# Risk-Based Capital Standards: Advanced Capital Adequacy Framework - Basel II > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/fr%3A07-5729 ## Record - **Collection:** Federal Register - **Document type:** Rule - **Published:** December 7, 2007 - **Citation:** 72 FR 69288 ## Text DEPARTMENT OF THE TREASURY Office of the Comptroller of the Currency 12 CFR Part 3 [Docket No. OCC-2007-0018] RIN 1557-AC91 FEDERAL RESERVE SYSTEM 12 CFR Parts 208 and 225 [Regulations H and Y; Docket No. R-1261] FEDERAL DEPOSIT INSURANCE CORPORATION 12 CFR Part 325 RIN 3064-AC73 DEPARTMENT OF THE TREASURY Office of Thrift Supervision 12 CFR Parts 559, 560, 563, and 567 RIN 1550-AB56; Docket No. OTS 2007-0021 Risk-Based Capital Standards: Advanced Capital Adequacy Framework — Basel II AGENCIES: Office of the Comptroller of the Currency, Treasury; Board of Governors of the Federal Reserve System; Federal Deposit Insurance Corporation; and Office of Thrift Supervision, Treasury. ACTION: Final rule. SUMMARY: The Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System (Board), the Federal Deposit Insurance Corporation (FDIC), and the Office of Thrift Supervision (OTS) (collectively, the agencies) are adopting a new risk-based capital adequacy framework that requires some and permits other qualifying banks 1 to use an internal ratings-based approach to calculate regulatory credit risk capital requirements and advanced measurement approaches to calculate regulatory operational risk capital requirements. The final rule describes the qualifying criteria for banks required or seeking to operate under the new framework and the applicable risk-based capital requirements for banks that operate under the framework. 1 For simplicity, and unless otherwise indicated, this final rule uses the term “bank” to include banks, savings associations, and bank holding companies (BHCs). The terms “bank holding company” and “BHC” refer only to bank holding companies regulated by the Board and do not include savings and loan holding companies regulated by the OTS. DATES: This final rule is effective April 1, 2008. FOR FURTHER INFORMATION CONTACT: OCC: Mark Ginsberg, Risk Expert, Capital Policy (202-927-4580) or Ron Shimabukuro, Senior Counsel, Legislative and Regulatory Activities Division (202-874-5090). Office of the Comptroller of the Currency, 250 E Street, SW., Washington, DC 20219. Board: Barbara Bouchard, Deputy Associate Director (202-452-3072 or barbara.bouchard@frb.gov ) or Anna Lee Hewko, Senior Supervisory Financial Analyst (202-530-6260 or anna.hewko@frb.gov ), Division of Banking Supervision and Regulation; or Mark E. Van Der Weide, Senior Counsel (202-452-2263 or mark.vanderweide@frb.gov ), Legal Division. For users of Telecommunications Device for the Deaf (“TDD”) only, contact 202-263-4869. FDIC: Jason C. Cave, Associate Director, Capital Markets Branch, (202) 898-3548, Bobby R. Bean, Chief, Policy Section, Capital Markets Branch, (202) 898-3575, Kenton Fox, Senior Policy Analyst, Capital Markets Branch, (202) 898-7119, Division of Supervision and Consumer Protection; or Michael B. Phillips, Counsel, (202) 898-3581, Supervision and Legislation Branch, Legal Division, Federal Deposit Insurance Corporation, 550 17th Street, NW., Washington, DC 20429. OTS: Michael D. Solomon, Director, Capital Policy, Supervision Policy (202) 906-5654; David W. Riley, Senior Analyst, Capital Policy (202) 906-6669; Austin Hong, Senior Analyst, Capital Policy (202) 906-6389; or Karen Osterloh, Special Counsel, Regulations and Legislation Division (202) 906-6639, Office of Thrift Supervision, 1700 G Street, NW., Washington, DC 20552. SUPPLEMENTARY INFORMATION: Table of Contents I. Introduction A. Executive Summary of the Final Rule B. Conceptual Overview 1. The IRB Approach for Credit Risk 2. The AMA for Operational Risk C. Overview of Final Rule D. Structure of Final Rule E. Overall Capital Objectives F. Competitive Considerations II. Scope A. Core and Opt-In Banks B. U.S. Subsidiaries of Foreign Banks C. Reservation of Authority D. Principle of Conservatism III. Qualification A. The Qualification Process 1. In General 2. Parallel Run and Transitional Floor Periods B. Qualification Requirements 1. Process and Systems Requirements 2. Risk rating and Segmentation Systems for Wholesale and Retail Exposures Wholesale Exposures Retail Exposures Rating Philosophy Rating and Segmentation Reviews and Updates 3. Quantification of Risk Parameters for Wholesale and Retail Exposures Probability of Default (PD) Loss Given Default (LGD) Expected Loss Given Default (ELGD) Economic Loss and Post-Default Extensions of Credit Economic Downturn Conditions Supervisory Mapping Function Pre-default Reductions in Exposure Exposure at Default (EAD) General Quantification Principles Portfolios With Limited Data or Limited Defaults 4. Optional Approaches That Require Prior Supervisory Approval 5. Operational Risk Operational Risk Data and Assessment System Operational risk Quantification System 6. Data management and maintenance 7. Control and oversight mechanisms Validation Internal Audit Stress Testing 8. Documentation C. Ongoing Qualification D. Merger and Acquisition Transition Provisions IV. Calculation of Tier 1 Capital and Total Qualifying Capital V. Calculation of Risk-Weighted Assets A. Categorization of Exposures 1. Wholesale Exposures 2. Retail Exposures 3. Securitization Exposures 4. Equity Exposures 5. Boundary Between Operational Risk and Other Risks 6. Boundary Between the Final Rule and the Market Risk Rule B. Risk-Weighted Assets for General Credit Risk (Wholesale Exposures, Retail Exposures, On-Balance Sheet Assets that Are Not Defined by Exposure Category, and Immaterial Credit Exposures) 1. Phase 1 — Categorization of Exposures 2. Phase 2 — Assignment of Wholesale Obligors and Exposures to Rating Grades and retail exposures to segments Purchased Wholesale Exposures Wholesale Lease Residuals 3. Phase 3 — Assignment of risk Parameters to Wholesale Obligors and Exposures and Retail Segments 4. Phase 4 — Calculation of Risk-Weighted Assets 5. Statutory Provisions on the Regulatory Capital Treatment of Certain Mortgage Loans C. Credit Risk Mitigation (CRM) Techniques 1. Collateral 2. Counterparty Credit Risk of Repo-Style Transactions, Eligible Margin Loans, and OTC Derivative Contracts Qualifying master netting agreement EAD for Repo-Style Transactions and Eligible Margin Loans Collateral Haircut Approach Simple VaR Methodology 3. EAD for OTC derivative Contracts Current Exposure Methodology 4. Internal Models Methodology Maturity Under the Internal Models Methodology Collateral Agreements Under the Internal Models Methodology Alternative Methods 5. Guarantees and Credit Derivatives That Cover Wholesale Exposures Eligible Guarantees