Risk-Based Capital Standards: Advanced Capital Adequacy Framework

Federal RegisterSep 25, 2006

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DEPARTMENT OF THE TREASURY

Office of the Comptroller of the Currency

12 CFR Part 3

[Docket No. 06-09]

RIN 1557-AC91

FEDERAL RESERVE SYSTEM

12 CFR Parts 208 and 225

[Regulations H and Y; Docket No. R-1261]

FEDERAL DEPOSIT INSURANCE CORPORATION

12 CFR Part 325

RIN 3064-AC73

DEPARTMENT OF THE TREASURY

Office of Thrift Supervision

12 CFR Part 566

RIN 1550-AB56

Risk-Based Capital Standards: Advanced Capital Adequacy Framework

AGENCIES:

Office of the Comptroller of the Currency, Treasury; Board of Governors of the Federal Reserve System; Federal Deposit Insurance Corporation; and Office of Thrift Supervision, Treasury.

ACTION:

Joint notice of proposed rulemaking.

SUMMARY:

The Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System (Board), the Federal Deposit Insurance Corporation (FDIC), and the Office of Thrift Supervision (OTS) (collectively, the agencies) are proposing a new risk-based capital adequacy framework that would require some and permit other qualifying banks

to use an internal ratings-based approach to calculate regulatory credit risk capital requirements and advanced measurement approaches to calculate regulatory operational risk capital requirements. The proposed rule describes the qualifying criteria for banks required or seeking to operate under the proposed framework and the applicable risk-based capital requirements for banks that operate under the framework.

For simplicity, and unless otherwise indicated, this notice of proposed rulemaking (NPR) uses the term “bank” to include banks, savings associations, and bank holding companies (BHCs). The terms “bank holding company” and “BHS” refer only to bank holding companies regulated by the board and do not include savings and loan holding companies regulated by the OTS.

DATES:

Comments must be received on or before January 23, 2007.

ADDRESSES:

Comments should be directed to:

OCC:

You should include OCC and Docket Number 06-09 in your comment. You may submit comments by any of the following methods:

•

Federal eRulemaking Portal: http://www.regulations.gov.

Follow the instructions for submitting comments.

•

OCC Web Site: http://www.occ.treas.gov.

Click on “Contact the OCC,” scroll down and click on “Comments on Proposed Regulations.”

•

E-mail address:

regs.comments@occ.treas.gov.

•

Fax:

(202) 874-4448.

•

Mail:

Office of the Comptroller of the Currency, 250 E Street, SW., Mail Stop 1-5, Washington, DC 20219.

•

Hand Delivery/Courier:

250 E Street, SW.,

Attn:

Public Information Room, Mail Stop 1-5, Washington, DC 20219.

Instructions:

All submissions received must include the agency name (OCC) and docket number or Regulatory Information Number (RIN) for this notice of proposed rulemaking. In general, OCC will enter all comments received into the docket without change, including any business or personal information that you provide. You may review comments and other related materials by any of the following methods:

•

Viewing Comments Personally:

You may personally inspect and photocopy comments at the OCC's Public Information Room, 250 E Street, SW., Washington, DC. You can make an appointment to inspect comments by calling (202) 874-5043.

Board:

You may submit comments, identified by Docket No. R-1261, by any of the following methods:

•

Agency Web Site: http://www.federalreserve.gov.

Follow the instructions for submitting comments at

http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm.

•

Federal eRulemaking Portal: http://www.regulations.gov.

Follow the instructions for submitting comments.

•

E-mail: regs.comments@federalreserve.gov.

Include docket number in the subject line of the message.

•

FAX:

202/452-3819 or 202/452-3102.

•

Mail:

Jennifer J. Johnson, Secretary, Board of Governors of the Federal Reserve System, 20th Street and Constitution Avenue, NW., Washington, DC 20551.

All public comments are available from the Board's Web site at

www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm

as submitted, unless modified for technical reasons. Accordingly, your comments will not be edited to remove any identifying or contact information. Public comments may also be viewed electronically or in paper in Room MP-500 of the Board's Martin Building (20th and C Streets, NW.) between 9 a.m. and 5 p.m. on weekdays.

FDIC:

You may submit comments, identified by RIN number, by any of the following methods:

•

Federal eRulemaking Portal: http://www.regulations.gov.

Follow the instructions for submitting comments.

•

Agency Web Site:

http://www.fdic.gov/regulations/laws/federal/propose.html.

•

Mail:

Robert E. Feldman, Executive Secretary, Attention: Comments, Federal Deposit Insurance Corporation, 550 17th Street, NW., Washington, DC 20429.

•

Hand Delivery/Courier:

Guard station at rear of the 550 17th Street Building (located on F Street) on business days between 7 a.m. and 5 p.m.

•

E-mail:

Comments@FDIC.gov.

•

Public Inspection:

Comments may be inspected at the FDIC Public Information Center, Room E-1002, 3502 Fairfax Drive, Arlington, VA 22226, between 9 a.m. and 5 p.m. on business days.

Instructions:

Submissions received must include the agency name and RIN for this rulemaking. Comments received will be posted without change to

http://www.fdic.gov/regulations/laws/federal/propose.html

including any personal information provided.

OTS:

You may submit comments, identified by No. 2006-33, by any of the following methods:

•

Federal eRulemaking Portal: http://www.regulations.gov.

Follow the instructions for submitting comments.

•

E-mail address: regs.comments@ots.treas.gov.

Please include No. 2006-33 in the subject line of the message and include your name and telephone number in the message.

•

Fax:

(202) 906-6518.

•

Mail:

Regulation Comments, Chief Counsel's Office, Office of Thrift Supervision, 1700 G Street, NW., Washington, DC 20552, Attention: No. 2006-33.

•

Hand Delivery/Courier:

Guard's Desk, East Lobby Entrance, 1700 G Street, NW., from 9 a.m. to 4 p.m. on business days,

Attention:

Regulation Comments, Chief Counsel's Office,

Attention:

No. 2006-33.

Instructions:

All submissions received must include the agency name and

docket number or Regulatory Information Number (RIN) for this rulemaking. All comments received will be posted without change to the OTS Internet Site at

http://www.ots.treas.gov/pagehtml.cfm?catNumber=67&an=1,

including any personal information provided.

Docket:

For access to the docket to read background documents or comments received, go to

http://www.ots.treas.gov/pagehtml.cfm?catNumber=67&an=1.

In addition, you may inspect comments at the Public Reading Room, 1700 G Street, NW., by appointment. To make an appointment for access, call (202) 906-5922, send an e-mail to

public.info@ots.treas.gov,

or send a facsimile transmission to (202) 906-7755. (Prior notice identifying the materials you will be requesting will assist us in serving you.) We schedule appointments on business days between 10 a.m. and 4 p.m. In most cases, appointments will be available the next business day following the date we receive a request.

FOR FURTHER INFORMATION CONTACT:

OCC:

Roger Tufts, Senior Economic Advisor, Capital Policy (202-874-4925) or Ron Shimabukuro, Special Counsel, Legislative and Regulatory Activities Division (202-874-5090). Office of the Comptroller of the Currency, 250 E Street, SW., Washington, DC 20219.

Board:

Barbara Bouchard, Deputy Associate Director (202-452-3072 or

barbara.bouchard@frb.gov

) or Anna Lee Hewko, Senior Supervisory Financial Analyst (202-530-6260 or

anna.hewko@frb.gov

), Division of Banking Supervision and Regulation; or Mark E. Van Der Weide, Senior Counsel (202-452-2263 or

mark.vanderweide@frb.gov

), Legal Division. For users of Telecommunications Device for the Deaf (“TDD”) only, contact 202-263-4869.

FDIC:

Jason C. Cave, Associate Director, Capital Markets Branch, (202) 898-3548, Bobby R. Bean, Senior Quantitative Risk Analyst, Capital Markets Branch, (202) 898-3575, Kenton Fox, Senior Capital Markets Specialist, Capital Markets Branch, (202) 898-7119, Division of Supervision and Consumer Protection; or Michael B. Phillips, Counsel, (202) 898-3581, Supervision and Legislation Branch, Legal Division, Federal Deposit Insurance Corporation, 550 17th Street, NW., Washington, DC 20429.

OTS:

Michael D. Solomon, Director, Capital Policy, Supervision Policy (202) 906-5654; David W. Riley, Senior Analyst, Capital Policy (202) 906-6669; or Karen Osterloh, Special Counsel, Regulations and Legislation Division (202) 906-6639, Office of Thrift Supervision, 1700 G Street, NW., Washington, DC 20552.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Introduction

A. Background

B. Conceptual Overview

1. The IRB Framework for Credit Risk

2. The AMA for Operational Risk

C. Overview of Proposed Rule

D. Structure of Proposed Rule

E. Quantitative Impact Study 4 and Overall Capital Objectives

1. Quantitative Impact Study 4

2. Overall Capital Objectives

F. Competitive Considerations

II. Scope

A. Core and Opt-In Banks

B. U.S. Depository Institution Subsidiaries of Foreign Banks

C. Reservation of Authority

III. Qualification

A. The Qualification Process

1. In General

2. Parallel Run and Transitional Floor Periods

B. Qualification Requirements

1. Process and Systems Requirements

2. Risk Rating and Segmentation Systems for Wholesale and Retail Exposures

Wholesale exposures

Retail exposures

Definition of default

Rating philosophy

Rating and segmentation reviews and updates

3. Quantification of Risk Parameters for Wholesale and Retail Exposures

Probability of default (PD)

Loss given default (LGD) and expected loss given default (ELGD)

Exposure at default (EAD)

General quantification principles

4. Optional Approaches That Require Prior Supervisory Approval

5. Operational Risk

Operational risk data and assessment system

Operational risk quantification system

6. Data Management and Maintenance

7. Control and Oversight Mechanisms

Validation

Internal audit

Stress testing

8. Documentation

C. Ongoing Qualification

IV. Calculation of Tier 1 Capital and Total Qualifying Capital

V. Calculation of Risk-Weighted Assets

A. Categorization of Exposures

1. Wholesale Exposures

2. Retail Exposures

3. Securitization Exposures

4. Equity Exposures

5. Boundary Between Operational Risk and Other Risks

6. Boundary Between the Proposed Rule and the Market Risk Amendment

B. Risk-Weighted Assets for General Credit Risk (Wholesale Exposures, Retail Exposures, On-Balance Sheet Assets That Are Not Defined by Exposure Category, and Immaterial Credit Exposures)

1. Phase 1—Categorization of Exposures

2. Phase 2—Assignment of Wholesale Obligors and Exposures to Rating Grades and Retail Exposures to Segments

Purchased wholesale receivables

Wholesale lease residuals

3. Phase 3—Assignment of Risk Parameters to Wholesale Obligors and Exposures and Retail Segments

4. Phase 4—Calculation of Risk-Weighted Assets

5. Statutory Provisions on the Regulatory Capital Treatment of Certain Mortgage Loans

C. Credit Risk Mitigation Techniques

1. Collateral

2. EAD for Counterparty Credit Risk

EAD for repo-style transactions and eligible margin loans

Collateral haircut approach

Standard supervisory haircuts

Own estimates of haircuts

Simple VaR methodology

3. EAD for OTC Derivative Contracts

Current exposure methodology

4. Internal Models Methodology

Maturity under the internal models methodology

Collateral agreements under the internal models methodology

Internal estimate of alpha

Alternative models

5. Guarantees and Credit Derivatives That Cover Wholesale Exposures

Eligible guarantees and eligible credit derivatives

PD substitution approach

LGD adjustment approach

Maturity mismatch haircut

Restructuring haircut

Currency mismatch haircut

Example

Multiple credit risk mitigants

Double default treatment

6. Guarantees and Credit Derivatives That Cover Retail Exposures

D. Unsettled Securities, Foreign Exchange, and Commodity Transactions

E. Securitization Exposures

1. Hierarchy of Approaches

Exceptions to the general hierarchy of approaches

Servicer cash advances

Amount of a securitization exposure

Implicit support

Operational requirements for traditional securitizations

Clean-up calls

2. Ratings-Based Approach (RBA)

3. Internal Assessment Approach (IAA)

4. Supervisory Formula Approach (SFA)

General requirements

Inputs to the SFA formula

5. Eligible Disruption Liquidity Facilities

6. Credit Risk Mitigation for Securitization Exposures

7. Synthetic Securitizations

Background

Operational requirements for synthetic securitizations

First-loss tranches

Mezzanine tranches

Super-senior tranches

8. Nth-to-Default Credit Derivatives

9. Early Amortization Provisions

Background

Controlled early amortization

Noncontrolled early amortization

F. Equity Exposures

1. Introduction and Exposure Measurement

Hedge transactions

Measures of hedge effectiveness

2. Simple Risk-Weight Approach (SRWA)

Non-significant equity exposures

3. Internal Models Approach (IMA)

IMA qualification

Risk-weighted assets under the IMA

4. Equity Exposures to Investment Funds

Full look-through approach

Simple modified look-through approach

Alternative modified look-through approach

VI. Operational Risk

VII. Disclosure

1. Overview

Comments on ANPR

2. General Requirements

Frequency/timeliness

Location of disclosures and audit/certification requirements

Proprietary and confidential information

3. Summary of Specific Public Disclosure Requirements

4. Regulatory Reporting

I. Introduction

A. Background

On August 4, 2003, the agencies issued an advance notice of proposed rulemaking (ANPR) (68 FR 45900) that sought public comment on a new risk-based regulatory capital framework based on the Basel Committee on Banking Supervision (BCBS)

April 2003 consultative paper entitled “ New Basel Capital Accord” (Proposed New Accord). The Proposed New Accord set forth a “three pillar” framework encompassing risk-based capital requirements for credit risk, market risk, and operational risk (Pillar 1); supervisory review of capital adequacy (Pillar 2); and market discipline through enhanced public disclosures (Pillar 3). The Proposed New Accord incorporated several methodologies for determining a bank’s risk-based capital requirements for credit, market, and operational risk.

The ANPR sought comment on selected regulatory capital approaches contained in the Proposed New Accord that the agencies believe are appropriate for large, internationally active U.S. banks. These approaches include the internal ratings-based (IRB) approach for credit risk and the advanced measurement approaches (AMA) for operational risk (together, the advanced approaches). The IRB framework uses risk parameters determined by a bank's internal systems in the calculation of the bank's credit risk capital requirements. The AMA relies on a bank's internal estimates of its operational risks to generate an operational risk capital requirement for the bank. The ANPR included a number of questions highlighting various issues for the industry's consideration. The agencies received approximately 100 public comments on the ANPR from banks, trade associations, supervisory authorities, and other interested parties. These comments addressed the agencies' specific questions as well as a range of other issues. Commenters generally encouraged further development of the framework, and most supported the overall direction of the ANPR. Commenters did, however, raise a number of conceptual and technical issues that they believed required additional consideration.

The BCBS is a committee of banking supervisory authorities, which was established by the central bank governors of the G-10 countries in 1975. It consists of senior representatives of bank supervisory authorities and central banks from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom, and the United States.

