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                                                                                            August 4, 2003

                                                                                            Part II

                                                                                            Department of the
                                                                                            Office of the Comptroller of the
                                                                                            12 CFR Part 3
                                                                                            Federal Reserve System
                                                                                            12 CFR Parts 208 and 225
                                                                                            Federal Deposit Insurance
                                                                                            12 CFR Part 325
                                                                                            Department of the Treasury
                                                                                            Office of Thrift Supervision
                                                                                            12 CFR Part 567

                                                                                            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

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      45900                   Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules

      DEPARTMENT OF THE TREASURY                              Other banking organizations that meet                 Street, NW., Washington, DC between 9
                                                              the criteria, standards, and requirements             a.m. and 4:30 p.m. on business days.
      Office of the Comptroller of the                        also would be eligible to use the                        OTS: Send comments to Regulation
      Currency                                                advanced approaches. Under the                        Comments, Chief Counsel’s Office,
                                                              advanced approaches, banking                          Office of Thrift Supervision, 1700 G
      12 CFR Part 3                                           organizations would use internal                      Street, NW., Washington, DC 20552,
                                                              estimates of certain risk components as               Attention: No. 2003–27. Delivery: Hand
      [Docket No. 03–14]
                                                              key inputs in the determination of their              deliver comments to the Guard’s desk,
      RIN Number 1557–AC48                                    regulatory capital requirements.                      east lobby entrance, 1700 G Street, NW.,
                                                                                                                    from 9 a.m. to 4 p.m. on business days,
                                                              DATES: Comments must be received no
      FEDERAL RESERVE SYSTEM                                                                                        Attention: Regulation Comments, Chief
                                                              later than November 3, 2003.
                                                                                                                    Counsel’s Office, Attention: No. 2003–
      12 CFR Parts 208 and 225                                ADDRESSES:   Comments should be                       27. Facsimiles: Send facsimile
                                                              directed to: OCC: Please direct your                  transmissions to FAX Number (202)
      [Regulations H and Y; Docket No. R–1154]                comments to: Office of the Comptroller                906–6518, Attention: No. 2003–27. E-
                                                              of the Currency, 250 E Street, SW.,                   mail: Send e-mails to
                                                              Public Information Room, Mailstop 1–5,      , Attention:
                                                              Washington, DC 20219, Attention:                      No. 2003–27, and include your name
                                                              Docket No. 03–14; fax number (202)                    and telephone number. Due to
      12 CFR Part 325
                                                              874–4448; or Internet address:                        temporary disruptions in mail service in
      RIN 3064–AC73                                  Due to                   the Washington, DC area, commenters
                                                              delays in paper mail delivery in the                  are encouraged to send comments by fax
      DEPARTMENT OF THE TREASURY                              Washington area, we encourage the                     or e-mail, if possible.
                                                              submission of comments by fax or e-                   FOR FURTHER INFORMATION CONTACT:
      Office of Thrift Supervision                            mail whenever possible. Comments may                     OCC: Roger Tufts, Senior Economic
                                                              be inspected and photocopied at the                   Advisor (202–874–4925 or
      12 CFR Part 567                                         OCC’s Public Information Room, 250 E        , Tanya Smith,
                                                              Street, SW., Washington, DC. You may                  Senior International Advisor (202–874–
      [No. 2003–27]
                                                              make an appointment to inspect                        4735 or, or
      RIN 1550–AB56                                           comments by calling (202) 874–5043.                   Ron Shimabukuro, Counsel (202–874–
                                                                Board: Comments should refer to                     5090 or
      Risk-Based Capital Guidelines;                          Docket No. R–1154 and may be mailed         
      Implementation of New Basel Capital                     to Ms. Jennifer J. Johnson, Secretary,                   Board: Barbara Bouchard, Assistant
      Accord                                                  Board of Governors of the Federal                     Director (202/452–3072 or
      AGENCIES: Office of the Comptroller of                  Reserve System, 20th Street and             , David
      the Currency, Treasury; Board of                        Constitution Avenue, NW., Washington,                 Adkins, Supervisory Financial Analyst
      Governors of the Federal Reserve                        DC 20551. However, because paper mail                 (202/452–5259 or
      System; Federal Deposit Insurance                       in the Washington area and at the Board     , Division of
      Corporation; and Office of Thrift                       of Governors is subject to delay, please              Banking Supervision and Regulation, or
      Supervision, Treasury.                                  consider submitting your comments by                  Mark Van Der Weide, Counsel (202/
                                                              e-mail to                                             452–2263 or
      ACTION: Advance notice of proposed
                                                    , or       , Legal
      rulemaking.                                                                                                   Division. For users of
                                                              faxing them to the Office of the
      SUMMARY: The Office of the Comptroller                  Secretary at (202) 452–3819 or (202)                  Telecommunications Device for the Deaf
      of the Currency (OCC), the Board of                     452–3102. Members of the public may                   (‘‘TDD’’) only, contact 202/263–4869.
      Governors of the Federal Reserve                        inspect comments in Room MP–500 of                       FDIC: Keith Ligon, Chief (202/898–
      System (Board), the Federal Deposit                     the Martin Building between 9 a.m. and                3618 or, Jason Cave,
      Insurance Corporation (FDIC), and the                   5 p.m. weekdays pursuant to § 261.12,                 Chief (202/898–3548 or,
      Office of Thrift Supervision (OTS)                      except as provided by § 261.14, of the                Division of Supervision and Consumer
      (collectively, the Agencies) are setting                Board’s Rules Regarding Availability of               Protection, or Michael Phillips, Counsel
      forth for industry comment their current                Information, 12 CFR 261.12 and 261.14.                (202/898–3581 or
                                                                                                                       OTS: Michael D. Solomon, Senior
      views on a proposed framework for                         FDIC: Written comments should be
                                                                                                                    Program Manager for Capital Policy
      implementing the New Basel Capital                      addressed to Robert E. Feldman,
                                                                                                                    (202/906–5654); David W. Riley, Project
      Accord in the United States. In                         Executive Secretary, Attention:
                                                                                                                    Manager (202/906–6669), Supervision
      particular, this advance notice of                      Comments, Federal Deposit Insurance
                                                                                                                    Policy; or Teresa A. Scott, Counsel
      proposed rulemaking (ANPR) describes                    Corporation, 550 17th Street, NW.,
                                                                                                                    (Banking and Finance) (202/906–6478),
      significant elements of the Advanced                    Washington, DC 20429. Commenters are
                                                                                                                    Regulations and Legislation Division,
      Internal Ratings-Based approach for                     encouraged to submit comments by
                                                                                                                    Office of the Chief Counsel, Office of
      credit risk and the Advanced                            facsimile transmission to (202) 898–
                                                                                                                    Thrift Supervision, 1700 G Street, NW.,
      Measurement Approaches for                              3838 or by electronic mail to
                                                                                                                    Washington, DC 20552.
      operational risk (together, the advanced       Comments also
      approaches). The ANPR specifies                         may be hand-delivered to the guard                    SUPPLEMENTARY INFORMATION:
      criteria that would be used to determine                station at the rear of the 550 17th Street            I. Executive Summary
      banking organizations that would be                     Building (located on F Street) on                        A. Introduction
                                                                                                                       B. Overview of the New Accord
      required to use the advanced                            business days between 8:30 a.m. and 5                    C. Overview of U.S. Implementation
      approaches, subject to meeting certain                  p.m. Comments may be inspected and                       The A–IRB Approach for Credit Risk
      qualifying criteria, supervisory                        photocopied at the FDIC’s Public                         The AMA for Operational Risk
      standards, and disclosure requirements.                 Information Center, Room 100, 801 17th                   Other Considerations

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                              Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules                                             45901

         D. Competitive Considerations                        current U.S. risk-based capital                        reaching a determination on a number
      II. Application of the Advanced Approaches              requirements are based on an                           of issues related to how the New Accord
            in the United States                              internationally agreed framework for                   would be proposed to be implemented
         A. Threshold Criteria for Mandatory                                                                         in the United States. In addition, in light
                                                              capital measurement that was
            Advanced Approach Organizations
         Application of Advanced Approaches at                developed by the Basel Committee on                    of the public comments submitted on
            Individual Bank/Thrift Levels                     Banking Supervision (Basel Supervisors                 the ANPR, the Agencies will seek
         U.S. Banking Subsidiaries of Foreign                 Committee or BSC) and endorsed by the                  appropriate modifications to the New
            Banking Organizations                             G–10 Governors in 1988.2 The                           Accord.
         B. Implementation for Advanced Approach              international framework (1988 Accord)
            Organizations                                                                                            B. Overview of the New Accord
                                                              accomplished several important
         C. Other Considerations                              objectives. It strengthened capital levels                The New Accord encompasses three
         General Banks                                                                                               pillars: minimum regulatory capital
                                                              at large, internationally active banks and
         Majority-Owned or Controlled Subsidiaries                                                                   requirements, supervisory review, and
         Transitional Arrangements                            fostered international consistency and
                                                              coordination. The 1988 Accord also                     market discipline. Under the first pillar,
      III. Advanced Internal Ratings-Based
                                                              reduced disincentives for banks to hold                a banking organization must calculate
            Approach (A–IRB)
         A. Conceptual Overview                               liquid, low-risk assets. Moreover, by                  capital requirements for exposure to
         Expected Losses versus Unexpected Losses             requiring banks to hold capital against                both credit risk and operational risk
         B. A–IRB Capital Calculations                        off-balance-sheet exposures, the 1988                  (and market risk for institutions with
         Wholesale Exposures: Definitions and                 Accord represented a significant step                  significant trading activity). The New
                                                              forward for regulatory capital                         Accord does not change the definition
         Wholesale Exposures: Formulas                                                                               of what qualifies as regulatory capital,
         Wholesale Exposures: Other                           measurement.
                                                                 Although the 1988 Accord has been a                 the minimum risk-based capital ratio, or
            Considerations                                                                                           the methodology for determining capital
         Retail Exposures: Definitions and Inputs             stabilizing force for the international
         Retail Exposures: Formulas                           banking system, the world financial                    charges for market risk. The New
         A–IRB: Other Considerations                          system has become increasingly more                    Accord provides several methodologies
         Purchased Receivables                                complex over the past fifteen years. The               for determining capital requirements for
         Credit Risk Mitigation Techniques                    BSC has been working for several years                 both credit and operational risk. For
         Equity Exposures                                     to develop a new regulatory capital                    credit risk there are two general
         C. Supervisory Assessment of A–IRB                                                                          approaches; the standardized approach
            Framework                                         framework that recognizes new
                                                                                                                     (essentially a package of modifications
         Overview of Supervisory Framework                    developments in financial products,
                                                                                                                     to the 1988 Accord) and the internal
         U.S. Supervisory Review                              incorporates advances in risk
                                                                                                                     ratings-based (IRB) approach (which
      IV. Securitization                                      measurement and management
                                                                                                                     uses an institution’s internal estimates
         A. General Framework                                 practices, and more precisely assesses
         Operational Criteria                                                                                        of key risk drivers to derive capital
                                                              capital charges in relation to risk. On
         Differences Between the General A–IRB                                                                       requirements). Within the IRB approach
                                                              April 29, 2003, the BSC released for
            Framework and the A–IRB Approach for                                                                     there is a foundation methodology, in
                                                              public consultation a document entitled
            Securitization Exposures                                                                                 which certain risk component inputs are
                                                              ‘‘The New Basel Capital Accord’’ (New
         B. Determining Capital Requirements                                                                         provided by supervisors and others are
         General Considerations                               Accord) that sets forth proposed                       supplied by the institutions, and an
         Capital Calculation Approaches                       revisions to the 1988 Accord. The BSC                  advanced methodology (A–IRB), where
         Other Considerations                                 will accept industry comment on the                    institutions themselves provide more
      V. AMA Framework for Operational Risk                   New Accord through July 31, 2003 and                   risk inputs.
         A. AMA Capital Calculation                           expects to issue a final revised Accord
         Overview of the Supervisory Criteria
                                                                                                                        The New Accord provides three
                                                              by the end of 2003. The BSC expects                    methodologies for determining capital
         B. Elements of an AMA Framework                      that the New Accord would have an
      VI. Disclosure                                                                                                 requirements for operational risk; the
                                                              effective date for implementation of                   basic indicator approach, the
         A. Overview
         B. Disclosure Requirements                           December 31, 2006.                                     standardized approach, and the
      VII. Regulatory Analysis                                   Accordingly, the Agencies are                       advanced measurement approaches
         A. Executive Order 12866                             soliciting comment on all aspects of this              (AMA). Under the first two
         B. Regulatory Flexibility Act                        ANPR, which is based on certain                        methodologies, capital requirements for
         C. Unfunded Mandates Reform Act of 1995              proposals in the New Accord.                           operational risk are fixed percentages of
         D. Paperwork Reduction Act                           Comments will assist the Agencies in                   specified, objective risk measures (for
         List of Acronyms
                                                                                                                     example, gross income). The AMA
                                                              regulatory capital as a percentage of both on- and
      I. Executive Summary                                    off-balance-sheet credit exposures with some gross
                                                                                                                     provides the flexibility for an institution
                                                              differentiation based on perceived credit risk. The    to develop its own individualized
      A. Introduction
                                                              Agencies’ capital rules may be found at 12 CFR Part    approach for measuring operational risk,
        In the United States, banks, thrifts,                 3 (OCC), 12 CFR Parts 208 and 225 (Board), 12 CFR      subject to supervisory oversight.
      and bank holding companies (banking                     Part 325 (FDIC), and 12 CFR Part 567 (OTS).               The second pillar of the New Accord,
                                                                 2 The BSC was established in 1974 by the central-
      organizations or institutions) are subject                                                                     supervisory review, highlights the need
                                                              bank governors of the Group of Ten (G–10)
      to minimum regulatory capital                           countries. Countries are represented on the BSC by     for banking organizations to assess their
      requirements. Specifically, U.S. banking                their central bank and also by authorities with bank   capital adequacy positions relative to
      organizations must maintain a                           supervisory responsibilities. Current member           overall risk (rather than solely to the
      minimum leverage ratio and two                          countries are Belgium, Canada, France, Germany,
                                                              Italy, Japan, Luxembourg, the Netherlands, Spain,
                                                                                                                     minimum capital requirement), and the
      minimum risk-based ratios.1 The                         Sweden, Switzerland, the United Kingdom, and the       need for supervisors to review and take
                                                              United States. The 1988 Accord is described in a       appropriate actions in response to those
        1 The leverage ratio measures regulatory capital as   document entitled ‘‘International Convergence of       assessments. The third pillar of the New
      a percentage of total on-balance-sheet assets as        Capital Measurement and Capital Standards.’’ This
      reported in accordance with generally accepted          document and other documents issued by the BSC
                                                                                                                     Accord imposes public disclosure
      accounting principles (GAAP) (with certain              are available through the Bank for International       requirements on institutions that are
      adjustments). The risk-based ratios measure             Settlements website at                    intended to allow market participants to

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      45902                    Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules

      assess key information about an                         additional direct capital charge for                       place sole reliance on the results of
      institution’s risk profile and its                      operational risk.                                          economic capital calculations for
      associated level of capital.                               Under this proposal, some U.S.                          purposes of computing minimum
         The Agencies do not expect the                       banking organizations would use the                        regulatory capital requirements.
      implementation of the New Accord to                     advanced approaches while others                           Banking organizations face risks other
      result in a significant decrease in                     would apply the general risk-based                         than credit and operational risks, and
      aggregate capital requirements for the                  capital rules. As a result, the United                     the assumed loss distributions
      U.S. banking system. Individual banking                 States would have a bifurcated                             underlying banking organizations’
      organizations may, however, face                        regulatory capital framework. That is,                     economic capital calculations are
      increases or decreases in their minimum                 U.S. capital rules would provide two                       subject to the risk of error.
      risk-based capital requirements because                 distinct methodologies for institutions                    Consequently, the Agencies continue to
      the New Accord is more risk sensitive                   to calculate risk-weighted assets (the                     view the leverage ratio tripwires
      than the 1988 Accord and the Agencies’                  denominator of the risk-based capital                      contained in existing PCA and other
      existing risk-based capital rules (general              ratios). Under the proposed framework,                     regulations as important components of
      risk-based capital rules). The Agencies                 all U.S. institutions would continue to                    the regulatory capital framework.
      will continue to analyze the potential                  calculate regulatory capital, the
                                                              numerator of the risk-based capital                        The A–IRB Approach for Credit Risk
      impact of the New Accord on both
      systemic and individual bank capital                    ratios, as they do now. Importantly, U.S.                     Under the A–IRB approach for credit
      levels.                                                 banking organizations would continue                       risk, an institution’s internal assessment
                                                              to be subject to a leverage ratio                          of key risk drivers for a particular
      C. Overview of U.S. Implementation                      requirement under existing regulations,                    exposure (or pool of exposures) would
        The Agencies believe that the                         and Prompt Corrective Action (PCA)                         serve as the primary inputs in the
      advanced risk and capital measurement                   legislation and implementing                               calculation of the institution’s minimum
      methodologies of the New Accord are                     regulations would remain in effect.4 It is                 risk-based capital requirements.
      the most appropriate approaches for                     recognized that in some cases, under the                   Formulas, or risk weight functions,
      large, internationally active banking                   proposed framework, the leverage ratio                     specified by supervisors would use the
      organizations. As a result, large,                      would serve as the most binding                            banking organization’s estimated inputs
      internationally active banking                          regulatory capital constraint.                             to derive a specific dollar amount
      organizations in the United States                         Implementing the capital framework                      capital requirement for each exposure
      would be required to use the A–IRB                      described in this ANPR would raise a                       (or pool of exposures). This dollar
      approach to credit risk and the AMA to                  number of significant practical and                        capital requirement would be converted
      operational risk. The Agencies are                      conceptual issues about the role of                        into a risk-weighted assets equivalent by
      proposing to identify three types of                    economic capital calculations relative to                  multiplying the dollar amount of the
      banking organizations: institutions                     regulatory capital requirements. The                       capital requirement by 12.5—the
      subject to the advanced approaches on                   capital formulas described in this                         reciprocal of the 8 percent minimum
      a mandatory basis (core banks);                         ANPR, as well as the economic capital                      risk-based capital requirement.
      institutions not subject to the advanced                models used by banking organizations,                      Generally, banking organizations using
      approaches on a mandatory basis, but                    assume the ability to assign precisely                     the A–IRB approach would assign assets
      that choose voluntarily to apply those                  probabilities to future credit and                         and off-balance-sheet exposures into
                                                              operational losses that might occur. The                   one of three portfolios: wholesale
      approaches (opt-in banks); and
                                                              term ‘‘economic capital’’ is often used to                 (corporate, interbank, and sovereign),
      institutions that are not mandatorily
                                                              refer to the amount of capital that                        retail (residential mortgage, qualifying
      subject to and do not apply the
                                                              should be allocated to an activity                         revolving, and other), and equities.
      advanced approaches (general banks).
                                                              according to the results of such an                        There also would be specific treatments
      Core banks would be those with total
                                                              exercise. For example, a banking                           for securitization exposures and
      banking (and thrift) assets of $250
                                                              organization might compute the amount                      purchased receivables. Certain assets
      billion or more or total on-balance-sheet
                                                              of income, reserves, and capital that it                   that do not constitute a direct credit
      foreign exposure of $10 billion or more.
                                                              would need to cover the 99.9th                             exposure (for example, premises,
      Both core banks and opt-in banks
                                                              percentile of possible credit losses                       equipment, or mortgage servicing rights)
      (advanced approach banks) would be
                                                              associated with a given type of lending.                   would continue to be subject to the
      required to meet certain infrastructure
                                                              The desired degree of certainty of                         general risk-based capital rules and risk
      requirements (including complying with
                                                              covering losses is related to several                      weighted at 100 percent. A brief
      specified supervisory standards for                     factors including, for example, the                        overview of each A–IRB portfolio
      credit risk and operational risk) and                   banking organization’s target credit                       follows.
      make specified public disclosures before                rating. The higher the loss percentile the
      being able to use the advanced                          institution wishes to provide protection                   Wholesale (Corporate, Interbank, and
      approaches for risk-based regulatory                    against, the less likely the capital held                  Sovereign) Exposures
      capital calculation purposes.3                          by the institution would be insufficient                      Wholesale credit exposures comprise
        General banks would continue to                       to cover losses, and the higher would be                   three types of exposures: corporate,
      apply the general risk-based capital                    the institution’s credit rating.                           interbank, and sovereign. Generally, the
      rules. Because the general risk-based                      While the Agencies intend to move to                    meaning of interbank and sovereign
      capital rules include a buffer for risks                a framework where regulatory capital is                    would be consistent with the general
      not easily quantified (for example,                     more closely aligned to economic                           risk-based capital rules. Corporate
      operational risk and concentration risk),               capital, the Agencies do not intend to                     exposures are exposures to private-
      general banks would not be subject to an                                                                           sector companies; interbank exposures
        3 The
                                                                4 Thus, for example, to be in the well-capitalized
                                                                                                                         are primarily exposures to banks and
              Agencies continue to reserve the right to       PCA category a bank must have at least a 10 percent
      require higher minimum capital levels for               total risk-based capital ratio, a 6 percent Tier I risk-
                                                                                                                         securities firms; and sovereign
      individual institutions, on a case-by-case basis, if    based capital ratio, and a 5 percent leverage ratio.       exposures are those to central
      necessary to address particular circumstances.          The other PCA categories also would not change.            governments, central banks, and certain

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                              Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules                                              45903

      other public-sector entities (PSEs).                    wholesale exposures, for retail                          is referred to as KIRB. If an originating
      Within the wholesale exposure category,                 exposures, an institution would assign a                 banking organization retains a position
      in addition to the treatment for general                common set of inputs (PD, LGD, and                       in a securitization that obligates the
      corporate lending, there would be four                  EAD) to predetermined pools of                           banking organization to absorb losses up
      sub-categories of specialized lending                   exposures, which are typically referred                  to or less than KIRB, the banking
      (SL). These are project finance (PF),                   to as segments, rather than to individual                organization would deduct the retained
      object finance (OF), commodities                        exposures.6 The inputs would be used                     position from capital as is currently
      finance (CF), and commercial real estate                in the risk weight functions to produce                  required under the general risk-based
      (CRE). CRE is further subdivided into                   a capital charge for the associated pool                 capital rules. The general risk-based
      low-asset-correlation CRE, and high-                    of exposures.                                            capital rules, however, require a dollar-
      volatility CRE (HVCRE).                                                                                          for-dollar risk-based capital deduction
         For each wholesale exposure, an                      Equity Exposures
                                                                                                                       for certain residual interests retained by
      institution would assign four                              Banking organizations would use a                     originating banking organizations in
      quantitative risk drivers (inputs): (1)                 market-based internal model for                          asset securitization transactions
      Probability of default (PD), which                      determining capital requirements for                     regardless of amount. The A–IRB
      measures the likelihood that the                        equity exposures in the banking book.                    framework would no longer require
      borrower will default over a given time                 The internal model approach would                        automatic deduction of such residual
      horizon; (2) loss given default (LGD),                  assess capital based on an estimate of                   interests. The amount to be deducted
      which measures the proportion of the                    loss under extreme market conditions.                    would be capped at KIRB for most
      exposure that will be lost if a default                 Some equity exposures, such as                           exposures. For a position in excess of
      occurs; (3) exposure at default (EAD),                  holdings in entities whose debt                          the KIRB threshold, the originating
      which is the estimated amount owed to                   obligations qualify for a zero percent                   banking organization would use an
      the institution at the time of default; and             risk weight, would continue to receive                   external-ratings-based approach (if the
      (4) maturity (M), which measures the                    a zero percent risk weight under the A–                  position has been rated by an external
      remaining economic maturity of the                      IRB approach to equities. Certain other                  rating agency or a rating can be inferred)
      exposure. Institutions generally would                  equity exposures, such as those made                     or a supervisory formula to determine
      be able to take into account credit risk                through a small business investment                      the capital charge for the position.
      mitigation techniques (CRM), such as                    company (SBIC) under the Small                              Non-originating banking organizations
      collateral and guarantees (subject to                   Business Investment Act or a                             that invest in a securitization exposure
      certain criteria), by adjusting their                   community development corporation                        generally would use an external-ratings-
      estimates for PD or LGD. The wholesale                  (CDC) or a community and economic                        based approach (if the exposure has
      A–IRB risk weight function would use                    development entity (CEDE), generally                     been rated by an external rating agency
      all four risk inputs to produce a specific              would be risk weighted at 100 percent                    or a rating can be inferred). For unrated
      capital requirement for each wholesale                  under the A–IRB approach to equities.                    liquidity facilities that banking
      exposure. There would be a separate,                    Banking organizations that are subject to                organizations provide to securitizations,
      more conservative risk weight function                  the Agencies’ market risk capital rules                  capital requirements would be based on
      for certain acquisition, development,                   would continue to apply those rules to                   several factors, including the asset
      and construction loans (ADC) in the                     assess capital against equity positions                  quality of the underlying pool and the
      HVCRE category.                                         held in the trading book.7 Banking                       degree to which other credit
                                                              organizations that are not subject to the                enhancements are available. These
      Retail Exposures
                                                              market risk capital rules would treat                    factors would be used as inputs to a
        Within the retail category, three                     equity positions in the trading account                  supervisory formula. Under the A–IRB
      distinct risk weight functions are                      as if they were in the banking book.                     approach to securitization exposures,
      proposed for three product areas that                                                                            banking organizations also would be
      exhibit different historical loss                       Securitization Exposures
                                                                                                                       required in some cases to hold
      experiences and different asset                           Under the A–IRB treatment for                          regulatory capital against securitizations
      correlations.5 The three retail sub-                    securitization exposures, a banking                      of revolving exposures that have early
      categories would be: (1) Exposures                      organization that originates a                           amortization features.
      secured by residential mortgages and                    securitization would first calculate the
      related exposures; (2) qualifying                       A–IRB capital charge that would have                     Purchased Receivables
      revolving exposures (QRE); and (3) other                been assessed against the underlying                        Purchased receivables, that is, those
      retail exposures. QRE would include                     exposures as if the exposures had not                    that are purchased from another
      unsecured revolving credits (such as                    been securitized. This capital charge                    institution either through a one-off
      credit cards and overdraft lines), and                  divided by the size of the exposure pool                 transaction or as part of an ongoing
      other retail would include most other                                                                            program, would be subject to a two-part
      types of exposures to individuals, as                     6 When the PD, LGD, and EAD parameters are             capital charge: one part is for the credit
      well as certain exposures to small                      assigned separately to individual exposures, it may      risk arising from the underlying
                                                              be referred to as a ‘‘bottom-up’’ approach. When         receivables and the second part is for
      businesses. The key inputs to the three                 those parameters are assigned to predetermined sets
      retail risk weight functions would be a                 of exposures (pools or segments), it may be referred     dilution risk. Dilution risk refers to the
      banking organization’s estimates of PD,                 to as a ‘‘top-down’’ approach.                           possibility that contractual amounts
      LGD, and EAD. There would be no                           7 The market risk capital rules were implemented       payable by the underlying obligors on
      explicit M component to the retail A–                   by the banking agencies in 1996. The market risk         the receivables may be reduced through
                                                              capital rules apply to any banking organization
      IRB risk weight functions. Unlike                       whose trading activity (on a consolidated
                                                                                                                       future cash payments or other credits to
                                                              worldwide basis) equals 10 percent or more of total      the accounts made by the seller of the
        5 Asset correlation is a measure of the tendency      assets, or $1 billion or more. The market risk capital   receivables. The framework for
      for the financial condition of a borrower in a          rules are found at 12 CFR Part 3, Appendix B             determining the capital charge for credit
      banking organization’s portfolio to improve or          (OCC), 12 CFR Parts 208 and 225, Appendix E
      degrade at the same time as the financial condition     (Board), and 12 CFR Part 325, Appendix C (FDIC).
                                                                                                                       risk permits a purchasing organization
      of other borrowers in the portfolio improve or          The OTS, to date, has not adopted the market risk        to use a top-down (pool) approach to
      degrade.                                                capital rules.                                           estimating PDs and LGDs when the

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      45904                   Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules

      purchasing organization is unable to                    incorporated into the credit risk                     requirements, or standards alone.
      assign an internal risk rating to each of               calculations for regulatory capital (and              Supervisors also would evaluate
      the purchased accounts. The capital                     would not be incorporated into                        whether the components of an
      charge for dilution risk would be                       operational risk capital calculations).               institution’s advanced approaches are
      calculated using the wholesale risk                     This would include credit-related fraud               consistent with the overall objective of
      weight function with some additional                    losses. Thus, in the above example, the               sound risk management and
      specified risk inputs.                                  loss from the loan would be attributed                measurement. An institution would
                                                              to credit risk (not operational risk) for             have to use appropriately the advanced
      The AMA for Operational Risk                            regulatory capital purposes. This                     approaches across all material business
        Under the A–IRB approach, capital                     separation between credit and                         lines, portfolios, and geographic regions.
      charges for credit risk would be directly               operational risk is supported by current              Exposures in non-significant business
      calibrated solely for such risk and, thus,              U.S. accounting standards for the                     units as well as asset classes that are
      unlike the 1988 Accord, would not                       treatment of credit risks.                            immaterial in terms of size and
      implicitly include a charge for                            With regard to the boundary between                perceived risk profile may be exempted
      operational risk. As a result, the                      the trading book and the banking book,                from the advanced approaches with
      Agencies are proposing that banking                     for institutions subject to the market risk           supervisory approval. These immaterial
      organizations operating under the A–                    rules, positions currently subject to                 portfolios would be subject to the
      IRB approach also would have to hold                    those rules include all positions held in             general risk-based capital rules.
      regulatory capital for exposure to                      the trading account consistent with                      Proposed supervisory guidance for
      operational risk. The Agencies are                      GAAP. The New Accord proposed                         corporate credit exposures and for
      proposing to define operational risk as                 additional criteria for positions                     operational risk is provided separately
      the risk of losses resulting from                       includable in the trading book for                    from this ANPR in today’s Federal
      inadequate or failed internal processes,                purposes of market risk capital                       Register. The draft supervisory guidance
      people, and systems, or external events.                requirements. The Agencies encourage                  for corporate credit exposures is entitled
      Under the AMA, each banking                             comment on these additional criteria                  ‘‘Supervisory Guidance on Internal-
      organization would be able to use its                   and whether the Agencies should                       Ratings-Based Systems for Corporate
      own methodology for assessing                           consider adopting such criteria (in                   Credit.’’ The guidance includes
      exposure to operational risk, provided                  addition to the GAAP criteria) in                     specified supervisory standards that an
      the methodology is comprehensive and                    defining the trading book under the                   institution’s internal rating system for
      results in a capital charge that is                     Agencies’ market risk capital rules. The              corporate exposures would have to
      reflective of the operational risk                      Agencies are seeking comment on the                   satisfy for the institution to be eligible
      experience of the organization. The                     proposed treatment of the boundaries                  to use the A–IRB approach for credit
      operational risk exposure would be                      between credit, operational, and market               risk. The draft operational risk guidance
      multiplied by 12.5 to determine a risk-                 risk.                                                 is entitled ‘‘Supervisory Guidance on
      weighted assets equivalent, which                                                                             Operational Risk Advanced
                                                              Supervisory Considerations
      would be added to the comparable                                                                              Measurement Approaches for
                                                                 The advanced approaches introduce                  Regulatory Capital.’’ The operational
      amounts for credit and market risk in
                                                              greater complexity to the regulatory                  risk guidance includes identified
      the denominator of the risk-based
                                                              capital framework and would require a                 supervisory standards for an
      capital ratios. The Agencies will be
                                                              high level of sophistication in the                   institution’s AMA framework for
      working closely with institutions over
                                                              banking organizations that implement                  operational risk. The Agencies
      the next few years as operational risk                  the advanced approaches. As a result,
      measurement and management                                                                                    encourage commenters to review and
                                                              the Agencies propose to require core                  comment on the draft guidance pieces
      techniques continue to evolve.                          and opt-in banks to meet certain                      in conjunction with this ANPR. The
      Other Considerations                                    infrastructure requirements and comply                Agencies intend to issue for public
                                                              with specific supervisory standards for               comment supervisory guidance on retail
      Boundary Issues
                                                              credit risk and for operational risk. In              credit exposures, equity exposures, and
         With the introduction of an explicit                 addition, banking organizations would                 securitization exposures over the next
      regulatory capital charge for operational               have to satisfy a set of public disclosure            several months.
      risk, an issue arises about the proper                  requirements as a prerequisite for
      treatment of losses that can be attributed              approval to using the advanced                        Supervisory Review
      to more than one risk factor. For                       approaches. Supervisory guidance for                     As mentioned above, the second pillar
      example, where a loan defaults and the                  each credit risk portfolio type, as well              of the New Accord focuses on
      banking organization discovers that the                 as for operational risk, is being                     supervisory review to ensure that an
      collateral for the loan was not properly                developed to ensure a sufficient degree               institution holds sufficient capital given
      secured, the banking organization’s                     of consistency within the supervisory                 its overall risk profile. The concepts of
      resulting losses would be attributable to               framework, while also recognizing that                Pillar 2 are not new to U.S. banking
      both credit and operational risk. The                   internal systems will differ between                  organizations. U.S. institutions already
      Agencies recognize that these types of                  banking organizations. The goal is to                 are required to hold capital sufficient to
      boundary issues are important and have                  establish a supervisory framework                     meet their risk profiles, and supervisors
      significant implications for how banking                within which all institutions must                    may require that an institution hold
      organizations would compile loss data                   develop their internal systems, leaving               more capital if its current levels are
      sets and compute regulatory capital                     exact details to each institution. In the             deficient or some element of its business
      charges.                                                case of operational risk in particular, the           practices suggest the need for more
         The Agencies are proposing the                       Agencies recognize that measurement                   capital. The Agencies also have the right
      following standard to govern the                        methodologies are still evolving and                  to intervene when capital levels fall to
      boundary between credit and                             flexibility is needed.                                an unacceptable level. Given these long-
      operational risk: A loss event that has                    It is important to note that supervisors           standing elements of the U.S.
      characteristics of credit risk would be                 would not look at compliance with                     supervisory framework, the Agencies

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                              Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules                                             45905

      are not proposing to introduce specific                 ongoing basis. This supervisory                        their minimum risk-based capital
      requirements or guidelines to                           assessment of the internal processes and               charges on some assets and decreases on
      implement Pillar 2. Instead, existing                   controls leading to an institution’s                   others. The results of a Quantitative
      guidance, rules, and regulations would                  internal ratings and other estimates                   Impact Study (QIS3) the BSC conducted
      continue to be enforced and                             must maintain the high level of internal               in late 2002 indicated the potential for
      supplemented as necessary as part of                    risk measurement and management                        the advanced approaches described in
      this proposed new regulatory capital                    processes contemplated in this ANPR.                   this document to produce significant
      framework. However, all institutions                       The BSC’s Accord Implementation                     changes in risk-based capital
      operating under the advanced                            Group (AIG), in which the Agencies                     requirements for specific activities; the
      approaches would be expected by                         play an active role, will seek to ensure               results also varied on an institution-by-
      supervisors to address specific                         that all jurisdictions uniformly apply                 institution basis. The results of QIS3 can
      assumptions embedded in the advanced                    the same high qualitative and                          be found at and
      approaches (such as diversification in                  quantitative standards to internationally              various results of QIS3 are noted at
      credit portfolios), and would be                        active banking institutions. However, to               pertinent places in this ANPR.
      evaluated for their ability to account for              the extent that different supervisory                     The Agencies do not believe the
      deviations from the underlying                          regimes implement these standards                      results of QIS3 are sufficiently reliable
      assumptions in their own portfolios.                    differently, there may be competitive                  to form the basis of a competitive
                                                              dislocations. One concern is that the                  impact analysis, both because the inputs
      Disclosure                                              U.S. supervisory regime will impose                    to the study were provided on a best-
         An integral part of the advanced                     greater scrutiny in its implementation                 efforts basis and because the proposals
      approaches is enhanced public                           standards, particularly given the                      in this ANPR are in some cases different
      disclosure practices and improved                       extensive on-site presence of bank                     than those that formed the basis of QIS3.
      transparency. Under the Agencies’                       examiners in the United States.                        The Agencies are nevertheless
      proposal, specific disclosure                              Quite distinct from the need for a                  interested in views on how changes in
      requirements would be applicable to all                 level playing field among                              regulatory capital (for the total of credit
      institutions using the advanced                         internationally active institutions are                and operational risk) of the magnitude
      approaches. These disclosure                            the competitive concerns of those                      described in QIS3, if such changes were
      requirements would encompass capital,                   institutions that do not elect to adopt or             in fact realized, would affect the
      credit risk, equities, credit risk                      may not qualify for the advanced                       competitive landscape for domestic
      mitigation, securitization, market risk,                approaches. Some banking                               banking organizations.
      operational risk, and interest rate risk in             organizations have expressed concerns                     The Agencies plan to conduct at least
      the banking book.                                       that small or regional banks would                     one more QIS, and potentially other
                                                              become more likely to be acquired by                   economic impact analyses, to better
      D. Competitive Considerations
                                                              larger organizations seeking to lever                  understand the potential impact of the
         It is essential that the Agencies gain               capital efficiencies. There also is a                  proposed framework on the capital
      a full appreciation of the possible                     qualitative concern about the impact of                requirements for individual U.S.
      competitive equity concerns that may be                 being considered a ‘‘second tier’’                     banking organizations and U.S. banking
      presented by the establishment of a new                 institution (one that does not implement               organizations as a whole. This may
      capital framework. The creation of a                    the advanced approaches) by the                        affect the Agencies’ further proposals
      bifurcated capital framework in the                     market, rating agencies, or sophisticated              through recalibrating the A–IRB risk
      United States—one set of capital                        customers such as government or                        weight formulas and making other
      standards applicable to large,                          municipal depositors and borrowers.                    modifications to the proposed
      internationally active banking                          Finally, there is the question of what, if             approaches if the capital requirements
      organizations (and those that choose to                 any, competitive distortions might be                  do not seem consistent with the overall
      apply the advanced approaches), and                     introduced by differences in regulatory                risk profiles of banking organizations or
      another set of standards applicable to all              capital minimums between the                           safe and sound banking practices.
      other institutions—has created concerns                 advanced approaches and the general                       If competitive effects of the New
      among some parties about the potential                  risk-based capital rules for loans or                  Accord are determined to be significant,
      impact on competitive equity between                    securities with otherwise similar risk                 the Agencies would need to consider
      the two sets of banking organizations.                  characteristics, and the extent to which               potential ways to address those effects
      Similarly, differences in supervisory                   such distortions may be mitigated in an                while continuing to seek to achieve the
      application of the advanced approaches                  environment in which well-managed                      objectives of the current proposal.
      (both within the United States and                      banking organizations continue to hold                 Alternatives could potentially include
      abroad) among large, internationally                    excess capital.8                                       modifications to the proposed
      active institutions may pose competitive                   Because the advanced framework                      approaches, as well as fundamentally
      equity issues among such institutions.                  described in this ANPR is more risk-                   different approaches. The Agencies
         The New Accord relies upon                           sensitive than the 1988 Accord and the                 recognize that an optimal capital system
      compliance with certain minimum                         general risk-based capital rules, banking              must strike a balance between the
      operational and supervisory                             organizations under the advanced                       objectives of simplicity and regulatory
      requirements to promote consistent                      approaches would face increases in                     consistency across banking
      interpretation and uniformity in                                                                               organizations on the one hand, and the
      application of the advanced approaches.                    8 The Agencies note that under the general risk-
                                                                                                                     degree of risk sensitivity of the
      Nevertheless, independent supervisory                   based capital rules some institutions currently are    regulation on the other. There are many
                                                              able to hold less capital than others on some types
      judgment will be applied on a case-by-                  of assets (for example, through innovative financing   criteria that must be evaluated in
      case basis. These processes, albeit                     structures or use of credit risk mitigation            achieving this balance, including the
      subject to detailed and explicit                        techniques). In addition, some institutions may        resulting incentives for improving risk
                                                              hold lower amounts of capital because the market
      supervisory guidance, contain an                        perceives them as highly diversified, while others
                                                                                                                     measurement and management
      inherent amount of subjectivity and                     hold higher amounts of capital because of              practices, the ease of supervisory and
      must be assessed by supervisors on an                   concentrations of credit risk or other factors.        regulatory enforcement, the degree to