and Eligible Credit Derivatives PD Substitution Approach LGD Adjustment Approach Maturity Mismatch Haircut Restructuring Haircut Currency Mismatch Haircut Example Multiple Credit Risk Mitigants Double Default Treatment 6. Guarantees and Credit Derivatives That Cover Retail Exposures D. Unsettled Securities, Foreign Exchange, and Commodity Transactions E. Securitization Exposures 1. Hierarchy of Approaches Gains-on-Sale and CEIOs The Ratings-Based Approach (RBA) The Internal Assessment Approach (IAA) The Supervisory Formula Approach (SFA) Deduction Exceptions to the General Hierarchy of Approaches Servicer Cash Advances Amount of a Securitization Exposure Implicit Support Operational Requirements for Traditional Securitizations Clean-Up Calls Additional Supervisory Guidance 2. Ratings-Based Approach (RBA) 3. Internal Assessment Approach (IAA) 4. Supervisory Formula Approach (SFA) General Requirements Inputs to the SFA Formula 5. Eligible Disruption Liquidity Facilities 6. CRM for Securitization Exposures 7. Synthetic Securitizations Background Operational Requirements for Synthetic Securitizations First-Loss Tranches Mezzanine Tranches Super-Senior Tranches 8. Nth-to-Default Credit Derivatives 9. Early Amortization Provisions Background Controlled Early Amortization Non-Controlled Early Amortization Securitization of Revolving Residential Mortgage Exposures F. Equity Exposures 1. Introduction and Exposure Measurement Hedge Transactions Measures of Hedge Effectiveness 2. Simple Risk-Weight Approach (SRWA) Non-Significant Equity Exposures 3. Internal Models Approach (IMA) IMA Qualification Risk-Weighted Assets Under the IMA 4. Equity Exposures to Investment Funds Full Look-Through Approach Simple Modified Look-Through Approach Alternative modified look-through approach VI. Operational Risk VII. Disclosure 1. Overview Comments on the Proposed Rule 2. General Requirements Frequency/Timeliness Location of Disclosures and Audit/Attestation Requirements Proprietary and Confidential Information 3. Summary of Specific Public Disclosure Requirements 4. Regulatory Reporting I. Introduction A. Executive Summary of the Final Rule On September 25, 2006, the agencies issued a joint notice of proposed rulemaking (proposed rule or proposal) (71 FR 55830) seeking public comment on a new risk-based regulatory capital framework for banks. 2 The agencies previously issued an advance notice of proposed rulemaking (ANPR) related to the new risk-based regulatory capital framework (68 FR 45900, August 4, 2003). The proposed rule was based on a series of releases from the Basel Committee on Banking Supervision (BCBS), culminating in the BCBS’s comprehensive June 2006 release entitled “International Convergence of Capital Measurement and Capital Standards: A Revised Framework” (New Accord). 3 The New Accord sets forth a “three pillar” framework encompassing risk-based capital requirements for credit risk, market risk, and operational risk (Pillar 1); supervisory review of capital adequacy (Pillar 2); and market discipline through enhanced public disclosures (Pillar 3). The New Accord includes several methodologies for determining a bank's risk-based capital requirements for credit, market, and operational risk. 2 The agencies also issued proposed changes to the risk-based capital rule for market risk in a separate notice of proposed rulemaking (71 FR 55958, September 25, 2006). A final rule on that proposal is under development and will be issued in the near future. 3 The BCBS is a committee of banking supervisory authorities established by the central bank governors of the G-10 countries in 1975. The BCBS issued the New Accord to modernize its first capital Accord, which was endorsed by the BCBS members in 1988 and implemented by the agencies in 1989. The New Accord, the 1988 Accord, and other documents issued by the BCBS are available through the Bank for International Settlements' Web site at http://www.bis.org. The proposed rule included the advanced capital methodologies from the New Accord, including the advanced internal ratings-based (IRB) approach for credit risk and the advanced measurement approaches (AMA) for operational risk (together, the advanced approaches). The IRB approach uses risk parameters determined by a bank's internal systems in the calculation of the bank's credit risk capital requirements. The AMA relies on a bank's internal estimates of its operational risks to generate an operational risk capital requirement for the bank. 4 4 The agencies issued draft guidance on the advanced approaches. See 72 FR 9084 (February 28, 2007). The agencies now are adopting this final rule implementing a new risk-based regulatory capital framework, based on the New Accord, that is mandatory for some U.S. banks and optional for others. While the New Accord includes several methodologies for determining risk-based capital requirements, the agencies are adopting only the advanced approaches at this time. The agencies received approximately 90 public comments on the proposed rule from banking organizations, trade associations representing the banking or financial services industry, supervisory authorities, and other interested parties. This section of the preamble highlights several fundamental issues that commenters raised about the agencies' proposal and briefly describes how the agencies have responded to those issues in the final rule. More detail is provided in the preamble sections below. Overall, commenters supported the development of the framework and the move to more risk-sensitive capital requirements. One overarching issue, however, was the areas where the proposal differed from the New Accord. Commenters said the divergences generally created competitive problems, raised home-host issues, entailed extra cost and regulatory burden, and did not necessarily improve the overall safety and soundness of banks subject to the rule. Commenters also generally disagreed with the agencies' proposal to adopt only the advanced approaches from the New Accord. Further, commenters objected to the agencies' retention of the leverage ratio, the transitional arrangements in the proposal, and the 10 percent numerical benchmark for identifying material aggregate reductions in risk-based capital requirements to be used for evaluating and responding to capital outcomes during the parallel run and transitional floor periods (discussed below). Commenters also noted numerous technical issues with the proposed rule. As noted in an interagency press release issued July 20, 2007 ( Banking Agencies Reach Agreement on Basel II Implementation ), the agencies have agreed to eliminate the language from the preamble concerning a 10 percent limitation on aggregate reductions in risk-based capital requirements. The press