# Risk-Based Capital Guidelines; Capital Adequacy Guidelines: Standardized Framework > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/fr%3AE8-16262 ## Record - **Collection:** Federal Register - **Document type:** Proposed Rule - **Published:** July 29, 2008 - **Citation:** 73 FR 43982 ## Text DEPARTMENT OF THE TREASURY Office of the Comptroller of the Currency 12 CFR Part 3 [Docket ID: OCC-2008-0006] RIN 1557-AD07 FEDERAL RESERVE SYSTEM 12 CFR Parts 208 and 225 [Regulations H and Y; Docket No. R-1318] FEDERAL DEPOSIT INSURANCE CORPORATION 12 CFR Part 325 RIN 3064-AD29 DEPARTMENT OF THE TREASURY Office of Thrift Supervision 12 CFR Part 567 [No. 2008-002] RIN 1550-AC19 Risk-Based Capital Guidelines; Capital Adequacy Guidelines: Standardized Framework AGENCIES: Office of the Comptroller of the Currency, Treasury; Board of Governors of the Federal Reserve System; Federal Deposit Insurance Corporation; and Office of Thrift Supervision, Treasury. ACTION: Joint notice of proposed rulemaking. SUMMARY: The Office of the Comptroller of the Currency (OCC), Board of Governors of the Federal Reserve System (Board), Federal Deposit Insurance Corporation (FDIC), and Office of Thrift Supervision (OTS) (collectively, the agencies) propose a new risk-based capital framework (standardized framework) based on the standardized approach for credit risk and the basic indicator approach for operational risk described in the capital adequacy framework titled “International Convergence of Capital Measurement and Capital Standards: A Revised Framework” (New Accord) released by the Basel Committee on Banking Supervision. The standardized framework generally would be available, on an optional basis, to banks, bank holding companies, and savings associations (banking organizations) that apply the general risk-based capital rules. DATES: Comments on this joint notice of proposed rulemaking must be received by October 27, 2008. ADDRESSES: Comments should be directed to: OCC: Because paper mail in the Washington, DC area and at the OCC is subject to delay, commenters are encouraged to submit comments by e-mail, if possible. Please use the title “Risk-Based Capital Guidelines; Capital Adequacy Guidelines: Standardized Framework; Proposed Rule and Notice” to facilitate the organization and distribution of the comments. You may submit comments by any of the following methods: • Federal eRulemaking Portal—“Regulations.gov”: Go to http://www.regulations.gov , under the “More Search Options” tab click next to the “Advanced Docket Search” option where indicated, select “Comptroller of the Currency” from the agency drop-down menu, then click “Submit.” In the “Docket ID” column, select OCC-2008-0006 to submit or view public comments and to view supporting and related materials for this notice of proposed rulemaking. The “How to Use This Site” link on the Regulations.gov home page provides information on using Regulations.gov, including instructions for submitting or viewing public comments, viewing other supporting and related materials, and viewing the docket after the close of the comment period. • E-mail: regs.comments@occ.treas.gov. • Mail: Office of the Comptroller of the Currency, 250 E Street, SW., Mail Stop 1-5, Washington, DC 20219. • Fax: (202) 874-4448. • Hand Delivery/Courier: 250 E Street, SW., Attn: Public Information Room, Mail Stop 1-5, Washington, DC 20219. Instructions: You must include “OCC” as the agency name and “Docket Number OCC-2008-0006” in your comment. In general, OCC will enter all comments received into the docket and publish them on the Regulations.gov Web site without change, including any business or personal information that you provide such as name and address information, e-mail addresses, or phone numbers. Comments received, including attachments and other supporting materials, are part of the public record and subject to public disclosure. Do not enclose any information in your comment or supporting materials that you consider confidential or inappropriate for public disclosure. You may review comments and other related materials that pertain to this [insert type of rulemaking action] by any of the following methods: • Viewing Comments Electronically: Go to http://www.regulations.gov , under the “More Search Options” tab click next to the “Advanced Document Search” option where indicated, select “Comptroller of the Currency” from the agency drop-down menu, then click “Submit.” In the “Docket ID” column, select “OCC-2008-0006” to view public comments for this rulemaking action. • Viewing Comments Personally: You may personally inspect and photocopy comments at the OCC's Public Information Room, 250 E Street, SW., Washington, DC. For security reasons, the OCC requires that visitors make an appointment to inspect comments. You may do so by calling (202) 874-5043. Upon arrival, visitors will be required to present valid government-issued photo identification and submit to security screening in order to inspect and photocopy comments. • Docket: You may also view or request available background documents and project summaries using the methods described above. Board: You may submit comments, identified by Docket No. R-1318, by any of the following methods: • Agency Web Site: http://www.federalreserve.gov. Follow the instructions for submitting comments at http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm. • Federal eRulemaking Portal: http://www.regulations.gov. Follow the instructions for submitting comments. • E-mail: regs.comments@federalreserve.gov. Include docket number in the subject line of the message. • FAX: (202) 452-3819 or (202) 452-3102. • Mail: Jennifer J. Johnson, Secretary, Board of Governors of the Federal Reserve System, 20th Street and Constitution Avenue, NW., Washington, DC 20551. All public comments are available from the Board's Web site at http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm as submitted, unless modified for technical reasons. Accordingly, your comments will not be edited to remove any identifying or contact information. Public comments may also be viewed electronically or in paper form in Room MP-500 of the Board's Martin Building (20th and C Street, NW.) between 9 a.m. and 5 p.m. on weekdays. FDIC: You may submit by any of the following methods: • Federal eRulemaking Portal: http://www.regulations.gov Follow the instructions for submitting comments. • Agency Web site: http://www.FDIC.gov/regulations/laws/federal/propose.html. • Mail: Robert E. Feldman, Executive Secretary, Attention: Comments/Legal ESS, Federal Deposit Insurance Corporation, 550 17th Street, NW., Washington, DC 20429. • Hand Delivered/Courier: The guard station at the rear of the 550 17th Street Building (located on F Street), on business days between 7 a.m. and 5 p.m. • E-mail: comments@FDIC.gov. • Public Inspection: Comments may be inspected and photocopied in the FDIC Public Information Center, Room E-1002, 3502 Fairfax Drive, Arlington, VA 22226, between 9 a.m. and 5 p.m. on business days. Instructions: Submissions received must include the Agency name and title for this notice. Comments received will be posted without change to http://www.FDIC.gov/regulations/laws/federal/propose.html , including any personal information provided. OTS: You may submit comments, identified by OTS-2008-0002, by any of the following methods: • Federal eRulemaking Portal: “Regulations.gov”: Go to http://www.regulations.gov , under the “more Search Options” tab click next to the “Advanced Docket Search” option where indicated, select “Office of Thrift Supervision” from the agency dropdown menu, then click “Submit.” In the “Docket ID” column, select “OTS-2008-0002” to submit or view public comments and to view supporting and related materials for this proposed rulemaking. The “How to Use This Site” link on the Regulations.gov home page provides information on using Regulations.gov, including instructions for submitting or viewing public comments, viewing other supporting and related materials, and viewing the docket after the close of the comment period. • Mail: Regulation Comments, Chief Counsel's Office, Office of Thrift Supervision, 1700 G Street, NW., Washington, DC 20552, Attention: OTS-2008-0002. • Facsimile: (202) 906-6518. • Hand Delivery/Courier: Guard's Desk, East Lobby Entrance, 1700 G Street, NW., from 9 a.m. to 4 p.m. on business days, Attention: Regulation Comments, Chief Counsel's Office, Attention: OTS-2008-0002. • Instructions: All submissions received must include the agency name and docket number for this rulemaking. All comments received will be entered into the docket and posted on Regulations.gov without change, including any personal information provided. Comments, including attachments and other supporting materials received are part of the public record and subject to public disclosure. Do not enclose any information in your comment or supporting materials that you consider confidential or inappropriate for public disclosure. • Viewing Comments Electronically: Go to http://www.regulations.gov , select “Office of Thrift Supervision” from the agency drop-down menu, then click “Submit.” Select Docket ID “OTS-2008-0002” to view public comments for this notice of proposed rulemaking. • Viewing Comments On-Site: You may inspect comments at the Public Reading Room, 1700 G Street, NW., by appointment. To make an appointment for access, call (202) 906-5922, send an e-mail to public.info@ots.treas.gov , or send a facsimile transmission to (202) 906-6518. (Prior notice identifying the materials you will be requesting will assist us in serving you.) We schedule appointments on business days between 10 a.m. and 4 p.m. In most cases, appointments will be available the next business day following the date we receive a request. FOR FURTHER INFORMATION CONTACT: OCC: Margot Schwadron, Senior Risk Expert, (202) 874-6022, Capital Policy Division; Carl Kaminski, Attorney; or Ron Shimabukuro, Senior Counsel, Legislative and Regulatory Activities Division, (202) 874-5090; Office of the Comptroller of the Currency, 250 E Street, SW., Washington, DC 20219. Board: Barbara Bouchard, Associate Director, (202) 452-3072; or William Tiernay, Senior Supervisory Financial Analyst, (202) 872-7579, Division of Banking Supervision and Regulation; or Mark E. Van Der Weide, Assistant General Counsel, (202) 452-2263; or April Snyder, Counsel, (202) 452-3099, Legal Division. For the hearing impaired only, Telecommunication Device for the Deaf (TDD), (202) 263-4869. FDIC: Nancy Hunt, Senior Policy Analyst, (202) 898-6643; Ryan Sheller, Capital Markets Specialist, (202) 898-6614; or Bobby R. Bean, Chief, Policy Section, Capital Markets Branch, (202) 898-3575, Division of Supervision and Consumer Protection; or Benjamin W. McDonough, Senior Attorney, (202) 898-7411, or Michael B. Phillips, Counsel, (202) 898-3581, Supervision and Legislation Branch, Legal Division, Federal Deposit Insurance Corporation, 550 17th Street, NW., Washington, DC 20429. OTS: Michael Solomon, Director, Capital Policy Division, (202) 906-5654; or Teresa Scott, Senior Project Manager, Capital Policy Division, (202) 906-6478, Office of Thrift Supervision, 1700 G Street, NW., Washington, DC 20552. SUPPLEMENTARY INFORMATION: Table of Contents I. Background II. Proposed Rule A. Applicability of the Standardized Framework B. Reservation of Authority C. Principle of Conservatism D. Merger and Acquisition Transition Provisions E. Calculation of Tier 1 and Total Qualifying Capital F. Calculation of Risk-Weighted Assets 1. Total Risk-Weighted Assets 2. Calculation of Risk-Weighted Assets for General Credit Risk 3. Calculation of Risk-Weighted Assets for Unsettled Transactions, Securitization Exposures, and Equity Exposures 4. Calculation of Risk-Weighted Assets for Operational Risk G. External and Inferred Ratings 1. Overview 2. Use of External Ratings H. Risk-Weight Categories 1. Exposures to Sovereign Entities 2. Exposures to Certain Supranational Entities and Multilateral Development Banks (MDBs) 3. Exposures to Depository Institutions, Foreign Banks, and Credit Unions 4. Exposures to Public Sector Entities (PSEs) 5. Corporate Exposures 6. Regulatory Retail Exposures 7. Residential Mortgage Exposures 8. Pre-Sold Construction Loans and Statutory Multifamily Mortgages 9. Past Due Loans 10. Other Assets I.Off-Balance Sheet Items J. OTC Derivative Contracts 1. Background 2. Treatment of OTC Derivative Contracts 3. Counterparty Credit Risk for Credit Derivatives 4. Counterparty Credit Risk for Equity Derivatives 5. Risk Weight for OTC Derivative Contracts K. Credit Risk Mitigation (CRM) 1. Guarantees and Credit Derivatives 2. Collateralized Transactions L. Unsettled Transactions M. Risk-Weighted Assets for Securitization Exposures 1. Securitization Overview and Definitions 2. Operational Requirements 3. Hierarchy of Approaches 4. Ratings-Based Approach (RBA) 5. Exposures that Do Not Qualify for the RBA 6. CRM for Securitization Exposures 7. Risk-Weighted Assets for Early Amortization Provisions 8. Maximum Capital Requirement N. Equity Exposures 1. Introduction and Exposure Measurement 2. Hedge Transactions 3. Measures of Hedge Effectiveness 4. Simple Risk-Weight Approach (SRWA) 5. Non-Significant Equity Exposures 6. Equity Exposures to Investment Funds 7. Full Look-Through Approach 8. Simple Modified Look-Through Approach 9. Alternative Modified Look-Through Approach 10. Money Market Fund Approach O. Operational Risk 1. Basic Indicator Approach (BIA) 2. Advanced Measurement Approach (AMA) P. Supervisory Oversight and Internal Capital Adequacy Assessment Q. Market Discipline 1. Overview 2. General Requirements 3. Frequency/Timeliness 4. Location of Disclosures and Audit/Certification Requirements 5. Proprietary and Confidential Information 6. Summary of Specific Public Disclosure Requirements III. Regulatory Analysis A. Regulatory Flexibility Act Analysis B. OCC Executive Order 12866 Determination C. OTS Executive Order 12866 Determination D. OCC Executive Order 13132 Determination E. Paperwork Reduction Act F. OCC Unfunded Mandates Reform Act of 1995 Determination G. OTS Unfunded Mandates Reform Act of 1995 Determination H. Solicitation of Comments on Use of Plain Language I. Background In 1989, the agencies implemented a risk-based capital framework for U.S. banking organizations (general risk-based capital rules). 1 The agencies based the framework on the “International Convergence of Capital Measurement and Capital Standards” (Basel I), released by the Basel Committee on Banking Supervision (Basel Committee) 2 in 1988. The general risk-based capital rules established a uniform risk-based capital system that was more risk sensitive and addressed several shortcomings in the capital regimes the agencies used prior to 1989. 