Risk-Based Capital Standards: Advanced Capital Adequacy Framework - Basel II

Federal RegisterDec 7, 2007

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DEPARTMENT OF THE TREASURY

Office of the Comptroller of the Currency

12 CFR Part 3

[Docket No. OCC-2007-0018]

RIN 1557-AC91

FEDERAL RESERVE SYSTEM

12 CFR Parts 208 and 225

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

FEDERAL DEPOSIT INSURANCE CORPORATION

12 CFR Part 325

RIN 3064-AC73

DEPARTMENT OF THE TREASURY

Office of Thrift Supervision

12 CFR Parts 559, 560, 563, and 567

RIN 1550-AB56; Docket No. OTS 2007-0021

Risk-Based Capital Standards: Advanced Capital Adequacy Framework — Basel II

AGENCIES:

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

ACTION:

Final rule.

SUMMARY:

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

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

For simplicity, and unless otherwise indicated, this final rule uses the term “bank” to include banks, savings associations, and bank holding companies (BHCs). The terms “bank holding company” and “BHC” refer only to bank holding companies regulated by the Board and do not include savings and loan holding companies regulated by the OTS.

DATES:

This final rule is effective April 1, 2008.

FOR FURTHER INFORMATION CONTACT:

OCC:

Mark Ginsberg, Risk Expert, Capital Policy (202-927-4580) or Ron Shimabukuro, Senior Counsel, Legislative and Regulatory Activities Division (202-874-5090). Office of the Comptroller of the Currency, 250 E Street, SW., Washington, DC 20219.

Board:

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

barbara.bouchard@frb.gov

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

anna.hewko@frb.gov

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

mark.vanderweide@frb.gov

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

FDIC:

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

OTS:

Michael D. Solomon, Director, Capital Policy, Supervision Policy (202) 906-5654; David W. Riley, Senior Analyst, Capital Policy (202) 906-6669; Austin Hong, Senior Analyst, Capital Policy (202) 906-6389; or Karen Osterloh, Special Counsel, Regulations and Legislation Division (202) 906-6639, Office of Thrift Supervision, 1700 G Street, NW., Washington, DC 20552.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Introduction

A. Executive Summary of the Final Rule

B. Conceptual Overview

1. The IRB Approach for Credit Risk

2. The AMA for Operational Risk

C. Overview of Final Rule

D. Structure of Final Rule

E. Overall Capital Objectives

F. Competitive Considerations

II. Scope

A. Core and Opt-In Banks

B. U.S. Subsidiaries of Foreign Banks

C. Reservation of Authority

D. Principle of Conservatism

III. Qualification

A. The Qualification Process

1. In General

2. Parallel Run and Transitional Floor Periods

B. Qualification Requirements

1. Process and Systems Requirements

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

Wholesale Exposures

Retail Exposures

Rating Philosophy

Rating and Segmentation Reviews and Updates

3. Quantification of Risk Parameters for Wholesale and Retail Exposures

Probability of Default (PD)

Loss Given Default (LGD)

Expected Loss Given Default (ELGD)

Economic Loss and Post-Default Extensions of Credit

Economic Downturn Conditions

Supervisory Mapping Function

Pre-default Reductions in Exposure

Exposure at Default (EAD)

General Quantification Principles

Portfolios With Limited Data or Limited Defaults

4. Optional Approaches That Require Prior Supervisory Approval

5. Operational Risk

Operational Risk Data and Assessment System

Operational risk Quantification System

6. Data management and maintenance

7. Control and oversight mechanisms

Validation

Internal Audit

Stress Testing

8. Documentation

C. Ongoing Qualification

D. Merger and Acquisition Transition Provisions

IV. Calculation of Tier 1 Capital and Total Qualifying Capital

V. Calculation of Risk-Weighted Assets

A. Categorization of Exposures

1. Wholesale Exposures

2. Retail Exposures

3. Securitization Exposures

4. Equity Exposures

5. Boundary Between Operational Risk and Other Risks

6. Boundary Between the Final Rule and the Market Risk Rule

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

1. Phase 1 — Categorization of Exposures

2. Phase 2 — Assignment of Wholesale Obligors and Exposures to Rating Grades and retail exposures to segments

Purchased Wholesale Exposures

Wholesale Lease Residuals

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

4. Phase 4 — Calculation of Risk-Weighted Assets

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

C. Credit Risk Mitigation (CRM) Techniques

1. Collateral

2. Counterparty Credit Risk of Repo-Style Transactions, Eligible Margin Loans, and OTC Derivative Contracts

Qualifying master netting agreement

EAD for Repo-Style Transactions and Eligible Margin Loans

Collateral Haircut Approach

Simple VaR Methodology

3. EAD for OTC derivative Contracts

Current Exposure Methodology

4. Internal Models Methodology

Maturity Under the Internal Models Methodology

Collateral Agreements Under the Internal Models Methodology

Alternative Methods

5. Guarantees and Credit Derivatives That Cover Wholesale Exposures

Eligible Guarantees and Eligible Credit Derivatives

PD Substitution Approach

LGD Adjustment Approach

Maturity Mismatch Haircut

Restructuring Haircut

Currency Mismatch Haircut

Example

Multiple Credit Risk Mitigants

Double Default Treatment

6. Guarantees and Credit Derivatives That Cover Retail Exposures

D. Unsettled Securities, Foreign Exchange, and Commodity Transactions

E. Securitization Exposures

1. Hierarchy of Approaches

Gains-on-Sale and CEIOs

The Ratings-Based Approach (RBA)

The Internal Assessment Approach (IAA)

The Supervisory Formula Approach (SFA)

Deduction

Exceptions to the General Hierarchy of Approaches

Servicer Cash Advances

Amount of a Securitization Exposure

Implicit Support

Operational Requirements for Traditional Securitizations

Clean-Up Calls

Additional Supervisory Guidance

2. Ratings-Based Approach (RBA)

3. Internal Assessment Approach (IAA)

4. Supervisory Formula Approach (SFA)

General Requirements

Inputs to the SFA Formula

5. Eligible Disruption Liquidity Facilities

6. CRM for Securitization Exposures

7. Synthetic Securitizations

Background

Operational Requirements for Synthetic Securitizations

First-Loss Tranches

Mezzanine Tranches

Super-Senior Tranches

8. Nth-to-Default Credit Derivatives

9. Early Amortization Provisions

Background

Controlled Early Amortization

Non-Controlled Early Amortization

Securitization of Revolving Residential Mortgage Exposures

F. Equity Exposures

1. Introduction and Exposure Measurement

Hedge Transactions

Measures of Hedge Effectiveness

2. Simple Risk-Weight Approach (SRWA)

Non-Significant Equity Exposures

3. Internal Models Approach (IMA)

IMA Qualification

Risk-Weighted Assets Under the IMA

4. Equity Exposures to Investment Funds

Full Look-Through Approach

Simple Modified Look-Through Approach

Alternative modified look-through approach

VI. Operational Risk

VII. Disclosure

1. Overview

Comments on the Proposed Rule

2. General Requirements

Frequency/Timeliness

Location of Disclosures and Audit/Attestation Requirements

Proprietary and Confidential Information

3. Summary of Specific Public Disclosure Requirements

4. Regulatory Reporting

I. Introduction

A. Executive Summary of the Final Rule

On September 25, 2006, the agencies issued a joint notice of proposed rulemaking (proposed rule or proposal) (71 FR 55830) seeking public comment on a new risk-based regulatory capital framework for banks.

The agencies previously issued an advance notice of proposed rulemaking (ANPR) related to the new risk-based regulatory capital framework (68 FR 45900, August 4, 2003). The proposed rule was based on a series of releases from the Basel Committee on Banking Supervision (BCBS), culminating in the BCBS’s comprehensive June 2006 release entitled “International Convergence of Capital Measurement and Capital Standards: A Revised Framework” (New Accord).

The New Accord sets forth a “three pillar” framework encompassing risk-based capital requirements for credit risk, market risk, and operational risk (Pillar 1); supervisory review of capital adequacy (Pillar 2); and market discipline through enhanced public disclosures (Pillar 3). The New Accord includes several methodologies for determining a bank's risk-based capital requirements for credit, market, and operational risk.

The agencies also issued proposed changes to the risk-based capital rule for market risk in a separate notice of proposed rulemaking (71 FR 55958, September 25, 2006). A final rule on that proposal is under development and will be issued in the near future.

The BCBS is a committee of banking supervisory authorities established by the central bank governors of the G-10 countries in 1975. The BCBS issued the New Accord to modernize its first capital Accord, which was endorsed by the BCBS members in 1988 and implemented by the agencies in 1989. The New Accord, the 1988 Accord, and other documents issued by the BCBS are available through the Bank for International Settlements' Web site at

http://www.bis.org.

The proposed rule included the advanced capital methodologies from the New Accord, including the advanced internal ratings-based (IRB) approach for credit risk and the advanced measurement approaches (AMA) for operational risk (together, the advanced approaches). The IRB approach uses risk parameters determined by a bank's internal systems in the calculation of the bank's credit risk capital requirements. The AMA relies on a bank's internal estimates of its operational risks to generate an operational risk capital requirement for the bank.

The agencies issued draft guidance on the advanced approaches.

See

72 FR 9084 (February 28, 2007).

The agencies now are adopting this final rule implementing a new risk-based regulatory capital framework, based on the New Accord, that is mandatory for some U.S. banks and optional for others. While the New Accord includes several methodologies for determining risk-based capital requirements, the agencies are adopting only the advanced approaches at this time.

The agencies received approximately 90 public comments on the proposed rule from banking organizations, trade associations representing the banking or financial services industry, supervisory authorities, and other interested parties. This section of the preamble highlights several fundamental issues that commenters raised about the agencies' proposal and briefly describes how the agencies have responded to those issues in the final rule. More detail is provided in the preamble sections below. Overall, commenters supported the development of the framework and the move to more risk-sensitive capital requirements. One overarching issue, however, was the areas where the proposal differed from the New Accord. Commenters said the divergences generally created competitive problems, raised home-host issues, entailed extra cost and regulatory burden, and did not necessarily improve the overall safety and soundness of banks subject to the rule.

Commenters also generally disagreed with the agencies' proposal to adopt only the advanced approaches from the New Accord. Further, commenters objected to the agencies' retention of the leverage ratio, the transitional arrangements in the proposal, and the 10 percent numerical benchmark for identifying material aggregate reductions in risk-based capital requirements to be used for evaluating and responding to capital outcomes during the parallel run and transitional floor periods (discussed below). Commenters also noted numerous technical issues with the proposed rule.

As noted in an interagency press release issued July 20, 2007 (

Banking Agencies Reach Agreement on Basel II Implementation

), the agencies have agreed to eliminate the language from

the preamble concerning a 10 percent limitation on aggregate reductions in risk-based capital requirements. The press release also stated that the agencies are retaining intact the transitional floor periods (see preamble sections I.E. and III.A.2.). In addition, while not specifically mentioned in the press release, the agencies are retaining the leverage ratio and the prompt corrective action (PCA) regulations without modification.

