Risk-Based Capital Standards: Market Risk

SUMMARY: The Office of the Comptroller of the Currency (OCC), the Board

of Governors of the Federal Reserve System (Board), and the Federal

Deposit Insurance Corporation (FDIC) (collectively, the Agencies) are

amending their respective risk-based capital standards to incorporate a

measure for market risk to cover all positions located in an

institution's trading account and foreign exchange and commodity

positions wherever located. The final rule implements an amendment to

the Basle Capital Accord that sets forth a supervisory framework for

measuring market risk. The effect of the final rule is that any bank or

bank holding company (institution) regulated by the OCC, the Board, or

the FDIC, with significant exposure to market risk must measure that

risk using its own internal value-at-risk model, subject to the

parameters contained in this final rule, and must hold a commensurate

amount of capital.

DATES: Effective date: January 1, 1997.

Compliance date: Mandatory compliance January 1, 1998.

FOR FURTHER INFORMATION CONTACT:

OCC: Margot Schwadron, Financial Analyst, Roger Tufts, Senior

Economic Advisor, or Christina Benson, Capital Markets Specialist,

Office of the Chief National Bank Examiner (202/874-5070). For legal

issues, Andrew Gutierrez, Attorney, or Ron Shimabukuro, Senior

Attorney, Legislative and Regulatory Activities Division (202/874-

5090), Office of the Comptroller of the Currency, 250 E Street, SW,

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 (TDD), Dorothea Thompson (202/452-3544), Federal Reserve

Board, 20th and C Streets, NW, Washington, D.C. 20551.

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

Browne, Deputy Assistant Director (202/898-6789), Kenton Fox, Senior

Capital Markets Specialist (202/898-7119), Division of Supervision;

Jamey Basham, Counsel (202/898-7265), Legal Division, Federal Deposit

Insurance Corporation, 550 17th Street, NW, Washington, D.C. 20429.

SUPPLEMENTARY INFORMATION:

I. Background

The Agencies' risk-based capital standards are based upon

principles contained in the July 1988 agreement entitled

``International Convergence of Capital Measurement and Capital

Standards'' (Accord). The Accord, developed by the Basle Committee on

Banking Supervision (Committee) and endorsed by the central bank

governors of the Group of Ten (G-10) countries,1 provides a

framework for assessing an institution's capital adequacy by weighting

its assets and off-balance-sheet exposures on the basis of counterparty

credit risk. In April 1995, the Committee issued a consultative

proposal to amend the Accord and require institutions to measure and

hold capital to cover their exposure to market risk, specifically,

market risk associated with foreign exchange and commodity positions,

and with debt and equity positions located in the trading

account.2

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\1\ The G-10 countries are Belgium, Canada, France, Germany,

Italy, Japan, Netherlands, Sweden, Switzerland, the United Kingdom,

and the United States. The Committee is comprised of representatives

of the central banks and supervisory authorities from the G-10

countries and Luxembourg. The Agencies each adopted risk-based

capital standards implementing the Accord in 1989.

\2\ Market risk consists of general market risk and specific

risk. General market risk refers to changes in the market value of

on-balance-sheet assets and liabilities and off-balance-sheet items

resulting from broad market movements, such as changes in the

general level of interest rates, equity prices, foreign exchange

rates, and commodity prices. Specific risk refers to changes in the

market value of individual positions due to factors other than broad

market movements and includes such risks as the credit risk of an

instrument's issuer.

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Market Risk Proposal

On July 25, 1995, the Agencies published a joint proposal to amend

their respective risk-based capital standards in accordance with the

Committee's consultative proposal (60 FR 38082) (market risk proposal).

Under the market risk proposal, an institution with significant trading

activity must calculate a capital charge for market risk using either

its own internal risk measurement model (internal models approach) or a

risk-weighting process developed by the Committee (standardized

approach). The market risk proposal requires an institution to

integrate the market risk capital charge into its risk-based capital

ratios used for supervisory purposes no later than year-end 1997.

The proposed internal models approach requires an institution to

employ an internal model to calculate daily value-at-risk (VAR)

measures 3 for each of four risk categories: interest rates,

equity prices, foreign exchange rates, and commodity prices, including

related options in each category. For regulatory capital purposes, the

market risk proposal requires an institution to calibrate VAR measures

to a ten-day movement in rates and prices and a 99 percent confidence

level. An institution must base its VAR measures upon rates and prices

observed over a period of at least one year. In deriving the overall

VAR measure, an institution could take into account historical

correlations within a risk category (e.g., between interest rates), but

not across risk categories (e.g., not between interest rates and equity

prices); in other words, the overall VAR measure equals the sum of the

VAR measures for each risk category. An institution's capital charge

for general market risk equals the greater of (1) the previous day's

overall VAR measure, or (2) the average of the preceding 60 days'

overall VAR measures multiplied by a factor of three (the

multiplication factor). Moreover, the market risk proposal requires an

institution to hold additional capital for specific risk associated

with debt and equity positions in the trading account to the extent

that its internal model does not incorporate that risk.

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\3\ The VAR measure represents an estimate of the amount by

which an institution's positions in a risk category could decline

due to general market movements during a given holding period,

measured with a specified confidence level.

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Under the market risk proposal, an institution's supervisor

evaluates its internal modeling and risk management process to ensure

that the institution is,

[[Page 47359]]

in fact, using its internal model for risk management purposes, that

the calculation of VAR for capital purposes conforms with the specified

quantitative criteria, and that the risk management process meets

certain qualitative criteria, such as requiring independent model

validations 4 and having an independent risk management unit. The

market risk proposal allows an institution's supervisor to increase its

multiplication factor (which applies to the 60-day VAR average) if

backtesting results suggest problems with the institution's internal

model or risk management process.

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\4\ The proposed qualitative criteria identify backtesting and

stress testing as two model validation techniques. Backtests provide

information about the accuracy of an internal model by comparing an

institution's daily VAR measures to its corresponding daily trading

profits and losses. Stress tests provide information about the

impact of adverse market events on an institution's positions.

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The standardized approach, the market risk proposal's alternative

to the internal models approach, requires an institution to apply

certain uniform techniques to calculate a capital charge for the

general market risk of positions in the four risk categories, as well

as for the specific risk of debt and equity positions located in the

trading account. The total capital charge is the sum of the capital

charges for each risk category.

An institution supports its market risk capital charges using a

combination of Tier 1 and Tier 2 capital instruments (as defined in the

credit risk-based capital standards), as well as a proposed new type of

capital (Tier 3). Generally, Tier 3 capital consists of short-term

subordinated debt subject to certain criteria, including a lock-in

provision that prevents the issuer from repaying the debt even at

maturity if the issuer's risk-based capital ratio is less than 8.0

percent following the payment.

In December 1995, the G-10 Governors endorsed a final amendment to

the Accord adopting, with some modification, the Committee's market

risk consultative proposal. At that same time, the Committee issued

supervisory guidance specifying the effect of backtesting results on an

institution's multiplication factor.

Backtesting Proposal

On March 7, 1996, the Agencies published for public comment a joint

proposal on backtesting (61 FR 9114) (backtesting proposal) that

reflected the Committee's backtesting guidance. The backtesting

proposal requires an institution to compare its daily net profits and

losses for the most recent 250 business days to the corresponding daily

VAR measures generated for internal risk management purposes, using a

99 percent confidence level and a one-day period of rate and price

movement. Each day for which a net trading loss exceeds the

corresponding VAR measure is counted as an exception. An institution

with five or more exceptions is presumed to have an inaccurate internal

model and must increase its multiplication factor from three up to a

maximum of four, depending on the number of exceptions. The backtesting

proposal requires an institution to begin backtesting one year after it

begins to calculate market risk capital charges. The delayed effective

date for backtesting provides an institution with sufficient time to

accumulate the required data for 250 business days.

II. Comment Summary

Market Risk Proposal

Together, the Agencies received 33 public comments on the market

risk proposal. Commenters strongly supported the proposed internal

models approach.5 Most commenters believed that approach provides

greater accuracy in measuring market risk than the standardized

approach and creates incentives for institutions to continue improving

their risk modeling and management techniques. Nevertheless, most

commenters stated that the proposed modeling constraints were

unnecessarily rigid and, especially when combined with the

multiplication factor of three, result in excessive capital charges.

The following discussion summarizes the responses to the Agencies'

specific questions about the proposal.

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\5\ Early versions of the Basle Committee's market risk

amendment did not allow for the use of internal models to determine

capital charges.

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General Topics

The Agencies asked commenters about the proposed criteria for

determining which institutions must calculate capital charges for

market risk. As proposed, the rule applied to: (1) Any institution with

total assets exceeding $5 billion and either trading activity totaling

at least 3 percent of total assets or the notional amount of trading

account derivative contracts in excess of $5 billion; and (2) any

institution with total assets of $5 billion or less and trading

activity representing at least 10 percent of total assets. Commenters

generally agreed that an institution with significant exposure to

market risk should hold capital against that exposure. However, some

believed it inappropriate to use the notional amount of trading account

derivative contracts as a criterion. Further, some objected to

different criteria for institutions of different asset size.

The Agencies asked about the burden associated with applying the

market risk measure to both banks and bank holding companies and, with

regard to bank holding companies, the burden associated with applying

the measure both with and without Section 20 subsidiaries. The Agencies

received mixed comments on the bank and bank holding company issue.

Some believed the measure should apply only at the bank holding company

level, pointing out that market risk usually is managed on a

consolidated basis at the bank holding company level. Some favored

applying the measure at the bank level. Others believed that an

institution should have a choice, depending on how it manages risk.

Most commenters discussing the Section 20 subsidiary issue supported

applying the rule on a fully consolidated basis (i.e., including

Section 20 subsidiaries).

The Agencies also asked whether to allow an institution to choose

either the standardized or internal models approaches, whether to allow

an institution to combine the two approaches for different risk

categories, and whether the two approaches result in similar capital

charges. While some commenters supported the flexibility of choosing

between the internal models and standardized approaches, those

commenters who anticipated that they would be subject to the market

risk capital requirements indicated that they intend to use only the

internal models approach. Other commenters thought that a choice of

approaches could be useful in certain situations, for example, when an

institution suddenly meets the applicability criteria but does not have

a completely developed internal model. Several commenters expressed

concerns about the accuracy of the standardized approach and urged its

elimination. The few commenters that addressed the question about

combining the two approaches supported the flexibility that this could

provide. A few commenters stated that capital charges would be higher

under the internal models approach than under the standardized

approach.6

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\6\ The summary does not include comments on particular issues

that might arise in applying the standardized approach (other than

comments on specific risk) because, as discussed below, the Agencies

have decided not to adopt the standardized approach in the final

rule. Public comments are available from the Board's and OCC's

Freedom of Information Office and the FDIC's Reading Room.

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[[Page 47360]]

The Internal Models Approach

The market risk proposal imposed several quantitative standards on

VAR measures used for regulatory capital purposes. The Agencies asked

about the potential burden associated with these standards and whether

the resulting capital charge sufficiently covered market risk.

Commenters overwhelmingly responded that the proposed modeling

constraints were unnecessarily rigid and would result in an excessive

capital charge. Many commenters suggested the Agencies allow an

institution to use the same internal modeling parameters for regulatory

capital purposes as for internal risk management.

Modeling Constraints. With regard to the proposed modeling

constraints, a few commenters supported basing capital charges on a

ten-day period of rate and price movements. Others indicated that the

period was too long, with most suggesting a one-day period. Some

commenters objected to any specified period. Several commenters opposed

the proposed 99 percent confidence level, noting that many institutions

use lower confidence levels. Others supported the proposed level and

still others suggested that regulators should not specify a confidence

level.

Many commenters strongly asserted that the proposed multiplication

factor of three was too high and suggested, instead, a minimum factor

of one. Most of these commenters believed that the proposal did not

adequately explain the rationale for a multiplication factor greater

than one. Several asked for clarification about how the Agencies will

measure a model's accuracy and adjust an institution's multiplication

factor. They advocated objective, well-defined criteria to ensure that

the Agencies apply the rules consistently.

Commenters strongly opposed the proposal's requirement that an

institution aggregate VAR measures by simple summation across the risk

categories. They asserted that ignoring the effects of cross

correlation among risk categories overstates exposure and understates

the merits of diversified portfolios.

The Agencies asked whether to require an institution to calculate

VARs using two observation periods. Specifically, the Agencies asked

about the tradeoff between enhanced prudential coverage and additional

burden associated with requiring an institution to make two VAR

measures, one based on a short observation period and one based on a

longer (over one year) period. Most commenters believed dual

observation periods would result in unnecessary costs and operational

burden. Commenters had varying opinions about the optimal length of

time for an observation period. Some commenters suggested that the

Agencies allow an institution to choose an appropriate observation

period.

Backtesting. The Agencies asked for comments about the potential

burden associated with backtesting to evaluate the accuracy of an

institution's internal model. Commenters generally viewed backtesting

as a useful tool for model validation purposes. Most believed that

backtesting should compare an institution's VAR calculated for internal

risk management purposes (rather than for regulatory capital purposes)

with actual profits and losses. A few commenters, noting the developing

nature of backtesting generally, urged regulators not to prescribe

specific regulations, guidelines, or methodologies for backtesting.

The Agencies also asked for comment about the types of stress tests

institutions should perform as part of their internal risk management

process. Several commenters recognized generally the importance of

stress testing. These and other commenters responded that the Agencies

should allow an institution to choose its methodology. Other commenters

questioned whether a stress testing requirement was necessary.

Specific Risk. The Agencies noted that the internal models approach

requires an institution to add a specific risk capital charge

calculated using the standardized approach if its internal model does

not adequately capture specific risk, and asked what modeling

techniques the Agencies should consider when evaluating an

institution's model for specific risk. While commenters generally

agreed that an institution should integrate specific risk into its

internal model, several objected to using capital charges calculated

under the standardized approach as the benchmark for specific risk

under the internal models approach. A few commenters asked for

clarification about what constitutes sufficient integration of specific

risk into a model to avoid the add-on capital charge. Some commenters

noted that internal models that incorporate specific risk elements are

still in the development stage, and stated that the Agencies should not

include a specific risk requirement in the internal models approach.

