Risk-Based Capital Standards: Market Risk

SUMMARY: 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) (the Agencies) are proposing to

amend their risk-based capital requirements to incorporate a measure

for market risk in foreign exchange and commodity activities and in the

trading of debt and equity instruments. Under the proposal, banks and

bank holding companies (institutions) regulated by the OCC, the Board,

and the FDIC with relatively large trading activities would calculate

their capital charges for market risk using either their own internal

value-at-risk model(s) or, alternatively, risk measurement techniques

that were developed by supervisors. The effect of the proposed market

risk measure would be that, in addition to existing capital

requirements for credit risk, certain institutions would be required to

hold capital based on the measure of their market risk exposure.

DATES: Comments must be received on or before September 18, 1995.

ADDRESSES: Comments should be directed to:

OCC: Comments may be submitted to Docket Number 95-19,

Communications Division, Third Floor, Office of the Comptroller of the

Currency, 250 E Street, S.W., Washington, DC 20219. Comments will be

available for inspection and photocopying at that address.

Board: Comments directed to the Board should refer to Docket No.R-

0884 and may be mailed to William W. Wiles, Secretary, Board of

Governors of the Federal Reserve System, 20th Street and Constitution

Avenue, N.W., Washington, D.C. 20551. Comments may also be delivered to

Room B-2222 of the Eccles Building between 8:45 and 5:15 p.m. weekdays,

or to the guard station in the Eccles Building courtyard on 20th

Street, N.W. (between Constitution Avenue and C Street) at any time.

Comments may be inspected in Room MP-500 of the Martin Building between

9 a.m. and 5 p.m. weekdays, except as provided in 12 CFR 261.8 of the

Board's rules regarding availability of information.

FDIC: Written comments should be sent to Jerry L. Langley,

Executive Secretary, Attention: Room F-402, Federal Deposit Insurance

Corporation, 550 17th Street N.W., Washington, D.C. 20429. Comments may

be hand-delivered to Room, F-402, 1776 F Street N.W., Washington, D.C.

20429, on business days between 8:30 a.m. and 5 p.m. (Fax number

(202)898-3838; Internet address: [email protected]). Comments will be

available for inspection and photocopying in Room 7118, 550 17th

Street, N.W., Washington, D.C. 20429, between 9 a.m. and 4:30 p.m. on

business days.

FOR FURTHER INFORMATION CONTACT:

OCC: Roger Tufts, Senior Economic Advisor (202/874-5070), or

Christina Benson, Capital Markets Specialist, (202/874-5070) Office of

the Chief National Bank Examiner. For legal issues, Ronald Shimabukuro,

Senior Attorney, Legislative and Regulatory Activities Division (202/

874-5090), Office of the Comptroller of the Currency, 250 E Street

S.W., Washington, D.C. 20219.

Board: Roger Cole, Deputy Associate Director (202/452-2618), James

Houpt, Assistant Director (202/452-3358), Barbara Bouchard, Supervisory

Financial Analyst (202/452-3072), Division of Banking Supervision and

Regulation; or Stephanie Martin, Senior Attorney (202/452-3198), Legal

Division. For the hearing impaired only, Telecommunication Device for

the Deaf, Dorothea Thompson (202/452-3544).

FDIC: William A. Stark, Assistant Director, (202/898-6972), Kenton

Fox, Senior Capital Markets Specialist, (202/898-7119), Division of

Supervision; Jamey Basham, Counsel, (202/898-7265), Legal Division,

FDIC, 550 17th Street, N.W., Washington, D.C. 20429.

SUPPLEMENTARY INFORMATION: The Agencies are proposing amendments to

their risk-based capital requirements to incorporate a measure for

market risk. The proposed amendments would generally apply only to

institutions that have (1) total assets exceeding $5 billion and either

on-balance-sheet trading activities representing at least 3.0 percent

of total assets or a volume of off-balance-sheet trading activities

with notional amounts exceeding $5 billion, or (2) total assets of $5

billion or less and a volume of trading activities representing at

least 10.0 percent of total assets.

I. Background

The Agencies' risk-based capital standards are based upon the

principles contained in the agreement on International Convergence of

Capital Measurement and Capital Standards of July, 1988 (the Accord)

that was agreed to by the Basle Committee on Banking Supervision (the

Committee) and endorsed by the central bank governors of the Group of

Ten (G-10) countries.1 That Accord sets forth a framework for

measuring capital adequacy under which weighted risk assets are

calculated by weighting an institution's assets and off-balance-sheet

items on the basis of their perceived credit risk using a relatively

small number of risk categories.

\1\ The Basle Supervisors' Committee is comprised of

representatives of the central banks and supervisory authorities

from the G-10 countries (Belgium, Canada, France, Germany, Italy,

Japan, The Netherlands, Sweden, Switzerland, the United Kingdom, and

the United States) plus Luxembourg.

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By focusing on credit risk, the risk that a loss will be incurred

due to an obligor or counterparty default on a transaction, the Accord

generally excludes coverage of risks arising from adverse movements in

market interest rates, foreign exchange rates, or commodity or equity

prices. The potential for loss from such movements is referred to as

market risk. In April 1993, the Committee, recognizing the need to

incorporate market risk into the risk-based capital standard, requested

comments on an initial measurement framework. The Agencies' current

proposal reflects substantial revisions to that 1993 paper and is based

upon revisions to the Accord that were proposed by the Committee on

April 12, 1995.2

\2\ The Committee's document is entitled ``Proposal to Issue a

Supplement to the Basle Capital Accord to Cover Market Risks'' and

is available through the Board's and the OCC's Freedom of

Information Office and the FDIC's Reading Room.

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The 1993 paper proposed standardized measurement procedures for

assessing risks in traded debt, equity,

[[Page 38083]]

and foreign exchange activities and provided only a limited role for a

bank's internal model(s) in measuring market risk exposure for

regulatory capital purposes. These procedures were strongly criticized

by commenters to the consultative document, especially by institutions

in the United States. These institutions generally believed that the

measurement framework was unduly cumbersome and potentially inaccurate,

especially for institutions with significant and diversified trading

activities.

In lieu of the standardized framework, these institutions urged the

Committee to allow greater use of an institution's internal market risk

models. They noted that large trading banks have materially expanded

the sophistication and coverage of their market risk trading models.

These models are typically described as ``value-at-risk'' (VAR) models,

which estimate the maximum amount by which an institution's portfolio

could decline in market value, given a certain level of statistical

confidence and an assumed holding period. The commenters believed that

these models would provide a more accurate risk measure and would be

better able to incorporate new products and activities than would the

standardized framework. They also believed that imposing a rigid

supervisory measurement system on institutions would result in

unnecessary costs and could encourage improper risk management

practices if institutions sought to minimize the capital requirements

resulting from the proposed risk measure. Many large European banks

also urged the use of internal models for measuring market risks for

regulatory capital purposes, but were generally less critical, in part

because the European Union had adopted into European law a regime

similar to the one outlined in the 1993 paper.3

\3\ The European Union's Second Directive sets forth a capital

regime for market risk that applies to banking and securities firms

that operate in EU member countries. These capital requirements

become effective at the beginning of 1996.

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In response to these and other comments and concerns, the Committee

issued a new proposal on April 12, 1995. In addition to expanding the

earlier proposal by providing measures for risks in commodities and

options, this latest proposal would allow institutions to use their

internal market risk models to measure the level of their market risk

exposure against which they would be required to hold capital. This

approach is referred to as the ``internal models approach.'' An

institution's use of this approach would be subject to the approval of

its appropriate supervisor and would be contingent upon conformance

with certain qualitative and quantitative standards regarding the

measurement and management of market risks. An institution whose

internal model failed to meet those standards or otherwise failed to

gain regulatory approval would be required to use standardized risk

measurement techniques as set forth in the Committee's April 1995

proposal. This latter approach is referred to as the ``standardized

risk measure'' approach, as it applies standardized assumptions and

risk factors to an institution's activities.

The Agencies are now proposing amendments to their risk-based

capital standards that are similar to the proposal recently issued by

the Committee.4 The Agencies would encourage institutions that are

affected by this proposal, and especially those with large trading

accounts, to comply with the proposed requirements by using the

proprietary internal models that they use to manage market risk.

4 As set forth in the regulatory text, the Agencies

propose to adopt the market risk requirements as new appendices to

their capital adequacy standards. The OCC may be required to make

additional conforming amendments to its risk-based capital

guidelines.

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The Agencies believe that such models should provide a more

accurate measure of market risk than the standardized risk measure and

would impose fewer costs and burdens on institutions. By using internal

models not only for operating purposes, but also as a basis for

determining capital requirements, institutions should be further

encouraged to continue their efforts to refine the accuracy of their

proprietary models, especially with regard to options risk. Given their

preference for the use of internal models for measuring market risk,

the Agencies request comments regarding whether institutions should be

permitted a choice between the two measurement procedures, or only be

permitted to use internal models.

II. Scope: Activities and Institutions Covered by the Proposal

This proposal would establish new capital requirements for general

market risk and specific risk as they pertain to the trading activities

of a banking organization and to the organization's other foreign

exchange and commodities activities. As such, the proposed standard, by

creating a risk-based capital ratio adjusted for market risk through

the addition of a market risk-equivalent assets measure, is an

integrated supplement to existing standards that address credit risk

through the current weighted-risk assets measure.

For purposes of this proposal, general market risk refers to

changes in the market value of the covered transactions that arise from

broad market movements, such as changing levels of market interest

rates, broad equity indices, or currency exchange rates. Specific risk

includes the credit risk of an issuer of a traded security, as well as

other factors that affect the market value of specific instruments, but

that do not materially alter broad market conditions. Consequently,

instruments other than over-the-counter (OTC) derivatives that are

covered by this proposal would, in effect, be removed from and no

longer subject to the credit risk standard previously established. OTC

derivatives would remain subject to the counterparty credit risk

requirements set forth in the existing risk-based capital standard.

This proposal defines trading activities as the sum of all trading

assets and liabilities as reported in the quarterly Consolidated

Reports of Condition and Income (call report) and would apply on a

fully consolidated basis to all national banks, state member banks, and

bank holding companies that meet the following criteria:

(1) The institution has total assets exceeding $5 billion, and (a)

the gross sum of trading assets and liabilities on a daily average

basis for the quarter account for 3.0 percent or more of total assets,

or (b) the sum of the notional amount of interest rate, foreign

exchange, equity and commodity off-balance-sheet derivative contracts

relating to trading activities exceeds $5 billion, or

(2) The institution has total assets of $5 billion or less and

trading assets and liabilities exceed 10 percent of total assets.

The Agencies may also apply the standard to other institutions for

safety and soundness purposes in limited circumstances and on a case-

by-case basis.

III. Definition of Capital and the Capital Requirement

The Agencies are also proposing to expand the definition and types

of qualifying capital that an institution could use to meet its market

risk capital requirements. This modification and others require that

the procedures for calculating an institution's overall risk-based

capital ratio be changed.

Definition of capital. The Accord permits institutions to meet

regulatory capital requirements with a combination of ``core'' (Tier 1)

and ``supplementary''

[[Page 38084]]

(Tier 2) capital. Tier 1 includes equity, noncumulative perpetual

preferred stock, and minority interest in consolidated subsidiaries,

less goodwill, while Tier 2 includes the allowance for loan and lease

losses, other preferred stock, and subordinated debt that has an

original weighted average maturity of at least five years.5

\5\ Bank holding companies may include cumulative perpetual

preferred stock in Tier 1 capital, subject to the conditions that

are specified in the Board's capital guidelines.

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This proposal would permit institutions to use a third tier of

capital (Tier 3), consisting of short-term subordinated debt. However,

this capital could be used only to meet capital requirements pertaining

to market risk and only if that debt meets certain qualifying

conditions: It must have an original maturity of at least two years, be

unsecured and fully paid up, and subject to a lock-in provision that

prevents the issuer from repaying the debt even at maturity if the

issuer's capital ratios are, or with repayment would become, less than

the minimum 8.0 percent risk-based capital requirement.

The agencies are proposing to allow the use of Tier 3 capital in

recognition that such short-term subordinated debt can help to protect

depositors and the Bank Insurance Fund against loss. Indeed, because

the underwriting activities of securities firms often create volatile

capital requirements, securities regulators in many countries permit

their institutions to treat such debt as capital, with similar

qualifications. The Agencies, however, believe that Tier 1 instruments

should remain a substantial proportion of an institution's total

capital and, therefore, propose the following constraints:

(1) Tier 3 capital may not exceed 250 percent of the amount of Tier

1 capital allocated for market risk, and

(2) Tier 1 capital must represent at least 50 percent of an

institution's total eligible capital--the sum of Tier 1, qualifying

Tier 2, and Tier 3 to the extent it is permitted in item (1), above.

Note that any element of Tier 2 capital must continue to conform

with the requirements of the original Accord; that is, Tier 2 may not

exceed total Tier 1 capital, and long-term subordinated debt may not

exceed 50 percent of Tier 1.

Calculation of the capital ratio. An institution subject to this

proposal would remain subject to the Agencies' risk-based capital

standards based on credit risk, but would also be required to

supplement its risk-based capital ratio to adjust it for market risk.

Under the proposal, an institution would accomplish this by multiplying

its capital requirement for market risk (as calculated by the internal

model or standardized approach) by 12.5 (the reciprocal of the minimum

capital ratio of 8.0 percent) and adding the resulting market risk

equivalent figure to its weighted risk assets, as calculated by the

credit risk standard. The institution's Tier 1 and total risk-based

capital ratios would be calculated as the sum of the eligible capital

as a percent of the sum of market risk-equivalent assets and weighted

risk assets. This approach avoids the distortions that could result

from allocating the necessary capital to either market or credit risk

and then calculating an institution's capital ratio on the basis of the

remaining capital. It also incorporates the risk-based capital ratio

adjusted for market risk into the capital category definitions under

the Agencies' prompt corrective action regulations.

Due to the 250 percent constraint on Tier 3 capital, an institution

that wishes to use Tier 3 capital must first calculate its minimum

credit risk requirement to determine the amount of Tier 1 capital that

is available to support market risk. This amount sets an upper limit on

the amount of Tier 3 capital that the institution may have. In

calculating its aggregate capital ratio, however, only that portion of

Tier 3 that is actually needed to meet its market risk requirement may

be included as eligible capital. Tier 3 capital in excess of this

amount will not be considered as eligible capital as it is not

permitted to meet credit risk. Eligible capital would be the sum of the

whole of the institution's Tier 1 capital, plus all of its Tier 2

capital under the limits imposed in the credit risk Accord, and Tier 3

capital subject to the above restrictions. The quoted ratio will thus

represent capital that is available to meet both credit risk and market

risk.6

\6\ For example, if an institution had $120 of Tier 1 capital,

of which $100 was needed to meet its minimum 8.0 percent risk-based

capital standard for credit risk, only $20 would be available for

market risk. That $20, in turn, would ``support'' as much as $50 of

Tier 3 capital ($20 X 250%) for purposes of meeting the capital

requirement for market risk. If the market risk capital requirement

were $50, the institution could count only $30 of Tier 3 capital as

eligible capital in calculating its regulatory capital requirements.