The final rule adopts without change the proposed criteria for identifying core banks (banks required to apply the advanced approaches) and continues to permit other banks (opt-in banks) to adopt the advanced approaches if they meet the applicable qualification requirements. Core banks are those with consolidated total assets (excluding assets held by an insurance underwriting subsidiary of a bank holding company) of $250 billion or more or with consolidated total on-balance-sheet foreign exposure of $10 billion or more. A depository institution (DI) also is a core bank if it is a subsidiary of another DI or bank holding company that uses the advanced approaches. The final rule also provides that a bank's primary Federal supervisor may determine that application of the final rule is not appropriate in light of the bank's asset size, level of complexity, risk profile, or scope of operations (see preamble sections II.A. and B.).

As noted above, the final rule includes only the advanced approaches. The July 2007 interagency press release stated that the agencies have agreed to issue a proposed rule that would provide non-core banks with the option to adopt an approach consistent with the standardized approach included in the New Accord. This new proposal (the standardized proposal) will replace the earlier proposal to adopt the so-called Basel IA option (Basel 1A proposal).

The press release also noted the agencies' intention to finalize the standardized proposal before core banks begin the first transitional floor period under this final rule.

71 FR 77445 (Dec. 26, 2006).

In response to commenters' concerns that some aspects of the proposed rule would result in excessive regulatory burden without commensurate safety and soundness enhancements, the agencies included a principle of conservatism in the final rule. In general, under this principle, in limited situations, a bank may choose not to apply a provision of the rule to one or more exposures if the bank can demonstrate on an ongoing basis to the satisfaction of its primary Federal supervisor that not applying the provision would, in all circumstances, unambiguously generate a risk-based capital requirement for each such exposure that is greater than that which would otherwise be required under the regulation, and the bank meets other specified requirements (see preamble section II.D.).

In the proposal, the agencies modified the definition of default for wholesale exposures from that in the New Accord to address issues commenters had raised on the ANPR. Commenters objected to the agencies’ modified definition of default for wholesale exposures, however, asserting that a definition different from the New Accord would result in competitive inequities and significant implementation burden without associated supervisory benefit. In response to these concerns, the agencies have adopted a definition of default for wholesale exposures that is consistent with the New Accord (see preamble section III.B.2.). For retail exposures, the final rule retains the proposed definition of default and clarifies that, subject to certain considerations, a foreign subsidiary of a U.S. bank may, in its consolidated risk-based capital calculations, use the applicable host jurisdiction definition of default for retail exposures of the foreign subsidiary in that jurisdiction (see preamble section III.B.2.).

Another concept introduced in the proposal that was not in the New Accord was the expected loss given default (ELGD) risk parameter. ELGD had four functions in the proposed rule—as a component of the calculation of expected credit loss (ECL) in the numerator of the risk-based capital ratios; in the expected loss (EL) component of the IRB risk-based capital formulas; as a floor on the value of the loss given default (LGD) risk parameter; and as an input into a supervisory mapping function. Many commenters objected to the inclusion of ELGD as a departure from the New Accord that would create regulatory burden and competitive inequity. Many commenters also objected to the supervisory mapping function, which the agencies intended as an alternative for banks that were not able to estimate reliably the LGD risk parameter. The agencies have eliminated ELGD from the final rule. Banks are required to estimate only the LGD risk parameter, which reflects economic downturn conditions (see preamble section III.B.3.). The supervisory mapping function also has been eliminated from the rule.

Commenters also objected to the agencies’ decision not to include a distinct risk weight function for exposures to small- and medium-size enterprises (SMEs) as provided in the New Accord. In the proposal, the agencies noted they were not aware of compelling evidence that smaller firms with the same probability of default (PD) and LGD as larger firms are subject to less systemic risk than is already reflected in the wholesale risk-based capital functions. The agencies continue to believe an SME-specific risk weight function is not supported by sufficient evidence and might give rise to competitive inequities across U.S. banks, and have not adopted such a function in the final rule (see preamble section V.A.1.)

With regard to the proposed treatment for securitization exposures, commenters raised a number of technical issues. Many objected to the proposed definition of a securitization exposure, which included exposures to investment funds with material liabilities (including exposures to hedge funds). The agencies agree with commenters that the proposed definition for securitization exposures was quite broad and captured some exposures that would more appropriately be treated under the wholesale or equity frameworks. To limit the scope of the IRB securitization framework, the agencies have modified the definition of traditional securitization in the final rule as described in preamble section V.A.3. Technical issues related to securitization exposures are discussed in preamble sections V.A.3. and V.E.

For equity exposures, commenters focused on the proposal's lack of a grandfathering period. The New Accord provides national discretion for each implementing jurisdiction to adopt a grandfather period for equity exposures. Commenters asserted that this omission would result in competitive inequity for U.S. banks as compared to other internationally active institutions. The agencies believe that, overall, the proposal's approach to equity exposures results in a competitive risk-based capital requirement. The final rule does not include a grandfathering provision, and the agencies have adopted the proposed treatment for equity exposures without significant change (see preamble section V.F.).

A number of commenters raised issues related to operational risk. Most significantly, commenters noted that activities besides securities processing and credit card fraud have highly predictable and reasonably stable losses and should be considered for operational risk offsets. The agencies believe that the proposed definition of

eligible operational risk offsets allows for the consideration of other activities in a flexible and prudent manner and, thus, are retaining the proposed definition in the final rule. Commenters also noted that the proposal appeared to place limits on the use of operational risk mitigants. The agencies have provided flexibility in this regard and under the final rule will take into consideration whether a particular operational risk mitigant covers potential operational losses in a manner equivalent to holding regulatory capital (see preamble sections III.B.5. and V.I.).

Many commenters expressed concern that the proposed public disclosures were excessive and would hinder, rather than facilitate, market discipline by requiring banks to disclose information that would not be well understood by or useful to the market. Commenters also expressed concern about possible disclosure of proprietary information. The agencies believe that it is important to retain the vast majority of the proposed disclosures, which are consistent with the New Accord. These disclosures will enable market participants to gain key insights regarding a bank's capital structure, risk exposures, risk assessment processes, and, ultimately, capital adequacy. The agencies have modified the final rule to provide flexibility regarding proprietary information.

B. Conceptual Overview

This final rule is intended to produce risk-based capital requirements that are more risk-sensitive than those produced under the agencies’ existing risk-based capital rules (general risk-based capital rules). In particular, the IRB approach requires banks to assign risk parameters to wholesale exposures and retail segments and provides specific risk-based capital formulas that must be used to transform these risk parameters into risk-based capital requirements.

The framework is based on “value-at-risk” (VaR) modeling techniques that measure credit risk and operational risk. Because bank risk measurement practices are both continually evolving and subject to uncertainty, the framework should be viewed as an effort to improve the risk sensitivity of the risk-based capital requirements for banks, rather than as an effort to produce a statistically precise measurement of risk.

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

ER07DE07.000

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

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

Assessing risk and assigning regulatory capital requirements by reference to a specific percentile of a probability distribution of potential losses is commonly referred to as a VaR approach. Such an approach was adopted by the FDIC, Board, and OCC for assessing a bank's risk-based capital requirements for market risk in 1996 (market risk rule). Under the market risk

rule, a bank's own internal models are used to estimate the 99th percentile of the bank's market risk loss distribution over a ten-business-day horizon. The bank's market risk capital requirement is based on this VaR estimate, generally multiplied by a factor of three. The agencies implemented this multiplication factor to provide a prudential buffer for market volatility and modeling uncertainty.

1. The IRB Approach for Credit Risk

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

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

Journal of Financial Intermediation,

July 2003. The IRB formulas are derived as an application of these results to a single-factor 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 (BCBS Explanatory Note). The document can be found on the Bank for International Settlements Web site at

http://www.bis.org.

The IRB approach is broadly similar to the credit VaR approaches used by a number of banks as the basis for their internal assessment of the economic capital necessary to cover credit risk. It is common for a bank's internal credit risk models to consider a one-year loss horizon and to focus on a high loss threshold confidence level. As with the internal credit VaR models used by banks, the output of the risk-based capital formulas in the IRB approach is an estimate of the amount of credit losses above ECL over a one-year horizon that would only be exceeded a small percentage of the time. The agencies believe that a one-year horizon is appropriate because it balances the difficulty of easily or rapidly exiting non-trading positions against the possibility that in many cases a bank can cover credit losses by raising additional capital should the underlying credit problems manifest themselves gradually. The nominal confidence level of the IRB risk-based capital formulas (99.9 percent) means that if all the assumptions in the IRB supervisory model for credit risk were correct for a bank, there would be less than a 0.1 percent probability that credit losses at the bank in any year would exceed the IRB risk-based capital requirement.

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

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

In combination with other supervisory assumptions and parameters underlying the IRB approach, the approach's 99.9 percent nominal confidence level reflects a judgmental pooling of available information, including supervisory experience. The framework underlying this final rule reflects a desire on the part of the agencies to achieve (i) risk-based capital requirements that are reflective of relative risk across different assets and that are broadly consistent with maintaining at least an investment-grade rating (for example, at least BBB) on the liabilities funding those assets, even in periods of economic adversity; and (ii) for the U.S. banking system as a whole, aggregate minimum regulatory capital requirements that are not a material reduction from the aggregate minimum regulatory capital requirements under the general risk-based capital rules.

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

The specific risk-based capital formulas in this final rule require the bank to estimate certain risk parameters for its wholesale and retail exposures, which the bank may do using a variety of techniques. These risk parameters are PD, LGD, exposure at default (EAD), and, for wholesale exposures, effective remaining maturity (M). The proposed rule included an additional risk parameter, ELGD. As discussed in section III.B.3. of the preamble, the agencies have eliminated the ELGD risk parameter from the final rule. The risk-based capital formulas into which the estimated risk parameters are inserted are simpler than the economic capital methodologies typically employed by banks, which often require complex computer simulations. In particular, an important property of the IRB risk-based capital formulas is portfolio invariance. That is, the risk-based capital requirement for a particular exposure generally does not depend on the other exposures held by the bank. Like the general risk-based capital rules, the total credit risk capital requirement for a bank's wholesale and retail exposures is the sum of the credit risk capital requirements on individual wholesale exposures and segments of retail exposures.

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

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

BCBS Explanatory Note.

The AVCs that appear in the IRB risk-based capital formulas for wholesale exposures decline with increasing PD; that is, the IRB risk-based capital formulas generally imply that a group of low-PD wholesale exposures are more correlated than a group of high-PD wholesale exposures. Thus, under the rule, a low-PD wholesale exposure would have a higher relative risk-based capital requirement than that implied by its PD were the AVC in the IRB risk-based capital formulas for wholesale exposures fixed rather than a decreasing function of PD. The AVCs included in the IRB risk-based capital formulas for both wholesale and retail exposures reflect a combination of supervisory judgment and empirical evidence.

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

See

BCBS Explanatory Note, section 5.3.