release also stated that the agencies are retaining intact the transitional floor periods (see preamble sections I.E. and III.A.2.). In addition, while not specifically mentioned in the press release, the agencies are retaining the leverage ratio and the prompt corrective action (PCA) regulations without modification. The final rule adopts without change the proposed criteria for identifying core banks (banks required to apply the advanced approaches) and continues to permit other banks (opt-in banks) to adopt the advanced approaches if they meet the applicable qualification requirements. Core banks are those with consolidated total assets (excluding assets held by an insurance underwriting subsidiary of a bank holding company) of $250 billion or more or with consolidated total on-balance-sheet foreign exposure of $10 billion or more. A depository institution (DI) also is a core bank if it is a subsidiary of another DI or bank holding company that uses the advanced approaches. The final rule also provides that a bank's primary Federal supervisor may determine that application of the final rule is not appropriate in light of the bank's asset size, level of complexity, risk profile, or scope of operations (see preamble sections II.A. and B.). As noted above, the final rule includes only the advanced approaches. The July 2007 interagency press release stated that the agencies have agreed to issue a proposed rule that would provide non-core banks with the option to adopt an approach consistent with the standardized approach included in the New Accord. This new proposal (the standardized proposal) will replace the earlier proposal to adopt the so-called Basel IA option (Basel 1A proposal). 5 The press release also noted the agencies' intention to finalize the standardized proposal before core banks begin the first transitional floor period under this final rule. 5 71 FR 77445 (Dec. 26, 2006). In response to commenters' concerns that some aspects of the proposed rule would result in excessive regulatory burden without commensurate safety and soundness enhancements, the agencies included a principle of conservatism in the final rule. In general, under this principle, in limited situations, a bank may choose not to apply a provision of the rule to one or more exposures if the bank can demonstrate on an ongoing basis to the satisfaction of its primary Federal supervisor that not applying the provision would, in all circumstances, unambiguously generate a risk-based capital requirement for each such exposure that is greater than that which would otherwise be required under the regulation, and the bank meets other specified requirements (see preamble section II.D.). In the proposal, the agencies modified the definition of default for wholesale exposures from that in the New Accord to address issues commenters had raised on the ANPR. Commenters objected to the agencies’ modified definition of default for wholesale exposures, however, asserting that a definition different from the New Accord would result in competitive inequities and significant implementation burden without associated supervisory benefit. In response to these concerns, the agencies have adopted a definition of default for wholesale exposures that is consistent with the New Accord (see preamble section III.B.2.). For retail exposures, the final rule retains the proposed definition of default and clarifies that, subject to certain considerations, a foreign subsidiary of a U.S. bank may, in its consolidated risk-based capital calculations, use the applicable host jurisdiction definition of default for retail exposures of the foreign subsidiary in that jurisdiction (see preamble section III.B.2.). Another concept introduced in the proposal that was not in the New Accord was the expected loss given default (ELGD) risk parameter. ELGD had four functions in the proposed rule—as a component of the calculation of expected credit loss (ECL) in the numerator of the risk-based capital ratios; in the expected loss (EL) component of the IRB risk-based capital formulas; as a floor on the value of the loss given default (LGD) risk parameter; and as an input into a supervisory mapping function. Many commenters objected to the inclusion of ELGD as a departure from the New Accord that would create regulatory burden and competitive inequity. Many commenters also objected to the supervisory mapping function, which the agencies intended as an alternative for banks that were not able to estimate reliably the LGD risk parameter. The agencies have eliminated ELGD from the final rule. Banks are required to estimate only the LGD risk parameter, which reflects economic downturn conditions (see preamble section III.B.3.). The supervisory mapping function also has been eliminated from the rule. Commenters also objected to the agencies’ decision not to include a distinct risk weight function for exposures to small- and medium-size enterprises (SMEs) as provided in the New Accord. In the proposal, the agencies noted they were not aware of compelling evidence that smaller firms with the same probability of default (PD) and LGD as larger firms are subject to less systemic risk than is already reflected in the wholesale risk-based capital functions. The agencies continue to believe an SME-specific risk weight function is not supported by sufficient evidence and might give rise to competitive inequities across U.S. banks, and have not adopted such a function in the final rule (see preamble section V.A.1.) With regard to the proposed treatment for securitization exposures, commenters raised a number of technical issues. Many objected to the proposed definition of a securitization exposure, which included exposures to investment funds with material liabilities (including exposures to hedge funds). The agencies agree with commenters that the proposed definition for securitization exposures was quite broad and captured some exposures that would more appropriately be treated under the wholesale or equity frameworks. To limit the scope of the IRB securitization framework, the agencies have modified the definition of traditional securitization in the final rule as described in preamble section V.A.3. Technical issues related to securitization exposures are discussed in preamble sections V.A.3. and V.E. For equity exposures, commenters focused on the proposal's lack of a grandfathering period. The New Accord provides national discretion for each implementing jurisdiction to adopt a grandfather period for equity exposures. Commenters asserted that this omission would result in competitive inequity for U.S. banks as compared to other internationally active institutions. The agencies believe that, overall, the proposal's approach to equity exposures results in a competitive risk-based capital requirement. The final rule does not include a grandfathering provision, and the agencies have adopted the proposed treatment for equity exposures without significant change (see preamble section V.F.). A number of commenters raised issues related to operational risk. Most significantly, commenters noted that activities besides securities processing and credit card fraud have highly predictable and reasonably stable losses and should be considered for operational risk offsets. The agencies believe that the proposed definition of 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. 