1 12 CFR part 3, Appendix A (OCC); 12 CFR parts 208 and 225, Appendix A (Board); 12 CFR part 325, Appendix A (FDIC); and 12 CFR part 567, subpart B (OTS). The risk-based capital rules generally do not apply to bank holding companies with less than $500 million in assets. 71 FR 9897 (February 28, 2006). 2 The Basel Committee was established in 1974 by central banks and governmental authorities with bank supervisory responsibilities. Current member countries are Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom, and the United States. In June 2004, the Basel Committee introduced a new capital adequacy framework, the New Accord, 3 that is designed to promote improved risk measurement and management processes and better align minimum risk-based capital requirements with risk. The New Accord includes three options for calculating risk-based capital requirements for credit risk and three options for operational risk. For credit risk, the three approaches are: standardized, foundation internal ratings-based, and advanced internal ratings-based. For operational risk, the three approaches are: basic indicator (BIA), standardized, and advanced measurement (AMA). The advanced internal ratings-based approach and the AMA together are referred to as the “advanced approaches.” 3 “International Convergence of Capital Measurement and Capital Standards, A Revised Framework, Comprehensive Version,” the Basel Committee on Banking Supervision, June 2006. The text is available on the Bank for International Settlements Web site at http://www.bis.org/publ/bcbs128.htm . On September 25, 2006, the agencies issued a notice of proposed rulemaking to implement the advanced approaches in the United States (advanced approaches NPR). 4 Many of the commenters on the advanced approaches NPR requested that the agencies harmonize certain provisions of the agencies' proposal with the New Accord and offer the standardized approach in the United States. A number of these commenters supported making the standardized approach available for all U.S. banking organizations. 4 71 FR 55830 (September 25, 2006). On December 7, 2007, the agencies issued a final rule implementing the advanced approaches (advanced approaches final rule). 5 The advanced approaches final rule is mandatory for certain banking organizations and voluntary for others. In general, the advanced approaches final rule requires a banking organization that has consolidated total assets of $250 billion or more, has consolidated on-balance sheet foreign exposure of $10 billion or more, or is a subsidiary or parent of an organization that uses the advanced approaches (core banking organization) to implement the advanced approaches. The implementation of the advanced approaches has created a bifurcated regulatory capital framework in the United States: one set of risk-based capital rules for banking organizations using the advanced approaches (advanced approaches organizations), and another set for banking organizations that do not use the advanced approaches (general banking organizations). 5 72 FR 69288 (December 7, 2007). On December 26, 2006, the agencies issued a notice of proposed rulemaking (Basel IA NPR), which proposed modifications to the general risk-based capital rules for general banking organizations. 6 One objective of the Basel IA NPR was to enhance the risk sensitivity of the risk-based capital rules without imposing undue regulatory burden. Specifically, the agencies proposed to increase the number of risk-weight categories, expand the use of external ratings for assigning risk weights, broaden recognition of collateral and guarantors, use loan-to-value ratios (LTV ratios) to risk weight most residential mortgages, increase the credit conversion factor for various short-term commitments, assess a risk-based capital requirement for early amortizations in securitizations of revolving retail exposures, and remove the 50 percent risk-weight limit for derivative transactions. The Basel IA NPR also sought comment on the extent to which certain advanced approaches organizations should be permitted to use approaches other than the advanced approaches in the New Accord. 6 71 FR 77446 (December 26, 2006). Most commenters on the Basel IA NPR supported the agencies' goal to make the general risk-based capital rules more risk sensitive without adding undue regulatory burden. However, a number of the commenters representing a broad range of U.S. banking organizations and trade associations urged the agencies to implement the New Accord's standardized approach for credit risk in the United States. These commenters generally stated that the standardized approach is more risk sensitive than the Basel IA NPR and would more appropriately address the industry's concerns regarding domestic and international competitiveness. Most of these commenters requested that the U.S. implementation of the standardized approach closely follow the New Accord. Certain commenters also requested that the agencies make some or all of the other options for credit risk and operational risk in the New Accord available in the United States. For example, some commenters preferred implementation of the standardized approach without a separate capital requirement for operational risk. Other commenters supported including one or more of the approaches in the New Accord for operational risk. II. Proposed Rule After considering the comments on both the Basel IA and the advanced approaches NPRs, the agencies have decided not to finalize the Basel IA NPR and to propose instead a new risk-based capital framework that would implement the standardized approach for credit risk, the BIA for operational risk, and related disclosure requirements (collectively, this NPR or this proposal). This NPR generally parallels the relevant approaches in the New Accord. This NPR, however, diverges from the New Accord where the U.S. markets have unique characteristics and risk profiles, notably the proposal for risk weighting residential mortgage exposures. The agencies have also sought to make this NPR consistent where relevant with the advanced approaches final rule. This NPR would not modify how a banking organization that uses the standardized framework would calculate its leverage ratio requirement. 7 Banking organizations face risks other than credit and operational risks that neither the New Accord nor this NPR addresses. The leverage ratio is a straightforward measure of solvency that supplements the risk-based capital requirements. Consequently, the agencies continue to view the tier 1 leverage ratio and other prudential safeguards such as Prompt Corrective Action as important components of the regulatory capital regime. 7 12 CFR 3.6(b) and (c)(OCC); 12 CFR part 208, Appendix B and 12 CFR part 225, Appendix D (Board); 12 CFR 325.3 (FDIC); and 12 CFR 567.8 (OTS). Question 1a: The agencies seek comments on all aspects of this proposal, including risk sensitivity, regulatory burden, and competitive impact . The agencies' general risk-based capital rules permit the use of external ratings issued by a nationally recognized statistical rating organization (NRSRO) to assign risk weights to recourse obligations, direct credit substitutes, certain residual interests, and asset- and mortgage-backed securities. The New Accord permits a banking organization to use external ratings to determine risk weights for a broad range of exposures, including sovereign, bank, corporate, and securitization exposures. It also provides, within certain limitations, for the use of both inferred ratings and issuer ratings. As discussed in more detail later in this preamble, the agencies propose that external, issuer, and inferred ratings be used to risk weight various exposures. While the agencies believe that the use of ratings proposed in this NPR can contribute to a more risk-sensitive framework, they are aware of the limitations associated with using credit ratings for risk-based capital purposes and, thus, are particularly interested in comments on the use of such ratings for those purposes. Numerous bank supervisory groups and committees, including the Basel Committee on Banking Supervision, the Financial Stability Forum, and the Senior Supervisors Group, have undertaken work to better understand the causes for and possible responses to the recent market events, discussing, among numerous other issues, the role of credit ratings. In addition, in March, the President's Working Group on Financial Markets (PWG) issued its report titled “Policy Statement on Financial Market Developments,” providing an analysis of the underlying factors contributing to the recent market stress and a set of recommendations to address identified weaknesses. Among its recommendations, the PWG encouraged regulators, including the Federal banking agencies, to review the current use of credit ratings in the regulation and supervision of financial institutions. In this regard, the PWG policy statement noted that certain investors and asset managers failed to obtain sufficient information or to conduct comprehensive risk assessments, with some investors relying exclusively on credit ratings for valuation purposes. More generally, the PWG statement also noted market participants, including originators, underwriters, asset managers, credit rating agencies, and investors, failed to obtain sufficient information or to conduct comprehensive risk assessments on complex instruments, including securitized credits and their underlying asset pools. The PWG policy statement also acknowledged the steps already taken by credit rating agencies to improve the performance of credit ratings and encouraged additional actions, potentially including the publication of sufficient information about the assumptions underlying their credit rating methodologies; changes to the credit rating process to clearly differentiate ratings for structured products from ratings for corporate and municipal securities; and ratings performance measures for structured credit products and other asset-backed securities readily available to the public in a manner that facilitates comparisons across products and credit ratings. Most directly relevant to this NPR, the agencies were encouraged to reinforce steps taken by the credit rating agencies through revisions to supervisory policy and regulation, including regulatory capital requirements that use ratings. At a minimum, regulators were urged to distinguish, as appropriate, between ratings of structured credit products and ratings of corporate and municipal bonds in regulatory and supervisory policies. Question 1b: The agencies seek comment on the advantages and disadvantages of the use of external credit ratings in risk-based capital requirements for banking organizations and whether identified weakness in the credit rating process suggests the need to change or enhance any of the proposals in this NPR. The agencies also seek comment on whether additional refinements to the proposals in the NPR should be considered to address more broadly the prudent use of credit ratings by banking organizations. For example, should there be operational conditions for banking organizations to make use of credit ratings in determining risk-based capital requirements, enhancements to minimum capital requirements, or modifications to the supervisory review process? The agencies also note that efforts are underway by the BCBS to review the treatment in the New Accord for certain off-balance sheet conduits, resecuritizations, such as collateralized debt obligations referencing asset-backed securities, and other securitization-related risks. The agencies are fully committed to working with the BCBS in this regard and also intend to review the agencies' current approach to securitization transactions to assess whether modifications might be needed. This review will take into account lessons learned from recent market-related events and may result in additional proposals for modification to the risk-based capital rules. Question 1c: The agencies seek commenters' views on what changes to the approaches set forth in this NPR, if any, should be considered as a result of recent market events, particularly with respect to the securitization framework described in this NPR . A. Applicability of the Standardized Framework Most commenters on the Basel IA NPR favored its opt-in approach, whereby a banking organization could voluntarily decide whether or not to use the proposed rules. They supported the flexibility of the opt-in provision and the ability of a general banking organization to remain under the general risk-based capital rules. Commenters observed that many banking organizations choose to hold capital well in excess of regulatory minimums and would not necessarily benefit from a more risk-sensitive capital rule. For these commenters, limiting regulatory burden was a higher priority than increasing the risk sensitivity of their risk-based capital requirements. The agencies acknowledge this concern and propose to make the standardized framework optional for banking organizations that do not use the advanced approaches final rule to calculate their risk-based capital requirements. 8 Under this NPR, a banking organization that opts to use the standardized framework generally would have to notify its primary Federal supervisor in writing of its intent to use the new rules at least 60 days before the beginning of the calendar quarter in which it first uses the standardized framework. This notice must include a list of any affiliated depository institutions or bank holding companies, if applicable, that seek supervisory exemption from the use of the standardized framework. Before it notifies its primary Federal supervisor, the banking organization should review its ability to implement the proposed rule and evaluate the potential impact on its regulatory capital. 8 The agencies are not proposing in this NPR to make this standardized framework available to banking organizations for which the application of the advanced approaches final rule is mandatory, unless such a banking organization is exempted in writing from the advanced approaches final rule by its primary Federal supervisor. Under this proposal, a banking organization that opts to use this standardized framework could return to the general risk-based capital rules by notifying its primary Federal supervisor in writing at least 60 days before the beginning of the calendar quarter in which it intends to opt out of the standardized framework. The banking organization would have to include in its notice an explanation of its rationale for ceasing to use the standardized framework and identify the risk-based capital framework it intends to use. The primary Federal supervisor would review this notice to ensure that the use of the general risk-based capital rules would be appropriate for that banking organization. 9 The agencies expect that a banking organization would not alternate between the general risk-based capital rules and this standardized framework. 