The Agencies asked whether they should specifically define the term

``liquid and well-diversified,'' as applied to specific risk in

equities, entitling an institution to a lower capital charge under the

standardized approach. Commenters differed as to the appropriate degree

of specificity. Some preferred a qualitative definition, as proposed,

and others supported a more explicit and objective definition.

Other Issues

Some commenters raised issues not directly addressed in the

Agencies' specific questions on the market risk proposal. One commenter

suggested that an institution could determine internally whether to

classify a debt instrument as qualifying or non-qualifying for purposes

of determining the applicable specific risk weight factor (qualifying

instruments receive a lower specific risk charge than non-qualifying

instruments). Another commenter recommended a zero percent specific

risk charge for debt instruments issued by local and regional

governments. Another recommended a zero percent specific risk charge

for instruments tracking an equity index.

Several commenters said that the proposed qualitative standards for

an institution's risk management system were reasonable. One

institution noted the qualitative standards provided a comprehensive

set of guidelines. Some commenters questioned the marketability of

short-term subordinated debt included as Tier 3 capital. A few

commenters discussed the relationship between market risk and credit

risk, with some arguing that when aggregating capital charges for

credit and market risk the Agencies should permit an institution to

recognize correlations between the two types of risk.

Backtesting Proposal

Together, the Agencies received 17 public comments on the

backtesting proposal. Commenters to that proposal generally supported

backtesting as a useful component of risk management. Several expressed

concern that the proposal was unnecessarily rigid, noting that

backtesting techniques are evolving, and suggested that the Agencies

reexamine backtesting prior to implementation of the final rule. A few

commenters questioned linking backtesting results to capital

requirements. Some commenters expressed the view that the Agencies

should take into account the severity of an exception, not just the

number of exceptions. Other commenters believed that the Agencies

should base capital requirements on an overall evaluation of an

institution's risk management process and not merely on the number of

exceptions. A few commenters suggested that the Agencies retain the

[[Page 47361]]

flexibility to adjust the multiplication factor below three if an

institution's model exhibits superior performance.

Among other specific questions, the Agencies asked about the merits

and problems associated with backtesting hypothetical trading outcomes

(profits and losses) versus backtesting actual trading outcomes.7

Almost all commenters supported using actual trading outcomes for

backtesting purposes rather than hypothetical outcomes. One commenter

supported giving an institution the option of what type of outcomes it

will backtest. Commenters who supported using actual trading outcomes

believed that these results appropriately included such factors as

gains and losses from trading activity, fee income, net interest

income, and management responses to changing portfolio conditions.

Commenters who objected to using hypothetical results noted that costs

associated with creating and operating a system for determining

hypothetical results were significant. Other commenters discussed the

potential burden of requiring an institution to calculate daily profits

and losses with an unreasonable degree of exactness. They noted that

global VARs are calculated by simulating changes in all market factors

and calculating resulting changes in portfolio values. They suggested

letting an institution estimate daily profit and losses using a

consistent, reasonable methodology.

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\7\ Generally, hypothetical outcomes are trading outcomes that

would result if the trading position as of the end of one business

day went unchanged during the next business day. Hypothetical

outcomes differ from actual outcomes because of the effects of such

items as changes in portfolio composition over the holding period,

fee income, commissions, and income from trading.

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The Agencies asked for comment on what types of events or regime

shifts (i.e., dramatic changes in market conditions that result in

numerous exceptions in a short period of time for the same reason)

might generate exceptions that do not warrant an increase in an

institution's multiplication factor. Several commenters asserted that

the Agencies should not list the types of regime shifts in advance. Two

commenters suggested that the Agencies should treat any market-wide or

asset-class event affecting a large number of institutions as a regime

shift. Commenters suggested the following examples of regime shifts:

sudden abnormal changes in interest or exchange rates, major political

events, and natural disasters. Some commenters suggested that the

Agencies should take into account an institution's reaction to

unanticipated trading results, such as how it adapts its internal model

to take into account changed conditions. A few commenters stated the

Agencies should not penalize an institution for exceptions after it

adjusts its model.

The Agencies asked about the proposed sample size of 250

independent observations. While several commenters on this question

responded that the proposed sample size was appropriate, some believed

that an institution should have flexibility to increase or decrease the

sample size. A few commenters asserted that all institutions should use

the same sample size.

Finally, the Agencies asked whether to require an institution to

backtest against its VAR measures generated for internal risk

management purposes, or against VAR measures calculated for market risk

capital requirements. Most commenters supported the former approach.

III. Final Rule

The Agencies believe it is important for an institution with

significant market risk to measure its exposure and hold commensurate

amounts of capital. The Agencies support the market risk amendment to

the Accord and are now issuing uniform market risk standards that will

implement that amendment for institutions regulated by the Agencies.

The final rule incorporates a measure for exposure to market risk into

the Agencies' credit risk-based capital standards. By January 1, 1998,

an institution that meets the applicability criteria must use its

internal model to measure its exposure to market risk and hold capital

in support of that exposure. The Agencies concur with commenters that

an institution with significant exposure to market risk can most

accurately measure that risk using detailed information available to

the institution about its particular portfolio processed by its own

risk measurement model. The final rule does not include the proposed

standardized approach for measuring general market risk. The final rule

does retain, however, the standardized approach methodologies for

determining capital charges for specific risk, which an institution

must use as the basis for its specific risk charge for debt and equity

positions in its trading account.

The final rule supplements the existing credit risk-based capital

standards by requiring an affected institution to adjust its risk-based

capital ratio to reflect market risk. Specifically, an institution must

adjust its risk-based capital ratio to take into account the general

market risk of all positions located in its trading account and of

foreign exchange and commodity positions, wherever located.

Additionally, the institution must account for the specific risk of

debt and equity positions located in its trading account. The positions

covered by this final rule (except for foreign exchange positions

outside the trading account and over-the-counter (OTC) derivatives) are

excluded from the credit risk capital charge. Foreign exchange

positions outside the trading account and OTC derivatives are subject

to the market risk capital charge, as well as the credit risk capital

charge.

Thus, the minimum capital charge for an institution that meets the

applicability criteria is its credit risk capital charge as calculated

under the Agencies' credit risk-based capital standards (excluding the

positions previously noted) plus its measure for market risk as

calculated under this final rule. The institution's risk-based capital

ratio adjusted for market risk is its risk-based capital ratio for

purposes of prompt corrective action and other statutory and regulatory

purposes.

Subject to supervisory approval that its internal model and risk

management processes meet the final rule's regulatory criteria, an

institution may choose to comply with the final rule as early as

January 1, 1997. Any institution that voluntarily complies with the

final rule prior to January 1, 1998, must comply with all of its

provisions, except for the backtesting provisions, which apply one year

after the institution begins to comply with the other provisions of the

final rule.

Institutions Subject to the Final Rule (Section 1(b))

The Agencies agree with commenters that all institutions with

significant market risk, regardless of size, should measure their

exposure and hold appropriate levels of capital. Thus, the Agencies

have revised the applicability criteria to eliminate the differential

criteria based on total asset size. The Agencies believe that the

capital requirements are appropriate both for an institution whose

trading activity is large relative to its total assets, and for an

institution with a substantial volume of trading activity.

The final rule applies to any bank or bank holding company whose

trading activity equals 10 percent or more of its total assets, or

whose trading activity equals $1 billion or more.8 For purposes

[[Page 47362]]

of these criteria, an institution's trading activity is defined as the

sum of its trading assets and trading liabilities as reported in its

most recent Consolidated Report of Condition and Income (Call Report)

for a bank, or its most recent Y-9C Report for a bank holding company.

Total assets means quarter-end total assets as most recently reported

by the institution.

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\8\ The Federal Reserve agrees with commenters that since market

risk usually is managed on a consolidated basis at the bank holding

company level, market risk should be measured at that level for

risk-based capital purposes. Thus, the final rule applies to bank

holding companies on a fully consolidated basis. In addition,

because the Accord applies to internationally active banks, the

final rule applies to consolidated banks. The Agencies may monitor

the market risk exposure of institutions on a non-consolidated basis

to ensure that significant imbalances within an organization do not

avoid supervision.

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In addition, on a case-by-case basis, an Agency may require an

institution that does not meet the applicability criteria to comply

with the final rule if the Agency deems it necessary for safety and

soundness purposes, or may exclude an institution that meets the

applicability criteria. For example, an Agency may require an

institution with trading activity less than $1 billion and less than 10

percent of total assets, but with significant foreign exchange exposure

outside of its trading account to comply with the provisions of the

final rule. On the other hand, an Agency may exempt an institution with

trading activity that exceeds 10 percent of its total assets as a

result of accounting, operational, or similar considerations, provided

this does not raise safety and soundness concerns.

An institution that does not meet the applicability criteria may,

subject to supervisory approval, comply voluntarily with the market

risk rule, but only if it complies with all of the final rule's

provisions (e.g., the backtesting requirements, after accumulating

sufficient trading outcomes).

Covered Positions (Section 2(a))

An institution subject to the final rule must hold capital to

support its exposure to general market risk arising from fluctuations

in interest rates, equity prices, foreign exchange rates, and commodity

prices and its exposure to specific risk associated with certain debt

and equity positions. Covered positions include all positions in an

institution's trading account and foreign exchange and commodity

positions throughout the institution (whether or not in the trading

account).

For market risk capital purposes, an institution's trading account

is defined in the instructions to the Call Report. For example, the

trading account includes on- and off-balance-sheet positions in

financial instruments acquired with the intent to resell in order to

profit from short-term price or rate movements (or other price or rate

variations). An institution may include in its measure for general

market risk certain non-trading account instruments that it

deliberately uses to hedge trading positions. Those instruments are not

subject to a specific risk capital charge, but instead, remain subject

to the credit risk capital requirements. An institution may not include

items in, or exclude items from, its trading account to manipulate

associated capital charges. All positions included in the trading

account must be marked to market and reflected in an institution's

earnings statement.

The market risk capital charge applies to all of an institution's

foreign exchange and commodities positions. An institution's foreign

exchange positions include, for each currency, such items as its net

spot position (including ordinary assets and liabilities denominated in

a foreign currency), forward positions, guarantees that are certain to

be called and likely to be unrecoverable, and any other items that

react primarily to changes in exchange rates. An institution may,

subject to supervisory approval, exclude from the market risk measure

any structural positions in foreign currencies. For this purpose,

structural positions include 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 capital assigned to foreign branches

that are denominated in foreign currencies, and (2) any positions

related to unconsolidated subsidiaries and other items that are

deducted from an institution's capital when calculating its capital

base. An institution's commodity positions include all positions that

react primarily to changes in commodity prices.

Adjustment to the Risk-Based Capital Ratio Calculation (Section 3)

An institution subject to the final rule must measure its market

risk and hold capital on a daily basis to maintain an overall minimum

8.0 percent ratio of total qualifying capital to risk-weighted assets

adjusted for market risk.

Risk-Based Capital Ratio Denominator (Section 3(a))

An institution's risk-based capital ratio denominator equals its

adjusted risk-weighted assets plus its market risk equivalent assets.

Adjusted risk-weighted assets are risk-weighted assets, as determined

under the credit risk-based capital standards, less the risk-weighted

amounts of all covered positions other than foreign exchange positions

outside the trading account and OTC derivatives. Covered positions

(except for foreign exchange positions outside the trading account and

OTC derivatives) are no longer subject to a credit risk capital charge.

An institution's market risk equivalent assets equals the measure for

market risk, as determined under this final rule, multiplied by 12.5

(the reciprocal of the minimum 8.0 percent capital ratio).

Measure for Market Risk (Section 3(a)(2))

The measure for market risk consists of an institution's VAR-based

capital charge plus an add-on capital charge for specific risk.\9\ The

VAR-based capital charge is the larger of either (1) the average VAR

measure for the last 60 business days, calculated under the regulatory

criteria and increased by a multiplication factor of between three and

four; or (2) the previous day's VAR, calculated under the regulatory

criteria but without the multiplication factor. An institution's

multiplication factor is three unless its backtesting results indicate

that a higher factor is appropriate or unless the institution's

supervisor determines that another action is appropriate.

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\9\ The final rule also provides that, on a case-by-case basis,

an Agency may permit an institution to measure de minimis exposures

to market risk using other techniques, provided the exposure is

truly de minimis, the associated risk is adequately measured, and

integration of the exposure into the institution's internal model

would impose an unnecessary regulatory burden.

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The Agencies believe this comparative approach will result in an

institution holding capital sufficient to cover peak levels of market

volatility. While the Agencies acknowledge some commenters' concerns

that a multiplication factor of three (or higher) imposes excessive

capital charges, the Agencies believe that adjustments in the final

rule to the internal models approach (e.g., requiring only a single

observation period and recognizing cross correlations among risk

categories) result in capital charges that are appropriate, given

existing industry practices. As institutions implement the final rule,

the Agencies will monitor resulting capital charges, will continue to

evaluate the appropriateness of the multiplication factor, and may

consider further refinements or adjustments to the final rule.

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Risk-Based Capital Ratio Numerator (Section 3(b))

An institution's risk-based capital ratio numerator consists of a

combination of core (Tier 1) capital, supplemental (Tier 2) capital\10\

and a third tier of capital (Tier 3), which consists of short-term

subordinated debt that meets certain conditions. Specifically, Tier 3

capital must have an original maturity of at least two years; it must

be unsecured and fully paid up; it must be subject to a lock-in clause

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

issuer's capital ratio is, or with repayment would become, less than

the minimum 8.0 percent risk-based capital ratio; it must not be

redeemable before maturity without the prior approval of the

institution's supervisor; and it must not contain or be covered by any

covenants, terms, or restrictions that may be inconsistent with safe

and sound banking practices. An institution may use Tier 3 capital only

to meet market risk capital requirements.

