail sub-categories into
portfolios or pools according to the sub-category's principal risk
drivers, and would have to be able to demonstrate that the resultant
segmentation effectively differentiates and rank orders risk and
provides reasonably accurate and consistent quantitative estimates of
PD, LGD, and EAD. With the exceptions noted below, the Agencies are not
proposing that institutions must consider any particular risk drivers
or employ any minimum number of portfolios or pools in any of the three
retail sub-categories. The only specific limitations that the Agencies
would propose in regard to the portfolio segmentation of retail
exposures are (1) banking organizations generally would not be
permitted to combine retail exposures from multiple countries into the
same portfolio segment (because of differences in national legal
systems and bankruptcy regimes), and (2) banking organizations would
need to separately segment delinquent retail exposures.
The inputs to the retail A-IRB capital formulas differ slightly
from the inputs to the wholesale A-IRB capital formulas. Measures of
PD, LGD, and EAD remain important elements, but there is no M input to
the retail A-IRB capital formulas. Rather, the retail A-IRB capital
formulas implicitly incorporate average maturity effects in general,
such as in the residential mortgage sub-category.
Aside from the applicable definition of default, discussed below,
the definitions of PD, LGD, and EAD for retail exposures are generally
equivalent to those for wholesale exposures. One additional element of
potential flexibility for banking organizations in the retail context
needs to be highlighted. The Agencies recognize that certain banking
organizations that may qualify for the advanced approaches segment
their retail portfolios for management purposes by EL, rather than by
separately measuring PD and LGD, as required under the A-IRB framework.
Therefore, the Agencies propose that banking organizations be permitted
substantial flexibility in translating measures of EL into the
requisite PD and LGD inputs. For non-revolving portfolio segments, EL
generally would equal the product of PD and LGD, so that if a banking
organization has an estimate of EL and either PD or LGD, it would be
able to infer an estimate of the other required input.
In addition, the Agencies are proposing that if one or the other of
PD and LGD did not tend to vary significantly across portfolio
segments, the banking organization would be permitted to apply a
general estimate of that input to multiple segments and to use that
general estimate, together with segment-specific estimates of EL, to
infer segment-specific estimates of the other required input. The
Agencies note, however, that this proposal offers substantial
flexibility to institutions and may, in fact, be overly flexible (for
example, because LGDs on residential mortgages tend to be quite
cyclical). For these loans, the above method of inferring PDs or LGDs
from a long-run average EL would not necessarily result in PD being
estimated as a long-run average, and LGD would not necessarily reflect
the loss rate expected to prevail when default rates are high. Banking
organizations using an EL approach to retail portfolio segmentation
would have to ensure that the A-IRB capital requirement under this
method is at least as conservative as a PD/LGD method in order to
minimize any potential divergences between capital requirements
computed under the PD/LGD approach versus an EL approach.
As in the wholesale A-IRB framework, a floor of 3 basis points
(0.03 percent) applies to the PD estimates for all retail exposures
(that is, the minimum PD is 3 basis points). In addition, for
residential mortgage exposures other than those guaranteed by a
sovereign government, a floor of 10 percent on the LGD estimate would
apply, based on the view that LGDs during periods of high default rates
are unlikely to fall below this level if measured appropriately. Along
with the overall monitoring of the implementation of the advanced
approaches and the determination whether to generally relax the floors
established during the initial implementation phases (that is, the 90
and 80 percent floors discussed above), the Agencies intend to review
the need to retain PD and LGD floors for retail exposures following the
first two years of implementation of the A-IRB framework.
The Agencies are proposing the following data requirements for
retail A-IRB. Banking organizations would have to have a minimum of
five years of data history for PD, LGD, and EAD, and preferably longer
periods so as to include a complete economic cycle. Banking
organizations would not have to give equal weight to all historical
factors if they can demonstrate that the more recent data are better
predictors of the risk inputs. Also, banking organizations would have
to have a minimum of three years of experience with their portfolio
segmentation and risk management systems.
Definition of Default and Loss
The retail definition of default and loss being proposed by the
Agencies differs significantly from that proposed for the wholesale
portfolio. Specifically, the Agencies propose to use the definitions of
loss recognition embodied in the Federal Financial Institutions
Examination Council (FFIEC) Uniform Retail Credit Classification and
Account Management Policy.\21\ All residential mortgages and all
revolving credits would be charged off, or charged down to the value of
the property, after a maximum of 180 days past due; other credits would
be charged off after a maximum of 120 days past due.
---------------------------------------------------------------------------
\21\ The FFIEC Uniform Retail Credit Classification and Account
Management Policy was issued on June 12, 2000. It is available on
the FFIEC Web site at www.FFIEC.gov.
---------------------------------------------------------------------------
In addition, the Agencies are proposing to define a retail default
to include the occurrence of any one of the three following events if
it occurs prior to the respective 120- or 180-day FFIEC policy trigger:
(1) A full or partial charge-off resulting from a significant decline
in credit quality of the exposure; (2) a distressed restructuring or
workout involving forbearance and loan modification; or (3) a
notification that the obligor has sought or been placed in bankruptcy.
Finally, for retail exposures (as opposed to wholesale exposures) the
definition of default may be applied to a particular facility, rather
than to the obligor. That is, default on one obligation would not
require a banking organization to treat all other obligations of the
same obligor as defaulted.
Undrawn Lines
The treatment of undrawn lines of credit, in particular those
associated with credit cards, merits specific discussion. Banking
organizations would be permitted to incorporate undrawn retail lines in
one of two ways. First, banking organizations could
[[Page 45918]]
incorporate them into their EAD estimates directly, by assessing the
likelihood that undrawn balances would be drawn at the time of an event
of default. Second, banking organizations could incorporate them into
LGD estimates by assessing the size of potential losses in default
(including those arising from both currently drawn and undrawn
balances) as a proportion of the current drawn balance. In the latter
case, it is possible that the relevant LGD estimates would exceed 100
percent. While the proposed EAD approach for undrawn wholesale and
retail lines is the same, the Agencies are aware that the sheer volume
of credit card undrawn lines and the ratio of undrawn lines to
outstanding balances create issues for undrawn retail lines that differ
from undrawn wholesale lines not only in degree but also in kind.
An additional issue arises in connection with the undrawn lines
associated with credit card accounts whose drawn balances (but not
undrawn balances) have been securitized. To the extent that banking
organizations remain exposed to the risk that such undrawn lines will
be drawn, but such undrawn lines are not themselves securitized, then
there is a need for institutions to hold regulatory capital against
such undrawn lines. The Agencies propose that a banking organization
would be required to hold capital against the full amount of any
undrawn lines regardless of whether drawn amounts are securitized. This
presumes that the institution itself is exposed to the credit risk
associated with future draws.
The Agencies are interested in comments and specific proposals
concerning methods for incorporating undrawn credit card lines that
are consistent with the risk characteristics and loss and default
histories of this line of business.
The Agencies are interested in further information on market
practices in this regard, in particular the extent to which banking
organizations remain exposed to risks associated with such accounts.
More broadly, the Agencies recognize that undrawn credit card lines
are significant in both of the contexts discussed above, and are
particularly interested in views on the appropriate retail A-IRB
treatment of such exposures.
Future Margin Income
In the New Accord, the retail A-IRB treatment of QREs includes a
unique additional input that arises because of the large amount of
expected losses typically associated with QREs. As noted above, the A-
IRB approach would require banking organizations to hold regulatory
capital against both EL and UL. Banking organizations typically seek to
cover expected losses through interest income and fees for all of their
business activities, and the Agencies recognize that this practice is a
particularly important aspect of the business model for QREs.
The Agencies are including in this proposal, for the QRE sub-
category only, that future margin income (FMI) be permitted to offset a
portion of the A-IRB retail capital charge relating to EL. For this
purpose, the Agencies propose to define the amount of eligible FMI for
the QRE sub-category as the amount of income anticipated to be
generated by the relevant exposures over the next twelve months that
can reasonably be assumed to be available to cover potential credit
losses on the exposures after covering expected business expenses, and
after subtracting a cushion to account for potential volatility in
credit losses (UL). FMI would not be permitted to include anticipated
income from new accounts and would have to incorporate assumptions
about income from existing accounts that are in line with the banking
organization's historical experience. The amount of the cushion to
account for potential volatility in credit losses would be set equal to
two standard deviations of the banking organization's annualized loss
rate on the exposures. The Agencies would expect banking organizations
to be able to support their estimates of eligible FMI on the basis of
historical data and would disallow the use of FMI in the QRE capital
formula if this is not the case. The step needed to recognize eligible
FMI is discussed below.
Permitting a FMI offset to the A-IRB capital requirement for QREs
could have a significant impact on the level of minimum regulatory
capital at institutions adopting the advanced approaches. The Agencies
would need to fully assess and analyze the impact of such an FMI offset
on institutions' risk-based capital ratios prior to final
implementation of the A-IRB approach. Furthermore, the Agencies
anticipate the need to issue additional guidance setting out more
specific expectations in this regard.
For the QRE sub-category of retail exposures only, the Agencies
are seeking comment on whether or not to allow banking organizations
to offset a portion of the A-IRB capital requirement relating to EL
by demonstrating that their anticipated FMI for this sub-category is
likely to more than sufficiently cover EL over the next year.
The Agencies are seeking comment on the proposed definitions of
the retail A-IRB exposure category and sub-categories. Do the
proposed categories provide a reasonable balance between the need
for differential treatment to achieve risk-sensitivity and the
desire to avoid excessive complexity in the retail A-IRB framework?
What are views on the proposed approach to inclusion of SMEs in the
other retail category?
The Agencies are also seeking views on the proposed approach to
defining the risk inputs for the retail A-IRB framework. Is the
proposed degree of flexibility in their calculation, including the
application of specific floors, appropriate? What are views on the
issues associated with undrawn retail lines of credit described here
and on the proposed incorporation of FMI in the QRE capital
determination process?
The Agencies are seeking comment on the minimum time
requirements for data history and experience with portfolio
segmentation and risk management systems: Are these time
requirements appropriate during the transition period? Describe any
reasons for not being able to meet the time requirements.
Retail Exposures: Formulas
The retail A-IRB capital formulas are very similar to the wholesale
A-IRB formulas, and are based on the same underlying concepts. However,
because there is no M adjustment associated with the retail A-IRB
framework, the retail A-IRB capital calculations generally involve
fewer steps than the wholesale A-IRB capital calculations. As with the
wholesale A-IRB framework, the output of the retail A-IRB formulas is a
minimum capital requirement, expressed in dollars, for the relevant
pool of exposures. The capital requirement would be converted into an
equivalent amount of risk-weighted assets by multiplying the capital
requirement by 12.5. The two key steps in implementing the retail A-IRB
capital formulas are (1) assessing the relevant asset correlation
parameter, and (2) calculating the minimum capital requirement for the
relevant pool of exposures.
Residential Mortgages and Related Exposures
For residential mortgage and related exposures, the retail A-IRB
capital formula requires only one step. This is because the asset
correlation parameter for such exposures is fixed at 15 percent,
regardless of the PD of any particular pool of exposures. The fixed
asset correlation parameter reflects the Agencies' view that the
arguments for linking the asset correlation to PD, as occurs in the
wholesale A-IRB framework and in the other two sub-categories of retail
exposures, are not as relevant for residential mortgage-related
exposures, whose performance is significantly influenced by broader
trends in the housing market for borrowers of all credit qualities. The
assumed asset correlation of 15 percent also seeks implicitly to
reflect the higher average maturity associated with
[[Page 45919]]
residential mortgage exposures and is therefore higher than would
likely be the case if a specific maturity adjustment were also included
in the retail A-IRB framework. The proposed retail A-IRB capital
formula for residential mortgage and related exposures is as follows:
K = EAD * LGD * N[1.08465 * G(PD) + 0.4201 * G(0.999)]
Where
K denotes the capital requirement;
EAD denotes exposure at default;
LGD denotes loss given default;
N(x) denotes the standard normal cumulative distribution function;
G(x) denotes the inverse of the standard normal cumulative distribution
function; and
PD denotes probability of default.
The following table depicts a range of representative capital
requirements (K) for residential mortgage and related exposures based
on this formula. Three different illustrative LGD assumptions are
shown: 15 percent, 35 percent, and 55 percent. For comparison purposes,
the current capital requirement on most first mortgage loans is 4
percent and on most home equity loans is 8 percent.
Capital Requirements
[In percentage points]
----------------------------------------------------------------------------------------------------------------
LGD
PD -----------------------------------------------
15 percent 35 percent 55 percent
----------------------------------------------------------------------------------------------------------------
0.05 percent.................................................... 0.17 0.41 0.64
0.10 percent.................................................... 0.30 0.70 1.10
0.25 percent.................................................... 0.61 1.41 2.22
0.50 percent.................................................... 1.01 2.36 3.70
1.00 percent.................................................... 1.65 3.86 6.06
2.00 percent.................................................... 2.64 6.17 9.70
5.00 percent.................................................... 4.70 10.97 17.24
10.00 percent................................................... 6.95 16.22 25.49
20.00 percent................................................... 9.75 22.75 35.75
----------------------------------------------------------------------------------------------------------------
Subject to the caveats noted earlier, evidence from QIS3 suggested
that advanced approach banking organizations would experience a
reduction in credit risk capital requirements for residential mortgage
exposures of about 56 percent.
Private Mortgage Insurance
The Agencies wish to highlight one issue associated with the A-IRB
capital requirements for the residential mortgage sub-category relating
to the treatment of private mortgage insurance (PMI). Most PMI
arrangements effectively provide partial compensation to the banking
organization in the event of a mortgage default. Accordingly, the
Agencies consider that it may be appropriate for banking organizations
to recognize such effects in the LGD estimates for individual mortgage
portfolio segments, consistent with the historical loss experience on
those segments during periods of high default rates. Such an approach
would avoid requiring banking organizations to quantify specifically
the effect of PMI on a loan-by-loan basis; rather, they could estimate
the effect of PMI on an average basis for each segment. This approach
effectively ignores the risk that the mortgage insurers themselves
could default.
The Agencies seek comment on the competitive implications of
allowing PMI recognition for banking organizations using the A-IRB
approach but not allowing such recognition for general banks. In
addition, the Agencies are interested in data on the relationship
between PMI and LGD to help assess whether it may be appropriate to
exclude residential mortgages covered by PMI from the proposed 10
percent LGD floor. The Agencies request comment on whether or the
extent to which it might be appropriate to recognize PMI in LGD
estimates.
More broadly, the Agencies are interested in information
regarding the risks of each major type of residential mortgage
exposure, including prime first mortgages, sub-prime mortgages, home
equity term loans, and home equity lines of credit. The Agencies are
aware of various views on the resulting capital requirements for
several of these product areas, and wish to ensure that all
appropriate evidence and views are considered in evaluating the A-
IRB treatment of these important exposures.
The risk-based capital requirements for credit risk of prime
mortgages could well be less than one percent of their face value
under this proposal. The Agencies are interested in evidence on the
capital required by private market participants to hold mortgages
outside of the federally insured institution and GSE environment.
The Agencies also are interested in views on whether the reductions
in mortgage capital requirements on mortgage loans contemplated here
would unduly extend the federal safety net and risk contributing to
a credit-induced bubble in housing prices. In addition, the Agencies
are also interested in views on whether there has been any shortage
of mortgage credit under the general risk-based capital rules that
would be alleviated by the proposed changes.
Qualifying Revolving Exposures
The second sub-category of retail exposures is QREs. The
calculation of A-IRB capital requirements for QREs would require three
steps: (1) Calculation of the relevant asset correlation parameter, (2)
calculation of the minimum capital requirement assuming no offset for
eligible FMI, and (3) application of the offset for eligible FMI. These
steps would be performed for each QRE portfolio segment individually.
As in the case of wholesale exposures, it is assumed that the asset
correlation for QREs declines as PD rises. This reflects the view that
pools of borrowers with lower credit quality (higher PD) are less
likely to experience simultaneous defaults than pools of higher credit
quality (lower PD) borrowers, because with higher PD borrowers defaults
are more likely to result from borrower-specific or idiosyncratic
factors. In the case of QREs, the asset correlation approaches an upper
bound value of 11 percent for very low PD values and approaches a lower
bound value of 2 percent for very high PD values. The specific formula
for determining the asset correlation parameter for QREs is as follows:
R = 0.02 * (1-EXP(-50 * PD)) + 0.11 * [1-(1-EXP(-50 * PD))]
Where
R denotes asset correlation;
EXP denotes the natural exponential function; and
PD denotes probability of default.
The second step in the A-IRB capital calculation for QREs would be
the calculation of the capital requirement assuming no FMI offset. The
specific formula to calculate this amount is as follows:
[[Page 45920]]
KNo FMI = EAD * LGD * N[(1-R)[caret]-0.5 * G(PD) + (R/(1-
R))[caret]0.5 * G(0.999)]
Where
KNo FMI denotes the capital requirement assuming no FMI
offset;
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
PD denotes probability of default.
Future Margin Income Adjustment
The result of this calculation effectively includes both an EL and
a UL component. As already discussed, for QREs only, the Agencies are
considering the possibility of allowing institutions to offset a
portion of the EL portion of the capital requirement using eligible
FMI. Up to 75 percent of the EL portion of the capital requirement
could potentially be offset in this fashion. The specific calculation
for determining the capital requirement (K) after application of the
potential offset for eligible FMI is as follows.
K = KNo FMI-eligible FMI offset
Where
K denotes the capital requirement after application of an offset for
eligible FMI;
KNo FMI denotes the capital requirement assuming no FMI
offset;
Eligible FMI offset equals:
0.75 * EL if estimated FMI equals or exceeds the expected 12-month
loss amount plus two standard deviations of the annualized loss rate,
or zero otherwise;
EL denotes expected loss (EL = EAD * PD * LGD);
FMI denotes future margin income;
EAD denotes exposure at default;
PD denotes probability of default; and
LGD denotes loss given default.
If eligible FMI did not exceed the required minimum, then
recognition of eligible FMI would be disallowed.
The Agencies are interested in views on whether partial
recognition of FMI should be permitted in cases where the amount of
eligible FMI fails to meet the required minimum. The Agencies also
are interested in views on the level of portfolio segmentation at
which it would be appropriate to perform the FMI calculation. Would
a requirement that FMI eligibility calculations be performed
separately for each portfolio segment effectively allow FMI to
offset EL capital requirements for QREs?
The following table depicts a range of representative capital
requirements (K) for QREs based on these formulas. In each case, it is
assumed that the maximum offset for eligible FMI has been applied. The
LGD is assumed to equal 90 percent, consistent with recovery rates for
credit card portfolios. The table shows capital requirements with
recognition of FMI and without recognition of FMI but using the same
formula in other respects. As PDs increase, the proportion of total
required capital held against EL after deducting the 75 percent offset
rises at an increasing rate and the proportion held against UL declines
at an increasing rate. Offsets from EL, as considered in this ANPR,
would therefore have a proportionally greater impact on reducing
required capital charges as default probabilities increase. For
comparison purposes, the current capital requirement on drawn credit
card exposures is 8 percent and is zero for undrawn credit lines.
Capital Requirement
[In percentage points]
------------------------------------------------------------------------
With FMI Without FMI
PD capital 8% capital 8%
------------------------------------------------------------------------
0.05.......................................... 0.68 0.72
0.10.......................................... 1.17 1.23
0.25.......................................... 2.24 2.41
0.50.......................................... 3.44 3.78
1.00.......................................... 4.87 5.55
2.00.......................................... 6.21 7.56
5.00.......................................... 7.89 11.27
10.0.......................................... 11.12 17.87
20.0.......................................... 17.23 30.73
------------------------------------------------------------------------
Subject to the same qualifications mentioned earlier, the QIS3
results estimated an increase in credit risk capital requirements for
QREs of about 16 percent.
Other Retail Exposures
The third and final sub-category of retail A-IRB exposures is other
retail exposures. This sub-category encompasses a wide variety of
different exposures including auto loans, student loans, consumer
installment loans, and some SME loans. Two steps would be required to
calculate the A-IRB capital requirement for other retail exposures: (1)
Calculating the relevant asset correlation parameter, and (2)
calculating the capital requirement. Both of these steps would be done
separately for each portfolio segment included within the other retail
sub-category.
As for wholesale exposures and QREs, the asset correlation
parameter for other retail exposures declines as PD rises. In the case
of other retail exposures, the asset correlation parameter approaches
an upper bound value of 17 percent for very low PD values and
approaches a lower bound value of 2 percent for very high PD values.
The specific formula for determining the asset correlation for other
retail exposures is as follows:
R = 0.02 * (1-EXP(-35 * PD)) + 0.17 * [1-(1-EXP(-35 * PD))]
Where
R denotes asset correlation;
EXP denotes the natural exponential function; and
PD denotes probability of default.
The second step in the A-IRB capital calculation for other retail
exposures would be the calculation of the capital requirement (K). The
specific formula to calculate this amount is as follows:
K = EAD * LGD * N[(1-R)[caret]-0.5 * G(PD) + (R / (1-R))[caret]0.5 *
G(0.999)]
Where
K denotes the capital requirement;
EAD denotes exposure at default;
LGD denotes loss given default;
PD denotes probability of default;
N(x) denotes the standard normal cumulative distribution function;
G(x) denotes the inverse of the standard normal cumulative distribution
function; and
R denotes asset correlation.
The following table depicts a range of representative capital
requirements (K) for other retail exposures based on this formula.
Three different LGD assumptions are shown--25 percent, 50 percent, and
75 percent--in order to depict a range of potential outcomes depending
on the characteristics of the underlying retail exposure. For
comparison purposes, the current capital requirement on most of the
exposures likely to be included in the other retail sub-category is 8
percent.