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      45906                   Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules

      which the overall level of regulatory                   achieving the goal of better matching                 to be a core bank unless it could
      capital in the banking system is broadly                regulatory capital to economic risks? Are             demonstrate to its primary Federal
      preserved, and the effects on domestic                  there specific modifications to the proposed          supervisor that it has substantially and
                                                              approaches or to the general risk-based
      and international competition. The                                                                            permanently downsized and should no
                                                              capital rules that the Agencies should
      Agencies are interested in commenters’                  consider?                                             longer be a core bank. The Agencies are
      views on alternatives to the advanced                                                                         proposing an annual test for assessing
      approaches that could achieve this                      II. Application of the Advanced                       banking organizations in reference to
      balance, and in particular on                           Approaches in the United States                       the threshold levels. However, as a
      alternatives that could do so without a                                                                       banking organization approaches either
                                                                 By its terms, the 1988 Accord applied              of the threshold levels the Agencies
      bifurcated approach.9
         The Agencies are committed to                        only to internationally active banks.                 would expect to have ongoing dialogue
      investigate the full scope of possible                  Under the New Accord, the scope of                    with that organization to ensure that
                                                              application has been broadened also to                appropriate practices are in place or are
      competitive impact and welcome all
                                                              encompass bank holding companies that                 actively being developed to prepare the
      comments in this regard. Some
                                                              are parents of internationally active                 organization for implementation of the
      questions are suggested below that may
                                                              ‘‘banking groups.’’                                   advanced approaches.
      serve to focus commenters’ general
      reactions. More specific questions also                 A. Threshold Criteria for Mandatory                     Institutions that by expansion or
      are suggested throughout this ANPR.                     Advanced Approach Organizations                       merger meet the threshold levels must
      These questions should not be viewed                                                                          qualify for use of the advanced
                                                                The Agencies believe that for large,
      as limiting the Agencies’ areas of                                                                            approaches and would be subject to the
                                                              internationally active U.S. institutions
      interest or commenters’ submissions on                                                                        same implementation plan requirements
                                                              only the advanced approaches are
      the proposals. The Agencies encourage                                                                         and minimum risk-based capital floors
                                                              appropriate. Accordingly, the Agencies
      commenters to provide supporting data                                                                         applicable to core and opt-in banks as
                                                              intend to identify three groups of
      and analysis, if available.                                                                                   described below. Institutions that seek
                                                              banking organizations: (1) Large,
                                                                                                                    to become opt-in banks would be
         What are commenters’ views on the                    internationally active banking
                                                                                                                    expected to notify their primary Federal
      relative pros and cons of a bifurcated                  organizations that would be subject to
      regulatory capital framework versus a single                                                                  supervisors well in advance of the date
                                                              the A–IRB approach and AMA on a
      regulatory capital framework? Would a                                                                         by which they expect to qualify for the
                                                              mandatory basis (core banks); (2)
      bifurcated approach lead to an increase in                                                                    advanced approaches. Based on the
                                                              organizations not subject to the
      industry consolidation? Why or why not?                                                                       aforementioned threshold levels, the
      What are the competitive implications for               advanced approaches on a mandatory
                                                                                                                    Agencies anticipate at this time that
      community and mid-size regional banks?                  basis, but that voluntarily choose to
                                                                                                                    approximately ten U.S. institutions
      Would institutions outside of the core group            adopt those approaches (opt-in banks);
                                                                                                                    would be core banks.
      be compelled for competitive reasons to opt-            and all remaining organizations that are
      in to the advanced approaches? Under what               not mandatorily subject to and do not                 Application of Advanced Approaches at
      circumstances might this occur and what are             apply the advanced approaches (general                Individual Bank/Thrift Levels
      the implications? What are the competitive              banks).
      implications of continuing to operate under                                                                      The Agencies are aware that some
                                                                For purposes of identifying core                    institutions might, on a consolidated
      a regulatory capital framework that is not risk         banks, the Agencies are proposing a set
      sensitive?                                                                                                    basis, exceed one of the threshold levels
         If regulatory minimum capital
                                                              of objective criteria for industry                    for mandatory application of the A–IRB
      requirements declined under the advanced                consideration. Specifically, the
                                                                                                                    approach and AMA and, yet, might be
      approaches, would the dollar amount of                  Agencies are proposing to treat as a core
                                                                                                                    comprised of distinct bank and thrift
      capital held by advanced approach banking               bank any banking organization that has
                                                                                                                    charters whose respective sizes fall well
      organizations also be expected to decline? To           (1) total commercial bank (and thrift)
      the extent that advanced approach
                                                                                                                    below the thresholds. In those cases, the
                                                              assets of $250 billion or more, as
      institutions have lower capital charges on                                                                    Agencies believe that all bank and thrift
                                                              reported on year-end regulatory reports
      certain assets, how probable and significant                                                                  institutions that are members of a
                                                              (with banking assets of consolidated
      are concerns that those institutions would                                                                    consolidated group that is itself a core
                                                              groups aggregated at the U.S. bank
      realize competitive benefits in terms of                                                                      bank or an opt-in bank should calculate
      pricing credit, enhanced returns on equity,             holding company level); 10 or (2) total
                                                                                                                    and report their risk-based capital
      and potentially higher risk-based capital               on-balance-sheet foreign exposure of
                                                                                                                    requirements under the advanced
      ratios? To what extent do similar effects               $10 billion or more, as reported on the
                                                                                                                    approaches. However, recognizing that
      already exist under the current general risk-           year-end Country Exposure Report
      based capital rules (for example, through
                                                                                                                    separate bank and thrift charters may, to
                                                              (FFIEC 009) (with foreign exposure of
      securitization or other techniques that lower                                                                 a large extent, be independently
                                                              consolidated groups aggregated at the
      relative capital charges on particular assets                                                                 managed and have different systems and
                                                              U.S. bank holding company level).
      for only some institutions)? If they do exist                                                                 portfolios, the Agencies are interested in
                                                              These threshold criteria are
      now, what is the evidence of competitive                                                                      comment on the efficacy and burden of
      harm?                                                   independent; meeting either condition
                                                                                                                    a framework that requires the advanced
         Apart from the approaches described in               would mean an institution is a core
                                                                                                                    approaches to be implemented by (or
      this ANPR, are there other regulatory capital           bank.
                                                                                                                    pushed down to) each of the separate
      approaches that are capable of ameliorating               Once an institution becomes a core
                                                                                                                    subsidiary banks and thrifts that make
      competitive concerns while at the same time             bank it would remain subject to the
                                                                                                                    up the consolidated group.
                                                              advanced approaches on a going
        9 In this regard, alternative approaches would
                                                              forward basis. If, in subsequent years,               U.S. Banking Subsidiaries of Foreign
      take time to develop, but might present fewer           such an institution were to drop below                Banking Organizations
      implementation challenges. Additional work would
      be necessary to advance the goal of competitive         both threshold levels it would continue                 Any U.S. bank or thrift that is a
      equity among internationally active banking                                                                   subsidiary of a foreign bank would have
      organizations. If consensus on alternative                10 For banks this means the December

      approaches could not be reached at the BSC, a           Consolidated Report of Condition and Income (Call
                                                                                                                    to comply with the prevailing U.S.
      departure from the Basel framework also could raise     Report). For thrifts this means the December Thrift   regulatory capital requirements applied
      significant international and domestic issues.          Financial Report.                                     to U.S. banks. Thus, if a U.S. bank or

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                              Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules                                                    45907

      thrift that is owned by a foreign bank                  realistically budgeted and made                       that a consistent and transparent
      meets the threshold levels for                          available. An institution’s board of                  process to oversee implementation of
      mandatory application of the advanced                   directors would need to approve its                   the advanced approaches would be
      approaches, the U.S. bank or thrift                     implementation plans.                                 crucial. The Agencies intend to develop
      would be a core bank. If it does not meet                  The Agencies expect core banks to                  interagency validation standards and
      those thresholds, it would have the                     make every effort to meet the                         procedures to help ensure consistency.
      choice to opt-in to the advanced                        supervisory standards as soon as                      The Agencies would consult with each
      approaches (and be subject to the same                  practicable. In this regard, it is possible           other on significant issues raised during
      supervisory framework as other U.S.                     that some core banks would not qualify                the validation process and ongoing
      banking organizations) or to remain a                   to use the advanced approaches in time                implementation.
      general bank. A top-tier U.S. bank                      to meet the effective date that is
                                                              ultimately established. For those                     C. Other Considerations
      holding company that is owned by a
      foreign bank also would be subject to                   banking organizations, the                            General Banks
      the same threshold levels for core bank                 implementation plan would need to                        The Agencies expect that the vast
      determination and would be subject to                   identify when the supervisory standards               majority of U.S. institutions would be
      the applicable U.S. bank holding                        would be met and when the institution                 neither core banks nor opt-in banks.
      company capital rules. However,                         would be ready for implementation. The                Most institutions would remain subject
      Federal Reserve SR Letter 01–1 (January                 Agencies note that developing an                      to the general risk-based capital rules.
      5, 2001) would remain in effect. Thus,                  appropriate infrastructure to support the             However, as has been the case since the
      subject to the conditions in SR Letter                  advanced approaches for regulatory                    1988 Accord was initially implemented
      01–1, a top-tier U.S. bank holding                      capital that fully complies with                      in the United States, the Agencies will
      company that is owned or controlled by                  supervisory conditions and expectations               continue to make necessary
      a foreign bank that is a qualifying                     and the associated supervisory guidance               modifications to the general risk-based
      financial holding company generally                     will be challenging. The Agencies                     capital rules as appropriate. In the event
      would not be required to comply with                    believe, however, that institutions                   changes are warranted, the Agencies
      the Board’s capital adequacy guidelines.                would need to be fully prepared before                could implement revisions through
        The Agencies are interested in comment on             moving to the advanced approaches.                    notice and comment procedures prior to
      the extent to which alternative approaches to              Use of the advanced approaches
                                                                                                                    the proposed effective date of the
      regulatory capital that are implemented                 would require the primary Federal
                                                                                                                    advanced approaches in 2007.
      across national boundaries might create                 supervisor’s approval. Core banks
      burdensome implementation costs for the                 unable to qualify for the advanced                       The Agencies seek comment on
      U.S. subsidiaries of foreign banks.                     approaches in time to meet the effective              whether changes should be made to the
                                                              date would remain subject to the general              existing general risk-based capital rules
      B. Implementation for Advanced                          risk-based capital rules existing at that             to enhance their risk-sensitivity or to
      Approach Organizations                                  time. The Agencies would consider the                 reflect changes in the business lines or
         As noted earlier, U.S. banking                       effort and progress made to meet the                  activities of banking organizations
      organizations that apply the advanced                   qualifying standards and would                        without imposing undue regulatory
      approaches would be required to                         consider whether, under the                           burden or complication. In particular,
      comply with supervisory standards                       circumstances, supervisory action                     the Agencies seek comment on whether
      prior to use.                                           should be taken against or penalties                  any changes to the general risk-based
         The BSC has targeted December 31,                    imposed on individual core banks that                 capital rules are necessary or warranted
      2006 as the effective date for the                      have not adhered to the schedule                      to address any competitive equity
      international capital rules based on the                outlined in the implementation plan                   concerns associated with the bifurcated
      New Accord. The Agencies are                            they submitted to their primary Federal               framework.
      proposing an implementation date of                     supervisor.
      January 1, 2007. The establishment of a                    Opt-in banks meeting the supervisory               Majority-Owned or Controlled
      final effective date in the United States,              standards could seek to qualify for the               Subsidiaries
      however, would be contingent on the                     advanced approaches in time to meet                     The New Accord generally applies to
      issuance for public comment of a Notice                 the ultimate final effective date or any              internationally active banking
      of Proposed Rulemaking, and                             time thereafter. Institutions                         organizations on a fully consolidated
      subsequent finalization of any changes                  contemplating opting-in to the advanced               basis. Thus, consistent with the
      in capital regulations that the Agencies                approaches would need to provide                      Agencies’ general risk-based capital
      ultimately decide to adopt.                             notice to, and submit an                              rules, subsidiaries that are consolidated
         Because of the need to pre-qualify for               implementation plan and schedule to be                under U.S. generally accepted
      the advanced approaches, banking                        approved by, their primary Federal                    accounting principles (GAAP) typically
      organizations would need to take a                      supervisor. As is true of core banks, opt-            should be consolidated for regulatory
      number of steps upon the finalization of                in banks would need to allow ample                    capital calculation purposes under the
      any changes to the capital regulations.                 time for developing and executing                     advanced approaches as well.11 With
      These steps would include developing                    implementation plans.                                 regard to investments in consolidated
      detailed written implementation plans                      An institution’s primary Federal                   insurance underwriting subsidiaries, the
      for the A–IRB approach and the AMA                      supervisor would have responsibility for              New Accord notes that deconsolidation
      and keeping their primary supervisors                   determining the institution’s readiness               of assets and deduction of capital is an
      advised of these implementation plans                   for an advanced approach and would be
      and schedules. Implementation plans                     ultimately responsible, after                           11 One notable exception exists at the bank level

      would need to address all supervisory                   consultation with other relevant                      where there is an investment in a financial
      standards for the A–IRB approach and                    supervisors, for determining whether                  subsidiary as defined in the Gramm-Leach-Bliley
                                                                                                                    Act of 1999. For such a subsidiary, assets would
      the AMA, include objectively                            the institution satisfies the supervisory             continue to be deconsolidated from the bank’s on-
      measurable milestones, and demonstrate                  expectations for the advanced                         balance-sheet assets, and capital at the subsidiary
      that adequate resources would be                        approaches. The Agencies recognize                    level would be deducted from the bank’s capital.

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      45908                   Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules

      appropriate approach. The Federal                          As a consequence, advanced approach                       Do the projected dates provide an adequate
      Reserve is actively considering several                 banking organizations would need to                       timeframe for core banks to be ready to
      approaches to the capital treatment for                 conduct two sets of capital calculations                  implement the advanced approaches? What
                                                                                                                        other options should the Agencies consider?
      investments by bank holding companies                   for at least three years. The pre-                           The Agencies seek comment on
      in insurance underwriting subsidiaries.                 implementation calculation of A-IRB                       appropriate thresholds for determining
      For example, the Federal Reserve is                     and AMA capital would not need to be                      whether a portfolio, business line, or
      currently assessing the merits and                      made public, but the banking                              geographic exposure would be material.
      weaknesses of an approach that would                    organization would be required to                         Considerations should include relative asset
      consolidate an insurance underwriting                   disclose risk-based capital ratios                        size, percentages of capital, and associated
      subsidiary’s assets at the holding                      calculated under both advanced and                        levels of risk for a given portfolio, business
      company level and permit excess capital                 general risk-based approaches during                      line, or geographic region.
      of the subsidiary to be included in the                 the two-year post-implementation                          III. Advanced Internal Ratings-Based
      consolidated regulatory capital of the                  period. The Agencies would not                            (A–IRB) Approach
      holding company. A deduction would                      propose to eliminate the floors after the
      be required for capital that is not readily                                                                          This section describes the proposed
                                                              two-year transition period for any
      available at the holding company level                                                                            A–IRB framework for the measurement
                                                              institution applying the advanced
      for general use throughout the                                                                                    of capital requirements for credit risk.
                                                              approaches until the Agencies are fully
      organization.                                                                                                     Under this framework, banking
                                                              satisfied that the institution’s systems
                                                                                                                        organizations that meet the A–IRB
        The Federal Reserve specifically seeks                are sound and accurately assess risk and
                                                                                                                        infrastructure requirements and
      comment on the appropriate regulatory                   that resulting capital levels are prudent.
      capital treatment for investments by bank
                                                                                                                        supervisory standards would
      holding companies in insurance
                                                                 These transitional arrangements and                    incorporate internal estimates of risk
      underwriting subsidiaries as well as other              the floors established above relate only                  inputs into supervisor-provided capital
      nonbank subsidiaries that are subject to                to risk-based capital ratios and do not                   formulas for the various debt and equity
      minimum regulatory capital requirements.                affect the continued applicability to all                 portfolios to calculate the capital
                                                              advanced banking organizations of the                     requirements for each portfolio. The
      Transitional Arrangements                               leverage ratio and associated PCA                         discussion below provides background
         Core and opt-in banks would be                       regulations for banks and thrifts.                        on the conceptual basis of the A–IRB
      required to calculate their capital ratios              Importantly, the minimum capital                          approach and then describes the
      using the A-IRB and AMA                                 requirements and the PCA thresholds                       specific details of the capital formulas
      methodologies, as well as the general                   would not be changed. Furthermore,                        for two of the main exposure categories,
      risk-based capital rules, for one year                  during the implementation period and                      wholesale and retail. Separate sections
      prior to using the advanced approaches                  before removal of the floors the                          follow that describe the A–IRB
      on a stand-alone basis. In order to begin               Agencies intend to closely monitor the                    treatments of loan loss reserves and
      this parallel-run year, however, the                    effect that the advanced approaches                       partial charge-offs, the A–IRB treatment
      institution would have to demonstrate                   would have on capital levels at                           of purchased receivables, the A–IRB
      to its supervisor that it meets the                     individual institutions and industry-                     treatment of equity exposures, and the
      supervisory standards. Therefore,                       wide capital levels. Once the results of                  A–IRB treatment of securitization
      banking organizations planning to meet                  this monitoring process are assessed, the                 exposures. The A–IRB supervisory
      the January 1, 2007 target effective date               Agencies may consider modifications to                    requirements and the A–IRB approach
      for implementation of the advanced                      the advanced approaches to ensure that                    to credit risk mitigation techniques also
      approaches would have to receive                        capital levels remain prudent.                            are discussed in separate sections.
      approval from their primary Federal
                                                                Given the general principle that the                    A. Conceptual Overview
      supervisor before year-end 2005.
                                                              advanced approaches are expected to be
      Banking organizations that later adopt                  implemented at the same time across all                      The A–IRB framework has as its
      the advanced approaches also would                      material portfolios, business lines, and                  conceptual foundation the belief that
      have a one-year dual calculation period                 geographic regions, to what degree should                 any range of possible losses on a
      prior to moving to stand-alone usage of                 the Agencies be concerned that, for example,              portfolio of credit exposures can be
      the advanced approaches.                                data may not be available for key portfolios,             represented by a probability density
         An institution would be subject to a                 business lines, or regions? Is there a need for           function (PDF) of possible losses over a
      minimum risk-based capital floor for                    further transitional arrangements? Please be              one-year time horizon. If known, the
      two years following moving to the                       specific, including suggested durations for
                                                              such transitions.
                                                                                                                        parameters of a PDF can be used to
      advanced approaches on a stand-alone                                                                              specify a particular level of capital that
      basis. Specifically, in the first year of                                                                         will lower the probability of the
      stand-alone usage of the advanced                       risk-weighted assets. The Agencies expect that the
                                                                                                                        institution’s insolvency due to adverse
      approaches, an institution’s calculated                 final language of the New Accord would need to be
                                                              consistent with this approach. The following              credit risk outcomes to a stated
      risk-weighted assets could not be less                  example reflects how the floor in the first year          confidence level. With a known or
      than 90 percent of risk-weighted assets                 would be applied by a U.S. banking organizaiton.          estimated PDF, the probability of
      calculated under the general risk-based                 If the banking organization’s general risk-based
                                                                                                                        insolvency can be measured or
      capital rules. In the following year, an                capital calculation produced risk-weighted assets of
                                                              $100 billion in its first year of implementation of       estimated directly, based on the level of
      institution’s minimum calculated risk-                  the advanced approaches, then its risk weighted           reserves and capital available to an
      weighted assets could not be less than                  assets in that year could not be less than $90 billion.   institution.
      80 percent of risk-weighted assets                      If the advanced approach calculation produced risk-
                                                                                                                           The A–IRB framework builds off this
      calculated under the general risk-based                 weighted assets of $75 billion (a decrease of one
                                                              quarter compared to the general risk-based capital        concept and reflects an effort to develop
      capital rules.12                                        rules), the organization would not calculate risk-        a common set of risk-sensitive formulas
                                                              based capital ratios on the basis of that $75 billion;    for the calculation of required capital for
        12 The agencies note that the text above differs      rather, its risk-weighted assets would be $90 billion.
      from the floor text in the New Accord, which is         Consequently, its minimum total risk-based capital
                                                                                                                        credit risk. To a large extent, this
      based on 90 and 80 percent of the minimum capital       charge would be $7.2 billion, and it would need $9        framework resembles more systematic
      requirements under the 1988 Accord, rather than on      billion to satisfy PCA well-capitalized criteria.         quantitative approaches to the

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                              Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules                                            45909

      measurement of credit risk that many                    measuring credit risk, but also are more               than do internal economic capital
      banking organizations have been                         straightforward to calculate than those                methodologies.
      developing. These approaches being                      typically employed by banking                          Expected Losses Versus Unexpected
      developed by banking organizations                      organizations (which often require                     Losses
      generally rely on a statistical or                      computer simulations). In particular, an
      probability-based assessment of credit                  important property of the A–IRB                           The diagram below shows a
      risk and use inputs broadly similar to                  formulas is portfolio invariance. That is,             hypothetical loss distribution for a
      those required under the A–IRB                          the A–IRB capital requirement for a                    portfolio of credit exposures over a one-
      approach. Like the value-at-risk (VaR)                  particular exposure generally does not                 year horizon. The loss distribution is
      model that forms the basis for the                      depend on the other exposures held by                  represented by the curve, and is drawn
      market risk capital rules, the output of                the banking organization; as with the                  in such a way that it depicts a higher
      these statistical approaches to credit risk             general risk-based capital rules, the total            proportion of losses falling below the
      is typically an estimate of loss threshold              credit risk capital requirement for a                  mean value than falling above the mean.
      on a credit exposure or pool of credit                  banking organization is simply the sum                 The average value of credit losses is
      exposures that is highly unlikely to be                 of the credit risk capital requirements                referred to as expected loss (EL). The
      exceeded by actual credit-related losses                                                                       losses that exceed the expected level are
                                                              on individual exposures or pools of
      on the exposure or pool.                                                                                       labeled unexpected loss (UL). An
         Many banking organizations now use                                                                          overarching policy question concerns
      such a credit VaR amount as the basis                      As with the existing credit VaR                     whether the proposed design of the A–
      for an internal assessment of the                       models, the output of the A–IRB                        IRB capital requirements should reflect
      economic capital necessary to cover                     formulas is an estimate of the amount of               an expectation that institutions would
      credit risk. In this context, it is common              credit losses over a one-year period that              allocate capital to cover both EL and a
      for banking organizations’ internal                     would only be exceeded a small                         substantial portion of the range of
      credit risk models to consider a one-year               percentage of the time. In the case of the             possible UL outcomes, or only the UL
      loss horizon, and to focus on a high loss               A–IRB formulas, this nominal                           portion of the range of possible losses
      threshold confidence level (that is, a                  confidence level is set to 99.9 percent.               (that is, from the EL point out to the
      loss threshold that has a small                         This means that within the context of                  99.9th percentile).
      probability of being exceeded), such as                 the A–IRB modeling assumptions a                          The Agencies recognize that some
      the 99.95th percentile. This is because                 banking organization’s overall credit                  institutions, in their comment letters on
      banking organizations typically seek to                 portfolio capital requirement can be                   earlier BSC proposals and in discussion
      hold an amount of economic capital for                  thought of as an estimate of the 99.9th                with supervisory staffs, have
      credit risk whose probability of being                  percentile of potential losses on that                 highlighted the view that regulatory
      exceeded is broadly consistent with the                 portfolio over a one-year period. In                   capital should not be allocated for EL.
      institution’s external credit rating and                practice, however, this 99.9 percent                   They emphasize that EL is normally
      its associated default probability. For                 nominal target likely overstates the                   incorporated into the interest rate and
      example, the one-year historical                        actual level of confidence because the                 spreads charged on specific products,
      probability of default for AA-rated firms               A–IRB framework does not explicitly                    such that EL is covered by net interest
      is less than 5 basis points (0.05 percent).             address portfolio concentration issues or              margin and provisioning. The
         There is a great deal of variation                   the possibility of errors in estimating                implication is that supervisors would
      across banking organizations in the                     PDs, LGDs, or EADs. The choice of the                  review provisioning policies and the
      specifics of their credit risk                          99.9th percentile reflects a desire on the             adequacy of reserves as part of a
      measurement approaches. It is                           part of the Agencies to align the                      supervisory review, much as they do
      important to recognize that the A–IRB                   regulatory capital standard with the                   today, and would require additional
      approach is not intended to allow                       default probabilities typically associated             reserves and/or regulatory capital for EL
      banking organizations to use all aspects                with maintaining low investment grade                  in cases where reserves were deemed
      of their own models to estimate                         ratings (that is, BBB) even in periods of              insufficient. However, the Agencies are
      regulatory capital for credit risk. The A–              economic adversity and to ensure                       concerned that the accounting
      IRB approach has been developed as a                    neither a substantial increase or                      definition of general reserves differs
      single, common methodology that all                     decrease in overall required capital                   significantly across countries, and that
      advanced approach banking                               levels among A–IRB banking                             banking practices with respect to the
      organizations would use, and consists of                organizations compared with the capital                recognition of impairment also are very
      a set of formulas (or functions) and a                  levels that would be required under the                different. Thus, the Agencies are
      single set of assumptions regarding                     general risk-based capital rules. It also              proposing to include EL in the
      critical parameters for the formulas. The               recognizes that the risk-based capital                 calibration of the risk weight functions.
      A–IRB approach draws on the same                        rules count a broader range of                            The Agencies also note that the
      conceptual underpinnings as the credit                  instruments as eligible capital (for                   current regulatory definition of capital
      VaR approaches that banking                             example, certain subordinated debt)                    includes a portion of general reserves.
      organizations have developed                                                                                   That is, general reserves up to 1.25
      individually, but likely differs in many                   13 The theoretical underpinnings for obtaining      percent of risk-weighted assets are
      specifics from the approach used by any                 portfolio-invariant capital charges within credit      included in the Tier 2 portion of total
      individual institution.                                 VaR models are provided in the paper ‘‘A Risk-         capital. If the risk weight functions were
         The specific A–IRB formulas require                  Factor Model Foundation for Ratings-Based Bank         calibrated solely to UL, it could be
                                                              Capital Rules,’’ by Michael Gordy, forthcoming in
      the banking organization first to                       the Journal of Financial Intermediation. The A–IRB
                                                                                                                     argued that the definition of capital
      estimate certain risk inputs, which the                 formulas are derived as an application of these        would also need to be revisited. In the
      organization may do using a variety of                  results to a single-factor CreditMetrics-style mode.   United States, such a discussion would
      techniques. The formulas themselves,                    For mathematical details of this model, see M.         require a review of the provisioning
                                                              Gordy, ‘‘A comparative Anatomy of Credit Risk
      into which the estimated risk inputs are                Models.’’ Journal of Banking and Finance, January
                                                                                                                     practices of institutions under GAAP
      inserted, are broadly consistent with the               2000, or H.R. Koyluogu and A. Hickman,                 and of the distinctions drawn between
      most common statistical approaches for                  ‘‘Reconcilable Differences.’’ Risk, October 1998.      specific and general provisions.

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      45910                   Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules

         The framework described in this                         Specifically, the A–IRB capital                       In contrast, the portfolio models of
      ANPR calibrates the risk-based capital                  formulas described in detail below are                credit risk employed by many banking
      requirements to the sum of EL plus UL,                  based on the assumption that                          organizations are quite sensitive to all
      which raises significant calibration                    correlation in defaults across borrowers              forms of diversification. That is, the
      issues. Those calibration issues would                  is attributable to their common                       economic capital charge assigned to a
      be treated differently if the calibration               dependence on one or more systematic                  loan within such a model will depend
      were based only on the estimate of UL.                  risk factors. The basis for this                      on the portfolio as a whole. In order to
      That is, decisions with respect to                      assumption is the observation that a                  apply a portfolio model to the
      significant policy variables that are                   banking organization’s borrowers are                  calibration of A–IRB capital charges, it
      described below hinge crucially on the                  generally susceptible to adverse changes              would be necessary to identify the
      initial decision to base the calibration                in the global economy. These systematic               assumptions needed so that a portfolio
      on EL plus UL, rather than UL only.                     factors are distinct from the borrower-               model would yield economic capital
      These issues include, for example, the                  specific, or idiosyncratic, risk factors              charges that do not depend on portfolio
      appropriate mechanism for                               that determine the probability that a                 characteristics. Recent advances in the
      incorporating any future margin income                  specific loan will be repaid. Like other              finance literature demonstrate that
      (FMI) that is associated with particular                risk-factor models, the A–IRB                         economic capital charges are portfolio-
      business lines, as well as the                          framework assumes that these borrower-                invariant if (and only if) two
      appropriate method for incorporating                    specific factors represent idiosyncratic              assumptions are imposed.14 First, the
      general and specific reserves into the                  sources of risk, and thus (unlike the                 portfolio must be infinitely fine-grained.
      risk-based capital ratios.                              systematic risk-factors) are diversified in           Second, there must be only a single
         A final overarching assumption of the                                                                      systematic risk factor.
                                                              a large lending portfolio.
      A–IRB framework is the role of asset                                                                             Infinite granularity, while never
      correlations. Within the A–IRB capital                     The A–IRB approach allows for much
                                                                                                                    literally attained, is satisfied in an
      formulas (as in the credit VaR models of                improved sensitivity to many of the
                                                                                                                    approximate sense by the portfolios of
      many banking organizations), asset                      loan-level determinants of economic
                                                                                                                    large, internationally active banks.
      correlation parameters provide a                        capital (such as PD and LGD), but does                Analysis of data provided by such
      measure of the extent to which changes                  not explicitly address how an                         institutions shows that taking account of
      in the economic value of separate                       exposure’s economic capital might vary                single-name concentrations in such
      exposures are presumed to move                          with the degree of concentration in the               portfolios would lead to only trivial
      together. A higher asset correlation                    overall portfolio to specific industries or           changes in the total capital requirement.
      between a particular asset and other                    regions, or even to specific borrowers.               The single risk-factor assumption would
      assets in the same portfolio implies a                  That is, it neither rewards nor penalizes             appear, at first glance, more
      greater likelihood that the asset will                  differences across banking organizations              troublesome. As an empirical matter,
      decline in value at the same time as the                in diversification or concentration                   there undoubtedly are distinct cyclical
      portfolio as a whole declines in value.                 across industry, geography, and names.                factors for different industries and
      Because this means a greater chance that                To introduce such rewards and                         different geographic regions. From a
      the asset will be a contributor to high                 penalties in an appropriate manner                    substantive perspective, however, the
                                                                                                                                                                        EP04AU03.000</GPH><Q P=’03’>

      loss scenarios, its capital requirement                 would necessarily entail far greater
      under the A–IRB framework also is                       operational complexity for both                         14 See forthcoming paper by M. Gordy referenced

      higher.                                                 regulatory and financial institutions.                in footnot number 12 above.

