# Regulatory Capital Rule: Large Banking Organizations and Banking Organizations With Significant Trading Activity > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/fr%3A2023-19200 ## Record - **Collection:** Federal Register - **Document type:** Proposed Rule - **Published:** September 18, 2023 - **Citation:** 88 FR 64028 ## Text DEPARTMENT OF THE TREASURY Office of the Comptroller of the Currency 12 CFR Parts 3, 6, 32 [Docket ID OCC-2023-0008] RIN 1557-AE78 FEDERAL RESERVE SYSTEM 12 CFR Parts 208, 217, 225, 238, 252 [Docket No. R-1813] RIN 7100-AG64 FEDERAL DEPOSIT INSURANCE CORPORATION 12 CFR Part 324 RIN 3064-AF29 Regulatory Capital Rule: Large Banking Organizations and Banking Organizations With Significant Trading Activity AGENCY: Office of the Comptroller of the Currency, Treasury; the Board of Governors of the Federal Reserve System; and the Federal Deposit Insurance Corporation. ACTION: Notice of proposed rulemaking. SUMMARY: The Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation are inviting public comment on a notice of proposed rulemaking (proposal) that would substantially revise the capital requirements applicable to large banking organizations and to banking organizations with significant trading activity. The revisions set forth in the proposal would improve the calculation of risk-based capital requirements to better reflect the risks of these banking organizations' exposures, reduce the complexity of the framework, enhance the consistency of requirements across these banking organizations, and facilitate more effective supervisory and market assessments of capital adequacy. The revisions would include replacing current requirements that include the use of banking organizations' internal models for credit risk and operational risk with standardized approaches and replacing the current market risk and credit valuation adjustment risk requirements with revised approaches. The proposed revisions would be generally consistent with recent changes to international capital standards issued by the Basel Committee on Banking Supervision. The proposal would not amend the capital requirements applicable to smaller, less complex banking organizations. DATES: Comments must be received by November 30, 2023. ADDRESSES: Comments should be directed to: OCC: Commenters are encouraged to submit comments through the Federal eRulemaking Portal, if possible. Please use the title “Regulatory capital rule: Amendments applicable to large banking organizations and to banking organizations with significant trading activity” to facilitate the organization and distribution of the comments. You may submit comments by any of the following methods: • Federal eRulemaking Portal—Regulations.gov: Go to https://regulations.gov/. Enter “Docket ID OCC-2023-0008” in the Search Box and click “Search.” Public comments can be submitted via the “Comment” box below the displayed document information or by clicking on the document title and then clicking the “Comment” box on the top-left side of the screen. For help with submitting effective comments, please click on “Commenter's Checklist.” For assistance with the Regulations.gov site, please call 1-866-498-2945 (toll free) Monday-Friday, 9 a.m.-5 p.m. ET, or email regulationshelpdesk@gsa.gov. • Mail: Chief Counsel's Office, Attention: Comment Processing, Office of the Comptroller of the Currency, 400 7th Street SW, Suite 3E-218, Washington, DC 20219. • Hand Delivery/Courier: 400 7th Street SW, Suite 3E-218, Washington, DC 20219. Instructions: You must include “OCC” as the agency name and “Docket ID OCC-2023-0008” in your comment. In general, the OCC will enter all comments received into the docket and publish the comments on the Regulations.gov website without change, including any business or personal information provided such as name and address information, email addresses, or phone numbers. Comments received, including attachments and other supporting materials, are part of the public record and subject to public disclosure. Do not include any information in your comment or supporting materials that you consider confidential or inappropriate for public disclosure. You may review comments and other related materials that pertain to this action by the following method: • Viewing Comments Electronically—Regulations.gov: Go to https://regulations.gov/. Enter “Docket ID OCC-2023-0008” in the Search Box and click “Search.” Click on the “Dockets” tab and then the document's title. After clicking the document's title, click the “Browse All Comments” tab. Comments can be viewed and filtered by clicking on the “Sort By” drop-down on the right side of the screen or the “Refine Comments Results” options on the left side of the screen. Supporting materials can be viewed by clicking on the “Browse Documents” tab. Click on the “Sort By” drop-down on the right side of the screen or the “Refine Results” options on the left side of the screen checking the “Supporting & Related Material” checkbox. For assistance with the Regulations.gov site, please call 1-866-498-2945 (toll free) Monday-Friday, 9 a.m.-5 p.m. ET, or email regulationshelpdesk@gsa.gov. The docket may be viewed after the close of the comment period in the same manner as during the comment period. Board: You may submit comments, identified by Docket No. R-1813, RIN 7100-AG64 by any of the following methods: Agency Website: https://www.federalreserve.gov. Follow the instructions for submitting comments at https://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm. Federal eRulemaking Portal: https://www.regulations.gov. Follow the instructions for submitting comments. Email: regs.comments@federalreserve.gov. Include the docket number and RIN in the subject line of the message. Fax: (202) 452-3819 or (202) 452-3102. Mail: Ann E. Misback, Secretary, Board of Governors of the Federal Reserve System, 20th Street and Constitution Avenue NW, Washington, DC 20551. In general, all public comments will be made available on the Board's website at www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm as submitted, and will not be modified to remove confidential, contact or any identifiable information. Public comments may also be viewed electronically or in paper in Room M-4365A, 2001 C St. NW, Washington, DC 20551, between 9 a.m. and 5 p.m. during Federal business weekdays. FDIC: The FDIC encourages interested parties to submit written comments. Please include your name, affiliation, address, email address, and telephone number(s) in your comment. You may submit comments to the FDIC, identified by RIN 3064-AF29 by any of the following methods: Agency Website: https://www.fdic.gov/resources/regulations/ federal-register-publications. Follow instructions for submitting comments on the FDIC's website. Mail: James P. Sheesley, Assistant Executive Secretary, Attention: Comments/Legal OES (RIN 3064-AF29), Federal Deposit Insurance Corporation, 550 17th Street NW, Washington, DC 20429. Hand Delivered/Courier: Comments may be hand-delivered to the guard station at the rear of the 550 17th Street NW, building (located on F Street NW) on business days between 7 a.m. and 5 p.m. Email: comments@FDIC.gov. Include the RIN 3064-AF29 on the subject line of the message. Public Inspection: Comments received, including any personal information provided, may be posted without change to https://www.fdic.gov/resources/regulations/federal-register-publications. Commenters should submit only information that the commenter wishes to make available publicly. The FDIC may review, redact, or refrain from posting all or any portion of any comment that it may deem to be inappropriate for publication, such as irrelevant or obscene material. The FDIC may post only a single representative example of identical or substantially identical comments, and in such cases will generally identify the number of identical or substantially identical comments represented by the posted example. All comments that have been redacted, as well as those that have not been posted, that contain comments on the merits of this document will be retained in the public comment file and will be considered as required under all applicable laws. All comments may be accessible under the Freedom of Information Act. FOR FURTHER INFORMATION CONTACT: OCC: Venus Fan, Risk Expert, Benjamin Pegg, Analyst, Andrew Tschirhart, Risk Expert, or Diana Wei, Risk Expert, Capital Policy, (202) 649-6370; Carl Kaminski, Assistant Director, Kevin Korzeniewski, Counsel, Rima Kundnani, Counsel, Daniel Perez, Counsel, or Daniel Sufranski, Senior Attorney, Chief Counsel's Office, (202) 649-5490, Office of the Comptroller of the Currency, 400 7th Street SW, Washington, DC 20219. If you are deaf, hard of hearing, or have a speech disability, please dial 7-1-1 to access telecommunications relay services. Board: Anna Lee Hewko, Associate Director, (202) 530-6260; Brian Chernoff, Manager, (202) 452-2952; Andrew Willis, Manager, (202) 912-4323; Cecily Boggs, Lead Financial Institution Policy Analyst, (202) 530-6209; Marco Migueis, Principal Economist, (202) 452-6447; Diana Iercosan, Principal Economist, (202) 912-4648; Nadya Zeltser, Senior Financial Institution Policy Analyst, (202) 452-3164; Division of Supervision and Regulation; or Jay Schwarz, Assistant General Counsel, (202) 452-2970; Mark Buresh, Special Counsel, (202) 452-5270; Andrew Hartlage, Special Counsel, (202) 452-6483; Gillian Burgess, Senior Counsel, (202) 736-5564; Jonah Kind, Senior Counsel, (202) 452-2045, Legal Division, Board of Governors of the Federal Reserve System, 20th Street and Constitution Avenue NW, Washington, DC 20551. For users of TTY-TRS, please call 711 from any telephone, anywhere in the United States. FDIC: Benedetto Bosco, Chief Capital Policy Section; Bob Charurat, Corporate Expert; Irina Leonova, Corporate Expert; Andrew Carayiannis, Chief, Policy and Risk Analytics Section; Brian Cox, Chief, Capital Markets Strategies Section; Noah Cuttler, Senior Policy Analyst; David Riley, Senior Policy Analyst; Michael Maloney, Senior Policy Analyst; Richard Smith, Capital Markets Policy Analyst; Olga Lionakis, Capital Markets Policy Analyst; Kyle McCormick, Senior Policy Analyst; Keith Bergstresser, Senior Policy Analyst, Capital Markets and Accounting Policy Branch, Division of Risk Management Supervision; Catherine Wood, Counsel; Benjamin Klein, Counsel; Anjoly David, Honors Attorney, Legal Division; regulatorycapital@fdic.gov, (202) 898-6888; Federal Deposit Insurance Corporation, 550 17th Street NW, Washington, DC 20429. SUPPLEMENTARY INFORMATION: Table of Contents I. Introduction A. Overview of the Proposal B. Use of Internal Models Under the Proposed Framework II. Scope of Application III. Proposed Changes to the Capital Rule A. Calculation of Capital Ratios and Application of Buffer Requirements 1. Standardized Output Floor 2. Stress Capital Buffer Requirement B. Definition of Capital 1. Accumulated Other Comprehensive Income 2. Regulatory Capital Deductions 3. Additional Definition of Capital Adjustments 4. Changes to the Definition of Tier 2 Capital Applicable to Large Banking Organizations C. Credit Risk 1. Due Diligence 2. Proposed Risk Weights for Credit Risk 3. Off-Balance Sheet Exposures 4. Derivatives 5. Credit Risk Mitigation D. Securitization Framework 1. Operational Requirements 2. Securitization Standardized Approach (SEC-SA) 3. Exceptions to the SEC-SA Risk-Based Capital Treatment for Securitization Exposures 4. Credit Risk Mitigation for Securitization Exposures E. Equity Exposures 1. Risk-Weighted Asset Amount F. Operational Risk 1. Business Indicator 2. Business Indicator Component 3. Internal Loss Multiplier 4. Operational Risk Management and Data Collection Requirements G. Disclosure Requirements 1. Proposed Disclosure Requirements 2. Specific Public Disclosure Requirements H. Market Risk 1. Background 2. Scope and Application of the Proposed Rule 3. Market Risk Covered Position 4. Internal Risk Transfers 5. General Requirements for Market Risk 6. Measure for Market Risk 7. Standardized Measure for Market Risk 8. Models-Based Measure for Market Risk 9. Treatment of Certain Market Risk Covered Positions 10. Reporting and Disclosure Requirements 11. Technical Amendments I. Credit Valuation Adjustment Risk 1. Background 2. Scope of Application 3. CVA Risk Covered Positions and CVA Hedges 4. General Risk Management Requirements 5. Measure for CVA Risk IV. Transition Provisions A. Transitions for Expanded Total Risk-Weighted Assets B. AOCI Regulatory Capital Adjustments V. Impact and Economic Analysis A. Scope and Data B. Impact on Risk-Weighted Assets and Capital Requirements C. Economic Impact on Lending Activity D. Economic Impact on Trading Activity E. Additional Impact Considerations VI. Technical Amendments to the Capital Rule A. Additional OCC Technical Amendments B. Additional FDIC Technical Amendments VII. Proposed Amendments to Related Rules and Related Proposals A. OCC Amendments B. Board Amendments C. Related Proposals VIII. Administrative Law Matters A. Paperwork Reduction Act B. Regulatory Flexibility Act C. Plain Language D. Riegle Community Development and Regulatory Improvement Act of 1994 E. OCC Unfunded Mandates Reform Act of 1995 Determination F. Providing Accountability Through Transparency Act of 2023 I. Introduction The Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System (Board), and the Federal Deposit Insurance Corporation (FDIC) (collectively, the agencies) are proposing to modify the capital requirements applicable to banking organizations 1 with total assets of $100 billion or more and their subsidiary depository institutions (large banking organizations) and to banking organizations with significant trading activity. The revisions set forth in the proposal would strengthen the calculation of risk-based capital requirements to better reflect the risks of these banking organizations' exposures. In addition, the proposed revisions would enhance the consistency of requirements across large banking organizations and facilitate more effective supervisory and market assessments of capital adequacy. 1 The term “banking organizations” includes national banks, state member banks, state nonmember banks, Federal savings associations, state savings associations, top-tier bank holding companies domiciled in the United States not subject to the Board's Small Bank Holding Company and Savings and Loan Holding Company Policy Statement (12 CFR part 225, appendix C), U.S. intermediate holding companies of foreign banking organizations, and top-tier savings and loan holding companies domiciled in the United States, except for certain savings and loan holding companies that are substantially engaged in insurance underwriting or commercial activities and savings and loan holding companies that are subject to the Small Bank Holding Company and Savings and Loan Holding Company Policy Statement. Following the 2007-09 financial crisis, the agencies adopted an initial set of reforms to improve the effectiveness of and address weaknesses in the regulatory capital framework. For example, in 2013, the agencies adopted a final rule that increased the quantity and quality of regulatory capital banking organizations must maintain. 