Capital Requirements
[In percentage points]
----------------------------------------------------------------------------------------------------------------
LGD
PD -----------------------------------------------
25 percent 50 percent 75 percent
----------------------------------------------------------------------------------------------------------------
0.05 percent.................................................... 0.33 0.66 0.99
[[Page 45921]]
0.10 percent.................................................... 0.56 1.11 1.67
0.25 percent.................................................... 1.06 2.13 3.19
0.50 percent.................................................... 1.64 3.28 4.92
1.00 percent.................................................... 2.35 4.70 7.05
2.00 percent.................................................... 3.08 6.15 9.23
5.00 percent.................................................... 3.94 7.87 11.81
10.00 percent................................................... 5.24 10.48 15.73
20.00 percent................................................... 8.55 17.10 25.64
----------------------------------------------------------------------------------------------------------------
Subject to the qualifications described earlier, QIS3 estimated a
25 percent reduction in credit risk-based capital requirements for the
other retail category.
The Agencies are seeking comment on the retail A-IRB capital
formulas and the resulting capital requirements, including the
specific issues mentioned. Are there particular retail product lines
or retail activities for which the resulting A-IRB capital
requirements would not be appropriate, either because of a
misalignment with underlying risks or because of other potential
consequences?
A-IRB: Other Considerations
As described earlier, the A-IRB capital requirement includes
components to cover both EL and UL. Because banking organizations have
resources other than capital to cover EL, the Agencies propose to
recognize certain of these measures as potential offsets to the A-IRB
capital requirement, subject to the limitations set forth below. The
use of eligible FMI for QREs is one such potential mechanism that has
already been discussed.
Loan Loss Reserves
A second important mechanism involves the allowance for loan and
lease losses (ALLL), also referred to as general loan loss reserves.
Under the general risk-based capital rules, an amount of the ALLL is
eligible for inclusion as an element of Tier 2 capital, up to a limit
equal to 1.25 percent of gross risk-weighted assets. Loan loss reserves
above this limit are deducted from risk-weighted assets, on a dollar-
for-dollar basis. The New Accord proposes to retain the 1.25 percent
limit on the eligibility of loan loss reserves as an element of Tier 2
capital. However, the New Accord also contains, and the Agencies are
proposing for comment, a feature that would allow the amount of the
ALLL (net of associated deferred tax) above this 1.25 percent limit to
be used to offset the EL portion of A-IRB capital requirements in
certain circumstances.
The offset would be limited to that amount of EL that exceeds the
1.25 percent limit. For example, if the 1.25 percent limit equals $100,
the ALLL equals $125, and the EL portion of the A-IRB capital
requirement equals $110, then $10 of the capital requirement may be
directly offset ($110-$100). The additional amount of the ALLL not
included in Tier 2 capital and not included as a direct offset against
the A-IRB capital requirement ($125-$110 = $15 in the example) would
continue to be deducted from risk-weighted assets.
It is important to recognize that this treatment would likely
result in a significantly more favorable treatment of such excess ALLL
amounts than simply deducting them from risk-weighted assets. Under the
proposal, banking organizations would be allowed to multiply the
eligible excess ALLL by a factor of 12.5 because the minimum total
capital requirement is 8 percent of risk-weighted assets. In effect,
this treatment is 12.5 times more favorable than the treatment
contained in the general risk-based capital rules, which allow only a
deduction against risk-weighted assets on a dollar-for-dollar basis. In
addition, it is important to note that a dollar-for-dollar offset
against the A-IRB capital requirement is also more favorable than the
inclusion of ALLL below the 1.25 percent limit in Tier 2 capital,
because the latter has no impact on Tier 1 capital ratios, while the
former does.
The Agencies recognize the existence of various issues in regard
to the proposed treatment of ALLL amounts in excess of the 1.25
percent limit and are interested in views on these subjects, as well
as related issues concerning the incorporation of expected losses in
the A-IRB framework and the treatment of the ALLL generally.
Specifically, the Agencies invite comment on the domestic
competitive impact of the potential difference in the treatment of
reserves described above.
Another issue the Agencies wish to highlight is the inclusion
within the New Accord of the ability for banking organizations to make
use of ``general specific'' provisions as a direct offset against EL
capital requirements. Such provisions are not specific to particular
exposures but are specific to particular categories of exposures and
are not allowed as an element of Tier 2 capital. While several other
countries make use of such provisions, the Agencies do not believe
existing elements of the ALLL in the United States qualify for such
treatment.
The Agencies seek views on this issue, including whether the
proposed U.S. treatment has significant competitive implications.
Feedback also is sought on whether there is an inconsistency in the
treatment of general specific provisions (all of which may be used
as an offset against the EL portion of the A-IRB capital
requirement) in comparison to the treatment of the ALLL (for which
only those amounts of general reserves exceeding the 1.25 percent
limit may be used to offset the EL capital charge).
Charge-Offs
Another potential offset to the EL portion of the A-IRB capital
requirements is the use of partial charge-offs, where a portion of an
individual exposure is written off. Given the A-IRB definition of
default, a partial charge-off would cause an exposure to be classified
as a defaulted exposure (that is, PD=100%), in which case the A-IRB
capital formulas ensure that the resulting capital requirement on the
defaulted exposure is equal to EAD * LGD, where EAD is defined as the
gross exposure amount prior to the partial charge-off. All of this
capital requirement can be considered to be covering EL.
The New Accord proposes that for such partially charged-off
exposures, the banking organization be allowed to use the amount of the
partial charge-off to offset the EL component of that asset's capital
charge on a dollar-for-dollar basis. In addition, to the extent that
the
[[Page 45922]]
partial charge-off on a defaulted exposure exceeds the EL capital
charge on that exposure, the amount of this surplus could be used to
offset the EL capital charges on other defaulted assets in the same
portfolio (for example, corporates, banks, residential mortgages,
etc.), but not for any other purpose.
An implication of this aspect of the New Accord is that if a
defaulted loan's charge-off were at least equal to its expected loss,
no additional capital requirement would be incurred on that exposure.
For example, consider a $100 defaulted exposure having an LGD of 40
percent, implying an expected loss of $40, equal to the IRB capital
charge. If the charge-off were equal to $40, under the New Accord
approach, there would be no additional capital required against the
resultant $60 net position. The Agencies do not believe this is a
prudent or acceptable outcome, since this position is not riskless and
a banking organization could be forced to recognize additional charge-
offs if the recoveries turn out to be less than expected.
To prevent this possibility, the Agencies propose that, for
defaulted exposures, the A-IRB capital charge (inclusive of any EL
offsets for charge-offs) be calculated as the sum of (a) EAD * LGD less
any charge-offs and (b) 8 percent of the carrying value of the loan
(that is, the gross exposure amount (EAD) less any charge-offs).
Also, the charged off amounts in excess of the EAD * LGD product
would not be permitted to offset the EL capital requirements for other
exposures. In effect, the proposed A-IRB capital charge on a defaulted
exposure adds a buffer for defaulted assets and results in a floor
equal to 8 percent of the remaining book value of the exposure if the
banking organization has taken a charge-off equal to or greater than
the EAD * LGD. Importantly, this treatment would not apply to a
defaulted exposure that has been restructured and where the obligor has
not yet defaulted on the restructured credit. Upon any restructuring,
whether associated with a default or otherwise, the A-IRB capital
charge would be based on the EAD, PD, LGD, and M applicable to the
exposure after it has been restructured. The existence of any partial
charge-offs associated with the pre-restructured credit would affect
the A-IRB capital charge on the restructured exposure only through its
impact on the post-restructured exposure's EAD, PD, and/or LGD.
Purchased Receivables
This section describes the A-IRB treatment for wholesale and retail
credit exposures acquired from another institution (purchased
receivables). The purchase of such receivables may expose the acquiring
banking organization to potential losses from two sources: credit
losses attributable to defaults by the underlying receivables obligors,
and losses attributable to dilution of the underlying receivables.\22\
The total A-IRB capital requirement for purchased receivables would be
the sum of (a) a capital charge for credit risk, and (b) a separate
capital charge for dilution risk, when dilution is a material factor.
---------------------------------------------------------------------------
\22\ Dilution refers to the possibility that the contractual
amounts payable by the receivables obligors may be reduced through
future cash or non-cash credits to the accounts of these obligors.
Examples include offsets or allowances arising from returns of goods
sold, disputes regarding product quality, possible debts of the
originator/seller to a receivables obligor, and any payment or
promotional discounts offered by the originator/seller (for example,
a credit for cash payments within 30 days).
---------------------------------------------------------------------------
Capital Charge for Credit Risk
The New Accord's proposed treatment of purchased loans would treat
a purchase discount as equivalent to a partial charge-off, and for this
reason it could imply a zero capital charge against certain exposures.
In general, a zero capital charge would emerge whenever the difference
between a loan's face value and purchase price (the purchase discount)
was greater than or equal to its LGD, as might be the case with a
secondary market purchase of deeply distressed debt. Again, the
Agencies believe that a zero capital charge in such a circumstance is
unwarranted because the position is not riskless.
The Agencies propose that for a credit exposure that is purchased
or acquired from another party, the A-IRB capital charge would be
calculated as if the exposure were a direct loan to the underlying
obligor in the amount of the loan's carrying value to the purchasing
banking organization with other attributes of the loan agreement (for
example, maturity, collateral, covenants) and, hence, LGD, remaining
unchanged. This treatment would apply regardless of whether the
carrying value to the purchasing banking organization was less than,
equal to, or greater than the underlying instrument's face value. Thus,
if a loan having a principal amount equal to $100 and associated PD and
LGD of 10 percent and 40 percent was purchased for $80, the capital
charge against the purchased loan would be calculated as if that loan
had an EAD equal to $80, PD equal to 10 percent, and LGD equal to 40
percent.
In general, the same treatment would apply to pools of purchased
receivables. However, under the conditions detailed below, an
alternative top-down approach (similar to that used for retail
exposures) may be applied to pools of purchased receivables if the
purchasing banking organization can only estimate inputs to the capital
function (PD, LGD, EAD, and M) on a pool or aggregate basis.
Top-Down Method for Pools of Purchased Receivables
Under the top-down approach, required capital would be determined
using the appropriate A-IRB capital formula (that is, for wholesale
exposures, the wholesale capital function, and for retail exposures,
the appropriate retail capital function) in combination with estimates
of PD, LGD, EAD, and M developed for pools of receivables. In
estimating the pool parameters, the banking organization first would
determine EL for the purchased receivables pool, expressed (in decimal
form) at an annual rate relative to the amount currently owed to the
banking organization by the obligors in the receivables pool. The
estimated EL would not take into account any assumptions of recourse or
guarantees from the seller of the receivables or other parties. If the
banking organization can decompose EL into PD and LGD components, then
it would do so and use those components as inputs into the capital
function. If the institution cannot decompose EL, then it would use the
following split: PD would equal the estimated EL, and LGD would be 100
percent. Under the top-down approach, EAD would equal the carrying
amount of the receivables and for wholesale exposures, M would equal
the exposure-weighted average effective maturity of the receivables in
the pool.\23\
---------------------------------------------------------------------------
\23\ If a banking organization can estimate the exposure-
weighted average size of the pool it also would use the firm-size
adjustment (S) in the wholesale framework.
---------------------------------------------------------------------------
Treatment of Undrawn Receivables Purchase Commitments
Capital charges against any undrawn portions of receivables
purchase facilities (`undrawn purchase commitments') also would be
calculated using the top-down methodology. The EL (and/or PD and LGD)
parameters would be determined on the basis of the current pool of
eligible receivables using the pool-level estimation methods described
above. For undrawn commitments under revolving purchase facilities, the
New Accord specifies that the EAD would be set at 75 percent of the
undrawn line. This treatment reflects a concern that relevant
[[Page 45923]]
historical data for estimating such EADs reliably is not available at
many banking organizations. For other undrawn purchase commitments, EAD
would be estimated by the banking organization providing the facility
and would be subject to the same operational standards that are
applicable to undrawn wholesale credit lines. The level of M associated
with undrawn purchase commitments would be the average effective
maturity of receivables eligible for purchase from that seller, so long
as the facility contains effective arrangements for protecting the
banking organization against an unanticipated deterioration. In the
absence of such protections, the M for an undrawn commitment would be
calculated as the sum of (a) the longest-dated potential receivable
under the purchase agreement, and (b) the remaining maturity of the
facility.
The Agencies seek comment on the proposed methods for
calculating credit risk capital charges for purchased receivables.
Are the proposals reasonable and practicable?
For committed revolving purchase facilities, is the assumption
of a fixed 75 percent conversion factor for undrawn lines
reasonable? Do banking organizations have the ability (including
relevant data) to develop their own estimate of EADs for such
facilities? Should banking organizations be permitted to employ
their own estimated EADs, subject to supervisory approval?
A banking organization may only use the top-down approach with
approval of its primary Federal supervisor. In addition, the purchased
receivables would have to have been purchased from unrelated, third
party sellers and the organization may not have originated the credit
exposures either directly or indirectly. The receivables must have been
generated on an arm's length basis between the seller and the obligor
(intercompany accounts receivable and receivables subject to contra-
accounts between firms that buy and sell to each other would not
qualify). Also, the receivables may not have a remaining maturity of
greater than one year, unless they are fully secured. The Agencies
propose that the bottom-up method would have to be used for receivables
to any single obligor, or to any group of related obligors, that
aggregate to more than $1 million.
Capital Charge for Dilution Risk
When dilution is a material risk factor,\24\ purchased receivables
would be subject to a separate capital charge for that risk. The
dilution capital charge may be calculated at the level of each
individual receivable and then aggregated, or, for a pool of
receivables, at the level of the pool as a whole. The capital charge
for dilution risk would be calculated using the wholesale A-IRB formula
and the following parameters: EAD would be equal to the gross amount of
receivable(s) balance(s); LGD would be 100 percent; M would be the
(exposure weighted-average) effective remaining maturity of the
exposure(s); and PD would be the expected dilution loss rate, defined
as total expected dilution losses over the remaining term of the
receivable(s) divided by EAD.\25\ Expected dilution losses would be
computed on a stand-alone basis; that is, under the assumption of no
recourse or other support from the seller or third-party guarantors.
---------------------------------------------------------------------------
\24\ If dilution risk is immaterial there would be no additional
capital charge.
\25\ If the remaining term exceeds one year, the expected
dilution loss rate would be specified at an annual rate.
---------------------------------------------------------------------------
The following table illustrates the dilution risk capital charges
(per dollar of EAD) implied by this approach for a hypothetical pool of
purchased receivables having a remaining maturity of one year or less.
As can be seen, the proposal implies capital charges for dilution risk
that are many multiples of expected dilution losses.
Capital Requirements
[In percentage points]
------------------------------------------------------------------------
Dilution risk
capital charge
Expected dilution loss rate (per dollar of
EAD, percent)
------------------------------------------------------------------------
0.05 percent............................................ 2.05
0.10 percent............................................ 3.42
0.25 percent............................................ 6.41
0.50 percent............................................ 9.77
1.00 percent............................................ 14.03
2.00 percent............................................ 19.03
5.00 percent............................................ 28.45
10.00 percent........................................... 41.24
------------------------------------------------------------------------
The Agencies seek comment on the proposed methods for
calculating dilution risk capital requirements. Does this
methodology produce capital charges for dilution risk that seem
reasonable in light of available historical evidence? Is the
wholesale A-IRB capital formula appropriate for computing capital
charges for dilution risk?
In particular, is it reasonable to attribute the same asset
correlations to dilution risk as are used in quantifying the credit
risks of wholesale exposures within the A-IRB framework? Are there
alternative method(s) for determining capital charges for dilution
risk that would be superior to that set forth above?
Minimum Requirements
The Agencies propose to apply standards for the estimation of risk
inputs and expected dilution losses and for the control and risk
management systems associated with purchased receivables programs that
are consistent with the general guidance contained in the New Accord.
These standards will aim to ensure that risk input and expected
dilution loss estimates are reliable and consistent over time, and
reflect all relevant information that is available to the acquiring
banking organization. The minimum operational requirements are intended
to ensure that the acquiring banking organization has a valid legal
claim to cash proceeds generated by the receivables pool, that the pool
and cash proceeds are closely monitored and controlled, and that
systems are in place to identify and address seller, servicer, and
other potential risks. A more detailed discussion of these requirements
will be provided when the Agencies release draft examination guidance
dealing with purchased receivables programs.
The Agencies seek comment on the appropriate eligibility
requirements for using the top-down method. Are the proposed
eligibility requirements, including the $1 million limit for any
single obligor, reasonable and sufficient?
The Agencies seek comment on the appropriate requirements for
estimating expected dilution losses. Is the guidance set forth in
the New Accord reasonable and sufficient?
Risk Mitigation
For purposes of reducing the capital charges for credit risk or
dilution risk with respect to purchased receivables, purchase
discounts, guarantees, and other risk mitigants may be recognized
through the same framework used elsewhere in the A-IRB approach.
Credit Risk Mitigation Techniques
The New Accord takes account of the risk-mitigating effects of both
financial and nonfinancial collateral, as well as guarantees, including
credit derivatives. For these risk mitigants to be recognized for
regulatory capital purposes, the banking organization must have in
place operational procedures and risk management processes that ensure
that all documentation used in collateralizing or guaranteeing a
transaction is binding on all parties and legally enforceable in all
relevant jurisdictions. The banking organization must have conducted
sufficient legal review to verify this conclusion, must have a well-
founded legal basis for the conclusion, and must reconduct such a
review as necessary to ensure continuing enforceability.
[[Page 45924]]
Adjusting LGD for the Effects of Collateral
A banking organization would be able to take into account the risk-
mitigating effect of collateral in its internal estimates of LGD,
provided the organization has established internal requirements for
collateral management, operational procedures, legal certainty, and
risk management processes that ensure that:
(1) The legal mechanism under which the collateral is pledged or
transferred ensures that the banking organization has the right to
liquidate or take legal possession of the collateral in a timely manner
in the event of the default, insolvency, or bankruptcy (or other
defined credit event) of the obligor and, where applicable, the
custodian holding the collateral;
(2) The banking organization has taken all steps necessary to
fulfill legal requirements to secure the organization's interest in the
collateral so that it has and maintains an enforceable security
interest;
(3) The banking organization has clear and robust procedures for
the timely liquidation of collateral to ensure observation of any legal
conditions required for declaring the default of the borrower and
prompt liquidation of the collateral in the event of default;
(4) The banking organization has established procedures and
practices for (i) conservatively estimating, on a regular ongoing
basis, the market value of the collateral, taking into account factors
that could affect that value (for example, the liquidity of the market
for the collateral and obsolescence or deterioration of the
collateral), and (ii) where applicable, periodically verifying the
collateral (for example, through physical inspection of collateral such
as inventory and equipment); and
(5) The banking organization has in place systems for requesting
and receiving promptly additional collateral for transactions whose
terms require maintenance of collateral values at specified thresholds.
In reflecting collateral in the LGD estimate, the banking
organization would need to consider the extent of any dependence
between the risk of the borrower and that of the collateral or
collateral provider. The banking organization's assessment of LGD would
have to address in a conservative way any significant degrees of
dependence, as well as any currency mismatch between the underlying
obligation and the collateral. The LGD estimates would have to be
grounded in historical recovery rates on the collateral and could not
be based solely upon the collateral's estimated market value.
Repo-Style Transactions Subject to Master Netting Agreements
Repo-style transactions include reverse repurchase agreements and
repurchase agreements and securities lending and borrowing
transactions, including those executed on an indemnified agency
basis.\26\ Many of these transactions are conducted under a bilateral
master netting agreement or equivalent arrangement. The effects of
netting arrangements generally would be recognized where the banking
organization takes into account the risk-mitigating effect of
collateral through an adjustment to EAD. To qualify for the EAD
adjustment treatment, the repo-style transaction would have to be
marked-to-market daily and be subject to a daily margin maintenance
requirement. Further, the repo-style transaction would have to be
documented under a qualifying master netting agreement that would have
to:
---------------------------------------------------------------------------
\26\ Some banking organizations, particularly those that are
custodians, lend, as agent, their customers' securities on a
collateralized basis. Typically, the agent banking organization
indemnifies the customer againts risk of loss in the event the
borrowing counterparty defaults. Where such indemnites are provided,
the agent banking organization has the same risks it would have if
it had entered into the transaction as principal.
---------------------------------------------------------------------------
(1) Provide the non-defaulting party the right to terminate and
close out promptly all transactions under the agreement upon an event
of default, including in the event of insolvency or bankruptcy of the
counterparty;
(2) Provide for the netting of gains and losses on transactions
(including the value of any collateral) terminated and closed out under
the agreement so that a single net amount is owed by one party to the
other;
(3) Allow for the prompt liquidation or setoff of collateral upon
the occurrence of an event of default; and
(4) Be, together with the rights arising from the provisions
required in (1) to (3) above, legally enforceable in each relevant
jurisdiction upon the occurrence of an event of default and regardless
of the counterparty's insolvency or bankruptcy.
Where a banking organization's repo-style transactions do not meet
these requirements, it would not be able to use the EAD adjustment
method. Rather, for each individual repo-style transaction it would
estimate an LGD that takes into account the collateral received. It
would use the notional amount of the transaction for EAD; it would not
take into account netting effects for purposes of determining either
EAD or LGD.
The method for determining EAD for repo-style transactions,
described below, is essentially the determination of an unsecured loan
equivalent exposure amount to the counterparty. Thus, no collateral
effects for these transactions would be recognized through LGD; rather,
the applicable LGD would be the one the banking organization would
estimate for an unsecured exposure to the counterparty.
To determine EAD, the banking organization would add together its
current exposure to the counterparty under the master netting
arrangement and a measure for PFE to the counterparty under the master
netting arrangement. The current exposure would be the sum of the
market values of all securities and cash lent, sold subject to
repurchase, or pledged as collateral to the counterparty under the
master netting agreement, less the sum of the market values of all
securities and cash lent, sold subject to repurchase, or pledged as
collateral by the counterparty. The PFE calculation would be based on
the market price volatilities of the securities delivered to, and the
securities received from, the counterparty, as well as any foreign
exchange rate volatilities associated with any cash or securities
delivered or received.