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                              Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules                                           45911

      relevant question is whether portfolios                 estimated inputs required to complete                 Probability of Default
      at large financial institutions are                     the capital calculations, a description of              The first principal input to the
      diversified across the various sub-                     the specific calculations required to                 wholesale A–IRB calculation is the
      sectors of the economy in a reasonably                  determine the A–IRB capital                           measure of PD. Under the A–IRB
      similar manner. If so, then the portfolio               requirement, and tables depicting a                   approach, a banking organization would
      can be modeled as if there were only a                  range of representative results.                      assign an internal rating to each of its
      single factor, namely, the credit cycle as                                                                    wholesale obligors (or in other words,
      a whole.                                                Wholesale Exposures: Definitions and
                                                              Inputs                                                assign each wholesale exposure to an
         The Agencies seek comment on the                                                                           internal rating grade applicable to the
      conceptual basis of the A–IRB approach,                    The Agencies propose that a single                 obligor). The internal rating would have
      including all of the aspects just described.                                                                  to be produced by a rating system that
                                                              credit exposure category—wholesale
      What are the advantages and disadvantages                                                                     meets the A–IRB infrastructure
      of the A–IRB approach relative to                       exposures—would encompass most
      alternatives, including those that would                non-retail credit exposures in the A–IRB              requirements and supervisory standards
      allow greater flexibility to use internal               framework. The wholesale category                     for wholesale exposures, which are
      models and those that would be more                     would include the sub-categories of                   intended to ensure (among other things)
      cautious in incorporating statistical                   corporate, sovereign, and interbank                   that the rating system results in a
      techniques (such as greater use of credit               exposures as well as all types of                     meaningful differentiation of risk among
      ratings by external rating agencies)? The               specialized lending exposures.                        exposures. For each internal rating, the
      Agencies also encourage comment on the                                                                        banking organization must associate a
      extent to which the necessary conditions of
                                                              Wholesale exposures would include
                                                              debt obligations of corporations,                     specific one-year PD value. Various
      the conceptual justification for the A–IRB                                                                    approaches may be used to develop
      approach are reasonably met, and if not, what           partnerships, limited liability
      adjustments or alternative approach would               companies, proprietorships, and                       estimates of PDs; however, regardless of
      be warranted.                                           special-purpose entities (including                   the specific approach, banking
         Should the A–IRB capital regime be based             those created specifically to finance                 organizations would be expected to
      on a framework that allocates capital to EL             and/or operate physical assets).                      satisfy the supervisory standards. The
      plus UL, or to UL only? Which approach
                                                              Wholesale exposures also would                        minimum PD that may be assigned to
      would more closely align the regulatory                                                                       most wholesale exposures is 3 basis
      framework to the internal capital allocation            include debt obligations of banks and
                                                                                                                    points (0.03 percent). Certain wholesale
      techniques currently used by large                      securities firms (interbank exposures),
                                                                                                                    exposures are exempt from this floor,
      institutions? If the framework were                     and debt obligations of central
                                                                                                                    including exposures to sovereign
      recalibrated solely to UL, modifications to             governments, central banks, and certain
      the rest of the A–IRB framework would be
                                                                                                                    governments, their central banks, the
                                                              public-sector entities (sovereign
      required. The Agencies seek commenters’                                                                       BIS, IMF, European Central Bank, and
                                                              exposures). The wholesale exposure                    high quality multilateral development
      views on issues that would arise as a result            category would not include
      of such recalibration.                                                                                        banks (MDBs) with strong shareholder
                                                              securitization exposures, or certain                  support.
      B. A–IRB Capital Calculations                           small-business exposures that are                       The Agencies intend to apply
        A common characteristic of the A–IRB                  eligible to be treated as retail exposures.           standards to the PD quantification
      capital formulas is that they calculate                    The Agencies propose that advanced                 process that are consistent with the
      the actual dollar value of the minimum                  approach banking organizations would                  broad guidance outlined in the New
      capital requirement associated with an                  use the same A–IRB capital formula to                 Accord. More detailed discussion of
      exposure (or, in the case of retail                     compute capital requirements on all                   those points is provided in the draft
      exposures, a pool of exposures). This                   wholesale exposures with two                          supervisory guidance on IRB
      capital requirement must be converted                   exceptions. First, wholesale exposures                approaches for corporate exposures
      to an equivalent amount of risk-                        to small- and medium-sized enterprises                published elsewhere in today’s Federal
      weighted assets in order to be inserted                 (SMEs) would use a downward                           Register.
      into the denominator of a banking                       adjustment to the wholesale A–IRB                     Loss Given Default
      organization’s risk-based capital ratios.               capital formula typically based on
      Because the minimum risk-based capital                  borrower size. Second, the A–IRB                        The second principal input to the A–
      ratio in the United States is 8 percent,                capital formula for HVCRE loans                       IRB capital formula for wholesale
      the minimum capital requirement on                      (generally encompassing certain                       exposures is LGD. Under the A–IRB
      any asset would be equal to 8 percent                   speculative ADC loans) would use a                    approach, banking organizations would
      of the risk-weighted asset amount                       higher asset correlation assumption than              estimate an LGD for each wholesale
      associated with that asset. Therefore, in               other wholesale exposures.                            exposure. An LGD estimate for a
      order to determine the amount of risk-                                                                        wholesale exposure should provide an
      weighted assets to associate with a given                  The proposed A–IRB capital                         assessment of the expected loss in the
      minimum capital requirement, it would                   framework for wholesale exposures                     event of default of the obligor, expressed
      be necessary to multiply the dollar                     would require banking organizations to                as a percentage of the institution’s
      capital requirement generated by the A–                 assign four key risk inputs for each                  estimated total exposure at default. The
      IRB formulas by the reciprocal of 8                     individual wholesale exposure: (1)                    LGD for a defaulted exposure would be
      percent, or 12.5.                                       Probability of default (PD); (2) loss given           estimated as the expected economic loss
        The following subsections of the                      default (LGD); (3) exposure at default                rate on that exposure taking into
      ANPR detail the specific features of the                (EAD); and (4) effective remaining                    account, where appropriate, recoveries,
      A–IRB capital formulas for two                          maturity (M). In addition, to use the                 workout costs, and the time value of
      principal categories of credit exposure:                proposed downward adjustment for                      money. Banking organizations would
      wholesale and retail. Both of these                     wholesale SMEs described in more                      estimate LGDs as the loss severities
      subsections include a proposed                          detail below, banking organizations                   expected to prevail when default rates
      definition of the exposure category, a                  would be required to provide an                       are high, unless they have information
      description of the banking organization-                additional input for borrower size (S).               indicating that recoveries on a particular

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      45912                   Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules

      class of exposure are unlikely to be                    Definition of Default and Loss                        contained in the New Accord. More
      affected to an appreciable extent by                       A banking organization would                       detailed discussion of these issues is
      cyclical factors. As with estimates of                  estimate inputs relative to the following             provided in the draft supervisory
      other A–IRB inputs, banking                             definition of default and loss. A default             guidance on IRB approaches for
      organizations would be expected to be                   is considered to have occurred with                   corporate exposures published
      conservative in assigning LGDs.                         respect to a particular borrower when                 elsewhere in today’s Federal Register.
         Although estimated LGDs should be                    either or both of the following two                      The Agencies seek comment on the
      grounded in historical recovery rates,                  events has taken place: (1) The banking               proposed definition of wholesale exposures
                                                              organization determines that the                      and on the proposed inputs to the wholesale
      the A–IRB approach is structured to
                                                                                                                    A–IRB capital formulas. What are views on
      allow banking organizations to assess                   borrower is unlikely to pay its                       the proposed definitions of default, PD, LGD,
      the differential impact of various                      obligations to the organization in full,              EAD, and M? Are there specific issues with
      factors, including, for example, the                    without recourse to actions by the                    the standards for the quantification of PD,
      presence of collateral or differences in                organization such as the realization of               LGD, EAD, or M on which the Agencies
      loan terms and covenants. The Agencies                  collateral; or (2) the borrower is more               should focus?
      expect to impose limitations on the use                 than 90 days past due on principal or                 Wholesale Exposures: Formulas
      of guarantees and credit derivatives in a               interest on any material obligation to the               The calculation of the A–IRB capital
      banking organization’s LGD estimates.                   organization. The Agencies believe that               requirement for a particular wholesale
      These limitations are discussed in the                  the use of the concept of ‘‘unlikely to               exposure would be accomplished in three
      separate section of this ANPR on the A–                 pay’’ is largely consistent with the                  steps:
      IRB treatment of credit risk mitigation                 practice of U.S. banking organizations in                (1) Calculation of the relevant asset
                                                              assessing whether a loan is on non-                   correlation parameter, which would be a
      techniques.                                                                                                   function of PD (as well as borrower size (S)
                                                              accrual status.
      Exposure at Default                                                                                           for SMEs);
                                                              Maturity                                                 (2) Calculation of a preliminary capital
        The third principal input to the                                                                            requirement assuming a maturity of one year,
                                                                 The fourth principal input to the A–               which would be a function of PD, LGD, EAD,
      wholesale A–IRB capital formula is                      IRB capital formula is effective                      and the asset correlation parameter
      EAD. The Agencies are proposing that                    remaining maturity (M), measured in                   calculated in the first step; and
      banking organizations would provide                     years. If a wholesale exposure is subject                (3) Application of a maturity adjustment
      their own estimate of EAD for each                      to a determinable cash flow schedule,                 for differences between the actual effective
      exposure. The EAD for an exposure                       the banking organization would                        remaining maturity of the exposure and the
      would be defined as the amount legally                                                                        one-year maturity assumption in the second
                                                              calculate M as the weighted-average                   step, where the adjustment would be a
      owed to the banking organization (net of                remaining maturity of the expected cash               function of both PD and M.
      any charge-offs) in the event that the                  flows, using the amounts of the cash                     These calculations result in the A–IRB
      borrower defaults on the exposure. For                  flows as the relevant weights. The                    capital requirement, expressed in dollars, for
      on-balance-sheet items, banking                         banking organization also would be able               a particular wholesale exposure. As noted
      organizations would estimate EAD as no                  to use the nominal remaining maturity                 earlier, this amount would be converted to a
      less than the current drawn amount. For                 of the exposure if the weighted-average               risk-weighted assets equivalent by
      off-balance-sheet items, except over-the-                                                                     multiplying the amount by 12.5, and the risk-
                                                              remaining maturity of the exposure                    weighted assets equivalent would be
      counter (OTC) derivative transactions,                  cannot be calculated. For OTC                         included in the denominator of the risk-
      banking organizations would assign an                   derivatives and repo-style transactions               based capital ratios.
      EAD equal to an estimate of the long-run                subject to master netting agreements, the             Asset Correlation
      default-weighted average EAD for                        institution would set M equal to the
      similar facilities and borrowers or, if                                                                          The first step in the calculation of the A–
                                                              weighted-average remaining maturity of                IRB capital requirement for a wholesale
      EADs are highly cyclical, the EAD                       the individual transactions, using the                exposure is the calculation of the asset
      expected to prevail when default rates                  notional amounts of the individual                    correlation parameter, which is denoted by
      are high. The EAD associated with OTC                   transactions as the relevant weights.                 the letter ‘‘R’’ in the formulas below. This
      derivative transactions would continue                     In all cases, M would be set no greater            asset correlation parameter is not a fixed
      to be estimated using the ‘‘add-on’’                    than five years and, with few                         amount; rather, the parameter varies as an
      approach contained in the general risk-                 exceptions, M would be set no lower                   inverse function of PD. For all wholesale
      based capital rules.15 In addition, there               than one year. The exceptions apply to                exposures except HVCRE exposures, the asset
                                                                                                                    correlation parameter approaches an upper
      would be a specific EAD calculation for                 certain transactions that are not part of             bound value of 24 percent for very low PD
      the recognition of collateral in the                    a banking organization’s ongoing                      values and approaches a lower bound value
      context of repo-style transactions                      financing of a borrower. For wholesale                of 12 percent for very high PD values. This
      subject to a master netting agreement,                  exposures that have an original maturity              reflects the Agencies’ view that borrowers
      the features of which are outlined below                of less than three months—including                   with lower credit quality (that is, higher PDs)
      in the section on the A–IRB treatment of                repo-style transactions, money market                 are likely to be more idiosyncratic in the
      credit risk mitigation techniques.16                    transactions, trade finance-related                   factors affecting their likelihood of default
                                                                                                                    than borrowers with higher credit quality
                                                              transactions, and exposures arising from              (lower PDs). Therefore, the higher PD
        15 Under the add-on approach, an institution          payment and settlement processes—M                    borrowers are proportionately less influenced
      would determine its EAD for an OTC derivative           may be set as low as one day. For OTC                 by systematic (sector-wide or economy-wide)
      contract by adding the current value of the contract    derivatives and repo-style transactions               factors common to all borrowers.17
      (zero if the current value is negative) and an
      estimate of potential future exposure (PFE) on the      subject to a master netting agreement, M                 An important practical impact of having
      contract. The estimated PFE would be equal to the       would be set at no less than five days.               asset correlation decline with increases in PD
      notional amount of the derivative multiplied by a          As with the assignment of PD
      supervisor-provided add-on factor that takes into       estimates, the Agencies propose to                      17 See Jose Lopez, ‘‘The Empirical Relationship
      account the type of instrument and its maturity.                                                              between Average Asset Correlation, Firm
        16 Repo-style transactions include reverse            apply supervisory standards for the                   Probability of Default, and Asset Size.’’ Federal
      repurchase agreements and repurchase agreements         estimation of LGD, EAD, and M that are                Reserve Bank of San Francisco Working Paper 02–
      and securities lending and borrowing.                   consistent with the broad guidance                    05 (June 2002).

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                                      Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules                                                                       45913

      is to reduce the speed with which capital                                N(x) denotes the standard normal cumulative                     depends on PD reflects the Agencies’ view
      requirements increase as PDs increase, and to                                 distribution function;                                     that there is a greater proportional need for
      increase the speed with which EL dominates                               R denotes asset correlation;                                    maturity adjustments for high-quality
      the total capital charge, thereby tending to                             G(x) denotes the inverse of the standard                        exposures (those with low PDs) because there
      reduce procyclicality in the application of                                   normal cumulative distribution function;                   is a greater potential for such exposures to
      the wholesale A–IRB capital formulas. The                                     and 18                                                     deteriorate in credit quality than for
      specific formula for determining the asset                               PD denotes probability of default.                              exposures whose credit quality is lower. The
      correlation parameter for all wholesale                                     There are several important aspects of this                  specific formula for applying the maturity
      exposures except HVCRE exposures is as                                   formula. First, it rises in a straight-line                     adjustment and generating the A–IRB capital
      follows:                                                                 fashion with increases in EAD, meaning that                     requirement is as follows:
      R = 0.12 * (1¥EXP(¥50 * PD)) + 0.24 *                                    a doubling of the exposure amount would                         K = K1 * [1 + (M¥2.5) * b]/[(1¥1.5 * b)],
           [1¥(1¥EXP(¥50 * PD))]                                               result in a doubling of the capital                                  where b = (0.08451¥0.05898 * LN(PD))2
      Where:                                                                   requirement. It also rises in a straight-line                   and:
      R denotes asset correlation;                                             fashion with increases in LGD, which                            K denotes the A–IRB capital requirement;
      EXP(x) denotes the natural exponential                                   similarly implies that a loan with an LGD                       K1 denotes the one-year-maturity capital
           function; and                                                       estimate twice that of an otherwise identical                        requirement;
      PD denotes probability of default.                                       loan would have twice the capital                               M denotes effective remaining maturity;
                                                                               requirement of the other loan. This also                        LN(x) denotes the natural logarithm; and
      Capital Requirement With Assumed One-                                    implies that as LGD or EAD estimates
      Year Maturity Adjustment                                                                                                                 PD denotes probability of default.
                                                                               approach zero, the capital requirement would
         The second step in the calculation of the                             likewise approach zero. The remainder of the                       In this formula, the value ‘‘b’’ effectively
      A–IRB capital requirement for a particular                               formula is a function of PD, asset correlation                  determines the slope of the maturity
      wholesale exposure is the calculation of the                             (R), which is itself a function of PD, and the                  adjustment and is itself a function of PD.
      capital requirement that would apply to the                              target loss percentile amount of 99.9 percent                   Note that if M is set equal to one, the
      exposure assuming a one-year effective                                   discussed earlier.                                              maturity adjustment also equals one and K
      remaining maturity. The specific formula to                                                                                              will therefore equal K1.
                                                                               Maturity Adjustment                                                To provide a more concrete sense of the
      calculate this one-year-maturity capital
      requirement is as follows:                                                  The third stage in the calculation of the A–                 range of capital requirements under the
                                                                               IRB capital requirement for a particular                        wholesale A–IRB framework, the following
      K1 = EAD * LGD * N[(1¥R)∧¥0.5 * G(PD)                                    wholesale exposure is the application of a                      table presents the A–IRB capital
           + (R/(1¥ R))∧0.5 * G(0.999)]                                        maturity adjustment to reflect the exposure’s                   requirements (K) for a range of values of both
      Where:                                                                   actual effective remaining maturity (M). The                    PD and M. In this table LGD is assumed to
      K1 denotes the one-year-maturity capital                                 A–IRB maturity adjustment multiplies the                        equal 45 percent. For comparison purposes,
           requirement;                                                        one-year-maturity capital requirement (K1) by                   the general risk-based capital rules assign a
      EAD denotes exposure at default;                                         a factor that depends on both M and PD. The                     capital requirement of 8 percent for most
      LGD denotes loss given default;                                          fact that the A–IRB maturity adjustment                         commercial loans.

                                                                                             CAPITAL REQUIREMENTS
                                                                                                  [In percentage points]

                                                                                                                                            Effective remaining maturity (M)
                                                                                                                               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                                        SME Adjustment                                                  demonstrate that it would be more
      formulas on minimum risk-based capital                                     For loans to SMEs not eligible for                            appropriate for the banking organization
      requirements for wholesale exposures                                     retail A–IRB treatment, the proposed                            to use the total assets of the borrower as
      would, of course, depend on the actual                                   calculation of the A–IRB capital                                its measure of borrower size. The
      values of PD, LGD, EAD, and M that                                       requirement has one additional                                  borrower size adjustment would be
      banking organizations would use as                                       element—a downward adjustment based                             made to the asset correlation parameter
      inputs to the wholesale formulas.                                        on borrower size (S). This adjustment                           (R), as shown in the following formula:
      Subject to the caveats noted earlier,                                    would effectively lower the A–IRB                               RSME = R¥0.04 * [1¥(S¥ 5)/45]
      evidence from QIS3 suggested an                                          capital requirement on wholesale
      average reduction in credit risk capital                                 exposures to SMEs with annual sales (or                         Where
      requirements for corporate exposures of                                  total assets) of less than $50 million.                         RSME denotes the size-adjusted asset
      about 26 percent for twenty large U.S.                                   The Agencies believe the measure of
      banking organizations.                                                   borrower size should be based on
                                                                               annual sales (rather than total assets),                        R denotes asset correlation; and
                                                                               unless the banking organization can
        18 The N(x) and G(x) functions are widely used in                      spreadsheet programs. A description of these                    most spreadsheet programs or in basic statistical
      statistics and are commonly available in computer                        functions may be found in the Help function of                  textbooks.

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      45914                           Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules

      S denotes borrower size (expressed in                                    condition of SMEs will be influenced                           the practical effect of the SME
          millions of dollars).                                                relatively more by idiosyncratic factors                       adjustment by depicting the capital
                                                                               than is the case for larger firms, and,                        requirements (K) across a range of PDs
         The maximum reduction in the asset                                    thus, SMEs would be less likely to                             and borrower sizes. As in the previous
      correlation parameter based on this                                      deteriorate simultaneously with other                          table, LGD is assumed to equal 45
      formula is 4 percent, and is achieved                                    exposures. This greater susceptibility to                      percent. For this table, M is assumed to
      when borrower size is $5 million. For                                    idiosyncratic factors would imply lower                        be equal to three years. Note that the last
      all borrower sizes below $5 million,                                     asset correlation. The evidence in favor                       column is identical to the three-year
      borrower size would be set equal to $5                                   of this view is mixed, particularly after                      maturity column in the preceding table
      million. The adjustment shrinks to zero                                  considering that the A–IRB framework                           because the SME adjustment is phased
      as borrower size approaches $50                                          already incorporates a negative                                out for borrowers of $50 million or more
      million. The broad rationale for this                                    relationship between asset correlation
                                                                                                                                              in size.
      adjustment is the view that the credit                                   and PD. The following table illustrates
                                                                                             CAPITAL REQUIREMENTS
                                                                                                  [In percentage points]

                                                                                                                                                 Borrower size (S)
                                                                                                                          $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                                          • Object finance (OF) exposures                                Most of the issues raised below for
      above, evidence from QIS3 suggested an                                   finance the acquisition of (typically                          comment are described in substantially
      average reduction in credit risk-based                                   moveable) physical assets, such as ships                       greater detail, in the context of CRE
      capital requirements for corporate SME                                   or aircraft, where the source of                               exposures, in a white paper entitled
      exposures of about 39 percent for                                        repayment is primarily the revenues                            ‘‘Loss Characteristics of CRE Loan
      twenty large U.S. banking organizations.                                 generated by the assets being financed,                        Portfolios,’’ released by the Federal
        If the Agencies include a SME adjustment,                              often through rental or lease contracts                        Reserve Board on June 10, 2003.
      are the $50 million threshold and the                                    with third parties.                                            Commenters are encouraged to read the
      proposed approach to measurement of                                         • Commodities finance (CF)                                  white paper in conjunction with this
      borrower size appropriate? What standards                                exposures are structured short-term                            section.
      should be applied to the borrower size                                   financings of reserves, inventories, or                           A defining characteristic of SL
      measurement (for example, frequency of                                   receivables of exchange-traded                                 exposures (including CRE) is that the
      measurement, use of size buckets rather than                             commodities, such as crude oil, metals,                        risk factors influencing actual default
      precise measurements)?                                                   or agricultural commodities, where the                         rates are likely to influence LGDs as
        Does the proposed borrower size
      adjustment add a meaningful element of risk
                                                                               source of repayment is the proceeds of                         well. This is because both the
      sensitivity sufficient to balance the costs                              the sale of the commodity.                                     borrower’s ability to repay an exposure
      associated with its computation? The                                        • Commercial real estate (CRE)                              and the banking organization’s recovery
      Agencies are interested in comments on                                   exposures finance the construction or                          on an exposure in the event of default
      whether it is necessary to include an SME                                acquisition of real estate (including land                     are likely to depend on the same
      adjustment in the A–IRB approach. Data                                   as well as improvements) where the                             underlying factors, such as the net cash
      supporting views is encouraged.                                          prospects for repayment and recovery                           flows of the property being financed.
      Wholesale Exposures: Other Considerations                                depend primarily on the cash flows
      Specialized Lending                                                      generated by the lease, rental, or sale of                     in aggregate default rates. For two portfolios with
                                                                               the real estate.19 The broad CRE                               the same EL, the portfolio with more highly variable
         The specialized lending (SL) asset class                                                                                             aggregate default rates warrants higher capital to
      encompasses exposures for which the                                      category is further divided into two                           cover UL (‘‘bad-tail events’’) with the same level of
      primary source of repayment is the income                                groups: low-asset-correlation CRE and                          confidence. Describing a portfolio as having a
      generated by the specific asset(s) being                                 HVCRE.20                                                       relatively high asset correlation does not imply that
                                                                                                                                              loans in that portfolio have relatively high PD, LGD,
      financed, rather than the financial capacity of                                                                                         or EL. In particular, loans in high asset correlation
      a broader commercial enterprise. The SL                                     19 CRE exposures are typically non-recourse
                                                                                                                                              portfolios may well have very low PDs and LGDs
      category encompasses four broad exposure                                 exposures, often to special purpose vehicles, and              and therefore ELs); conversely, loans in low asset
      types:                                                                   are distinguishable from corporate exposures that              correlation portfolios may have very high PDs and
         • Project finance (PF) exposures finance                              are collateralized by real estate for which the                LGDs (and ELs). For any two loans from a portfolio
                                                                               prospects for repayment and recovery depend                    with a given asset correlation (or from two different
      large, complex, expensive installations that
                                                                               primarily on the financial performance of the                  portfolios with the same asset correlation), the loan
      produce goods or services for sale, such as                              broader commercial enterprise that is the obligor.             with the lower EL should be assigned a lower risk
      power plants, chemical processing plants,                                   20 To describe a loan portfolio as having a
                                                                                                                                              weight. For any two loans with the same EL, the
      mines, or transportation infrastructure, where                           relatively high asset correlation means that any               loan from the portfolio with the lower asset
      the source of repayment is primarily the                                 defaults that occur in that portfolio are relatively           correlation should incur a lower capital charge,
      revenues generated by sale of the goods or                               likely to occur at the same time, and for this reason          because bad-tail events are less likely to occur in
      services by the installations.                                           the portfolio is likely to exhibit greater variability         that portfolio.

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                                      Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules                                                                           45915

      This suggests a positive correlation                                      addition, supervisory risk weights                                     one of two risk weight functions. The
      between observed default frequencies                                      would be assigned to each of these                                     first risk weight function is the
      and observed loss rates on defaulted                                      supervisory rating grades. To assist                                   wholesale risk weight function and
      loans, with both declining during                                         banking organizations in implementing                                  applies to all PF, OF, and CF exposures,
      periods of favorable economic                                             these supervisory rating grades, for                                   as well as to all low-asset-correlation
      conditions and both increasing during                                     reference purposes the New Accord                                      CRE exposures (including in-place
      unfavorable economic periods. While                                       associates each with an explicit range of                              commercial properties). The second risk
      cyclicality in LGDs may be significant                                    external rating grades. If the SSC                                     weight function applies to all HVCRE
      for a number of lending activities, the                                   approach were allowed in the United                                    exposures. It also is the same as the
      Agencies believe that cyclicality is                                      States, the Agencies would have to                                     wholesale risk weight function, except
      likely to be the norm for SL portfolios,                                  develop slotting criteria that would take                              that it incorporates a higher asset
      and that a banking organization’s                                         into account factors such as market                                    correlation parameter. The asset
      procedures for estimating LGD inputs                                      conditions; financial ratios such as debt                              correlation equation for HVCRE is as
      for SL exposures should assess and                                        service coverage or loan-to-value ratios;                              follows:
      quantify this cyclicality in a                                            cash flow predictability; strength of
                                                                                                                                                       R = 0.12 × (1¥EXP (¥50 × PD)) + 0.30
      comprehensive and systematic fashion.                                     sponsor or developer; and other factors
                                                                                                                                                             × [EXP (¥50 × PD)]
        The Agencies invite comment on ways to
                                                                                likely to affect the PD and/or LGD of
                                                                                each loan.                                                             Where
      deal with cyclicality in LGDs. How can risk
      sensitivity be achieved without creating                                     The Agencies invite comment on the                                  R denotes asset correlation;
      undue burden?                                                             merits of the SSC approach in the United                               EXP denotes the natural exponential
                                                                                States. The Agencies also invite comment on                                  function; and
        For core and opt-in banks that may                                      the specific slotting criteria and associated
      not be able to provide sufficiently                                                                                                              PD denotes probability of default.
                                                                                risk weights that should be used by
      reliable estimates of PD, LGD, and M for                                  organizations to map their internal rating                                The following table presents the A–
      each SL exposure, the New Accord                                          grades to supervisory rating grades if the SSC                         IRB capital requirement (K) for a range
      offers a Supervisory Slotting Criteria                                    approach were to be adopted in the United                              of values of both PD and M. In this
      (SSC) approach. Under this approach,                                      States.                                                                table, LGD is assumed to equal 45
      rather than estimating the loan-level risk                                  Under the A–IRB approach, a banking                                  percent. This LGD is used for
      parameters, banking organizations                                         organization would estimate the risk                                   consistency with the similar table above
      would use slotting criteria to map their                                  inputs for each SL exposure and then                                   for wholesale exposures and should not
      internal risk rating grades to one of five                                calculate the A–IRB capital charge for                                 be construed as an indication that 45
      supervisory rating grades: Strong, Good,                                  the exposure by substituting the                                       percent is a typical LGD for HVCRE
      Satisfactory, Weak, and Default. In                                       estimated PD, LGD, EAD, and M into                                     exposures.

                                                                                      HVCRE CAPITAL REQUIREMENTS
                                                                                                   [In percentage points]

                                                                                                                                                             Effective remaining maturity
                                                                                                                                                        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                                       in the United States but in other                                      recognize and incorporate into its
      HVCRE exposures, unless the borrower                                      countries as well.                                                     implementation of the New Accord the
      has ‘‘substantial equity’’ at risk or the                                    Under the New Accord, SL loans                                      high asset correlation determinations of
      property is pre-sold or sufficiently pre-                                 financing the construction of one- to                                  other national supervisory authorities
      leased. In part, this reflects some                                       four-family residential properties (single                             for loans made in their respective
      empirical evidence suggesting that most                                   or in subdivisions) are included with                                  jurisdictions. Thus, when the Agencies
      ADC loans have relatively high asset                                      other ADC loans in the high asset                                      designate certain CRE properties as
      correlations. It also, however, reflects a                                correlation category. However, loans                                   HVCRE, foreign banking organizations
      longstanding supervisory concern that                                     financing the construction of pre-sold                                 making extensions of credit to those
      CRE lending to finance speculative                                        one- to four-family residential                                        properties also would be expected to
      construction and development is                                           properties would be eligible to be                                     treat them as HVCRE. Similarly, when
      vulnerable to, and may worsen,                                            treated as low-asset-correlation CRE
                                                                                                                                                       non-U.S. supervisory authorities
                                                                                exposures. In some cases the loans may
      speculative swings in CRE markets,                                                                                                               designate certain CRE as HVCRE, U.S.
                                                                                finance the construction of subdivisions
      especially when there is little borrower                                                                                                         banking organizations that extend credit
                                                                                or other groups of houses, some of
      equity at risk. Such lending was a major                                  which are pre-sold while others are not.                               to those properties would be expected to
      factor causing the stress experienced by                                     Under the New Accord, each national                                 treat them as HVCRE.
      many banks in the early 1990s, not only                                   supervisory authority is directed to

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      45916                   Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules

        The Agencies invite the submission of                 to applying the risk weight. If the                   own decisions to borrow and repay, up
      empirical evidence regarding the (relative or           banking organization is the debt                      to a limit established by the banking
      absolute) asset correlations characterizing             participant, the exposure would be                    organization. Most credit card exposures
      portfolios of ADC loans, as well as comments            treated as any other wholesale exposure.              to individuals and overdraft lines on
      regarding the circumstances under which
      such loans would appropriately be                          The Agencies are seeking comment on the            individual checking accounts would be
      categorized as HVCRE.                                   wholesale A–IRB capital formulas and the              QREs.
        The Agencies also invite comment on the               resulting capital requirements. Would this               The third sub-category of retail
      appropriateness of exempting from the high-             approach provide a meaningful and                     exposures, other retail exposures,
      asset-correlation category ADC loans with               appropriate increase in risk sensitivity in the       includes two types of exposures. First,
      substantial equity or that are pre-sold or              sense that the results are consistent with            it encompasses all exposures to
      sufficiently pre-leased. The Agencies invite            alternative assessments of the credit risks           individuals for non-business purposes
      comment on what standard should be used                 associated with such exposures or the capital         that are generally managed as part of a
      in determining whether a property is                    needed to support them? If not, where are             pool of similar exposures and that do
      sufficiently pre-leased when prevailing                 there material inconsistencies?                       not meet the conditions for inclusion in
      occupancy rates are unusually low.                         Does the proposed A–IRB maturity
                                                              adjustment appropriately address the risk
                                                                                                                    the first two sub-categories of retail
        The Agencies invite comment on whether
      high-asset-correlation treatment for one- to            differences between loans with differing              exposures. The Agencies are not
      four-family residential construction loans is           maturities?                                           proposing to establish a fixed upper
      appropriate, or whether they should be                                                                        limit on the size of exposures to
      included in the low-asset-correlation                   Retail Exposures: Definitions and Inputs              individuals that are eligible for the other
      category. In cases where loans finance the                                                                    retail treatment. In addition, the
                                                                 The second major exposure category
      construction of a subdivision or other group                                                                  Agencies are proposing that the other
      of houses, some of which are pre-sold while             in the A–IRB framework is the retail
                                                                                                                    retail sub-category include certain SME
      others are not, the Agencies invite comment             exposure category. This category                      exposures that are managed on a pool
      regarding how the ‘‘pre-sold’’ exception                encompasses the vast majority of credit               basis similar to retail exposures. These
      should be interpreted.                                  exposures to individual consumers. The                exposures could be to a company or to
        The Agencies invite comment on the                    Agencies also are considering whether                 an individual. The Agencies are
      competitive impact of treating defined                  certain SME exposures should be
      classes of CRE differently. What are                                                                          considering an individual borrower
                                                              eligible for retail A–IRB treatment. The              exposure threshold of $1 million for
      commenters’ views on an alternative                     retail exposure category has three
      approach where there is only one risk weight                                                                  such exposures. For the purpose of
      function for all CRE? If a single risk weight
                                                              distinct sub-categories: (1) Residential              assessing compliance with the
      function for all CRE is considered, what                mortgages (and related exposures); (2)                individual borrower exposure threshold,
      would be the appropriate asset correlation to           qualifying revolving exposures (QREs);                the banking organization would
      employ?                                                 and (3) other retail exposures. There are             aggregate all exposures to a particular
                                                              separate A–IRB capital formulas for                   borrower on a fully consolidated basis.
      Lease Financings                                        each of these three sub-categories to                 Credit card accounts with balances
         Under the wholesale A–IRB                            reflect different levels of associated risk.          between $100,000 and $1 million would
      framework, some lease financings                           The Agencies propose that the                      be considered other retail exposures
      require special consideration. A                        residential mortgage exposure sub-                    rather than QRE, even if the accounts
      distinction is made for leases that                     category be defined to include loans                  are extended to or guaranteed by an
      expose the lessor to residual value risk,               secured by first or subsequent liens on               individual and used exclusively for
      namely the risk of the fair value of the                one-to four-family residential                        small business purposes.
      assets declining below the banking                      properties, including term loans and
      organization’s estimate of residual risk                revolving lines of credit secured by                     The Agencies are interested in comment on
                                                                                                                    whether the proposed $1 million threshold
      at lease inception. If a banking                        home equity. There would be no upper
                                                                                                                    provides the appropriate dividing line
      organization has exposure to residual                   limit on the size of the exposure that                between those SME exposures that banking
      value risk, it would assign a 100 percent               could be included in the residential                  organizations should be allowed to treat on
      risk weight to the residual value amount                mortgage exposure sub-category, but the               a pooled basis under the retail A–IRB
      and determine a risk-weighted asset                     borrower would have to be an                          framework and those SME exposures that
      equivalent for the lease’s remaining net                individual and the banking organization               should be rated individually and treated
      investment (net of residual value                       should generally manage the exposure                  under the wholesale A–IRB framework.
      amount) using the same methodology as                   as part of a pool of similar exposures.                 One of the most significant
      for any other wholesale exposure. The                   Residential mortgage exposures that are               differences between the wholesale and
      sum of these components would be the                    individually internally rated and                     retail A–IRB categories is that the risk
      risk-weighted asset amount for a                        managed similarly to commercial                       inputs for retail exposures do not have
      particular lease. Where a banking                       exposures, rather than managed and                    to be assigned at the level of an
      organization does not have exposure to                  internally rated as pools, would be                   individual exposure. The Agencies
      residual value risk, the lease’s net                    treated under the wholesale A–IRB                     recognize that banking organizations
      investment would be subject to a capital                framework.                                            typically manage retail exposures on a
      charge using the same methodology                          The second sub-category of retail                  portfolio or pool basis, where each
      applied to any other wholesale                          exposures is qualifying revolving                     portfolio or pool contains exposures
      exposure.                                               exposures (QREs). The Agencies                        with similar risk characteristics.
         This approach would be used                          propose to define QREs as exposures to                Therefore, a key characteristic of the
      regardless of accounting classification as              individuals that are revolving,                       retail A–IRB framework is that the risk
      a direct finance, operating or leveraged                unsecured, uncommitted, less than                     inputs for retail exposures would be
      lease. For leveraged leases, when the                   $100,000, and managed as part of a pool               assigned to portfolios or pools of
      banking organization is the equity                      of similar exposures. In practice, QREs               exposures rather than to individual
      participant it would net the balance of                 will include primarily exposures where                exposures.
      the non-recourse debt against the                       customers’ outstanding borrowings are                   It is important to highlight that within
      discounted lease payment stream prior                   permitted to fluctuate based on their                 each of the three sub-categories of retail

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                              Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules                                                    45917

      exposures, the retail A–IRB framework                   EL, rather than by separately measuring               of implementation of the A–IRB
      is intended to provide banking                          PD and LGD, as required under the A–                  framework.
      organizations with substantial flexibility              IRB framework. Therefore, the Agencies                   The Agencies are proposing the
      to use the retail portfolio segmentation                propose that banking organizations be                 following data requirements for retail
      that they believe is most appropriate for               permitted substantial flexibility in                  A–IRB. Banking organizations would
      their activities. In determining how to                 translating measures of EL into the                   have to have a minimum of five years
      group their retail exposures within each                requisite PD and LGD inputs. For non-                 of data history for PD, LGD, and EAD,
      sub-category into portfolio segments for                revolving portfolio segments, EL                      and preferably longer periods so as to
      the purpose of assigning A–IRB risk                     generally would equal the product of PD               include a complete economic cycle.
      inputs, the Agencies believe that                       and LGD, so that if a banking                         Banking organizations would not have
      banking organizations should use a                      organization has an estimate of EL and                to give equal weight to all historical
      segmentation approach that is                           either PD or LGD, it would be able to                 factors if they can demonstrate that the
      consistent with their approach for                      infer an estimate of the other required               more recent data are better predictors of
      internal risk assessment purposes and                   input.                                                the risk inputs. Also, banking
      that classifies exposures according to                     In addition, the Agencies are                      organizations would have to have a
      predominant risk characteristics.                       proposing that if one or the other of PD              minimum of three years of experience
         As general principles for                            and LGD did not tend to vary                          with their portfolio segmentation and
      segmentation, banking organizations                     significantly across portfolio segments,              risk management systems.
      should group exposures in each of the                   the banking organization would be
                                                                                                                    Definition of Default and Loss
      three retail sub-categories into portfolios             permitted to apply a general estimate of
      or pools according to the sub-category’s                that input to multiple segments and to                  The retail definition of default and
      principal risk drivers, and would have                  use that general estimate, together with              loss being proposed by the Agencies
      to be able to demonstrate that the                      segment-specific estimates of EL, to                  differs significantly from that proposed
      resultant segmentation effectively                      infer segment-specific estimates of the               for the wholesale portfolio. Specifically,
      differentiates and rank orders risk and                 other required input. The Agencies note,              the Agencies propose to use the
      provides reasonably accurate and                        however, that this proposal offers                    definitions of loss recognition embodied
      consistent quantitative estimates of PD,                substantial flexibility to institutions and           in the Federal Financial Institutions
      LGD, and EAD. With the exceptions                       may, in fact, be overly flexible (for                 Examination Council (FFIEC) Uniform
      noted below, the Agencies are not                       example, because LGDs on residential                  Retail Credit Classification and Account
      proposing that institutions must                        mortgages tend to be quite cyclical). For             Management Policy.21 All residential
      consider any particular risk drivers or                 these loans, the above method of                      mortgages and all revolving credits
      employ any minimum number of                            inferring PDs or LGDs from a long-run                 would be charged off, or charged down
      portfolios or pools in any of the three                 average EL would not necessarily result               to the value of the property, after a
      retail sub-categories. The only specific                in PD being estimated as a long-run                   maximum of 180 days past due; other
      limitations that the Agencies would                     average, and LGD would not necessarily                credits would be charged off after a
      propose in regard to the portfolio                      reflect the loss rate expected to prevail             maximum of 120 days past due.
      segmentation of retail exposures are (1)                when default rates are high. Banking                    In addition, the Agencies are
      banking organizations generally would                   organizations using an EL approach to                 proposing to define a retail default to
      not be permitted to combine retail                      retail portfolio segmentation would                   include the occurrence of any one of the
      exposures from multiple countries into                  have to ensure that the A–IRB capital                 three following events if it occurs prior
      the same portfolio segment (because of                  requirement under this method is at                   to the respective 120- or 180-day FFIEC
      differences in national legal systems and               least as conservative as a PD/LGD                     policy trigger: (1) A full or partial
      bankruptcy regimes), and (2) banking                    method in order to minimize any                       charge-off resulting from a significant
      organizations would need to separately                  potential divergences between capital                 decline in credit quality of the exposure;
      segment delinquent retail exposures.                    requirements computed under the PD/                   (2) a distressed restructuring or workout
         The inputs to the retail A–IRB capital               LGD approach versus an EL approach.                   involving forbearance and loan
      formulas differ slightly from the inputs                   As in the wholesale A–IRB                          modification; or (3) a notification that
      to the wholesale A–IRB capital                          framework, a floor of 3 basis points                  the obligor has sought or been placed in
      formulas. Measures of PD, LGD, and                      (0.03 percent) applies to the PD                      bankruptcy. Finally, for retail exposures
      EAD remain important elements, but                      estimates for all retail exposures (that is,          (as opposed to wholesale exposures) the
      there is no M input to the retail A–IRB                 the minimum PD is 3 basis points). In                 definition of default may be applied to
      capital formulas. Rather, the retail A–                 addition, for residential mortgage                    a particular facility, rather than to the
      IRB capital formulas implicitly                         exposures other than those guaranteed                 obligor. That is, default on one
      incorporate average maturity effects in                 by a sovereign government, a floor of 10              obligation would not require a banking
      general, such as in the residential                     percent on the LGD estimate would                     organization to treat all other obligations
      mortgage sub-category.                                  apply, based on the view that LGDs                    of the same obligor as defaulted.
         Aside from the applicable definition                 during periods of high default rates are              Undrawn Lines
      of default, discussed below, the                        unlikely to fall below this level if
      definitions of PD, LGD, and EAD for                     measured appropriately. Along with the                  The treatment of undrawn lines of
      retail exposures are generally equivalent               overall monitoring of the                             credit, in particular those associated
      to those for wholesale exposures. One                   implementation of the advanced                        with credit cards, merits specific
      additional element of potential                         approaches and the determination                      discussion. Banking organizations
      flexibility for banking organizations in                whether to generally relax the floors                 would be permitted to incorporate
      the retail context needs to be                          established during the initial                        undrawn retail lines in one of two ways.
      highlighted. The Agencies recognize                     implementation phases (that is, the 90                First, banking organizations could
      that certain banking organizations that                 and 80 percent floors discussed above),                  21 The FFIEC Uniform Retail Credit Classification
      may qualify for the advanced                            the Agencies intend to review the need                and Account Management Policy was issued on
      approaches segment their retail                         to retain PD and LGD floors for retail                June 12, 2000. It is available on the FFIEC Web site
      portfolios for management purposes by                   exposures following the first two years               at