The BCBS developed the Proposed New Accord to modernize its first capital Accord, which was endorsed by the G-10 governors in 1988 and implemented by the agencies in the United States in 1989. The BCBS's 1988 Accord is described in a document entitled “International Convergence of Capital Measurement and Capital Standards.” This document and other documents issued by the BCBS are available through the Bank for International Settlements Web site at

http://www.bis.org.

The agencies' implementing regulations are available at 12 CFR part 3, Appendices A and B (national banks); 12 CFR part 208, Appendices A and E (state member banks); 12 CFR part 225, Appendixes A and E (bank holding companies); 12 CFR part 325, Appendices A and C (state nonmember banks); and 12 CFR part 567 (savings associations).

Since the issuance of the ANPR, the agencies have worked domestically and with other BCBS member countries to modify the methodologies in the Proposed New Accord to reflect comments received during the international consultation process and the U.S. ANPR comment process. In June 2004, the BCBS issued a document entitled “International Convergence of Capital Measurement and Capital Standards: A Revised Framework” (New Accord or Basel II). The New Accord recognizes developments in financial products, incorporates advances in risk measurement and management practices, and assesses capital requirements that are generally more sensitive to risk. It is intended for use by individual countries as the basis for national consultation and implementation. Accordingly, the agencies are issuing this proposed rule to implement the New Accord for banks in the United States.

B. Conceptual Overview

The framework outlined in this proposal (IRB framework) is intended to produce risk-based capital requirements that are more risk-sensitive than the existing risk-based capital rules of the agencies (general risk-based capital rules). The proposed framework seeks to build on improvements to risk assessment approaches that a number of large banks have adopted over the last decade. In particular, the proposed framework requires banks to assign risk parameters to exposures and provides specific risk-based capital formulas that would be used to transform these risk parameters into risk-based capital requirements.

The proposed framework is based on the “value-at-risk” (VaR) approach to measuring credit risk and operational risk. VaR modeling techniques for measuring risk have been the subject of economic research and are used by large banks. The proposed framework has benefited significantly from comments on the ANPR, as well as consultations organized in conjunction with the BCBS's development of the New Accord. Because bank risk measurement practices are both continually evolving and subject to model and other errors, the proposed framework should be viewed less as an effort to produce a statistically precise measurement of risk, and more as an effort to improve the risk sensitivity of the risk-based capital requirements for banks.

The proposed framework's conceptual foundation is based on the view that risk can be quantified through the assessment of specific characteristics of the probability distribution of potential losses over a given time horizon. This approach assumes that a suitable estimate of that probability distribution, or at least of the specific characteristics to be measured, can be produced. Figure 1 illustrates some of the key concepts associated with the proposed framework. The figure shows a probability distribution of potential losses associated with some time horizon (for example, one year). It could reflect, for example, credit losses, operational losses, or other types of losses.

EP25SE06.075

The area under the curve to the right of a particular loss amount is the probability of experiencing losses exceeding this amount within a given time horizon. The figure also shows the statistical mean of the loss distribution, which is equivalent to the amount of loss that is “expected” over the time horizon. The concept of “expected loss” (EL) is distinguished from that of “unexpected loss” (UL), which represents potential losses over and above the expected loss amount. A given level of unexpected loss can be defined by reference to a particular percentile threshold of the probability distribution. In the figure, for example, the 99.9th percentile is shown. Unexpected losses, measured at the 99.9th percentile level, are equal to the value of the loss distribution corresponding to the 99.9th percentile, less the amount of expected losses. This is shown graphically at the bottom of the figure.

The particular percentile level chosen for the measurement of unexpected losses is referred to as the “confidence level” or the “soundness standard” associated with the measurement. If capital is available to cover losses up to and including this percentile level, then the bank will remain solvent in the face of actual losses of that magnitude. Typically, the choice of confidence level or soundness standard reflects a very high percentile level, so that there is a very low estimated probability that actual losses would exceed the unexpected loss amount associated with that confidence level or soundness standard.

Assessing risk and assigning regulatory capital requirements by reference to a specific percentile of a probability distribution of potential losses is commonly referred to as a VaR approach. Such an approach was adopted by the FDIC, Board, and OCC for assessing a bank's risk-based capital requirements for market risk in 1996 (market risk amendment or MRA). Under the MRA, a bank's own internal models are used to estimate the 99th percentile of the bank's market risk loss distribution over a ten-business-day horizon. The bank's market risk capital requirement is based on this VaR estimate, generally multiplied by a factor of three. The agencies implemented this multiplication factor to provide a prudential buffer for market volatility and modeling error.

1. The IRB Framework for Credit Risk

The conceptual foundation of this proposal's approach to credit risk capital requirements is similar to the MRA's approach to market risk capital requirements, in the sense that each is VaR-oriented. That is, the proposed framework bases minimum credit risk capital requirements largely on estimated statistical measures of credit risk. Nevertheless, there are important differences between this proposal and the MRA. The MRA approach for assessing market risk capital requirements currently employs a nominal confidence level of 99.0 percent and a ten-business-day horizon, but otherwise provides banks with substantial modeling flexibility in determining their market risk loss distribution and capital requirements. In contrast, the IRB framework for assessing credit risk capital requirements is based on a 99.9 percent nominal confidence level, a one-year horizon, and a supervisory model of credit losses embodying particular assumptions about the underlying drivers of portfolio credit risk, including loss correlations among different asset types.

The theoretical underpinnings for the supervisory model of credit risk underlying this proposal are provided in Michael Gordy, “A Risk-Factor Model Foundation for Ratings-Based Bank Capital Rules,”

Journal of Financial Intermediation,

July 2003. The IRB formulas are derived as an application of these results to a single-factor CreditMetrics-style model. For mathematical details on this model, see Michael Gordy, “A Comparative Anatomy of Credit Risk Models,”

Journal of Banking and Finance,

January 2000, or H.U. Koyluogu and A. Hickman, “Reconcilable Differences,”

Risk,

October 1998. For a less technical overview of the IRB formulas, see the BCBS's “An Explanatory Note on the Basel II Risk Weight Functions,” July 2005 (Explanatory Note). The document can be found on the Bank for International Settlements Web site at

http://www.bis.org.

The IRB framework is broadly similar to the credit VaR approaches used by many banks as the basis for their internal assessment of the economic capital necessary to cover credit risk. It is common for a bank's internal credit risk models to consider a one-year loss horizon, and to focus on a high loss threshold confidence level. As with the internal credit VaR models used by banks, the output of the risk-based capital formulas in the IRB framework is an estimate of the amount of credit losses above expected credit losses (ECL) over a one-year horizon that would only be exceeded a small percentage of the time. The agencies believe that a one-year horizon is

appropriate because it balances the fact that banking book positions likely could not be easily or rapidly exited with the possibility that in many cases a bank can cover credit losses by raising additional capital should the underlying credit problems manifest themselves gradually. The nominal confidence level of the IRB risk-based capital formulas (99.9 percent) means that if all the assumptions in the IRB supervisory model for credit risk were correct for a bank, there would be less than a 0.1 percent probability that credit losses at the bank in any year would exceed the IRB risk-based capital requirement.

Banks' internal economic capital models typically focus on measures of equity capital, whereas the total regulatory capital measure underlying this proposal includes not only equity capital, but also certain debt and hybrid instruments, such as subordinated debt. Thus, the 99.9 percent nominal confidence level embodied in the IRB framework is not directly comparable to the nominal solvency standards underpinning banks' economic capital models.

As noted above, the supervisory model of credit risk underlying the IRB framework embodies specific assumptions about the economic drivers of portfolio credit risk at banks. As with any modeling approach, these assumptions represent simplifications of very complex real-world phenomena and, at best, are only an approximation of the actual credit risks at any bank. To the extent these assumptions (described in greater detail below) do not characterize a given bank precisely, the actual confidence level implied by the IRB risk-based capital formulas may exceed or fall short of the framework's nominal 99.9 percent confidence level.

In combination with other supervisory assumptions and parameters underlying this proposal, the IRB framework's 99.9 percent nominal confidence level reflects a judgmental pooling of available information, including supervisory experience. The framework underlying this proposal reflects a desire on the part of the agencies to achieve (i)

relative

risk-based capital requirements across different assets that are broadly consistent with maintaining at least an investment grade rating (for example, at least BBB) on the liabilities funding those assets, even in periods of economic adversity; and (ii) for the U.S. banking system as a whole, aggregate minimum regulatory capital requirements that are not a material reduction from the aggregate minimum regulatory capital requirements under the general risk-based capital rules.

A number of important explicit generalizing assumptions and specific parameters are built into the IRB framework to make the framework applicable to a range of banks and to obtain tractable information for calculating risk-based capital requirements. Chief among the assumptions embodied in the IRB framework are: (i) Assumptions that a bank's credit portfolio is infinitely granular; (ii) assumptions that loan defaults at a bank are driven by a single, systematic risk factor; (iii) assumptions that systematic and non-systematic risk factors are log-normal random variables; and (iv) assumptions regarding correlations among credit losses on various types of assets.

The specific risk-based capital formulas in this proposed rule require the bank to estimate certain risk parameters for its wholesale and retail exposures, which the bank may do using a variety of techniques. These risk parameters are probability of default (PD), expected loss given default (ELGD), loss given default (LGD), exposure at default (EAD), and, for wholesale exposures, effective remaining maturity (M). The risk-based capital formulas into which the estimated risk parameters are inserted are simpler than the economic capital methodologies typically employed by banks (which often require complex computer simulations). In particular, an important property of the IRB risk-based capital formulas is portfolio invariance. That is, the risk-based capital requirement for a particular exposure generally does not depend on the other exposures held by the bank. Like the general risk-based capital rules, the total credit risk capital requirement for a bank's wholesale and retail exposures is the sum of the credit risk capital requirements on individual wholesale exposures and retail exposures.

The IRB risk-based capital formulas contain supervisory asset value correlation (AVC) factors, which have a significant impact on the capital requirements generated by the formulas. The AVC assigned to a given portfolio of exposures is an estimate of the degree to which any unanticipated changes in the financial conditions of the underlying obligors of the exposures are correlated (that is, would likely move up and down together). High correlation of exposures in a period of economic downturn conditions is an area of supervisory concern. For a portfolio of exposures having the same risk parameters, a larger AVC implies less diversification within the portfolio, greater overall systematic risk, and, hence, a higher risk-based capital requirement.

For example, a 15 percent AVC for a portfolio of residential mortgage exposures would result in a lower risk-based capital requirement than a 20 percent AVC and a higher risk-based capital requirement than a 10 percent AVC.

See

Explanatory Note.

The AVCs that appear in the IRB risk-based capital formulas for wholesale exposures decline with increasing PD; that is, the IRB risk-based capital formulas generally imply that a group of low-PD wholesale exposures are more correlated than a group of high-PD wholesale exposures. Thus, under the proposed rule, a low-PD wholesale exposure would have a higher relative risk-based capital requirement than that implied by its PD were the AVC in the IRB risk-based capital formulas for wholesale exposures fixed rather than a function of PD. This inverse relationship between PD and AVC for wholesale exposures is broadly consistent with empirical research undertaken by G10 supervisors and moderates the sensitivity of IRB risk-based capital requirements for wholesale exposures to the economic cycle.

Question 1: The agencies seek comment on and empirical analysis of the appropriateness of the proposed rule's AVCs for wholesale exposures in general and for various types of wholesale exposures (for example, commercial real estate exposures).

The AVCs included in the IRB risk-based capital formulas for retail exposures also reflect a combination of supervisory judgment and empirical evidence.

However, the historical data available for estimating these correlations was more limited than was the case with wholesale exposures, particularly for non-mortgage retail exposures. As a result, supervisory judgment played a greater role. Moreover, the flat 15 percent AVC for residential mortgage exposures is based largely on empirical analysis of traditional long-term, fixed-rate mortgages.

Question 2: The agencies seek comment on and empirical analysis of the appropriateness and risk sensitivity of the proposed rule's AVC for residential mortgage exposures—not only for long-term, fixed-rate mortgages, but also for adjustable-rate mortgages, home equity lines of credit, and other mortgage products—and for other retail portfolios.

See

Explanatory Note, section 5.3.

Another important conceptual element of the IRB framework concerns the treatment of EL. The ANPR generally would have required banks to hold capital against the measured amount of UL plus EL over a one-year horizon, except in the limited instance of credit card exposures where future

margin income (FMI) was allowed to offset EL. The ANPR treatment also would have maintained the existing definition of regulatory capital, which includes the allowance for loan and lease losses (ALLL) in tier 2 capital up to a limit equal to 1.25 percent of risk-weighted assets. The ANPR requested comment on the proposed treatment of EL. Many commenters on the ANPR objected to this treatment on conceptual grounds, arguing that capital is not the appropriate mechanism for covering EL. In response to this feedback, the agencies sought and obtained changes to the BCBS's proposals in this area.

The agencies supported the BCBS's proposal, announced in October 2003, to remove ECL (as defined below) from the risk-weighted assets calculation. This NPR, consistent with the New Accord, removes ECL from the risk-weighted assets calculation but requires a bank to compare its ECL to its eligible credit reserves (as defined below). If a bank's ECL exceeds its eligible credit reserves, the bank must deduct the excess ECL amount 50 percent from tier 1 capital and 50 percent from tier 2 capital. If a bank's eligible credit reserves exceed its ECL, the bank would be able to include the excess eligible credit reserves amount in tier 2 capital, up to 0.6 percent of the bank's credit risk-weighted assets. This treatment is intended to maintain a capital incentive to reserve prudently and seeks to ensure that ECL over a one-year horizon is covered either by reserves or capital. This treatment also recognizes that prudent reserving that considers probable losses over the life of a loan may result in a bank holding reserves in excess of ECL measured with a one-year horizon. The BCBS calibrated the proposed 0.6 percent limit on inclusion of excess reserves in tier 2 capital to be approximately as restrictive as the existing cap on the inclusion of ALLL under the general risk-based capital rules, based on data obtained in the BCBS's Third Quantitative Impact Study (QIS-3).

Question 3: The agencies seek comment and supporting data on the appropriateness of this limit.

BCBS, “QIS 3: Third Quantitative Impact Study,” May 2003.

The agencies are aware that certain banks believe that FMI should be eligible to cover ECL for the purposes of such a calculation, while other banks have asserted that, for certain business lines, prudential reserving practices do not involve setting reserves at levels consistent with ECL over a horizon as long as one year. The agencies nevertheless believe that the proposed approach is appropriate because banks should receive risk-based capital benefits only for the most highly reliable ECL offsets.

The combined impact of these changes in the treatment of ECL and reserves will depend on the reserving practices of individual banks. Nevertheless, if other factors are equal, the removal of ECL from the calculation of risk-weighted assets will result in a lower amount of risk-weighted assets than the proposals in the ANPR. However, the impact on risk-based capital ratios should be partially offset by related changes to the numerators of the risk-based capital ratios—specifically, (i) the ALLL will be allowed in tier 2 capital up to certain limits only to the extent that it and certain other reserves exceed ECL, and (ii) if ECL exceeds reserves, the reserve shortfall must be deducted 50 percent from tier 1 capital and 50 percent from tier 2 capital.