Banking organizations would use a VaR-type measure for determining
PFE for repo-style transactions subject to master netting agreements.
Banking organizations would be required to use a 99th percentile, one-
tailed confidence interval for a five-day holding period using a
minimum one-year historical observation period of price data. Banking
organizations would have to update their data sets no less frequently
than once every three months and reassess them whenever market prices
are subject to material changes. The illiquidity of lower-quality
instruments would have to be taken into account through an upward
adjustment in the holding period where the five-day holding period
would be inappropriate given the instrument's liquidity. No particular
model would be prescribed for the VaR-based measure, but the model
would have to capture all material risks for included transactions.
Banking organizations using a VaR-based approach to measuring PFE
would be permitted to take into account correlations in the price
volatilities among instruments delivered to the counterparty, among
instruments received from the counterparty, as well as between the two
sets of instruments. The VaR-based approach for calculating PFE for
repo-style transactions would be available to all banking organizations
[[Page 45925]]
that received supervisory approval for an internal market risk model
under the market risk capital rules. Other banking organizations could
apply separately for supervisory approval to use their internal VaR
models for calculation of PFE for repo-style transactions.
A banking organization would use the following formula to determine
EAD for each counterparty with which it has a master netting agreement
for repo-style transactions.
EAD = max {0, [([b.Sgr] E - [b.Sgr]C) + (VaR output from internal
market risk model x multiplier)]{time}
Where:
E denotes the current value of the exposure (that is, all securities
and cash delivered to the counterparty); and
C denotes the current value of the collateral received (that is, all
securities and cash received from the counterparty).
The multiplier in the above formula would be determined based on
the results of the banking organization's backtesting of the VaR
output. To backtest the output, the banking organization would be
required to identify on an annual basis twenty counterparties that
include the ten largest as determined by the banking organization's own
exposure measurement approach and ten others selected at random. For
each day and for each of the twenty counterparties, the banking
organization would compare the previous day's VaR estimate for the
counterparty portfolio to the change in the current exposure of the
previous day's portfolio. This change represents the difference between
the net value of the previous day's portfolio using today's market
prices and the net value of that portfolio using the previous day's
market prices. Where this difference exceeds the previous day's VaR
estimate, an exception would have occurred.
At the end of each quarter, the banking organization would identify
the number of exceptions it has observed for its twenty counterparties
over the most recent 250 business days, that is, the number of
exceptions in the most recent 5000 observations. Depending on the
number of exceptions, the output of the VaR model would be scaled up
using a multiplier as provided in the table below.
------------------------------------------------------------------------
Number of
Zone exceptions Multiplier
------------------------------------------------------------------------
Green Zone...................... 0-99.............. None (=1)
Yellow Zone..................... 100-119........... 2.0
120-139........... 2.2
140-159........... 2.4
160-179........... 2.6
180-199........... 2.8
Red Zone........................ 200 or more....... 3.0
------------------------------------------------------------------------
The Agencies seek comments on the methods set forth above for
determining EAD, as well as on the proposed backtesting regime and
possible alternatives banking organizations might find more
consistent with their internal risk management processes for these
transactions. The Agencies also request comment on whether banking
organizations should be permitted to use the standard supervisory
haircuts or own estimates haircuts methodologies that are proposed
in the New Accord.
Guarantees and Credit Derivatives
The Agencies are proposing that banking organizations reflect the
credit risk mitigating effects of guarantees and credit derivatives
through adjusting the PD or the LGD estimate (but not both) of the
underlying obligation that is protected. The banking organization would
be required to assign the borrower and guarantor to an internal rating
in accordance with the minimum requirements set out for unguaranteed
(unhedged) exposures, both prior to the adjustments and on an ongoing
basis. The organization also would be required to monitor regularly the
guarantor's condition and ability and willingness to honor its
obligation. For guarantees on retail exposures, these requirements
would also apply to the assignment of an exposure to a pool and the
estimation of the PD of the pool.
For purposes of reflecting the effect of guarantees in regulatory
capital requirements, the Agencies are proposing that a banking
organization have clearly specified criteria for adjusting internal
ratings or LGD estimates--or, in the case of retail exposures, for
allocating exposures to pools to reflect use of guarantees and credit
derivatives--that take account of all relevant information. The
adjustment criteria would have to require a banking organization to (i)
meet all minimum requirements for an unhedged exposure when assigning
borrower or facility ratings to guaranteed/hedged exposures; (ii) be
plausible and intuitive; (iii) consider the guarantor's ability and
willingness to perform under the guarantee; (iv) consider the extent to
which the guarantor's ability and willingness to perform and the
borrower's ability to repay may be correlated (that is, the degree of
wrong-way risk); and (v) consider the payout structure of the credit
protection and conservatively assess its effect on the level and timing
of recoveries. The banking organization also would be required to
consider any residual risk to the borrower that may remain--for
example, a currency mismatch between the credit protection and the
underlying exposure.
Banking organizations would be required to make adjustments to
alter PD or LGD estimates in a consistent way for a given type of
guarantee or credit derivative. In all cases, the adjusted risk weight
for the hedged obligation could not be less than the risk weight
associated with a comparable direct exposure on the protection
provider. As a practical matter, this guarantor risk weight floor on
the risk weight of the hedged obligation would require a banking
organization first to determine the risk weight on the hedged
obligation using the adjustment it has made to the PD or LGD estimate
to reflect the hedge. The banking organization would then compare that
risk weight to the risk weight assigned to a direct obligation of the
guarantor. The higher of the two risk weights would then be used to
determine the risk-weighted asset amount of the hedged obligation.
Notwithstanding the guarantor risk weight floor, the proposed
approach gives institutions a great deal of flexibility in their
methodology for recognizing the risk-reducing effects of guarantees and
credit derivatives. At the same time, the approach does not
differentiate between various types of guarantee structures, which may
have widely varying characteristics, that a banking organization may
use. For example, a company to company guarantee, such as a company's
guarantee of an affiliate or a supplier, is fundamentally different
from a guarantee obtained from an unrelated third party that is in the
business of extending financial guarantees. Examples of the latter type
of guarantee include standby letters of credit, financial guarantee
insurance, and credit derivatives. These products tend to be
standardized across institutions and, thus, arguably should be
recognized for capital purposes in a consistent fashion across
institutions. The problem of inconsistent treatment could be
exacerbated in the case of protection in the form of credit
derivatives, which are tradable and which further can be distinguished
by their characteristic of allowing a banking organization to have a
recovery claim on two parties, the obligor and the derivative
counterparty, rather than just one.
Industry comment is sought on whether a more uniform method of
adjusting PD or LGD estimates should be adopted for various types of
guarantees to minimize inconsistencies in
[[Page 45926]]
treatment across institutions and, if so, views on what methods
would best reflect industry practices. In this regard, the Agencies
would be particularly interested in information on how banking
organizations are currently treating various forms of guarantees
within their economic capital allocation systems and the methods
used to adjust PD, LGD, EAD, and any combination thereof.
Double Default Effects
The Agencies are proposing that neither the banking organization's
criteria nor rating process for guaranteed/hedged exposures be allowed
to take into account so-called ``double default'' effects--that is, the
joint probability of default of the borrower and guarantor. As a result
of not being able to recognize double default probabilities, the
adjusted risk weight for the hedged obligation could not be less than
the risk weight associated with a direct exposure on the protection
provider. The Agencies are seeking comment on the proposed
nonrecognition of double default effects. On June 10, 2003, the Federal
Reserve released a white paper on this issue entitled, ``Treatment of
Double Default and Double Recovery Effects for Hedged Exposures Under
Pillar I of the Proposed New Basel Capital Accord.'' Commenters are
encouraged to take into account the white paper in formulating their
responses to the ANPR.
The Agencies also are interested in obtaining commenters' views on
alternative methods for giving recognition to double default effects in
a manner that is operationally feasible and consistent with safety and
soundness. With regard to the latter, commenters are requested to bear
in mind the concerns outlined in the double default white paper,
particularly in connection with concentrations, wrong-way risk
(especially in stress periods), and the potential for regulatory
capital arbitrage. In this regard, information is solicited on how
banking organizations consider double default effects on credit
protection arrangements in their economic capital calculations and for
which types of credit protection arrangements they consider these
effects.
Requirements for Recognized Guarantees and Credit Derivatives
The Agencies are not proposing any restrictions on the types of
eligible guarantors or credit derivative providers. Rather, a banking
organization would be required to have clearly specified criteria for
those guarantors they will accept as eligible for regulatory capital
purposes. It is proposed that guarantees and credit derivatives
recognized for regulatory capital purposes: (1) Be required to
represent a direct claim on the protection provider; (2) explicitly
reference specific exposures or classes thereof; (3) be evidenced in
writing through a contract that is irrevocable by the guarantor; (4)
not have a clause that would (i) allow the protection provider
unilaterally to cancel the credit protection (other than in the event
of nonpayment or other default by the protection buying banking
organization) or (ii) increase the effective cost of credit protection
as the credit quality of the underlying obligor deteriorates; (5) be in
force until the underlying obligation is satisfied in full (to the
amount and tenor of the guarantee); and (6) be legally enforceable
against the guarantor in a jurisdiction where the guarantor has assets
to attach and enforce a judgment.
The Agencies view the risk mitigating benefits of conditional
guarantees--that is, guarantees that prescribe certain conditions under
which the guarantor would not be obliged to perform--as particularly
difficult to quantify. The Agencies are proposing that as a general
matter such guarantees would not be recognized under the A-IRB
approach. In certain circumstances, however, conditional guarantees
could be recognized where the banking organization can demonstrate that
its assignment criteria fully reflect the reduction in credit risk
mitigation arising from the conditionality and that the guarantee
provides a meaningful degree of credit protection.
Additional Requirements for Recognized Credit Derivatives
The Agencies are proposing that credit derivatives, whether in the
form of credit default swaps or total return swaps, recognized for A-
IRB risk-based capital purposes meet additional criteria. The credit
events specified by the contracting parties would be required to
include at a minimum: (i) Failure to pay amounts due under the terms of
the underlying obligation; (ii) bankruptcy, insolvency, or inability of
the obligor to pay its debt; and (iii) restructuring of the underlying
obligation that involves forgiveness or postponement of principal,
interest, or fees that results in a credit loss.
With regard to restructuring events, the Agencies note that the New
Accord suggests that a banking organization may not need to include
restructuring credit events when it has complete control over the
decision of whether or not there will be a restructuring of the
underlying obligation. This would occur, for example, where the hedged
obligation requires unanimous consent of the creditors for a
restructuring. The Agencies have concerns that this approach could have
the incidental effect of dictating terms in underlying obligations in
ways that over time could diverge from creditors' business needs. The
Agencies also question whether such clauses actually eliminate
restructuring risk on the underlying obligation, particularly as many
credit derivatives hedge only a small portion of a banking
organization's exposure to the underlying obligation.
The Agencies invite comment on this issue, as well as
consideration of an alternative approach whereby the notional amount
of a credit derivative that does not include restructuring as a
credit event would be discounted. Comment is sought on the
appropriate level of discount and whether the level of discount
should vary on the basis of, for example, whether the underlying
obligor has publicly outstanding rated debt or whether the
underlying obligor is an entity whose obligations have a relatively
high likelihood of restructuring relative to default (for example, a
sovereign or PSE). Another alternative that commenters may wish to
discuss is elimination of the restructuring requirement for credit
derivatives with a maturity that is considerably longer--for
example, two years--than that of the hedged obligation.
Consistent with the New Accord, the Agencies are proposing not to
recognize credit protection from total return swaps where the hedging
banking organization records net payments received on the swap as net
income, but does not record offsetting deterioration in the value of
the hedged obligation either through reduction in fair value or by an
addition to reserves. The Agencies are considering imposing similar
non-recognition on credit default swaps where mark-to-market gains in
value are recognized in income and, thus, in Tier 1 capital, but no
offsetting deterioration in the hedged obligation is recorded. (This
situation generally would not arise where both the hedged obligation
and the credit default swap are recorded in the banking book because
under GAAP increases in the swap's value are recorded in the Other
Comprehensive Income account, which is not included in regulatory
capital.)
Comment is sought on this matter, as well as on the possible
alternative treatment of recognizing the hedge in these two cases
for regulatory capital purposes but requiring that mark-to-market
gains on the credit derivative that have been taken into income be
deducted from Tier 1 capital.
Mismatches in Credit Derivatives Between Reference and Underlying
Obligations
The Agencies are proposing to recognize credit derivative hedges
for
[[Page 45927]]
A-IRB capital purposes only where the reference obligation on which the
protection is based is the same as the underlying obligation except
where: (1) the reference obligation ranks pari passu with or is more
junior than the underlying obligation, and (2) the underlying
obligation and reference obligation share the same obligor and legally
enforceable cross-default or cross-acceleration clauses are in place.
Treatment of Maturity Mismatch
The Agencies are proposing to recognize on a discounted basis
guarantees and credit derivatives that have a shorter maturity than the
hedged obligation. A guarantee or credit derivative with less than one-
year remaining maturity that does not have a matching maturity to the
underlying obligation, however, would not be recognized. The formula
for discounting the amount of a maturity-mismatched hedge that is
recognized is proposed as follows:
Pa = P * t/T
Where:
Pa denotes the value of the credit protection adjusted for maturity
mismatch;
P denotes the amount of the credit protection;
t denotes the lesser of T and the remaining maturity of the hedge
arrangement, expressed in years; and
T denotes the lesser of five and the remaining maturity of the
underlying obligation, expressed in years.
The Agencies have concerns that the proposed formulation does
not appropriately reflect distinctions between bullet and amortizing
underlying obligations. Comment is sought on the best way of making
such a distinction, as well as more generally on alternative methods
for dealing with the reduced credit risk coverage that results from
a maturity mismatch.
Treatment of Counterparty Risk for Credit Derivative Contracts
The Agencies are proposing that the EAD for derivative contracts
included in either the banking book or trading book be determined in
accordance with the rules for calculating the credit equivalent amount
for such contracts set forth under the general risk-based capital
rules. The Agencies are proposing to include in the types of derivative
contracts covered under these rules credit derivative contracts
recorded in the trading book. Accordingly, where a banking organization
buys or sells a credit derivative through its trading book, a
counterparty credit risk capital charge would be imposed based on the
replacement cost plus the following add-on factors for PFE:
------------------------------------------------------------------------
Protection Protection
Total return or credit default swap buyer seller
(percent) (percent)
------------------------------------------------------------------------
Qualifying Reference Obligation*.............. 5 **5
Non-Qualifying Reference Obligation*.......... 10 **10
------------------------------------------------------------------------
*The definition of qualifying would be the same as for the
``qualifying'' category for the treatment of specific risk for covered
debt positions under the market risk capital rules.
**The protection seller of a credit default swap would only be subject
to the add-on factor where the contract is subject to close-out upon
the insolvency of the protection buyer while the underlying obligor is
still solvent.
The Agencies also are considering applying a counterparty credit
risk charge on all credit derivatives that are marked-to-market,
including those recorded in the banking book. Such a treatment would
promote consistency with other OTC derivatives, which are assessed the
same counterparty credit risk charge regardless of where they are
booked.
Further, the Agencies note that, if credit derivatives booked in
the banking book are not assessed a counterparty credit risk charge,
banking organizations would be required to exclude these derivatives
from the net current exposure of their other derivative exposures to a
counterparty for purposes of determining regulatory capital
requirements. On balance, the Agencies believe a better approach would
be to align the net derivative exposure used for capital purposes with
that used for internal risk management purposes to manage counterparty
risk exposure and collateralization thereof. This approach would
suggest imposing a counterparty risk charge on all credit derivative
exposures that are marked to market, regardless of where they are
booked.
The Agencies are seeking industry views on the PFE add-ons
proposed above and their applicability. Comment is also sought on
whether different add-ons should apply for different remaining
maturity buckets for credit derivatives and, if so, views on the
appropriate percentage amounts for the add-ons in each bucket.
Equity Exposures
Banking organizations using the A-IRB approach for any credit
exposure would be required to use an internal models market-based
approach to calculate regulatory capital charges for equity exposures.
Minimum quantitative and qualitative requirements for using an internal
model would have to be met on an ongoing basis. An advanced approach
banking organization that is transitioning into an internal models
approach to equity exposures or that fails to demonstrate compliance
with the minimum operational requirements for using an internal models
approach to equity exposures would be required to develop a plan for
compliance, obtain approval of the plan from its primary Federal
supervisor, and implement the plan in a timely fashion. In addition, a
banking organization's primary Federal supervisor would have the
authority to impose additional operational requirements on a case-by-
case basis. Until it is fully compliant with all applicable
requirements, the banking organization would apply a minimum 300
percent risk weight to all publicly traded equity investments (that is,
equity investments that are traded on a nationally recognized
securities exchange) and a minimum 400 percent risk weight to all other
equity investments.
Positions Covered
All equity exposures held in the banking book, along with any
equity exposures in the trading book that are not currently subject to
a market risk capital charge, would be subject to the A-IRB approach
for equity exposures. In general, equity exposures are distinguished
from other types of exposures based on the economic substance of the
exposure. Equity exposures would include both direct and indirect
ownership interests, whether voting or non-voting, in the assets or
income of a commercial enterprise or financial institution that are not
consolidated or deducted for regulatory capital purposes. Holdings in
funds containing both equity investments and non-equity investments
would be treated either as a single investment based on the majority of
the fund's holdings or, where possible, as separate and distinct
investments in the fund's component holdings based on a ``look-through
approach'' (that is, based on the individual component holdings).
An instrument generally would be considered to be an equity
exposure if it (1) would qualify as Tier 1 capital under the general
risk-based capital rules if issued by a banking organization; (2) is
irredeemable in the sense that the return of invested funds can be
achieved only by the sale of the investment or sale of the rights to
the investment or in the event of the liquidation of the issuer; (3)
conveys a residual claim on the assets or income
[[Page 45928]]
of the issuer; and (4) does not embody an obligation on the part of the
issuer.
An instrument that embodies an obligation on the part of the issuer
would be considered an equity exposure if the instrument meets any of
the following conditions: (1) The issuer may defer indefinitely the
settlement of the obligation; (2) the obligation requires, or permits
at the issuer's discretion, settlement by the issuance of a fixed
number of the issuer's equity interests; (3) the obligation requires,
or permits at the issuer's discretion, settlement by the issuance of a
variable number of the issuer's equity interests, and all things being
equal, any change in the value of the obligation is attributable to,
comparable to, and in the same direction as, the change in value of a
fixed number of the issuer's equity shares; or (4) the holder has the
option to require that the obligation be settled by issuance of the
issuer's equity interests, unless the banking organization's primary
Federal supervisor has opined in writing that the instrument should be
treated as a debt position.
Debt obligations and other securities, derivatives, or other
instruments structured with the intent of conveying the economic
substance of equity ownership would be considered equity exposures for
purposes of the A-IRB capital requirements. For example, options and
warrants on equities and short positions in equity securities would be
characterized as equity exposures. If a debt instrument is convertible
into equity at the option of the holder, it would be deemed equity upon
conversion. If such debt is convertible at the option of the issuer or
automatically by the terms of the instrument, it would be deemed equity
from inception. In addition, instruments with a return directly linked
to equities would be characterized as equity exposures under most
circumstances. A banking organization's primary Federal supervisor
would have the discretion to allow a debt characterization of such an
equity-linked instrument, however, if the instrument is directly hedged
by an equity holding such that the net position does not involve
material equity risk to the holder. Equity instruments that are
structured with the intent of conveying the economic substance of debt
holdings, or securitization exposures would not be considered equity
exposures. For example, some issuances of term preferred stock may be
more appropriately characterized as debt.
In all cases, the banking organization's primary Federal supervisor
would have the discretion to recharacterize debt holdings as equity
exposures or equity holdings as debt or securitization exposures for
regulatory capital purposes.
The Agencies encourage comment on whether the definition of an
equity exposure is sufficiently clear to allow banking organizations
to make an appropriate determination as to the characterization of
their assets.
Materiality
As noted above, a banking organization that is required or elects
to use the A-IRB approach for any credit portfolio would also generally
be required to use the A-IRB approach for its equity exposures.
However, if the aggregate equity holdings of a banking organization are
not material in amount, the organization would not be required to use
the A-IRB approach to equity exposures. For this purpose, a banking
organization's equity exposures generally would be considered material
if their aggregate carrying value, including holdings subject to
exclusions and transitional provisions (as described below), exceeds 10
percent of the organization's Tier 1 and Tier 2 capital on average
during the prior calendar year. To address concentration concerns,
however, the materiality threshold would be lowered to 5 percent of the
banking organization's Tier 1 and Tier 2 capital if the organization's
equity portfolio consists of less than ten individual holdings. Banking
organizations would risk weight at 100 percent equity exposures
exempted from the A-IRB equity treatment under a materiality threshold.
Comment is sought on whether the materiality thresholds set
forth above are appropriate. Exclusions from the A-IRB Equity
Capital Charge
Zero and Low Risk Weight Investments
The New Accord provides that national supervisors may exclude from
the A-IRB capital charge those equity exposures to entities whose debt
obligations qualify for a zero risk weight under the New Accord's
standardized approach for credit risk. Entities whose debt obligations
qualify for a zero risk weight generally include (i) sovereigns rated
AAA to AA-; (ii) the BIS; (iii) the IMF; (iv) the European Central
Bank; (v) the European Community; and (vi) high-quality multilateral
development banks (MDBs) with strong shareholder support.\27\ The
Agencies intend to exclude from the A-IRB equity capital charge equity
investments in these entities. Instead, these investments would be risk
weighted at zero percent under the A-IRB approach.