2 These changes were broadly consistent with an initial set of reforms published by the Basel Committee on Banking Supervision (Basel Committee) following the financial crisis. 3 The Board also implemented capital planning and stress testing requirements for large bank holding companies and savings and loan holding companies 4 and an additional capital buffer requirement to mitigate the financial stability risks posed by U.S. global systemically important banking organizations (GSIBs), 5 as well as other enhanced prudential standards, consistent with the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act). 6 2 The Board and the OCC issued a joint final rule on October 11, 2013 (78 FR 62018) and the FDIC issued a substantially identical interim final rule on September 10, 2013 (78 FR 55340). In April 2014, the FDIC adopted the interim final rule as a final rule with no substantive changes. 79 FR 20754 (April 14, 2014). 3 The Basel Committee is a committee composed of central banks and banking supervisory authorities, which was established by the central bank governors of the G-10 countries in 1975. 4 See 12 CFR 225.8; 12 CFR part 238, subparts N, O, P, R, S; 12 CFR part 252, subparts D, E, F, N, O. 5 12 CFR part 217, subpart H. 6 See 12 CFR part 252; 12 U.S.C. 5365. The proposal would build on these initial reforms by making additional changes developed in response to the 2007-09 financial crisis and informed by experience since the crisis. Requirements under the proposal would generally be consistent with international capital standards issued by the Basel Committee, commonly known as the Basel III reforms. 7 Where appropriate, the proposal differs from the Basel III reforms to reflect, for example, specific characteristics of U.S. markets, requirements under U.S. generally accepted accounting principles (GAAP), 8 practices of U.S. banking organizations, and U.S. legal requirements and policy objectives. 7 See the consolidated Basel Framework at https://www.bis.org/basel_framework/. 8 GAAP often serve as a foundational measurement component for U.S. capital requirements. The proposal would strengthen risk-based capital requirements for large banking organizations by improving their comprehensiveness and risk sensitivity. These proposed revisions, including removal of certain internal models, would increase capital requirements in the aggregate, in particular for those banking organizations with heightened risk profiles. Increased capital requirements can produce both economic costs and benefits. The agencies assessed the likely effect of the proposal on economic activity and resilience, and expect that the benefits of strengthening capital requirements for large banking organizations outweigh the costs. 9 9 See the impact and economic analysis presented in section V of this SUPPLEMENTARY INFORMATION . Historical experience has demonstrated the impact individual banking organizations can have on the stability of the U.S. banking system, in particular banking organizations that would have been subject to the proposal. Large banking organizations that experience an increase in their capital requirements resulting from the proposal would be expected to be able to absorb losses with reduced disruption to financial intermediation in the U.S. economy. Enhanced resilience of the banking sector supports more stable lending through the economic cycle and diminishes the likelihood of financial crises and their associated costs. The agencies seek comment on all aspects of the proposal. A. Overview of the Proposal The proposal would improve the risk capture and consistency of capital requirements across large banking organizations and reduce complexity and operational costs through changes across multiple areas of the agencies' risk-based capital framework. For most parts of the framework, the proposal would eliminate the use of banking organizations' internal models to set regulatory capital requirements and in their place apply a simpler and more consistent standardized framework. For market risk, the proposal would retain banking organizations' ability to use internal models, with an improved models-based measure for market risk that better accounts for potential losses. The use of internal models would be subject to enhanced requirements for model approval and performance and a new “output floor” to limit the extent to which a banking organization's internal models may reduce its overall capital requirement. The proposal would also adopt new standardized approaches for market risk and credit valuation adjustment (CVA) risk that better reflect the risks of banking organizations' exposures. This new framework for calculating risk-weighted assets (the expanded risk-based approach) would apply to banking organizations with total assets of $100 billion or more and their subsidiary depository institutions. The revised requirements for market risk would also apply to other banking organizations with $5 billion or more in trading assets plus trading liabilities or for which trading assets plus trading liabilities exceed 10 percent of total assets. The expanded risk-based approach would be more risk-sensitive than the current U.S. standardized approach by incorporating more credit-risk drivers (for example, borrower and loan characteristics) and explicitly differentiating between more types of risk (for example, operational risk, credit valuation adjustment risk). In this manner, the expanded risk-based approach would better account for key risks faced by large banking organizations. The proposed changes would also enhance the alignment of capital requirements to the risks of banking organizations' exposures and increase incentives for prudent risk management. To ensure that large banking organizations would not have lower capital requirements than smaller, less complex banking organizations, the proposal would maintain the capital rule's dual-requirement structure. Under this structure, a large banking organization would be required to calculate its risk-based capital ratios under both the new expanded risk-based approach and the standardized approach (including market risk, as applicable), and use the lower of the two for each risk-based capital ratio. 10 All capital buffer requirements, including the stress capital buffer requirement, would apply regardless of whether the expanded risk-based approach or the existing standardized approach produces the lower ratio. 10 Banking organizations' risk-based capital ratios are the common equity tier 1 capital ratio, tier 1 capital ratio, and total capital ratio. See 12 CFR 3.10 (OCC), 12 CFR 217.10 (Board), and 12 CFR 324.10 (FDIC). For banking organizations subject to Category III or IV capital standards, 11 the proposal would align the calculation of regulatory capital—the numerator of the regulatory capital ratios—with the calculation for banking organizations subject to Category I or II capital standards, providing the same approach for all large banking organizations. Banking organizations subject to Category III or IV capital standards would be subject to the same treatment of accumulated other comprehensive income (AOCI), capital deductions, and rules for minority interest as banking organizations subject to Category I or II capital standards. This change would help ensure that the regulatory capital ratios of these banking organizations better reflect their capacity to absorb losses, including by taking into account unrealized losses or gains on securities positions reflected in AOCI. 11 In 2019, the agencies adopted rules establishing four categories of capital standards for U.S. banking organizations with $100 billion or more in total assets and foreign banking organizations with $100 billion or more in combined U.S. assets. Under this framework, Category I capital standards apply to U.S. global systemically important bank holding companies and their depository institution subsidiaries. Category II capital standards apply to banking organizations with at least $700 billion in total consolidated assets or at least $75 billion in cross-jurisdictional activity and their depository institution subsidiaries. Category III capital standards apply to banking organizations with total consolidated assets of at least $250 billion or at least $75 billion in weighted short-term wholesale funding, nonbank assets, or off-balance sheet exposure and their depository institution subsidiaries. Category IV capital standards apply to banking organizations with total consolidated assets of at least $100 billion that do not meet the thresholds for a higher category and their depository institution subsidiaries. See 12 CFR 3.2 (OCC), 12 CFR 252.5, 12 CFR 238.10 (Board), 12 CFR 324.2 (FDIC); “Prudential Standards for Large Bank Holding Companies, Savings and Loan Holding Companies, and Foreign Banking Organizations,” 84 FR 59032 (November 1, 2019); and “Changes to Applicability Thresholds for Regulatory Capital and Liquidity Requirements,” 84 FR 59230 (November 1, 2019). The proposal would expand application of the supplementary leverage ratio and the countercyclical capital buffer to banking organizations subject to Category IV capital standards. This change would bring further alignment of capital requirements across large banking organizations and is consistent with the proposal's goal of strengthening the resilience of large banking organizations. The proposal would also introduce enhanced disclosure requirements to facilitate market participants' understanding of a banking organization's financial condition and risk management practices. Also, the proposal would align Federal Reserve's regulatory reporting requirements with the changes to capital requirements. The agencies anticipate that revisions to the reporting forms of the Federal Financial Institutions Examination Council (FFIEC) applicable to large banking organizations and to banking organizations with significant trading activity will be proposed in the near future, which would align with the proposed revisions to the capital rule. The proposed changes would take effect subject to the transition provisions described in section IV of this SUPPLEMENTARY INFORMATION . The revisions introduced by the proposal would interact with several Board rules, including by modifying the risk-weighted assets used to calculate total loss-absorbing capacity requirements, long-term debt requirements, and the short-term wholesale funding score included in the GSIB surcharge method 2 score. Also, the proposal would revise the calculation of single-counterparty credit limits by removing the option of using a banking organization's internal models to calculate derivatives exposure amounts and requiring the use of the standardized approach for counterparty credit risk for this purpose. The proposal would also remove the exemption from calculating risk-weighted assets under subpart E of the capital rule currently available to U.S. intermediate holding companies of foreign banking organizations under the Board's enhanced prudential standards. In parallel, the Board is issuing a notice of proposed rulemaking revising the GSIB surcharge calculation applicable to GSIBs and the systemic risk report applicable to large banking organizations. 12 12 On October 24, 2019, the Board published in the Federal Register a notice of proposed rulemaking inviting comment on a proposal to establish risk-based capital requirements for depository institution holding companies significantly engaged in insurance activities. See 84 FR 57240 (October 24, 2019). The Board anticipates that any final rule based on the proposal in this Supplementary Information would include appropriate adjustments as necessary to take into account any final insurance capital rule. Question 1: The Board invites comment on the interaction of the revisions under the proposal with other existing rules and with the other notice of proposed rulemaking. In particular, comment is invited on the impact of the proposal on the single-counterparty credit limit framework. What are the advantages and disadvantages of the proposed approach? Which alternatives, if any, should the Board consider and why? B. Use of Internal Models Under the Proposed Framework The proposal would remove the use of internal models to set credit risk and operational risk capital requirements (the so-called advanced approaches) for banking organizations subject to Category I or II capital standards. These internal models rely on a banking organization's choice of modeling assumptions and supporting data. Such model assumptions include a degree of subjectivity, which can result in varying risk-based capital requirements for similar exposures. Moreover, empirical verification of modeling choices can require many years of historical experience because severe credit risk and operational risk losses can occur infrequently. In the agencies' previous observations, the advanced approaches have produced unwarranted variability across banking organizations in requirements for exposures with similar risks. 13 This unwarranted variability, combined with the complexity of these models-based approaches, can reduce confidence in the validity of the modeled outputs, lessen the transparency of the risk-based capital ratios, and challenge comparisons of capital adequacy across banking organizations. 13 The Basel Committee has published analysis illustrating the variability of credit-risk-weighted assets across banking organizations. See https://www.bis.org/publ/bcbs256.pdf and https://www.bis.org/bcbs/publ/d363.pdf. Standardization of credit and operational risk capital requirements would improve the consistency of requirements. Standardized requirements, together with robust public disclosure and reporting requirements, would enhance the transparency of capital requirements and the ability of supervisors and market participants to make independent assessments of a banking organization's capital adequacy, individually and relative to its peers. The use of robust, risk-sensitive standardized approaches for credit and operational risk would also improve the efficiency of the capital framework by reducing operational costs. Under the advanced approaches, banking organizations subject to Category I or II capital standards must develop and maintain internal modeling systems to determine capital requirements, which may differ from the risk measurement approaches they use to monitor risk for internal assessments. Further, any material changes to a banking organization's internal models must be fully documented and presented to the banking organization's primary Federal supervisor for review. 