Several commenters stated that the proposed AVCs for wholesale exposures were too high in general, and a few claimed that, in particular, the AVCs for multi-family residential real estate exposures should be lower. Other commenters suggested that the AVCs of wholesale exposures should be a function of obligor size rather than PD. Similarly, several commenters maintained that the proposed AVCs for retail exposures were too high. Some of these commenters suggested that the AVCs for qualifying revolving exposures (QREs), such as credit cards, should be in the range of 1 to 2 percent, not 4 percent as proposed. Similarly, some of those commenters opposed the proposed flat 15 percent AVC for residential mortgage exposures; one commenter suggested that the agencies should consider employing lower AVCs for home equity loans and lines of credit (HELOCs) to take into account their shorter maturity relative to traditional mortgage exposures.

However, most commenters recognized that the proposed AVCs were consistent with those in the New Accord and recommended that the agencies use the AVCs contained in the New Accord to avoid international competitive inequity and unnecessary burden. Several commenters suggested that the agencies should reconsider the AVCs going forward, working with the BCBS.

The agencies agree with the prevailing view of the commenters that using the AVCs in the New Accord alleviates a potential source of international inconsistency and implementation burden. The final rule therefore maintains the proposed AVCs. As the agencies gain more experience with the advanced approaches, they may revisit the AVCs for wholesale exposures and retail exposures, along with other calibration issues identified during the parallel run and transitional floor periods (as described below) and make changes to the rule as necessary. The agencies would address this issue working with the BCBS and other supervisory and regulatory authorities, as appropriate.

Another important conceptual element of the IRB approach concerns the treatment of ECL. The IRB approach assumes that reserves should cover ECL while capital should cover credit losses exceeding ECL (that is, unexpected credit losses). Accordingly, the final rule, consistent with the proposal and the New Accord, removes ECL from the risk-weighted assets calculation but requires a bank to compare its ECL to its eligible credit reserves (as defined below). If a bank's ECL exceeds its eligible credit reserves, the bank must deduct the excess ECL amount 50 percent from tier 1 capital and 50 percent from tier 2 capital. If a bank's eligible credit reserves exceed its ECL, the bank may include the excess eligible credit reserves amount in tier 2 capital, up to 0.6 percent of the bank's credit risk-weighted assets.

This treatment is intended to maintain a capital incentive to reserve prudently and ensure that ECL over a one-year horizon is covered either by reserves or capital. This treatment also recognizes that prudent reserving that considers probable losses over the life of a loan may result in a bank holding reserves in excess of ECL measured with a one-year horizon. The BCBS calibrated the 0.6 percent limit on inclusion of excess reserves in tier 2 capital to be approximately as restrictive as the existing cap on the inclusion of allowance for loan and lease losses (ALLL) under the 1988 Accord, based on data obtained in the BCBS's Third Quantitative Impact Study (QIS-3).

In contrast, under the general risk-based capital rules, the allowance for loan and lease losses (ALLL) may be included in tier 2 capital up to 1.25 percent of total risk-weighted assets.

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

In developing the New Accord, the BCBS sought broadly to maintain the current overall level of minimum risk-based capital requirements within the banking system. Using data from QIS-3, the BCBS conducted an analysis of the risk-based capital requirements that would be generated under the New Accord. Based on this analysis, the BCBS concluded that a “scaling factor” (multiplier) should apply to credit risk-weighted assets. The BCBS, in the New Accord, indicated that the best estimate of the scaling factor was 1.06. In May 2006, the BCBS decided to maintain the 1.06 scaling factor based on the results of a fourth quantitative impact study (QIS-4) conducted in some jurisdictions, including the United States, and a fifth quantitative impact study (QIS-5), not conducted in the United States.

The BCBS noted that national supervisory authorities will continue to monitor capital requirements during implementation of the New Accord, and that the BCBS, in turn, will monitor national experiences with the framework.

BCBS press release, “Basel Committee maintains calibration of Base II Framework,” May 24, 2006.

The agencies generally agree with the BCBS regarding calibration of the New Accord. Therefore, consistent with the New Accord and the proposed rule, the final rule contains a scaling factor of 1.06 for credit-risk-weighted assets. As the agencies gain more experience with the advanced approaches, the agencies will revisit the scaling factor along with other calibration issues identified during the parallel run and transitional floor periods (described below) and will make changes to the rule as necessary, working with the BCBS and other supervisory and regulatory authorities, as appropriate.

2. The AMA for Operational Risk

The final rule also includes the AMA for determining risk-based capital requirements for operational risk. Under the final rule (consistent with the proposed rule), operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events. This definition of operational risk includes legal risk—which is the risk of loss (including litigation costs,

settlements, and regulatory fines) resulting from the failure of the bank to comply with laws, regulations, prudent ethical standards, and contractual obligations in any aspect of the bank's business—but excludes strategic and reputational risks.

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

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

C. Overview of Final Rule

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

Banks using the final rule also are subject to supervisory review of their capital adequacy (Pillar 2) and certain public disclosure requirements to foster transparency and market discipline (Pillar 3). In addition, each bank using the advanced approaches remains subject to the tier 1 leverage ratio requirement,

and each DI (as defined in section 3 of the Federal Deposit Insurance Act (12 U.S.C. 1813)) using the advanced approaches remains subject to the prompt corrective action (PCA) thresholds.

Banks using the advanced approaches also remain subject to the market risk rule, where applicable.

See 12 CFR part 3.6(b) and (c) (national banks); 12 CFR part 208, appendix B (state member banks); 12 CFR part 225, appendix D (bank holding companies); 12 CFR 325.3 (state nonmember banks); 12 CFR 567.2(a)(2) and 567.8 (savings associations).

See 12 CFR part 6 (national banks); 12 CFR part 208, subpart D (state member banks); 12 CFR 325.103 (state nonmember banks); 12 CFR part 565 (savings associations). In addition, savings associations remain subject to the tangible capital requirement at 12 CFR 567.2(a)(3) and 567.9.

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

Wholesale exposures under the final rule include most credit exposures to companies, sovereigns, and other governmental entities. For each wholesale exposure, a bank must assign four quantitative risk parameters: PD (which is expressed as a decimal (that is, 0.01 corresponds to 1 percent) and is an estimate of the probability that an obligor will default over a one-year horizon); LGD (which is expressed as a decimal and reflects an estimate of the economic loss rate if a default occurs during economic downturn conditions); EAD (which is measured in dollars and is an estimate of the amount that would be owed to the bank at the time of default); and M (which is measured in years and reflects the effective remaining maturity of the exposure). Banks may factor into their risk parameter estimates the risk mitigating impact of collateral, credit derivatives, and guarantees that meet certain criteria. Banks must input the risk parameters for each wholesale exposure into an IRB risk-based capital formula to determine the risk-based capital requirement for the exposure.

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

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

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

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

Banks may use an internal models approach (IMA) for determining risk-based capital requirements for equity exposures, subject to certain qualifying criteria and floors. If a bank does not have a qualifying internal model for equity exposures, or chooses not to use such a model, the bank must apply a simple risk weight approach (SRWA) in which publicly traded equity exposures

generally are assigned a 300 percent risk weight and non-publicly traded equity exposures generally are assigned a 400 percent risk weight. Under both the IMA and the SRWA, equity exposures to certain entities or made pursuant to certain statutory authorities (such as community development laws) are subject to a 0 to 100 percent risk weight.

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

Under the final rule, a bank must calculate its tier 1 and total risk-based capital ratios by dividing tier 1 capital by total risk-weighted assets and by dividing total qualifying capital by total risk-weighted assets, respectively. To calculate total risk-weighted assets, a bank must first convert the dollar risk-based capital requirements for exposures produced by the IRB risk-based capital approaches and the AMA into risk-weighted asset amounts by multiplying the capital requirements by 12.5 (the inverse of the overall 8.0 percent risk-based capital requirement). After determining the risk-weighted asset amounts for credit risk and operational risk, a bank must sum these amounts and then subtract any excess eligible credit reserves not included in tier 2 capital to determine total risk-weighted assets.

The final rule contains specific public disclosure requirements to provide important information to market participants on the capital structure, risk exposures, risk assessment processes, and, hence, the capital adequacy of a bank. The public disclosure requirements apply only to the DI or bank holding company representing the top consolidated level of the banking group that is subject to the advanced approaches, unless the entity is a subsidiary of a non-U.S. banking organization that is subject to comparable disclosure requirements in its home jurisdiction. All banks subject to the rule, however, must disclose total and tier 1 risk-based capital ratios and the components of these ratios. The agencies also proposed a package of regulatory reporting templates for the agencies' use in assessing and monitoring the levels and components of bank risk-based capital requirements under the advanced approaches.

These templates will be finalized shortly.

71 FR 55981 (September 25, 2006).

The agencies are aware that the fair value option in generally accepted accounting principles as used in the United States (GAAP) raises potential risk-based capital issues not contemplated in the development of the New Accord. The agencies will continue to analyze these issues and may make changes to this rule at a future date as necessary. The agencies would address these issues working with the BCBS and other supervisory and regulatory authorities, as appropriate.

D. Structure of Final Rule

The agencies are implementing a regulatory framework for the advanced approaches in which each agency has an advanced approaches appendix that incorporates (i) definitions of tier 1 and tier 2 capital and associated adjustments to the risk-based capital ratio numerators, (ii) the qualification requirements for using the advanced approaches, and (iii) the details of the advanced approaches.

The agencies also are incorporating their respective market risk rules, by cross-reference.

As applicable, certain agencies are also making conforming changes to existing regulations as necessary to incorporate the new appendices.

12 CFR part 3, Appendix B (for national banks), 12 CFR part 208, Appendix E (for state member banks), 12 CFR part 225, Appendix E (for bank holding companies), and 12 CFR part 325, Appendix C (for state nonmember banks). OTS intends to codify a market risk rule for savings associations at 12 CFR part 567, Appendix D.

In this final rule, as in the proposed rule, the agencies are not restating the elements of tier 1 and tier 2 capital, which largely remain the same as under the general risk-based capital rules. Adjustments to the risk-based capital ratio numerators specific to banks applying the final rule are in part II of the rule and explained in greater detail in section IV of this preamble.

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

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

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

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

E. Overall Capital Objectives

The preamble to the proposed rule described the agencies’ intention to avoid a material reduction in overall risk-based capital requirements under the advanced approaches. The agencies also identified other objectives, such as ensuring that differences in capital requirements appropriately reflect differences in risk and ensuring that the U.S. implementation of the New Accord will not be a significant source of competitive inequity among internationally active banks or among domestic banks operating under different risk-based capital rules. The final rule modifies and clarifies the approach the agencies will use to achieve these objectives.

The agencies proposed a series of transitional floors to provide a smooth transition to the advanced approaches and to temporarily limit the amount by which a bank's risk-based capital requirements could decline over a period of at least three years. The transitional floors are described in more detail in section III.A.2. of this preamble. The floors generally prohibit a bank's risk-based capital requirement under the advanced approaches from falling below 95 percent, 90 percent, and 85 percent of what it would be under the general risk-based capital

rules during the bank's first, second, and third transitional floor periods, respectively. The proposal stated that banks would be required to receive the approval of their primary Federal supervisor before entering each transitional floor period.