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      45918                   Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules

      incorporate them into their EAD                         seek to cover expected losses through                 desire to avoid excessive complexity in the
      estimates directly, by assessing the                    interest income and fees for all of their             retail A–IRB framework? What are views on
      likelihood that undrawn balances would                  business activities, and the Agencies                 the proposed approach to inclusion of SMEs
                                                                                                                    in the other retail category?
      be drawn at the time of an event of                     recognize that this practice is a
                                                                                                                       The Agencies are also seeking views on the
      default. Second, banking organizations                  particularly important aspect of the                  proposed approach to defining the risk
      could incorporate them into LGD                         business model for QREs.                              inputs for the retail A–IRB framework. Is the
      estimates by assessing the size of                         The Agencies are including in this                 proposed degree of flexibility in their
      potential losses in default (including                  proposal, for the QRE sub-category only,              calculation, including the application of
      those arising from both currently drawn                 that future margin income (FMI) be                    specific floors, appropriate? What are views
      and undrawn balances) as a proportion                   permitted to offset a portion of the A–               on the issues associated with undrawn retail
                                                              IRB retail capital charge relating to EL.             lines of credit described here and on the
      of the current drawn balance. In the
                                                              For this purpose, the Agencies propose                proposed incorporation of FMI in the QRE
      latter case, it is possible that the                                                                          capital determination process?
      relevant LGD estimates would exceed                     to define the amount of eligible FMI for                 The Agencies are seeking comment on the
      100 percent. While the proposed EAD                     the QRE sub-category as the amount of                 minimum time requirements for data history
      approach for undrawn wholesale and                      income anticipated to be generated by                 and experience with portfolio segmentation
      retail lines is the same, the Agencies are              the relevant exposures over the next                  and risk management systems: Are these time
      aware that the sheer volume of credit                   twelve months that can reasonably be                  requirements appropriate during the
      card undrawn lines and the ratio of                     assumed to be available to cover                      transition period? Describe any reasons for
                                                              potential credit losses on the exposures              not being able to meet the time requirements.
      undrawn lines to outstanding balances
      create issues for undrawn retail lines                  after covering expected business                      Retail Exposures: Formulas
      that differ from undrawn wholesale                      expenses, and after subtracting a
                                                              cushion to account for potential                         The retail A–IRB capital formulas are
      lines not only in degree but also in kind.                                                                    very similar to the wholesale A–IRB
         An additional issue arises in                        volatility in credit losses (UL). FMI
                                                              would not be permitted to include                     formulas, and are based on the same
      connection with the undrawn lines
                                                              anticipated income from new accounts                  underlying concepts. However, because
      associated with credit card accounts
                                                              and would have to incorporate                         there is no M adjustment associated
      whose drawn balances (but not
                                                              assumptions about income from existing                with the retail A–IRB framework, the
      undrawn balances) have been
                                                              accounts that are in line with the                    retail A–IRB capital calculations
      securitized. To the extent that banking
                                                              banking organization’s historical                     generally involve fewer steps than the
      organizations remain exposed to the risk
                                                              experience. The amount of the cushion                 wholesale A–IRB capital calculations.
      that such undrawn lines will be drawn,
                                                              to account for potential volatility in                As with the wholesale A–IRB
      but such undrawn lines are not
                                                              credit losses would be set equal to two               framework, the output of the retail A–
      themselves securitized, then there is a
                                                              standard deviations of the banking                    IRB formulas is a minimum capital
      need for institutions to hold regulatory
                                                              organization’s annualized loss rate on                requirement, expressed in dollars, for
      capital against such undrawn lines. The
                                                              the exposures. The Agencies would                     the relevant pool of exposures. The
      Agencies propose that a banking
                                                              expect banking organizations to be able               capital requirement would be converted
      organization would be required to hold
                                                              to support their estimates of eligible                into an equivalent amount of risk-
      capital against the full amount of any
                                                              FMI on the basis of historical data and               weighted assets by multiplying the
      undrawn lines regardless of whether
                                                              would disallow the use of FMI in the                  capital requirement by 12.5. The two
      drawn amounts are securitized. This
                                                              QRE capital formula if this is not the                key steps in implementing the retail A–
      presumes that the institution itself is
                                                              case. The step needed to recognize                    IRB capital formulas are (1) assessing
      exposed to the credit risk associated
                                                              eligible FMI is discussed below.                      the relevant asset correlation parameter,
      with future draws.
                                                                 Permitting a FMI offset to the A–IRB               and (2) calculating the minimum capital
         The Agencies are interested in comments              capital requirement for QREs could have               requirement for the relevant pool of
      and specific proposals concerning methods               a significant impact on the level of                  exposures.
      for incorporating undrawn credit card lines
      that are consistent with the risk                       minimum regulatory capital at                         Residential Mortgages and Related
      characteristics and loss and default histories          institutions adopting the advanced                    Exposures
      of this line of business.                               approaches. The Agencies would need
         The Agencies are interested in further               to fully assess and analyze the impact of                For residential mortgage and related
      information on market practices in this                 such an FMI offset on institutions’ risk-             exposures, the retail A–IRB capital
      regard, in particular the extent to which               based capital ratios prior to final                   formula requires only one step. This is
      banking organizations remain exposed to                 implementation of the A–IRB approach.                 because the asset correlation parameter
      risks associated with such accounts. More                                                                     for such exposures is fixed at 15
                                                              Furthermore, the Agencies anticipate
      broadly, the Agencies recognize that                                                                          percent, regardless of the PD of any
      undrawn credit card lines are significant in            the need to issue additional guidance
                                                              setting out more specific expectations in             particular pool of exposures. The fixed
      both of the contexts discussed above, and are
      particularly interested in views on the                 this regard.                                          asset correlation parameter reflects the
      appropriate retail A–IRB treatment of such                                                                    Agencies’ view that the arguments for
                                                                 For the QRE sub-category of retail
      exposures.                                              exposures only, the Agencies are seeking
                                                                                                                    linking the asset correlation to PD, as
                                                              comment on whether or not to allow banking            occurs in the wholesale A–IRB
      Future Margin Income                                                                                          framework and in the other two sub-
                                                              organizations to offset a portion of the A–IRB
         In the New Accord, the retail A–IRB                  capital requirement relating to EL by                 categories of retail exposures, are not as
      treatment of QREs includes a unique                     demonstrating that their anticipated FMI for          relevant for residential mortgage-related
      additional input that arises because of                 this sub-category is likely to more than              exposures, whose performance is
      the large amount of expected losses                     sufficiently cover EL over the next year.             significantly influenced by broader
      typically associated with QREs. As                         The Agencies are seeking comment on the            trends in the housing market for
                                                              proposed definitions of the retail A–IRB
      noted above, the A–IRB approach would                   exposure category and sub-categories. Do the          borrowers of all credit qualities. The
      require banking organizations to hold                   proposed categories provide a reasonable              assumed asset correlation of 15 percent
      regulatory capital against both EL and                  balance between the need for differential             also seeks implicitly to reflect the higher
      UL. Banking organizations typically                     treatment to achieve risk-sensitivity and the         average maturity associated with

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                                      Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules                                                                       45919

      residential mortgage exposures and is                                     Where                                                                     The following table depicts a range of
      therefore higher than would likely be                                     K denotes the capital requirement;                                     representative capital requirements (K)
      the case if a specific maturity                                           EAD denotes exposure at default;                                       for residential mortgage and related
      adjustment were also included in the                                      LGD denotes loss given default;                                        exposures based on this formula. Three
      retail A–IRB framework. The proposed                                      N(x) denotes the standard normal                                       different illustrative LGD assumptions
      retail A–IRB capital formula for                                              cumulative distribution function;                                  are shown: 15 percent, 35 percent, and
      residential mortgage and related                                          G(x) denotes the inverse of the standard                               55 percent. For comparison purposes,
      exposures is as follows:                                                      normal cumulative distribution                                     the current capital requirement on most
      K = EAD * LGD * N[1.08465 * G(PD) +                                           function; and                                                      first mortgage loans is 4 percent and on
           0.4201 * G(0.999)]                                                   PD denotes probability of default.                                     most home equity loans is 8 percent.

                                                                                              CAPITAL REQUIREMENTS
                                                                                                   [In percentage points]

                                                                                                                                                       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,                                   assess whether it may be appropriate to                                correlation parameter, (2) calculation of
      evidence from QIS3 suggested that                                         exclude residential mortgages covered by                               the minimum capital requirement
      advanced approach banking                                                 PMI from the proposed 10 percent LGD floor.                            assuming no offset for eligible FMI, and
      organizations would experience a                                          The Agencies request comment on whether                                (3) application of the offset for eligible
                                                                                or the extent to which it might be appropriate
      reduction in credit risk capital                                          to recognize PMI in LGD estimates.
                                                                                                                                                       FMI. These steps would be performed
      requirements for residential mortgage                                        More broadly, the Agencies are interested                           for each QRE portfolio segment
      exposures of about 56 percent.                                            in information regarding the risks of each                             individually.
      Private Mortgage Insurance                                                major type of residential mortgage exposure,                              As in the case of wholesale exposures,
                                                                                including prime first mortgages, sub-prime                             it is assumed that the asset correlation
         The Agencies wish to highlight one                                     mortgages, home equity term loans, and                                 for QREs declines as PD rises. This
      issue associated with the A–IRB capital                                   home equity lines of credit. The Agencies are                          reflects the view that pools of borrowers
      requirements for the residential                                          aware of various views on the resulting                                with lower credit quality (higher PD) are
      mortgage sub-category relating to the                                     capital requirements for several of these
                                                                                product areas, and wish to ensure that all
                                                                                                                                                       less likely to experience simultaneous
      treatment of private mortgage insurance                                                                                                          defaults than pools of higher credit
      (PMI). Most PMI arrangements                                              appropriate evidence and views are
                                                                                considered in evaluating the A–IRB treatment                           quality (lower PD) borrowers, because
      effectively provide partial compensation                                                                                                         with higher PD borrowers defaults are
                                                                                of these important exposures.
      to the banking organization in the event                                     The risk-based capital requirements for                             more likely to result from borrower-
      of a mortgage default. Accordingly, the                                   credit risk of prime mortgages could well be                           specific or idiosyncratic factors. In the
      Agencies consider that it may be                                          less than one percent of their face value                              case of QREs, the asset correlation
      appropriate for banking organizations to                                  under this proposal. The Agencies are                                  approaches an upper bound value of 11
      recognize such effects in the LGD                                         interested in evidence on the capital required                         percent for very low PD values and
      estimates for individual mortgage                                         by private market participants to hold
                                                                                mortgages outside of the federally insured
                                                                                                                                                       approaches a lower bound value of 2
      portfolio segments, consistent with the                                                                                                          percent for very high PD values. The
      historical loss experience on those                                       institution and GSE environment. The
                                                                                Agencies also are interested in views on                               specific formula for determining the
      segments during periods of high default                                                                                                          asset correlation parameter for QREs is
                                                                                whether the reductions in mortgage capital
      rates. Such an approach would avoid                                       requirements on mortgage loans                                         as follows:
      requiring banking organizations to                                        contemplated here would unduly extend the
      quantify specifically the effect of PMI on                                                                                                       R = 0.02 * (1–EXP(¥50 * PD)) + 0.11 *
                                                                                federal safety net and risk contributing to a
      a loan-by-loan basis; rather, they could                                                                                                               [1–(1–EXP(¥50 * PD))]
                                                                                credit-induced bubble in housing prices. In
      estimate the effect of PMI on an average                                  addition, the Agencies are also interested in                          Where
      basis for each segment. This approach                                     views on whether there has been any                                    R denotes asset correlation;
      effectively ignores the risk that the                                     shortage of mortgage credit under the general
                                                                                                                                                       EXP denotes the natural exponential
      mortgage insurers themselves could                                        risk-based capital rules that would be
                                                                                alleviated by the proposed changes.                                          function; and
      default.                                                                                                                                         PD denotes probability of default.
        The Agencies seek comment on the                                        Qualifying Revolving Exposures
                                                                                                                                                          The second step in the A–IRB capital
      competitive implications of allowing PMI                                    The second sub-category of retail                                    calculation for QREs would be the
      recognition for banking organizations using
      the A–IRB approach but not allowing such                                  exposures is QREs. The calculation of                                  calculation of the capital requirement
      recognition for general banks. In addition, the                           A–IRB capital requirements for QREs                                    assuming no FMI offset. The specific
      Agencies are interested in data on the                                    would require three steps: (1)                                         formula to calculate this amount is as
      relationship between PMI and LGD to help                                  Calculation of the relevant asset                                      follows:

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      45920                           Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules

      KNo FMI = EAD * LGD * N[(1–R)∧¥0.5                                        appropriate to perform the FMI calculation.                            required to calculate the A–IRB capital
          * G(PD) + (R/(1–R))∧0.5 * G(0.999)]                                   Would a requirement that FMI eligibility                               requirement for other retail exposures:
                                                                                calculations be performed separately for each                          (1) Calculating the relevant asset
      Where                                                                     portfolio segment effectively allow FMI to
      KNo FMI denotes the capital requirement                                   offset EL capital requirements for QREs?
                                                                                                                                                       correlation parameter, and (2)
          assuming no FMI offset;                                                                                                                      calculating the capital requirement.
                                                                                  The following table depicts a range of                               Both of these steps would be done
      EAD denotes exposure at default;                                          representative capital requirements (K)
      LGD denotes loss given default;                                                                                                                  separately for each portfolio segment
                                                                                for QREs based on these formulas. In                                   included within the other retail sub-
      N(x) denotes the standard normal                                          each case, it is assumed that the
          cumulative distribution function;                                                                                                            category.
                                                                                maximum offset for eligible FMI has                                      As for wholesale exposures and QREs,
      R denotes asset correlation;                                              been applied. The LGD is assumed to
      G(x) denotes the inverse of the standard                                                                                                         the asset correlation parameter for other
                                                                                equal 90 percent, consistent with                                      retail exposures declines as PD rises. In
          normal cumulative distribution                                        recovery rates for credit card portfolios.
          function; and                                                                                                                                the case of other retail exposures, the
                                                                                The table shows capital requirements                                   asset correlation parameter approaches
      PD denotes probability of default.                                        with recognition of FMI and without                                    an upper bound value of 17 percent for
      Future Margin Income Adjustment                                           recognition of FMI but using the same                                  very low PD values and approaches a
                                                                                formula in other respects. As PDs                                      lower bound value of 2 percent for very
         The result of this calculation                                         increase, the proportion of total required
      effectively includes both an EL and a UL                                                                                                         high PD values. The specific formula for
                                                                                capital held against EL after deducting                                determining the asset correlation for
      component. As already discussed, for                                      the 75 percent offset rises at an
      QREs only, the Agencies are considering                                                                                                          other retail exposures is as follows:
                                                                                increasing rate and the proportion held
      the possibility of allowing institutions                                  against UL declines at an increasing                                   R = 0.02 * (1¥EXP(¥35 * PD)) + 0.17
      to offset a portion of the EL portion of                                  rate. Offsets from EL, as considered in                                     * [1¥(1¥EXP(¥35 * PD))]
      the capital requirement using eligible                                    this ANPR, would therefore have a                                      Where
      FMI. Up to 75 percent of the EL portion                                   proportionally greater impact on                                       R denotes asset correlation;
      of the capital requirement could                                          reducing required capital charges as                                   EXP denotes the natural exponential
      potentially be offset in this fashion. The                                default probabilities increase. For                                         function; and
      specific calculation for determining the                                  comparison purposes, the current                                       PD denotes probability of default.
      capital requirement (K) after application                                 capital requirement on drawn credit
      of the potential offset for eligible FMI is                                                                                                        The second step in the A–IRB capital
                                                                                card exposures is 8 percent and is zero                                calculation for other retail exposures
      as follows.                                                               for undrawn credit lines.                                              would be the calculation of the capital
      K = KNo FMI¥eligible FMI offset                                                                                                                  requirement (K). The specific formula to
      Where                                                                                    CAPITAL REQUIREMENT                                     calculate this amount is as follows:
      K denotes the capital requirement after                                                      [In percentage points]
                                                                                                                                                       K = EAD * LGD * N[(1¥R)∧¥0.5 *
            application of an offset for eligible                                                                                                           G(PD) + (R / (1¥R))∧0.5 * G(0.999)]
            FMI;                                                                                                 With FMI            Without FMI
                                                                                           PD                                                          Where
                                                                                                                capital 8%           capital 8%
      KNo FMI denotes the capital requirement
            assuming no FMI offset;                                                                                                                    K denotes the capital requirement;
                                                                                0.05    ...................              0.68                   0.72
      Eligible FMI offset equals:                                               0.10    ...................              1.17                   1.23   EAD denotes exposure at default;
         0.75 * EL if estimated FMI equals or                                   0.25    ...................              2.24                   2.41   LGD denotes loss given default;
            exceeds the expected 12-month loss                                  0.50    ...................              3.44                   3.78   PD denotes probability of default;
            amount plus two standard                                            1.00    ...................              4.87                   5.55   N(x) denotes the standard normal
                                                                                2.00    ...................              6.21                   7.56        cumulative distribution function;
            deviations of the annualized loss                                   5.00    ...................              7.89                  11.27
            rate, or zero otherwise;                                                                                                                   G(x) denotes the inverse of the standard
                                                                                10.0    ...................             11.12                  17.87        normal cumulative distribution
      EL denotes expected loss (EL = EAD *                                      20.0    ...................             17.23                  30.73
            PD * LGD);                                                                                                                                      function; and
      FMI denotes future margin income;                                           Subject to the same qualifications                                   R denotes asset correlation.
      EAD denotes exposure at default;                                          mentioned earlier, the QIS3 results                                      The following table depicts a range of
      PD denotes probability of default; and                                    estimated an increase in credit risk                                   representative capital requirements (K)
      LGD denotes loss given default.                                           capital requirements for QREs of about                                 for other retail exposures based on this
         If eligible FMI did not exceed the                                     16 percent.                                                            formula. Three different LGD
      required minimum, then recognition of                                                                                                            assumptions are shown—25 percent, 50
                                                                                Other Retail Exposures                                                 percent, and 75 percent—in order to
      eligible FMI would be disallowed.
                                                                                  The third and final sub-category of                                  depict a range of potential outcomes
         The Agencies are interested in views on                                retail A–IRB exposures is other retail                                 depending on the characteristics of the
      whether partial recognition of FMI should be
      permitted in cases where the amount of
                                                                                exposures. This sub-category                                           underlying retail exposure. For
      eligible FMI fails to meet the required                                   encompasses a wide variety of different                                comparison purposes, the current
      minimum. The Agencies also are interested                                 exposures including auto loans, student                                capital requirement on most of the
      in views on the level of portfolio                                        loans, consumer installment loans, and                                 exposures likely to be included in the
      segmentation at which it would be                                         some SME loans. Two steps would be                                     other retail sub-category is 8 percent.

                                                                                              CAPITAL REQUIREMENTS
                                                                                                   [In percentage points]

                                                                                                                                                       25 percent     50 percent     75 percent

      0.05 percent .................................................................................................................................          0.33            0.66          0.99

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                                      Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules                                                                        45921

                                                                                  CAPITAL REQUIREMENTS—Continued
                                                                                                   [In percentage points]

                                                                                                                                                       25 percent      50 percent      75 percent

      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                                 offset the EL portion of A–IRB capital                                    Another issue the Agencies wish to
      earlier, QIS3 estimated a 25 percent                                      requirements in certain circumstances.                                 highlight is the inclusion within the
      reduction in credit risk-based capital                                       The offset would be limited to that                                 New Accord of the ability for banking
      requirements for the other retail                                         amount of EL that exceeds the 1.25                                     organizations to make use of ‘‘general
      category.                                                                 percent limit. For example, if the 1.25                                specific’’ provisions as a direct offset
        The Agencies are seeking comment on the                                 percent limit equals $100, the ALLL                                    against EL capital requirements. Such
      retail A–IRB capital formulas and the                                     equals $125, and the EL portion of the                                 provisions are not specific to particular
      resulting capital requirements, including the                             A–IRB capital requirement equals $110,                                 exposures but are specific to particular
      specific issues mentioned. Are there                                      then $10 of the capital requirement may                                categories of exposures and are not
      particular retail product lines or retail                                 be directly offset ($110¥$100). The                                    allowed as an element of Tier 2 capital.
      activities for which the resulting A–IRB                                  additional amount of the ALLL not                                      While several other countries make use
      capital requirements would not be                                                                                                                of such provisions, the Agencies do not
      appropriate, either because of a misalignment
                                                                                included in Tier 2 capital and not
                                                                                included as a direct offset against the A–                             believe existing elements of the ALLL in
      with underlying risks or because of other                                                                                                        the United States qualify for such
      potential consequences?                                                   IRB capital requirement ($125¥$110 =
                                                                                $15 in the example) would continue to                                  treatment.
      A–IRB: Other Considerations                                               be deducted from risk-weighted assets.                                    The Agencies seek views on this issue,
                                                                                                                                                       including whether the proposed U.S.
         As described earlier, the A–IRB                                           It is important to recognize that this                              treatment has significant competitive
      capital requirement includes                                              treatment would likely result in a                                     implications. Feedback also is sought on
      components to cover both EL and UL.                                       significantly more favorable treatment of                              whether there is an inconsistency in the
      Because banking organizations have                                        such excess ALLL amounts than simply                                   treatment of general specific provisions (all
      resources other than capital to cover EL,                                 deducting them from risk-weighted                                      of which may be used as an offset against the
      the Agencies propose to recognize                                         assets. Under the proposal, banking                                    EL portion of the A–IRB capital requirement)
                                                                                organizations would be allowed to                                      in comparison to the treatment of the ALLL
      certain of these measures as potential                                                                                                           (for which only those amounts of general
      offsets to the A–IRB capital requirement,                                 multiply the eligible excess ALLL by a                                 reserves exceeding the 1.25 percent limit may
      subject to the limitations set forth                                      factor of 12.5 because the minimum                                     be used to offset the EL capital charge).
      below. The use of eligible FMI for QREs                                   total capital requirement is 8 percent of
      is one such potential mechanism that                                      risk-weighted assets. In effect, this                                  Charge-Offs
      has already been discussed.                                               treatment is 12.5 times more favorable
                                                                                                                                                         Another potential offset to the EL
                                                                                than the treatment contained in the
      Loan Loss Reserves                                                                                                                               portion of the A–IRB capital
                                                                                general risk-based capital rules, which
                                                                                                                                                       requirements is the use of partial
        A second important mechanism                                            allow only a deduction against risk-
                                                                                                                                                       charge-offs, where a portion of an
      involves the allowance for loan and                                       weighted assets on a dollar-for-dollar
                                                                                                                                                       individual exposure is written off.
      lease losses (ALLL), also referred to as                                  basis. In addition, it is important to note
                                                                                                                                                       Given the A–IRB definition of default, a
      general loan loss reserves. Under the                                     that a dollar-for-dollar offset against the
                                                                                                                                                       partial charge-off would cause an
      general risk-based capital rules, an                                      A–IRB capital requirement is also more
                                                                                                                                                       exposure to be classified as a defaulted
      amount of the ALLL is eligible for                                        favorable than the inclusion of ALLL
                                                                                                                                                       exposure (that is, PD=100%), in which
      inclusion as an element of Tier 2                                         below the 1.25 percent limit in Tier 2
                                                                                                                                                       case the A–IRB capital formulas ensure
      capital, up to a limit equal to 1.25                                      capital, because the latter has no impact
                                                                                                                                                       that the resulting capital requirement on
      percent of gross risk-weighted assets.                                    on Tier 1 capital ratios, while the former
                                                                                                                                                       the defaulted exposure is equal to EAD
      Loan loss reserves above this limit are                                   does.
                                                                                                                                                       * LGD, where EAD is defined as the
      deducted from risk-weighted assets, on                                       The Agencies recognize the existence of                             gross exposure amount prior to the
      a dollar-for-dollar basis. The New                                        various issues in regard to the proposed                               partial charge-off. All of this capital
      Accord proposes to retain the 1.25                                        treatment of ALLL amounts in excess of the                             requirement can be considered to be
      percent limit on the eligibility of loan                                  1.25 percent limit and are interested in views
                                                                                                                                                       covering EL.
                                                                                on these subjects, as well as related issues
      loss reserves as an element of Tier 2                                                                                                              The New Accord proposes that for
                                                                                concerning the incorporation of expected
      capital. However, the New Accord also                                     losses in the A–IRB framework and the
                                                                                                                                                       such partially charged-off exposures, the
      contains, and the Agencies are                                            treatment of the ALLL generally. Specifically,                         banking organization be allowed to use
      proposing for comment, a feature that                                     the Agencies invite comment on the domestic                            the amount of the partial charge-off to
      would allow the amount of the ALLL                                        competitive impact of the potential                                    offset the EL component of that asset’s
      (net of associated deferred tax) above                                    difference in the treatment of reserves                                capital charge on a dollar-for-dollar
      this 1.25 percent limit to be used to                                     described above.                                                       basis. In addition, to the extent that the

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      45922                   Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules

      partial charge-off on a defaulted                       exposures acquired from another                         However, under the conditions detailed
      exposure exceeds the EL capital charge                  institution (purchased receivables). The                below, an alternative top-down
      on that exposure, the amount of this                    purchase of such receivables may                        approach (similar to that used for retail
      surplus could be used to offset the EL                  expose the acquiring banking                            exposures) may be applied to pools of
      capital charges on other defaulted assets               organization to potential losses from                   purchased receivables if the purchasing
      in the same portfolio (for example,                     two sources: credit losses attributable to              banking organization can only estimate
      corporates, banks, residential mortgages,               defaults by the underlying receivables                  inputs to the capital function (PD, LGD,
      etc.), but not for any other purpose.                   obligors, and losses attributable to                    EAD, and M) on a pool or aggregate
         An implication of this aspect of the                 dilution of the underlying receivables.22               basis.
      New Accord is that if a defaulted loan’s                The total A–IRB capital requirement for
      charge-off were at least equal to its                   purchased receivables would be the sum                  Top-Down Method for Pools of
      expected loss, no additional capital                    of (a) a capital charge for credit risk, and            Purchased Receivables
      requirement would be incurred on that                   (b) a separate capital charge for dilution                 Under the top-down approach,
      exposure. For example, consider a $100                  risk, when dilution is a material factor.               required capital would be determined
      defaulted exposure having an LGD of 40                                                                          using the appropriate A–IRB capital
      percent, implying an expected loss of                   Capital Charge for Credit Risk
                                                                                                                      formula (that is, for wholesale
      $40, equal to the IRB capital charge. If                   The New Accord’s proposed                            exposures, the wholesale capital
      the charge-off were equal to $40, under                 treatment of purchased loans would                      function, and for retail exposures, the
      the New Accord approach, there would                    treat a purchase discount as equivalent                 appropriate retail capital function) in
      be no additional capital required against               to a partial charge-off, and for this                   combination with estimates of PD, LGD,
      the resultant $60 net position. The                     reason it could imply a zero capital                    EAD, and M developed for pools of
      Agencies do not believe this is a                       charge against certain exposures. In                    receivables. In estimating the pool
      prudent or acceptable outcome, since                    general, a zero capital charge would                    parameters, the banking organization
      this position is not riskless and a                     emerge whenever the difference                          first would determine EL for the
      banking organization could be forced to                 between a loan’s face value and                         purchased receivables pool, expressed
      recognize additional charge-offs if the                 purchase price (the purchase discount)                  (in decimal form) at an annual rate
      recoveries turn out to be less than                     was greater than or equal to its LGD, as                relative to the amount currently owed to
      expected.                                               might be the case with a secondary                      the banking organization by the obligors
         To prevent this possibility, the                     market purchase of deeply distressed                    in the receivables pool. The estimated
      Agencies propose that, for defaulted                    debt. Again, the Agencies believe that a                EL would not take into account any
      exposures, the A–IRB capital charge                     zero capital charge in such a                           assumptions of recourse or guarantees
      (inclusive of any EL offsets for charge-                circumstance is unwarranted because                     from the seller of the receivables or
      offs) be calculated as the sum of (a) EAD               the position is not riskless.                           other parties. If the banking organization
      * LGD less any charge-offs and (b) 8                       The Agencies propose that for a credit
                                                                                                                      can decompose EL into PD and LGD
      percent of the carrying value of the loan               exposure that is purchased or acquired
                                                                                                                      components, then it would do so and
      (that is, the gross exposure amount                     from another party, the A–IRB capital
                                                                                                                      use those components as inputs into the
      (EAD) less any charge-offs).                            charge would be calculated as if the
                                                                                                                      capital function. If the institution
         Also, the charged off amounts in                     exposure were a direct loan to the
                                                                                                                      cannot decompose EL, then it would use
      excess of the EAD * LGD product would                   underlying obligor in the amount of the
                                                                                                                      the following split: PD would equal the
      not be permitted to offset the EL capital               loan’s carrying value to the purchasing
                                                                                                                      estimated EL, and LGD would be 100
      requirements for other exposures. In                    banking organization with other
                                                                                                                      percent. Under the top-down approach,
      effect, the proposed A–IRB capital                      attributes of the loan agreement (for
                                                              example, maturity, collateral,                          EAD would equal the carrying amount
      charge on a defaulted exposure adds a
                                                              covenants) and, hence, LGD, remaining                   of the receivables and for wholesale
      buffer for defaulted assets and results in
                                                              unchanged. This treatment would apply                   exposures, M would equal the exposure-
      a floor equal to 8 percent of the
                                                              regardless of whether the carrying value                weighted average effective maturity of
      remaining book value of the exposure if
                                                              to the purchasing banking organization                  the receivables in the pool.23
      the banking organization has taken a
      charge-off equal to or greater than the                 was less than, equal to, or greater than                Treatment of Undrawn Receivables
      EAD * LGD. Importantly, this treatment                  the underlying instrument’s face value.                 Purchase Commitments
      would not apply to a defaulted exposure                 Thus, if a loan having a principal
                                                                                                                        Capital charges against any undrawn
      that has been restructured and where                    amount equal to $100 and associated PD
                                                                                                                      portions of receivables purchase
      the obligor has not yet defaulted on the                and LGD of 10 percent and 40 percent
                                                                                                                      facilities (‘undrawn purchase
      restructured credit. Upon any                           was purchased for $80, the capital
                                                                                                                      commitments’) also would be calculated
      restructuring, whether associated with a                charge against the purchased loan
                                                                                                                      using the top-down methodology. The
      default or otherwise, the A–IRB capital                 would be calculated as if that loan had
                                                                                                                      EL (and/or PD and LGD) parameters
      charge would be based on the EAD, PD,                   an EAD equal to $80, PD equal to 10
                                                                                                                      would be determined on the basis of the
      LGD, and M applicable to the exposure                   percent, and LGD equal to 40 percent.
                                                                 In general, the same treatment would                 current pool of eligible receivables using
      after it has been restructured. The                                                                             the pool-level estimation methods
      existence of any partial charge-offs                    apply to pools of purchased receivables.
                                                                                                                      described above. For undrawn
      associated with the pre-restructured                                                                            commitments under revolving purchase
                                                                22 Dilution refers to the possibility that the
      credit would affect the A–IRB capital                                                                           facilities, the New Accord specifies that
                                                              contractual amounts payable by the receivables
      charge on the restructured exposure                     obligors may be reduced through future cash or          the EAD would be set at 75 percent of
      only through its impact on the post-                    non-cash credits to the accounts of these obligors.     the undrawn line. This treatment
      restructured exposure’s EAD, PD, and/or                 Examples include offsets or allowances arising from
                                                                                                                      reflects a concern that relevant
      LGD.                                                    returns of goods sold, disputes regarding product
                                                              quality, possible debts of the originator/seller to a
      Purchased Receivables                                   receivables obligor, and any payment or                   23 If a banking organization can estimate the

                                                              promotional discounts offered by the originator/        exposure-weighted average size of the pool it also
         This section describes the A–IRB                     seller (for example, a credit for cash payments         would use the firm-size adjustment (S) in the
      treatment for wholesale and retail credit               within 30 days).                                        wholesale framework.

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                              Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules                                                      45923

      historical data for estimating such EADs                may be calculated at the level of each                       inputs and expected dilution losses and
      reliably is not available at many banking               individual receivable and then                               for the control and risk management
      organizations. For other undrawn                        aggregated, or, for a pool of receivables,                   systems associated with purchased
      purchase commitments, EAD would be                      at the level of the pool as a whole. The                     receivables programs that are consistent
      estimated by the banking organization                   capital charge for dilution risk would be                    with the general guidance contained in
      providing the facility and would be                     calculated using the wholesale A–IRB                         the New Accord. These standards will
      subject to the same operational                         formula and the following parameters:                        aim to ensure that risk input and
      standards that are applicable to                        EAD would be equal to the gross                              expected dilution loss estimates are
      undrawn wholesale credit lines. The                     amount of receivable(s) balance(s); LGD                      reliable and consistent over time, and
      level of M associated with undrawn                      would be 100 percent; M would be the                         reflect all relevant information that is
      purchase commitments would be the                       (exposure weighted-average) effective                        available to the acquiring banking
      average effective maturity of receivables               remaining maturity of the exposure(s);                       organization. The minimum operational
      eligible for purchase from that seller, so              and PD would be the expected dilution                        requirements are intended to ensure that
      long as the facility contains effective                 loss rate, defined as total expected                         the acquiring banking organization has
      arrangements for protecting the banking                 dilution losses over the remaining term                      a valid legal claim to cash proceeds
      organization against an unanticipated                   of the receivable(s) divided by EAD.25                       generated by the receivables pool, that
      deterioration. In the absence of such                   Expected dilution losses would be                            the pool and cash proceeds are closely
      protections, the M for an undrawn                       computed on a stand-alone basis; that is,                    monitored and controlled, and that
      commitment would be calculated as the                   under the assumption of no recourse or                       systems are in place to identify and
      sum of (a) the longest-dated potential                  other support from the seller or third-                      address seller, servicer, and other
      receivable under the purchase                           party guarantors.                                            potential risks. A more detailed
      agreement, and (b) the remaining                           The following table illustrates the
                                                                                                                           discussion of these requirements will be
      maturity of the facility.                               dilution risk capital charges (per dollar
                                                                                                                           provided when the Agencies release
        The Agencies seek comment on the                      of EAD) implied by this approach for a
                                                                                                                           draft examination guidance dealing with
      proposed methods for calculating credit risk            hypothetical pool of purchased
                                                              receivables having a remaining maturity                      purchased receivables programs.
      capital charges for purchased receivables.
      Are the proposals reasonable and                        of one year or less. As can be seen, the                        The Agencies seek comment on the
      practicable?                                            proposal implies capital charges for                         appropriate eligibility requirements for using
        For committed revolving purchase                      dilution risk that are many multiples of                     the top-down method. Are the proposed
      facilities, is the assumption of a fixed 75             expected dilution losses.                                    eligibility requirements, including the $1
      percent conversion factor for undrawn lines                                                                          million limit for any single obligor,
      reasonable? Do banking organizations have
      the ability (including relevant data) to                            CAPITAL REQUIREMENTS                             reasonable and sufficient?
      develop their own estimate of EADs for such                               [In percentage points]                        The Agencies seek comment on the
      facilities? Should banking organizations be                                                                          appropriate requirements for estimating
      permitted to employ their own estimated                                                              Dilution risk   expected dilution losses. Is the guidance set
      EADs, subject to supervisory approval?                                                             capital charge    forth in the New Accord reasonable and
                                                                   Expected dilution loss rate            (per dollar of   sufficient?
         A banking organization may only use                                                             EAD, percent)
      the top-down approach with approval of                                                                               Risk Mitigation
      its primary Federal supervisor. In                      0.05 percent ..........................              2.05
      addition, the purchased receivables                     0.10 percent ..........................              3.42      For purposes of reducing the capital
      would have to have been purchased                       0.25 percent ..........................              6.41    charges for credit risk or dilution risk
      from unrelated, third party sellers and                 0.50 percent ..........................              9.77    with respect to purchased receivables,
                                                              1.00 percent ..........................             14.03
      the organization may not have                                                                                        purchase discounts, guarantees, and
                                                              2.00 percent ..........................             19.03
      originated the credit exposures either                  5.00 percent ..........................             28.45    other risk mitigants may be recognized
      directly or indirectly. The receivables                 10.00 percent ........................              41.24    through the same framework used
      must have been generated on an arm’s                                                                                 elsewhere in the A–IRB approach.
      length basis between the seller and the                    The Agencies seek comment on the
      obligor (intercompany accounts                          proposed methods for calculating dilution                    Credit Risk Mitigation Techniques
      receivable and receivables subject to                   risk capital requirements. Does this
                                                              methodology produce capital charges for                         The New Accord takes account of the
      contra-accounts between firms that buy                                                                               risk-mitigating effects of both financial
      and sell to each other would not                        dilution risk that seem reasonable in light of
                                                              available historical evidence? Is the                        and nonfinancial collateral, as well as
      qualify). Also, the receivables may not                 wholesale A–IRB capital formula appropriate                  guarantees, including credit derivatives.
      have a remaining maturity of greater                    for computing capital charges for dilution                   For these risk mitigants to be recognized
      than one year, unless they are fully                    risk?                                                        for regulatory capital purposes, the
      secured. The Agencies propose that the                     In particular, is it reasonable to attribute
                                                                                                                           banking organization must have in place
      bottom-up method would have to be                       the same asset correlations to dilution risk as
                                                              are used in quantifying the credit risks of                  operational procedures and risk
      used for receivables to any single
                                                              wholesale exposures within the A–IRB                         management processes that ensure that
      obligor, or to any group of related
                                                              framework? Are there alternative method(s)                   all documentation used in
      obligors, that aggregate to more than $1
                                                              for determining capital charges for dilution                 collateralizing or guaranteeing a
      million.                                                risk that would be superior to that set forth                transaction is binding on all parties and
      Capital Charge for Dilution Risk                        above?                                                       legally enforceable in all relevant
        When dilution is a material risk                      Minimum Requirements                                         jurisdictions. The banking organization
      factor,24 purchased receivables would                                                                                must have conducted sufficient legal
                                                                The Agencies propose to apply
      be subject to a separate capital charge                                                                              review to verify this conclusion, must
                                                              standards for the estimation of risk
      for that risk. The dilution capital charge                                                                           have a well-founded legal basis for the
                                                                25 If the remaining term exceeds one year, the
                                                                                                                           conclusion, and must reconduct such a
        24 If
            dilution risk is immaterial there would be no     expected dilution loss rate would be specified at an         review as necessary to ensure
      additional capital charge.                              annual rate.                                                 continuing enforceability.

