[Federal Register: December 7, 2007 (Volume 72, Number 235)] [Rules and Regulations] [Page 69287-69445] From the Federal Register Online via GPO Access [wais.access.gpo.gov] [DOCID:fr07de07-12] [[Page 69287]] ----------------------------------------------------------------------- Part II Department of the Treasury ----------------------------------------------------------------------- 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 Parts 559, 560, 563 and 567 ----------------------------------------------------------------------- Risk-Based Capital Standards: Advanced Capital Adequacy Framework-- Basel II; Final Rule [[Page 69288]] ----------------------------------------------------------------------- DEPARTMENT OF THE TREASURY Office of the Comptroller of the Currency 12 CFR Part 3 [Docket No. OCC-2007-0018] RIN 1557-AC91 FEDERAL RESERVE SYSTEM 12 CFR Parts 208 and 225 [Regulations H and Y; Docket No. R-1261] FEDERAL DEPOSIT INSURANCE CORPORATION 12 CFR Part 325 RIN 3064-AC73 DEPARTMENT OF THE TREASURY Office of Thrift Supervision 12 CFR Parts 559, 560, 563 and 567 RIN 1550-AB56; Docket No. OTS 2007-0021 Risk-Based Capital Standards: Advanced Capital Adequacy Framework -- Basel II 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: Final rule. ----------------------------------------------------------------------- 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 adopting a new risk-based capital adequacy framework that requires some and permits other qualifying banks \1\ to use an internal ratings-based approach to calculate regulatory credit risk capital requirements and advanced measurement approaches to calculate regulatory operational risk capital requirements. The final rule describes the qualifying criteria for banks required or seeking to operate under the new framework and the applicable risk-based capital requirements for banks that operate under the framework. --------------------------------------------------------------------------- \1\ For simplicity, and unless otherwise indicated, this final rule uses the term ``bank'' to include banks, savings associations, and bank holding companies (BHCs). The terms ``bank holding company'' and ``BHC'' refer only to bank holding companies regulated by the Board and do not include savings and loan holding companies regulated by the OTS. --------------------------------------------------------------------------- DATES: This final rule is effective April 1, 2008. FOR FURTHER INFORMATION CONTACT: OCC: Mark Ginsberg, Risk Expert, Capital Policy (202-927-4580) or Ron Shimabukuro, Senior Counsel, Legislative and Regulatory Activities Division (202-874-5090). Office of the Comptroller of the Currency, 250 E Street, SW., Washington, DC 20219. Board: Barbara Bouchard, Deputy Associate Director (202-452-3072 or barbara.bouchard@frb.gov) or Anna Lee Hewko, Senior Supervisory Financial Analyst (202-530-6260 or anna.hewko@frb.gov), Division of Banking Supervision and Regulation; or Mark E. Van Der Weide, Senior 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: Jason C. Cave, Associate Director, Capital Markets Branch, (202) 898-3548, Bobby R. Bean, Chief, Policy Section, Capital Markets Branch, (202) 898-3575, Kenton Fox, Senior Policy Analyst, Capital Markets Branch, (202) 898-7119, Division of Supervision and Consumer Protection; or Michael B. Phillips, Counsel, (202) 898-3581, Supervision and Legislation Branch, Legal Division, Federal Deposit Insurance Corporation, 550 17th Street, NW., Washington, DC 20429. OTS: Michael D. Solomon, Director, Capital Policy, Supervision Policy (202) 906-5654; David W. Riley, Senior Analyst, Capital Policy (202) 906-6669; Austin Hong, Senior Analyst, Capital Policy (202) 906- 6389; or Karen Osterloh, Special Counsel, Regulations and Legislation Division (202) 906-6639, Office of Thrift Supervision, 1700 G Street, NW., Washington, DC 20552. SUPPLEMENTARY INFORMATION: Table of Contents I. Introduction A. Executive Summary of the Final Rule B. Conceptual Overview 1. The IRB Approach for Credit Risk 2. The AMA for Operational Risk C. Overview of Final Rule D. Structure of Final Rule E. Overall Capital Objectives F. Competitive Considerations II. Scope A. Core and Opt-In Banks B. U.S. Subsidiaries of Foreign Banks C. Reservation of Authority D. Principle of Conservatism III. Qualification A. The Qualification Process 1. In General 2. Parallel Run and Transitional Floor Periods B. Qualification Requirements 1. Process and Systems Requirements 2. Risk rating and Segmentation Systems for Wholesale and Retail Exposures Wholesale Exposures Retail Exposures Rating Philosophy Rating and Segmentation Reviews and Updates 3. Quantification of Risk Parameters for Wholesale and Retail Exposures Probability of Default (PD) Loss Given Default (LGD) Expected Loss Given Default (ELGD) Economic Loss and Post-Default Extensions of Credit Economic Downturn Conditions Supervisory Mapping Function Pre-default Reductions in Exposure Exposure at Default (EAD) General Quantification Principles Portfolios With Limited Data or Limited Defaults 4. Optional Approaches That Require Prior Supervisory Approval 5. Operational Risk Operational Risk Data and Assessment System Operational risk Quantification System 6. Data management and maintenance 7. Control and oversight mechanisms Validation Internal Audit Stress Testing 8. Documentation C. Ongoing Qualification D. Merger and Acquisition Transition Provisions IV. Calculation of Tier 1 Capital and Total Qualifying Capital V. Calculation of Risk-Weighted Assets A. Categorization of Exposures 1. Wholesale Exposures 2. Retail Exposures 3. Securitization Exposures 4. Equity Exposures 5. Boundary Between Operational Risk and Other Risks 6. Boundary Between the Final Rule and the Market Risk Rule B. Risk-Weighted Assets for General Credit Risk (Wholesale Exposures, Retail Exposures, On-Balance Sheet Assets that Are Not Defined by Exposure Category, and Immaterial Credit Exposures) 1. Phase 1 -- Categorization of Exposures 2. Phase 2 -- Assignment of Wholesale Obligors and Exposures to Rating Grades and retail exposures to segments Purchased Wholesale Exposures Wholesale Lease Residuals 3. Phase 3 -- Assignment of risk Parameters to Wholesale Obligors and Exposures and Retail Segments 4. Phase 4 -- Calculation of Risk-Weighted Assets 5. Statutory Provisions on the Regulatory Capital Treatment of Certain Mortgage Loans C. Credit Risk Mitigation (CRM) Techniques 1. Collateral 2. Counterparty Credit Risk of Repo-Style Transactions, Eligible Margin Loans, and OTC Derivative Contracts Qualifying master netting agreement [[Page 69289]] EAD for Repo-Style Transactions and Eligible Margin Loans Collateral Haircut Approach Simple VaR Methodology 3. EAD for OTC derivative Contracts Current Exposure Methodology 4. Internal Models Methodology Maturity Under the Internal Models Methodology Collateral Agreements Under the Internal Models Methodology Alternative Methods 5. Guarantees and Credit Derivatives That Cover Wholesale Exposures Eligible Guarantees and Eligible Credit Derivatives PD Substitution Approach LGD Adjustment Approach Maturity Mismatch Haircut Restructuring Haircut Currency Mismatch Haircut Example Multiple Credit Risk Mitigants Double Default Treatment 6. Guarantees and Credit Derivatives That Cover Retail Exposures D. Unsettled Securities, Foreign Exchange, and Commodity Transactions E. Securitization Exposures 1. Hierarchy of Approaches Gains-on-Sale and CEIOs The Ratings-Based Approach (RBA) The Internal Assessment Approach (IAA) The Supervisory Formula Approach (SFA) Deduction Exceptions to the General Hierarchy of Approaches Servicer Cash Advances