The preamble to the proposal noted that if there was a material reduction in aggregate minimum regulatory capital upon implementation of the advanced approaches, the agencies would propose regulatory changes or adjustments during the transitional floor periods. The preamble further noted that in this context, materiality would depend on a number of factors, including the size, source, and nature of any reduction; the risk profiles of banks authorized to use the advanced approaches; and other considerations relevant to the maintenance of a safe and sound banking system. The agencies also stated that they would view a 10 percent or greater decline in aggregate minimum required risk-based capital (without reference to the effects of the transitional floors), compared to minimum required risk-based capital as determined under the general risk-based capital rules, as a material reduction warranting modification to the supervisory risk functions or other aspects of the framework.

Further, the agencies stated that they were “identifying a numerical benchmark for evaluating and responding to capital outcomes during the parallel run and transitional floor periods that do not comport with the overall capital objectives.” The agencies also stated that “[a]t the end of the transitional floor periods, the agencies would reevaluate the consistency of the framework, as (possibly) revised during the transitional floor periods, with the capital goals outlined in the ANPR and with the maintenance of broad competitive parity between banks adopting the framework and other banks, and would be prepared to make further changes to the framework if warranted.” The agencies viewed the parallel run and transitional floor periods as “a trial of the new framework under controlled conditions.”

71 FR 55839-40 (September 25, 2006).

The agencies sought comment on the appropriateness of using a 10 percent or greater decline in aggregate minimum required risk-based capital as a numerical benchmark for material reductions when determining whether capital objectives were achieved. Many commenters objected to the proposed transitional floors and the 10 percent benchmark on the grounds that both safeguards deviated materially from the New Accord and the rules implemented by foreign supervisory authorities. In particular, commenters expressed concerns that the aggregate 10 percent limit added a degree of uncertainty to their capital planning process, since the limit was beyond the control of any individual bank. They maintained that it might take only a few banks that decided to reallocate funds toward lower-risk activities during the transition period to impose a penalty on all U.S. banks using the advanced approaches. Other commenters stated that the benchmark lacked transparency and would be operationally difficult to apply.

Commenters also criticized the duration, level, and construct of the transitional floors in the proposed rule. Commenters believed it was inappropriate to extend the transitional floors by an additional year (to three years), and raised concerns that the floors were more binding than those proposed in the New Accord. Commenters strongly urged the agencies to adopt the transition periods and floors in the New Accord to limit any competitive inequities that could arise among internationally active banks.

To better balance commenters’ concerns and the agencies' capital adequacy objectives, the agencies have decided not to include the 10 percent benchmark language in this preamble. This will alleviate uncertainty and enable each bank to develop capital plans in accordance with its individual risk profile and business model. The agencies have taken a number of steps to address their capital adequacy objectives. Specifically, the agencies are retaining the existing leverage ratio and PCA requirements and are adopting the three transitional floor periods at the proposed numerical levels.

Under the final rule, the agencies will jointly evaluate the effectiveness of the new capital framework. The agencies will issue a series of annual reports during the transition period that will provide timely and relevant information on the implementation of the advanced approaches. In addition, after the end of the second transition year, the agencies will publish a study (interagency study) that will evaluate the advanced approaches to determine if there are any material deficiencies. For any primary Federal supervisor to authorize any bank to exit the third transitional floor period, the study must determine that there are no such material deficiencies that cannot be addressed by then-existing tools, or, if such deficiencies are found, they must be first remedied by changes to regulation. Notwithstanding the preceding sentence, a primary Federal supervisor that disagrees with the finding of material deficiency may not authorize a bank under its jurisdiction to exit the third transitional floor period unless the supervisor first provides a public report explaining its reasoning.

The agencies intend to establish a transparent and collaborative process for conducting the interagency study, consistent with the recommendations made by the U.S. Government Accountability Office (GAO) in its report on implementation of the New Accord in the United States.

In conducting the interagency study the agencies would consider, for example, the following:

United States Government Accountability Office, “Risk-Based Capital: Bank Regulators Need to Improve Transparency and Overcome Impediments to Finalizing the Proposed Basel II Framework” (GAO-07-253), February 15, 2007.

• The level of minimum required regulatory capital under U.S. advanced approaches compared to the capital required by other international and domestic regulatory capital standards.

• Peer comparisons of minimum regulatory capital requirements, including but not limited to banks' estimates of risk parameters for portfolios of similar risk.

• The processes banks use to develop and assess risk parameters and advanced systems, and supervisory assessments of their accuracy and reliability.

• Potential cyclical implications.

• Changes in portfolio composition or business mix, including those that might result in changes in capital requirements per dollar of credit exposure.

• Comparison of regulatory capital requirements to market-based measures of capital adequacy to assess relative minimum capital requirements across banks and broad asset categories. Market-based measures might include credit default swap spreads, subordinated debt spreads, external rating agency ratings, and other market measures of risk.

• Examination of the quality and robustness of advanced risk management processes related to assessment of capital adequacy, as in the comprehensive supervisory assessments performed under Pillar 2.

• Additional reviews, including analysis of interest rate and concentration risks that might suggest the need for higher regulatory capital requirements.

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 important to promote continual advancement of the risk measurement and management practices of large and internationally active banks.

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 a number of banks, the agencies believe that the general risk-based capital rules continue to provide a reasonable alternative for regulatory risk-based capital measurement purposes. However, the agencies recognize that a bifurcated risk-based capital framework inevitably raises competitive considerations. The agencies have received comments on risk-based capital proposals issued in the past several years

stating that for some portfolios, competitive inequities would be worse under a bifurcated framework. These commenters expressed concern that banks operating under the general risk-based capital rules would be at a competitive disadvantage relative to banks applying the advanced approaches because the IRB approach would likely result in lower risk-based capital requirements for certain types of exposures.

See

68 FR 45900 (Aug. 4, 2003), 70 FR 61068 (Oct. 20, 2005), 71 FR 55830 (Sept. 25, 2006), and 71 FR 77446 (Dec. 26, 2006).

The agencies recognize the potential competitive inequities associated with a bifurcated risk-based capital framework. As part of their effort to develop a risk-based capital framework that minimizes competitive inequities and is not disruptive to the banking sector, the agencies issued the Basel IA proposal in December 2006. The Basel IA proposal included modifications to the general risk-based capital rules to improve risk sensitivity and to reduce potential competitive disparities between domestic banks subject to the advanced approaches and domestic banks not subject to the advanced approaches. Recognizing that some banks might prefer not to incur the additional regulatory burden of moving to modified capital rules, the Basel IA proposal retained the existing general risk-based capital rules and permitted banks to opt in to the modified rules. The agencies extended the comment period for the advanced approaches proposal to coincide with the comment period on the Basel IA proposal so that commenters would have an opportunity to analyze the effects of the two proposals concurrently.

See

71 FR 77518 (Dec. 26, 2006).

Seeking to minimize potential competitive inequities and regulatory burden, a number of commenters on both the advanced approaches proposal and the Basel IA proposal urged the agencies to adopt all of the approaches included in the New Accord—including the foundation IRB and standardized approaches for credit risk and the standardized and basic indicator approaches for operational risk. In response to these comments, the agencies have decided to issue a new standardized proposal, which would replace the Basel IA proposal for banks that do not apply the advanced approaches. The standardized proposal would allow banks that are not core banks to implement a standardized approach for credit risk and an approach to operational risk consistent with the New Accord. Like the Basel IA proposal, the standardized proposal will retain the existing general risk-based capital rules for those banks that do not wish to move to the new rules. The agencies expect to issue the standardized proposal in the first quarter of 2008.

A number of commenters expressed concern about competitive inequities among internationally active banks arising from differences in implementation and application of the New Accord by supervisory authorities in different countries. In particular, some commenters asserted that the proposed U.S. implementation would be different from other countries in a number of key areas, such as the definition of default, and that these differences would give rise to substantial implementation cost and burden. Other commenters continued to raise concern about the delayed implementation schedule in the United States.

As discussed in more detail throughout this preamble, the agencies have made a number of changes from the proposal to conform the final rule more closely to the New Accord. These changes should help minimize regulatory burden and mitigate potential competitive inequities across national jurisdictions. In addition, 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. The BCBS also has established a Capital Interpretation Group to foster consistency in applying the New Accord on an ongoing basis. The agencies intend to participate fully in these groups to ensure that issues relating to international implementation and competitive effects are addressed. While supervisory judgment will play a critical role in the evaluation of risk measurement and management practices at individual banks, supervisors remain committed to and have made significant progress toward 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.

With regard to implementation timing concerns, the agencies believe that the transitional arrangements described in preamble section III.A.2. below provide a prudent and reasonable framework for moving to the advanced approaches. Where international implementation differences affect an individual bank, the agencies are working with the bank and appropriate national supervisory authorities to ensure that implementation proceeds as efficiently as possible.

II. Scope

The agencies have identified three groups of banks: (i) Large or internationally active banks that are required to adopt the advanced approaches (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 is required to meet certain qualification requirements to the satisfaction of its primary Federal supervisor, which in turn will consult with other relevant supervisors, before the bank may use the advanced approaches for risk-based capital purposes.

Pillar 1 of the New Accord requires all banks subject to the New Accord to calculate capital requirements for exposure to credit risk and operational risk. The New Accord sets forth three approaches to calculating the credit risk capital requirement and three approaches to calculating the 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 agencies have taken a different approach. This final rule focuses on the largest and most internationally active banks and requires those banks to comply with the most advanced approaches for calculating credit and operational risk capital requirements (the IRB and the AMA). The final rule allows other U.S. banks to “opt in” to the advanced approaches. The agencies have decided at this time to require large, internationally active U.S. banks to use the most advanced approaches of the New Accord. The less advanced approaches of the New Accord lack the degree of risk sensitivity of the advanced approaches. The agencies have the view that risk-sensitive regulatory capital requirements are integral to ensuring that large, sophisticated banks and the financial system have an adequate capital cushion to absorb financial losses. Also, the advanced approaches provide more substantial incentives for banks to improve their risk measurement and management practices than do the other approaches. The agencies do not believe that competitive equity concerns are sufficiently compelling to warrant permitting large, internationally active U.S. banks to adopt the standardized approaches in the New Accord.

A. Core and Opt-In Banks

Under section 1(b) of the proposed rule, a DI would be a core bank if it met 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 or guarantor located in another country, plus redistributed guaranteed amounts to the country of head office or guarantor. The agencies also proposed that a DI would be 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

would be a core bank if the BHC had: (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.

OTS does not currently impose any explicit capital requirements on savings and loan holding companies and is not implementing the advanced approaches for these holding companies.

The agencies included a question in the proposal seeking commenters’ views on using consolidated total assets (excluding assets held by an insurance underwriting subsidiary) as one criterion to determine whether a BHC would be viewed as a core BHC. Some of the commenters addressing this issue supported the proposed approach, noting it was a reasonable proxy for mandatory applicability of a framework designed to measure capital requirements for consolidated risk exposures of a BHC. Other commenters, particularly foreign banking organizations and their trade associations, contended that the BHC asset size threshold criterion instead should be $250 billion of assets in U.S. subsidiary DIs. These commenters further suggested that if the Board kept the proposed $250 billion consolidated total BHC assets criterion, it should limit the scope of this criterion to BHCs with a majority of their assets in U.S. DI subsidiaries. The Board has decided to retain the proposed approach using consolidated total assets (excluding assets held by an insurance underwriting subsidiary) as one threshold criterion for BHCs in this final rule. This approach 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 final rule continues to exclude assets held in an insurance underwriting subsidiary of a BHC from the asset threshold because the advanced approaches were not designed to address insurance underwriting exposures.