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      45924                   Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules

      Adjusting LGD for the Effects of                        could not be based solely upon the                         The method for determining EAD for
      Collateral                                              collateral’s estimated market value.                    repo-style transactions, described
                                                                                                                      below, is essentially the determination
         A banking organization would be able                 Repo-Style Transactions Subject to
                                                                                                                      of an unsecured loan equivalent
      to take into account the risk-mitigating                Master Netting Agreements
                                                                                                                      exposure amount to the counterparty.
      effect of collateral in its internal                       Repo-style transactions include                      Thus, no collateral effects for these
      estimates of LGD, provided the                          reverse repurchase agreements and                       transactions would be recognized
      organization has established internal                   repurchase agreements and securities                    through LGD; rather, the applicable LGD
      requirements for collateral management,                 lending and borrowing transactions,                     would be the one the banking
      operational procedures, legal certainty,                including those executed on an                          organization would estimate for an
      and risk management processes that                      indemnified agency basis.26 Many of                     unsecured exposure to the counterparty.
      ensure that:                                            these transactions are conducted under                     To determine EAD, the banking
         (1) The legal mechanism under which                  a bilateral master netting agreement or                 organization would add together its
      the collateral is pledged or transferred                equivalent arrangement. The effects of                  current exposure to the counterparty
      ensures that the banking organization                   netting arrangements generally would                    under the master netting arrangement
      has the right to liquidate or take legal                be recognized where the banking                         and a measure for PFE to the
      possession of the collateral in a timely                organization takes into account the risk-               counterparty under the master netting
      manner in the event of the default,                     mitigating effect of collateral through an              arrangement. The current exposure
      insolvency, or bankruptcy (or other                     adjustment to EAD. To qualify for the                   would be the sum of the market values
      defined credit event) of the obligor and,               EAD adjustment treatment, the repo-                     of all securities and cash lent, sold
      where applicable, the custodian holding                 style transaction would have to be                      subject to repurchase, or pledged as
      the collateral;                                         marked-to-market daily and be subject                   collateral to the counterparty under the
         (2) The banking organization has                     to a daily margin maintenance                           master netting agreement, less the sum
      taken all steps necessary to fulfill legal              requirement. Further, the repo-style                    of the market values of all securities and
      requirements to secure the                              transaction would have to be                            cash lent, sold subject to repurchase, or
      organization’s interest in the collateral               documented under a qualifying master                    pledged as collateral by the
      so that it has and maintains an                         netting agreement that would have to:                   counterparty. The PFE calculation
      enforceable security interest;                             (1) Provide the non-defaulting party                 would be based on the market price
         (3) The banking organization has clear               the right to terminate and close out                    volatilities of the securities delivered to,
      and robust procedures for the timely                    promptly all transactions under the                     and the securities received from, the
      liquidation of collateral to ensure                     agreement upon an event of default,                     counterparty, as well as any foreign
      observation of any legal conditions                     including in the event of insolvency or                 exchange rate volatilities associated
      required for declaring the default of the               bankruptcy of the counterparty;                         with any cash or securities delivered or
                                                                 (2) Provide for the netting of gains and             received.
      borrower and prompt liquidation of the
                                                              losses on transactions (including the                      Banking organizations would use a
      collateral in the event of default;
                                                              value of any collateral) terminated and                 VaR-type measure for determining PFE
         (4) The banking organization has                     closed out under the agreement so that                  for repo-style transactions subject to
      established procedures and practices for                a single net amount is owed by one                      master netting agreements. Banking
      (i) conservatively estimating, on a                     party to the other;                                     organizations would be required to use
      regular ongoing basis, the market value                    (3) Allow for the prompt liquidation                 a 99th percentile, one-tailed confidence
      of the collateral, taking into account                  or setoff of collateral upon the                        interval for a five-day holding period
      factors that could affect that value (for               occurrence of an event of default; and                  using a minimum one-year historical
      example, the liquidity of the market for                   (4) Be, together with the rights arising             observation period of price data.
      the collateral and obsolescence or                      from the provisions required in (1) to (3)              Banking organizations would have to
      deterioration of the collateral), and (ii)              above, legally enforceable in each                      update their data sets no less frequently
      where applicable, periodically verifying                relevant jurisdiction upon the                          than once every three months and
      the collateral (for example, through                    occurrence of an event of default and                   reassess them whenever market prices
      physical inspection of collateral such as               regardless of the counterparty’s                        are subject to material changes. The
      inventory and equipment); and                           insolvency or bankruptcy.                               illiquidity of lower-quality instruments
         (5) The banking organization has in                     Where a banking organization’s repo-                 would have to be taken into account
      place systems for requesting and                        style transactions do not meet these                    through an upward adjustment in the
      receiving promptly additional collateral                requirements, it would not be able to                   holding period where the five-day
      for transactions whose terms require                    use the EAD adjustment method. Rather,                  holding period would be inappropriate
      maintenance of collateral values at                     for each individual repo-style                          given the instrument’s liquidity. No
      specified thresholds.                                   transaction it would estimate an LGD                    particular model would be prescribed
         In reflecting collateral in the LGD                  that takes into account the collateral                  for the VaR-based measure, but the
      estimate, the banking organization                      received. It would use the notional                     model would have to capture all
      would need to consider the extent of                    amount of the transaction for EAD; it                   material risks for included transactions.
      any dependence between the risk of the                  would not take into account netting                        Banking organizations using a VaR-
      borrower and that of the collateral or                  effects for purposes of determining                     based approach to measuring PFE
      collateral provider. The banking                        either EAD or LGD.                                      would be permitted to take into account
      organization’s assessment of LGD would                    26 Some banking organizations, particularly those
                                                                                                                      correlations in the price volatilities
      have to address in a conservative way                   that are custodians, lend, as agent, their customers’
                                                                                                                      among instruments delivered to the
      any significant degrees of dependence,                  securities on a collateralized basis. Typically, the    counterparty, among instruments
      as well as any currency mismatch                        agent banking organization indemnifies the              received from the counterparty, as well
      between the underlying obligation and                   customer againts risk of loss in the event the          as between the two sets of instruments.
                                                              borrowing counterparty defaults. Where such
      the collateral. The LGD estimates would                 indemnites are provided, the agent banking
                                                                                                                      The VaR-based approach for calculating
      have to be grounded in historical                       organization has the same risks it would have if it     PFE for repo-style transactions would be
      recovery rates on the collateral and                    had entered into the transaction as principal.          available to all banking organizations

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                              Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules                                              45925

      that received supervisory approval for                                        Number of                        banking organization also would be
                                                                    Zone                                Multiplier
      an internal market risk model under the                                       exceptions                       required to consider any residual risk to
      market risk capital rules. Other banking                                                                       the borrower that may remain—for
      organizations could apply separately for                                    160–179 ........    2.6            example, a currency mismatch between
      supervisory approval to use their                                           180–199 ........    2.8            the credit protection and the underlying
                                                              Red Zone ......     200 or more ..      3.0
      internal VaR models for calculation of                                                                         exposure.
      PFE for repo-style transactions.                                                                                  Banking organizations would be
                                                                The Agencies seek comments on the
         A banking organization would use the                 methods set forth above for determining
                                                                                                                     required to make adjustments to alter
      following formula to determine EAD for                  EAD, as well as on the proposed backtesting            PD or LGD estimates in a consistent way
      each counterparty with which it has a                   regime and possible alternatives banking               for a given type of guarantee or credit
      master netting agreement for repo-style                 organizations might find more consistent               derivative. In all cases, the adjusted risk
      transactions.                                           with their internal risk management                    weight for the hedged obligation could
      EAD = max {0, [(è E ¥ èC) + (VaR                        processes for these transactions. The                  not be less than the risk weight
           output from internal market risk                   Agencies also request comment on whether               associated with a comparable direct
           model × multiplier)]}                              banking organizations should be permitted to           exposure on the protection provider. As
                                                              use the standard supervisory haircuts or own           a practical matter, this guarantor risk
      Where:                                                  estimates haircuts methodologies that are
      E denotes the current value of the                                                                             weight floor on the risk weight of the
                                                              proposed in the New Accord.
           exposure (that is, all securities and                                                                     hedged obligation would require a
           cash delivered to the counterparty);               Guarantees and Credit Derivatives                      banking organization first to determine
           and                                                   The Agencies are proposing that                     the risk weight on the hedged obligation
      C denotes the current value of the                      banking organizations reflect the credit               using the adjustment it has made to the
           collateral received (that is, all                                                                         PD or LGD estimate to reflect the hedge.
                                                              risk mitigating effects of guarantees and
           securities and cash received from                                                                         The banking organization would then
                                                              credit derivatives through adjusting the
           the counterparty).                                                                                        compare that risk weight to the risk
                                                              PD or the LGD estimate (but not both)
                                                                                                                     weight assigned to a direct obligation of
         The multiplier in the above formula                  of the underlying obligation that is
                                                                                                                     the guarantor. The higher of the two risk
      would be determined based on the                        protected. The banking organization
                                                                                                                     weights would then be used to
      results of the banking organization’s                   would be required to assign the
                                                                                                                     determine the risk-weighted asset
      backtesting of the VaR output. To                       borrower and guarantor to an internal
                                                                                                                     amount of the hedged obligation.
      backtest the output, the banking                        rating in accordance with the minimum                     Notwithstanding the guarantor risk
      organization would be required to                       requirements set out for unguaranteed                  weight floor, the proposed approach
      identify on an annual basis twenty                      (unhedged) exposures, both prior to the                gives institutions a great deal of
      counterparties that include the ten                     adjustments and on an ongoing basis.                   flexibility in their methodology for
      largest as determined by the banking                    The organization also would be required                recognizing the risk-reducing effects of
      organization’s own exposure                             to monitor regularly the guarantor’s                   guarantees and credit derivatives. At the
      measurement approach and ten others                     condition and ability and willingness to               same time, the approach does not
      selected at random. For each day and for                honor its obligation. For guarantees on                differentiate between various types of
      each of the twenty counterparties, the                  retail exposures, these requirements                   guarantee structures, which may have
      banking organization would compare                      would also apply to the assignment of                  widely varying characteristics, that a
      the previous day’s VaR estimate for the                 an exposure to a pool and the estimation               banking organization may use. For
      counterparty portfolio to the change in                 of the PD of the pool.                                 example, a company to company
      the current exposure of the previous                       For purposes of reflecting the effect of            guarantee, such as a company’s
      day’s portfolio. This change represents                 guarantees in regulatory capital                       guarantee of an affiliate or a supplier, is
      the difference between the net value of                 requirements, the Agencies are                         fundamentally different from a
      the previous day’s portfolio using                      proposing that a banking organization                  guarantee obtained from an unrelated
      today’s market prices and the net value                 have clearly specified criteria for                    third party that is in the business of
      of that portfolio using the previous day’s              adjusting internal ratings or LGD                      extending financial guarantees.
      market prices. Where this difference                    estimates—or, in the case of retail                    Examples of the latter type of guarantee
      exceeds the previous day’s VaR                          exposures, for allocating exposures to                 include standby letters of credit,
      estimate, an exception would have                       pools to reflect use of guarantees and                 financial guarantee insurance, and
      occurred.                                               credit derivatives—that take account of                credit derivatives. These products tend
         At the end of each quarter, the                      all relevant information. The adjustment               to be standardized across institutions
      banking organization would identify the                 criteria would have to require a banking               and, thus, arguably should be
      number of exceptions it has observed for                organization to (i) meet all minimum                   recognized for capital purposes in a
      its twenty counterparties over the most                 requirements for an unhedged exposure                  consistent fashion across institutions.
      recent 250 business days, that is, the                  when assigning borrower or facility                    The problem of inconsistent treatment
      number of exceptions in the most recent                 ratings to guaranteed/hedged exposures;                could be exacerbated in the case of
      5000 observations. Depending on the                     (ii) be plausible and intuitive; (iii)                 protection in the form of credit
      number of exceptions, the output of the                 consider the guarantor’s ability and                   derivatives, which are tradable and
      VaR model would be scaled up using a                    willingness to perform under the                       which further can be distinguished by
      multiplier as provided in the table                     guarantee; (iv) consider the extent to                 their characteristic of allowing a
      below.                                                  which the guarantor’s ability and                      banking organization to have a recovery
                                                              willingness to perform and the                         claim on two parties, the obligor and the
                           Number of                          borrower’s ability to repay may be                     derivative counterparty, rather than just
           Zone                                 Multiplier
                           exceptions                         correlated (that is, the degree of wrong-              one.
      Green Zone ...     0–99 ..............   None (=1)      way risk); and (v) consider the payout                   Industry comment is sought on whether a
      Yellow Zone ..     100–119 ........      2.0            structure of the credit protection and                 more uniform method of adjusting PD or LGD
                         120–139 ........      2.2            conservatively assess its effect on the                estimates should be adopted for various types
                         140–159 ........      2.4            level and timing of recoveries. The                    of guarantees to minimize inconsistencies in

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      45926                   Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules

      treatment across institutions and, if so, views         capital purposes: (1) Be required to                  of the creditors for a restructuring. The
      on what methods would best reflect industry             represent a direct claim on the                       Agencies have concerns that this
      practices. In this regard, the Agencies would           protection provider; (2) explicitly                   approach could have the incidental
      be particularly interested in information on
                                                              reference specific exposures or classes               effect of dictating terms in underlying
      how banking organizations are currently
      treating various forms of guarantees within             thereof; (3) be evidenced in writing                  obligations in ways that over time could
      their economic capital allocation systems and           through a contract that is irrevocable by             diverge from creditors’ business needs.
      the methods used to adjust PD, LGD, EAD,                the guarantor; (4) not have a clause that             The Agencies also question whether
      and any combination thereof.                            would (i) allow the protection provider               such clauses actually eliminate
                                                              unilaterally to cancel the credit                     restructuring risk on the underlying
      Double Default Effects
                                                              protection (other than in the event of                obligation, particularly as many credit
         The Agencies are proposing that                      nonpayment or other default by the                    derivatives hedge only a small portion
      neither the banking organization’s                      protection buying banking organization)               of a banking organization’s exposure to
      criteria nor rating process for                         or (ii) increase the effective cost of                the underlying obligation.
      guaranteed/hedged exposures be                          credit protection as the credit quality of               The Agencies invite comment on this
      allowed to take into account so-called                  the underlying obligor deteriorates; (5)              issue, as well as consideration of an
      ‘‘double default’’ effects—that is, the                 be in force until the underlying                      alternative approach whereby the notional
      joint probability of default of the                     obligation is satisfied in full (to the               amount of a credit derivative that does not
      borrower and guarantor. As a result of                  amount and tenor of the guarantee); and               include restructuring as a credit event would
      not being able to recognize double                      (6) be legally enforceable against the                be discounted. Comment is sought on the
      default probabilities, the adjusted risk                guarantor in a jurisdiction where the                 appropriate level of discount and whether
      weight for the hedged obligation could                  guarantor has assets to attach and                    the level of discount should vary on the basis
      not be less than the risk weight                        enforce a judgment.                                   of, for example, whether the underlying
      associated with a direct exposure on the                   The Agencies view the risk mitigating              obligor has publicly outstanding rated debt or
      protection provider. The Agencies are                                                                         whether the underlying obligor is an entity
                                                              benefits of conditional guarantees—that
                                                                                                                    whose obligations have a relatively high
      seeking comment on the proposed                         is, guarantees that prescribe certain                 likelihood of restructuring relative to default
      nonrecognition of double default effects.               conditions under which the guarantor                  (for example, a sovereign or PSE). Another
      On June 10, 2003, the Federal Reserve                   would not be obliged to perform—as                    alternative that commenters may wish to
      released a white paper on this issue                    particularly difficult to quantify. The               discuss is elimination of the restructuring
      entitled, ‘‘Treatment of Double Default                 Agencies are proposing that as a general              requirement for credit derivatives with a
      and Double Recovery Effects for Hedged                  matter such guarantees would not be                   maturity that is considerably longer—for
      Exposures Under Pillar I of the                         recognized under the A–IRB approach.                  example, two years—than that of the hedged
      Proposed New Basel Capital Accord.’’                    In certain circumstances, however,                    obligation.
      Commenters are encouraged to take into                  conditional guarantees could be                         Consistent with the New Accord, the
      account the white paper in formulating                  recognized where the banking                          Agencies are proposing not to recognize
      their responses to the ANPR.                            organization can demonstrate that its                 credit protection from total return swaps
         The Agencies also are interested in                  assignment criteria fully reflect the                 where the hedging banking organization
      obtaining commenters’ views on                          reduction in credit risk mitigation                   records net payments received on the
      alternative methods for giving                          arising from the conditionality and that              swap as net income, but does not record
      recognition to double default effects in                the guarantee provides a meaningful                   offsetting deterioration in the value of
      a manner that is operationally feasible                 degree of credit protection.                          the hedged obligation either through
      and consistent with safety and                                                                                reduction in fair value or by an addition
      soundness. With regard to the latter,                   Additional Requirements for
                                                              Recognized Credit Derivatives                         to reserves. The Agencies are
      commenters are requested to bear in                                                                           considering imposing similar non-
      mind the concerns outlined in the                         The Agencies are proposing that                     recognition on credit default swaps
      double default white paper, particularly                credit derivatives, whether in the form               where mark-to-market gains in value are
      in connection with concentrations,                      of credit default swaps or total return               recognized in income and, thus, in Tier
      wrong-way risk (especially in stress                    swaps, recognized for A–IRB risk-based                1 capital, but no offsetting deterioration
      periods), and the potential for regulatory              capital purposes meet additional                      in the hedged obligation is recorded.
      capital arbitrage. In this regard,                      criteria. The credit events specified by              (This situation generally would not arise
      information is solicited on how banking                 the contracting parties would be                      where both the hedged obligation and
      organizations consider double default                   required to include at a minimum: (i)                 the credit default swap are recorded in
      effects on credit protection                            Failure to pay amounts due under the                  the banking book because under GAAP
      arrangements in their economic capital                  terms of the underlying obligation; (ii)              increases in the swap’s value are
      calculations and for which types of                     bankruptcy, insolvency, or inability of               recorded in the Other Comprehensive
      credit protection arrangements they                     the obligor to pay its debt; and (iii)                Income account, which is not included
      consider these effects.                                 restructuring of the underlying                       in regulatory capital.)
                                                              obligation that involves forgiveness or
      Requirements for Recognized                             postponement of principal, interest, or                 Comment is sought on this matter, as well
      Guarantees and Credit Derivatives                       fees that results in a credit loss.                   as on the possible alternative treatment of
                                                                                                                    recognizing the hedge in these two cases for
        The Agencies are not proposing any                      With regard to restructuring events,
                                                                                                                    regulatory capital purposes but requiring that
      restrictions on the types of eligible                   the Agencies note that the New Accord                 mark-to-market gains on the credit derivative
      guarantors or credit derivative                         suggests that a banking organization                  that have been taken into income be
      providers. Rather, a banking                            may not need to include restructuring                 deducted from Tier 1 capital.
      organization would be required to have                  credit events when it has complete
      clearly specified criteria for those                    control over the decision of whether or               Mismatches in Credit Derivatives
      guarantors they will accept as eligible                 not there will be a restructuring of the              Between Reference and Underlying
      for regulatory capital purposes. It is                  underlying obligation. This would                     Obligations
      proposed that guarantees and credit                     occur, for example, where the hedged                    The Agencies are proposing to
      derivatives recognized for regulatory                   obligation requires unanimous consent                 recognize credit derivative hedges for

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                              Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules                                        45927

      A–IRB capital purposes only where the                   would be imposed based on the                        requirements for using an internal
      reference obligation on which the                       replacement cost plus the following                  model would have to be met on an
      protection is based is the same as the                  add-on factors for PFE:                              ongoing basis. An advanced approach
      underlying obligation except where: (1)                                                                      banking organization that is
      the reference obligation ranks pari                       Total return or    Protection        Protection    transitioning into an internal models
      passu with or is more junior than the                      credit default       buyer             seller     approach to equity exposures or that
                                                                     swap           (percent)        (percent)
      underlying obligation, and (2) the                                                                           fails to demonstrate compliance with
      underlying obligation and reference                     Qualifying Ref-                                      the minimum operational requirements
      obligation share the same obligor and                      erence                                            for using an internal models approach to
      legally enforceable cross-default or                       Obligation* .....             5               **5 equity exposures would be required to
      cross-acceleration clauses are in place.                Non-Qualifying                                       develop a plan for compliance, obtain
                                                                 Reference                                         approval of the plan from its primary
      Treatment of Maturity Mismatch                             Obligation* .....           10              **10 Federal supervisor, and implement the
         The Agencies are proposing to                           *The definition of qualifying would be the plan in a timely fashion. In addition, a
      recognize on a discounted basis                         same as for the ‘‘qualifying’’ category for the banking organization’s primary Federal
      guarantees and credit derivatives that                  treatment of specific risk for covered debt po- supervisor would have the authority to
      have a shorter maturity than the hedged                 sitions under the market risk capital rules.
                                                                 **The protection seller of a credit default impose additional operational
      obligation. A guarantee or credit                       swap would only be subject to the add-on fac- requirements on a case-by-case basis.
      derivative with less than one-year                      tor where the contract is subject to close-out Until it is fully compliant with all
      remaining maturity that does not have a                 upon the insolvency of the protection buyer applicable requirements, the banking
      matching maturity to the underlying                     while the underlying obligor is still solvent.
                                                                                                                   organization would apply a minimum
      obligation, however, would not be                           The Agencies also are considering                300 percent risk weight to all publicly
      recognized. The formula for discounting                 applying a counterparty credit risk                  traded equity investments (that is,
      the amount of a maturity-mismatched                     charge on all credit derivatives that are            equity investments that are traded on a
      hedge that is recognized is proposed as                 marked-to-market, including those                    nationally recognized securities
      follows:                                                recorded in the banking book. Such a                 exchange) and a minimum 400 percent
      Pa = P * t/T                                            treatment would promote consistency                  risk weight to all other equity
      Where:                                                  with other OTC derivatives, which are                investments.
      Pa denotes the value of the credit                      assessed the same counterparty credit
                                                              risk charge regardless of where they are             Positions Covered
           protection adjusted for maturity
           mismatch;                                          booked.                                                 All equity exposures held in the
      P denotes the amount of the credit                          Further, the Agencies note that, if              banking book, along with any equity
           protection;                                        credit derivatives booked in the banking exposures in the trading book that are
      t denotes the lesser of T and the                       book are not assessed a counterparty                 not currently subject to a market risk
           remaining maturity of the hedge                    credit risk charge, banking organizations capital charge, would be subject to the
           arrangement, expressed in years;                   would be required to exclude these                   A-IRB approach for equity exposures. In
           and                                                derivatives from the net current                     general, equity exposures are
      T denotes the lesser of five and the                    exposure of their other derivative                   distinguished from other types of
           remaining maturity of the                          exposures to a counterparty for                      exposures based on the economic
           underlying obligation, expressed in                purposes of determining regulatory                   substance of the exposure. Equity
           years.                                             capital requirements. On balance, the                exposures would include both direct
         The Agencies have concerns that the
                                                              Agencies believe a better approach                   and indirect ownership interests,
      proposed formulation does not appropriately             would be to align the net derivative                 whether voting or non-voting, in the
      reflect distinctions between bullet and                 exposure used for capital purposes with assets or income of a commercial
      amortizing underlying obligations. Comment              that used for internal risk management               enterprise or financial institution that
      is sought on the best way of making such a              purposes to manage counterparty risk                 are not consolidated or deducted for
      distinction, as well as more generally on               exposure and collateralization thereof.              regulatory capital purposes. Holdings in
      alternative methods for dealing with the                This approach would suggest imposing
      reduced credit risk coverage that results from
                                                                                                                   funds containing both equity
                                                              a counterparty risk charge on all credit             investments and non-equity investments
      a maturity mismatch.
                                                              derivative exposures that are marked to              would be treated either as a single
      Treatment of Counterparty Risk for                      market, regardless of where they are                 investment based on the majority of the
      Credit Derivative Contracts                             booked.                                              fund’s holdings or, where possible, as
         The Agencies are proposing that the                     The Agencies are seeking industry views           separate and distinct investments in the
      EAD for derivative contracts included in                on the PFE add-ons proposed above and their fund’s component holdings based on a
      either the banking book or trading book                 applicability. Comment is also sought on             ‘‘look-through approach’’ (that is, based
                                                              whether different add-ons should apply for           on the individual component holdings).
      be determined in accordance with the                    different remaining maturity buckets for
      rules for calculating the credit                        credit derivatives and, if so, views on the             An instrument generally would be
      equivalent amount for such contracts set                appropriate percentage amounts for the add-          considered to be an equity exposure if
      forth under the general risk-based                      ons in each bucket.                                  it (1) would qualify as Tier 1 capital
      capital rules. The Agencies are                                                                              under the general risk-based capital
      proposing to include in the types of                    Equity Exposures                                     rules if issued by a banking
      derivative contracts covered under these                    Banking organizations using the A–               organization; (2) is irredeemable in the
      rules credit derivative contracts                       IRB approach for any credit exposure                 sense that the return of invested funds
      recorded in the trading book.                           would be required to use an internal                 can be achieved only by the sale of the
      Accordingly, where a banking                            models market-based approach to                      investment or sale of the rights to the
      organization buys or sells a credit                     calculate regulatory capital charges for             investment or in the event of the
      derivative through its trading book, a                  equity exposures. Minimum                            liquidation of the issuer; (3) conveys a
      counterparty credit risk capital charge                 quantitative and qualitative                         residual claim on the assets or income

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      45928                   Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules

      of the issuer; and (4) does not embody                  recharacterize debt holdings as equity                exclude from the A-IRB equity capital
      an obligation on the part of the issuer.                exposures or equity holdings as debt or               charge equity investments in these
         An instrument that embodies an                       securitization exposures for regulatory               entities. Instead, these investments
      obligation on the part of the issuer                    capital purposes.                                     would be risk weighted at zero percent
      would be considered an equity exposure                     The Agencies encourage comment on                  under the A-IRB approach.
      if the instrument meets any of the                      whether the definition of an equity exposure            In addition, the Agencies are
      following conditions: (1) The issuer may                is sufficiently clear to allow banking                proposing to exempt from the A-IRB
      defer indefinitely the settlement of the                organizations to make an appropriate                  equity capital charge investments in
      obligation; (2) the obligation requires, or             determination as to the characterization of           non-central government public-sector
      permits at the issuer’s discretion,                     their assets.                                         entities (PSEs) that are not traded
      settlement by the issuance of a fixed                   Materiality                                           publicly and generally are held as a
      number of the issuer’s equity interests;                                                                      condition of membership. Examples of
      (3) the obligation requires, or permits at                 As noted above, a banking                          such holdings include stock of a Federal
      the issuer’s discretion, settlement by the              organization that is required or elects to            Home Loan Bank or a Federal Reserve
      issuance of a variable number of the                    use the A–IRB approach for any credit                 Bank. These investments would be risk-
      issuer’s equity interests, and all things               portfolio would also generally be                     weighted as they would be under the
      being equal, any change in the value of                 required to use the A–IRB approach for                general risk-based capital rules—20
      the obligation is attributable to,                      its equity exposures. However, if the                 percent or zero percent, respectively, in
      comparable to, and in the same                          aggregate equity holdings of a banking                the examples.
      direction as, the change in value of a                  organization are not material in amount,
                                                              the organization would not be required                  Comment is sought on whether other types
      fixed number of the issuer’s equity                                                                           of equity investments in PSEs should be
      shares; or (4) the holder has the option                to use the A–IRB approach to equity                   exempted from the A–IRB capital charge on
      to require that the obligation be settled               exposures. For this purpose, a banking                equity exposures, and if so, the appropriate
      by issuance of the issuer’s equity                      organization’s equity exposures                       criteria for determining which PSEs should
      interests, unless the banking                           generally would be considered material                be exempted.
      organization’s primary Federal                          if their aggregate carrying value,
                                                                                                                    Legislated Program Equity Exposures
      supervisor has opined in writing that                   including holdings subject to exclusions
      the instrument should be treated as a                   and transitional provisions (as described                Under the New Accord, national
      debt position.                                          below), exceeds 10 percent of the                     supervisors may exclude from the A–
         Debt obligations and other securities,               organization’s Tier 1 and Tier 2 capital              IRB capital charge on equity exposures
      derivatives, or other instruments                       on average during the prior calendar                  certain equity exposures made under
      structured with the intent of conveying                 year. To address concentration                        legislated programs that involve
      the economic substance of equity                        concerns, however, the materiality                    government oversight and restrictions
      ownership would be considered equity                    threshold would be lowered to 5 percent               on the types or amounts of investments
      exposures for purposes of the A-IRB                     of the banking organization’s Tier 1 and              that may be made (legislated program
      capital requirements. For example,                      Tier 2 capital if the organization’s equity           equity exposures). Under the New
      options and warrants on equities and                    portfolio consists of less than ten                   Accord, a banking organization would
      short positions in equity securities                    individual holdings. Banking                          be able to exclude from the A–IRB
      would be characterized as equity                        organizations would risk weight at 100                capital charge on equity exposures
      exposures. If a debt instrument is                      percent equity exposures exempted                     legislated program equity exposures in
      convertible into equity at the option of                from the A–IRB equity treatment under                 an amount up to 10 percent of the
      the holder, it would be deemed equity                   a materiality threshold.                              banking organization’s Tier 1 plus Tier
      upon conversion. If such debt is                                                                              2 capital.
                                                                Comment is sought on whether the
      convertible at the option of the issuer or                                                                       The Agencies propose that equity
                                                              materiality thresholds set forth above are
      automatically by the terms of the                       appropriate. Exclusions from the A–IRB                investments by a banking organization
      instrument, it would be deemed equity                   Equity Capital Charge                                 in a small business investment company
      from inception. In addition, instruments                                                                      (SBIC) under section 302(b) of the Small
      with a return directly linked to equities               Zero and Low Risk Weight Investments                  Business Investment Act of 1958 would
      would be characterized as equity                          The New Accord provides that                        be legislated program equity exposures
      exposures under most circumstances. A                   national supervisors may exclude from                 eligible for the exclusion from the A–
      banking organization’s primary Federal                  the A–IRB capital charge those equity                 IRB equity capital charge in an amount
      supervisor would have the discretion to                 exposures to entities whose debt                      up to 10 percent of the banking
      allow a debt characterization of such an                obligations qualify for a zero risk weight            organization’s Tier 1 plus Tier 2 capital.
      equity-linked instrument, however, if                   under the New Accord’s standardized                   A banking organization would be
      the instrument is directly hedged by an                 approach for credit risk. Entities whose              required to risk weight at 100 percent
      equity holding such that the net                        debt obligations qualify for a zero risk              any amounts of legislated program
      position does not involve material                      weight generally include (i) sovereigns               equity exposures that qualify for this
      equity risk to the holder. Equity                       rated AAA to AA–; (ii) the BIS; (iii) the             exclusion from the A–IRB equity capital
      instruments that are structured with the                IMF; (iv) the European Central Bank; (v)              charge.
      intent of conveying the economic                        the European Community; and (vi) high-                  The Agencies seek comment on what
      substance of debt holdings, or                          quality multilateral development banks                conditions might be appropriate for this
      securitization exposures would not be                   (MDBs) with strong shareholder                        partial exclusion from the A–IRB equity
      considered equity exposures. For                        support.27 The Agencies intend to                     capital charge. Such conditions could
      example, some issuances of term                                                                               include limitations on the size and types of
      preferred stock may be more                               27 These are, at present, the World Bank group

      appropriately characterized as debt.                    comprised of the International Bank for               Development, the Inter-American Development
                                                              Reconstruction and Development and the                Bank, the European Investment Bank, the Islamic
         In all cases, the banking                            International Finance Corporation, the Asian          Development Bank, the Nordic Investment Bank,
      organization’s primary Federal                          Development Bank, the African Development Bank,       the Caribbean Development Bank, and the Council
      supervisor would have the discretion to                 the European Bank for Reconstruction and              of Europe Development Bank.

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                              Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules                                            45929

      businesses in which the banking organization            rule. However, if additional shares are               level and degree of concentration.
      invests, geographical limitations, or                   acquired such that the holder’s                       Institutions with equity portfolios
      limitations on the size of individual                   proportional share of ownership                       containing holdings with values that are
                                                              increases, the additional shares would                highly nonlinear in nature (for example,
         U.S. banking organizations also make                 not be grandfathered. Thus, if a banking              equity derivatives or convertibles)
      investments in community development                    organization owned 100 shares of a                    would have to employ an internal
      corporations (CDCs) or community and                    company on the date of adoption of the                model designed to appropriately capture
      economic development entities (CEDEs)                   final rule and subsequently acquired an               the risks associated with these
      that promote the public welfare. These                  additional 50 shares, the original 100                instruments.
      investments receive favorable tax                       shares would be exempt from the A–IRB                    The Agencies recognize that the type
      treatment and investment subsidies that                 equity capital charge for the ten-year                and sophistication of internal modeling
      make their risk and return                              period from the date of adoption of the               systems will vary across institutions due
      characteristics markedly different (and                 final rule, but the additional 50 shares              to differences in the nature and
      more favorable to investors) than equity                would be immediately subject to the A–                complexity of business lines in general
      investments in general. Recognizing this                IRB equity capital charge.                            and equity exposures in particular.
      more favorable risk-return structure and                                                                      Although the Agencies intend to use a
      the importance of these investments to                  Description of Quantitative Principles                VaR methodology as a benchmark for
      promoting important public welfare                         The primary focus of the A–IRB                     the internal model approach, the
      goals, the Agencies are proposing the                   approach to equity exposures is to                    Agencies recognize that some
      exclusion of all such investments from                  assess capital based on an internal                   institutions employ models for internal
      the A–IRB equity capital charge. Unlike                 estimate of loss under extreme market                 risk management and capital allocation
      the exclusion for SBIC exposures, the                   conditions on an institution’s portfolio              purposes that, given the nature of their
      exclusion of CDC and CEDE investments                   of equity holdings or, in simpler forms,              equity holdings, can be more risk-
      would not be subject to a percentage of                 its individual equity investments. The                sensitive than some VaR models. For
      capital limit. All CDC and CEDE equity                  methodology or methodologies used to                  example, some institutions employ
      exposures would receive a 100 percent                   compute the banking organization’s                    rigorous historical scenario analysis and
      risk weight.                                            estimated loss should be those used by                other techniques in assessing the risk of
                                                              the institution for internal risk                     their equity portfolios. It is not the
        The Agencies seek comment on whether
      any conditions relating to the exclusion of             management purposes. The model                        Agencies’ intention to dictate the form
      CDC/CEDE investments from the A-IRB                     should be fully integrated into the                   or operational details of banking
      equity capital charge would be appropriate.             banking organization’s risk management                organizations’ risk measurement and
      These conditions could serve to limit the               infrastructure.                                       management practices for their equity
      exclusion to investments in such entities that             A banking organization’s use of                    exposures. Accordingly, the Agencies
      meet specific public welfare goals or to limit          internal models would be subject to                   do not expect to prescribe any particular
      the amount of such investments that would               supervisory approval and ongoing                      type of model for computing A-IRB
      qualify for the exclusion from the A–IRB                review by the institution’s primary
      equity capital charge. The Agencies also seek                                                                 capital charges for equity exposures.
      comment on whether any other classes of
                                                              Federal supervisor. Given the unique                     For purposes of evaluating the A–IRB
      legislated program equity exposures should              nature of equity portfolios and                       equity capital charges produced by a
      be excluded from the A–IRB equity capital               differences in modeling techniques, the               banking organization’s selected
      charge.                                                 supervisory model review process                      methodology, the Agencies would
                                                              would be, in many respects, institution-              expect to use as a benchmark a VaR
      Grandfathered Investments                               specific. The sophistication and nature               methodology using a 99.0 percent (one-
         Equity exposures held as of the date                 of the modeling technique used for a                  tailed) confidence level of estimated
      of adoption of the final A–IRB capital                  particular type of equity exposure                    maximum loss over a quarterly time
      rule governing equity exposures would                   should correspond to the banking                      horizon using a long-term sample
      be exempt from the A–IRB equity                         organization’s exposure, concentration                period. Moreover, A–IRB equity capital
      capital charge for a period of ten years                in individual equity issues of that type,             charges would have to produce risk
      from that date. A banking organization                  and the particular risk of the holding                weights for equity exposures that are at
      would be required to risk weight these                  (including any optionality). Institutions             least equal to a 200 percent risk weight
      holdings during the ten-year period at                  would have to use an internal model                   for publicly traded equity exposures,
      100 percent. The investments that                       that is appropriate for the risk                      and a 300 percent risk weight for all
      would be considered grandfathered                       characteristics and complexity of their               other equity exposures.
      would be equal to the number of shares                  equity portfolios. The model would                       VaR-based internal models must use a
      held as of the date of the final rule, plus             have to be able to capture adequately all             historical observation period that
      any shares that the holder acquires                     of the material risks embodied in equity              includes a sufficient amount of data
      directly as a result of owning those                    returns, including both general market                points to ensure statistically reliable and
      shares, provided that any additional                    risk and idiosyncratic (that is, specific)            robust loss estimates relevant to the
      shares do not increase the holder’s                     risk of the institution’s equity portfolio.           long-term risk profile of the institution’s
      proportional ownership share in the                        In their evaluations of institutions’              specific holdings. The data used to
      company.                                                internal models, the Agencies would                   represent return distributions should
         For example, if a banking organization               consider, among other factors, (a) the                reflect the longest sample period for
      owned 100 shares of a company on the                    nature of equity holdings, including the              which data are available and should
      date of adoption of the final rule, and                 number and types of equities (for                     meaningfully represent the risk profile
      the issuer thereafter declared a pro rata               example, public, private, long, short);               of the banking organization’s specific
      stock dividend of 5 percent, the entire                 (b) the risk characteristics and makeup               equity holdings. The data sample
      post-dividend holdings of 105 shares                    of institutions’ equity portfolio                     should be long-term in nature and, at a
      would be exempt from the A–IRB equity                   holdings, including the extent to which               minimum, should encompass at least
      capital charge for a period of ten years                publicly available price information is               one complete equity market cycle
      from the date of the adoption of the final              obtainable on the exposures; and (c) the              relevant to the institution’s holdings,