---------------------------------------------------------------------------
\27\ These are, at present, the World Bank group comprised of
the International Bank for Reconstruction and Development and the
International Finance Corporation, the Asian Development Bank, the
African Development Bank, the European Bank for Reconstruction and
Development, the Inter-American Development Bank, the European
Investment Bank, the Islamic Development Bank, the Nordic Investment
Bank, the Caribbean Development Bank, and the Council of Europe
Development Bank.
---------------------------------------------------------------------------
In addition, the Agencies are proposing to exempt from the A-IRB
equity capital charge investments in non-central government public-
sector entities (PSEs) that are not traded publicly and generally are
held as a condition of membership. Examples of such holdings include
stock of a Federal Home Loan Bank or a Federal Reserve Bank. These
investments would be risk-weighted as they would be under the general
risk-based capital rules--20 percent or zero percent, respectively, in
the examples.
Comment is sought on whether other types of equity investments
in PSEs should be exempted from the A-IRB capital charge on equity
exposures, and if so, the appropriate criteria for determining which
PSEs should be exempted.
Legislated Program Equity Exposures
Under the New Accord, national supervisors may exclude from the A-
IRB capital charge on equity exposures certain equity exposures made
under legislated programs that involve government oversight and
restrictions on the types or amounts of investments that may be made
(legislated program equity exposures). Under the New Accord, a banking
organization would be able to exclude from the A-IRB capital charge on
equity exposures legislated program equity exposures in an amount up to
10 percent of the banking organization's Tier 1 plus Tier 2 capital.
The Agencies propose that equity investments by a banking
organization in a small business investment company (SBIC) under
section 302(b) of the Small Business Investment Act of 1958 would be
legislated program equity exposures eligible for the exclusion from the
A-IRB equity capital charge in an amount up to 10 percent of the
banking organization's Tier 1 plus Tier 2 capital. A banking
organization would be required to risk weight at 100 percent any
amounts of legislated program equity exposures that qualify for this
exclusion from the A-IRB equity capital charge.
The Agencies seek comment on what conditions might be
appropriate for this partial exclusion from the A-IRB equity capital
charge. Such conditions could include limitations on the size and
types of
[[Page 45929]]
businesses in which the banking organization invests, geographical
limitations, or limitations on the size of individual investments.
U.S. banking organizations also make investments in community
development corporations (CDCs) or community and economic development
entities (CEDEs) that promote the public welfare. These investments
receive favorable tax treatment and investment subsidies that make
their risk and return characteristics markedly different (and more
favorable to investors) than equity investments in general. Recognizing
this more favorable risk-return structure and the importance of these
investments to promoting important public welfare goals, the Agencies
are proposing the exclusion of all such investments from the A-IRB
equity capital charge. Unlike the exclusion for SBIC exposures, the
exclusion of CDC and CEDE investments would not be subject to a
percentage of capital limit. All CDC and CEDE equity exposures would
receive a 100 percent risk weight.
The Agencies seek comment on whether any conditions relating to
the exclusion of CDC/CEDE investments from the A-IRB equity capital
charge would be appropriate. These conditions could serve to limit
the exclusion to investments in such entities that meet specific
public welfare goals or to limit the amount of such investments that
would qualify for the exclusion from the A-IRB equity capital
charge. The Agencies also seek comment on whether any other classes
of legislated program equity exposures should be excluded from the
A-IRB equity capital charge.
Grandfathered Investments
Equity exposures held as of the date of adoption of the final A-IRB
capital rule governing equity exposures would be exempt from the A-IRB
equity capital charge for a period of ten years from that date. A
banking organization would be required to risk weight these holdings
during the ten-year period at 100 percent. The investments that would
be considered grandfathered would be equal to the number of shares held
as of the date of the final rule, plus any shares that the holder
acquires directly as a result of owning those shares, provided that any
additional shares do not increase the holder's proportional ownership
share in the company.
For example, if a banking organization owned 100 shares of a
company on the date of adoption of the final rule, and the issuer
thereafter declared a pro rata stock dividend of 5 percent, the entire
post-dividend holdings of 105 shares would be exempt from the A-IRB
equity capital charge for a period of ten years from the date of the
adoption of the final rule. However, if additional shares are acquired
such that the holder's proportional share of ownership increases, the
additional shares would not be grandfathered. Thus, if a banking
organization owned 100 shares of a company on the date of adoption of
the final rule and subsequently acquired an additional 50 shares, the
original 100 shares would be exempt from the A-IRB equity capital
charge for the ten-year period from the date of adoption of the final
rule, but the additional 50 shares would be immediately subject to the
A-IRB equity capital charge.
Description of Quantitative Principles
The primary focus of the A-IRB approach to equity exposures is to
assess capital based on an internal estimate of loss under extreme
market conditions on an institution's portfolio of equity holdings or,
in simpler forms, its individual equity investments. The methodology or
methodologies used to compute the banking organization's estimated loss
should be those used by the institution for internal risk management
purposes. The model should be fully integrated into the banking
organization's risk management infrastructure.
A banking organization's use of internal models would be subject to
supervisory approval and ongoing review by the institution's primary
Federal supervisor. Given the unique nature of equity portfolios and
differences in modeling techniques, the supervisory model review
process would be, in many respects, institution-specific. The
sophistication and nature of the modeling technique used for a
particular type of equity exposure should correspond to the banking
organization's exposure, concentration in individual equity issues of
that type, and the particular risk of the holding (including any
optionality). Institutions would have to use an internal model that is
appropriate for the risk characteristics and complexity of their equity
portfolios. The model would have to be able to capture adequately all
of the material risks embodied in equity returns, including both
general market risk and idiosyncratic (that is, specific) risk of the
institution's equity portfolio.
In their evaluations of institutions' internal models, the Agencies
would consider, among other factors, (a) the nature of equity holdings,
including the number and types of equities (for example, public,
private, long, short); (b) the risk characteristics and makeup of
institutions' equity portfolio holdings, including the extent to which
publicly available price information is obtainable on the exposures;
and (c) the level and degree of concentration. Institutions with equity
portfolios containing holdings with values that are highly nonlinear in
nature (for example, equity derivatives or convertibles) would have to
employ an internal model designed to appropriately capture the risks
associated with these instruments.
The Agencies recognize that the type and sophistication of internal
modeling systems will vary across institutions due to differences in
the nature and complexity of business lines in general and equity
exposures in particular. Although the Agencies intend to use a VaR
methodology as a benchmark for the internal model approach, the
Agencies recognize that some institutions employ models for internal
risk management and capital allocation purposes that, given the nature
of their equity holdings, can be more risk-sensitive than some VaR
models. For example, some institutions employ rigorous historical
scenario analysis and other techniques in assessing the risk of their
equity portfolios. It is not the Agencies' intention to dictate the
form or operational details of banking organizations' risk measurement
and management practices for their equity exposures. Accordingly, the
Agencies do not expect to prescribe any particular type of model for
computing A-IRB capital charges for equity exposures.
For purposes of evaluating the A-IRB equity capital charges
produced by a banking organization's selected methodology, the Agencies
would expect to use as a benchmark a VaR methodology using a 99.0
percent (one-tailed) confidence level of estimated maximum loss over a
quarterly time horizon using a long-term sample period. Moreover, A-IRB
equity capital charges would have to produce risk weights for equity
exposures that are at least equal to a 200 percent risk weight for
publicly traded equity exposures, and a 300 percent risk weight for all
other equity exposures.
VaR-based internal models must use a historical observation period
that includes a sufficient amount of data points to ensure
statistically reliable and robust loss estimates relevant to the long-
term risk profile of the institution's specific holdings. The data used
to represent return distributions should reflect the longest sample
period for which data are available and should meaningfully represent
the risk profile of the banking organization's specific equity
holdings. The data sample should be long-term in nature and, at a
minimum, should encompass at least one complete equity market cycle
relevant to the institution's holdings,
[[Page 45930]]
including both increases and decreases in relevant equity values over a
long-term data period. The data used should be sufficient to provide
conservative, statistically reliable, and robust loss estimates that
are not based purely on subjective or judgmental considerations.
The parameters and assumptions used in a VaR model must be subject
to a rigorous and comprehensive regime of stress-testing. Banking
organizations utilizing VaR models would be required to subject their
internal model and estimation procedures, including volatility
computations, to either hypothetical or historical scenarios that
reflect worst-case losses given underlying positions in both public and
private equities. At a minimum, banking organizations that use a VaR
model would be required to employ stress tests to provide information
about the effect of tail events beyond the level of confidence assumed
in the internal models approach.
Banking organizations using non-VaR internal models that are based
on stress tests or scenario analyses would have to estimate losses
under worst-case modeled scenarios. These scenarios would have to
reflect the composition of the organization's equity portfolio and
should produce capital charges at least as large as those that would be
required to be held against a representative market index under a VaR
approach. For example, for a portfolio consisting primarily of publicly
held equity securities that are actively traded, capital charges
produced using historical scenario analyses would have to be greater
than or equal to capital charges produced by a baseline VaR approach
for a major index that is representative of the institution's holdings.
The measure of an equity exposure on which A-IRB capital
requirements would be based would be the value of the equity presented
in a banking organization's financial statements. For investments held
at fair value, the exposure amount would be equal to the fair value
presented in the balance sheet. For investments held at the lower of
cost or market value, the exposure amount would be equal to the cost or
market value presented in the balance sheet.
The loss estimate derived from the internal model would constitute
the A-IRB capital charge to be assessed against the equity exposure.
The A-IRB equity capital charge would be incorporated into an
institution's risk-based capital ratio through the calculation of risk-
weighted equivalent assets. To convert the A-IRB equity capital charge
into risk-weighted equivalent assets, a banking organization would
multiply the capital charge by a factor of 12.5.
Consistent with the general risk-based capital rules, 45 percent of
the positive change in value held in the tax-adjusted separate
component of equity--that is, 45 percent of revaluation gains on
available-for-sale (AFS) equity securities--would be includable in Tier
2 capital under the A-IRB framework.
Comment is specifically sought on whether the measure of an
equity exposure under AFS accounting continues to be appropriate or
whether a different rule for the inclusion of revaluation gains
should be proposed.
C. Supervisory Assessment of A-IRB Framework
A banking organization would have to satisfy all the A-IRB
infrastructure requirements and supervisory standards before it would
be able to use the A-IRB approach for calculating capital requirements
for credit risk. This section describes key elements of the framework
on which the Agencies propose to base the A-IRB qualifying requirements
for U.S. banking organizations. The Agencies intend to provide more
detailed implementation guidance in regard to these issues for
wholesale and retail exposures, as well as for equity and
securitization exposures. As noted earlier, draft guidance for
corporate exposures that identifies associated supervisory standards
was published elsewhere in today's Federal Register.
Overview of Supervisory Framework
Many of the supervisory standards are focused on requirements for a
banking organization's internal risk rating system. Emphasis is placed
on a banking organization's ability to rank order and quantify risk in
a consistent, reliable and valid manner. In sum, a banking
organization's internal risk rating system would have to provide for a
meaningful differentiation of the riskiness of borrowers, as well as
the risks inherent in individual transactions. To ensure the
reliability of these estimates, internal risk rating systems would need
to be subject to review by independent control units. Data sources and
estimation methods used by banking organizations would need to be
sufficiently robust to support the production of consistent
quantitative assessments of risk over time. Finally, to ensure that
ratings are not derived solely for regulatory capital purposes,
internal risk rating systems and quantification methods would need to
form an integral part of the management of the institution, as outlined
below.
It is important to emphasize that the Agencies believe that meeting
the A-IRB infrastructure requirements and supervisory standards will
require significant efforts by banking organizations. The A-IRB
supervisory standards will effectively ``raise the bar'' in regard to
sound credit risk management practices.
Rating System Design
The design of an internal risk rating system is key to its
effectiveness. By definition, a rating system comprises all of the
processes that support the assessment of credit risk, the assignment of
internal risk ratings, and the quantification of default and loss
estimates. Banking organizations would be able to rely on one or more
systems for assessing their credit risk exposures. When this is the
case, the banking organization would have to demonstrate that each
system used for A-IRB capital purposes complies with the supervisory
standards.
The Agencies believe that banking organizations' internal rating
systems should accurately and consistently differentiate degrees of
risk. For wholesale exposures, banking organizations would need to have
a two-dimensional rating system that separately assesses the risk of
borrower default, as well as transaction-specific factors that focus on
the amount that would likely be collected in the event of default. Such
factors may include whether an exposure is collateralized, its
seniority, and the product type. In contrast to the individual
evaluation required for wholesale exposures, retail exposures would be
assessed on a pool basis. Banking organizations would need to group
their retail exposures into portfolio segments based on the risk
characteristics that they consider relevant--for example borrower
characteristics such as credit scores or transaction characteristics
such as product or collateral type. Delinquent or defaulted exposures
would need to be separated from those that are current.
Banking organizations would be required to define clearly their
wholesale rating categories and retail portfolio segments. The clarity
and transparency of the ratings criteria are critical to ensuring that
ratings are assigned in a consistent and reliable manner. The Agencies
believe it is important for banking organizations to document the
operating procedures for their internal risk rating system in writing.
For example, the documentation should describe which parties within the
organization would have the authority to approve exceptions. Further,
the documentation
[[Page 45931]]
would have to clearly specify the frequency of review, as well as
describe the oversight to be provided by management of the ratings
process.
Banking organizations using the A-IRB approach would need to be
able to generate sound measurements of the key risk inputs to the A-IRB
capital formulas. Banking organizations would be able to rely on data
based either on internal experience or generated by an external source,
as long as the banking organization can demonstrate the relevance of
external data to its own experience.
In assigning a rating to an obligor, a banking organization must
assess the risk of default, taking into account possible adverse events
that might increase the obligor's likelihood of default. The A-IRB
supervisory standards in the supervisory guidance provide banking
organizations with a degree of flexibility in determining precisely how
to reflect adverse events in obligor ratings. However, banking
organizations are required to clearly articulate the approach chosen,
and to articulate the implications for capital planning and for capital
adequacy during times of systematic economic stress. The Agencies
recognize that banking organizations' internal risk rating systems may
include a range of statistical models or other methods to assign
borrower or facility ratings or to estimate key inputs. The burden of
proof would remain on the banking organization as to whether a specific
model or procedure satisfies the supervisory standards.
Risk Rating System Operations
The risk rating system would have to form an integral part of the
loan approval process wherein ratings are assigned to all borrowers,
guarantors, or facilities depending upon whether the extension of
credit is wholesale or retail in nature. Any deviations from policies
that govern the assignment of ratings must be clearly documented and
monitored.
Data maintenance is another key aspect of risk rating system
operations. Banking organizations would be expected to collect and
store data on key borrower and facility characteristics. The data would
have to be sufficiently detailed to allow for future reconsideration of
the way in which obligors and facilities have been allocated to grades.
Furthermore, banking organizations would have to collect, retain, and
disclose data on aspects of their internal ratings as described under
the disclosure section of this proposal.
Banking organizations would be required to have in place sound
stress testing processes for use in the assessment of capital adequacy.
Stress testing would have to involve identifying possible events or
future changes in economic conditions that could have unfavorable
effects on a banking organization's credit exposures. Specifically,
institutions would need to assess the effect of certain specific
conditions on their A-IRB regulatory capital requirements. The choice
of test to be employed would remain with the individual banking
organization provided the method selected is meaningful and reasonably
conservative.
Corporate Governance and Oversight
The Agencies view the involvement of the board of directors and
management as critical to the successful implementation of the A-IRB
approach. The board of directors and management would be responsible
for maintaining effective internal controls over the banking
organization's information systems and processes for assessing adequacy
of regulatory capital and determining regulatory capital charges
consistent with this ANPR. All significant aspects of the rating and
estimation processes would have to be approved by the banking
organization's board of directors or a designated committee thereof and
senior management. These parties would need to be fully aware of
whether the system complies with the supervisory standards, makes use
of the necessary data, and produces reliable quantitative estimates.
Ongoing management reports would have to accurately capture the
performance of the rating system.
Oversight would also need to involve independent credit risk
control units responsible for ensuring the performance of the rating
system, the accuracy of the ratings and parameter estimates, and
overall compliance with supervisory standards and capital regulations.
The Agencies believe it is critical that such units remain functionally
independent from the personnel and management responsible for
originating credit exposures. Among other responsibilities, the control
units should be charged with testing and monitoring the appropriateness
of the rating scale, verifying the consistent use of ratings for a
given exposure type across the organization, and reviewing and
documenting any changes to be made to the system.
Use of Internal Ratings
To qualify to use the A-IRB framework, a banking organization's
rating systems would have to form an integral part of its day-to-day
credit risk management process. The Agencies expect that banking
organizations would rely on their internal risk rating systems when
making decisions about whether to extend credit as well as in their
ongoing monitoring of credit exposures. For example, ratings
information would have to be incorporated into other key processes,
such as reserving determinations and when allocating economic capital
internally.
Risk Quantification
Ratings quantification is the process of assigning values to the
key risk components of the A-IRB approach: PD, LGD, EAD and M. With the
exception of M, the risk components are unobservable and must be
estimated. The estimates would have to be consistent with sound
practice and supervisory standards. Banking organizations' rating
system review and internal audit functions would need to serve as
control mechanisms that ensure the process of rating assignments and
quantification are functioning according to policy and that non-
compliance or weaknesses are identified.
Validation of Internal Estimates
An equally important element would be a robust system for
validating the accuracy and consistency of a banking organization's
rating system, as well as the estimation of risk components. The
standards in the supervisory guidance require that banking
organizations use a broad range of validation tools, including
evaluation of developmental evidence, ongoing monitoring of rating and
quantification processes, benchmarking against alternative approaches,
and comparison of outcomes with estimates. Details of the validation
process would have to be consistent with the operation of the banking
organization's rating system and data would have to be maintained and
updated to support oversight and validation work. Banking organizations
would have to have well-articulated standards for situations where
deviations of realized values from expectations become significant
enough to call the validity of the estimates into question. Rating
systems with appropriate data and oversight feedback mechanisms should
create an environment that promotes integrity and improvements in the
rating system over time.
U.S. Supervisory Review
The primary Federal supervisor would be responsible for evaluating
an institution's initial and ongoing
[[Page 45932]]
compliance with the infrastructure requirements and supervisory
standards for approval to use the A-IRB approach for regulatory capital
purposes. As noted, the Agencies will be developing and issuing
specific implementation guidance describing the supervisory standards
for wholesale, retail, equity and securitization exposures. The
Agencies will issue the draft implementation guidance for each
portfolio for public comment to ensure that there is an opportunity for
banking organizations and others to provide feedback on the Agencies'
expectations in regard to A-IRB systems.
The Agencies seek comment on the extent to which an appropriate
balance has been struck between flexibility and comparability for
the A-IRB requirements. If this balance is not appropriate, what are
the specific areas of imbalance, and what is the potential impact of
the identified imbalance? Are there alternatives that would provide
greater flexibility, while meeting the overall objectives of
producing accurate and consistent ratings?
The Agencies also seek comment on the supervisory standards
contained in the draft guidance on internal ratings-based systems
for corporate exposures. Do the standards cover all of the key
elements of an A-IRB framework? Are there specific practices that
appear to meet the objectives of accurate and consistent ratings but
that would be ruled out by the supervisory standards related to
controls and oversight? Are there particular elements from the
corporate guidance that should be modified or reconsidered as the
Agencies draft guidance for other types of credit?
In addition, the Agencies seek comment on the extent to which
these proposed requirements are consistent with the ongoing
improvements banking organizations are making in credit-risk
management processes.
IV. Securitization
A. General Framework
This section describes the calculation of A-IRB capital
requirements for securitization exposures. A securitization exposure is
any on- or off-balance-sheet position created by aggregating and then
tranching the risks of a pool of assets, commitments, or other
instruments (underlying exposures) into multiple financial interests
where, typically, the pooled risks are not shared pro rata. The pool
may include one or more underlying exposures. Examples include all
exposures arising from traditional and synthetic securitizations, as
well as partial guarantee arrangements where credit losses are not
divided proportionately among the parties (often referred to as
tranched cover). Asset- and mortgage-backed securities (including those
privately issued and those issued by GSEs such as Fannie Mae and
Freddie Mac), credit enhancements, liquidity facilities, and credit
derivatives that have the characteristics noted above would be
considered securitization exposures.
With ongoing advances in financial engineering, the Agencies
recognize that securitization exposures having similar risks can take
different legal forms. For this reason, both the designation of
positions as securitization exposures and the calculation of A-IRB
capital requirements for securitization exposures would be guided by
the economic substance of a given transaction, rather than by its legal
form.
Operational Criteria
Banking organizations would have to satisfy certain operational
criteria to be eligible to use the A-IRB approach to securitization
exposures. Moreover, all banking organizations that use the A-IRB
approach for the underlying exposures that have been securitized would
have to apply the A-IRB treatment for securitization exposures. Minimum
operational criteria would apply to traditional and synthetic
securitizations. The Agencies propose to establish supervisory criteria
for determining when, for risk-based capital purposes, a banking
organization may treat exposures that it has originated directly or
indirectly as having been securitized and, hence, not subject to the
same capital charge as if the banking organization continued to hold
the assets. The Agencies anticipate these supervisory criteria will be
substantially equivalent to the criteria contained in the New Accord
(paragraphs 516-520). Broadly, these criteria are intended to ensure
that securitization transactions transfer significant credit risk to
third parties and, in the case of traditional securitizations, that
each transaction qualifies as a true sale under applicable accounting
standards.
The supervisory criteria also would describe the types of clean-up
calls that may be incorporated within transactions qualifying for the
A-IRB securitization treatment.\28\ Specifically, any clean-up call
would have to meet the following conditions: (a) Its exercise is at the
discretion of the originating banking organization; (b) it does not
serve as a credit enhancement; and (c) it is only exercisable when 10
percent or less of the original underlying portfolio or reference
portfolio value remains. If a clean-up call does not meet all of these
criteria, the originating banking organization would have to treat the
underlying exposures as if they had not been securitized.