9 The primary Federal supervisor may waive the 60-day notice period for opting in to the standardized framework and for returning to the general risk-based capital rules. Any general banking organization could generally continue to calculate its risk-based capital requirements using the general risk-based capital rules without notifying its primary Federal supervisor. The primary Federal supervisor would, however, have the authority to require a general banking organization to use a different risk-based capital rule if that supervisor determines that a particular capital rule is appropriate in light of the banking organization's asset size, level of complexity, risk profile, or scope of operations. Under section 1(b) of the proposed rule, if a bank holding company opts in to the standardized framework, its subsidiary depository institutions also would apply the standardized framework. Similarly, if a depository institution opts in to the standardized framework, its parent bank holding company (where applicable) and any subsidiary depository institutions of the parent holding company generally would be required to apply the standardized rules as well. Savings and loan holding companies, however, are not subject to risk-based capital rules. Accordingly, if a savings association opts in to the proposed rule, the proposed rule would not apply to the savings and loan holding company or to a subsidiary depository institution of that holding company, unless the subsidiary depository institution is directly controlled by the savings association. The agencies believe that this approach serves as an important safeguard against regulatory capital arbitrage among affiliated banking organizations. The agencies recognize, however, that there may be infrequent situations where the use of the standardized rules could create undue burden at individual depository institutions within a corporate family. Therefore, under section 1(c) of the proposed rule, a banking organization that would otherwise be required to apply the standardized rule because a related banking organization has elected to apply it may instead use the general risk-based capital rules if its primary Federal supervisor determines in writing that that application of the standardized framework is not appropriate in light of the banking organization's asset size, level of complexity, risk profile, or scope of operations. When seeking such a determination, the banking organization should provide a rationale for its request. The primary Federal supervisor may consider potential capital arbitrage issues within a corporate structure in making its determination. Question 2: The agencies seek comment on the proposed applicability of the standardized framework and in particular on the degree of flexibility that should be provided to individual depository institutions within a corporate family, keeping in mind regulatory burden issues as well as ways to minimize the potential for regulatory capital arbitrage . In the advanced approaches final rule, the agencies require core banking organizations to use only the most advanced approaches provided in the New Accord. As proposed, the standardized framework generally would be available only for banking organizations that are not core banking organizations. Question 3: The agencies seek comment on whether or to what extent core banking organizations should be able to use the proposed standardized framework . B. Reservation of Authority Under this NPR, a primary Federal supervisor could require a banking organization to hold an amount of capital greater than would otherwise be required if that supervisor determines that the risk-based capital requirements under the standardized framework are not commensurate with the banking organization's credit, market, operational, or other risks. In addition, the agencies expect that there may be instances when the standardized framework would prescribe a risk-weighted asset amount for one or more exposures that was not commensurate with the risks associated with the exposures. In such a case, the banking organization's primary Federal supervisor would retain the authority to require the banking organization to assign a different risk-weighted asset amount for the exposures or to deduct the amount of the exposures from regulatory capital. Similarly, this NPR proposes to authorize a banking organization's primary Federal supervisor to require the banking organization to assign a different risk-weighted asset amount for operational risk if the supervisor were to find that the risk-weighted asset amount for operational risk produced by the banking organization under this NPR is not commensurate with the operational risks of the banking organization. C. Principle of Conservatism The agencies believe that in some cases it may be reasonable to allow a banking organization not to apply a provision of the proposed rule if not doing so would yield a more conservative result. Under section 1(f) of the proposed rule, a banking organization may choose not to apply a provision of the rule to one or more exposures provided that: (i) The banking organization can demonstrate on an ongoing basis to the satisfaction of its primary Federal supervisor that not applying the provision would, in all circumstances, unambiguously generate a risk-based capital requirement for each exposure greater than that which would otherwise be required under the rule; (ii) the banking organization appropriately manages the risk of those exposures; (iii) the banking organization provides written notification to its primary Federal supervisor prior to applying this principle to each exposure; and (iv) the exposures to which the banking organization applies this principle are not, in the aggregate, material to the banking organization. The agencies emphasize that a conservative capital requirement for a group of exposures does not reduce the need for appropriate risk management of those exposures. Moreover, the principle of conservatism applies to the determination of capital requirements for specific exposures; it does not apply to the disclosure requirements in section 71 of the proposed rule. D. Merger and Acquisition Transition Provisions A banking organization that uses the standardized framework and that merges with or acquires another banking organization operating under different risk-based capital rules may not be able to quickly integrate the acquired organization's exposures into its risk-based capital system. Under this NPR, a banking organization that uses the standardized framework and that merges with or acquires a banking organization that uses the general risk-based capital rules could continue to use the general risk-based capital rules to calculate the risk-based capital requirements for the merged or acquired banking organization's exposures for up to 12 months following the last day of the calendar quarter during which the merger or acquisition is consummated. The risk-weighted assets of the merged or acquired company calculated under the general risk-based capital rules would be included in the banking organization's total risk-weighted assets. Deductions associated with the exposures of the merged or acquired company would be deducted from the banking organization's tier 1 capital and tier 2 capital. Similarly, where both banking organizations calculate their risk-based capital requirements under the standardized framework, but the merged or acquired banking organization uses different aspects of the framework, the banking organization may continue to use the merged or acquired banking organization's own systems to determine its organization's risk-weighted assets for, and deductions from capital associated with, the merged or acquired banking organization's exposures for the same time period. A banking organization that merges with or acquires an advanced approaches banking organization may use the advanced approaches risk-based capital rules to determine the risk-weighted asset amounts for, and deductions from capital associated with, the merged or acquired banking organization's exposures for up to 12 months after the calendar quarter during which the merger or acquisition consummates. During the period when the advanced approaches risk-based capital rules apply to the merged or acquired company, any allowance for loan and lease losses (ALLL) associated with the merged or acquired company's exposures must be excluded from the banking organization's tier 2 capital. Any excess eligible credit reserves associated with the merged or acquired banking organization's exposures may be included in that banking organization's tier 2 capital up to 0.6 percent of that banking organization's risk-weighted assets. (Excess eligible credit reserves would be determined according to section 13(a)(2) of the advanced approaches risk-based capital rules.) If a banking organization relies on these merger provisions, it would be required to disclose publicly the amounts of risk-weighted assets and total qualifying capital calculated under the applicable risk-based capital rules for the acquiring banking organization and for the merged or acquired banking organization. E. Calculation of Tier 1 and Total Qualifying Capital This NPR would maintain the minimum risk-based capital ratio requirements of 4.0 percent tier 1 capital to total risk-weighted assets and 8.0 percent total qualifying capital to total risk-weighted assets. A banking organization's total qualifying capital is the sum of its tier 1 (core) capital elements and tier 2 (supplemental) capital elements, subject to various limits, restrictions, and deductions (adjustments). The agencies are not restating the elements of tier 1 and tier 2 capital in the proposed rule. Those capital elements generally would be unchanged from the general risk-based capital rules. 10 Deductions or other adjustments would also be unchanged, except for those provisions discussed below. 10 See 12 CFR part 3, Appendix A, section 2 (national banks); 12 CFR part 208, Appendix A, section II (state member banks); 12 CFR part 225, Appendix A, section II (bank holding companies); 12 CFR part 325, Appendix A, section I (state nonmember banks); and 12 CFR 567.5 (savings associations). Under this NPR, a banking organization would make certain other adjustments to determine its tier 1 and total qualifying capital. Some of these adjustments would be made only to tier 1 capital. Other adjustments would be made 50 percent to tier 1 capital and 50 percent to tier 2 capital. If the amount deductible from tier 2 capital exceeds the banking organization's actual tier 2 capital, the banking organization would have to deduct the shortfall amount from tier 1 capital. Consistent with the agencies' general risk-based capital rules, a banking organization would have to have at least 50 percent of its total qualifying capital in the form of tier 1 capital. Under this NPR, a banking organization would deduct from tier 1 capital any after-tax gain-on-sale resulting from a securitization. Gain-on-sale means an increase in a banking organization's equity capital that results from a securitization, other than an increase in equity capital that results from the banking organization's receipt of cash in connection with the securitization. The agencies included this deduction to offset accounting treatments that produce an increase in a banking organization's equity capital and tier 1 capital at the inception of a securitization, for example, a gain attributable to a credit-enhancing interest-only strip receivable (CEIO) that results from Financial Accounting Standard (FAS) 140 accounting treatment for the sale of underlying exposures to a securitization special purpose entity (SPE). 11 The agencies expect that the amount of the required deduction would diminish over time as the banking organization realizes the increase in equity capital and, thus, tier 1 capital booked at the inception of the securitization, through actual receipt of cash flows. 11 See Statement of Financial Accounting Standards No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” (September 2000). Under the general risk-based capital rules, a banking organization must deduct CEIOs, whether purchased or retained, from tier 1 capital to the extent that the CEIOs exceed 25 percent of the banking organization's tier 1 capital. Under this NPR, a banking organization would have to deduct CEIOs from tier 1 capital to the extent they represent after-tax gain-on-sale, and would have to deduct any CEIOs that do not constitute an after-tax gain-on-sale 50 percent from tier 1 capital and 50 percent from tier 2 capital. Under the FDIC, OCC, and Board general risk-based capital rules, a banking organization must deduct from its tier 1 capital certain percentages of the adjusted carrying value of its nonfinancial equity investments. In contrast, OTS general risk-based capital rules require the deduction of most investments in equity securities from total capital. 12 Under this NPR, however, a banking organization would not deduct these investments. Instead, the banking organization's equity exposures generally would be subject to the treatment provided in Part V of this proposed rule. 12 OTS general risk-based capital rules require savings associations to deduct all “equity investments” from total capital. 12 CFR 567.5(c)(2)(ii). “Equity investments” are defined to include: (i) Investments in equity securities (other than investments in subsidiaries, equity investments that are permissible for national banks, indirect ownership interests in certain pools of assets (for example, mutual funds), Federal Home Loan Bank stock and Federal Reserve Bank stock); and (ii) investments in certain real property. 