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      45930                   Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules

      including both increases and decreases                  equivalent assets, a banking                            It is important to emphasize that the
      in relevant equity values over a long-                  organization would multiply the capital               Agencies believe that meeting the
      term data period. The data used should                  charge by a factor of 12.5.                           A–IRB infrastructure requirements and
      be sufficient to provide conservative,                    Consistent with the general risk-based              supervisory standards will require
      statistically reliable, and robust loss                 capital rules, 45 percent of the positive             significant efforts by banking
      estimates that are not based purely on                  change in value held in the tax-adjusted              organizations. The A–IRB supervisory
      subjective or judgmental considerations.                separate component of equity—that is,                 standards will effectively ‘‘raise the bar’’
         The parameters and assumptions used                  45 percent of revaluation gains on                    in regard to sound credit risk
      in a VaR model must be subject to a                     available-for-sale (AFS) equity                       management practices.
      rigorous and comprehensive regime of                    securities—would be includable in Tier
      stress-testing. Banking organizations                   2 capital under the A–IRB framework.                  Rating System Design
      utilizing VaR models would be required                    Comment is specifically sought on whether              The design of an internal risk rating
      to subject their internal model and                     the measure of an equity exposure under AFS           system is key to its effectiveness. By
      estimation procedures, including                        accounting continues to be appropriate or             definition, a rating system comprises all
      volatility computations, to either                      whether a different rule for the inclusion of         of the processes that support the
      hypothetical or historical scenarios that               revaluation gains should be proposed.                 assessment of credit risk, the assignment
      reflect worst-case losses given                                                                               of internal risk ratings, and the
      underlying positions in both public and                 C. Supervisory Assessment of A–IRB                    quantification of default and loss
      private equities. At a minimum, banking                 Framework                                             estimates. Banking organizations would
      organizations that use a VaR model                         A banking organization would have to               be able to rely on one or more systems
      would be required to employ stress tests                satisfy all the A–IRB infrastructure                  for assessing their credit risk exposures.
      to provide information about the effect                 requirements and supervisory standards                When this is the case, the banking
      of tail events beyond the level of                      before it would be able to use the A–IRB              organization would have to demonstrate
      confidence assumed in the internal                      approach for calculating capital                      that each system used for A–IRB capital
      models approach.                                        requirements for credit risk. This                    purposes complies with the supervisory
         Banking organizations using non-VaR                  section describes key elements of the                 standards.
      internal models that are based on stress                framework on which the Agencies                          The Agencies believe that banking
      tests or scenario analyses would have to                propose to base the A–IRB qualifying                  organizations’ internal rating systems
      estimate losses under worst-case                        requirements for U.S. banking                         should accurately and consistently
      modeled scenarios. These scenarios                      organizations. The Agencies intend to                 differentiate degrees of risk. For
      would have to reflect the composition of                provide more detailed implementation                  wholesale exposures, banking
      the organization’s equity portfolio and                 guidance in regard to these issues for                organizations would need to have a
      should produce capital charges at least                 wholesale and retail exposures, as well               two-dimensional rating system that
      as large as those that would be required                as for equity and securitization                      separately assesses the risk of borrower
      to be held against a representative                     exposures. As noted earlier, draft                    default, as well as transaction-specific
      market index under a VaR approach. For                  guidance for corporate exposures that                 factors that focus on the amount that
      example, for a portfolio consisting                     identifies associated supervisory                     would likely be collected in the event of
      primarily of publicly held equity                       standards was published elsewhere in                  default. Such factors may include
      securities that are actively traded,                    today’s Federal Register.                             whether an exposure is collateralized,
      capital charges produced using                                                                                its seniority, and the product type. In
      historical scenario analyses would have                 Overview of Supervisory Framework                     contrast to the individual evaluation
      to be greater than or equal to capital                     Many of the supervisory standards are              required for wholesale exposures, retail
      charges produced by a baseline VaR                      focused on requirements for a banking                 exposures would be assessed on a pool
      approach for a major index that is                      organization’s internal risk rating                   basis. Banking organizations would
      representative of the institution’s                     system. Emphasis is placed on a                       need to group their retail exposures into
      holdings.                                               banking organization’s ability to rank                portfolio segments based on the risk
         The measure of an equity exposure on                 order and quantify risk in a consistent,              characteristics that they consider
      which A–IRB capital requirements                        reliable and valid manner. In sum, a                  relevant—for example borrower
      would be based would be the value of                    banking organization’s internal risk                  characteristics such as credit scores or
      the equity presented in a banking                       rating system would have to provide for               transaction characteristics such as
      organization’s financial statements. For                a meaningful differentiation of the                   product or collateral type. Delinquent or
      investments held at fair value, the                     riskiness of borrowers, as well as the                defaulted exposures would need to be
      exposure amount would be equal to the                   risks inherent in individual                          separated from those that are current.
      fair value presented in the balance                     transactions. To ensure the reliability of               Banking organizations would be
      sheet. For investments held at the lower                these estimates, internal risk rating                 required to define clearly their
      of cost or market value, the exposure                   systems would need to be subject to                   wholesale rating categories and retail
      amount would be equal to the cost or                    review by independent control units.                  portfolio segments. The clarity and
      market value presented in the balance                   Data sources and estimation methods                   transparency of the ratings criteria are
      sheet.                                                  used by banking organizations would                   critical to ensuring that ratings are
         The loss estimate derived from the                   need to be sufficiently robust to support             assigned in a consistent and reliable
      internal model would constitute the                     the production of consistent                          manner. The Agencies believe it is
      A–IRB capital charge to be assessed                     quantitative assessments of risk over                 important for banking organizations to
      against the equity exposure. The A–IRB                  time. Finally, to ensure that ratings are             document the operating procedures for
      equity capital charge would be                          not derived solely for regulatory capital             their internal risk rating system in
      incorporated into an institution’s risk-                purposes, internal risk rating systems                writing. For example, the
      based capital ratio through the                         and quantification methods would need                 documentation should describe which
      calculation of risk-weighted equivalent                 to form an integral part of the                       parties within the organization would
      assets. To convert the A–IRB equity                     management of the institution, as                     have the authority to approve
      capital charge into risk-weighted                       outlined below.                                       exceptions. Further, the documentation

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      would have to clearly specify the                         Banking organizations would be                      rating systems would have to form an
      frequency of review, as well as describe                required to have in place sound stress                integral part of its day-to-day credit risk
      the oversight to be provided by                         testing processes for use in the                      management process. The Agencies
      management of the ratings process.                      assessment of capital adequacy. Stress                expect that banking organizations would
         Banking organizations using the                      testing would have to involve                         rely on their internal risk rating systems
      A–IRB approach would need to be able                    identifying possible events or future                 when making decisions about whether
      to generate sound measurements of the                   changes in economic conditions that                   to extend credit as well as in their
      key risk inputs to the A–IRB capital                    could have unfavorable effects on a                   ongoing monitoring of credit exposures.
      formulas. Banking organizations would                   banking organization’s credit exposures.              For example, ratings information would
      be able to rely on data based either on                 Specifically, institutions would need to              have to be incorporated into other key
      internal experience or generated by an                  assess the effect of certain specific                 processes, such as reserving
      external source, as long as the banking                 conditions on their A–IRB regulatory                  determinations and when allocating
      organization can demonstrate the                        capital requirements. The choice of test              economic capital internally.
      relevance of external data to its own                   to be employed would remain with the
                                                                                                                    Risk Quantification
      experience.                                             individual banking organization
                                                              provided the method selected is                         Ratings quantification is the process
         In assigning a rating to an obligor, a
                                                              meaningful and reasonably                             of assigning values to the key risk
      banking organization must assess the
                                                              conservative.                                         components of the A–IRB approach: PD,
      risk of default, taking into account
                                                                                                                    LGD, EAD and M. With the exception of
      possible adverse events that might                      Corporate Governance and Oversight                    M, the risk components are
      increase the obligor’s likelihood of
                                                                 The Agencies view the involvement of               unobservable and must be estimated.
      default. The A–IRB supervisory
                                                              the board of directors and management                 The estimates would have to be
      standards in the supervisory guidance                   as critical to the successful                         consistent with sound practice and
      provide banking organizations with a                    implementation of the A–IRB approach.                 supervisory standards. Banking
      degree of flexibility in determining                    The board of directors and management                 organizations’ rating system review and
      precisely how to reflect adverse events                 would be responsible for maintaining                  internal audit functions would need to
      in obligor ratings. However, banking                    effective internal controls over the                  serve as control mechanisms that ensure
      organizations are required to clearly                   banking organization’s information                    the process of rating assignments and
      articulate the approach chosen, and to                  systems and processes for assessing                   quantification are functioning according
      articulate the implications for capital                 adequacy of regulatory capital and                    to policy and that non-compliance or
      planning and for capital adequacy                       determining regulatory capital charges                weaknesses are identified.
      during times of systematic economic                     consistent with this ANPR. All
      stress. The Agencies recognize that                     significant aspects of the rating and                 Validation of Internal Estimates
      banking organizations’ internal risk                    estimation processes would have to be                   An equally important element would
      rating systems may include a range of                   approved by the banking organization’s                be a robust system for validating the
      statistical models or other methods to                  board of directors or a designated                    accuracy and consistency of a banking
      assign borrower or facility ratings or to               committee thereof and senior                          organization’s rating system, as well as
      estimate key inputs. The burden of                      management. These parties would need                  the estimation of risk components. The
      proof would remain on the banking                       to be fully aware of whether the system               standards in the supervisory guidance
      organization as to whether a specific                   complies with the supervisory                         require that banking organizations use a
      model or procedure satisfies the                        standards, makes use of the necessary                 broad range of validation tools,
      supervisory standards.                                  data, and produces reliable quantitative              including evaluation of developmental
      Risk Rating System Operations                           estimates. Ongoing management reports                 evidence, ongoing monitoring of rating
                                                              would have to accurately capture the                  and quantification processes,
         The risk rating system would have to                 performance of the rating system.                     benchmarking against alternative
      form an integral part of the loan                          Oversight would also need to involve               approaches, and comparison of
      approval process wherein ratings are                    independent credit risk control units                 outcomes with estimates. Details of the
      assigned to all borrowers, guarantors, or               responsible for ensuring the                          validation process would have to be
      facilities depending upon whether the                   performance of the rating system, the                 consistent with the operation of the
      extension of credit is wholesale or retail              accuracy of the ratings and parameter                 banking organization’s rating system
      in nature. Any deviations from policies                 estimates, and overall compliance with                and data would have to be maintained
      that govern the assignment of ratings                   supervisory standards and capital                     and updated to support oversight and
      must be clearly documented and                          regulations. The Agencies believe it is               validation work. Banking organizations
      monitored.                                              critical that such units remain                       would have to have well-articulated
         Data maintenance is another key                      functionally independent from the                     standards for situations where
      aspect of risk rating system operations.                personnel and management responsible                  deviations of realized values from
      Banking organizations would be                          for originating credit exposures. Among               expectations become significant enough
      expected to collect and store data on key               other responsibilities, the control units             to call the validity of the estimates into
      borrower and facility characteristics.                  should be charged with testing and                    question. Rating systems with
      The data would have to be sufficiently                  monitoring the appropriateness of the                 appropriate data and oversight feedback
      detailed to allow for future                            rating scale, verifying the consistent use            mechanisms should create an
      reconsideration of the way in which                     of ratings for a given exposure type                  environment that promotes integrity and
      obligors and facilities have been                       across the organization, and reviewing                improvements in the rating system over
      allocated to grades. Furthermore,                       and documenting any changes to be                     time.
      banking organizations would have to                     made to the system.
      collect, retain, and disclose data on                                                                         U.S. Supervisory Review
      aspects of their internal ratings as                    Use of Internal Ratings                                 The primary Federal supervisor
      described under the disclosure section                     To qualify to use the A–IRB                        would be responsible for evaluating an
      of this proposal.                                       framework, a banking organization’s                   institution’s initial and ongoing

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      45932                   Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules

      compliance with the infrastructure                      those issued by GSEs such as Fannie                      criteria, the originating banking
      requirements and supervisory standards                  Mae and Freddie Mac), credit                             organization would have to treat the
      for approval to use the A-IRB approach                  enhancements, liquidity facilities, and                  underlying exposures as if they had not
      for regulatory capital purposes. As                     credit derivatives that have the                         been securitized.
      noted, the Agencies will be developing                  characteristics noted above would be
                                                                                                                          The Agencies seek comment on the
      and issuing specific implementation                     considered securitization exposures.                     proposed operational requirements for
      guidance describing the supervisory                        With ongoing advances in financial
                                                                                                                       securitizations. Are the proposed criteria for
      standards for wholesale, retail, equity                 engineering, the Agencies recognize that
                                                                                                                       risk transference and clean-up calls
      and securitization exposures. The                       securitization exposures having similar
                                                                                                                       consistent with existing market practices?
      Agencies will issue the draft                           risks can take different legal forms. For
      implementation guidance for each                        this reason, both the designation of                     Differences Between General A–IRB
      portfolio for public comment to ensure                  positions as securitization exposures                    Approach and the A–IRB Approach for
      that there is an opportunity for banking                and the calculation of A–IRB capital                     Securitization Exposures
      organizations and others to provide                     requirements for securitization
      feedback on the Agencies’ expectations                  exposures would be guided by the                            In contrast to the proposed A–IRB
      in regard to A–IRB systems.                             economic substance of a given                            framework for traditional loans and
                                                              transaction, rather than by its legal form.              commitments, the A–IRB securitization
         The Agencies seek comment on the extent                                                                       framework does not rely on a banking
      to which an appropriate balance has been                Operational Criteria                                     organization’s own internal assessments
      struck between flexibility and comparability
      for the A-IRB requirements. If this balance is
                                                                 Banking organizations would have to                   of the PD and LGD of a securitization
      not appropriate, what are the specific areas            satisfy certain operational criteria to be               exposure. For securitization exposures
      of imbalance, and what is the potential                 eligible to use the A–IRB approach to                    backed by pools of multiple assets, such
      impact of the identified imbalance? Are there           securitization exposures. Moreover, all                  assessments require implicit or explicit
      alternatives that would provide greater                 banking organizations that use the A–                    estimates of correlations among the
      flexibility, while meeting the overall                  IRB approach for the underlying                          losses on those assets. Such correlations
      objectives of producing accurate and                    exposures that have been securitized                     are extremely difficult to estimate and
      consistent ratings?                                     would have to apply the A–IRB
         The Agencies also seek comment on the
                                                                                                                       validate in an objective manner and on
                                                              treatment for securitization exposures.                  a going-forward basis. For this reason,
      supervisory standards contained in the draft            Minimum operational criteria would
      guidance on internal ratings-based systems                                                                       the A–IRB framework generally would
      for corporate exposures. Do the standards
                                                              apply to traditional and synthetic                       not permit a banking organization to use
      cover all of the key elements of an A–IRB               securitizations. The Agencies propose to                 its internal risk assessments of PD or
      framework? Are there specific practices that            establish supervisory criteria for                       LGD when such assessments depend,
      appear to meet the objectives of accurate and           determining when, for risk-based capital                 implicitly or explicitly, on estimates of
      consistent ratings but that would be ruled out          purposes, a banking organization may                     correlation effects. The A–IRB treatment
      by the supervisory standards related to                 treat exposures that it has originated                   of securitization exposures would rely
      controls and oversight? Are there particular            directly or indirectly as having been
      elements from the corporate guidance that                                                                        principally on two sources of
                                                              securitized and, hence, not subject to
      should be modified or reconsidered as the                                                                        information, when available: (i) An
                                                              the same capital charge as if the banking
      Agencies draft guidance for other types of                                                                       assessment of the securitization
                                                              organization continued to hold the
      credit?                                                                                                          exposure’s credit risk made by an
         In addition, the Agencies seek comment on
                                                              assets. The Agencies anticipate these
                                                                                                                       external rating agency; and (ii) the
      the extent to which these proposed                      supervisory criteria will be substantially
                                                              equivalent to the criteria contained in                  A–IRB capital charge that would have
      requirements are consistent with the ongoing                                                                     been assessed against the underlying
      improvements banking organizations are                  the New Accord (paragraphs 516–520).
                                                              Broadly, these criteria are intended to                  exposures had the exposures not been
      making in credit-risk management processes.
                                                              ensure that securitization transactions                  securitized (the pool’s A–IRB capital
      IV. Securitization                                      transfer significant credit risk to third                charge), along with other information
                                                              parties and, in the case of traditional                  about the transaction.
      A. General Framework
                                                              securitizations, that each transaction                   B. Determining Capital Requirements
         This section describes the calculation               qualifies as a true sale under applicable
      of A–IRB capital requirements for                       accounting standards.                                    General Considerations
      securitization exposures. A                                The supervisory criteria also would
      securitization exposure is any on- or off-              describe the types of clean-up calls that                   Because the information available to a
      balance-sheet position created by                       may be incorporated within transactions                  banking organization about a
      aggregating and then tranching the risks                qualifying for the A–IRB securitization                  securitization exposure often reflects the
      of a pool of assets, commitments, or                    treatment.28 Specifically, any clean-up                  organization’s role in a securitization
      other instruments (underlying                           call would have to meet the following                    transaction, the Agencies are proposing
      exposures) into multiple financial                      conditions: (a) Its exercise is at the                   that the method of calculating the
      interests where, typically, the pooled                  discretion of the originating banking                    A–IRB capital requirement for a
      risks are not shared pro rata. The pool                 organization; (b) it does not serve as a                 securitization exposure may depend on
      may include one or more underlying                      credit enhancement; and (c) it is only                   whether a banking organization is an
      exposures. Examples include all                         exercisable when 10 percent or less of                   originator or a third-party investor in
      exposures arising from traditional and                  the original underlying portfolio or                     the securitization transaction. In
      synthetic securitizations, as well as                   reference portfolio value remains. If a                  general, a banking organization would
      partial guarantee arrangements where                    clean-up call does not meet all of these                 be considered an originator of a
      credit losses are not divided                                                                                    securitization if the organization
      proportionately among the parties (often                  28 In general terms, a clean-up call is an option      directly or indirectly originated the
                                                              that permits an originating banking organization to      underlying exposures or serves as the
      referred to as tranched cover). Asset-                  call the securitization exposures (for example, asset-
      and mortgage-backed securities                          or mortgage-backed securities) before all of the
                                                                                                                       sponsor of an asset-backed commercial
      (including those privately issued and                   underlying exposures have been repaid.                   paper (ABCP) conduit or similar

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                               Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules                                                       45933

      program.29 If a banking organization is                     2. Otherwise, apply the SFA                           charge generally would not be greater
      not deemed an originator of a                               b. If KIRB cannot be determined:                      after securitization than before, while
      securitization transaction, then it would                   i. Apply the Look-Through Approach                    also addressing the Agencies’ safety and
      be considered an investor in the                         if the exposure is an eligible liquidity                 soundness concerns with respect to
      securitization.                                          facility, subject to supervisory approval                credit-enhancing interest-only strips
        There are several methods for                             ii. Otherwise, deduct the exposure                    and other capitalized assets.31
      determining the A–IRB capital                            from total capital                                          The proposed maximum A–IRB
      requirement for a securitization                            3. When an A–IRB approach does not                    capital requirement effectively would
      exposure: the Ratings-Based Approach                     exist for the underlying exposures do                    reverse one aspect of the general risk-
      (RBA), the Alternative RBA, the                          the following:                                           based capital rules for securitization
      Supervisory Formula Approach (SFA),                         a. Apply the Look-Through Approach                    exposures referred to as residual
      the Look-Through Approach, deduction                     if the exposure is an eligible liquidity                 interests. Under the general risk-based
      from Tier 1 capital, and deduction from                  facility, subject to supervisory approval                capital rules, banking organizations are
      total capital. The following table                          b. Otherwise, apply the Alternative                   required to hold a dollar in capital for
      summarizes conditions under which a                      RBA                                                      every dollar in residual interest,
      banking organization would apply each                                                                             regardless of the capital requirement on
      of these methods. In this table, KIRB                    Deductions of Gain-on-Sale or Other
                                                                                                                        the underlying exposures. One of the
      denotes the ratio of (a) the pool’s A–IRB                Accounting Elements That Result in
                                                                                                                        reasons the Agencies adopted the
      capital charge to (b) the notional or loan               Increases in Equity Capital
                                                                                                                        ‘‘dollar-for-dollar’’ capital treatment for
      equivalent amount of underlying                             Any increase in equity capital                        residual interests is that in many
      exposures in the pool.                                   resulting from a securitization                          instances the relative size of the
      Steps for Determining A–IRB Capital                      transaction (for example, a gain                         exposure retained by the originating
      Requirements for Securitization                          resulting from FAS 140 accounting                        banking organization reveals additional
      Exposures                                                treatment of the sale of assets) would be                market information about the quality of
                                                               deducted from Tier 1 capital. Such                       the underlying exposures and deal
         For an investing banking organization:                deductions are intended to offset any                    structure that may not have been
         1. Deduct from total capital any                      gain on sale or other accounting                         captured in the capital requirement on
      credit-enhancing interest-only strips                    treatments (‘‘gain on sale’’) that result in
         2. When an external or inferred rating                                                                         the underlying exposures, had those
                                                               an increase in an originating banking                    exposures remained on the banking
      exists, apply the RBA                                    organization’s shareholders’ equity and
         3. When an external or inferred rating                                                                         organization’s balance sheet. The
                                                               Tier 1 capital. Over time, as banking                    Agencies will continue to review the
      does not exist, do the following:
         a. Subject to supervisory review and                  organizations, from an accounting                        proposal for safety and soundness
      approval, if the investing banking                       perspective, realize the increase in                     considerations and may consider
      organization can determine KIRB, then                    equity that was booked at origination of                 retaining the current dollar-for-dollar
      calculate required capital as would an                   a securitization transaction through                     capital treatment for residual interests,
      originating banking organization using                   actual receipt of cash flows, the amount                 especially in those instances where an
      the steps described in 2.a. below                        of the required deduction would be                       originator retains first loss and other
         b. Otherwise, deduct the exposure                     reduced accordingly.                                     deeply subordinated interests in
      from total capital                                          Banking organizations would have to                   amounts that significantly exceed the
         For an originating banking                            deduct from total capital any on-                        pool’s A–IRB capital charge plus
      organization:*                                           balance-sheet credit-enhancing interest-                 required deductions.
         1. Deduct from Tier 1 capital any                     only strips (net of any increase in the
                                                                                                                           Comments are invited on the
      increase in capital resulting from the                   shareholders’ equity deducted from Tier                  circumstances under which the retention of
      securitization transaction and deduct                    1 capital as described in the previous                   the treatment in the general risk-based capital
      from total capital any credit-enhancing                  paragraph).30 Credit-enhancing interest-                 rules for residual interests for banking
      interest-only strips (net of deductions                  only strips are defined in the general                   organizations using the A–IRB approach to
      from Tier 1 capital due to increases in                  risk-based capital rules and include                     securitization would be appropriate.
      capital)                                                 items, such as excess spread, that                          Should the Agencies require originators to
         2. When an A–IRB approach exists for                  represent subordinated cash flows of                     hold dollar-for-dollar capital against all
      the underlying exposures do the                                                                                   retained securitization exposures, even if this
                                                               future margin income.
                                                                                                                        treatment would result in an aggregate
      following:                                                                                                        amount of capital required of the originator
         a. If KIRB can be determined:                         Maximum Capital Requirement
                                                                                                                        that exceeded the pool’s A–IRB capital
         i. For a securitization exposure (or                     Where an A–IRB approach exists for                    charge plus any applicable deductions?
      portion thereof) that is at or below KIRB,               the underlying exposures, an originating                 Please provide the underlying rationale.
      deduct the exposure from total capital                   banking organization’s total A–IRB
         ii. For a securitization exposure (or                 capital charge for exposures associated                  Investors
      portion thereof) that is above KIRB:                     with a given securitization transaction                    Third-party investors generally do not
         1. Apply the RBA whenever an                          would be subject to a maximum or                         have access to detailed, ongoing
      external or inferred rating is available                 ceiling. This maximum A–IRB capital                      information about the credit quality of
         29 A banking organization is generally considered
                                                               charge would equal the pool’s A–IRB                      the underlying exposures in a
      a sponsor of an ABCP conduit or similar program
                                                               capital charge plus any required                         securitization. In such cases, investors
      if, in fact or in substance, it manages or advises the   deductions, as described in the                          often rely upon credit assessments made
      conduit program, places securities into the market       preceding paragraphs. The aim of this                    by external rating agencies. For a
      for the program, or provides liquidity support or        treatment is to ensure that an                           securitization exposure held by an
      credit enhancements to the program.
         * In addition to the capital treatments delineated,   institution’s effective A–IRB capital                    investing banking organization, and
      an originating banking organization’s total A–IRB
      capital charge with regard to any single                   30 Deductions other than of increases in equity          31 The maximum capital, requirement also

      securitization transaction is subject to a maximum       capital are to be taken 50 percent from Tier 1 capital   applies to investing banking organizations that
      or ceiling, as described later in this section.          and 50 percent from Tier 2 capital.                      receive approval to use the SFA.

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      45934                    Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules

      where an A–IRB treatment for the                        retained securitization exposure’s A–                    quality of the underlying exposures. For
      underlying exposures exists, the                        IRB capital requirement depends on the                   example, if the pool’s A–IRB capital
      institution would use the Ratings-Based                 relationship between KIRB, T, and L. If                  charge were to increase after the
      Approach (RBA) described below if the                   an originator cannot determine KIRB,                     inception of a securitization, additional
      securitization exposure is externally                   any retained securitization exposure                     portions of securitization exposures
      rated or if an inferred rating is available             would be deducted from capital. For                      held by an originator may fall below
      (as defined in the RBA discussion                       eligible liquidity facilities (defined                   KIRB and, thus, become subject to
      below). When neither an external rating                 below in the Look Through Approach)                      deduction. Therefore, when an
      nor an inferred rating is available, an                 provided to ABCP programs where a                        originator retains a first-loss
      investing banking organization would                    banking organization lacks the                           securitization exposure well in excess of
      compute the A–IRB capital charge for                    information necessary to calculate KIRB,                 KIRB, the originator’s A–IRB capital
      the exposure using the methodology                      the Look-Through Approach described                      requirement on the exposure could
      described below for originating                         below would be applied on a temporary                    climb rapidly in the event of any
      institutions (subject to supervisory                    basis and subject to supervisory                         marked deterioration of the underlying
      review and approval). Otherwise, the                    approval.                                                exposures. In general, an originator
      securitization exposure would be                                                                                 could minimize variability in future
      deducted 50 percent from Tier 1 capital                 Positions Below KIRB
                                                                                                                       capital charges by minimizing the size
      and 50 percent from Tier 2 capital. The                    An originating banking organization                   of any retained first-loss securitization
      Agencies anticipate that investing                      would deduct from capital any retained                   exposures.
      banking organizations would apply the                   securitization exposure (or part thereof)
      RBA in the vast majority of situations.                 that absorbs losses at or below the level                Positions Above KIRB
      Originators                                             of KIRB (that is, an exposure for which                     When an originating banking
                                                              L+T ≤ KIRB).33 This means that an                        organization retains a securitization
         This section presumes that an A–IRB                  originating banking organization would                   exposure, or part thereof, that absorbs
      approach exists for the underlying                      be given no risk-based capital relief                    losses above the KIRB amount (that is,
      exposures. If no A–IRB treatment exists                 unless it sheds at least some exposures                  an exposure for which L + T > KIRB)
      for the underlying exposures, then an                   below KIRB. Deduction from capital                       and the banking organization has not
      originating banking organization                        would be required regardless of the                      already met the maximum capital
      (originator) would use the Alternative                  securitization exposure’s external rating.               requirement for securitization exposures
      RBA discussed below.                                    This deduction treatment is in contrast                  described previously, the A–IRB capital
         In contrast to third-party investors,                to the A–IRB capital treatment for                       requirement for the exposure would be
      banking organizations that originate                    investors, who would be able to look to                  calculated as follows. For securitization
      securitizations are presumed to have
                                                              the external (or inferred) rating of a                   exposures having an external or inferred
      much greater access to information
                                                              securitization exposure regardless of                    rating, the organization would calculate
      about the current credit quality of the
                                                              whether the exposure was below KIRB.                     its A–IRB capital requirement using the
      underlying exposures. In general, when
                                                                 While this disparate treatment of                     RBA. However, if neither an external
      an originator retains a securitization
                                                              originators and investors may be viewed                  rating nor an inferred rating is available,
      exposure, the A–IRB securitization
                                                              as inconsistent with the principle of                    an originator would be able to use the
      framework would require the institution
                                                              equal capital for equal risk, the Agencies               SFA, subject to supervisory review and
      to calculate, on an ongoing basis, the
                                                              believe it is appropriate in order to                    approval. Otherwise, the organization
      underlying exposure pool’s A–IRB
                                                              provide incentives for originating banks                 would deduct the securitization
      capital requirement had the underlying
      exposures not been securitized (the                     to shed highly subordinated                              exposure from total capital.
      pool’s A–IRB capital charge), which                     securitization exposures. Such                             The Agencies seek comment on the
      would be based on the notional dollar                   exposures contain the greatest credit                    proposed treatment of securitization
      amount of underlying exposures (the                     risks. Moreover, these risks are difficult               exposures held by originators. In particular,
      size of the pool). The pool’s A–IRB                     to evaluate, and risk quantifications                    the Agencies seek comment on whether
                                                              tend to be highly sensitive to modeling                  originating banking organizations should be
      capital charge would be calculated                                                                               permitted to calculate A–IRB capital charges
      using the top-down or bottom-up                         assumptions that are difficult to validate
                                                              objectively. The proposal to prevent an                  for securitizations exposures below the KIRB
      method applicable to the type(s) of                                                                              threshold based on an external or inferred
      underlying exposure(s).32 As noted                      originator from using the RBA for
                                                                                                                       rating, when available.
      above, the pool’s A–IRB capital charge                  securitization exposures below KIRB                        The Agencies seek comment on whether
      divided by the size of the pool is                      reflects, in part, a concern by the                      deduction should be required for all non-
      denoted KIRB.                                           Agencies that the market discipline                      rated positions above KIRB. What are the
         An originator also would be expected                 underpinning an external credit rating                   advantages and disadvantages of the SFA
      to know: (a) Its retained securitization                may be less effective when the rating                    approach versus the deduction approach?
      exposure’s nominal size relative to the                 applies to a retained, non-traded
                                                                                                                       Capital Calculation Approaches
      size of the pool (the exposure’s                        securitization exposure and is sought by
      ‘‘thickness,’’ denoted T); and (b) the                  an originator primarily for regulatory                   The Ratings-Based Approach (RBA)
      notional amount of all more junior                      capital purposes.                                           The RBA builds upon the widespread
      securitization exposures relative to the                   The Agencies note that the specific                   acceptance of external ratings by third-
      size of the pool (the exposure’s ‘‘credit               securitization exposures retained by an                  party investors as objective assessments
      enhancement level,’’ denoted L). The                    originator that are subject to deduction                 of a securitization exposure’s stand-
                                                              treatment could change over time in                      alone credit risk. Certain minimum
        32 For the purpose of determining the A–IRB           response to variations in the credit                     requirements would have to be satisfied
      capital requirement for a securitization exposure,                                                               in order for a banking organization to
      the top-down method could be used regardless of            33 If an originator holds a securitization exposure

      the maturity of the underlying exposures, provided      that straddles KIRB, the exposure must be
                                                                                                                       rely on an external credit rating for
      the other eligibility criteria for employing the top-   decomposed into two separate positions—one that          determining its A–IRB capital charge for
      down approach are satisfied.                            is above KIRB and another that is at or below KIRB.      a securitization exposure. To be

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                                        Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules                                                                                  45935

      recognized for regulatory capital                                            or short-term assessment of the                                         corporate bond having a given level of
      purposes, the external credit rating on a                                    exposure’s credit risk, and (iii) a                                     stand-alone credit risk (for example, as
      securitization exposure would have to                                        measure of the effective number—or                                      measured by its expected loss rate), a
      be public and reflect the entire amount                                      granularity—of the underlying                                           securitization tranche having the same
      of credit risk exposure the banking                                          exposures (N).34 For a securitization                                   level of stand-alone risk—but backed by
      organization has with regard to all                                          exposure rated AA or AAA, the RBA                                       a reasonably granular and diversified
      payments owed to it under the                                                capital charge also would depend on a                                   pool—will tend to exhibit more
      exposure. In particular, if a banking                                        measure of the exposure’s relative                                      systematic risk.37 This effect is most
      organization is owed both principal and                                      seniority in the overall transaction (Q).35                             pronounced for below-investment grade
      interest on a securitization exposure, the                                      Tables 1 and 2 below present the risk                                tranches, and is the primary reason why
      external rating on the exposure would                                        weights that would result from the RBA
                                                                                                                                                           the RBA risk weights increase rapidly as
      have to fully reflect the credit risk                                        when a securitization exposure’s
                                                                                                                                                           ratings deteriorate over this range—
      associated with both payment streams.                                        external rating (or inferred rating)
                                                                                   represents a long-term or short-term                                    much more rapidly than for similarly
      The Agencies propose to establish
                                                                                   credit rating, respectively. In both                                    rated corporate bonds. Similarly, for
      criteria to ensure the integrity of
      external ratings processes and banking                                       tables, the risk weights in column 2                                    highly granular pools, the risk weights
      organizations’ use of these ratings under                                    would apply to AA and AAA-rated                                         expected to apply to most AA and AAA-
      the RBA. These criteria are expected to                                      securitization exposures when the                                       rated securitization exposures (7 percent
      be consistent with the proposed                                              effective number of exposures (N) is 100                                and 10 percent, respectively) decline
      guidance provided in the New Accord                                          or more, and the exposure’s relative                                    steeply relative to the risk weight
      (paragraph 525).                                                             seniority (Q) is greater than or equal to                               applicable to A-rated exposures (20
         In certain circumstances, an ‘‘inferred                                   0.1 + 25/N. If the underlying exposures                                 percent, column 3)—again, more so than
      rating’’ may be used for risk weighting                                      are retail exposures, N would be treated                                might be the case for similarly rated
      a non-rated securitization exposure.                                         as infinite and the minimum qualifying                                  corporate bonds. The decline in risk
      Similar to the general risk-based capital                                    value of Q would be 0.10. The Agencies                                  weights as ratings improve over the
      rules, to qualify for use of an inferred                                     anticipate that these risk weights would                                investment grade range is less
      rating, a non-rated securitization                                           apply to AA and AAA-rated tranches of                                   pronounced for the Base Case and for
      exposure would have to be senior in all                                      most retail securitizations. Column 4                                   tranches backed by non-granular pools
      respects to a subordinate rated position                                     would apply only to securitizations                                     (column 4).
      within the same securitization                                               involving non-retail exposures for
                                                                                                                                                              For securitization exposures rated
      transaction. Further, the junior rated                                       which N is less than 6, and column 3
                                                                                                                                                           below BB¥, the proposed A–IRB
      tranche would have to have an                                                would apply in all other situations.
      equivalent or longer remaining maturity                                         Within each table, risk weights                                      treatment—deduction from capital—
      than the non-rated exposure. Where                                           increase as external rating grades                                      would be somewhat more conservative
      these conditions are met, the non-rated                                      decline. Under the Base Case (column                                    than suggested by credit risk modeling
      exposure would be treated as if it had                                       3), for example, the risk weights range                                 analyses. However, the Agencies believe
      the same rating (an ‘‘inferred rating’’) as                                  from 12 percent for AAA-rated                                           this more conservative treatment would
      that of the junior rated tranche. External                                   exposures to 650 percent for exposures                                  be appropriate in light of modeling
      and inferred ratings would be treated                                        rated BB¥. This pattern of risk weights                                 uncertainties and the tendency for
      equivalently.                                                                is broadly consistent with analyses                                     securitization exposures in this range, at
         Under the RBA, the capital charge per                                     employing standard credit risk models                                   least at the inception of the
      dollar of a securitization exposure                                          and a range of assumptions regarding                                    securitization transaction, to be non-
      would depend on: (i) The external rating                                     correlation effects and the types of                                    traded positions retained by an
      (or inferred rating) of the exposure, (ii)                                   exposures being securitized.36 These                                    originator because they cannot be sold
      whether the rating reflects a long-term                                      analyses imply that, compared with a                                    at a reasonable price.

                                                                                                  Thick tranches backed by                                                             Tranches backed by non-
                             External rating (illustrative)                                                                                              Base case
                                                                                                    highly granular 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

        34 N is defined more formally in the discussion                            expressed as a decimal. Thus, for a securitization                        36 See Vladislav Peretyatkin and William

      below of the Supervisory Formula Approach.                                   transaction having an AAA-rated tranche in the                          Perraudin, ‘‘Capital for Asset-Backed Securities,’’
        35 Q is defined as the total size of all                                   amount of 70 percent of the pool, an AAA-rated                          Bank of England, February 2003.
                                                                                   tranche of 10 percent, a BBB-rated tranche of 10
      securitization exposures rated at least AA¥ that are                                                                                                   37 See, for example, Michael Pykhtin and Ashish
                                                                                   percent, and a non-rated tranche of 10 percent, the
      pari passu or junior to the exposure of interest,                            values of Q associated with these positions would                       Dev, ‘‘Credit Risk in Asset Securitizations:
      measured relative to the size of the pool and                                be 0.80, 0.10, 0, and 0, respectively.                                  Analytical Model,’’ Risk (May 2002) S16–S20.