14 Replacing the use of internal models with standardized approaches would reduce costs associated with maintaining such modeling systems and eliminate the associated submissions to the agencies. 14 See 12 CFR 3.123(a) (OCC); 12 CFR 217.123(a) (Board); 12 CFR 324.123(a) (FDIC). Eliminating the use of internal models to set credit and operational risk capital requirements would not reduce the overall risk capture of the regulatory framework. In addition to the calculation of expanded risk-based approach and standardized approach capital requirements, a large banking organization would continue to be required to maintain capital commensurate with the level and nature of all risks to which the banking organization is exposed, 15 to have a process for assessing its overall capital adequacy in relation to its risk profile and a comprehensive strategy for maintaining an appropriate level of capital, 16 and, where applicable, to conduct internal stress tests. 17 Also, holding companies subject to the Board's capital plan rule would continue to be subject to a stress capital buffer requirement that is based on a supervisory stress test of the holding company's exposures. 18 Although the proposal would remove use of internal models for calculating capital requirements for credit and operational risk, internal models can provide valuable information to a banking organization's internal stress testing, capital planning, and risk management functions. Large banking organizations should employ internal modeling capabilities as appropriate for the complexity of their activities. 15 See 12 CFR 3.10(e)(1) (OCC); 12 CFR 217.10(e)(1) (Board); 12 CFR 324.10(e)(1) (FDIC). 16 See 12 CFR 3.10(e)(2) (OCC); 12 CFR 217.10(e)(2) (Board); 12 CFR 324.10(e)(2) (FDIC). 17 See 12 CFR 46 (OCC); 12 CFR 252 subpart B and F (Board); 12 CFR 325 (FDIC). 18 See 12 CFR 225.8 and 12 CFR 238.170. The proposal would continue to allow use of internal models to set market risk capital requirements for portfolios where modeling can be demonstrated to be appropriate. In addition, the proposal would provide for conservative but risk-sensitive standardized alternatives where modeling is not supported. In contrast to credit and operational risk, market risk data allows for daily feedback on model performance to support empirical verification. The proposal would limit the use of models to only those trading desks for which a banking organization has received approval from its primary Federal supervisor. Ongoing use of such models would depend upon a banking organization's ability to demonstrate through robust testing that the models are sufficiently conservative and accurate for purposes of calculating market risk capital requirements. In cases where a banking organization cannot demonstrate acceptable performance of its internal models for a given trading desk, the banking organization would be required to use the standardized measure for market risk which acts as a risk-sensitive alternative. II. Scope of Application The proposal's expanded risk-based approach would apply to banking organizations with total assets of $100 billion or more and their subsidiary depository institutions. 19 These banking organizations are large and exhibit heightened complexity. Application of the expanded risk-based approach to large banking organizations would provide granular, generally standardized requirements that result in robust risk capture and appropriate risk sensitivity. By strengthening the requirements that apply to large banking organizations, the proposal would enhance their resilience and reduce risks to U.S. financial stability and costs they may pose to the Federal Deposit Insurance Fund in case of material distress or failure. Relative to smaller, less complex banking organizations, these banking organizations have greater operational capacity to apply more sophisticated requirements. 19 The proposal would also apply to depository institutions with total assets of $100 billion or more that are not consolidated subsidiaries of depository institution holding companies, and to depository institutions with total assets of $100 billion or more that are subsidiaries of depository institution holding companies that are not assigned a category under the capital rule. Previously, the agencies determined that the advanced approaches requirements should not apply to banking organizations subject to Category III or IV capital standards, as the agencies considered such requirements to be overly complex and burdensome relative to the safety and soundness benefits that they would provide for these banking organizations. 20 The expanded risk-based approach generally is based on standardized requirements, which would be less complex and costly. In addition, recent events demonstrate the impact banking organizations subject to Category III or IV capital standards can have on financial stability. While the recent failure of banking organizations subject to Category IV capital standards may be attributed to a variety of factors, the effect of these failures on financial stability supports further alignment of the regulatory capital framework across large banking organizations. 20 See “Prudential Standards for Large Bank Holding Companies, Savings and Loan Holding Companies, and Foreign Banking Organizations,” 84 FR 59032 (November 1, 2019). Banking organizations with significant trading activities are subject to substantial market risk and, therefore, would be subject to market risk capital requirements. Recognizing that the dollar-based threshold for the application of market risk requirements was established in 1996, the proposal would increase this dollar-based threshold from $1 billion to $5 billion of trading assets plus trading liabilities. Banking organizations would also continue to be subject to market risk requirements if their trading assets plus trading liabilities represent 10 percent or more of total assets. The proposal would revise the calculation of the dollar-based threshold amount to be based on four-quarter averages of trading assets and trading liabilities instead of point-in-time amounts. Banking organizations that would no longer meet these minimum thresholds for being subject to market risk capital requirements would calculate risk-weighted assets for trading exposures under the standardized approach. Additionally, under the proposal, large banking organizations would be subject to market risk capital requirements regardless of trading activities. The proposal would expand application of the countercyclical capital buffer to banking organizations subject to Category IV capital standards. The countercyclical capital buffer is a macroprudential tool that can be used to increase the resilience of the financial system by increasing capital requirements for large banking organizations during a period of elevated risk of above-normal losses. Failure or distress of a banking organization with assets of $100 billion or more during a time of elevated risk or stress can have significant destabilizing effects for other banking organizations and the broader financial system—even if the banking organization does not meet the criteria for being subject to Category II or III capital standards. Applying the countercyclical capital buffer to banking organizations subject to Category IV capital standards would increase the resilience of these banking organizations and, in turn, improve the resilience of the broader financial system. The proposed approach also has the potential to moderate fluctuations in the supply of credit over time. The proposal would also modify how the countercyclical capital buffer amount is determined to reflect the proposed changes to market risk capital requirements. Specifically, the risk-weighted asset amount for private sector credit exposures that are market risk covered positions under the proposal would be determined using the standardized default risk capital requirement for such positions rather than using the specific risk add-on of the current rule. The proposal also would expand application of the supplementary leverage ratio requirement to banking organizations subject to Category IV capital standards. In contrast to the risk-based capital requirements, a leverage ratio does not differentiate the amount of capital required by exposure type. Rather, a leverage ratio puts a simple and transparent limit on banking organization leverage. Leverage requirements protect against underestimation of risk both by banking organizations and by risk-based capital requirements and serve as a complement to risk-based capital requirements. The supplementary leverage ratio measures tier 1 capital relative to total leverage exposure, which includes on-balance sheet assets and certain off-balance sheet exposures. The proposed change would ensure that all large banking organizations are subject to a consistent and robust leverage requirement that serves as a complement to risk-based capital requirements and takes into account on- and off-balance sheet exposures. Question 2: What are the advantages and disadvantages of applying the expanded risk-based approach to banking organizations subject to Category III or IV capital standards? To what extent is the expanded risk-based approach appropriate for banking organizations with different risk profiles, including from a cost and operational burden perspective? Are there specific areas, such as the market risk capital framework, for which the agencies should consider a materiality threshold to better balance cost and operational burden and risk sensitivity, and if so what should that threshold be and why? What would the appropriate exposure treatment be for banking organizations with such exposures beneath any materiality threshold, and how would that treatment be consistent with the overall calibration of the expanded risk-based approach? What alternatives, if any, should the agencies consider to help ensure that the risks of large banking organizations are appropriately captured under minimum risk-based capital requirements and why? Question 3: What are the advantages and disadvantages of harmonizing the calculation of regulatory capital across large banking organizations? What are any unintended consequences of the proposal and what steps should the agencies consider to mitigate those consequences? What are the advantages and disadvantages of harmonizing the calculation of regulatory capital across large banking organizations and using different approaches (for example, the expanded risk-based approach and the U.S. standardized approach) for the calculation of risk-weighted assets? Question 4: What are the advantages and disadvantages of applying the countercyclical capital buffer and supplementary leverage ratio to banking organizations subject to Category IV capital standards? III. Proposed Changes to the Capital Rule A. Calculation of Capital Ratios and Application of Buffer Requirements Under the proposal, large banking organizations would be required to calculate total risk-weighted assets under two approaches: (1) the expanded risk-based approach, and (2) the standardized approach. Total risk-weighted assets under the expanded risk-based approach (expanded total risk-weighted assets) would equal the sum of risk-weighted assets for credit risk, equity risk, operational risk, market risk, and CVA risk, as described in this proposal, minus any amount of the banking organization's adjusted allowance for credit losses that is not included in tier 2 capital and any amount of allocated transfer risk reserves. For calculating standardized total risk-weighted assets, the proposal would revise the methodology for determining market risk-weighted assets and would require banking organizations subject to Category III or IV capital standards to use the standardized approach for counterparty credit risk (SA-CCR) for derivative exposures. 21 21 The proposed methodology for determining market risk-weighted assets, in certain instances, would require a banking organization that is subject to subpart E to apply risk weights from subpart D for purposes of determining its standardized total risk-weighted assets and from subpart E for purposes of determining its expanded total risk-weighted assets. This approach would apply in the case of: (i) capital add-ons for re-designations, (ii) term repo-style transactions the banking organization elects to include in market risk, (iii) the standardized default risk capital requirement for securitization positions non-CTP, and (iv) the standardized default risk capital requirement for correlation trading positions, each as discussed further below. To determine its applicable risk-based capital ratios, a large banking organization would calculate two sets of risk-based capital ratios (common equity tier 1 capital ratio, tier 1 capital ratio, and total capital ratio), one using expanded total risk-weighted assets and one using standardized total risk-weighted assets. A banking organization's common equity tier 1 capital ratio, tier 1 capital ratio, and total capital ratio would be the lower of each ratio of the two approaches. The proposal would not change the minimum risk-based capital ratios under the capital rule. Also, the capital conservation buffer would continue to apply to risk-based capital ratios as under the capital rule, except that the stress capital buffer requirement—a component of the capital conservation buffer that is applicable to banking organizations subject to the Board's capital plan rule—would apply to a banking organization's risk-based capital ratios regardless of whether the ratios result from the expanded risk-based approach or the standardized approach. Question 5: What are the advantages and disadvantages of banking organizations being required to calculate risk-based capital ratios in two different ways and what alternatives, such as a single calculation, should the agencies consider and why? What modifications, if any, to the proposed structure of the risk-based capital calculation should the agencies consider? 