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\10\ Tier 1 and Tier 2 capital components are discussed in the

Agencies' credit risk capital standards. Generally, Tier 1 includes

common stockholder's equity, noncumulative perpetual preferred

stock, and minority equity interests in consolidated subsidiaries,

less goodwill and other deductions. Bank holding companies may

include certain amounts of cumulative perpetual preferred stock in

Tier 1. Tier 2 includes the allowance for loan and lease losses,

other preferred stock, and subordinated debt with an original

average maturity of at least five years.

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To determine its risk-based capital ratio numerator, an institution

should first allocate Tier 1 and Tier 2 capital equal to 8.0 percent of

its risk-weighted assets (adjusted for the positions that are no longer

subject to the credit risk rules). Next, the institution should

allocate Tier 1, Tier 2, and Tier 3 capital to support its measure for

market risk. The risk-based capital ratio numerator (i.e., total

qualifying capital), is the sum of Tier 1 capital (whether or not

allocated for credit risk or market risk), Tier 2 capital (whether or

not allocated for credit risk or market risk and subject to certain

limits), and Tier 3 capital (allocated for market risk and subject to

certain limits).

The Agencies continue to believe that Tier 1 capital should

constitute a substantial proportion of an institution's total capital.

Thus, the final rule includes the existing credit risk-based capital

constraints that at least 50 percent of an institution's total

qualifying capital must be Tier 1 capital, and that term subordinated

debt (and intermediate-term preferred stock and related surplus) may

not exceed 50 percent of Tier 1 capital. In addition, the sum of Tier 2

and Tier 3 capital allocated for market risk must not exceed 250

percent of Tier 1 capital allocated for market risk. This requirement

means that an institution must support at least 28.6 percent of its

measure for market risk with Tier 1 capital.

Internal Models (Section 4)

The Agencies recognize that institutions can and will use different

assumptions and modeling techniques and that such differences often

reflect distinct business strategies and approaches to risk management.

For example, an institution may calculate VAR using internal models

based on variance-covariance matrices, historical simulations, Monte

Carlo simulations, or other statistical approaches. In all cases,

however, the model must cover the institution's material risks.\11\

While the Agencies are not specifying modeling parameters for internal

risk management purposes, the final rule does include minimum

qualitative requirements for internal risk management processes, as

well as certain quantitative requirements for the parameters and

assumptions for internal models used to measure market risk exposure

for regulatory capital purposes.

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\11\ For an institution using an externally developed or

outsource risk measurement model, the model may be used for risk-

based capital purposes provided it complies with the requirements of

the final rule, management fully understands the model, the model is

integrated into the institution's daily risk management, and the

institution's overall risk management process is sound.

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Qualitative Requirements (Section 4(b))

The qualitative requirements reiterate several basic components of

sound risk management. For example, one of the final rule's qualitative

requirements is that an institution must have a risk control unit that

reports directly to senior management and that is independent from

business trading functions. The Agencies expect that a risk control

unit will conduct regular backtests to evaluate the model's accuracy

and stress tests to identify the impact of adverse market events on the

institution's portfolio.

The other qualitative requirements in the final rule are also

elements of sound risk management practices. For example, an

institution must have an internal model that is integrated into its

daily management, must have policies and procedures for conducting

appropriate stress tests and backtests and for responding to the

results of those tests, and must conduct independent reviews of its

risk measurement and management systems at least annually.

The Agencies agree with commenters that an institution should

develop and use stress tests appropriate to its particular situation.

Thus, the final rule does not require specific stress test

methodologies. The Agencies expect an institution to conduct stress

tests that are rigorous and comprehensive and that cover a range of

factors that could create extraordinary losses in a trading portfolio,

or make the control of risk in a portfolio difficult. The Agencies

believe stress tests should be both qualitative and quantitative,

should incorporate both market risk and liquidity aspects of market

disturbances, and should reflect the impact of an event on positions

with linear and non-linear price characteristics. Where stress tests

reveal a particular vulnerability, the institution should take

effective steps to appropriately manage those risks.

An institution's independent review of its risk management process

should include both the activities of business trading units and the

risk control unit. For example, the Agencies expect that an

institution's review would include assessing whether its risk

management system is fully integrated into the daily management process

and whether its risk management system is adequately documented. The

review should evaluate the organizational structure of the risk control

unit and analyze the approval process for risk pricing models and

valuation systems. The review should also consider the scope of market

risks captured by the risk measurement model, the accuracy and

completeness of position data, the verification of the consistency,

timeliness, and reliability of data sources used to run the internal

model, the accuracy and appropriateness of volatility and correlation

assumptions, and the validity of valuation and risk transformation

calculations.

Market Risk Factors (Section 4(c))

The final rule provides that an institution's internal model must

use risk factors that address market risk associated with interest

rates, equity prices, exchange rates, and commodity prices, including

the market risk associated with options in each of these risk

categories. Although an institution has discretion to use market risk

factors that it has determined affect the value of its positions and

the risks to which it is exposed, the Agencies expect an institution to

use sufficient risk factors to cover the risks inherent in its

portfolio.

[[Page 47364]]

For example, the Agencies believe that interest rate risk factors

should correspond to interest rates in each currency in which the

institution has interest-rate-sensitive positions. The risk measurement

system should model the yield curve using one of a number of generally

accepted approaches, such as by estimating forward rates or zero coupon

yields, and should incorporate risk factors to capture spread risk. The

yield curve should be divided into various maturity segments to capture

variation in the volatility of rates along the yield curve. For

material exposures to interest rate movements in the major currencies

and markets, modeling techniques should capture at least six segments

of the yield curve.

The risk measurement system should incorporate risk factors

corresponding to individual foreign currencies in which the

institution's positions are denominated, to each of the equity markets

in which the institution has significant positions (at a minimum, a

risk factor should capture market-wide movements in equity prices), and

to each of the commodity markets in which the institution has

significant positions. Risk factors should measure the volatilities of

rates and prices underlying option positions. An institution with a

large or complex options portfolio should measure the volatilities of

options positions by different maturities. The sophistication and

nature of the modeling techniques should correspond to the level of the

institution's exposure.

Quantitative Requirements (Section 4(d))

While an institution has flexibility in developing the precise

nature of its model for internal risk management purposes, the Agencies

continue to believe that when determining capital charges for exposure

to market risk an institution's VAR measures should meet certain

quantitative requirements. Such requirements are designed to ensure

that an institution with significant market risk holds prudential

levels of capital and that capital charges are sufficiently consistent

across institutions with similar exposures. The Agencies have

considered commenters' concerns that the proposed modeling constraints,

when combined, would result in excessive capital charges. The Agencies

believe that certain of the proposed constraints, such as a 99 percent

(one-tailed) confidence level and a ten-day movement in rates and

prices, are appropriate and therefore they have been retained in the

final rule. However, the Agencies agree with commenters that other

proposed or considered requirements are not necessary. For example, the

Agencies have determined that a dual observation period would

unnecessarily increase regulatory burden without providing a

substantial benefit. Thus, the final rule employs a single observation

period.

The Agencies also agree with commenters that, for regulatory

capital purposes, an institution should be permitted to use models that

recognize cross correlations among risk categories. The final rule

permits an institution to recognize cross correlations. The Agencies

believe this revision eliminates a significant source of rigidity in

the market risk proposal and should result in internal modeling for

capital purposes that is more consistent with observed industry

practice. The Agencies also believe this revision will appropriately

recognize and reward portfolio diversification. These adjustments to

the quantitative requirements are consistent with the final amendment

to the Accord.

The final rule contains the following quantitative requirements for

an institution's VAR measures, upon which regulatory capital

requirements are based:

(1) VAR measures must be computed each business day based on a 99

percent (one-tailed) confidence level of estimated maximum loss.

(2) VAR measures must be based on a price shock equivalent to a

ten-day movement in rates or prices. An institution may adjust VAR

measures (including VAR measures for options) based on shorter periods

to a ten-day standard (e.g., by multiplying by the square root of

time).12 The Agencies do not believe that a price or rate movement

period less than ten days is sufficient to reflect the risk associated

with options positions (or other instruments with non-linear price

characteristics), but recognize that it may be overly burdensome for an

institution to apply a ten-day price or rate movement to such positions

at this time. The Agencies expect an institution with concentrations of

options to make substantive progress in developing a modeling system

that measures the non-linear price characteristics of options positions

(or other instruments with non-linear price characteristics), over a

full ten-day period.

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

\12\ For example, under certain statistical assumptions, an

institution 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 (approximately 3.16).

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

(3) Internal models must include the non-linear price

characteristics of options positions and the sensitivity of the market

value of those positions to changes in the volatility of the option's

underlying rates and prices.

(4) VAR measures must be based on a minimum historical observation

period of at least one year for estimating future price and rate

changes. A model that uses a weighting scheme or other method for the

historical observation period must use an effective observation period

of at least one year. That is, the weighted average time lag of the

individual observations must be at least six months, the figure that

would prevail in an equally weighted one-year observation period.

(5) An institution must update its model data at least once every

three months and more frequently if market conditions warrant.

(6) VAR measures may incorporate empirical correlations (calculated

from historical data on rates and prices) both within broad risk

categories and across broad risk categories, subject to agreement by

the institution's supervisor that the model's system for measuring such

correlation is sound. If an institution's model does not incorporate

empirical correlations across risk categories, then the bank must

calculate the VAR measures used for regulatory capital purposes by

summing the separate VAR measures for the four broad risk categories

(i.e., interest rates, equity prices, foreign exchange rates, and

commodity prices).

The Agencies believe that, taken together, the modeling parameters

are appropriate for regulatory capital purposes and also that they are

compatible, as much as practicable, with existing modeling procedures.

During the examination process, the Agencies will review an

institution's risk management process and internal model to ensure that

the model processes all relevant data and that modeling and risk

management practices conform to the parameters and requirements of the

final rule.13

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\13\ When reviewing an institution's internal model for risk-

based capital purposes, the Agencies may consider reports and

opinions about the accuracy of the model that have been generated by

external auditors or qualified consultants.

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Backtesting (Section 4(e))

The Agencies have considered commenters' responses to the

backtesting proposal. The Agencies believe backtesting can be a useful

tool for internal model validation, and have determined to include the

backtesting provisions in the final rule, as proposed. An institution

subject to the final rule must perform backtests of its VAR measures as

calculated for internal risk management purposes. The backtests must

compare daily VAR measures

[[Page 47365]]

calibrated to a one-day movement in rates and prices and a 99 percent

(one-tailed) confidence level against the institution's actual daily

net trading profit or loss (trading outcome) for each of the preceding

250 business days. The backtests must be performed once each

quarter.14 Net trading outcomes include such items as fees and

commissions associated with trading activities, as well as changes in

market valuations associated with changing portfolio positions.

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\14\ An institution's obligation to backtest for regulatory

capital purposes does not arise until the institution has been

subject to the final rule for 250 business days (approximately one

year) and, thus, has accumulated the requisite number of

observations to be used in backtesting.

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An institution must identify the number of occurrences when its net

trading loss (if any) for a particular day exceeds the corresponding

daily VAR measure. In general, an institution's multiplication factor

increases incrementally beginning with five or more exceptions during

the previous 250 business days, and rises to a multiplication factor of

four for an institution with 10 or more exceptions during the period.

While the number of exceptions creates a presumption as to an

institution's multiplication factor, the institution's supervisor may

make other adjustments to the multiplication factor or may take other

appropriate actions. For example, the supervisor may exclude exceptions

that result from regime shifts, such as sudden abnormal changes in

interest rates or exchange rates, major political events, or natural

disasters. The supervisor may also consider such other factors as the

magnitude of an exception (that is, the extent of the difference

between the VAR measure and the actual trading loss), and an

institution's reaction in response to an exception.

The Agencies recognize that backtesting is evolving and acknowledge

commenters' concerns that it may not be appropriate to penalize an

institution by applying a higher multiplication factor if the

institution has refined the accuracy of its model in response to an

exception or has taken other action to improve its risk management

processes. The Agencies emphasize that they will implement the

backtesting requirements of the final rule with significant flexibility

and examiner judgment. The Agencies will continue to monitor industry

progress in developing backtesting methodologies and may consider

adjusting the backtesting requirements in the near future.

Specific Risk (Section 5)

The Agencies agree with the provisions in the final amendment to

the Accord that require an institution to hold capital in support of

the specific risk associated with debt and equity positions in an

institution's trading account. Thus, the final rule provides that an

institution must measure and hold capital in support of specific risk

associated with those positions. The capital charge for specific risk

is determined either by an institution's internal model or by the

standardized risk measurement techniques specified by the Agencies (the

standardized approach).

Standardized Approach

Under the standardized approach, the specific risk charge for debt

positions is calculated by multiplying the current market value of each

net long or short position in a trading account debt instrument by the

appropriate specific risk weighting factor as set forth in the final

rule, based on the identity of the obligor, and in the case of some

instruments such as corporate debt, on the credit rating and remaining

maturity of the instrument. An institution must risk weight derivatives

(e.g., swaps, futures, forwards, or options on certain debt

instruments) according to the relevant underlying instrument. For

example, for a forward contract, an institution must risk weight the

market value of the effective notional amount of the underlying

instrument (or index portfolio). An institution may net long and short

positions in identical debt instruments with exactly the same issuer,

coupon, currency, and maturity. An institution may also offset a

matched position in a derivative instrument and its corresponding

underlying instrument. The specific risk weighting factor for debt

instruments of OECD 15 central governments is zero percent. Other

debt instruments with qualifying ratings (essentially investment grade

corporate securities) receive risk weights ranging from 0.25 percent to

1.6 percent, depending on remaining maturity. Nonqualifying debt

instruments receive a risk weight of 8.0 percent.

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\15\ The Organization for Economic Cooperation and Development

(OECD) is defined in the credit risk-based capital standards.

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

The specific risk charge for equity positions is based on an

institution's gross equity position for each national market. The gross

equity position is defined as the sum of all long and short equity

positions, including positions arising from derivatives such as equity

swaps, forwards, futures, and options. An institution must risk weight

the current market value of each gross equity position by the

appropriate factor. An institution must risk weight derivatives

according to the relevant underlying equity instrument. An institution

may net long and short positions in identical equity issues or indices

in each national market. An institution may also offset a matched

position in a derivative instrument and its corresponding underlying

instrument.