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      45936                           Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules

                                                                                            Thick tranches backed by                                                                Tranches backed by non-
                           External rating (illustrative)                                                                                             Base case
                                                                                              highly granular 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                                     The Supervisory Formula Approach                                          of underlying exposures that have been
      proposed treatment of securitization                                    (SFA)                                                                     securitized (E), the A–IRB capital charge
      exposures under the RBA. For rated                                                                                                                had the underlying exposures not been
      securitization exposures, is it appropriate to
                                                                                 As noted above, when an explicit A–
                                                                              IRB approach exists for the underlying                                    securitized (KIRB); the tranche’s credit
      differentiate risk weights based on tranche                                                                                                       enhancement level (L); the tranche’s
      thickness and pool granularity?                                         exposures, originating and investing
                                                                              banking organizations would be able to                                    thickness (T); the pool’s effective
         For non-retail securitizations, will                                                                                                           number of exposures (N); and the pool’s
      investors generally have sufficient                                     apply the SFA to non-rated exposures
                                                                              above the KIRB threshold, subject to                                      exposure-weighted average loss-given-
      information to calculate the effective number                                                                                                     default (LGD). In general, the estimates
      of underlying exposures (N).                                            supervisory approval and review. The
                                                                              Agencies anticipate that, in addition to                                  of N and LGD would be developed as a
         What are views on the thresholds, based on                                                                                                     by-product of the process used to
      N and Q, for determining when the different                             its application to liquidity facilities and
                                                                              to other traditional and synthetic                                        determine KIRB.
      risk weights apply in the RBA?                                                                                                                      The SFA capital charge for a given
         Are there concerns regarding the reliability                         securitization exposures, the SFA would
                                                                              be used when calculating A–IRB capital                                    securitization tranche would be
      of external ratings and their use in                                                                                                              calculated as the notional amount of
      determining regulatory capital? How might                               requirements for tranched guarantees
                                                                              (for example, a loan for which a                                          underlying exposures that have been
      the Agencies address any such potential
                                                                              guarantor assumes a first-loss position                                   securitized (E), multiplied by the greater
                                                                              that is less than the full amount of the                                  of: (i) 0.0056 * T or (ii) the following
         Unlike the A–IRB framework for wholesale
                                                                              loan).                                                                    expression: 39
      exposures, there is no maturity adjustment
      within the proposed RBA. Is this reasonable                                Under the SFA, the A–IRB capital                                       K[L + T]¥K[L] + {(0.05 * d * KIRB *
      in light of the criteria to assign external                             charge for a securitization tranche                                             e¥20(L¥KIRB)/KIRB) *
      ratings?                                                                would depend on six institution-                                                (1¥e¥20T/KIRB)},
                                                                              supplied inputs: 38 the notional amount                                   where,40

                                                            h = (1 − KIRB / LGD)

                                                           c = KIRB / (1 − h )

                                                                  (LGD − KIRB) KIRB                   + 0.25 (1 − LGD) KIRB
                                                                v + KIRB2
                                                            f =
                                                                           − c2  +
                                                                                    (1 − KIRB) KIRB − v
                                                                1− h                   (1 − h) ∗1000
                                                                  (1 − c) c       − 1
                                                           a = g∗c
                                                            b = g ∗ (1 − c)
                                                           d = 1 − (1 − h ) ∗ (1 − Beta [KIRB a, b])
                                                            K[x] = (1 − h ) ∗ (x ∗ (1 − Beta [x; a, b]) + c ∗ Beta[x; a + 1, b]).

      Although visually daunting, the above                                   components have intuitive                                                 per dollar of tranche exposure. While
      supervisory formula is easily                                           interpretations.                                                          acknowledging that such a floor is not
      programmable within standard                                               Part (i), noted above, of the SFA                                      risk-sensitive, the Agencies believe that
      spreadsheet packages, and its various                                   effectively imposes a 56 basis point                                      some minimum prudential capital
                                                                              minimum or floor A–IRB capital charge                                     charge is nevertheless appropriate. The

        38 When the banking organization holds only a                           39 The SFA applies only to exposures above KIRB.                          40 In these expressions, Beta[X; a, b] refers to the

      proportional interest in the tranche, that position’s                   When a securitization tranche straddles KIRB, for                         cumulative beta distribution with parameters a and
      A–IRB capital charge equals the prorated share of                       the purpose of applying the SFA the tranche should                        b evaluated at X. The cumulative beta distribution
      the capital charge for the entire tranche.                              be decomposed into a position at or below KIRB                            function is available in Excel as the function
                                                                              and another above KIRB. The latter would be the

                                                                              position to which the SFA is actually applied.

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                              Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules                                                     45937

      floor has been proposed at 56 basis                     addition, this specification embodies                 spread account or overcollateralization)
      points partly on the basis of empirical                 the well-known result that a pool’s total             that provides credit enhancement to the
      analyses suggesting that, across a broad                systematic risk (that is, KIRB) tends to              tranche of interest. Credit-enhancing
      range of modeling assumptions and                       be redistributed toward more senior                   interest-only strips would not be
      exposure types, this level provides a                   tranches as the effective number of                   included in the calculation of L.
      reasonable lower bound on the capital                   underlying exposures in the pool (N)                     Thickness (T). This input would be
      charges implied by standard credit risk                 declines.43 The importance of pool                    measured (in decimal form) as the ratio
      models for securitization tranches                      granularity depends on the pool’s                     of (a) the notional amount of the tranche
      meeting the standards for an external                   average loss-rate-given-default, as                   of interest to (b) the notional or loan
      rating of AAA.41 This floor also is                     increases in LGD also tend to shift                   equivalent amount of underlying
      consistent with the lowest capital                      systematic risk toward senior tranches                exposures in the pool (E).
      charge available under the RBA.                         when N is small. For highly granular                     Effective number of exposures (N).
         Part (ii) of the SFA also is a blend of              pools, such as securitizations of retail              This input would be calculated as
      credit risk modeling results and                        exposures, LGD would have no
      supervisory judgment. The function                      influence on the SFA capital charge.                                              
      denoted K[x] represents a pure model-                      The Agencies propose to establish                                      ∑ EAD i 
      based estimate of the pool’s aggregate                  criteria for determining E, KIRB, L, T, N,                                        
                                                                                                                                     N= i
      systematic or non-diversifiable credit
      risk that is attributable to a first-loss
                                                              and LGD that are consistent with those
                                                              suggested in the New Accord. A                                             ∑ EADi 2

      position covering pool losses up to and                 summary of these requirements is
                                                                                                                    where EADi represents the exposure-at-
      including x. Because the tranche of                     presented below.
                                                                 E. This input would be measured (in                default associated with the i-th
      interest (defined in terms of a credit
                                                              dollars) as the A–IRB estimate of the                 underlying exposure in the pool.
      enhancement level L, and thickness T)
      covers losses between L and L+T, its                    exposures in the underlying pool of                   Multiple underlying exposures to the
      total systematic risk can be represented                securitized exposures, as if they were                same obligor would be consolidated
      as K[L + T]¥K[L], which are the first                   held directly by the banking                          (that is, treated as a single exposure). If
      two terms in (1). The term in braces                    organization, rather than securitized.                the pool contains any underlying
      within (1) represents a supervisory add-                This amount would reflect only those                  exposures that are themselves
      on to the pure model-based result. This                 underlying exposures that have actually               securitization exposures (for example,
      add-on is intended primarily to avoid                   been securitized to date. Thus, for                   one or more asset-backed securities),
      potential behavioral distortions                        example, E would exclude undrawn                      each of these would be treated as a
      associated with what would otherwise                    lines associated with revolving credit                single exposure for the purpose of
      be a discontinuity in capital charges for               facilities (for example, credit card                  measuring N.44
      relatively thin mezzanine tranches lying                accounts).                                               Exposure-weighted average LGD. This
      just below and just above KIRB: all                        KIRB. This input would be measured                 input would be calculated (in decimal
      tranches at or below KIRB would be                      (in decimal form) as the ratio of (a) the             form) as
      deducted from capital, whereas a very                   pool’s A–IRB capital requirement to (b)
      thin tranche just above KIRB would                      the notional or loan equivalent amount                                     ∑ LGDi ⋅ EADi
      incur a pure model-based capital charge                 of the underlying exposures in the pool                                    i
                                                                                                                               LGD =
      that could vary between zero and one,                   (E). The pool’s A–IRB capital                                                ∑ EADi
      depending upon the number of effective                  requirement would be calculated in                                                 i
      underlying exposures in the pool (N).                   accordance with the applicable A–IRB                  where LGDi represents the average LGD
      The add-on would apply primarily to                     standard for the type of underlying                   associated with all underlying
      positions just above KIRB, and its                      exposure. This calculation would                      exposures to the i-th obligor. In the case
      quantitative effect would diminish                      incorporate the effect of any credit risk             of re-securitization (a securitization of
      rapidly as the distance from KIRB                       mitigant that is applied to the                       securitization exposures), an LGD of 100
      widens.                                                 underlying exposures (either                          percent would be assumed for any
         Most of the complexity of the                        individually or to the entire pool), and              underlying exposure that was itself a
      supervisory formula is a consequence of                 hence benefits all of the securitization              securitization exposure.45
      attempting to make K[x] as consistent as                exposures. Consistent with the
      possible with the parameters and                        measurement of E, the estimate of KIRB                   44 Within the supervisory formula, the probability

      assumptions of the A–IRB framework                      would reflect only the underlying                     distribution of credit losses associated with the pool
      that would apply to the underlying                                                                            of underlying exposures is approximated by treating
                                                              exposures that have been securitized.                 the pool as if it consisted of N homogeneous
      exposures if held directly by a banking                 For example, KIRB generally would                     exposures, each having an A–IRB capital charge of
      organization.42 The specification of K[x]               exclude the A–IRB capital charges                     KIRB/N. The proposed treatment of N implies, for
      assumes that KIRB is an accurate                        against the undrawn portions of                       example, that a pool containing one ABS tranche
      measure of the pool’s total systematic                                                                        backed by 1 million effective loans behaves more
                                                              revolving credit facilities.                          like a single loan having an A–IRB capital charge
      credit risk, and that a securitization                     Credit enhancement level (L). This                 of KIRB than a pool of 1 million loans, each having
      merely redistributes this systematic risk               input would be measured (in decimal                   an A–IRB capital charge of KIRB/1,000,000.
      among its various tranches. In this way,                form) as the ratio of (a) the notional                   45 As noted above, the A–IRB securitization

      K[x] embodies precisely the same asset                  amount of all securitization exposures                framework does not permit banking organizations to
      correlations as are assumed elsewhere                                                                         use their own internal estimates of LGDs (and PDs)
                                                              subordinate to the tranche of interest to             for securitization exposures because such
      within the A–IRB framework. In                          (b) the notional or loan equivalent                   quantification requires implicit or explicit estimates

                                                              amount of underlying exposures in the                 of loss correlations among the underlying
         41 See Vladislav Peretyatkin and William                                                                   exposures. Recall that LGDs should be measured as
                                                              pool (E). L would incorporate any
      Perraudin, ‘‘Capital for Asset-Backed Securities,’’                                                           the loss rates expected to prevail when default rates
      Bank of England, February 2003.                         funded reserve account (for example,                  are high. While setting LGDs equal to 100 percent
         42 The conceptual basis for specification of K[x]                                                          is reasonable for certain types of ABSs, such as
      is developed in Michael B. Gordy and David Jones,         43 See Michael Pykhtin and Ashish Dev, ‘‘Coarse-    highly subordinated or thin tranches, this level of

      ‘‘Random Tranches,’’ Risk (March 2003) 78–83.           granied CDOs,’’ Risk (January 2003) 113–116.                                                      Continued

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      45938                   Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules

        Simplified method for computing N                     the underlying exposures are retail                     is no more than 0.03 (or 3 percent of the
      and LGD. Under the conditions                           exposures, the SFA may be                               pool), the banking organization would
      provided below, banking organizations                   implemented by setting h = 0 and v =                    be able to set LGD = 0.50 and N equal
      would be able to employ simplified                      0, subject to supervisory approval and                  to:
      methods for calculating N and the                       review. When the share of the pool
      exposure-weighted average LGD. When                     associated with the largest exposure, C1,

                                                                          C − Cl                   
                                                             N =  ClCm +  m       max{1 − mC l , 0} ,
                                                                          m −1                     

      provided that the banking organization                  propose that its applicability be                       Agencies propose that the risk weight be
      can measure Cm, which denotes the                       restricted to liquidity facilities that are             set equal to the risk weight applicable
      share of the pool corresponding to the                  structured to minimize the extent to                    under the general risk-based capital
      largest ‘‘m’’ exposures (for example, a 15              which the facilities provide credit                     rules for banking organizations not
      percent share corresponds to a value of                 support to the conduit. The Look-                       using the A–IRB approach (that is, to the
      0.15).46 Alternatively, when only C1 is                 Through Approach would only be                          underlying assets or obligors after
      available and this amount is no more                    available to liquidity facilities that meet             consideration of collateral or guarantees
      than 0.03, then the banking organization                the following criteria:                                 or, if applicable, external ratings).
      would be able to set LGD = 0.50 and N                      (a) The facility documentation clearly
      = 1/ C1.                                                identifies and limits the circumstances                    The Agencies seek comment on the
                                                              under which it may be drawn. In                         proposed treatment of eligible liquidity
        The Agencies seek comment on the
                                                              particular, the facility must not be able               facilities, including the qualifying criteria for
      proposed SFA. How might it be simplified
      without sacrificing significant risk                    to cover losses already sustained by the                such facilities. Does the proposed Look-
      sensitivity? How useful are the alternative             pool of underlying exposures (for                       Through Approach—to be available as a
      simplified computation methodologies for N              example, to acquire assets from the pool                temporary measure—satisfactorily address
      and LGD                                                 at above fair value) or be structured                   concerns that, in some cases, it may be
                                                              such that draw-down is highly probable                  impractical for providers of liquidity
      The Look-Through Approach for                                                                                   facilities to apply either the ‘‘bottom-up’’ or
      Eligible Liquidity Facilities                           (as indicated by regular or continuous
                                                              draws);                                                 ‘‘top-down’’ approach for calculating KIRB?
         ABCP conduits and similar programs                      (b) The facility is subject to an asset              It would be helpful to understand the degree
      sponsored by U.S. banking                               quality test that prevents it from being                to which any potential obstacles are likely to
      organizations are major sources of                      drawn to cover underlying exposures                     persist.
      funding for financial and non-financial                 that are in default;                                       Feedback also is sought on whether
      companies. Liquidity facilities                            (c) The facility cannot be drawn after               liquidity providers should be permitted to
      supporting these programs are                           all applicable (specific and program-                   calculate A–IRB capital charges based on
      considered to be securitization                         wide) credit enhancements from which                    their internal risk ratings for such facilities in
      exposures of the banking organizations                  the liquidity facility would benefit have               combination with the appropriate RBA risk
      providing the liquidity, and generally                  been exhausted;                                         weight. What are the advantages and
      would be treated under the rules                           (d) Repayment of any draws on the                    disadvantages of such an approach, and how
      proposed for originators. As a general                  facility (that is, assets acquired under a              might the Agencies address concerns that the
      matter, the Agencies expect that banking                purchase agreement or loans made                        supervisory validation of such internal
      organizations using the A–IRB approach                  under a lending agreement) may not                      ratings would be difficult and burdensome?
      would apply the SFA when determining                    represent a subordinated obligation of                  Under such an approach, would the lack of
      the A–IRB capital requirement for                       the pool or be subject to deferral or                   any maturity adjustment with the RBA be
      liquidity facilities provided to ABCP                   waiver; and                                             problematic for assigning reasonable risk
      conduits and similar programs.                             (e) Reduction in the maximum drawn                   weights to liquidity facilities backed by
      However, if it would not be practical for               amount, or early termination of the                     relatively short-term receivables, such as
      a banking organization to calculate KIRB                facility, occurs if the quality of the pool             trade credit?
      for the underlying exposures using a                    falls below investment grade.                           Other Considerations
      top-down or a bottom-up approach, the                      Under the Look-Through Approach,
      banking organization may be allowed to                  the liquidity facility’s A–IRB capital                  Capital Treatment Absent an A–IRB
      use the Look-Through Approach,                          charge would be computed as the                         Approach—The Alternative RBA
      described below, for determining the A–                 product of (a) 8 percent, (b) the
      IRB capital requirement, subject to                     maximum potential drawdown under                           For originating banking organizations
      supervisory approval and only for a                     the facility, (c) the applicable credit                 when there is not a specific A–IRB
      temporary period of time to be                          conversion factor (CCF), and (d) the                    treatment for an underlying exposure or
      determined in consultation with the                     applicable risk weight. The CCF would                   group of underlying exposures, the
      organization’s primary Federal                          be set at 50 percent if the liquidity                   Agencies propose that a securitization
      supervisor.                                             facility’s original maturity is one year or             exposure’s A–IRB capital charge be
         Because the Look-Through Approach                    less, and at 100 percent if the original                based exclusively on the exposure’s
      has limited risk sensitivity, the Agencies              maturity is more than one year. The                     external or inferred credit rating using

      LGD may be conservative for other types of ABSs.        IRB capital charges for originators, owing to the         46 The level of m is to be set by each banking

      However, the Agencies believe that the complexity       combined effects of (a) the dollar-for-dollar A–IRB     organization.
      and burden assoicated with a more refined               capital charge on positions at or below KIRB, and
                                                                                                                         47 The Alternative RBA does not apply to eligible
      treatment of LGDs would outweigh any                    (b) the maximum or cap on an originator’s total A–

      improvement in the overall risk sensitivity of A–       IRB capital charge.                                     liquidity facilities, which may use the Look-

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                               Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules                                                     45939

      the Alternative RBA.47 Under the                          investors’ interest in a securitization             excess spread under the terms of the
      Alternative RBA, a risk weight of 20                      when (i) the organization sells                     securitization; and
      percent is applied to exposures rated                     exposures into a securitization that                   B. The excess spread level at which
      AAA to AA¥, 50 percent to exposures                       contains an early amortization feature,             an early amortization would be
      rated A+ to A¥, and 100 percent to                        and (ii) the underlying exposures sold              triggered.
      exposures rated BBB+ to BBB-.                             are of a revolving nature. The A–IRB                   In cases where a transaction does not
      Securitization exposures having ratings                   capital charge attributed to the                    require excess spread to be trapped, the
      below investment grade, or that are non-                  originator that is associated with the              first trapping point would be deemed to
      rated, would be deducted from risk-                       investors’ interest is calculated as the            be 4.5 percentage points greater than the
      based capital on a dollar-for-dollar                      product of (a) the A–IRB capital charge             excess spread level at which an early
      basis.                                                    that would be imposed on the entire                 amortization is triggered.
         Should the A–IRB capital treatment for                 investors’ interest if it were held by the             The banking organization would
      securitization exposures that do not have a               originating banking organization, and               divide the distance between the two
      specific A–IRB treatment be the same for                                                                      points described above into four equal
      investors and originators? If so, which
                                                                (b) an applicable CCF.
                                                                   In general, the CCF would depend on              segments. For example if the spread
      treatment should be applied—that used for
      investors (the RBA) or originators (the                   whether the early amortization feature              trapping point is 4.5 percent and the
      Alternative RBA)? The rationale for the                   repays investors through a controlled or            early amortization trigger is zero
      response would be helpful.                                non-controlled mechanism, and                       percent, then 4.5 percent would be
                                                                whether the underlying exposures                    divided into four equal segments of
      Structures With Early Amortization                                                                            112.5 basis points each. The following
      Provisions                                                represent uncommitted revolving retail
                                                                facilities that are unconditionally                 conversion factors, based on illustrative
         Many securitizations of revolving                      cancellable without prior notice (for               segments, would apply to the investors’
      credit facilities (for example, credit card               example, credit card receivables) or                interest.
      accounts) contain provisions that call                    other credit lines (for example,
      for the securitization to be wound down                   revolving corporate facilities).                     CONTROLLED EARLY AMORTIZATION OF
      if the excess spread falls below a certain                                                                      UNCOMMITTED RETAIL CREDIT LINES
                                                                   An early amortization provision
      threshold.48 This decrease in excess
                                                                would be considered controlled if,
      spread can, in some cases, be caused by                                                                                                                 Credit Con-
                                                                throughout the duration of the                           3-month average excess               version Fac-
      deterioration in the credit quality of the
                                                                securitization transaction, including the                        spread                        tor (CCF)
      underlying exposures. An early
                                                                amortization period, there is a pro rata                                                       (percent)
      amortization event can increase a
                                                                sharing of interest, principal, expenses,
      banking organization’s capital needs if                                                                        450 basis points (bp) or more ..                   0
                                                                losses, and recoveries based on the
      any new draws on the revolving                                                                                 Less than 450 bp to 337.5 bp ..                    1
                                                                balances of receivables outstanding at
      facilities would need to be financed by                                                                        Less than 337.5 bp to 225 bp ..                    2
      the banking organization itself using on-                 the beginning of each month. Further,                Less than 225 bp to 112.5 bp ..                   20
      balance-sheet sources of funding. The                     the pace of repayment may not be any                 Less than 112.5 bp ...................            40
      payment allocations used to distribute                    more rapid than would be allowed
      principal and finance charge collections                  through straight-line amortization over a             All other securitizations of revolving
      during the amortization phase of these                    period sufficient for 90 percent of the             facilities (that is, those containing
      structures also can expose a banking                      total debt outstanding at the beginning             underlying exposures that are
      organization to greater risk of loss than                 of the early amortization period to have            committed or non-retail) having
      in other securitization structures. To                    been repaid or recognized as in default.            controlled early amortization features
      account for the risks that early                          In addition to these criteria, banking              would be subject to a CCF of 90 percent.
      amortization structures pose to                           organizations with structures containing
                                                                controlled early amortization features              Determination of CCFs for Non-
      originating banking organizations, the                                                                        Controlled Early Amortization
      capital treatment described below                         would also have to have appropriate
                                                                plans in place to ensure that there is              Structures
      would apply to securitizations of
                                                                sufficient capital and liquidity available             The process for determining CCFs
      revolving credit facilities containing
                                                                in the event of an early amortization.              when a securitization of revolving credit
      such features.
         In addition to the A–IRB capital                       When these conditions are not met, the              facilities contains a non-controlled early
      charge an originating banking                             early amortization provision would be               amortization mechanism would be the
      organization would incur on the                           treated as non-controlled.                          same as that described above for
      securitization exposures it retains, an                                                                       controlled early amortization structures,
                                                                Determination of CCFs for Controlled                except that different CCFs would apply
      originator would be required to hold                      Early Amortization Structures
      capital against all or a portion of the                                                                       to the various excess spread segments.
                                                                  The following method for determining              For non-controlled structures, the
      Through Approach as described above.                      CCFs applies to a securitization of                 following conversion factors, based on
      Additionally, the securitization exposures subject to     revolving credit facilities containing a            illustrative segments, would apply:
      the Alternative RBA are not limited by the                controlled early amortization
      maximum capital requirement discussed above.              mechanism. When the pool of                         NON-CONTROLLED EARLY AMORTIZA-
         48 Excess spread is defined as gross finance charge

      collections and other income received by the trust
                                                                underlying exposures includes                        TION  OF   UNCOMMITTED RETAIL
      or special purpose entity (SPE) minus certificate         uncommitted retail credit lines (for                 CREDIT LINES
      interest, servicing fees, charge-offs, and other senior   example, credit card receivables), an
      trust or SPE expenses.                                    originator would first compare the                                                            Credit Con-
         29 A banking organization is generally considered
                                                                securitization’s three-month average                     3-month average excess               version Fac-
      a sponsor of an ABCP conduit or similar program                                                                            spread                        tor (CCF)
      if, in fact or in substance, it manages or advises the    excess spread against the following two                                                        (percent)
      conduit program, places securities into the market        reference levels:
      for the program, or provides liquidity support or           A. The point at which the banking                  450 basis points (bp) or more ..                   0
      credit enhancements to the program.
                                                                organization would be required to trap               Less than 450 bp to 337.5 bp ..                    5

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      45940                   Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules

      NON-CONTROLLED EARLY AMORTIZA- Overlapping Credit Enhancements or                                             V. AMA Framework for Operational
       TION  OF   UNCOMMITTED RETAIL Liquidity Facilities                                                           Risk
       CREDIT LINES—Continued          In some ABCP or similar programs, a                                             This section describes features of the
                                                          banking organization may provide                          proposed AMA framework for
                                             Credit Con- multiple facilities that may be drawn                      measuring the regulatory capital
          3-month average excess             version Fac-                                                           requirement for operational risk. Under
                    spread                    tor (CCF)   under varying circumstances. The
                                              (percent)   Agencies do not intend that a banking                     this framework, a banking organization
                                                          organization incur duplicative capital                    meeting the AMA supervisory standards
      Less than 337.5 bp to 225 bp ..                  10 requirements against these multiple                       would use its internal operational risk
      Less than 225 bp to 112.5 bp ..                  50 exposures as long as, in the aggregate,                   measurement system to calculate its
      Less than 112.5 bp ...................          100                                                           regulatory capital requirement for
                                                          multiple advances are not permitted
                                                          against the same collateral. Rather, a                    operational risk. The discussion below
         All other securitizations of revolving           banking organization would be required                    provides background information on
      credit facilities (that is, those containing to hold capital only once for the                                operational risk and the conceptual
      underlying exposures that are                       exposure covered by the overlapping                       underpinnings of the AMA, followed by
      committed or non-retail) having non-                facilities (whether they are general                      a discussion of the AMA supervisory
      controlled early amortization                       liquidity facilities, eligible liquidity                  standards.49
      mechanisms would be subject to a CCF                facilities, or the facilities serve as credit                The Agencies’ general risk-based
      of 100 percent. In other words, no risk             enhancements). Where the overlapping                      capital rules do not currently include an
      transference would be recognized for                facilities are subject to different                       explicit capital charge for operational
      these structures; an originator’s A–IRB             conversion factors, the banking                           risk, which is defined as the risk of loss
      capital charge would be the same as if              organization would attribute the                          resulting from inadequate or failed
      the underlying exposures had not been               overlapping part to the facility with the                 processes, people, and systems or from
      securitized.                                        highest conversion factor. However, if                    external events. When developing the
                                                          different banking organizations provide                   general risk-based capital rules, the
         The Agencies seek comment on the                 overlapping facilities, each institution                  Agencies recognized that institutions
      proposed treatment of securitization of             would hold capital against the entire                     were exposed to non-credit related risks,
      revolving credit facilities containing early        maximum amount of its facility. That is,                  including operational risk.
      amortization mechanisms. Does the proposal          there may be some duplication of                          Consequently, the Agencies built a
      satisfactorily address the potential risks such capital charges for overlapping facilities                    ‘‘buffer’’ into the general risk-based
      transactions pose to originators?                                                                             capital rules to implicitly cover other
                                                          provided by multiple banking
         Comments are invited on the interplay                                                                      risks such as operational risk. With the
      between the A–IRB capital charge for                                                                          introduction of the A–IRB framework
      securitization structures containing early              Servicer Cash Advances                                for credit risk in this ANPR, which
      amortization features and that for undrawn
                                                                Subject to supervisory approval,                    results in a more risk-sensitive
      lines that have not been securitized. Are
                                                              servicer cash advances that are                       treatment of credit risk, there is no
      there common elements that the Agencies
                                                              recoverable would receive a zero                      longer an implicit capital buffer for
      should consider? Specific examples would be
                                                              percent CCF. This treatment would                     other risks.
                                                              apply when servicers, as part of their                   The Agencies recognize that
         Are proposed differences in CCFs for
                                                              contracts, may advance cash to the pool               operational risk is a key risk in financial
      controlled and non-controlled amortization
      mechanisms appropriate? Are there other
                                                              to ensure an uninterrupted flow of                    institutions, and evidence indicates that
      factors that the Agencies should consider?              payments to investors, provided the                   a number of factors are driving increases
                                                              servicer is entitled to full                          in operational risk. These include the
      Market-Disruption Eligible Liquidity                    reimbursement and this right is senior                recent experience of a number of high-
      Facilities                                              to other claims on cash flows from the                profile, high-severity losses across the
                                                              pool of underlying exposures.                         banking industry highlighting
         A banking organization would be able                                                                       operational risk as a major source of
                                                                When providing servicer cash advances,
      to apply a 20 percent CCF to an eligible                are banking organizations obligated to                unexpected losses. Because the
      liquidity facility that can be drawn only               advance funds up to a specified recoverable           regulatory capital buffer for operational
      in the event of a general market                        amount? If so, does the practice differ by            risk would be removed under the
      disruption (that is, where a capital                    asset type? Please provide a rationale for the        proposal, the Agencies are now seeking
      market instrument cannot be issued at                   response given.                                       comment on a risk-sensitive capital
      any price), provided that any advance                   Credit Risk Mitigation                                framework for the largest, most complex
      under the facility represents a senior                                                                        institutions that would include an
      secured claim on the assets in the pool.                   For securitization exposures covered               explicit risk-based capital requirement
      A banking organization using this                       by collateral or guarantees, the credit               for operational risk. The Agencies
      treatment would recognize 20 percent of                 risk mitigation rules discussed earlier               propose to require banking
      the A–IRB capital charge required for                   would apply. For example, a banking                   organizations using the A–IRB approach
      the facility through use of the SFA. If                 organization may reduce the A–IRB                     for credit risk also to use the AMA to
                                                              capital charge when a credit risk                     compute capital charges for operational
      the market disruption eligible liquidity
                                                              mitigant covers first losses or losses on             risk.
      facility is externally rated, a banking
                                                              a proportional basis. For all other cases,
      organization would be able to rely on
                                                              a banking organization would assume                      49 For a more detailed discussion of the concepts
      the external rating under the RBA for
                                                              that the credit risk mitigant covers the              set forth in this ANPR and definitions of relevant
      determining the A–IRB capital                           most senior portion of the securitization             terms, see the accompanying interagency
      requirement provided the organization                   exposure (that is, that the most junior               ‘‘Supervisory Guidance on Operational Risk
      assigns a 100 percent CCF rather than a                                                                       Advanced Measurement Approaches for Regulatory
                                                              portion of the securitization exposure is             Capital’’ (supervisory guidance) published
      20 percent CCF to the facility.                         uncovered).                                           elsewhere in today’s Federal Register.

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                              Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules                                              45941

         The Agencies are proposing the AMA to                Overview of the Supervisory Criteria                  cover the key elements of an operational risk
      address operational risk for regulatory capital                                                               framework?
                                                                 Use of the AMA would be subject to
      purposes. The Agencies are interested,
                                                              supervisory approval. A banking                          An institution’s operational risk
      however, in possible alternatives. Are there
                                                              organization would have to demonstrate                framework would have to include an
      alternative concepts or approaches that might
                                                              that it has satisfied all supervisory                 independent operational risk
      be equally or more effective in addressing
                                                              standards before it would be able to use              management function, line of business
      operational risk? If so, please provide some
      discussion on possible alternatives.
                                                              the AMA for risk-based capital                        oversight, and independent testing and
                                                              purposes. The supervisory standards are               verification. Both the institution’s board
      A. AMA Capital Calculation                              briefly described below. Because an                   of directors and management would
                                                              institution would have significant                    have to have responsibilities in
         The AMA capital requirement would                    flexibility to develop its own                        establishing and overseeing this
      be based on the measure of operational                  methodology for calculating its risk-                 framework. The institution would have
      risk exposure generated by a banking                    based capital requirement for                         to have clear policies and procedures in
      organization’s internal operational risk                operational risk, it would be necessary               place for identifying, measuring,
      measurement system. In calculating the                  for supervisors to ensure that the                    monitoring, and controlling operational
      operational risk exposure, an AMA-                      institution’s methodology is                          risk.
      qualified institution would be expected                 fundamentally sound. In addition,
      to estimate the aggregate operational                                                                            An institution would have to establish
                                                              because different institutions may adopt              an analytical framework that
      risk loss that it faces over a one-year                 different methodologies for assessing
      period at a soundness standard                                                                                incorporates internal operational loss
                                                              operational risk, the requirement to                  event data, relevant external loss event
      consistent with a 99.9 percent                          satisfy supervisory standards offers                  data, assessments of the business
      confidence level. The institution’s AMA                 some assurance to institutions and their              environment and internal control
      capital requirement for operational risk                supervisors that all AMA-qualified                    factors, and scenario analysis. The
      would be the sum of EL and UL, unless                   institutions would be subject to a                    institution would have to have
      the institution can demonstrate that an                 common set of standards.                              standards in place to capture all of these
      EL offset would meet the supervisory                       While the supervisory standards are
                                                                                                                    elements. The combination of these
      standards for operational risk. The                     rigorous, institutions would have
                                                                                                                    elements would determine the
      institution would have to use a                         substantial flexibility in terms of how
                                                                                                                    institution’s quantification of
      combination of internal loss event data,                they satisfy the standards in practice.
                                                                                                                    operational risk and related regulatory
      relevant external loss event data,                      This flexibility is intended to encourage
                                                                                                                    capital requirement.
      business environment and internal                       an institution to adopt a system that is
      control factors, and scenario analysis in               responsive to its unique risk profile,                   The supervisory standards for the
      calculating its operational risk exposure.              foster improved risk management, and                  AMA have both quantitative and
      The institution also would be allowed to                allow for future innovation. The                      qualitative elements. Effective
      recognize the effect of risk dependency                 Agencies recognize that operational risk              operational risk quantification is critical
      (for example, correlation) and, to a                    measurement is evolving rapidly and                   to the objective of a risk-sensitive
      limited extent, the effect of insurance as              wish to encourage continued evolution                 capital requirement. Consequently, a
      a risk mitigant.                                        and innovation. Nevertheless, the                     number of the supervisory standards are
                                                              Agencies also acknowledge that this                   aimed at ensuring the integrity of the
         As with the proposed A–IRB capital
                                                              flexibility would make cross-institution              process by which an institution arrives
      requirement for credit risk, the
                                                              comparisons more difficult than if a                  at its estimated operational risk
      operational risk exposure would be
                                                              single supervisory approach were to be                exposure.
      converted to an equivalent amount of
      risk-weighted assets for the calculation                mandated for all institutions. The                       It is not sufficient, however, to focus
      of an institution’s risk-based capital                  supervisory standards outlined below                  solely on operational risk measurement.
      ratios. An AMA-qualified institution                    are intended to allow flexibility while               If the Agencies are to rely on
      would multiply the operational risk                     also being sufficiently objective to                  institutions to determine their risk-
      exposure generated by its analytical                    ensure consistent supervisory                         based capital requirements for
      framework by a factor of 12.5 to convert                assessment and enforcement of                         operational risk, there would have to be
      the exposure to a risk-weighted assets                  standards across institutions.                        assurances that institutions have in
      equivalent. The resulting figure would                     The Agencies seek comment on the extent            place sound operational risk
      be added to the comparable figures for                  to which an appropriate balance has been              management infrastructures. In
      credit and market risk in calculating the               struck between flexibility and comparability          addition, risk management elements
      institution’s risk-based capital                        for the operational risk requirement. If this         would be critical inputs into the
                                                              balance is not appropriate, what are the              quantification of operational risk
      denominator.                                            specific areas of imbalance and what is the
        Does the broad structure that the Agencies                                                                  exposure, that is, operational risk
                                                              potential impact of the identified imbalance?         quantification would have to take into
      have outlined incorporate all the key                      The Agencies are considering additional
      elements that should be factored into the               measures to facilitate consistency in both the        account such risk management elements
      operational risk framework for regulatory               supervisory assessment of AMA frameworks              as the quality of an institution’s internal
      capital? If not, what other issues should be            and the enforcement of AMA standards                  controls. Likewise, the AMA capital
      addressed? Are any elements included not                across institutions. Specifically, the Agencies       requirement derived from an
      directly relevant for operational risk                  are considering enhancements to existing              institution’s quantification methodology
      measurement or management? The Agencies                 interagency operational and managerial                would need to offer incentives for an
                                                              standards to directly address operational risk        institution to improve its operational
      have not included indirect losses (for
                                                              and to articulate supervisory expectations for
      example, opportunity costs) in the definition           AMA frameworks. The Agencies seek
                                                                                                                    risk management practices. Ultimately,
      of operational risk against which institutions          comment on the need for and effectiveness of          the Agencies believe that better
      would have to hold capital; because such                these additional measures.                            operational risk management will
      losses can be substantial, should they be                  The Agencies also seek comment on the              enhance operational risk measurement,
      included in the definition of operational risk?         supervisory standards. Do the standards               and vice versa.