The final rule also retains the threshold criterion for core bank/BHC status of consolidated total on-balance sheet foreign exposure of $10 billion or more at the most recent year-end. The calculation of this exposure amount is unchanged in the final rule.

In the preamble to the proposed rule, the agencies also included a question on potential regulatory burden associated with requiring a bank that applies the advanced approaches to implement the advanced approaches at each subsidiary DI—even if those subsidiary DIs do not individually meet a threshold criterion. A number of commenters addressed this issue. While they expressed a range of views, most commenters maintained that small DI subsidiaries of core banks should not be required to implement the advanced approaches. Rather, commenters asserted that these DIs should be permitted to use simpler methodologies, such as the New Accord's standardized approach. Commenters asserted there would be regulatory burden and costs associated with the proposed push-down approach, particularly if a stand-alone AMA is required at each DI.

The agencies have considered comments on this issue and have decided to retain the proposed approach. Thus, under the final rule, each DI subsidiary of a core or opt-in bank is itself a core bank required to apply the advanced approaches. The agencies believe that this approach serves as an important safeguard against regulatory capital arbitrage among affiliated banks that would otherwise be subject to substantially different capital rules. Moreover, to calculate its consolidated IRB risk-based capital requirements, a bank must estimate risk parameters for all credit exposures within the bank except for exposures in portfolios that, in the aggregate, are immaterial to the bank. Because the consolidated bank must already estimate risk parameters for all material portfolios of wholesale and retail exposures in all of its consolidated subsidiaries, the agencies believe that there is limited additional regulatory burden associated with application of the IRB approach at each subsidiary DI. Likewise, to calculate its consolidated AMA risk-based capital requirements, a bank must estimate its operational risk exposure using a unit of measure (defined below) that does not combine business activities or operational loss events with demonstrably different risk profiles within the same loss distribution. Each subsidiary DI could have a demonstrably different risk profile that would require the generation of separate loss distributions.

However, the agencies recognize there may be situations where application of the advanced approaches at an individual DI subsidiary of an advanced approaches bank may not be appropriate. Therefore, the final rule includes the proposed provision that

permits a core or opt-in bank's primary Federal supervisor to determine in writing that application of the advanced approaches is not appropriate for the DI in light of the bank's asset size, level of complexity, risk profile, or scope of operations.

B. U.S. Subsidiaries of Foreign Banks

Under the proposed rule, any U.S.-chartered DI that is a subsidiary of a foreign banking organization would be subject to the U.S. regulatory capital requirements for domestically-owned U.S. DIs. Thus, if the U.S. DI subsidiary of a foreign banking organization met any of the threshold criteria, it would be a core bank and would be subject to the advanced approaches. If it did not meet any of the criteria, the U.S. DI could remain a general bank or could opt in to the advanced approaches, subject to the same qualification process and requirements as a domestically-owned U.S. DI.

The proposed rule also provided that a top-tier U.S. BHC, and its subsidiary DIs, that was owned by a foreign banking organization would be subject to the same threshold levels for core bank determination as a top-tier BHC that is not owned by a foreign banking organization.

The preamble noted that a U.S. BHC that met the conditions in Federal Reserve SR letter 01-01

and that was 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. A DI subsidiary of such a U.S. BHC also would be a core bank and would be required to adopt the advanced approaches and meet the minimum capital ratio requirements.

The Board notes that it generally does not apply regulatory capital requirements to subsidiary BHCs of top-tier U.S. BHCs, regardless of whether the top-tier U.S. BHC is itself a subsidiary of a foreign banking organization.

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

Under the final rule, consistent with SR 01-01, a foreign-owned U.S. BHC that is a core bank and that also is subject to SR 01-01 will, as a technical matter, be required to adopt the advanced approaches, and compute and report its capital ratios and make other required disclosures. It will not, however, be required to maintain the minimum capital ratios at the U.S. consolidated holding company level unless otherwise required to do so by the Board. In response to the potential burden issues identified by commenters and outlined above, the Board notes that the final rule allows the Board to exempt any BHC from mandatory application of the advanced approaches. The Board will make such a determination in light of the BHC's asset size (including subsidiary DI asset size relative to total BHC asset size), level of complexity, risk profile, or scope of operation. Similarly, the final rule allows a primary Federal supervisor to exempt any DI under its jurisdiction from mandatory application of the advanced approaches. A primary Federal supervisor will consider the same factors in making its determination.

C. Reservation of Authority

The proposed rule restated the authority of a bank's primary Federal supervisor to require a bank to hold an overall amount of capital greater than would otherwise be required under the rule if the agency determined that the bank's risk-based capital requirements were not commensurate with the bank's credit, market, operational, or other risks. In addition, the preamble of the proposed rule noted the agencies' expectation that there may be instances when the rule would generate a risk-weighted asset amount for specific exposures that is not commensurate with the risks posed by such exposures. Accordingly, 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 when calculating the risk-weighted asset amount for those exposures. Similarly, the proposed rule provided explicit 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 found that the risk-weighted asset amount for operational risk produced by the bank under the rule was not commensurate with the operational risks of the bank. Any agency that exercised a reservation of authority was expected to notify each of the other agencies of its determination.

Several commenters raised concerns with the scope of the reservation of authority, particularly as it would apply to operational risk. These commenters asserted, for example, that the agencies should address identified operational risk-related capital deficiencies through Pillar 2, rather than through requiring a bank to adjust input variables or techniques used for the calculation of Pillar 1 operational risk capital requirements. Commenters were concerned that excessive agency Pillar 1 intervention on operational risk might inhibit innovation.

While the agencies agree that innovation is important and that general supervisory oversight likely would be sufficient in many cases to address risk-related capital deficiencies, the agencies also believe that it is important to retain as much supervisory flexibility as possible as they move forward with implementation of the final rule. In general, the proposed reservation of authority represented a reaffirmation of the current authority of a bank's primary Federal supervisor to require the bank to hold an overall amount of regulatory capital or maintain capital ratios greater than would be required under the general risk-based capital rules. There may be cases where requiring a bank to assign a different risk-weighted asset amount for operational risk may not sufficiently address problems associated with underlying quantification practices and may cause an ongoing misalignment between the operational risk of a bank and the risk-weighted asset amount for operational risk generated by the bank's operational risk quantification system. In view of this and the inherent flexibility provided for operational risk measurement under the AMA, the agencies believe it is appropriate to articulate the specific measures a primary Federal supervisor may take if it determines that a bank's risk-weighted asset amount for operational risk is not commensurate with the operational risks of the bank. Therefore, the final rule retains the reservation of authority as proposed. The agencies emphasize that any decision to exercise this authority would be made judiciously and that a bank bears the primary responsibility for maintaining the integrity, reliability, and accuracy of its risk management and measurement systems.

D. Principle of Conservatism

Several commenters asked whether it would be permissible not to apply an aspect of the rule for cost or regulatory burden reasons, if the result would be

a more conservative capital requirement. For example, for purposes of the RBA for securitization exposures, some commenters asked whether a bank could choose not to track the seniority of a securitization exposure and, instead, assume that the exposure is not a senior securitization exposure. Similarly, some commenters asked if risk-based capital requirements for certain exposures could be calculated ignoring the benefits of risk mitigants such as collateral or guarantees.

The agencies believe that in some cases it may be reasonable to allow a bank to implement a simplified capital calculation if the result is more conservative than would result from a comprehensive application of the rule. Under a new section 1(d) of the final rule, a bank may choose not to apply a provision of the rule to one or more exposures provided that (i) the bank can demonstrate on an ongoing basis to the satisfaction of its primary Federal supervisor that not applying the provision would, in all circumstances, unambiguously generate a risk-based capital requirement for each exposure greater than that which would otherwise be required under this final rule, (ii) the bank appropriately manages the risk of those exposures, (iii) the bank provides written notification to its primary Federal supervisor prior to applying this principle to each exposure, and (iv) the exposures to which the bank applies this principle are not, in the aggregate, material to the bank.

The agencies emphasize that a conservative capital requirement for a group of exposures does not reduce the need for appropriate risk management of those exposures. Moreover, the principle of conservatism applies to the determination of capital requirements for specific exposures; it does not apply to the qualification or disclosure requirements in sections 22 and 71 of the final rule. Sections V.A.1., V.A.3., and V.E.2. of this preamble contain examples of the appropriate use of this principle of conservatism.

III. Qualification

A. The Qualification Process

1. In General

Supervisory qualification to use the advanced approaches is an iterative and ongoing process that begins when a bank's board of directors adopts an implementation plan and continues as the bank operates under the advanced approaches. Under the final rule, as under the proposal, a bank 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 final rule, and complete a satisfactory “parallel run” (discussed below) before it may use the advanced approaches for risk-based capital purposes. A bank's primary Federal supervisor is responsible, after consultation with other relevant supervisors, for evaluating the bank's initial and ongoing compliance with the qualification requirements for the advanced approaches.

Under the final rule, as 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 final 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 internal growth or merger, are 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. Under the final rule, each core and opt-in bank must submit its implementation plan, together with a copy of the minutes of the board of directors' approval of the plan, to its primary Federal supervisor at least 60 days before the bank proposes to begin its parallel run, unless the bank's primary Federal supervisor waives this prior notice provision. The submission to the primary Federal supervisor should indicate the date that the bank proposes to begin its parallel run.

In developing an implementation plan, a bank must assess its current state of readiness relative to the qualification requirements in this final rule. This assessment must 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 transitional 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 that are available to implement the plan.

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

The proposed rule allowed a bank to exclude a portfolio of exposures from the advanced approaches if the bank could demonstrate to the satisfaction of its primary Federal supervisor that the portfolio, when combined with all other portfolios of exposures that the bank sought to exclude from the advanced approaches, was not material to the bank. Some commenters asserted that a bank should be permitted to exclude from the advanced approaches any business line, portfolio, or exposure that is immaterial on a stand-alone basis (regardless of whether the excluded exposures in the aggregate are material to the bank). The agencies believe that it is not appropriate for a bank to permanently exclude a material portion of its exposures from the enhanced risk sensitivity and risk measurement and management requirements of the advanced approaches. Accordingly, the final rule retains the requirement that 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.

During implementation of the advanced approaches, a bank should work closely with its primary Federal supervisor to ensure that its risk measurement and management systems are 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 the qualification process. 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 should be made subject to the ongoing supervisory discussion between the bank and its primary Federal supervisor.

2. Parallel Run and Transitional Floor Periods

Under the proposed and final rules, 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. The proposed rule defined a satisfactory parallel run as a period of at least four consecutive calendar quarters during which a bank complied with all of the qualification requirements to the satisfaction of its primary Federal supervisor.