Amount of a Securitization Exposure Implicit Support Operational Requirements for Traditional Securitizations Clean-Up Calls Additional Supervisory Guidance 2. Ratings-Based Approach (RBA) 3. Internal Assessment Approach (IAA) 4. Supervisory Formula Approach (SFA) General Requirements Inputs to the SFA Formula 5. Eligible Disruption Liquidity Facilities 6. CRM for Securitization Exposures 7. Synthetic Securitizations Background Operational Requirements for Synthetic Securitizations First-Loss Tranches Mezzanine Tranches Super-Senior Tranches 8. Nth-to-Default Credit Derivatives 9. Early Amortization Provisions Background Controlled Early Amortization Non-Controlled Early Amortization Securitization of Revolving Residential Mortgage Exposures F. Equity Exposures 1. Introduction and Exposure Measurement Hedge Transactions Measures of Hedge Effectiveness 2. Simple Risk-Weight Approach (SRWA) Non-Significant Equity Exposures 3. Internal Models Approach (IMA) IMA Qualification Risk-Weighted Assets Under the IMA 4. Equity Exposures to Investment Funds Full Look-Through Approach Simple Modified Look-Through Approach Alternative modified look-through approach VI. Operational Risk VII. Disclosure 1. Overview Comments on the Proposed Rule 2. General Requirements Frequency/Timeliness Location of Disclosures and Audit/Attestation Requirements Proprietary and Confidential Information 3. Summary of Specific Public Disclosure Requirements 4. Regulatory Reporting I. Introduction A. Executive Summary of the Final Rule On September 25, 2006, the agencies issued a joint notice of proposed rulemaking (proposed rule or proposal) (71 FR 55830) seeking public comment on a new risk-based regulatory capital framework for banks.\2\ The agencies previously issued an advance notice of proposed rulemaking (ANPR) related to the new risk-based regulatory capital framework (68 FR 45900, August 4, 2003). The proposed rule was based on a series of releases from the Basel Committee on Banking Supervision (BCBS), culminating in the BCBS's comprehensive June 2006 release entitled ``International Convergence of Capital Measurement and Capital Standards: A Revised Framework'' (New Accord).\3\ The New Accord sets forth a ``three pillar'' framework encompassing risk-based capital requirements for credit risk, market risk, and operational risk (Pillar 1); supervisory review of capital adequacy (Pillar 2); and market discipline through enhanced public disclosures (Pillar 3). The New Accord includes several methodologies for determining a bank's risk- based capital requirements for credit, market, and operational risk. --------------------------------------------------------------------------- \2\ The agencies also issued proposed changes to the risk-based capital rule for market risk in a separate notice of proposed rulemaking (71 FR 55958, September 25, 2006). A final rule on that proposal is under development and will be issued in the near future. \3\ The BCBS is a committee of banking supervisory authorities established by the central bank governors of the G-10 countries in 1975. The BCBS issued the New Accord to modernize its first capital Accord, which was endorsed by the BCBS members in 1988 and implemented by the agencies in 1989. The New Accord, the 1988 Accord, and other documents issued by the BCBS are available through the Bank for International Settlements' Web site at http://www.bis.org . --------------------------------------------------------------------------- The proposed rule included the advanced capital methodologies from the New Accord, including the advanced internal ratings-based (IRB) approach for credit risk and the advanced measurement approaches (AMA) for operational risk (together, the advanced approaches). The IRB approach uses risk parameters determined by a bank's internal systems in the calculation of the bank's credit risk capital requirements. The AMA relies on a bank's internal estimates of its operational risks to generate an operational risk capital requirement for the bank.\4\ --------------------------------------------------------------------------- \4\ The agencies issued draft guidance on the advanced approaches. See 72 FR 9084 (February 28, 2007). --------------------------------------------------------------------------- The agencies now are adopting this final rule implementing a new risk-based regulatory capital framework, based on the New Accord, that is mandatory for some U.S. banks and optional for others. While the New Accord includes several methodologies for determining risk-based capital requirements, the agencies are adopting only the advanced approaches at this time. The agencies received approximately 90 public comments on the proposed rule from banking organizations, trade associations representing the banking or financial services industry, supervisory authorities, and other interested parties. This section of the preamble highlights several fundamental issues that commenters raised about the agencies' proposal and briefly describes how the agencies have responded to those issues in the final rule. More detail is provided in the preamble sections below. Overall, commenters supported the development of the framework and the move to more risk-sensitive capital requirements. One overarching issue, however, was the areas where the proposal differed from the New Accord. Commenters said the divergences generally created competitive problems, raised home-host issues, entailed extra cost and regulatory burden, and did not necessarily improve the overall safety and soundness of banks subject to the rule. Commenters also generally disagreed with the agencies' proposal to adopt only the advanced approaches from the New Accord. Further, commenters objected to the agencies' retention of the leverage ratio, the transitional arrangements in the proposal, and the 10 percent numerical benchmark for identifying material aggregate reductions in risk-based capital requirements to be used for evaluating and responding to capital outcomes during the parallel run and transitional floor periods (discussed below). Commenters also noted numerous technical issues with the proposed rule. As noted in an interagency press release issued July 20, 2007 (Banking Agencies Reach Agreement on Basel II Implementation), the agencies have agreed to eliminate the language from [[Page 69290]] the preamble concerning a 10 percent limitation on aggregate reductions in risk-based capital requirements. The press release also stated that the agencies are retaining intact the transitional floor periods (see preamble sections I.E. and III.A.2.). In addition, while not specifically mentioned in the press release, the agencies are retaining the leverage ratio and the prompt corrective action (PCA) regulations without modification. The final rule adopts without change the proposed criteria for identifying core banks (banks required to apply the advanced approaches) and continues to permit other banks (opt-in banks) to adopt the advanced approaches if they meet the applicable qualification requirements. Core banks are those with consolidated total assets (excluding assets held by an insurance underwriting subsidiary of a bank holding company) of $250 billion or more or with consolidated total on-balance-sheet foreign exposure of $10 billion or more. A depository institution (DI) also is a core bank if it is a subsidiary of another DI or bank holding company that uses the advanced approaches. The final rule also provides that a bank's primary Federal supervisor may determine that application of the final rule is not appropriate in light of the bank's asset size, level of complexity, risk profile, or scope of operations (see preamble sections II.A. and B.). As noted above, the final rule includes only the advanced approaches. The July 2007 interagency press release stated that the agencies have agreed to issue a proposed rule that would provide non- core banks with the option to adopt an approach consistent with the standardized approach included in the New Accord. This new proposal (the standardized proposal) will replace the earlier proposal to adopt the so-called Basel IA option (Basel 1A proposal).