12 CFR 567.1. The proposed treatment of investments in equity securities is discussed above. Equity investments in real estate would continue to be deducted to the same extent as under the general risk-based capital rules. A banking organization also would have to deduct from total capital the amount of certain unsettled transactions and certain securitization exposures. These deductions are provided in section 21, section 38, and Part IV of this proposed rule. Consistent with the advanced approaches final rule, for bank holding companies with consolidated insurance underwriting subsidiaries that are functionally regulated (or subject to comparable supervision and minimum regulatory capital requirements in their home jurisdiction), the following treatment would apply. The assets and liabilities of the subsidiary would be consolidated for purposes of determining the bank holding company's risk-weighted assets. The bank holding company, however, would deduct 50 percent from tier 1 capital and 50 percent from tier 2 capital an amount equal to the insurance underwriting subsidiary's minimum regulatory capital requirement as determined by its functional (or equivalent) regulator. For U.S. regulated insurance subsidiaries, this amount generally would be 200 percent of the subsidiary's Authorized Control Level as established by the appropriate state insurance regulator. Under the general risk-based capital rules, such subsidiaries typically are fully consolidated with the bank holding company. While the elements of tier 1 and tier 2 capital are the same across the general risk-based capital rules, the advanced approaches final rule, and this NPR, the deductions from those elements are different for each of the three risk-based capital frameworks. As a result, each framework has a distinct definition of tier 1, tier 2, and total qualifying capital. Securitization-related deductions create a significant difference in the calculation of tier 1 and tier 2 capital across the three frameworks. Under the general risk-based capital rules, only certain CEIOs must be deducted from capital; all other high-risk exposures for which dollar-for-dollar capital must be held may be “grossed-up” in accordance with the regulatory reporting instructions, effectively increasing the denominator of the risk-based capital ratio but not affecting the numerator. In contrast, under the advanced approaches final rule and this NPR, certain high risk securitization exposures must be deducted directly from total capital. Other significant differences in the definition of tier 1, tier 2, and total qualifying capital across the three frameworks include the treatment of nonfinancial equity investments for banks and bank holding companies, certain equity investments for savings associations, certain unsettled transactions, consolidated insurance underwriting subsidiaries of bank holding companies, and the ALLL/eligible credit reserves. The different definitions of tier 1, tier 2, and total capital across the risk-based capital frameworks raise a number of issues. The agencies clarified in the preamble to the advanced approaches rule that a banking organization's tier 1 capital and tier 2 capital for all non-regulatory-capital supervisory and regulatory purposes (for example, lending limits and Regulation W quantitative limits) is the banking organization's tier 1 capital and tier 2 capital as calculated under the risk-based capital framework to which it is subject. The agencies did not specifically state a position regarding the numerator of the leverage ratio. One potential approach is for each banking organization to use its applicable risk-based definition of tier 1 capital for determining both the risk-based and leverage capital ratios. Another potential approach is to define a numerator for the tier 1 leverage ratio that would be the same for all banking organizations. This approach could require banks to calculate one measure of tier 1 capital for risk-based capital purposes and another measure of tier 1 capital for leverage ratio purposes. 13 13 To the extent that the agencies decide to change the numerator of the leverage ratio, they would propose such changes in a separate rulemaking. As a related matter, the OTS advanced approaches final rule incorrectly states that the leverage ratio is calculated using the revised definition of tier 1 and tier 2 capital. This NPR would remove this provision until the agencies conclusively resolve this matter. Question 4: Given the potential for three separate definitions of tier 1 capital under the three frameworks, the agencies solicit comment on all aspects of the tier 1 leverage ratio numerator, including issues related to burden and competitive equity . F. Calculation of Risk-Weighted Assets (1) Total Risk-Weighted Assets Under this NPR, a banking organization's total risk-weighted assets would be the sum of its total risk-weighted assets for general credit risk, unsettled transactions, securitization exposures, equity exposures, and operational risk. Banking organizations that use the market risk rule (MRR) would supplement their capital calculations with those provisions. 14 14 12 CFR part 3, Appendix B (national banks); 12 CFR part 208, Appendix E (state member banks); 12 CFR part 225, Appendix E (bank holding companies); and 12 CFR part 325, Appendix C (state nonmember banks). OTS intends to codify a market risk capital rule for savings associations at 12 CFR part 567, Appendix D. (2) Calculation of Risk-Weighted Assets for General Credit Risk For each of its general credit risk exposures (that is, credit exposures that are not unsettled transactions subject to section 38 of the proposed rule, securitization exposures, or equity exposures), a banking organization must first determine the exposure amount and then multiply that amount by the appropriate risk weight set forth in section 33 of the proposed rule. General credit risk exposures include exposures to sovereign entities; exposures to supranational entities and multilateral development banks; exposures to public sector entities; exposures to depository institutions, foreign banks, and credit unions; corporate exposures; regulatory retail exposures; residential mortgage exposures; pre-sold construction loans; statutory multifamily mortgage exposures; and other assets. Generally, the exposure amount for the on-balance sheet component of an exposure is the banking organization's carrying value for the exposure. If the exposure is classified as a security available for sale, however, the exposure amount is the banking organization's carrying value of the exposure adjusted for unrealized gains and losses. The exposure amount for the off-balance sheet component of an exposure is typically determined by multiplying the notional amount of the off-balance sheet component by the appropriate credit conversion factor (CCF) under section 34 of the proposed rule. The exposure amount for over-the-counter (OTC) derivative contracts is determined under section 35 of the proposed rule. Exposure amounts for collateralized OTC derivative contracts, repo-style transactions, or eligible margin loans may be determined under particular rules in section 37 of the proposed rule. (3) Calculation of Risk-Weighted Assets for Unsettled Transactions, Securitization Exposures, and Equity Exposures (a) Unsettled Transactions Risk-weighted assets for specified unsettled and failed securities, foreign exchange, and commodities transactions are calculated according to paragraph (f) of section 38 of the proposed rule. 15 15 Certain transaction types are excluded from the scope of section 38, as provided in paragraph (b) of section 38. (b) Securitization Exposures Risk-weighted assets for securitization exposures are calculated according to Part IV of the proposed rule. Generally, a banking organization would calculate the risk-weighted asset amount of a securitization exposure by multiplying the amount of the exposure as determined in section 42 of the proposed rule by the appropriate risk weight in section 43 of this NPR. Part IV of the proposed rule provides a hierarchy of approaches for calculating risk-weighted assets for securitization exposures. Among the approaches included in Part IV is a ratings-based approach (RBA), which calculates the risk-weighted asset amount of a securitization exposure by multiplying the amount of the exposure by risk-weights that correspond to the applicable external or applicable inferred rating of the securitization. Part IV provides other treatments for specific types of securitization exposures including deduction from capital for certain exposures, and different risk-weighted asset computations for certain securitizations exposures that do not qualify for the RBA and for securitizations that have an early amortization provision. (c) Equity Exposures Risk-weighted assets for equity exposures are calculated according to the rules in Part V of the proposed rule. Generally, risk-weighted assets for equity exposures that are not exposures to investment funds would be calculated according to the simple risk-weight approach (SRWA) in section 52 of this proposed rule. Risk-weighted assets for equity exposures to investment funds would, with certain exceptions, be calculated according to one of three look-through approaches or, if the investment fund qualifies, calculated according to the money market fund approach. These approaches are described in section 53 of the proposed rule. (4) Calculation of Risk-Weighted Assets for Operational Risk Risk-weighted assets for operational risk are calculated under the BIA provided in section 61 of this proposed rule. G. External and Inferred Ratings (1) Overview The agencies' general risk-based capital rules permit the use of external ratings issued by a nationally recognized statistical rating organization (NRSRO) to assign risk weights to recourse obligations, direct credit substitutes, residual interests (other than a credit-enhancing interest-only strip), and asset- and mortgage-backed securities. 16 Under the ratings-based approach in the general risk-based capital rules, a banking organization must use the lowest NRSRO external rating if multiple ratings exist. The approach also requires one rating for a traded exposure and two ratings for a non-traded exposure and allows the use of inferred ratings within a securitization structure. When the agencies revised their general risk-based capital rules to permit the use of external ratings issued by an NRSRO for these exposures, the agencies acknowledged that these ratings eventually could be used to determine the risk-based capital requirements for other types of debt instruments, such as externally rated corporate bonds. 16 Some synthetic structures also may be subject to the external rating approach. For example, certain credit-linked notes issued from a synthetic securitization are risk weighted according to the rating given to the notes. 66 FR 59614, 59622 (November 29, 2001). The New Accord would permit a banking organization to use external ratings to determine risk weights for a broad range of exposures. It also provides for the use of both inferred and, within certain limitations, issuer ratings, but discourages the use of unsolicited ratings. Generally consistent with the New Accord, and in response to favorable comments on the Basel IA NPR's proposal to expand the use of external ratings, the agencies propose that external, issuer, and inferred ratings be used to risk weight various exposures. This proposed use of ratings is a more risk-sensitive approach than relying on membership in the Organization for Economic Cooperation and Development (OECD) 17 to differentiate the risk of exposures to sovereign entities, depository institutions, foreign banks, and credit unions. The proposed approach also would use a greater number of risk weights than the general risk-based capital rules, which would further improve the risk sensitivity of a banking organization's risk-based capital requirements. 17 The OECD-based group of countries comprises all full members of the OECD, as well as countries that have concluded special lending arrangements with the International Monetary Fund (IMF) associated with the IMF's General Arrangements to Borrow. The list of OECD countries is available on the OECD Web site at http://www.oecd.org. Consistent with the agencies' general risk-based capital rules and the advanced approaches final rule, the agencies propose to recognize only credit ratings that are issued by an NRSRO. For the purposes of this NPR, NRSRO means an entity registered with the U.S. Securities and Exchange Commission (SEC) as an NRSRO under section 15E of the Securities Exchange Act of 1934 (15 U.S.C. 78o-7). 18 18 See 17 CFR 240.17g-1. On September 29, 2006, the President signed the Credit Rating Agency Reform Act of 2006 (“Reform Act”) (Pub. L. 109-291) into law. The Reform Act requires a credit rating agency that wants to represent itself as an NRSRO to register with the SEC. The agencies may review their risk-based capital rules, guidance and proposals from time to time to determine whether any modification of the agencies' definition of an NRSRO is appropriate. (2) Use of External Ratings Under this NPR, a banking organization would use the applicable external rating of an exposure (for certain exposures that have external ratings) to determine its risk weight. Additionally, consistent with the New Accord, the banking organization would infer a rating for certain exposures that do not have external ratings from the issuer rating of the obligor or from the external rating of another specific issue of the obligor. The agencies' proposal for the use of external and inferred ratings, however, differs in some respects from the New Accord, as described below. (a) External Ratings Under this NPR, an external rating means a credit rating that is assigned by an NRSRO to an exposure, provided that the credit rating fully reflects the entire amount of credit risk with regard to all payments owed to the holder of the exposure. If, for example, a holder is owed principal and interest on an exposure, the credit rating must fully reflect the credit risk associated with timely repayment of principal and interest. If a holder is owed only principal on an exposure, the credit rating must fully reflect only the credit risk associated with timely repayment of principal. Furthermore, a credit rating would qualify as an external rating only if it is published in an accessible form and is or will be included in the transition matrices made publicly available by the NRSRO that summarize the historical performance of positions rated by the NRSRO. An external rating may be either solicited or unsolicited by the obligor issuing the rated exposure. This definition is consistent with the definition of “external rating” in the advanced approaches final rule. Under this NPR, a banking organization would determine the risk weight for certain exposures with external ratings based on the applicable external ratings of the exposures. If an exposure to a sovereign or public sector entity (PSE), a corporate exposure, or a securitization exposure has only one external rating, that rating is the applicable external rating. If such an exposure has multiple external ratings, the applicable external rating would be the lowest external rating. This approach for determining the applicable external rating differs from the New Accord. In the New Accord, if an exposure has two external ratings, a banking organization would apply the lower rating to the exposure to determine the risk weight. If an exposure has three or more external ratings, the banking organization would use the second lowest external rating to risk weight the exposure. The agencies believe that the proposed approach, which is designed to mitigate the potential for external ratings arbitrage, more reliably promotes safe and sound banking practices. (b) Inferred Ratings Consistent with the New Accord, the agencies propose that a banking organization must, subject to certain conditions, infer a rating on an exposure to a sovereign entity or a PSE or on a corporate exposure that does not have an applicable external rating (unrated exposure). 