Using data from QIS-3, the BCBS conducted an analysis of the risk-based capital requirements that would be generated under the New Accord, taking into account the aggregate effect of ECL-related changes to both the numerator and the denominator of the risk-based capital ratios. The BCBS concluded that to offset these changes relative to the credit risk-based capital requirements of the Proposed New Accord, it might be necessary under the New Accord to apply a “scaling factor” (multiplier) to credit risk-weighted assets. The BCBS, in the New Accord, indicated that the best estimate of the scaling factor using QIS-3 data adjusted for the EL-UL decisions was 1.06. The BCBS noted that a final determination of any scaling factor would be reconsidered prior to full implementation of the new framework. The agencies are proposing a multiplier of 1.06 at this time, consistent with the New Accord.

The agencies note that a 1.06 multiplier should be viewed as a placeholder. The BCBS is expected to revisit the determination of a scaling factor based on the results of the latest international QIS (QIS-5, which was not conducted in the United States).

The agencies will consider the BCBS's determination, as well as other factors including the most recent QIS conducted in the United States (QIS-4, which is described below),

in determining a multiplier for the final rule. As the agencies gain more experience with the proposed advanced approaches, the agencies will revisit the scaling factor along with other calibration issues identified during the parallel run and transitional floor periods (described below) and make changes to the rule as necessary. While a scaling factor is one way to ensure that regulatory capital is maintained at a certain level, particularly in the short- to medium-term, the agencies also may address calibration issues through modifications to the underlying IRB risk-based capital formulas.

See http://www.bis.org/bcbs/qis/qis5.htm.

See

“Summary Findings of the Fourth Quantitative Impact Study,” February 24, 2006.

2. The AMA for Operational Risk

The proposed rule also includes the AMA for determining risk-based capital requirements for operational risk. Under the proposed rule, operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events. This definition of operational risk includes legal risk—which is the risk of loss (including litigation costs, settlements, and regulatory fines) resulting from the failure of the bank to comply with laws, regulations, prudent ethical standards, and contractual obligations in any aspect of the bank's business—but excludes strategic and reputational risks.

Under the AMA, a bank would use its internal operational risk management systems and processes to assess its exposure to operational risk. Given the complexities involved in measuring operational risk, the AMA provides banks with substantial flexibility and, therefore, does not require a bank to use specific methodologies or distributional assumptions. Nevertheless, a bank using the AMA must demonstrate to the satisfaction of its primary Federal supervisor that its systems for managing and measuring operational risk meet established standards, including producing an estimate of operational risk exposure that meets a 1-year, 99.9th percentile soundness standard. A bank's estimate of operational risk exposure includes both expected operational loss (EOL) and unexpected operational loss (UOL) and forms the basis of the bank's risk-based capital requirement for operational risk.

The AMA allows a bank to base its risk-based capital requirement for operational risk on UOL alone if the bank can demonstrate to the satisfaction of its primary Federal supervisor that the bank has eligible operational risk offsets, such as certain operational risk reserves, that equal or exceed the bank's EOL. To the extent that eligible operational risk offsets are less than EOL, the bank's risk-based capital requirement for operational risk must incorporate the shortfall.

C. Overview of Proposed Rule

The proposed rule maintains the general risk-based capital rules' minimum tier 1 risk-based capital ratio of 4.0 percent and total risk-based capital ratio of 8.0 percent. The components of tier 1 and total capital are also generally the same, with a few adjustments described in more detail below. The primary difference between the general risk-based capital rules and the proposed rule is the methodologies used for calculating risk-weighted assets. Banks applying the proposed rule generally would use their internal risk measurement systems to calculate the inputs for determining the risk-weighted asset amounts for (i) general credit risk (including wholesale and retail exposures); (ii) securitization exposures; (iii) equity exposures; and (iv) operational risk. In certain cases, however, external ratings or supervisory risk weights would be used to determine risk-weighted asset amounts. Each of these areas is discussed below.

Banks using the proposed rule also would be subject to supervisory review of their capital adequacy (Pillar 2) and certain public disclosure requirements to foster transparency and market discipline (Pillar 3). In addition, each bank using the advanced approaches would continue to be subject to the tier 1 leverage ratio requirement, and each depository institution (DI) (as defined in section 3 of the Federal Deposit Insurance Act (12 U.S.C. 1813)) using the advanced approaches would continue to be subject to the prompt corrective action (PCA) thresholds. Those banks subject to the MRA also would continue to be subject to the MRA.

Under the proposed rule, a bank must identify whether each of its on- and off-balance sheet exposures is a wholesale, retail, securitization, or equity exposure. Assets that are not defined by any exposure category (and certain immaterial portfolios of exposures) generally would be assigned risk-weighted asset amounts equal to their carrying value (for on-balance sheet exposures) or notional amount (for off-balance sheet exposures).

Wholesale exposures under the proposed rule include most credit exposures to companies and governmental entities. For each wholesale exposure, a bank would assign five quantitative risk parameters: PD (which is stated as a percentage and measures the likelihood that an obligor will default over a 1-year horizon); ELGD (which is stated as a percentage and is an estimate of the economic loss rate if a default occurs); LGD (which is stated as a percentage and is an estimate of the economic loss rate if a default occurs during economic downturn conditions); EAD (which is measured in dollars and is an estimate of the amount that would be owed to the bank at the time of default); and M (which is measured in years and reflects the effective remaining maturity of the exposure). Banks would be able to factor into their risk parameter estimates the risk mitigating impact of collateral, credit derivatives, and guarantees that meet certain criteria. Banks would input the risk parameters for each wholesale exposure into an IRB risk-based capital formula to determine the risk-based capital requirement for the exposure.

Retail exposures under the proposed rule include most credit exposures to individuals and small businesses that are managed as part of a segment of exposures with similar risk characteristics, not on an individual-exposure basis. A bank would classify each of its retail exposures into one of three retail subcategories—residential mortgage exposures, qualifying revolving exposures (QREs) (for example, credit cards and overdraft lines), and other retail exposures. Within these three subcategories, the bank would group exposures into segments with similar risk characteristics. The bank would then assign the risk parameters PD, ELGD, LGD, and EAD to each retail segment. The bank would be able to take into account the risk mitigating impact of collateral and guarantees in the segmentation process and in the assignment of risk parameters to retail segments. Like wholesale exposures, the risk parameters for each retail segment would be used as inputs into an IRB risk-based capital formula to determine the risk-based capital requirement for the segment.

Question 4: The agencies seek comment on the use of a segment-based approach rather than an exposure-by-exposure approach for retail exposures.

For securitization exposures, the bank would apply one of three general approaches, subject to various conditions and qualifying criteria: the Ratings-Based Approach (RBA), which uses external ratings to risk-weight exposures; an Internal Assessment Approach (IAA), which uses internal ratings to risk-weight exposures to asset-backed commercial paper programs (ABCP programs); or the Supervisory Formula Approach (SFA). Securitization exposures in the form of gain-on-sale or credit-enhancing interest-only strips (CEIOs)

and securitization exposures that do not qualify for the RBA, the IAA, or the SFA would be deducted from regulatory capital.

A CEIO is an on-balance-sheet asset that (i) represents the contractual right to receive some or all of the interest and no more than a minimal amount of principal due on the underlying exposures of a securitization and (ii) exposes the holder to credit risk directly or indirectly associated with the underlying exposures that exceeds its pro rata claim on the underlying exposures whether through subordination provisions or other credit-enhancement techniques.

Banks would be able to use an internal models approach (IMA) for determining risk-based capital requirements for equity exposures, subject to certain qualifying criteria and floors. If a bank does not have a qualifying internal model for equity exposures, or chooses not to use such a model, the bank must apply a simple risk weight approach (SRWA) in which publicly traded equity exposures would have a 300 percent risk weight and non-publicly traded equity exposures would have a 400 percent risk weight. Under both the IMA and the SRWA, equity exposures to certain entities or made pursuant to certain statutory authorities would be subject to a 0 to 100 percent risk weight.

Banks would have to develop qualifying AMA systems to determine risk-based capital requirements for operational risk. Under the AMA, a bank would use its own methodology to identify operational loss events, measure its exposure to operational risk, and assess a risk-based capital requirement for operational risk.

Under the proposed rule, a bank would calculate its risk-based capital ratios by first converting any dollar risk-based capital requirements for exposures produced by the IRB risk-based capital formulas into risk-weighted asset amounts by multiplying the capital requirements by 12.5 (the inverse of the overall 8.0 percent risk-based capital requirement). After determining the risk-weighted asset amounts for credit risk and operational risk, a bank would sum these amounts and then subtract any allocated transfer risk reserves and excess eligible credit reserves not included in tier 2 capital (defined below) to determine total risk-weighted assets. The bank would then calculate its risk-based capital ratios by dividing its tier 1 capital and total qualifying capital by the total risk-weighted assets amount.

The proposed rule contains specific public disclosure requirements to provide important information to market participants on the capital structure, risk exposures, risk assessment processes, and, hence, the

capital adequacy of a bank. The public disclosure requirements would apply only to the DI or bank holding company representing the top consolidated level of the banking group that is subject to the advanced approaches. In addition, the agencies are also publishing today proposals to require certain disclosures from subsidiary DIs in the banking group through the supervisory reporting process. The agencies believe that the reporting of key risk parameter estimates for each DI applying the advanced approaches will provide the primary Federal supervisor of the DI and other relevant supervisors with important data for assessing the reasonableness and accuracy of the institution's calculation of its risk-based capital requirements under this proposal and the adequacy of the institution's capital in relation to its risks. Some of the proposed supervisory reports would be publicly available (for example, on the Call Report or Thrift Financial Report), and others would be confidential disclosures to the agencies to augment the supervisory process.

D. Structure of Proposed Rule

The agencies are considering implementing a comprehensive regulatory framework for the advanced approaches in which each agency would have an advanced approaches regulation or appendix that sets forth (i) the elements of tier 1 and tier 2 capital and associated adjustments to the risk-based capital ratio numerator, (ii) the qualification requirements for using the advanced approaches, and (iii) the details of the advanced approaches. For proposal purposes, the agencies are issuing a single proposed regulatory text for comment. Unless otherwise indicated, the term “bank” in the regulatory text includes banks, savings associations, and bank holding companies (BHCs). The term “[AGENCY]” in the regulatory text refers to the primary Federal supervisor of the bank applying the rule. Areas where the regulatory text would differ by agency—for example, provisions that would only apply to savings associations or to BHCs—are generally indicated in appropriate places.

In this proposed rule, the agencies are not restating the elements of tier 1 and tier 2 capital, which would generally remain the same as under the general risk-based capital rules. Adjustments to the risk-based capital ratio numerators specific to banks applying the advanced approaches are in part II of the proposed rule and explained in greater detail in section IV of this preamble. The OCC, Board, and FDIC also are proposing to incorporate their existing market risk rules by cross-reference and are proposing modifications to the market risk rules in a separate NPR issued concurrently.

The OTS is proposing its own market risk rule, including the proposed modifications, as a part of that separate NPR. In addition, the agencies may need to make additional conforming amendments to certain of their regulations that use tier 1 or total qualifying capital or the risk-based capital ratios for various purposes.

See elsewhere in today's issue of the

Federal Register

The proposed rule is structured in eight broad parts. Part I identifies criteria for determining which banks are subject to the rule, provides key definitions, and sets forth the minimum risk-based capital ratios. Part II describes the adjustments to the numerator of the risk-based capital ratios for banks using the advanced approaches. Part III describes the qualification process and provides qualification requirements for obtaining supervisory approval for use of the advanced approaches. This part incorporates critical elements of supervisory oversight of capital adequacy (Pillar 2).

Parts IV through VII address the calculation of risk-weighted assets. Part IV provides the risk-weighted assets calculation methodologies for wholesale and retail exposures; on-balance-sheet assets that do not meet the regulatory definition of a wholesale, retail, securitization, or equity exposure; and certain immaterial portfolios of credit exposures. This part also describes the risk-based capital treatment for over-the-counter (OTC) derivative contracts, repo-style transactions, and eligible margin loans. In addition, this part describes the methodology for reflecting eligible credit risk mitigation techniques in risk-weighted assets for wholesale and retail exposures. Furthermore, this part sets forth the risk-based capital requirements for failed and unsettled securities, commodities, and foreign exchange transactions.

Part V identifies operating criteria for recognizing risk transference in the securitization context and outlines the approaches for calculating risk-weighted assets for securitization exposures. Part VI describes the approaches for calculating risk-weighted assets for equity exposures. Part VII describes the calculation of risk-weighted assets for operational risk. Finally, Part VIII provides public disclosure requirements for banks employing the advanced approaches (Pillar 3).

The structure of the preamble generally follows the structure of the proposed regulatory text. Definitions, however, are discussed in the portions of the preamble where they are most relevant.

E. Quantitative Impact Study 4 and Overall Capital Objectives

1. Quantitative Impact Study 4

After the BCBS published the New Accord, the agencies conducted the additional quantitative impact study referenced above, QIS-4, in the fall and winter of 2004-2005, to better understand the potential impact of the proposed framework on the risk-based capital requirements for individual U.S. banks and U.S. banks as a whole. The results showed a substantial dollar-weighted average decline and variation in risk-based capital requirements across the 26 participating U.S. banks and their portfolios.

In an April 2005 press release,

the agencies expressed their concern about the magnitude of the drop in QIS-4 risk-based capital requirements and the dispersion of those requirements and decided to undertake further analysis.

Since neither an NPR and associated supervisory guidance nor final regulations implementing a Basel II-based framework had been issued in the United States at the time of data collection, all QIS-4 results relating to the U.S. implementation of Basel II are based on the description of the framework contained in the QIS-4 instructions. These instructions differed from the framework issued by the BCBS in June 2004 in several respects. For example, the QIS-4 articulation of the Basel II framework does not include the 1.06 scaling factor. The QIS-4 instructions are available at

http://www.ffiec.gov/qis4

See

“Banking Agencies to Perform Additional Analysis Before Issuing Notice of Proposed Rulemaking Related to Basel II,” Apr. 29, 2005.

The QIS-4 analysis indicated a dollar-weighted average reduction of 15.5 percent in risk-based capital requirements at participating banks when moving from the current Basel I-based framework to a Basel II-based framework.

Table A provides a numerical summary of the QIS-4 results, in total and by portfolio, aggregated across all QIS-4 participants.

The first column shows

changes in dollar-weighted average minimum required capital (MRC) both by portfolio and overall, as well as in dollar-weighted average overall effective MRC. Column 2 shows the relative contribution of each portfolio to the overall dollar-weighted average decline of 12.5 percent in MRC, representing both the increase/decrease and relative size of each portfolio. The table also shows (column 3) that risk-based capital requirements declined by more than 26 percent in half the banks in the study. Most portfolios showed double-digit declines in risk-based capital requirements for over half the banks, with the exception of credit cards. It should be noted that column 3 gives every participating bank equal weight. Column 4 shows the analogous weighted median change, using total exposures as weights.