\5\ The press release also noted the agencies' intention to finalize the standardized proposal before core banks begin the first transitional floor period under this final rule. --------------------------------------------------------------------------- \5\ 71 FR 77445 (Dec. 26, 2006). --------------------------------------------------------------------------- In response to commenters' concerns that some aspects of the proposed rule would result in excessive regulatory burden without commensurate safety and soundness enhancements, the agencies included a principle of conservatism in the final rule. In general, under this principle, in limited situations, a bank may choose not to apply a provision of the rule to one or more exposures if the bank can demonstrate on an ongoing basis to the satisfaction of its primary Federal supervisor that not applying the provision would, in all circumstances, unambiguously generate a risk-based capital requirement for each such exposure that is greater than that which would otherwise be required under the regulation, and the bank meets other specified requirements (see preamble section II.D.). In the proposal, the agencies modified the definition of default for wholesale exposures from that in the New Accord to address issues commenters had raised on the ANPR. Commenters objected to the agencies' modified definition of default for wholesale exposures, however, asserting that a definition different from the New Accord would result in competitive inequities and significant implementation burden without associated supervisory benefit. In response to these concerns, the agencies have adopted a definition of default for wholesale exposures that is consistent with the New Accord (see preamble section III.B.2.). For retail exposures, the final rule retains the proposed definition of default and clarifies that, subject to certain considerations, a foreign subsidiary of a U.S. bank may, in its consolidated risk-based capital calculations, use the applicable host jurisdiction definition of default for retail exposures of the foreign subsidiary in that jurisdiction (see preamble section III.B.2.). Another concept introduced in the proposal that was not in the New Accord was the expected loss given default (ELGD) risk parameter. ELGD had four functions in the proposed rule--as a component of the calculation of expected credit loss (ECL) in the numerator of the risk- based capital ratios; in the expected loss (EL) component of the IRB risk-based capital formulas; as a floor on the value of the loss given default (LGD) risk parameter; and as an input into a supervisory mapping function. Many commenters objected to the inclusion of ELGD as a departure from the New Accord that would create regulatory burden and competitive inequity. Many commenters also objected to the supervisory mapping function, which the agencies intended as an alternative for banks that were not able to estimate reliably the LGD risk parameter. The agencies have eliminated ELGD from the final rule. Banks are required to estimate only the LGD risk parameter, which reflects economic downturn conditions (see preamble section III.B.3.). The supervisory mapping function also has been eliminated from the rule. Commenters also objected to the agencies' decision not to include a distinct risk weight function for exposures to small- and medium-size enterprises (SMEs) as provided in the New Accord. In the proposal, the agencies noted they were not aware of compelling evidence that smaller firms with the same probability of default (PD) and LGD as larger firms are subject to less systemic risk than is already reflected in the wholesale risk-based capital functions. The agencies continue to believe an SME-specific risk weight function is not supported by sufficient evidence and might give rise to competitive inequities across U.S. banks, and have not adopted such a function in the final rule (see preamble section V.A.1.) With regard to the proposed treatment for securitization exposures, commenters raised a number of technical issues. Many objected to the proposed definition of a securitization exposure, which included exposures to investment funds with material liabilities (including exposures to hedge funds). The agencies agree with commenters that the proposed definition for securitization exposures was quite broad and captured some exposures that would more appropriately be treated under the wholesale or equity frameworks. To limit the scope of the IRB securitization framework, the agencies have modified the definition of traditional securitization in the final rule as described in preamble section V.A.3. Technical issues related to securitization exposures are discussed in preamble sections V.A.3. and V.E. For equity exposures, commenters focused on the proposal's lack of a grandfathering period. The New Accord provides national discretion for each implementing jurisdiction to adopt a grandfather period for equity exposures. Commenters asserted that this omission would result in competitive inequity for U.S. banks as compared to other internationally active institutions. The agencies believe that, overall, the proposal's approach to equity exposures results in a competitive risk-based capital requirement. The final rule does not include a grandfathering provision, and the agencies have adopted the proposed treatment for equity exposures without significant change (see preamble section V.F.). A number of commenters raised issues related to operational risk. Most significantly, commenters noted that activities besides securities processing and credit card fraud have highly predictable and reasonably stable losses and should be considered for operational risk offsets. The agencies believe that the proposed definition of [[Page 69291]] eligible operational risk offsets allows for the consideration of other activities in a flexible and prudent manner and, thus, are retaining the proposed definition in the final rule. Commenters also noted that the proposal appeared to place limits on the use of operational risk mitigants. The agencies have provided flexibility in this regard and under the final rule will take into consideration whether a particular operational risk mitigant covers potential operational losses in a manner equivalent to holding regulatory capital (see preamble sections III.B.5. and V.I.). Many commenters expressed concern that the proposed public disclosures were excessive and would hinder, rather than facilitate, market discipline by requiring banks to disclose information that would not be well understood by or useful to the market. Commenters also expressed concern about possible disclosure of proprietary information. The agencies believe that it is important to retain the vast majority of the proposed disclosures, which are consistent with the New Accord. These disclosures will enable market participants to gain key insights regarding a bank's capital structure, risk exposures, risk assessment processes, and, ultimately, capital adequacy. The agencies have modified the final rule to provide flexibility regarding proprietary information. B. Conceptual Overview