19 An inferred rating may be based on the issuer rating of the sovereign, PSE, or corporate obligor or based on another externally rated exposure of that obligor. Exposures with an inferred rating would be treated the same as exposures with an identical external rating. 19 The treatment of inferred ratings for securitization exposures is discussed in section M.(4) of this preamble. (i) Determining Inferred Ratings To determine the risk weight for an unrated exposure to a sovereign entity or a PSE, or for an unrated corporate exposure, a banking organization must first determine if, within the framework established in this NPR, the exposure has one or more inferred ratings. An unrated exposure may have inferred ratings based both on the issuer ratings of the obligor and the external ratings of specific issues of the obligor. A banking organization would not be able to use an external rating assigned to an obligor or specific issues of the obligor to infer a rating for an exposure to the obligor's affiliate. (A) Inferred Rating Based on an Issuer Rating Under this NPR, a senior unrated exposure to a sovereign entity or a PSE, or a senior unrated corporate exposure where the corporate issuer has one or more issuer ratings, has inferred ratings based on those issuer ratings. For purposes of inferring a rating from an issuer rating, a senior exposure would be an exposure that ranks at least pari passu (that is, equal) with the obligor's general creditors in the event of bankruptcy, insolvency, or other similar proceeding. This NPR defines an issuer rating as a credit rating assigned by an NRSRO to the obligor that reflects the obligor's capacity and willingness to satisfy all of its financial obligations, and is published in an accessible form and is or will be included in the transition matrices made publicly available by the NRSRO that summarize the historical performance of the NRSRO's ratings. (B) Inferred Rating Based on a Specific Issue Rating Under this NPR, an unrated exposure to a sovereign entity or a PSE, or an unrated corporate exposure may have one or more inferred ratings based on external ratings assigned to another exposure issued by the obligor. An unrated exposure would have an inferred rating equal to the external rating of another exposure issued by the same obligor and secured by the same collateral (if any), if the externally rated exposure: (i) Ranks pari passu with the unrated exposure (or at the banking organization's option, is subordinated in all respects to the unrated exposure); (ii) has a long-term rating; (iii) does not benefit from any credit enhancement that is not available to the unrated exposure, (iv) has an effective remaining maturity that is equal to or longer than that of the unrated exposure, and (v) is denominated in the same currency as the unrated exposure. The currency requirement would not apply where the unrated exposure that is denominated in a foreign currency arises from a participation in a loan extended by a multilateral development bank or is guaranteed by a multilateral development bank against convertibility and transfer risk. If the banking organization's participation is only partially guaranteed against convertibility and transfer risk, the banking organization could use the external rating for the portion of the participation that benefits from the multilateral development bank's participation. If the externally rated exposure does not meet these requirements, it cannot be used to infer a rating for the unrated exposure. The inferred rating approach provides a special treatment for inferred ratings from low-quality ratings (ratings that correspond to a risk weight of 100 percent or greater for an exposure to a PSE and 150 percent for an exposure to a sovereign entity or a corporate exposure). An unrated exposure would have inferred rating(s) equal to the long-term external rating(s) of exposures with low-quality ratings that are issued by the same obligor and that are senior in all respects to the unrated exposure. This approach for inferred ratings differs from the New Accord, which would require that any low-quality rating of an exposure issued by an obligor be assigned to any unrated exposure to the obligor. The agencies have concluded that this treatment could result in an inappropriately high capital charge in some circumstances. For example, an obligor for business reasons may choose to issue subordinated debt that receives a low-quality rating. The New Accord suggests this low-quality rating should be assigned to unrated senior exposures of the obligor, even if the unrated senior exposures are also senior to exposures with a high-quality rating. Under this NPR, a banking organization in that situation could assign the high-quality rating to the unrated senior secured exposure. (ii) Determining the Applicable Inferred Rating Once a banking organization has determined all the inferred ratings for an unrated exposure, it must determine the applicable inferred rating for the exposure. Under this NPR, the applicable inferred rating for an exposure that has only one inferred rating would be the inferred rating. If the unrated exposure has two or more inferred ratings, the applicable inferred rating would be the lowest inferred rating. The agencies believe that this approach for determining the applicable inferred rating for an unrated exposure is appropriately risk sensitive and consistent with the principles for use of external ratings in this NPR and the advanced approaches final rule. The agencies are aware, however, that the proposed use of unsolicited external ratings in this NPR may raise certain issues. The New Accord suggests that banking organizations generally should use solicited ratings and expresses concern that NRSROs might potentially use unsolicited ratings to put pressure on issuers to obtain solicited ratings. Question 5: The agencies seek comment on the use of solicited and unsolicited external ratings as proposed in this NPR. H. Risk-Weight Categories (1) Exposures to Sovereign Entities The agencies' general risk-based capital rules generally assign a risk weight to an exposure to a sovereign entity based on the type of exposure and membership of the sovereign in the OECD. Consistent with the New Accord, the agencies propose to risk weight an exposure to a sovereign entity based on the exposure's applicable external or applicable inferred rating (see Table 1). 20 20 The ratings examples used throughout this document are illustrative and do not express any preferences or determinations on any NRSRO. For purposes of this NPR, sovereign entity means a central government (including the U.S. government) or an agency, department, ministry, or central bank of a central government. In the United States, this definition would include the twelve Federal Reserve Banks. The definition would not include commercial enterprises owned by the central government that are engaged in activities involving trade, commerce, or profit, which are generally conducted or performed in the private sector. Where a sovereign entity's banking supervisor allows a banking organization under its jurisdiction to apply a lower risk weight to the same exposure to that sovereign than Table 1 provides, a U.S. banking organization would be able to assign that lower risk weight to its exposures to that sovereign entity provided the exposure is denominated in that sovereign entity's domestic currency, and the banking organization has at least the equivalent amount of liabilities in that currency. Table 1.—Exposures to Sovereign Entities Applicable external or applicable inferred rating for an exposure to a sovereign entity Example Risk weight (in percent) Highest investment grade rating AAA 0 Second-highest investment grade rating AA 0 Third-highest investment grade rating A 20 Lowest investment grade rating BBB 50 One category below investment grade BB 100 Two categories below investment grade B 100 Three categories or more below investment grade CCC 150 No applicable rating N/A 100 (2) Exposures to Certain Supranational Entities and Multilateral Development Banks Consistent with the New Accord's treatment of exposures to supranational entities, the agencies propose to assign a zero percent risk weight to exposures to the Bank for International Settlements, the European Central Bank, the European Commission, and the International Monetary Fund. Generally consistent with the New Accord, the agencies also propose that an exposure to a multilateral development bank (MDB) receive a zero percent risk weight. This proposed risk weight would apply only to those MDBs listed below and is based on the generally high credit quality of these MDBs, their strong shareholder support, and a shareholder structure comprised of a significant proportion of sovereign entities with high quality issuer ratings. In this NPR, MDB means the International Bank for Reconstruction and Development, the International Finance Corporation, the Inter-American Development Bank, the Asian Development Bank, the African Development Bank, the European Bank for Reconstruction and Development, the European Investment Bank, the European Investment Fund, the Nordic Investment Bank, the Caribbean Development Bank, the Islamic Development Bank, the Council of Europe Development Bank, and any other multilateral lending institution or regional development bank in which the U.S. government is a shareholder or contributing member or which the primary Federal supervisor determines poses comparable credit risk. Exposures to regional development banks and multilateral lending institutions that do not meet these requirements would generally be treated as corporate exposures. (3) Exposures to Depository Institutions, Foreign Banks, and Credit Unions The agencies' general risk-based capital rules assign a risk weight of 20 percent to all exposures to U.S. depository institutions, foreign banks, and credit unions incorporated in an OECD country. Short-term exposures to such entities incorporated in a non-OECD country receive a 20 percent risk weight and long-term exposures to such entities in these countries receive a 100 percent risk weight. Since this NPR eliminates the OECD/non-OECD distinction, the agencies propose that exposures to a depository institution, a foreign bank, or a credit union receive a risk weight based on the lowest issuer rating of the entity's sovereign of incorporation. In this NPR, sovereign of incorporation means the country where an entity is incorporated, chartered, or similarly established. In general, exposures to a depository institution, foreign bank, or credit union would receive a risk weight one category higher than the risk weight assigned to an exposure to the entity's sovereign of incorporation. For exposures to a depository institution, foreign bank, or credit union where the sovereign of incorporation is rated one or two categories below investment grade or is unrated, the risk weight would be 100 percent. If the sovereign of incorporation is rated three or more categories below investment grade, these exposures would receive a risk weight of 150 percent. Table 2 illustrates the proposed risk weights for exposures to depository institutions, foreign banks, and credit unions. A depository institution is defined as in section 3 of the Federal Deposit Insurance Act (12 U.S.C. 1813), and foreign bank means a foreign bank as defined in section 211.2 of the Federal Reserve Board's Regulation K (12 CFR 211.2) other than a depository institution. Table 2.—Exposures to Depository Institutions, Foreign Banks, and Credit Unions Lowest issuer rating of the sovereign of incorporation Example Exposure risk weight (in percent) Highest investment grade rating AAA 20 Second-highest investment grade rating AA 20 Third-highest investment grade rating A 50 Lowest investment grade rating BBB 100 One category below investment grade BB 100 Two categories below investment grade B 100 Three categories or more below investment grade CCC 150 No issuer rating N/A 100 Consistent with the general risk-based capital rules and the New Accord, exposures to a depository institution or foreign bank that are includable in the regulatory capital of that institution would receive a risk weight no lower than 100 percent unless the exposure is subject to deduction as a reciprocal holding. 21 21 12 CFR part 3, Appendix A, section 2(c)(6)(ii) (OCC); 12 CFR parts 208 and 225, Appendix A, section II.B.3 (FRB); 12 CFR part 325, Appendix A, I.B.(4) (FDIC); and 12 CFR 567.5(c)(2)(i) (OTS). The proposal outlined above is consistent with one of the two options available in the New Accord for risk weighting claims on banks. The alternative approach, which the agencies propose for exposures to PSEs, risk weights exposures based on the applicable external or applicable inferred rating of the exposures. This alternative approach for exposures to PSEs is described below. Question 6: The agencies seek comment on this proposed approach, as well as on the appropriateness of applying the alternative approach to exposures to depository institutions, credit unions, and foreign banks. (4) Exposures to Public Sector Entities (PSEs) The agencies' general risk-based capital rules assign a 20 percent risk weight to general obligations of states and other political subdivisions of OECD countries. 22 Exposures to entities that rely on revenues from specific projects, rather than general revenues (for example, revenue bonds), receive a risk weight of 50 percent. Generally, other exposures to state and political subdivisions of OECD countries (including industrial revenue bonds) and exposures to political subdivisions of non-OECD countries receive a risk weight of 100 percent. 22 Political subdivisions of the United States include a state, county, city, town or other municipal corporation, a public authority, and generally any publicly owned entity that is an instrument of a state or municipal corporation. Consistent with the New Accord, the agencies propose that an exposure to a PSE receive a risk weight based on the applicable external or applicable inferred rating of the exposure. This approach would apply to both general obligation and revenue bonds. In no case, however, may an exposure to a PSE receive a risk weight that is lower than the risk weight that corresponds to the lowest issuer rating of a PSE's sovereign of incorporation (see Table 1 for risk weights for exposures to sovereign entities). The proposed rule defines a PSE as a state, local authority, or other governmental subdivision below the level of a sovereign entity. This definition would not include commercial companies owned by a government that engage in activities involving trade, commerce, or profit, which are generally conducted or performed in the private sector. Table 3 illustrates the risk weights for exposures to PSEs. Table 3.