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IV. Partial Models

With supervisory approval, institutions whose internal models do

not cover all elements of their trading activities may use components

of the alternative standardized approach to measure market risks for

risk-based capital purposes. Such combinations, however, should be

limited to situations in which the institution is in the process of

developing and implementing the internal models approach for all of its

trading activities and would be permitted only on a temporary basis. In

addition, the combination of approaches used should be consistent with

the method the institution uses in managing its risks. For example, if

an institution has a comprehensive value-at-risk model for its interest

rate exposures in its trading portfolio but not for its equities

exposures, the agencies would expect the institution to use the

standardized measure for equities and the internal model for interest

rate exposures. These conditions are designed to prevent institutions

from selecting the lower of alternative risk measures and are also

intended to encourage institutions to develop and improve their risk

measurement and management practices.

When combinations of the two risk measurement techniques are used,

the institution should measure a complete risk category using a single

approach and not mix techniques within a given category of risk. For

this purpose, the risk categories are defined as interest rates,

foreign exchange, equity prices, and commodity prices. Moreover, once

an institution adopts a comprehensive value-at-risk model that is

acceptable, it may not revert to the standardized risk measure, except

in unusual circumstances and only with supervisory consent. The

proposal provides some flexibility for de minimis positions, activities

in remote locations, in minor currencies, or in activities that present

negligible risk to the institution.

V. Internal Models Approach

The Agencies believe that an institution's market risk can be most

accurately measured using detailed information available only to the

institution and processed by its own proprietary risk measurement

model(s). Accordingly, the Agencies would encourage all institutions--

especially those with significant trading activities--to pursue this

approach. To be most reliable, however, the modelling process must be

fully integrated into the institution's broader procedures for managing

risk and must be actively supported by senior management. It must also

conform with other specific qualitative and quantitative standards that

the Agencies believe are necessary in order to achieve an adequate

level of rigor and consistency in a capital standard. Under this

proposal, institutions that plan to use internal models in calculating

their capital requirements for market risk

[[Page 38085]]

would need to contact their appropriate supervisor and make

arrangements for having their models validated for regulatory capital

purposes.

Modelling Market Risk

In order to measure exposures when evaluating trading risks, many

institutions calculate the ``value-at-risk'' (VAR), representing the

maximum amount by which the market value of their trading portfolios

could decline during a specific period of time and with a certain

degree of statistical confidence. For example, at the close of business

on day one a bank might calculate its VAR to be $10 million, indicating

that it has only some small chance of losing more than that amount on

its existing holdings, if they were held through the end of day two.

Most institutions use this measure as a management tool for evaluating

their trading positions, limits, and strategies. By measuring the risk

daily, management can quickly revise its positions, limits and

strategies as market conditions change.

A value-at-risk model requires a variety of inputs: (1) Accurate

and timely information about the institution's trading positions, (2)

information about past movements of relevant market prices and rates,

and (3) several key measurement parameters, such as the length of the

historical period for which market changes are observed (observation

period), management's required level of confidence, and the assumed

holding period for which the value of current trading positions may

change. When evaluating their current positions and estimating future

market volatility, institutions typically use a series of ``market risk

factors'' that they have determined affect the value of their positions

and the risks to which they are exposed. These factors, in turn, can be

grouped into four categories, depending on the nature of the underlying

risk: interest rates, exchange rates, and equity and commodity prices,

with related options volatilities included in each risk factor

category.

Having determined which risk factors to use, an institution

estimates the potential future volatility of the factors. Most often

this calculation is based on the past movements of these factors over

some specified time horizon, with some institutions using long

historical time periods and others focusing on more recent market

behavior. However derived, the estimates of potential market movements

are combined with current position data to calculate an estimate of the

potential loss that may arise from those positions for a specified

holding period. Just as institutions use different historical time

periods when computing possible changes in market risk factors, they

also use different confidence levels to estimate potential losses. Some

institutions use a 90 or 95 percent confidence level (one-tail), while

others use a higher level of statistical confidence.

Institutions also use different modelling procedures in calculating

their market risk exposures. The most common models are based upon

variance/covariance methodologies, historical simulations, or Monte

Carlo simulation techniques. In the case of the variance/covariance

approach, the change in value of the portfolio is calculated by

combining the risk factor sensitivities of the individual positions--

derived from valuation models--with a variance/covariance matrix based

on risk factor volatilities and correlations. An institution would

calculate the volatilities and correlations of the risk factors on the

basis of the holding period and the observation period. Value-at-risk

is determined according to the desired level of statistical confidence.

Using historical simulations, an institution would calculate the

hypothetical change in value of the current portfolio in the light of

actual historical movements in risk factors. This calculation is done

for each of the defined holding periods over a given historical

measurement horizon to arrive at a range of simulated profits and

losses, and the confidence level, again, determines the value-at-risk.

Monte Carlo techniques also consider historical movements, but only

to determine the probability of particular price and rate changes.

Using these probabilities, the institution would then construct a large

number of theoretical movements to evaluate the range of its

portfolio's potential market values and identify the maximum loss

consistent with the necessary confidence level.

Proposed Modelling Constraints

The Agencies recognize that institutions have adopted different

assumptions and measurement techniques in their internal market risk

models and that such differences often reflect distinct business

strategies and approaches to risk management. In developing a framework

for the use of internal models for regulatory capital purposes, the

Agencies believe that some constraints should be placed on model

parameters and assumptions. Such restrictions would help to ensure that

prudential capital levels are maintained and that institutions with

similar risk exposures have similar capital requirements.

Since institutions use VAR to guide them in setting trading limits,

rather than for evaluating capital adequacy, they set their model

parameters to address normal conditions. Indeed, the models are

designed to ensure that actual trading results often exceed the

projected levels so that management is better able to evaluate the

model's predictive accuracy and to respond to events that generate

unexpectedly large gains or losses. During a given year, for example, a

model based on a 90 percent confidence level (one tail) could be

expected to underestimate actual trading losses more than 20 times.

Moreover, knowing that a day's trading results could be expected to

exceed the VAR ten percent, five percent, or even only one percent of

the time, says nothing about the magnitude by which the VAR might be

exceeded. The probabilities of VAR models cannot be extended to

estimate the size of a highly unlikely event because most models assume

that market movements are distributed normally. While that assumption

may be adequate for a model's intended purpose, it permits the model to

greatly understate the likelihood of a large loss. For example,

assuming a normal distribution, the likelihood of experiencing a four

standard deviation event is approximately 3 in 100,000--in trading

terms, about once in 130 years. In practice, however, such unusual

market movements are seen in most major markets on average almost every

year.7

\7\ Daily rate or price movements of a half-dozen major

currencies and U.S. Treasury maturities and of several U.S. equity

indices each moved by at least four standard deviations on average

about once a year during the period 1977-1994. The drop in the value

of the S&P 500 index on October 19, 1987 represented a 20 standard

deviation event in terms of daily price movements.

These conditions require that regulators impose some constraints or

other adjustments to the VAR figure that each institution derives in

order to provide the rigor and consistency that a capital requirement

demands. At the same time, the Agencies want to minimize the costs and

dislocations to an internal modelling system that external constraints

could create and have sought to balance these conflicting objectives

through a combination of qualitative and quantitative constraints.

Qualitative Standards

The qualitative standards are designed to ensure that institutions

using internal models have market risk management systems that are

conceptually sound and implemented

[[Page 38086]]

with integrity.8 The internal risk measurement model should be

closely integrated in the daily risk management process and serve as a

basis for reporting of risk exposures to senior officers. Institutions

should have, for example, highly trained personnel who can evaluate the

adequacy of the risk models and who are organizationally independent of

personnel responsible for executing trades. These individuals should

compare actual daily trading gains and losses with VAR figures

generated by the model as part of their on-going evaluations of the

modelling process. At least annually, internal auditors should assess

the institution's overall process for managing and measuring trading

risks.

\8\ With respect to the qualitative standards, the OCC is

planning to provide additional guidance through supplementary

banking issuances.

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Notwithstanding the use of VAR as a basis for a regulatory capital

charge, institutions should also routinely evaluate their exposures to

highly stressful events, selected to identify the circumstances to

which their particular trading portfolios are most vulnerable. Such a

program of stress testing supplements the capital standard and

illustrates management's commitment to evaluating trading risks fully.

The stress testing process, along with other relevant internal

policies, controls, and procedures, should be well documented and

available for examiners to review. Examiners will need this

information, as well as comparisons of VAR measures with actual daily

trading results, to judge the acceptability of the institution's model

on an initial and periodic basis. Under the proposal, if key management

procedures are missing or weak, or if the integrity of a model is

questionable, the appropriate supervisor may either disallow the model

for regulatory capital purposes or require capital above the minimum

specified in the proposal. The latter may be done by increasing the

size of the multiplier that would be applied to an institution's VAR

(discussed below under ``Capital Requirement''). Typically, the

Agencies would expect to see any management or modelling shortcomings

addressed and the risk measure improved, rather than seek to resolve

the matter by applying a larger multiplier to a marginally satisfactory

or questionable modelling or management approach.

Quantitative Standards

Whereas the qualitative standards focus on the integrity of the

modelling process and incorporate standards of sound practice, the

quantitative standards are designed to develop a prudential capital

requirement by addressing the level of rigor in an institution's models

and the consistency of model parameters among institutions. The

Agencies have sought to minimize the quantitative constraints and to

make those that were deemed necessary as compatible as practicable with

existing procedures of institutions. The Agencies recognize, however,

that some of these standards may require an institution to make certain

modifications to its internal model when using it for computing

regulatory capital requirements. The Agencies propose that an

institution that elects to use the internal model approach be subject

to the following standards for its internal model:

(1) Value-at-risk should be computed each business day and should

be based on a 99 percent (one-tailed) confidence level of estimated

maximum loss.

(2) The assumed holding period used for the VAR measure must be 10

business days, although for positions that display linear price

characteristics (not options, which display nonlinear characteristics)

the institution may use results based on one-day periods, increased to

ten days by multiplying by the square root of time.9

\9\ For example, one can estimate the ten day price volatility

of an instrument by multiplying the volatility calculated on one-day

changes by the square root of ten.

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(3) The model must measure all material risks incurred by the

institution, although no specific type of model is prescribed.

(4) The model may utilize historical correlations within broad

categories of risk factors (interest rates, exchange rates, and equity

and commodity prices), but not among these categories. That is, the

consolidated value-at-risk is the sum of the individual VARs measured

for each broad category.

(5) The non-linear price characteristics of options must be

adequately addressed, both by ensuring that the model incorporates

potential non-linear price behavior and by evaluating actual minimum 10

day holding periods, rather than multiplying the results based on one-

day periods by the square root of time. The volatility of the rates and

prices (vega) underlying the options must also be included among the

risk factors.

(6) The historical observation period used to estimate future price

and rate changes must have a minimum length of one year. The Agencies

request specific comment on whether they should also require

institutions to calculate their exposures using a shorter observation

period (e.g. less than 6 months), with the capital requirement based on

the higher result.

(7) Data must be updated no less frequently than once every three

months and more frequently if market conditions warrant.

(8) Each yield curve in a major currency must be modeled using at

least six risk factors, selected to reflect the characteristics of the

interest rate sensitive instruments that the institution trades. The

model must also take account of spread risk.

Several of these constraints warrant a discussion of their

underlying rationale:

Minimum holding period (and issues regarding options). Typically,

longer holding periods lead to larger expected price changes and,

consequently, to larger measures of risk. When estimating risk in

trading activities for management purposes, most institutions assume

only a one-day holding period, since trading decisions are made

constantly, and some instruments are held for only minutes or hours.

This approach may be fully satisfactory for day-to-day management

purposes but seems less appropriate when designing a prudent capital

standard.

In periods of market turmoil, when an institution's capital is most

needed, many financial instruments could become unexpectedly illiquid,

as market participants become less willing to accept market risk. One

method of increasing the rigor of the risk measure and addressing an

unexpectedly large price change that could result from a decline in

market liquidity would be to assume a longer holding period. The

proposed requirement that institutions use a 10-day holding period does

not imply that the Agencies would expect them to plan for that

eventuality. Indeed, some positions, such as those involving spot

foreign exchange contracts, will mature and settle within that time

frame and could not be held for 10 days, in any event. Therefore, in

this context, the 10-day period should be viewed simply as a way of

producing a more stressful market shock by assuming an instantaneous

price movement of a size that one would normally expect to witness only

over the longer period of time.

However, in order to minimize modelling costs and recognize the

linear nature of price movements of many financial instruments, the

Agencies would permit institutions to estimate a 10-day price or rate

movement--for instruments other than options--using the risk factor

changes calculated on the basis of one-day holding periods. This

adjustment could be accomplished using the ``square root of time''

method

[[Page 38087]]

by multiplying the one-day results by 3.16 (the square root of ten

trading days).

The prices of options, however, do not change proportionately with

the price of the underlying instrument, and their potential price

volatility cannot be so easily estimated. Therefore, institutions would

be required to take steps to identify the non-linear behavior of option

prices with respect to changes in underlying rates or prices. In

addition, institutions would not, for example, be allowed to scale the

price volatility of an option that was based on one-day sensitivities

using the square root of ten. However, since the price or rate

volatility of the instrument on which the option is based is considered

to increase proportionately with the square root of time, institutions

would be permitted to use the square root of time technique to expand

the one-day volatility of the option's underlying instrument when

calculating the price volatility of the option itself. Alternatively,

institutions could estimate the changes in the value of options on the

basis of actual movements in underlying factors measured during a full

10-day period.

Institutions should also evaluate the effect of changes in the

volatility of rate or price movements of instruments underlying their

option positions (vega) on option values. This can be done by modelling

volatilities as additional risk factors and including them in the

overall set of risk factors affecting the value of the institution's

trading positions. Institutions with relatively large or complex

options portfolios should also measure volatilities across different

points along the maturity yield curve.

Aggregating Exposures

When evaluating the potential change in a portfolio's market value,

one must consider the likelihood that prices of certain instruments in

the portfolio may move together (or in opposite directions). However,

observed correlations among the prices of some instruments are

themselves volatile and may be especially likely to change during

periods of market stress. Therefore, which assumptions are prudent and

which ones are not cannot be determined in advance. Moreover, one

correlation assumption is not always more conservative than another,

since the outcome depends on whether an institution's position in a

given instrument is long or short. In practice, most models calculate

the correlations within risk factor categories, but differ in their

recognition of historical correlations across broad categories of risk

factors (interest rates, foreign exchange, etc.).