6 6 The theoretical underpinnings for the supervisory model of credit risk underlying the IRB approach are provided in a paper by Michael Gordy, “A Risk-Factor Model Foundation for Ratings-Based Bank Capital Rules,” Journal of Financial Intermediation, July 2003. The IRB formulas are derived as an application of these results to a single-factor CreditMetrics TM -style model. For mathematical details on this model, see Michael Gordy, “A Comparative Anatomy of Credit Risk Models,” Journal of Banking and Finance, January 2000, or H.U. Koyluogu and A. Hickman, “Reconcilable Differences,” Risk, October 1998. For a less technical overview of the IRB formulas, see the BCBS's “An Explanatory Note on the Basel II Risk Weight Functions,” July 2005 (BCBS Explanatory Note). The document can be found on the Bank for International Settlements Web site at http://www.bis.org. The IRB approach is broadly similar to the credit VaR approaches used by a number of banks as the basis for their internal assessment of the economic capital necessary to cover credit risk. It is common for a bank's internal credit risk models to consider a one-year loss horizon and to focus on a high loss threshold confidence level. As with the internal credit VaR models used by banks, the output of the risk-based capital formulas in the IRB approach is an estimate of the amount of credit losses above ECL over a one-year horizon that would only be exceeded a small percentage of the time. The agencies believe that a one-year horizon is appropriate because it balances the difficulty of easily or rapidly exiting non-trading positions against the possibility that in many cases a bank can cover credit losses by raising additional capital should the underlying credit problems manifest themselves gradually. The nominal confidence level of the IRB risk-based capital formulas (99.9 percent) means that if all the assumptions in the IRB supervisory model for credit risk were correct for a bank, there would be less than a 0.1 percent probability that credit losses at the bank in any year would exceed the IRB risk-based capital requirement. 7 7 Banks' internal economic capital models typically focus on measures of equity capital, whereas the total regulatory capital measure underlying this rule includes not only equity capital, but also certain debt and hybrid instruments, such as subordinated debt. Thus, the 99.9 percent nominal confidence level embodied in the IRB approach is not directly compatable to the nominal solvency standards underpinning banks' economic capital models. As noted above, the supervisory model of credit risk underlying the IRB approach embodies specific assumptions about the economic drivers of portfolio credit risk at banks. As with any modeling approach, these assumptions represent simplifications of very complex real-world phenomena and, at best, are only an approximation of the actual credit risks at any bank. If these assumptions (described in greater detail below) are incorrect or otherwise do not characterize a given bank precisely, the actual confidence level implied by the IRB risk-based capital formulas may exceed or fall short of a true 99.9 percent confidence level. In combination with other supervisory assumptions and parameters underlying the IRB approach, the approach's 99.9 percent nominal confidence level reflects a judgmental pooling of available information, including supervisory experience. The framework underlying this final rule reflects a desire on the part of the agencies to achieve (i) risk-based capital requirements that are reflective of relative risk across different assets and that are broadly consistent with maintaining at least an investment-grade rating (for example, at least BBB) on the liabilities funding those assets, even in periods of economic adversity; and (ii) for the U.S. banking system as a whole, aggregate minimum regulatory capital requirements that are not a material reduction from the aggregate minimum regulatory capital requirements under the general risk-based capital rules. A number of important explicit general assumptions and specific parameters are built into the IRB approach to make the framework applicable to a range of banks and to obtain tractable information for calculating risk-based capital requirements. Chief among the assumptions embodied in the IRB approach are: (i) Assumptions that a bank's credit portfolio is infinitely granular; (ii) assumptions that loan defaults at a bank are driven by a single, systematic risk factor; (iii) assumptions that systematic and non-systematic risk factors are log-normal random variables; and (iv) assumptions regarding correlations among credit losses on various types of assets. The specific risk-based capital formulas in this final rule require the bank to estimate certain risk parameters for its wholesale and retail exposures, which the bank may do using a variety of techniques. These risk parameters are PD, LGD, exposure at default (EAD), and, for wholesale exposures, effective remaining maturity (M). The proposed rule included an additional risk parameter, ELGD. As discussed in section III.B.3. of the preamble, the agencies have eliminated the ELGD risk parameter from the final rule. The risk-based capital formulas into which the estimated risk parameters are inserted are simpler than the economic capital methodologies typically employed by banks, which often require complex computer simulations. In particular, an important property of the IRB risk-based capital formulas is portfolio invariance. That is, the risk-based capital requirement for a particular exposure generally does not depend on the other exposures held by the bank. Like the general risk-based capital rules, the total credit risk capital requirement for a bank's wholesale and retail exposures is the sum of the credit risk capital requirements on individual wholesale exposures and segments of retail exposures. The IRB risk-based capital formulas contain supervisory asset value correlation (AVC) factors, which have a significant impact on the capital requirements generated by the formulas. The AVC assigned to a given portfolio of exposures is an estimate of the degree to which any unanticipated changes in the financial conditions of the underlying obligors of the exposures are correlated (that is, would likely move up and down together). High correlation of exposures in a period of economic downturn conditions is an area of supervisory concern. For a portfolio of exposures having the same risk parameters, a larger AVC implies less diversification within the portfolio, greater overall systematic risk, and, hence, a higher risk-based capital requirement. 