Many commenters objected to the proposed requirement that the bank had to meet all of the qualification requirements before it could begin the parallel run period. The agencies recognize that certain qualification requirements, such as outcomes analysis, become more meaningful as a bank gains experience employing the advanced approaches. The agencies therefore are modifying the definition of a satisfactory parallel run in the final rule. Under the final rule, a satisfactory parallel run is a period of at least four consecutive calendar quarters during which the bank complies with the qualification requirements to the satisfaction of its primary Federal supervisor. This revised definition, which does not contain the word “all,” recognizes that the qualification of banks for the advanced approaches during the parallel run period will be an iterative and ongoing process. The agencies intend to assess individual advanced approaches methodologies through numerous discussions, reviews, data collection and analysis, and examination activities. The agencies also emphasize the critical importance of ongoing validation of advanced approaches methodologies both before and after initial qualification decisions. A bank's primary Federal supervisor will review a bank's validation process and documentation for the advanced approaches on an ongoing basis through the supervisory process. The bank should include in its implementation plan the steps it will take to enhance compliance with the qualification requirements during the parallel run period.

Commenters also requested the flexibility, permitted under the New Accord, to apply the advanced approaches to some portfolios and other approaches (such as the standardized approach in the New Accord) to other portfolios during the transitional floor periods. The agencies believe, however, that banks applying the advanced approaches should move expeditiously to extend the robust risk measurement and management practices required by the advanced approaches to all material exposures. To preserve these positive risk measurement and management incentives for banks and to prevent “cherry picking” of portfolios, the final rule retains the provision in the proposed rule that states that a bank may enter the first transitional floor period only if it fully complies with the qualification requirements in section 22 of the rule. As described above, the final rule allows a simplified approach for portfolios that are, in the aggregate, immaterial to the bank.

Another concern identified by commenters regarding the parallel run was the asymmetric treatment of mergers and acquisitions consummated before and after the date a bank qualified to use the advanced approaches. Under the proposed rule, a bank qualified to use the advanced approaches that merged with or acquired a company would have up to 24 months following the calendar quarter during which the merger or acquisition was consummated to integrate the merged or acquired company into the bank's advanced approaches capital calculations. In contrast, the proposed rule could be read to provide that a bank that merged with or acquired a company before the bank qualified to use the advanced approaches had to fully implement the advanced approaches for the merged or acquired company before the bank could qualify to use the advanced approaches. The agencies agree that this asymmetric treatment is not appropriate. Accordingly, the final rule applies the merger and acquisition transition provisions both before and after a bank qualifies to use the advanced approaches. The merger and acquisition transition provisions are described in section III.D. of this preamble.

During the parallel run period, a bank continues to be subject to the general risk-based capital rules but simultaneously calculates its risk-based capital ratios under the advanced approaches. During this period, a bank will report its risk-based capital ratios under 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.

As described above, a bank must provide its board-approved implementation plan to its primary Federal supervisor at least 60 days before the bank proposes to begin its parallel run period. A bank also must receive approval from its primary Federal supervisor before beginning its first transitional floor period. In evaluating whether to grant approval to a bank to begin using the advanced approaches for risk-based capital purposes, the bank's primary Federal supervisor must determine that the bank fully complies with all the qualification requirements, the bank has conducted a satisfactory 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 imposed 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 exit the last transitional floor period and move to stand-alone use of the advanced approaches. Table A sets forth the proposed transitional floor periods for banks moving to the advanced approaches:

Table A.—Transitional Floors

Transitional floor period

Transitional floor percentage

First floor period

Second floor period

Third floor period

During the proposed 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 advanced approaches definitions and rules. 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 the 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 proposed 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, 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.

The Board notes that, under the applicable leverage ratio rule, a BHC that is rated composite “1” or that has adopted the market risk rule has a minimum leverage ratio requirement of 3 percent. For other BHCs, the minimum leverge ratio requirement is 4 percent.

Under the proposed rule, after a bank completed its transitional floor periods and its primary Federal supervisor determined the bank could 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.

Although one commenter supported the proposed transitional provisions, many commenters objected to these transitional provisions. Commenters urged the agencies to conform the transitional provisions to those in the New Accord. Specifically, they requested that the three transitional floor periods be reduced to two periods and that the transitional floor percentages be reduced from 95 percent, 90 percent, and 85 percent to 90 percent and 80 percent. Commenters also requested that the transitional floor calculation methodology be conformed to the generally less restrictive methodology of the New Accord. Moreover, they expressed concern about the requirement that a bank obtain supervisory approval to move from one transitional floor period to the next, which could potentially extend each floor period beyond four calendar quarters.

The agencies believe that the prudential transitional safeguards are necessary to address concerns identified in the analysis of the results of QIS-4.

Specifically, the transitional safeguards will ensure that implementation of the advanced approaches will not result in a precipitous drop in risk-based capital requirements, and will provide a smooth transition process as banks refine their advanced systems. Banks' computation of risk-based capital requirements under both the general risk-based capital rules and the advanced approaches during the parallel run and transitional floor periods 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. Therefore, the agencies are adopting in this final rule the proposed level, duration, and calculation methodology of the transitional floors, with the revised process for determining when banks may exit the third transitional floor period discussed in section I.E., above.

Preliminary analysis of the QIS-4 submissions evidenced material reductions in the aggregate minimum required capital for the QIS-4 participant population and significant dispersion of results across institutions and portfolio types. See Interagency Press Release, Banking “Agencies To Perform Additional Analysis Before Issuing Notice of Proposed Rulemaking Related To Basel II,” April 29, 2005.

Under the final rule, as under the proposed rule, banks that meet the threshold criteria in section 1(b)(1) (core banks) as of the effective date of this final rule, and banks that opt in pursuant to section 1(b)(2) at the earliest possible date, must use the general risk-based capital rules both during the parallel run and as a basis for the transitional floor calculations. Should the agencies finalize a standardized risk-based capital rule, the agencies expect that a bank that opts in after the earliest possible date or becomes a core bank after the effective date of the final rule would use the risk-based capital regime (the general risk-based capital rules or the standardized risk-based capital rules) used by the bank immediately before the bank begins its parallel run both during the parallel run and as a basis for the transitional floor calculations. Under the final rule, 2008 is the first possible year for a bank to begin its parallel run and 2009 is the first possible year for a bank to begin its first of three transitional floor periods.

B. Qualification Requirements

Because the advanced approaches use banks' estimates of certain key risk parameters to determine risk-based capital requirements, they introduce greater complexity to the regulatory capital framework and require banks to possess a high level of sophistication in risk measurement and risk management systems. As a result, the final rule requires each core or opt-in bank to meet the qualification requirements described in section 22 of the final 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 floor provisions for at least an additional three years). The qualification requirements are written broadly to accommodate the many ways a bank may design and implement robust internal credit and operational risk measurement and management systems, 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 advanced approaches framework is to provide appropriate incentives for banks to develop and use better techniques for measuring and managing their risks and to ensure that capital is adequate to support those risks. Section 3 of the final rule requires a bank to hold capital commensurate with the level and nature of all risks to which the bank is exposed. Section 22 of the final rule specifically requires a bank to have a rigorous process for assessing its overall capital adequacy in relation to its risk profile and a comprehensive strategy for maintaining appropriate capital levels (known as the internal capital adequacy assessment process or ICAAP). Another objective of the advanced approaches framework is to ensure comprehensive supervisory review of capital adequacy.

On February 28, 2007, the agencies issued proposed guidance setting forth supervisory expectations for a bank's ICAAP and addressing the process for a comprehensive supervisory assessment of capital adequacy.

As set forth in that guidance, and consistent with existing supervisory practice, a bank's primary Federal supervisor will evaluate how well the bank is assessing its capital needs relative to its risks. The supervisor will assess the bank's overall capital adequacy and will take into account a bank's ICAAP, its compliance with the minimum capital requirements set forth in this rule, and all other relevant information. The primary Federal supervisor will require a bank to increase its capital levels or ratios if the supervisor determines that current levels or ratios are deficient or some element of the bank's business practices suggests the need for higher capital levels or ratios. In addition, the primary Federal supervisor may, under its enforcement authority, require a bank to modify or enhance risk management and internal control authority, or reduce risk exposures, or take any other action as deemed necessary to address identified supervisory concerns.

72 FR 9189.

As outlined in the proposed guidance, the agencies expect banks to implement and continually update the fundamental elements of a sound ICAAP—identifying and measuring material risks, setting capital adequacy goals that relate to risk, and ensuring the integrity of internal capital adequacy assessments. A bank is expected to ensure adequate capital is held against all material risks.

In developing its ICAAP, a bank should be particularly mindful of the limitations of regulatory risk-based capital requirements as a measure of its full risk profile—including risks not covered or not adequately quantified in the risk-based capital requirements—as well as specific assumptions embedded in risk-based regulatory capital requirements (such as diversification in credit portfolios). A bank should also be mindful of the capital adequacy effects of concentrations that may arise within each risk type or across risk types. In general, a bank's ICAAP should reflect an appropriate level of conservatism to account for uncertainty in risk identification, risk mitigation or control, quantitative processes, and any use of modeling. In most cases, this conservatism will result in higher levels of capital or higher capital ratios being regarded as adequate.

As noted above, each core and opt-in bank must apply the advanced approaches for risk-based capital purposes at the consolidated top-tier U.S. legal entity level (either the top-tier U.S. BHC or top-tier DI that is a core or opt-in bank) and at each DI that is a subsidiary of such a top-tier legal entity (unless a primary Federal supervisor provides an exemption under section 1(b)(3) of the final rule). Each bank that applies the advanced approaches must have an appropriate infrastructure with risk measurement and management processes that meet the final 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 an affiliate of the bank, each legal entity that applies the advanced approaches must ensure that the risk parameters (PD, LGD, EAD, and, for wholesale exposures, M) and reference data used to determine its risk-based capital requirements are representative of its own credit and operational risk exposures.

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

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

To implement the IRB approach, 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 other governmental entities, as well as some exposures to individuals. Retail exposures include most credit exposures to individuals and small credit exposures to 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 loss severity rating grades (or LGD estimates) that approximately reflect the loss severity expected in the event of default during economic downturn conditions. As discussed below, the final rule requires banks to treat wholesale exposures differently from retail exposures when differentiating among degrees of credit risk; specifically, risk parameters for retail exposures are assigned at the segment level.

Wholesale Exposures

Under the proposed rule, a bank would be required to have an internal risk rating system that indicates the likelihood of default of each individual

obligor and would either use an internal risk rating system that indicates the economic loss rate upon default of each individual exposure or directly assign an LGD estimate to each individual exposure. A bank would assign an internal risk rating to each wholesale obligor that reflected the obligor's likelihood of default.

Several commenters objected to the proposed requirement to assign an internal risk rating to each wholesale obligor that reflected the obligor's likelihood of default. Commenters asserted that this requirement was burdensome and unnecessary where a bank underwrote an exposure based solely on the financial strength of a guarantor and used the PD substitution approach (discussed below) to recognize the risk mitigating effects of an eligible guarantee on the exposure. In such cases, commenters maintained that banks should be allowed to assign a PD only to the guarantor and not the underlying obligor.