The Agencies do not want to specify correlations or to set

standards for what levels of correlations could be recognized by a

model. Given the importance--but also the uncertainty--of historical

correlations, the Agencies propose to permit institutions to use

correlations within categories of risk factors, but not among

categories, where the interrelationships of market factors may be more

tenuous, especially during periods of market stress.10 Thus, total

VAR would be the simple sum of the calculated VAR for individual

categories. The Agencies recognize that this approach is conservative

and believe that it is appropriate for a capital charge against market

price moves during periods of stress, when historic correlations have

been observed to breakdown. The Agencies also note that it is

consistent with the risk measurement practices of many large trading

banks.

\10\ Use of correlations is permitted provided the supervisor is

satisfied that the calculation of correlations within a category is

performed with integrity.

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Minimum Observation Period

In managing market risk, institutions draw from a broad range of

historical periods to calculate historical volatilities and

correlations for the purpose of estimating future price and rate

movements. Some institutions use periods as short as 30-60 days, while

others use periods extending as long as several years. Although the

choice of historical periods may have little effect on a trading

portfolio's level of expected VAR over an extended period of time, it

can have a significant effect on the measure of exposure at any

specific time. VARs based on short historical periods will be more

volatile and responsive to changing market conditions than measures

based on longer periods, producing relatively large VARs during periods

of high market volatility and low VARs when the markets are calm.

Conversely, VARs based on longer periods will exhibit more stability,

reflecting a wider range of market conditions and the smaller effect of

recent observations.

Since VARs based on short periods may, at times, produce small

estimates of risk and could also produce a wide range of risk measures

among institutions having similar portfolios, the Agencies are

proposing a minimum historical observation period of one year. That

constraint should reduce the dispersion and help ensure that

institutions have adequate capital requirements at all times. While the

Agencies believe such a one-year constraint may be sufficient, they are

also requesting comment on whether institutions should be required to

calculate their exposures using two observation periods--one as

constrained above and the other representing a shorter period, such as

six months or less. Under this dual observation approach, the capital

requirement would be based on the period that indicated the greater

risk.

Minimum Number of Risk Factors

The risk factors contained in an institution's market risk

measurement system should be sufficiently comprehensive to capture all

of the material risks inherent in the portfolio of its on- and off-

balance sheet trading positions, including interest and exchange rates,

equity and commodity prices, and the volatilities related to option

positions. Although institutions will have substantial flexibility in

specifying the risk factors that are most relevant to their portfolios,

the Agencies expect the number and composition of factors to be

commensurate with the nature and scope of each institution's risks.

In order to adequately measure exposures to interest rates and to

bring about greater conformity of results among institutions, the

Agencies are proposing a minimum of six maturity bands (each

representing a separate risk factor) to be used for material positions

in the major currencies and markets. All institutions would be expected

to measure spread risk (e.g., the difference between rates on corporate

and U.S. government instruments) adequately, with the required level of

sophistication being a function of the nature and scope of the

institution's activities and exposures.

Capital Requirement

Experience has shown that financial markets can have brief periods

of high volatility preceded or followed by extended periods of calm.

Under some modelling procedures, the large number of small daily market

changes can substantially offset the infrequent periods of high

volatility. Even when constrained and calculated as proposed, there are

several reasons why an institution's need for capital might sometimes

exceed this figure:

(1) The past is not always a good guide to the future;

(2) The assumptions about statistical ``normality'' built into some

models may not be justified because of the relatively high frequency of

large market movements;

[[Page 38088]]

(3) The correlations assumed in the model may prove to be

incorrect;

(4) Market liquidity may become inadequate to close out positions;

and

(5) The institution may face multiple stressful events over short

periods of time.

Consequently, the Agencies believe that in order for an

institution's VAR figure to serve as an adequate basis for a capital

requirement, it should be multiplied by an appropriate prudential

factor. The Agencies are proposing a minimum multiple of three, which

could be increased if the results of ``back-testing'' are not

sufficiently satisfactory.11

\11\ Back-testing refers to the process of comparing calculated

daily VARs with actual daily trading results to determine how

effectively the risk measure identified the boundaries of gains or

losses consistent with the predetermined level of statistical

confidence.

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The Agencies also recognize that institutions may change their

trading positions rapidly and may substantially increase their

exposures for brief periods in order to respond to perceived

opportunities or market conditions. At such times, an institution's

exposure to market risk may be larger than its average VAR times three.

In order to address such circumstances, the Agencies are proposing that

institutions maintain capital on a daily basis to support the larger of

either (1) the average VAR figure for the last 60 business days,

calculated under the proposed criteria and increased by the assigned

multiple, or (2) the previous day's VAR, similarly calculated but

without the multiple. By considering not only an average VAR but also a

single day's measure, the Agencies expect institutions to hold capital

sufficient to cover peak levels of market volatility and to manage

their activities accordingly.

Many VAR models focus principally on measuring general market risks

and incorporate only partial elements of specific risk. Therefore,

institutions would remain subject to separate capital requirements to

cover specific risk on equities and traded debt, to the extent it is

not addressed by their VAR models. This separate charge would be added

after the VAR figure is increased by the multiplier and would, in no

case, be less than one-half the specific risk charge calculated using

the standardized approach. The Agencies specifically request comments

on which features to consider when reviewing models in order to

evaluate their coverage of specific risk.

VI. Standardized Risk Measure

The standardized risk measure calculates separate capital

requirements for specific and general market risks and uses different

techniques to measure an institution's risk exposure, depending upon

its source: debt instruments, equities, foreign currencies, and

commodities, including their respective options.12

\12\ Several techniques are offered for measuring the price risk

in options (see ``Options'', discussed below or in the proposed

regulatory language for each agency). Under one approach, called the

``delta-plus'' approach, an institution would include the delta-

equivalent value of the underlying instrument when evaluating the

market risk of each category of instruments (debt, equity, etc.).

Under the two other approaches, the underlying instrument of an

option may be ``carved-out'', not subject to the prescribed risk

measure for the underlying, and evaluated together with its option

according to the procedures described for options.

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Debt instruments held in trading portfolios

The market risk capital requirement for debt instruments in a

trading account consists of separate charges for general market and

specific risks.

a. General market risk. The general market risk capital requirement

for debt instruments (including off-balance-sheet derivatives) that are

part of trading activities is designed to capture the potential loss

that may arise from movements in market interest rates. An institution

may determine this component of its capital requirement either by using

standardized risk weights that approximate the price sensitivity of

various instruments or by calculating, itself, the precise duration of

each instrument, weighted by a specified change in interest rates.

Both methods use a maturity-ladder approach that employs a series

of time bands and zones, designed to take into account differences in

price sensitivities and interest rate volatilities across various

maturities. Under either method, the institution's capital charge for

general market risk would be the sum of a base charge that results from

fully netting various risk-weighted positions (i.e., longs versus

shorts) and a series of additional charges (add-ons) that effectively

disallow part of the previous full netting in order to address basis

and yield curve risk. The capital charges would be separately computed

for each currency in which an institution has significant positions. No

netting of positions or charges would be allowed across different

currencies.

When using the first approach, referred to as the ``maturity''

method, an institution would first distribute its on- and off-balance-

sheet positions in each currency among a range of time-bands based on

the maturity or nearest interest rate reset date of the instrument.

Long positions would be treated as positive amounts and short positions

would be treated as negative amounts. The institution would then

calculate its net long or short position for each time-band and would

multiply that net position by the risk weight provided by the

supervisor for that time-band. The resulting risk-weighted position

represents the amount by which the market value of that debt position

is expected to change for a specified movement in interest rates. The

risk weights and associated interest rate changes are shown in each

Agency's proposed regulatory language (OCC--Table 2, Board--Table I,

and FDIC--Table 1).13 Adding the sum of all risk-weighted

positions (long or short) across all time-bands results in a final net

risk-weighted position. This amount would be the base capital charge

for general market risk.14

\13\ In the case of securities backed by fixed rate mortgages,

an institution would slot the instruments into time bands on the

basis of their current expected weighted average lives (reflecting

the effect of expected prepayments at current market interest

rates), rather than by their contractual maturities.

\14\ Since the price sensitivity of zero coupon and low coupon

instruments can be materially greater than that of instruments with

higher coupons, institutions would be required to assign higher risk

weights to low coupon instruments as shown in the proposed Tables.

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The base charge is calculated differently under the second, or

alternative ``duration'' method. In this case, an institution would

calculate the estimated price movement for a specific instrument by

multiplying the instrument's modified duration by a specified interest

rate shock that is based on the instrument's duration as shown in the

proposed regulatory language.15 That product, representing the

amount of expected price change of the instrument, is then distributed

into the array of time-bands on the basis of the instrument's duration

(see proposed Table 4--OCC, Table III--Board, Table 3--FDIC). For

example, an instrument with a maturity of 4 years and 3 months might

have a modified duration of 3.5 years. Based on its duration, it would

be ``shocked'' by 75 basis points, resulting in an expected price

change of 2.625 percent (3.5 x 0.75 percent). That estimated 2.625

percent change, multiplied by the current value of the instrument,

would be placed into the 3.3 to 4.0 year time-band for

[[Page 38089]]

determining the charge for general market risk.

\15\ The duration of an instrument indicates its approximate

percentage change in price for a small parallel shift in the yield

curve assuming that its cash flow does not change when the yield

curve shifts.

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As in the maturity method, the base capital charge for general

market risk is the sum of the estimated price changes across all time

bands. If that sum is negative, the base charge would be its absolute

value. Different time-bands are used for the two methods because an

instrument's duration can be substantially different from its maturity.

In addition to the base capital charge for general market risk, as

reflected by the institution's net risk-weighted position, an

institution would be subject to a series of capital ``add-ons'' that

are designed to take into account imperfect and uncertain correlations

among instrument types and maturities. These add-ons recognize that

long and short positions might not, in practice, offset each other by

the full amount that their risk-weightings would suggest, and

therefore, some portion of the hedged or offsetting position should be

disallowed.

The first disallowance (referred to as the vertical disallowance)

is intended to address the basis risk that exists between instruments

with the same or similar maturities and also the possibly different

price movements that may be experienced by different instruments within

the same time-band due to the range of maturities (or repricing

periods) that may exist within a time-band. To capture this risk, a

vertical disallowance is applied to the smaller of the offsetting (long

or short) positions within a time-band.16 This disallowance is 10

percent under the maturity method, and 5 percent under the duration

method. For example, under the maturity method, if the sum of weighted

long positions within a time-band equals $100 million and the sum of

weighted short positions equals $90 million, the vertical disallowance

for the time-band would be 10 percent of $90 million, or $9 million.

This amount would be added to the institution's base capital charge.

The use of two different vertical disallowances recognizes that because

the duration method takes into account an instrument's specific

characteristics (maturity and coupon), there is less opportunity for

measurement error.17

\16\ If the offsetting amounts (long and short) are equal, the

disallowance can be applied to either figure.

\17\ In the case of cash positions and transactions conducted on

an exchange (e.g. futures) an institution has the opportunity to

adjust its market risk either by acquiring a new position or selling

an existing one. However, that is not typically the case with

interest rate swaps, for which an institution almost always adjusts

its position by entering into a new or offsetting swap, rather than

by selling or unwinding one that it already holds. This procedure,

required partly because of the lack of standardization in the terms

and credit risk characteristics of swaps, can produce large swap

portfolios and potentially large disallowances under the

standardized approach.

Consequently, the Agencies' proposal would allow institutions

with large swap books to use alternative procedures for calculating

the amounts that would be distributed into the maturity or duration

time bands. One approach would be to convert the payments required

by a swap into their present values using zero coupon yields and

then to place those amounts into their appropriate time bands using

the procedures that apply to zero (or low) coupon bonds. The net

amounts for each time band would then be weighted and subject to the

disallowances of the general market risk framework as if they were

bonds. The Agencies would also consider other procedures.

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The second disallowance (or horizontal disallowance) addresses the

risk that interest rates along the yield curve are not perfectly

correlated and that risk-weighted positions that might have been

expected to offset will not fully offset, in practice. The horizontal

disallowance applies to the smaller of the offsetting positions across

different time-bands. The amount of this disallowance varies in size by

zone (that is, a grouping of contiguous time bands), with greater

netting allowed for positions in different time bands but within the

same zone than is allowed for positions that are in different zones

(Table 3--OCC, Table II--Board, Table 2--FDIC in the proposed

regulatory language). The horizontal disallowances range from 30

percent to 100 percent of the smaller figure in a pair of offsetting

transactions.18

18 Since the disallowance is applied to only one side of an

offsetting transaction, a 100 percent disallowance effectively

treats the hedge as being 50 percent effective.

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In calculating these disallowances, an institution would first

determine its offsetting positions within a zone and the associated

``within zone'' disallowance amounts. Once the institution has netted

its positions within a zone, it would determine the amount of

offsetting and associated disallowances across zones. An institution's

general market risk requirement for debt instruments within a given

currency would be the sum of (1) the value of its net risk-weighted

position (base charge) and (2) all of its vertical and horizontal

disallowances.

b. Specific risk. Under the proposal, generally every traded

security, whether long or short, would be assessed a capital charge for

specific market risk. In the debt portfolio this charge is based on the

identity of the obligor and, in the case of corporate securities, on

the credit rating and maturity of the instrument. Consistent with the

original Accord, debt instruments of national governments of OECD

countries are assigned zero specific risk. Other securities are

assigned risk weights ranging from 0.25 percent to 1.6 percent if they

are issued by qualifying borrowers. Securities of nonqualifying issuers

are charged a specific risk of 8.0 percent. To be considered as

qualifying, the security must be rated as investment grade by at least

two nationally recognized credit rating firms or, if the issuer has

securities listed on a recognized stock exchange, it must be deemed to

be of comparable investment quality by the reporting institution.

This latter condition is provided to accommodate the fact that in

some countries credit ratings and the coverage of credit rating firms

are not as extensive as in the United States. Consequently, the

securities of many large and well-established foreign companies may not

be rated. In such cases, a company's listing on an organized exchange

may be an acceptable substitute for credit ratings if such listings are

limited to financially strong and well-established firms. In these

cases, and in the absence of independent credit ratings, the securities

of a listed company may qualify for a lower capital charge if the

trading institution and its appropriate supervisor believe the

securities are equivalent to investment grade. However, the Agencies

are proposing that, given the presence and wide coverage in the United

States of credit rating firms, institutions would not be allowed to

qualify the securities of a U.S. firm on the basis of a listing on an

organized exchange.

During the examination process, the Agencies would also consider

the extent to which an institution trades non-investment grade

instruments (sometimes called high yield debt) that do not qualify for

risk weights less than 8.0 percent because of the lack of investment

grade ratings. If these holdings are not well diversified or if they

otherwise represent material exposures to the institution, the Agencies

may prevent an institution from netting the exposures arising from

these instruments with otherwise offsetting exposures resulting from

positions in qualifying instruments.