The specific risk charge is 8.0 percent of the gross equity

position, unless the institution's portfolio is both liquid and well-

diversified, in which case the capital charge is 4.0 percent. A

portfolio is liquid and well-diversified if: (1) it is characterized by

a limited sensitivity to price changes of any single equity or closely

related group of equity issues held in a portfolio; (2) the volatility

of the portfolio's value is not dominated by the volatility of any

individual equity issue or by equity issues from any single industry or

economic sector; (3) it contains a large number of individual equity

positions, with no single position representing a substantial portion

of the portfolio's total market value; and (4) it consists mainly of

issues traded on organized exchanges or in well-established over-the-

counter markets.

For positions in an index comprising a diversified portfolio of

equities, the specific risk charge is 2.0 percent of the net long or

short position in the index. In addition, a 2.0 percent specific risk

charge applies to only one side (long or short) in the case of certain

futures-related arbitrage strategies (for instance, long and short

positions in the same index at different dates or different market

centers, and long and short positions at the same date in different,

but similar indices). Finally, under certain conditions, futures

positions on a broadly-based index that are matched against positions

in the equities comprising the index are subject to a specific risk

charge of 2.0 percent against each side of the transaction.

Internal Models Approach

The final rule permits an institution to use its internal model to

determine capital charges for specific risk if it can demonstrate to

its supervisor that the modeling process adequately addresses elements

of specific risk for debt and/or equity positions. In particular, an

institution may use the model-based estimates of specific risk in place

of the standardized capital charge. However, if the specific risk

component of the institution's VAR measure (when multiplied by the

backtesting multiplication factor, with respect to a

[[Page 47366]]

60-day average VAR figure) is not equal to at least 50 percent of the

specific risk charge resulting from the standardized calculation, then

the institution has a specific risk add-on in the amount of the

difference. For example, if the standardized approach indicates a

specific risk charge of $100, but the institution's 60-day average VAR

figure includes only $10 for specific risk, then the institution has a

specific risk add-on of $20 (that is, 50 percent of $100 minus three

times $10). However, if the 60-day average VAR figure includes $20 from

specific risk, then the institution would have no specific risk add-on

because the VAR-based charge (three times $20) exceeds 50 percent of

$100.

An institution (in conjunction with its supervisor) must separately

determine whether its model incorporates specific risk for debt

positions and equity positions. For instance, if the model addresses

the specific risk of debt positions but not equity positions, then the

institution can use the model-based specific risk charge (subject to

the limitations described earlier) for debt positions, but must use the

full standard specific risk charge for equity positions. If, however,

the model addresses the specific risk of both debt and equity

positions, then the institution must make the comparison based on the

total specific risk figure for debt and equity positions, taking into

account any correlations between the specific risk of debt and equity

positions that are built into the model.

This treatment provides an institution with an incentive to

incorporate specific risk into its internal model, while maintaining an

overall floor on the amount of capital it must hold against specific

risk. The Agencies believe that a minimum requirement for specific risk

is useful, at least for an initial period, since methods for

incorporating specific risk into VAR models are still in a process of

development at many institutions. The Agencies will continue to study

these developments and likely will issue further guidance on these

procedures as institutions implement this final rule in the coming

months.

IV. Regulatory Flexibility Act Analysis

OCC Regulatory Flexibility Act Analysis

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

OCC certifies that this final rule will not 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.

The impact of this final rule on banks regardless of size is expected

to be minimal. Further, the OCC's comparison of the applicability

section of this final rule to Call Report data on all existing banks

shows that application of the rule to small banks will be the rare

exception.

Board Regulatory Flexibility Act Analysis

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

Board does not believe this final rule will 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.). The Board's comparison of the applicability section of this

final rule to Call Report data on all existing banks shows that

application of the rule to small entities will be the rare exception.

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 rule will 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 final rule

will not have a significant impact on a substantial number of small

entities. The FDIC's comparison of the applicability section of this

final rule to Call Report data on all existing banks shows that

application of the rule to small entities will be the rare exception.

V. Paperwork Reduction Act

OCC Paperwork Reduction Act

The OCC has determined that his final rule does 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.).

Board Paperwork Reduction Act

In accordance with the Paperwork Reduction Act of 1995 (44 U.S.C.

Ch. 3506; 5 CFR 1320 Appendix A.1), the Board reviewed the proposed

rule under the authority delegated to the Board by the Office of

Management and Budget. No collections of information pursuant to the

Paperwork Reduction Act are contained in the final rule.

FDIC Paperwork Reduction Act

The FDIC has determined that this final rule does not contain any

collections of information as defined by the Paperwork Reduction Act

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

VI. OCC Executive Order 12866 Determination

The OCC has determined that this final rule is not a significant

regulatory action under Executive Order 12866.

VII. OCC Unfunded Mandates Reform Act of 1995 Determination

The OCC has determined that this final rule will not result in

expenditures by state, local, and tribal governments, or by the private

sector, of $100 million or more in any one year. Accordingly, a

budgetary impact statement is not required under section 202 of the

Unfunded Mandates Reform Act of 1995. This final rule will apply only

to a small number of national banks. Moreover, most (if not all) of

those banks already have internal VAR models that measure market risk,

thus reducing this final rule's implementation costs.

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.

Office of the Comptroller of the Currency

12 CFR CHAPTER I

Authority and Issuance

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

chapter I of the Code of Federal Regulations is amended as follows:

PART 3--[AMENDED]

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

[[Page 47367]]

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

note, 1835, 3907, and 3909.

2. Section 3.6 is amended by revising paragraph (a) to read as

follows:

Sec. 3.6 Minimum capital ratios.

(a) Risk-based capital ratio. All national banks must have and

maintain the minimum risk-based capital ratio as set forth in appendix

A (and, for certain banks, in appendix B).

* * * * *

3. A new appendix B is added to part 3 to read as follows:

Appendix B to Part 3--Risk-Based Capital Guidelines; Market Risk

Adjustment

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

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

banks with significant exposure to market risk maintain adequate

capital to support that exposure.1 This appendix supplements

and adjusts the risk-based capital ratio calculations under appendix

A of this part with respect to those banks.

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\1\ This appendix is based on a framework developed jointly by

supervisory authorities from the countries represented on the Basle

Committee on Banking Supervision and endorsed by the Group of Ten

Central Bank Governors. The framework is described in a Basle

Committee paper entitled ``Amendment to the Capital Accord to

Incorporate Market Risk,'' January 1996.

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(b) Applicability. (1) This appendix applies to any national

bank whose trading activity 2 (on a worldwide consolidated

basis) equals:

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\2\ Trading activity means the gross sum of trading assets and

liabilities as reported in the bank's most recent quarterly

Consolidated Report of Condition and Income (Call Report).

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

(i) 10 percent or more of total assets; 3 or

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

\3\ Total assets means quarter-end total assets as reported in

the bank's most recent Call Report.

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

(ii) $1 billion or more.

(2) The OCC may apply this appendix to any national bank if the

OCC deems it necessary or appropriate for safe and sound banking

practices.

(3) The OCC may exclude a national bank otherwise meeting the

criteria of paragraph (b)(1) of this section from coverage under

this appendix if it determines the bank meets such criteria as a

consequence of accounting, operational, or similar considerations,

and the OCC deems it consistent with safe and sound banking

practices.

(c) Scope. The capital requirements of this appendix support

market risk associated with a bank's covered positions.

(d) Effective date. This appendix is effective as of January 1,

1997. Compliance is not mandatory until January 1, 1998. Subject to

supervisory approval, a bank may opt to comply with this appendix as

early as January 1, 1997.4

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\4\ A bank that voluntarily complies with the final rule prior

to January 1, 1998, must comply with all of its provisions.

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Section 2. Definitions

For purposes of this appendix, the following definitions apply:

(a) Covered positions means all positions in a bank's trading

account, and all foreign exchange 5 and commodity positions,

whether or not in the trading account.6 Positions include on-

balance-sheet assets and liabilities and off-balance-sheet items.

Securities subject to repurchase and lending agreements are included

as if they are still owned by the lender.

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\5\ Subject to supervisory review, a bank may exclude structural

positions in foreign currencies from its covered positions.

\6\ The term trading account is defined in the instructions to

the Call Report.

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(b) Market risk means the risk of loss resulting from movements

in market prices. Market risk consists of general market risk and

specific risk components.

(1) General market risk means changes in the market value of

covered positions resulting from broad market movements, such as

changes in the general level of interest rates, equity prices,

foreign exchange rates, or commodity prices.

(2) Specific risk means changes in the market value of specific

positions due to factors other than broad market movements and

includes such risk as the credit risk of an instrument's issuer.

(c) Tier 1 and Tier 2 capital are the same as defined in

appendix A of this part.

(d) Tier 3 capital is subordinated debt that is unsecured; is

fully paid up; has an original maturity of at least two years; is

not redeemable before maturity without prior approval by the OCC;

includes a lock-in clause precluding payment of either interest or

principal (even at maturity) if the payment would cause the issuing

bank's risk-based capital ratio to fall or remain below the minimum

required under appendix A of this part; and does not contain and is

not covered by any covenants, terms, or restrictions that are

inconsistent with safe and sound banking practices.

(e) Value-at-risk (VAR) means the estimate of the maximum amount

that the value of covered positions could decline during a fixed

holding period within a stated confidence level, measured in

accordance with section 4 of this appendix.

Section 3. Adjustments to the Risk-Based Capital Ratio Calculations

(a) Risk-based capital ratio denominator. A bank subject to this

appendix shall calculate its risk-based capital ratio denominator as

follows:

(1) Adjusted risk-weighted assets. Calculate adjusted risk-

weighted assets, which equals risk-weighted assets (as determined in

accordance with appendix A of this part), excluding the risk-

weighted amounts of all covered positions (except foreign exchange

positions outside the trading account and over-the-counter

derivative positions).7

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\7\ Foreign exchange positions outside the trading account and

all over-the-counter derivative positions, whether or not in the

trading account, must be included in adjusted risk-weighted assets

as determined in appendix A of this part.

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(2) Measure for market risk. Calculate the measure for market

risk, which equals the sum of the VAR-based capital charge, the

specific risk add-on (if any), and the capital charge for de minimis

exposure (if any).

(i) VAR-based capital charge. The VAR-based capital charge

equals the higher of:

(A) The previous day's VAR measure; or

(B) The average of the daily VAR measures for each of the

preceding 60 business days multiplied by three, except as provided

in section 4(e) of this appendix;

(ii) Specific risk add-on. The specific risk add-on is

calculated in accordance with section 5 of this appendix; and

(iii) Capital charge for de minimis exposure. The capital charge

for de minimis exposure is calculated in accordance with section

4(a) of this appendix.

(3) Market risk equivalent assets. Calculate market risk

equivalent assets by multiplying the measure for market risk (as

calculated in paragraph (a)(2) of this section) by 12.5.

(4) Denominator calculation. Add market risk equivalent assets

(as calculated in paragraph (a)(3) of this section) to adjusted

risk-weighted assets (as calculated in paragraph (a)(1) of this

section). The resulting sum is the bank's risk-based capital ratio

denominator.

(b) Risk-based capital ratio numerator. A bank subject to this

appendix shall calculate its risk-based capital ratio numerator by

allocating capital as follows:

(1) Credit risk allocation. Allocate Tier 1 and Tier 2 capital

equal to 8.0 percent of adjusted risk-weighted assets (as calculated

in paragraph (a)(1) of this section).8

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

\8\ A bank may not allocate Tier 3 capital to support credit

risk (as calculated under appendix A).

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

(2) Market risk allocation. Allocate Tier 1, Tier 2, and Tier 3

capital equal to the measure for market risk as calculated in

paragraph (a)(2) of this section. The sum of Tier 2 and Tier 3

capital allocated for market risk must not exceed 250 percent of

Tier 1 capital allocated for market risk. (This requirement means

that Tier 1 capital allocated in this paragraph (b)(2) must equal at

least 28.6 percent of the measure for market risk.)

(3) Restrictions. (i) The sum of Tier 2 capital (both allocated

and excess) and Tier 3 capital (allocated in paragraph (b)(2) of

this section) may not exceed 100 percent of Tier 1 capital (both

allocated and excess).9

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

\9\ Excess Tier 1 capital means Tier 1 capital that has not been

allocated in paragraphs (b)(1) and (b)(2) of this section. Excess

Tier 2 capital means Tier 2 capital that has not been allocated in

paragraph (b)(1) and (b)(2) of this section, subject to the

restrictions in paragraph (b)(3) of this section.

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

(ii) Term subordinated debt (and intermediate-term preferred

stock and related surplus) included in Tier 2 capital (both

allocated and excess) may not exceed 50 percent of Tier 1 capital

(both allocated and excess).

(4) Numerator calculation. Add Tier 1 capital (both allocated

and excess), Tier 2 capital (both allocated and excess), and Tier 3

capital (allocated under paragraph (b)(2) of this section). The

resulting sum is the bank's risk-based capital ratio numerator.

Section 4. Internal Models

(a) General. For risk-based capital purposes, a bank subject to

this appendix

[[Page 47368]]

must use its internal model to measure its daily VAR, in accordance

with the requirements of this section.10 The OCC may permit a

bank to use alternative techniques to measure the market risk of de

minimis exposures so long as the techniques adequately measure

associated market risk.

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

\10\ A bank's internal model may use any generally accepted

measurement techniques, such as variance-covariance models,

historical simulations, or Monte Carlo simulations. However, the

level of sophistication and accuracy of a bank's internal model must

be commensurate with the nature and size of its covered positions. A

bank that modifies its existing modeling procedures to comply with

the requirements of this appendix for risk-based capital purposes

should, nonetheless, continue to use the internal model it considers

most appropriate in evaluating risks for other purposes.

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

(b) Qualitative requirements. A bank subject to this appendix

must have a risk management system that meets the following minimum

qualitative requirements:

(1) The bank must have a risk control unit that reports directly

to senior management and is independent from business trading units.

(2) The bank's internal risk measurement model must be

integrated into the daily management process.