The Basel II framework on which QIS-4 is based uses a UL-only approach (even though EL requirements were included in QIS-4). But the current Basel I risk-based capital requirements use a UL+EL approach. Therefore, in order to compare the Basel II results from QIS-4 with the current Basel I requirements, the EL requirements from QIS-4 had to be added to the UL capital requirements from QIS-4.

In the table, “Minimum required capital” (MRC) refers to the total risk-based capital requirement before incorporating the impact of reserves. “Effective MRC” is equal to MRC adjusted for the impact of reserves. As noted above, under the Basel II framework, a shortfall in reserves generally increases the total risk-based capital requirement and a surplus in reserves generally

reduces the total risk-based capital requirement, though not with equal impact.

EP25SE06.076

QIS-4 results (not shown in Table A) also suggested that tier 1 risk-based capital requirements under a Basel II-based framework would be lower for many banks than they are under the general risk-based capital rules, in part reflecting the move to a UL-only risk-based capital requirement. Tier 1 risk-based capital requirements declined by 22 percent in the aggregate. The unweighted median indicates that half of the participating banks reported reductions in tier 1 risk-based capital requirements of over 31 percent. The MRC calculations do not take into account the impact of the tier 1 leverage ratio requirement. Were such results produced under a fully implemented Basel II-based risk-based capital regime, the existing tier 1 leverage ratio requirement could be a more important constraint than it is currently.

Evidence from some of the follow-up analysis also illustrated that similar loan products at different banks may have resulted in very different risk-based capital requirements. Analysis

determined that this dispersion in capital requirements not only reflected differences in actual risk or portfolio composition, but also reflected differences in the banks' estimated risk parameters for similar exposures.

Although concerns with dispersion might be remedied to some degree with refinements to internal bank risk measurement and management systems and through the rulemaking process, the agencies also note that some of the dispersion encountered in the QIS-4 exercise is a reflection of the flexibility in methods to quantify the risk parameters that may be allowed under implementation of the proposed framework.

The agencies intend to conduct other analyses of the impact of the Basel II framework during both the parallel run and transitional floor periods. These analyses will look at both the impact of the Basel II framework and the preparedness of banks to compute risk-based capital requirements in a manner consistent with the Basel II framework.

2. Overall Capital Objectives

The ANPR stated: “The Agencies do not expect the implementation of the New Accord to result in a significant decrease in aggregate capital requirements for the U.S. banking system. Individual banking organizations may, however, face increases or decreases in their minimum risk-based capital requirements because the New Accord is more risk sensitive than the 1988 Accord and the Agencies' existing risk-based capital rules (general risk-based capital rules).”

The ANPR was in this respect consistent with statements made by the BCBS in its series of Basel II consultative papers and its final text of the New Accord, in which the BCBS stated as an objective broad maintenance of the overall level of risk-based capital requirements while allowing some incentives for banks to adopt the advanced approaches.

68 FR 45900, 45902 (Aug. 4, 2003).

The agencies remain committed to these objectives. Were the QIS-4 results just described produced under an up-and-running risk-based capital regime, the risk-based capital requirements generated under the framework would not meet the objectives described in the ANPR, and thus would be considered unacceptable.

When considering QIS-4 results and their implications, it is important to recognize that banking organizations participated in QIS-4 on a best-efforts basis. The agencies had not qualified any of the participants to use the Basel II framework and had not conducted any formal supervisory review of their progress toward meeting the Basel II qualification requirements. In addition, the risk measurement and management systems of the QIS-4 participants, as indicated by the QIS-4 exercise, did not yet meet the Basel II qualification requirements outlined in this proposed rule.

As banks work with their supervisors to refine their risk measurement and management systems, it will become easier to determine the actual quantitative impact of the advanced approaches. The agencies have decided, therefore, not to recalibrate the framework at the present time based on QIS-4 results, but to await further experience with more fully developed bank risk measurement and management systems.

If there is a material reduction in aggregate minimum regulatory capital requirements upon implementation of Basel II-based rules, the agencies will propose regulatory changes or adjustments during the transitional floor periods. In this context, materiality will depend on a number of factors, including the size, source, and nature of any reduction; the risk profiles of banks authorized to use Basel II-based rules; and other considerations relevant to the maintenance of a safe and sound banking system. In any event, the agencies will view a 10 percent or greater decline in aggregate minimum required risk-based capital (without reference to the effects of the transitional floors described in a later section of this preamble), compared to minimum required risk-based capital as determined under the existing rules, as a material reduction warranting modifications to the supervisory risk functions or other aspects of this framework.

The agencies are, in short, identifying a numerical benchmark for evaluating and responding to capital outcomes during the parallel run and transitional floor periods that do not comport with the overall capital objectives outlined in the ANPR. At the end of the transitional floor periods, the agencies would re-evaluate the consistency of the framework, as (possibly) revised during the transitional floor periods, with the capital goals outlined in the ANPR and with the maintenance of broad competitive parity between banks adopting the framework and other banks, and would be prepared to make further changes to the framework if warranted.

Question 5: The agencies seek comment on this approach to ensuring that overall capital objectives are achieved.

The agencies also noted above that tier 1 capital requirements reported in QIS-4 declined substantially more than did total capital requirements. The agencies have long placed special emphasis on the importance of tier 1 capital in maintaining bank safety and soundness because of its ability to absorb losses on a going concern basis. The agencies will continue to monitor the trend in tier 1 capital requirements during the parallel run and transitional floor periods and will take appropriate action if reductions in tier 1 capital requirements are inconsistent with the agencies' overall capital goals.

Similar to the attention the agencies will give to overall risk-based capital requirements for the U.S. banking system, the agencies will carefully consider during the transitional floor periods whether dispersion in risk-based capital results across banks and portfolios appropriately reflects differences in risk. A conclusion by the agencies that dispersion in risk-based capital requirements does not appropriately reflect differences in risk could be another possible basis for proposing regulatory adjustments or refinements during the transitional floor periods.

It should also be noted that given the bifurcated regulatory capital framework that would result from the adoption of this rule, issues related to overall capital may be inextricably linked to the competitive issues discussed elsewhere in this document. The agencies indicated in the ANPR that if the competitive effects of differential capital requirements were deemed significant, “the Agencies would need to consider potential ways to address those effects while continuing to seek the objectives of the current proposal. Alternatives could potentially include modifications to the proposed approaches, as well as fundamentally different approaches.”

In this regard, the agencies view the parallel run and transitional floor periods as a trial of the new framework under controlled conditions. While the agencies hope and expect that regulatory changes proposed during those years would be in the nature of adjustments made within the framework described in this proposed rule, more fundamental changes cannot be ruled out if warranted based on future experience or comments received on this proposal.

68 FR 45900, 45905 (August 4, 2003).

The agencies reiterate that, especially in light of the QIS-4 results, retention of the tier 1 leverage ratio and other existing prudential safeguards (for example, PCA) is critical for the

preservation of a safe and sound regulatory capital framework. In particular, the leverage ratio is a straightforward and tangible measure of solvency and serves as a needed complement to the risk-sensitive Basel II framework based on internal bank inputs.

F. Competitive Considerations

A fundamental objective of the New Accord is to strengthen the soundness and stability of the international banking system while maintaining sufficient consistency in capital adequacy regulation to ensure that the New Accord will not be a significant source of competitive inequity among internationally active banks. The agencies support this objective and believe that it is crucial to promote continual advancement of the risk measurement and management practices of large and internationally active banks. For this reason, the agencies propose to implement only the advanced approaches of the New Accord because these approaches utilize the most sophisticated and risk-sensitive risk measurement and management techniques.

While all banks should work to enhance their risk management practices, the advanced approaches and the systems required to support their use may not be appropriate for many banks from a cost-benefit point of view. For these banks, the agencies believe that, with some modifications, the general risk-based capital rules are a reasonable alternative. As discussed in section E.2. above, this proposal's bifurcated approach to risk-based capital requirements raises difficult issues and inextricably links competitive considerations with overall capital issues. One such issue relates to concerns about competitive inequities between U.S. banks operating under different regulatory capital regimes. The ANPR cited this concern, and a number of commenters expressed their belief that in some portfolios competitive inequities would be worsened under the proposed bifurcated framework. These commenters expressed the concern that the Proposed New Accord might place community banks operating under the general risk-based capital rules at a competitive disadvantage to banks applying the advanced approaches because the IRB framework would likely result in lower risk-based capital requirements on some types of exposures, such as residential mortgage exposures, other retail exposures, and small business loans.

Some commenters asserted that the application of lower risk-based capital requirements under the Proposed New Accord would create a competitive disadvantage for banks operating under the general risk-based capital rules, which in turn may adversely affect their asset quality and cost of capital. Other commenters suggested that if the advanced approaches in the Proposed New Accord are implemented, the agencies should consider revising their general risk-based capital rules to enhance risk sensitivity and to mitigate potential competitive inequities associated with the bifurcated system.

The agencies recognize that the industry has concerns with the potential competitive inequities associated with a bifurcated risk-based capital framework. The agencies reaffirm their intention, expressed in the ANPR, to address competitive issues while continuing to pursue the objectives of the current proposal. In addition to the QIS-4 analysis discussed above, the agencies have also researched discrete topics to further understand where competitive pressures might arise. As part of their effort to develop a bifurcated risk-based capital framework that minimizes competitive inequities and is not disruptive to the banking sector, the agencies issued an Advance Notice of Proposed Rulemaking (Basel IA ANPR) considering various modifications to the general risk-based capital rules to improve risk sensitivity and to reduce potential competitive disparities between Basel II banks and non-Basel II banks.

The comment period for the Basel IA ANPR ended on January 18, 2006, and the agencies intend to consider all comments and issue for public comment a more fully developed risk-based capital proposal for non-Basel II banks. The comment period for the non-Basel II proposal is expected to overlap that of this proposal, allowing commenters to analyze the effects of the two proposals concurrently.

See

70 FR 61068 (Oct. 20, 2005).

In addition, some commenters expressed concern about competitive inequities arising from differences in implementation and application of the New Accord by supervisory authorities in different countries. In particular, some commenters expressed concern about the different implementation timetables of various jurisdictions, and differences in the scope of application in various jurisdictions or in the range of approaches that different jurisdictions will allow. The BCBS has established an Accord Implementation Group, comprised of supervisors from member countries, whose primary objectives are to work through implementation issues, maintain a constructive dialogue about implementation processes, and harmonize approaches as much as possible within the range of national discretion embedded in the New Accord.

While supervisory judgment will play a critical role in the evaluation of risk measurement and management practices at individual banks, supervisors are committed to developing protocols and information-sharing arrangements that should minimize burdens on banks operating in multiple countries and ensure that supervisory authorities are implementing the New Accord as consistently as possible. The New Accord identifies numerous areas where national discretion is encouraged. This design was intended to enable national supervisors to implement the methodology, or combination of methodologies, most appropriate for banks in their jurisdictions. Disparate implementation decisions are expected, particularly during the transition years. Over time, the agencies expect that industry and supervisory practices likely will converge in many areas, thus mitigating differences across countries. Competitive considerations, both internationally and domestically, will be monitored and discussed by the agencies on an ongoing basis. With regard to implementation timing concerns, the agencies believe that the transitional arrangements described in section III.A. of this preamble below provide a prudent and reasonable framework for moving to the advanced approaches. Where international implementation differences affect an individual bank, the agencies expect to work with the bank and appropriate national supervisory authorities for the bank to ensure that implementation proceeds as smoothly as possible.

Question 6: The agencies seek comment on all potential competitive aspects of this proposal and on any specific aspects of the proposal that might raise competitive concerns for any bank or group of banks.

II. Scope

The agencies have identified three groups of banks: (i) Large or internationally active banks that would be required to adopt the advanced approaches in the proposed rule (core banks); (ii) banks that voluntarily decide to adopt the advanced approaches (opt-in banks); and (iii) banks that do not adopt the advanced approaches (general banks). Each core and opt-in bank would be required to meet certain qualification requirements to the satisfaction of its primary Federal supervisor, in consultation with other

relevant supervisors, before the bank may use the advanced approaches for risk-based capital purposes.

Pillar I of the New Accord requires all banks subject to the New Accord to calculate capital requirements for exposure to both credit risk and operational risk. The New Accord provides a bank three approaches to calculate its credit risk capital requirement and three approaches to calculate its operational risk capital requirement. Outside the United States, countries that are replacing Basel I with the New Accord generally have required all banks to comply with the New Accord, but have provided banks the option of choosing among the New Accord's various approaches for calculating credit risk and operational risk capital requirements.

For banks in the United States, the NPR, like the ANPR, takes a different approach. It would not subject all U.S. banks to the New Accord, but instead focuses on only the largest and most internationally active banks. Due to the size and complexity of these banks, the NPR would require core banks to comply with the most advanced approaches for calculating credit and operational risk capital requirements “ that is, the IRB and the AMA. In addition, the NPR would allow other U.S. banks to “opt in” to Basel II-based rules, but, as with core banks, the only Basel II-based rules available to U.S. “opt-in” banks would be the New Accord's most advanced approaches.

Question 7: The agencies request comment on whether U.S. banks subject to the advanced approaches in the proposed rule (that is, core banks and opt-in banks) should be permitted to use other credit and operational risk approaches similar to those provided under the New Accord. With respect to the credit risk capital requirement, the agencies request comment on whether banks should be provided the option of using a U.S. version of the so-called “standardized approach” of the New Accord and on the appropriate length of time for such an option.

Despite the options provided in national legislation and rules, most non-U.S. banks comparable in size and complexity to U.S. core banks are adopting some form of the advanced approaches. For example, based on currently available information, the vast majority of large, internationally-active banks based outside of the United States plan to employ an internal ratings-based approach in the calculation of credit risk capital requirements.

A. Core and Opt-In Banks

A DI is a core bank if it meets either of two independent threshold criteria: (i) Consolidated total assets of $250 billion or more, as reported on the most recent year-end regulatory reports; or (ii) consolidated total on-balance sheet foreign exposure of $10 billion or more at the most recent year-end. To determine total on-balance sheet foreign exposure, a bank would sum its adjusted cross-border claims, local country claims, and cross-border revaluation gains (calculated in accordance with the Federal Financial Institutions Examination Council (FFIEC) Country Exposure Report (FFIEC 009)). Adjusted cross-border claims would equal total cross-border claims less claims with the head office/guarantor located in another country, plus redistributed guaranteed amounts to the country of head office/guarantor. A DI also is a core bank if it is a subsidiary of another DI or BHC that uses the advanced approaches.

Under the proposed rule, a U.S.-chartered BHC

is a core bank if the BHC has: (i) Consolidated total assets (excluding assets held by an insurance underwriting subsidiary) of $250 billion or more, as reported on the most recent year-end regulatory reports; (ii) consolidated total on-balance sheet foreign exposure of $10 billion or more at the most recent year-end; or (iii) a subsidiary DI that is a core bank or opt-in bank. Currently 11 top-tier banking organizations meet these criteria. The agencies note that, using this approach to define whether a BHC is a core bank, it is possible that no single DI under a BHC would meet the threshold criteria, but that all of the BHC's subsidiary DIs would be core banks.