Equities Held in Trading Portfolios

The standardized measure of market risk in traded equities also

consists of separate charges for specific and general market risk.

These charges would apply not only to direct holdings of equity

securities, but also to equity derivatives and off-balance-sheet

positions whose market values are directly affected by equity prices.

a. General market risk. An institution's general market risk

capital charge would be 8.0 percent of its net

[[Page 38090]]

equity position--the difference between the sum of its long and the sum

of its short positions. The net long or short position against which a

general market risk charge would be assessed must be calculated on a

market-by-market basis, i.e., a separate calculation must be computed

for each national market in which the institution holds equities.

Institutions would not, for example, be able to net a long position in

U.S. companies traded on the New York Stock Exchange against a short

position in Japanese companies traded on the Tokyo Stock Exchange.

b. Specific risk. The capital charge for specific risk is based on

the reporting institution's gross equity positions (i.e., the absolute

sum of all long equity positions and of all short equity positions,

with netting allowed only when the institution has long and short

positions in exactly the same instrument). This charge would also be

8.0 percent, unless the portfolio is both liquid and well-diversified

or the position relates to an index comprising a diversified portfolio

of equities.

Examiners will verify that any portfolio designated as ``liquid and

well-diversified'' by an institution is characterized by a limited

sensitivity to price changes of any single equity issue or closely

related group of equity issues held in the portfolio. In particular,

the volatility of the value of the portfolio should not be dominated by

the volatility of any individual equity issue or by equity issues from

any single industry or economic sector. In general, such portfolios

should be characterized by a large number of individual equity

positions, with no single position representing a large portion of the

portfolio's total market value. In addition, it would generally be the

case that a sizeable proportion of the portfolio would be comprised of

issues traded on organized exchanges.

For such liquid and well-diversified portfolios, the specific risk

charge would be 4.0 percent. A specific risk charge of 2.0 percent

would apply to the net long or short position in a broad-based,

diversified equity index and is viewed as necessary to provide for the

risk that the performance of the index will differ from those of other

market measures and also for potential difficulties that could arise in

executing transactions at expected prices.

Foreign Exchange

This capital requirement covers the risk of holding or taking

positions in foreign currencies, including gold, and is based on an

institution's net positions in individual currencies, whether or not

those positions are booked in the trading account. Net positions, in

turn, include an institution's net spot and forward positions; any

guarantees that are certain to be called and likely to be

irrecoverable; net future income and expenses that are not yet accrued,

but that are already fully hedged; and any other items representing a

profit or loss in foreign currencies. Forward and future positions

would be converted into the reporting currency at spot market rates.

Institutions may, subject to supervisory approval, exclude from

this calculation any structural positions in foreign currencies. For

this purpose, such structural positions are limited to transactions

designed to hedge an institution's capital ratios against the effect of

adverse exchange rate movements on (1) subordinated debt, equity, or

minority interests in consolidated subsidiaries and dotation capital

assigned to foreign branches that are denominated in foreign

currencies, and (2) any positions related to unconsolidated

subsidiaries and to other items that are deducted from an institution's

capital when calculating its capital base. In any event, such

structural foreign currency positions should reflect long-term policies

of the institution and not relate to trading positions.

The standardized approach assumes the same volatility for all

currencies and requires an institution to hold capital equal to 8.0

percent of the sum of (a) its net position in gold and (b) the sum of

the net short positions or the sum of the net long positions in each

foreign currency, whichever is greater. With supervisory approval, an

institution may be exempt from this capital requirement if the sum of

its gross long and short positions does not exceed 100 percent of its

eligible capital and its overall net foreign exchange position does not

exceed 2.0 percent of this capital, as defined above in Section II.

Commodities

The capital requirement for commodities risk applies to holdings or

positions taken in commodities, including precious metals, but

excluding gold (which is treated as a foreign currency because of its

market liquidity). As with foreign currencies, the coverage extends to

all commodities positions of the institution, not only to those booked

in trading accounts. For this purpose, a commodity is defined as a

physical product which is or can be traded on a secondary market, e.g.,

agricultural products, minerals, and precious metals. The standardized

approach for measuring general market risk in commodities provides only

a rough indication of the risk exposure and is appropriate only for

institutions with relatively small amounts of commodities activity.

Within the standardized approach, two alternative measures are

available, referred to as the ``simple'' and the ``maturity'' methods.

Both measures address directional risk, which is the risk that a

commodity's spot price will increase or decrease, as well as basis

risk, interest rate risk, and forward gap risk, which are also

important risks, especially for institutions that engage in forward or

derivative contracts. These institutions can face significant losses in

their positions as a result of adverse changes in the relationship

between prices of similar commodities, increases in the cost of

financing forward positions, or changes in forward prices produced by

any number of economic or market conditions.

Both the simple and maturity approaches require an institution to

calculate its net position in each commodity on the basis of spot

rates. Long and short positions in the same commodity may be netted,

but positions in different commodities would generally not be allowed

to offset, except where different sub-categories of commodities are

deliverable against each other.

Under the simple approach, an institution's capital charge for

directional risk would equal 15 percent of its net position, long or

short, in each commodity. A supplemental charge of 3.0 percent of the

gross position in each commodity would be added to cover basis,

interest rate and forward gap risk.

The capital charge using the maturity method reflects not only the

net and gross positions in each commodity, but also the maturity of

each commodity contract. For each commodity, positions would first be

distributed among seven time bands. Physical holdings of commodities

would be allocated to the first band. The matched long position plus

the matched short position within each time-band would then be

multiplied by a ``spread rate,'' (proposed at a uniform 1.5 percent

rate) to capture forward gap and interest rate risk. Net positions from

one time-band must be used to offset opposite positions in another

time-band and would incur a ``surcharge'' equal to 0.6 percent of the

net position for every time-band it is carried forward in recognition

that such offsetting may not be perfect. This process ultimately

produces an overall net position for each commodity. A 15 percent

capital charge would be applied to that net position. The total capital

charge for any given commodity would be the sum of (a) the initial 1.5

percent

[[Page 38091]]

charge for the matched positions in each time band, (b) any surcharge,

and (c) the charge on the overall net position.

Options

The Agencies recognize the diversity of activities in options and

the difficulties in measuring an option's price risk. Accordingly, the

proposal provides three alternative risk measures for institutions that

do not adopt the internal models approach. These alternatives are: (a)

a ``simplified'' method, which is available to institutions that only

purchase traded options, (b) a ``scenario analysis'' method that

evaluates option values under a range of market scenarios, and (c) a

``delta-plus'' method that provides specific measures of individual

components of an option's risk. The method used should be commensurate

with and appropriate for the nature and scope of the institution's

options activities. Institutions that have extensive dealings in

options must have appropriately accurate measures of risk.

Several variables determine an option's price:

(1) The current price of the underlying asset;

(2) The strike price of the option, which is the price of the

underlying security at which the option has value;

(3) The volatility of the price of the underlying security;

(4) The time remaining before the option expires; and

(5) The prevailing ``risk free'' interest rate.

The effect of these variables on an option's value are represented

by a series of Greek letters: delta (the price sensitivity of an option

relative to price changes in the underlying security, rate, or index--

the ``underlying''), gamma (the change in delta for a given change in

the underlying), vega (the effect of changes in the volatility of the

underlying), theta (the effect given the passage of time), and rho (how

the option price changes for a given change in risk free interest

rates). Delta is a frequently used indicator of an option's risk, but

others--particularly gamma--should be specifically addressed by

institutions that trade options to any material extent. Such

institutions should not rely merely on linear approximations of price

movements, but should undertake to capture the non-linear relation

between changes in the option's price and changes in the underlying

rate or price.

Simplified Approach

The simplified approach for options may only be used by

institutions whose options activities are confined to a small volume of

purchased options. This approach permits an institution either to

``carve out'' both the option and a corresponding underlying position

from other elements of the standardized approach or to view the option

as ``naked''--that is, without a matching cash position. In order to

avoid potentially penalizing an institution for purchasing an option,

institutions could avoid linking (and subsequently carving-out) a

purchased option and a corresponding cash position if doing so would

create an exposure within the underlying position and produce a capital

requirement that exceeded the value of the purchased option.

Consequently, there are two possibilities:

(1) If a carve-out is made, the capital charge is equal to the

specific and general market risk charge on the underlying position,

less the amount the option is in the money, bounded at zero.

(2) If the purchased option is viewed by itself, the charge for the

option is the smaller of (a) its market value or (b) the sum of the

specific and general market risk charge that would apply to its

underlying instrument. Any existing related (but not linked) cash

position would continue to receive the full specific and general market

risk charge produced by other elements of the standardized approach.

In both cases, the method is relatively conservative, creating an

incentive for institutions to use a more accurate measure of risk.

Institutions that want a more accurate measure of option risk or whose

trading activities include the writing (selling) of options must use

either the scenario or the delta-plus methods offered under the

standardized approach, or the previously described internal models

approach.

Scenario Analysis

Using scenario analysis, institutions would evaluate the market

values of their options and related hedging positions by changing the

underlying rate or price over a specified range and by also assuming

different levels of volatility for that rate or price. Each combination

of assumed volatilities and rate or price changes would represent a

scenario.

The range of rate or price movements would be based on the nature

of the option. For options based on debt instruments or interest rates,

the range would be consistent with the maximum rate movement indicated

in the proposal dealing with traded debt: 100 basis points for

underlying instruments in zone 1, 90 basis points for those in zone 2,

and 75 basis points for those in zone 3. Similarly, the ranges used for

other options would be consistent with the assumed price or rate change

applied to their underlying cash positions: 8 percent for foreign

exchange, 12 percent for individual equities, 8 percent for equity

indices, and 15 percent for commodities. In all cases, the range would

cover both an increase and decrease from current values of the

underlying security (or rate) by these percentages and would be divided

into at least 10 equally spaced intervals centered by the current rate

or price.

Given the near-linear relationship between volatility and option

values for many options, the Agencies believe it would be sufficient in

most cases to evaluate the option portfolio assuming a 25 percent

increase and decrease in the level of volatility from that implied by

current market prices. If warranted, however, the Agencies may require

a different change in volatility and the consideration of intermediate

points.

An institution would determine the market value of each option and

any related hedging position or group of options and related hedging

positions for each scenario.19 Such options and positions based on

debt instruments in the same zone, or on the same equity, equity index,

exchange rate, or commodity may be grouped together and evaluated on a

portfolio basis when evaluating the effect of a given scenario. The

market risk capital charge for a portfolio would be the largest loss

estimated for that portfolio from among the evaluated scenarios. The

charge for all option portfolios would be the sum of the charges on the

individual portfolios. The Agencies recognize that this approach is

conservative, since it assumes that the largest loss will occur within

each segment of the option portfolio simultaneously.

\19\ For this purpose, a single option and any related hedging

position and a group of options and any related hedging positions

are all referred to as an ``options portfolio.''

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The delta-plus method

Institutions that write options would be allowed to include delta-

weighted options positions within the standardized methodology. Such

options should be reported as a position equal to the market value of

the underlying instrument multiplied by the delta. However, since an

option's delta does not sufficiently address other risks associated

with the option's market value, institutions would also be required to

measure the option's gamma and vega in order to calculate the total

capital charge for the option. These sensitivities would be calculated

by an approved exchange model or by the

[[Page 38092]]

institution's proprietary options pricing model, subject to oversight

by the appropriate supervisor.

Delta-weighted positions of options based on debt securities or

interest rates would be slotted into the debt securities time-bands, as

set out above for debt instruments, under the following procedure. A

two-legged approach would be used as for other derivatives, requiring

one entry at the time the underlying contract takes effect and a second

at the time the underlying contract matures. For instance, a bought

call option on a June three-month interest-rate future will in April be

considered, on the basis of its ``delta'' equivalent value, to be a

long position with a maturity of five months and a short position with

a maturity of two months. The written option would be similarly slotted

as a long position with a maturity of two months and a short position

with a maturity of five months. Floating rate instruments with caps or

floors would be treated as a combination of floating rate securities

and a series of European-style options. For example, the holder of a

three-year floating rate bond indexed to six month LIBOR with a cap of

15 percent would treat the instrument as: (1) A debt security that

reprices in six months; and (2) a series of five written call options

on a floating rate asset (FRA) with a basis of 15 percent, each with a

negative sign at the time the underlying FRA takes effect and a

positive sign at the time the underlying FRA matures.

In addition to the above capital charges arising from delta risk,

the proposal requires capital for gamma and vega risks. Institutions

using this method would be required to calculate the gamma and vega for

each option position. The results would be slotted into separate

maturity ladders by currency. For options such as caps and floors whose

underlying instrument is an interest rate, the delta and gamma would be

expressed in terms of a hypothetical underlying security. Subsequently:

(1) For gamma risk, for each time-band, net gammas which are

negative would be multiplied by the risk weights set out in the

proposed regulatory language (OCC--Table 5, Board--Table IV, FDIC--

Table 4) and by the square of the market value of the underlyings (net

gammas which are positive would be disregarded);

(2) For volatility risk, institutions would be required to

calculate the capital charges for vegas in each time-band assuming a

proportional shift in volatility of 25 percent;

(3) The capital charge would be the absolute value of the sum of

the individual capital charges for net negative gammas plus the

absolute value of the sum of the individual capital charges for vega

risk for each time-band.

The capital charge for options on equities would also be based on

the delta weighted positions of the options by incorporating those

weighted positions into the market risk measure for equities described

above. For purposes of this calculation individual equity issues and

indices are to be treated as separate underlyings. In addition to the

capital charge for delta risk, institutions would apply a further

capital charge for gamma and vega risk:

(1) For gamma risk, the net negative gammas for each underlying

instrument would be multiplied by 0.72 percent when that instrument is

an individual equity and by 0.32 percent when it is an index.20

That product would then be multiplied by the square of the market value

of the underlying;

20 Using the Taylor expansion, the risk weights are

calculated as follows: Risk weight for gamma =0.5 x (assumed price

change of underlying)\2\ For an individual equity, 0.5 x 0.12\2\=

0.72%. In the case of an index as the underlying, the assumed price

change of the underlying equals 8.0 percent.

(2) For volatility risk, institutions would be required to

calculate the capital charges for vegas for each underlying instrument

assuming a proportional shift in volatility of plus or minus 25

percent;

(3) The capital charge would be the absolute value of the sum of

the individual capital charges for net negative gammas plus the

absolute value of the sum of the individual capital charges for vega

risk.

The capital charge for options on foreign exchange and gold

positions would be based on the shorthand method set out earlier. For

delta risk, the net delta (or delta-based) equivalent of the total book

of foreign currency and gold options would be incorporated into the

measurement of the exposure in a single currency position. The gamma

and vega risks would be measured as follows:

(1) For gamma risk, for each underlying exchange rate net gammas

which are negative would be multiplied by 0.32 percent and by the

square of the market value of the position; 21

\21\ The assumed price change is 8.0 percent.