1. Standardized Output Floor To enhance the consistency of capital requirements and ensure that the use of internal models for market risk does not result in unwarranted reductions in capital requirements, the proposal would introduce an “output floor” to the calculation of expanded total risk- weighted assets. This output floor would correspond to 72.5 percent of the sum of a banking organization's credit risk-weighted assets, equity risk-weighted assets, operational risk-weighted assets, and CVA risk-weighted assets under the expanded risk-based approach and risk-weighted assets calculated using the standardized measure for market risk, minus any amount of the banking organization's adjusted allowance for credit losses that is not included in tier 2 capital and any amount of allocated transfer risk reserves. The output floor would serve as a lower bound on the risk-weighted assets under the expanded risk-based approach. In other words, if the risk-weighted assets under the expanded risk-based approach were less than the output floor, the output floor would have to be used as the risk-weighted asset amount to determine the expanded risk-based approach capital ratios. The proposed calibration of the output floor aims to strike a balance between allowing internal models to enhance the risk sensitivity of market risk capital requirements and ensuring that these models would not result in unwarranted reductions in capital requirements. The output floor would be consistent with the Basel III reforms, which would promote consistency in capital requirements for large, complex, and internationally active banking organizations across jurisdictions. EP18SE23.000 Question 6: What are the advantages and disadvantages of the proposed output floor? 2. Stress Capital Buffer Requirement Under the current capital rule, each banking organization is subject to one or more buffer requirements, and must maintain capital ratios above the sum of its minimum requirements and buffer requirements to avoid restrictions on capital distributions and certain discretionary bonus payments. 22 Banking organizations that are subject to the Board's capital plan rule 23 (bank holding companies, U.S. intermediate holding companies, and savings and loan holding companies that have over $100 billion or more in total consolidated assets) are currently subject to a standardized approach capital conservation buffer requirement, which is calculated as the sum of the banking organization's stress capital buffer requirement, applicable countercyclical capital buffer requirement, and applicable GSIB surcharge. The standardized approach capital conservation buffer requirement applies to a banking organization's standardized approach risk-based capital ratios. In addition, banking organizations that are subject to the capital plan rule and the advanced approaches requirements are subject to an advanced approaches capital conservation buffer requirement, which applies to their advanced approaches risk-based capital ratios, and which is calculated in the same manner as the standardized approach capital conservation buffer requirement, except that the banking organization's stress capital buffer requirement is replaced with a 2.5 percent buffer requirement. 24 22 12 CFR 3.11 (OCC); 12 CFR 217.11 (Board); 12 CFR 324.11 (FDIC). 23 12 CFR 225.8 (bank holding companies and U.S. intermediate holding companies of foreign banking organizations); 12 CFR 238.170 (savings and loan holding companies). 24 See 12 CFR 217.11(c). The stress capital buffer requirement integrates the results of the Board's supervisory stress tests with the risk-based requirements of the capital rule to determine capital distribution limitations. As a result, required capital levels for each banking organization more closely align with the banking organization's risk profile and projected losses as measured by the Board's stress test. 25 The stress capital buffer requirement is generally calculated as (1) the difference between the banking organization's starting and minimum projected common equity tier 1 capital ratios under the severely adverse scenario in the supervisory stress test (stress test losses) plus (2) the sum of the dollar amount of the banking organization's planned common stock dividends for each of the fourth through seventh quarters of the planning horizon as a percentage of risk-weighted assets (dividend add-on). 26 A banking organization's stress capital buffer requirement cannot be less than 2.5 percent of standardized total risk-weighted assets. 25 See 85 FR 15576 (March 18, 2020). 26 12 CFR 225.8(f)(2); 12 CFR 238.170(f)(2). Currently, the stress test losses and dividend add-on portion of the stress capital buffer requirement are calculated using only the standardized approach common equity tier 1 capital ratio. This is consistent with the exclusion of the stress capital buffer requirement from the advanced approaches capital conservation buffer requirement, and with the Board's stress testing and capital plan rules, under which banking organizations are not required to project capital ratios using the advanced approaches. The Board is proposing to amend its capital plan rule, stress testing rule, and the buffer framework in its capital rule to take into account capital ratios calculated under the expanded risk-based approach, in addition to the standardized approach. Under the proposal, banking organizations subject to the capital plan rule would be subject to a single capital conservation buffer requirement, which would include the stress capital buffer requirement, applicable countercyclical capital buffer requirement, and applicable GSIB surcharge, and would apply to the banking organization's risk-based capital ratios, regardless of whether the ratios result from the expanded risk-based approach or the standardized approach. In this manner, the proposal would ensure that the stress capital buffer requirement contributes to the robustness and risk-sensitivity of the risk-based capital requirements of these banking organizations. Application of the stress capital buffer requirement to the risk-based capital ratios derived from the expanded risk-based approach would not introduce complexity given the fixed balance sheet assumption currently used in the Board stress tests and because the expanded risk-based approach is based in mostly standardized requirements. 27 27 Initially, the Board did not incorporate the stress capital buffer requirement into the advanced approaches capital conservation buffer requirement owing to the complexity involved in doing so. Additionally, the proposal would revise the calculation of the stress capital buffer requirement for large banking organizations. Under the proposal, both the stress test losses and dividend add-on components of the stress capital buffer requirement would be calculated using the binding common equity tier 1 capital ratio, as of the final quarter of the previous capital plan cycle, regardless of whether it results from the expanded risk-based approach or the standardized approach. 28 The proposed calculation methodology would limit complexity relative to potential alternatives, such as introducing two stress capital buffer requirements for each banking organization (one for each approach to calculating total risk-weighted assets). In addition, the proposed approach recognizes that the binding approach for a banking organization is unlikely to change within the period in which a given stress capital buffer requirement is applicable. 28 The Board's Stress Testing Policy Statement includes an assumption that the magnitude of a banking organization's balance sheet will be fixed throughout the projection horizon under the supervisory stress test. 12 CFR part 252, appendix B. Under this assumption, because the denominators of the common equity tier 1 capital ratios as calculated under the standardized approach and the expanded risk-based approach would remain the same throughout the stress test, the approach under which the binding common equity tier 1 capital ratio is calculated would remain the same throughout the final quarter of the previous capital plan cycle and the projection horizon. As part of the capital buffer framework, the stress capital buffer requirement helps ensure that a banking organization can withstand losses from a severely adverse scenario, while still meeting its minimum regulatory capital requirements and thereby continuing to serve as a viable financial intermediary. Because this proposal aims to better reflect the risk of banking organizations' exposures in the calculation of risk-weighted assets, without changing the targeted level of conservatism of the minimum capital requirements, the Board is not proposing associated changes to the targeted severity of the stress capital buffer requirement. The Board evaluates the minimum risk-based capital requirements, which are largely determined by risk-weighted assets, and the stress capital buffer requirement individually for their specific intended purposes in the capital framework, and holistically as they determine the aggregate capital banking organizations hold in the normal course of business. In addition to revising the stress capital buffer requirement, the proposal would amend the Board's stress testing and capital plan rules to require banking organizations subject to Category I, II, or III standards to project their risk-based capital ratios in their company-run stress tests and capital plans using the calculation approach that results in the binding ratios as of the start of the projection horizon (generally, as of December 31 of a given year). Also, the proposal would require banking organizations subject to Category IV standards to project their risk-based capital ratios under baseline conditions in their capital plans and FR Y-14A submissions using the risk-weighted assets calculation approach that results in the binding ratios as of the start of the projection horizon. The use of the binding approach to calculating risk-based capital ratios aims to conform company-run stress tests and capital plans with the binding risk-based capital ratios in the proposed capital rule and promote simplicity relative to possible alternatives (such as requiring that firms project ratios under both the expanded risk-based approach and the standardized approach). Question 7: The Board invites comment on the appropriate level of risk capture for the risk-weighted assets framework and the stress capital buffer requirement, both for their respective roles in the capital framework and for their joint determination of overall capital requirements. How should the Board balance considerations of overall capital requirements with the distinct roles of minimum requirements and buffer requirements? What adjustments, if any, to either piece of the framework should the Board consider? Which, if any, specific portfolios or exposure classes merit particular attention and why? Question 8: What are the advantages and disadvantages of applying the same stress capital buffer requirement to a banking organization's risk-based capital ratios regardless of whether they are determined using the standardized or expanded risk-based approach? What would be the advantages and disadvantages of applying different stress capital buffer requirements for each set of risk-based capital ratios? Question 9: What, if any, adjustments should the Board consider with respect to the buffer requirements to account for the transitions in this proposal, particularly related to expanded total risk-weighted assets? For example, what would be the advantages and disadvantages of the Board determining stress capital buffer requirements using fully phased-in expanded total risk-weighted assets versus transitional expanded total risk-weighted assets? What, if any, additional adjustments to stress capital buffer requirements should the Board consider during the expanded total risk-weighted assets transition? B. Definition of Capital The agencies regularly review their capital framework to help ensure it is functioning as intended. Consistent with this ongoing assessment, the agencies believe it is appropriate to align the definition of capital for banking organizations subject to Category III or IV capital standards with the definition currently applicable to banking organizations subject to Category I or II capital standards. The current definition of capital applicable to banking organizations subject to Category I or II capital standards provides for risk sensitivity and transparency that is commensurate with the size, complexity, and risk profile of banking organizations subject to Category III or IV capital standards. The proposed alignment of the numerator and denominator of regulatory capital ratios of large banking organizations would support the transparency of the capital rule as it facilitates market participants' assessment of loss absorbency and would promote consistency of requirements across large banking organizations. As described in more detail below, under the proposal, banking organizations subject to Category III or IV capital standards would be required to recognize most elements of AOCI in regulatory capital consistent with the treatment for banking organizations subject to Category I or II capital standards. Banking organizations subject to Category III or IV capital standards would also apply the capital deductions and minority interest treatments that are currently applicable to banking organizations subject to Category I or II capital standards. The proposal would also apply total loss absorbing capacity (TLAC) holdings deduction treatments to banking organizations subject to Category III or IV capital standards. The proposal includes a three-year transition period for AOCI. 1. Accumulated Other Comprehensive Income Under the current capital rule, banking organizations subject to Category I or II capital standards are required to include most elements of AOCI in regulatory capital; whereas all other banking organizations including those subject to Category III or IV capital standards were provided an opportunity to make a one-time election to opt-out of recognizing most elements of AOCI and related deferred tax assets (DTAs) and deferred tax liabilities within regulatory capital (AOCI opt-out banking organizations). 29 Under the proposal, consistent with the treatment applicable to banking organizations subject to Category I or II capital standards, banking organizations subject to Category III or IV capital standards would be required to include all AOCI components in common equity tier 1 capital, except gains and losses on cash-flow hedges where the hedged item is not recognized on a banking organization's balance sheet at fair value. This would require all net unrealized holding gains and losses on available-for-sale (AFS) debt securities 30 from changes in fair value to flow through to common equity tier 1 capital, including those that result primarily from fluctuations in benchmark interest rates. This treatment would better reflect the point in time loss-absorbing capacity of banking organizations subject to Category III or IV capital standards and would align with banking organizations subject to Category I or II capital standards. 