(3) The bank's policies and procedures must identify, and the

bank must conduct, appropriate stress tests and backtests.11

The bank's policies and procedures must identify the procedures to

follow in response to the results of such tests.

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

\11\ Stress tests provide information about the impact of

adverse market events on a bank's covered positions. Backtests

provide information about the accuracy of an internal model by

comparing a bank's daily VAR measures to its corresponding daily

trading profits and losses.

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

(4) The bank must conduct independent reviews of its risk

measurement and risk management systems at least annually.

(c) Market risk factors. The bank's internal model must use risk

factors sufficient to measure the market risk inherent in all

covered positions. The risk factors must address interest rate

risk,12 equity price risk, foreign exchange rate risk, and

commodity price risk.

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

\12\ For material exposures in the major currencies and markets,

modeling techniques must capture spread risk and must incorporate

enough segments of the yield curve--at least six--to capture

differences in volatility and less than perfect correlation of rates

along the yield curve.

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

(d) Quantitative requirements. For regulatory capital purposes,

VAR measures must meet the following quantitative requirements:

(1) The VAR measures must be calculated on a daily basis using a

99 percent, one-tailed confidence level with a price shock

equivalent to a ten-business day movement in rates and prices. In

order to calculate VAR measures based on a ten-day price shock, the

bank may either calculate ten-day figures directly or convert VAR

figures based on holding periods other than ten days to the

equivalent of a ten-day holding period (for instance, by multiplying

a one-day VAR measure by the square root of ten).

(2) The VAR measures must be based on an historical observation

period (or effective observation period for a bank using a weighting

scheme or other similar method) of at least one year. The bank must

update data sets at least once every three months or more frequently

as market conditions warrant.

(3) The VAR measures must include the risks arising from the

non-linear price characteristics of options positions and the

sensitivity of the market value of the positions to changes in the

volatility of the underlying rates or prices. A bank with a large or

complex options portfolio must measure the volatility of options

positions by different maturities.

(4) The VAR measures may incorporate empirical correlations

within and across risk categories, provided that the bank's process

for measuring correlations is sound. In the event that the VAR

measures do not incorporate empirical correlations across risk

categories, then the bank must add the separate VAR measures for the

four major risk categories to determine its aggregate VAR measure.

(e) Backtesting. (1) Beginning one year after a bank starts to

comply with this appendix, a bank must conduct backtesting by

comparing each of its most recent 250 business days' actual net

trading profit or loss 13 with the corresponding daily VAR

measures generated for internal risk measurement purposes and

calibrated to a one-day holding period and a 99 percent, one-tailed

confidence level.

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

\13\ Actual net trading profits and losses typically include

such things as realized and unrealized gains and losses on portfolio

positions as well as fee income and commissions associated with

trading activities.

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

(2) Once each quarter, the bank must identify the number of

exceptions, that is, the number of business days for which the

magnitude of the actual daily net trading loss, if any, exceeds the

corresponding daily VAR measure.

(3) A bank must use the multiplication factor indicated in Table

1 of this appendix in determining its capital charge for market risk

under section 3(a)(2)(i)(B) of this appendix until it obtains the

next quarter's backtesting results, unless the OCC determines that a

different adjustment or other action is appropriate.

Table 1.--Multiplication Factor Based on Results of Backtesting

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

Multiplication

Number of exceptions factor

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

4 or fewer.............................................. 3.00

5....................................................... 3.40

6....................................................... 3.50

7....................................................... 3.65

8....................................................... 3.75

9....................................................... 3.85

10 or more.............................................. 4.00

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

Section 5. Specific Risk

(a) Specific risk add-on. For purposes of section 3(a)(2)(ii) of

this appendix, a bank's specific risk add-on equals the standard

specific risk capital charge calculated under paragraph (c) of this

section. If, however, a bank can demonstrate to the OCC that its

internal model measures the specific risk of covered debt and/or

equity positions and that those measures are included in the VAR-

based capital charge in section 3(a)(2)(i) of this appendix, then

the bank may reduce or eliminate its specific risk add-on under this

section. The determination as to whether a model incorporates

specific risk must be made separately for covered debt and equity

positions.

(1) If a model includes the specific risk of covered debt

positions but not covered equity positions (or vice versa), then the

bank can reduce its specific risk charge for the included positions

under paragraph (b) of this section. The specific risk charge for

the positions not included equals the standard specific risk capital

charge under paragraph (c) of this section.

(2) If a model addresses the specific risk of both covered debt

and equity positions, then the bank can reduce its specific risk

charge for both covered debt and equity positions under paragraph

(b) of this section. In this case, the comparison described in

paragraph (b) of this section must be based on the total VAR-based

figure for the specific risk of debt and equity positions, taking

into account any correlations that are built into the model.

(b) VAR-based specific risk capital charge. In all cases where a

bank measures specific risk in its internal model, the total capital

charge for specific risk (i.e., the VAR-based specific risk capital

charge plus the specific risk add-on) must equal at least 50 percent

of the standard specific risk capital charge (this amount is the

minimum specific risk charge).

(1) If the portion of a bank's VAR measure that is attributable

to specific risk (multiplied by the bank's multiplication factor if

required in section 3(a)(2) of this appendix) is greater than or

equal to the minimum specific risk charge, then the bank has no

specific risk add-on and its capital charge for specific risk is the

portion included in the VAR measure.

(2) If the portion of a bank's VAR measure that is attributable

to specific risk (multiplied by the bank's multiplication factor if

required in section 3(a)(2) of this appendix) is less than the

minimum specific risk charge, then the bank's specific risk add-on

is the difference between the minimum specific risk charge and the

specific risk portion of the VAR measure (multiplied by the bank's

multiplication factor if required in section 3(a)(2) of this

appendix).

(c) Standard specific risk capital charge. The standard specific

risk capital charge equals the sum of the components for covered

debt and equity positions as follows:

(1) Covered debt positions. (i) For purposes of this section 5,

covered debt positions means fixed-rate or floating-rate debt

instruments located in the trading account and instruments located

in the trading account with values that react primarily to changes

in interest rates, including certain non-convertible preferred

stock, convertible bonds, and instruments subject to repurchase and

lending agreements. Also included are derivatives (including written

and purchased options) for which the underlying instrument is a

covered debt instrument that is subject to a non-zero specific risk

capital charge.

(A) For covered debt positions that are derivatives, a bank must

risk-weight (as

[[Page 47369]]

described in paragraph (c)(1)(iii) of this section) the market value

of the effective notional amount of the underlying debt instrument

or index portfolio. Swaps must be included as the notional position

in the underlying debt instrument or index portfolio, with a

receiving side treated as a long position and a paying side treated

as a short position; and

(B) For covered debt positions that are options, whether long or

short, a bank must risk-weight (as described in paragraph

(c)(1)(iii) of this section) the market value of the effective

notional amount of the underlying debt instrument or index

multiplied by the option's delta.

(ii) A bank may net long and short covered debt positions

(including derivatives) in identical debt issues or indices.

(iii) A bank must multiply the absolute value of the current

market value of each net long or short covered debt position by the

appropriate specific risk weighting factor indicated in Table 2 of

this appendix. The specific risk capital charge component for

covered debt positions is the sum of the weighted values.

Table 2--Specific Risk Weighting Factors for Covered Debt Positions

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

Weighting

Remaining maturity factor

Category (contractual) (in

percent)

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

Government \1\...................... N/A.................... 0.00

Qualifying \2\...................... 6 months or less....... 0.25

Over 6 months to 24 1.00

months.

Over 24 months......... 1.60

Other \3\........................... N/A.................... 8.00

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

\1\ The ``government'' category includes all debt instruments of central

governments of OECD countries (as defined in appendix A of this part)

including bonds, Treasury bills, and other short-term instruments, as

well as local currency instruments of non-OECD central governments to

the extent the bank has liabilities booked in that currency.

\2\ The ``qualifying'' category includes debt instruments of U.S.

government-sponsored agencies (as defined in appendix A of this part),

general obligation debt instruments issued by states and other

political subdivisions of OECD countries, multilateral development

banks (as defined in appendix A of this part), and debt instruments

issued by U.S. depository institutions or OECD-banks (as defined in

appendix A of this part) that do not qualify as capital of the issuing

institution. This category also includes other debt instruments,

including corporate debt and revenue instruments issued by states and

other political subdivisions of OECD countries, that are: (1) Rated

investment grade by at least two nationally recognized credit rating

services; (2) rated investment grade by one nationally recognized

credit rating agency and not rated less than investment grade by any

other credit rating agency; or (3) unrated, but deemed to be of

comparable investment quality by the reporting bank and the issuer has

instruments listed on a recognized stock exchange, subject to review

by the OCC.

\3\ The ``other'' category includes debt instruments that are not

included in the government or qualifying categories.

(2) Covered equity positions. (i) For purposes of this section

5, covered equity positions means equity instruments located in the

trading account and instruments located in the trading account with

values that react primarily to changes in equity prices, including

voting or non-voting common stock, certain convertible bonds, and

commitments to buy or sell equity instruments. Also included are

derivatives (including written and purchased options) for which the

underlying is a covered equity position.

(A) For covered equity positions that are derivatives, a bank

must risk weight (as described in paragraph (c)(2)(iii) of this

section) the market value of the effective notional amount of the

underlying equity instrument or equity portfolio. Swaps must be

included as the notional position in the underlying equity

instrument or index portfolio, with a receiving side treated as a

long position and a paying side treated as a short position; and

(B) For covered equity positions that are options, whether long

or short, a bank must risk weight (as described in paragraph

(c)(2)(iii) of this section) the market value of the effective

notional amount of the underlying equity instrument or index

multiplied by the option's delta.

(ii) A bank may net long and short covered equity positions

(including derivatives) in identical equity issues or equity indices

in the same market.14

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

\14\ A bank may also net positions in depository receipts

against an opposite position in the underlying equity or identical

equity in different markets, provided that the bank includes the

costs of conversion.

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

(iii)(A) A bank must multiply the absolute value of the current

market value of each net long or short covered equity position by a

risk weighting factor of 8.0 percent, or by 4.0 percent if the

equity is held in a portfolio that is both liquid and well-

diversified.15 For covered equity positions that are index

contracts comprising a well-diversified portfolio of equity

instruments, the net long or short position is multiplied by a risk

weighting factor of 2.0 percent.

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

\15\ A portfolio is liquid and well-diversified if: (1) It 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; (2) the volatility of the portfolio's value is not

dominated by the volatility of any individual equity issue or by

equity issues from any single industry or economic sector; (3) it

contains a large number of individual equity positions, with no

single position representing a substantial portion of the

portfolio's total market value; and (4) it consists mainly of issues

traded on organized exchanges or in well-established over-the-

counter markets.

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

(B) For covered equity positions from the following futures-

related arbitrage strategies, a bank may apply a 2.0 percent risk

weighting factor to one side (long or short) of each position with

the opposite side exempt from charge:

(1) Long and short positions in exactly the same index at

different dates or in different market centers; or

(2) Long and short positions in index contracts at the same date

in different but similar indices.

(C) For futures contracts on broadly-based indices that are

matched by offsetting positions in a basket of stocks comprising the

index, a bank may apply a 2.0 percent risk weighting factor to the

futures and stock basket positions (long and short), provided that

such trades are deliberately entered into and separately controlled,

and that the basket of stocks comprises at least 90 percent of the

capitalization of the index.

(iv) The specific risk capital charge component for covered

equity positions is the sum of the weighted values.

Section 6. Reservation of Authority

The OCC reserves the authority to modify the application of any

of the provisions in this appendix to any bank, upon reasonable

justification.

Dated: August 6, 1996.

Eugene A. Ludwig,

Comptroller of the Currency.

Federal Reserve System

12 CFR CHAPTER II

For the reasons set out in the joint preamble, parts 208 and 225 of

title 12 of chapter II of the Code of Federal Regulations are amended

as follows:

PART 208--MEMBERSHIP OF STATE BANKING INSTITUTIONS IN THE FEDERAL

RESERVE SYSTEM (REGULATION H)

1. The authority citation for part 208 is revised to read as

follows:

Authority: 12 U.S.C. 36, 248(a), 248(c), 321-338a, 371d, 461,

481-486, 601, 611, 1814, 1823(j), 1828(o), 1831o, 1831p-1, 3105,

3310, 3331-3351, and 3906-3909; 15 U.S.C. 78b, 78l(b), 78l(g),

78l(i), 78o-4(c)(5), 78q, 78q-1, and 78w; 31 U.S.C. 5318; 42 U.S.C.

4012a, 4104a, 4104b, 4106, and 4128.

2. Section 208.13 is revised to read as follows:

Sec. 208.13 Capital Adequacy.

The standards and guidelines by which the capital adequacy of state

member banks will be evaluated by the Board are set forth in appendix A

and appendix E for risk-based capital purposes, and, with respect to

the ratios relating capital to total assets, in appendix B to part 208

and in appendix B to the Board's Regulation Y, 12 CFR part 225.

3. Appendix A is amended in the introductory text by adding a new

paragraph after the second undesignated paragraph to read as follows:

[[Page 47370]]

Appendix A to Part 208--Capital Adequacy Guidelines for State Member

Banks; Risk Based Measure

* * * * *

In addition, when certain banks that engage in trading activities

calculate their risk-based capital ratio under this appendix A, they

must also refer to appendix E of this part, which incorporates capital

charges for certain market risks into the risk-based capital ratio.

When calculating their risk-based capital ratio under this appendix A,

such banks are required to refer to appendix E of this part for

supplemental rules to determine qualifying and excess capital,

calculate risk-weighted assets, calculate market risk equivalent

assets, and calculate risk-based capital ratios adjusted for market

risk.

* * * * *

4. A new appendix E is added to read as follows:

Appendix E to Part 208--Capital Adequacy Guidelines for State Member

Banks; Market Risk Measure

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

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

banks with significant exposure to market risk maintain adequate

capital to support that exposure.1 This appendix supplements

and adjusts the risk-based capital ratio calculations under appendix

A of this part with respect to those banks.