---------------------------------------------------------------------------

(2) For volatility risk, institutions would be required to

calculate the capital charges for vegas for each currency pair and gold

assuming a proportional shift in volatility of plus or minus 25

percent;

(3) The capital charge would be the absolute value of the sum of

the individual capital charges for net negative gammas plus the

absolute value of the sum of the individual capital charges for vega

risk.

The capital charge for options on commodities would be based on the

same approach set out above for commodities. The delta weighted

positions would be incorporated into one of the two measures described

in that section. In addition to the capital charge for delta risk,

institutions would incur a further capital charge for gamma and vega

risk:

(1) For gamma risk, net negative gammas for each underlying would

be multiplied by 1.125 percent and by the square of the market value of

the commodity; 22

\22\ The assumed price change is 15 percent.

---------------------------------------------------------------------------

(2) For volatility risk, institutions would be required to

calculate the capital charges for vegas for each commodity as defined

above in the section dealing with commodities, assuming a proportional

shift in volatility of plus or minus 25 percent;

(3) The capital charge would be the absolute value of the sum of

the individual capital charges for net negative gammas plus the

absolute value of the sum of the individual capital charges for vega

risk.

A worked example of the delta-plus method for commodities is set

out in Attachment IV of the Board's and the FDIC's proposed regulatory

language. In the case of options based on debt securities or interest

rates and with the approval of the appropriate supervisor, institutions

that are significant traders in options could be allowed to net

positive and negative gammas and vegas across time-bands to a limited

extent. However, such netting would be permitted only if it is based on

prudent and conservative assumptions and the institution materially

satisfies the qualitative standards outlined under the internal models

approach.

In addition, instead of applying a uniform relative change in

volatility to measure vega risk, institutions may base the calculation

on a volatility ladder in which the implied change in volatility varies

with the maturity of the option. When using such a volatility ladder

the assumed proportional shift in volatility should be at least 25

percent at the short end of the maturity spectrum. The proportional

shift in volatility for longer maturities should be at least as

stringent in statistical terms as the 25 percent shift at the short

end. Use of this alternative would be subject to validation by the

supervisor, and to the qualitative standards listed in the internal

models section that are relevant to this aspect of the institution's

[[Page 38093]]

business. In the long term, institutions using this alternative would

be expected to move to fully articulated value-at-risk models, subject

to the full qualitative and quantitative standards for models.

Besides the options risks mentioned above, the Agencies recognize

that there are other risks associated with options, e.g., rho and

theta. While they are not proposing a measurement system for those

risks at present, institutions undertaking significant options business

would still be expected to monitor such risks closely.

VII. Questions on Which the Agencies Specifically Request Comment

General Topics

1. The Agencies propose to apply these standards to a relatively

small number of institutions that have material trading activities. As

the criteria are proposed, about 25 ``large'' institutions and a few

other smaller institutions with relatively more significant trading

activities would meet the requirements and be subject to the new

capital standards. Is the exemption of smaller institutions

appropriate, given their risk profile and the implied regulatory

burden, or does it provide them with an undue competitive advantage? On

the other hand, would the amendment affect too many institutions, given

the nature of their trading activities and market risk profiles?

2. Consistent with their procedures for existing capital standards,

the Agencies would apply the proposed standard to any national bank,

state member bank and bank holding company that meets the criteria on a

consolidated basis. What are the burden implications of applying the

standard to both banks and bank holding companies?

3. The Board currently evaluates the capital adequacy of bank

holding companies that have Section 20 subsidiaries on a fully

consolidated basis and also without the assets and capital of the

Section 20 subsidiaries. Should it continue this practice regarding

market risk, or should it focus on only the consolidated holding

company?

4. Should the Agencies permit institutions the choice of the

standardized or internal model approaches, or should it permit only the

internal model approach on the basis that the institution's trading

activities are sufficient to warrant the more accurate measure of risk?

5. The Agencies are interested in comments on whether the internal

model quantitative standards, together with the scaling factor, could

result in capital requirements that on average are significantly

different (for example, higher) than those required under the

standardized approach.

6. The Agencies propose to allow institutions to use the

standardized method for measuring some categories of risk (e.g., debt,

equities, etc.), and internal models for other categories. Should

institutions be given this flexibility, or should they be required to

use one approach throughout?

7. The Agencies propose a reduced capital charge for specific risk

in equities if an institution's equities portfolio is ``liquid and

well-diversified,'' a concept that is defined in qualitative terms in

the proposal. Should this concept be described more specifically and,

if so, what criteria should be applied?

Questions on the Standardized Method

1. Under the proposal, institutions would be allowed to net

offsetting positions in different commodities only if the commodities

were deliverable against each other. To what extent, if any, should the

Agencies allow netting on the basis of the historical correlations of

price movements of different commodities within the standardized

approach? If netting is allowed on the basis of past correlations, what

specific criteria should be required?

2. One of the alternative ways of measuring the market risk of

options in the standardized approach is to calculate separate charges

for an option's delta, gamma, and vega risk (see the delta-plus

method). This approach permits an institution to measure the risk of

its options positions while measuring the risk of its other positions

and, thereby, to evaluate them more fully on a portfolio basis. It also

permits an institution to avoid incurring the worst-case charge for the

option under the scenario method. The delta-plus calculations, however,

are complex and potentially inaccurate since they do not permit full

use of a revaluation model. Is the method sufficiently useful to

warrant its complexity, and does it provide a sufficiently conservative

measure of risk for institutions that write options but do not have

options pricing models integrated into their risk measurement systems?

Questions on the Internal Model Method

1. The Agencies are considering whether to require institutions to

calculate their VARs using two observation periods (one long, one

short) and basing the capital requirement on the larger figure. What

are the costs and burden implications of requiring such a dual

calculation?

2. All institutions affected by the proposal would be required to

have capital covering both general market and specific risks.

Institutions using the internal model approach would be required to

apply the specific risk charge (or a portion thereof) calculated using

the standardized approach, if their models do not adequately capture

specific risk. What modelling techniques should the Agencies consider

when evaluating an institution's model and determining the extent to

which the model includes specific risk in its VAR measure?

3. As part of an on-going process of evaluating the accuracy of an

institution's internal model, actual daily trading profits and losses

would be compared with the measured VAR (so-called ``back-testing'').

The Agencies would expect this back-testing normally to rely upon the

VARs actually used by the institution for nonregulatory purposes, which

in most cases would reflect a confidence level less than the 99 percent

level on which the capital requirement would be based. Would this

approach be less burdensome to the institution than requiring a

separate calculation for the 99 percent confidence level, and would it

provide a more statistically reliable basis for evaluating the results?

Please comment on these procedures and any other considerations the

Federal Reserve should take into account in reviewing back-tests.

4. The Agencies recognize that daily VAR is used by institutions

for setting daily trading limits, rather than for evaluating capital

adequacy. The regulatory use of VAR as a basis for a capital

requirement is predicated on the specification of several constraints

on modelling parameters, as well as the use of a multiplication factor.

Do these constraints provide sufficient capital for the underlying

activities?

5. To qualify for the use of the internal models approach, an

institution must have a rigorous stress testing program which would be

subject to supervisory review. What stress tests for market risk should

institutions be expected to perform as part of their internal

management process?

VIII. Regulatory Flexibility Act Analysis

OCC Regulatory Flexibility Act Analysis

Pursuant to section 605(b) of the Regulatory Flexibility Act, the

Comptroller of the Currency certifies that this proposal would not have

a significant impact on a substantial

[[Page 38094]]

number of small business entities in accord with the spirit and

purposes of the Regulatory Flexibility Act (5 U.S.C. 601 et seq.).

Accordingly, a regulatory flexibility analysis is not required. The

impact of this proposed rule on banks regardless of size is expected to

be minimal. Further, this proposed rule generally would apply to larger

banks with significant trading account activities and would cover only

trading activities and foreign exchange and commodity positions

throughout the bank.

Board Regulatory Flexibility Act Analysis

Pursuant to section 605(b) of the Regulatory Flexibility Act, the

Board does not believe this proposal would have a significant impact on

a substantial number of small business entities in accord with the

spirit and purposes of the Regulatory Flexibility Act (5 U.S.C. 601 et

seq.). Accordingly, a regulatory flexibility analysis is not required.

In addition, because the risk-based capital standards generally do not

apply to bank holding companies with consolidated assets of less than

$150 million, this proposal would not affect such companies.

FDIC Regulatory Flexibility Act Analysis

Pursuant to section 605(b) of the Regulatory Flexibility Act (Pub.

L. 96-354, 5 U.S.C. 601 et seq.), it is certified that the proposed

rule would not have a significant impact on a substantial number of

small entities.

IX. Paperwork Reduction Act and Regulatory Burden

OCC Regulatory Burden

Section 302 of the Riegle Community Development and Regulatory

Improvement Act of 1994, Pub. L. 103-325, 108 Stat. 2160 (September 23,

1994), provides that the federal banking agencies must consider the

administrative burdens and benefits of any new regulations that impose

additional requirements on insured depository institutions. As

discussed, this proposed rule would affect only a small number of banks

and generally would cover only trading account activities and foreign

exchange and commodity positions throughout the bank. Additionally, any

burden imposed would be lessened to the extent that a bank may use its

own qualifying internal market risk model. The OCC believes that any

additional burden placed on a bank is outweighed by the advantages of

greater accuracy in risk management and capital allocation, which

contribute to increased safety and soundness in the banking system.

Board Paperwork Reduction Act and Regulatory Burden

The Board has determined that this proposal would not increase the

regulatory paperwork burden of banking organizations pursuant to the

provisions of the Paperwork Reduction Act (44 U.S.C. 3501 et seq.).

Section 302 of the Riegle Community Development and Regulatory

Improvement Act of 1994 (Pub. L. 103-325, 108 Stat 2160) provides that

the federal banking agencies must consider the administrative burdens

and benefits of any new regulations that impose additional requirements

on insured depository institutions. As noted above, the proposed market

risk measure would affect only a small number of institutions. The

Board believes that any additional burden placed on these institutions

is outweighed by the advantages of greater accuracy in risk measurement

and capital allocation, which contribute to increased safety and

soundness in the banking system.

FDIC Paperwork Reduction Act

The FDIC has determined that his proposed rulemaking does not

contain any collections of information as defined by the Paperwork

Reduction Act (44 U.S.C. 3501 et seq.).

X. OCC Executive Order 12866 Determination

The Comptroller of the Currency has determined that this notice of

proposed rulemaking is not a significant regulatory action under

Executive Order 12866.

XI. OCC Unfunded Mandates Reform Act of 1995 Determination

Section 202 of the Unfunded Mandates Reform Act of 1995 (Unfunded

Mandates Act), Pub. L. 104-4, 109 Stat. 48 (March 22, 1995) requires

that an agency prepare a budgetary impact statement before promulgating

a rule that includes a Federal mandate that may result in the

expenditure by state, local, and tribal governments, in the aggregate,

or by the private sector, of $100 million or more in any one year. If a

budgetary impact statement is required, section 205 of the Unfunded

Mandates Act also requires an agency to identify and consider a

reasonable number of regulatory alternatives before promulgating a

rule. Because the OCC has determined that this notice of proposed

rulemaking will not result in expenditures by state, local and tribal

governments, or by the private sector, of more than $100 million in any

one year, the OCC has not prepared a budgetary impact statement or

specifically addressed the regulatory alternatives considered. As

discussed in the preamble, this proposed rule may require additional

capital for market risks. However, the application of this proposed

rule would be generally limited to banks with significant trading

account activities and would cover only foreign exchange and commodity

positions throughout the bank. Currently, the OCC estimates that less

than 25 national banks will be subject to the requirements of this

proposed rule. In addition, any burden imposed on this small group of

national banks would be lessened to the extent that a bank may use its

own qualifying internal market risk model.

List of Subjects

12 CFR Part 3

Administrative practice and procedure, Capital, National banks,

Reporting and recordkeeping requirements, Risk.

12 CFR Part 208

Accounting, Agriculture, Banks, banking, Confidential business

information, Crime, Currency, Federal Reserve System, Mortgages,

Reporting and recordkeeping requirements, Securities.

12 CFR Part 225

Administrative practice and procedure, Banks, banking, Federal

Reserve System, Holding companies, Reporting and recordkeeping

requirements, Securities.

12 CFR Part 325

Administrative practice and procedure, Banks, banking, Capital

adequacy, Reporting and recordkeeping requirements, Savings

associations, State non-member banks.

Authority and Issuance

OFFICE OF THE COMPTROLLER OF THE CURRENCY

12 CFR Chapter I

For the reasons set out in the preamble, part 3 of title 12,

chapter I of the Code of Federal Regulations is proposed to be amended

as set forth below.

PART 3--MINIMUM CAPITAL RATIOS; ISSUANCE OF DIRECTIVES

1. The authority citation for part 3 continues to read as follows:

Authority: 12 U.S.C. 93a, 161, 1818, 1828(n), 1828 note, 1831n

note, 1835, 3907, and 3909.

[[Page 38095]]

2. New appendix B is added to part 3 to read as follows:

Appendix B to Part 3--Market Risk

Section 1. Purpose, Applicability, Effective Date, and Definitions

(a) Purpose. The purpose of this appendix B is to ensure that

banks maintain adequate capital for market risk. Market risk is

generally the risk of loss arising from movements in market prices.

The market risk requirements of this appendix B are limited to the

market risk associated with the trading account of the bank and to

the overall foreign exchange risk and the commodities risk

throughout the bank, including related options and other derivative

contracts. Under this appendix B a bank may measure its market risk

exposure with either its own qualifying internal market risk model

or the alternative standardized market risk model provided. However,

the OCC generally expects that banks with significant trading

activities will calculate their market risk using a qualifying

internal market risk model.

(b) Applicability. The market risk requirement of this appendix

B applies to the following banks:

(1) Any bank with total assets in excess of $5 billion and

either total on-balance sheet trading account activities of 3

percent or more of the total assets of the bank, or total notional

off-balance sheet trading account activities in excess of $5

billion; and

(2) Any bank with total assets of $5 billion or less and total

trading account activities in excess of 10 percent of the total

assets of the bank; and

(3) Any bank with a significant exposure to market risk and the

OCC deems necessary to protect the safety and soundness of the bank.

(c) Effective date. The market risk requirements of this

appendix B are effective December 31, 1997.

(d) Definitions. For the purposes of this appendix B, the

following definitions apply:

(1) Covered market risk assets means all trading account assets

plus all other on- and off-balance sheet assets which have foreign

exchange risk, equity price risk, and commodity risk throughout the

bank including related options and other derivative contracts.

(2) Derivative contract means generally a financial contract

whose value is derived from the values of one or more underlying

asset, reference rate or index of asset values. Derivative contracts

include both standardized contracts that are traded on exchanges and

customized, privately negotiated contracts known as over-the-counter

(OTC) derivative contracts.