\28\ In general terms, a clean-up call is an option that permits
an originating banking organization to call the securitization
exposures (for example, asset- or mortgage-backed securities) before
all of the underlying exposures have been repaid.
The Agencies seek comment on the proposed operational
requirements for securitizations. Are the proposed criteria for risk
transference and clean-up calls consistent with existing market
practices?
Differences Between General A-IRB Approach and the A-IRB Approach for
Securitization Exposures
In contrast to the proposed A-IRB framework for traditional loans
and commitments, the A-IRB securitization framework does not rely on a
banking organization's own internal assessments of the PD and LGD of a
securitization exposure. For securitization exposures backed by pools
of multiple assets, such assessments require implicit or explicit
estimates of correlations among the losses on those assets. Such
correlations are extremely difficult to estimate and validate in an
objective manner and on a going-forward basis. For this reason, the A-
IRB framework generally would not permit a banking organization to use
its internal risk assessments of PD or LGD when such assessments
depend, implicitly or explicitly, on estimates of correlation effects.
The A-IRB treatment of securitization exposures would rely principally
on two sources of information, when available: (i) An assessment of the
securitization exposure's credit risk made by an external rating
agency; and (ii) the A-IRB capital charge that would have been assessed
against the underlying exposures had the exposures not been securitized
(the pool's A-IRB capital charge), along with other information about
the transaction.
B. Determining Capital Requirements
General Considerations
Because the information available to a banking organization about a
securitization exposure often reflects the organization's role in a
securitization transaction, the Agencies are proposing that the method
of calculating the A-IRB capital requirement for a securitization
exposure may depend on whether a banking organization is an originator
or a third-party investor in the securitization transaction. In
general, a banking organization would be considered an originator of a
securitization if the organization directly or indirectly originated
the underlying exposures or serves as the sponsor of an asset-backed
commercial paper (ABCP) conduit or similar
[[Page 45933]]
program.\29\ If a banking organization is not deemed an originator of a
securitization transaction, then it would be considered an investor in
the securitization.
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\29\ A banking organization is generally considered a sponsor of
an ABCP conduit or similar program if, in fact or in substance, it
manages or advises the conduit program, places securities into the
market for the program, or provides liquidity support or credit
enhancements to the program.
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There are several methods for determining the A-IRB capital
requirement for a securitization exposure: the Ratings-Based Approach
(RBA), the Alternative RBA, the Supervisory Formula Approach (SFA), the
Look-Through Approach, deduction from Tier 1 capital, and deduction
from total capital. The following table summarizes conditions under
which a banking organization would apply each of these methods. In this
table, KIRB denotes the ratio of (a) the pool's A-IRB capital charge to
(b) the notional or loan equivalent amount of underlying exposures in
the pool.
Steps for Determining A-IRB Capital Requirements for Securitization
Exposures
For an investing banking organization:
1. Deduct from total capital any credit-enhancing interest-only
strips
2. When an external or inferred rating exists, apply the RBA
3. When an external or inferred rating does not exist, do the
following:
a. Subject to supervisory review and approval, if the investing
banking organization can determine KIRB, then calculate required
capital as would an originating banking organization using the steps
described in 2.a. below
b. Otherwise, deduct the exposure from total capital
For an originating banking organization:\*\
---------------------------------------------------------------------------
\*\ In addition to the capital treatments delineated, an
originating banking organization's total A-IRB capital charge with
regard to any single securitization transaction is subject to a
maximum or ceiling, as described later in this section.
---------------------------------------------------------------------------
1. Deduct from Tier 1 capital any increase in capital resulting
from the securitization transaction and deduct from total capital any
credit-enhancing interest-only strips (net of deductions from Tier 1
capital due to increases in capital)
2. When an A-IRB approach exists for the underlying exposures do
the following:
a. If KIRB can be determined:
i. For a securitization exposure (or portion thereof) that is at or
below KIRB, deduct the exposure from total capital
ii. For a securitization exposure (or portion thereof) that is
above KIRB:
1. Apply the RBA whenever an external or inferred rating is
available
2. Otherwise, apply the SFA
b. If KIRB cannot be determined:
i. Apply the Look-Through Approach if the exposure is an eligible
liquidity facility, subject to supervisory approval
ii. Otherwise, deduct the exposure from total capital
3. When an A-IRB approach does not exist for the underlying
exposures do the following:
a. Apply the Look-Through Approach if the exposure is an eligible
liquidity facility, subject to supervisory approval
b. Otherwise, apply the Alternative RBA
Deductions of Gain-on-Sale or Other Accounting Elements That Result in
Increases in Equity Capital
Any increase in equity capital resulting from a securitization
transaction (for example, a gain resulting from FAS 140 accounting
treatment of the sale of assets) would be deducted from Tier 1 capital.
Such deductions are intended to offset any gain on sale or other
accounting treatments (``gain on sale'') that result in an increase in
an originating banking organization's shareholders' equity and Tier 1
capital. Over time, as banking organizations, from an accounting
perspective, realize the increase in equity that was booked at
origination of a securitization transaction through actual receipt of
cash flows, the amount of the required deduction would be reduced
accordingly.
Banking organizations would have to deduct from total capital any
on-balance-sheet credit-enhancing interest-only strips (net of any
increase in the shareholders' equity deducted from Tier 1 capital as
described in the previous paragraph).\30\ Credit-enhancing interest-
only strips are defined in the general risk-based capital rules and
include items, such as excess spread, that represent subordinated cash
flows of future margin income.
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\30\ Deductions other than of increases in equity capital are to
be taken 50 percent from Tier 1 capital and 50 percent from Tier 2
capital.
---------------------------------------------------------------------------
Maximum Capital Requirement
Where an A-IRB approach exists for the underlying exposures, an
originating banking organization's total A-IRB capital charge for
exposures associated with a given securitization transaction would be
subject to a maximum or ceiling. This maximum A-IRB capital charge
would equal the pool's A-IRB capital charge plus any required
deductions, as described in the preceding paragraphs. The aim of this
treatment is to ensure that an institution's effective A-IRB capital
charge generally would not be greater after securitization than before,
while also addressing the Agencies' safety and soundness concerns with
respect to credit-enhancing interest-only strips and other capitalized
assets.\31\
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\31\ The maximum capital, requirement also applies to investing
banking organizations that receive approval to use the SFA.
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The proposed maximum A-IRB capital requirement effectively would
reverse one aspect of the general risk-based capital rules for
securitization exposures referred to as residual interests. Under the
general risk-based capital rules, banking organizations are required to
hold a dollar in capital for every dollar in residual interest,
regardless of the capital requirement on the underlying exposures. One
of the reasons the Agencies adopted the ``dollar-for-dollar'' capital
treatment for residual interests is that in many instances the relative
size of the exposure retained by the originating banking organization
reveals additional market information about the quality of the
underlying exposures and deal structure that may not have been captured
in the capital requirement on the underlying exposures, had those
exposures remained on the banking organization's balance sheet. The
Agencies will continue to review the proposal for safety and soundness
considerations and may consider retaining the current dollar-for-dollar
capital treatment for residual interests, especially in those instances
where an originator retains first loss and other deeply subordinated
interests in amounts that significantly exceed the pool's A-IRB capital
charge plus required deductions.
Comments are invited on the circumstances under which the
retention of the treatment in the general risk-based capital rules
for residual interests for banking organizations using the A-IRB
approach to securitization would be appropriate.
Should the Agencies require originators to hold dollar-for-
dollar capital against all retained securitization exposures, even
if this treatment would result in an aggregate amount of capital
required of the originator that exceeded the pool's A-IRB capital
charge plus any applicable deductions? Please provide the underlying
rationale.
Investors
Third-party investors generally do not have access to detailed,
ongoing information about the credit quality of the underlying
exposures in a securitization. In such cases, investors often rely upon
credit assessments made by external rating agencies. For a
securitization exposure held by an investing banking organization, and
[[Page 45934]]
where an A-IRB treatment for the underlying exposures exists, the
institution would use the Ratings-Based Approach (RBA) described below
if the securitization exposure is externally rated or if an inferred
rating is available (as defined in the RBA discussion below). When
neither an external rating nor an inferred rating is available, an
investing banking organization would compute the A-IRB capital charge
for the exposure using the methodology described below for originating
institutions (subject to supervisory review and approval). Otherwise,
the securitization exposure would be deducted 50 percent from Tier 1
capital and 50 percent from Tier 2 capital. The Agencies anticipate
that investing banking organizations would apply the RBA in the vast
majority of situations.
Originators
This section presumes that an A-IRB approach exists for the
underlying exposures. If no A-IRB treatment exists for the underlying
exposures, then an originating banking organization (originator) would
use the Alternative RBA discussed below.
In contrast to third-party investors, banking organizations that
originate securitizations are presumed to have much greater access to
information about the current credit quality of the underlying
exposures. In general, when an originator retains a securitization
exposure, the A-IRB securitization framework would require the
institution to calculate, on an ongoing basis, the underlying exposure
pool's A-IRB capital requirement had the underlying exposures not been
securitized (the pool's A-IRB capital charge), which would be based on
the notional dollar amount of underlying exposures (the size of the
pool). The pool's A-IRB capital charge would be calculated using the
top-down or bottom-up method applicable to the type(s) of underlying
exposure(s).\32\ As noted above, the pool's A-IRB capital charge
divided by the size of the pool is denoted KIRB.
---------------------------------------------------------------------------
\32\ For the purpose of determining the A-IRB capital
requirement for a securitization exposure, the top-down method could
be used regardless of the maturity of the underlying exposures,
provided the other eligibility criteria for employing the top-down
approach are satisfied.
---------------------------------------------------------------------------
An originator also would be expected to know: (a) Its retained
securitization exposure's nominal size relative to the size of the pool
(the exposure's ``thickness,'' denoted T); and (b) the notional amount
of all more junior securitization exposures relative to the size of the
pool (the exposure's ``credit enhancement level,'' denoted L). The
retained securitization exposure's A-IRB capital requirement depends on
the relationship between KIRB, T, and L. If an originator cannot
determine KIRB, any retained securitization exposure would be deducted
from capital. For eligible liquidity facilities (defined below in the
Look Through Approach) provided to ABCP programs where a banking
organization lacks the information necessary to calculate KIRB, the
Look-Through Approach described below would be applied on a temporary
basis and subject to supervisory approval.
Positions Below KIRB
An originating banking organization would deduct from capital any
retained securitization exposure (or part thereof) that absorbs losses
at or below the level of KIRB (that is, an exposure for which L+T <=
KIRB).\33\ This means that an originating banking organization would be
given no risk-based capital relief unless it sheds at least some
exposures below KIRB. Deduction from capital would be required
regardless of the securitization exposure's external rating. This
deduction treatment is in contrast to the A-IRB capital treatment for
investors, who would be able to look to the external (or inferred)
rating of a securitization exposure regardless of whether the exposure
was below KIRB.
---------------------------------------------------------------------------
\33\ If an originator holds a securitization exposure that
straddles KIRB, the exposure must be decomposed into two separate
positions--one that is above KIRB and another that is at or below
KIRB.
---------------------------------------------------------------------------
While this disparate treatment of originators and investors may be
viewed as inconsistent with the principle of equal capital for equal
risk, the Agencies believe it is appropriate in order to provide
incentives for originating banks to shed highly subordinated
securitization exposures. Such exposures contain the greatest credit
risks. Moreover, these risks are difficult to evaluate, and risk
quantifications tend to be highly sensitive to modeling assumptions
that are difficult to validate objectively. The proposal to prevent an
originator from using the RBA for securitization exposures below KIRB
reflects, in part, a concern by the Agencies that the market discipline
underpinning an external credit rating may be less effective when the
rating applies to a retained, non-traded securitization exposure and is
sought by an originator primarily for regulatory capital purposes.
The Agencies note that the specific securitization exposures
retained by an originator that are subject to deduction treatment could
change over time in response to variations in the credit quality of the
underlying exposures. For example, if the pool's A-IRB capital charge
were to increase after the inception of a securitization, additional
portions of securitization exposures held by an originator may fall
below KIRB and, thus, become subject to deduction. Therefore, when an
originator retains a first-loss securitization exposure well in excess
of KIRB, the originator's A-IRB capital requirement on the exposure
could climb rapidly in the event of any marked deterioration of the
underlying exposures. In general, an originator could minimize
variability in future capital charges by minimizing the size of any
retained first-loss securitization exposures.
Positions Above KIRB
When an originating banking organization retains a securitization
exposure, or part thereof, that absorbs losses above the KIRB amount
(that is, an exposure for which L + T KIRB) and the banking
organization has not already met the maximum capital requirement for
securitization exposures described previously, the A-IRB capital
requirement for the exposure would be calculated as follows. For
securitization exposures having an external or inferred rating, the
organization would calculate its A-IRB capital requirement using the
RBA. However, if neither an external rating nor an inferred rating is
available, an originator would be able to use the SFA, subject to
supervisory review and approval. Otherwise, the organization would
deduct the securitization exposure from total capital.
The Agencies seek comment on the proposed treatment of
securitization exposures held by originators. In particular, the
Agencies seek comment on whether originating banking organizations
should be permitted to calculate A-IRB capital charges for
securitizations exposures below the KIRB threshold based on an
external or inferred rating, when available.
The Agencies seek comment on whether deduction should be
required for all non-rated positions above KIRB. What are the
advantages and disadvantages of the SFA approach versus the
deduction approach?
Capital Calculation Approaches
The Ratings-Based Approach (RBA)
The RBA builds upon the widespread acceptance of external ratings
by third-party investors as objective assessments of a securitization
exposure's stand-alone credit risk. Certain minimum requirements would
have to be satisfied in order for a banking organization to rely on an
external credit rating for determining its A-IRB capital charge for a
securitization exposure. To be
[[Page 45935]]
recognized for regulatory capital purposes, the external credit rating
on a securitization exposure would have to be public and reflect the
entire amount of credit risk exposure the banking organization has with
regard to all payments owed to it under the exposure. In particular, if
a banking organization is owed both principal and interest on a
securitization exposure, the external rating on the exposure would have
to fully reflect the credit risk associated with both payment streams.
The Agencies propose to establish criteria to ensure the integrity of
external ratings processes and banking organizations' use of these
ratings under the RBA. These criteria are expected to be consistent
with the proposed guidance provided in the New Accord (paragraph 525).
In certain circumstances, an ``inferred rating'' may be used for
risk weighting a non-rated securitization exposure. Similar to the
general risk-based capital rules, to qualify for use of an inferred
rating, a non-rated securitization exposure would have to be senior in
all respects to a subordinate rated position within the same
securitization transaction. Further, the junior rated tranche would
have to have an equivalent or longer remaining maturity than the non-
rated exposure. Where these conditions are met, the non-rated exposure
would be treated as if it had the same rating (an ``inferred rating'')
as that of the junior rated tranche. External and inferred ratings
would be treated equivalently.
Under the RBA, the capital charge per dollar of a securitization
exposure would depend on: (i) The external rating (or inferred rating)
of the exposure, (ii) whether the rating reflects a long-term or short-
term assessment of the exposure's credit risk, and (iii) a measure of
the effective number--or granularity--of the underlying exposures
(N).\34\ For a securitization exposure rated AA or AAA, the RBA capital
charge also would depend on a measure of the exposure's relative
seniority in the overall transaction (Q).\35\
---------------------------------------------------------------------------
\34\ N is defined more formally in the discussion below of the
Supervisory Formula Approach.
\35\ Q is defined as the total size of all securitization
exposures rated at least AA- that are pari passu or junior to the
exposure of interest, measured relative to the size of the pool and
expressed as a decimal. Thus, for a securitization transaction
having an AAA-rated tranche in the amount of 70 percent of the pool,
an AAA-rated tranche of 10 percent, a BBB-rated tranche of 10
percent, and a non-rated tranche of 10 percent, the values of Q
associated with these positions would be 0.80, 0.10, 0, and 0,
respectively.
---------------------------------------------------------------------------
Tables 1 and 2 below present the risk weights that would result
from the RBA when a securitization exposure's external rating (or
inferred rating) represents a long-term or short-term credit rating,
respectively. In both tables, the risk weights in column 2 would apply
to AA and AAA-rated securitization exposures when the effective number
of exposures (N) is 100 or more, and the exposure's relative seniority
(Q) is greater than or equal to 0.1 + 25/N. If the underlying exposures
are retail exposures, N would be treated as infinite and the minimum
qualifying value of Q would be 0.10. The Agencies anticipate that these
risk weights would apply to AA and AAA-rated tranches of most retail
securitizations. Column 4 would apply only to securitizations involving
non-retail exposures for which N is less than 6, and column 3 would
apply in all other situations.
Within each table, risk weights increase as external rating grades
decline. Under the Base Case (column 3), for example, the risk weights
range from 12 percent for AAA-rated exposures to 650 percent for
exposures rated BB-. This pattern of risk weights is broadly consistent
with analyses employing standard credit risk models and a range of
assumptions regarding correlation effects and the types of exposures
being securitized.\36\ These analyses imply that, compared with a
corporate bond having a given level of stand-alone credit risk (for
example, as measured by its expected loss rate), a securitization
tranche having the same level of stand-alone risk--but backed by a
reasonably granular and diversified pool--will tend to exhibit more
systematic risk.\37\ This effect is most pronounced for below-
investment grade tranches, and is the primary reason why the RBA risk
weights increase rapidly as ratings deteriorate over this range--much
more rapidly than for similarly rated corporate bonds. Similarly, for
highly granular pools, the risk weights expected to apply to most AA
and AAA-rated securitization exposures (7 percent and 10 percent,
respectively) decline steeply relative to the risk weight applicable to
A-rated exposures (20 percent, column 3)--again, more so than might be
the case for similarly rated corporate bonds. The decline in risk
weights as ratings improve over the investment grade range is less
pronounced for the Base Case and for tranches backed by non-granular
pools (column 4).
---------------------------------------------------------------------------
\36\ See Vladislav Peretyatkin and William Perraudin, ``Capital
for Asset-Backed Securities,'' Bank of England, February 2003.
\37\ See, for example, Michael Pykhtin and Ashish Dev, ``Credit
Risk in Asset Securitizations: Analytical Model,'' Risk (May 2002)
S16-S20.
---------------------------------------------------------------------------
For securitization exposures rated below BB-, the proposed A-IRB
treatment--deduction from capital--would be somewhat more conservative
than suggested by credit risk modeling analyses. However, the Agencies
believe this more conservative treatment would be appropriate in light
of modeling uncertainties and the tendency for securitization exposures
in this range, at least at the inception of the securitization
transaction, to be non-traded positions retained by an originator
because they cannot be sold at a reasonable price.
Table 1.--ABS Risk Weights Based on Long-Term External Credit Assessments
----------------------------------------------------------------------------------------------------------------
Thick tranches backed
External rating (illustrative) by highly granular Base case Tranches backed by non-
pools granular pools
----------------------------------------------------------------------------------------------------------------
AAA.................................. 7%..................... 12%.................... 20%
AA................................... 10%.................... 15%.................... 25%
A.................................... N/A.................... 20%.................... 35%
BBB+................................. N/A.................... 50%.................... 50%
BBB.................................. N/A.................... 75%.................... 75%
BBB-................................. N/A.................... 100%................... 100%
BB+.................................. N/A.................... 250%................... 250%
BB................................... N/A.................... 425%................... 425%
BB-.................................. N/A.................... 650%................... 650%
Below BB-............................ N/A.................... Deduction.............. Deduction
----------------------------------------------------------------------------------------------------------------
[[Page 45936]]
Table 2.--ABS Risk Weights Based on Short-Term External Credit Assessments
----------------------------------------------------------------------------------------------------------------
Thick tranches backed
External rating (illustrative) by highly granular Base case Tranches backed by non-
pools granular pools
----------------------------------------------------------------------------------------------------------------
A-1/P-1.............................. 7%..................... 12%.................... 20%
A-2/P-2.............................. N/A.................... 20%.................... 35%
A-3/P-3.............................. N/A.................... 75%.................... 75%
All other ratings.................... N/A.................... Deduction.............. Deduction
----------------------------------------------------------------------------------------------------------------
The Agencies seek comment on the proposed treatment of
securitization exposures under the RBA. For rated securitization
exposures, is it appropriate to differentiate risk weights based on
tranche thickness and pool granularity?
For non-retail securitizations, will investors generally have
sufficient information to calculate the effective number of
underlying exposures (N).
What are views on the thresholds, based on N and Q, for
determining when the different risk weights apply in the RBA?
Are there concerns regarding the reliability of external ratings
and their use in determining regulatory capital? How might the
Agencies address any such potential concerns?
Unlike the A-IRB framework for wholesale exposures, there is no
maturity adjustment within the proposed RBA. Is this reasonable in
light of the criteria to assign external ratings?
The Supervisory Formula Approach (SFA)
As noted above, when an explicit A-IRB approach exists for the
underlying exposures, originating and investing banking organizations
would be able to apply the SFA to non-rated exposures above the KIRB
threshold, subject to supervisory approval and review. The Agencies
anticipate that, in addition to its application to liquidity facilities
and to other traditional and synthetic securitization exposures, the
SFA would be used when calculating A-IRB capital requirements for
tranched guarantees (for example, a loan for which a guarantor assumes
a first-loss position that is less than the full amount of the loan).
Under the SFA, the A-IRB capital charge for a securitization
tranche would depend on six institution-supplied inputs: \38\ the
notional amount of underlying exposures that have been securitized (E),
the A-IRB capital charge had the underlying exposures not been
securitized (KIRB); the tranche's credit enhancement level (L); the
tranche's thickness (T); the pool's effective number of exposures (N);
and the pool's exposure-weighted average loss-given-default (LGD). In
general, the estimates of N and LGD would be developed as a by-product
of the process used to determine KIRB.
