# Risk-Based Capital Standards: Market Risk

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URL: https://www.frixlaw.com/law-library/documents/fr%3A95-17542

## Record

- **Collection:** Federal Register
- **Document type:** Proposed Rule
- **Published:** July 25, 1995
- **Citation:** 60 FR 38082

## Text

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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

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.''
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

(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).
---------------------------------------------------------------------------

(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 d

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A95-17542. Public record. Not legal advice.