This final rule is intended to produce risk-based capital requirements that are more risk-sensitive than those produced under the agencies' existing risk-based capital rules (general risk-based capital rules). In particular, the IRB approach requires banks to assign risk parameters to wholesale exposures and retail segments and provides specific risk-based capital formulas that must be used to transform these risk parameters into risk-based capital requirements. The framework is based on ``value-at-risk'' (VaR) modeling techniques that measure credit risk and operational risk. Because bank risk measurement practices are both continually evolving and subject to uncertainty, the framework should be viewed as an effort to improve the risk sensitivity of the risk-based capital requirements for banks, rather than as an effort to produce a statistically precise measurement of risk. The framework's conceptual foundation is based on the view that risk can be quantified through the estimation of specific characteristics of the probability distribution of potential losses over a given time horizon. This approach assumes that a suitable estimate of that probability distribution, or at least of the specific characteristics to be measured, can be produced. Figure 1 illustrates some of the key concepts associated with the framework. The figure shows a probability distribution of potential losses associated with some time horizon (for example, one year). It could reflect, for example, credit losses, operational losses, or other types of losses. [GRAPHIC] [TIFF OMITTED] TR07DE07.000 The area under the curve to the right of a particular loss amount is the probability of experiencing losses exceeding this amount within a given time horizon. The figure also shows the statistical mean of the loss distribution, which is equivalent to the amount of loss that is ``expected'' over the time horizon. The concept of ``expected loss'' (EL) is distinguished from that of ``unexpected loss'' (UL), which represents potential losses over and above the EL amount. A given level of UL can be defined by reference to a particular percentile threshold of the probability distribution. For example, in the figure UL is measured at the 99.9th percentile level and thus is equal to the value of the loss distribution corresponding to the 99.9th percentile, less the amount of EL. This is shown graphically at the bottom of the figure. The particular percentile level chosen for the measurement of UL is referred to as the ``confidence level'' or the ``soundness standard'' associated with the measurement. If capital is available to cover losses up to and including this percentile level, then the bank should remain solvent in the face of actual losses of that magnitude. Typically, the choice of confidence level or soundness standard reflects a very high percentile level, so that there is a very low estimated probability that actual losses would exceed the UL amount associated with that confidence level or soundness standard. Assessing risk and assigning regulatory capital requirements by reference to a specific percentile of a probability distribution of potential losses is commonly referred to as a VaR approach. Such an approach was adopted by the FDIC, Board, and OCC for assessing a bank's risk-based capital requirements for market risk in 1996 (market risk rule). Under the market risk [[Page 69292]] rule, a bank's own internal models are used to estimate the 99th percentile of the bank's market risk loss distribution over a ten- business-day horizon. The bank's market risk capital requirement is based on this VaR estimate, generally multiplied by a factor of three. The agencies implemented this multiplication factor to provide a prudential buffer for market volatility and modeling uncertainty. 1. The IRB Approach for Credit Risk The conceptual foundation of this final rule's approach to credit risk capital requirements is similar to the market risk rule's approach to market risk capital requirements, in the sense that each is VaR- oriented. Nevertheless, there are important differences between the IRB approach and the market risk rule. The current market risk rule specifies a nominal confidence level of 99.0 percent and a ten- business-day horizon, but otherwise provides banks with substantial modeling flexibility in determining their market risk loss distribution and capital requirements. In contrast, the IRB approach for assessing credit risk capital requirements is based on a 99.9 percent nominal confidence level, a one-year horizon, and a supervisory model of credit losses embodying particular assumptions about the underlying drivers of portfolio credit risk, including loss correlations among different asset types.\6\ --------------------------------------------------------------------------- \6\ The theoretical underpinnings for the supervisory model of credit risk underlying the IRB approach are provided in a paper by Michael Gordy, ``A Risk-Factor Model Foundation for Ratings-Based Bank Capital Rules,'' Journal of Financial Intermediation, July 2003. The IRB formulas are derived as an application of these results to a single-factor CreditMetricsTM-style model. For mathematical details on this model, see Michael Gordy, ``A Comparative Anatomy of Credit Risk Models,'' Journal of Banking and Finance, January 2000, or H.U. Koyluogu and A. Hickman, ``Reconcilable Differences,'' Risk, October 1998. For a less technical overview of the IRB formulas, see the BCBS's ``An Explanatory Note on the Basel II Risk Weight Functions,'' July 2005 (BCBS Explanatory Note). The document can be found on the Bank for International Settlements Web site at http://www.bis.org. --------------------------------------------------------------------------- The IRB approach is broadly similar to the credit VaR approaches used by a number of banks as the basis for their internal assessment of the economic capital necessary to cover credit risk. It is common for a bank's internal credit risk models to consider a one-year loss horizon and to focus on a high loss threshold confidence level. As with the internal credit VaR models used by banks, the output of the risk-based capital formulas in the IRB approach is an estimate of the amount of credit losses above ECL over a one-year horizon that would only be exceeded a small percentage of the time. The agencies believe that a one-year horizon is appropriate because it balances the difficulty of easily or rapidly exiting non-trading positions against the possibility that in many cases a bank can cover credit losses by raising additional capital should the underlying credit problems manifest themselves gradually. The nominal confidence level of the IRB risk-based capital formulas (99.9 percent) means that if all the assumptions in the IRB supervisory model for credit risk were correct for a bank, there would be less than a 0.1 percent probability that credit losses at the bank in any year would exceed the IRB risk-based capital requirement.