While the agencies believe that maintaining internal risk ratings of both a protection provider and underlying obligor provides helpful information for risk management purposes and facilitates a greater understanding of so-called double default effects, the agencies appreciate the commenters' concerns about burden in this context. Accordingly, the final rule does not require a bank to assign an internal risk rating to an underlying obligor to whom the bank extends credit based solely on the financial strength of a guarantor, provided that all of the bank's exposures to that obligor are fully covered by eligible guarantees and the bank applies the PD substitution approach to all of those exposures. A bank in this situation is only required to assign an internal risk rating to the guarantor. However, a bank must immediately assign an internal risk rating to the obligor if a guarantee can no longer be recognized under this final rule.

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 adapt to changes in the economy and the competitive environment.

Under the proposed rule, a bank would assign each legal entity wholesale obligor to a single rating grade. Accordingly, if a single wholesale exposure of the bank to an obligor triggered the proposed rule's definition of default, all of the bank's wholesale exposures to that obligor would be in default for risk-based capital purposes. In addition, under the proposed rule, a bank would not be allowed to 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. A bank would, however, 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.

While a few commenters expressly supported the proposal's requirement for banks to assign each legal entity wholesale obligor to a single rating grade, a substantial number of commenters expressed reservations about this requirement. These commenters observed that in certain circumstances an exposure's transaction-specific characteristics affect its likelihood of default. Commenters asserted that the agencies should provide greater flexibility and allow banks to depart from the one-rating-per-obligor requirement based on the economic substance of an exposure. In particular, commenters maintained that income-producing real estate lending should be exempt from the one-rating-per-obligor requirement. The commenters noted that the probability that an obligor will default on any one such facility depends primarily on the cash flows from the individual property securing the facility, not the overall condition of the obligor. Similarly, several commenters asserted that exposures involving transfer risk and non-recourse exposures should be exempted from the one-rating-per-obligor requirement.

In general, the agencies believe that a two-dimensional rating system that strictly separates borrower and exposure-level characteristics is a critical underpinning of the IRB approach. However, the agencies agree that exposures to the same borrower denominated in different currencies may have different default probabilities. For example, a sovereign government may impose prohibitive exchange restrictions that make it impossible for a borrower to transfer payments in one particular currency.

In addition, the agencies agree that certain income-producing real estate exposures for which the bank, in economic substance, does not have recourse to the borrower beyond the real estate serving as collateral for the exposure, have default probabilities distinct from that of the borrower. Such situations would arise, for example, where real estate collateral is located in a state where a bank, under applicable state law, effectively does not have recourse to the borrower if the bank pursues the real estate collateral in the event of default (for example, in a “one-action” state or a state with a similar law). In one-action states such as Arizona, California, Idaho, Montana, Nevada, and Utah, or in a state with a similar law, such as New York, the applicable foreclosure laws materially limit a bank's ability to collect against both the collateral and the borrower.

A third instance in which exposures to the same borrower may have significantly different default probabilities is when a borrower enters bankruptcy and the bank extends additional credit to the borrower under the auspices of the bankruptcy proceedings. This so-called debtor in possession (DIP) financing is unique from other exposure types because it typically has priority over existing debt, equity, and other claims on the borrower. The agencies believe that because of this unique priority status, if a bank has an exposure to a borrower that declares bankruptcy and defaults on that exposure, and the bank subsequently provides DIP financing to that obligor, it may not be appropriate to require the bank to treat the DIP financing exposure at inception as an exposure to a defaulted borrower.

To address these circumstances and clarify the application of the one-rating-per-obligor requirement, the agencies added a definition of obligor in the final rule. The final rule defines an obligor as the legal entity or natural person contractually obligated on a wholesale exposure except that a bank may treat three types of exposures to the same legal entity or natural person as having separate obligors. First, exposures to the same legal entity or natural person denominated in different currencies. Second, (i) income-producing real estate exposures for which all or substantially all of the repayment of the exposure is reliant on cash flows of the real estate serving as collateral for the exposure;

the bank, in economic substance, does not have recourse to the borrower beyond the real estate serving as collateral for the exposure; and no cross-default or cross-acceleration clauses are in place other than clauses obtained solely in an abundance of caution; and (ii) other credit exposures to the same legal entity or natural person. Third, (i) wholesale exposures authorized under section 364 of the U.S. Bankruptcy Code (11 U.S.C. 364) to a legal entity or natural person who is a debtor-in-possession for purposes of Chapter 11 of the Bankruptcy Code; and (ii) other credit exposures to the same legal entity or natural person. All exposures to a single legal entity or natural person must be treated as exposures to a single obligor unless they qualify for one of these three exceptions in the final rule's definition of obligor.

A bank's obligor 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 differentiate sufficiently the creditworthiness of non-defaulted wholesale obligors.

A bank must capture the estimated loss severity upon default for a wholesale exposure either by directly assigning an 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 LGD of the exposure). LGD is described in more detail below. Whether a bank chooses to assign LGD values directly or, alternatively, to assign exposures to rating grades and then quantify the LGD for the rating grades, the key requirement is that the bank must identify exposure characteristics that influence LGD. Each of the loss severity rating grades must be associated with an empirically supported LGD estimate. Banks employing loss severity grades must have a sufficiently granular loss severity grading system to avoid grouping together exposures with widely ranging 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 treatment of wholesale and retail exposures is that the risk parameters for wholesale exposures are assigned at the individual exposure level, whereas risk parameters for retail exposures are assigned at the segment 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 final rule's retail framework is that the risk parameters for retail exposures are assigned to segments of exposures rather than to individual exposures. Under the retail framework, a bank groups its retail exposures into segments with homogeneous risk characteristics and estimates PD and LGD for each segment.

Some commenters stated that for internal risk management purposes they assign risk parameters at the individual retail exposure level rather than at the segment level. These commenters requested confirmation that this practice would be permissible for risk-based capital purposes under the final rule. The agencies believe that a bank may use its advanced systems, including exposure-level risk parameter estimates, to group exposures into segments with homogeneous risk characteristics. Such exposure-level estimates must be aggregated in order to assign segment-level risk parameters to each segment of retail exposures.

A bank must group its retail exposures into three separate subcategories: (i) Residential mortgage exposures; (ii) QREs; and (iii) other retail exposures. The bank must classify the retail exposures in each subcategory into segments to produce a meaningful differentiation of risk. The final 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 LGD to reflect the risk mitigating effects of financial collateral from other retail eligible margin loans. Otherwise, the agencies do not 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 ratios, credit scores, loan terms and structure, origination channel, geographical location of the borrower, collateral type, and bank internal estimates of likelihood of default and loss severity given default. Regardless of the risk drivers used, a bank must be able to demonstrate to its primary Federal supervisor that its system assigns accurate and reliable PD and LGD estimates for each retail segment on a consistent basis.

Definition of Default

Wholesale 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. The ANPR's definition of default was generally consistent with the New Accord.

A number of commenters on the ANPR encouraged the agencies to use a wholesale definition of default that varied from the New Accord but conformed more closely to that used by bank risk managers. Many of these commenters recommended that the agencies define default for wholesale exposures as the entry into non-accrual or charge-off status. In the proposed rule, the agencies amended the ANPR definition of default to respond to these concerns. Under the proposed definition of default, a bank's wholesale obligor would be in default if, for any wholesale exposure of the bank to the obligor, the bank had (i) placed the exposure on non-accrual status consistent with the Consolidated Report of Condition and Income (Call Report) Instructions or the Thrift Financial Report (TFR) and the TFR 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.

The agencies received extensive comment on the proposed definition of default for wholesale exposures. Commenters observed that the proposed definition of default was different from and more prescriptive than the definition in the New Accord and employed in other major jurisdictions. They asserted that the proposed definition would impose unjustifiable systems burden and expense on banks operating across multiple jurisdictions. Commenters also asserted that many

banks' data collection systems are based on the New Accord's definition of default, and therefore historical data relevant to the proposed definition of default are limited. Moreover, commenters expressed concern that risk parameters estimated using the proposed definition of default would differ materially from those estimated using the New Accord's definition of default, resulting in different capital requirements for U.S. banks relative to their foreign peers.

The 5 percent credit-related loss trigger in the proposed definition of default for wholesale obligors was the focus of significant commenter concern. Commenters asserted that the trigger inappropriately imported LGD and maturity-related considerations into the definition of default, could hamper the use of loan sales as a risk management practice, and could cause obligors that are performing on their obligations to be considered defaulted. These commenters also claimed that the 5 percent trigger would add significant implementation burden by, for example, requiring banks to distinguish between credit-related and non-credit-related losses on sale.

Many commenters requested that the agencies conform the U.S. wholesale definition of default to the New Accord. Other commenters requested that banks be allowed the option to apply either the U.S. or the New Accord definition of default.

The agencies agree that the proposed definition of default for wholesale obligors could have unintended consequences for implementation burden and international consistency. Therefore, the final rule contains a definition of default for wholesale obligors that is similar to the definition proposed in the ANPR and consistent with the New Accord. Specifically, under the final rule, a bank's wholesale obligor is in default if, for any wholesale exposure of the bank to the obligor: (i) The bank considers that the obligor is unlikely to pay its credit obligations to the bank in full, without recourse by the bank to actions such as realizing collateral (if held); or (ii) the obligor is past due more than 90 days on any material credit obligation to the bank. The final rule also clarifies, consistent with the New Accord, that an overdraft is past due once the obligor has breached an advised limit or has been advised of a limit smaller than the current outstanding balance.

Consistent with the New Accord, the following elements may be indications of unlikeliness to pay under this definition:

(i) The bank places the exposure on non-accrual status consistent with the Call Report Instructions or the TFR and the TFR Instruction Manual;

(ii) The bank takes a full or partial charge-off or write-down on the exposure due to the distressed financial condition of the obligor;

(iii) The bank incurs a material credit-related loss 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;

(iv) The bank consents to a distressed restructuring of the exposure that is likely to result in a diminished financial obligation caused by the material forgiveness or postponement of principal, interest or (where relevant) fees;

(v) The bank has filed as a creditor of the obligor for purposes of the obligor's bankruptcy under the U.S. Bankruptcy Code (or a similar proceeding in a foreign jurisdiction regarding the obligor's credit obligation to the bank); or

(vi) The obligor has sought or has been placed in bankruptcy or similar protection that would avoid or delay repayment of the exposure to the bank.

If a bank carries a wholesale exposure at fair value for accounting purposes, the bank's practices for determining unlikeliness to pay for purposes of the definition of default should be consistent with the bank's practices for determining credit-related declines in the fair value of the exposure.

Like the proposed definition of default for wholesale obligors, the final rule states that 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 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.

Retail default.

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

Specifically, revolving retail exposures and residential mortgage exposures 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 had 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 had 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.

Although some commenters supported the proposed rule's retail definition of default, others urged the agencies to adopt a 90-days-past-due default trigger consistent with the New Accord's definition of default for retail exposures. Other commenters requested that a non-accrual trigger be added to the retail definition of default similar to that in the proposed wholesale definition of default. The commenters viewed this as a practical way to allow a foreign banking organization to harmonize the U.S. retail definition of default to a home country definition of default that has a 90-days-past-due trigger.