29 See 12 CFR 3.22(b) (OCC); 12 CFR 217.22(b) (Board); 12 CFR 324.22(b) (FDIC). A banking organization that made an opt-out election is currently required to adjust common equity tier 1 capital as follows: subtract any net unrealized holding gains and add any net unrealized holding losses on available-for-sale securities; subtract any accumulated net gains and add any accumulated net losses on cash flow hedges; subtract any amounts recorded in AOCI attributed to defined benefit postretirement plans resulting from the initial and subsequent application of the relevant GAAP standards that pertain to such plans (excluding, at the banking organization's option, the portion relating to pension assets deducted under § __.22(a)(5) of the current capital rule); and, subtract any net unrealized holding gains and add any net unrealized holding losses on held-to-maturity securities that are included in AOCI. 30 AFS securities refers to debt securities. ASC Subtopic 321-10 eliminated the classification of equity securities with readily determinable fair values not held for trading as available-for-sale and generally requires investments in equity securities to be measured at fair value with changes in fair value recognized in net income. Changes in the fair value of ( i.e., the unrealized gains and losses on) a banking organization's equity securities are recognized through net income rather than other comprehensive income. The agencies have previously observed that the requirement to recognize elements of AOCI in regulatory capital has helped improve the transparency of regulatory capital ratios, as it better reflects banking organizations' actual loss-absorbing capacity at a specific point in time, notwithstanding the potential volatility that such recognition may pose for their regulatory capital ratios. The agencies have also previously observed that AOCI is an important indicator used by market participants to evaluate the capital strength of a banking organization. 31 More recently, the agencies have observed generally higher levels of securities classified as held-to-maturity (HTM) among banking organizations that recognize AOCI in regulatory capital. 32 31 84 FR 59230, 59249 (November 1, 2019). 32 GAAP set forth restrictions on the classification of a debt security as HTM, circumstances not consistent with the HTM classification, and situations that call into question or taint a banking organization's intent to hold securities in the HTM category. Changes in interest rates have led to net unrealized losses for banking organizations' investment portfolios and brought into focus the importance of regulatory capital measures reflecting the loss absorbing capacity of a banking organization. The agencies have observed that adverse trends in a banking organization's GAAP equity can have negative market perception and liquidity implications. 33 Specifically, net unrealized losses on AFS securities included in AOCI have reduced banking organizations' tangible book value and liquidity buffers, 34 which can adversely affect market participants' assessments of capital adequacy and liquidity. Banking organizations are often reluctant to sell these AFS securities as the unrealized losses would become realized losses upon sale, thus reducing regulatory capital. However, banking organizations may need to take such steps in order to meet liquidity needs. Recognizing elements of AOCI in regulatory capital thus achieves a better alignment of regulatory capital with market participants' assessment of loss-absorbing capacity. 33 See Board of Governors of the Federal Reserve System, Supervision and Regulation Report, at 11 (November 2022); Office of the Comptroller of the Currency, Semiannual Risk Perspective, at 22 (Fall 2022); Federal Deposit Insurance Corporation, Fourth Quarter 2022 Quarterly Banking Profile, at 5, 22 (February 2023), Managing Sensitivity to Market Risk in a Challenging Interest Rate Environment (FIL-46-2013, October 8, 2013). 34 See 12 CFR part 50 (OCC); 12 CFR part 249 (Board); 12 CFR part 329 (FDIC). Question 10: What complementary measures should the banking agencies consider regarding the regulatory capital treatment for securities held as HTM rather than AFS? 2. Regulatory Capital Deductions The agencies have long limited the amount of intangible and higher-risk assets, such as mortgage servicing assets (MSAs) and certain temporary difference DTAs, included in regulatory capital and required deduction of the amounts above the limits. This is due to the relatively high level of uncertainty regarding the ability of banking organizations to both accurately value and realize value from these assets, especially under adverse financial conditions. The current capital rule also limits the amount of investments in the capital instruments of other banking organizations that can be reflected in regulatory capital. Furthermore, the current capital rule limits the inclusion of minority interest 35 in regulatory capital in recognition that minority interest is generally not available to absorb losses at the banking organization's consolidated level and to prevent highly capitalized subsidiaries from overstating the amount of capital available to absorb losses at the consolidated organization. 35 Minority interest, also referred to as non-controlling interest, reflects investments in the capital instruments of subsidiaries of banking organizations that are held by third parties. Under the current capital rule, banking organizations subject to Category I or II capital standards must deduct from common equity tier 1 capital amounts of MSAs, temporary difference DTAs that the banking organization could not realize through net operating loss carrybacks, and significant investments in the capital of unconsolidated financial institutions in the form of common stock 36 (collectively, threshold items) that individually exceed 10 percent of the banking organization's common equity tier 1 capital minus certain deductions and adjustments. 37 Banking organizations subject to Category I or II capital standards must also deduct from common equity tier 1 capital the aggregate amount of threshold items not deducted under the 10 percent threshold deduction but that nevertheless exceeds 15 percent of the banking organization's common equity tier 1 capital minus certain deductions and adjustments. Under the current capital rule, banking organizations subject to Category III or IV capital standards are required to deduct from common equity tier 1 capital any amount of MSAs, temporary difference DTAs that the banking organization could not realize through net operating loss carrybacks, and investments in the capital of unconsolidated financial institutions 38 that individually exceed 25 percent of common equity tier 1 capital of the banking organization minus certain deductions and adjustments. 36 A significant investment in the capital of an unconsolidated financial institution is defined as an investment in the capital of an unconsolidated financial institution where a banking organization subject to Category I or II capital standards owns more than 10 percent of the issued and outstanding common stock of the unconsolidated financial institution. 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC). 37 See 12 CFR 3.22(c)(6), (d)(2) (OCC); 12 CFR 217.22(c)(6), (d)(2) (Board); 12 CFR 324.22(c)(6), (d)(2) (FDIC). 38 For banking organizations that are not subject to Category I or II capital standards, the current capital rule does not have distinct treatments for significant and nonsignificant investments in the capital of unconsolidated financial institutions. Rather, the regulatory capital treatment for an investment in the capital of unconsolidated financial institutions would be based on the type of instrument underlying the investment. Under the proposal, banking organizations subject to Category III or IV capital standards would be required to deduct threshold items from common equity tier 1 capital and apply other capital deductions that are currently applicable to banking organizations subject to Category I or II capital standards instead of the deductions applicable to all other banking organizations, thereby creating alignment across all banking organizations subject to the proposal. In addition to deductions for the threshold items, the current capital rule requires that a banking organization subject to Category I or II capital standards deduct from regulatory capital any amount of the banking organization's nonsignificant investments 39 in the capital of unconsolidated financial institutions that exceeds 10 percent of the banking organization's common equity tier 1 capital minus certain deductions and adjustments. 40 Further, significant investments in the capital of unconsolidated financial institutions not in the form of common stock must be deducted from regulatory capital in their entirety. 41 Under the proposal, banking organizations subject to Category III or IV capital standards would be required to make these deductions. 39 A non-significant investment in the capital of an unconsolidated financial institution is defined as an investment in the capital of an unconsolidated financial institution where a banking organization subject to Category I or II capital standards owns 10 percent or less of the issued and outstanding common stock of the unconsolidated financial institution. 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC). 40 12 CFR 3.22(c)(5) (OCC); 12 CFR 217.22(c)(5) (Board); 12 CFR 324.22(c)(5) (FDIC). 41 12 CFR 3.22(c)(6) (OCC); 12 CFR 217.22(c)(6) (Board); 12 CFR 324.22(c)(6) (FDIC). Similar to the deductions for investments in the capital of unconsolidated financial institutions, the current capital rule requires banking organizations subject to Category I or II capital standards to deduct covered debt instruments from regulatory capital. 42 Under the proposal, banking organizations subject to Category III or IV capital standards would be required to apply the deduction requirements for certain investments in unsecured debt instruments issued by U.S. or foreign GSIBs (covered debt instruments) that currently apply to banking organizations subject to Category I or II capital standards. 43 The current capital rule generally treats investments in unsecured debt instruments issued by U.S. or foreign GSIBs as tier 2 capital instruments for purposes of applying deduction requirements. 42 See 12 CFR 3.22(c) (OCC); 12 CFR 217.22(c) (Board); 12 CFR 324.22(c) (FDIC). 43 Similar to banking organizations subject to Category II capital standards, the definition of excluded covered debt and the applicable capital treatment, would not apply to banking organizations subject to Category III and IV capital standards. See 12 CFR 3.2 (OCC); 12 CFR 217.2) (Board); 12 CFR 324.2 (FDIC). The current capital rule also limits the amount of minority interest that banking organizations subject to Category I or II capital standards may include in regulatory capital based on the amount of capital held by a consolidated subsidiary, relative to the amount of capital the subsidiary would have had to maintain to avoid any restrictions on capital distributions and discretionary bonus payments under capital conservation buffer requirements. 44 Under the current capital rule, banking organizations subject to Category III or IV capital standards are allowed to include: (i) common equity tier 1 minority interest comprising up to 10 percent of the parent banking organization's common equity tier 1 capital; (ii) tier 1 minority interest comprising up to 10 percent of the parent banking organization's tier 1 capital; and (iii) total capital minority interest comprising up to 10 percent of the parent banking organization's total capital. 45 Under the proposal, the limitations on minority interests that apply to banking organizations subject to Category I or II capital standards would also apply to banking organizations subject to Category III or IV capital standards. 44 See 12 CFR 3.21(b) (OCC); 12 CFR 217.21(b) (Board); 12 CFR 324.21(b) (FDIC). 45 See 12 CFR 3.21(a) (OCC); 12 CFR 217.21(a) (Board); 12 CFR 324.21(a) (FDIC). 3. Additional Definition of Capital Adjustments The current capital rule applies an additional capital eligibility criterion to banking organizations subject to Category I or II capital standards for their additional tier 1 and tier 2 capital instruments. The criterion requires that the governing agreement, offering circular or prospectus for the instrument must disclose that the holders of the instrument may be fully subordinated to interests held by the U.S. government in the event the banking organization enters into a receivership, insolvency, liquidation, or similar proceeding. Under the proposal, this eligibility criterion would also apply to instruments issued after the date on which the issuer becomes subject to the proposed rule, which generally would be the effective date of a final rule for banking organizations subject to Category III or IV capital standards. Instruments issued by banking organizations subject to Category III or IV capital standards prior to the effective date of a final rule that currently count as regulatory capital would continue to count as regulatory capital as long as those instruments remain outstanding. 4. Changes to the Definition of Tier 2 Capital Applicable to Large Banking Organizations The current capital rule defines an element of tier 2 capital to include the allowance for loan and lease losses (ALLL) or the adjusted allowance for credit losses (AACL), as applicable, up to 1.25 percent of standardized total risk-weighted assets not including any amount of the ALLL or AACL, as applicable (and excluding in the case of a banking organization subject to market risk requirements, its standardized market risk-weighted assets). Further, as part of its calculations for determining its total capital ratio, a banking organization subject to Category I or II standards must determine its advanced-approaches-adjusted total capital by (1) deducting from its total capital any ALLL or AACL, as applicable, included in its tier 2 capital and; (2) adding to its total capital any eligible credit reserves that exceed the banking organization's total expected credit losses to the extent that the excess reserve amount does not exceed 0.6 percent of credit-risk-weighted assets. Due to changes in GAAP, all large banking organizations are no longer using ALLL and must use AACL. In addition, the concept of eligible credit reserves is related to use of the internal ratings-based approach, which the proposal would eliminate. Therefore, under the proposal, a large banking organization would determine its expanded risk-based approach-adjusted total capital by (1) deducting from its total capital AACL included in its tier 2 capital and; (2) adding to its total capital any AACL up to 1.25 percent of total credit risk-weighted assets. The proposal would define total credit risk-weighted assets as the sum of total risk-weighted assets for: (1) general credit risk as calculated under § __.110; (2) cleared transactions and default fund contributions as calculated under § __.114; (3) unsettled transactions as calculated under § __.115; and (4) securitization exposures as calculated under § __.132. Question 11: The agencies seek comment on the proposed definition of total credit risk-weighted assets in connection with determining a banking organization's total capital ratio. What, if any, modifications should the agencies consider making to this definition and why? C. Credit Risk Credit risk arises from the possibility that an obligor, including a borrower or counterparty, will fail to perform on an obligation. While loans are a significant source of credit risk, other products, activities, and services also expose banking organizations to credit risk, including investments in debt securities and other credit instruments, credit derivatives, and cash management services. Off-balance sheet activities, such as letters of credit, unfunded loan commitments, and the undrawn portion of lines of credit, also expose banking organizations to credit risk. In this section of the Supplementary Information , subsection III.C.1. describes expectations for completing due diligence on a banking organization's credit risk portfolio; subsection III.C.2. describes the risk-weight treatment for on-balance sheet exposures under the proposal; subsection III.C.3. describes the proposed approach to determine the exposure amount for off-balance sheet exposures; and subsections III.C.4.