8 For example, a 15 percent AVC for a portfolio of residential mortgage exposures would result in a lower risk-based capital requirement than a 20 percent AVC and a higher risk-based capital requirement than a 10 percent AVC. 8 See BCBS Explanatory Note. The AVCs that appear in the IRB risk-based capital formulas for wholesale exposures decline with increasing PD; that is, the IRB risk-based capital formulas generally imply that a group of low-PD wholesale exposures are more correlated than a group of high-PD wholesale exposures. Thus, under the rule, a low-PD wholesale exposure would have a higher relative risk-based capital requirement than that implied by its PD were the AVC in the IRB risk-based capital formulas for wholesale exposures fixed rather than a decreasing function of PD. The AVCs included in the IRB risk-based capital formulas for both wholesale and retail exposures reflect a combination of supervisory judgment and empirical evidence. 9 However, the historical data available for estimating correlations among retail exposures, particularly for non-mortgage retail exposures, was more limited than was the case with wholesale exposures. As a result, supervisory judgment played a greater role. Moreover, the flat 15 percent AVC for residential mortgage exposures is based largely on supervisory experience with and analysis of traditional long-term, fixed-rate mortgages. 9 See BCBS Explanatory Note, section 5.3. Several commenters stated that the proposed AVCs for wholesale exposures were too high in general, and a few claimed that, in particular, the AVCs for multi-family residential real estate exposures should be lower. Other commenters suggested that the AVCs of wholesale exposures should be a function of obligor size rather than PD. Similarly, several commenters maintained that the proposed AVCs for retail exposures were too high. Some of these commenters suggested that the AVCs for qualifying revolving exposures (QREs), such as credit cards, should be in the range of 1 to 2 percent, not 4 percent as proposed. Similarly, some of those commenters opposed the proposed flat 15 percent AVC for residential mortgage exposures; one commenter suggested that the agencies should consider employing lower AVCs for home equity loans and lines of credit (HELOCs) to take into account their shorter maturity relative to traditional mortgage exposures. However, most commenters recognized that the proposed AVCs were consistent with those in the New Accord and recommended that the agencies use the AVCs contained in the New Accord to avoid international competitive inequity and unnecessary burden. Several commenters suggested that the agencies should reconsider the AVCs going forward, working with the BCBS. The agencies agree with the prevailing view of the commenters that using the AVCs in the New Accord alleviates a potential source of international inconsistency and implementation burden. The final rule therefore maintains the proposed AVCs. As the agencies gain more experience with the advanced approaches, they may revisit the AVCs for wholesale exposures and retail exposures, along with other calibration issues identified during the parallel run and transitional floor periods (as described below) and make changes to the rule as necessary. The agencies would address this issue working with the BCBS and other supervisory and regulatory authorities, as appropriate. Another important conceptual element of the IRB approach concerns the treatment of ECL. The IRB approach assumes that reserves should cover ECL while capital should cover credit losses exceeding ECL (that is, unexpected credit losses). Accordingly, the final rule, consistent with the proposal and the New Accord, removes ECL from the risk-weighted assets calculation but requires a bank to compare its ECL to its eligible credit reserves (as defined below). If a bank's ECL exceeds its eligible credit reserves, the bank must deduct the excess ECL amount 50 percent from tier 1 capital and 50 percent from tier 2 capital. If a bank's eligible credit reserves exceed its ECL, the bank may include the excess eligible credit reserves amount in tier 2 capital, up to 0.6 percent of the bank's credit risk-weighted assets. 10 This treatment is intended to maintain a capital incentive to reserve prudently and ensure that ECL over a one-year horizon is covered either by reserves or capital. This treatment also recognizes that prudent reserving that considers probable losses over the life of a loan may result in a bank holding reserves in excess of ECL measured with a one-year horizon. The BCBS calibrated the 0.6 percent limit on inclusion of excess reserves in tier 2 capital to be approximately as restrictive as the existing cap on the inclusion of allowance for loan and lease losses (ALLL) under the 1988 Accord, based on data obtained in the BCBS's Third Quantitative Impact Study (QIS-3). 11 10 In contrast, under the general risk-based capital rules, the allowance for loan and lease losses (ALLL) may be included in tier 2 capital up to 1.25 percent of total risk-weighted assets. 11 BCBS, “QIS 3: Third Quantitative Impact Study,” May 2003. In developing the New Accord, the BCBS sought broadly to maintain the current overall level of minimum risk-based capital requirements within the banking system. Using data from QIS-3, the BCBS conducted an analysis of the risk-based capital requirements that would be generated under the New Accord. Based on this analysis, the BCBS concluded that a “scaling factor” (multiplier) should apply to credit risk-weighted assets. The BCBS, in the New Accord, indicated that the best estimate of the scaling factor was 1.06. In May 2006, the BCBS decided to maintain the 1.06 scaling factor based on the results of a fourth quantitative impact study (QIS-4) conducted in some jurisdictions, including the United States, and a fifth quantitative impact study (QIS-5), not conducted in the United States. 12 The BCBS noted that national supervisory authorities will continue to monitor capital requirements during implementation of the New Accord, and that the BCBS, in turn, will monitor national experiences with the framework. 