—Exposures to Public Sector Entities: Long-Term Credit Rating Applicable external or applicable inferred rating of an exposure to a PSE Example Risk weight (in percent) Highest investment grade rating AAA 20 Second-highest investment grade rating AA 20 Third-highest investment grade rating A 50 Lowest investment grade rating BBB 50 One category below investment grade BB 100 Two categories below investment grade B 100 Three categories or more below investment grade CCC 150 No applicable rating N/A 50 The New Accord also suggests that a national supervisor may permit a banking organization to assign a risk weight to an exposure to a PSE as if it were an exposure to the sovereign entity in whose jurisdiction the PSE is established. The agencies are not proposing to risk weight exposures to PSEs in the United States in this manner. In certain cases, however, the agencies have allowed a banking organization to rely on the risk weight that a foreign banking supervisor assigns to its own PSEs. Therefore, the agencies propose to allow a banking organization to risk weight an exposure to a foreign PSE according to the risk weight that the foreign banking supervisor assigns. In no event, however, could the risk weight for an exposure to a foreign PSE be lower than the lowest risk weight assigned to that PSE's sovereign of incorporation. The New Accord contains an alternative approach to risk weight exposures to a PSE, which is based on the lowest issuer rating of the PSE's sovereign of incorporation. The agencies are proposing this approach for exposures to depository institutions, foreign banks, and credit unions as described in the previous section. Question 7: The agencies seek comment on the pros and cons of the proposed approach for risk weighting exposures to PSEs as well as on the appropriateness of applying, instead, the approach proposed in this NPR for depository institutions. The New Accord does not incorporate the use of short-term ratings for exposures to PSEs. The agencies recognize, however, that an NRSRO may assign a short-term municipal rating to an exposure to a PSE that has a maturity of up to three years (for example, a bond anticipation note). Further, the agencies understand that there are different techniques for comparing these short-term ratings to other types of ratings, both short-term and long-term. The agencies are considering whether to permit the use of these short-term ratings for risk weighting short-term exposures to PSEs using the risk weights in Table 4. Table 4.—Public Sector Entities: Short-Term Ratings Applicable external rating of an exposure to a PSE Example Risk weight (in percent) Highest investment grade SP-1/MIG-1 20 Second-highest investment grade SP-2/MIG-2 50 Third-highest investment grade SP-3/MIG-3 100 Below investment grade Non-prime 150 No applicable external rating N/A 50 Question 8: The agencies solicit comment on the use of short-term ratings for exposures to PSEs generally and specifically on the ratings and related risk weights in Table 4. (5) Corporate Exposures Under the agencies' general risk-based capital rules, most corporate exposures receive a risk weight of 100 percent. Exposures to securities firms incorporated in the United States or in an OECD country may receive a 20 percent risk weight if they meet certain requirements, and exposures to U.S. government-sponsored agencies or entities (GSEs) may also receive a 20 percent risk weight. GSEs include an agency or corporation originally established or chartered by the U.S. Government to serve public purposes specified by the U.S. Congress, but whose obligations are not explicitly guaranteed by the full faith and credit of the U.S. Government. In this NPR, corporate exposure means a credit exposure to a natural person or a company (including an industrial development bond, an exposure to a GSE, or an exposure to a securities broker or dealer) that is not an exposure to: a sovereign entity, the Bank for International Settlements, the European Central Bank, the European Commission, the International Monetary Fund, an MDB, a depository institution, a foreign bank, a credit union, or a PSE; a regulatory retail exposure; a residential mortgage exposure; a pre-sold construction loan; a statutory multifamily mortgage; a securitization exposure; or an equity exposure. Consistent with the New Accord, the agencies propose to permit a banking organization to elect one of two methods to risk weight corporate exposures. Regardless of the method a banking organization chooses, it would have to use that approach consistently for all corporate exposures. First, a banking organization could risk weight all of its corporate exposures at 100 percent without regard to external ratings. Second, a banking organization could risk weight a corporate exposure based on its applicable external or applicable inferred rating. Table 5 provides the proposed risk weights for corporate exposures with applicable external or applicable inferred ratings based on long-term credit ratings. Table 6 provides the proposed risk weights for corporate exposures with applicable external ratings based on short-term credit ratings. If a corporate exposure has no external rating, that exposure could not receive a risk weight lower than the risk weight that corresponds to the lowest issuer rating of the obligor's sovereign of incorporation in Table 1. In addition, if an obligor has any exposure with a short-term external rating that corresponds to a risk weight of 150 percent under Table 6, a banking organization would assign a 150 percent risk weight to any corporate exposure to that obligor that does not have an external rating and that ranks pari passu with or is subordinated to the externally rated exposure. Table 5.—Corporate Exposures: Long-Term Credit Rating Applicable external or applicable inferred rating Example Exposure risk weight (in percent) Highest investment grade rating AAA 20 Second-highest investment grade rating AA 20 Third-highest investment grade rating A 50 Lowest investment grade rating BBB 100 One category below investment grade BB 100 Two categories below investment grade B 150 Three categories or more below investment grade CCC 150 No applicable rating N/A 100 Table 6.—Corporate Exposures: Short-Term Credit Rating Applicable external rating Example Exposure risk weight (in percent) Highest investment grade A-1/P-1 20 Second-highest investment grade A-2/P-2 50 Third-highest investment grade A-3/P-3 100 Below investment grade B, C, and non-prime 150 No applicable external rating N/A 100 As provided in the New Accord, this NPR (outside of the securitization framework) would not allow a banking organization to infer a rating from an exposure based on a short-term external rating. Consistent with this position, this NPR does not include the New Accord provision that assigns a risk weight of at least 100 percent to all unrated short-term exposures of an obligor if any rated short-term exposure of that obligor receives a 50 percent risk weight. Question 9: The agencies seek comment on the appropriateness of including either or both of these aspects of the New Accord in any final rule implementing the standardized framework. The New Accord would treat securities firms that meet certain requirements like depository institutions. The agencies propose, however, to risk weight exposures to securities firms as corporate exposures, parallel with the treatment of bank holding companies and savings association holding companies. The agencies also propose that exposures to GSEs be treated as corporate exposures and risk weighted based on the NRSRO credit ratings. These ratings on individual GSE exposures are often based in part on the NRSRO assessments of the extent to which the U.S. government might come to the financial aid of a GSE. The agencies believe that risk-weight determinations should not be based on the possibility of U.S. government financial assistance, except where the U.S. government has legally committed to provide such assistance. In addition to the credit ratings on individual GSE exposures, the NRSROs also publish issuer ratings that evaluate the financial strength of some GSEs without respect to any implied financial assistance from the U.S. government. These financial strength ratings are monitored by the issuing NRSROs but are not included in the NRSROs' transition matrices. Accordingly, the financial strength ratings would not meet the definition of an external rating in this NPR. Further, the use of these ratings is also problematic because NRSROs provide financial strength ratings for issuers, but not for specific issues, and do not provide the same level of differentiation between short- and long-term debt and various levels of subordination as NRSRO ratings of specific exposures. In addition, NRSROs have not published financial strength ratings for all GSEs. Question 10: The agencies seek comment on the use of financial strength ratings to determine risk weights for exposures to GSEs, and seek comment on how such ratings might be applied. The agencies also seek input on how subordination and maturity of exposures could be embodied in such an approach, and what requirements should be developed for recognizing ratings assigned to GSEs. (6) Regulatory Retail Exposures The general risk-based capital rules generally assign a risk weight of 100 percent to non-mortgage retail exposures, secured or unsecured, including personal, auto, and credit card loans. Consistent with the New Accord, the agencies propose that a banking organization apply a 75 percent risk weight to regulatory retail exposures that meet the following criteria: (i) A banking organization's aggregate exposure to a single obligor does not exceed $1 million; (ii) the exposure is part of a well diversified portfolio; and (iii) the exposure is not an exposure to a sovereign entity, the Bank for International Settlements, the European Central Bank, the European Commission, the International Monetary Fund, an MDB, a PSE, a depository institution, a foreign bank, or a credit union; an acquisition, development and construction loan; a residential mortgage exposure; a pre-sold construction loan; a statutory multifamily mortgage; a securitization exposure; an equity exposure; or a debt security. Examples of regulatory retail exposures would include a revolving credit or line of credit (including credit card and overdraft lines of credit), a personal term loan or lease (including an installment loan, auto loan or lease, student or educational loan, personal loan), and a facility or commitment to a company. Any retail exposure that does not meet these requirements generally would be considered a corporate exposure and would receive a risk weight based on the risk-weight tables for corporate exposures (see Tables 5 and 6). Question 11: The agencies seek comment on whether a specific numerical limit on concentration should be incorporated into the provisions for regulatory retail exposures. For example, the New Accord suggests a 0.2 percent limit on an aggregate exposure to one obligor as a measure of concentration within the regulatory retail portfolio. The agencies solicit comment on the appropriateness of a 0.2 percent limit as well as on other types of measures of portfolio concentration that may be appropriate. (7) Residential Mortgage Exposures The general risk-based capital rules assign exposures secured by one-to-four family residential properties to either the 50 percent or 100 percent risk weight category. Most exposures secured by a first lien on a one-to-four family residential property meet the criteria to receive a 50 percent risk weight. 23 The New Accord applies a similarly broad treatment to residential mortgages. It provides a risk weight of 35 percent for most first-lien residential mortgage exposures that meet prudential criteria such as the existence of a substantial margin of additional security over the amount of the loan. 23 12 CFR part 3, Appendix A, section 3(c)(iii) (OCC); 12 CFR parts 208 and 225, Appendix A, section III.C.3 (Board); 12 CFR part 325, Appendix A, section II.C.3 (FDIC); and 12 CFR 567.1 (definition of “qualifying mortgage loan”) and 12 CFR 567.6(a)(1)(iii)(B) (50 percent risk weight) (OTS). In the Basel IA NPR, the agencies proposed to assign a risk weight for one-to-four family residential mortgage exposures based on the LTV ratio. The agencies noted that the LTV ratio is a meaningful indicator of potential loss and borrower default. Commenters on the Basel IA NPR generally supported this LTV ratio approach. In this NPR, the agencies propose substantially the same treatment for residential mortgage exposures as was proposed in the Basel IA NPR. Given the characteristics of the U.S. residential mortgage market, the agencies believe that the risk weights in the New Accord do not reflect the appropriate spectrum of risk for these assets. The agencies believe the wider range of risk weights that the agencies proposed in the Basel IA NPR is more appropriate for the U.S. residential mortgage market. The agencies believe that an LTV ratio approach to residential mortgage exposures would not impose a significant burden on banking organizations because LTV information is readily available and is commonly used in the underwriting process. Use of LTV ratios to assign risk weights to residential mortgage exposures would not substitute for, or otherwise release a banking organization from, its responsibility to have prudent loan underwriting and risk management practices consistent with the size, type, and risk of its mortgage business. 24 Through the supervisory process, the agencies would continue to assess a banking organization's underwriting and risk management practices consistent with supervisory guidance and safety and soundness. The agencies would continue to use their supervisory authority to require a banking organization to hold additional capital for residential mortgage exposures where appropriate. 