OTS does not currently impose any explicit capital requirements on savings and loan holding companies and does not propose to apply the Basel II proposal to these holding companies.

The proposed BHC consolidated asset threshold is different from the threshold in the ANPR, which applied to the total consolidated DI assets of a BHC. The proposed shift to total consolidated assets (excluding assets held by an insurance underwriting subsidiary) recognizes that BHCs can hold similar assets within and outside of DIs and reduces potential incentives to structure BHC assets and activities to arbitrage capital regulations. The proposed rule excludes assets held in an insurance underwriting subsidiary of a BHC because the New Accord was not designed to address insurance company exposures.

Question 8A: The Board seeks comment on the proposed BHC consolidated non-insurance assets threshold relative to the consolidated DI assets threshold in the ANPR.

A bank that is subject to the proposed rule either as a core bank or as an opt-in bank would be required to apply the rule unless its primary Federal supervisor determines in writing that application of the rule is not appropriate in light of the bank's asset size, level of complexity, risk profile, or scope of operations.

Question 8B: The agencies seek comment on the proposed scope of application. In particular, the agencies seek comment on the regulatory burden of a framework that requires the advanced approaches to be implemented by each subsidiary DI of a BHC or bank that uses the advanced approaches.

B. U.S. DI Subsidiaries of Foreign Banks

Any U.S.-chartered DI that is a subsidiary of a foreign banking organization is subject to the U.S. regulatory capital requirements applied to domestically-owned U.S. DIs. Thus, if the U.S. DI subsidiary of a foreign banking organization meets any of the threshold criteria, it would be a core bank and would be subject to the advanced approaches. If it does not meet any of the criteria, the U.S. DI may remain a general bank or may opt-in to the advanced approaches, subject to the same qualification process and requirements as a domestically-owned U.S. DI. A top-tier U.S. BHC, and its subsidiary DIs, that is owned by a foreign banking organization also would be subject to the same threshold levels for core bank determination as would a top-tier BHC that is not owned by a foreign banking organization. A U.S. BHC that meets the conditions in Federal Reserve SR letter 01-01

and is a core bank would not be required to meet the minimum capital ratios in the Board's capital adequacy guidelines, although it would be required to adopt the advanced approaches, compute and report its capital ratios in accordance with the advanced approaches, and make the required public and regulatory disclosures.

SR 01-01, “Application of the Board's Capital Adequacy Guidelines to Bank Holding Companies Owned by Foreign Banking Organizations,” January 5, 2001.

A DI subsidiary of such a U.S. BHC would be a core bank and would be required to adopt the advanced approaches (unless specifically exempted from the advanced approaches by its primary Federal supervisor) and meet the minimum capital ratio requirements. In addition, the Board retains its supervisory authority to require any BHC, including a U.S. BHC owned or controlled by a foreign banking organization that is or is treated as a financial holding company (FHC), to maintain capital levels above

the regulatory minimums.

Question 9: The agencies seek comment on the application of the proposed rule to DI subsidiaries of a U.S. BHC that meets the conditions in Federal Reserve SR letter 01-01 and on the principle of national treatment in this context.

C. Reservation of Authority

The proposed rule would restate the authority of a bank's primary Federal supervisor to require the bank to hold an overall amount of capital greater than would otherwise be required under the rule if the agency determines that the bank's risk-based capital requirements under the rule are not commensurate with the bank's credit, market, operational, or other risks. In addition, the agencies anticipate that there may be instances when the proposed rule generates a risk-weighted asset amount for specific exposures that is not commensurate with the risks posed by such exposures. In these cases, under the proposed rule, the bank's primary Federal supervisor would retain the authority to require the bank to use a different risk-weighted asset amount for the exposures or to use different risk parameters (for wholesale or retail exposures) or model assumptions (for modeled equity or securitization exposures) than those required in the proposed rule when calculating the risk-weighted asset amount for those exposures. Similarly, the proposed rule would provide authority for a bank's primary Federal supervisor to require the bank to assign a different risk-weighted asset amount for operational risk, to change elements of its operational risk analytical framework (including distributional and dependence assumptions), or to make other changes to the bank's operational risk management processes, data and assessment systems, or quantification systems if the supervisor finds that the risk-weighted asset amount for operational risk produced by the bank under the rule is not commensurate with the operational risks of the bank. Any agency that exercises this reservation of authority would notify each of the other agencies of its determination.

III. Qualification

A. The Qualification Process

1. In General

Supervisory qualification to use the advanced approaches is a continuous and iterative process that begins when a bank's board of directors adopts an implementation plan and continues as the bank operates under the advanced approaches. Before a bank may use the advanced approaches for risk-based capital purposes, it must develop and adopt a written implementation plan, establish and maintain a comprehensive and sound planning and governance process to oversee the implementation efforts described in the plan, demonstrate to its primary Federal supervisor that it meets the qualification requirements in section 22 of the proposed rule, and complete a satisfactory “parallel run” (discussed below). A bank's primary Federal supervisor would be responsible, after consultation with other relevant supervisors, for evaluating the bank's initial and ongoing compliance with the qualification requirements for the advanced approaches.

The agencies will jointly issue supervisory guidance describing agency expectations for wholesale, retail, securitization, and equity exposures, as well as for operational risk.

The agencies recognize that a consistent and transparent process to oversee implementation of the advanced approaches is crucial, and will consult with each other on significant issues raised during the implementation process.

The agencies have issued for public comment draft supervisory guidance on corporate and retail exposures and operational risk.

See

68 FR 45949 (Aug. 4, 2003); 69 FR 62748 (Oct. 27, 2004).

Under the proposed rule, a bank preparing to implement the advanced approaches must adopt a written implementation plan, approved by its board of directors, describing in detail how the bank complies, or intends to comply, with the qualification requirements. A core bank must adopt a plan no later than six months after it meets a threshold criterion in section 1(b)(1) of the proposed rule. If a bank meets a threshold criterion on the effective date of the final rule, the bank would have to adopt a plan within six months of the effective date. Banks that do not meet a threshold criterion, but are nearing any criterion by direct growth or merger, would be expected to engage in ongoing dialogue with their primary Federal supervisor regarding implementation strategies to ensure their readiness to adopt the advanced approaches when a threshold criterion is reached. An opt-in bank may adopt an implementation plan at any time, but must adopt an implementation plan and notify its primary Federal supervisor in writing at least twelve months before it proposes to begin the first floor period (as discussed later in this section of the preamble).

In developing an implementation plan, a bank must assess its current state of readiness relative to the qualification requirements in this proposed rule and related supervisory guidance. This assessment would include a gap analysis that identifies where additional work is needed and a remediation or action plan that clearly sets forth how the bank intends to fill the gaps it has identified. The implementation plan must comprehensively address the qualification requirements for the bank and each of its consolidated subsidiaries (U.S. and foreign-based) with respect to all portfolios and exposures of the bank and each of its consolidated subsidiaries. The implementation plan must justify and support any proposed temporary or permanent exclusion of a business line, portfolio, or exposure from the advanced approaches. The business lines, portfolios, and exposures that the bank proposes to exclude from the advanced approaches must be, in the aggregate, immaterial to the bank. The implementation plan must include objective, measurable milestones (including delivery dates and a date when the bank's implementation of the advanced approaches will be fully operational). For core banks, the implementation plan must include an explicit first floor period start date that is no later than 36 months after the later of the effective date of the rule or the date the bank meets at least one of the threshold criteria.

Further, the implementation plan must describe the resources that the bank has budgeted and are available to implement the plan.

The bank's primary Federal supervisor may extend the bank's first floor period start date.

During implementation of the advanced approaches, a bank would work closely with its primary Federal supervisor to ensure that its risk measurement and management systems are fully functional and reliable and are able to generate risk parameter estimates that can be used to calculate the risk-based capital ratios correctly under the advanced approaches. The implementation plan, including the gap analysis and action plan, will provide a basis for ongoing supervisory dialogue and review during this period. The primary Federal supervisor will assess a bank's progress relative to its implementation plan. To the extent that adjustments to target dates are needed, these adjustments would be made subject to the ongoing supervisory discussion between the bank and its primary Federal supervisor.

2. Parallel Run and Transitional Floor Periods

Once a bank has adopted its implementation plan, it must complete

a satisfactory parallel run before it may use the advanced approaches to calculate its risk-based capital requirements. A satisfactory parallel run is a period of at least four consecutive calendar quarters during which the bank complies with all of the qualification requirements to the satisfaction of its primary Federal supervisor. During this period, the bank would continue to be subject to the general risk-based capital rules but would simultaneously calculate its risk-based capital ratios under the advanced approaches. During the parallel run period, a bank would report its risk-based capital ratios under both the general risk-based capital rules and the advanced approaches to its primary Federal supervisor through the supervisory process on a quarterly basis. The agencies will share this information with each other for calibration and other analytical purposes.

A bank's primary Federal supervisor would notify the bank of the date when it may begin to use the advanced approaches for risk-based capital purposes. A bank would not be permitted to begin using the advanced approaches for risk-based capital purposes until its primary Federal supervisor is satisfied that the bank fully complies with the qualification requirements, the bank has satisfactorily completed a parallel run, and the bank has an adequate process to ensure ongoing compliance with the qualification requirements.

To provide for a smooth transition to the advanced approaches, the proposed rule would impose temporary limits on the amount by which a bank's risk-based capital requirements could decline over a period of at least three years (that is, at least four consecutive calendar quarters in each of the three transitional floor periods). Based on its assessment of the bank's ongoing compliance with the qualification requirements, a bank's primary Federal supervisor would determine when the bank is ready to move from one transitional floor period to the next period and, after the full transition has been completed, to move to stand-alone use of the advanced approaches. Table B sets forth the proposed transitional floor periods for banks moving to the advanced approaches:

Table B.—Transitional Floors

Transitional floor period

Transitional floor percentage

First floor period

Second floor period

Third floor period

During the transitional floor periods, a bank would calculate its risk-weighted assets under the general risk-based capital rules. Next, the bank would multiply this risk-weighted assets amount by the appropriate floor percentage in the table above. This product would be the bank's “floor-adjusted” risk-weighted assets. Third, the bank would calculate its tier 1 and total risk-based capital ratios using the definitions of tier 1 and tier 2 capital (and associated deductions and adjustments) in the general risk-based capital rules for the numerator values and floor-adjusted risk-weighted assets for the denominator values. These ratios would be referred to as the “floor-adjusted risk-based capital ratios.”

The bank also would calculate its tier 1 and total risk-based capital ratios using the definitions and rules in this proposed rule. These ratios would be referred to as the “advanced approaches risk-based capital ratios.” In addition, the bank would calculate a tier 1 leverage ratio using tier 1 capital as defined in this proposed rule for the numerator of the ratio.

During a bank's transitional floor periods, the bank would report all five regulatory capital ratios described above—two floor-adjusted risk-based capital ratios, two advanced approaches risk-based capital ratios, and one leverage ratio. To determine its applicable capital category for PCA purposes and for all other regulatory and supervisory purposes, a bank's risk-based capital ratios during the transitional floor periods would be set equal to the lower of the respective floor-adjusted risk-based capital ratio and the advanced approaches risk-based capital ratio. During the transitional floor periods, a bank's tier 1 capital and tier 2 capital for all non-risk-based-capital supervisory and regulatory purposes (for example, lending limits and Regulation W quantitative limits) would be the bank's tier 1 capital and tier 2 capital as calculated under the advanced approaches.

Thus, for example, in order to be well capitalized under PCA, a bank would have to have a floor-adjusted tier 1 risk-based capital ratio and an advanced approaches tier 1 risk-based capital ratio of 6 percent or greater, a floor-adjusted total risk-based capital ratio and an advanced approaches total risk-based capital ratio of 10 percent or greater, and a tier 1 leverage ratio of 5 percent or greater (with tier 1 capital calculated under the advanced approaches). Although the PCA rules do not apply to BHCs, a BHC would be required to report all five of these regulatory capital ratios and would have to meet applicable supervisory and regulatory requirements using the lower of the respective floor-adjusted risk-based capital ratio and the advanced approaches risk-based capital ratio.

After a bank completes its transitional floor periods and its primary Federal supervisor determines the bank may begin using the advanced approaches with no further transitional floor, the bank would use its tier 1 and total risk-based capital ratios as calculated under the advanced approaches and its tier 1 leverage ratio calculated using the advanced approaches definition of tier 1 capital for PCA and all other supervisory and regulatory purposes.

The transitional floor calculations described above are linked to the general risk-based capital rules. As noted above, the agencies issued the Basel IA ANPR outlining possible modifications to those rules and are developing an NPR in this regard. The agencies are still considering the extent and nature of these modifications to the general risk-based capital rules and the scope of application of these modifications, including for banks that transition to the advanced approaches. The agencies expect banks that meet the threshold criteria in section 1(b)(1) of the proposed rule (that is, core banks) as of the effective date of the rule, and banks that opt-in pursuant to section 1(b)(2) at the earliest possible date, will use the general risk-based capital rules in place immediately before the rule becomes effective both during the parallel run and as a basis for the transitional floor calculations. Other changes to the general risk-based capital rules (outside the scope of the changes outlined in the Basel IA ANPR) may be considered by the agencies, as appropriate.

Question 10: The agencies seek comment on this approach, including the transitional floor thresholds and transition period, and on how and to what extent future modifications to the general risk-based capital rules should be incorporated into the transitional floor calculations for advanced approaches banks.

Banks' computation of risk-based capital requirements under both the general risk-based capital rules and the advanced approaches will help the agencies assess the impact of the advanced approaches on overall capital requirements, including whether the change in capital requirements relative to the general risk-based capital rules is consistent with the agencies' overall capital objectives.

Question 11: The agencies seek comment on what other information should be considered in deciding whether those overall capital goals have been achieved.

The agencies are proposing to make 2008 the first possible year for a bank to conduct its parallel run and 2009-2011 the first possible years for the three transitional floor periods.

Question 12: The agencies seek comment on this proposed timetable for implementing the advanced approaches in the United States.

B. Qualification Requirements

Because the Basel II framework uses banks' estimates of certain key risk parameters to determine risk-based capital requirements, the advanced approaches would introduce greater complexity to the regulatory capital framework and would require banks using the advanced approaches to possess a high level of sophistication in risk measurement and risk management systems. As a result, the agencies propose to require each core or opt-in bank to meet the qualification requirements described in section 22 of the proposed rule to the satisfaction of its primary Federal supervisor for a period of at least four consecutive calendar quarters before using the advanced approaches to calculate its minimum risk-based capital requirements (subject to the transitional floors for at least an additional three years). The qualification requirements are written broadly to accommodate the many ways a bank may design and implement a robust internal credit and operational risk measurement and management system and to permit industry practice to evolve.

Many of the qualification requirements relate to a bank's advanced IRB systems. A bank's advanced IRB systems must incorporate five interdependent components in a framework for evaluating credit risk and measuring regulatory capital:

(i) A risk rating and segmentation system that assigns ratings to individual wholesale obligors and exposures and assigns individual retail exposures to segments;

(ii) A quantification process that translates the risk characteristics of wholesale obligors and exposures and segments of retail exposures into numerical risk parameters that are used as inputs to the IRB risk-based capital formulas;

(iii) An ongoing process that validates the accuracy of the rating assignments, segmentations, and risk parameters;

(iv) A data management and maintenance system that supports the advanced IRB systems; and

(v) Oversight and control mechanisms that ensure the advanced IRB systems are functioning effectively and producing accurate results.