(3) Lock-in clause means a provision in a subordinated debt

agreement that precludes payment by the bank of either interest or

principal (even upon maturity) of the subordinated debt if such

payment would cause the issuing bank to fall or remain below the

minimum risk-based capital requirement as provided in appendix A of

this part 3 as adjusted for market risk.

(4) Market risk means the risk of loss resulting from movements

in market prices. Market risks consist of both general and specific

market risks. General market risk is the change in market value of a

particular asset that results from broad market movements such as a

change in market interest rates, foreign exchange rates, equity

prices, and commodity prices. Specific market risks are those risks

that affect the market value of a specific instrument, such as the

credit risk of the issuer of that particular instrument, but do not

materially alter broad market conditions.

(5) Tier 3 capital means capital that may be used by a bank to

satisfy the market risk capital requirements under this appendix B

as determined in accordance with section 3 of this appendix B.

(6) Total assets means the quarter-end total assets figure

required to be computed for and stated in a bank's most recent

quarterly Consolidated Report of Condition and Income (Call Report).

(7) Trading account activities means the sum of trading account

assets and trading account liabilities.

(8) Trading account assets means all positions in financial

instruments acquired with the intent to resell in order to profit

from short-term price movements. Trading account assets include, but

are not limited to:

(i) Assets acquired with the intent to resell to customers;

(ii) Positions in financial instruments arising from matched

principal brokering or market making; or

(iii) Positions in financial instruments taken in order to hedge

positions in other financial instruments of the trading

account.1

\1\ When non-trading account instruments are hedged with trading

account instruments, whether on- or off-balance-sheet, the bank may

include the non-trading account instruments in the measure for

general market risk. However, such non-trading account instruments

remain subject to the credit risk capital charges of appendix A of

this part.

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(9) Value-at-risk means the statistical estimate representing

the maximum amount by which the market value of covered market risk

assets could decline during a specific period for a stated level of

statistical confidence.

Section 2. Market Risk Capital Requirement

(a) Capital requirement. All banks subject to this appendix B

shall maintain a minimum market risk capital ratio of 8 percent. The

market risk capital ratio is the ratio of eligible market risk

capital to adjusted market risk assets. Eligible market risk capital

consists of Tier 1, Tier 2, and Tier 3 capital as determined in

accordance with section 3 of this appendix B. Adjusted market risk

assets is the sum of the risk weighted assets as determined in

accordance with appendix A of this part 3 (risk-based capital

guidelines) plus the market risk equivalent assets. The market rate

equivalent assets equal 12.5 times the market risk exposure as

determined in accordance with section 4 of this appendix B.

(b) Relationship to risk-based capital requirement. The amount

of capital required for market risk is in addition to the amount of

capital required for counterparty credit risk under the risk-based

capital guidelines as determined in accordance with appendix A of

this part 3.

Section 3. Eligible Market Risk Capital

(a) Types of eligible market risk capital. A bank may use Tier 1

and Tier 2 capital, as determined in accordance with Sec. 3.2 of

this part 3, to satisfy the market risk requirement. A bank also may

use Tier 3 capital to satisfy its market risk requirement as

determined in accordance with section 3(b) and subject to the

limitations of section 3(c) of this appendix B.

(b) Tier 3 capital. For the purposes of this appendix B, Tier 3

capital consists of short-term subordinated debt subject to a lock-

in clause. In addition, the subordinated debt must have an original

maturity of at least two years, be unsecured and subordinated to the

claims of depositors must be fully paid-in, and may not be subject

to any covenants, terms, or restrictions inconsistent with safe and

sound banking practices.

(c) Limitations. Tier 3 capital only may be used to satisfy the

market risk capital requirements under this appendix B and may not

be used to satisfy the capital risk-based capital requirements for

counterparty risk under appendix A of this part 3, including

counterpart credit risk associated with derivative transactions in

either the trading or nontrading accounts. In addition, the use of

Tier 3 capital is subject to the following quantitative limitations:

(1) Tier 3 capital may not exceed 250 percent of a bank's Tier 1

capital allocated for market risk.

(2) The total of Tier 2 capital and Tier 3 capital is limited to

100 percent of Tier 1 capital.

(3) Tier 2 capital may be substituted for Tier 3 capital up

subject to the same 250 percent limitation on Tier 3 capital and all

other limitations on Tier 2 capital under the risk-based capital

guidelines, as determined by appendix A of this part 3.

Section 4. Market Risk Exposure

Market risk exposure represents the total dollar amount at risk

arising from movements in market prices. A bank may determine its

market risk exposure either through a qualifying internal market

risk model as provided in accordance with section 5 of this appendix

B, or through the standardized market risk model as provided in

accordance with section 6 of this appendix B.

(a) Qualifying internal market risk model. For a bank permitted

or required by the OCC to use a qualifying internal market risk

model, the market risk exposure of covered market risk assets is

equal to the greater of:

(1) The aggregate value-at-risk amount for the previous day; or

(2) The average of the daily value-at-risk amounts for each of

the preceding 60 business days times a multiplication factor of

three.

(b) Standardized market risk model. For banks using the

standardized market risk model, the market risk exposure equals the

measured value-at-risk amount for covered market risk assets as

determined in section 6 of this appendix B.

Section 5. Qualifying Internal Market Risk Model

As provided in this section, a bank may use a qualifying

internal market risk model

[[Page 38096]]

to determine its market risk exposure. The qualifying internal market

risk model may use any generally accepted measurement technique

including, but not limited to, variance-covariance models,

historical simulations, or monte carlo simulations; however, the

qualifying internal market risk model must capture all material

market risk.

(a) Value-at-risk measurement. A qualifying internal market risk

model must incorporate a value-at-risk measurement that adequately

evaluates the market risk associated with all covered market risk

assets.

(b) Risk factor categories. The value-at-risk measurement must

include risk factors sufficient to capture the market risk inherent

in all covered market risk assets. In addition, the risk factors

must cover the risk categories of interest rates, exchange rates,

equity prices, commodity prices, and the volatility of related

market factors.

(c) Prior approval. Prior OCC approval is required before a bank

may use an internal market risk model for the purposes of the market

risk requirement of this appendix B. A qualifying internal market

risk model must satisfy the following criteria:

(1) Qualitative factors. (i) The level of sophistication and

accuracy of the internal market risk model must be commensurate with

the nature and volume of bank's trading account activities.

(ii) The market risk management systems must adequately monitor

compliance with internal procedures and controls which generally

would include independent risk management, annual internal audits,

back testing, and stress testing.

(2) Quantitative factors. (i) The value-at-risk measurement must

be calculated with sufficient frequency to allow the bank enough

time to react to changing market conditions.

(ii) The value-at-risk measurement must be based on a 99th

percentile, one-tailed confidence interval 2 with an assumed

holding period of ten trading days.

\2\ A one-tailed confidence interval of 99 percent means that

there is a 1 percent probability based on historical experience that

the combination of positions in a bank's portfolio would result in a

loss higher than the measured value-at-risk.

---------------------------------------------------------------------------

(iii) For positions that display linear price relationships, a

bank may use value-at-risk measurement using shorter holding periods

which are scaled up to ten days by the square root of time.3

\3\ This transformation entails multiplying a bank's value-at-

risk by the square root of the ratio of the required holding period

(ten days) to the holding period embodied in the value-at-risk

exposure. For example, the value-at-risk calculated according to a

one-day holding period would be scaled-up by the ``square root of

time'' by multiplying the value-at-risk by 3.16 (the square root of

the ratio of a ten-day holding period to a one-day holding period).

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(iv) The value-at-risk measurement must be calculated using an

observation period of at least one year to measure historical

changes in rates and prices.

(v) A bank must update its historical rates and prices at least

once every three months and must reassess them whenever market

conditions change materially.

(vi) A bank may incorporate into its value-at-risk measurement

empirical correlations within each risk category. However, empirical

correlations across risk categories may not be incorporated. The

value-at-risk measurement for each risk category must be added

together on a simple sum basis to determine the aggregate value-at-

risk exposure.

(vii) The value-at-risk measurement must capture the unique

risks associated with options within each of the risk categories

subject to the following criteria:

(A) The value-at-risk measurement must capture the non-linear

price characteristics of option positions using an options pricing

technique.

(B) The bank must apply a minimum ten-day holding period to

option positions or positions that display option-like

characteristics. Options may not be scale-up the daily value-at-risk

exposure by the square root of time.

(C) The value-at-risk measurement must capture the volatilities

of the rates and prices underlying option positions.

(viii) The accuracy of a bank's qualifying internal market risk

model must be validated by auditors.

Section 6. Standardized Market Risk Model

As provided in this section, a bank may use the standardized

market risk model to determine its market risk exposure.

(a) Debt Instruments. (1) Specific Risk. (i) The market risk

requirement for specific risk is based on the identity of the

obligor and, in the case of corporate securities, on the credit

rating and maturity of the instrument. The specific risk is

calculated by weighting the current market value of each individual

position, whether long or short, by the appropriate specific risk

factor and summing the weighted values. In measuring specific risk,

the bank may offset and exclude from its calculations any matched

positions in the identical issue (including positions in derivative

contracts). Even if the issuer is the same, offsetting is not

permitted between different issues. The specific risk factors are

set forth in Table 1--Specific Risk Factors for Debt Instruments, as

follows:

Table 1.--Specific Risk Factors for Debt Instruments

------------------------------------------------------------------------

Remaining contractual Factor (In

Category maturity percent)

------------------------------------------------------------------------

Government................... N/A......................... 0.00

Qualifying................... 6 months or less............ 0.25

Over 6 to 12 months......... 1.00

Over 12 months.............. 1.60

Other........................ N/A......................... 8.00

------------------------------------------------------------------------

(ii) The government category includes all forms of debt

instruments of central governments of the OECD-based group of

countries including bonds, Treasury bills and other short-term

instruments, as well as local currency instruments of non-OECD

central governments to the extent that the bank has liabilities

booked in that currency.

(iii) The qualifying category includes securities of U.S.

government-sponsored agencies, general obligation securities issued

by states and other political subdivisions of the OECD-based group

of countries, multilateral development banks, and debt instruments

issued by U.S. depository institutions or OECD-banks that do not

qualify as capital of the issuing institution. It also includes

other securities, including revenue securities issued by states and

other political subdivisions of the OECD-based group of countries,

that are rated investment-grade by at least two nationally

recognized credit rating services, or rated investment-grade by one

nationally recognized credit rating agency and not less than

investment-grade by any other credit rating agency, or, with the

exception of securities issued by U.S. firms and subject to review

by the OCC, unrated but deemed to be of comparable investment

quality by the reporting bank and the issuer has securities listed

on a recognized stock exchange.

(iv) The other category includes debt securities not qualifying

as government or qualifying securities. This would include non-OECD

central government securities that do not meet the criteria for the

government or qualifying categories. This category also includes

instruments that qualify as capital issued by other banking

organizations.

(v) The OCC will consider the extent of a bank's position in

non-investment grade instruments (sometimes referred to as ``high

yield debt'') that do not have investment-grade ratings. If those

holdings are not well-diversified or otherwise represent a material

position to the institution, the OCC may prohibit a bank from

offsetting positions in these instruments with other positions in

qualifying instruments that may be offset when calculating its

general market risk requirement. In addition, the OCC may impose a

specific risk capital requirement as high as 16.0 percent.

(2) General Market Risk. (i) A bank may measure its exposure to

general market risk using, on a continuous basis, either the

maturity method (which uses standardized risk weights that

approximate the price sensitivity of various instruments) or the

duration method (where the institution calculates the precise

duration of each instrument, weighted by a specified change in

interest rates).

(ii) Both methods use a maturity-ladder that incorporates a

series of ``time bands'' and ``zones'' to group together securities

of similar maturities and that are designed to take into account

differences in price sensitivities and interest rate volatilities

across different maturities. Under either method, the capital

requirement for general market risk is the sum of a base charge that

results from fully netting various risk-weighted positions and a

series of additional charges (add-ons), which effectively

``disallow'' part of the previous full netting to address basis and

yield curve risk.

(iii) For each currency in which a bank has significant

positions, a separate capital requirement must be calculated. No

netting of positions is permitted across different currencies.

Offsetting positions of the same amount in the same issues, whether

actual or

[[Page 38097]]

notional, may be excluded from the calculation, as well as closely

matched swaps, forwards, futures, and forward rate agreements (FRAs)

that meet the conditions set out in section 6(a)(3) of this appendix

B.

(iv) In the maturity method, the bank distributes each long or

short position (at current market value) of a debt instrument into

the time bands of the maturity ladder. Fixed-rate instruments are

allocated according to the remaining term to maturity and floating-

rate instruments according to the next repricing date. A callable

bond trading above par is slotted according to its first call date,

while a callable bond priced below par is slotted according to

remaining maturity. Fixed-rate mortgage-backed securities, including

collateralized mortgage obligations (CMOs) and real estate mortgage

investment conduits (REMICs), are slotted according to their

expected weighted average lives.

(v) Once all long and short positions are slotted into the

appropriate time band, the long positions in each time-band are

summed and the short positions in each time-band are summed. The

summed long and/or short positions are multiplied by the appropriate

risk-weight factor (reflecting the price sensitivity of the

positions to changes in interest rates) to determine the risk-

weighted long and/or short position for each time-band. The risk

weights for each time-band are set out in Table 2--Maturity Method:

Time-Band and Weights, as follows:

Table 2.--Maturity Method: Time-Bands and Weights

------------------------------------------------------------------------

Coupon less than 3% and Risk

Zone Coupon 3% or more zero coupon bonds weights

------------------------------------------------------------------------

1....... Up to 1 month............ Up to 1 month........... 0.00

1 up to 3 months......... 1 up to 3 months........ 0.20

3 up to 6 months......... 3 up to 6 months........ 0.40

6 up to 12 months........ 6 up to 12 months....... 0.70

2....... 1 up to 2 years.......... 1 up to 1.9 years....... 1.25

2 up to 3 years.......... 1.9 up to 2.8 years..... 1.75

3 up to 4 years.......... 2.8 up to 3.6 years..... 2.25

3....... 4 up to 5 years.......... 3.6 up to 4.3 years..... 2.75

5 up to 7 years.......... 4.3 up to 5.7 years..... 3.25

7 up to 10 years......... 5.7 up to 7.3 years..... 3.75

10 up to 15 years........ 7.3 up to 9.3 years..... 4.50

15 up to 20 years........ 9.3 up to 10.6 years.... 5.25

Over 20 years............ 10.6 up to 12 years..... 6.00

12 up to 20 years....... 8.00

Over 20 years........... 12.50

------------------------------------------------------------------------

(vi) Within each time-band for which there are risk-weighted

long and short positions, the risk-weighted long and short positions

are then netted, resulting in a single net risk-weighted long or

short position for each time-band. Because different instruments and

different maturities may be included and netted within each time-

band, a capital requirement, referred to as the vertical

disallowance, is assessed for basis risk. The vertical disallowance

capital requirement is 10.0 percent of the position eliminated by

the intra-time-band netting, that is, 10.0 percent of the smaller of

the net risk-weighted long or net risk-weighted short position, or

if the positions are equal, 10.0 percent of either position.4

The vertical disallowances for each time-band are absolute values,

that is, neither long nor short. The vertical disallowances for all

time-bands in the maturity ladder are summed and included as an

element of the general market risk capital requirement.