-5 provide the available approaches for recognizing the benefits of credit risk mitigants including certain guarantees, certain credit derivatives and financial collateral. 1. Due Diligence Banking organizations must maintain capital commensurate with the level and nature of the risks to which they are exposed. 46 The agencies' safety and soundness guidelines establish standards for banking organizations to have an adequate understanding of the impact of their lending decisions on the banking organization's credit risk. 47 A banking organization's performance of due diligence on their credit portfolios is central to meeting both of these obligations. For example, under the safety and soundness guidelines, a banking organization is expected to have established effective internal policies, processes, systems, and controls to ensure that the banking organization's regulatory reporting is accurate and reflects appropriate risk weights assigned to credit exposures. 48 46 See 12 CFR 3.10(e) (OCC); 12 CFR 217.10(e) (Board); 12 CFR 324.10(e) (FDIC). 47 See 12 CFR part 30, appendix A (OCC); 12 CFR, appendix D-1 to part 208 (Board); 12 CFR, appendix A to part 364 (FDIC). 48 When performing due diligence, banking organizations must adhere to the operational and managerial standards for loan documentation and credit underwriting as set forth in the Interagency Guidelines Establishing Standards for Safety and Soundness (safety and soundness guidelines). When properly performed, due diligence may lead a banking organization to conclude that the minimum regulatory capital requirements for certain exposures do not sufficiently account for their potential credit risk. In such instances, the banking organization should take appropriate risk mitigating measures such as allocating additional capital, establishing larger credit loss allowances, or requiring additional collateral. Adherence to due diligence standards, as established through the agencies' safety and soundness guidelines, directly supports and facilitates requirements for banking organizations to maintain capital commensurate with the level and nature of the risks to which they are exposed. Question 12: The agencies seek comment on whether due diligence requirements should be directly integrated into the text of the final rule. What would be the advantages and disadvantages of specifying increases in risk weights that would be required to the extent that due diligence requirements are not met, similar to the proposed risk-weight treatment for securitization exposures as described in section III.D of this Supplementary Information ? 2. Proposed Risk Weights for Credit Risk The proposal would replace the use of internal models to set regulatory capital requirements for credit risk as set out in subpart E of the current capital rule with a new expanded risk-based approach for credit risk applicable to large banking organizations. The proposed expanded risk-based approach for credit risk would retain many of the same definitions § __.2 of the current capital rule including among others a sovereign, a sovereign exposure, certain supranational entities, a multilateral development bank, a public sector entity (PSE), a government-sponsored enterprise (GSE), other assets, and a commitment. Some elements of the proposed expanded risk-based approach for credit risk would apply the same risk-weight treatment provided in subpart D of the current capital rule (current standardized approach) for on-balance sheet exposures, including exposures to sovereigns, certain supranational entities and multilateral development banks, government sponsored entities (GSEs) in the form of senior debt and guaranteed exposures, Federal Home Loan Bank (FHLB) and Federal Agricultural Mortgage Corporation (Farmer Mac) equity exposures, 49 public sector entities (PSEs), and other assets. The proposal would also apply the same risk-weight treatment provided in the current standardized approach to the following real estate exposures: pre-sold construction loans, statutory multifamily mortgages, and high-volatility commercial real estate (HVCRE) exposures. 49 For treatment of other exposures to GSEs, see discussion related to equity exposures in section III.E. and exposures to subordinated debt instruments in section III.C.2.d. of this Supplementary Information . Relative to the internal models-based approaches in the advanced approaches under the current capital rule, the proposed expanded risk-based approach would result in more transparent capital requirements for credit risk exposures across banking organizations. The proposal would also facilitate comparisons of capital adequacy across banking organizations by reducing excessive, unwarranted variability in risk-weighted assets for similar exposures. Relative to the current standardized approach, the proposal would incorporate more granular risk factors to allow for a broader range of risk weights. Specifically, the proposal would introduce the expanded risk-based approach for exposures to depository institutions, foreign banks, and credit unions; exposures to subordinated debt instruments, including those to GSEs; and real estate, retail, and corporate exposures. The proposal would also increase risk capture for certain off-balance sheet exposures through a new exposure methodology for commitments without pre-set limits and would modify the credit conversion factors applicable to commitments. Additionally, the proposal would introduce new definitions for defaulted exposures and defaulted real estate exposures. Under the proposal, a banking organization would determine the risk-weighted asset amount for an on-balance sheet exposure by multiplying the exposure amount by the applicable risk weight, consistent with the method used under the current standardized approach. The on-balance sheet exposure amount would generally be the banking organization's carrying value 50 of the exposure, consistent with the value of the asset on the balance sheet as determined in accordance with GAAP, which is the same as under the current capital rule. For all assets other than AFS securities and purchased credit-deteriorated assets, the carrying value is not reduced by any associated credit loss allowance that is determined in accordance with GAAP. Using the value of an asset under GAAP to determine a banking organization's exposure amount would reduce burden and provide a consistent framework that can be easily applied across all banking organizations of the proposal because, in most cases, GAAP serve as the basis for the information presented in financial statements and regulatory reports. 51 50 Carrying value under § __. 2 of the current capital rule means, with respect to an asset, the value of the asset on the balance sheet of the banking organization as determined in accordance with GAAP. For all assets other than available-for-sale debt securities or purchased credit deteriorated assets, the carrying value is not reduced by any associated credit loss allowance that is determined in accordance with GAAP. See 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC). The exposure amount arising from an OTC derivative contract; a repo-style transaction or an eligible margin loan; a cleared transaction; a default fund contribution; or a securitization exposure would be calculated in accordance with §§ __.113, 121, or 131 of the proposal, respectively, as described in sections III.C.4, II.C.5.b., and III.D. of this Supplementary Information . 51 See 12 U.S.C. 1831n. The proposal would group credit risk exposures into the following categories: sovereign exposures; exposures to certain supranational entities and multilateral development banks; exposures to GSEs; exposures to depository institutions, foreign banks, and credit unions; exposures to PSEs; real estate exposures; retail exposures; corporate exposures; defaulted exposures; exposures to subordinated debt instruments; and off-balance sheet exposures. The proposed categories with amended risk-weight treatments relative to the current standardized approach include equity exposures to GSEs and exposures to subordinated debt instruments issued by GSEs; exposures to depository institutions, foreign banks, and credit unions; exposures to subordinated debt instruments; real estate exposures; retail exposures; corporate exposures; defaulted exposures; and some off-balance sheet exposures such as commitments. The proposed risk weight treatments for each of these categories are described in the following sections of this Supplementary Information . a. Defaulted Exposures The proposal would introduce an enhanced definition of a defaulted exposure that would be broader than the current capital rule's definition of a defaulted exposure under subpart E. The proposed scope and criteria of the defaulted exposure category is intended to appropriately capture the elevated credit risk of exposures where the banking organization's reasonable expectation of repayment has been reduced, including exposures where the obligor is in default on an unrelated obligation. Under the proposal, a defaulted exposure would be any exposure that is a credit obligation and that meets the proposed criteria related to reduced expectation of repayment, and that is not an exposure to a sovereign entity, 52 a real estate exposure, 53 or a policy loan. 54 The proposal would define a credit obligation as any exposure where the lender but not the obligor is exposed to credit risk. In other words, for these exposures, the lender would have a claim on the obligor that does not give rise to counterparty credit risk 55 and would exclude derivative contracts, cleared transactions, default fund contributions, repo-style transactions, eligible margin loans, equity exposures, and securitization exposures. 52 Under the proposal, the expanded risk-based approach would rely on the treatment of sovereign default in the current standardized approach in the capital rule. See 12 CFR 3.32(a)(6) (OCC); 12 CFR 217.32(a)(6) (Board); 12 CFR 324.32 (a)(6) (FDIC). 53 For the treatment of defaulted real estate exposures, see section III.C.2.e.vii of this Supplementary Information . 54 A policy loan is defined under § __.2 of the current capital rule to mean means a loan by an insurance company to a policy holder pursuant to the provisions of an insurance contract that is secured by the cash surrender value or collateral assignment of the related policy or contract. A policy loan includes: (1) A cash loan, including a loan resulting from early payment benefits or accelerated payment benefits, on an insurance contract when the terms of contract specify that the payment is a policy loan secured by the policy; and (2) An automatic premium loan, which is a loan that is made in accordance with policy provisions which provide that delinquent premium payments are automatically paid from the cash value at the end of the established grace period for premium payments. See 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC). 55 Counterparty credit risk is the risk that the counterparty to a transaction could default before the final settlement of the transaction where there is a bilateral risk of loss. For all other exposure categories (excluding an exposure to a sovereign entity, real estate exposure, a retail exposure, or a policy loan), the proposed definition of defaulted exposure would look to the performance of the borrower with respect to credit obligations to any creditor. Specifically, if the banking organization determines that an obligor meets any of the of the defaulted criteria for exposures that are not retail exposures, described further below, the proposal would require the banking organization to treat all exposures that are credit obligations of that obligor as defaulted exposures. Additionally, the proposal would differentiate the criteria for determining whether an exposure is a defaulted exposure between exposures that are retail exposures and those that are not. Retail exposures are originated to individuals or small- and medium-sized businesses. Evaluating whether a retail borrower has other exposures that are in default as defined by the proposal may be difficult to operationalize for banking organizations given many unique obligors. For other types of exposures that are not retail exposures, evaluating default at the obligor level is appropriate because those obligors are more likely to have additional credit obligations that are large and held by multiple banking organizations. Default on one of those credit obligations would be indicative of increased riskiness of the exposure held by a banking organization, and hence a banking organization should account for this in evaluating the risk profile of the borrower. Under the proposal, for a retail exposure, a credit obligation would be considered a defaulted exposure if any of the following has occurred: (1) the exposure is 90 days past due or in nonaccrual status; (2) the banking organization has taken a partial charge-off, write-down of principal, or negative fair value adjustment on the exposure for credit-related reasons, until the banking organization has reasonable assurance of repayment and performance for all contractual principal and interest payments on the exposure; or (3) a distressed restructuring of the exposure was agreed to by the banking organization, until the banking organization has reasonable assurance of repayment and performance for all contractual principal and interest payments on the exposure as demonstrated by a sustained period of repayment performance, provided that a distressed restructuring includes the following made for credit-related reasons: forgiveness or postponement of principal, interest, or fees, term extension, or an interest rate reduction. A sustained period of repayment performance by the borrower is generally a minimum of six months in accordance with the contractual terms of the restructured exposure. For exposures that are not retail exposures (excluding an exposure to a sovereign entity, a real estate exposure, or a policy loan), a credit obligation would be considered a defaulted exposure if either of the following has occurred: (1) the obligor has a credit obligation to the banking organization that is 90 days or more past due 56 or in nonaccrual status; or (2) the banking organization determines that, based on ongoing credit monitoring, the obligor is unlikely to pay its credit obligations to the banking organization in full, without recourse by the banking organization. If a banking organization determines that an obligor meets these proposed criteria, the proposal would require the banking organization to treat all exposures that are credit obligations of that obligor as defaulted exposures. 