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

\1\ This appendix is based on a framework developed jointly by

supervisory authorities from the countries represented on the Basle

Committee on Banking Supervision and endorsed by the Group of Ten

Central Bank Governors. The framework is described in a Basle

Committee paper entitled ``Amendment to the Capital Accord to

Incorporate Market Risk,'' January 1996.

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

(b) Applicability. (1) This appendix applies to any insured

state member bank whose trading activity 2 (on a worldwide

consolidated basis) equals:

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

\2\ Trading activity means the gross sum of trading assets and

liabilities as reported in the bank's most recent quarterly

Consolidated Report of Condition and Income (Call Report).

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

(i) 10 percent or more of total assets; 3 or

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

\3\ Total assets means quarter-end total assets as reported in

the bank's most recent Call Report.

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

(ii) $1 billion or more.

(2) The Federal Reserve may additionally apply this appendix to

any insured state member bank if the Federal Reserve deems it

necessary or appropriate for safe and sound banking practices.

(3) The Federal Reserve may exclude an insured state member bank

otherwise meeting the criteria of paragraph (b)(1) of this section

from coverage under this appendix if it determines the bank meets

such criteria as a consequence of accounting, operational, or

similar considerations, and the Federal Reserve deems it consistent

with safe and sound banking practices.

(c) Scope. The capital requirements of this appendix support

market risk associated with a bank's covered positions.

(d) Effective date. This appendix is effective as of January 1,

1997. Compliance is not mandatory until January 1, 1998. Subject to

supervisory approval, a bank may opt to comply with this appendix as

early as January 1, 1997.4

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

\4\ A bank that voluntarily complies with the final rule prior

to January 1, 1998, must comply with all of its provisions.

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

Section 2. Definitions

For purposes of this appendix, the following definitions apply:

(a) Covered positions means all positions in a bank's trading

account, and all foreign exchange 5 and commodity positions,

whether or not in the trading account.6 Positions include on-

balance-sheet assets and liabilities and off-balance-sheet items.

Securities subject to repurchase and lending agreements are included

as if they are still owned by the lender.

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

\5\ Subject to supervisory review, a bank may exclude structural

positions in foreign currencies from its covered positions.

\6\ The term trading account is defined in the instructions to

the Call Report.

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

(b) Market risk means the risk of loss resulting from movements

in market prices. Market risk consists of general market risk and

specific risk components.

(1) General market risk means changes in the market value of

covered positions resulting from broad market movements, such as

changes in the general level of interest rates, equity prices,

foreign exchange rates, or commodity prices.

(2) Specific risk means changes in the market value of specific

positions due to factors other than broad market movements and

includes such risk as the credit risk of an instrument's issuer.

(c) Tier 1 and Tier 2 capital are defined in appendix A of this

part.

(d) Tier 3 capital is subordinated debt that is unsecured; is

fully paid up; has an original maturity of at least two years; is

not redeemable before maturity without prior approval by the Federal

Reserve; includes a lock-in clause precluding payment of either

interest or principal (even at maturity) if the payment would cause

the issuing bank's risk-based capital ratio to fall or remain below

the minimum required under appendix A of this part; and does not

contain and is not covered by any covenants, terms, or restrictions

that are inconsistent with safe and sound banking practices.

(e) Value-at-risk (VAR) means the estimate of the maximum amount

that the value of covered positions could decline during a fixed

holding period within a stated confidence level, measured in

accordance with section 4 of this appendix.

Section 3. Adjustments to the Risk-Based Capital Ratio Calculations

(a) Risk-based capital ratio denominator. A bank subject to this

appendix shall calculate its risk-based capital ratio denominator as

follows:

(1) Adjusted risk-weighted assets. Calculate adjusted risk-

weighted assets, which equals risk-weighted assets (as determined in

accordance with appendix A of this part), excluding the risk-

weighted amounts of all covered positions (except foreign exchange

positions outside the trading account and over-the-counter

derivative positions).7

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

\7\ Foreign exchange positions outside the trading account and

all over-the-counter derivative positions, whether or not in the

trading account, must be included in adjusted risk weighted assets

as determined in appendix A of this part.

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

(2) Measure for market risk. Calculate the measure for market

risk, which equals the sum of the VAR-based capital charge, the

specific risk add-on (if any), and the capital charge for de minimis

exposures (if any).

(i) VAR-based capital charge. The VAR-based capital charge

equals the higher of:

(A) The previous day's VAR measure; or

(B) The average of the daily VAR measures for each of the

preceding 60 business days multiplied by three, except as provided

in section 4(e) of this appendix;

(ii) Specific risk add-on. The specific risk add-on is

calculated in accordance with section 5 of this appendix; and

(iii) Capital charge for de minimis exposure. The capital charge

for de minimis exposure is calculated in accordance with section

4(a) of this appendix.

(3) Market risk equivalent assets. Calculate market risk

equivalent assets by multiplying the measure for market risk (as

calculated in paragraph (a)(2) of this section) by 12.5.

(4) Denominator calculation. Add market risk equivalent assets

(as calculated in paragraph (a)(3) of this section) to adjusted

risk-weighted assets (as calculated in paragraph (a)(1) of this

section). The resulting sum is the bank's risk-based capital ratio

denominator.

(b) Risk-based capital ratio numerator. A bank subject to this

appendix shall calculate its risk-based capital ratio numerator by

allocating capital as follows:

(1) Credit risk allocation. Allocate Tier 1 and Tier 2 capital

equal to 8.0 percent of adjusted risk-weighted assets (as calculated

in paragraph (a)(1) of this section).8

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

\8\ A bank may not allocate Tier 3 capital to support credit

risk (as calculated under appendix A of this part).

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

(2) Market risk allocation. Allocate Tier 1, Tier 2, and Tier 3

capital equal to the measure for market risk as calculated in

paragraph (a)(2) of this section. The sum of Tier 2 and Tier 3

capital allocated for market risk must not exceed 250 percent of

Tier 1 capital allocated for market risk. (This requirement means

that Tier 1 capital allocated in this paragraph (b)(2) must equal at

least 28.6 percent of the measure for market risk.)

(3) Restrictions. (i) The sum of Tier 2 capital (both allocated

and excess) and Tier 3 capital (allocated in paragraph (b)(2) of

this section) may not exceed 100 percent of Tier 1 capital (both

allocated and excess).9

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

\9\ Excess Tier 1 capital means Tier 1 capital that has not been

allocated in paragraphs (b)(1) and (b)(2) of this section. Excess

Tier 2 capital means Tier 2 capital that has not been allocated in

paragraph (b)(1) and (b)(2) of this section, subject to the

restrictions in paragraph (b)(3) of this section.

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

(ii) Term subordinated debt (and intermediate-term preferred

stock and related

[[Page 47371]]

surplus) included in Tier 2 capital (both allocated and excess) may

not exceed 50 percent of Tier 1 capital (both allocated and excess).

(4) Numerator calculation. Add Tier 1 capital (both allocated

and excess), Tier 2 capital (both allocated and excess), and Tier 3

capital (allocated under paragraph (b)(2) of this section). The

resulting sum is the bank's risk-based capital ratio numerator.

Section 4. Internal Models.

(a) General. For risk-based capital purposes, a bank subject to

this appendix must use its internal model to measure its daily VAR,

in accordance with the requirements of this section.10 The

Federal Reserve may permit a bank to use alternative techniques to

measure the market risk of de minimis exposures so long as the

techniques adequately measure associated market risk.

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

\10\ A bank's internal model may use any generally accepted

measurement techniques, such as variance-covariance models,

historical simulations, or Monte Carlo simulations. However, the

level of sophistication and accuracy of a bank's internal model must

be commensurate with the nature and size of its covered positions. A

bank that modifies its existing modeling procedures to comply with

the requirements of this appendix for risk-based capital purposes

should, nonetheless, continue to use the internal model it considers

most appropriate in evaluating risks for other purposes.

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

(b) Qualitative requirements. A bank subject to this appendix

must have a risk management system that meets the following minimum

qualitative requirements:

(1) The bank must have a risk control unit that reports directly

to senior management and is independent from business trading units.

(2) The bank's internal risk measurement model must be

integrated into the daily management process.

(3) The bank's policies and procedures must identify, and the

bank must conduct, appropriate stress tests and backtests.11

The bank's policies and procedures must identify the procedures to

follow in response to the results of such tests.

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

\11\ Stress tests provide information about the impact of

adverse market events on a bank's covered positions. Backtests

provide information about the accuracy of an internal model by

comparing a bank's daily VAR measures to its corresponding daily

trading profits and losses.

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

(4) The bank must conduct independent reviews of its risk

measurement and risk management systems at least annually.

(c) Market risk factors. The bank's internal model must use risk

factors sufficient to measure the market risk inherent in all

covered positions. The risk factors must address interest rate

risk,12 equity price risk, foreign exchange rate risk, and

commodity price risk.

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

\12\ For material exposures in the major currencies and markets,

modeling techniques must capture spread risk and must incorporate

enough segments of the yield curve--at least six--to capture

differences in volatility and less than perfect correlation of rates

along the yield curve.

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

(d) Quantitative requirements. For regulatory capital purposes,

VAR measures must meet the following quantitative requirements:

(1) The VAR measures must be calculated on a daily basis using a

99 percent, one-tailed confidence level with a price shock

equivalent to a ten-business day movement in rates and prices. In

order to calculate VAR measures based on a ten-day price shock, the

bank may either calculate ten-day figures directly or convert VAR

figures based on holding periods other than ten days to the

equivalent of a ten-day holding period (for instance, by multiplying

a one-day VAR measure by the square root of ten).

(2) The VAR measures must be based on an historical observation

period (or effective observation period for a bank using a weighting

scheme or other similar method) of at least one year. The bank must

update data sets at least once every three months or more frequently

as market conditions warrant.

(3) The VAR measures must include the risks arising from the

non-linear price characteristics of options positions and the

sensitivity of the market value of the positions to changes in the

volatility of the underlying rates or prices. A bank with a large or

complex options portfolio must measure the volatility of options

positions by different maturities.

(4) The VAR measures may incorporate empirical correlations

within and across risk categories, provided that the bank's process

for measuring correlations is sound. In the event that the VAR

measures do not incorporate empirical correlations across risk

categories, then the bank must add the separate VAR measures for the

four major risk categories to determine its aggregate VAR measure.

(e) Backtesting. (1) Beginning one year after a bank starts to

comply with this appendix, a bank must conduct backtesting by

comparing each of its most recent 250 business days' actual net

trading profit or loss 13 with the corresponding daily VAR

measures generated for internal risk measurement purposes and

calibrated to a one-day holding period and a 99 percent, one-tailed

confidence level.

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

\13\ Actual net trading profits and losses typically include

such things as realized and unrealized gains and losses on portfolio

positions as well as fee income and commissions associated with

trading activities.

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

(2) Once each quarter, the bank must identify the number of

exceptions, that is, the number of business days for which the

magnitude of the actual daily net trading loss, if any, exceeds the

corresponding daily VAR measure.

(3) A bank must use the multiplication factor indicated in Table

1 of this appendix in determining its capital charge for market risk

under section 3(a)(2)(i)(B) of this appendix until it obtains the

next quarter's backtesting results, unless the Federal Reserve

determines that a different adjustment or other action is

appropriate.

Table 1.--Multiplication Factor Based on Results of Backtesting

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

Multiplication

Number of exceptions factor

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

4 or fewer.............................................. 3.00

5....................................................... 3.40

6....................................................... 3.50

7....................................................... 3.65

8....................................................... 3.75

9....................................................... 3.85

10 or more.............................................. 4.00

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

Section 5. Specific Risk

(a) Specific risk add-on. For purposes of section 3(a)(2)(ii) of

this appendix, a bank's specific risk add-on equals the standard

specific risk capital charge calculated under paragraph (c) of this

section. If, however, a bank can demonstrate to the Federal Reserve

that its internal model measures the specific risk of covered debt

and/or equity positions and that those measures are included in the

VAR-based capital charge in section 3(a)(2)(i) of this appendix,

then the bank may reduce or eliminate its specific risk add-on under

this section. The determination as to whether a model incorporates

specific risk must be made separately for covered debt and equity

positions.

(1) If a model includes the specific risk of covered debt

positions but not covered equity positions (or vice versa), then the

bank can reduce its specific risk charge for the included positions

under paragraph (b) of this section. The specific risk charge for

the positions not included equals the standard specific risk capital

charge under paragraph (c) of this section.

(2) If a model addresses the specific risk of both covered debt

and equity positions, then the bank can reduce its specific risk

charge for both covered debt and equity positions under paragraph

(b) of this section. In this case, the comparison described in

paragraph (b) of this section must be based on the total VAR-based

figure for the specific risk of debt and equity positions, taking

into account any correlations that are built into the model.

(b) VAR-based specific risk capital charge. In all cases where a

bank measures specific risk in its internal model, the total capital

charge for specific risk (i.e., the VAR-based specific risk capital

charge plus the specific risk add-on) must equal at least 50 percent

of the standard specific risk capital charge (this amount is the

minimum specific risk charge).

(1) If the portion of a bank's VAR measure that is attributable

to specific risk (multiplied by the bank's multiplication factor if

required in section 3(a)(2) of this appendix) is greater than or

equal to the minimum specific risk charge, then the bank has no

specific risk add-on and its capital charge for specific risk is the

portion included in the VAR measure.

(2) If the portion of a bank's VAR measure that is attributable

to specific risk (multiplied by the bank's multiplication factor if

required in section 3(a)(2) of this appendix) is less than the

minimum specific risk charge, then the bank's specific risk add-on

is the difference between the minimum specific risk charge and the

specific risk portion of the VAR measure (multiplied by the bank's

multiplication factor if required in section 3(a)(2) of this

appendix).

[[Page 47372]]

(c) Standard specific risk capital charge. The standard specific

risk capital charge equals the sum of the components for covered

debt and equity positions as follows:

(1) Covered debt positions. (i) For purposes of this section 5,

covered debt positions means fixed-rate or floating-rate debt

instruments located in the trading account and instruments located

in the trading account with values that react primarily to changes

in interest rates, including certain non-convertible preferred

stock, convertible bonds, and instruments subject to repurchase and

lending agreements. Also included are derivatives (including written

and purchased options) for which the underlying instrument is a

covered debt instrument that is subject to a non-zero specific risk

capital charge.