12 BCBS press release, “Basel Committee maintains calibration of Base II Framework,” May 24, 2006. The agencies generally agree with the BCBS regarding calibration of the New Accord. Therefore, consistent with the New Accord and the proposed rule, the final rule contains a scaling factor of 1.06 for credit-risk-weighted assets. As the agencies gain more experience with the advanced approaches, the agencies will revisit the scaling factor along with other calibration issues identified during the parallel run and transitional floor periods (described below) and will make changes to the rule as necessary, working with the BCBS and other supervisory and regulatory authorities, as appropriate. 2. The AMA for Operational Risk The final rule also includes the AMA for determining risk-based capital requirements for operational risk. Under the final rule (consistent with the proposed rule), operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events. This definition of operational risk includes legal risk—which is the risk of loss (including litigation costs, settlements, and regulatory fines) resulting from the failure of the bank to comply with laws, regulations, prudent ethical standards, and contractual obligations in any aspect of the bank's business—but excludes strategic and reputational risks. Under the AMA, a bank must use its internal operational risk management systems and processes to assess its exposure to operational risk. Given the complexities involved in measuring operational risk, the AMA provides banks with substantial flexibility and, therefore, does not require a bank to use specific methodologies or distributional assumptions. Nevertheless, a bank using the AMA must demonstrate to the satisfaction of its primary Federal supervisor that its systems for managing and measuring operational risk meet established standards, including producing an estimate of operational risk exposure that meets a one-year, 99.9th percentile soundness standard. A bank's estimate of operational risk exposure includes both expected operational loss (EOL) and unexpected operational loss (UOL) and forms the basis of the bank's risk-based capital requirement for operational risk. The AMA allows a bank to base its risk-based capital requirement for operational risk on UOL alone if the bank can demonstrate to the satisfaction of its primary Federal supervisor that the bank has eligible operational risk offsets, such as certain operational risk reserves, that equal or exceed the bank's EOL. To the extent that eligible operational risk offsets are less than EOL, the bank's risk-based capital requirement for operational risk must incorporate the shortfall. C. Overview of Final Rule The final rule maintains the general risk-based capital rules' minimum tier 1 risk-based capital ratio of 4.0 percent and total risk-based capital ratio of 8.0 percent. The components of tier 1 and total capital in the final rule are also the same as in the general risk-based capital rules, with a few adjustments described in more detail below. The primary difference between the general risk-based capital rules and the final rule is the methodologies used for calculating risk-weighted assets. Banks applying the final rule generally must use their internal risk measurement systems to calculate the inputs for determining the risk-weighted asset amounts for (i) general credit risk (including wholesale and retail exposures); (ii) securitization exposures; (iii) equity exposures; and (iv) operational risk. In certain cases, however, banks must use external ratings or supervisory risk weights to determine risk-weighted asset amounts. Each of these areas is discussed below. Banks using the final rule also are subject to supervisory review of their capital adequacy (Pillar 2) and certain public disclosure requirements to foster transparency and market discipline (Pillar 3). In addition, each bank using the advanced approaches remains subject to the tier 1 leverage ratio requirement, 13 and each DI (as defined in section 3 of the Federal Deposit Insurance Act (12 U.S.C. 1813)) using the advanced approaches remains subject to the prompt corrective action (PCA) thresholds. 14 Banks using the advanced approaches also remain subject to the market risk rule, where applicable. 13 See 12 CFR part 3.6(b) and (c) (national banks); 12 CFR part 208, appendix B (state member banks); 12 CFR part 225, appendix D (bank holding companies); 12 CFR 325.3 (state nonmember banks); 12 CFR 567.2(a)(2) and 567.8 (savings associations). 14 See 12 CFR part 6 (national banks); 12 CFR part 208, subpart D (state member banks); 12 CFR 325.103 (state nonmember banks); 12 CFR part 565 (savings associations). In addition, savings associations remain subject to the tangible capital requirement at 12 CFR 567.2(a)(3) and 567.9. Under the final rule, a bank must identify whether each of its on- and off-balance sheet exposures is a wholesale, retail, securitization, or equity exposure. Assets that are not defined by any exposure category (and certain immaterial portfolios of exposures) generally are assigned risk-weighted asset amounts equal to their carrying value (for on-balance sheet exposures) or notional amount (for off-balance sheet exposures). Wholesale exposures under the final rule include most credit exposures to companies, sovereigns, and other governmental entities. For each wholesale exposure, a bank must assign four quantitative risk parameters: PD (which is expressed as a decimal (that is, 0.01 corresponds to 1 percent) and is an estimate of the probability that an obligor will default over a one-year horizon); LGD (which is expressed as a decimal and reflects an estimate of the economic loss rate if a default occurs during economic downturn conditions); EAD (which is measured in dollars and is an estimate of the amount that would be owed to the bank at the time of default); and M (which is measured in years and reflects the effective remaining maturity of the exposure). Banks may factor into their risk parameter estimates the risk mitigating impact of collateral, credit derivatives, and guarantees that meet certain criteria. Banks must input the risk parameters for each wholesale exposure into an IRB risk-based capital formula to determine the risk-based capital requirement for the exposure. Retail exposures under the final rule include most credit exposures to individuals and small credit exposures to businesses that are managed as part of a segment of exposures with similar risk characteristics and not managed on an individual-exposure basis. A bank must classify each of its retail exposures into one of three retail subcategories—residential mortgage exposures; QREs, such as credit cards and overdraft lines; and other retail exposures. Within these three subcategories, the bank must group exposures into segments with similar risk