The agencies believe that adding a non-accrual trigger to the retail definition of default is not appropriate. Retail non-accrual practices vary considerably among banks, and adding a non-accrual trigger to the retail definition of default would result in greater inconsistency among banks in the treatment of retail exposures. Moreover, a bank that considers retail exposures to be defaulted at 90 days past due could have significantly different risk parameter estimates than one that uses 120- and 180-days-past-due thresholds. Such a bank would likely have higher PD estimates and lower LGD estimates due to the established tendency of a nontrivial proportion of U.S. retail exposures to “cure” or return to performing status after becoming 90 days past due and before becoming 120 or 180 days past due. The agencies believe that the 120- and 180-days-past-due thresholds, which are consistent with national discretion provided by the New Accord, reflect a point at which retail exposures in the United States are unlikely to return to performing status. Therefore, the agencies are incorporating the proposed retail definition of default without substantive change in the final rule. (Parallel to the full or partial

charge-off or write-down trigger for retail exposures not held at fair value, the agencies added a material negative fair value adjustment of principal for credit-related reasons trigger for retail exposures held at fair value.)

The New Accord provides discretion for national supervisors to set the retail default trigger at up to 180 days past due for different products, as appropriate to local conditions. Accordingly, banks implementing the IRB approach in multiple jurisdictions may be subject to different retail definitions of default in their home and host jurisdictions. The agencies recognize that it could be costly and burdensome for a U.S. bank to track default data and estimate risk parameters based on both the U.S. definition of default and the definitions of default in non-U.S. jurisdictions where subsidiaries of the U.S. bank implement the IRB approach. The agencies are therefore incorporating flexibility into the retail definition of default. Specifically, for a retail exposure held by a U.S. bank's non-U.S. subsidiary subject to an internal ratings-based approach to capital adequacy consistent with the New Accord in a non-U.S. jurisdiction, the final rule allows the bank to elect to use the definition of default of that jurisdiction, subject to prior approval by the bank's primary Federal supervisor. The primary Federal supervisor will revoke approval for a bank to use this provision if the supervisor finds that the bank uses the provision to arbitrage differences in national definitions of default.

The definition of default for retail exposures differs from the definition for the wholesale portfolio in that the retail default definition applies on an exposure-by-exposure basis rather than on an obligor-by-obligor basis. In other words, default on one retail exposure does not require a bank to treat all other retail obligations of the same borrower 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 borrowers. In addition, it is quite common for retail borrowers that default on some of their obligations to continue payment on others.

Although the retail definition of default does not explicitly include credit-related losses in connection with loan sales and the agencies have replaced the 5 percent credit-related loss threshold for wholesale exposures with a less prescriptive treatment that is consistent with the New Accord, the agencies expect banks to ensure that exposure sales do not bias or otherwise distort the estimated risk parameters assigned by a bank to its wholesale exposures and retail segments.

Rating Philosophy

A bank's internal risk rating policy for wholesale exposures must describe the bank's rating philosophy, which 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 rating 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, 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, 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 must 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

Each wholesale obligor rating and (if applicable) wholesale exposure loss severity rating must reflect 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. Under the proposed rule, a bank's retail exposure segmentation system would provide for the review and update (as appropriate) of assignments of retail exposures to segments whenever the bank received new material information. The proposed rule specified that the review would be required no less frequently than quarterly.

One commenter noted that quarterly reviews may not be appropriate for high-quality retail portfolios, such as retail exposures associated with a bank's wealth management or private banking businesses. The commenter suggested that banks should have the flexibility to review and update segmentation assignments for such portfolios on a less frequent basis appropriate to the credit quality of the portfolios.

The agencies agree that it may be appropriate for a bank to review and update segmentation assignments for certain high-quality retail exposures on a less frequent basis than quarterly, provided a bank is following sound risk management practices. Therefore, the final rule generally requires a quarterly review and update, as appropriate, of retail exposure segmentation assignments, allowing some flexibility to accommodate sound internal risk management practices.

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, 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 data, should be transparent, well supported, and documented. The following sections of the preamble discuss the rule's definitions of the risk parameters for wholesale exposures and retail segments.

Probability of Default (PD)

As noted above, under the final 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 is the bank's empirically based best estimate of the long-run average one-year default rate 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.

In addition, under the final rule, a bank must assign a PD to each segment of retail exposures. Some types of retail exposures typically display a 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. Because of the one-year IRB horizon, the proposed rule provided two different definitions of PD for 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. Under the proposed rule, PD for a segment of non-defaulted retail exposures for which seasoning effects

were not

material, or for a segment of non-defaulted retail exposures in a retail exposure subcategory for which seasoning effects

were 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. PD for a segment of non-defaulted retail exposures for which seasoning effects

were

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.

Commenters objected to this treatment of retail exposures with material seasoning effects. They asserted that requiring banks to use an annualized cumulative default rate to recognize seasoning effects was too prescriptive and would preclude other reasonable approaches. The agencies believe that commenters have presented reasonable alternative approaches to recognizing the effects of seasoning in PD and are, therefore, providing additional flexibility for recognizing those effects in the final rule.

Based on comments and additional consideration, the agencies also are clarifying that a segment of retail exposures has material seasoning effects if there is a material relationship between the time since origination of exposures within the segment and the bank's best estimate of the long-run average one-year default rate for the exposures in the segment. Moreover, because the agencies believe that the IRB approach must, at a minimum, require banks to hold appropriate amounts of risk-based capital to address credit risks over a one-year horizon, the final rule's incorporation of seasoning effects is explicitly one-directional. Specifically, a bank must increase PDs above the best estimate of the long-run average one-year default rate for segments of unseasoned retail exposures, but may not decrease PD below the best estimate of the long-run average one-year default rate for a segment of retail exposures that the bank estimates will have lower PDs in future years due to seasoning.

The final rule defines PD for a segment of non-defaulted retail exposures as the bank's empirically based best estimate of the long-run average one-year default rate 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 and adjusted upward as appropriate for segments for which seasoning effects are material. If a bank does not adjust PD to reflect seasoning effects for a segment of exposures, it should be able to demonstrate to its primary Federal supervisor, using empirical analysis, why seasoning effects are not material or why adjustment is not relevant for the segment.

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

Loss Given Default (LGD)

Under the proposed rule, a bank would directly estimate an ELGD and LGD risk parameter for each wholesale exposure or would 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 downturn loss severity grade. In addition, a bank would estimate an ELGD and LGD risk parameter for each segment of retail exposures.

Expected Loss Given Default (ELGD)

The proposed rule defined 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 expected 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) defaulted within a one-year horizon.

The proposed rule defined ELGD for a segment of retail exposures as the bank's empirically based best estimate of the default-weighted average economic loss per dollar of EAD the bank expected to incur on exposures in the segment that default within a one-year horizon. ELGD estimates would incorporate a mix of economic conditions (including economic downturn conditions). ELGD had four functions in the proposed rule—as a component of the calculation of ECL in the numerator of the risk-based capital ratios; in the EL component of the IRB risk-based capital formulas; as a floor on the value of the LGD risk parameter; and as an input into the supervisory mapping function.

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

Many commenters objected to the proposed rule's requirement for banks to estimate ELGD for each wholesale exposure and retail segment, noting that ELGD estimation is not required under the New Accord. Commenters asserted that requiring ELGD estimation would create a competitive disadvantage by creating additional systems, compliance, calculation, and reporting burden for those banks subject to the U.S. rule, many of which have already substantially developed their systems based on the New Accord. They also maintained that it would decrease the comparability of U.S. banks’ capital requirements and public disclosures relative to those of foreign banking organizations applying the advanced approaches. Several commenters also contended that defining ECL in terms of ELGD instead of LGD raised tier 1 risk-based capital requirements for U.S. banks compared to foreign banks using the New Accord's LGD-based ECL definition.

The agencies have concluded that the regulatory burden and potential competitive inequities identified by commenters outweigh the supervisory benefits of the proposed ELGD risk parameter, and are, therefore, not including it in the final rule. Instead, consistent with the New Accord, a bank must use LGD for the calculation of ECL and the EL component of the IRB risk-based capital formulas. Because the proposed ELGD risk parameter was equal to or less than LGD, this change generally will have the effect of decreasing both the numerator and denominator of the risk-based capital ratios.

Consistent with the New Accord, under the final rule, the LGD of a wholesale exposure or retail segment must not be less than the bank's

empirically based best estimate of the long-run default-weighted average economic loss, per dollar of EAD, the bank would expect to incur if the obligor (or a typical obligor in the loss severity grade assigned by the bank to the exposure or segment) were to default within a one-year horizon over a mix of economic conditions, including economic downturn conditions. The final rule also specifies that LGD may not be less than zero. The implications of eliminating the ELGD risk parameter for the supervisory mapping function are discussed below.

Economic Loss and Post-Default Extensions of Credit

Commenters requested additional clarity regarding the treatment of post-default extensions of credit. LGD is an estimate of the economic loss that would be incurred on an exposure, relative to the exposure's EAD, if the obligor were to default within a one-year horizon during economic downturn conditions. The estimated 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) are expected to occur after the date of default, the estimated 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 possibility of post-default extensions of credit made to facilitate collection of an exposure would be treated as negative cash flows and reflected in LGD.

For example, assume a loan to a retailer goes into default. The bank determines that the recovery would be enhanced by some additional expenditure to ensure an orderly workout process. One option would be for the bank to hire a third-party to facilitate the collection of the loan. Another option would be for the bank to extend additional credit directly to the defaulted obligor to allow the obligor to make an orderly liquidation of inventory. Both options represent negative cash flows on the original exposure, which must be discounted at a rate that is appropriate to the risk of the exposure.

Economic Downturn Conditions

The expected loss severities of some exposures may be substantially higher during economic downturn conditions than during other periods, while for other types of exposures they may not. Accordingly, the proposed rule required banks to use an LGD estimate that reflected economic downturn conditions for purposes of calculating the risk-based capital requirements for wholesale exposures and retail segments.

Several commenters objected to the requirement that LGD estimates must reflect economic downturn conditions. Some of these commenters stated that empirical evidence of correlation between economic downturn and LGD is inconclusive, except in certain cases. A few noted that estimates of expected LGD include conservative inputs, such as a conservative estimate of potential loss in the event of default or a conservative discount rate or collateral assumptions. One commenter suggested that if a bank can demonstrate it has been prudent in its LGD estimation and it has no evidence of the cyclicality of LGDs, it should not be required to calculate downturn LGDs. Other commenters remarked that the requirement to incorporate downturn conditions into LGD estimates should not be used as a surrogate for proper modeling of PD/LGD correlations. Finally, a number of commenters supported a pillar 2 approach for addressing LGD estimation.

Consistent with the New Accord, the final rule maintains the requirement for a bank 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. More specifically, banks must produce for each wholesale exposure (or 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.

For the purpose of defining economic downturn conditions, the proposed rule identified 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 defined 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) were significantly higher than average.

The agencies specifically sought 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. Some commenters stated that the proposed requirement is at a sufficiently granular level. Others asserted that the requirement should be eliminated or made less granular. Those commenters favoring less granularity stated that aggregate default rates for different product subcategories in different countries are unlikely to peak at the same time and that requiring economic downturn ana

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