1. Process and Systems Requirements

One of the objectives of the proposed framework is to provide appropriate incentives for banks to develop and use better techniques for measuring and managing their risks. The proposed rule specifically requires a bank to have a rigorous process for assessing its overall capital adequacy in relation to its total risk profile and a comprehensive strategy for maintaining appropriate capital levels. Consistent with Pillar 2 of the New Accord, a bank's primary Federal supervisor will evaluate how well the bank is assessing its capital needs relative to its risks and, if deficiencies are identified, will take any necessary action to ensure that appropriate and prudent levels of capital are maintained.

A bank should address all of its material risks in its overall capital assessment process. Although not every risk can be measured precisely, the following risks, at a minimum, should be factored into a bank's capital assessment process: credit risk, market risk, operational risk, interest rate risk in the banking book, liquidity risk, concentration risk, reputational risk, and strategic risk. With regard to interest rate risk in the banking book, the agencies note that for some assets—for example, a long-term mortgage loan—interest rate risk may be as great as, or greater than, the credit risk of the asset. The agencies will continue to focus attention on exposures where interest rate risk may be significant and will foster sound interest rate risk measurement and management practices across banks. Additionally, because credit risk concentrations can pose substantial risk to a bank that might be managing individual credits in a satisfactory manner, a bank also should give proper attention to such concentrations.

Banks already are required to hold capital sufficient to meet their risk profiles, and existing rules allow Federal supervisors to require a bank to increase its capital if its current capital levels are deficient or some element of its business practices suggests the need for more capital. Existing supervisory guidance directs banks to meaningfully tie the identification, monitoring, and evaluation of risk to the determination of the bank's capital needs. Banks are expected to implement and continually update the fundamental elements of a sound internal capital adequacy analysis—identifying and measuring all material risks, setting capital adequacy goals that relate to risk, and assessing conformity to the bank's stated objectives. The agencies expect that all banks operating under the advanced approaches would address specific assumptions embedded in the advanced approaches (such as diversification in credit portfolios), and would evaluate these banks, in part, on their ability to account for deviations from the underlying assumptions in their own portfolios.

As noted, each core or opt-in bank would apply the advanced approaches for risk-based capital purposes at the consolidated top-tier legal entity level (that is, either the top-tier BHC or top-tier DI that is a core or opt-in bank) and at the level of each DI that is a subsidiary of such a top-tier legal entity. Thus, each bank that applies the advanced approaches must have an appropriate infrastructure with risk measurement and management processes that meet the proposed rule's qualification requirements and that are appropriate given the bank's size and level of complexity. Regardless of whether the systems and models that generate the risk parameters necessary for calculating a bank's risk-based capital requirements are located at any affiliate of the bank, each legal entity that applies the advanced approaches must ensure that the risk parameters (that is, PD, ELGD, LGD, EAD, and M) and reference data used to determine its risk-based capital requirements are representative of its own credit and operational risk exposures.

The proposed rule also requires that the systems and processes that an advanced approaches bank uses for risk-based capital purposes must be sufficiently consistent with the bank's internal risk management processes and management information reporting systems such that data from the latter processes and systems can be used to verify the reasonableness of the inputs the bank uses for risk-based capital purposes.

2. Risk Rating and Segmentation Systems for Wholesale and Retail Exposures

To implement the IRB framework, a bank must have internal risk rating and segmentation systems that accurately and reliably differentiate between degrees of credit risk for wholesale and retail exposures. As described below, wholesale exposures include most credit exposures to companies, sovereigns, and governmental entities, as well as some exposures to individuals. Retail exposures include most credit exposures to individuals and small businesses that are managed as part of a segment of exposures with homogeneous risk characteristics. Together, wholesale and retail

exposures cover most credit exposures of banks.

To differentiate among degrees of credit risk, a bank must be able to make meaningful and consistent distinctions among credit exposures along two dimensions—default risk and loss severity in the event of a default. In addition, a bank must be able to assign wholesale obligors to rating grades that approximately reflect likelihood of default and must be able to assign wholesale exposures to rating grades (or ELGD and LGD estimates) that approximately reflect the loss severity expected in the event of default. As discussed below, the proposed rule requires banks to treat wholesale exposures differently from retail exposures when differentiating among degrees of credit risk.

Wholesale exposures.

For wholesale exposures, a bank must have an internal risk rating system that indicates the likelihood of default of each individual obligor and may use an internal risk rating system that indicates the economic loss rate upon default of each individual exposure.

A bank would assign an internal risk rating to each wholesale obligor, which should reflect the obligor's PD—that is, its long-run average one-year default rate over a reasonable mix of economic conditions. PD is defined in more detail below.

As explained below, a bank that chooses not to use an internal risk rating system for ELGD and LGD for a wholesale exposure must directly assign an ELGD and LGD estimate to the wholesale exposure.

In determining an obligor rating, a bank should consider key obligor attributes, including both quantitative and qualitative factors that could affect the obligor's default risk. From a quantitative perspective, this could include an assessment of the obligor's historic and projected financial performance, trends in key financial performance ratios, financial contingencies, industry risk, and the obligor's position in the industry. On the qualitative side, this could include an assessment of the quality of the obligor's financial reporting, non-financial contingencies (for example, labor problems and environmental issues), and the quality of the obligor's management based on an evaluation of management's ability to make realistic projections, management's track record in meeting projections, and management's ability to effectively deal with changes in the economy and the competitive environment.

A bank must assign each legal entity wholesale obligor to a single rating grade. Accordingly, if a single wholesale exposure of the bank to an obligor triggers the proposed rule's definition of default, all of the bank's wholesale exposures to that obligor are in default for risk-based capital purposes. In addition, a bank may not consider the value of collateral pledged to support a particular wholesale exposure (or any other exposure-specific characteristics) when assigning a rating to the obligor of the exposure, even in the context of nonrecourse loans and other loans underwritten primarily based on the operating income or cash flows from real estate collateral. A bank may, of course, consider all available financial information about the obligor—including, where applicable, the total operating income or cash flows from all of the obligor's projects or businesses—when assigning an obligor rating.

Question 13: The agencies seek comment on this aspect of the proposed rule and on any circumstances under which it would be appropriate to assign different obligor ratings to different exposures to the same obligor (for example, income-producing property lending or exposures involving transfer risk).

A bank's rating system must have at least seven discrete (non-overlapping) obligor grades for non-defaulted obligors and at least one obligor grade for defaulted obligors. The agencies believe that because the risk-based capital requirement of a wholesale exposure is directly linked to its obligor rating grade, a bank must have at least seven non-overlapping obligor grades to sufficiently differentiate the creditworthiness of non-defaulted wholesale obligors.

A bank would capture the estimated loss severity upon default for a wholesale exposure either by directly assigning an ELGD and LGD estimate to the exposure or by grouping the exposure with other wholesale exposures into loss severity rating grades (reflecting the bank's estimate of the ELGD or LGD of the exposure). The LGD of an exposure is an estimate of the economic loss rate on the exposure, taking into account related material costs and recoveries, in the event of the obligor's default during a period of economic downturn conditions. LGD is described in more detail below. Whether a bank chooses to assign ELGD and LGD values directly or, alternatively, to assign exposures to rating grades and then quantify the ELGD or LGD, as appropriate, for the rating grades, the key requirement is that the bank must identify exposure characteristics that influence ELGD and LGD. Each of the loss severity rating grades would be associated with an empirically supported ELGD or LGD estimate. Banks employing loss severity grades must have a sufficiently granular loss severity grading system to avoid grouping together exposures with widely ranging ELGDs or LGDs.

Retail exposures.

To implement the advanced approach for retail exposures, a bank must have an internal system that segments its retail exposures to differentiate accurately and reliably among degrees of credit risk. The most significant difference between the proposed rule's treatment of wholesale and retail exposures is that the risk parameters for retail exposures are not assigned at the individual exposure level. Banks typically manage retail exposures on a segment basis, where each segment contains exposures with similar risk characteristics. Therefore, a key characteristic of the proposed rule's retail framework is that the risk parameters for retail exposures would be assigned to segments of exposures rather than to individual exposures. Under the retail framework, a bank would group its retail exposures into segments with homogeneous risk characteristics and then estimate PD, ELGD, and LGD for each segment.

A bank must first group its retail exposures into three separate subcategories: (i) Residential mortgage exposures; (ii) QREs; and (iii) other retail exposures. The bank would then classify the retail exposures in each subcategory into segments to produce a meaningful differentiation of risk. The proposed rule requires banks to segment separately (i) defaulted retail exposures from non-defaulted retail exposures and (ii) retail eligible margin loans for which the bank adjusts EAD rather than ELGD and LGD to reflect the risk mitigating effects of financial collateral from other retail eligible margin loans. Otherwise, the agencies are not proposing to require that banks consider any particular risk drivers or employ any minimum number of segments in any of the three retail subcategories.

In determining how to segment retail exposures within each subcategory for the purpose of assigning risk parameters, a bank should use a segmentation approach that is consistent with its approach for internal risk assessment purposes and that classifies exposures according to predominant risk characteristics or drivers. Examples of risk drivers could include loan-to-value (LTV) ratios, credit scores, loan terms and structure (for example, interest only or payment option adjustable rate mortgages), origination channel, geographical location of the borrower, and collateral type. A bank must be able to demonstrate to its primary Federal

supervisor that its system assigns accurate and reliable PD, ELGD, and LGD estimates for each retail segment on a consistent basis.

Definition of default.

In the ANPR, the agencies proposed to define default for a wholesale exposure as either or both of the following events: (i) The bank determines that the borrower is unlikely to pay its obligations to the bank in full, without recourse to actions by the bank such as the realization of collateral; or (ii) the borrower is more than 90 days past due on principal or interest on any material obligation to the bank.

A number of commenters encouraged the agencies to use a definition of default that conforms more closely to that used by bank risk managers. Many of these commenters recommended that the agencies define default as the entry into non-accrual status for wholesale exposures and the number of days past due for retail exposures, or as the entry into charge-off status for wholesale and retail exposures. The agencies have amended the ANPR definitions of default to respond to these concerns and recognize that the definition of default in this proposed rule is different from the definitions that are being implemented in other jurisdictions.

Under the proposed rule's definition of default, a bank's wholesale obligor would be in default if, for any credit exposure of the bank to the obligor, the bank has (i) placed the exposure on non-accrual status consistent with the Call Report Instructions or the Thrift Financial Report and the Thrift Financial Report Instruction Manual; (ii) taken a full or partial charge-off or write-down on the exposure due to the distressed financial condition of the obligor; or (iii) incurred a credit-related loss of 5 percent or more of the exposure's initial carrying value in connection with the sale of the exposure or the transfer of the exposure to the held-for-sale, available-for-sale, trading account, or other reporting category. Under the proposed definition, a wholesale exposure to an obligor remains in default until the bank has reasonable assurance of repayment and performance for all contractual principal and interest payments on all exposures of the bank to the obligor (other than exposures that have been fully written-down or charged-off). The agencies would expect a bank to employ standards for determining whether it has a reasonable assurance of repayment and performance that are similar to those for determining whether to restore a loan from non-accrual to accrual status.

When a bank sells a set of wholesale exposures, the bank must examine the sale prices of the individual exposures contained in the set and evaluate whether a credit loss of 5 percent or more of the exposure's initial carrying value has occurred on any given exposure. Write-downs of securities that are not credit-related (for example, a write-down that is due to a change in market interest rates) would not be a default event.

Question 14: The agencies seek comment on this proposed definition of default and on how well it captures substantially all of the circumstances under which a bank could experience a material credit-related economic loss on a wholesale exposure. In particular, the agencies seek comment on the appropriateness of the 5 percent credit loss threshold for exposures sold or transferred between reporting categories. The agencies also seek commenters' views on specific issues raised by applying different definitions of default in multiple national jurisdictions and on ways to minimize potential regulatory burden, including use of the definition of default in the New Accord, keeping in mind that national bank supervisory authorities must adopt default definitions that are appropriate in light of national banking practices and conditions.

In response to comments on the ANPR, the agencies propose to define default for retail exposures according to the timeframes for loss classification that banks generally use for internal purposes and that are embodied in the FFIEC's Uniform Retail Credit Classification and Account Management Policy.

Specifically, revolving retail exposures and residential mortgages would be in default at 180 days past due; other retail exposures would be in default at 120 days past due. In addition, a retail exposure would be in default if the bank has taken a full or partial charge-off or write-down of principal on the exposure for credit-related reasons. Such an exposure would remain in default until the bank has reasonable assurance of repayment and performance for all contractual principal and interest payments on the exposure.

FFIEC, “Uniform Retail Credit Classification and Account Management Policy,” 65 FR 36903 (June 12, 2000).

The proposed definition of default for retail exposures differs from the proposed definition for the wholesale portfolio in several important respects. First, the proposed retail default definition applies on an exposure-by-exposure basis (rather than, as is the case for wholesale exposures, on an obligor-by-obligor basis). In other words, default on one retail exposure would not require a bank to treat all other obligations of the same obligor to the bank as defaulted. This difference reflects the fact that banks generally manage retail credit risk based on segments of similar exposures rather than through the assignment of ratings to particular obligors. In addition, it is quite common for retail borrowers that default on some of their obligations to continue payment on others.

Second, the retail definition of default, unlike the wholesale definition of default, does not include exposures placed on non-accrual status. The agencies recognize that retail non-accrual practices vary considerably among banks. Accordingly, the agencies have determined that removing non-accrual from the retail definition of default would promote greater consistency among banks in the treatment of retail exposures.

In addition, the retail definition of default, unlike the wholesale definition of default, does not explicitly state that an exposure is in default if a bank incurs credit-related losses of 5 percent or more in connection with the sale of the exposure. Because of the large number of diverse retail exposures that banks usually sell in a single transaction, banks typically do not allocate the sales price of a pool of retail exposures in such a way as to enable the bank to calculate the premium or discount on individual retail exposures. Although the proposed rule's definition of retail default does not explicitly include credit-related losses in connection with loan sales, the agencies would expect banks to assess carefully the impact of retail exposure sales in quantifying the risk parameters calculated by the bank for its retained retail exposures.

Rating philosophy.

A bank must explain to its primary Federal supervisor its rating philosophy—that is, how the bank's wholesale obligor rating assignments are affected by the bank's choice of the range of economic, business, and industry conditions that are considered in the obligor rating process. The philosophical basis of a bank's ratings system is important because, when combined with the credit quality of individual obligors, it will determine the frequency of obligor rating changes in a changing economic environment. Rating systems that rate obligors based on their ability to perform over a wide range of economic, business, and industry conditions, sometimes described as “through-the-cycle” systems, would tend to have ratings that migrate more slowly as conditions change. Banks that rate

obligors based on a more narrow range of likely expected conditions (primarily on recent conditions), sometimes called “point-in-time” systems, would tend to have ratings that migrate more frequently. Many banks will rate obligors using an approach that considers a combination of the current conditions and a wider range of other likely conditions. In any case, the bank would need to specify the rating philosophy used and establish a policy for the migration of obligors from one rating grade to another in response to economic cycles. A bank should understand the effects of ratings migration on its risk-based capital requirements and ensure that sufficient capital is maintained during all phases of the economic cycle.