\4\ For example, if the sum of the weighted longs in a time-band

is $100 million and the sum of the weighted shorts is $90 million,

the vertical disallowance for the time-band is 10.0 percent of $90

million, or $9 million.

---------------------------------------------------------------------------

(vii) Within each zone for which there are risk-weighted long

and short positions in different time-bands, the weighted long and

short positions in all of the time-bands within the zone are then

netted, resulting in a single net long or short position for each

zone. Because different instruments and different maturities may be

included and netted within each zone, a capital requirement,

referred to as the horizontal disallowance, is assessed to allow for

the imperfect correlation of interest rates along the yield curve.

The horizontal disallowance capital requirement is calculated as a

percentage of the position eliminated by the intra-zone netting,

that is, a percentage of the smaller of the net risk-weighted long

or net risk-weighted short position, or if the positions are equal,

a percentage of either position.5 The percent disallowance

factors for intra-zone netting are set out in Table 3--Horizontal

Disallowances in section 6(a)(2)(H). The horizontal disallowances,

like the vertical disallowances, are absolute values that are summed

and included as an element of the general market risk capital

requirement.

\5\ For example, if the sum of the weighted longs in the 1- to

3-month time-band in Zone 1 is $8 million and the sum of the

weighted shorts in the 3- to 6-month time-band is $10 million, the

horizontal disallowance for the zone is 40 percent of $8 million, or

$3.2 million.

(viii) Risk-weighted long and short positions in different zones

are then netted between the zones. Zone 1 and zone 2 are netted if

possible, reducing or eliminating the net long or short position in

zone 1 or zone 2 as appropriate. Zone 2 and zone 3 are then netted

if possible, reducing or eliminating the net long or short position

in zone 2 or zone 3 as appropriate. Zone 3 and zone 1 are then

netted if possible, reducing or eliminating the long or short

position in zone 3 and zone 1 as appropriate. A horizontal

disallowance capital requirement is then assessed, calculated as a

percentage of the position eliminated by the inter-zone netting. The

horizontal disallowance capital requirements for each zone are then

summed as absolute values and included in the general market risk

capital charge. The percent disallowance factors for inter-zone

netting are set out in Table 3--Horizontal Disallowances, as

follows:

Table 3.--Horizontal Disallowances

------------------------------------------------------------------------

Between

Within the adjacent Between

Zone Time-band zone zones zones 1 and

(percent) (percent) 3 (percent)

------------------------------------------------------------------------

1....... 0 up to 1 month........ 40 40 100

1 up to 3 months.......

3 up to 6 months ......

[[Page 38098]]

6 up to 12 months......

2....... 1 up to 2 years........ 30 40 100

2 up to 3 years

3 up to 4 years

3....... 1 up to 5 years........ 30 40 100

5 up to 7 years

7 up to 10 years

10 up to 15 years

15 up to 20 years

Over 20 years

------------------------------------------------------------------------

(ix) Finally, the net risk-weighted long or net risk-weighted

short positions remaining in the zones are summed to reach a single

net risk-weighted long or net risk-weighted short position for the

bank's portfolio. The sum of the absolute value of this position and

the vertical and horizontal disallowances is the capital requirement

for general market risk.

(x) In the duration method, the bank, after calculating each

instrument's modified duration,6 multiplies that modified

duration by the interest rate shock specified for an instrument of

that duration in Table 4--Duration Method: Time-Band and Assumed

Changes in Yield in section 6(a)(2)(K). The resulting product

(representing the expected percentage change in the price of the

instrument for the given interest rate shock) is then multiplied by

the current market value of the instrument. The resulting amount is

then slotted as a long or short position into a time-band in the

maturity ladder in Table 4--Duration Method: Time-Band and Assumed

Changes in Yield on the basis of the instrument's modified

duration.7

\6\ The duration of an instrument is its approximate percentage

change in price for a 100 basis point parallel shift in the yield

curve assuming that its cash flows do not change when the yield

curve shifts. Modified duration is duration divided by a factor of 1

plus the interest rate.

\7\ Example, an instrument held by a bank with a maturity of 4

years and 3 months and a current market value of $1,000 might have a

modified duration of 3.5 years. Based on its modified duration, it

would be subjected to the 75-basis point interest rate shock,

resulting in an expected price change of 2.625 percent (3.5 x

0.75). The corresponding expected change in price of $26.25,

calculated as 2.625 percent of $1,000, would be slotted as a long

position in the 3.3 to 4.0 year time-band of the maturity ladder.

---------------------------------------------------------------------------

(xi) Once all of the bank's traded debt instruments have been

slotted into the maturity ladder, the bank conducts the same rounds

of netting and disallowances described in sections 6(a)(2)(F)

through (H) of the maturity method in this appendix B, with the

exception that the vertical disallowance requirement for the

duration method is 5.0 percent (horizontal disallowances continue to

be those set out in Table 3--Horizontal Disallowances). As with the

maturity method, the sum of the absolute value of the final net

position and the vertical and horizontal disallowances is the

general market risk capital requirement.

(xii) The duration method maturity ladder is set out in Table

4--Duration Method: Time Bands and Assumed Changes in Yield, as

follows:

Table 4.--Duration Method: Time-Bands and Assumed Changes in Yield

------------------------------------------------------------------------

Assumed

Zone Time-band change in

yield

------------------------------------------------------------------------

1....... Up to 1 month.................................... 1.00

1 up to 3 months................................. 1.00

3 up to 6 months................................. 1.00

6 up to 12 months................................ 1.00

2....... 1.0 up to 1.8 years.............................. 0.90

1.8 up to 2.6 years.............................. 0.80

2.6 up to 3.3 years.............................. 0.75

3....... 3.3 up to 4.0 years.............................. 0.75

4.0 up to 5.2 years.............................. 0.70

5.2 up to 6.8 years.............................. 0.65

6.8 up to 8.6 years.............................. 0.60

8.6 up to 9.9 years.............................. 0.60

9.9 up to 11.3 years............................. 0.60

11.3 up to 16.6 years............................ 0.60

Over 16.6 years.................................. 0.60

------------------------------------------------------------------------

(3) Interest rate derivative contracts. (i) Derivative contracts

and other off-balance sheet positions that are affected by changes

in interest rates are included in the measurement system under

section 6(a) of this appendix B (except for options and the

associated underlyings, which are included in the measurement system

under the treatment discussed in section 6(e) of this appendix B).

(ii) Derivatives are converted into positions in the relevant

underlying instrument and are included in the calculation of

specific and general market risk capital charges as described above.

The amount to be included is the market value of the principal

amount of the underlying or of the notional underlying.

(iii) Futures and forward contracts (including FRAs) are broken

down into a combination of a long position and short position in the

notional security. The maturity of a future or a FRA is the period

until delivery or exercise of the contract, plus the life of the

underlying instrument.8 Where a range of instruments may be

delivered to fulfill the contract, the bank may chose which

deliverable instrument goes into the maturity or duration ladder as

the notional underlying. In the case of a future on a corporate bond

index, positions are included at the market value of the notional

underlying portfolio of securities.

\8\ For example, a long position in a June three-month interest

rate future (taken in April) is reported as a long position in a

government security with a maturity of five months and a short

position in a government security with a maturity of two months.

---------------------------------------------------------------------------

(iv) Swaps are treated as two notional positions in the relevant

instruments with appropriate maturities. The receiving side is

treated as the long position and the paying side is treated as the

short position.9 The separate sides of cross-currency swaps or

forward foreign exchange transactions are slotted in the relevant

maturity ladders for the currencies concerned. For swaps that pay or

receive a fixed or floating interest rate against some other

reference price, for example, an equity index, the interest rate

component is slotted into the appropriate repricing maturity

category, with the long or short position attributable to the equity

component being included in the equity framework set out in section

6(b) of this appendix B.10

\9\ For example, an interest rate swap in which a bank is

receiving floating-rate interest and paying fixed is treated as a

long position in a floating rate instrument with a maturity

equivalent to the period until the next interest rate reset date and

a short position in a fixed-rate instrument with a maturity

equivalent to the remaining life of the swap.

\10\ A bank with a large swap book may, with prior approval of

the OCC, use alternative formulae to calculate the positions to be

included in the maturity or duration ladder. For example, a bank

could first convert the payments required by the swap into present

values. For that purpose, each payment would be discounted using

zero coupon yields, and the payment's present value entered into the

appropriate time-band using procedures that apply to zero (or low)

coupon bonds. The net amounts would then be treated as bonds, and

slotted into the general market risk framework. Such alternative

treatments will, however, only be allowed if: (i) the OCC is

satisfied with the accuracy of the system being used, (ii) the

calculated positions fully reflect the sensitivity of the cash flows

to interest rate changes; and (iii) the positions are denominated in

the same currency.

[[Page 38099]]

---------------------------------------------------------------------------

(v) A bank may offset long and short positions (both actual and

notional) in identical derivative instruments with exactly the same

issuer, coupon, currency, and maturity before slotting these

positions into time-bands. A matched position in a future and its

corresponding underlying may also be fully offset and, thus,

excluded from the calculation, except when the future comprises a

range of deliverable instruments. However, in cases where, among the

range of deliverable instruments, there is a readily identifiable

underlying instrument that is most profitable for the trader with a

short position to deliver, positions in the futures contract and the

instrument may be offset. No offsetting is allowed between positions

in different currencies.

(vi) Offsetting positions in the same category of instruments

can in certain circumstances be regarded as matched and treated by

the bank as a single net position which should be entered into the

appropriate time-band. To qualify for this treatment the positions

must be based on the same underlying instrument, be of the same

nominal value, and be denominated in the same currency. The separate

sides of different swaps may also be ``matched'' subject to the same

conditions. In addition:

(A) For futures, offsetting positions in the notional or

underlying instruments to which the futures contract relates must be

for identical instruments and the instruments must mature within

seven days of each other;

(B) For swaps and FRAs, the reference rate (for floating rate

positions) must be identical and the coupon closely matched; and

(C) For swaps, FRAs and forwards, the next interest reset date,

or for fixed coupon positions or forwards the remaining maturity,

must correspond within the following limits: If the reset (remaining

maturity) dates occur within one month, then the reset (remaining

maturity) dates must be on the same day; if the reset (remaining

maturity) dates occur between one month and one year later, then the

reset (remaining maturity) dates must occur within seven days of

each other, or if the reset (remaining maturity) dates occur over

one year later, then the reset (remaining maturity) dates must occur

within thirty days of each other.

(vii) Interest rate and currency swaps, FRAs, forward foreign

exchange contracts and interest rate futures are not subject to a

specific risk charge. This exemption also applies to futures on a

short-term (e.g., LIBOR) interest rate index. However, in the case

of futures contracts where the underlying is a debt security, or an

index representing a basket of debt securities, a specific risk

charge will apply according to the category of the issuer as set out

in section 6(a)(2) of this appendix B.

(b) Equities. (1) Specific risk. The measure of specific risk is

calculated on the basis of the bank's gross equity positions, that

is, the absolute sum of the current market value of all long equity

positions and of all short equity positions.11 The specific

risk capital requirement is 8.0 percent of that sum, unless the

portfolio is both liquid and well-diversified, in which case the

specific risk capital requirement is 4.0 percent of the gross equity

position. A specific risk charge of 2.0 percent applies to the net

long or short position in a broad, diversified equity index.

\11\ Matched positions in each identical equity in each national

market may be treated as offsetting and excluded from the capital

calculation, with any remaining position included in the

calculations for specific and general market risk. For example, a

future in a given equity may be offset against an opposite cash

position in the same equity.

---------------------------------------------------------------------------

(2) General market risk. The measure of general market risk is

based on the difference between the sum of the long positions and

the sum of the short positions (i.e., the overall net position in an

equity market) at current market value. An overall net position must

be separately calculated for each national market in which the bank

holds equities. The capital requirement for general market risk is

8.0 percent of the net position in each equity market.

(3) Equity derivatives. (i) Equity derivatives and other off-

balance-sheet positions that are affected by changes in equity

prices are included in the measurement system under section 6(b) of

this appendix B (except for equity options, equity index options,

and the associated underlying, which are included in the measurement

system under the treatment discussed in section 6(e) of this

appendix B).12 This includes futures and swaps on both

individual equities and on equity indices. Equity derivatives should

be converted into notional equity positions in the relevant

underlying.

\12\ Where equities are part of a forward contract (both

equities to be received or to be delivered), any interest rate or

foreign currency exposure from the other side of the contract should

be appropriately included in sections 6(a) and (c) of this appendix

B.

---------------------------------------------------------------------------

(ii) Futures and forward contracts relating to individual

equities should be reported as current market prices of the

underlying. Futures relating to equity indices should be reported as

the marked-to-market value of the notional underlying equity

portfolio. Equity swaps are treated as two notional positions, with

the receiving side as the long position and the paying side as the

short position.13 If one of the legs involves receiving/paying

a fixed or floating interest rate, the exposure should be slotted

into the appropriate repricing maturity band for debt securities.

The stock index is covered by the equity treatment.

\13\ For example, an equity swap in which a bank is receiving an

amount based on the change in value of one particular equity or

equity index and paying a different index will be treated as a long

position in the former and a short position in the latter.

---------------------------------------------------------------------------

(iii) In the case of futures-related arbitrage strategies, the

2.0 percent specific risk charge applicable to broad diversified

equity indices may be applied to only one index. The opposite

position is exempt from a specific risk charge. The strategies

qualifying for this treatment are:

(A) When the bank takes an opposite position in exactly the same

index at different dates; and

(B) When the bank has an opposite position in different but

similar indices at the same date, subject to supervisory oversight.

(iv) If a bank engages in a deliberate arbitrage strategy, in

which a futures contract on a broad diversified equity index matches

a basket of securities, it may exclude both positions from the

standardized approach on the condition that the trade has been

deliberately entered into and separately controlled and the

composition of the basket of stocks represents at least 90 percent

of the market value of the index. In such a case, the minimum

capital requirement is 4.0 percent (that is, 2.0 percent of the

gross value of the positions on each side). This applies even if all

of the securities comprising the index are held in identical

proportions. Any excess value of the securities comprising the

basket over the value of the futures contract or excess value of the

futures contract over the value of the basket is treated as an open

long or short position.