---------------------------------------------------------------------------
\38\ When the banking organization holds only a proportional
interest in the tranche, that position's A-IRB capital charge equals
the prorated share of the capital charge for the entire tranche.
---------------------------------------------------------------------------
The SFA capital charge for a given securitization tranche would be
calculated as the notional amount of underlying exposures that have
been securitized (E), multiplied by the greater of: (i) 0.0056 * T or
(ii) the following expression: \39\
---------------------------------------------------------------------------
\39\ The SFA applies only to exposures above KIRB. When a
securitization tranche straddles KIRB, for the purpose of applying
the SFA the tranche should be decomposed into a position at or below
KIRB and another above KIRB. The latter would be the position to
which the SFA is actually applied.
K[L + T]-K[L] + {(0.05 * d * KIRB * e-20(L-KIRB)/KIRB) * (1-
---------------------------------------------------------------------------
e-20T/KIRB){time} ,
where,\40\
---------------------------------------------------------------------------
\40\ In these expressions, Beta[X; a, b] refers to the
cumulative beta distribution with parameters a and b evaluated at X.
The cumulative beta distribution function is available in Excel as
the function BETADIST.
[GRAPHIC] [TIFF OMITTED] TP04AU03.004
Although visually daunting, the above supervisory formula is easily
programmable within standard spreadsheet packages, and its various
components have intuitive interpretations.
Part (i), noted above, of the SFA effectively imposes a 56 basis
point minimum or floor A-IRB capital charge per dollar of tranche
exposure. While acknowledging that such a floor is not risk-sensitive,
the Agencies believe that some minimum prudential capital charge is
nevertheless appropriate. The
[[Page 45937]]
floor has been proposed at 56 basis points partly on the basis of
empirical analyses suggesting that, across a broad range of modeling
assumptions and exposure types, this level provides a reasonable lower
bound on the capital charges implied by standard credit risk models for
securitization tranches meeting the standards for an external rating of
AAA.\41\ This floor also is consistent with the lowest capital charge
available under the RBA.
---------------------------------------------------------------------------
\41\ See Vladislav Peretyatkin and William Perraudin, ``Capital
for Asset-Backed Securities,'' Bank of England, February 2003.
---------------------------------------------------------------------------
Part (ii) of the SFA also is a blend of credit risk modeling
results and supervisory judgment. The function denoted K[x] represents
a pure model-based estimate of the pool's aggregate systematic or non-
diversifiable credit risk that is attributable to a first-loss position
covering pool losses up to and including x. Because the tranche of
interest (defined in terms of a credit enhancement level L, and
thickness T) covers losses between L and L+T, its total systematic risk
can be represented as K[L + T]-K[L], which are the first two terms in
(1). The term in braces within (1) represents a supervisory add-on to
the pure model-based result. This add-on is intended primarily to avoid
potential behavioral distortions associated with what would otherwise
be a discontinuity in capital charges for relatively thin mezzanine
tranches lying just below and just above KIRB: all tranches at or below
KIRB would be deducted from capital, whereas a very thin tranche just
above KIRB would incur a pure model-based capital charge that could
vary between zero and one, depending upon the number of effective
underlying exposures in the pool (N). The add-on would apply primarily
to positions just above KIRB, and its quantitative effect would
diminish rapidly as the distance from KIRB widens.
Most of the complexity of the supervisory formula is a consequence
of attempting to make K[x] as consistent as possible with the
parameters and assumptions of the A-IRB framework that would apply to
the underlying exposures if held directly by a banking
organization.\42\ The specification of K[x] assumes that KIRB is an
accurate measure of the pool's total systematic credit risk, and that a
securitization merely redistributes this systematic risk among its
various tranches. In this way, K[x] embodies precisely the same asset
correlations as are assumed elsewhere within the A-IRB framework. In
addition, this specification embodies the well-known result that a
pool's total systematic risk (that is, KIRB) tends to be redistributed
toward more senior tranches as the effective number of underlying
exposures in the pool (N) declines.\43\ The importance of pool
granularity depends on the pool's average loss-rate-given-default, as
increases in LGD also tend to shift systematic risk toward senior
tranches when N is small. For highly granular pools, such as
securitizations of retail exposures, LGD would have no influence on the
SFA capital charge.
---------------------------------------------------------------------------
\42\ The conceptual basis for specification of K[x] is developed
in Michael B. Gordy and David Jones, ``Random Tranches,'' Risk
(March 2003) 78-83.
\43\ See Michael Pykhtin and Ashish Dev, ``Coarse-granied
CDOs,'' Risk (January 2003) 113-116.
---------------------------------------------------------------------------
The Agencies propose to establish criteria for determining E, KIRB,
L, T, N, and LGD that are consistent with those suggested in the New
Accord. A summary of these requirements is presented below.
E. This input would be measured (in dollars) as the A-IRB estimate
of the exposures in the underlying pool of securitized exposures, as if
they were held directly by the banking organization, rather than
securitized. This amount would reflect only those underlying exposures
that have actually been securitized to date. Thus, for example, E would
exclude undrawn lines associated with revolving credit facilities (for
example, credit card accounts).
KIRB. This input would be measured (in decimal form) as the ratio
of (a) the pool's A-IRB capital requirement to (b) the notional or loan
equivalent amount of the underlying exposures in the pool (E). The
pool's A-IRB capital requirement would be calculated in accordance with
the applicable A-IRB standard for the type of underlying exposure. This
calculation would incorporate the effect of any credit risk mitigant
that is applied to the underlying exposures (either individually or to
the entire pool), and hence benefits all of the securitization
exposures. Consistent with the measurement of E, the estimate of KIRB
would reflect only the underlying exposures that have been securitized.
For example, KIRB generally would exclude the A-IRB capital charges
against the undrawn portions of revolving credit facilities.
Credit enhancement level (L). This input would be measured (in
decimal form) as the ratio of (a) the notional amount of all
securitization exposures subordinate to the tranche of interest to (b)
the notional or loan equivalent amount of underlying exposures in the
pool (E). L would incorporate any funded reserve account (for example,
spread account or overcollateralization) that provides credit
enhancement to the tranche of interest. Credit-enhancing interest-only
strips would not be included in the calculation of L.
Thickness (T). This input would be measured (in decimal form) as
the ratio of (a) the notional amount of the tranche of interest to (b)
the notional or loan equivalent amount of underlying exposures in the
pool (E).
Effective number of exposures (N). This input would be calculated
as
[GRAPHIC] [TIFF OMITTED] TP04AU03.005
where EADi represents the exposure-at-default associated
with the i-th underlying exposure in the pool. Multiple underlying
exposures to the same obligor would be consolidated (that is, treated
as a single exposure). If the pool contains any underlying exposures
that are themselves securitization exposures (for example, one or more
asset-backed securities), each of these would be treated as a single
exposure for the purpose of measuring N.\44\
---------------------------------------------------------------------------
\44\ Within the supervisory formula, the probability
distribution of credit losses associated with the pool of underlying
exposures is approximated by treating the pool as if it consisted of
N homogeneous exposures, each having an A-IRB capital charge of
KIRB/N. The proposed treatment of N implies, for example, that a
pool containing one ABS tranche backed by 1 million effective loans
behaves more like a single loan having an A-IRB capital charge of
KIRB than a pool of 1 million loans, each having an A-IRB capital
charge of KIRB/1,000,000.
---------------------------------------------------------------------------
Exposure-weighted average LGD. This input would be calculated (in
decimal form) as
[GRAPHIC] [TIFF OMITTED] TP04AU03.010
where LGDi represents the average LGD associated with all
underlying exposures to the i-th obligor. In the case of re-
securitization (a securitization of securitization exposures), an LGD
of 100 percent would be assumed for any underlying exposure that was
itself a securitization exposure.\45\
---------------------------------------------------------------------------
\45\ As noted above, the A-IRB securitization framework does not
permit banking organizations to use their own internal estimates of
LGDs (and PDs) for securitization exposures because such
quantification requires implicit or explicit estimates of loss
correlations among the underlying exposures. Recall that LGDs should
be measured as the loss rates expected to prevail when default rates
are high. While setting LGDs equal to 100 percent is reasonable for
certain types of ABSs, such as highly subordinated or thin tranches,
this level of LGD may be conservative for other types of ABSs.
However, the Agencies believe that the complexity and burden
assoicated with a more refined treatment of LGDs would outweigh any
improvement in the overall risk sensitivity of A-IRB capital charges
for originators, owing to the combined effects of (a) the dollar-
for-dollar A-IRB capital charge on positions at or below KIRB, and
(b) the maximum or cap on an originator's total A-IRB capital
charge.
---------------------------------------------------------------------------
[[Page 45938]]
Simplified method for computing N and LGD. Under the conditions
provided below, banking organizations would be able to employ
simplified methods for calculating N and the exposure-weighted average
LGD. When the underlying exposures are retail exposures, the SFA may be
implemented by setting h = 0 and v = 0, subject to supervisory approval
and review. When the share of the pool associated with the largest
exposure, C1, is no more than 0.03 (or 3 percent of the
pool), the banking organization would be able to set LGD = 0.50 and N
equal to:
[GRAPHIC] [TIFF OMITTED] TP04AU03.006
provided that the banking organization can measure Cm, which
denotes the share of the pool corresponding to the largest ``m''
exposures (for example, a 15 percent share corresponds to a value of
0.15).\46\ Alternatively, when only C1 is available and this
amount is no more than 0.03, then the banking organization would be
able to set LGD = 0.50 and N = 1/ C1.
\46\ The level of m is to be set by each banking organization.
The Agencies seek comment on the proposed SFA. How might it be
simplified without sacrificing significant risk sensitivity? How
useful are the alternative simplified computation methodologies for
N and LGD
The Look-Through Approach for Eligible Liquidity Facilities
ABCP conduits and similar programs sponsored by U.S. banking
organizations are major sources of funding for financial and non-
financial companies. Liquidity facilities supporting these programs are
considered to be securitization exposures of the banking organizations
providing the liquidity, and generally would be treated under the rules
proposed for originators. As a general matter, the Agencies expect that
banking organizations using the A-IRB approach would apply the SFA when
determining the A-IRB capital requirement for liquidity facilities
provided to ABCP conduits and similar programs. However, if it would
not be practical for a banking organization to calculate KIRB for the
underlying exposures using a top-down or a bottom-up approach, the
banking organization may be allowed to use the Look-Through Approach,
described below, for determining the A-IRB capital requirement, subject
to supervisory approval and only for a temporary period of time to be
determined in consultation with the organization's primary Federal
supervisor.
Because the Look-Through Approach has limited risk sensitivity, the
Agencies propose that its applicability be restricted to liquidity
facilities that are structured to minimize the extent to which the
facilities provide credit support to the conduit. The Look-Through
Approach would only be available to liquidity facilities that meet the
following criteria:
(a) The facility documentation clearly identifies and limits the
circumstances under which it may be drawn. In particular, the facility
must not be able to cover losses already sustained by the pool of
underlying exposures (for example, to acquire assets from the pool at
above fair value) or be structured such that draw-down is highly
probable (as indicated by regular or continuous draws);
(b) The facility is subject to an asset quality test that prevents
it from being drawn to cover underlying exposures that are in default;
(c) The facility cannot be drawn after all applicable (specific and
program-wide) credit enhancements from which the liquidity facility
would benefit have been exhausted;
(d) Repayment of any draws on the facility (that is, assets
acquired under a purchase agreement or loans made under a lending
agreement) may not represent a subordinated obligation of the pool or
be subject to deferral or waiver; and
(e) Reduction in the maximum drawn amount, or early termination of
the facility, occurs if the quality of the pool falls below investment
grade.
Under the Look-Through Approach, the liquidity facility's A-IRB
capital charge would be computed as the product of (a) 8 percent, (b)
the maximum potential drawdown under the facility, (c) the applicable
credit conversion factor (CCF), and (d) the applicable risk weight. The
CCF would be set at 50 percent if the liquidity facility's original
maturity is one year or less, and at 100 percent if the original
maturity is more than one year. The Agencies propose that the risk
weight be set equal to the risk weight applicable under the general
risk-based capital rules for banking organizations not using the A-IRB
approach (that is, to the underlying assets or obligors after
consideration of collateral or guarantees or, if applicable, external
ratings).
The Agencies seek comment on the proposed treatment of eligible
liquidity facilities, including the qualifying criteria for such
facilities. Does the proposed Look-Through Approach--to be available
as a temporary measure--satisfactorily address concerns that, in
some cases, it may be impractical for providers of liquidity
facilities to apply either the ``bottom-up'' or ``top-down''
approach for calculating KIRB? It would be helpful to understand the
degree to which any potential obstacles are likely to persist.
Feedback also is sought on whether liquidity providers should be
permitted to calculate A-IRB capital charges based on their internal
risk ratings for such facilities in combination with the appropriate
RBA risk weight. What are the advantages and disadvantages of such
an approach, and how might the Agencies address concerns that the
supervisory validation of such internal ratings would be difficult
and burdensome? Under such an approach, would the lack of any
maturity adjustment with the RBA be problematic for assigning
reasonable risk weights to liquidity facilities backed by relatively
short-term receivables, such as trade credit?
Other Considerations
Capital Treatment Absent an A-IRB Approach--The Alternative RBA
For originating banking organizations when there is not a specific
A-IRB treatment for an underlying exposure or group of underlying
exposures, the Agencies propose that a securitization exposure's A-IRB
capital charge be based exclusively on the exposure's external or
inferred credit rating using
[[Page 45939]]
the Alternative RBA.\47\ Under the Alternative RBA, a risk weight of 20
percent is applied to exposures rated AAA to AA-, 50 percent to
exposures rated A+ to A-, and 100 percent to exposures rated BBB+ to
BBB-. Securitization exposures having ratings below investment grade,
or that are non-rated, would be deducted from risk-based capital on a
dollar-for-dollar basis.
\47\ The Alternative RBA does not apply to eligible liquidity
facilities, which may use the Look-Through Approach as described
above. Additionally, the securitization exposures subject to the
Alternative RBA are not limited by the maximum capital requirement
discussed above.
---------------------------------------------------------------------------
Should the A-IRB capital treatment for securitization exposures
that do not have a specific A-IRB treatment be the same for
investors and originators? If so, which treatment should be
applied--that used for investors (the RBA) or originators (the
Alternative RBA)? The rationale for the response would be helpful.
Structures With Early Amortization Provisions
Many securitizations of revolving credit facilities (for example,
credit card accounts) contain provisions that call for the
securitization to be wound down if the excess spread falls below a
certain threshold.\48\ This decrease in excess spread can, in some
cases, be caused by deterioration in the credit quality of the
underlying exposures. An early amortization event can increase a
banking organization's capital needs if any new draws on the revolving
facilities would need to be financed by the banking organization itself
using on-balance-sheet sources of funding. The payment allocations used
to distribute principal and finance charge collections during the
amortization phase of these structures also can expose a banking
organization to greater risk of loss than in other securitization
structures. To account for the risks that early amortization structures
pose to originating banking organizations, the capital treatment
described below would apply to securitizations of revolving credit
facilities containing such features.
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\48\ Excess spread is defined as gross finance charge
collections and other income received by the trust or special
purpose entity (SPE) minus certificate interest, servicing fees,
charge-offs, and other senior trust or SPE expenses.
---------------------------------------------------------------------------
In addition to the A-IRB capital charge an originating banking
organization would incur on the securitization exposures it retains, an
originator would be required to hold capital against all or a portion
of the investors' interest in a securitization when (i) the
organization sells exposures into a securitization that contains an
early amortization feature, and (ii) the underlying exposures sold are
of a revolving nature. The A-IRB capital charge attributed to the
originator that is associated with the investors' interest is
calculated as the product of (a) the A-IRB capital charge that would be
imposed on the entire investors' interest if it were held by the
originating banking organization, and (b) an applicable CCF.
In general, the CCF would depend on whether the early amortization
feature repays investors through a controlled or non-controlled
mechanism, and whether the underlying exposures represent uncommitted
revolving retail facilities that are unconditionally cancellable
without prior notice (for example, credit card receivables) or other
credit lines (for example, revolving corporate facilities).
An early amortization provision would be considered controlled if,
throughout the duration of the securitization transaction, including
the amortization period, there is a pro rata sharing of interest,
principal, expenses, losses, and recoveries based on the balances of
receivables outstanding at the beginning of each month. Further, the
pace of repayment may not be any more rapid than would be allowed
through straight-line amortization over a period sufficient for 90
percent of the total debt outstanding at the beginning of the early
amortization period to have been repaid or recognized as in default. In
addition to these criteria, banking organizations with structures
containing controlled early amortization features would also have to
have appropriate plans in place to ensure that there is sufficient
capital and liquidity available in the event of an early amortization.
When these conditions are not met, the early amortization provision
would be treated as non-controlled.
Determination of CCFs for Controlled Early Amortization Structures
The following method for determining CCFs applies to a
securitization of revolving credit facilities containing a controlled
early amortization mechanism. When the pool of underlying exposures
includes uncommitted retail credit lines (for example, credit card
receivables), an originator would first compare the securitization's
three-month average excess spread against the following two reference
levels:
A. The point at which the banking organization would be required to
trap excess spread under the terms of the securitization; and
B. The excess spread level at which an early amortization would be
triggered.
In cases where a transaction does not require excess spread to be
trapped, the first trapping point would be deemed to be 4.5 percentage
points greater than the excess spread level at which an early
amortization is triggered.
The banking organization would divide the distance between the two
points described above into four equal segments. For example if the
spread trapping point is 4.5 percent and the early amortization trigger
is zero percent, then 4.5 percent would be divided into four equal
segments of 112.5 basis points each. The following conversion factors,
based on illustrative segments, would apply to the investors' interest.
Controlled Early Amortization of Uncommitted Retail Credit Lines
------------------------------------------------------------------------
Credit
Conversion
3-month average excess spread Factor
(CCF)
(percent)
------------------------------------------------------------------------
450 basis points (bp) or more.............................. 0
Less than 450 bp to 337.5 bp............................... 1
Less than 337.5 bp to 225 bp............................... 2
Less than 225 bp to 112.5 bp............................... 20
Less than 112.5 bp......................................... 40
------------------------------------------------------------------------
All other securitizations of revolving facilities (that is, those
containing underlying exposures that are committed or non-retail)
having controlled early amortization features would be subject to a CCF
of 90 percent.
Determination of CCFs for Non-Controlled Early Amortization Structures
The process for determining CCFs when a securitization of revolving
credit facilities contains a non-controlled early amortization
mechanism would be the same as that described above for controlled
early amortization structures, except that different CCFs would apply
to the various excess spread segments. For non-controlled structures,
the following conversion factors, based on illustrative segments, would
apply:
Non-Controlled Early Amortization of Uncommitted Retail Credit Lines
------------------------------------------------------------------------
Credit
Conversion
3-month average excess spread Factor
(CCF)
(percent)
------------------------------------------------------------------------
450 basis points (bp) or more.............................. 0
Less than 450 bp to 337.5 bp............................... 5
[[Page 45940]]
Less than 337.5 bp to 225 bp............................... 10
Less than 225 bp to 112.5 bp............................... 50
Less than 112.5 bp......................................... 100
------------------------------------------------------------------------
All other securitizations of revolving credit facilities (that is,
those containing underlying exposures that are committed or non-retail)
having non-controlled early amortization mechanisms would be subject to
a CCF of 100 percent. In other words, no risk transference would be
recognized for these structures; an originator's A-IRB capital charge
would be the same as if the underlying exposures had not been
securitized.
The Agencies seek comment on the proposed treatment of
securitization of revolving credit facilities containing early
amortization mechanisms. Does the proposal satisfactorily address
the potential risks such transactions pose to originators?
Comments are invited on the interplay between the A-IRB capital
charge for securitization structures containing early amortization
features and that for undrawn lines that have not been securitized.
Are there common elements that the Agencies should consider?
Specific examples would be helpful.
Are proposed differences in CCFs for controlled and non-
controlled amortization mechanisms appropriate? Are there other
factors that the Agencies should consider?
Market-Disruption Eligible Liquidity Facilities
A banking organization would be able to apply a 20 percent CCF to
an eligible liquidity facility that can be drawn only in the event of a
general market disruption (that is, where a capital market instrument
cannot be issued at any price), provided that any advance under the
facility represents a senior secured claim on the assets in the pool. A
banking organization using this treatment would recognize 20 percent of
the A-IRB capital charge required for the facility through use of the
SFA. If the market disruption eligible liquidity facility is externally
rated, a banking organization would be able to rely on the external
rating under the RBA for determining the A-IRB capital requirement
provided the organization assigns a 100 percent CCF rather than a 20
percent CCF to the facility.
Overlapping Credit Enhancements or Liquidity Facilities
In some ABCP or similar programs, a banking organization may
provide multiple facilities that may be drawn under varying
circumstances. The Agencies do not intend that a banking organization
incur duplicative capital requirements against these multiple exposures
as long as, in the aggregate, multiple advances are not permitted
against the same collateral. Rather, a banking organization would be
required to hold capital only once for the exposure covered by the
overlapping facilities (whether they are general liquidity facilities,
eligible liquidity facilities, or the facilities serve as credit
enhancements). Where the overlapping facilities are subject to
different conversion factors, the banking organization would attribute
the overlapping part to the facility with the highest conversion
factor. However, if different banking organizations provide overlapping
facilities, each institution would hold capital against the entire
maximum amount of its facility. That is, there may be some duplication
of capital charges for overlapping facilities provided by multiple
banking organizations.
Servicer Cash Advances
Subject to supervisory approval, servicer cash advances that are
recoverable would receive a zero percent CCF. This treatment would
apply when servicers, as part of their contracts, may advance cash to
the pool to ensure an uninterrupted flow of payments to investors,
provided the servicer is entitled to full reimbursement and this right
is senior to other claims on cash flows from the pool of underlying
exposures.