Rating and segmentation reviews and updates.

A bank must have a policy that ensures that each wholesale obligor rating and (if applicable) wholesale exposure loss severity rating reflects current information. A bank's internal risk rating system for wholesale exposures must provide for the review and update (as appropriate) of each obligor rating and (if applicable) loss severity rating whenever the bank receives new material information, but no less frequently than annually. A bank's retail exposure segmentation system must provide for the review and update (as appropriate) of assignments of retail exposures to segments whenever the bank receives new material information, but no less frequently than quarterly.

3. Quantification of Risk Parameters for Wholesale and Retail Exposures

A bank must have a comprehensive risk parameter quantification process that produces accurate, timely, and reliable estimates of the risk parameters—PD, ELGD, LGD, EAD, and (for wholesale exposures) M—for its wholesale obligors and exposures and retail exposures. Statistical methods and models used to develop risk parameter estimates, as well as any adjustments to the estimates or empirical default data, should be transparent, well supported, and documented. The following sections of the preamble discuss the proposed rule's definitions of the risk parameters for wholesale and retail exposures.

Probability of default (PD).

As noted above, under the proposed rule, a bank must assign each of its wholesale obligors to an internal rating grade and then must associate a PD with each rating grade. PD for a wholesale exposure to a non-defaulted obligor would be the bank's empirically based best estimate of the long-run average of one-year default rates for the rating grade assigned by the bank to the obligor, capturing the average default experience for obligors in the rating grade over a mix of economic conditions (including economic downturn conditions) sufficient to provide a reasonable estimate of the average one-year default rate over the economic cycle for the rating grade. This estimate of the long-run average PD is converted into an estimate of PD under economic downturn conditions as part of the IRB risk-based capital formulas.

In addition, under the proposed rule, a bank must assign a PD to each segment of retail exposures. The proposed rule provides two different definitions of the PD of a segment of non-defaulted retail exposures based on the materiality of seasoning effects for the segment or for the segment's retail exposure subcategory. Some types of retail exposures display a distinct seasoning pattern—that is, the exposures have relatively low default rates in their first year, rising default rates in the next few years, and declining default rates for the remainder of their terms. A bank must use a separate definition of PD that addresses seasoning effects for a segment of non-defaulted retail exposures unless the bank has determined that seasoning effects are not material for the segment or for the segment's entire retail exposure subcategory.

The proposed rule provides a definition of PD for segments of non-defaulted retail exposures where seasoning is not a material consideration that tracks closely the wholesale PD definition. Specifically, PD for a segment of non-defaulted retail exposures for which seasoning effects are not material, or for a segment of non-defaulted retail exposures in a retail exposure subcategory for which seasoning effects are not material, would be the bank's empirically based best estimate of the long-run average of one-year default rates for the exposures in the segment, capturing the average default experience for exposures in the segment over a mix of economic conditions (including economic downturn conditions) sufficient to provide a reasonable estimate of the average one-year default rate over the economic cycle for the segment. Banks that use this PD formulation for a segment of retail exposures should be able to demonstrate to their primary Federal supervisor, using empirical data, why seasoning effects are not material for the segment or the retail exposure subcategory in which the segment resides.

Because of the one-year IRB horizon, the agencies are proposing a different PD definition for retail segments with material seasoning effects. Under the proposed rule, PD for a segment of non-defaulted retail exposures for which seasoning effects are material would be the bank's empirically based best estimate of the annualized cumulative default rate over the expected remaining life of exposures in the segment, capturing the average default experience for exposures in the segment over a mix of economic conditions (including economic downturn conditions) to provide a reasonable estimate of the average performance over the economic cycle for the segment. A bank's PD estimates for these retail segments with material seasoning effects also should reflect potential changes in the expected remaining life of exposures in the segment over the economic cycle.

For wholesale exposures to defaulted obligors and for segments of defaulted retail exposures, PD would be 100 percent.

Loss given default (LGD) and expected loss given default (ELGD).

Under the proposed rule, a bank must directly estimate an ELGD and LGD risk parameter for each wholesale exposure or must assign each wholesale exposure to an expected loss severity grade and a downturn loss severity grade, estimate an ELGD risk parameter for each expected loss severity grade, and estimate an LGD risk parameter for each loss severity grade. In addition, a bank must estimate an ELGD and LGD risk parameter for each segment of retail exposures. The same ELGD and LGD may be appropriate for more than one retail segment.

LGD is an estimate of the economic loss that would be incurred on an exposure, relative to the exposure's EAD, if the exposure were to default within a one-year horizon during economic downturn conditions. The economic loss amount must capture all material credit-related losses on the exposure (including accrued but unpaid interest or fees, losses on the sale of repossessed collateral, direct workout costs, and an appropriate allocation of indirect workout costs). Where positive or negative cash flows on a wholesale exposure to a defaulted obligor or on a defaulted retail exposure (including proceeds from the sale of collateral, workout costs, and draw-downs of unused credit lines) occur after the date of default, the economic loss amount must reflect the net present value of cash flows as of the default date using a discount rate appropriate to the risk of the exposure.

The LGD of some exposures may be substantially higher during economic downturn conditions than during other periods, while for other types of exposures it may not. Accordingly, the proposed rule requires banks to use an LGD estimate that reflects economic downturn conditions for purposes of calculating the risk-based capital requirements for wholesale exposures and retail segments; however, the LGD of an exposure may never be less than the exposure's ELGD. More specifically, banks must produce for each wholesale exposure (or downturn loss severity rating grade) and retail segment an estimate of the economic loss per dollar of EAD that the bank would expect to incur if default were to occur within a one-year horizon during economic downturn conditions. The estimate of LGD can be thought of as the ELGD plus an increase if appropriate to reflect the impact of economic downturn conditions.

For the purpose of defining economic downturn conditions, the proposed rule identifies two wholesale exposure subcategories—high-volatility commercial real estate (HVCRE) wholesale exposures and non-HVCRE wholesale exposures (that is, all wholesale exposures that are not HVCRE exposures)—and three retail exposure subcategories—residential mortgage exposures, QREs, and other retail exposures. The proposed rule defines economic downturn conditions with respect to an exposure as those conditions in which the aggregate default rates for the exposure's entire wholesale or retail subcategory held by the bank (or subdivision of such subcategory selected by the bank) in the exposure's national jurisdiction (or subdivision of such jurisdiction selected by the bank) are significantly higher than average.

Under this approach, a bank with a geographical or industry sector concentration in a subcategory of exposures may find that information relating to a downturn in that geographical region or industry sector may be more relevant for the bank than a general downturn affecting many regions or industries. At this time, however, the proposed rule does not require a bank with a geographical, industry sector, or other concentration to subdivide exposure subcategories or national jurisdictions to reflect such concentrations; rather, the proposed rule allows banks to subdivide exposure subcategories or national jurisdictions as they deem appropriate given the exposures held by the bank. The agencies understand that downturns in particular geographical subdivisions of national jurisdictions or in particular industrial sectors may result in significantly increased loss rates in material subdivisions of a bank's exposures in an exposure subcategory.

Question 15: In light of the possibility of significantly increased loss rates at the subdivision level due to downturn conditions in the subdivision, the agencies seek comment on whether to require banks to determine economic downturn conditions at a more granular level than an entire wholesale or retail exposure subcategory in a national jurisdiction.

The proposed rule provides banks two methods of generating LGD estimates for wholesale and retail exposures. First, a bank may use its own estimates of LGD for a subcategory of exposures if the bank has prior written approval from its primary Federal supervisor to use internal estimates for that subcategory of exposures. In approving a bank's use of internal estimates of LGD, a bank's primary Federal supervisor will consider whether the bank's internal estimates of LGD are reliable and sufficiently reflective of economic downturn conditions. The supervisor will also consider whether the bank has rigorous and well-documented policies and procedures for identifying economic downturn conditions for the exposure subcategory, identifying material adverse correlations between the relevant drivers of default rates and loss rates given default, and incorporating identified correlations into internal LGD estimates. If a bank has supervisory approval to use its own estimates of LGD for an exposure subcategory, it must use its own estimates of LGD for all exposures within that subcategory.

As noted above, the LGD of an exposure or segment may never be less than the ELGD of that exposure or segment. The proposed rule defines the ELGD of a wholesale exposure as the bank's empirically-based best estimate of the default-weighted average economic loss per dollar of EAD the bank expects to incur in the event that the obligor of the exposure (or a typical obligor in the loss severity grade assigned by the bank to the exposure) defaults within a one-year horizon.

For a segment of retail exposures, ELGD is the bank's empirically-based best estimate of the default-weighted average economic loss per dollar of EAD the bank expects to incur on exposures in the segment that default within a one-year horizon. ELGD estimates must incorporate a mix of economic conditions (including economic downturn conditions). For example, given appropriate data, the ELGD could be estimated by calculating the default-weighted average economic loss per dollar of EAD given default for exposures in a particular loss severity grade or segment observed over a complete credit cycle.

Under the proposal, ELGD is not the statistical expected value of LGD.

As an alternative to internal estimates of LGD, the proposed rule provides a supervisory mapping function for converting ELGD into LGD for risk-based capital purposes. Although the agencies encourage banks to develop internal LGD estimates, the agencies are aware that it may be difficult at this time and in the near future for banks to produce internal estimates of LGD that are sufficient for risk-based capital purposes because LGD data for important portfolios may be sparse, and there is very limited industry experience with incorporating downturn conditions into LGD estimates. Accordingly, under the proposed rule, a bank that does not qualify for use of its own estimates of LGD for a subcategory of exposures must instead compute LGD by applying a supervisory mapping function to its internal estimates of ELGD for such exposures. The bank would adjust its ELGDs upward to LGDs using the linear supervisory mapping function: LGD = 0.08 + 0.92 x ELGD. Under this mapping function, for example, an ELGD of 0 percent is converted to an LGD of 8 percent, an ELGD of 20 percent is converted to an LGD of 26.4 percent, and an ELGD of 50 percent is converted to an LGD of 54 percent. A bank would not have to apply the supervisory mapping function to repo-style transactions, eligible margin loans, and OTC derivative contracts (defined below in section V.C. of the preamble). For these exposures, the agencies believe that the difference between a bank's estimate of LGD and its estimate of ELGD is likely to be small. Instead a bank would set LGD equal to ELGD for these exposures.

As noted, the proposed rule would permit a bank to use the supervisory mapping function to translate ELGDs to LGDs and would only permit a bank to use its own estimates of LGD for an exposure subcategory if the bank has received prior written approval from its primary Federal supervisor. The agencies also are considering whether to require every bank, as a condition to qualifying for use of the advanced approaches, to be able to produce credible and reliable internal estimates of LGD for all its wholesale and retail exposures. Under this stricter approach, a bank that is unable to demonstrate to

its primary Federal supervisor that it could produce credible and reliable internal estimates of LGD would not be permitted to use the advanced approaches.

Question 16: The agencies seek comment on and supporting empirical analysis of (i) the proposed rule's definitions of LGD and ELGD; (ii) the proposed rule's overall approach to LGD estimation; (iii) the appropriateness of requiring a bank to produce credible and reliable internal estimates of LGD for all its wholesale and retail exposures as a precondition for using the advanced approaches; (iv) the appropriateness of requiring all banks to use a supervisory mapping function, rather than internal estimates, for estimating LGDs, due to limited data availability and lack of industry experience with incorporating economic downturn conditions in LGD estimates; (v) the appropriateness of the proposed supervisory mapping function for translating ELGD into LGD for all portfolios of exposures and possible alternative supervisory mapping functions; (vi) exposures for which no mapping function would be appropriate; and (vii) exposures for which a more lenient (that is, producing a lower LGD for a given ELGD) or more strict (that is, producing a higher LGD for a given ELGD) mapping function may be appropriate (for example, residential mortgage exposures and HVCRE exposures).

The agencies are concerned that some approaches to ELGD or LGD quantification could produce estimates that are pro-cyclical, particularly if these estimates are based on economic indicators, such as frequently updated loan-to-value (LTV) ratios, that are highly sensitive to current economic conditions.

Question 17: The agencies seek comment on the extent to which ELGD or LGD estimates under the proposed rule would be pro-cyclical, particularly for longer-term secured exposures. The agencies also seek comment on alternative approaches to measuring ELGDs or LGDs that would address concerns regarding potential pro-cyclicality without imposing undue burden on banks.

This proposed rule incorporates comments on the ANPR suggesting a need to better accommodate certain credit products, most prominently asset-based lending programs, whose structures typically result in a bank recovering substantial amounts of the exposure prior to the default date—for example, through paydowns of outstanding principal. The agencies believe that actions taken prior to default to mitigate losses are an important component of a bank's overall credit risk management, and that such actions should be reflected in ELGD and LGD when banks can quantify their effectiveness in a reliable manner. In the proposed rule, this is achieved by measuring ELGD and LGD relative to the exposure's EAD (defined in the next section) as opposed to the amount actually owed at default.

To illustrate, suppose that for a particular asset-based lending exposure, the EAD equaled $100 and that for every $1 owed by the obligor at the time of default, the bank's recovery would be $0.40. Furthermore, suppose that in the event of default, within a one-year horizon, pre-default paydowns of $20 would reduce the exposure amount to $80 at the time of default. In this case, the bank's economic loss rate measured relative to the amount owed at default (60%) would exceed the economic loss rate measured relative to EAD (48% = 60% × ($100 − $20)/$100), because the former does not reflect fully the impact of the pre-default paydowns.

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In practice, the agencies would expect methods for estimating ELGD and LGD, and the way those methods reflect changes in exposure during the period prior to default, to be consistent with other aspects of the proposed rule. For example, a default horizon that is longer than one year could result in lower estimates of economic loss due to greater contractual amortization prior to default, or a greater likelihood that covenants would enable a bank to accelerate paydowns of principal as the condition of an obligor deteriorates, but such long horizons could be inconsistent with the one-year default horizon incorporated in other aspects of this proposed rule, such as the quantification of PD.

The agencies intend to limit recognition of the impact on ELGD and LGD of pre-default paydowns to certain types of exposures where the pattern is common, measurable, and especially significant, as with various types of asset-based lending. In addition, not all paydowns during the period prior to default warrant recognition as part of the recovery process. For example, a pre-default reduction in the outstanding amount on one exposure may simply reflect a refinancing by the obligor with the bank, with no reduction in the bank's total exposure to the obligor.