(v) If a bank takes a position in depository receipts 14

against an opposite position in the underlying equity, it may offset

the position.

\14\ Depository receipts are instruments issued by a trust

company or other depository institution evidencing the deposit of

foreign securities and facilitating trading in such instruments on

U.S. stock exchanges.

---------------------------------------------------------------------------

(c) Foreign Exchange Risk. (1) The capital requirement for

foreign exchange risk covers the risk of holding or taking positions

in foreign currencies, including gold, and is based on a bank's net

open long positions or net open short positions in each currency,

whether or not those positions are in the trading portfolio, plus

the net open position in gold, regardless of sign.15

\15\ Where a bank has future and forward contracts to deliver

and receive gold, a maturity ladder should be constructed in

accordance with section 6(a) of this appendix B treating gold as a

zero coupon instrument.

(2) A bank's net open position in each currency (and gold) is

calculated by summing:

(i) The net spot position (i.e., all asset items less all

liability items, including accrued interest earned but not yet

received and accrued expenses, denominated in the currency in

question);

(ii) All foreign exchange derivative instruments and other off-

balance-sheet positions that are affected by changes in exchange

rates are included in the measurement system under section 6(c) of

this appendix B (except for options and their associated

underlyings, which are included in the measurement system under the

treatment discussed in section 6(e) of this appendix B). Forward

currency positions should be valued at current spot market exchange

rates. For a bank in which the basis of its normal management

accounting is to use net present values, forward positions may be

discounted to net present values as an acceptable way of measuring

currency positions for regulatory capital purposes;

(iii) Guarantees (and similar instruments) that are certain to

be called and are likely to be irrevocable;

(iv) Net future income/expenses not yet accrued but already

fully hedged (at the discretion of the bank). A bank that includes

future income and expenses must do so on a consistent basis without

selecting expected future flows in order to reduce the bank's

position; and

(v) Any other item representing a profit or loss in foreign

currencies.

[[Page 38100]]

(3) For measuring a bank's open positions, positions in

composite currencies, such as the ECU, may be either treated as a

currency in their own right or split into their component parts on a

consistent basis. Positions in gold are measured in the same manner

as described in section 6(d) of this appendix B.16

\16\ Where gold is part of a forward contract (quantity of gold

to be received or to be delivered), any interest rate or foreign

currency exposure from the other side of the contract should be

reported as set out in section 6(a) and (c) of this appendix B.

---------------------------------------------------------------------------

(4) The capital requirement is determined by converting the

nominal amount (or net present value) of the net open position in

each foreign currency (and gold) at spot rates into the reporting

currency. The capital requirement is 8.0 percent of the sum of:

(i) The greater of the sum of the net short open positions or,

the sum of the net long open positions; and

(ii) The net open position in gold, regardless of sign.17

\17\ For example, a bank has the following net currency

positions: Yen = +50, DM = +100, GB = +150, FFR = -20, US$= -180,

and gold = -35. The bank would sum its long positions (total = +300)

and sum its short positions (total = -200). The bank's capital

requirement for foreign exchange market risk would be: (300 (the

larger of the summed long and short positions) + 35 (gold)) x 8.0%

= $26.80.

---------------------------------------------------------------------------

(5) A bank doing negligible business in foreign currency and

that does not take foreign exchange positions for its own account

may be exempted from the capital requirement for foreign exchange

risk provided that:

(i) Its foreign currency business, defined as the greater of the

sum of its gross long positions and the sum of its gross short

positions in all foreign currencies, does not exceed 100 percent of

eligible capital as defined in section 3 of this appendix B; and

(ii) Its overall net open foreign exchange position as

determined in section 6(c)(2) does not exceed 2.0 percent of its

eligible capital.

(6) Where a bank is assessing its foreign exchange risk on a

consolidated basis, it may be impractical in the case of some

marginal operations to include the currency positions of a foreign

branch or subsidiary of the bank. In such cases, the internal limit

in each currency may be used as a proxy for the positions, provided

there is adequate ex post monitoring of actual positions complying

with such limits. In these circumstances, the limits should be

added, regardless of sign, to the net open position in each

currency.

(d) Commodities risk. (1) Measurement methods. This section

provides a minimum capital requirement to cover the risk of holding

or taking positions in commodities. There are two methods under the

standardized approach for measuring commodity market risk--the

simplified method and the maturity method. These methods are only

appropriate for banks that conduct a limited amount of commodities

business. All other banks must adopt an internal measurement system

conforming to the criteria in section 5 of this appendix B.

(2) Base capital requirement. Under both the simplified and

maturity methods, each long and short commodity position (spot and

forward) is expressed in terms of the standard unit of measurement

(such as barrels, kilos, or grams). The open positions in each

category of commodities are then converted at current spot rates

into U.S. currency, with long and short positions offset to arrive

at the net open position in each commodity. Positions in different

categories of commodities may not, generally, be offset.18

Under either method, the base capital requirement is 15.0 percent of

the net open position, long or short, in each commodity.19

\18\ However, netting is permitted between different sub-

categories of the same commodity in cases where the sub-categories

are deliverable against each other.

\19\ When the funding of a commodity position opens a bank to

interest rate or foreign exchange exposure the relevant positions

should be included in the measures of interest rate and foreign

exchange risk described in sections 6(a) and (c) of this appendix B.

When a commodity is part of a forward contract, any interest or

foreign currency exposure from the other side of the contract should

be appropriately included in sections 6(a) and 6(c) of this appendix

B.

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(3) Simplified method. To protect a bank against basis risk,

interest rate risk, and forward gap risk, each category of commodity

is also subject to a 3.0 percent capital requirement on the bank's

gross positions, long plus short, in the particular commodity. In

valuing gross positions in commodity derivatives for this purpose, a

bank should use the current spot price. The total capital

requirement for commodities risk is the sum of the 15.0 percent base

charges for each net commodity position and the 3.0 percent

requirements on the gross commodity positions.

(4) Maturity method. (i) Under this method, a bank must slot

each long and short commodity position (converted into U.S. currency

at current spot rates) into a maturity ladder. The time-bands for

the maturity ladder are; from zero to one month, one up to three

months, three up to six months, six up to twelve months, one up to

two years, two up to three years, and over three years. A separate

maturity ladder is used for each category of commodity. Physical

commodities are allocated to the first time-band.

(ii) In order to capture forward gap and interest rate risk

within a time-band (together sometimes referred to as curvature/

spread risk), offsetting long and short positions in each time-band

are subject to an additional capital requirement. Beginning with the

shortest-term time-band and continuing with subsequent time-bands,

the amount of the matched short positions plus the amount of the

matched long position is multiplied by a spread rate of 1.5 percent.

(iii) The unmatched net position from a shorter-term time-band

must be carried forward to offset exposures in longer-term time-

bands. A capital requirement of 0.6 percent of the net position

carried forward is added for each time-band that the net position is

carried forward.20 The total capital requirement for

commodities risk is the sum of the 15.0 percent base capital

requirement for each net commodity position and the additional

requirements for matched positions and for unmatched positions

carried forward.

\20\ For example, if $200 short is carried forward from the 3-6

month time-band to the 1-2 year time-band, the capital charge would

be $200 x .006 x 2 = $2.40.

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(5) Commodity derivatives and other off-balance-sheet positions

that are affected by changes in commodity prices are included in the

measurement system under section 6(d) of this appendix B (except for

options and the associated underlying, which are included in the

measurement system under the treatment discussed in section 6(e) of

this appendix B). Commodity derivatives are converted into notional

commodity positions. Under the maturity method, the positions are

slotted into maturity time-bands as follows:

(i) Futures and forward contracts relating to individual

commodities are incorporated in the measurement system as notional

amounts (of, for example, barrels or kilos) that are converted to

U.S. dollars at current spot rates and are assigned a maturity

according to expiration date;

(ii) Commodity swaps where one side of the contract is a fixed

price and the other side is the current market price are

incorporated as a series of positions equal to the notional amount

of the contract at current spot rates, with one position

corresponding to each payment on the swap and slotted in the

maturity ladder accordingly. The positions are long positions if the

bank is paying a fixed price and receiving a floating price, and

short positions if the bank is receiving a fixed price and paying a

floating price; 21 and

\21\ If one of the sides of the transaction involves receiving/

paying a fixed or floating interest rate, that exposure should be

slotted into the appropriate repricing maturity band in section 6(a)

of this appendix B.

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(iii) Commodity swaps where the sides of the transaction are in

different commodities are included in the relevant reporting ladder.

No offsetting is allowed unless the commodities are in the same sub-

category.

(e) Options. (1) Several alternatives are available for a bank

to use in measuring its market risk for options activities. A bank

that only has purchased options may use the simplified method set

forth in section 6(e)(2) of this appendix B. A bank that also writes

options may use the scenario method described in section 6(e)(3) of

this appendix B, or the delta-plus method set forth in section

6(e)(4) of this appendix B.22 These methods may only be used by

banks which, in relative terms, have limited options activities.

Banks with more significant options business are expected to adopt

an internal measurement system conforming to the criteria in section

5 of this appendix B. Regardless of the method used, specific risk

related to the issuer of an instrument still applies to options

positions for equities, equity indices and corporate debt securities

as set forth in sections 6(a) and (b) of this appendix B. There

remains a separate capital

[[Page 38101]]

requirement for counterparty credit risk as set forth in appendix A to

this part 3.

\22\ Unless all their written option positions are hedged by

perfectly matched long positions in exactly the same options, in

which case there is no capital requirement for market risk.

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(2) Under the simplified and scenario methods, the positions for

the options and the associated underlying, cash or forward, are not

included in the measurement framework for debt securities, equities,

foreign exchange or commodities risk as set forth in sections 6(a)

through (d) of this appendix B. Rather, they are subject to capital

requirements as calculated in this section. The capital requirements

calculated under this section should then be added to the capital

requirements for debt securities, equities, foreign exchange and

commodities risk as appropriate. Under the delta-plus method, the

delta equivalent position 23 for each option is included in the

measurement frameworks set forth in sections 6(a) through (d) of

this appendix B.

23 The delta equivalent of an option is the option's delta

value multiplied by its principal or notional value. The delta value

of an option represents the expected change in the option's price as

a proportion of a small change in the price of the underlying

instrument. For example, an option whose price changes $1 for every

$2 dollar change in the price of the underlying instrument has a

delta of 0.50.

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(3) A bank that has only a limited amount and range of purchased

options may use the following simplified approach to measure its

market risk exposure: 24

24 For example, if a holder of 100 shares currently valued at

$10 each has an equivalent put option with a strike price of $11,

the capital charge would be: $1,000 x 16.0 percent (e.g., 8.0

percent specific plus 8.0 percent general market risk) = $160, less

the amount the option is in the money ($11-$10) x 100 = $100,

i.e., the capital charge would be $60. A similar methodology applies

for options whose underlying is a foreign currency, a debt security

or a commodity.

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(i) For a bank with a long cash position and a long put or with

a short cash position and a long call, the capital requirement is

the market value of the underlying instrument multiplied by the sum

of the specific and general market risk requirements for the

underlying (that is, the specific and general market risk

requirements that would have applied to the underlying directly

under sections 6(a) through (d) of this appendix B), less the amount

the option is in the money (if any) bounded at zero.25

\25\ Some options (e.g., where the underlying is an interest

rate, a currency, or a commodity) bear no specific risk but specific

risk will be present in the case of options on corporate debt

securities and for options on equities and equity indices.

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(ii) For a bank with a long call or a long put, the capital

charge is the lesser of:

(A) The market value of the underlying security multiplied by

the sum of specific and general market risk requirements for the

underlying (that is, the specific and general market risk

requirements that would have applied to the underlying directly

under sections 6(a) through (d) of this appendix B); or

(B) The market value of the option.

(iii) Under this measure, the capital requirement for currency

options is 8.0 percent of the market value of the underlying and for

commodity options is 15.0 percent of the market value of the

underlying.

(4) Under the scenario approach, a bank revalues its options and

related hedging positions by changing the underlying rate or price

over a specified range and by assuming different levels of

volatility for that rate or price.

(i) For each of its option portfolios, a bank constructs a grid

based on a fixed range of changes in the portfolio's risk factors

and calculates changes in the value of the option portfolio at each

point within the grid. For this purpose, an option portfolio

consists of an option and any related hedging positions or multiple

options and related hedging positions that are grouped together

according to their remaining maturity or the type of underlying.

(ii) Options based on interest rates and debt instruments are

grouped into portfolios according to the maturity zones that are set

forth in section 6(a) of this appendix B. (Zone 1 instruments have a

remaining maturity of up to 1 year, zone 2 instruments have a

remaining maturity from 1 year up to 4 years, and zone 3 instruments

have a remaining maturity of 4 years or more.)

(iii) These options and the associated hedging positions should

be evaluated under the assumption that the relevant interest rates

move simultaneously. For options based on equities, separate grids

are constructed for each individual equity issue and index. For

options based on exchange rates, separate grids are constructed for

individual exchange rates. For options based on commodities,

separate grids are constructed for each category of commodity (as

defined in sections 6(a) and (d) of this appendix B).

(iv) For option portfolios with options based on equities,

exchange rates, and commodities, the first dimension of the grid

consists of rate or price changes within a specified range above and

below the current market value of the underlying; for equities, the

range is +/- 12.0 percent (or in the case of an index +/- 8.0

percent), for exchange rates the range is +/- 8.0 percent, and for

commodities the range is +/- 15.0 percent. For option portfolios

with options based on interest rates, the range for the first

dimension of the grid depends on the remaining maturity zone. The

range for zone 1 is +/- 100 basis points, the range for zone 2 is +/

- 90 basis points, and the range for zone 3 is +/- 75 basis points.

For all option portfolios, the range is divided into at least ten

equally spaced intervals. The second dimension of each grid is a

shift in the volatility of the underlying rate or price equal to +/-

25.0 percent of the current volatility.26

26 For example, if the underlying in an equity instrument with

a current market value of $100 and a volatility of 20 percent, the

first dimension of the grid would range from $88 to $112, divided

into ten intervals of $2.40 and the second dimension would assume

volatilities of 15 percent, 20 percent, and 25 percent.

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(v) For each assumed volatility and rate or price change (a

scenario), the bank revalues each option portfolio. The market risk

capital requirement for the portfolio is the largest loss in value

from among the scenario revaluations. The total market risk capital

requirement for all option portfolios is the sum of the individual

option portfolio capital requirements.

(vi) The OCC will review the application of the scenario

approach, particularly regarding the precise way the analysis is

constructed. A bank using the scenario approach should meet the

appropriate qualitative criteria set forth in section 5 of this

appendix B.

(5) Under the delta-plus method, a bank that writes options may

include delta-weighted options positions within each measurement

framework as set forth in sections 6(a) through 6(d) of this

appendix B.

(i) Options positions should be measured as a positi

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