56 Overdrafts are past due and are considered defaulted exposures once the obligor has breached an advised limit or been advised of a limit smaller than the current outstanding balance. For purposes of the second criterion, the proposal would require a banking organization to consider an obligor as unlikely to pay its credit obligations if any of the following criteria apply: (1) the obligor has any credit obligation that is 90 days or more past due or in nonaccrual status with any creditor; (2) any credit obligation of the obligor has been sold at a credit-related loss; (3) a distressed restructuring of any credit obligation of the obligor was agreed to by any creditor, provided that a distressed restructuring includes the following made for credit-related reasons: forgiveness or postponement of principal, interest, or fees, term extension or an interest rate reduction; (4) the obligor is subject to a pending or active bankruptcy proceeding; or (5) any creditor has taken a full or partial charge-off, write-down of principal, or negative fair value adjustment on a credit obligation of the obligor for credit-related reasons. Under the proposal, banking organizations are expected to conduct ongoing credit monitoring regarding relevant obligors. The proposal would require banking organizations to continue to treat an exposure as a defaulted exposure until the exposure no longer meets the definition or until the banking organization determines that the obligor meets the definition of investment grade 57 or the proposed definition of speculative grade. 58 The proposal would revise the definition of speculative grade, consistent with the current definition of investment grade, to allow the definition to apply to entities to which the banking organization is exposed through a loan or security. In addition, the proposal would make the same revision to the definition of sub-speculative grade. 57 Under § __.2 of the current capital rule, investment grade means that the entity to which the banking organization is exposed through a loan or security, or the reference entity with respect to a credit derivative, has adequate capacity to meet financial commitments for the projected life of the asset or exposure. Such an entity or reference entity has adequate capacity to meet financial commitments if the risk of its default is low and the full and timely repayment of principal and interest is expected. See 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC). 58 The proposal would revise the definition of speculative grade to mean that the entity to which a banking organization is exposed through a loan or security, or the reference entity with respect to a credit derivative, has adequate capacity to meet financial commitments in the near term, but is vulnerable to adverse economic conditions, such that should economic conditions deteriorate, the issuer or the reference entity would present an elevated default risk. A banking organization would assign a 150 percent risk weight to a defaulted exposure including any exposure amount remaining on the balance sheet following a charge-off, and any other non-retail exposure to the same obligor, to reflect the increased uncertainty as to the recovery of the remaining carrying value. The proposed risk weight is intended to reflect the impaired credit quality of defaulted exposures and to help ensure that banking organizations maintain sufficient regulatory capital for the increased probability of losses on these exposures. A banking organization may apply a risk weight to the guaranteed or secured portion of a defaulted exposure based on (1) the risk weight under § __.120 of the proposal if the guarantee or credit derivative meets the applicable requirements or (2) the risk weight under § __.121 of the proposal if the collateral meets the applicable requirements. Question 13: How does the defaulted exposure definition compare with banking organizations' existing policies relating to the determination of the credit risk of a defaulted exposure and the creditworthiness of a defaulted obligor? What additional clarifications are necessary to determine the point at which retail and non-retail exposures should no longer be treated as defaulted exposures? Question 14: What operational challenges, if any, would a banking organization face in identifying which exposures meet the proposed definition of defaulted exposure? In particular, the agencies seek comment on the ability of a banking organization to obtain the necessary information to assess whether the credit obligations of a borrower to creditors other than the banking organization would meet the proposed criteria? What operational challenges, if any, would a banking organization face in identifying whether obligors on non-retail credit obligations are subject to a pending or active bankruptcy proceeding? Question 15: For the purposes of retail credit obligations, the agencies invite comment on the appropriateness of including a borrower's bankruptcy as a criterion for a defaulted exposure. What operational challenges, if any, would a banking organization face in identifying whether obligors on retail credit obligations are subject to a pending or active bankruptcy proceeding? To what extent would criteria (1) through (3) in the proposed defaulted exposure definition for retail exposures sufficiently capture the risk of a borrower involved in a bankruptcy proceeding? Question 16: What alternatives to the proposed treatment should the agencies consider while maintaining a risk-sensitive treatment for credit risk of a defaulted borrower? For example, what would be the advantages and disadvantages of limiting the defaulted borrower scope to obligations of the borrower with the banking organization? b. Exposures to Government-Sponsored Enterprises The proposal would assign a 20 percent risk weight to GSE 59 exposures that are not equity exposures, securitization exposures or exposures to a subordinated debt instrument issued by a GSE, consistent with the current standardized approach. 60 Under the proposal, an exposure to the common stock issued by a GSE would be an equity exposure. An exposure to the preferred stock issued by a GSE would be an equity exposure or an exposure to a subordinated debt instrument, depending on the contractual terms of the preferred stock instrument. Equity exposures to a GSE must be assigned a risk-weighted asset amount as calculated under §§ __.140 through __.142 of subpart E. An exposure to a subordinated debt instrument issued by a GSE must be assigned a 150 percent risk weight, unless issued by a FHLB or Farmer Mac. As discussed later in sections III.E. and III.C.2.d. of this Supplementary Information , equity exposures and exposures to subordinated debt instruments would generally be subject to an increased risk-based capital requirement to reflect their heightened risk relative to exposures to senior debt. 59 Government-sponsored enterprise (GSE) under § __. 2 of the current capital rule means an entity established or chartered by the U.S. government to serve public purposes specified by the U.S. Congress but whose debt obligations are not explicitly guaranteed by the full faith and credit of the U.S. government. See 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC). 60 Similar to the treatment of senior debt exposures to GSEs and GSE exposures that are not equity exposures or exposures to a subordinated debt instrument issued by a GSE, the proposal would apply the same 20 percent risk weight to all exposures to FHLB or Farmer Mac, including equity exposures and exposures to subordinated debt instruments, which continues the treatment under the current standardized approach. c. Exposures to Depository Institutions, Foreign Banks, and Credit Unions The proposal would define the scope of exposures to depository institutions, foreign banks, and credit unions in a manner that is consistent with the definitions and scope of exposures covered under the current capital rule. Under the proposal, a bank exposure would mean an exposure (such as a receivable, guarantee, letter of credit, loan, OTC derivative contract, or senior debt instrument) to any depository institution, foreign bank, or credit union. 61 61 Under § __.2 of the current capital rule, a depository institution means a depository institution as defined in section 3 of the Federal Deposit Insurance Act, a foreign bank means a foreign bank as defined in section 211.2 of the Federal Reserve Board's Regulation K (12 CFR 211.2) (other than a depository institution), and a credit union means an insured credit union as defined under the Federal Credit Union Act (12 U.S.C. 1751 et seq. ). See 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC). Exposures to other financial institutions, such as bank holding companies, savings and loans holding companies, and securities firms, generally would be considered corporate exposures. See 78 FR 62087 (October 11, 2013). The proposed treatment for bank exposures supports the simplicity, transparency, and consistency objectives of the proposal in a manner that is appropriately risk sensitive. The proposal would provide three categories for bank exposures that are ranked from the highest to the lowest in terms of creditworthiness: Grade A, Grade B, and Grade C. The assignment of the bank exposure category would be based on the obligor depository institution, foreign bank, or credit union. As outlined below, the proposal would rely on the current capital rule's definition of investment grade and the proposed definition of speculative grade for differentiating the credit risk of bank exposures. In addition, the proposal would incorporate publicly disclosed capital levels to differentiate the financial strength of a depository institution, foreign bank, or credit union in a manner that is both objective and transparent to supervisors and the public. More specifically, a Grade A bank exposure would mean a bank exposure for which the obligor depository institution, foreign bank, or credit union (1) is investment grade, and (2) whose most recent publicly disclosed capital ratios meet or exceed the higher of: (a) the minimum capital requirements and any additional amounts necessary to not be subject to limitations on distributions and discretionary bonus payments under the capital rules established by the prudential supervisor of the depository institution, foreign bank, or credit union, and (b) if applicable, the capital ratio requirements for the well-capitalized category under the agencies' prompt corrective action framework, 62 or under similar rules of the National Credit Union Administration. 63 For example, an exposure to an investment grade depository institution could qualify as a Grade A bank exposure if the depository institution was not subject to limitations on distributions and discretionary bonus payments under the capital rules and had risk-based capital ratios that met the well capitalized thresholds under the agencies' prompt corrective action framework. Further, a bank exposure to a depository institution that had opted into the community bank leverage ratio (CBLR) framework and is investment grade would be considered to be a Grade A bank exposure, even if the obligor depository institution were in the grace period under the CBLR framework. 64 Under the proposal, a depository institution that uses the CBLR framework would not be required to calculate or disclose risk-based capital ratios for purposes of qualifying as a Grade A bank exposure. 62 The capital ratios used for this determination are the ratios on the depository institution's most recent quarterly Consolidated Report of Condition and Income (Call Report). 63 See 12 CFR part 702 (National Credit Union Administration). 64 See 12 CFR 3.12(a)(1) (OCC); 12 CFR 217.12(a)(1) (Board); 12 CFR 324.12(a)(1) (FDIC). A Grade B bank exposure would mean a bank exposure that is not a Grade A bank exposure and for which the obligor depository institution, foreign bank, or credit union (1) is speculative grade or investment grade, and (2) whose most recent publicly disclosed capital ratios meet or exceed the higher of: (a) the applicable minimum capital requirements under capital rules established by the prudential supervisor of the depository institution, foreign bank, or credit union, and (b) if applicable, the capital ratio requirements for the adequately-capitalized category 65 under the agencies' prompt corrective action framework, 66 or under similar rules of the National Credit Union Administration. 67 65 See 12 CFR 6.4(b)(2) (OCC); 12 CFR 208.43(b)(2) (Board); 12 CFR 324.403(b)(2) (FDIC). 66 The capital ratios used for this determination are the ratios on the depository institution's most recent quarterly Call Report. 