When providing servicer cash advances, are banking organizations
obligated to advance funds up to a specified recoverable amount? If
so, does the practice differ by asset type? Please provide a
rationale for the response given.
Credit Risk Mitigation
For securitization exposures covered by collateral or guarantees,
the credit risk mitigation rules discussed earlier would apply. For
example, a banking organization may reduce the A-IRB capital charge
when a credit risk mitigant covers first losses or losses on a
proportional basis. For all other cases, a banking organization would
assume that the credit risk mitigant covers the most senior portion of
the securitization exposure (that is, that the most junior portion of
the securitization exposure is uncovered).
V. AMA Framework for Operational Risk
This section describes features of the proposed AMA framework for
measuring the regulatory capital requirement for operational risk.
Under this framework, a banking organization meeting the AMA
supervisory standards would use its internal operational risk
measurement system to calculate its regulatory capital requirement for
operational risk. The discussion below provides background information
on operational risk and the conceptual underpinnings of the AMA,
followed by a discussion of the AMA supervisory standards.\49\
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\49\ For a more detailed discussion of the concepts set forth in
this ANPR and definitions of relevant terms, see the accompanying
interagency ``Supervisory Guidance on Operational Risk Advanced
Measurement Approaches for Regulatory Capital'' (supervisory
guidance) published elsewhere in today's Federal Register.
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The Agencies' general risk-based capital rules do not currently
include an explicit capital charge for operational risk, which is
defined as the risk of loss resulting from inadequate or failed
processes, people, and systems or from external events. When developing
the general risk-based capital rules, the Agencies recognized that
institutions were exposed to non-credit related risks, including
operational risk. Consequently, the Agencies built a ``buffer'' into
the general risk-based capital rules to implicitly cover other risks
such as operational risk. With the introduction of the A-IRB framework
for credit risk in this ANPR, which results in a more risk-sensitive
treatment of credit risk, there is no longer an implicit capital buffer
for other risks.
The Agencies recognize that operational risk is a key risk in
financial institutions, and evidence indicates that a number of factors
are driving increases in operational risk. These include the recent
experience of a number of high-profile, high-severity losses across the
banking industry highlighting operational risk as a major source of
unexpected losses. Because the regulatory capital buffer for
operational risk would be removed under the proposal, the Agencies are
now seeking comment on a risk-sensitive capital framework for the
largest, most complex institutions that would include an explicit risk-
based capital requirement for operational risk. The Agencies propose to
require banking organizations using the A-IRB approach for credit risk
also to use the AMA to compute capital charges for operational risk.
[[Page 45941]]
The Agencies are proposing the AMA to address operational risk
for regulatory capital purposes. The Agencies are interested,
however, in possible alternatives. Are there alternative concepts or
approaches that might be equally or more effective in addressing
operational risk? If so, please provide some discussion on possible
alternatives.
A. AMA Capital Calculation
The AMA capital requirement would be based on the measure of
operational risk exposure generated by a banking organization's
internal operational risk measurement system. In calculating the
operational risk exposure, an AMA-qualified institution would be
expected to estimate the aggregate operational risk loss that it faces
over a one-year period at a soundness standard consistent with a 99.9
percent confidence level. The institution's AMA capital requirement for
operational risk would be the sum of EL and UL, unless the institution
can demonstrate that an EL offset would meet the supervisory standards
for operational risk. The institution would have to use a combination
of internal loss event data, relevant external loss event data,
business environment and internal control factors, and scenario
analysis in calculating its operational risk exposure. The institution
also would be allowed to recognize the effect of risk dependency (for
example, correlation) and, to a limited extent, the effect of insurance
as a risk mitigant.
As with the proposed A-IRB capital requirement for credit risk, the
operational risk exposure would be converted to an equivalent amount of
risk-weighted assets for the calculation of an institution's risk-based
capital ratios. An AMA-qualified institution would multiply the
operational risk exposure generated by its analytical framework by a
factor of 12.5 to convert the exposure to a risk-weighted assets
equivalent. The resulting figure would be added to the comparable
figures for credit and market risk in calculating the institution's
risk-based capital denominator.
Does the broad structure that the Agencies have outlined
incorporate all the key elements that should be factored into the
operational risk framework for regulatory capital? If not, what
other issues should be addressed? Are any elements included not
directly relevant for operational risk measurement or management?
The Agencies have not included indirect losses (for example,
opportunity costs) in the definition of operational risk against
which institutions would have to hold capital; because such losses
can be substantial, should they be included in the definition of
operational risk?
Overview of the Supervisory Criteria
Use of the AMA would be subject to supervisory approval. A banking
organization would have to demonstrate that it has satisfied all
supervisory standards before it would be able to use the AMA for risk-
based capital purposes. The supervisory standards are briefly described
below. Because an institution would have significant flexibility to
develop its own methodology for calculating its risk-based capital
requirement for operational risk, it would be necessary for supervisors
to ensure that the institution's methodology is fundamentally sound. In
addition, because different institutions may adopt different
methodologies for assessing operational risk, the requirement to
satisfy supervisory standards offers some assurance to institutions and
their supervisors that all AMA-qualified institutions would be subject
to a common set of standards.
While the supervisory standards are rigorous, institutions would
have substantial flexibility in terms of how they satisfy the standards
in practice. This flexibility is intended to encourage an institution
to adopt a system that is responsive to its unique risk profile, foster
improved risk management, and allow for future innovation. The Agencies
recognize that operational risk measurement is evolving rapidly and
wish to encourage continued evolution and innovation. Nevertheless, the
Agencies also acknowledge that this flexibility would make cross-
institution comparisons more difficult than if a single supervisory
approach were to be mandated for all institutions. The supervisory
standards outlined below are intended to allow flexibility while also
being sufficiently objective to ensure consistent supervisory
assessment and enforcement of standards across institutions.
The Agencies seek comment on the extent to which an appropriate
balance has been struck between flexibility and comparability for
the operational risk requirement. If this balance is not
appropriate, what are the specific areas of imbalance and what is
the potential impact of the identified imbalance?
The Agencies are considering additional measures to facilitate
consistency in both the supervisory assessment of AMA frameworks and
the enforcement of AMA standards across institutions. Specifically,
the Agencies are considering enhancements to existing interagency
operational and managerial standards to directly address operational
risk and to articulate supervisory expectations for AMA frameworks.
The Agencies seek comment on the need for and effectiveness of these
additional measures.
The Agencies also seek comment on the supervisory standards. Do
the standards cover the key elements of an operational risk
framework?
An institution's operational risk framework would have to include
an independent operational risk management function, line of business
oversight, and independent testing and verification. Both the
institution's board of directors and management would have to have
responsibilities in establishing and overseeing this framework. The
institution would have to have clear policies and procedures in place
for identifying, measuring, monitoring, and controlling operational
risk.
An institution would have to establish an analytical framework that
incorporates internal operational loss event data, relevant external
loss event data, assessments of the business environment and internal
control factors, and scenario analysis. The institution would have to
have standards in place to capture all of these elements. The
combination of these elements would determine the institution's
quantification of operational risk and related regulatory capital
requirement.
The supervisory standards for the AMA have both quantitative and
qualitative elements. Effective operational risk quantification is
critical to the objective of a risk-sensitive capital requirement.
Consequently, a number of the supervisory standards are aimed at
ensuring the integrity of the process by which an institution arrives
at its estimated operational risk exposure.
It is not sufficient, however, to focus solely on operational risk
measurement. If the Agencies are to rely on institutions to determine
their risk-based capital requirements for operational risk, there would
have to be assurances that institutions have in place sound operational
risk management infrastructures. In addition, risk management elements
would be critical inputs into the quantification of operational risk
exposure, that is, operational risk quantification would have to take
into account such risk management elements as the quality of an
institution's internal controls. Likewise, the AMA capital requirement
derived from an institution's quantification methodology would need to
offer incentives for an institution to improve its operational risk
management practices. Ultimately, the Agencies believe that better
operational risk management will enhance operational risk measurement,
and vice versa.
[[Page 45942]]
Corporate Governance
An institution's operational risk framework would have to include
an independent firm-wide operational risk management function, line of
business management oversight, and independent testing and verification
functions. While no specific management structure would be mandated,
all three components would have to be evident.
The institution's board of directors would have to oversee the
development of the firm-wide operational risk framework, as well as
major changes to the framework. Management roles and accountability
would have to be clearly established. The board and management would
have to ensure that appropriate resources have been allocated to
support the operational risk framework.
The independent firm-wide operational risk management function
would be responsible for overseeing the operational risk framework at
the firm level to ensure the development and consistent application of
operational risk policies, processes, and procedures throughout the
institution. This function would have to be independent from line of
business management and the testing and verification functions. The
firm-wide operational risk management function would have to ensure
appropriate reporting of operational risk exposures and loss data to
the board and management.
Lines of business would be responsible for the day-to-day
management of operational risk within each business unit. Line of
business management would have to ensure that internal controls and
practices within their lines of business are consistent with firm-wide
policies and procedures that support the management and measurement of
the institution's operational risk.
The Agencies are introducing the concept of an operational risk
management function, while emphasizing the importance of the roles
played by the board, management, lines of business, and audit. Are
the responsibilities delineated for each of these functions
sufficiently clear and would they result in a satisfactory process
for managing the operational risk framework?
Operational Risk Management Elements
An institution would have to have policies and procedures that
clearly describe the major elements of its operational risk framework,
including identifying, measuring, monitoring, and controlling
operational risk. Management reports would need to be developed to
address both firm-wide and line of business results. These reports
would summarize operational risk exposure, operational loss experience,
and relevant assessments of business environment and internal control
factors, and would have to be produced at least quarterly. Operational
risk reports, which summarize relevant firm-wide operational risk
information, would also have to be provided periodically to senior
management and the board. An institution's internal control system and
practice would have to be adequate in view of the complexity and scope
of its operations. In addition, an institution would be expected to
meet or exceed minimum supervisory standards as set forth in the
Agencies' supervisory policy statements and other guidance.
B. Elements of an AMA Framework
An institution would have to demonstrate that it has adequate
internal loss event data, relevant external loss event data,
assessments of business environments and internal control factors, and
scenario analysis to support its operational risk management and
quantification framework. These inputs would need to be consistent with
the regulatory definition of operational risk. The institution would
have to have clear standards for the collection and modification of
operational risk inputs.
There are a number of standards that banking organizations would
have to meet with respect to internal operational loss data.
Institutions would have to have at least five years of internal
operational risk loss data captured across all material business lines,
events, product types, and geographic locations.\50\ An institution
would have to establish thresholds above which all internal operational
losses would be captured. The New Accord introduces seven loss event
type classifications; the Agencies are not proposing that an
institution would be required to internally manage its operational risk
according to these specific loss event type classifications, but
nevertheless it would have to be able to map its internal loss data to
these loss event categories. The institution would have to provide
consistent treatment for the timing of reporting an operational loss in
its internal data systems. As highlighted earlier in this ANPR, credit
losses caused or exacerbated by operational risk events would be
treated as credit losses for regulatory capital purposes; these would
include fraud-related credit losses.
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\50\ With supervisory approval, a shorter initial observation
period may be acceptable for institutions that are newly authorized
to use an AMA methodology.
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An institution would have to establish and adhere to policies and
procedures that provide for the use of relevant external loss data in
the operational risk framework. External data would be particularly
relevant where an institution's internal loss history is not sufficient
to generate an estimate of major unexpected losses. Management would
have to systematically review external data to ensure an understanding
of industry experience. The Agencies seek comment on the use of
external data and its optimal function in the operational risk
framework.
While internal and external data provide an important historic
picture of an institution's operational risk profile, it is important
that institutions take a forward-looking view as well. Consequently, an
institution would have to incorporate assessments of the business
environment and internal control factors (for example, audit scores,
risk and control assessments, risk indicators, etc.) into its AMA
capital assessment. In addition, an institution would have to
periodically compare its assessment of these factors with actual
operational loss experience.
Another element of the AMA framework is scenario analysis. Scenario
analysis is a systematic process of obtaining expert opinions from
business managers and risk management experts to derive reasoned
assessments of the likelihood and impact of plausible operational
losses consistent with the regulatory soundness standard. While
scenario analysis may rely, to a large extent, on internal or,
especially, external data (for example, where an institution looks to
industry experience to generate plausible loss scenarios), it is
particularly useful where internal and external data do not generate a
sufficient assessment of the institution's operational risk profile.
An institution would be required to have a comprehensive analytical
framework that provides an estimate of the aggregate operational loss
that it faces over a one-year period at a soundness standard consistent
with a 99.9 percent confidence level. The institution would have to
document the rationale for all assumptions underpinning its chosen
analytical framework, including the choice of inputs, distributional
assumptions, and weighting of quantitative and qualitative elements.
The institution would also have to document and justify any subsequent
changes to these assumptions.
An institution's operational risk analytical framework would have
to use a combination of internal operational loss event data, relevant
external
[[Page 45943]]
operational loss event data, business environment and control factors,
as well as scenario analysis. The institution would have to combine
these elements in the manner that most effectively enables it to
quantify its operational risk exposure. The institution would have to
develop an analytical framework that is appropriate to its business
model and risk profile.
Regulatory capital for operational risk would be based on the sum
of EL and UL. There may be instances where an EL offset could be
recognized, but the Agencies believe that this is likely to be
difficult given existing supervisory and accounting standards. The
Agencies have considered both reserving and budgeting as potential
mechanisms for EL offsets. The use of reserves may be hampered by
accounting standards, while budgeting raises concerns about
availability over a one-year time horizon to act as a capital
replacement mechanism. The Agencies are interested in specific examples
of how business practices might be used to offset EL in the operational
risk framework.
An institution would have to document how its chosen analytical
framework accounts for dependence (for example, correlation) among
operational losses across and within business lines. The institution
would have to demonstrate that its explicit and embedded dependence
assumptions are appropriate, and where dependence assumptions are
uncertain, the institution would have to use conservative estimates.
An institution would be able to reduce its operational risk
exposure by no more than 20 percent to reflect the impact of risk
mitigants such as insurance. Institutions would have to demonstrate
that qualifying risk mitigants meet a series of criteria (described in
the supervisory guidance) to assess whether the risk mitigants are
sufficiently capital-like to warrant a reduction of the operational
risk exposure.
The Agencies seek comment on the reasonableness of the criteria
for recognition of risk mitigants in reducing an institution's
operational risk exposure. In particular, do the criteria allow for
recognition of common insurance policies? If not, what criteria are
most binding against current insurance products? Other than
insurance, are there additional risk mitigation products that should
be considered for operational risk?
An institution using an AMA for regulatory capital purposes would
have to use advanced data management practices to produce credible and
reliable operational risk estimates. These practices are comparable to
the data maintenance requirements set forth under the A-IRB approach
for credit risk.
The institution would have to test and verify the accuracy and
appropriateness of the operational risk framework and results. Testing
and verification would have to be done independently of the firm-wide
risk management function and the lines of business.
VI. Disclosure
Market discipline is a key component of the New Accord. The
disclosure requirements summarized below seek to enhance the public
disclosure practices, and thereby the transparency, of advanced
approach organizations. Commenters are encouraged to consult the New
Accord for specifics on the disclosure requirements under
consideration. The Agencies view enhanced market discipline as an
important complement to the advanced approaches to calculating minimum
regulatory capital requirements, which would be heavily based on
internal methodologies. Increased disclosures, especially regarding a
banking organization's use of the A-IRB approach for credit risk and
the AMA for operational risk, would allow a banking organization's
private sector investors to more fully evaluate the institution's
financial condition, risk profile, and capital adequacy. Given better
information, private shareholders and debt holders can better influence
the funding and capital costs of a banking organization. Such actions
would enhance market discipline and supplement supervisory oversight of
the organization's risk-taking and management.
A. Overview
Disclosure requirements would apply to the bank holding company
representing the top consolidated level of the banking group.
Individual banks within the holding company or consolidated group would
not generally be required to fulfill the disclosure requirements set
out below. An exception to the general rule would be that individual
banks and thrifts within a group would still be required to disclose
Tier 1 and total capital ratios and their components (that is, Tier 1,
Tier 2, and Tier 3 capital), as is the case today. In addition, all
banks and thrifts would continue to be required to submit appropriate
information to regulatory authorities (for example, Report of Condition
of Income (Call Reports) or Thrift Financial Reports).\51\
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\51\ In order to meet supervisory responsibilities, the Agencies
plan to collect more detailed information through the supervisory
process or regulatory reports. Much of this information may be
proprietary and accordingly would not be made public.
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The Agencies are proposing a set of disclosure requirements that
would allow market participants to assess key pieces of information
regarding a banking group's capital structure, risk exposures, risk
assessment processes, and ultimately, the capital adequacy of the
institution. Failure to meet these minimum disclosure requirements, if
not corrected, would render a banking organization ineligible to use
the advanced approaches or would otherwise cause the banking
organization to forgo potential capital benefits arising from the
advanced approaches. In addition, other supervisory measures may be
taken if appropriate.
Management would have some discretion to determine the appropriate
medium and location of the required disclosure. Disclosures made in
public financial reports (for example, in financial statements or
Management's Discussion and Analysis included in periodic reports or
SEC filings) or other regulatory reports (for example, FR Y-9C
Reports), could fulfill the applicable disclosure requirements and
would not need to be repeated elsewhere. For those disclosures that are
not made under accounting or other requirements, the Agencies are
seeking comment on the appropriate means of providing this data to
market participants. Institutions would be encouraged to provide all
related information in one location; at a minimum, institutions would
be required to provide a cross reference to the location of the
required disclosures.
The Agencies intend to maximize a banking organization's
flexibility regarding where to make the required disclosures while
ensuring that the information is readily available to market
participants without unnecessary burden. To balance these contrasting
objectives, the Agencies are considering requiring banking
organizations to provide a summary table on their public websites that
indicate where all disclosures may be found. Such an approach also
would allow institutions to cross-reference other web addresses (for
example, those containing public financial reports or regulatory
reports or other risk-oriented disclosures) where certain of the
disclosures are located.
Given longstanding requirements for robust quarterly disclosure in
the United States, and recognizing the potential for rapid change in
risk profiles, the Agencies intend to require that the disclosures be
made on a
[[Page 45944]]
quarterly basis. However, qualitative disclosures that provide a
general summary of a banking organization's risk management objectives
and policies, reporting system, and definitions would be able to be
published on an annual basis, provided any significant changes to these
are disclosed in the interim. When significant events occur, banking
organizations would be required to publish material information as soon
as practicable rather than at the end of the quarter.
The risks to which banking organizations are exposed and the
techniques that they use to identify, measure, monitor, and control
those risks are important factors that market participants consider in
their assessment of an institution. Accordingly, banking organizations
would be required to have a formal disclosure policy approved by the
board of directors that addresses the institution's approach for
determining the disclosures it will make. The policy also would have to
address the associated internal controls and disclosure controls and
procedures. The board of directors and senior management would have to
ensure that appropriate verification of the disclosures takes place and
that effective internal controls and disclosure controls and procedures
are maintained.
Consistent with sections 302 and 404 of the Sarbanes-Oxley Act of
2002, management would have to certify to the effectiveness of internal
controls over financial reporting and disclosure controls and
procedures, and the banking organization's external auditor would have
to attest to management's assertions with respect to internal controls
over financial reporting. The scope of these reports would need to
include all information included in regulatory reports and the
disclosures outlined in this ANPR. Section 36 of the Federal Deposit
Insurance Act has similar requirements. Accordingly, banking
organizations would have to implement a process for assessing the
appropriateness of their disclosures, including validation and
frequency. Unless otherwise required by accounting or auditing
standards, or by other regulatory authorities, the proposed
requirements do not mandate that the new disclosures be audited by an
external auditor for purposes of opining on whether the financial
statements are presented in accordance with GAAP.
B. Disclosure Requirements
Banking organizations would be required to provide disclosures
related to scope of application, capital structure, capital adequacy,
credit risk, equities in the banking book, credit risk mitigation,
asset securitization, market risk, operational risk and interest rate
risk in the banking book. The disclosure requirements are summarized
below.
The required disclosures pertaining to the scope of application of
the advanced approaches would include a description of the entities
found in the consolidated banking group. Additionally, banking
organizations would be required to disclose the methods used to
consolidate them, any major impediments on the transfer of funds or
regulatory capital within the banking group, and specific disclosures
related to insurance subsidiaries.
Capital structure disclosures would provide summary information on
the terms and conditions of the main features of capital instruments
issued by the banking organization, especially in the case of
innovative, complex, or hybrid capital instruments. Quantitative
disclosures include the amount of Tier 1, Tier 2, and Tier 3 capital,
deductions from capital, and total eligible capital.
Capital adequacy disclosures would include a summary discussion of
the banking organization's approach to assessing the adequacy of its
capital to support current and future activities. These requirements
also include a breakdown of the capital requirements for credit,
equity, market, and operational risks. Banking organizations also would
be required to disclose their Tier 1 and total capital ratios for the
consolidated group, as well as those of significant bank or thrift
subsidiaries.
For each separate risk area, a banking organization would describe
its risk management objectives and policies. Such disclosures would
include an explanation of the banking organization's strategies and
processes; the structure and organization of the relevant risk
management function; the scope and nature of risk reporting and/or
measurement systems; and the policies for hedging and/or mitigating
risk and strategies and processes for monitoring the continuing
effectiveness of hedges/mitigants.
The credit risk disclosure regime is intended to enable market
participants to assess the credit risk exposure of A-IRB banking
organizations and the overall applicability of the A-IRB framework,
without revealing proprietary information or duplicating the role of
the supervisor in validating the framework the banking organization has
put into place.