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      45942                   Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules

      Corporate Governance                                    risk exposure, operational loss                          An institution would have to establish
         An institution’s operational risk                    experience, and relevant assessments of               and adhere to policies and procedures
      framework would have to include an                      business environment and internal                     that provide for the use of relevant
      independent firm-wide operational risk                  control factors, and would have to be                 external loss data in the operational risk
      management function, line of business                   produced at least quarterly. Operational              framework. External data would be
      management oversight, and                               risk reports, which summarize relevant                particularly relevant where an
      independent testing and verification                    firm-wide operational risk information,               institution’s internal loss history is not
      functions. While no specific                            would also have to be provided                        sufficient to generate an estimate of
      management structure would be                           periodically to senior management and                 major unexpected losses. Management
      mandated, all three components would                    the board. An institution’s internal                  would have to systematically review
      have to be evident.                                     control system and practice would have                external data to ensure an
         The institution’s board of directors                 to be adequate in view of the complexity              understanding of industry experience.
      would have to oversee the development                   and scope of its operations. In addition,             The Agencies seek comment on the use
      of the firm-wide operational risk                       an institution would be expected to                   of external data and its optimal function
      framework, as well as major changes to                  meet or exceed minimum supervisory                    in the operational risk framework.
                                                              standards as set forth in the Agencies’                  While internal and external data
      the framework. Management roles and
                                                              supervisory policy statements and other               provide an important historic picture of
      accountability would have to be clearly
                                                              guidance.                                             an institution’s operational risk profile,
      established. The board and management
                                                                                                                    it is important that institutions take a
      would have to ensure that appropriate                   B. Elements of an AMA Framework                       forward-looking view as well.
      resources have been allocated to support
                                                                 An institution would have to                       Consequently, an institution would
      the operational risk framework.
         The independent firm-wide                            demonstrate that it has adequate                      have to incorporate assessments of the
      operational risk management function                    internal loss event data, relevant                    business environment and internal
                                                              external loss event data, assessments of              control factors (for example, audit
      would be responsible for overseeing the
                                                              business environments and internal                    scores, risk and control assessments,
      operational risk framework at the firm
                                                              control factors, and scenario analysis to             risk indicators, etc.) into its AMA
      level to ensure the development and
                                                              support its operational risk management               capital assessment. In addition, an
      consistent application of operational
                                                              and quantification framework. These                   institution would have to periodically
      risk policies, processes, and procedures
                                                              inputs would need to be consistent with               compare its assessment of these factors
      throughout the institution. This
                                                              the regulatory definition of operational              with actual operational loss experience.
      function would have to be independent                                                                            Another element of the AMA
      from line of business management and                    risk. The institution would have to have
                                                              clear standards for the collection and                framework is scenario analysis. Scenario
      the testing and verification functions.                                                                       analysis is a systematic process of
      The firm-wide operational risk                          modification of operational risk inputs.
                                                                 There are a number of standards that               obtaining expert opinions from business
      management function would have to                                                                             managers and risk management experts
      ensure appropriate reporting of                         banking organizations would have to
                                                              meet with respect to internal                         to derive reasoned assessments of the
      operational risk exposures and loss data                                                                      likelihood and impact of plausible
      to the board and management.                            operational loss data. Institutions would
                                                              have to have at least five years of                   operational losses consistent with the
         Lines of business would be                                                                                 regulatory soundness standard. While
      responsible for the day-to-day                          internal operational risk loss data
                                                              captured across all material business                 scenario analysis may rely, to a large
      management of operational risk within                                                                         extent, on internal or, especially,
      each business unit. Line of business                    lines, events, product types, and
                                                              geographic locations.50 An institution                external data (for example, where an
      management would have to ensure that                                                                          institution looks to industry experience
      internal controls and practices within                  would have to establish thresholds
                                                                                                                    to generate plausible loss scenarios), it
      their lines of business are consistent                  above which all internal operational
                                                                                                                    is particularly useful where internal and
      with firm-wide policies and procedures                  losses would be captured. The New
                                                                                                                    external data do not generate a sufficient
      that support the management and                         Accord introduces seven loss event type
                                                                                                                    assessment of the institution’s
      measurement of the institution’s                        classifications; the Agencies are not
                                                                                                                    operational risk profile.
      operational risk.                                       proposing that an institution would be                   An institution would be required to
                                                              required to internally manage its                     have a comprehensive analytical
        The Agencies are introducing the concept
      of an operational risk management function,             operational risk according to these                   framework that provides an estimate of
      while emphasizing the importance of the                 specific loss event type classifications,             the aggregate operational loss that it
      roles played by the board, management, lines            but nevertheless it would have to be                  faces over a one-year period at a
      of business, and audit. Are the                         able to map its internal loss data to                 soundness standard consistent with a
      responsibilities delineated for each of these           these loss event categories. The
      functions sufficiently clear and would they                                                                   99.9 percent confidence level. The
                                                              institution would have to provide                     institution would have to document the
      result in a satisfactory process for managing           consistent treatment for the timing of
      the operational risk framework?                                                                               rationale for all assumptions
                                                              reporting an operational loss in its                  underpinning its chosen analytical
      Operational Risk Management Elements                    internal data systems. As highlighted                 framework, including the choice of
        An institution would have to have                     earlier in this ANPR, credit losses                   inputs, distributional assumptions, and
      policies and procedures that clearly                    caused or exacerbated by operational                  weighting of quantitative and qualitative
      describe the major elements of its                      risk events would be treated as credit                elements. The institution would also
      operational risk framework, including                   losses for regulatory capital purposes;               have to document and justify any
      identifying, measuring, monitoring, and                 these would include fraud-related credit              subsequent changes to these
      controlling operational risk.                           losses.                                               assumptions.
      Management reports would need to be                       50 With supervisory approval, a shorter initial
                                                                                                                       An institution’s operational risk
      developed to address both firm-wide                     observation period may be acceptable for
                                                                                                                    analytical framework would have to use
      and line of business results. These                     institutions that are newly authorized to use an      a combination of internal operational
      reports would summarize operational                     AMA methodology.                                      loss event data, relevant external

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                              Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules                                                   45943

      operational loss event data, business                   under the A–IRB approach for credit                      The Agencies are proposing a set of
      environment and control factors, as well                risk.                                                 disclosure requirements that would
      as scenario analysis. The institution                      The institution would have to test and             allow market participants to assess key
      would have to combine these elements                    verify the accuracy and appropriateness               pieces of information regarding a
      in the manner that most effectively                     of the operational risk framework and                 banking group’s capital structure, risk
      enables it to quantify its operational risk             results. Testing and verification would               exposures, risk assessment processes,
      exposure. The institution would have to                 have to be done independently of the                  and ultimately, the capital adequacy of
      develop an analytical framework that is                 firm-wide risk management function                    the institution. Failure to meet these
      appropriate to its business model and                   and the lines of business.                            minimum disclosure requirements, if
      risk profile.                                                                                                 not corrected, would render a banking
         Regulatory capital for operational risk              VI. Disclosure                                        organization ineligible to use the
      would be based on the sum of EL and                       Market discipline is a key component                advanced approaches or would
      UL. There may be instances where an                     of the New Accord. The disclosure                     otherwise cause the banking
      EL offset could be recognized, but the                  requirements summarized below seek to                 organization to forgo potential capital
      Agencies believe that this is likely to be              enhance the public disclosure practices,              benefits arising from the advanced
      difficult given existing supervisory and                and thereby the transparency, of                      approaches. In addition, other
      accounting standards. The Agencies                      advanced approach organizations.                      supervisory measures may be taken if
      have considered both reserving and                      Commenters are encouraged to consult                  appropriate.
      budgeting as potential mechanisms for                   the New Accord for specifics on the                      Management would have some
      EL offsets. The use of reserves may be                  disclosure requirements under                         discretion to determine the appropriate
      hampered by accounting standards,                       consideration. The Agencies view                      medium and location of the required
      while budgeting raises concerns about                   enhanced market discipline as an                      disclosure. Disclosures made in public
      availability over a one-year time horizon               important complement to the advanced                  financial reports (for example, in
      to act as a capital replacement                         approaches to calculating minimum                     financial statements or Management’s
      mechanism. The Agencies are interested                  regulatory capital requirements, which                Discussion and Analysis included in
      in specific examples of how business                    would be heavily based on internal                    periodic reports or SEC filings) or other
      practices might be used to offset EL in                 methodologies. Increased disclosures,                 regulatory reports (for example, FR Y–
      the operational risk framework.                         especially regarding a banking                        9C Reports), could fulfill the applicable
         An institution would have to                         organization’s use of the A–IRB                       disclosure requirements and would not
      document how its chosen analytical                      approach for credit risk and the AMA                  need to be repeated elsewhere. For those
      framework accounts for dependence (for                  for operational risk, would allow a                   disclosures that are not made under
      example, correlation) among operational                 banking organization’s private sector                 accounting or other requirements, the
      losses across and within business lines.                investors to more fully evaluate the                  Agencies are seeking comment on the
      The institution would have to                           institution’s financial condition, risk               appropriate means of providing this
      demonstrate that its explicit and                       profile, and capital adequacy. Given                  data to market participants. Institutions
      embedded dependence assumptions are                     better information, private shareholders              would be encouraged to provide all
      appropriate, and where dependence                       and debt holders can better influence                 related information in one location; at a
      assumptions are uncertain, the                          the funding and capital costs of a                    minimum, institutions would be
      institution would have to use                           banking organization. Such actions                    required to provide a cross reference to
      conservative estimates.                                 would enhance market discipline and                   the location of the required disclosures.
         An institution would be able to                      supplement supervisory oversight of the                  The Agencies intend to maximize a
      reduce its operational risk exposure by                 organization’s risk-taking and                        banking organization’s flexibility
      no more than 20 percent to reflect the                  management.                                           regarding where to make the required
      impact of risk mitigants such as                                                                              disclosures while ensuring that the
      insurance. Institutions would have to                   A. Overview                                           information is readily available to
      demonstrate that qualifying risk                          Disclosure requirements would apply                 market participants without
      mitigants meet a series of criteria                     to the bank holding company                           unnecessary burden. To balance these
      (described in the supervisory guidance)                 representing the top consolidated level               contrasting objectives, the Agencies are
      to assess whether the risk mitigants are                of the banking group. Individual banks                considering requiring banking
      sufficiently capital-like to warrant a                  within the holding company or                         organizations to provide a summary
      reduction of the operational risk                       consolidated group would not generally                table on their public websites that
      exposure.                                               be required to fulfill the disclosure                 indicate where all disclosures may be
        The Agencies seek comment on the                      requirements set out below. An                        found. Such an approach also would
      reasonableness of the criteria for recognition          exception to the general rule would be                allow institutions to cross-reference
      of risk mitigants in reducing an institution’s          that individual banks and thrifts within              other web addresses (for example, those
      operational risk exposure. In particular, do            a group would still be required to                    containing public financial reports or
      the criteria allow for recognition of common            disclose Tier 1 and total capital ratios              regulatory reports or other risk-oriented
      insurance policies? If not, what criteria are           and their components (that is, Tier 1,                disclosures) where certain of the
      most binding against current insurance
      products? Other than insurance, are there
                                                              Tier 2, and Tier 3 capital), as is the case           disclosures are located.
      additional risk mitigation products that                today. In addition, all banks and thrifts                Given longstanding requirements for
      should be considered for operational risk?              would continue to be required to submit               robust quarterly disclosure in the
                                                              appropriate information to regulatory                 United States, and recognizing the
        An institution using an AMA for                                                                             potential for rapid change in risk
                                                              authorities (for example, Report of
      regulatory capital purposes would have                                                                        profiles, the Agencies intend to require
                                                              Condition of Income (Call Reports) or
      to use advanced data management                                                                               that the disclosures be made on a
                                                              Thrift Financial Reports).51
      practices to produce credible and
      reliable operational risk estimates.                      51 In order to meet supervisory responsibilities,   regulatory reports. Much of this information may be
      These practices are comparable to the                   the Agencies plan to collect more detailed            proprietary and accordingly would not be made
      data maintenance requirements set forth                 information through the supervisory process or        public.

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      45944                   Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules

      quarterly basis. However, qualitative                   B. Disclosure Requirements                            the framework the banking organization
      disclosures that provide a general                                                                            has put into place.
                                                                 Banking organizations would be                        Credit risk disclosures would include
      summary of a banking organization’s
                                                              required to provide disclosures related               breakdowns of the banking
      risk management objectives and                          to scope of application, capital
      policies, reporting system, and                                                                               organization’s exposures by type of
                                                              structure, capital adequacy, credit risk,             credit exposure, geographic distribution,
      definitions would be able to be                         equities in the banking book, credit risk
      published on an annual basis, provided                                                                        industry or counterparty type
                                                              mitigation, asset securitization, market              distribution, residual contractual
      any significant changes to these are                    risk, operational risk and interest rate
      disclosed in the interim. When                                                                                maturity, amount and type of impaired
                                                              risk in the banking book. The disclosure              and past due exposures, and
      significant events occur, banking                       requirements are summarized below.                    reconciliation of changes in the
      organizations would be required to                         The required disclosures pertaining to             allowances for exposure impairment.
      publish material information as soon as                 the scope of application of the advanced                 Banking organizations would provide
      practicable rather than at the end of the               approaches would include a description                disclosures discussing the status of the
      quarter.                                                of the entities found in the consolidated             regulatory acceptance process for the
         The risks to which banking                           banking group. Additionally, banking                  adoption of the A–IRB approach,
      organizations are exposed and the                       organizations would be required to                    including supervisory approval of such
      techniques that they use to identify,                   disclose the methods used to                          transition. The disclosures would
      measure, monitor, and control those                     consolidate them, any major                           provide an explanation and review of
      risks are important factors that market                 impediments on the transfer of funds or               the structure of internal rating systems
      participants consider in their                          regulatory capital within the banking                 and relation between internal and
      assessment of an institution.                           group, and specific disclosures related               external ratings; the use of internal
      Accordingly, banking organizations                      to insurance subsidiaries.                            estimates other than for A–IRB capital
      would be required to have a formal                         Capital structure disclosures would                purposes; the process for managing and
      disclosure policy approved by the board                 provide summary information on the                    recognizing credit risk mitigation; and,
      of directors that addresses the                         terms and conditions of the main                      the control mechanisms for the rating
      institution’s approach for determining                  features of capital instruments issued by             system including discussion of
                                                              the banking organization, especially in               independence, accountability, and
      the disclosures it will make. The policy
                                                              the case of innovative, complex, or                   rating systems review. Required
      also would have to address the
                                                              hybrid capital instruments. Quantitative              qualitative disclosures would include a
      associated internal controls and                                                                              description of the internal ratings
      disclosure controls and procedures. The                 disclosures include the amount of Tier
                                                              1, Tier 2, and Tier 3 capital, deductions             process and separate disclosures
      board of directors and senior                                                                                 pertaining to the banking organization’s
      management would have to ensure that                    from capital, and total eligible capital.
                                                                 Capital adequacy disclosures would                 wholesale, retail and equity exposures.
      appropriate verification of the                                                                                  There would be two categories of
      disclosures takes place and that                        include a summary discussion of the
                                                              banking organization’s approach to                    quantitative disclosures for credit risk:
      effective internal controls and                                                                               those that focus on the analysis of risk
      disclosure controls and procedures are                  assessing the adequacy of its capital to
                                                              support current and future activities.                and those that focus on the actual
      maintained.                                                                                                   results. Risk assessment disclosures
                                                              These requirements also include a
         Consistent with sections 302 and 404                 breakdown of the capital requirements                 would include the percentage of total
      of the Sarbanes-Oxley Act of 2002,                      for credit, equity, market, and                       credit exposures to which A–IRB
      management would have to certify to                     operational risks. Banking organizations              disclosures relate. Also, for each
      the effectiveness of internal controls                  also would be required to disclose their              portfolio except retail, the disclosures
      over financial reporting and disclosure                 Tier 1 and total capital ratios for the               would have to provide (1) a presentation
      controls and procedures, and the                        consolidated group, as well as those of               of exposures across a sufficient number
      banking organization’s external auditor                 significant bank or thrift subsidiaries.              of PD grades (including default) to allow
      would have to attest to management’s                                                                          for a meaningful differentiation of credit
                                                                 For each separate risk area, a banking             risk,52 and (2) the default weighted-
      assertions with respect to internal                     organization would describe its risk
      controls over financial reporting. The                                                                        average LGD for each PD, and the
                                                              management objectives and policies.                   amount of undrawn commitments and
      scope of these reports would need to                    Such disclosures would include an
      include all information included in                                                                           weighted average EAD.53 For retail
                                                              explanation of the banking                            portfolios, banking organization would
      regulatory reports and the disclosures                  organization’s strategies and processes;
      outlined in this ANPR. Section 36 of the                                                                      provide either 54 (a) disclosures outlined
                                                              the structure and organization of the
      Federal Deposit Insurance Act has                       relevant risk management function; the                  52 Where banking organizations are aggregating
      similar requirements. Accordingly,                      scope and nature of risk reporting and/               PD grades for the purposes of disclosure, this would
      banking organizations would have to                     or measurement systems; and the                       be a representative breakdown of the distribution of
      implement a process for assessing the                   policies for hedging and/or mitigating                PD grades used in the A–IRB approach.
                                                                                                                      53 Banking organizations need only provide one
      appropriateness of their disclosures,                   risk and strategies and processes for                 estimate of EAD for each portfolio. However, where
      including validation and frequency.                     monitoring the continuing effectiveness               banking organizations believe it is helpful, in order
      Unless otherwise required by                            of hedges/mitigants.                                  to give a more meaningful assessment of risk, they
      accounting or auditing standards, or by                    The credit risk disclosure regime is               may also disclose EAD estimates across a number
                                                                                                                    of EAD categories, against the undrawn exposures
      other regulatory authorities, the                       intended to enable market participants                to which these relate.
      proposed requirements do not mandate                    to assess the credit risk exposure of A–                54 Banking organizations would normally be
      that the new disclosures be audited by                  IRB banking organizations and the                     expected to follow the disclosures provided for the
      an external auditor for purposes of                     overall applicability of the A–IRB                    non-retail portfolios. However, banking
                                                                                                                    organizations would be able to adopt EL grades at
      opining on whether the financial                        framework, without revealing                          the basis of disclosure where they believe this can
      statements are presented in accordance                  proprietary information or duplicating                provide the reader with a meaningful differentiation
      with GAAP.                                              the role of the supervisor in validating              of credit risk. Where banking organizations are

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      above on a pool basis (that is, the same                include information about the main                    commenter believes certain of the required
      as for non-retail portfolios), or (b)                   types of guarantor or credit derivative               information would be proprietary or
      analysis of exposures on a pool basis                   counterparties, and any risk                          confidential, the Agencies seek comment on
      against a sufficient number of EL grades                concentrations arising from the use of a              why that is so and alternatives that would
      to allow for a meaningful differentiation               mitigation technique.                                 meet the objectives of the required
                                                                 Securitization disclosures would                   disclosure.
      of credit risk.
                                                                                                                      The Agencies also seek comment regarding
         Quantitative disclosures pertaining to               summarize a banking organization’s
                                                                                                                    the most efficient means for institutions to
      historical results would include actual                 accounting policies for securitization                meet the disclosure requirements.
      losses (for example, charge-offs and                    activities and the current year’s                     Specifically, the Agencies are interested in
      specific provisions) in the preceding                   securitization activity. Further, banking             comments about the feasibility of requiring
      period for each portfolio and how this                  organizations would be expected to                    institutions to provide all requested
      differs from past experience and a                      disclose the names of the external credit             information in one location and also whether
      discussion of the factors that affected                 rating providers used for securitizations.            commenters have other suggestions on how
      the loss experience in the preceding                    They would also provide details of the                to ensure that the requested information is
      period. In addition, disclosures would                  outstanding exposures securitized by                  readily available to market participants.
      include banking organizations’                          the banking organization and subject to               VII. Regulatory Analysis
      estimates against actual outcomes over a                the securitization framework, including
      longer period.55 At a minimum, this                     impairments and losses, exposures                        Federal agencies are required to
      would include information on estimates                  retained or purchased broken down into                consider the costs, benefits, or other
      of losses against actual losses in each                 risk weight bands, and aggregate                      effects of their regulations for various
      portfolio over a period sufficient to                   outstanding amounts of securitized                    purposes described by statute or
      allow for a meaningful assessment of the                revolving exposures.                                  executive order. In particular, an
      performance of the internal rating                         Disclosures for market risk would                  executive order and several statutes may
      processes. Banking organizations would                  include a description of the models,                  require the preparation of detailed
      further be expected to decompose this to                stress testing, and backtesting used in               analyses of the costs, benefits, or other
      provide analysis of PD, LGD and EAD                     assessing market risk, as well as                     effects of rules, depending on threshold
      estimates against estimates provided in                 information on the scope of supervisory               determinations as to whether the
      the quantitative risk assessment                        acceptance. Quantitative disclosures                  rulemaking in question triggers the
      disclosures above.56                                    would include the aggregate VaR, the                  substantive requirements of the
         Disclosures for banking book equity                  high, mean, and low VaR values over                   applicable statute or executive order.
      positions would include both balance                    the reporting period, and a comparison
      sheet and fair values, and the types and                                                                         For the reasons described above, the
                                                              of VaR estimates with actual outcomes.                proposed and final rules that the
      nature of investments. The total                           A key disclosure under the
      cumulative realized gains or losses                                                                           Agencies may issue to implement the
                                                              operational risk framework would be a
      arising from sales and liquidations                                                                           New Accord would represent a
                                                              description of the AMA the banking
      would be disclosed, together with total                                                                       significant change to their current
                                                              organization uses, including a
      unrealized gains/losses and any                                                                               approach to the measurement of
                                                              discussion of relevant internal and
      amounts included in Tier 1 and/or Tier                                                                        regulatory capital ratios, and the
                                                              external factors considered in the
      2 capital. Details on the equity capital                                                                      supervision of institutions’ internal risk
                                                              banking organization’s measurement
      requirements would also be disclosed.                                                                         management processes with respect to
                                                              approach. In addition, the banking
         Disclosures relating to credit risk                                                                        capital allocations. First, in this ANPR,
                                                              organization would disclose the
      mitigation would include a description                                                                        core and opt-in banks would rely on
                                                              operational risk charge before and after
      of the policies and processes for netting                                                                     their own analyses to derive some of the
                                                              any reduction in capital resulting from
      and collateral valuation and                                                                                  principal inputs that would determine
                                                              the use of insurance or other potential
      management, and the types of collateral                                                                       their regulatory capital requirements.
                                                              risk mitigants.
      accepted by the bank. Banking                              Finally, disclosures relating to interest          Core and opt-in banks would incur new
      organizations would also be expected to                 rate risk in the banking book would                   costs to create and refine their internal
                                                              include the nature of that risk, key                  systems and to attract and train the staff
      aggregating internal grades (either PD/LGD or EL)       assumptions made, and the frequency of                expertise necessary to develop, oversee,
      for the purposes of disclosure, this should be a                                                              manage and test those systems. Second,
      representative breakdown of the distribution of         risk measurement. They would also
      those grades used in the IRB approach.                  include the increase or decline in                    the measured regulatory capital ratios
         55 For banking organizations implementing the
                                                              earnings or economic value for upward                 (although not the minimums) would
      A–IRB and AMA in 2007, the disclosures would be         and downward rate shocks according to                 likely change, perhaps substantially for
      required from year-end-2008; in the meantime,
                                                              management’s method for measuring                     core and opt-in banks. Third, the
      early adoption would be encouraged. The phased                                                                Agencies’ approach to supervising
      implementation is to allow banking organizations        interest rate risk in the banking book.
      sufficient time to build up a longer run of data that                                                         capital adequacy would become
      will make these disclosures meaningful. For
                                                                The Agencies seek comment on the                    bifurcated; that is, general banks would
      banking organizations that may adopt the advanced       feasibility of such an approach to the
                                                              disclosure of pertinent information and also
                                                                                                                    continue to use the general risk-based
      approaches at a later date, they would also be
      subject to a one-year phase in period after which       whether commenters have any other                     capital rules, either in their current form
      the disclosures would be required.                      suggestions regarding how best to present the         or as modified. As a result, there may be
         56 Banking organizations would have to provide       required disclosures.                                 significant differences in the regulatory
      this further decomposition where it would allow           Comments are requested on whether the               capital assigned to a particular type of
      users greater insight into the reliability of the       Agencies’ description of the required formal          asset depending on whether the bank is
      estimates provided in the quantitative disclosures:     disclosure policy is adequate, or whether
      risk assessment. In particular, banking                                                                       a core, opt-in, or general bank. To the
                                                              additional guidance would be useful.                  extent that an institution’s product mix
      organizations should provide this information
      where there are material differences between the
                                                                Comments are requested regarding whether
                                                              any of the information sought by the                  would be directly affected by a change
      PD, LGD or EAD estimates given by banking
      organizations compared in actual outcomes over the      Agencies to be disclosed raises any particular        in the landscape of regulatory capital
      long run. Banking organizations should also             concerns regarding the disclosure of                  requirements, this might also affect the
      provide explanations for such differences.              proprietary or confidential information. If a         customers of those institutions due to

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      45946                   Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules

      the changes in pricing and market                       annual effect on the economy of $100                         For purposes of determining whether
      strategies.                                             million or more or adversely affect in a                  this rulemaking would constitute an
         The economic impact that would be                    material way the economy, a sector of                     ‘‘economically significant regulatory
      created by these possibly unforeseen                    the economy, productivity, competition,                   action,’’ as defined by E.O. 12866, and
      competitive effects is difficult to                     jobs, the environment, public health or                   to assist any economic analysis that E.O.
      estimate, and the Agencies encourage                    safety, or state, local, or tribal                        12866 may require, the OCC and the
      comment. In particular, the Agencies are                governments or communities. * * *’’ 57                    OTS encourage commenters to provide
      interested in comments on the                           Regulatory actions that satisfy one or                    information about:
      competitive impact that a change in the                 more of these criteria are called                            • The direct and indirect costs, for
      regulatory capital regime applied to                    ‘‘economically significant regulatory                     core banks and those banks who intend
      large institutions would have relative to               actions.’’ E.O. 12866 applies to the OCC                  to qualify as opt-in banks, of compliance
      the competitive position of smaller                     and the OTS, but not the Board or the                     with the approach described in this
      institutions that remain subject to the                 FDIC. If the OCC or the OTS determines                    ANPR and the related supervisory
      general risk-based capital rules.                       that the rules implementing the New                       guidance;
      Conversely, if the regulatory burden of                 Accord comprise an ‘‘economically                            • The costs, for general banks, of
      the more prescriptive A–IRB approach                    significant regulatory action,’’ then the                 adopting the approach;
      applied to core institutions were so                    agency making that determination                             • The effects on regulatory capital
      large as to offset the potential for a                  would be required to prepare and                          requirements for core, opt-in, and
      lower measured capital requirement for                  submit to the Office of Management and                    general banks;
      certain exposures, then the competitive                 Budget’s (OMB) Office of Information                         • The effects on competitiveness, in
      position of large institutions, with                    and Regulatory Affairs (OIRA) an                          both domestic and international
      respect to both their domestic and                      economic analysis that includes:                          markets, for core, opt-in, and general
      international competitors, might be                        • A description of the need for the                    banks. This would include the possible
      worsened. The Agencies are also                         rules and an explanation of how they                      effects on the customers served by these
      interested in comments that address the                 will meet the need;                                       U.S. institutions through changes in the
      competitive position of regulated                          • An assessment of the benefits                        mix of product offerings and prices;
      institutions in the United States with                  anticipated from the rules (for example,                     • The economic benefits of the
      respect to financial service providers,                 the promotion of the efficient                            approach for core, opt-in, or general
      both domestic and foreign, that are not                 functioning of the economy and private                    banks, as measured by lower regulatory
      subject to the same degree of regulatory                markets) together with, to the extent                     capital ratios, and a potentially more
      oversight.                                              feasible, a quantification of those                       efficient allocation of capital. This
         None of the Agencies has yet made                    benefits;                                                 might also include estimates of savings
      the threshold determinations required                      • An assessment of the costs                           associated with regulatory capital
      by executive order or statute with                      anticipated from the rules (for example,                  arbitrage transactions that are currently
      respect to this ANPR. Because the                       the direct cost both to the government                    undertaken in order to optimize return
      proposed approaches to assessing                        in administering the regulation and to                    on capital under the current capital
      capital adequacy described in this                      businesses and others in complying                        regime. That is, what estimates might
      ANPR are new, the Agencies currently                    with the regulation, and any adverse                      exist to quantify the improvements in
      lack information that is sufficiently                   effects on the efficient functioning of the               market efficiency from no longer
      specific or complete to permit those                    economy, private markets (including                       pursuing regulatory capital arbitrage
      determinations to be made or to prepare                 productivity, employment, and                             transactions?
      any economic analysis that may                          competitiveness)), together with, to the                     • The features of the A–IRB approach
      ultimately be required. Therefore, this                 extent feasible, a quantification of those                that provide an incentive for a bank to
      section of the ANPR describes the                       costs; and                                                seek to qualify to use it, that is, to
      relevant executive order and statutes,                     • An assessment of the costs and                       become an opt-in bank.
      and asks for comment and information                    benefits of potentially effective and                        The OCC and the OTS also encourage
      that will assist in the determination of                reasonably feasible alternatives to the                   comment on any alternatives to the
      whether such analyses would be                          planned regulation (including                             regulatory approaches described in the
      necessary before the Agencies published                 improving the current regulation and                      ANPR that the Agencies should
      proposed or final rules.                                reasonably viable nonregulatory                           consider.
         Quantitative information would be                    actions), and an explanation why the
      the most useful to the Agencies.                                                                                  B. Regulatory Flexibility Act
                                                              planned regulatory action is preferable
      However, commenters may also provide                    to the identified potential alternatives.58                  The Regulatory Flexibility Act (RFA)
      estimates of costs, benefits, or other                                                                            generally requires agencies to prepare a
      effects, or any other information they                     57 Executive Order 12866 (Sept. 30, 1993), 58 FR       ‘‘regulatory flexibility analysis’’ unless
      believe would be useful to the Agencies                 51735 (Oct. 4, 1993), as amended by Executive             the head of the agency certifies that a
      in making the determinations. In                        Order 13258, 67 FR 9385 (referred to hereafter as         regulation will not ‘‘have a significant
                                                              E.O. 12866). For the complete text of the definition
      addition, commenters are asked to                       of ‘‘significant regulatory action,’’ see E.O. 12866 at   economic impact on a substantial
      identify or estimate start-up, or non-                  § 3(f). A ‘‘regulatory action’’ is ‘‘any substantive      number of small entities.’’ 59 The RFA
      recurring, costs separately from costs or               action by an agency (normally published in the            applies to all of the Agencies.
      effects they believe would be ongoing.                  Federal Register) that promulgates or is expected to         The Agencies understand that the
                                                              lead to the promulgation of a final rule or
                                                              regulation, including notices of inquiry, advance         RFA has been construed to require
      A. Executive Order 12866
                                                              notices of proposed rulemaking, and notices of
        Executive Order 12866 requires                        proposed rulemaking.’’ E.O. 12866 at § (e).               Order 12866’’ (January 11, 1996). This publication
      preparation of an economic analysis for                    58 The components of the economic analysis are         is available on OMB’s Web site at http://
      agency actions that are ‘‘significant                   set forth in E.O. 12866 § 6(a)(3)(C)(i)–(iii). For a
                                                              description of the methodology that OMB                   OMB recently published revisions to this
      regulatory actions.’’ ‘‘Significant                     recommends for preparing an economic analysis,            publication for comment. See 68 FR 5492 (February
      regulatory actions’’ include, among                     see Office of Management and Budget, ‘‘Economic           3, 2003).
      other things, regulations that ‘‘have an                Analysis of Federal Regulations Under Executive              59 The RFA is codified at 5 U.S.C. 601 et seq.

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                              Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules                                             45947

      consideration only of the direct impact                 regulatory alternatives before                            accordance with the Agencies’
      on small entities.60 The Small Business                 promulgating the rule in question. The                    applicable rules.
      Administration (SBA) has said: ‘‘The                    UMRA applies to the OCC and the OTS,                        While it will be difficult to identify
      courts have held that the RFA requires                  but not the Board or the FDIC.                            those requirements with precision
      an agency to perform a regulatory                         The OCC and the OTS have asked for                      before a proposed rule is issued, this
      flexibility analysis of small entity                    comments and information from core                        notice and the draft supervisory
      impacts only when a rule directly                       and opt-in banks on compliance costs                      guidance published elsewhere in
      regulates them,’’ that is, when it directly             and, generally, on alternative regulatory                 today’s Federal Register generally
      applies to them.61 Since the proposed                   approaches, for purposes of evaluating                    describes aspects of the Agencies’
      approach would directly apply to only                   what actions they need to take in order                   implementation of the New Accord
      a limited number of large banking                       to comply with E.O. 12866. That same                      where new reporting and recordkeeping
      organizations, it would appear that the                 information (with cost information                        requirements would be likely.
      Agencies may certify that the issuance                  adjusted annually for inflation) is                       Commenters are asked to provide any
      of this ANPR would not have significant                 relevant to those agencies’                               estimates they can reasonably derive
      economic impact on a substantial                        determination of whether a budgetary                      about the time, effort, and financial
      number of small entities.                               impact statement is necessary pursuant                    resources that will be required to
         Do the potential advantages of the A–                to the UMRA. Commenters are therefore                     provide the Agencies with the requisite
      IRB approach, as measured by the                        asked to be mindful of the UMRA                           plans, reports, and records that are
      specific capital requirements on lower-                 requirements when they provide                            described in this notice and in the
      risk loans, create a competitive                        information about compliance costs and                    supervisory guidance. Commenters also
      inequality for small institutions, which                in suggesting alternatives to the                         are requested to identify any activities
      are effectively precluded from adopting                 approach described in this ANPR.                          that will be conducted as a result from
      the A–IRB due to stringent qualification                                                                          the capital and methodological
      standards? Conversely, would small                      D. Paperwork Reduction Act                                standards in the framework presented in
      institutions that remain on the general                    Each of the Agencies is subject to the                 this ANPR that would impose new
      risk-based capital rules be at a                        Paperwork Reduction Act of 1995                           recordkeeping or reporting burden.
      competitive advantage from specific                     (PRA).63 The PRA requires burden                          Commenters should specify whether
      capital requirements on higher risk                     estimates that will likely be based on                    certain capital and methodological
      assets vis-a-vis advanced approach                      some of the same information that is                      standards would necessitate the
      institutions? How might the Agencies                    necessary to prepare an economic                          acquisition or development of new
      estimate the effect on credit availability              analysis under E.O. 12866 or an                           compliance/ information systems or the
      to small businesses or retail customers                 estimate of private sector expenditures                   significant modification of existing
      of general banks?                                       pursuant to the UMRA.                                     compliance/information systems.
      C. Unfunded Mandates Reform Act of                         In particular, an agency may not                       List of Acronyms
      1995                                                    ‘‘conduct or sponsor’’ a collection of
                                                              information without conducting an                         ABCP Asset-Backed Commercial Paper
        The Unfunded Mandates Reform Act                                                                                ADC Acquisition, Development, and
                                                              analysis that includes an estimate of the
      of 1995 (UMRA) requires preparation of                                                                              Construction
                                                              ‘‘burden’’ imposed by the collection. A
      a written budgetary impact statement                                                                              AFS Available-for-Sale (securities)
                                                              collection of information includes,
      before promulgation of any rule likely to                                                                         AIG Accord Implementation Group
                                                              essentially, the eliciting of identical
      result in a ‘‘Federal mandate’’ that ‘‘may                                                                        A–IRB Advanced Internal Ratings-
                                                              information—whether through
      result in the expenditure by State, local,                                                                          Based (approach for credit risk)
                                                              questions, recordkeeping requirements,
      and tribal governments, in the aggregate,                                                                         ALLL Allowance for Loan and Lease
                                                              or reporting requirements—from ten or
      or by the private sector, of $100,000,000                                                                           Losses
                                                              more persons. ‘‘Burden’’ means the
      or more (adjusted annually for inflation)                                                                         AMA Advanced Measurement
                                                              ‘‘time, effort, or financial resources
      in any 1 year.’’ 62 A ‘‘Federal mandate’’                                                                           Approach (for operational risk)
                                                              expended by persons to generate,
      includes any regulation ‘‘that would                                                                              ANPR Advance Notice of Proposed
                                                              maintain, or provide information’’ to the
      impose an enforceable duty upon the                                                                                 Rulemaking
                                                              agency. The rulemaking initiated by this
      private sector. * * *’’ If a budgetary                                                                            BIS Bank for International Settlements
                                                              ANPR will likely impose requirements,
      impact statement is required, the UMRA                                                                            BSC Basel Committee on Banking
                                                              either in the regulations themselves or
      further requires the agency to identify                                                                             Supervision
                                                              as part of interagency implementation                     CCF Credit Conversion Factor
      and consider a reasonable number of                     guidance, that are covered by the PRA.                    CDC Community Development
         60 With respect to banks, the Small Business
                                                              In order to estimate burden, the                            Corporations
      Administration (SBA) has defined a small entity to      Agencies will need to know, for                           CEDE Community and Economic
      be a bank with total assets of $150 million or less.    example, the cost—in terms of time and                      Development Entity
      13 CFR § 121.201.                                       money—that mandatory and opt-in                           CF Commodities Finance
         61 SBA Office of Advocacy, A Guide for
                                                              banks would have to expend to develop                     CRE Commercial Real Estate
      Government Agencies, ‘‘How to Comply with the
      Regulatory Flexibility Act (May 2003), at 20
                                                              and maintain the systems, procedures,                     CRM Credit Risk Mitigation
      (emphasis added). See also Mid-Tex Electric             and personnel that compliance with the                    EAD Exposure at Default
      Cooperative, Inc. v. FERC. 773 F.2d 327, 340–43         rules would require. With this in mind,                   EL Expected Loss
      (D.C. Cir. 1985) (‘‘[W]e conclude that an agency may    to assist in their analysis of the
      properly certify that no regulatory flexibility
                                                                                                                        FFIEC Federal Financial Institutions
      analysis is necessary when it determines that the
                                                              treatment of retail portfolios and other                    Examination Council
      rule will not have a significant economic impact on     exposures, the Agencies intend to                         FMI Future Margin Income
      a substantial number of small entities that are         request from U.S. institutions additional                 GAAP Generally Accepted Accounting
      subject to the requirements of the rule.’’) (emphasis   quantitative data for which confidential                    Principles
      added) (construing language in the RFA that was
      unchanged by subsequent statutory amendments).
                                                              treatment may be requested in                             HVCRE High Volatility Commercial
         62 The Unfunded Mandates Reform Act is                                                                           Real Estate
      codified at 2 U.S.C. 1532 et seq.                            63 44   U.S.C. § 3501 et seq.                        IMF International Monetary Fund

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      45948                   Federal Register / Vol. 68, No. 149 / Monday, August 4, 2003 / Proposed Rules

      IRB Internal Ratings-Based                              S Borrower-Size                                         Dated: July 17, 2003.
      KIRB Capital for Underlying Pool of                     SBIC Small Business Investment                        John D. Hawke, Jr.,
        Exposures (securitizations)                             Company                                             Comptroller of the Currency.
      LGD Loss Given Default
      M Maturity                                              SFA Supervisory Formula Approach                        By order of the Board of Governors of the
      MDB Multilateral Development Bank                         (securitizations)                                   Federal Reserve System, July 21, 2003.
      OF Object Finance                                                                                             Jennifer J. Johnson,
                                                              SL Specialized Lending
      OTC Over-the-Counter (derivatives)                                                                            Secretary of the Board.
      PCA Prompt Corrective Action                            SME Small-to Medium-Sized
                                                                Enterprise                                            Dated at Washington, DC, this 11th day of
        (regulation)                                                                                                July, 2003.
      PD Probability of Default                               SPE Special Purpose Entity
                                                                                                                      By order of the Board of Directors.
      PDF Probability Density Function                        SSC Supervisory Slotting Criteria
      PF Project Finance                                                                                            Federal Deposit Insurance Corporation.
      PFE Potential Future Exposure                           UL Unexpected Loss                                    Robert E. Feldman,
      PMI Private Mortgage Insurance                          UMRA Unfunded Mandates Reform                         Executive Secretary.
      PRA Paperwork Reduction Act                               Act                                                   Dated: July 18, 2003.
      PSE Public-Sector Entity
      QIS3 Third Quantitative Impact Study                    VaR Value at Risk (model)                               By the Office of Thrift Supervision.
      QRE Qualifying Revolving Exposures                                                                            James E. Gilleran,
      R Asset Correlation                                                                                           Director.
      RBA Ratings-Based Approach                                                                                    [FR Doc. 03–18977 Filed 8–1–03; 8:45 am]
        (securitizations)                                                                                           BILLING CODE 4810–33–P; 6210–01–P; 6714–01–P;
      RFA Regulatory Flexibility Act                                                                                6720–01–P

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