\7\ --------------------------------------------------------------------------- \7\ Banks' internal economic capital models typically focus on measures of equity capital, whereas the total regulatory capital measure underlying this rule includes not only equity capital, but also certain debt and hybrid instruments, such as subordinated debt. Thus, the 99.9 percent nominal confidence level embodied in the IRB approach is not directly compatable to the nominal solvency standards underpinning banks' economic capital models. --------------------------------------------------------------------------- As noted above, the supervisory model of credit risk underlying the IRB approach embodies specific assumptions about the economic drivers of portfolio credit risk at banks. As with any modeling approach, these assumptions represent simplifications of very complex real-world phenomena and, at best, are only an approximation of the actual credit risks at any bank. If these assumptions (described in greater detail below) are incorrect or otherwise do not characterize a given bank precisely, the actual confidence level implied by the IRB risk-based capital formulas may exceed or fall short of a true 99.9 percent confidence level. In combination with other supervisory assumptions and parameters underlying the IRB approach, the approach's 99.9 percent nominal confidence level reflects a judgmental pooling of available information, including supervisory experience. The framework underlying this final rule reflects a desire on the part of the agencies to achieve (i) risk-based capital requirements that are reflective of relative risk across different assets and that are broadly consistent with maintaining at least an investment-grade rating (for example, at least BBB) on the liabilities funding those assets, even in periods of economic adversity; and (ii) for the U.S. banking system as a whole, aggregate minimum regulatory capital requirements that are not a material reduction from the aggregate minimum regulatory capital requirements under the general risk-based capital rules. A number of important explicit general assumptions and specific parameters are built into the IRB approach to make the framework applicable to a range of banks and to obtain tractable information for calculating risk-based capital requirements. Chief among the assumptions embodied in the IRB approach are: (i) Assumptions that a bank's credit portfolio is infinitely granular; (ii) assumptions that loan defaults at a bank are driven by a single, systematic risk factor; (iii) assumptions that systematic and non-systematic risk factors are log-normal random variables; and (iv) assumptions regarding correlations among credit losses on various types of assets. The specific risk-based capital formulas in this final rule require the bank to estimate certain risk parameters for its wholesale and retail exposures, which the bank may do using a variety of techniques. These risk parameters are PD, LGD, exposure at default (EAD), and, for wholesale exposures, effective remaining maturity (M). The proposed rule included an additional risk parameter, ELGD. As discussed in section III.B.3. of the preamble, the agencies have eliminated the ELGD risk parameter from the final rule. The risk-based capital formulas into which the estimated risk parameters are inserted are simpler than the economic capital methodologies typically employed by banks, which often require complex computer simulations. In particular, an important property of the IRB risk-based capital formulas is portfolio invariance. That is, the risk-based capital requirement for a particular exposure generally does not depend on the other exposures held by the bank. Like the general risk-based capital rules, the total credit risk capital requirement for a bank's wholesale and retail exposures is the sum of the credit risk capital requirements on individual wholesale exposures and segments of retail exposures. The IRB risk-based capital formulas contain supervisory asset value correlation (AVC) factors, which have a significant impact on the capital requirements generated by the formulas. The AVC assigned to a given portfolio of exposures is an estimate of the degree to which any unanticipated changes in the financial conditions of the underlying obligors of the exposures are correlated (that is, would likely move up and down together). High correlation of exposures in a period of economic downturn conditions is an area of supervisory concern. For a portfolio of exposures having the same risk parameters, a larger AVC implies less [[Page 69293]] diversification within the portfolio, greater overall systematic risk, and, hence, a higher risk-based capital requirement.\8\ For example, a 15 percent AVC for a portfolio of residential mortgage exposures would result in a lower risk-based capital requirement than a 20 percent AVC and a higher risk-based capital requirement than a 10 percent AVC. --------------------------------------------------------------------------- \8\ See BCBS Explanatory Note. --------------------------------------------------------------------------- The AVCs that appear in the IRB risk-based capital formulas for wholesale exposures decline with increasing PD; that is, the IRB risk- based capital formulas generally imply that a group of low-PD wholesale exposures are more correlated than a group of high-PD wholesale exposures. Thus, under the rule, a low-PD wholesale exposure would have a higher relative risk-based capital requirement than that implied by its PD were the AVC in the IRB risk-based capital formulas for wholesale exposures fixed rather than a decreasing function of PD. The AVCs included in the IRB risk-based capital formulas for both wholesale and retail exposures reflect a combination of supervisory judgment and empirical evidence.\9\ However, the historical data available for estimating correlations among retail exposures, particularly for non- mortgage retail exposures, was more limited than was the case with wholesale exposures. As a result, supervisory judgment played a greater role. Moreover, the flat 15 percent AVC for residential mortgage exposures is based largely on supervisory experience with and analysis of traditional long-term, fixed-rate mortgages. --------------------------------------------------------------------------- \9\ See BCBS Explanatory Note, section 5.3. --------------------------------------------------------------------------- Several commenters stated that the proposed AVCs for wholesale exposures were too high in general, and a few claimed that, in particular, the AVCs for multi-family residential real estate exposures should be lower. Other commenters suggested that the AVCs of wholesale exposures should be a function of obligor size rather than PD. Similarly, several commenters maintained that the proposed AVCs for retail exposures were too high. Some of these commenters suggested that the AVCs for qualifying revolving exposures (QREs), such as credit cards, should be in the range of 1 to 2 percent, not 4 percent as proposed. Similarly, some of those commenters opposed the proposed flat 15 percent AVC for residential mortgage exposures; one commenter suggested that the agencies should consider employing lower AVCs for home equity loans and lines of credit (HELOCs) to take into account their shorter maturity relative to traditional mortgage exposures. However, most commenters recognized that the proposed AVCs were consistent with those in the New Accord and recommended that the agencies use the AVCs contained in the New Accord to avoid international competitive inequity and unnecessary burden. Several commenters suggested that the agencies should reconsider the AVCs going forward, working with the BCBS. The agencies agree with the prevailing view of the commenters that using the AVCs in the New Accord alleviates a potential source of international inconsistency and implementation burden. The final rule therefore maintains the proposed AVCs. As the agencies gain more experience with the advanced approaches, they may revisit the AVCs for wholesale exposures and retail exposures, along with other calibration issues identified during the parallel run and transitional floor periods (as described below) and make changes to the rule as necessary. The agencies would address this issue working with the BCBS and other supervisory and regulatory authorities, as appropriate. Another important conceptual element of the IRB approach concerns the treatment of ECL. The IRB approach assumes that reserves should cover ECL while capital should cover credit losses exceeding ECL (that is, unexpected credit losses). Accordingly, the final rule, consistent with the proposal and the New Accord, removes ECL from the risk- weighted assets calculation but requires a bank to compare its ECL to its eligible credit reserves (as defined below). If a bank's ECL exceeds its eligible credit reserves, the bank must deduct the excess ECL amount 50 percent from tier 1 capital and 50 percent from tier 2 capital. If a bank's eligible credit reserves exceed its ECL, the bank may include the excess eligible credit reserves amount in tier 2 capital, up to 0.6 percent of the bank's credit risk-weighted assets.