67 See 12 CFR part 702 (National Credit Union Administration). For a foreign bank to qualify as a Grade A or Grade B bank exposure, the proposal would require the applicable capital standards imposed by the home country supervisor to be consistent with international capital standards issued by the Basel Committee. A Grade C bank exposure would mean a bank exposure that does not qualify as a Grade A or Grade B bank exposure. For example, a bank exposure would be a Grade C bank exposure if the obligor depository institution, foreign bank, or credit union has not publicly disclosed its capital ratios within the last six months. In addition, an exposure would be a Grade C bank exposure if the external auditor of the depository institution, foreign bank, or credit union has issued an adverse audit opinion or has expressed substantial doubt about the ability of the depository institution, foreign bank, or credit union to continue as a going concern within the previous 12 months. Under the proposal, a foreign bank exposure that is a Grade A or Grade B bank exposure and is a self-liquidating, trade-related contingent item that arises from the movement of goods and that has a maturity of three months or less may be assigned a risk weight that is lower than the risk weight applicable to other exposures to the same foreign bank. The proposed approach to providing a preferential risk weight for short-term self-liquidating, trade-related contingent items would be consistent with the current standardized approach. The proposal would also address the risk that capital and foreign exchange controls imposed by a sovereign entity in which a foreign bank is located could prevent or materially impede the ability of the foreign bank to convert its currency to meet its obligations or transfer funds. The proposal would, therefore, provide a risk weight floor for foreign bank exposures based on the risk weight applicable to a sovereign exposure for the jurisdiction where the foreign bank is incorporated when (1) the exposure is not in the local currency of the jurisdiction where the foreign bank is incorporated; or (2) the exposure to a foreign bank branch that is not in the local currency of the jurisdiction in which the foreign branch operates (sovereign risk-weight floor). 68 The risk weight floor would not apply to short-term self-liquidating, trade-related contingent items that arise from the movement of goods. 68 See § __.111 for the proposed sovereign risk-weight table, which is identical to Table 1 to § __.32 in the current capital rule. As provided in Table 1, the proposed risk weights for bank exposures generally would range from 40 percent to 150 percent. EP18SE23.001 Question 17: What are the advantages and disadvantages of assigning a range of risk weights based on the bank's creditworthiness? What alternatives, if any, should the agencies consider, including to address potential concerns around procyclicality? Question 18: What are the advantages and disadvantages of incorporating specific capital levels in the determination of each of the three categories of bank exposures? What, if any, other risk factors should the banking agencies consider to differentiate the credit risk of bank exposures? What concerns, if any, could limitations on available information about foreign banks raise in the context of determining the appropriate risk weights for exposures to such banks and how should the agencies consider addressing such concerns? Question 19: What is the impact of limiting the lower risk weight for self-liquidating, trade-related contingent items that arise from the movement of goods to those with a maturity of three months or less? What would be the advantages and disadvantages of expanding this risk weight treatment to include such exposures with a maturity of six months or less? What would be the advantages and disadvantages of limiting this reduced risk weight treatment to only foreign banks whose home country has an Organization for Economic Cooperation and Development (OECD) Country Risk Classification (CRC) 69 of 0, 1, 2, or 3, or is an OECD member with no CRC, consistent with the current standardized approach? 70 69 Under § __. 2 of the current capital rule, a Country Risk Classification (CRC) for a sovereign means the most recent consensus CRC published by the Organization for Economic Cooperation and Development (OECD) as of December 31st of the prior calendar year that provides a view of the likelihood that the sovereign will service its external debt. See 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); 12 CFR 324.2 (FDIC). For more information on the OECD country risk classification methodology, see OECD, “Country Risk Classification,” available at https://www.oecd.org/trade/topics/export-credits/arrangement-and-sector-understandings/financing-terms-and-conditions/country-risk-classification/. 70 The CRCs reflect an assessment of country risk, used to set interest rate charges for transactions covered by the OECD arrangement on export credits. The CRC methodology classifies countries into one of eight risk categories (0-7), with countries assigned to the zero category having the lowest possible risk assessment and countries assigned to the 7 category having the highest possible risk assessment. See 78 FR 62088 (October 11, 2018). d. Subordinated Debt Instruments The proposal would introduce a definition and an explicit risk weight treatment for exposures in the form of subordinated debt instruments. The proposed definition of a subordinated debt instrument would capture exposures that are financial instruments and present heightened credit risk but are not equity exposures, including: (1) any preferred stock that does not meet the definition of an equity exposure, (2) any covered debt instrument, including a TLAC debt instrument, that is not deducted from regulatory capital, and (3) any debt instrument that qualifies as tier 2 capital under the current capital rule or that would otherwise be treated as regulatory capital by the primary Federal supervisor of the issuer and that is not deducted from regulatory capital. The proposal would define a subordinated debt instrument as (1) a debt security that is a corporate exposure, a bank exposure, or an exposure to a GSE, including a note, bond, debenture, similar instrument, or other debt instrument as determined by the primary Federal supervisor, that is subordinated by its terms, or separate intercreditor agreement, to any creditor of the obligor, or (2) preferred stock that is not an equity exposure. For these purposes, a debt security would be subordinated if the documentation creating or evidencing such indebtedness (or a separate intercreditor agreement) provides for any of the issuer's other creditors to rank senior to the payment of such indebtedness in the event the issuer becomes the subject of a bankruptcy or other insolvency proceeding, with the scope of applicable bankruptcy or other insolvency proceedings being defined in the applicable documentation. The scope of the definition of a subordinated debt instrument is meant to capture the types of entities that issue subordinated debt instruments and for which the level of subordination is a meaningful determinant of the credit risk of the instrument. In addition, even though the provision of collateral typically reduces the risk of loss on indebtedness, the proposal includes secured as well as unsecured subordinated debt securities in the scope of subordinated debt instruments, since the effect of subordination may result in the collateral providing little or no real value to the subordinated debt holder in the event the issuer becomes to subject of a bankruptcy or other insolvency proceeding. A subordinated debt instrument would not include any loan, including a syndicated loan, a debt security issued by a sovereign, public sector entity, multilateral development bank, or supranational entity, or a security that would be captured under the securitization framework. Due to the contractual obligations and structures associated with subordinated debt instruments, such exposures generally pose increased risk relative to a senior loan, including a syndicated loan, or a senior debt security to the same entity because investments in subordinated debt instruments are usually considered junior creditors and subordinate to obligations specified in the definition of senior debt in the document governing the junior creditors' obligations. The proposal generally would apply a 150 percent risk weight for exposures that meet the definition of a subordinated debt instrument, including any preferred stock that is not an equity exposure, and any tier 2 instrument or covered debt instrument that is not deducted from regulatory capital, including TLAC debt instruments, and any debt instrument that would otherwise be treated as regulatory capital by the primary Federal supervisor of the issuer and that is not deducted from regulatory capital. 71 71 Covered debt instruments are subject to deduction by banking organizations subject to Category I or II capital standards similar to the deduction framework for exposures to capital instruments. See 12 CFR 3.22(c) (OCC); 12 CFR 217.22(c) (Board); 12 CFR 324.22(c) (FDIC). As noted in section III.B.3. of this Supplementary Information , under the proposal, this deduction framework will be expanded to banking organizations subject to Category III or IV capital standards. As discussed in section III.C.2.b. above, exposures to subordinated debt instruments issued by an FHLB or by Farmer Mac would be assigned a 20 percent risk weight. The instruments included in the scope of subordinated debt instruments present a greater risk of loss to an investing banking organization relative to more senior debt exposures to the same issuer because subordinated debt instruments have a lower priority of repayment in the event of default. As a result, the proposal would apply an increased risk weight to recognize this increase in loss given default. Since a covered debt instrument that qualifies as a TLAC debt instrument shares similar risk characteristics with a subordinated debt instrument, the proposal would require banking organizations to apply the same 150 percent risk weight to any such exposures that are not otherwise deducted from regulatory capital. Question 20: The agencies seek comment on the scope of the proposed definition of a subordinated debt instrument. What, if any, operational challenges might the proposed definition pose for banking organizations, such as identifying the level of subordination in debt securities or similar instruments, and how should the agencies consider addressing such challenges? Question 21: Would expanding the definition of a subordinated debt instrument to include loans that are not securities more appropriately capture the types of exposures that pose elevated risk and, if so, why? Question 22: The agencies seek comment on applying a heightened 150 percent risk weight to exposures to subordinated debt instruments issued by GSEs. What would be the advantages and disadvantages of this proposed regulatory capital requirement? Would there be any challenges for banking organizations to be able to identify which GSE exposures would be subject to the 150 percent risk weight? Please provide specific examples of any challenges and supporting data. e. Real Estate Exposures The proposal would define a real estate exposure as an exposure that is neither a sovereign exposure nor an exposure to a PSE and that is (1) a residential mortgage exposure, (2) secured by collateral in the form of real estate, 72 (3) a pre-sold construction loan, 73 (4) a statutory multifamily mortgage, 74 (5) a high volatility commercial real estate (HVCRE) exposure, 75 or (6) an acquisition, development, or construction (ADC) exposure. A pre-sold construction loan, a statutory multifamily mortgage, and an HVCRE exposure are collectively referred to as statutory real estate exposures for purposes of this Supplementary Information . Under the proposal, the risk weight treatment for statutory real estate exposures that are not defaulted real estate exposures would be consistent with the current standardized approach. 72 For purposes of the proposal, “secured by collateral in the form of real estate” should be interpreted in a manner that is consistent with the current definition for “a loan secured by real estate” in the Call Report and Consolidated Financial Statements for Holding Companies (FR Y-9C) instructions. 73 The Resolution Trust Corporation Refinancing, Restructuring, and Improvement Act of 1991 (RTCRRI Act) mandates that each agency provide in its capital regulations (i) a 50 percent risk weight for certain one-to-four-family residential pre-sold construction loans that meet specific statutory criteria in the RTCRRI Act and any other underwriting criteria imposed by the agencies, and (ii) a 100 percent risk weight for one-to-four-family residential pre-sold construction loans for residences for which the purchase contract is cancelled. See 12 U.S.C. 1831n, note. 74 The RTCRRI Act mandates that each agency provide in its capital regulations a 50 percent risk weight for certain multifamily residential loans that meet specific statutory criteria in the RTCRRI Act and any other underwriting criteria imposed by the agencies. See 12 U.S.C. 1831n, note. 75 Section 214 of the Economic Growth, Regulatory Relief, and Consumer Protection Act imposes certain requirements on high volatility commercial real estate acquisition, development, or construction loans. Section 214 of Public Law 115-174, 132 Stat. 1296 (2018). See 12 U.S.C. 1831bb. The proposal would differentiate the credit risk of real estate exposures that are not statutory real estate exposures by introducing the following categories: regulatory residential real estate exposures, regulatory commercial real estate exposures, ADC exposures, and other real estate exposures. The applicable risk weight for these non-statutory real estate exposures would depend on (1) whether the real estate exposure meets the definitions of regulatory residential real estate exposure, regulatory commercial real estate exposure, ADC exposure, or other real estate exposure, described below; (2) whether the repayment of such exposures is dependent on the cash flows generated by the underlying real estate (such as rental properties, leased properties, hotels); and (3) in the case of regulatory residential or regulatory commercial real estate exposures, the loan-to-value (LTV) ratio of the exposure. These proposed criteria for differentiating the credit risk of real estate exposures would be based on information already collected and maintained by a banking organization as part of its mortgage lending activities and underwriting practices. Under the proposal, regulatory residential and regulatory commercial real estate exposures would be required to meet prudential criteria that are intended to reduce the likelihood of default relative to other real estate exposures. The criteria in these definitions generally align with existing Interagency Guidelines for Real Estate Lending Policies (real estate lending guidelines). 76 Real estate loans in which repayment is dependent on the cash flows generated by the real estate can expose a banking organization to elevated credit risk relative to comparable exposures 77 as the borrower may be unable to meet its financial commitments when cash flows from the property decrease, such as when tenants default or properties are unexpectedly vacant. 78 In addition, LTV ratios can be a useful risk indicator because the amount of a borrower's equity in a real estate property correlates inversely with default risk and provides banking organizations with a degree of protect [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%3A2023-19200. Public record. Not legal advice.