(A) For covered debt positions that are derivatives, a bank must

risk-weight (as described in paragraph (c)(1)(iii) of this section)

the market value of the effective notional amount of the underlying

debt instrument or index portfolio. Swaps must be included as the

notional position in the underlying debt instrument or index

portfolio, with a receiving side treated as a long position and a

paying side treated as a short position; and

(B) For covered debt positions that are options, whether long or

short, a bank must risk-weight (as described in paragraph

(c)(1)(iii) of this section) the market value of the effective

notional amount of the underlying debt instrument or index

multiplied by the option's delta.

(ii) A bank may net long and short covered debt positions

(including derivatives) in identical debt issues or indices.

(iii) A bank must multiply the absolute value of the current

market value of each net long or short covered debt position by the

appropriate specific risk weighting factor indicated in Table 2 of

this appendix. The specific risk capital charge component for

covered debt positions is the sum of the weighted values.

Table 2.--Specific Risk Weighting Factors for Covered Debt Positions

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

Weighting

Remaining maturity factor

Category (contractual) (in

percent)

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

Government.......................... N/A.................... 0.00

Qualifying.......................... 6 months or less....... 0.25

Over 6 months to 24 1.00

months.

Over 24 months......... 1.60

Other............................... N/A.................... 8.00

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

(A) The government category includes all debt instruments of

central governments of OECD-based countries 14 including bonds,

Treasury bills, and other short-term instruments, as well as local

currency instruments of non-OECD central governments to the extent

the bank has liabilities booked in that currency.

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

\14\ Organization for Economic Cooperation and Development

(OECD)-based countries is defined in appendix A of this part.

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

(B) The qualifying category includes debt instruments of U.S.

government-sponsored agencies, general obligation debt instruments

issued by states and other political subdivisions of OECD-based

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.15 This category

also includes other debt instruments, including corporate debt and

revenue instruments issued by states and other political

subdivisions of OECD countries, that are:

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

\15\ U.S. government-sponsored agencies, multilateral

development banks, and OECD banks are defined in appendix A of this

part.

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

(1) Rated investment-grade by at least two nationally recognized

credit rating services;

(2) Rated investment-grade by one nationally recognized credit

rating agency and not rated less than investment-grade by any other

credit rating agency; or

(3) Unrated, but deemed to be of comparable investment quality

by the reporting bank and the issuer has instruments listed on a

recognized stock exchange, subject to review by the Federal Reserve.

(C) The other category includes debt instruments that are not

included in the government or qualifying categories.

(2) Covered equity positions. (i) For purposes of this section

5, covered equity positions means equity instruments located in the

trading account and instruments located in the trading account with

values that react primarily to changes in equity prices, including

voting or non-voting common stock, certain convertible bonds, and

commitments to buy or sell equity instruments. Also included are

derivatives (including written and purchased options) for which the

underlying is a covered equity position.

(A) For covered equity positions that are derivatives, a bank

must risk weight (as described in paragraph (c)(2)(iii) of this

section) the market value of the effective notional amount of the

underlying equity instrument or equity portfolio. Swaps must be

included as the notional position in the underlying equity

instrument or index portfolio, with a receiving side treated as a

long position and a paying side treated as a short position; and

(B) For covered equity positions that are options, whether long

or short, a bank must risk weight (as described in paragraph

(c)(2)(iii) of this section) the market value of the effective

notional amount of the underlying equity instrument or index

multiplied by the option's delta.

(ii) A bank may net long and short covered equity positions

(including derivatives) in identical equity issues or equity indices

in the same market.16

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

\16\ A bank may also net positions in depository receipts

against an opposite position in the underlying equity or identical

equity in different markets, provided that the bank includes the

costs of conversion.

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

(iii)(A) A bank must multiply the absolute value of the current

market value of each net long or short covered equity position by a

risk weighting factor of 8.0 percent, or by 4.0 percent if the

equity is held in a portfolio that is both liquid and well-

diversified.17 For covered equity positions that are index

contracts comprising a well-diversified portfolio of equity

instruments, the net long or short position is multiplied by a risk

weighting factor of 2.0 percent.

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

\17\ A portfolio is liquid and well-diversified if: (1) It 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; (2) the volatility of the portfolio's value is not

dominated by the volatility of any individual equity issue or by

equity issues from any single industry or economic sector; (3) it

contains a large number of individual equity positions, with no

single position representing a substantial portion of the

portfolio's total market value; and (4) it consists mainly of issues

traded on organized exchanges or in well-established over-the-

counter markets.

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

(B) For covered equity positions from the following futures-

related arbitrage strategies, a bank may apply a 2.0 percent risk

weighting factor to one side (long or short) of each position with

the opposite side exempt from charge, subject to review by the

Federal Reserve:

(1) Long and short positions in exactly the same index at

different dates or in different market centers; or

(2) Long and short positions in index contracts at the same date

in different but similar indices.

(C) For futures contracts on broadly-based indices that are

matched by offsetting positions in a basket of stocks comprising the

index, a bank may apply a 2.0 percent risk weighting factor to the

futures and stock basket positions (long and short), provided that

such trades are deliberately entered into and separately controlled,

and that the basket of stocks comprises at least 90 percent of the

capitalization of the index.

(iv) The specific risk capital charge component for covered

equity positions is the sum of the weighted values.

PART 225--BANK HOLDING COMPANIES AND CHANGE IN BANK CONTROL

(REGULATION Y)

1. The authority citation for part 225 continues to read as

follows:

Authority: 12 U.S.C. 1817(j)(13), 1818, 1831i, 1831p-1,

1843(c)(8), 1844(b), 1972(l), 3106, 3108, 3310, 3331-3351, 3907, and

3909.

2. Appendix A is amended in the introductory text, by adding a new

paragraph after the second undesignated paragraph to read as follows:

Appendix A to Part 225--Capital Adequacy Guidelines for Bank Holding

Companies: Risk-Based Measure

* * * * *

In addition, when certain organizations that engage in trading

activities calculate their risk-based capital ratio under this

appendix A, they must also refer to appendix E of this part, which

incorporates capital charges for certain market risks into the risk-

based capital ratio. When calculating their risk-based capital ratio

under this appendix A, such organizations are required to refer to

[[Page 47373]]

appendix E of this part for supplemental rules to determine

qualifying and excess capital, calculate risk-weighted assets,

calculate market risk equivalent assets, and calculate risk-based

capital ratios adjusted for market risk.

* * * * *

3. A new appendix E is added to read as follows:

Appendix E to Part 225--Capital Adequacy Guidelines for Bank Holding

Companies: Market Risk Measure

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

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

holding companies (organizations) with significant exposure to

market risk maintain adequate capital to support that

exposure.1 This appendix supplements and adjusts the risk-based

capital ratio calculations under appendix A of this part with

respect to those organizations.

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

\1\ This appendix is based on a framework developed jointly by

supervisory authorities from the countries represented on the Basle

Committee on Banking Supervision and endorsed by the Group of Ten

Central Bank Governors. The framework is described in a Basle

Committee paper entitled ``Amendment to the Capital Accord to

Incorporate Market Risk,'' January 1996.

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

(b) Applicability. (1) This appendix applies to any bank holding

company whose trading activity 2 (on a worldwide consolidated

basis) equals:

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

\2\ Trading activity means the gross sum of trading assets and

liabilities as reported in the bank holding company's most recent

quarterly Y-9C Report.

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

(i) 10 percent or more of total assets; 3 or

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

\3\ Total assets means quarter-end total assets as reported in

the bank holding company's most recent Y-9C Report.

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

(ii) $1 billion or more.

(2) The Federal Reserve may additionally apply this appendix to

any bank holding company if the Federal Reserve deems it necessary

or appropriate for safe and sound banking practices.

(3) The Federal Reserve may exclude a bank holding company

otherwise meeting the criteria of paragraph (b)(1) of this section

from coverage under this appendix if it determines the organization

meets such criteria as a consequence of accounting, operational, or

similar considerations, and the Federal Reserve deems it consistent

with safe and sound banking practices.

(c) Scope. The capital requirements of this appendix support

market risk associated with an organization's covered positions.

(d) Effective date. This appendix is effective as of January 1,

1997. Compliance is not mandatory until January 1, 1998. Subject to

supervisory approval, a bank holding company may opt to comply with

this appendix as early as January 1, 1997.4

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

\4\ A bank holding company that voluntarily complies with the

final rule prior to January 1, 1998, must comply with all of its

provisions.

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

Section 2. Definitions

For purposes of this appendix, the following definitions apply:

(a) Covered positions means all positions in an organization's

trading account, and all foreign exchange 5 and commodity

positions, whether or not in the trading account.6 Positions

include on-balance-sheet assets and liabilities and off-balance-

sheet items. Securities subject to repurchase and lending agreements

are included as if still owned by the lender.

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

\5\ Subject to supervisory review, a bank may exclude structural

positions in foreign currencies from its covered positions.

\6\ The term trading account is defined in the instructions to

the Call Report.

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

(b) Market risk means the risk of loss resulting from movements

in market prices. Market risk consists of general market risk and

specific risk components.

(1) General market risk means changes in the market value of

covered positions resulting from broad market movements, such as

changes in the general level of interest rates, equity prices,

foreign exchange rates, or commodity prices.

(2) Specific risk means changes in the market value of specific

positions due to factors other than broad market movements and

includes such risk as the credit risk of an instrument's issuer.

(c) Tier 1 and Tier 2 capital are defined in appendix A of this

part.

(d) Tier 3 capital is subordinated debt that is unsecured; is

fully paid up; has an original maturity of at least two years; is

not redeemable before maturity without prior approval by the Federal

Reserve; includes a lock-in clause precluding payment of either

interest or principal (even at maturity) if the payment would cause

the issuing organization's risk-based capital ratio to fall or

remain below the minimum required under appendix A of this part; and

does not contain and is not covered by any covenants, terms, or

restrictions that are inconsistent with safe and sound banking

practices.

(e) Value-at-risk (VAR) means the estimate of the maximum amount

that the value of covered positions could decline due to market

price or rate movements during a fixed holding period within a

stated confidence level, measured in accordance with section 4 of

this appendix.

Section 3. Adjustments to the Risk-Based Capital Ratio Calculations

(a) Risk-based capital ratio denominator. An organization

subject to this appendix shall calculate its risk-based capital

ratio denominator as follows:

(1) Adjusted risk-weighted assets. Calculate adjusted risk-

weighted assets, which equals risk-weighted assets (as determined in

accordance with appendix A of this part) excluding the risk-weighted

amounts of all covered positions (except foreign exchange positions

outside the trading account and over-the-counter derivative

positions).7

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

\7\ Foreign exchange positions outside the trading account and

all over-the-counter derivative positions, whether or not in the

trading account, must be included in adjusted risk weighted assets

as determined in appendix A of this part.

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

(2) Measure for market risk. Calculate the measure for market

risk, which equals the sum of the VAR-based capital charge, the

specific risk add-on (if any), and the capital charge for de minimis

exposures (if any).

(i) VAR-based capital charge. The VAR-based capital charge

equals the higher of:

(A) The previous day's VAR measure; or

(B) The average of the daily VAR measures for each of the

preceding 60 business days multiplied by three, except as provided

in section 4(e) of this appendix;

(ii) Specific risk add-on. The specific risk add-on is

calculated in accordance with section 5 of this appendix; and

(iii) Capital charge for de minimis exposure. The capital charge

for de minimis exposure is calculated in accordance with section

4(a) of this appendix.

(3) Market risk equivalent assets. Calculate market risk

equivalent assets by multiplying the measure for market risk (as

calculated in paragraph (a)(2) of this section) by 12.5.

(4) Denominator calculation. Add market risk equivalent assets

(as calculated in paragraph (a)(3) of this section) to adjusted

risk-weighted assets (as calculated in paragraph (a)(1) of this

section). The resulting sum is the organization's risk-based capital

ratio denominator.

(b) Risk-based capital ratio numerator. An organization subject

to this appendix shall calculate its risk-based capital ratio

numerator by allocating capital as follows:

(1) Credit risk allocation. Allocate Tier 1 and Tier 2 capital

equal to 8.0 percent of adjusted risk-weighted assets (as calculated

in paragraph (a)(1) of this section).8

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

\8\ An institution may not allocate Tier 3 capital to support

credit risk (as calculated under appendix A of this part).

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

(2) Market risk allocation. Allocate Tier 1, Tier 2, and Tier 3

capital equal to the measure for market risk as calculated in

paragraph (a)(2) of this section. The sum of Tier 2 and Tier 3

capital allocated for market risk must not exceed 250 percent of

Tier 1 capital allocated for market risk. (This requirement means

that Tier 1 capital allocated in this paragraph (b)(2) must equal at

least 28.6 percent of the measure for market risk.)

(3) Restrictions. (i) The sum of Tier 2 capital (both allocated

and excess) and Tier 3 capital (allocated in paragraph (b)(2) of

this section) may not exceed 100 percent of Tier 1 capital (both

allocated and excess).9

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

\9\ Excess Tier 1 capital means Tier 1 capital that has not been

allocated in paragraphs (b)(1) and (b)(2) of this section. Excess

Tier 2 capital means Tier 2 capital that has not been allocated in

paragraph (b)(1) and (b)(2) of this section, subject to the

restrictions in paragraph (b)(3) of this section.

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

(ii) Term subordinated debt (and intermediate-term preferred

stock and related surplus) included in Tier 2 capital (both

allocated and excess) may not exceed 50 percent of Tier 1 capital

(both allocated and excess).

(4) Numerator calculation. Add Tier 1 capital (both allocated

and excess), Tier 2 capital (both allocated and excess), and Tier 3

capital (allocated under paragraph (b)(2) of this section). The

resulting sum is the organization's risk-based capital ratio

numerator.