\10\ This treatment is intended to maintain a capital incentive to reserve prudently and ensure that ECL over a one-year horizon is covered either by reserves or capital. This treatment also recognizes that prudent reserving that considers probable losses over the life of a loan may result in a bank holding reserves in excess of ECL measured with a one-year horizon. The BCBS calibrated the 0.6 percent limit on inclusion of excess reserves in tier 2 capital to be approximately as restrictive as the existing cap on the inclusion of allowance for loan and lease losses (ALLL) under the 1988 Accord, based on data obtained in the BCBS's Third Quantitative Impact Study (QIS-3).\11\ --------------------------------------------------------------------------- \10\ In contrast, under the general risk-based capital rules, the allowance for loan and lease losses (ALLL) may be included in tier 2 capital up to 1.25 percent of total risk-weighted assets. \11\ BCBS, ``QIS 3: Third Quantitative Impact Study,'' May 2003. --------------------------------------------------------------------------- In developing the New Accord, the BCBS sought broadly to maintain the current overall level of minimum risk-based capital requirements within the banking system. Using data from QIS-3, the BCBS conducted an analysis of the risk-based capital requirements that would be generated under the New Accord. Based on this analysis, the BCBS concluded that a ``scaling factor'' (multiplier) should apply to credit risk-weighted assets. The BCBS, in the New Accord, indicated that the best estimate of the scaling factor was 1.06. In May 2006, the BCBS decided to maintain the 1.06 scaling factor based on the results of a fourth quantitative impact study (QIS-4) conducted in some jurisdictions, including the United States, and a fifth quantitative impact study (QIS-5), not conducted in the United States.\12\ The BCBS noted that national supervisory authorities will continue to monitor capital requirements during implementation of the New Accord, and that the BCBS, in turn, will monitor national experiences with the framework. --------------------------------------------------------------------------- \12\ BCBS press release, ``Basel Committee maintains calibration of Base II Framework,'' May 24, 2006. --------------------------------------------------------------------------- The agencies generally agree with the BCBS regarding calibration of the New Accord. Therefore, consistent with the New Accord and the proposed rule, the final rule contains a scaling factor of 1.06 for credit-risk-weighted assets. As the agencies gain more experience with the advanced approaches, the agencies will revisit the scaling factor along with other calibration issues identified during the parallel run and transitional floor periods (described below) and will make changes to the rule as necessary, working with the BCBS and other supervisory and regulatory authorities, as appropriate. 2. The AMA for Operational Risk The final rule also includes the AMA for determining risk-based capital requirements for operational risk. Under the final rule (consistent with the proposed rule), operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events. This definition of operational risk includes legal risk--which is the risk of loss (including litigation costs, [[Page 69294]] settlements, and regulatory fines) resulting from the failure of the bank to comply with laws, regulations, prudent ethical standards, and contractual obligations in any aspect of the bank's business--but excludes strategic and reputational risks. Under the AMA, a bank must use its internal operational risk management systems and processes to assess its exposure to operational risk. Given the complexities involved in measuring operational risk, the AMA provides banks with substantial flexibility and, therefore, does not require a bank to use specific methodologies or distributional assumptions. Nevertheless, a bank using the AMA must demonstrate to the satisfaction of its primary Federal supervisor that its systems for managing and measuring operational risk meet established standards, including producing an estimate of operational risk exposure that meets a one-year, 99.9th percentile soundness standard. A bank's estimate of operational risk exposure includes both expected operational loss (EOL) and unexpected operational loss (UOL) and forms the basis of the bank's risk-based capital requirement for operational risk. The AMA allows a bank to base its risk-based capital requirement for operational risk on UOL alone if the bank can demonstrate to the satisfaction of its primary Federal supervisor that the bank has eligible operational risk offsets, such as certain operational risk reserves, that equal or exceed the bank's EOL. To the extent that eligible operational risk offsets are less than EOL, the bank's risk- based capital requirement for operational risk must incorporate the shortfall. C. Overview of Final Rule The final rule maintains the general risk-based capital rules' minimum tier 1 risk-based capital ratio of 4.0 percent and total risk- based capital ratio of 8.0 percent. The components of tier 1 and total capital in the final rule are also the same as in the general risk- based capital rules, with a few adjustments described in more detail below. The primary difference between the general risk-based capital rules and the final rule is the methodologies used for calculating risk-weighted assets. Banks applying the final rule generally must use their internal risk measurement systems to calculate the inputs for determining the risk-weighted asset amounts for (i) general credit risk (including wholesale and retail exposures); (ii) securitization exposures; (iii) equity exposures; and (iv) operational risk. In certain cases, however, banks must use external ratings or supervisory risk weights to determine risk-weighted asset amounts. Each of these areas is discussed below. Banks using the final rule also are subject to supervisory review of their capital adequacy (Pillar 2) and certain public disclosure requirements to foster transparency and market discipline (Pillar 3). In addition, each bank using the advanced approaches remains subject to the tier 1 leverage ratio requirement,\13\ and each DI (as defined in section 3 of the Federal Deposit Insurance Act (12 U.S.C. 1813)) using the advanced approaches remains subject to the prompt corrective action (PCA) thresholds.