24 See, for example, “Interagency Guidance on Nontraditional Mortgage Product Risks,” 71 FR 58609 (Oct. 4, 2006) and “Statement on Subprime Mortgage Lending,” 72 FR 37569 (July 10, 2007). The proposed rule defines a residential mortgage exposure as an exposure (other than a pre-sold construction loan) that is primarily secured by a one-to-four family residential property. The proposed rule identifies two types of residential mortgage exposures (first-lien residential mortgage exposures and junior-lien residential mortgage exposures), and provides a separate treatment for each type of exposure. A first-lien residential mortgage exposure is a residential mortgage exposure secured by a first lien or a residential mortgage exposure secured by first and junior lien(s) where no other party holds an intervening lien. This treatment is similar to the treatment of mortgage exposures under the general risk-based capital rules. A junior-lien residential mortgage exposure is a residential mortgage exposure that is secured by a junior lien and that is not a first-lien residential mortgage exposure. (a) Exposure Amount The proposed rule provides that a banking organization would hold capital for both the funded and the unfunded portions of residential mortgage exposures. For the funded portion of a residential mortgage exposure, the banking organization would assign a risk weight to the carrying value of the exposure (that is, the principal amount of the exposure). For the unfunded portion of a residential mortgage exposure (for example, potential exposure from a negative amortization feature or a home equity line of credit (HELOC)), a banking organization would risk weight the notional amount of the exposure (that is, the maximum contractual commitment) multiplied by the appropriate credit conversion factor. For a residential mortgage exposure that has both funded and unfunded components, a banking organization would calculate separate risk-weighted asset amounts for the unfunded and funded portions, based on separately calculated LTV ratios as discussed below. (b) Risk Weights The agencies propose that a banking organization risk weight first-lien residential mortgage exposures that meet certain qualifying criteria according to Table 7. The risk weights in Table 7 would apply only to a first-lien residential mortgage exposure that is secured by property that is owner-occupied or rented, is prudently underwritten, is not 90 days or more past due, and is not on nonaccrual. A first-lien residential mortgage exposure that has been restructured may receive a risk weight lower than 100 percent, only if the banking organization updates the LTV ratio at the time of the restructuring and according to the discussion below and in section 33 of the proposed rule. First-lien residential mortgage exposures that do not meet these criteria would receive a 100 percent risk weight if they have an LTV ratio less than or equal to 90 percent, and would receive a 150 percent risk weight if they have an LTV ratio greater than 90 percent. Table 7.—Risk Weights for First-Lien Residential Mortgage Exposures Loan-to-value ratio (in percent) Risk weight (in percent) Less than or equal to 60 20 Greater than 60 and less than or equal to 80 35 Greater than 80 and less than or equal to 85 50 Greater than 85 and less than or equal to 90 75 Greater than 90 and less than or equal to 95 100 Greater than 95 150 Under the general risk-based capital rules, a banking organization must assign a risk weight to an exposure secured by a junior lien on residential property at 100 percent, unless the banking organization also holds the first lien and there are no intervening liens. The New Accord does not specifically discuss the treatment of exposures secured by junior liens on residential property. The agencies continue to believe that stand-alone junior-lien residential mortgage exposures have a different risk profile than first-lien residential mortgage exposures and should be risk weighted accordingly. Under the proposed rule, a banking organization would compute an LTV ratio as described below for a junior-lien residential mortgage exposure that is not 90 days or more past due or on nonaccrual based upon the loan amounts for the junior-lien residential mortgage exposure and all senior exposures as described below. The banking organization would then assign a risk weight to the exposure amount of the junior-lien residential mortgage exposure according to Table 8. This treatment is similar to the Basel IA NPR and recognizes that stand-alone junior-lien residential mortgage exposures generally default at a higher rate than first-lien residential mortgage exposures. A banking organization would risk weight a junior-lien residential mortgage exposure that is 90 days or more past due or on nonaccrual at 150 percent. Table 8.—Risk Weights for Junior-Lien Residential Mortgage Exposures Loan-to-value ratio (in percent) Risk weight (in percent) Less than or equal to 60 75 Greater than 60 and less than or equal to 90 100 Greater than 90 150 (c) Loan-to-Value Ratio Calculation The agencies propose that a banking organization calculate the LTV ratio on an ongoing basis as described below. The denominator of the LTV ratio, that is, the value of the property, would be equal to the lesser of the acquisition cost for the property (for a purchase transaction) or the estimate of a property's value at the origination of the exposure or, at the banking organization's option, at the time of restructuring. The estimate of value would be based on an appraisal or evaluation of the property in conformance with the agencies' appraisal regulations 25 and should conform to the “Interagency Appraisal and Evaluation Guidelines” 26 and the “Real Estate Lending Guidelines.” 27 If a banking organization's first-lien residential mortgage exposure consists of both first and junior liens on a property, a banking organization could update the estimate of value at the origination of the junior-lien mortgage. 25 12 CFR part 34, subpart C (OCC); 12 CFR part 208, subpart E and part 225, subpart G (Board); 12 CFR part 323 (FDIC); and 12 CFR part 564 (OTS). 26 “The Comptroller's Handbook for Commercial Real Estate and Construction Lending”, Appendix E (OCC); SR 94-55 (Board); FIL-74-94 (FDIC); and 12 CFR part 564 (OTS). 27 12 CFR part 34, subpart D, Appendix A (OCC); 12 CFR part 208, subpart E, Appendix C and part 225, subpart G (Board); 12 CFR part 365 (FDIC); and 12 CFR 560.100-101 (OTS). The numerator of the ratio, that is, the loan amount, would depend on whether the exposure is funded or unfunded, and on whether the exposure is a first-lien residential mortgage exposure or a junior-lien residential mortgage exposure. The loan amount of the funded portion of a first-lien residential mortgage exposure would be the principal amount of the exposure. The loan amount of the funded portion of a junior-lien residential mortgage exposure would be the principal amount of the exposure plus the maximum contractual amounts of all senior exposures secured by the same residential property. Senior unfunded commitments may include negative amortization features and HELOCs. A banking organization would be required to calculate a separate loan amount and LTV ratio for the unfunded portion of a residential mortgage exposure. The loan amount of the unfunded portion of a residential mortgage exposure would be the loan amount of the funded portion of the exposure, as described above, plus the unfunded portion of the maximum contractual amount of the commitment. The agencies believe that a banking organization should be able to reflect the risk mitigating effects of loan-level private mortgage insurance (PMI) when calculating the LTV ratio of a residential mortgage exposure. Loan-level PMI is insurance that protects a lender in the event of borrower default up to a predetermined portion of the residential mortgage exposure and that does not have a pool-level cap that could effectively reduce coverage below the predetermined amount of the exposure. Under this proposed rule, a banking organization could reduce the loan amount of a residential mortgage exposure up to the amount covered by loan-level PMI, provided the PMI issuer is a regulated mortgage insurance company, is not an affiliate 28 of the banking organization, and (i) has long-term senior debt (without credit enhancement) that has an external rating that is in at least the third-highest investment grade rating category or (ii) has a claims-paying rating that is in at least the third-highest investment grade rating category. The agencies believe that pool-level PMI generally should not be reflected in the calculation of the LTV ratio, because pool-level PMI is not structured in such a way that a banking organization can determine the LTV ratio for a mortgage loan. 28 An affiliate of a banking organization is defined as any company that controls, is controlled by, or is under common control with, the banking organization. A person or company controls a company if it: (i) Owns, controls, or holds the power to vote 25 percent or more of a class of voting securities of the company, or (ii) consolidates the company for financial reporting purposes. Question 12: The agencies request comment on all aspects of the proposed treatment of PMI under this framework. (d) Example of LTV Ratio Calculation Assume a banking organization originates a first-lien residential mortgage exposure with a negative amortization feature; the property is valued at $100,000; the original and outstanding principal amount of the exposure is $81,000; and the negative amortization feature has a 10 percent cap and extends for ten years (that is, the mortgage loan balance can contractually negatively amortize to 110 percent of the original balance over the next 10 years). The funded loan amount of $81,000 has an 81 percent LTV ratio, which is risk weighted at 50 percent (based on Table 7). The negative amortization feature is an unfunded commitment with a maximum contractual amount of $8,100. It would receive a 50 percent CCF, resulting in an exposure amount of $4,050. The loan amount of the unfunded portion would be $81,000 funded amount plus the $8,100 maximum contractual unfunded amount, resulting in an LTV of 89.1 percent. The unfunded commitment exposure amount of $4,050 would therefore receive a 75 percent risk weight (based on Table 7). The total risk-weighted assets for the exposure would be $43,538, as illustrated in Table 9: Table 9.—Example of Proposed Risk-Based Capital Calculation for First-Lien Residential Mortgage Exposures With Negative Amortization Features Funded Risk-Weighted Assets Calculation (1) Amount to Risk Weight $81,000 (2) Funded LTV Ratio = Funded Loan Amount / Property Value = $81,000/$100,000 = 81% (3) Risk Weight based on Table 7 50% (4) RW Assets for Funded Loan Amount = $81,000 × .50 = $40,500 Unfunded Risk-Weighted Assets Calculation (1) Exposure Amount = Unfunded Maximum Amount × CCF = $8,100 × .50 = $4,050 (2) Unfunded LTV Ratio = (Funded Amount + Unfunded Amount)/Property Value = ($81,000 + $8,100)/$100,000 = 89.1% (3) Risk Weight based on Table 7 75% (4) RW Assets for Unfunded Amount = $4,050 × 0.75 $3,038 Total Risk-Weighted Assets for a Loan with Negative Amortizing Features RW Assets for Funded Amount + RW for Unfunded Amount = $40,500 + $3,038 = $43,538 Note: The funded and unfunded amount of the loan will change over time once the loan begins to negatively amortize. (e) Alternative LTV Ratio Calculation The agencies are considering an alternative for calculating the LTV ratio and risk-weighted asset amount for residential mortgage exposures with unfunded commitments. This alternative is less complex but may result in different capital implications. Under the alternative, a banking organization would not calculate a separate risk-weighted asset amount for the funded and unfunded portion of the residential mortgage exposure. The alternative calculation would require only the calculation of a single LTV ratio representing a combined funded and unfunded amount when calculating the LTV ratio for a given exposure. Under the alternative, the loan amount of a first-lien residential mortgage exposure would equal the funded principal amount (or combined exposures provided there is no intervening lien) plus the exposure amount of any unfunded commitment (that is, the unfunded amount of the maximum contractual amount of any commitment multiplied by the appropriate CCF). The loan amount of a junior-lien residential mortgage exposure would equal the sum of: (i) The funded principal amount of the exposure, (ii) the exposure amount of any undrawn commitment associated with the junior-lien exposure, and (iii) the exposure amount of any senior exposure held by a third party on the date of origination of the junior-lien exposure. Where a senior exposure held by a third party includes an undrawn commitment, such as a HELOC or a negative amortization feature, the loan amount for a junior-lien residential mortgage exposure would include the maximum contractual amount of that commitment multiplied by the appropriate CCF. The denominator of the LTV ratio would be the same under both alternatives. Question 13: The agencies seek comment on the pros and cons associated with the two alternatives for calculating the LTV ratio. While the agencies believe risk weighting one-to-four family residential mortgage exposures based on the LTV ratio appropriately captures a large number of mortgage exposures with differing risk, the agencies have considered basing the risk weight for these exposures on other parameters. Examples include using pricing information that the Home Mortgage Disclosure Act (HMDA) requires many banking organizations to report, or borrower credit scores. Question 14: The agencies seek industry views on any other risk-sensitive methods that could be used to segment residential mortgage exposures by risk level and solicit comment on how such alternatives might be applied. (8) Pre-Sold Construction Loans and Statutory Multifamily Mortgages The general risk-based capital rules assign 50 percent and 100 percent risk weights to certain one-to-four family residential pre-sold construction loans and multifamily residential loans. The agencies adopted these provisions as a result of the Resolution Trust Corporation Refinancing, Restructuring, and Improvement Act of 1991 (RTCRRI Act). The RTCRRI Act mandates that each agency provide in its capital regulations (i) a 50 percent risk weight for certain one-to-four-family residential pre-sold construction loans and multifamily residential loans that meet specific statutory criteria in the RTCRRI Act and any other underwriting criteria imposed by the agencies, and (ii) a 100 percent risk weight for one-to-four-family residential pre-sold construction loans for residences for which the purchase contract is cancelled. Consistent with the RTCRRI Act, a pre-sold construction loan would be subject to a 50 percent risk weight unless the purchase contract is cancelled. The NPR defines a pre-sold construction loan as any one-to-four family residential pre-sold construction loan for a residence meeting the requirements under section 618(a)(1) or (2) of the RTCRRI Act and under 12 CFR part 3, Appendix A, section 3(a)(3)(iv) (for national banks); 12 CFR part 208, Appendix A, section III.C.3. (for state member banks); 12 CFR part 225, Appendix A, section III.C.3. (for bank holding companies); 12 CFR part 325, Appendix A, section II.C. (for state nonmember banks), and that is not 90 days or more past due or on nonaccrual; or 12 CFR 567.1 (definition of “qualifying residential construction loan”) (for savings associations), and that is not on nonaccrual. Also consistent with the RTCRRI Act, under the NPR, a statutory multifamily mortgage would receive a 50 percent risk weight. The NPR defines statutory multifamily mortgage as any multifamily residential mortgage meeting the requirements under section 618(b)(1) of the RTCRRI Act, and under 12 CFR part 3, Appendix A, section 3(a)(3)(v) (for national banks); 12 CFR part 208, Appendix A, section III.C.3. (for state member banks); 12 CFR part 225, Appendix A, section III.C.3. (for bank holding companies); 12 CFR part 325, Appendix A, section II.C.a. (for state nonmember banks); or 12 CFR 567.1 (definition of “qualifying multifamily mortgage loan”) and 12 CFR 567.6(a)(1)(iii) (for savings associations), and that is not on nonaccrual. 