Credit risk disclosures would include breakdowns of the banking
organization's exposures by type of credit exposure, geographic
distribution, industry or counterparty type distribution, residual
contractual maturity, amount and type of impaired and past due
exposures, and reconciliation of changes in the allowances for exposure
impairment.
Banking organizations would provide disclosures discussing the
status of the regulatory acceptance process for the adoption of the A-
IRB approach, including supervisory approval of such transition. The
disclosures would provide an explanation and review of the structure of
internal rating systems and relation between internal and external
ratings; the use of internal estimates other than for A-IRB capital
purposes; the process for managing and recognizing credit risk
mitigation; and, the control mechanisms for the rating system including
discussion of independence, accountability, and rating systems review.
Required qualitative disclosures would include a description of the
internal ratings process and separate disclosures pertaining to the
banking organization's wholesale, retail and equity exposures.
There would be two categories of quantitative disclosures for
credit risk: those that focus on the analysis of risk and those that
focus on the actual results. Risk assessment disclosures would include
the percentage of total credit exposures to which A-IRB disclosures
relate. Also, for each portfolio except retail, the disclosures would
have to provide (1) a presentation of exposures across a sufficient
number of PD grades (including default) to allow for a meaningful
differentiation of credit risk,\52\ and (2) the default weighted-
average LGD for each PD, and the amount of undrawn commitments and
weighted average EAD.\53\ For retail portfolios, banking organization
would provide either \54\ (a) disclosures outlined
[[Page 45945]]
above on a pool basis (that is, the same as for non-retail portfolios),
or (b) analysis of exposures on a pool basis against a sufficient
number of EL grades to allow for a meaningful differentiation of credit
risk.
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\52\ Where banking organizations are aggregating PD grades for
the purposes of disclosure, this would be a representative breakdown
of the distribution of PD grades used in the A-IRB approach.
\53\ Banking organizations need only provide one estimate of EAD
for each portfolio. However, where banking organizations believe it
is helpful, in order to give a more meaningful assessment of risk,
they may also disclose EAD estimates across a number of EAD
categories, against the undrawn exposures to which these relate.
\54\ Banking organizations would normally be expected to follow
the disclosures provided for the non-retail portfolios. However,
banking organizations would be able to adopt EL grades at the basis
of disclosure where they believe this can provide the reader with a
meaningful differentiation of credit risk. Where banking
organizations are aggregating internal grades (either PD/LGD or EL)
for the purposes of disclosure, this should be a representative
breakdown of the distribution of those grades used in the IRB
approach.
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Quantitative disclosures pertaining to historical results would
include actual losses (for example, charge-offs and specific
provisions) in the preceding period for each portfolio and how this
differs from past experience and a discussion of the factors that
affected the loss experience in the preceding period. In addition,
disclosures would include banking organizations' estimates against
actual outcomes over a longer period.\55\ At a minimum, this would
include information on estimates of losses against actual losses in
each portfolio over a period sufficient to allow for a meaningful
assessment of the performance of the internal rating processes. Banking
organizations would further be expected to decompose this to provide
analysis of PD, LGD and EAD estimates against estimates provided in the
quantitative risk assessment disclosures above.\56\
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\55\ For banking organizations implementing the A-IRB and AMA in
2007, the disclosures would be required from year-end-2008; in the
meantime, early adoption would be encouraged. The phased
implementation is to allow banking organizations sufficient time to
build up a longer run of data that will make these disclosures
meaningful. For banking organizations that may adopt the advanced
approaches at a later date, they would also be subject to a one-year
phase in period after which the disclosures would be required.
\56\ Banking organizations would have to provide this further
decomposition where it would allow users greater insight into the
reliability of the estimates provided in the quantitative
disclosures: risk assessment. In particular, banking organizations
should provide this information where there are material differences
between the PD, LGD or EAD estimates given by banking organizations
compared in actual outcomes over the long run. Banking organizations
should also provide explanations for such differences.
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Disclosures for banking book equity positions would include both
balance sheet and fair values, and the types and nature of investments.
The total cumulative realized gains or losses arising from sales and
liquidations would be disclosed, together with total unrealized gains/
losses and any amounts included in Tier 1 and/or Tier 2 capital.
Details on the equity capital requirements would also be disclosed.
Disclosures relating to credit risk mitigation would include a
description of the policies and processes for netting and collateral
valuation and management, and the types of collateral accepted by the
bank. Banking organizations would also be expected to include
information about the main types of guarantor or credit derivative
counterparties, and any risk concentrations arising from the use of a
mitigation technique.
Securitization disclosures would summarize a banking organization's
accounting policies for securitization activities and the current
year's securitization activity. Further, banking organizations would be
expected to disclose the names of the external credit rating providers
used for securitizations. They would also provide details of the
outstanding exposures securitized by the banking organization and
subject to the securitization framework, including impairments and
losses, exposures retained or purchased broken down into risk weight
bands, and aggregate outstanding amounts of securitized revolving
exposures.
Disclosures for market risk would include a description of the
models, stress testing, and backtesting used in assessing market risk,
as well as information on the scope of supervisory acceptance.
Quantitative disclosures would include the aggregate VaR, the high,
mean, and low VaR values over the reporting period, and a comparison of
VaR estimates with actual outcomes.
A key disclosure under the operational risk framework would be a
description of the AMA the banking organization uses, including a
discussion of relevant internal and external factors considered in the
banking organization's measurement approach. In addition, the banking
organization would disclose the operational risk charge before and
after any reduction in capital resulting from the use of insurance or
other potential risk mitigants.
Finally, disclosures relating to interest rate risk in the banking
book would include the nature of that risk, key assumptions made, and
the frequency of risk measurement. They would also include the increase
or decline in earnings or economic value for upward and downward rate
shocks according to management's method for measuring interest rate
risk in the banking book.
The Agencies seek comment on the feasibility of such an approach
to the disclosure of pertinent information and also whether
commenters have any other suggestions regarding how best to present
the required disclosures.
Comments are requested on whether the Agencies' description of
the required formal disclosure policy is adequate, or whether
additional guidance would be useful.
Comments are requested regarding whether any of the information
sought by the Agencies to be disclosed raises any particular
concerns regarding the disclosure of proprietary or confidential
information. If a commenter believes certain of the required
information would be proprietary or confidential, the Agencies seek
comment on why that is so and alternatives that would meet the
objectives of the required disclosure.
The Agencies also seek comment regarding the most efficient
means for institutions to meet the disclosure requirements.
Specifically, the Agencies are interested in comments about the
feasibility of requiring institutions to provide all requested
information in one location and also whether commenters have other
suggestions on how to ensure that the requested information is
readily available to market participants.
VII. Regulatory Analysis
Federal agencies are required to consider the costs, benefits, or
other effects of their regulations for various purposes described by
statute or executive order. In particular, an executive order and
several statutes may require the preparation of detailed analyses of
the costs, benefits, or other effects of rules, depending on threshold
determinations as to whether the rulemaking in question triggers the
substantive requirements of the applicable statute or executive order.
For the reasons described above, the proposed and final rules that
the Agencies may issue to implement the New Accord would represent a
significant change to their current approach to the measurement of
regulatory capital ratios, and the supervision of institutions'
internal risk management processes with respect to capital allocations.
First, in this ANPR, core and opt-in banks would rely on their own
analyses to derive some of the principal inputs that would determine
their regulatory capital requirements. Core and opt-in banks would
incur new costs to create and refine their internal systems and to
attract and train the staff expertise necessary to develop, oversee,
manage and test those systems. Second, the measured regulatory capital
ratios (although not the minimums) would likely change, perhaps
substantially for core and opt-in banks. Third, the Agencies' approach
to supervising capital adequacy would become bifurcated; that is,
general banks would continue to use the general risk-based capital
rules, either in their current form or as modified. As a result, there
may be significant differences in the regulatory capital assigned to a
particular type of asset depending on whether the bank is a core, opt-
in, or general bank. To the extent that an institution's product mix
would be directly affected by a change in the landscape of regulatory
capital requirements, this might also affect the customers of those
institutions due to
[[Page 45946]]
the changes in pricing and market strategies.
The economic impact that would be created by these possibly
unforeseen competitive effects is difficult to estimate, and the
Agencies encourage comment. In particular, the Agencies are interested
in comments on the competitive impact that a change in the regulatory
capital regime applied to large institutions would have relative to the
competitive position of smaller institutions that remain subject to the
general risk-based capital rules. Conversely, if the regulatory burden
of the more prescriptive A-IRB approach applied to core institutions
were so large as to offset the potential for a lower measured capital
requirement for certain exposures, then the competitive position of
large institutions, with respect to both their domestic and
international competitors, might be worsened. The Agencies are also
interested in comments that address the competitive position of
regulated institutions in the United States with respect to financial
service providers, both domestic and foreign, that are not subject to
the same degree of regulatory oversight.
None of the Agencies has yet made the threshold determinations
required by executive order or statute with respect to this ANPR.
Because the proposed approaches to assessing capital adequacy described
in this ANPR are new, the Agencies currently lack information that is
sufficiently specific or complete to permit those determinations to be
made or to prepare any economic analysis that may ultimately be
required. Therefore, this section of the ANPR describes the relevant
executive order and statutes, and asks for comment and information that
will assist in the determination of whether such analyses would be
necessary before the Agencies published proposed or final rules.
Quantitative information would be the most useful to the Agencies.
However, commenters may also provide estimates of costs, benefits, or
other effects, or any other information they believe would be useful to
the Agencies in making the determinations. In addition, commenters are
asked to identify or estimate start-up, or non-recurring, costs
separately from costs or effects they believe would be ongoing.
A. Executive Order 12866
Executive Order 12866 requires preparation of an economic analysis
for agency actions that are ``significant regulatory actions.''
``Significant regulatory actions'' include, among other things,
regulations that ``have an annual effect on the economy of $100 million
or more or adversely affect in a material way the economy, a sector of
the economy, productivity, competition, jobs, the environment, public
health or safety, or state, local, or tribal governments or
communities. * * *'' \57\ Regulatory actions that satisfy one or more
of these criteria are called ``economically significant regulatory
actions.'' E.O. 12866 applies to the OCC and the OTS, but not the Board
or the FDIC. If the OCC or the OTS determines that the rules
implementing the New Accord comprise an ``economically significant
regulatory action,'' then the agency making that determination would be
required to prepare and submit to the Office of Management and Budget's
(OMB) Office of Information and Regulatory Affairs (OIRA) an economic
analysis that includes:
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\57\ Executive Order 12866 (Sept. 30, 1993), 58 FR 51735 (Oct.
4, 1993), as amended by Executive Order 13258, 67 FR 9385 (referred
to hereafter as E.O. 12866). For the complete text of the definition
of ``significant regulatory action,'' see E.O. 12866 at Sec. 3(f).
A ``regulatory action'' is ``any substantive action by an agency
(normally published in the Federal Register) that promulgates or is
expected to lead to the promulgation of a final rule or regulation,
including notices of inquiry, advance notices of proposed
rulemaking, and notices of proposed rulemaking.'' E.O. 12866 at
Sec. (e).
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[sbull] A description of the need for the rules and an explanation
of how they will meet the need;
[sbull] An assessment of the benefits anticipated from the rules
(for example, the promotion of the efficient functioning of the economy
and private markets) together with, to the extent feasible, a
quantification of those benefits;
[sbull] An assessment of the costs anticipated from the rules (for
example, the direct cost both to the government in administering the
regulation and to businesses and others in complying with the
regulation, and any adverse effects on the efficient functioning of the
economy, private markets (including productivity, employment, and
competitiveness)), together with, to the extent feasible, a
quantification of those costs; and
[sbull] An assessment of the costs and benefits of potentially
effective and reasonably feasible alternatives to the planned
regulation (including improving the current regulation and reasonably
viable nonregulatory actions), and an explanation why the planned
regulatory action is preferable to the identified potential
alternatives.\58\
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\58\ The components of the economic analysis are set forth in
E.O. 12866 Sec. 6(a)(3)(C)(i)-(iii). For a description of the
methodology that OMB recommends for preparing an economic analysis,
see Office of Management and Budget, ``Economic Analysis of Federal
Regulations Under Executive Order 12866'' (January 11, 1996). This
publication is available on OMB's Web site at http://www.whitehouse.gov/omb/inforeg/riaguide.html.
OMB recently published
revisions to this publication for comment. See 68 FR 5492 (February
3, 2003).
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For purposes of determining whether this rulemaking would
constitute an ``economically significant regulatory action,'' as
defined by E.O. 12866, and to assist any economic analysis that E.O.
12866 may require, the OCC and the OTS encourage commenters to provide
information about:
[sbull] The direct and indirect costs, for core banks and those
banks who intend to qualify as opt-in banks, of compliance with the
approach described in this ANPR and the related supervisory guidance;
[sbull] The costs, for general banks, of adopting the approach;
[sbull] The effects on regulatory capital requirements for core,
opt-in, and general banks;
[sbull] The effects on competitiveness, in both domestic and
international markets, for core, opt-in, and general banks. This would
include the possible effects on the customers served by these U.S.
institutions through changes in the mix of product offerings and
prices;
[sbull] The economic benefits of the approach for core, opt-in, or
general banks, as measured by lower regulatory capital ratios, and a
potentially more efficient allocation of capital. This might also
include estimates of savings associated with regulatory capital
arbitrage transactions that are currently undertaken in order to
optimize return on capital under the current capital regime. That is,
what estimates might exist to quantify the improvements in market
efficiency from no longer pursuing regulatory capital arbitrage
transactions?
[sbull] The features of the A-IRB approach that provide an
incentive for a bank to seek to qualify to use it, that is, to become
an opt-in bank.
The OCC and the OTS also encourage comment on any alternatives to
the regulatory approaches described in the ANPR that the Agencies
should consider.
B. Regulatory Flexibility Act
The Regulatory Flexibility Act (RFA) generally requires agencies to
prepare a ``regulatory flexibility analysis'' unless the head of the
agency certifies that a regulation will not ``have a significant
economic impact on a substantial number of small entities.'' \59\ The
RFA applies to all of the Agencies.
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\59\ The RFA is codified at 5 U.S.C. 601 et seq.
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The Agencies understand that the RFA has been construed to require
[[Page 45947]]
consideration only of the direct impact on small entities.\60\ The
Small Business Administration (SBA) has said: ``The courts have held
that the RFA requires an agency to perform a regulatory flexibility
analysis of small entity impacts only when a rule directly regulates
them,'' that is, when it directly applies to them.\61\ Since the
proposed approach would directly apply to only a limited number of
large banking organizations, it would appear that the Agencies may
certify that the issuance of this ANPR would not have significant
economic impact on a substantial number of small entities.
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\60\ With respect to banks, the Small Business Administration
(SBA) has defined a small entity to be a bank with total assets of
$150 million or less. 13 CFR Sec. 121.201.
\61\ SBA Office of Advocacy, A Guide for Government Agencies,
``How to Comply with the Regulatory Flexibility Act (May 2003), at
20 (emphasis added). See also Mid-Tex Electric Cooperative, Inc. v.
FERC. 773 F.2d 327, 340-43 (D.C. Cir. 1985) (``[W]e conclude that an
agency may properly certify that no regulatory flexibility analysis
is necessary when it determines that the rule will not have a
significant economic impact on a substantial number of small
entities that are subject to the requirements of the rule.'')
(emphasis added) (construing language in the RFA that was unchanged
by subsequent statutory amendments).
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Do the potential advantages of the A-IRB approach, as measured by
the specific capital requirements on lower-risk loans, create a
competitive inequality for small institutions, which are effectively
precluded from adopting the A-IRB due to stringent qualification
standards? Conversely, would small institutions that remain on the
general risk-based capital rules be at a competitive advantage from
specific capital requirements on higher risk assets vis-[agrave]-vis
advanced approach institutions? How might the Agencies estimate the
effect on credit availability to small businesses or retail customers
of general banks?
C. Unfunded Mandates Reform Act of 1995
The Unfunded Mandates Reform Act of 1995 (UMRA) requires
preparation of a written budgetary impact statement before promulgation
of any rule likely to result in a ``Federal mandate'' that ``may result
in the expenditure by State, local, and tribal governments, in the
aggregate, or by the private sector, of $100,000,000 or more (adjusted
annually for inflation) in any 1 year.'' \62\ A ``Federal mandate''
includes any regulation ``that would impose an enforceable duty upon
the private sector. * * *'' If a budgetary impact statement is
required, the UMRA further requires the agency to identify and consider
a reasonable number of regulatory alternatives before promulgating the
rule in question. The UMRA applies to the OCC and the OTS, but not the
Board or the FDIC.
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\62\ The Unfunded Mandates Reform Act is codified at 2 U.S.C.
1532 et seq.
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The OCC and the OTS have asked for comments and information from
core and opt-in banks on compliance costs and, generally, on
alternative regulatory approaches, for purposes of evaluating what
actions they need to take in order to comply with E.O. 12866. That same
information (with cost information adjusted annually for inflation) is
relevant to those agencies' determination of whether a budgetary impact
statement is necessary pursuant to the UMRA. Commenters are therefore
asked to be mindful of the UMRA requirements when they provide
information about compliance costs and in suggesting alternatives to
the approach described in this ANPR.
D. Paperwork Reduction Act
Each of the Agencies is subject to the Paperwork Reduction Act of
1995 (PRA).\63\ The PRA requires burden estimates that will likely be
based on some of the same information that is necessary to prepare an
economic analysis under E.O. 12866 or an estimate of private sector
expenditures pursuant to the UMRA.
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\63\ 44 U.S.C. Sec. 3501 et seq.
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In particular, an agency may not ``conduct or sponsor'' a
collection of information without conducting an analysis that includes
an estimate of the ``burden'' imposed by the collection. A collection
of information includes, essentially, the eliciting of identical
information--whether through questions, recordkeeping requirements, or
reporting requirements--from ten or more persons. ``Burden'' means the
``time, effort, or financial resources expended by persons to generate,
maintain, or provide information'' to the agency. The rulemaking
initiated by this ANPR will likely impose requirements, either in the
regulations themselves or as part of interagency implementation
guidance, that are covered by the PRA. In order to estimate burden, the
Agencies will need to know, for example, the cost--in terms of time and
money--that mandatory and opt-in banks would have to expend to develop
and maintain the systems, procedures, and personnel that compliance
with the rules would require. With this in mind, to assist in their
analysis of the treatment of retail portfolios and other exposures, the
Agencies intend to request from U.S. institutions additional
quantitative data for which confidential treatment may be requested in
accordance with the Agencies' applicable rules.
While it will be difficult to identify those requirements with
precision before a proposed rule is issued, this notice and the draft
supervisory guidance published elsewhere in today's Federal Register
generally describes aspects of the Agencies' implementation of the New
Accord where new reporting and recordkeeping requirements would be
likely. Commenters are asked to provide any estimates they can
reasonably derive about the time, effort, and financial resources that
will be required to provide the Agencies with the requisite plans,
reports, and records that are described in this notice and in the
supervisory guidance. Commenters also are requested to identify any
activities that will be conducted as a result from the capital and
methodological standards in the framework presented in this ANPR that
would impose new recordkeeping or reporting burden. Commenters should
specify whether certain capital and methodological standards would
necessitate the acquisition or development of new compliance/
information systems or the significant modification of existing
compliance/information systems.
List of Acronyms
ABCP Asset-Backed Commercial Paper
ADC Acquisition, Development, and Construction
AFS Available-for-Sale (securities)
AIG Accord Implementation Group
A-IRB Advanced Internal Ratings-Based (approach for credit risk)
ALLL Allowance for Loan and Lease Losses
AMA Advanced Measurement Approach (for operational risk)
ANPR Advance Notice of Proposed Rulemaking
BIS Bank for International Settlements
BSC Basel Committee on Banking Supervision
CCF Credit Conversion Factor
CDC Community Development Corporations
CEDE Community and Economic Development Entity
CF Commodities Finance
CRE Commercial Real Estate
CRM Credit Risk Mitigation
EAD Exposure at Default
EL Expected Loss
FFIEC Federal Financial Institutions Examination Council
FMI Future Margin Income
GAAP Generally Accepted Accounting Principles
HVCRE High Volatility Commercial Real Estate
IMF International Monetary Fund
[[Page 45948]]
IRB Internal Ratings-Based
KIRB Capital for Underlying Pool of Exposures (securitizations)
LGD Loss Given Default
M Maturity
MDB Multilateral Development Bank
OF Object Finance
OTC Over-the-Counter (derivatives)
PCA Prompt Corrective Action (regulation)
PD Probability of Default
PDF Probability Density Function
PF Project Finance
PFE Potential Future Exposure
PMI Private Mortgage Insurance
PRA Paperwork Reduction Act
PSE Public-Sector Entity
QIS3 Third Quantitative Impact Study
QRE Qualifying Revolving Exposures
R Asset Correlation
RBA Ratings-Based Approach (securitizations)
RFA Regulatory Flexibility Act
S Borrower-Size
SBIC Small Business Investment Company
SFA Supervisory Formula Approach (securitizations)
SL Specialized Lending
SME Small-to Medium-Sized Enterprise
SPE Special Purpose Entity
SSC Supervisory Slotting Criteria
UL Unexpected Loss
UMRA Unfunded Mandates Reform Act
VaR Value at Risk (model)
Dated: July 17, 2003.
John D. Hawke, Jr.,
Comptroller of the Currency.
By order of the Board of Governors of the Federal Reserve
System, July 21, 2003.
Jennifer J. Johnson,
Secretary of the Board.
Dated at Washington, DC, this 11th day of July, 2003.
By order of the Board of Directors.
Federal Deposit Insurance Corporation.
Robert E. Feldman,
Executive Secretary.
Dated: July 18, 2003.
By the Office of Thrift Supervision.
James E. Gilleran,
Director.
[FR Doc. 03-18977 Filed 8-1-03; 8:45 am]
BILLING CODE 4810-33-P
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