\14\ Banks using the advanced approaches also remain subject to the market risk rule, where applicable. --------------------------------------------------------------------------- \13\ See 12 CFR part 3.6(b) and (c) (national banks); 12 CFR part 208, appendix B (state member banks); 12 CFR part 225, appendix D (bank holding companies); 12 CFR 325.3 (state nonmember banks); 12 CFR 567.2(a)(2) and 567.8 (savings associations). \14\ See 12 CFR part 6 (national banks); 12 CFR part 208, subpart D (state member banks); 12 CFR 325.103 (state nonmember banks); 12 CFR part 565 (savings associations). In addition, savings associations remain subject to the tangible capital requirement at 12 CFR 567.2(a)(3) and 567.9. --------------------------------------------------------------------------- Under the final rule, a bank must identify whether each of its on- and off-balance sheet exposures is a wholesale, retail, securitization, or equity exposure. Assets that are not defined by any exposure category (and certain immaterial portfolios of exposures) generally are assigned risk-weighted asset amounts equal to their carrying value (for on-balance sheet exposures) or notional amount (for off-balance sheet exposures). Wholesale exposures under the final rule include most credit exposures to companies, sovereigns, and other governmental entities. For each wholesale exposure, a bank must assign four quantitative risk parameters: PD (which is expressed as a decimal (that is, 0.01 corresponds to 1 percent) and is an estimate of the probability that an obligor will default over a one-year horizon); LGD (which is expressed as a decimal and reflects an estimate of the economic loss rate if a default occurs during economic downturn conditions); EAD (which is measured in dollars and is an estimate of the amount that would be owed to the bank at the time of default); and M (which is measured in years and reflects the effective remaining maturity of the exposure). Banks may factor into their risk parameter estimates the risk mitigating impact of collateral, credit derivatives, and guarantees that meet certain criteria. Banks must input the risk parameters for each wholesale exposure into an IRB risk-based capital formula to determine the risk-based capital requirement for the exposure. Retail exposures under the final rule include most credit exposures to individuals and small credit exposures to businesses that are managed as part of a segment of exposures with similar risk characteristics and not managed on an individual-exposure basis. A bank must classify each of its retail exposures into one of three retail subcategories--residential mortgage exposures; QREs, such as credit cards and overdraft lines; and other retail exposures. Within these three subcategories, the bank must group exposures into segments with similar risk characteristics. The bank must then assign the risk parameters PD, LGD, and EAD to each retail segment. The bank may take into account the risk mitigating impact of collateral and guarantees in the segmentation process and in the assignment of risk parameters to retail segments. Like wholesale exposures, the risk parameters for each retail segment are used as inputs into an IRB risk-based capital formula to determine the risk-based capital requirement for the segment. For securitization exposures, the bank must apply one of three general approaches, subject to various conditions and qualifying criteria: the Ratings-Based Approach (RBA), which uses external ratings to risk-weight exposures; the Internal Assessment Approach (IAA), which uses internal ratings to risk-weight exposures to asset-backed commercial paper programs (ABCP programs); or the Supervisory Formula Approach (SFA), which uses bank inputs that are entered into a supervisory formula to risk-weight exposures. Securitization exposures in the form of gain-on-sale or credit-enhancing interest-only strips (CEIOs)\15\ and securitization exposures that do not qualify for the RBA, the IAA, or the SFA must be deducted from regulatory capital. --------------------------------------------------------------------------- \15\ A CEIO is an on-balance sheet asset that, in form or in substance, (i) represents the contractual right to receive some or all of the interest and no more than a minimal amount of principal due on the underlying exposures of a securitization and (ii) exposes the holder to credit risk directly or indirectly associated with the underlying exposures that exceeds its pro rata claim on the underlying exposures, whether through subordination provisions or other credit-enhancement techniques. --------------------------------------------------------------------------- Banks may use an internal models approach (IMA) for determining risk-based capital requirements for equity exposures, subject to certain qualifying criteria and floors. If a bank does not have a qualifying internal model for equity exposures, or chooses not to use such a model, the bank must apply a simple risk weight approach (SRWA) in which publicly traded equity exposures [[Page 69295]] generally are assigned a 300 percent risk weight and non-publicly traded equity exposures generally are assigned a 400 percent risk weight. Under both the IMA and the SRWA, equity exposures to certain entities or made pursuant to certain statutory authorities (such as community development laws) are subject to a 0 to 100 percent risk weight. Banks must develop qualifying AMA systems to determine risk-based capital requirements for operational risk. Under the AMA, a bank must use its own methodology to identify operational loss events, measure its exposure to operational risk, and assess a risk-based capital requirement for operational risk. Under the final rule, a bank must calculate its tier 1 and total risk-based capital ratios by dividing tier 1 capital by total risk- weighted assets and by dividing total qualifying capital by total risk- weighted assets, respectively. To calculate total risk-weighted assets, a bank must first convert the dollar risk-based capital requirements for exposures produced by the IRB risk-based capital approaches and the AMA into risk-weighted asset amounts by multiplying the capital requirements by 12.5 (the inverse of the overall 8.0 percent risk-based capital requirement). After determining the risk-weighted asset amounts for credit risk and operational risk, a bank must sum these amounts and then subtract any excess eligible credit reserves not included in tier 2 capital to determine total risk-weighted assets. The final rule contains specific public disclosure requirements to provide important information to market participants on the capital structure, risk exposures, risk assessment processes, and, hence, the capital adequacy of a bank. The public disclosure requirements apply only to the DI or bank holding company representing the top consolidated level of the banking group that is subject to the advanced approaches, unless the entity is a subsidiary of a non-U.S. banking organization that is subject to comparable disclosure requirements in its home jurisdiction. All banks subject to the rule, however, must disclose total and tier 1 risk-based capital ratios and the components of these ratios. The agencies also proposed a package of regulatory reporting templates for the agencies' use in assessing and monitoring the levels and components of bank risk-based capital requirements under the advanced approaches.