29 A multifamily mortgage that does not meet the definition of a statutory mortgage would be treated as a corporate exposure. 29 Under these proposed definitions, a loan that is 90 days or more past due or on nonaccrual would not qualify as a pre-sold construction loan or a statutory multifamily mortgage. These loans would be accorded the treatment described in the next section. (9) Past Due Loans Under the general risk-based capital rules, the risk weight of a loan generally does not change if the loan becomes past due, with the exception of certain residential mortgage loans. The New Accord provides risk weights ranging from 50 to 150 percent for loans that are more than 90 days past due, depending on the amount of specific provisions a banking organization has recorded. Most banking organizations in the United States do not recognize specific provisions. Therefore, the treatment of past due exposures in the New Accord is not applicable for those banking organizations. Accordingly, to reflect impaired credit quality, the agencies propose to risk weight most exposures that are 90 days or more past due or on nonaccrual at 150 percent, except for past due residential mortgage exposures. A banking organization could reduce the risk weight of the exposure to reflect financial collateral or eligible guarantees. Question 15: The agencies seek comment on whether, for those banking organizations that are required to maintain specific provisions, it would be appropriate to follow the New Accord treatment, that is, the risk weight would vary depending on the amount of specific provisions the banking organization has recorded. (10) Other Assets The agencies propose to use the following risk weights, which are generally consistent with the risk weights in the general risk-based capital rules, for other exposures: (i) A banking organization could assign a zero percent risk weight to cash owned and held in all of its offices or in transit; to gold bullion held in its own vaults, or held in another depository institution's vaults on an allocated basis, to the extent gold bullion assets are offset by gold bullion liabilities; and to derivative contracts that are publicly traded on an exchange that requires the daily receipt and payment of cash-variation margin; (ii) a banking organization could assign a 20 percent risk weight to cash items in the process of collection; and (iii) a banking organization would have to apply a 100 percent risk weight to all assets not specifically assigned a different risk weight under this NPR (other than exposures that are deducted from tier 1 or tier 2 capital). I. Off-Balance Sheet Items Under the general risk-based capital rules, a banking organization generally determines the risk-based asset amount for an off-balance sheet exposure using a two-step process. The banking organization applies a CCF to the off-balance sheet amount to obtain an on-balance sheet credit equivalent amount and then applies the appropriate risk weight to that amount. In general, the agencies propose to calculate the exposure amount of an off-balance sheet item by multiplying the off-balance sheet component, which is usually the notional amount, by the applicable CCF. The agencies also propose to retain most of the CCFs in the general risk-based capital rules. 30 Consistent with the New Accord, however, the agencies propose that a banking organization apply a 20 percent CCF to all commitments with an original maturity of one year or less (short-term commitments) that are not unconditionally cancelable rather than the zero percent in the general risk-based capital rules. The agencies believe that a 20 percent CCF for these short-term commitments better reflects the risk of these exposures. 30 The discussion of the risk-based capital treatment for off-balance sheet securitization exposures, including liquidity facilities for asset-backed commercial paper, is presented in Part IV of the proposed rule. Equity commitments are discussed in Part V of the proposed rule. For purposes of this NPR, a commitment means any legally binding arrangement that obligates a banking organization to extend credit or to purchase assets. In this NPR, unconditionally cancelable means, with respect to a commitment, that a banking organization may, at any time, with or without cause, refuse to extend credit under the facility (to the extent permitted under applicable law). In the case of a residential mortgage exposure that is a line of credit, a banking organization is deemed able to unconditionally cancel the commitment if it can, at its option, prohibit additional extensions of credit, reduce the credit line, and terminate the commitment to the full extent permitted by applicable law. Under this NPR, if a banking organization commits to provide a commitment on an off-balance sheet item, that is, a commitment to make a commitment, the agencies propose that a banking organization apply the lower of the two applicable CCFs. If a banking organization provides a commitment that is structured as a syndication, it would only be required to calculate the exposure amount for its pro rata share of the commitment. There is no reference to note issuance facilities (NIFs) and revolving underwriting facilities (RUFs) in the proposed rule as the agencies are not aware that any such transactions exist in the United States. Under the agencies' general risk-based capital rules, capital is required against any on-balance sheet exposures that arise from securities financing transactions (that is, repurchase agreements, reverse repurchase agreements, securities lending transactions, and securities borrowing transactions); for example, capital is required against the cash receivable that a banking organization generates when it borrows a security and posts cash collateral to obtain the security. A banking organization faces counterparty credit risk on securities financing transactions, however, regardless of whether the transaction generates an on-balance sheet exposure. In contrast to the general risk-based capital rules, this NPR requires a banking organization to hold risk-based capital against all securities financing transactions. Similar to other exposures, a banking organization would determine the exposure amount of a securities financing transaction and then risk weight that amount based on the counterparty or, if applicable, collateral or guarantee. In general, a banking organization must apply a 100 percent CCF to the off-balance sheet component of a repurchase agreement or securities lending or borrowing transaction. The off-balance sheet component of a repurchase agreement equals the sum of the current market values of all positions the banking organization has sold subject to repurchase. The off-balance sheet component of a securities lending transaction is the sum of the current market values of all positions the banking organization has lent under the transaction. For securities borrowing transactions, the off-balance sheet component is the sum of the current market values of all non-cash positions the banking organization has posted as collateral under the transaction. In certain circumstances, a banking organization may instead determine the exposure amount of the transaction as described in the collateralized transaction section of this preamble and in section 37 of the proposed rule. J. OTC Derivative Contracts (1) Background Under the general risk-based capital rules for over-the-counter (OTC) derivative contracts, a banking organization must hold risk-based capital for counterparty credit risk. 31 To determine the capital requirement, a banking organization must first compute a credit equivalent amount for a contract and then apply to that amount a risk weight based on the obligor, counterparty, eligible guarantor, or recognized collateral. For an OTC derivative contract that is not subject to a qualifying bilateral netting contract, the credit equivalent amount is the sum of (i) the greater of the current exposure (mark-to-market value) or zero and (ii) an estimate of the potential future credit exposure (PFE). PFE is the notional principal amount of the contract multiplied by a credit conversion factor. 31 OTS rules on the calculation of credit equivalent amounts for derivative contracts differ from the rules of the other agencies. That is, OTS rules address only interest rate and foreign exchange rate contracts and include certain other differences. Accordingly, the description of the current provisions in this preamble primarily reflects the other banking agencies' rules. Under the general risk-based capital rules for OTC derivative contracts subject to a qualifying bilateral netting contract, the credit equivalent amount is calculated by adding the net current exposure of the netting contract and the sum of the estimates of PFE for the individual contracts. The net current exposure is the sum of all positive and negative mark-to-market values of the individual contracts but not less than zero. A banking organization recognizes the effects of the bilateral netting contract on the gross potential future exposure of the contracts by calculating an adjusted add-on amount based on the ratio of net current exposure to gross current exposure, either on a counterparty-by-counterparty basis or on an aggregate basis. (2) Treatment of OTC Derivative Contracts Consistent with the treatment in the New Accord and the general risk-based capital rules, the proposed rule defines an OTC derivative contract as a derivative contract that is not traded on an exchange that requires the daily receipt and payment of cash-variation margin. A derivative contract would be defined as a financial contract whose value is derived from the values of one or more underlying assets, reference rates, or indices of asset values or reference rates. Derivative contracts would include interest rate derivative contracts, exchange rate derivative contracts, equity derivative contracts, commodity derivative contracts, credit derivatives, and any other instrument that poses similar counterparty credit risks. The proposed rule also defines derivative contracts to include unsettled securities, commodities, and foreign exchange trades with a contractual settlement or delivery lag that is longer than the normal settlement period (which the proposed rule defines as the lesser of the market standard for the particular instrument and five business days). This includes, for example, mortgage-backed securities transactions that the GSEs conduct in the To-Be-Announced market. The current exposure method for determining the exposure amount for single OTC derivative contracts contained in the New Accord is similar to the method in the agencies' general risk-based capital rules. The agencies propose to retain this risk-based capital treatment for OTC derivative contracts. Under the agencies' general risk-based capital rules, a banking organization must obtain a written and well-reasoned legal opinion for each of its bilateral qualifying master netting agreements that cover OTC derivative contracts to recognize the netting benefit. In this NPR, the agencies propose that to use netting treatment for multiple OTC derivative contracts, the contracts must be subject to a qualifying master netting agreement. In this NPR, a qualifying master netting agreement means any written, legally enforceable bilateral netting agreement, provided that (i) the agreement creates a single legal obligation for all individual transactions covered by the agreement upon an event of default, including bankruptcy, insolvency or similar proceeding, of the counterparty; (ii) the agreement provides the banking organization the right to accelerate, terminate, and close out on a net basis all transactions under the agreement and to liquidate or set off collateral promptly upon an event of default, including upon an event of bankruptcy, insolvency, or similar proceeding, of the counterparty, provided that, in any such case, any exercise of rights under the agreement will not be stayed or avoided under applicable law in the relevant jurisdictions; (iii) the banking organization has conducted sufficient legal review to conclude with a well-founded basis (and maintain sufficient written documentation of that legal review) that the agreement meets the requirements of part (ii) of this definition and that, in the event of legal challenge (including one resulting from default, bankruptcy, insolvency, or similar proceeding), the relevant court and administrative authorities would find the agreement to be legal, valid, binding, and enforceable under the law of the relevant jurisdictions; (iv) the banking organization establishes and maintains procedures to monitor possible changes in relevant law and to ensure that the agreement continues to satisfy the requirements of the definition of a qualifying master netting agreement; and (v) the agreement does not contain a walkaway clause. In some cases, the legal review requirement could be met by reasoned reliance on a commissioned legal opinion or an in-house counsel analysis. In other cases, for example, those involving certain new derivative transactions or derivative counterparties in atypical jurisdictions, the banking organization would need to obtain an explicit, written legal opinion from external or internal legal counsel addressing the particular situation. If an OTC derivative contract is collateralized by financial collateral, a banking organization would first determine the exposure amount of the OTC derivative contract as described above and in section 35 of this proposed rule. To take into account the risk-reducing effects of the financial collateral, a banking organization could recognize the credit risk mitigation benefits of the financial collateral using the simple approach for collateralized transactions provided in section 37(b) of this proposed rule. Alternatively, a banking organization could, if the financial collateral is marke [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3AE8-16262. Public record. Not legal advice.