Question 18: The agencies seek comment on the feasibility of recognizing such pre-default changes in exposure in a way that is consistent with the safety and soundness objectives of this proposed rule. The agencies also seek comment on appropriate restrictions to place on any such recognition to ensure that the results are not counter to the objectives of this proposal to ensure adequate capital within a more risk-sensitive capital framework. In addition, the agencies seek comment on whether, for wholesale exposures, allowing ELGD and LGD to reflect anticipated future contractual paydowns prior to default may be inconsistent with the proposed rule's imposition of a one-year floor on M (for certain types of exposures) or may lead to some double-counting of the risk-mitigating benefits of shorter maturities for exposures not subject to this floor.

Exposure at default (EAD)

. Except as noted below, EAD for the on-balance- sheet component of a wholesale or retail exposure means (i) the bank's carrying value for the exposure (including net accrued but unpaid interest and fees)

less any allocated transfer risk reserve for the exposure, if the exposure is held-to-maturity or for trading; or (ii) the bank's carrying value for the exposure (including net accrued but unpaid interest and fees) less any allocated transfer risk reserve for the exposure and any unrealized gains on the exposure, plus any unrealized losses on the exposure, if the exposure is available for sale. For the off-balance-sheet component of a wholesale or retail exposure (other than an OTC derivative contract, repo-style transaction, or eligible margin loan) in the form of a loan commitment or line of credit, EAD means the bank's best estimate of net additions to the outstanding amount owed the bank, including estimated future additional draws of principal and accrued but unpaid interest and fees, that are likely to occur over the remaining life of the exposure assuming the exposure were to go into default. This estimate of net additions must reflect what would be expected during a period of economic downturn conditions. For the off-balance-sheet component of a wholesale or retail exposure other than an OTC derivative contract, repo-style transaction, eligible margin loan, loan commitment, or line of credit issued by a bank, EAD means the notional amount of the exposure.

“Net accrued but unpaid interest and fees” are accrued but unpaid interest and fees net of any amount expensed by the bank as uncollectable.

For a segment of retail exposures, EAD is the sum of the EADs for each individual exposure in the segment. For wholesale or retail exposures in which only the drawn balance has been securitized, the bank must reflect its share of the exposures' undrawn balances in EAD. The undrawn balances of exposures for which the drawn balances have been securitized must be allocated between the seller's and investors' interests on a pro rata basis, based on the proportions of the seller's and investors' shares of the securitized drawn balances. For example, if the

EAD of a group of securitized exposures' undrawn balances is $100, and the bank's share (seller's interest) in the securitized exposures is 25 percent, the bank must reflect $25 in EAD for the undrawn balances.

The proposed rule contains a special treatment of EAD for OTC derivative contracts, repo-style transactions, and eligible margin loans, which is in section 32 of the proposed rule and discussed in more detail in section V.C. of the preamble.

General quantification principles.

The proposed rule requires data used by a bank to estimate risk parameters to be relevant to the bank's actual wholesale and retail exposures and of sufficient quality to support the determination of risk-based capital requirements for the exposures. For wholesale exposures, estimation of the risk parameters must be based on a minimum of 5 years of default data to estimate PD, 7 years of loss severity data to estimate ELGD and LGD, and 7 years of exposure amount data to estimate EAD. For segments of retail exposures, estimation of risk parameters must be based on a minimum of 5 years of default data to estimate PD, 5 years of loss severity data to estimate ELGD and LGD, and 5 years of exposure amount data to estimate EAD. Default, loss severity, and exposure amount data must include periods of economic downturn conditions or the bank must adjust its estimates of risk parameters to compensate for the lack of data from such periods. Banks must base their estimates of PD, ELGD, LGD, and EAD on the proposed rule's definition of default, and must review at least annually and update (as appropriate) their risk parameters and risk parameter quantification process.

In all cases, banks would be expected to use the best available data for quantifying the risk parameters. A bank could meet the minimum data requirement by using internal data, external data, or pooled data combining internal data with external data. Internal data refers to any data on exposures held in a bank's existing or historical portfolios, including data elements or information provided by third parties. External data refers to information on exposures held outside of the bank's portfolio or aggregate information across an industry.

For example, for new lines of business where a bank lacks sufficient internal data, it must use external data to supplement its internal data. The agencies recognize that the minimum sample period for reference data provided in the proposed rule may not provide the best available results. A longer sample period usually captures varying economic conditions better than a shorter sample period; in addition, a longer sample period will include more default observations for ELGD, LGD, and EAD estimation. Banks should consider using a longer-than-minimum sample period when possible. However, the potential increase in precision afforded by a larger sample should be weighed against the potential for diminished comparability of older data to the existing portfolio; striking the correct balance is an important aspect of quantitative modeling.

Both internal and external reference data should not differ systematically from a bank's existing portfolio in ways that seem likely to be related to default risk, loss severity, or exposure at default. Otherwise, the derived PD, ELGD, LGD, or EAD estimates may not be applicable to the bank's existing portfolio. Accordingly, the bank must conduct a comprehensive review and analysis of reference data at least annually to determine the relevance of reference data to the bank's exposures, the quality of reference data to support PD, ELGD, LGD, and EAD estimates, and the consistency of reference data to the definition of default contained in the proposed rule. Furthermore, a bank must have adequate data to estimate risk parameters for all its wholesale and retail exposures as if they were held to maturity, even if some loans are likely to be sold or securitized before their long-term credit performance can be observed.

As noted above, periods of economic downturn conditions must be included in the data sample (or adjustments to risk parameters must be made). If the reference data include data from beyond the minimum number of years (to capture a period of economic downturn conditions or for other valid reasons), the reference data need not cover all of the intervening years. However, a bank should justify the exclusion of available data and, in particular, any temporal discontinuities in data used. Including periods of economic downturn conditions increases the size and potentially the breadth of the reference data set. According to some empirical studies, the average loss rate is higher during periods of economic downturn conditions, such that exclusion of such periods would bias ELGD, LGD, or EAD estimates downward and unjustifiably lower risk-based capital requirements.

Risk parameter estimates should take into account the robustness of the quantification process. The assumptions and adjustments embedded in the quantification process should reflect the degree of uncertainty or potential error inherent in the process. In practice, a reasonable estimation approach likely would result in a range of defensible risk parameter estimates. The choices of the particular assumptions and adjustments that determine the final estimate, within the defensible range, should reflect the uncertainty in the quantification process. That is, more uncertainty in the process should be reflected in the assignment of final risk parameter estimates that result in higher risk-based capital requirements relative to a quantification process with less uncertainty. The degree of conservatism applied to adjust for uncertainty should be related to factors such as the relevance of the reference data to a bank's existing exposures, the robustness of the models, the precision of the statistical estimates, and the amount of judgment used throughout the process. Margins of conservatism need not be added at each step; indeed, that could produce an excessively conservative result. Instead, the overall margin of conservatism should adequately account for all uncertainties and weaknesses in the quantification process. Improvements in the quantification process (including use of more complete data and better estimation techniques) may reduce the appropriate degree of conservatism over time.

Judgment will inevitably play a role in the quantification process and may materially affect the estimates of risk parameters. Judgmental adjustments to estimates are often necessary because of some limitations on available reference data or because of inherent differences between the reference data and the bank's existing exposures. The bank must ensure that adjustments are not biased toward optimistically low risk parameter estimates. This standard does not prohibit individual adjustments that result in lower estimates of risk parameters, as both upward and downward adjustments are expected. Individual adjustments are less important than broad patterns; consistent signs of judgmental decisions that lower risk parameter estimates materially may be evidence of systematic bias, which would not be permitted.

In estimating relevant risk parameters, banks should not rely on the possibility of U.S. government financial assistance, except for the financial assistance that the government has legally committed to provide.

4. Optional Approaches That Require Prior Supervisory Approval

A bank that intends to apply the internal models methodology to

counterparty credit risk, the double default treatment for credit risk mitigation, the internal assessment approach (IAA) for securitization exposures to ABCP programs, or the internal models approach (IMA) to equity exposures must receive prior written approval from its primary Federal supervisor. The criteria on which approval would be based are described in the respective sections below.

5. Operational Risk

A bank must have operational risk management processes, data and assessment systems, and quantification systems that meet the qualification requirements in section 22(h) of the proposed rule. A bank must have an operational risk management function independent from business line management. The operational risk management function is responsible for the design, implementation, and oversight of the bank's operational risk data and assessment systems, operational risk quantification systems, and related processes. The roles and responsibilities of the operational risk management function may vary between banks, but must be clearly documented. The operational risk management function should have organizational stature commensurate with the bank's operational risk profile. At a minimum, the bank's operational risk management function should ensure the development of policies and procedures for the explicit management of operational risk as a distinct risk to the bank's safety and soundness.

A bank also must establish and document a process to identify, measure, monitor, and control operational risk in bank products, activities, processes, and systems. This process should provide for the consistent and comprehensive collection of the data needed to estimate the bank's exposure to operational risk. The process must also ensure reporting of operational risk exposures, operational loss events, and other relevant operational risk information to business unit management, senior management, and to the board of directors (or a designated committee of the board). The proposed rule defines operational loss events as events that result in loss and are associated with internal fraud; external fraud; employment practices and workplace safety; clients, products, and business practices; damage to physical assets; business disruption and system failures; or execution, delivery, and process management. A bank's operational risk management processes should reflect the scope and complexity of its business lines, as well as its corporate organizational structure. Each bank's operational risk profile is unique and requires a tailored risk management approach appropriate for the scale and materiality of the operational risks present in the bank.

Operational risk data and assessment system.

A bank must have an operational risk data and assessment system that incorporates on an ongoing basis the following four elements: internal operational loss event data, external operational loss event data, results of scenario analysis, and assessments of the bank's business environment and internal controls. These four operational risk elements should aid the bank in identifying the level and trend of operational risk, determining the effectiveness of operational risk management and control efforts, highlighting opportunities to better mitigate operational risk, and assessing operational risk on a forward-looking basis. A bank's operational risk data and assessment system must be structured in a manner consistent with the bank's current business activities, risk profile, technological processes, and risk management processes.

The proposed rule defines operational loss as a loss (excluding insurance or tax effects) resulting from an operational loss event. Operational losses include all expenses associated with an operational loss event except for opportunity costs, forgone revenue, and costs related to risk management and control enhancements implemented to prevent future operational losses. The definition of operational loss is an important issue, as it is a critical building block in a bank's calculation of its operational risk capital requirement under the AMA. More specifically, under the proposed rule, the bank's estimate of operational risk exposure—the basis for determining a bank's risk-weighted asset amount for operational risk—is an estimate of aggregate operational losses generated by the bank's AMA process.

The agencies are considering whether to define operational loss based solely on the effect of an operational loss event on a bank's regulatory capital or to use a definition of operational loss that incorporates, to a greater extent, economic capital concepts. In either case, operational losses would continue to be determined exclusive of insurance and tax effects.

With respect to most operational loss events, the agencies believe that the operational loss amount incorporated into a bank's AMA process would be substantially the same whether viewed from the perspective of its effect on the bank's regulatory capital or an alternative approach that more directly incorporates economic capital concepts. In the case of operational loss events associated with premises and other fixed assets, however, potential loss amounts used in a bank's estimate of its operational risk exposure could be considerably different under the two approaches. The agencies recognize that, for purposes of economic capital analysis, banks often use replacement cost or market value, and not carrying value, to determine the amount of an operational loss with respect to fixed assets. The use of carrying value would be consistent with a definition of operational loss that covers a loss event's effect on a bank's regulatory capital, but may not reflect the full economic impact of a loss event in the case of assets that have a carrying value that is different from their market value.

Further, the agencies recognize that there is a potential to double-count all or a portion of the risk-based capital requirement associated with fixed assets. Under section 31(e)(3) of the proposed rule, which addresses calculation of risk-weighted asset amounts for assets that are not included in an exposure category, the risk-weighted asset amount for a bank's premises will equal the carrying value of the premises on the financial statements of the bank, determined in accordance with generally accepted accounting principles (GAAP). A bank's operational risk exposure estimate addressing bank premises generally will be different than the risk-based capital requirement generated under section 31(e)(3) of the proposed rule and, at least in part, will address the same risk exposure.

Question 19: The agencies solicit comment on all aspects of the proposed treatment of operational loss and, in particular, on (i) the appropriateness of the proposed definition of operational loss; (ii) whether the agencies should define operational loss in terms of the effect an operational loss event has on the bank's regulatory capital or should consider a broader definition based on economic capital concepts; and (iii) how the agencies should address the potential double-counting issue for premises and other fixed assets.

A bank must have a systematic process for capturing and using internal operational loss event data in its operational risk data and assessment systems. Consistent with the ANPR, the proposed rule defines internal operational loss event data for a bank as gross operational loss amounts, dates,

recoveries, and relevant causal information for operational loss events occurring at the bank. A bank's operational risk data and assessment system must include a minimum historical observation period of five years of internal operational losses. With approval of its primary Federal supervisor, however, a bank may use a shorter historical observation period to address transitional situations such as integrating a new business line. A bank may refrain from collecting internal operational loss event data for individual operational losses below established dollar threshold amounts if the bank can demonstrate to the satisfaction of its primary Federal supervisor that the thresholds are reasonable, do not exclude important internal operational loss event data, and permit the bank to capture substantially all the dollar value of the bank's operational losses.

A bank also must establish a systematic process for determining its methodologies for incorporating external operational loss event data into its operational risk data and assessment systems. The proposed rule defines external operational loss event data for a bank as gross operational loss amounts, dates, recoveries, and relevant causal information for operational loss events occurring at organizations other than the bank. External operational loss event data may serve a number of different purposes in a bank's operational risk data and assessment systems. For example, external operational loss event data may be a particularly useful input in determining a bank's level of exposure to operational risk when internal operational loss event data are limited. In addition, external operational loss event data provide a means for the bank to understand industry experience and, in turn, provide a means for the bank to assess the adequacy of its internal operational loss event data.

While internal and external operational loss event data provide a historical perspective on operational risk, it is also important that a bank incorporate forward-looking elements in its operational risk data and assessment systems. Accordingly, a bank must incorporate a business environment and internal control factor analysis in its operational risk data and assessment systems to fully assess its exposure to operational risk. In principle, a bank with strong internal controls in a stable business environment would have less exposure to operational risk than a bank with internal control weaknesses that is growing rapidly or introducing new products. In this regard, a bank should identify and assess the level and trends in operational risk and related control structures at the bank. These assessments should be current, should be comprehensive across the bank, and should identify the operational risks facing the bank. The framework established by a bank to maintain these risk assessments should be sufficiently flexible to accommodate increasing complexity, new activities, changes in internal control systems, and an increasing volume of information. A bank must also periodically compare the results of its prior business environment and internal control factor assessments against the bank's actual operational losses incurred in the intervening period.

Similar to business environment and internal control factor assessments, the results of scenario analysis provide a means for a bank to incorporate a forward-looking element in its operational risk data and assessment systems. Under the proposed rule, scenario analysis is a systematic process of obtaining expert opinions from business managers and risk management experts to derive reasoned assessments of the likelihood and loss impact of plausible high-severity operational losses that may occur at a bank. A bank must establish a systematic process for determining its methodologies for incorporating scenario analysis into its operational risk data and assessment systems. As an input to a bank's operational risk data and assessment systems, scenario analysis is especially relevant for business lines or loss event types where internal data, external data, and assessments of the business environment and inter

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