characteristics. The bank must then assign the risk parameters PD, LGD, and EAD to each retail segment. The bank may take into account the risk mitigating impact of collateral and guarantees in the segmentation process and in the assignment of risk parameters to retail segments. Like wholesale exposures, the risk parameters for each retail segment are used as inputs into an IRB risk-based capital formula to determine the risk-based capital requirement for the segment. For securitization exposures, the bank must apply one of three general approaches, subject to various conditions and qualifying criteria: the Ratings-Based Approach (RBA), which uses external ratings to risk-weight exposures; the Internal Assessment Approach (IAA), which uses internal ratings to risk-weight exposures to asset-backed commercial paper programs (ABCP programs); or the Supervisory Formula Approach (SFA), which uses bank inputs that are entered into a supervisory formula to risk-weight exposures. Securitization exposures in the form of gain-on-sale or credit-enhancing interest-only strips (CEIOs) 15 and securitization exposures that do not qualify for the RBA, the IAA, or the SFA must be deducted from regulatory capital. 15 A CEIO is an on-balance sheet asset that, in form or in substance, (i) represents the contractual right to receive some or all of the interest and no more than a minimal amount of principal due on the underlying exposures of a securitization and (ii) exposes the holder to credit risk directly or indirectly associated with the underlying exposures that exceeds its pro rata claim on the underlying exposures, whether through subordination provisions or other credit-enhancement techniques. Banks may use an internal models approach (IMA) for determining risk-based capital requirements for equity exposures, subject to certain qualifying criteria and floors. If a bank does not have a qualifying internal model for equity exposures, or chooses not to use such a model, the bank must apply a simple risk weight approach (SRWA) in which publicly traded equity exposures generally are assigned a 300 percent risk weight and non-publicly traded equity exposures generally are assigned a 400 percent risk weight. Under both the IMA and the SRWA, equity exposures to certain entities or made pursuant to certain statutory authorities (such as community development laws) are subject to a 0 to 100 percent risk weight. Banks must develop qualifying AMA systems to determine risk-based capital requirements for operational risk. Under the AMA, a bank must use its own methodology to identify operational loss events, measure its exposure to operational risk, and assess a risk-based capital requirement for operational risk. Under the final rule, a bank must calculate its tier 1 and total risk-based capital ratios by dividing tier 1 capital by total risk-weighted assets and by dividing total qualifying capital by total risk-weighted assets, respectively. To calculate total risk-weighted assets, a bank must first convert the dollar risk-based capital requirements for exposures produced by the IRB risk-based capital approaches and the AMA into risk-weighted asset amounts by multiplying the capital requirements by 12.5 (the inverse of the overall 8.0 percent risk-based capital requirement). After determining the risk-weighted asset amounts for credit risk and operational risk, a bank must sum these amounts and then subtract any excess eligible credit reserves not included in tier 2 capital to determine total risk-weighted assets. The final rule contains specific public disclosure requirements to provide important information to market participants on the capital structure, risk exposures, risk assessment processes, and, hence, the capital adequacy of a bank. The public disclosure requirements apply only to the DI or bank holding company representing the top consolidated level of the banking group that is subject to the advanced approaches, unless the entity is a subsidiary of a non-U.S. banking organization that is subject to comparable disclosure requirements in its home jurisdiction. All banks subject to the rule, however, must disclose total and tier 1 risk-based capital ratios and the components of these ratios. The agencies also proposed a package of regulatory reporting templates for the agencies' use in assessing and monitoring the levels and components of bank risk-based capital requirements under the advanced approaches. 16 These templates will be finalized shortly. 16 71 FR 55981 (September 25, 2006). The agencies are aware that the fair value option in generally accepted accounting principles as used in the United States (GAAP) raises potential risk-based capital issues not contemplated in the development of the New Accord. The agencies will continue to analyze these issues and may make changes to this rule at a future date as necessary. The agencies would address these issues working with the BCBS and other supervisory and regulatory authorities, as appropriate. D. Structure of Final Rule The agencies are implementing a regulatory framework for the advanced approaches in which each agency has an advanced approaches appendix that incorporates (i) definitions of tier 1 and tier 2 capital and associated adjustments to the risk-based capital ratio numerators, (ii) the qualification requirements for using the advanced approaches, and (iii) the details of the advanced approaches. 17 The agencies also are incorporating their respective market risk rules, by cross-reference. 18 17 As applicable, certain agencies are also making conforming changes to existing regulations as necessary to incorporate the new appendices. 18 12 CFR part 3, Appendix B (for national banks), 12 CFR part 208, Appendix E (for state member banks), 12 CFR part 225, Appendix E (for bank holding companies), and 12 CFR part 325, Appendix C (for state nonmember banks). OTS intends to codify a market risk rule for savings associations at 12 CFR part 567, Appendix D. In this final rule, as in the proposed rule, the agencies are not restating the elements of tier 1 and tier 2 capital, which largely remain the same as under the general risk-based capital rules. Adjustments to the risk-based capital ratio numerators specific to banks applying the final rule are in part II of the rule and explained in greater detail in section IV of this preamble. The final rule has eight parts. Part I identifies criteria for determining which banks are subject to the rule, provides key definitions, and sets forth the minimum risk-based capital ratios. Part II describes the adjustments to the numerator of the regulatory capital ratios for banks using the advanced approaches. Part III describes the qualification process and provides qualification requirements for obtaining