Section 4. Internal Models

(a) General. For risk-based capital purposes, a bank holding

company subject to this appendix must use its internal model to

measure its daily VAR, in accordance with

[[Page 47374]]

the requirements of this section.10 The Federal Reserve may

permit an organization to use alternative techniques to measure the

market risk of de minimis exposures so long as the techniques

adequately measure associated market risk.

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

\10\ An organization's internal model may use any generally

accepted measurement techniques, such as variance-covariance models,

historical simulations, or Monte Carlo simulations. However, the

level of sophistication and accuracy of an organization's internal

model must be commensurate with the nature and size of its covered

positions. An organization that modifies its existing modeling

procedures to comply with the requirements of this appendix for

risk-based capital purposes should, nonetheless, continue to use the

internal model it considers most appropriate in evaluating risks for

other purposes.

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

(b) Qualitative requirements. A bank holding company subject to

this appendix must have a risk management system that meets the

following minimum qualitative requirements:

(1) The organization must have a risk control unit that reports

directly to senior management and is independent from business

trading units.

(2) The organization's internal risk measurement model must be

integrated into the daily management process.

(3) The organization's policies and procedures must identify,

and the organization must conduct, appropriate stress tests and

backtests.11 The organization's policies and procedures must

identify the procedures to follow in response to the results of such

tests.

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

\11\ Stress tests provide information about the impact of

adverse market events on a bank's covered positions. Backtests

provide information about the accuracy of an internal model by

comparing an organization's daily VAR measures to its corresponding

daily trading profits and losses.

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

(4) The organization must conduct independent reviews of its

risk measurement and risk management systems at least annually.

(c) Market risk factors. The organization's internal model must

use risk factors sufficient to measure the market risk inherent in

all covered positions. The risk factors must address interest rate

risk,12 equity price risk, foreign exchange rate risk, and

commodity price risk.

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

\12\ For material exposures in the major currencies and markets,

modeling techniques must capture spread risk and must incorporate

enough segments of the yield curve--at least six--to capture

differences in volatility and less than perfect correlation of rates

along the yield curve.

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

(d) Quantitative requirements. For regulatory capital purposes,

VAR measures must meet the following quantitative requirements:

(1) The VAR measures must be calculated on a daily basis using a

99 percent, one-tailed confidence level with a price shock

equivalent to a ten-business day movement in rates and prices. In

order to calculate VAR measures based on a ten-day price shock, the

organization may either calculate ten-day figures directly or

convert VAR figures based on holding periods other than ten days to

the equivalent of a ten-day holding period (for instance, by

multiplying a one-day VAR measure by the square root of ten).

(2) The VAR measures must be based on an historical observation

period (or effective observation period for an organization using a

weighting scheme or other similar method) of at least one year. The

organization must update data sets at least once every three months

or more frequently as market conditions warrant.

(3) The VAR measures must include the risks arising from the

non-linear price characteristics of options positions and the

sensitivity of the market value of the positions to changes in the

volatility of the underlying rates or prices. An organization with a

large or complex options portfolio must measure the volatility of

options positions by different maturities.

(4) The VAR measures may incorporate empirical correlations

within and across risk categories, provided that the organization's

process for measuring correlations is sound. In the event that the

VAR measures do not incorporate empirical correlations across risk

categories, then the organization must add the separate VAR measures

for the four major risk categories to determine its aggregate VAR

measure.

(e) Backtesting. (1) Beginning one year after a bank holding

company starts to comply with this appendix, it must conduct

backtesting by comparing each of its most recent 250 business days'

actual net trading profit or loss 13 with the corresponding

daily VAR measures generated for internal risk measurement purposes

and calibrated to a one-day holding period and a 99th percentile,

one-tailed confidence level.

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

\13\ Actual net trading profits and losses typically include

such things as realized and unrealized gains and losses on portfolio

positions as well as fee income and commissions associated with

trading activities.

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

(2) Once each quarter, the organization must identify the number

of exceptions, that is, the number of business days for which the

magnitude of the actual daily net trading loss, if any, exceeds the

corresponding daily VAR measure.

(3) A bank holding company must use the multiplication factor

indicated in Table 1 of this appendix in determining its capital

charge for market risk under section 3(a)(2)(i)(B) of this appendix

until it obtains the next quarter's backtesting results, unless the

Federal Reserve determines that a different adjustment or other

action is appropriate.

Table 1.--Multiplication Factor Based on Results of Backtesting

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

Multiplication

Number of exceptions factor

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

4 or fewer.............................................. 3.00

5....................................................... 3.40

6....................................................... 3.50

7....................................................... 3.65

8....................................................... 3.75

9....................................................... 3.85

10 or more.............................................. 4.00

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

Section 5. Specific Risk

(a) Specific risk add-on. For purposes of section 3(a)(2)(ii) of

this appendix, a bank holding company's specific risk add-on equals

the standard specific risk capital charge calculated under paragraph

(c) of this section. If, however, an organization can demonstrate to

the Federal Reserve that its internal model measures the specific

risk of covered debt and/or equity positions and that those measures

are included in the VAR-based capital charge in section 3(a)(2)(i)

of this appendix, then it may reduce or eliminate its specific risk

add-on under this section. The determination as to whether a model

incorporates specific risk must be made separately for covered debt

and equity positions.

(1) If a model includes the specific risk of covered debt

positions but not covered equity positions (or vice versa), then the

organization can reduce its specific risk charge for the included

positions under paragraph (b) of this section. The specific risk

charge for the positions not included equals the standard specific

risk capital charge under paragraph (c) of this section.

(2) If a model addresses the specific risk of both covered debt

and equity positions, then the organization can reduce its specific

risk charge for both covered debt and equity positions under

paragraph (b) of this section. In this case, the comparison

described in paragraph (b) of this section must be based on the

total VAR-based figure for the specific risk of debt and equity

positions, taking account of any correlations that are built into

the model.

(b) VAR-based specific risk capital charge. In all cases where a

bank holding company measures specific risk in its internal model,

the total capital charge for specific risk (i.e., the VAR-based

specific risk capital charge plus the specific risk add-on) must

equal at least 50 percent of the standard specific risk capital

charge (this amount is the minimum specific risk charge).

(1) If the portion of an organization's VAR measure that is

attributable to specific risk (multiplied by the organization's

multiplication factor if required in section 3(a)(2) of this

appendix) is greater than or equal to the minimum specific risk

charge, then the organization has no specific risk add-on and its

capital charge for specific risk is the portion included in the VAR

measure.

(2) If the portion of an organization's VAR measure that is

attributable to specific risk (multiplied by the organization's

multiplication factor if required in section 3(a)(2) of this

appendix) is less than the minimum specific risk charge, then the

organization's specific risk add-on is the difference between the

minimum specific risk charge and the specific risk portion of the

VAR measure (multiplied by the multiplication factor if required in

section 3(a)(2) of this appendix).

(c) Standard specific risk capital charge. The standard specific

risk capital charge equals the sum of the components for covered

debt and equity positions as follows:

(1) Covered debt positions. (i) For purposes of this section 5,

covered debt positions means fixed-rate or floating-rate debt

instruments located in the trading account or instruments located in

the trading account with values that react primarily to changes in

interest rates, including certain non-

[[Page 47375]]

convertible preferred stock, convertible bonds, and instruments

subject to repurchase and lending agreements. Also included are

derivatives (including written and purchased options) for which the

underlying instrument is a covered debt instrument that is subject

to a non-zero specific risk capital charge.

(A) For covered debt positions that are derivatives, an

organization must risk-weight (as described in paragraph (c)(1)(iii)

of this section) the market value of the effective notional amount

of the underlying debt instrument or index portfolio. Swaps must be

included as the notional position in the underlying debt instrument

or index portfolio, with a receiving side treated as a long position

and a paying side treated as a short position; and

(B) For covered debt positions that are options, whether long or

short, an organization must risk-weight (as described in paragraph

(c)(1)(iii) of this section) the market value of the effective

notional amount of the underlying debt instrument or index

multiplied by the option's delta.

(ii) An organization may net long and short covered debt

positions (including derivatives) in identical debt issues or

indices.

(iii) An organization must multiply the absolute value of the

current market value of each net long or short covered debt position

by the appropriate specific risk weighting factor indicated in Table

2 of this appendix. The specific risk capital charge component for

covered debt positions is the sum of the weighted values.

Table 2.--Specific Risk Weighting Factors for Covered Debt Positions

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

Weighting

Remaining maturity factor

Category (contractual) (in

percent)

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

Government.......................... N/A.................... 0.00

Qualifying.......................... 6 months or less....... 0.25

Over 6 months to 24 1.00

months.

Over 24 months......... 1.60

Other............................... N/A.................... 8.00

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

(A) The government category includes all debt instruments of

central governments of OECD-based countries 14 including bonds,

Treasury bills, and other short-term instruments, as well as local

currency instruments of non-OECD central governments to the extent

the organization has liabilities booked in that currency.

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\14\ Organization for Economic Cooperation and Development

(OECD)-based countries is defined in appendix A of this part.

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(B) The qualifying category includes debt instruments of U.S.

government-sponsored agencies, general obligation debt instruments

issued by states and other political subdivisions of OECD-based

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.15 This category

also includes other debt instruments, including corporate debt and

revenue instruments issued by states and other political

subdivisions of OECD countries, that are:

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\15\ U.S. government-sponsored agencies, multilateral

development banks, and OECD banks are defined in appendix A of this

part.

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(1) Rated investment-grade by at least two nationally recognized

credit rating services;

(2) Rated investment grade by one nationally recognized credit

rating agency and not rated less than investment grade by any other

credit rating agency; or

(3) Unrated, but deemed to be of comparable investment quality

by the reporting organization and the issuer has instruments listed

on a recognized stock exchange, subject to review by the Federal

Reserve.

(C) The other category includes debt instruments that are not

included in the government or qualifying categories.

(2) Covered equity positions. (i) For purposes of this section

5, covered equity positions means equity instruments located in the

trading account and instruments located in the trading account with

values that react primarily to changes in equity prices, including

voting or non-voting common stock, certain convertible bonds, and

commitments to buy or sell equity instruments. Also included are

derivatives (including written or purchased options) for which the

underlying is a covered equity position.

(A) For covered equity positions that are derivatives, an

organization must risk weight (as described in paragraph (c)(2)(iii)

of this section) the market value of the effective notional amount

of the underlying equity instrument or equity portfolio. Swaps must

be included as the notional position in the underlying equity

instrument or index portfolio, with a receiving side treated as a

long position and a paying side treated as a short position; and

(B) For covered equity positions that are options, whether long

or short, an organization must risk weight (as described in

paragraph (c)(2)(iii) of this section) the market value of the

effective notional amount of the underlying equity instrument or

index multiplied by the option's delta.

(ii) An organization may net long and short covered equity

positions (including derivatives) in identical equity issues or

equity indices in the same market.16

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\16\ An organization may also net positions in depository

receipts against an opposite position in the underlying equity or

identical equity in different markets, provided that the

organization includes the costs of conversion.

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(iii)(A) An organization must multiply the absolute value of the

current market value of each net long or short covered equity

position by a risk weighting factor of 8.0 percent, or by 4.0

percent if the equity is held in a portfolio that is both liquid and

well-diversified.17 For covered equity positions that are index

contracts comprising a well-diversified portfolio of equity

instruments, the net long or short position is to be multiplied by a

risk weighting factor of 2.0 percent.

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\17\ A portfolio is liquid and well-diversified if: (1) it 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; (2) the volatility of the portfolio's value is not

dominated by the volatility of any individual equity issue or by

equity issues from any single industry or economic sector; (3) it

contains a large number of individual equity positions, with no

single position representing a substantial portion of the

portfolio's total market value; and (4) it consists mainly of issues

traded on organized exchanges or in well-established over-the-

counter markets.

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(B) For covered equity positions from the following futures-

related arbitrage strategies, an organization may apply a 2.0

percent risk weighting factor to one side (long or short) of each

equity position with the opposite side exempt from charge, subject

to review by the Federal Reserve:

(1) Long and short positions in exactly the same index at

different dates or in different market centers; or

(2) Long and short positions in index contracts at the same date

in different but similar indices.

(C) For futures contracts on broadly-based indices that are

matched by offsetting positions in a basket of stocks comprising the

index, an organization may apply a 2.0 percent risk weighting factor

to the futures and stock basket positions (long and short), provided

that such trades are deliberately entered into and separately

controlled, and that the basket of stocks comprises at least 90

percent of the capitalization of the index.

(iv) The specific risk capital charge component for covered

equity positions is the sum of the weighted values.

By order of the Board of Governors of the Federal Reserve

System, August 29, 1996.

William W. Wiles,

Secretary of the Board.

Federal Deposit Insurance Corporation

12 CFR CHAPTER III

For the reasons indicated in the preamble, the FDIC Board of

Directors hereby amends part 325 of chapter III of title 12 of the Code

of Federal Regulations as follows.

PART 325--[AMENDED]

1. The authority citation for part 325 continues to read as

follows:

Authority: 12 U.S.C. 1815(a), 1815(b), 1816, 1818(a), 1818(b),

1818(c), 1818(t), 1819(Tenth), 1828(c), 1828(d), 1828(i), 1828(n),

1828(o), 1831o, 3907, 3909, 4808; Pub. L. 102-233, 105 Stat. 1761,

1789, 1790 (12 U.S.C. 1831n note); Pub. L. 102-242, 105 Stat. 2236,

2355, 2386 (12 U.S.C. 1828 note).

2. Appendix A to part 325 is amended in the introductory text, by

adding a new paragraph after the third undesignated paragraph to read

as follows:

Appendix A to Part 325--Statement of Policy on Risk-Based Capital

* * * * *

In addition, when certain banks that engage in trading

activities calculate their risk-based capital ratio under this

appendix A, they must also refer to appendix C of this

[[Page 47376]]

part, which incorporates capital charges for certain market risks

into the risk-based capital ratio. When calculating their risk-based

capital ratio under this appendix A, such banks are required to

refer to appendix C of this part for supplemental rules to determine

qualifying and excess capital, calculate risk-weighte

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