\16\ These templates will be finalized shortly. --------------------------------------------------------------------------- \16\ 71 FR 55981 (September 25, 2006). --------------------------------------------------------------------------- The agencies are aware that the fair value option in generally accepted accounting principles as used in the United States (GAAP) raises potential risk-based capital issues not contemplated in the development of the New Accord. The agencies will continue to analyze these issues and may make changes to this rule at a future date as necessary. The agencies would address these issues working with the BCBS and other supervisory and regulatory authorities, as appropriate. D. Structure of Final Rule The agencies are implementing a regulatory framework for the advanced approaches in which each agency has an advanced approaches appendix that incorporates (i) definitions of tier 1 and tier 2 capital and associated adjustments to the risk-based capital ratio numerators, (ii) the qualification requirements for using the advanced approaches, and (iii) the details of the advanced approaches.\17\ The agencies also are incorporating their respective market risk rules, by cross- reference.\18\ --------------------------------------------------------------------------- \17\ As applicable, certain agencies are also making conforming changes to existing regulations as necessary to incorporate the new appendices. \18\ 12 CFR part 3, Appendix B (for national banks), 12 CFR part 208, Appendix E (for state member banks), 12 CFR part 225, Appendix E (for bank holding companies), and 12 CFR part 325, Appendix C (for state nonmember banks). OTS intends to codify a market risk rule for savings associations at 12 CFR part 567, Appendix D. --------------------------------------------------------------------------- In this final rule, as in the proposed rule, the agencies are not restating the elements of tier 1 and tier 2 capital, which largely remain the same as under the general risk-based capital rules. Adjustments to the risk-based capital ratio numerators specific to banks applying the final rule are in part II of the rule and explained in greater detail in section IV of this preamble. The final rule has eight parts. Part I identifies criteria for determining which banks are subject to the rule, provides key definitions, and sets forth the minimum risk-based capital ratios. Part II describes the adjustments to the numerator of the regulatory capital ratios for banks using the advanced approaches. Part III describes the qualification process and provides qualification requirements for obtaining supervisory approval for use of the advanced approaches. This part incorporates critical elements of supervisory oversight of capital adequacy (Pillar 2). Parts IV through VII address the calculation of risk-weighted assets. Part IV provides the risk-weighted assets calculation methodologies for wholesale and retail exposures; on-balance sheet assets that do not meet the regulatory definition of a wholesale, retail, securitization, or equity exposure; and certain immaterial portfolios of credit exposures. This part also describes the risk-based capital treatment for over-the-counter (OTC) derivative contracts, repo-style transactions, and eligible margin loans. In addition, this part describes the methodologies for reflecting credit risk mitigation in risk-weighted assets for wholesale and retail exposures. Furthermore, this part sets forth the risk-based capital requirements for failed and unsettled securities, commodities, and foreign exchange transactions. Part V identifies operating criteria for recognizing risk transference in the securitization context and outlines the approaches for calculating risk-weighted assets for securitization exposures. Part VI describes the approaches for calculating risk-weighted assets for equity exposures. Part VII describes the calculation of risk-weighted assets for operational risk. Finally, Part VIII provides public disclosure requirements for banks employing the advanced approaches (Pillar 3). The structure of the preamble generally follows the structure of the regulatory text. Definitions, however, are discussed in the portions of the preamble where they are most relevant. E. Overall Capital Objectives The preamble to the proposed rule described the agencies' intention to avoid a material reduction in overall risk-based capital requirements under the advanced approaches. The agencies also identified other objectives, such as ensuring that differences in capital requirements appropriately reflect differences in risk and ensuring that the U.S. implementation of the New Accord will not be a significant source of competitive inequity among internationally active banks or among domestic banks operating under different risk-based capital rules. The final rule modifies and clarifies the approach the agencies will use to achieve these objectives. The agencies proposed a series of transitional floors to provide a smooth transition to the advanced approaches and to temporarily limit the amount by which a bank's risk-based capital requirements could decline over a period of at least three years. The transitional floors are described in more detail in section III.A.2. of this preamble. The floors generally prohibit a bank's risk-based capital requirement under the advanced approaches from falling below 95 percent, 90 percent, and 85 percent of what it would be under the general risk-based capital [[Page 69296]] rules during the bank's first, second, and third transitional floor periods, respectively. The proposal stated that banks would be required to receive the approval of their primary Federal supervisor before entering each transitional floor period. The preamble to the proposal noted that if there was a material reduction in aggregate minimum regulatory capital upon implementation of the advanced approaches, the agencies would propose regulatory changes or adjustments during the transitional floor periods. The preamble further noted that in this context, materiality would depend on a number of factors, including the size, source, and nature of any reduction; the risk profiles of banks authorized to use the advanced approaches; and other considerations relevant to the maintenance of a safe and sound banking system. The agencies also stated that they would view a 10 percent or greater decline in aggregate minimum required risk-based capital (without reference to the effects of the transitional floors), compared to minimum required risk-based capital as determined under the general risk-based capital rules, as a material reduction warranting modification to the supervisory risk functions or other aspects of the framework. Further, the agencies stated that they were ``identifying a numerical benchmark for evaluating and responding to capital outcomes during the parallel run and transitional floor periods that do not comport with the overall capital objectives.'' The agencies also stated that ``[a]t the end of the transitional floor periods, the agencies would reevaluate the consistency of the framework, as (possibly) revised during the transitional floor periods, with the capital goals outlined in the ANPR and with the maintenance of broad competitive parity between banks adopting the framework and other banks, and would be prepared to make further changes to the framework if warranted.'' The agencies viewed the parallel run and transitional floor periods as ``a trial of the new framework under controlled conditions.'' \19\ --------------------------------------------------------------------------- \19\ 71 FR 55839-40 (September 25, 2006). --------------------------------------------------------------------------- The agencies sought comment on the appropriateness of using a 10 percent or greater decline in aggregate minimum required risk-based capital as a numerical benchmark for material reductions when determining whether capital objectives were achieved. Many commenters objected to the proposed transitional floors and the 10 percent benchmark on the grounds that both safeguards deviated mate