supervisory approval for use of the advanced approaches. This part incorporates critical elements of supervisory oversight of capital adequacy (Pillar 2). Parts IV through VII address the calculation of risk-weighted assets. Part IV provides the risk-weighted assets calculation methodologies for wholesale and retail exposures; on-balance sheet assets that do not meet the regulatory definition of a wholesale, retail, securitization, or equity exposure; and certain immaterial portfolios of credit exposures. This part also describes the risk-based capital treatment for over-the-counter (OTC) derivative contracts, repo-style transactions, and eligible margin loans. In addition, this part describes the methodologies for reflecting credit risk mitigation in risk-weighted assets for wholesale and retail exposures. Furthermore, this part sets forth the risk-based capital requirements for failed and unsettled securities, commodities, and foreign exchange transactions. Part V identifies operating criteria for recognizing risk transference in the securitization context and outlines the approaches for calculating risk-weighted assets for securitization exposures. Part VI describes the approaches for calculating risk-weighted assets for equity exposures. Part VII describes the calculation of risk-weighted assets for operational risk. Finally, Part VIII provides public disclosure requirements for banks employing the advanced approaches (Pillar 3). The structure of the preamble generally follows the structure of the regulatory text. Definitions, however, are discussed in the portions of the preamble where they are most relevant. E. Overall Capital Objectives The preamble to the proposed rule described the agencies’ intention to avoid a material reduction in overall risk-based capital requirements under the advanced approaches. The agencies also identified other objectives, such as ensuring that differences in capital requirements appropriately reflect differences in risk and ensuring that the U.S. implementation of the New Accord will not be a significant source of competitive inequity among internationally active banks or among domestic banks operating under different risk-based capital rules. The final rule modifies and clarifies the approach the agencies will use to achieve these objectives. The agencies proposed a series of transitional floors to provide a smooth transition to the advanced approaches and to temporarily limit the amount by which a bank's risk-based capital requirements could decline over a period of at least three years. The transitional floors are described in more detail in section III.A.2. of this preamble. The floors generally prohibit a bank's risk-based capital requirement under the advanced approaches from falling below 95 percent, 90 percent, and 85 percent of what it would be under the general risk-based capital rules during the bank's first, second, and third transitional floor periods, respectively. The proposal stated that banks would be required to receive the approval of their primary Federal supervisor before entering each transitional floor period. The preamble to the proposal noted that if there was a material reduction in aggregate minimum regulatory capital upon implementation of the advanced approaches, the agencies would propose regulatory changes or adjustments during the transitional floor periods. The preamble further noted that in this context, materiality would depend on a number of factors, including the size, source, and nature of any reduction; the risk profiles of banks authorized to use the advanced approaches; and other considerations relevant to the maintenance of a safe and sound banking system. The agencies also stated that they would view a 10 percent or greater decline in aggregate minimum required risk-based capital (without reference to the effects of the transitional floors), compared to minimum required risk-based capital as determined under the general risk-based capital rules, as a material reduction warranting modification to the supervisory risk functions or other aspects of the framework. Further, the agencies stated that they were “identifying a numerical benchmark for evaluating and responding to capital outcomes during the parallel run and transitional floor periods that do not comport with the overall capital objectives.” The agencies also stated that “[a]t the end of the transitional floor periods, the agencies would reevaluate the consistency of the framework, as (possibly) revised during the transitional floor periods, with the capital goals outlined in the ANPR and with the maintenance of broad competitive parity between banks adopting the framework and other banks, and would be prepared to make further changes to the framework if warranted.” The agencies viewed the parallel run and transitional floor periods as “a trial of the new framework under controlled conditions.” 19 19 71 FR 55839-40 (September 25, 2006). The agencies sought comment on the appropriateness of using a 10 percent or greater decline in aggregate minimum required risk-based capital as a numerical benchmark for material reductions when determining whether capital objectives were achieved. Many commenters objected to the proposed transitional floors and the 10 percent benchmark on the grounds that both safeguards deviated 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. 20 In conducting the interagency study the agencies would consider, for example, the following: 20 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 21 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. 21 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. 22 22 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 23 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. 23 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. 24 The preamble noted that a U.S. BHC that met the conditions in Federal Reserve SR letter 01-01 25 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. 24 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. 25 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. 26 Further, the implementation plan must describe the resources that the bank has budgeted and that are available to implement the plan. 26 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 95 Second floor period 90 Third floor period 85 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. 27 27 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. 28 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. 28 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. 29 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. 29 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. [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A07-5729. Public record. Not legal advice.